| RELIANT ENERGY INC Item 1A Risk Factors |
| Risks Related to the Retail and Wholesale Energy Industries The financial results of our wholesale and retail energy segments are subject to market risks beyond our control |
| Our results of operations, financial condition and cash flows are significantly impacted by the prevailing demand and market prices for electricity, purchased power, fuel and emission allowances over which we have no control |
| Market prices can fluctuate dramatically in response to many factors, including weather conditions; changes in the prices of related commodities; changes in law and regulation; regulatory intervention (including the imposition of price limitations, bidding rules or similar mechanisms); market illiquidity; transmission constraints; environmental limitations; generation unit outages; fuel supply issues; and other events |
| The wholesale and retail electricity markets in which we operate are relatively immature markets that are characterized by elements of both deregulated and regulated markets |
| The introduction of competition into the United States electricity market is a relatively recent development |
| As a result, the market is characterized by elements of both a regulated electricity market and a deregulated electricity market |
| Consequently, our ability to set rates at market prices may be constrained by regulatory restrictions or possible regulatory or political intervention |
| In many instances, the regulatory structures governing these markets are still evolving, creating gaps in the regulatory framework and associated uncertainty |
| The new competitive market has attracted a number of new participants |
| The emergence of aggressive competitors may put downward pressure on our retail margins and sales volumes over time |
| Other competitors are smaller, less well-capitalized entities that may default on their obligations to the market |
| These defaults may impose costs and burdens on the remaining market participants such as us |
| As an emerging market, a significant potential for industry consolidation exists as companies seek to expand and grow their operations, which may lead to stronger, more well-capitalized competitors in the industry |
| 12 _________________________________________________________________ Our operations are subject to extensive regulations |
| Changes in these regulations could adversely affect the cost, manner or feasibility of conducting our business |
| We operate in a regulatory environment that is undergoing significant changes as a result of varying restructuring initiatives at both state and federal levels |
| We cannot predict the future direction of these initiatives or the ultimate effect that this changing regulatory environment will have on our business |
| Moreover, existing regulations may be revised or reinterpreted and new laws and regulations may be adopted or become applicable to our facilities or our commercial activities |
| Such future changes in laws and regulations may have an adverse effect on business |
| See "e Business—Regulation "e in Item 1 of this Form 10-K We depend on facilities and systems that we do not own or control for our fuel and fuel supply and to deliver electricity to and bill our customers |
| Any disruption in these facilities or systems could have an adverse effect on our business |
| We depend on (a) fuel sources and fuel supply facilities owned and operated by third parties to supply our generation plants and (b) power transmission, distribution facilities and metering systems owned and operated by third parties to deliver electricity to our customers and provide energy usage data |
| If these facilities or systems, over which we have no control, fail, we may be unable to generate and/or deliver electricity |
| In addition, inaccurate or untimely information from third parties could hinder our ability to bill customers and collect amounts owed |
| The operation of generation facilities involves significant risks that could interrupt operations and increase our costs |
| Ownership of generation assets exposes us to risks relating to the breakdown of equipment or processes, fuel supply or transportation interruptions, shortages of equipment, material and labor, operational restrictions resulting from environmental limitations and governmental interventions, as well as other operational risks |
| In addition, many of our facilities are old and require significant maintenance expenditures |
| If (a) our workers were to engage in a strike, work stoppage or other slowdown, (b) other employees were to become unionized or (c) the terms and conditions in future labor agreements were renegotiated, we could experience a significant disruption in our operations and higher ongoing labor costs |
| Similarly, we have an aging workforce at a number of our plants creating potential knowledge and expertise gaps as those workers retire |
| If we are unable to secure fuel, we will not be able to run our generation units |
| If a generation unit fails, we may have to purchase replacement power from third parties at higher prices |
| We have insurance, subject to limits and deductibles, covering some types of physical damage and business interruption related to our generation units |
| However, this insurance may not always be available on commercially reasonable terms |
| In addition, there is no assurance that (a) insurance proceeds will be sufficient to cover all losses, (b) insurance payments will be timely made or (c) the policies themselves will be free of substantial deductibles |
