oversight

Tennessee Valley Authority: Assessment of the 10-Year Business Plan

Published by the Government Accountability Office on 1999-04-30.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                  United States General Accounting Office

GAO               Report to Congressional Requesters




April 1999
                  TENNESSEE VALLEY
                  AUTHORITY

                  Assessment of the
                  10-Year Business Plan




GAO/AIMD-99-142
                   United States
GAO                General Accounting Office
                   Washington, D.C. 20548                                                                                  Leter




                   Accounting and Information
                   Management Division

                   B-281916                                                                                      Letter

                   April 30, 1999

                   The Honorable Bob Franks
                   The Honorable Marty Meehan
                   The Honorable Zach Wamp
                   The Honorable Bob Clement
                   House of Representatives

                   This report responds to your June 5, 1998, and September 24, 1998, requests
                   asking us to review the Tennessee Valley Authority’s (TVA) 10-year
                   business plan. Increasing competition in electricity markets led TVA
                   management to develop this plan to position TVA to be more competitive
                   by, among other things, reducing its high debt servicing and other fixed
                   costs. Because of concerns about TVA’s ability to achieve the 10-year plan’s
                   objectives by 2007—when competitive pressures are likely to be greater
                   and when many of TVA’s long-term contracts could expire—you asked us to
                   determine whether TVA will be able to reduce debt as envisioned in the
                   plan and whether its goals and assumptions regarding capital expenditures
                   and revenues and expenses are achievable or reasonable.

                   In order to obtain more information about TVA’s competitive position as
                   you consider its role in a deregulating electricity industry, you specifically
                   asked us to determine whether the 10-year plan (1) addresses key issues
                   facing TVA, (2) takes into consideration all applicable costs and revenue
                   sources, (3) contains goals and assumptions that are achievable or
                   reasonable and in line with industry estimates and expectations, and
                   (4) has been updated to reflect significant changes in key goals and
                   assumptions or actual experience. In addition, you asked us, based on our
                   analysis of the plan, to conclude whether TVA is likely to achieve the plan’s
                   strategic objectives.



Results in Brief   Implementation of the 10-year plan is moving TVA in the right direction
                   toward its strategic objectives by addressing the key issues it faces—its
                   high fixed financing costs and large investment in nonproducing and other
                   deferred assets1 that have not been recovered through rates. The plan,
                   which was issued in July 1997, calls for lowering fixed costs by reducing


                   1
                     Deferred assets consist of nonproducing nuclear generating units and unamortized regulatory assets.
                   At the time the plan was issued, the balances of these items were $6.3 billion and $2.2 billion,
                   respectively. The costs of these assets have been deferred and have not been recovered through rates.




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outstanding debt by about one-half—to about $14 billion—by 2007. The
plan also provides for the recovery through rates of all but about
$500 million of the $8.5 billion in deferred assets outstanding as of the plan
issuance date.

The year 2007 is key for TVA because it expects to face greater competitive
pressures by then and because many long-term contracts with customers
could expire at about that time. As a result, the plan emphasizes changes
designed to enable TVA to offer competitive rates by the end of 2007. The
more progress TVA makes toward addressing the key issues it faces while it
maintains its legislative protections and before its customer contracts
could begin to expire, the better positioned it will be to successfully
operate in a competitive market.

While focusing on the right issues, TVA’s plan does not fully address certain
costs. Not addressing these costs could jeopardize full achievement of the
plan’s objectives. Specifically, the plan does not include (1) the capital
costs of increasing generating capacity to meet the growth in demand for
power as is now currently planned; instead, it provides for meeting the
growth in demand for power by purchasing power from other utilities,
(2) the cost of complying with new and proposed environmental
regulations, and (3) the cost of nonpower programs that were formerly
fully funded through appropriations. TVA estimates that these additional
costs will total about $1 billion over the remaining life of the plan and will
likely be higher.

We also found that while many of the plan's goals and assumptions were
achievable or reasonable, certain of them were not, largely due to the
additional expected costs described above. For example, the plan calls for
capital expenditures to be limited to about $600 million per year, which is
not feasible given the additional costs that will likely be incurred to comply
with new environmental regulations and to invest in new generating
capacity to meet growth in demand for power. However, some of these
additional costs could be offset by increases in expected market rates of
power in 2007. Specifically, since many power producers will incur
additional costs for the new and proposed environmental regulations, it is
anticipated that the market price of power will increase across the board to
help absorb these costs. However, the extent to which different producers
will be affected, and the resultant impact on their power prices, is unknown
at this time.




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             Because of the additional costs not addressed in the 10-year plan, it is
             unlikely that TVA can reduce its debt to the extent planned by 2007.
             Estimates in TVA’s fiscal year 2000 federal budget request indicate that its
             debt reduction goal will likely not be achieved until 2009. The added costs
             will also negatively impact TVA’s ability to meet its goal of reducing the
             balance of its deferred assets, since TVA may not have the ability to begin
             recovering these costs through rates if it does not sufficiently reduce its
             other costs first. Achieving these goals is key to TVA meeting its strategic
             objective of increasing financial flexibility by reducing fixed costs. This in
             turn is key to its ability to offer competitively priced power in 2007—TVA’s
             ultimate objective.

             However, since it is not possible to accurately predict what the market
             price of power will be in 2007, TVA could still achieve its objective of
             offering competitively priced power, even if it does not fully achieve the
             plan’s other goals and objectives. Conversely, depending on the market
             price of power, TVA could fully achieve all of the goals and objectives
             outlined in the plan and still not be positioned to offer competitively priced
             power in 2007 and beyond. Nevertheless, any progress it makes toward its
             goals and objectives will put TVA in a better competitive position.

             While TVA has acknowledged major changes to several of the plan’s goals
             and assumptions and has factored these into its internal planning, the
             10-year plan has not been formally updated to reflect these changes. Until
             the plan is formally updated, the Congress and other external users of the
             plan will not have the current information needed to make policy,
             oversight, and investment decisions related to TVA. Because of this, we
             have recommended that TVA (1) move quickly to formally update the plan
             and (2) periodically report to the Congress and other plan users about its
             progress toward meeting the plan’s objectives.



Background   The Energy Policy Act of 1992 (EPAct) provides TVA with certain
             protections from competition. Additionally, under the TVA Act of 1933
             (TVA Act), as amended, TVA is not subject to most of the regulatory and
             oversight requirements that must be satisfied by commercial electric
             utilities; instead, all authority to run and operate TVA is vested in its three-
             member board of directors. In 1959, the Congress amended the TVA Act by
             establishing what is commonly referred to as the TVA “fence,” which
             prohibits TVA—with some exceptions—from entering into contracts to sell
             power outside the service area that TVA and its distributors were serving
             on July 1, 1957. Under EPAct, TVA is exempt from having to allow other



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utilities to use its transmission lines to transmit power to customers within
TVA’s service area. This legislative framework generally insulates TVA
from direct wholesale competition and, as a result, TVA remains in a
position similar to a regulated utility monopoly.

However, TVA is still subject to some forms of indirect competition. For
example, TVA has no protection against its industrial customers relocating
outside its service area or businesses deciding not to move to its service
area for reasons related to the cost of power. In addition, customers can
decide to generate their own power. Accordingly, TVA is currently subject
to some competitive pressures.

EPAct’s requirement that utilities make their transmission lines accessible
to other utilities to transmit (wheel) wholesale electricity has enabled
wholesale customers to obtain electricity from a variety of competing
suppliers and has resulted in increased wholesale competition in the
electric utility industry across the United States. This requirement does not
apply to TVA if the power is going to be consumed within its service
territory. Most of TVA’s sales are wholesale because they are to its power
distributors. In addition, continuing deregulation efforts in some states
have led to competition at the retail level. Industry experts expect that
retail deregulation will continue to occur on a state-by-state basis over the
next several years. As this occurs, industrial, commercial, and, ultimately,
residential consumers will be able to choose their power supplier from
among several competitors rather than from one utility monopoly, as is
now the case for long distance telephone service and cellular phones.

Because EPAct exempts TVA from having power wheeled to consumers in
its territory, TVA has not been directly impacted by the ongoing
deregulation of the electric utility industry to the same extent as other
utilities. However, if TVA were to lose its exemption from the wheeling
provisions of EPAct, its customers would have the option of obtaining their
power from other sources after the expiration of their contracts. Under
legislation proposed by the administration to promote retail competition in
the electric power industry, which TVA supports, TVA's exemption from the
wheeling provisions of EPAct would be eliminated after January 1, 2003. If
the legislation is enacted, TVA may be required to use its transmission lines
to transmit the power of other utilities for consumption within TVA's
service territory. In addition, the proposed legislation would remove the
statutory restrictions that prevent TVA from selling power outside its
service territory.




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Most of TVA’s power is sold to municipal and cooperative power
distributors who would be directly affected in the future by retail
competition through their customers’ ability to choose alternate power
suppliers. Further, deregulation and the possibility of TVA losing its
legislative protections have made many of TVA’s customers more aware of
price differences among utilities, raised expectations of lower prices, and
increased demands for more competitive pricing.

