Unassociated Document
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.  20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For The Quarterly Period Ended September 30, 2012
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For The Transition Period from ____ to ____

Commission
 
Registrants; States of Incorporation;
 
I.R.S. Employer
File Number
 
Address and Telephone Number
 
Identification Nos.
         
1-3525
 
AMERICAN ELECTRIC POWER COMPANY, INC. (A New York Corporation)
 
13-4922640
1-3457
 
APPALACHIAN POWER COMPANY (A Virginia Corporation)
 
54-0124790
1-3570
 
INDIANA MICHIGAN POWER COMPANY (An Indiana Corporation)
 
35-0410455
1-6543
 
OHIO POWER COMPANY (An Ohio Corporation)
 
31-4271000
0-343
 
PUBLIC SERVICE COMPANY OF OKLAHOMA (An Oklahoma Corporation)
 
73-0410895
1-3146
 
SOUTHWESTERN ELECTRIC POWER COMPANY (A Delaware Corporation)
 
72-0323455
   
1 Riverside Plaza, Columbus, Ohio 43215-2373
   
   
Telephone (614) 716-1000
   

Indicate by check mark whether the registrants (1) have filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrants were required to file such reports), and (2) have been subject to such filing requirements for the past 90 days.
           
Yes
X
 
No
   

Indicate by check mark whether the registrants have submitted electronically and posted on their corporate websites, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrants were required to submit and post such files).
           
Yes
X
 
No
   

Indicate by check mark whether American Electric Power Company, Inc. is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer
X
 
Accelerated filer
   
           
Non-accelerated filer
   
Smaller reporting company
   

Indicate by check mark whether Appalachian Power Company, Indiana Michigan Power Company, Ohio Power Company, Public Service Company of Oklahoma and Southwestern Electric Power Company are large accelerated filers, accelerated filers, non-accelerated filers or smaller reporting companies.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer
   
Accelerated filer
   
           
Non-accelerated filer
X
 
Smaller reporting company
   

Indicate by check mark whether the registrants are shell companies (as defined in Rule 12b-2 of the Exchange Act).
Yes
   
No
X
 

Appalachian Power Company, Indiana Michigan Power Company, Ohio Power Company, Public Service Company of Oklahoma and Southwestern Electric Power Company meet the conditions set forth in General Instruction H(1)(a) and (b) of Form 10-Q and are therefore filing this Form 10-Q with the reduced disclosure format specified in General Instruction H(2) to Form 10-Q.

 
 

 

     
Number of shares of common stock outstanding of the registrants at
October 25, 2012
       
American Electric Power Company, Inc.
   
485,249,096
     
($6.50 par value)
Appalachian Power Company
   
13,499,500
     
(no par value)
Indiana Michigan Power Company
   
1,400,000
     
(no par value)
Ohio Power Company
   
27,952,473
     
(no par value)
Public Service Company of Oklahoma
   
9,013,000
     
($15 par value)
Southwestern Electric Power Company
   
7,536,640
     
($18 par value)

 
 

 

AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES
INDEX OF QUARTERLY REPORTS ON FORM 10-Q
September 30, 2012

   
Page
Number
Glossary of Terms
 
i
     
Forward-Looking Information
 
iv
     
Part I. FINANCIAL INFORMATION
   
       
 
Items 1, 2 and 3 - Financial Statements, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and Quantitative and Qualitative Disclosures About Market Risk:
 
   
American Electric Power Company, Inc. and Subsidiary Companies:
   
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
1
 
Condensed Consolidated Financial Statements
 
30
 
Index of Condensed Notes to Condensed Consolidated Financial Statements
 
36
       
Appalachian Power Company and Subsidiaries:
   
 
Management’s Narrative Discussion and Analysis of Results of Operations
 
82
 
Condensed Consolidated Financial Statements
 
88
 
Index of Condensed Notes to Condensed Financial Statements of Registrant Subsidiaries
 
94
       
Indiana Michigan Power Company and Subsidiaries:
   
 
Management’s Narrative Discussion and Analysis of Results of Operations
 
96
 
Condensed Consolidated Financial Statements
 
103
 
Index of Condensed Notes to Condensed Financial Statements of Registrant Subsidiaries
 
109
       
Ohio Power Company Consolidated:
   
 
Management’s Narrative Discussion and Analysis of Results of Operations
 
111
 
Condensed Consolidated Financial Statements
 
119
 
Index of Condensed Notes to Condensed Financial Statements of Registrant Subsidiaries
 
125
       
Public Service Company of Oklahoma:
   
 
Management’s Narrative Discussion and Analysis of Results of Operations
 
127
 
Condensed Financial Statements
 
130
 
Index of Condensed Notes to Condensed Financial Statements of Registrant Subsidiaries
 
136
       
Southwestern Electric Power Company Consolidated:
   
 
Management’s Narrative Discussion and Analysis of Results of Operations
 
138
 
Condensed Consolidated Financial Statements
 
143
 
Index of Condensed Notes to Condensed Financial Statements of Registrant Subsidiaries
 
149
       
Index of Condensed Notes to Condensed Financial Statements of Registrant Subsidiaries
 
150
       
Combined Management’s Narrative Discussion and Analysis of Registrant Subsidiaries
 
207
       
Controls and Procedures
 
214
 
 
 

 
         
Part II.  OTHER INFORMATION
   
     
 
Item 1.
Legal Proceedings
 
215
 
Item 1A.
Risk Factors
 
215
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
 
217
 
Item 4.
Mine Safety Disclosures
 
217
 
Item 5.
Other Information
 
218
 
Item 6.
Exhibits:
 
218
         
Exhibit 10
   
         
Exhibit 12
   
         
Exhibit 31(a)
   
         
Exhibit 31(b)
   
         
Exhibit 32(a)
   
         
Exhibit 32(b)
Exhibit 95
   
         
Exhibit 101.INS
   
         
Exhibit 101.SCH
   
         
Exhibit 101.CAL
   
         
Exhibit 101.DEF
   
         
Exhibit 101.LAB
   
         
Exhibit 101.PRE
   
               
SIGNATURE
   
219

This combined Form 10-Q is separately filed by American Electric Power Company, Inc., Appalachian Power Company, Indiana Michigan Power Company, Ohio Power Company, Public Service Company of Oklahoma and Southwestern Electric Power Company.  Information contained herein relating to any individual registrant is filed by such registrant on its own behalf. Each registrant makes no representation as to information relating to the other registrants.

 
 

 

GLOSSARY OF TERMS

When the following terms and abbreviations appear in the text of this report, they have the meanings indicated below.

Term
 
Meaning
     
AEGCo
 
AEP Generating Company, an AEP electric utility subsidiary.
AEP or Parent
 
American Electric Power Company, Inc., a utility holding company.
AEP Consolidated
 
AEP and its majority owned consolidated subsidiaries and consolidated affiliates.
AEP Credit
 
AEP Credit, Inc., a consolidated variable interest entity of AEP which securitizes accounts receivable and accrued utility revenues for affiliated electric utility companies.
AEP East companies
 
APCo, I&M, KPCo and OPCo.
AEP Energy
 
AEP Energy, Inc., a wholly-owned retail electric supplier for customers in Ohio, Illinois and other deregulated electricity markets throughout the United States.  BlueStar began doing business as AEP Energy, Inc. in June 2012.
AEP System
 
American Electric Power System, an integrated electric utility system, owned and operated by AEP’s electric utility subsidiaries.
AEPSC
 
American Electric Power Service Corporation, an AEP service subsidiary providing management and professional services to AEP and its subsidiaries.
AFUDC
 
Allowance for Funds Used During Construction.
AOCI
 
Accumulated Other Comprehensive Income.
APCo
 
Appalachian Power Company, an AEP electric utility subsidiary.
APSC
 
Arkansas Public Service Commission.
BlueStar
 
BlueStar Energy Holdings, Inc., a wholly-owned retail electric supplier for customers in Ohio, Illinois and other deregulated electricity markets throughout the United States.  BlueStar began doing business as AEP Energy, Inc. in June 2012.
BOA
 
Bank of America Corporation.
CAA
 
Clean Air Act.
CLECO
 
Central Louisiana Electric Company, a nonaffiliated utility company.
CO2
 
Carbon dioxide and other greenhouse gases.
Cook Plant
 
Donald C. Cook Nuclear Plant, a two-unit, 2,191 MW nuclear plant owned by I&M.
CRES
 
Competitive Retail Electric Service.
CSPCo
 
Columbus Southern Power Company, a former AEP electric utility subsidiary that was merged into OPCo effective December 31, 2011.
DCC Fuel
 
DCC Fuel LLC, DCC Fuel II LLC, DCC Fuel III LLC, DCC Fuel IV LLC and DCC Fuel V LLC, consolidated variable interest entities formed for the purpose of acquiring, owning and leasing nuclear fuel to I&M.
DHLC
 
Dolet Hills Lignite Company, LLC, a wholly-owned lignite mining subsidiary of SWEPCo.
E&R
 
Environmental compliance and transmission and distribution system reliability.
EIS
 
Energy Insurance Services, Inc., a nonaffiliated captive insurance company and consolidated variable interest entity of AEP.
ERCOT
 
Electric Reliability Council of Texas regional transmission organization.
ESP
 
Electric Security Plans, filed with the PUCO, pursuant to the Ohio Amendments.
ETT
 
Electric Transmission Texas, LLC, an equity interest joint venture between AEP and MidAmerican Energy Holdings Company Texas Transco, LLC formed to own and operate electric transmission facilities in ERCOT.
FAC
 
Fuel Adjustment Clause.
FASB
 
Financial Accounting Standards Board.
Federal EPA
 
United States Environmental Protection Agency.
FERC
 
Federal Energy Regulatory Commission.
FGD
 
Flue Gas Desulfurization or scrubbers.
 
 
i

 
FTR
 
Financial Transmission Right, a financial instrument that entitles the holder to receive compensation for certain congestion-related transmission charges that arise when the power grid is congested resulting in differences in locational prices.
GAAP
 
Accounting Principles Generally Accepted in the United States of America.
I&M
 
Indiana Michigan Power Company, an AEP electric utility subsidiary.
IGCC
 
Integrated Gasification Combined Cycle, technology that turns coal into a cleaner-burning gas.
Interconnection Agreement
 
An agreement by and among APCo, I&M, KPCo and OPCo, defining the sharing of costs and benefits associated with their respective generating plants.
IRS
 
Internal Revenue Service.
IURC
 
Indiana Utility Regulatory Commission.
KPCo
 
Kentucky Power Company, an AEP electric utility subsidiary.
KPSC
 
Kentucky Public Service Commission.
KWh
 
Kilowatthour.
LPSC
 
Louisiana Public Service Commission.
MISO
 
Midwest Independent Transmission System Operator.
MMBtu
 
Million British Thermal Units.
MPSC
 
Michigan Public Service Commission.
MTM
 
Mark-to-Market.
MW
 
Megawatt.
MWh
 
Megawatthour.
NEIL
 
Nuclear Electric Insurance Limited insures domestic and international nuclear utilities for the costs associated with interruptions, damages, decontaminations and related nuclear risks.
NOx
 
Nitrogen oxide.
Nonutility Money Pool
 
Centralized funding mechanism AEP uses to meet the short-term cash requirements of certain nonutility subsidiaries.
OCC
 
Corporation Commission of the State of Oklahoma.
OPCo
 
Ohio Power Company, an AEP electric utility subsidiary.
OPEB
 
Other Postretirement Benefit Plans.
OTC
 
Over the counter.
PJM
 
Pennsylvania – New Jersey – Maryland regional transmission organization.
PM
 
Particulate Matter.
POLR
 
Provider of Last Resort revenues.
PSO
 
Public Service Company of Oklahoma, an AEP electric utility subsidiary.
PUCO
 
Public Utilities Commission of Ohio.
PUCT
 
Public Utility Commission of Texas.
Registrant Subsidiaries
 
AEP subsidiaries which are SEC registrants; APCo, I&M, OPCo, PSO and SWEPCo.
Risk Management Contracts
 
Trading and nontrading derivatives, including those derivatives designated as cash flow and fair value hedges.
Rockport Plant
 
A generating plant, consisting of two 1,300 MW coal-fired generating units near Rockport, Indiana, owned by AEGCo and I&M.
RTO
 
Regional Transmission Organization, responsible for moving electricity over large interstate areas.
Sabine
 
Sabine Mining Company, a lignite mining company that is a consolidated variable interest entity for AEP and SWEPCo.
SEC
 
U.S. Securities and Exchange Commission.
SEET
 
Significantly Excessive Earnings Test.
 
 
ii

 
SIA
 
System Integration Agreement, effective June 15, 2000, provides contractual basis for coordinated planning, operation and maintenance of the power supply sources of the combined AEP.
SNF
 
Spent Nuclear Fuel.
SO2
 
Sulfur dioxide.
SPP
 
Southwest Power Pool regional transmission organization.
Stall Unit
 
J. Lamar Stall Unit at Arsenal Hill Plant, a 543 MW natural gas unit owned by SWEPCo.
SWEPCo
 
Southwestern Electric Power Company, an AEP electric utility subsidiary.
TCC
 
AEP Texas Central Company, an AEP electric utility subsidiary.
TNC
 
AEP Texas North Company, an AEP electric utility subsidiary.
Transition Funding
 
AEP Texas Central Transition Funding I LLC, AEP Texas Central Transition Funding II LLC and AEP Texas Central Transition Funding III LLC, wholly-owned subsidiaries of TCC and consolidated variable interest entities formed for the purpose of issuing and servicing securitization bonds related to Texas restructuring law.
Turk Plant
 
John W. Turk, Jr. Plant, a 600 MW coal-fired plant under construction in Arkansas that is 73% owned by SWEPCo.
Utility Money Pool
 
Centralized funding mechanism AEP uses to meet the short-term cash requirements of certain utility subsidiaries.
VIE
 
Variable Interest Entity.
Virginia SCC
 
Virginia State Corporation Commission.
WPCo
 
Wheeling Power Company, an AEP electric utility subsidiary.
WVPSC
 
Public Service Commission of West Virginia.
     
