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Current Issues

Electric Competition

Wholesale Competition.     The Energy Policy Act of 1992 and the Federal Energy Regulatory Commission (FERC's) subsequent rulemaking activities opened the wholesale energy market to competition. Open-access transmission for wholesale customers, as defined by the FERC's rules, provides energy suppliers, including Duke Energy, with opportunities to sell and deliver capacity and energy at market-based prices. From the FERC's open-access rule, Franchised Electric obtained the rights to sell capacity and energy at market-based rates from its own assets, which also allows Franchised Electric to purchase, at attractive rates, a portion of its capacity and energy requirements resulting in lower overall costs to customers. Open access also provides Franchised Electric's existing wholesale customers with competitive opportunities to seek other suppliers for their capacity and energy requirements.

In 1999 and 2000, the FERC issued its Order 2000 and Order 2000-A regarding Regional Transmission Organizations (RTOs). These orders set minimum characteristics and functions RTOs must meet, including independent authority to establish the terms and conditions of transmission service over the facilities they control. The orders provide for an open and flexible RTO structure to meet the needs of the market, and for the possibility of incentive ratemaking and other benefits for transmission owners that participate. The FERC proposes to have RTOs or other independent transmission providers operate transmission systems in all regions of the country.

As a result of these rulemakings, Duke Power and the franchised electric units of two other investor-owned utilities, Carolina Power & Light Company and South Carolina Electric & Gas Company, planned to establish GridSouth Transco, LLC (GridSouth), as an RTO responsible for the functional control of the companies' combined transmission systems. As of December 31, 2003, Duke Energy had invested $41 million in GridSouth, including carrying costs calculated through December 31, 2002. This amount is included in Other Regulatory Assets and Deferred Debits on the Consolidated Balance Sheets. The sponsors expected that GridSouth would be substantially operational by the FERC's Order 2000 "deadline" date of December 15, 2001. However, in July 2001 the FERC ordered GridSouth and other utilities in the Southeast to join in a mediation to negotiate terms of a southeastern RTO. It does not appear that the FERC will issue an order specifically based on that proceeding. In 2002, the GridSouth sponsors withdrew their applications to the NCUC and the PSCSC for approval of the transfer of functional control of their electric transmission assets to GridSouth, and announced that development of the GridSouth implementation project had been suspended until the sponsors have an opportunity to further consider regulatory circumstances. Duke Energy believes that more open wholesale electric markets will at some point provide benefits to consumers and other market participants. Duke Energy continues to examine options relative to RTOs in light of the existing complex regulatory environment. Management expects it will recover its investment in GridSouth.

Today, the pace of electricity restructuring varies quite substantially across the U.S. Duke Energy is actively engaged in most markets, particularly those in which it owns assets. Duke Energy continues to believe that wholesale competitive markets bring added value to consumers; therefore, Duke Energy supports the continued restructuring of wholesale electric markets through a disciplined, prudent transition to regional markets. Transforming the current regulated industry into efficient, competitive wholesale and retail electric markets is a complex undertaking, and will continue to require careful planning and coordination between federal and state regulators and other key stakeholders. Duke Energy intends to continue to work with customers, legislators and regulators to address all the important issues. Management currently cannot predict the impact, if any, of these competitive forces on future consolidated results of operations, cash flows or financial position.

Natural Gas Competition

The FERC is continually proposing and implementing new rules and regulations affecting those segments of the natural gas industry, most notably interstate natural gas transmission companies, which remain subject to the FERC's jurisdiction. These initiatives may also affect the intrastate transportation of gas under certain circumstances. The stated purpose of these regulatory changes is to promote competition among the various sectors of the natural gas industry and these initiatives generally reflect more light-handed regulation of the natural gas industry.

Retail Competition.     Changes in regulation to allow retail competition could affect Duke Energy's natural gas transportation contracts with local natural gas distribution companies. Since natural gas retail deregulation is in the very early stages of development, management believes the effects of this matter will have no material adverse effect on Duke Energy's future consolidated results of operations, cash flows or financial position.

