ML060650126

Tennessee Valley Authority 2005 Annual Report

ML060650126
Person / Time
Site:	Browns Ferry, Watts Bar, Sequoyah, Bellefonte
Issue date:	03/01/2006
From:	Morris G Tennessee Valley Authority
To:	Document Control Desk, Office of Nuclear Reactor Regulation
References
-RFPFR
Download: ML060650126 (172)

Text

Tennessee Valley Authority, 1101 Market Street, Chattanooga, Tennessee 37402-2801 March 1, 2006 U.S. Nuclear Regulatory Commission ATTN: Document Control Desk Washington, D.C. 20555-0001 Gentlemen:

In the Matter of

)

Docket Nos. 50-327 50-259 Tennessee Valley Authority

)

50-328 50-260 50-390 50-296 50-391 50-438 50-439 TVA 2005 ANNUAL REPORT In accordance with the requirements of 10 CFR 50.71(b) and 10 CFR 140.21 (e), enclosed is a copy of TVA's 2005 Annual Report. This report contains the financial data required by both regulations.

If you have questions regarding this report., please call me at (423) 751-7267.

Sincere y, lenn W. Morris Manager, Corporate Nuclear Licensing and Industry Affairs Enclosure cc (Enclosure):

Dr. William Travers, Regional Administrator U.S. Nuclear Regulatory Commission Region II Sam Nunn Atlanta Federal Center 61 Forsyth Street, SW, Suite 23T85 Atlanta, Georgia 30303-8931

• 2D030 A-ce Printed on recycled paper

(-9 Uj 0-

j

-"-I-E Financial Highlights For the years ended September 30 (in millions) 2005 2004 PERCENT CHANGE I

I Summary statements of income Operating revenues Operating expenses Operating income Other income, net Unrealized gains (losses) on derivative contracts, net Interest expense, net Net income

$ 7,794 (6.503) 7,533 (5.873) 1,291 1,660 33 37 3

(7)

(1,242)

(1,304) 85 386 3

11 (22)

(11)

NM (5)

(78)

Unless otherwise indicated, years (2005, 2004, etc.) in this report refer to TVA's fiscal years ended September 30.

A<\\

1 i

t~wf Ia r

_1 =A 9

i 000;00l_etI'Z0

___TV0_

A letter from Chairman Bill Baxter It is my privilege to serve as TVA's Chairman, along with Director Skila Harris, in an important and exciting period of transition.

As TVA prepares for the future, we are focused on sustaining our momentum in the key areas of

1) operational excellence in generating and transmitting electricity, 2) environmental stewardship, 3) our mission of fostering economic development in the Tennessee Valley and 4) our disciplined work to increase TVA's financial flexibility.

A Successful Year in Operational Excellence TVA's generation and transmission system enjoyed its most successful year on record in fiscal year (FY) 2005, selling more than 171 billion kilowatt-hours of elec-tricity to our customers and earning revenue totaling almost $7.8 billion.

The TVA power system's performance throughout the year is a tribute to operational excellence in fossil, nuclear, hydro, bulk power trading, transmission and all parts of the TVA system.

For the sixth year in a row, TVA's transmission system delivered power to customers with 99.999-percent reliability.

On July 25 and 26, the power system met TVA record peaks of 31,703 and 31,924 megawatts, respectively.

The second peak was 1,958 megawatts, or 6.5 percent, higher than the TVA record before July 25.

In the years to come, the system is expected to grow even stronger. Work to restart the Browns Ferry Nuclear Plant Unit 1 reactor is on budget and on schedule for completion in 2007. Scheduled to be the nation's first nuclear unit to come online in the 21st century, Browns Ferry 1 is expected to add 1,280 megawatts of zero-air-emission, low-cost base-load power to the TVA system.

Environmental Stewardship TVA is doing its part to make the Valley's air cleaner for our children and grandchildren. During 2005, TVA invested $202 million in clean-air equipment.

__
-

I

.

. -

-

.;

, -

_ I I 1 -

1.

, I

-1 2

l

L When our current commitments are completed, TVA.

expects to have invested $5.7 billion to reduce emissions.

As stewards of the Tennessee River system, TVA works with partners across the Valley to improve water quality through watershed teams and initiatives like the Clean Marina program.

Economic Development Meanwhile, TVA continues to deliver on its mission of economic development, partnering with public officials and community leaders who work to bring quality jobs to the region and keep them here, enabling communities to realize their dreams and making life better in the Valley.

Chairman Baxter and Director Skila Harris preside at ajily board meeting in Knoxville.

In FY 2005, TVA and our state and local partners helped attract or retain 57,000 jobs and leveraged investments of $3.6 billion in our region.

Financial Flexibility TVA is taking aggressive steps to reduce debt and give the corporation the financial flexibility it needs to meet the Valley's ever-increasing demand for electricity. This year we reduced our total financing obligations by

$301 million. This brought the total reduction of our financing obligations to $2.1 billion, from $27.7 billion at the end of 1996 to $25.6 billion at the end of FY 2005. In those nine years, the amount of each revenue dollar used to pay interest and other financing expenses has declined from 34 cents to 18 cents.

An Exciting Future This year we were pleased to welcome to TVA Tom Kilgore, who in March became President and Chief Operating Officer. Tom is an outstanding choice for leading TVA's operations.

Tom has 30 years of experience in the electric-utility industry, most recently as President and Chief Executive Officer of Progress Ventures in North Carolina. He is hard-nosed but gracious, and a natural leader, with a keen understanding of the complex challenges facing TVA in an era of competition.

At the corporate level, TVA is moving toward completion of its transition to a nine-member board of directors and a single CEO.

Director Harris and I look forward to welcoming the seven new directors when they are nominated by the President, confirmed by the Senate, and sworn in as members of the TVA Board. Once in place, the new board will name a chief executive officer to run TVA's day-to-day operations. This new management structure will enable TVA to move more quickly to adjust to a fast-changing business environment.

This is a time of transition, ongoing improvements and positive changes. What is not changing is TVA's commitment to our mission of service to the Valley.

As we adapt to changing conditions, TVA will continue to provide the benefits of our unique combination of energy, environment and economic development.

As it has been for 72 years, the winners are the people, businesses and communities of the Tennessee Valley.

Bill Baxter Chairman Proudly partnering with distributor customers to serve 8.6 million neighbors and 650,000 businesses in seven states L

I '. : '-_.

I.

-I 1 I r 7-

.o 2 '

3

!I S

=

g t

I I I.,

%.,

c. -. t--177 I

-4
1-1 dwa T.'-v-7..

2 r

VM7Z 4

A conversation with President and Chief Operating Officer Tom Kilgore Tom Kilgore was named President and Chief Operating Officer of TVA in March 2005.

Kilgore previously served as President and Chief Executive Officer at both Progress Ventures, a subsidiary of Progress Energy, and Oglethorpe Powver, which supplies powerfrom fossil, nuclear and hydroelectricplantsfor 39 consumer-ou'ned utilities in Georgia.

A native ofAlabama, he earned a bachelor's degree in mechanical engineering from the University ofAlabama and a master's in industrial engineering from Texas A&M University.

He is a member of the Alabama Engineering Hall of Fame and a Distinguished Engineering Fellow at the University of Alabama.

Q: What were your main impressions of TVA before you came on board?

I grew up in North Alabama. I saw firsthand how TVA fostered the economic health of the area.

One of my first jobs during college was on a TVA fossil-plant testing crew, so I have always been familiar with the size and scope of TVA's operations.

My previous experience gave me an appreciation for the importance of TVA's relationship with its distributor customers.

The people of TVA have much to be proud of, and one of my goals is to reinforce employees' pride in their own and in TVA's proud history of achievements.

5

\\1

Q: What were the top operational accomplishments in 2005?

Overall, this was the best that TVA's integrated power system has ever performed. For the year, TVA's system supplied our customers with more than 171 billion kilowatt-hours of electricity. You have to give credit to my predecessor, Ike Zeringue, for leaving the operating facilities in a high state of readiness.

The biggest test came during a stretch of scorching days in July, when the TVA system met peak power demands of over 29,000 megawatts on eight consecutive days.

It was the first time the system had ever had peaks of over 29,000 megawatts on any two days in a row, let alone eight. During that streak, we met our two highest peak demands ever, and the high demand continued through the fall. Starting in June, TVA set new monthly peak-demand records for five consecutive months, extending into the new fiscal year.

For the year, TVA's coal-fired plants generated 98.4 bil-lion kilowatt-hours of electricity, 4 percent above last year's total. Our system of 11 coal-fired plants achieved its best reliability ever recorded for a fiscal year.

Six fossil units set continuous-run records, including Widows Creek Unit 3, which in April completed 819 days of continuous operation to set what was at the time a national record for nuclear and coal-fired units.

All five nuclear units ran near full capacity during the crucial summer months. Their equipment reliability for the fiscal year was the best ever, with days offline due to equipment failures totaling just 6.2.

Thanks in part to our ongoing hydro power-train modernization program, TVA dams generated 15.7 bil-lion kilowatt-hours, 13 percent above normal. This is especially impressive since rainfall for the year was 9 percent below normal.

it was the best year ever for TVA's transmission-system reliability. We not only completed the sixth year in a row of 99.999-percent reliability to our customers, but we also achieved our best-ever performance in a key reliability indicator-Load Not Served. Looking to the future, we plan to continue making significant invest-ments in TVA's transmission system.

n E t-.

I, __,

-- ~

=

=

=

a I

• _ *7 _-

j 6

Q: What were TVA's top accomplishments as stewards of the Valley for 2005?

One of the basic aims of TVnA is to be a good Valley steward, improving our environment, fostering economic development and supporting communities.

TVA continues to improve its management of the nation's fifth-largest river system. In its first full year of operation, TVA's new reservoir operations policy helped us meet flow commitments, keep water levels high through Labor Day and generate much-needed hydropower to help meet record power demands.

Fifty-three marinas have now joined the TVA Clean Marina program. The program recognizes marinas that adhere to practices of responsible waste management and overall environmental compliance in their operations and by their boating customers.

Tahnika Rodriguez of Bulk Powrer Trading buys and sells megawatt-hours in tbepoicer market.

Our watershed teams, working in partnership with 8,100 volunteers, collected more than 300 tons of trash and debris from area reservoirs, streams, parks and roadways.

And TVA's series of locks and navigation channels enabled the low-cost barge transport of some 50 million tons of cargo, saving shippers almost

$550 million over the next-cheapest alternative.

7

-- I. -

___ __ I __

I -

I But I am most excited about the positive changes we are making to keep improving the air wve breathe.

Studies show that air quality in the Tennessee Valley, including the Smoky Mountains, is better now than at any time since at least the 1970s. In part this is the result of TVA's emissions-control program, which is one of the most aggressive in the nation.

TVA expects to add five sulfur-dioxide (S02) scrubbers to the six already in operation. Two are under construction, at Paradise Fossil Plant in Kentucky and Bull Run Fossil Plant in Tennessee. When the five are finished, overall S02 emissions are expected to be reduced by 80 to 85 percent below 1977 levels.

With this year's addition of two new selective catalytic reduction systems, TVA now has 20 in operation.

These and other measures have reduced summer nitrogen-oxide emissions by 80 percent since 1995.

TVA's economic development efforts helped retain or attract some 57,000 Valley jobs.

In response to the growing need for large industrial properties, or 'megasites," for automotive-manufacturing or assembly plants, TVA two years ago introduced an industrial-site certification program.

IVA contracted with the site-location firm McCallum Sweeney Consulting to identify, evaluate and certify potential megasites. In the past two years, five mega-sites have been certified-one in Kentucky, two in Mississippi and two in Tennessee.

An important aspect of corporate citizenship comes from the employees who make up TVA. Their contri-butions to our quality of life can be seen in numerous, often unheralded activities performed every day.

These activities were exemplified by selfless acts on the part of employees and retirees in the relief efforts following Hurricanes Katrina and Rita.

Winston Churchill said, NWe make a living by what we get, but we make a life by what we give." I am proud __ __,

I r"I",

__

- 7 I

- I '.

= - -

l

__ -6

8

q that TVA employees and retirees continue to demon-strate that they know what life in this Valley is about.

Q: What is TVA's top challenge in 2006?

The rising prices of coal, natural gas and purchased power present one of our toughest ongoing challenges.

Moreover, the ever-increasing demand for coal means we face mounting difficulties in getting our coal delivered, in terms of cost and availability.

Q: What are your main areas of focus moving forward?

Four important keys to TVA's future are:

1) Operational Excellence - We intend to continue meeting rising energy demands day after day through the most efficient use of system resources.

2) Financial Flexibility-Being frugal in a smart way, we must continue to reduce our debt so we are ready to meet future challenges.

This year we were able to pay down our total financing obligations by over $300 million, which was more than what was budgeted for the year.

This brings our total reduction since the end of 1996 to $2.1 billion.

This is a good trend. Still, it is not aggressive enough.

We plan to more than double that reduction over the next 10 years.

3) CustomerRelationships-To be successful, we must work effectively with the 158 power companies that serve 8.6 million people across the Valley and with our 61 directly served customers.

4) Quality of Life in the Valley - We are committed to TVA's core mission of managing the Valley's natural resources, stimulating economic growth and supporting communities as they work to improve the quality of life in our region. a "I

I

-

I
I -

-1 ;

--

-

I I

I I

I 7

9

I4 Dc 10

Tracy Holland AcCroty and Chip Troy conmpare notes in the Systemns Operations Center.

The energy to be on top of our game Throughout the challenging summer and fall, TVA's 12,700 employees - like Tracy Holland McCrory and Chip Troy of the Systems Operations Center (above) - and contractors kept more than 50 generating units running and 17,000 miles of transmission lines delivering power.

In 2005, TVA produced an amount of power equivalent to more than 13 percent of the electricity consumed by all U.S. households.

Overall, TVA's power system performed better than ever in 2005. This success is a tribute to operational excellence in fossil, nuclear, hydro, bulk power trading, transmission and all parts of the TVA system.

TVA's fossil plants continued to set records for reliability as well as continuous-run records.

TVA's 59 coal-fired units ran continuously for more than 159 hours0.00184 days <br />0.0442 hours <br />2.628968e-4 weeks <br />6.04995e-5 months <br /> - Fossil's longest stretch ever without any type of outage.

All five nuclear units generated roughly 300 million kilowatt-hours more than expected during the heavy summer demand.

Nucleonics lVeek ranked Browns Ferry and Sequoyah nuclear plants as having the nation's first-and second-lowest production costs, respectively, over a three-year period.

Watts Bar Nuclear Plant ranked third among single-unit sites. Sequoyah achieved a 100-percent index score from the Institute of Nuclear Power Operations.

Watts Bar completed its first cycle of irradiation services for tritium production, supporting the presidential directive requiring the Department of Energy to have a new supply of tritium available this year.

In spite of low rainfall, TVA dams produced 13 percent more electricity than normal.

The North American Electric Reliability Council cited TVA as an "Example of Excellence" for its reliability and internal procedures.

Along with TVA's generation mix, the bulk power trading market is a key tool for ensuring the necessary balance of power supply and demand. In 2005, TVA's Bulk Power Trading Group acquired some 12 billion kilowatt-hours through off-system purchases.

"If the market can sell us power for less than our cost of producing it," says Beth Creel of Bulk Power Trading, "we buy the power.

If we have surplus power, we sell it."

J 11

A world-class partnership At its plant in Philadelphia, Mississippi, Weyerhaeuser-one of the largest forest-products companies in the world-uses the plentiful, reliable electricity distributed by Central Electric Power Association of Carthage, Mississippi.

With 27,000 residential and 5,500 commercial and industrial customers, Central EPA is one of TVA's largest and fastest-growing Mississippi distributor customers. The area's vibrant growth is built on an excellent infrastructure, a desirable quality of life and a world-class workforce.

It is led by such regional success stories as Weyerhaeuser, the Choctaw Reservation and new facilities like Attala Steel, going up in Kosciusko.

"When Katrina hit and knocked out power all across our entire service area," says Central EPA Manager Paul Long, 'TVA was by our side with line crews, equipment, materials and technical assistance until we returned power to our customers.

"Whether it's in operational maintenance or technical services or planning to meet the needs of our new base of end-use customers, we can always count on TVA to be a strong partner," Long adds. "Right now TVA is building a 161-kilovolt interconnection point in our service area to ensure that we can continue to serve our customers with reliable power, even as our load keeps growing."

Allyson Kirkwood and Danny Burnett of Central Electric Power Association work with TVA's Earl Clardy to better senv Weyerhaeusers energy needs.

,=x, z-at!i p-z IV 12

II 7m 13

I 14

_;II.I.. _;
- _. -

-.-

_A
,

F_ 7
-

-;

i
" 4 f- -

i.-
_
 ;

I

-_, 1.,

, - -1 Jennifer Call and Roger Tanner lead the charge for cleaner air.

Caring for the air we breathe Meteorologist Jennifer Call and air monitoring specialist Roger Tanner (above) are on the front lines of TVA's efforts to monitor and improve air quality in the Tennessee Valley.

Tanner analyzes the chemistry of the atmosphere. Call creates models for predicting ozone and particulate levels across the region and provides forecast support to the states of Tennessee and Alabama.

"We've been helping forecast air quality since 2001," says Call, "and we've noticed a great improvement, not only in ozone levels but also in air quality in general."

During 2005, TVA invested $202 million in clean-air equipment, including scrubbers to reduce sulfur-dioxide emissions and selective catalytic reduction (SCR) as well as selective noncatalytic reduction systems to reduce nitrogen-oxide emissions from coal-fired plants.

With this year's addition of two new SCR systems, TVA now has 20 in operation. These systems and other measures have reduced summer nitrogen-oxide emissions by 80 percent since 1995.

In coming years, TVA expects to add five scrubbers to the six already in operation. With two scrubbers under construction, at Paradise Fossil Plant in Kentucky and Bull Run Fossil Plant in Tennessee, TVA is on track to reduce sulfur-dioxide emissions by 80 to 85 percent from 1977 levels.

I 15

r Many benefits flow from the river In June 2004, TVA adopted a new reservoir operating policy designed to enhance water-based recreation opportunities while continuing to meet other needs: reducing flood damage, protecting water quality and aquatic resources, providing year-round navigation, and providing water for power production and municipal and industrial use.

The new policy was shaped with extensive public input from citizens across the Valley as well as representatives from state and other federal agencies. It shifts the focus of TVA reservoir operations from achieving specific summer pool elevations on TVA-managed reservoirs to managing the flow of water through the river system.

Under the new policy, the drawdown of tributary storage reservoirs is restricted until Labor Day, subject to meeting downstream flow requirements.

Implementation of the new policy has gone smoothly, according to Randy Kerr, Manager of River Forecasting. "We had the wettest fall on record in 2004, and this past summer has been abnormally dry, so our new operating policy has been put to a good test. In both years, we've been able to store water to minimize flooding and supply water for a full range of downstream uses, including providing hydropower to offset the higher costs of gas-fired generating sources. By all measures, the new operating policy has been a success."

Randy Kerr and son Connor enjoy a recreational moment on Ft. Loudoun Reservoir.

-1

.7 t

16

kf--

!
,-

17

v 18

Bill Adams displays TM~sites.con, uhich helps companies find the best locations.

Attracting and retaining jobs Bill Adams, TVA Economic Development target market specialist for auto-motive assembly site consultants, says, "My goal is to find the best location for a prospective industry's needs while saving them time and money and reducing investment risk factors."

Today's economic-development world is fast-paced, competitive and global.

Through TVAsites.com, a comprehensive GIS-based land and properties database, TVA offers businesses immediate access to information that can help them with expansion and relocation decisions.

TVA target market specialists are focusing recruitment efforts on key industries-automotive, plastics, life sciences, food, and distribution/ware-housing-while nurturing businesses growing up in the Valley.

Steve Morrison (left, at control panel) started Uni-Tec Roll Inc. four years ago in the Bessemer (Ala.) Business Incubation System. He has expanded with help from TVA Economic Development loans and now has annual sales of $1 million.

TVA's Economic Development staff works with our customers, communities and stakeholders to make life better in the Valley. In FY 2005, TVA's eco-nomic-development efforts helped retain or attract some 57,000 Valley jobs.

These include 650 jobs at a T-Mobile call center in Chattanooga; 860 at Jewelry Television's distribution headquarters in Knoxville; 300 at Cullman Casting Corporation, an industrial manufacturing facility being built in Cullman, Alabama; 400 at Baldor, an electric-engine manufacturer in Columbus-Lowndes County, Mississippi; and 250 at a Benson International truck-and-trailer-body plant in Trigg County, Kentucky.

19

Aft

S -C

D At iI 20

TVA Police Officer Thomas McDaniel unpacks boxes at Second Havest Food Bank during the Combined Federal Campaign Day of Caring.

Helping our neighbors

'An important aspect of corporate citizenship comes from the employees who make up TVA," says President and Chief Operating Officer Tom Kilgore. "Their contributions to our quality of life are seen through numerous, often unheralded activities performed every day."

The events of Hurricanes Katrina and Rita brought to light the charitable acts done by TVA employees and retirees on a regular basis.

The week after Katrina struck, retirees and employees loaded tractor-trailers with 84,000 bottles of water and sent them to the Gulf Coast region. Retirees and employees then collected an additional $27,000 in cash donations to provide other much-needed supplies such as diapers and baby formula.

In the weeks afterward, employees and retirees contributed $212,000 and $34,000, respectively, to assist those affected by the tragedy.

TVA matched those funds, making the cash contributions total more than $480,000.

No one exemplifies the spirit of can-do contribution to the community more than TVA Police Officer Thomas McDaniel (above). Last June, McDaniel was recognized at an awards ceremony and reception at the White House as a 2005 National Combined Federal Campaign Hero.

Over the past 16 years, he has done it all as a volunteer, serving as a CFC key worker and campaign co-chair, running clothing drives for local shelters, teaching school children about water safety on TVA reservoirs and gang prevention in the streets, and working with the Junior Olympics.

21

1]

-[

A=--;

7:=-i-An-F

^ i:: b' ffi A: :S = M-:

i: W:=:A:

t X - -atr t P -1 MS-

- ' - Q

= ::-

W s

- o A-: f

-SX f.

A. +'-

_ S

,'-='

f _

Ax-,

A..'?'

Nation's largest public power provider 33,981 megawatts of capacity (net winter dependable) 11 fossil plants (59 units) 3 nuclear plants (5 units) 29 hydro plants (109 units); 1 pumped-storage plant (4 units) 6 combustion turbine plants (72 units) 9 diesel units 16 solar energy sites 1 wind energy site (18 turbines)

Transmission system consisting of over 17,000 miles of line Funded almost entirely by power revenues and financings, receiving no system tax dollars One of the nation's most aggressive emissions-reduction programs Stewards of the Tennessee River, the nation's fifth-largest river system 49 dams for integrated river management 11,000 miles of reservoir shoreline 293,000 acres of reservoir land managed for multiple benefits 650,000 surface acres of water for recreational use 100+ public recreation areas Clean water initiatives Green Power Switch" program

$365 million in tax-equivalent payments to Valley states and counties

$2.3 billion spent in Valley states for goods, fuel and services

$4 million to administer economic-develop-ment-related projects for the Appalachian Regional Commission

$2.3 million for regional industrial development associations (RIDAs) in partnership with distributors of TVA power

$776,000 in contributions to Chambers of Commerce 10 Economic Development field offices 158 power distributor customers 108 municipal utilities

• 50 electric cooperatives 61 directly served industries and federal agencies 12 exchange power arrangements*

8.6 million residents and 650,000 busi-nesses and industries across an 80,000-square-mile service area covering most l of Tennessee and parts of Alabama, Georgia, Kentucky, Mississippi, North Carolina and Virginia

'Includes an exchange arrangement with Tapoco Inc., a division of Alcoa Inc., which is one of PVA's 61 directly served customers TVA's power system helps the region to thrive and residents to enjoy a better quality of life by delivering reliable, affordable electric power.

TVA provides one of the most efficient and reliable transmission systems in the nation:

• Achieving 99.999-percent reliability for six straight years

• Monitoring and maintaining 17,000 miles of transmission line

• Providing accessibility through 1,025 individual interchange and connection points

• Managing 258,000 right-of-way acres Valley residents and visitors Outdoor recreation enthusiasts Industries shipping goods by barge Communities located along the Tennessee River and its tributaries, as well as those along the Ohio and Mississippi Rivers Watershed coalitions and environmental groups State and local governments and other federal agencies Municipal water utilities State and national fish and wildlife agencies and park services U

TVA is working aggressively to further improve air quality.

TVA manages the following uses of the Tennessee River system:

• Flood damage reduction

• Navigation

• Power production

• Water quality

• Water supply

• Recreation

• Land use TVAs management of the river system provides a platform for economic development throughout the Valley and supports 21.8 million recreation-user-days annually.

TVA builds business and community partnerships that bring jobs to our region-and keep them here-to make our economy stronger.

Resources include:

• World-class power reliability and attractive rate options

• Site-location services, such as TVAsites.com, a comprehensive land-and-buildings database

• Help for target industries-automotive, plastics, life sciences, food, and distribution/warehousing

• Certified megasites that feature industry-ready properties

• Financial and technical assistance for new and existing industries

• Programs to help communities prepare for economic growth 158 power distributor customers Site-selection consultants Industries Valley communities Federal agencies S[Elo st-Regional industrial development associations State and local economic developers Chambers of commerce Public officials Business incubation network Universities and colleges I

W-- f li T_'

f

=,

22

))J Bill Baxter Chairman Was appointed by President George W. Bush...sworn into office November 2001 to become the 27th member of the TVA Board of Directors...named Chairman in June 2005...prior to his appointment, was Chairman and Chief Executive Officer of his family-owned business, Holston Gases Inc., headquartered in Knoxville...appointed Commissioner of Economic and Community Development for the State of Tennessee... during his three-year tenure, the state achieved three consecutive years of record private capital investment and job creation...board member of the Grand Teton National Park Foundation and Friends of the Smokies... also serves on the U.S. Department of Energy's National Renewable Energy Laboratory National Advisory Council...B.A. from Duke University and law degree from the University of Tennessee. He and his wife, Ginger, have four children-Elizabeth, Jennifer, Joe and John.

Skila Harris Director Was appointed by President Bill Clinton to a nine-year term as the 25th member of the TVA Board of Directors in November 1999...the first woman to hold the post of TVA Director...18 years of public and private experience in the energy field.. served in the Department of Energy in both the Clinton and Carter administrations.. from 1993 to 1997, served as special assistant to Vice President Al Gore and as Tipper Gore's chief of staff...was Vice President for Development and Compliance at Steiner-Liff Iron and Metal Company from 1989 to 1992...was a contract and project manager at the U.S.

Synthetic Fuels Corporation...B.A. in political science from Western Kentucky University...M.A. in legislative affairs from George Washington University.

Terry Boston Executive Vice President, Power System Operations John J. Bradley Senior Vice President, Economic Development Kenneth R. Breeden Executive Vice President, Customer Service and Marketing Joseph R. Bynum Executive Vice President, Fossil Power Group Maureen H. Dunn Executive Vice President and General Counsel Theresa A. Flaim Senior Vice President, Pricing and Strategic Planning Kathryn J. Jackson Executive Vice President, River System Operations and Environment, and Environmental Executive Tom Kilgore President and Chief Operating Officer John E. Long, Jr.

Executive Vice President, Administrative Services Michael E. Rescoe Chief Financial Officer and Executive Vice President, Financial Services Ellen Robinson Executive Vice President, Communications Karl W. Singer Chief Nuclear Officer and Executive Vice President, TVA Nuclear I i i-

1

-'
,t-

I;

.7,,

23

Financing Goal TVA's financing goal is to offer unique investment opportunities that provide Key features of TVA bonds exceptional value for both the investor and TVA.

Bond and Note Maturities At September 30, 2005, TVA had 80 long-term debt issues outstanding of various final maturities, which totaled

$20.6 billion.

TVA had $2.5 billion in short-term discount notes outstanding at September 30, 2005.

Financing Structure At September 30, 2005, TVA had $23.1 billion of bonds and notes outstanding, including short-term notes, electronotes, PARRS, VIPS and other Power Bonds.

TVA also had $2.5 billion of other financing obligations outstanding for total financing obligations of $25.6 billion.

• Discount Notes U <1 through 10 years

• 11 through 30 years U 31 through 50 years Other Long-Term Power Bonds

• Other Financing Obligations U Short-Term Notes M electronotesQ Putable Automatic Rate Reset Securities (PARRS)

M Valley Inflation-Indexed Power Securities (VIPS)

• Credit Ratings: TVA's rated Power Bonds are rated Aaa by Moody's Investors Service and AAA by Standard & Poor's and Fitch Ratings.

• Statutory Requirements:

The TVA Act requires TVA to set power rates sufficient to pay, among other things, debt service on outstanding bonds.

• First Pledge of Payment:

Holders of TVA's senior bonds and notes are given first pledge of pay-ment from net power proceeds.

• Purpose of Issuance: TVA may only issue securities to provide capital for its power program or to refund existing indebtedness.

• State & Local Tax Exemption:

Both the principal and interest on TVA securities are generally exempt from state and local income taxes.

• Survivor's Option: Some issues contain an option that allows for redemption at par value upon the death of the beneficial owner (subject to certain limitations).

TVA securities are backed solely by the net power proceeds of the TVA power system and are neither obligations of nor guaranteed by the U. S. Government.

Form and Denomination Security electronotess PARRS (2 issues) 2003 Series A Global 2001 Series B Global 1998 Series H Global 1996 Series C Global Other Power Bonds (19 issues)

Book-Entry Form The Depository Trust Company The Depository Trust Company The Depository Trust Company The Depository Trust Company The Depository Trust Company The Depository Trust Company Federal Reserve Bank System Denomination*

$1,000

$25

£1,000

£1,000

£1,000 DM1,000

$1,000 Payments Varies with offering Quarterly Annual Annual Semi-annual Annual Various Description of TVA Securities E W TVA's electronotes program is a leces retail bond program that offers bond issues in a variety of different structures targeted to individual investors. These bonds are generally issued in denominations of $1,000, with maturities ranging from one to 30 years.

Putable Automatic Rate Reset Securities (PARRS)

These bonds trade on the New York Stock Exchange under the symbols "TVC" and "TVE." They were issued in denominations of

$25 and pay interest quarterly. An annual reset provision provides for a possible reduction in the coupon rate under certain market conditions. If the rate is reset, the bond owner has the option to put (return) the bonds to TVA at par value.

Valley Inflation-Indexed Power Securities (VIPS)

These bonds are indexed to inflation as measured by the Consumer Price Index (CPI). Investors receive a fixed coupon rate, but the principal is adjusted for the changes in the CPI over time.

Discount Notes These are short-term notes offered for sale on a continuing basis to investment dealers and dealer banks. Discount notes are sold at a discount, in book-entry form, in principal amounts of $100,000 and additional increments of $1,000.

Other TVA Power Bonds TVA has both global and domestic bonds of varying maturities, structures, currencies, and interest payment frequencies.

Market prices and broker policies may require investors to pay more or less than par value for a security in the secondary market. TVA does not guarantee the availability of any securities or the existence of any secondary markets. These pages do not include all information about TVA or its securities that is important for making investment decisions.

Neither the 2005 Annual Report nor the 2005 Information Statement constitutes an offer to sell or a solicitation of an offer to buy any 7VA securities.

KENTUCKY-K E N T U C K

Y e

1 R G I N I A e'

A j z

IkrCmek I

-I 14 N O R

T H C A R O L I N A 7ftio I

J Upper Cear crek D; G E O R G I A aI A L A B A M A

Iffl N

I I

I

=:

State Line Water Power Service Area TVA Dam dI TVA Fossil Plant TVA Nuclear Plant A

TVA Combustion Turbine Plant TVA Pumped-Storage Plant TVA Customer Service Office TVA Economic Development Office Green Power Switche Solar Site It Green Power Switche Wind Site ss Green Power Switch Methane Site U

i,

I I

I te (I mi ioIns) t I

At September 30 or for the years ended September 30, as appropri.

" - I

. 2005

 ; -

2004 11 I

.1 1,
t" I

PERCENT CHANGE At~~~

Setme 30o:o h er ne etme 0 taporit I iloo

.20 04PRETCAG System Input (millions of kilowatt-hours)

System generation Hydro, including pumped storage -

Fossil

Nuclear Combustion turbine Green power Total net generation Purchased -

Total system input 15,723 98,404 45,156 595 18 I

1 3,916 I

94,648 46,003 278 T 3 I 18

-13;

- 4.

0 ;(2).

..114 3,

- : 4 159,896 154,863 1 6,637 15,148 176,533 t170,011.1 Quvefam mifnuie Imillinne nf tuilnuumtt..hnuira I

Sales.

Municipalities and cooperatives 1 36,640 133,161 3

Industries directly served

.30,872 29,344 5

Federal agencies and other 3,986 3,353 19 Total sales 1

171,498 165,858 3

Other i1'806 1,378 31 Losses 3,229-2,775 16 Total system output

--176,533 170,011 4

Winter net dependable capacity (megawatts).

33,981 33,189 2

System peak load (megawatts) -summer 31,924 29,966 7

System peak load (megawatts) - winter 29,278 27,997

_5 Annual load factor (percent).

62.4 64.2 (3)

Number of employees at September 30 12,703 12,742 Percent winter dependable capacity by fuel source Fossil 49%

50%

(2)

Nuclear r

19%.

Hydro 17%

16%

6' Combustion turbine 15%

15%'

In the 2004 Information Statement and Annual Report, TVA began presenting ronsolidated financwl statements that Icdjde both power and nonpower activities.

0 1;---

-5 '.'if 25

..l Please help us improve the Annual Report by taking a moment to fill out this card. Just check your responses, IJ then tear off and mail the card by December 31. The postage is prepaid. You may also respond to the survey www.tva.cam at tva.com/finance. Thank you.

For the questions below, please indicate your level of agreement:

Which of the following groups best How uch ofthe report Strongly Strongly L Power distributor customer diid 'yOr read?

Disagree DisagieetAgreesAgree u

Diagre Dsagee gre Agee Li Directly served customer t All of it The financial information was easy to understand.

L O

L O

L Member of the financial community LiSome of it Li Chamber of Commerce/Economic L None of it The report helped me understand how TVA Ci El.

F]..

developer El Looked at pictures only provides affordable, reliable power, sustainable-

.E l Business or community leader economic development, and environmental

i Elected official Did you know TVA's Annual stewardship to the communities it serves.

L. Other (please specify)

Report is on tva.com?

The report gave a clear picture of TVA's customers

- Li Lfi L:

-_E]_._C Li Yes L

No and partners and how they benefit from TVA's products and services.

Other comments:

Would you like to receive a The report helped me see how TVA works with i

Li

[

0 printed copy next year?

communities in the Valley to improve the quality Li Yes L

No of life in the region.

Please provide your name and contact The report helped me develop a more informed Li Li Li if back to you.

opinion of TVA.

B NO POSTAGE NECESSARY IF MAILED IN THE UNITED STATES

-m BUSINESS REPLY MAIL FIRST-CLASS MAIL PERMIT NO. 00138 CHATTANOOGA, TN POSTAGE WILL BE PAID BY ADDRESSEE TENNESSEE VALLEY AUTHORITY 400 W SUMMIT HILL DR ET 6A kNOXVILLE TN 37902-9913 III IIuIIIhIIIIuuItuIIIIIIIIIEIIIIuamIII.tItIuImmIhI

4 I

i I

I i

General Inquiries Investor Inquiries Ellen Robinson Executive Vice President, Communications Tennessee Valley Authority 400 West Summit Hill Drive Knoxville, TN 37902 E-mall Address tvainfoitva.com Phone/Fax Numbers 865-632-6263 Fax: 865-632-4760 John M. Hosidns Senior Vice President, Treasurer/lInvestor Relations Tennessee Valley Authority 400 West Summit Hill Drive Knoxville, TN 37902 Web Site and E-mail Address www.tva.com/finance investoritva.com Phone/Fax Numbers 888-882-4975 (toll-free In the U.S.)

888-882-4967 (toll-free outside the U.S.)

Fax: 865-632-6673 i

iIIiII ii iiI It ii E-mail alert E-mail alerts are conveniently sent to a subscriber's e-mail address whenever certain new information about TVA bonds is available. To learn more about how to subscribe to e-mall alerts. visit TVA's web site at www.tva.corm/finance.

Addtonal Information Please visit www.tva.com/finance for more details on TVA investment opportunities as well as offering circulars for specific securities, or call TWAS Treasury organization toil-free at 888-882-4975. TVA does not sell securities directly to investors. TVA securities may generally be purchased through a broker, bank or other financial institution.

Gulide to using TVA's Annual Report and Information Statement This 2005 Annual Report is intended to provide highlighted information of interest about TVA's business and operations during the 2005 fiscal year. The Annual Report should be read in conjunction with the 2005 Information Statement, which is attached to this report. The Information Statement provides additional financial, operational and descriptive information, including financial statements for TVAs fiscal year 2005.

The Information Statement also provides important information about various risks to which TVA is exposed in the course of its operations, which may be important to consider before investing in any TVA securities.

The 2005 TVA Annual Report and 2005 Information Statement do not contain all information about specific TVA securities that is important for making investment decisions. Please refer to the appropriate Offering Circular, or relevant supplements, for detailed information on TVA securities.

TVA is an equal opportuniy and affirmative action employer. TVA also provides that the benefits of programs receiving TVA &inancial assistance are available to all eligible persons regardless of race, color, sex, national origin, religion, disability or age. This document can be made available in an alternate formal upon request.

This report Is prInted on 30% post-consumer recycled paper and uses soy-based inks.

6M 05-319 I

1

-1)

2005 INFORMATION STATEMENT TENNESSEE VIALLEY AUTHORITY A Wholly Owned Corporate Agency and Instrumentality of the United States of America The Tennessee Valley Authority ("TVA" or the 'Corporation") presents this Information Statement (this "Statement") for the infor-mation of interested individuals and potential purchasers of (1) its Power Bonds ("Power Bonds"), (2) its Discount Notes

("Discouht Notes"), and (3) any other evidences of indebtedress ("Other Indebtedness") it may issue pursuant lo the Tennessee ValleyAuthorityActof 1933, as amended, 16 U.S.C. §§ 831-831ee (2000 and Supp. 11 2002) (the "Act" or the 'TVAAct"). TVA issues Power Bonds pursuant to the Act and the Basic Tennessee Valley Authority Power Bond Resolution adopted by the Board of Directors of TVA (the "Board" or the 'TVA Board") on October 6, 1960, as amended on September 23, 1976, October 17, 1989, and March 25, 1992, (the 'Basic Resolution"). TV/A issues Discount Notes and Other Indebtedness pursuant to the Act and their authorizing resolutions. Power Bonds, Discount Notes, and Other Indebtedness are collectively referred to in this Statement as 'Evidences of Indebtedness."

Evidences of Indebtedness are not obligations of the United States of America, and the United States of America does not guarantee the payment of the principal of or Interest on any Evidences of Indebtedness. TVA Is not required to register Evidences of Indebtedness with the Securities and Exchange Commission ("SEC") under the Securities Act of 1933 or to make periodic reports under the Securities Exchange Act of 1934. Beginning with TVA's 2006 annual report, however, TVA will be required to file annual reports, quarterly reports, and current reports with the SEC under section 37 of the Securities Exchange Act of 1934. (See "Management's Discussion and Analysis of Financial Condition and Results of Operations-"Legislative and Regulatory Matters" in Part II.)

TVA may offer Evidences of Indebtedness from time to time or on a continuous basis either by direct placement or through selected investment dealers, dealer banks, underwriters, or underwriting syndicates.

For Power Bonds offered from time to time, TVA typically prepares an offering circular describing the specific terms and conditions of the Power Bonds.

For Power Bonds offered under a program on a continuous basis, TVA typically prepares a single offering circular that describes the general terms and conditions common to all securities issued under the program.

For offerings of Discount Notes, TVA typically prepares a single offering circular describing the general terms and conditions common to all offerings of Discount Notes.

For offerings of Other Indebtedness, TVA typically prepares either an offering circular describing the specific terms and conditions of the particular offering or a more general offering circular, as TVA deems appropriate.

For any offerings made through a program under which Evidencrs of Indebtedness are offered on a continuous basis, the offer-ing circular typically describes how, if at all, the offerinwill be supplemented in order to reflect, among other things, the specific terms and conditions of the securitiesling offered. You should read this Statement, as it may be supplemented or amended, together with the appropriate offering circular, as it may be supplemented or amended, for each offering.

For each offering of an Evidence of Indebtedness, you should rely only on the information contained in (1) this Statement, (2)

,the relevant offering circular, and (3) any supplements or amendments to these documents approved by TVA. TVA has not authorized anyone to provide you with any information that is different from that found in this Statement and each relevant offer-ing circular and any supplements or amendments to such documents. This Statement does not constitute ar offer to sell or a solicitation of an offer to buy any Evidences of Indebtedness in any jurisdiction to any person to whom it is unlawful to make an offer or solicitation.

This Statement is accurate only as of its date. TVA may supplement, amend, or replace this Statement from time to time, gen-erally no more often than annually, to reflect its annual financial results or otherwise as TVA deems appropriate. However, TVA assumes no duty to update this Statement. If TVA does supplement, amend, or replace this Statement, you should rely on the most recent supplements or amendments to or replacement of this Statement over different information in this Statement.

Any statements in this Statement involving matters of opinion, regardless of whether expressly so identified, are opinions only and not factual representations. This Statement is not a contract with the purchaser of any Evidences of Indebtedness.

You may obtain additional copies of this Statement by writing to Tennessee Valley Authority, 400 West Summit Hill Drive, Knoxville, Tennessee 37902-1401, Attention: Investor Relations, by calling 1-888-882-4975, or on the TVA website:

www.tva.com.

The date of this Information Statement Is November 18, 2005.

TABLE OF CONTENTS: ;-

2005 Information Statement Page PART I Business............................'....................................'............

1 Properties.........................................................

8 Legal Proceedings.;

16 Certain Provisions of the Tennessee Valley Authority Act and Related Laws.18 The Basic Resolution; Power Bonds, Discount Notes and Other Indebtedness.....................

19 PART 11, Selected Financial Data 24 Management's Discussion and Analysis of Financial Condition and Results of Operations

.27' Qualitative and Quantitative Disclosures about Market Risk 71 Financial Statements and Supplementary Data...................................

79 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure....

125 Controls and Procedures.....

125 PART III Directors and Executive Officers............................

127.

Labor Agreements and Compensation............................

128 Code of Ethics.............................

.129 Principal Accountant Fees and Services............................

129 PART IV Statistical and Financial Summaries...........................

130 Certifications~

C~~~~er iiain:

...........-............... j......;..1.-............-.- :..:.13 Supplemental Schedule

.135 Pagei

s FPART l BUSINESS FARTI General Forward-Looking Information This Statement contains forward-looking statements relating to future events and future performance. Any statements regarding expectations, beliefs, plans, projections, estimates, objectives, intentions, assumptions, or oth-erwise relating to future events or performance may be forward-looking.

In certain cases, forward-looking statements can be identified by the use of words such as "may," "will,"

"should," "expect," "anticipate," "believe,","intend," "project," "plan," "predict," "assume," "forecast," "estimate," "objec-tive," "possible," "potential," or other similar expressions.

Some examples of forward-looking statements include statements regarding strategic object ves; estimates of costs for disposing of certain tangible long-lived assets; expectations about the adequacy of TVA's nuclear decom-missioning fund; the impact of new accounting pronouncements and interpretations, including Financial Accounting Standards Board ("FASB") Interpretation No. 46, 'Consolidation of Variable Interest Entities - an interp'etation of ARB No. 51,'which was amended by FASB Interpretation No. 46R, and Statement of Financial Accounting Standards No.

151, "Inventory Costs -

an amendment of ARB No. 43, Chapter 4," and FASB Interpretation No. 47, 'Accounting for Conditional Asset Retirement Obligations -

an interpretation of FASB Statement No. 143;" TVA's plans to continue using short-term debt to meet current obligations; and the anticipated cost and timetable for returning Browns Ferry Unit 1 to service.

Although TVA believes that the assumptions underlying the forward-looking statements are reasonable, TVA does not guarantee the accuracy of these statements. Numerous factors could cause actual results to differ material-ly from those in the forward-looking statements. These factors include, among other things, new laws, regulations, and administrative orders, especially those related to the restructuring of the electric power industry and various envi-ronmental matters; increased competition among electric utilities; changes to the Anti-Cherrypicking Provision; legal and administrative proceedings affecting TVA; the financial and economic environment; performance of TVA's gener-ation and transmission assets; fuel prices; demand for electricity; changes in technology; changes in the price of power; loss of any significant customers or suppliers; creditworthiness of counterparties; weather conditions and other natural phenomena; damage to power production or transmission facilities or systems due to accidental events or ter-rorist activity; changes in accounting standards; and unforeseeable events. New factors emerge from time to time, and it is not possible for management to predict all such factors or to assess the extent to which any factor or combi-nation of factors may impact TVA's business or cause results to differ materially from those contained in any forward-looking statement.

TVA undertakes no obligation to update any forward-looking statement to reflect developments that occur after the statement is made.

Fiscal Year,!

Unless otherwise indicated, years (2005, 2004,, etc.) in this Statement refer to TVA's fiscal years ended September 30.

Notes References to "notes" are to the Notes to Financial Statements contained in Part II.

The Corporation TVA is a wholly-owned corporate agency and instrumentality of the United States government created in 1933 by the WVAAct and charged with providing improvement for navigation, flood damage reduction, agricultural and indus-trial development, and electric power to the Tennessee Valley region. TVA has developed and operates one of the largest electric power systems in the United States, having produced nearly 160 billion kilowatt-hours ('kWh") of elec-tricity in 2005.

I I

Page I

TVA is currently administered by a board of three persons appointed by the President and confirmed by the Senate, although only two Board members are currently in office. Appointments are currently for nine-year sta'gered terms, with one term expiring each three-year interval.

The Consolidated Appropriations Act, 2005, among other things, included provisions which will result in the restructuring of the Board and the establishment cf the position of a Chief Executive Officer. 'The legislation restruc-tures the Board by increasing the number of directors from three full-time members to nine part-time members, at least seven of whom must be legal residents of the'TVA service'area. As with the current Board, future Board members will be appointed by the President and confirmed by the Senate, but will serve, after a transition period, five-year terms rather than the current nine-year terms. The Board's role will continue to be, among other things, ':o develop long-term plans and strategies for TVA, approve annual budgets and an employee compensation plan for iVA, and have gener-al responsibility for TVA policies. The Board will also create an audit committee consisting of members of the Board Independent of the management" to review reports from TVA's external auditors and Inspector General and make rec-ommendations to the full Board. Congress also reaffirmed the authority of the Board to set electric rates charged by TVA. These provisions will go into effect on the date when three new members of the Board take office. The mem-bers of the Board will select a member to serve as Chairman.

Historically, the programs at TVA have consisted of power and nonpower programs. Revenues and expens-es of the power program are segregated from othe r revenues and expenses.! Substantially all of TVA's revenues and assets are attributable to its power program. For a discussion of the funding of TVA's nonpower programs, see note 13 in Part II. The financial'statements included in this Statement include the combined results of all TVA programs.

The'Act requires the power program to be self-supporting from 'power system revenues and capital TVA rais-es through its power program financings. The Act authorizes TVA to issue Evidences of Indebtedness in an amount not exceeding $30 billion outstanding at any one ti-ne. See "Certain Provisions of the Tennessee Valley Authority Act and Related Laws"- 'Public Law No. 105-62" and "The Basic Resolution; Power Bonds, Discount Notes and Other Indebtedness" in' Part I.

Under certain circumstances, the Act permits TVA to borrow up to $150 million for a period of one year or less from the United States Treasury ("Treasury"). :'The Act requires TVA to obtain the approval of :he Secretary of the Treasury of the issue date and maximum interest rate for any issuance of an' Evidence of Indebtedness with a term of one year or longer. 'The Office of Management and Budget ("OMB") includes TVA's finances as part of the budget of the United States. '

'The Act requires TVA to anriually file a financial statement and complete report as to its business with the President and Congress., The Government Corporation Control Act authorizes the Comptroller General of the United States to periodically audit the transactions of TVA. '

Regulation of TVA Congress TVA exists pursuant to legislation enacted by Congress and operates within the bounds set by this legislation.

Congress has the authority to control TVA's activities, reduce such activities, change TVA's structure, or even eliminate TVA through legislation. In order to'allow TVA more freddor tb'6perate'than a traditional agency, however, Congress, in passing the TVA Act in 1933, exempted TVA frcm many general federal laws that govern other agencies, such'as laws related to the hiring of employees, the procurement of supplies and services, and the acquisition of land. Since 1933, Congress has exempted TVA from certain federal laws applicable to other agencies in recognition of TVA's unique status. Other federal laws enacted since the creation of TVA have been made applicable to TVA including those related to the protection of the environment and cultural resources and civil rights laws.

Federal Energy Regulatory Commission i A

-a'-TVA is not a "public utility" as defined in the Federal Power Act ("FPA"). Therefore, TVA is not subject to the plenary jurisdiction of the Federal Energy Regulatory Commission ('FERC") under the FPA. TVA is, however, an "elec-tric utility" as defined in the FPA and, thus, is subject to certain aspects of FERC's jurisdiction under Sections 210 to 212 of the FPA. TVA has elected to implement various FERC orders and regulations on a voluntary basis to the extent consistent with TVA's obligations under the TVA Act.

Page 2

The Energy Bill signed by the President on August 8, 2005,-gave FERC additional authority over TWA in lim-ited areas:

TVA is subject to FERC review of transmission rates and terms and conditions of service to ensure com-

, parability of treatment of its and others regarding the same transmission service. The bill also reaffirms the Anti-Cherrypicking Provision in providing that TVA distributors will be afforded native load preference regarding firm transmission rights on the TVA transmission system, but in a way that (i) will not affect the requirements of the Anti-Cherrypicking Provision and (ii) will not itself provide a new. basis for any FERC

, order that would be contrary to the purposes of the Anti-Cherrypicking Provision. (Native load refers to the customers on whose behalf a company, by statute, franchise, regulatory requirement, cr contract, has undertaken an obligation to serve. The Ariti-Cherrypicking Provision provides that FERC, cannot order TVA to deliver power from a non-TVA source to a customer if the power would be consumed within TVA's defined service territory.)

FERC's authority to order refunds of excessive prices on short-term sales (transactions lasting 31. days or less) in market manipulation and price gouging situations is expanded to include authority over TVA if TVA makes such sales under a FERC approved tariff.

I

• TVA is subject to new prohibitions on (i) using manipulative or deceptive devices or contrivances in con-

- nection with the purchase or sale of electric energy or the purchase or sale of transmission services sub-ject to jurisdiction and (ii) willfully and knowingly reporting false information on the price of electricity sold at wholesale or the availability of transmission capacity to a federal agency with intent to fraudulently affect the data being compiled by the agency. This includes becoming subject to FERC's investigative

.and enforcement authority in these two areas.

FERC is authorized to issue regulations requiring the reporting, on a timely basis, of information about the availability and prices of wholesale electric energy and transmission service by all market participants, including TVA.

States The Supremacy Clause of the United States Constitution prohibits states, without congressional consent, from regulating the manner in which the federal government conducts its activities. As a federal agency, TVA is exempt from regulation, control, and taxation by states except in certain areas such as air and water quality where Congress has given the states limited powers to regulate federal activities.

Governmental Entities TVA's activities and records are also subject to review by various governmental entities including TVA's Office of Inspector General, the Government Accountability Off ce, the Congressional Budget Office, the Nuclear Regulatory Commission, the Environmental Protection Agency, and OMB.

The Area Supplied by the Tennessee Valley Authority TVA supplies power in most of Tennessee, northern Alabama, northeastern Mississippi, and southwestern Kentucky, and in small portions of Georgia, North Carolina, and Virginia. TVA serves a population of more than eight million people. Subject to certain minor exceptions, TVA may not without specific authorization by act of Congress enter into contracts which would have the effect of making it or the distributors of its power a source of power supply outside the area for which TVA or the distributors were the primary source of power supply on July 1, '957.

Rates and Customers TVAis primarily a wholesaler of power. Its customers consist of three major groups: (1) distributors, consist-ing of municipalities and cooperatives; (2) industries that have large or unusual loads; and (3) federal agencies.

Additionally, TVA has entered into exchange power arrangements with most of the electric systems that border its serv-ice territory as allowed by the TVA Act.

E Page 3

' The Act gives the Board sole responsibility for establishing the rates TVA charges for power and authorizes the Board to include in power contracts terms and conditions that it judges necessary or desirable for carrying out the purposes of the Act. The Act requires TVA to charge rates for power which, among other things, will produce gross revenues sufficient to provide funds for (1) operation, maintenance, and administration of its power system; (2) pay-ments to states and counties in lieu of taxes; (3) debt service on outstanding Evidences of Indebtedness; and (4) annu-al payments to the Treasury in repayment of and as a return on the government's appropriation investment in TVA power facilities. See "Certain Provisions of the Tennessee 'Valley Authority Act and Related Laws" and "The Basic Resolution; Power Bonds, Discount Notes and Other Indebtedness" -

"Rate Covenant" in Part I. Rates set by the Board are not subject to review or approval by any state or federal regulatory body. In a future restructured electric power industry (discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations" - "TVA and Competition" in Part II), it is possible that the ability of the Board to set TVA's rates as spec-ified in the TVA Act could be adversely affected by legislative changes or by competitive pressures.

A summary of operating revenues by customer type for each of the last five years ended September 30 is shown in "Selected Financial Data" in Part II.

Municipal and Cooperative Distributors Sales to municipal and cooperative distributors customers ("distributors") accounted for approximately 84 per-cent of TVA's total operating revenues in 2005. TVA has wholesale power contracts with 158 municipal and coopera-tive distributors. All of these contracts require distributors to purchase substantially all of their electric power and ener-gy requirements from TVA.

All distributors purchase power under one of three basic arrangements.': Forty-eight distributors purchase power under contracts that require ten years' notice to terminate. These contracts provide that on each anniversary beginning on the tenth anniversary, one additional year is automatically added to the term. Five distributors have con-tracts that require 15 years' notice to terminate the contract. On each anniversary of these contracts, beginning on the fifth anniversary, one additional year is automatically added to the term. TVA has also offered distributors the option of moving from ten-year or 15-year termination notice periods to a five-year termination notice period. Ninety-eight dis-tributors, including two of the largest, have entered into contractual arrangements of this type. Sales to these two dis-tributors generated approximately 12 percent of TVA's total operating revenues in 2005. Nine of the 158 distributors have given TVA notice to terminate their power contracts, and seven of these notices remain in'effect. As a result, these seven distributors effectively have contracts with'durations of less than five years. See "Termination Notices" below.

The number of distributors with the contract arrangements described above, the revenues derived from such arrangements in 2005, and the percentage of TVA's 2005 total operating revenues represented by these revenues are summarized in the table below.

Sales to Percentage of Number of Distributors --

Total Operating Revenues Contract Arrangement Distributors in 2005 in 2005 (in millions) 15-Year Termination Notice

- 5 75 1.0%

10-Year Termination Notice

.48

- 2,174 27.9%

o.

5-Year Termination Notice 98 4,062' 52.1%

5-Year Termination Notice 7

250 3.2%

• (Scheduded to terminate due to distribuitor notice)

TVA's wholesale power contracts contain standard provisions specifying the wholesale rate and terms and conditions under which power is sold to distributors. Under these contracts, TVA, on a quarterly basis, may determine and make adjustments in the wholesale rate schedules necessary to enable TVA to meet all the requirements of the Act and the financial requirements, covenants, and provisions of its bond resolutions. The contracts provide for agree-ment between the parties on general or major changes in the 'wholes6le schedules.: If, however,' agreement is not reached, the contracts permit TVA to make changes in these schedules to carry out the objectives of the Act, to meet financial requirements and covenants, and to comply with the provisions of its bond resolutions.

Page 4

{ -

Most of the power contracts between TVA and the distributors specify the resale rates that distributors charge the ultimate power customers. These rates are revised from time to time to reflect changes in costs, including changes in the wholesale cost of power. They are designed to promote the Act's objective of providing an adequate supply of power at the lowest feasible rates.

A number of TVA distributors, including some wth the largest loads, have expressed interest in further revis-ing their wholesale power contracts to allow them more cptions with respect to contract terms and other matters, such as purchasing a portion of their power requirements from suppliers other than TVA. TVA is working with distributors and the Tennessee Valley Public Power Association ("TVPPA"), an association that represents all distributors of TVA power, to develop future wholesale pricing options and new long-term contract options.

TVA has also entered into agreements with four distributors that significantly reduce TVA's involvement with their, resale rates and with five distributors that provide for TVA's termination notice period to generally be ten years even if the distributor has chosen the five-year option described above. Contracts with two distributors contain both of these features.

I l

I For a discussion of the effects of competition in a restructured electric power market, see 'Management's Discussion and Analysis of Financial Condition and Results of Operations" -'"TVA and Competition" in Part II.

During October 2002, TVA introduced the Discounted Energy Units ("DEU") program. Under this program, TVA customers purchase DEUs, generally in $1 million increments, which entitle them to a 0.025 dollar/kilowatt-hour discount on a specified quantity of firm load over a period of years (five, ten, 15, or 20) for each kilovatt-hour in the prepaid block. The remainder of the price of the kilowatt-hours delivered is due upon billing. Upon termination of the power contract, the DEU agreement terminates unless TVA and the distributor agree to other supply arrangements.

Absent such agreement, the remaining net present value of the balance of the unearned revenue will be returned to the distributor upon termination.

TVA did not offer the DEU program in 2005. Hcwever, as of September 30, 2005, TVA had en:ered into sales agreements for 54.5 DEUs totaling $54.5 million. TVA is accounting for the prepaid power as unearned revenue. (See "Management's Discussion and Analysis of Financial Condition and Results of Operations" -Energy Prepayment Obligations' in Part II.)

-. C In November 2003, TVA, Memphis Light, Gas and Water Division ("MLGW"), and the City of Memphis entered into an arrangement whereby MLGW prepaid a portion of its power requirements for 15 years for a fixed amount of kilowatt-hours. The prepayment will be applied to MLGW's 'monthly power bill on a straight-line basis over the same 15-year period. The amount of the prepayment was $1.5 billion. TVA is' accounting for the prepaid power as unearned revenue (see "Management's Discussion and Analysis of Financial Condition and Results of Operations" -

"Energy Prepayment Obligations" in Part II).

Other Sources of Revenues

• Revenues from directly served industries and federal agencies, exchange power arranernerits with other power systems, and other revenue sources accounted for approximately 16 percent of TVA's total operating revenues in 2005. Contracts with industries and federal agencies directly served by TVA are normally for ten-year terms. These contracts are subject to termination by TVA or the 6ustomer upon a minimum notice period that varies according to the customer's contract demand and the period of time sen/ice has been provided to the location where service would be terminated. TVA establishes the rates it charges to industrial customers it directly serves. These rates normally are the same as those charged by the distributors of TVA power to large customers (those with demand greater than 25,000 kilowatts).

