<PAGE>
                                                                      EXHIBIT 13

                1998  Yankee Energy System, Inc. Annual Report

YES

The Energy Magazine for Investors


                                                            Unlocking new growth

[PICTURE APPEARS HERE]

                             New data drives growth      Natural gas stock Q&A
      --------------------------------------------------------------------------
INSIDE
      --------------------------------------------------------------------------
               R.M. Services joins Dun & Bradstreet         Getting Y2-capable
<PAGE>

Unlocking new growth at the core of our business

COMPANY PROFILE

Yankee Energy was founded in 1989 to provide natural gas distribution to
residential, commercial, and industrial customers in Connecticut. The demand for
natural gas has increased steadily, as has our ability to bring it to market and
produce a return. Here is a report on how Yankee continues to grow with the
demands of the southern New England energy market.

Yankee Energy System, Inc. (YES or the Company), headquartered in Meriden,
Connecticut, is a diversified company specializing in the distribution,
conversion and control of energy to meet our customers' needs. Our principal
operating subsidiary is Yankee Gas Services Company (Yankee Gas).

Yankee Gas, the largest natural gas distribution company in Connecticut,
provides service to more than 183,000 customers in 68 of the state's cities and
towns. The Company's other operating subsidiaries support our core business in
natural gas distribution, or allow us to expand our growing business in
energy-related services.

Yankee Energy Services Company (YESCo) provides a wide range of energy-related
services for its customers including comprehensive building automation with
engineering, installation, and maintenance of building control systems through
its YESCo Controls division, and comprehensive heating, ventilating and air
conditioning (HVAC), boiler and refrigeration equipment services and
installation through its YESCo Mechanical Services division.

In addition to Yankee Gas and YESCo, two other subsidiaries are taking advantage
of market opportunities. R.M. Services, Inc. provides collection services for
companies throughout the United States, and Yankee Energy Financial Services
Company provides a full range of equipment and home improvement financing
options through programs like the Hometown Energy Loan Program. Another
subsidiary, NorConn Properties, Inc. (NorConn) owns selected system real estate
and leases it to Yankee Gas.

Additional company information can be found at the YES web site,
www.yankeeenergy.com.


                   [CAPTION OF YEAR IN REVIEW APPEARS HERE]

                         YANKEE'S YEAR IN REVIEW 1998

Yankee Energy Stats
$315 million 
Gross annual revenue for Yankee Energy hits the $315 million mark.

183,000 Utility Customers
and growing. In 1998, Yankee added nearly 2,000 more customers--residential, 
commercial and industrial--to its base.

Key Characteristics
Strong management with diverse experience; attractive yield; solid dividend 
growth for eight straight years; secure opportunities in basic natural gas 
business; clearly articulated business strategy.

68 Towns
Yankee Gas' service area covers approximately half of Connecticut's land area 
representing 44 percent of the state's 1.3 million households.

Four-year contract signed with International Brotherhood of Electrical Workers. 

Three awards received for safety and environmental responsibility.

Charles E. Gooley named President and CEO; Emery G. Olcott assumes chairmanship.

Eight consecutive annual increase in shareholder dividend.

Yankee Financial forms national home energy loan program.

                       [PICTURE YANKEE GAS SERVICE AREA]


R.M. Services forms alliance with Dun and Bradstreet.

98 Financial HIGHLIGHTS
     
<TABLE> 
<CAPTION> 
Years Ended September 30,                    1998            1997           % Change
-----------------------------------------------------------------------------------------
<S>                                     <C>              <C>                <C>                                  
FINANCIAL (In thousands)
Utility revenues                        $   283,839      $   318,954             (11.0)%
Nonutility revenues                     $    30,928      $     6,087             408.1%
Net income                              $    10,883      $    16,957             (35.8)%
Capital expenditures                    $    39,496      $    35,211              12.2%
Net utility and nonutility plant        $   380,711      $   370,176               2.8%
                                                           
COMMON STOCK                                               
Earnings per share                      $      1.04      $      1.62             (35.8)%
Stock price (end of year)               $     26.19      $     23.69              10.6%
Quarterly dividend (end of year)        $     0.345      $     0.335               3.0%
Yield (end of year)                             5.3%             5.7%             (7.7)%
Weighted average common
   shares outstanding                    10,495,806       10,451,165               0.4%
Book value per share (end of year)      $     15.65      $     15.85              (1.3)%

OPERATIONS
Gas sales (MMcf)                             31,077           38,022             (18.3)%
Gas transportation (MMcf)                    16,070           10,912              47.3%
Degree days (normal 6,151)                    5,502            5,979              (8.0)%
Customers (average)                         183,070          181,242               1.0%
----------------------------------------------------------------------------------------
</TABLE> 



<TABLE> 
<CAPTION> 
                                   1994            1995          1996          1997           1998
                                   ----            ----          ----          ----           ----    
<S>                                <C>             <C>           <C>           <C>            <C> 
Market Price Per Share             $  21.50         21.375        22.875        23.6875       26.1875
Book Value Per Share               $ 14.536         14.596        15.509          15.85        15.646
Earnings                           $   1.81           1.20          2.10           1.62          1.04
Dividends Paid                     $   1.19           1.24          1.28           1.32          1.36
Cash Flow                          $   31.7           38.5          36.4           28.6          18.5
   In millions                                                                                               
                                                                                               ------
</TABLE> 


<PAGE>
 
                           Cover Stories & Features


                                 COVER STORIES



                             [PICTURE APPEARS HERE]   MESSAGE TO
                                                      SHAREHOLDERS




TECHNOLOGICAL
ADVANCEMENTS

[PICTURE APPEARS HERE]



                                                          [PICTURE APPEARS HERE]

                                                       FORECASTING GROWTH
                                                       IN 1999


                                                  4   YANKEE FINANCIAL

                                                  5   R.M. SERVICES

                                                  9   Y2K PREPARATIONS PROGRESS

                                                 10   Q&A: WHY A UTILITY STOCK?

                                                 12   QUESTIONS & ANSWERS

                                                 13   DIRECTORS AND OFFICERS

                                                 14   FINANCIAL INFORMATION
                                   CONTENTS

1998 Yankee Energy System Annual Report

                                       1
<PAGE>
 
      [PICTURE APPEARS HERE]

Emery G. Olcott       Charles E. Gooley


In September of 1998, your board of directors elected Charles E. Gooley, a
senior officer since the Company's inception, as President and CEO of the
Company and Emery G. Olcott, a director since 1989, as Chairman of the Board of
Directors.


TO OUR SHAREHOLDERS


After more than 17 years of combined experience with Yankee Energy, we are
privileged to have the opportunity to lead the Company into a new millennium.
And so it is an appropriate time to reflect on our accomplishments, our
challenges and, most important, to share with you our vision for the future of
this Company.

Yankee Energy has risen from relative obscurity in 1989 to being recognized as
one of the most progressive energy companies in the United States. We remain the
largest distributor of natural gas in Connecticut and Yankee has become an
identifiable brand name to Connecticut consumers. Because of our core strength
in the natural gas distribution business, we have returned a dividend to our
investors for the tenth consecutive year. We intend to focus and build on the
strengths of our core business.

Over the last two years, we have spent a great deal of
management time and attention on investments in power generation, building
control systems, and the installation and servicing of HVAC, boiler, and
refrigeration equipment. As we expanded the geographic reach of these energy
services businesses through our YESCo subsidiary, it became more difficult for
our newly formed YESCo organization to manage the new businesses, acquisitions,
and greater geographical reach. For the third consecutive year, YESCo failed to
reach profitability. This mandated a careful analysis that has led to this
conclusion: While there are opportunities in energy services we will continue to
exploit, we will only pursue them when they are complementary to our core
strengths and support the expansion of our natural gas distribution business.

                                       2
<PAGE>
 
As a result of this new focus we have decided to divest all of the
power-generation assets located outside Connecticut. We will continue to assist
power generation developers in procuring reliable sources of natural gas for
their projects but we will tend to concentrate on such projects closer to home.

We continue to have confidence of our ability to operate the building controls
and HVAC businesses profitably. In fact, we have already taken steps to shift
existing HVAC capabilities under YESCo's operation to support our strength in
natural gas distribution services. We also have centralized YESCo's operations
to bring staff, dispatching, purchasing and billing under one roof.

These measures, combined with strict cost management, will enable us to price
our services aggressively, still earn reasonable returns, and continue to
provide excellent service to our customers. Then, once we have proven to you
that we can deliver reasonable returns in the energy services business, we will
consider expanding our investments in that sector. But our primary focus will
continue to be on energy services that enhance the use of natural gas in the
current 68-town Yankee Gas service area.

Our strategic plan to accomplish this will employ data secured through
advanced market research. The new data are showing us the precise areas where
natural gas expansion can be unlocked at the greatest level of profitability in
all customer segments. While we pursue these opportunities we will intensify the
cost-management strategies that have been successful in the past. Our base
natural gas prices have not increased since 1992 and we intend to continue to
avoid base price increases.

Because of our core strength in the natural gas distribution business, we have
returned a dividend to our investors for the tenth consecutive year.

Our primary focus will continue to be on energy services that enhance the use of
natural gas in the current 68-town Yankee Gas service area.


We will only pursue energy services when they are complementary to our core
strengths and support the expansion of our natural gas distribution business.

                                       3
<PAGE>
 
Last year we reported progress in the area of firm transportation by our Yankee
Gas subsidiary, enabling commercial and industrial customers to purchase natural
gas from other suppliers. Since our profits are derived from the transportation
of natural gas and not the sale of natural gas itself, this area of business
promises greater opportunities for our customers to benefit from the direct
purchase of gas from another supplier at lower prices. Firm transportation
continues to provide excellent value to our non-residential customer base.

This, then, is the plan for increasing Yankee Energy's value to you, our
shareholders: achieve greater market share along our mains; contain costs;
capitalize on higher margin energy services opportunities; maintain our strong
presence in regulatory and legislative affairs; elevate customer service to new
heights; and develop non-weather-dependent revenue sources for the future.

Now, we'd like to share with you some exciting developments that have grown from
Yankee Energy's expertise in energy and energy management.

In the past year, our R.M. Services subsidiary has entered into an alliance with
Dun & Bradstreet Receivables Management Services, the world's largest supplier
of business-to-business credit management services. This new partnership will
put our consumer collections expertise to work for D&B clients, with a goal
being to unlock the massive national market of uncollected utility debt.

Yankee Energy Financial Services, which for years has offered home energy-
related financing to residential, commercial, and industrial customers here in
Connecticut, is now working in conjunction with the American Public Gas
Association to offer the Hometown Energy Loan Program. This national endeavor,
financed by Fannie Mae and administered by Yankee Financial based on its core
expertise in energy loans, markets home-energy improvement financing to more
than three million APGA customers. This effort will not affect Yankee
Financial's ability to continue to support Yankee Gas and YESCo by enabling
Connecticut customers to purchase equipment.

With this new direction set, and with promising new partnerships already at
work, we report to you that our earnings for 1998 were less than desired: $1.24
per share, exclusive of nonrecurring charges, down $0.38 from $1.62 in 1997.
Warm weather also diminished our financial results in 1998. Earnings for the
year were reduced by $0.42 per share due to warmer-than-normal temperatures.
Also reflected in 1998 results is a one-time charge against earnings of $0.20.
This is largely associated with the restructuring of our unregulated business
under YESCo.

With those restructuring charges behind us and a solid plan for the future, We
look forward with great enthusiasm to the second decade of your Company's
existence.


/s/ Charles E. Gooley                       /s/ Emery G. Olcott

Charles E. Gooley                           Emery G. Olcott
Chief Executive Officer                     Chairman of the Board
and President

                                       4
<PAGE>

Yankee Financial teams with APGA and Fannie Mae in home energy loan program.
 
Yankee Energy is tapping into the national home energy improvement market
through a loan program based on a successful model developed by Yankee Energy
Financial Services Company. For years, Yankee Financial has helped Connecticut
customers finance natural gas-fueled energy systems and equipment. Yankee
Financial's role has become more than an added service; Yankee Financial is
involved in the negotiations YESCo conducts with its commercial and industrial
customers for energy equipment. In 1998, the sale and installation of several
cogeneration systems were possible because of Yankee Financial's ability to make
energy improvements affordable for the commercial and industrial sector, which
is where the greatest profit margins exist for the Company. And now, Connecticut
homeowners enjoy the convenience of qualifying for a loan over the phone or
electronically through Yankee Energy's web site. On the strength of its success,
Yankee Financial joined Fannie Mae and the American Public Gas Association
(APGA) in a national home energy-improvement program. The Hometown Energy Loan
Program (HELP) offers broad-based, low-cost home energy improvement financing.
"This opportunity grew directly from one of our core competencies in the natural
gas business," said Matthew Ide, manager of Finance Services. "We were
approached by the APGA based on our track record in providing energy financing
for homeowners here in our home state. We have the expertise in the utilities
sector to handle the types of loans this program brings to the market." Yankee
Financial will continue to provide financing programs for in-state commercial
and industrial customers. HELP works like this: APGA-member utilities in the
lower 48 states are eligible to participate. Their customers can finance home
improvements such as insulation, ductwork, windows, and heating and cooling
equipment up to $15,000 for up to 10 years, with locked-in interest rates.
Fannie Mae provides the capital. The utility markets the program to its
customers. Yankee provides a turnkey loan program and earns revenue on every
loan processed. There are no prepayment penalties, and utilities are protected
from losses on defaulted loans, thereby eliminating credit risk. "HELP is a
low-cost answer to every homeowner's desire to improve what is probably their
biggest investment," said Ide. "And it can connect Yankee Energy to an
additional 3.8 million potential loan customers nationwide. It's a good example
of how new revenue can grow from our bedrock business in serving natural gas
customers."

YANKEE'S R.M. SERVICES FORMS
PARTNERSHIP WITH DUN & BRADSTREET


Yankee Energy is taking advantage of the estimated $29.2 billion that goes
uncollected each year in utility industries through a new alliance with an
internationally renowned corporation. Dun & Bradstreet, the world leader in
industrial receivables management services, has joined forces with Yankee
Energy's R.M. Services, Inc., giving Dun & Bradstreet the ability to penetrate
the vast market of consumer receivables in regulated industries such as energy
and telecommunications. The new alliance, based at Yankee Energy's headquarters
in Meriden, Connecticut, gives Yankee a new revenue source that is independent
of New England winter weather. "A few years ago, R.M. Services reduced Yankee
Energy's bad debt by 50 percent and added $2.0 million to their bottom line
through state-of-the-art collection services," said Murry K. Staples, the firm's
vice president and general manager. "We're bringing that capability to our
alliance with Dun & Bradstreet. Now we can attract a wide range of clients."
Staples pointed out that companies can increase their overall value by reducing
bad debt. But advanced infrastructure such as professionally staffed call
centers and dedicated computer systems is needed to implement an aggressive
receivables collection program. The Dun & Bradstreet/R.M. Services partnership
immediately puts these resources -and extensive management expertise -- to work
for their clients. "R.M. Services' core strength in collecting unpaid consumer
utility bills was recognized by Dun & Bradstreet," said Staples. "Together,
we're capable of capitalizing on this huge market."