     

 
iii

 

FORWARD-LOOKING INFORMATION

This report made by AEP and its Registrant Subsidiaries contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934.  Many forward-looking statements appear in “Item 7 – Management’s Financial Discussion and Analysis” of the 2011 Annual Report, but there are others throughout this document which may be identified by words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “will,” “should,” “could,” “would,” “project,” “continue” and similar expressions, and include statements reflecting future results or guidance and statements of outlook.  These matters are subject to risks and uncertainties that could cause actual results to differ materially from those projected.  Forward-looking statements in this document are presented as of the date of this document.  Except to the extent required by applicable law, we undertake no obligation to update or revise any forward-looking statement.  Among the factors that could cause actual results to differ materially from those in the forward-looking statements are:

·
The economic climate and growth in, or contraction within, our service territory and changes in market demand and demographic patterns.
·
Inflationary or deflationary interest rate trends.
·
Volatility in the financial markets, particularly developments affecting the availability of capital on reasonable terms and developments impairing our ability to finance new capital projects and refinance existing debt at attractive rates.
·
The availability and cost of funds to finance working capital and capital needs, particularly during periods when the time lag between incurring costs and recovery is long and the costs are material.
·
Electric load, customer growth and the impact of retail competition, particularly in Ohio.
·
Weather conditions, including storms, and our ability to recover significant storm restoration costs through applicable rate mechanisms.
·
Available sources and costs of, and transportation for, fuels and the creditworthiness and performance of fuel suppliers and transporters.
·
Availability of necessary generating capacity and the performance of our generating plants.
·
Our ability to resolve cost-related issues regarding I&M’s Donald C. Cook Nuclear Plant Unit 1 restoration and outage through warranty, insurance and the regulatory process.
·
Our ability to recover increases in fuel and other energy costs through regulated or competitive electric rates.
·
Our ability to build or acquire generating capacity and transmission lines and facilities (including our ability to obtain any necessary regulatory approvals and permits) when needed at acceptable prices and terms and to recover those costs (including the costs of projects that are cancelled) through applicable rate cases or competitive rates.
·
New legislation, litigation and government regulation, including oversight of nuclear generation, energy commodity trading and new or heightened requirements for reduced emissions of sulfur, nitrogen, mercury, carbon, soot or particulate matter and other substances or additional regulation of fly ash and similar combustion products that could impact the continued operation and cost recovery of our plants and related assets.
·
Evolving public perception of the risks associated with fuels used before, during and after the generation of electricity, including nuclear fuel.
·
A reduction in the federal statutory tax rate could result in an accelerated return of deferred federal income taxes to customers.
·
Timing and resolution of pending and future rate cases, negotiations and other regulatory decisions, including rate or other recovery of new investments in generation, distribution and transmission service and environmental compliance.
·
Resolution of litigation.
·
Our ability to constrain operation and maintenance costs.
·
Our ability to develop and execute a strategy based on a view regarding prices of electricity, coal, natural gas and other energy-related commodities.
·
Prices and demand for power that we generate and sell at wholesale.
·
Changes in technology, particularly with respect to new, developing or alternative sources of generation.
·
Our ability to recover through rates or market prices any remaining unrecovered investment in generating units that may be retired before the end of their previously projected useful lives.
·
Volatility and changes in markets for electricity, coal, natural gas and other energy-related commodities.
 
 
iv

 
·
Changes in utility regulation, including the implementation of ESPs and the transition to market and expected legal separation for generation in Ohio and the allocation of costs within regional transmission organizations, including PJM and SPP.
·
Our ability to successfully manage negotiations with stakeholders and obtain regulatory approval to terminate or amend the Interconnection Agreement.
·
Changes in the creditworthiness of the counterparties with whom we have contractual arrangements, including participants in the energy trading market.
·
Actions of rating agencies, including changes in the ratings of our debt.
·
The impact of volatility in the capital markets on the value of the investments held by our pension, other postretirement benefit plans, captive insurance entity and nuclear decommissioning trust and the impact on future funding requirements.
·
Accounting pronouncements periodically issued by accounting standard-setting bodies.
·
Other risks and unforeseen events, including wars, the effects of terrorism (including increased security costs), embargoes, cyber security threats and other catastrophic events.

The forward looking statements of AEP and its Registrant Subsidiaries speak only as of the date of this report or as of the date they are made.  AEP and its Registrant Subsidiaries expressly disclaim any obligation to update any forward-looking information.  For a more detailed discussion of these factors, see “Risk Factors” in the 2011 Annual Report and in Part II of this report.
 

 
 
v

 
AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

EXECUTIVE OVERVIEW

June 2012 – May 2015 Ohio ESP Including Capacity Charge

In August 2012, the PUCO issued an order which adopted and modified a new ESP through May 2015.  The ESP allowed the continuation of the fuel adjustment clause and established a non-bypassable Distribution Investment Rider (DIR) effective September 2012 through May 2015 to recover, with certain caps, post-August 2010 distribution investment.  The DIR is capped at $86 million in 2012, $104 million in 2013, $124 million in 2014 and $52 million for the period January through May 2015, for a total of $366 million.  The ESP also maintained recovery of several previous ESP riders and required OPCo to contribute $2 million per year during the ESP to the Ohio Growth Fund.  In addition, the ESP approved a storm damage recovery mechanism which allowed OPCo to defer the majority of the incremental distribution operation and maintenance costs from 2012 storms.

Finally, the PUCO ordered OPCo to conduct an energy-only auction for 10% of the standard service offer (SSO) load with delivery beginning six months after the receipt of ESP and corporate separation orders and extending through December 2014.  The PUCO also ordered OPCo to conduct an energy-only auction for a total of 60% of the SSO load with delivery beginning June 2014 through May 2015.  In addition, the PUCO ordered OPCo to conduct an energy-only auction for the remaining 40% of the SSO load for delivery from January 2015 through May 2015.  Starting in June 2015, OPCo will conduct energy and capacity auctions for its entire SSO load.  In September 2012, OPCo and intervenors filed applications with the PUCO for rehearing.  Rehearing of this order is pending at the PUCO.

In July 2012, the PUCO issued an order in a separate capacity proceeding which stated that OPCo must charge CRES providers the Reliability Pricing Model (RPM) price and authorized OPCo to defer a portion of its incurred capacity costs not recovered from CRES providers to the extent that the total incurred capacity costs do not exceed $188.88/MW day.  The RPM price is approximately $20/MW day through May 2013.  Several parties, including OPCo, requested rehearing of the July 2012 PUCO order, which was upheld by the PUCO in October 2012.  In the August 2012 PUCO order which adopted and modified the new ESP, the PUCO established a non-bypassable Retail Stability Rider (RSR), effective September 2012.  The RSR is intended to provide $508 million over the ESP period and will be collected from customers at $3.50/MWh through May 2014 and $4.00/MWh for the period June 2014 through May 2015, with $1.00/MWh applied to the deferred capacity costs.  In August 2012, the Industrial Energy Users-Ohio (IEU) filed a claim before the Supreme Court of Ohio stating, among other things, that OPCo’s collection of its capacity costs is illegal.  OPCo and the PUCO filed motions to dismiss IEU’s claim.  If OPCo is ultimately not permitted to fully collect its deferred capacity costs and ESP rates, including the RSR, it would reduce future net income and cash flows and impact financial condition.  See “Ohio Electric Security Plan Filing” section of Note 2.

Ohio Customer Choice

In our Ohio service territory, various CRES providers are targeting retail customers by offering alternative generation service.  As a result, in comparison to the third quarter of 2011 and the first nine months of 2011, we lost approximately $67 million and $165 million, respectively, of gross margin.  This reduction in gross margin is partially offset by (a) collection of capacity revenues from CRES providers, (b) off-system sales, (c) deferral of unrecovered capacity costs, (d) Retail Stability Rider collections from Ohio retail distribution customers and (e) revenues from AEP Energy, our CRES provider and member of our Generation and Marketing segment.  As of September 30, 2012, based upon an average annual load, approximately 42% of our Ohio load had switched to CRES providers and approximately 6% of our Ohio load had formally initiated the switching process to a CRES provider for a total of 48%.  To enhance our competitive position in Ohio, AEP Energy targets retail customers, both within and outside of our retail service territory.

 
1

 
Proposed Corporate Separation and Termination of the Interconnection Agreement

In March 2012, OPCo filed an application with the PUCO for approval of the corporate separation of its generation assets including the transfer of generation assets to a nonregulated AEP subsidiary at net book value.  In October 2012, the PUCO issued an order which approved the transfer of OPCo’s generation assets at net book value to AEP Generation Resources, Inc. (AEPGenCo), a nonregulated affiliate in the Generation and Marketing segment.  AEPGenCo will also assume the associated generation liabilities.  Management intends to file an application with the FERC in the fourth quarter of 2012 related to corporate separation.  Our results of operations related to generation in Ohio will be largely determined by our ability to sell power and capacity at a profit at rates determined by the prevailing market.  If we are unable to sell power and capacity at a profit, it could reduce future net income and cash flows and impact financial condition.

In December 2010, each of the members of the Interconnection Agreement gave notice to AEPSC and each other of its decision to terminate the Interconnection Agreement effective as of December 31, 2013 or such other date as ordered by the FERC.  Management intends to file an application with the FERC in the fourth quarter of 2012 to terminate the Interconnection Agreement.  It is unknown whether the Interconnection Agreement will be replaced by a new agreement among some or all of the members, whether individual companies will enter into bilateral or multi-party contracts with each other for power sales and purchases or asset transfers, or if each company will choose to operate independently.  If any of the members of the Interconnection Agreement experience decreases in revenues or increases in costs as a result of the termination of the Interconnection Agreement and are unable to recover the change in revenues and costs through rates, prices or additional sales, it could reduce future net income and cash flows.

Based on the interdependent nature of generation activities subject to the Interconnection Agreement, the AEP East companies’ generation assets are evaluated for their accounting recoverability collectively as an asset group.  We are monitoring the potential impact that the proposed corporate separation of OPCo’s generation assets and the proposed termination of the Interconnection Agreement could have on the accounting evaluation of the recoverability of the net book values of OPCo’s generation assets.  The net book value of the OPCo units that we plan to retire included in the table below in the “Environmental Controls Impact on the Generating Fleet” section and our share of W. C. Beckjord Generating Station was $284 million as of September 30, 2012.  These generating assets are being depreciated through May 2015.

Significantly Excessive Earnings Test

In January 2011, the PUCO issued an order on the 2009 SEET filing, which resulted in a write-off in 2010 and a subsequent refund to customers during 2011.  In May 2011, the Industrial Energy Users-Ohio and the Ohio Energy Group filed appeals with the Supreme Court of Ohio challenging the PUCO’s SEET decision.  In July 2011, OPCo filed its 2010 SEET filing with the PUCO based upon the approach in the PUCO’s 2009 order.  Subsequent testimony and legal briefs from intervenors recommended refunds of a portion of 2010 earnings.  OPCo is required to file its 2011 SEET filing with the PUCO in 2012 on a separate CSPCo and OPCo company basis.  The PUCO approved OPCo’s request to file the 2011 SEET one month after the PUCO issues an order on the 2010 SEET.  Management does not currently believe that there were significantly excessive earnings in 2011 for either CSPCo or OPCo.  See “Ohio Electric Security Plan Filing” section of Note 2.

Indiana Base Rate Case

In September 2011, I&M filed a request with the IURC for a net annual increase in Indiana base rates of $149 million based upon a return on common equity of 11.15%.  The $149 million net annual increase reflects an increase in base rates of $178 million offset by proposed corresponding reductions of $13 million to the off-system sales sharing rider, $9 million to the PJM cost rider and $7 million to the clean coal technology rider rates.  The request included an increase in depreciation rates that would result in an increase of approximately $25 million in annual depreciation expense.  Included in the depreciation rates increase was a decrease in the average remaining life of Tanners Creek Plant to account for the change in the retirement date of Tanners Creek Plant, Units 1-3 from 2020 to 2014.  In May 2012, I&M filed rebuttal testimony which changed the retirement date for Tanners Creek Plant, Units 1-3 to 2015.

 
2

 
In May 2012, the Indiana Office of Utility Consumer Counselor filed testimony that recommended an increase in base rates of $28 million, excluding reductions to certain riders, based upon a return on common equity of 9.2%.  I&M filed rebuttal testimony in May 2012 which supported an increase of $170 million in base rates, excluding reductions to certain riders.  Final hearings were held in June 2012.  A decision from the IURC is expected in the fourth quarter of 2012.  See “2011 Indiana Base Rate Case” section of Note 2.

Turk Plant

SWEPCo is currently constructing the Turk Plant, a new base load 600 MW pulverized coal ultra-supercritical generating unit in Arkansas, which is scheduled to be in service in the fourth quarter of 2012.  SWEPCo owns 73% (440 MW) of the Turk Plant and will operate the completed facility.  See “Turk Plant” section of Note 2.

