Tennessee Valley Authority - Annual Report: 2006 (Form 10-K)

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(MARK ONE)

þ		ANNUAL REPORT PURSUANT TO SECTION 13, 15(d), OR 37 OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended September 30, 2006

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

TENNESSEE VALLEY AUTHORITY

A corporate agency of the United States created by an act of Congress		62-0474417
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

400 W. Summit Hill Drive Knoxville, Tennessee		37902
(Address of principal executive offices)		(Zip Code)

(865) 632-2101
Registrant’s telephone number, including area code

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark whether the registrant is a well-known, seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13, Section 15(d), or Section 37 of the Exchange Act. Yes o No þ

Indicate by check mark whether the registrant (1) has 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 registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes o No þ

Indicate by check mark 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 registrant’s 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. þ

Indicate by check mark whether 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. (Check one):

Large accelerated filer o           Accelerated filer o           Non-accelerated filer þ

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

Yes o No þ

 

 

Table of Contents

Forward-Looking Information							4
General Information							5
				Part I
Item 1.				Business			6
				The Corporation			6
				Governance			6
				Service Area			6
				Customers			8
				Rate Authority			10
				Rate Actions			11
				Power and Energy Forecasts			11
				Power Supply			11
				Nuclear			15
				Fuel Supply			16
				Transmission Operations			18
				Stewardship Activities			19
				Seasonality			19
				Competition			20
				Regulation			21
				Payments in Lieu of Taxes			22
				Environmental Matters			22
				Employee Relations			26
Item 1A.				Risk Factors			26
				Strategic Risks			26
				Operational Risks			28
				Financial Risks			30
Item 1B.				Unresolved Staff Comments			32
Item 2.				Properties			32
				Generating Properties			32
				Transmission Properties			33
				Resource Stewardship Properties			33
				Buildings			33
				Disposal of Property			33
Item 3.				Legal Proceedings			34
Item 4.				Submission of Matters to a Vote of Security Holders			37
				Part II
Item 5.				Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities			38
Item 6.				Selected Financial Data			38
				Statements of Income Data			38
				Balance Sheets Data			39
				Financial Obligations			39
				Reconciliation of Non-GAAP Items Required by Securities and Exchange Commission Rules			39
				Comparative Five-Year Data Statistical and Financial Summaries			41
Item 7.				Management’s Discussion and Analysis of Financial Condition and Results of Operations			42
				Business Overview			42
				Liquidity and Capital Resources			45
				Results of Operations			51
				Off-Balance Sheet Arrangements			56
				Critical Accounting Policies and Estimates			57
				New Accounting Standards and Interpretations			61
				Legislative and Regulatory Matters			64
				Environmental Matters			65

				Legal Proceedings			68
				Risk Management Activities			68
				Management Changes			74
				Subsequent Events			74
Item 7A.				Quantitative and Qualitative Disclosures About Market Risk			74
Item 8.				Financial Statements and Supplementary Data			75
				Statements of Income			75
				Balance Sheets			76
				Statements of Cash Flows			77
				Statements of Changes in Proprietary Capital			78
				Notes to Financial Statements			79
				Report of Independent Registered Public Accounting Firm			119
Item 9.				Changes in and Disagreements With Accountants on Accounting and Financial Disclosure			120
Item 9A.				Controls and Procedures			121
Item 9B.				Other Information			121
				Part III
Item 10.				Directors and Executive Officers of the Registrant			122
				Directors			122
				Executive Officers			123
				Code of Ethics			126
				Audit Committee			126
				Other Committees			126
Item 11.				Executive Compensation			126
				Director Compensation			126
				Executive Compensation			128
				Retirement Benefits			131
				Long-Term Deferred Compensation Plan Agreements			135
				Other Agreements			135
				Compensation Committee Interlocks and Insider Participation			136
Item 12.				Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters			136
Item 13.				Certain Relationships and Related Transactions			136
Item 14.				Principal Accountant Fees and Services			136
				Part IV
Item 15.				Exhibits and Financial Statement Schedules			138
Signatures							141
Ex-3.1 Tennessee Valley Authority Act, As Amended
Ex-3.2 TVA By-laws
Ex-4.1 October 6, 1960 Power Bond Resolution
Ex-10.1 Fall Credit Agreement
Ex-10.2 Spring Maturity Credit Agreement
Ex-10.3 TVA Discount Notes Selling Group Agreement
Ex-10.4 Electronotes Selling Agent Agreement
Ex-10.5 Commitment Agreement
Ex-10.6 Power Contract Supplement No. 95
Ex-10.7 Void Walk Away Agreement
Ex-10.8 Power Contract Supplement No. 96
Ex-10.9 Overview of TVA's 09/26/03 Lease
Ex-10.10 Participation Agreement
Ex-10.11 Network Lease Agreement
Ex-10.12 Head Lease Agreement
Ex-10.13 Leasehold Security Agreement
Ex-10.14 Directors/Officers Compensation Overview
Ex-10.15 Supplemental Executive Retirement Plan
Ex-10.16 Executive Annual Incentive Plan
Ex-10.17 Executive Long-Term Incentive Plan
Ex-10.18 Long Term Deferred Compensation Plan
Ex-10.19 Tom D. Kilgore Employment Contract
Ex-10.20 Michal E. Rescoe Employment Contract
Ex-10.21 Ashok S. Bhatnagar First Deferral Agreement
Ex-10.22 Ashok S. Bhatnagar Second Deferral Agreement
Ex-10.23 Joseph R. Bynum Deferral Agreement
Ex-10.24 Tom D. Kilgore Deferral Agreement
Ex-10.25 Karl W. Singer First Deferral Agreement
Ex-10.26 Karl W. Singer Second Deferral Agreement
Ex-14 Disclosure and financial Ethics Code
Ex-31.1 Section 302 Certification
Ex-31.2 Section 302 Certification
Ex-32.1 Section 906 Certification
Ex-32.2 Section 906 Certification

FORWARD-LOOKING INFORMATION

     This Annual Report on Form 10-K (“Annual Report”) contains forward-looking statements relating to future events and future performance. All statements other than those that are purely historical may be forward-looking statements.

     In certain cases, forward-looking statements can be identified by the use of words such as “may,” “will,” “should,” “expect,” “anticipate,” “believe,” “intend,” “project,” “plan,” “predict,” “assume,” “forecast,” “estimate,” “objective,” “possible,” “probably,” “likely,” “potential,” or other similar expressions.

     Examples of forward-looking statements include, but are not limited to:

	•		Statements regarding strategic objectives;
	•		Projections regarding potential rate actions;
	•		Estimates of costs of certain retirement obligations;
	•		Estimates regarding power and energy forecasts;
	•		Expectations about the adequacy of TVA’s pension plans and nuclear decommissioning trust;
	•		Estimates regarding the reduction of total financing obligations;
	•		The impact of new accounting pronouncements and interpretations, including Statement of Financial Accounting Standards No. 158, “Employers Accounting for Defined Benefit Pension and Other Postretirement Plans — an amendment of FASB Statements No. 87, 88, 106, and 132(R);”
	•		Estimates of amounts to be reclassified from Other Comprehensive Income to earnings over the next year;
	•		TVA’s plans to continue using short-term debt to meet current obligations; and
	•		The anticipated cost and timetable for returning Browns Ferry Unit 1 to service.

     Although the Tennessee Valley Authority (“TVA”) believes that the assumptions underlying the forward-looking statements are reasonable, TVA does not guarantee the accuracy of these statements. Numerous factors could cause actual results to differ materially from those in the forward-looking statements. These factors include, among other things:

•

New laws, regulations, and administrative orders, especially those related to:

– TVA’s protected service area, – The sole authority of the TVA Board to set power rates, – Various environmental and nuclear matters, – TVA’s management of the Tennessee River system, – TVA’s credit rating, and – TVA’s debt ceiling;

	•		Performance of TVA’s generation and transmission assets;
	•		Availability of fuel supplies;
	•		Compliance with existing environmental laws and regulations;
	•		Significant delays or cost overruns in construction of generation and transmission assets;
	•		Significant changes in demand for electricity;
	•		Legal and administrative proceedings;
	•		Weather conditions;
	•		Failure of transmission facilities;
	•		An accident at any nuclear facility, even one unaffiliated with TVA;
	•		Catastrophic events such as fires, earthquakes, floods, pandemics, wars, terrorist activities, and other similar events, especially if these events occur in or near TVA’s service area;
	•		Changes in the market price of commodities such as coal, uranium, natural gas, fuel oil, electricity, and emission allowances;
	•		Changes in the prices of equity securities, debt securities, and other investments;
	•		Changes in interest rates;
	•		Creditworthiness of TVA or its counterparties;
	•		Rising pension costs and health care expenses;
	•		Increases in TVA’s financial liability for decommissioning its nuclear facilities;
	•		Limitations on TVA’s ability to borrow money;
	•		Changes in economic environments;
	•		Ineffectiveness of TVA’s disclosure controls and procedures;
	•		Changes in accounting standards;
	•		The loss of TVA’s ability to use regulatory accounting;
	•		Loss of key personnel;
	•		Changes in technology; and
	•		Unforeseeable events.

     Additionally, other risks that may cause actual results to differ from the predicted results are set forth in Item 1A, Risk Factors. New factors emerge from time to time, and it is not possible for management to predict all such factors or to assess the extent to which any factor or combination of factors may impact TVA’s business or cause results to differ materially from those contained in any forward-looking statement.

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

GENERAL INFORMATION

Fiscal Year

     Unless otherwise indicated, years (2006, 2005, etc.) in this Annual Report refer to TVA’s fiscal years ended September 30. References to years in the biographical information about directors and executive officers in Item 10, Directors and Executive Officers of the Registrant are to calendar years.

Notes

     References to “Notes” are to the Notes to Financial Statements contained in Item 8, Financial Statements and Supplementary Data.

Available Information

     The public may read and copy any reports or other information that TVA files with the Securities and Exchange Commission (“SEC”) at the SEC’s Public Reference Room at 100 F Street, N.E., 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. TVA’s SEC reports are also available to the public without charge from the website maintained by the SEC at www.sec.gov and TVA’s website at www.tva.gov. Information contained on TVA’s website shall not be deemed incorporated into, or to be a part of, this Annual Report.

PART I

ITEM 1. BUSINESS

The Corporation

     The Tennessee Valley Authority (“TVA”) is a wholly-owned corporate agency and instrumentality of the United States. TVA was created by the U.S. Congress in 1933 by virtue of the Tennessee Valley Authority Act of 1933, as amended, 16 U.S.C. §§ 831-831ee (2000 & Supp. IV 2004) (as amended, the “TVA Act”). TVA was created to improve navigation on the Tennessee River, reduce flood damage, provide agricultural and industrial development, and provide electric power to the Tennessee Valley region. TVA manages the Tennessee River and its tributaries for multiple river-system purposes, such as navigation; flood damage reduction; power generation; environmental stewardship; shoreline use; and water supply for power plant operations, consumer use, recreation, industry, and other stewardship purposes. TVA’s power system operations, however, constitute the majority of its activities and provide virtually all of its revenues.

     Although TVA is similar to power companies in many ways, there are many features that make it different. Some of these include:

	•		TVA was created by an act of the U.S. Congress and is a wholly-owned corporate agency of the United States.
	•		TVA’s board of directors (the “TVA Board”) is appointed by the President with the advice and consent of the U.S. Senate.
	•		TVA holds its real properties as an agent for the United States.
	•		TVA is required to make payments to the U.S. Treasury as a repayment of and a return on the appropriation investment that the United States provided TVA for its power program (the “Appropriation Investment”).
	•		TVA is not authorized to issue equity securities such as common or preferred stock. Accordingly, TVA finances its operations primarily with cash flows from operations and proceeds from issuing debt.
	•		The TVA Board sets the rates TVA charges for power. In setting rates, the TVA Board must have due regard for the objective that power be sold at rates as low as are feasible.
	•		TVA is exempt from paying federal income taxes and state and local taxes but must pay certain states and counties an amount in lieu of taxes equal to five percent of TVA’s gross revenues from the sale of power during the preceding year excluding sales or deliveries to other federal agencies and exchange sales with other utilities, with a provision for minimum payments under certain circumstances.

     For a discussion of the more significant of these features, see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations — Business Overview.

Governance

     TVA is governed by the TVA Board. The Consolidated Appropriations Act, 2005, amended the TVA Act by restructuring the TVA Board from three full-time members to nine part-time members, at least seven of whom must be legal residents of the TVA service area. TVA Board members are appointed by the President of the United Stated with the advice and consent of the U.S. Senate. After an initial phase-in period, TVA Board members serve five-year terms, and at least one member’s term ends each year. The TVA Board’s role, among other things, is to establish broad goals, objectives, and policies for TVA; establish long-range plans to carry out these goals, objectives, and policies; approve annual budgets; and establish a compensation plan for employees. Information about members of the TVA Board and TVA’s executive officers is discussed in Item 10, Directors and Executive Officers of the Registrant.

Service Area

     TVA operates the nation’s largest public power system. TVA supplies power in most of Tennessee, northern Alabama, northeastern Mississippi, and southwestern Kentucky and in portions of northern Georgia, western North Carolina, and southwestern Virginia to a population of approximately 8.7 million people.

     Subject to certain minor exceptions, TVA may not, without specific authorization by act of the U.S. Congress, enter into contracts which would have the effect of making it, or the distributor customers of its power, a source of power supply outside the area for which TVA or its distributor customers were the primary source of power

supply on July 1, 1957. This statutory provision is referred to as the “fence” because it bounds TVA’s sales activities, essentially limiting TVA to power sales within a defined service area.

     Correspondingly, the Federal Power Act (“FPA”), primarily through its anti-cherrypicking provision, prevents the Federal Energy Regulatory Commission (“FERC”) from ordering TVA to provide access to its transmission lines to others for the purpose of delivering power to customers within its defined service area. The anti-cherrypicking provision helps to minimize the financial exposure of TVA to loss of revenue.

