Global Warming: Can We Find Common Ground? | Cinergy 2004 Annual Report

My seven-year-old granddaughter Emma surprised me during a recent holiday visit when she told me she wanted “to protect endangered species.” It was her answer to my question about what she wanted to do when she grew up. As I listened, it became clear to me that she understood what this meant and why it was important to her. Her concern for the future of our planet is the same concern at the heart of the global warming debate and the struggle to find the best way forward.

All of us have a stake in the increasingly heated debate on global warming in our nation and around the world. In uncertain times, it’s even more important to listen to those who have a vested interest in our future and to find the common ground that allows us to move ahead in a sensible manner.

To that end and for this annual report, we interviewed 23 people representing eight stakeholder groups to find out whether they believe it is possible to find common ground on global warming. You can read quotes from their interviews in the section after this letter, and I invite you to read their interviews on Cinergy.com.

You might think of the lines on the cover of this report as representing public views on global warming and the policy choices we face — colorful, disparate and diverging initially — but ultimately converging at a common center that is more united than divided.

One idea the interviewees all share is simple: finding common ground starts with real dialogue. It starts with a willingness to speak openly, candidly, without fear and with imagination and hope. It starts first with a belief that we must steward this planet, not just for ourselves but for future generations. It starts by asking tough questions that require direct answers.

I’m sure you might expect us to duck this issue. After all, we burn 25 to 30 million tons of coal each year. We are one of the largest burners of coal in the U.S. power industry, and coal, like all fossil fuels, has been linked to global warming. Further, no law currently mandates the reduction of carbon dioxide (CO₂) and other greenhouse gas (GHG) emissions from our power plants.

Additionally, there is an unresolved but robust debate on the “science” of global warming. We know that human activity is contributing to the warming of our planet. However, the debate is over the extent of that contribution and the magnitude of the consequences. To simply avoid this debate and fail to understand the implications of the regulation of CO₂ and GHG on our company is not an option. This conclusion is underpinned by the numerous signposts we have observed in the last few years:

SIGNPOST #1
THE STATES ARE TAKING ACTION:

Four states have an overall cap on GHG emissions and two states have a cap on power plant CO₂ emissions.
Four states require source reporting of CO₂ emissions and three have voluntary reporting programs.
Eight states regulate GHG emissions.
18 states have mandatory renewable energy portfolio standards.
Eight states have filed suits against Cinergy and four other coal-burning utilities to curb GHG emissions.

SIGNPOST #2
AN INCREASING NUMBER OF U.S. SENATORS ARE EXPRESSING CONCERN ABOUT GLOBAL WARMING:

In 1997, the U.S. Senate voted 95-0 to reject ratification of the Kyoto Protocol. But in 2003, the McCain-Lieberman Climate Stewardship Act, that would have regulated CO₂ emissions, fell just eight votes short of passing, with two senators not voting. The Act has been reintroduced in the new Congress.
This may mean the likelihood of passing comprehensive legislation regulating the emission of sulfur dioxide (SO₂), nitrogen oxides (NO_X) and mercury (Hg) from coal-fired power plants is highly uncertain unless CO₂ is also addressed. It has become “the elephant in the room” in the debate on comprehensive environmental legislation.

SIGNPOST #3
THE KYOTO PROTOCOL TO REDUCE GHG WAS APPROVED BY 38 INDUSTRIAL NATIONS AND BECAME LAW ON FEBRUARY 16, 2005:

Europe wants to accelerate GHG mitigation and develop adaptation measures. Some countries are already focused on what to do after the Kyoto accord expires in 2012 and have already released their draft post-Kyoto strategies.
British Prime Minister Tony Blair is so focused on the issue of global warming that it will be at the center of the G8 nations’ summit meeting this year. In his recent address at the World Economic Forum meeting in Davos, Switzerland, he said, “The climate debate will be how and on what time scale it is confronted; not whether.”

