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Our Public Power: the Next Generation

INSIDE:

Achieving Financial Stability .........3

Meeting Utility Priorities ..................4

The Big Picture .....................................7

Fast Facts ...............................................8

Surveying the Horizon ................... 10

Two Future Scenarios .................... 12

Strong today, preparing for tomorrow: Strategic planning at your Chelan County PUD

Context paper

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2014 - We Are Meeting Our Goal To Pay Down Debt

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Three years ago, Chelan County PUD celebrated its 75th anniversary. The milestone puts into perspective the foresight of the citizens of this county who voted, in 1936, to bring affordable power to county residents. Our local utility first delivered electricity 11 years later. Then in 1951, we leased part of the Rock Island Dam from Puget Sound Power and Light, securing the financing to build new turbines to supply Alcoa. In 1955, we acquired the Lake Chelan Dam from Washington Water Power. By 1956, we bought Rock Island Dam and plans were in the works to secure a federal license to build Rocky Reach Dam. It was a big vision for a small utility, but early public power leaders believed that if they could gather investors, build a dam and maintain local control of it, then Chelan County residents would reap the benefits for generations to come.

It’s important to keep our past in mind as we chart the future of Chelan County PUD. As we update our Strategic Plan for 2015 and beyond, we intend to keep our utility on a path toward optimizing

Debt Outstandingmillions

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value for our customer-owners. The challenge is how to prepare for two possible futures: 1) one in which we have surplus revenue available to provide additional benefits for our customer-owners; and 2) a less likely scenario, in which we struggle to cover our costs.

In order to make the best decisions possible, we want to give our customer-owners a strategic picture so that you can provide informed input and guidance about the future role we should play in the community of Chelan County.

ACHIEVING FINANCIAL STABILITYIn the 2010-2014 Strategic Plan, Chelan PUD committed to "ensure lasting financial stability by developing and implementing a comprehensive, sustainable business model.” In 2010, Chelan PUD carried a debt load of more than $1 billion. Moody’s Investor Services and Fitch Ratings both assigned our utility a negative outlook (in 2009 and 2011, respectively) due to our reliance on market sales of surplus hydropower, which they viewed as risky because of variability in market prices and water availability, and because of our debt levels.

During the 2010-2014 strategic planning process, Chelan PUD established financial policies to achieve an appropriate framework for making spending and investment decisions. We addressed our reliance on wholesale power markets by instituting programs to manage our exposure to wholesale electric market risks and to reduce our debt. The ratings agencies now view our outlook as “stable.”

By the end of 2014, our debt is projected to be $735 million — a reduction of nearly $300 million since 2010 — and we do not anticipate increasing debt in the foreseeable future. Despite the improvement, Chelan PUD still carries a significant amount of debt. The graph (at left) illustrates the debt load carried by Chelan PUD beginning in 1949 and ending in 2019 (future years are planned estimates).

In May 2014, the Commission approved the revision of financial policies for the District for 2015 through 2019. This included achieving a debt leverage ratio of <60% in 2014 and <35% by the end of 2019 which is a strong statement of the Commission’s commitment to debt reduction.

It’s important to keep our past in mind as we chart the future of Chelan County PUD.

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MEETING UTILITY PRIORITIESOur debt reduction strategy creates a fundamental improvement in our financial situation, assuming the momentum can be maintained. It also provides the opportunity for a different kind of conversation in this strategic planning process. First, however, let’s consider where Chelan PUD stands with regard to four basic utility criteria: low rates, high reliability, environmental stewardship and customer-owner satisfaction.

1 Providing Low Retail Electric RatesIn 2012, average residential rates in Chelan County were 3.2 cents per kWh, compared with the Washington State average of about

8.5 cents per kWh1 (and a national average of nearly 12 cents per kWh). According to data from the American Public Power Association, Chelan PUD has the second lowest rates of any electric utility in Washington State, and the fourth lowest in the country.2

1 Table 5.6.B. Average Retail Price of Electricity to Ultimate Customers by End-Use Sector, by State, Year-to-Date through December 2012 and 2011 (Cents per Kilowatt-hour) http://www.eia.gov/electricity/monthly/current_year/february2013.pdf.

