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Article by DailyStocks_admin    (08-18-08 05:53 AM)

Reliant Energy Inc. CEO MARK M JACOBS bought 25000 shares on 8-08-2008 at $17.03

BUSINESS OVERVIEW

Business

General

We provide electricity and energy services to retail and wholesale customers through two business segments.


• Retail energy —provides electricity and energy services to more than 1.8 million retail electricity customers in Texas, including residential and small business customers and commercial, industrial and governmental/institutiona l customers. Our next largest market is the PJM Market, where we serve commercial, industrial and governmental/institutiona l customers. We regularly evaluate entering additional markets.

• Wholesale energy —provides electricity and energy services in the competitive wholesale energy markets in the United States through our ownership and operation of or contracting for power generation capacity. As of December 31, 2007, we had approximately 16,000 MW of power generation capacity.

For information about our corporate history, business segments and disposition activities, see notes 1, 18, 20, 21 and 22 to our consolidated financial statements and “Selected Financial Data” in Item 6 of this Form 10-K.

Retail Energy

As a retail electricity provider, we arrange for the transmission and delivery of electricity to our customers, bill customers and collect payment for electricity sold, and maintain call centers to provide customer service. We purchase the electricity we sell to customers from generation companies, utilities, power marketers and other retail energy companies in the wholesale market. We obtain our transmission and distribution services in Texas from entities regulated by the PUCT.

Our retail business for residential and small business customers is primarily concentrated in Texas. Based on metered locations, as of December 31, 2007, we had approximately 1.6 million residential and 147,000 small business customers, making us the second largest mass market electricity provider in Texas. Approximately 65% of our Texas customers are in the Houston area. We also have customers in other Texas cities, including Dallas, Ft. Worth and Corpus Christi.

In Texas and the PJM Market, we market electricity and energy services to commercial, industrial and governmental/institutiona l customers. These customers include refineries, chemical plants, manufacturing facilities, hospitals, universities, governmental agencies, restaurants and other facilities. Based on metered locations, as of December 31, 2007, we had approximately 93,000 commercial, industrial and governmental/institutiona l customers.

During 2007, we began to pilot residential and small business products and services in Texas that use advanced technology to help reduce customer consumption during peak usage periods. “Smart Energy” products are expected to lower our supply and operating costs, moderate consumer bills, reduce emissions and enhance our position as a retail market leader.

Under our supply strategy for our retail business, we structure our supply portfolio to match our load demands by procuring sufficient power prior to or concurrent with entering into retail sales commitments. Because of our credit-enhanced retail structure with a third party credit provider, we are not required to post collateral for our retail supply purchases.

Wholesale Energy

As of December 31, 2007, we owned, had an interest in or leased 38 operating electric power generation facilities with an aggregate net generating capacity of 16,337 MW in five regions of the United States. The net generating capacity of these facilities consists of approximately 42% base-load, 34% intermediate and 24% peaking capacity.

We sell electricity and energy services from our generation portfolio in hour-ahead, day-ahead and forward markets in bilateral and ISO markets. We sell these products to investor-owned utilities, municipalities, cooperatives and other companies that serve end users or purchase power at wholesale for resale. We obtain transmission and distribution services for our power generation from ERCOT, various RTOs, utilities and municipalities. Because our facilities are not subject to traditional cost-based regulation, we can generally sell electricity at market-determined prices.

Through the PJM Market’s reliability pricing model auctions, we have committed approximately 6,400 MW of capacity through the planning year ending May 2011. We expect that a substantial portion of our capacity that clears a PJM auction will continue to be committed to the PJM Market up to three years in advance. Revenue from these capacity sales is determined by market rules designed to ensure regional reliability, encourage competition and reduce price volatility. The California Public Utility Commission and Cal ISO are considering possible enhancements to existing resource adequacy requirements, including alternatives similar to capacity markets designed in New England and PJM.

To ensure adequate fuel supplies, we contract for natural gas, coal and fuel oil for our generation facilities. For our natural gas-fired plants, we also arrange for, schedule and balance natural gas from our suppliers and through transporting pipelines. To perform these functions, we lease natural gas transportation and storage capacity.

In February 2006, we completed an evaluation of our wholesale energy segment’s hedging strategy and use of capital. As a result of our evaluation, we substantially reduced hedging activity.

Regulation

Texas

We are certified by the PUCT to provide retail electric service in Texas. We sell electricity in the competitive areas of ERCOT to customers at unregulated prices. Our activities in Texas are subject to standards and regulations adopted by ERCOT. See “Risk Factors” in Item 1A of this Form 10-K.

Until January 1, 2007, we were required to make electricity available to Houston area residential and small business customers at the PUCT-approved “price-to-beat.” Any residential “price-to-beat” customers who did not select an alternative product by December 31, 2006 continued being served under our residential services plan.

Other States

We are certified in Delaware and Illinois to supply retail electric service to commercial and industrial customers in those states. Our retail activities in Delaware and Illinois are subject to standards and regulations adopted by PJM and each state’s utility commission.

We operate electric generation facilities in regions administered by PJM, Cal ISO and MISO. These ISOs operate under FERC-approved market rules. The market rules include price limits or caps applicable to all

generators and numerous other FERC-approved requirements relative to the manner in which we must operate our generating facilities.

Federal Energy Regulatory Commission

A number of our subsidiaries are public utilities under the Federal Power Act and are subject to FERC rules and oversight regulations. As public utilities, these subsidiaries sell power at either market-based rates (if FERC has granted market-based rate authority) or cost-based rates. Each of these subsidiaries has been granted market-based rate authority, although a limited number of services sold by some of them are sold at cost-based rates.

Competition and Seasonality

The retail and wholesale energy industries are intensely competitive. Our competitors include merchant energy companies, utilities, retail electric service providers and other companies, including in recent years companies owned by investment banking firms, hedge funds and private equity funds. Our principal competitors in the retail electricity markets outside of Houston are typically incumbent retail electric providers, which have the advantage of long-standing relationships with customers. In general, competition in the retail and wholesale energy markets is on the basis of price, service, brand image and product offerings, as well as market perceptions of creditworthiness. For additional information on the effect of competition and for a discussion of how seasonality impacts our business, see “Risk Factors” in Item 1A of this Form 10-K and note 17 to our consolidated financial statements.

Environmental Matters

We are subject to numerous federal, state and local requirements relating to the protection of the environment and the safety and health of personnel and the public. These requirements relate to a broad range of our activities, including the discharge of compounds into the air, water and soil; the proper handling of solid, hazardous and toxic materials and waste; noise and safety and health standards applicable to the workplace.

Based on existing regulations, our market outlook, and our current assessment of the costs of labor and materials and the state of evolving technologies, we estimate that we will invest approximately $261 million in 2008, $115 million in 2009 and $33 million to $338 million in 2010 through 2014 on projects to reduce our emission levels and lessen the environmental impact of our operations. These amounts include $39 million for future ash landfill expansions from 2008 through 2014. As described below, a significant amount of these expenditures relate to our election to upgrade the SO 2 emissions controls at some of our facilities.

In some cases, which are described below, environmental laws and regulations are pending, are under consideration, are in dispute or could be revised. Unless otherwise noted, we cannot predict the ultimate effect of these matters on our business. For additional information on how environmental matters may impact our business, see “Risk Factors” in Item 1A of this Form 10-K and note 13(b) to our consolidated financial statements.

