RESULTS OF OPERATIONS

The following discussion summarizes the major items impacting Nicor Gas’ operating income.

Operating revenues.   Operating revenues are impacted by changes in natural gas costs, which are passed directly through to customers without markup, subject to ICC review.

For the year 2007, revenues increased $175.2 million as compared to 2006 due to colder weather in 2007 (approximately $240 million increase) partially offset by lower natural gas prices (approximately $25 million decrease) and demand unrelated to weather (approximately $12 million decrease).

For the year 2006, revenues decreased $457.3 million as compared to 2005 due to lower natural gas costs (approximately $300 million decrease) and the negative impact of warmer weather than in 2005 (approximately $250 million decrease), partially offset by higher demand unrelated to weather (approximately $35 million increase) and the impact of the base rate increase (approximately $36 million increase).

Margin.   Nicor Gas utilizes a measure it refers to as “margin” to evaluate the operating income impact of revenues.  Revenues include natural gas costs, which are passed directly through to customers without markup, subject to ICC review, and revenue taxes, for which Nicor Gas earns a small administrative fee.  These items often cause significant fluctuations in revenues, and yet they have virtually no direct impact on operating income.

A reconciliation of revenues and margin follows (in millions):

For the year 2007, margin increased $8.1 million from 2006 due to colder weather than in 2006 (approximately $17 million increase), partially offset by lower average distribution rates (approximately $6 million decrease which included the negative impact of approximately $2 million attributable to the ICC’s rate order rehearing decision that went into effect in April 2006) and the impact of customer interest (approximately $2 million decrease).

For the year 2006, margin increased $19.0 million from 2005 due primarily to the impact of the base rate increase (approximately $36 million) and higher demand unrelated to weather (approximately $5 million increase), partially offset by the negative impact of warmer weather than in 2005 (approximately $17 million decrease) and the passage of Chicago Hub revenues through the PGA rider effective with the rate order (approximately $8 million decrease).

Operating and maintenance expense.   The $1.1 million increase in operating and maintenance expense in 2007 as compared with the prior year is due to higher bad debt expense ($14.9 million increase), partially offset by lower company use gas and storage-related gas costs ($13.1 million decrease) attributable primarily to lower prices paid for natural gas.

The $13.6 million increase in operating and maintenance expense in 2006 as compared with the prior year reflects higher storage-related gas costs ($14.9 million increase) and company use gas ($9.9 million increase), partially offset by lower bad debt expense ($4.5 million decrease), net claims arising from normal operations ($4.5 million decrease) and payroll and benefit-related costs ($3.1 million decrease).

The rate order, which became effective in the fourth quarter of 2005, results in certain storage-related gas costs   being   charged to operating and maintenance expense.  Prior to the effective date of the rate order, storage-related gas costs were charged to cost of gas and passed through to customers as part of the PGA rider.

Mercury-related costs (recoveries), net.   Mercury-related costs (recoveries), net reflect the estimated costs, recoveries and reserve adjustments associated with the company’s mercury inspection and repair program.  Mercury-related recoveries in 2007 reflect a $7.2 million reserve adjustment and $0.8 million in cost recoveries recorded during the first quarter of 2007.  During 2006, a mercury-related recovery of $3.8 million was realized from a settlement reached with an independent contractor of Nicor Gas.  Net mercury-related costs (recoveries) were insignificant in 2005.  Additional information about the company’s mercury inspection and repair program is presented in Item 8 – Notes to the Consolidated Financial Statements – Note 16 – Contingencies – Mercury.

Other income (expense), net.   Pretax other income was $6.2 million, $8.9 million and $4.0 million in 2007, 2006 and 2005.

Property sale gains and losses vary from year-to-year depending upon property sales activity.  During 2007 and 2006, Nicor Gas realized pretax gains of $2.0 million and $3.3 million, respectively, on the sale of property.  Property sale gains and losses were insignificant during 2005.  The company continually  assesses its ownership of certain real estate holdings.