SIGNPOST #4
A GROWING NUMBER OF INDIVIDUAL SHAREHOLDERS AND SHAREHOLDER GROUPS ARE ASKING COMPANIES, SUCH AS CINERGY, TO QUANTIFY THE RISKS ASSOCIATED WITH GHG EMISSIONS:

Investors are requesting that companies discuss the climate change issue publicly, disclose their emissions and demonstrate that they are taking proactive steps to plan for a carbon-constrained world.
The assets of socially responsible mutual funds are growing faster than the mutual fund industry as a whole. Investments in these funds have increased 156 percent in five years to $32 billion, according to recent reports. These funds are stepping up their advocacy efforts. All socially responsible investing has grown seven percent in the last five years to $2.2 trillion.
The California Public Employees’ Retirement System (Calpers) announced that it will sign on to the Global Carbon Disclosure Project, an international effort to improve the transparency of business risks associated with climate change.

SIGNPOST #5
CO₂ AND GHG EMISSIONS TRADING MARKETS ARE DEVELOPING IN EUROPE AND THE UNITED STATES:

In January 2005, the European Union initiated its Emissions Trading Scheme, which imposes a mandatory CO₂ emissions cap and facilitates the trading of CO₂ allowances among 12,000 EU industrial installations.
The Chicago Climate Exchange, which was established in late 2003 as the world’s first multi-national and multi-sector marketplace for trading GHG emissions, has grown from 13 to 85 members.
A coalition of nine Northeast states has initiated the Regional Greenhouse Gas Initiative, which would create a regional market-based CO₂ cap-and-trade program for these states.

SIGNPOST #6
GLOBAL WARMING IS BECOMING PART OF OUR EVERYDAY CONSCIOUSNESS:

Global warming was on the covers of BusinessWeek and National Geographic in 2004. National Geographic said “2004 was the year global warming got respect.”
Last year, global warming was the basis for a major motion picture, a television miniseries and a best-selling novel by Michael Crichton.
In 2005, a respected industry trade publication, Public Utilities Fortnightly, featured global warming as the cover story for its February issue.

Collectively, these signposts indicate that there is growing concern about global warming and that the regulation of CO₂ is being increasingly considered. We have not been required to curb our emissions of CO₂ or GHG at this time. Yet, we realize that this may change in the future. New CO₂ regulations would probably increase our cost of generating electricity over time and ultimately result in higher prices for our customers. We believe it is prudent to plan for a scenario where CO₂ is regulated in the future, so that we will be able to comply with those regulations in a cost-effective manner for our shareholders and customers.

WHAT IS CINERGY DOING TO ADDRESS ITS GREENHOUSE GAS EMISSIONS?

We have taken steps to reduce our dependence on coal. In the last five years, we spent about $1 billion to add 2,000 megawatts of natural gas-fired generating capacity. We converted one of our oldest coal plants to natural gas. These actions allow us to meet peak electricity demand with reduced emissions. For example, gas-fired plants produce electricity with two-thirds less CO₂ emissions than typical coal plants. Our total coal-fired generation capacity has dropped from approximately 87 to 73 percent since 1998.

And, we stepped up our activities to address GHG emissions in 2004. First, we announced our plans to meet the GHG reduction commitments we made in 2003. Between 2004 and 2010, we will spend approximately $21 million on projects to reduce or offset GHG emissions. Developed in collaboration with Environmental Defense, these projects will improve the efficiency of our generating units and expand our renewable energy portfolio of hydroelectric and landfill gas plants to include wind and photovoltaic demonstration projects.

Second, we published a report on the impact of reducing GHG on our electric generation system. It was written in collaboration with scientists, economists, environmentalists, customers and investors, including Mission Responsibility Through Investment and Environmental Justice of the Presbyterian Church (USA). We invite you to review our Air Issues Report to Stakeholders, which can be found on Cinergy.com.