                                       5
<PAGE>
 
[PICTURE APPEARS HERE]

Intelligent growth, driven by new data


               ADVANCED MAPPING SYSTEMS AND MARKET ANALYSIS ARE
         ENABLING INTELLIGENT, COST-EFFICIENT GROWTH FOR YANKEE ENERGY

In the past year, Yankee Gas added 1377 new residential customers and 451 new
commercial and industrial customers to its core natural gas business. These
increases in Yankee's customer base are part of a two-year trend that has seen a
customer growth rate nearly twice that experienced over the previous two years
(FY 95 and 96).

This growth reflects a shift in Yankee's sales strategy, which now provides
greater incentives for the sales force to develop more profitable areas of
business, particularly the commercial sector, where there has been an increase
of approximately 60 percent in the last year. Riding the momentum of this
success, Yankee's marketing efforts are taking on a sharp new focus through a
highly detailed market research study.

"The new data enable us to do several things better than we've done them
before," said John Ferrantino, director of Market Development. "First, we can
determine precisely where the greatest potential is for growth. Second, our
research shows that we can grow more efficiently by influencing the
preconstruction decision-making process surrounding natural gas. Third, we can
pinpoint markets where our cost of doing business is lowest and our
profitability greatest."

Seeing new potential in existing markets

Working with the Connecticut Economic Resource Center (CERC), Yankee has
developed grids that provide greater detail of the Yankee distribution system
and the location of businesses within each town eligible for natural gas
service.

This provides an easy-to-use visual analysis of potential prospects in relation
to the Yankee distribution system. "We've always known that the
commercial/industrial markets are where the greatest volume and profitability
exist," said Ferrantino. "Now we can target this part of our market with greater
efficiency."

                                       6
<PAGE>
 
Lowering CDB

Another factor influencing Yankee's marketing efforts is the analysis of
service-installation costs. "We know our labor and material costs for connecting
new customers to our mains," said Ferrantino. "But different towns have
different ordinances and restrictions that affect our cost of doing business.
When we compare this information to forecasted statewide housing growth, we can
determine which parts of our service area offer the best potential for
profitable growth."

Building markets from the ground up

Different markets require different marketing approaches. While the residential
customers are the ones who pay the gas bill, they are typically not the ones who
specify the type of heating system for their home. This decision is heavily
influenced by the contractor or builder. By strengthening relationships with
this group, Yankee can achieve a greater return on its marketing efforts.

"For each of the past two years, we added approximately 1300 residential
customers, mainly former oil customers who switch to natural gas for performance
and environmental reasons, regardless of cost," said Ferrantino. "But the 80 to
96 percent efficiency of new natural gas heating systems means that less of the
commodity may be used. That means we must market more individual burner tips in
each customer site, whether it's a natural gas fireplace, grill, clothes dryer
or stove. The best way to do that is to go after the people in the business of
developing real estate. This will result in better market penetration in the
residential, commercial and industrial segments of our business."



[PICTURE APPEARS HERE]

Companies like the Bristol-Myers Squibb Pharmaceutical Research Institute in
Wallingford, are turning to Yankee for energy solutions that increase efficiency
and profitability. And all-gas housing complexes like Deep Brook Harbor,
Suffield (left), reflect Yankee's efforts to capitalize on residential markets
through marketing efforts with contractors and developers.

Pushing and pulling new market potential

Ferrantino describes the overall Yankee marketing plan in classic marketing
terms: While contractors, builders and architects are pushed to recommend and
specify natural gas from the outset of construction, residential and
commercial/industrial targets will be pulled into requesting natural gas with
consistent, focused sales and marketing efforts.

"We're smarter than we've ever been," said Ferrantino. "We better understand
where our markets are, how to reach them, and where we can do business at the
greatest level of profitability. We have all the tools to saturate our markets
efficiently."

                                       7

<PAGE>
 
Technological advancements move forward


The driving force behind Yankee Energy's successful advancement is the effective
use of new systems that capture and organize data. Information concerning
markets and operations will be harnessed and directed toward greater expansion,
better service and improved overall performance. Here's how.

CCIS sharpens customer focus

Yankee is installing a new system for customer billing, customer data storage
and retrieval. The Customer Connection Information System (CCIS), to be
operational in April 1999, will bring the Company's customer service to a higher
level.

"CCIS instantly gives us a full view of the customer," said Project Director
Mike Marinaccio. "It shows the type of structure, the equipment in place, the
metering system, and the customer's service record, payment history, and usage
patterns. It strengthens our ability to serve all customers immediately and
efficiently."

HR software organizes internal data

Employees are people, but they also represent data. Payroll, benefits, training,
and job performance are just a few categories of information that need to be
logged and updated for every employee. A newly installed human resources system
by PeopleSoft(TM) is enabling Yankee to keep better records on employees and
maintain better employee relations.

"This Company employs 835 people," said Scott Waleski, director of Information
Services. "The PeopleSoft program lets us track individual benefits, vacation
time, flex time, payroll data, and other aspects of each person. It's a huge
boost to internal efficiency."

The new system also tracks the training and professional advancement of
employees. "It's an example of how technology can be used not only to organize
statistical data, but to help people develop," said Waleski.

E-business coordinates commodity flow

Yankee's Electronic Bulletin Board (EBB), implemented last year, continues to
improve the Company's communication with gas marketers. The system has
drastically reduced the paper and voice mail previously used to communicate with
those who sell the natural gas that flows through Yankee's distribution system.
According to Waleski, "Commodity marketers use the EBB to reserve capacity on
our mains, so we can forecast the volume of natural gas we'll need to
distribute. It improves the efficiency of both our external communications and
our business."

Virtual reality comes to gas cooling

Gas cooling has traditionally been difficult to sell. A new CD-based virtual
reality module is helping companies better understand this technology.

SolutionsPlus(TM), developed by Yankee's marketing department, is a first in the
industry. It is currently being used by gas companies throughout the country to
show potential customers the virtues of desiccant, absorption, and engine-driven
cooling systems in an interactive format.

The customized sales tool shows the configuration of a gas-cooling system at
work in a building, illustrating the flow of refrigerant and air throughout the
structure. The program also includes information on load-balancing, case
studies, and financing and installing equipment.

                                       8

<PAGE>
 
[PICTURE APPEARS HERE]

SCADA: Enhancing total system control

Yankee's SCADA system (Supervisory Control and Data Acquisition), installed in
December of 1998, oversees all key functions in the Yankee natural gas
distribution network.

SCADA's role in Yankee's future cannot be undervalued. It enables the Company to
monitor the amount of commodity in the system, temperature and pressure readings
along every mile of main, the performance of natural gas transmission lines and
gate stations, and other important functions.

Because of the high level of control it provides, SCADA allows Yankee
to select which pipeline it opens to bring more natural gas into the Company's
distribution system. For example, if it is more efficient or cost-effective to
bring in more natural gas through the Algonquin pipeline rather than the
Tennessee pipeline, SCADA enables Yankee to issue the command through phone
lines and make the adjustment quickly and efficiently.

yankeeenergy.com wins award, and opens doors

Yankee's web site won "Best Energy Site" from the Web Marketing Association,
Inc., affirming Yankee's efforts to make it a front door to the Company for
everyone -- consumers, companies, gas marketers, regulators and investors.

There is a wealth of data available at the site and the design makes it easy for
lower-speed modems to move through it quickly.

The site includes a page for investors with real-time stock quotes and access to
detailed corporate information. Other features include access to gas usage data
for customers, and links to every Yankee subsidiary.

According to Steve Laden, vice president, Sales, Marketing and External Affairs,
"We are keeping the content and design interesting and interactive, so that once
people come through the front door, they stay for a while. And then come back
again."


Y2K Preparations Progress

Yankee began addressing Year 2000 systems issues in 1995. At the time of this
report, all mainframe computer systems are Y2K compliant. But the concerns over
Y2K consequences reach every level of corporate operations.

The PC systems within the Company are being prepared in a dedicated testing lab.
The LAN environment, embedded chip, and software equipment is being upgraded
simultaneously. Representatives from every department of the Company have been
assigned to make sure that Y2K issues are addressed. To ensure and expedite
clear, consistent communication, Yankee is using its intranet system to
continually update personnel on available resources, and the need to make
progress in this area.

Scott Waleski, director of Information Services for Yankee Gas, said "We got
a head start on this issue. The result is we're ahead of schedule for securing
operations in the new millennium, which in turn means we can focus on other
areas of technology that will improve our operations."

                                       9

<PAGE>
 
Q&A


Why invest in a Natural Gas Utility Stock?

Daniel M. Fidell is a securities analyst with A.G. Edwards & Sons, Inc., a
full-service investment firm and NYSE member. Here he shares his views on the
value of investing in natural gas utilities stock.

                                                                             
Are natural gas stocks currently undervalued?

Our universe of gas utility stocks at A.G. Edwards consists of 41 companies [of
which Yankee Energy is one]. At current prices, gas utility stocks trade near 15
times estimated fiscal 1999 EPS, a valuation level approaching the group's five-
year low and below electric and water utility indices.

We've seen a roller coaster ride on Wall Street recently. How does market
turbulence factor into the decision of whether or not to buy a gas utility
stock?

Typically, gas utility stocks perform well during periods of overall
market uncertainty. Attractive yields and the ability to maintain
earnings growth despite an economic slowdown could make such stocks attractive
to investors if the volatility we've seen continues.

Since the share prices of gas utility stocks vary in accordance with long-term
interest rates and government bonds, tell us what's been happening in this area.

We're experiencing a favorable interest rate environment right now. Long-term
government bond yields have declined to a level near 5.2 percent without an
accompanying increase in the price of gas utility stocks. Consequently, the
potential returns of gas stocks related to government bonds have improved.

www.yankeeenergy.com

www.yankeeenergy.com

                                      10

<PAGE>
 
What overall improvements do you see in how natural gas companies do business?

Gas utilities have worked hard to improve efficiency in the last few years. As a
result, earnings growth has increased, profitability ratios have risen, dividend
payout has decreased and balance sheets are stronger. And it looks like this
trend toward greater efficiency will continue. The other trend is toward
diversification. Many gas utilities have diversified their operations to include
nonregulated operations such as energy production, power generation,
consultation, and other energy-related ventures. Diversification is likely to
lead to increased earnings growth, albeit at a modest increase to the company's
overall risk profile.

What do you see with regard to demand for the commodity itself?

The American Gas Association indicated demand has increased 35 percent since
1986 in the United States. Still, only 65 percent of the residential homes in
the U.S. heat with natural gas. Market share expansion should continue for years
to come, especially in light of the fact that it's an environmentally friendly
fuel.

Describe your views on takeover and merger activity in this sector.

Consolidation activity within the sector is expected to continue going forward
and, as in the past, will most likely involve electric utilities paying a
premium price to acquire gas utilities. The median price paid for a gas utility
over the last three years has been approximately 20 times forward earnings, 2.3X
book value, 10.2X cash flow and $1,143 per customer, respectively.

                                      11

<PAGE>
 
Yankee Energy Officers


Seven leaders. 115 years of experience.

Meet the people leading Yankee Energy. They have more than a century of
experience in the energy industry, with an average tenure of nine years here at
Yankee Energy. Their work is at the root of the Company's continuing new growth
in the business of natural gas distribution.

[PICTURE OF CHARLES E GOOLEY APPEARS HERE]

Charles E. Gooley
President and
Chief Executive Officer

[PICTURE OF MARY J. HEALEY APPEARS HERE]

Mary J. Healey
Vice President,
General Counsel and
Secretary

[PICTURE OF ELLEN J. QUINN APPEARS HERE]

Ellen J. Quinn
Vice President

[PICTURE OF STEVEN P. LADEN APPEARS HERE]

Steven P. Laden
Vice President

[PICTURE OF JAMES M. SEPANSKI APPEARS HERE]

James M. Sepanski
Vice President,
Chief Financial Officer and
Treasurer

[PICTURE OF THOMAS J. HOUDE APPEARS HERE]

Thomas J. Houde
Vice President

[PICTURE OF NICHOLAS A. RINALDI APPEARS HERE]

Nicholas A. Rinaldi
Controller


Board of Directors

[PHOTO OF SANFORD CLOUD, JR APPEARS HERE]

Sanford Cloud, Jr. /2/, /3/
President and
Chief Executive Officer
The National Conference for 
Community and Justice
New York, NY

[PHOTO OF JOHN J. RANDO APPEARS HERE]

John J. Rando /2/, /3/
Senior Vice President and Group General Manager of Compaq Services at Compaq 
Computer Corporation
Stow, MA

[PHOTO OF EMERY G. OLCOTT APPEARS HERE]

Emery G. Olcott /1/, /4/, /5/
Chairman
Yankee Energy System, Inc.
Chairman, President and
Chief Executive Officer
Packard BioScience Company
Meriden, CT

[PHOTO OF CHARLES E. GOOLEY APPEARS HERE]

Charles E. Gooley /1/
President and
Chief Executive Officer
Yankee Energy System, Inc.
Meriden, CT

[PHOTO OF EILEEN S. KRAUS APPEARS HERE]

Eileen S. Kraus /2/, /4/, /5/
Chairman, Connecticut Fleet National Bank
Hartford, CT

[PHOTO OF PATRICIA M. WORTHY APPEARS HERE]

Patricia M. Worthy /2/, /3/
Professor
Howard University
School of Law
Washington, D.C.


Committees of the Board
1 Executive     2 Audit     3 Finance     4 Organization and Compensation
5 Committee on Board Affairs

                                      12

<PAGE>
 
FINANCIAL INFORMATION

Contents


Management's Discussion and Analysis


Management and Independent Public Accountants Reports


Consolidated Statements of Income


Consolidated Balance Sheets


Consolidated Statements of Cash Flows


Consolidated Statements of Capitalization


Consolidated Statements of Common Shareholders' Equity


Notes to Consolidated Financial Statements


Selected Financial and Operating Data


Shareholder and Stock Information
<PAGE>
 
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS


OVERVIEW

Yankee Energy System, Inc. (YES or the Company), headquartered in Meriden,
Connecticut, is a diversified company specializing in the distribution,
conversion, and control of energy to meet our customers' needs. Our principal
operating subsidiary is Yankee Gas Services Company (Yankee Gas). Yankee Gas,
the largest natural gas distribution company in Connecticut, provides service to
more than 183,000 customers in 68 cities and towns. The Company's other
operating subsidiaries support our core business in natural gas distribution, or
allow us to expand our growing business in energy-related services. Yankee
Energy Services Company (YESCo) provides a wide range of energy-related services
for its customers, including comprehensive building automation with engineering,
installation and maintenance of building control systems through its YESCo
Controls division, and comprehensive heating, ventilation and air-conditioning
(HVAC), boiler and refrigeration equipment services and installation through its
YESCo Mechanical Services division. During fiscal 1998, YESCo's Power division
also provided expertise related to the production of thermal and/or electric
power. In addition to Yankee Gas and YESCo, two other subsidiaries are taking
advantage of opportunities by positioning services once exclusively provided to
local energy customers to a broader marketplace. R.M. Services, Inc. (RMS),
through its alliance with Dun & Bradstreet Receivables Management Services,
provides consumer collection services for companies throughout the United
States, and Yankee Energy Financial Services Company (Yankee Financial) provides
a full range of equipment and home improvement financing options through
programs like the Hometown Energy Loan Program. NorConn Properties, Inc.
(NorConn) owns selected system real estate, which it leases to Yankee Gas.
Additional company information can be found at the Company web site,
www.yankeeenergy.com.