Interest income was $5.2 million, $6.3 million and $4.3 million in 2007, 2006 and 2005, respectively.  The decrease of $1.1 million in 2007 from 2006 was due to lower investment balances, offset in part by higher average rates.  The increase of $2.0 million in 2006 from 2005 was due primarily to higher interest rates and investment balances along with increased income from balances on deposit in the Nicor cash management pool.

 

Income tax expense.   The effective income tax rate was 34.0 percent, 32.2 percent and 32.8 percent for 2007, 2006 and 2005, respectively.  The increase in the effective tax rate in 2007 when compared to 2006 is primarily due to higher pretax income (which causes a higher effective income tax rate since permanent differences and tax credits are a smaller share of pretax income).  The decrease in the effective income tax rate in 2006 when compared to 2005 is primarily due to an increase in certain tax credits and permanent items, offset, in part, by higher pretax income.

Interest expense.   Interest expense for 2007 decreased $10.4 million over the year-earlier period.  This decrease primarily reflects the impact of lower interest on income tax matters ($10.9 million decrease).  In the fourth quarter of 2007, Nicor Gas recorded the effects of a settlement with the IRS related to the timing of certain deductions taken as part of a change in accounting method on its 2002 tax return.  As a result of the settlement, Nicor Gas reduced its reserve for interest payable by $10.4 million.

Interest expense for 2006 increased $2.3 million over the year-earlier period.  This increase is primarily due to the impact of higher average interest rates ($1.7 million increase).

FINANCIAL CONDITION AND LIQUIDITY

The company believes it has access to adequate resources to meet its needs for capital expenditures, debt redemptions, dividend payments and working capital.  These resources include net cash flow from operating activities, access to capital markets, lines of credit and short-term investments.

Operating cash flows.   The company’s business is highly seasonal and operating cash flow may fluctuate significantly during the year and from year-to-year due to factors such as weather, natural gas prices, the timing of collections from customers, natural gas purchasing, and storage and hedging practices.  The company relies on short-term financing to meet seasonal increases in working capital needs.  Cash requirements generally increase over the last half of the year due to increases in natural gas purchases, gas in storage and accounts receivable.  During the first half of the year, positive cash flow generally results from the sale of gas in storage and the collection of accounts receivable.  This cash is typically used to substantially reduce, or eliminate, short-term debt during the first half of the year.

Nicor Gas maintains a margin account related to financial derivative transactions.  This margin account may cause large fluctuations in cash needs or sources in a relatively short period of time due to daily settlements resulting from changes in natural gas futures prices.  The company manages these fluctuations with short-term borrowings and investments.

In 2003, Nicor Gas received an income tax refund of approximately $100 million attributable to a tax loss carryback associated with a change in tax accounting method (which increased its deferred income tax liability), subject to IRS review and approval as part of normal ongoing audits.  Through December 31, 2004, the total current tax benefits previously recorded under this accounting method approximated $135 million (amounts recorded were offset by increases to the deferred tax liability with no net effect on reported net federal income tax expense).  In 2005, the IRS revised the regulations pertaining to the aforementioned tax accounting method.  The new regulations required repayment in 2005 and 2006 of amounts previously taken as current tax deductions.  During 2006 and 2005, the company reclassified income tax expense from deferred to current and repaid approximately $135 million equally over those years.

Investing activities.   Net cash flow used for investing activities was $150.8 million, $155.0 million and $184.2 million in 2007, 2006 and 2005, respectively.

Capital expenditures is an internal measure utilized by management that represents cash additions to property, plant and equipment, adjusted for items including the accrual of work performed through period end and other non-cash items, contributions in aid of construction and expenditures associated with asset retirement obligations.

Capital expenditures decreased $5 million to $159 million in 2007 from $164 million in 2006 due to a reduction in costs for information technology system improvements (approximately $7 million decrease) and the impact of lower customer additions (approximately $6 million decrease), partially offset by higher expenditures associated with storage system projects (approximately $5 million increase).