Air Quality

Under the Clean Air Act, the EPA has implemented a number of emission control programs that affect industrial sources, including power plants, by limiting emissions of NOx and SO 2 . NOx and SO 2 are precursors to the formation of acid rain, fine particulate matter and regional haze. NOx is also a precursor to the formation of ozone.

NO x and SO 2 Emissions

In March 2005, the EPA finalized a regulation, referred to as the Clean Air Interstate Rule, to further reduce emissions of NOx and SO 2 in the Eastern United States in two phases. The first phase, which takes effect in 2009 for NOx and 2010 for SO 2 , requires overall reductions within the area of approximately 50% in NOx and SO 2 emissions on an annual basis. The second phase, which takes effect in 2015, requires additional reductions of approximately 10% for a 60% total reduction in NOx and approximately 15% for a 65% reduction in SO 2 . The EPA regulations include the use of cap-and-trade programs to achieve these reductions.

These regulations require us to provide an allowance for each ton of NOx and SO 2 that we emit under a cap-and-trade program. We maintain emission allowances that at a minimum correspond with forward power sales. In general, we do not have emission allowances for all of our generation. We purchase emission allowances, as needed, to correspond with our generation of electricity.

We have undertaken studies to evaluate possible impacts of the Clean Air Interstate Rule and similar legislative and regulatory proposals, which will primarily affect our coal-fired facilities in the Eastern United States. Based on an economic analysis that includes plant operability, changes in the emission allowances market, potential impact of state-imposed regulations and our estimates at this time of capital expenditures, we have elected to invest $217 million in 2008, $51 million in 2009 and an estimated $26 million to $304 million in 2010 through 2013 to principally reduce our emissions of SO 2 .

Mercury Emissions

In March 2005, the EPA finalized the Clean Air Mercury Rule (CAMR), a national rule designed to reduce mercury emissions from coal plants in two phases through a cap-and-trade system. CAMR targets phase I reductions of approximately 30% in 2010 and phase II reductions of approximately 70% in 2018.

States are permitted to adopt regulations that conform to CAMR or adopt their own mercury regulations that are stricter than CAMR. Ohio has adopted regulations implementing CAMR. Pennsylvania has finalized stricter regulations for mercury emissions. Pennsylvania’s program generally requires mercury reductions on a facility basis in two phases, with 80% reductions in 2010 and 90% reductions in 2015.

Several states initiated litigation targeting CAMR, in particular to require mercury control on a facility basis, instead of through a cap-and-trade system. In February 2008, a federal appeals court struck down CAMR as unlawful. The outcome of this ruling on Ohio and some other state regulations is uncertain, but it may impact our ultimate requirements to control mercury. Pennsylvania is expected to continue implementation of its program.

Our preliminary estimate of capital expenditures to comply primarily with the first phase of Pennsylvania’s mercury control program is $88 million to $103 million for 2008 through 2010. Our analysis and evaluation of alternatives for compliance with the second phase of Pennsylvania’s program, including potential capital expenditures for controls, is underway.

Air Particulates

In September 2006, the EPA issued revised national ambient air quality standards for fine particulate matter with an aerodynamic diameter less than or equal to 2.5 microns, or PM2.5. Individual states must identify the sources of emissions in noncompliant areas and develop emission reduction plans. These plans may be state-specific or regional in scope. If our generating assets are located in areas that are not in compliance, we could be required to take additional or accelerated steps to reduce our NOx and SO 2 emissions.

Greenhouse Gas Emissions

There is increasing focus within the United States over the direction of domestic climate change policy. Several states in the northeastern, midwestern and western United States, are increasingly active in developing state-specific or regional regulatory initiatives to stimulate CO 2 emission reductions in the electric power generation industry and other industries. The United States Congress is considering numerous bills that would impose mandatory limitation of CO 2 and other greenhouse gas emissions for the domestic power generation sector. The specific impact on our business will depend upon the form of emissions-related legislation or regulations ultimately adopted by the federal government or states in which our facilities are located. Ten northeastern states, including New Jersey and Maryland, have formed the Regional Greenhouse Gas Initiative, or RGGI, which requires power generators to reduce CO 2 emissions by ten percent by 2019, beginning in 2009. California adopted legislation designed to reduce greenhouse gas emissions to 25% below 1990 levels by 2020, beginning in 2012.

In addition, the EPA has announced plans to consider regulations to address CO 2 emissions as part of the Clean Air Act’s New Source Review program. Individual states may also begin to take into account CO 2 emissions when considering permits to construct or modify significant sources of emissions.

In September 2007, we joined the Chicago Climate Exchange, a voluntary greenhouse gas registry, reduction and trading system. By joining the exchange, we have committed to reduce our greenhouse gas emissions to six percent below the average of our 1998-2001 levels by 2010. We expect to satisfy our reduction targets through previously implemented unit retirements and capacity factor reductions and ongoing heat rate improvement efforts and transacting on the exchange.

Water Quality

In July 2007, the EPA suspended its 2004 regulations relating to cooling water intake structures at large existing power plants pending further rulemaking. This action was in response to the Second Circuit Court of Appeals’ January 2007 remand of the 2004 regulations. The EPA retained interim requirements that associated intakes employ best technology available controls as determined on a plant-by-plant, best professional judgment basis.

Other

As a result of their age, many of our facilities contain significant amounts of asbestos insulation, other asbestos containing materials, as well as lead-based paint. Existing state and federal rules require the proper management and disposal of these potentially toxic materials. We believe we properly manage and dispose of such materials in compliance with these state and federal rules. See note 13(b) to our consolidated financial statements.

We do not believe we have any material liabilities or obligations under the Comprehensive Environmental Response Corporation and Liability Act of 1980 or similar state laws. These laws impose clean up and restoration liability on owners and operators of facilities from or at which there has been a release or threatened release of hazardous substances, together with those who have transported or arranged for the disposal of those substances.

CEO BACKGROUND

Mark M. Jacobs has served as our President and Chief Executive Officer since May 2007. Prior to that, he served as our Executive Vice President and Chief Financial Officer from July 2002 to October 2007.

Brian Landrum has served as our Executive Vice President and Chief Operating Officer since May 2007. Prior to that, he served as our Executive Vice President, Operations from February 2006 to May 2007. He was Senior Vice President, Commercial and Retail Operations, IT from February 2005 to February 2006; Senior Vice President, Customer Operations and Information Technology from January 2004 to February 2005; President, Reliant Energy Retail Services from June 2003 to January 2004 and Senior Vice President, Retail Operations from August 2001 to May 2003.

Rick J. Dobson has served as our Executive Vice President and Chief Financial Officer since October 2007. Prior to that, he served as Senior Vice President and Chief Financial Officer of Novelis Inc., an international aluminum rolling and recycling company, from July 2006 to August 2007 and Senior Vice President and Chief Financial Officer of Aquila, Inc., an electric and natural gas distribution company that also owns and operates generation assets, from October 2002 to July 2006.

Charles S. Griffey has served as our Senior Vice President, Market Design and Regulatory Affairs since December 2007. Prior to that, he was Senior Vice President, Regulatory Affairs from February 2003 to December 2007 and Vice President, Regulatory Planning and Analysis from December 1998 to February 2003.

D. Rogers Herndon has served as our Senior Vice President, Strategic Planning and Business Development since November 2007. He was Senior Vice President, Commercial Operations and Origination from May 2006 to November 2007. Prior to that, he was a Managing Director for PSEG Energy Resources and Trade and from March 2002 to March 2003, he was Managing Director—Global Derivatives for Bank of America.