Texas Base Rate Case

In July 2012, SWEPCo filed a request with the PUCT to increase annual base rates by $83 million based upon an 11.25% return on common equity to be effective January 2013.  The requested base rate increase included a return on and of the Texas jurisdictional share of the Turk Plant generation investment as of December 2011, total Turk Plant related estimated transmission investment costs and associated operations and maintenance costs.  In September 2012, an Administrative Law Judge issued an order that granted the establishment of SWEPCo’s existing rates as temporary rates beginning in late January 2013, subject to true-up to the final PUCT-approved rates.  A decision from the PUCT is expected in the second quarter of 2013.  See “2012 Texas Base Rate Case” section of Note 2.

Special Rate Mechanism for Ormet

In October 2012, the PUCO issued an order approving a delayed payment plan for Ormet of its October and November 2012 power billings in equal monthly installment payments over the period January 2014 to May 2015 without interest.  In the event Ormet, a large industrial customer in Ohio, does not pay the deferred billings, the PUCO permitted OPCo to recover the unpaid balance up to $20 million in future rates.  To the extent unpaid deferred billings exceed $20 million, it will reduce future net income and cash flows.

Cook Plant

Unit 1 Fire and Shutdown

In September 2008, I&M shut down Cook Plant Unit 1 (Unit 1) due to turbine vibrations, caused by blade failure, which resulted in a fire on the electric generator.  Repair of the property damage and replacement of the turbine rotors and other equipment cost approximately $400 million.  Management believes that I&M should recover a significant portion of repair and replacement costs through the turbine vendor’s warranty, insurance and the regulatory process.  If the ultimate costs of the incident are not covered by warranty, insurance or through the related regulatory process or if any future regulatory proceedings are adverse, it would reduce future net income and cash flows and impact financial condition.  See “Cook Plant Unit 1 Fire and Shutdown” section of Note 3.

Nuclear Regulatory Commission

As a result of the nuclear plant situation in Japan following a March 2011 earthquake, the Nuclear Regulatory Commission (NRC) initiated a review of safety procedures and requirements for nuclear generating facilities.  As a result, the NRC issued orders and guidance that increase procedures and testing requirements, require physical modifications to the plant and will increase future operating costs at the Cook Plant.  We anticipate that future cumulative compliance costs will range from $40 million to $50 million.  Approximately half of this estimate is expected to be capital.  The remainder will be operating expenses that generally is expected to be incurred over the plant’s life.

 
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The NRC is also looking into the fuel used at eleven reactors, including the units at the Cook Plant.  Their concern relates to fuel temperatures if abnormal conditions are experienced.  We continue to monitor this issue and respond to the NRC’s inquiry, as necessary. In addition to the review by the NRC, Congress could consider legislation increasing oversight of nuclear generating facilities.  We are unable to predict the impact of potential future regulation of nuclear facilities.

Cook Plant Life Cycle Management Project

In April and May 2012, I&M filed a petition with the IURC and the MPSC, respectively, for approval of the Cook Plant Life Cycle Management Project (LCM Project), which consists of a group of capital projects for Cook Plant Units 1 and 2.  The estimated cost of the LCM Project is $1.2 billion to be incurred through 2018, excluding AFUDC.  In Indiana, I&M requested recovery of certain project costs, including interest, through a rider effective January 2013.  A hearing at the IURC is scheduled for January 2013.  In Michigan, I&M requested that the MPSC approve a Certificate of Need and authorize I&M to defer, on an interim basis, incremental depreciation and related property tax costs, including interest, along with study, analysis and development costs until the applicable LCM costs are included in I&M’s base rates.  As of September 30, 2012, I&M has incurred $109 million related to the LCM Project, including AFUDC.  Several intervenors filed testimony with various recommendations.  If I&M is not ultimately permitted to recover its incurred costs, it would reduce future net income and cash flows.  See “Cook Plant Life Cycle Management Project” section of Note 2.

LITIGATION

In the ordinary course of business, we are involved in employment, commercial, environmental and regulatory litigation.  Since it is difficult to predict the outcome of these proceedings, we cannot predict the eventual resolution, timing or amount of any loss, fine or penalty.  We assess the probability of loss for each contingency and accrue a liability for cases that have a probable likelihood of loss if the loss can be estimated.  For details on our regulatory proceedings and pending litigation see Note 3 – Rate Matters, Note 5 – Commitments, Guarantees and Contingencies and the “Litigation” section of “Management’s Financial Discussion and Analysis” in the 2011 Annual Report.  Additionally, see Note 2 – Rate Matters and Note 3 – Commitments, Guarantees and Contingencies included herein.  Adverse results in these proceedings have the potential to reduce future net income and cash flows and impact financial condition.

ENVIRONMENTAL ISSUES

We are implementing a substantial capital investment program and incurring additional operational costs to comply with new environmental control requirements.  We will need to make additional investments and operational changes in response to existing and anticipated requirements such as CAA requirements to reduce emissions of SO2, NOx, PM and hazardous air pollutants from fossil fuel-fired power plants, new proposals governing the beneficial use and disposal of coal combustion products and proposed clean water rules.
 
We are engaged in litigation about environmental issues, have been notified of potential responsibility for the clean-up of contaminated sites and incur costs for disposal of SNF and future decommissioning of our nuclear units.  We are also engaged in the development of possible future requirements including the items discussed below and reductions of CO2 emissions to address concerns about global climate change.  We, along with various industry groups, affected states and other parties have challenged some of the Federal EPA requirements in court.  The U.S. House of Representatives passed legislation called the Transparency in Regulatory Analysis of Impacts on the Nation (the TRAIN Act) that would delay implementation of certain Federal EPA rules and facilitate a comprehensive analysis of their impacts.  The Senate is considering similar legislation.  We believe that further analysis and better coordination of these environmental requirements would facilitate planning and lower overall compliance costs while achieving the same environmental goals.

See a complete discussion of these matters in the “Environmental Issues” section of “Management’s Financial Discussion and Analysis” in the 2011 Annual Report.  We will seek recovery of expenditures for pollution control technologies and associated costs from customers through rates in regulated jurisdictions.  We should be able to recover certain of these expenditures through market prices in deregulated jurisdictions.  If not, the costs of environmental compliance could reduce future net income and cash flows and impact financial condition.

 
4

 
Environmental Controls Impact on the Generating Fleet

The rules and proposed environmental controls discussed in the next several sections will have a material impact on the generating units in the AEP System.  We continue to evaluate the impact of these rules, project scope and technology available to achieve compliance.  As of September 30, 2012, the AEP System had a total generating capacity of 37,035 MWs, of which 23,900 MWs are coal-fired.  We continue to refine the cost estimates of complying with these rules and other impacts of the environmental proposals on our coal-fired generating facilities.  Based upon our estimates, investment to meet these proposed requirements ranges from approximately $6 billion to $7 billion between 2012 and 2020.  These amounts include investments to convert 1,055 MWs of coal generation to natural gas capacity.  If natural gas conversion is not completed, the units could be closed sooner than planned.

The cost estimates will change depending on the timing of implementation and whether the Federal EPA provides flexibility in the final rules.  The cost estimates will also change based on: (a) the states’ implementation of these regulatory programs, including the potential for state implementation plans or federal implementation plans that impose more stringent standards, (b) additional rulemaking activities in response to court decisions, (c) the actual performance of the pollution control technologies installed on our units, (d) changes in costs for new pollution controls, (e) new generating technology developments, (f) total MWs of capacity retired and replaced, including the type and amount of such replacement capacity and (g) other factors.

Subject to the factors listed above and based upon our continuing evaluation, we have given notice to the applicable RTOs of our intent to retire the following plants or units of plants before or during 2016:

       
Generating
Company
 
Plant Name and Unit
 
Capacity
       
(in MWs)
APCo
 
Clinch River Plant, Unit 3
    235
APCo
 
Glen Lyn Plant
    335
APCo
 
Kanawha River Plant
    400
APCo/OPCo
 
Philip Sporn Plant, Units 1-4
    600
I&M
 
Tanners Creek Plant, Units 1-3
    495
KPCo
 
Big Sandy Plant, Unit 1
    278
OPCo
 
Conesville Plant, Unit 3
    165
OPCo
 
Kammer Plant
    630
OPCo
 
Muskingum River Plant, Units 1-4
    840
OPCo
 
Picway Plant
    100
SWEPCo
 
Welsh Plant, Unit 2
    528
Total
        4,606

Duke Energy Corporation, the operator of W. C. Beckjord Generating Station, has announced its intent to close the facility in 2015.  OPCo owns 12.5% (54 MWs) of one unit at that station.

In September 2012, based upon an agreement in principle with the Federal EPA, the State of Oklahoma and other parties, PSO filed an environmental compliance plan with the OCC to retire Units 3 and 4 of the Northeastern Station, a total of 930 MWs, in 2026 and 2016, respectively.  See “Oklahoma Environmental Compliance Plan” and “Regional Haze” sections below.

Natural gas prices and pending environmental rules could also have an adverse impact on the accounting evaluation of the recoverability of the net book values of certain coal-fired units.  We are still evaluating our plans for and the timing of conversion of some of our coal units to natural gas, installing emission control equipment on other units and closure of existing units based on changes in emission requirements and demand for power.  To the extent existing generation assets and the cost of new equipment and converted facilities are not recoverable under our accounting evaluations, it could materially reduce future net income and cash flows.

 
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Environmental Compliance Applications

Rockport Plant Environmental Controls

I&M filed an application with the IURC seeking approval of a Certificate of Public Convenience and Necessity (CPCN) to retrofit one unit at its Rockport Plant with environmental controls estimated to cost $1.4 billion to comply with new requirements.  AEGCo and I&M jointly own Unit 1 and jointly lease Unit 2 of the Rockport Plant.  I&M is also evaluating options related to the maturity of the lease for Rockport Plant Unit 2 in 2022 and continues to investigate alternative compliance technologies for these units as part of its overall compliance strategy.  As of September 30, 2012, we have incurred $48 million, including AFUDC.  If we are not ultimately permitted to recover our incurred costs, it would reduce future net income and cash flows.

In July 2012, certain intervenors filed testimony which recommended cost caps ranging from $1.1 billion to $1.4 billion if the IURC approved the CPCN.  In addition, the Indiana Office of Utility Consumer Counselor recommended the CPCN be denied until a more detailed project plan and cost estimates are filed with the IURC.  If I&M receives approval of a CPCN, I&M will file for cost recovery associated with the retrofit using the Clean Coal Technology Rider recovery mechanism.  A hearing is scheduled for December 2012.

Big Sandy Unit 2 FGD System

In May 2012, KPCo withdrew its application to the KPSC seeking approval of a Certificate of Public Convenience and Necessity to retrofit Big Sandy Unit 2 with a dry FGD system.  KPCo is currently re-evaluating its options to meet the short and long-term energy needs of its customers at the most reasonable costs.  As of September 30, 2012, KPCo has incurred $30 million related to the FGD project.  Management intends to pursue recovery of all costs related to the FGD project.  If KPCo is not ultimately permitted to recover its incurred costs, it would reduce future net income and cash flows.

Flint Creek Plant Environmental Controls

In February 2012, SWEPCo filed a petition with the APSC seeking a declaratory order to install environmental controls at the Flint Creek Plant to comply with the standards established by the CAA.  The estimated cost of the project is $408 million, excluding AFUDC and company overheads.  As a joint owner of the Flint Creek Plant, SWEPCo’s portion of those costs is estimated at $204 million.  Through September 30, 2012, SWEPCo has incurred $10 million related to this project, including AFUDC.  The APSC staff and the Sierra Club filed testimony that recommended the APSC deny the requested declaratory order.  A hearing at the APSC was held in October 2012 and a decision is pending from the APSC.  If SWEPCo is not ultimately permitted to recover its incurred costs, it would reduce future net income and cash flows.

Oklahoma Environmental Compliance Plan

In September 2012, PSO filed an environmental compliance plan with the OCC which requested approval for (a) full cost recovery through base rates by 2026 of an estimated $256 million of new environmental investment that will be incurred prior to 2016 at Northeastern Station Unit 3, (b) full cost recovery through 2026 of Northeastern Station Units 3 and 4 net book value (combined net book value of the two units is $235 million as of September 30, 2012), (c) full cost recovery through base rates of an estimated $83 million of new investment incurred through 2016 at various gas units and (d) a new 15-year purchase power agreement with Calpine Oneta Power, effective in 2016, with cost recovery through a rider, including an earnings component of $3 million.  Although the environmental compliance plan does not seek to put any new costs into rates at this time, PSO anticipates seeking cost recovery when filing its next base rate case, which is expected to occur no later than 2014.

 
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Clean Air Act Requirements

The CAA establishes a comprehensive program to protect and improve the nation’s air quality and control sources of air emissions.  The states implement and administer many of these programs and could impose additional or more stringent requirements.

The Federal EPA issued a Clean Air Visibility Rule (CAVR), detailing the CAA’s requirement that certain facilities install best available retrofit technology (BART) to address regional haze in federal parks and other protected areas.  BART requirements apply to facilities built between 1962 and 1977 that emit more than 250 tons per year of certain pollutants in specific industrial categories, including power plants.  CAVR will be implemented through individual state implementation plans (SIPs) or, if SIPs are not adequate or are not developed on schedule, through federal implementation plans (FIPs).  The Federal EPA proposed disapproval of SIPs in a few states, including Arkansas and Oklahoma.  The Federal EPA finalized a FIP for Oklahoma that contains more stringent control requirements for SO2 emissions from affected units in that state.  The Arkansas SIP was disapproved and the state is developing a revised submittal.  In June 2012, the Federal EPA published revisions to the regional haze rules to allow states participating in the Cross-State Air Pollution Rule (CSAPR) trading programs to use those programs in place of source-specific BART for SO2 and NOx emissions based on its determination that CSAPR results in greater visibility improvements than source-specific BART in the CSAPR states.  This rule is being challenged in the United States Court of Appeals for the District of Columbia Circuit and its fate is uncertain given recent developments in the CSAPR litigation.