Capital expenditures decreased $22 million to $164 million in 2006 from $186 million in 2005 due, in part, to the absence of expenditures related to the acquisition of a storage compressor in 2005 (approximately $9 million decrease) and a reduction in costs for information technology system improvements (approximately $8 million decrease).  In 2006, the company implemented a new customer care and billing system.

Capital expenditures are expected to increase $66 million to $225 million in 2008 versus 2007 due, in part, to higher expenditures associated with gas distribution, transmission and storage system improvements and facility construction.

Financing activities.   The current credit ratings for Nicor Gas are as follows:

In June 2007, Fitch revised Nicor Gas’ short-term commercial paper rating to “F-1” from “F-1+”.  The revision of Nicor Gas’ short term rating reflects a change by Fitch in its short-term ratings methodology.  Per a Fitch press release dated June 28, 2007, “The short-term rating revision does not reflect any change in the credit profile of Nicor Gas.”

Long-term debt.   The company typically uses the net proceeds from long-term debt for refinancing outstanding debt, for construction programs to the extent not provided by internally generated funds, and for general corporate purposes.

At December 31, 2007, Nicor Gas had the capacity to issue approximately $395 million of First Mortgage Bonds under the terms of its indenture, of which $75 million was available for issuance under a July 2001 shelf registration filing.   Nicor Gas believes it is in compliance with its debt covenants and believes it will continue to remain so.  The long-term debt agreements do not include ratings triggers or material adverse change provisions.  Substantially all properties are subject to the lien of the indenture securing Nicor Gas’ First Mortgage Bonds.

In December 2006, Nicor Gas, through a private placement, issued $50 million of First Mortgage Bonds at 5.85 percent, due in 2036.  Proceeds from this issuance were applied to the $50 million 5.55 percent First Mortgage Bond series, which matured in December 2006.

Short-term debt.   In October 2007, Nicor Gas established a $400 million, 210-day seasonal revolver, which expires in May 2008, to replace the $400 million, 210-day seasonal revolver, which expired in May 2007.  In September 2005, Nicor and Nicor Gas established a $600 million, five-year revolver, expiring September 2010.  These facilities were established with major domestic and foreign banks and serve as backup for the issuance of commercial paper.  The company had $369 million and $350 million of commercial paper borrowings outstanding at December 31, 2007 and 2006, respectively.  The company expects that funding from commercial paper and related backup line-of-credit agreements will continue to be available in the foreseeable future and sufficient to meet estimated cash requirements.

The company expects to refinance the $75 million First Mortgage Bonds due in August 2008.

Common stock.   The company paid dividends of approximately $69 million, $47 million and $37 million in 2007, 2006 and 2005, respectively.  Nicor Gas is restricted by the amount it can dividend to Nicor.  Dividends are only allowed to the extent of Nicor Gas’ retained earnings balance.

Other.   Nicor Gas is restricted by regulation in the amount it can loan to affiliates.  The balance of cash advances from Nicor Gas to an affiliate at any time shall not exceed the unused balance of funds actually available to that affiliate under its existing bank credit agreements or its commercial paper facilities with

 

 

unaffiliated third parties.  In addition, Nicor Gas may not extend cash advances to an affiliate if Nicor Gas has any outstanding short-term borrowings.

Off-balance sheet arrangements.   The company does not have off-balance sheet arrangements that would have a material effect on its financial condition.

Contractual obligations.   As of December 31, 2007, Nicor Gas had contractual obligations with payments due as follows (in millions):

                                                                               

In addition to the contractual obligations included in the table above, Nicor has potential liabilities to taxing authorities (unrecognized tax benefits) which are dependent on the resolution of particular income tax positions.  The timing of future cash outflows, if any, associated with such potential liabilities is uncertain.  The company has accrued estimated unrecognized tax benefits of approximately $1 million at December 31, 2007.

