ITEM 1.  BUSINESS

The Corporation

Tennessee Valley Authority ("TVA") is a corporate agency and instrumentality of the United States ("U.S.") that was created in 1933 by legislation enacted by the U.S. Congress in response to a request by President Franklin D. Roosevelt.  TVA was created to, among other things, improve navigation on the Tennessee River, reduce the damage from destructive flood waters within the Tennessee River system and downstream on the lower Ohio and Mississippi Rivers, further the economic development of TVA’s service area in the southeastern United States, and sell the electricity generated at the facilities TVA operates.

Today, TVA operates the nation’s largest public power system and supplies power in most of Tennessee, northern Alabama, northeastern Mississippi, and southwestern Kentucky and in portions of northern Georgia, western North Carolina, and southwestern Virginia to a population of over nine million people.  In 2012 , the revenues generated from TVA’s electricity sales were $11.1 billion and accounted for virtually all of TVA’s revenues.

TVA manages the Tennessee River, its tributaries, and certain shorelines to provide, among other things, year-round navigation, flood damage reduction, and affordable and reliable electricity.  Consistent with these primary purposes, TVA also manages the river system to provide recreational opportunities, adequate water supply, improved water quality, natural resource protection, and economic development.  TVA performs these management duties in cooperation with other federal and state agencies which have jurisdiction and authority over certain aspects of the river system.  The TVA Board of Directors (the "TVA Board") also established a council under the Federal Advisory Council Act to advise TVA on its stewardship activities. TVA’s stewardship responsibilities are conducted within the Tennessee watershed, whose boundaries are similar to, though not exactly the same as, the TVA service area.  TVA’s management of the Tennessee River, its tributaries, and certain shorelines is sometimes referred to as TVA’s “stewardship” program in this Annual Report.

Initially, all TVA operations were funded by federal appropriations.  Direct appropriations for the TVA power program ended in 1959, and appropriations for TVA’s stewardship, economic development, and multipurpose activities ended in 1999.  Since 1999, TVA has funded all of its operations almost entirely from the sale of electricity and power system financings. TVA’s power system financings consist primarily of the sale of debt securities and secondarily of alternative forms of financing such as lease arrangements.  As a wholly-owned government corporation, TVA is not authorized to issue equity securities.

Service Area

The area in which TVA sells power, its service area, is defined by the TVA Act.  Under the TVA Act, subject to certain minor exceptions, TVA may not, without specific authorization from the U.S. Congress, enter into contracts that would have the effect of making it, or the distributor customers of its power, a source of power supply outside the area for which TVA or its distributor customers were the primary source of power supply on July 1, 1957.  This provision is referred to as the “fence” because it bounds TVA’s sales activities, essentially limiting TVA to power sales within a defined service area.

In addition, an amendment to the Federal Power Act ("FPA") includes a provision that helps protect TVA’s ability to sell power within its service area.  This provision, called the "anti-cherrypicking" provision, prevents the Federal Energy Regulatory Commission ("FERC") from ordering TVA to provide access to its transmission lines to others for the purpose of using TVA’s transmission lines to deliver power to customers within TVA’s defined service area.  As a result, the anti-cherrypicking provision reduces TVA’s exposure to loss of customers.

TVA’s revenues by state for each of the last three years are detailed in the table below.

 

Note

See Current Power Supply — Coal-Fired for a discussion of idled coal-fired units .     

Customers

TVA is primarily a wholesaler of power.  It sells power to distributor customers which then resell power to their customers at retail rates.  TVA’s distributor customers consist of (1) municipalities and other local government entities (referred to collectively below as "municipalities") and (2) customer-owned entities ("cooperatives") .  These municipalities and cooperatives operate public power electric systems that are not doing business for profit but are operated primarily for the purpose of supplying electricity to the general public or members.  TVA also sells power to directly served customers, consisting

primarily of federal agencies and customers with large or unusual loads.  In addition, power that exceeds the needs of the TVA system may, where consistent with the provisions of the TVA Act, be sold under exchange power arrangements with other electric systems.