The Federal EPA has also issued new, more stringent national ambient air quality standards (NAAQS) for SO2, NOx and lead, and is currently reviewing the NAAQS for ozone and PM.  States are in the process of evaluating the attainment status and need for additional control measures in order to attain and maintain the new NAAQS and may develop additional requirements for our facilities as a result of those evaluations.  We cannot currently predict the nature, stringency or timing of those requirements.

Notable developments in significant CAA regulatory requirements affecting our operations are discussed in the following sections.

Cross-State Air Pollution Rule (CSAPR)

In August 2011, the Federal EPA issued CSAPR.  Certain revisions to the rule were finalized in March 2012.  CSAPR relies on newly-created SO2 and NOx allowances and individual state budgets to compel further emission reductions from electric utility generating units in 28 states.  Interstate trading of allowances is allowed on a restricted sub-regional basis.  Arkansas and Louisiana are subject only to the seasonal NOx program in the rule.  Texas is subject to the annual programs for SO2 and NOx in addition to the seasonal NOx program.  The annual SO2 allowance budgets in Indiana, Ohio and West Virginia were reduced significantly in the final rule.  A supplemental rule includes Oklahoma in the seasonal NOx program.  The supplemental rule was finalized in December 2011 with an increased NOx emission budget for the 2012 compliance year.  The Federal EPA issued a final Error Corrections Rule and further CSAPR revisions in 2012 to make corrections to state budgets and unit allocations and to remove the restrictions on interstate trading in the first phase of CSAPR.

Numerous affected entities, states and other parties filed petitions to review the CSAPR in the United States Court of Appeals for the District of Columbia Circuit.  Several of the petitioners filed motions to stay the implementation of the rule pending judicial review.  In December 2011, the court granted the motions for stay.  In August 2012, the panel issued a decision vacating and remanding CSAPR to the Federal EPA with instructions to continue implementing the Clean Air Interstate Rule until a replacement rule is finalized.  The majority determined that the CAA does not allow the Federal EPA to “overcontrol” emissions in an upwind state and that the Federal EPA exceeded its statutory authority by failing to allow states an opportunity to develop their own implementation plans before issuing a FIP.  The Federal EPA and other respondents have filed petitions for rehearing.  Separate appeals of the supplemental rule, the Error Corrections Rule and the further revisions have been filed, but are being held in abeyance until the court responds to the rehearing petition in the main CSAPR appeal.

The time frames and stringency of the required emission reductions, coupled with the lack of robust interstate trading and the elimination of historic allowance banks, pose significant concerns for the AEP System and our electric utility customers.  We cannot predict the outcome of the pending litigation.

 
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Mercury and Other Hazardous Air Pollutants (HAPs) Regulation

In February 2012, the Federal EPA issued a rule addressing a broad range of HAPs from coal and oil-fired power plants.  The rule establishes unit-specific emission rates for mercury, PM (as a surrogate for particles of nonmercury metal) and hydrogen chloride (as a surrogate for acid gases) for units burning coal on a site-wide 30-day rolling average basis.  In addition, the rule proposes work practice standards, such as boiler tune-ups, for controlling emissions of organic HAPs and dioxin/furans.  The effective date of the final rule was April 16, 2012 and compliance is required within three years.  We are participating through various organizations in the petitions for administrative reconsideration and judicial review that have been filed.  In July 2012, the Federal EPA issued a letter announcing that it will grant petitions for administrative reconsideration of certain issues related to the new source standards, including measurement issues and application of variability factors that may have an impact on the level of the standards.  The letter also announced a three-month stay in the effective date of the new source standards.  It is uncertain whether any of the information generated during the reconsideration process will affect the standards for existing sources.

The final rule contains a slightly less stringent PM limit for existing sources than the original proposal and allows operators to exclude periods of startup and shutdown from the emissions averaging periods.  The compliance time frame remains a serious concern.  A one-year administrative extension may be available if the extension is necessary for the installation of controls or to avoid a serious reliability problem.  In addition, the Federal EPA issued an enforcement policy describing the circumstances under which an administrative consent order might be issued to provide a fifth year for the installation of controls or completion of reliability upgrades.  We are concerned about the availability of compliance extensions and the inability to foreclose citizen suits being filed under the CAA for failure to achieve compliance by the required deadlines.  We are participating in petitions for review filed in the United States Court of Appeals for the District of Columbia Circuit by several organizations of which we are members.  Certain issues related to the standards for new coal-fired units have been severed from the main case.  The Federal EPA granted petitions to reconsider certain issues related to the new source standards.  Action by the court on these severed issues is being held in abeyance pending action on those petitions.  The case is proceeding on the remaining issues and briefing is scheduled to be completed by April 2013.

Regional Haze

In March 2011, the Federal EPA proposed to approve in part and disapprove in part the regional haze SIP submitted by the State of Oklahoma through the Department of Environmental Quality.  The Federal EPA proposed to approve all of the NOx control measures in the SIP and disapprove the SO2 control measures for six electric generating units, including two units owned by PSO.  The Federal EPA proposed a FIP that would require these units to install technology capable of reducing SO2 emissions to 0.06 pounds per million British thermal units within three years of the effective date of the FIP.  PSO submitted comments on the proposed action demonstrating that the cost-effectiveness calculations performed by the Federal EPA were unsound, challenging the period for compliance with the final rule and showing that the visibility improvements secured by the proposed SIP were significant and cost-effective.  The Federal EPA finalized the FIP in December 2011 that mirrored the proposed rule but established a five-year compliance schedule.  PSO filed a petition for review of the FIP in the Tenth Circuit Court of Appeals and engaged in settlement discussions with the Federal EPA, the State of Oklahoma and other parties.  In April 2012, we reached an agreement in principle that would provide for submission of a revised Regional Haze SIP requiring the retirement of one coal-fired unit of PSO’s Northeastern Station no later than 2016, installation of emission controls on the second coal-fired Northeastern unit in 2016 and retirement of the second unit no later than 2026.  The parties are working toward finalizing a settlement agreement which is intended to allow PSO to meet its compliance obligations under the regional haze and HAPs rules.

 
8

 
CO2 Regulation

In March 2012, the Federal EPA issued a proposal to regulate CO2 emissions from new fossil fuel-fired electricity generating units.  The proposed rule establishes a new source performance standard of 1,000 pounds of CO2 per megawatt hour of electricity generated, a rate that most natural gas combined cycle units can meet, but that is substantially below the emission rate of a new pulverized coal generator or an integrated gas combined cycle unit that uses coal for fuel.  As proposed, the rule does not apply to new gas-fired stationary combustion turbines used as peaking units, does not apply to existing, modified or reconstructed sources, and does not apply to units whose CO2 emission rate increases as a result of the addition of pollution control equipment to control criteria pollutant emissions or HAPs.  The rule is not anticipated to have a significant immediate impact on the AEP System since it does not apply to existing units or units that have already commenced construction, like our Turk Plant.  The comment period closed in June 2012.  New Source Performance Standards affect units that have not yet received permits, but complete the permitting process while the proposal is pending.  The standards have been challenged in the United States Court of Appeals for the District of Columbia Circuit.  We cannot predict the outcome of that litigation.

In June 2012, the United States Court of Appeals for the District of Columbia Circuit issued a decision upholding, in all material respects, the Federal EPA’s endangerment finding, its regulatory program for CO2 emissions from new motor vehicles and its plan to phase in regulation of CO2 emissions from stationary sources under the Prevention of Significant Deterioration (PSD) and Title V operating permit programs. A petition for rehearing was filed and the court ordered the Federal EPA to respond in October 2012.   The Federal EPA also finalized a rule in June 2012 that retains the current thresholds for permitting stationary sources under the PSD and Title V operating permit programs at 100,000 tons per year for new sources and 75,000 tons per year for modified sources.  The Federal EPA also confirmed that it will re-evaluate these thresholds during its five-year review in 2016.  Our generating units are large sources of CO2 emissions and we will continue to evaluate the permitting obligations in light of these thresholds.

Coal Combustion Residual Rule

In June 2010, the Federal EPA published a proposed rule to regulate the disposal and beneficial re-use of coal combustion residuals, including fly ash and bottom ash generated at coal-fired electric generating units.  The rule contains two alternative proposals.  One proposal would impose federal hazardous waste disposal and management standards on these materials and another would allow states to retain primary authority to regulate the beneficial re-use and disposal of these materials under state solid waste management standards, including minimum federal standards for disposal and management.  Both proposals would impose stringent requirements for the construction of new coal ash landfills and would require existing unlined surface impoundments to upgrade to the new standards or stop receiving coal ash and initiate closure within five years of the issuance of a final rule.  In October 2011, the Federal EPA issued a notice of data availability requesting comments on a number of technical reports and other data received during the comment period for the original proposal and requesting comments on potential modeling analyses to update its risk assessment.  The Federal EPA has also announced its intention to complete a risk assessment of various beneficial uses of coal ash.

Currently, approximately 40% of the coal ash and other residual products from our generating facilities are re-used in the production of cement and wallboard, as structural fill or soil amendments, as abrasives or road treatment materials and for other beneficial uses.  Certain of these uses would no longer be available and others are likely to significantly decline if coal ash and related materials are classified as hazardous wastes.  In addition, we currently use surface impoundments and landfills to manage these materials at our generating facilities and will incur significant costs to upgrade or close and replace these existing facilities under the proposed solid waste management alternative.  Regulation of these materials as hazardous wastes would significantly increase these costs.  As the rule is not final, we are unable to determine a range of potential costs that are reasonably possible of occurring but expect the costs to be significant.

 
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Clean Water Act Regulations

In April 2011, the Federal EPA issued a proposed rule setting forth standards for existing power plants that will reduce mortality of aquatic organisms pinned against a plant’s cooling water intake screen (impingement) or entrained in the cooling water.  Entrainment is when small fish, eggs or larvae are drawn into the cooling water system and affected by heat, chemicals or physical stress.  The proposed standards affect all plants withdrawing more than two million gallons of cooling water per day and establish specific intake design and intake velocity standards meant to allow fish to avoid or escape impingement.  Compliance with this standard is required within eight years of the effective date of the final rule.  The proposed standard for entrainment for existing facilities requires a site-specific evaluation of the available measures for reducing entrainment.  The proposed entrainment standard for new units at existing facilities requires either intake flows commensurate with closed cycle cooling or achieving entrainment reductions equivalent to 90% or greater of the reductions that could be achieved with closed cycle cooling.  Plants withdrawing more than 125 million gallons of cooling water per day must submit a detailed technology study to be reviewed by the state permitting authority.  We are evaluating the proposal and engaged in the collection of additional information regarding the feasibility of implementing this proposal at our facilities.  In June 2012, the Federal EPA issued additional Notices of Data Availability and requested public comments.  We submitted comments in July 2012.  Issuance of a final rule is not expected until July 2013.  We are preparing to begin activities to implement the rule following its issuance and an analysis of the final requirements.

Global Warming

National public policy makers and regulators in the 11 states we serve have conflicting views on global warming.  While comprehensive economy-wide regulation of CO2 emissions might be achieved through future legislation, Congress has yet to enact such legislation.  The Federal EPA continues to take action to regulate CO2 emissions under the existing requirements of the CAA.

Several states have adopted programs that directly regulate CO2 emissions from power plants, but none of these programs are currently in effect in states where we have generating facilities.  Certain of our states have passed legislation establishing renewable energy, alternative energy and/or energy efficiency requirements, including Michigan, Ohio, Texas and Virginia.  We are taking steps to comply with these requirements.

Certain groups have filed lawsuits alleging that emissions of CO2 are a “public nuisance” and seeking injunctive relief and/or damages from small groups of coal-fired electricity generators, petroleum refiners and marketers, coal companies and others.  We have been named in pending lawsuits, which we are defending.  It is not possible to predict the outcome of these lawsuits or their impact on our operations or financial condition.  See “Carbon Dioxide Public Nuisance Claims” and “Alaskan Villages’ Claims” sections of Note 3.

Future federal and state legislation or regulations that mandate limits on the emission of CO2 would result in significant increases in capital expenditures and operating costs, which in turn, could lead to increased liquidity needs and higher financing costs.  Excessive costs to comply with future legislation or regulations might force our utility subsidiaries to close some coal-fired facilities and could lead to possible impairment of assets.  As a result, mandatory limits could reduce future net income and cash flows and impact financial condition.

For additional information on global warming, other environmental issues and the actions we are taking to address potential impacts, see Part I of the 2011 Form 10-K under the headings entitled “Business – General – Environmental and Other Matters” and “Management’s Financial Discussion and Analysis.”

 
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RESULTS OF OPERATIONS

SEGMENTS

Our primary business is the generation, transmission and distribution of electricity.  Within our Utility Operations segment, we centrally dispatch generation assets and manage our overall utility operations on an integrated basis because of the substantial impact of cost-based rates and regulatory oversight.  Intersegment sales and transfers are generally based on underlying contractual arrangements and agreements.

While our Utility Operations segment remains our primary business segment, the advancement of an area of our business prompted us to identify a new reportable segment.  Starting in the fourth quarter of 2011, we established our new Transmission Operations segment as described below:

Utility Operations

·
Generation of electricity for sale to U.S. retail and wholesale customers.
·
Transmission and distribution of electricity through assets owned and operated by our ten utility operating companies.

