**UNITEDSTATES SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

----

 

**FORM 10-K**

 

**ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the fiscal year ended December 31,2004**

**Commission file number 333-89725**

 

**AES EasternEnergy, L.P.**

(Exact name of registrant asspecified in its charter)

 
| **Delaware**                                                    | ** ** | **54-1920088**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |
|                                                            |       |                                  |
| **4300 Wilson Boulevard  Arlington, Virginia**                  | ** ** | **22203**                             |
| (Address of principal executive  offices)                       |       | (Zip Code)                            |

 

Registrant’s telephone number,including area code: **703-522-1315**

 

Securities registered pursuant to Section 12(b) ofthe Act: **None**

Securities registered pursuant to Section 12(g) ofthe Act: **None**

 

(Title of each class)

 

----

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.

 

Yes ý  No  o

 

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the Act).

 

Yes o  No  ý

 

State the aggregate market value of the voting andnon-voting common equity held by non-affiliates computed by reference to theprice at which the common equity was last sold, or the average bid and askedprice of such common equity, as of the last business day of the registrant’smost recently completed second fiscal quarter: $0

 

Registrant is a wholly owned subsidiary of The AESCorporation. Registrant meets the conditions set forth in General InstructionI(1)(a) and (b) of Form 10-K and is filing this AnnualReport on Form 10-K with the reduced disclosure format authorized byGeneral Instruction I.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

None

 

 

----

 

TABLE OF CONTENTS

 
| PART I   |                                                                                      |
|---------------|-------------------------------------------------------------------------------------------|
|          |                                                                                      |   |
| Item 1        | Business                                                                                  |   |
|          |                                                                                      |   |
| Item 2        | Properties                                                                                |   |
|          |                                                                                      |   |
| Item 3        | Legal Proceedings                                                                         |   |
|          |                                                                                      |   |
| Item 4        | Submission of Matters to a Vote of Security Holders                                       |   |
|          |                                                                                      |   |
| PART II  |                                                                                      |
|          |                                                                                      |   |
| Item 5        | Market for the Registrant’s Common Equity and Related Stockholder Matters            |   |
|          |                                                                                      |   |
| Item 6        | Selected Financial Data                                                                   |   |
|          |                                                                                      |   |
| Item 7        | Management’s Discussion and Analysis of Financial Condition and Results of Operation |   |
|          |                                                                                      |   |
| Item 7A       | Quantitative and Qualitative Disclosures About Market Risk                                |   |
|          |                                                                                      |   |
| Item 8        | Consolidated Financial Statements and Supplementary Data                                  |   |
|          |                                                                                      |   |
| Item 9        | Changes in and Disagreements With Accountants on Accounting and Financial Disclosure      |   |
|          |                                                                                      |   |
| Item 9A       | Controls and Procedures                                                                   |   |
|          |                                                                                      |   |
| Item 9B       | Other Information                                                                         |   |
|          |                                                                                      |   |
| PART III |                                                                                      |
|          |                                                                                      |   |
| Item 10       | Directors and Officers of Our Company                                                     |   |
|          |                                                                                      |   |
| Item 11       | Executive Compensation                                                                    |   |
|          |                                                                                      |   |
| Item 12       | Security Ownership of Certain Beneficial Owners and Management                            |   |
|          |                                                                                      |   |
| Item 13       | Certain Relationships and Related Transactions                                            |   |
|          |                                                                                      |   |
| Item 14       | Principal Accounting Fees and Services                                                    |   |
|          |                                                                                      |   |
| PART IV  |                                                                                      |
|          |                                                                                      |   |
| Item 15       | Exhibits and Financial Statement Schedules                                                |   |
|          |                                                                                      |   |
| Signatures    |                                                                                      |

 

----

 

**Item 1.****   ****Business**

 

(a) General Development of Business

 

Our company is a Delaware limited partnership. Our company was formed on December 2,1998 as an indirect wholly owned subsidiary of The AES Corporation to take partin the acquisition by subsidiaries of The AES Corporation of six coal-firedelectricity generating stations and related assets located in the western andwest central part of New York State. AES NY, L.L.C. is the sole general partner of our company andAES NY2, L.L.C. is the sole limited partner of our company. The AESCorporation owns indirectly all of the member interests in both AES NY, L.L.C.and AES NY2, L.L.C. The mailing address of our principal executive officesis 4300 Wilson Boulevard, Arlington, Virginia 22203, telephone no.(703) 522-1315.

 

New York State Electric & Gas Corporation andits affiliate NGE Generation, Inc. (whom we refer to collectively as “NYSEG”)sold these six electricity generating stations and related assets as part ofNYSEG’s overall plan to divest itself of its coal-fired electricity generatingassets. On May 14, 1999, twelve special purpose business trusts formed bythree institutional investors that are not affiliated with us or with The AESCorporation acquired from NYSEG and leased to us the assets constituting theSomerset Generating Station (“Somerset”)(formerly known as the KintighGenerating Station) and the Cayuga Generating Station (“Cayuga”)(formerly knownas the Milliken Generating Station), excluding the real property on which theyare located. On that date, we acquired from NYSEG the real property on whichSomerset and Cayuga are located and two additional coal-fired electricitygenerating stations, the Westover Generating Station (“Westover”)(formerlyknown as the Goudey Generating Station) and the Greenidge Generating Station (“Greenidge”)(togetherwith the real property upon which they are located). We leased a portion of thereal property on which Somerset and Cayuga are located and a selectivecatalytic reduction system (“SCR”), which reduces emissions of nitrogen oxides,that was then being installed at Somerset to the special purpose businesstrusts, which subleased them back to us. As part of the transaction, AES NY3,L.L.C., an indirect wholly owned subsidiary of The AES Corporation that we donot control, acquired the stock of the Somerset Railroad Corporation (“SomersetRailroad”), which owns short line railroad assets used to transport coal toSomerset. Somerset Railroad entered into a coal hauling agreement with us totransport coal. AES Creative Resources, L.P.(“ACR”), an indirect wholly ownedsubsidiary of The AES Corporation that we do not control, acquired the balanceof the assets that were purchased from NYSEG, consisting of two older,coal-fired electricity generating stations, the Jennison Generating Station (“Jennison”)andthe Hickling Generating Station (“Hickling”).

 

We operate our electricity generating stations throughour wholly owned subsidiaries. Westover and Greenidge are owned by our whollyowned subsidiary, AEE2, L.L.C. Our other subsidiaries do not own any of ourelectricity generating stations but operate them pursuant to operations andmaintenance agreements with us.

 

We wish to caution readers that ourbusiness and operations involve risks and uncertainties, including thefollowing important factors. These factors should be considered when reviewingour business, financial condition, results of operations and future prospects,and are relied upon by us in issuing any forward-looking statements. Suchfactors could affect our actual operating results and cause such results todiffer materially from those expressed in any forward-looking statements madeby, or on behalf of, us. Some or all of these factors may apply to our businessas currently conducted or as we intend to conduct it.

 

•                          We will be required to make substantialpayments under our leases and other contracts and we may have difficultyresponding to unforeseen requirements.

 

•                          We may have difficulty meeting our paymentobligations if our operations are not as successful as we have projected.

 

•                          Operation of our electricity generatingstations might be disrupted by: interruptions in fuel supply; disruptions inelectrical transmission; facility shutdown due to breakdowns or failures ofequipment or

 

1

----

 

processes, violations ofpermit requirements, operator error or terrorist activity or other catastrophicevents; or labor disputes.

 

•                          Our electricity generating stations are notnew and will require careful maintenance if they are to operate efficiently.

 

•                          We may have trouble meeting our obligationsif our electricity generating stations are not dispatched nearly continually.

 

•                          The perception of the public and governmentofficials in the markets we serve and in other deregulated markets thatderegulated prices for electric energy are higher than expected may result insome degree of re-regulation of the markets in which we sell our electricenergy, unforced capacity and ancillary services.  This re-regulation might take the form, forexample, of lowering of caps on wholesale electric energy prices during periodsof peak demand.

 

•                          The addition of new generating capacity inthe New York region in excess of the amount required to meet increased demandcould result in the reduction of market clearing prices in periods of peakdemand, which would reduce the profitability of our operations.

 

•                          We operate in an industry where there are alimited number of vendors for supplies which are critical to the operation ofour business. If one of our vendors should have production problems, a shortagein these commodities could affect our ability to operate or cause prices torise for these commodities that may negatively affect our operating results.

 

•                          An increase in the real price of coal maynegatively affect our operating results.

 

•                          Our business is extensively regulated and newregulations may impose requirements that we are unable to meet or that requireus to make additional expenditures.

 

•                          We have responsibility for environmentalliabilities that existed prior to our ownership of our electricity generatingstations and we will incur expenses as a result. These expenses may exceed ourestimates.

 

•                          We may be subject to significant newrestrictions on emissions which may force us to restrict our operations orincur significant expenses.

 

•                          Under the Asset Purchase Agreement with NYSEGrelating to the acquisition of our electricity generating stations, we haveassumed liabilities of NYSEG that could result in unexpected expenses and wehave given up the right to make claims for problems we may discover later.

 

•                          We are controlled by The AES Corporation andThe AES Corporation may pursue its own interests to the detriment of ourcreditors and holders of pass through trust certificates issued to finance theacquisition of Somerset and Cayuga.

 

•                          The AES Corporation is not obligated toprovide further funding to us if we are unable to pay our obligations.

 

•                          In the future we might compete with otherelectricity generating stations owned by The AES Corporation.

 

2

----

 

(b) FinancialInformation About Industry Segments

 

Weoperate in only one business segment, electrical generation.

 

(c) NarrativeDescription of Business

 

Adiagram of the corporate structure of The AES Corporation as it relates to ourcompany is included below:

 

 

TheAES Corporation

 

****The AES Corporation is a leadingglobal power company, with 2004 sales of $9.5 billion. AES generating assetsinclude interests in 120 facilities in 27 countries totaling 44 gigawatts ofcapacity. Its 30,000 people are committed to operational excellence and meetingthe world’s growing power needs. Approximately 23% of AES’s revenues come frombusinesses in North America, 17% from the Caribbean, 41% from South America,11% from Europe and Africa, and 8% from Asia.****

 

3

----

 

New York Power Market

 

The New York Independent SystemOperator (“NYISO”) commenced operations in November 1999 and consists ofthe NYISO and the New York State Reliability Council. The NYISO is a non-profitNew York corporation under the Federal Energy Regulatory Commission’sjurisdiction. It is governed by a board of directors with 10 members and threecommittees; the management committee, the operating committee, and the businessissues committee, which are composed of representatives from all marketparticipants, including buyers of power, sellers of power, consumer groups andtransmission owners. The New York State Reliability Council has the primaryresponsibility to preserve the reliability of electricity service on the bulkpower system within New York State and sets the reliability standards to beused by the NYISO. The NYISO operates a two-settlement system for calculatingLocation-Based Marginal Prices (“LBMP”) of electric energy.  The first settlement system is a financiallybinding market for delivery of electric energy on the following day and thesecond settlement system is the balancing market for immediate delivery ofelectric energy. LBMP is the incremental cost to supply load at a specificlocation in the grid. Locational energy price differentials represent theopportunity cost for transmission between specific locations in the grid.

 

On July 31, 2002, Federal Energy Regulatory Commission(“FERC”)issued a Standard Market Design Notice of Proposed Rulemaking. It proposedamong other things to establish a single flexible transmission service, NetworkAccess Service, with a single open access transmission tariff that applies toall transmission customers - wholesale, unbundled retail and bundled retail anda standard market design for wholesale electric markets. In 2003, FERC issued awhite paper on the proposed standard market design.

 

The NYISO’s current market design has many of the proposedcharacteristics that are included in the July 31, 2002 Standard MarketDesign Notice of Public Rulemaking. FERC has not set a date for issuance of thestandard market design final notice of proposed rule making. We cannotpredict the outcome or actual implementation date of this final rule proceedingor the total effect it will have on the markets in which we do business.

 

The New York power market is interconnected with ISO New England to thenortheast, Hydro Quebec and Ontario Hydro to the north, and Pennsylvania-NewJersey-Maryland Interconnection (PJM) to the south.

 

The transmission of electricity between states andbetween regions within New York State is constrained by physical limits ontransmission capacity and limits on the amount of electricity that may beimported into a power pool imposed by power pools to enhance reliability.Therefore, the generating assets in any given region have a competitiveadvantage in that region over generators not in the region. There is anexisting natural market for the unforced capacity and the electric energy ofour electricity generating stations in Western New York, which includes theretail service territories of NYSEG, Niagara Mohawk Power Corporation andRochester Gas & Electric Corporation. The existing transmissioninfrastructure also permits us to access neighboring markets. However, ourability to sell electric energy into neighboring markets is limited byconstraints imposed by transmission capacity limitations and limits on importedelectricity imposed by power pools in those markets for reliabilityconsiderations. Our ability to sell electric energy into neighboring markets isalso limited because we have entered into bilateral contracts for the sale of asubstantial portion of our unforced capacity to load serving entities, i.e., anentity selling electric energy to consumers of electric energy, includingregulated distribution utilities, municipalities and energy supply companies,in New York. See “Unforced Capacity Market.”

 

InNovember 2000, we entered into a three-year agreement for energy marketingservices with AES Odyssey, L.L.C. (“Odyssey”), a direct wholly-owned subsidiaryof The AES Corporation. In March 2002, a new five-year agreement wasreached, through February 28, 2007, pursuant to which Odyssey providesdata management, marketing, scheduling, invoicing and risk management servicesfor a fee of $300,000 per month. On September 4, 2003, we signed anamendment to our March 2002 agreement. Odyssey will also manage our coaland environmental emission credit positions for an additional fee of $100,000per month. Odyssey acts as agent on behalf of us in the over-the-counter andNYISO markets.

 

Asagent, Odyssey manages all energy transactions under our name including (i) preparingconfirmations for us and approving confirmations with counterparties, (ii) conductingmonthly check-outs with counterparties as appropriate before the preparation ofinvoices, (iii) invoicing counter-parties for the term of the transactionsand (iv) otherwise managing and executing the terms of the transactions inaccordance with their provisions.

 

4

----

 

Odysseyprovides data management for us by maintaining databases of pricing, load,transmission, weather and generation data to aid in analysis to optimize thevalue of our assets.

 

Odysseymaintains a transaction management system to manage day-ahead commitments withthe NYISO and swap and physical values with counterparties and to provide dailyfinancial reporting and end of day budget variance, forward mark-to-market andcommercially accepted risk analysis.

 

New York Wholesale Electric Energy Market. Electricenergy generators may sell electric energy, unforced capacity and ancillaryservices at the wholesale level to regulated distribution utilities,municipalities and energy supply companies. Electric energy generators may alsosell electric energy, unforced capacity and ancillary services in thecentralized wholesale market coordinated by the NYISO. Competition in wholesaleand retail markets has led to unbundling of and distinct markets for electricenergy, unforced capacity and ancillary services.

 

Electric Energy Markets. Any generator in New YorkState can sell its output of electric energy to any wholesale customer statewideincluding utilities, municipalities, and energy supply companies. Generatorscan sell electric energy under bilateral contracts, with pricing and otherprovisions determined by two-party negotiation, or they can bid into either orboth of two centralized settlement systems for electric energy, a market fordelivery on the following day or a market for delivery on an immediate basis,which is intended primarily to balance actual loads and resources. The systempricing is based upon market clearing price, which is the price at whichsufficient electric energy is supplied to satisfy all demand for which bidshave been submitted. If a generator’s bid is equal to or less than the marketclearing price, the generator will be paid the market clearing price, ratherthan its bid price, at the point it supplies electric energy to the system andthe purchaser will pay the market clearing price at the point it receiveselectric energy from the system. If a generator’s bid exceeds the marketclearing price, the generator will not be dispatched.

 

In December 2003, the NYISO adopted changes toits credit policy. Previously, the working capital fund was collected fromthe load side of the marketplace. The recent change now collects the fundfrom both the load and supply side based on a 50/50% ratio. Actual workingcapital obligation is based on a participant’s net market activity per thetotal activity of the market. This obligation is eligible to receive interestand is adjusted each year based on a participant’s net activity from theprevious year. Further, if a participant leaves the marketplace, it isreimbursed its working capital contribution. The Partnership’s working capitalcontribution of approximately $1.5 million was deducted in the first half of2004.

 

In general, we sell the electric energy generated byour electricity generating stations directly into the NYISO market. However, onoccasion, we enter into bilateral and physical sales contracts.

 

Unforced Capacity Market. A market inwhich electricity generators can sell commitments of their unforced generatingcapacity has been established to ensure there is enough generation capacityavailable to produce sufficient electric energy to meet retail demand andancillary service requirements. Any load serving entity is required to procurecapacity commitments sufficient to meet its capacity requirements based on itsforecasted annual electric energy requirements at times of maximum usage plus areserve requirement. On May 20, 2003, FERC issued an order approving the NYISOproposal to replace its then existing, administratively set, vertical installedcapacity (“ICAP”) market structure with a sloped demand curve structure knownas the ICAP Demand Curve. The FERC determined that capacity beyond the minimuminstalled requirement provides both incremental reliability benefits andsignificant benefits to the competitive energy market. Under the initial ICAPmarket structure, load serving entities were only required to purchase enoughcapacity to meet the Minimum Requirement determined by the New York StateReliability Council.  The StatewideMinimum Requirement was set at 118%.  TheICAP Demand Curve introduced the concept of a sloped demand curve. Load servingentities are required to purchase capacity equal to the maximum amount ofcapacity offered into the market up to a maximum level determined on the demandcurve. The demand curve structure more realistically reflects the economicvalue of capacity reserves with capacity prices that decrease as more supply isoffered into the capacity market. Previously, each load serving entity wasrequired to purchase unforced capacity commitments equal to approximately 112%of its forecasted annual maximum usage. The load serving entity could havesecured these capacity commitments through a bilateral contract or throughunforced capacity auctions. Any capacity commitment which is not procured

 

5

----

 

locally needs to satisfy the requirement that, as animport, it does not violate transmission constraints.

 

Starting with the 2001 - 2002 WinterCapability Period, the NYISO implemented a revised capacity market design inthe New York control area that employs unforced capacity as the measure of thecapacity of a generator rather than the old measure of installed capacity.Unforced capacity factors in the probability that a generator willbe available to serve load.  Unforced capacity is thedemonstrated maximum output of a generator (installed capacity) with a formulaapplied that takes into account a generator’s forced outage rate over a definedperiod of time.

 

Suppliersof unforced capacity are not required to supply the associated electric energyto the load serving entity with whom they have a contract to provide unforcedcapacity. For reliabilityreasons, the NYISO requires that electricity generators that sell unforcedcapacity into New York must make their electric energy available in the eventof a system emergency. This prevents generators from entering into firmcontracts to sell electric energy into one market and unforced capacity intoanother. If the unforced capacity supplier’s offer in the electric energymarket for delivery on the following day is not accepted, the unforced capacitysupplier, for the next day, will be free either to offer to sell its electricenergy in the market for delivery on an immediate basis or to sell electricenergy to any customer, including out-of-state customers.

 

Ancillary Services Market. The NYISOwill procure various ancillary services required for reliability fromgenerators as needed. Services to be procured on a market basis includeoperating reserves and regulation and frequency support. Generators arecompensated for other services, including voltage support and black startcapability, on a cost basis.

 

OTC Swap Market. A fairly liquidover-the-counter swap market has developed in several of the NYISO Zones, (1) Westor Zone A, (2) East or Zone G and (3) New York City or Zone J. A zoneis a defined portion of the New York electric system that encompasses a set ofload and generation buses. Each zone has an associated zonal price that iscalculated as a weighted average price. Currently New York State is dividedinto eleven zones, corresponding to ten major transmission interfaces that canbecome congested. The swaps settle against the Day Ahead LBMP for Zone A. Ourelectricity generating station prices are highly correlated to the Zone A priceand the swaps are highly effective products for managing our price risk.

 

Transmission System Market. Transmission lines in New York are controlledby the NYISO. Transmission access is available to all market participants on acomparable and non-discriminatory basis. A party transmitting electric energythrough or out of New York State pays the NYISO a transmission service chargeto cover the revenue requirements of the transmission owner. Electric energysold under a bilateral contract is subject to a congestion charge. Thecongestion charge reflects the differences between the LBMP at the source anddestination on the transmission system. Parties can hedge their exposure tocongestion charges through transmission congestion contracts which areauctioned biannually.

 

Regions. New York State hasregional transmission constraints which divide the state’s power market intodistinct regions. The most significant transmission constraints impede thetransmission of electricity going west to east. As a result, the mostsignificant regional differences in the power market are between the westernand eastern regions. The eastern region includes the service areas of the LongIsland Power Authority, Key Span Energy Corporation, Consolidated EdisonCompany of New York, Inc., Orange & Rockland Utilities, Inc.and Central Hudson Gas & Electric Corporation. The western regionincludes service areas of Niagara Mohawk Power Corporation, Rochester Gas &Electric Corporation, the New York Power Authority and most of NYSEG.

 

The western region is dominated bylow cost nuclear, coal and hydro facilities which, together with non-utility generatorsthat must be permitted to run under their power purchase agreements with localutilities, form 83% of installed capacity. The eastern region has apredominance of facilities which are economically viable only at periods ofpeak demand, which form 80% of its installed capacity. Even though the westernregion has only 40% of the New York power market’s generation capacity, powernormally flows from the west into the east. The flow of power from the lowerpriced western region to the higher priced eastern region is limited toapproximately 5,000MW by transmission limits and reliability considerations.When this limit is reached, higher cost units in the New York City area aredirected to run even when lower cost units in the western region are available.

 

6

----

 

Interconnection. Western and central New York arerelatively unattractive markets for the transmission of imported power due tothe low generation costs of existing facilities and low on-peak electric energyprices relative to the area’s adjacent markets, ISO New England, PJMInterconnection and eastern New York. The existing transmission infrastructurepermits us to access these neighboring markets, subject to constraints imposedby capacity limitations and reliability considerations and subject to ourobligation to offer to sell our electric energy in the New York market for thedelivery of electric energy on the following day to the extent that we havesold our unforced capacity to a load serving entity in New York in accordancewith the rules of the NYISO.

 

FuelSupply

 

Ourelectricity generating stations are located in close proximity to importantcoal producers. In addition, both Somerset and Cayuga are equipped with fluegas desulfurization (“FGD”) systems that allow the plants to burn lessexpensive medium- and high-sulfur coal while staying within sulfur dioxide (“SO2”)emission regulation requirements.

 

Coalmines in the Pittsburgh Seam coal formation near our electricity generatingstations include some of the lowest cost coal supply sources producing atvolume. Although more expensive low-sulfur coals are available for unitswithout FGD systems, the high sulfur content of the coals from the PittsburghSeam have historically made coal-fired generating stations equipped with FGDsystems the primary market for Pittsburgh Seam producers. Since both Somersetand Cayuga have installed FGD systems and are capable of burning higher sulfurcoals, we expect to maintain a fuel cost advantage over competitors without FGDsystems.

 

OnJuly 23, 2003, Somerset was granted approval by the New YorkState Department of Environmental Conservation(“NYSDEC”) to burn petroleum coke as a supplemental fuelthough a modification of its Prevention of Significant Deterioration and TitleV air permits.

 

The Electricity Generating Stations

 

We believe that our two principal coal-firedelectricity generating stations, Somerset and Cayuga, are among the lowestvariable cost facilities in the New York power market. We expect them to befully dispatched when available in the deregulated and competitive New Yorkpower market. We also intend to make appropriate investments of capital tomaintain our electricity generating stations. Somerset, Cayuga, Westover andGreenidge have an aggregate net generating capacity of 1,268MW.

 

TheSomerset Generating Station

 

Somersetis the largest and newest of our electricity generating stations and is locatednortheast of Niagara Falls, alongside the southern shore of Lake Ontario nearBarker, New York. There is a single operating unit, which began generatingelectricity in 1984. The maximum net generating capacity of Somerset is 675MW.

 

Somerset is believed to be among the lowestvariable cost facilities in the New York power market. It can be run economicallyeven at times of minimum demand for electric energy. Somerset also is capableof burning low cost medium- and high-sulfur coal as a result of being equippedwith a FGD system to control SO2 emissions and a selective catalytic reduction(“SCR”) system to control nitrogen oxide(“NOx”) emissions. When Somerset is notbeing dispatched at maximum load, its periodic load can be varied to meet bothsystem load demand and provide transmission system support and the plant canprovide both operating reserves that are available immediately or on tenminutes notice. The plant is also equipped with Automatic Generation Controlsenabling it to provide regulation and frequency support.

 

TheCayuga Generating Station

 

Cayugais located alongside the east shore of Cayuga Lake, near the town of Lansing,New York. There are two operating units at Cayuga, Unit 1 and Unit 2, whichbegan generating electricity in 1955 and 1958, respectively.  The maximum aggregate net generating capacityof the two units is 306MW. Cayuga Unit 1 currently has a net generatingcapacity of 150MW.  Unit 2 currently hasa net generating capacity of 156MW.

 

Cayuga is believed to be among the lowestvariable cost facilities in the New York power market. It can be runeconomically even at times of minimum demand for electric energy.  Cayuga also is capable of burning low costmedium- and high-sulfur coal as a result of being

 

7

----

 

equipped with a FGD systemto control SO2 emissions.  When Cayuga isnot being dispatched at maximum load, its periodic load can be varied to meetboth system load demand and provide transmission system support, and the plantcan provide both operating reserves that are available immediately or on tenminutes notice.  The plant is alsoequipped with Automatic Generation Controls enabling it to provide regulationand frequency support. We installed a SCR system to control NOx emissions onUnit 1, which became operational on June 7, 2001.

 

WestoverGenerating Station

 

Westover is located alongside the Susquehanna Rivernear Johnson City, New York, and began generating electricity in the early 1900’s.Units 1 through 6 have been retired and physically removed. Westover presentlyconsists of two units, Unit 7 and Unit 8, with a combined maximum netgenerating capacity of 126MW. During 2003, Westover installed an overfire airsystem on Unit 8 to control NOx emissions.

 

Westoveris capable of providing both operating reserves that are available immediatelyor on ten minutes notice. The station is equipped with Automatic GenerationControls, which connect it to the NYISO power control center and enable it toprovide regulation, frequency support, and when directed by the NYISO, voltagesupport.

 

GreenidgeGenerating Station

 

Greenidgeis located on the west shore of Seneca Lake adjacent to the village of Dresden,New York, and began generating electricity in 1938.  Units 1 and 2 have been retired andphysically removed. Greenidge presently consists of two units, Unit 3 and Unit4, with a combined maximum net generating capacity of 161MW.

 

Greenidgeis capable of providing both operating reserves available immediately and onten minutes notice. The station is equipped with Automatic Generation Controls,which connect it to the NYISO power control center and enable it to provideregulation, frequency support, and, when directed by the NYISO, voltagesupport.

 

On October 16, 2001, Greenidge was awarded aFederal Clean Coal Grant that, if accepted, will fund 50% of the capital costsfor backend technology and 30% of the operations and maintenance costs for atest and demonstration period. This technology will include a single bed,in-duct SCR unit in combination with low-NOx combustion technology, onGreenidge Unit 4 firing on coal and biomass. It will also include a CirculatingDry Scrubber for SO2, mercury and acid gas removal. Greenidge had submitted awritten request to the Department of Energy, which administers the Clean Coalprogram, for a 12 to 18 month delay in starting the grant. This request wasmade in light of the current difficult electricity and credit markets and theuncertain state regulatory environment.

 

We have started a two prong the process to re-startthis project; we have to submitted documents to initiate a process, whichconcludes in signing a Co-operative agreement with the Department of Energy andwe have completed a bidding process to select an EPC contractor. On December 9,2004, the AES Board of Directors passed a resolution to fund the Greenidge’s$29.9 million share of the project.

 

Somerset Railroad Corporation

 

The Somerset Railroad was acquired by AES NY3, L.L.C.,an indirect wholly owned subsidiary of AES. The Somerset Railroad owns a shortline railroad assets used to transport coal and limestone. We have entered intoa contract with Somerset Railroad pursuant to which Somerset Railroad will haulcoal and limestone to the Somerset Plant and make its rail cars available totransport coal to the Cayuga Plant. As a result of the adoption of revisedFinancial Accounting Standards Board (FASB) interpretation No. 46(R)”Consolidationof Variable Interest Entities”, on January 1, 2004, we began consolidatingthe financial results of Somerset Railroad with our consolidated financialstatements. See Note 2 of our audited financial statements, which are includedin this Annual Report on Form 10-K, for further discussion.

 

8

----

 

**Regulation**

 

**Energy RegulatoryMatters**

 

General

 

We and our ownership and operation of our electricity generatingstations are regulated under numerous federal, state and local statutes andregulations. Among other aspects of electric generation, these statutes andregulations govern the rates that we may charge for the output of ourelectricity generating stations, establish in certain instances the operatingparameters of our electricity generating stations and define standards forownership of our electricity generating stations. While there exists interestat both the federal and state level to deregulate certain aspects of theelectric generation industry, we currently remain subject to extensiveregulation.