TVA also has exchange power arrangements with 12 neighboring powerrsystems. As part of the TVA self-financing legislation enacted by Congress in 1959, TVAwas restricted to selling power outside of the IVAservice area to what were then 14 power generating companies. Due to mergers and acquisitions over the years, there are now 12 of these grandfathered organizations remaining. The agreements are open-ended but do have termination provi-sions.

Termination Notices During 2005, TVA received notices from three distributors in Kentucky terminating their power contracts with TVA. In December 2004, TVA received notice from Paclucah Power System ("PPS") that terminates its, power contract Page 5

with TVA effective December 2009.

In January 2005, TVA received notice from Princeton Electric Plant Board

('PEPB") that terminates its power contract with TVA effective January2010: In August 2005, TVA received notice from Hopkinsville Electric System (HES") that terminates its power contract with TVA effective August 2010. In 2005, 0.4 percent of TVA's total operating revenues were from sales to PPS; less than 0.1 percent of TVA's total operating rev-enues were from sales to PEPB; and less than 0.3 percent of TVA's total operating revenues were from sales to HES.

Since October 2002, nine of TVA's distributors have given notice to terminate their powercontracts with TVA.

Notices from two of these distributors -

Bowling Green Municipal Utilities and Meriwether Lewis Electric Cooperative have since been withdrawn and deemed to be of no force and effect by the mutual agreement of the distributor and TVA. In addition, Duck River Electric Membership Corporation ("DREMC") and TVA have agreed in principle to a con-tract amendment that, if executed, would extend DREMC's termination date from August 2008 until August 2010.

The table below lists the names and locations of the seven distributors whose termination notices are still in effect, their contract termination dates, the amount of revenues that TVA generated by selling power to these distribu-tors in 2005, and the percentage of TVA's total 2005 operating revenues represented by these revenues.

Date of Sales to Percentage of Termination of Distributor Operating Distributor

.Location Power Contract In 2005 Revenues In 2005 (in millions)

Warren Rural Electric Kentucky April2008 82 1.0%

Cooperative Corporation Duck RIver Electric Tennessee August 2008 85 1.1%

Membership Corporation Monticello Electric Plant Board Kentucky November 2008 5

0.1%

Glasgow Electric Plant Board Kentucky December 2008 1

0.2%

Paducah Power System Kentucky December 2009 33 0.4%

Princeton Electric Plant Board Kentucky January 2010 6

0.1%

Hopkinsville Electric System Kentucky August 2010 21 0.3%

Total

$250 3.2%

In addition to the six Kentucky distributors listed above, TVA has 11 other distributors located in Kentucky.

Sales to these 11 distributors generated approximately three percent of TVA's total operating revenues in 2005. See

'Management's Discussion and Analysis of Financial, Condition and. Results of Operations" -

'Legislative, and Regulatory Matters"- 'Other Matters" in Part II of this Statemerit for discussion of a bill that would effectively remove any area within Kentucky from coverage of the Anti-Cherrypicking Provision.

In January 2004, the United States Enrichment Corporation ('USEC") announced it will begin constructing its new commercial centrifuge facility in Piketon, Ohio. While it is unclear how much electricity USEC will need to acquire from TVA for its Paducah, Kentucky, facility ('Paducah Facility") once this new facility is opened, it is expected to be substantially less. Under the current contract with TVA, USECis required to purchase a fixed amount of electricity for its Paducah Facility through May 2006. In 2005, sales to USEC for its Paducah Facility generated approximately 4.4 percent of WA's total operating revenues. TVA does not expect any,loss of revenues from sales to USEC to have a material effect on TVA's financial condition.

Power and Energy Requirements TVA prepares annual forecasts of future power and energy requirements as part of its planning and budget-ing process. TVA's forecast procedure involves producing a range of load forecasts for the explicit purpose of bound-ing the range of uncertainty associated with load growth. TVA produces the load forecasts probabilistically. TVA believes that there is a 90 percent probability that the actual load will be less than the high load forecast, a 50 percent probability that the actual load will be less than medium load forecast, and a ten percent probability that the actual load will be less than the low load forecast. TVA's current load forecast through 2007 reflects an average annual eriergy growth rate of 1.4 percent with 2.8 percent for the high and (0.4) percent for the low load forecasts. Numerous factors could cause actual results to differ materially from TVA's forecasts. See 'Business"- 'General- 'Forward Looking Information"in Part I.

Page 6

Fuel

-i.,

Management believes the sources and availability of fuel materials essential to its business should be ade-quate for the foreseeable future.

Fossil Fuel Coal consumption at TVA generating facilities during 2005 was 45 million tons. Coal is purchased under con-tracts ranging from a single delivery to multiple deliveries over several years. TVA coal inventory targets vary from plant to plant based upon a probabilistic inventory model. As of September 30, 2005, TVA had 16 days' system-wide coal supply in inventory at full burn., Coal Inventories have been impacted by recent shortfalls in deliveries of mid and low sulfur coals from the Powder River Basin (Wyoming) ("PRB"), Uinta Basin (Colorado and Utah), and Illinois Basin.

Problems with rail transportation from the PRB and mine production problems in the Uinta and Illinois Basin regions are the primary causes for the shortfalls in deliveries. Evaluation of alternative fuel supplies indicates that obtaining low cost replacement coals that meet plant and regulatory requirements will be more difficult than past experience.

Total fossil fuel inventory at September 30, 2005, and 2004, amounted to $185 million and $193 million, respectively, of which $149 million and $158 million, respectively, related to coal inventory.

TVA has in place term coal contracts which supplied 89 percent of TVA's total coal requirements for 2005.

The remaining 11 percent was purchased in the spot coal market under contracts with terms of one year or less. Thirty-nine percent of TVA's coal supply comes from the Illinois Basin; 23 percent from the PRB of Wyoming; 22 percent from the Uinta Basin of Utah; and 16 percent from the Appalachian Basin of Kentucky, Pennsylvania, Tennessee, Virginia, and West Virginia. Thirty-seven percent of TVA's coal supply was delivered by train, 19 percent was delivered by barge, and 36 percent was delivered by a combination of barges and trains. The remainder was delivered by truck.

During 2005, TVA purchased substantially all of its natural gas requirements under contracts with terms of one year or less. TVA purchases substantially all of its natural gas to operate combustion turbine peaking units and to sup-ply fuel under power purchase agreements in which TVA is the fuel supplier. As a result of hurricanes Katrina and Rita during the summer of 2005, the Energy Information Agency ("EIA") has estimated that 76 percent of Gulf Coast gas supplies were "shut-in" as of September 30, 2005, meaning that the gas wells were not able to produce. The EIA expects a significant amount of Gulf Coast gas supplies to remain shut-in through December 2005 with recovery to continue well into 2006. This may result in tight supplies or shortages and higher prices during the 2005-2006 winter season. TVA has natural gas supply in storage and inteids to make forward purchases of natural gas for future deliv-ery in order to meet TVA's expected demand. All of TVA's combustion turbines are dual fuel capable, arid TVA has fuel oil stored on each site as a backup to natural gas. The combustion turbine units produced less than 0.4 percent of the electricity that TVA generated during 2005. See note 8 -Financial Trading Program.

Nuclear Fuel i;

TVA owns all nuclear fuel held for its nuclear units. The net book value of this fuel was $340 million as of September 30, 2005.: TVA plans to meet future uranium requirements through a combination of temi and spot pur-chase contracts while maintaining diversity of supply sources., TVA currently'has approximately 61 pe rcent of its for-ward five-year (2006 through 2010) uranium requirements either in inventory or under contract for its boilingiwater reactor units at its Browns Ferry Nuclear Plant and has 29 percent of its forward five-year (2006 through 2010) urani-um requirements under contract for its pressurized water reactor ("PWR") units at its Sequoyah and Watts Bar Nuclear Plants. At its July 2005 Board Meeting, the Board approved the purchase of uranium concentrates (refined raw ura-nium) and uranium conversion services (chemical process readying the concentrates for the enrichment process). The converted material will be fabricated into fuel for use in the Sequoyah and Watts Bar Units. Negotiations of contracts for these purchases were in progress at the end of 2005.

TVA also has agreements with the Department of Energy ("DOE") and Framatome ANP to use blended low enriched fuel at its reactors. This fuel was successfully loaded in Browns Ferry Unit 2 in April 2005 and will provide approximately 11 to 12 more reloads for the Browns Ferry reactors (see note Blended Low Enriched Uranium Program).

Page 7

PROPERTIES The Tennessee River system provides multiple benefits for people of the Tennessee Valley. TVA manages the use of resources among its multiple river-system responsibilities: navigation, flood damage reduction, power gen-eration, environmental stewardship, shoreline use, and water supply for power plant operations, consumer use, recre-ation, and industry.

TVA's power system is one of the largest in the United States in capacity and in energy production. Its size permitted the construction of large facilities which -has resulted in lower unit costs. TVA's dams were completed decades ago when construction costs were far below present-day levels. In accordance with the Act, all real estate acquired by TVA is acquired in the name of the United States. See 'Certain Provisions of the Tennessee Valley Authority Act and Related Laws" in Part I.

Generating Resources '

TVA's power generating facilities at September 30, 2005, included 29 conventional hydroelectric plants, one pumped storage hydroelectric plant, 11 coal-fired plants, three nuclear plants, six combustion turbine plants, one wind energy site, and 16 solar photovoltaic sites. Energy is delivered to TVA customers over a transmission system which interconnects with neighboring power systems at numerous points.

The following table summarizes TVA's net generation in millions of kilowatt-hours by generating source for the years indicated:

GENERATION BY FUEL SOURCE (millions of kWh) 2005 2004 2003 2002 2001 Hydroelectric 15,723 13,916 16,103 10,205 9,508 Coal Fired 98,404 94,648 90,975.

94,930 100,118 Nuclear 45,156 46,003 43,167 45,179 45,615 Combustion Turbine and Diesel Generators 595 278 817 1,190 1,073 Other 18 18 15 18 5

Total 5:

159,896

' 154,863 151,522 156,319 Hydroelectric power plays a vital role in the TVA power system because it is economical and reliable, and it can be brought online quickly when the demand for electricity is high or when energy is needed due to system prob-lems or lost generation. TVA maintains 29 conventional hydroelectric dams and one pumped storage plant for the pro-duction of electricity.' Nine of these hydroelectric dams are on the main channel of the Tennessee River, and 20 are on tributary rivers: The hydroelectric system typically generates between six and 11 percent of TVA's electricity sup-ply each year.

TVA's fossil plants include coal-fired plants and combustion turbines that are fueled by natural gas and fuel oil. The 59 units at TVA's 11 coal-fired plants typically provide nearly two-thirds of the power produced by TVA. The 72 combustion turbine units at six sites are quick-start facilities that, at times of peak demand, bolster TVA's ability to supply its customers with power. The combustion turbines typically generate less than one percent of TVA's power annually.

TVA began building nuclear power plants in the 1960s and currently has five operating units at three sites.

These plants'typically supply approximately 29 percent of TVA's power. A sixth unit is currently in recovery and is expected to be online in 2007. (See Nuclear Power Program"'below.)

During 2005, 62 percent of the power generated by the TVA coordinated system was by coal-fired plants and combustion turbines, 28 percent by nuclear units, and nearly ten percent by hydroelectric units.

'Page 8

I 7

,

I-I 1

11I

'j TVA:SERVICE AREA I K

'k I

I I

Virg ini.

j*

t

.,,l TVA Hydro Plant TVA Fossil Plant TVA Nuclear Plant TVA Pumped Storage TVA Power Service Area The following table summarizes the winter net ed system as of September 30, 2005:

dependable capacity ("NDC") in megawatts ("MW") on this coordinat-I.I Page 9

TVA WINTER NET DEPENDABLE CAPACITY TVA-OWNED/LEASED FACILITIES I.

,I j, Number Location of Units Winter Net Dependable Capacity (MW) (I)

Date Last Unit Placed in Service Hydroelectric Conventional Plants Pumped Storage Total Hydro North Carolina, Tennessee,

Georgia, Alabama, and Kentucky Tennessee 109 4

113 3,507 1,597 5,104 1914-1972 1979 Coal-Fired Allen Bull Run Colbert Cumberland Gallatin John Sevier Johnsonville Kingston Paradise Shawnee Widows Creek Total Coal-Fired Tennessee Tennessee Alabama

• Tennessee Tennessee Tennessee Tennessee Tennessee Kentucky Kentucky Alabama 3

1 5

2 4

4 10 9

3

• 10 8

59 750 883 1,201 2,524 988 712 1,254 1,448 2,318 1,369 1,628 15,075 1959 1967 1965 1973 1959 1957 1959 1955 1970 1956 1965 Nuclear Browns Ferry.

Sequoyah Watts Bar Total Nuclear Alabama Tennessee Tennessee 2

2 1

5 2,286 2,336 1,168 5,790 1977 1982 1996 Combustion Turbine Allen Colbert I Gallatin Johnsonville Kemper Lagoon Creek Total Combustion Turbine Tennessee Alabama Tennessee Tennessee Mississippi Tennessee 20 8

I.

8 20 4

12 72 575 486 i. -, -: ; 730

,-,; ~ 1,372 374 1,125 4,662 (2) 1972 1972 2000 f

2000.

2002 2002 Diesel Generator Meridian Albertville Total Diesel Generators Mississippi Alabama 5

4 9

9 4

13 (2) 1998 1999 Total TVA-Owned /Leased Facilities OTHER FACILITIES (NON-TVA OWNED)(3)

TAPOCO, Inc.

U.S. Army Corps of Engineers Purchased Power Agreements Total Other Facilities RENEWABLE ASSETS (PPAs and non-TVA owned)

TOTAL LONG-TERM AVAILABLE CAPACITY 348 ()

405 '5' 2,578 (6) 3,331 6

33,981 Page 10

Notes (1) NDC is the net power output which can be obtained for a period adequate to satisfy the daily load patterns und ar expected con-ditions of operation with equipment in an average state of maintenance excluding any fluctuations in capacity that riay occur due to planned outages, unplanned outages, and deratings. For planning purposes, TVA currently estimates summer dependable total hydro capacity of approximately 5,439 rnigaivatts, coal-fired capacity of approximately '14,698 miegawatts, nuclear power capacity of approximately 5,643 megawatts, combustion turbine capacity (oh gas at 95 degrees Fahrenheit) of approximately 3,838 megawatts,-

diesel generator capacity of approximately 13 megawatts, and capacity at other facilities of approximately 2,628 megawatts for a total summer NDC of approximately 32,259 megawatts.

(2) Combustion turbine and diesel generator capacities include 4,662 megawatts for turbines (on gas at 25 degrees Fahrenheit) and 13 megawatts for generators. As of September 30, 2005, 24 of TVA's combustion turbine units were leased to private entities and leased back to TVA under long-term leases..,.

(3) Other facilities (non-TVA owned) include generation that TVA has purchased or acquired to meet the peak load and energy requirements of its customers:

(4) Four hydro plants owned by TAPOCO, Inc., a subsidiary of Alcoa, Inc., are operated in coordination with the TVA power sys-tem. Under contractual arrangements with TAPOCO, Inc., electric power generated atthese facilities is used.to partially supply Alcoa's energy needs.

e.

I (5) Under..arrangements among TVA, the.U.S. Army Corps of Engineers (the."CORPS"), and the Southeastern Power Administration ("SEPA"), eight hydro plants of the CORPS on the Cumberland River system are operated in coordination with the TVA system. These arrangements further provide for capacity (405 megawatts) and all surplus energy from the Cumberland River sys-tem to be supplied to TVA by SEPA at the points of generation at a price based on the operating and maintenance expenses and amortization of the power facilities. A portion of the output of the Cumberland River system is also made available to SEPA's cus-tomers outside the TVA region. The agreement with SEPA covering these arrangements for power from the Cumberland River sys-tem can be terminated upon three years' notice. This notice may be given beginning June 30, 2017.'

(6) TVA has contracted with various independent power producers and power distributors for additional capacity to be provided by their facilities.

In total, these agreements constitute 2,578 megawatts of winter net dependable capacity. See note 12-Commitments -

Power Purchase Obligations.

TVA has also supplemented its existing generation portfolio with additional renewable resource assets (wind, solar, methane gas, and wood waste/digester gas cofiring technologies).' Due to the nature of these sources, TVA includes only a6portion of them in net winter deperidable. capacity. Six megawatts of solar and lardfill gas are includ-ed. An additional 32 megawatts of wind and cofire capacity exist for a total of 38 medawatts of renewable generating capacity. Cofiring is a neardtermr, low-cost option for efficiently and cleanly converting biomass to elect icity by adding biomass as a partial substitute fuel in coal boilers.

j ;

r~~~~~~~~~

1 I-l;j'

!)I,....

Transmission Operations

• i; The' TVA transmission systerm is one of the largest'in North America, delivering nearly 172 billion kilowatt-hbt~rs' of electricity in 205 and, maintaining 99.999 percent reliability over the last six years in delivering electricity to customers. This system is comprised of about 17,000 circuit miles of transmission lines and includes 2,400 nmiles of extra-high-voltage (500,000 volt) transmission lines, and 536 substations, power switchyards, and switching stations.

There are 258,000 righi-of-way acres and 1,025 individual interchange and customer connection points.' During 2005, TVA constructed 92 miles of transmission lines.

TVA executed an agreement with' the Midwest Independent Transmission System Operator, inc. ("MISO") in August 200'tot become'a "market participant" and executed an agreement with the PJM Interconnection,-L.L.C.

("PJM") in July 2004 as an "other supplier." These arrangements facilitate the purchase and sale' of electric energy.

when beneficial to TVA and in accordance with TVA's statutory limitations on the sale of surplus generation.

" 'Changes in' the fundamental business model for 'bulk transmission system operations, including the emer-gence of large riiarkets in many areas of the eastern United States, have created new reliability risks and exposure for the TVA system as well as other systems. This has manifested itself in actual blackouts (August 14, 2003, in the mid-'

west and northeast United States) and in more frequent interconnection excursions such as frequency deviations.

To prorote grid reliability, VA coritinues to work closely with independent generators to enhaice compatibil-ity with the transmission system, develop and implement consistent operating procedures, and minimize practices that can result in interrupted service.

Page 11

Nuclear Power Program

'Overview TVA has five operating nuclear units, three deferred nuclear units, and one nuclear unit in recovery that is scheduled to be returned to service in 2007. Selected statistics of each of these units are included in the chart below.

Net Date of Date of Installed Capacity '

Expiration of Expiration of Capacity Factor for Operating Construction Nuclear Unit Status (MW) 2005 v

License License Sequoyah Unit 1 Operating 1,221")

90.9 2020 -'-

Sequoyah Unit 2 Operating 1,221"'

89.0 2021 Browns Ferry Unit 2 Operating -

1,190 88.7 2014 Browns Ferry Unit 3 Operating 1,190 94.8 2016 Watts Bar Unit 1 Operating 1,2701) 87.8 2035 Watts Bar Unit 2 Deferred2 '

2010 Bellefonte Unit 1 Deferred_2)

'6 2011 Bellefonte Unit 2 Deferred 2 2014 Browns Ferry Unit 1 Recovery 2013 Notes (1) While the nameplate ratings of the units have not changed, the net electrical output of these units has been increased slightly through license amendments issued by the Nuclear Regulatory Commission ("NRC").

(2) Per NRC's definition'of deferred nuclear plant units., -

Status of Certain Nuclear Units Browns Ferry Unit 1 was taken offline in 1 for plant lrrodifications and regulatory-improvemrents. The undepreciated cost ofBrowns Ferry Unit 1.of $24'million is included in net completed plant and is being depreciated as part of the recoverable cost'of the plant over the remaining license period. In May 2002, the Board deternined the operation of all three units at Browns Ferry over an extended license period could reduce TA's delivered cost of power relative to the market giving TVA' more financial flexibility for the future. Accordingly, the Board initiated activities for the return of Browns Ferry Unit 1 to service. It is anticipated that the Browns Ferry Unit 1 recovery project will cost approximately $1.8 billion, excluding allowance for funds used during construction ("AFUDC") and estimated asset retirement obligation. Browns Ferry Unit 1 is expected to return to service in 2007 and is expected to provide addition-al generating capacity of approximately 1,280 megawatts.

In 2005, TVA incurred approximately,$474 million of costs on the restart project, including $57 million of AFUDC, which is 'in line with the total planned costs' for the project.

Planned expenditures for 2006 and 2007. are'$420 million arid $81 million, respectively..

WTA hasthree units in deferred status. In 1988, TVA suspended construction activities on Watts Bar Unit 2.

Bellefonte Unit 1 and Unit 2 were deferred in 1988 and 1985, respectively.

In December 1994, TVA determined that it would not, by itself, complete Bellefonte Unit,1 and Unit 2 and Watts Bar Unit 2 as nuclear plan'ts. The TWA Board determined as of the 'end of 2001 that the values of.some of its existing assets were not'appropriate in a competitive marketplace. Certain nuclear assets.- portions of Bellefonte Unit 1 and Unit 2 and Watts Bar Unit 2 in its entirety-iereidentified as assets for which the estimated cash flows expected to be provided through future rates were 'less than recorded book values. Consequently, in 2001 TVA reval-ued these assets downward by $2.2 billion and recognized an impairment loss. In 2004, it was determined that cer-tain assets at the Bellefonte site, such, as the diesel generators, training facilities, transmission structures, and other assets, had achieved a usable state. Consequently, during 2004, the Board approved the reclassificatioin of appr'oxi-mately $203 million of Bellefonte assets from DEFERRED NuCLEAR GENERATING UNITS to COMPLETED PLANT.

In July, 2005, the Board approved the amortization of TVA's remaining investment in the deferred generating units at Bellefonte Nuclear Plant over a ten-year period beginning in 2006 (see note.1 -Cost-Based Regulation and note, 5).

The Board action to begin amortizing the investment of the $3.9 billion of deferred nuclear generating' units at Page 12

Bellefonte Nuclear Plant will not limit TVA's ability to use the Bellefonte site in the future. Estimated 20016 expenditures for the three deferred units are limited to costs incurred to ensure that options for the future use of the units remain viable.

In September 2005, NuStart Development LLC ("NuStart"), of which TVA is a member, selected Bellefonte as one of.the two potential sites in the country for a new advanced design nuclear plant. Although neither IVA nor NuStart has decided to build an advanced nuclear reactor at this time, NuStart does intend to seek combined construction and operating licenses for the site for the new Advanced Passive 1000 reactor design by Westinghouse Electric Co. The combined operating license-approach allows the applicant to seek both a construction permit and an operating license at the front end to help provide greater certainty of the outcome, so long as the applicant closely builds what is described in the application. TVA also recently led a team which prepared a cost and schedule study on building an Advanced Boiling Water Reactor ("ABWR') on the Bellefonte site. Other members of the team, operating under the DOE's Nuclear Power 2010 program, include Toshiba Corp., General Electric Corp., Bechtel Corp., USEC, and Global Nuclear Fuels--Americas. The ABWR has been design-certified in the United States by the Nuclear Regulatory Commission ("NRC"). The study was designed to verify the costs of building a new ABWR plant, which could provide another option for utilities interested in preserving the nuclear option for the future.

Blended Low Enriched Uranium Program On December 5, 2004, TVA received the first fuel assembly, under the Blended Low Enriched Uranium

("BLEU") fuel program for loading into its Browns Ferry Nuclear Plant Unit 2. The unit ended its most recent refueling outage in April 2005, which initiated the amortization of the costs of the BLEU fuel assemblies to nuclear fuel expense.

The BLEU fuel program is implemented, in part, through agreements with counterparties, including an inter-agency agreement with DOE to provide raw nuclear fuel materials to be processed into usable fuel for TVA nuclear reactors, and other contracts with third-party nuclear fuel processors under which the nuclear fuel processors, either by themselves or through subcontractors (collectively, "Third Party Fuel Processors"), acquire land, corstruct facilities, and process the raw materials from DOE into usable fuel for TVA nuclear reactors.

Under the terms of the interagency agreement, DOE supplies off-specification,-highly enriched uranium mate-rials to the appropriate Third Party Fuel Processors for processing into usable fuel for WVA. In exchangel, DOE will par-ticipate to a degree in the savings generated by TVA's use of this blended nuclear fuel product. As of September 30, 2005, TVA projects that DOE's share of savings generated by TVA's use of this blended nuclear fuel product could result in future payments to DOE of as much as $212 million. TVA anticipates these future payments could begin in 2010. However, due to the uncertainty of the ultimate fuel cost savings and related payments to DOE under the pro-gram, TVA has not accrued an obligation related to such future potential payments. TVA will re-assess the estimated amount and probability of these future potential payments each time a BLEU fuel assembly is loaded into one of TVA's nuclear reactors. The next BLEU fuel reload is currently scheduled for March 2006.

The Third Party Fuel Processors own the conversion and processing facilities and will retain title to all land, property, plant, and equipment used in the BLEU fuel program. There is no provision for TVA to own or otherwise take title to the facilities, materials, or equipment now or at any time in the future. See note 1-Blended Low Enriched Uranium Program.

Spent Nuclear Fuel Pursuant to the Nuclear Waste Policy Act of 1982, TVA (and all other domestic nuclear utilities) entered into a contract with DOE for the disposal of spent nuclear fuel ("SNF"). Payments to DOE are based upon TVA's nuclear generation and charged to nuclear fuel expense. Although the contracts called for DOE to begin accepting SNF from the utilities by January 31, 1998, DOE announced that it will n6t begin receiving SNF from any domestic nuclear utili-ty until 2010 at the earliest. TVA, like other utilities, stores SNF in pools of borated water at its nuclear sites. Although TVAwould have had sufficient space'to continue to store SNF in those storage pools at its Sequoyah and Browns Ferry Nuclear Plants indefinitely had DOE begun accepting SNF, DOE's failure to do so required TVA to construct dry cask storage facilities at its Browns Ferry and Sequoyah Nuclear Plants and to purchase special storage containers for the SNF. (Watts Bar Nuclear Plant currently has sufficient storage capacity in its spent fuel pool to last until 2018.) The Sequoyah and Browns Ferry facilities have been constructed and approved by the NRC and are now in use. To recov-er the cost of providing long-term, on-site storage for SNF, TVA filed a breach of contract suit against the United States in the Court of Federal Claims in 2001. The case went to trial in'June 2005, and the court's decision is expected by the end of calendar year 2005. See "Legal Proceedings."

Page 13

Low-Level Radioactive Waste Low-level radioactive waste ("radwaste") resulting from the normal operation of nuclear units includes such materials as disposable protective clothing, mops, and filters. Disposal costs for radwaste have increased significant-ly in recent years.; Pursuant to the Low-Level Radioactive Waste Policy Act, each state is responsible for disposal of radwaste generated in that state. States may form regional compacts to jointly fulfill their disposal responsibilities. The states of Tennessee and Alabama (where TVA's nuclear plants are located) have joined with other southeastern states to form the Southeast Compact Commission for Low-Level Radioactive Waste Management. This commission regu-lates the siting of new disposal facilities and the disposal of radwaste within the southeastern states.

e0:. s

'rq ie to

.ips o

-their

.. ;1 Until July 1995, the radwaste generators located in the southeastern states were required to dispose of their radwaste at the Barnwell, South Carolina, disposal facility. South Carolina is no longer a member of the interstate com-pact serving the southeastern states and is now a member of the Atlantic Interstate Low-Level Radioactive Waste Compact. South Carolina has volume caps that cannot be exceeded for radwaste generated in states that are not members of the Atlantic Interstate Low-Level Radioactive Waste Compact. After June 2008, no waste will be accept-ed from such states, which include Tennessee and Alabama.

After reviewing its storage and disposal options for radwaste management, TVA, in 1999, began temporary self-storage of the type of radwaste that had previously been'sent to'Barnwell at the storage facilities located at two of TVA's plant sites. These facilities are sized to handle the anticipated storage'needs for the foreseeable life of TVA's operating plants.: A liability was recognized for this undisposed waste. In 2003, TVA resumed shipping the stored waste to Barnwell for disposal, and TVA has contracted to dispose of radwaste at Barnwell through June 2008.

'Nuclear Decommissioning Costs

'TVA's current accounting policy for nuclear decommissioning costs recognizes all obligations related to clo-sure and removal of its nuclear units as incurred (see note 5). TVA measures and records such liabilities, at their fair values, in the period in which they are incurred along with an accompanying addition to the recorded cost of the long-lived assets. The fair values of these liabilities represent the present value of the estimated future cash outflows to decommission the assets. The' present value of the liabilities is determined by discounting the future cash outflows using a credit-adjusted rate of interest. The recorded amounts for the liabilities-and assets may be subsequently mod-'

ified to comply with the prevailing accounting provisions. Earnings from decommissionin g'fund investments, amorti-zation expense of the decommissioning regulatory asset, and interest expense on the decommissioning liability are deferred in accordance with Statement of Financial Accounting Standards ("SFAS") No. 71, "Accounting for the Effects of Certain Types of Regulation" (see note 1 2-Contingencies-Decommissioning Costs).

Nuclear Insurance The Price-Anderson Act establishes a framework for providing coverage for the general public in the event of a nuclear accident. This act, which was established in 1957 by Congress, was renewed for an additional 20 years by the' Energy Policy Act of 2005. -

The Price-Anderson Act provides a layered framework of protection to compensate for losses arising from a nuclear event. For the first layer, all NRC nuclear plant licensees, including TVA, purchase $300 million of nuclear lia-bility insurance from American Nuclear Insurers ("ANI") for each plant with an operating license. The second layer, the Secondary Financial Program ('SFP"), would come from an assessment of up to $100.6 million from the licensees of each of the 104 NRC licensed reactors inthe.United States. The assessment for any nuclear accident would be-lim-ited to $15 million per year per reactor. ANI, under a contract with the NRC, administers the SFP. With its six licensed units, TVA could be required to pay a maximum of $603.5 million per nuclear incident, but it would have to pay no more than $90 million per incident in any one year. When the contributions of the nuclear plant licensees are added to the insurance proceeds of $300 million, over $10.7 billion would be available. -Under the Price-Anderson Act, if the first two layers are exhausted, Congress is required to take action to provide additional funds to cover the additional loss-es.

Nuclear Decontamination and Property Insurance l

i.

-, I 1

r TVA carries property, decommissioning, and decontamination insurance of $2.1 billion for its licensed nuclear plants to cover the cost of stabilizing or shutting down a reactor afteran accident. Some of this insurance may require the payment of retrospective premiums up to a maximum of approximately $62 million.

Page 14

Accidental Outage Insurance:

TVA purchases accidental outage (business interruption) insurance for TVA's nuclear sites from Nuclear Electric Insurance Limited ("NEIL"). In the event that an accident covered by this policy takes a nuclear unit offline or keeps a nuclear unit offline, NEIL will pay TVA, after a deductible waiting period, an indemnity (a set dcollar amount per week) up to a maximum indemnity of $490 million per unit. This insurance policy may require the payment of retro-spective premiums up to a maximum of approximately $24 million.

Operating License Extensions In December 2003, TVA submitted an application to the NRC for a 20-year extension of the operating licens-es for three reactors at Browns Ferry Nuclear Plant. Current expiration dates of the operating licenses for the Browns Ferry units are:

I Browns Ferry Unit18 :

2013 Browns Ferry Unit 2 2014 Browns Ferry Unit 3 2016 The original 40-year term on licenses issued pursuant to the Atomic Energy Act and the NRC regulations was based on economic and antitrust considerations and not on limitations of technology. If the NRC approves the appli-cation, it will allow TVA to continue production of power from the facilities until 2033, 2034, and 2036 for Units 1, 2, and 3, respectively. The NRC has set a 28-month schedule to review TVA's application. This review is a fevw months longer than a more standard review due to the complexity and uniqueness of the application, since it involves Browns Ferry Unit 1, which has been shut down for 19 years. The license renewal proceeding is uncontested.

Tritium-Related Services In September 2002, the NRC issued an amendment to the Watts Bar Nuclear Plant operating license, allow-ing TVA to irradiate tritium-producing burnable absorber rods ("TPBARS") at the plant to assist DOE in producing tri-tium.- TVA's license amendment currently allows operation with a maximum of 240 TPBARS in the Watts Bar reactor.

A planned future license amendment will permit installation of up to 2,304 TPBARS. In general, the 1PBARS will be irradiated for a full cycle, which lasts about 18 months. TVA then removes the irradiated TPBARS for shipment to DOE's tritium-extraction facility and loads a fresh set of TPBARS into the reactor. TVA began irradiating TPBARS at Watts Bar in the fall of 2003 with the first removal of TPBARS occurring in the spring of 2005. The first batch of irra-diated TPBARS has been successfully shipped to the DIOE facility. Also in September 2002, the NRC issued a simi-lar amendment to the Sequoyah Nuclear Plant operating license allowing TVA to provide tritium-related irradiation services. At this time, no tritium-related services have been scheduled at the Sequoyah Nuclear Plant. While irradi-ating TPBARS, TVA is able to operate the reactors for ius program mission of producing electricity. Income related to these services is included in OTHER REVENUE.

TVA has a long-term interagency agreement with DOE to utilize TVA's Sequoyah and Waits Bar Nuclear Plants to irradiate TPBARS This agreement, ending in 2035, requires DOE to reimburse TVA for cos:s incurred plus a fee per TPBAR produced for irradiation services.

Stewardship Activities I

I TVA has federal jurisdiction for managing the United States' fifth largest river system -the Tennessee River and its tributaries - to deliver multiple benefits, including year-round navigation, flood damage reduction, affordable and reliable electricity, and, consistent with these primary purposes, recreational opportunities, adequate water sup-ply, and improved water quality. TVA owns and opera':es 49 dams which comprise its integrated reservoir system.

Twenty-nine of these dams produce conventional hydroelectric power, and one additional project is solely a pumped storage hydroelectric project. The reservoir system provides 800 miles of commercially navigable waterways and also provides significant flood reduction benefits both within the Valley and downstream on the lower Ohio and Mississippi Rivers. Total flood damage averted since the development of the TVA reservoir system is estimated to be over $5.8 billion. The reservoir system also provides a water supply for residential and industrial customers, including cooling water for TVA thermal power. projects.

TVA's responsibilities for managing public resources began with its creation in 1933. It has direct steward-ship responsibility for 293,000 acres of public land, 11,000 miles of shoreline, and 650,000 acres of reservoir water surface available for recreation and other purposes. TVA reservoirs and public lands provide outdoor recreation P'age 15

opportunities for millions of visitors each year. TVA has over 100 recreation facilities including campgrounds, boat ramps, fishing piers, and picnic areas. More than 239,000 acres of the public land managed by TVA have been des-ignated for resource management and recreation, including the enhancement of wildlife habitat, protection of sen-sitive resources, and development of public recreation facilities.

As of September 30, 2005, TVA's stewardship program manages assets of $672 million representing multi-purpose dams and reservoirs used for navigation, flood control, recreation, and economic development (see Part I and note 13).

LEGAL PROCEEDINGS TVA is involved in various claims amounting to approximately $89 million incidental to the conduct of its busi-ness for which it has assessed the likelihood of gain or loss. The claims, grouped by likelihood of loss, include (1) claims recorded by TVA in the amount of $13 million representing probable losses of $12 million and losses deemed reasonably possible of $1 million, and (2) claims of about $76 million for which a determination of loss cannot be made at this time. (See note 17 -

Legal.)

In the fall of 1999, the Environmental Protection Agency ("EPA") commenced judicial or administrative actions against a number of utilities in the eastern United States, including TVA, alleging that they modified their coal-fired units without complying with the new source review ("NSR") 'requirements under the Clean Air Act ("CA"). Although no decision was rendered on the merits, TVA eventually prevailed in this litigation.

The National Parks Conservation Association ("NPCA") and the Sierra Club filed cases in two federal district courts in 2001 alleging that TVA modified its Bull Run Fossil Plant ("Bull Run") and Colbert Fossil Plant Unit 5 ("Colbert Unit 5") without complying with the NSR requirements of the CAA. In March 2005, the district court granted TVA's motion to dismiss the lawsuit in the Bull Run case. The plaintiffs' motion for reconsideration was denied, and they have appealed to the Court of Appeals for the Sixth Circuit ('Sixth Circuit"). In the Colbert Unit 5 case, the parties have filed motions for summary judgment, The judge has ruled on' some but not all of these motions, and dispositive motions remain to be considered. In similar lawsuits filed by EPA and others against other utility companies, the rulings by the respective courts differ widely.

Environmental groups are taking legal action against TVA, as well as against other utilities across the coun-try, for allegedly violating opacity limits and other environmental regulations applicable to coal-fired plants.

5I The Alabama Environmental Council and the Sierra Club filed a lawsuit in federal district court in Florence, Alabama, alleging that TVA violated CAA opacity limits applicable to Colbert Fossil Plant between July 1, 1997, and June 30, 2002. The groups sought a court order that could require TVA to incur substantial costs, in addition to the costs TVA is already planning to incur for environmental controls, and pay civil penalties of up to approximately $250 million. On September 14, 2004, the court found that TVA had not violated the CAA, and the complaint was dismissed in its entirety. The plaintiffs have appealed the district court's deci-sion to the Court of Appeals for the Eleventh Circuit (the "Eleventh Circuit"), which held oral argument on the case on August 17, 2005. The parties are awaiting the Eleventh Circuit's decision.

On July 25, 2003, TVA received a notice of intent to sue from Our Children's Earth Foundation ("OCE"). OCE contends that TVA violated the NSR requirements of the CM by undertaking major modifications of TVA's Allen Unit 3, Bull Run, Cumberland Units 1 and 2, Kingston Units 6 and 8, John Sevier Unit 3, Paradise Units 1, 2, and 3, Shawnee Units 1 and 4, Colbert Unit 5, and Widows Creek Unit 5 without installing additional pol-lution control equipment., OCE also contends the CM new source performance standards at Colbert Unit 5 and the operations at TVA's Johnsonville Fossil Plant have not met the applicable opacity requirements. This notice does not specify a monetary amount of TVA's claimed liability. OCE's allegations about Bull Run and Colbert Unit 5 are already the subject of litigation in federal district courts initiated by the NPCA and the Sierra Club. In 2004, OCE obtained the district court's permission to join as a plaintiff in the Bull Run NSR suit: It made a similar request in the Colbert'NSR suit which the court denied as untimely.

l

~

~

~

The Sierra Club gave notice in a September 26, 2002, letter that it intends to sue TVA for violating CM opac-ity limits applicable to the John Sevier and Kingston Fossil Plants. The notice claims that TVA violated opac-ity standards atfthe two plants from July 1, 1997. The alleged opacity violations substantially overlap those that were challenged in a lawsuit filed by the NPCA four years ago in federal court in Knoxville, Tennessee.

TVA ultimately prevailed in that lawsuit. The Sierra Club has not filed suit. -;

Page 16

, For a discussion of TVA's CM activities, see,Management's Discussion and Analysis of Financial Condition and Results of Operations"- 'Environmental Matters" in Part II. -

On December 28, 2001, Bowater Incorporated and Bowater Newsprint South, Inc. (together, 'Bowater") filed a lawsuit against TVA in federal court in Knoxville challenging TVA's charges for Economy Surplus Power ("ESP") and Testing and Restart Power ("TRP") for two Bowater plants. -The lawsuit sought, among other things, compensatory damages in excess of $45 million, plus interest. TVA and Bowater settled the lawsuit by entering into revised and extended power supply arrangements at the two plants. The settlement agreement does not require TVA to pay Bowater the damages sought. On March 8, 2005, the court dismissed this case with prejudice.

i On August 31, 1999, Birmingham Steel Corporation filed a lawsuit in the U.S. District Court for the Northern District of Alabama alleging that TVA overcharged for ES? during the summer of 1998. The lawsuit was filed as a class action on behalf of industrial customers who participated in TVA's ESP program. Under ESP contracts, the hourly ESP energy price is calculated using TVA's actual incremental cost of supplying the ESP load in each hour. The plaintiff alleges that TVA overcharged for ESP during the summer of 1998 by including in the price of ESP same costs that were added to TVA's incremental cost. The complaint seeks over $100 million in damages on behalf of Birmingham Steel and the other class members. In September 2002, the district court decertified the class and then dismissed Birmingham Steel's individual claim without prejudice on a jurisdictional issue. The class lawyers appealed the ruling on class decertification, and in December 2003, the Eleventh Circuit reversed that ruling and sent the case back to the district court to allow the class lawyers a reasonable time to find a new class representative. The district court allowed the substitution of Johns Manville Corporation to represent the class. Motions for summary judgment were filed in October 2005. -

In December 2004, a federal judge in Nashville, Tennessee, dismissed a lawsuit filed agairst TVA and 22 electric cooperatives by Tennessee residents and customers of some of the cooperatives, in part challenging TVA's practice of setting rates for electric power charged by distributors via its contracts. Both TVA and the cooperatives had filed motions to dismiss, which the court granted. The judge dismissed the plaintiffs' claims alleging violations of state law because the plaintiffs failed to carry out the steps necessary to bring these claims in court. The dismissal was with-out prejudice, allowing the plaintiffs to re-file the claims if these steps are carried out and suit is filed within the statu-tory period. As to the plaintiffs' allegations of federal law violations, the court found that Congress had specifically authorized TVA to set the rates charged by distributors via its contracts. In the face of such express Congressional authorization, the plaintiffs' federal law claims failed as a matter of law and were dismissed with prejuc ice, precluding them from being brought again. The plaintiffs moved for reconsideration of the dismissal, and the judge denied the plaintiffs' motion. The plaintiffs subsequently appealed to the Sixth Circuit.

In July 2004, two lawsuits were filed against TVA in federal court in New York City alleging that global warm-ing is a public nuisance and that carbon dioxide ("CO2") emissions from TVA's fossil-fired electric generating facilities should be ordered abated because they contribute to causing the nuisance. The first case was filed by the States of California, Connecticut, Iowa, New Jersey, New York, Rhode Island, Vermont, and Wisconsin and the City of New York against TVA, American Electric Power, Inc., American Electric Power Service Corporation, Southern Company, Xcel Energy, Inc., and Cinergy Corporation. The second case, which alleges both public and private nuisance,,was filed against the same defendants by Open Space Institute, Inc., Open Space Conservancy, Inc., and the Audubon Society of New Hampshire. There are no CAA requirements limiting C02 emissions, and, accordingly, the suits do not involve allegations of regulatory noncompliance. The theory of the cases is that global warming constitutes a nuisance and defendants' CO2 emissions are contributing to the nuisance. Plaintiffs do not seek monetary damages, but do 'seek injunctive relief. Specifically, plaintiffs seek a court order requiring each defendant to'cap its C02 emissions and then reduce these emissions by a specified percentage each year for at least a decade. The defendants filed motions to dismiss on September 30, 2004. Oral argument was held on the motions on August 12,2005. In September 2005, the district court dismissed both lawsuits, concluding that they raised political questions that should not be decided by the courts. The plaintiffs have filed notices of appeal to the Court of Appeals for the Second Circuit.

Pursuant to the Nuclear Waste Policy Act of 1982, TVA (and all other domestic nuclear utilities) entered into a contract with DOE for the disposal of SNF. Payments to DOE are based upon TVA's nuclear generation and charged to nuclear fuel expense. Although the contracts called for DOE to begin accepting SNF from the utilities by January 31, 1998, DOE announced that it would not begin picking up spent nuclear fuel from any domestic nuclear utility until 2010 at the earliest. TVA, like other utilities, stores SNF in pools of borated water at its nuclear sites. Although TVA would have had sufficient space to continue to store SNF in those storage pools at its Sequoyah and Browns Ferry Nuclear Plants indefinitely had DOE begun accepting SNF, DOE's failure to do so required TVA to construct dry cask storage facilities at its Browns Ferry and Sequoyah Nuclear Plants and to purchase special storage containers for the SNF. (Watts Bar Nuclear Plant currently has sufficient storage capacity in its spent fuel pool to last until 2018.) Both Page 17

Sequoyah's and Browns Ferry's dry cask storage facilities are operational., To recover the cost of providing long-term, on-site storage for SNF, TVA filed a breach of contract suit against the United States in the Court of Federal Claims in 2001. The evidentiary portion of the case for damages through 2004 was completed in Washington D.C. in July 2005.

Closing arguments were made in October 2005. A decision is expected before the end of the calendar year 2005.

It is not possible to predict with certainty whether TVA will incur any liability or to estimate the damages, if any, that TVA might incur in connection with the legal proceedings described above except as specifically noted.

CERTAIN PROVISIONS OF THE TENNESSEE VALLEY AUTHORITY ACT AND RELATED LAWS The following summaries of certain provisions of the Act and related laws are not complete and are quali-fied in their entireties by reference to the full text of the Act and related laws.

Payments in Lieu of Taxes TVA is not subject to federal income taxes, and it, its property, franchises, and income are not subject to tax-ation by states or their subdivisions. However, the Act requires TVA to make payments in lieu of taxes to states and counties in which the Corporation conducts power operations and in which the Corporation has acquired properties previously subject to state and local taxation. The basic amount of these payments is five percent of gross revenues from the sale of power during the preceding year excluding sales or deliveries to other federal agencies and off-sys-tem sales to other utilities, with a provision for minimum payments under certain circumstances. During 2005 and 2004, TVA made payments totaling $365 million and $338 million, respectively, to the states of Alabama, Georgia, Illinois, Kentucky, Mississippi, North Carolina, Tennessee, and Virginia.

Payments to the Treasury Initially, TVA's power program was financed with Congressional appropriations (the 'Appropriation Investment"). Prior to 1961, TVA paid the Treasury $185 million in repayment of arid as a return on the Appropriation Investment. In 1959, Congress amended the Act to require TVA to make certain payments to the Treasury each year, beginning in 1961, from Net Power Proceeds in excess of those required for debt service as a return on and reduction of the Appropriation Investment. Under the 1959 amendment, TVA is required to repay an additional $1 billion of the Appropriation Investment, after which TVA would have no further requirement 'to repay further the Appropriation Investment. Payments under the 1959 amendment began in 1961 (see note 7). The balance of the Appropriation Investment totaled $428 million as of September 30, 2005, and the remaining amount to be repaid under the 1959 amendment totaled $170 million as of September 30, 2005. Once TVA fulfills its requirement to' repay the $1 billion portion of the Appropriation Investment under the 1959 amendment, the remaining balance of the Appropriation Investment will be $258 million (assuming TVA does not receive additional appropriations for its power program). W TVA will continue to pay a return to the Treasury on this remaining balance each year..

Net Power Proceeds are defined as the remainder of gross power revenues from TVA's power program after deducting the costs of operating, maintaining, and administering its power properties (including multiple-pur-pose properties in the proportion that multiple-purpose costs are allocated to power) and payments to states and counties in lieu of taxes, but before deducting depreciation accruals or other charges representing the amortization of capital expenditures, plus the net proceeds of the sale or other disposition of any interest in TVA's power properties that con-.

stitute an operating unit or system.

• V Page 18

Acquisition of Real Estate The Act empowers TVA to acquire real estate in the name of the United States of America by purchase or by exercise of the right of eminent domain, 'and thereupon all suchreal estate.shall be entrusted to the Corporation as the agent of the United States to accomplish the purposes of [the] Act." Thus, all references in this Statement to TVA properties, and to the amounts invested in TVA properties, should be read and construed in the light of this provision of the Act.

{

k Public Law No. 105-62 i

In October 1997, Congress enacted the Energy and Water Development Appropriations Act, 1998, Pub.- L.

No. 105-62, 111 Stat. 1320, 1338 (1997). The paragraph captioned 'TENNESSEE VALLEY AUTHORITY" in Title IV of this act (the 'Appropriations Act Paragraph") requires TVA, beginning with -1999,;to fund nonpower programs that constitute "essential stewardship activities" with revenues derived from one or more of various sources, including power revenues, notwithstanding provisions of the Act and power bond covenants to the contrary.. These programs historically had been funded primarily with appropriated funds rather than power revenues.

In compliance with the Appropriations Act Paragraph, TVA is and plans to continue funding its essential stew-ardship activities with funds primarily from.its power program (and other funds to the extent available) so long as Congress does not make appropriations available for these activities.

f':

. -. In 1999, the last year TVA received appropriated funds, it spent a total of approximately $75 rrillion on essen-tial stewardship activities, $30 million of which was power funds. In 2005 and 2004, TVA spent a total of approximate-ly $93 million and $87 million, respectively, on essential stewardship activities. -

THE BASIC RESOLUTION; POWER BONDS, DISCOUNT NOTES AND OTHER INDEBTEDNESS, TVA issues Power Bonds pursuant to section 15d of the Act and pursuant to the Basic Resolution. At September 30, 2005, TVA had $18.7 billion, DM1.5 billion (issued in September 1996), and £600 million (£200 million issued in December 1998, £250 million issued in July 2001, and £150 million issued in June 2003) principal amount of Power Bonds outstanding. TVA may issue Power Bonds only to provide capital for TVA's power program (including refunding any Evidences of Indebtedness issued for like purposes) and only as authorized by law at the time of issuance. However, see also 'Certain Provisions of the Tennessee Valley Authority Act and Related Laws"- "Public Law No. 105-62." Power Bonds are payable as to both principal and interest solely from Net Power Prcceeds, but TVA may, at its option, pay Power Bonds from the proceeds Of refunding obligations or otherfunds legally available for such payment. Net Power Proceeds (as defined in 'Certain Provisions of the Tennessee Valley Authority Act and Related Laws"- 'Payments to the Treasury'on page 20) for.2005,-2004, and 2003 were $2.9 billion, $31 billion, and $2.8 bil-lion, respectively. Power Bonds of each series must be further authorized by Supplemental Resolution. Power Bonds are not obligations of, or guaranteed by, the United States of America..

i t*.

I.,!i'Ssi.,,:i,.,:

W-TVA intends from time to time to issue new Power Bonds with maturities and terms determined in light of mar-ket conditions at the time of sale. TVA may sell new Powter Bonds to dealers or underwriters, who may resell the new Power Bonds in public offerings or otherwise. Additionally, TVA may sell new Power Bonds directly orthrough other entities.

i

(.,

I

-L The offering circular, and any appropriate amendment or supplement to the offering circular, for each offering of new Power Bonds, except for new Power Bonds offered under a program on a continuous basis, typically sets forth the following information: (1) the aggregate principal amount, (2) maturity, (3) interest rate or method for determining such rate, (4) interest payment dates, if any, (5) purchase price to be paid to TVA, (6) any terms for redemption or other special terms, (7) form and denomination of new Power Bonds, (8) if applicable, information as to any stock exchange listing, (9) the names of any dealers, underwriters, or agents, (10) a description of any amendments or supplements to the Basic Resolution in connection with the sale of the new.Power Bonds, and (11) other terms of the new Power Bonds.

' i For Power Bonds'offered under a program on a continuous basis,.TVA typically prepares a single offer-ing circular that describes the general terms and conditions common to all Power Bonds-issued under the pro-gram. The offering circular typically describes how, ifat all, the offering circular will be supplemented in order to reflect, among other things, the specific terms and conditions of the Power Bonds being offered. At the time of each sale, TVA typically~determines if the Power Bonds being sold will be subject to redemption prior to the Page 19

maturity date and will establish the purchase price, principal amount, interest rate or interest rate formula, matu-rity date, and certain other terms of such sale.

TVA also issues Discount Notes pursuant to section 15d of the Act and in accordance with section 2.5 of the Basic Resolution. As of September 30, 2005, TVA had approximately $2.5 billion in Discount Notes outstanding.

Discount Notes are payable solely from Net Power Proceeds,' but TVA may, at its option, pay Discount Notes from the proceeds of refunding obligations or other funds legally available for such payment. TVA intends to offer Discount Notes for sale on a continuous basis to a group of securities dealers selected by TVA, who will resell the notes. TVA will issue Discount Notes in a form and upon terms and conditions as it deems appropriate. Certain information about Discount Notes is typically set forth in a Discount Notes offering circular and any appropriate supplement to the offer-ing circular. Discount Notes are not obligations of, or guaranteed by, the United States of America.

TVA may issue Other Indebtedness pursuant to section 15d of the Act and in accordance with section 2.5 of the Basic Resolution. An offering circular, and any appropriate amendment or supplement to the offering circular, for each offering of Other Indebtedness typically sets forth the following information: (1) the aggregate principal amount, (2) maturity, (3) interest rate or method for determining such rate, (4) interest payment date(s), (5) purchase price to be paid to TVA, (6) any terms for redemption or other special terms, (7) form and denomination of Other Indebtedness, (8) if applicable, information as to any stock exchange listing, (9) the names of any dealers, underwriters or agents, and (10) other terms of Other Indebtedness.. Other Indebtedness will not be obligations of, or guaranteed by, the United States of America.

Income on Evidences of, Indebtedness issued by TVA is subject to United States federal income taxation and various other federal tax consequences. There is no special exemption for Evidences of Indebtedness from federal estate and gift taxes. Under the Act, Evidences of Indebtedness are exempt both as to principal and interest from all taxation now or hereafter imposed by any state or local taxing authority except estate, inheritance, and gift taxes. This exemption might not extend to franchise or other nonproperty taxes imposed on corporations or to gain or loss real-ized upon the sale or exchange of an Evidence of Indebtedness even though such gain might in some cases be treat-ed as interest income for federal income tax purposes.

The following summary of certain provisions of the Basic Resolution is not complete and is qualified in its entirety by reference to the full text of the Basic Resolution. See also 'Certain Provisions of the Tennessee Valley Authority Act and Related Laws"- 'Public Law No. 105-62."

Application of Net Power Proceeds Section 2.3 of the Basic Resolution provides as follows:

Net Power Proceeds shall be applied, and the Corporation hereby specifically pledges them for'application, first to payments due as interest on Bonds, on Bond Anticipation Obligations, and on any Evidences of Indebtedness issued pursuant to section 2.5 which rank on a parity with Bonds as to interest; to payments of the principal due on Bonds for the payment of which other provisions have not been made and on any Evidences of Indebtedness issued pursuant to section 2.5 which rank on a parity with Bonds as to principal and for the payment of which other provisions have not been 'made; and to meeting requirements of sinking funds or other analogous funds under any Supplemental Resolutions. The remaining Net Power Proceeds shall be used only for:

(a) Required interest payments on any Evidences of Indebtedness issued pursuant to section 2.5 which do not rank on a parity with Bonds as to interest.

(b) Required payments of or on account of principal of any Evidences of Indebtedness which do not rank on a parity with Bonds as to principal.

(c) Minimum payments into the United States Treasury required by the Act in repayment of and as a return on the Appropriation Investment.

(d) Investment in Power Assets, additional reductions of the Corporation's capital obligations, and other law-ful purposes related to the Power Program; provided, however, that payments into the United States Treasury in any fiscal year in reduction of the Appropriation Investment in addition to the minimum amounts required for such purpose by the Act may be made only if there is a net reduction during such year in the dollar amount of outstanding Evidences of Indebtedness issued for capital purposes, and only Page 20

to such extent that the percentage of aggregate reduction in the Appropriation Investment during such

' year does not exceed the percentage of net reduction during the year in the dollar amount of outstand-ing Evidences of Indebtedness issued for -apital purposes.

Section 2.4 of the Basic Resolution provides as follows:

The Corporation, having first adopted a SupplementalrResolution authorizing the issuance of a series of Bonds and pending such issuance, may issue Bond Anticipation Obligations and renewals thereof (including

'-Interim Obligations to the Secretary of the Treasury) to be paid from the proceeds of such ';;eries of Bonds when issued or from other funds that may be available for that purpose.

Section 2.5 of the Basic Resolution provides as follows: -

To assist in financing its Power Program the Corporation may issue Evidences of Indebtedness other than Bonds and Bond Anticipation Obligations, which may be payable out of Net Power Proceeds subject to the provisions of section 2.3 hereof. Such other Evidences of Indebtedness may rank on parity With but shall not

.rank ahead of the Bonds as to payments on account of the principal thereof or the interest thereon.-

.See "Certain Provisions of the Tennessee ValleyAuthorityAct and Related Laws"-"Public Law No. 105-62" and note 4 in Part II for a discussion of legislation relating to appropriations for TVA's nonpower programs and the fund-ing of such programs, including the use of power revenues; Rate'Covenant -

K Section 3.2 of the Basic Resolution provides as folhows:

i.

The Corporation shall fix, maintain,- and'collect rates for power sufficient to meet in each fiscal year the requirements of that portion of the present subsection (f) of section 15d of the Act which reads as follows:

Fws

' i-'

The Corporation shall charge rates for power which will produce gross revenues sufficient to provide funds

' for operation, maintenance, and administration of its power system; payments to States and counties in lieu

of taxes; debt service on outstanding bonds, including provision and maintenance of reserve -unds and other funds established in connection therewith; payments to the Treasury as a return on the appropriation invest-ment pursuant to subsection (e) hereof; payment to the Treasury of the repayment sums specified in subsec-tion (e) hereof; and such additional margin as the Board may consider desirable for investment in power sys-tem assets, retirement of outstanding bonds in advance of maturity, additional reduction of appropriation investment,' and other purposes connected with the Corporation's power business, having due regard for the primary objectives of the Act, including the objective that power shall be sold at rates as low as are feasible.

• For purposes of this Resolution, "debt service on outstanding bonds," as used in the above provision of the Act,' shall mean for any fiscal year the sum of all amounts required to be (a) paid during such fiscal year as

-f interest on Evidences of Indebtedness, (b) accumulated in such fiscal year in any sinking or other analogous fund provided for in connection with any Evidences of Indebtedness, and (c) paid in such fiscal year on account of the principal of any Evidences of Indebtedness for the payment of which funds will not be avail-

,able from sinking or other analogous funds, from the proceeds of refunding issues, or from other sources; provided, however, that for purposes of clause (c) of this definition Bond Anticipation Obligations !and renewals thereof shall be deemed to mature in the proportions and at the times provided for paying or setting aside funds for the payment of the principal of the authorized Bonds in anticipation of the issuance of which such Bond Anticipation Obligations were issued.

The rates for power fixed by the Corporation shall also be sufficient so that they would cover all requirements of the above-quoted provision of subsection (f) of section 15d of the Act as if, in such requirements, there

• were substituted for debt service on outstanding bonds for any fiscal year the amount which if applied annu-ally for 35 years would retire, with interest at the rates applicable thereto, the originally issued amounts of all series of Bonds and other Evidences of Indebtedness, any part of which was outstanding on October 1 of such year.

Page 21

I, Rates set by the Board are not subject to review or, approval by any state or federal regulatory body. In a future restructured electric power industry (discussed in l.Management's Discussion and Analysis of Financial Condition and Results of Operations"-

'TVA and Competition" in Part 11), it is possible, however, that the ability of TVA's Board to set TVA's rates as specified in the TVA Act and the Basic Resolution could be adversely affected by legislative changes or by competitive pressures.

I.-

.' m. -

. hi Covenant for Protection of Bondholders' Investment.

