UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

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

For the Quarterly Period Ended September 30, 2006

or

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

Commission file number 0-19281

THE AES CORPORATION

(Exact name of registrant as specified in its charter)

 

(703) 522-1315

(Registrant’s Telephone Number, Including Area Code)

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 x   No o

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 x      Accelerated filer o      Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o   No x

The number of shares outstanding of Registrant’s Common Stock, par value $0.01 per share, at October 30, 2006, was 664,188,411.

 

THE AES CORPORATION

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006

TABLE OF CONTENTS

 

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PART I:   FINANCIAL INFORMATION

ITEM 1.                 FINANCIAL STATEMENTS

THE AES CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in Millions, Except Per Share Amounts)
(Unaudited)

 

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THE AES CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(Amounts in Millions, Except Shares and Par Value)
(Unaudited)

 

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THE AES CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in millions)
(Unaudited)

 

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THE AES CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1.   FINANCIAL STATEMENT PRESENTATION

Consolidation

The condensed consolidated financial statements include The AES Corporation, its subsidiaries and controlled affiliates (“Company” or “AES”). Furthermore, variable interest entities in which the Company has an interest have been consolidated where the Company is identified as the primary beneficiary. Investments in which the Company has the ability to exercise significant influence but not control are accounted for using the equity method. Intercompany transactions and balances have been eliminated in consolidation.

Interim Financial Presentation

The accompanying unaudited condensed consolidated financial statements and footnotes have been prepared in accordance with generally accepted accounting principles in the United States of America for interim financial information and Article 10 of Regulation S-X of the Securities and Exchange Commission (“SEC”). Accordingly, they do not include all the information and footnotes required by generally accepted accounting principles in the United States of America for annual fiscal reporting periods.

In the opinion of management, the interim financial information includes all adjustments of a normal recurring nature necessary for a fair statement of the results of operations, financial position and cash flows for the interim periods, with the exception of adjustments that were included in the results of operations for the three and nine months ended September 30, 2006 to correct errors related to prior periods that decreased net income by $15 million, or $0.02 diluted earnings per share for the quarter ended September 30, 2006. These adjustments include $20 million of additional income tax expense that was recorded in the current period to correct an error in reported income tax expense for the fourth quarter of 2005 as a result of an incorrect 2004 tax return to accrual adjustment. The Company evaluated the impact of the adjustments and determined that although the income tax error was quantitatively material to the fourth quarter of 2005, the total adjustments were not material on both a quantitative or qualitative basis with respect to net income for any other period, individually or in the aggregate, including the year ended December 31, 2005, the quarter ended September 30, 2006 or for estimated income for the full fiscal year ending 2006. Therefore, the Company has not restated any financial statements for prior periods.

The results of operations for the three and nine months ended September 30, 2006 are not necessarily indicative of results that may be expected for the year ending December 31, 2006.The accompanying condensed consolidated financial statements are unaudited and should be read in conjunction with the audited 2005 consolidated financial statements and notes thereto, which are included in the Company’s Annual Report on Form 10 K for the year ended December 31, 2005 as filed with the SEC on April 4, 2006.

New Accounting Standards

Share-Based Payment.   In December 2004, the Financial Accounting Standards Board (“FASB”) issued a revised Statement of Financial Accounting Standard (“SFAS”) No. 123, “Share-Based Payment,” (“SFAS No. 123R”). AES adopted SFAS No. 123R and related guidance on January 1, 2006. See Note 11 to the condensed consolidated financial statements for disclosure of the Company’s employee stock-based compensation and the effect of the adoption of SFAS No. 123R.

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In April 2006, the FASB issued FASB staff position (“FSP”) FIN 46(R)-6, “Determining the Variability to be Considered in Applying FASB Interpretation No. 46(R)”. This FSP addresses how a reporting enterprise should determine the variability to be considered in applying FIN 46(R). The guidance is to be applied to all entities with which the Company becomes involved and to all entities required to be analyzed under FIN 46(R) when a reconsideration event has occurred beginning the first day of the first reporting period after June 15, 2006. The Company adopted the provisions of this position on July 1, 2006.

In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN No. 48”) which is effective for fiscal years beginning after December 15, 2006. The Company will adopt FIN No. 48 on January 1, 2007 and record the cumulative effect of applying the provisions of this Interpretation as an adjustment to beginning retained earnings. FIN No. 48 applies to all tax positions accounted for in accordance with SFAS No. 109. The Company is determining the impact at this time.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurement” (“SFAS No. 157”). The new standard addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP and expands the disclosure requirements about such measures. The new guidance is effective for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The Company plans to adopt the standard on January 1, 2008. The Company is determining the impact at this time.

In September 2006, the FASB also issued SFAS No. 158 “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (“SFAS No. 158”). The new guidance is effective for fiscal years ending after December 15, 2006. SFAS No. 158 requires a company to recognize the funded status of its defined benefit plans on its balance sheet. In addition, SFAS No. 158 changes the disclosure requirements for plans that are accounted for under SFAS No. 87 and No. 106. The Company will record a cumulative adjustment to adopt the recognition provisions of SFAS No. 158 as of December 31, 2006. While SFAS No. 158 will change certain disclosure information, it will not materially affect the assets, liabilities or equity accounts of the AES balance sheet. The Company does not expect the adoption of SFAS No. 158 to have a material impact on its consolidated financial position or results of operations. The Company will adopt the measurement date provisions of the standard for the fiscal year ending December 31, 2007.

In September 2006, the SEC staff issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 was issued in order to eliminate the diversity of practice surrounding how public companies quantify financial statement misstatements. In SAB 108, the SEC staff established an approach that requires quantification of financial statement misstatements based on the effects of the misstatements on each of the company’s financial statements and the related financial statement disclosures. This model is commonly referred to as a “dual approach” because it requires quantification of errors under both the iron curtain and the rollover methods. The Company will initially apply the provisions of SAB 108 using the cumulative effect transition method in connection with the preparation of our annual financial statements for the year ending December 31, 2006. When the Company initially applies the provisions of SAB 108, the Company does not expect the impact to be material to the financial statements.

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2.   INVENTORY

Inventory consists of the following (in millions):

 

3.   LONG-TERM DEBT

Non-Recourse Debt

Debt Defaults

Subsidiary non-recourse debt in default, classified as current in the accompanying condensed consolidated balance sheet, as of September 30, 2006 is as follows (in millions):

(1)          Kelanitissa is in violation of a covenant under its $65 million credit facility because of a cross default to a material agreement for the plant. The outstanding debt balance as of September 30, 2006 was $63 million.

Edelap had debt in default at three banks as of June 30, 2006. In July 2006, AES (through its subsidiaries) reached an agreement to buy back a loan with a face value of $12 million. On September 26, 2006, Edelap reached an agreement with the other two banks to restructure debt with unpaid principal of $19 million in default at June 30, 2006. Edelap paid $2.3 million in past due principal and interest as part of the restructuring. Interest rates were reduced and the final maturity, which was previously December 2010, was postponed to December 2012. As a result of these agreements, Edelap debt is no longer in default at September 30, 2006.