 

**Federal EnergyRegulation**

 

Federal Power Act. Under the Federal Power Act, theFERC possesses exclusive rate-making jurisdiction over wholesale sales ofelectricity and transmission in interstate commerce. FERC regulates the ownersof facilities used for the wholesale sale of electricity and transmission ininterstate commerce as “public utilities” under the Federal Power Act.

 

Our rate schedule was approved by FERC, asrequired under the act, as a market-based rate schedule and, accordingly,FERC granted us waivers of the principal accounting, record-keeping andreporting requirements that otherwise are imposed on utilities with acost-based rate schedule.

 

Public Utility Holding Company Act. The Public UtilityHolding Company Act (“PUHCA”) provides that any corporation, partnership orother entity or organized group that owns, controls or holds power to vote 10%or more of the outstanding voting securities of a “public utility company” or acompany that is a “holding company” of a public utility company is subject toregulation under PUHCA, unless an exemption is established or an order isissued by the SEC declaring it not to be a holding company. Registered holdingcompanies under PUHCA are required to limit their utility operations to asingle integrated utility system and to divest any other operations notfunctionally related to the operation of the utility system. In addition, apublic utility company that is a subsidiary of a registered holding companyunder PUHCA is subject to financial and organizational regulation, includingapproval by the SEC of certain of its financing transactions. However, underthe Energy Policy Act of 1992, a company engaged exclusively in the business ofowning and/or operating a facility used for the generation of electric energyexclusively for sale at wholesale may be exempted from PUHCA regulation as an “exemptwholesale generator.” On February 5, 1999, we received exempt wholesalegenerator status from FERC for our ownership and operation of generation andassociated facilities. If, after having received this status, there is a “materialchange” in facts that might affect our continued eligibility for exempt wholesalegenerator status, within 60 days of this material change, we must (a) filea written explanation of why the material change does not affect our exemptwholesale generator status, (b) file a new application for exemptwholesale generator status or (c) notify FERC that we no longer wish tomaintain exempt wholesale generator status. However, if we should lose exemptwholesale generator status, then we would either have to restructure ourselvesor risk subjecting ourselves and our affiliates to PUHCA regulation.

 

State Regulation. In New York State, legislation hassignificantly deregulated the rate setting aspects of the industry. However,significant risks remain, including, but not limited to, the potential that thestate deregulation initiatives could be reversed or nullified. In November 2004,we received approval from the New York State Public Service Commission toincrease of our current working capital facility.

 

Lease Transactions Filings and Approvals. We believethat the special purpose business trusts have obtained all energy-relatedapprovals required to be obtained by them. The special purpose business trustshave been included in the approval by FERC of the transfer of jurisdictionalfacilities and the acquisition and leaseback of FERC-jurisdictional facilities,and FERC has granted a disclaimer of jurisdiction over each of theinstitutional investors and the special purpose business trusts and thetrustees of those trusts as public utilities under Part II or III of theFederal Power Act. The special purpose business trusts have receiveddeterminations from FERC that they are exempt wholesale generators. The specialpurpose business trusts obtained a no-action letter from the SEC staff that noenforcement

 

9

----

 

action would be recommended against them under PUHCA if theyproceeded with the lease transactions prior to obtaining exempt wholesalegeneration determinations from FERC.

 

**EnvironmentalRegulatory Matters**

 

General

 

As is typical for electric generators, our electricitygenerating stations are required to comply with federal, state and localenvironmental statutes and regulations relating to the safety and health ofpersonnel and the public, including

 

•                  theidentification, generation, storage, handling, transportation, disposal,record-keeping, labeling, reporting of and emergency response in connectionwith hazardous and toxic materials associated with our electricity generatingstations;

 

•                  safety andhealth standards, practices and procedures applicable to the operation of ourelectricity generating stations; and

 

•                  environmentalprotection requirements, including standards and limitations relating to thedischarge of air and water pollutants.

 

Failure to comply with any of these statutes or regulationscould have material adverse effects on us, including the imposition of criminalor civil liability by regulatory agencies or civil fines and liability toprivate parties, and the required expenditure of funds to bring our electricitygenerating stations into compliance. In addition, pursuant to the AssetPurchase Agreement with NYSEG, we (as assignee of AES NY, L.L.C.) have, with afew exceptions, agreed to indemnify NYSEG against the consequences of NYSEG’shandling, storage or emission of hazardous and toxic materials on any of thesites of our electricity generating stations and the Lockwood and Weberoff-site ash disposal sites and for NYSEG’s past non-compliance, if any, withenvironmental requirements.

 

It is likely that the stringency of environmentalstatutes and regulations affecting us and our operations will increase in thefuture. In the meantime, we will monitor potential legislative and regulatorydevelopments that may impact our operations and we will participate asappropriate.

 

Expenditures. Compliance with environmental standardswill continue to be reflected in our capital expenditures and operating costs.Based on the current status of regulatory requirements, other than theexpenditures for the SCRs at Somerset and Cayuga Unit 1 including theconstruction of new landfill space to manage ash from Somerset’s SCR systemoperations, expenditures for possible installation of a SCR system on CayugaUnit 2, the U.S. Department of Energy Power Plant Improvement project onGreenidge Unit 4, any other costs to bring us in to compliance with the January 11,2005 Consent Decree discussed below under “Air Emissions” and expenditures forstudies and capital and operating expenses to bring the electricity generatingstations into compliance with the new federal cooling water intake standards,we do not anticipate that any capital expenditures or operating expensesassociated with our compliance with current laws and regulations will have amaterial effect on our operations or our financial condition.

 

Air Emissions

 

The federal Clean Air Act and many state laws,including the laws of the State of New York, require significant reductions inutility sulfur dioxide and nitrogen oxides emissions that result from burningfossil fuels in order to reduce acid rain and ground-level ozone (smog).

 

Sulfur Dioxide (SO2). SO2 emissions are regulatedunder Title IV of the federal Clean Air Act Amendments and by the New York AcidDeposition Control Act. The SO2 emission reduction requirements under Title IVgenerally apply to almost all fossil-fuel fired electric generating unitsproducing electricity for sale. Power plants subject to Title IV are requiredto obtain acid rain permits, to hold sufficient emission allowances to covertheir SO2 emissions, and to comply with various monitoring and record-keepingrequirements. The federal SO2 requirements were implemented in two phases—PhaseI applies to the 110 plants listed in section 404 of the Act and Phase IIgenerally affects all other fossil-fuel fired electric generating plantsselling over 25MW to the electricity distribution grid. Phase I of the federalClean Air Act Amendments SO2 program went into effect January 1, 1995,

 

10

----

 

with Cayuga Unit 1 and Unit 2 and Greenidge Unit 4 fallingunder the program. Phase II went into effect January 1, 2000 and affectsall the units.

 

FGD systems are operated at both Somerset and Cayuga to reduce total SO2 emissions from these plants to quantities substantially below the Title IV SO2 “allowance” allocations for the units at these plants. An allowance is a freely transferable right to emit one ton of a substance, in this case, SO2. The excess allowances are accumulated and can either be used for our other electricity generating stations, banked for future use or sold to provide liquidity to us. We may need to purchase SO2 allowances to cover SO2 emissions for Greenidge and Westover. Market prices for SO2 allowances currently range from about $640 to $750 per ton. We had shortfalls of approximately 6,600, 10,000 and 1,000 SO2 allowances in 2002, 2003 and 2004, respectively. The majority of the 2002 SO2 allowance shortfall was covered with allowances purchased from the electricity generating stations owned by ACR, which are on long-term cold standby. The allowances were purchased at quoted market prices. The 2003 and 2004 shortfalls were covered by purchasing SO2 allowances at market price from unrelated companies in the open market.

 

Based on current market pricing of electricity and SO2 allowance forwards for the years 2005 and 2006, respectively, we forecast that we will have surplus SO2 allowances.

 

Nitrogen Oxides (NOx).  New York State and the other states in theMid-Atlantic and Northeast region are classified as the Ozone Transport Regionin the federal Clean Air Act, which designates the Ozone Transport Region asnot being in compliance with the ozone National Ambient Air Quality Standard.The states in the Ozone Transport Region have agreed to implement a three-phaseprocess to reduce NOx emissions in the region in order to comply with thefederal Clean Air Act Title I requirements for ozone non-compliance areas.

 

The Phase I regulations requirefacilities in New York State to implement NOx control requirements based onreasonably available control technology (“RACT”).  Somerset, Cayuga, Greenidge and Westoveroperate under a common averaging plan, whereby the stations that emit wellbelow the system-wide limit reduce the overall average for electricitygenerating stations that emit in excess of the system-wide limit known as aRACT Rate.

 

Implementation of the Phase IIemission rules commenced on May 1, 1999. The Phase II NOx regulationsset forth a NOx allowance allocation program which gave us 6,292 NOx emissionallowances annually through 2002. Each allowance authorized us to emit one tonof NOx during the ozone season (May 1 to September 30), beginning in1999.

 

Implementationof the Phase III emission rules commenced on May 1, 2003. ThePhase III emission rules have been superseded by the transition to thefederal NOx SIP Call rule, which imposes NOx ozone season emission reductionrequirements through an allowance system similar to the Phase III emissionrules.  Under the NOx SIP Call rule,electric generating facilities in 21 Northeast and Mid-Atlantic states and theDistrict of Columbia are required to hold allowances sufficient to cover theozone season NOx emissions emitted by such facilities. Each of our electricitygenerating stations is subject to the NOx SIP Call rule, and we have beenallocated 2,492 NOx allowances for the 2005 ozone season. The NOx SIP Callprogram commenced on May 31, 2004.

 

To comply with the stricter emissionsregulations beginning in 1999, we installed a SCR system at Somerset, whichbecame operational in June 1999. During 2001, we installed a SCR system onUnit 1 of Cayuga, which became operational on June 7, 2001. During 2003,we installed an overfire air system to control NOx emissions on Westover Unit8.

 

Somerset and Cayuga’s Unit 1 generated excess NOxallowances in 2003 and 2002.  We expectthat Somerset and Cayuga will accumulate excess allowances during the 2005ozone season. Our compliance strategy involves potential installation ofadditional NOx control technology at our electricity generating stations,reduced operations of our non-reheat units during the ozone season, reducingemission rates and/or the selling/buying or trading of NOx allowances. Thisincludes trades between our electricity generating stations as needed to offsetNOx emissions. During 2002, we were a net seller of NOx allowances. In 2003 and2004, we were short approximately 1,200 and 1,020 NOx allowances, respectively.The 2003 shortfall was covered by purchasing 70 NOx allowances from AESIronwood, an indirect wholly owned subsidiary of The AES Corporation, at marketprices and the remainder of 2003 and 2004 shortfall of NOx allowances wascovered by purchasing NOx allowances from unrelated companies in the openmarket at market prices.

 

11

----

 

Based on current market pricing of electricity and NOxallowance forwards for the years 2005 and 2006, respectively, we forecast thatwe will have a shortfall of approximately 400 and 310 NOx allowances. Theshortfalls will be covered by purchasing NOx allowances at market price fromunrelated companies in the open market or by reduced operations of ournon-reheat units and/or reducing emission rates.

 

The capital costof the Somerset SCR was $31 million. We expect that the system will operate for20 years. We havedeveloped a catalyst maintenance plan to insure the SCR’s performance, whichconsists of changing out one of the three layers of catalyst every eighteenmonths. We purchased a layer of regenerated catalyst for $900,000 and installedit during our fall 2003 scheduled outage. During the scheduled outage, we removed a layer, which will beregenerated and stored until our next scheduled outage at a cost of $1 million.Catalyst layers will continue to be rotated and regenerated on an approximately18-month schedule at a cost of approximately $1 million perrotation. The capital cost of the Cayuga SCR on Unit 1 was $11.2 million andit was operational on June 7, 2001. We expect that the system will operatefor 20 years. We are reviewing our options for a catalyst maintenance plan. We have estimated that the current catalystmaintenance which is scheduled for 2006 will cost $280,000.

 

Our electricity generating stations have generallyachieved continuous compliance with the current NOx reduction requirements withthe exception noted below.

 

We voluntarily disclosed to the NYSDEC and the UnitedStates Environmental Protection Agency (“EPA”) on November 27, 2002 thatNOx exceedences appear to have occurred on October 30 and 31 and November 1-8and 10 of 2002. The exceedences were discovered through an audit by plantpersonnel of the electricity generating stations’ NOx RACT tracking system. Webelieve that we have taken all reasonable, good faith efforts to assess andcorrect the exceedences. Immediately upon discovery of the exceedences, the SCRat Somerset was activated to reduce NOx emissions. Emission data indicates thatthe system had already returned to a compliant operation by the time theexceedences were discovered. The EPA has decided to defer to the NYSDEC forreview of the self-disclosure letter and technical issues. Recently, we havelearned of a Notice of Violation (“NOV”) issued by the NYSDEC for the NOx RACTexceedences through a review of the November 2004 release of the EPA’sEnforcement and Compliance History “ECHO” database. We have not yet receivedthe NOV from the NYSDEC. We are unable to predict any potential actions orfines the NYSDEC may require, if any.

 

New York StateAir Emission Regulations. In October 1999, New York Governor Patakiannounced a new initiative which directed NYSDEC to issue regulations requiringelectric generators to reduce SO2 emissions by another 50% below Phase IIstandards and reguire non-ozone season NOx emissions reductions based on 1.15 lbs/Mmbtu.The final regulations (6 NYCRR Parts 237 and 238) were adopted in March 2003.The new NOx regulations became effective October 1, 2004 and the new SO2regulations will be phased in starting January 1, 2005, with fullimplementation complete by January 1, 2008.

 

On May 26, 2004, the New York Supreme Courtstruck down the Acid Deposition Reduction Program regulations (6 NYCRR Parts237 and 238). The Court ruledthat the regulations had been adopted improperly after the State missed adeadline for publication of a notice to inform the public of proposed changesin the regulations. On July 1, 2004, NYSDEC appealed the Court’s ruling.

 

On August 17, 2004, the NYSDEC announced theadoption of emergency regulations to implement the Acid Deposition ReductionProgram as originally scheduled. A number of entities challenged the adoptionof the emergency regulations. On October 19, 2004, a State Supreme CourtJudge dismissed the petition challenging New York State’s adoption of emergencyregulations to implement the Acid Deposition Reduction Program as originallyscheduled.

 

In January 2004, NYSDEC determined the amount ofSO2 emissions allowances that would be allocated to our electricity generatingstations. The allocation is approximately our average historical SO2 emissionsfor our electricity generating stations.

 

In September 2003, New York State determined theamount of NOx emissions allowances that would be allocated to our electricitygenerating stations. The allocation is several thousand tons short of ouraverage historical NOx emissions for our electricity generating stations duringthe control period.

 

Ourcompliance strategy involves reduced operations of our non-reheat units,

 

12

----

 

reducing emission rates and/or theselling/buying or trading of New York State SO2 and NOx allowances.  See Item 7 - Management's Discussion andAnalysis - Future Issues and Other Matters.

 

Muti-Pollutant Proposed Regulations. On March 10,2005, the EPA Acting Adminstrator signed the final Clear Air Interstate Rule thatwill require further emission reductions in NOx and SO2 emitted from powerplants and other sources that significantly contribute to fine particulate (“PM2.5”)and ozone pollution in downwind states.  NOx and SO2 are precursors ofPM2.5, and NOx is a precursor of ozone.  The final rule directs 28states, including New York, to issue new regulations that will require majorSO2 and NOx reductions by 2015. States must achieve the required NOx andSO2 reductions by meeting a state-specific emissions budget through one of twocompliance methods: (i) requiring electric generating facilities in thestate to participate in an EPA-administered cap and trade regime that capsemissions in two phases with the first phase in 2010 and a second phasecommencing in 2015, or (ii) meeting the budget levels through measuresselected by a particular state that are approved by the EPA. States areencouraged to use a cap and emission trading approach. At this point, wecannot determine what the costs would be to comply with new federal SO2 and NOxemission reduction requirements.

 

On November 10, 2004, the Ozone TransportCommission, a multi-state organization created under the Clean Air Act, agreedto develop a multi-pollutant emission control program for power plants for theNortheast/Mid-Atlantic states.  A model rule foreach state to use is due no later than June 2006. Until these rules aredeveloped, we cannot determined the effects of this rule on our financialcondition or results of operations.

 

New Source Review (NSR). We received an informationrequest letter dated October 12, 1999 from the New York Attorney Generalwhich sought detailed operating and maintenance history for Westover andGreenidge. On January 13, 2000, we received a subpoena from the NYSDECseeking similar operating and maintenance history for all four of ourelectricity generating stations. We have provided materials responding to therequests from the Attorney General and the NYSDEC. This information was sought inconnection with the Attorney General’s and the NYSDEC’s investigations ofseveral electric generation stations in New York which were suspected ofundertaking modifications in the past (from as far back as 1977) withoutundergoing an air permitting review.

 

On April 14, 2000, we received a request forinformation pursuant to Section 114 of the Clean Air Act from the EPAseeking detailed operating and maintenance history data for Cayuga andSomerset. EPA has commenced an industry-wide investigation of coal-firedelectric power generators to determine compliance with environmentalrequirements under the Clean Air Act associated with repairs, maintenance,modifications and operational changes made to coal-fired facilities over theyears. The EPA’s focus is on whether the changes were subject to new sourcereview or new source performance standards, and whether best available controltechnology was or should have been used. We have provided the requesteddocumentation.

 

By letter dated May 25, 2000, the NYSDEC issued aNOV to NYSEG for violations of the Clean Air Act and the New York EnvironmentalConservation Law at Greenidge and Westover related to NYSEG’s alleged failureto obtain an air permitting review for repairs and improvements made during the1980s and 1990s, which was prior to the acquisition of the electricitygenerating stations by us. Pursuant to the Asset Purchase Agreement relating tothe acquisition of the electricity generating stations from NYSEG, we agreed toassume responsibility for environmental liabilities that arose while NYSEGowned the electricity generating stations. On September 12, 2000, weagreed with NYSEG that we would assume the defense of and responsibility forthe NOV, subject to a reservation of our right to assert applicable exceptionsto our contractual undertaking to assume preexisting environmental liabilities.

 

On January 11, 2005, three subsidiarieswhich we control (AEE2, L.L.C., AES Greenidge, L.L.C. and AES Westover, L.L.C.)and two subsidiaries controlled by ACR (“AES Entities”) entered into a consentagreement to settle all outstanding NOVs and civil claims that could have beenbrought by the State of New York against the AES Entities and NYSEG for thealleged violations of the new source review and new source performance standardprovisions of the Clean Air Act and its applicable regulations, similarprovisions under the New York Environmental Conservation Law and its applicableregulations, common law, and State Executive Law (the “Consent Decree”). TheConsent Decree is expected to be entered by the United States District Courtfor the Western District of New York after completion of a public commentperiod and a separate 45 day period in which the Federal Government may submitcomments.  The Federal Government also hasthe opportunity to intervene in the case. The Consent Decree will become

 

13

----

 

effectivewhen it is entered by the Court. Under the terms and conditions of the ConsentDecree, upon entering into effect, the State of New York covenants not to sueand releases the participating AES Entities and NYSEG from alleged violationsunder the above-mentioned air emission laws and regulations and also covenantsnot to sue or bring any administrative enforcement actions against theparticipating AES Entities for claims under the above-mentioned air emissionlaws and regulations associated with work required pursuant to the ConsentDecree or other changes at the electricity generating stations commenced afterentry of the Consent Decree, but prior to December 31, 2009 and completedby December 31, 2010.  Under theConsent Decree, the AES Entities have agreed to pay a $700,000 civil penaltyfor the violations assessed to NYSEG and will deposit $1,000,000 in an AESEnvironmental Mitigation Project Account that will be used to carry out one ormore projects pertaining to energy efficiency, renewable energy and/or cleanair projects that are approved by the NYSDEC and the Office of the AttorneyGeneral. The Consent Decree does not address the Somerset and Cayugaelectricity generating stations, and it is possible that these two plants maybe subject to a separate enforcement action filed either by the United StatesEnvironmental Protection Agency, NYSDEC, or the New York State AttorneyGeneral.

 

The Consent Decree sets forth mandated emissionreductions and requires the installation of new emission control technologieson certain units or the repowering of or the ceasing of operations of suchunits. On Greenidge Unit 4, we are obligated to control SO2 and NOx emissionsthrough a multi-pollutant control clean coal project (“MCP Project”). Thisobligation is subject to the partial funding of the MCP Project by the U.S.Department of Energy and the absence of any force majeure event or materialadverse change in circumstances that affects the economic viability of the MCPProject. We are required to commence initial operation of the MCP Project by September 1,2006 or a date eighteen months after entry of the Consent Decree, whichever islater.  We are also obligated to use goodfaith efforts to meet certain NOx emission rates and achieve a certain SO2removal efficiency during normal operations on Greenidge Unit 4.  If the MCP Project on Greenidge Unit 4 isdiscontinued, we are required by December 31, 2009 either to (i) installcontrol technology that will meet the Consent Decree emission limits, (ii) repowerwith a non-coal fuel source or (iii) cease operations.

 

On Westover Unit 8, we are obligated under theConsent Decree to take one of the following three actions by December 31,2009 and to notify the NYSDEC of which action we elect to take by June 1,2007: (i) control NOx and SO2 using technology similar to the MCP Projecton Greenidge Unit 4, (ii) repower with a non-coal fuel source or (iii) ceaseoperations.  Beginning in 2005 andlasting through 2009, Westover Unit 8 is subject to a declining SO2 emissionscap that starts with a cap in 2005 and declines per year until 2009.  Should we elect to install emission controltechnology on Westover Unit 8 by December 31, 2009, then we are obligatedunder the Consent Decree to use good faith efforts to meet a certain NOxemissions rate and a certain SO2 removal efficiency.

 

Under the Consent Decree, Greenidge Unit 3 andWestover Unit 7 are required either to (i) install control technologyequivalent to Best Available Control Technology or BACT, (ii) be repoweredwith a non-coal fuel, or (iii) cease operations, no later than December 31,2009.  During the years 2007, 2008, and2009, these two units will be subject to an annual operating limit of 1,400hours with an SO2 emission rate of 3.0 lb/mmBtu. The Consent Decree does allowus to use up to a 30% blend of sub-bituminous (reduced sulfur) coal at eitherthe Greenidge or Westover electricity generating stations.

 

The Consent Decree also requires the surrenderof federal Acid Rain Program SO2 allowances for Greenidge Units 3 and 4 andWestover Units 7 and 8 starting in the year 2012.  The amount of allowances that will be surrendereddepends on which compliance option we ultimately select for these units.

 

In the event that we fail to comply with one ormore terms of the Consent Decree, we are obligated to pay stipulated penaltiesthat are set forth in the Consent Degree with the exception of noncompliancedue to force majeure events or certain material adverse conditions affectingthe economic viability of the MCP Project. Upon achieving compliance with the material requirements of the ConsentDecree, then the parties to the settlement may petition the court fortermination of the Consent Decree.  Weexpect that the emission reduction and control technology requirements setforth in the Consent Decree will be incorporated into each electricitygenerating stations’s Title V air operating permit.

 

We have projected that our share of the capitalcosts to install the MCP Project at Greenidge Unit 4 will be approximately $29million, however, there can be no assurance that this will be the actual costsince we have not entered into an agreement for engineering, procurement andconstruction of the MCP Project at Greenidge Unit 4.

 

14

----

 

At this time, we have not made decisionsregarding the options of either installing pollution control technology, repoweringor ceasing operations at the other units subject to the terms of the ConsentDecree, and thus we are unable to project the potential costs associated withcomplying with the other provisions of the Consent Decree on our financialcondition or the effect on future operations.

 

The EPA is not a signatory to the ConsentDecree, and it is possible that EPA could separately issue us a NOV for allegedviolations of the federal Clean Air Act and federally enforceable New York airregulations at the Greenidge and Westover electricity generating stationsinvolving suspected past modifications of plant equipment without undergoing anair permitting review.  If EPA does filean enforcement action against Greenidge and Westover, then penalties may beasserted and further emission reductions might be necessary which could requireus to make substantial expenditures. We are unable to estimate the effect ofany EPA-issued NOV on our financial condition or results of future operations.

 

Mercury. On March 15, 2005, the EPA ActingAdminstrator signed the final Clear Air Mercury Rule that will regulatemercury emissions from existing and new coal-fired power plants.  Thefinal rule requires the reduction of mercury emissions to be achievedthrough a cap and emission trading program with the first phase commencing in2010 and the second phase starting in 2018. At this point, we cannot determinewhat the costs would be to comply with new federal mercury emission reductionrequirements.

 

Carbon Dioxide (CO2). Future initiatives regarding theimpacts of greenhouse gases (e.g., carbon dioxide, “CO2”) emissions and globalwarming continue to be the subject of intense debate. The Kyoto Protocolrelating to reduction of greenhouse gas emissions was signed by the UnitedStates but has since been rejected by President Bush, who instead has askedU.S. industry to achieve an 18% decrease in carbon intensity on a voluntarybasis. We will monitor any future initiatives on this issue and the ultimateeffects of the Kyoto Protocol and the President’s initiatives. On February 16,2005, the Kyoto Protocol became effective.

 

In addition, Northeastern U.S. states (including NewYork) have agreed to work to develop a regional market-based emissions tradingsystem to reduce power plants’ CO2 emissions. The goal is to reach an agreementby April 2005 on a cap and emissions trading program. Until such time asthe rules are developed to implement such a program, we cannot determinewhat its impact would be on our financial position or results of operations.

 

We voluntarily disclosed to the NYSDEC in January 2003that Cayuga had inadvertently burned synfuel (coal with a latex binderapplied), which it is not permitted to burn. We had entered into an agreement with a supplier to purchase coal. Wereceived approximately one 9000-ton train shipment per month from April 24,2001 to December 27, 2002. In January 2003, we became aware that theproduct we were receiving was synfuel. We suspended all shipments from thatsupplier until a resolution was reached. We reviewed the emission and operationdata which showed there was no adverse effect to air quality with respect toapplicable permit emissions limits attributable to burning the material. We areunable to predict any potential actions or fines the NYSDEC may require, ifany. In July 2003, we reached an agreement with the supplier to resumeshipments of coal in order to satisfy contractual obligations. As part as thisagreement, the supplier has provided a written guarantee stating that all fuelshipments will be coal.

 

Particulates and Opacity. Each of our electricitygenerating stations is currently in compliance with particulate emissionlimits. Each of our electricity generating stations is required to meet anopacity limit. In the past, several of the electricity generating stationsexceeded these limits. This was a common problem at coal-fired electricitygenerating stations, and the NYSDEC has initiated an enforcement action againstseveral utilities, including NYSEG.

 

In January 2000, we received a draft consentorder from the NYSDEC that alleges violations of the opacity emissionlimitations in the air permits for Cayuga, Westover, and Greenidge occurringsince our electricity generating stations were purchased from NYSEG.  The draft consent order would require us toprepare an opacity compliance plan and would impose penalties for opacityviolations occurring after May 14, 1999, the date of the acquisition. Wedo not know when the NYSDEC will issue a final consent order. Potential finesand required actions cannot be divulged to the public until a final consentorder is signed. Nevertheless, we expect that any consent order will likelyrequire continued operation at the current level of opacity compliance that hasbeen achieved over the past year. AES NY, L.L.C. also received notice fromNYSEG that NYSEG has received a draft consent order from the NYSDEC seeking

 

15

----

 

penalties primarily for opacity violations occurring prior toMay 14, 1999.  In the notice, NYSEGasserts that it will seek indemnification from AES NY, L.L.C. for anypenalties, attorney fees, and related costs that it incurs in connection withthe consent order. We and AES NY, L.L.C. have denied liability for thepre-closing violations and intend to vigorously defend this claim if NYSEGpursues litigation or arbitration.

 

Water Issues

 

In July 2004, the EPA final rule forregulating existing power plants under Section 316(b) of the CleanWater Act was published in the Federal Register. This rule becameeffective on September 7, 2004. This new rule imposes new compliancerequirements, with potentially significant costs, on operating plants acrossthe nation with cooling water intake structures. Cost items include variousenvironmental and engineering studies and potential capital and maintenancecosts. We have not yet determined the effects of this rule on ourfinancial condition or results of operations.

 

Our electricity generating stations and their ashdisposal sites have been designed and are operated to comply with strict waterand wastewater compliance standards. Groundwater protection measures includecoal pile liners at all plants, lined active ash disposal sites, no active flyash settling ponds, and a network of groundwater monitoring wells. New YorkState has not only technology-based effluent limitations for surface waterdischarges, but is one of the first states in the nation to impose morerestrictive limits on wastewater discharges to ensure that very protectivewater quality-based standards are maintained. Our electricity generatingstations have numerous wastewater treatment facilities in order to ensurecompliance with these restrictive discharge limits. In addition, Somersetnormally operates in a zero process wastewater discharge mode, reusingwastewater for various plant processes. Similarly, the ash disposal sites mustcomply with both technology and water quality-based discharge limits. Wherenecessary, a lime treatment is employed to remove metals from ash sitewastewater prior to discharge.