Michael L. Jines has served as our Senior Vice President, General Counsel and Corporate Secretary since May 2003. He was our Deputy General Counsel and Senior Vice President and General Counsel, Wholesale Group from March 2002 to May 2003.

Suzanne L. Kupiec has served as our Senior Vice President, Risk and Structuring since January 2004. In July 2007, she also began serving as our Corporate Compliance Officer. She was our Vice President and Chief Risk and Corporate Compliance Officer from June 2003 to January 2004. From 2000 until the time she joined us, she was a partner at Ernst & Young LLP, where she led its Energy Trading and Risk Management Practice serving both audit and advisory service clients.

Thomas C. Livengood has served as our Senior Vice President and Controller since May 2005. Prior to that, he served as our Vice President and Controller from August 2002 to May 2005.

Albert H. Myres has served as our Senior Vice President, Government and Public Affairs since December 2007. He served as Shell Oil Corporation’s Chief of Staff and Senior Advisor to the President and Country Chairman from August 2005 to December 2007 and Senior Advisor, Government Affairs from June 2002 to August 2005.

Karen D. Taylor has served as our Senior Vice President, Human Resources since December 2003. In November 2005, she was appointed as our Chief Diversity Officer. Ms. Taylor was Vice President, Human Resources from February 2003 to December 2003 and Vice President, Administration, Wholesale Group from October 1998 to February 2003.

MANAGEMENT DISCUSSION FROM LATEST 10K

Business Overview

Our objective is to be a leader in delivering the benefits of competitive electricity markets to customers. Our business focuses on the competitive retail and wholesale electricity markets.

Our strategy is based on our core beliefs about the power industry and the retail and wholesale electricity markets. We are committed to delivering superior returns from competitive markets through insights into the fundamentals of our core markets and a commitment to risk-weighted investments whose return on invested capital exceeds our weighted-average cost of capital.

Retail Energy. The retail energy segment is a low capital investment electricity resale business with relatively stable earnings (excluding unrealized gains/losses on energy derivatives). The key earnings drivers in the retail energy segment are the volume of electricity we sell to customers, the unit margins received on those sales and the cost of acquiring and serving those customers. We earn a margin by selling electricity to end-use customers and simultaneously acquiring supply. While short-term earnings in this business are impacted by local weather patterns and the competitive tactics of other retailers in the market, the longer-term earnings drivers of the business are delivering a superior customer experience, retaining and growing market share in our existing markets through innovative product offerings and expanding into new competitive markets.

Our core beliefs about the retail market are:


• We are a leader in delivering the benefits of competitive electricity markets to retail customers, which results in a business that has a high return on invested capital and relatively stable earnings;

• Retail competition provides opportunities to add value through customer segmentation, product and service innovation and brand;

• Increases in wholesale supply costs will provide conservation and load management opportunities that will dramatically alter load; and

• Continued success in markets currently open to retail competition will drive new competitive market openings.

These core beliefs set the stage for our strategic direction. We will focus on the following value-creation levers:


• Strengthening our competitive position by improving our operating cost and effectiveness, using customer segmentation to identify and provide innovative products and services, providing superior customer service and continuing to build our brand;

• Leading the development of “Smart Energy” to encourage more efficient power consumption and provide a superior customer experience, including increasing transparency of customer bills, providing time of use signals, disaggregating customer usage and providing enhanced control over power consumption; and

• Entering and developing new competitive markets.

Wholesale Energy. The wholesale energy segment is a capital-intensive, cyclical business. Earnings are significantly impacted by spark spreads and capacity prices. Spark spreads are driven by a number of factors, including the prices of natural gas, coal and fuel oil, the cost of emissions, transmission, weather and global macro-economic factors, none of which we control. The key earnings drivers are the amount of electricity we generate, the margin we earn for each unit of electricity sold and the availability of our generating assets to meet demand. The factor that we have the most control over is the percentage of time that our generating assets are available to run when it is economical for them to do so. Longer-term earnings are driven by regional supply and demand fundamentals, the level of commodity prices and capacity markets.

Our core beliefs about the wholesale market are:


• Capital intensive, cyclical industries generally earn returns below their cost of capital over a full cycle;

• New build investment typically under earns its cost of capital unless there is a significant cost advantage; and

• Over the next several years, we anticipate significant tightening of supply/demand.

These core beliefs set the stage for our strategic direction. We will focus on the following value-creation levers:


• Realizing the value from anticipated improving supply and demand fundamentals in the wholesale markets from our existing portfolio of assets;

• Achieving operating and commercial excellence in order to reliably and economically meet customer needs; and

• Optimizing and growing our portfolio of assets by utilizing a highly-disciplined capital investment process with a return on invested capital focus.

Company-wide. We will focus on the following value-creation levers:


• Establishing and maintaining a strong, flexible capital structure that ensures a competitive cost of capital with an ability to invest in value creating opportunities throughout the cycle, including returning capital to shareholders;

• Building a highly disciplined return on invested capital focus; and

• Continuing to develop innovative structures and transactions that improve returns and reduce risk.

We also believe that stockholder value is enhanced through the development of a highly motivated and customer-focused work force. We continue to focus on:


• communicating openly with our employees;

• fostering company pride among our employees;

• providing a satisfying and safe work environment;

• recognizing and rewarding employee contributions and capabilities; and

• motivating our employees to be collaborative leaders committed to our future.

Our ability to achieve these strategic objectives and execute these actions is subject to a number of factors, some of which we may not be able to control. See “Cautionary Statement Regarding Forward-Looking Information” and “Risk Factors” in Item 1A of this Form 10-K.

Recent Events. In February 2008, we entered into an agreement to sell our interests in Channelview, subject to approval of the court overseeing Channelview’s bankruptcy proceedings and other closing conditions. Sale proceeds will be used to settle creditors’ claims and a cash sharing agreement. Residual proceeds will be retained by us and will affect the amount of any gain or loss on the sale. It is possible an impairment could be recognized if the net proceeds and remaining assets (including cash and working capital) do not exceed our net investment in and receivables from Channelview. See note 21 to our consolidated financial statements.

Consolidated Results of Operations

The following discussion includes non-GAAP financial measures, which are not standardized; therefore it may not be possible to compare these financial measures with other companies’ non-GAAP financial measures having the same or similar names. We strongly encourage investors to review our consolidated financial statements and publicly filed reports in their entirety and not rely on any single financial measure.

2007 Compared to 2006 and 2006 Compared to 2005

We reported $365 million consolidated net income, or $1.04 diluted income per share, for 2007 compared to $328 million consolidated net loss, or $1.07 loss per share, for 2006 and $331 million consolidated net loss, or $1.09 loss per share, for 2005.
Retail Energy Segment

In analyzing the results of our retail energy segment, we use the non-GAAP financial measures “retail gross margin” and “retail contribution margin,” which exclude the item described below, as well as our retail energy segment profit and loss measure, “contribution margin, including unrealized gains/losses on energy derivatives.” Retail gross margin and retail contribution margin should not be relied upon without considering the GAAP financial measures. The item that is excluded from these non-GAAP financial measures has a recurring effect on our earnings and reflects aspects of our business that are not taken into account by this measure.