2 Average Revenue per kWh, 2012 for Electric Utilities in the U.S. Calculated by APPA from data reported by each utility to the Energy Information Administration on Form EIA-861.

Another way of looking at Chelan PUD’s electric rates is to consider retail electric rates (an average of residential, commercial and industrial rates). In 2012, our revenue from retail electric sales was roughly $50 million. If we charged retail rates on par with the state average, this revenue would more than double. In other words, Chelan PUD’s low rates theoretically saved all retail electric customers in the county approximately $63 million compared with the state average.

While our rates are among the best in the country today, a reduction in revenue from the wholesale power market, an increase in our costs, or reduced output from our hydropower system could create pressure to raise local retail rates, particularly because our utility still carries a significant amount of debt.

2Maintaining High ReliabilityReliable electric distribution service is critical to our Strategic Plan objective of providing excellent customer service.

In 2013, Chelan PUD was awarded a Platinum designation under the American Public Power Association Reliable Public Power Provider program. We invest millions each year in tree trimming, underground cable replacements and line upgrades. Our goal is 99.99% system reliability, which is the benchmark from the American Public Power Reliability Survey. Despite challenges presented by a diverse service area ranging from remote mountainous regions to urban centers, and environmental influences like wind and snow storms or wild fires, we achieve or nearly achieve that goal every year.

Residential Electric Rates, per kilowatt hour (2012)

Chelan CountyWashington State

average U.S. average3.2 cents 8.5 cents 11.9 cents

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Chelan PUD 2010

Chelan PUD 2011

Chelan PUD 2012

American Public Power Association

Survey

Institute of Electrical and

Electronics Engineers Survey

Power availability (percent of time over 1 year) 99.977 99.983 99.92 99.995 98.37

While we have been managing the pace of system replacements, the need to replace much of our aging infrastructure is a growing issue. For example, some underground cables installed in the 1970s and ‘80s are near the end of their life.

Another metric for ensuring we are meeting our production and reliability goals is the percentage of time our hydropower generating units are available to produce power. Between 2011 and 2012, Rocky Reach average unit availability was 98.5%; Rock Island was 92.5% and Lake Chelan was 98.5%—all significantly better than the average for large hydropower units of about 85%3. This past year, however, we experienced a design flaw that affected four of the Rocky Reach turbine units, significantly hampering Rocky Reach’s availability.

3Meeting Environmental MilestonesOur hydropower dams emit no air emissions, including greenhouse gases.

Instead, our primary environmental impact is on fish. In 2013, after a decade of implementing Habitat Conservation Plans (HCPs) with state and federal fish agencies and two Northwest tribes, we met our goal of having "no-net-impact" on salmon and

3 gkshydro, beyond benchmarking. 2011 Navigant Consulting, Inc.

steelhead migrating through our hydropower dams. Under the HCPs, solutions are tailored to each dam based on the best available science. These HCPs are in place until 2054, and will continue to provide reasonable operating certainty for Chelan PUD and verified protection for the species. Also, for each hydropower dam, we hold a federal license that allows us to operate the project. To do so, we must remain in compliance with a multitude of other environmental obligations in addition to numerous engineering and operating conditions.

We are also meeting targets for achieving energy conservation. Our conservation programs, including weatherization for residential homes and incentives for industrial and commercial customers, are popular and being utilized. In addition, because saving energy in the county allows Chelan PUD to sell more power on the wholesale power market (where it is typically worth more than the amount charged to retail customers), there is an opportunity to benefit all customer-owners by accelerating our goals for achieving energy efficiency.

Our goal is 99.99% system reliability.

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Chelan County PUD Revenues: 2013 Audited Results

79%

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3% 2%

near 0%

Surplus Hydro Generation Retail Electric Fiber & Telecom Water Wastewater

This graphic illustrates the revenues of certain segments of Chelan County PUD and excludes revenues from miscellaneous sources (network transmission, internal services and certain non-operating revenues)

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4Customer SatisfactionChelan PUD conducted a Customer Satisfaction Survey in February 2014, consisting of

403 telephone interviews with residential customers. The survey addressed customer attitudes and opinions on Chelan PUD service, responsiveness, communication, problem resolution, interaction with utility staff and general performance. This survey was used to benchmark Chelan PUD against approximately 50 peer utilities. The results were better than the peer average in every category. The table at top, right, shows the percent of customer-owners who answered that they were “satisfied” or “very satisfied” with Chelan PUD.