Third, we co-sponsored a two-day national summit meeting on the future of coal with the University of Kentucky. Entitled “Coal 2020 — Burning Questions,” the conference attracted national and regional experts. Copies of all the presentations are on Cinergy.com.

Fourth, we announced our intention to study the feasibility of building one of the first full-scale Integrated Gasification Combined Cycle (IGCC) plants with General Electric and Bechtel Corporation. IGCC technology turns coal into cleaner-burning gas, while using less water and producing fewer emissions than a conventional coal-fired plant, with state of the art scrubbers. John Rice, the CEO of GE Energy, and David Hawkins of the Natural Resources Defense Council (NRDC), both believe that this technology, along with sequestration of CO₂, has the potential to dramatically improve the business of using coal throughout the industrialized and developing world. You will meet both of them later in this report.

We will continue to look for opportunities to reduce our CO₂ emissions in the future.

IF COAL CREATES SO MANY EMISSIONS, WHY DOES CINERGY CONTINUE TO USE IT TO PRODUCE ELECTRICITY?

Coal is the most abundant and affordable energy fuel in North America. More than 50 percent of the electricity generated in the United States, and 40 percent in the world, comes from coal. While energy conservation, demand management and cleaner methods of generating electricity may reduce our reliance on coal over time, coal will continue to play a significant role, even in a carbon-constrained world.

Despite the renewed focus on nuclear power, the costs of constructing new nuclear-fueled power plants remain high and the questions of waste disposal go unanswered. Natural gas supplies are constrained and are being depleted. Renewable energy, while promising, can only serve a small portion of our nation’s increasing demand for energy with currently available technology. All of these technologies will be needed to meet our ever-growing appetite for energy. However, coal is, and will continue to be, our primary source of fuel in the United States and in the world.

Addressing global warming now is consistent with our efforts to be a sustainability leader. Our goal is to be a company that you want to invest in over the long term; a company you want to do business with and to work for; and a company known for leadership in its communities and in the energy industry. In 2004, Cinergy was named to the Dow Jones Sustainability Indexes for the second consecutive year. We believe this is further evidence of our commitment to balancing competing interests to find common ground.

FINANCIAL STRENGTH IS THE KEY TO OUR ABILITY TO CONFRONT ENVIRONMENTAL CHALLENGES

Whatever the future may hold with regard to carbon regulation, it is obvious that we will need to continue to make investments that reduce the size of our environmental footprint. Several of our 2004 key accomplishments should improve our earnings and cash flow considerably over the next several years. We believe these actions put us in a stronger position to meet immediate and longer-term environmental challenges.

2004 RESULTS: POSITIONING FOR THE FUTURE

Milder than normal weather and rising costs experienced during 2004 made for a challenging year. Most notably, fuel and emission allowance costs and the costs associated with employee labor and benefits, each rose significantly over our expectations for the year.

Cinergy’s earnings were $2.18 per share on a diluted basis, after net charges totaling $0.26 per share primarily for write-downs of certain investments, implementation of the company’s continuous improvement initiative and a gain from the sale of certain technology assets. Excluding the net impact of these items, ongoing earnings for 2004 of $2.44 per share were below our expectations for the year.

Yet, we made Cinergy a much stronger company in 2004. We completed large, unprecedented regulatory initiatives — one of which, as I will discuss later, specifically addresses our higher fuel and emission allowance costs. We took proactive steps to address the next wave of federal environmental laws and regulations. We built on our track record of operational excellence and of implementing comprehensive productivity improvements throughout every aspect of our business. We supported the measured growth of our commercial businesses. And, we further strengthened our balance sheet and improved our liquidity.

Our board recently showed its confidence in our prospects for the future. In January 2005, our directors authorized an increase in the annual dividend from $1.88 to $1.92 per share. This is the third consecutive year in which the board has voted for an increase and reflects our continued commitment to the steady, competitive growth of our dividend.