Unrealized Gains/Losses on Energy Derivatives. We use derivative instruments to manage operational or market constraints and to execute our retail energy segment’s supply procurement strategy. We are required to record in our consolidated statement of operations non-cash gains/losses related to future periods based on current changes in forward commodity prices for derivative instruments receiving mark-to-market accounting treatment. We refer to these gains and losses prior to settlement, as well as ineffectiveness on cash flow hedges, as “unrealized gains/losses on energy derivatives.” In substantially all cases, the underlying transactions being hedged receive accrual accounting treatment, resulting in a mismatch of accounting treatments. Since the application of mark-to-market accounting has the effect of pulling forward into current periods non-cash gains/losses relating to and reversing in future delivery periods, analysis of results of operations from one period to another can be difficult. We believe that excluding these unrealized gains/losses on energy derivatives provides a more meaningful representation of our economic performance in the reporting period and is therefore useful to us, investors, analysts and others in facilitating the analysis of our results of operations from one period to another.

Our retail energy segment’s contribution margin, including unrealized gains/losses on energy derivatives was $942 million in 2007 compared to $250 million in 2006. The $692 million increase was primarily due to the net change in unrealized gains/losses on energy derivatives of $725 million, partially offset by a $32 million decrease in retail gross margin. Our retail energy segment’s contribution margin, including unrealized gains/losses on energy derivatives was $250 million in 2006 compared to $342 million in 2005. The $92 million decrease was primarily due to the increase in unrealized losses on energy derivatives of $218 million. In addition, contribution margin was impacted by a $232 million increase in retail gross margin and a $106 million increase in operation and maintenance, selling and marketing and bad debt expense. See “—Retail Energy Margins” below for explanations.

Retail Energy Revenues.

Wholesale Energy Segment

In analyzing the results of our wholesale energy segment, we use the non-GAAP financial measures “open energy gross margin,” “open wholesale gross margin” and “open wholesale contribution margin,” which exclude the items described below, as well as our wholesale energy segment profit and loss measure, “contribution margin, including historical and operational wholesale hedges and unrealized gains/losses on energy derivatives.” Open energy gross margin, open wholesale gross margin and open wholesale contribution margin should not be relied upon without considering the GAAP financial measures. The items that are excluded from these non-GAAP financial measures have or have had a recurring effect on our earnings and reflect aspects of our business that are not taken into account by these measures.

Historical and Operational Wholesale Hedges. We exclude the effect of certain historical, although recurring until the contracts terminate, wholesale hedges that were entered into in order to hedge the economics of a portion of our wholesale operations. These amounts primarily relate to settlements of forward power hedges, long-term tolling purchases, long-term natural gas transportation contracts not serving our generation assets and our legacy energy trading. We also exclude the effect of certain on-going operational wholesale hedges that were entered into primarily to mitigate certain operational risks at our generation assets. These amounts primarily relate to settlements of fuel hedges, long-term natural gas transportation contracts and storage contracts. Operational wholesale hedges are derived based on methodology consistent with the calculation of open energy gross margin. We believe that it is useful to us, investors, analysts and others to show our results in the absence of both historical and operational hedges. The impact of these hedges on our financial results is not a function of the operating performance of our generation assets, and excluding the impact better reflects the operating performance of our generation assets based on prevailing market conditions.

Unrealized Gains/Losses on Energy Derivatives. We use derivative instruments to manage operational or market constraints and to increase the return on our generation assets. We are required to record in our consolidated statement of operations non-cash gains/losses related to future periods based on current changes in forward commodity prices for derivative instruments receiving mark-to-market accounting treatment. We refer to these gains and losses prior to settlement, as well as ineffectiveness on cash flow hedges, as “unrealized gains/losses on energy derivatives.” In some cases, the underlying transactions being hedged receive accrual accounting treatment, resulting in a mismatch of accounting treatments. Since the application of mark-to-market accounting has the effect of pulling forward into current periods non-cash gains/losses relating to and reversing in future delivery periods, analysis of results of operations from one period to another can be difficult. We believe that excluding these unrealized gains/losses on energy derivatives provides a more meaningful representation of our economic performance in the reporting period and is therefore useful to us, investors, analysts and others in facilitating the analysis of our results of operations from one period to another. These gains/losses are also not a function of the operating performance of our generation assets, and excluding their impact helps isolate the operating performance of our generation assets under prevailing market conditions.

Changes in California-Related Receivables and Reserves. In 2005, we excluded the impact of changes in receivables and reserves relating to energy sales in California from October 2000 through June 2001. We reached a settlement concerning these receivables during the third quarter of 2005. Because of the market conditions and regulatory events that underlie the changes in these receivables and reserves, we believe that excluding this item provides a more meaningful representation of our results of operations on an ongoing basis and is therefore useful to us, investors, analysts and others in facilitating the analysis of our results of operations from one period to another. For additional information, see note 14(a) to our consolidated financial statements.

Our wholesale energy segment’s contribution margin, including historical and operational wholesale hedges and unrealized gains/losses on energy derivatives was $524 million in 2007 compared to $146 million in 2006. The $378 million increase was primarily due to (a) reduced negative effect of historical and operational wholesale hedges of $284 million and (b) $184 million increase in open wholesale gross margin. These increases were partially offset by (a) net change in unrealized gains/losses on energy derivatives of $49 million and (b) $40 million increase in operation and maintenance expense. Our wholesale energy segment’s contribution margin, including historical and operational wholesale hedges and unrealized gains/losses on energy derivatives was $146 million in 2006 compared to $110 million in 2005. The $36 million increase was primarily due to (a) net change in unrealized gains/losses on energy derivatives of $179 million and (b) reduced negative effect of historical and operational wholesale hedges of $108 million. These increases were partially offset by (a) $199 million decrease in open wholesale gross margin and (b) $55 million increase in operation and maintenance expense. See “—Wholesale Energy Margins” below for explanations.

MANAGEMENT DISCUSSION FOR LATEST QUARTER

Business Overview

Our objective is to be a leader in delivering the benefits of competitive electricity markets to customers. Our business focuses on the competitive retail and wholesale electricity markets.

Our strategy is based on our core beliefs about the power industry and the retail and wholesale electricity markets. We are committed to delivering superior returns from competitive markets through insights into the fundamentals of our core markets and a commitment to risk-weighted investments whose return on invested capital exceeds our weighted-average cost of capital.

Retail Energy. The retail energy segment is a low capital investment electricity resale business with relatively stable earnings (excluding unrealized gains/losses on energy derivatives). The key earnings drivers in the retail energy segment are the volume of electricity we sell to customers, the unit margins received on those sales and the cost of acquiring and serving those customers. We earn a margin by selling electricity to end-use customers and simultaneously acquiring supply. While short-term earnings in this business are impacted by local weather patterns and the competitive tactics of other retailers in the market, the longer-term earnings drivers of the business are delivering a superior customer experience, retaining and growing market share in our existing markets through innovative product offerings and expanding into new competitive markets.

Our core beliefs about the retail market are:


• We are a leader in delivering the benefits of competitive electricity markets to retail customers, which results in a business that has a high return on invested capital and relatively stable earnings;

• Retail competition provides opportunities to add value through customer segmentation, product and service innovation and brand;

• Increases in wholesale supply costs will provide conservation and load management opportunities that will dramatically alter load; and

• Continued success in markets currently open to retail competition will drive new competitive market openings.