We are pleased to report that ratings in all categories were very good. Providing excellent service to our customer-owners is the most important thing we do. These ratings motivate us to continue our efforts to do even more to improve and earn your satisfaction.

% Satisfied or very satisfiedOverall Satisfaction 91.8%

Rates for Electric Service compared to other utility services such as cable, gas or water

89.5%

Reliability 96.0%

Customer Service 95.6%

Employees 95.1%

Communication 91.4%

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THE BIG PICTURE: HYDROPOWER IS THE SOURCE OF OUR FINANCIAL VALUE Our hydropower assets are the source of financial value that makes our utility unique. Chelan PUD's hydropower dams can generate five times the amount of electricity used by Chelan PUD customers at a cost well below most other electricity

generation options. These valuable generating assets are the core of our financial strength and allow us to have such low rates. Chelan PUD also generates revenue from its retail electric, water, wastewater and fiber businesses, but the primary source

of revenue is selling surplus hydro generation power into western electricity power markets. This value has been used to keep all rates to Chelan PUD customer-owners lower than the actual cost.

Chelan County PUD “Operational Gaps”: 2013 Audited Results

This graphic illustrates the gaps between revenues and expenses of certain segments of Chelan County PUD and excludes miscellaneous impacts associated with Network Transmission, Internal Services and certain Non-Operating activities.

$0 $10 $20 $30 $40 $50 $60 $70 $80 $90

$100 $110 $120 $130 $140 $150 $160 $170 $180 $190 $200 $210 $220 $230 $240 $250

Revenues Expenses Revenues Expenses Revenues Expenses Revenues Expenses Revenues Expenses

Surplus Hydro Generation Retail Electric Fiber & Telecom Water Wastewater

Revenues Expenses Gap: Deficit Gap: Surplus

Chelan PUD Electric System

$0 $1 $2 $3 $4 $5 $6

Revenues Expenses Revenues Expenses

Water Wastewater

Revenues Expenses Gap: Deficit

Note scale for water and wastewater systems. Revenues and expenses are less than $5 million and $1 million respectively.

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This graphic illustrates the gaps between revenues and expenses of certain segments of Chelan County PUD and excludes miscellaneous impacts associated with network transmission, internal services and certain non-operating activities. Surplus hydropower generation produces more revenue than costs while other businesses have more expenses than revenues.

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Fast Facts: How we deliver low-cost power• Chelan PUD serves

approximately 48,500 retail electric meters, 5,500 water customers, 500 wastewater customers and 12,000 wholesale fiber connections.

• Less than one-fifth of Chelan County power is used in Chelan County by retail customers (residential, commercial and industrial). The rest is sold through long-term contracts to other Northwest utilities and Alcoa or through mid-term or short-term contracts on the wholesale power market.

• Most of our revenue does not come from rates paid by Chelan County retail customers. Wholesale power sales from surplus hydropower (generated above and beyond the electric needs of our Chelan County) represent about 79% of annual revenue.

• Wholesale power market sales essentially provide enough extra revenue to support low retail electric rates here at home.

• Other business units (water, wastewater and fiber) provide some revenues, but generally do not cover their associated costs. This is even true for Chelan PUD’s retail electric business, where revenues in 2013 were about $50 million, but expenses totaled $60 million.

• In 2013, revenue from surplus hydropower generation was over $92 million greater than associated expenses. Much of this surplus is being used to pay off Chelan PUD’s long-term debt and fund hydropower capital investments so as to avoid incurring additional debt. Surplus hydropower sales also have enabled Chelan PUD to contribute capital funds to other utility services in the amount of $117 million for fiber investments; $21 million for water systems and $2 million for wastewater systems in the past.

• Allocating capital from surplus hydropower sales to these services slows down the rate at which Chelan PUD could otherwise reduce its debt load. To put this in perspective, for every $100 million increase in debt there is an approximate 10% increase in the retail electric rates required to pay for that debt, roughly $4-$5 million in interest payments.

