Larry Philbin, Principal Engineer Santee Cooper - Quality & Performance Support November 13, 2006

Risk-Based Modeling Approaches for Determining Current Liability for Future Asset Retirement ObligationsThe 2006 Palisade User Conference: AmericasMiami, Florida Larry Philbin, Principal Engineer Santee Cooper - Quality & Performance Support November 13, 2006

Agenda • Santee Cooper background • Financial Obligation Underfunding Background • Santee Cooper Asset Retirement Obligation (ARO) • ARO Modeling Methodology • Example @Risk ARO Models • Concluding Thoughts • Questions

Santee Cooper • Established in 1939 • Non-profit, owned by State of South Carolina • Senate-confirmed board of directors • $1.4 billion revenue • 149,024 direct customers • $5.0 billion total assets • 1,740 employees • 4,277megawatts generation capacity

Purchases & Net Interchanges 6.1% Coal 73.9% Hydro 1.9% Nuclear 9.7% Oil & Gas 8.4% Our Electricity Source - Energy Supply (2005)

Quality and Performance Support Services • Business Planning/Benchmarking • Process Mapping/Improvement • Management/Decision Analysis Tools • Performance Measures • Survey Questionnaires • Statistical Analysis • Forecasting & Scheduling Models • Economic Analysis • Maintenance Management Systems • Project Management • Simulation Modeling & Analysis • Risk Management Modeling

Financial Obligation Underfunding Background • 2005: U.S. Pension Benefit Guarantee Corporation (PBGC)1: • estimates that total underfunding in the single-employer defined benefit plans it insures exceeded $450 billion as of September 30, 2005 • 2006: Public Pension Funds Survey2: • one-quarter had actuarial funding ratios below 80% • shortfall approaches one trillion for all public systems • 1 http://www.pbgc.gov/media/news-archive/ExecutiveTestimony/tm1166.html, retrieved 10/31/2006. • 2 E.J. mcMahon. “Public Pension Price Tag.” The Wall Street Journal, 21 August 2006

Financial Obligation Underfunding Background • President Bush Signs H.R. 4, the Pension Protection Act of 2006 • requires companies who underfund their pension plans to pay additional premiums • insists that companies measure obligations of their pension plans more accurately

Financial Obligation Underfunding Background • The present underfunding of Medicare ($29.7 trillion) is more than seven times that of Social Security ($4 trillion). • To bring Social Security into balance over the next 75 years would require a 15 percent increase in payroll taxes today. • Bringing Medicare into balance would require an immediate 107 percent increase in revenue. < Thomas J. Healey and Robert SteelMEDICARE: Rx for Medicare Hoover Digest 2005 No. 3 Retrieved11/01/2006 http://www.hooverdigest.org/053/healey.html>

Financial Obligation Underfunding Background • Currently, 53 utility companies have nuclear plants. It will cost $33 billion to decommission them. <Federal Accounting Standards Board (FASB) March 2000> • Typical (57%) decommissioning accounting method is to record expected costs as a depreciation expense, thus removing the liability from the balance sheet. • Next most common (26%) method is to record expected costs as a liability accrued over the life of the asset rather than the present value thus significantly understating the real costs. • Neither method establishes current funding.

Financial Obligation Underfunding Background • 1996 U.S. Environmental Protection Agency (EPA): • determined that the cost estimates prepared by owners and operators for 89 of the 100 hazardous waste facilities reviewed were lower than the corresponding cost estimates prepared under EPA recommended methodology • cost estimates for 54 of the facilities were more than 50 percent below the estimates prepared under their methodology • cost estimates for 35 facilities were 50 percent or less than 50 percent lower than the estimates prepared under their methodology <Patterson, Susan (1996). Revised Draft Report on Analysis of Cost Estimates for Closure and Post-Closure Care. U.S. Environmental Protection Agency-Headquarters Office of Solid Waste, 5-6>

<Patterson, Susan (1996). Revised Draft Report on Analysis of Cost Estimates for Closure and Post-Closure Care. U.S. Environmental Protection Agency-Headquarters Office of Solid Waste, 6>

Financial Obligation Underfunding Background • The main variables are in the discount rate used to calculate the present value of costs, assumed inflation rates, expected age used to estimate when expenditures will commence and the amount of costs that will become payable. • Tendency to use a lower inflation rate, a higher discount rate that reflects expected investment returns or perhaps an average of past investment returns (versus a risk free rate of return-usually based on Treasury securities), and later expected ages that do not assume increased rates (amounts) of costs.