Other Current Issues

For information on other current issues related to Duke Energy, see the following Notes to the Consolidated Financial Statements: Note 4, Notices of Proposed Rulemaking section; Note 17, Environmental and Litigation sections.

New Accounting Standards

SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity." In May 2003, the FASB issued SFAS No. 150 which establishes standards for classification and measurement of certain financial instruments with characteristics of both liabilities and equities. Under SFAS No. 150, such financial instruments are required to be classified as liabilities in the statement of financial position. The financial instruments affected include mandatorily redeemable stock, certain financial instruments that require or may require the issuer to buy back some of its shares in exchange for cash or other assets, and certain obligations that can be settled with shares of stock. SFAS No. 150 is effective for all financial instruments entered into or modified after May 31, 2003 and has been applied to Duke Energy's existing financial instruments beginning on July 1, 2003.

As a result of the adoption of SFAS No. 150, Long-term Debt included trust preferred securities which had been previously included on the Consolidated Balance Sheet as Guaranteed Preferred Beneficial Interests in Subordinated Notes of Duke Energy or Subsidiaries. However, upon the adoption of the provisions of FIN 46R as of December 31, 2003, which required deconsolidation of the trust subsidiary, this long-term debt of $876 million has been reclassified as an affiliate debt balance in the Consolidated Balance Sheet. In addition, Long-term Debt, including current maturities, as of December 31, 2003 also included $25 million of preferred stock with sinking fund requirements, which had been previously included on the Consolidated Balance Sheet as Preferred and Preference Stock with Sinking Fund Requirements. In addition, $23 million of DEFS' preferred members' interest held by ConocoPhillips, which had previously been included on the Consolidated Balance Sheets as Minority Interests was reclassified to Long-term Debt. As of December 31, 2003, DEFS had redeemed all outstanding amounts of the preferred members' interest. In accordance with the requirements of SFAS No. 150, prior period amounts have not been reclassified to be in conformity with the current presentation.

Duke Energy's financial statements do not include any effects for the application of SFAS No. 150 to non-controlling interests in certain limited life entities, which are required to be liquidated or dissolved on a certain date, based on the decision of the FASB in November 2003 to defer these provisions indefinitely with the issuance of FASB Staff Position 150-3, "Effective Date, Disclosures, and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests under FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity." Duke Energy has a non-controlling interest in a limited life entity in Bolivia, whereby the entity is required to be liquidated 99 years after formation. Upon termination or liquidation of the entity in 2094, the remaining assets of the entity are to be sold, the liabilities liquidated and any remaining cash distributed to the owners based upon their ownership percentages. At December 31, 2003 the fair value of the entity's non-controlling interest of approximately $40 million is approximately $5 million less than its carrying value. Duke Energy continues to evaluate the potential significance of these aspects of SFAS No. 150, but does not anticipate this will have a material impact on Duke Energy's consolidated results of operations, cash flows or financial position. SFAS No. 150 continues to be interpreted by the FASB and it is possible that significant changes could be made by the FASB during such future deliberations. Therefore, Duke Energy is not able to conclude as to whether such future changes would be likely to materially affect the amounts already recorded and disclosed under the provisions of SFAS No. 150.

Revised SFAS No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits."     In December 2003, the FASB revised the provisions of SFAS No. 132 to include additional disclosures related to defined benefit pension plans and other defined benefit postretirement plans, such as the following: (1) long-term rate of return on plan assets along with narrative discussion of basis for selecting the rate of return used; (2) information about plan assets for each major asset category (i.e. equity securities, debt securities, real estate, etc) along with the targeted allocation percentage of plan assets by each major asset category and the actual allocation percentage at the measurement date; (3) amount of benefit payments expected to be paid in each of the next five years and the following five year period, in the aggregate; (4) current best estimate of range of contributions expected to be made in following year; (5) the accumulated benefit obligation for defined benefit pension plans; and (6) disclosure of measurement date utilized. Additionally, interim reports require certain additional disclosures related to the components of net periodic pension cost recognized and amounts paid or expected to be paid to the plan in the current fiscal year, if materially different than amounts previously disclosed the provisions of revised SFAS No. 132 do not change the measurement or recognition provisions of defined benefit pension and postretirement plans as required by previous accounting standards. Except as discussed below, the provisions of revised SFAS No. 132 are effective for fiscal years ending after December 15, 2003 (December 31, 2003 for calendar-year entities) and all interim periods beginning after December 15, 2003 (March 31, 2004 for calendar-year entities). The disclosure provisions of estimated future benefit payments and information about foreign plans are effective for fiscal years ending after June 15, 2004 (December 31, 2004 for calendar-year entities). See Note 21 to the Consolidated Financial Statements for additional disclosures required as of December 31, 2003.