| Our business operations expose us to the risk of loss if third parties fail to perform their contractual obligations |
| We may incur losses if third parties default on their obligations to pay us money; buy or sell electricity, fuel, emission allowances and other commodities; or provide us with fuel transportation services, power transmission or distribution services |
| For additional information about third party default risk, including our efforts to mitigate against this risk, see "e Managementapstas Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Credit Risk "e in Item 7 of this Form 10-K and note 2(e) to our consolidated financial statements |
| 13 _________________________________________________________________ We have a substantial coal- and oil-fired generation portfolio that poses environmental issues |
| Our costs of compliance with environmental laws are significant and can affect our future financial results |
| Our wholesale energy segment is subject to extensive and evolving environmental regulations, particularly our coal- and oil-fired generation units |
| We incur significant costs in complying with these regulations and, if we fail to comply, could incur significant penalties |
| In addition, failure to comply with environmental requirements could require us to shut down or reduce production on our generation units or create liability exposure |
| New environmental laws or regulations may be adopted that would further constrain our operations or increase our environmental compliance costs |
| We also may be responsible for the environmental liabilities associated with generation units even if a prior owner caused the liabilities |
| We concluded that since our generating assets dispatch based on market prices, we should maintain an emission allowances inventory that corresponds with forward power sales |
| We plan to sell some excess emission allowances inventory if the price is equal to or above our fundamental view |
| To the extent allowances are required in the future to operate our facilities, such allowances may be unavailable or only available at costs exceeding our sales price |
| See "e Business—Environmental Matters "e in Item 1 of this Form 10-K and note 12(b) to our consolidated financial statements |
| Failure to obtain or maintain any required permits or approvals could prevent or limit us from operating our business |
| To operate our generating units and retail electric business, we must obtain and maintain various permits, approvals and certificates from governmental agencies |
| In some jurisdictions, we must also meet minimum requirements for customer service and comply with local consumer protection and other laws |
| Our failure to obtain or maintain any necessary governmental permits or to satisfy these legal requirements, including environmental compliance provisions, could limit our ability to operate our business or create liability exposure |
| Significant events beyond our control, such as hurricanes and other weather-related problems or acts of terrorism, could have a material adverse effect on our businesses |
| The uncertainty associated with events beyond our control, such as significant weather events and the risk of future terrorist activity, may affect our results of operations and financial condition in unpredictable ways |
| These events could result in adverse changes in the insurance markets and disruptions of power and fuel markets |
| In addition, terrorist actions could damage or shut down our generation facilities or the fuel and fuel supply facilities or the power transmission and distribution facilities upon which our generation and retail businesses are dependent |
| These events could also adversely affect the United States economy, create instability in the financial markets and, as a result, have an adverse effect on our ability to access capital on terms and conditions acceptable to us |
| Special Risks Relating to Our Texas Retail Operations We depend on third parties to provide electricity to supply our Texas retail customers |
| We own a very limited amount of generation capacity in Texas, which is insufficient to supply the electricity requirements of our Texas retail operations |
| We purchase substantially all of our Texas supply requirements from third parties |
| As a result, our financial performance depends on our ability to obtain adequate supplies of electric generation from third parties at prices below the prices we charge our customers |
| Initiatives undertaken by the PUCT may negatively impact the wholesale cost of power |
| The PUCT is expected to propose a new rule on resource adequacy and market power in the ERCOT Region |
| In this rule, the PUCT is considering an increase to the current price cap applicable 14 _________________________________________________________________ to generation bids into the ERCOT energy market, elimination of current market power mitigation measures and adoption of new market power guidelines |
| It is expected that these rules will be implemented sometime after the summer of 2006 |
| If market power abuses are not adequately monitored and mitigated, these rules may have the impact of increasing the wholesale cost of power, which could adversely impact our gross margins in the Texas retail market |
| The financial performance of our Texas retail electric operations depends on the amount of gross margin, or headroom, available in the "e price-to-beat "e tariff |
| Our retail energy segment derives a significant portion of its revenue from sales to "e price-to-beat "e customers |