Last year’s dividend increase allowed us to return about $340 million in cash to our shareholders in 2004. This, in turn, helped contribute to another year of solid performance on the important metric of Total Shareholder Return (TSR). Cinergy’s TSR for 2004 was 12.6 percent. We have been a consistent strong performer on this metric. Our three-year annualized TSR (2002-2004) was 13.3 percent compared to 10.1 percent for the S&P Electric Utility Index, 9.9 percent for the S&P Super Composite Electric Utility Index and 3.6 percent for the S&P 500 over the same period.

Over the next few pages, I want to describe in a little more detail why I believe our 2004 accomplishments position us for strong growth in 2005 and beyond.

SUCCESSFUL REGULATORY INITIATIVES

The earnings of our Regulated Business Unit and Commercial Business Unit (which includes the earnings from long-term purchased power agreements with our regulated utilities) are impacted significantly by regulatory decisions. In 2004, we successfully concluded two of the largest, most complex regulatory initiatives in our company’s history.

PSI Energy Rate Order: Last May, the Indiana Utility Regulatory Commission (IURC) approved a $140 million rate increase for our Indiana operating company, PSI Energy. The IURC’s approval reflects its commitment to ensure adequate generating capacity to meet the ongoing energy demands of our Indiana customers. The order authorized adding $1.3 billion to our Indiana rate base, which includes approximately $570 million for our investment in approximately 1,100 megawatts of additional gas-fired generation and $310 million for PSI’s environmental investments.

In addition to the PSI rate order, the IURC issued orders in an environmental compliance proceeding reflecting its commitment to keeping our low-cost, coal-fired generation viable even in the face of new environmental laws and regulations. The commission authorized PSI to recover through rates, ongoing financing, operating and depreciation costs related to further NO_x reductions at our plants.

Cincinnati Gas & Electric Rate Stabilization Plan: In late November of last year, the Public Utilities Commission of Ohio (PUCO) issued an order that provides greater clarity to what had become an ambiguous and uncertain regulatory environment in Ohio. Concerned about possible rate shock caused by high and volatile market prices for electricity, the PUCO approved a rate stabilization plan that mitigates this impact for CG&E electric customers. At the same time, the plan compensates CG&E for committing its low-cost generation to serve its Ohio load through 2008.

Allow me to say a few more words about the significance of this order. When Ohio deregulated the electric industry effective January 1, 2001, CG&E was obligated to freeze its total electric rate as part of a legislatively mandated transition to market rates. This means that CG&E has had no opportunity to recover the approximately $242 million of net rate base additions we’ve made to our Ohio electric distribution system since 1992.

Even more important from the standpoint of our 2004 performance, the rate freeze meant that we had no opportunity to recover the substantially higher cost of fuel and emission allowances necessary to operate our Ohio generation fleet. By way of example, the market price of SO₂ emission allowances rose more than 200 percent in 2004 when compared to 2003. The rate stabilization plan allows us to begin recovering these higher costs from our Ohio commercial and industrial customers in 2005, and from our Ohio residential customers in 2006.

The rate stabilization plan also allows us to recover environmental expenditures, purchased power costs to maintain adequate capacity and energy reserves, and transmission costs related to the operation of the Midwest grid by the Midwest Independent Transmission System Operator (Midwest ISO) through 2008.

Proactive Environmental Steps: The EPA has been developing new rules to further restrict emissions from coal-fired power plants. These rules should go into effect in 2005. They will require additional reductions of SO₂ and NO_x emissions over and above the significant reductions we have achieved since 1990. They will also mandate the reduction of mercury emissions from our plants for the first time.

In anticipation of these rules, we filed a plan with the IURC last fall seeking pre-approval of expenditures to add scrubbers on PSI’s larger power plants. The plan would allow us to recover and account for financing costs (even during the construction phase) as well as ongoing operating and depreciation expense. By planning ahead, we hope to line up the necessary labor, materials and equipment for these scrubbers at the lowest possible cost. We anticipate IURC approval of our environmental compliance plan and rate recovery proposals by the end of the third quarter of 2005.

