MGE ENERGY INC - Annual Report: 2005 (Form 10-K)

United States

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

[X] Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the fiscal year ended:

December 31, 2005

[ ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from __________ to __________

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

None.

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

Indicate by checkmark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Indicate by checkmark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

Indicate by checkmark whether the registrants (1) have filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrants were required to file such reports) and (2) have been subject to such filing requirements for the past 90 days. Yes X No

Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants' knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.

Indicate by checkmark if the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act:

 MGE Energy, Inc.

Large accelerated filer

 X

Accelerated filer

Non-accelerated filer

 Madison Gas and Electric Company

Large accelerated filer

Accelerated filer

Non-accelerated filer

 X

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).

The aggregate market value of the voting and nonvoting common equity held by nonaffiliates of each registrant as of June 30, 2005, was as follows:

The number of shares outstanding of each registrant's common stock as of February 1, 2006, were as follows:

Documents Incorporated by Reference

Portions of MGE Energy, Inc.'s definitive proxy statement to be filed April 17, 2006, relating to its annual meeting of shareholders, are incorporated by reference into Part III of this annual report on Form 10-K.

Madison Gas and Electric Company meets the conditions set forth in General Instruction (I)(1)(a) and (b) of Form 10-K and is therefore omitting (I.) the information otherwise required by Item 601 of Regulation S-K relating to a list of subsidiaries of the registrant as permitted by General Instruction (I)(2)(b), (ii.) the information otherwise required by Item 6 relating to Selected Financial Data, (iii.) the information otherwise required by Item 10 relating to Directors and Executive Officers as permitted by General Instruction (I)(2)(c), (iv.) the information otherwise required by Item 11 relating to executive compensation as permitted by General Instruction (I)(2)(c), (v.) the information otherwise required by Item 12 relating to Security Ownership of Certain Beneficial Owners and Management, and (vi.) the information otherwise required by Item 13 relating to Certain Relationships and Related Transactions.

Table of Contents

Filing Format

Forward-Looking Statements

Where to Find More Information

Definitions

PART I.

Item 1. Business.

Item 1A. Risk Factors.

Item 1B. Unresolved Staff Comments.

Item 2. Properties.

Item 3. Legal Proceedings.

Item 4. Submission of Matters to a Vote of Security Holders.

PART II.

Item 5. Market for Registrants' Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities.

Item 6. Selected Financial Data.

Item 7. Management's Discussion and Analysis of Financial Condition andResults of Operations.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk - MGE Energy and MGE.

Item 8. Financial Statements and Supplementary Data.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.

Item 9A. Controls and Procedures.

Item 9B. Other Information.

PART III.

Item 10. Directors and Executive Officers of the Registrant.

Item 11. Executive Compensation.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.

Item 13. Certain Relationships and Related Transactions.

Item 14. Principal Accountant Fees and Services.

PART IV.

Item 15. Exhibits and Financial Statement Schedules.

Signatures - MGE Energy, Inc.

Signatures - Madison Gas and Electric Company

Filing Format

This combined Form 10-K is being filed separately by MGE Energy, Inc. (MGE Energy) and Madison Gas and Electric Company (MGE). MGE is a wholly owned subsidiary of MGE Energy and represents a substantial portion of its assets, liabilities, revenues, expenses, and operations. Thus, all information contained in this report relates to, and is filed by, MGE Energy. Information that is specifically identified in this report as relating solely to MGE Energy, such as its financial statements and information relating to its nonregulated business, does not relate to, and is not filed by, MGE. MGE makes no representation as to that information.

Forward-Looking Statements

This report, and other documents filed by MGE Energy and MGE with the Securities and Exchange Commission (SEC) from time to time, contain forward-looking statements that reflect management's current assumptions and estimates regarding future performance and economic conditions—especially as they relate to future load growth, revenues, expenses, capital expenditures, financial resources, regulatory matters, and the scope and expense associated with future environmental regulation. These forward-looking statements are made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995. Both MGE Energy and MGE caution investors that these forward-looking statements are subject to known and unknown risks and uncertainties that may cause actual results to differ materially from those projected, expressed, or implied. The factors that could cause actual results to differ materially from the forward-looking statements made by a registrant include those factors discussed in a) Item 1A. Risk Factors, b) Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations, c) Item 8. Financial Statements and Supplementary Data, d) other factors discussed in filings made by MGE Energy and MGE with the SEC.

Readers are cautioned not to place undue reliance on these forward-looking statements, which apply only as of the date of this report. MGE Energy and MGE undertake no obligation to publicly release any revision to these forward-looking statements to reflect events or circumstances after the date of this report.

Where to Find More Information

The public may read and copy any reports or other information that MGE Energy and MGE file with the SEC at the SEC's public reference room at 100 F Street, NE, Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. These documents are also available to the public from commercial document retrieval services and the web site maintained by the SEC at http://www.sec.gov.

Our Internet site addresses are www.mgeenergy.com and www.mge.com. On our sites, we have made available, free of charge, our most recent annual report on Form 10-K and proxy statement. We also provide, free of charge, our other filings with the SEC as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Information contained on MGE Energy's and MGE's web sites shall not be deemed incorporated into, or to be a part of, this report.

Definitions

Abbreviations, acronyms, and definitions used in the text and notes of this report are defined below.

PART I.

Item 1. Business.

MGE Energy operates in the following business segments:

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Electric utility operations—generating, purchasing, and distributing electricity through MGE.

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Gas utility operations—purchasing and distributing natural gas through MGE.

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Nonregulated energy operations—constructing, owning, and leasing new electric generating capacity through its wholly owned subsidiaries MGE Power, MGE Power Elm Road and MGE Power West Campus.

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Transmission Investments- investing in companies in the business of providing electric transmission services, such as ATC. In the 4^th quarter of 2005, the investment in ATC was transferred from the electric utility to MGE Transco.

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All Other—investing in companies and property which relate to the regulated operations, financing the regulated operations, or providing construction services to the other subsidiaries through its wholly owned subsidiaries Corporate, MGE Construct, MAGAEL and CWDC.

MGE's utility operations represent a substantial portion of the assets, liabilities, revenues, expenses, and operations of MGE Energy. MGE Energy's nonregulated energy operations currently relate to the ownership of a controlling interest in the electric generation plant of a natural gas-fired cogeneration facility on the UW campus, and an undivided 8.33% ownership interest in each of two 615 MW generating units being constructed in Oak Creek, Wisconsin.

As a public utility, MGE is subject to regulation by the PSCW and the FERC. The PSCW has authority to regulate most aspects of MGE's business including rates, accounts, issuance of securities, and plant and transmission line siting. The PSCW also has authority over certain aspects of MGE Energy as a holding company of a public utility. FERC has jurisdiction, under the Federal Power Act, over certain accounting practices and certain other aspects of MGE's business.

MGE Energy's subsidiaries are also subject to regulation under local, state, and federal laws regarding air and water quality and solid waste disposal. See "Environmental" below.

MGE Energy was organized as a Wisconsin corporation in 2001. MGE was organized as a Wisconsin corporation in 1896. Their principal offices are located at 133 South Blair Street, Madison, Wisconsin 53703.

Electric Utility Operations

MGE generates and distributes electricity in a service area covering the 250-square-mile area of Dane County, Wisconsin. Its service area includes the city of Madison, Wisconsin.

At December 31, 2005, MGE supplied electric service to nearly 136,000 customers, with approximately 121,000 located in the cities of Fitchburg, Madison, Middleton, and Monona and 15,000 in adjacent areas. Of the total number of customers, approximately 86.6% were residential and 13.4% were commercial or industrial. Electric revenues for 2005 and 2004 were comprised of the following:

Electric operations accounted for approximately 60.8%, 59.3%, and 60.2% of MGE's total 2005, 2004, and 2003 regulated revenues, respectively.

See Item 2, Properties, for a description of MGE's electric utility plant.

MGE was a member of MAIN, a regional reliability group. As of December 31, 2005, the MAIN reliability council no longer exists. MGE has chosen to join the MRO as their regional reliability council. The essential purposes of the MRO are: (1) the development and implementation of regional and NERC reliability standards, and (2) determining compliance with those standards, including enforcement mechanisms. The MRO also provides other services consistent with its reliability charter.

MGE Transco is part owner, along with other Wisconsin utilities, of ATC, a for-profit transmission company resulting from Reliability 2000 legislation enacted in Wisconsin. Part of that legislation mandated the creation of a statewide transmission company to own the investor-owned utilities' transmission assets. ATC's purpose is to provide reliable, economic transmission service to all customers in a fair and equitable manner. ATC plans, constructs, operates, maintains, and expands transmission facilities that it owns to provide adequate and reliable transmission of power. ATC is regulated by FERC for all rate terms and conditions of service and is a transmission-owning member of the MISO. MGE is a non-transmission owning member of the MISO.

Effective January 1, 2001, MGE transferred all of its electric utility transmission assets to ATC in exchange for an ownership interest. ATC is owned and governed by the utilities that contributed facilities or capital in accordance with Wisconsin law. On October 28, 2005, MGE transferred $37.6 million of their investment in ATC to MGE Transco. MGE Transco is a majority owned non-regulated subsidiary of MGE. On October 31, 2005, MGE Energy contributed $1.4 million to MGE Transco. In exchange for the funds contributed by MGE Energy to MGE Transco, MGE Energy received an ownership interest in MGE Transco. MGE Energy's share of the equity and net income of MGE Transco are reflected as minority interest within MGE's Consolidated Financial Statements. At December 31, 2005, MGE Transco had approximately a 4.4% ownership interest in ATC.

On February 1, 2002, MGE started taking network transmission service from the MISO. MISO is a nonprofit RTO approved by FERC. The MISO is responsible for monitoring the electric transmission system that delivers power from generating plants to wholesale power transmitters. Its role is to ensure equal access to the transmission system and to maintain or improve electric system reliability in the Midwest.

As a FERC approved RTO, MISO is required to provide real-time energy services and a market based mechanism for congestion management. On April 1, 2005, the MISO implemented its bid-based energy market. At that time, MGE began offering substantially all of its generation on the MISO market and purchasing much of its load requirement from the MISO market in accordance with the MISO Tariff.

Fuel supply and generation

During the year ended December 31, 2005, MGE's generation was provided from the following sources:

Sources used depended on generating unit availability, weather, and customer demand.

MGE has a 22% ownership interest in two 512-MW coal-burning units at Columbia. The coal inventory supply for the units decreased from 41 days on December 31, 2004, to 35 days on December 31, 2005. The co-owners' current goal is to maintain approximately a 35-day inventory. The units burn low-sulfur coal obtained (pursuant to long-term contracts) from the Powder River Basin coal fields located in Wyoming and Montana.

Wind Power Purchase Agreement

On July 16, 2004, MGE signed a 20-year power purchase agreement for 40 MW of wind energy to be located near Waupun, Wisconsin. Construction has not begun on this project, and discussions are currently on-going related to its viability. As a result, no final decisions or financial commitments have been made.

Gas Utility Operations

MGE transports and distributes natural gas in a service area covering 1,350 square miles in seven south-central Wisconsin counties. Its service area includes the city of Madison, Wisconsin.

On December 31, 2005, MGE supplied natural gas service to nearly 137,000 customers in the cities of Elroy, Fitchburg, Lodi, Madison, Middleton, Monona, Prairie du Chien, Verona, and Viroqua; 24 villages; and all or parts of 45 townships. Of the total number of customers, approximately 122,000 were residential and 15,000 were commercial or industrial. Gas revenues for 2005 and 2004 were comprised of the following:

Gas operations accounted for approximately 39.2%, 40.7%, and 39.8% of MGE's total 2005, 2004, and 2003 regulated revenues, respectively.

MGE can curtail gas deliveries to its interruptible customers. Approximately 5% of gas sold in 2005 and 2004 was to interruptible customers.

Gas supply

MGE has physical interconnections with ANR and NNG. MGE's primary service territory, which includes Madison and the surrounding area, receives deliveries at one NNG and four ANR gate stations. MGE also receives deliveries at NNG gate stations located in Elroy, Prairie du Chien, Viroqua, and Crawford County. Interconnections with two major pipelines provide competition in interstate pipeline service and a more reliable and economical gas supply mix, which includes gas from Canada and from the mid-continent and Gulf/offshore regions in the United States.

During the winter months, when customer demand is high, MGE is primarily concerned with meeting its obligation to firm customers. MGE meets customer demand by using firm supplies under contracts finalized before the heating season, supplies in storage (injected during the summer), and other firm supplies purchased during the winter period.

By contract, a total of 4,942,822 Dth can be injected into ANR's storage fields in Michigan from April 1 through October 31. These gas supplies are then available for withdrawal during the subsequent heating season, November 1 through March 31. Using storage allows MGE to buy gas supplies during the summer season, when prices are normally lower, and withdraw these supplies during the winter season, when prices are typically higher. Storage also gives MGE more flexibility in meeting daily load fluctuations. Storage quantities were close to planned levels on December 31, 2005.

MGE's contracts for firm transportation service include winter maximum daily quantities of:

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161,150 Dth (including 86,078 Dth of storage withdrawals) on ANR.

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59,608 Dth on NNG.

Nonregulated Energy Operations

MGE Energy, through its subsidiaries, is seeking to develop generation sources that will assist MGE in meeting the electricity needs of its customers. Decisions on the type of energy source and its size, timing, ownership, and financing depend upon a number of factors including the growth of customer demand in MGE's service area and surrounding areas, the effectiveness of customer demand management efforts, the costs and availability of alternative power sources, the availability of transmission capacity, issues associated with siting power generation sources, available financing and ownership structures, regulatory treatment and recovery, construction lead times and risks, and other factors. The decisions tend to involve long-time horizons due to the lead time involved in siting and constructing new generation sources and the associated transmission infrastructure.

WCCF

MGE Energy, through MGE Power, MGE Power West Campus, and MGE Construct, has constructed a natural gas-fired cogeneration facility on the UW campus. The facility has the capacity to produce 20,000 tons of chilled water, 500,000 pounds per hour of steam, and approximately 150 MW of electricity. The UW and MGE Power West Campus jointly own the facility. The UW owns a controlling interest in the chilled-water and steam plants, which are used to meet the UW's growing need for air-conditioning and steam-heat capacity. MGE Power West Campus owns a controlling interest in the electric generation plant, which is used to provide electricity to MGE's customers.

The total construction cost is estimated to be $187.6 million, of which $103.6 million is MGE Power West Campus' estimated portion. As of December 31, 2005, MGE Power West Campus had incurred $102.1 million (excluding capitalized interest) of costs on the project, which is reflected in Property, Plant, and Equipment on MGE and MGE Energy's condensed consolidated balance sheets. Of this amount, $0.8 million has not yet been paid. MGE Power West Campus estimates an additional $1.5 million in capital expenditures for this project. These amounts primarily relate to water mitigation and laydown restoration costs. These amounts have not yet been incurred or included in MGE or MGE Energy's Property, Plant, and Equipment balance.