After completing a recent review of the various operating functions of YESCo,
management of the Company has decided to focus the efforts of YESCo primarily on
its controls and HVAC lines of business and to significantly reduce its cost
structure. As a result, the Company intends to dispose of the assets of YESCo's
Power division in fiscal 1999. In addition, the Company has restructured its
HVAC business, including the consolidation of locations and better focusing its
business both geographically and operationally.

The Company reported consolidated net income, exclusive of nonrecurring charges,
of $13.0 million, or basic and diluted earnings per share of $1.24, for its
fiscal year ended September 30, 1998. This compares with consolidated net income
of $16.9 million and $21.9 million, reflecting basic and diluted earnings per
share of $1.62 and $2.10, respectively, for fiscal years ended September 30,
1997 and 1996. Earnings for fiscal 1998 inclusive of nonrecurring items are
$10.9 million, or $1.04 basic and diluted earnings per share.

Earnings for fiscal year 1998 decreased due to warmer weather and customer bill
credits. In addition, earnings were unfavorably impacted by nonrecurring charges
related to the restructuring of the HVAC operations of YESCo, impairments of
certain YESCo Power division assets, and severance charges. In fiscal 1998,
weather was 11 percent warmer than normal and 8 percent warmer than the prior
fiscal year. Management estimates warmer weather reduced earnings by $4.4
million, or $0.42 per share, in the current fiscal year compared to normal, and
reduced earnings by $3.7 million, or $0.35 per share, compared to the prior
fiscal year. Customer bill credits resulting from a rate review settlement
approved by the Connecticut Department of Public Utility Control (DPUC) in
October 1997 reduced earnings by approximately $1.9 
<PAGE>
 
million, or $0.18 per share, for the fiscal year ended September 30, 1998. In
the fourth quarter, the Company recorded restructuring charges for YESCo,
including the impact of management's decisions to restructure its HVAC
operations and dispose of the existing assets and projects under development for
the Power division. The HVAC restructuring includes the consolidation of four
locations into one operating center, thereby eliminating redundant
administrative and operating positions, and better focusing its business both
geographically, by discontinuing non-Connecticut activities, and operationally,
by discontinuing the HVAC equipment sales operation. The after-tax charge for
YESCo restructuring totaled $1.6 million, or $0.15 per share. YESCo recorded
losses of $3.0 million, exclusive of nonrecurring charges, and $2.7 million for
the years ended September 30, 1998 and 1997, respectively. Finally, Yankee
Energy recorded an after-tax charge for severance, due to the resignation of two
senior executives, of approximately $0.5 million, or $0.05 per share.

Earnings for fiscal 1997 decreased as compared to fiscal 1996 primarily due to
operating losses incurred by the Company's nonutility subsidiaries. Delays in
bringing new business on line and integrating these companies into YESCo
contributed to losses. These losses were partially offset by strong operating
performance at Yankee Gas during fiscal 1997 due primarily to a reduction in
operation and maintenance expense principally as a result of cost controls
implemented by the Company. Higher earnings in fiscal 1996 were primarily due to
colder weather in fiscal 1996 as compared with fiscal 1998 and 1997, and the
gain realized from the sale of the Company's equity interest in the Iroquois Gas
Transmission System (Iroquois). Earnings on the Company's investment in Iroquois
for the first six months of fiscal 1996 were approximately $1.5 million and
contributed $0.14 to earnings per share. Upon the sale of Iroquois, earnings for
fiscal 1996 reflected a gain of $2.5 million, or $0.24 per share. Thus, total
earnings related to the investment in Iroquois, including the gain on sale, were
$0.38 per share in fiscal 1996.

In fiscal 1998, the Company adopted Statement of Financial Accounting Standards
No. 128, "Earnings per Share" (FAS 128), which changed the method for computing
earnings per share and requires the Company to present basic and diluted
earnings per share. As a result, all prior periods have been restated to reflect
the application of FAS 128. The effect of this accounting change on previously
reported earnings per share data was immaterial. The basic weighted average
shares outstanding for fiscal 1998, 1997 and 1996 were 10,495,806, 10,451,165
and 10,435,231, respectively, and the diluted weighted average shares
outstanding for fiscal 1998, 1997 and 1996 were 10,501,411, 10,453,318 and
10,437,461, respectively.

RESULTS OF OPERATIONS
<PAGE>
 
OPERATING REVENUES

Utility revenues decreased $35.1 million, or 11 percent, in fiscal 1998 from
fiscal 1997 and decreased $20.1 million, or 6 percent, in fiscal 1997 from
fiscal 1996. These decreases were offset by increases in operating revenues from
nonutility operations of $24.8 million and $5.2 million, respectively. The
components of operating revenues for the past three years are provided in the
following table:

<TABLE>
<CAPTION>
Years Ended September 30,              1998         1997         1996     
(In thousands)                                                          
<S>                                <C>            <C>          <C>      
Firm sales                           $237,136     $276,299     $299,681 
Firm transportation                    18,709        7,433          258 
Interruptible/off-system sales         20,303       29,183       32,332 
Interruptible transportation            3,646        2,646          730 
Other utility revenues                  4,045        3,393        6,044 
                                     --------     --------     -------- 
                                                                        
Total utility revenues                283,839      318,954      339,045 
Nonutility revenues                    30,928        6,087          895 
                                     --------     --------     -------- 
                                                                        
Total operating revenues             $314,767     $325,041     $339,940 
                                     --------     --------     -------- 
                                     --------     --------     -------- 
                                                                        
Utility operating margin             $139,655     $146,143     $149,857 
                                     --------     --------     -------- 
                                     --------     --------     -------- 
                                                                        
Nonutility operating margin          $  6,356     $  2,141     $    579 
                                     --------     --------     -------- 
                                     --------     --------     -------- 
</TABLE>

Throughput corresponding to utility revenues is as follows:

<TABLE>  
<CAPTION>
Years Ended September 30,               1998       1997      1996
<S>                                    <C>        <C>        <C>   
(Mcf-thousands)                                            
Firm sales                             26,116     31,447     35,139
</TABLE> 
<PAGE>
 
<TABLE> 
<S>                                    <C>        <C>        <C>  
Firm transportation                     9,426      4,059        178
Interruptible/off-system sales          4,961      6,575      9,513
Interruptible transportation            6,644      6,853      2,444
                                       ------     ------     ------
                                                                   
Total throughput                       47,147     48,934     47,274
                                       ------     ------     ------ 
                                       ------     ------     ------ 
</TABLE>

The decrease in utility revenues in fiscal 1998 primarily reflected weather that
was 8 percent warmer in fiscal 1998 compared to fiscal 1997 and customer bill
credits during fiscal 1998 of $3.2 million. The warmer weather in the fiscal
1998 heating season directly reduced sales to firm sales customers. Firm sales
contribute the highest per-unit operating margin of all utility revenues, and
thus, the primary reason for the decrease in utility operating margin from
fiscal 1997. In addition, an increasing number of commercial and industrial
customers continued to shift from gas sales to transportation service resulting
in a decrease in utility revenues. Interruptible revenues have decreased
primarily as a result of lower oil prices in fiscal 1998 compared to fiscal
1997. The decrease in utility revenues from fiscal 1996 to fiscal 1997 primarily
reflected a decrease in firm sales volumes of approximately 11 percent. This
decrease primarily related to the shift of firm sales to firm transportation and
a decrease in residential sales volumes related to weather that was 5 percent
warmer than fiscal 1996. These decreases were partially offset by the increase
in firm and interruptible transportation from 1996 to 1997. Revenues from
nonutility operations increased $24.8 million from 1997 to 1998 and increased
$5.2 million from 1996 to 1997 due to the growth of nonutility subsidiaries,
primarily due to acquisitions.

OPERATING EXPENSES
Total operating expenses decreased $0.5 million in 1998 compared to 1997 and
decreased $10.8 million in 1997 compared to 1996 as a result of the following
items:

-    Cost of gas decreased $28.6 million, or 17 percent, in 1998 compared to
     1997 and decreased $16.4 million, or 9 percent, in 1997 compared to 1996.
     Yankee Gas defers differences between actual purchased gas costs and the
     current cost recovery, and recovers or refunds such differences in future
     periods. This deferral results in an increase or decrease to gas costs in
     each fiscal year. The fiscal 1998 and fiscal 1997 decreases were due
     primarily to an increase in deferred gas costs and a 16 percent and 9
     percent decrease in utility revenues, excluding transportation revenues,
     respectively, as a result of the warmer weather. Cost of gas was also
     impacted by transportation customers who 
<PAGE>
 
     purchase their own gas supply, which is transported through the Yankee Gas
     distribution systems.

-    Cost of goods sold increased $20.6 million in 1998 compared to 1997 and
     $3.6 million in 1997 compared to 1996, due to increased YESCo activity from
     acquisitions, particularly mechanical contracting.

-    Operation and maintenance expense decreased $3.5 million in 1998 compared
     to 1997 and increased $0.1 million in 1997 compared to 1996. The 1998
     decrease was primarily due to a decrease in uncollectible expense, as a
     result of lower revenues from the warmer weather, and a decrease in pension
     expense, offset by increases in nonutility operating expenses. The 1997
     increase was primarily due to increased expenses related to nonutility
     operations, partially offset by a decrease in Yankee Gas operation and
     maintenance expense as a result of cost controls implemented by Yankee Gas.

-    Nonrecurring charges relate to restructuring charges for the HVAC
     operations of YESCo, impairments of certain YESCo Power division assets and
     severance expense. Restructuring charges for YESCo included the impact of
     management's decisions to restructure its HVAC operations and dispose of
     the existing assets and projects under development for the Power division.
     The charge for YESCo restructuring matters totaled $3.5 million in the
     fourth quarter of fiscal 1998. Also, in the fourth quarter of fiscal 1998,
     YES recorded a charge for severance, of approximately $0.9 million, due to
     the resignation of two senior executives.

-    Depreciation and amortization expense increased $1.7 million in 1998
     compared to 1997 and increased $1.2 million in 1997 from 1996. The 1998 and
     1997 increases were primarily due to additions in both plant assets and
     investments.

-    Taxes other than income taxes decreased $2.1 million in 1998 compared to
     1997 and increased $0.6 million in 1997 compared to 1996. The 1998 decrease
     was primarily due to decreases in both gross earnings tax, due to lower
     revenues in fiscal 1998 compared to fiscal 1997, and Connecticut
     unemployment taxes due to lower than expected unemployment costs from
     Yankee Gas' transformation project in fiscal 1995. The 1997 increase was
     primarily due to higher Connecticut unemployment taxes and municipal taxes,
     partially offset by lower gross earnings taxes resulting from lower
     revenues in fiscal 1997 compared to fiscal 1996.

Other income remained consistent in 1998 compared to 1997 and decreased $5.4
million in 1997 compared to 1996. The 1997 decrease was primarily due to the
gain from the sale of investments associated with the Company's interest in
Iroquois in 1996 and the absence of earnings associated with Iroquois.
<PAGE>
 
Interest expense in 1998 increased $1.4 million as compared to 1997 primarily
due to higher levels of outstanding short-term debt, offset by a slight decrease
in outstanding long-term debt. Interest expense in 1997 decreased $2.5 million
as compared to 1996 primarily due to lower levels of debt and lower interest
expense on Yankee Gas' deferred fuel balance.

Federal and state income taxes decreased $5.1 million in 1998 compared to 1997,
and decreased $2.0 million in 1997 compared to 1996. The 1998 decrease was
primarily due to lower pre-tax income as a result of the warmer weather and
nonrecurring charges. The 1997 decrease was primarily due to lower taxable
income as a result of operating losses incurred by the Company's nonutility
subsidiaries. Please refer to Note 2 to the Consolidated Financial Statements
for additional information concerning the components of federal and state income
taxes.

One of Yankee Gas' largest customers is the Foxwoods Hotel and Casino
(Foxwoods), operated by the Mashantucket Pequot Indian Tribe (Pequots). The City
of Norwich, Connecticut has completed construction of a pipeline extending from
their distribution system to Foxwoods and began service to Foxwoods on December
1, 1998. Norwich, pursuant to an agreement with the Pequots, will become the
sole provider of gas transportation service to the Pequots. Foxwoods had
generated approximately $650,000 in annual margin for the Company.

LIQUIDITY AND CAPITAL RESOURCES

Cash and temporary cash investments at September 30, 1998 totaled $1.9 million.
Cash provided by operating activities was $18.5 million in fiscal 1998, $28.6
million in fiscal 1997 and $36.4 million in fiscal 1996. The decrease in cash
provided by operating activities was primarily due to the decrease in net income
from the warmer weather and customer bill credits from the rate review
settlement with the DPUC in fiscal 1998. Additionally, an increase in YESCo's
working capital requirements for fiscal 1998 contributed to the decrease. Cash
provided by operating activities in fiscal 1998 was used primarily for changes
in working capital, dividend payments and capital expenditures. The Company
increased dividends paid per share to $1.36 in 1998, up 3.0 percent from the
$1.32 per share in 1997, the eighth straight year the Company has increased its
dividend. Expenditures for plant, property and investments totaled $39.4 million
in 1998 reflecting a $4.3 million increase from 1997. Fiscal 1998 capital
expenditures included approximately $8.4 million related to the installation of
a new customer service system. The Company's estimated capital expenditures for
fiscal 1999 is $30.5 million. The Company expects to finance the fiscal 1999
capital expenditures through a combination of internally generated funds and
short-term borrowings.

In addition to cash provided by operating activities, the Company
<PAGE>
 
generated cash through financing activities, primarily by the issuance of new
common stock and increases in short-term borrowings. During fiscal 1998, the
Company issued 82,708 new shares under its Shareholder Investment Plan and 8,240
shares under its Long-Term Incentive Plans. These new shares provided
approximately $2.2 million of new equity funding in fiscal 1998. In fiscal 1997,
the Company issued 4,860 new shares of common stock under its Long-Term
Incentive Plans.

The seasonal nature of gas revenues, inventory purchases and construction
expenditures create a need for short-term borrowing to supplement internally
generated funds. Short-term borrowings increased $36.7 million during fiscal
1998. Yankee Gas has arranged a $60 million revolving line of credit with a
group of four banks whereby funds may be borrowed on a short-term revolving
basis using either fixed or variable rate loans. Yankee Gas also has a $27
million credit line available on an uncommitted basis. Yankee Gas had $63.2
million outstanding under its agreements at September 30, 1998 and $36.3 million
outstanding at September 30, 1997. In addition, Yankee Energy had $12.5 million
and $2.7 million outstanding as of September 30, 1998 and 1997, respectively, on
a $25 million line of credit, which is available to fund the development of the
Company's nonutility businesses. The weighted average interest rates on short-
term borrowing at September 30, 1998 and 1997 were 5.8 percent and 6.0 percent,
respectively. Management is currently planning a $50 million new long-term debt
financing for Yankee Gas in fiscal 1999 for the purposes of replacing a portion
of the existing outstanding short-term debt and to refinance Yankee Gas' Series
A Tranche D First Mortgage Bonds, which become redeemable by Yankee Gas in
August 1999.

The long-term credit needs of Yankee Gas are being met by a first mortgage bond
indenture that provides for the issuance of bonds from time to time as the need
arises, subject to certain restrictions. At September 30, 1998, indenture
requirements, including the required coverage ratio, would allow for the
issuance of an additional $200 million of bonds at an assumed interest rate of 7
percent.