Transmission Operations

·
Development, construction and operation of transmission facilities through investments in our wholly-owned transmission subsidiaries and transmission joint ventures.  These investments have PUCT-approved or FERC-approved returns on equity.

AEP River Operations

·
Commercial barging operations that transport coal and dry bulk commodities primarily on the Ohio, Illinois and lower Mississippi Rivers.

Generation and Marketing

·
Nonregulated generation in ERCOT.
·
Marketing, risk management and retail activities in ERCOT, PJM and MISO.

The table below presents our consolidated Income Before Extraordinary Item by segment for the three and nine months ended September 30, 2012 and 2011.  We reclassified prior year amounts to conform to the current year’s presentation.

   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2012
   
2011
   
2012
   
2011
 
   
(in millions)
 
Utility Operations
  $ 471     $ 633     $ 1,220     $ 1,357  
Transmission Operations
    14       9       31       19  
AEP River Operations
    (1 )     17       11       23  
Generation and Marketing
    10       8       4       20  
All Other (a)
    (6 )     (10 )     (25 )     (54 )
Income Before Extraordinary Item
  $ 488     $ 657     $ 1,241     $ 1,365  

(a)
While not considered a reportable segment, All Other includes:
 
·
Parent’s guarantee revenue received from affiliates, investment income, interest income and interest expense and other nonallocated costs.
 
·
Forward natural gas contracts that were not sold with our natural gas pipeline and storage operations in 2004 and 2005.  These contracts were financial derivatives which settled and expired in the fourth quarter of 2011.
 
·
Revenue sharing related to the Plaquemine Cogeneration Facility which ended in the fourth quarter of 2011.

 
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AEP CONSOLIDATED

Third Quarter of 2012 Compared to Third Quarter of 2011

Income Before Extraordinary Item decreased from $657 million in 2011 to $488 million in 2012 primarily due to:

·
A decrease in carrying costs income due to the recognition in the third quarter 2011 of a regulatory asset related to TCC capacity auction true-up amounts that were originally written off in 2005.
·
The loss of retail customers in Ohio to various CRES providers.
·
A decrease in weather-related usage.
·
A decrease in AEP River Operations' earnings due to the impact of the 2012 drought.

These decreases were partially offset by:

·
The third quarter 2011 plant impairments of Sporn Unit 5 and the FGD project at Muskingum River Unit 5.

Average basic shares outstanding increased from 482 million in 2011 to 485 million in 2012.  Actual shares outstanding were 485 million as of September 30, 2012.

Nine Months Ended September 30, 2012 Compared to Nine Months Ended September 30, 2011

Income Before Extraordinary Item decreased from $1,365 million in 2011 to $1,241 million in 2012 primarily due to:

·
A decrease in carrying costs income due to the recognition in the third quarter 2011 of a regulatory asset related to TCC capacity auction true-up amounts that were originally written off in 2005.
·
The loss of retail customers in Ohio to various CRES providers.
·
A decrease in weather-related usage.
·
The increase in depreciation expenses as a result of shortened depreciable lives for certain OPCo generating plants.

These decreases were partially offset by:

·
The third quarter 2011 plant impairments of Sporn Unit 5 and the FGD project at Muskingum River Unit 5.
·
The first quarter 2012 reversal of an obligation to contribute to Partnership with Ohio and Ohio Growth Fund as a result of the PUCO's February 2012 rejection of OPCo's modified stipulation.
·
A second quarter 2012 partial reversal of a 2011 deferred fuel adjustment based on an April 2012 PUCO order related to the 2009 FAC audit.
·
A first quarter 2011 settlement of litigation with BOA and Enron.

Average basic shares outstanding increased from 482 million in 2011 to 484 million in 2012.  Actual shares outstanding were 485 million as of September 30, 2012.

Our results of operations are discussed below by operating segment.

 
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UTILITY OPERATIONS

We believe that a discussion of the results from our Utility Operations segment on a gross margin basis is most appropriate in order to further understand the key drivers of the segment.  Gross Margin represents total revenues less the related direct cost of fuel, including consumption of chemicals and emissions allowances and purchased electricity.  We reclassified prior year amounts to conform to the current year’s presentation.

   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
   
September 30,
 
   
2012
   
2011
   
2012
   
2011
 
   
(in millions)
 
Revenues
  $ 3,839     $ 4,074     $ 10,482     $ 10,986  
Fuel and Purchased Electricity
    1,401       1,609       3,766       4,136  
Gross Margin
    2,438       2,465       6,716       6,850  
Other Operation and Maintenance
    858       884       2,383       2,586  
Asset Impairments and Other Related Charges
    13       90       13       90  
Depreciation and Amortization
    458       435       1,318       1,226  
Taxes Other Than Income Taxes
    219       210       632       618  
Operating Income
    890       846       2,370       2,330  
Interest and Investment Income
    2       17       5       21  
Carrying Costs Income
    11       291       42       323  
Allowance for Equity Funds Used During Construction
    19       23       59       65  
Interest Expense
    (221 )     (222 )     (662 )     (681 )
Income Before Income Tax Expense and Equity
                               
Earnings
    701       955       1,814       2,058  
Income Tax Expense
    231       324       596       704  
Equity Earnings of Unconsolidated Subsidiaries
    1       2       2       3  
Income Before Extraordinary Item
  $ 471     $ 633     $ 1,220     $ 1,357  

Summary of KWh Energy Sales for Utility Operations
                         
   
Three Months Ended
 
Nine Months Ended
   
September 30,
 
September 30,
 
2012 
 
2011 
 
2012 
 
2011 
   
(in millions of KWhs)
Retail:
                     
 
Residential
 
 17,664 
   
 18,238 
   
 45,617 
   
 48,690 
 
Commercial
 
 14,091 
   
 14,274 
   
 38,444 
   
 38,833 
 
Industrial
 
 14,729 
   
 15,206 
   
 44,798 
   
 44,688 
 
Miscellaneous
 
 824 
   
 854 
   
 2,325 
   
 2,354 
Total Retail (a)
 
 47,308 
   
 48,572 
   
 131,184 
   
 134,565 
                       
Wholesale
 
 12,876 
   
 13,164 
   
 30,409 
   
 32,532 
                       
Total KWhs
 
 60,184 
   
 61,736 
   
 161,593 
   
 167,097 
                         
(a)  Represents energy delivered to distribution customers.

 
13

 
Cooling degree days and heating degree days are metrics commonly used in the utility industry as a measure of the impact of weather on net income.  In general, degree day changes in our eastern region have a larger effect on net income than changes in our western region due to the relative size of the two regions and the number of customers within each region.

Summary of Heating and Cooling Degree Days for Utility Operations
                         
   
Three Months Ended
 
Nine Months Ended
   
September 30,
September 30,
   
2012 
 
2011 
 
2012 
 
2011 
   
(in degree days)
Eastern Region
                     
Actual - Heating (a)
 
 9 
   
 6 
   
 1,388 
   
 1,995 
Normal - Heating (b)
 
 7 
   
 7 
   
 1,923 
   
 1,914 
                         
Actual - Cooling (c)
 
 816 
   
 838 
   
 1,245 
   
 1,209 
Normal - Cooling (b)
 
 709 
   
 700 
   
 1,012 
   
 999 
                         
Western Region
                     
Actual - Heating (a)
 
 - 
   
 - 
   
 348 
   
 702 
Normal - Heating (b)
 
 1 
   
 1 
   
 602 
   
 601 
                         
Actual - Cooling (d)
 
 1,525 
   
 1,669 
   
 2,619 
   
 2,813 
Normal - Cooling (b)
 
 1,367 
   
 1,359 
   
 2,201 
   
 2,179 
                         
(a)
Eastern Region and Western Region heating degree days are calculated on a 55 degree temperature base.
(b)
Normal Heating/Cooling represents the thirty-year average of degree days.
(c)
Eastern Region cooling degree days are calculated on a 65 degree temperature base.
(d)
Western Region cooling degree days are calculated on a 65 degree temperature base for PSO/SWEPCo and a 70 degree temperature base for TCC/TNC.

 
14

 
 
 
Third Quarter of 2012 Compared to Third Quarter of 2011
 
Reconciliation of Third Quarter of 2011 to Third Quarter of 2012
 
Income from Utility Operations before Extraordinary Item
 
(in millions)
 
       
Third Quarter of 2011
  $ 633  
         
Changes in Gross Margin:
       
Retail Margins
    (38 )
Off-system Sales
    (20 )
Transmission Revenues
    20  
Other Revenues
    11  
Total Change in Gross Margin
    (27 )
         
Changes in Expenses and Other:
       
Other Operation and Maintenance
    26  
Asset Impairments and Other Related Charges
    77  
Depreciation and Amortization
    (23 )
Taxes Other Than Income Taxes
    (9 )
Interest and Investment Income
    (15 )
Carrying Costs Income
    (280 )
Allowance for Equity Funds Used During Construction
    (4 )
Interest Expense
    1  
Equity Earnings of Unconsolidated Subsidiaries
    (1 )
Total Change in Expenses and Other
    (228 )
         
Income Tax Expense
    93  
         
Third Quarter of 2012
  $ 471  

The major components of the decrease in Gross Margin, defined as revenues less the related direct cost of fuel, including consumption of chemicals and emissions allowances, and purchased electricity were as follows:

·
Retail Margins decreased $38 million primarily due to the following:
 
·
An $80 million decrease attributable to Ohio customers switching to alternative CRES providers.  This decrease in Retail Margins is partially offset by an increase in Transmission Revenues related to CRES providers detailed below.
 
·
A $29 million decrease in weather-related usage primarily due to a 3% and 9% decrease in cooling degree days in our eastern and western service territories, respectively.
 
·
A $10 million net decrease in regulated revenue due to the elimination of POLR charges, effective June 2011, partially offset by the third quarter 2011 provision for refund of POLR charges.  The refund provision was recorded as a result of the October 2011 PUCO remand order.
 
These decreases were partially offset by:
 
·
Successful rate proceedings in our service territories which include:
   
·
A $44 million rate increase for OPCo.
   
·
A $24 million rate increase for APCo.
       
For the rate increases described above, $36 million of these increases relate to riders/trackers which have corresponding increases in other expense items below.
   
·
A $13 million decrease in recoverable PJM expenses in Ohio.
·
Margins from Off-system Sales decreased $20 million primarily due to lower market prices, reduced physical sales volumes and lower trading and marketing margins.
·
Transmission Revenues increased $20 million primarily due to net increases in ERCOT and increased transmission revenues from Ohio customers who have switched to alternative CRES providers.  The increase in transmission revenues related to CRES providers offsets a portion of the lost revenues included in Retail Margins above.
 
 
15

 
·
Other Revenues increased $11 million primarily due to an increase in revenues related to TCC's issuance of securitization bonds in March 2012.  This increase is partially offset by an increase in Depreciation and Amortization expense.

Expenses and Other and Income Tax Expense changed between years as follows:

·
Other Operation and Maintenance expenses decreased $26 million primarily due to the following:
 
·
A $40 million decrease in plant outage and other plant operating and maintenance expenses.
 
·
A $9 million decrease due to the third quarter 2011 write-off of Ohio allocated Front-End Engineering and Design (FEED) study costs related to the Mountaineer Carbon Capture Project.
 
·
A $4 million decrease in employee-related expenses.
 
These decreases were partially offset by:
 
·
A $16 million increase in energy efficiency programs and other expenses currently recovered dollar-for-dollar in rate recovery riders/trackers within Gross Margin.
 
·
A $12 million increase in storm expenses primarily due to the 2012 summer storms.
·
Asset Impairments and Other Related Charges decreased $77 million primarily due to the third quarter 2011 plant impairments of Sporn Unit 5 and the FGD project at Muskingum River Unit 5.
·
Depreciation and Amortization expenses increased $23 million primarily due to the following:
 
·
A $20 million increase due to TCC’s issuance of securitization bonds in March 2012.  The increase in TCC’s securitization related amortizations are offset within Gross Margin.
 
·
A $17 million increase due to shortened depreciable lives for certain OPCo generating plants effective December 2011.
 
·
A $15 million combined increase in depreciation for APCo and I&M primarily due to increases in depreciation rates effective February 2012 (Virginia) and April 2012 (Michigan), respectively.  The majority of this increase in depreciation is offset within Gross Margin.
 
·
A $4 million increase in amortization as a result of the Virginia E&R surcharge and the Virginia Environmental Rate Adjustment Clause, both effective February 2012.  This increase in amortization is offset within Gross Margin.
 
·
A $4 million increase in amortization of the Deferred Asset Recovery Rider assets as approved by the PUCO in the 2011 Ohio Distribution Base Rate Case effective January 2012.  This increase in amortization is offset within Gross Margin.
 
·
Overall higher depreciable property balances.
 
These increases were partially offset by:
 
·
A $21 million decrease due to OPCo's amortization of debt and equity carrying costs on deferred fuel as a result of the October 2011 PUCO remand order which allowed the POLR refund to be applied against any deferred fuel balances.  The equity amortization was partially offset by amounts recognized in Carrying Costs Income as discussed below.
 
·
A $10 million decrease due to an amortization adjustment approved by the PUCO in the 2011 Ohio Distribution Base Rate Case effective January 2012.
 
·
A $9 million decrease due to the deferral of capacity-related depreciation costs as a result of the PUCO's July 2012 approval of OPCo's capacity rate proceeding.
·
Interest and Investment Income decreased $15 million primarily due to interest income recorded in the third quarter of 2011 for favorable adjustments related to the 2001-2006 federal income tax audit.
·
Carrying Costs Income decreased $280 million primarily due to the following:
 
·
A $261 million decrease in carrying costs income due to the recognition in the third quarter 2011 of a regulatory asset related to TCC capacity auction true-up amounts that were originally written off in 2005.
 