Purchase obligations consist primarily of natural gas purchase agreements, and natural gas transportation and storage contracts.  Natural gas purchase agreements include obligations to purchase natural gas at future market prices, calculated using December 31, 2007 New York Mercantile Exchange futures prices.  The company also has long-term obligations for postretirement benefits which are not included in the above table.  Information regarding the company’s obligations for postretirement benefits can be found in Item 8 – Notes to the Consolidated Financial Statements – Note 9 – Postretirement Benefits.

Operating leases are primarily for office space and equipment.  Rental expense under operating leases was $1.1 million, $1.1 million and $1.0 million in 2007, 2006 and 2005, respectively.  Other long-term obligations consist of redeemable preferred stock.

Nicor Gas signed an agreement in 2006 to purchase approximately 16 Bcf of synthetic natural gas annually for a 20-year term beginning as early as 2010.  Since the agreement is contingent upon various milestones to be achieved by the counterparty to the agreement and the fact that the counterparty can terminate, without penalty, prior to the realization of these milestones, the company’s obligation under this agreement is not certain at this time.

OUTLOOK

Nicor Gas’ outlook assumes normal weather for 2008, but excludes, among other things, any future impacts associated with the ICC’s PBR plan/PGA review or other contingencies.  While these items could materially affect 2008 earnings, they are currently not estimable.

Nicor Gas expects lower pretax operating results due, in part, to higher operating and maintenance and depreciation costs and the absence of mercury-related recoveries.  Operating and maintenance expenses are expected to be higher due primarily to higher payroll and benefit-related costs and bad debt expense.  Nicor Gas also expects earnings to be adversely impacted by the absence of the interest expense reduction recorded in 2007 resulting from the settlement with the IRS related to the timing of certain deductions.

The company estimates that a 100-degree day variation from normal weather would affect Nicor Gas’ net income by approximately $1.6 million.

Nicor Gas is currently not earning its authorized return and is evaluating the need to file for rate relief.  Although Nicor Gas has not reached a final conclusion on whether or when it might file for rate relief, the company will not hesitate to seek relief in an amount fully sufficient to allow it an opportunity to earn a fair rate of return.  The ICC normally has 11 months to complete its review of a general rate filing.

CONTINGENCIES

The following contingencies of Nicor Gas are in various stages of investigation or disposition.  Although in some cases the company is unable to estimate the amount of loss reasonably possible in addition to any amounts already recognized, it is possible that the resolution of these contingencies, either individually or in aggregate, will require the company to take charges against, or will result in reductions in, future earnings.  It is the opinion of management that the resolution of these contingencies, either individually or in aggregate, could be material to earnings in a particular period but is not expected to have a material adverse impact on Nicor Gas’ liquidity or financial condition.

PBR plan .  Nicor Gas’ PBR plan for natural gas costs went into effect in 2000 and was terminated by the company effective January 1, 2003.  Under the PBR plan, Nicor Gas’ total gas supply costs were compared to a market-sensitive benchmark.  Savings and losses relative to the benchmark were determined annually and shared equally with sales customers.  The PBR plan is currently under ICC review.  There are allegations that the company acted improperly in connection with the PBR plan, and the ICC and others are reviewing these allegations.  On June 27, 2002, the Citizens Utility Board (“CUB”) filed a motion to reopen the record in the ICC’s proceedings to review the PBR plan (the “ICC Proceedings”).  As a result of the motion to reopen, Nicor Gas, the Cook County State’s Attorney Office (“CCSAO”), the staff of the ICC and CUB entered into a stipulation providing for additional discovery.  The Illinois Attorney General’s Office (“IAGO”) has also intervened in this matter.  In addition, the IAGO issued Civil Investigation Demands (“CIDs”) to CUB and the ICC staff.  The CIDs ordered that CUB and the ICC staff produce all documents relating to any claims that Nicor Gas may have presented, or caused to be presented, false information related to its PBR plan.  The company has committed to cooperate fully in the reviews of the PBR plan.