Financial Obligation Underfunding Background • 2001 EPA Continued: • developed requirements & methodology for determining accuracy of cost estimates for closure and post-closure care of hazardous waste treatment, storage, and disposal facilities (TSDF) under the Resource Conservation and Recovery Act (RCRA) • includes closure activities, factors affecting cost estimate accuracy, and cost estimating worksheets <EPA Introduction to RCRA Financial Assurance (40 CFR Parts 264/265, Subpart H)>

Santee Cooper Asset Retirement Obligation (ARO) • Santee Cooper maintains ash ponds at each of its four coal-fired generating stations: • Cross (CGS) • Grainger (GGS) • Jefferies (JGS) • Winyah (WGS) • FASB 143 / FIN 47 requires that if there is a legal requirement that involves cost of retiring assets, Santee Cooper must book the liability for those retirements in the current year. South Carolina / DHEC regulations require that Santee Cooper account for its ash pond (asset) retirement obligations. • Several areas of uncertainty exist regarding ash pond retirement costs. • Based on FASB 143, the primary uncertainties must be addressed in determining Santee Cooper’s accounting treatment by creating and quantifying multiple retirement scenarios.

<http://www.tfhrc.gov/hnr20/recycle/waste/cfa51.htm>

Coal-fired Combustion By-Products • Fly ash-a fine-grained powdery particulate material suspended in flue gases. • Bottom ash-agglomerated ash particles coarse, with grain sizes spanning from fine sand to fine gravel.

Santee Cooper Asset Retirement Obligation (ARO) • Santee Cooper maintains ash ponds at each of its four coal-fired generating stations: • Cross (CGS) • Grainger (GGS) • Jefferies (JGS) • Winyah (WGS) • FASB 143 / FIN 47 requires that if there is a legal requirement that involves cost of retiring assets, Santee Cooper must book the liability for those retirements in the current year. South Carolina / DHEC regulations require that Santee Cooper account for its ash pond (asset) retirement obligations. • Several areas of uncertainty exist regarding ash pond retirement costs. • Based on FASB 143, the primary uncertainties must be addressed in determining Santee Cooper’s accounting treatment by creating and quantifying multiple retirement scenarios.

Santee Cooper Asset Retirement Obligation (ARO) The primary uncertainties, or variables, in this analysis were identified as: • Retirement year (the year of remediation, for each generating station) • Retirement cost (permitting, engineering, quality control & construction) • Inflation rate • Credit adjusted risk-free reinvestment interest rate • Market risk (reflects the uncertainty of future bond initiation and funding costs-5% is used in this analysis)

ARO Modeling Methodology • An Excel model was created to compute a single funding schedule for Santee Cooper’s total ash pond ARO • Two scenarios were modeled for each station, for a total of eight independent scenarios (2 scenarios x 4 stations). • The scenarios were based on using two different retirement years. • In addition to quantifying scenarios based on retirement year, Santee Cooper incorporated the range of uncertainty regarding retirement costs, inflation rate, reinvestment interest rates, and market risk premiums . This uncertainty was addressed by assigning probability distributions (representing the likelihood of occurrence) to these variables. • A different credit adjusted risk-free reinvestment interest rate was used for each scenario, as it is based on the retirement year used and principal amount.