| The "e price-to-beat "e includes a component (fuel factor) that, subject to PUCT approval, can be adjusted to reflect changes in the market price of natural gas and purchased power costs |
| Under PUCT rules, we can request this adjustment twice a year |
| However, the PUCT or government officials may seek to (a) limit these adjustments in periods of concern over price levels or (b) change the existing rules for adjusting the "e price-to-beat "e rates |
| The price of natural gas embedded in power supply purchases associated with our "e price-to-beat "e energy commitments can be different than that reflected in the fuel factor due to: • varying supply procurement strategies used and the timing of entering into related contracts; • subsequent changes in the overall price of natural gas; • daily, monthly or seasonal fluctuations in the price of natural gas relative to the 12-month forward prices; • changes in market heat rate (ie, the relationship between power and natural gas prices); • timing of prospective fuel factor adjustments; and • other factors |
| Our earnings could be adversely affected in any period in which our power supply costs rise at a greater rate than our "e price-to-beat "e fuel factor |
| The declines we have experienced in our Houston retail gross margins may continue or accelerate |
| In recent years, we have experienced significant declines in our gross margins in the Houston retail market |
| This trend could continue and be exacerbated by regulatory intervention |
| See "e Managementapstas Discussion and Analysis of Financial Condition and Results of Operations—Business Overview—Factors Affecting Future Performance "e |
| We may lose further market share in the Houston retail electricity market, which is a significant contributor of income to our consolidated results |
| In recent years, we have experienced declines in our share of the Houston retail electricity market, which represents approximately 75prca of our customer base |
| This trend could continue if competition increases |
| See "e Managementapstas Discussion and Analysis of Financial Condition and Results of Operations—Business Overview—Factors Affecting Future Performance "e |
| Our ability to set rates at market prices in Texas may be constrained by new legislative or regulatory restrictions |
| The PUCT is evaluating the retail electric service provided after January 2007 by incumbent providers, such as us, to customers who have not selected a non "e price-to-beat "e product since the Texas retail electricity market opened to competition |
| In addition, the Texas Legislature is studying the effects of competition in the Texas retail electricity market |
| New legislation or rules governing the retail 15 _________________________________________________________________ electric prices we are allowed to charge after January 2007 could have an adverse effect on our financial condition, results of operations and cash flows |
| We depend on the ERCOT ISO to communicate operating and system information in a timely and accurate manner |
| Corrections to prior estimated billing and other information can have an impact on our future reported financial results |
| The ERCOT ISO communicates information relating to a customerapstas choice of retail electric provider and other data needed for servicing of customer accounts to utilities and retail electric providers |
| Any failure to perform these tasks will result in delays and other problems in enrolling, switching and billing customers |
| The ERCOT ISO is also responsible for settling all electricity supply volumes in the ERCOT Region |
| Information that is not accurate or timely may result in incorrect estimates of our settled volumes and supply costs that would need to be corrected when such information is received |
| See "e Managementapstas Discussion and Analysis of Financial Condition and Results of Operations—New Accounting Pronouncements, Significant Accounting Policies and Critical Accounting Estimates—Critical Accounting Estimates "e in Item 7 of this Form 10-K We could be liable for a share of the payment defaults of other retail electric providers within the ERCOT market |
| If a retail electric provider defaults on its payment obligations to ERCOT, we, together with other ERCOT market participants, are liable for a portion of the defaulted amount based on our respective share of the total load |
| As of December 31, 2005, we accounted for approximately 20prca of the total ERCOT load |
| Risks Related to Our Company Our borrowing levels and debt service obligations may adversely affect our business |
| As of December 31, 2005, we had total debt from continuing operations of dlra5dtta1 billion: • We must dedicate a substantial portion of our cash flows to pay debt service requirements, which reduces the amount of cash available for other business purposes; • The covenants in our debt agreements restrict our ability to, among other things, (a) obtain additional financing, (b) make investments or acquisitions, (c) create additional liens on our assets and (d) take other actions to react to changes in our business; • If we do not comply with the payment and other material covenants, including the financial ratios, under our debt agreements, our debt holders could require us to repay our debt immediately and, in the case of our revolving credit facilities and receivables facility, terminate their commitment to lend us money; • So long as our debt remains at current levels, and substantially all our assets are pledged to secure repayment of our debt, we are unlikely to obtain an investment grade credit rating; • Our debt levels and credit ratings may affect the evaluation of our creditworthiness by customers, which could put us at a competitive disadvantage to competitors with less debt; • We have to post collateral with substantially all of our commercial counterparties and levels of our collateral postings are impacted by changes in commodity prices |