Under the Act and section 3.3 of the Basic Resolution, TVA must, in each successive five-year period begin-ning October 1, 1960, use an amount of Net Power Proceeds at least equal to the sum of (1) depreciation accruals and other charges representing the amortization of capital expenditures and (2) the net proceeds from any disposition of power facilities (such sum being hereafter referred to as the "Section 3.3 Amount") for either (a) the reduction of its capital obligations (including Evidences of Indebtedness and the Appropriation Investment) or (b) investment in power assets.

TVA made the calculation under section 3.3 of the Basic Resolution at the end of 2005 and passed the sec-tion 3.3 test as of September 30, 2005. Before.TVA calculated the Section 3.3 Amount, it had concluded and previ-ously disclosed that write-downs are generally not included in the Section 3.3 Amount because write-downs do not constitute depreciation or amortization under generally accepted accounting principles. Accordingly, when it calculat-ed the Section 3.3 Amount at the end of 2005, TVA excluded most of the write-down that occurred in 2001: In 2001, TVA identified assets that would not be recovered in future rates and reduced the value of these assets by a total of

$3.4 billion. Of this amount $2.2 billion was attributable to deferred nuclear generating units, $789 million was attrib-utable to deferred debt refinancing costs, and $410 million was attributable to plant held for future use.- Of these amounts, only the $789 million of deferred debt refinancing costs was included in the section 3.3 test calculation in 2005 because this amount was being amortized at the time it was written down.

Issuance of Additional Bonds and Other Evidences of Indebtedness The Act limits the issuance of Evidences of Indebtedness by TVA to a total of $30 billion outstanding at any one time. At September 30, 2005, TVA had approximately U.S. $21.2 billion, DM1.5 billion (issued in September 1996),

£600 million (£200 million issued in December 1998; £250 million issued in July 2001, and £150 million issued in June 2003) of Evidences of Indebtedness outstanding. -The Basic Resolution and the Act permit the issuance of Power Bonds only to finance TVA's power program, including the refunding of any Evidences of Indebtedness issued for that purpose. However, see also 'Certain Provisions of the Tennessee ValleyAuthorityAct and Related Laws"-

'Public Law No. 105-62."

i

.i i

,,i '

Power Bonds, the terms and conditions of which may not be inconsistent with the Basic Resolution, must also be authorized by a Supplemental Resolution. -

Pending the issuance of Power Bonds authorized by a Supplemental Resolution, TVA may issue Bond Anticipation Obligations and renewals of Bond Anticipation Obligations (including Interim Obligations to the Secretary of the Treasury), to be paid from the proceeds of such Power Bonds when issued or from other funds that may be avail-able for that purpose.

, i ' '- '

-I 'ii;Iri TVA may also issue Evidences of Indebtedness other than Power-Bonds and Bond Anticipation Obligations, such as Discount Notes, to assist in financing TVA's power program. They may be payable out of Net Power Proceeds subject to the provisions of section 2.3 of the Basic Resolution. They may not rank ahead of the Power Bonds as to principal or.interest.

a Mortgaging and Disposal of Power Properties TVA may not mortgage any part of its power~properties and may not dispose of all or any substantial portion of these properties unless it provides for a continuance of the interest, principal, and sinking fund payments due and to become due on all outstanding Evidences of Indebtedness, or for the retirement of such Evidences of Indebtedness.

Conditions for disposal of property are outlined in sections 4(k) and 31 of the Act. Section 31 of the Act provides that no real estate shall be held except what is necessary in the opinion of the Board to carry out TVA's plans and projects.

This finding is made by the Board in its approval of the disposal. TVA may also dispose of property in certain circum-stances in connection with the construction of power facilities under section 15d(g).

Page 22

Modifications of Resolutions and Outstanding Bonds The Basic Resolution provides for amendments to it, to any Supplemental Resolution, and to any outstand-ing Power Bonds. Generally, TVA may make amendments to the respective rights and obligations of TVA and the bondholders with the written consent of the holders of at least 662/3 percent in principal amount o1 the outstanding Power Bonds to which the amendment applies. However, TVA may not make changes in the maturity of the principal of any Power Bond or any interest installment thereon or reduction in the principal amount, redemption premium, or rate of interest with respect to any Power Bond, or in the above percentage for any such consent, without the consent of the holder of such Power Bond.

Additionally, TVA may amend the Basic Resolution or any Supplemental Resolution without the consent of the bondholders in order (1) to close the Basic Resolution against the issuance of additional Power Bonds or to restrict such issuance by imposing additional conditions or restrictions; (2) to add other covenants and agreements to be observed by TVA or to eliminate any right, power, or privilege conferred upon TVA by the Basic Resolution; (3) to mod-ify any provisions to release TVA from any of its obligations, covenants, agreements, limitations, conditions, or restric-tions, provided that such modification or release shall not become effective with respect to any Power Bonds issued prior to the adoption of such amendment; (4) to correct any defect, ambiguity, or inconsistency in, or to make provi-sions in regard to matters or questions arising under, the Basic Resolution or any Supplemental Resolution, so long as such amendments are not contrary to, or inconsistent with, the Basic Resolution or such Supplemental Resolution; or (5) to make any other modification or amendment which the Board by resolution determines will not materially and adversely affect the interests of holders of the Power Bonds; provided, however, that no such amendatory resolution shall be deemed to waive or modify any restriction or obligation imposed by the Basic Resolution or any Supplemental Resolution upon TVA in respect of, or for the benefit of, any of the then outstanding Power Bonds.

Events of Default Any of the following shall be deemed an Event of Default under the Basic Resolution: (1) default in the pay-ment of the principal or redemption price of any Power Bond when due and payable at maturity, by call for redemption or otherwise; (2) default in the payment of any installment of interest on any Power Bond when due and payable for more than 30 days; or (3) failure of TVA to duly perform any other covenant, condition, or agreement contained in the Power Bonds or in the Basic Resolution or any Supplemental Resolution for 90 days after written notice specifying such failure has been given to TVA by the holders of at least five percent in aggregate principal amount of the then-outstanding Power Bonds.

Upon any,.such Event of Default, the holders of the Power Bonds may proceed to protect End enforce their respective rights, subject to the restrictions described below. The holders of at least five.percent in aggregate princi-pal amount of Power Bonds then outstanding shall, subject to certain restrictions, have the right and power to institute a proceeding (1) to enforce TVA's covenants and agreements; (2) to enjoin any acts in violation of the rights of hold-ers of Power Bonds, and (3) to protect and enforce the rights of holders of Power Bonds. Such holders have no right to bring any such action or proceeding against TVA unless they have given TVA written notice of an Event of Default and TVA has had a reasonable opportunity to take appropriate corrective action with respect thereto and has failed or refused to do so. Power Bonds do not provide for acceleration upon an Event of Default.

Holders of a majority in aggregate principal amount of the outstanding Power Bonds have the right to direct the time, method, and place of conducting any proceeding for any remedy available and may waive any default and its consequences, except a default in the payment of the principal of or premium, if any, or interest on any Power Bonds.

Fourth Amendatory Resolution to the Basic Resolution On March 25, 1992, TVA adopted a resolution amending the Basic Resolution, entitled 'Fourth Amendatory Resolution to Basic Tennessee Valley Authority Power Bond Resolution," that (1) deleted from the EBasic Resolution limitations on issuance of Power Bonds formerly set forth as section 3.4 thereof and (2) amended the Basic Resolution to permit issuance of other Evidences of Indebtedness under section 2.5 thereof that rank on a parity with Power Bonds as to principal and interest. With the deletion of section 3.4 of the Basic Resolution, sections :3.5 through 3.10 were renumbered as appropriate. This amendatory resolution became effective December 16, 1999, with retroactive application to all Power Bonds issued after March 25, 1992.

Page 23

PART II SELECTED FINANCIAL DATA I

I I..

The following selected financial data for the years 2001 through 2005 should be read in conjunction with the audited financial statements and notes thereto (collectively, the "Financial Statements") presented in 'Financial Statements and Supplementary Data." Certain reclassifications have been made to the 2003, 2002, and 2001 financial state-ments to conform to the 2004 and 2005 presentation.

STATEMENTS OF INCOME DATA (in millions)

For the years ended September 30 2005 2004 2003 2002 2001 Operating revenues........

7,794 Operating expenses

.(6,503)

Operating income

.1,291 Other income, net

.33 Unrealized gains (losses) on derivative contracts, net 3

Loss on asset impairment.

7,533 (5,873) (12) 1,660 37 (7) 6,953 (5,398) 1,555 29 (7) 6,798 (5,323) '

1,475 17 6,896 (5,445) 1,451

.258 Interest expense, net...........

(1,242)

Cumulative effect of accounting changes............

(1,304)

(1,350) 217 I'S I -

(3,419) (4)

(1,429))

(1,633).,-

NET INCOME (LOSS)...........................

85 386 444 63

$ (3,343)

Notes:

(1j During 2005, TVA recognized a total of $24 million in impairment losses related to its property, plant and equipment. The losses included a $16 million write-down of certain CONSTRUCTION IN PROGRESS assets related to new pollution-control and other technolo-gies that had not been proven effective, and an $8 million write-down on one of two buildings in TVA's Knoxville Office Complex

('KOC") based on TVA's desire, intent, and plans to sell or lease the East Tower of the KOC. See note 6.

(2)

During 2004, TVA was notified by a supplier that it would not proceed with manufacturing of fuel cells to be installed in the partial-ly completed Regenesys energy storage plant in Columbus, Mississippi. Accordingly, TVA recognized a net $20 million loss on the cancellation of the Regenesys project. See note 1 -

Project Cancellation.

(3)

Due to changes in the market forecast, TVA elected not to complete a gas-fired combine cycle plant in 2002. TVA recognized a

$154 million loss related to the cancellation of this project.

(4)

During 2001, TVA identified certain assets for which the estimated cash flows provided through future rates were likely to be less than recorded book values. Accordingly, a $3,419 million impairment loss was recognized.

(5)

The cumulative effects of $217 million are due to two accounting changes. Effective October 1, 2002, the Board approved a change in the methodology for estimating unbilled revenue from electricity sales. The impact of this change resulted in an increase in accounts receivable of $412 million with a corresponding cumulative effect gain for the change in accounting for unbilled rev-enue. In addition, TVA adopted SFAS No. 143, 'Accounting forAsset Retirement Obligations," which resulted in a cumulative effect charge to income of $195 million and an increase in accumulated depreciation of $206 million. See note 1-Accounting Changes.

Page 24

,BALANCE SHEETS DATA (in millions)

At September 30 2C05 2004 2003 2002 Assets Current assets..........................

Property, plant, and equipment, net................

Investment funds..............................

Regulatory and other long-term assets.............

TOTAL ASSETS.

2.269 23 888 858 7,551

$ 34,566 2,386 23,699 744 7,451

$ 34,280 2,321 23,125 638 7,027

$ 33,111 1,682 22,175 510 2'

6,522

$ 30,889 2001 1,624 22,152 -

606 6,061

$ 30,443 Liabilities and proprietary capital Current liabilities..............................

Regulatory and other liabilities...............

Long-term debt, net of discount..................

Total liabilities..............................

Retained earnings.............................

Other proprietary capital.......

Total proprietary capital......................

6,817 7,606 17,751 32,174 1,244 1i48 2,392 5,511 7,168 19,337 32,016 1,162 1,102 2,264 5,902 5,114 20,201 31,217 783

• 1,111 1,894

t.

4,811 3,304 21,358 29,473 349 1,067 1,416 I :

I I 6,339 2,806 19,851 28,996 306 1,141 1,447 TOTAL LIABILITIES AND PROPRIETARY CAPITAL..

$ 34,566

$ 34,280

$ 33,111

$ 30,889

$ 30,443

_z

~ I Or:

FINANCIAL OBLIGATIONS (in millions) 2005 Long-term debt, Including current maturities *.....

$ 20,671

- I At September 30 2004 2003 2002

$ 21,439

$ 22,760

$ 21,543 2001

$ 22,038 Other financial obligations Capital leases.;..-.....

Lease/leaseback commitments..................

Energy prepayment obligations..................

Total other financial obligations................

I 1

II I i 1.143 1, 3 5 0

-2,643 138 1,178 1,455 2,771 151 -.

1,238 47,

• 1,436 162 561 723 172 271 i -

443 Total long-term obligations.

23,314 DISCOUNT NOTES.2,469 24,210 24,196 1,924 2,080 3,492 3,016 FINANCIAL OBLIGATIONS...................

$ 25,783

I L

6I: ' I

$ 2,14

$ 26,276 25,758

$ 25,497 r

For additional discussion on long-term obligations, see "Mana!gement's Discussion and Analysis of Financial Condition and Results of Operations' -'Liquidity and Capital Resources -'Cash Requirements and Contractual Obligations."

• Includes foreign currency transaction (losses) gains of ($52) million, ($113) million, $35 million. $220 million, and $321 million for 2005, 2004, 2003, 2002, and 2001, respectively.

Page 25

COMPARATIVE FIVE-YEAR DATA STATISTICAL AND FINANCIAL SUMMARIES For the years ended September 30 i -2005 Sales (millions of kWh) '

Municipalities and cooperatives

.................... 136,640 Industries directly served 30,872 Federal agencies and other.....

3,986 Total sales 171,498 Operating revenues (millions of dollars)

Electric Municipalities and cooperatives.........

$ 6,561 Industries directly served........................

962 Federal agencies and other...

181 Other.................................................

90 Total revenues.........

$ 7,794 Electric revenue per kWh (cents).........................

4.48 Winter net dependable generating capacity (megawatts) m)

Hydro.5,104 Fossil.15,075 Nuclear units in service 5......................

5,790 Combustion turbine and diesel generators 4,67 TVA facilities........

I 30,644 Other facilities.........

3,33 Total long term available capacity 33981 System peak load (megawatt)-summer.....

31,924 2004 133,161 29,344 3,353 165,858

$ 6,457 842

- 140 94

$ 7.533 2003 2002 I

-130,769 128,600 27,756 26,478 3,009 3,579 161,534 158,657 2001 129,760 -

23,306:

5,967 159,0O33

$ 5,974 781 120 78

$ 6.953

$ '5,856

$ 5,908 4.49 4.26 I,;

- v 4,981 5,022 15,076 15,029 5,777 5,776 4,685 4,65 30,519 30,482 2,670 1,176 33,189 31,658 29,966 28,530 732 120 90 4.23 4,924 15,023 5,751 4,643 30,341 1,176 31,57 29,052 659 226 103

$ 6.896 4.27 4,941 15,050 5,715 3,923 29,629 736

~30,365 27,368 27,163

'64%

6%

29%

1%

System peak load (megawatt)-winter Percent gross generation by fuel source Fossil............................

Hydro................................................

Nuclear.

I Combustion turbine.....................................

~

.1

",J Fuel cost per kWh (cents)

Fossil...

Combustion turbine.....................................

Nuclear...............................................

Aggregate fuel cost per kWh net thermal generation...........

Notes:

29,278 62%

10%

"'28%

<1%

1.65 11.44 0.39 1.30 27,997 29,866 26,061 i 61%

60%

I 63%

9%

11%

6%

30%

29%

`

30%

<1%

<1%

1%

1.48 9.01 0.39 1.14 O.1' I

• 1.43 7.61 0.39

.1.14 a...

X.,

1.39; -

1.32 4.65 6.07 0.41 0.44 1.11 1.08

'(a) SaIes arnd revenues have been adjusted to include sales to other utilitie and to' exclude intedivisional sales.-

(b) See 'Properties"- Generating Resources" in Part I.

(c) As of September 30, 2005, includes twenty-four 85-megawatt units subject to lease/leaseback arrangements.

(d) Total summer NDC for 2005, 2004, 2003, 2002, and 2001 was approximately 32,259 megawatts, 32,059 megawatts, 30,743 megawatts, 30,477 megawatts, and 29,405 megawatts, respectively.

Page 26

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Dollars in million except where noted);

Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&An) explains the results of operations and general financial condition of TVA.. In this MD&A, TVA's future outlook is discussed as well as its regulatory environment and liquidity and capital resources. The MD&A then discusses the results of oper-ations, both operational and financial, critical accounting policies and estimates, risk management activities, account-ing changes, and new accounting pronouncements. Finally, TVA's competitive and regulatory environment and busi-ness strategy are discussed as well as environmental matters, subsequent events, and various uncertainties that could affect future results of operations. The MD&A should be read in conjunction with the Financial Statements.

Overview

[

The power industry is changing, and it is anticipated that TVA's customers could eventually have a choice of suppliers. Potential changes in the market could affect TVA, its stakeholders, and the way it fulfills its obligations.

TVWA's financial health in the future will depend on what changes may come and how well it is able to adapt to those changes. Over the next several years, TVA plans to concentrate on four specific areas:

Developing new, more highly differentiated prices, services, and contract terms that more closely tie the cost and the risk of the product to its terms and p icing. During the past year, work has focuseJ on developing long-term contract terms and conditions that would provide value to distributors and help strengthen TVA's financial viability under competition, assessing how different wholesale rate structures would impact TVA's ability to compete in wholesale markets, and developing a new industrial portfolio to better align the cost and risk of production with the prices that customers pay.

Addressing the range of issues related to wholesale market design and transmission pricing, Including how TVA will interface with the markets that are expected to surround it, as well as how TVA will price transmis-sion services within its service area when distributors can choose other suppliers.

Increasing cash flow through cost reductions and rate increases in order to accelerate reduction in total financing obligations and to provide the financial flexibility needed to tolerate the higher levels of revenue and cost volatility associated with a more competitive market.

Maintaining and operating its generation and transmission assets so that it can continue tc fulfill its supply obligations in a safe and reliable manner.

Customers In October 2003, TVA implemented a multi-part rate action, which included a rate adjustment and a rate change.

On July 22, 2005, the Board apiproved a 7.52 percent increase in firm wholesale electric rates effective on October 1, 2005. The rate increase is expected to provide additional revenues of approximately $524 million in fiscal year 2006. See 'Liquidity and Capital Resources" -

'Rate Actions' below.

Notwithstanding the rate increases" the total average retail rates in the TVA service area remain competitive with other areas of the region and below the national average.

In addition' to rates charged to customers, TVA is'developing new, more differentiated prices, services, and customer contracts that more closely tie risk, cost, and product differences tb pricing (see 'Business'-

'Rates and Customers in Part I).

,. i Wholesale Market Design and Transmission Pricing By the late 1990s, the nation appeared to be well on its way to restructuring both wholesale and 'retail elec-tricity markets. Recently, however, market and regulatory events have increased the uncertainty about the ultimate outcome and timing of electricity market restructuring in the United States., Despite the current uncertainty, TVA believes that wholesale customer choice is likely to continue to evolve in its service territory.

Page 2 7

While TVA is gene6ally not subject to Federal Energy Regulat6ry Commission ("FERC") jurisdiction TA com-plies with FERC transmission regulations where consistent with the provisions of the TVA Act and other provisions of federal law. Several fully integrated utilities, as well as regional transmission organizations, now border TVA, and all operate under FERC regulations. TVA will continue to operate within the bounds of applicable laws and regulations and will adapt as they may change in the future. In addition; TVA is voluntarily seeking ways to meet FERC's objective to improve regional transmission operations in a manner consistent with TVA's responsibilities under the TVA Act.

Reduction of Total Financing Obligations In 2004; TVA redoubled it efforts to reduce debt and certain debt-like instruments in its capitalization, collec-tively called 'total financing obligations," which include debt, lease/leaseback obligations, and energy prepayments.

Due to the uneven nature of TVA's expenditures both for expense and capital cost, the amount of total financing obli-gations that TVA can retire will vary in each year as a function of its margin on power sales, its ability to control its oper-ating costs, and requirements for capital: Capital requirements generally can be broken down into base capital need-ed to sustain existing plant, environmental capital such as the funds required to build facilities that reduce emissions on TVA's fossil fleet, and growth capital such as that needed for increasing the capacity of TVA's generating plants and transmission grid.

The reduction in total financing obligations is being considered under several options, and in combination with and in the context of, setting multi-year annual performance plans and budgets, including:

X.

Continued emphasis on cost reduction through process improvements, Asset improvements to increase performance, -

Capital rationing: --

- Deferring and/or canceling capital projects when necessary and appropriate,

- Synchronizing investment criteria with the changing portfolio of customer contracts and commitments, and Rate adjustments and rate changes consistent with changes in market and power supply conditions.

Principal threats to TVA's ability to reduce total financing obligations are loss of load, increased operating expenses (including fuel), need for new base load generation, and unforeseen capital costs due to changing environ-mental standards that are not made up through rate increases. TVA evaluates business conditions, regulations, and costs to identify ways to improve financial flexibility.

Maintain Assets While it is unclear how competitive markets will affect TVA in the future, even indirect competitive pressure will mean that TVA's financial health will be more dependent on its ability to control expenses, while keeping power rates competitive.

At TVA is working to reduce its total financing obligations, improve efficiency, and maintain the viability of its gen-erating fleet so that it will continue to be the provider of choice for its customers in a competitive environment. TVA's generating fleet, supplemented by purchased power, as appropriate, isexpectedlto be adequate to meet demand in TVA's service area for the next ten years, especially as Browns Ferry Nuclear Plant Unit 1 is brought on line. This unit is expected to begin operations in 2007 and is expected to add 1,280. megawatts of energy to TVA's system and have the effect of reducing TVA's cost of power.

Part of maintaining the viability of TVA's generating fleet involves investment of capital in the maintenance of fleet assets. TVA, along with other electric utilities, is challenged by an aging fleet of coal-fired generating units. Eight of TVA's 11 coal plants are more than 40 years old and require capital investment to maintain performance and avail-ability. TVA's nuclear plants require ongoing capital investment to maintain plant reliability and performance. In addi-tion, nuclear plants occasionally require investmernt to address new regulatory requirements or design-specific plant aging and degradation, such as the replacement of steam generators in certain reactors. TVA's hydro plarits aie als6 aging'- the average actual age of TVA's hydro units is more than 65 years. TVA is in the midst of a long-term capital improvement program that will modernize the power production equipment at major hydro facilities.

Page 28

TVA expects to have adequate cash flow in coming years to be able to complete its current clean air commit-ments and currently planned investments in its power system. This includes currently planned expenditures for main-tenance.of existing power system assets. However, new environmental mandates, other required expenditures, or a decline in power demand, among other things, could threaten expected cash flows.

Economic Outlook TVA's current load forecast through 2007 rreflects an average annual energy growth rate of 1.4 percent.

Numerous factors, such as weather conditions and the health of the regional economy, could cause actual results to differ materially from TVA's forecasts.; TVA's regional economic outlook is a major driver of its sales forecast. The health of the regional economy can be measured in three ways.. Generally, population is most imponrant for residen-tial sales, employment for commercial sales, and regional gross domestic product for manufacturing sales. The esti-mated growth rates through 2007 from TVA's economic outlook are:

- --VRange of Forecast High Medium Low Regional Gross Domestic Product 5.1%/6 3.4%,.-

1.3%

Total Nonfarm Payroll Employment 2.90%6 1.5%

-0.4%

! Total Population 1.60%6 1.0%

0.4%

For additional information on TVA's longer-term future outlool,' see 'TVA anrd Conrrpetition" and 'Business Strategy"-

'Strategic Plan" below.

Legislative and Regulatory Matteris l

ii;

~I v

I;j,.,.

TVA Governance.

i-,.2

^i In December 2004, the Consolidated Appropriations Act, 2005, was signed by the President as Public Law No. 108-447. This legislation restructures the Board by increasing the number of directors from three full-time mem-bers to nine part-time members, at least seven of whom,must be legal residents of the TVA service area. As with the current Board, future Board members will be appointed by the President and confirmed by the SenatE, but will serve, after a transition period, five-year terms rather than the current nine-year terms. The Board's role will continue to be, among other things, to develop long-term plans and strategies for TVA, approve annual budgets and an employee compensation plan for TVA, and have general responsibility for TVA policies. The Board will also create an audit com-mittee consisting of members of the Board "independent of the management" tor6vi6ve reports from TVA's external auditors and Inspector General and make recommendations to the full Board. Congress 'also reaffirmed the authority of the Board to set electric rates charged by TVA These provisionswill go into effect on the date when at least three new Board members take office.

h p

i g n

e o t d

w a leas t The legislation also creates the position of Chief Executive Officer ('CEO") for TVA. The CEO will be appoint-ed by the Board and viii be' resporiisible 'for de'elopm'nt and implementation of TVA's strategic directi6n. The CEO willserve at the pleasure ofthe Board.

!,- i The legislation also amends the Securities Exchange Act of 1934 to provide that beginning with its annual report for fiscal year 2006, WA will be.required to file annual reports' (10-Ks), quarterly reports (10-ls), ard current reports (8-Ks) with the 'SEC., Also, TVA will be deemed an issuer for s6me of the audit-related provisions of section 1OA of the Securities Exchange Act of 1934 but not for {hbse provisions of section 1 PA that are iriconiistent with TVA's structure under the TVAAct. The legislation does not rEquire TVA to register securities under either the Securities Act of 1933 or the Securities Exchange Act of 1934. The legislation provides that TVA securities are 'government securi-ties" under, the Securities Exchange Act of 1934, and that nothing in the amendment interferes with or. affects the Board's authority to carry out its statutory functions uridr tie TVA Act.

in i

The American Jobs Creation Act of 2004, H.R. 4520, was signd bythe President in October 2004 as Public Law No. 108-357.' It contains provisions designed to Eiit the use of sale/leaseback and lease/leasejack financings by tax-exempt entities, such as TVA. TVA has used lease/leaseback financings in the last several years and o6tained a more favorable financing rate than it would have obtained by issuing bonds. These provisions of H.R. 4520 will reduce or eliminate the attractiveness of using lease/leaseback transactions as a financing alternative for TVA in the future.

r PA zi;.

¢ r

-Page 29

Energy Bill On August 8, 2005, President Bush signed H.R. 6, the wide-ranging energy bill, as Public Law No. 109-58.

Among other things, the legislation provides incentives to energy companies, including tax breaks and loan guaran-tees for new nuclear power plants, clean coal technology and wind energy. Provisions in the bill relevant to TVA include:

TVA is subject to FERC review of transmission rates and terms and conditions of service to ensure compara-bility of treatment of its and others regarding the same transmission service.,The bill also reaffirms the Anti-Cherrypicking Provision in providing that TVA distributors will be afforded native load preference regarding firm transmission rights on the TVA transmission system, but in a way that (i) will not affect the requirements of the Anti-Cherrypicking Provision and (ii) will not itself provide a new basis for any FERC order that would be contrary to the purposes of the Anti-Cherrypicking Provision. (Native load refers to the customers on whose behalf a company, by statute, franchise, regulatory requirement, or contract, has undertaken an obli-gation to serve. The Anti-Cherrypicking Provision provides that FERC cannot order TVA to deliver power from a non-TVA source to a customer if the power would be consumed within TVA's defined service territory. See

'Risk of Loss of Customers" below.)

FERC's authority to order refunds of excessive prices on short-term sales (transactions lasting 31 days or less) in market manipulation and price gouging situations is expanded to include authority over TVA if TVA makes such sales under a FERC approved tariff.

TVA is subject to new prohibitions on (i) using manipulative or deceptive devices or contrivances in connec-tion with the purchase or sale of electric energy or the purchase or sale of transmission services subject to jurisdiction and (ii) willfully and knowingly reporting false information on the price of electricity sold at whole-sale or the availability of transmission capacity to a federal agency with intent to fraudulently affect the data being compiled by the agency. TVA is also subject to FERC's investigative and enforcement authority in these two areas.

FERC is authorized to issue regulations requiring the reporting, on a timely basis, of information about the availability and prices of wholesale electric energy and transmission service by all market participants, includ-ing TVA.

FERC is also directed to help transform the current national and regional, contractually-based, electric relia-bility councils into regulatory agencies. As such, the resulting electric reliability organizations, with FERC oversight, will exercise federal regulatory authority over utilities,' including TVA, rather than rely on contractu-ally-based reliability standards. The exact nature of these new regulatory bodies has'not yet been fully deter-mined.

Three new standards are added to the Public Utility Regulatory Policies Act (PURPA"), requiring TVA, as a "state" regulatory authority, to consider its suitability for application to distributors and itself. The new stan-dards to be considered are (i) net metering, (ii) smart metering, and (iii) interconnection.

TVA is authorized to participate in regional transmission organizations ("RTOs"), but only under contractual relationships that (i) do not impair the requirements of federal laws and contracts, (ii) set performance stan-dards to assure that the federal transmission assets in question are managed in ways consistent with feder-al laws and contracts, and (iii) enable withdrawal from the RTO if those performance standards are not met.

In summary, the impacts of this energy bill on TVA directly will primarily be in regulatory process and admin-istrative cost. TVA has not joined a RTO, but currerntly has a Joint Reliability Coordination Agreement with the Midwest Independent Transmission System Operator, Inc. ("Midwest ISO") and PJM Interconnection that provides' for cooper-ation in the management and operation of the electric transmission grid over a major portion of the eastern United States and for the coordination of planning and congestion management to ensure reliability and market liquidity in the Eastern Interconnection.

Environmental In March 2005, the EPA issued its final Clean Air Interstate Rule ("CAIR") that requires certain states to reduce sulfur dioxide ("S02") and nitrogen oxide ("NO.") emissions from fossil-fuel fired power plants to eliminate interstate pol-lutant transport in significant amounts. All states served by TVA would be subject to CAIR. CAIR allows the trading of credits to satisfy its requirements.

Page 30

- In March 2005, the EPA also released its final Clean Air Mercury Rule that would limit annual mercury emis-sions collectively from power plants to 38 tons in 2010 and 15 tons in 2018. The final rule also allovis the trading of credits to satisfy requirements.

A number of existing environmental regulatory programs have been and are being made more stringent in their application to fossil-fuel units, and additional regulatory programs potentially affecting fossil-fuel units have been proposed. The total cost of future compliance with NO.,, S02, and mercury reduction requirements and other environ-mental-related requirements cannot reasonably be determined at this time because of the uncertainties, among other things, surrounding emerging regulations, resultant compliance strategies, potential for the development of 'new emis-sion control technologies, litigation, and future amendments to the Clean Air Act (see note 12 -- Environmental Matters). Litigation over emissions from coal-fired generating units is growing, including litigation against TVA (see

'Legal Proceedings" in Part I). It is not possible to predict with any precision how these developments will impact the operation of existing and new fossil-fuel generating units. It is virtually certain that environmental requirements placed on the operation of fossil-fuel generating units will become more restrictive.;

Other Matters I

• In July 2005, Senator Jim Bunning (R-KY) and Senator Mitch McConnell (R-KY) introduced S.1499, a bill that would effectively remove any area within Kentucky from coverage by the Anti-Cherrypicking Provision.

See

'Management's Discussion and Analysis of Financial Condition and Results of Operations" - 'Risk of Loss of Customers" for further discussion of the Anti-Cherrypicking Provision. If the bill were to become law, FERC could require TVA to wheel power from a supplier other than TVA for use inside that portion of TVA's service area that is with-in Kentucky. The bill was referred to and remains in the Senate Energy and Natural Resources Committee.

In June 2005, OMB transmitted draft legislaton to Congress that would expand the type of evidences of indebtedness that count toward TVA's $30 billion debt, ceiling.. Under this legislation, long-term obligations that finance capital assets would count toward the debt ceiling, including lease-leaseback arrangements and power prepayment agreements whose original term,exceeded one year. This legislation, which would be effective for transactions into which TVA entered after December 31, 1999, has not yet been introduced in Congress.

It is difficult to predict whether the initiatives discussed above will become law in the future and what their impact would be'on TVA.

Liquidity and Capital Resources Capital Structure TVA is very different from investor-owned utilities ("iOUs") in its capital structure. Primarily during the first 25 years of TVA's existence, the U.S. Government made aop'ropriation investments in TVA power facilitiesi. In 1959, TVA was authorized by statute to issue bonds in order to finance its growing power program. Since that time, TVA's power program has been required to be self-supporting.. As a result, TVA funds its capital requirements through internal cash generation, through borrowings (subject to-a congressionally-mandated $30 billion limit on the amount of Evidences of Indebtedness outstanding), and through other financing arrangements including customer prepayments and lease/leaseback transactions.

TVA's Power Bonds are currently rated "Aaa" by Moody's Investors Service and "AAA" by Standard and Poor's and Fitch Ratings (the 'rating agencies"). TVA's capital structure is composed primarily of debt and reflects a strong credit rating and investor confidence, both of which are important to TVA's financial health. P/A's current rat-ings are based to a large extent upon the body of legislation that defines TVA's business structure, including the Board's ratemaking authority and TVA's status as a corporate agency and instrumentality of the U.S. Government.

VA's current debt, including its short-term debt,Tis either retired o refinanced as it matures. A reduction in TVA's cred-it rating could impact its currently expected cash flows, which could result in some combination of the need to increase borrowings, the need to reduce other expenses or capital expenditures, and the need to increase rates.- Other factors that could potentially create volatility for TVA's cash flows include, among other things, changes in legislation, load changes or shifts, and weather extremes.

TVA is required to pay the U.S. Government a return on the appropriation investment in TVA power facilities

("Appropriation Investment"), plus a repayment of the investment as specified by law. The combined payment for 2005 was $36 million. Cumulative repayments and returncan investment paid by TVA to the U.S. Treasury ('Treasury")

Page 31

approximate $3.6 billion. Approximately $1.0 billion of the $1.4 billion Appropriation Investment has been repaid. See note 7 -

Appropriation Investment.

Appropriation Investment In Power Program as of September 30, 2005 Appropriations from Congress 1,419 Transfers of Property to TVA 24 Transfers of Property from TVA Program Expenditures Repayments to U.S. Treasury 142015) 428 When monitoring its financial condition, TVA considers its ability to generate adequate cash flow from opera-tions, the extent to which cash flow covers interest expense, and the proportion of interest expense to the amount of revenue generated. TVA has recently improved these measures and is committed to improving its financial flexibility in the future. Nonetheless, TVA is very dependent upon liquidity provided by the capital markets in order to run its busi-ness and refinance its debt. Loss of its current ratings, loss of access to the capital markets, or an inability to recov-er its costs, among other things, could lead to potentially severe financial distress.

Cash Flow Because TVA's business is highly influenced by seasonal and economic factors, it is helpful to look at aver-age cash flow over a multi-year period.

TVA's summary cash flows for the years ended September 30 are:

Years ended September 30 2005 2004 2003 Cash provided by (used in):

Operating activities

$ 1,346

$ 3,191

$ 1,629 Investing activities (1,072)

(1,619)

(1,942)

Financing activities (255)

(1.586) 446 Net increase (decrease) in cash and cash equivalents 19 (14) 5 133 Excluding the $1.5 billion energy prepayment transaction in 2004 (see 'Energy Prepayment Obligations"-

'Prepayment of Energy Services" below), WVA's cash from operations was $1.3, $1.7 and $1.6 billion for 2005, 2004, and 2003, respectively. This positive trend is a continuation of increases in cash generated from operations since the mid 1990's. With the upward trend in cash from its power operations coupled with a downward trend in investing activ-ities, primarily due to a reduction in capital spending, TWA has been able to use funds to reduce its financing obliga-tions as shown in the table above. TWA continues to assess other factors that could create volatility for its cash flows including, among other things, changes in legislation, volatility of fue! and purchased power-costs, load changes or shifts, and weather extremes.

2005 Compared to 2004 Net cash provided by operating activities decreased $1.9 billion from $3.2 billion in 2004 to $1.3 billion in 2005. This decrease resulted from:,.,.

Proceeds of $1.5 billion received in 2004 for energy prepayments not present in the current year; Decreased cash provided from net income components of $218 million;...

An increase in expenditures for nuclear refueling outages of $36 million due to the number and timing of out-

- ages; and:

An increase in other deferred items of $28 million primarily due to increased contributions to the TWA Retirement System.

Net cash used by changes in working capital components increased $59 million from $10 million in 2004 to

$69 million in 2005. The unfavorable working capital fluctuation primarily resulted from:

Page 32

A larger increase of $71 million in accounts receivable due to increased sales volume during the summer

, months; An increase in inventories and prepaid expenses of $12 million in 2005, compared to a decrease in invento-ries and other of $10 million in 2004 due to purchases of emission allowances and prepayrrent of insurance premiums for new programs in 2005; anid A larger decrease in accrued interest of $17 million due to a lower level of total outstanding debt during 2005 as compared to 2004.

These items were partially offset by:

A larger increase of $51 million in accounts payable and accrued liabilities primarily due to the receipt of a

$107 million collateral deposit and higher fuel and purchased power expense of $71 million offset by the tim-ing and payment of other accruals, including a $41 million payment related to Browns Ferry Nuclear Unit 1 accrued in 2004 and paid in 2005, a $10 milliDn settlement for litigation accrued in 2004 and paid in 2005, a

$19 million rate settlement accrued in 2004 and paid in 2005, $6 million in lump sum leave accrued in 2004 and paid in 2005, and an additional $18 millicn of performance incentives paid in 2005 over 2004.

'Net cash pr6vided by net incorie components decreased'$218 Million from $1.8 billion in 2034 to $1.6 billion in 2005. This decrease was the result of:

Increased cash paid for fuel and purchased power of $521 million which was driven by both higher volume arid increased market prices, and An increase in tax equivalent payments of $27 million.

i;- These items were partially offset by:.

An increase in cash provided by operating revenues of $251 million resulting primarily from increased sales volume; A decrease in cash outlays for interest of $42 million; and A decrease in cash outlays for operatinig and maintenance costs of $36 nmillion primarily due to $33 million in severance and restructuring costs'that were recognized in'2004:

Cash used in investing activities decreased $547 million from $1.6 billion to $1.1 billion for the years ended September 30, 2004, and 2005, respectively. The change is primarily duie'to:

A decrease in expenditures for capital projects of $214 million primarily due to decreases in clean air expen-ditures of $210 million partially offset by increases in expenditures'for the Browns Ferry Unil 1 restart; A corresponding increase in funds from AFUDC of $i7 million; Proceeds'received in 2005 from the sale of certain power'distributor loans receivable of $55 million (see note 1-Sale of Loans);

Cash providedby net c6llections on loans and long-terrn receivables of $6 million as opposed to $5 million in the prior year, and net lr6ceeds from investment activity of $1 -million; and Maturity of short-term investments in 2005 of $335 million compared to an increase in short-term investments

- 'f $68 million in 2004.

These items are partially offset by:

An increase in expenditures for the enrichment and fabrication of nuclear fuel of $22 million as four nuclear units completed refueling outages in 2005; Proceeds of $15 million provided in 2004 by the cancellation of the Regenesys project; and Restrictions on cash of $107 million resulting from the collateral deposits (see note 1-Resiricted Cash and Investments).

Net cash used in financing activities was $255 million for the year ended September 30, 2005, compared with net cash used in financing activities of $1.6 billion in the prior year. The net decrease of $1.3 billion in funds used is primarily due to:

Page 33

An increase in issuances of long-term debt of $878 million;'

Net issuances of short-term debt of $546 million in 2005 compared to net redemptions of short-term debt of

$157 million in 2004; A decrease in payments to the Treasury of $2 million due to lower interest rates; and A decrease in lease payments of $26 million.

These items were partially offset by:

An increase in redemptions of long-term debt of $117 million primarily due to the refinancing of callable debt at lower interest rates; Decreased proceeds from bond premium received of $97 million,-'

Decreased proceeds'from swap receivable m6netizatioh of $55 million; and An increase in net financing costs of $14 million related to bond transactions.

2004 Compared to 2003.

Net cash provided by operating activities increased $1.6 billion from $1.6 billion in 2003 to $3.2 billion in 2004.

This increase resulted from:

Proceeds of $1.5 billion received in 2004 for energy prepayments; Higher operating revenues of $580 million driven primarily by the 2004 rate increase coupled with increased sales volume offset by $92 million of prepaid energy services; A decrease in cash outlays for interest of $17 million; and A decrease in expenditures for nuclear refueling outages of $7 million due to the number and timing of out-ages.

These items were partially offset by:

Increased cash paid for fuel and purchased power of $121 million; and, Increased cash outlays for operating and maintenance costs of $92 million.

Additionally, these items were partially offset by a change in net cash used in working capital components of

$174 million, from net cash provided of $164 million in 2003 to net cash used of $10 million in 2004. The unfavorable working capital fluctuation is primarily a result of:

An increase in accounts receivable of $41 million in 2004, resulting from the rate increase and an increase in sales volume, as opposed to a $78 million reduction in the prior year; A smaller increase in accounts payable and accrued liabilities of $123 million due to the timing of accruals made in 2003 and paid in 2004; and A decrease in accrued interest of $5 million, due to a lower level of total outstanding debt during 2004 as com-pared to 2003, as opposed to an increase of $2 million in the previous year.

These iterrss were partially offset by a $10 million reduction'in inventory-in 2004, partially due 'to a reduction in the number of days of inventory supply on hand, as opposed to a $65 million increase in the previous year.

Net cash used in investing activities decreased $323 million from $1.9 billion in 2003 to $1.6 billion in 2004.

This change resulted primarily from:

A decrease in expenditures for capital projects of $141 million; An increase inAFUDC of $25 million; A decrease in nuclear fuel expenditures of $68 million due to the cOmpletion' of inuclear plant refueling out-ages between September 2003 and September 2004 and use of certain nuclear fuel inventory that built up during the prior year in preparation for the reloads; Proceeds received in 2004 from the Regenesys project cancellation settlerment of $15 rnillion; Page 34

"* Net cash provided by loans and long-term recivables of $5 million as opposed to net cash used by the same

.items of $9 million in the prior year; and A smaller increase in short-term investments of $50 million.

Net cash used in financing activities was $1.6 billion for the year ended September 30, 2004, compared to net cash provided by financing activities of $446 million in the prior year. This $2.0 billion change resulted primarily from:

A decrease in long-term debt issues of $1.5 billion primarily due to the receipt of $1.5 billion in proceeds from MLGW for energy prepayments; An increase in redemptions of long-term debt of $966 million due to the refinancing of callable debt at lower interest rates; Proceeds of $256 million from bond call monetization s n ot present in 2004; Proceeds of $389 million from qualified technological equipment leasing not present in 2004.;

Proceeds of $325 million from combustion turbine leasing not present in 2004; and

• r. --

Equipment lease payments of $29 million in 2004.

These items were partially offset by:

A decrease in redemptions net of issuances of short-term debt of $1.3 billion compared to the prior year due to lower outstanding short-term debt balances during the year; Proceeds of $97 million of bond reopening premium not present in 2063;'

Proceeds of $55 million from payment on a swap receivable monetization (see note 8) not present in the prior year; A decrease in payments to the Treasury of $4 million; and A decrease in net financing costs of $55 million.

Working Capital The table below summarizes the components of working capital and short-term debt. At September 30, 2005, TVA had negative working capital of $4.6 billion, largely attributable to $5.2 billion in short-term indebtedness. TVA's cash management policy is to use cash provided by operations as well as Discount Notes to fund current cash require-ments, and TVA plans to continue to use such financing instruments as long as short-term interest rates remain favor-able.

Years ended September 30 2005 2004 2003 Current assets

$ 2,269

$ 2,386

$ 2,321 Current liabilities (6,817)

(5.511)

(5,902)

Working capital (deficit)

$ (4,548)

$ (3,125) :

$ (3,581)

Discount notes <90 days

$ 2,469

$ 1,924

$ 2,080 Current portion of long-term debt I. 2,693 2,000 2,336 Total short-term debt

$ 5,162

$ 3,924

$ 4,416 Capital Resources lOUs typically raise capital through the issuance 6f a combination of common stock, preferred stock, and short and long-term debt. By contrast, the Act limits TVA's firancing methods which results in a capital structure that is very different from that of an IOU and is part of the reason why TVA's debt levels are generally higher than an IOU of com-parable size. Power bonds and notes comprise about 90 percent of TVA's total financing obligations. Though interest rates may increase, the overall average interest rates cn TVA bonds and notes should be somewhat insulated, reflect-ing the 16-year average life of TVA's long-term bond and note portfolio.

From October 1, 2004, to September 30, 2005, TVA redeemed at par $182 million of ele6tronotesO with an average interest rate of 6118 percent, the 2000 Series E QUINTS with a $100 million par amount anc an interest rate Page 35

of 7.75 percent, and the 1995 Series A Global Power Bonds with $2 billion par amount and an interest rate of 6.38 per-cent. In addition, on June 1, 2005, the interest rate on the TVA 1998 Series D Putable Automatic Rate Reset Securities

("PARRS") reset from 5.95 percent to 5.49 percent. The rate may be reset again.under certain circumstances on June 1, 2006, and annually thereafter, until maturity. In conjunction with the reset, $86 million of the $552 million of 1998 Series D PARRS outstanding was redeemed by bondholders. The remaining bonds mature on June 1, 2028 but may be put back to TVA at par any time the interest rate is reset.

l TVA issued $1.7 billion of long-term debt during the year ended September 30, 2005, including $150 million par amount of electronotes' with maturity dates ranging from 2010 to 2025 and an average interest rate of 4.74 per-cent, Global Power Bonds 2005 Series A maturing on June 15, 2035, with a paramount of $500 million and an inter-est rate of 4.65 percent, and Global Power Bonds 2005 Series B maturing on June 15, 2015, with a par amount of $1 billion and an interest rate of 4.38 percent. TVA also has access to financing arrangements with the Treasury, where-by the Treasury is authorized to accept a short-term note with the maturity of one year in an amount not to exceed

$150 million. TVA may draw any portion of the authorized $150 million during the year. Interest is accrued daily and paid quarterly at a rate determined by the Secretary of the Treasury each month based 6n the average of outstanding obligations of the United States with maturities of one year or less. During 2005,2004, and 2003, the daily average amounts outstanding were approximately $103, $35, and $12 million, respectively. The outstanding balances were repaid quarterly. See note 9-Short-Term Debt.

Revolving Credit Facility Agreement On May 26, 2005, TVA and a national bank entered into a revolving credit facility agreement with an initial term of 180 days. On November 9, 2005, the term was extended until May 22, 2006. The facility provides TVA with an unsecured revolving line of credit of up to $2.5 billion. The interest rate on any borrowing under this agreement is variable and based on market factors and the rating of TVA's senior unsecured long-term non-credit enhanced debt at the time TVA draws on the facility. TVA is required to pay an unused facility fee on the portion of the $2.5 billion against which TVA has not borrowed. This fee is similar to fees charged in the banking industry to similar customers for sim-ilar products and may fluctuate depending upon the rating of TVA's senior unsecured long-term non-credit enhanced debt. There were no outstanding borrowings under the facility at September 30, 2005.

Sale of Loans

'On December 2, 2004 TVA sold a portfolio of 51 power distributor loans receivable. The portfolio was sold for $55 million without recourse and contained loans with maturities ranging from less than one year to over 34 years.

The principal amount due on the loans at the time of sale was $57 million.:- The $2 million loss is reported on OTHER INCOME, NET on the Income Statement for the year ended September 30, 2005.

Energy Prepayment Obligations l Discounted Energy Units. During October 2002, TVA introduced the Discounted Energy Units ("DEU") pro-gram. Under this program TVA customers purchase DEUs generally in $1 million increments, and each DEU entitles them to a $0.025/kilowatt-hour discount on a specified quantity of firm power over a period of years (five, ten, 15, or

20) for each kilowatt-hour in the prepaid block. The remainder of the price of the kilowatt-hours delivered is due upon billing.

TVA did not offer the DEU program in 2005. Sales for the 2004 program included 5.5 DEUs totaling $5.5 mil-lion over a ten-year period and 1.75 DEUs totaling $1.75 million over a five-year period. Total sales for the program since inception are $54.5 million. TVA is accounting for the prepayment proceeds as unearned revenue and is report-ing the obligations to deliver power as ENERGY PREPAYMENT OBLIGATIONS and CURRENT PORTION OF ENERGY PREPAYMENT OBLIGATIONS on the September 30, 2005 and 2004 Balance Sheets. TVA recognizes revenue as electricity is delivered to customers, based on the ratio of units of kilowatt-hours delivered to total units of kilowatt-hours under contract. As of September 30, 2005, over $14.6 million had been applied against power billings on a cumulative basis during the life of the program, $5.6 million of which was recognized as noncash revenue during 2005 and over $5.5 million of which was recognized as noncash revenue during 2004.,

Prepayment of Energy Services. During 2004, TVA and its largest customer, MLGW, entered into an energy prepayment agreement under which MLGW prepaid TVA $1.5 billion for' the future costs of electricity to be delivered by TVA to MLGW over a period of 180 months. In exchange for this prepayment, MLGW receives a credit on its month-ly bills during this period. TVA received the $1.5 billion prepayment in December 2003, accounted for the prepayment Page 36

as unearned revenue, and is reporting the obligation to deliver power, under this arrangement as ENERGY PREPAYMENT OBLIGATIONS and CURRENT PORTION OF ENERGY PREPAYMENT OBLIGATIONS on the September 30, 2005 arid 2004 Balance Sheets. TVA expects to recognize approximately $100 million of noncash revenue in each year of the arrangement as electricity is delivered to MLGW based on the ratio of units of kilowatt-hours delivered to total units of kilowatt-hours under contract. As of September 30, 2005, over $190.3 million has been recognized as noncash revenue on a cumu-lative basis during the life of the agreement, $100 million of which was recognized as noncash reveiue during 2005 and over $90.3 million of which was recognized as noncash revenue during 2004.

Rate Actions On July 22, 2005, the Board approved a 7.52 percent increase in firm wholesale electric rates effective on October 1, 2005. The rate increase is expected to provide additional revenues of approximately $524 million in fiscal year 2006. TVA approved the rate adjustment to fund in creases in fuel and purchased power costs as well as increased transportation costs. Utilities surrounding the Tennessee Valley are also increasing rates, and 12 of the 14 surround-ing utilities have fuel-adjustment clauses that allow them to pass fuel increases along to their customrers. TVA's rela-tive competitive position is not expected to change as a result of the rate increase. In the coming year, TVA will con-tinue to monitor the cost of fuel and purchased power. Current projections have these costs increasing significantly above the amount upon which the October1, 2005, rate increase was based. This will place an upward pressure on rates and could possibly result in further rate actions in the near term.

Monetization of Call Options, 7

During 2002, TVA monetized the call provisions on a $1 billion public bond issue by entering into a swaption agreement with a third party in exchange for $175 million. In 2003, TVA monetized the call provisions on a second public bond issue of $476 million by entering into a swaption agreement with a third party in exchange for $81 million.

In the third quarter of 2005, TVA monetized the call provisions on two electronotesO issues ($42 million total par value) by entering into swaption agreements with a third party in exchange for $5 million. A swaption essentially grants a third party the right to exercise the embedded call provision of the applicable bond while TVA continues to pay the holders of the swaption pursuant to the original bond issuance. In February 2004, the counterparty to the 200', swaption trans-action exercised its option to enter into a swap with TVA, effective April 10, 2004, requiring TVA to make fixed rate pay-ments to the counterparty of 6.875 percent and the counterparty to make floating payments to TVA based on London Interbank Offered Rate ('LIBOR"). These payments are based on a notional principal amount of $476 million, and the parties began making these payments on June 15, 2004. The 2002 swaption is recorded in OTHER LIABILITIES on the September 30, 2005 Balance Sheet and is designated as a hedge of future changes in the fair value of the original call provision. Under SFAS No. 133, as amended, TVA records the changes in market value of both the Ewaotion and the embedded call. These values historically have been highly correlated; however, to the extent that the values do not perfectly offset, any differences will be recognized currently through earnings. These differences (including those for the 2003 swaption prior to its being exercised in February 2004) amounted to a nearly $10 million noncash gain for the year ended September 30, 2004, and a $27 million noncash gain for the year ended September 30, 2'005. The swap entered into pursuant to the 2003 swaption and the two electronotes" swaptions are also recorded in OTHER LIABILITIES on the September 30, 2005 Balance Sheet, and the changes in market value are recognized currently in earnings.

These changes amounted to a $23 million noncash loss for the year ended September 30, 2004, and a $19 million noncash loss for the year ended September 30, 2005.

Lease/Leaseback Transactions During the summer of 2002, TVA completed construction of two sets of four combustion turDine ('CT') units which were part of a series of new peaking CT units. Of the financing options available to TVA for these units, long-term lease and leaseback arrangements provided outcomes that were the most economically favorable to TVA. The lease/leaseback for the first set of four units was finalized during the first quarter of 2003 and provided about $163 mil-lion in lease proceeds. The cost of the first lease agreement approximated a full-term implicit rate of just above four percent. The lease/leaseback of the second set of four units was finalized during the third quarter of 2003 and provid-ed about $162 million in lease proceeds. The cost of the second lease agreement approximated a full-term implicit rate of slightly more than three and one half percent.

In addition to the financing activity for the CTs described above, TVA entered into another firancing arrange-ment late in 2003 related to various Qualified Technological Equipment ("QTE") consisting of certain transmission equipment and related software. Such QTE was leased to a group of investors and subsequently leased back by TVA under terms and conditions which substantially mirrored those contained in the CT lease/leaseback arrangements.

Page 37

The transaction resulted in financing proceeds of approximately $389 million. The cost of the QTE lease agreement approximated a full-term implicit rate of slightly less than four percent.

TVA accounted for the respective CT and QTE lease proceeds as financing obligations in accordance with SFAS No. 66, 'Accounting for Sales of Real Estate," and SFAS No. 98, "Accounting for Leases.' As of September 30, 2004, the outstanding financing obligations of $1.2 billion were included in LEASE/LEASEBACK OBLIGATIONS ($1.1 -billion) and CURRENT PORTION OF LEASE/LEASEBACKMOBLIGATIONS

($35 million), respectively, on TVA's 2004 year-e nd Balance Sheet. The outstanding financing obligations of $1.1 billion at September 30, 2005, are included in LEAsE/LEASEBACK OBLIGATIONS ($1.1 billion) and CURRENT PORTION of LEASE/LEASEBACK OBLIGATIONS ($35 million), respectively, on TVAs 2005 year-end Balance Sheet.

Cash Requirements and Contractual Obligations Due to the nature of the power industry, which requires large multi-year capital investments, using trends and multi-year'forecasts are important in assessing the effectiveness of management's decisions related to capital expen-ditures, pricing and accessing capital markets.

The future planned construction expenditures for property, plant, and equipment additions, including clean air projects and new generation, are expected to be internally funded and are estimated to be as follows:

Actual Estimated Construction Expenditures 2005 2006 2007 2008 2009 2010 Browns Ferry Unit 1 Restart 417 420 81' Clean Air Expenditures

-'201 201 305 335 306 290 Transmission Expenditures (

173 245 i-l.

211 313 319 312 Other Capital Expenditures (2),

431 467

• 492 596 510 560 Total Capital Projects Requirements

$ 1,222

$ 1,333

$i109

$ 1,244 1,135 1,162 Notes:

(1), Transmission Expenditures includes reimbursable projects.

(2) Other Capital Expenditures are primarily associated with short lead time construction expenditure projects aimed at the continued safe and reliable operation of generating assets.,

TVA conducts a continuing-review of its construction expenditures and financing programs. The amounts shown in the table above are forward-looking amounts based on a number of assumptions and are subject to various uncertaintiesl Actual amounts may differ materially based up6n a number of factors, including changes in assumptions about system load growth, environmental reg'ulation, rates of inflation, total cost of major projects, and availability and cost of external sources of capital, as well as the outcome of the ongoing restructuring of the electric industry.