 

Hazardous Material and Wastes

 

The electric utility industry typically uses and/orgenerates in its operations a range of potentially hazardous products andby-products. We have identified a number of site remediation issues at ourelectricity generating stations. Under the terms of the Asset PurchaseAgreement with NYSEG, NYSEG retained pre-closing off-site environmentalliabilities associated with our electricity generating stations (other thanliabilities arising from the Weber and Lockwood ash disposal sites), but weassumed responsibility for contamination at our electricity generating stationsand at the Lockwood ash disposal site.

 

We had budgeted $7.6 million for the cost forenvironmental liabilities at our plants (excluding closure and post closure forthe Weber and Lockwood ash disposal sites), based on estimates of environmentalconsultants retained by NYSEG and The AES Corporation. In 2002 and 2003, wereduced our liability by $800,000 and $180,000, respectively as remediation wascompleted or the more current estimates received were lower than the amountspreviously estimated. We have budgeted approximately $6.2 million for closureand post-closure (monitoring and maintenance) expenses for the Weber andLockwood ash disposal sites, based solely on amounts previously budgeted forthese activities by NYSEG. In 2001 and 2002, we reduced this liability by$600,000 and $1.4 million, respectively, as remediation was completed at lowercosts than previously estimated. On January 1, 2003, $4.2 million wasreclassified into a liability obligation in accordance with SFAS 143.

 

ACR assumed responsibility for one-half of the closurecosts of the Weber ash disposal site. Our subsidiary, AEE2, L.L.C., hascontributed one-half of the closure costs for the Weber ash disposal site basedon the amount of ash disposed at the site from Westover and Greenidge, whichare owned by AEE2, L.L.C., compared to the amount disposed from Hickling andJennison, which were acquired by ACR. In October 1999, ACR entered into aconsent order with the NYSDEC to resolve alleged violations of the waterquality standards in the groundwater downgradient of the Weber ash disposalsite. As a result, the site was closed. AEE2, L.L.C. contributed approximately$2 million which was one-half of the closure costs, and it will contributeadditional costs for long-term groundwater monitoring. Nevertheless, if agroundwater remediation is required, AEE2, L.L.C. may be responsible for aportion of such costs.

 

We expect to develop a new area, Area 3, of theon-site landfill located at Somerset to contain ammonia-contaminated fly ashproduced during operation of the SCR system and stabilized sludge producedduring simultaneous operation of the FGD system. As designed,

 

16

----

 

Area 3 will comply with modern landfill design andperformance standards. On April 26, 1999, the New York State Board onElectric Generation Siting and the Environment approved the plan to use Area 3,subject to approval by the NYSDEC of more detailed design submissions. TheNYSDEC has defined non-ammoniated waste material to contain less than 0.5 partsper million of ammonia.  Most of the flyash generated during operation of the SCR at Somerset qualifies asnon-ammoniated. The NYSDEC approved disposal of non-ammoniated waste materialgenerated during the operation of the SCR system in an existing area of thelandfill, Area 1. We are working with the NYSDEC to complete an approved designfor the Area 3 expansion.

 

The Somerset landfill is under the jurisdiction of theNew York Public Service Commission. NYSEG’s original compliance filing with thePublic Service Commission in 1983 provided that the landfill would beconstructed in a 200 acre section of the site, which NYSEG divided intothree areas (Areas 1, 2, and 3). The landfill was designed to comply with thethen-existing solid waste landfill standards of the NYSDEC. Each area was toreceive a separate landfill unit lined with a low permeability material,usually clay. However, the first 17-acre section of Area 1 of thelandfill was lined with compacted soil only. Only Area 1 was used by NYSEG. TheArea 1 landfill has been expanded seven times during the years since 1983. Whena portion of Area 1 reaches the maximum allowable elevation (130 feet), it is “capped”by adding compacted soil and planting ground cover. The entire process is meantto be self-implementing, with little input from the Public Service Commissionunless there is a problem or a change in design or operation.

 

OnDecember 23, 2003, Somerset was granted approval by the New York StateBoard on Electric Generation Siting and the Environment to amend theCertificate of Environmental Compatibility and Public Need to modify the slopesand height of Area 1 and allow the landfilling of petroleum coke fly ash andstabilized sludge produced during operation of the SCR and FGD system at Area1.

 

OnApril 28, 2004, the Public Service Commission approved a compliance filingfor Area 2 in part. The compliance filing addressed the design and operation ofArea 2 which will accept stabilized coal combustion by-products after Area 1has reached capacity. The Public Service Commission did not permit thelandfilling of “ammoniated sludge” until we have submitted a petition to modifythe Certificate of Environmental Compatibility and Public Need. We havesubmitted a petition to clarify and/or amend the Certificate of EnvironmentalCompatibility and Public Need and are expecting the New York State Board onElectric Generation Siting and the Environment to issue an order.

 

In the period since the original approval of theSomerset landfill, the NYSDEC has modified its solid waste landfill regulationsextensively. As a result of these changes, these regulations currently allowconstruction or expansion of landfills only with low permeability liners andsophisticated leachate collection systems, and impose higher standards forcapping and closing solid waste facilities.

 

Natural groundwater conditions present at the Somersetsite make it very difficult to distinguish between landfill leachate andnaturally occurring substances in the groundwater. Substances that aretypically considered indicators of leachate infiltration into groundwater fromash monofill operations, namely sulfates, iron and manganese, are alsonaturally occurring in the groundwater around and beneath Area 1. NYSEGcommissioned independent consultants to perform groundwater testing usingsophisticated geochemical fingerprinting techniques, which distinguish themajor ions of a water sample. NYSEG’s consultants have shown, to thesatisfaction of the Public Service Commission, that there has been no materialrelease of leachate from Area 1 into the groundwater.

 

In April 1999, the NYSDEC and the Public ServiceCommission negotiated a Memorandum of Understanding that clarifies theirrespective roles with respect to the regulation of the Somerset landfill.According to the Memorandum of Understanding, the Public Service Commission’sdecisions will continue to control all aspects of Areas 1 and 2 of thelandfill, but the Public Service Commission must defer to current and futureNYSDEC regulations, standards and policies with respect to the development, useand closure of Area 3. The Memorandum of Understanding was approved by the NewYork State Board on Electric Generation Siting and the Environment and wasincorporated as part of the April 26, 1999 amendment to the Certificate ofEnvironmental Compatibility and Public Need for Somerset that we received inconnection with installation of the SCR.

 

Factors which could cause actual costs of disposal inAreas 1, 2 and 3 to vary include, but are not limited to, adoption of morestringent solid waste landfill regulations

 

17

----

 

by the NYSDEC, the discovery of groundwater contaminationfrom Area 1, and escalation of the costs of landfill development.

 

The existing Cayuga on-site landfillcurrently complies with modern landfill design and performance standards andwill receive any ammonia-contaminated fly ash or ammoniated sludge producedduring operation of the SCR system on Unit 1. Cayuga has seen concentrations of certainanalytical parameters above established action levels in ground watermonitoring wells down gradient from the ash disposal area. Remedies are beingdiscussed with the NYSDEC. Actions may include operational changes or cappingthe existing landfill, construction of a new landfill cell, or a combination ofthese actions.

 

In an area adjacent to the Lockwood ash disposal site,our environmental consultant reported that approximately 500 to 700 drums ofabrasives were disposed in the early 1970s and covered with ash. We havebudgeted $520,000 to conduct a site investigation and remove the drums. Inaddition, groundwater sampling in this area and around the Lockwood ashdisposal site indicates that some monitoring wells have parameters, whichexceed state regulatory limits. There can be no guarantee that the currentlybudgeted amounts will be sufficient to investigate and remediate the site, ifneeded.

 

In 2000, the EPA confirmed that ash disposed of inlandfills should be regulated as non-hazardous waste. Nevertheless, the EPAdetermined that additional solid waste regulations will be developed for coalash disposal in landfills and surface impoundments.  At this point, we cannot determine whethersuch new regulations will, or to what extent they will, have an impact on ourash disposal practices.

 

These projected environmental cost estimates are not aguarantee that additional environmental liabilities will not be incurred, andit is possible that the actual costs could be significantly higher. Inaddition, it is possible that previously unknown environmental conditions willbe discovered in the future, which could result in a material cost to us orotherwise adversely impact our financial condition or results of operations.

 

**Noise**

 

The Certificate of Environmental Compatibility andPublic Need that was issued to NYSEG in 1978 for the development and operationof Somerset contains a number of requirements for mitigating environmentalimpacts from the facility, including noise impacts. Among the noiserequirements was an obligation to obtain noise easements from neighboringlandowners or, as subsequently approved by the Public Service Commission, topurchase their property in a buffer zone where noncompliance with noisestandards was expected to occur. Subsequent analyses predicted that theseexceedances would occur only in connection with ash disposal operations whenArea 2 of the Somerset landfill was constructed. Prior to the acquisition ofour electricity generating stations, NYSEG had purchased neighboring propertiesfor a combined cost totaling approximately $1.5 million and had a standingoffer to purchase the remainder. We obtained an appraisal of the remainingproperties which places their aggregate current value at approximately $3.1million in 1999 dollars. We have not budgeted any amount for the acquisition ofthese properties.

 

The Public Service Commission has also required that anoise mitigation plan be developed and submitted for Public Service Commissionapproval at least one year prior to commencement of Area 2 development.

 

The Public Service Commission could require additionalnoise control measures at that time. We do not expect that the noise compliancecosts we may incur, including as a result of taking over the land purchaseprogram, will be material.

 

**People**

 

As of December 2004, we employed approximately300 people who operate our electricity generating stations. The InternationalBrotherhood of Electrical Workers (the “IBEW”) represents hourly labor atSomerset, Cayuga, Westover and Greenidge. The IBEW represents approximately 244 workers. We have negotiatedcollective bargaining agreements with respect to each electricity generatingstation on an individual electricity generating station basis.  This gives us continuing labor harmony andencourages the adoption of The AES Corporation’s culture by emphasizingindividual businesses with responsibility and ownership of local issues. Webelieve that relations with the people employed at our electricity generatingstations are satisfactory.

 

18

----

 

**Item 2.****                                  ****Properties**

 

The following table shows the material propertieswhich we or our subsidiaries own or lease. See “Business—The ElectricityGenerating Stations” for more information about these properties.

 

Electricity

 
| **Generating  Station** | ** ** | **Location**     | ** ** | **Capacity** | ** ** | **Owned  or Leased** | ** ** | **Expiration  of Lease** |
|-------------------------|------------|------------------|------------|--------------|------------|----------------------|------------|--------------------------|
|                    |       |             |       |         |       |                 |       |                     |
| Somerset                |       | Barker, NY       |       | 675MW        |       | Leased*              |       | February 13, 2033   |
|                    |       |             |       |         |       |                 |       |                     |
| Cayuga                  |       | Lansing, NY      |       | 306MW        |       | Leased*              |       | November 13, 2027   |
|                    |       |             |       |         |       |                 |       |                     |
| Westover                |       | Johnson City, NY |       | 126MW        |       | Owned                |       | Not Applicable           |
|                    |       |             |       |         |       |                 |       |                     |
| Greenidge               |       | Dresden, NY      |       | 161MW        |       | Owned                |       | Not Applicable           |

 

----

*                 We own all of theland on which Somerset and Cayuga are located and we lease the portion on whichthe facilities of those stations are located to the special purpose businesstrusts that own those facilities. We lease the facilities of those stations andsublease the land on which they are located from the special purpose businesstrusts.

 

**Item 3.****                                  ****Legal Proceedings**

 

Certain legal proceedings are discussed in “Business -Narrative Description of Business - Environmental Regulatory Matters”.

 

On March 30, 2001,Pozament Corp. filed a Summons and Complaint to be served on AES Westover, LLC,wherein it seeks to recover damages for breach of contract. The plaintiffalleges that it had an exclusive agreement with Westover to remove all of itscoal flyash. We believe that the contract in question is unenforceable and voidand intend to vigorously defend this claim. We feel that any award orsettlement in this case would not materially affect our financial position orresults of operations.

 

On February 5, 2004,Grover Hedgecock filed a Summons and Complaint to be served on AES Westover,LLC, wherein he seeks to recover damages for negligence. The plaintiff, hiredby an outside contractor, alleges that Westover was negligent in an accidentthat the plaintiff had at Westover in November 2002. Our insurance willcover the loss, if any, minus a deductible. We have turned this matter over toour insurance carrier’s attorneys.

 

**Item 4.****                                  ****Submission of Matters to a Vote of Security Holders**

 

Not applicable.

 

**PART II**

 

**Item 5.****                                  ****Market for our Company’s Common Equity and Related Stockholder Matters**

 

All outstanding equity interests in our company areowned indirectly by The AES Corporation.

 

19

----

 

**Item 6.****                                  ****Selected Financial Data**

 
| **As of December 31,**      | ** ** | **2004*** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
|----------------------------------|------------|-----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Balance Sheet Data (in millions) |       |      |       |     |       |     |       |     |       |     |       |
| Total assets                     |       | $         | 1,103      |     | $          | 1,118    |       | $        | 1,126      |     | $          | 1,194 |   | $ | 1,185 |   |
| Long term  liabilities           |       | $         | 711        |     | $          | 682      |       | $        | 688        |     | $          | 699 |   | $ | 678 |   |
| Minority  Interest               |       | $         | 8          |     | —     |     | —     |     | —     |     | —     |   |
| Partners’  capital          |       | $         | 227        |     | $          | 348      |       | $        | 382        |     | $          | 433 |   | $ | 441 |   |

 
| **For the period ending December 31,** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
|---------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Statement of Income Data (in millions)      |       |     |       |     |       |     |       |     |       |     |       |
| Total  revenue                              |       | $        | 411        |     | $          | 426      |       | $        | 367        |     | $          | 378 |   | $ | 388 |   |
| Operating  income                           |       | $        | 114        |     | $          | 147      |       | $        | 114        |     | $          | 106 |   | $ | 151 |   |
| Net income                                  |       | $        | 57         |     | $          | 89       |       | $        | 59         |     | $          | 52 |   | $ | 98 |   |

 

----

*Includes assets and liabilities of Somerset Railroad whichis now consolidated in our consolidated financial statements in accordance withrevised Financial Accounting Standards Board Interpretation No. 46(R), “Consolidationof Variable Interest Entities”. See Note 2 of our audited financial statements,which are included in this Annual Report on Form 10-K.

 

SELECTED QUARTERLY FINANCIAL DATA(Unaudited)

 

The following table summarizes the quarterlyconsolidated statements of income (in thousands):

 
| ** **                                                             | ** ** | **First  Quarter** | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
|------------------------------------------------------------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|
| YEAR ENDED DECEMBER 31,  2004:                                    |       |               |       |                |       |               |       |                |       |
| Operating  revenue**                                                   |       | $                  | 104,987    |                | $          | 98,783             |       | $                   | 103,148    |   | $ | 103,736 |   |
| Operating  income                                                      |       | 32,838             |       | 25,067              |       | 28,355             |       | 27,480              |       |
| Net income  from continuing operations Before minority interest        |       | 18,415             |       | 10,862              |       | 13,933             |       | 13,525              |       |
| Net income                                                             |       | 18,484             |       | 10,910              |       | 14,192             |       | 13,713              |       |
|                                                                   |       |               |       |                |       |               |       |                |       |
| YEAR ENDED DECEMBER 31,  2003:                                    |       |               |       |                |       |               |       |                |       |
| Operating  revenue**                                                   |       | $                  | 109,064    |                | $          | 99,228             |       | $                   | 119,324    |   | $ | 98,414 |   |
| Operating  income                                                      |       | 43,220             |       | 35,794              |       | 47,767             |       | 20,337              |       |
| Net income  before cumulative effect of change in accounting principle |       | 29,248             |       | —              |       | —             |       | —              |       |
| Net income                                                             |       | 27,592             |       | 21,659              |       | 33,492             |       | 6,323               |       |

 

----

**Certain prior period amountshave been reclassified in the quarterly consolidated financial statements toconform with the year-end 2004 presentation.

 

**Item 7.****                                  ****Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

 

Overview

 

The information in this Management’s Discussion andAnalysis should be read in conjunction with the accompanying consolidatedfinancial statements, the related Notes to the Financial Statements and theselected financial data. Forward looking statements in this Management’sDiscussion and Analysis are qualified by the cautionary statement in theForward Looking Statements section of the Management’s Discussion andAnalysis.

 

All four of our electricity generating stationsoperate as merchant plants, which means that we sell their output in power poolspot market transactions or in transactions negotiated from time to timedirectly with another party rather than selling the output under a long-termpower sales contract. As merchant plants, our electricity generating stationsgenerally will be dispatched, that is, they will supply electricity, wheneverthe market price of electricity exceeds their variable cost of generatingelectricity. Our energy

 

20

----

 

revenue will be directly affected by the price ofelectricity, which is usually highest during the summer and winter peakseasons.

 

The economics of any electric power facility areprimarily a function of the price of electricity, the quantity of electricitywhich is purchased and the level of operating expenses. The greater thepercentage of time a unit is dispatched, the greater the revenues associatedwith that unit.

 

The markets for wholesale electric energy, unforcedcapacity and ancillary services in the New York power market were largelyderegulated in November 1999. In a competitive market where the order inwhich electricity generating plants are dispatched will be based on bids forthe sale of electric energy by the generating assets in the region, we expectthat the lower marginal cost facilities will bid lower prices and thereforethose facilities will be dispatched more often than higher marginal costfacilities.

 

We believe that our electricity generating stationsare among the lowest variable cost facilities in the New York power market. Wealso believe that our electricity generating stations are among the mostefficient coal units in the region. We expect that our electricity generatingstations will almost always be dispatched. The efficiency of our electricitygenerating stations provides several important advantages: a relatively stablepricing structure, the ability to benefit from energy price spikes in themarket and relatively little risk that our electricity generating stations willbe idle while other generating stations are directed to run.

 

Our electricity generating stations havehistorically been available to run a high percentage of the time due to theregulated utility-grade nature of their design and construction. In 2004, 2003and 2002, the stations had a weighted average (based on capacity) equivalentavailability factor of 96%, 93% and 96%, respectively (excluding the scheduledoutages at Cayuga from April to June 2004 for a major scheduled maintenanceturbine outage). We believe that we can maintain or improve the availability ofour electricity generating stations.

 

NYSEG has brought a proceeding to obtain a refund ofreal estate taxes it paid in connection with Somerset while NYSEG owned it.NYSEG had little incentive to contest the tax valuation of its electricitygenerating stations while it owned them because the real property taxes it paidwere included among the expenses it was permitted to recover through regulatedelectricity rates and were therefore passed along to its customers.

 

If NYSEG is successful in obtaining substantialrefunds of prior real estate taxes, local governments may be forced to raisereal estate tax rates to bring revenues into balance with expenditures.  It is too early to tell what impact, if any,this will have on our financial condition and results of operations.

 

Critical Accounting Policies

 

General

 

We prepare our consolidated financial statements inaccordance with accounting principles generally accepted in the United States ofAmerica. As such, we are required to make certain estimates, judgments andassumptions that we believe are reasonable based upon the informationavailable. These estimates and assumptions affect the reported amounts ofassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the periods presented. The significantaccounting policies which we believe are most critical to understanding andevaluating our reported financial results include the following: RevenueRecognition; Property, Plant and Equipment, Contingencies and Derivatives.

 

Revenue Recognition

 

Revenues from the sale of electricity are recorded based uponoutput delivered and rates specified under contract terms. Gains and losses,generated from the hedging of future sales using commodity forwards, swaps andoptions, reported in other comprehensive income, are reclassified to earningsin the periods in which earnings are impacted by the variability of the cashflows of the hedged item. The ineffective portions of the change in fair valueof derivatives and the change in the fair value of derivatives not designatedas hedges for accounting purposes are recognized in current period earnings.Revenues for ancillary and other services are recorded when the services arerendered. The Transmission Congestion Contract, expired in October and wasnot renewed, was not deemed to be a hedge based on the definitions in Statementof Financial Accounting Standards (“SFAS”) No. 133. Therefore, this contractwas marked-to-market at the end of every period. The mark-to-market value wascomputed based on a

 

21

----

 

regression of historical eastern and western locationalprices. This regression was used with forecasted eastern and western locationalprices to calculate the forward congestion for the remainder of the contractterm. This accounting treatment contributed to the income statement volatilityof this contract.

 

Property, Plant and Equipment

 

Electric generation assets thatexisted at the date of acquisition were recorded at fair market value. Somersetand Cayuga, which represent $650million of the electric generation assets, are subject to a leasing arrangementaccounted for as a financing. Additions or improvements thereafter are recordedat cost. Depreciation is computed using the straight-line method over the 34-yearand 28.5-year lease terms for Somerset and Cayuga, respectively, and overthe estimated useful lives for the other fixed assets, which range from 7 to 35years. A significant overabundance of supply of electricity and asustained, significant decline in market prices to below our variable costcould cause a decrease in the estimated useful lives of our electric generationassets. If the useful life of any of our property, plant and equipment ischanged, the new life would be based on engineering studies and expected usage.The estimated average remaining useful life of our property, plant andequipment is approximately 21 years. If the estimated average remaining life ofour property, plant and equipment were to decrease by five years, annualdepreciation would increase by $7.7 million. Maintenance and repairs are charged to expenses as incurred.

 

Contingencies

 

We accrue for loss contingencies when the amount of the lossis probable and estimable. We are subject to various environmental regulations,and we are involved in certain legal proceedings. If our actual environmentaland/or legal obligations are materially different from our estimates, therecognition of the actual amounts may have a material impact on our operatingresults and financial condition.

 

Derivatives

 

We account for derivative instruments and hedging activitiesin accordance with SFAS No. 133, “Accounting for Derivative Instrumentsand Hedging Activities,” which, as amended, established new accounting andreporting standards for derivative instruments and hedging activities. SFAS No. 133requires that all derivatives (including derivatives embedded in othercontracts) be recorded as either assets or liabilities at fair value on thebalance sheet. Changes in the derivative’s fair value are to be recognized inearnings in the period of change, unless hedge accounting criteria are met.Hedge accounting allows the derivative’s gains or losses in fair value tooffset the related results of the hedged item. We utilize derivative financialinstruments to manage commodity price risk. Although the majority of ourderivative instruments qualify for hedge accounting, SFAS No. 133 may resultin more variation to our results of operations from changes in commodityprices.  We have chosen to use thehypothetical derivative methodology for testing whether our hedges meet thecriteria to qualify for hedge accounting treatment. A historical regression isperformed between the electricity generating stations’ delivery points into theNYISO and the NYISO zones in which the hedges are settled. Comparing theresults of the historical regression and the actual changes in the market valueof the hedges determines if the hedges qualify for hedge accounting criteriatreatment.  For the years ended December 31,2004, 2003 and 2002, we recognized losses of $3.8 million and $6.2 million andincome of $8.9 million, respectively, pursuant to SFAS No. 133 related toderivatives which did not qualify for hedge accounting.  See Note 2 of our audited financialstatements, which are included in this Annual Report on Form 10-Kfor a more complete discussion of the accounting for derivatives under SFAS No. 133.

 

Results of Operations

(Amounts in Millions)

 
| **For the Year Ended December 31,** | ** ** | **2004** | ** ** | **2003** | ** ** | **%  Change** | ** ** | **2002** | ** ** | **%  Change** | ** ** |
|------------------------------------------|------------|----------|------------|----------|------------|---------------|------------|----------|------------|---------------|------------|
| Energy  Revenue                          |       | $        | 382.7      |     | $          | 394.2         |       | (2.9     | )          | $             | 315.0      |   | 25.1 |   |
|                                     |       |     |       |     |       |          |       |     |       |          |       |
| Capacity  Revenue                        |       | 23.1     |       | 29.7     |       | (22.2         | )          | 36.6     |       | (18.9         | )          |
|                                     |       |     |       |     |       |          |       |     |       |          |       |
| Transmission  Congestion Contract        |       | —   |       | —   |       | —        |       | 8.9      |       | —        |       |
|                                     |       |     |       |     |       |          |       |     |       |          |       |
| Other                                    |       | 4.8      |       | 2.2      |       | —        |       | 6.9      |       | (68.1         | )          |
|                                          |            |          |            |          |            |               |            |          |            |               |            |  |  |  |

 

22

----

 

Energy revenues for the year ended December 31, 2004 were $382.7 million, compared to $394.2 million for the year ended December 31, 2003, a decrease of 2.9%. The decrease in energy revenues is primarily due to a scheduled major maintenance outage at Cayuga of approximately 63 days for Unit 2 that was offset by higher market prices and demand. Market prices for peak and offpeak electricity were 1.84% and 3.08% higher than the year ended December 31, 2003. Demand for peak and offpeak electricity increased 1.25% compared to the demand for the year ended December 31, 2003. Energy revenues for the year ended December 31, 2003 were $394.2 million, compared to $315 million for the year ended December 31, 2002, an increase of 25.1%. The increase in energy revenues was primarily due to higher market prices and stable demand. Market prices for peak and offpeak electricity were 41.6% and 40.5% higher than the year ended December 31, 2002. Demand for peak and offpeak electricity was flat compared to demand for the year ended December 31, 2002.

 

Capacity revenues for the year ended December 31,2004 were $23.1 million, compared to $29.7 million for the year ended December 31,2003, a decrease of 22.2%. The decrease in capacity revenue is primarily due tolower prices for capacity sales on the open market for both the summer andwinter capacity period. Capacity revenues for the year ended December 31,2003 were $29.7 million, compared to $36.6 million for the year ended December 31,2002, a decrease of 18.9%. The decrease in capacity revenue was primarily dueto lower prices for capacity sales on the open market for the summer capacityperiod (June - October) and the winter capacity period (November-May).

 

The foregoing market price and demand data were basedon statistics obtained from the NYISO.

 

The Transmission Congestion Contract, which expired inOctober 2004 and was not renewed, was essentially a swap between thecongestion component of the locational prices posted by the NYISO in westernNew York and the more populated areas in eastern New York.  The Transmission Congestion Contract becameeffective on November 1, 2000 and terminated on October 1, 2004. Weentered into this agreement because it provided a reasonable settlement forresolving a FERC dispute between us and Niagara Mohawk Power Corporation. Thiscontract was not deemed to be a hedge based on the definitions in SFAS 133.Therefore, this contract was marked to market at the end of every period.  The mark-to-market value was computed basedon a regression of historical eastern and western locational prices. Thisregression was used with forecasted eastern and western locational prices tocalculate the forward congestion for the remainder of the contract term. Thisaccounting treatment contributed to the income statement volatility of thiscontract.

 

Operating Expenses

 
| **For the Year Ended December 31,** | ** ** | **2004** | ** ** | **2003** | ** ** | **%  Change** | ** ** | **2002** | ** ** | **%  Change** | ** ** |
|------------------------------------------|------------|----------|------------|----------|------------|---------------|------------|----------|------------|---------------|------------|
| Fuel expense                             |       | $        | 156.2      |     | $          | 148.3         |       | 5.3      |       | $             | 137.2      |   | 8.1 |   |
|                                     |       |     |       |     |       |          |       |     |       |          |       |
| Depreciation  and amortization           |       | 39.4     |       | 36.1     |       | 9.1           |       | 35.5     |       | 1.7           |       |
|                                     |       |     |       |     |       |          |       |     |       |          |       |
| Operations  and maintenance              |       | 30.7     |       | 28.6     |       | 7.3           |       | 21.4     |       | 33.6          |       |
|                                     |       |     |       |     |       |          |       |     |       |          |       |
| General and  administrative              |       | 65.6     |       | 59.2     |       | 10.8          |       | 59.1     |       | 0.2           |       |
|                                     |       |     |       |     |       |          |       |     |       |          |       |
| Transmission  Congestion Contract        |       | 3.8      |       | 6.2      |       | (38.7         | )          | —   |       | —        |       |
|                                          |            |          |            |          |            |               |            |          |            |               |            |  |  |  |

 

Fuel expense for the year ended December 31, 2004was $156.2 million, compared to $148.3 million for the year ended December 31,2003, an increase of 5.3%. The increase in fuel expense is primarily due tohigher contract coal prices and higher allowance prices. Fuel expense for theyear ended December 31, 2003 was $148.3 million, compared to $137.2million for the year ended December 31, 2002, an increase of 8.1%. Theincrease in fuel expense was primarily due to higher operating levels, whichnecessitated greater coal usage and greater coal purchases on the spot market.

 

Depreciation and amortization expense for the yearended December 31, 2004 was $39.4 million, compared to $36.1 million forthe year ended December 31, 2003, an increase of 9.1%. This increase isprimary due to the consolidation of Somerset Railroad’s depreciation of $2.4million. Depreciation and amortization expense for the year ended December 31,2003 was $36.1 million, compared to $35.5 million for the year ended December 31,2002, an increase of 1.7%. This increase is primarily due to the capitalizationof a net asset of $3.3 million due to adoption of SFAS No. 143 at January 1,2003 and the overfire air system installed at Westover Unit 8.

 

23

----

 

Operations and maintenance expense for the year ended December 31,2004 was $30.7 million, compared to $28.6 million for the year ended December 31,2003, an increase of 7.3%. This increase was primarily due to maintenanceexpenses incurred during a scheduled major turbine maintenance outage at Cayugaof approximately 63 days for Unit 2, which are not annually recurringexpenses.  Operations and maintenanceexpense for the year ended December 31, 2003 was $28.6 million, comparedto $21.4 million for the year ended December 31, 2002, an increase of33.6%. This increase is primarily due to maintenance expenses incurred duringscheduled boiler outages at every electricity generating station during 2003.