We also plan to construct scrubbers on Miami Fort Station Units 7 and 8 owned by CG&E. The Ohio rate stabilization plan provides for the recovery of costs associated with this effort through 2008. We currently estimate that the total cost of environmental compliance for all of our facilities will be approximately $1.8 billion between 2005 and 2009.

OPERATIONAL EXCELLENCE

Production: 2004 marked the fourth consecutive year in which Cinergy reported the lowest non-fuel operation and maintenance costs among the top 40 power generators in the United States, according to Platts PowerDat, an energy data provider. In fact, Cinergy’s costs were 59 percent lower than this benchmark group’s average.

Our generation teams kept our plants running at the highest availability in our history. Having our low-cost plants available to sell power for more hours continues to enhance our margin opportunity each year. As I noted earlier, over the next four years, the Ohio rate stabilization plan will substantially reduce the margin erosion we experienced in the past two years from higher fuel and emission allowance prices.

Transmission and Distribution: Our commitment to excellence extends to our electric transmission and distribution businesses, where our service cost per customer is 28 percent lower than the Midwest utility benchmark average. We rank among the best utilities in the three states in which we operate in terms of reliability, service restoration following storms and number of customer complaints.

The service of Cinergy’s customer call centers was recognized in 2005, when CG&E and PSI earned the distinction of being the first energy companies in the nation to achieve J.D. Power and Associates certification of call center excellence for providing “An Outstanding Customer Service Experience.”

The commitment of our people to go the extra mile was evident when disaster hit customers outside our service territory. Three times last year we sent more than 100 workers to assist Florida utilities with the massive power outages caused by the devastating hurricanes that hit the state. In recognition of this service, our employees received the Edison Electric Institute’s Emergency Response Award for their dedicated service during these disasters.

As a result of these and other achievements by our employees, Cinergy was named Power Company of the Year by Platts Publishing in their Global Energy Awards competition. Last December, I had the honor of accepting the award on behalf of our 7,800 employees, who every day honor our values and work hard to make our company succeed for all of our stakeholders.

Continuous Improvement: Last year, I challenged our people again to renew our commitment to excellence and efficiency. We called this effort “CIN-10,” which stands for Continuous Improvement Now — 10 years since the merger that created Cinergy. Our employees rose to the challenge.

They generated over 6,500 ideas that were thoroughly reviewed by me and the senior management team. We selected 900 ideas which, when implemented, will deliver approximately $50 million in savings in 2005.

The CIN-10 process is becoming part of our culture and discipline. As I did last year, I will again meet face to face this year with over 1,000 of our frontline supervisors, managers, senior managers and labor union leaders to listen to their issues and concerns. I learn from our employees every day. They set standards and accomplish tasks that show the power of collaboration, imagination and a commitment to excel. As a result, we continue to find ways to conduct our business more productively and efficiently.

COMMERCIAL BUSINESS UNIT

Our Commercial Business Unit continued to make profitable contributions to Cinergy’s overall growth in 2004. For example, we experienced gross margins on power marketing, trading and origination contracts that were $24 million higher than the previous year. We accomplished this result by trading approximately 185 million megawatt-hours of electricity with 286 active counterparties, placing this business in the top 10 U.S. power trading businesses. And, we accomplished this result in a very low risk manner — with an average daily value at risk (VaR) of only $1.3 million.

We moved approximately 1.5 billion cubic feet of gas per day to U.S. markets, managed 38.5 billion cubic feet of storage capacity, and traded approximately 52 billion cubic feet per day with 661 active counterparties. This performance placed our gas business in the top 10 U.S. gas trading businesses.