     Sales of electricity accounted for substantially all of TVA’s operating revenues in 2006, 2005, and 2004, amounting to $9.1 billion, $7.7 billion, and $7.4 billion, respectively. TVA’s revenues by state for the last three years are detailed in the table below:

Electricity Sales by State
(in millions)

		2006				2005				2004
Alabama		$	1,268			$	1,054			$	1,033
Georgia			228				186				182
Kentucky			909				832				731
Mississippi			826				674				658
North Carolina			47				39				38
Tennessee			5,764				4,820				4,734
Virginia			7				4				4
			9,049				7,609				7,380
Sale for resale			13				95				59
		$	9,062			$	7,704			$	7,439

TVA SERVICE AREA

Customers

     TVA is primarily a wholesaler of power. TVA sells power at wholesale to distributor customers, consisting of municipalities and cooperatives, that resell the power to their customers at a retail rate. TVA also sells power (1) to directly served customers, consisting primarily of federal agencies and customers with large or unusual loads, and (2) to exchange power customers (electric systems that border TVA’s service area) with which TVA has entered into exchange power arrangements as allowed by the TVA Act.

     Operating revenues by customer type for each of the last three years are set forth in the table below. In this table, sales to directly-served industries are included in Industries Directly Served, and sales to directly-served federal agencies and to exchange power customers are included in Federal Agencies and Other.

Operating Revenues by Customer Type
(in millions)

		2006				2005				2004
Municipalities and cooperatives		$	7,880			$	6,561			$	6,457
Industries directly served			1,066				962				842
Federal agencies and other
Federal agencies directly served			103				86				81
Exchange sales			13				95				59
Total		$	9,062			$	7,704			$	7,439

Municipalities and Cooperatives

     Revenues from distributor customers accounted for 85.8 percent of TVA’s total operating revenues in 2006. At September 30, 2006, TVA had wholesale power contracts with 158 municipalities and cooperatives. All of these contracts require distributor customers to purchase all of their electric power and energy requirements from TVA.

     All distributor customers purchase power under one of three basic termination notice arrangements:

	•		Contracts that require five years’ notice to terminate;
	•		Contracts that require 10 years’ notice to terminate; and
	•		Contracts that require 15 years’ notice to terminate.

     The number of distributor customers with the contract arrangements described above, the revenues derived from such arrangements in 2006, and the percentage of TVA’s 2006 total operating revenues represented by these revenues are summarized in the table below.

TVA Distributor Customer Contracts
As of September 30, 2006

		Number of				Sales to				Percentage of Total
		Distributor				Distributor				Operating Revenues
Contract Arrangement		Customers				Customers in 2006				in 2006
		(in millions)
15-Year Termination Notice			5			$	92				1.0	%
10-Year Termination Notice			48				2,625				28.6	%
5-Year Termination Notice *			99				4,893				53.3	%
Notice Given - Less than 5 Years
Remaining*			6				270				2.9	%
			158			$	7,880				85.8	%

     TVA’s two largest distributor customers — Memphis, Light Gas and Water Division (“MLGW”) and Nashville Electric Service (“NES”) – have contracts with five-year and 10 year termination notice periods, respectively.

Although no single customer accounted for 10 percent or more of TVA’s total operating revenues in 2006, sales to MLGW and NES accounted for 9.1 percent and 7.7 percent, respectively. In 2004, TVA and MLGW entered into a prepayment agreement under which MLGW prepaid TVA $1.5 billion for the future costs for a portion of the electricity to be delivered by TVA to MLGW over a period of 180 months. See Note 1 — Energy Prepayment Obligations for more information about this prepayment arrangement.

     On September 26, 2006, the city of Bristol, Virginia, announced that it had selected TVA as the new power provider for its municipal electric system, Bristol Virginia Utilities (“BVU”), beginning in January 2008. TVA had provided wholesale power to BVU from 1945 to 1997. The contract has a minimum 15-year term, and a five-year termination notice may not be given until January 2018. The rates under this contract are intended to recover the cost of reintegrating BVU into TVA’s power-supply plan and serving its customer load.

     All of the power contracts between TVA and the distributor customers provide for purchase of power by the distributor customers at the rates established by the TVA Board, which beginning with the current fiscal year, will be adjusted quarterly to reflect changing fuel and purchased power costs. In addition, most of the power contracts between TVA and the distributor customers specify the resale rates that distributor customers charge their power customers. These resale rates are divided into the classifications of residential, general power, and manufacturing. The general power and manufacturing classifications are further divided into sub-classifications according to their load size. These rates are revised from time to time to reflect changes in costs, including changes in the wholesale cost of power, and are designed to promote the TVA Act’s objective of providing an adequate supply of power at the lowest feasible rates.

Termination Notices

     Six of TVA’s distributor customers had notices in effect terminating their power contracts with TVA as of September 30, 2006. On November 3, 2006, TVA announced that distributor customers that have given notice to terminate their power contracts with TVA will have an opportunity to rescind their notices on or before January 10, 2007, without any additional costs. After January 10, 2007, TVA will consider requests for rescission of the notice, but would consider serving the returning distributor customer at the standard prevailing rate plus a reintegration fee for any additional costs necessary to supply the returning load. In December 2006, Warren Rural Electric Cooperative Corporation (“Warren”) announced its intention to take advantage of this opportunity and to enter into a new power supply contract with TVA.

     The table below lists the names and locations of the six distributor customers whose termination notices were still in effect, their contract termination dates, the amount of revenues that TVA generated by selling power to these distributor customers in 2006, and the percentage of TVA’s total 2006 operating revenues represented by these revenues.

Distributor Customers with Termination Notices in Effect
As of September 30, 2006

						TVA Sales to
						Distributor				Percentage
				Date of Termination		Customer				of TVA Operating
Distributor Customer		Location		of Power Contract		in 2006				Revenues in 2006
		(in millions)
Monticello Electric Plant Board		Kentucky		November 2008		$	6				0.1	%
Glasgow Electric Plant Board		Kentucky		November 2008			21				0.2	%
Warren Rural Electric Cooperative Corporation		Kentucky		April 2009			97				1.0	%
Paducah Power System		Kentucky		December 2009			39				0.4	%
Princeton Electric Plant Board		Kentucky		January 2010			6				0.1	%
Duck River Electric Membership Corporation		Tennessee		August 2010			101				1.1	%
Total						$	270				2.9	%

     In 2006, TVA agreed to a one-year extension of the effective date of termination of TVA’s power supply contract with Warren and a two-year extension with Duck River Electric Membership. Warren’s one-year extension includes a surcharge for costs associated with the additional year. (The extended termination dates are shown in the table above).

Other Customers

     Revenues from directly served industrial customers accounted for 11.6 percent of TVA’s total operating revenues in 2006. Directly served customer contracts are normally for 10-year terms. These contracts are subject to termination by TVA or the customer upon a minimum notice period that varies according to the customer’s contract demand and the period of time service has been provided.

     The United States Enrichment Corporation (“USEC”) is TVA’s largest directly served industrial customer, with sales to USEC for its Paducah, Kentucky, facility representing 3.9 percent of TVA’s total operating revenues in 2006. TVA’s current contract with USEC expires on June 1, 2010. In January 2004, USEC announced it will begin constructing a new commercial centrifuge facility in Piketon, Ohio, which is outside TVA’s service area. Once this new facility is opened (scheduled to be in 2010), it is unclear how much electricity USEC will acquire from TVA for its Paducah, Kentucky, facility, but it is expected to be substantially less than current levels.

Rate Authority

     TVA is self-regulated and the TVA Act gives the TVA Board sole responsibility for establishing the rates TVA charges for power. These rates are not subject to review or approval by any state or federal regulatory body.

     According to the TVA Act, TVA is required to charge rates for power which will produce gross revenues sufficient to provide funds for:

	•		Operation, maintenance, and administration of its power system;
	•		Payments to states and counties in lieu of taxes;
	•		Debt service on outstanding indebtedness;
	•		Payments to the U.S. Treasury in repayment of and as a return on the Appropriation Investment in TVA’s power facilities; and
	•		Such additional margin as the TVA Board may consider desirable for investment in power system assets, retirement of outstanding indebtedness, additional reduction of the Appropriation Investment, and other purposes connected with TVA’s power business.

     In setting TVA’s rates, the TVA Board is charged by the TVA Act to have due regard for the primary objectives of the TVA Act, including the objective that power shall be sold at rates as low as are feasible.

Revenue Requirements

     In conjunction with setting rates to cover the costs set out in the TVA Act, TVA uses a debt-service coverage (“DSC”) methodology to derive annual revenue requirements in a manner similar to that used by other public power entities that also use the DSC rate methodology. The DSC method is essentially a measure of an organization’s ability to cover its operating costs and to satisfy its obligations to pay principal and interest on debt. TVA believes this method is appropriate because of TVA’s debt-intensive capital structure. This ratemaking approach is particularly suitable for use by highly leveraged enterprises (i.e., financed primarily, if not entirely, by debt capital). In these enterprises common equity capital does not function, as it does in companies that issue equity, as primary risk capital by providing an adequate buffer against earnings volatility.

     The revenue requirements (or projected costs) are typically calculated under the DSC method as the sum of the following components:

	1)		Fuel and purchased power costs;
	2)		Operating and maintenance costs;
	3)		Taxes; and
	4)		Debt service coverage.

     Once the revenue requirements (or projected costs) are determined, this amount is compared to the projected revenues for the test year at existing rates to arrive at the shortfall or surplus of revenues as compared to the projected costs. In the event of a projected shortfall, the rates would be adjusted upward to a level sufficient to produce revenues approximately equal to the projected costs. Conversely, in the event of a projected surplus, the rates would be adjusted downward to a level to produce revenues approximately equal to the projected costs. This

reflects the cause-and-effect relationship between a regulated entity’s costs and the corresponding rates the entity charges for its regulated products and services.

Rate Actions

     On July 22, 2005, the TVA Board approved a 7.52 percent increase in firm wholesale electric rates effective on October 1, 2005. The TVA Board approved the rate adjustment to fund increases in fuel and purchased power costs as well as increased fuel transportation costs. In 2006, fuel and purchased power costs represented about 38 percent of TVA’s total costs. Costs continued to increase significantly, and on February 13, 2006, the TVA Board approved a 9.95 percent increase in firm wholesale electric rates effective on April 1, 2006. The combined rate increases provided additional revenues of approximately $873 million during 2006.

     On July 28, 2006, the TVA Board approved a 4.50 percent decrease in firm wholesale electric rates effective on October 1, 2006. In connection with the same rate adjustment, the TVA Board also implemented a fuel cost adjustment (“FCA”) to be applied quarterly as a mechanism to adjust TVA’s rates to reflect changing fuel and purchased power costs beginning in fiscal year 2007. The FCA is initially set to zero and will have its first impact on rates effective January 1, 2007. The FCA amount to be implemented on January 1, 2007, is 0.01 cents per kilowatt-hour and is expected to produce an estimated $3.9 million in revenue.

Power and Energy Forecasts

     TVA forecasts future power and energy requirements by producing a range of load forecasts to bound the range of uncertainty associated with load growth. TVA produces the load forecasts using probabilities. TVA believes that there is a 90 percent probability that the actual load will be less than the high load forecast, a 50 percent probability that the actual load will be less than medium load forecast, and a 10 percent probability that the actual load will be less than the low load forecast. TVA’s current forecast through 2007 is a high load forecast of 4.0 percent growth, a medium load forecast of 2.9 percent growth, and a low load forecast of 0.4 percent growth. Numerous factors, such as weather conditions and the health of the regional economy, could cause actual results to differ materially from TVA’s forecasts.

Power Supply

General

     TVA’s power generating facilities in operation at September 30, 2006, included 29 conventional hydroelectric plants, one pumped storage hydroelectric plant, 11 coal-fired plants, three nuclear plants, six combustion turbine plants, two diesel generator plants, one wind energy site, one digester gas plant, and 16 solar energy sites. In addition, TVA acquires power under power purchase agreements, as well as through spot market purchases.

TVA-Owned Generation Facilities

     The following table summarizes TVA’s net generation in millions of kilowatt-hours (“kWh”) by generating source and the percentage of all electric power generated by TVA for the years indicated:

Power Supply from TVA-Owned Generation Facilities
As of September 30
(millions of kWh)

		2006									2005									2004									2003									2002
Coal-fired			99,630				64	%				98,404				62	%				94,648				61	%				90,975				60	%				94,930				63	%
Nuclear			45,313				29	%				45,156				28	%				46,003				30	%				43,167				29	%				45,179				30	%
Hydroelectric			9,961				6	%				15,723				10	%				13,916				9	%				16,103				11	%				10,205				6	%
Combustion turbine and diesel generators			613				<1	%				595				<1	%				278				<1	%				817				<1	%				1,190				1	%
Renewable resources			19				<1	%				18				<1	%				18				<1	%				15				<1	%				18				<1	%
Total			155,536				100	%				159,896				100	%				154,863				100	%				151,077				100	%				151,522				100	%

     Coal-Fired. TVA has 11 coal fired power plants consisting of 59 units. At September 30, 2006, these facilities accounted for 15,081 megawatts of winter net dependable capacity. Net dependable capacity is defined as the net power output which can be obtained for a period adequate to satisfy the daily load patterns under expected

conditions of operation with equipment in an average state of maintenance excluding any fluctuations in capacity that may occur due to planned outages, unplanned outages, and deratings. Each of TVA’s coal-fired units was placed in service between 1951 and 1973.

     Nuclear. TVA has three nuclear plants consisting of five units currently in operation. At September 30, 2006, these facilities accounted for 5,770 megawatts of winter net dependable capacity. For a detailed discussion of TVA’s nuclear power program, see Item 1, Business — Nuclear.

     Hydroelectric. TVA has 29 conventional hydroelectric plants consisting of 109 units. In addition, TVA has one pumped storage facility consisting of 4 units. At September 30, 2006, these facilities accounted for 5,144 megawatts of winter net dependable capacity. The amount of electricity that TVA is able to generate from its hydroelectric plants depends on a number of factors, including the amount of precipitation, watershed levels, the need for water for competing water management objectives, and the availability of its hydroelectric generation plants. When these factors are unfavorable, TVA must increase its reliance on more expensive generation plants and purchased power.