VA doles not anticipatereceiving a financial return on its clean air expenditures because these expenditures neither generate revenues-nor reduce costs. In' fact, clean air equipment will reduce the operating efficiency and increase the operating costs of TVA's fossil units. In the near term, TVA will be negatively impacted by investments in new generation (i.e., Browns Ferry Unit 1) that are not expected to return a cash contribution until 2007. TVA also has contractual cash obligations, including minimum payments on operating leases, purchase obligations, power purchase contracts, and fuel purchase contracts (see note 12-Commitments). For reporting purposes, TVA defines "contrac-tual cash obligations" as written agreements to purchase goods and services that may or may not be legal commit-ments but which TVA intends'to exercise. TVA expects that cash provided by operating activities and new financing activities will be adequate to meet these estimated,cash requirements, as well as capital expenditures.. In the coming year, TVA will continue to monitor the cost of fuel and purchased power. If these costs continue to increase, there will be upward pressure on TVA's rates. As 'of September 30, 2005, the amounts of contractual cash obligations for each of the next five years and thereafter are shown below:

I l

~~~~~~~~~~~-,'

Page 38

Debt Interest on debt Leases Lease/leaseback transactions Power purchase obligations Other obligations Fuel purchase obligations Decommissioning Retirement system Total 2006 2007 2008 2009 2010 Thereaftor Total 5,240 $

970 91

$ 2,031 42

$ 14,71.4

$ 23,088 1,220 1,027' 1,001 945 891 12,193 17,280 84 82 72

• 66 63 43 413 85 85 89 85 89 1,209 1,642 184 1165 133 138 139 3,563 4,324 420 146 111 5

2 7

691 958 33, 299 208 166 363 2,327 25 25

,75

-. i

• -I.

75

$ 8,291

$ 2,806

$ 1,796

$ 3,478

$ 1,392

$ 32,10)

$ 49,865 Note:

• Contributions/payments beyond 2006 to be determined based or. funding requirements.

In addition to the cash requirements above, TVA has contractual obligations in the form of revenue dis-counts related to energy prepayments discussed above.

2006 2007 2008 2009 2010 Thereafter Total Energy Prepayment Obligations 106 106 105 105 105 823

$ 1,350 Debt At September 30, 2005, TVA had outstanding short-term debt of $2.5 billion and long-term debt (including cur-rent maturities) at varying maturities and interest rates of $20.6 billion for total outstanding indebtedness of $23.1 bil-lion (see note 9).

Interest on Debt At September 30, 2005, TVA's interest obligalion related to its short-and long-term debt, if held to maturity, was $17.3 billion.

Leases TVA leases certain property, plant, and equipment under agreements with terms ranging from one to 30 years.

Obligations under capital lease agreements in effect at September 30, 2005, total $60 million for 2006, $63 million for 2007, $59 million for 2008, $57 million for 2009, $57 million for 2010, and an aggregate of $36 million thereafter, for a total commitment of $332 million. Of this amount, $76 million represents the cost of financing. Obligations under non-cancelable operating lease agreements in effect at September 30, 2005, total $24 million for 2006, $19 million for 2007,

$13 million for 2008, $9 million for 2009, $6 million for 2010, and $10 million thereafter for a total commitment of $81 million.

Lease/Leaseback Transactions Obligations under the lease/leaseback transactions in effect at September 30, 2005, total $85 million annu-ally for 2006 and 2007, $89 million for 2008, $85 million for 2009, $89 million for 2010, and an aggregate of $1.2 bil-lion thereafter, for a total commitment of $1.6 billion. Of this amount, $499 million represents the cost of financing (see notes 10 and 12).

I Power Purchase Obligations TVA has contracted with various independent power producers and power distributors for additional capacity to be made available to TVA. In.total,'these agreements constitute 2,578 megawatts of winter net dependable capac-ity. Approximately 80 percent of this total capacity is made available to'TVA under power purchase agreements that will expire within two years. The total financial obligation of these contracts is approximately $4.2 billion. Additionally, TVA has contracted with various other counterparties for the purchase of power from renewable sources (wind and Page 39

methane gas technologies).. These arrangements constitute about 33 megawatts of capacity.

Of this total, 27 megawatts are attributable to wind generation, and due to the nature of this energy source, they are not included in the determination of net winter dependable capacity. TVA's financial obligation related to these renewable resource power purchase agreements is $100 million. In total, TVA's financial obligation for all of its power purchase agreements is approximately $4.3 billion. Costs under these contracts are included in the Statements of Income for the years ended September 30, 2005, 2004, and 2003 as FuEL AND PURCHASED POWER expense and are expensed as incurred in accordance with the normal purchases and sales exemption described in SFAS No. 133, 'Accounting for Derivative Instruments and Hedging Activities,"as amended.

Under the Public Utility Regulatory Policies Act of 1978, TVA is obligated to purchase power from qualifying facilities." There are currently two independent power producers, with a combined capacity of 1,600 megawatts, that qualify under this program. However, the potential for TVA being required to take substantial amounts of power from these facilities under these circumstances has been mitigated by certain contractual arrangements entered into in 2005. Costs associated with these purchases are based on rates as specified in 'Attachment A" of the Dispersed Power Production Guidelines for TVA and the Distributors of TVA Power as approved annually by the Board.

TVA'also has an agreenent with the Southeastern P Administration to receive 405 megawatts of net dependable capacity from the Cumberland River Basin Projects for use in the TVA system. TVA receives a yearly ener-gy allocation of 607,500 megawatt hours which is based on the reserved capacity. Once this allocation is exceeded, TVA is assessed an additional energy charge for the excess generation received based on rates as specified in the Federal Register.

Other Obligations Other obligations of $691 million consist of contracts negotiated as of September 30, 2005, for goods and services primarily related to capital projects as well as other major recurring operating costs. TVA has approximately

$587 million in long-term construction commitments consisting primarily of the construction of generating assets (including Browns Ferry Unit 1), and emission control equipment.. In addition to construction commitments, TVA is com-mitted under various other contracts for recurring goods and services of $104 million with terms extending into 2010.

Fuel Purchase Obligations TVA has approximately;$1.2 billion in long-term fuel purchase commitments'ranging in terms of 'up to four years for the purchase and transportation of coal and approximately $1.1 billion of long-term commitments ranging in terms of up to ten years for the purchase of enriched uranium and fabrication of nuclear fuel assemblies.

Pension Contribution TVA's Board approved a pension contribution of $75 million for,2006.

Decommissioning Fund Contribution'*

.' i' TVA's Board approved a decommissioning fund contribution of $25 million for 2006.

Results of Operations Operational Results

.. Generation. TVA prepares a power supply. plan;.semi-annually, to help generation assets meet projected loads and to -enhance system reliability. This plan considers historical seasonal weather and water availability infor-mation, projected load growth, expected generation asset performance, and market price forecasts. This plan is also a key element in the planning of generation asset outages. The plan is updated monthly to reflect factors such as near term weather forecasts, actual runoff which affects availability of water for hydroelectric power, and generation asset availability, including outage schedule revisions.

During 2005, there was an increase in hydro generation due to the availability of water in storage even though rainfall and runoff were below normal. The dry weather in the later part of 2005 may impact 2006 generation unless the situation changes. '

1

'Page 40

Asset Availability. During 2005, asset availability exceeded plan due to better performance by TVA's fossil and nuclear generating units. Fossil's favorable performance was primarily due to favorable equivalent forced outage rates ('EFOR"). The EFOR calculation compares the number of hours a facility was out of service during the year, including outage hours incurred because of a forced curtailment, such as an equipment malfunction, to the total num-ber of hours in that same period. Fossil's increased availability was due to the improved material condition of the plants, increased focus on human performance issues and stricter adherence to operating procedures. Favorable nuclear performance was primarily due to better refueling outage execution. While some fossil, hydro and nuclear gen-erating units did not meet targets, the overall system performance was not adversely affected: See 'Business Strategy" -TVA's Six Strategic Objectives" below.

Transmission. In 2005, TVA's Transmission/Power Supply organization.set another record in reducing the duration of customer outages. Load-not-served decreased from 9.45 system minutes in 1999 to 3.34 system minutes in 2005 (a 65 percent improvement). A key indicator of reliability, that is, measuring the average number of interrup-tions per year at customer connection points, has declined from 1.40 in 2000 to 0.785 in 2005 -

a 44 percent improve-ment. Additionally, power was delivered with 99.999 percent reliability for the sixth straight year. Also during the year, TVA built 92 miles of new transmission lines. Continuing its response to the investigation which found that improper right-of-way maintenance was a major cause of the 2003 midwest/northwest blackout, TVA remained focused on removing vegetation in its own service area that could come into contact with power lines. TVA removed over 760,000 trees during 2005 that could have jeopardized reliability.

! Id 0

.v, of; -; ;

-f..r.

Hurricane Katrina entered the TVA service area in August 2005 near Meridian, MississiDpi, and passed through to the north and east fairly quickly, causing a relatively small amount of transmission damage compared to the systems to TVA's south. Transmission service to all of TVA's customers was restored by the following day.

In addition to providing reliable electric service to its own seven-state region, TVA, under separate agree-ments, provides system reliability coordinator services for several neighboring systems, including Associated Electric Cooperative, Inc., Big Rivers Electric Corporation, Eas' Kentucky Power Cooperative, and Electric Erergy.Inc. These agreements enhance compliance with the North American Electric Reliability Council ("NERC") reliability standards for the entire service territory. On October 7, 2005, LG8.E Energy asked the Federal Energy Regulatory Commission

("FERC") for permission to pull its two Kentucky utilities from the Midwest Independent Transmission System ('M!SO")

and hire TVA to serve as their reliability coordinator. LG&E Energy filed the request on behalf of its Kentucky Utilities and Louisville Gas & Electric subsidiaries. A Kentucky Public Service Commission hearing on the costs of the MISO concluded recently and a ruling is pending. Under-the proposal filed with FERC, the LG&E energy subsidiaries would continue to control transmission under normal circumstances, but during times of constraints, TVA would direct them.

TVA has load served off the Kentucky Utilities transmission system in several remote areas. Typically serv-ing that load has cost TVA approximately $50,000 to $60,000 per month. With the loads located in MISO, TVA may now incur congestion charges that may result in a significant increase in costs for a service that is not any better than the service TVA obtained before Kentucky Utilities joined MISO.

Changes in the fundamental business model for bulk transmission system operations, including the emer-gence of large markets in many areas of the eastern United States, have created new reliability risks and exposure for the TVA system,-as well as other systems. This has manifested itself in actual blackouts (August 14, 2003, in the mid-west and northeast United States) and in more frequent interconnection excursions, such as frequency deviations.",

To further grid reliability, TVA works closely with independent generators to enhance compatibility with the transmission system, develop and implement consistent operating procedures, and minimize practices that can result in interrupted service.

Rates and Customers. On July 22, 2005, the Board approved a 7.52 percent increase in firm wholesale elec-tric rates effective on October 1, 2005. The rate increase is expected to provide additional revenues of approximate-ly $524 million in fiscal year 2006. TVA's relative competitive position is not expected to change as a result of the rate increase. In the coming year, TVA will continue to monitor the cost of fuel and purchased power. Based upon a cur-rent forecast, these costs could increase significantly. Current projections have these costs increasing significantly above the amount upon which the October 1, 2005, rate increase Was based. This will place upward Fressure on rates and could possibly result in further rate actions in the near term.

Rates for customers in the TVA service territory continue to compare favorably to regional and national aver-ages, despite recent TVA-rate increases. -TVA estimates that the average retail rate for electricity consumers in the Page 41

TVA service area for the 12 months ending June 30, 2005, was 5.75 cents per kilowatt-hour, comprised of 6.99 cents, 6.85 cents, and 3.55 cents per kilowatt-hour for residential, commercial, and industrial customers, respectively.

According to information filed with the Energy Information Administration ("EIA") for the 12 months ending June 30, 2005, the average rate in areas served by 14 neighboring utilities for this same period was estimated to be 6.14 cents per kilowatt-hour, which includes 7.45 cents, 6.47 cents, and 4.45 cents per kilowatt-hour for residential, commercial, and industrial customers, respectively. The average rate for a sample of 328 companies, statistically chosen by EIA, that sell power in the U.S., was 7.79 cents for this same time period, comprised of 9.16 cents, 8.34 cents, and 5.32 cents per kilowatt-hour for residential, commercial, and industrial customers, respectively. In total, the average retail rate in the TVA service territory was six and 26 percent lower than these regional and national averages, respectively.

In addition, TVAs system has been designed and built over the years to optimize serving major power 'load centers" in the Valley, such as major cities. This means that power is generated close to where it is consumed, which increases reliability and reduces cost. TVAs power system operates across two time zones and possesses geograph-ic weather diversity, which helps diversify peak power demands, and because of the region's natural seasonality, the TVA system peaks in both the summer and winter.

- Financial Results:

The following table compares operating results and selected statistics for the years ended September 30:

Summary Statements of Income 2005 2004 2003 Operating revenues Operating expenses Operating income Other income, net Unrealized gains (losses) on derivative contracts, net Interest expense, net Income before cumulative effects of accounting changes Cumulative effects of accounting changes, net Net income 7,7

' 1,2 (1.2

'94 7,533 6,953

03)

(5.873)

(5,398) 291 1,660 1,555 33 37 29 3

(7)

(7)'.

42)

(1.304)

(1.350)

85.

386

'227 5

38 4217 85 386 444 2005 Sales (millions of kWh)

Heating degree days (normal 3,459)

Cooling degree days (normal 1,777) 171,498 2,973 -

2,022 2004 i~

I 165,858 3,266 1,702

,I I 2003 161,534 3,505 1,602 2005 Compared to 2004 Net income for 2005 was $85 million compared with net income of $386 million for 2004. Significant items contributing to the $301 million decrease in net income include a $630 million increase in operating expenses, par-tially offset by an increase in operating revenues of $261 million, lower net interest expense of $62 million, and a $3 million unrealized gain on derivative contracts in 2005 as compared to a $7 million unrealized loss on derivative con-tracts in 2004.

Operating Revenues. A detailed table of electricity sales and operating revenue is as follows:

Sales of Electricity.

Operating Revenues Years ended September 30 Years ended September 30 III (millions of kWh)

(millions of dollars)

Sales of electricity and operating revenue Municipalities and cooperatives Industries directly served Federal agencies and other utilities Other revenue Total sales of electricity and operating revenue Percent Percent 2005 2004 Change 2005 2004 Change 136,640 133,161 2.6% -

$ 6,561 30,872 29,344 5.2%

962

+

3,986 3,353 18.9%

181 a

90

- $ 6,457 842 140 94 1.6%

14.3%

29.3%

(4.3%:

171,498 165,858 3.4%

$ 7,794

$ 7,533 3.5%

Page 42

Significant items contributing to the $261 million increase in operating revenues include:

A $104 million increase in revenues from municipalities and cooperatives primarily due to increases in volume. Sales to municipalities and cooperatives are more sensitive to weather than the other cate-gories of sales since they service the more volatile residential markets. During 2005, iere were 320, or 19 percent, more cooling degree days offset by 293, or nine percent, less heating degree days.

A $120 million increase in revenues from industries directly served primarily due to increased rates and volume. Also, operating revenues and sales of electricity to one of TVA's largest consumers of industri-al power increased 35 percent and 19 percent, respectively, over the prior year.

A $36 million increase in revenues from off-system sales (included in FEDERAL AGENCIES AND OTHER) due to increased generation available for sale as a result of favorable market conditions.,

Favorable market conditions relate to electricity demands both inside and outside the TVAservice area in addition to advantageous market rates.

Significant items contributing to the 5,640 million kilowatt-hour increase in electricity sales include:

I aj o

d{

,j.-,'.

.i

' I;,1 A 3,479 million kilowatt-hour, or three percent, increase in sales to municipalities and cooperatives primarily due to increased volume as a result of warmer-summerlweather.

A 1,528 million kilowatt-hour, or five percent, increase in sales to industries directly served due in large part to increases in volume due to economic growth..

A 419 million kilowatt-hour, or 22 percent, increase in off-system sales (included in FEDERAL AGENCIES AND OTHER) due to increased generation available for sale and favorable market conditions.

.4,000 - *,,.o I

I Weather Degree Days 3,500 I,

i-- -,---

3.000 co 2,500

-.T D

2,000 1,000 500 0

2003.

, 2004 2005.,

Heating degree days (normal)

Cooling degree days (nornal)

Heating degree days (actual)

Cooling degree days (actual)

A Weather Degree Day" is a unit of measure used to express the extent to which temperatures vary from a specific reference temperature during a given period. TVA uses 65 degrees Fahrenheit as the standard reference for both heating and cooling degree days.

'Page 43

Operating Expenses. A detailed table of operating expenses is as follows:

Years ended September 30 Percent 2005 2004 Change Operating expenses Fuel and purchased power i

$ 2,601

$ -2,081 25.0%

Operating and maintenance 2,359 2,319 1.7%

Depreciation and accretion

,1 1,54 1,115 3.5%/

Tax-equivalents 365 338 8.0%

Loss on asset impairment/project cancellation 24 20 20.0%

Total operating expenses i

503~

$ 5.873 10.7%

Significant items contributing to the $630 million increase in total operating expenses for 2005 include:

A $269 million increase in fuel expense attributable primarily to higher coal prices and increased generation at coal fired plants; A $251 million increase in purchased power expense which is attributable to' higher market prices f6r off-sys-tem power; I

A $77 million increase in pension and post retirement expense due primarily to increased interest cost cou-pled with increased amortization of actuarial loss (see note 5);

-1 A $29 millionincrease in depreciation expense attributable to capital projects placed in service; An $9 million increase in amortization expense related to the amortization of the capital lease recognized for the blended low enriched uranium program (see note 1 -

Blended Low Enriched Uranium Program); and A $24 million impairment loss related to the $16 million write-down of certain assets related to a new technol-ogy that had not been proven effective and a $8 million loss equal to the difference in the book value and mar-ket price of the East Tower of the Knoxville Office Complex (see note 1 -Impairment of Assets and note 6).

These items were partially offset by a $33 million reduction in severance expense due to recognition of ter-mination benefit costs in the prior period.

Other Income. TVA had net other income of $33 million in 2005 compared with net other income of $37 mil-lion in 2004. The decrease in' net other income relates to a decrease in non-electric business activity.

Unrealized Gain on Derivative Contracts, Net. Significant items contributing to the $3 million unrealized gain on derivative contracts include a $116 million unrealized net gain related to the mark-to-market valuation adjustment of an embedded call option contract.

This items were partially offset by:

A $17 million unrealized net loss related to the mark-to-market valuation adjustment of an interest rate swap contract; i

A $6 million unrealized net loss related to the mark-to-market valuation of S02 emissions allowance call options; and A $90 million unrealized net loss related to the mark-to'-market valuation of three swaption contracts.

Interest Expense. A detailed table of interest expense, outstanding debt and interest rates is as follows:

5 Page 44

Years ended September 30 2005 Interest expense 2

I I 4

I Interest on debt 1,337 Amortization of debt discount, issue, and reacquisition costs, net 21 Allowance for funds used during construction (116)

Net interest expense 1,242

... I 2004 -

1,379

. 24 (91 )

1,304 Percent Change 1:3.0%)

(12.5%)

17.2%

_ 4.8%)

Outstanding bonds and notes 23,8

___23_25

_J --0.7 %

II f,

Years ended September 30 (percent) 2005 2004 Percent Change Interest rates (average)

Long-term Short-term Blended 6.25 2.72 5.99 6.36 (1.7%)

1.15 136.5%

6.16 (2.8%)

Significant items contributing to the $62 million decrease in net interest expense include:

A reduction of approximately $1,089 million in the average balance of long-term debt outstanding; and A $17 million increase in AFUDC due to a higher level of construction work-in-progress in 2305. -

These items were partially offset by an increase of approximately $822 million in the average balance of short-term debt outstanding coupled with an increase in average short-term interest rates from 1.15 percent to 2.72 percent.

2004 Compared to 2003 Net income for 2004 was $386 million, compared with net income of $444 million for 2003. The decrease was primarily due to two non-cash accounting changes implemented in the first quarter of 2003. These accounting changes included a $412 million gain related to a change in accounting for unbilled revenue and a $195 million charge related to a change in accounting for asset retirement obligations. Income before cumulative effects of accounting changes for 2004 increased $159 million compared to 2003. This increase was primarily due to the rate adjustment implemented in October of 2003.

Operating Revenues. A detailed table of electricity sales and operating revenue is as follows:

I Sales of Electricity Years ended September 30 (millions of kWh)

Operating Revenue Years ended September 30 (millions of dollars)

Percent

-. 2004 2003 Change Percent 2004 2003 Change Sales of electricity and operating revenue Municipalities and cooperatives Industries directly served Federal agencies and other Other revenue Total sales of electricity and operating revenue 133,161

• 29,344 3,353 130,769 27,756 3,009 1.8%

15.7%

11.4%

6,457 842 140 94 5,974 781 120

_ 78 8.1%

7.8%

16.7%

20.5%

~1685.

161534 2.7%

7,533 6,953-8.3%

I Significant items contributing to the $580 million, or eight percent, increase in revenue for 2(004 compared to 2003 include:

• - An increase in sales to municipalities and cooperatives of $483 million related to a higher average rate due to the rate adjustment implemented in October of 2003, partially offset by $42 million in prepaid revenue dis-counts; An increase of $61 million in'revenue from industries directly served due t6 a six percent increase in sales Page 45

volume to directly served industrial customers, partially offset by decreased rates to large manufacturing cus-tomers due to the October 2003 rate action; and An increase in other revenue of $16 million primarily attributable to increased external business activity.

The TVA service territory experienced six percent more cooling degree days' and s6ven percent fewer heat-ing degree days in 2004 compared to 2003. Although the net effect should have been minimal to sales to TVA's cus-tomers, total kilowatt-hour sales to customers increased four billion kilowatt-hours, or three percent, from 162 billion in 2003 to 166 billion in 2004. This increase can be attributed to population growth, increased demand in the industrial sector, and increased demand for electricity across the Valley.

Operating Expenses. A detailed table of operating expenses is as follows:

,.. -Years ended September 30 2004 2003 Percent Change Operating expenses Fuel and purchased power 2,081 1,957 6.3%

Operating and maintenance 2,319 2,039 13.7%

Depreciation and accretion 1,115 1,073 3.9%

Tax-equivalents 338 329 2.7%

Loss on asset impairment/project cancellation 20 Total operating expenses 5,873 5,398 8.8%

Significant items contributing to the increase of $475 million, or approximately nine percent,'in 'operating expenses in 2004 over 2003 include:

An $81 million, or five percent, increase in fuel costs driven by reduced hydro generation and an increase in the price of coal and natural gas; A 2.7 percent increase in electricity sales in 2004 as compared to 2003; An increase of $43 million in purchased power costs primarily due to higher off-system prices partially offset by lower volume;

• • A $280 million increase in OPERATING AND MAINTENANCE (MO&M") primarily due to pension financing expense which changed from a $49 million credit in 2003 to a $66 million charge in 2004., This $115 million change is due primarily to the increased amortization of certain unrecognized pension costs, in the form of actuarial losses, which resulted from the end-of-year valuation of TVA's pension plan. The additional amortizable actu-arial losses were a result of TVA's lowering the plan valuation discount rate from 7.05 percent to 6.00 percent; A $68 million increase in scheduled outage costs attributable to increased amortization of refueling outages at nuclear plants and increases in outages at fossil plants to install emission control equipment; A recognition of severance expense of $36 million in 2004 compared to no severance expense in 2003 (see

' note 1-Reduction in Workforce) due to attrition of 690 employees to voluntary and involuntary reductions in force; A $22 million increase in pension service costs due to decreasing the discount rate used to calculate the PBO;

• and A $42 million increase in depreciation and accretion due primarily to capital projects placed in service during the year.

i In December 2003, TVA was notified that Regenesys Technologies Limited ("RTL") would not proceed with manufacturing of the fuel cells to be installed in the partially completed Regenesys energy storage plant in Columbus, Mississippi. TVA had invested approximately $35 million in the Regenesys project. RTL reimbursed TVA for early ter-mination of the contract in the amount of $15 million, which reduced the net loss to $20 million on the cancellation of the Regenesys project (see note 1 -

Project Cancellation).

Unrealized Loss on Derivative'Contracts, Net. Unrealized' losses 'on derivative contracts were $7 million in 2004 and 2003 due primarily to losses on mark-to-market adjustments on swaption and swap contracts (see note 8).

Other Income. TVA had net other income of $37 million in 2004 compared with net other income of $29 mil-lion in 2003. The increase in net other income relates to an increase in non-electric business activity.

Interest Expense. A detailed table of interest expense, outstanding debt and interest rates is as follows:

Page 46

Years ended September 30 2004 2003 Percent Change Interest expense Interest on debt 1,379 1,396 (1.2%)

Amortization of debt discount, issue, and reacquisition costs, net 24 28 (14.3%)

Allowance for funds used during construction (99)

(74)

(33.8%)

Net interest expense 1,304 1,350 (3.4%)

Outstanding bonds and notes

$ 23,250

$ 24,875 Years ended September 30 (percent) 2004 2003 Percent Change Interest rates (average)

Long-term 6.36 6.22 2.3%

Short-term 1.15 1.28 (1(1.2%)

Blended 6.16 5.66 8.8%

Net interest expense was $1,304 million for the year ended September 30, 2004, compared to $1,350 million for the year ended September 30, 2003. This decrease resulted from:

A lower level of total outstanding debt during 2004 as compared to 2003; and An increase in allowance for funds used during construction ("AFUDC") due to increased construction work in progress.

Total outstanding indebtedness, excluding discounts and premiums, as of September 30, 2004, was $23.3 billion with a blended average interest rate (of long-term and short-term debt) of 6.16 percent; as of September 30, 2003, total debt outstanding, excluding discounts and premiums, was $24.9 billion with a blended average interest rate of 5.66 percent. The average long-term and short-term interest rates for the year ended September 30, 2004, were 6.36 percent and 1.15 percent, respectively, as compared with 6.22 percent and 1.28 percent for 2003. Net interest expense is one of TVA's largest single expenses. Interest expense as a percentage of revenue declined from 34 cents of every revenue dollar in 1997 to 17 cents in 2004.

Critical Accounting Policies and Estimates The preparation of financial statements requires TVA to estimate the effects of various matte s that are inher-ently uncertain as of the date of the financial statements. Although the statements are prepared in conformity with gen-erally accepted accounting principles, management Is. required to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the amounts of rev-enues and expenses reported during the reporting period. Each of these estimates varies in regards to the level of judgment involved and its potential impact on TVA's financial results. Estimates are deemed critical either when a dif-ferent estimate could have reasonably been used, or where changes in the estimate are reasonably likely to occur from period to period, and such use or change would materially impact TVA's financial condition, changes in financial posi-tion, or results of operations. TVA's critical accounting policies are' also discussed in note 1.

Regulatory Assets and Liabilities Although TVA's power rates are not subject to regulation through a public service commiss on or other sim-ilar agency, its Board of Directors is authorized by the TVA Act to maintain and operate the property of TVA and to set binding rates for power sold to its customers in accordance with the provisions' of the TVA Act. The rate-setting authority vested in the TVA Board by the TVAAct meets the "self-regulated' provisions of SFAS No. 71, 'Accounting for the Effects of Certain Types of Regulation," and TVA meets the remaining criteria of SFAS No. 71. Accordingly, TVA records certain assets and liabilities that result from the regulated ratemaking process that would not be record-ed under generally accepted accounting principles ("GAAP") for non-regulated entities. Regulatory assets general-ly represent incurred costs that have been deferred because such costs are probable of future recovery in customer rates. Regulatory liabilities generally represent obligations to make refunds to customers for previous collections for costs that are not likely to be incurred. Management assesses whether the regulatory assets are probable of Page 47

future recovery by considering factors such as applicable regulatory changes, potential legislation, and changes in technology. Based on this assessment, management believes the existing regulatory assets are probable of recov-ery. This determination reflects the current'r6gulatory and political environment and is subject to change in the future. If future recovery of regulatory assets ceases to be probable, TVA could be required to write-off these costs under the provisions of SFAS No. 101, "Regulated Enterprises-Accounting for the Discontinuation of Application of FASB Statement No. 71." Any asset write-offs would be required to be recognized in earnings in the period in which regulatory accounting under SFAS No. 71 ceased to apply.

Regulatory assets capitalized under the provisions of SFAS No. 71 are included in DEFERRED NUCLEAR GENERATING UNITS and OTHER REGuLATORY ASSETS on the September 30, 2005 and 2004 Balance Sheets. Components of OTHER REGULATORY ASSETS include certain charges related to the closure and removal from service of nuclear gen-erating units, unrealized losses related to mark-to-market valuations of a purchased power contract, deferred capital lease asset costs, deferred outage costs, reacquisition costs, and an adjustment to accrue the minimum pension lia-bility. See note 1 -

Cost-Based Regulation, note 2, and note 5.

The year-end balances of TVA's regulatory assets and liabilities are as follows:

At September 30 2005 2004 Regulatory Assets:

Adjustment to accrue minimum pension liability 1,158 1,243 Nuclear decommissioning costs...

716 755 Reacquisition costs 264 277 Deferred outage costs 103 86 Capital leases 84 90 Unrealized losses on purchase power contract 42 59 Subtotal 2,367 -2,510-Deferred nuclear generating units 3,912

- 3,909 I

v 1

Total 6,279 6,419 Regulatory Liabilities:

Unrealized gain on coal purchase contracts

^

i 791 478 Capital lease liability 106 122 Total

.897 i-,

600, -

Reacquisition expenses, call premiums, and other related costs, such as unamortized debt issue costs asso-ciated with redeemed bond issues, are deferred under the provisions -of the FERC Uniform System of Accounts Prescribed for Public Utilities and Licensees Subject to the Provisions~of the Federal Power Act. These costs are deferred and amortized (accreted) on a pooled straight-line basis over the weighted average life of TVA's debt portfo-lio. (Even though TVA is not a public utility subject generally to FERC jurisdiction, the TVA Act requires TVA to keep accounts in accordance with the requirements established by FERC.)

r I

Deferred capital lease asset costs,-,representing the difference.between the FERC Uniform System of Accounts model balances and the SFAS No. 13, 'Accounting for Leases," model balances are also included in OTHER REGULATORY ASSETS.

Under FERC accounting model, TVA recognized the initial capital lease asset and liability at inception of the lease in accordance with SFAS No. 13; however, the annual expense is equal to the annual lease pay-ments, which differs from SFAS No. 13 accounting treatment.. This practice results in TVA's capital lease asset bal-ances being higher than they otherwise would have been under the SFAS No. 13 model, with the difference represent-ing a regulatory asset related to each capital lease. These costs are being amortized over the respective lease terms as lease payments are made.

l Nuclear decommissioning costs include certain charges related to the future closure and decommissioning of TVA's nuclear generating units under NRC requirements. -These future costs will be funded through a combination of investment funds already set aside by TVA, future earnings on those investment funds, and if necessary under TVA's funding requirements, additional TVA cash contributions to the investment funds. See note 1 -

Investment Funds and note 4.

Page 48

Due to negative pension plan asset returns from 2002 and 2001, TVA's accumulated benefit obligation at September 30, 2005 and 2004 exceeded plan assets. As a result, TVA was required to recognize an additional mini-mum pension liability as prescribed by SFAS No.. 87, 'Employers' Accounting for Pensions.' Thesa future pension costs will be funded through a combination of the pension investment funds already set aside by TVA, future earnings on those pension investment funds, and, if necessary under TVA's funding requirements, future TVA cash contributions to the pension plan.

Unrealized loss on a purchase power contract represents the estimated unrealized loss related to the mark-to-market valuation of the contract. Under the accounting rules-contained in SFAS No. 133, 'Accounting for Derivative Instruments and Hedging Activities," as amended, this contract qualifies as a derivative contract but does not qualify for cash flow hedge accounting treatment. As a result, TVA recognizes the changes in the market value of this deriv-ative contract as a regulatory asset.' This treatment reflects TA's ability and intent to recover the cost of this commod-ity contract on a settlement basis for ratemaking purposes. TVA has historically recognized the.actual cost of'pur-chased power received under this contract in purchased power expense at the time of settlement. The contract expires in 2007. See note 8.

TVA's investment in the fuel used in the Sequoyah, Watts Bar, and Browns Ferry nuclear uni's is being amor-tized and accounted for as a component of fuel expense (see note 2). Nuclear refueling outage and maintenance costs are deferred and amortized on a straight-line basis over the estimated period until the next refueling outage. 'The amounts of deferred outage costs for the years ended September 30, 2005, 2004, and 2003 were $103 million, $86 million, and $100 million, respectively.

At September 30, 2005, construction of the Bellefonte Nuclear Plant ("Bellefonte") remains in a deferred sta-tus (see note 2). In July 2005, the Board approved th a amortization of, and inclusion into rates, TVW's investment in the deferred nuclear generating units at Bellefonte over a ten-year period beginning in 2006.

Regulatory liabilities accounted for under the provisions of SFAS No.-71 consist of mark-to-market valuation gains on certain derivative contracts and capital leases.

Unrealized gain on coal purchase contracts represents the estimated unrealized gains related to the mark-to-market valuation of coal purchase contracts. Under the accounting rules contained in SFAS No. 133, as amended, these contracts qualify as derivative contracts but do not qualify for cash flow hedge accounting treatment. As a result, TVA recognizes the changes in the market value of thEse derivative contracts as a regulatory liability. This treatment reflects TVA's ability and intent to recover the cost of these commodity contracts on a settlement basis for ratemaking purposes. TVA has historically recognized the actual cost of fuel received under these contracts in fuel expense at the time the fuel is used to generate electricity. These contracts expire at various times through 2017. See note 8..

-As a result of.a capital lease paymentstream requiring larger cash payments during the latter years of the lease term than during the early years of the lease term, TVA levelized the annual lease expense recognition related to this lease in order to promote the fair and equitable cost recovery from ratepayers. These costs are being amor-tized over the lease term.

Long-LivedAssets,.

^

.v a i ;:

,. l J~

~

~ ~~~~

i 1

TVA capitalizes long-lived assets such as property, plant, and equipment at historical cost which includes direct and indirect-costs and an allowance for funds used during construction. TVA recovers the costs of these long-lived assets through depreciation of the physical assets as they are consumed in the process of providing products or services. Depreciation is generally computed on a straight-line basis over the estimated productive lives of the vari-ous classes of assets. When TVA retires its regulated long-lived assets, it charges the original asset cost plus removal costs, less salvage value, to accumulated depreciation in accordance with utility industry practice.

-Long-Lived Asset Impairments

'-I'-' '

TVA evaluates the carrying value of long-lived assets when circumstances indicate the carrying value of those assets may not be recoverable., Under the provisions of SFAS No. 144, 'Accounting for the Impairment or Disposal of Long-Lived Assets," an asset impairment-exists for a long-lived asset to be held and used when the.carrying value exceeds the sum of estimates of the undiscounted cash flows expected to result from the use and eventual disposi-tion of the asset. -If the asset is impaired, the asset's carrying value is adjusted downward to its estimated fair value with a corresponding impairment loss recognized in eamnings.

Page 49

... TVA is marketing the East Tower of the Knoxville Office Complex ("KOC") to local, national and international real estate investors. TVA intends to complete a sale or lease of the facility as soon as practical, but it is not probable the sale or lease will be completed in the next year. In September 2005, based on TVA's desire, intent, and plans to sell or lease the East Tower of the KOC, TVA recognized an impairment loss of $8 million on the asset equal to the dif-ference between the book value of $20 million and current market value of $12 million. The loss has been charged to the Income Statement for the year ended September 30, 2005.

If TVA ceased to qualify as a regulated entity as a result of future legislation, competitive pressures, or other factors, TVA would be required to evaluate all of its long-lived assets, including generating plants and transmission facilities, to determine whether they were impaired under the provisions of SFAS No. 144. This evaluation could result in asset impairment losses due to a lower expected level of cash flows associated with certain assets in a competitive environment. Other assets, however, might produce future cash flows in a competitive environment which are greater than the current carrying values of those assets. In'such circumstances the asset carrying values would remain unchanged instead of being adjusted upward to reflect the increase in expected cash flows.

Revenue Recognition

,~~~~

t

,!,i-

': i y1 Revenues.from power sales are recorded as power is delivered to customers. TVA accrues estimated unbilled revenues for power sales provided to customers for the period of time from the end of the billing cycle to the end of the month. The methodology for estimating unbilled revenue from electricity sales uses generation for the cur-rent billing period. (See note 1 -

Accounting Changes.)

Off-system sales are presented in the Statements of Income as a 'component of SALES OF ELEcTRIcITY -

FEDERAL AGENCIES AND OTHER. Off-system sales are sales of excess power after meeting TVA native load and direct served requirements.

-'Normal Purchases and Normal Sales Special Exemption A unique characteristic of the electric utility industry is that electricity cannot readily be stored in significant quantities and, as a result,'some contracts to buy'and sell electricity afford the buyer some flexibility in determining when to take electricity, and in what quantity, to meet fluctuating demands. These contracts would normally qualify as derivatives, but because electricity cannot be readily stored and an entity engaged in selling electricity is obligated to maintain sufficient capacity to meet the electricity-needs of its customers, an option contract for the purchase of elec5-tricity qualifies for the normal purchases and sales exemption described in paragraph ten of SFAS No. 133, as amend-ed by SFAS No. 149, 'Amendment of Statement 133 on Derivative Instruments and Hedging Activities, "and Derivative Implementation Group ("DIG") Issue No. C15, "Scope Exceptions: Normal Purchases and Normal Sales Exception for Option-Type Contracts in Electricity," also as amended by SFAS No. 149. Contracts for the sale or purchase of power in future periods that meet the criteria of DIG Issue C15 have been categorized as 'normal purchase, normal sales" contracts and are exempted from recognition in the financial statements until power is delivered to customers.

Asset Retirement Obligations In accordance with the provisions of SFAS No. 143, Accounting for Asset Retirement Obligations,"TVA rec-ognizes legal obligations associated with the future retirement of certain tangible long-lived assets (see note 4). TVA records estimates of such disposal costs at the time the legal obligation arises or costs are actually incurred. Based on new engineering studies performed annually In accordance with NRC requirements, revisions to the amount and timing of certain cash flow estimates of nuclear asset retirement obligations may be made.:

NuclearDecommissioning At September 30, 2005, the present value of the estimated future nuclear decommissioning cost of $1.6 bil-lion was included in ASSET RETIREMENT OBLIGATIONS, and the unamortized regulatory asset of $716 million was includ-ed in OTHER REGULATORY ASSETS.

Under the NRC's regulations, the present value of the estimated future nuclear decommissioning cost amounts to $1.1 billion.- This decommissioning cost estimate is based on NRC's requirements for removing a plant from service, releasing the property for unrestricted use, and 'terminating the operating license.

The actual decommissioning costs may vary from the derived estimates because of changes in current assumptions, such as the assumed dates of decommissioning, changes in regulatory requirements, changes in technology, and changes in the cost of labor, materials, and equipment. Utilities that own and operate nuclear plants are required to use different procedures in estimating nuclear decommissioning costs under SFAS No. 143 than those that are used Page 50

in estimating nuclear decommissioning costs that are reported to the NRC. Accordingly, the two sets of procedures produce different estimates for the costs of decommissioning.

TVA maintains a nuclear decommissioning trust fund to provide money for the ultimate decommissioning of its nuclear power plants. The fund is invested in securities generally designed to achieve a return in line with overall equity market performance. The nature of these investments comprises physical securities and certain derivative instruments. The derivative instruments that are used include options, futures, forwards, and swaps. These instruments are used across various asset classes to achieve a cesired investment structure. The derivative instruments in the fund are comprised of 919 contracts. These contracts include futures, options on futures, and swap agreements.

Investments held in the decommissioning fund are staved at fair value, which is determined by the Trustee of the fund.

Futures and options on futures positions are marked to market on a daily basis. The swap agreements are marked to market on a monthly basis. The assets of the fund as of September 30, 2005, totaled $835 million including total gains of $115 million of which $48 million was unrealized. The assets of the fund as of September 30, 2004, totaled $720 million including total gains of $88 million of which $29 million was unrealized. The assets of the fund as of September 30, 2003, totaled $632 million including total gains of $133 million of which $132 million was unrealized. The balance as of September 30, 2005 is less than the present value of the estimated future nuclear decommissioning costs. In October 2003, TVA provided a schedule of annual funding targets to the NRC and stated its commitment to make con-tributions to the decommissioning trust fund or provide other methods of decommissioning funding assurance neces-sary to match projected decommissioning fund balances. TVA is monitoring the monetary value of its nuclear decom-missioning trust fund in light of recent market performance and believes that, over the long term and before cessation of nuclear plant operations and commencement of decommissioning activities, adequate funds from investments will be available to support decommissioning. TVA's nuclear power units are currently authorized to operate until 2013-2035, depending on the unit, with an additional 20 years of operation for each unit in the event the NRC approves the renewal of each unit's license (see OProperties"-.Nulear Power Program'-

'Operating License E&tensions" in Part The following key assumptions can have a significant effect on estimates related to the nuclear decommis-sioning costs:

Timing - In projecting decommissioning costs, two assumptions must be made to estimate the timing of plant decommissioning. First, the date of the plant's retirement must be estimated. At a multiple unit site, the expi-ration of the unit with the operating license with the latest expiration date is typically used fcr this purpose, or an assumption could be made that the plant will be relicensed and operate for some time beyond the origi-nal license term. Second, an assumption must be made whether decommissioning will begin immediately upon plant retirement, or whether the plant will be held in "safestor" status for later decommissioning, as per-mitted by applicable regulations. While the impact of these assumptions cannot be determined with preci-sion, assuming either license extension or use of "safestor" status can significantly decrease the present value of these obligations.

Technology and Regulation - Because of the age of the nuclear plants in the United States, there is limited a experience with actual decommissioning of large nuclear facilities. Changes in technology and experience as well as changes in regulations regarding nuclear decommissioning could cause cost estimates to change significantly. The impact of these potential changes is not presently determinable. TVA's cost studies assume current technology and regulations.,

Discount Rate - TVA's decommissioning fund uses a blended rate of 5.65 percent to calculate the present

-value of the weighted estimated cash flows required to satisfy TVA's decommissioning obligation.

Investment Rate of Return - TVA assumes that its decommissioning fund will achieve a five percent real rate of return.

Cost Escalation Factors - TVA's decommissioning estimates include an assumption that decommissioning costs will escalate over present cost levels by four percent annually.

Actuarial Assumptions TVA utilizes professional actuaries to perform valuation services related to the areas of pension, postretire-ment, and postemployment benefits. Net periodic pension, postretirement, and postemployment benefit costs are determined using assumptions as of the beginning of each year. Funded status for each plan is determined using Page 51

assumptions as of the end of each year. The valuations performed at the end of 2005 were based on actuarial assumptions that were consistent for all of TVA's benefit plans (see note 11).

Pension and Other Postretirement Benefits. TVA sponsors defined benefit pension-plans which cover sub-stantially all employees; Additionally, TVA provides postretirement health care benefits for substantially all employees who reach retirement age while still working for TVA. TVA's reported costs of providing these benefits, as described in note 11 to the financial statements, are impacted by numerous factors including the provisions of the plans, chang-ing employee demographics, and various actuarial calculations, assumptions, and accounting mechanisms. Because of the complexity of these calculations, the long-term nature of these obligations, and the importance of the assump-tions utilized, the costs as reported represent critical accounting estimates for TVA and its stakeholders.

- Key actuarial assumptions utilized in determining these costs include:

.* Discount rates used in determining the future benefit obligations; Projected health care cost trend rates;'

Expected long-term rate of return on plan assets; and Rate of increase in future compensation levels.

-TVA reviews these assumptions on an annual basis and adjusts them as necessary. The falling interest rate

,environment and poor performance of the financial equity markets over the past several years have impacted TVA's funding and reported costs for these benefits. In addition, these trends have caused TVA to make a number of adjust-ments to its assumptions.

In selecting an assumed discount rate, TVA reviews market yields on high-quality corporate debt and long-term obligations of the U.S. Treasury. Based on recent market trends, TVA reduced its discount rate from 6.00 per-cent and 5.81 percent at the end of 2003 and 2004 respectively, to 5.375 percent at the end of 2005. TVA reviews actual recent cost trends and projected future trends in establishing health care cost trend rates. Based on this review process, TVA reset its health care cost trend rate assumption used in calculating the 2005 accumulated postretirement benefit obligation. The assumed health care cost trend rate has been reset to 9.0 percent at the end of 2005 and mir-

• rors the 9.0 percent trend rate'used during 2004. TVA has reset its health care cost trend rate at the end of each of the last four years. The health care cost trend rate of nine percent is assumed to gradually decrease each successive year until it reaches a five percent annual increase in health care costs in 2013 and beyond.

In determining its expected long-term rate of return -on pension plan assets,-TVA reviews past long-term per-formance, asset allocations, and long-term inflation assumptions. TVA targets an asset allocation for its pension plan assets of approximately 60 percent equity securities and 40 percent fixed income securities.- Pursuant to its allocation

.policy, the asset allocations are to be comprised of approximately 45 percent United State equities, of which five per-cent may be private equity or other similar investments, but not to include holding title to real property; 40 percent fixed income, of which ten percent may be high yield securities; and 15 percent non-United States equities. TVA's policy includes a permissible three percent deviation, plus or minus, from these target allocations. The TVA Retirement System Board (see note 11 Pension Plans and Other Retirement Benefits -paragraph one) can take action,: as appro-priate, to rebalance the system's assets consistent with the asset allocation policy.- TVA decreased its expected long-

• term rate of return on pension plan assets from 8.50 percent at the end of 2003 to 8.25 percent at the end of 2004 and will continue to use a similar asset return assumption for 2005. TVA utilized a rate of return of 8.00 percent during 2003 in the aftermath of the market declines of 2002 and 2001.

TVA does not presently set aside assets dedicated solely to fund its postretirement benefits. Instead, TVA pays the costs of its postretirement benefit plan through premiums collected from participating retirees and TVA con-tributions.-

I

-*(---,}

Page 52

The following chart reflects the sensitivity of pension cost to changes in certain actuarial assumptions:

t:

Actuarial Ass

• I.

.. I Change in

.i Impact on 2005

,umption Assumption Pension Cost sumption I

1 I

1 i

Impact on 2006 Projected Benefit Obligation (InrrPeaPs in millionsi Discount Rate' (0.25%)

12 224 2 Rate of Return on plan assets (0.25%)

14 NA The following chart reflects the sensitivity of postretirement benefit cost to changes in certain actuarial assumptions:

I ;

I.

I iI I

I I

Change in Actuarial Assumption -

Assumption

't.. I..

Impact on 2005 Postretirement Benefit Cost Impact on 2006 Projected Postretirernent Benefit Obligation I

(Increase in millions)

Discount Rate (0.25%)

15 Health care cost trend.

0.25%

2-16.

Each fluctuation above assumes that the other components of the calculation are held constant.

Accounting Mechanisms. In accordance with SFAS No. 87, Employers' Accounting for Pensions,"TVA uti lizes a number of accounting mechanisms that reduce the volatility of reported pension costs. Differences between actuarial assumptions and actual plan results are deferred and are amortized into cost only when the accumulated dif-ferences exceed ten percent of the greater of the projected benefit obligation or the market-related value of plan assets. If necessary, the excess is amortized over the average remaining service period of active employees. ;

Additionally, TVA smoothes the impact of asset performance on pension expense over a three-year phase-in period through a "market-related" value of assets calculation. Since the market-related value of assets recognizes investment gains and losses over a three year period, tie future value of assets will be impacted as previously deferred gains or losses are recognized. As a result, the losses that the pension plan assets experienced in 2002 and 2001

.may have an adverse impact on pension cost in future years depending on whether the actuarial losses at each meas-

• urement date exceed the ten percent corridor in accordance with SFAS No. 87.

Costs and Funding. In 2005, TVXs total pension cost was $243 million. TVA expects 2006( pension cost to increase to $244 million due to a decrease in the discount rate from 5.81 percent to 5.375 percert.

. However, the impact of the lower, discount rate was primarily offset by the recognition of certain actuarial gains. r Pension funding amounted to $53 million for 2005 and is projected to be $75 million for 2006..

Due to negative pension plan assetreturns from 2002 and 2001, TVA's accumulated beriefit obligation at September,30, 2005 and 2004 exceeded plan assets. As a result, TVA was required to recognize an additional mini-

,-mum pension liability as prescribed in SFAS No. 87. The charge to establish the minimum liability and the subsequent increases and decreases thereto were entered to OTHER COMPREHENSIVE INCOME, again in accordance with the require-ments of SFAS No..87. However, TVA reclassified all such minimum pension liability changes to a regulatory asset in accordance with SFAS No. 71. The regulatory treatment of the original changes was deemed necessary from the per-spective that it would be improper to presume a level of future earnings on pension assets sufficient to fully recover, within a period of one year, all such costs included in OTHER COMPREHENSIVE INCOME.

,-Total postretirement health care costs for TVA in 2005 were $46 million. The set of assumptions used for the end-of-year actuarial valuation process had no effect on postretirement benefit costs for 2005, 2004, or 2003 but, when

,coupled with further experience adjustments related to claims and contributions, will increase postretirement benefits

,1expense for 2006 by approximately $12 million compa ed to 2005. TVA expects 2006 postretirement health care cost to approximate $58 million which represents an increase of $12 million over 2005 costs, excluding special termination benefits. ;.

In December 2003, the "Medicare Prescription Drug, Improvement and Modernization Act of 2003" became

-law. The act introduces a prescription drug benefit under Medicare (Part D) as well as a federal subsidy to employers who provide a retiree prescription drug benefit that is al; least actuarially equivalent to Medicare Part D. TVA has deter-mined that it does not directly qualify for the subsidy; however, TVA continues to investigate alternatives that could pro-duce similar subsidy benefits for its retirees.

Page 53

Tennessee ValleyAuthority Retirement System As previously stated, TVA provides retirement benefits through its sponsorship of defined benefit pension plans which cover substantially all employees. The Tennessee Valley Authority Retirement System ('TVARS") is a sep-arate legal entity comprised of and controlled by an independent, seven-member Board of Directors that not only administers TVA's defined benefit plan, but administers TVA's defined contribution plan as well. The System is com-prised of assets placed in two investment funds within the plan: the Fixed Benefit Fund and the Variable Annuity Fund.

As the Plan sponsor, TVA contributes to the Fixed Benefit Fund such amounts as are necessary on an actuarial basis to provide the System with assets sufficient to meet benefit obligations of the plan. Benefits are provided in the form of a pension funded by TVA contributions and, if eligible, an annuity derived from member contributions.

WARS prepares proprietary audited financial statements in accordance with SFAS No. 35, 'Accounting and Reporting by Defined Pension Plans," which provides the accounting basis underlying the presentation of the actuari-ally determined plan benefit obligations and assets. The primary objective of the plan's financial statements is to pro-vide financial information that is useful in assessing the plan's present and future ability to pay benefits when due. In accordance with the guidance contained within SFAS No. 35, current plan benefit obligations are determined by apply-ing discount rates of interest to future obligations consistent with the assumed rate of return on the assets of the plan.

Thus assets of the plan of $6.4 billion, as reported in the WARS annual report for the year ended September 30, 2004, when compared to corresponding plan benefit obligations of about $6.6 billion indicated a plan funding ratio of approx-imately 97 percent for the period so ended. Calculations under SFAS No. 35 may differ from calculations for other pur-poses, such as determining TVA's benefit obligations under SFAS No. 87, "Employers'Accounting for Pensions," and, in fact, the WARS Board of Directors' determination of the valuation (and therefore the funded status) of the WARS plan under SFAS No. 35 differs from TVA's determination under SFAS No. 87. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -

'"Critical Accounting Policies and Estimates" -

"Regulatory Assets and Liabilities" and notes 5 and 11.

Risk Management Activities Risk Governance In August 2005, the TVA Board approved further changes to the structure "of risk management at TVA. The Board dissolved the existing Portfolio Risk Management Committee ("PRMC") and created a new Enterprise Risk Council ("ERC") to strengthen and formalize TVA's effort to manage enterprise-wide risk. The ERC is responsible for the highest level of risk oversight at TVA. The ERC is als6 responsible for communicating any enterprise-wide risks with policy implications to the Board or a designated Board committee. The ERC's current members are the President and Chief Operating Officer (chair), the Chief Financial Officer, the Executive Vice President and General Counsel, the Chief Risk Officer ("CRO"), and a designated representative from the Office of the lnspector General ("OIG") (adviso-ry). Risk Management & Economic Analysis is responsible for providing the tools and analytical support necessary to ensure that all significant enterprise-wide risk issues are effectively communicated to the ERC.

i In addition to the ERC, subordinate risk committees were created to segregate risks into natural groupings.

There are'currently three subordinate risk committees: the Financial Risk Committee, the Operational Risk Committee, and the Strategic Risk Committee. Each of the subordinate committees reports directly to the ERC. Membership in the subordinate committees includes senior management from organizations that "own" the applicable risks, the CRO, and advisory representatives from the OIG and from the Office of the General Counsel.

See 'Qualitative and Quantitative Disclosures About Market Risk."'

Derivatives

'To manage the volatility attributable to its various risk exposures, TVA has entered into'Variois nontrading derivative transactions. TVA risk management policies provide for the'use of derivative financial instruments to man-

'age financial exposures but prohibit the use of these instruments for speculative purposes. TVA acc6unts for these derivative instruments in accordance with the provisions of SFAS No. 133, "Accounting for Derivative Instruments and Hedging;Activities," as amended by SFAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities," and SFAS No. 149, 'Amendment of Statement 133 on Derivative Instruments and Hedging Activities."

Certain derivative contracts utiliz'ed by TVA;-the inflation swap and the currency swaps'-

qualify for cash flow hedge accounting treatment under SFAS No. 133, as amended. Consequently, the effective portions of gains and

-Page 54

losses related to these types of contracts are deferred and reported in ACCUMULATED OTHER COMPREHENSIVE INCOME with corresponding adjustments to the derivatives' book values until the contracts actually settle. The ineffective portions of the derivatives' changes in fair value are recognized immediately in the determination of earnings, as are the gains and losses of an interest rate swap that does not qualify for hedge accounting treatment under SI-AS No. 133, as amended and the 2005 swaptions, for which TVA elected to forego hedge accounting treatment. The 2002 swaption agreement qualifies for fair value hedge accounting under SFAS Nos. 133 and 138 with gains and losses on the hedged items and the hedging item recognized immediately in the determination of earnings. TVA also holds pur-chased options related to futures contacts with changes in fair value recognized immediately in the determination of earnings.

TVA has purchased power option contracts and coal contracts that contain volume options. Gains or losses on these contracts are deferred and recorded as regulatory assets or liabilities in accordance with SFAS No. 71 until settlement, at which time they are recognized in fuel and purchased power expense. Such treatment reflects TVA's ability and intent to account for these derivative instruments on a settlement basis for rate-making purposes. (See note 8 for a more detailed discussion of TVA's derivative activities.)

Summary of Derivative Instruments that Receive Hedge Accounting Treatmentl As of September 30, 2005 Derivative Hedging Instrument Hedged Item Inflation Swap Variable-principal debt Purpose of Hedge Transaction To fix the debts variable cash flows to a fixed flow Type of Hedge-Fair Value (FV) or Cash Flow (CF)

Accounting for Derivative Accounting for the Hedging Instrument Hedged Item CF Cumulative gains and losses are recorded in other comprehensive income to the extent they are offset by cumulative gains and losses on the hedged transaction.

NO adjustment is mz.de to the basis of the! hedged item.

Currency Swaps Anticipated payment Tc denominated in a ct foreign currency fic ra protect againsl CF Cumulative gains and No adjustment is hanges in cash losses are recorded in made to the basis of ows caused by I -

other comprehensive the! hedged item.

ianges in foreign-,

income to the extent irrency exchange they are offset by

,tes cumulative gains and losses on the hedged transaction.

protect against a FV All gains and losses All gains and losses

-crease in value on the derivative are on the hedged item the embedded recorded in earnings as arm recorded in III unrealized gain/loss on eamnings as unrealized

, derivative contracts.

gan/loss on derivative contracts.

Swaption (2002)

-. :, z Embedded call -

I

.1 TC of I

1 7

i i

I.i.1 I:

i I "..

!

r I I I.

I

-
:

I 11 I.

I i -

. I I

I

", p 1.

i",

-J. !.

1

J, I.[i i

I ZZ I i.

I Page 55

- -Summary of Derivative Instruments that Do Not Receive Hedge Accounting Treatment

,7 v -

As of September 30, 2005 I

X I

Derivative Type.

Purpose of Derivative Accounting for Derivative Instrument,; -.

tuations in market Gains and losses are recorded as regulatory e purchased assets or liabilities until settlement at which time they are recognized in fuel and pur-chased power expense.

• Coal Contracts-Volume Options To protect against fluc prices of the item to be

. Purchase Power Option Contracts To prote prices o

!ct against fluctuations in market Gains and losses are recorded as regulatory f the item to be purchased assets or liabilities until settlement, at which time they are recognized in fuel and pur-chased power expense.

Interest Rate Swap To fix short-term debt variable rate to a a fixed rate To protect against decreases in value of the embedded call call Fixed and variable interest cash flows are recorded in earnings as interest expense.

MTM gains and losses are recorded in earn-ings as unrealized gains/losses on derivative contracts.

Gains and losses are recorded in earnings as unrealized gains/losses on derivative con-tracts.

Swaptions (2005)

Weather Risk

,1 1 The weather affects TVA's ability to both generate and sell electricity. Hot water temperatures in the summer can limit TVA's ability to use water from the Tennessee River for cooling at generating facilities. Extreme peaks in either the summer or winter may require TVA to purchase electricity in the more expensive short-term market to meet demands from customers.

Historically, the weather risk has created short-term variability only. Over periods of one year or longer, the financial risks associated with weather have historically been modest, for reasons including averaging of effects over a large service territory, averaging of effects over different times of the year (which is particularly helpful to TVA since it is a 'double-peaking utility"), and minor changes in hydroelectric generation during high-value periods.

Operational Risk The financial risks associated with the operation of the transmission system are modest over periods of one year or more. However, the increasing 'need for coordination with surrounding regional transmission organizations introduces new costs that are difficult to quantify at this point.

Annual financial targets can be noticeably influenced by the unforeseen interruption of key generating facili-ties during peak seasons. The likelihood of such interruptions increases with an aging generation fleet.

Corporate Insurance Although TVA uses private companies to administer its health-care plans for eligible active and retired employees not covered by Medicare, TVA does not purchase health insurance. Consulting actuaries assist TVA in determining certain liabilities for self-assumed claims. TVA recovers the costs of losses through power rates and through adjustments to the participants' contributions to their benefit plans.

TVA purchases nuclear liability insurance, nuclear property, decommissioning, and decontamination insur-ance, and nuclear accidental outage insurance. (See note 12 -

Contingencies -

Nuclear Insurance.)

Page 56

d

- TVA does not currently, purchase commercial general liability, auto liability, or workers'!cornpensation insur-ance.,TVA recovers the costs of losses through powe' rates. The Federal Employees',Compensation Act governs lia-bility to employees for service-connected injuries.

On March 31, 2005, ;the TVA Board approved the purchase of property and business interruption/outage insurance for its non-nuclear assets. TVA implemented the property insurance program on October 1, 2005, and the outage insurance program on November 7, 2005.

On April 25, 2005,Jthe TVA Board approved the purchase of Directors and Officers Liability insurance. This type of insurance provides coverage, subject to the terms and conditions of the policy, for claims against corporate directors and officers for alleged breach of duty while acting in their capacity as a director or officer of TVA. The insur-ance program went into effect on May 20, 2005.

Additional information on risk management activities and the financial impact of these activities is provided in notes 8 and 12.

Rate Setting It is possible that the ability of the Board to set TVA's rates as specified in the TVA Act could be adversely affected by legislative changes or by competitive pressures. TVA continues to monitor the cost of fual and purchased power. Current projections have these costs increasing significantly above the amount upon which the October 1, 2005, rate increase was based. This will place upward pressure on rates and could possibly result in further rate actions in the near term.

Risk of Loss of Customers

'".iThe 1959 ameidments t theTVA Act proviie that, subject'to certain minor exceptions, heither TVA nor its distributors may be a source of power supply outside TVA's defined service area.; This statutory provision is referred to as the 'Fence" because it bounds TVA's sales activities, essentially limiting TVAto power sales within a defined serv-ice territory that includes most of Tennessee and parts of six other states: Kentucky, Mississippi, Aebama, Georgia, North Carolina, and Virginia. '(See "Management's Discussion and Analysis of Financial Condition and Results of Operations"- TVA and Competition.')

While the Fence essentially confines TVA to this defined service territory, the Anti-Cherrypicking Provisi6n provides that the Federal Energy Regulatory Commission cannot order TVA to deliver power from -an outside source to a customer if the power would be consumed within TVA's service territory. Thus,'TVA cannot be Crdered to provide access to its transmission lines for the purpose of delivering power to wholesale customrers within its defined service territory.

The Anti-Cherrypicking Provision minliiizes the financial exposure of TVA to loss 'f distributors due to their limited access to transmission resources Howeversen'ators frorii Kentucky have questione'd the aopropriateness of applying the Anti-Cherrypicking Provision to a&distributor whose notice of termination of its TVA power contract has become effective. In addition, due t6 the-uncertainties in rulings related to the nation's transmission systems, TVA's financial exposure to customer losses may increase in the future. See 'Legislative and Regulatory Matters"- 'Other Matters" for discussion of a bill that would effectively remove any area within Kentucky from coverage of the Anti-Cherrypicking Provision. :

~'

I,

,1i'H

~'

i

- q'i.

Termination Notices. During 2005, TVA received notices from three distributors in Kentucky terminating their power contracts with TVA. In"December 2004,'TVA received notice fromri Paducah'P6wer System ('PPS") that termi-niates its power contract with TVA effective December 2009. In January 2005, TVA received notice from Princeton Electric Planit Board ("PEPB") that ternrlinates its powe; contract with TVA effective January 2010. In August 2005, TVA received notice from Hopkinsville Electric System ("HES") that terminates its power contract with TVA effective August 2010. In 2005, 0.4 percent of TVA's total operating revenues were from sales to PPS; less than 0.1 percent of TVA's total operating revenues were from'sales to PEPB; and less than 0.3 percent of TVA's total operating revenues were from sales to HES.

Since October 2002, nine of TVA's distributors have given notice to terminate their power contracts with TVA.

Notices'from two of these distributors -

Bowling Green Municipal Utilities and Meriwether Lewis Electric Cooperative have since been withdrawn and deemed to be of 66'force and effect by the mrutual agreement of the 'distributors Page 57

and TVA. In addition, Duck River Electric Membership Corporation ('DREMC") and TVA have agreed in principle to a contract amendment that, if executed, will extend DREMC's termination date from August 2008 until August 2010.

The following table lists the names and locations of the seven distributors whose termination notices are still in effect, their contract termination dates, the amount of revenues that TVA generated by selling power to these dis-tributors in 2005, and the percentage of TVA's total 2005 operating revenues represented by these revenues.

Date of Sales to Percentage of Termination of Distributor Operating Distributor Location Power Contract in 2005 Revenues in 2005 Warren Rural Electric Kentucky April 2008 82 1.0%

Cooperative Corporation Duck River Electric Tennessee August 2008 85 1.1%

Membership Corporation Monticello Electric Plant Board Kentucky November 2008 5

0.1%

Glasgow Electric Plant Board Kentucky December 2008 18 0.2%

Paducah Power System Kentucky December 2009 33 0.4%

Princeton Electric Plant Board Kentucky January 2010 6

0.1%

Hopkinsville Electric System Kentucky August 2010 21 0.3%

Total

$ 250 3.2%

In addition to the six Kentucky distributors listed above, TVA has 11 other distributors located in Kentucky.

Sales to these 11 distributors generated approximately three percent of TVA's total operating revenues in 2005.

On October 1, 2004, East Kentucky Power Cooperative ('EKPC") filed an application with the Federal Energy Regulatory Commission ("FERC") ostensibly seeking an order requiring EKPC to be interconnected with TVA's trans-mission system. If this interconnection is granted, EKPC would be able to use TVA's transmission system to provide power to Warren Rural Electric Cooperative Corporation ('WRECC") when WRECC's contract with TVA terminates in April 2008. TVA submitted a response to FERC stating that if FERC grants the requested relief, the actual effect would be to require WVA to provide free transmission service across TVA's transmission system in violation of the Anti-Cherrypicking Provision of the Federal Power Act. On April 13, 2005, FERC issued a proposed order granting EKPC's application. The parties tried without success to resolve their differences.

On August 3, 2005, FERC issued an order for TVA to interconnect with EKPC and to provide EKPC with coor-dination services necessary to deliver energy to WRECC. The order recognized that TVA is entitled to be compensat-ed for the use of the TVA system caused by the interconnections and asked TVA to file a new agreement within 30 days, covering the terms, conditions and rates TVA believes it should receive for this use. TVA filed a proposed agree-ment as requested by FERC. FERC has not issued a final order. After FERC issues a final order, TVA can request a rehearing and ultimately appeal to the Court of Appeals.

In January 2004, the United States Enrichment Corporation ("USEC") announced it will begin constructing its new commercial centrifuge facility in Piketon, Ohio. While it is unclear how much electricity USEC will need to acquire from TVA for its Paducah, Kentucky facility ("Paducah Facility") once this new facility is opened it is expected to be sub-stantially less. Under the current contract with TVA, USEC is required to purchase a fixed amount of electricity for its Paducah Facility through May 2006. In 2005, sales to USEC for its Paducah Facility generated approximately 4.4 per-cent of TVA's total operating revenues. TVA does not expect any loss of revenues from sales to USEC to have a mate-rial effect on TVA's financial condition.

Long-Term Contracts. A number of TVA distributors, including some with large loads, have expressed inter-est in further revising their wholesale power contracts to allow them more options with respect to contract term and other matters, such as purchasing a portion of their power requirements from suppliers other than TVA.

Representatives of TVA and distributors have been meeting to discuss various potential long-term contract structures that could provide more certainty to both TVA and distributors. While these discussions have not yet resulted in any agreed upon structure, TVA and the distributors plan to continue with the process.

Page 58

Accounting Changes Effective October 1, 2002, the Board approved a change in the methodology for estimating unbilled revenue from electricity sales. The change in calculating unbi led revenue was from a method using cumulative generation to a method.that uses only generation for the current billing period. TVA was able to make this change based on improved metering technology that allows TVA to moe accurately capture the number of days power has been gen-erated and transferred to its customers but not yet billed to those customers. Changing to this more accurate estimat-ing methodology resulted in an increase in accounts receivable of $412 million.

On October 1, 2002, TVA adopted SFAS No. 143, "Accounting for Asset Retirement Obligations," which requires the recognition of a liability and capitalization of the associated asset retirement cost as part of the carrying amount of the long-lived asset for legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development, and/or normal operation of long-lived assets. The effect of the adoption of SFAS No. 143 during 2003 included a cumulative effect charge to income of $195 million, a recognition of a correspon-ding additional long-term liability of $734 million, a recognition of an increase in assets of $745 million, and related accumulated depreciation of $206 million.

New Accounting Standards and Interpretations Variable Interest Entities In January 2003, the Financial Accounting Standards Board ("FASB") published FASB Interpretation No. 46

("FIN 46"), "Consolidation of Variable Interest Entities-an interpretation of ARB No. 51," which was later revised by FIN No. 46(R) ("FIN 46R") in December 2003. The interpretation explains how to identify a variable interest entity

("VIE") and how an enterprise assesses its interests in a VIE to decide whether to consolidate that entity. It also clar-ifies the application of Accounting Research Bulletin ("ARB") No. 51, Consolidated Financial Statements," to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have suffi-cient equity at risk for the entity to finance its activities without additional subordinated financial support from other par-ties. The interpretation applies to nonpublic enterprises, and it becomes effective for TVA beginning October 1, 2005, for VIEs created on or before December 31, 2003, and immediately for.ViEs created after December 31, 2003.

WVA considered the provisions of FIN 46(R) for application to its lease/leaseback transactions. Under FIN 46(R), TVA would be deemed the primary beneficiary of the variable interest entities created in connection with these transactions and would therefore be required to consolidate the assets and liabilities of these VlEs. TVA has already effectively consolidated these assets and liabilities under the accounting guidance provided by SFAS No. 66 and SFAS No. 98 as described in 'Management's Discussion and Analysis of Financial Condition and Results of Operations"-

1Liquidity and Capital Resources"-

"Lease/Leaseback Transactions" and note 10.

TVA has not identified any material VIEs created, or interest in VIEs obtained, after De-ember 31, 2003, which require consolidation or.disclosure under FIN 46(R). TVA continues to assess the existence of any interests in VIEs created on or prior to December 31, 2003, which may or may not be material to its results of operations or finan-cial position as it determines whether it can obtain the financial information necessary to make the assessment.

In March 2005, the FASB released FASB Staff Position ("FSP") FIN 46(R)-5, "Implicit Variable Interests under FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities," which is applicable to both nonpublic and public reporting enterprises. This FSP addresses transactions in which a reporting enterprise has an interest in, or other involvement with, a VIE or potential VIE that is not considered a variable interest, and the reporting enterprise's related party (a non-VIE) has a variable interest in the same entity. This FSP mnust be applied in accordance with the FIN 46R effective date and transition. At this time, TVA continues the process of evaluating the requirements of this interpretation and does not yet know the impact of its implementation, which may or may not be material to TVA's results of operations or financial position.

Medicare Prescription Drug, Improvement and Modernization Act of 2003 In December 2003, the 'Medicare Prescription Drug, Improvement and Modernization Act of 2003" became law. The act introduces a prescription drug benefit under Medicare (Part D) as well as a federal subsidy to employers who provide a retiree prescription drug benefit that is a least actuarially equivalent to Medicare Pat D. TVA decided that its retiree drug plan is not actuarially equivalent as described by the Act of 2003, and accordingly, has not includ-ed or utilized any manner of subsidy in the determination of APBO or postretirement benefit cost (see note 11 Benefit Page 59

Other Matters Cash Balance Benefit Plans In 2005, pension plan reform bills applicable to qualified defined benefit plans were introduced in the House and Senate. The reform bills would amend ERISA and Section 412 of the Internal Revenue Code to provide new min-imum funding rules for defined benefit plans. The Senate's version of the bill has also included several versions of a provision that would approve either prospectively or retroactively hybrid plans, such as cash balance plans, provided that certain conditions and conversion requirements have been met.

The outcome of any pension plan reform legislation cannot be predicted at this tme. The TVARS defined ben-efit plans, as other governmental plans, are not subject to the minimum funding rules under ERISA and Section 412 of the Intemal Revenue Code, and it is unclear whether such legislation would have any effect on the TVARS defined benefit plans, generally, or the TVARS cash balance benefit plan, specifically.

FERC Interconnect Order On October 1, 2004, East Kentucky Power Cooperative ('EKPC") filed an application with the Federal Energy Regulatory Commission (FERC") ostensibly seeking an order requiring EKPC to be interconnected with TVA's trans-mission system at.several locations. If these interconnections are granted, EKPC would be able to use TVA's trans-mission system to provide power to Warren Rural Electric Cooperative Corporation ("WRECC") when WRECC's con-tract with TVA terminates in April 2008. TVA submitted a response to FERC stating that if FERC grants the requested relief, the actual effect would be to require TVA to provide free transmission service across TVA's transmission system in violation of the Anti-Cherrypicking Provision of the Federal Power Act. On April 13, 2005, FERC issued a proposed order granting EKPC's application. The parties tried without success to resolve their differences.

On August 3, 2005, FERC issued an order for TVA to interconnect with EKPC and to provide EKPC with coor-dination services necessary to deliver energy to WRECC. The order recognized that TVA is entitled to be compensat-ed for the use of the TVA system caused by the interconnections and asked TVA to file a new agreement within 30 days, covering the terms, conditions and rates TVA believes it should receive for this use. TVA filed a proposed agree-ment as requested by FERC. FERC has not issued a final order. After FERC issues a final order, TVA can request a rehearing and ultimately appeal to the Court of Appeals.

Organizational Structure Changes On September 20, 2005, TVA announced changes in its organizational structure to prepare for the transition to a new governance structure at TVA and to assist in adapting to a changing legislative environment while working to improve its competitive position. The changes are as follows:

Effective as of September 20,2005, all Board Services functions and the Government Affairs office based in Washington, D.C., began reporting to Maureen H. Dunn, Executive Vice President and General Counsel.

l*

Aso effective as of September 20, 2005, the Administrative Services organization was created, which reports to John E. Long, Jr., Executive Vice President, Administrative Services. Administrative Services consolidates Facilities Management, Information Services, Procurement, Admiriistration Business Services, TVA Police, Enterprise Performance and Analysis, Employee Relations and Diversity, and Human Resources.

Effective as of October 31, 2005, Bulk Power Trading will report to W. Terry Boston, Executive Vice President, Power System Operations.

Also during 2005, TVA made additional organizationral changes:

Theresa Flairm, Senior Vice President. Strategic Planning and Analysis, was named Senior Vice President, Pricing and Strategic Planning. In the new role, Ms. Fialm will continue to direct TVA's strate-gic planning efforts reporting in this regard directly to TVA's President and Chief Operating Officer, and she will lead the Contracts and Pricing organization in Customer Service and Marketing, reporting in this regard to Kenneth R. Breeden, TVA's Executive Vice President, Customer Service and Marketing.

Page 69

change in accounting estimate effected by a change in accounting principle. The statement will become effective for TVA beginning in 2007 with early adoption permitted for accounting changes and corrections of errcrs made in fiscal years beginning after the date the statement is issued.

Accounting for Purchases and Sales of Inventory with the Same Counterparty On September 28, 2005, the EITF ratified Issue No. 04-13, 'Accounting for Purchases and sales of Inventory with the Same Counterparty." This issue relates to comnpanies that sell inventory to another entity in the same line of business from which it also purchases inventory. The staff believes that the transition guidance in Issue 04-13 should apply to all contracts entered into after March 15, 2006. The adoption of EITF Issue No. 04-13 beginning in the sec-ond quarter of 2006 is not expected to have a material effect on TVA's results of operations or financial position.

Put and Call Options.C In September 2005 the Derivatives Implementation Group of the FASB ("DIG") discussed several issues relat-ed to the settlement of a debtor's obligation on the exercise of a call or put option and the exercise cnly by the debtor of the right to accelerate settlement of a debt with an embedded call option., DIG Implementation Issue No. B38,

'Embedded Derivatives: Evaluation of Net Settlemen! with Respect to the Settlement of a Debt Instrument through Exercise of an Embedded Put Option or Call Option," addresses whether the settlement of a debtor's obligation on exercise of a call or put option meets the net settlement criterion in paragraph.9(a) of SFAS No. 133.

DIG Implementation Issue No. B-39, 'Embedded Derivatives: Application of Paragraph 13(b) to Call Options That Are Exercisable Only by the Debtor," addresses whether or not Paragraph 13(b) of SFAS No. 133 does riot apply to a call option embedded with a debt host if the right to accelerate settlement of the debt can be exercised oily by the debtor.

The effective date of the implementation guidance in these Issues is the first day of the first fiscal quarter beginning after December 15, 2005. TVA is evaluating the potential implications of these Issues on its transactions related to future call and put options which may or may not be material to its financial position or results of operations.

TVA and Competition J.

I By the late 1990s, the nation appeared to be well on its way to restructuring both wholesale and retail elec-tricity markets. Recently, however, market and regulatory events have increased the uncertainty about the ultimate outcomeand timing of electricity market restructuring in the United States. -Despite the current uncertainty, however, TVA believes that wholesale competitive electricity markets are likely to continue to evolve. -,-

Among the early initiatives that have begun tb promote industry competition is the Energy Policy Act of 1992 (the 'Energy Act"). The Energy Act and related FERC: orders already allow competitors of a utility to access that util-ity's transmission system to sell electricity to other electric power suppliers and wholesale customers. In TVA's case, some special provisions apply.

Under the VA Act, subject to certain minor exceptions, TVA may not currenty enter into contracts that would have the effect of making it or the distributors of its power a source of power supply outside a statutorily specified area.

Inside that same area, under the Anti-Cherrypicking Provision, TVA is not required to provide its competitors access to its transmission system to transmit power for consumption within the area that TVA or the distributors of its power may serve. Thus, while TVA may not freely sell power outside its current service area, -TVA cannot be compelled to permit its competitors to use its transmission system to sell power within TVA's service area.