None of the subsidiaries listed above that are currently in default is a material subsidiary under AES’s corporate debt agreements in order for such defaults to trigger an event of default or permit acceleration under such indebtedness. However, as a result of additional dispositions of assets, other significant reductions in asset carrying values or other matters in the future that may impact our financial position and results of operations, it is possible that one or more of these subsidiaries could fall within the definition of a “material subsidiary” and thereby, upon an acceleration, trigger an event of default and possible acceleration of the indebtedness under the AES parent company’s outstanding debt securities.

As discussed in Note 12 to the Condensed Consolidated Financial Statements, in September 2006, AES’s wholly owned subsidiary, Transgás Empreendimentos S.A. (“Transgás”), sold 33% of Eletropaulo Metropolitana Eletricidade de Sao Paulo S.A. (“Eletropaulo”), a regulated electric utility in Brazil for net proceeds of $522 million. The proceeds from the sale, as well as additional proceeds obtained by Brasiliana Energia (“Brasiliana”) through a bridge facility, enabled Brasiliana to repay debt held by the Brazilian National Development Bank (“BNDES”) in full on October 2, 2006. This debt was repaid prior to the scheduled maturity date. The Company has reclassified $552 million of principal from long-term to current non-recourse debt on the balance sheet at September 30, 2006.

Recourse Debt

Recourse debt obligations are direct borrowings of the parent corporation.

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On March 3, 2006, the Company redeemed all of its outstanding 8.875% senior subordinated debentures (the “Debentures”) due 2027 (approximately $115 million aggregate principal amount). The redemption was made pursuant to the optional redemption provisions of the indenture governing the Debentures. The Debentures were redeemed at a redemption price equal to 100% of the principal amount thereof, plus a make-whole premium of $35 million determined in accordance with the terms of the indenture, plus accrued and unpaid interest up to the redemption date.

The Company entered into a $500 million senior unsecured credit facility agreement effective as of March 31, 2006. On May 1, 2006, the Company exercised its option to extend the total amount of the senior unsecured credit facility by an additional $100 million to a total of $600 million. The credit facility will be used for general corporate purposes and to provide letters of credit to support AES’s investment commitment as well as the underlying funding for the equity portion of its investment in AES Maritza East 1 on an intermediate-term basis. AES Maritza East 1 is a coal-fired generation project that began construction in the second quarter of 2006. At September 30, 2006, the Company had no outstanding borrowings under the senior unsecured credit facility. At September 30, 2006, the company had $397 million of letters of credit outstanding under the senior unsecured credit facility.

4.   EARNINGS PER SHARE

Basic and diluted earnings per share are based on the weighted average number of shares of common stock and potential common stock outstanding during the period. Potential common stock, for purposes of determining diluted earnings per share, includes the effects of dilutive stock options, warrants, deferred compensation arrangements, and convertible securities. The effect of such potential common stock is computed using the treasury stock method or the if-converted method, as applicable.

The following table presents a reconciliation (in millions, except per share amounts) of the numerators and denominators of the basic and diluted earnings per share computation. In the table below, income represents the numerator and shares represent the denominator:

 

The calculation of diluted earnings per share excluded 4,333,643 and 8,543,108 options outstanding at September 30, 2006 and 2005, respectively, because the exercise price of those options exceeded the average market price during the related period. In addition, all convertible debentures were omitted from the earnings per share calculation for the three months ended September 30, 2006 and 2005 because they were anti-dilutive.

 

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The calculation of diluted earnings per share excluded 5,220,546 and 8,543,108 options outstanding at September 30, 2006 and 2005, respectively, because the exercise price of those options exceeded the average market price during the related period. In addition, all convertible debentures were omitted from the earnings per share calculation for the nine months ended September 30, 2006 and 2005 because they were anti-dilutive.

5.   SUMMARIZED INCOME STATEMENT INFORMATION OF AFFILIATES

The following table summarizes financial information (in millions) of the entities in which the Company has the ability to exercise significant influence but does not control, and that are accounted for using the equity method.

 

In accordance with Accounting Principles Board (“APB”) Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock,” the Company discontinues the application of the equity method when an investment is reduced to zero and does not provide for additional losses when the Company does not guarantee the obligations of the investee, or is not otherwise committed to provide further financial support for the investee. The above table excludes income statement information for the Company’s investments in which the Company has discontinued the application of the equity method. Furthermore, in accordance with APB No. 18, the Company’s policy is to resume the application of the equity method if the investee subsequently reports net income only after the Company’s share of that net income equals the share of net losses not recognized during the period the equity method was suspended.

In March 2006, AES’s wholly-owned subsidiary, AES Kingston Holdings, B.V., sold it’s 50% indirect ownership interest in Kingston Cogeneration Limited Partnership (“KCLP”), a 110 MW cogeneration plant located in Ontario, Canada. AES received $110 million in net proceeds for the sale of its investment and recognized a pre-tax gain of $87 million on the sale.

In May 2006, AES, through its wholly-owned subsidiary, AES Grand Itabo, purchased an additional 25% interest in Itabo, a power generation business located in the Dominican Republic for approximately $23 million. Prior to May, the Company held a 25% interest in Itabo indirectly through its Gener subsidiary in Chile and had accounted for the investment using the equity method of accounting. As a result of the transaction, AES now has a 48% economic interest in Itabo, and a majority voting interest, thus requiring consolidation. Through the purchase date in May, AES’s 25% share in Itabo’s net income is included in the “Equity in earnings from affiliates” line item on the income statement. Subsequent to the Company’s purchase of the additional 25% interest, Itabo is reflected as a consolidated entity included at 100% in the financial statements, with an offsetting charge to minority interest expense for the minority shareholders’ interest. The Company engaged a third-party valuation specialist to determine the purchase price allocation for the additional 25% investment. The valuation resulted in fair values of current assets and total liabilities in excess of the purchase price. Therefore, the Company recognized a $21 million after-tax extraordinary gain on the transaction in the second quarter of 2006.

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6.   DISCONTINUED OPERATIONS

In May 2006, the Company reached an agreement to sell 100% of its interest in Eden, a regulated utility located in Argentina. Governmental approval of the transaction is still pending in Argentina, but the Company has determined that the sale is probable at this time. Therefore, Eden, a wholly-owned subsidiary of AES, has been classified as “held for sale” and reflected as such on the face of the financial statements. The Company recognized a $66 million impairment charge to adjust the carrying value of Eden’s assets to their estimated net realizable value. This impairment expense is included in the 2006 net losses for the nine months then ended in the table below. Eden is a distribution company that is part of the Regulated Utilities segment. The sale is expected to close by the end of the year.