·
An $11 million decrease primarily due to the recognition of equity carrying costs income on deferred fuel as a result of the October 2011 PUCO remand order which allowed the POLR refund to be applied against any deferred fuel balances.  The equity carrying costs income was offset by amounts in Depreciation and Amortization discussed above.
·
Income Tax Expense decreased $93 million primarily due to a decrease in pre-tax book income.

 
16

 
 
Nine Months Ended September 30, 2012 Compared to Nine Months Ended September 30, 2011

Reconciliation of Nine Months Ended September 30, 2011 to Nine Months Ended September 30, 2012
Income from Utility Operations before Extraordinary Item
(in millions)
         
Nine Months Ended September 30, 2011
 
$
 1,357 
 
         
Changes in Gross Margin:
       
Retail Margins
   
 (153)
 
Off-system Sales
   
 (19)
 
Transmission Revenues
   
 55 
 
Other Revenues
   
 (17)
 
Total Change in Gross Margin
   
 (134)
 
         
Changes in Expenses and Other:
       
Other Operation and Maintenance
   
 203 
 
Asset Impairments and Other Related Charges
   
 77 
 
Depreciation and Amortization
   
 (92)
 
Taxes Other Than Income Taxes
   
 (14)
 
Interest and Investment Income
   
 (16)
 
Carrying Costs Income
   
 (281)
 
Allowance for Equity Funds Used During Construction
   
 (6)
 
Interest Expense
   
 19 
 
Equity Earnings of Unconsolidated Subsidiaries
   
 (1)
 
Total Change in Expenses and Other
   
 (111)
 
         
Income Tax Expense
   
 108 
 
         
Nine Months Ended September 30, 2012
 
$
 1,220 
 

The major components of the decrease in Gross Margin, defined as revenues less the related direct cost of fuel, including consumption of chemicals and emissions allowances, and purchased electricity were as follows:

·
Retail Margins decreased $153 million primarily due to the following:
 
·
A $204 million decrease attributable to Ohio customers switching to alternative CRES providers.  This decrease in Retail Margins is partially offset by an increase in Transmission Revenues related to CRES providers detailed below.
 
·
A $119 million decrease in weather-related usage in our eastern and western regions primarily due to decreases of 30% and 50%, respectively, in heating degree days and a 7% decrease in cooling degree days in our western region.
 
·
An $81 million net decrease in regulated revenue due to the elimination of POLR charges, effective June 2011, partially offset by the third quarter 2011 provision for refund of POLR charges.  The refund provision was recorded as a result of the October 2011 PUCO remand order.
 
These decreases were partially offset by:
 
·
Successful rate proceedings in our service territories which include:
   
·
A $94 million rate increase for OPCo.
   
·
A $56 million rate increase for APCo.
   
·
A $16 million rate increase for I&M.
   
·
An $11 million rate increase for PSO.
     
For the rate increases described above, $108 million of these increases relate to riders/trackers which have corresponding increases in other expense items below.
 
·
A $35 million increase due to OPCo’s second quarter 2012 partial reversal of a 2011 fuel provision based on an April 2012 PUCO order related to the 2009 FAC audit.
 
·
A $30 million decrease in recoverable PJM expenses in Ohio.
 
 
17

 
 
·
A $9 million deferral of APCo's additional wind purchase recovery costs as a result of the June 2012 Virginia SCC fuel factor order.
·
Margins from Off-system Sales decreased $19 million primarily due to lower market prices, reduced physical sales volumes and lower trading and marketing margins, partially offset by higher PJM capacity revenues.
·
Transmission Revenues increased $55 million primarily due to net increases in ERCOT and increased transmission revenues from Ohio customers who have switched to alternative CRES providers.  The increase in transmission revenues related to CRES providers offsets a portion of the lost revenues included in Retail Margins above.
·
Other Revenues decreased $17 million primarily due to a decrease in gains on miscellaneous sales, partially offset by an increase in revenues related to TCC's issuance of securitization bonds in March 2012.  This increase in revenues from securitization bonds is partially offset by an increase in Depreciation and Amortization expense.

Expenses and Other and Income Tax Expense changed between years as follows:

·
Other Operation and Maintenance expenses decreased $203 million primarily due to the following:
 
·
A $115 million decrease in plant outage and other plant operating and maintenance expenses.
 
·
An $87 million decrease in employee-related expenses.
 
·
A $41 million decrease due to the first quarter 2011 write-off of a portion of the West Virginia share of the Mountaineer Carbon Capture and Storage Product Validation Facility as denied for recovery by the WVPSC.
 
·
A $30 million net decrease related to the reversal of an obligation to contribute to Partnership with Ohio and Ohio Growth Fund as a result of the PUCO’s February 2012 rejection of the Ohio modified stipulation and the PUCO's August 2012 approval of the June 2012-May 2015 ESP.
 
·
A $14 million decrease due to APCo's deferral of transmission costs for the Virginia Transmission Rate Adjustment Clause as allowed by the Virginia SCC.
 
·
A $9 million decrease due to the third quarter 2011 write-off of Ohio allocated FEED study costs related to the Mountaineer Carbon Capture Project.
 
These decreases were partially offset by:
 
·
A $33 million increase due to the first quarter 2011 deferral of 2009 storm costs and the 2010 cost reduction initiatives as allowed by the WVPSC in 2011.
 
·
A $24 million increase in energy efficiency programs and other expenses currently recovered dollar-for-dollar in rate recovery riders/trackers within Gross Margin.
 
·
A $14 million increase due to expenses related to the 2012 sustainable cost reductions.
 
·
An $11 million gain from the sale of land in January 2011.
·
Asset Impairments and Other Related Charges decreased $77 million primarily due to the third quarter 2011 plant impairments of Sporn Unit 5 and the FGD project at Muskingum River Unit 5.
·
Depreciation and Amortization expenses increased $92 million primarily due to the following:
 
·
A $49 million increase due to shortened depreciable lives for certain OPCo generating plants effective December 2011.
 
·
A $42 million increase due to TCC’s issuance of securitization bonds in March 2012.  The increase in TCC’s securitization related amortizations are offset within Gross Margin.
 
·
A $35 million combined increase in depreciation for APCo and I&M primarily due to increases in depreciation rates effective February 2012 (Virginia) and April 2012 (Michigan), respectively.  The majority of this increase in depreciation is offset within Gross Margin.
 
·
A $10 million increase in amortization as a result of the Virginia E&R surcharge and the Virginia Environmental Rate Adjustment Clause, both effective February 2012.  This increase in amortization is offset within Gross Margin.
 
·
A $9 million increase in amortization of OPCo's Deferred Asset Recovery Rider assets as approved by the PUCO in the 2011 Ohio Distribution Base Rate Case effective January 2012.  This increase in amortization is offset within Gross Margin.
 
·
Overall higher depreciable property balances.
 
These increases were partially offset by:
 
 
18

 
 
·
A $29 million decrease due to an amortization adjustment approved by the PUCO in the 2011 Ohio Distribution Base Rate Case effective January 2012.
 
·
A $21 million decrease due to OPCo's amortization of debt and equity carrying costs on deferred fuel as a result of the October 2011 PUCO remand order which allowed the POLR refund to be applied against any deferred fuel balances.  The equity amortization was offset by amounts recognized in Carrying Costs Income as discussed below.
 
·
A $13 million decrease in OPCo’s depreciation due to the third quarter 2011 plant impairment of Sporn Unit 5.
 
·
A $9 million decrease due to the deferral of capacity-related depreciation costs as a result of the PUCO's July 2012 approval of OPCo's capacity rate proceeding.
·
Taxes Other Than Income Taxes increased $14 million primarily due to increased property taxes as a result of increased capital investments.
·
Interest and Investment Income decreased $16 million primarily due to interest income recorded in the third quarter of 2011 for favorable adjustments related to the 2001-2006 federal income tax audit.
·
Carrying Costs Income decreased $281 million primarily due to the following:
 
·
A $261 million decrease in carrying costs income due to the recognition in the third quarter 2011 of a regulatory asset related to TCC capacity auction true-up amounts that were originally written off in 2005.
 
·
An $11 million decrease due to the recognition of equity carrying costs income on deferred fuel as a result of the October 2011 PUCO remand order which allowed the POLR refund to be applied against any deferred fuel balances.  The equity carrying costs income was offset by amounts in Depreciation and Amortization discussed above.
 
·
A $5 million reduction in debt carrying charges associated with the 2008 coal contract settlement for the period January 2009 through March 2012 as ordered by the PUCO in April 2012 related to the 2009 FAC audit.
 
These decreases were offset by:
 
·
An $8 million increase due to the recording of debt carrying costs prior to TCC’s issuance of securitization bonds in March 2012.
·
Interest Expense decreased $19 million primarily due to lower outstanding long-term debt balances and lower long-term interest rates.
·
Income Tax Expense decreased $108 million primarily due to a decrease in pre-tax book income and audit settlements for previous years.

TRANSMISSION OPERATIONS

Third Quarter of 2012 Compared to Third Quarter of 2011

Net Income from our Transmission Operations segment increased from $9 million in 2011 to $14 million in 2012 primarily due to an increase in investments by ETT and our wholly-owned transmission subsidiaries.

Nine Months Ended September 30, 2012 Compared to Nine Months Ended September 30, 2011

Net Income from our Transmission Operations segment increased from $19 million in 2011 to $31 million in 2012 primarily due to an increase in investments by ETT and our wholly-owned transmission subsidiaries.

 
19

 
AEP RIVER OPERATIONS

Third Quarter of 2012 Compared to Third Quarter of 2011

Net Income from our AEP River Operations segment decreased from income of $17 million in 2011 to a loss of $1 million in 2012 primarily due to reduced volumes and rates as a result of the 2012 drought which impacted both river conditions and grain harvests.  In addition, as a result of Hurricane Isaac, shipping in the Gulf Region ceased for a period of time in late August and early September 2012.

Nine Months Ended September 30, 2012 Compared to Nine Months Ended September 30, 2011

Net Income from our AEP River Operations segment decreased from $23 million in 2011 to $11 million in 2012 primarily due to reduced volumes and rates as a result of the 2012 drought which impacted both river conditions and grain harvests.  In addition, as a result of Hurricane Isaac, shipping in the Gulf Region ceased for a period of time in late August and early September 2012.

GENERATION AND MARKETING

Third Quarter of 2012 Compared to Third Quarter of 2011

Net Income from our Generation and Marketing segment increased from $8 million in 2011 to $10 million in 2012 primarily due to higher trading margins and higher retail margins in PJM partially offset by lower gross margins at the Oklaunion Plant and the expiration of wind-related production tax credits in 2011.

Nine Months Ended September 30, 2012 Compared to Nine Months Ended September 30, 2011

Net Income from our Generation and Marketing segment decreased from $20 million in 2011 to $4 million in 2012 primarily due to the expiration of wind-related production tax credits in 2011 and lower gross margins at the Oklaunion Plant, partially offset by higher retail margins in PJM and higher trading margins.

ALL OTHER

Third Quarter of 2012 Compared to Third Quarter of 2011

Net Income from All Other increased from a loss of $10 million in 2011 to a loss of $6 million in 2012 primarily due to a reduction in interest expense partially offset by a 2011 gain on sale of assets.

Nine Months Ended September 30, 2012 Compared to Nine Months Ended September 30, 2011

Net Income from All Other increased from a loss of $54 million in 2011 to a loss of $25 million in 2012 primarily due to a loss incurred in the first quarter of 2011 related to the settlement of litigation with BOA and Enron.

AEP SYSTEM INCOME TAXES

Third Quarter of 2012 Compared to Third Quarter of 2011

Income Tax Expense decreased $93 million primarily due to a decrease in pretax book income.

Nine Months Ended September 30, 2012 Compared to Nine Months Ended September 30, 2011

Income Tax Expense decreased $166 million primarily due to a decrease in pretax book income and the 2011 unrealized capital loss valuation allowance related to a deferred tax asset associated with the settlement of litigation with BOA and Enron.

 
20

 
FINANCIAL CONDITION

We measure our financial condition by the strength of our balance sheet and the liquidity provided by our cash flows.

LIQUIDITY AND CAPITAL RESOURCES

Debt and Equity Capitalization

   
September 30, 2012
 
December 31, 2011
   
(dollars in millions)
Long-term Debt, including amounts due within one year
$
 17,227 
 
 51.0 
%
 
$
 16,516 
 
 50.3 
%
Short-term Debt
 
 1,216 
 
 3.6 
     
 1,650 
 
 5.0 
 
Total Debt
 
 18,443 
 
 54.6 
     
 18,166 
 
 55.3 
 
AEP Common Equity
 
 15,306 
 
 45.4 
     
 14,664 
 
 44.7 
 
Noncontrolling Interests
 
 - 
 
 - 
     
 1 
 
 - 
 
                       
Total Debt and Equity Capitalization
$
 33,749 
 
 100.0 
%
 
$
 32,831 
 
 100.0 
%

Our ratio of debt-to-total capital decreased from 55.3% as of December 31, 2011 to 54.6% as of September 30, 2012.  Long-term debt outstanding increased primarily due to the March 2012 issuance of $800 million of securitization bonds.