 

General and administrative expense for the year ended December 31,2004 was $65.6 million, compared to $59.2 million for the year ended December 31,2003, an increase of 10.8%. This increase was primarily due to significantincreases in property taxes and property and medical insurance.  General and administrative expense for theyear ended December 31, 2003 was $59.2 million, compared to $59.1 millionfor the year ended December 31, 2002, an increase of 0.2%.

 

Other Income/Expenses

 
| **For the Year Ended December 31,** | ** ** | **2004** | ** ** | **2003** | ** ** | **%  Change** | ** ** | **2002** | ** ** | **%  Change** | ** ** |
|------------------------------------------|------------|----------|------------|----------|------------|---------------|------------|----------|------------|---------------|------------|
| Interest  expense                        |       | $        | 58.9       |     | $          | 58.5          |       | 0.7      |       | $             | 57.7       |   | 1.4 |   |
|                                     |       |     |       |     |       |          |       |     |       |          |       |
| Interest  Income                         |       | 1.9      |       | 2.1      |       | 9.5           |       | 2.1      |       | —        |       |
|                                          |            |          |            |          |            |               |            |          |            |               |            |  |  |  |

 

Other Income/Expenses for the year ended December 31, 2004 were net expenses of $57 million, compared to net expenses of $56.4 million for the year ended December 31, 2003, an increase of 1.1%. The interest portions of the payments under the leases for Somerset and Cayuga were set at the issuance and vary from year to year. Other Income/Expenses for the year ended December 31, 2003 were net expenses of $57 million, compared to net expenses of $55.6 million for the year ended December 31, 2002, an increase of 1.4%. This increase is primarily due to higher interest expense.

 

Liquidity and Capital Resources

 

Operating Activities

 

Net Cash provided by operating activities of $89.8million for the year ended December 31, 2004 reflects the decrease in netincome due to decreased electricity revenues offset in part by the changes incurrent assets and liabilities.

 

Investing Activities

 

Net cash provided by investing activities of $11.1million for the year ended December 31, 2004 reflects a decrease in ourrestricted cash accounts of $26.4 million offset by approximately $13.8 millionin capital expenditures and the $1.5 million increase in the NYSISO workingcapital fund.

 

We incurred approximately $13.8 million, $5.4 millionand $7.1 million in capital expenditures with regard to our assets for theyears ended December 31, 2004, 2003 and 2002, respectively. These amountsinclude $1.4 million for the overfire air project to reduce NOx emissions atWestover Unit 8 in 2003. We will make capital expenditures thereafter accordingto the maintenance program for our electricity generating stations. In additionto capital requirements associated with the ownership and operation of ourelectricity generating stations, we will have significant fixed chargeobligations in the future, principally with respect to the leases of Somersetand Cayuga.

 

Compliance with environmental standards will continueto be reflected in our capital expenditures and operating costs. Based on thecurrent status of regulatory requirements, other than the expenditures for theSCRs at Somerset and Cayuga including the construction of new landfill space tomanage ash from Somerset’s SCR system operations, expenditures for possibleinstallation of a SCR system on Cayuga Unit 2, the U.S. Department of EnergyPower Plant Improvement project on Greenidge Unit 4, any other costs to bringus into compliance with the January 11, 2005 Consent Decree, andexpenditures for studies and capital and operating expenses to bring theelectricity generating stations into compliance with the new federal coolingwater intake standards, we do not anticipate that any capital expenditures oroperating expenses associated with our compliance with current laws andregulations will have

 

24

----

 

a material effect on our operations or our financialcondition. See “Business—Regulation—Environmental Regulatory Matters.”

 

Financing Activities

 

Net cash used in financing activities for the yearended December 30, 2004 of $100.9 million reflects principal payments onour leases of $9.7 million, payment of a distribution to our partners of $89.9million and payments for deferred financing of $1.8 million offset by a partner’scontribution of $415,000 and proceeds from other debt of $137,000.

 

The leases for Somerset and Cayuga require that wemake fixed semiannual payments of rent on each January 2 and July 2during the terms of the leases commencing on January 2, 2000 in amountscalculated to be sufficient (1) to pay principal and interest when due onthe debt incurred in connection with the leases for Somerset and Cayuga and (2) topay the economic return of the institutional investors that formed the specialpurpose business trusts.  Our minimumrent obligation under the leases is $59.9 million for 2005, $61.6 million for2006, $62.5 million for 2007, $62.5 million for 2008, $62.5 million for 2009and a total of $1,127.2 million for the years thereafter.  For purposes of the minimum rent obligationsdescribed in the preceding sentence, we treated the semiannual rent paymentsthat are due on January 2 of each year as though they would be paid in thepreceding year. You can find information concerning our minimum rentalobligations that treats rent payments as obligations for the years in whichthey are due in Note 6 of our audited financial statements, which are includedin this Annual Report on Form 10-K. Through July 2, 2020, andso long as no lease event of default exists, we may defer payment of rentobligations under each lease in excess of the amount required to pay principaland interest on the secured lease obligation notes until after the finalscheduled payment date of the secured lease obligation notes.  As of December 31, 2004, we have notdeferred any portion of our lease obligations. In addition, we are required tomaintain a rent reserve account equal to the maximum semiannual payment withrespect to the sum of basic rent (other than deferrable basic rent) and fixedcharges expected to become due on any one basic rent payment date in theimmediately succeeding three-year period. At December 31, 2004 and 2003,the amounts deposited in the rent reserve account were $31.7 million and $31.7million, respectively.

 

We are also obligated to make payments under the coalhauling agreement with Somerset Railroad in an amount sufficient, when added tofunds available from other sources, to enable Somerset Railroad to pay, when due,all of its operating expenses and other expenses. Through this agreement wehave, in effect, guaranteed the interest on and principal of Somerset Railroad’soutstanding indebtedness. On August 14, 2000, Somerset Railroad enteredinto a $26 million credit facility with Fortis Capital Corp. which replaced inits entirety a credit facility for the same amount previously provided toSomerset Railroad by an affiliate of CIBC World Markets.  The credit facility provided by FortisCapital Corp. consists of a 14-year term note (maturing on May 6,2014), with principal and interest payments due quarterly.

 

As a result of these obligations, we must dedicate asubstantial portion of our cash flow from operations to payments of rent underthe leases, payments under our working capital facility and payments under thecoal hauling agreement with Somerset Railroad, which in turn allow SomersetRailroad to pay principal and interest under its credit facility with FortisCapital Corp. The principal payments for Somerset Railroad’s $26 million creditfacility are $1.9 million per year.

 

In April 2001, we entered into a $35 millionsecured revolving working capital and letter of credit facility with Union Bankof California, N.A. This facility had a term of approximately twenty-onemonths. We could borrow up to $35 million for working capital purposes underthis facility. In addition, we could have letters of credit issued under thisfacility up to $25 million, provided that the total amount of working capitalborrowings and letters of credit issuances could not exceed the $35 millionlimit on the entire facility.  Through November 20,2002, we made three borrowings under this facility. The first borrowing was for$7 million on July 13, 2001 at an interest rate of 8.125% and was repaidin full on July 31, 2001. The second borrowing was for $8.5 million on January 11,2002 at an interest rate of 6.125% and was repaid in full on February 28,2002. The third borrowing was for $14.0 million on July 9, 2002, at aninterest rate of 6.125% and was repaid in full in two installments: $7.2million on July 31, 2002 and $6.8 million on August 28, 2002.

 

On November 20, 2002, we signed an agreement withUnion Bank of California, N.A. for a one-year extension of the working capitaland letter of credit facility. On April 16, 2003, we signed an amendmentto our November 20, 2002 credit agreement with Union Bank of California,N.A. The amendment included another one-year extension of the facility whichextended the maturity date of the working capital and letter of credit facilityto January 2, 2005. The

 

25

----

 

amendment also increased Union Bank of California’scommitment from $15 million to $20 million. On April 25, 2003, we furtheramended our November 20, 2002 credit agreement with Union Bank ofCalifornia, N.A. The amendment included a commitment from Citibank, N.A. forthe remaining $15 million of the facility. There were five borrowings underthis facility. The first borrowing was for $9.7 million on January 10,2003 at an interest rate of 5.75%. This borrowing was repaid in full on January 28,2003. The second borrowing was for $9.7 million on July 9, 2003 at aninterest rate of 5.5%. This borrowing was repaid in full on July 25, 2003.The third borrowing was for $12.9 million on January 9, 2004 at aninterest rate of 5.5%. This borrowing was repaid in full in two installments:$6.2 million on January 27, 2004 and $6.7 million on February 26,2004. The fourth borrowing was for $1 million on February 20, 2004 at aninterest rate of 5.5%. This borrowing was repaid in full on February 26,2004. The fifth borrowing was for $14.3 million on July 9, 2004 at aninterest rate of 5.75%. This borrowing was repaid in full on July 26,2004.

 

The AES Corporation on January 6, 2003 and February 25,2003 authorized us to issue letters of credit to counterparties on its $350million senior secured revolving credit facility to the amount of $25 millionand $35 million for the years of 2003 and 2004, respectively.

 

On February 12, 2004, we signed a two-yearagreement, effective January 1, 2004 (the “AES Letter of Credit Agreement”),with The AES Corporation to obtain up to $35 million and $25 million of lettersof credit or cash collateral for 2004 and 2005, respectively. This agreementsuperseded the authorization of AES on February 25, 2003. The agreementlimited the letters of credit amounts and cash collateral to the stated amountsand set into place a fee structure and repayment terms.

 

On October 26, 2004, we and The AES Corporationagreed to terminate the commitment of The AES Corporation to provide letters ofcredit and cash collateral for our benefit under the AES Letter of CreditAgreement.

 

Pursuant to the AES Letter of Credit Agreement, TheAES Corporation had agreed to provide, or cause to be provided, letters ofcredit and cash collateral to counterparties to support our obligations arisingin connection with our sale of electricity. The AES Corporation agreed that themaximum amount of letters of credit and cash collateral that The AESCorporation would provide, or cause to be provided, pursuant to the AES Letterof Credit Agreement would be $95 million from April 28, 2004 until December 31,2004 and $60 million from January 1, 2005 until December 30, 2005. OnOctober 14, 2004, The AES Corporation Board of Directors passed aresolution regarding extension of authorized credit support for us. The Boardof Directors resolved to authorize The AES Corporation to extend us use of $95million in letter of credit capacity through December 31, 2006. As of December 31,2004, we had obtained letters of credit in the amount of $58.9 million, whichhave been provided as additional margin to support normal, ongoing hedgingactivities with a number of counterparties.

 

The termination of AES’s commitment under the AESLetter of Credit Agreement does not affect outstanding authorizations ofletters of credit or cash collateral. We remain obligated to perform ourresponsibilities under the AES Letter of Credit Agreement with respect to anyoutstanding letters of credit or cash collateral agreements until the earlierof such time as we replace such outstanding letters of credit or cashcollateral agreements or the stated expiration date of such letters of creditor cash collateral agreements shall occur.

 

The AES Corporation is not obligated to provide anysuch letters of credit in the future and will review any request for theissuance of an authorization for such letters of credit on a case by case basisand may refuse any request for the issuance of such letters of credit for anyreason, or for no reason.

 

On October 26, 2004, we entered into an Amendedand Restated Credit Agreement with Calyon New York Branch and the Banks and theIssuing Banks named therein (the “Calyon Credit Facility”). Also on October 26,2004, Calyon New York Branch purchased the outstanding loans made under ourexisting $35,000,000 credit facility, dated as of April 10, 2001, asamended, and the unreimbursed drawings under letters of credit issued under theexisting credit facility.  In addition,Calyon New York Branch assumed all of the rights and obligations of the banksunder the existing credit facility including the commitments of such banks tomake loans and issue letters of credit.

 

Under the Calyon Credit Facility, the Banks haveagreed, from time to time until January 28, 2008, to make loans to andissue letters of credit on our behalf. The maximum aggregate principal amount of loans, outstanding letters ofcredit and unreimbursed drawings under letters of credit issued under theCalyon Credit Facility which may be at any one time outstanding initially was$35 million and was increased to $75 million when subsquent approval by the New

 

26

----

 

York State Public Service Commission was obtained on November 10,2004.  We may borrow, pay or prepay andreborrow loans.

 

Loans may, at our option, be made under the CalyonCredit Facility as Base Rate Loans or Eurodollar Rate Loans or any combinationthereof. Base Rate Loans bear interest at an interest rate per annum equal tothe sum of (1) the higher of (a) the Prime Rate announced by CalyonNew York Branch from time to time in effect and (b) the sum of the FederalFunds Rate in effect plus 0.50%, plus (2) an applicable margin of 0.75%until October 26, 2006 and 1% thereafter. Eurodollar Rate Loans bearinterest at an interest rate per annum (rounded upwards, if necessary, to thenearest whole multiple of 1/100 of 1%) equal to the sum of (1) the Londoninterbank offered rate for deposits in Dollars two business days prior to thefirst day of an Interest Period (a period of one, two, three or six monthsselected by us) for a term comparable to such Interest Period, plus (2) anapplicable margin of 1.75% until October 26, 2006 and 2% thereafter. As ofDecember 31, 2004, of the $75 million committed, we had obtained lettersof credit of $51.6 million, which have been provided as additional margin tosupport normal, ongoing hedging activities with a number of counterparties.

 

Our obligations under the Calyon Credit Facility aresecured by our pledge of the membership interests in our wholly ownedsubsidiary, AEE2, L.L.C. (which owns the Westover and Greenidge electricgenerating plants), as well as AEE2, L.L.C.’s wholly owned subsidiaries, AESWestover, L.L.C. (which operates the Westover electric generating plant) andAES Greenidge, L.L.C. (which operates the Greenidge electric generating plant).

 

Our future ability to obtain additional debt financingfor working capital, capital expenditures or other purposes is limited byfinancial covenants restricting our ability to incur debt and liens containedin the agreements governing the leases of Somerset and Cayuga.  With certain exceptions, these agreementslimit us to a maximum of $100 million of indebtedness, including no more than$25 million of indebtedness for purposes other than to provide working capital.

 

Cash flow from our operations was sufficient to coveraggregate rental payments under the leases for Somerset and Cayuga on each ofthe rent payment dates from the first payment January 2, 2001 through January 2,2005. We believe that cash flow from our operations will be sufficient to coveraggregate rental payments on each rent payment date thereafter. We also believethat our cash flow from operations, together with amounts we can borrow underour $75 million Calyon Credit Facility, will be sufficient to cover expectedcapital requirements over the terms of the leases. If we are required to makeunanticipated capital expenditures, our cash flow available for the payment ofDebt, distributions to partners and operating income in the period incurredwould be reduced.

 

The outage at Cayuga for almost the entire period fromMarch 31, 2004 to June 4, 2004 did not impair our ability to meet ourobligations during this period. Subsequent to this outage, our four electricitygenerating stations are all available for service and are being dispatched togenerate electricity when market conditions warrant.

 

The agreements governing the leases of Somerset andCayuga and our working capital credit facility impose severe restrictions onour ability to make distributions of cash or other assets to our owners and onthe ability of our owners to withdraw cash or other assets from us. Theserestrictions are intended to assure that we have paid all of our operating andmaintenance expenses and all of our obligations under our leases and under ourworking capital credit facility before any assets are distributed to orwithdrawn by our owners.  We may make adistribution to our owners on or within ten business days after a rent paymentdate for the Somerset and Cayuga leases so long as the following conditions aresatisfied:

 

(1) all rent under the leases for Somerset andCayuga, including deferrable payments, must have been paid to date;

 

(2) amounts on deposit or deemed on deposit inthe rent reserve account and the additional liquidity account established inconnection with the leases of Somerset and Cayuga must be equal to or greaterthan the rent reserve account required balance or the additional liquidityrequired balance, as applicable;

 

(3) no lease material default, lease event ofdefault or event of default under any permitted indebtedness shall haveoccurred and be then continuing;

 

(4) no amounts maybe outstanding under the working capital credit facility;

 

(5) we have noindemnity currently due and payable under specified provisions of theparticipation agreements relating to the Somerset and Cayuga leases or anyother operative document or any obligation to fund the indemnity accounts (asdefined in the leases) under the leases;

 

27

----

 

(6) the coverageratios for each of the two semiannual rent payment periods immediatelypreceding the rent payment date (based on actual operating history) must beequal to or greater than the required coverage ratio and the pro forma coverageratios for each of the four semiannual periods immediately succeeding this rentpayment date must be equal to or greater than the required coverage ratio;

 

(7) with respect tothe Somerset Railroad credit facility or any replacement facility, no event ofdefault shall have occurred and be then continuing under the facilities and theremaining term of the Somerset Railroad credit facility or any replacementfacility shall not be less than 30 days.

 

The AES Corporation contributed approximately$415,000, $162,000 and $1.5 million to us in 2004, 2003 and 2002, respectively.The contributions, which were accounted for as a partner’s contribution,related to stock option compensation expense in 2004 and 2003 and theconstruction of the SCR on Unit 1 of Cayuga, which became operational on June 7,2001.

 

Credit Rating Discussion

 

Credit ratings affect our ability toexecute our commercial strategies in a cost-effective manner. In determiningour credit rating, the rating agencies consider a number of factors.Quantitative factors that appear to have significant weight include, amongother things, earnings before interest, taxes and depreciation and amortization(“EBITDA”); operating cash flow; total debt outstanding; fixed charges such asinterest expense and lease payments; liquidity needs and availability andvarious ratios calculated from these factors. Qualitative factors appear toinclude, among other things, predictability of cash flows, business strategy,industry position and contingencies.

 

On October 3, 2002, Standard &Poor’s lowered its rating on our $550 million pass though trust certificatesissued to finance the acquisition of Somerset and Cayuga and $35 millionworking capital and letter of credit facility to BB+ from BBB- solely due toour rating linkage to The AES Corporation. The rating was also placed onCreditWatch with negative implications. In a press release announcing theratings downgrade of our debt, Standard & Poor’s noted that in mostcircumstances, it will not rate the debt of a wholly owned subsidiary higherthan the rating of the parent.  Eventhough we believe that the provisions of our financing arrangements render usbankruptcy remote from The AES Corporation, Standard & Poor’s statedthat it did not view these provisions as 100% preventative of the risk ofsubstantive consolidation in the event of a bankruptcy of The AES Corporation.Therefore, Standard & Poor’s limited the rating differential providedby such structural elements to three notches and stated that our credit ratingscannot be higher than BB+.

 

TriggerEvents

 

Ourcommercial agreements typically include adequate assurance provisions relatingto trade credit and some agreements have credit rating triggers. These triggerevents typically would give counterparties the right to suspend or terminatecredit if our credit ratings were downgraded. Under such circumstances, wewould need to post collateral to continue transacting risk-management businesswith many of our counterparties under either adequate assurance or specificcredit rating trigger clauses. The cost of posting collateral would have anegative effect on our profitability. If such collateral were not posted, ourability to continue transacting business as before the downgrade would beimpaired.

 

As ofthe date of filing this Annual Report on Form 10-K, the pass throughtrust certificates issued to finance the acquisition of Somerset and Cayugacarry a non-investment grade rating (BB+) from Standard & Poor’sRatings Services and Fitch IBCA, Inc. ratings agencies and anon-investment grade rating (Ba1) from Moody’s Investors Service, Inc.rating agency.

 

New Accounting Pronouncements

 

Variable Interest Entities

 

In January 2003, the FASB issued FASBInterpretation No. (“FIN”) 46, “Consolidation of Variable InterestEntities” which provides guidance on how to identify a variable interest entity(VIE), and when the assets, liabilities, noncontrolling interests and resultsof operations of a VIE need to be included in a company’s consolidatedfinancial statements. This interpretation was revised in December 2003with the issuance of FIN 46(R), “Consolidation of Variable Interest Entities”(FIN 46(R)).

 

28

----

 

In general, a VIE is an entity that lacks sufficientequity or its equity holders lack adequate decision making ability. If eitherof these characteristics is present, the entity is subject to a variableinterests consolidation model, and consolidation is based on variableinterests, not on ownership of the entity’s outstanding voting stock. Variableinterests are defined as contractual, ownership, or other money interests in anentity that change with fluctuations in the entity’s net asset value. Theprimary beneficiary consolidates the VIE; the primary beneficiary is defined asthe enterprise that absorbs a majority of expected losses or receives amajority of residual returns (if the losses or returns occur), or both.

 

On January 1, 2004, we adopted FIN 46(R) andprospectively charged the method of accounting to consolidate SRC Prior periodamounts have not been restated. Our consolidated balance sheet as of December 31,2004 reflects additional assets of approximately $25.6 million and liabilitiesof approximately $17.3 million as a result of this consolidation. Since SRC isowned by another affiliate of The AES Corporation, the consolidated balancesheets and consolidated statements of income and cash flow included in ourfinancial statements show such ownership as minority interest.

 

Share-BasedPayment

 

In December 2004, the FASB issued a revisedSFAS No.123 (“SFAS No. 123R”), “Share-Based Payment”, which is a revisionof SFAS No. 123. SFAS No. 123R eliminates the intrinsic value methodunder APB 25 as an alternative method of accounting for stock-based awards byrequiring that all share-based payments to employees, including grants of stockoptions for all outstanding years be recognized in the financial statementsbased on their fair values. It also revises the fair-value based method ofaccounting for share-based payment liabilities, forfeitures and modificationsof stock-based awards and clarifies SFAS No. 123’s guidance related to measurementof fair value, classifying an award as equity or as a liability and attributingcompensation to reporting periods.  In addition, SFAS No. 123R amendsSFAS No. 95, “Statement of Cash Flows”, to require that excess taxbenefits be reported as a financing cash flow rather than as an operating cashflow.

 

We are required to adopt SFAS No. 123R for the interim periodbeginning July 1, 2005 using a modified version of prospectiveapplication.  We may apply a modified retrospective application to periodsbefore the required effective date.  We plan to adopt SFAS No. 123Rno later than July 1, 2005, but has not determined what method it willuse.  We are currently evaluating the effect of adoption of SFAS No. 123R,but does not expect the adoption to have a material effect on our financialcondition, results of operations or cash flows, as we have previously adoptedincome statement treatment for compensation related to share-based paymentsunder SFAS No. 123.

 

Contractual Obligations

 

Below is a summary of certain obligations that willrequire significant capital(in thousands):

 
| **Contractual  Obligations**                            | ** ** | **Total** | ** ** | **Less  than 1  year** | ** ** | **1-3  years** | ** ** | **3-5  years** | ** ** | **After 5  years** | ** ** |
|---------------------------------------------------------|------------|-----------|------------|------------------------|------------|----------------|------------|----------------|------------|--------------------|------------|
| Debt  Obligations                                       |       | $         | 18,870     |                   | $          | 2,459          |       | $              | 4,226      |               | $          | 3,821 |   | $ | 8,364 |   |
| Capital  Lease Obligations (1)                          |       | $         | 1,435,673  |                   | $          | 59,450         |       | $              | 124,050    |               | $          | 125,000 |   | $ | 1,127,173 |   |
| Purchase “Take-or-Pay”  Obligations           |       | $         | 187,931    |                   | $          | 105,099        |       | $              | 82,832     |               | —     |   | — |   |
| Other  Long-term Obligations reflected on Balance Sheet |       | 29,772    |       | 4,739                  |       | 5,309          |       | 3,170          |       | 16,554             |       |
| TOTAL                                                   |       | 1,672,246 |       | 171,747                |       | 216,417        |       | 131,991        |       | 1,152,590          |       |

 

----

(1) Capital LeaseObligations includes imputed interest.

 

29

----

 

Future Issues and Other Matters

 

Because of current quoted prices of Federal SO2 allowances,New York SO2 and NOx allowances and coal prices, the older non-reheat units ofGreenidge and Westover Plant’s total production costs are at or higher than thecurrent New York Independent System Operator’s dispatch prices as of March 31,2005. This will limit the dispatch of these units until either energy priceincrease or there is a reduction in coal or federal and state allowance prices.We are working to minimize the effects to our operating income, with thereduction of coal or environmental credits purchased or selling any excess,therefore we do not think that the reduced capacity factors will have amaterial impact on our financial positions or results of operations.

 

Certain Future Issues and Other Matters are discussedin “Business - Narrative Description of Business - Environmental Matters”

 

Forward-looking Statements

 

Certain statements contained in this Annual Report on Form 10-Kare forward-looking statements as that term is defined in the PrivateSecurities Litigation Reform Act of 1995. These forward-looking statementsspeak only as of the date hereof. Forward-looking statements can be identifiedby the use of forward-looking terminology such as “believes,” “expects,” “may,”“intends,” “will,” “should” or “anticipates” or the negative forms or othervariations of these terms or comparable terminology, or by discussions ofstrategy. Future results covered by the forward-looking statements may not beachieved. Forward-looking statements are subject to risks, uncertainties andother factors which could cause actual results to differ materially from futureresults expressed or implied by such forward-looking statements. The mostsignificant risks, uncertainties and other factors are discussed under theheading “Business—General Development of Business” in this Annual Report on Form 10-K,and you are urged to consider carefully such factors.

 

**Item 7A.****                         ****Quantitative and Qualitative Disclosures About Market Risk**

 

We are exposed to market risks associated withcommodity prices. We often utilize financial instruments to hedge against suchfluctuations. We utilize financial and commodity derivatives for the purpose ofhedging exposures to market risk. We do not enter into derivative instrumentsfor trading or speculative purposes.

 

We are exposed to the impact of market fluctuations inthe prices of electricity and coal. Our current and expected future revenuesare derived from wholesale energy sales without significant long-term revenueor supply contracts. Our results of operations are subject to the volatility ofelectricity and coal prices in competitive markets. We hedge certain aspects ofour “net open” positions. We have used a hedging strategy, where appropriate,to hedge our financial performance against the effects of fluctuations inenergy commodity prices. The implementation of this strategy involves the useof commodity forward contracts, swaps and options.

 

We adopted a value at risk (VaR) approach to assessand manage risk.  VaR measures thepotential loss in a portfolio’s value due to market volatility, over aspecified time horizon, stated with a specific degree of probability.  The quantification of market risk using VaRprovides a consistent measure of risk across diverse markets and instruments. TheVaR approach was adopted because we feel that statistical models of riskmeasurement, such as VaR, provide an objective, independent assessment of ourrisk exposure. The use of VaR requires a number of key assumptions, includingthe selection of a confidence level for expected losses, the holding period forliquidation and the treatment of risks outside the VaR methodology, includingliquidity risk and event risk.  VaR,therefore, is not necessarily indicative of actual results that may occur.

 

The use of VaR allows us to compare risk on a consistentbasis and identify the drivers of risk. Because of the inherent limitations of VaR, including those specific tothe variance/covariance approach, specifically the assumption that values orreturns are normally distributed, we rely on VaR as only one component in ourrisk assessment process.  In addition tousing VaR measures, we perform Cash Flow at Risk, stress and scenario analysesto estimate the economic impact of market changes on the value of our portfolios.  These results are used to supplement the VaRmethodology.

 

30

----

 

We perform our VaR calculation using a model based onthe variance/covariance methodology with a delta gamma model foroptionality.  We express VaR as a dollaramount of the potential loss in the fair value of our portfolio based on a 95%confidence level and a one-day holding period. Our daily VaR for commodityprice sensitive instruments as of December 31, 2004, 2003 and 2002 was$10.1 million, $5.8 million and $4.8 million, respectively.  These amounts include the financialinstruments that serve as hedges and do not include the underlying physicalassets. In the year ended December 31, 2004, the daily VaR amount wasnever greater than the year-end amount. In the year ended December 31,2003, the daily VaR amount was greater than the year-end amount on March 31,and June 30, 2003. During 2002, the daily VaR amount was greater than theyear-end amount at the end of each quarter in 2002.

 

**Item8.****                                  ****FinancialStatements and Supplementary Data**

 

The following financial statements areattached to this Annual Report on Form 10-K following the signaturepage:

 
| AES EASTERN ENERGY, L.P.                                                                                                  |   |
|---------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                      |   |
| Report  of Independent Registered Public Accounting Firm                                                                  |   |
|                                                                                                                      |   |
| Financial Statements:                                                                                                     |   |
|                                                                                                                      |   |
| Consolidated Balance  Sheets as of December 31, 2004 and 2003                                                        |   |
| Consolidated  Statements of Income for the years ended December 31, 2004, 2003 and  2002.                            |   |
| Consolidated  Statements of Changes in Partners’ Capital for the years ended  December 31, 2004, 2003 and 2002. |   |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2004, 2003 and  2002.                        |   |
| Notes to  Consolidated Financial Statements                                                                               |   |
|                                                                                                                      |   |
| AES NY, L.L.C. (General Partner of AES Eastern Energy,  L.P.)*                                                            |   |
|                                                                                                                      |   |
| Report  of Independent Registered Public Accounting Firm                                                                  |   |
|                                                                                                                      |   |
| Financial Statements:                                                                                                     |   |
|                                                                                                                      |   |
| Consolidated Balance  Sheets as of December 31, 2004 and 2003                                                        |   |
| Notes to  Consolidated Balance Sheets                                                                                     |   |

 

----

*                                         TheConsolidated Balance Sheets of AES NY, L.L.C. contained in this Annual Reporton Form 10-K should be considered only in connection with its statusas the general Partner of AES Eastern Energy, L.P.