Because of these ongoing deregulation efforts, TVA management, like many
industry experts, anticipates that TVA may lose its legislative protections in
the future. Even if TVA does not lose its legislative protections, TVA’s
management has recognized the need to take action to better position TVA
to be competitive in an era of increasing competition and customer choice
and, in July 1997, issued a 10-year business plan with that goal in mind.
TVA established a 10-year horizon for implementing the key changes
outlined in the plan largely because TVA officials expect to be facing
greater competitive pressures within that time frame and many of its long-
term contracts with customers could begin to expire in 2007. The
published plan, which formed the basis of our evaluation, contains three
strategic objectives:

• reducing TVA’s cost of power in order to be in a position to offer
  competitively priced power in 2007,
• increasing financial flexibility by reducing fixed costs, and
• building customer allegiance.

In developing the 10-year plan, TVA set several goals and made certain
assumptions about the future.2 These goals and assumptions are that

• the future market price of wholesale power will be 3.4 to 3.5 cents per
  kilowatthour3 (kWh) by 2007;
• annual growth in demand through 2007 will average 2 percent;
• fuel costs will increase 1.7 percent annually through 2007;
• improvements in supply chain management4 will save $50 million
  annually;


2
    Dollars discussed in this report are nominal dollars.

3A    kilowatthour is 1,000 watthours. A watthour is equal to 1 watt of power applied for 1 hour.

4
  Supply chain management is a comprehensive process that begins with examining the need for the
product, progresses through procurement, and ends with utilization or disposition.




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• TVA’s labor force will be reduced and additional cost savings will be
  achieved through the creation of shared services5 and other initiatives;
• debt will be reduced by about one-half to about $14 billion, and the
  balance of deferred assets will be reduced from $8.5 billion to
  $500 million—TVA’s estimated net realizable value of these assets;6
• capital expenditures will be limited to about $600 million annually and
  increases in demand through 2007 will be met primarily through
  purchased power;
• $200 million will be saved annually through cost improvement initiatives
  primarily related to refinancing Federal Financing Bank (FFB) and
  public bond debt, pursuing changes to its retirement plan, and
  improving business processes;
• revenues from power sales will be increased by about $325 million
  annually by implementing a rate increase in 1998 and maintaining it
  through 2007; and
• customer relations will improve through new contract and pricing
  options.

To implement the 10-year plan, TVA has developed action plans and has
linked the goals and objectives of the 10-year plan to its corporate and
business unit goals. For example, one of TVA’s corporate goals is to lower
costs; one of the 10-year plan’s strategic objectives is to increase financial
flexibility by reducing fixed costs; and the Fossil and Hydro Power
business unit’s business plan includes a unit goal of maximizing net return
by reducing fixed and variable costs.7 However, TVA has not yet completed
the process of developing performance measures to provide accountability.
TVA expects to develop these performance measures later in 1999,
business units will be expected to meet performance goals in 2000, and unit
managers and TVA executives are expected to be held directly accountable
through the use of compensation incentives in 2001.




5
  Shared services involve consolidating similar operations from various business units and thereby
reducing duplicative efforts.

6While not specifically discussed in the published plan, TVA’s supporting materials establish a goal of
recovering about $8 billion in nonproducing nuclear generating units and unamortized regulatory assets
(deferred assets) by 2007 in conjunction with its reduction of debt.

7
  Fixed costs (such as interest expense) remain fairly constant and do not fluctuate with the volume of
production. Variable costs (such as fuel) fluctuate in the same manner as the volume of production.




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Objectives, Scope, and   We evaluated the three strategic objectives of TVA’s plan and the underlying
                         goals and assumptions for reasonableness, achievability, and
Methodology              completeness. As agreed with your offices, we did not (1) assess whether
                         achieving the objectives of the plan would ensure TVA’s future
                         competitiveness or (2) develop independent estimates of key elements of
                         the plan, such as the future market price of power. We relied on
                         comparisons of past performance to future projections, the opinions of
                         industry experts, and economic forecasts made by knowledgeable sources
                         to determine whether the individual components of the plan and the plan as
                         a whole were achievable or reasonable. Additional information on our
                         objectives, scope, and methodology is contained in appendix I.

                         We conducted our review from June 1998 through April 1999 in accordance
                         with generally accepted government auditing standards. We provided a
                         draft of this report to TVA for comment. While generally agreeing with the
                         report’s contents, TVA did provide oral and written comments, which we
                         have incorporated, as appropriate. TVA’s written comments are
                         reproduced in appendix II.



Plan Objectives          Implementation of the 10-year plan is moving TVA in the right direction and
                         addresses important issues facing TVA: its high fixed financing costs and
Address Key Issues       limited financial flexibility to respond to competitive pressure and the large
Confronting TVA          amount of deferred assets that have not been recovered through rates.
                         These deferred assets, which totaled about $8.5 billion as of the beginning
                         of the plan period, are primarily the result of investments made since the
                         1970s in nuclear generating plants that were never put into production.
                         This helped contribute to TVA’s large debt, which totaled about $27 billion
                         as of September 30, 1998, and resultant high fixed financing costs.

                         TVA’s ability to meet its strategic objective of being in a position to offer
                         competitively priced power by 2007 and to improve its financial flexibility
                         hinges largely on its being able to meet its goal of reducing debt by about
                         one-half—to about $14 billion—by 2007. While not specifically stated in
                         the plan, TVA also plans to recover through rates all but $500 million of its
                         deferred asset costs by the end of the period covered by the plan. 8



                         8
                           The remaining $500 million is TVA’s estimate of the net realizable value of its deferred assets at the end
                         of 2007.




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                        These issues were highlighted in reports9 we issued in 1995 and 1997, in
                        which we stated that TVA’s annual financing costs and deferred assets were
                        substantially greater than those of the utilities with which TVA would most
                        likely have to compete. We also reported that these high fixed costs and
                        deferred assets would limit TVA’s flexibility to adjust its rates in a
                        competitive environment. TVA, through its 10-year plan, is taking steps to
                        address these issues. Other utilities are taking similar actions to prepare
                        for competition. For example, utilities we previously identified as those
                        most likely to compete with TVA are also taking steps to refinance debt at
                        lower interest rates and accelerate recovery of the costs of their regulatory
                        assets. However, as we reported in 1995 and 1997, these other utilities
                        generally have fewer financing costs and deferred assets than TVA, giving
                        them more flexibility to respond to changing market conditions. To the
                        extent TVA recovers the costs of its deferred assets and increases its
                        financial flexibility, it will increase its ability to adjust rates as necessary to
                        meet changing market conditions. TVA’s focus on these areas before the
                        full advent of competition is key to its chances of being competitive
                        without legislative protections.



Plan Does Not Include   The 10-year plan includes costs that correspond to those incurred in prior
                        years and to those reported by other utilities. In addition, the plan
Certain Major Costs     considers costs for Year 2000 compliance10 and likely environmental
                        expenditures under existing Comprehensive Environmental Response,
                        Compensation, and Liability Act (CERCLA) and Resource Conservation
                        and Recovery Act (RCRA) regulations.11 However, the plan does not



                        9
                         Tennessee Valley Authority: Financial Problems Raise Questions About Long-term Viability (GAO/
                        AIMD/RCED-95-134, August 17, 1995) and Federal Electricity Activities: The Federal Government’s Net
                        Cost and Potential for Future Losses (GAO/AIMD-97-110 and 110A, September 19, 1997).

                        10The  Year 2000 problem is rooted in the way dates are recorded and computed in many computer
                        systems. For the past several decades, systems have typically used two digits to represent the year—
                        such as “98” for 1998—to save electronic data storage space and reduce operating costs. With this two-
                        digit format, however, the year 2000 is indistinguishable from 1900, 2001 from 1901, and so on. As a
                        result of this ambiguity, system or application programs that use dates to perform calculations may
                        generate incorrect results when working with years after 1999. We verified that TVA’s plan had
                        considered the cost for Year 2000 compliance. However, we did not determine whether TVA would be
                        Year 2000 compliant or assess its estimated costs for becoming compliant.

                        11
                          CERCLA (as amended) governs cleanup of both federal and nonfederal hazardous waste sites. RCRA
                        addresses prevention and remediation of releases of hazardous waste from both current and past
                        industrial operations. As a power producer, TVA has been identified by the Environmental Protection
                        Agency as a potentially responsible party for releases from various sites.




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                               include certain major costs. Specifically, the plan does not include the
                               following:

                               • The capital costs of additional generating capacity that may be acquired
                                 to meet growth in demand for power. The plan assumes that TVA would
                                 meet the increasing demand for power over the plan period by
                                 purchasing power from other utilities. The costs of the power
                                 purchases are reflected as operating costs in the 10-year plan.
                               • The cost of complying with new environmental regulations.
                               • The cost of nonpower programs that, to date, have been funded
                                 primarily through appropriations. These appropriations, which
                                 amounted to $70 million in fiscal year 1998, are expected to be
                                 substantially reduced or discontinued beginning in fiscal year 2000.

                               By not including these costs, TVA will have less cash than contemplated in
                               the plan to pay down debt and reduce fixed costs, which could jeopardize
                               full achievement of the plan’s objectives.