Municipalities and Cooperatives

Revenues from distributor customers accounted for 85 percent of TVA’s total operating revenues in 2012 .  At September 30, 2012 , TVA had wholesale power contracts with 155 municipalities and cooperatives.  Each of these contracts requires distributor customers to purchase from TVA all of their electric power and energy consumed within the TVA service area.

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

The number of distributor customers with the contract arrangements described above, the revenues derived from such arrangements in 2012 , and the percentage of TVA’s 2012 total operating revenues represented by these revenues are summarized in the table below.

Note

(1)  Ordinarily the distributor customer and TVA have the same termination notice period; however, in contracts with six of the distributor customers with five-year termination notices, TVA has a 10-year termination notice (which becomes a five-year termination notice if TVA loses its discretionary wholesale rate-setting authority). Also, under TVA’s contract with Bristol Virginia Utilities, a five-year termination notice may not be given by the distributor customer until January 2018.

TVA’s two largest distributor customers — Memphis Light, Gas and Water Division ("MLGW") and Nashville Electric Service ("NES") — have contracts with five-year and 10-year termination notice periods, respectively.  Although no single customer accounted for 10 percent or more of TVA’s total operating revenues in 2012 , sales to MLGW and NES accounted for nine percent and eight percent, respectively.

The power contracts between TVA and the distributor customers provide for purchase of power by the distributor customers at the wholesale rates established by the TVA Board.  Under section 10 of the TVA Act, the TVA Board is authorized to regulate the municipal and cooperative distributors of TVA power to carry out the purposes of the TVA Act through contract terms and conditions as well as through rules and regulations.  TVA regulates distributor customers primarily through the provisions of TVA’s wholesale power contracts.  All of the power contracts between TVA and the distributor customers require that power purchased from TVA be sold and distributed to the ultimate consumer without discrimination among consumers of the same class, and prohibit direct or indirect discriminatory rates, rebates, or other special concessions.  In addition, there are a number of wholesale power contract provisions through which TVA seeks to ensure that the electric system revenues of the distributor customers are used only for electric system purposes.  Furthermore, almost all of these contracts specify the specific resale rates and charges at which the distributor customers must resell TVA power to their customers.  These rates are revised

from time to time, subject to TVA approval, to reflect changes in costs, including changes in the wholesale cost of power.  The regulatory provisions in TVA’s wholesale power contracts are designed to carry out the objectives of the TVA Act, including the objective of providing for an adequate supply of power at the lowest feasible rates. See Rates — Rate Methodology below.

Other Customers

Revenues from directly served industrial customers accounted for 13 percent of TVA’s total operating revenues in 2012 .  Contracts with these customers are subject to termination by the customer or TVA upon a minimum notice period that varies according to the customer’s contract demand and the period of time service has been provided.

The United States Enrichment Corporation ("USEC"), a subsidiary of USEC, Inc. , is TVA’s largest directly served industrial customer.  Sales to USEC for its Paducah, Kentucky, facility represented five percent of TVA’s total operating revenues in 2012 .  TVA's power supply commitments to USEC end on May 31, 2013.     

Rates

Rate Authority

The TVA Act gives the TVA Board sole responsibility for establishing the rates TVA charges for power.  These rates are not subject to judicial review or to review or approval by any state or federal regulatory body.

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

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

Rate Methodology

In view of demand for electricity and the level of competition, it is reasonable to assume that rates, set at levels that will recover TVA’s costs, can be charged and collected from customers.  Further, the TVA Board has the discretion to determine when costs will be recovered in rates.  As a result of these factors, TVA records certain assets and liabilities that result from the self-regulated ratemaking process that could not otherwise be so recorded under accounting principles generally accepted in the United States.  See Note 1 — Cost-Based Regulation and Note 7 .