An agreement was reached in May 2006 in which the Company agreed to sell AES Indian Queens Power Limited and AES Indian Queens Operations Limited, (collectively “IQP”), which is part of the Competitive Supply segment. IQP is an Open Cycle Gas Turbine, located in the U.K. In September 2006, the sale of IQP was completed. Proceeds from the sale were $28 million in cash and the buyer’s assumption of debt of $30 million. The Company recognized a net gain on the sale of $5 million. The results of operations of IQP and the associated gain on the sale are reflected in the discontinued operations line items on the financial statements.

The following table summarizes the revenue and net income (losses) for these discontinued operations for the three and nine months ended September 30, 2006 and 2005 (in millions):

 

7.   COMMITMENTS AND CONTINGENT LIABILITIES

Environmental

The Company reviews its obligations as they relate to compliance with environmental laws, including site restoration and remediation. As of September 30, 2006, the Company has accrued liabilities of $16 million for projected environmental remediation costs. Because of the uncertainties associated with environmental assessment and remediation activities, future costs of remediation could be higher or lower than the amount currently accrued. Based on currently available information and analysis, the Company believes that it is possible that costs associated with such liabilities or as yet unknown liabilities may exceed current reserves in amounts that could be material, but cannot be estimated as of September 30, 2006.

Financial Commitments

At September 30, 2006, AES had provided outstanding financial and performance related guarantees or other credit support commitments for the benefit of its subsidiaries, which were limited by the terms of the agreements to an aggregate of approximately $529 million (excluding those collateralized by letter of credit and surety bond obligations discussed below).

At September 30, 2006, the Company had $486 million in letters of credit outstanding under the revolving credit facility and under the senior unsecured credit facility that operate to guarantee performance relating to certain project development activities and subsidiary operations. The Company pays a letter of credit fee ranging from 1.63% to 2.64% per annum on the outstanding amounts. In addition, the Company had $1 million in surety bonds outstanding at September 30, 2006.

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Litigation

The Company is involved in certain claims, suits and legal proceedings in the normal course of business. The Company has accrued for litigation and claims where it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. The Company believes, based upon information it currently possesses and taking into account established reserves for estimated liabilities and its insurance coverage that the ultimate outcome of these proceedings and actions is unlikely to have a material adverse effect on the Company’s financial statements. It is possible, however, that some matters could be decided unfavorably to the Company, and could require the Company to pay damages or make expenditures in amounts that could be material but cannot be estimated as of September 30, 2006.

In 1989, Centrais Elétricas Brasileiras S.A. (“Eletrobrás”) filed suit in the Fifth District Court in the State of Rio de Janeiro against Eletropaulo Eletricidade de São Paulo S.A. (“EEDSP”) relating to the methodology for calculating monetary adjustments under the parties’ financing agreement. In April 1999, the Fifth District Court found for Eletrobrás and, in September 2001, Eletrobrás initiated an execution suit in the Fifth District Court to collect approximately R$615.7 million (US$284.5 million) and R$49.4 million (US$22.8 million) from Eletropaulo and CTEEP, respectively (Eletropaulo was spun off of EEDSP in 1998 pursuant to a privatization). Eletropaulo appealed and, in September 2003, the Appellate Court of the State of Rio de Janeiro ruled that Eletropaulo was not a proper party to the litigation because any alleged liability was with CTEEP pursuant to the privatization. Subsequently, both Eletrobrás and CTEEP filed separate appeals to the Superior Court of Justice. In June 2006, the Superior Court of Justice reversed the Appellate Court decision, reintroducing Eletropaulo as a defendant in the execution suit, and remanded the case to the Fifth District Court for further proceedings. Eletropaulo believes it has meritorious defenses to the claims asserted against it and will defend itself vigorously in these proceedings.

In September 1999, a state appellate court in Minas Gerais, Brazil, granted a temporary injunction suspending the effectiveness of a shareholders’ agreement between Southern Electric Brasil Participacoes, Ltda. (“SEB”) and the state of Minas Gerais concerning Companhia Energetica de Minas Gerais (“CEMIG”), an integrated utility in Minas Gerais. The Company’s investment in CEMIG is through SEB. This shareholders’ agreement granted SEB certain rights and powers in respect of CEMIG (“Special Rights”). In March 2000, a lower state court in Minas Gerais held the shareholders’ agreement invalid where it purported to grant SEB the Special Rights and enjoined the exercise of the Special Rights. In August 2001, the state appellate court denied an appeal of the merits decision and extended the injunction. In October 2001, SEB filed two appeals against the state appellate court’s decision, one with the Federal Superior Court and the other with the Supreme Court of Justice. The state appellate court denied access of these appeals to the higher courts, and in August 2002 SEB filed two interlocutory appeals against such denial, one with the Federal Superior Court and the other with the Supreme Court of Justice. In December 2004, the Federal Superior Court declined to hear SEB’s appeal. However, the Supreme Court of Justice is considering whether to hear SEB’s appeal. SEB intends to vigorously pursue a restoration of the value of its investment in CEMIG by all legal means; however, there can be no assurances that it will be successful in its efforts. Failure to prevail in this matter may limit SEB’s influence on the daily operation of CEMIG.

In August 2000, the Federal Energy Regulatory Commission (“FERC”) announced an investigation into the organized California wholesale power markets in order to determine whether rates were just and reasonable. Further investigations involved alleged market manipulation. FERC requested documents from each of the AES Southland, LLC plants and AES Placerita, Inc. AES Southland and AES Placerita have cooperated fully with the FERC investigation. AES Southland was not subject to refund liability because it did not sell into the organized spot markets due to the nature of its tolling agreement. AES Placerita is currently subject to refund liability of $588,000 plus interest for spot sales to the California Power Exchange for the period of October 2, 2000 to June 20, 2001 (“Refund Period”). In September 2004, the Ninth Circuit Court of Appeals issued an order addressing FERC’s decision not to

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impose refunds for the alleged failure to file rates, including transaction specific data, for sales during 2000 and 2001 (“September 2004 Decision”). Although it did not order refunds, the Ninth Circuit remanded the case to FERC for a refund proceeding to consider remedial options. In July 2006, the Ninth Circuit denied rehearing of that order. The Ninth Circuit has temporarily stayed the remand to FERC until March 2, 2007, so that settlement discussions may take place. In addition, in August 2006 in a separate case, the Ninth Circuit issued an order on the scope of refunds and the transactions subject to refunds, confirming the Refund Period but expanding the transactions subject to refunds to include multi-day transactions (“August 2006 Decision”). The August 2006 Decision also expanded the potential liability of sellers to include tariff violations that may have occurred prior to the Refund Period. Further, the August 2006 Decision remanded the matter to FERC. The Ninth Circuit temporarily stayed its August 2006 Decision until the end of February 2007, to facilitate settlement discussions. The August 2006 Decision may allow FERC to reopen closed investigations and to order relief. Placerita made sales during the periods at issue in the September 2004 and August 2006 Decisions. Both appeals may be subject to further court review, and further FERC proceedings on remand would be required to determine potential liability, if any. Prior to the August 2006 Decision, AES Placerita’s liability could have approximated $23 million plus interest. However, given the September 2004 and August 2006 Decisions, it is unclear whether AES Placerita’s potential liability is less than or exceeds that amount. AES Placerita believes it has meritorious defenses to the claims asserted against it and will defend itself vigorously in these proceedings.