MGE Energy, MGE Power West Campus, and MGE Construct had contractually assumed certain risks related to the construction of WCCF. In the EPC Agreement, MGE Power West Campus is responsible for cost overruns and MGE Construct was responsible for the construction process of the entire facility, paying liquidated damages relating to failure to achieve specified completion date guarantees and certain performance level guarantees. During 2005, MGE Construct achieved satisfactory completion on all guarantees and was not responsible for payment of any liquidated damages. MGE Energy was the guarantor of MGE's Construct's obligations under the EPC Agreement.

MGE received approval from the PSCW to collect approximately $12.1 million in carrying costs incurred by MGE Power West Campus during construction of the facility. MGE is collecting these costs in rates over a period of ten years. Of these costs, $4.1 million relate to the capitalized interest and the debt portion of the facility. These costs are recognized over the period in which the facility is being depreciated (40 years). The remaining amount of $8.0 million represents the equity portion and is being recognized over the ten-year period for recovery in rates. As of December 31, 2005, $0.6 million has been recognized as revenue.

Elm Road

On November 4, 2005, MGE Power Elm Road closed on the exercise of an option to acquire an undivided 8.33% ownership interest in each of two 615 MW advanced technology, coal-fired generating units being constructed by We Energies in Oak Creek, Wisconsin. On that date, MGE Power Elm Road also made its initial payment for construction costs. MGE Power Elm Road's estimated share of capital costs for its 8.33% ownership interest in both units is approximately $170 million which it intends to finance primarily through funds received from MGE Energy. MGE Energy expects that these funds will be raised through the sale of securities (via the Stock Plan), short-term debt, and normal operations. At December 31, 2005, MGE Power Elm Road had incurred $24.4 million (excluding capitalized interest) of costs on the project, which is reflected in the Construction Work In Progress balance on MGE and MGE Energy's condensed consolidated balance sheets. Of this amount, $2.1 million has not yet been paid.

On the date of acquisition, MGE Energy and its subsidiaries entered into various agreements, including a facility lease agreement. This facility lease agreement is between MGE Power Elm Road (a nonregulated subsidiary of MGE Energy) and MGE. The financial terms of the facility lease include a capital structure of 55% equity and 45% long-term debt, and return on equity of 12.7%, a lease term of 30 years, and a 5% rent reduction in the first five years.

On November 1, 2005, MGE received approval from the PSCW to defer payments made to MGE Power Elm Road for carrying costs during construction of the facility, management fees, and community impact mitigation costs. MGE will begin collecting the carrying costs in rates in 2006. MGE estimates total carrying costs to be approximately $54 million. This amount is expected to be collected over multiple years. Of these costs, $10 million is estimated to relate to the capitalized interest and the debt portion of the facility. These costs will be recognized over the period in which the facility will be depreciated. The remaining $44 million is estimated to represent the equity portion and will be recognized over the period recovered in rates. MGE expects to begin collecting the management fees and community impact mitigation costs in rates in 2008. These costs are expected to be collected over a four year period.

Environmental

MGE is subject to local, state, and federal regulations concerning air quality, water quality, and solid waste disposal. The EPA administers certain federal statutes relating to such matters. The DNR administers certain state statutes as to such matters and has primary jurisdiction over standards relating to air and water quality and solid and hazardous waste. Those regulations affect the manner in which MGE conducts its operations, the costs of those operations, as well as some capital and operating expenditures. It can also affect the siting, timing, and cost of new projects or other significant actions affecting the environment. MGE is not able to predict the direction of future regulations or if compliance with any such regulations will involve additional expenditures for pollution control equipment, plant modifications, or curtailment of operations. Such actions could reduce capacity or efficiency at existing plants or delay the construction and operation of future generating facilities.

Air quality

Air quality regulations promulgated by the EPA and DNR in accordance with the Federal Clean Air Act and the Clean Air Act Amendments of 1990 impose restrictions on emission of particulates, sulfur dioxide (SO₂) nitrogen oxides (NO_x) and other pollutants and require permits for operation of emission sources. Such permits have been obtained by MGE and must be renewed periodically. Various initiatives, including the Clean Air Interstate Rule (CAIR), Clean Air Mercury Rule (CAMR), maximum achievable emission technology (MACT) standards and existing and proposed state mercury emissions limits, may affect operating and capital expenditure costs at Blount and Columbia.

On May 12, 2005, the EPA promulgated the CAIR that is designed to mitigate the transport of fine particulate matter and ozone pollution by imposing emission reduction requirements on SO₂ and NO_x in 29 eastern states and the District of Columbia, including Wisconsin. These reductions would be implemented in two phases and may include a cap-and-trade system. Regional SO₂ emissions would be reduced in 2010 by approximately 40% below 2003 levels and by approximately 70% below 2003 levels by 2015. Regional emissions of NO_x would be cut in 2009 by approximately 55% below 2003 levels and in 2015 by approximately 65% below 2003 levels.

The Clean Air Act also requires the EPA to develop standards to control major sources of hazardous air pollutants to levels consistent with the lowest-emitting facilities in similar source categories (i.e., MACT standards). The EPA has adopted final MACT standards for industrial, commercial, and institutional boilers, which will apply to MGE in 2007 (although no additional controls are anticipated). MGE operates several other emissions sources in its electric generation operations that may be subject to the new MACT standards including electric utility steam generating units; combustion turbines; and reciprocating internal combustion engines. All sources, except the Blount and Columbia coal-fired units, are expected to be exempt from implementing additional emission-control strategies. WCCF is subject to the MACT standard for combustion turbines, but no additional controls are anticipated beyond those that were constructed as a part of the facility. Complying with the MACT standards may increase capital expenditures and operating and maintenance expenses.

The EPA has also promulgated rules aimed at reducing mercury emissions from utility boilers. The EPA rules contain several compliance options. DNR is required by state statute to modify existing state mercury control rules to conform to the federal rules. As a joint owner of Columbia, MGE may have increased capital expenditures and operating and maintenance expenses if the Columbia owners choose to control mercury emissions at Columbia.

In 1998, the EPA issued a rule that imposed a NO_x emission budget for emission sources in Wisconsin. In 2000, the Court of Appeals for the District of Columbia invalidated a portion of the rule as applied to Wisconsin; however, the Court stayed that portion of the challenge concerning Wisconsin's alleged impacts on downwind, eight-hour ozone nonattainment areas. EPA has also stayed that portion of the rule concerning Wisconsin alleged impacts on downwind eight-hour ozone nonattainment areas. If that portion of the rule concerning eight-hour ozone nonattainment areas is upheld, the resulting NO_x emission budget for Wisconsin could potentially affect the level of permissible NO_x emissions from Blount, Columbia, and WCCF. The new NO_x limits could increase capital expenditures and operating and maintenance expenses at those facilities.

In December 2000, February 2001, June 2002, and January 2003, Alliant received requests from the EPA seeking information concerning Columbia's compliance with the Clean Air Act. The requests appear to be part of an industry-wide EPA initiative to assess the regulatory consequences of past investments in utility generation, energy efficiency, maintenance, and environmental protection. Alliant, the plant operator, has responded to all requests. Alliant has not informed MGE of any definitive increase in capital expenditures or operating and maintenance expenses arising from the EPA's inquiry.

Water quality

MGE is subject to water quality regulations issued by the DNR. These regulations include categorical-effluent discharge standards, which require the use of effluent-treatment processes equivalent to categorical "best practicable" or "best available" technologies under compliance schedules established under the Federal Water Pollution Control Act. The DNR has published categorical regulations for chemical and thermal discharges from electric-steam generating plants. The regulations limit discharges from MGE's plants into Lake Monona and other Wisconsin waters. The State has also proposed rules regarding thermal discharge which are subject to comment and further modification. Depending on the terms of the final rules, MGE may be required to make additional capital expenditures.

Pursuant to a court order, the EPA on July 9, 2004, promulgated final rules addressing cooling water intake structures for existing large power plants. The rule is currently being challenged by a coalition of states and environmental groups. Pursuant to the provisions of the rule, MGE, in its current draft WPDES renewal for Blount, has been granted an extension to no later than January 7, 2008, to comply with the various requirements. The new rules may result in additional capital expenditures; however, MGE is unable to determine the timing or amount, if any, of that impact.

MGE submitted a permit renewal application to the Wisconsin DNR for a WPDES permit for Blount. The DNR has received public comments and is expected to issue the permit in 2006.

Solid waste

MGE is listed as a potentially responsible party for a site the EPA has placed on the national priorities Superfund list. The Lenz Oil site in Lemont, Illinois, was used for storing and processing waste oil for several years. This site requires clean up under the Comprehensive Environmental Response, Compensation and Liability Act. A group of companies, including MGE, is currently working on cleaning up the site. Management believes that its share of the final cleanup costs for the Lenz Oil site will not result in any materially adverse effects on MGE's operations, cash flows, or financial position. Insurance may cover a portion of the cleanup costs. Management believes that the cleanup costs not covered by insurance will be recovered in current and future rates. As of December 31, 2005, a $0.1 million liability was accrued for this matter.

Global climate change

The ongoing issue of global warming could result in significant costs to reduce CO₂ emissions from fossil fuel-fired generation sources such as coal. MGE does not yet know the amounts of these expenditures or the period of time over which they may be required.

Environmental Cooperative Agreement

On September 26, 2002, MGE and the DNR signed an Environmental Cooperative Agreement under which MGE committed to work toward superior environmental performance at Blount. Among other things, the five-year agreement requires MGE to evaluate combustion efficiency improvements, enhance new pollution controls on Boiler 8, increase use of alternative fuels, attempt to increase beneficial reuse of fly ash and bottom ash, study cogeneration possibilities, and upgrade MGE's environmental management system to be consistent with ISO 14001 standards. Implementing these and other actions required by the agreement is expected to increase capital expenditures and operating and maintenance expenses over the next five years. In addition, MGE conducts voluntary audits of Blount's compliance with various environmental laws. The auditors had previously identified some possible compliance exceptions which were timely addressed and disclosed pursuant to a state statute that provides for qualified civil enforcement immunity. MGE believes that it has adequately responded to the audit's findings and does not anticipate any enforcement action by the state regulators.

Employees

As of December 31, 2005, MGE had 746 employees. MGE employs 261 employees who are covered by a collective bargaining agreement with Local Union 2304 of the International Brotherhood of Electrical Workers, and 105 employees who are covered by a collective bargaining agreement with Local Union No. 39 of the Office and Professional Employees International Union. Both of these collective bargaining agreements expire on May 1, 2006. There are also 5 employees covered by a collective bargaining agreement with Local Union No. 2-111 of the United Steel, Paper and Forestry, Rubber, Manufacturing, Energy, Allied Industrial, and Service Workers International Union. This collective bargaining agreement expires on October 29, 2006. MGE will negotiate with each of the unions above during 2006.

Financial Information About Segments

See Footnote 21 of the Notes to Consolidated Financial Statements for financial information relating to MGE Energy's and MGE's business segments.

Executive Officers of the Registrants

Item 1A. Risk Factors.

MGE Energy and its subsidiaries, including MGE, operate in a market environment that involves significant risks, many of which are beyond their control. The following risk factors may adversely affect their results of operations, cash flows and market price for their publicly traded securities. While MGE Energy and MGE believe they have identified and discussed below the key risk factors affecting their business, there may be additional risks and uncertainties that are not presently known or that are not currently believed to be significant that may adversely affect their performance or financial condition in the future.

Regulatory Risk

We are subject to extensive government regulation in our business, which affects our costs and responsiveness to changing events and circumstances.

Our business is subject to regulation at the State and Federal levels. We are subject to regulation as a holding company by the PSCW. MGE is regulated by the PSCW as to its rates, terms and conditions of service; various business practices and transactions; financing; and transactions between it and its affiliates, including MGE Energy. MGE is also subject to regulation by the FERC, which regulates certain aspects of its business. The regulations adopted by the State and Federal agencies affect the manner in which we do business, our ability to undertake specified actions since pre-approval or authorization may be required, the costs of operations, and the level of rates charged to recover such costs. Our ability to attract capital is also dependent in part, by our ability to obtain a fair return from the PSCW.

We face risk for the recovery of fuel and purchased power costs when they exceed the base rate established in MGE's current rate structure.

MGE burns natural gas in several of its peak electric generation facilities, and in many cases, the cost of purchased power is tied to the cost of natural gas. MGE bears significant regulatory risk for the recovery from customers of such fuel and purchased power costs when they are higher than the base rate established in its current rate structure.

We are subject to environmental laws and regulations which may affects our costs and business plans.

Our subsidiaries are subject to environmental laws and regulations that may increase our cost of operations, impact or limit our business plans, or expose us to environmental liabilities.

Numerous environmental regulations govern many aspects of our present and future operations, including air emissions, water quality, wastewater discharges, solid waste, and hazardous waste. These laws and regulations can result in increased capital, operating, and other costs, particularly with regard to enforcement efforts focused on power plant emissions obligations. These laws and regulations generally require us to obtain and comply with a wide variety of environmental licenses, permits, inspections, and other approvals. Both public officials and private individuals may seek to enforce applicable environmental laws and regulations. We cannot predict the financial or operational outcome of any related litigation that may arise.

In addition, we may be a responsible party for environmental clean up at sites identified by a regulatory body. We cannot predict with certainty the amount and timing of all future expenditures related to environmental matters because of the difficulty of estimating clean up costs. There is also uncertainty in quantifying liabilities under environmental laws that impose joint and several liability on all potentially responsible parties.

We cannot assure that existing environmental regulations will not be revised or that new regulations seeking to protect the environment will not be adopted or become applicable to us. Revised or additional regulations which result in increased compliance costs or additional operating restrictions, particularly if those costs are not fully recoverable from our customers, could have an adverse effect on our results of operations and on our ability to pay dividends on our common stock.

Our business may be negatively affected by the restructuring of the energy industry.

MGE is a member of the MISO, a FERC-approved RTO. Effective April 1, 2005, MISO implemented its bid-based energy market. MGE cannot predict the impact the new market may ultimately have on its electric operations. Also, the ability of MISO to maintain its members is an important factor in the success of its operations.

Operating Risk

We are affected by weather, which affects customer demand and can affect the operation of our facilities.

The demand for electricity and gas is affected by weather. Very warm and very cold temperatures, especially for prolonged periods, can dramatically increase the demand for electricity for cooling and heating, respectively, as opposed to the softening effect of more moderate temperatures. Our electric revenues are sensitive to the summer cooling season and, to a lesser extent, the winter heating season. Similarly, very cold temperatures can dramatically increase the demand for gas for heating. A significant portion of our gas system demand is driven by heating. Extreme summer conditions or storms may stress electric transmission and distribution systems, resulting in increased maintenance costs and limiting the ability to meet peak customer demand.

We are affected by economic activity within our service area.

Higher levels of development and business activity generally increase the numbers of customers and their use of electricity and gas. Likewise, periods of recessionary economic conditions generally adversely affect our results of operations.

Our ability to manage our purchased power costs is influenced by a number of uncontrollable factors.