In setting rates to cover the costs set out in the TVA Act, TVA uses a wholesale rate structure that is comprised of a base rate and a fuel rate that is automatically determined by the operation of the fuel cost adjustment formula each month.  In setting the base rates, TVA uses a debt-service coverage ("DSC") methodology to derive annual revenue requirements in a manner similar to that used by other public power entities that also use the DSC rate methodology.  Under the DSC methodology, rates are calculated so that an entity will be able to cover its operating costs and to satisfy its obligations to pay principal and interest on debt.  This ratemaking approach is particularly suitable for use by entities financed primarily, if not entirely, by debt capital, such as TVA.

TVA’s revenue requirements for costs or projected costs (other than the fuel, purchased power, and related costs covered by the fuel rate) are calculated under the DSC methodology as the sum of the following components:

This methodology reflects the cause-and-effect relationship between TVA's costs and the corresponding rates TVA charges for its regulated products and services.  Once the revenue requirements (or projected costs) are determined, they are compared to the projected revenues for the year in question, at existing rates, to arrive at the shortfall or surplus of revenues as

compared to the projected costs.  Power rates are adjusted by the TVA Board to a level deemed by the TVA Board to be sufficient to produce revenues approximately equal to projected costs (exclusive of the costs collected through the fuel rate).

TVA’s wholesale and retail rate structures include time-of-use ("TOU") and seasonal demand and energy ("SDE") rate structures.  These rate structures provide price signals intended to incentivize distributor and end-use customers to shift energy usage from high-cost generation periods to less expensive generation periods.  The rates are intended to more closely align TVA's revenues with its costs.

For distributor customers, the default wholesale rate structure is seasonal TOU.  The wholesale rate provisions originally specified the SDE option would expire in September 2012.  In April 2012, the TVA Board approved optional enhanced TOU and SDE structures which became effective in October 2012. TVA recently allowed distributors to elect one of these wholesale rate structures and make retail adjustments consistent with their wholesale elections. Distributor elections went into effect October 1, 2012 as follows: 142 chose the enhanced TOU structure, six chose the default seasonal TOU structure, and seven chose the enhanced SDE structure.

As noted above, TVA’s rates also include a fuel cost recovery mechanism that automatically adjusts TVA's rates each month to recover TVA’s fuel costs which include the costs of natural gas, fuel oil, purchased power, coal, emission allowances, nuclear fuel and other fuel-related commodities; realized gains and losses on derivatives purchased to hedge the costs of such commodities; and tax equivalents associated with the fuel cost adjustments. TVA sometimes refers to this separate fuel rate as the total fuel rate.

Additionally, TVA’s rates include an adjustment to fund investment in equipment associated with TVA's clean air program. This adjustment was approved by the TVA Board in August 2003 and is scheduled to terminate in September 2013.

The TVA Board has not approved any 2013 rate adjustments. See Item 7, Management's Discussion of Financial Condition and Results of Operations — Key Initiatives and Challenges — Ratemaking .

Current Power Supply

General

Power generating facilities operated by TVA at September 30, 2012 , included 29 conventional hydroelectric sites, one pumped-storage hydroelectric site (all units were out of service at September 30, 2012 but one unit returned to limited service on October 24, 2012), 11 coal-fired sites, three nuclear sites, 14 natural gas and/or oil-fired sites (with six units temporarily out of service), two diesel generator sites, 16 solar energy sites, digester gas cofiring capacity at one coal-fired site, biomass cofiring potential (located at coal-fired sites), and one wind energy site (out of service).  TVA acquires power under power purchase agreements of varying durations as well as short-term contracts of less than 24-hours in duration.

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

Note

(1)  Operation and maintenance issues reduced the available renewable generation during 2012, 2011 and 2010 from several facilities, including those utilizing methane, solar, and wind.

Net Capability

The following table summarizes the summer net capability in megawatts ("MW") TVA had available at September 30, 2012 :

Notes

(1)  Net capability is defined as the maximum generating output level a unit can sustain for a given time period with no equipment, operating, or regulatory

restrictions less any plant electrical loads.

(2) Eight MW of cofired methane is accounted for as coal-fired generation rather than being included in TVA Renewable Resources.