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Water5,500 customers$70,000 positive margin* On a cash flow basis (not including depreciation) the cash loss from water capital and O&M expenditures averages approximately $50,000 per year over the next 5 years.

Retail ElectricAverage annual sales = 1.5 million MWh of electricity

48,500 electric customers

$12 million net shortfall*

Wastewater500 customers$200,000 net shortfall* On a cash flow basis (not including depreciation) the annual change in cash ranges from a cash loss of $100,00 to $350,000 over the next 5 years.

Fiber12,000 end user connections$2 million net shortfall* On a cash flow basis (not including depreciation) the annual change in cash ranges from a cash loss of $2 million to a cash gain of $500,000 over the next 5 years.

Chelan PUD... Surplus hydro generation keeps local rates low

10 million MWh of electricity generated annually

Enough to power a city of 1 million people

Surplus hydro generationAverage annual sales = 8.5 million MWh of electricity sold to others who then sell it to their customersEnough to power a city of 850,000 people$85 million positive margin*Includes $14 million net shortfall from utilities*

Integrated ElectricGeneration, Transmission & Distribution

* Based on 2014 Adopted Budget

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SURVEYING THE HORIZON – RISKS AND OPPORTUNITIESSeveral types of risk can affect our hydropower assets and the value we derive from them. These include debt load, asset protection, market risk and public policy changes. Failure to effectively manage these risks and opportunities would risk losing value for our customers. Maintaining and enhancing our hydropower assets protects our fundamental source of financial value, which enables us to serve the needs of our customer-owners and enables us to keep rates low.

1DebtEven after the measures we’ve taken to reduce debt over the past several years, Chelan PUD has significantly more debt per retail electric

customer than other public power utilities with AAA or AA bond ratings from Fitch Ratings agency. As shown, Chelan PUD’s debt per retail customer is more than five times the median of similarly-rated public power

utilities. In order to mitigate some of the risk of this debt to our retail customers, Chelan PUD has entered into long term contracts for 51% of the power produced by Rocky Reach and Rock Island. Under these contracts, Alcoa and Puget Sound Energy make payments to Chelan PUD for their share of project debt. This helps reduce but not eliminate the risk.

High debt brings risk because we are obligated to pay bondholders whether or not we have a good year selling surplus hydropower on the wholesale power market. A reduction in revenue from the wholesale power market (or reduced output from the hydropower projects due to a poor water year or equipment issues) could threaten our ability to keep retail electric rates low. While these events may be unlikely, they should not be ignored. Reducing our debt load, managing risk and maintaining prudent financial reserves could help us withstand financial downturns.

Comparison of Debt to Retail Customer

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2009 2010 2011 2012 2013 2014

Chelan PUD debt per retail customer Obligated Chelan PUD debt per retail customer* AAA/AA Utility median debt per retail customer

*Fitch Ratings data is as of June, 2013. Obligated debt represents total debt per retail customer which is not contractually covered by long term take or pay power contracts with Puget Sound Energy and Alcoa.

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*Fitch Ratings data as of June, 2013. Obligated debt represents total debt per retail customer which is not contractually covered by long-term “take or pay” power contracts with Puget Sound Energy and Alcoa.

2013 and 2014 out years not available

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2Asset ProtectionIn order to protect our revenue source, we must identify long-term investment plans for our hydropower assets. An example of possible threats

to our physical assets was brought home when the design flaw in the Rocky Reach turbines sidelined four of our most productive units last year. While this particular problem was associated with unit design (and was not a maintenance issue), the temporary loss of generation capacity highlights the importance of investing in the long-term future of our hydropower assets. We also face potential impacts on our system operations and revenue generation due to the integrated nature of the Columbia River hydropower system. As witnessed after the fracture in Wanapum Dam was discovered, we can be affected by problems elsewhere in the system. In addition, we need to attract and retain people who have the skills to unlock the value of our hydropower assets. If the ability of these hydropower dams to produce power is compromised, the primary financial revenue stream that supports our utility operations will be diminished.

3Market TransformationBecause we derive most of our financial value from wholesale power markets, changes in those markets present risks and opportunities.