 

**Item 9.****                                  ****Changes in and Disagreements with Accountants on Accounting and FinancialDisclosure**

 

Not applicable.

 

**Item 9A.****                         ****Controls and Procedures**

 

Evaluationof Disclosure Controls and Procedures. We carried out an evaluation, under thesupervision and with the participation of our management, including theprincipal executive officer and principal financial officer of our GeneralPartner, of the effectiveness of our “disclosure controls and procedures” (asdefined in the Securities Exchange Act of 1934 Rules 13a-15(e) or15d-15(e)) as required by paragraph (b) of Exchange Act Rules 13a-15or 15d-15 as of December 31, 2004. Our management, including theprincipal executive officer and principal financial officer of our GeneralPartner, is engaged in a comprehensive effort to review, evaluate and improveour controls; however, management does not expect that our disclosure controlsor our internal controls over financial reporting will prevent all errors andall fraud. A control system, no matter how well how designed and operated, canprovide only reasonable, not absolute, assurance that the control system’sobjectives would be met.

 

31

----

 

Based upon the controls evaluation performed, theprincipal executive officer and principal financial officer of our General Partnerhave concluded that as of December 31, 2004, our disclosure controls andprocedures were effective to provide reasonable assurance that materialinformation relating to us and our consolidated subsidiaries is recorded,processed, summarized and reported within the time periods specified in theSecurities and Exchange Commission’s rules and forms.

 

Changes in Internal Controls.  In the course of our evaluation of disclosurecontrols and procedures, management considered certain internal control areas inwhich we have made and are continuing to make changes to improve and enhancecontrols. Based upon that evaluation, the principal executive officer andprincipal financial officer of our General Partner concluded that there were nochanges in our internal controls over financial reporting identified inconnection with the evaluation required by paragraph (d) of Exchange Act Rules 13a-15or 15d-15 that occurred during the fourth quarter that have materiallyaffected, or are reasonably likely to materially affect, our internal controlsover financial reporting.

 

Compliance with Section 404 of the SarbanesOxley Act of 2002. Beginning with the year ending December 31, 2006, Section 404of the Sarbanes-Oxley Act of 2002 will require us to include an internal controlreport of management with our annual report on Form 10-K. Theinternal control report must contain (1) a statement of management’sresponsibility for establishing and maintaining adequate internal controls overour financial reporting, (2) a statement identifying the framework used bymanagement to conduct the required evaluation of the effectiveness of ourinternal controls over financial reporting, (3) management’s assessment ofthe effectiveness of our internal controls over financial reporting as of theend of our most recent fiscal year, including a statement as to whether or notour internal controls over financial reporting are effective, and (4) astatement that our independent auditors have issued an attestation report onmanagement’s assessment of our internal controls over financial reporting.

 

Management will develop a comprehensive plan in orderto achieve compliance with Section 404 within the prescribed period and toreview, evaluate and improve the design and effectiveness of our controls andprocedures on an on-going basis.  Thecomprehensive compliance plan will include (1) documentation andassessment of the adequacy of our internal controls over financial reporting, (2) remediationof control weaknesses, (3) validation through testing that controls arefunctioning as documented and (4) implementation of a continuous reportingand improvement process for internal controls over financial reporting. As a result of this initiative, we have made and will continue to make changesfrom time to time in our internal controls over financial reporting.

 

**Item 9B.****                         ****Other Information**

 

Notapplicable.

 

**PART III**

 

**Item 10.****                           ****Directors and Executive Officers of Our Company**

 

We are a Delaware limited partnership. Under theDelaware Revised Uniform Limited Partnership Act and our Agreement of LimitedPartnership, the general partner of our company, AES NY, L.L.C., manages ourbusiness and affairs. Our managers are appointed by AES NY, L.L.C., as generalpartner of our company. Our managers may be appointed from time to time by AESNY, L.L.C. and hold their positions at the discretion of AES NY, L.L.C. AES NY,L.L.C. may elect to appoint additional managers from time to time. The AESCorporation indirectly owns all member interests in and controls AES NY, L.L.C.

 

The following table sets forth certain informationconcerning our management team as of March 15, 2005.

 
| **Name**         | ** ** | **Age** | ** ** | **Position**                                   |
|------------------|------------|---------|------------|------------------------------------------------|
|             |       |    |       |                                           |
| Dan Rothaupt     |       | 53      |       | General Manager                                |
| Kevin Pierce     |       | 47      |       | AEE Business Leader and Somerset Plant Manager |
| Jerry Goodenough |       | 40      |       | Cayuga Plant Manager                           |
| James Mulligan   |       | 57      |       | Westover Plant Manager                         |
| Douglas Roll     |       | 49      |       | Greenidge Plant Manager                        |
| Amy Conley       |       | 31      |       | Chief Financial Officer                        |

 

32

----

 

Dan Rothaupt, is Vice President of The AES Corporationresponsible for North America - East Operations since May 2003.Previously, he was President and Group Manager for AES Endeavor, covering AESbusiness activities in the Northeast US and Canada and has been our generalmanager since May 1999. Prior to that he was the President and PlantManager of AES Thames from 1995 to 1999. Mr. Rothaupt has a Bachelor ofScience degree in Mechanical Engineering from the United States Coast GuardAcademy.

 

Kevin Pierce has served as AEE Business Leader andPresident and Plant Manager of Somerset since August 2003, and prior tothat as President and Plant Manager of Somerset since September 2001.Previously, he was President and Plant Manager of AES Hawaii from June 1998until September 2001. Mr. Pierce has a Bachelor of Science degree inMarine Engineering from Maine Maritime Academy.

 

Jerry Goodenough has served as President and PlantManager of Cayuga since March 2001. Previously, he was the Cayuga controlroom team leader from April 1999 to March 2001. From January 1998to March 2001, he was employed by NYSEG in a variety of engineeringsupervisory roles. Mr. Goodenough holds a Bachelor of Arts degree inPhysics from Ithaca College and a Master of Science degree in ElectricalEngineering from the State University of New York at Binghamton.

 

James Mulligan has served as President and PlantManager of Westover since May 1999. Previously, Mr. Mulligan wasemployed as the Milliken Station Manager under NYSEG from January 1997 to May 1999.Mr. Mulligan has a Bachelor of Science degree in Mechanical Engineeringfrom the New York Institute of Technology.

 

Douglas J. Roll has served as President and PlantManager of Greenidge since May of 1999. Previously, Mr. Roll wasemployed as the Greenidge Station Manager under NYSEG from March 1994 to May 1999.Mr. Roll is a registered Professional Engineer in the State of New York. Mr. Rollholds a Bachelor of Science degree in Mechanical Engineering from CornellUniversity and a Bachelor of Arts degree in Biology from Queens College of theCity University of New York.

 

Amy Conley has served as the Chief Financial Officerfor AES Eastern Energy and AES NY, L.L.C. since June 2001. Previously, Ms. Conleywas employed as the Somerset Plant Accountant from January 2000 to June 2001.Ms. Conley is a Certified Public Accountant. Ms. Conley holds aBachelor of Science degree in Accounting from St. John Fisher College and aMaster of Business Administration degree from Rochester Institute ofTechnology.

 

Management of AES NY, L.L.C., the General Partner ofOur Company

 

AES NY, L.L.C., the general partner of our company, isa Delaware limited liability company managed by managers who are designated asdirectors. The Board of Directors of AES NY, L.L.C. comprises two classes ofdirectors, the Class A Directors and the Class B Director. There arethree Class A Directors, Edward Convery, Kevin Pierce and Dan Rothaupt,each elected by the members of the limited liability company. The business andaffairs of AES NY, L.L.C. are managed by the Class A Directors. The Class BDirector’s only participation in the management of AES NY, L.L.C. is in mattersof bankruptcy or related matters. Mr. Rothaupt is also the President ofAES NY, L.L.C.

 

Edward Convery has 25 years experience in the powerand chemicals industries, and has worked for The AES Corporation for 11 years.Mr Convery is a Vice President at Indiana Power and Light, a subsidiary of TheAES Corporation, responsible for the Harding Street and the Eagle Valleyelectricity generating stations since November 15, 2004. Previously, Mr. Converywas the Business Leader for the AES Warrior Run and the AES Beaver Valleyfacilities from June 1, 2002 to November 15, 2004. Mr. Converywas responsible for the start-up and operations of the AES Warrior Runfacility. Mr. Convery has a Bachelor of Science degree in ChemicalEngineering from the University of Delaware.

 

**Item 11.****                           ****Executive Compensation**

 

Not Applicable.

 

33

----

 

**Item 12.****                           ****Security Ownership of Certain Beneficial Owners and Management**

 

Not Applicable.

 

**Item 13.****                           ****Certain Relationships and Related Transactions**

 

Not Applicable.

 

**Item 14.****                           ****Principal Accounting Fees andServices**

 

The aggregate fees billed for each of the last twofiscal years for professional services rendered by the principal accountant forthe audit of the registrant’s annual financial statements and review of thefinancial statements included in the registrant’s Form 10-Q (17 CRF249.308a) or services that or normally provided by the accountant in connectionwith statutory and regulatory filings or engagements for those fiscal year wereapproximately $509,000 and $335,000 for the years ended December 31, 2004and 2003, respectively.

 

There were no other fees paid to the principal accountant forthe years ended December 31, 2004 and 2003, respectively.

 

**PART IV**

 

**Item 15.****                           ****Exhibits and Financial Statement Schedules**

 

(a)          FinancialStatements, Financial Statement Schedules and Exhibits.

 

(1)          The followingfinancial statements are attached to this Annual Report on Form 10-Kfollowing the signature page and certifications:

 
| AES  EASTERN ENERGY, L.P.                                                                                                |   |
|--------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                     |   |
| Report  of Independent Registered Public Accounting Firm                                                                 |   |
|                                                                                                                     |   |
| Financial  Statements:                                                                                                   |   |
|                                                                                                                     |   |
| Consolidated Balance  Sheets as of December 31, 2004 and 2003                                                       |   |
| Consolidated  Statements of Income for the years ended December 31, 2004, 2003 and  2002                            |   |
| Consolidated  Statements of Changes in Partners’ Capital for the years ended  December 31, 2004, 2003 and 2002 |   |
|                                                                                                                     |   |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2004, 2003 and  2002                        |   |
| Notes to Consolidated  Financial Statements                                                                              |   |
|                                                                                                                     |   |
| AES  NY, L.L.C. (General Partner of AES Eastern Energy, L.P.)*                                                           |   |
|                                                                                                                     |   |
| Report  of Independent Registered Public Accounting Firm                                                                 |   |
|                                                                                                                     |   |
| Financial  Statements:                                                                                                   |   |
|                                                                                                                     |   |
| Consolidated Balance  Sheets as of December 31, 2004 and 2003                                                       |   |
| Notes to  Consolidated Balance Sheets                                                                                    |   |

 

----

*                 TheConsolidated Balance Sheets of AES NY, L.L.C. contained in this Annual Reporton Form 10-K should be considered only in connection with its statusas the general partner of AES Eastern Energy, L.P.

 

(2)          Financial StatementSchedules

 

Schedules are omitted as the information is either notapplicable, not required or has been furnished in the financial statements ornotes thereto included in this Annual Report on Form 10-K.

 

(3)          Exhibits

 

34

----

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                   |
|----------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                 |       |                                                                                                                                                                                                                                                                                                                              |
| 3.1                  |       | Certificate of Limited Partnership of AES Eastern Energy,  L.P.*                                                                                                                                                                                                                                                                  |
|                 |       |                                                                                                                                                                                                                                                                                                                              |
| 3.2                  |       | Agreement of Limited Partnership of AES Eastern Energy,  L.P., dated as of May 4, 1999*                                                                                                                                                                                                                                      |
|                 |       |                                                                                                                                                                                                                                                                                                                              |
| 4.1                  |       | Form of 9.0% Series 1999-A Pass Through  Certificate*                                                                                                                                                                                                                                                                   |
|                 |       |                                                                                                                                                                                                                                                                                                                              |
| 4.2                  |       | Form of 9.67% Series 1999-B Pass Through  Certificate*                                                                                                                                                                                                                                                                  |
|                 |       |                                                                                                                                                                                                                                                                                                                              |
| 4.3a                 |       | Pass Through Trust Agreement A, dated as of May 1,  1999, between AES Eastern Energy, L.P. and Bankers Trust Company, as Pass  Through Trustee, made with respect to the formation of the Pass Through  Trust, Series 1999-A and the issuance of 9.0% Pass Through  Certificates, Series 1999-A*                   |
|                 |       |                                                                                                                                                                                                                                                                                                                              |
| 4.3b                 |       | Schedule identifying substantially identical agreement  to Pass Through Trust Agreement constituting Exhibit 4.3a hereto*                                                                                                                                                                                               |
|                 |       |                                                                                                                                                                                                                                                                                                                              |
| 4.4a                 |       | Participation Agreement (Kintigh A-1), among AES  Eastern Energy, L.P., as Lessee, Kintigh Facility Trust A-1, as Owner  Trust, DCC Project Finance Fourteen, Inc., as Owner Participant, Bankers  Trust Company, as Indenture Trustee, and Bankers Trust Company, as Pass  Through Trustee, dated as of May 1, 1999*   |
|                 |       |                                                                                                                                                                                                                                                                                                                              |
| 4.4b                 |       | Schedule identifying substantially identical agreement  to Participation Agreement constituting Exhibit 4.4a hereto*                                                                                                                                                                                                    |
|                 |       |                                                                                                                                                                                                                                                                                                                              |
| 4.5a                 |       | Participation Agreement (Milliken A-1), among AES  Eastern Energy, L.P., as Lessee, Milliken Facility Trust A-1, as Owner  Trust, DCC Project Finance Fourteen, Inc., as Owner Participant, Bankers  Trust Company, as Indenture Trustee, and Bankers Trust Company, as Pass  Through Trustee, dated as of May 1, 1999* |
|                 |       |                                                                                                                                                                                                                                                                                                                              |
| 4.5b                 |       | Schedule identifying substantially identical agreement  to Participation Agreement constituting Exhibit 4.5a hereto*                                                                                                                                                                                                    |
|                 |       |                                                                                                                                                                                                                                                                                                                              |
| 4.6a                 |       | Facility Lease Agreement (Kintigh A-1), between  Kintigh Facility Trust A-1, as Lessor, and AES Eastern Energy, L.P., as  Lessee, dated as of May 1, 1999*                                                                                                                                                                   |
|                 |       |                                                                                                                                                                                                                                                                                                                              |
| 4.6b                 |       | Schedule identifying substantially identical agreements  to Facility Lease Agreement constituting Exhibit 4.6a hereto*                                                                                                                                                                                                  |
|                 |       |                                                                                                                                                                                                                                                                                                                              |
| 4.7a                 |       | Facility Lease Agreement (Milliken A-1), between  Milliken Facility Trust A-1, as Lessor, and AES Eastern Energy, L.P.,  as Lessee, dated as of May 1, 1999*                                                                                                                                                                 |
|                 |       |                                                                                                                                                                                                                                                                                                                              |
| 4.7b                 |       | Schedule identifying substantially identical  agreements to Facility Lease Agreement constituting Exhibit 4.7a hereto*                                                                                                                                                                                                  |

 

35

----

 
| 4.8a   |   | Indenture of Trust and Security Agreement (Kintigh A-1),  between Kintigh Facility Trust A-1, as Owner Trust, and Bankers Trust  Company, as Indenture Trustee, dated as of May 1, 1999*                                                                                                                                                                                                                                |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.8b   |   | Schedule identifying substantially identical  agreements to Indenture of Trust and Security Agreement constituting Exhibit 4.8a  hereto*                                                                                                                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.9a   |   | Indenture of Trust and Security Agreement (Milliken A-1),  between Milliken Facility Trust A-1, as Owner Trust, and Bankers Trust  Company, as Indenture Trustee, dated as of May 1, 1999*                                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.9b   |   | Schedule identifying substantially identical  agreements to Indenture of Trust and Security Agreement constituting Exhibit 4.9a  hereto*                                                                                                                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.10   |   | [Reserved]                                                                                                                                                                                                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.11   |   | Registration Rights Agreement, between AES Eastern Energy,  L.P., and Morgan Stanley & Co. Inc., Credit Suisse First Boston  Corp. and CIBC World Markets Corp., dated as of May 11, 1999*                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.12   |   | [Reserved]                                                                                                                                                                                                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.13   |   | [Reserved]                                                                                                                                                                                                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.1   |   | Asset Purchase Agreement, among NGE Generation, Inc.,  New York State Electric & Gas Corporation (“NYSEG”), and AES NY,  L.L.C. (“AES NY”), dated as of August 3, 1998, (incorporated herein by  reference to exhibit 10.2 of the Annual Report on Form 10-K of  Energy East Corp. for the year ended December 31, 1998 filed on March 29,  1999, SEC file #001-14766) |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.2a  |   | Milliken Operating Agreement, between AES NY and NYSEG, dated  as of August 3, 1998*                                                                                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.2b  |   | Amendment No. 1 to the Milliken Operating Agreement,  dated as of May 6, 1999*                                                                                                                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.3a  |   | Interconnection Agreement, between AES NY and NYSEG, dated  as of August 3, 1998*                                                                                                                                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.3b  |   | Amendment No. 1 to the Interconnection Agreement,  dated as of May 6, 1999*                                                                                                                                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.4   |   | Interconnection Implementation Agreement, between NYSEG and  AES NY, dated as of May 6, 1999*                                                                                                                                                                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.6   |   | Scheduling and Settlement Agreement, among NYSEG, AES  Creative Resources, L.P., AES Eastern Energy and EME Homer City Generation,  dated as of March 18, 1999*                                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.7   |   | Agreement to Assign Transmission Rights and Obligations,  between AES NY and NYSEG, dated as of August 3, 1998*                                                                                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.8   |   | [Reserved]                                                                                                                                                                                                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.9a  |   | Reciprocal Easement Agreement (Kintigh Station), between  AES NY and NYSEG, dated as of August 3, 1998*                                                                                                                                                                                                                                                                                                                 |

 

36

----

 
| 10.9b  |   | Reciprocal Easement Agreement (Milliken Station), between  AES NY and NYSEG, dated as of August 3, 1998*                                                                                                                                                                                                     |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                              |
| 10.9c  |   | Reciprocal Easement Agreement (Greenidge Station), between  AES NY and NYSEG, dated as of August 3, 1998*                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                              |
| 10.9d  |   | Reciprocal Easement Agreement (Goudey Station), between AES  NY and NYSEG, dated as of August 3, 1998*                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                              |
| 10.13  |   | Coal Hauling Agreement, among Somerset Railroad  Corporation, AES NY3, L.L.C., and AES Eastern Energy L.P., dated as of May 6,  1999*                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                              |
| 10.14  |   | Scheduling and Settlement Agreement, among CSX  Transportation, Inc., Norfolk Southern Corporation, Norfolk Southern  Railway Company and NYSEG, dated as of February 20, 1998*                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                              |
| 10.15  |   | [Reserved]                                                                                                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                              |
| 10.17  |   | Omnibus Agreement, between NYSEG and AES NY, dated as of May 7,  1999*                                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                              |
| 10.18  |   | Assignment and Assumption Agreement, among NGE, NYSEG and  AES NY, dated as of May 14, 1999*                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                              |
| 10.19  |   | Amended and Restated Deposit and Disbursement Agreement  among AEE, Calyon New York Branch (successor to Union Bank of California,  N.A.), as Agent under the Working Capital Facility, as Working Capital  Provider, and Bankers Trust Company, as Depositary Agent, et al., dated as of  April 10, 2001.** |
|   |   |                                                                                                                                                                                                                                                                                                              |
| 10.20  |   | [Reserved]                                                                                                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                              |
| 10.21a |   | Omnibus Amendment to Kintigh A-1 Transaction  Documents dated as of December 1, 2000                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                              |
| 10.21b |   | Schedule identifying substantially identical  agreements to Omnibus Agreement constituting Exhibit 10.21a hereto                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                              |
| 10.22a |   | Omnibus Amendment to Milliken A-1 Transaction  Documents dated as of December 1, 2000                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                              |
| 10.22b |   | Schedule identifying substantially identical  agreements to Omnibus Agreement constituting Exhibit 10.22a hereto                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                              |
| 10.23a |   | Agreement and Appendix A dated as of April 10, 2001**                                                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                              |
| 10.23b |   | Schedule identifying substantially identical  agreements to Second Amendment constituting Exhibit 10.23a hereto**                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                              |
| 10.24a |   | Second Amendment to Milliken A-1 Participation  Agreement and Appendix A dated as of April 10, 2001**                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                              |
| 10.24b |   | Schedule identifying substantially identical  agreements to Second Amendment constituting Exhibit 10.24a hereto**                                                                                                                                                                                       |

 

37

----

 
| 10.25  |   | Amended and Restated Credit Agreement dated as of October 26,  2004 among AEE, as borrower, Calyon New York Branch, as agent, and the Banks  and Issuing Banks named therein. |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                               |
| 12.1   |   | Statement regarding ratio of earnings to fixed charges.  ****                                                                                                                      |
|   |   |                                                                                                                                                                               |
| 21.1   |   | Subsidiaries Schedule*                                                                                                                                                             |
|   |   |                                                                                                                                                                               |
| 24.1   |   | Power of Attorney ****                                                                                                                                                             |
|   |   |                                                                                                                                                                               |
| 31.1   |   | Certification by Chief Executive Officer Required by Rule 13a-14(a) or  15d-14(a) of the Securities Exchange Act of 1934. ****                                      |
|   |   |                                                                                                                                                                               |
| 31.2   |   | Certification by Chief Financial Officer Required by Rule 13a-14(a) or  15d-14(a) of the Securities Exchange Act of 1934. ****                                      |
|   |   |                                                                                                                                                                               |
| 32     |   | Certification Required by Rule 13a-14(b) or  15d-14(b) of the Securities Exchange Act of 1934. ****                                                                 |

 

----

*                                         Incorporatedherein by reference to similarly numbered exhibit to the Registration Statementon Form S-4 of AES Eastern Energy, L.P. (Reg. No. 333-89725),filed with the Securities and Exchange Commission on October 26, 1999.

 

**                                  Incorporatedherein by reference to similarly numbered exhibit to the Quarterly Report ofAES Eastern Energy, L.P. (Reg. No. 333-89725) for the quarterlyperiod ended September 30, 2001, filed with the Securities and ExchangeCommission on November 14, 2001.

 

***                           Incorporatedherein by reference to similarly numbered exhibit to the Report of AES EasternEnergy, L.P. (Reg. No. 333-89725) for the quarterly period ended June 30,2003, filed with the Securities and Exchange Commission on August 14,2003.

 

****                    Filed herewith

 

38

----

 

**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, as amended, AES Eastern Energy, L.P. hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 

Date:  March 31,2005

 
|   | AES EASTERN ENERGY, L.P.               |
|--------|----------------------------------------|
|   | By: AES NY, L.L.C., as General Partner |
|   |                                   |
|   | By:                                    | /s/ Dan Rothaupt |   |
|   |                                   | Dan Rothaupt |
|   |                                   | President |

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, as amended, this report has been signed below by thefollowing persons in the capacities and on the dates indicated.

 
| **Signature**      | ** ** | **Title**                                                                        | ** ** | **Date**            |
|--------------------|------------|----------------------------------------------------------------------------------|------------|---------------------|
| /s/ Dan Rothaupt   |       | President (chief executive officer) and Class A  Director of AES NY, L.L.C. |       | March 31, 2005 |
| Dan Rothaupt       |       |                                                                             |       |
|               |       |                                                                             |       |                |
| /s/ Kevin Pierce   |       | Class A Director of AES NY, L.L.C.                                          |       | March 31, 2005 |
| Kevin Pierce       |       |                                                                             |       |                |
|               |       |                                                                             |       |                |
| /s/ Edward Convery |       | Class A Director of AES NY, L.L.C.                                          |       | March 31, 2005 |
| Edward Convery     |       |                                                                             |       |                |
|               |       |                                                                             |       |                |
| /s/ Amy Conley     |       | Vice President and Treasurer (principal financial officer)  of AES NY, L.L.C.    |       | March 31, 2005 |
| Amy Conley         |       |                                                                             |       |

 

39

----

 

**Index to Financial Statements**

 
| AES EASTERN ENERGY, L.P.                                       |   |
|----------------------------------------------------------------|--------|
|                                                           |   |
| Report  of Independent Registered Public Accounting Firm       |   |
|                                                           |   |
| Financial Statements:                                          |   |
|                                                           |   |
| Consolidated Balance  Sheets                                   |   |
|                                                           |   |
| Consolidated  Statements of Income                             |   |
|                                                           |   |
| Consolidated  Statements of Changes in Partners’ Capital  |   |
|                                                           |   |
| Consolidated  Statements of Cash Flows                         |   |
|                                                           |   |
| Notes to  Consolidated Financial Statements                    |   |
|                                                           |   |
| AES NY, L.L.C. (General Partner of AES Eastern Energy,  L.P.)* |   |
|                                                           |   |
| Report  of Independent Registered Public Accounting Firm       |   |
|                                                           |   |
| Financial Statements:                                          |   |
|                                                           |   |
| Consolidated Balance  Sheets                                   |   |
|                                                           |   |
| Notes to  Consolidated Balance Sheets                          |   |

 

----

*The Consolidated Balance Sheets of AES NY, L.L.C. containedin this Annual Report on Form 10-K should be considered only inconnection with its status as the general partner of AES Eastern Energy, L.P.The pass through trust certificates do not represent an interest in or an obligationof AES NY, L.L.C.

 

40

----

 

Report of Independent Registered Public Accounting Firm

 

To the Partners ofAES Eastern Energy, L.P.

 

We have audited the accompanying consolidated balance sheetsof AES Eastern Energy, L.P. (an indirect wholly owned subsidiary of The AESCorporation) and its subsidiaries (the Partnership) as of December 31,2004 and 2003, and the related consolidated statements of income, changes inpartners’ capital, and cash flows for each of the three years in the periodended December 31, 2004. These financial statements are the responsibilityof the Partnership’s management. Our responsibility is to express an opinion onthese financial statements based on our audits.

 

We conducted our audits in accordance with the standards ofthe Public Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement. ThePartnership is not required to have, nor were we engaged to perform, an auditof its internal control over financial reporting. Our audit includedconsideration of internal control over financial reporting as a basis fordesigning audit procedures that are appropriate in the circumstances, but notfor the purpose of expressing an opinion on the effectiveness of thePartnership’s internal control over financial reporting.  Accordingly, we express no such opinion.  An audit also includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation. We believe that our audits provide a reasonable basis for ouropinion.

 

In our opinion, such consolidated financial statementspresent fairly, in all material respects, the financial position of AES EasternEnergy, L.P., and its subsidiaries as of December 31, 2004 and 2003, andthe results of their operations and their cash flows for each of the threeyears in the period ended December 31, 2004, in conformity with accountingprinciples generally accepted in the United States of America.

 

Asdiscussed in Note 2 to the consolidated financial statements, on January 1,2004, the Partnership adopted Financial Accounting Standards BoardInterpretation No. 46(R), “Consolidation of Variable Interest Entities”and prospectively changed its method of accounting for special purposeentities.