(3) Includes only active units. See Current Power Supply — Coal-Fired for a discussion of TVA’s plans for idling coal-fired units.

(4) All four units at Raccoon Mountain were temporarily out of service at September 30, 2012. Unit 2 returned to limited service on October 24, 2012.

(5) See Current Power Supply — Natural Gas and/or Oil-Fired for a discussion of TVA-operated natural gas and/or oil-fired facilities subject to leaseback and long-

term lease arrangements.

(6) Peak firing of simple-cycle combustion turbine units accounts for an additional 257 MW of short term capability.

(7) The Allen Simple-Cycle Facility had four units (64 MW) out of service pending maintenance at September 30, 2012.

(8) The Gallatin Simple-Cycle Facility had two units (144 MW) out of service pending maintenance at September 30, 2012.

(9) The units at the Gleason Simple-Cycle Facility were derated to 360 MW as of September 30, 2012, pending maintenance.

(10) John Sevier Combined-Cycle Facility is a single steam cycle driven by 3 gas turbines (3x1 configuration).

(11) Lagoon Creek is a single steam cycle driven by 2 gas turbines (2x1 configuration).

(12) TVA’s three wind turbines (2 MW nameplate capacity) at its Buffalo Mountain site in Tennessee were not operational as of September 30, 2012. TVA will be conducting studies

to determine options for these assets.  TVA has 0.4 MW of solar installations at 16 sites.

(13) Contract Renewable Resources include Generation Partners, Renewable Standard Offer, and 15 wind turbine generators located on Buffalo Mountain. See

Current Power Supply — Purchased Power and Other Agreements for a discussion on additional renewable energy purchases.

Coal-Fired

TVA began its coal-fired plant construction program in the 1940s, and its coal-fired units were placed in service between 1951 and 1973. Coal-fired units are either active or inactive. TVA considers units to be in an active state when the unit is generating, available for service, or is temporarily unavailable due to equipment failures, inspections, or repairs.  As of September 30, 2012 , TVA had 11 coal-fired plants consisting of 50 active units, accounting for 13,605 MW of summer net capability. As of September 30, 2012 , TVA had nine inactive units. Inactive units may be in three categories: retired, mothballed, or inactive reserve. Retired units are unavailable for service and are not expected to return to service in the future. TVA currently has no retired units. Mothballed units are unavailable for service but can be brought back into service after some maintenance with an appropriate amount of notification, typically weeks or months.  As of September 30, 2012 , TVA had eight mothballed units: Shawnee Fossil Plant ("Shawnee") Unit 10, Johnsonville Fossil Plant ("Johnsonville") Unit 7, and Widows Creek Fossil Plant ("Widows Creek") Units 1-6.  Inactive reserve is the state in which a unit is unavailable for service but can be brought back into service after some minor maintenance in a relatively short duration of time, typically measured in days.  As of September 30, 2012 , TVA had one unit in inactive reserve: Johnsonville Unit 8.  TVA refers to units which are in inactive reserve or mothballed status as idled.

Coal-fired plants have been subject to increasingly stringent regulatory requirements over the last few decades, including those of the Clean Air Act ("CAA") and subsequent laws and regulations. In April 2011, TVA entered into two agreements (collectively, the "Environmental Agreements") .  The first agreement is a Federal Facilities Compliance Agreement with the Environmental Protection Agency ("EPA") .  The second agreement is with Alabama, Kentucky, North Carolina, Tennessee, and three environmental advocacy groups: the Sierra Club, National Parks Conservation Association, and Our Children’s Earth Foundation.  Under the Environmental Agreements, TVA agreed to retire 18 of its 59 coal-fired units by the end of 2017 and was generally absolved from any liability, subject to certain limitations and exceptions, under the New Source Review ("NSR") requirements of the CAA for maintenance, repair, and component replacement projects that were commenced at TVA's coal-fired units prior to the execution of the agreements. Failure to comply with the terms of the Environmental Agreements would subject TVA to penalties stipulated in the agreements. TVA is taking the actions necessary to comply with the Environmental Agreements.