ARO Modeling Methodology • The basis of the scenarios, the year of retirement, is the following: • Scenario Group 1: External depreciation study performed in Fall 2001 (for year-end 2000) • Scenario Group 2: Internal Santee Cooper Construction Management estimates provided in December 2005 • The @Risk Excel add-in software by Palisade, Inc. was used to compute the results. It was also used to: • Determine the appropriate probability distribution to model the uncertainty within the retirement cost and inflation rate estimates • Apply Monte Carlo methodology in modeling the large number of potential combinations of the variables. Five thousand runs (5,000 simulations) were performed for each of the eight scenarios in order to generate reliable confidence intervals for the calculated outputs.

ARO Modeling Methodology • The basis of the scenarios, the year of retirement, is the following: • Scenario Group 1: Depreciation study performed in Fall 2001 (for year-end 2000) • Scenario Group 2: Santee Cooper Construction Management estimates provided in December 2005 • The @Risk and BestFit Excel add-in software by Palisade, Inc. was used to compute the results. It was also used to: • Determine the appropriate probability distributions to model the uncertainty within the retirement cost and inflation rate estimates • Apply Monte Carlo methodology in modeling the large number of potential combinations of the variables. Five thousand runs (5,000 simulations) were performed for each of the eight scenarios in order to generate reliable confidence intervals for the calculated outputs

Inflation Rate “Raw Data”GDP Implicit Price Deflators Used for Inflation Factor<U.S. Department of Commerce: Bureau of Economic Analysis>

Statistical Fit of Inflation Rate DataGDP Implicit Price Deflators Used for Inflation Factor<U.S. Department of Commerce: Bureau of Economic Analysis>

Retirement Cost Estimates

Statistical Fit of Retirement Cost DataResults from applying retirement cost estimate distribution (triangular distribution from -10.56% to 22.78%) to the single-point estimated retirement cost

ARO Modeling Methodology

ARO Modeling Methodology • Running a scenario, or executing the model, performs the following steps: • A retirement cost is sampled from the range of possible values • The 5% bond risk premium is applied to the retirement cost sampled • An inflation rate is sampled from the range of possible values • The retirement cost is carried-forward (escalated) to a future value, based on the sampled inflation rate • The retirement cost is then discounted back to a present value based on the fixed credit adjusted risk-free rate • The result of the run is stored in the @Risk software • The above steps are performed 4,999 additional times • All 5,000 results are combined to produce a range of possible outcomes, along with confidence levels, for the given scenario

ARO Modeling Methodology • The results of each scenario are presented in the form of a cumulative probability graph showing Present Value Costs and associated levels of confidence. • In accordance with a fiscally conservative approach, Santee Cooper has decided to use the Present Value Cost calculated at the 90% level of confidence. This means Santee Cooper is 90% certain that sufficient funds will exist to cover the estimated remediation cost. • An funding schedule is then created for each scenario (using the Present Value Cost corresponding to 90% level of confidence).

ARO Modeling Methodology • The results of each scenario are presented in the form of a cumulative probability graph showing Present Value Costs and associated levels of confidence. • In accordance with a fiscally conservative approach, Santee Cooper has decided to use the Present Value Cost calculated at the 90% level of confidence. This means Santee Cooper is 90% certain that sufficient funds will exist to cover the estimated remediation cost. • An annualized funding requirement schedule is then created for each scenario (using the Present Value Cost corresponding to 90% level of confidence) and the credit adjusted risk-free rate.

ARO Modeling Methodology • Weights, or the probabilities of occurrence, were assigned to the two scenarios run for each station: • Scenario 1: 80% (Santee Cooper Construction Management estimates provided in December 2005) • Scenario 2: 20% (Depreciation study performed in Fall 2001) • The funding schedules generated by running each of the eight scenarios are weighted at the above values (80% and 20%), and are then added to produce one funding schedule per station (for a total of four schedules). • These four schedules are then added to produce a single funding schedule. This single funding schedule is the schedule for all stations.

Larry Philbin, Principal Engineer Santee Cooper - Quality & Performance Support November 13, 2006