 

As discussed in Note 2 to the consolidated financialstatements, on January 1, 2003, the Partnership adopted Statement ofFinancial Accounting Standard No. 143, “Accounting for Asset RetirementObligations”.

 
| /s/Deloitte & Touche LLP |   |
|-----------------------------------|--------|
|                              |
|                              |
| McLean, Virginia                  |
| March 31, 2005               |

 

41

----

 

**AES EASTERN ENERGY, L.P.**

**CONSOLIDATEDBALANCE SHEETS,**

**DECEMBER 31, 2004 and DECEMBER 31,2003**

 

***(Amounts in Thousands*****)**

 
| **December 31,**                                                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                                  |       |     |       |     |       |
| **ASSETS**                                                                            |       |     |       |     |       |
| Current  Assets:                                                                      |       |     |       |     |       |
| Restricted  cash:                                                                     |       |     |       |     |       |
| Operating -  cash and cash equivalents                                                |       | $        | 2,364      |     | $          | 2,540 |   |
| Revenue  account                                                                      |       | 59,218   |       | 85,231   |       |
| Accounts  receivable - trade                                                          |       | 42,112   |       | 34,883   |       |
| Accounts  receivable - affiliates                                                     |       | 394      |       | 203      |       |
| Accounts receivable  - other                                                          |       | 836      |       | 1,264    |       |
| Derivative  valuation asset - current                                                 |       | 1,240    |       | 8,153    |       |
| Inventory                                                                             |       | 38,317   |       | 27,700   |       |
| Prepaid  expenses                                                                     |       | 8,306    |       | 8,019    |       |
| Total current assets                                                                  |       | 152,787  |       | 167,993  |       |
| PROPERTY,  PLANT, EQUIPMENT, AND RELATED ASSETS:                                      |       |     |       |     |       |
| Land                                                                                  |       | 8,298    |       | 7,054    |       |
| Electric  generation assets -net of accumulated depreciation of $242,094 and $156,259 |       | 904,136  |       | 902,662  |       |
| Total  property, plant, equipment and related assets                                  |       | 912,434  |       | 909,716  |       |
| OTHER  ASSETS:                                                                        |       |     |       |     |       |
| Deferred  financing -net of accumulated amortization of $892 and $328                 |       | 2,089    |       | 303      |       |
| Derivative  valuation asset - non-current                                             |       | 2,774    |       | 7,990    |       |
| Credit  reserves                                                                      |       | 1,494    |       | —   |       |
| Rent reserve  account                                                                 |       | 31,717   |       | 31,717   |       |
| TOTAL ASSETS                                                                          |       | $        | 1,103,295  |     | $          | 1,117,719 |   |
|                                                                                  |       |     |       |     |       |
| LIABILITIES  AND PARTNERS’ CAPITAL                                               |       |     |       |     |       |
|                                                                                  |       |     |       |     |       |
| CURRENT  LIABILITIES:                                                                 |       |     |       |     |       |
| Accounts  payable                                                                     |       | $        | 1,649      |     | $          | 830 |   |
| Long-term  lease financing - current                                                  |       | 4,411    |       | 7,846    |       |
| Other  long-term debt - current                                                       |       | 2,459    |       | 347      |       |
| Accrued  interest expense                                                             |       | 27,663   |       | 28,004   |       |
| Derivative  valuation liability - current                                             |       | 82,125   |       | 26,043   |       |
| Transmission  congestion contract                                                     |       | —   |       | 359      |       |
| Due to The  AES Corporation and affiliates                                            |       | 12,864   |       | 8,930    |       |
| Accrued coal  and rail expense                                                        |       | 7,431    |       | 6,456    |       |
| Environmental  remediation                                                            |       | 332      |       | —   |       |
| Loss  contingency                                                                     |       | 1,200    |       | —   |       |
| Other  accrued expenses and liabilities                                               |       | 16,697   |       | 9,624    |       |
| Total  current liabilities                                                            |       | 156,831  |       | 88,439   |       |
| LONG-TERM  LIABILITIES:                                                               |       |     |       |     |       |
| Lease  financing - long term                                                          |       | 625,404  |       | 629,815  |       |
| Other  long-term debt - non-current                                                   |       | 16,411   |       | 744      |       |
| Environmental  remediation                                                            |       | 4,778    |       | 5,051    |       |
| Defined  benefit plan obligation                                                      |       | 13,304   |       | 16,558   |       |
| Derivative  valuation liability - non-current                                         |       | 38,151   |       | 17,581   |       |
| Asset  retirement obligation                                                          |       | 11,525   |       | 9,900    |       |
| Other  liabilities                                                                    |       | 1,907    |       | 1,944    |       |
| Total  long-term liabilities                                                          |       | 711,480  |       | 681,593  |       |
| TOTAL  LIABILITIES                                                                    |       | 868,311  |       | 770,032  |       |
|                                                                                  |       |     |       |     |       |
| COMMITMENTS  AND CONTINGENCIES (Note 7)                                               |       |     |       |     |       |
|                                                                                  |       |     |       |     |       |
| MINORITY  INTEREST                                                                    |       | 8,229    |       | —   |       |
|                                                                                  |       |     |       |     |       |
| PARTNERS’  CAPITAL                                                               |       | 226,755  |       | 347,687  |       |
| TOTAL  LIABILITIES AND PARTNERS’ CAPITAL                                         |       | $        | 1,103,295  |     | $          | 1,117,719 |   |

 

The notes are an integral part of theconsolidated financial statements

 

42

----

 

**AES EASTERN ENERGY, L.P.**

**CONSOLIDATEDSTATEMENTS OF INCOME**

**YEARS ENDED DECEMBER 31,2004, 2003 AND 2002**

 

***(Amounts in Thousands*****)**

 
| **Year ended December 31,**                                | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-----------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| OPERATING  REVENUES:                                            |       |     |       |     |       |     |       |
| Energy                                                          |       | $        | 382,742    |     | $          | 394,227  |       | $ | 315,026 |   |
| Capacity                                                        |       | 23,122   |       | 29,653   |       | 36,644   |       |
| Transmission  congestion contract                               |       | —   |       | —   |       | 8,875    |       |
| Other                                                           |       | 4,790    |       | 2,150    |       | 6,879    |       |
|                                                            |       |     |       |     |       |     |       |
| Total  revenues                                                 |       | 410,654  |       | 426,030  |       | 367,424  |       |
| OPERATING  EXPENSES:                                            |       |     |       |     |       |     |       |
| Fuel                                                            |       | 156,222  |       | 148,339  |       | 137,175  |       |
| Depreciation  and amortization*                                 |       | 39,383   |       | 36,076   |       | 35,538   |       |
| Operating  and maintenance                                      |       | 30,690   |       | 28,581   |       | 21,364   |       |
| General and  administrative                                     |       | 65,632   |       | 59,194   |       | 59,112   |       |
| Transmission  congestion contract                               |       | 3,771    |       | 6,226    |       | —   |       |
| Loss on  asset disposal                                         |       | 321      |       | —   |       | —   |       |
| Derivative  ineffectiveness                                     |       | 36       |       | (193     | )          | 27       |       |
| Accretion  expense                                              |       | 859      |       | 689      |       | —   |       |
|                                                            |       |     |       |     |       |     |       |
| Total operating  expenses                                       |       | 296,914  |       | 278,912  |       | 253,216  |       |
|                                                            |       |     |       |     |       |     |       |
| OPERATING  INCOME                                               |       | 113,740  |       | 147,118  |       | 114,208  |       |
|                                                            |       |     |       |     |       |     |       |
| OTHER INCOME  (EXPENSE):                                        |       |     |       |     |       |     |       |
| Interest  expense                                               |       | (58,930  | )          | (58,455  | )          | (57,694  | )          |
| Interest  income                                                |       | 1,925    |       | 2,059    |       | 2,116    |       |
|                                                            |       |     |       |     |       |     |       |
| Total other  expense                                            |       | (57,005  | )          | (56,396  | )          | (55,578  | )          |
| Net income  from continuing operations before minority interest |       | 56,735   |       | 90,722   |       | 58,630   |       |
|                                                            |       |     |       |     |       |     |       |
| Minority  interest                                              |       | 564      |       | —   |       | —   |       |
|                                                            |       |     |       |     |       |     |       |
| Cumulative  effect of change in accounting principle            |       | —   |       | (1,656   | )          | —   |       |
|                                                            |       |     |       |     |       |     |       |
| NET INCOME                                                      |       | $        | 57,299     |     | $          | 89,066   |       | $ | 58,630 |   |

 

The notes are an integral part of theconsolidated financial statements

 

43

----

 

**AES EASTERN ENERGY, L.P.**

**CONSOLIDATEDSTATEMENTS OF CHANGES IN PARTNERS’ CAPITAL**

**YEARSENDED DECEMBER 31, 2004, 2003 AND, 2002**

 

**(*Amounts inThousands)***

 
| ** **                                 | ** ** | **General  Partner** | ** ** | **Limited  Partner** | ** ** | **Total** | ** ** | **Accumulated  Other  Comprehensive  Income/(Loss)** | ** ** | **Comprehensive  Income** | ** ** |
|--------------------------------------------|------------|----------------------|------------|----------------------|------------|-----------|------------|------------------------------------------------------|------------|---------------------------|------------|
|                                       |       |                 |       |                 |       |      |       |                                                 |       |                      |       |
| BALANCE, DECEMBER 31,  2001           |       | 4,331                |       | 428,708              |       | 433,039   |       | $                                                    | 28,544     |                      |       |   |
| Partners’  Contribution, (See Note 8) |       | 15                   |       | 1,498                |       | 1,513     |       |                                                 |       |                      |       |
| Net income                                 |       | 586                  |       | 58,044               |       | 58,630    |       |                                                 |       | 58,630                    |       |
| Dividends  paid                            |       | (640                 | )          | (63,320              | )          | (63,960   | )          |                                                 |       |                      |       |
| Other  comprehensive loss                  |       | (470                 | )          | (46,506              | )          | (46,976   | )          | (46,976                                              | )          | (46,976                   | )          |
| Comprehensive  income                      |       |                 |       |                 |       |      |       |                                                 |       | 11,654                    |       |
| BALANCE, DECEMBER 31,  2002           |       | 3,822                |       | 378,424              |       | 382,246   |       | (18,432                                              | )          |                      |       |
| Partners’  Contribution, (See Note 8) |       | 2                    |       | 160                  |       | 162       |       |                                                 |       |                      |       |
| Net income                                 |       | 891                  |       | 88,175               |       | 89,066    |       |                                                 |       | 89,066                    |       |
| Dividends  paid                            |       | (1,146               | )          | (113,454             | )          | (114,600  | )          |                                                 |       |                      |       |
| Other  comprehensive loss                  |       | (92                  | )          | (9,095               | )          | (9,187    | )          | (9,187                                               | )          | (9,187                    | )          |
| Comprehensive  income                      |       |                 |       |                 |       |      |       |                                                 |       | 79,879                    |       |
| BALANCE, DECEMBER 31,  2003           |       | 3,477                |       | 344,210              |       | 347,687   |       | (27,619                                              | )          |                      |       |
| Partners’  Contribution, (See Note 8) |       | 5                    |       | 410                  |       | 415       |       |                                                 |       |                      |       |
| Net income                                 |       | 573                  |       | 56,726               |       | 57,299    |       |                                                 |       | 57,299                    |       |
| Dividends  paid                            |       | (899                 | )          | (89,001              | )          | (89,900   | )          |                                                 |       |                      |       |
| Other  comprehensive loss                  |       | (887                 | )          | (87,859              | )          | (88,746   | )          | (88,746                                              | )          | (88,746                   | )          |
| Comprehensive  loss                        |       |                 |       |                 |       |      |       |                                                 |       | $                         | (31,447    | ) |
| BALANCE, DECEMBER 31,  2004           |       | $                    | 2,269      |                 | $          | 224,486   |       | $                                                    | 226,755    |                      | $          | (116,365 | ) |   |   |
|                                            |            |                      |            |                      |            |           |            |                                                      |            |                           |            |  |  |  |  |  |

 

The notes are an integral part of theconsolidated financial statements.

 

44

----

 

AES EASTERN ENERGY, L.P.

CONSOLIDATED STATEMENTS OF CASH FLOWS

YEARS ENDED DECEMBER 31,2004, 2003 AND 2002

 

*(Amountsin Thousands)*

 
| **Year ended December 31,**                                                       | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| CASH FLOWS  FROM OPERATING ACTIVITIES:                                                 |       |     |       |     |       |     |       |
| Net income                                                                             |       | $        | 57,299     |     | $          | 89,066   |       | $ | 58,630 |   |
| Adjustments  to reconcile net income to  Net cash used in operating activities:        |       |     |       |     |       |     |       |
| Minority  Interest                                                                     |       | (564     | )          | —   |       | —   |       |
| Cumulative  effect of change in accounting principle                                   |       | —   |       | 1,656    |       | —   |       |
| Loss on sale  of asset                                                                 |       | 321      |       | —   |       | —   |       |
| Net Asset  retirement obligation accretion                                             |       | 781      |       | 689      |       | —   |       |
| Depreciation  and amortization                                                         |       | 39,383   |       | 36,076   |       | 35,521   |       |
| Realized  loss (gain) on derivative                                                    |       | (323     | )          | 2,583    |       | (5,895   | )          |
| Write off of  deferred financing                                                       |       | —   |       | 21       |       | —   |       |
| Net defined  benefit plan cost                                                         |       | (3,254   | )          | (881     | )          | 471      |       |
| Changes in  current assets and liabilities:                                            |       |     |       |     |       |     |       |
| Accounts  receivable                                                                   |       | (7,535   | )          | 118      |       | (6,436   | )          |
| Inventory                                                                              |       | (10,617  | )          | (718     | )          | 2,633    |       |
| Prepaid  expenses                                                                      |       | (149     | )          | (402     | )          | (1,153   | )          |
| Accounts  payable                                                                      |       | 6,959    |       | (365     | )          | (468     | )          |
| Accrued  interest expense                                                              |       | (341     | )          | (74      | )          | (275     | )          |
| Due to AES  Corporation and affiliates                                                 |       | 4,798    |       | 1,985    |       | 531      |       |
| Other  liabilities                                                                     |       | 2,993    |       | (1,296   | )          | (2,065   | )          |
|                                                                                   |       |     |       |     |       |     |       |
| Net cash  provided by operating activities                                             |       | 89,751   |       | 128,458  |       | 81,494   |       |
| CASH FLOWS  FROM INVESTING ACTIVITIES:                                                 |       |     |       |     |       |     |       |
| Payments for  capital additions                                                        |       | (13,757  | )          | (5,421   | )          | (7,136   | )          |
| Decrease (increase)  in restricted cash                                                |       | 26,386   |       | (6,600   | )          | (5,372   | )          |
| Credit  reserves                                                                       |       | (1,494   | )          | —   |       | —   |       |
| Net change  in rent reserve account                                                    |       | —   |       | —   |       | 2        |       |
|                                                                                   |       |     |       |     |       |     |       |
| Net cash  used in investing activities                                                 |       | 11,135   |       | (12,021  | )          | (12,506  | )          |
| CASH FLOWS  FROM FINANCING ACTIVITIES:                                                 |       |     |       |     |       |     |       |
| Dividends  paid                                                                        |       | (89,900  | )          | (114,600 | )          | (63,960  | )          |
| Payments for  deferred financing                                                       |       | (1,834   | )          | (335     | )          | (317     | )          |
| Principal  payments on obligations                                                     |       | (9,704   | )          | (1,664   | )          | (6,224   | )          |
| Proceeds  from other debt                                                              |       | 137      |       | —   |       | —   |       |
| Partner’s  contribution                                                           |       | 415      |       | 162      |       | 1,513    |       |
|                                                                                   |       |     |       |     |       |     |       |
| Net cash  used in financing activities                                                 |       | (100,886 | )          | (116,437 | )          | (68,988  | )          |
|                                                                                   |       |     |       |     |       |     |       |
| CHANGE IN  CASH AND CASH EQUIVALENTS                                                   |       | —   |       | —   |       | —   |       |
| CASH AND  CASH EQUIVALENTS, BEGINNING OF PERIOD                                        |       | —   |       | —   |       | —   |       |
|                                                                                   |       |     |       |     |       |     |       |
| CASH AND  CASH EQUIVALENTS, END OF PERIOD                                              |       | $        | —     |     | $          | —   |       | $ | — |   |
|                                                                                   |       |     |       |     |       |     |       |
| Supplemental  Disclosure of Cash Flow Information:                                     |       |     |       |     |       |     |       |
|                                                                                   |       |     |       |     |       |     |       |
| Interest  paid                                                                         |       | $        | 55,604     |     | $          | 55,885   |       | $ | 56,354 |   |
|                                                                                   |       |     |       |     |       |     |       |
| Supplemental  Disclosure of Non-cash Flow Information:                                 |       |     |       |     |       |     |       |
|                                                                                   |       |     |       |     |       |     |       |
| Assets of  the Somerset Railroad Corporation Consolidated at January 1, 2004      |       | $        | 28,492     |     | $          | —   |       | $ | — |   |
| Liabilities  of the Somerset Railroad Corporation Consolidated at January 1, 2004 |       | $        | 19,586     |     | $          | —   |       | $ | — |   |
|                                                                                   |       |     |       |     |       |     |       |
| Adoption of  SFAS No. 143                                                         |       | $        | —     |     | $          | 3,396    |       | $ | — |   |

 

The notes are an integral part of theconsolidated financial statements.

 

45

----

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

YEARS ENDED DECEMBER 31, 2004, 2003 AND2002

 

1.             GENERAL

 

AES Eastern Energy, L.P. (the Partnership), a Delawarelimited partnership, was formed on December 2, 1998. The Partnership’swholly owned subsidiaries are AES Somerset, L.L.C., AES Cayuga, L.L.C., andAEE2, L.L.C., (which wholly owns AES Westover, L.L.C. and AES Greenidge,L.L.C.). The Partnership began operations on May 14, 1999 (see Note 3).Prior to that date, the Partnership had no operations. The Partnership is anindirect wholly owned subsidiary of The AES Corporation (AES).

 

The Partnership was established for the purpose of owning orleasing and operating four coal-fired electric generating stations (the Plants)with a total combined capacity of 1,268 MW. The partners of the Partnership arecomprised of AES NY, L.L.C. (the General Partner) and AES NY2, L.L.C. (theLimited Partner), both of which are indirect wholly owned subsidiaries of AES.The Plants are owned or leased by the Partnership (see Note 3 and Note 6) andare operated by the Partnership’s wholly owned subsidiaries in the State of NewYork, pursuant to operation and maintenance agreements with the Partnership.

 

AES NY3, L.L.C., an indirect wholly owned subsidiary of AESacquired the stock of the Somerset Railroad Corporation (SRC), which owns shortline railroad assets used to transport coal and limestone. The Partnership hasentered into a contract with SRC pursuant to which SRC will haul coal andlimestone to the Somerset Plant and make its rail cars available to transportcoal to the Cayuga Plant. The Partnership will pay amounts sufficient to enableSRC to pay all of its operating and other expenses, including all out-of-pocketexpenses, taxes, interest on and principal of SRC’s outstanding indebtedness,and all capital expenditures necessary to permit SRC to continue to providerail service to the Somerset and Cayuga Plants. The Partnership has concludedthat under the revised Financial Accounting Standards Board (FASB)interpretation No. 46(R)”Consolidation of Variable Interest Entities”, thePartnership needs to consolidate SRC into its consolidated financial statementsas of January 1, 2004. (See Note 2)

 

The Plants sell generated electricity, as well as unforcedcapacity and ancillary services, directly into the markets operated by the NewYork Independent System Operator (NYISO) system, PJM (Pennsylvania, New Jersey,Maryland) Interconnection and ISO New England. For Federal regulatory purposes,the Partnership is an exempt wholesale generator (EWG). As an EWG, thePartnership cannot make retail sales of electricity and can only make wholesalesales of electricity, unforced capacity, and ancillary services into wholesalepower markets.

 

In November 2000, the Partnership entered into athree-year agreement for energy marketing services with AES Odyssey,L.L.C.(Odyssey), a direct wholly owned subsidiary of AES. In March 2002, anew agreement was reached, for a term of five years through February 28,2007 pursuant to which Odyssey provides data management, marketing, scheduling,invoicing and risk management services for a fee of $300,000 per month. On September 4,2003, the Partnership signed an amendment to its March 2002 agreement.Odyssey will also manage the Partnership’s coal and environmental emissioncredit positions for an additional fee of $100,000 per month. Odyssey acts asagent on behalf of the Partnership in the over-the-counter and NYISOmarkets.(see Note 8).

 

2.             SIGNIFICANTACCOUNTING POLICIES

 

Principles of Consolidation - The consolidated financialstatements include the accounts of the Partnership, AES Somerset, L.L.C., AESCayuga, L.L.C., and AEE2, L.L.C. (which includes its subsidiaries, AESWestover, L.L.C., and AES Greenidge, L.L.C.) and SRC. All material intercompanytransactions have been eliminated.

 

Restricted Cash - Under the terms of the deposit anddisbursement agreement entered into in connection with the lease of two Plants(see Note 6), all revenues of the Partnership and its subsidiaries aredeposited into a revenue account administered by Deutsche Bank (formerlyBankers Trust Company), as depositary agent. On request of the Partnership andin accordance with the terms of the deposit and disbursement agreement, fundsare transferred from the revenue account to other operating accountsadministered by the depositary agent for payment of operating and maintenancecosts, lease obligations, debt service, reserve requirements, anddistributions. Payment of operating and maintenance costs (other than actualfuel costs) in excess of 125% of the annual operating budget is not permittedunder the terms of the lease documents. Amendments, modifications orreallocations of the annual operating budget that result in changes of 25%(positive or negative) in the amounts set forth in the annual operating budgetrequire confirmation from an independent engineer that such payment is based onreasonable assumptions.

 

Inventory - Inventory is valued at the lower of cost (averagecost basis) or market, and consists of coal and other raw materials used ingenerating electricity, and spare parts, materials, and supplies.

 

46

----

 

Inventory, as of December 31 consisted of thefollowing (in thousands):

 

| ** **                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|
| Coal and  other raw materials         |       | $        | 23,613     |     | $          | 12,329 |   |
| Spare parts,  materials, and supplies |       | 14,704   |       | 15,371   |       |
|                                  |       |     |       |     |       |
| Total                                 |       | $        | 38,317     |     | $          | 27,700 |   |

 

Property, Plant, Equipment, and Related Assets -Electric generation assets that existed at the date of acquisition (see Note 3)were recorded at fair market value. The Somerset (formerly known as Kintigh)and Cayuga (formerly known as Milliken) Plants, which represent $650 million ofthe electric generation assets, are subject to a leasing arrangement accountedfor as a financing (see Note 6). Additions or improvements thereafter arerecorded at cost. Depreciation is computed using the straight-line method overthe 34-year and 28.5-year lease terms for the Somerset and CayugaPlants, respectively, and over the estimated useful lives for the other fixedassets, which range from 7 to 35 years. Maintenance and repairs are charged toexpense as incurred.

 

Electric generation assets as of December 31consisted of the following:

 
| **Description of Asset**        | ** ** | **Depreciable Life** | ** ** | **Net Book Value  at December 31,  2004** | ** ** | **Net Book Value  at December 31,  2003** | ** ** |
|---------------------------------|------------|----------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                      | ** ** | ** **           | ** ** | **(in thousands)**                             | ** ** | **(in thousands)**                             | ** ** |
| Buildings                       |       | 35                   |       | $                                              | 2,488      |                                           | $          | 2,612 |   |
| Landfills                       |       | 5                    |       | 7,129                                          |       | 3,095                                          |       |
| General  Plant                  |       | 5-35                 |       | 830,766                                        |       | 859,969                                        |       |
| Office  Equipment               |       | 7                    |       | 339                                            |       | 183                                            |       |
| Leasehold  Improvements         |       | 5-34                 |       | 36,878                                         |       | 34,046                                         |       |
| Asset  Retirement Obligations   |       | 3-30                 |       | 2,962                                          |       | 2,757                                          |       |
| SRC Track &  Structure |       | 30                   |       | 18,363                                         |       | —                                         |       |
| SRC Freight  Cars               |       | 15                   |       | 5,211                                          |       | —                                         |       |
|                            |       |                 |       | $                                              | 904,136    |                                           | $          | 902,662 |   |

 

Rent Reserve Account - As part of the Partnership’slease obligation (see Note 6), the Partnership is required to maintain a rentreserve account equal to the maximum semiannual payment with respect to the sumof basic rent (other than deferrable payments) and fixed charges expected tobecome due on any one basic rent payment date in the immediately succeedingthree-year period. As of December 31, 2004 and 2003, the Partnership hadfulfilled this obligation by entering into a Payment Undertaking Agreement,dated as of May 1, 1999, among the Partnership, each Owner Trust (see Note3) and Morgan Guaranty Trust Company of New York (the Payment UndertakingAgreement). On May 14, 1999, the Partnership deposited with MorganGuaranty Trust Company of New York approximately $28.7 million pursuant to thePayment Undertaking Agreement. The accreted value of the Payment UndertakingAgreement at any time includes interest earned thereunder at an interest rateof 4.79% per annum. Interest earnings as of December 31, 2004, 2003, and2002 were approximately $1.5 million for each year, respectively, and areincluded in the rent reserve account balance. At December 31, 2004 and2003, the accreted value of the Payment Undertaking Agreement exceeded therequired balance of the rent reserve account. This amount is being accountedfor as a restricted cash balance and is included within the rent reserveaccount on the accompanying balance sheets, as it can only be utilized tosatisfy lease obligations. In the future, the Partnership may fulfill itsobligation to maintain the required balance of the rent reserve account eitherby deposits into the rent reserve account or by making amounts available underthe Payment Undertaking Agreement, such that the aggregate amount of suchdeposits in the rent reserve account and amounts available to be paid under thePayment Undertaking Agreement are equal to the required balance of the rentreserve account. 

 

Income Taxes - A provision for Federal and stateincome taxes has not been made in the accompanying financial statements sincethe Partnership does not pay income taxes but rather allocates its revenues andexpenses to the individual partners.

 

Use of Estimates - The preparation of financialstatements in conformity with accounting principles generally accepted in theUnited States of America requires the Partnership to make estimates andassumptions that affect reported amounts of assets and liabilities and disclosuresof contingent assets and liabilities at the date of the financial statements,as well as the reported amounts of revenues and expenses during the reportingperiod. Actual results could differ from those estimates.

 

Comprehensive Income(Loss) - Comprehensive Income ispresented in the Consolidated Statement of Changes in Partner’s Capital andincludes net income and other comprehensive income/(loss) arising from cashflow hedge accounting under SFAS No. 133. In the years prior to the adoption of SFAS No. 133, the Partnershipdid not have any items of other comprehensive income.

 

47

----

 

Accounting for Derivative Instruments and HedgingActivities - The Partnership accounts for derivative instruments and hedgingactivities in accordance with SFAS No. 133, “Accounting for DerivativeInstruments and Hedging Activities”. The Statement requires that thePartnership recognize all derivatives, as defined in the Statement, on thebalance sheet at fair value. As of December 31, 2004, the Partnership hasrecorded $116.4 million in accumulated other comprehensive loss due to hedgingactivities. The Partnership utilizes derivative financial instruments to hedgecommodity price risk. The Partnership utilizes electric derivative instruments,including swaps and forwards, to hedge the risk related to forecastedelectricity sales over the next two years. The majority of the Partnership’selectric derivatives are designated and qualify as cash flow hedges. ThePartnership has chosen to use the hypothetical derivative methodology fortesting whether its hedges meet the criteria to qualify for cash flow hedgeaccounting treatment. A historical regression is performed between theelectricity generating stations’ delivery points into the NYISO and the NYISOzones in which the hedges are settled. Comparing the results of the historicalregression and the actual changes in the market value of the hedges determinesif the hedges qualify for cash flow hedge accounting criteria treatment. Nohedges were derecognized or discontinued during the year ended December 31,2004. Hedge ineffectiveness is recognized in current period earnings during theyear ended December 31, 2004.

 

Approximately $80.9 million of other comprehensiveincome is expected to be recognized as a reduction to earnings over the nexttwelve months. Amounts recorded in Accumulated Other Comprehensive Incomeduring the year ended December 31, 2004, were as follows (in millions):

 

| Beginning  balance on January 1, 2004 |   | $      | (27.6  | ) |
|--------------------------------------------|--------|--------|--------|---|
| Reclassified  to earnings                  |   | 29.3   |   |
| Change in  fair value                      |   | (118.1 | )      |
| Balance, December 31,  2004           |   | $      | (116.4 | ) |

 

In addition to the electric derivatives classified ascash flow hedge contracts, the Partnership had a Transmission CongestionContract that was a derivative under the definition of SFAS No. 133, butdid not qualify for hedge accounting.  This contract, which expired in October 2004and was not renewed, was recorded at fair value on the balance sheet withchanges in the fair value recognized through earnings. (See Note 7 -Transmission Agreements)

 

Revenue Recognition - Revenues from the sale ofelectricity are recorded based upon output delivered and rates specified undercontract terms. Gains and losses, generated from the hedging of future salesusing commodity forwards, swaps and options, reported in other comprehensive income,are reclassified to energy revenues in the periods in which earnings areimpacted by the variability of the cash flows of the hedged item. Theineffective portions of the change in fair value of derivatives and the changein the fair value of derivatives not designated as hedges for accountingpurposes are recognized in current period earnings. Revenues for ancillary andother services are recorded when the services are rendered.

 

Asset Retirement Obligation - On January 1, 2003,the Partnership adopted SFAS No. 143, “Accounting for Asset RetirementObligations”. SFAS No. 143, requires entities to record the fair value ofa legal liability for an asset retirement obligation in the period in which itis incurred. The Partnership capitalized the costs of the liability byincreasing the carrying amount of the related long-lived asset. The liabilityis accreted to its present value each period, and the capitalized cost isdepreciated over the useful life of the related asset.  Upon settlement of the liability, thePartnership will settle the obligation for its recorded amount or incur a gainor loss upon settlement.

 

The Partnership’s asset retirement obligationsprimarly consist of active ash landfills and water treatment basins. Uponadoption of SFAS No. 143, the Partnership recorded a liability ofapproximately $9.2 million and a net asset of approximately $3.3 million,which is included in the electric generation assets, and reversed a $4.2million environmental remediation liability it had previously recorded (seeNote 3). The difference between the amounts previously recorded and the netSFAS No. 143 liability is a loss recorded as the cumulative effect of achange in accounting principle of $1.7 million. Reconciliation of the assetretirement obligation liability for the year ended December 31, 2004 wasas follows (in millions):

 

| ** **                    | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Balance as  of January 1 |       | $        | 9.9        |     | $          | 9.2 |   |
| Accretion                     |       | $        | 0.8        |     | $          | 0.7 |   |
| Revision of  cash flow        |       | $        | 0.8        |     | $          | — |   |
| Balance, December 31     |       | $        | 11.5       |     | $          | 9.9 |   |

 

Stock-Based Compensation - In December 2002, theFASB issued SFAS No. 148, “Accounting for Stock-Based Compensation -Transition and Disclosure.” SFAS No. 148 amends SFAS No. 123, “Accountingfor Stock-Based Compensation” to provide alternative methods of transition fora voluntary change to the fair value based method of accounting for stock-basedemployee compensation. In addition, this Statement amends the disclosurerequirements of SFAS No. 123 to

 

48

----

 

require prominent disclosures in both annual andinterim financial statements about the method of accounting for stock-basedemployee compensation and the effect of the method used on reportedresults. The Partnership expects to use the prospective method to transitionto the fair value based method of accounting for stock-based employee compensation. Allemployee awards granted, modified, or settled after January 1, 2003, will berecorded using the fair value based method of accounting (See Note 10). The Partnership’sadoption of the prospective method of accounting for stock-based employeecompensation did not have any material impact on its financial position orresults of operations.