We are exposed to additional purchased power costs to the extent that our power needs cannot be fully covered by the supplies available from our existing facilities and contractual arrangements. Those needs, and our costs, could be affected by:

•

Increased demand due to, for example, weather, customer growth, or customer obligations,

•

The inability to transmit our contracted power from its generation source to our customers due to transmission line constraints, outages, or equipment failures,

•

Reductions in the availability of power from our owned or contracted generation sources due to equipment failures, shortages of fuel or environmental limitations on operations, and

•

Failure to perform on the part of any party from which we purchase capacity or energy.

An unexpected change in demand or the availability of generation or transmission facilities can expose us to increased costs of sourcing electricity in the short-term market where pricing may be more volatile.

Our financial performance depends on the equipment and facilities in our distribution system being operational.

Weather conditions, accidents, catastrophic events, and failures of equipment or facilities can disrupt or limit our ability to deliver electricity and gas. Efforts to repair or replace equipment and facilities may not be successful, or we may be unable to make the necessary improvements to our distribution system, causing service interruptions. The resulting interruption of services could result in lost revenues and additional costs.

We face construction risk in connection with the completion of the Elm Road Coal Generating Units

We have assumed risks under the agreements related to our undivided 8.33% ownership interest in two 615 MW generating units being constructed in Oak Creek, Wisconsin. MGE Power Elm Road is subject to usual construction risks over which we will have limited or no control and which might adversely affect project costs and completion time. These risks include, but are not limited to, shortages of, the inability to obtain or the cost of labor or materials, the inability of the general contractor or subcontractors to perform under their contracts, strikes, adverse weather conditions, the inability to obtain necessary permits in a timely manner and changes in applicable laws or regulations, governmental actions and events in the global economy. If the final costs for the construction of the Elm Road units exceed the fixed costs allowed in the PSCW order, this excess cannot be recovered from MGE or its customers unless specifically allowed by the PSCW. Project costs above the authorized amount, but below the 5% cap will be subject to a prudence determination made by the PSCW.

Financial Risk

We are exposed to commodity price risk relating to our purchases of natural gas, electricity, coal and oil.

We face commodity price risk exposure with respect to our purchases of natural gas, electricity, coal and oil, SO₂ allowance and risk through our use of derivatives, such as futures, forwards and swaps, to manage that commodity price risk. We could experience increased costs as a result of volatility in the market values of those commodities. We could also experience losses on our derivative contracts as a result of that market value volatility or if a counterparty fails to perform under a contract. In the absence of actively quoted market prices and pricing information from external sources, the valuation of these derivative contracts involves our exercise of judgment and use of estimates. As a result, changes in the underlying assumptions or use of alternative valuation methods could affect the value of the reported fair value of these contracts.

We are exposed to interest rate risk.

We are exposed to interest rate risk on our variable rate financing. MGE Energy had $82.5 million of variable-rate debt outstanding at December 31, 2005, including $66.0 million for MGE. Borrowing levels under commercial paper arrangements vary from period to period depending upon capital investments and other factors. Such interest rate risk may make it more difficult to satisfy our obligations and to pay dividends on our common stock at the current rate.

Market performance affects our employee benefit plan asset values.

The performance of the capital markets affects the values of the assets that are held in trust to satisfy the future obligations under our pension and postretirement benefit plans. We have significant obligations in these areas and hold significant assets in these trusts. A decline in the market value of those assets may increase our funding requirements for these obligations.

We are exposed to credit risk primarily through our regulated energy business.

Credit risk is the loss that may result from counterparty nonperformance. We face credit risk primarily through MGE's regulated energy business. Failure of such counterparties to perform their obligations may result in increased expenses for MGE and may negatively impact the dividend we receive from MGE and, thus, our results of operations and our ability to pay dividends on our common stock..

As a holding company, we are dependent on upstream cash flows from our subsidiaries for the payment of dividends on our common stock.

As a holding company, we have no operations of our own, our ability to pay dividends on our common stock is dependent on the earnings and cash flows of our operating subsidiaries and their ability to pay upstream dividends or to repay funds to us. Prior to funding us, our subsidiaries have financial obligations that must be satisfied, including among others, debt service and obligations to trade creditors, and are subject to contractual and regulatory restrictions on the payment of dividends.

Item 1B. Unresolved Staff Comments.

MGE Energy and MGE

None.

Item 2. Properties.

MGE's net generating capability in service at December 31, 2005, was as follows:

Major electric distribution lines and substations in service at December 31, 2005, are as follows:

A significant portion of the electric and gas distribution facilities is located over or under highways, streets, other public places or property owned by others, for which permits, grants, easements or licenses, deemed satisfactory by MGE but without examination of underlying land titles, have been obtained.

As required by Wisconsin law, MGE and other Wisconsin electric utilities transferred their electric transmission assets to ATC on January 1, 2001. MGE received an approximate 4.4% ownership interest in ATC in exchange for its transmission plant and related deferred taxes and deferred investment tax credits. MGE receives a return on its investment in ATC that is approximately equal to the return it would have earned by retaining its transmission facilities. A small portion of the 69 kV lines and substations has been classified as distribution assets.

Gas facilities include 2,330 miles of distribution mains.

Item 3. Legal Proceedings.

MGE Energy and MGE

MGE Energy and its subsidiaries, including MGE, from time to time are involved in various legal proceedings that are handled and defended in the ordinary course of business. While MGE Energy and MGE are unable to predict the outcome of these matters, management does not believe, based upon currently available facts, that the ultimate resolution of any of such proceedings would have a material adverse effect on their overall financial condition or results of operations.

Also see "Environmental" under Item 1, Business, for a description of several environmental proceedings involving MGE.

Item 4. Submission of Matters to a Vote of Security Holders.

MGE Energy and MGE

None.

PART II.

Item 5. Market for Registrants' Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities.

Market for Common Equity

MGE Energy.

MGE Energy common stock is traded on Nasdaq under the symbol MGEE. On March 1, 2006, there were approximately 19,398 registered shareholders of record. The following table shows high and low sale prices for the common stock on Nasdaq for each quarter over the past two years.

MGE.

As of March 1, 2006, there were 17,347,889 outstanding shares of common stock, all of which were held by MGE Energy. There is no public trading market for shares of common stock of MGE.

Dividends

MGE Energy.

The following table sets forth MGE Energy's quarterly cash dividends paid during 2005 and 2004:

MGE.

The following table sets forth MGE's quarterly cash dividends paid during 2005 and 2004:

See "Liquidity and Capital Resources - Capital Requirements and Investing Activities for MGE Energy and MGE" under Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, for a description of restrictions applicable to dividend payments by MGE.

Issuer Purchases of Equity Securities

MGE Energy.

The below table gives information on a monthly basis regarding purchases made by MGE Energy of its common stock:

*In March 2005, MGE Energy switched from issuing new shares of common stock for its Stock Plan to purchasing shares on the open market through a securities broker-dealer on behalf of the plan participants. These shares are then re-issued, as needed, under the Stock Plan. The share purchases are driven by share purchases under the Stock Plan. Thus, there is no specified limit and no specified termination date.

Total shares reissued under the Plan for the quarter ended December 31, 2005, were 118,667. Total treasury shares held at December 31, 2005 were 3,384. The cost basis of these shares is shown as a reduction to shareholders' equity on MGE Energy's condensed consolidated financial statements.

MGE.

None

Item 6. Selected Financial Data.

MGE Energy

(In thousands, except per-share amounts)

*The change in accounting principle in 2001 is due to MGE's adoption of SFAS No. 133.

**Includes current maturities.

Item 7. Management's Discussion and Analysis of Financial Condition and

Results of Operations.

General

MGE Energy is a holding company operating through subsidiaries in five business segments: electric utility operations, gas utility operations, nonregulated energy operations, transmission investments, and all other. Our principal subsidiary is MGE, which conducts our electric utility and gas utility operations and represents a substantial portion of our assets, liabilities, revenues, and expenses. MGE generates and distributes electricity to nearly 136,000 customers in Dane County, Wisconsin, including the city of Madison, and purchases and distributes natural gas to nearly 137,000 customers in the Wisconsin counties of Columbia, Crawford, Dane, Iowa, Juneau, Monroe, and Vernon.

Other subsidiaries, which constitute of our nonregulated energy operations and all other segment, have been formed to own and construct new electric generating capacity. Our nonregulated energy operations relate principally to the leasing of the cogeneration project on the UW-Madison campus. The WCCF facility began producing electricity on April 26, 2005. The nonregulated energy operations relating to this cogeneration plant are included in MGE's consolidated financial statements as a result of the accounting requirements of FIN 46R. On November 4, 2005, MGE Power Elm Road finalized an agreement to acquire an undivided 8.33% ownership interest in each of two 615 MW generating units being constructed in Oak Creek, Wisconsin. This entity is also included in the non-regulated energy operations segment and is included in MGE's consolidated financial statements as a result of the accounting requirements of FIN 46R. For the year ended December 31, 2005, this entity has an immaterial impact on MGE or MGE Energy's operations.

The transmission investment segment consists of our equity earnings in ATC.

Our primary focus today and for the foreseeable future is our core utility customers at MGE. MGE continues to face the challenge of providing its customers with reliable power at competitive prices. It plans to meet this challenge by building more efficient generation projects and continuing its efforts to control its operational costs. We believe it is critical to continue maintaining a strong credit standing and financial strength in MGE as well as the parent company in order to accomplish these goals.

Results of Operations

Year Ended December 31, 2005 Versus the Year Ended December 31, 2004

Executive Summary

In 2005, our earnings were $32.1 million or $1.57 per share compared to $33.8 million or $1.77 per share in the prior year. During 2005, utility operations experienced an increase in electric revenues of $60.6 million. This increase is attributable to an increase in rates that became effective in January 2005, an increase in sales for resale, and warmer temperatures, which increased demand for the summer months. These increases were offset by increased fuel and purchased power costs. In 2005, fuel used for electric generation increased $22.0 million, or 51.1%, compared to 2004. Additionally, purchased power expense increased by $29.7 million. These increases are largely due to the natural disasters that have occurred in the Gulf of Mexico and the reduced availability of natural gas supplies.

During the year ended December 31, 2005, gas revenues increased $28.8 million. This increase is due to higher costs of gas, slightly offset by a decrease in transportation revenues. For the year ended December 31, 2005, natural gas purchased increased $31.5 million or 27.4%, largely due to higher natural gas prices.

Operation and maintenance expenses increased due to higher electric transmission expenses. These increases were partially offset by lower distribution expenses and general and administrative costs.

Electric Utility Operations

Electric sales and revenues

The following table compares MGE's electric retail revenues and electric kWh sales by customer class during the years ended December 31, 2005 and 2004:

Electric operating revenues were up 24.2% in 2005 due to the following:

•

Rates. On December 21, 2004, the PSCW authorized MGE to increase 2005 electric revenues by $27.4 million to cover rising fuel costs, commercial operation of WCCF, and increased transmission expenses.

On November 11, 2005, the PSCW approved MGE's request for an interim fuel surcharge to increase electric rates in 2005 due to a significant increase in fuel costs. MGE recorded $1.7 million in additional electric revenues during 2005 under this interim order.

The PSCW also authorized increases in MGE's electric rates effective January 14, 2004, to cover rising fuel costs and increased system demands. In 2004, MGE recorded a reduction to electric revenues of $3.4 million, to reflect a fuel credit refund due to customers as a result of a PSCW proceeding initiated on August 10, 2004. Of this amount, $1.8 million was included in customers' 2004 bills, resulting in a reduction to 2004 rates. Additionally, during 2003 a fuel credit in the amount of $4.0 million was recognized. Of this amount, $3.2 million was refunded to customers in the first quarter of 2004. This also resulted in a reduction to 2004 electric rates, and contributed to the aforementioned change.

•

Sales for resale. During 2005, sales for resale increased $16.6 million. Sales for resale include transactions conducted on the PJM and MISO markets reflecting our involvement in the PJM and MISO markets since their establishment on May 1, 2004, and April 1, 2005, respectively. This increase is attributable to MGE's involvement in these markets.

MGE has recorded transactions on the PJM and MISO markets in which we are buying and selling power within the same period to meet our electric energy delivery requirements on a net basis. This treatment resulted in a $122.2 million and $3.2 million reduction to sales for resale and purchased power expense for the years ended December 31, 2005 and December 31, 2004, respectively.

•

Volume. During 2005, there was a 4.9% increase in total retail sales volumes. This increase is primarily attributable to warmer temperatures. Cooling degree days for the year ended December 31, 2005, increased 88.2% from 450 for the year ended December 31, 2004 to 847 for the year ended December 31, 2005.

•

Other Revenues. Other electric revenues decreased $3.9 million for the year ended December 31, 2005, compared to the prior year. During 2005, MGE began recovering in electric rates the payments to MGE Power West Campus for carrying costs on construction expenditures for the WCCF. The electric revenues were offset by a reduction to other electric revenues, as these amounts are recorded by MGE Power West Campus. For the year ended December 31, 2005, a total reduction of $0.8 million was recorded to other electric revenues.

Additionally, during the first quarter of 2004, MGE reversed the 2003 fuel credit liability, which was refunded to customers during the first quarter of 2004. The actual fuel refund decreased retail revenues and was offset by an increase in other electric revenues. The fuel credit liability was previously recorded from August 2003 to January 2004 as a reduction in other electric revenues.

Electric fuel and purchased power

In 2005, fuel used for electric generation increased $22.0 million, or 51.1%, compared to 2004. This increase is due to an increase in the costs of internal generation and an increase in internally generated power. The per-unit cost of internal generation increased 45.6% for the year ended December 31, 2005, when compared to the same period in the prior year, reflecting the increased cost of natural gas . That increase is largely due to the natural disasters that have occurred in the Gulf of Mexico and the reduced availability to natural gas supplies. The volume of internal generation increased 3.8% for the year ended December 31, 2005 when compared to the same period in the prior year.

Purchased power expense increased by $29.7 million, or 57.1%, for 2005, compared to 2004. This increase reflects a 33.4% increase in the per-unit-cost and a 17.7% increase in the volume of purchased power.

MGE has recorded transactions on the PJM and MISO markets in which we are buying and selling power within the same period to meet our electric energy delivery requirements on a net basis. This treatment resulted in a $122.2 million and $3.2 million reduction to purchased power expense for the years ended December 31, 2005 and December 31, 2004, respectively.

.

Electric operating expenses

Electric operating expense increased $13.9 million in 2005. The following changes contributed to the net change in electric operating expenses for 2005:

(a)

This increase relates to the commencement of the leasing arrangement between MGE and MGE Power West Campus in 2005. In accordance with the terms of this leasing arrangement, the electric segment recorded $10.1 million in rent expense for the year ended December 31, 2005. Upon consolidation, this amount is eliminated.

(b)

The increase in transmission costs reflects a rate increase , which became effective on January 1, 2005, and an increase in the volume of transmitted electricity over 2004.

Electric maintenance expense

In 2005, electric maintenance expense decreased $0.2 million, or 1.5%, due to a decrease in the maintenance of distribution assets ($0.7 million), partially offset by an increase in the maintenance of production assets, including turbine and generator overhauls $0.5 million.