On February 1, 1996, the Company's system real estate subsidiary, NorConn,
secured a $6 million bank term loan to refinance two existing real estate loans.
Under the agreement, the interest rate is fixed at 6.2 percent for the seven-
year term of the loan and requires an annual $250,000 sinking fund payment.

On April 1, 1997, Yankee Gas redeemed all $30 million Series A Tranche C First
Mortgage Bonds, which matured on that date. Yankee Gas used cash on hand and the
issuance of a $30 million principal amount of Series E First Mortgage Bonds on
April 1, 1997, through a private placement, to redeem the Series A Tranche C
First Mortgage Bonds. The bonds were sold by the initial purchaser to "qualified
institutional buyers" as defined in and pursuant to Rule 144A under the
Securities Act of 1933. The 
<PAGE>
 
bonds will mature April 1, 2012 and interest is payable at an annual rate of 7.2
percent.

REGULATORY DEVELOPMENTS

On August 25, 1996, Yankee Gas filed an application with the DPUC for a
Financial and Operational Review (Review). This Review was required under
Connecticut statute since Yankee Gas' last rate approval was on August 26, 1992.
On July 9, 1997, the DPUC issued its decision in Docket No. 96-08-05. The DPUC
decision, which is not a rate order, called for a lowering of Yankee Gas'
authorized Return on Equity (ROE) from 12.43 percent to 11.15 percent. The DPUC
believed that lower current interest rates and recently allowed rates of return
for other Connecticut utilities justified a lower ROE for Yankee Gas. On October
1, 1997, the DPUC approved a settlement whereby Yankee Gas would credit
approximately $3.2 million to firm sales customers through the Purchased Gas
Adjustment Clause (PGA) during fiscal year 1998. As of September 30, 1998, the
entire $3.2 million has been accrued and approximately $2.9 million had been
credited to firm sales customers. The remaining $0.3 million has been included
in the Company's annual deferred fuel calculation and beginning in October 1998
was credited to firm sales customers. The settlement also allows Yankee Gas to
maintain its base rates until the end of fiscal year 2000, resulting in an 
eight-year period in which Yankee Gas will have gone without an increase in its
base rates.

On January 3, 1996, the DPUC issued a Final Decision in reopened Docket No. 92-
02-19 to approve a rate agreement Yankee Gas reached with the Office of Consumer
Counsel (OCC.). The agreement states that Yankee Gas may apply a portion of
credits received from pipeline refunds, excess interruptible margins, deferred
gas costs, capacity release agreements and off-system sale margins to reduce or
eliminate certain deferred regulatory assets. These credits are provided by a
mechanism established by the DPUC for the Connecticut Local Distribution
Companies (LDCs) to recover the gas supply transition costs relating to Federal
Energy Regulatory Commission Order No. 636.

Through September 30, 1998, Yankee Gas paid approximately $20.5 million of the
gas supply transition costs and an additional $2.5 million are anticipated. To
date, Yankee Gas has collected $46.3 million through a combination of credits
received from pipeline refunds, capacity release agreements, deferred gas costs,
off-system sale margins, and excess interruptible margins. These excess
collections of approximately $25.8 million have been applied against certain
regulatory assets in accordance with the January 3, 1996 DPUC decision.

On January 24, 1996, the DPUC issued a Final Decision on Docket No. 92-02-19
Reopen I (the Decision). The Decision enabled Yankee Gas to implement firm
transportation (FT) rates and services as contemplated in an August 2, 1995
decision. The 
<PAGE>
 
Decision allows Yankee Gas to offer a broad array of service options to
commercial and industrial FT customers. Yankee Gas implemented these new FT
rates and services on April 1, 1996. On October 28, 1998, the DPUC issued an
Interim Decision on Docket No. 92-02-19 Reopen Re: Unbundling, that addressed
changes to the existing commercial and industrial FT program, effective January
1, 1999. These modifications are intended to make improvements to the existing
FT program based on the initial two-plus years of FT experience.

A switch by existing sales customers to transportation tariffs will result in
decreased revenues for Yankee Gas as the portion of revenues representing gas
costs will now be borne directly by those customers. Yankee Gas does not expect
customer conversions to transportation services to affect its net income because
the cost of gas has traditionally been a pass-through item with no income
impact. As of September 30, 1998, Yankee Gas had approximately 3,100 customers
under the new FT service.

LEGAL PROCEEDINGS

In fiscal 1996, Yankee Gas received revised property tax bills from the City of
Meriden, Connecticut (the City). The City is asserting a claim for approximately
$5.0 million for back taxes and interest resulting from a retroactive
reassessment and revaluation of Yankee Gas' personal property filings. The City
did not locate or identify any property which Yankee Gas omitted from its
filings. The tax bills reflect a reassessment of property using a different
methodology than that previously accepted by the City. Yankee Gas is currently
in the process of litigating this retroactive reassessment and the court in this
matter has recently recommended that the parties attempt mediation/arbitration
of the issue. Although it is anticipated that the outcome of this claim will not
have a material impact on the Company, based on the information available at
this time, management cannot predict what the ultimate impact might be.

In November 1995, a purported class action suit was filed in Connecticut
Superior Court against Yankee Gas and the state's two other LDCs by the
Connecticut Heating and Cooling Contractors' Association, Inc. et al,. The
action alleges that the LDCs unfairly competed with licensed plumbers and
contractors by performing customer service work using employees who did not
possess state trade licenses.

On January 27, 1998, the court struck 31 out of the plaintiffs' 32 counts
contained in their complaint leaving only one count alleging violations of
Connecticut's anti-trust statute. The court also noted that although the
plaintiffs' action purports to be a class action, the plaintiffs have failed to
obtain certification as such. Thereafter, the plaintiffs' filed another
purported class action against all three LDCs alleging unfair trade practices
and additional separate actions against each LDC alleging various business
torts. The LDCs have asserted that 
<PAGE>
 
such licenses are not required for this work based on statutory exemption
enacted in 1965 and amended in 1967. However, in a separate proceeding, a
Connecticut Superior Court has upheld an administrative ruling against the LDC's
position which was affirmed on appeal. In 1995, the Connecticut General Assembly
enacted legislation that established prospectively a separate procedure for
state certification of gas service employees.

Recently, the lawsuits were transferred to the Complex Litigation Docket of the
Superior Court where the presiding judge chose to try the case against
Connecticut Natural Gas (CNG) first. No other material action in Yankee Gas'
lawsuit will be taken pending the outcome of the CNG trial which is expected to
commence in August 1999. While the ultimate resolution of the actions cannot be
predicted, management does not expect that they will have a material adverse
effect on the Company's consolidated results of operations or financial
position.

In August 1997, CNG filed suit against Yankee Gas alleging that Yankee Gas'
plans to provide gas service to a 119 unit residential subdivision in the town
of Berlin violated CNG's utility franchise rights within that town. The lawsuit
was tried in the Connecticut Superior Court in January 1998. The court issued a
decision on October 30, 1998 in favor of CNG, and entered an order prohibiting
Yankee Gas from continuing to serve that particular subdivision within Berlin.
Yankee Gas' other existing activities within Berlin remain unaffected.

The Company has elected not to appeal this decision. The parties have been
ordered by the court to confer and agree on a suitable amount to be paid by CNG
to Yankee Gas as compensation for facilities constructed by Yankee Gas to serve
the subdivision. The Company does not anticipate that the outcome of this
lawsuit will have a material adverse effect on the Company's consolidated
results of operations or financial position.

TAX AUDITS

The Company is currently under audit by the State of Connecticut regarding the
Company's Gross Earnings Tax Returns for the calendar years 1994, 1995 and 1996,
by the City of Naugatuck, Connecticut regarding the Company's Personal Property
Tax Schedules for the years 1995, 1996 and 1997, and by the Internal Revenue
Service regarding the Company's Federal Income Tax Return for the calendar year
1995. The Company is responding to all information document requests put forth
by the auditors. At this time, the Company does not have sufficient information
to determine the amount, if any, of additional liability that may result from
these proceedings. At this time the Company does not anticipate that any of
these audits will have a material effect on its consolidated results of
operations or financial position.

ENVIRONMENTAL MATTERS
<PAGE>
 
Fourteen sites containing coal tar became the property of Yankee Gas at
divestiture from Northeast Utilities, in 1989. Contamination at these sites was
caused by operations of former manufactured gas plants at those locations.
Yankee Gas has reported the results of its environmental studies to the
Connecticut Department of Environmental Protection (DEP). The DEP has not
required that any remedial action be undertaken to date. However, eight of the
fourteen sites are presently listed on the Connecticut Inventory of Hazardous
Waste Sites. Inclusion of a site on this list indicates that remediation may be
required in the future.

Remediation has been conducted at three of these properties. In addition, Yankee
Gas has developed a cost estimate for the remaining sites based on various
factors including the probability of clean-up. As a result of this effort,
Yankee Gas recorded a liability of $35 million in fiscal 1993 for future
environmental clean-up. Recovery of remediation costs has been specifically
allowed by Yankee Gas' 1992 rate case decision. Presently, $325,000 is allowed
annually in rates. If costs are expected to exceed $2.5 million on an annual
basis, Yankee Gas is required to review such expenditures with the DPUC. The
DPUC has stated that "to the extent that coal tar remediation expenses are
prudently incurred, they should be allowed as proper operating expenses," and
therefore, management continues to believe a regulatory asset is appropriate for
this item.

Yankee Gas expects to finance such expenditures through a combination of
internally generated funds, short-term debt, and through insurance settlements,
of which $9.6 million has been received through September 30, 1998. The proceeds
are being reflected as reductions in the regulatory asset associated with
recoverable environmental clean-up costs, as shown in the accompanying balance
sheets.

YEAR 2000

The Company is currently implementing new information systems and enhancing
existing information systems to address Year 2000 issues, which could have
significant adverse effects on the Company if not properly resolved. In fiscal
1995, the Company began testing and remediation for Year 2000 problems and has
assigned dedicated personnel to its Year 2000 project. Remediated programs are
being tested prior to being declared compliant.

As of September 30, 1998, YES has completed the inventory and the assessment of
risk phases of the Year 2000 project for all mainframe systems. The Company is
currently in the remediation and testing phases. As part of the process, a
detailed inventory of all hardware and software currently utilized by the
Company has been prepared, and a timetable has been established to ensure
testing of all applications. The scope of the assessment phase also included the
Company's interface systems with significant 
<PAGE>
 
suppliers, government agencies and other third parties. However, there can be no
guarantee that the systems of these third parties will be converted on a timely
basis and will not have an adverse effect on the Company's operations or
systems.

All mainframe systems that are being remediated are now in the testing phase,
which as of September 30, 1998, is approximately 95 percent complete. In
addition to remediating existing systems, the Company has purchased and is
currently installing a new human resource information system (HRIS) and a new
customer service (CS) system. These systems were purchased to improve
functionality of the application software and to improve efficiency and customer
service. In addition, any Year 2000 issues associated with these systems will be
eliminated. The new HRIS system is expected to be operational in January 1999
and the CS system is expected to be operational in April 1999. For all other
mainframe systems, the target date for completion of the remediation program is
December 1998, with some systems completed prior to this date.

For non-mainframe systems, except the supervisory control and data acquisition
system (SCADA system), which monitors gas flows and pressures within the
distribution system, the Company is developing a test environment to carry out
the remainder of the remediation program. The inventory and risk assessment
phase of all non-mainframe systems should be completed by the end of 1998,
followed by completion of the remediation/replacement and testing phases by June
1999. The Company is in the process of installing a new SCADA system, which will
eliminate any Year 2000 issues associated with that system. The new SCADA system
should be operational in December 1998.

The Company currently estimates that total costs to update all of the Company's
systems for Year 2000 compliance will be approximately $17.4 million, including
approximately $0.6 million for the new HRIS system, $15 million for the new CS
system and $1.3 million for the new SCADA system. All such costs associated with
system enhancements have and will continue to be expensed as incurred and the
costs of new systems will be capitalized as appropriate. As of September 30,
1998, 1997 and 1996, the Company expensed approximately $152,000, $217,000 and
$2,000, respectively, and capitalized approximately $9.7 million, $5.9 million
and $0.2 million, respectively, of these costs. The remaining costs will be
incurred in fiscal 1999. These costs have been financed through short-term
borrowing and internally generated funds.

The primary business risk associated with Year 2000 is the Company's ability to
continue to transport and distribute gas to its customers without interruption.
In the event the Company and/or its suppliers and vendors are unable to
remediate the Year 2000 problem prior to January 1, 2000, operations of the
Company could be significantly impacted. In order to mitigate this risk, the
Company is developing a contingency plan to continue 
<PAGE>
 
operations through manual intervention and other procedures should it become
necessary to do so. Such procedures are expected to include back-up power supply
for its critical pipeline and storage operations and, if necessary, curtailment
of supply. The Company expects to complete its operational contingency plan by
the end of fiscal 1999.

Although the Company expects its systems to be Year 2000 compliant on or before
December 31, 1999, it cannot predict the outcome or the success of its Year 2000
program, or that the costs required to address the Year 2000 issue, or that the
impact of a failure to achieve substantial Year 2000 compliance, will not have a
material adverse effect on the Company's business, financial condition or
results of operations.

OTHER MATTERS

On May 6, 1998, the Company filed an application with the DPUC to discontinue 
on-demand, non-contract service work. Hearings had been held on this matter and
the DPUC felt strongly that the Company should continue to provide this service
and would consider allowing the Company an increase in the applicable service
rates. The Company withdrew its application and has resumed providing this
service.

The Company's wholly-owned, nonregulated subsidiary, Yankee Financial, has
recently sold its loan receivable portfolio to an independent party and
recognized a small gain as a result of the sale. The transaction was recorded as
a sale for financial reporting purposes.

RMS, a wholly-owned subsidiary of the Company, recently entered into an
agreement with Dun & Bradstreet Receivable Management Services (D&B), under
which RMS will extend its collection activities in the transitioning energy,
telecommunication and other industries by supporting the extensive network of
D&B in its pursuit of additional consumer business. RMS has extensive experience
and specialized skills in residential utility collection practices and computer-
aided calling technology.

In June 1997, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standards No. 130, "Reporting Comprehensive Income,"
which requires that changes in comprehensive income be shown in a financial
statement that is displayed with the same prominence as other financial
statements and Statement of Financial Accounting Standards No. 131, "Disclosure
about Segments of an Enterprise and Related Information," which establishes
annual and interim reporting standards for an enterprise's operating segments
and related disclosures about its products, services, major customers and the
countries in which the entity holds assets and reports revenues. In February
1998, the FASB issued Statement of Financial Accounting Standards No. 132,
"Employers' Disclosure about Pensions and Other Postretirement Benefits," which
revises disclosures, but does not change the measurement or recognition of
postretirement plans. Management is currently evaluating the impact of these
standards and believes their adoption will not impact the Company's consolidated
financial position, results of operations or cash flows, and any impact will be
limited to the form and content of its disclosures. All of these statements are
effective for the Company's fiscal year 1999.

In March 1998, the Accounting Standards Executive Committee issued Statement of
Position (SOP) 98-1, "Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use." This SOP provides guidance on accounting for the
costs of computer software developed or obtained for internal use. The Company
is reviewing the requirements of the SOP and does not expect it to significantly
change its current accounting for software costs. SOP 98-1 is required to be
adopted by the Company for its fiscal year 2000.