These core beliefs set the stage for our strategic direction. We will focus on the following value-creation levers:


• Strengthening our competitive position by improving our operating cost and effectiveness, using customer segmentation to identify and provide innovative products and services, providing superior customer service and continuing to build our brand;

• Leading the development of “Smart Energy” to encourage more efficient power consumption and provide a superior customer experience, including increasing transparency of customer bills, providing time of use signals, disaggregating customer usage and providing enhanced control over power consumption; and

• Entering and developing new competitive markets.

Wholesale Energy. The wholesale energy segment is a capital-intensive, cyclical business. Earnings are significantly impacted by spark spreads and capacity prices. Spark spreads are driven by a number of factors, including the prices of natural gas, coal and fuel oil, the cost of emissions, transmission, weather and global macro-economic factors, none of which we control. The key earnings drivers are the amount of electricity we generate, the margin we earn for each unit of electricity sold and the availability of our generating assets to meet demand. The factor that we have the most control over is the percentage of time that our generating assets are available to run when it is economical for them to do so. Longer-term earnings are driven by regional supply and demand fundamentals, the level of commodity prices and capacity markets.

Our core beliefs about the wholesale market are:


• Capital intensive, cyclical industries generally earn returns below their cost of capital over a full cycle;

• New build investment typically under earns its cost of capital unless there is a significant cost advantage; and

• Over the next several years, we anticipate significant tightening of supply/demand.

These core beliefs set the stage for our strategic direction. We will focus on the following value-creation levers:


• Realizing the value from anticipated improving supply and demand fundamentals in the wholesale markets from our existing portfolio of assets;

• Achieving operating and commercial excellence in order to reliably and economically meet customer needs; and

• Optimizing and growing our portfolio of assets by utilizing a highly-disciplined capital investment process with a return on invested capital focus.

Company-wide. We will focus on the following value-creation levers:


• Establishing and maintaining a strong, flexible capital structure that ensures a competitive cost of capital with an ability to invest in value creating opportunities throughout the cycle, including returning capital to shareholders;

• Building a highly disciplined return on invested capital focus; and

• Continuing to develop innovative structures and transactions that improve returns and reduce risk.

We also believe that stockholder value is enhanced through the development of a highly motivated and customer-focused work force. We continue to focus on:


• communicating openly with our employees;

• fostering company pride among our employees;

• providing a satisfying and safe work environment;

• recognizing and rewarding employee contributions and capabilities; and

• motivating our employees to be collaborative leaders committed to our future.

Our ability to achieve these strategic objectives and execute these actions is subject to a number of factors, some of which we may not be able to control. See “Cautionary Statement Regarding Forward-Looking Information” and “Risk Factors” in Item 1A of this Form 10-K.

Recent Events. In February 2008, we entered into an agreement to sell our interests in Channelview, subject to approval of the court overseeing Channelview’s bankruptcy proceedings and other closing conditions. Sale proceeds will be used to settle creditors’ claims and a cash sharing agreement. Residual proceeds will be retained by us and will affect the amount of any gain or loss on the sale. It is possible an impairment could be recognized if the net proceeds and remaining assets (including cash and working capital) do not exceed our net investment in and receivables from Channelview. See note 21 to our consolidated financial statements.

Consolidated Results of Operations

The following discussion includes non-GAAP financial measures, which are not standardized; therefore it may not be possible to compare these financial measures with other companies’ non-GAAP financial measures having the same or similar names. We strongly encourage investors to review our consolidated financial statements and publicly filed reports in their entirety and not rely on any single financial measure.

2007 Compared to 2006 and 2006 Compared to 2005

We reported $365 million consolidated net income, or $1.04 diluted income per share, for 2007 compared to $328 million consolidated net loss, or $1.07 loss per share, for 2006 and $331 million consolidated net loss, or $1.09 loss per share, for 2005.
Retail Energy Segment

In analyzing the results of our retail energy segment, we use the non-GAAP financial measures “retail gross margin” and “retail contribution margin,” which exclude the item described below, as well as our retail energy segment profit and loss measure, “contribution margin, including unrealized gains/losses on energy derivatives.” Retail gross margin and retail contribution margin should not be relied upon without considering the GAAP financial measures. The item that is excluded from these non-GAAP financial measures has a recurring effect on our earnings and reflects aspects of our business that are not taken into account by this measure.

Unrealized Gains/Losses on Energy Derivatives. We use derivative instruments to manage operational or market constraints and to execute our retail energy segment’s supply procurement strategy. We are required to record in our consolidated statement of operations non-cash gains/losses related to future periods based on current changes in forward commodity prices for derivative instruments receiving mark-to-market accounting treatment. We refer to these gains and losses prior to settlement, as well as ineffectiveness on cash flow hedges, as “unrealized gains/losses on energy derivatives.” In substantially all cases, the underlying transactions being hedged receive accrual accounting treatment, resulting in a mismatch of accounting treatments. Since the application of mark-to-market accounting has the effect of pulling forward into current periods non-cash gains/losses relating to and reversing in future delivery periods, analysis of results of operations from one period to another can be difficult. We believe that excluding these unrealized gains/losses on energy derivatives provides a more meaningful representation of our economic performance in the reporting period and is therefore useful to us, investors, analysts and others in facilitating the analysis of our results of operations from one period to another.

Our retail energy segment’s contribution margin, including unrealized gains/losses on energy derivatives was $942 million in 2007 compared to $250 million in 2006. The $692 million increase was primarily due to the net change in unrealized gains/losses on energy derivatives of $725 million, partially offset by a $32 million decrease in retail gross margin. Our retail energy segment’s contribution margin, including unrealized gains/losses on energy derivatives was $250 million in 2006 compared to $342 million in 2005. The $92 million decrease was primarily due to the increase in unrealized losses on energy derivatives of $218 million. In addition, contribution margin was impacted by a $232 million increase in retail gross margin and a $106 million increase in operation and maintenance, selling and marketing and bad debt expense. See “—Retail Energy Margins” below for explanations.

Retail Energy Revenues.

Wholesale Energy Segment

In analyzing the results of our wholesale energy segment, we use the non-GAAP financial measures “open energy gross margin,” “open wholesale gross margin” and “open wholesale contribution margin,” which exclude the items described below, as well as our wholesale energy segment profit and loss measure, “contribution margin, including historical and operational wholesale hedges and unrealized gains/losses on energy derivatives.” Open energy gross margin, open wholesale gross margin and open wholesale contribution margin should not be relied upon without considering the GAAP financial measures. The items that are excluded from these non-GAAP financial measures have or have had a recurring effect on our earnings and reflect aspects of our business that are not taken into account by these measures.

Historical and Operational Wholesale Hedges. We exclude the effect of certain historical, although recurring until the contracts terminate, wholesale hedges that were entered into in order to hedge the economics of a portion of our wholesale operations. These amounts primarily relate to settlements of forward power hedges, long-term tolling purchases, long-term natural gas transportation contracts not serving our generation assets and our legacy energy trading. We also exclude the effect of certain on-going operational wholesale hedges that were entered into primarily to mitigate certain operational risks at our generation assets. These amounts primarily relate to settlements of fuel hedges, long-term natural gas transportation contracts and storage contracts. Operational wholesale hedges are derived based on methodology consistent with the calculation of open energy gross margin. We believe that it is useful to us, investors, analysts and others to show our results in the absence of both historical and operational hedges. The impact of these hedges on our financial results is not a function of the operating performance of our generation assets, and excluding the impact better reflects the operating performance of our generation assets based on prevailing market conditions.