A reduction in revenue could create serious risk for retail rates, partly because we would remain responsible for paying off our substantial debt. There may be periods of time where wholesale power markets do not provide the surplus revenues we rely upon. If this happens, we will need to be able to weather circumstances — by entering into long-term, fixed-price contracts and/or having savings in the bank — until the situation improves.

Why are market conditions such a risk? The western power markets in which we operate are going through

transformative change. Public policy that has incentivized large amounts of new renewable energy resources, and the expansion of U.S. shale gas production coupled with environmental regulations, is prompting the phase-out of coal-fired plants. Supply and demand is being fundamentally altered. California represents roughly half the western power market, and a significant amount of Chelan PUD’s surplus hydro generation is sold into that state each year. Currently, California is adding so much solar that within just a few years, more power could be available in some seasons than can be sold to California customers in what has historically been peak daytime hours. This radical change in power markets will alter the value we can obtain from our surplus hydropower generation. A critical component of assuring Chelan PUD’s future financial health will be employing people with the skills to respond to market changes and explore new opportunities. For example, Chelan PUD is beginning to gain additional value for our power’s “environmental attributes.” This is due to smart people who understand how to derive value from evolving power markets.

4Public Policy ChangesMany matters of public policy will be decided outside of Chelan County that directly impact Chelan PUD’s ability to generate value. While

Chelan PUD is a relatively small public power utility in terms of retail electric sales, we are relatively large in terms of our generation portfolio. Increasingly, we face issues that require us to be engaged on the state, federal and even international levels. These issues range from transmission planning and reliability standards to environmental laws and regulations and even the future of the Columbia River Treaty with Canada. This creates both risk and opportunity for Chelan PUD which must be managed through developing the human resources to stay abreast of a rapidly evolving policy environment.

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TWO FUTURE SCENARIOSChelan PUD's five-year forecast estimates net income of more than $80 million annually. In order to continue meeting our current financial objectives, net revenue must be at least $60 – $70 million per year for at least the next five years. Depending on the opportunities and risks that develop over time, the amount needed to optimize our utility could increase as we identify new ways to add value for our customer-owners through our hydropower assets or improved processes and customer service. Such improvements would also be intended to boost net revenue.

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Liquidity Forecast: Two Future Scenariosmillions

As we think about the future of our utility, our greatest challenge is how to prepare for those two future scenarios – one of plenty, and one of relative financial stress.

Financial forecasts are based on the best known assumptions at the time, but reality may unfold differently than anticipated. Five years ago, few people would have anticipated the rapid development of low-cost U.S. natural gas production due to technological innovation, or the rapid expansion of solar and wind resources prompted by government policy. While we anticipate revenues in this range, our strategic plan and financial policy metrics consider less fortunate scenarios as well. As an example, the Cash Forecast graph below depicts two diverse scenarios. The baseline is the amount of reserves Chelan PUD needs to ensure timely payment of bills, maintain a fund to address unforeseen events, preserve funds for system improvements and reliability and meet expectations of a AA rated utility. The expected scenario reflects

current wholesale market forward price curves, average water conditions, estimated customer growth and forecasted expenditures. The low-revenue scenario reflects simulated forward prices that are depressed by low natural gas prices and an influx of wind and solar energy; the lowest 10 consecutive water years on record (84% of average); and an additional 5% increase to estimated capital, operation and maintenance costs. The difference between these two scenarios illustrates the tremendous challenge embedded in our strategic planning process. Will we have a healthy financial outlook or will we face significant financial challenges?

MODEL USED S:\FINANCE\public\Cognos_data\Model_Runs\[ForecastModel_20140512_What if.xlsx]Results

Liquidity (in millions)2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027

4-30-14 Forecast (expected) 341$ 309$ 287$ 325$ 342$ 373$ 362$ 417$ 408$ 470$ 537$ 620$ 666$ 718$ 771$ Updated by Craig K, 5-29-2014

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4-30-14 Forecast (expected scenario) Liqudity Minimum Baseline(Computed or $175M) 4-30-14 Forecast (low-revenue scenario)