The following table summarizes the retirement actions TVA is required to take under the Environmental Agreements, and the status of those actions.

Notes

(1)  If TVA decides to add emission controls to these units, TVA must continuously operate the emission controls once they are installed.

(2) Convert to renewable biomass.

Exclusive of the actions required under the Environmental Agreements TVA idled Shawnee Unit 10 in October 2010.     

TVA’s long-range plans will continue to attempt to balance the costs and benefits of significant investments at its remaining coal-fired plants without scrubbers and/or SCRs. TVA expects to decide whether to control, convert, or retire its remaining coal-fired capacity on a unit-by-unit schedule.

Transmission upgrades may be required to maintain reliability when some coal-fired units become inactive. TVA invested $48 million in such upgrades between 2011 and 2012, and estimates future expenditures for transmission upgrades to accommodate inactive coal-fired units to be $430 million for 2013 to 2016.

Thermal Challenges Impacting Generation . Generation at Gallatin Fossil Plant ("Gallatin") and Cumberland Fossil Plant ("Cumberland") was curtailed during the summer of 2012 because of high river temperatures and the need to comply with thermal permit limits. These plants are located on the Cumberland River, where summer stream flows have been reduced by the U.S. Army Corps of Engineers to support its remediation work on the Wolf Creek and Center Hill dams. Strategic operation of the affected waterways and TVA's increased reliance on generation from natural gas-fired units has helped TVA manage this challenge.

Coal Combustion Residual Facilities. As a result of the December 2008 ash spill at the Kingston Fossil Plant ("Kingston") , TVA retained an independent third-party engineering firm to perform a multi-phased evaluation of the overall stability and safety of all existing embankments associated with TVA’s wet coal combustion residual ("CCR") facilities.  The first phase of the evaluation, which is finished, involved a detailed inspection of all wet CCR facilities, detailed documentation reviews, and a determination of any immediate actions necessary to reduce risks.  The second phase of the program, which is also complete, included geotechnical explorations, material testing, stability analyses, and studies.  The study showed that none of TVA’s other coal-fired plants showed the same set of conditions that existed at Kingston at the time of the ash spill, and that the ongoing remediation work being done at the plants should bring all of them within industry standards in terms of stability.  The third phase of the program, which is implementation of recommended actions, is ongoing.  This phase includes risk mitigation steps such as performance monitoring, designing and completing repairs, developing planning documents, obtaining permits, and generally implementing the lessons learned from the Kingston ash spill at TVA’s other CCR facilities.  As a part of this effort, an ongoing dam oversight program has been undertaken, and TVA employees have received additional training in dam safety and monitoring.

TVA is planning to convert all of its wet CCR facilities to dry collection facilities. The expected cost of the CCR work is between $1.5 billion and $2.0 billion, and the work is expected to be completed by 2022.  At September 30, 2012 , $428 million of costs had been incurred since the start of the work. See Note 9 for a discussion of the Kingston ash spill.

In December 2010, a leak was identified in the clay liner of the gypsum pond at Kingston. TVA submitted to the Tennessee Department of Environment and Conservation ("TDEC") a two-phase Corrective Action Plan to install a synthetic liner on the gypsum pond. Work on the first phase of the new gypsum storage facility was completed on October 21, 2011, and TDEC approval to place the facility back in operation was received on November 16, 2011. The plan for the second phase of the work has been incorporated into the overall Kingston CCR storage strategy, with the specific phase two work to be completed by January 2015, as part of the CCR conversion program.

TVA is studying the adequacy of CCR storage capacity at other coal-fired plants. If TVA determines that the remaining capacity is not adequate, additional storage facilities will need to be permitted and built or off site disposal will need to be arranged.

* An extension request has been submitted to the NRC. See Nuclear Reactor Licensing below.

Nuclear Regulatory Commission Safety Improvements Orders . On March 9, 2012, the Nuclear Regulatory Commission ("NRC") issued three new safety orders stemming from lessons learned from the 2011 events at the Fukushima Daiichi Nuclear