Unrealized Gains/Losses on Energy Derivatives. We use derivative instruments to manage operational or market constraints and to increase the return on our generation assets. We are required to record in our consolidated statement of operations non-cash gains/losses related to future periods based on current changes in forward commodity prices for derivative instruments receiving mark-to-market accounting treatment. We refer to these gains and losses prior to settlement, as well as ineffectiveness on cash flow hedges, as “unrealized gains/losses on energy derivatives.” In some cases, the underlying transactions being hedged receive accrual accounting treatment, resulting in a mismatch of accounting treatments. Since the application of mark-to-market accounting has the effect of pulling forward into current periods non-cash gains/losses relating to and reversing in future delivery periods, analysis of results of operations from one period to another can be difficult. We believe that excluding these unrealized gains/losses on energy derivatives provides a more meaningful representation of our economic performance in the reporting period and is therefore useful to us, investors, analysts and others in facilitating the analysis of our results of operations from one period to another. These gains/losses are also not a function of the operating performance of our generation assets, and excluding their impact helps isolate the operating performance of our generation assets under prevailing market conditions.

Changes in California-Related Receivables and Reserves. In 2005, we excluded the impact of changes in receivables and reserves relating to energy sales in California from October 2000 through June 2001. We reached a settlement concerning these receivables during the third quarter of 2005. Because of the market conditions and regulatory events that underlie the changes in these receivables and reserves, we believe that excluding this item provides a more meaningful representation of our results of operations on an ongoing basis and is therefore useful to us, investors, analysts and others in facilitating the analysis of our results of operations from one period to another. For additional information, see note 14(a) to our consolidated financial statements.

Our wholesale energy segment’s contribution margin, including historical and operational wholesale hedges and unrealized gains/losses on energy derivatives was $524 million in 2007 compared to $146 million in 2006. The $378 million increase was primarily due to (a) reduced negative effect of historical and operational wholesale hedges of $284 million and (b) $184 million increase in open wholesale gross margin. These increases were partially offset by (a) net change in unrealized gains/losses on energy derivatives of $49 million and (b) $40 million increase in operation and maintenance expense. Our wholesale energy segment’s contribution margin, including historical and operational wholesale hedges and unrealized gains/losses on energy derivatives was $146 million in 2006 compared to $110 million in 2005. The $36 million increase was primarily due to (a) net change in unrealized gains/losses on energy derivatives of $179 million and (b) reduced negative effect of historical and operational wholesale hedges of $108 million. These increases were partially offset by (a) $199 million decrease in open wholesale gross margin and (b) $55 million increase in operation and maintenance expense. See “—Wholesale Energy Margins” below for explanations.

Economic generation
• Supply and demand fundamentals

• Spark spreads

• Generation asset fuel type and efficiency
Commercial capacity factor
• Operations excellence

• Maintenance practices
Unit margin
• Supply and demand fundamentals

• Commodity prices

• Generation asset fuel type and efficiency
Other margin
• Capacity prices

• Power purchase agreements sold to others

• Ancillary services
Operating costs
• Operating efficiencies

• Maintenance practices

• Generation asset fuel type
Recent Events
Bighorn Plant. In April 2008, we entered into an agreement to sell our Bighorn natural gas-fired combined-cycle electric generation facility located in Clark County, Nevada with a nominal capacity of 598 megawatts for $500 million and assign some related contracts. See note 15 to our interim financial statements for further discussion.
Retail Energy Segment. The Houston area experienced thirty-year record heat in late May and early June 2008. As a result, load demand in Houston and south Texas was greater than we expected. Additionally, transmission constraints limited the ability to move power into the Houston and south Texas zones, which caused some of our power supply to be unavailable to meet expected demand. In response, we purchased power in Houston and south Texas to meet our increased load at market prices, which resulted in negative retail contribution margin in our retail energy segment for the second quarter of 2008. We have secured retail supply for the remainder of 2008 and beyond from sources in Houston and south Texas for our expected load, which will result in lower third quarter retail contribution margin in 2008 compared to 2007. Given the significant volatility in supply prices, we have and will continue to refine our pricing and supply strategies. See “—Consolidated Results of Operations” below for further explanation and “Risk Factors” in Item 1A of our Form 10-K.
Channelview. In July 2008, Channelview completed the sale of its plant for $500 million. See note 14 to our interim financial statements for further discussion.
Environmental Matters. In July 2008, the District of Columbia Circuit Court of Appeals vacated the EPA’s Clean Air Interstate Rule (CAIR) and remanded it to the EPA. The decision raises questions as to whether the EPA can design new cap-and-trade programs for nitrogen oxides (NO x ) and sulfur dioxide (SO 2 ) that are consistent with the Clean Air Act provisions that address upwind contributions to downward states’ noncompliance with national ambient air quality standards for ozone and fine particulate matter. The decision sets aside CAIR’s proposed annual allowance-based NO x program and the increased surrender rate for SO 2 allowances. The existing ozone season NO x program and the SO 2 allowance requirements under the Clean Air Act’s acid rain program will continue. We do not know if the EPA will appeal the decision. We cannot reasonably estimate changes, if any, to our capital expenditures or operating costs for this ruling or any additional regulations that may be enacted.
In June 2008, we revised our estimated capital expenditures for compliance with the first phase of Pennsylvania’s mercury control program to approximately $50 million. This amount is adjusted from our preliminary estimate for the first phase of the program of $88 million to $103 million as a result of refined site-specific engineering and technology evaluations.

CONF CALL

Dennis Barber - Vice President of Investor Relations

Good morning and welcome to the Reliant Energy's second quarter 2008 earnings conference call. Leading the call this morning are Mark Jacobs, President and CEO; Brian Landrum, Chief Operating Officer; and Rick Dobson, our CFO. Following our prepared remarks, we'll have a question-and-answer session. Please limit yourself to one question with one follow up so others can participate. Both our earnings release and the slide presentation we are using today are available on our website at www.reliant.com in the Investors section. A replay of this call will also be available on the website approximately two hours after the call.

Consistent with our past practice, we are using several non-GAAP measures, to provide additional insight into operating results. Reconciliations of the non-GAAP measures to GAAP figures are available on the website. An item adjusted for this quarter is unrealized gains and losses on energy derivatives, which is an ongoing adjustment

As many of you know, we update our outlook each quarter using forward commodity prices. The current outlook uses forward commodity prices as of June 20th that was the last Friday of the quarter for which there was a traded contract for July. Any projections or forward-looking statements made on this call are subject to cautionary statements on forward-looking information contained in our SEC filings.

I'll now turn it over to Mark.

Mark M. Jacobs - President and Chief Executive Officer

Thank you, Dennis, and good morning everyone. Welcome to our quarterly call. Those of you that regularly follow Reliant Energy know how deeply we believe in the value proposition of our company and how much progress we've made to position the company for success. But I'm sure that most of you saw this morning's earnings release and the very disappointing retail results. So, I want to mention that upfront before I cover a few other topics. I'm going to provide some context on retail, and then Brian will go through the specifics around what happened and more importantly, what we are doing in response.

Extreme weather conditions resulted in significantly higher load than we expected. Our cost to serve that incremental load was very expensive, due to commodity prices at the time, and transmission constraints that severely limited the ability to import power into the Houston zone. The result, we had to buy more power at higher prices and that led to a supply cost variance that was unprecedented for the business.