Expected scenario

Low-revenue scenario

Minimum Liquidity Reserve Target

Reflects a 50/50 probability of being better or worse

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To be best prepared for low-revenue scenarios, we will continue to meet our financial objectives and the priorities identified by our customer-owners during the last phase of the strategic planning process (i.e. maintain reliable assets, pay down debt, save for a rainy day and keep rates affordable with any adjustments modest and predictable). Continuing to reduce debt creates financial flexibility to respond if our financial picture deteriorates. However, in good years Chelan PUD may have revenue available to provide additional value to this county. This additional value is most likely to be created if we:

1. Do not encounter unexpected events that reduce the potential for meeting planned net revenue targets (such as the Rocky Reach turbine repairs and Rock Island drawdown due to the fracture at Wanapum dam);

2. Operate and maintain our utility and hydropower assets sustainably;

3. Have funds set aside in advance of a potential expenditure;

4. Work within our statutory authority as a public power utility; and

5. Continue to attract and retain employees with the talent and knowledge necessary to extract optimum value from Chelan PUD’s resources.

In order to create value for stockholders, for-profit companies (such as investor-owned utilities) can offer stock “dividends.” As a public power utility, Chelan PUD can only provide benefits within our statutorily granted authority under state law.

This gives us express authority to own and operate electric, water and wastewater systems; provide wholesale telecommunication services; own and operate energy generation facilities; and fund electric/water conservation measures. We also have some ability to carry out activities closely related to these purposes. We are not allowed to lend credit or give money or property to private entities or for private purposes. If there is doubt whether a particular power has been granted, it is denied. Within these guidelines, additional “public power benefits” could be delivered in a variety of ways to improve the quality of life in this community.

Through the end of 2014, we will be reaching out to engage our customer-owners in an in-depth conversation about the priorities of our utility and how we could best provide “a public power benefit” if and when we exceed our financial metrics and have available revenue. If we exceed our financial goals, what form or forms should Chelan PUD’s “public power benefit” take?

We want to explore these options and other ideas with county residents through our strategic planning process. Within the framework of existing statutory authority, where we believe we should remain, we enter this process with a few thoughts about possible options:

• Reduce retail rates or provide customer rebates.

• Consider capital projects with a lower return on investment than normally meets budgeting requirements that increase value to county residents.

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• Address economic development within our statutory authority, such as changes to the line extension policy or re-evaluation of the rate treatment of large electric users in order to attract new businesses.

• Make strategic investments to improve reliability.

• Make additional investments in water/wastewater assets.

• Improve service for existing fiber customers.

• Make additional investments in the fiber system.

• Take actions to increase customer satisfaction, such as improving outage management.

• Evaluate increasing the District’s role in managing and operating its park system.

• Explore carbon reduction efforts that could benefit Chelan County.

• Limit rate increases for water, wastewater or fiber customers even if the costs of these businesses are not being recovered.

The potential costs and benefits of various options will be part of the conversation we will have with our customer-owners in focus groups, surveys, a leadership summit and workshops by the end of 2014. Our hope is to create a framework for delivering value back to the county in a manner that targets the highest priorities of our customer-owners without losing sight of long-term financial stability. It is also our hope to accomplish this planning in a manner that helps to unify the county around the theme of enhancing the quality of life for the whole county. Our mantra is the best (value) for the most (people) for the longest (period of time).

While there are no guarantees that there will be public power benefits to distribute, it makes sense to do good planning now in case they appear. If our financial circumstances will allow the distribution of public power benefits, there will not be enough money to tackle every project with potential benefits, nor can we do everything under our statutory authority. In addition, options for creating value also may have costs, such as the potential need to hire employees, or increase operation and maintenance to support new capital investments, that must be taken into account.

There may have been times in the past where Chelan PUD made expenditures on actions that would not likely recover their costs without having the funds set aside ahead of time. In the future, we believe that expenditures above and beyond what we need to keep our utility healthy only should be made when we have the dollars available.

As we think about the future of our utility, our greatest challenge is how to prepare simultaneously for those two very different future scenarios – one of plenty, and one of relative financial stress.

If we are successful at our planning efforts, we will be better prepared to take advantage of real opportunities to enhance the quality of life in this community while we shape the future of our utility. Please choose to play an active part.

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