In June 1998, the FASB issued Statement of Financial Accounting Standards No.
133, "Accounting for Derivative Instruments and Hedging Activities," which
requires the Company to recognize all derivatives as either assets or
liabilities in the consolidated balance sheets and measure those instruments at
fair value. Management is currently evaluating the impact of this standard and
believes the adoption will not impact the Company's consolidated financial
position, results of operations or cash flows. This statement is effective for
the Company in the first quarter of fiscal year 2000.

FORWARD-LOOKING STATEMENTS

This report contains statements which, to the extent they are not recitations of
historical fact, constitute "forward-looking statements" within the meaning of
the Private Securities Litigation Reform Act of 1995. Such forward-looking
statements involve risks and uncertainties. Actual results may differ materially
from such forward-looking statements for reasons including, but not limited to,
changes to and developments in the legislative and regulatory environments
affecting the Company's business, the impact of competitive products and
services, changes in the natural gas industry caused by deregulation and other
factors, certain environmental matters, internal and/or third party delays or
failures in achieving Year 2000 compliance, as well as such other factors as set
forth in the Company's Form 10-K for the year ended September 30, 1998 and other
filings with the Securities and Exchange Commission.
<PAGE>
 
MANAGEMENT REPORT

The consolidated financial statements of Yankee Energy System, Inc. and
subsidiaries and other sections of this Annual Report were prepared by
management, which is responsible for their integrity and objectivity. These
financial statements, which were audited by Arthur Andersen LLP, were prepared
in accordance with generally accepted accounting principles using estimates and
judgement, where required, and giving consideration to materiality.

The Company maintains a system of internal controls over financial reporting,
which is designed to provide reasonable assurance to the Company's management
and Board of Directors regarding the preparation of reliable published financial
statements. The system contains self-monitoring mechanisms, and actions are
taken to correct deficiencies as they are identified. Even an effective internal
control system, no matter how well designed, has inherent limitations, including
the possibility of the circumvention or overriding of controls, and such systems
can provide only reasonable assurance with respect to financial statement
preparation. Further, because of changes in conditions, internal control system
effectiveness may vary over time.

Through established programs, the Company regularly emphasizes to its management
employees their internal control responsibilities and policies prohibiting
conflicts of interest. The Audit Committee of the Board of Directors is composed
entirely of outside directors. This Committee meets periodically with
management, the internal auditors and the independent auditors to review the
activities of each and to discuss audit matters, financial reporting and the
adequacy of internal controls.

Management believes that its system of internal accounting controls and control
environment provide reasonable assurance that its assets are safeguarded from
loss or unauthorized use and that its financial records, which are the basis for
the preparation of all financial statements, are reliable.


Charles E. Gooley
President and
Chief Executive Officer

James M. Sepanski
Vice President,
Chief Financial Officer and Treasurer
<PAGE>
 
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To the Board of Directors and Shareholders of Yankee Energy System, Inc.:

We have audited the accompanying consolidated balance sheets and consolidated
statements of capitalization of Yankee Energy System, Inc. (a Connecticut
corporation) and subsidiaries (the Company) as of September 30, 1998 and 1997,
and the related consolidated statements of income, common shareholders' equity
and cash flows, for each of the three years in the period ended September 30,
1998. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Yankee Energy System, Inc. and
subsidiaries as of September 30, 1998 and 1997 and the results of their
operations and their cash flows for each of the three years in the period ended
September 30, 1998, in conformity with generally accepted accounting principles.


Arthur Andersen LLP
Hartford, Connecticut                 
November 16, 1998
<PAGE>
 
<TABLE> 
<CAPTION> 
YANKEE ENERGY SYSTEM, INC. AND SUBSIDIARIES
Consolidated Statements of Income
(In thousands, except per share amounts)

For the Years Ended September 30,     1998     1997      1996
<S>                                <C>       <C>       <C>
Revenues:
  Utility revenues                 $283,839  $318,954  $339,045
  Nonutility revenues                30,928     6,087       895
                                   --------  --------  -------- 
  Total Revenues                    314,767   325,041   339,940
                                   --------  --------  --------
 
Operating Expenses:
  Cost of gas/goods sold            168,755   176,757   189,504
  Operations                         62,496    58,569    58,375
  Maintenance                         5,978     6,382     6,477
  Nonrecurring charges                4,436        --        --
  Depreciation and amortization      19,789    18,130    16,895
  Taxes other than income taxes      20,431    22,519    21,949
                                   --------  --------  --------
 
  Total Operating Expenses          281,885   282,357   293,200
                                   --------  --------  --------
 
 
Operating Income                     32,882    42,684    46,740
 
Other Income/Expense:
  Other income, net                     174       159     5,572
  Interest expense, net              13,853    12,463    14,942
                                   --------  --------  --------
 
Income Before Income Taxes           19,203    30,380    37,370
 
Provision for Income Taxes            8,320    13,423    15,451
 
                                   --------  --------  --------     
Net Income                         $ 10,883  $ 16,957  $ 21,919
                                   ========  ========  ========
 
 
 
Basic and Diluted Earnings
per Common Share                      $1.04     $1.62     $2.10
                                   ========  ========  ======== 
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.
<PAGE>
 
<TABLE> 
<CAPTION>  
YANKEE ENERGY SYSTEM, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
(In thousands)
 
At September 30,                                                                 1998      1997
<S>                                                                            <C>       <C> 
ASSETS
Utility Plant, at original cost                                                $547,098  $524,221
  Less: Accumulated provision for depreciation                                  207,872   192,506
                                                                               --------  --------
                                                                                339,226   331,715
  Construction work in progress                                                  28,707    19,150
                                                                               --------  --------
     Total Net Utility Plant                                                    367,933   350,865
                                                                               --------  --------
Other Property and Investments                                                   12,778    19,311
Assets held for sale                                                             12,361        --
 
Current Assets:
  Cash and temporary cash investments                                             1,881     2,239
  Accounts receivable, less accumulated
     provision for uncollectible accounts of
     $8,132 in 1998 and $7,713 in 1997                                           35,946    27,002
  Fuel supplies                                                                   1,418    10,370
  Other materials and supplies                                                    1,972     2,186
  Accrued utility revenues                                                        4,028     4,667
  Deferred gas costs, current portion                                             1,879     2,034
  Prepaid expenses and other                                                     25,327    13,932
                                                                               --------  --------
     Total Current Assets                                                        72,451    62,430
                                                                               --------  --------
 
Deferred Gas Costs                                                                8,601     8,364
Recoverable Environmental Cleanup Costs                                          33,670    31,667
Recoverable Income Taxes                                                         10,673    11,038
Recoverable Postretirement Benefits Costs                                         1,725     1,515
Other Deferred Debits                                                            15,092    15,174
                                                                               --------  --------
     Total Assets                                                              $535,284  $500,364
                                                                               ========  ========
</TABLE>
 
<TABLE>
CAPITALIZATION AND LIABILITIES
<S>                                                                            <C>       <C>
Capitalization (see accompanying statements):
  Common shareholders' equity                                                  $164,992  $165,706
  Long-term debt, net of current portion                                        131,048   135,265
                                                                               --------  --------
     Total Capitalization                                                       296,040   300,971
                                                                               --------  --------
 
Current Liabilities:
  Notes payable to banks                                                         75,700    39,000
  Long-term debt, current portion                                                 4,217     4,017
  Accounts payable                                                               19,643    22,741
  Accrued interest                                                                3,176     2,008
  Pipeline transition costs payable                                               2,516     3,538
  Other                                                                           8,402     6,480
 
     Total Current Liabilities                                                  113,654    77,784
                                                                               --------  --------
 
Accumulated Deferred Income Taxes                                                72,816    68,205
Accumulated Deferred Investment Tax Credits                                       8,325     8,703
Reserve for Environmental Cleanup Costs                                          35,000    35,000
Postretirement Benefits Obligation                                                3,353     2,840
Other Deferred Credits                                                            6,096     6,861
                                                                                     
Commitments and Contingencies (Note 9)                                               --        --
                                                                               --------  --------
     Total Capitalization and Liabilities                                      $535,284  $500,364
                                                                               ========  ========
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.
 
<PAGE>
 
<TABLE>
<CAPTION>  
YANKEE ENERGY SYSTEM, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(In thousands)

For the Years Ended September 30,                                       1998       1997     1996 
<S>                                                                   <C>       <C>      <C>
Cash Flows From Operating Activities:
Net income                                                              $10,883 $16,957  $ 21,919
Adjusted for the following:
  Depreciation and amortization                                          19,789  18,130    16,895
  Asset impairment, nonrecurring charge                                   2,037       -         -
  Equity earnings from investments                                         (216)   (105)   (2,766)
  Gain on sale of investment in Iroquois                                      -       -    (2,688)
  Deferred income taxes, net                                              4,598   6,927     9,267
  Deferred gas costs activity and other
   non-cash items                                                        (3,688) (5,007)   (3,986)
  Changes in working capital:
   Accounts receivable and
     accrued utility revenues                                            (8,305)   (271)   (4,668)
   Prepaid expenses and other                                           (11,395) (5,106)   (2,644)
   Accounts payable                                                      (3,098)    170     4,271
   Other working capital (excludes cash)                                  7,885  (3,089)      787
                                                                        ------- -------   -------
Net cash provided by
 operating activities                                                    18,490 $28,606    36,387
                                                                        ------- -------   -------
 
Cash Flows From Financing Activities:
  Net proceeds from common
    stock issuance                                                        2,232     105     1,216
  Issuance of long-term debt                                                  -  30,000     2,150
  Retirement of long-term debt                                           (4,017)(34,017)   (5,817)
  Increase (decrease) in
   short-term debt                                                       36,700  18,700    (8,225)
  Cash dividends                                                        (14,267)(13,797)  (13,357)
                                                                        ------- -------   -------
Net cash provided by (used for)
    financing activities                                                 20,648     991   (24,033)
                                                                        ------- -------   -------
 
Investment In Plant And Other:
  Utility Plant                                                         (36,649)(31,320)  (25,663)
  Other property and investments                                         (4,847) (3,891)   (4,380)
  Iroquois distribution                                                       -       -     2,625
  Proceeds from Iroquois sale                                                 -       -    22,192
                                                                        ------- -------   -------
Net cash used for plant and
  other                                                                 (39,496)(35,211)   (5,226)
                                                                        ------- -------   -------
 
Net Increase (Decrease) In Cash and
  Temporary Cash Investments
  For The Period                                                           (358) (5,614)    7,128
Cash and Temporary Cash Investments,
  beginning of period                                                     2,239   7,853       725
                                                                        ------- -------   -------
Cash and Temporary Cash Investments,
  end of period                                                         $ 1,881 $ 2,239   $ 7,853
                                                                        ======= =======   =======

Supplemental Cash Flow Information:
  Cash paid during the period for:
  Interest, net of amounts capitalized                                  $13,273 $14,203   $13,484
  Income taxes                                                          $ 6,469 $12,140   $14,213
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.
<PAGE>
 
<TABLE>
<CAPTION>
YANKEE ENERGY SYSTEM, INC. AND SUBSIDIARIES
Consolidated Statements of Capitalization
(In thousands)
 
At September 30,                                                   1998       1997 
<S>                                                            <C>        <C>
Common Shareholders' Equity:
  Common shares - $5 par value, authorized
    20,000,000 shares; 10,545,362 and
    10,454,414 shares outstanding at
    September 30, 1998 and 1997                                $ 52,727   $ 52,272
  Capital surplus, paid in                                       89,949     88,151
  Unearned compensation-restricted
    stock awards (a)                                               (131)      (148)
  Retained earnings                                              23,047     26,431
  Employee stock ownership plan guarantee (b)                      (600)    (1,000)
                                                               --------   --------
    Total common shareholders' equity                           164,992    165,706
                                                               --------   --------
 
Long-term Debt:
 
 First mortgage bonds
    Maturity                      Interest rates
 
      2004                           10.03%                      20,165     23,532
      2005                            6.75%                      20,000     20,000
      2012                            7.19%                      30,000     30,000
      2019                           10.07%                      19,000     19,000
      2022                            8.48%                      20,000     20,000
      2023                            8.63%                      20,000     20,000
                                                               --------   --------
Total first mortgage bonds                                      129,165    132,532
 
Term loan agreement, 6.24%
   due February, 2003                                             5,500      5,750
 
Guarantee of employee stock ownership plan
   term loan agreement, 10.38%,
   due July, 1999 (b)                                               600      1,000
                                                               --------   --------
Total long-term debt                                            135,265    139,282
Less amounts due within one year (b)(c)                           4,217      4,017
                                                               --------   --------
 
Long-term debt, net                                             131,048    135,265
                                                               --------   --------
 
Total Capitalization                                           $296,040   $300,971
                                                               ========   ========
</TABLE>
                                       
(a) Consistent with the terms of the Non-Employee Directors' Stock Compensation
Plan, incentive awards of 1,200 shares and 900 shares of restricted common stock
were granted to Directors during 1998 and 1997, respectively. Under the
directors' plan, the market value of the restricted stock awards has been
recorded as unearned compensation and is shown as a separate component of
shareholders' equity. The earned compensation is charged to administrative and
general expense as shares become vested. Earned compensation was approximately
$29,000 for fiscal 1998 and $22,000 for fiscal 1997.

Consistent with the terms of the Long-Term Incentive Compensation Plans of the
Company, incentive awards of 1,711 and 2,917 shares of restricted common stock
were granted to employees during 1998 and 1997, respectively. Under the Long-
Term Compensation Plans, the market value of the restricted stock awards has
been recorded as unearned compensation and is shown as a separate component of
shareholders' equity. The earned compensation is charged to administrative and
general expense as shares become vested. Earned compensation was approximately
$78,000 for fiscal 1998 and $44,000 for fiscal 1997.

(b) On July 20, 1989, Yankee Energy became guarantor of a term loan agreement
between the Trustee for the Company's 401(k) Employee Stock Ownership Plan
(ESOP), and a commercial bank, in the amount of $4,000,000. The proceeds were
used by the Trustee exclusively to acquire outstanding shares of Yankee Energy
common stock pursuant to the terms of the Company's ESOP. The final maturity
date of the agreement is July 1, 1999 with sinking fund requirement of $600,000.

(c) Long-term debt maturities and cash sinking fund requirements on debt
outstanding at September 30, 1998 for each of the fiscal years 1999 through 2003
(excluding the ESOP sinking fund requirement and early redemption options the
Company may utilize) are $3,617,000;$4,567,000; $4,567,000; $4,567,000; and
$8,817,000, respectively.