Plan Does Not Include Costs    TVA estimates that the demand for peaking power12 in its service territory
Associated With Investing in   through 2007 will exceed its current and planned generating capacity. TVA
                               currently has several options planned or underway to meet a portion of this
New Generating Capacity
                               excess demand, including (1) purchasing new gas-fired combustion
                               turbines, (2) purchasing power that was already under contract when the
                               10-year plan was issued, (3) modernizing hydro facilities, (4) improving the
                               efficiency of certain existing fossil plants and combustion turbines,
                               (5) contracting for the power from a new lignite13 plant, (6) upgrading
                               certain nuclear plants, and (7) issuing a request for proposal for purchasing
                               power generated from renewable resources. TVA projected that these
                               measures would not be sufficient to meet the entire increase in demand,
                               and the 10-year plan assumes that TVA will purchase power from other
                               utilities to make up the difference, which is inconsistent with prior year
                               practices.

                               However, since the plan was finalized, TVA officials have told us that they
                               plan to evaluate other power supply options and to invest in new capacity if


                               12Peakingunits are used to meet the demand for power that exceeds the capacity of generating
                               equipment that is operated to meet normal demand.

                               13
                                 Lignite is low-grade coal with high moisture and volatile matter content that is used almost
                               exclusively for electric power generation.




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                              the resulting long-term increase in costs to produce power (interest and
                              operating expense) would ultimately be less than the cost of purchased
                              power. TVA has already decided to invest in new capacity rather than
                              purchasing power in at least one case—in 1998, TVA announced plans to
                              purchase eight gas-fired combustion turbine units14 that will be used to
                              replace a like amount of purchased peaking power that was assumed in the
                              original plan.

                              According to TVA officials, while they expect this decision to result in a
                              positive cash flow by fiscal year 2010, the decision to purchase these units
                              will require about $65 million more in cash disbursements through 2007
                              than would have been necessary to purchase a comparable amount of
                              power from other utilities. But, according to TVA’s analysis, while
                              acquiring this new generating capacity in lieu of purchasing power will
                              initially increase capital expenditures and thus reduce the amount of cash
                              available to pay down debt, it will also decrease TVA’s annual cost of power
                              because it will be less expensive for TVA to operate this new equipment
                              than to purchase a like amount of power from other utilities. Decreasing
                              the cost of power should, in the long term, improve TVA’s ability to meet its
                              ultimate objective of offering competitively priced power. In addition,
                              purchasing new generating capacity provides the added benefit of
                              removing the uncertainty of having to rely on another utility for power.
                              Based on our discussions with TVA officials, while it may make economic
                              sense in the long term, additional decisions to increase capacity in lieu of
                              purchasing power from other utilities will likely further reduce TVA’s cash
                              available for debt reduction through 2007, thus jeopardizing its ability to
                              fully meet the plan’s debt reduction goals by 2007.


Plan Does Not Include Costs   The 10-year plan does not include estimated costs of complying with recent
of Complying With             and proposed environmental regulations because TVA did not believe the
                              costs were estimable at the time the plan was developed. Since that time,
Environmental Regulations
                              some of these costs have become estimable.

                              In October 1998, the Environmental Protection Agency (EPA) issued a
                              regulation requiring states to develop plans to reduce nitrogen oxide
                              emissions. TVA now estimates that it could spend about $500 million to
                              $600 million for capital modifications to its fossil plants to comply with


                              14
                                TVA estimates that these new units will produce about 576 megawatts of power each year beginning
                              in fiscal year 2000.




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                              state plans that would be implemented under this regulation, which is
                              commonly referred to as the NOx SIP Call.15 The time frame for TVA’s
                              compliance with the states’ plans is 2003, within the scope of the 10-year
                              plan. In October 1998, EPA also issued a proposed regulation regarding
                              regional haze,16 which EPA expects to be put into effect during the life of
                              the plan but for which EPA does not expect compliance until after 2004.
                              TVA has estimated that this regulation could require capital expenditures of
                              about $450 million to $500 million. It is likely that at least a portion of these
                              costs will be incurred during the time frame of the 10-year plan. 17
                              Additionally, all of the estimated $500 million to $600 million in costs
                              related to the NOx SIP Call will be incurred during the plan time frame and,
                              thus, will negatively impact TVA’s ability to meet its cost reduction goals.18
                              However, as discussed later, TVA officials told us that they still believe TVA
                              will be in a position to offer competitively priced power in 2007 because
                              these same types of costs will be incurred by many other power suppliers
                              and therefore would tend to increase the future market price of power.


Plan Does Not Include Costs   The plan does not include the costs of nonpower programs that historically
of Nonpower Programs          have been funded through appropriations but now are likely to be funded
                              through power revenues. The plan assumes that TVA will continue to
Formerly Funded Through
                              receive appropriations for its nonpower programs, such as flood control
Appropriations                and navigation. While this assumption was reasonable when the plan was
                              developed, TVA’s nonpower appropriations have been sharply curtailed in
                              recent years, from $109 million in fiscal year 1996 to only $7 million in TVA’s
                              budget request for fiscal year 2000.19




                              15
                                   63 Fed. Reg. 57356, 57491 (1998) (to be codified at 40 C.F.R. pt. 51).

                              16
                               63 Fed. Reg. 56394 (1998) (to be codified at 40 C.F.R. pts. 52 and 98) (proposed Oct. 21, 1998).
                              Regional haze concerns visibility problems from airborne particles.
                              17
                                TVA estimates that the impact of the NOx SIP Call and regional haze regulation on the future market
                              price of power would be to increase it by up to .3 cents per kWh. As is discussed later, this also impacts
                              TVA’s projection for its target price of power in 2007.

                              18In addition to the EPA regulations, the Kyoto Protocol--an international treaty to reduce net emissions
                              of certain greenhouse gases--could impact the future market price of power. Because the treaty has not
                              been ratified, the methods to be used and time frame for compliance have not been established.
                              Therefore, the 10-year plan appropriately does not address costs related to the treaty.

                              19
                               As of April 21, 1999, the appropriations bill containing TVA's requested appropriations had not been
                              passed.




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                      TVA officials have indicated publicly that future appropriations for
                      nonpower programs are likely to be eliminated or substantially reduced
                      and, in accordance with the fiscal year 1998 Energy and Water
                      Development Appropriations Act, have indicated they will use power
                      revenues to continue these nonpower activities. These costs totaled
                      approximately $70 million in fiscal year 1998 and are expected to range
                      from about $50 million to $60 million annually in the future.20 Since
                      funding nonpower activities with power revenues was not assumed in the
                      10-year plan, these costs will further reduce the cash available to reduce
                      debt to the level envisioned in the plan.



Seven Key Goals and   We assessed 10 goals and assumptions TVA made about the future in
                      developing the 10-year plan. Based on economic forecasts, comparisons
Assumptions Are       with TVA’s results of past operations, and the opinions of industry experts,
Achievable or         we concluded that seven of the goals and assumptions were achievable or
                      reasonable, two were unachievable, and one was uncertain. The goals and
Reasonable, While     assumptions we assessed, and our conclusions about each, are summarized
Three Are             in table 1 and discussed in detail in the following sections.
Unachievable or
Uncertain
                      Table 1: GAO Conclusions About the 10-Year Plan’s Goals and Assumptions

                      Goal or assumption assessed                                           GAO conclusion
                      Future market price of power                                          Reasonable
                      Increase in demand for power                                          Reasonable
                      Increase in fuel costs                                                Reasonable
                      Supply chain savings                                                  Achievable
                      Labor force reductions                                                Reasonable
                      Debt reduction and recovery of deferred assets                        Unachievable
                      Capital expenditure limitation                                        Unachievable
                      Cost improvement initiatives                                          Achievable
                      Increased revenues                                                    Uncertain
                      Customer relations improvements                                       Achievable




                      20
                        TVA officials have indicated that they will seek to identify and implement operating efficiency
                      measures that are expected to reduce the costs associated with nonpower programs without affecting
                      program operations.




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Assumption About the     TVA’s assumption about the future market price of wholesale power is
Future Market Price of   important to the success of the plan because it establishes a target that TVA
                         must achieve in order to offer what it considers to be competitively priced
Power Is Reasonable
                         power in 2007. TVA estimated that the price of wholesale power in 2007
                         would fall between 3.0 cents to 3.7 cents per kWh, with its best estimate
                         being 3.4 to 3.5 cents per kWh. The Energy Information Administration
                         (EIA) within the Department of Energy (DOE) estimated that the price of
                         wholesale power in 2007 would be 3.69 cents per kWh, while Standard and
                         Poor’s DRI21 estimated that it would be 3.91 cents per kWh. The combined
                         range of EIA and DRI estimates was 3.57 cents to 4.35 cents per kWh.22
                         Since TVA’s projection of the future market price of power in the 10-year
                         plan is lower, TVA is forced to be aggressive in pursuing its options to
                         reduce costs and increase revenue.

                         TVA officials said that if they were to prepare the 10-year plan today, their
                         projection for the market price of wholesale power in 2007 would increase
                         to between 3.5 and 3.8 cents per kWh, due primarily to new environmental
                         regulations. TVA officials stated that the new environmental regulations
                         would likely drive up the market price of power and affect many utilities
                         similarly. Any upward revision in the projected price of wholesale power in
                         2007 would have a positive impact on TVA’s ability to achieve the objectives
                         of the plan and would help offset some of the previously identified costs
                         that are not currently considered in the plan—specifically, costs for the
                         new environmental regulations.

                         However, the extent to which new environmental regulations affect any
                         utility depends on the type and condition of its generating equipment, the
                         portion of its power generated by coal, and the types of controls it chooses
                         to meet the new environmental regulations. Although, in aggregate, the
                         mix of generating plants among investor-owned utilities in the states that
                         border on TVA’s service territory is similar to its own, TVA and these
                         utilities will not necessarily all be affected equally, depending on the
                         condition of their equipment and the compliance options they choose.