- In the future, it appears possible that the current law that serves to limit competition between TVA and its com-petitors may change. In the past six years, numerous bills have been introduced in Congress, designed to restructure the electric utility industry and mandate or promote competition in the industry. Within the context of restructuring leg-islation, some of the key issues for TVA are (1) whether TVA rates and transmission system will be regulated by FERC, (2) whether TVA and the distributors of TVA power will be able to sell power outside the TVA service area and whether TVA will be required to provide its competitors access; to its transmission system to transmit power for consumption within the TVA service area, and (3) whether Congress will attempt to shorten the terms of TVA's current wholesale power contracts with the distributors of, its power.. Whether TVA's existing customers will be expressly entitled by statute to "native load preference" under an unbundled transmission scenario is uncertain.

In the spring,of calendar year 2000, TVA, the Tennessee Valley Public Power Association ("TVPPA"), an association representing the distributors of TVA power, and the Tennessee Valley Industrial Committee ("TVIC"), an organization representing industries that TVA directly serves, reached consensus on draft legislation on the relation-ships between TVA and its customers in a restructured electric power industry. The draft legislation, as revised by Page 61

TVA, TVPPA, and TVIC in 2003, provides for (1) simultaneous repeal on the effective date of the restructuring-leg-islation of the Anti-Cherrypicking Provision and the provision that limits the area in which TVA and the distributors of TVA power can be a source of power supply, (2) a distributor option to gradually take up to a maximum of 30-per-cent partial requirements from other suppliers with advance notice to TVA, (3) new limitations on TVA retail sales in TVA's current service area, (4) stranded cost recovery through 2007, (5) FERC regulation of TVA's transmission service rates and terms and conditions of service to ensure that those TVA charges and imposes on other users of its system are comparable to those TVA charges and imposes on itself, (6) TVA's subjection to antitrust laws (with the exception of monetary damages and attorney's fees), (7) as elected by individual distributors, reduction in TVA's existing regulatory role with respect to distributors,-and (8) an express statutory limitation on new TVA generation to that needed to meet demand within the current TVA service area.

During the past year, work has focused on developing long-term contract terms and conditions that would pro-vide value to distributors and help strengthen TVA's financial viability under competition, assessing how different whole-sale rate structures would impact TVA's ability to compete in wholesale markets, and developing a new industrial port-folio to better align the cost and risk of production with the prices that customers pay.

Regional Transmission Organizations While not generally subject to FERC jurisdiction, TVA is voluntarily seeking ways to meet FERC's objective to improve regional transmission operations in a manner consistent with TVA's responsibilities under the TVAAct. WVA is moving forward on following initiatives:

I.

WTA supports the need for regional solutions to resolve transmission issues faced by the industry.'

TVA has been working with federal and state authorities, public power entities, investor-owned utilities, 'and emerging regional transmission organizations ("RTOs') to address today's critical concerns.

TVA has been developing regional transmission partnerships that meet FERC's intent for regional trarismis-sion. This effort includes entering into coordinating agreements (Memorandums of Understanding ('MOUs"))

with neighboring utilities, public power providers and RTOs.

The initial step of this coordination effort was to establish a joint transmission reliability area with TVA's pub-lic power partners. In 2002, TVA entered into Reliability Coordination Agreements with Associated Electric Membership Cooperative, Big Rivers Electric Corp, and East Kentucky Power Cooperative. In 2004 Electric Energy, Inc. joined this reliability partnership.

i TVA has been designated by the North American Electric Reliability Council ('"NERC") to serve as the relia-bility coordinator for parts of eleven states covering 192,000 square miles with a population of nearly ten million peo-ple. As the reliability coordinator for this region, TVA is responsible for monitoring and ensuring the reliable operation of the bulk transmission system in an eleven state region that includes Tennessee and portions of Alabama, Georgia, Illinois, Iowa,' Kentucky,-Mississippi, Missouri, North Carolina, Oklahoma, and Virginia. TVA is one of four reliability coordination offices in the Southeastern Electric Reliability Council ('SERC").

Through its MOU coordination, WVAcontinues to develop analysis and operational processes with Southern Company and Entergy for transmission reliability and interchange activities in support of regional transmission.

TVA has initiated a joint effort with MISO and PJM to create broad, seamless transmission services and facil-itate'working energy markets across 'a large region while imriplementing solutions to improve the reliability and adequa-cy of the transmission infrastructure. A joint reliability coordination agreement has been executed that provides a coor-dinated approach to transmission capacity availability, system outage approval, congestion management, and trans-mission planning.

¢ Our continuing efforts with public-power partners, Southern and Entergy, and jointly with the-Midwest Independent Transmission System Operator ("MISO") and PJM Interconnection, L.L.C. ("PJM"), provide a'mechanism for TVA to pursue regional transmission solutions in a manner consistent with our public service' mission obligations.

Changes in the fundamental business model for bulk transmission system operations, including the emer-gence of large markets in many areas of the eastern United States, have created new reliability risks and exposure for the TVA system as well as other systems. This has manifested itself in actual blackouts (August 14, 2003, in the' mid-west and northeast United States) and in more frequent interconnection excursions such as frequency deViations.'

Page 62

Business Strategy TVA's Six Strategic Objectives TVA's strategic objectives encompass excellence in operating performance, leadership in economic develop-ment, and sensitivity to its stakeholders' needs. Critical success factors have been developed and targets established to reach performance goals. TVA's Strategic Objectives are:

Improve life in the Tennessee Valley through integrated management of the river system and environmental stewardship. TVA is committed to environmental stewardship. TVA will improve the quality of life in the Valley by man-aging the Tennessee River system in accordance with a strategythat manages the diverse benefits of navigation, flood control, power production, water quality, and recreation for the greatest public good.

Meet customers' needs with affordable, reliable electric power. Electric power is the fuel of TVA's regional economy, and TVA's power system is growing and improving to keep pace with the ever-increasing demand. In step with America's energy policy for the 21 st century, TVA is prepared to play a vital role as a public power provider, ded-icated to public service and providing competitively priced electricity in an increasingly open energy marketplace.

Demonstrate leadership in sustainable economic' development in the Valley. TVA will continue to work with the communities it serves in order to help attract and retain new and better jobs for the people of the Valley.

Continue the trend of debt reduction. TVA is committed to reducing its level of total financing obligations in order to create more financial flexibility for the future business environment.

Reduce TVA's delivered cost of power relative to the market. The bottom line for TVA is the creation of value for the public. TVA will be responsive to the marketplace through its initiatives for promoting innovation and continu-ous improvement. TVA will generate more for less for the good of many.

Strengthen working relationships with all of TVA's stakeholders. TVA will strengthen its relationships with Valley residents, communities, and businesses; with customers and suppliers; andwith leaders at all levels of govern-ment.

1.

11-:

Page 63

Key Indicators and Objectives

= Better than target 4

Measure Strategic Objective Customer Meet customers' needs with Cusi affordable, reliable electric relia power uct tI

• (pen

= On target

= Worse than target Statusas of i

September 30, 2005 2005 Indicator 2005 Actual Target tomer satisfaction on power t

bility, billing reliability, prod-I imeliness, competitive price

-ent) 107 100 I

I i

).

f I

~

I.

Demonstrate leadership in sus-

,tamable economic development in the Valley I

I

'i I

Jobs added or retained In f -

the Valley, capital investment leveraged, and quality-job measure (index)

.123

-100.-i

I I

,
'I-t Operations Meet customers' needs with Asset availability t

102

• affordable, reliable electric power

' (percent of actual to plan) m 98

, r I..

I II Improve life in the Valley through Environmental impact on air qual-

, integrated management of the ity, water quality, land, waste pro-river system and environmental duction, energy consumption -

-stewardship

- (index of environmental factors) 55 78

-,~1

. I

-Ean I

I H

Financial

~

I 1

Reduce TVAs delivered cost of !

power relative to the market I

.~

I 6 perating costs including O&M, -

t depreciation, tax equivalents, and external business (millions of $)

3,493 3,584 Continue trend of improving financial flexibility Meet customers' needs with affordable, reliable electric power Strengthen working relationship with all of TVAs stakeholders Financial Strength (net reduction in total financing obligations in millions of $)

Productivity (kWh/$)

All injury rate (injuries/hours worked)

_t 301 225 160.9 153.7 1.82 2.12 People Strategic Plan To prepare for a more competitive electricity market, TVA has implemented a strategic planning process that analyzes how the new market may function, what competitive pressures TVA will face, and how TVA must prepare now for success in the future. More specifically, the process focuses on what TVA needs to do in order to preserve TVA's core mission of providing low-cost power, promoting economic prosperity in the Tennessee Valley, and exercising stew-ardship while remaining financially viable in a competitive market.

These challenges are not unique to TVA. Fiscally and strategically, the federal government, corporations, and the utility industry are dealing with cost pressures, competition for customers, the need to develop new technologies, and the need to efficiently manage all resources.

Page 64

TVA's strategic plan is based on an analysis of possible market conditions and gives a qualitative basis for better decision-making as TVA moves into a world where laws restricting competition will be modified. The plan is based on the most thorough analysis of possible future market conditions that TVA has ever done.

f -

ITVA believes that wholesale competitive markets are going to continue to evolve and bring four fundamental changes to the business environment:

First, the wholesale electricity markets that border TVA to the North either already have or are expected to include the following core features:

Independent, real-time operation of the regional transmission system, integrated with Voluntary day-ahead and real-time energy markets, Locational marginal pricing to reflect locational differences in generation costs caused by transmission constraints, and Financial congestion revenue rights to allow buyers and sellers to hedge the cost of energy delivered to a particular location.

-i Efforts to develop independently administered, structured spot markets in the South are stalled for the time being. Thus, markets in the South are expected to remain bilateral in nature for the foreseeable future.

Second, current law restricts TVA's ability to sell outside the TVA region and restricts the ability of other sup-:

pliers to sell power inside the TVA region. TVA must begin to prepare for a future where the laws restricting competi-tion are modified, allowing distributors to choose other suppliers for all or part of their energy needs and allowing TVA to sell surplusrpower outside the region.: -,,-

I

'.1

,., (

j Third, TVA's historic monopoly on power sales in its service area appears likely to change, although market share is protected for the near term by existing contracts requiring at least five-years notice of termination. If other suppliers can provide services to distributors, TWA's planning, pricing, and financial structure must adapt to the poten-tial reality that investments in long-lived facilities will face market risk..

Fourth, in the past TVA has relied almost entirely on debt to fund power system investments and support all activities related to its broad mission., This financing approach was very successful in the past, but will be risky in a world where distributors can select other suppliers. ! Under,competition, TVA's effective monopoly position in the Valley will erode and will bring more cost and revenue volatility. TVA will need to reduce its debt and develop a more flexible financial structure so that it can weather the greater volatility of. revenues that will come with competition.,

TVA's Strategic Plan was adopted by the Board in January 2004. The plan identifies a number of steps that TWA needs to take to begin to prepare for a more competitive future. Specifically, over the next several years, TVA needs to concentrate on four major areas:

.. ~ ~

~

~

~

f as:>'.

" ;.!i.:

serce, and5, 5

(1) );Developing new, more highly differentiated prices, services, and contract terms that more closely tie the cost and the risk of the product to its terms and pricing.. During the past year, work has focused on devel-oping long-term contract terms and conditions that would provide value to distributors and help strength-en TVA's financial viability under competition, assessing how different wholesale rate structures would impact TVAWs ability to compete in wholesale markets, and developing a new industrial portfolio to better

/ align the cost and risk of production with the prices that customers pay.

I,

-4.................

(2) Addressing the. range of issues related to wholesale market design and transmission pricing, including how TVA will interface with the markets that are expected to surround TVA, as well as how TVA will price transmission services within the TVA's power service area when distributors can choose other suppliers.-

(3) Increasing cash flow through cost reductions or rate increases in order to accelerate reduction in total financing obligations and to provide the financial flexibility needed to tolerate the higher levels of revenue and cost volatility associated with a more competitive market.

(4) Maintaining and operating its generation and transmission assets so that it continues to fulfill its supply obligations in a safe and reliable manner.

n to te p

p n

fr a,

i,

.mr e i

-.According to the plan, preparing for a moreicompetitive market requires TVA to begin working with' Page 65

distributors to develop new, more highly differentiated prices for power, unbundled services, and new con-tract terms. TVA also will assess the way it provides and prices transmission service to its customers and decide whether to integrate its transmission system into a larger regional market.

The plan recommends a reduction target of at least $3 billion to $5 billion in debt over the next ten to 12 years but notes that debt-reduction targets will be updated annually depending on TVA priorities and changing market con-ditions. TVA anticipates that accelerated debt reduction can be achieved through continued emphasis on cost reduc-tion, increased productivity, asset improvements to increase performance, further limiting capital projects where appro-priate, and rate adjustments and rate changes consistent with market and power-supply conditions.

Because the plan is a 'living" document, it will continue to evolve, providing a framework for TVA to respond to future market challenges.

Environmental Matters As is the case across the utility industry and in other industrial sectors, TVA's activities are subjected to cer-tain federal, state, and local environmental statutes and regulations. Major areas of regulation affecting TVA's activi-ties include air quality control, water quality control, and management and disposal of solid and hazardous wastes.

TVA has incurred and continues to incur substantial capital and operating/maintenance costs in order to com-ply with evolving environmental requirements. Many of these costs are associated with the operation of TVA's 59 coal-fired generating units. While it is not possible to predict with any precision how these evolving requirements will impact the operation of existing and new coal-fired and other fossil-fuel generating units, it is virtually certain that environmen-tal requirements placed on the operation of these generating units will continue to become more restrictive. Litigation over emissions from coal-fired generating units is also growing, including litigation against TVA (see "Legal Proceedings" in Part I).

r Several existing regulatory programs have been and are being made more stringent in their application to fos-sil-fuel units and additional regulatory programs affecting fossil-fuel units have been promulgated in the past year. The total cost of future compliance with nitrogen oxide ("NO."), sulfur dioxide ("SO2"), and mercury emission reduction requirements cannot reasonably be determined with precision at this time because of the uncertainties surrounding emerging EPA regulations, resultant compliance strategies, the potential for the development of new emission control technologies, court litigation,,and future amendments to the Clean Air Act ("CAA"). However, additional costs for future regulation could be $3.0 to $3.5 billion' through 2020, in 'addition to the costs to install SCRs and scrubbers as described below. In addition to these costs, there could be other substantial costs if reductions of carbon dioxide

("CO2") are mandated (discussed in more detail below). Predicting how and when C02 may be regulated is very uncer-tain, even more so than the future regulation of other substances. TVA will continue to monitor this issue and will assess and respond to potential financial impacts as they become more certain.

Expenditures related to the clean air projects during 2005 and 2004 were approximately $202 million and

$400 million, respectively. During 2005, TVA spent $51 million on its publicly announced SCR program and $146 mil-lion on its publicly announced scrubber programs.

Clean Air Developments Air quality in the United States has significantly improved since the enactment of the modern CAA in 1970.

These air quality improvements are expected to continue as the CAA and its implementing programs evolve through legislative and regulatory changes. Three substances emitted from coal-fired units have historically been the focus of emission reduction regulatory programs: S02, NO., and particulates.

VA's total cost through 2010 is expected to reach $5.7 billion to reduce these emissions, $4.4 billion of which TVA had already spent as of September 30, 2005.

This figure includes the publicly announced SCR and scrubber programs outlined above, but not the $3.0 to $3.5 bil-lion in potential future costs for additional reductions. Recently, attention has been given to two other substances emit-ted by coal fired units: mercury and CO2. Increasingly stringent regulation-of some or all of these substances will con-tinue to result in significant capital and operating costs for coal-fired generating units, including those operated by TVA.

.*SulfurDioxide..

Coal-fired utilities have historically emitted large amounts of SO2. Utility SO2 emissions are extensively reg-ulated and will be regulated further under state programs to achieve and maintain EPA's National Ambient Air Quality Page 66

Standard for SO2, the acid rain control program, and - depending on when units commenced operation and their effect on sensitive areas - the regional haze program. EPA's new, stringent fine particle national ambient air quality stan-dard is expected to result in additional significant reductions of utility S02 emissions because S02 can transform into sulfates, and sulfates are a major component of fine particles in the eastern United States. Since 1977, TVA has reduced its S02 emissions by approximately 78 percent by switching to lower-sulfur coals, re-powering a unit at its Shawnee Fossil Plant with the advanced Atmospheric Fluidized Bed Combustion Technology, and installing flue gas desulphurization technology ("scrubbers") on six of its larger units. A seventh scrubber at unit 3 of its Paradise Fossil Plant is under construction. In 2005, TVA broke ground on its eighth scrubber at its Bull Run Fossil Plant in East Tennessee, as part of its previously announced plans to install additional scrubbers to achieve a total SO2 emission reduction of 80 to 85 percent. TVA also has switched, or plans to switch to lower sulfur coal on several additional units in the next few years. These plans may change depending on the timing and severity of new S02 emission reductions that have been promulgated but not yet fully implemented under the Clean Air Interstate Rule ("CAIR"). The State of North Carolina also petitioned EPA under Section 126 of the CAA to impose additional emission reductions require-ments for S02 and NO. emitted by coal-fired power plants in 13 states, including Kentucky, Tennessee, and Alabama where TVA's coal-fired power plants are located. The EPA proposes to deny the North Carolina petition primarily on the basis that CAIR remedies the problem.

Nitrogen Oxide Utility NO. emissions are extensively regulated and will be regulated further under state programs to achieve and maintain EPA's national ambient air quality standard for ozone (NOt combines with volatile organic compounds in the presence of sunlight to produce ozone under certain meteorological conditions), the acid rain control program, and depending on when units commenced operation and their effect on sensitive areas -

the regional haze program.

EPA's new, more stringent eight-hour ozone and fine particle national ambient air quality standarcs could result in requirements to further reduce NO, emissions from coal-fired power plants and other fossil-fuel generation such as combustion turbines. (NOa emissions can transform into nitrates, another component of fine particles.) Since 1995, TVA has reduced its NO. emissions during the summer (when ozone levels increase) by approximately 80 percent by installing various combustion controls on all 59 coal fired units. TVA has also installed selective catalyt c reduction tech-nology ("SCRs") on 20 of its units and is in the process of installing an SCR on one additional unit. Also in 2005, TVA began evaluations of Selective Non-Catalytic Reduction ("SNCR") systems at two units. TVA's NO. emission reduction program will continue to depend primarily on SCRs, but will also likely incorporate SNCRs if the evaluations are favor-able. These plans may change depending on the timing and severity of new NOa emission requirements that have been promulgated under CAIR but not yet finally implemented. The State of North Carolina has petitioned EPA to establish additional emission reductions requirements for SO2 and NO. emitted by coal-fired power plants in 13 states, including Kentucky, Tennessee, and Alabama where TVA's coal-fired power plants are located. :-The EPA proposes to deny the North Carolina petition primarily on the basis that CAIR remedies the problem:

Particulates/Opacity Larger particulates (fly ash), as opposed to fine particles discussed above, have.long been regulated by states to meet EPA's national ambient air quality standard for particulate matter (this has evolved into the new fine par-ticle standard). TVA's coal-fired units have been equipped with mechanical collectors, electrostatic precipitators, scrub-bers, or baghouses, which have reduced particulate emissions from the TVA system by more than 99 percent As part of the periodic review of the national ambient air quality standards, EPA is evaluating additional, more stringent options for setting the standard. Issues about utility compliance with state opacity requirements are also increasing. Opacity measures the denseness (or color) of power plant plumes and has traditionally been used by states as a means of monitoring good maintenance and operation of particulate control equipment. Under some conditions, retrofitting a unit with additional equipment to better control S02 and NC). emissions can adversely affect opacity performance, and TVA and other utilities are now addressing this issue. There are also disputes with special interest groups over the role of continuous opacity monitors in determining compliance %iith opacity limitations.

i I

i I

Mercury The EPA has issued a rule to regulate mercury emissions from coal-fired generating units under the CM.

TVA supports a cap and trade program for mercury due to the resounding success of the same program when it was used to reduce S02 emissions. TVA endorses EPA's approach to setting the first phase of mercury recuctions at a level consistent with the co-benefits received from the reduction of S02 and NO. under CAIR. The billions cf dollars TVA has spent and will continue to spend in response to CAIR and other rules to further reduce SO2 and NO) emissions will help TVA satisfy the additional requirements of EPA's mercury rule.

Page 67

Carbon Dioxide The existence, cause, and importance of climate change continue to be widely debated. C02 is a greenhouse gas and is believed by some to contribute to climate change. Legislation has been introduced in Congress to require reductions of C02, and if enacted,-could result in significant additional costs for TVA and other coal-fired utilities. The Bush Administration has proposed a voluntary initiative that established a goal of reducing the greenhouse gas inten-sity of the U.S. economy by 18 percent and has asked the electric utility sector and other industry sectors to support this'initiative. TVA is supporting this effort in cooperation with electric utility industry trade associations and the Department of Energy. The last administration also asked utilities to voluntary participate in an effort to reduce, sequester, or avoid greenhouse gases. Under that program, TVA reduced, sequestered, or avoided more than 275 mil-lion tons of C02 from 1994 through 2004, as reported under Section 1605b of the Energy Policy Act. TVA has also brought on line about 3,850 megawatts of non C02-emitting generation since 1990, and is in the process of adding another 1,800 megawatts of non C02-emitting generation.

Clean Water Developments In the second phase of a three-part rulemaking to minimize the adverse impacts from cooling water intake structures on fish and shellfish, as required under section 316(b) of the Clean WaterAct, EPA promulgated a final rule for existing power producing facilities that became effective on September 7, 2004. The new rule requires existing facilities t6 select one of the following compliance options for reducing the number of organisms pinned against and/or drawn into the cooling systems; (1) have specific designated features, (2) install specific technologies, (3) meet per-formance standards or (4) seek a site-specific compliance option based on application of cost/cost or cost/benefit tests.

The site specific tests are designed to ensure that a facility's costs are not significantly greater than cost projections in the rule, or than benefits derived from taking mitigation actions. Actions taken to compensate for any impacts by restor-ing habitat, or pursuing other options such as building hatcheries for fish/shellfish production, count toward compliance.

Some northeastern states and environmental groups have challenged the new regulation, and especially the compli-ance flexibility it offers, in federal court.

All of TVA's existing coal-fired and nuclear generating facilities will be regulated by this rule. Compliance will involve some level of new assessments at all generating plants, and will likely require some capital and/or operating expenditures at some or all facilities. -The assessments, however, are complicated somewhat by the uncertainty cre-ated by pending legal action challenging EPA's rule.

As is the case across the utility industry and in other industrial sectors, TVA is facing more stringent require-ments related to protection of wetlands, reductions in storm water impacts from construction activities, water quality degradation and criteria, and laboratory analytical methods. TVA is also following litigation related to the use of herbi-cides, water transfers, and releases from dams. TVA has a good compliance record and is not facing any substantive requirements related to non-compliance with existing Clean Water Act regulations.

Hazardous Substances Liability for releases and cleanup of hazardous substances is regulated by the federal Comprehensive Environmental Response, Compensation, and Liability Act, among others, and similar state statutes. In a manner sim-ilar -to many other industries and power systems, TVA has generated or used hazardous substances over the years.

TVA is aware of hazardous-substance releases at eleven offsite areas for which it may. have some liability. TVA's potential liabilities for its share of cleanup costs at these sites are uncertain. In addition, TVA operations at some TVA-owned facilities have resulted in releases of oil and/or hazardous substances which require cleanup and/or remedia-tion.

At September 30, 2005, and 2004, TVA's estimated liability for environmental cleanup for those sites for which sufficient information is available to develop an estimate was $28 million and $29 million, respectively, and was includ-ed in OTHER LIABILITIES on the Balance Sheet. However, TVA has insufficient information to develop an estimate for some of the sites.

Legal Proceedings For a discussion of TVA's current legal proceedings and anticipated outcomes,' see "Lega/Proceedings" in Part I.

Page 68

Other Matters j

-Cash Balance Benefit Plans -.

In 2005, pension plan reform bills applicable to qualified defined benefit plans were introduced in the House and Senate. The reform bills would amend ERISAancl Section 412 of the Internal Revenue Code to provide new min-imum funding rules for defined benefit plans. The Senate's version of the bill has also included several versions of a provision that would approve either prospectively or retroactively hybrid plans, such as cash balance plans, provided that certain conditions and conversion requirements have been met.

' The outcome of any pension plan reform legislation cannot be predicted at this time. The TVARS defined ben-efit plans, as other governmental plans, are not subject to the minimum funding rules under ERISA and Section 412 of the Internal Revenue Code, and it is unclear whether such legislation would have any effect on the TVARS defined benefit plans, generally, or the TVARS cash balance benefit plan, specifically.

FERC Interconnect Order On October1, 2004, East Kentucky Power Cooperative ("EKPC") filed an application with the Federal Energy Regulatory Commission ("FERC") ostensibly seeking an order requiring EKPC to be interconnected with TVA's trans-mission system at several locations. If these interconnections are granted, EKPC would be able to use TVA's trans-mission system to provide power to Warren Rural Electric Cooperative Corporation ("WRECC") when WRECC's con-tract with TVA terminates in April 2008. TVA submitted a response to FERC stating that if FERC grants the requested relief, the actual effect would be to require TVA to provide free transmission service across TVA's transmission system in violation of the Anti-Cherrypicking Provision of the Federal Power Act. On April 13, 2005, FERC issued a proposed order granting EKPC's application. The parties tried without success to resolve their differences.

On August 3, 2005, FERC issued an order for TVA to interconnect with EKPC and to provide EKPC with coor-dination services necessary to deliver energy to WRECC. The order recognized that TVA is entitled to be compensat-ed for the use of the TVA system caused by the interconnections and asked TVA to file a new agreement within 30 days, covering the terms, conditions and rates TVA believes it should receive for this use. TVA filed a proposed agree-ment as requested by FERC. FERC has not issued a final order. After FERC issues a final order, TV'A can request a rehearing and ultimately appeal to the Court of Appeals.

Organizational Structure Changes;.i)

On September 20, 2005, TVA announced changes in its organizational structure to prepare for the transition to a new governance structure at TVA and to assist in adapting to a changing legislative environment: while working to improve its competitive position. The changes are as follows:

,Effective as of September 20,2005, all Board Services functions and the Government Alfairs office based in Washington, D.C., began reporting wo Maureen H. Dunn, Executive Vice President and General Counsel.

i Also 6ffective'as of September 20,;2005, the Administrative Services organization wes created, which reports to John E. Long, Jr., Executive'Vice President, Administrative Services. Administrative Services consolidates Facilities Management, Information Services, Procurement, Admiriistration Business Services, TVA Police, Enterprise Performance and Analysis, Employee Relations and Diversity, and Human Resources.

i.-.!

r'

Effective as of October 31, 2005,' Bulk Power Trading will report to W. Terry Boston, Executi'e Vice

..President, Power System Operations.

Also during 2bo5, TVA made additional organizational changes:.

Theresa Flaim, Senior Vice President, Strategic Planning and Analysis, was named.Senior Vice President, Pricing and Strategic Planning. In the new role, Ms. Flaim will continue to direct TVA's strate-gic planning efforts reporting in this regard directly to TVA's President and.Chief Operating Officer, and she will lead the Contracts and Pricing organization in.CustomerService and Marketing, reporting in this regard to Kenneth R. Breeden, TVA' Executive Vice.President, Customer Service and Marketing.

Page 69

TVA's Power Resources and Operations Planning organization was restructured and the functions reas-signed to existing TVA organizations. The Senior Vice President, Power Resources and Operations Planning, Jack A. Bailey, was selected to lead TVA's Nuclear Asset Recovery and Strategic Projects organization in TVA Nuclear.

Subsequent Events Debt Securities In October 2005, TVA issued $27 million of electronotese with an interest rate of 5.00 percent which mature in 2015.

In November 2005, TVA issued $11 million of electronotese with an interest rate of 5.5 percent which mature in 2020 and are callable in 2008.

On October 2, 2005, TVA redeemed at par five bonds in the TVA electronotesO series. The bonds TVA redeemed are all of its 2001 6.35 percent electronotese due June 15, 2021, with a par amount of $28 million, all of its 2001 6.10 percent electronotese due August 15, 2021, with a par amount of $23 million, all of its 2002 6.00 percent electronotes' due May 15, 2017, with a par amount of $40 million, all of its 2003 5.50 percent electronotes" due August 15, 2018, with a par amount of $43 million, and all of its 2003 5.625 percent electronotese due October 15, 2023, with a par amount of $14 million.

Legal On November 9, 2005, TVA received two invoices totalling $76 million from Areva for Framatome ANP, Inc, the predecessor of Babock and Wilcox Company ("B&W"). In 1970, TVA and B&W entered into a contract for fuel fab-rication services for the Bellefonte Nuclear Plant. Areva's invoices are based upon its belief that the 1970 contract required TVA to buy more fuel fabrication services from B&W than TVA did. TVA is reviewing Areva's claim.

Management In November 2005, the President of the United States sent to the Senate nominations of five people to serve on the TVA Board. The Senate has not announced when it will consider the nominations. As soon as three new Board members take office, the restructured Board provided for in the Consolidated Appropriations Act, 2005, will take effect.

Forward-Looking Information This Statement contains forward-looking statements relating to future events and future performance. Any statements regarding expectations, beliefs, plans, projections, estimates, objectives, intentions, assumptions, or oth-erwise relating to future events or performance may be forward-looking.

In certain cases, forward-looking statements can be identified by the use of words such as "may," "will,"

"should," 'expect,","anticipate," "believe," 'intend," "project," "plan," "predict," "assume," "forecast," "estimate," "objec-tive," "possible," "potential," or other similar expressions.

Some examples of forward-looking statements include statements regarding strategic objectives; estimates of costs for disposing of certain tangible long-lived assets; expectations about the adequacy of TVA's decommissioning fund; the impact of new accounting pronouncements and interpretations, including Financial Accounting Standards Board ("FASB") Interpretation No. 46, "Consolidation of Variable Interest Entities - an amendment of ARB No. 51,"

which was amended by FASB Interpretation No. 46R, Statement of Financial Accounting Standards No. 151, 'Inventory Costs - an amendment of ARB No. 43, Chapter 4," and FASB Interpretation No. 47, "Accounting for Conditional Asset Retirement Obligations - an interpretation of FASB Statement No. 143;" TVA's plans to continue using short-term debt to meet current obligations; and the anticipated cost and timetable for returning Browns Ferry Unit 1 to service.

Although TVA believes that the assumptions underlying the forward-looking statements are reasonable, TVA does not guarantee the accuracy of these statements. Numerous factors could cause actual results to differ material-ly from those in the forward-looking statements. These factors include, among other things, new laws, regulations, and administrative orders, especially those related to the restructuring of the electric power industry and various environ-mental matters; increased competition among electric utilities; changes to the Anti-Cherrypicking Provision; legal and Page 70

administrative proceedings affecting TVA; the financial and economic environment; performance oc TVA's generation and transmission assets; fuel prices; demand for electricity; changes in technology; changes in the price of power; loss of any significant customers or suppliers; creditworthiness of counterparties; weather conditions and other natural phe-nomena; damage to power production or transmission facilities or systems due to accidental events or terrorist activi-ty; changes in accounting standards; and unforeseeable events. New factors emerge from time to time, and it is not possible for management to predict all such factors or to assess the extent to which any factor or-combination of fac-tors may impact TVA's business or cause results to differ materially from those contained in any forward-looking state-ment.

TVA undertakes no obligation to update any forward-looking statement to reflect developments that occur after the statement is made.

QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK The Enterprise Risk Council ("ERC") was created in August 2005 to strengthen and formalize TVA's enter-prise-wide risk management efforts. The ERC is responsible for the highest level of risk oversight at TVA and is also responsible for communicating enterprise-wide risks with policy implications to the Board or a designated Board com-mittee. Three subordinate risk committees, Financial, Operation, and Strategic, have also been created to manage risks in these areas and report to the ERC.

Through the normal course of its business, TVA does not engage in wholesale trading operations for the pur-poses of speculation. Rather, when necessary in order to balance TVA's load obligation, TVA will engage in some aspects of physical trading. Further, TVA employs commodity-based instruments which include forwards, futures, and option contracts to manage risks associated with market fluctuations in the price and transportation costs of certain commodities and fuels including, but not limited to, coal, natural gas, and electricity.

TVA is exposed to market risks, including changes in interest rates, inflation rates, foreign currency exchange rates in association with TVA bonds, the prices of energy related commodities (electricity, natural cas, and coal), and equity market prices, and losses in the event of counterparties' nonperformance. To manage the volatility attributed to certain of these exposures, TVA has entered into various nontrading derivative transactions, principally an interest rate swap agreement, an inflation swap agreement, foreign currency swap contracts, swaptions, coal contracts, power pur-chase contracts, and natural gas contracts. Additionally, to manage volatility in the emission allowance markets, TVA has obtained options related to S02 and NO. allowances (see note 8-Commodity Contracts). These options expired in 2005. The exposure to losses in the event of the counterparties' nonperformance has been mitigated through con-trols to determine the creditworthiness of counterparties before transactions take place.

Cash Flow at Risk Cash Flow at Risk (CFaR") is the probability that a company will meet its cash flow targets. At TVA, CFaR is evaluated using a computer model for short-term and a separate model for the medium term. The short-term frame-work forecasts one week to reflect operating margins only. A one-year projection is developed to examine enterprise-wide free cash flow.

CFaR is calculated based on the simulation of future financial statements, taking as its input the projected values of the financial prices relevant to TVA. Its purpose is to build a probabilistic picture of the impact of various risks on the cash flow in much the same way as Value at Risk ("VaR") is used to find the probability of losses on a portfolio of assets. TVA measures the operating margin portion of CFaR on a weekly basis.

At the beginning of 2006, TVA estimated its expected annual 2006 free cash flow available to pay down its financing obligations. This value includes not only short-term operating margins but also costs associated with capi-tal investments and financing agreements. Based on data available at the end of September 2005, TVA expects that its 2006 total enterprise free cash flow could range between $(188) million and $598 million. This range reflects mod-eling results for the tenth percentile and ninetieth percentile in free cash flow. Estimated enterprise Cash Flow at Risk for 2006 is $545 million.

TVA manages its daily cash needs through issuance of Discount Notes and other short-term borrowings.

These borrowings expose TVA to fluctuations in short-term interest rates. A near-term one percentage point change in interest rates would not have a material impact on TVA's financial position or results of operations.

Page 71

Value at Risk

-..The commodity market risk exposure is measured through TVA's VaR calculation. VaR is a single summary statistic of possible portfolio losses due to normal market movements for a given confidence level over a selected peri-od of time. TVA measures VaR on a daily basis. TVA's VaR exposure for the electricity, natural gas, and other com-modities in which TVA has market positions, assuming a ten-day holding period and a one-day holding period,. is described below:

Electricity Electricity Value at Risk Associated with Energy Trading Contracts and Related Energy Derivative Contracts For the Year Ended September 30, 2005 Company Wide VaR (in millions) 95% Confidence level, ten-day holding period, two-tailed For the year ended September 30, 2005.................................................

$ 57.83 Average for the period.........3..................................................................

39.44 High ;.........

..'.68.00 Low.

20.25 L

99% Confidence level, one-day holding period, two-tailed For the year ended September 30, 2005...........................

23.59 Average for the period.....

a:.:.:.:.:.

16.09 High.:................

27.74 Low............................................................i................:.....;..;..........-

82 Low....

I i

8.26 Notes:

The VaR calculations are for the TVA 5x16 electricity portfolio for 2005. The calculations' are for the rolling forward 12-month portfolio.

The VaR method used is the parametric variance/covariance method accepted as an industry standard.

From the table above, given a 95 percent confidence level at September 30, 2005, there is a 2.5 percent probability TVA's electricity portfolio could lose more than $57.83 million over the next ten days. The average VaR for the entire year for the ten-day holding period is $39.44 mil-lion. Further, given a 99 percent confidence level at September 30, 2005, there is a 0.5 percent probability that TVA's electricity portfolio could lose more than $23.59 million over the next day. The average VaR for the entire year for the one-day holding period is $16.09 million.

. ~~

~

Back-testing of the VaR calculation is done using a statistical procedure called the chi-square test. -TVA per-forms back-tests of the actual daily Mark-to-Market ("MTM") fluctuations for three-month, six-month, and 12-month periods. The chi-square test measures how well the'actual distribution of mark-to-market fluctuations matches the ideal distribution. The chi-square value for the period is within the selected significance level indicating a valid VaR calculation.'

TVA has no merchant capacity assets or transactions which expose TVA to market risk. TVA does have long-term transactions, the energy supplied under which will serve native load requirements (see note 12-Commitments Power Purchase Obligations). The market risk associated with the structure of these transactions is captured in the VaR estimates above.

• As indicated by the following chart, TVA's average electricity market risk exposure decreased from 2001 to 2003 and then increased from 2003 to 2005. The increase is largely due to'increased volatility in the electricity mar-kets and the increased consistency of TVAs short 'position due to load growth.'

_ ~ ~~~~~

L' j-*-'

q I-Page 72

Electricity VaR

$80.00 (95% 10-Day Holding Period)

-*Low-Average.

$60.00

-- Hg 30-Sep

$20.00

$0.00 2001

22.

2003 2004 2005 Year Natural Gas Natural Gas Value at Risk Associated with Energy Trading Contracts and Related Energy Derivative Contracts For the Year Ended September,30,,2005 95% Confidence level, ten;-day' holding pleriod, two-tIe '

(i mlios

'For the year ended September 30, 2005...............

27.90 Average for the period;---......................................14.34 High---.....................................................30.02 Low---.....................................................6.45 99% Confidence level, one-day holding period, two-tailed

For the year ended September 30, 2005..

I.

1.8 Average for the period..:.........................................5.85 H igh 12.25 Low---.........................................................

2.63. -

Notes:

The VaR calculations are for the TVA natural gas portfolio for 2005. The calculations are for the rolling forward 12-month portfolio. The VaR method used is the parametric variance/covariance method accepted as an industry standard.

Back-testing of the VaR calculation is done using a statistical procedure called the chi-sq6wre test., TVA performs' back-tests of the actual daily MTM profit and loss fluctuations for three-month, six-month, ani 12-month periods. The chi-square value for the pericdl is within the select-ed significance level indicating a valid VaR calculation.

Page 73

The historical performance of TVA's natufral gas VaR calculation is represented in the following graph:

I Natural Gas VaR

$40.00 (95% 10-Day Holding Period)

$30.008/

.2

$20.00

$10.00 Low

-Average

-+-High

-030-Sep

$0.00 2001 2002 2003 2004 2005 Year TVA has tracked natural gas VaR exposure since 2001. 'As shown in the graph above, the average natural gas VaR decreased from 2001 through 2004, but increased in 2005. This is in large part because TVA's expected nat-ural gas needs have increased. Natural gas demand has increased in large part due to the increase in volume of elec-tricity deals which are indexed to natural gas. TVA has made a strategic decision to replace a large percentage of elec-tricity forwards with purchase power agreements with counterparties that own combined cycle natural gas generators within the Tennessee Valley. These transactions are called natural gas tolling agreements ("Tolls"). Tolls are agree-ments in which TVA purchases the right to generation produced from a given generator provided that TVA supplies the natural gas to run in the counterparty's generator during contractually agreed periods of time.

Fuel Oil TVA purchases fuel oil as a substitute fuel source for TVAs gas turbine fleet. TVA's hedge against market risk for fuel oil is the use of natural gas and is captured in the natural gas VaR. TVA monitors the spread between fuel oil and natural gas for hedging purposes. During 2005, natural gas had a significant advantage over fuel oil for most of the year. Therefore, TVA's fuel oil position was not materially affected by market risk.

Coal TVA's contracts with coal suppliers have specified rates and volumetric flexibility which limit TVA's exposure to market risk. Given TVA's contract mix, TVA is approximately 89 percent hedged to coal market risk exposure through 2006, a nine percent decrease over the previous year. There are two primary contributors to this decrease. First, increases in generation forecasts caused the coal demand to increase for 2006 (Central Appalachian ("CAP") and Illinois Basin ("ILB") are the only coal options available to meet this increase in demand). Second, continued poor per-formance of the western railroad has limited receipts of coal from the Powder River Basin and Colorado. TVA is plan-ning to expand the use of eastern coals such as CAP and ILB to fill this need. Because of issues concerning coal's lack of fungibility and market transparency, TVA does not currently maintain a coal VaR calculation.

Page 74

Sulfur Dioxide (S02) Allowances SO2 Allowance Value at Risk Associated with Energy Trading Contracts and Related Energy Derivative Contracts For the Year Ended September 30, 2005

• 8.<

..Company Wide VaR (in millions) 95% Confidence level, ten-day holding period, two-tailed For the year ended September 30, 2005.

16.34 Average for the period.....................................................

.15.56 High

.37.31 Low............................................................................................................

3.10 99% Confidence level, one-day holding period, two-tailed For the year ended September 30, 2005.......................................

6.67 Average for the period..........................

6.35 High..................

15.22 Low.1.27 Notes:

The VaR calculations are for the TVA S02 allowance portfolio for 2005. The calculations are for the rolling forward nine-year portfolio. The VaR method used is the parametric variance/covariance method accepted as an industry standard.

Back-testing of the VaR calculation is done using a statistical procedure called the chi-square test. TVA performs back-tests of the actual daily MTM profit and loss fluctuations for three-month, six-month, anc 12-month periods. The chi-square test measures how well the actual distri-bution of mark-to-market fluctuations matches the ideal distribution. The chi-square value for the period is within the selected significance level indicating a valid VaR calculation.

Nitrogen Oxides (NO.) Allowances NO. Allowance Value at Risk Associated with Energy Trading Contracts and Related Energy Derivative Contracts For the Year Ended September 30, 2005

,Cormrany Wide VaR (in million.)

95% Confidence level, ten-day holding period, two-tailed For the year ended September 30, 2005.$

6.58 Average for the period..............

10.36 High....

22.09 Hi h

................................................................;.....\\..................................2.0 Low.5.22 99% Confidence level, one-day holding period, two-tailed For the year ended September 30, 2005.$

2.69 Average for the period..............................................................................

4.23 High

.9.01 Low

.2.13 Notes:

The VaR calculations are for the TVA NO. allowance portfolio for 2005. The calculations are for the rolling forward nine-year portfolio. The VaR method used is the parametric variance/covariance methoc accepted as an industry standard.

Back-testing of the VaR calculation is done using a statistical procedure called the chi-square test. TVA performs back-tests of the actual daily MTM fluctuations for three-month, six-month, and 12-month periods. The chi-square test measures how well the actual distribution of mark-to-market fluctuations matches the ideal distribution. The chi-square value for the period is within the selected significance level indi-cating a valid VaR calculation.

Page 75

Mark-to-Market Valuation Sensitivity analyses are performed on a daily and weekly basis to determine the market price impact on TVA's electricity portfolio when the market price moves beyond TVA's projections.

TVA also monitors the mark-to-market ('MTM") fair value of electricity assets in future years. MTM account-ing reports contracts at their 'fair value" (the value a willing third party would pay for the particular contract at the time a valuation is made). These transactions include, but are not limited to, native system load contracts, energy forwards, energy options, and other energy derivative instruments for unit specific generation units: Due to the public service nature of its business, TVA historically values its resource positions for at least the year ahead. TVA values certain of its resource positions further in the future as necessary.

When available, quoted market prices are used to record a contract's fair value. However, market values for energy trading contracts may not be readily determinable because the duration of the contracts exceeds the liquid activity in a particular market. If no active trading market exists for a commodity, holders of these contracts must cal-culate fair value using pricing models based on contracts with similar terms and risks.

Based on September 30, 2005, closing prices, the MTM value of TVA's electricity portfolio for 2006 is $3.6 billion. The fair value calculation determines a profit or loss for each source of fair value, e.g. load, based on market prices. Market prices for electricity have a small impact on TVA margins because only a small portion of TVA's ener-gy needs are bought or sold in the market.

Credit Risk, Credit risk is the exposure to economic loss that would occur as a result of a counterparty's nonperformance of its contractual obligations.

The majority of TVA's credit risk is limited to trade accounts receivable from delivered power sales to munic-ipal and cooperative distributors, all located in the seven-state Tennessee Valley region. To a lesser extent, TVA is exposed to credit risk from industries and federal agencies directly served and from exchange power arrangements with a small number of investor-owned regional utilities related to either delivered power or the replacement of open positions of longer-term purchased power or fuel agreements.i Where exposed to credit risk, TVA analyzes the counterparty's financial condition prior to entering into an agreement, establishes credit limits, monitors the appropriateness of those limits on an ongoing basis, and employs credit mitigation measures, such as collateral or prepayment arrangements and master purchase and sale agree-ments, to mitigate credit risk.

The table below summarizes TVA's counterparty credit risk exposure as of September 30, 2005:

Page 76

Counterparty Credit Risk Exposure :

b (in millions)

A n

Trade Accounts Receivable: -

Municipalities & Cooperative Distributors,.,

Investment Grade.....................

.... $ 659 9 Internally Rated -

Investment Grade 369 Industries & Federal Agencies Directly Served Investment Grade.

30 Non-investment Grade 25 Internally Rated -

Investment Grade. :.....

.6 Internally Rated -,Non-investment Grade 7

Exchange PowerArrangements Investment Grade................

10 Non-investment Grade................

Internally Rated-Investment Grade.................................. '

3 Internally Rated -

Non-investment Grade 1

Subtotal.....

* ::v*

1,110 Other Accounts Receivable:

Miscellaneous Accounts..............

42 Provision for Uncollectible Accounts;.

(7)

Subtotal 35 Tota I

$ 1,145 Notes:

(1),Includes unbilled power receivables of $786 million.

(2) Includes receivable of $17 million from one customer rated "B2" by Moody's Investor Service and 'B-by Standard and Poor's.

TVA has concentratioos of accounts receivable from seven customers that represented 35.9 percent oftotal accounts receivable as of September 30,2005. '

p o t accounts Rating Triggers In the normal course of business,;TVA enter; into physical 'and financial contracts, some of which contain rat-ing triggers. Under most of these rating'triggers, the amount of the collateral that TVA would have to post under cer-tain circumstances would increase if TVA's credit rating were downgraded. So long as TVA maintains an investment grade credit rating,-the requirement to post collateral under these contracts, if triggered, would not have a material effect on TVA's financial condition.

4..I Derivatives,,

I.

To manage the volatility attributable to its various risk exposures, TVA has entered into various nontrading derivative transactions. TVA risk management policies provide for the use of derivative financial instruments to man-age financial exposures but prohibit the use of these instruments for speculative trading purposes. TVA accounts for these derivative instruments in accordance with the provisions of SFAS No. 133, `Accountirng. for Derivative Instruments and Hedging Activities," as amended by SFAS No. 138, 'Accounting for Certain Derivative Instruments and Certain Hedging Activities," and SFAS No. 149, 'Amendment of Statement 133 on Derivative Instruments and Hedging Activities." '

Derivative contracts utilized bVTVA include currency, inflation, and interest rate swap agreements, swaptions, futures contracts, and option contracts on various coal and electricity commodities. An inflation sw'ap'is used to hedge TVA's exposure related'to its inflation-indexed accreting principal bonds, and currency swap cont acts are used as hedges for foreign currency denominated debt issues (see note 8 -

Foreign Currency, Interest Rate, and Inflation Swaps). Based on TVA's overall interest rate exposure at September 30, 2005, including derivative and other interest rate sensitive instruments, a near-term one percentage point change in interest rates would not have a material impact on TVA's financial condition.

Forward Contracts Kr-TVA enters into electricity forward contracts for the sole purpose of limiting or otherwise hedging its econom-ic risks directly associated with meeting its power supply obligations in the Tennessee Valley region. During 2005, TVA supplied approximately 2.1 percent of system requirements with power purchased under electricity forward contracts.

Page 77

These contracts qualify for normal purchase and normal sale accounting under SFAS No. 133, as interpreted by DIG Issue C1 5 (see "Management's Discussion and Analysis of Financial Condition and Results of Operations"- "Critical Accounting Policies and Estimates"- "Normal Purchases and Normal Sales Special Exemption"). At September 30, 2005, management does not anticipate a materially adverse effect on TVA's financial position or results of operations as a result of electricity market fluctuations.

Financial Trading Program A financial trading pilot program to reduce TVA's economic risk exposure associated with TVA's physical elec-tricity generation, purchases, and sales was approved by the Board on September 11, 2003 ("Pilot Program"). Under the Pilot Program, TVA was authorized to use futures and options on futures to hedge economic risks directly associ-ated with the cost of natural gas and fuel oil for TVA's power generation operations and risks under power purchase or sale arrangements where the energy price varies based upon a fuel index.

The Pilot Program was scheduled to end on August 31, 2005, but on May 17, 2005, the Board established a permanent financial trading program ("Program" and, together with the Pilot Program, "Programs") that allows TVA to:

(1) continue to hedge the risks authorized under the Pilot Program; (2) broaden the type of risks that TVA can hedge to include economic risks directly associated with both the cost of natural gas for tolling agreements and the purchase or sale arrangements where the energy price is based at least in part upon a fuel price index or proxy; and (3) hedge risks more effectively by using swaps and options on swaps in addition to futures and options on futures. Trading is not authorized for speculative purposes under this Program. See note 8 -

Financial Trading Program.

At September 30, 2005, TWA had 112 derivative positions outstanding under the Program. The Programs have enabled TVA to effectively-hedge the price risk associated with a portion of its natural gas and power purchases.

TVA recognized unrealized gains of approximately $0.5 million which were included as an offset to purchased power expense-for the year ended September 30, 2005. The same year also produced realized gains of about $3.3 million which were included as an offset to pu'rchased power expense: The gains on the positions were less than eight per-cent of the total natural gas expense for the period.

Financial Trading Program Activity

'For the Year ended September 30

2005.

2004 Notional Notional Amount Contract Amount Contract (in mmBtu)

Value (in mm8tu)

Value Futures contracts Financial positions at beginning of period 7

Purchased.

j.4,370,000 33.2 1,250,000 8.0 Sold (3,490,000)

(26.9)

(1,250,000)

(7.0)

Realized gains (losses) 3.3 (1.0)

Net positions-long 880,000 9.6 Options contracts ;

c Financial positions at beginning of period Calls purchased 580,000 0.6 Calls and puts sold e

• 980,000 (0.6) 7 Positions closed or expired l

(1,320,000).

Net positions-long 240,000 Holding gains (losses)

- Unrealized gain at beginning of period, net Unrealized gain for the period-.

0.5 Unrealized gains at end of period, net 0.5 Financial positions at end of period, net 1,120,000 10.1 Page 78

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA'-

TENNESSEE VALLEY AUTHORITY STATEMENTS OF INCOME For the years ended September 30 (in millions)

- nnn 2

.2004 Operating revenues Sales of electricity Municipalities and cooperatives.

Industries directly served.......................................

Federal agencies and other Other revenue...............

Total operating revenues.

Operating expenses Fuel and purchased power.............................-

Operating and maintenance........................................

Depreciation and accretion..................

Tax-equivalents.........

Loss on asset impairment/project cancellation.........................

Total operating expenses...........................................

Operating income..............................................

Other income, net...............................................

$ 6,5

.91 11 7,7' 2,6 2,3 1,1 3!

6,5i 1,2' 61

$ 6,457 62 842 81 140 90

.94 94 7,533 01 2,081 59 2,319 54 1,115

65.

338 24 20 i3 5,873 91 1,660 33 37 3

(7) 2003 5,974

781, 120 78 6,953 1,957 2 039 1,073

329, 5 5,398 1,555 29 (7)

Unrealized gains (losses) on derivative contracts, net...................

1. e

'I i, ' ~.

` !!+,

Interest expense a

Interest on debt..........

1,337 1,379 1,396 Amortization of debt discount, issue, and reacquisition costs, net 21 24 28 Allowance for funds used during construction (116)

(99)

(74)

Net interest expense 1,242; 304j '

1,350 Income before cumulative effects of accounting changes.......

.85, 386 227 Cumulative effect of change in accounting for unbilled revenue.-

412 Cumulative effect of change in accounting for asset retirement obligations.......

(195);

Net Income

'.$.85 386!

444.

The accompanying notes are Ein integral part of these financial statements.

11 I,

, 1.

I I I

-~

I I

Page 79

TENNESSEE VALLEY AUTHORITY ;

BALANCE SHEETS At September 30 (in millions) _

~ASSETS I.;

II

.. 2005 Current assets Cash and cash equivalents...................

Restricted cash and investments (note-1)

Short-term investments, net......................:

Accounts receivable, net............................................

Inventories and other (note 1)........................................

Total current assets...................

Property, plant, and equipment (note 3)

Completed plant.......

Less accumulated depreciation........................................

Net completed plant....,................

Construction in progress............................................

Nuclear fuel and capital leases.......................................

Total property, plant, and equipment, net...............................

Investment funds (note 1)...................

Regulatory and other long-term assets (note 5)

Deferred nuclear generating units.

Other regulatory assets Subtotal........................................................

Other long-term assets................

e.............................

Total regulatory and other long-term assets..............................

538 107 1,145 479 2,269 35,215 (14,407)

.20,808 2,643 437 23,888 858 3,912 2,367 6X279 1X272 7,551 2004 519 335 1,034 498 2,386 34,786 (13,424) 21,362 1,923 414

.23,699 744 3,909 2,510 6,419 1,032 7,451

$34,280 761 284 402 35 105

,1,924 2,000 5,511 2,293 600 1,782 1,143 16350 7X168 Total assets..................

34w566 LIABILITIES AND PROPRIETARY CAPITAL Current liabilities Accounts payable...........

Accrued liabilities......

Accrued interest Current portion of lease/leaseback obligations...........................

Current portion of energy prepayment obligations.........................

Short-term debt, net......................................

Current maturities of long-term debt, net (note 9)...........................

Total current liabilities.............................................

Other liabilities Other liabilities....... :

Regulatory liabilities (note 5).........................................

Asset retirement obligations.............................................

Lease/leaseback obligations...........................

Energy prepayment obligations (note 1)................................

Total other liabilities................................................

860

.274,

380 35 106 2,469.

-'2,693 6,817

.I r

2,500 897

.1,857 1,108 1,244 7,606 Long-term debt, net (note 9)........................................

Total liabilities....................................................

d Commitments and contingencies (note 12)

Proprietary capital Appropriation investment............................................

Retained earnings.................................................

Accumulated other comprehensive income (loss).........................

Accumulated net expense of nonpower programs........................

Total proprietary capital.............................................

17,751 32,174 4,783 1,244 27 (3,662) 2,332 19,337 32,016 4,803 1,162 (52)

(3,649) 2,264

$ 34,280 Total liabilities and proprietary capital.....

$ 34,566 The accompanying notes are an integral part of these financial statements.

Page 80

TENNESSEE VALLEY AUTHORITY ;

I ~ STATEMENTS OF CASH FLOWS

i For the years ended September 30 (in millions),

2005 Cash flows from operating activities Net income..

85 Items not requiring (providing) cash Depreciation, amortization, and accretion 1,280 Allowance for funds used during construction.........

(116)

Nuclear fuel amortization 131 Loss on asset impairment/project cancellation 24 Cumulative effects of accounting changes.

Other, net 188 Changes in current assets and liabilities Accounts receivable, net (112)

Inventories and other current assets...........

(12)

Accounts payable and accrued liabilities..........

77 Accrued interest....................

(22)

Proceeds from energy prepayments...........................

Refueling outage costs (122)

Other...................................................

(55)

Net cash provided by operating activities.

1,346 2004 2003 386 444 1,239 1,140 (99)

(74) 132 127 20 (217) 132 10i (41) 78 10 (65) 26 149 (5) 2 1,504 51 (86)

(93)

(27)

(14) 3,191 1,629 Cash flows from Investing activities Construction expenditures

.(1,338)

Proceeds from project cancellation settlement (note 1)...........

Allowance for funds used during construction...............

116 Nuclear fuel expenditures.

(141)

Investments Short-term investments, net.........................

335 Change in restricted cash and investments (107)

Purchases.

1 Loans and other receivables Advances (12)

Repayments 18 Proceeds from sale of loans (note 1)...

....:' '*i- -55' Other, net Net cash used in investing activities

.(1,072)

I.

. I.....

(1,552)

(1693 15 '

99**

74 j(119)

(187)

(68)

(118)

Cash flows from financing activities Long-term debt Issues...............................................

Redemptions and repurchases............................

Short-term borrowings (redemptions), net.....................

Proceeds from call monetizations............................

Proceeds from equipment financing..........................

Proceeds from combustion turbine financing...................

Bond premium received...................................

Proceeds from swap receivable monetization...................

Payments on lease/leaseback financing.......................

Payments on equipment financing...........................

Financing costs, net......................................

Payments to U.S. Treasury.................................

Net cash (used in) provided by financing activities.................

1,650 (2,368) 546 5

(29)

(6)

(17)

(36)

(255)

(17) 22 1

(1,619) 772 (2,251)

(157) 97 55 (32)

(29)

(3)

(38)

(1,586)

(14) 533 519 (33) 24 (9)

(1,942) 2,309 (1,285)

(1,412) 256 389 325 (36)

(58)

(42) 446 133 400 533 Net change in cash and cash equivalents........................

19 Cash and cash equivalents at beginning of period.................

519 Cash and cash equivalents at end of period.......

538 The accompanying notes are an integral part of these financial statements.

Page 81

TENNESSEE VALLEY AUTHORITY STATEMENTS OF CHANGES IN PROPRIETARY CAPITAL For the years ended September 30 (in millions)

Accumulated Accumulated Other Net Expense Balance at S eptember 30, 2002..

Net income (loss).............

Return on appropriation investment......

Other comprehensive income (note 7)......

Return of appropriation investment......

Balance at September 30, 2003........

Net income (loss)....

Return on appropriation investment......

Other comprehensive income (note 7).

Return of appropriation investment.......

Balance at September 30, 2004.......

Net income (loss)........

Return on appropriation investment..

Other comprehensive income (note 7).

Return of appropriation investment.

Approp6i, Investm 4,8, ation Retained ient Earnings 43 349 456 (22)

Comprehensive of Nonpower

Comprehensive (Loss)/Income Programs Total Income (150)

(3,626) 1,416 (12) 444 444 (22);.

76 76 76-(20 (20) 4,823 783 397 (18)

(20).

(74) 22 (3.638) 1,894 (11) 386

'(18) 22 (20) 520 386 22 4,803 S

1,162 (52) 98 (16) 79 (20)

(3,649) 2,264 (13)

.85 (16)

!79 (20) 408 85 79 Balance at September 30, 2005.$

4.783 1,

22

, - 2 1

1,244 27 r$

(3,662).

. 2,392.

164 e

.p n e

. I e f

t The accompanying notes are an integral part of these financial statements. -

r ;,

.~ ~~~

~

~

I.

i A;I I

Jj

~

I,

.I I

I, I

I

( !

I Page 82

NOTES TO FINANCIAL STATEMENTS (Dollars in millions except wliere noted) l

1. Summary of Significant Accounting Policies General TVA is a wholly owned corporate agency and instrumentality of the United States. It was established by the Tennessee Valley Authority Act of 1933, as amended, 16 U.S.C. §§ 831-831ee (2000 and Supp. II 2002) (the "Act" or the "TVA Act') with the objective of developing the resources of the Tennessee Valley region in order to strengthen the regional and national economy and the national defense by providing: (1) an ample supply of power within the region, (2) navigable channels and flood control for the Tennessee River system, and (3) agricultural and industrial develop-ment and improved forestry in the region. TVA carries out these regional and national responsibilities in a service area that centers on Tennessee and includes parts of Alabama, Georgia, Kentucky, Mississippi, North Carolina,: and Virginia.

TVA's operations have historically been divided into two types of activities, the power program and the non-power programs. Substantially all TVA revenues and assets are attributable to the power program. The power pro-gram has historically been separate and distinct from the nonpower programs and is required to be self-supporting from power revenues and proceeds from power financings, such as proceeds from the issuance of debt. Although TVA no longer receives congressional appropriations, it is required to make annual payments to the United States Treasury in repayment of, and as a return on, the government's appropriation investment in TVA power facilities. Until 2000, most of the funding for TVA's nonpower programs was provided by congressional appropriations. These programs are now funded largely with power funds. Certain nonpower activities are also funded with various revenues and user fees.

Prior to 2004, TVA presented information separately on its power program and nonpower programs in its financial statements. Because of the change in funding explained above, beginning with the fourth quarter of 2004, TVA began presenting consolidated financial statements which include both power and nonpower activities. See notes 3 and 14 for information related to TVA's power and nonpower programs.

Power rates are established by the TVA Board of Directors ("Board' or."TVA Board") as authorized by the TVA Act. The TVAAct requires TVA to charge rates for power that, among other things, will produce gross revenues suffi-cient to provide funds for operation, maintenance, and administration of its power system; payments to states and counties in lieu of taxes; and debt service on outstanding indebtedness. Rates set by the Board are not subject to review or approval by any state or federal regulatory body. In a future restructured electric power industry, it is possi-ble, however, that the ability of the Board to set TVA's rates as specified in the TVA Act could be adversely affected by legislative changes or by competitive pressures.

TVA prepares its financial statements in conformity with generally accepted accounting principles in the United States of America applied on a consistent basis and, in some cases, TVWA's financial statements reflect amounts based on the best estimates and judgment of management.

Fiscal Year Unless otherwise indicated, years (2005, 2004, etc.) refer to TVA's fiscal years ended September 30.

Cost-Based Regulation Although TVA's power rates are not subject to regulation through a-public-service commission or other simi-lar agency, its Board of Directors is authorized by the TVA Act to maintain and operate the property of TVA and to set binding rates for power sold to its customers in accordance with the provisions of the TVAAct. The rate-setting author-ity vested in the TVA Board by the TVA Act meets the "self-regulated" provisions of SFAS No. 71, 'Accounting for the Effects of Certain Types of Regulation,' and TVA meets the remaining criteria of SFAS No. 71. Accordingly, TVA records certain assets and liabilities that result from the regulated ratemaking process that would not be recorded under generally accepted accounting principles ("GAAP') for non-regulated entities. Regulatory assets generally rep-resent incurred costs that have been deferred because such costs are probable of future recovery in customer rates.

Regulatory liabilities generally represent obligations to make refunds to customers for previous collections for costs that are not likely to be incurred or deferral of gains that will be credited to customers in future periods. Management assesses whether the regulatory assets are probable of future recovery by considering factors such as applicable reg-ulatory changes, potential legislation, and changes in technology. Based on this assessment, management believes the existing regulatory assets are probable of recove y. This determination reflects the current regulatory and political environment and is subject to change in the future. If future recovery of regulatory assets ceases tc be probable, TVA Page 83

could be required to write-off these costs under the provisions of SFAS No. 101, "Regulated Enterprises-Accounting for the Discontinuation of Application of FASB Statement No. 71." Any asset write-offs would be required to be recog-nized in earnings in the period in which regulatory accounting under SFAS No. 71 ceased to apply.

Management Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclo-sure of contingent assets and liabilities at the date of the financial statements and the related amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

Reclassifications i

Certain reclassifications have been made to the 2003 and 2004 financial statements to conform to the 2005 presentation, including reclassification of cash flows associated with short term investments, reclassification of foreign currency translation gains and losses from UNAMORTIZED DISCOUNT AND PREMIUM, NET to SHORT-TERM DEBT, NET and LONG-TERM DEBT, NET and reclassification of certain assets from OTHER LONG-TERM ASSETS and DEFERRED NUCLEAR GENERATING UNITS to OTHER REGULATORY AssETs.

I m

t

'I; ' '. '.. .Ii" Cash flows associated with the net activity of short-term investments were reclassified from 'cash used in operating activities to cash provided by investing activities. The reclassification improved operating cash flows by $68 million and $118 million in 2004 and 2003, respectively, and conversely was an additional use of cash in investing activ-ities on the 2004-and 2003 Statements Cash Flows.

1.-'

Deferred outage costs of $86 million and reacquisition costs of $277 million, previously reported as OTHER DEFERRED CHARGES and capital lease assets of $90 million previously reported as NUCLEAR FUEL and CAPITAL LEASES, increased OTHER REGULATORY ASSETS by $453 million on the September 30, 2004 Balance Sheet.

In addition, DEFERRED NUCLEAR GENERATING UNITS of $3.9 billion on the September 30, 2004 Balance Sheet have been reclassified

,to REGULATORY AND OTHER LONG-TERM ASSETS on the September 30,12004 Balance Sheet.:,

Foreign currency translation losses of $113 million were previously reported as UNAMORTIZED DISCOUNT AND

,OTHER ADJUSTMENTS on the September 30, 2004 Balance Sheet. These losses have been reclassified to LONG-TERM DEBT, NET. ' Capital lease obligations of $122 million previously reported as OTHER LIABILITIES on the-September 30, 2004 Balance Sheet have been reclassified to REGULATORY LIABILITIES.

These reclassifications had no effect on previously reported results of operations and net cash flows.

Cash and Cash Equivalents:..

Cash and cash equivalents include the cash available in TVA's commercial bank accounts and Treasury accounts, as well as short-term securities held for the primary purpose of general liquidity. Such securities mature with-in three months from the original date of issuance.

I I'

i

.4;

.i Restricted Cash and Investments As of September 30, 2005, TVA had $107 million in restricted cash and investments on its balance sheet as

-a result of collateral posted with TVA by a swap counterparty in accordance with certain credit terms included in the swap contract. Due to the uncertainty of the timing of the return of these funds to the counterparty, the funds are report-

-ed in RESTRICTED CASH AND INVESTMENTS and the corresponding. liability is reported in ACCOUNTS. PAYABLE on the

'September 30, 2005, Balance Sheet.

Accounts Receivable a;

1

-Accounts Receivable. Accounts receivable primarily consist of amounts due from customers for power sales.

The table below summarizes the types and amounts of receivables:

A Page 84

At September 30 2005 2004 Power receivables billed 323 288 Power receivables unbilled 787 713 Total power receivables 1,110 1,001 Other receivables 42 41 Allowance for uncollectible accounts (7)

(8)

Net accounts receivable 1,145 1,034 Allowance for Uncollectible Accounts. The allowance for uncollectible accounts reflects TVAJs best estimate of probable losses inherent in the accounts receivable and loans receivable balances., TVA determines the allowance based on known accounts, historical experience, and other currently available evidence including events such as cus-tomer bankruptcy and/or a customer failing to fulfill payment arrangements after 90 days. TVAs corporate credit department is consulted to assess the financial condition of a customer and quality of the accounts. The allowance for doubtful accounts was $7 million and $8 million at September 30, 2005, and 2004, respectively, for accounts receiv-able and $15 million and $14 million at September 30, 2005 and 2004, respectively, for loans receivable.

Inventories Fuel, materials, and supplies. Coal, oil, limestone, tire-based fuel inventories, and materials and supplies inventories are valued using an average unit cost melhod. A new average cost is computed after each transaction and

-inventory issuances are priced at the latest moving weighted average unit cost. At September 30, 2C05, and 2004 WVA had $185 million and $193 million, respectively, in fuel inventories and $283 million and $299 million, respectively, in materials and supplies inventory.

J Allowance for Inventory Obsolescence. TVA reviews supplies and materials inventories by category and usage on a periodic basis. Each category is assigned a probability of becoming obsolete based or, the type of mate-rial and historical usage data. Based on the estimated value of the inventory, WVA adjusts its allowance for inventory obsolescence. The allowance for surplus and obsolete inventory was $36 million at September 30. 2005 and 2004.

Emission.Allowances.

WVA has emission allowances for sulfur dioxide ("SOP) and nitrcgen oxide ('NO.")

which are accounted for as inventory. The average cost of allowances used each month is charged to operating expense based on tons of SO2 and NO. emitted.

Property, Plant, and Equipment, and Depreciation I

Additions to plant are recorded at cost, which includes direct and indirect costs and an allowance for funds used during construction.

The cost of current repairs and minor replacements is charged to operating expense.

Nuclear fuel inventories, which are included in PROFPERTY, PLANT, AND EQUIPMENT, are valued using the average cost method -for raw materials and the specific identification method for nuclear fuel in a reactor. Amoitization of nuclear fuel is calculated on a units-of-production basis and is included in fuel expense. The VA Act requires WA's Board to allocate-the cost of completed multipurpose projects between the power and nonpower programs, subject to the approval of the President of the United States. TVA accounts for its electric properties using the composite conven-tion of accounting. Accordingly, the original cost of p'operty retired, together with removal costs less salvage value, is charged to accumulated depreciation. Depreciation is generally computed on a straight-line basis over the estimated service lives of the various classes of assets. Depreciation expense expressed as a percentage of the average annu-al depreciable completed plant was 3.33 percent for 2005 and 3.32 percent for 2004 and 2003. Depreciation rates (percent) by asset class are as follows:

Page 85

As of September 30 Asset Class Nuclear Coal-Fired Hydro Combustion turbine/diesel generators Transmission Other Blended Low Enriched Uranium Program 2005 3.40 3.53 1.78 4.55 2.52 5.60 2004 2003 3.37 3.51 1.72 4.41 2.53 6.05 3.36 3.48 1.70 4.63 2.53 6.26 1,

I II i I

. I.

7 1

.. I On December 5, 2004, TVA received the first fuel assembly under the Blended Low Enriched Uranium ("BLEU")

fuel program for loading into its Browns Ferry Nuclear Plant Unit 2. The unit ended its most recent refueling outage in April 2005, which initiated the amortization of the costs of the BLEU fuel assemblies to nuclear fuel expense.

The BLEU fuel program is implemented, in part, through agreements with counterparties, including an interagency agreement with DOE to provide raw nuclear fuel materials to be processed into usable fuel for TVA nuclear reactors, and other contracts with third-party nuclear fuel processors under which the nuclear fuel processors, either by themselves or through subcontractors (collectively, "Third Party Fuel Processors"), acquire land, construct facilities, and process the raw materials from DOE into usable fuel for TVA nuclear reactors.

Under the terms of the interagency agreement, DOE supplies off-specification, highly enriched uranium materials to the appropriate Third Party Fuel Processors for processing into usable fuel for TVA. In exchange, DOE will participate to a degree in the savings generated by TVA's use of this blended nuclear fuel product. As of September 30, 2005, TVA proj-ects that DOE's share of savings generated by TVA's use of this blended nuclear fuel product could result in future payments to DOE of as much as $212 million. TVA anticipates these future payments could begin in 2010. However, due to the uncer-tainty of the ultimate fuel cost savings and related payments to DOE under the program, TVA has not accrued an obligation related to such future potential payments. TVA will re-assess the estimated amount and probability of these future potential payments each time a BLEU fuel assembly is loaded into one of TVA's nuclear reactors. The next BLEU fuel reload is cur-rently scheduled for March 2006.

The Third Party Fuel Processors own the conversion and processing facilities and will retain title to all land, prop-erty, plant, and equipment used in the BLEU fuel program. There is no provision for TVAto own or otherwise take title to the facilities, materials, or equipment now or at any time in the future. However, in accordance with the requirements of EITF No. 01-08, 'Determining Whetheran Arrangement Contains a Lease,"and SFAS No. 13, 'Accounting forLeases,"TVA rec-ognized a capital lease asset and corresponding lease obligation related to amounts paid or payable to a Third Party Fuel Processor. Accounting recognition of the capital lease asset and obligation was brought about due to a contract modifica-tion to the pre-existing fuel fabrication contract.

!During the quarter ended March 31, 2005, TVA recorded a capital lease asset of $60 million comprised of $23 mil-lion in pre-recharacterization contract payments and $37 million in post-recharacterization contract payments either paid or payable. Also during the quarter, TVA recorded an initial capital lease obligation of $37 million. This obligation has subse-quently been reduced by $19 million in post-recharacterization principal payments leaving an unpaid capital lease obligation of $18 million at September 30, 2005. Additionally, TVA has recognized asset amortization expense of $9 million and inter-est expense of $2 million related to the capital lease obligation through September 30, 2005.

Investment Funds Investment funds consist primarily of trust funds designated to fund nuclear decommissioning requirements (see note 12-Contingencies -

Decommissioning Costs). Decommissioning funds, which are classified as trading, are invest-ed in portfolios of securities generally designed to earn returns in line with overall equity market performance.

Energy Prepayment Obligations During October 2002, TVA introduced an energy prepayment program, the Discounted Energy Units ("DEU") pro-gram. Under this program, TVA customers purchase DEUs generally in $1 million increments, and each DEU entitles them to a $0.025/kilowatt-hour discount on a specified quantity of firm power over a period of years (five, ten, 15, or 20) for each kilowatt-hour in the prepaid block. The remainder of the price of the kilowatt-hours delivered to the customer is due upon billing.

Page 86

TVA did not offer the DEU program in 2005. Sales for the 2004 program included 5.5 DEUs totalling $5.5 mil-lion over a ten year period and 1.75 DEUs totalling $1.75 million over a five year period. Total sales for the program since inception are $54.5 million., TVA is accounting for the prepayment proceeds as unearned revenue and is report-ing the obligations to deliver power as ENERGY PREPAYMENT OBLIGATIONS and CURRENT PORTION OF ENERGY PREPAYMENT OBLIGATIONS on the September 30, 2005, and 2004 Balance Sheets. TVA recognizes revenue as electricity is deliv-ered to customers, based on the ratio of units of kilowatt-hours delivered to total units of kilowatt-hours under contract.

As of September 30, 2005, nearly $15 million has been applied against power billings on a cumulative basis during the life of the program, of which nearly $6 million was recognized as noncash revenue during 2005 anc 2004.

During 2004, TVA and its largest customer, MLGW, entered into an energy prepayment agreement under which MLGW prepaid TVA $1.5 billion for the future costs of electricity to be delivered by TVA to MLGW over a period of 180 months.

TVA received the $1.5 billion prepayment in December 2003, accounted for the prepayment as unearned revenue, and is reporting the obligation tc deliver power under this arrangement as ENERGY PREPAYMENT OBLIGATIONS and CURRENT PORTION OF ENERGY PREPAYMENT OBLIGATIONS on the September 30, 2005 and 2004 Balance Sheets. TVA expects to recognize approximately $100 million of noncash revenue in each year of the arrangement as electricity is delivered to MLGW based on.the ratio cf units of kilowatt-hours delivered to total units of kilowatt-hours under contract. As of September 30, 2005, over $190 million had been recognized as noncash revenue on a cumu-lative basis during the life of the agreement, $100 million of which was recognized as noncash revenue during 2005 and over $90 million of which was recognized as noncash revenue during 2004.

Insurance Although TVA uses private companies to administer its health-care plans for eligible active and retired employees not covered by Medicare, TVA does not purchase health insurance. Consulting actuaries assist TVA in determining certain liabilities for self-assumed claims. TVA recovers the costs of losses through power rates and through-adjustments to the participants' contributions to their~benefit plans. These liabilities are included in OTHER LIABILITIES on the Balance Sheet.

WTVA purchases nuclear liability insurance, nuclear property, decommissioning, and decontamination insur-ance and nuclear accidental outage insurance. (See note 12 -

Contingencies -

Nuclear Insurance.)

TVA does not currently purchase commercial general liability, auto liability, or workers' co'npensation insur-ance. TVA recovers the costs of losses through power rates. The Federal Employees' Compensation Act governs lia-bility to employees for service-connected injuries.'

'On March 31, 2005, the TVA Board approved the purchase of property and business interruption/outage insurance for its non-nuclear assets.-. TVA implemented the property insurance program on October 1, 2005, and the outage insurance program on November 7, 2005.

On April 25, 2005, the TVA Board approved the purchase of Directors and Officers Liability insurance. This type of insurance provides coverage, subject to the terms and conditions of the policy, for claims against corporate directors and officers for alleged breach of duty while acting in their capacity as a director or officer of TVA. The insur-ance program went into effect on May 20,'2005.

Revenues f

A,