The accompanying notes are an integral part of these consolidated financial
statements.
<PAGE>
 
YANKEE ENERGY SYSTEM, INC. AND SUBSIDIARIES
Consolidated Statements of Common Shareholders' Equity
(In thousands)
 
<TABLE>
<CAPTION>
                                                                                       Employee
                                                                                       Stock
                                                                   Capital  (a)        Ownership
                                                          Common   Surplus,  Retained  Plan
                                                          Shares   Paid In  Earnings  Guarantee  Total
<S>                                                       <C>      <C>      <C>       <C>        <C>
Balance at
September
30, 1995                                                  $51,982  $86,862  $ 14,709   $(1,800)  $151,753
 
Net income                                                                    21,919               21,919
 
Issuance of
53,032 common
shares - $5
par value                                                     266      973                          1,239
 
Cash dividends
on common
shares - $1.28
per share                                                                    (13,357)             (13,357)
 
Employee stock
ownership plan
loan repayment                                                                             400        400
 
Unearned
compensation-restricted
stock awards (b)                                                       112                            112
 
                                                           ------   ------    ------    ------    ------- 
Balance at
September
30, 1996                                                  $52,248  $87,947   $23,271   $(1,400)  $162,066
 
Net Income                                                                    16,957               16,957
 
Issuance of
4,860 common
shares - $5
par value                                                      24       81                            105
 
Cash dividends on
common shares -                               
$1.32 per share                                                              (13,797)             (13,797) 
 
Employee stock
ownership plan
loan repayment                                                                             400        400
 
Unearned compensation-                               
restricted stock                                     
awards (b)                                                             (25)                           (25)

                                                           ------   ------    ------    ------    -------
Balance at
September
30, 1997                                                  $52,272  $88,003   $26,431   $(1,000)  $165,706
 
Net Income                                                                    10,883               10,883
 
Issuance of
90,948
common shares -                               
$5 par value                                                  455    1,777                          2,232  
 
Cash dividends
on common shares -                               
$1.36 per share                                                              (14,267)             (14,267) 
 
Employee stock
ownership plan
loan repayment                                                                             400        400
 
Unearned
compensation-                         
restricted stock                      
awards (b)                                                              38                             38
 
Balance at
September
30, 1998                                                  $52,727  $89,818   $23,047   $  (600)  $164,992
                                                           ------   ------    ------   -------    -------
                                                           ------   ------    ------   -------    ------- 
</TABLE>


(a) Yankee Gas has dividend restrictions imposed by its Bond Purchase
Agreements. At September 30, 1998, retained earnings available for common
dividends under the terms of the Series A Agreement and Series B and C
Agreements totaled approximately $39.3 million and $49.7 million, respectively.

(b) See note (a) of the Consolidated Statements of Capitalization.

The accompanying notes are an integral part of these consolidated financial
statements.
<PAGE>
 
YANKEE ENERGY SYSTEM, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1)   Summary of Significant Accounting Policies

Yankee Energy System, Inc. (YES or the Company), headquartered in Meriden,
Connecticut, is a diversified company specializing in the distribution,
conversion, and control of energy to meet our customers' needs. Our principal
operating subsidiary is Yankee Gas Services Company (Yankee Gas). Yankee Gas,
the largest natural gas distribution company in Connecticut, provides service to
more than 183,000 customers in 68 cities and towns. The Company's other
operating subsidiaries support our core business in natural gas distribution, or
allow us to expand our growing business in energy-related services. Yankee
Energy Services Company (YESCo) provides a wide range of energy-related services
for its customers, with comprehensive building automation with engineering,
installation and maintenance of building control systems through its YESCo
Controls division, and comprehensive heating, ventilation and air-conditioning
(HVAC), boiler and refrigeration equipment services and installation through its
YESCo Mechanical Services division. During fiscal 1998, YESCo's Power division
also provided expertise related to the production of thermal and/or electric
power. In addition to Yankee Gas and YESCo, two other subsidiaries are taking
advantage of opportunities by offering services once exclusively provided to
local energy customers to a broader marketplace. R.M. Services, Inc. (RMS),
through its alliance with Dun & Bradstreet Management Receivables Services,
provides consumer collection services for companies throughout the United
States, and Yankee Energy Financial Services Company (Yankee Financial) provides
a full range of equipment and home improvement financing options through
programs like the Hometown Energy Loan Program. NorConn Properties, Inc.
(NorConn) owns selected system real estate, which it leases to Yankee Gas.
Additional company information can be found at the Company web site,
www.yankeeenergy.com.

Principles of Consolidation: The consolidated financial statements of the
Company include the accounts of all subsidiaries. Intercompany transactions have
been eliminated in consolidation.

Public Utility Regulation: Yankee Gas is subject to regulation for rates and
other matters by the Connecticut Department of Public Utility Control (DPUC) and
follows accounting policies prescribed by the DPUC. The Company prepares its
financial statements in accordance with generally accepted accounting principles
which includes the provisions of Statement of Financial Accounting Standards No.
71, "Accounting for the Effects of Certain Types of Regulation," (FAS 71). FAS
71 requires a cost-based, rate-regulated enterprise such as Yankee Gas to
reflect the impact of regulatory decisions in its financial statements. The
DPUC, through the rate regulation process, can create regulatory assets that
result when costs are allowed for ratemaking purposes in a period other than the
period in which the costs would be charged to expense by an unregulated
enterprise.
<PAGE>
 
Following the provisions of FAS 71, Yankee Gas has recorded regulatory assets or
liabilities as appropriate primarily related to deferred gas costs, pipeline
transition costs, hardship customer receivables, environmental cleanup costs,
income taxes and postretirement benefit costs. The specific amounts related to
these items are disclosed in the consolidated balance sheets. Yankee Gas
continues to be subject to cost-of-service-based rate regulation by the DPUC.
Based upon current regulation and recent regulatory decisions, the Company
believes that its use of regulatory accounting in accordance with the provisions
of FAS 71 is appropriate.

Revenues: Utility revenues are based on authorized rates applied to each
customer's use of gas. Rates can be changed only through a formal proceeding
before the DPUC. At the end of each accounting period, a revenue estimate for
the amount of gas delivered but unbilled is recorded.

Depreciation: The provision for utility depreciation is calculated using the
straight-line method based on estimated remaining useful lives of depreciable
utility plant in service, adjusted for net salvage value and removal costs as
approved by the DPUC. The depreciation rates for the several classes of plant in
service are equivalent to an overall composite rate of 3.3 percent in fiscal
years 1998, 1997 and 1996.

Purchased Gas Adjustment Clause (PGA): The DPUC-approved rates include an
adjustment clause under which gas costs above or below base rate levels are
charged or credited to customers. As prescribed by the DPUC, differences between
the actual purchased gas costs and the current cost recovery are deferred and
recovered or refunded over future periods.

Equity Accounting: The Company accounts for YESCo's investments in energy
production facilities using the equity method, recording their proportionate
share of earnings (losses) with corresponding increases (decreases) in their
investment. Distributions received reduce the carrying amount of these
investments.

Income Taxes: Differences exist between the periods in which transactions affect
income in the financial statements and the periods in which they affect the
determination of income subject to tax. The tax effect of such timing
differences is accounted for in accordance with the ratemaking treatment
required by the DPUC. Additionally, in accordance with FAS 71, as of September
30, 1998, the Company has a deferred tax liability and a corresponding
regulatory asset of approximately $11 million, due to the effect of Statement of
Financial Accounting Standards No. 109, "Accounting for Income Taxes."


Reclassifications: Certain prior year amounts have been reclassified to conform
with current year classifications.
<PAGE>
 
Use of Estimates: The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.

Earnings per Share: The Company follows the provisions of Statement of Financial
Accounting Standards No. 128, "Earnings per Share" (FAS 128), which requires
computing and presenting basic and diluted earnings per share. The effect of
this accounting change on previously reported earnings per share data was
immaterial. The basic weighted average shares outstanding for fiscal 1998, 1997
and 1996 were 10,495,806, 10,451,165 and 10,435,231, respectively, and the
diluted weighted average shares outstanding for fiscal 1998, 1997 and 1996 were
10,501,411, 10,453,318 and 10,437,461, respectively. As such, there is no
difference between basic and diluted earnings per share.

Recent Accounting Pronouncements: In June 1997, the Financial Accounting
Standards Board (FASB) issued Statement of Financial Accounting Standards No.
130, "Reporting Comprehensive Income," which requires that components of
comprehensive income be shown in a financial statement that is displayed with
the same prominence as other financial statements and Statement of Financial
Accounting Standards No. 131," Disclosure About Segments of an Enterprise and
Related Information," which establishes annual and interim reporting standards
for an enterprise's operating segments and related disclosures about its
products, services, major customers and the countries in which the entity holds
assets and reports revenues. In February 1998, the FASB issued Statement of
Financial Accounting Standards No. 132, "Employers' Disclosure about Pensions
and Other Postretirement Benefits," which revises disclosure, but does not
change the measurement or recognition of postretirement benefit plans.
Management is currently evaluating the impact of these standards and believes
their adoption will not impact the Company's consolidated financial position,
results of operations or cash flows, and any impact will be limited to the form
and content of its disclosures. All of these statements are effective for the
Company's 1999 fiscal year.

In March 1998, the Accounting Standards Executive Committee issued Statement of
Position (SOP) 98-1, "Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use." This SOP provides guidance on accounting for the
costs of computer software developed or obtained for internal use. The Company
is reviewing the requirements of the SOP and does not expect it to significantly
change its current accounting for software costs. SOP 98-1 is required to be
adopted by the Company for its fiscal year 2000.
<PAGE>
 
In June 1998, the FASB issued Statement of Financial Accounting Standards No.
133, "Accounting for Derivative Instruments and Hedging Activities," which
requires the Company to recognize all derivatives as either assets or
liabilities in the consolidated balance sheets and measure those instruments at
fair value. Management is currently evaluating the impact of this standard and
believes the adoption will not impact the Company's consolidated financial
position, results of operations or cash flows. This statement is effective for
the Company in the first quarter of fiscal year 2000.

Note 2)  Income Tax Expense

The components of the federal and state income tax provisions are:
 
<TABLE>
<CAPTION>
Years Ended September 30,                                               1998      1997      1996
(In thousands)
 
Charged to income:
 
<S>                                                                  <C>       <C>       <C>
Current income taxes:
  Federal                                                            $ 2,252   $ 4,509   $ 5,297
  State                                                                  624     1,979       894
                                                                     -------   -------   -------
     Total current                                                     2,876     6,488     6,191
                                                                     -------   -------   -------
 
Deferred income taxes, net:
  Investment tax credits                                                (377)     (377)     (377)
  Federal                                                              5,528     6,004     8,158
  State                                                                  293     1,308     1,479
                                                                     -------   -------   -------
     Total deferred                                                    5,444     6,935     9,260
                                                                     -------   -------   -------
 
Total income tax expense                                             $ 8,320   $13,423   $15,451
                                                                     -------   -------   -------
                                                                     -------   -------   -------
</TABLE>
 
Deferred income tax liabilities (assets) are comprised of the following:
 
<PAGE>
 
<TABLE>
<CAPTION>
At September 30,                         1998                1997
(In thousands)
<S>                                    <C>                 <C>
Depreciation                           $75,238             $70,428
Other                                   (2,422)             (2,223)
                                       -------             -------
 
Net deferred income tax
  liability                            $72,816             $68,205
                                       -------             -------
                                       -------             ------- 
</TABLE>
 
The differences between the effective income tax rate recorded by the Company
and the statutory federal tax rate are reconciled as follows:
 
<TABLE>
<CAPTION>
                                    1998      1997      1996
 
<S>                                <C>       <C>       <C>
Federal statutory rate             35.0%     35.0%     35.0%
 Tax effect of differences:
  Depreciation                      9.3       5.1       3.7
  State income taxes net      
    of federal benefit              3.1       6.9       3.9
  Pension accrual                  (4.0)     (0.1)        -
  Miscellaneous                    (0.1)     (2.7)     (1.3)
                                   ----      ----      ----
  Effective income tax rate        43.3%     44.2%     41.3%
                                   ----      ----      ----
                                   ----      ----      ----
</TABLE>

Note 3)  Leases

The Company has entered into operating lease agreements for the use of office
equipment, vehicles and buildings. For fiscal 1998, 1997 and 1996, these lease
payments were $1,999,000, $2,064,000 and $1,939,000, respectively. Future
minimum lease payments, excluding associated costs such as property taxes, state
use taxes, insurance and maintenance, under long-term noncancelable leases as of
September 30, 1998, are approximately:
<PAGE>
 
<TABLE>
<CAPTION>
                 Year                (In thousands)
                 <S>                 <C>     
                 1999                    $1,797
                 2000                     1,457
                 2001                     1,168
                 2002                       748
                 2003                       352
                 After 2003                 541
                                         ______
                                        
                 Future minimum lease   
                 payments                $6,063
                                         ______
                                         ______
</TABLE>

Note 4)  Postretirement Benefits

The Company has a noncontributory defined benefit retirement plan covering
employees of Yankee Gas and RMS. Benefits are based on years of service and
employees' highest consecutive 60 months of compensation during the last 120
months of employment. It is the Company's policy to fund annually an amount at
least equal to that which will satisfy the requirements of the Employee
Retirement Income Security Act and the Internal Revenue Code. No contributions
were required or made in fiscal 1998, 1997 and 1996. Pension assets are invested
primarily in equity securities and investment grade bonds.

The components of net pension cost (income) were:

<TABLE>
<CAPTION>
Years Ended September 30,          1998      1997      1996
(In thousands)
 
<S>                                <C>     <C>       <C>
Service cost                     $ 2,099   $ 1,992   $ 1,890
Interest cost                      4,814     4,522     4,216
Net amortization                  (1,195)   13,128     4,373
Less:  Return on plan assets       7,903    20,147    10,577
                                 -------   -------   -------
Net pension income               $(2,185)  $  (505)  $   (98)
                                 -------   -------   -------
                                 -------   -------   -------
</TABLE>

Total pension cost resulted in income of $2,100,000, $420,000 and $13,000 for
the years ended September 30, 1998, 1997, and 1996, respectively. Pension cost
for 1998, 1997, and 1996 includes $85,000 in cost of living increases each year
for Northeast 
<PAGE>
 
Utilities (NU System) retirees who were previously employed in the
gas business operated by The Connecticut Light and Power Company, a subsidiary
of NU System. These payments were agreed to at the time of divestiture from NU
System.

For calculating the plan's cost and year-end-funded status, the following
assumptions were used:

<TABLE>
<CAPTION>
Years Ended September 30,          1998       1997      1996
<S>                                <C>        <C>        <C>
Discount rate                      7.00%      7.50%     7.75%
Expected long-term rate
  of return                        9.00%      9.00%     9.00%
Compensation/progression rate      4.00%      4.50%     4.50%
</TABLE>
 
The following table represents the plan's funded status reconciled to amounts
included in the consolidated balance sheets:
 
<TABLE>
<CAPTION>
At September 30,                          1998      1997
(In thousands)
 
<S>                                     <C>       <C>
Accumulated benefit obligation,
  including vested benefits of
  $54,942 and $50,045, respectively     $59,874   $51,210
                                        -------   -------
 
Projected benefit obligation            $73,352   $64,845
Less: Market value of plan assets       $88,837   $89,966
                                        -------   -------
 
 
Plan surplus                             15,485    25,121
Unrecognized transition amount             (617)     (703)
Unrecognized prior service cost             665       (26)
Unrecognized net gain                   (16,629)  (27,728)
                                        -------   -------
Accrued pension liability               $(1,096)  $(3,336)
                                        -------   -------
                                        -------   -------
</TABLE>
<PAGE>
 
During fiscal 1994, the Company adopted an Excess Benefit Plan (EBP) that
provides retirement benefits to executive officers and other key management
staff. The EBP recognizes total compensation and service that would otherwise be
disregarded due to Internal Revenue Code limitations on compensation in
determining benefits under the regular retirement plan. The EBP is not funded
and benefits are paid from general corporate assets when due.