Liquidity

Liquidity, or access to cash, is an important factor in determining our financial stability.  We believe we have adequate liquidity under our existing credit facilities.  As of September 30, 2012, we had $3.25 billion in aggregate credit facility commitments to support our operations.  Additional liquidity is available from cash from operations and a receivables securitization agreement.  We are committed to maintaining adequate liquidity.  We generally use short-term borrowings to fund working capital needs, property acquisitions and construction until long-term funding is arranged.  Sources of long-term funding include issuance of long-term debt, sale-and-leaseback or leasing agreements or common stock.

Credit Facilities

We manage our liquidity by maintaining adequate external financing commitments.  As of September 30, 2012, our available liquidity was approximately $3 billion as illustrated in the table below:

     
Amount
 
Maturity
     
(in millions)
   
Commercial Paper Backup:
         
 
Revolving Credit Facility
 
$
 1,500 
 
June 2015
 
Revolving Credit Facility
   
 1,750 
 
July 2016
Total
   
 3,250 
   
Cash and Cash Equivalents
   
 443 
   
Total Liquidity Sources
   
 3,693 
   
Less:
AEP Commercial Paper Outstanding
   
 520 
   
 
Letters of Credit Issued
   
 132 
   
             
Net Available Liquidity
 
$
 3,041 
   

We have credit facilities totaling $3.25 billion to support our commercial paper program.  The credit facilities allow us to issue letters of credit in an amount up to $1.35 billion.

 
21

 
We use our commercial paper program to meet the short-term borrowing needs of our subsidiaries.  The program is used to fund both a Utility Money Pool, which funds the utility subsidiaries, and a Nonutility Money Pool, which funds the majority of the nonutility subsidiaries.  In addition, the program also funds, as direct borrowers, the short-term debt requirements of other subsidiaries that are not participants in either money pool for regulatory or operational reasons.  The maximum amount of commercial paper outstanding during the first nine months of 2012 was $1.2 billion.  The weighted-average interest rate for our commercial paper during 2012 was 0.45%.

Securitized Accounts Receivable

In June 2012, we renewed our receivables securitization agreement.  The agreement provides a commitment of $700 million from bank conduits to purchase receivables.  A commitment of $385 million expires in June 2013 and the remaining commitment of $315 million expires in June 2015.

Securitization of Regulatory Assets

In March 2012, West Virginia passed securitization legislation which allows the WVPSC to establish a regulatory framework to securitize certain deferred Expanded Net Energy Charge (ENEC) balances and other ENEC related assets.  In August 2012, APCo and WPCo filed with the WVPSC a request for a financing order to securitize $422 million related to APCo’s December 2011 under-recovered ENEC deferral balance, other ENEC-related assets and related financing costs.  A hearing is scheduled in December 2012.

In August 2012, OPCo filed an application with the PUCO requesting securitization of the Deferred Asset Recovery Rider (DARR) balance.  As of September 30, 2012, OPCo’s DARR balance was $296 million, including $139 million of unrecognized equity carrying costs.  Currently, the DARR is being recovered through 2018 by a non-bypassable rider.

Debt Covenants and Borrowing Limitations

Our revolving credit agreements contain certain covenants and require us to maintain our percentage of debt to total capitalization at a level that does not exceed 67.5%.  The method for calculating outstanding debt and capitalization is contractually defined in our revolving credit agreements.  Debt as defined in the revolving credit agreements excludes junior subordinated debentures, securitization bonds and debt of AEP Credit.  As of September 30, 2012, this contractually-defined percentage was 49.5%.  Nonperformance under these covenants could result in an event of default under these credit agreements.  As of September 30, 2012, we complied with all of the covenants contained in these credit agreements.  In addition, the acceleration of our payment obligations, or the obligations of certain of our major subsidiaries, prior to maturity under any other agreement or instrument relating to debt outstanding in excess of $50 million, would cause an event of default under these credit agreements and in a majority of our non-exchange traded commodity contracts which would permit the lenders and counterparties to declare the outstanding amounts payable.  However, a default under our non-exchange traded commodity contracts does not cause an event of default under our revolving credit agreements.

The revolving credit facilities do not permit the lenders to refuse a draw on any facility if a material adverse change occurs.

Utility Money Pool borrowings and external borrowings may not exceed amounts authorized by regulatory orders.  As of September 30, 2012, we had not exceeded those authorized limits.

Dividend Policy and Restrictions

The Board of Directors declared a quarterly dividend of $0.47 per share in October 2012.  Future dividends may vary depending upon our profit levels, operating cash flow levels and capital requirements, as well as financial and other business conditions existing at the time.  Our income derives from our common stock equity in the earnings of our utility subsidiaries.  Various financing arrangements and regulatory requirements may impose certain restrictions on the ability of our utility subsidiaries to transfer funds to us in the form of dividends.

 
22

 
We have the option to defer interest payments on the AEP Junior Subordinated Debentures for one or more periods of up to 10 consecutive years per period.  During any period in which we defer interest payments, we may not declare or pay any dividends or distributions on, or redeem, repurchase or acquire, our common stock.

We do not believe restrictions related to our various financing arrangements and regulatory requirements will have any significant impact on Parent’s ability to access cash to meet the payment of dividends on its common stock.

Credit Ratings

We do not have any credit arrangements that would require material changes in payment schedules or terminations as a result of a credit downgrade, but our access to the commercial paper market may depend on our credit ratings.  In addition, downgrades in our credit ratings by one of the rating agencies could increase our borrowing costs.  Counterparty concerns about the credit quality of AEP or its utility subsidiaries could subject us to additional collateral demands under adequate assurance clauses under our derivative and non-derivative energy contracts.

CASH FLOW

Managing our cash flows is a major factor in maintaining our liquidity strength.

 
Nine Months Ended
 
 
September 30,
 
 
2012
 
2011
 
 
(in millions)
 
Cash and Cash Equivalents at Beginning of Period
$ 221   $ 294  
Net Cash Flows from Operating Activities
  2,912     3,338  
Net Cash Flows Used for Investing Activities
  (2,281 )   (1,967 )
Net Cash Flows Used for Financing Activities
  (409 )   (1,119 )
Net Increase in Cash and Cash Equivalents
  222     252  
Cash and Cash Equivalents at End of Period
$ 443   $ 546  

Cash from operations and short-term borrowings provides working capital and allows us to meet other short-term cash needs.
 
Operating Activities
 
 
Nine Months Ended
 
 
September 30,
 
 
2012
 
2011
 
 
(in millions)
 
Net Income
$ 1,241   $ 1,638  
Depreciation and Amortization
  1,353     1,258  
Other
  318     442  
Net Cash Flows from Operating Activities
$ 2,912   $ 3,338  

Net Cash Flows from Operating Activities were $2.9 billion in 2012 consisting primarily of Net Income of $1.2 billion and $1.4 billion of noncash Depreciation and Amortization.  Other changes represent items that had a current period cash flow impact, such as changes in working capital, as well as items that represent future rights or obligations to receive or pay cash, such as regulatory assets and liabilities.  A significant change in other items includes the unfavorable impact of an increase in fuel inventory due to the mild winter weather.  Cash was used to pay real and personal property taxes and to reduce accounts payable.  Deferred Income Taxes increased primarily due to provisions in the Small Business Jobs Act and the Tax Relief, Unemployment Insurance Reauthorization and Jobs Creation Act and an increase in tax versus book temporary differences from operations.  We also contributed $100 million to our qualified pension trust.

 
23

 
Net Cash Flows from Operating Activities were $3.3 billion in 2011 consisting primarily of Net Income of $1.6 billion and $1.3 billion of noncash Depreciation and Amortization.  Other changes represent items that had a current period cash flow impact, such as changes in working capital, as well as items that represent future rights or obligations to receive or pay cash, such as regulatory assets and liabilities.  Following a Supreme Court of Texas opinion, we recorded an Extraordinary Item, Net of Tax of $273 million for the third quarter 2011 recognition of a regulatory asset related to TCC capacity auction true-up amounts that were originally written off in 2005.  We also recorded $261 million in Carrying Costs Income related to the TCC extraordinary item.  A significant change in other items includes the favorable impact of a decrease in fuel inventory.  Deferred Income Taxes increased primarily due to provisions in the Small Business Jobs Act and the Tax Relief, Unemployment Insurance Reauthorization and Jobs Creation Act, the settlement with BOA and Enron and an increase in tax versus book temporary differences from operations.  In February 2011, we paid $425 million to BOA of which $211 million was used to settle litigation with BOA and Enron. The remaining $214 million was used to acquire cushion gas as discussed in Investing Activities below.  We also contributed $150 million to our qualified pension trust.
 
Investing Activities
 
 
Nine Months Ended
 
 
September 30,
 
 
2012
 
2011
 
 
(in millions)
 
Construction Expenditures
$ (2,108 ) $ (1,849 )
Acquisitions of Nuclear Fuel
  (13 )   (104 )
Acquisitions of Assets/Businesses
  (89 )   (10 )
Acquisition of Cushion Gas from BOA
  -     (214 )
Proceeds from Sales of Assets
  13     116  
Other
  (84 )   94  
Net Cash Flows Used for Investing Activities
$ (2,281 ) $ (1,967 )

Net Cash Flows Used for Investing Activities were $2.3 billion in 2012 primarily due to Construction Expenditures for new generation, environmental, distribution and transmission investments.  Acquisitions of Assets/Businesses include our March 2012 purchase of BlueStar for $70 million.

Net Cash Flows Used for Investing Activities were $2 billion in 2011 primarily due to Construction Expenditures for new generation, environmental, distribution and transmission investments.  We paid $214 million to BOA for cushion gas as part of a litigation settlement.
 
Financing Activities
 
 
Nine Months Ended
 
 
September 30,
 
 
2012
 
2011
 
 
(in millions)
 
Issuance of Common Stock, Net
$ 64   $ 70  
Issuance of Debt, Net
  262     (469 )
Dividends Paid on Common Stock
  (687 )   (668 )
Other
  (48 )   (52 )
Net Cash Flows Used for Financing Activities
$ (409 ) $ (1,119 )

Net Cash Flows Used for Financing Activities in 2012 were $409 million.  Our net debt issuances were $262 million. The net issuances included issuances of $800 million of securitization bonds, $550 million of senior unsecured notes, $197 million of notes payable and other debt and $65 million of pollution control bonds offset by retirements of $513 million of senior unsecured and other debt notes, $220 million of pollution control bonds, $171 million of securitization bonds and a decrease in short-term borrowing of $434 million.  We paid common stock dividends of $687 million.  See Note 10 – Financing Activities for a complete discussion of long-term debt issuances and retirements.

 
24

 
Net Cash Flows Used for Financing Activities in 2011 were $1.1 billion.  Our net debt retirements were $469 million. The net retirements included retirements of $683 million of senior unsecured and other debt notes, $678 million of pollution control bonds, $159 million of securitization bonds and a decrease in short-term borrowing of $67 million offset by issuances of $600 million of senior unsecured notes and $526 million of pollution control bonds.  We paid common stock dividends of $668 million.

In October 2012, I&M retired $29 million of Notes Payable related to DCC Fuel.

In October 2012, AEP Transmission Company, LLC completed a $350 million debt offering.  This debt offering resulted in the October 2012 issuance of $250 million of Senior Notes in three tranches.  The tranches are $104 million at 3.3% due in 2022, $85 million at 4% due in 2032 and $61 million at 4.73% due in 2042.  The remaining $100 million will be issued in two tranches in December 2012 and March 2013.

OFF-BALANCE SHEET ARRANGEMENTS

In prior periods, under a limited set of circumstances, we entered into off-balance sheet arrangements for various reasons including reducing operational expenses and spreading risk of loss to third parties.  Our current guidelines restrict the use of off-balance sheet financing entities or structures to traditional operating lease arrangements that we enter in the normal course of business.  The following identifies significant off-balance sheet arrangements:

 
September 30,
 
December 31,
 
 
2012
 
2011
 
 
(in millions)
 
Rockport Plant Unit 2 Future Minimum Lease Payments
$ 1,552   $ 1,626  
Railcars Maximum Potential Loss From Lease Agreement
  25     25  

For complete information on each of these off-balance sheet arrangements see the “Off-balance Sheet Arrangements” section of “Management’s Financial Discussion and Analysis” in the 2011 Annual Report.

CONTRACTUAL OBLIGATION INFORMATION

A summary of our contractual obligations is included in our 2011 Annual Report and has not changed significantly from year-end other than the debt issuances and retirements discussed in the “Cash Flow” section above.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES, NEW ACCOUNTING PRONOUNCEMENTS

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

See the “Critical Accounting Policies and Estimates” section of “Management’s Financial Discussion and Analysis” in the 2011 Annual Report for a discussion of the estimates and judgments required for regulatory accounting, revenue recognition, the valuation of long-lived assets, the accounting for pension and other postretirement benefits and the impact of new accounting pronouncements.

ACCOUNTING PRONOUNCEMENTS

Future Accounting Changes

The FASB’s standard-setting process is ongoing and until new standards have been finalized and issued, we cannot determine the impact on the reporting of our operations and financial position that may result from any such future changes.  The FASB is currently working on several projects including revenue recognition, financial instruments, leases, insurance, hedge accounting and consolidation policy.  We also expect to see more FASB projects as a result of its desire to converge International Accounting Standards with GAAP.  The ultimate pronouncements resulting from these and future projects could have an impact on future net income and financial position.

 
25

 
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market Risks

Our Utility Operations segment is exposed to certain market risks as a major power producer and through its transactions in wholesale electricity, coal and emission allowance trading and marketing contracts.  These risks include commodity price risk, interest rate risk and credit risk.  In addition, we are exposed to foreign currency exchange risk as we occasionally procure various services and materials used in our energy business from foreign suppliers.  These risks represent the risk of loss that may impact us due to changes in the underlying market prices or rates.