~~~~I;

- s-jA1Sz1-1 Revenues from power sales are recorded as power is delivered to customers.

TVA accrues estimated unbilled revenues for power sales provided to customers for the period of time from the end of the billing cycle to month's end.

Off-system sales are presented in the accompanying Statements of Income as a component of SALES OF ELECTRIcITY-FEDERAL AGENCIES AND OTHER. Off-systern sales are sales of excess power after meetirng TVA native load and direct served requirements.

Sale of Loans.

On December 2, 2004, TVA sold a portfolio of 51 power distributor loans receivable. The portfolio was sold for $55 million without recourse and contained loans with maturities ranging from less than one year to over 34 years.

The principal amount due on the loans at the time of the sale was $57 million. The $2 million loss is reported in OTHER INCOME, NET on the Income Statement for the year ended September 30, 2005.

Page 87

-- :Asset Retirement Obligations

' "i '5 In accordance with the provisions of SFAS No. 143, "Accounting forAsset Retirement Obligations,°TVA rec-ognizes legal obligations associated with the future retirement of certain tangible long-lived assets. TVA only records estimates of such disposal costs at the time the legal obligation arises or costs are actually incurred. See note 4.

Based on new engineering studies performed annually in accordance with NRC requirements, revisions to the amount and timing of certain cash flow estimates of nuclear asset retirement obligations may be made. TVA rec-ognizes as incurred all obligations related to closure and removal of its nuclear units. TVA measures the liability for closure at the present value of the weighted estimated cash flows required to satisfy the related obligation, discount-ed at the credit adjusted rate of interest in effect at the time the liability was actually incurred or originally accrued, and subsequently modified to comply with -the prevailing accounting provisions. Earnings from decommissioning fund investments, amortization of the decommissioning regulatory asset, and interest expense on the decommissioning lia-bility are deferred (see note 12-Contingencies-Decommissioning Costs). Beginning in 2003, TVA evaluated the nature and scope of its decommissioning policy as it relates to all electric'plant. The evaluation was ufsed 'to determine the need for recognition of additional asset retirement obligations as described in SFAS No. 143, Accounting forAsset Retirement Obligations." SFAS No. 143 became effective for TVA iat the beginning of 2003 (see note 4).

Allowance for Funds Used During Construction -

TVA capitalizes an allowance for funds used during construction based on the average rate of TVA's outstand-ing debt. The allowance is applicable to construction in progress, excluding deferred nuclear generating units.

Tax Equivalents The TWAAct requires TVA to make payments to states and local governments where the power operations of the Corporation are conducted and in which TVA has acquired properties previously subject to state and local taxation.

The amount is five percent of gross receipts from the prior year's sale of power, excluding sales or deliveries to other federal agencies and off-system sales with other utilities, with a provision for minimum payments under certain circum-stances.

Project Cancellation In December 2003, TVA was notified that Regenesys Technologies Limited ("RTL") would not proceed with manufacturing of the fuel cells to be installed in the partially completed Regenesys energy storage plant in Columbus, Mississippi. TVA had invested approximately $35 million in the Regenesys project. RTL reimbursed WVA for early ter-mination of the contract in the amount of $15 million, which reduced the net loss to $20 million on the cancellation'of the Regenesys project.

'arnImpairment of Assets' TVA evaluate's-long-lived assets for impairment in accordance with the provisions of SFAS' No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets, "when events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. For long-lived assets to be held and used, TVA bases its evaluation on impairment indicators such as the nature of the assets, the future economic benefit of the assets, any historical or future profitability measurements, and other external market conditions or factors that may be present. If such impairment indicators are present or other factors exist that indicate that the carrying amount of an asset may not be recoverable, TVA determines whether an impairment 'has occurred based on an estimate of 'undiscounted cash flows attributable to the asset, as compared with the carrying value of the asset. If an impairment has occurred, the amount of the impairment recognized is measured as the excess of the asset's carrying value over its fair value. See note6.

Reduction in Workforce During 2004, organizations within TVA performed program and staffing reviews to identify surplus staffing sit-uations. In areas where surplus staffing existed, TVA asked for employees to apply for voluntary resignations begin-ning in February 2004. To the 'extent there were not enough volunteers, TVA conducted an' involuntary Reduction in Force ('RIF"). As of September 30,2005, there were 739 employees impacted by this change -49 employees in 2005 and 690 employees in 2004. As shown in the table below, TVA has recognized total expense in the amount of

'Page 88

$40 million for termination costs incurred through September 30,2005. Payout of benefits occurs as employees retire from TVA. Substantially all affected employees will have retired by the end of 2005, and no further reductions are antic-ipated at this time.

Changes in the associated liability are as fol[ows:

Termination Costs Liability Activity At September 30

- - 2005 2004

,Terminati6n costs liability at October 1 14 Liability incurred 4

36 Actual costs paid (14)

(22)

-Termination costs liability at September 30 4

14 Impact of New Accounting Standards and Interpretations

• . Variable Interest Entities. In January 2003, the Financial Accounting Standards Board ("FASB") published FASB, Interpretation No. 46 ("FIN 46"), Consolidation of Variable Interest Entities-an interpretation of ARB No. 51,"

which was later revised by FIN No..46(R) ("FIN (46R)") in December 2003. The interpretation explains how to identi-fy a variable interest entity ("VIE") and how an enterprise assesses its interests in a VIE to decide v hether to consoli-date that entity. It also clarifies the application of Accounting Research Bulletin ("ARB") No. 51, 'Consolidated Financial Statements," to certain entities in which equity investors do not have the characteristics of a controll ng financial inter-est or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The interpretation applies 1o nonpublic enterprises, and it becomes effective for TVA begin-ning October 1, 2005, for VIEs created on or before December 31, 2003, and immediately for VIEs created after December 31, 2003.

i TVA considered the provisions of FIN 46(R) for application to its lease/leaseback transactions. Under FIN 46(R), TVA would be deemed the primary beneficiary of the variable interest entities created in connection with these transactions and would therefore be required to consolidate the assets and liabilities of these VIEs. TVA has already effectively consolidated these assets and liabilities under the accounting guidance provided by SFAS No. 66 and SFAS No. 98 as described in note 10..

TVA has not identified any material VIEs created or interest in VIEs obtained after December 31,2003, which require consolidation or disclosure under FIN 46(R). TVA continues to assess the existence of any interests in VIEs created on or prior to December 31, 2003, which may or may not be material to its results of operations or financial position, and is still in the process of determining whether it can obtain the financial information necessary to make the assessment.

In March 2005, the FASB released FASB Staff Position ("FSP") FIN 46(R)-5,.Implicit Variable Interests under FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities," which is applicable to both nonpublic and public reporting enterprises. This FSP addresses transactions in which a reporting enterprise has an interest in, or other involvement with, a VIE or potential VIE that is not considered a variable interest, and the reporting enterprise's related party (a non-VIE) has a variable interest in the same entity. This FSPimust be applied in accordance with the FIN 46(R) effective date and transition. At this time, TVA continues the process of evaluating the requirements of this interpretation and does not yet know the impact of its implementation, which may or may not be material to TVA's results of operations or financial position.-

-.. Medicare Prescription Drug, Improvement and Modemization Act of 2003. In December 2C03, the "Medicare Prescription Drug, Improvement and Modernization Act of 2003" became law. The act introduces a prescription drug benefit under Medicare (Part D) as well as a federal subsidy to employers who provide a retiree prescription drug ben-efit that is at least actuarially equivalent to Medicare Part D. Beginning in 2006, Medicare will provide prescription drug coverage under Medicare Part D. After analyzing a number of options available to plan sponsors for integration with the new Medicare Part D, TVA elected to provide an employer-sponsored Part D prescription drug plan ("PDP"), with alternative coverage over and above Medicare standard Part D coverage, for Medicare-eligible retirees who participate in TVA's Medicare supplement. By providing an errployer-sponsored PDP, any.Medicare subsidies will be passed through to retirees in the form of lower participant premiums and should not affect TVA's cost of providing prescription drug coverage.

Page 89

Inventory Costs. In November 2004, the FASB issued SFAS No. 151, 'Inventory Costs-an amendment of ARB No. 43, Chapter 4." This statement amends the guidance in ARB No. 43, Chapter 4, 'Inventory Pricing,'" to clar-ify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage).

The statement requires that those items be recognized as current-period charges. In addition, this statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the pro-duction facilities. This statement will become effective for inventory costs incurred during fiscal years beginning after June 15, 2005, with earlier application permitted. The adoption of SFAS No. 151 is not expected to have a material impact on TVA's results of operations or financial condition.

Exchanges of NonmonetaryAssets. In December 2004, the FASB published SFAS No. 153, "Exchanges of Nonmonetary Assets-an amendment of APB Opinion No. 29," which eliminates the exception to fair value for exchanges of similar productive assets and replaces it with a general exception for exchange transactions that do not have commercial substance-that is, transactions that are not expected to result in significant changes in the cash flows of the reporting entity. This statement is intended to produce financial reporting that more faithfully represents the economics of the transactions. This guidance is effective for fiscal periods beginning after June 15, 2005. The adoption of SFAS No. 153 is not expected to have a material impact on TVA's results of operations or financial condi-tion.

Conditional Asset Retirement Obligations. In March 2005, the FASB issued FIN No. 47, "Accounting for Conditional Asset Retirement Obligations-an interpretation of FASB Statement No. 143." This interpretation clarifies that the term conditional asset retirement obligation ("conditional ARO") as used in SFAS No. 143, 'Accounting for Asset Retirement Obligations," refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity.

Accordingly, an entity is required to recognize a liability for the fair value of a conditional ARO if the fair value of the liability can be reasonably estimated. The fair value of a liability for the conditional ARO should be recognized when incurred. This interpretation also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an ARO. This interpretation is effective-no later than the end of fiscal years ending after December 15, 2005. TVA is evaluating the potential implications of this interpretation for its AROs, which may or may not be materi-al to its financial position or results of operations.

Accounting Changes and Error Corrections. In May 2005, the FASB issued SFAS No. 154, 'Accounting Changes and Error Corrections-a replacement of APB Opinion No. 20 and SFAS No. 3,"which replaces Accounting Principles Board ("APB") Opinion No. 20, "Accounting Changes," and FASB Statement No. 3, 'Reporting Accounting Changes in Interim Financial Statements." This statement applies to all voluntary changes in accounting principles and also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. This statement requires, unless impracticable, retrospective application to prior periods' financial statements of changes in accounting principles. If it is impracticable to determine the period-specific effects of an accounting change on one or more individual prior periods presented, this statement requires that the new accounting principle be applied to the balances of assets and liabilities as of the beginning of the earliest peri-od for which retrospective application is practicable and that a corresponding adjustment be made to the opening bal-ance of retained earnings for that period rather than being reported in an income statement. When it is impracticable to determine the cumulative effect of applying a change in accounting principle to all prior periods, this statement requires that the new accounting principle be applied as if it were adopted prospectively from the earliest date practi-cable. This statement also requires that a change in depreciation, amortization, or depletion method for long-lived, nonfinancial assets be accounted for as a change in accounting estimate effected by a change in accounting princi-ple. The statement will become effective for TVA beginning in 2007 with early adoption permitted for accounting changes and corrections of errors made in fiscal years beginning after the date the statement is issued.

Accounting for Purchases and Sales of Inventory with the Same Counterparty. On September 28, 2005, the EITF ratified Issue No. 04-13, "Accounting for Purchases and Sales of Inventory with the Same Counterparty." This issue relates to companies that sell inventory to another entity in the same line of business from which it also purchas-es inventory. The staff believes that the transition guidance in EITF Issue 04-13 should apply to all contracts entered into after March 15, 2006. The adoption of EITF Issue No. 04-13 beginning in the second quarter of 2006 is not expect-ed to have a material effect on TVA's results of operations or financial position.'

Put and Call Options. In September 2005 the Derivatives Implementation Group of the FASB ("DIG") dis-cussed several issues related to the settlement of a debtor's obligation on the exercise of a call or put option and the exercise only by the debtor of the right to accelerate settlement of a debt with an embedded call option.

DIG Implementation Issue No. B38, "Embedded Derivatives: Evaluation of Net Settlement with Respect to the Settlement Page 90

of a Debt Instrument through Exercise of an Embedded Put Option or Call Option," addresses whether the settlement of a debtor's obligation on exercise of a call or put option meets the net settlement criterion in paragraph 9(a) of SFAS No. 133, as amended. DIG Implementation Issue No. B39, 'Embedded Derivatives: Application of Paragraph 13(b) to Call Options That Are Exercisable Only by the Debtor," addresses'whether or not Paragraph 13(b) of SFAS No. 133, as amended, does not apply to a call option embedded with a debt host if the right to accelerate settlement of the debt can be exercised only by the debtor. The effective date of the implementation guidance in these Issues is the first day of the first fiscal quarter beginning after December 15, 2005.

TVA is evaluating the potential implications of these Issues on its transactions related to future call and put options which may or may not be material to its financial posi-tion or results of operations.

v Accounting Changes.

Effective October 1, 2002, the Board approved a change in the methodology for estimating unbilled revenue from electricity sales. The change in calculating unbillad revenue was from a method using cumulative generation to a method that uses only generation for the current billing period. TVA was able to make this change based on improved metering technology that allows TVA to more accurately capture the number of days power has been gen-erated and transferred to its customers but not yet billed to those customers. Changing to this more accurate estimat-ing methodology resulted in an increase in accounts receivable of $412 million.

On October 1, 2002, TVA adopted SFAS No. 143, "Accounting for Asset Retirement Obligations," which requires the recognition of a liability and capitalization of the associated asset retirement costs as part of the carrying amount of the long-lived asset for legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development, and/or normal operation of long-lived assets. The effect of the adoption of SFAS No. 143 during 2003 included a cumulative effect charge to income of $195 million, a recognition of a correspon-ding additional long-term liability of $734 million, an increase in assets of $745 million, and a recognition of related accumulated depreciation of $206 million.

2. Nuclear Power Program At September 30, 2005, TVA's nuclear power program consisted of nine units--five operating, one in recovery, and three in deferred status (discussed below). The operating and recovery units are in three locations with investments in property, plant and equipment as follows and in the status indicated:

Browns Ferry*

Sequoyah Watts Bar Raw materials Total Operating Units 2

2 1

5 Installed Capacity Completed Construction Fuei (MW)

Plant, Net

in Progress Investment 2,380 2,115 1,439 118 2,442 1,778 28 93 1,270 5,496 111 50 2

98 79 6q,092 9,389 1,578 340 Note Browns Ferry unit 1, a unit in recovery, is discussed below.

Browns Ferry Unit I was taken offline in 1985 for plant modifications and regulatory improvements and will continue to remain in an inoperative status until recovered. In May 2002, the TVA Board initiated activities for the return of Unit 1 to service in order to meet long-term power requirements. The decision was made upon completion of the Detailed Scoping, Estimating and Planning project and the Final Supplemental Environmental Impact Statement, which demonstrated that Unit 1 could be returned to safe operation in a controlled manner and that operating the unit would have no significant, adverse impacts on the environment. TVA has determined that restarting Unit I is the best alter-native currently available among the mix of generation options. It is anticipated the Unit 1 recovery project will add approximately 1,280 megawatts of generation at a cost of approximately $1.8 billion, exclusive of AFUDC and estimat-ed asset retirement obligation. Unit 1 is expected to return to service in 2007. The undepreciated cost of Unit 1 of $24 million is included in net completed plant and is being depreciated as part of the recoverable cost of the plant over the remaining license period. At September 30, 2005, IVA had incurred approximately $1.3 billion of costs, including AFUDC of $102 million, on the restart project, and the project was approximately 70 percent complete.

TVA has three units in deferred status. In 1988, TVA suspended construction activities on Watts Bar Unit 2.

Page 91

Bellefonte Unit 1 and Unit 2 were deferred in 1988 and 1985, respectively. In December 1994, TVA determined that it would not, by itself, complete Bellefonte Unit 1 and Unit 2 and Watts Bar Unit 2 as nuclear plants. The TVA Board deter-mined as of the end of 2001 that the values of some of its existing assets were not appropriate in a competitive mar-ketplace. Certain nuclear assets -

portions of Bellefonte Unit 1 and Unit 2 and Watts Bar Unit 2 in its entirety - were identified as assets for which the estimated cash flows expected to be provided through future rates were less than recorded book values. Consequently, in 2001 TVA revalued these assets downward by $2.2 billion and recognized an impairment loss. In 2004, it was determined that certain assets at the Bellefonte site, such as the diesel generators, training facilities, transmission structures, and other assets, had achieved a usable state. Consequently, during 2004, the Board approved the reclassification of approximately $203 million of Bellefonte assets from DEFERRED NUCLEAR GENERATING UNITS to COMPLETED PLANT. In July 2005, the Board approved the amortization of TVA's remaining invest-ment in the deferred generating units at Bellefonte Nuclear Plant over a ten-year period beginning in 2006 (see note 1--Cost-Based Regulation). The Board action to begin amortizing the investment of the $3.9 billion deferred nuclear generating units at Bellefonte Nuclear Plant will not limit TVA's ability to use the Bellefonte site in the future; In September 2005, NuStart Development LLC ("NuStart"), of which TVA is a member, selected Bellefonte as one of the two potential sites in the country for a new advanced design nuclear plant. Although neither TVA nor NuStart has decided to build an advanced nuclear reactor at this time, NuStart does intend to seek combined construction and operating licenses for the site for the new Advanced Passive 1000 reactor design by Westinghouse Electric Co. The combined operating license-approach allows the applicant to seek both a construction permit and an operating license at the front end to help ensure greater certainty of the outcome, so long as the applicant closely builds what is described in the application. TVA also recently led a team which prepared a cost and schedule study on building an Advanced Boiling Water Reactor ("ABWR") on the Bellefonte site. Other members of the team, operating under the DOE's Nuclear Power'2010 program, include Toshiba Corp., General Electric Corp., Bechtel Corp., USEC, and Global Nuclear Fuels'- Americas., The ABWR has been design-certified in the United States by the Nuclear Regulatory Commission ('NRC"). The study was designed to verify the costs of building a new ABWR plant, which could provide another option for utilities interested in preserving the nuclear option for the future.

In December 2003, TVA submitted an application to the NRC for a 20-year extension of the operating licens-es for three reactors at Browns Ferry Nuclear Plant. Current expiration dates of the operating licenses for the Browns Ferry units are:

Browns Ferry Unit 1 2013 Browns Ferry Unit 2 2014 Browns Ferry Unit 3 2016 The original 40-year term on licenses per the Atomic Energy Act and the NRC regulations was based on eco-nomic and antitrust considerations and not based on limitations of technology. If the NRC approves the application, it will allow TVA to continue production of power from the facility until 2033, 2034, and 2036 for units 1, 2, and 3, respec-tively.

Page 92

3. Completed Plant Completed plant consists of the following at September 30:

2005 2004 Accumulated

Accumulated*-

-Cost Depreciation Net Cost Depreciation Net Power Program Fossil

$ 10,164

$ 4,912

$ 5,252

$ 9,869 4,614

$ 5,255.

Combustion Turbine 1,176 447

. 729 1,171 393

. 778 Nuclear 15,517 6,128 9,389 15,441 5,623 9,818 Transmission 4,227 1,512 2,715 4,165 1,422 2,743 Hydro 1,861 648 1,213 1,823 616 1,207 Other 1,264 426 838 1,306 429 877 Total Power 34,209 14,073 20,136 33,775 13,097

• 20,678 Nonpower Program Multipurpose Dams

.962 326 636 963 318 645 Other

44.

8, 36 48 9

39 Total Nonpower 1,006 334 672 1,011 327 684

' Total

$ 35,215

$ 14,407

$ 20,808

$ 34,786

$ 13,424

$ 21,362

4. Asset Retirement Obligations Effective October 1, 2002, TVA adopted SFA0 No. 143, 'Accounting forAsset Retirement Obligations, "which requires the recognition of a liability, and capitalization of the associated asset retirement cost as part of the carrying amount of the long-lived asset, for legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development, and/or normal operation of long-lived assets. TVA identified and reviewed all relevant information in the determination of its potential asset retirement obligations ("AROs"). TVA identified three categories of AROs which represent legal obligations of TVA under the requirements set forth in the standard. Costs associated with retirement of coal-fir6d (including ash/waste ponds) and gas/oil turbine generating plants are being expensed as period costs while costs associated with retirement of nuclear generating plants are receiving SFAS No.

71, 'Accounting for the Effects of Certain Types of Regulation," treatment based on the partially funied status of the nuclear decommissioning obligation (see note 1-Ccost-Based Regulation).

Nuclear Generating Plants. Prior to implementing SFAS No. 143, TVA had recognized a decommissioning liability related to its nuclear generating plants in accordance with NRC requirements. The adoption of SFAS No. 143 resulted in a change in the methodology of quantifying this nuclear decommissioning obligation in accordance with the new accounting standard. TVA has increased the nuclear decommissioning liability on the balance slieet to reflect the new methodology but has retained its regulatory accounting treatment of capturing all changes in the liability, invest-ment funds, and certain other deferred charges as changes in the regulatory asset instead of recording these items on the income statement. This nuclear decommissioning liability is reported as ASSET RETIREMENT OULIGATJONs on the 2005 and 2004 Balance Sheets.

Coal-Fired Generating Plants. The activities associated with coal plant retirement include plant shutdown, securing the physical property, closure of storage and/or waste areas (including.ash/waste ponds), maintenance of stack lights, security patrols, and measures to contain asbestos and other hazardous materials from release into the environment. The estimated costs of these activities have been included in the calculation of TVA's coal plant AROs.

Certain ash ponds and waste areas have estimated useful lives that are independent of the lives of the coal plants themselves. Accordingly, these specific ash/waste pond areas were quantified as separate AROs based on their spe-cific estimated useful lives.

Gas/Oil Turbine Generating Plants. The activities associated with gas and oil turbine plant retirement include annual operating costs for site security, lighting, powerhouse and grounds maintenance, containment of asbestos, paint, and other materials, and groundwater monitoring. The estimated costs of these activities have been identified to be included in the calculation of TVA's combustion turbine plant AROs.

Page 93

For each ARO identified, TVA calculated the net present value of the obligation as of the current period, the original and incremental cost of the long-lived asset at the time of initial operation, the cumulative effect of deprecia-tion on the adjusted asset base, and accretion of the liability from the date of initial operation to the current period.

In September 2004, an additional ARO layer was added to the gas/oil turbine plants ARO category due to cer-tain assets placed in service. The result was an increase in the original cost of the gas/oil assets of $0.7 million and a corresponding increase in the gas/oil retirement obligation of $3.9 million at September 30, 2004. During the first quarter of 2005, there was a change in the estimated closure date related to the Bellefonte diesel generators. The original estimate assumed asset retirement in 2029 and a six year waiting period before closure work would begin in 2035. The new estimate assumes that closure work will begin at the date the assets cease to operate in 2029. This change'in estimate resulted in a decrease in the total future liability of nearly $1 million, and an increase in the current net present value of the ARO asset liability of less than $0.1 million.

In February 2004 and March 2005, TVA made revisions to the amount and timing of certain cash flow esti-mates related to its nuclear asset retirement obligations. The revisions in cost were based on new engineering stud-ies performed annually in accordance with requirements of the Nuclear Regulatory Commission ("NRC"). The effect of the changes in estimates produced obligations that were less than the amounts originally recorded on an accreted basis. Accordingly, TVA made adjustments in the recorded amounts to properly reflect such revised balances based on the latest cost estimates. In 2005, the adjustments resulted in an aggregate decrease of $25 million in the ARO, a S7 million reduction in the asset base, a $3 million reduction in accumulated depreciation, and a decrease of $21 mil-lion in the originally recorded regulatory asset. The 2004 adjustments resulted in an aggregate decrease of $40 mil-lion in the asset retirement obligation, a $12 million reduction in the asset base, a $5 million reduction in accumulated depreciation, and a decrease of $33 million in the originally recorded regulatory asset which TVA created in accordance with SFAS No. 71. Therefore, the result of the change described did not impact net income for.the years ended September 30, 2005 and 2004.

During 2004, TVA's total ARO liability increased $57 million due to accretion expense of $97 million partially offset by the $40 million revision to the nuclear ARO described above..The nuclear accretion expense of $85 million was deferred and charged to a regulatory asset in accordance with SFAS No. 71. The remaining accretion expense of $12 million, related to coal-fired and gas/oil plants, was expensed during 2004. During 2005, TVA's total ARO lia-bility increased $75 million due to accretion expense of $100 million partially offset by the $25 million revision in cash flow described above. The nuclear accretion expense of $87 million was deferred and charged to a regulatory asset in accordance with SFAS No. 71. The remaining accretion expense of $13 million, related to coal-fired and gas/oil plants, was expensed in 2005.

Reconciliation of Asset Retirement Obligation Liability Year ended September 30 2005 2004 Balance at beginning of year

$ 1,782

$ 1,725 Liabilities settled Accretion expense 100 97 Revisions in estimated cash flows (25 (40)

Balance at end of year

$4 1857

$_ 1782

5. Regulatory Assets and Liabilities Regulatory assets capitalized under the provisions of SFAS No. 71 are included in DEFERRED NUCLEAR GENERATING UNITS and Other REGULATORY AssETs on the September 30, 2005 and 2004 Balance Sheets. Components of OTHER REGULATORY ASSETS include certain charges related to the closure and removal from service of nuclear gen-erating units, reacquisition costs, deferred outage costs, unrealized losses related to mark-to-market valuations and a purchase power contract, deferred capital lease asset costs, and an adjustment to accrue the minimum pension liabil-ity. See note 1 -

Cost-Based Regulation and note 2.

Page 94

The year-end balances of TVA's regulatory assets and liabilities are as follows:

At September 30 2005 2004 Regulatory Assets:

Adjustment to accrue minimum pension liability

$ 1,158 1,243

. Nuclear decommissioning costs

.716 755 Reacquisition costs 264 277 Deferred outage costs 103 86 Capital leases 84 90 Unrealized losses on purchase power contract 42 59 Subtotal 2,367 2,510 Deferred nuclear generating units 3,912 3,909 Total 6,279 6,419 Regulatory Liabilities:

Unrealized gain on coal purchase contracts 791 478 Capital lease liability 106 122 Total 897 600 Reacquisition expenses, call premiums, and other related costs, such as unamortized debt issue costs asso-ciated with redeemed bond issues, are deferred under provisions of the FERC's Uniform System of Accounts Prescribed for Public Utilities and Licensees Subject to the Provisions of the 'Federal Power Act. These costs are deferred and amortized (accreted) on a pooled'straight-line basis over the'weighted average life of TVA's debt portfo-lio. (Even though TVA is not a public utility subject generally to FERC jurisdiction, the TVA Act requires TVA to keep accounts in accordance with the requirements established by FERC.)

Deferred capital lease asset costs, representing the difference between the FERC's Uniform System of Accounts model balances and the SFAS No. 13, "Accounting for Leases," model balances, are also included in regu-latory assets. Under the FERC uniform system of accounts, TVA recognized the initial capital lease asset and liabili-ty at inception of the lease in accordance with SFAS No. 13; however, the annual expense is equal to the annual lease payments, which differs from SFAS No. 13 accounting treatment. This practice results in TVA's capital lease asset bal-ances being higher than they otherwise would have been under the SFAS No. 13 model, with the difference between FERC model balances 'and the SFAS No. 13 model balances representing an embedded regulatory asset within each capital lease. These costs are being amortized over the respective lease terms. '

Nuclear decommissioning costs include certain charges related to the future closure and decommissioning of TVA's nuclear generating units under NRC requirements. These future costs will be funded through a combination of investment funds already set aside by TVA, future earnings on those investment funds, and if necessary, TVA cash contributions to the investment funds. See note 1 - Investment Funds and note 4.

Due to negative pension plan asset returns from 2002 and 2001, TVA's accumulated benefit obligation at September 30, 2005 and 2004 exceeded plan assets. As a result, TVA was required to recognize an additional mini-mum pension liability as prescribed'by SFAS No. 87, "Employers'Accounting for Pensions.' These future pension costs will be funded through a'combination of the pension investment funds already'set aside by TVA, future earnings on those pension investment funds, and, if necessary, future TVA cash contributions to the pension plan.