We delivered these results while conservatively managing risk exposure. Daily VaR for commercial gas in 2004 averaged approximately $1.8 million. Although growth in our gas margins was essentially flat in 2004, we took steps — such as the expansion of gas trading into Canada with our March acquisition of Calgary-based ProMark — that will position gas margins to continue contributing solidly to Cinergy’s earnings in 2005 and beyond.

Cinergy Solutions, which provides cogeneration, combined heat and power, and energy management and outsourcing services, continued to build its customer base for future growth. In 2004, Cinergy Solutions began operating its largest project ever, the 755-megawatt, gas-fired Texas City plant near Houston, Texas. This state-of-the-art project, which is jointly owned by BP and Cinergy Solutions, is significantly reducing emissions and was named Power magazine’s top plant in 2004.

We remain strongly committed to growing this business unit. You have my commitment that we will manage the necessary incremental risk required to meet our growth expectations.

STRENGTHENING OUR BALANCE SHEET

Over the past few years, we have been proactive in strengthening our balance sheet, improving our liquidity and protecting our credit quality. Since late 2001, we have raised over $1 billion in additional equity, including a $250 million issuance in December 2004. These steps have helped us steadily reduce our debt as a percentage of total capitalization over the last few years. We also increased our liquidity last year by expanding the capacity of our revolving lines of credit from $1 billion to $2 billion.

Our senior unsecured debt is currently rated BBB+, Baa2 and BBB by the major credit ratings agencies, and we remain committed to maintaining strong investment-grade credit ratings.

As I anticipate the investments that we will make to implement our environmental compliance plan and grow our businesses, I believe we are starting from a very solid position. And, as we have in the past, we will further strengthen this position through the continued issuance of equity each year under our various employee benefit and dividend reinvestment plans.

We believe that these steps — together with the improved cash flow from operations we expect as a result of the regulatory accomplishments I described earlier — will help to preserve our strong credit ratios over the long term.

READY FOR THE NEXT 10 YEARS

2004 was Cinergy’s 10th anniversary. I am proud to lead the great men and women who work for this company. They produced our decade of progress and I thank them for their accomplishments.

I want to thank our shareholders for investing in us over the long-term and our customers who give us the opportunity to exceed their expectations every day. I am grateful for the support of our board, our suppliers and partners, and for the vision of our policymakers and regulators. We look forward to continued stewardship in our communities. We all share a commitment to look out for the future generations. This is the common ground that unites us as stakeholders.

As you read the interviews on global warming in the next section, I believe you will find one attitude that runs through just about all the commentary — humility. It’s not a word you’d expect to find in an annual report. Yet it is fundamental if we are going to listen and learn from each other. Contrary to what some people believe, humility doesn’t lessen the strength and conviction of our leaders, but it can help to clear our vision. We need humility to successfully address an issue the size and scale of global warming.

In this report, we are experimenting with a collaborative process. We’ve asked our stakeholders to give us their perspectives on the global warming issue. It is a first step toward a collaborative decision-making process on this complex topic. We thank our stakeholders for sharing their candid thoughts and opinions, and most of all, for their willingness to work with us in finding common ground.

I believe in the possibilities of such a process to resolve this and other issues. My belief in the power of this process was furthered by a recent speech by Bill Ruckelshaus, former U.S. EPA administrator and a contributor to this annual report. On February 3, 2005, at the John H. Chafee Memorial Lecture on Science and the Environment in Washington, D.C., Bill said:

“ The value of utter transparency, inclusiveness and a willingness to listen and adapt is front and center an essential precept of our democracy. Increasingly for many of our environment and natural resource problems, we are seeking to resolve them by the use of collaborative processes.”

When you read the quotes from our stakeholders in the next section of this report and their interviews on Cinergy.com, you will learn a lot from their wisdom about what’s at stake for the future of our world and our company. Based on their perspectives and their passion to find common ground on global warming, I am optimistic about Emma’s, and all of my grandchildren’s, future on this planet.

James E. Rogers
President, Chief Executive Officer and
Chairman of the Board
March 1, 2005