                         21DRI is an economic forecasting and consulting company with expertise in the energy industry. DRI
                         did not project the future market price of wholesale power based on the same criteria as TVA and EIA;
                         we extrapolated an estimate from the data it provided.

                         22
                           In all cases, data from other sources is not 100 percent comparable to TVA’s data because of slight
                         differences in geographic boundaries, timing differences (for example, TVA’s plan was developed in
                         mid-1997 and we conferred with other sources in late 1998 and early 1999), and possible differences in
                         methodologies.




                         Page 13                                            GAO/AIMD-99-142 Tennessee Valley Authority
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                            Therefore, the relative impact of the new and proposed environmental
                            regulations on TVA, its neighboring utilities, and the market price of power
                            is uncertain.


Assumption About the        The 10-year plan assumes that the increase in demand for power in TVA’s
Increase in Demand for      service region will average 2 percent per year over the plan period. While
                            TVA’s recent historical increase in demand for power has averaged over 3
Power Is Reasonable
                            percent annually, TVA officials were conservative in this regard because
                            they do not expect this level of growth in demand to continue. We obtained
                            other estimates of the increase in demand for power in TVA’s geographic
                            area from EIA, DRI, and ICF Kaiser Consulting Group, an organization
                            hired by the Edison Electric Institute (EEI), an industry group for investor-
                            owned utilities, to analyze TVA’s 10-year plan.23 Their estimates of growth
                            in demand ranged from 1.7 percent to 2.5 percent. TVA’s assumption about
                            growth in demand for power is reasonable based on this range of estimates
                            established by industry experts.


Assumption About the        The 10-year plan assumes that TVA’s fuel cost, including its mix of both
Increase in Fuel Costs Is   nuclear and coal as a fuel source, will increase 1.7 percent annually over
                            the plan period. We obtained a cost increase estimate of 1.4 percent
Reasonable
                            annually from EIA, which was based on a blended coal and nuclear fuel
                            mix. We also obtained a cost increase estimate of 2.2 percent annually
                            from DRI, which was based on using only coal as a fuel. Based on the
                            range of these estimates, TVA’s assumption about fuel costs is reasonable.

                            To control fuel costs, TVA officials stated that they competitively bid all
                            coal contracts, use a cost model to determine which type of coal to
                            purchase, and have reduced inventories to save carrying costs. These fuel-
                            handling initiatives are expected to reduce fuel expense by $1.6 million per
                            year. In addition, TVA has expanded its by-product program24 and expects
                            revenue from this program to be over $5 million per year. TVA’s efforts to



                            23Although  ICF was hired to analyze TVA’s 10-year plan by utilities that would likely compete with TVA
                            in a deregulated environment and therefore lacks independence in this instance, ICF does offer
                            specialized knowledge of TVA and surrounding areas. We did not rely exclusively on ICF for
                            confirmation of TVA’s assertions.

                            24
                              By-products are produced from burning coal. Under the by-product program, TVA avoids certain
                            disposal costs and generates revenues from the sale of ash for ready-mix concrete, gypsum for
                            wallboard, and structural landfill products.




                            Page 14                                            GAO/AIMD-99-142 Tennessee Valley Authority
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                         control these costs are positive steps toward the plan’s cost reduction
                         goals.


Goal for Supply Chain    The 10-year plan assumes that improvements made to supply chain
Savings Is Achievable    management will save, on average, $50 million per year over the 10 years
                         covered by the plan. And, by expanding its supply chain management
                         efforts in the future, TVA officials believe that they can increase efficiency,
                         save money, and maintain quality. For example, through contract
                         management improvements, TVA expects to realize cost savings by
                         consolidating its blanket purchasing contracts, reducing the number of
                         small purchase orders, and renegotiating the terms and conditions of its
                         purchases.

                         From the publication of the 10-year plan in July 1997 through September
                         1998, TVA had documented savings of about $75 million, some of which
                         represents categories of savings that should occur on a monthly basis. The
                         balance represents savings on individual purchases and other procurement
                         initiatives, some of which may also recur. As TVA implements additional
                         supply chain management initiatives and applies lessons learned from
                         industry and individual plants to other TVA functions, supply chain savings
                         are expected to increase. For the first 6 months of fiscal year 1999, TVA
                         documented savings of about $37 million, or about $6.2 million per month.
                         Of the $6.2 million, about $4.9 million should recur monthly. On an annual
                         basis, TVA’s supply chain savings are therefore likely to be at least
                         $59 million, making this goal achievable.


Assumption About Labor   The 10-year plan assumed that TVA would reduce its labor costs by
Force Reductions Is      reducing its labor force size from 14,960 at June 30, 1997, to 14,275 by
                         September 30, 1997. Although TVA did not achieve this staffing level by
Reasonable
                         September 30, 1997, it had reduced staff to 14,194 by December 31, 1997,
                         and to 13,818 by September 30, 1998. Since TVA has exceeded its labor
                         force reduction goal, the corresponding cost savings will be greater than
                         originally anticipated.

                         In addition, TVA has taken or planned a number of other actions that will
                         further help reduce labor costs, including

                         • negotiating compensation levels with one of its large unions, which TVA
                           expects will help to curtail the rise in future labor costs,




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                           • replacing higher paid employees with lower paid employees as its aging
                             workforce retires, and
                           • implementing a “shared services” concept, which involves consolidating
                             similar operations and reducing duplicative efforts.

                           Although TVA did not quantify the dollar savings it expects through its
                           labor initiatives, TVA’s current efforts in this area should help it reduce
                           costs.


Debt Reduction and         The 10-year plan calls for reducing debt by about one-half to about
Deferred Assets Recovery   $14 billion by 2007. This reduction, in turn, would lower TVA’s annual
                           interest costs by half—from about $2 billion in 1997 to about $1 billion in
Goals Are Unachievable
                           2007. The additional cash that is made available as debt is paid down and
                           interest costs are reduced can be used to further reduce debt. This
                           interrelationship is integral to meeting the debt reduction goal. In addition
                           to reducing interest costs by reducing debt, TVA is pursuing other interest
                           savings by refinancing outstanding debt, as discussed later in this report.

                           TVA’s ability to meet its strategic objective of being in a position to offer
                           competitively priced power by 2007 depends, to a large extent, on meeting
                           its debt reduction goal. The plan calls for the cash flow needed to achieve
                           this debt reduction to be provided by a combination of planned revenue
                           enhancements, cost savings initiatives, and capital expenditure limitations.
                           However, as discussed previously, the plan excluded additional capital
                           costs related to investing in new generating capacity to meet growth in
                           demand for power, complying with new environmental regulations, and
                           funding nonpower programs that were previously funded through
                           appropriations. As shown in figure 1, TVA exceeded its debt reduction
                           goals for the first 2 years of the plan but does not expect to meet its original
                           estimates for the remaining years due to the additional capital expenditures
                           for new generating capacity and environmental regulations discussed
                           previously.




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Figure 1: Comparison of Planned to Actual and Revised Annual Debt Reduction Plan
                      2,500




                      2,000




                      1,500
Dollars in millions




                      1,000




                       500




                         0
                              1996   1997   1998           1999          2000           2001   2002        2003           2004          2005   2006   2007
                                                   Actual and Revised Debt Reduction Planned          Original Debt Reduction Planned



                                                                  Source: GAO analysis based on data from TVA.


                                                                  As a result of changes in certain of its cost estimates, TVA now does not
                                                                  expect to reduce debt by one-half until fiscal year 2009, about 2 years after
                                                                  the plan’s original target date. This revised goal is reflected in TVA’s fiscal
                                                                  year 2000 federal budget request. TVA’s original and revised debt reduction
                                                                  timetable is shown in figure 2.




                                                                  Page 17                                           GAO/AIMD-99-142 Tennessee Valley Authority
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                      Figure 2: Original and Revised Debt Reduction Timetable
                                                                                                              Actual and Revised Debt Reduction
                                                                                                              Timetable

                                             30

                                             25
                       Dollars in billions



                                             20

                                             15

                                             10                     Original Debt Reduction Timetable
                                                                                                                                                        $13.8 billion

                                              5

                                                  0
                                                      1996
                                                             1997
                                                                    1998
                                                                           1999
                                                                                  2000

                                                                                         2001

                                                                                                2002

                                                                                                       2003

                                                                                                              2004

                                                                                                                     2005

                                                                                                                            2006

                                                                                                                                   2007

                                                                                                                                          2008

                                                                                                                                                 2009
                                                                             Fiscal years




                      Source: GAO analysis based on data from TVA.


                      TVA’s planned revenue enhancements and cost savings were also intended
                      to provide TVA with the opportunity to recover a portion of the cost of its
                      deferred assets. As noted previously, TVA expects to recover all but about
                      $500 million–its estimated net realizable value–of the deferred assets.
                      However, TVA’s ability to include the costs of these assets in its rates
                      without further rate increases is directly related to its ability to meet the
                      plan’s revenue and cost savings targets. To the extent TVA does not
                      recover the cost of its deferred assets while it is legislatively protected
                      from competition, competitive pressures could prevent it from selling
                      power at rates sufficient to recover the cost of these assets indefinitely.