In November 2000, the Company was named in a purported class action along with six other defendants, alleging unlawful manipulation of the California wholesale electricity market, allegedly resulting in inflated wholesale electricity prices throughout California. The alleged causes of action include violation of the Cartwright Act, the California Unfair Trade Practices Act and the California Consumers Legal Remedies Act. In December 2000, the case was removed from the San Diego County Superior Court to the U.S. District Court for the Southern District of California. On July 30, 2001, the Court remanded the case to San Diego Superior Court. The case was consolidated with five other lawsuits alleging similar claims against other defendants. In March 2002, the plaintiffs filed a new master complaint in the consolidated action, which reasserted the claims raised in the earlier action and names the Company, AES Redondo Beach, LLC, AES Alamitos, LLC, and AES Huntington Beach, LLC as defendants. In May 2002, the case was removed by certain cross-defendants from the San Diego County Superior Court to the U.S. District Court for the Southern District of California. The plaintiffs filed a motion to remand the case to state court, which was granted on December 13, 2002. Certain defendants appealed aspects of that decision to the U.S. Court of Appeals for the Ninth Circuit. On December 8, 2004, a panel of the Ninth Circuit issued an opinion affirming in part and reversing in part the decision of the District Court, and remanding the case to state court. On July 8, 2005, defendants filed a demurrer in state court seeking dismissal of the case in its entirety. On October 3, 2005, the court sustained the demurrer and entered an order of dismissal. On December 2, 2005, plaintiffs filed a notice of appeal with the California Court of Appeal. The case is now fully briefed on appeal, and the parties are awaiting the Court of Appeal’s decision. The AES defendants believe they have meritorious defenses to the claims asserted against them and will defend themselves vigorously in these proceedings.

In August 2001, the Grid Corporation of Orissa, India (“Gridco”), filed a petition against the Central Electricity Supply Company of Orissa Ltd. (“CESCO”), an affiliate of the Company, with the Orissa Electricity Regulatory Commission (“OERC”), alleging that CESCO had defaulted on its obligations as an OERC-licensed distribution company, that CESCO management abandoned the management of CESCO, and asking for interim measures of protection, including the appointment of an administrator to manage CESCO. Gridco, a state-owned entity, is the sole wholesale energy provider to CESCO. Pursuant to the OERC’s August 2001 order, the management of CESCO was replaced with a government administrator who was appointed by the OERC. The OERC later held that the Company and other CESCO shareholders were not necessary or proper parties to the OERC proceeding. In August 2004, the OERC issued a notice to CESCO, the Company and others giving the recipients of the notice until

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November 2004 to show cause why CESCO’s distribution license should not be revoked. In response, CESCO submitted a business plan to the OERC. In February 2005, the OERC issued an order rejecting the proposed business plan. The order also stated that the CESCO distribution license would be revoked if an acceptable business plan for CESCO was not submitted to, and approved by, the OERC prior to March 31, 2005. In its April 2, 2005 order, the OERC revoked the CESCO distribution license. CESCO has filed an appeal against the April 2, 2005 OERC order and that appeal remains pending in the Indian courts. In addition, Gridco asserted that a comfort letter issued by the Company in connection with the Company’s indirect investment in CESCO obligates the Company to provide additional financial support to cover all of CESCO’s financial obligations to Gridco. In December 2001, Gridco served a notice to arbitrate pursuant to the Indian Arbitration and Conciliation Act of 1996 on the Company, AES Orissa Distribution Private Limited (“AES ODPL”), and Jyoti Structures (“Jyoti”) pursuant to the terms of the CESCO Shareholders Agreement between Gridco, the Company, AES ODPL, Jyoti and CESCO (the “CESCO arbitration”). In the arbitration, Gridco appears to seek approximately $188.5 million in damages plus undisclosed penalties and interest, but a detailed alleged damages analysis has yet to be filed by Gridco. The Company has counterclaimed against Gridco for damages. An arbitration hearing with respect to liability was conducted on August 3-9, 2005 in India. Final written arguments regarding liability were submitted by the parties to the arbitral tribunal in late October 2005. A decision on liability has not yet been issued. Moreover, a petition remains pending before the Indian Supreme Court concerning fees of the third neutral arbitrator and the venue of future hearings with respect to the CESCO arbitration. The Company believes that it has meritorious defenses to the claims asserted against it and will defend itself vigorously in these proceedings.

In December 2001, a petition was filed by Gridco in the local India courts seeking an injunction to prohibit the Company and its subsidiaries from selling their shares in Orissa Power Generation Company Pvt. Ltd. (“OPGC”), an affiliate of the Company, pending the outcome of the above-mentioned CESCO arbitration. OPGC, located in Orissa, is a 420 MW coal-based electricity generation business from which Gridco is the sole off-taker of electricity. Gridco obtained a temporary injunction, but the District Court eventually dismissed Gridco’s petition for an injunction in March 2002. Gridco appealed to the Orissa High Court, which in January 2005 allowed the appeal and granted the injunction. The Company has appealed the High Court’s decision to the Supreme Court of India. In May 2005, the Supreme Court adjourned this matter until August 2005. In August 2005, the Supreme Court adjourned the matter again to await the award of the arbitral tribunal in the CESCO arbitration. The Company believes that it has meritorious claims and defenses and will assert them vigorously in these proceedings.

In early 2002, Gridco made an application to the OERC requesting that the OERC initiate proceedings regarding the terms of OPGC’s existing power purchase agreement (“PPA”) with Gridco. In response, OPGC filed a petition in the India courts to block any such OERC proceedings. In early 2005 the Orissa High Court upheld the OERC’s jurisdiction to initiate such proceedings as requested by Gridco. OPGC appealed that High Court’s decision to the Supreme Court and sought stays of both the High Court’s decision and the underlying OERC proceedings regarding the PPA’s terms. In April 2005, the Supreme Court granted OPGC’s requests and ordered stays of the High Court’s decision and the OERC proceedings with respect to the PPA’s terms. The matter is awaiting further hearing. Unless the Supreme Court finds in favor of OPGC’s appeal or otherwise prevents the OERC’s proceedings regarding the PPA terms, the OERC will likely lower the tariff payable to OPGC under the PPA, which would have an adverse impact on OPGC’s financials. OPGC believes that it has meritorious claims and defenses and will assert them vigorously in these proceedings.