Electric depreciation

Electric depreciation expense increased $1.9 million in 2005. This increase is attributable to higher levels of electric plant assets.

Gas Utility Operations

Gas deliveries and revenues

The following table compares MGE's gas retail revenues and gas delivered by customer class during each of the years ended December 31, 2005 and 2004:

Gas revenues increased 16.7% in 2005 due to the following:

•

Gas costs/rates. Gas costs increased significantly in 2005. The average rate per therm for residential customers in 2005 increased 13.1%. See Footnote 16 of the Notes to Consolidated Financial Statements for additional information on gas base rates.

•

Retail gas deliveries. In 2005, retail gas deliveries increased 1.0%. This increase is primarily attributable to additional commercial and industrial use.

•

Gas transportation. In 2005, there was a 6.9% decrease in deliveries. This decrease represents customers switching from gas to other fuel options, due to the higher price of gas.

•

Other revenues. Other revenues increased $1.4 million in 2005. This increase relates to increases in miscellaneous gas income under MGE's GCIM.

Natural gas purchased

In 2005, natural gas purchased increased $31.5 million, or 27.4%. This increase is primarily due to higher average wellhead prices. Natural gas prices (cost per therm) increased 27.5% in 2005. A PGA clause allows MGE to pass along to customers the cost of gas, subject to certain limited incentives. The PGA is authorized by the PSCW. This increase was slightly offset by a decrease in the volume of natural gas purchased (0.1%) for the year ended December 31, 2005.

Gas operating expenses

Gas operating expense decreased $1.5 million, or 5.3%, in 2005. The following changes contributed to the net change in gas operating expense for the year:

Gas maintenance expenses

For the year ended December 31, 2005, compared to the same period in the prior year, gas maintenance expense increased $0.1 million or 3.8%. This increase is attributable to an increase in the maintenance of distribution assets.

Gas depreciation

Gas depreciation expense increased $0.5 million in 2005 as a result of additional gas plant assets.

Gas cost incentives

Under MGE's GCIM, if actual gas commodity costs are above or below a benchmark set by the PSCW, then MGE's gas sales service customers and shareholders share equally in any increased costs or savings. The PSCW allows MGE to resell gas pipeline capacity reserved to meet peak demands but not needed every day to serve customers. Revenues from capacity release that exceed or fall short of PSCW-targeted levels are shared equally. In 2005 and 2004, MGE shareholders received the benefit of $2.7 and $1.4 million from capacity release revenues and commodity savings under the GCIM, respectively.

Other Income (Loss)

Other income for the year ended December 31, 2005, for the electric and gas segments was $0.1 million, compared to other expense of $0.9 million for the same period in the prior year. During 2005, the gas and electric segments recognized a total of $0.4 million in AFUDC-equity and a $0.1 million gain on the sale of assets. This income was offset by $0.2 million in charitable contributions and $0.2 million in miscellaneous expense, net.

For the year ended December 31, 2004, the gas and electric segments recognized a total of $0.5 million in AFUDC-equity funds and $0.8 million in miscellaneous income. This income was offset by $2.2 million in charitable contributions recorded in the electric and gas segments.

Interest Expense

For the year-ended December 31, 2005, total interest expense for the electric and gas segments increased $0.7 million when compared to the same period in the prior year. For the year ended December 31, 2005, there was a $0.9 million increase in interest expense on short-term debt at the electric and gas segments as a result of increased levels of short-term debt. These increases were offset by a $0.2 million decrease in interest expense on long-term debt at the electric and gas segments.

Nonregulated Energy Operations

Nonregulated Energy operating revenues

Operating revenues from nonregulated energy operations were $10.7 million for the year ended December 31, 2005. This amount includes $10.1 million in interdepartmental revenues. The interdepartmental revenues relate to the leasing arrangement between MGE and MGE Power West Campus which commenced on April 26, 2005. In accordance with the provisions of this leasing arrangement, the Non-regulated Energy Operations, via MGE Power West Campus, recorded $10.1 million in lease revenue for the year ended December 31, 2005. Upon consolidation, this amount is eliminated.

Also included in operating revenues is the recognition of $0.6 million in revenues related to carrying costs. MGE received approval from the PSCW to collect approximately $12.1 million in carrying costs incurred by MGE Power West Campus during construction of the WCCF facility. MGE is collecting these costs in rates over a period of ten years. Of these costs, $4.1 million relate to the capitalized interest and the debt portion of the facility. These costs are recognized over the period in which the facility is being depreciated (40 years). The remaining amount of $8.0 million represents the equity portion and is recognized over the ten-year period for recovery in rates. On April 26, 2005, the WCCF facility lease between MGE and MGE Power West Campus commenced and MGE Power West Campus began recognizing revenue related to these carrying costs.

Nonregulated Energy operations and maintenance expense

For the year ended December 31, 2005, other operations and maintenance expense decreased $0.1 million, when compared to the same period in the prior year. This is primarily related to lower administrative and general expenses at MGE Power West Campus.

Nonregulated Energy depreciation expense

Depreciation expense began when the WCCF commenced generation on April 26, 2005 and was $1.9 million for 2005.

Nonregulated Energy interest expense, net

For the year ended December 31, 2005, interest expense, net at the nonregulated energy operations segment increased $1.5 million or 100%, compared to the same period in the prior year. During construction of the WCCF, MGE Power West Campus recorded capitalized interest in accordance with the provisions of SFAS 34. As such, during 2004, $2.1 million in capitalized interest was recognized as an offset to interest expense. On April 26, 2005, when the electric generation facilities of WCCF began generating electricity, MGE Power West Campus discontinued the capitalization of interest, as the project was deemed to be substantially complete. As such, during the year ended 2005, only $0.7 million of capitalized interest was recorded.

Additionally, interest expense increased as a result of a new long-term facility. On October 27, 2005, MGE Power West Campus issued $20.0 million of 5.19% senior secured notes due September 25, 2033. Interest expense for the year ended December 31, 2005, related to this facility was $0.1 million.

Transmission Investment Operations

Transmission Investment other income (loss)

For the year ended December 31, 2005, other income at the transmission investment segment was $4.9 million, compared to $4.2 million for the same period in the prior year. The transmission investment segment holds our interest in ATC, and its income reflects our equity in the earnings of ATC.

All Other Nonregulated Operations

All Other nonregulated revenues

MGE Construct received service fees of $1.3 million and $2.7 million from the State in 2005 and 2004, respectively. The service fees earned relate to MGE Construct's role as EPC contractor for WCCF. This amount is classified as nonregulated revenue within MGE Energy's financial statements. The total fee of $5.0 million had been recognized at December 31, 2005. This amount was recognized as services were rendered and was collected over a 22-month period.

All Other operations and maintenance expense

All other operations and maintenance expense for the year ended December 31, 2005, decreased $0.2 million when compared to the same period in the prior year. This decrease is related to a decrease in general and administrative expense at corporate.

All Other nonregulated other income (expense)

Other income (expense) decreased $0.6 million or 100% for the year ended December 31, 2005, when compared to the same period in the prior year. For the year ended December 31, 2004, the all other nonregulated segment recorded a $0.6 million gain of the sale of assets. This relates to the gain on the sale of land held by Magael.

All Other interest income (expense)

All other interest income for the year ended December 31, 2005 was $0.1 million, compared to interest expense for the year ended December 31, 2004 of $0.1 million. This increase is largely due to interest earned on outstanding other receivables.

Consolidated Other General Taxes

MGE Energy and MGE's other general taxes increased 4.4% in 2005 primarily because MGE's license fee tax increased. The annual license fee tax expense is based on adjusted operating revenues of the prior year. Tax rates have not increased.

Consolidated Income Taxes

MGE Energy's effective income tax rate is 38.2% for 2005 compared to 37.9% in 2004. The higher income tax rate is primarily due to a higher state tax rate as a result of a tax settlement in 2005 for the Wisconsin 1990 to 1996 exam cycle.

Minority Interest, Net of Tax

For the year ended December 31, 2005, MGE Energy (through its wholly owned subsidiary MGE Power) had earned $5.4 million and less than $0.1 million, net of tax, for its interest in MGE Power West Campus and MGE Power Elm Road, respectively. Additionally, MGE Energy had earned less than $0.1 million, net of tax for its interest in MGE Transco. These amounts are recorded as minority interest expense, net of tax, on MGE's Consolidated Statement of Income.

Year Ended December 31, 2004 Versus Year Ended December 31, 2003

Executive Summary

In 2004, our earnings were $33.8 million, or $1.77 per share. Gas retail deliveries declined slightly, but retail electric sales increased 1.6%. MGE's increase in base rates to cover, in large part rising fuel costs, led to an increase in utility revenues. Operations and maintenance costs increased due to higher fees for outside professional services, overall customer service and administrative costs, and higher distribution costs. During 2004, MGE Energy benefitted from lower pension and benefit expenses, lower transmission costs, and decreased interest costs due to lower levels of short and long-term debt during the latter portion of 2004.

Electric Utility Operations

Electric sales and revenues

The following table compares MGE's electric retail revenues and electric kWh sales by customer class during the years ended December 31, 2004 and 2003:

Electric operating revenues were up 3.6% in 2004, due to the following:

•

Rates. The PSCW authorized increases in MGE's electric rates effective January 14, 2004, to cover rising fuel costs and increased system demands. In 2004, MGE recorded a reduction to electric revenues of $3.4 million, to reflect a fuel credit refund due to customers as a result of a PSCW proceeding initiated on August 10, 2004. Of this amount, $1.8 million has been included in customers' 2004 bills and $1.6 million was refunded to customers in January 2005.

The 2003 retail revenues reflect a fuel credit in the amount of $4.0 million. Of this amount, $1.2 million was reflected in customers' 2003 bills and $2.8 million was refunded to customers in the first quarter of 2004. An additional $0.4 million was recorded and refunded to customers' in January 2004, related to the 2003 proceedings. The liability for this fuel credit was previously accrued from August 2003 through January 2004, as a decrease to other electric revenues.

•

Volume. During 2004, there was a 1.6% increase in total retail sales volumes. This increase is primarily attributable to additional commercial and industrial users coming on-line in 2004, and business growth at some of MGE's preexisting, large commercial and industrial users.

•

Other Revenues. Other electric revenues increased $5.8 million for the year ended December 31, 2004, compared to the prior year. This increase is due to the reversal of the 2003 fuel credit liability, which was refunded to customers in the first quarter of 2004.

•

Sales for resale. During 2004, sales for resale decreased $4.2 million. The decrease in sales for resale represents lower sales volume due to the expiration of a contract with Alliant to sell 25 MW of electric capacity. The contract was in effect from January 2003 through August 2003. Sales for resale also includes transactions conducted on the PJM market since our involvement in the PJM market since its establishment on May 1, 2004.

MGE has recorded transactions on the PJM market in which we are buying and selling power within the same period to meet our electric energy delivery requirements on a net basis. This treatment resulted in a $3.2 million reduction to sales for resale and purchased power expense for the year ended December 31, 2004.

Electric fuel and purchased power

In 2004, fuel used for electric generation increased $2.0 million, or 4.9%, compared to 2003. This increase is due to an increase in the year-to-date electric generation at MGE's baseload plants ($1.7 million) and a slight increase in rates ($0.3 million). MGE's internal generation increased 4.2% during 2004, when compared to 2003, mainly due to a 16.5% increase during the first quarter of 2004. This large increase was the result of the Columbia facility being off line during a portion of the first quarter of 2003, but back on line for the first quarter of 2004. The per-unit cost of internal generation increased 0.6% for the year ended December 31, 2004, when compared to the same period in the prior year.

Purchased power expense increased by $2.5 million, or 5.1%, for 2004, compared to 2003. This increase represents a 18.7% increase in the per-unit-cost partially offset by a 11.3% decrease in the volume of purchased power.

Electric operating expenses

Electric operating expense decreased $0.3 million, or (0.4%), in 2004. The following changes contributed to the net change in electric operating expenses for the year:

Maintenance expense

In 2004, electric maintenance expense increased $0.4 million, or 2.8%, reflecting an increase in the maintenance of production assets, including turbine and generator overhauls ($0.6 million). This increase was partially offset by a $0.2 million decrease in maintenance of distribution assets.

Electric depreciation

Electric depreciation expense increased $1.1 million in 2004. The increase in electric depreciation expense in 2004 reflects higher levels of electric plant assets. Gross electric assets at December 31, 2004 were $612.6 million, compared to gross electric plant assets of $573.1 million at December 31, 2003.

Gas Utility Operations

Gas deliveries and revenues

The following table compares MGE's gas retail revenues and gas delivered by customer class during the years ended December 31, 2004 and 2003:

Gas revenues increased 7.5% in 2004 due to the following:

• Gas costs/rates. The PSCW authorized increases in MGE's gas rates effective January 14, 2004, and March 1, 2003, to cover increased system demands. Gas costs increased significantly in both 2004 and 2003. The average rate per therm for residential customers in 2004 increased 12.6%. Additionally in 2003, the average rate per therm for residential customers increased 23%. See Footnote 16 of the Notes to Consolidated Financial Statements for additional information on gas base rates.

• Retail gas deliveries. In 2004, retail gas deliveries decreased 4.2%. This decrease is attributable to warmer-than-normal temperatures as reflected by the 5.9% decrease in heating degree days.

• Gas transportation. In 2004, there was a 2.5% decrease in deliveries. This decrease represents customers switching from gas to other fuel options, due to the higher price of gas.

• Other revenues. Other effects decreased $0.1 million in 2004. This decrease relates to decreases in miscellaneous gas income as a result of MGE's GCIM.

Natural gas purchased

In 2004, natural gas purchased increased $10.5 million, or 10.1%. This increase is primarily due to higher average wellhead prices. Natural gas prices (cost per therm) increased 14.8% in 2004. A PGA clause allows MGE to pass along to customers the cost of gas, subject to certain limited incentives. The PGA is authorized by the PSCW.

Gas operating expenses

Gas operating expense increased $3.2 million, or 11.4%, in 2004. The following changes contributed to the net change in gas operating expense for the year:

Gas depreciation

Gas depreciation expense increased $0.5 million in 2004, as a result of additional gas plant assets.

Gas cost incentives

Under MGE's GCIM, if actual gas commodity costs are above or below a benchmark set by the PSCW, then MGE's gas sales service customers and shareholders share equally in any increased costs or savings. The PSCW allows MGE to resell gas pipeline capacity reserved to meet peak demands but not needed every day to serve customers. Revenues from capacity release that exceed or fall short of PSCW-targeted levels are shared equally. Beginning February 1, 2004, the PSCW lowered the formula used in establishing the benchmark for gas commodity costs. The benchmark moved to 99.5% of what it would have been under the prior formula. This change was intended to better reflect market conditions. In 2004 and 2003, MGE shareholders benefitted $1.4 million from capacity release revenues and commodity savings under the GCIM.