Capital Expenditure   The plan assumes that capital expenditures will be limited to about
Limitation Goal Is    $600 million per year and excludes any capital costs for increasing
                      generating capacity and complying with new environmental regulations.
Unachievable
                      However, as discussed previously, known environmental costs alone are an
                      estimated $500 million to $600 million. In addition, costs for complying
                      with a proposed environmental regulation that is likely to be implemented
                      within the plan period could amount to another $450 million to



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                             $500 million, some of which would be incurred before 2007. Also, the costs
                             for meeting growth in demand for power with additional generating
                             capacity, which are not fully estimable at this time, could further increase
                             TVA’s required capital expenditures within the period covered by the 10-
                             year plan.25 Even though upward revisions in TVA’s projected market price
                             of wholesale power could offset some of these additional costs, TVA is
                             likely to exceed its annual $600 million planned capital expenditures limit,
                             thus making this goal unachievable.


Cost Improvement             The 10-year plan calls for TVA to undertake cost improvement initiatives
Initiatives Goal Is          that are assumed to save about $200 million a year over the life of the plan.
                             These initiatives include refinancing TVA’s Federal Financing Bank (FFB)
Achievable
                             debt, refinancing and replacing other debt at lower interest rates, changing
                             retirement benefits, and improving business processes. Overall, the goals
                             related to these initiatives are achievable.

Reducing Interest Costs by   To achieve a large portion of the $200 million annual cost improvement
Refinancing Debt             initiatives, the plan called for TVA to obtain authority from the Congress to
                             prepay, without penalty, the $3.2 billion that TVA then owed FFB, then to
                             refinance that debt at lower interest rates. TVA received that authority in
                             the fiscal year 1999 Treasury and General Government Appropriations Act.
                             TVA refinanced the FFB debt with $2.7 billion of long-term bonds having an
                             average interest rate of 5.37 percent compared to the original 9.67 percent
                             FFB debt, plus $469 million of short-term debt which, as of April 1999, had
                             a current interest rate of about 4.8 percent. Based on the actual interest
                             rates of the refinanced FFB debt, we estimate that the interest savings will
                             total about $1 billion through 2007, providing an average annual savings of
                             about $116 million toward the $200 million plan goal.

                             In addition to reducing interest by refinancing the FFB debt, the plan calls
                             for reducing annual interest costs by refinancing a portion of the $24 billion
                             in outstanding publicly held debt and replacing maturing debt, as needed,
                             with lower interest rate borrowings. Since the plan was issued, TVA has
                             refinanced about $6 billion of long-term public bonds that had an average
                             interest rate of 6.96 percent with long-term bonds having an average
                             interest rate of 6.00 percent and $699 million of short-term borrowings that
                             had about a 4.8 percent interest rate as of April 1999. We estimate that


                             25
                               As previously discussed, TVA believes any capital investments for generating capacity will lower its
                             cost of power relative to the estimate contained in the plan.




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                               these actions will save an average of $44 million in annual interest expense
                               through 2007.

                               TVA may have further opportunities to refinance additional long-term
                               public bonds at favorable rates since as of April 1, 1999, about $11 billion of
                               TVA’s outstanding long-term public debt had interest rates higher than
                               TVA’s estimated 6.55 percent borrowing rate.26 Of the $11 billion,
                               $6.3 billion is callable during the plan period; however, none was callable as
                               of April 1, 1999.

Retirement Plan Changes        According to TVA officials, another $20 million to $25 million a year will be
                               saved by changes made to TVA’s retirement plan. The costs of certain
                               retiree health benefits that TVA was paying for from operations were
                               discontinued, while at the same time a supplemental pension benefit was
                               added to the retirement plan. The result, according to TVA officials, was a
                               net cash flow saving of about $20 million to $25 million per year. According
                               to TVA officials and as confirmed by TVA’s fiscal year 1998 audited financial
                               statements, the pension plan is currently overfunded because it has an
                               excess of plan assets over projected benefit obligations of $323 million as
                               of September 30, 1998. TVA does not expect to have to make any additional
                               contributions to the pension plan through 2007.

Business Process Improvement   TVA also expects to achieve cost savings from business process
Initiatives                    improvement initiatives that involve bringing teams of TVA staff together to
                               evaluate how TVA does business. For example, TVA has established teams
                               from throughout the organization to (1) improve the technology used to
                               process information, (2) benchmark best practices of industry as well as
                               individual TVA plants, and (3) adopt identified best practices across the
                               organization. While some teams appear to be well established, others are
                               only getting started. Because these initiatives are in the early stages, their
                               benefits have not yet been quantified, and TVA officials told us that they are
                               only now beginning to identify cost saving techniques that can be shared
                               throughout the organization.

                               As shown in figure 3, TVA substantially achieved the $200 million cost
                               savings goal for fiscal year 1999 by reducing interest costs and changing its
                               retirement plan. Assuming that TVA’s annual savings from refinancing debt
                               and changing its retirement plan average $160 million and $20 million,


                               26
                                 This rate represents an average rate estimated to be available to TVA for callable and noncallable
                               long-term public bonds.




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                        respectively, TVA must save an additional $20 million annually by
                        improving business processes, refinancing additional debt, and reducing
                        other costs to achieve the $200 million savings assumed in the plan. Since
                        this required additional savings of $20 million is relatively small—less than
                        half of 1 percent of TVA’s fiscal year 1998 operating revenues of
                        $6.7 billion—we believe that it is feasible that these changes will enable
                        TVA to save the additional amount needed to achieve the $200 million
                        annual cost reduction goal.



                        Figure 3: Cost Savings for Fiscal Year 1999 Under TVA’s Cost Improvement
                        Initiatives

                                                                                         Savings from retirement plan
                                                                                                   changes
                                                                                                     10%


                                                                           $20 million
                               Savings from FFB debt   $116 million                               Assumed savings from
                                     refinancing                                                additional refinancings and
                                         58%                                                         business process
                                                                         $20 million                   improvements
                                                                                                            10%



                                                                        $44 million




                                                                                      Savings from public bond
                                                                                            refinancing
                                                                                                22%




                        Source: GAO analysis based on data from TVA.




Assumption About        TVA’s revenues increased significantly in fiscal year 1998 due to a rate
Increased Revenues Is   increase and to increased energy sales. TVA’s fiscal year 1998 revenues
                        totaled about $6.7 billion, compared to $5.9 billion in fiscal year 1997—an
Uncertain
                        increase of about $800 million. According to TVA, about $350 million of the
                        increase is attributed to the rate increase; the balance is attributable to
                        increased sales volume that resulted from extreme weather in the summer
                        months and other factors.

                        The 10-year plan assumes that this rate increase is sustainable and will
                        generate additional revenues of about $325 million annually through 2007.



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However, based on the decline in TVA’s average revenue per kWh over the
past 10 years, and expectations of increasing competition in the electricity
industry, we agree with some industry experts who question TVA’s ability to
meet the plan’s assumption about future revenue. Specifically, an analyst
from the Congressional Budget Office (CBO) with expertise in issues
related to TVA and consultants from ICF Kaiser (which was hired by the
Edison Electric Institute to analyze TVA’s 10-year plan) questioned TVA’s
ability to meet its future revenue projections given the decline in its
average revenue per kWh over the last several years.

As shown in figure 4, from 1988 through 1997, TVA’s average revenues per
kWh declined steadily, despite a steady increase in the amount of
kilowatthours of energy sold. This decline in average revenues per kWh
was attributable to credits given to large industrial customers. The actual
decline in average revenues per kWh over the past 10 years contrasts
sharply with the increase projected in the 10-year plan for 1998 through
2007.




Page 22                               GAO/AIMD-99-142 Tennessee Valley Authority
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Figure 4: Comparison of Average Revenue per kWh to Kilowatthours Sold
                          5.00                                                                                                             250,000


                          4.50


                          4.00                                                                                                             200,000


                          3.50
Average revenue per kWh




                                                                                                                                                     Kilowatthours sold
                          3.00                                                                                                             150,000


                          2.50


                          2.00                                                                                                             100,000


                          1.50


                          1.00                                                                                                             50,000


                          0.50


                           -                                                                                                               -
                                 1988   1990   1992   1994        1996           1998    2000          2002          2004      2006



                                                       Average revenue per kWh          Kilowatthours sold



                                                        Source: GAO analysis based on data from TVA.


                                                        In order to offer competitive rates to its industrial customers, TVA offers
                                                        price breaks to its larger industrial customers. In fact, to offset the impact
                                                        of the last rate increase, TVA expanded its existing credit program to
                                                        include companies with commitments to purchase firm loads of more than
                                                        1 megawatt. (Previously this credit had been limited to industrial
                                                        customers with firm load commitments of more than 5 megawatts.)
                                                        Although deregulation of the electric utility industry is expected to put
                                                        downward pressure on rates, the 10-year plan assumes that TVA will not
                                                        have to offer any additional price breaks to its large industrial customers
                                                        through 2007. This assumption is questionable given that TVA has offered
                                                        new credits to reduce the rates of its larger industrial customers for the
                                                        past 10 years and competition in the industry is increasing.

                                                        Because deregulation of the electric utility industry is expected to continue
                                                        to cause future wholesale and retail electricity prices to fall, TVA will likely



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                           feel pressure to continue to reduce rates. In addition, recent media
                           coverage about competition has made many utility customers more aware
                           of price differences among utilities and raised expectations of lower prices.
                           All of these factors combined make it uncertain whether TVA can generate
                           an additional $325 million in annual revenues on a sustained basis through
                           2007.