     Combustion Turbines. At September 30, 2006, TVA had six combustion turbine plants consisting of 72 units, and these facilities accounted for 4,663 megawatts of winter net dependable capacity. TVA’s combustion turbines are fueled by natural gas and fuel oil and are quick-start facilities that TVA can use at times of peak demand to supply power to its customers. As of September 30, 2006, 24 of TVA’s combustion turbine units were leased to private entities and leased back to TVA under long-term leases. See Note 11 — Other Financing Obligations. In addition, the TVA Board has authorized the purchase of two additional combustion turbine facilities. In October 2006, the TVA Board authorized the acquisition of a 742 megawatt winter peaking capacity, dual-fuel combustion turbine facility and certain related transmission facilities located in Marshall County, Kentucky from KGen Marshall County LLC. In November 2006, the TVA Board approved the acquisition of a natural gas-fired combustion turbine facility located in Weakley County, Tennessee, from Allegheny Energy Supply Gleason Generating Facility, LLC. This facility can produce 555 megawatts of winter peaking capacity.

     Diesel Generators. TVA has two diesel generator plants consisting of nine units. At September 30, 2006, these facilities provided 13 megawatts of winter net dependable capacity.

     Renewable Resources. TVA has one wind energy site with three wind turbines, one digester gas cofiring site, and 16 solar energy sites. At September 30, 2006, the digester gas cofiring site provided TVA with five megawatts of winter net dependable capacity. In addition, the wind energy site and the photovoltaic sites provided two megawatts of capacity, but because of the nature of this capacity, it is not considered to be winter net dependable capacity.

Purchased Power

     TVA acquires power from a variety of power producers through long-term and short-term power purchase agreements as well as through spot market purchases. During 2006, TVA acquired 31 percent of the power that it purchased on the spot market, 40 percent through short-term power purchase agreements and 29 percent through long-term power purchase agreements that expire more than one year after September 30, 2006.

     At September 30, 2006, TVA’s power purchase agreements provided TVA with 4,275 megawatts of winter net dependable capacity. Counterparties to contracts for 3,008 megawatts of this capacity were in bankruptcy, but the counterparties have continued to perform under their power purchase agreements with TVA throughout their bankruptcy proceedings. See Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations — Risk Management Activities — Credit Risk. A portion of TVA’s winter net dependable capacity provided by power purchase agreements is provided under long-term contracts that expire between 2010 and 2032, and the most significant of these contracts are discussed below.

	•		Tapoco, Inc. Four hydroelectric plants owned by Tapoco, Inc. (“Tapoco”), a subsidiary of Alcoa, Inc. (“Alcoa”), are operated in coordination with the TVA system. Under contractual arrangements with Tapoco which terminate on June 20, 2010, TVA purchases the electric power generated at these facilities and uses it to partially supply Alcoa’s energy needs. TVA’s arrangement with Tapoco provides 362 megawatts of winter net dependable capacity.
	•		Southeastern Power Administration. Under arrangements among TVA, the U.S. Army Corps of Engineers, and the Southeastern Power Administration (“SEPA”), eight hydroelectric plants of the U.S. Army Corps of Engineers on the Cumberland River system are operated in coordination with the TVA system. These arrangements provide for 405 megawatts of winter net dependable capacity as well as

all surplus energy from the Cumberland River system to be supplied to TVA by SEPA at the points of generation at a price based on the operating and maintenance expenses and amortization of the power facilities. A portion of the output of the Cumberland River system is also made available to SEPA’s customers outside the TVA region. The agreement with SEPA covering these arrangements for power from the Cumberland River system can be terminated upon three years’ notice, but this notice of termination may not become effective prior to June 30, 2017.

•

Choctaw Generation, L.P. TVA has contracted with Choctaw Generation L.P. (“Choctaw”) for 440 megawatts of winter net dependable capacity from a lignite-fired generating plant in Chester, Mississippi. TVA’s contract with Choctaw expires on March 31, 2032.

     Under the Public Utility Regulatory Policies Act of 1978, as amended (“PURPA”), TVA is obligated to purchase such energy at TVA’s avoided cost as may be “put” to TVA from time to time from qualifying independent, non-utility power producers. At September 30, 2006, TVA had such PURPA-required contracts with seven such producers, with a combined capacity of 906 megawatts, but in October 2006, one of these contracts expired. The expired contract was with a producer with approximately three megawatts of capacity. Because of the nature of TVA’s obligations under these PURPA-required contracts, the capacity of the associated qualifying generation facilities is not included in TVA’s net dependable capacity calculations.

     During the past five years, TVA supplemented its power generation through power purchases as follows:

Purchased Power
(in millions of kWh)

2006		2005		2004		2003		2002
20,017		16,637		15,148		15,760		12,241

     These purchase agreements provide between 7.5 percent and 11.4 percent of TVA’s total power supply during these years.

     For more information regarding TVA’s power purchase obligations, see Note 13 — Commitments — Power Purchase Obligations.

Net Dependable Capacity

     The following table summarizes the winter net dependable capacity in megawatts TVA had available as of September 30, 2006:

TVA WINTER NET DEPENDABLE CAPACITY
As of September 30, 2006

								Winter Net				Date First Unit				Date Last Unit
				Number of				Dependable				Placed in				Placed in
Source of Capacity		Location		Units				Capacity (MW) 1				Service				Service
Coal-Fired
Allen		Tennessee			3				750				1959				1959
Bull Run		Tennessee			1				889				1967				1967
Colbert		Alabama			5				1,201				1955				1965
Cumberland		Tennessee			2				2,524				1973				1973
Gallatin		Tennessee			4				988				1956				1959
John Sevier		Tennessee			4				712				1955				1957
Johnsonville		Tennessee			10				1,254				1951				1959
Kingston		Tennessee			9				1,448				1954				1955
Paradise		Kentucky			3				2,318				1963				1970
Shawnee		Kentucky			10				1,369				1953				1956
Widows Creek		Alabama			8				1,628				1952				1965
Total Coal-Fired					59				15,081
Nuclear
Browns Ferry		Alabama			2				2,269				1974				1977
Sequoyah		Tennessee			2				2,333				1981				1982
Watts Bar		Tennessee			1				1,168				1996				1996
Total Nuclear					5				5,770
Hydroelectric
Conventional Plants		Alabama			36				1,146				1925				1962
		Georgia			2				32				1931				1956
		Kentucky			5				165				1944				1948
		North Carolina			8				536				1940				1956
		Tennessee			58				1,647				1912				1972
Pumped Storage		Tennessee			4				1,618				1978				1979
Total Hydroelectric					113				5,144
Combustion Turbine
Allen		Tennessee			20				575				1971				1972
Colbert		Alabama			8				486				1972				1972
Gallatin		Tennessee			8				730				1975				2000
Johnsonville		Tennessee			20				1,372				1975				2000
Kemper		Mississippi			4				374				2001				2001
Lagoon Creek		Tennessee			12				1,126				2002				2002
Total Combustion Turbine					72				4,663	2
Diesel Generator
Meridian		Mississippi			5				9				1998				1998
Albertville		Alabama			4				4				2000				2000
Total Diesel Generators					9				13
Renewable Resources Owned by TVA									5
Total TVA-Owned Generation Facilities									30,676
Power Purchase Agreements
Tapoco									362
SEPA									405
Choctaw									440
Other Power Purchase Agreements									3,068
Total Power Purchase Agreements									4,275
Total Winter Net Dependable Capacity									34,951

Nuclear

Overview

     TVA has five operating nuclear units, one deferred nuclear unit, and one nuclear unit in recovery that is scheduled to be returned to service in 2007. Two units were canceled during 2006. Selected statistics of each of these units are included in the table below.

TVA Nuclear Power
As of September 30, 2006

Installed

Capacity

Net Capacity

Date of Expiration of

Date of Expiration of

Nuclear Unit

Status

(Megawatts)

Factor for 2006

Operating License

Construction License

Sequoyah Unit 1

Operating

1,221

88.9

2020

–

Sequoyah Unit 2

Operating

1,221

98.0

2021

–

Browns Ferry Unit 2

Operating

1,190

96.4

2034

3

–

Browns Ferry Unit 3

Operating

1,190

84.7

2036

3

–

Watts Bar Unit 1

Operating

1,270

84.0

2035

–

Watts Bar Unit 2

Deferred 1

–

–

–

2010

Bellefonte Unit 1

Canceled 2

–

–

–

–

Bellefonte Unit 2

Canceled 2

–

–

–

–

Browns Ferry Unit 1

Recovery 4

1,150

–

2033

3

–

Spent Nuclear Fuel

     Under the Nuclear Waste Policy Act of 1982, TVA (and other domestic nuclear utility licensees) entered into a contract with the U.S. Department of Energy (“DOE”) for the disposal of spent nuclear fuel. Payments to DOE are based upon TVA’s nuclear generation and charged to nuclear fuel expense. Although the contracts called for DOE to begin accepting spent nuclear fuel from the utilities by January 31, 1998, DOE announced that it will not begin receiving spent nuclear fuel from any domestic nuclear utility until 2010 at the earliest. TVA, like other nuclear utilities, stores spent nuclear fuel in pools of borated water at its nuclear sites. Although TVA would have had sufficient space to continue to store spent nuclear fuel in those storage pools at its Sequoyah and Browns Ferry Nuclear Plants indefinitely had DOE begun accepting spent nuclear fuel, DOE’s failure to do so required TVA to construct dry cask storage facilities at its Browns Ferry and Sequoyah Nuclear Plants and to purchase special storage containers for the spent nuclear fuel. (Watts Bar Nuclear Plant currently has sufficient storage capacity in its spent fuel pool to last until approximately 2018.) The Browns Ferry and Sequoyah dry cask storage facilities have been constructed and approved by the NRC and are now in use. To recover the cost of providing long-term, on-site storage for spent nuclear fuel, TVA filed a breach of contract suit against the United States in the Court of Federal Claims in 2001. In August 2006, the United States paid TVA the damages awarded by the Court of Federal Claims. The damages, amounting to almost $35 million, partially offset the construction costs of the dry cask storage facilities that TVA incurred through 2004. The cumulative cost of the capitalized storage facilities totaled approximately $61 million as of September 30, 2006, and is included in Property, plant, and equipment on the Balance Sheets. TVA plans to bring additional claims against DOE to recover costs that TVA has incurred after 2004.

Low-Level Radioactive Waste

     Low-level radioactive waste (“radwaste”) results from the normal operation of nuclear units and includes such materials as disposable protective clothing, mops, and filters. TVA has contracted to dispose of radwaste at a Barnwell, South Carolina, disposal facility through June 2008. After June 2008, TVA will no longer be able to use this

disposal facility and will have to consider other options, which may include storing the radwaste at its own facilities as it has done in the past.

Nuclear Decommissioning Trust

     TVA maintains a nuclear decommissioning trust to provide money for the ultimate decommissioning of its nuclear power plants. The trust is invested in securities generally designed to achieve a return in line with overall equity market performance. The assets of the trust as of September 30, 2006, totaled $937 million, which is greater than the present value of TVA’s estimated future nuclear decommissioning costs as computed under the NRC funding requirements. See Note 13 — Contingencies — Decommissioning Costs.

Nuclear Insurance

     The Price-Anderson Act provides a layered framework of protection to compensate for losses arising from a nuclear event. For the first layer, all NRC nuclear plant licensees, including TVA, purchase $300 million of nuclear liability insurance from American Nuclear Insurers (“ANI”) for each plant with an operating license. The second layer, the Secondary Financial Program (“SFP”), would come from an assessment of up to $101 million from the licensees of each of the 104 NRC licensed reactors in the United States. The assessment for any nuclear accident would be limited to $15 million per year per reactor. ANI, under a contract with the NRC, administers the SFP. With its six licensed units, TVA could be required to pay a maximum of $604 million per nuclear incident, but it would have to pay no more than $90 million per incident in any one year. When the contributions of the nuclear plant licensees are added to the insurance proceeds of $300 million, over $10.7 billion would be available. Under the Price-Anderson Act, if the first two layers are exhausted, Congress is required to take action to provide additional funds to cover the additional losses.

     TVA carries property, decommissioning, and decontamination insurance of $4.2 billion for its licensed nuclear plants, with up to $2.1 billion available for a loss at any one site, to cover the cost of stabilizing or shutting down a reactor after an accident. Some of this insurance may require the payment of retrospective premiums up to a maximum of approximately $64 million.

     TVA purchases accidental outage (business interruption) insurance for TVA’s nuclear sites from Nuclear Electric Insurance Limited (“NEIL”). In the event that an accident covered by this policy takes a nuclear unit offline or keeps a nuclear unit offline, NEIL will pay TVA, after a deductible waiting period, an indemnity (a set dollar amount per week) up to a maximum indemnity of $490 million per unit. This insurance policy may require the payment of retrospective premiums up to a maximum of approximately $23 million. See Note 13 — Contingencies — Nuclear Insurance.

Tritium-Related Services

     TVA helps produce tritium at certain nuclear facilities under a contract with DOE. See Note 13 — Commitments — Tritium-Related Services.

Fuel Supply

General

     TVA’s consumption of various types of fuel depends on several factors, the most important of which are the demand for electricity by TVA’s customers, the availability of various generating units, and the availability and cost of fuel. The following table indicates TVA’s costs for various fuels for the years indicated:

Fuel cost
(in millions of dollars)

		2006				2005				2004				2003				2002
Coal		$	1,835			$	1,495			$	1,254			$	1,242			$	1,233
Natural Gas			60				63				22				42				50
Fuel Oil			46				28				17				40				14
Uranium			71				44				16				42				38
Total		$	2,012			$	1,630			$	1,309			$	1,366			$	1,335

     The following table indicates TVA’s average fuel costs in cents per kilowatt-hours for the years indicated:

Fuel Cost Per kWh
(cents/kWh)

		2006				2005				2004				2003				2002
Coal			2.02				1.65				1.48				1.43				1.39
Natural gas and fuel oil			10.65				11.44				9.01				7.61				4.65
Nuclear			0.38				0.39				0.39				0.39				0.41
Aggregate fuel cost per kWh net thermal generation			1.54				1.30				1.14				1.14				1.11

     Beginning with the implementation of the fuel cost adjustment mechanism on October 1, 2006, TVA’s rates will be adjusted on a quarterly basis to reflect changing fuel and purchased power costs. See Item 1, Business — Rate Actions.

Coal

     Coal consumption at TVA’s coal-fired generating facilities during 2006 was 46.4 million tons. As of September 30, 2006, and 2005, TVA had 20 days and 16 days of system-wide coal supply at full burn, respectively, with a net book value of coal inventory of $214 million and $149 million, respectively.