 

New Accounting Pronouncements

 

Variable Interest Entities - In January 2003, theFASB issued FASB Interpretation No. (FIN) 46, “Consolidation of VariableInterest Entities” which provides guidance on how to identify a variableinterest entity (VIE), and when the assets, liabilities, noncontrollinginterests and results of operations of a VIE need to be included in a company’sconsolidated financial statements. This interpretation was revised in December 2003with the issuance of FIN 46(R), “Consolidation of Variable Interest Entities”.

 

In general, a VIE is an entity that lacks sufficientequity or its equity holders lack adequate decision making ability. If eitherof these characteristics is present, the entity is subject to a variableinterests consolidation model, and consolidation is based on variableinterests, not on ownership of the entity’s outstanding voting stock. Variableinterests are defined as contractual, ownership, or other money interests in anentity that change with fluctuations in the entity’s net asset value. Theprimary beneficiary consolidates the VIE; the primary beneficiary is defined asthe enterprise that absorbs a majority of expected losses or receives amajority of residual returns (if the losses or returns occur), or both.

 

On January 1, 2004, the Partnership adopted FIN46(R) and prospectively changed the method of accounting to consolidate SRC.Prior period amounts have not been restated. The Partnership’s consolidatedbalance sheet as of December 31, 2004 reflects additional assets ofapproximately $25.6 million and liabilities of approximately $17.3 million as aresult of this consolidation. Since SRC is owned by another affiliate of AES,the consolidated balance sheets and consolidated statements of income and cashflow included in the Partnership’s financial statements show such ownership asminority interest.

 

Share-Based Payment - In December 2004,the FASB issued a revised SFAS No.123 (“SFAS No. 123R”), “Share-BasedPayment”, which is a revision of SFAS No. 123. SFAS No. 123Reliminates the intrinsic value method under APB 25 as an alternative method ofaccounting for stock-based awards by requiring that all share-based payments toemployees, including grants of stock options for all outstanding years berecognized in the financial statements based on their fair values. It alsorevises the fair-value based method of accounting for share-based paymentliabilities, forfeitures and modifications of stock-based awards and clarifiesSFAS No. 123’s guidance related to measurement of fair value, classifyingan award as equity or as a liability and attributing compensation to reportingperiods.  In addition, SFAS No. 123R amends SFAS No. 95, “Statementof Cash Flows”, to require that excess tax benefits be reported as a financingcash flow rather than as an operating cash flow.

 

The Partnership is required to adopt SFAS No. 123Rfor the interim period beginning July 1, 2005 using a modified version ofprospective application.  The Partnership may apply a modifiedretrospective application to periods before the required effective date. The Partnership plans to adopt SFAS No. 123R no later than July 1,2005, but has not determined what method it will use.  The Partnership iscurrently evaluating the effect of adoption of SFAS No. 123R, but does notexpect the adoption to have a material effect on our financial condition,results of operations or cash flows, as the Partnership had previously adoptedincome statement treatment for compensation related to share-based paymentsunder SFAS No. 123.

 

Reclassifications - Certain prior period amounts havebeen reclassified on the consolidated financial statements to conform with the2004 presentation. This includes a reclass of amounts related to theTransmission Congestion and Derivatives from long-term to current liabilitiesat December 31, 2003.

 

3.             ACQUISITION

 

On May 14, 1999, the Partnership’sfour Plants were acquired from NYSEG for approximately $914 million. ThePartnership acquired ownership of two of the Plants, Westover (formerly knownas Goudey) and Greenidge. The other two Plants, Somerset and Cayuga, wereacquired for $650 million by twelve unrelated third-party owner trusts(collectively, the Owner Trusts) organized by three unrelated institutionalinvestors. Simultaneously, the Partnership entered into separate leasing agreementsfor the Somerset and Cayuga Plants with the Owner Trusts. The Partnershipaccounts for these leases as a financing.(See Note 6).

 

The acquisition was financed bycapital contributions from the General Partner and the Limited Partner in anaggregate amount equal to the purchase price for the Plants, certain associatedcosts and expenses, and certain amounts for working capital less the netproceeds from the leasing transactions with respect to the Somerset and CayugaPlants described above. The acquisition has been accounted for as an assetpurchase.

 

In connection with the acquisition,NYSEG engaged an environmental consulting firm to perform an environmentalanalysis of the potential required remediations for soil and ground water

 

49

----

 

contamination. The Partnershipengaged another environmental consulting firm to evaluate the costs estimatedby NYSEG’s consultants. The environmental analysis and the Partnership’sestimate of other environmental remediation costs indicated that there existeda range of potential remediation costs of between $8.5 million and $19.7million, with a most probable liability of approximately $12 million. ThePartnership recorded $12.2 million as an undiscounted liability under purchaseaccounting for the projected remediation cost. In 2001 and 2002, thePartnership reduced its undiscounted liability by approximately $587,000 and$2.2 million, respectively, as remediation was completed or more currentestimates were received that were lower than previously estimated. On January 1,2003, $4.2 million of this environmental remediation liability was reclassifiedinto the asset retirement obligation in accordance with SFAS No. 143 (seeNote 2). As of December 31, 2004, $332,000 of the liability which pertainsto the opacity consent order with the NYSDEC was classified as a currentliability, and the remaining $4.8 million is classified as long-term.

 

4.             PARTNERSHIPAGREEMENT

 

The Partnership was capitalized with an initialcontribution of $10 from the General Partner and $990 from the Limited Partner.Subsequently, the General Partner and the Limited Partner contributed $354million to the Partnership (see Note 5).

 

The General Partner is responsible for the day-to-daymanagement of the Partnership and its operations and affairs, and isresponsible for all liabilities and obligations of the Partnership. Under theterms of the Partnership Agreement, the Limited Partner is not liable for anyobligations, liabilities, debts, or contracts of the Partnership and is onlyresponsible to make capital contributions when required under the PartnershipAgreement. All distributions, profits, and losses of the Partnership areallocated among the partners based on their ownership interests, currently 1%for the General Partner and 99% for the Limited Partner.

 

5.             CAPITALIZATION

 

The Partnership is indirectly owned by AES New YorkFunding, L.L.C. (AES Funding), which is a special purpose financing vehicleestablished to raise a portion of the capital contributed to the Partnershipthrough the General Partner and the Limited Partner. AES Funding is a direct whollyowned subsidiary of AES.

 

On November 30, 2001, AES Funding entered into athirty-nine month loan agreement with a syndicate of financial institutions andinstitutional lenders, with Citibank, N.A. as Agent, in the amount of $300million.  The proceeds were used torefinance in full the debt outstanding under the original Loan Agreement dated May 11,1999. Collateral for the loan includes a pledge of AES common stock.

 

On July 23, 2002, AES announced that AES Fundinghad amended the thirty-nine month loan agreement in the amount of $300 million.The amendment capped the number of shares of AES common stock required to bepledged to secure the loan. The amendment also provided that the loan would be prepaidin part ($75 million) no later than December 15, 2002. The prepayment waspaid on September 9, 2002.

 

On July 29, 2003, AES amended and restated itssenior secured bank credit facilities.  As amended and restated, the creditfacilities provide for a $250 million revolving loan and letter of creditfacility and a $700 million term loan facility. The total amount of creditavailable under the amended facilities was increased by $135 million. This increase, together with cash on hand, was used to repay in full theoutstanding balance of the AES Funding loan, resulting in the release of theunregistered common stock of AES and other collateral that secured such loan.

 

Collateral for the loan also included a pledge of themembership interests of AES New York Holdings, L.L.C., a direct wholly ownedsubsidiary of AES Funding, which is the 100% direct owner of both the GeneralPartner and the Limited Partner.

 

6.             DEBT

 

The Partnership’s leases for the Somerset and CayugaPlants are accounted for as a financing (see Note 3). Minimum lease paymentsand the present value of the lease obligations are as follows (in thousands):

 
| **Fiscal Years ending December 31,** | ** ** | **Principal  Portion** | ** ** | **Interest  Imputed** | ** ** | **Lease  Payments** | ** ** |
|-------------------------------------------|------------|------------------------|------------|-----------------------|------------|---------------------|------------|
|                                      |       |                   |       |                  |       |                |       |
| 2005                                      |       | $                      | 4,411      |                  | $          | 55,039              |       | $ | 59,450 |   |
| 2006                                      |       | 6,898                  |       | 54,652                |       | 61,550              |       |
| 2007                                      |       | 8,495                  |       | 54,005                |       | 62,500              |       |
| 2008                                      |       | 9,256                  |       | 53,244                |       | 62,500              |       |
| 2009                                      |       | 10,086                 |       | 52,414                |       | 62,500              |       |
| Thereafter                                |       | 590,669                |       | 536,504               |       | 1,127,173           |       |
| Total  minimum lease payments             |       | 629,815                |       | 805,858               |       | 1,435,673           |       |
|                                      |       |                   |       |                  |       |                |       |
| Less imputed  interest                    |       |                   |       |                  |       | (805,858            | )          |
|                                      |       |                   |       |                  |       |                |       |
| Present  value of minimum lease payments  |       |                   |       |                  |       | $                   | 629,815    |   |
|                                      |       |                   |       |                  |       |                |       |
| Less current  portion                     |       |                   |       |                  |       | (4,411              | )          |
| Lease  financing - long term              |       |                   |       |                  |       | $                   | 625,404    |   |
|                                           |            |                        |            |                       |            |                     |            |  |  |  |

 

50

----

 

Through July 2, 2020, and solong as no lease event of default exists, a portion of the rent payable undereach lease may be deferred until after the final scheduled payment of the debt incurredby the Owner Trusts to acquire the Somerset and Cayuga Plants. As of December 31,2004, the Partnership has not deferred any portion of the lease obligations.

 

The lease obligations are payable tothe Owner Trusts. These obligations bear imputed interest at 9.252% and 9.024%for the Somerset and Cayuga Plants, respectively. Total assets under the leasesof these two Plants were $650 million at December 31, 2004. These amountsare included in electric generation assets. The related accumulated depreciation, combined for both leased Plants, asof December 31, 2004 and 2003, was approximately $113.3 million and $92.9million, respectively. The agreements governing the leases restrict thePartnership’s ability to incur additional indebtedness, engage in otherbusinesses, sell its assets, or merge with another entity. The ability of thePartnership to make distributions to its partners is restricted unless certaincovenants, including the maintenance of certain coverage ratios, are met (seeNote 13). In connection with the lease agreements, the Partnership is requiredto maintain an additional liquidity account. The required balance in theadditional liquidity account was initially equal to the greater of $65 millionless the balance in the rent reserve account on May 14, 1999 (see Note 2)or $29 million. As of December 31, 2004, the Partnership had fulfilled itsobligation to fund the additional liquidity account by establishing a letter ofcredit, issued by Bank of America (formerly Fleet Bank) dated May 14,1999, in the stated amount of approximately $36 million (the AdditionalLiquidity Letter of Credit). This letter of credit was established by AES forthe benefit of the Partnership. However, the Partnership is obligated toreplenish or replace this letter of credit in the event it is drawn upon orneeds to be replaced.

 

An aggregate amount in excess of $65million is available to be drawn under the Payment Undertaking Agreement (seeNote 2) and the Additional Liquidity Letter of Credit for making rentalpayments. In the event sufficient amounts to make rental payments are notavailable from other sources, a withdrawal from the additional liquidityaccount (which may include making a drawing under the Additional LiquidityLetter of Credit) and from the rent reserve account (which may include making ademand under the Payment Undertaking Agreement) may be made for rental payments.

 

The Leases for Somerset and Cayugaexpire on February 13, 2033 and November 13, 2027, respectively.

 

On August 14, 2000, SRC entered into a$26 million credit facility with Fortis Capital Corp. which replaced in itsentirety a credit facility for the same amount previously provided to SRC by anaffiliate of CIBC World Markets. The new credit facility provided by FortisCapital Corp. consists of a 14-year term note (maturing on May 6,2014), with principal and interest payments due quarterly. (inthousands):

 
| **Fiscal Years ending December 31,** | ** ** | **Principal  Portion** | ** ** |
|-------------------------------------------|------------|------------------------|------------|
|                                      |       |                   |       |
| 2005                                      |       | $                      | 1,857      |   |
| 2006                                      |       | 1,857                  |       |
| 2007                                      |       | 1,857                  |       |
| 2008                                      |       | 1,857                  |       |
| 2009                                      |       | 1,857                  |       |
| Thereafter                                |       | 8,358                  |       |
| Total minimum  lease payments             |       | 17,643                 |       |
|                                      |       |                   |       |
| Less current  portion                     |       | 1,857                  |       |
| Lease  financing - long term              |       | $                      | 15,786     |   |

 

7.             COMMITMENTSAND CONTINGENCIES

 

Coal Purchases - Inconnection with the acquisition of the Plants, the Partnership assumed from NYSEGan agreement to purchase the coal required by the Somerset and Cayuga Plants.The termination date for the contract was December 31, 2003. The agreementwas not extended.

 

As of the acquisition dateof the Plants, the contract prices for the coal purchased through 2002 wereabove the market price, and the Partnership recorded a purchase accountingliability for

 

51

----

 

approximately $15.7 millionrelated to the fulfillment of its obligation to purchase coal under this agreement.The purchase accounting liability was amortized as a reduction to coal expense overthe life of the contract. As of December 31, 2002, the purchase accountingliability was fully amortized.

 

The Partnership has expectedcoal purchases, composed of short and medium term contracts with various mines,ranging between $100.1 million and $110.4 million, and $78.8 million and $86.9 millionfor 2005 and 2006, respectively.

 

Transmission Agreements - OnAugust 3, 1998, the General Partner entered into an agreement for the purposeof transferring certain rights and obligations from NYSEG to the GeneralPartner under an existing transmission agreement among Niagara Mohawk PowerCorporation (NIMO), the New York Power Authority, NYSEG, and Rochester Gas &Electric Corporation, and an existing transmission agreement between NYSEG andNIMO. This agreement provides for the assignment of rights to transmit energy fromthe Somerset Plant and other sources to remote load areas and other deliverypoints, and was assumed by the Partnership on the date of acquisition of thePlants. In accordance with its plan, as of the acquisition date, thePartnership discontinued using this service. The Partnership did not intend totransmit over these lines and was required to pay the current fees until the effectivecancellation date, November 19, 1999.

 

The Partnership was informedby NIMO that the Partnership would be responsible for the monthly fees of$500,640 under the existing transmission agreement to the originally scheduledtermination date of October 1, 2004. On October 5, 1999, thePartnership filed a complaint against NIMO alleging that the Partnership has aright to non-firm transmission service upon six months prior notice withoutpayment of $500,640 in monthly fees subsequent to the cancellation date of November 19,1999. On March 9, 2000, a settlement was reached between the Partnershipand NIMO, which was subsequently approved by the Federal Energy RegulatoryCommission (FERC). According to the settlement, the Partnership paid NIMO afixed rate of $500,640 per month during the period of November 20, 1999 toOctober 1, 2004, and in turn, received a form of transmission service commencingon May 1, 2000. The Partnership had the right under a Remote Load WheelingAgreement (RLWA) to transmit 298 MW over firm transmission lines from theSomerset Plant. The Partnership had the right to designate alternate points ofdelivery on NIMO’s transmission system provided that the Partnership was notentitled to receive any transmission service charge credit on the NIMO system.

 

The contractwas accounted for as a derivative under SFAS No. 133. The transmissioncontract was entered into because it provided a reasonable settlement forresolving a FERC issue. The agreement was essentially a swap between thecongestion component of the locational prices posted daily by the NYISO inwestern New York and the more heavily populated areas in eastern New York. The agreementwas a financially settled contract since there is no requirement to flow powerunder this agreement. The agreement generated gains or losses from exposure toshifts or changes in market prices. The Partnership recorded losses ofapproximately $3.8 million and $6.2 million and a gain of $8.9 million for theyears ended December 31, 2004, 2003 and 2002, respectively, related tothis contract.

 

On June 25, 2003, AESSomerset L.L.C. filed a complaint against NIMO with the FERC. The complaint involvedoutstanding station service charges for the period April 2000 to May 2003.The Plant has calculated that the outstanding charges owed were $290,000, whileNIMO has calculated that the outstanding charges were $3.6 million. In December 2003,FERC reiterated its 2001 ruling that independent power plants can net stationservice power in the Somerset and Nine Mile orders. NIMO is appealing theruling. As of December 31, 2004, AES Somerset has accrued approximately$1.6 million.

 

Line of Credit Agreement -In April 2001, the Partnership entered into a $35 million secured revolvingworking capital and letter of credit facility with Union Bank of California,N.A. This facility had a term of approximately twenty-one months. ThePartnership could borrow up to $35 million for working capital purposes underthis facility. In addition, the Partnership could have letters of credit issuedunder this facility up to $25 million, provided that the total amount of workingcapital borrowings and letters of credit issuances could not exceed the $35million limit on the entire facility. 

 

On November 20, 2002,the Partnership signed an agreement with Union Bank of California, N.A. for aone-year extension of the working capital and letter of credit facility. On April 16,2003, the Partnership signed an amendment to its November 20, 2002 creditagreement with Union Bank of California, N.A. The amendment included anotherone-year extension of the current Facility, which extended the maturity date ofthe working capital and letter of credit facility to January 2, 2005. Theamendment also increased Union Bank of California’s commitment from $15 millionto $20 million. On April 25, 2003, the Partnership further amended its November 20,2002 credit agreement with Union Bank of California, N.A. The amendmentincluded a commitment from Citibank, N.A. for the remaining $15 million of thefacility.

 

AES on January 6,2003 and February 25, 2003 authorized the Partnership to issue letters ofcredit to counterparties on its $350 million senior secured revolving creditfacility to the amount of $25 million and $35 million for the years of 2003 and2004, respectively.

 

On February 12,2004, the Partnership signed a two-year agreement, effective January 1,2004 (AES Letter of Credit Agreement), with AES to obtain up to $35 million and$25 million of letters of

 

52

----

 

credit or cashcollateral for 2004 and 2005, respectively. This agreement superseded the authorizationof AES on February 25, 2003. The agreement limited the letters of creditamounts and cash collateral to the stated amounts and set into place a feestructure and repayment terms.

 

On October 26, 2004,the Partnership and AES agreed to terminate the commitment of AES to provide lettersof credit and cash collateral for the benefit of the Partnership under the AESLetter of Credit Agreement.

 

Pursuant to the AES Letterof Credit Agreement, AES had agreed to provide, or cause to be provided, to thePartnership letters of credit and cash collateral to counterparties to support thePartnership’s obligations arising in connection with the Partnership’s sale ofelectricity. AES agreed that the maximum amount of letters of credit and cashcollateral that AES would provide, or cause to be provided, pursuant to theLetter of Credit Agreement would be $95 million from April 28, 2004 until December 31,2004 and $60 million from January 1, 2005 until December 30, 2005. OnOctober 14, 2004, the AES Board of Directors passed a resolution regardingextension of authorized credit support for the Partnership. The Board ofDirectors resolved to authorize AES to extend the Partnership use of $95million in letter of credit capacity through December 31, 2006. As of December 31,2004, the Partnership had obtained letters of credit in the amount of $58.9million, which have been provided as additional margin to support normal,ongoing hedging activities with a number of counterparties. 

 

The termination of AES’scommitment under the AES Letter of Credit Agreement does not affect outstandingauthorizations of letters of credit or cash collateral. The Partnership remainsobligated to perform its responsibilities under the AES Letter of CreditAgreement with respect to any outstanding letters of credit or cash collateralagreements until the earlier of such time as the Partnership replaces suchoutstanding letters of credit or cash collateral agreements or the statedexpiration date of such letters of credit or cash collateral agreements shalloccur.

 

AES is notobligated to provide any such letters of credit in the future and will reviewany request for the issuance of an authorization for such letters of credit ona case by case basis and may refuse any request for the issuance of suchletters of credit for any reason, or for no reason.

 

On October 26, 2004,the Partnership entered into an Amended and Restated Credit Agreement with CalyonNew York Branch and the Banks and the Issuing Banks named therein (the CalyonCredit Facility). Also on October 26, 2004, Calyon New York Branchpurchased the outstanding loans made under the Partnership’s existing $35,000,000credit facility, dated as of April 10, 2001, as amended, and theunreimbursed drawings under letters of credit issued under the existing credit facility.  In addition, Calyon New York Branch assumedall of the rights and obligations of the banks under the existing creditfacility including the commitments of such banks to make loans and issueletters of credit.

 

Under the Calyon CreditFacility, the Banks have agreed, from time to time until January 28, 2008,to make loans to and issue letters of credit on behalf of the Partnership.  The maximum aggregate principal amount ofloans, outstanding letters of credit and unreimbursed drawings under letters ofcredit issued under the Calyon Credit Facility which may be at any one timeoutstanding initially was $35 million and was increased to $75 million whensubsequent approval by the New York State Public Service Commission wasobtained on November 10, 2004.  ThePartnership may borrow, pay or prepay and reborrow loans.

 

Loans may, at the option ofthe Partnership, be made under the Calyon Credit Facility as Base Rate Loans orEurodollar Rate Loans or any combination thereof. Base Rate Loans bear interestat an interest rate per annum equal to the sum of (1) the higher of (a) thePrime Rate announced by Calyon New York Branch from time to time in effect and (b) thesum of the Federal Funds Rate in effect plus 0.50%, plus (2) an applicablemargin of 0.75% until October 26, 2006 and 1% thereafter. Eurodollar RateLoans bear interest at an interest rate per annum (rounded upwards, if necessary,to the nearest whole multiple of 1/100 of 1%) equal to the sum of (1) theLondon interbank offered rate for deposits in Dollars two business days priorto the first day of an Interest Period (a period of one, two, three or sixmonths selected by the Partnership) for a term comparable to such InterestPeriod, plus (2) an applicable margin of 1.75% until October 26, 2006and 2% thereafter.  As of December 31,2004, of the $75 million committed, the Partnership had obtained letters ofcredit of $51.6 million, which have been provided as additional margin tosupport normal, ongoing hedging activities with a number of counterparties.

 

The obligations of thePartnership under the Calyon Credit Facility are secured by the Partnership’spledge of the membership interests in the Partnership’s wholly ownedsubsidiary, AEE2, L.L.C. (which owns the Westover and Greenidge electricgenerating plants), as well as AEE2, L.L.C.’s wholly owned subsidiaries, AESWestover, L.L.C. (which operates the Westover electric generating plant) andAES Greenidge, L.L.C. (which operates the Greenidge electric generating plant).

 

On October 3,2002, Standard & Poor’s lowered its rating on the Partnership’s $550million pass through trust certificates and $35 million working capital andletter of credit facility to BB+ from BBB- solely due to the Partnership’srating linkage to AES. The rating was also placed on CreditWatch with negative implications. (see Note 2)

 

53

----

 

Environmental - ThePartnership has recorded a liability for environmental remediation associated withthe acquisition of the Plants (see Note 3). On an ongoing basis, thePartnership monitors its compliance with environmental laws. Because of theuncertainties associated with environmental compliance and remediationactivities, future costs of compliance or remediation could be higher or lowerthan the amount currently accrued.

 

The Partnership received aninformation request letter dated October 12, 1999 from the New York AttorneyGeneral, which sought detailed operating and maintenance history for theWestover and Greenidge Plants. On January 13, 2000, the Partnershipreceived a subpoena from New York State Department of EnvironmentalConservation (NYSDEC) seeking similar operating and maintenance history fromthe Plants. This information was sought in connection with the Attorney General’sand the NYSDEC’s investigations of several electricity generating stations inNew York that were suspected of undertaking modifications in the past withoutundergoing an air permitting review.

 

On April 14, 2000, thePartnership received a request for information pursuant to Section 114 of theClean Air Act from the U.S. Environmental Protection Agency (EPA) seeking detailedoperating and maintenance history data for the Cayuga and Somerset Plants. TheEPA has commenced an industry-wide investigation of coal-fired electric powergenerators to determine compliance with environmental requirements under theClean Air Act associated with repairs, maintenance, modifications andoperational changes made to coal-fired facilities over the years. The EPA’s focusis on whether the changes were subject to new source review or new sourceperformance standards, and whether best available control technology was orshould have been used. The Partnership has provided the requesteddocumentation.

 

By letterdated May 25, 2000, the NYSDEC issued a Notice of Violation (NOV) to NYSEGfor violations of the Clean Air Act and the New York Environmental ConservationLaw at the Greenidge and Westover Plants related to NYSEG’s alleged failure toobtain an air permitting review for repairs and improvements made during the1980s and 1990s, which was prior to the acquisition of the Plants by the Partnership.Pursuant to the purchase agreement relating to the acquisition of the Plantsfrom NYSEG, the Partnership agreed to assume responsibility for environmental liabilitiesthat arose while NYSEG owned the Plants. On September 12, 2000, thePartnership agreed with NYSEG that the Partnership would assume the defense ofand responsibility for the NOV, subject to a reservation of its right to assertapplicable exceptions to its contractual undertaking to assume preexistingenvironmental liabilities.

 

On January 11, 2005,three subsidiaries which the Partnership controls and two subsidiaries controlledby ACR (AES Entities) entered into a consent agreement to settle alloutstanding NOVs and civil claims that could have been brought by the State ofNew York against the AES Entities and NYSEG for the alleged violations of thenew source review and new source performance standard provisions of the CleanAir Act and its applicable regulations, similar provisions under the New York EnvironmentalConservation Law and its applicable regulations, common law, and StateExecutive Law (Consent Decree). The Consent Decree is expected to be entered bythe United States District Court for the Western District of New York aftercompletion of a public comment period and a separate 45 day period in which theFederal Government may submit comments. The Federal Government also has the opportunity to intervene in thecase.  The Consent Decree will becomeeffective when it is entered by the Court. Under the terms and conditions of theConsent Decree, upon entering into effect, the State of New York covenants notto sue and releases the participating subsidiaries and NYSEG from alleged violationsunder the Clean Air Act and regulations and also covenants not to sue or bringany administrative enforcement actions against the AES Entities for claimsunder the above-mentioned air emission laws and regulations associated withwork required pursuant to the Consent Decree or other changes at the Plantscommenced after entry of the Consent Decree, but prior to December 31, 2009and completed by December 31, 2010. Under the Consent Decree, the AES Entities have agreed to pay a $700,000civil penalty for the violations assessed to NYSEG and will deposit $1,000,000in an AES Environmental Mitigation Project Account that will be used to carryout one or more projects pertaining to energy efficiency, renewable energyand/or clean air projects that are approved by the NYSDEC and the Office of theAttorney General. The Consent Decree does not address the Somerset and CayugaPlants, and it is possible that these two Plants may be subject to a separateenforcement action filed either by the United States Environmental ProtectionAgency, NYSDEC, or the New York State Attorney General.

 

The Consent Decree setsforth mandated emission reductions and requires the installation of new emissioncontrol technologies on certain units or the repowering of or the ceasing ofoperations of such units. On Greenidge Unit 4, the AES Entities are obligatedto control sulfur dioxide (SO2) and nitrogen oxide (NOx) emissions through amulti-pollutant control clean coal project (“MCP Project”). This obligation issubject to the partial funding of the MCP Project by the U.S. Department ofEnergy and the absence of any force majeure event or material adverse change incircumstances that affects the economic viability of the MCP Project. The AESEntities are required to commence initial operation of the MCP Project by September 1,2006 or a date eighteen months after entry of the Consent Decree, whichever islater.  The AES Entities are alsoobligated to use good faith efforts to meet certain NOx emission rates andachieve a certain SO2 removal efficiency during normal operations on GreenidgeUnit 4.  If the MCP Project on GreenidgeUnit 4 is discontinued, the AES Entities are required by December 31, 2009either to (i) install control technology that will meet the Consent Decreeemission limits, (ii) repower with a non-coal fuel source or (iii) ceaseoperations. 

 

On Westover Unit 8, the AESEntities are obligated under the Consent Decree to take one of the followingthree actions by December 31, 2009 and to notify the NYSDEC of whichaction they elect to

 

54

----

 

take by June 1,2007:  (i) control NOx and SO2 usingtechnology similar to the MCP Project on Greenidge Unit 4, (ii) repowerwith a non-coal fuel source or (iii) cease operations.  Beginning in 2005 and lasting through 2009,Westover Unit 8 is subject to a declining SO2 emissions cap that starts with acap in 2005 and declines per year until 2009. Should the AES Entities elect to install emission control technology onWestover Unit 8 by December 31, 2009, then they are obligated under theConsent Decree to use good faith efforts to meet a certain NOx emissions rateand a certain SO2 removal efficiency.