In April 2002, IPALCO Enterprises, Inc. (“IPALCO”) and certain former officers and directors of IPALCO were named as defendants in a purported class action filed in the U.S. District Court for the Southern District of Indiana. On May 28, 2002, an amended complaint was filed in the lawsuit. The amended complaint asserts that IPALCO and former members of the pension committee for the

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Indianapolis Power & Light Company thrift plan breached their fiduciary duties to the plaintiffs under the Employees Retirement Income Security Act by investing assets of the thrift plan in the common stock of IPALCO prior to the acquisition of IPALCO by the Company. In December 2002, plaintiffs moved to certify this case as a class action. The Court granted the motion for class certification on September 30, 2003. On October 31, 2003, the parties filed cross-motions for summary judgment on liability. On August 11, 2005, the Court issued an order denying the summary judgment motions, but striking one defense asserted by defendants. A trial addressing only the allegations of breach of fiduciary duty began on February 21, 2006 and concluded on February 28, 2006. Post-trial briefing was completed on April 20, 2006. The parties are awaiting a ruling by the Court. If the Court rules against the IPALCO defendants, one or more trials on reliance, damages, and other issues will be conducted separately. IPALCO believes it has meritorious defenses to the claims asserted against it and intends to defend itself vigorously in this lawsuit.

In March 2003, the office of the Federal Public Prosecutor for the State of Sao Paulo, Brazil (“MPF”) notified AES Eletropaulo that it had commenced an inquiry related to the Brazilian National Development Bank (“BNDES”) financings provided to AES Elpa and AES Transgás and the rationing loan provided to Eletropaulo, changes in the control of Eletropaulo, sales of assets by Eletropaulo and the quality of service provided by Eletropaulo to its customers, and requested various documents from Eletropaulo relating to these matters. In July 2004, the MPF filed a public civil lawsuit in federal court alleging that BNDES violated Law 8429/92 (the Administrative Misconduct Act) and BNDES’s internal rules by:  (1) approving the AES Elpa and AES Transgás loans; (2) extending the payment terms on the AES Elpa and AES Transgás loans; (3) authorizing the sale of Eletropaulo’s preferred shares at a stock-market auction; (4) accepting Eletropaulo’s preferred shares to secure the loan provided to Eletropaulo; and (5) allowing the restructurings of Light Serviços de Eletricidade S.A. and Eletropaulo. The MPF also named AES Elpa and AES Transgás as defendants in the lawsuit because they allegedly benefited from BNDES’s alleged violations. In June 2005, AES Elpa and AES Transgás presented their preliminary answers to the charges. In May 2006, the federal court ruled that the MPF could pursue its claims based on the first, second, and fourth alleged violations noted above. The MPF subsequently filed an interlocutory appeal seeking to require the federal court to consider all five alleged violations. Also, in July 2006, AES Elpa and AES Transgás filed an interlocutory appeal seeking to enjoin the federal court from considering any of the alleged violations. The MPF’s lawsuit before the federal court has been stayed pending those interlocutory appeals. AES Elpa and AES Transgás believe they have meritorious defenses to the allegations asserted against them and will defend themselves vigorously in these proceedings.

In May 2003, there were press reports of allegations that in April 1998 Light Serviços de Eletricidade S.A. (“Light”) colluded with Enron in connection with the auction of Eletropaulo. Enron and Light were among three potential bidders for Eletropaulo. At the time of the transaction in 1998, AES owned less than 15% of the stock of Light and shared representation in Light’s management and Board with three other shareholders. In June 2003, the Secretariat of Economic Law for the Brazilian Department of Economic Protection and Defense (“SDE”) issued a notice of preliminary investigation seeking information from a number of entities, including AES Brasil Energia, with respect to certain allegations arising out of the privatization of Eletropaulo. On August 1, 2003, AES Elpa responded on behalf of AES-affiliated companies and denied knowledge of these allegations. The SDE began a follow-up administrative proceeding as reported in a notice published on October 31, 2003. In response to the Secretary of Economic Law’s official letters requesting explanations on such accusation, Eletropaulo filed its defense on January 19, 2004. On April 7, 2005 Eletropaulo responded to a SDE request for additional information. On July 11, 2005, the SDE ruled that the case was dismissed due to the passing of the statute of limitations. Subsequently, the case was sent to the Administrative Council for Economic Defense, the Brazilian antitrust authority for final review of the decision.

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AES Florestal, Ltd. (“Florestal”), had been operating a pole factory and had other assets in the State of Rio Grande do Sul, Brazil (collectively, “Property”). AES Florestal had been under the control of AES Sul since October 1997, when AES Sul was created pursuant to a privatization by the Government of the State of Rio Grande do Sul. After it came under the control of AES Sul, AES Florestal performed an environmental audit of the entire operational cycle at the pole factory. The audit discovered 200 barrels of solid creosote waste and other contaminants at the pole factory. The audit concluded that the prior operator of the pole factory, Companhia Estadual de Energia Elétrica (CEEE), had been using those contaminants to treat the poles that were manufactured at the factory. AES Sul and AES Florestal subsequently took the initiative of communicating with Brazilian authorities, as well as CEEE, about the adoption of containment and remediation measures. The Public Attorney’s Office has initiated a civil inquiry (Civil Inquiry n. 24/05) to investigate potential civil liability and has requested that the police station of Triunfo institute a Police Investigation (IP number 1041/05) to investigate the potential criminal liability regarding the contamination at the pole factory. The environmental agency (“FEPAM”) has also started a procedure (Procedure n. 088200567/05-9) to analyze the measures that shall be taken to contain and remediate the contamination. The measures that must be taken by AES Sul and CEEE are still under discussion. In 2005, the control of AES Florestal was transferred from AES Sul to AES Guaíba II in accordance with Federal Law n. 10848/04. AES Florestal subsequently became a non-operative company. Also, in March 2000, AES Sul filed suit against CEEE in the 2nd Court of Public Treasure of Porto Alegre seeking to register in AES Sul’s name the Property that it acquired through the privatization but that remained registered in CEEE’s name. During those proceedings, a court-appointed expert acknowledged that AES Sul had paid for the Property but opined that the Property could not be re-registered in AES Sul’s name because CEEE did not have authority to transfer the Property through the privatization. Therefore, AES waived its claim to re-register the Property and asserted a claim to recover the amounts paid for the Property. That claim is pending. Moreover, in February 2001, CEEE and the State of Rio Grande do Sul brought suit in the 7th Court of Public Treasure of Porto Alegre against AES Sul, AES Florestal, and certain public agents that participated in the privatization. The plaintiffs alleged that the public agents unlawfully transferred assets and created debts during the privatization. In November 2005, the Court ruled that the Property must be returned to CEEE. Subsequently, AES Sul and CEEE jointly possessed the pole factory for a time, but CEEE has had sole possession of the pole factory since April 2006. The rest of the Property will be returned to CEEE after inspection by a court-appointed expert.