FASB Interpretation No. 46 (FIN 46), "Consolidation of Variable Interest Entities."     In January 2003, the FASB issued FIN 46 which requires the primary beneficiary of a variable interest entity's activities to consolidate the variable interest entity. FIN 46 defines a variable interest entity as an entity in which the equity investors do not have substantive voting rights and there is not sufficient equity at risk for the entity to finance its activities without additional subordinated financial support. The primary beneficiary is the party that absorbs a majority of the expected losses and/or receives a majority of the expected residual returns of the variable interest entity's activities. In December 2003, FIN 46 was revised with the issuance of FIN 46R, which supercedes and amends certain provisions of FIN 46. While FIN 46R retains many of the concepts and provisions of FIN 46, it also provides additional guidance related to the application of FIN 46, provides for certain additional scope exceptions, and incorporates several FASB Staff Positions issued related to the application of FIN 46.

The provisions of FIN 46 are immediately applicable to variable interest entities created, or interests in variable interest entities obtained, after January 31, 2003 and the provisions of FIN 46R are required to be applied to such entities, except for special-purpose entities, by the end of the first reporting period ending after March 15, 2004 (March 31, 2004 for calendar-year entities). For variable interest entities created, or interests in variable interest entities obtained, on or before January 31, 2003, FIN 46 or FIN 46R is required to be applied to special-purpose entities by the end of the first reporting period ending after December 15, 2003 (December 31, 2003 for calendar-year entities) and is required to be applied to all other non-special purpose entities by the end of the first reporting period ending after March 15, 2004 (March 31, 2004 for calendar-year entities). FIN 46 and FIN 46R may be applied prospectively with a cumulative-effect adjustment as of the date it is first applied, or by restating previously issued financial statements with a cumulative-effect adjustment as of the beginning of the first year restated. FIN 46 and FIN 46R also require certain disclosures of an entity's relationship with variable interest entities.

Duke Energy has not identified any material variable interest entities created, or interests in variable entities obtained, after January 31, 2003 which require consolidation or disclosure under FIN 46 and continues to assess the existence of any interests in variable interest entities created on or prior to January 31, 2003. Duke Energy currently anticipates certain non-special purpose entities, previously accounted for under the equity method of accounting, will be consolidated by Duke Energy in the first quarter of 2004 under the provisions of FIN 46R. These entities, which are substantive entities, have total assets of approximately $225 million as of December 31, 2003 and total revenue of approximately $150 million for the year ended December 31, 2003. Duke Energy's maximum exposure to loss as a result of its involvement with these entities is approximately $100 million, generally limited to Duke Energy's investment and guarantee obligations in these entities, as of December 31, 2003. Duke Energy adopted the provisions of FIN 46R on December 31, 2003, related to its special-purpose entities consisting of the trust subsidiaries that have issued the trust preferred securities, as discussed in Note 15 to the Consolidated Financial Statements. Since Duke Energy is not the primary beneficiary of such trust subsidiaries, these entities have been deconsolidated in the accompanying consolidated financial statements effective December 31, 2003. This deconsolidation resulted in Duke Energy reflecting affiliate debt to the trusts in Long-term Debt in the Consolidated Balance Sheets. Interest paid to the subsidiary trust will be classified as Interest Expense in the accompanying Consolidated Statements of Operations beginning January 1, 2004 consistent with the classification under SFAS No. 150. Additionally, Duke Energy has a significant variable interest in, but is not the primary beneficiary of, DCS due to certain guarantee obligations as discussed in Note 18 to the Consolidated Financial Statements. As further discussed in Note 18 to the Consolidated Financial Statements, Duke Energy's maximum exposure to loss as a result of its variable interest in DCS cannot be quantified. Duke Energy continues to assess FIN 46R but does not anticipate that it will have a material impact on its consolidated results of operations, cash flows or financial position.