Note 5)  Postretirement Benefits Other Than Pensions

The Company provides certain health care and life insurance benefits to its
retired Yankee Gas and RMS employees. The Company recognizes the cost of
postretirement benefits over the employment period that encompasses eligibility
to receive such benefits. On July 1, 1990, in accordance with terms of the
divestiture, Yankee Gas began compensating the NU System for a portion of the NU
System's liability for certain health care and life insurance expenses of
retirees or surviving spouses. Yankee Gas and the NU System will share costs in
a defined manner until June 30, 2005. The cost of providing those benefits for
NU System retirees was approximately $1,032,000 for the fiscal year ended
September 30, 1998 and $1,103,000 and $1,104,000 for the comparable periods in
1997 and 1996, respectively.

The Company has established two Internal Revenue Code Section 501(c)(9)
Voluntary Employee Beneficiary Association (VEBA) Trusts, one for union
employees and one for non-union employees, to fund its future liabilities for
retiree health care and life insurance benefits. Contributions to the VEBA
Trusts totaled $1.7 million for both fiscal 1998 and fiscal 1997. Assets of the
VEBA Trusts are invested primarily in equity securities and investment grade
bonds.

The components of net postretirement benefits costs were:

<TABLE>
<CAPTION>
Years Ended September 30,                    1998     1997
(In thousands)
 
<S>                                         <C>      <C>
Service cost                                $  922   $  913
Interest cost                                1,597    1,685
Net transition amortization                    876      875
Net other deferrals                            (20)   1,055
Less:  Return on assets                      1,309    1,646
                                            ------   ------
Net postretirement benefits costs           $2,066   $2,882
                                            ------   ------
                                            ------   ------
</TABLE>
<PAGE>
 
For Yankee Gas, the DPUC is allowing $1.7 million of associated expenses to be
recovered in rates and up to an additional $1.5 million annually, which is being
collected through the rate settlement process.

For calculating the plan's year-end-funded status, as well as the postretirement
benefits costs, the following assumptions were used:

<TABLE>
<CAPTION>
Years Ended September 30,               1998   1997
 
<S>                                     <C>    <C>
Discount rate                           7.00%  7.50%
Expected long-term rate of return       9.00%  9.00%
Health care cost trend rate
     - First year                       6.00%  8.00%
     - Ultimate                         5.00%  5.00%
</TABLE>

Trend rates are assumed to decrease one percent per year until they reach the
ultimate rate. A one percent increase in the weighted average trend rate
assumption of health care claims would result in a 17 percent increase in
accumulated benefit obligations and a 21 percent increase in net periodic
postretirement benefit costs.

The following table represents the postretirement benefit plan's funded status
reconciled to amounts included in the consolidated balance sheets:

<TABLE>
<CAPTION>
At September 30,                        1998       1997
(In thousands)
 
<S>                                   <C>        <C>
Accumulated benefit obligation        $ 27,465   $ 21,803
Less:  Market value of assets           11,893     10,790
                                      --------   --------
Accumulated benefit obligation in
 excess of plan assets                 (15,572)   (11,013)
Unrecognized transition amount          12,731     13,607
Unrecognized net gain                   (2,529)    (6,730)
                                      --------   --------
Accrued postretirement benefit
   liability                          $ (5,370)  $ (4,136)
                                      --------   --------
                                      --------   --------
</TABLE>
<PAGE>
 
Note 6)  Stock-Based Compensation

Yankee Energy established Long-Term Incentive Compensation Plans in 1991 and
1996. Options on 63,800 and 73,400 shares of common stock were granted under the
1996 plan, in fiscal 1996 and 1998, respectively. Under the terms of the options
granted, the exercise price of any option may not be less than 100 percent of
the fair market value of the common stock on the date of the grant. The stock
options generally vest over a five year period, with 20 percent becoming
exercisable on each of the first five anniversaries of the grant. All stock
options expire ten years from the date of grant. Options granted to a senior
executive were accelerated and deemed fully vested as of September 30, 1998, as
part of a severance agreement (see Note 9). The Company recorded expenses of
approximately $101,000 due to the change in the measurement date.

The Company accounts for stock options in accordance with Accounting Principles
Board Opinion No. 25, under which no compensation costs have been recognized for
stock option awards. Had compensation costs of option awards been determined
under a fair value alternative method as stated in Statement of Financial
Accounting Standards No. 123, "Accounting for Stock-Based Compensation," the
Company would have been required to value such options and record such amounts
in the financial statements as compensation expense. Pro forma net income and
net income per share for fiscal 1998, 1997 and 1996 would have been $10,832,000
and $1.03, $16,919,000 and $1.62, and $21,881,000 and $2.10, respectively. For
purposes of this calculation the Company arrived at the fair value of each stock
grant at the date of grant by using the Black Scholes option pricing model with
the following weighted average assumptions used for grants for the fiscal years
ended September 30, 1998 and September 30, 1996: risk-free interest rate of 5.7
and 5.4 percent, respectively, expected life of 5.0 years, expected volatility
of 17 and 18 percent, respectively, and a dividend yield of 5.3 and 5.7 percent,
respectively. No stock options were granted for the fiscal year ended September
30, 1997.

The following summarizes stock option transactions for the fiscal years ended
September 30, 1998, 1997 and 1996:


<TABLE>
<CAPTION>
                                            Weighted         Number
                         Option Prices    Average Price    of Shares
<S>                      <C>              <C>              <C> 
</TABLE> 
<PAGE>
 
<TABLE>
<S>                       <C>                  <C>           <C>
Outstanding Options
  September 30, 1995      $21.38-$21.63        $21.59         61,120 
     Granted              $       23.69        $23.69         63,800 
     Exercised            $       21.63        $21.63           (820)
     Canceled             $21.63-$23.69        $21.92         (9,100)
                                                             ------- 
Outstanding Options                                                  
  September 30, 1996      $21.38-$23.69        $22.73        115,000 
                                                                     
     Exercised            $21.63-$23.69        $21.73         (4,860)
     Canceled             $21.63-$23.69        $22.97         (8,980)
                                                             ------- 
Outstanding Options                                                  
  September 30, 1997      $21.38-$23.69        $22.75        101,160 
                                                                     
     Granted              $23.13-$26.19        $24.63         73,400 
     Exercised            $21.63-$23.69        $21.93         (8,240)
     Canceled             $21.63-$23.72        $23.01        (45,260)
                                                             ------- 
                                                                     
Outstanding Options                                                  
  September 30, 1998      $21.38-$26.19        $23.85        121,060  
</TABLE>

At September 30, 1998, 1997, and 1996, there were 63,388 options, 38,136
options, and 21,000 options exercisable, respectively, which have weighted
average exercise prices of $24.24 per share, $22.20 per share, and $21.58 per
share, respectively.


Note 7)  Short-Term Debt

Yankee Gas has arranged a $60 million revolving line of credit with a group of
four banks whereby funds may be borrowed on a short-term revolving basis using
either fixed or variable rate loans. Yankee Gas also has an additional $27
million of credit lines available on an uncommitted basis. Yankee Gas had $63.2
million and $36.3 million outstanding under its agreements at September 30, 1998
and 1997, respectively. In addition, Yankee Energy had $12.5 and $2.7 million
outstanding at September 30, 1998 and 1997, respectively, on a $25 million line
of credit. The weighted average interest rates on short-term debt at September
30, 1998 and 1997 were 5.8 percent and 6.0 percent, respectively.

Note 8)  Fair Value of Financial Instruments


The carrying amount of cash and temporary cash investments approximates fair
value. The fair values of the Company's first mortgage bonds, which are fixed
rate long-term debt, are based upon borrowing rates currently available to the
Company.
<PAGE>
 
Adjustable rate securities are assumed to have a fair value equal to their
carrying value. The carrying amount of the first mortgage bonds (including
current maturities) was $129,165,000 and $132,532,000 as of September 30, 1998
and 1997, respectively. The fair value was $144,100,000 and $142,896,000 as of
September 30, 1998 and 1997, respectively. These fair values have been reported
to meet the disclosure requirements of Statement of Financial Accounting
Standards No. 107, "Disclosures About Fair Values of Financial Instruments," and
do not purport to represent the amounts at which those obligations would be
settled.


Note 9)  Commitments and Contingencies


Construction Program:  The Company's estimated capital expenditures for fiscal
1999 is $30.5 million. The Company intends to use $28.0 million of these
estimated expenditures to maintain the reliability of the distribution system
and in projects that will generate or support gas sales and transportation
activities.

Environmental Matters:  Fourteen sites containing coal tar became the property
of Yankee Gas at divestiture from Northeast Utilities in 1989. Contamination at
these sites was caused by operations of former manufactured gas plants at those
locations. Yankee Gas has reported the results of its environmental studies to
the Connecticut Department of Environmental Protection (DEP). The DEP has not
required that any remedial action be undertaken to date. However, eight of the
fourteen sites are presently listed on the Connecticut Inventory of Hazardous
Waste Sites. Inclusion of a site on this list indicates that remediation may be
required in the future.

Remediation has been conducted at three of these properties. In addition, Yankee
Gas has developed a cost estimate for the remaining sites based on various
factors including the probability of clean-up. As a result of this effort,
Yankee Gas recorded a liability of $35 million in fiscal 1993 for future
environmental clean-up. Recovery of remediation costs has been specifically
allowed by Yankee Gas' 1992 rate case decision. Presently, $325,000 is allowed
annually in rates. If costs are expected to exceed $2.5 million on an annual
basis, Yankee Gas is required to review such expenditures with the DPUC. The
DPUC has stated that "to the extent that coal tar remediation expenses are
prudently incurred, they should be allowed as proper operating expenses," and
therefore, management continues to believe a regulatory asset is appropriate for
this item.

Yankee Gas has received funds from certain of its insurance carriers in
settlement of certain claims for actual or potential contamination at certain
sites that may give rise to environmental liabilities. The terms of the
aforementioned 
<PAGE>
 
settlements are subject to confidentiality provisions in agreements between
Yankee Gas and its insurance carriers. The proceeds are being reflected as
reductions in the regulatory asset associated with recoverable environmental
clean-up costs, as shown in the accompanying balance sheets.

Transition Costs-Order No. 636: On April 8, 1992, the Federal Energy Regulatory
Commission (FERC) issued Order No. 636 on pipeline restructuring. In essence,
the FERC found that absent the unbundling of traditional merchant services,
pipelines would not be able to achieve the FERC's long-term goal of open access
and provide transportation services that are indifferent to the seller of the
gas.

Order No. 636 acknowledges that the restructuring of the pipelines' traditional
services will cause pipelines to incur transition costs in several areas and
provides mechanisms for the pipelines to fully recover prudently incurred
transition costs attributable to the implementation of Order No. 636.

On July 8, 1994, the DPUC issued a decision on the implementation of FERC Order
No. 636 by the Connecticut Local Distribution Companies (LDCs). The DPUC is
allowing the LDCs to offset the transition costs billed by pipelines under Order
No. 636 with recoveries from capacity release activity, refunds of deferred gas
costs for the 1992-93 period and all subsequent annual deferred gas costs, gas
supplier refunds, off-system sales margin and interruptible margin earned in
excess of target amounts.

Through September 30, 1998, Yankee Gas paid approximately $20.5 million of
transition costs and an additional $2.5 million is anticipated. To date, Yankee
Gas has collected $46.3 million through a combination of credits received from
gas supplier refunds, deferred gas costs, excess interruptible margin, off-
system sales margin, and capacity release agreements.

On January 3, 1996, the DPUC issued a Final Decision in reopened Docket No. 92-
02-19. The Docket allows for recovery of certain deferred regulatory assets with
the stipulation that Yankee Gas would not increase its rates before October 1,
1998, except in the event of certain circumstances which would adversely affect
Yankee Gas' financial condition. Yankee Gas may apply a portion of excess
transition credits received from pipeline refunds, interruptible excess margin,
deferred gas costs, capacity release activity, and off-system sales margin to
certain regulatory assets. As of September 30, 1998, excess collections of
approximately $25.8 million were applied against the deferred regulatory assets
specified in the decision.

Firm Transportation: On January 24, 1996, the DPUC issued a Final Decision on
Docket No. 92-02-19 Reopen I (the Decision). The Decision enabled Yankee Gas to
implement firm transportation (FT) rates and services as contemplated in an
August 2, 1995 decision. The Decision allows Yankee Gas to offer a broad array
of service 
<PAGE>
 
options to commercial and industrial FT customers. Yankee Gas implemented these
new FT rates and services on April 1, 1996. On October 28, 1998, the DPUC issued
an Interim Decision on Docket No. 92-02-19 Reopen Re: Unbundling, that addressed
changes to the existing commercial and industrial FT program, effective January
1, 1999. These modifications are intended to make improvements to the existing
FT program based on the initial two-plus years of FT experience.

A switch by existing sales customers to transportation tariffs will result in
decreased revenues for Yankee Gas as the portion of revenues representing gas
costs will now be borne directly by those customers. Yankee Gas, however, does
not expect customer conversions to transportation services to affect its net
income because the cost of gas has traditionally been a pass-through item with
no income impact. As of September 30, 1998, Yankee Gas had approximately 3,100
customers under the new FT service.

Rate Review: On August 25, 1996, Yankee Gas filed an application with the DPUC
for a Financial and Operational Review (Review). This Review was required under
Connecticut statutes since Yankee Gas' last rate approval was on August 26,
1992. On July 9, 1997, the DPUC issued its decision in Docket No. 96-08-05. The
DPUC decision, which is not a rate order, called for a lowering of Yankee Gas'
authorized Return on Equity (ROE) from 12.43 percent to 11.15 percent. The DPUC
believed that lower current interest rates and recently allowed rates of return
for other Connecticut utilities justified a lower ROE for Yankee Gas. On October
1, 1997, the DPUC approved a settlement whereby Yankee Gas would credit
approximately $3.2 million to firm sales customers through the PGA during fiscal
year 1998. As of September 30, 1998, the entire $3.2 million has been accrued
and approximately $2.9 million had been credited to firm sales customers. The
remaining $0.3 million has been included in the Company's annual deferred fuel
calculation and beginning in October 1998 was credited back to firm sales
customers. The settlement also allows Yankee Gas to maintain its base rates
until the end of fiscal year 2000, resulting in an eight-year period in which
Yankee Gas will have gone without an increase in its base rates.

Gas Supply Hedging Activities: Yankee Gas has gas service agreements with two
customers to supply gas at fixed prices. Because Yankee Gas purchases gas on a
variable price basis, it has found it necessary to hedge gas prices with
derivatives to respond to customers' needs for fixed pricing. Both agreements
are similar in structure in that Yankee Gas executed a commodity swap contract
with a commodity trading firm. Under a master commodity swap agreement, the
price of a specified quantity of gas is fixed over the term of the gas service
agreement with the customer. In both cases, Yankee Gas is acting as an agent
using its credit to provide fixed pricing to its customers using a commodity
swap. Yankee Gas' results of operations are unaffected by the hedge transaction
given that it passes through the cost of the hedge to either the commodity
trading firm or its customer
<PAGE>
 
depending on the difference in the fixed and floating prices for gas. Also, the
customers are accountable for all costs incurred by Yankee Gas to execute and
maintain the commodity swap contract.