On January 27, 2004, the Company received notice of a “Formulation of Charges” filed against the Company by the Superintendence of Electricity of the Dominican Republic. In the “Formulation of Charges,” the Superintendence asserts that the existence of three generation companies (Empresa Generadora de Electricidad Itabo, S.A., Dominican Power Partners, and AES Andres BV) and one distribution company (Empresa Distribuidora de Electricidad del Este, S.A.) in the Dominican Republic, violates certain cross-ownership restrictions contained in the General Electricity law of the Dominican Republic. On February 10, 2004, the Company filed in the First Instance Court of the National District of the Dominican Republic (“Court”) an action seeking injunctive relief based on several constitutional due process violations contained in the “Formulation of Charges” (“Constitutional Injunction”). On or about February 24, 2004, the Court granted the Constitutional Injunction and ordered the immediate cessation of any effects of the “Formulation of Charges,” and the enactment by the Superintendence of Electricity of a special procedure to prosecute alleged antitrust complaints under the General Electricity Law. On March 1, 2004, the Superintendence of Electricity appealed the Court’s decision. On or about July 12, 2004, the Company divested any interest in Empresa Distribuidora de Electricidad del Este, S.A. The Superintendence of Electricity’s appeal is pending. The Company believes it has meritorious defenses to the claims asserted against it and will defend itself vigorously in these proceedings.

In July 2004, the Corporación Dominicana de Empresas Eléctricas Estatales (“CDEEE”) filed two lawsuits against Empresa Generadora de Electricidad Itabo, S.A. (“Itabo”), an affiliate of the Company,

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one in the First Chamber of the Civil and Commercial Court of First Instance for the National District (“First Chamber”), and the other in the Fifth Chamber of the Civil and Commercial Court of First Instance of the National District (“Fifth Chamber”). In both lawsuits, CDEEE alleges that Itabo spent more than was necessary to rehabilitate two generation units of an Itabo power plant, and, in the Fifth Chamber lawsuit, that those funds were paid to affiliates and subsidiaries of AES Gener and Coastal Itabo, Ltd. (“Coastal”) without the required approval of Itabo’s board of administration. Both AES Gener and Coastal were private shareholders of Itabo at the time of the rehabilitation, which was performed from January 2000 to September 2003, but in May 2006 Coastal sold its interest in Itabo to an indirect subsidiary of the Company. In the First Chamber lawsuit, CDEEE seeks an order that Itabo provide an accounting of its transactions relating to the rehabilitation. In November 2004, the First Chamber dismissed the case for lack of legal basis. In February 2005, CDEEE appealed the decision to the Court of Appeals of Santo Domingo, which in October 2005 decided the appeal in Itabo’s favor, reasoning that it lacked jurisdiction over the dispute because the parties’ contracts mandated arbitration. In January 2006, CDEEE appealed the Court of Appeals’ decision to the Supreme Court of Justice, which is considering the appeal. In the Fifth Chamber lawsuit, which also names Itabo’s former president as a defendant, CDEEE requests an order that requiring, among other things, Itabo to pay approximately $15 million in damages and the assets of Itabo to be seized for any failure to comply with the order. In October 2005, the Fifth Chamber held that it lacked jurisdiction to adjudicate the dispute given the arbitration provisions in the parties’ contracts, which decision was ratified by the First Chamber of the Court of Appeal in September 2006. In a related proceeding, in May 2005, Itabo filed a lawsuit in the U.S. District Court for the Southern District of New York seeking to enjoin CDEEE from prosecuting its claims in the Dominican Republic courts and to compel CDEEE to arbitrate its claims against Itabo. The petition was denied in July 2005, and Itabo appealed that decision to the U.S. Court of Appeal for the Second Circuit in September 2005. The Second Circuit stayed the appeal in September 2006. In another related proceeding, in February 2005, Itabo initiated arbitration against CDEEE and the Fondo Patrimonial de las Empresas Reformadas (“FONPER”) in the International Chamber of Commerce (“ICC”) seeking, among other relief, to enforce the arbitration provisions in parties’ contracts. In March 2006, Itabo and FONPER executed an agreement resolving all of their respective claims in the arbitration, which agreement was subsequently approved by the ICC. Itabo and CDEEE later attended an evidentiary hearing before the arbitral tribunal on the remaining claims in the arbitration. In September 2006, the ICC issued a decision that it lacked jurisdiction to decide the arbitration. Itabo believes it has meritorious claims and defenses and will assert them vigorously in these proceedings.

In October 2004, Raytheon Company (“Raytheon”) filed a lawsuit against AES Red Oak LLC (“Red Oak”) in the Supreme Court of the State of New York, County of New York. The complaint purports to allege claims for breach of contract, fraud, interference with contractual rights and equitable relief relating to the construction and/or performance of the Red Oak project, an 800 MW combined cycle power plant in Sayreville, New Jersey. The complaint seeks the return from Red Oak of approximately $30 million that was drawn by Red Oak under a letter of credit that was posted by Raytheon for the construction and/or performance of the Red Oak project. Raytheon also seeks $110 million in purported additional expenses allegedly incurred by Raytheon in connection with the guaranty and construction agreements entered with Red Oak. In December 2004, Red Oak answered the complaint and filed breach of contract and fraud counterclaims against Raytheon. In March 2005, Raytheon filed a partial motion for summary judgment seeking return of approximately $16 million of the letter of credit draw, which sum allegedly represented the amount of the draw that had yet to be utilized for the performance/construction issues. Red Oak filed an opposition to the motion in April 2005. Raytheon also filed a motion to dismiss Red Oak’s fraud counterclaims, which Red Oak opposed in April 2005. In December 2005, the Court dismissed Red Oak’s fraud counterclaims and ordered Red Oak to pay Raytheon approximately $16.3 million plus interest. In April 2006, Red Oak paid Raytheon approximately $16.3 million, plus approximately $1.8 million in interest. Pursuant to a joint stipulation, in May 2006, Raytheon posted a new credit in the amount of

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approximately $16.3 million. Discovery in the case is ongoing. In July 2006, Red Oak appealed the dismissal of its fraud counterclaims to the Appellate Division of the Supreme Court. Raytheon also filed a related action against Red Oak in the Superior Court of Middlesex County, New Jersey, in May 2005, seeking to foreclose on a construction lien filed against property allegedly owned by Red Oak, in the amount of $31 million. Red Oak was served with the Complaint in September 2005, and filed its answer, affirmative defenses, and counterclaim in October 2005. Raytheon has stated that it wishes to stay the New Jersey action pending the outcome of the New York action. Red Oak has not decided whether it wishes to oppose the lien or consent to a stay. Red Oak believes it has meritorious claims and defenses and will assert them vigorously in these proceedings.