Other Income (Loss)

For the year ended December 31, 2004, other expense at the gas and electric segments was $0.9 million, compared to $1.8 million for the same year in the prior year. During the year ended December 31, 2005, the gas and electric segments recognized a total of $0.5 million in AFUDC-equity funds and $0.8 million in miscellaneous income. This income was offset by $2.2 million in charitable contributions recorded in the electric and gas segments.

For the year ended December 31, 2004, the gas and electric segments recognized a total of $0.5 million in AFUDC-equity funds and $0.6 million in miscellaneous income. This income was offset by $2.9 million in charitable contributions recorded in the electric and gas segments.

Interest Expense

For the year ended December 31, 2004, interest expense at the electric and gas segments decreased $0.9 million, compared to the same period in the prior year. This decrease is due to a $0.7 million decrease on interest expense incurred by the gas and electric segments on long-term debt. This is a result of lower levels of long-term debt outstanding during the third and fourth quarters. Additionally, there was a $0.2 million decrease in interest expense on short-term debt expense incurred by the gas and electric segments. During the latter portion of 2004, there were lower levels of short-term debt as a result of the proceeds raised in the equity offering.

Nonregulated Energy Operations

Nonregulated Energy operations and maintenance expense

Other operations and maintenance expense increased $0.2 million for the year ended December 31, 2004, when compared to the same period in the prior year. This increase primarily relates to higher administrative and general expenses at MGE Power West Campus.

Transmission Investment Operations

Other income

For the year ended December 31, 2004, the transmission investment segment recorded $4.2 million in equity earnings from ATC, compared to $3.7 million for the year ended December 31, 2003. This resulted in a $0.5 million increase in other income between the periods.

All Other Nonregulated Operations

All Other nonregulated operating revenues

MGE Construct received service fees of $2.7 million and $1.0 million from the State in 2004 and 2003, respectively. The service fees covered MGE Construct's role as EPC contractor for WCCF. This amount is classified as revenue from nonregulated operations within MGE Energy's financial statements. This amount was recognized as services were rendered and was collected over a 22-month period.

All Other nonregulated operations and maintenance expense

All other operations and maintenance expense increased $0.1 million for the year ended December 31, 2004, when compared to the same period in the prior year. This increase is a result of increased general and administrative expenses in 2004 at Corporate.

All Other nonregulated other income (expense)

For the year ended December 31, 2004, the All Other segment recorded a $0.6 million gain of the sale of assets. This gain was related to the sale of land held by Magael.

All Other nonregulated interest expense, net

Interest expense for the year ended December 31, 2004, was $0.1 million, compared to interest income of less than $0.1 million for the year ended December 31, 2003. This increase is due to an increase in levels of short-term borrowings.

Consolidated Other General Taxes

MGE Energy's other general taxes increased 9.7% in 2004 primarily because MGE's license fee tax increased. The annual license fee tax expense is based on adjusted operating revenues of the prior year. Tax rates have not increased.

Consolidated Income Taxes

MGE Energy's effective income tax rate is 37.9% for 2004 compared to 39.4% in 2003. The lower effective income tax rate is primarily due to accounting for the Medicare Part D federal subsidy and the favorable resolution of a tax contingency, for which a liability had been established.

Liquidity and Capital Resources

Cash Flows

The following summarizes cash flows for MGE Energy and MGE during 2005, 2004, and 2003:

Cash Provided by Operating Activities

MGE Energy

MGE Energy's consolidated net cash provided by operating activities is derived mainly from the electric and gas operations of its principal subsidiary, MGE.

2005 vs. 2004

Cash provided by operating activities decreased $9.7 million for the year ended December 31, 2005, when compared to the same period in the prior year. This decrease is attributable to a slight decrease in net income and increased amounts of inventories, receivables, unbilled revenues, and payables. For the year ended December 31, 2005, unbilled revenues increased $5.6 million compared to $3.2 million in the prior year and trade and other receivables increased $16.8 million compared to $6.1 million in the prior year. This increase is primarily attributable to increased revenues period over period as a result of higher rates and increased volumes. During 2005, there was a $6.2 million increase in materials and supplies and a $6.3 million increase in natural gas held in storage. The increase in the materials and supplies account is attributable to a significant increase in the cost of SO₂ emission allowances. These allowances are classified within inventory at the lower of market or average cost on the consolidated balance sheet. The increase in stored natural gas and accounts payable is largely attributable to the increase in the price of natural gas. These increases were slightly offset by a decrease in prepaid taxes and the collection of a $2.5 million retainage receivable. During 2005, MGE Construct collected $2.5 million of the retainage receivable from the State under the EPC agreement related to the construction of the WCCF. Additionally, there was a $2.1 million increase in deferred tax expense and a $4.4 million increase in depreciation expense between 2005 and 2004, primarily provided by the WCCF.

Other non-current items, net contributed $3.4 million to cash flows from operations for the year ended December 31, 2005, compared to $4.3 million in 2004.

2004 vs. 2003

Cash provided by operating activities was $59.6 million in 2004, compared to $66.1 million for the same period in the prior year. During 2004, there was a $15.8 million increase in current asset balances and a $7.9 million rise in current liability balances. Current assets were up due to increases in trade and other receivables ($6.1 million), stored natural gas ($4.8 million), unbilled revenues ($3.2 million), and prepayments ($1.6 million). Current liabilities were up due to increases in accounts payable ($8.4 million). This increase in accounts payable was offset by a $0.4 million decrease in other current liabilities. A change in other noncurrent items, net, of $4.3 million, also contributed to the increase in cash provided by operating activities.

MGE

2005 vs. 2004

Cash provided by operating activities was $29.3 million for 2005 compared to $57.7 million for 2004. This decrease is attributable to a slight decrease in net income and increased amounts of inventories, receivables, unbilled revenues, and payables. The decrease in net income is largely due to increased fuel costs in 2005. The increases in unbilled revenues and accounts receivable is primarily attributable to increased revenues period over period as a result of higher rates and increased volumes. The increase in the materials and supplies account is related to a significant increase in the cost of SO₂ emission allowances. These allowances are classified within inventory at the lower of market or average cost on the consolidated balance sheet. The increase in stored natural gas is a result of the increase in the price of natural gas.

These increases were offset by a decrease in prepaid taxes and an increase in accrued taxes and interest. Additionally, there was a $4.4 million increase in depreciation expense between 2005 and 2004, primarily provided by the WCCF, a $2.1 million increase in deferred tax expense, and $5.4 million in minority interest expense, net of tax. This amount relates to net income earned by MGE Energy from its interest in MGE Power West Campus and MGE Transco.

2004 vs. 2003

Cash provided by operating activities was $57.7 million for 2004, compared to $70.7 million in 2003. Current asset balances increased $13.8 million increase and $5.3 million increase in the current liabilities balances. Current assets rose due to increases in trade and other receivables ($3.5 million), stored natural gas ($4.8 million), unbilled revenues ($3.2 million), and prepayments ($2.2 million). Current liabilities were higher due to increases in accounts payable ($5.9 million), offset by a $0.5 million decrease in other current liabilities. A change in other noncurrent items, net, of $4.2 million also contributed to the increase in cash provided by operating activities.

Capital Requirements and Investing Activities

MGE Energy

2005 vs. 2004

In 2005, MGE Energy's cash used for investing activities decreased $25.3 million. Capital expenditures for the year ended December 31, 2005, were $85.8 million. This amount represents a $10.0 million decrease from those made in the prior year. Capital expenditures related to WCCF decreased $36.5 million for the year ended December 31, 2005, compared to the same period in the prior year. This decrease was slightly offset by additional MGE utility plant additions ($1.9 million) and additions made for Elm Road ($24.6 million). During 2005, MGE Energy made a $1.4 million capital contribution to ATC and $0.3 million in additional capital contributions to other investments. In 2004, total capital contributions to ATC were $3.5 million. Dividend income received from ATC was $3.6 million during 2005, compared to $3.1 million during 2004. In the first quarter 2005, MGE collected $13.0 million in funds previously advanced to ATC in conjunction with the WCCF project. No additional funds were advanced to ATC directly during 2005. During 2004, MGE advanced $2.3 million to ATC related to WCCF. Although MGE Energy did not advance any funds to ATC directly in 2005, funds were indirectly advanced to ATC. Namely, in 2005 in connection with the Elm Road project MGE Power Elm Road advanced $1.6 million in funds to the WEPCO, who in turn provided these funds to ATC. These funds will be used by ATC for transmission system upgrades related to the Elm Road project. These funds are expected to be repaid in full. During 2004, MGE Energy also recorded $1.6 million in proceeds from the sale of property. Cash provided by other investing activities were $0.4 million in 2005 compared to cash used by other investing activities of $0.6 million in the prior year.

2004 vs. 2003

In 2004, MGE Energy's cash used for investing activities increased $6.4 million. This increase is primarily attributable to an increase in capital expenditures and additional capital contributions made to ATC during 2004. Capital expenditures related to WCCF increased $18.7 million for the year ended December 31, 2004, compared to the same period in the prior year. However, MGE utility plant additions decreased $6.0 million during 2004 compared to 2003. During 2004, MGE also made $3.5 million in additional capital contributions to ATC. Dividend income received from ATC for the year ended December 31, 2005, was $3.1 million, compared to $2.6 million for the same period in the prior year. These increases in investing activities were offset by decreases in the advance to ATC related to WCCF ($6.9 million), proceeds from the sale of property ($1.6 million), and other investing activities ($0.9 million).

MGE

2005 vs. 2004

Cash used for investing activities was $72.0 million for 2005, compared to $98.2 million in the prior year. As of December 31, 2003, MGE Power West Campus was consolidated into MGE in accordance with FIN 46(R). Therefore, MGE's cash used for investing activities includes the capital expenditures related to WCCF. Capital expenditures related to WCCF decreased $36.5 million for the year ended December 31, 2005, when compared to the same period in the prior year. This decrease was offset in part by increases in utility plant additions ($1.9 million) and additions made for Elm Road ($24.6 million). During 2005, MGE Transco made capital contributions to ATC totaling $1.4 million and MGE made $0.1 million in other capital contributions. Dividend income from ATC for the year ended December 31, 2005, was $3.6 million, compared to $3.1 million for the same period in the prior year. In the first quarter of 2005, MGE collected $13.0 million in funds previously advanced to ATC in conjunction with the WCCF project. No additional funds were advanced to ATC directly during 2005. During 2004, MGE advanced $2.3 million to ATC related to WCCF.

Although MGE did not advance any funds to ATC directly in 2005, funds were indirectly advanced to ATC. Namely, in 2005 in connection with the Elm Road project, MGE Power Elm Road advanced $1.6 million in funds to WEPCO, who in turn provided these funds to ATC. These funds will be used by ATC for transmission system upgrades related to the Elm Road project. These funds are expected to be repaid in full.

2004 vs. 2003

Cash used for investing activities was $98.2 million for 2004, compared to $51.9 million in the prior year. As of December 31, 2003, MGE Power West Campus is being consolidated into MGE in accordance with FIN 46(R). Therefore, for all of 2004, MGE's cash used for investing activities includes the capital expenditures related to WCCF. MGE also made capital contributions to ATC totaling $3.5 million. Dividend income received from ATC for the year ended December 31, 2005, was $3.1 million, compared to $2.6 million for the same period in the prior year. These increases are offset by a decrease in capital expenditures related to MGE utility plant in the amount of $6.0 million, a decrease in the advance made to ATC related to WCCF ($6.9 million), proceeds from the sale of property ($1.0 million), and a decrease in cash used for other investing activities (0.9 million).

Capital Expenditures

The following table shows MGE Energy's estimated capital expenditures for 2006, actual for 2005, and the three-year average for 2003 to 2005:

MGE Energy's and MGE's liquidity are primarily affected by their construction requirements. We allocate common plant for the financial statements and footnotes based on a prescribed formula (60% (electric) and 40% (gas)). MGE Energy's major 2005 capital projects include WCCF and Elm Road. During 2005, $10.6 million in capital additions were made for the construction of WCCF. This amount includes $0.7 million of interest capitalized in accordance with the provisions set forth in SFAS No. 34, Capitalization of Interest Cost. Additionally, $24.6 million in capital additions were made for the construction of Elm Road. This amount includes $0.2 million in capitalized interest.

MGE Energy used funds received as dividend payments from MGE as well as short- and long-term external financing to meet its 2005 capital requirements and cash obligations, including dividend payments. External financing included short-term financing under existing lines of credit. While dividends from MGE will remain a significant source for the cash needs of MGE Energy, lease revenues from the WCCF will supplement those dividends.

During 2005, ATC solicited its investors for 2005 and 2006 voluntary capital contributions. In response to this request, MGE Transco made a $1.4 million voluntary capital contribution on October 31, 2005. ATC has requested an additional $2.9 million in voluntary contributions for 2006. MGE Transco has not formally committed to make these contributions, however it is likely that MGE Transco will agree to do so. During January 2006, a $0.7 million capital contribution was made by MGE Transco to ATC in response to this request.

Financing Activities and Capitalization Matters

MGE Energy

2005 vs. 2004

Cash provided by MGE Energy's financing activities was $22.2 million for 2005, compared to $39.5 million for 2004. On October 27, 2005, MGE Energy, through its wholly-owned subsidiary MGE Power West Campus, issued $20.0 million of 5.19% senior secured notes due September 25, 2033. For the year ended December 31, 2005, net short term debt borrowings were $29.2 million. Proceeds from stock issued under the Stock Plan were $2.3 million. These cash in flows were offset by cash dividends paid of $28.1 million and other financing cash uses of $1.1 million. The cash dividends for 2005 were higher than those paid in 2004 as result of higher dividend per share ($1.37 vs. $1.36) and an increase in the number of shares outstanding. Additionally, as of March 2005, shares to satisfy the Stock Plan were purchased on the open market, rather than through the issuance of new shares. The aforementioned change resulted in $0.1 million balance for the purchase of treasury stock. During 2004, proceeds from the issuance of common stock were $63.2 million. This cash inflow is largely attributable to the equity issuance completed September 15, 2004. Proceeds received under this issuance were primarily utilized to repay short-term debt obligations. Additional equity was issued under the Distribution Agreement through BOCM and through the Stock Plan. During 2004, MGE Energy made $20.0 million in repayments on pre-existing long-term facilities. No additional long-term debt was issued during 2004. However, there was $21.6 million in net short term debt borrowings. Cash dividends for 2004 were $25.9 million and cash provided by other financing activities was $0.7 million.

No major equity issuances were completed in 2005. Shares issued though the Stock Plan for the year ended December 31, 2005, resulted in net proceeds of $2.3 million. As mentioned, in March 2005, MGE switched from issuing new shares of common stock for the Stock Plan to purchasing shares on the open market. As such, during 2005, equity issuances were not a major source of capital.