     During 2006, TVA had in place coal contracts with terms of more than one year, which supplied 83 percent of TVA’s total coal requirements for 2006. These contracts have expiration dates ranging from October 1, 2006, to September 30, 2017, and TVA plans to continue signing contracts of various lengths, terms, and quality to meet its expected burn requirements. The remaining 17 percent of coal purchased during 2006 was purchased in the spot coal market under contracts with terms of one year or less. During 2006, TVA’s coal supply was acquired as follows:

	•		37 percent from the Illinois Basin;
	•		25 percent from the Powder River Basin in Wyoming;
	•		19 percent from the Uinta Basin of Utah and Colorado; and
	•		19 percent from the Appalachian Basin of Kentucky, Pennsylvania, Tennessee, Virginia, and West Virginia.

     During 2006, TVA purchased additional Appalachian Basin and Illinois Basin coals to replace shortages in deliveries from the Powder River Basin and Uinta Basin. By early summer 2006, coal inventories were at or above normal levels. During 2006, 40 percent of TVA’s coal supply was delivered by rail, 21 percent was delivered by barge, and 34 percent was delivered by a combination of barge and rail. The remainder was delivered by truck.

Natural Gas and Fuel Oil

     During 2006, TVA purchased substantially all of its natural gas requirements from a variety of suppliers under contracts with terms of one year or less. TVA purchases substantially all of its natural gas to operate combustion turbine peaking units and to supply fuel under power purchase agreements in which TVA is the fuel supplier. At September 30, 2006, all of TVA’s combustion turbines were dual fuel capable, and TVA has fuel oil stored on each site as a backup to natural gas. During 2006, TVA purchased substantially all of its fuel oil on the spot market. At September 30, 2006, and 2005, the net book value of TVA’s natural gas in inventory was $2 million and $0.4 million, respectively, and the net book value of TVA’s fuel oil in inventory was $54 million and $35 million, respectively.

Nuclear Fuel

     Converting uranium to nuclear fuel generally involves four stages: the mining and milling of uranium ore to produce uranium concentrates; the conversion of uranium concentrates to uranium hexafluoride gas; enrichment of uranium hexafluoride; and the fabrication of the enriched uranium hexafluoride into usable fuel assemblies. TVA currently has 100 percent of its forward five-year (2007 through 2011) uranium requirements either in inventory or under contract for its boiling water reactor units at Browns Ferry Nuclear Plant and has 100 percent of its forward five-year (2007 through 2011) uranium requirements under contract for its pressurized water reactor units at Sequoyah and Watts Bar Nuclear Plants. In addition, TVA has 100 percent of its conversion, enrichment, and fabrication needs under contract through 2011. TVA plans to meet future uranium requirements through a combination of term and spot purchase contracts.

     TVA, DOE, and nuclear fuel contractors have entered into agreements providing for surplus DOE uranium that exceeds enrichment levels that can be used in a nuclear power plant to be blended with other uranium down to a level that allows the blended uranium to be fabricated into fuel that can be used in a nuclear plant. This fuel was successfully loaded in Browns Ferry Unit 3 in April 2006 and will provide approximately 11 to 12 more reloads for the Browns Ferry reactors. Under the terms of the interagency agreement, DOE supplies off-specification, highly enriched uranium materials to the appropriate third party fuel processors, either by themselves or through subcontractors, for processing into usable fuel for TVA. In exchange, DOE will participate to a degree in the savings generated by TVA’s use of this blended nuclear fuel product. Over the life of the program, TVA projects that DOE’s share of savings generated by TVA’s use of this blended nuclear fuel could result in future payments to DOE of as much as $272 million under the interagency agreement. TVA anticipates these future payments could begin in 2009. See Note 1 — Blended Low Enriched Uranium Program, for a more detailed discussion of the blended low enriched uranium project.

     TVA owns all nuclear fuel held for its nuclear plants. As of September 30, 2006, and 2005, the net book value of this nuclear fuel was $491 million and $340 million, respectively.

     For a discussion of TVA’s plans with respect to spent nuclear fuel storage, see Item 1, Business — Nuclear — Spent Nuclear Fuel.

Transmission Operations

     The TVA transmission system is one of the largest in North America having delivered nearly 172 billion kilowatt-hours of electricity in 2006 and having maintained 99.999 percent reliability over the last seven years in delivering electricity to customers. This system is comprised of:

	•		Approximately 17,000 circuit miles of transmission lines, including 2,400 miles of extra-high-voltage (500,000 volt) transmission lines;
	•		537 substations, power switchyards, and switching stations;
	•		1,045 individual interchange and customer connection points; and
	•		260,000 right-of-way acres.

     The TVA transmission organization offers transmission services, similar to those offered by other transmission operators, in accordance with standards of conduct that separate its transmission functions from TVA’s marketing functions.

     Also, TVA is cooperating with other transmission systems to improve regional coordination in the operation of the bulk transmission system. The initial step of this coordination effort was to establish a joint transmission reliability area with other public power systems. In 2002, TVA entered into reliability coordination agreements with Associated Electric Cooperative Inc., Big Rivers Electric Corporation, and East Kentucky Power Cooperative, Inc. In 2004, Electric Energy, Inc. joined this effort, and in 2006, TVA began providing reliability coordination services for Kentucky Utilities Company and Louisville Gas and Electric Company.

     TVA has been designated by the North American Electric Reliability Council (“NERC”) to serve as the reliability coordinator for parts of 11 states covering 199,000 square miles with a population of nearly 11 million people. As the reliability coordinator for this region, TVA is responsible for monitoring and helping to ensure the reliable operation of the bulk transmission system in a region that includes portions of Alabama, Georgia, Illinois, Iowa, Kentucky, Mississippi, Missouri, North Carolina, Oklahoma, Tennessee, and Virginia. TVA is one of 17 reliability coordination offices in NERC.

     TVA has a joint reliability coordination agreement with the Midwest Independent Transmission System Operator and PJM Interconnection, LLC to improve the reliability of the regional grid. This effort includes a coordinated approach to transmission capacity availability, system outage approval, congestion management, and transmission planning. Similar agreements to develop analysis and operational processes in support of regional transmission reliability have been executed with Entergy Services, Inc., Southwest Power Pool, Inc., and VACAR South RC (a Virginia Carolina reliability group). An agreement is pending with Southern Company Services, Inc.

Reliability Coordinator Map

Stewardship Activities

     TVA is responsible for managing the Tennessee River and its tributaries – the United States’ fifth largest river system – to provide, among other things, year-round navigation, flood damage reduction, affordable and reliable electricity, and, consistent with these primary purposes, recreational opportunities, adequate water supply, improved water quality, and economic development. TVA owns and operates 49 dams, which comprise its integrated reservoir system. Twenty-nine of these dams produce conventional hydroelectric power, and one additional project is solely a pumped storage hydroelectric project. The reservoir system provides 800 miles of commercially navigable waterway, and also provides significant flood reduction benefits both within the Tennessee River system and downstream on the lower Ohio and Mississippi Rivers. The reservoir system also provides a water supply for residential and industrial customers, including cooling water for some of TVA’s fossil fuel and nuclear power plants.

     TVA reservoirs and public lands provide outdoor recreation opportunities for millions of visitors each year. TVA has stewardship responsibility for 293,000 acres of reservoir land, 11,000 miles of shoreline, and 650,000 acres of reservoir water surface available for recreation and other purposes. TVA owns over 100 recreation facilities such as campgrounds, boat ramps, fishing piers, and picnic areas.

Seasonality

     Weather affects both the demand for and the market prices of electricity. TVA’s power system peaks in both the summer and the winter, so TVA typically sells more electricity during the summer and the winter than in the spring and the fall. See Item 1A, Risk Factors, for a discussion of the potential impact of weather on TVA.

     TVA uses weather degree days to measure the impact of weather on TVA’s power operations. TVA calculates weather degree days for each of the five largest cities in TVA’s service area. If the average temperature

for a given day in one of these cities exceeds 65 degrees Fahrenheit, that city will have cooling degree days for that day equal to the amount by which the average temperature for that day exceeds 65 degrees Fahrenheit. Similarly, if the average temperature for a given day in one of these cities is lower than 65 degrees Fahrenheit, that city will have heating degree days for that day equal to the amount by which 65 degrees Fahrenheit exceeds the average temperature for that day.

     During 2006, TVA had 162 more heating degree days and 32 more cooling degree days than in 2005. The graph below shows the number of heating and cooling degree days for 2006, 2005, and 2004 as compared to the normal number of heating and cooling degree days.

Heating and Cooling Degree Days

Competition

     TVA sells electricity in a service area that is largely free of competition from other electric power providers. This service area is defined primarily by two provisions of law: one called the “fence” and one called the “anti-cherrypicking” provision. The fence limits the region in which TVA or distributors of TVA power may provide power. The anti-cherrypicking provision limits the ability of others to provide power within the service area because they are not entitled to use the TVA transmission system for the purpose of delivering power to customers within the service area. Bristol, Virginia, was exempted from the anti-cherrypicking provision.

     Of the six distributors that had notices terminating their power contracts still in effect at September 30, 2006, five are in Kentucky. See Item 1, Business — Customers — Termination Notices. Power rates in Kentucky are among the lowest in the nation. Warren Rural Electric Cooperative Corporation (“Warren”) and East Kentucky Power Cooperative (“East Kentucky”) have entered into an arrangement under which Warren will become a member of East Kentucky, and East Kentucky will supply Warren after its power contract with TVA expires in 2009. After agreeing to become Warren’s power supplier, East Kentucky asked TVA to provide transmission service to East Kentucky for its service to Warren. TVA denied the request on the basis that, under the anti-cherrypicking provision, it was not required to do so. East Kentucky then asked to interconnect its transmission system with the TVA transmission system in three places that are currently delivery points through which TVA supplies power to Warren. TVA did not agree to provide the interconnections, and East Kentucky asked the Federal Energy Regulatory Commission (“FERC”) to order TVA to provide the interconnections. In January 2006, FERC issued a final order directing TVA to interconnect its transmission facilities with East Kentucky’s system at three locations on the TVA transmission system. TVA believes this order is contrary to the anti-cherrypicking provision, and, on August 11, 2006, TVA filed an appeal in the U.S. Court of Appeals for the District of Columbia Circuit seeking review of this order. See Note 16 — Customers.

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

were to become law, FERC could require TVA to provide wheeling from other power suppliers to wholesale customers inside that portion of TVA’s service area that is within Kentucky. The bill was referred to and remains in the Senate Energy and Natural Resources Committee.

     In 2000, restructuring legislation for competition in the electric power industry appeared imminent. In response, TVA, the Tennessee Valley Public Power Association (“TVPPA”), an association representing distributors of TVA power, and the Tennessee Valley Industrial Committee (“TVIC’’), an organization representing industries that TVA directly serves, reached consensus on draft legislation addressing the relationships between TVA and its customers in a restructured electric power industry. The draft legislation, as revised by TVA, TVPPA, and TVIC in 2003, provides for:

	•		Simultaneous repeal, on the effective date of the restructuring legislation, of the fence and the anti-cherrypicking provision,
	•		A distributor customer option to gradually take up to a maximum of 30 percent of its power requirements from other suppliers with advance notice to TVA,
	•		New limitations on TVA retail sales in TVA’s current service area,
	•		Stranded cost recovery through 2007,
	•		FERC regulation to ensure that TVA charges others transmission service rates and imposes on others terms and conditions of service comparable to those TVA charges and imposes on itself,
	•		TVA to be subject to antitrust laws (with the exception of monetary damages and attorney’s fees),
	•		At individual distributor customer election, a reduction in TVA’s existing regulation of distributor customers, and
	•		New TVA generation to be limited to that needed to meet demand within the current TVA service area.

     While earlier versions of this legislation were introduced in Congress, the 2003 version has never been introduced and is not part of any pending or anticipated bill.

Regulation

Congress

     TVA exists pursuant to legislation enacted by Congress and carries on its operations in accordance with this legislation. Congress has the authority to change this legislation and thereby expand or reduce TVA’s activities or significantly change TVA’s structure. To allow TVA to operate more flexibly than a traditional government agency, Congress exempted TVA from some general federal laws that govern other agencies, such as laws related to the hiring of employees, the procurement of supplies and services, and the acquisition of land. Other federal laws enacted since the creation of TVA have been made applicable to TVA including those related to the protection of the environment and cultural resources and civil rights laws.

Securities and Exchange Commission

     As part of the Consolidated Appropriations Act, 2005, Congress added Section 37 to the Securities Exchange Act of 1934, as amended (the “Exchange Act”). This section requires TVA to file with the Securities and Exchange Commission beginning with this Annual Report such periodic, current, and supplementary information, documents, and reports as would be required pursuant to Section 13 of the Exchange Act if TVA were an issuer of a security registered pursuant to Section 12 of the Exchange Act.

Federal Energy Regulatory Commission

     Although TVA is not a “public utility” as defined in the Federal Power Act (“FPA”) and is thus not subject to the full jurisdiction of the FERC under the FPA, FERC regulation does affect some of TVA’s activities, including transmission, interconnection, and, potentially, a limited type of power transaction that TVA does not now use.

Nuclear Regulatory Commission

     TVA operates its nuclear facilities in a highly regulated environment and is overseen by the NRC, an independent agency which sets the rules that users of radioactive materials must follow. The NRC has broad authority to impose requirements relating to the licensing, operation, and decommissioning of nuclear generating facilities.

Environmental Protection Agency

     TVA is subject to regulation by the Environmental Protection Agency (“EPA”) in a variety of areas, including air quality control, water quality control, and management and disposal of hazardous wastes. See Item 1, Business — Environmental Matters.

States

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

Governmental Entities

     TVA’s activities and records are also subject to review by various entities including TVA’s Office of Inspector General and the following agencies: the Government Accountability Office, the Congressional Budget Office, and the Office of Management and Budget.

Payments in Lieu of Taxes

     TVA is not subject to federal income taxes, and neither TVA nor its property, franchises, or income are subject to taxation by states or their subdivisions. However, the TVA Act requires TVA to make payments in lieu of taxes to states and counties in which TVA conducts power operations and in which TVA has acquired properties previously subject to state and local taxation. The amount of these payments is five percent of gross revenues from the sale of power during the preceding year excluding sales or deliveries to other federal agencies and exchange sales with other utilities, with a provision for minimum payments under certain circumstances.