In January 2005, the City of Redondo Beach (“City”), California, issued an assessment against Williams Power Co., Inc., (“Williams”) and AES Redondo Beach, LLC (“AES Redondo”), an indirect subsidiary of the Company, for approximately $71.7 million in allegedly overdue utility users’ tax (“UUT”), interest, and penalties relating to the natural gas used at AES Redondo’s power plant from May 1998 through September 2004 to generate electricity. After an administrative hearing on AES Redondo’s and Williams’ respective objections to the assessment, in September 2005, the Tax Administrator issued a decision holding AES Redondo and Williams jointly and severally liable for approximately $56.7 million, over $20 million of which constituted interest and penalties. In October 2005, AES Redondo and Williams filed their respective appeals of that decision with the City Manager, who appointed a hearing officer to decide the appeal. A schedule to hear and decide the appeal has not been established. In addition, in July 2005, AES Redondo filed a lawsuit in Los Angeles Superior Court seeking a refund of UUT paid since February 2005, and an order that the City cannot charge AES Redondo UUT going forward. Williams later filed a similar complaint that was related to AES Redondo’s lawsuit. At an August 2006 hearing on the City’s demurrers to AES Redondo’s and Williams’ respective complaints, the Superior Court addressed whether AES Redondo and Williams must prepay to the City any allegedly owed UUT prior to judicially challenging the merits of the UUT, and ordered further briefing on that issue. In September 2006, the Superior Court issued an order denying the demurrers. At October 2006 hearing, the Superior Court phased the case to address the City’s objections based on administrative exhaustion and the pay-first-litigate-later doctrine, which potentially requires a taxpayer to prepay taxes allegedly owed before challenging the merits of those taxes in court. The Superior Court also directed the City to file a motion for summary judgment on those objections, which is scheduled to be heard on February 28, 2007. The Superior Court further authorized discovery on the City’s objections, but otherwise stayed the case pending the outcome of the City’s anticipated motion for summary judgment. Furthermore, in December 2005 and January, June, and September 2006, the Tax Administrator issued assessments against AES Redondo and Williams totaling approximately $4 million for allegedly overdue UUT on the gas used at the power plant from October 2004 through June 2006 (collectively, “New UUT Assessments”). AES Redondo has objected to those and any future UUT assessments. The Tax Administrator has stated that AES Redondo’s objections to the December 2005 UUT assessment are moot in light of his September 2005 decision, which, as noted above, is on appeal. The Tax Administrator has not scheduled a hearing on the New UUT assessments, but has indicated that if there is one he will only address the amount of those assessments, not the merits of them. AES Redondo believes that it has meritorious claims and defenses and will assert them vigorously in these proceedings.

In February 2006, the local Kazakhstan tax commission imposed an environmental fine of approximately $4 million (including interest) on Maikuben West mine, for alleged unauthorized disposal of overburden in the mine during 2003 and 2004. Maikuben West is currently disputing the fine. The commission also imposed a fine of approximately $54,000 for alleged unauthorized drain water discharge during 2004. This fine has been paid.

In March 2006, the Government of the Dominican Republic and Secretariat of State of the Environment and Natural Resources of the Dominican Republic (collectively, “Government of the

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Dominican Republic”) filed a complaint in the U.S. District Court for the Eastern District of Virginia against The AES Corporation, AES Aggregate Services, Ltd., AES Atlantis, Inc., and AES Puerto Rico, LP (collectively, “AES Defendants”), and unrelated parties, Silver Spot Enterprises and Roger Charles Fina. In June 2006, the Government of the Dominican Republic filed a substantially similar amended complaint against the defendants, alleging that the defendants improperly disposed of “coal ash waste” in the Dominican Republic, and that the alleged waste was generated at AES Puerto Rico’s power plant in Guayama, Puerto Rico. Based on these allegations, the amended complaint asserts seven claims against the defendants:  violation of 18 U.S.C. §§ 1961-68, the Racketeer Influenced and Corrupt Organizations Act (“RICO Act”); conspiracy to violate section 1962(c) of the RICO Act; civil conspiracy to violate the Foreign Corrupt Practices Act (“FCPA”) and other unspecified laws concerning bribery and waste disposal; aiding and abetting the violation of the FCPA and other unspecified laws concerning bribery and waste disposal; violation of unspecified nuisance law; violation of unspecified product liability law; and violation of 28 U.S.C. § 1350, the Alien Tort Statute (which the Government of the Dominican Republic later voluntarily dismissed without prejudice). While the amended complaint does not specify the amount of alleged damages sought from the defendants, the Government of the Dominican Republic and its attorneys have stated in press reports that it is seeking to recover at least $80 million. The AES Defendants have filed a motion to dismiss the lawsuit in its entirety for failure to state a claim upon which relief can be granted. The district court has taken the motion to dismiss under advisement. The AES Defendants believe they have meritorious defenses to the claims asserted against them and will defend themselves vigorously in this lawsuit.

AES Eastern Energy voluntarily disclosed to the New York State Department of Environmental Conservation (“NYSDEC”) and the U.S. Environmental Protection Agency (“EPA”) on November 27, 2002 that nitrogen oxide (“NOx”) exceedances appear to have occurred on October 30 and 31, and November 1-8 and 10 of 2002. The exceedances were discovered through an audit by plant personnel of the Plant’s NOx Reasonably Available Control Technology (“RACT”) tracking system. Immediately upon the discovery of the exceedances, the selective catalytic reduction (“SCR”) at the Somerset plant was activated to reduce NOx emissions. AES Eastern Energy learned of a notice of violation (the “NOV”) issued by the NYSDEC for the NOx RACT exceedances through a review of the November 2004 release of the EPA’s Enforcement and Compliance History (“ECHO”) database. However, AES Eastern Energy has not yet seen the NOV from the NYSDEC. AES Eastern Energy is currently negotiating with NYSDEC concerning this matter.

In June 2006, AES Ekibastuz was found to have breached a local tax law by failing to obtain a license for use of local water for the period of January 1, 2005 through October 3, 2005, in a timely manner. As a result, an additional permit fee was imposed, brining the total permit fee to approximately $135,000. The company has appealed this decision to the Supreme Court.

In October 2006, the Constitutional Chamber of the Venezuelan Supreme Court decided that it would review a lawsuit filed in 2000 alleging that the Company’s acquisition of a controlling stake in C.A. La Electricidad de Caracas (“EDC”) in 2000 is void because the acquisition was not approved by the Venezuelan National Assembly. The Supreme Court also ordered that EDC and other interested persons be notified of its decision to review the lawsuit. AES believes that it complied with all existing laws with respect to the acquisition and that there are meritorious defenses to the allegations in this lawsuit.

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Tax Examinations

The Company and certain of its subsidiaries are under examination by the relevant taxing authorities for various tax years. The Company regularly assesses the potential outcome of these examinations in each of the taxing jurisdictions when determining the adequacy of the provision for income taxes. Tax reserves have been established, which the Company believes to be adequate in relation to the potential for additional assessments. Once established, reserves are adjusted only when there is more information available or when an event occurs necessitating a change to the reserves. While the Company believes that the amount of the tax estimates is reasonable, it is possible that the ultimate outcome of current or future examinations may exceed current reserves in amounts that could be material but cannot be estimated as of September 30, 2006.