Unrealized loss on a purchase power contract represents the-estimated unrealized loss related to the mark-to-market valuation of the contract. Under the account ng rules contained in SFAS No. 133, "Accounting for Derivative Instruments and 'Hedging Activities, this contract qualifies as a derivative contract but does not qualify for cash flow hedge accounting treatment. As a result, TVA recognizes the changes in the market value of this derivative contract as a regulatory asset. This treatment reflects TVA's ability and intent to recover the cost of this commodity contract on a settlement basis for ratemaking purposes. TVA has historically recognized the actual cost of purchased power received under this contract in purchased power expense at the time of settlement. 'The 'contract expires in 2007. See note 8.

Page 95

At September 30, 2005, construction of the Bellefonte Nuclear Plant ("Bellefonte") remains in a deferred sta-tus (see note 2). In July 2005, the Board approved the amortization TVA's investment in the deferred nuclear gener-ating units over a ten-year period beginning in 2006.

Regulatory liabilities accounted for under the provisions of SFAS No. 71 consist of mark-to-market valuation gains on certain derivative contracts and capital leases.

Unrealized gain on coal purchase contracts represents the estimated unrealized gains related to the mark-to-market valuation of coal purchase contracts. Under the accounting rules contained in SFAS No. 133, 'Accounting for Derivative Instruments and Hedging Activities," these contracts qualify as derivative contracts but do not qualify for cash flow hedge accounting treatment. As a result, TVA recognizes the changes in the market value of these deriva-tive contracts as a regulatory liability. This treatment reflects TVA's ability and intent to recover the cost of these com-modity contracts on a settlement basis for ratemaking purposes. TVA has historically recognized the actual cost of fuel received under these contracts in fuel expense at the time the fuel is used to generate electricity. These contracts expire at various times through 2017. See note 8.

As a result of a capital lease payment stream requiring larger cash payments during the latter years of the lease term than during the early years of the lease term, TVA levelized the annual lease expense recognition related to this lease in order to promote the fair and equitable cost recovery from ratepayers. These costs are being amor-tized over the lease term.

Nuclear Fuel and Refueling Outage Costs a

TVA's investment in the fuel used in the Sequoyah, Watts Bar, and Browns Ferry nuclear units is being amor-tized and accounted for as a component of fuel expense (see note 2). Nuclear refueling outage and maintenance costs are deferred and amortized on a straight-line basis over the estimated period until the next refueling outage., The amounts of deferred outage costs for the years ended September 30, 2005, 2004, and 2003 were $103 million, $86 million, and $100 million, respectively.

, a.

6. Asset Impairment During 2005, TVA recognized a total of $24 million in impairment losses related to its property, plant and equipment. The losses included a $16 million write-down of certain CONSTRUCTION IN PROGRESS assets related to new pollution-control and other technologies that had not been proven effective, and an $8 million write-down on one of two buildings in TVA's Knoxville Office Complex ('KOC"). Based on TVA's desire, intent, and plans to sell or lease the East Tower of the KOC, TVA has recognized an impairment loss equal to the difference between the net book value of the East Tower of $20 million and the current estimated market value of $12 million. See note 1 -Impairment of Assets.

7. Proprietary Capital a

i Appropriation Investment Since its creation in 1933 and continuing through 1999, TVA received appropriations from Congress to carry out its power and nonpower programs. The table below summarizes TVA's activities related to these funds. The TVA Act requires TVA to make annual payments to the Treasury from net power proceeds as a return on the investment that Congress made in the power system (the "Appropriation Investment") and as a repayment of $1 billion of the Appropriation Investment. The payments required by the TVAAct may be deferred under certain circumstances for not more than two years. TVA paid $20 million each year for 2005, 2004, and 2003 as a repayment of the Appropriation Investment. In addition, TVA paid the 'Treasury $16 million in 2005, $18 million in 2004, and $22 million in 2003 as a return on the Appropriation Investment. The return is based on the amount of the Appropriation Investment as of the beginning of the year and on the computed average interest rate payable by the Treasury on its total marketable pub-lic obligations as of the same date. These rates were 3.71 percent, 3.82 percent, and 4.63 percent at September 30, 2005, 2004, and 2003, respectively. Cumulative repayments and return on investment paid by TVA's power program to the Treasury approximate $3.6 billion. Approximately $1.0 billion of the Appropriation Investment of $1.4 billion has been repaid. Of the $1.0 billion portion of the Appropriation Investment TVA is required to repay, $170 million remains unpaid at September 30, 2005.

Page 96

Appropriations from CongrE Transfers of Property to TV Transfers of Property from -

Program Expenditures Repayments to U.S. Treast Total Congressional Appropriations Appropriation Investment Appropriations for Nonpower Program in Power Program ess 11,055 9,636 1,419 A

66 42 24 TVA (56)

(56)

(5,221)

(5,221)

'ry I

(46J 4,783 4,355 428 Accumulated Other Comprehensive Income SFAS No. 130, "Reporting Comprehensive Income,"requires the disclosure of comprehensive income or loss to reflect changes in capital that result from transactions and economic events from nonowner sources. The items included in accumulated other comprehensive logs consist of market valuation adjustments for certain derivative instru-ments (see note 8). The accumulated other comprehensive income (loss) as of September 30, 2005, 2004 and 2003, was $26 million, $(52) million, and $(74) million, respectively.;

Total Other Comprehensive (Loss) Income Activity Accumulated other comprehensive loss, October 1, 2002 Changes in fair value:

Inflation 1

i Foreign currency swaps Accumulated other comprehensive loss, September 30, 2003 -'

$ (150),

13 63 (74)

' e '

I Changes in fair value:

Inflation

)

4 Foreign currency swaps

.18 Accumulated other comprehensive loss, September 30, 2004 (52)

Changes in fair value:

Inrlaaion q

Foreign currency swaps 75 Accumulated other comprehensive income, September 30, 2005 27

8. Risk Management Activities and Derivative Transactions TVA is exposed to market risks, including changes in interest rates, foreign currency exchange rates, inflation rates, and certain commodity and equity market prices. To manage the volatility attributable to these exposures, TVA has entered into various nontrading derivative transactions, principally an interest rate swap agreement, an inflation swap agreement, foreign currency swap contracts, swaptions, and futures and option contracts on various commodi-ties.

TVA is exposed to losses in the event of counterparties' nonperformance and accordingly has established controls to determine the creditworthiness of counterparties in order to mitigate exposure to credit risk.

With respect to hedging activities, TVA risk management policies provide for the use of derivative financial instruments to manage financial exposures but prohibit the use of these instruments for speculative or trading purpos-es. Prior to October 1, 2000, TVA accounted for hedging activities using the deferral method, and gains and losses were recognized in the financial statements when the related hedged transaction occurred. During 2001, TVA adopt-ed SFAS No. 133, 'Accounting for Derivative Instruments and Hedging Activities," as amended by SFAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities," and SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities."

Page 97

The recorded amounts of certain derivative financial instruments are as follows:

Mark-to-Market Values of TVA Derivatives at September 30 2005 2004 2005 Notional Balance Balance Amount Year of Expiration Inflation swap Interest rate swap 17 (158)

$ 2 (140)

$300 million

$476 million 2007 2044 Currency swaps:

Deutschemark Sterling Sterling.

Sterling,

Swaptions:

$1 billion notional

$28 million notional

$14 million notional (68) 21 89 I-

.^

36 I-f (314)

(4)

-2 (62) 13 79 32 DM1.5 billion

£200 million

£250 million

'£150 million 2006 2021 2032 2043 2042 2022 2022 (225)

$1 billion

$28 million

$14 million Emission allowance call options 6

Coal contracts-volume options-Purchase power option contracts 791 478 118 million tons 2005 2017 2007 (42),

(59).,

500 MW.

In accordance with SFAS No. 133, as amended, the inflation swap and foreign currency swap contracts are accounted for on a mark-to-market basis and resulted in a gain of $79 million, $22 million, and $76 million for 2005, 2004, and 2003, respectively. Since such contracts represent cash flow hedges of certain debt transactions, the gains have been recognized in AcCUMULATED OTHER COMPREHENSIVE INCOME (LOSS). Because of the highly effective nature of these hedging transactions, TVA was not required to recognize gains from these transactions in the Statements of Income. If any loss/(gain) were to be incurred as a result of the early termination of the inflation swap contract or a foreign currency swap contract, any resulting charge/(income) would be amortized over the remaining life of the asso-ciated bond as a component of interest expense.

I-i !

I

1. I '

- I I I

, I I

I I

i 11 I I

I 4

I I I

I -

I -

I

.Z I

i.,

.1

.

I I.

I il, :

I I

I 1.
1.

I I

I

-Page 98

Summary of Derivative Instruments that Receive Hedge Accounting Treatment As of September 30, 2005 Derivative Hedging Instrument Inflation Swap Hedged Item Variable-principal debt Ty Purpose of Hedge Fai Transaction CZ To fix the debtst; variable cash fSws to a fixed flow To protect against changes in cash flows caused by changes in foreign-currency exche nge rates To protect against a decrease in value of the embedde3d call

• I

.I w

pe of Hedge-r Value (FV) or Accounting for Derivative Accounting for the ish Flow (CF)

Hedging Instrument Hedged Item CF Cumulative gains and losses are recorded in other comprehensive income to the extent they are offset by cumulative gains and losses on the hedged transaction.

CF Cumulative gains and losses are recorded in other comprehensive income to the extent they are offset by cumulative gains and losses on the hedged transaction.

No adjustment is made to the basis of

-ie hedged item.

No adjustment is made to the basis of the hedged item.

Currency S%Yaps Anticipated payment denominated in a foreign currency Embedded call Swaption (2002)

FV All gains and losses All gains and losses on the derivative are on the hedged item recorded in earnings as are recorded in unrealized gain/loss on earnings as unrealized derivative contracts.

gain/loss on derivative I -1 contracts.

i,

I

,, i Summary of Derivative Instruments that Do Not Receive Hedge Accounting Treatment I.

As Of September 30, 2005 Derivative Type

, I Coal Contracts-Volume Options Pu rh

.O Ctc Purchase Power Option Contracts; Purpose of Derivative To protect against fluctuatiors in market prices of the item to be purchased To protect against fluctuatior s in market prices of the item to be purchased Accounting for Derivative Instrument Gains and losses are recorded as regulatory assets or liabilities until settlement at which time they are recognized in fuel and pur-chased power expense.

Gains and losses are recordeJ as reg 6iatory assets or liabilities until settlement, at which -

• time they are recognized in fuel and pur-chased power expense.

Interest Rate Swap

.To fix short-term debt variab e rate to a

..I Fixed and variable interest cash flows are a fixed rate.

.I recorded in earnings as interest expense.

MTM gains and losses are recorded in earn-ings as unrealized gains/losses on derivative contracts.

Swaptions (2005)

To protect against a decrease in value of the embedded call call Gains and losses are recorded in earnings as unrealized gains/losses on derivative con-tracts.

I I I

I

.2 Jo Page 99

Commodity Contracts

1..
.

I TVA enters into forward contracts that hedge cash flow exposures to market fluctuations in the price and deliv-ery of certain commodities including coal, natural gas, and electricity. TVA expects to take or make delivery, as appro-priate, under these forward contracts. Accordingly, these contracts qualify for normal purchases and normal sales accounting under SFAS No. 133, as amended, which describes the criteria that must be met in order for such contracts to qualify for the use of normal purchases and normal sales accounting.

Gains and losses on cash flow hedges are deferred in ACCUMULATED OTHER COMPREHENSIVE INCOME (Loss) and recognized as adjustments to the carrying amount of the items hedged. Deferral of the gains and losses continues until the items hedged are recognized in income. Gains and losses on derivatives not qualifying for hedge accounting are deferred in accordance with SFAS No. 71.

Foreign Currency, Interest Rate, and Inflation Swaps During 1996, TVA entered into a currency swap contract as a hedge for a foreign currency denominated debt transaction. TVA issued DM1.5 billion of bonds and entered into a currency swap to hedge fluctuations in the DM exchange rate. The overall effective cost to TVA of these bonds and the associated swap was 7.13 percent. TVA also entered into currency swap contracts during 2003, 2001, and 1999 as hedges for sterling-denominated debt transac-tions in which TVA issued £150 million, £250 million, and £200 million of bonds, respectively. The overall effective cost to TVA of these bonds and the associated swaps was 4.96 percent, 6.59 percent, and 5.81 percent, respectively. Any gains or losses on the debt instruments due to the foreign currency transactions are offset by losses or gains on the swap contracts. At September 30, 2005, and 2004, the currency transactions had resulted in net translation losses of S52 million and of $113 million, respectively, which are included in CURRENT MATURITIES OF LONG-TERM DEBT, NET and LONG-TERM DEBT, NET. However, the net translation losses were offset by corresponding gains on the swap contracts, which are reported as a deferred asset.

Additionally, in 1997 TVA issued $300 million of inflation-indexed accreting principal bonds. The ten-year bonds have a fixed coupon rate that is paid on the inflation-adjusted principal amount. TVA hedged its inflation expo-sure under the securities through a receive-floating, pay-fixed inflation swap agreement. The overall effective cost to TVA of these bonds and the associated swap was 6.64 percent. On September 21, 2004, VA received a payment of

$55 million from the swap counterparty representing the present value of the accretion as of that date. The present value of the accretion is recorded as a long-term receivable on the September 30,.2005, and 2004 Balance Sheets.

At the termination of the swap, instead of receiving the entire accreted balance from the counterparty, VA will receive only the additional accretion from September 22, 2004, through the end of the swap.

Cal/ Monetizations During 2002, TVA monetized the call provisions on a $1 billion public bond issue by entering into a swaption agreement with a third party in exchange for $175 million. In 2003, TVA monetized the call provisions on a second public bond issue of $476 million by entering into a swaption agreement with a third party in exchange for $81 million.

In the third quarter of 2005, TVA monetized the call provisions on two electronotes' issues ($42 million total par value) by entering into swaption agreemer ts with a third party in exchange for $5 million. A swaption essentially grants a third party the right to exercise the embedded call provision of the applicable bond while TVA continues to pay the holders of the swaption pursuant to the original bond issuance. In February 2004, the counterparty to the 2003 swaption trans-action exercised its option to enter into a swap with TVA, effective April 10, 2004, requiring TVA to make fixed rate pay-ments to the counterparty of 6.875 percent and the counterparty to make floating payments to TVA based on London Interbank Offered Rate ("LIBOR"). These payments are based on a notional principal amount of $476 million, and the parties began making these payments on June 15, 2004. The 2002 swaption is recorded in OTHER LIABILITIES on the September 30, 2005 Balance Sheet and is designated as a hedge of future changes in the fair value of the original call provision. Under SFAS No. 133, as amended, TVA records the changes in market value of both the swaption and the embedded call. These values historically have been highly correlated; however, to the extent that the values do not perfectly offset, any differences will be recognized currently through earnings. These differences (including those for the 2003 swaption prior to its being exercised in February 2004) amounted to a nearly $10 million noncash gain for the year ended September 30, 2004, and a $27 million noncash gain for the year ended September 30, 2005. The swap entered into pursuant to the 2003 swaption and the two electronotesO swaptions are also recorded in OTHER LIABILITIES on the September 30, 2005 Balance Sheet, and the changes in market value are recognized currently in earnings.

These changes amounted to a $23 million noncash loss for the year ended September 30, 2004, and a $19 million noncash loss for the year ended September 30, 2005.

Page 100

Financial Trading Program I

A financial trading pilot program to reduce TV's economic risk exposure associated with TVXs physical elec-tricity generation, purchases, and sales was approved by the Board on September 11, 2003 ('Pilot Program"). :Under the Pilot Program, TVA was authorized to use futures and options on futures to hedge economic risks directly associ-'

ated with the cost of natural gas and fuel oil for TVA's power generation operations and risks under power purchase or sale arrangements where the energy price varies based upon a fuel index.,

The Pilot Program was scheduled to end on August 31, 2005, but on May 17, 2005, the Board established a permanent financial trading program ("Program" and, together with the Pilot Program,.~Programs") that allows TVA to:

(1) continue to hedge the risks authorized under the Pilot Program; (2) broaden the type of risks that TVA can hedge to include economic risks directly associated with both the cost of natural gas for tolling agreements and the purchase or sale arrangements where the energy price is based at least in part upon a fuel price index or proxy; and (3) hedge risks more effectively by using swaps and options on swaps in addition to futures and options on futures. Trading is not authorized for speculative purposes under the Programs.

At September 30, 2005, TVA had 112 derivative positions outstanding under the Program The Programs have enabled WVA to effectively hedge the price risk associated with a portion of its natural gas and power purchases.

TVA recognized unrealized gains of approximately $0.5 million which were included as an offset to purchased power expense for the year ended September 30, 2005. The same year also produced realized gains'of about $3.3 million which were included as an offset to purchased power expense. The gains on the positions were less than eight per-cent of the total natural gas expense for the period.-'

R

XE.

--;.i,,,,. ;,

FinancialTrading Program Activity i

I For the Year ended September 30, 2005 2005 20104

Notional, Contract Notional Contract Amount Value Amount Value I(in mnBtu)

,(in mmBtu) 7.

Futures contracts i

___(n______'_

Financial positions at beginning of period' K _

$^

Purchased 4,370,000 33.2 1,250,000 8 0 Sold (3,490,000)

(26.9) f nf(1,250,000)

(7.0),

Realized gains (losses),

I 3.3-' 2-

'(1 0)

Net positions-long 880,000.

7 Options contracts Financial positions at beginning of period Calls purchased 580,000 0.6 Calls and puts sold 980,000 (0.6)

Positions closed oi expired (1,320,000)

Net positions-long 240,000';

Holding gains (losses),

l-

,l; Unrealized gain at beginning of period, net Unrealized gain for the period 0.5' Unrealized gains at end of period, net 0.5 Financial positions at end of period, net 1,123,000 10.1i

=

I

9. Debt Borrowing Authority The TVA Act authorizes TVA to issue bonds, notes,' and other evidences of indebtedness up to a total of $30 billion outstanding at any one time. TVA must meet certain financial tests that are contained in the TVA Act and the Basic Resolution. Debt service on these obligations, which is payable solely from TVA's net power. proceeds, has precedence over payments to the Treasury (see note 7-Appropriation Investment).

IPage 101

Short-Term Debt The weighted average rates applicable to short-term debt outstanding inmthe public market as of September 30, 2005, 2004, and 2003, were 3.64 percent, 1.70 percent, and 1.00 percent, respectively. :During 2005, 2004, and 2003, the maximum outstanding balances of short-term borrowings held by the public were $3.1 billion, $2.1 billion, and $3.4 billion, respectively. For these same years, the average amounts (and weighted average interest rates) of short-term borrowings were approximately $1.7 billion (2.72 percent), $859 million (1.15 percent), and $2.8 billion (1.28 percent), respectively.

TVA also has access to a financing arrangement with the Treasury whereby it is authorized to accept a short-term note with the maturity of one year in an amount not to exceed $150 million. WTVA may draw any portion of the authorized $150 million during the year.- Interest is accrued daily and paid quarterly at a rate determined by the Secretary of theTreasury each month based on the average rate on outstanding marketable obligations of the United States with maturities of one year or less. During 2005, 2004, and 2003, the daily average amounts outstanding (and average interest rates) were approximately $103 million (2.46 -percent),' $35 million (1.06 percent),-'and $12 million (1.33 percent), respectively.

On May 26, 2005, TVA and a national bank entered into a revolving credit facility agreement with an initial term of 180 days. On November 9, 2005, the term was extended until May 22,'2006.The facility provides TVA with an unsecured revolving line of credit of up to $2.5 billion. The interest rate on any borrowing under this agreement is vari-able and based on market factors and the rating of VA's senior unsecured long-term non-credit enhanced debt at the time TVA draws on the facility. TVA is required to pay an unused facility fee on the portion of the $2.5 billion against which TVA has not borrowed. This fee is similar to fees charged in the banking industry to similar customers for sim-ilar products and may fluctuate depending upon the rating of TVA's senior unsecured long-term non-credit enhanced debt. There were no outstanding borrowings under the facility at September 30, 2005.

Put and Call Options Bond issues of $2.3 billion held by the public are redeemable in whole or in part, at TVA's option, on call dates ranging from the present' to 2020 and at call prices ranging from 100 percent to 106 percent of the principal amount.

Additionally, TVA has bond issues of $2.2 billion held by the public that are redeemable in whole or in part at the option of the respective bondholders, as follows: one bond issue totaling $121 million, which matures in April 2036, is redeemable in 2006 by the bondholders; a second issue totaling $1.5 billion, which matures in April 2036, is redeemable in 2006 at the 'option of -the bondholders; and a third issue totaling $600 million, which matures in December 2016, is redeemable in 2007 at the option of the bondholders. Each of these issues is reported in the debt schedule with maturity dates corresponding to the earliest redemption dates. Fifty-five issues totaling $1 :1 billion, with maturity dates ranging from 2008 to 2025, include a 'survivor's option," which allows for right of redemption upon the death of a beneficial owner in certain specified circumstances. There is no accounting difference between a "survivor's option" put and a "regular" put on a put bond.

I

.1.

Additionally, TVA has two issues of Putable Automatic Rate Reset Securities ("PARRS") outstanding. After a fixed-rate period of five years, the coupon rate on the PARRS may automatically be reset downward under certain mar-ket conditions on an annual basis. Investors have the option to redeem the bonds at par if and when the interest rate is reset. One PARRS issue totals $466 million, matures in June 2028, and had its first reset date in June 2003. The rate reset to 5.952 percent from 6.75 percent in June 2003, at which time $23 million of the original $575 million 1998 Series D PARRS were redeemed at par,'and reset to 5.49 percent from 5.952 percent in June 2005, at which time $86 million of the 1998 Series D PARRS were redeemed at par. -The second issue of PARRS totals $410 million, matures in May 2029, and had its first rate reset date in May 2004. The rate reset in May 2004 to 5.618 percent from 6.50 per-cent, and $115 million of the original $525 million 1999 Series A PARRS were redeemed at par. If the potential reset rate is less than the current coupon on the bond, the bond automatically resets to the lower rate. If the coupon rate is reset, the bondholders have the option to put their bonds back to TVA at par.

Debt Securities Activity The table below summarizes TVA's debt securities activity for the period from October 1, 2004, to September 30, 2005.

Jo, Page 102

Activity from October 1, 2004 to September 30, 2005 i

R :

! U r

,;ii

.X :

PrincipalAmount I

I Redemptons/MaturIte 205 2

I Redemp~tions/Maturities:

2005 2004 electronotes"

,, t,,

First quarter.......................

3

• 15 Second quarter 75 30 Third quarter..............................................

101

.3 Fourth quarter...

L 3

132 Fourth qarter.

3......................

53 2000E QUINTS 100 1998D PARRS 86 1995 Series A.....

2,000 1998 Series I 400 2000C QUINTS....................-

25 2000D QUINTS

_5 1993 Series F 476 1999 Series A 115 2003 Series C...............................................

o 2001 Series C 1,00 Total 2,368

$ 2,251 Issues t i

!l electrori6tese i

First quarter...............................................

1 3

Second quarter 25 1-14 Third quarter

~.

5 105

-15 Fourth quarter 20 2005 Series A 500 2005 Series B..........

1,000 2002 Series A'(reopening) 550 Total 1,650 772

-inflation-indexed bond accretion......................

11

.10 Debt Outstanding Debt outstanding at September 30, 2005 and 2004, consisted of the following:

2005 2004 Short-term debt Discount notes (net of discount)..

2,469 1.924:

Current maturities of long-term debt, net - 5.50% to 7.125%

2,693 2,000 Total short-term debt, net 3,924 Long-term debt Maturing in 2006 - 5.880% to 7.125%.......

2,575 Maturing in 2007 - 4.875% to 6.643%.......

970 9;9 Maturing in 2008 - 2.45% to 3.30%........

91 31 Maturing in 2009 - 3.20% to 5.375%'

m

...... ?.

2,031 i

i t i 2,031 Maturing in 2010 - 4.125%.42 Maturing in 2011 - 5.625%..................

1,000 1,000 Maturing in 2012 - 4.375% to 7.14%.1,525 1,5:25 Maturing in 2013 through 2045 - 3.50% to 8.25%:...............

12,319 11,58 Total long-term debt, net...............................

17,978 19,4:39 Unamortized discounts, premiums, and other...................

(227)

.(1D2)