| A significant change in commodity prices could significantly increase our collateral posting obligations and require us to seek additional sources of liquidity, including additional debt; and • We may be more vulnerable to adverse economic and industry conditions, including changes in short-term interest rates |
| 16 _________________________________________________________________ Although we have taken steps to achieve greater financial flexibility, there is no assurance that we will be successful in achieving this goal |
| In February 2004, we announced a goal of achieving, by the end of 2006, an adjusted net debt-to-adjusted EBITDA ratio of 3dtta0 |
| Although we have taken steps to repay debt and implement other measures intended to improve our financial flexibility, we do not believe that we will achieve this goal in 2006 |
| Even if we achieve our goal, or otherwise obtain credit metrics similar to those held by entities traditionally assigned investment grade credit ratings, there is no assurance credit rating agencies will improve our credit ratings |
| Because of our debt levels and the capital-intensive nature of our business, we are vulnerable to reductions in our cash flows or liquidity |
| If we were unable to generate sufficient cash flows, access funds from operations or raise cash from other sources, we would not be able to meet our debt service, collateral postings and other obligations |
| This situation could result from adverse developments in the energy, fuel or capital markets, a disruption in our operations or those of third parties or other events adversely affecting our cash flows and financial performance |
| We could experience reductions in liquidity if changes in commodity prices trigger our contractual obligations to pledge additional collateral under commodity contracts |
| See "e Managementapstas Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources "e in Item 7 of this Form 10-K Our hedging and other risk management activities may not work as planned |
| Our hedges may not be effective as a result of basis price differences, transmission issues, price correlation, volume variations or other factors |
| See "e Quantitative and Qualitative Disclosures about Non-Trading and Trading Activities and Related Market Risks "e in Item 7A of this Form 10-K Changes in the wholesale energy market or sales of generation assets could result in impairments |
| If our outlook for the wholesale energy market changes negatively, or if our ongoing evaluation of our wholesale energy segment results in decisions to mothball, retire or dispose of generation assets, we could have impairment charges related to goodwill or our fixed assets |
| See notes 2(h) and 4 to our consolidated financial statements |
| Lawsuits and regulatory proceedings could adversely affect our business |
| From time to time, we are named as a party to lawsuits and regulatory proceedings |
| Litigation can involve complex factual and legal questions and its outcome is uncertain |
| Any claim that is successfully asserted against us could result in significant damage claims and other losses |
| Even if we were to prevail, any litigation could be costly and time-consuming and would divert the attention of our management and key personnel from our business operations, which could adversely affect our financial condition, results of operations or cash flows |
| See notes 12 and 13 to our consolidated financial statements |
| In addition, our retail and other commercial operations are highly dependent on computer and other operating systems, including telecommunications systems |
| Any interruptions in these arrangements or systems could significantly disrupt our business operations |
| In recent years, we have entered into outsourcing arrangements, such as information technology production software, infrastructure and development and certain functions within customer operations, with third party service providers |
| If these service providers do not perform their obligations, we may incur significant costs and experience interruptions in our business operations in connection with 17 _________________________________________________________________ switching to other service providers or assuming these obligations ourselves |
| We are also highly dependent on our specialized computer and communications systems, the operation of which could be interrupted by fire, flood, power loss, computer viruses and similar disruptions |
| Although we have some backup systems and disaster recovery plans, there is no guarantee that these systems and plans will be effective |
| If we acquire or develop additional generation assets, or dispose of existing generation assets, we may incur additional costs and risks |
| Subject to restrictions in our debt agreements and available capital resources, we may seek to purchase or develop additional generation units or dispose of existing generation units |
| There is no assurance that our efforts to identify and acquire additional generation units or to dispose of existing generation assets will be successful |
| In the sale of generation units, we may be required to indemnify a purchaser against certain liabilities |
| To finance future acquisitions, we may be required to issue additional equity securities or incur additional debt |