In response to these allegations, on July 18, 2002, the Nicor Board of Directors appointed a special committee of independent, non-management directors to conduct an inquiry into issues surrounding natural gas purchases, sales, transportation, storage and such other matters as may come to the attention of the special committee in the course of its investigation.  The special committee presented the report of its counsel (“Report”) to Nicor’s Board of Directors on October 28, 2002.  A copy of the Report is available at the Nicor website and has been previously produced to all parties in the ICC Proceedings.

 

In response, the Nicor Board of Directors directed the company’s management to, among other things, make appropriate adjustments to account for, and fully address, the adverse consequences to ratepayers of the items noted in the Report, and conduct a detailed study of the adequacy of internal accounting and regulatory controls.  The adjustments were made in prior years’ financial statements resulting in a $24.8 million liability.  Included in such $24.8 million liability is a $4.1 million loss contingency.  A $1.8 million adjustment to the previously recorded liability, which is discussed below, was made in 2004 increasing the recorded liability to $26.6 million.  Nicor Gas estimates that there is $26.9 million due to the company from the 2002 PBR plan year, which has not been recognized in the financial statements due to uncertainties surrounding the PBR plan.  In addition, interest due to the company on certain components of these amounts has not been recognized in the financial statements due to the same uncertainties.  By the end of 2003, the company completed steps to correct the weaknesses and deficiencies identified in the detailed study of the adequacy of internal controls.

Pursuant to the agreement of all parties, including the company, the ICC re-opened the 1999 and 2000 purchased gas adjustment filings for review of certain transactions related to the PBR plan and consolidated the reviews of the 1999-2002 purchased gas adjustment filings with the PBR plan review.

On February 5, 2003, the CCSAO and CUB filed a motion for $27 million in sanctions against the company in the ICC Proceedings.  In that motion, CCSAO and CUB alleged that Nicor Gas’ responses to certain CUB data requests were false.  Also on February 5, 2003, CUB stated in a press release that, in addition to $27 million in sanctions, it would seek additional refunds to consumers.  On March 5, 2003, the ICC staff filed a response brief in support of CUB’s motion for sanctions.  On May 1, 2003, the Administrative Law Judges issued a ruling denying CUB and CCSAO’s motion for sanctions.  CUB has filed an appeal of the motion for sanctions with the ICC, and the ICC has indicated that it will not rule on the appeal until the final disposition of the ICC Proceedings.  It is not possible to determine how the ICC will resolve the claims of CCSAO, CUB or other parties to the ICC Proceedings.

In November 2003, the ICC staff, CUB, CCSAO and the IAGO filed their respective direct testimony in the ICC Proceedings.  The ICC staff is seeking refunds to customers of approximately $108 million and CUB and CCSAO were jointly seeking refunds to customers of approximately $143 million.  The IAGO direct testimony alleges adjustments in a range from $145 million to $190 million.  The IAGO testimony as filed is presently unclear as to the amount which IAGO seeks to have refunded to customers.  On February 27, 2004, the above referenced intervenors filed their rebuttal testimony in the ICC Proceedings.  In such rebuttal testimony, CUB and CCSAO amended the alleged amount to be refunded to customers from approximately $143 million to $190 million.  In 2004, the evidentiary hearings on this matter were stayed in order to permit the parties to undertake additional third party discovery from Entergy-Koch Trading, LP (“EKT”), a natural gas, storage and transportation trader and consultant with whom Nicor did business under the PBR plan.  In December 2006, the additional third party discovery from EKT was obtained, Nicor Gas withdrew its previously filed testimony and the Administrative Law Judges issued a scheduling order that provided for Nicor Gas to submit direct testimony by April 13, 2007.  In its direct testimony filed pursuant to the scheduling order, Nicor Gas seeks a reimbursement of approximately $6 million, which includes interest due to the company as noted above of $1.6 million, as of March 31, 2007.  No date has been set for evidentiary hearings on this matter.