Our Generation and Marketing segment conducts marketing, risk management and retail activities in ERCOT, PJM and MISO.  This segment is exposed to certain market risks as a marketer of wholesale and retail electricity.  These risks include commodity price risk, interest rate risk and credit risk.  These risks represent the risk of loss that may impact us due to changes in the underlying market prices or rates.

We employ risk management contracts including physical forward purchase and sale contracts and financial forward purchase and sale contracts.  We engage in risk management of power, coal and natural gas and, to a lesser degree, heating oil and gasoline, emission allowance and other commodity contracts to manage the risk associated with our energy business.  As a result, we are subject to price risk.  The amount of risk taken is determined by the Commercial Operations and Finance groups in accordance with our established risk management policies as approved by the Finance Committee of our Board of Directors.  Our market risk oversight staff independently monitors our risk policies, procedures and risk levels and provides members of the Commercial Operations Risk Committee (CORC) various daily, weekly and/or monthly reports regarding compliance with policies, limits and procedures.  The CORC consists of our Chief Operating Officer, Chief Financial Officer, Senior Vice President of Commercial Operations and Chief Risk Officer.  When commercial activities exceed predetermined limits, we modify the positions to reduce the risk to be within the limits unless specifically approved by the CORC.

 
26

 
The following table summarizes the reasons for changes in total mark-to-market (MTM) value as compared to December 31, 2011:

 
MTM Risk Management Contract Net Assets (Liabilities)
 
Nine Months Ended September 30, 2012
   
       
Generation
   
   
Utility
and
 
   
Operations
Marketing
Total
   
(in millions)
Total MTM Risk Management Contract Net Assets
               
 
as of December 31, 2011
$
 59 
 
$
 132 
 
$
 191 
(Gain) Loss from Contracts Realized/Settled During the Period and
               
 
Entered in a Prior Period
 
 2 
   
 (2)
   
 - 
Fair Value of New Contracts at Inception When Entered During the
               
 
Period (a)
 
 5 
   
 16 
   
 21 
Acquisition of Supply Contracts (b)
 
 - 
   
 (25)
   
 (25)
Changes in Fair Value Due to Market Fluctuations During the
               
 
Period (c)
 
 4 
   
 2 
   
 6 
Changes in Fair Value Allocated to Regulated Jurisdictions (d)
 
 4 
   
 - 
   
 4 
Total MTM Risk Management Contract Net Assets
               
 
as of September 30, 2012
$
 74 
 
$
 123 
   
 197 
                   
Commodity Cash Flow Hedge Contracts
             
 1 
Interest Rate and Foreign Currency Cash Flow Hedge Contracts
             
 (39)
Fair Value Hedge Contracts
             
 2 
Collateral Deposits
             
 30 
Total MTM Derivative Contract Net Assets as of September 30, 2012
           
$
 191 

(a)
Reflects fair value on primarily long-term structured contracts which are typically with customers that seek fixed pricing to limit their risk against fluctuating energy prices.  The contract prices are valued against market curves associated with the delivery location and delivery term.  A significant portion of the total volumetric position has been economically hedged.
(b)
Reflects liabilities associated with supply contracts from the BlueStar acquisition in March 2012.
(c)
Market fluctuations are attributable to various factors such as supply/demand, weather, etc.
(d)
Relates to the net gains (losses) of those contracts that are not reflected on the condensed statements of income.  These net gains (losses) are recorded as regulatory liabilities/assets.

See Note 7 – Derivatives and Hedging and Note 8 – Fair Value Measurements for additional information related to our risk management contracts.  The following tables and discussion provide information on our credit risk and market volatility risk.

 
27

 
Credit Risk

We limit credit risk in our wholesale marketing and trading activities by assessing the creditworthiness of potential counterparties before entering into transactions with them and continuing to evaluate their creditworthiness on an ongoing basis.  We use Moody’s Investors Service, Standard & Poor’s and current market-based qualitative and quantitative data as well as financial statements to assess the financial health of counterparties on an ongoing basis.

We have risk management contracts with numerous counterparties.  Since open risk management contracts are valued based on changes in market prices of the related commodities, our exposures change daily.  As of September 30, 2012, our credit exposure net of collateral to sub investment grade counterparties was approximately 6%, expressed in terms of net MTM assets, net receivables and the net open positions for contracts not subject to MTM (representing economic risk even though there may not be risk of accounting loss).  As of September 30, 2012, the following table approximates our counterparty credit quality and exposure based on netting across commodities, instruments and legal entities where applicable:

     
Exposure
         
Number of
 
Net Exposure
   
Before
   
Counterparties
of
   
Credit
Credit
Net
>10% of
Counterparties
Counterparty Credit Quality
Collateral
Collateral
Exposure
Net Exposure
>10%
     
(in millions, except number of counterparties)
Investment Grade
 
$
 651 
 
$
 - 
 
$
 651 
   
 2 
 
$
 268 
Split Rating
   
 - 
   
 - 
   
 - 
   
 - 
   
 - 
Noninvestment Grade
   
 2 
   
 2 
   
 - 
   
 - 
   
 - 
No External Ratings:
                             
 
Internal Investment Grade
   
 109 
   
 - 
   
 109 
   
 2 
   
 27 
 
Internal Noninvestment Grade
   
 60 
   
 10 
   
 50 
   
 1 
   
 36 
Total as of September 30, 2012
 
$
 822 
 
$
 12 
 
$
 810 
   
 5 
 
$
 331 
                                 
Total as of December 31, 2011
 
$
 960 
 
$
 19 
 
$
 941 
   
 5 
 
$
 348 

Value at Risk (VaR) Associated with Risk Management Contracts

We use a risk measurement model, which calculates VaR, to measure our commodity price risk in the risk management portfolio.  The VaR is based on the variance-covariance method using historical prices to estimate volatilities and correlations and assumes a 95% confidence level and a one-day holding period.  Based on this VaR analysis, as of September 30, 2012, a near term typical change in commodity prices is not expected to have a material effect on our net income, cash flows or financial condition.

The following table shows the end, high, average and low market risk as measured by VaR for the trading portfolio for the periods indicated:

VaR Model

Nine Months Ended
 
Twelve Months Ended
September 30, 2012
 
December 31, 2011
End
 
High
 
Average
 
Low
 
End
 
High
 
Average
 
Low
(in millions)
 
(in millions)
$
 
$
 
$
 
$
 
$
 
$
 
$
 
$

We back-test our VaR results against performance due to actual price movements.  Based on the assumed 95% confidence interval, the performance due to actual price movements would be expected to exceed the VaR at least once every 20 trading days.

 
28

 
As our VaR calculation captures recent price movements, we also perform regular stress testing of the portfolio to understand our exposure to extreme price movements.  We employ a historical-based method whereby the current portfolio is subjected to actual, observed price movements from the last four years in order to ascertain which historical price movements translated into the largest potential MTM loss.  We then research the underlying positions, price movements and market events that created the most significant exposure and report the findings to the Risk Executive Committee or the CORC as appropriate.

Interest Rate Risk

We utilize an Earnings at Risk (EaR) model to measure interest rate market risk exposure. EaR statistically quantifies the extent to which our interest expense could vary over the next twelve months and gives a probabilistic estimate of different levels of interest expense.  The resulting EaR is interpreted as the dollar amount by which actual interest expense for the next twelve months could exceed expected interest expense with a one-in-twenty chance of occurrence.  The primary drivers of EaR are from the existing floating rate debt (including short-term debt) as well as long-term debt issuances in the next twelve months.  As calculated on debt outstanding as of September 30, 2012 and December 31, 2011, the estimated EaR on our debt portfolio for the following twelve months was $32 million and $29 million, respectively.

 
29

 

AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES
 
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
 
For the Three and Nine Months Ended September 30, 2012 and 2011
 
(in millions, except per-share and share amounts)
 
(Unaudited)
 
                         
   
Three Months Ended
   
Nine Months Ended
 
   
2012
   
2011
   
2012
   
2011
 
REVENUES
                       
Utility Operations
  $ 3,814     $ 4,044     $ 10,412     $ 10,901  
Other Revenues
    342       289       920       771  
TOTAL REVENUES
    4,156       4,333       11,332       11,672  
EXPENSES
                               
Fuel and Other Consumables Used for Electric Generation
    1,180       1,371       3,137       3,407  
Purchased Electricity for Resale
    327       294       855       856  
Other Operation
    775       747       2,150       2,130  
Maintenance
    255       283       769       864  
Asset Impairments and Other Related Charges
    13       90       13       90  
Depreciation and Amortization
    470       445       1,353       1,258  
Taxes Other Than Income Taxes
    224       213       648       628  
TOTAL EXPENSES
    3,244       3,443       8,925       9,233  
                                 
OPERATING INCOME
    912       890       2,407       2,439  
                                 
Other Income (Expense):
                               
Interest and Investment Income
    2       19       6       24  
Carrying Costs Income
    11       291       42       323  
Allowance for Equity Funds Used During Construction
    23       26       70       69  
Interest Expense
    (233 )     (242 )     (697 )     (723 )
                                 
INCOME BEFORE INCOME TAX EXPENSE AND EQUITY EARNINGS
    715       984       1,828       2,132  
                                 
Income Tax Expense
    241       334       620       786  
Equity Earnings of Unconsolidated Subsidiaries
    14       7       33       19  
                                 
INCOME BEFORE EXTRAORDINARY ITEM
    488       657       1,241       1,365  
                                 
EXTRAORDINARY ITEM, NET OF TAX
    -       273       -       273  
                                 
NET INCOME
    488       930       1,241       1,638  
                                 
Net Income Attributable to Noncontrolling Interests
    1       1       3       3  
                                 
NET INCOME ATTRIBUTABLE TO AEP SHAREHOLDERS
    487       929       1,238       1,635  
                                 
Preferred Stock Dividend Requirements of Subsidiaries
    -       1       -       2  
                                 
EARNINGS ATTRIBUTABLE TO AEP COMMON SHAREHOLDERS
  $ 487     $ 928     $ 1,238     $ 1,633  
                                 
WEIGHTED AVERAGE NUMBER OF BASIC AEP COMMON SHARES OUTSTANDING
    484,979,543       482,498,734       484,437,875       481,862,128  
                                 
BASIC EARNINGS PER SHARE ATTRIBUTABLE TO AEP COMMON SHAREHOLDERS
                               
Income Before Extraordinary Item
  $ 1.00     $ 1.35     $ 2.55     $ 2.82  
Extraordinary Item, Net of Tax
    -       0.57       -       0.57  
                                 
TOTAL BASIC EARNINGS PER SHARE ATTRIBUTABLE TO AEP COMMON
                               
SHAREHOLDERS
  $ 1.00     $ 1.92     $ 2.55     $ 3.39  
                                 
WEIGHTED AVERAGE NUMBER OF DILUTED AEP COMMON SHARES OUTSTANDING
    485,362,858       482,796,945       484,826,123       482,126,964  
                                 
DILUTED EARNINGS PER SHARE ATTRIBUTABLE TO AEP COMMON SHAREHOLDERS
                               
Income Before Extraordinary Item
  $ 1.00     $ 1.35     $ 2.55     $ 2.82  
Extraordinary Item, Net of Tax
    -       0.57       -       0.57  
                                 
TOTAL DILUTED EARNINGS PER SHARE ATTRIBUTABLE TO AEP COMMON
                               
SHAREHOLDERS
  $ 1.00     $ 1.92     $ 2.55     $ 3.39  
                                 
CASH DIVIDENDS DECLARED PER SHARE
  $ 0.47     $ 0.46     $ 1.41     $ 1.38  
                                 
See Condensed Notes to Condensed Consolidated Financial Statements beginning on page 36.
                               

 
30

 


AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES
 
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
 
For the Three and Nine Months Ended September 30, 2012 and 2011
 
(in millions)
 
(Unaudited)
 
                         
   
Three Months Ended
   
Nine Months Ended
 
   
2012
   
2011
   
2012
   
2011
 
Net Income
  $ 488     $ 930     $ 1,241     $ 1,638  
                                 
OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAXES
                               
Cash Flow Hedges, Net of Tax of $7 and $11 for the Three Months Ended
                               
September 30, 2012 and 2011, Respectively, and $4 and $8 for the Nine
                               
Months Ended September 30, 2012 and 2011, Respectively
    13       (20 )     (8 )     (14 )
Securities Available for Sale, Net of Tax of $- and $2 for the Three Months
                               
Ended September 30, 2012 and 2011, Respectively, and $1 and $2 for the
                               
Nine Months Ended September 30, 2012 and 2011, Respectively
    1       (4 )     2       (3 )
Amortization of Pension and OPEB Deferred Costs, Net of Tax of $4
                               
and $3 for the Three Months Ended September 30, 2012 and 2011,
                               
Respectively, and $12 and $9 for the Nine Months Ended September 30,
                               
2012 and 2011, Respectively
    7       6       22       18  
                                 
TOTAL OTHER COMPREHENSIVE INCOME (LOSS)
    21       (18 )     16       1  
                                 
TOTAL COMPREHENSIVE INCOME
    509       912       1,257       1,639  
                                 
Total Comprehensive Income Attributable to Noncontrolling Interests
    1       1       3       3  
                                 
TOTAL COMPREHENSIVE INCOME ATTRIBUTABLE TO AEP
                               
SHAREHOLDERS
    508       911       1,254       1,636  
                                 
Preferred Stock Dividend Requirements of Subsidiaries
    -       1