TVA In Lieu of Tax Payments by State
(in millions)

		2006				2005				2004
Alabama		$	93			$	89			$	81
Georgia			6				6				5
Illinois			<1				<1				<1
Kentucky			33				30				27
Mississippi			20				20				19
North Carolina			2				2				2
Tennessee			221				218				203
Virginia			<1				<1				<1
		$	376			$	365			$	338

Environmental Matters

     As is the case across the utility industry and in other industrial sectors, TVA’s activities are subject to certain federal, state, and local environmental statutes and regulations. Major areas of regulation affecting TVA’s activities include air quality control, water quality control, and management and disposal of solid and hazardous wastes.

     TVA has incurred and continues to incur substantial capital and operating and maintenance costs in order to comply with evolving environmental requirements. Many of these costs are associated with the operation of TVA’s 59 coal-fired generating units. While it is not possible to predict with any precision how these evolving requirements will impact the operation of existing and new coal-fired and other fossil-fuel generating units, it is virtually certain that environmental requirements placed on the operation of these generating units will continue to become more restrictive. Litigation over emissions from coal-fired generating units is also occurring, including litigation against TVA. See Item 3, Legal Proceedings.

     Several existing regulatory programs have been and are being made more stringent in their application to fossil-fuel units, and additional regulatory programs affecting fossil-fuel units were promulgated in 2005, including the Clean Air Interstate Rule (“CAIR”), which requires significant utility reductions of emissions of sulfur dioxide (“SO₂”) and nitrogen oxides (“NO_x”) in the eastern half of the United States (including in all of TVA’s operating area), and the

Clean Air Mercury Rule (“CAMR”). TVA had previously estimated its total capital cost for reducing emissions from its power plants from 1977 through 2010 to reach $5.8 billion, $4.6 billion of which had already been spent as of September 30, 2006. TVA estimates that compliance with CAIR and CAMR could lead to additional costs of $3.0 billion to $3.5 billion in the next decade if TVA should continue to operate all of its present coal plants. As discussed in more detail below, there could be additional material costs if reductions of carbon dioxide (“CO₂”) are mandated, or if future legislative, regulatory, or judicial actions lead to more stringent emission reduction requirements, but these costs cannot reasonably be predicted at this time. TVA will continue to monitor those developments and will assess any potential financial impacts as information becomes available.

Clean Air Developments

     Air quality in the United States has significantly improved since the enactment of the modern Clean Air Act (“CAA”) in 1970. These air quality improvements are expected to continue as the CAA continues to be implemented and through the evolution of programs as a result of legislative and regulatory changes. Three substances emitted from coal-fired units have been the focus of emission reduction regulatory programs: SO₂, NO_x, and particulates. Expenditures related to clean air projects during 2006 and 2005 were approximately $182 million and $202 million, respectively. These figures include expenditures in 2006 of $6 million to continue to reduce NO_x emissions through the installation of selective catalytic reduction (“SCR”) systems, and of $146 million for the installation of flue gas desulphurization systems (“scrubbers”) to continue to reduce SO₂ emissions, each of which are explained in more detail below. The aforementioned estimates do not include additional capital costs of $3.0 billion to $3.5 billion that TVA expects to incur over the next decade to comply with CAIR and CAMR. Increasingly stringent regulation of some or all of these substances, and possibly carbon dioxide, will continue to result in significant capital and operating costs for coal-fired generating units, including those operated by TVA.

Sulfur Dioxide

     Coal-fired utilities have historically emitted large amounts of SO₂. Utility SO₂ emissions are currently regulated under the Federal Acid Rain Program and state programs designed to meet the National Ambient Air Quality Standards for SO₂ and fine particulate matter. Looking forward, additional regulation of SO₂ emissions from some units will result from implementation of the Regional Haze Program and for more units as a result of the CAIR. In May 2005, EPA finalized CAIR to reduce the interstate transport of fine particulate matter and ozone by requiring large reductions in utility emissions of NO_X and SO₂ from 28 eastern states. CAIR is currently in effect in all of these states as a federal rule. States in TVA’s service area are submitting plans to EPA to implement CAIR as state rules and have only proposed a few minor modifications to the federal model rule which establishes an emission allowance driven program, capping regional emissions of SO₂ and NO_x among the targeted states. SO₂ caps are reduced in two phases, 2010 and 2015.

     Since 1977, TVA has reduced its SO₂ emissions by approximately 80 percent by switching to lower-sulfur coals, re-powering a unit at its Shawnee Fossil Plant with the advanced Atmospheric Fluidized Bed Combustion (“AFBC”) technology, and installing scrubbers on six of its larger units. A seventh scrubber at unit 3 of the Paradise Fossil Plant has been constructed and is going through shakedown testing prior to being placed in operation. TVA broke ground in 2005 on its eighth scrubber at its Bull Run Fossil Plant and in 2006 broke ground on two more scrubbers at its Kingston Fossil Plant as part of its previously announced plans to achieve a total SO₂ emission reduction of 80 to 85 percent compared to the 1977 level. Additionally, TVA has switched, or plans to switch, to lower sulfur coal on several additional units in the next few years. These near-term plans are unlikely to change. It is likely that additional emission reduction measures will have to be undertaken after these planned actions are completed to achieve compliance with CAIR and possible future tightening of applicable requirements.

Nitrogen Oxides

     Utility NO_x emissions are extensively regulated and will be regulated further under state programs to achieve and maintain EPA’s national ambient air quality standard for ozone, the acid rain control program, the regional haze program (depending on when units commenced operations and their effects on sensitive areas), and CAIR, as discussed above. Since 1995, TVA has reduced its NO_x emissions during the summer (when ozone levels increase) by 81 percent by installing various controls including low-NO_x burners and/or combustion controls on 58 of its coal fired units. (The AFBC unit at Shawnee is inherently low NO_x emitting.) TVA has also installed SCR’s on 21 of its largest units. In 2005, TVA installed Selective Non-Catalytic Reduction (“SNCR”) systems on two units to demonstrate long term technology capability. TVA has continued operating these two new SNCR installations through the 2006 ozone season. SNCRs generally cost less to install than SCRs but have lower NO_x removal capabilities. Early in 2006, TVA began testing a High Energy Reagent Technology (“HERT”) on three units for potential future application. HERT is similar to SNCR, has lower capital costs than SCRs, and appears to have lower NO_x removal capabilities than SCRs but higher removal capabilities than SNCRs. The initial HERT testing program

was successful. As a result, in 2007, TVA will install this technology on two coal-fired units that were previously targeted for SNCR installations to demonstrate the HERT technology on a potentially permanent basis. TVA’s NO_x emission reduction program is expected to continue to depend primarily on SCRs, but will also likely incorporate some mix of SNCRs and/or HERTs as TVA gains more experience with these technologies. These plans may change depending on the timing and severity of future regulatory developments potentially affecting power plant emissions. For example, EPA is currently reviewing the existing national ambient air quality standard for ozone and may make it more stringent.

     In 2004, EPA issued final non-attainment designations under the current eight-hour ozone standard. Several counties within the TVA region were designated as not in attainment with that standard. Some of these counties have entered into “Early Action Compacts” with EPA and have taken steps such as instituting vehicle emissions testing, lowering speed limits, and other activities to help reduce summer ozone levels. In exchange, these counties are exempted from some of the negative consequences of a “non-attainment” designation. The TVA NO_x emission reductions described above have been a contributor to improving summer ozone levels in those areas, especially in Tennessee. Current monitoring indicates that all counties are making progress toward meeting the lower standard and achieving an attainment designation. The NO_x reduction requirements of CAIR will continue to help states achieve EPA’s ozone and fine particle standards. CAIR caps and reduces NO_x emissions in two steps, 2009 and 2015.

Particulates/Opacity

     Coarse particulates (particulates of 10 micrometers or larger and especially fly ash) have long been regulated by states to meet EPA’s national ambient air quality standard for particulate matter. TVA’s coal-fired units have been equipped with mechanical collectors, electrostatic precipitators, scrubbers, or baghouses, which have reduced particulate emissions from the TVA system by more than 99 percent compared to uncontrolled units. In 1997, the EPA for the first time issued separate national ambient air quality standards for even smaller particles with a size of up to 2.5 micrometers (“fine particles”). In December 2004 and April 2005, EPA issued final determinations regarding which areas of the country are not in attainment with the 1997 fine particles standard. Those non-attainment areas include counties and parts of counties in the Knoxville and Chattanooga, Tennessee metropolitan areas. In September 2006, EPA revised the 1997 standards. The 2006 revisions tighten the 24-hour fine particle standard and retain the current annual fine particle standard. EPA also decided to retain the existing 24-hour standard for coarse particles, but revoked the related annual standard. A preliminary review of the current monitoring data indicates that no additional counties likely will be classified as non-attainment areas under the revised 2006 standards, although actual designations will be based on subsequent year’s monitoring data. CAIR is intended to help states attain the fine particle standards, and actions taken to reduce emissions under CAIR, including those planned by TVA, are expected to continue the reduction in fine particle levels.

     Issues regarding utility compliance with state opacity requirements are also increasing. Opacity measures the denseness (or color) of power plant plumes and has traditionally been used by states as a means of monitoring good maintenance and operation of particulate control equipment. Under some conditions, retrofitting a unit with additional equipment to better control SO₂ and NO_x emissions can adversely affect opacity performance, and TVA and other utilities are now addressing this issue. There are also disputes with special interest groups over the role of continuous opacity monitors in determining compliance with opacity limitations.

Mercury

     In December 2000, the EPA determined that it was appropriate and necessary to regulate mercury emissions from oil and coal-fired power plants as a hazardous air pollutant under the CAA. In March 2005, it reversed that earlier decision, and instead issued CAMR. CAMR establishes caps for overall mercury emissions in two phases, with the first phase becoming effective in 2010 and the second in 2018. It allows the states to regulate mercury emissions through a market-based cap-and-trade program. All of the states in which TVA operates potentially affected sources are expected to adopt CAMR without significant change. In response to a request for reconsideration, EPA confirmed its approach in May 2006. In June 2006, 16 states and several environmental groups filed law suits challenging CAMR. This lawsuit is currently pending. TVA cannot predict the outcome of the pending challenge of CAMR, or what effects any decision may have that would require the EPA to regulate mercury as a hazardous air pollutant. If the EPA’s decisions are upheld and CAMR is implemented, TVA expects to achieve the required mercury reductions at least for Phase I of CAMR as co-benefits of the installation of additional emission control technology in connection with the implementation of CAIR.

     CAMR does, however, require the installation of new mercury emission monitoring equipment prior to January 1, 2009. TVA is planning to comply with this requirement by procuring, installing, and certifying approximately 23 monitoring systems by calendar year 2008.

Carbon Dioxide

     The causes and importance of climate change observed over recent decades continue to be widely debated. CO₂ is a greenhouse gas and is believed by some to contribute to global warming. Legislation has been introduced in Congress to require reductions of CO₂ and, if enacted, could result in significant additional costs for TVA and other coal-fired utilities. The current Administration has proposed a voluntary initiative that established a goal of reducing the greenhouse gas intensity of the U.S. economy by 18 percent and has asked the electric utility sector and other industry sectors to support this initiative. TVA is supporting this effort in cooperation with electric utility industry trade associations and the Department of Energy. In addition to these activities, TVA is a member of the Southeast Regional Carbon Sequestration Partnership and is working with the Electric Power Research Institute and other electric utilities on projects investigating technologies for CO₂ capture and geologic storage, as well as carbon sequestration via reforestation. The previous Administration also asked utilities to voluntarily participate in an effort to reduce, sequester, or avoid greenhouse gases. Under that program, TVA reduced, sequestered, or avoided more than 305 million tons of CO₂ from 1994 through 2005, as reported under Section 1605b of the Energy Policy Act. TVA’s clean air strategy, as it relates to investments on coal-fired generating facilities, allows for continued review of decisions for clean air and other capital investments as potential climate change legislation is developed.

     In addition to legislative activity, climate change issues are the subject of several lawsuits including lawsuits against TVA. See Item 3, Legal Proceedings. On November 29, 2006, the United States Supreme Court heard a case concerning whether EPA has the authority and duty to regulate CO₂ emissions under the Clean Air Act. The District of Columbia Circuit Court of Appeals earlier affirmed EPA’s decision not to regulate CO₂. While the case focuses on CO₂ emissions from the transportation industry, it could set a precedent for regulation in other industrial sectors depending upon how the Supreme Court rules. States are also becoming more active on the climate change front. Several northeastern states have formed the Regional Greenhouse Gas Initiative which is in the process of being implemented, and California recently passed a bill capping greenhouse gas emissions in the state. Other states are considering a variety of actions. However, in the southeast, to TVA’s knowledge, only North Carolina, where TVA does not operate any coal-fired generating facilities, is studying initiatives aimed at climate change under the provisions of the state’s Clean Smokestacks Act of 2002. This act required the State Division of Air Quality to study potential control of CO₂ emissions from coal-fired utility plants and other stationary sources. This effort has also prompted actions to develop a climate action plan for North Carolina.

Clean Water Developments

     In the second phase of a three-part rulemaking to minimize the adverse impacts from cooling water intake structures on fish and shellfish, as required under Section 316(b) of the Clean Water Act, EPA promulgated a final rule for existing power producing facilities that became effective on September 7, 2004. The new rule requires existing facilities to select among several different compliance options for reducing the number of organisms pinned against and/or drawn into the cooling systems. These include development of a site-specific compliance option based on application of cost/cost or cost/benefit tests. The site specific tests are designed to ensure that a facility’s costs are not significantly greater than cost projections in the rule or the benefits derived from taking mitigation actions. Actions taken to compensate for any impacts by restoring habitat, or pursuing other options such as building hatcheries for fish/shellfish production, count toward compliance. Some northeastern states and environmental groups have challenged the new regulation, especially the compliance flexibility it offers, in federal court.

     All of the intakes at TVA’s existing coal-fired and nuclear generating facilities are subject to this rule. Compliance assessments are underway for these facilities to determine what should be done to meet the new requirements. Some capital and/or operating expenditures may have to be made to comply at some or all facilities. The assessments, however, are complicated by the uncertainty created by pending legal action challenging EPA’s rule.

     As is the case across the utility industry and in other industrial sectors, TVA is facing more stringent requirements related to protection of wetlands, reductions in storm water impacts from construction activities, water quality degradation and criteria, and laboratory analytical methods. TVA is also following litigation related to the use of herbicides, water transfers, and releases from dams. TVA has a good compliance record and is not facing any substantive requirements related to non-compliance with existing Clean Water Act regulations.