Goal to Improve Customer   TVA’s management recognizes that in a competitive environment, its
Relations Is Achievable    current customers would be free to obtain power from other utilities after
                           giving appropriate notice. Therefore, to improve its future competitive
                           position, TVA’s management decided that it must offer contract flexibility
                           to improve relationships with its customers—159 distributors and 64
                           industrial and federal concerns. The 10-year plan calls for TVA to build
                           customer allegiance by developing contract and pricing structures that
                           better meet its customers’ needs. TVA has taken actions geared toward this
                           goal.

                           For example, one new contract option allows distributors to change the
                           length of their power contracts with TVA from a rolling27 10-year term to a
                           rolling 5-year term, after a period of 5 years (5+5 contract). This 5+5
                           contract, like all of TVA’s power contracts with its distributors, requires the
                           distributor to purchase all of its electric power from TVA. TVA has also
                           implemented a new program for its large industrial customers that permits
                           customers with power usage of more than 1 megawatt annually to be billed
                           under real-time pricing (RTP),28 which will enable these customers to
                           reduce their electricity costs by adjusting usage patterns. TVA has
                           implemented the RTP program on a 3-year pilot basis. TVA expects that in
                           the long-term, the RTP program will increase revenues by increasing the
                           demand for power. Both the 5+5 contracts and the real-time pricing
                           program are options that TVA developed as a result of input from
                           customers.

                           Customer groups we contacted were pleased with the efforts TVA is
                           making to provide more flexible contracts. Since these options were
                           developed in response to customer input and the initial customer response



                           27Rolling   contracts automatically renew each year (referred to as the “evergreen” provision).

                           28
                             RTP reflects the actual cost differences of producing power, which vary from hour to hour. RTP
                           allows customers to reduce costs by scheduling production to take advantage of variable prices.




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                      has been positive, we determined that TVA’s goal to improve customer
                      relations is achievable.



Plan Has Not Been     As previously discussed, since the 10-year plan was issued in July 1997,
                      actual experience related to certain key goals and assumptions has differed
Updated to Reflect    from that projected in the plan, and certain expectations about the future
Significant Changes   have changed. For example, TVA officials indicated that if they were to
                      update the 10-year plan today, they would increase their projection for the
                      future market price of power and would include costs for new
                      environmental regulations. However, TVA has not formally updated the
                      plan to reflect these and other changes. Examples of actual experience
                      that differ from expectations in the plan or goals and assumptions that have
                      changed since the plan was developed, along with their impact on the
                      overall plan, are shown in table 2.



                      Table 2: Summary of Changes and Their Impact on TVA’s 10-Year Plan

                      Changes                                        Impact on plan
                      Purchase of 8 turbines in lieu of              Reduce net cash flow by $65 million through
                      purchasing power                               2007, but also expected to reduce the cost of
                                                                     power
                      Environmental regulations:

                      (1) Nitrogen oxide                             (1) Reduce total cash flow by $500 million to
                                                                     $600 million through 2007

                      (2) Regional haze                              (2) Reduce total cash flow by up to $500 million
                                                                     through 2007 a
                      Funding nonpower programs                      Reduce total cash flow by $400 million to $480
                      through power revenues                         million through 2007 b
                      Possible upward adjustment in the              Reduce the amount of cost reduction and/or
                      future market price of power                   revenue needed to meet a market price
                                                                     projection
                      Debt not reduced as quickly as                 Delay debt reduction goal from 2007 to 2009;
                      planned                                        Increase risk that TVA will be unable to offer
                                                                     competitively priced power by 2007
                      aDue to uncertainty regarding the timing for compliance, not all expenditures may occur during the time
                      frame of the plan.
                      b
                       The estimate is based on estimated expenditures of about $50 million to $60 million per year. TVA
                      officials stated that they would seek to identify and implement operating efficiency measures that are
                      expected to reduce the costs associated with nonpower programs without affecting program
                      operations.




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Changes in individual goals or assumptions or actual experience that
differs from that projected when the plan was developed can affect the
entire plan. For example, the unplanned purchase of additional generating
capacity results in a decrease in projected cash flow through 2007. This
affects the availability of cash to pay down debt, which further impacts
interest costs. Funding nonpower programs through power revenues has
the same effect. The result of these and other unplanned expenditures,
such as for new environmental regulations, is that TVA’s time frame to meet
its debt reduction goal has been extended from 2007 to 2009. In contrast,
any upward change in TVA’s assumption for the future market price of
power increases TVA’s target price for power in 2007. This means that TVA
could reduce the level of cost reduction and/or revenue enhancement
planned through 2007 and still be in a position to offer competitively priced
power at that time.

TVA officials told us that they have internally analyzed the combined
impact of an upward revision in the projected market price of wholesale
power in 2007 and lower-than-planned debt reduction on TVA’s ultimate
objective, which is to be in a position to offer competitively priced power in
2007. While TVA officials acknowledge that they will not meet the debt
reduction goal by 2007, they believe, based on their internal analyses, that
TVA will still be in a position to offer competitively priced power in 2007.
However, these analyses have not been formalized, nor have the results
been communicated to users of the plan.

Although TVA views the plan as a living document and recognizes that
projections in the plan will change over time, there is no formal mechanism
for communicating changes to those who use the plan. In addition, there is
no mechanism available to plan users to gauge TVA’s progress toward
achieving the plan’s goals and objectives. Therefore, while variances in
results, changes in goals and assumptions, and progress toward plan
objectives may be known to TVA, they are generally not known by the
plan’s users. These users include public policymakers considering
legislation that might impact TVA’s future, analysts and investors who use
information in the plan when assessing the desirability of TVA’s debt
offerings, and customers who are considering alternative sources of
electricity in the future. As a result, those who rely on the plan to make
investment and policy decisions cannot fully assess the impact of the
variances and changes in assumptions on TVA’s ability to meet its strategic
objectives as set forth in the plan.




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              The legislation proposed by the administration to promote retail
              competition in the electric power industry, which was discussed previously
              in this report, would require that TVA annually report several types of
              information to the Congress. If enacted, the legislation would require that
              TVA annually report, among other things, its progress toward its goal of
              competitively priced power, its prospects for meeting the objectives of the
              10-year plan, any changes in assumptions that may have a material effect
              on its long-range financial plans, the amount by which its debt has been
              reduced, and the projected amount by which its debt will be reduced. This
              type of reporting to the Congress would help provide the information
              needed to monitor TVA’s readiness for a competitive environment.



Conclusions   TVA management recognizes the need for TVA to be positioned to compete
              with other utilities in a changing marketplace. The 10-year plan is moving
              TVA in the right direction by addressing the most important issues facing
              TVA: its high fixed financing costs and limited financial flexibility and the
              large amount of deferred assets that TVA has not recovered through rates.
              The more progress TVA makes in addressing these issues while it maintains
              its legislative protections, the greater its prospects for being competitive if
              it loses these protections in the future.

              Because TVA’s actual experience and assumptions about the future market
              price of power, capital expenditures, and planned debt reduction have
              varied in significant ways from those envisioned in the 10-year plan, it is
              unlikely that TVA will generate sufficient cash flow to reduce debt and the
              corresponding fixed interest costs to the extent stated in the plan through
              2007. This will impact TVA’s ability to recover the cost of its deferred assets
              to the extent planned. TVA has acknowledged that its debt reduction goal
              will not be achieved until at least 2009. To the extent it does not
              sufficiently reduce debt and related fixed costs and increase financial
              flexibility during the 10-year period, TVA’s ultimate strategic objective—to
              be able to offer competitively priced power by the end of 2007—could be
              jeopardized, depending on market conditions at the time.

              However, since no one knows what the market price of power will be in
              2007, it is uncertain whether TVA will be in a position to offer competitively
              priced power at that time. TVA could fall short of its objectives and still be
              competitive if its cost of producing power is at or below market.
              Conversely, TVA could achieve all of its objectives and not be competitive if
              its cost of producing power is higher than market.




              Page 27                                GAO/AIMD-99-142 Tennessee Valley Authority
                      B-281916




                      Because of changing electricity markets and other economic conditions, it
                      is essential that TVA continuously update the plan and communicate the
                      results of these updates, as well as TVA’s progress toward its goals and
                      objectives, periodically and formally to the Congress as it considers TVA’s
                      future in a deregulating electricity industry and to other users who have a
                      vested interest in TVA.



Recommendations       We recommend that the Chairman of the Board of Directors of the
                      Tennessee Valley Authority move quickly to improve the reporting of
                      information to the plan’s users. Specifically, we recommend that the
                      Chairman ensure that TVA take the following actions:

                      • Revise and reissue the plan to reflect evolving conditions and operating
                        plans and their impact on TVA’s ability to meet the strategic objectives
                        outlined in the plan by 2007. TVA should also include a discussion of its
                        plans to recover the costs of its deferred assets. As further significant
                        changes occur, the plan should be updated to communicate these
                        changes to plan users.
                      • Periodically communicate its progress toward achieving the 10-year
                        plan’s strategic objectives to those who rely on the information
                        contained in the plan. One option would be for TVA to expand its
                        discussion of the 10-year plan in its annual reports, including reporting
                        • how actual results compare to all of the plan’s key goals and
                           assumptions, including those for revenues, debt reduction, capital
                           expenditures, cost savings, and the market price of power;
                        • progress toward achieving performance measures related to the plan,
                           when developed; and
                        • an overall assessment of whether TVA is on course to provide
                           competitive power in 2007.