During the course of the SEC investigation discussed below, the company became aware of additional information relating to the activities of individuals affecting the PBR plan for the period from 1999 through 2002, including information consisting of third party documents and recordings of telephone conversations from EKT.  Review of additional information completed in 2004 resulted in the $1.8 million adjustment to the previously recorded liability referenced above.

 

Although the Report of the special committee’s counsel did not find that there was criminal activity or fraud, a review of this additional information (which was not available to the independent counsel who prepared the Report) and re-interviews of certain Nicor Gas personnel in 2004 indicated that certain former Nicor Gas personnel may have engaged in potentially fraudulent conduct regarding the PBR plan in violation of company policy, and in possible violation of SEC rules and applicable law.  Further, certain former Nicor Gas personnel also may have attempted to conceal their conduct in connection with an ICC review of the PBR plan.  The company has reviewed all third party information it has obtained and will continue to review any additional third party information the company may obtain.  The company terminated four employees in connection with this matter in 2004.

Nicor Gas is unable to predict the outcome of the ICC’s review or the company’s potential exposure thereunder.  Because the PBR plan and historical gas costs are still under ICC review, the final outcome could be materially different than the amounts reflected in the company’s financial statements as of December 31, 2007.

SEC and U.S. Attorney Inquiries.   In 2002, the staff of the SEC Division of Enforcement (“SEC Staff”) informed Nicor that the SEC was conducting a formal inquiry regarding the PBR plan.  A representative of the Office of the United States Attorney for the Northern District of Illinois (the “U.S. Attorney”) also notified Nicor that that office was conducting an inquiry on the same matter that the SEC was investigating, and a grand jury was also reviewing this matter.  In April 2004, Nicor was advised by the SEC Staff that it intended to recommend to the SEC that it bring a civil injunctive action against Nicor, alleging that Nicor violated Sections 17(a) of the Securities Act of 1933 and Sections 10(b) and 13(a) of the Securities Exchange Act of 1934 and Rules 10b-5, 12b-20, 13a-1 and 13a-13 thereunder.  In July 2006, Nicor announced that it reached a tentative agreement with the SEC Staff in settlement of an anticipated civil action to which Nicor and the SEC would be parties.  The SEC commissioners approved the settlement in March 2007, and a final judgment was entered by a federal court approving the settlement on April 30, 2007.  Under the terms of the settlement, Nicor was required to disgorge one dollar and pay a monetary fine of $10 million and is subject to an injunction prohibiting violations of certain provisions of the federal securities laws.  Nicor neither admits nor denies any wrongdoing.  In July 2006, Nicor deposited the $10 million in escrow.  Those funds were released following entry of the federal court judgment approving the settlement.  Nicor recorded a $10 million charge to its 2006 second quarter earnings in connection with this matter.  As the settlement is between Nicor and the SEC, Nicor Gas did not record a liability associated with the outcome of the SEC matter.  In December 2006, the U.S. Attorney advised that it was closing its separate inquiry and would not seek to prosecute the company in connection with this matter.

Mercury.   Information about mercury contingencies is presented in Item 8 – Notes to the Consolidated Financial Statements – Note 16 – Contingencies – Mercury.

Manufactured gas plant sites.   The company is conducting environmental investigations and remedial activities at former manufactured gas plant sites.  Additional information about these sites is presented in Item 8 – Notes to the Consolidated Financial Statements – Note 16 – Contingencies – Manufactured Gas Plant Sites.

PCBs.   Information about PCB contingencies is presented in Item 8 – Notes to the Consolidated Financial Statements – Note 16 – Contingencies – PCBs.

Municipal Tax Matters.   Information about municipal tax contingencies is presented in Item 8 – Notes to the Consolidated Financial Statements – Note 16 – Contingencies – Municipal Tax Matters.

 

Other contingencies.   The company is involved in legal or administrative proceedings before various courts and agencies with respect to general claims, taxes, environmental, gas cost prudence reviews and other matters.  See Item 8 – Notes to the Consolidated Financial Statements – Note 8 – Income Taxes and Note 16 – Contingencies.