Hazardous Substances

     Liability for releases and cleanup of hazardous substances is regulated by the federal Comprehensive Environmental Response, Compensation, and Liability Act, among others, and similar state statutes. In a manner similar to many other industries and power systems, TVA has generated or used hazardous substances over the years. TVA operations at some TVA-owned facilities have resulted in releases of hazardous substances and/or oil

which require cleanup and/or remediation. TVA also is aware of alleged hazardous-substance releases at 10 non-TVA areas for which it may have some liability. TVA has reached agreements with EPA to settle its liability at two of the non-TVA areas for a total of less than $0.1 million. There have been no recent assertions of TVA liability for six of the non-TVA areas, and (depending on the site) there is little or no known evidence that TVA contributed any significant quantity of hazardous substances to these six sites. There is evidence that TVA sent materials to the remaining two non-TVA areas. The information necessary to estimate the total cleanup costs, and most of the evidence that might be used to estimate TVA’s allocated share of such costs and evaluate the likely effectiveness of TVA’s potential defenses either have not been developed and/or are under the control of parties other than TVA. Consequently, TVA is unable at this time to estimate its liability related to these sites.

     As of September 30, 2006, TVA’s estimated liability for environmental cleanup for those sites for which sufficient information is available to develop a cost estimate (primarily the TVA sites) is approximately $23 million on a non-discounted basis and is included in Other Liabilities on the Balance Sheet.

Coal-Combustion Wastes

     Coal combustion waste disposed in landfills and surface impoundments continues to be regulated as non-hazardous. As part of this 2000 regulatory determination, EPA committed to developing stricter standards for the management of coal-combustion wastes. EPA has also been petitioned to develop stringent regulations relative to the disposal of coal combustion waste. EPA now is developing national solid waste management standards to address coal-combustion wastes disposed in unlined landfills and surface impoundments or placed in mines. These standards are likely to include increased groundwater monitoring, more stringent siting requirements, and closure of existing waste-management facilities not meeting minimum standards. EPA is expected to issue these new management standards sometime in 2007 according to its published Regulatory Agenda. TVA is monitoring these developments and will evaluate the potential impact of these rules upon its operations as more information becomes available.

Employee Relations

     On September 30, 2006, TVA had approximately 12,600 employees, of whom approximately 5,285 were trades and labor employees. Neither the federal labor relations laws covering most private sector employers nor those covering most federal agencies apply to TVA. However, the TVA Board has a long-standing policy of acknowledging and dealing with recognized representatives of its employees, and that policy is reflected in long-term agreements to recognize the unions (or their successors) that represent TVA employees. Federal law prohibits TVA employees from engaging in strikes against TVA.

ITEM 1A. RISK FACTORS

     The risk factors described below, as well as the other information included in this Annual Report, should be carefully considered. Risks and uncertainties described in these risk factors could cause future results to differ materially from historical results as well as from the results predicted in forward-looking statements. Although the risk factors described below are the ones that TVA management considers significant, additional risk factors that are not presently known to TVA management or that TVA management presently considers insignificant may also impair TVA’s business operations. Although TVA has the authority to set its own rates and thus mitigate some risks by increasing rates, it is possible that partially or completely eliminating one or more of these risks through rate increases might adversely affect TVA commercially or politically. Accordingly, the occurrence of any of the following could have a material adverse effect on TVA’s cash flows, results of operations, and financial condition.

     For ease of reference, the risk factors are presented in three categories: strategic risks, operating risks, and financial risks.

Strategic Risks

New laws and regulations may negatively affect TVA’s cash flows, results of operations, and financial condition as well as the way TVA conducts its business.

Although it is difficult to predict exactly how any new laws and regulations would impact TVA, some of the possible effects are described below.

•

TVA could lose its protected service territory.

			TVA’s service area is primarily defined by two provisions of law.

	–		The TVA Act provides that, subject to certain minor exceptions, neither TVA nor its distributor customers may be a source of power supply outside of TVA’s defined service area. This provision is often called the “fence” since it limits TVA’s sales activities to a specified service area.
	–		The Federal Power Act prevents FERC from ordering TVA to provide access to its transmission lines for the purpose of delivering power to customers within TVA’s defined service area. This provision is often called the “anti-cherrypicking provision” since it prevents competitors from “cherrypicking” TVA’s customers.

If Congress were to eliminate or reduce the coverage of the anti-cherrypicking provision, TVA could lose a significant number of its customers, and the loss of these customers could adversely affect TVA’s cash flows, results of operations, and financial condition.

•

The TVA Board could lose its sole authority to set rates for electricity.

Under the TVA Act, the TVA Board has the sole authority to set the rates that TVA charges for electricity, and these rates are not subject to review. The loss of this authority could have materially adverse effects on TVA including, but not limited to, the following:

	–		TVA might be unable to set rates at a level sufficient to generate adequate revenues to service its financial obligations, properly operate and maintain its power assets, and provide for reinvestment in its power program; and
	–		TVA might be subject to additional regulatory oversight that could impede TVA’s ability to manage its business.
	•		TVA could become subject to increased environmental regulation.

There is a risk that new environmental laws and regulations could become applicable to TVA or its facilities and that existing environmental regulations could be revised or reinterpreted in a way that adversely affects TVA. Any such developments could require TVA to make significant capital expenditures, increase TVA’s operating and maintenance costs, or even lead to TVA’s closing certain facilities. For example, proposals in Congress that would regulate carbon dioxide and other greenhouse gases could require TVA and other electric utilities to incur significant increased costs. See Item 1, Business — Environmental Matters.

•

TVA could become subject to increased regulation by the NRC.

The NRC has broad authority to impose requirements relating to the licensing, operation, and decommissioning of nuclear generation facilities. If the NRC modifies existing requirements or imposes new requirements, TVA could be required to make substantial capital expenditures at its nuclear plants or make substantial contributions to its nuclear decommissioning trust. In addition, if TVA fails to comply with requirements promulgated by the NRC, the NRC has the authority to impose fines, shut down units, or modify, suspend, or revoke TVA’s operating licenses.

•

TVA could lose responsibility for managing the Tennessee River system.

TVA’s management of the rivers is important to effective operation of the power system. TVA’s ability to integrate management of the Tennessee River system with power system operations increases power system reliability and reduces costs. Restrictions on how TVA manages the river system could negatively affect TVA’s operations.

•

Congress could take actions that lead to a downgrade of TVA’s credit rating.

TVA’s rated securities are currently rated “Aaa” by Moody’s Investors Service and “AAA” by Standard and Poor’s and Fitch Ratings, which are the highest ratings assigned by these rating agencies. TVA’s credit ratings are not based solely on its underlying business or financial condition, which by themselves may not be commensurate with a triple-A rating. TVA’s current ratings are based to a large extent on the body of legislation that defines TVA’s business structure. Key characteristics of TVA’s business defined by legislation include (1) the TVA Board’s ratemaking authority, (2) the current competitive environment, which is defined by the fence and the anti-cherrypicking provision, and (3) TVA’s status as a corporate agency and

instrumentality of the United States. Accordingly, if Congress takes any action that effectively alters any of these characteristics, TVA’s credit ratings could be downgraded.

•

TVA’s debt ceiling could become more restrictive.

The TVA Act provides that TVA can issue bonds, notes, and other evidences of indebtedness (“Bonds”) in an amount not to exceed $30 billion outstanding at any time. If Congress either lowers the debt ceiling or broadens the types of financial instruments that are covered by the debt ceiling, TVA might not be able to raise enough capital to, among other things, service its financial obligations, properly operate and maintain its power assets, and provide for reinvestment in its power program.

TVA may lose some of its customers.

As of September 30, 2006, six distributor customers had notices in effect terminating their power contracts with TVA. Although sales to these six distributor customers generated only 2.9 percent of TVA’s total operating revenues in 2006, the loss of additional customers could have a material adverse effect on TVA’s cash flows, results of operations, and financial condition. See Item 1, Business —Customers — Termination Notices.

Operational Risks

TVA’s generation and transmission assets may not operate as planned.

Many of TVA’s generation and transmission assets have been operating since the 1950s and have been in near constant service since they were completed. If these assets fail to operate as planned, TVA, among other things:

	•		Might have to invest a significant amount of resources to repair or replace the assets;
	•		Might be unable to operate the assets for a significant period of time;
	•		Might have to purchase replacement power on the open market;
	•		Might not be able to meet its contractual obligations to deliver power; and
	•		Might have to remediate collateral damage caused by a failure of the assets.

In addition, the failure of TVA’s assets to perform as planned could result in such events as the failure of a dam or a nuclear accident. Any of these potential outcomes could negatively affect TVA’s cash flows, results of operations, and financial condition.

TVA’s fuel supply might be disrupted.

TVA purchases coal, uranium, fuel oil, and natural gas from a number of suppliers. Disruption in the acquisition or delivery of fuel, such as the disruptions TVA experienced in 2006 in acquiring coal, may result from a variety of factors, including, but not limited to, weather, production or transportation difficulties, labor relations, or environmental regulations affecting TVA’s fuel suppliers. These disruptions could adversely affect TVA’s ability to operate its facilities and could require TVA to acquire power at higher prices on the spot market, thereby adversely affecting TVA’s cash flows, results of operations, and financial condition.

Compliance with existing environmental laws and regulations may affect TVA’s operations in unexpected ways.

TVA is subject to risks from existing federal, state, and local environmental laws and regulations including, but not limited to, the following:

	•		Compliance with existing environmental laws and regulations may cost TVA more than it anticipates.
	•		At some of TVA’s older facilities, it may be uneconomical for TVA to install the necessary equipment to comply with existing environmental laws, which may cause TVA to shut down those facilities.
	•		TVA may be responsible for on-site liabilities associated with the environmental condition of facilities that it has acquired or developed, regardless of when the liabilities arose and whether they are known or unknown.

•

TVA may be unable to obtain or maintain all required environmental regulatory approvals. If there is a delay in obtaining any required environmental regulatory approvals or if TVA fails to obtain, maintain, or comply with any such approval, TVA may be unable to operate its facilities or may have to pay fines or penalties.

See Item 1, Business — Environmental Matters.

TVA is the sole power provider for customers within its service area, and if demand for power in TVA’s service area increases, TVA is contractually obligated to take steps to meet this increased demand.

If demand for power in the TVA’s service area increases, TVA may need to meet this increased demand by purchasing power from other sources, building new generation facilities, or purchasing existing generation facilities. Purchasing power from external sources, as well as acquiring or building new generation facilities, could negatively affect TVA’s cash flows, results of operations, and financial condition.

TVA may incur delays and additional costs in power plant construction.

TVA is in the process of restarting Browns Ferry Unit 1 and may need to construct more generating facilities in the future. The completion of such facilities involves substantial risks of delays and cost overruns. If TVA is unable to complete the development or construction of a facility or decides to delay or cancel construction of a facility, TVA’s cash flows, financial condition, and results of operations could be negatively affected. In addition, if construction projects are not completed according to specifications, TVA may suffer reduced plant efficiency and higher operating costs. See Item 1, Business — Nuclear.

TVA is involved in various legal proceedings whose outcomes may affect TVA’s finances and operations.

TVA is involved in various legal proceedings and will become involved in other legal proceedings in the future in the ordinary course of business. Although TVA cannot predict the outcome of the individual matters in which TVA is involved or will become involved, the resolution of these matters could require TVA to make expenditures in excess of established reserves and in amounts that could have a material adverse effect on TVA’s cash flows, results of operations, and financial condition. Similarly, resolution could require TVA to change its business practices or procedures, which could also have a material adverse effect on TVA’s cash flows, results of operations, and financial condition. See Item 3, Legal Proceedings.

TVA’s ability to supply power and its customers’ demands for power are influenced by weather conditions.

Extreme peaks in either the summer or winter may increase the demand for power and require TVA to purchase power at high prices in order to meet the demand from customers, while unusually mild weather may result in decreased demand for power and lead to reduced electricity sales. In addition, weather conditions affect TVA’s ability to supply power to its customers, because in periods of low rainfall or drought, TVA’s low-cost hydroelectric generation may be reduced, requiring TVA to purchase power or use more costly means of producing power. Furthermore, high temperatures in the summer may limit TVA’s ability to use water from the Tennessee River system for cooling at its generating facilities, thereby limiting TVA’s ability to operate its generating facilities.

TVA’s transmission reliability could be affected by problems at other utilities or its own facilities.

TVA’s transmission facilities are directly interconnected with the transmission facilities of neighboring utilities and are thus part of an interstate power transmission grid. Accordingly, problems at other utilities, or at TVA’s own facilities, may cause interruptions in TVA’s transmission service. If TVA were to suffer a transmission service interruption, TVA’s cash flows, results of operations, and financial condition could be negatively affected.

An incident at any nuclear facility, even one unaffiliated with TVA, could result in increased expenses and oversight.

A nuclear incident at a TVA facility could have significant consequences including loss of life and damage to or loss of the facility. Any nuclear incident, even at a facility unaffiliated with TVA, has the potential to impact TVA adversely by obligating TVA to pay up to $90 million per year and a total of $604 million per nuclear incident under the Price Anderson Act. In addition, a nuclear incident could negatively affect TVA by, among other things, obligating TVA to pay retrospective premiums, reducing the availability of insurance, increasing the costs of operating nuclear units, or leading to increased regulation or restriction on the construction, operation, and decommissioning of nuclear facilities.

Catastrophic events could affect TVA’s ability to supply electricity or reduce demand for electricity.

TVA could be adversely affected by catastrophic events such as fires, earthquakes, floods, wars, terrorist activities, pandemics, and other similar events. These events, the frequency and severity of which are unpredictable, could directly impact TVA’s power operations and negatively affect TVA’s cash flows, results of operations, and financial condition. Additionally, such events could indirectly impact TVA by, among other things, disrupting supply lines or operations of a contractor or supplier, leading to an economic downturn, or creating instability in the financial markets.

Demand for electricity supplied by TVA could be reduced by changes in technology.