Agency Comments and   In oral and written comments on a draft of this report, TVA generally
                      agreed with the report’s contents. TVA also provided us with technical
Our Evaluation        comments, which we have incorporated as appropriate. TVA’s written
                      comments are reproduced in appendix II and discussed below.

                      TVA commented that the market price of power is the most significant
                      uncertainty in achieving its goal to be in a competitive pricing position as
                      the industry is deregulated. TVA also stated that the target cost of power in
                      the 10-year plan is aggressive and that it has not yet altered its estimate of



                      Page 28                                GAO/AIMD-99-142 Tennessee Valley Authority
B-281916




the future market price of power, even though there are indications of
upward movement in market price forecasts. Our report noted that TVA’s
target for the cost of its power in the 10-year plan is lower than projections
by other knowledgeable sources and therefore forces TVA to be aggressive
in pursuing its options to reduce costs and increase revenue. During the
course of our review, TVA officials told us that if they were to formally
update the 10-year plan, they would increase their projection of the future
market price of power. As we note in our report, TVA has not formally
updated the 10-year plan, even though certain expectations about the
future have changed and actual experience related to key goals and
assumptions has differed from projections in the plan.

TVA stated that while it will likely incur the costs of funding traditional
river management programs that have historically been funded largely
through appropriations, the Congress has also enacted legislation allowing
TVA to refinance its FFB debt for a savings of over $100 million a year.
While we agree with both of these statements, the anticipated savings from
refinancing the FFB debt were included in the 10-year plan, but the
additional cost of funding traditional river management programs was not.
Therefore, for purposes of gauging progress toward achievement of the
plan’s goals, the planned savings cannot be assumed to offset these
unplanned expenditures. Our report separately discusses each of these
points.

TVA noted that although its decision to purchase additional generating
capacity for periods of peak demand rather than purchasing power from
other utilities will adversely impact its ability to reduce debt to the extent
planned, it will also help TVA achieve a lower cost of power and improve
system reliability. Our report acknowledges these points and states that
the decision will impact TVA’s ability to reduce debt, but that TVA believes
the decision will reduce the cost of its power and remove the uncertainty of
having to rely on another utility for power.

With regard to our recommendations, TVA stated that its planning process
is being refined and will improve over time and that TVA has committed to
update the 10-year plan as material changes occur so that stakeholders will
know how TVA is doing in comparison to the plan. As we noted in our
report, TVA has made significant changes in assumptions and its actual
experience has differed from projections since the plan was issued in July
1997, but TVA has not formally updated the plan to reflect these changes.
Therefore, it is important that TVA move quickly to improve the reporting




Page 29                                GAO/AIMD-99-142 Tennessee Valley Authority
Page 31   GAO/AIMD-99-142 Tennessee Valley Authority
Contents



Letter                                                                                              1


Appendix I                                                                                         34
Objectives, Scope, and
Methodology

Appendix II                                                                                        40
Comments From the
Tennessee Valley
Authority

Appendix III                                                                                       42
Major Contributors to
This Report

Tables                   Table 1: GAO Conclusions About the 10-Year Plan’s Goals and
                           Assumptions                                                             12
                         Table 2: Summary of Changes and Their Impact on TVA’s 10-Year
                           Plan                                                                    25



Figures                  Figure 1: Comparison of Planned to Actual and Revised Annual Debt
                           Reduction Plan                                                          17
                         Figure 2: Original and Revised Debt Reduction Timetable                   18
                         Figure 3: Cost Savings for Fiscal Year 1999 Under TVA’s Cost
                           Improvement Initiatives                                                 21
                         Figure 4: Comparison of Average Revenue per kWh to Kilowatthours
                           Sold                                                                    23




                         Page 32                            GAO/AIMD-99-142 Tennessee Valley Authority
Contents




Abbreviations

CBO        Congressional Budget Office
CERCLA     Comprehensive Environmental Response, Compensation, and
           Liability Act
DOE        Department of Energy
EEI        Edison Electric Institute
EIA        Energy Information Administration
EPA        Environmental Protection Agency
EPAct      Energy Policy Act of 1992
FFB        Federal Financing Bank
kWh        kilowatthour
NRC        Nuclear Regulatory Commission
OMB        Office of Management and Budget
RCRA       Resource Conservation and Recovery Act
RTP        real-time pricing
TVA        Tennessee Valley Authority



Page 33                           GAO/AIMD-99-142 Tennessee Valley Authority
Appendix I

Objectives, Scope, and Methodology                                                                                      AppIexndi




              We were asked to determine whether the goals and assumptions in TVA’s
              10-year plan are achievable or reasonable in light of TVA’s strategic
              objectives to (1) reduce the cost of power to a competitive level,
              (2) increase financial flexibility by reducing fixed costs, and (3) build
              customer allegiance. Specifically, we were asked to determine whether the
              10-year plan (1) addresses key issues facing TVA, (2) takes into
              consideration all applicable costs and revenue sources, (3) contains
              assumptions that are reasonable and in line with industry estimates and
              expectations, and (4) has been updated to reflect significant changes in key
              assumptions or actual experience that differs from TVA’s expectations
              when the plan was developed. In addition, you asked us, based on our
              analysis of the plan, to conclude whether TVA is likely to achieve the plan’s
              strategic objectives.

              TVA’s plan consists of three strategic objectives, with goals and
              assumptions designed to help accomplish the strategic objectives. We
              evaluated the achievability and reasonableness1 of 10 of the goals and
              assumptions and their impact on TVA’s ability to accomplish its 3
              objectives. Specifically, we assessed the achievability and reasonableness
              of the following goals and assumptions:

              • the future market price of wholesale power will be 3.4 to 3.5 cents per
                kWh by 2007;
              • annual growth in demand through 2007 will average 2 percent;
              • fuel costs will increase 1.7 percent annually through 2007;
              • improvements in supply chain management will save $50 million
                annually;
              • TVA’s labor force will be reduced, and additional costs savings will be
                achieved through the creation of shared services and other initiatives;
              • debt will be reduced by about one-half to about $14 billion, and the
                balance of deferred assets will be reduced from $8.5 billion to
                $500 million—TVA’s estimated net realizable value of these assets;
              • capital expenditures will be limited to about $600 million annually and
                increases in demand through 2007 will be met primarily through
                purchased power;
              • $200 million will be saved annually through cost improvement initiatives
                primarily related to refinancing Federal Financing Bank (FFB) and



              1
                We assessed the achievability of the 5 goals and the reasonableness of the 5 assumptions contained in
              TVA’s 10-year plan.




              Page 34                                            GAO/AIMD-99-142 Tennessee Valley Authority
                             Appendix I
                             Objectives, Scope, and Methodology




                               public bond debt, pursuing changes to its retirement plan, and
                               improving business processes;
                             • revenues from power sales will be increased by about $325 million
                               annually by implementing a rate increase in 1998 and maintaining it
                               through 2007; and
                             • customer relations will improve through new contract and pricing
                               options.

                             As agreed with your offices, we did not (1) assess whether achieving the
                             objectives of the plan would ensure TVA’s future competitiveness or
                             (2) develop independent estimates of key elements of the plan, such as the
                             future market price of power. Instead, we relied on comparisons of past
                             performance to future projections, the opinions of industry experts, and
                             economic forecasts made by knowledgeable sources to determine whether
                             the individual components of the plan and the plan as a whole were
                             achievable and reasonable.


Assessing Whether the Plan   To determine whether the three objectives of the 10-year plan addressed
Addressed Key Issues         key issues confronting TVA as it seeks to increase its prospects for being
                             competitive in the future, we (1) examined the actions that were being
Confronting TVA
                             taken by other utilities to prepare for competition and compared them to
                             TVA’s plan, (2) reviewed prior GAO reports on issues confronting TVA,
                             (3) interviewed TVA officials, (4) reviewed TVA’s annual reports for 1997
                             and 1998, (5) spoke with officials from the Congressional Budget Office
                             (CBO) and Office of Management and Budget (OMB) with expertise in
                             issues pertaining to TVA, (6) interviewed industry representatives from
                             TVA’s customer groups, and (7) interviewed representatives from both the
                             public power and investor-owned segments of the industry familiar with
                             TVA and its service area.


Assessing Whether            To determine whether the 10-year plan considered appropriate costs and
Appropriate Costs and        revenue sources, we (1) reviewed prior GAO reports on TVA,
                             (2) interviewed TVA officials, (3) reviewed other electric utilities’ annual
Revenues Were Considered
                             reports and audited financial statements to determine the types of costs
                             they were reporting, (4) reviewed TVA fiscal years’ 1997 and 1998 annual
                             reports and audited financial statements to determine the types of costs
                             and revenues TVA had reported, (5) analyzed comparative historical and
                             forecast operating statement percentages calculated from TVA financial
                             model information underlying the 10-year plan, (6) spoke with an official
                             from the Environmental Protection Agency (EPA) regarding environmental



                             Page 35                               GAO/AIMD-99-142 Tennessee Valley Authority
                           Appendix I
                           Objectives, Scope, and Methodology




                           costs under new regulations and TVA’s status as a potentially responsible
                           party under CERCLA and RCRA, (7) interviewed industry experts familiar
                           with TVA and its service area, (8) spoke with an official from the Nuclear
                           Regulatory Commission (NRC) on the adequacy of TVA’s nuclear
                           decommissioning fund, (9) determined that TVA’s external financial
                           statements auditor was satisfied with TVA’s nuclear decommissioning
                           obligations and trust fund assets as part of its fiscal year 1998 audit, and
                           (10) inquired about costs related to TVA’s plans to comply with Year 2000
                           computer issues. However, we did not assess TVA’s readiness to deal with
                           Year 2000 computer issues.