FASB Staff Position (FSP) FAS 106-1, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003."     In January 2004, the FASB staff issued FSP FAS 106-1, which allows a one-time election to defer accounting for the effects of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Act), which became law in December 2003. The Act introduced a prescription drug benefit under Medicare as well as a federal subsidy to sponsors of retiree health care benefit plans. FSP FAS 106-1 allows a sponsor to defer recognizing the effects of the Act in accounting for its postretirement benefit plans under SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" until further authoritative accounting guidance is issued. Duke Energy has a measurement date of September 30 th for its SFAS No. 106 postretirement benefit plans and has elected to defer application of SFAS No. 106 to the provisions of the Act under the guidance given in FSP FAS 106-1. Therefore, the accumulated postretirement benefit obligation and net periodic postretirement benefit cost contained in Note 21 to the Consolidated Financial Statements do not reflect the effects of the Act. Specific authoritative guidance on the accounting for the federal subsidy is pending and such guidance, when issued, could require a change to previously reported information. Duke Energy is still reviewing the potential impacts of the Act on its postretirement benefit plans, but currently anticipates it will qualify for the federal subsidy under the Act.

Subsequent Events

In January 2004, Duke Energy, through its wholly owned subsidiary Duke Energy Royal, LLC, agreed to sell its interest in six energy service agreements and Duke Energy Huntington Beach, LLC. In February 2004, DEFS entered into a purchase and sale agreement to sell certain gas gathering and processing plant assets in West Texas. Also in February 2004, DEM sold its 15-percent ownership interest in Caribbean Nitrogen Company. Additionally, during the first quarter of 2004, DENA sold turbines and surplus equipment. In total, all of these transactions will result in cash proceeds of approximately $265 million and a net gain of approximately $10 million.

In February 2004, DETM sold certain physical power contracts in which it held a liability position. As part of the sale, DETM paid a third party an immaterial amount, which approximated the carrying value of the contracts at December 31, 2003.

On March 1, 2004, Duke Capital Corporation, a Delaware corporation which is a wholly owned subsidiary of Duke Energy, announced that it had changed its form of organization from a corporation to a Delaware limited liability company. The change in form of organization was effected by conversion pursuant to Section 266 of the General Corporation Law of the State of Delaware and Section 18-214 of the Delaware Limited Liability Company Act. Pursuant to the conversion, all rights and liabilities of Duke Capital Corporation vested in Duke Capital LLC, a Delaware limited liability company. This conversion will not have any effect on the Duke Energy consolidated results of operations or financial position.

On March 10, 2004, DEFS entered into an agreement to acquire gathering, processing and transmission assets in Southeast New Mexico from ConocoPhillips for approximately $75 million. Pending approval from the government authorities, the transaction is scheduled to close in the second quarter of 2004.

In February 2003, Duke Energy received a Western District of North Carolina Grand Jury subpoena for documents related to the audit by the NCUC and the PSCSC of Duke Power regarding certain Duke Power regulatory accounting entries from 1998 to 2000. On March 10, 2004, Duke Energy received notice from the U.S. Attorney for the Western District of North Carolina that its investigation had been closed and that no action against Duke Energy or any individual was warranted. For additional information on subsequent events related to litigation and contingencies refer to Note 17 (Litigation section) to the Consolidated Financial Statements.

On March 14, 2004, Duke Energy entered into a share sale agreement with Alinta Ltd. to purchase Duke Energy's assets in Australia and New Zealand for approximately US$1.2 billion. The sale will result in a gain for Duke Energy and is expected to close in second quarter 2004.

For information on subsequent events related to debt and other financing matters refer to Financing Cash Flows and Liquidity—Significant Financing Activities and Other Financing Matters sections. For information on subsequent events related to Regulatory Matters refer to Note 4 to the Consolidated Financial Statements.