CRITICAL ACCOUNTING ESTIMATES

Nicor Gas prepares its consolidated financial statements in accordance with accounting principles generally accepted in the United States, which regularly require Nicor Gas’ management to exercise judgment in the selection and application of accounting methods.  The application of accounting methods includes making estimates using subjective assumptions and judgments about matters that are inherently uncertain.

The use of estimates and the selection of accounting policies affect Nicor Gas’ reported results and financial condition.  The company has adopted several significant accounting policies and is required to make significant accounting estimates that are important to understanding its financial statements.  These significant policies and estimates are described throughout Item 8 – Notes to the Consolidated Financial Statements.

Although there are numerous areas in which Nicor Gas’ management makes significant accounting estimates, it believes its critical estimates are those that require management’s most difficult and subjective or complex judgments.  Nicor Gas’ management has a practice of reviewing its critical accounting estimates and policy decisions with the audit committee of its board of directors.  Its critical estimates typically involve loss contingencies, derivative instruments, pension and other postretirement benefits, credit risk, unbilled revenues and regulatory assets and liabilities because they are estimates which could materially impact Nicor Gas’ financial statements.

Loss contingencies.   Nicor Gas records contingent losses as liabilities when a loss is both probable and the amount or range of loss, including related legal defense costs, is reasonably estimable.  When only a range of potential loss is estimable, the company records a liability for the minimum anticipated loss.  Nicor Gas is involved in various legal and regulatory proceedings and is exposed to various loss contingencies.  These loss contingencies are in some cases resolved in stages over time, estimates may change significantly from period to period, and the company’s ultimate obligations may differ materially from its recorded amounts.  Of particular note is the PBR plan contingency at Nicor Gas described in Item 8 – Notes to the Consolidated Financial Statements – Note 16 – Contingencies.

Derivative instruments.   The rules for determining whether a contract meets the definition of a derivative instrument or qualifies for hedge accounting treatment are numerous and complex.  The treatment of a single contract may vary from period to period depending upon accounting elections, changes in management’s assessment of the likelihood of future hedged transactions or new interpretations of accounting rules.  As a result, management judgment is required in the determination of the appropriate accounting treatment.  In addition, the estimated fair value of derivative instruments may change significantly from period to period depending upon market projections, and changes in hedge effectiveness may impact the accounting treatment.  These determinations and changes in estimates may have a material impact on reported results.

Pension and other postretirement benefits.   The company’s cost of providing postretirement benefits is dependent upon various factors and assumptions, including life expectancies, the discount rate used in determining the projected benefit obligation, the expected long-term rate of return on plan assets, the long-term rate of compensation increase and anticipated health care costs.  Changes in these assumptions typically do not have a significant impact on the expenses recorded from year to year.  However, actual experience in any one period, particularly the actual return on plan assets, often varies significantly from these mostly long-term assumptions.  When cumulatively significant, the gains and losses generated from

 

 

such variances are amortized into operating income over the remaining service lives of employees covered by the plans (approximately 11 years for the pension plan and 13 years for the health care plan).  Additional information is presented in Item 8 – Notes to the Consolidated Financial Statements – Note 9 – Postretirement Benefits, including plan asset investment allocation, estimated future benefit payments, general descriptions of the plans, significant assumptions, the impact of certain changes in assumptions, and significant changes in estimates.

The company’s estimated postretirement benefit cost included in operating income was $4.8 million, $5.5 million and $9.6 million in 2007, 2006 and 2005, respectively.  Nicor Gas expects to record postretirement benefit cost for 2008 of $2.8 million.  Actuarial assumptions affecting 2008 include an expected rate of return on plan assets of 8.50 percent, consistent with the prior year, and a discount rate of 6.25 percent compared with 5.75 percent a year earlier. The 6.25 percent discount rate was determined by performing a bond matching study and referencing the Citigroup Pension Liability Index rate.  Periodically, the company will perform bond matching studies, using non-callable, high quality bonds (AA- or better), whose expected cash flows match the timing and amount of future benefit payments of the plans.  Such studies have historically yielded a single equivalent discount rate comparable to the Citigroup Pension Liability Index rate.