Other

In exchange for the termination of $863 million of outstanding Brasiliana Energia (“Brasiliana”) debt and accrued interest during 2004, the Brazilian National Development Bank (“BNDES”) received $90 million in cash, 53.85% ownership of Brasiliana and a one-year call option (“Sul Option”) to acquire a 53.85% ownership interest of Sul. The Sul Option, which would require the Company to contribute its equity interest in Sul to Brasiliana, became exercisable on December 22, 2005. In June 2006, BNDES and AES reached an agreement to terminate the Sul Option in exchange for the transfer of another wholly owned AES subsidiary, AES Infoenergy Ltda., to Brasiliana and $15 million in cash. The agreement closed on August 15, 2006 resulting in a gain on sale of investment of $9 million, net of income taxes of $1 million, including the extinguishment of the Sul Option.

8.   COMPREHENSIVE INCOME (LOSS)

The components of comprehensive income for the three and nine months ended September 30, 2006 and 2005 are as follows (in millions):

 

Accumulated other comprehensive loss is as follows (in millions) at September 30, 2006:

 

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9.   SEGMENTS

AES reports its financial results in three business segments of the electricity industry: Regulated Utilities, Contract Generation and Competitive Supply. Although the product—electricity—is the same in all three segments, the segments are differentiated by the nature of the customers, operational differences, cost structure, regulatory environment and risk exposure.

·       The Regulated Utilities segment primarily consists of 14 distribution companies in seven countries that maintain a franchise within a defined service area.

·       The Contract Generation segment consists of 73 power generation facilities in 16 countries that have contractually limited their exposure to electricity price volatility by entering into long-term (five years or longer) power sales agreements for 75% or more of their output capacity. Exposure to fuel supply risks is also limited through long-term fuel supply contracts or through tolling arrangements. These contractual agreements generally reduce exposure to fuel commodity and electricity price volatility, and thereby increase the predictability of their cash flows and earnings.

·       The Competitive Supply segment consists primarily of 23 power plants selling electricity to wholesale customers in six countries through competitive markets, and as a result, the cash flows and earnings of such businesses are more sensitive to fluctuations in the market price of electricity, natural gas, coal, oil and other fuels.

Information about the Company’s operations by segment for the three and nine months ended September 30, 2006 and 2005, respectively, is as follows (in millions):

As disclosed in Note 21 to the Consolidated Financial Statements included in Item 8 of Form 10-K filed with the Securities and Exchange Commission on April 4, 2006, beginning in the second quarter of 2005, the large utilities and growth distribution segments were merged into one segment entitled “Regulated Utilities.” The Company’s segment information for the three and nine months ended September 30, 2005 has been restated to conform to the 2006 segment presentation.

(1)          Sales between the segments (“intersegment revenues”) are accounted for on an arm’s-length basis as if the sales were to third parties. Intersegment revenues for the three months ended September 30, 2006 and 2005 were $257 million and $212 million, respectively, and $766 million and $563 million for the nine months ended September 30, 2006 and 2005, respectively. These amounts have been eliminated in the appropriate segment. Sales from our Brazil generation business, Tietê (reported in the Contract Generation segment), to our Brazil distribution company, Eletropaulo (reported in the Regulated Utilities segment), are eliminated within the Regulated Utilities segment due to the pass through nature of these costs. These intersegment revenues were $170 million and $132 million for the three months ended September 30, 2006 and September 30, 2005, respectively, and $507 million and $345 million for the nine months ended September 30, 2006 and September 30, 2005, respectively.

(2)          For consolidated subsidiaries, the Company uses gross margin as a measure of profit or loss for the Company’s reportable segments. Gross margin equals revenues less cost of sales on the condensed consolidated statement of operations for each period presented.

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Information about the Company’s assets by segment as of September 30, 2006 and December 31, 2005, respectively, is as follows (in millions):

 

10.   BENEFIT PLANS

Total pension cost for the three and nine months ended September 30, 2006 and 2005 includes the following components (in millions):

 

The total amounts of employer contributions paid for the nine months ended September 30, 2006 were $40 million for the U.S. subsidiaries and $160 million for foreign subsidiaries. The expected remaining scheduled annual employer contributions for 2006 are less than $1 million for U.S. subsidiaries, and $41 million for foreign subsidiaries.

11.   STOCK-BASED COMPENSATION

In December 2004, the FASB issued a revised SFAS No. 123, “Share-Based Payment.” SFAS No. 123R eliminates the intrinsic value method as an alternative method of accounting for stock-based awards under APB No. 25 by requiring that all share-based payments to employees, including grants of stock options for all outstanding years, be recognized in the financial statements based on their fair values. It also revises the fair value-based method of accounting for share-based payment liabilities, forfeitures and modifications of stock-based awards and clarifies the guidance under SFAS No. 123 related to measurement of fair value, classifying an award as equity or as a liability and attributing compensation to reporting periods. In addition, SFAS No. 123R amends SFAS No. 95, “Statement of Cash Flows,” to require that excess tax benefits be reported as a financing cash flow rather than as an operating cash flow.

Effective January 1, 2003, the Company adopted the fair value recognition provision of SFAS No. 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure,” prospectively for all employee awards granted, modified or settled after January 1, 2003. AES adopted SFAS No. 123R and related guidance on January 1, 2006, using the modified prospective transition method. Under this transition method, compensation cost will be recognized (a) based on the requirements of SFAS No. 123R for all share-based awards granted subsequent to January 1, 2006 and (b) based on the original provisions of SFAS No. 123 for all awards granted prior to January 1, 2006, but

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not vested as of this date. Results for prior periods will not be restated. The total number of shares authorized for awards of options and restricted stock units is 10 million at September 30, 2006.

Stock Options

AES grants options to purchase shares of common stock under stock option plans. Under the terms of the plans, the Company may issue options to purchase shares of the Company’s common stock at a price equal to 100% of the market price at the date the option is granted. Stock options are generally granted based upon a percentage of an employee’s base salary. Stock options issued under these plans in 2004, 2005 and 2006 have a three year vesting schedule and vest in one-third increments over the three year period. The stock options have a contractual term of 10 years. In all circumstances, stock options granted by AES do not entitle the holder the right, or obligate AES, to settle the stock option in cash or other assets of AES.

The weighted average fair value of each option grant has been estimated, as of the grant date, using the Black-Scholes option-pricing model with the following weighted average assumptions:

 

N/A—There were no options granted during the three months ended September 30, 2006.

Prior to January 1, 2006, the Company used the historic volatility of the daily closing price of its stock over the same term as the expected option term, as its expected volatility to determine the fair value using the Black-Scholes option-pricing model. Beginning January 1, 2006, the Company exclusively relies on implied volatility as the expected volatility to determine the fair value using the Black-Scholes option-pricing model. The implied volatility may be exclusively relied upon due to the following factors:

·       The Company utilizes a valuation model that is based on a constant volatility assumption to value its employee share options;

·       The implied volatility is derived from options to purchase AES stock that are actively traded;

·       The market prices of both the traded options and the underlying share are measured at a similar point in time to each other and on a date reasonably close to the grant date of the employee share options;

·       The traded options have exercise prices that are both near-the-money and close to the exercise price of the employee share options; and

·       The remaining maturities of the traded options on which the estimate is based are at least one year.

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