Total long-term debt, net.,

17,751

$ 19,337

~~~.

Note:

The above table includes net translation losses from currency transactions of $52 million and $113 million at September 30, 2005, and 2004, respectively.

Page 103

Interest and Capital Costs., -

i a

' 'I X During 2005, 2004, and 2003, cash'paid for interest on outstanding indebtedness (net of amount capitalized) is summarized below:

Schedule of Interest Paid Year Ended September 30

. 'i

. I I ".

I, Statutory Debt (note 9)

Other Financing Obligations (note 10)

Return on Appropriation (note 7)

I I

2005 2004.

1,243.

.1,286 73 73 16 18 2003 1,320 58 22 Total 1,332 1,377.

$ 1,400

10. Fair Value of Financial Instruments f ;

TVA uses the methods and assumptions described below to estimate the fair value of each significant class of financial instrument. The fair market value of the financial instruments held at September 30, 2005, may not be rep-resentative of the actual gains or losses that will be recorded when these instruments mature or if they are called or presented for early redemption.

The estimated values of TVA's financial instruments at September 30 are as follows:

2005 2004 Carrying Amount Cash and cash equivalents 538 Short-term investments Investment funds 858 Loans and other long-term receivables 93 Short-term debt, net of discount 2,469 Long-term debt (including current portion), net of discount 20,671 Other financing obligations A,

, 1,143 Fair Carrying Value

'Amount 538 858 93 2,469 22,552

',1,143 519 335 744 144 1,924 21,337

• 1,178 Fair

• Value 519 335 744 144

'1,924 23,249 1,178 Cash and Cash Equivalents, Short-Term Investments, and Short-Term Debt Because of the short-term maturity of these instruments, the carrying amount'approximates fair value.

Investment Funds Information on investments by major type at September 30 is as follows:

I, Securities held as trading Other Total investment funds 2005 2004 835 720 23

.24

$ 858 744

f

. I Gains and losses on trading securities are recognized in current earnings and subsequently reclassified to a regulatory asset account in accordance with TVA's decommissioning accounting policy (see note 1-Decommissioning Costs). The decommissioning fund had unrealized gains of $118 million in 2005, unrealized gains of $88 million in 2004, and Unrealized gains of $129 million in 2003. -

Page 104

Loans and Other Long-Term Receivables Fair values for these homogeneous categoriesWof loans and receivables are estimated by determining the present value of future cash flows using a discounted rate equal to lending rates for similar loans made to borrowers with similar credit ratings and for the same remaining maturities. The carrying amount approximates fair value.

Long-Term Debt Fair value of long-term debt traded in the public market is determined by multiplying the par value of the bonds by the indicative market price at the balance sheet date.

Other Financing Obligations In 2003, 2002, and 2000, TVA received approximately $325 million, $320 million, and $300( million, respec-tively, in proceeds by entering into lease/leaseback transactions for 24 new peaking combustion turbine units. TVA also received approximately $389 million in proceeds by entering into a lease/leaseback transaction for qualified tech-nological equipment in 2003. Due to the nature of the transactions, the carrying amount of the oblig ation and the fair market value are equal. At September 30, 2005, and 2004, the total balances of the obligations were $1,143 million and $1,178 million, respectively.

Due to TVA's continuing involvement in the operation and maintenance of the leased units and equipment, and its control over the distribution of power produced by the facilities during the leaseback term, TP/A accounted for the respective lease proceeds of $714 million, $320 million, and $300 million as financing obligations as required in accordance with SFAS No. 66, 'Accounting for Sales of Real Estate," and SFAS No. 98, 'Accounting for Leases."

Accordingly, the outstanding lease/leaseback obligations of $1,143 million at September 30, 2005, and $1,178 million at September 30, 2004, are included in CURRENT PORTION OF LEASE/LEASEBACK OBLIGATIONS ($35 million and $35 mil-lion, respectively) and LEASE/LEASEBAcK OBLIGATIONS ($1,108 million and $1,143 million, respectively) in TVA's 2005 and 2004 year-end Balance Sheets.

11. Benefit Plans Pension and Other Postretirement Benefits

-l,; I -

TVA sponsors defined benefit pension plans which cover substantially all employees. Additionally, TVA pro-vides postretirement health care benefits for substantially all employees who reach retirement age while still working for TVA. TVA's reported costs of providing these benefits, as described herein,,are impacted by numerous factors including the provisions of the plans, changing employee demographics, and various actuarial calculations, assump-tions, and accounting mechanisms.

In selecting an assumed discount rate, TVA reviews market yields on high-quality corporate debt and long-term obligations of the U.S. Treasury. Based on recent market trends, TVA reduced its discount rate from 6.00 per-cent and 5.81 percent at the end of 2003 and 2004, respectively, to 5.375 percent at the end of 2005. TVA reviews actual recent cost trends and projected future trends in establishing health care cost trend rates. Based on this review process, VA reset its health care cost trend rate assumption used in calculating the 2005 accumulated postretirement benefit obligation. The assumed health care cost trend rate has been reset to 9.0 percent at the end of 2005 and mir-rors the 9.0 percent trend rate used during 2004. TVA has reset its health-care cost trend rate at the end of each of the last four years. The health care cost trend rate of nine percent is assumed to gradually decrease each successive year until it reaches a five percent annual increase in health care costs in 2013 and beyond.

In determining its expected long-term rate of return on pension plan assets, TVA reviews past long-term performance, asset allocations, and long-term inflat on assumptions. TVA targets an asset allocation for its pen-sion plan assets of approximately 60 percent equity securities and 40 percent fixed income securities. Pursuant to its allocation policy, the asset allocations are to be comprised of approximately 45 percent United States equi-ties, of which five percent may be private equity or other similar investments, but not to include holding title to real property; 40 percent fixed income, of which ten percent may be high yield securities; and 15 percent non-United States equities. TVA's policy includes a permissible three percent deviation, plus or minus, from these target allo-cations. The Board can take action, as appropriate, to rebalance the system's assets consistent with the asset Page 105

allocation policy. TVA decreased its expected long-term rate of return on pension plan assets from 8.50 percent at the end of 2003 to 8.25 percent at the end of 2004 and will continue to use a similar asset return assumption for 2005. TVA utilized a rate of return of 8.00 percent during 2003 in the aftermath of the market declines of 2002 and 2001.

Actuarial Assumptions TVA utilizes professional actuaries to perform valuation services related to the areas of pension, postretire-ment, and postemployment benefits. Net periodic pension cost is determined using assumptions as of the beginning of each year. Funded status is determined using assumptions as of the end of each year. The valuations performed at the end of 2005 were based on applications of actuarial assumptions that were consistent for all of TVA's benefit plans as can be seen in the disclosure tables that follow. For 2005, TVA recognized pension expense of $243 million, postretirement benefit expense of $46 million, which includes $0.5 million in special termination cost, and postemploy-ment benefit expense of $71 million. Comparable items of expense for prior years include, respectively, for 2004, pen-sion expense of $178 million, postretirement benefit expense of $36 million, which includes $7 million in special termi-nation cost, and postemployment benefit expense of $66 million, and for 2003, pension expense of $41 million, postre-tirement benefit expense of $36 million, and postemployment benefit expense of $90 million..

During 2003, TVA transitioned actuaries through a process in which both sets of actuaries performed calcu-lations of the benefit obligations and other estimates inherent in the valuations for 2002. Since the 2002 valuations serve as the basis for amounts recorded in 2003, differences in actuarially calculated estimates were reconciled.

Adjustments proposed by both predecessor and successor actuaries have been included in 2003 expense and reflect-ed as amendments in the disclosure tables of the related pension and postretirement benefits obligations that follow.

Pension Plans and Other Retirement Benefits TVA has a defined benefit plan for most of its full-time employees that provides two benefit structures: the Original Benefit Structure and the Cash Balance Benefit Structure. The plan is controlled and administered by a legal entity separate from TVA, the TVA Retirement System ('TVARS"), which is governed by its own independent board of directors. The plan assets are primarily stocks and bonds. TVA contributes to the plan such amounts as are agreed upon by the TVA and WARS boards of directors.

The pension benefit for a member participating in the Original Benefit Structure is based on the member's years of creditable service, the member's average base pay for the highest three consecutive years, and the pension rate for the member's age and years of service, less a Social Security offset. The pension benefit for a member par-ticipating in the Cash Balance Benefit Structure is based on credits accumulated in the member's account and the member's age. A member's account receives credits each pay period equal to 6.0 percent of his or her straight-time earnings. The account also increases at an interest rate equal to the change in the Consumer Price Index ("CPI") plus 3.0 percent, with the provision that the rate may not be less than 6.0 percent or more than 10.0 percent. The actual change in the CPI for 2005 and 2004 was 2.4 percent and 1.7 percent, which resulted in interest rates of 6.0 percent and 6.0 percent, respectively.

Members of both the Original Benefit Structure and the Cash Balance Benefit Structure can also become eli-gible for a vested supplemental pension benefit, based on age and years of service, which is designed to help retirees offset the cost of medical insurance. WARS also administers a defined contribution plan, a 401(k) plan to which TVA makes matching contributions of 25 cents on the dollar (up'to 1.5 percent of pay) for members participating in the Original Benefit Structure and of 75 cents on the dollar (up to 4.5 percent of pay) for members participating in the Cash Balance Benefit Structure. TVA made matching contributions of about $17 million to the plan during 2005.

Certain Pension Plan Results Effective for the end of year measurement date and the calculation of funded status, the discount rate was reduced from 5.81 percent for 2004 to 5.375 percent for 2005. The cost of living rate was adjusted upward from the 2004 rate of 2.30 percent to 2.50 percent for 2005 to reflect current market and demographic conditions. Additionally, TVA continued to use its assumption related to mortality based on results of an experience study performed during the prior year which underlies the use of 1983 mortality tables. Based on the use of the assumptions described, the pro-jected benefit obligation ('PBO") at September 30, 2005, increased approximately $823 million compared to the restat-ed PBO at October 1, 2004. The PBO at the beginning of fiscal 2005 was restated after a January 2005 TVARS Board approved plan change was effected in which future fixed growth rates on certain retirement accounts will now decrease Page 106

fifty basis points per annum until the adjusted rate reaches a WARS Board approved floor. Prior to the plan change, such retirement accounts were assumed to grow at a ten percent rate per annum. The effect of the change was to lower the September 30, 2004, PBO by $144 million from $7.8 billion to a recalculated value of $7.6 billion at October 1, 2004. From that point forward, PBO increased a total of $823 million comprised, in part, of an increase of $191 mil-lion due to normal operation of the plan (in the form of service cost and interest accruals, etc.). The remaining $632 million increase in the PBO is due to changes in the discount rate ($396 million), and changes in the cost of living assumptions ($134 million), and incurred liability losses ($102 million) related primarily to more-than-assumed early retirements. The assumptions used in the 2005 end-of-year actuarial valuation process had no effect on pension costs for 2005, 2004, or 2003. However, in conjunction with changes in the assumptions utilized and othe, plan participant dynamics, TVA expects pension expense for 2006 to increase approximately $1 million compared to 2005. The accu-mulated benefit obligation (or ABO) at September 30, 2005, October 1, 2004, and September 30, 2004, was $8.0 bil-lion, $7.2 billion, and $7.4 billion respectively.

Other Postretirement Benefits TVA sponsors an unfunded postretirement plan that provides for non-vested contributions toward the cost of certain retirees' medical coverage. This plan formerly covered all retirees participating in the TVA medical plan, and TVA's contributions were a flat dollar amount based on the participants' ages and years of service and certain pay-ments toward the plan costs. This plan now operates on a much more limited basis, covering only ce-tain retirees and surviving dependents who do not qualify for WARS benefits, including the vested supplemental pension benefit.

The initial annual assumed cost trend for covered benefits was 9.0 percent in 2005, decreasing by one-half percent per year to a level of 5.0 percent in 2013 and thereafter. For 2004 and 2003, annual trend rates of 8.5 per-cent and 8.5 percent, respectively, were assumed. The effect of the change in assumptions on the cost basis was not significant. Increasing/(reducing) the assumed health-care cost trend rates by one percent would increase/(reduce) the accumulated postretirement benefit obligation ("APBO") as of September 30, 2005, by $66 million/($73 million) and the aggregated service and interest cost components of net periodic postretirement benefit cost for 2005 by $5 mil-lion/($5 million). The weighted average discount rate used in determining the end-of-year APBO was 5.375 percent for 2005, 5.81 percent for 2004, and 6.00 percent for 2003. Any net unrecognized gain or loss resulting from experi-ence different from that assumed or from changes in assumptions, and exceeding ten percent of the APBO, is amor-tized over the average remaining service period of active plan participants.

Based on the use of the assumptions described, the 2005 APBO for postretirement benefits increased approximately $97 million. The change in the obligation was comprised of a $16 million increase due to normal oper-ation of the plan (in the form of service cost and interest accruals, etc.) and an increase of $81 million due to other actuarial and experience adjustments and losses. The $81 million increase in the obligation is comprised of two com-ponents. The first component of the loss is comprised of an actuarial loss of approximately $29 million related prima-rily to the actuarial discount rate which was lowered to 5.38 percent in 2005 from 5.81 percent in 2004. The second component includes a combined loss of approximately $52 million due to TVA's decision to reset its heath care cost trend rate assumption at the end of 2005 from what would have been about 8.5 percent to nine percent: and an increase in retiree medical credit benefits (see next paragraph) available to TVA retirees to defray their out-of-pocket medical premiums. TVA not only bears the incremental funding requirement associated with these increased benefits but must recognize the funding costs as additional expense. TVA's exposure to further increases in these benefits will contin-ue until such time as the cap established for this benefit is reached by all eligible retirees. The total payments made by TVA on behalf of its retirees increased by about 25 percent and the number of retirees receiving the medical cred-it increased by about 30 percent.

The set of assumptions used for the end-of-year actuarial valuation process had no effect on postretirement benefit costs for 2005, 2004, or 2003 but, when coupled with further experience adjustments related to claims and con-tributions, will increase postretirement benefits expense for 2006 by approximately $12 million compared to 2005. TVA expects 2006 postretirement health care cost to approximate $58 million, an increase of $12 million over 2005 costs, excluding special termination benefits.

Effective July 1, 2002 (applied retroactively to January 1, 2002), TVA changed its retiree medical plan to pro-vide an enhanced TVA contribution for certain retirees who retired with 20 or more years of service and are eligible for the supplemental pension benefit from TVARS. The benefit is in the form of a credit provided by TVA to eligible retirees to help offset the cost of medical premiums. The additional benefit increased the accumulated postretirement benefit obligation approximately $97 million at the end of 2002. Pursuant to SFAS No. 106, "Employers'Accounting for Postretirement Benefits Other Than Pensions," the increase in cost is combined with the existing net unrecognized Page 107

prior service cost and amortized to expense over future periods. -Expense for 2003 increased approximately $17 mil-lion (from $19 million in 2002 to $36 million in 2003) due primarily to the additional prior service cost amortization and corresponding increases in service cost and interest cost coupled with changes in demographic information and actu-arial assumptions.

Medicare Prescription Drug Improvement and Modernization Act of 2003 In December 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 became law; The act introduces a prescription drug benefit under Medicare (Part D) as well as a federal subsidy to employers that provide a retiree prescription drug benefit that is at least actuarially equivalent to Medicare Part D. TVA decided that its retiree drug plan is not actuarially equivalent as described by the Act of 2003, and accordingly, has not includ-ed or utilized any manner of subsidy in the determination of APBO or postretirement benefit cost (see note 11 Benefit Plans), for the current or prior periods, in accordance with the requirements contained within the FASB3 Staff Position

("FSP-), FSP FAS 106-2, 'Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003.

Beginning in 2006, Medicare will provide prescription drug coverage under Medicare Part D. After analyzing a number of options available to plan sponsors for integration with the new Medicare Part D, WVA elected to provide an employer.;sponsored Part D prescription drug plan ("POP"), with alterna-tive coverage over and above Medicare standard Part D coverage, for Medicare-eligible retirees who participate in WVA's Medicare supplement., By providing* an -employer-sponsored PDPR an~y Medicare subsidies will be passed through to retirees in the form of lower participant premiums and should not affect WVA's cost of providing, prescription drug coverage.

-Page 108

Components of Pension and Postretirement Benefits The components of pension expense and other postretirement benefits expense for the years ended September 30 were:

Pension Benefits 2005 2004 Other Postretirement 1

Benefits 2005

-2004 Change in benefit obligation Benefit obligation at beginning of year.....................

Service cost.........................................

Interest cost........

Plan participants' contributions.......................

Amendments, including special events....................

Actuarial loss........................................

Net transfers from variable fund/401 (k) plan...........

Expenses paid........

Benefits paid.........................................

Benefit obligation at end of year...................

Change in plan assets Fair value of plan assets at beginning of year...............

Adjustment to reconcile to system asset value..............

Actual return on plan assets............................

Plan participants' contributions...........................

Net transfers from variable fund/401(k) plan................

Employer contributions......

Expenses paid.......................................

Benefits paid.......................................

Fair value of plan assets at end of year....................

Funded status........................................

Unrecognized net actuarial loss..........................

Unrecognized prior service cost..........................

Unrecognized transition obligations.......................

Prepaid (accrued) benefit cost...........................

7,754 117 428 41 489 24 (4)

(416) 8,433

$' 6,415 1

902 41 24 53 11 (4)

(416) 7,015

$ (1,418) 1,554 311 447

$ 6,950 112 406 43 605 21 (5)'

(378)

$ 7,754 5,930 781 '

43 21.

23 (5)

(378)

$ 6,415

$ (1,338) 1,628 347 637 447 6

25 63 91 544 63 25 (544) 237 44 (2E3) 314 5

19 i59 7

120 (77) 447

. 1 59 18 k

1 77)

(447) 156 49 (242~)

Amount recognized on balance sheet Prepaid benefit cost............

Accrued benefit liability (1,010)

Other long-term asset........

311 Accumulated OCI reclassified to regulatory assets............

I -

1,146 Net amount recognized...............

447 I

i

-.~

y r.

Weighted average assu'mptions as of September 30 Discount rate Expected return on plan assets Rate of compensation increase Initial health care trend rate Ultimate health care trend rate Ultimate year in which trend rate is reached

'Page I 2005 5.38%

8.25%'

3.3% - 10.1%

NA NA NA (945)

(263)

(242) 347 1,235 7

637

$.J?(;)

(242) 2004 2005 2004 5.81%

5.38%Y6 5.81%

8.25%

NA NA 3.3%-10.1%

NA NA NA 9.00%

9.00%

NA 5.00%

5.00%

NA 201:3 2012 0.

I I

109

Other Pension Benefits Postretirement Benefits 2005 2004 2003 2005 2004 2003 Components of net periodic benefit cost Service cost 117 112 Interest cost.

429 406 Expected return on plan assets

........... (457)

(464)

Amortization of prior service cost 36 36 Amortization of transition obligation.........

Recognized net actuarial loss..........

118 88 Net periodic benefit cost.

243 178 Special events.............................

Total benefits cost..........................

243 178 90 411 (496) 36 6

25 NA 5

5 6

18 23 NA NA 5

5 41 41 10 46 46 I 1 29 7

36 2

36 36 Pension Benefits 2005 2004 Other

-Postretirement Benefits 2003

. 2005 2004 2003 Weighted average assumptions used to determine expense Discount rate Expected return on plan assets Rate of compensation increase Initial health care trend rate Ultimate health care trend rate Ultimate year in which trend rate is reached 5.81%

8.25%

3.3%-10.1%

NA NA NA 6.00%

8.50%

3.3%-10.1%

NA NA NA 7.05%

8.50%

3.3%-10.10i/

NA.

NA NA 5.81 %

NA NA

, 9.00%

• 5.00%

2012 6.00%

NA NA_.

8.50%

5.00%

2010 7.05%

NA NA 8.50%

5.00%

2009 Sensitivity to the assumed health care cost trend rates for 2005 1% Increase Effect on total of service and interest cost components 5

Effect on end-of-year accumulated postretirement benefit obligation 66 Estimated future benefit payments Fiscal Year 2006 Fiscal Year 2007 Fiscal Year 2008 Fiscal Year 2009 Fiscal Year 2010 Fiscal Years 2011-2015 Pension

$ 498 507 522 537 549 2,955 1% Decrease (5)

(73)

Other 21 24

.27 i 30 33 187 Investments held in the TVA retirement plan are stated at fair value, which is determined by the Trustee of the fund..

The WARS Board adopted the following revised asset allocation policy for investment of the TVARS's funds:

45 percent United States equities, of which five percent (as measured as a percentage of the total fund) may be pri-vate equity or other similar alternative investments as long as such investments do not involve holding title to real prop-erty; 40 percent fixed income, of which ten percent may be high yield (as measured as a percentage of the total fund);

and 15 percent non-United States equities. A three percent deviation, either plus or minus, from these target alloca-tions, including the target allocations for private equity and high yield fixed income, is permissible. The WARS Board also renewed the Executive Secretary's authority to take action, as appropriate, to rebalance the TVARS's assets con-sistent with this asset allocation policy.

'Plan Contributions TVA contributed $53 million to its qualified pension plans in 2005 and expects to contribute $75 million in 2006.

Other Non-Qualified Retirement and Deferred Compensation Plans In 1995, TVA established a Supplemental Executive Retirement Plan ("SERP") to provide additional benefits to specified individuals that are not available under the qualified pension plan. The SERP is invested in securities gen-erally designed to achieve a return in line with a combination of overall fixed income and equity market performance.

Page 110

The nature of these investments comprises physical securities and certain derivative instruments. The derivative instru-ments used include futures contracts. These instruments are used across various asset classes to achieve a desired investment structure. The derivative instruments in the fund are comprised of 228 contracts. 'Investments held in the SERP are stated at fair value, which is determined by 'he Trustee of the fund. Futures positions are marked to mar-ket on a daily basis. TVA has historically funded the annual calculated expense and due to the immaterial nature of the amounts, TVA has not made financial statement disclosures related to this plan. As of and for the year ended September 30, 2005, TVA recognized certain amounts related to the plan including plan assets in trust of $17 million, a regulatory asset of $12 million; an intangible asset of $1 million, an estimated accrued and minimum pension plan obligation of $35 million, expense of $6 million, and current year gains on plan assets of $1 million of which all was realized. In addition, $2 million in benefit payments were made from the plan during the year, and TVA will make con-tributions of $7 million to the plan in October 2005. As of and for the year ended September 30, 2004, TVA recognized certain amounts related to the plan including plan assets in trust of $18 million with gains on plan assets of $0.7 mil-lion of which $0.2 million was unrealized. In addition, $2 million in benefit payments were made from the plan during the year, and TVA made contributions of $3 million to the plan during the year.

Other Postemployment Benefits Other postemployment benefits include workers' compensation provided to former or inactive employees and their beneficiaries and covered dependents for the period after employment but before retirement. TVA's workers' com-pensation program is administered through the Department of Labor by the Office of Workers' Compensation Programs

('OWCP") in accordance with the provisions of the Federal Employees' Compensation Act ("FECA"). FECA provides compensation benefits to federal employees for permanent and temporary disability due to employment-related injury or disease. TVA recognizes these costs as incurred.

Postemployment benefit cost estimates are revised to properly reflect changes in actuarial assumptions made at the end of the year. TVA modified certain of its assumptions based on information in existence at the end of 2004 and determined it appropriate to shorten slightly the period of time over which it expects to pay Dut claims relat-ed to certain estimated losses. Accordingly, TVA lowered its 2004 discount rate assumption. For 2005, TVA has deter-mined to utilize a discount rate of 4.34 percent representing the risk-free rate corresponding to the U. S. Treasury rate for a ten year maturity. Use of the ten year maturity co-responds to calculated average durations of TVA's future esti-mated postemployment claims payments. The use of a 4.34 percent discount rate resulted in the recognition of 2005 annual expense of approximately $72 million and an unpaid benefit obligation of about $429 million al year end. TVA utilized a discount rate of 5.75 percent and 6.00 percent in 2004 and 2003 respectively. The changes in 2005 assump-tions had no effect on postemployment expense for 2004 and 2003.

12. Commitments and Contingencies As of September 30, 2005, the amounts of contractual cash obligations maturing in each of the next five years and thereafter are shown below:

2006 2007 2008 2009 2010:

Thereafter Total Debt 5,240 $

970 91 2,031 42

$ 14,714

$ :23,088 Interest on debt 1,220 1,027 1,001 945 891 12,196 17,280 Leases 84 82 72 66 63 46

.413 Lease/leaseback transactions 85 85 89 85 89 1,209' 1,642 Power purchase obligations 184 165

133 138 139 3,565 4,324 Other obligations 420 146 111 i

5 2

7 691 Fuel purchase obligations 958 333 299 208 166 36$i 2,327 Decommissioning 25 25 Retirement system 75 75 Total 8,291

$ 2,808

$ 1,796

$ 3,478

$ 1,392

$ 32,100

$ 49,865' Notes:

• Contributions/payments beyond 2006 to be determined based on funding requirements.

In addition to the cash requirements above, TVA has contractual obligations in the form of revenue dis-counts related to energy prepayments discussed above.

Page 111

2006 i

2007 2008 2009 2010 Thereafter' Total Energy Prepayment Obligations 106 106 105 105 105 823 3_50 Commitments Leases. TVA leases certain property, plant, and equipment under agreements with terms ranging from one to 30 years. Obligations under capital lease agreements in effect at September 30, 2005, total $60 million for 2006,

$63 million for 2007, $59 million for 2008, $57 million for 2009, $57 million for 2010, and an aggregate of $36 million thereafter, for a total commitment of $332 million. Of this amount, $76 million represents the cost of financing; Obligations under non-cancelable operating lease agreements in effect at September 30, 2005, total $24 million for 2006, $19 million for 2007, $13 million for 2008, $9 million for 2009, $6 million for 2010, and $10 million thereafter for a total commitment of $81 million.

i.

I Lease/Leaseback Transactions. Obligations under combustion turbine and qualified technological equipment lease/leaseback transactions in effect at September 30, 2005, total $85 million annually for 2006 and 2007, $89 mil-lion for 2008, $85 million for 2009, $89 million for 2010, and an aggregate of $1.2 billion thereafter, for a total commit-ment of $1.6 billion. Of this amount, $499 million represents the cost of financing.,.

Power Purchase Obligations.

VA has contracted with various independent power producers and power dis-tributors for additional capacity to be made available to TVA. In total, these agreements constitute 2,578 megawatts of winter net dependable capacity. Approximately 80 percent of this total capacity is made available to TVA under power purchase agreements that will expire within two years. The total financial obligation of these contracts is approx-imately $4.2 billion. Additionally, TVA has contracted with various other counterparties for the purchase of power from renewable sources (wind and methane gas technologies). 'These arrangements constitute about 33 megawatts of capacity. Of this total, 27 megawatts are attributable to wind generation, and due to the nature of this energy source, they are not included in the determination of net winter dependable capacity. TVA's financial obligation related to these renewable resource power purchase agreements is $100 million. In total, TVA's financial obligation for all of its power purchase agreements is approximately $4.3 billion.. Costs under these contracts are included in the Statements of Income for the years ended September 30, 2005, 2004, and 2003 as FUEL AND PURCHASED POWER expense and are expensed as incurred in accordance with the normal purchases and sales exemption described in SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, " as amended.

Under the Public Utility Regulatory Policies Act of 1978, TVA is obligated to purchase power from qualifying facilities. There are currently two independent power producers, with a combined capacity of 1,600 megawatts, that qualify under this program. However, the potential for TVA being required to take substantial amounts of power from these facilities under these circumstances has been mitigated by certain contractual arrangements entered into in 2005.. Costs associated with these purchases are based on rates as specified in 'Attachment A" of the Dispersed Power Production Guidelines for TVA and the Distributors of TVA Power as approved annually by the Board.

TVA also has an agreement with the Southeastern Power Administration to receive 405 megawatts of net dependable capacity from the Cumberland River Basin Projects for use in the TVA system. TVA receives a yearly ener-gy allocation of 607,500 megawatt hours which is based on the reserved capacity. Once this allocation is exceeded, TVA is assessed an additional energy charge for the excess generation received based on rates as specified in the Federal Register.

Other Obligations. Other obligations of $691 million consist of contracts negotiated as of September 30, 2005, for goods and services primarily related to capital projects as well as other major recurring operating costs. TVA has approximately $587 million in long-term construction commitments consisting primarily of the construction of gen-erating assets (including Browns Ferry Unit 1), and emission control equipment. In addition to construction commit-ments, TVA is committed under various other contracts for recurring goods and services of $104 million with terms extending into 2010.

Fuel Purchase Obligations. TVA has approximately $1.2 billion in long-term fuel purchase commitments rang-ing in terms of up to four years for the purchase and transportation of coal, and approximately $1.1 billion of long-term commitments ranging in terms of up to 10 years for the purchase of enriched uranium and fabrication of nuclear fuel assemblies.

Page 112

Tritium-Related Services. In September 2002, the NRC issued an amendment to the Watts B r Nuclear Plant operating license, allowing TVA to irradiate tritium-producing burnable absorber rods ("TPBARS") at the plant to assist DOE in producing tritium. TVA's license amendment currently allows operation with a maximum of 240 TPBARS in the Watts Bar reactor. A planned future license amendmen: will permit installation of up to 2,304 TPBARS. In general, the TPBARS will be irradiated for a full cycle, which lasts about 18 months. 'TVA will then remove the irradiated TPBARS for shipment to DOE's tritium-extraction facility and load a fresh set of TPBARS into the reactor. TVA began irradiat-ing TPBARS at Watts Bar in the fall of 2003 with the first removal of TPBARS occurring in the spring o' 2005. The first batch of irradiated TPBARS has been successfully shipped to the DOE facility. Also in September 2002, the NRC issued a similar amendment to the Sequoyah Nuclear Plant operating license allowing TVA to provide tritium-related irradiation services. :At this time, no tritium-related services.have been scheduled at.the Sequoyah Nuclear Plant.

While irradiating TPBARS, TVA is able to operate the reactors for its program mission of producing electricity. Income related to these services is included in OTHER REVENUE.

TVA has a long-term interagency agreement with DOE to utilize TVA's Sequoyah and Watts Bar Nuclear Plants to produce tritium. This agreement, ending in.2035, requires DOE to reimburse TVA for costs incurred plus a fee per TPBAR produced for irradiation services.

Contingencies Concentration of Credit Risk. Seven customers, which represented an aggregate of 35 percent of TVA's total power sales in 2005, 2004 and 2003, purchased power from TVA under contracts that require either five or ten years' notice to terminate. Outstanding accounts receivable for these customers at September 30, 2005, were $411 million, or 36 percent, and at September 30, 2004, were $368 million, or 35 percent, of total outstanding accounts receivable.

Nuclear Insurance. The Price-Anderson Act provides a layered framework of protection to compensate for losses arising from a nuclear event. For the first layer, all NRC nuclear plant licensees, including TVA, purchase $300 million of nuclear liability insurance from American Nuclear Insurers (CANI") for each plant with an operating license.

The second layer, the Secondary Financial Program ("SFP"), would come from an assessment of up $100.59 million from the licensees of each of the 104 NRC licensed reactors in the United States. The assessment for any nuclear accident would be limited to $15 million per year per reactor. ANI, under a contract with the NRC, adm nisters the SFP.

With its six licensed units, TVA could be required to pay a maximum of $603.54 million per nuclear incicent, but it would have to pay no more than $90 million per incident in any one year. When the contributions of the nuclear plant licensees are added to the insurance proceeds of $300 million, over $10.7 billion would be available. Under the Price-Anderson Act, if the first two layers are exhausted, Congress is required to take action to provide additional funds to cover the additional losses.

.,1 I

.i e

TVA carries property, decommissioning, and decontamination insurance of $2.06 billion for its licensed nuclear plants to cover the cost of stabilizing or shutting down a reactor after an accident. Some of this insurance may require the payment of retrospective premiums up to a maximum of approximately $62 million.

TVA purchases accidental outage (business interruption) insurance for TVAs nuclear sitEs from Nuclear Electric Insurance Limited ("NEIL"). In the event that an accident covered by this policy takes a nuclear unit offline or keeps a nuclear unit offline, NEIL will pay TVA, after a deductible waiting period, an indemnity (a set dollar amount per week) up to a maximum indemnity of $490 million per unit. This insurance policy may require the payment of retro-spective premiums up to a maximum of approximately $24 million.

Decommissioning Costs.

Provision for decommissioning costs of nuclear generating units is based on options prescribed by NRC procedures to dismantle and decontaminate the facilities to meet NRC criteria for license termination.

TVA recognizes as incurred all obligations related to closure and removal of its nuclear units. The liability for closure is measured as the present value of the weighted estimated cash flows required to satisfy the related obliga-tion and discounted at the credit adjusted rate of interest in effect at the time the liability was actually incurred or orig-inally accrued, and subsequently modified to comply w th the prevailing accounting provisions. The charge to recog-nize the additional obligation is effected by adjusting the corresponding regulatory asset. Earnings from decommis-sioning fund investments, amortization expense of the decommissioning regulatory asset, and interest expense on the decommissioning liability are deferred in accordance with SFAS No. 71, 'Accounting for the Effects of Certain Types of Regulation." At September 30, 2005, the present valje of the estimated future decommissioning cost of $1.6 billion was included in ASSET RETIREMENT OBLIGATIONS, and the unamortized regulatory asset of $716 million was included in Page 113

OTHER REGULATORY ASSETS. This decommissioning cost estimate is based on amounts prescribed by the NRC for removing a plant from service, releasing the property for unrestricted use, and terminating the operating license. The actual decommissioning costs may vary from the derived estimates because of, among other things, changes in the assumed dates of decommissioning, changes in regulatory requirements, changes in technology, and changes in the cost of labor, materials, and equipment. Utilities that own and operate nuclear plants are required to use different pro-cedures in calculating nuclear decommissioning costs under SFAS No. 143 than those that are used in calculating nuclear decommissioning costs when reporting to the NRC. Accordingly, the two sets of procedures produce different estimates for the costs of decommissioning. See note 4.

TVA maintains a decommissioning trust fund to provide funding for the decommissioning of nuclear plants.

The fund is invested in securities generally designed to achieve a return in line with overall equity market performance.

The nature of these investments comprises physical securities and certain derivative instruments. --The derivative instruments that may be used include options, futures, forwards, and swaps. These instruments are used across var-ious asset classes to achieve a desired investment structure. The derivative instruments in the fund are comprised of 919 contracts. These contracts include futures, options on futures, and swap agreements. Investments held in the decommissioning fund are stated at fair value, which is determined by the Trustee of the fund. Futures and options on futures positions are marked to market on a daily basis. The swap agreements are marked to market on a month-ly basis. The assets of the fund as of September 30, 2005, totaled $835 million for a total gain of $115 million of which

$48 million was unrealized. The assets of the fund as of September 30, 2004, totaled $720 million for a total gain of

$88 million of which $29 million was unrealized. The assets of the fund as of September 30, 2003, totaled $632 mil-lion for a total gain of $133 million of which $132 million was unrealized.

Cost-Based Regulation. Regulatory assets for TVA totaled approximately $6.3 billion and regulatory liabili-ties totaled approximately $897 million at September 30, 2005. Management cannot predict the potential impact, if any, of the change in the regulatory environment on TVA's future financial position and results of operations. (See note 1-Cost-Based Regulation and note 5.)

Environmental Matters. TVA's activities are subject to certain federal, state, and local environmental statutes and regulations., Major areas of regulation affecting TVA's activities include air quality control, water quality control, and management and disposal of solid and hazardous wastes.

TVA has incurred and continues to incur substantial capital and operating/maintenance costs in order to com-ply with evolving environmental requirements. Many of these costs are associated with the operation of TVA's 59 coal-fired generating units. While it is not possible to predict with any precision how these evolving requirements will impact the operation of existing and new coal-fired and other fossil-fuel generating units, it is virtually certain that environmen-tal requirements placed on the operation of these generating units will continue to become more restrictive. Litigation over emissions from coal-fired generating units is also growing, including litigation against TVA.

Several existing regulatory programs have been and are being made more stringent in their application to fos-sil-fuel units and additional regulatory programs affecting fossil-fuel units have been promulgated in the past year. The total cost of future compliance with nitrogen oxide ('NO."), sulfur dioxide ("S02"), and mercury emission reduction requirements cannot reasonably be determined with precision at this time because of the uncertainties surrounding emerging EPA regulations, resultant compliance strategies, the potential for the development of new emission control technologies, court litigation, and future amendments to the Clean Air Act ("CAA"). However, additional costs for future regulations could be $3.0 to $3.5 billion through 2020, in addition to the costs to install SCRs and scrubbers described below. In addition to these costs, there could be other substantial costs if reductions of carbon dioxide ("CO2") are man-dated (discussed in more detail below). Predicting how and when C02 may be regulated is very uncertain, even more so than the future regulation of other substances. TVA will continue to monitor this issue and will assess and respond to potential financial impacts as they become more certain.

Expenditures related to TVA's clean air projects during 2005 and 2004 were approximately $202 million and

$400 million, respectively. During 2005, TVA spent $51 million on its publicly announced SCR program and $146 mil-lion on its publicly announced scrubber programs.

Clean Air Developments. Air quality in the United States has significantly improved since the enactment of the modern CAA in 1970. These air quality improvements are expected to continue as the CM and its implementing programs evolve through legislative and regulatory changes. Three substances emitted from coal-fired units have his-torically been the focus of emission reduction regulatory programs: SO2, NO., and particulates. TVA's total cost through 2010 is expected to reach $5.7 billion to reduce these emissions, $4.4 billion of which TVA has already spent as of Page 114

September 30, 2005. This figure includes the publicly announced SCR and scrubber programs outlined above, but not the $3.0 to $3.5 billion in potential future costs for additional reductions. Recently, attention has been given to two other substances emitted by coal fired units: mercury and C02. Increasingly stringent regulation of some or all of these substances will continue to result in significant capital and operating costs for coal-fired generating units, including those operated by TVA.

Sulfur Dioxide. Coal-fired utilities have historically emitted large amounts of SO2. Utility S02 emissions are extensively regulated and will be regulated further under state programs to achieve and maintain EPA's National Ambient Air Quality Standard for SO2, the acid rain control program, and - depending on when units commenced oper-ation and their effect on sensitive areas - the regional haze program. EPA's new, stringent fine particle national ambi-ent air quality standard is expected to result in additional significant reductions of utility S02 emissions because S02 can transform into sulfates, and sulfates are a major component of fine particles in the eastern United States., Since 1977, TVA has reduced its S02 emissions by approximately 78 percent by switching to lower-sulfur coals, re-powering a unit at its Shawnee Fossil Plant with the advanced Atmospheric Fluidized Bed Combustion Technology, and installing flue gas desulphurization technology (scrubbers') on six of its larger units. A seventh scrubber at unit 3 of Its Paradise Fossil Plant is under construction. In 2005, TVA broke ground on its eighth scrubber at its Bull Run Fossil Plant in East Tennessee, as part of its previously announced plans to install additional scrubbers to achieve a total S02 emission reduction of 80.to 85 percent. TVA also has switched, or plans to switch to lower sulfur coal on several additional units in the next few years. These plans may change depending on the timing and severity of new S02emission reductions that have been promulgated but not yet fully implemented under the Clean Air Interstate Rule ("CAIR"). The State of North Carolina also petitioned EPA under Section 126 of the CAA to impose additional emission reductions require-ments for SO2 and NO emitted by coal-fired power plants in 13 states, including Kentucky, Tennessee, and Alabama where TVA's coal-fired power plants are located. The EPA proposes to deny the North Carolina petition primarily on the basis that CAIR remedies the problem.

Nitrogen Oxide. Utility NO. emissions are extensively regulated and are expected to be regulated further under state programs to achieve and maintain EPA's national ambient air quality standard for ozone (NO. combines with volatile organic compounds in the presence of sunlight to produce ozone under certain meteorological conditions),

the acid rain control program, and - depending on when units commenced operation and their effect on sensitive areas

- the regional haze program. EPA's new, more stringent eight-hour ozone and fine particle national ambient air quality standards could result in requirements to further reduce NO. emissions from coal-fired power plants and other fossil-fuel generation such as combustion turbines. (NO emissions can transform into nitrates, another component of fine particles.) Since 1995, TVA has reduced its NO. emissions during the summer (when ozone levels Increase) by approx-imately 80 percent by installing various combustion controls on all 59 coal fired units. TVA has also installed selective catalytic reduction technology ("SCRs) on 20 of its units and is in the process of installing an SCR on one additional unit. Also in 2005, TVA began evaluations of Selective Non-Catalytic Reduction ("SNCR") systems at two units. TVA's NO. emission reduction program is expected to continue to depend primarily on SCRs, but will also likely incorporate SNCRs if the evaluations are favorable. These plans may change depending on the timing and severity of new NO.

emission requirements that have been promulgated under CAIR but have not yet been finally implemented. The State of North Carolina has petitioned EPA to establish additional emission reduction requirements for S02 and NO. emitted by coal-fired power plants in 13 states, including Kentucky, Tennessee, and Alabama where TVA's coal-fired power plants are located. The EPA proposes to deny the North Carolina petition primarily on the basis that CAIR remedies the problem.

Particulates/Opacity Larger particulates (fly ash), as opposed to fine particles discussed above, have long been regulated by states to meet EPA's national ambient air -quality standard for particulate matter (this has evolved into the new fine particle standard). TVA's coal-fired units have been equipped with mechanical collectors, electrostat-ic precipitators, scrubbers, or baghouses, which have reduced particulate emissions from the TVA system by more than 99 percent. As part of the periodic review of the national ambient air quality standards, EPA is evaluating additional, more stringent options for setting the standard. Issues about utility compliance with state opacity requirements are also increasing. Opacity measures the denseness (or color) of power plant plumes and has traditionally been used by states as a means of monitoring good maintenance and operation of particulate control equipment. Under some con-ditions, retrofitting a unit with additional equipment to better control S02 and NO. emissions can adversely affect opac-ity performance, and TWA and other utilities are now addressing this issue. There are also disputes with special inter-est groups over the role of continuous opacity monitors In determining compliance with opacity limitations.

Mercury. The EPA has issued a rule to regulate mercury emissions from coal-fired generating units under the CM. TVA supports a cap and trade program for mercury due to-the resounding success of the same program when it was used to reduce S02 emissions. TVA endorses EPA's approach to setting the first phase of mercury reductions Page 115

at a level consistent with the co-benefits'received from the reduction of S02 and NO under the CAIR. The billions of dollars TVA has spent and will continue to spend in response to CAIR and other rules to further reduce S02 and NO.

emissions Is expected to help TVA satisfy the additional requirements of EPA's mercury rule.

Carbon Dioxide. The existence, cause, and importance of global climate change continue to be widely debat-ed. 002is a greenhouse gas and is believed by some to contribute to climate change. Legislation has been introduced in Congress to require reductions of C02 that, if enacted, could result in significant additional costs for TVA and other coal-fired utilities. The Bush Administration has proposed a voluntary initiative that established a goal of reducing the greenhouse gas intensity-of the U.S. economy by 18 percent and has asked the electric utility sector and other indus-try sectors to support this initiative. TVA is supporting thisleffort in cooperation with electric utility industry trade asso-ciations and the Department of Energy. The last administration also asked utilities to voluntary participate In an effort to reduce, sequester, or avoid greenhouse gases. Uhder that program, TVA reduced,' sequestered, or avoided rhore than 275 million tons of C02 from 1994 through 2004, as reported under Section 1605b of the Energy Policy Act. TVA has also brought on line about 3,850 megawatts of non C02-emitting generation since 1990, and is In the process of adding another 1,800 megawatts of non C0-emitting generation.

Clean Water Developments. 'in the second phase of a three-part rulemaking to minimize the adverse Impacts from cooling water Intake structures on fish and shellfish, as required under section 316(b) of the Clean Water Act, EPA, promulgated a final rule for existing power producing facilities that became effective on September 7, 2004. The new rule requires existing facilities to select one of the following compliance options for reducing the number of organisms pinned against and/or drawn into the cooling systems: (1) have specific designated features, (2) install specific tech-nologies, (3) meet performance standards or (4) seek a site-specific compliance option based on application of cost/cost or cost/benefit tests. The site specific tests are designed to ensure that a facility's costs are not significant-ly greater than cost projections in the rule, or than benefits derived from taking mitigation actions. Actions taken to com-pensate for any impacts by restoring habitat, or pursuing other options such as building hatcheries for fish/shellfish pro-duction count toward compliance. Some northeastern states and environmental groups have challenged the new reg-ulation, and especially the compliance flexibility it offers, in federal court.

i All of TVA's existing coal-fired and nuclear generating facilities will be regulated by this rule. Compliance will involve some level of new assessments at all generating plants, and will likely require some capital and/or operating expenditures at some or all facilities. The assessments, however, are complicated somewhat by the uncertainty cre-ated by pending legal action challenging EPA's rule. Since TVA's generating facilities are located in areas which are not particularly sensitive to the effects of Intake structures, and its only previously identified intake related adverse impact has already been mitigated.

As is the case across the utility industry and in other industrial sectors, TVA is facing more stringent require-ments related to protection of wetlands, reductions in storm water impacts from construction activities, water-quality degradation and criteria, and laboratory -analytical methods. TVA is also following litigation related to the use of herbi-cides, water transfers, and releases from dams. TVA has a good compliance record and is not facing any substantive requirements related to non-compliance with, existing Clean Water Act regulations.

Hazardous Substances. Liability for releases and cleanup of hazardous substances is regulated by the fed-eral Comprehensive Environmental Response, Compensation, and Liability Act, among others, and similar state statutes. In a manner similar to many other industries and power systems, TVA has generated or used hazardous sub-stances over the years. TVA is aware of hazardous-substance releases at eleven offsite areas for which it may have some liability. TVA's potential liabilities for its share of cleanup costs at these sites are uncertain. In addition, TVA operations at some TVA-owned facilities have resulted in releases of oil and/or hazardous substances which require cleanup and/or remediation.

At September 30,2005, and 2004, TVA's estimated liability for enVironmental cleanup for those sites forwhich sufficient information is available to develop an estimate was $28 million and $29 million, respectively, and was includ-ed in OTHER LIABILITIES on the 2005 and 2004 year-end Balance Sheets. However, WVA has insufficient information to develop an estimate for some of the sites. -

Legal. TVA Is involved in various claims amounting to approximately $89 million incidental to the conduct of its business for which it has assessed the likelihood of gain or loss. The claims, grouped by likelihood of loss, include (1) claims recorded by TVAIn the amount of $13 million representing probable losses of $12 million and losses deemed reasonably possible of $1 million, and (2) claims of about $76 million for which a determination of loss, cannot be made at this time. (See note 17-Legal.)

Page 116

In the fall of 1999, the Environmental Protection Agency ("EPA") commenced judicial oradmi istrative actions against a number of utilities in the eastern United States, including TVA,'alleging that they modified their coal-fired units without complying with the new source review ("NSR") requirements under the CAA. Although no decision was ren-dered on the merits, TVA eventually prevailed in this litigation.

The National Parks Conservation Association ("NPCA") and the Sierra Club filed cases in two federal district courts in 2001 alleging that TVA modified its Bull Run Fossil Plant ("Bull Run") and Colbert Fossil Plant Unit 5 ("Colbert Unit 5") without complying with the NSR requirements of the CM. In March 2005, the district court granted TVA's motion to dismiss the lawsuit in the Bull Run case. The plaintiffs' motion for reconsideration was denied, and they have appealed to the Court of Appeals for the Sixth Circuit ("Sixth Circuit").. In the Colbert Unit 5 case, the parties have filed motions for summary judgment. The judge has ruled on some but not all of these motions, and dispositive motions remain to be considered. In similar lawsuits filed by EPA and others against other utility companies, the rulings by the respective courts differ widely.

-Environmental groups are taking legal action against TVA, as well as against other utilities across the coun-try, for allegedly violating opacity limits and other environmental regulations applicable to coal-fired plants.

The Alabama Environmental Council and the Sierra Club filed a lawsuit in federal district court in Florence, Alabama, alleging that TVA violated CM opacity limits applicable to'Colbert Fossil Plant between July 1, 1997, and June 30, 2002. The groups sought a court order that could require TVA to incur substantial costs, in addition to the costs TVA is already planning to incur for environmental con-trols, and pay civil penalties of up to approximately $250 million.; On September-14, 2004, the court found that TVA had not violated the CAA,-and the complaint was dismissed in its entirety. The plaintiffs have appealed the district court's decision to the Court of Appeals for the Eleventh Circuit (the "Eleventh Circuit"), which held oral argument on the case on August 17, 2005. The parties are awaiting the Eleventh Circuit's decision.

i,-.......-

, 1 On July 25, 2003, TVA received a notice of intent to sue from Our Children's Earth Foundation ("OCE").

OCE contends that WA violated the NSR requirements of the CM by undertaking major modifications

,of TVA's Allen Unit 3, Bull Run, Cumberland Units 1 and 2, Kingston Units 6 and 8, John Sevier Unit 3,

, Paradise.Units 1, 2, and 3, Shawnee Units 1 and 4, Colbert Unit 5, and Widows Creek Unit 5 without installing additional pollution control equipment. OCE also contends theCAA new source performance standards at Colbert Unit 5 and the operetions at TVA's Johnsonville Fossil Plant have not met the appli-cable opacity requirements. This notice does not specify a monetary amount of TVA's claimed liability.

- OCE's allegations about Bull Run and Colbert Unit 5 are already the subject of litigation in federal dis-trict courts initiated by the NPCA and the Sierra Club. In 2004, OCE obtained the district court's permis-sion to join as a plaintiff in the Bull Run NSR suit. It made a similar request in the Colbert NSR suit which the court denied as untimely.

The Sierra Club gave notice in a September 26, 2002, letter that it intends to sue TVA for violating CAA opacity limits applicable to the John Sevier and Kingston Fossil Plants. The notice claims that WTA vio-lated opacity standards at the two plants from July 1, 1997,- to the present.. The alleged opacity viola-

!tions substantially overlap those that were challenged in a lawsuit filed by the NPCA four years ago in

-,federal court in Knoxville, Tennessee. TVA ultimately prevailed in that lawsuit.' -The Sierra Club has notfiled suit.,

i

^ *

- On December 28, 2001, Bowater Incorporated and Bowater Newsprint South, Inc. (together, "Bowater") filed a lawsuit against TVA in federal court in Knoxville challenging TVA's charges for Economy Surplus Power ("ESP") and Testing and Restart Power ("TRP") for two Bowater plants. The lawsuit sought, among other things, compensatory damages in excess of $45 million; plus interest. TVA and Bowater settled the lawsuit by entering into revised and extended power supply arrangements at the two plants. The settlement agreement does not require TVA to pay Bowater for the damages sought. On March 8, 2005, the court dismissed this case with prejudice.

On August 31, 1999, Birmingham Steel Corporation filed a lawsuit in the U.S. District Court for the Northern District of Alabama alleging that TVA overcharged for E',P during the summer of 1998. The lawsuit was filed as a class action on behalf of industrial customers who participated in TVA's ESP program. Under ESP contracts, the hourly ESP energy price is calculated using TVA's actual incremental cost of supplying the ESP load in each hour. The'plaintiff alleges that TVA overcharged for ESP during the summer of 1998 by. including in the price of ESP some costs that were added to TVA's incremental cost. The complaint seeks over $100 million in damages on behalf of Birmingham Steel and the other class members. In September 2002, the district court decertified the class and then dismissed Page, 1)7

Birmingham Steel's individual claim without prejudice on a jurisdictional issue. The class lawyers appealed the ruling on class decertification, and in December 2003, the Eleventh Circuit reversed that ruling and sent the case back to the district court to allow the class lawyers a reasonable time to find a new class representative. The district court allowed the substitution of Johns Manville Corporation to represent the class; Motions for summary judgment were filed in October 2005.

l In December 2004;,a federal judge in Nashville, Tennessee, dismissed a lawsuit filed against TVA and 22 electric cooperatives by Tennessee residents and customers of some of the cooperatives, in part challenging TVA's practice of setting rates for electric power charged by distributors via its contracts. Both TVA and the cooperatives had filed motions to dismiss, which the court granted. The judge dismissed the plaintiffs' claims alleging violations of state law because the plaintiffs failed to carry out the steps necessary to bring these claims in court. The dismissal waswith-out prejudice, allowing the plaintiffs to re-file the claims if these steps are carried out and suit is filed within the statu-tory period. As to the plaintiffs' allegations of federal law violations, the court found that Congress had specifically authorized TVA to set the rates charged by distributors via its contracts. In the face of such express Congressional authorization, the plaintiffs' federal law claims failed as a matter of law and were dismissed with prejudice,} precluding them from being brought again. The plaintiffs moved for reconsideration of the dismissal, and the judge denied the plaintiffs' motion. The plaintiffs subsequently appealed to the Sixth Circuit.

In July 2004, two lawsuits were filed against TVA in federal court in New York City alleging that global warm-ing is a'public nuisance and that carbon dioxide ("CO2") emissions from TVA's fossil-fired electric generating facilities should be ordered abated because they contribute to causing the nuisance. The first case was filed by the States of California, Connecticut, Iowa, New Jersey, New York, Rhode Island, Vermont, and Wisconsin and the City of New York against TVA, American Electric Power, Inc., American Electric Power Service Corporation, Southern Company, Xcel Energy,'-lnc., and Cinergy Corporation. The second case, which alleges both public and private nuisance, was filed against the same defendants by Open Space Institute, Inc., Open Space Conservancy, Inc., and the Audubon Society of New Hampshire. There are no CM requirements limiting C02emissions, and, accoirdingly, the suits do not involve allegations of regulatory noncompliance. The theory of the cases is that global warming constitutes a nuisance and defendants' C02 emissions are contributing to the nuisance. Plaintiffs do not seek monetary damages, but do seek injunctive relief. Specifically, plaintiffs seek a court order requiring each defendant to cap its C02 emissions and then reduce these emissions by a specified percentage each year for at least a decade. The defendants filed motions to dismiss on September 30, 2004.' Oral argument was held on the motions'on August 12; 2005. In September 2005, the district court dismissed both lawsuits, concluding that they raised political questions that sh6uld not be decided by the courts. The plaintiffs have filed notices of appeal to the Court of Appeals for the Second Circuit.

Pursuant to the Nuclear Waste Policy Act of 1982, TVA (and all other domiestic-nuclear utilities) entered into a contract with DOE for the disposal of spent nuclear fuel ("SNF"). 1 Payments to DOE are based upon TVA's nuclear generation -and charged to nuclear fuel expense. Although the contracts called for DOE to begin accepting SNF from the utilities by January 31, 1998, DOE has announced that it would not begin picking up spent nuclear fuel from any domestic nuclear utility until 2010 at the earliest. TVA, like other utilities, stores SNF in pools of borated water at its nuclear sites. Although TVA would ihave had sufficient space to continue to store SNF in those storage pools at its Sequoyah and Browns Ferry Nuclear Plants indefinitely had DOE begun accepting SNF, DOE's failure to do so required TVA to construct dry cask storage facilities at its Browns Ferry and Sequoyah Nuclear Plants and to purchase special storage containers for the SNF. -(Watts Bar Nuclear Plant currently has sufficient storage capacity in its spent fuel pool to last until 2018.) Both Sequoyah's and Browns Ferry's dry cask storage facilities are operational. To recov-er the cost of providing long-term, on-site storage for SNF, TVA filed a breach of contract suit against the United States in the Court of Federal Claims in 2001. The evidentiary portion of the case for damages through 2004 was complet-ed in Washington D.C. in July 2005.- Closing arguments were made in October 2005. AXdecision is expected before the end of the calendar year 2005.

It is not possible to predict with' certainty whether TVA will incur any liability or to estimate the damages, if any, that TVA might incur in connection with the legal proceedings described above except as specifically noted.

13. Stewardship Responsibilities During 2005, TVA continued to' conduct certain nonpower programs, including maintaining navigable river channels, reducing flood damage, and overseeing certain recreation facilities. TVA's responsibilities include reservoir operations, navigation, dam safety, and the general stewardship of land, water, and natural resources.,'

Page 118

Historically, nonpower programs were primarily funded with federal appropriations. Certain nonpower pro-gram activities have also been funded with user fees and outside services revenues. In October 1997, Congress passed legislation that directed TVA to fund essential stewardship activities related to its management of the Tennessee River system and TVA properties with revenues from TVA's power program and other TVA revenue sources in the event that there were insufficient appropriations to pay for such activities in any year.

Beginning in 2000, Congress stopped providing appropriations to TVA to fund essential stewardship activi-ties. Consequently, in 2005, 2004, and 2003, TVA paid $93 million, $87 million, and $83 million, respeztively, for essen-tial stewardship activities primarily with power revenues. In addition, administrative jurisdiction over Land Between The Lakes was transferred to the Secretary of Agriculture effective October 1, 1999. As part of the transfer, TVA assumed responsibility for certain transition expenses associated with the transfer and has paid $10 million of transition expens-es with the last payment of $1 million having been made in 2004. TVA retains responsibility for management of the remaining nonpower assets and settlement of nonpower obligations..

At September 30,2005, the net completed p'ant balances for multipurpose dams and other plant were $636 million and $36 million, respectively (see note 3). At September 30, 2004, the net completed plant balances for mul-tipurpose dams and other plant were $645 million and $39 million, respectively.

14. Power and Nonpower Activities In the fourth quarter of 2004, TVA began reporting its power and nonpower program activities on a consoli-dated basis in its financial statements. The table below details the separate results of operations of each program.

2005 2004 2003 Power Nonpower Power Nonpower Power Nonpower Program Program Total Program Program Total Program Program Total (in millions)

Operatino revenues Sales of electricity

$ 7,704

$ 7,704

$ 7,439

$ 7,439

$ 6.875

$ 6,875 Other revenue 90 90 94 94 77 1

78 Total operating revenues 7,794 7,794 7,533 7,533 6,952 1

6,953 Operatina expenses Fuel and purchased power 2,601 2.601 2,081 2,081 1,957 1,957 Operating and maintenance 2,356 3

2,359 2,319 2,319 2,037 2

2,039 Depreciation and accretion 1,144 10 1,154 1,104 11 1,115 1,062 11 1,073 Tax-equivalents 365 365 338 338 329 329 Loss on asset impairment/

project cancellation 24 24 20 20 Total operating expenses 6,490 13 6,503 5.862 11 5,873 5,385 13 5,398 Operating income (loss)

$ 1,304 S

(13)

$ 1,291

$ 1,671 (11)

$ 1,660

$ 1,567 (12)

$ 1,555

15. Related Parties-TVA is a wholly-owned corporate agency of the federal government, and because of this relationship, TVA's revenues and expenses are included as part of the federal budget. TVA's purpose and responsibilities as an agency are described under the 'Other Agencies" section of the federal budget. Although TVA's bonds are not guaranteed by the federal government, they are included in the federal budget. TVA's bonds are supported solely by the TVA power system.

TVA receives no appropriations from the government and funds its business using internally generated power system revenues, power financings, and other revenues. TVA is actually a source of cash to the federal government.

Until TVA repays $1 billion of the government's Appropriation Investment under the self-financing amendment to the TVA Act, TVA repays a portion of the government's investment in the TVA power system and also pays a return on this investment (see Note 7-Appropriation Investment).

In the normal course of business, TVA contracts with other fed-eral agencies for sales of electricity and other services. Transactions with agencies of the federal government were as follows:

Page 119

I Related Party Transactions I

I. 2005,.

2004 2003 Sales of electricity services Other revenues Other expenses Receivables at September 30 Payables at September 30 Return on appropriation investment (note 7)

Return of appropriation investment (note 7) 168 15 222 26 131 16 20

$ 153 16 202 18

-203 18 20 141 254 22 211

-22 20

16. Unaudited Consolidated Quarterly Financial Information A summary of the unaudited quarterly results of operations for the years 2005 and 2004 follows. It should be read in conjunction with the audited financial statements appearing herein. Results for interim periods may fluctuate as a result of seasonal weather conditions, changes in rates, and other factors..-.

2005 (in millions)

First Second Third Fourth Total Operating revenues............

$. 1,834 Operating expenses.............................

1,435.

Operating income..............................

399 Net income (loss)..............

90

$ 1,839 1,562 277 (24) 1,881 2,240 1,553 1,953 328 287 (15) 34

-$. 7,794

_ 6,503 1,291 85 2004 First Second Third Fourth Total (in millions)

Operating revenues...........

1,777 1,879 1,857

$ 2,020 7,533 Historical operating expenses.....

1,378 Addition of nonpower expense.....

3 Reclassification of lease expense "'....

2 Operating expense after reclassification....

1,38 Operating income.

394 Reclassification of MTM gains (2).......

Net income (loss)..........

67 KIM-JIZ 1,443 3

3 1,44 430 118 1,463 3

2 1,468 389 (3) i$

105 1,568 5,852

- 2 11 3

10 1,573-5.873 447 1,660 3

96 386 (1) In 2004, TVA reclassified certain lease expenses from other expenses to Operating and Maintenance ("O&M'). The result was an in crease in O&M expense of $10 million and corresponding increase in Other Income, net of $10 million for year rep7 resented.

(2) Mark-to-market gains of $3 million on purchases emissions allowance options have been reclassified to OTHER INCOME, NET from OCI. The reclassification was also transferred from the fourth quarter of 2004 to the third quarter of 2004.

17. Subsequent Events I

na-1 ASer{A

~~

,i I

,. I I

I E

I'

'I 1

i '~j t

I I,

I O GU lius.

In October 2005, TVA issued $27 million of electronotes3 with an interest rate of 5.00 percent which mature in 2015 and are callable in 2007.

In November 2005, WVA issued $11 million of electronotes" with an interest rate of 5.5 percent which mature in 2020 and are callable in 2008.

Page 120

On October 2, 2005, TVA redeemed at par five bonds, in the ffVA electronotes' series. The bonds TVA redeemed are all of its 2001 6.35 percent electronotes" due June 15, 2021, with a par amount of $28 million, all of its 2001 6.10 percent electronotes" due August 15, 2021, with a par amount of $23 million, all of its 2002 6.00 percent electronotese due May 15, 2017, with a par amount of $40 million, all of its 2003 5.50 percent electronotese due August 15, 2018, with a par amount of $43 million, and all of its 2003 5.625 percent electronotesO due October 15, 2023, with a par amount of $14 million.

Legal On November 9, 2005, TVA received two invoices totalling $76 million from Areva for Framatome ANP, Inc, the predecessor of Babock and Wilcox Company ("B&W^"). In 1970, TVA and B&W entered into a contract for fuel fab-rication services for the Bellefonte Nuclear Plant.: Arefva's invoices are based upon its belief that the 1970 contract required TVA to buy more fuel fabrication services from B&W than TVA did. TVA is reviewing Areva's claim.

Management In November 2005, the President of the United States sent to the Senate nominations of five! people to serve on the TVA Board. The Senate has not announced when it will consider the nominations. As soon as three new Board members take office, the restructured Board provided for in the Consolidated Appropriations Act, 2005, will take effect.

Page 121

REPORT OF INDEPENDENT AUDITORS,

H.

To the Board of Directors of the Tennessee Valley Authority:

In ouriopinion, the accompanying balance sheets and the related statements of income, statements of cash flows, and statements of changes in proprietary capital present fairly, in all material respects, the financial position of the Tennessee Valley Authority at September 30, 2005, and 2004, and the results of its operations and its cash flows for each of the three years in the period ended September 30, 2005, in conformity with accounting principles generally-accepted in the United States of America. These financial statements are the responsibility of the Tennessee Valley Authority's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining,'

on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the account-ing principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

As discussed in note 1 to the financial statements, effective October 1, 2002, Tennessee Valley Authority changed the methodology for estimating unbilled revenue from electricity sales and adopted Statement of Financial Accounting Standards No. 143, Accounting forAsset Retirement Obligations."

Lu A PricewaterhouseCoopers LLP Knoxville, Tennessee November 17, 2005

'Page 122

2' 'REPORT OF MANAGEMENT--

Management is responsible for the preparation, integrity, and objectivity of the financial statements o` the Tennessee Valley Authority as well as all other information contained in the Information Statement. The financial statements have been prepared in conformity with generally accepted accounting principles applied on a consistent basis and, in some cases, reflect amounts based on the best estimates and judgments of management, giving due considera-tion to materiality. Financial information contained in the Information Statement is consistent with that in the financial statements.

_t r

f I

The Tennessee Valley Authority maintains an adequate system of internal controls to provide reasonable assurance.

that transactions are executed in accordance with management's authorization, that financial statements are pre-pared in accordance with generally accepted accounting principles, and that the assets of the corpon3tion are prop-erly safeguarded. The system of internal controls is documented, evaluated, and tested on a continuing basis. No internal control system can provide absolute assurance that errors and irregularities will not occur dua to the inher-ent limitations of the effectiveness of internal controls; however, management strives to maintain a balance, recog-nizing that the cost of such a system should not exceed the benefits derived. TVA performed an assessment of its internal control system and concluded that, as a result of internal control deficiencies, TVA's disclosure controls and. i procedures were not effective as of September 30, 2005 (see 'Controls and Procedures" in Part II):

PricewaterhouseCoopers LLP was engaged to audit the financial statements of the Tennessee Valley Authority and issue reports thereon. Its audits were conducted in accordance with auditing standards generally accepted in the United States of America. Such standards require a review of internal controls and an examination of selected transactions and other procedures sufficient to provide reasonable assurance that the financial statements neither are misleading nor contain material errors. The Report of Independent Auditors does not limit the responsibility of, management for information contained in the financial statements and elsewhere in the Information Statement.

Michael E. Rescoe Chief Financial Officer and Executive Vice President of Financial Services November 17, 2005 Page 123

REPORT OF INSPECTOR GENERAL To the Board of Directors of the Tennessee Valley Authority The Tennessee Valley Authority (TVA) contracted with the independent certified public accounting firm of PricewaterhouseCoopers LLP (PricewaterhouseCoopers) to audit the balance sheets as of September 30, 2005 and 2004, and the related statements of income, changes in proprietary capital, and cash flows for each of the three years in the period ended September 30, 2005. The contract required the audit be done in accordance with general-ly accepted government auditing standards.

Under the Inspector General Act, the Inspector General (IG) is responsible for taking appropriate steps to assure that any work performed by nonfederal auditors, including PricewaterhouseCoopers, complies with generally accepted government auditing standards. 'The Chief Financial Officers Act also places responsibilities on the IG regarding TVA's annual financial statement audit. In 'keeping with these statutory responsibilities, the TVA Office of Inspector General reviewed PricewaterhouseCoopers' reports and related audit documentation, interviewed their representatives, and performed such other procedures as we deemed appropriate in the circumstances to provide reasonable assurance the audit was performed in accordance with generally accepted government auditing stan-dards.

The objective of our review was not intended to enable us to express, and we do not express, an opinion on the TVA's financial statements or on management's conclusions about the effectiveness of its system of internal control. PricewaterhouseCoopers is responsible for the auditor's reports dated November 17, 2005, and the conclu-sions expressed in the reports. However, our review disclosed no instances where PricewaterhouseCoopers did not comply, in all material respects, with generally accepted government auditing standards. Our review was performed in accordance with generally accepted government auditing standards.

Richard W. Moore Inspector General November 18, 2005 Page 124

CHANGES IN AND DISAGREEMENTS WITH ACCOLINTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE During 2005, there were no changes in or disagreements with'TVA's independent auditors on accourting matters or'-

financial disclosure.

CONTROLS AND PROCEDURES A 'm i

i TVA maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in its financial statements is'recorded,1processed, summarized, authorized and reported on a timely basis, and that such'information is accumulated and communicated to TVA management, including members of the Board; the Disclosure Control Committee, and the Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

A

(,

JI)';

n

^

- i-S9>i An evaluation has been performed under the supervision of TVA management, including members of the Board and of the Disclosure Control Committee (including the Chief Financial Officer-and -the Controller) of the effec-tiveness of TVA's disclosure controls and procedures as of September 30, 2005. Based on that evaluation, the mem-bers of the Board and of the Disclosure Control Committee (including the Chief Financial Officer and the Controller) concluded that, as a result of internal control deficiencies (described below), TVA's disclosure controls and procedures were not effective as of September 30, 2005. However. to assess the financial statement impact of these internal con-trol deficiencies, TVA performed additional analyses,- interim proceduies,-and monitoring activities. As a result of these measures and through reliance on compensating controls, the' members'of the Board and of the Disclosure Control Committee (including the Chief.Financial'Officer.and the Controller) have determined that there is reasonable assur-ance that the financial statements included in this Statement fairly present, in all material respects, -TVIs financial con-'

dition, results of operations and cash flows as of, and for, the periods presented. ) However, these' identified internal control deficiencies, if not remediated,-could individually or in the aggregate result in a material weakness.

Note: The Public CompanyAccounting Oversight Board (PCAOB") has defined significant deficiency as "a control deficiency, or combination of control deficiencies<, that adversely affects the company's ability to initiate, author-ize, record, process, or report external financial data reliably in accordance with generally accepted accounting princi-ples such that there is more than a remote likelihood that a misstatement of the company's annual or interim financial statements that is more than inconsequential will not be prevented or detected.'

Further, the PCA OB has defined material weakness as 'a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected."

During the fourth quarter of 2005, TVA management identified a significant deficiency related to controls over the completeness, accuracy, and authorization of TVA's property, plant, and equipment transactions and balances. To remediate this deficiency, TVA is implementing additional internal controls in the areas of project approval and cost classification, timely accounting review of account balances and asset addition and retirement transactions, and for-mal documentation of management's reviews and approvals.

General computer controls are policies and procedures that relate to many applications and support the effec-tive functioning of application controls by helping ensure the continued operation of information systems. As of June 30, 2005, an internal control deficiency was identified related to TVA's general computer controls as follows:

Program development and program changes including (1) documentation of change authorization and (2) restricting programmer access to the production environment, and Unrestricted access to programs and data including (1) user administration, (2) application and system security configurations, and (3) periodic user access validation.

TVA is taking corrective actions to address this significant deficiency by implementing stronger controls over data and program changes, stricter logging and monitoring processes of data and program changes, and additional documentation and security procedures.

P'age 125

Previously, during the fourth quarter of 2004, management identified a significant deficiency related to TVA's end use billing arrangements with wholesale power customers. Under these arrangements, TVA relies on the cus-tomers to calculate major components of their own power bills. Without some assurance of the adequacy of customer internal controls, TVA cannot be reasonably satisfied that internal control deficiencies within the customer control envi-ronments do not exist. TVA has developed and communicated a plan to obtain annual Statement on Auditing Standards ('SAS") 70 internal control reports on 12 specific, control objectives from customers and their third party billing processors. The first SAS 70 reports will be due to TVA on August 31, 2006.

Also during the fourth quarter of 2004, TVA management identified a significant deficiency related to the mark-to-market valuation of coal contracts that contain volumetric optionality. Although key controls have been designed to facilitate the complete and accurate capture and processing of coal contract activities, many control activities were not standardized. To improve controls in this area, personnel have performed independent reviews of all new contracts to be included, supplements included, and changes made to the valuation model during the quarter ended September 30, 2005. TVA has also implemented standard control procedures to address this internal control deficiency which include independent reviews of the input of contract terms into the valuation model and proper segregation of duties.

During the fourth quarter 2005, TVA improved the design of controls over the conduct of physical observa-tions of materials and supplies inventory by requiring blind cycle counts, performing independent reviewsiand audits of periodic cycle counts, and segregating the cycle count duties between the personnel performing the counts and those recording and clearing differences. TVA also implemented the Automated Journal Entry System which automat-ed the approval of manual journal entries and resulted in increased oversight and improvement in the completeness and management of supporting documentation.

TVA management believes that a control system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the control system are met, and no evaluation, of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company can be detected. TVAs con-trols and procedures can only provide reasonable, not absolute, assurance that the objectives will be met. It should be noted that the design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all poten-tial future conditions, regardless of how remote.

Page 126

PART II'il-i

,9 t-i

ZI _t' DIRECTORS AND EXECUTIVE OFFICERS TVA is currently administered by a board of directors ("Board") composed of three persons appointed by the President of the United States and confirmed by the Senate, although'only two Board members were in office as of

'September 30, 2005. TVA's management'structure includes an Executive Committee which works with the Board to determine TVA's strategic mission and future direction, provides management oversight, and ensures that'policies of the Board are carried out.

However, the Consolidated Appropriations Act, 2005 includes provisions which will result in the restructuring of the Board and the appointment of a Chief Executive Officer. The legislation restructures the Board by increasing the number of directors from three full-time members to nine part-time members, at least seven of whom must be legal residents of the TVA service area. As with the current E3oard, future Board members will be appointed by the President and confirmed by the Senate, but after a transition peiod will serve five-year terms rather than the current nine-year terms. The Board's role will continue to be, among other things, to develop long-term plans and st ategies' for TVA, approve annual budgets and an employee compensation plan for TVA, and have general responsibility for TVA poli-

'cies. The Board will also create an audit committee consisting of members of the Board "independert of the manage-ment" to review reports from TVA's external auditors and Inspector General and make recommendations to the full Board. Congress also reaffirmed the authority of the Board to set electric rates charged by TVA. These provisions will go into effect on the date when three new members of the Board take office. The members of the BDard will select a member to serve as Chairman. Additionally, the Board will appoint a Chief Executive Officer who will report directly to the' Board.

'The Board and selected officers, their ages, their years of employment with TVA, and their principal occupations for recent years are as follows:

Directors

'Aae YearAbDointed"'

Year Term Exoire's 7

William W. Baxter, Chairman 52 2001 2011 Skila Harris, Director' a

'55 1999 2008 Mr. Baxter was appointed to the Board in November 2001.

Prior to Joining the Board, Mr. Baxter was

-Chairman and Chief Exe6utive Officer of Holston Gases Inc. of Knoxville,:Tennessee. : Before joining Holston Gases Inc. in 1981, Mr. Baxter was an attorney with Garrett, Coffee, McGee & Baxter in Knoxville. From December 1997 through December 2000, Mr. Baxter was Commissioner of the Department of Economic and Community Development for the State of Tennessee.

Ms. Harris was appointed to the Board in'November 1999. Prior to her current position, sie served at the Department of Energy ("DOE") as Executive Director of the Secretary of EnergyAdvisory Board. From 1993 until 1997, she was a Special Assistant to Vice President Gore and Mrs. Gore's Chief of Staff. She came to the White House from Steiner-Liff Iron and Metal Company in Nashville, Tennessee, where she was Vice President for Development and Compliance. Ms. Harris served as a project manager at the U.S. Synthetic Fuels Corporation, and She was with the DOE during the CarterAdministration. She has also held positions with management and engineering consulting firms specializing in energy-related work.

.Year Executive Officers Title -

Tom D. Kilgore..

President and Chief Operating Of icer Michael E. Rescoe Chief Financial Officer & Executive Vice President of Financial Services Maureen H. Dunn Executive Vice President and General Counsel John E. Long, Jr.

Executive Vice President, Administrative Services -

Kenneth R. Breeden Executive Vice President, Customer Service and Marketing Ellen Robinson Executive Vice President, Communications John Bradley Senior Vice President, Economic Development Theresa A. Flaim Senior Vice President, Pricing and Strategic Planning Employment

• , Age Commenced 57

2005

53 2003 56 1978

' 53 1980 I57 2004 51 2001 45 2002

, 56 2002 Page 127

Mr. Kilgore was named President and Chief Operating Officer in March 2005. Prior to his current position, he served as president and chief executive officer of Progress Ventures, a subsidiary of Progress Energy. Prior to his tenure at Progress Ventures, he was senior vice president of power operations for Carolina Power & Light directing the operation of fossil-fuel plants and president and chief executive officer of Oglethorpe Power Corporation in Georgia from 1991-1998.

f~~~~~-

,'-,I 0

Mr. Rescoe was named Chief FlinancialOfficer and Executive Vice President of Financial Services in July

• 2003. Prior to his current position, he served as Senior Vice President of Finance and Planning and Chief Financial Officer with 3Com Corp., as Chief Financial Officer of Pacific Gas & Electric, and as an investment banker serving util-ity and energy sectors with the New York-based Bear Stearns and Kidder, Peabody.

Ms. Dunnjoined TVA as an attorney, in May 1978, assumed the position of Assistant General Counsel in September 1986, and assumed the position of Executive Vice President and General Counsel in January 2001..

Mr. Long was named Executive Vice President of Administrative Services in September 2005. Since 2000, he had served as Vice President of Human Resources.; Since 1992, he has also served as a management appointee to the TVA Retirement System Board. Mr..Long joined TVA in 1980 as a Personnel Officer in the Engineering Division.

~ ~~/

Mr. Breeden was named Executive Vice President of Customer Service and Marketing in August 2004.- He has more than 20 years of utility-industry experience having served in officerlpositions at TXU Corp. in Dallas and at Entergy Services, Inc. in Little Rock, Arkansas. Before joining Entergy, Mr., Breeden worked for 11 years with South Central Bell in Nashville and Memphis and with AT&T in Nashville andNew Jersey.

Ms. Robinson was named Executive Vice President of Communications and Government Relations in June 2001. This position was retitled Executive Vice President of Communications in connection with the September 20, 2005, reorganization discussed in 'Management's Discussion and Analysis of Financial Condition and Results of Operations"-'Other Matters"-"Organizational Structure Changes" in Part II. She served as Senior Vice President of Communications and Government Affairs at CNH Global NV in Racine, Wisconsin, and before that as Vice President of Communications and Government Affairs at Case Corporation. Ms. Robinson joined Case from Burson-Marsteller in New York, where she was a Vice President and a head of the business-to-business marketing unit.

Mr. Bradley was named Senior Vice President of Economic Development in August 2002. He is responsible for recruitment and retention of capital investment and job creation, business development, technical services, and community development. Mr. Bradley served as Senior Vice President for Economic-Development for the Memphis Regional Chamber of Commerce from 1996 to 2002, and he worked in Memphis Light, Gas & Water's-economic devel-opment department from 1980 to 1996.

Dr. Flaim was named as Senior Vice President of Pricing and Strategic Planning in August 2005 after serving as the Senior Vice President of Strategic Planning and Analysis since June 2002. She is responsible for developing pricing and strategies related to the ongoing competitive restructuring of the electric-utility industry. She served for nine years -as Vice Presidentxof: Strategic Planning for Niagara Mohawk., Dr. Flaim also worked at the Solar Energy Research Institute and the Los Alamos National Laboratory.

l-w LABOR AGREEMENTS AND COMPENSATION On September 30, 2005, TVA had 12,703 employees, of whom approximately 5,331 were trades and labor employees.,- Neither the federal labor relations laws covering most private sector employers nor those covering most federal agencies apply to TVA. However, the TVA Board has a long-standing policy of acknowledging and dealing with recognized representatives of its employees, which policy is reflected in long-term agreements to recognize the unions (or their successors) that represent TVA employees. Federal law prohibits TVA employees from engaging in strikes against TVA.

Salaries of regular TVA employees are limited by a federal pay cap (at September 30, 2005, the Executive Level IlIl (Chairman) was $149,200 and Executive Level IV was $140,300). The federal pay~cap makes it a challenge for TVA to recruit and retain top management talent. In response, TVA has developed and implemented supplemen-tary compensation arrangements to reduce the impact of the pay cap and to enhance TVA's ability to attract and retain the caliber of executive talent required to manage one-of the largest power systems in the country. TVA believes the implementation of these arrangements is within its legal authority. In the past, the Government Accountability Office

("GAO") has expressed the opinion that some of TVA's compensation arrangements are not within TVA's legal author-

-Page 128

ity. However, GAO has no authority to issue binding legalopinions on this matter or to stop any TVA payments.

Congress has been aware of TVA's supplemental compensation arrangements and has not taken any action that would undermine TVA's position that the arrangements are within its legal authority.

The Consolidated Appropriations Act, 2005, in addition to providing for the restructuring of the Board and the creation of the position of a Chief Executive Officer, changed several aspects with respect to the compensation of TVA's employees. These changes will become effective when at least three members nominated under this act take office and include:

The elimination of the requirement that no TVA officer or employee could have a salary in excess of that received by members of the Board.

The Board will approve a compensation plan that:

Specifies the compensation for the Chief Executive Officer and employees of TVA; Is based upon an annual survey of prevailing compensation for similar positions in p ivate industries, including engineering and electric utility companies, publicly-owned electric utilities, and federal, state, and local governments; and Provides that education, experience, level of responsibility, geographic differences, and retention and recruitment needs will be taken into account.

The Board will approve the compensation of all managers and technical personnel that report to the Chief Executive Officer.

For purposes of the Consolidated Appropriations Act, 2005, "compensation" includes salary or any other pay, bonuses, benefits, incentives, and any other form of remuneration.

In October 1995, the President issued an Executive Order requiring government corporations, including TVA, to submit information to the Office of Management and Budget ("OMB") on bonuses paid to its senior executives. TVA submits information on these bonuses annually to OMB and also publicly disseminates this information. OMB approval of TVA's bonuses is not required.

CODE OF ETHICS TVA has a Disclosure and Financial Ethics Code ("Ethics Code") that applies to all executive officers and directors of TVA as well as to all employees who certify information contained in quarterly reports, annual reports, or information statements or who have responsibility for internal control self-assessments. The Ethics Code includes pro-visions covering conflicts of interest, ethical conduct, compliance with applicable laws, rules and regulations, respon-sibility for full, fair, accurate, timely, and understandable disclosures, and accountability for adherence to the Ethics Code. The Ethics Code is posted on TVA's website at: www.tva.com. TVA will provide a current copy of the Ethics Code to any person, without charge, upon request. Requests may be made by calling 888-882-4975 or by sending an e-mail to: investor@tva.com. Any waivers of or changes to provisions of the Ethics Code will be promptly disclosed to the public, subject to limitations imposed by law.

PRINCIPAL ACCOUNTANT FEES AND SERVICES The following table presents fees for professional services rendered by PricewaterhouseCoopers LLP for the years ended September 30, 2005 and 2004.

2005 2004 Audit Fees (1)..............

785,008 624,208 Audit-Related Fees (2)..............

512,607 TOTAL..............

1,297,615 624,208 (1) Audit fees consist of professional services rendered for the audit of TVA's annual financial statements and the review of the f.nancial statements included in TVA's quarterly reports.

(2)

Audit-related fees are fees for services which are usually performed by the auditor and consist primarily of accounting assistance on proposed transactions and accounting standards and accounting assistance related to the adoption of the Sarbanes-Oxley Act.

Page 129

i -

I APART IV:!

i i..

STTISI
,L AD

.F I

S U A: R 9

STATISTICAL AND FINANCIAL SUMMARIES. '

.I --

-, ; -, ---, -- ;, -11I

, r
.

,
,.,

-t I t-I 11 I

.1.

.1 o I

-F.ii I

II RI I'

.:1: ' I -

i l

'~

, I

?"-,., -

- 1 z

I'

,r~ I i.-

- j-!

f

. I I

.) 11 I

I I

-. I 1 !

I

, I I

("

I I, I I -

I

I

.I I j

 ;

I -.1 I -

I-i 1.", 'i, I.

I. I I I : e

I



I.

-~,

I I

I f I

i '.

^ :.

i f.

-1 Page 130

STATISTICAL AND FINANCIAL SUMMARIES For the years ended September 30 Unaudited 2

2004 200 2002 2001 200 1

Winter net dependable generating capacity (megawatt)"'

Hydro...........................................

Fossil...........................................

Nuclear units in service.............................

Combustion turbine and diesel generators ".............

TVA facilities......................................

Other facilities....................................

Total long-term available capacity.....................

System peak load (megawatt) - summer.............

System peak load (megawatt) - winter...............

Percent gross generation by fuel source Fossil...........................................

Hydro...........................................

Nuclear..........................................

Combustion turbine................................

Fuel cost per kWh (cents)

Fossil...........................................

Combustion turbine................................

Nuclear Aggregate fuel cost per kWh net thermal generation......

5,104 15,075 5,790 43674 30,6544 3,337 33.981 4,981 15,076 5,777 4.685 30,519 2.670 33.189 5,022 4,924 15,029 15,023 5,776 5,751 4.655 4.643 30,482 30,341 1.176 1.176 31.658 31,517 4,941 4,808 4,756 15,050 15,042 15,049 5,715 5,729 5,729 3923 3.154, 2 232 29,629 28,733 27,766 736 736 736 30.365 29.469 -

28.502 27,368 29,344 28,295 27,163 25,940 26,388 199 199 196

.19 4,755 4,648 4,652 4,489 15,003 15,014 15,012 15,032 5,620 5,625 5,545.

3,342 2.384 2.394 2,268 2,232 27,762 27,681 27,477 25,095 736 736 736 736 28.498 28.417 28,213 25 831 27,253 26,661 25,376

-:-25,496 31,924 29,966 28,530 29,052 29,278 27,997 29,866 26,061 23,204 62%

61%

60%

63%

64%

63%

10%

9%

11%

6%

6%

6%

28%

30%

29%

30%

29%

31%

<1%

<1%

<1%

1%

1%

NM 1.65 1.48 1.43 1.39 1.32 1.27 11.44 9.01 7.61 4.65 6.07 6.22 0.39 0.39 0.39 0.41 0.44 0.49 1.30 1.14 1.14 1.11 1.08 1.05 63%

62%

7%

10%

30%

28%

NM NM 1.28 1.25 3.94 4.01 0.51 0.71 1.05 1.10 26,670 25,995 24,676 61%

65%

71%

11%

11%

12%

28%

24%,-

17%

NM NM R NM 1.23 1.23 1.26 5.22 4.54 3.61 0.58 0.56 0.61 1.04 1.06 1.14 Fuel data Net thermal generation (millions of kWh).....

144,114 140,890 134,931 141,272 146,806 (143,224' 137,169 139,727, 135,736 131,898 118,097 Billion Btu........................................

1,478,398 1,446,284 1,391,933 1,458,367 1,505,504 1,470,452 1,403,110 1,426,151 1,381,837 1,338,157 1,197,295 Fuel expense (millions of dollars).......

1,870 1,602 1,534 1,564 1,588 1,504 1,434 1,538 1,406 1,395 1,348 Cost per million Btu (cents)........

126.48 110.75 110.21 107.25 105.47 102.29 102.21 107.81 101.73 104.22,*

112.61 Net heat rate, total system..................

10,259 10,265 10,316 10,323 10,255 10,267 10,229 10,207 10,180 10,145 10,138 (a) See 'Properties-

'Generating Resources in Part I.

(b) As of September 30, 2005, includes twenty-four 85-megawatt units subject to lease/leaseback arrangements.

(c) TVA changed its method of expensing the interest component of nuclear fuel expense in 1995.

INDEPENDENT ACCOUNTANTS The financial statements of TVA at September 30, 2005 and 2004, and for each of the three fiscal years in the period ended September 30, 2005, included herein as part of this Statement, have been audited by PricewaterhouseCoopers LLP, independent accountants, as stated in their report, dated November 17, 2005, which report is also included herein.

This Information Statement has been approved by duly authorized officers of the Tennessee Valley Authority.

Tennessee Valley Authority By: IsI MICHAEL E. RESCOE Michael E. Rescoe Chief Financial Officer and Executive Vice President of Financial Services By: IsI RANDY TRUSLEY Randy Trusley Vice President & Controller I'

, I' I

I.

Page 132

CERTIFICATIONS OF THE INDIVIDUAL. MEMBERS OF THE BOARD OF DIRECTORS Bill Baxter and Skila Harris individually certify that:

1.

I have reviewed this Information Statement ('Statement") of the Tennessee Valley Authority;

2.

Based on my knowledge, this Statement does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the periods covered by this Statement;

3.

Based on my knowledge, the financial statements and other financial information included in this Statement fairly present in all material respects the financial condition, results of operations, and cash flows of the Tennessee Valley Authority as of, and for, the periods presented in this Statement;

4.

The other certifiers and I are responsible for establishing and maintaining disclosure controls and pro-cedures for the Tennessee Valley Authority and have:

a) designed such disclosure controls and procedures, or caused such disclosure controls and pro-cedures to be designed under our supervision, to ensure that material information relating to the Tennessee Valley Authority is made known to us by others particularly during the period in which this Statement is being prepared;

, b) evaluated the effectiveness of the Tennessee Valley Authority's disclosure controls and proce-dures and presented in this Statement our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this Statement based on such evaluation; and c) disclosed in this Statement any change in internal control over financial reporting that occurred during the fourth quarter ended September 30, 2005, that has materially affected, or is reason-ably likely to materially affect, the Tennessee Valley Authority's internal control over financial reporting; and

5.

The other certifiers and I have disclosed, based on our most recent evaluation of internal control over.

financial reporting, to the Tennessee Valley Authority's auditors and the Inspector General of the Tennessee Valley Authority:

a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Tennessee Valley Authority's ability to record, process, summarize, and report financial information; and b)..any fraud, whether or not material, that involves management or other employees who have a significant role in the Tennessee Valley Authority's internal control over financial reporting.

Date: November 17, 2005 Bill Baxter Skila Harris Chairman Director IPage 133

CERTIFICATION OF THE CHIEF FINANCIAL OFFICER I, Michael E. Rescoe, certify that:

l

1.

I have reviewed this Information Statement ("Statement") of the Tennessee Valley Authority;

2.

Based on my knowledge, this Statement does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the periods covered by this Statement;

3.

Based on my knowledge, the financial statements and other financial information included in this Statement fairly present in all material respects the financial condition, results of operations, and cash flows of the Tennessee Valley Authority as of, and for, the periods presented in this Statement;

4.

The other certifiers and I are responsible for establishing and maintaining disclosure controls and pro-cedures for the Tennessee Valley Authority and have:

a) designed such disclosure controls and procedures, or caused such disclosure controls and pro-cedures to be designed under our supervision, to ensure that material information relating to the Tennessee Valley Authority is made known to us by others particularly during the period in which this Statement is being prepared; b) evaluated the effectiveness of the Tennessee Valley Authority's disclosure controls and proce-dures and presented in this Statement our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this Statement based on such evaluation; and c) disclosed in this Statement any change in internal control over financial reporting that occurred during the fourth quarter ended September 30, 2005, that has materially affected, or is reason-ably likely to materially affect, the Tennessee Valley Authority's internal control over financial reporting; and

5.

The other certifiers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the Tennessee Valley Authority's auditors and the Inspector General of the Tennessee Valley Authority:

a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Tennessee Valley Authority's ability to record, process, summarize, and report financial information; and

.b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Tennessee Valley Authority's internal control over financial reporting.

Date: November 17, 2005 Michael E. Rescoe Chief Financial Officer and Executive Vice President of Financial Services Page 134

SUPPLEMENTAL SCHEDULE Valuation and Qualifying Accounts and Reserves Balance at Additions Charged Balance at Description Beginning of Year to Expense Deductions End of Year (in millions)

For the year ended September 30, 2005 Allowance for doubtful accounts Receivables 8

(1) 7 Loans 14 1

15 Allowance for inventory obsolescence 36 15 (15) 36 Total allowances deducted from assets 58 16 (16) 58 For the year ended September 30, 2004 Allowance for doubtful accounts Receivables 8

8 Loans 14 14 Allowance for inventory obsolescence 33 11 (8) 36 Total allowances deducted from assets 55 11 (L8) 58 For the year ended September 30, 2003 Allowance for doubtful accounts Receivables 13 (5) 8 Loans 13 1

14 Allowance for inventory obsolescence 29 I

10 (6) 33 Total allowances deducted from assets 55 11 (11) 55 Page 135

j

- 1 1 i i l i

I I

I o i (This page intentionally left blank)

M General Inquiries Investor Inquiries Ellen Robinson Executive Vice President, Communications John M. Hosidns Senior Vice President, Treasurer/lnvestor Relations Tennessee Valley Authority 400 West Summit Hill Drive Knoxville, TN 37902 Tennessee Valley Authority 400 West Summit Hill Drive Knoxville, TN 37902 E-mail Address tvainfo tva.com Phone/Fax Numbers 865-632-6263 Fax: 865-632-4760 Web Site and E-mail Address www.tva.com/finance investor~tva.com Phone/Fax Numbers 888-882-4975 (toll-free in the U.S.)

888-882-4967 (toll-free outside the U.S.)

Fax: 865-632-6673 E-mail alert E-mail alerts are conveniently sent to a subscriber's e-mail address whenever certain new information about TVA bonds is available. To learn more about how to subscribe to e-mail alerts, visit TVA's web site at www.tva.com/finance.

Additional Information Please visit www.tva.com/finance for more details on TVA investment opportunities as well as offering circulars for specific securities, or call TVAs Treasury organization toll-free at 888-882-4975. TVA does not sell securities directly to investors. TVA securities may generally be purchased through a broker, bank or other financial institution.

Guide to using TVA's Annual Report and Inforration Statement This 2005 Annual Report is intended to provide highlighted information of interest about TVA's business and operations during the 2005 fiscal year. The Annual Report should be read in conjunction with the 2005 Information Statement, which is attached to this report. The Information Statement provides additional financial, operational and descriptive information, including financial statements for TVA's fiscal year 2005.

The Information Statement also provides important information about various risks to which TVA is exposed in the course of its operations, which may be important to consider before investing in any TVA securities.

The 2005 TVA Annual Report and 2005 Information Statement do not contain all information about specific TVA securities that is important for making investment decisions. Please refer to the appropriate Offering Circular, or relevant supplements, for detailed information on TVA securities.

TVA is an equal opportunity and affirmative action employer. TVA also provides that the benefits of programs receiving TVA financial assistance are available to all eligible persons regardless of race, color, sex, national origin, religion, disability or age. This document can be made available in an alternate format upon request.

This report is printed on 30% post-consumer recycled paper and uses soy-based inks.

6M 05-319 I/