While we expect the retail financial results to vary with market conditions, we consider the magnitude of this variation to be unacceptable. While the quarter and outlook for the full year have been impacted accordingly, we have some hard-earned lessons and have responded with specific actions, which Brian will address. Bottom line is, we believe we'll be better positioned to manage the risks in our retail business in the future.

On slide three, you can see a summary of quarterly results and or revised outlook through 2010. Despite the Q2 anomaly, we continue to believe retail is a valuable business. It has an extraordinary return on invested capital. It represents an attractive longer-term growth opportunity. We have a strong franchise notwithstanding the quarter's results. In fact, during periods of stress and market dislocation in the Texas retail market, we've been able to improve our competitive position.

Moving to the wholesale business. We had good performance in the quarter. Improved plant performance and better market conditions translated into higher contribution margin. Changes in the forward curve had a significantly positive impact on our outlook for the balance of 2008, 2009 and 2010. As Dennis mentioned, this outlook is based on forward curves for commodity prices on June 20sup>th/sup>. Commodity prices have been particularly volatile, and that results in big ups and downs in the near term wholesale outlook numbers. Forward curves have come-off sharply since June 20sup>th/sup>, and if we were to remark with more recent commodity prices, the outlook would be substantially lower. But commodity prices are going to move up and down. I think there are two important points to focus on. First, forward curves don't reflect tightening supply and demand, and that's inconsistent with our fundamental analysis.

Secondly; across our portfolio, forward curves implied low single digit rates of return on new build, as supply and demand fundamentals tightened, we expect rates of return on new build to increase. As you can see on the chart, that would have a $600 million impact on our 2010 earnings. To me, that's a more important long-term value driver than daily changes in commodity prices. I know that recent market events have caused many to question whether or not the wholesale market recovery will happen. In our opinion, an economic slowdown would impact the timing of a recovery, but it wont undo the laws of economics.

Now, I want to spend a few minutes reviewing our key priorities for 2008. You'll remember we established these at the beginning of the year. Rather than discuss them all, I want to hit a few with the high points. One of our priorities in the wholesale business is to invest in the portfolio to create value and an opportunity we constantly evaluate is the investment in environmental upgrades. Recently a Federal Appeals Court vacated the Clean Air Interstate Rule. Here's what that means for Reliant Energy, we will likely see a reduction in our operating cost in the near and intermediate term. But longer term, we anticipate the Clean Air Interstate Rule to be replaced with something else.

Turning to priorities in the retail business, obviously these are in addition to the retail supply actions that Brain will discuss. One of our key retail initiatives is Smart Energy. As we've discussed we expect Smart Energy to play a big role in enhancing the value of our core Texas residential franchise. There are two key developments related to Smart Energy that I wanted share. First, Jason Few has joined Reliant Energy to lead our efforts. Jason joins us from Motorola, where he ran the worldwide Mobile Phones Accessories business. Prior to Motorola, Jason was with SBC and led the team that developed the DSL Internet business. Jason has a track record of successfully launching new technologies to the consumer market which makes him the ideal person to lead our efforts.

Secondly, there has been an important regulatory development. A unanimous settlement was reached in Centerpoint Energy's request to install an advanced meter information network or AMIN plant. The settlement is scheduled for consideration at the Texas Public Utility Commissions August 14sup>th/sup> meeting. Reliant Energy was instrumental in developing that plan and reaching consensus among the various stakeholders. Here is why this plan is important; it allows us to provide our Smart Energy products to consumers more quickly. The AMIN plant allows us to ask Centerpoint to install smart meters for our customer on demand driven basis. That means we will be able to move past the pilot phase and start providing our new Smart Energy products more broadly to consumers this year.

I want touch on the last point on this page, our financial model for investing in our business. Over the last several months we've all witnessed extraordinary events in the financial markets and there is growing concern about the health of the global economy. Notably for us, the merchant energy sector has undergone a significant revaluation and we have been impacted more than our peers. Ironically, all of this is occurring at a time when most key indicators within our company point in a positive direction. We have restored our balance sheet strength, to a level that is distinctive among our peers. We have robust liquidity levels. And we expect to generate in excess of $2 billion of free cash flow through 2010 in a wide range of commodity price scenarios. Clearly, we will have significant resources to reinvest and create value for our shareholders.

We've discussed our approach to capital reinvestment with you on the last few calls. That slide is in the appendix. We continue to evaluate all of our reinvestment alternatives, including share repurchases. In our view the value proposition in our stock is even better than it was at the beginning of the year. There are many considerations when deciding to implement a share repurchase program.

One of those considerations is economic and financial market conditions. Among the experts, there is wide divergence of opinion on what the future holds. While we hope the optimists are correct, we need to be prepared in the event the pessimists get it right. In this unstable environment, we place a very high premium on our strong balance sheet and robust liquidity level. A share buyback or any other transaction that significantly reduce liquidity levels for that matter would not be consistent with that consideration. That being said, we understand that share buybacks are an effective tool to return value to shareholders and certainly an alternative that we will continue to evaluate.

In conclusion, yes, we were disappointed in the performance of our retail business in Q2. But overall, Reliant Energy is a company with a lot of positive momentum and offers an outstanding value proposition for shareholders. I'll now turn the call over to Brian Landrum, our Chief Operating Officer.

Brian Landrum - Executive Vice President and Chief Operating Officer

Thanks Mark. I'll cover our operational performance and outlook, starting with retail. As Mark said, the retail outlook for the year is down significantly. Extreme weather and market conditions during the quarter caused part of the variance. Our basic approach in retail is to match supply with sales to customers. In concept, if we sell a one year fixed price product to a customer, we buy one year fixed price supply. In reality, what we sell and what we buy can't match up perfectly. For instance, due to the tightness of generation in the Houston zone, we consistently buy some power at much lower cost from other zones to serve our Houston area load. We also buy supply for expected load under normal weather conditions, plus a position to mitigate some of the cost from hotter weather.

Every period, we determine how much to spend, to reduce potential cost of abnormal weather and transmission congestion, using a long term economic view. In Houston, during late May and early June, we had the hottest weather in over thirty years. During this period of high Houston load, North South transmission constraints and changes in how ERCOT managed congestion, forbidden us from meeting the increased demand with lower cost power from other zones. We had to buy power from higher cost sources in the Houston zone. Higher ERCOT wholesale price caps also increased costs to record levels, for an unprecedented number of periods during the quarter. This combination of weather, transmission congestion and ERCOT protocol changes, reduced second quarter results by about $100 million.

We have a set of other supply costs that can be difficult to hedge, but have historically been a small part of total cost with low volatility. An example would be ERCOT charges that cannot be assigned to individual retailers, that are allocated by volume shares across all retailers. Each quarter, we also see variances to forecast on certain supply cost that we bundle into customer products. Costs in this category can fluctuate but have ultimately tended to net out overtime. Given the unusual level of volatility however, we would not expect to recover roughly $50 million of additional costs incurred during the quarter. The second quarter was a difficult time for retailers in Texas in general, with eight companies going out of business five of which dropped customers to the providers at last resort. During the quarter, we assessed the risk of continued high and volatile costs as more likely given how ERCOT was managing congestion at the time. As a result, we took steps for the balance of the year, to mitigate potentially large additional exposures.