Credit risk.   Nicor Gas is required to estimate credit risk in establishing allowances for doubtful accounts.  Actual credit losses could vary materially from Nicor Gas’ estimates.  Nicor Gas’ allowance for doubtful accounts at December 31, 2007, 2006 and 2005 was $32.8 million, $30.9 million and $30.1 million, respectively, as presented on Schedule II in Item 15 – Exhibits and Financial Statement Schedules.

Unbilled revenues.   Nicor Gas estimates revenues for natural gas deliveries not yet billed to customers from the last billing date to month-end.  Unbilled revenue estimates are dependent upon a number of customer-usage factors which require management judgment, including weather factors.  These estimates are adjusted when actual billings occur, and variances in estimates can be material.  Accrued unbilled revenues for Nicor Gas at December 31, 2007, 2006 and 2005 were $189.3 million, $158.9 million and $300.4 million, respectively.

Regulatory assets and liabilities.   Nicor Gas is regulated by the ICC, which establishes the rules and regulations governing utility rates and services in Illinois.  As a rate-regulated company, Nicor Gas applies SFAS No. 71, Accounting for the Effects of Certain Types of Regulation , which requires Nicor Gas to recognize the economic effects of rate regulation and, accordingly, has recorded regulatory assets and liabilities.  Regulatory assets represent probable future revenue associated with certain costs that are expected to be recovered from customers through rate riders or base rates, upon approval by the ICC.  Regulatory liabilities represent probable future reductions in revenues collected from ratepayers through a rate rider or base rates.  If Nicor Gas’ operations become no longer subject to the provisions of SFAS No. 71, a write-off of net regulatory liabilities would be required.  Additional information on regulatory assets and liabilities is presented in Item 8 – Notes to the Consolidated Financial Statements – Note 1 – Accounting Policies.

NEW ACCOUNTING PRONOUNCEMENTS

For information concerning FIN No. 48, Accounting for Uncertainty in Income Taxes , SFAS No. 157, Fair Value Measurements , FSP No. FIN 39-1, Amendment of FIN 39, Offsetting of Amounts Related to Certain Contracts , and SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans , see Item 8 – Notes to the Consolidated Financial Statements – Note 2 – New Accounting Pronouncements.

 

CAUTION CONCERNING FORWARD-LOOKING STATEMENTS

This document includes certain forward-looking statements about the expectations of Nicor Gas.  Although Nicor Gas believes these statements are based on reasonable assumptions, actual results may vary materially from stated expectations.  Such forward-looking statements may be identified by the use of forward-looking words or phrases such as “anticipate,” “believe,” “expect,” “intend,” “may,” “planned,” “potential,” “should,” “will,” “would,” “project,” “estimate,” “ultimate”, or similar phrases.  Actual results may differ materially from those indicated in the company’s forward-looking statements due to the direct or indirect effects of legal contingencies (including litigation) and the resolution of those issues, including the effects of an ICC review, and undue reliance should not be placed on such statements.

Other factors that could cause materially different results include, but are not limited to, weather conditions; natural disasters; natural gas prices; fair value accounting adjustments; inventory valuation; health care costs; insurance costs or recoveries; legal costs; borrowing needs; interest rates; credit conditions; economic and market conditions; accidents, leaks, equipment failures, service interruptions, environmental pollution, and other operating risks; energy conservation; legislative and regulatory actions; tax rulings or audit results; asset sales; significant unplanned capital needs; future mercury-related charges or credits; changes in accounting principles, interpretations, methods, judgments or estimates; performance of major customers, transporters, suppliers and contractors; labor relations; and acts of terrorism.

Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this filing.  Nicor Gas undertakes no obligation to publicly release any revision to these forward-looking statements to reflect events or circumstances after the date of this filing.