2004 vs. 2003

Cash provided by MGE Energy's financing activities was $39.5 million for 2004, compared to $26.2 million for 2003. This increase is related to an increase in the proceeds from the issuance of common stock and the reduction of long-term net borrowings during 2004. Proceeds from the issuance of common stock increased $40.0 million for 2004 when compared to the prior year. This increase is a result of the equity issuance completed September 15, 2004. Proceeds received under this issuance were primarily utilized to repay short-term obligations. Additional equity was issued under the Distribution Agreement through BOCM and through the Stock Plan. During 2004 and 2003, MGE Energy made $20.0 million in repayments on pre-existing long-term facilities. No additional long-term debt was issued during 2004 or 2003. There was a $21.6 million increase in the short-term debt balance during 2004 and a $2.6 million reduction in the short-term debt balance during 2003. Cash dividends for 2004 increased $1.8 million and cash received from other financing activities increased $0.9 million compared to the prior year.

MGE

2005 vs. 2004

During 2005, cash provided by MGE's financing activities was $42.6 million compared to cash provided by financing activities of $41.0 million in 2004. On October 27, 2005, MGE Energy, through its wholly-owned subsidiary MGE Power West Campus, issued $20.0 million of 5.19% senior secured notes due September 25, 2033. For the year ended December 31, 2005, net short term debt borrowings were $25.7 million. During 2005, $7.1 million in equity contributions were received by MGE Power West Campus and MGE Transco from MGE Energy. These amounts are included in minority interest on the MGE consolidated balance sheet. Additionally, for the year ended December 31, 2005, $25.4 million in affiliate financing was received by MGE Power Elm Road. These funds were used to finance the Elm Road project. The aforementioned cash inflows were offset by cash dividends paid from MGE to MGE Energy of $25.8 million and cash dividends paid by MGE Power West Campus to MGE Energy of $10.5 million. During 2005, there were also other financing cash uses of $0.7 million.

Dividend payments by MGE to MGE Energy are subject to restrictions arising under a PSCW rate order and, to a lesser degree, MGE's First Mortgage Bonds. The PSCW order limits the amount of dividends that MGE may pay MGE Energy when its common equity ratio, calculated in the manner used in the rate proceeding, is less than 55%. Under those circumstances, MGE may not pay dividends in excess of $26.1 million plus dividends on shares issued in excess of the shares issued in the rate proceeding forecast if the proceeds are invested in MGE. MGE's common equity ratio at December 31, 2005, is estimated to be 55.7% as determined under the calculation used in the rate proceeding. The rate proceeding calculation includes as indebtedness imputed amounts for MGE's outstanding purchase power capacity payments and other PSCW adjustments, but does not include the indebtedness associated with MGE Power West Campus, which is consolidated in accordance with FIN 46(R) into MGE's financial statements.

In addition, MGE has covenanted with the holders of its First Mortgage Bonds not to declare or pay any dividend or make any other distribution on or purchase any shares of its common stock unless, after giving effect thereto, the aggregate amount of all such dividends and distributions and all amounts applied to such purchases, after December 31, 1945, shall not exceed the earned surplus (retained earnings) accumulated subsequent to December 31, 1945. As of December 31, 2005, approximately $148.2 million was available for the payment of dividends under this covenant.

2004 vs. 2003

During 2004, cash provided by MGE's financing activities was $41.0 million compared to cash used for financing activities of $18.9 million in 2003. This change resulted from consolidating MGE Power West Campus into MGE in accordance with FIN 46(R). MGE's financing activities for 2004 include an equity contribution made from MGE Energy to WCCF for $40.4 million and $0.4 million of affiliate financing for WCCF. Cash dividends to the parent decreased $4.5 million, and equity contributions from the parent increased $0.9 million between 2004 and 2003. During 2004, short-term borrowings increased $24.8 million, $20.0 million in long-term debt was repaid, and no new long-term debt was issued. Additionally, during 2004 there was a $0.3 million decrease in cash used by other financing activities compared to 2003.

MGE Energy's capitalization ratios were as follows:

Below is a table of MGE's current credit ratings. MGE Energy is not rated because it has not issued any debt securities.

A security rating is not a recommendation to buy, sell, or hold securities and may be subject to revision or withdrawal at any time by the assigning rating agency. MGE's access to the capital markets, including the commercial paper market, and its financing costs in those markets are dependent on its securities' ratings. None of MGE's borrowing is subject to default or prepayment due to downgrading of securities' ratings, although such a down grading could increase fees and interest charges under MGE's and MGE Energy's credit facilities.

On December 21, 2005, MGE entered into an amended and restated unsecured revolving credit facility under which it may borrow up to $55 million from a group of lenders. This credit facility amends and replaces the revolving facility dated July 14, 2004, in the amount of $45 million. The credit facility is available for the issuance of letters of credit. The credit facility matures December 21, 2010. Interest rates on borrowings under the credit facility are based on either prime or LIBOR plus an adder based on the senior unsecured credit rating of MGE. Interest is payable monthly. The credit agreement requires MGE to maintain a ratio of consolidated debt to consolidated total capitalization not to exceed a maximum of 65%.

On December 21, 2005, MGE also amended its existing uncommited, unsecured $20 million line of credit note with JPMorgan Chase Bank, N.A. to extend the availability of the full $20 million, until March 31, 2006. Prior to this amendment, the availability was scheduled to reduce to $10 million on December 31, 2005 through March 31, 2006. The line of credit note was originally entered into on November 28, 2005.

On December 21, 2005, MGE Energy entered into an unsecured revolving credit facility under which it may borrow up to $80 million from a group of lenders. MGE Energy has the right to request an increase in the aggregate commitment amount up to a maximum amount of $20 million so long as no default or unmatured default exists. Interest rates on borrowings under the credit facility are based on either prime or LIBOR plus an adder based on the senior unsecured credit rating of MGE. Interest is payable monthly. Amounts borrowed may be repaid and reborrowed from time to time until maturity. The credit agreement requires MGE to maintain a ratio of consolidated debt to consolidated total capitalization not to exceed a maximum of 65%.

Contractual Obligations and Commercial Commitments for MGE Energy and MGE

MGE Energy's and MGE's contractual obligations as of December 31, 2005, representing cash obligations that are considered to be firm commitments, are as follows:

For additional information about:

(a) Long-term debt consisting of secured First Mortgage Bonds, unsecured medium-term notes, and debt held by MGE Power West Campus. See Footnote 9 of the Notes to Consolidated Financial Statements.

(b) Short-term debt consisting of commercial paper for MGE and borrowings under MGE Energy lines of credit, see Footnote 10 of the Notes to Consolidated Financial Statements.

(c) Amount represents interest expense on long-term facilities. See Footnote 9 of the Notes to Consolidated Financial Statements for further discussion of the long term debt outstanding at December 31, 2005.

(d) Operating leases. See Footnote 17 of the Notes to Consolidated Financial Statements.

(e) Purchase obligations for MGE consist of the purchase of electricity and natural gas, electric transmission, natural gas storage capacity, natural gas pipeline transportation, and the purchase and transport of coal. The Waupun wind power purchase agreement is not reflected in these figures as MGE is not currently able to estimate the related commitment as the site has not yet been constructed. See Footnote 17 of the Notes to Consolidated Financial Statements for additional discussion.

(f) Other long-term obligations are related to a special assessment for decontaminating and decommissioning of nuclear facilities. See Footnote 6 of the Notes to Consolidated Financial Statements.

(g) Purchase obligations for MGE Energy related to contracts for equipment and services related to the construction of WCCF.

(h) Purchase obligations for MGE and MGE Energy related to contracts for equipment and services related to the construction of Elm Road. See Footnotes 17 and 20 of the Notes to Consolidated Financial Statements.

(i) Short-term debt consisting of commercial paper. See Footnote 10 of the Notes to Consolidated Financial Statements.

The above amounts do not include any contributions that may be made for MGE's pension and postretirement plans. There are no required contributions for the 2006 plan year; however, MGE may be legally required under IRS standards to make contributions to the Plans in years subsequent to 2006. Due to uncertainties in the future economic performance of plan assets, discount rates, and other key assumptions, management is unable to estimate these amounts at this time. MGE made a $4.0 million contribution in 2006, related to the 2005 plan year. This payment was made strictly at MGE's discretion as there were no contributions required related to the 2005 plan year.

MGE has also made a $1.8 million conditional commitment to the City of Madison for certain "green energy" projects. This amount has not been included in the above table as the commitments are conditional. Namely, funds will not be provided to the City of Madison until MGE has reviewed each project's goals and objectives. If the funding eligibility criteria is met, the funds will be paid out ratably over a eight year period.

MGE Energy's and MGE's commercial commitments as of December 31, 2005, representing commitments triggered by future events and including financing arrangements to secure obligations of MGE Energy and MGE, and guarantees by MGE, are as follows:

(a) Amount includes those facilities discussed in (c) plus an additional line of credit. Namely, MGE Energy has available at any time a $80 million committed revolving credit agreement, expiring in December 2010. Additionally, at December 31, 2005, there was $16.5 million on this credit facility outstanding.

(b) Amounts include those guarantees described in (d) as well as guarantees held by MGE Energy. Namely, MGE Energy has guaranteed debt service payments on a development project.

(c) Lines of credit consisting of a five-year, $55 million committed revolving credit agreement expiring in December 2010, and an additional $20 million credit note that matures on March 31, 2006. Each credit facility is used to support commercial paper issuances. At December 31, 2005, there were no borrowings under either credit facility. Additionally, at December 31, 2005, there was $66 million of commercial paper outstanding.

(d) MGE has guaranteed repayment of certain receivables it sold to a financial institution under a chattel paper agreement. See Footnotes 17 of the Notes to Consolidated Financial Statements.

Other Factors

Due to the performance of the United States debt and equity markets, the value of assets held in trusts to satisfy the obligations of pension and postretirement benefit plans may vary.

Business and Regulatory Environment

Electric Transmission - ATC

On January 1, 2001, MGE transferred substantially all of its electric transmission facilities to ATC in exchange for an interest in this joint venture. At December 31, 2005, MGE Transco has a 4.4% ownership interest in ATC. ATC is comprised of Wisconsin investor-owned utilities and some Wisconsin municipal utilities, cooperatives, and power supply agencies.

The PSCW authorized an electric rate surcharge of $4.5 million, or 2.0%, over a twelve-month period ended October 23, 2003, for MGE to recover deferred costs associated with ATC's formation and ongoing incremental transmission costs during 2001 and 2002.

On November 21, 2002, MGE and ATC entered into an interconnection agreement related to transmission system upgrades for WCCF. MGE issued to ATC a "Notice to Proceed for the Procurement of the Equipment" for the system upgrades. MGE advanced a total of $12.8 million in funds for construction of transmission equipment and work done by ATC related to WCCF. These funds and the interest incurred by ATC were collected by MGE during 2005.

WEPCO and ATC entered into an interconnection agreement related to transmission system upgrades for Elm Road, of which MGE Power Elm Road has an undivided 8.33% ownership interest in. At December 31, 2005, MGE advanced Elm Road Services, LLC $1.6 million in funds for construction of transmission equipment and work done by ATC related to Elm Road. MGE will be reimbursed for all previously advanced funds upon completion of the project.

Regulatory Issues - Transmission

On April 1, 2005, the Midwest ISO implemented its bid-based energy market. Midwest ISO, a FERC approved RTO, is required to provide real-time energy services and a market-based mechanism for congestion management. This market-based platform for valuing transmission congestion is premised upon the LMP system that has been implemented in other states.

MGE received FTRs through the Midwest ISO allocation process. The Midwest ISO has also made available additional FTRs through an auction-based system run by the Midwest ISO. See footnote 15 of the Notes to the condensed consolidated financial statements for further discussion.

Wind Power Purchase Agreement

On July 16, 2004, MGE signed a 20-year power purchase agreement for 40 MW of wind energy to be located near Waupun, Wisconsin. Construction has not begun on this project, and discussions are currently on-going related to its viability. As a result, no final decisions or financial commitments have been made.

Blount Generating Station

On January 19, 2006, MGE announced a plan subject to certain conditions, that includes discontinuing coal use at the end of 2011 at Blount. The plant is capable of burning coal and natural gas. The plant will continue to run on natural gas but will be reduced from its current approximate 190 MW capacity to 100 MW when coal burning is discontinued. MGE anticipates full regulatory recovery of the costs associated with the discontinuance of coal at Blount.

Nonregulated Energy Outlook

WCCF

MGE Energy, through MGE Power, MGE Power West Campus, and MGE Construct, has constructed a natural gas-fired cogeneration facility on the UW campus. The facility has the capacity to produce 20,000 tons of chilled water, 500,000 pounds per hour of steam, and approximately 150 MW of electricity. The UW and MGE Power West Campus jointly own the facility. The UW owns a controlling interest in the chilled-water and steam plants, which are used to meet the UW's growing need for air-conditioning and steam-heat capacity. MGE Power West Campus owns a controlling interest in the electric generation plant, which is used to provide electricity to MGE's customers. See "Nonregulated Energy Operations" under Item 1, Business, for additional information regarding the WCCF, its construction and the lease arrangement between MGE Power West Campus and MGE.

For the year ended December 31, 2005, MGE Construct received a total service fee of $1.3 million (pretax) from the State in relation to its role as EPC contractor for WCCF. This amount is classified as revenue from nonregulated operations within MGE Energy's financial statements. As of December 31, 2005 the entire $5.0 million was recognized. This amount was recognized as services were rendered and was collected over a 22-month period.

On April 10, 2005, acceptance testing for the steam and chilled water portion of the facility began. On this date, MGE began allocating charges to the UW based on the operating agreement. Under the provisions of this arrangement, the UW is required to reimburse MGE for their allocated portion of fuel and operating expenses. These allocations are based on formulas outlined in the operating agreement. For the year ended December 31, 2005, the State was allocated $0.9 million in fuel and operating costs.

Elm Road

On November 4, 2005, MGE Power Elm Road closed on the exercise of an option to acquire an undivided 8.33% ownership interest in each of two 615 MW advanced technology, coal-fired generating units being constructed by We Energies in Oak Creek, Wisconsin. On that date, MGE Power Elm Road also made its initial payment for construction costs. MGE Power Elm Road's estimated share of capital costs for its 8.33% ownership interest in both units is approximately $170 million, which it intends to finance primarily through funds received from MGE Energy. MGE Energy expects that these funds will be raised through the sale of securities (via the Stock Plan), short-term debt, and normal operations. At December 31, 2005, MGE Power Elm Road had incurred $24.4 million (excluding capitalized interest) of costs on the project, which is reflected in the Construction Work In Progress balance on MGE and MGE Energy's condensed consolidated balance sheets. Of this amount, $2.1 million has not yet been paid.

On this date, MGE Energy and its subsidiaries entered into various agreements, including a facility lease agreement. This facility lease agreement is between MGE Power Elm Road (a nonregulated subsidiary of MGE Energy) and MGE. The financial terms of the facility lease include a capital structure of 55% equity and 45% long-term debt, and return on equity of 12.7%, a lease term of 30 years, and a 5% rent reduction in the first five years.