We acquired supply to better match our load in each zone and we bought additional fixed price ancillary services in the forward market. The cost of these positions is about $55 million higher than our prior outlook. The remainder of the variance to our prior outlook is associated with reversing the declining customer count we discussed in our last earnings call. We made a concerted effort to improve marketing of across pricing, channels and positioning. Since we implemented this new program in May, our customer count increased by over 25,000 customers, which is a dramatic turnaround and a meaningful increase even after taking into account, customers we acquired from defaulting retailers.

We are taking a longer-term view of customer value that can have a negative impact on results in the near-term, but will increase the overall value for the time we serve the customer.

As a result, our contribution margin was lower by about $10 million during the quarter, and we estimate an additional $20 million reduction for the balance of the year. In total, we are lowering our retail outlook for the year by about $240 million. As Mark said, we consider the magnitude of this variance to be unacceptable. We are applying the learning's from this series of events, to how we manage the business. We worked closely with our ERCOT, on a better approach to managing congestion between zones. We have conducted a comprehensive review of our retail risk management approach, and are updating the economic trade-offs for hedging each risk, especially those that have been historically small.

We are looking at creative alternatives, to reduce variability on the difficult to hedge risks, including the degree to which we bundle these costs in the products versus passing them through to the customers. While we expect to continue to see quarterly and sometimes annual variations from weather, congestion and the difficult to hedge components of supply, we are committed to delivering more consistent retail financial results.

We've had a long track record of success in retail and our overall franchise value remains strong. As the outlook for 2009 and 2010 shows, we do not expect the extraordinary market conditions of the second quarter to have a long term impact on the retail business. The move to a nodal market in Texas should also mitigate some of the congestion exposure. And as we continue to make progress on our Smart Energy offerings and increased sales in new markets, we will further strengthen the value of our retail business.

Let me now turn to wholesale. The outlook for wholesale contribution margin is up significantly, based on June 20sup>th/sup> commodity curves. As Mark noted, commodity prices are substantially lowered today. If we were to remark the curves to last week, wholesale's cumulative three year margin including the impact of hedges and adjusting for lower emissions amortization, would be about $275 million higher than what we showed in last quarter's call. Without the hedges, wholesale margin over the three year's is about $300 million less than our prior outlook.

You will note that market implied heat rates in the PJM and MISO forward curves from last week are backward dated [ph], through 2010, and are lower than they were in our outlook last quarter. We continue to believe that the forward curves do not reflect the tightening of supply and demand we expect to see in the future.

We saw strong performance in our plant operations, with commercial capacity factor, or CCF, almost 93% in June. We're maintaining our 87.4% CCF outlook for the year. Coal prices continue to climb during the quarter. As you may recall, we're fully hedged for 2008, and are now about 55% hedged for 2009 coal requirements, including Seward [ph]. Mark discussed our perspective on the Federal Courts decision to vacate the Clean Air Interstate Rule. In that context, we remain on schedule to complete the scrubbers at Cheswick and Keystone during 2009.

We updated our plant to comply with new Mercury Emissions Regulations in Pennsylvania, by investing approximately $50 million on controlled equipment. The team developed creative solutions that lowered the investment from our prior estimate by about $40 million to $50 million. Our wholesale business is performing well, and the tightening of supply and demand in our core markets will continue to increase the value of our fleet. I will now turn the call over to Rick Dobson, our Chief Financial Officer.

Rick Dobson - Executive Vice President and Chief Financial Officer

Thanks Brian. Let's start with our financial highlights on slide nine. Our open EBITDA decreased $131 million, driven by the challenges in our Texas retail business that Mark and Brian discussed. Our adjusted EBITDA decreased $12 million from 2007. As in the past, lower historical power hedges and in-the-money coal hedges that were procured before the 2008 coal price increases, primarily bridged this $119 million difference.

Now lets move on to the retail business on slide 10. As you can see from this slide, the factor that Brian talked about including weather, transmission congestion and our zone-to-zone supply strategy and competitive pricing decisions were the big factors that contribute to our lower mass and C&I gross margins and ultimately drove the $166 million year-over-year negative variance.

Now let's turn to the wholesale business on slide 11. As was previously discussed, improved plant availability and unit margins generated by tightening supply and demand fundamental and higher commodity prices are the primary story behind the open [ph] contribution margin increase over the prior year's quarter. These improvements were the catalyst for the three positive margin variances. There was a $17 million commercial capacity factors improvement over 2007, powered by fuel plant outages, we experienced unit margin increases of $15 million that were propelled by solid June power prices.

Lastly, there was a $10 million improvement in other margin, primarily resulting from improved capacity payments in PJM. In addition to these positive margin variances, we had 9 million of lower quarter-over-quarter O&M due to fewer planned outages.

On the other side of the ledger, we earned $27 million less as a result of lower off-peak spread and the deconsolidation of Channelview in the third quarter of 2007. The Channelview sale was completed on July 1st, yielding $15 million in initial cash with an additional $50 million expected over the next year.

Moving to slide 12, let's take a look at our year-to-date cash flows. In short, stronger wholesale performance during the first half of 2008 more than offset poor second quarter retail performance, resulting in a $272 million positive free cash flow variance.

Now let's move to our 2008 to 2010 outlook on slide 13. The key takeaway is that we will produce in excess of 2 billion of free cash flow over a variety of commodity price scenarios during this three year timeframe. For this outlook, we have also made modifications to our 2008 retail forecast, primarily driven by our second quarter results and zone-to-zone supply risk mitigation steps taken for the third and fourth quarters of 2008.

The 2009 and 2010 retail outlook amounts are not impacted by the extraordinary market conditions seen in the second quarter of this year. The combination of the June 20th commodity price levels and our hedge portfolio are the primary drivers behind the significant upward revisions from our last outlook.

Given the increase in this outlook, it implies that our entire net operating loss will be utilized before the end of 2009. That being the case, we've included cash taxes of approximately $500 million in this free cash flow outlook.

As we continuingly note, commodity prices can be extremely volatile. In the appendix, we provide directional sensitivities related to the major commodity price drivers so that you can make adjustments to our date specific outlook amounts based on subsequent commodity price movements. We developed a flexible capital structure to allow for all reasonable financial and commodity-based market fluctuations as we move up the tightening supply and demand curve, much like the volatile commodity price environment and unstable financial markets that exist today.

As we discussed earlier this year, it makes sense for a company of our size to maintain permanent debt in the $2 billion to $2.5 billion range in a dynamic and uncertain marketplace. This is a level of debt that allows for flexibility to create value in good environments as well as in more the challenging times. Going forward, we will actually manage Reliant's capital structure by balancing our primary goal of delivering long-term shareholder value with the need to provide adequate liquidity to manage our business throughout the market cycles.

Now let me turn it back over to Mark for some concluding remarks.

Mark M. Jacobs - President and Chief Executive Officer

Thanks Rick. Let me wrap up on slide 14 with a summary of key points. We believe there is a robust value proposition in Reliant Energy stock. In the wholesale business, we expect higher levels of profit and cash flow over time as we come out of the trough of the cycle. And we need to remember that point. It shouldn't get muddled with day-to-day volatility in commodity prices.

In the retail business, we had a difficult quarter. But we are taking specific actions to ensure that we are better equipped to manage through extreme events in the future. Stepping back, we have a solid retail franchise with a successful track record. We are financially strong with ample liquidity. And finally, we expect to generate substantial free cash flow in the next few years. Our commitment is to deploy that capital in a manner that creates the highest long-term value for shareholders.

Thank you and we'll open the line for questions.

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