Research and development activities are ongoing to improve existing and alternative technologies to produce electricity, including gas turbines, fuel cells, microturbines, and solar cells. It is possible that advances in these or other alternative technologies could reduce the costs of electricity production from alternative technologies to a level that will enable these technologies to compete effectively with traditional power plants like TVA’s. To the extent these technologies become a more cost-effective option for certain customers, TVA’s sales to these customers could be reduced, thereby negatively affecting TVA’s cash flows, results of operations, and financial condition.

Financial Risks

TVA is subject to a variety of market risks that could negatively affect TVA’s cash flows, results of operations, and financial position.

TVA is subject to a variety of market risks, including, but not limited to, commodity price risk, investment price risk, interest rate risk, and credit risk.

	•		Commodity Price Risk. Prices of commodities critical to TVA’s operations, including coal, uranium, natural gas, fuel oil, emission allowances, and electricity, have been extremely volatile in recent years. If TVA fails to effectively manage its commodity price risk, customers may look for alternative power suppliers.
	•		Investment Price Risk. TVA is exposed to investment price risk in both its nuclear decommissioning trust and its pension fund. If the value of the investments held in the nuclear decommissioning trust or the pension fund decreases significantly, TVA could be required to make substantial unplanned contributions to these funds, which would negatively affect TVA’s cash flows, results of operations, and financial condition.
	•		Interest Rate Risk. Changes in interest rates could negatively affect TVA’s cash flows, results of operations, and financial condition by increasing the amount of interest that TVA pays on new Bonds that it issues, decreasing the return that TVA receives on its short-term investments, decreasing the value of the investments in TVA’s pension fund and nuclear decommissioning trust, and increasing the losses on the mark-to-market valuation of certain derivative transactions into which TVA has entered.
	•		Credit Risk. TVA is exposed to the risk that its counterparties will not be able to perform their contractual obligations. If TVA’s counterparties fail to perform their obligations, TVA’s cash flows, results of operations, and financial condition could be adversely affected. In addition, the failure of a counterparty to perform could make it difficult for TVA to perform its obligations, particularly if the counterparty is a supplier of electricity or fuel to TVA.

     See Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations — Risk Management Activities for more information regarding market risks.

TVA and owners of TVA securities could be impacted by a downgrade of TVA’s credit rating.

A downgrade in TVA’s credit rating could have material adverse effects on TVA’s cash flows, results of operations, and financial condition as well as on investors in TVA securities. Among other things, a downgrade could have the following effects:

•

A downgrade would increase TVA’s interest expense by increasing the interest rates that TVA pays on new debt securities that it issues. An increase in TVA’s interest expense would reduce the amount of cash available for other purposes, which could result in the need to increase borrowings, to reduce other expenses or capital investments, or to increase electricity rates.

	•		A significant downgrade could result in TVA’s having to post collateral under certain physical and financial contracts that contain rating triggers.
	•		A downgrade below a contractual threshold would prevent TVA from borrowing under two credit facilities totaling $2.5 billion without the consent of the national bank that is the counterparty to the credit facilities.
	•		A downgrade could lower the price of TVA securities in the secondary market, thereby hurting investors who sell TVA securities after the downgrade and diminishing the attractiveness and marketability of TVA Bonds.

See Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources.

     TVA may have to make significant unplanned contributions to fund its pension and other postretirement benefit plans.

TVA’s costs of providing pension benefits and other postretirement benefits depend upon a number of factors, including, but not limited to:

	•		Provisions of the pension and postretirement benefit plans;
	•		Changing employee demographics;
	•		Rates of increase in compensation levels;
	•		Rates of return on plan assets;
	•		Discount rates used in determining future benefit obligations;
	•		Rates of increase in health care costs;
	•		Levels of interest rates used to measure the required minimum funding levels of the plans;
	•		Future government regulation; and
	•		Contributions made to the plans.

Any number of these factors could increase TVA’s costs of providing pension and other postretirement benefits and require TVA to make significant unplanned contributions to the plans. Such contributions would negatively affect TVA’s cash flows, results of operations, and financial condition.

TVA may have to make significant unplanned contributions to its nuclear decommissioning trust.

TVA maintains a nuclear decommissioning trust for the purpose of providing funds to decommission TVA’s nuclear facilities. The decommissioning trust is invested in securities generally designed to achieve a return in line with overall equity market performance. TVA might have to make significant unplanned contributions to the trust if, among other things:

	•		The value of the investments in the trust declines significantly;
	•		The laws or regulations regarding nuclear decommissioning change the decommissioning funding requirements;
	•		The assumed rate of return on plan assets, which is currently five percent, has been approved by the TVA Board;
	•		Changes in technology and experience related to decommissioning cause decommissioning cost estimates to increase significantly; or
	•		TVA is required to decommission a nuclear plant sooner than TVA anticipates.

If TVA makes unplanned contributions to the trust, the contributions would negatively affect TVA’s cash flows, results of operations, and financial condition.

TVA may be unable to meet its current cash requirements if its access to the debt markets is limited.

TVA’s cash management policy is to use cash provided by operations together with proceeds from issuing discount notes and drawing on a $150 million note with the U.S. Treasury to fund TVA’s current cash requirements. In addition, TVA has access to $2.5 billion of credit facilities with a national bank. In light of TVA’s cash management policy, it is critical that TVA continue to have access to the debt markets, for if TVA is unable to access the debt markets, TVA might be unable to meet its current cash requirements. The importance of

having access to the debt markets is underscored by the fact that TVA, unlike many utilities, relies almost entirely on the debt markets to raise capital since it is not authorized to issue equity securities.

Approaching or reaching its debt ceiling could limit TVA’s ability to carry out its business.

At September 30, 2006, TVA had approximately $22.9 billion of Bonds outstanding. TVA has a statutorily imposed ceiling of $30 billion on outstanding Bonds. Approaching or reaching this debt ceiling could adversely affect TVA’s business by limiting TVA’s ability to borrow money and increasing the cost of servicing TVA’s debt. In addition, approaching or reaching this debt ceiling could lead to increased legislative or regulatory oversight of TVA’s activities.

TVA’s cash flows, results of operations, and financial condition could be negatively affected by economic downturns.

Sustained downturns or weakness in the economy in TVA’s service area or other parts of the United States could reduce overall demand for electricity and thus reduce TVA’s electricity sales and cash flows, especially as TVA’s industrial customers reduce their operations and thus their consumption of electricity.

TVA’s financial control system cannot guarantee that all control issues and instances of fraud will be detected.

No financial control system, no matter how well designed and operated, can provide absolute assurance that the objectives of the control system are met, and no evaluation of financial controls can provide absolute assurance that all control issues and instances of fraud can be detected. The design of any system of financial controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote. See Item 9A, Controls and Procedures for TVA’s assessment as of September 30, 2006, which includes two material weakness items.

TVA could lose the ability to use regulatory accounting and be required to write off a significant amount of regulatory assets.

TVA is able to use regulatory accounting because it satisfies the requirements set forth in Statement of Financial Accounting Standards (“SFAS”) No. 71, “Accounting for the Effects of Certain Types of Regulation.” Accordingly, TVA records as assets certain costs that would not be recorded as assets under generally accepted accounting principles for non-regulated entities. As of September 30, 2006, TVA had $5.3 billion of regulatory assets. If TVA loses its ability to use regulatory accounting, TVA could be required to write-off its regulatory assets. Any asset write-offs would be required to be recognized in earnings in the period in which regulatory accounting under SFAS No. 71 ceased to apply to TVA.

ITEM 1B. UNRESOLVED STAFF COMMENTS

Not applicable.

ITEM 2. PROPERTIES

     TVA holds personal property in its own name but holds real property as agent for the United States of America. TVA may acquire real property by negotiated purchase or by eminent domain.

Generating Properties

     At September 30, 2006, TVA’s generating assets consisted of 59 coal-fired units, five nuclear units, 109 conventional hydroelectric units, four pumped storage units, 72 combustion turbine units, nine diesel generator units, one digester gas site, one wind energy site, and 16 solar energy sites. See Item 1, Business — Power Supply for a chart that indicates the location, capacity, and in-service dates for each of these properties. In addition, TVA is in the process of restarting Browns Ferry Unit 1. Browns Ferry Unit 1 is scheduled to go online in early 2007 and as of September 30, 2006, was 94 percent complete.

     Twenty-four of TVA’s combustion turbines are subject to lease-leaseback arrangements. For more information regarding these arrangements, see Note 11 — Other Financing Obligations.

Transmission Properties

     TVA’s transmission system interconnects with systems of surrounding utilities and consists primarily of the following assets:

	•		Approximately 17,000 circuit miles of transmission lines, including 2,400 miles of extra-high-voltage (500,000 volt) transmission lines;
	•		537 substations, power switchyards, and switching stations;
	•		1,045 individual interchange and customer connection points; and
	•		260,000 right-of-way acres.

     The easements and rights-of-way give TVA the right to construct, operate, and maintain the transmission lines, as well as remove trees located outside the rights of way. Fee title to the land remains with the landowner.

     In 2003, TVA entered into a lease-leaseback of certain qualified technological equipment and other software related to TVA’s transmission system. For more information regarding this transaction, see Note 11 — Other Financing Obligations.

Resource Stewardship Properties

     TVA owns and operates 49 dams and manages the following resource stewardship properties:

	•		11,000 miles of reservoir shoreline;
	•		293,000 acres of reservoir land;
	•		650,000 surface acres of water; and
	•		Over 100 public recreation areas.

Buildings

     TVA owns a variety of buildings throughout its service area in addition to the buildings located at its generation and transmission facilities, including office buildings, customer service centers, power service centers, warehouses, visitor centers, and crew quarters. The most significant of these buildings is the Knoxville Office Complex. TVA also leases buildings when it deems appropriate, including its Chattanooga Office Complex. TVA’s lease of the Chattanooga Office Complex expires in 2011, but TVA has the right to extend the lease for up to 30 years. TVA also owns and leases a significant number of buildings in Muscle Shoals, Alabama.

Disposal of Property

     Under the TVA Act, TVA has broad authority to dispose of personal property but only limited authority to dispose of real property. TVA’s primary sources of authority to dispose of real property are briefly described below:

	•		Under Section 31 of the TVA Act, TVA has authority to dispose of surplus real property at a public auction.
	•		Under Section 4(k) of the TVA Act, TVA can dispose of real property for certain specified purposes, including to provide replacement lands for certain entities whose lands were flooded or destroyed by dam or reservoir construction and to grant easements and rights-of-way upon which are located transmission or distribution lines.
	•		Under Section 15d(g) of the TVA Act, TVA can dispose of real property in connection with the construction of generating plants or other facilities under certain circumstances.
	•		Under 40 U.S.C. § 1314, TVA has authority to grant easements for rights-of-way or other purposes.

     In addition, TVA’s bond covenants prohibit TVA from mortgaging any part of its power properties and from disposing of all or any substantial portion of these properties unless TVA provides for a continuance of the interest, principal, and sinking fund payments due and to become due on all outstanding Bonds, or for the retirement of such Bonds.

ITEM 3. LEGAL PROCEEDINGS

     TVA is involved in various claims amounting to approximately $54 million incidental to the conduct of its business for which it has assessed the likelihood of gain or loss. The claims, grouped by likelihood of loss, include (1) claims recorded by TVA in the amount of $28 million representing probable losses of $27 million and losses deemed reasonably possible of $1 million, and (2) claims of about $26 million for which a determination of loss cannot be made at this time.

Economy Surplus Power Case

On August 31, 1999, suit was filed against TVA in the United States District Court for the Northern District of Alabama by Birmingham Steel Corporation, on behalf of itself and a class of TVA industrial customers who contracted for economy surplus power. While Birmingham Steel Corporation was the original class representative, it filed for bankruptcy and was excluded from the class. Johns Manville Corporation was substituted as the class representative. The lawsuit alleges that TVA overcharged for economy surplus power during the summer of 1998 by improperly including some incremental costs when calculating the price of economy surplus power. The class members seek over $100 million in damages. On April 18, 2006, the district court ruled on motions for summary judgment filed by both sides. The court held that TVA improperly included charges for approximately 500 hours of power purchased in advance and breached the contracts. The court rejected TVA’s position that the additional price charged for all hours represented actual incremental costs incurred by TVA in supplying economy surplus power and thus was an appropriate part of the economy surplus power contract price. The court granted the plaintiffs’ motion for summary judgment on liability, even though it acknowledged that there are disputed factual issues as to TVA’s defenses. TVA filed a motion seeking permission to take an interlocutory appeal of the court’s ruling on summary judgment. On July 31, 2006, the court reconsidered its decision on summary judgment with respect to TVA’s affirmative defenses and held that TVA is entitled to a trial on its affirmative defenses. A mediator has been selected and the parties anticipate engaging in mediation in December 2006. Trial on TVA’s affirmative defenses and the class members’ damages is scheduled for February 5, 2007.

Case Against TVA and 22 Electric Cooperatives

On December 2, 2004, the United States District Court for the Middle District of Tennessee, dismissed a lawsuit filed by John McCarthy, Stan Cooper, Joe Sliger, Mike Bell, Don Rackley, Terry Motley, Billy Borchert, Jim Foster, and Ryan Hargis on behalf of themselves and all others similarly situated against TVA and the Middle Tennessee Electric Membership Cooperative, Appalachian Electric Cooperative, Caney Fork Electric Corporation, Inc., Chickasaw Electric Cooperative, Cumberland Electric Membership Corporation, Duck River Electric Membership Corporation, Fayetteville Public Utilities, Forked Deer Electric Cooperative, Inc., Fort Loudoun Electric Cooperative, Gibson Electric Membership Corporation, Holston Electric Cooperative, Inc., Meriwether Lewis Electric Cooperative, Mountain Electric Cooperative, Inc., Pickwick Electric Cooperative, Plateau Electric Cooperative, Powell Valley Electric Cooperative, Sequachee Valley Electric Cooperative, Southwest Tennessee Electric Membership Corporation, Tennessee Valley Electric Cooperative, Tri-County Electric Membership Cooperation, Tri-State Electric Membership Cooperation, Upper Cumberland Electric Membership Corporation, and Volunteer Energy Cooperative. The lawsuit in part challenged TVA’s practice of setting rates for electric power charged by distributor customers through TVA’s contracts with distributor customers. In granting the defendants’ motions to dismiss, the court held that the claims alleging violations of state law failed because the plaintiffs (consisting of Tennessee residents and customers of certain of the cooperatives) had not completed the steps necessary to bring these claims in court. With respect to the claim against TVA, the court held that the alleged violations of federal law failed as a matter of law because Congress had specifically authorized TVA to set the rates charged by distributor customers through TVA’s contracts with distributor customers. The plaintiffs appealed to the United States Court of Appeals for the Sixth Circuit (“Sixth Circuit”), and on October 17, 2006, the Sixth Circuit affirmed the district court’s decision, and held, among other things, that TVA’s rates were not subject to judicial review and that TVA is not subject to antitrust liability when doing so would interfere with TVA’s purposes.