Of the two gas service hedging agreements currently in force, only one is
material relative to the significance of gas volumes being hedged. This
agreement has a ten-year term and requires Yankee Gas to supply approximately
one BCF of gas per year, with relatively low margin, at a fixed price beginning
August 1, 1995. The price is allowed to escalate by a predetermined rate every
year after the first year. The commodity swap contract for this hedging
agreement was executed August 17, 1994. Yankee Gas is responsible for margin
calls collateralizing the commodity swap contract from August 17, 1994 through
the term of the gas service agreement. Currently, Yankee Gas has a letter of
credit in the amount of $1.5 million issued to the commodity trading firm
collateralizing the commodity contract.

Legal Issues:  In fiscal 1996, Yankee Gas received revised property tax bills
from the City of Meriden, Connecticut (the City). The City is asserting a claim
for approximately $5.0 million for back taxes and interest resulting from a
retroactive reassessment and revaluation of Yankee Gas' personal property
filings. The City did not locate or identify any property which Yankee Gas
omitted from its filings. The tax bills reflect a reassessment of property using
a different methodology than that previously accepted by the City. Yankee Gas is
currently in the process of litigating this retroactive reassessment and the
court in this matter has recently recommended that the parties attempt
mediation/arbitration of the issue. Although it is anticipated that the outcome
of this claim will not have a material impact on the Company, based on the
information available at this time, management cannot predict what the ultimate
impact might be.

In November 1995, a purported class action suit was filed in Connecticut
Superior Court against Yankee Gas and the state's two other LDCs by the
Connecticut Heating and Cooling Contractors' Association, Inc. et al,. The
action alleges that the LDCs unfairly competed with licensed plumbers and
contractors by performing customer service work using employees who did not
possess state trade licenses.

On January 27, 1998, the court struck 31 out of the plaintiffs' 32 counts
contained in their complaint leaving only one count alleging violations of
Connecticut's anti-trust statute. The court also noted that although the
plaintiffs' action purports to be a class action, the plaintiffs have failed to
obtain certification as such. Thereafter, the plaintiffs filed another purported
class action against all three LDCs alleging unfair trade practices and
additional separate actions against each LDC alleging various business torts.
The LDCs have asserted that such licenses are not required for this work based
on statutory exemption enacted in 1965 and amended in 1967. However, in a
<PAGE>
 
separate proceeding, a Connecticut Superior Court has upheld an administrative
ruling against the LDC's position which was affirmed on appeal. In 1995, the
Connecticut General Assembly enacted legislation that established prospectively
a separate procedure for state certification of gas service employees.

Recently, the lawsuits were transferred to the Complex Litigation Docket of the
Superior Court where the presiding judge chose to try the case against
Connecticut Natural Gas (CNG) first. No other material action in Yankee Gas'
lawsuit will be taken pending the outcome of the CNG trial which is expected to
commence in August 1999. While the ultimate resolution of the actions cannot be
predicted, management does not expect that they will have a material adverse
effect on the Company's consolidated results of operations or financial
position.

In August 1997, CNG filed suit against Yankee Gas alleging that Yankee Gas'
plans to provide gas service to a 119 unit residential subdivision in the town
of Berlin violated CNG's utility franchise rights within that town. The lawsuit
was tried in New Britain Superior Court in January 1998. The court issued a
decision on October 30, 1998 in favor of CNG, and entered an order prohibiting
Yankee Gas from continuing to serve that particular subdivision within Berlin.
Yankee Gas' other existing activities within Berlin remain unaffected.

The Company has elected not to appeal from this decision. The parties have been
ordered by the court to confer and agree on a suitable amount to be paid by CNG
to Yankee Gas as compensation for these facilities. The Company does not
anticipate that the outcome of this lawsuit will have a material adverse effect
on the Company's consolidated results of operations or financial position.

Tax Audits:  The Company is currently under audit by the State of Connecticut
regarding its Gross Earnings Tax returns for the calendar years 1994, 1995, and
1996, by the City of Naugatuck, Connecticut regarding its Personal Property Tax
Schedules for the years 1995, 1996, and 1997, and by the Internal Revenue
Service regarding its Federal Income Tax Return for the calendar year 1995. The
Company is responding to all information document requests put forth by the
auditors. At this time, the Company does not have sufficient information to
determine the amount, if any, of additional liability that may result from these
proceedings. However, the Company does not anticipate any of these audits to
have a material effect on its consolidated results of operations or financial
position.

Nonrecurring Charges:  In connection with YESCo's HVAC restructuring and
impairments of certain Power division assets, the Company recorded a pre-tax
charge of approximately $3.5 million. Of the total charge, $1.6 million
represents impairment of HVAC and Power divisions' long-lived assets such as
property and goodwill and $1.9 million pertains to YESCo restructuring
<PAGE>
 
charges such as lease costs, severance and moving expenses. In addition, in the
fourth quarter of fiscal 1998, the Company recorded a charge for severance, due
to the resignation of two senior executives. In connection with these
resignations, a one-time pre-tax charge of approximately $0.9 million was
recorded relating to the estimated costs to the Company for severance expenses.

The Company has commenced marketing its existing Power investments, including an
operating landfill gas fueled generating facility in Brookhaven, NY, interests
in two operating cogeneration facilities, development stage projects and other
less significant assets. The total investment at September 30, 1998 is
approximately $12 million. Two of the development stage projects are land fill
gas (LFG) fueled generating facilities in the state of Illinois. Pursuant to
existing state legislation, electric utility purchases of LFG produced power are
entitled to a tax credit that is scheduled to expire on January 6, 1999. If not
reinstated, expiration of the tax credit could substantially impact the
economics of the Company's existing investment in these development stage
projects (approximately $3 million), as well as other LFG projects in that
state. The Company and its partners are closely monitoring and active in the
legislative process to address this matter. However, there can be no assurance
such legislation will ultimately be approved.


Note 10)  Quarterly Financial Data (Unaudited)

The following table provides information with respect to the consolidated
quarterly results of operations for the fiscal years ended September 30, 1998
and 1997, and reflects the seasonal nature of the Company's operations. The
results of any one quarter during the year are not indicative of the results of
future quarters.


<TABLE>
<CAPTION>
                   (In thousands, except per share amounts)
 
                                          Quarter Ended
Fiscal Year 1998         December 31         March 31       June 30        September 30
<S>                      <C>                 <C>            <C>            <C> 
Operating
 revenues                   $102,595          $113,193        $54,327        $ 44,652                    

Operating income                                                                                         
  (loss)                      20,334            23,828            402         (11,682)                   

Net income (loss)              9,091            10,810         (1,902)         (7,116)                   

Basic and diluted                                                                                        
  earnings (loss) per                                                                                    
  common share (1)          $   0.87          $   1.03        $ (0.18)       $  (0.68)                   
</TABLE>
 
<TABLE>
<CAPTION>
                                         Quarter Ended
Fiscal Year 1997         December 31         March 31       June 30        September 30
<S>                      <C>                 <C>            <C>            <C>
Operating
  revenues                 $ 95,681           $127,568       $59,435         $ 42,357            
                                                                                                 
Operating income                                                                                 
  (loss)                     19,162             27,769         2,663           (6,910)           
                                                                                                 
Net income (loss)             8,879             13,478          (442)          (4,958)           
                                                                                                 
Basic and diluted                                                                                
  earnings (loss) per                                                                            
  common share (1)         $   0.84           $   1.29       $ (0.04)        $  (0.47)           
</TABLE>
 
(1)  Basic and diluted earnings (loss) per common share were calculated on the
basic weighted average common shares outstanding of 10,495,806 and 10,451,165
and the diluted weighted average common shares outstanding of 10,501,411 and
10,453,318 for the twelve months ended September 30,1998 and 1997, respectively.
<PAGE>
 
YANKEE ENERGY SYSTEM, INC. AND SUBSIDIARIES
Selected Financial and Operating Data

<TABLE>
<CAPTION>
September 30,  1998      1997      1996      1995      1994
Balance Sheet Data:
(In thousands)
<S>            <C>       <C>       <C>       <C>       <C>
Net Utility
 Plant          $367,933  $350,865  $335,488  $324,870  $315,063
Total Assets     535,284   500,364   478,749   479,301   481,518
Total
 Capitalization  296,040   300,971   271,348   292,802   276,513

Income and Share Data:
(In thousands, except per share amounts)

Operating
 Revenues       $314,767  $325,041  $339,940  $294,022  $317,298
Cost of Gas/
 Goods Sold      168,755   176,757   189,504   155,404   168,816
Other O&M
 Expenses         68,474    64,951    64,852    65,473    62,733
Depreciation and
 Amortization     19,789    18,130    16,895    16,520    16,993
Net Income (1)    10,883    16,957    21,919    12,358    19,485
Earnings
 per Share (1)  $   1.04  $   1.62  $   2.10  $   1.20  $   1.89
 
Revenues:
(In thousands)
Gas:
Residential     $134,292  $140,750  $145,364  $127,493  $140,403
Commercial        73,495    95,098   103,787    88,983    95,286
Industrial        50,055    70,743    82,725    73,715    77,850
Miscellaneous      3,642     2,312     6,217     2,161     3,328
Transportation    22,355    10,051       952     1,631       431
                --------  --------  --------  --------  --------
 
 Total Gas      $283,839  $318,954  $339,045  $293,983  $317,298
                --------  --------  --------  --------  --------
Nonutility
  Revenue         30,928     6,087       895        39         -
                --------  --------  --------  --------  --------
  Total Operating
   Revenues     $314,767  $325,041  $339,940  $294,022  $317,298

Sales and Transportation:
(Mcf-thousands)

Firm:
   Residential    11,888    12,473    13,185    11,591    13,101
   Commercial      6,930     9,222    10,521     9,022     9,998
   Industrial      7,382     9,862    11,438    10,007    10,421
   Transportation  9,426     4,059       178       589       128
   Unbilled and
    Other            (84)     (111)      969       793       245
                --------  --------  --------  --------  --------

   Total Firm     35,542    35,505    36,291    32,002    33,893


Non-Firm:
   Commercial      1,293     1,595     1,746     1,809     1,549
   Industrial      3,668     4,983     6,792     7,286     7,149
   Transportation  6,644     6,853     2,444     3,654       559
                --------  --------  --------  --------  --------

   Total
     Non-Firm     11,605    13,431    10,982    12,749     9,257
                --------  --------  --------  --------  --------
Total Sales and
 Transportation   47,147    48,936    47,273    44,751    43,150


Customers:
(Average)

Residential      160,917   159,541   157,526   156,539   155,874
Commercial (2)    17,910    18,930    19,313    19,167    19,156
Industrial (2)     1,821     2,005     2,112     2,145     1,980
Firm
  Transportation   2,422       766        19         -         -
Resale                 -         -         2         1         1
                --------  --------  --------  --------  --------

  Total
     Customers   183,070   181,242   178,972   177,852   177,011


Sources of Gas:
 (Mcf-thousands)

Domestic           7,668    15,594    21,331    13,534    16,162
Canadian Gas
 Firm             29,941    24,919    24,721    24,283    24,440
Spot Market Gas        -        97       710     2,836     2,318
Produced Gas           4        34        19         9        30
Company Use/
 Unaccounted For    (440)     (440)     (509)     (403)     (592)
                --------  --------  --------  --------  --------

 Total Sources    32,173    40,204    46,272    40,259    42,358


Peak Day Data:

Peak Day Send
 Out (Mcf per
 day) (3)        260,470   250,448   239,348   250,518   262,794
Peak Day Date    3/12/98   1/17/97   2/05/96   2/06/95   1/19/94
Peak Day
 Degree Days          50        55        62        59        55
Total Annual
 Heating
 Degree Days       5,502     5,979     6,302     5,595     6,454
</TABLE>

(1)  Exclusive of an $879,900 charge, or $0.08 per share, resulting from the
early redemption premium on the Company's preferred stock in fiscal 1994.

(2)  Non-firm transportation customers who utilize both gas sales and
transportation service are included in these customer categories. Average non-
firm transportation customers are as follows: 1998:19, 1997:18, 1996:12,
1995:23, and 1994:17.

(3)  Converted from BTU-millions assuming 1,020 BTU per CF. 1994 sendout
includes one time delivery of 17,425 Mcf to Con Ed.
<PAGE>
 
SHAREHOLDER AND STOCK INFORMATION INFORMATION


Annual Meeting

The Annual Meeting of Shareholders will take place on Friday, January 29, 1999, 
at 10:30 a.m. at the Ramada Plaza Hotel in Meriden, Connecticut.

Market for Common Stock

As of October 31, 1998, there were 24,255 holders of record of Yankee Energy
common stock. Yankee Energy's stock is quoted on the New York Stock Exchange
(NYSE) under the symbol "YES" although it is frequently presented as "YanEnS" in
various financial publications.

<TABLE> 
<CAPTION> 
          High and Low Stock Prices and Dividend Information ($/Share)                     
          Year Ended September 30, 1998         High           Low        Dividend    
          <S>                                  <C>           <C>          <C>            
          First Quarter, 1998                  26.813        22.563         0.335   
          Second Quarter, 1998                 25.750        24.563         0.335   
          Third Quarter, 1998                  24.750        22.563         0.345   
          Fourth Quarter, 1998                 26.188        23.438         0.345   
                                                                                    
          Year Ended September 30, 1997                                             

          First Quarter, 1997                  23.625        21.250         0.325   
          Second Quarter, 1997                 23.750        21.125         0.325   
          Third Quarter, 1997                  24.750        21.000         0.335   
          Fourth Quarter, 1997                 24.625        22.750         0.335    
</TABLE> 

Dividends

Dividends are considered quarterly by the Board of Directors and, if declared,
are payable at the end of March, June, September and December. The dividend
record date is generally three weeks prior to the dividend payable date. Yankee
Energy offers registered shareholders the ability to have quarterly dividends
deposited directly into their bank account.

Shareholder Investment Plan

The Yankee Energy Shareholder Investment Plan is administered by the Company's
stock transfer agent, ChaseMellon Shareholder Services (ChaseMellon). The Plan
provides registered shareholders and their family members a convenient way to
acquire shares of common stock. Shares can be purchased by having quarterly
dividends automatically reinvested in additional shares or by sending in funds
to purchase additional shares. In addition, holders of fewer than 100 shares may
sell all their shares at any time for no fee. The Plan also offers charitable
donation and share safekeeping services as well. Copies of the Plan are
available from ChaseMellon or Yankee Energy.

Transfer Agent

Shareholders who have questions about their accounts or desire to transfer their
stock from one name to another should contact ChaseMellon at 1.888.451.0192 or
write:

For Transfers and Transfer Inquiries:         All Other Inquiries:
ChaseMellon Shareholder Services,             ChaseMellon Shareholder Services, 
L.L.C.                                        L.L.C.
85 Challenger Road                            P.O. Box 3315
Ridgefield Park, NJ 07660                     South Hackensack, NJ 07606-1915

Yankee Energy News and Information

Yankee Energy has a toll-free news and information service which includes
current news releases, a Chairman's message, earnings and dividend information
as well as access to the transfer agent or the Company's Investor Relations
Department.
1.800.YES.9989

Shareholders, interested investors and analysts may also contact Yankee Energy
by calling or writing to:

Thomas D. Dorsey                              Phone 203.639.4643
Director, Investor Relations                  Fax 203.639.4667
Yankee Energy System, Inc.                    Email: invest@yankeegas.com
599 Research Parkway
Meriden, CT 06450-1030

Yankee Energy will provide shareholders with a copy of its 1998 Annual Report to
the Securities and Exchange Commission on Form 10-K, without charge, upon
written request.

 
<PAGE>
 
YANKEEENERGY
-----------------


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