Assessing Whether the      To determine whether goals and assumptions were achievable or
Plan’s Goals and           reasonable and in line with industry estimates and expectations, we
                           (1) interviewed TVA officials, (2) compared past results of TVA’s operations
Assumptions Were
                           to projections in the plan, and (3) spoke with officials from (a) the Energy
Achievable or Reasonable   Information Administration (EIA), the statistical agency within DOE,
                           (b) Standard and Poor’s DRI, an economic forecasting and consulting
                           company with expertise in the energy industry, (c) EPA, (d) CBO, (e) NRC,
                           (f) groups of TVA customers, including both distributors and direct-served
                           customers, and (g) industry groups representing both the public power and
                           investor-owned utility segments of the industry.

                           For each goal or assumption, we compared TVA’s projections with those of
                           the appropriate agencies and with TVA’s historical results. Specifically, to
                           determine whether each goal or assumption was achievable or reasonable,
                           we did the following work:

                           • Future market price of wholesale power: We interviewed TVA officials
                             and spoke with EIA, DRI, and industry experts familiar with TVA and its
                             service area. We then compared TVA’s projections with those of these
                             other entities.
                           • Annual growth in demand: We reviewed TVA’s past annual growth
                             history and interviewed TVA, CBO, DRI, and EIA officials and industry
                             experts familiar with TVA and its service area. We also relied on
                             previous GAO work on TVA’s demand growth methodology done in 1995;
                             we did not reassess this methodology because our comparison of TVA’s
                             projections with past results and the projections of DRI and EIA gave us
                             no reason to believe that any changes TVA may have made in its
                             methodology would have caused a significant difference. Based on the
                             results of our review, we determined the reasonableness of TVA’s
                             assumptions.



                           Page 36                               GAO/AIMD-99-142 Tennessee Valley Authority
Appendix I
Objectives, Scope, and Methodology




• Increase in fuel costs: We reviewed TVA’s annual fuel costs for prior
  years, interviewed TVA officials, and spoke with officials from DRI and
  EIA. We then compared TVA’s projections to those of these other
  entities to determine reasonableness.
• Improvements in supply chain management: We interviewed TVA
  officials and examined documentation on (1) changes in procurement
  policies and procedures, including the use of blanket contracts versus
  individual purchase orders, (2) savings achieved since 1997, both
  recurring and nonrecurring, and (3) plans to phase in additional cost
  savings programs. We then analyzed whether these changes would be
  likely to enable TVA to achieve and sustain the level of savings projected
  in the 10-year plan.
• Reduced labor force: We interviewed TVA officials, reviewed the
  decrease in personnel over the last 10 years, and analyzed whether TVA’s
  assumptions seemed reasonable.
• Reduced debt and related interest costs and recovery of deferred assets:
  We interviewed TVA officials, analyzed information in the President’s
  fiscal year 2000 budget, contacted Moody’s Investors Service in regard
  to the effect of bond ratings on interest rates, and analyzed and verified
  the plan’s supporting documentation by tracing it to TVA’s audited
  financial statements. In addition, to determine whether TVA’s plan to
  recover through rates the costs of deferred assets was achievable, we
  interviewed TVA officials, spoke with a CBO official about the impact of
  planned revenues on the availability of income to recover the costs of
  these assets, and analyzed supporting schedules provided to us by TVA.
  We also spoke with TVA officials about its plans for the Bellefonte
  nuclear plant, which comprises the bulk of TVA’s deferred nuclear
  generating units.
• Capital expenditures: We interviewed TVA officials, a CBO analyst, and
  industry experts. Additionally, for each of the two capital expenditure
  issues, we performed additional procedures. Specifically:
  • for capital expenditures for new capacity and upgrades to existing
      capacity, we compared TVA’s historical capital expenditures to its
      planned expenditures and analyzed whether the plan’s goal of
      meeting future growth in demand by purchasing power from other
      utilities was achievable and
  • for expenditures related to new environmental regulations, we
      obtained data from EPA and EIA on projected costs under new and
      proposed environmental regulations. We then compared TVA’s
      projections with those of EPA and EIA to determine the achievability
      of TVA’s goals.




Page 37                               GAO/AIMD-99-142 Tennessee Valley Authority
                              Appendix I
                              Objectives, Scope, and Methodology




                              • Cost improvement initiatives: We interviewed TVA officials, examined
                                documentation relating to TVA’s business process improvement efforts,
                                reviewed information in TVA’s annual report on its pension fund,
                                analyzed the impact of TVA’s refinancing efforts to date, obtained
                                projected interest rates through 2007 from EIA, and compared the plan’s
                                projections to TVA’s actual portfolio interest rates and EIA’s projections.
                              • Projected revenues: We interviewed TVA officials, reviewed TVA’s
                                revenue experience over the past 10 years, analyzed the correlation
                                between kWhs sold and revenue, spoke to TVA’s customer groups about
                                their expectations for TVA’s price of power, and interviewed CBO and
                                industry representatives about the reasonableness of TVA’s revenue
                                projections.
                              • Improved customer relations: We interviewed TVA officials,
                                representatives of TVA’s customer groups, and industry representatives
                                from both the public power and investor-owned segments of the market.


Assessing Whether the Plan    To determine whether TVA had updated the plan for significant changes,
Had Been Updated for          we (1) determined whether significant changes had occurred based on the
                              procedures described above, (2) examined the process whereby TVA
Significant Changes
                              internally updates its projections, and (3) interviewed TVA officials about
                              whether they had updated the plan internally or externally and/or had any
                              plans to do so.


Assessing Whether Strategic   After we determined the achievability or reasonableness of each of the
Objectives Are Achievable     underlying goals and assumptions of the plan, we assessed the plan in its
                              entirety to determine whether all of these separate elements added up to a
                              cohesive, reasonable plan that should enable TVA to achieve its three
                              strategic objectives. For the two interrelated strategic objectives—
                              reducing the total delivered cost of power and increasing financial
                              flexibility by reducing fixed costs—we analyzed whether achieving the
                              goals of the plan was possible and whether achieving the goals would
                              necessarily help TVA achieve the strategic objectives. For the third
                              strategic objective, building customer allegiance, we analyzed the results of
                              our discussions with both TVA’s customer groups as well as industry
                              representatives from both the public power and investor-owned segments
                              of the market.

                              We conducted our review from June 1998 through April 1999 in accordance
                              with generally accepted government auditing standards.




                              Page 38                               GAO/AIMD-99-142 Tennessee Valley Authority
                             Appendix I
                             Objectives, Scope, and Methodology




Organizations                During the course of our work, we contacted the following organizations.

Contacted

Federal Agencies             •   Congressional Budget Office
                             •   Department of Energy’s Energy Information Administration
                             •   Environmental Protection Agency
                             •   Nuclear Regulatory Commission
                             •   Office of Management and Budget
                             •   Tennessee Valley Authority


Bond Rating Agency           • Moody’s Investors Service, New York, New York



Customer Representative or   • American Public Power Association, Washington, D.C.
Trade Groups                 • Tennessee Municipal Electric Power Association, Brentwood,
                               Tennessee
                             • Tennessee Valley Industrial Committee/Associated Valley Industries,
                               Columbia, Tennessee
                             • Tennessee Valley Public Power Association, Chattanooga, Tennessee


Consulting Firms             • Gas Research Institute, Chicago, Illinois
                             • ICF Kaiser Consulting Group, Fairfax, Virginia
                             • Standard and Poor’s DRI, Lexington, Massachusetts


Others                       • Federal Accounting Standards Advisory Board
                             • Edison Electric Institute’s TVA Watch Group, Washington, D.C.
                             • McMinnville Electric System, McMinnville, Tennessee




                             Page 39                              GAO/AIMD-99-142 Tennessee Valley Authority
Appendix II

Comments From the Tennessee Valley
Authority                                                           ApIpexndi




              Page 40      GAO/AIMD-99-142 Tennessee Valley Authority
Appendix II
Comments From the Tennessee Valley
Authority




Page 41                              GAO/AIMD-99-142 Tennessee Valley Authority
Appendix III

Major Contributors to This Report                                                                      AIpIexndi




Accounting and          Robert E. Martin, Assistant Director
                        Donald R. Neff, Senior Audit Manager
Information             Patricia B. Petersen, Senior Auditor
Management Division,    John C. Warner, Senior Auditor
                        Meg Mills, Communications Analyst
Washington, D.C.

Office of the General   Thomas H. Armstrong, Assistant General Counsel
                        Amy M. Shimamura, Senior Attorney
Counsel, Washington,
D.C.

Atlanta Field Office    Marshall L. Hamlett, Senior Auditor




(913828)       eL
                rtet    Page 42                               GAO/AIMD-99-142 Tennessee Valley Authority
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