Global Warming Cases

On July 21, 2004, two lawsuits were filed against TVA in the United States District Court for the Southern District of New York alleging that global warming is a public nuisance and that carbon dioxide emissions from fossil-fuel electric generating facilities should be ordered abated because they contribute to causing the nuisance. The first case was filed by various states (California, Connecticut, Iowa, New Jersey, New York, Rhode Island, Vermont, and Wisconsin) and the City of New York against TVA and other power companies. The second case, which alleges both public and private nuisance, was filed against the same defendants by Open Space Institute, Inc., Open Space Conservancy, Inc., and the Audubon Society of New Hampshire. There are no Clean Air Act requirements limiting carbon dioxide emissions, and, accordingly, the suits do not involve allegations of regulatory noncompliance. The plaintiffs do not seek monetary damages, but instead seek a court order requiring each defendant to cap its carbon dioxide emissions and then reduce these emissions by an unspecified percentage each year for at least a decade. In September 2005, the district court dismissed both lawsuits because they raised political questions that should not be decided by the

courts. The plaintiffs appealed to the U.S. Court of Appeals for the Second Circuit (“Second Circuit”). Oral argument was held before the Second Circuit on June 7, 2006, and the parties are awaiting a decision.

Case Involving Modifications to the Colbert Fossil Plant

The National Parks Conservation Association, Inc. (“NPCA”), and Sierra Club, Inc. (“Sierra Club”), filed suit on February 13, 2001, in the United States District Court for the Northern District of Alabama, alleging that TVA violated the Clean Air Act and implementing regulations at TVA’s Colbert Fossil Plant (“Colbert”), a coal-fired electric generating facility located in Tuscumbia, Alabama. The plaintiffs allege that TVA made major modifications to one of the power generating units, specifically Colbert Unit 5, without obtaining preconstruction permits (in alleged violation of the Prevention of Significant Deterioration (“PSD”) program and the Nonattainment New Source Review (“NNSR”) program) and without complying with emission standards (in alleged violation of the New Source Performance Standards (“NSPS”) program). The plaintiffs seek injunctive relief; civil penalties of $25,000 per day for each violation on or before January 30, 1997, and $27,500 per day for each violation after that date; an order that TVA pay up to $100,000 for beneficial mitigation projects; and costs of litigation, including attorney and expert witness fees. On November 29, 2005, the district court held that sovereign immunity precluded the plaintiffs from recovering civil penalties against TVA. On January 17, 2006, the district court dismissed the action, on the basis that plaintiffs failed to provide adequate notice of NSPS claims and that the statute of limitations curtailed the PSD and NNSR claims. The plaintiffs appealed to the U.S. Court of Appeals for the Eleventh Circuit (“Eleventh Circuit”) on January 25, 2006. Briefing of the appeal to the Eleventh Circuit was completed in July 2006. Oral argument of the appeal is scheduled for January 11, 2007. If the decision is reversed on appeal, there is a reasonable possibility that TVA will be ordered to install additional controls on Colbert Unit 5.

Case Involving Modifications to Bull Run Fossil Plant

The NPCA and the Sierra Club filed suit against TVA on February 13, 2001, in the United States District Court for the Eastern District of Tennessee, alleging that TVA did not comply with the New Source Review requirements of the Clean Air Act when TVA modified its Bull Run Fossil Plant (“Bull Run”), a coal-fired electric generating facility located in Anderson County, Tennessee. In March 2005, the district court granted TVA’s motion to dismiss the lawsuit on statute of limitation grounds. The plaintiffs’ motion for reconsideration was denied, and they appealed to the Sixth Circuit. Amicus curiae briefs supporting the plaintiffs’ appeal have been filed by New York, Connecticut, Illinois, Iowa, Maryland, New Hampshire, New Jersey, New Mexico, Rhode Island, Kentucky, Massachusetts, and Pennsylvania. Several Ohio utilities filed an amicus curiae brief supporting TVA. Briefing of the appeal to the Sixth Circuit was completed in May 2006. Oral argument was held on September 18, 2006, and the parties are awaiting a decision.

Case Involving Opacity at Colbert

On September 16, 2002, the Sierra Club and the Alabama Environmental Council filed a lawsuit in the United States District Court for the Northern District of Alabama alleging that TVA violated Clean Air Act opacity limits applicable to Colbert between July 1, 1997, and June 30, 2002. The plaintiffs seek a court order that could require TVA to incur substantial additional costs for environmental controls, and pay civil penalties of up to approximately $250 million. After the court dismissed the complaint (finding that the challenged emissions were within Alabama’s two percent de minimis rule, which provided a safe harbor if emissions did not exceed allowable opacity limits by more than two percent each quarter), the plaintiffs appealed the district court’s decision to the Eleventh Circuit. On November 22, 2005, the Eleventh Circuit affirmed the district court’s dismissal of the claims for civil penalties, but held that the Alabama de minimis rule was not applicable because Alabama had not yet obtained EPA approval of that rule. The case was remanded to the district court for further proceedings, and the plaintiffs filed a motion for summary judgment. On May 23, 2006, the district court issued orders staying the matter until a decision is issued in a Clean Air Act case accepted by the Supreme Court, United States v. Duke Energy; referring the action to mediation to be completed before the close of business on December 15, 2006, unless the district court extends the deadline; and denying as moot the plaintiffs’ motions to hold TVA liable (with leave to file again, if necessary, after the stay is lifted). On May 26, 2006, the plaintiffs asked the district court to reconsider its orders, and in the alternative to allow an interlocutory appeal, and on July 5, 2006, the district court denied plaintiffs’ motion. The parties participated in mediation on September 7, 2006, and for several weeks thereafter. The case remains stayed.

Case Brought by North Carolina Alleging Public Nuisance

On January 30, 2006, North Carolina’s Attorney General filed suit against TVA in the United States District Court for the Western District of North Carolina alleging that TVA’s operation of its coal-fired power plants in Tennessee, Alabama, and Kentucky constitute public nuisances. On April 3, 2006, TVA moved to dismiss the suit on grounds that the case is not suitable for judicial resolution because of separation of powers principles, including the fact that these matters are based on policy decisions left to TVA’s discretion in its capacity as a government agency and thus are not subject to tort liability (the “discretionary function doctrine”), as well as the Supremacy Clause. In July 2006, the court denied TVA’s motion, and set the trial for the term of court beginning October 2007. On August 4, 2006, TVA filed a motion requesting permission to file an interlocutory appeal with the United States Court of Appeals for the Fourth Circuit (the “Fourth Circuit”) which the district court granted on September 7, 2006. On September 21,

2006, TVA petitioned the Fourth Circuit to allow the interlocutory appeal. The Fourth Circuit has granted the petition and set a briefing schedule, with briefing to be completed in January 2007. The district court did not stay the case during this appeal, and trial remains scheduled for October 2007.

Case Involving North Carolina’s Petition to the EPA

In 2005, the State of North Carolina petitioned the EPA under Section 126 of the Clean Air Act to impose additional emission reduction requirements for sulfur dioxide and nitrogen oxides emitted by coal-fired power plants in 13 states, including states where TVA’s coal-fired power plants are located. In March 2006, the EPA denied the North Carolina petition primarily on the basis that the Clean Air Interstate Rule remedies the problem. In June 2006, North Carolina filed a petition for review of EPA’s decision with the United States Court of Appeals for the District of Columbia Circuit.

Case Arising out of Hurricane Katrina

In April 2006, TVA was added as a defendant to a class action lawsuit brought in the United States District Court for the Southern District of Mississippi by 14 residents of Mississippi allegedly injured by Hurricane Katrina. The plaintiffs sued seven large oil companies and an oil company trade association, three large chemical companies and a chemical trade association, and 31 large companies involved in the mining and/or burning of coal, including TVA and other utilities. The plaintiffs allege that the defendants’ greenhouse gas emissions contributed to global warming and were a proximate and direct cause of Hurricane Katrina’s increased destructive force. The plaintiffs are seeking monetary damages among other relief. TVA has moved to dismiss the complaint on grounds that TVA’s operation of its coal-fired plants is not subject to tort liability due to the discretionary function doctrine.

Claim Involving Areva Fuel Fabrication

On November 9, 2005, TVA received two invoices totaling $76 million from Areva (“Areva”) and an affiliated company, the successor of Babcock and Wilcox Company (“B&W”). In 1970, TVA and B&W entered into a contract for fuel fabrication services for its Bellefonte Nuclear Plant. Areva’s invoices are based upon its belief that the 1970 contract required TVA to buy more fuel fabrication services from B&W than TVA actually purchased. A meeting was held between TVA and Areva on May 31, 2006, to discuss the issue. TVA subsequently received a letter from Areva which reasserted its claim, but reduced the value of the claim to $26 million. Areva has not provided any further information concerning the claim nor has it explained the reason for the reduction in the claim amount.

Notification of Potential Liability for Ward Transformer Site

TVA has been notified by one of the parties involved with clean-up of the Ward Transformer (“Ward”) Superfund Site, a facility located in Raleigh, North Carolina, that it considers TVA a potentially responsible party (“PRP”) and intends to pursue a claim against TVA. Under the Comprehensive Environmental Response, Compensation, and Liability Act (“CERCLA”), any entity which arranges for disposal of a CERCLA hazardous substance at a site may bear liability for the cost of cleaning up the site. There is evidence that TVA sent transformers to Ward that contained Polychlorinated Biphenyls. Several responsible parties have entered into a settlement agreement with EPA to clean up on-site contamination at the site, and the cost of the on-site cleanup is currently estimated to be $20 million. EPA is also investigating off-site contamination from Ward operations, but TVA has no information as to the estimated costs, if any, of cleaning up off-site contamination. It is unknown at this time what level of liability, if any, TVA will have in these matters, whether it will be required to contribute, and, if so, how much such a contribution would be.

     TVA is engaged in various administrative and legal proceedings arising from employment disputes. These matters are governed by federal law and involve issues typical of those encountered in the ordinary course of business of a utility. They may include allegations of discrimination or retaliation (including retaliation for raising nuclear safety or environmental concerns), wrongful termination, and failure to pay overtime. Adverse outcomes in these proceedings would not normally be material to TVA’s business, although it is possible that some outcomes could require TVA to change how it handles certain personnel matters or operates its plants.

     It is not possible to predict with certainty whether TVA will incur any liability or to estimate the damages, if any, that TVA might incur in connection with the lawsuits and claims described above except as specifically noted. TVA has recognized charges to earnings and actual costs, including legal fees and expenses, related to litigation. No assurance can be given that TVA will not be subject to significant additional claims and material additional liabilities.

     If actual liabilities significantly exceed the estimates made, the results of operations, liquidity, and financial condition could be materially adversely affected. In accordance with SFAS No. 5, “Accounting for Contingencies,” TVA has accrued approximately $28 million as of September 30, 2006, related to the cases described above.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Not applicable.

PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Not applicable.

ITEM 6. SELECTED FINANCIAL DATA

The following selected financial data for the years 2002 through 2006 should be read in conjunction with the audited financial statements and notes thereto (collectively, the “Financial Statements”) presented in Item 8, Financial Statements and Supplementary Data. In 2003, TVA changed its method for recording interdivisional sales, displacement sales, and limestone used for the production of electricity. Certain reclassifications have been made to the 2002 financial statements to conform to the 2003, 2004, 2005, and 2006 presentation.

Statements of Income Data

For the years ended September 30
(in millions)

		2006				2005				2004				2003				2002
Operating revenues		$	9,185			$	7,794			$	7,533			$	6,953			$	6,798
Operating expenses			(7,582	) 1			(6,503	) 1			(5,873	) 2			(5,398	)			(5,323	) 3
Operating income			1,603				1,291				1,660				1,555				1,475
Other income, net 4			65				52				43				32				19
Unrealized (loss)/gain on derivative contracts, net			(15	)			3				(7	)			(7	)			–
Interest expense, net 4			(1,215	)			(1,261	)			(1,310	)			(1,353	)			(1,431	)
Cumulative effect of accounting changes			(109	) 5			–				–				217	6			–
Total net income		$	329			$	85			$	386			$	444			$	63

Balance Sheets Data

At September 30
(in millions)

		2006				2005				2004				2003 1				2002 1
Assets
Current assets 2		$	2,669			$	2,176			$	2,295			$	2,238			$	1,626
Property, plant, and equipment, net			24,434				23,888				23,699				23,125				22,175
Investment funds			972				858				744				638				510
Regulatory and other long-term assets			6,445				7,551				7,451				7,027				6,522
Total assets		$	34,520			$	34,473			$	34,189			$	33,028			$	30,833
Liabilities and proprietary capital
Current liabilities 2		$	5,203			$	6,724			$	5,420			$	5,8193			$	4,755
Regulatory and other liabilities			7,074				7,606				7,168				5,114				3,304
Long-term debt, net of discount			19,544				17,751				19,337				20,201				21,358
Total liabilities			31,821				32,081				31,925				31,134				29,417
Retained earnings			1,565				1,244				1,162				783				349
Other proprietary capital			1,134				1,148				1,102				1,111				1,067
Total proprietary capital			2,699				2,392				2,264				1,894				1,416
Total liabilities and proprietary capital		$	34,520			$	34,473			$	34,189			$	33,028			$	30,833

Financial Obligations

As of September 30
(in millions)

		2006				2005				2004				2003				2002
Long-term debt, including current maturities		$	20,529			$	20,444			$	21,337			$	22,537			$	21,358
Other long-term obligations
Capital leases *			128				150				138				151				162
Lease/leaseback commitments			1,108				1,143				1,178				1,238				561
Energy prepayment obligations			1,244				1,350				1,455				47				–
Total other financing obligations			2,480				2,643				2,771				1,436				723
Discount notes			2,376				2,469				1,924				2,080				3,492
Financial obligations		$	25,385			$	25,556			$	26,032			$	26,053			$	25,573