On November 1, 2005, MGE received approval from the PSCW to defer payments made to MGE Power Elm Road for carrying costs during construction of the facility, management fees, and community impact mitigation costs. MGE will begin collecting the carrying costs in rates in 2006. MGE estimates total carrying costs to be approximately $54 million. This amount is expected to be collected over multiple years. Of these costs, $10 million is estimated to relate to the capitalized interest and the debt portion of the facility. These costs will be recognized over the period in which the facility will be depreciated. The remaining $44 million is estimated to represent the equity portion and will be recognized over the period recovered in rates. MGE expects to begin collecting the management fees and community impact mitigation costs in rates in 2008. These costs are expected to be collected over a four year period.

Critical Accounting Policies - MGE Energy and MGE

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to unbilled revenues, pension obligations, income taxes, derivatives, and regulatory assets and liabilities. We base our estimates on historical experience and on various assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Unbilled Revenues

Revenues from the sale of electricity and gas to customers are recorded when electricity/gas is delivered to those customers. The quantity of those sales is measured by customers' meters. Due to the large volume of those meters, it is impractical to read all of them at month end. Meters are read on a systematic basis throughout the month based on established meter-reading schedules. Consequently, at the end of any month, there exists a quantity of electricity and gas that has been delivered to customers but has not been captured by the meter readings. As a result, management must estimate revenue related to electricity and gas delivered to customers between their meter-read dates and the end of the period. These estimates include:

• The amount of electricity expected to be lost in the process of its transmission and distribution to customers (line loss) and the amount of electricity actually delivered to customers.

• The mix of sales between customer rate classes, which is based upon historical utilization assumptions.

During 2003, many of MGE's largest customers were shifted to a calendar-month-end bill. As a result of this shift, the majority of these customers' electricity usage is now accounted for in the unbilled calculation. The unbilled amounts for a month are based on actual usage billed the following month. Due to this billing shift and its impact on the unbilled calculation, MGE has seen the ratio of unbilled receivables to total electric sales climb. The ratio has settled into a range of 40% to 60%, and MGE will continue to monitor and track this range.

Allowance for Doubtful Accounts

MGE maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. The Company determines the allowance based on historical write-off experience, regional economic data, and review of the accounts receivable aging. The Company reviews its allowance for doubtful accounts monthly. Although management believes that the allowance for doubtful accounts is the Company's best estimate of the amount of probable credit losses, if the financial condition of the Company's customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

Pension Plans and Postretirement

MGE provides employees with certain retirement (pension) and postretirement (health care and life insurance) benefits. In order to measure the expense and obligations associated with these benefits, management must make a variety of estimates, including discount rates used to value certain liabilities, the expected return on plan assets set aside to fund these costs, the rate of compensation increase, employee turnover rates, retirement rates, health care trends, mortality rates, and other factors. These accounting estimates bear the risk of change due to the uncertainty attached to the estimate as well as the fact that these estimates are difficult to measure. Different estimates used by us could result in recognizing different amounts of expense over different periods of time.

We use third-party specialists to assist us in evaluating our assumptions as well as appropriately measure the costs and obligations associated with these retirement benefits. The discount rate and expected return on plan assets are based primarily on investment yields available and the historical performance of our plan assets. They are critical accounting estimates because they are subject to management's judgment and can materially affect net income.

• Assumed return on assets. This assumption represents the rate of return on plan assets reflecting the average rate of earnings expected on the funds invested (or to be invested) to provide for the benefits included in the projected benefit obligation. For 2005, MGE used a 9.0% assumed return on assets. One of the approaches MGE used in determining its assumed return on assets is based on historical returns. As of December 31, 2005, the ten-year historical return was 11.4%. Holding other assumptions constant, for every 1% reduction in the expected rate of return on plan assets, annual pension expense would increase by approximately $1.1 million, before taxes.

• Discount rate. The discount rate represents the rate at which pension obligations could effectively be settled on a present-value basis. MGE uses high-grade bond yields as a benchmark.

• Medical trend assumptions. The health care cost trend rate is the assumed rate of increase in per-capita health care charges. The health trend assumption for 2004 was reset from 12% to 10% as a result of an expanded relationship with a managed care health provider with a greater emphasis on preventive care, provider discounts and better utilization management.

Income Tax Provision

MGE Energy's and MGE's income tax provisions, including both current and deferred components, are based on estimates, assumptions, calculations, and interpretation of tax statutes for the current and future years. Determination of current-year federal and state income tax will not be settled for years.

Management regularly makes assessments of tax return outcomes relative to financial statement tax provisions and adjusts the tax provisions in the period when facts become final.

Additionally, in determining our current income tax provision we assess temporary differences resulting from differing treatments of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are recorded in our balance sheets. When we maintain deferred tax assets, we must assess the likelihood that these assets will be recovered through adjustments to future taxable income. To the extent we believe recovery is more likely than not, we establish a valuation allowance. We record an allowance reducing the asset to a value we believe will be recoverable based on our expectation of future taxable income. We believe the accounting estimate related to the valuation allowance is a critical accounting estimate because it is highly susceptible to change from period to period as it requires management to make assumptions about our future income over the lives of the deferred tax assets, and the impact of increasing or decreasing the valuation allowance is potentially material to our results of operations.

Accounting for Derivative Instruments

MGE accounts for derivative financial instruments under SFAS No. 133, Accounting for Derivatives and Hedging Activities, and SFAS No. 149, Amendment of SFAS No. 133 on Derivative Instruments and Hedging Activities. Under the provisions of SFAS No. 133, all derivatives except those qualifying for the normal purchase normal sale exception are recognized on the balance sheet at their fair value. Fair value is determined using current quoted market prices. If a contract is designated as a cash flow hedge, the change in its market value is generally deferred as a component of other comprehensive income until the transaction it is hedging is completed. Conversely, the change in the market value of a derivative not designated as a cash flow hedge is recorded in current period earnings. A cash flow hedge is a hedge of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability.

In the third quarter of 2002, MGE received approval from the PSCW to establish a regulatory asset or liability for the deferral of the effects of mark-to-market accounting as required by SFAS No. 133 on contracts related to MGE's regulated operations.

Regulatory Assets/Liabilities

Regulatory assets represent costs that have been deferred to future periods when it is probable that the regulator will allow future recovery of those costs through rates. MGE bases its assessment of recovery by precedents established by the regulatory body. Regulatory liabilities represent previous collections from customers to fund future expected costs or amounts received in rates that are expected to be refunded to customers in future periods. These costs typically include deferral of energy costs, the normalization of income taxes, and the deferral of losses incurred on debt retirements. The accounting for these regulatory assets and liabilities is in accordance with the provisions of SFAS No. 71.

MGE continually assesses whether the regulatory assets meet the criteria for probability of future recovery. This assessment considers factors such as changes in the regulatory environment, recent rate orders to other regulated entities under the same jurisdiction, and the status of any pending or potential deregulation legislation. If future recovery of costs becomes no longer probable, the assets and liabilities would be recognized as current-period revenues or expenses.

Amortization of regulatory assets is provided over the recovery period as allowed in the related regulatory agreement.

Conditional ARO

As of December 31, 2005, MGE adopted FASB Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations" (FIN 47). FIN 47 clarified that a legal obligation associated with the retirement of a long-lived asset whose timing and/or method of settlement are conditional on a future event is within the scope of SFAS No. 143. Under FIN 47, MGE is required to record a conditional ARO at its estimated fair value if that fair value can be reasonably estimated. As of December 31, 2005, MGE had a liability of $9.2 million associated with its conditional AROs.

The adoption of FIN 47 required MGE to update an existing inventory of AROs, originally created for the adoption of SFAS No. 143, and to determine which, if any, of the conditional AROs could be reasonably estimated. The ability to reasonably estimate a conditional ARO was a matter of management judgment, based upon management's ability to estimate a settlement date or range of settlement dates and a method or potential method of settlement of its conditional AROs. In determining whether our conditional AROs could be reasonably estimated, management considered past practices, industry practices, management's intent, and the estimated economic life of the assets. The fair value of the conditional AROs was then estimated using an expected present value technique. Changes in management's assumptions regarding settlement dates, settlement methods, or assigned probabilities could have a material effect on the liability recorded at December 31, 2005. The liabilities associated with conditional AROs will be adjusted on an ongoing basis due to the passage of time and revisions to either the timing or the amount of the original estimates of undiscounted cash flows. These adjustments could have a significant impact on the Consolidated Balance Sheets. For more information regarding the adoption and ongoing application of FIN 47, see Note 18 of the Notes to Consolidated Financial Statements.

Adoption of Accounting Principles and Recently Issued Accounting Pronouncements - MGE Energy and MGE

FIN 46(R)

In January 2003, the FASB issued FIN 46, Consolidation of Variable Interest Entities - an Interpretation of ARB No. 51. In December 2003, the FASB issued the updated and final interpretation FIN 46(R). FIN 46(R) requires that an equity investor in a VIE have significant equity at risk (generally a minimum of 10%, which is an increase from 3% required under the previous guidance) and hold a controlling interest, evidenced by voting rights, and absorb a majority of the entity's expected losses, receive a majority of the entity's expected returns, or both. If the equity investor is unable to evidence these characteristics, the entity that retains these ownership characteristics will be required to consolidate the VIE as the primary beneficiary. FIN 46 was applicable immediately to VIEs created or obtained after January 31, 2003. FIN 46(R) was effective on December 31, 2003, for interests in entities that were previously considered special-purpose entities under then existing authoritative guidance.

MGE Power West Campus and MGE Power Elm Road are VIEs pursuant to FIN 46(R), as the equity investment was not sufficient to permit the entity to finance its activities without additional support. MGE concluded a VIE relationship exists due to the long-term lease arrangements between MGE and MGE Power West Campus and MGE and MGE Power Elm Road. MGE Power West Campus and MGE Power Elm Road will lease a major portion of their assets, a power plant and an undivided interest in a power plant, to MGE, pursuant to these leasing arrangements, and MGE will absorb a majority of the expected losses, residual returns, or both.

FIN 46(R) also requires MGE to assess whether the participants within its Shared Savings program constitute VIEs in which MGE might be considered to be the consolidating entity. MGE has reviewed 88% of the total Shared Savings program balance and has determined that the provisions of FIN 46(R) are not applicable via the "business scope exception." For the remaining 12% of the total Shared Savings program balance, MGE has not performed this assessment. These entities are not legally obligated to provide the financial information to MGE that is necessary to determine whether MGE must consolidate these entities. MGE will continue to attempt to obtain information from these customers in order to determine whether they should be consolidated by MGE.

FSP 106-2

On December 8, 2003, the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 was signed into law, authorizing Medicare to provide prescription drug benefits to retirees. FSP 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003, was issued on May 19, 2004. The FSP provides guidance on accounting for the effects of the new Medicare prescription drug legislation by employers whose prescription drug benefits are actuarially equivalent to the drug benefit under Medicare Part D.

During the third quarter of 2004, MGE adopted the provisions of FSP 106-2, resulting in a remeasurement of its postretirement plans' assets and APBO as of January 1, 2004. The effect of the subsidy on benefits attributable to past service was accounted for as an actuarial experience gain, resulting in a decrease in the APBO of $4.3 million. The annualized reduction in the net periodic postretirement benefit cost is estimated to be $0.7 million compared to the annual cost calculated without considering the effects of the Prescription Drug Act. Previously reported financial information for the three months ended March 31, 2004 and June 30, 2004 have also been adjusted to reflect a reduction in net periodic postretirement benefit cost as if FSP 106-2 was adopted as of January 1, 2004. Amounts for these periods, when presented for comparative purposes, are presented as such.

FSP 109-1

In December 2004, the FASB issued FSP 109-1, "Application of FASB Statement No. 109, 'Application for Income Taxes,' to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004" (FSP FAS 109-1). The American Jobs Creation Act of 2004 (Act), signed into law on October 22, 2004, provided, generally, for a tax deduction, effective for taxable years beginning after December 31, 2004, for domestic manufacturing activities of up to nine percent (when fully phased-in) of the lesser of "qualified production activities income," as defined in the Act, or taxable income. FSP 109-1 clarified that the tax deduction for domestic manufacturing activities under the Act should be accounted for as a special deduction in accordance with SFAS No. 109, "Accounting for Income Taxes" (SFAS No. 109). MGE estimates its tax deduction for 2005 to be $0.3 million. The benefit of the 2005 deduction was deferred by the PSCW resulting in a regulatory liability in the amount of $0.2 million as of December 31, 2005 on the balance sheets of both MGE Energy and MGE.

EITF 03-01 and FSP 115-1

In March 2004, the EITF reached consensus on and the FASB ratified EITF Issues No. 03-01, The Meaning Other-Than-Temporary Impairment and its Application to Certain Investments (EITF 03-01). EITF 03-01 provides guidance for evaluating whether an investment is other-than-temporarily impaired. MGE and MGE Energy adopted the disclosure requirements of EITF 03-01 for investments accounted for under SFAS No. 115 for the year ended December 31, 2004. On September 30, 2004, the FASB issued EITF 03-01-01, Effective Date of Paragraphs 10-20 of EITF Issue No. 03-01, 'The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments,' which delayed the effective date of the application guidance on impairment of securities included within EITF 03-01. The EITF and the FASB are reconsidering the conclusions reached within EITF 03-01.

In November 2005, FASB issued FSP 115-1 and 124-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments." This FSP addresses the determination as to when an investment is considered impaired, whether the impairment is other-than-temporary, and the measurement of an impairment loss. The investment is impaired if the fair value is less than cost. The impairment is other-than-temporary for equity and debt securities that can contractually be prepaid or otherwise settled in such a way that the investor would not recover substantially all of its costs. If an impairment is deemed to be other-than-temporary, an impairment loss shall be recognized in earnings equal to the difference between the investment's cost and its fair value. The guidance in this FSP is effective in reporting periods beginning after December 15, 2005. The Company has reviewed FSP 115-1 and 124-1 and does not expect the adoption of this FSP to have a material impact on its operating results or financial position.

FIN 47

In March 2005, the FASB issued FIN 47, Accounting for Conditional Asset Retirement Obligations an Interpretation of FASB Statement No. 143. This Interpretation clarifies that an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation when incurred if the liability's fair value can be reasonably estimated. Additionally, this Interpretation clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. As of December 31, 2005, MGE adopted FIN 47. Under FIN 47, MGE is required to record a conditional ARO at its estimated fair value if that fair value can be reasonably estimated. As of December 31, 2005, MGE had a liability of $9.2 million associated with its conditional AROs. The cumulative effect of the change in accounting principle related to FIN 47 had no impact on the utility company's Consolidated Statements of Income due to the application of SFAS No. 71. On December 12, 2005, MGE received notice from the PSCW permitting recognition of a regulatory asset or liability associated with the adoption of FIN 47, and the differences in ongoing expense recognition under FIN 47 for conditional ARO costs.

SFAS No. 153

In December 2004, the FASB issued FAS Statement No. 153, "Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29, 'Accounting for Nonmonetary Transactions'" (SFAS No. 153). Previously, APB Opinion No. 29 had required that the accounting for an exchange of a productive asset for a similar productive asset or an equivalent interest in the same or similar productive asset should be based on the recorded amount of the asset relinquished. The amendments made by SFAS No. 153 are based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged.

SFAS No. 154

In May 2005, the FASB issued SFAS No. 154, Accounting for Changes and Error Corrections, a replacement of APB (Accounting Principles Board) Opinion No. 20 and SFAS No. 3. Previously, APB Opinion No. 20, Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements, required the inclusion of the cumulative effect of changes in accounting principle in net income of the period of the change. SFAS No. 154 requires companies to recognize a change in accounting principle, including a change required by a new accounting pronouncement when the pronouncement does not include specific transition provisions, retrospectively to prior periods' financial statements. MGE and MGE Energy will assess the impact of a retrospective application of any change in accounting principle in accordance with SFAS No. 154 when such a change arises after the effective date of January 1, 2006.

Inflation

The current financial statements report operating results in terms of historical cost, but they do not evaluate the impact of inflation. Because utilities can depreciate only the historical cost of utility plant, there may not be adequate cash flows from existing plant to replace this investment. Under PSCW rate treatment, projected operating costs, including the impacts of inflation, are recovered in revenues.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk - MGE Energy and MGE.

MGE Energy and MGE are potentially exposed to market risk associated with interest rates, commodity prices, weather, and equity returns. MGE currently has no exposure to foreign currency risk. MGE manages some risk exposure through risk management policies and uses derivative instruments. MGE's market risk has not changed between 2004 and 2005. MGE does not enter into speculative trading transactions.

Weather Risk

MGE's sales forecasts, used to establish rates, are set by the PSCW based upon estimated temperatures, which approximate 20-year averages. MGE's electric revenues are sensitive to the summer cooling season and, to some extent, to the winter heating season. A significant portion of MGE's gas system demand is driven by heating. MGE's gas margin (revenues less gas purchased) is collected under a combination of fixed and volumetric rates set by the PSCW based on "normal weather." As a result of weather-sensitive demand and volumetric rates, a portion of MGE's gas margin is at risk for warmer-than-normal weather. MGE may use weather derivatives, pursuant to its risk management program, to reduce the impact of weather volatility on its gas margin.

On October 17, 2005, MGE entered into two non-exchange traded weather derivatives. The first agreement extended from November 2005 until December 2005. This agreement had a premium of $0.1 million. Additionally, any payment or receipt under this agreement is limited to $0.4 million. The second agreement extends from January 2006 until March 2006. This agreement also has a premium of $0.1 million. Additionally, any payment or receipt under this agreement is limited to $0.6 million.

The Company is accounting for the HDD Collar using the intrinsic value method pursuant to the requirements of EITF No. 99-2, Accounting for Weather Derivatives. Through December 31, 2005, actual HDD were 2,201, resulting in less than a $0.1 million loss for MGE.

A summary of actual weather information in the utility segment's service territory during 2005, 2004, and 2003, as measured by degree days, may be found in Results of Operations.

Commodity Price Risk

MGE has commodity price risk exposure with respect to the price of natural gas, electricity, coal, and oil. MGE employs established policies and procedures to reduce the market risks associated with changing commodity prices, including the use of commodity and financial instruments (see Footnote 15 of the Notes to Consolidated Financial Statements). MGE's commodity risks are somewhat mitigated by the current ratemaking process in place for recovering electric fuel, purchased energy, and the cost of natural gas purchased for resale. MGE's electric fuel costs are subject to fuel rules established by the PSCW, which further mitigate commodity risk. Under the fuel rules, if electric fuel costs exceed or fall below a 3.0% bandwidth set by the PSCW, MGE can apply for a fuel surcharge or may have a fuel credit to its customers. Under the PGA authorized by the PSCW, MGE passes through to customers the cost of gas, subject to certain limited incentives. Effective January 1, 2006, the PSCW modified MGE's fuel rules bandwidth to a range of -.5% to +2.0%. MGE may be required to refund to customers if the fuel rules costs fall outside the lower end of the range (0.5%), and would be allowed to request a surcharge if the fuel rules costs exceeded the upper end of the range (2%).

Under the fuel rules, MGE may include the costs and benefits of fuel price risk management tools implemented under a risk management plan approved by the PSCW. In 2004, the PSCW extended its conditional approval of MGE's Electric Procurement Risk Management Program through December 31, 2005.

MGE has a limited number of financial gas commodity contracts. These contracts are primarily comprised of exchange-traded option contracts to manage the cost of gas and over-the-counter financial floating-to-fixed price swaps and calls for the "Winter Set-Price Firm Gas Sales Service" pilot program. The derivative amounts recorded as a result of these gas contracts are offset with a corresponding regulatory asset or liability because these transactions are part of the PGA and not subject to incentive participation.

Interest Rate Risk

Both MGE and MGE Energy have short term borrowings at varying interest rates. MGE issues commercial paper for its short-term borrowings, while MGE Energy draws from its current credit facility to meet its short term borrowing needs (see Footnote 10 of the Notes to Consolidated Financial Statements). Borrowing levels vary from period to period depending upon capital investments and other factors. Future short-term interest expense and payments will reflect both future short-term interest rates and borrowing levels. MGE Energy and MGE manage interest rate risk by limiting its variable rate exposure and continually monitoring the effects of market changes on interest rates. MGE is not exposed to changes in interest rates on a substantial portion of its long-term debt until that debt matures and is refinanced at market rates. Assuming the current level of variable rate borrowings and assuming a 1% change in the 2005 average interest rate under these borrowings, it is estimated that our 2005 interest expense and net income would have changed by $0.7 million for MGE and $0.8 million for MGE Energy.

Equity Price Risk - Pension-Related Assets

MGE currently funds its liabilities related to employee benefits through trust funds. These funds, which include investments in debt and equity securities, are managed by various investment managers. Changes in market value of these investments can have an impact on the future expenses related to these liabilities. Holding other assumptions constant, for every 1% reduction in the expected rate of return on plan assets, annual pension expense would increase by approximately $1.1 million, before taxes. MGE's risk of expense and annuity payments, as a result of changes in the market value of the trust funds, is mitigated in part through future rate actions by the PSCW.

Construction Risk

On November 4, 2005, MGE Power Elm Road closed on the exercise of an option to acquire an undivided 8.33% ownership interest in each of two 615 MW advanced technology, coal-fired generating units being constructed by We Energies in Oak Creek, Wisconsin. The PSCW previously issued an order that approves key financial terms of the leased generation contracts including fixed construction cost of the two Elm Road units.

Large construction projects of this type are subject to usual construction risks over which we will have limited or no control and which might adversely affect project costs and completion time. These risks include, but are not limited to, shortages of, the inability to obtain or the cost of labor or materials, the inability of the general contractor or subcontractors to perform under their contracts, strikes, adverse weather conditions, the inability to obtain necessary permits in a timely manner and changes in applicable laws or regulations, governmental actions and events in the global economy. If the final costs for the construction of the Elm Road units exceed the fixed costs allowed in the PSCW order, this excess cannot be recovered from MGE or its customers unless specifically allowed by the PSCW. Project costs above the authorized amount, but below the 5% cap will be subject to a prudence determination by the PSCW.

The start of construction was delayed by litigation. Thus, We Energies estimates that project costs will increase. MGE Power Elm Road's estimated share of the increase is approximately $4.0 million. This represents an increase of approximately 2.4% in the total cost of the project. We Energies believes these costs are ultimately recoverable under the terms of the lease agreements, however, recovery is subject to final calculation of costs and also to review and approval by the PSCW.

In September 2003, several parties filed a request with the Wisconsin Department of Natural Resources (WDNR) for a contested case hearing in connection with the application to the WDNR for a Chapter 30 permit for wetlands and waterways alterations and construction on the bed of Lake Michigan for the construction of the Oak Creek expansion. That request was granted and assigned to an administrative law judge. The hearing took place in August 2004 and in November 2004, the administrative law judge approved the WDNR's issuance of the Chapter 30 permit for the Oak Creek expansion. In December 2004, opponents filed a petition for review of the decision in Dane County Circuit Court. In March 2005, the court dismissed the appeal. The opponents appealed the court's dismissal to the Wisconsin Court of Appeals. In February 2006, the Wisconsin Court of Appeals affirmed the lower court's dismissal of the case. The opponents can seek reconsideration of the court's decision or can petition the Wisconsin Supreme Court for review.

We Energies applied to the WDNR to modify the existing Wisconsin Pollution Discharge Elimination System (WPDES) permit that is required for operation of the water intake and discharge system for the planned Oak Creek expansion and existing Oak Creek generating units. In March 2005, the WDNR determined that the proposed cooling water intake structure and water discharge system meets regulatory requirements and reissued the WPDES permit with specific limitations and conditions. The opponents filed a petition for judicial review in Dane County Circuit Court and a request for a contested case proceeding with the WDNR. In September 2005, the judicial review proceeding in Dane County Circuit Court was dismissed. All parties to this action agreed to the dismissal. The WDNR granted a contested case hearing and the administrative law judge has scheduled a hearing for March 2006. A decision by the administrative law judge is anticipated in 2006.

In May 2005, We Energies received the Army Corps of Engineers federal permit necessary for the construction of the Oak Creek expansion. Opponents may appeal the permit in federal court.

Regulatory Recovery Risk

MGE's electric operations burn natural gas in several of its peak power plants or as a supplemental fuel at several coal-fired plants and, in many cases, the cost of purchased power is tied to the cost of natural gas. MGE bears significant regulatory risk for the recovery of such fuel and purchased power costs when they are higher than the base rate established in its current rate structure.

As noted above in Commodity Price Risk, the electric operations of MGE operate under a "fuel rules" adjustment clause for fuel and purchased power costs associated with the generation and delivery of electricity. This clause establishes a base rate for fuel and purchased power. In 2005 and 2004, MGE assumed the risks and benefits of variances that were within a 3.0% bandwidth. For 2005 and 2004, fuel and purchased power costs included in MGE's base fuel rates were $102.4 million and $95.0 million, respectively. In 2005, a fuel rules surcharge was in place from November 11, 2005 through December 31, 2005, which totaled $1.7 million. In 2004, the base fuel rates included a fuel credit in the amount of $3.8 million. Effective January 1, 2006, the PSCW modified MGE's fuel rules bandwidth to a range of -0.5% to +2.0%. MGE may be required to refund to customers if the fuel rules costs fall outside the lower end of the range (0.5%), and would be allowed to request a surcharge if the fuel rules costs exceeded the upper end of the range (2%).

Credit Risk - Counterparty

Credit risk is the loss that may result from counterparty nonperformance. MGE is exposed to credit risk primarily through its merchant energy business. MGE uses credit policies to manage its credit risk, which includes utilizing an established credit approval process, monitoring counterparty limits, employing credit mitigation measures such as collateral or prepayment arrangements, and using netting agreements.

Due to the possibility of extreme volatility in the prices of energy commodities and derivatives, the market value of contractual positions with individual counterparties could exceed established credit limits or collateral provided by those counterparties. If such a counterparty were then to fail to perform its obligations under its contract (for example, fail to deliver the electricity MGE originally contracted for), MGE could sustain a loss that could have a material impact on its financial results.

Additionally, if a counterparty were to default and MGE were to liquidate all contracts with that entity, MGE's credit loss would include the loss in value of mark-to-market contracts; the amount owed for settled transactions; and additional payments, if any, to settle unrealized losses on accrual contracts.

MGE is obligated to provide service to all electric and gas customers within its respective franchised territories. As a result, MGE has a broad customer base. For the year ended December 31, 2005, MGE's ten largest electric customers represented approximately 17.2% of its retail electric revenues. MGE's ten largest gas customers represented approximately 5.0% of its gas revenues. Credit risk for electric and gas is managed by MGE's credit and collection policies, which are consistent with state regulatory requirements.

Cash, cash equivalents, and customer accounts receivable are the financial instruments that potentially subject MGE Energy and MGE to concentrations of credit risk. MGE Energy and MGE place their cash and cash equivalents with high credit-quality financial institutions. MGE has limited concentrations of credit risk from customer accounts receivable because of the large number of customers and strong economy in its service territory.

Item 8. Financial Statements and Supplementary Data.

MGE Energy

Management's Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15f. Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an assessment of the effectiveness of our internal control over financial reporting based on the framework in Internal Control- Integrated Framework issued by the Committee Sponsoring Organizations of the Treadway Commission. Based on our assessment under the framework in Internal Control- Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2005.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Our management's assessment of the effectiveness of our internal control over financial reporting as of December 31, 2005, has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which is included herein.

Report of Independent Registered Public Accounting Firm

To the Board of Directors and

Shareholders of MGE Energy, Inc.:

We have completed integrated audits of MGE Energy, Inc.'s 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005, and an audit of its 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

Consolidated financial statements and financial statement schedule

In our opinion, the consolidated financial statements listed in the index appearing under 15(a)(1), present fairly, in all material respects, the financial position of MGE Energy, Inc. and its subsidiaries at December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). 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 of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting 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 18 to the consolidated financial statements, the Company changed its method of accounting for asset retirement obligations in accord with FIN 47, "Accounting for Conditional Asset Retirement Obligations," as of December 31, 2005, and FASB No. 143, "Accounting for Asset Retirement Obligations," as of January 1, 2003. Further, as discussed in Note 2 to the consolidated financial statements, the Company adopted the provisions of FIN No. 46, "Consolidation of Variable Interest Entities - an interpretation of ARB No. 51 (revised December 2003)," as of December 31, 2003.

Internal control over financial reporting

Also, in our opinion, management's assessment, included in Management's Report on Internal Control Over Financial Reporting appearing under Item 8, that the Company maintained effective internal control over financial reporting as of December 31, 2005 based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the COSO. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management's assessment and on the effectiveness of the Company's internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (I) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

/s/ PricewaterhouseCoopers LLP

Chicago, Illinois

March 1, 2006

Report of Independent Registered Public Accounting Firm

To the Board of Directors and

Shareholder of Madison Gas and Electric Company:

In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of Madison Gas and Electric Company and its subsidiaries at December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). 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 accounting 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 18 to the consolidated financial statements, the Company changed its method of accounting for asset retirement obligations in accord with FIN 47, "Accounting for Conditional Asset Retirement Obligations," as of December 31, 2005, and FASB No. 143, "Accounting for Asset Retirement Obligations," as of January 1, 2003. Further, as discussed in Note 2 to the consolidated financial statements, the Company adopted the provisions of FIN No. 46, "Consolidation of Variable Interest Entities - an interpretation of ARB No. 51 (revised December 2003)," as of December 31, 2003.

/s/ PricewaterhouseCoopers LLP

Chicago, Illinois

March 1, 2006

 MGE Energy, Inc.

 Consolidated Statements of Income

 (In thousands, except per-share amounts)

The accompanying notes are an integral part of the above consolidated financial statements.

 MGE Energy, Inc.

 Consolidated Statements of Cash Flows

 (In thousands)

The accompanying notes are an integral part of the above consolidated financial statements.

 MGE Energy, Inc.

 Consolidated Balance Sheets

 (In thousands)