 

Under the Consent Decree,Greenidge Unit 3 and Westover Unit 7 are required either to (i) install controltechnology equivalent to Best Available Control Technology or BACT, (ii) berepowered with a non-coal fuel, or (iii) cease operations, no later than December 31,2009.  During the years 2007, 2008, and2009, these two units will be subject to an annual operating limit of 1,400hours with an SO2 emission rate of 3.0 lb/mmBtu. The Consent Decree does allowthe AES Entities to use up to a 30% blend of sub-bituminous (reduced sulfur)coal at either the Greenidge or Westover Plants. 

 

The Consent Decree alsorequires the surrender of federal Acid Rain Program SO2 allowances for GreenidgeUnits 3 and 4 and Westover Units 7 and 8 starting in the year 2012.  The amount of allowances that will besurrendered depends on which compliance option the Partnership ultimately selectfor these units.

 

In the event that the AESEntities fail to comply with one or more terms of the Consent Decree, the AESEntities are obligated to pay stipulated penalties that are set forth in theConsent Decree with the exception of noncompliance due to force majeure eventsor certain material adverse conditions affecting the economic viability of theMCP Project.  Upon achieving compliancewith the material requirements of the Consent Decree, then the parties to thesettlement may petition the court for termination of the Consent Decree.  The Partnership expects that the emission reductionand control technology requirements set forth in the Consent Decree will beincorporated into each Plant’s Title V air operating permit.

 

The Partnership hasprojected that its share of the capital costs to install the MCP Project at GreenidgeUnit 4 will be approximately $29 million, however, there can be no assurancethat this will be the actual cost since the Partnership has not entered into anagreement for engineering, procurement and construction of the MCP Project atGreenidge Unit 4. 

 

At this time, thePartnership has not made decisions regarding the options of either installing pollutioncontrol technology, repowering or ceasing operations at the other units subjectto the terms of the Consent Decree, and the Partnership is unable to projectthe potential costs associated with complying with the other provisions of theConsent Decree on its financial condition or the effect on future operations.

 

The EPA is not a signatoryto the Consent Decree, and it is possible that EPA could separately issue thePartnership a NOV for alleged violations of the federal Clean Air Act andfederally enforceable New York air regulations associated with suspected pastmodifications of plant equipment without undergoing an air permitting review.  If EPA does file an enforcement action againstGreenidge and Westover, then penalties may be asserted and further emissionreductions might be necessary which could require the Partnership to makesubstantial expenditures. The Partnership is unable to estimate the effect ofany EPA-issued NOV on our financial condition or results of future operations.

 

NitrogenOxide and Sulfur Dioxide Emission Allowances - The Plants emit NOx and SO2 as aresult of burning coal to produce electricity.

 

ThePlants have been allocated allowances by the NYSDEC to emit NOx during theozone season, which runs from May 1 to September 30. Each NOxallowance authorizes the emission of one ton of NOx during the ozone season. IfNOx emissions exceed the allowance amounts allocated to the Plants, then thePartnership may need to purchase additional allowances on the open market orotherwise reduce its production of electricity to stay within the allocatedamounts. New York State and the other states in the Mid-Atlantic and Northeast regionare classified as the Ozone Transport Region in the federal Clean Air Act,which designates the Ozone Transport Region as not being in compliance with theozone National Ambient Air Quality Standard. The states in the Ozone Transport Regionhave agreed to implement a three phase process to reduce NOx emissions in theregion in order to comply with the federal Clean Air Act Title I requirementsfor ozone non-compliance areas. Implementation of Phase III emission rules commencedon May 1, 2003. ThePhase III emission rules have been superseded by the transition to thefederal NOx SIP Call rule, which imposes NOx ozone season emission reductionrequirements through an allowance system similar to the Phase III emissionrules.  Under the NOx SIP Call rule,electric generating facilities in 21 Northeast and Mid- Atlantic states and theDistrict of Columbia are required to hold allowances sufficient to cover the ozoneseason NOx emissions emitted by such facilities.  Each of the Partnership’s Plants is subject tothe NOx SIP Call rule, and the Partnership has been allocated 2,492 NOxallowances for the 2005 ozone season. The NOx SIP Call program commenced on May 31, 2004. The Plants werenet sellers of NOx allowances in 2002. The Plants had a shortfall of approximately1,020 and 1,200 NOx allowances in 2004 and 2003,respectively. The 2003shortfall was covered by purchasing 70 NOx allowances from AES Ironwood, anindirect wholly owned subsidiary of AES, at market prices and the remainder ofthe 2003 and 2004 shortfalls of NOx allowances were covered by purchasing NOxallowances at market prices from unrelated companies in the open market.

 

The Plants are also subjectto SO2 emission allowance requirements imposed by the EPA.

 

55

----

 

Each SO2 allowanceauthorizes the emission of one ton of SO2 during the calendar year. SO2 allowancesmay be bought, sold, or traded. If SO2 emissions exceed the allowance amountsallocated to the Plants, then the Partnership may need to purchase additionalallowances on the open market or otherwise reduce its production of electricityto stay within the allocated amounts. The Plants had shortfalls ofapproximately 6,600, 10,000 and 1,000 SO2 allowances in 2002, 2003 and 2004, respectively.The majority of the 2002 SO2 allowance shortfall was covered with allowances purchasedfrom the electricity generating stations owned by an affiliate of thePartnership, AES Creative Resources, L.P. (ACR), which are on long-term coldstandby. Those allowances were purchased at quoted market prices. The 2003 and2004 shortfall was covered by purchasing SO2 allowances at market prices fromunrelated companies in the open market. 

 

In October 1999, NewYork State Governor Pataki announced an executive order mandating additional emissionreductions from New York State power plants. The Governor’s initiative requiresnon-ozone season NOx emission reductions based on an emission rate of 0.15lbs/Mmbtu starting in 2004, and a 50% reduction from the power plants’ Title IVSO2 emissions being phased in from 2005 to 2008. The program will beimplemented through a market-based mechanism. The rules implementing the Governor’sinitiative (6 NYCRR Parts 237 and 238) were adopted in March 2003.

 

In September 2003, NewYork State determined the amount of NOx emissions allowances that would be allocatedto the Plants. The allocation is several hundred tons short of the Partnership’saverage historical NOx emissions for the Plants during the control period.

 

In January 2004, NYSDECdetermined the amount of SO2 emissions allowances that would be allocated tothe Plants. The allocation is approximately the Partnership’s averagehistorical SO2 emissions for the Plants. 

 

On May 26, 2004, theNew York Supreme Court struck down the Acid Deposition Reduction Program regulations(6 NYCRR 237 and 238). The Court ruled that the regulations had been adopted improperlyafter the State missed a deadline for publication of a notice to inform thepublic of proposed changes in the regulations. On July 1, 2004, NYSDECappealed the Court’s ruling.

 

On August 17, 2004, the NYSDEC announcedthe adoption of emergency regulations to implement the Acid DepositionReduction Program as originally scheduled. A number of entities challenged the adoptionof the emergency regulations. On October 19, 2004, a State Supreme CourtJudge dismissed the petition challenging New York State’s adoption of emergencyregulations to implement the Acid Deposition Reduction Program as originallyscheduled.

 

The new NOxregulations became effective October 1, 2004, and the new SO2 regulations willbe phased in starting January 1, 2005, with full implementation complete byJanuary 1, 2008.  The Partnership’scompliance strategy involves reduced operations from the Plants’ non-reheatunits, reducing emission rates and/or the selling/buying or trading of New YorkState SO2 and NOx allowances.

 

On March 10, 2005, theEPA Acting Administrator signed the final Clear Air Interstate Rule that willrequire further emission reductions in NOx and SO2 emitted from power plantsand other sources that significantly contribute to fine particulate (“PM2.5”)and ozone pollution in downwind states.  NOx and SO2 are precursors ofPM2.5, and NOx is a precursor of ozone.  The final rule directs 28states, including New York, to issue new regulations that will require majorSO2 and NOx reductions by 2015. States must achieve the required NOx andSO2 reductions by meeting a state-specific emissions budget through one of twocompliance methods: (i) requiring electric generating facilities in thestate to participate in an EPA-administered cap and trade regime that capsemissions in two phases starting with a first phase in 2010 and a second phasecommencing in 2015, or (ii) meeting the budget levels through measuresselected by a particular state that are approved by EPA. States are encouragedto use a cap and emission trading approach.  At this point, thePartnership cannot determine what the costs would be to comply with new federalSO2 and NOx emission reduction requirements.

 

On March 15, 2005, theEPA Acting Administrator signed the final Clear Air Mercury Rule that willregulate mercury emissions from existing and new coal-fired power plants. The final rule requires the reduction of mercury emissions to be achievedthrough a cap and emission trading program with the first phase commencing in2010 and the second phase starting in 2018. At this point, the Partnershipcannot determine what the costs would be to comply with the new federal mercuryemission reductions requirements.

 

The Partnership voluntarilydisclosed to the NYSDEC and EPA on November 27, 2002 that NOx exceedencesappear to have occurred on October 30 and 31 and November 1-8and 10 of 2002. The exceedences were discovered through an audit by plantpersonnel of the Plant’s NOx RACT tracking system. The Partnership believesthat it has taken all reasonable, good faith efforts to assess and correct theexceedences. Immediately upon the discovery of the exceedences, the SCR at theSomerset Plant was activated to reduce NOx emissions. Emission data indicatesthat the system had already returned to a compliant operation by the time theexceedences were discovered. The EPA has decided to defer to the NYSDEC forreview of the self-disclosure letter and technical issues. Recently, thePartnership learned of a Notice of Violation issued by the NYSDEC for the NOxRACT exceedences through a review of the November 2004 release of the EPA’sEnforcement and Compliance History “ECHO” database. The Partnership has not yetseen the NOV from the NYSDEC. The Partnership is unable to predict anypotential actions or fines the NYSDEC may require, if any.

 

56

----

 

The Partnership voluntarilydisclosed to the NYSDEC in January 2003 that the Cayuga Plant hadinadvertently burned synfuel (coal with a latex binder applied), which it isnot permitted to burn. The Partnership had entered into an agreement with asupplier to purchase coal. It received approximately one 9000-ton trainshipment per month from April 24, 2001 to December 27, 2002. In January 2003,the Partnership became aware that the product the Cayuga Plant was receivingwas synfuel. The Partnership suspended all shipments from that supplier until aresolution was reached. The Partnership reviewed the emission and operationdata which showed there was no adverse effect to air quality with respect toapplicable permit emissions limits attributable to burning the material. ThePartnership is unable to predict any potential actions or fines the NYSDEC mayrequire, if any. In July 2003, the Partnership reached an agreement withthe supplier to resume shipment of coal in order to satisfy contractualobligations. As part of this agreement, the supplier has provided a writtenguarantee stating that all fuel shipments will be coal.

 

In July 2004, the EPAfinal rule for regulating existing power plants under Section 316(b) ofthe Clean Water Act was published in the Federal Register. This rule becameeffective on September 7, 2004. This new rule will impose newcompliance requirements, with potentially significant costs, on operatingplants across the nation with cooling water intake structures. Cost itemsinclude various environmental and engineering studies and potential capital andmaintenance costs. The Partnership has not yet determined the effects of this rule onits financial condition or results of operations.

 

Northeastern U.S. states(including New York) have agreed to work to develop a regional market-basedemissions trading system to reduce power plants’ carbon dioxide emissions. Thegoal is to reach an agreement by April 2005 on a cap and emissions tradingprogram. Until such time as the rules are developed to implement such aprogram, the Partnership cannot determine what its impact would be on thePartnership’s financial position or results of operations.

 

8.             RELATEDPARTY TRANSACTIONS

 

The Partnership has enteredinto a contract with Somerset Railroad Corporation (SRC), a wholly ownedsubsidiary of AES NY3, L.L.C., which is an indirect wholly owned subsidiary ofAES, pursuant to which SRC will haul coal and limestone to the Somerset Plantand make its rail cars available to transport coal to the Cayuga Plant. Throughthis agreement, the Partnership has, in effect, guaranteed interest on andprincipal of SRC’s outstanding indebtedness and will pay amounts sufficient toenable SRC to pay all of its operating and other expenses, including allout-of-pocket expenses, taxes, and all capital expenditures necessary to permitSRC to continue to provide rail service to the Somerset and Cayuga Plants. Asof December 31, 2003 and 2002, $3.1 million and $3.8 million,respectively, has been recorded by the Partnership as operating expenses andother accrued liabilities under this agreement.

 

In November 2000, thePartnership entered into a three-year agreement for energy marketing serviceswith Odyssey. In March 2002, a new agreement was reached, for a term offive years through February 28, 2007 pursuant to which Odyssey providesdata management, marketing, scheduling, invoicing and risk management servicesfor a fee of $300,000 per month. On September 4, 2003, the Partnershipsigned an amendment to its March 2002 agreement. Odyssey will also managethe Partnership’s coal and environmental emission credit positions for anadditional fee of $100,000 per month. Odyssey acts as agent on behalf of thePartnership in the over-the-counter and NYISO markets.

 

As agent, Odyssey managesall energy transactions under the Partnership’s name including (i) preparingconfirmations for the Partnership and approving confirmations withcounterparties, (ii) conducting monthly check-outs with counterparties asappropriate before the preparation of invoices, (iii) invoicingcounterparties for the term of the transactions and (iv) otherwisemanaging and executing the terms of the transactions in accordance with theirprovisions.

 

Odyssey provides datamanagement for us by maintaining databases of pricing, load, transmission,weather and generation data to aid in analysis to optimize the value of ourassets. Odyssey maintains a transaction management system to manage day-aheadcommitments with the NYISO and swap and physical values with counterparties andto provide daily financial reporting and end of day budget variance, forwardmark-to-market and commercially accepted risk analysis.

 

Odyssey also managesenvironmental emission credit positions for other AES facilities. Theseallowances were purchased on the open market at market prices. From time to timethe allowances will be temporarily placed into the Somerset Plant’s allowanceaccount while awaiting transfer to the purchasing facility. In 2003, allowanceswere purchased and sold in this manner for AES Deepwater, AES Red Oak and AESIronwood, all indirect wholly owned subsidiaries of AES.

 

For the year ended December 31,2002, the Partnership purchased approximately 6,000 SO2 allowances forapproximately $843,000, from the electricity generating stations owned by anaffiliate of the Partnership, ACR that are on long-term cold standby. Thoseallowances were purchased at quoted market prices. 

 

For the year ended December 31,2003,Odyssey purchased for the Partnership’s account 70 NOx allowances atmarket prices for approximately $322,000 from AES Ironwood, a wholly ownedsubsidiary of AES.

 

Until the sale of AES NewEnergy in the third quarter of 2002, the Partnership entered into bilateralcontract transactions with AES New Energy, a wholly owned subsidiary of AES.These

 

57

----

 

transactions includedforward sales of electric energy and unforced capacity at market based rates.For the year ended December 31, 2002, the Partnership recognized revenuesof approximately $13.9 million, related to the physical delivery of electricityor unforced capacity and the subsequent change in the market value of thesecontracts. AES New Energy was sold in the third quarter of 2002. As of December 31,2002, the related account receivable - trade between AES New Energy and the Partnershipwas zero. The exposure at December 31, 2002 related to these contracttransactions was less than 10% of the Partnership’s estimated cash revenues forthe year then ended.

 

AEScontributed approximately $415,000 and $162,000 to the Partnership in 2004 and2003, respectively, related to the cost of stock options compensation expense.Also, AES contributed approximately $1.5 million to the Partnership in 2002related to the construction of the SCR on Unit 1 of the Cayuga Plant, whichbecame operational on June 7, 2001.

 

9.             BENEFITPLANS

 

Effective May 14, 1999,the Partnership adopted The Retirement Plan for Employees of AES NY, L.L.C.(the Plan), a defined benefit pension plan. The Plan covers people employedboth under collectively bargained and non-collectively bargained arrangements.Certain people formerly employed by NYSEG (the Transferred Persons) receivecredit under the Plan for compensation and service earned while employed byNYSEG. The amount of any benefit payable under the Plan to a Transferred Personwill be offset by the amount of any benefit payable to such Transferred Personunder the Retirement Plan for Employees of NYSEG. Effective May 29, 1999,the ability to commence participation in the Plan and the accrual of benefitsunder the Plan ceased with respect to non-collectively bargained people and theaccrued benefits of any such participant were fixed as of such date. As of December 31,2004, the Plan was funded at least to the extent required by Internal RevenueCode (IRC) Section 412 minimum funding and not more than the requirementof IRC Section 404, maximum contribution limits. The Partnership will makeat least the required minimum contribution within the Employee RetirementIncome Security Act (ERISA) guidelines. Pension benefits are based on years ofcredited service, age of the participant, and average earnings. During 2004 and2003, collectively bargained people were offered the opportunity to freezetheir accrued benefit payable under the Plan and opt into the AES Profit Sharingand Stock Ownership Plans.

 

The assets and liabilitiesof the Plan were valued as of October 31, 2004 and 2003. The values of theassets and liabilities as of October 31, 2004 and 2003 were not materiallydifferent than the values as of December 31, 2004 and 2003.

 
| ** **                                              | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------------|------------|----------|------------|----------|------------|
| Projected  Benefit Obligation                           |       |     |       |     |       |
| Change in  projected benefit obligation (in thousands): |       |     |       |     |       |
| Projected  benefit obligation, beginning of period      |       | $        | 24,888     |     | $          | 25,267 |   |
| Service cost                                            |       | 683      |       | 375      |       |
| Interest  cost                                          |       | 1,540    |       | 1,495    |       |
| Actuarial  (gain) loss                                  |       | 1,443    |       | (1,419   | )          |
| Benefits  paid                                          |       | (759     | )          | (830     | )          |
| Curtailment                                             |       | —   |       | —   |       |
| Special  Termination Loss                               |       | —   |       | —   |       |
|                                                    |       |     |       |     |       |
| Projected  benefit obligation, end of period            |       | $        | 27,795     |     | $          | 24,888 |   |
| Plan Assets:                                            |       |     |       |     |       |
| Change in  plan assets (in thousands):                  |       |     |       |     |       |
| Fair value  of plan assets, beginning of period         |       | $        | 9,417      |     | $          | 7,153 |   |
| Actual  return on plan assets                           |       | 103      |       | 933      |       |
| Employer  contributions                                 |       | 4,571    |       | 2,161    |       |
| Benefits  paid                                          |       | (759     | )          | (830     | )          |
|                                                    |       |     |       |     |       |
| Fair value  of plan assets, end of period               |       | $        | 13,332     |     | $          | 9,417 |   |
| Funded  status/accrued benefit liability                |       | $        | (14,463    | )        | $          | (15,471 | ) |
| Unrecognized  Net Loss                                  |       | 1,159    |       | (1,087   | )          |
| (Accrued)/Prepaid  Pension Cost, end of period          |       | $        | (13,304    | )        | $          | (16,558 | ) |

 
| ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** | **2002** | ** ** |
|---------------------------------------------------------|------------|------------|------------|------------|------------|----------|------------|
| Defined  Benefit Pension Plan Costs:                    |       |       |       |       |       |     |       |
| Components  of net periodic benefit cost (in thousands) |       |       |       |       |       |     |       |
| Service cost                                            |       | $          | 683        |       | $          | 366      |       | $ | 416 |   |
| Interest  cost                                          |       | 1,540      |       | 1,522      |       | 1,358    |       |
| Expected  return on plan assets                         |       | (907       | )          | (607       | )          | (474     | )          |
|                                                    |       |       |       |       |       |     |       |
| Net periodic  benefit cost                              |       | $          | 1,316      |       | $          | 1,281    |       | $ | 1,300 |   |

 

58

----

 

The discount rate utilizedfor determining future pension obligations is based on a review of long- termbond rates. The discount rate was reduced to 5.75% to reflect current long-termrates. Future actual pension benefit obligations will depend on futureinvestment performance, changes in future discount rates and various otherfactors related to the populations participating in the Partnership’s pensionplans. 

 
| ** **                                        | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|
| Discount rate                                     |       | 5.75     | %          | 6.25     | %          |
| Expected  long-term rate of return on plan assets |       | 8.00     | %          | 8.00     | %          |
| Rate of  compensation increase                    |       | 4.75     | %          | 4.75     | %          |

 

The accumulated benefitobligation was approximately $24.0 million and $21.8 million as of December 31,2004 and 2003, respectively.

 

Significant assumptions wereused in the calculations of the net benefit cost and projected benefit obligationfor the periods ending October 31, 2004 and 2003. In developing thePartnership’s expected long-term rate of return assumption, the Partnershipevaluated input from its actuaries and plan asset manager. Projected returnsare based on a broad range of equity and bond indices. The Partnership’sexpected 8% long-term rate of return on Qualified Plan assets is based on the allocationassumption of 60% equities (50% growth and 50% value), with a 10% long termrate of return, and 40% in fixed income investments, with a 5.5% long-term rateof return. Because of market fluctuation, its actual allocation was 54% and 58%equities and 46% and 42% in fixed income investments as of October 31,2004 and 2003, respectively. However, the Partnership believes that itslong-term asset allocation on average will approximate 60% equities and 40%fixed income investments. The Partnership regularly reviews the assetallocation with the asset manager and periodically rebalances the Plan’sinvestments to its targeted allocation when appropriate. The Partnershipcontinues to believe that 8% is a reasonable long-term rate of return on its qualifiedplan assets, despite the market downturn. The Partnership will continue toevaluate its actuarial assumptions, including its expected rate of return, atleast annually, and will adjust as necessary.

 

As of December 31,2004, the Plan had 260 active participants.

 

Plan Assets

 

The overall expectedlong-term rate-of-return-on-assets assumption is based upon a building-block method,whereby the expected rate of return on each asset class is broken down intothree components: (1) inflation, (2) the real risk-free rate ofreturn (i.e., the long-term estimate of future returns on default-free U.S.government securities), and (3) the risk premium for each asset class(i.e., the expected return in excess of the risk-free rate).

 

All three components arebased primarily on historical data, with modest adjustments to take into accountadditional relevant information that is currently available.  For theinflation and risk- free return components, the most significant additionalinformation is that provided by the market for nominal and inflation-indexedU.S. Treasury securities.  That market provides implied forecasts of boththe inflation rate and risk-free rate for the period over whichcurrently-available securities mature. The historical data on risk premiums foreach asset class is adjusted to reflect any systemic changes that have occurredin the relevant markets; e.g., the higher current valuations for equities, as amultiple of earnings, relative to the longer-term average for such valuations.

 

Cash Flows

 

The Partnership expects tocontribute $4.1 million to its pension plan in 2005.

 

Estimated Future BenefitsPayments

 

The followingbenefit payments, which reflect expected future service, as appropriate, are expectedto be paid:

 
| **Fiscal Years ending December 31,** | ** ** | **Payments** | ** ** |
|-------------------------------------------|------------|--------------|------------|
| 2005                                      |       | 979          |       |
| 2006                                      |       | 1,075        |       |
| 2007                                      |       | 1,210        |       |
| 2008                                      |       | 1,354        |       |
| 2009                                      |       | 1,511        |       |
| Thereafter                                |       | 9,907        |       |
| Total  Estimated Future Benefits          |       | $            | 16,036     |   |
|                                           |            |              |            |  |

 

Additionally, people of thePartnership and its subsidiaries participate in the AES Profit Sharing andStock Ownership Plans. The plans provide Partnership matching contributions.Participants are fully vested in their own contributions and the Partnership’smatching contributions. The

 

59

----

 

Partnership contributed toAES Profit Sharing and Stock Ownership Plans approximately $899,000, $885,000and $809,000 in 2004, 2003 and 2002, respectively.

 

Other Postretirement BenefitPlan

 

OnJuly 1, 2000, AES Greenidge adopted SFAS No. 106 “Employees’Accounting for Postretirement Benefit Other Than Pension.” Prior years costwere deemed immaterial for presentation purposes. The net periodic cost was$231,000 for the year ended December 31, 2002. On July 1, 2003, aspart of AES Greenidge’s collective bargaining agreement with the InternationalBrotherhood of Electrical workers, AES Greenidge established a Voluntary Employees’ Beneficiary Association (“VEBA”)to fund their retired union members’, spouses’ and dependents’ medicalexpenses.

 

The Plants also have createdseparate VEBAs to fund their retiree medical expenses. Employer contributionsto pay the claims of the employees are deposited in the VEBA Trusts. Currently,the VEBA Trusts are to pay the medical claims of the employees who are unionmembers and who retire from the Partnership and the medical claims of theirspouses and dependants. Some of the VEBA trusts offer supplemental Medicarebenefits, the other Trusts’ coverage end when the employee is Medicareeligible. The AES Somerset, AES Cayuga and AES Westover VEBA trusts were createdin 2002, and the AES Greenidge VEBA trust was created in 2003. The funding schedule forthe trusts are as follows: (in thousands)

 
| **Fiscal Years ending December 31,** | ** ** | **Payments** | ** ** |
|-------------------------------------------|------------|--------------|------------|
|                                      |       |         |       |
| 2005                                      |       | 534          |       |
| 2006                                      |       | 434          |       |
| 2007                                      |       | 172          |       |
| 2008                                      |       | 172          |       |
| 2009                                      |       | —       |       |
| Total funding  payments                   |       | $            | 1,312      |   |
|                                           |            |              |            |  |

 

10.           LONG-TERMINCENTIVE PROGRAM

 

Stock Option Plan -Employees of the Partnership participate in the AES Stock Option Plan (the SOP)that provides for grants of stock options to eligible participants. Prior to2003, the Partnership accounted for the SOP under the recognition andmeasurement provisions of APB Opinion No. 25, “Accounting for Stock Issuedto Employees,” and related Interpretations. No stock-based employee compensation cost is reflected in 2002 netincome, as all options granted under the SOP in those years had an exerciseprice equal to the market value of the underlying common stock on the date ofgrant. Effective January 1, 2003, the Partnership adopted the fair value recognitionprovisions of SFAS No.123, “Accounting for Stock-Based Compensation”,prospectively to all employee awards granted, modified or settled after January 1,2003.  Awards under the SOP vest overperiods ranging from two to five years. Therefore, the cost related to stock-based employee compensationincluded in the determination of net income for 2003 is less than that whichwould have been recognized if the fair value based method had been applied toall awards from the inception of the Partnership. The expense recognized underthe prospective method was approximately $415,000 and $162,000 in 2004 and2003, respectively.

 

11.           FAIR VALUEOF FINANCIAL INSTRUMENTS

 

The fair value of thePartnership’s current financial assets and liabilities approximate their carryingvalues. The fair value estimates are based on pertinent information availableas of December 31, 2004. The Partnership is not aware of any factors thatwould significantly affect the estimated fair value amounts since that date.The fair value of the long-term debt (the leasing debt) would not be at thecarrying value. The fair value of the long-term debt is $680.6 million.

 

12.           SEGMENTINFORMATION

 

Under the provisions of SFASNo. 131, “Disclosures About Segments of an Enterprise and Related Information”,the Partnership’s business is expected to be operated as one reportablesegment, with operating income or loss being the measure of performancemeasured by the chief operating decision-maker.

 

13.           RESTRICTIONSON DISTRIBUTIONS TO PARTNERS

 

The Partnership’s ability tomake distributions to its partners is restricted by the terms of the agreementsgoverning the leases of the Somerset and Cayuga Plants. The Partnership maymake a distribution to its partners only on or within ten business days after asemiannual rent payment date (commencing with the rent payment date occurringon July 2, 2000), so long as the conditions as specified in the agreementshave been met. The Partnership has made nine distributions to its partners todate: July 11, 2000, in the amount of $35 million; January 12, 2001,in the amount of $32.5 million; July 12, 2001, in the amount of $65.7million; January 9, 2002, in the amount of $32.6 million; July 5,2002, in the amount of $31.4 million; January 8, 2003, in the amount of $38.7million; and July 7, 2003, in the amount of $75.9 million; January 8,2004, in the amount of $48.7 million; and July 8, 2004, in the amount of$41.2 million.

 

60

----

 

14.           SUBSEQUENT EVENTS

 

Cash flow from thePartnership’s operations during the second half of 2004 was sufficient to coverthe aggregate rental payments under the leases on the Somerset and CayugaPlants due January 2, 2005. On this date, rental payments were made in theamount of $31.7 million.

 

Cash flow from operations inexcess of the aggregate rental payments under the Partnership’s leases may bedistributed to its partners if certain criteria are met. On January 7,2005, the Partnership made a distribution payment of $25.0 million.

 

ThePartnership borrowed $21 million on January 10, 2005 and an additional$750,000 on February 9, 2005, for working capital purposes under the $75million Calyon Credit Facility. The borrowings were at an interest rate of 6%.A partial repayment of $4.6 million was made on January 27, 2005, and theremaining balance of $17.2 million was repaid on February 28, 2005.

 

61

----

 

Report of Independent Registered PublicAccounting Firm

 

 

To the Member ofAES NY, L.L.C.

 

We have audited the accompanying consolidated balance sheetsof AES NY, L.L.C. (an indirect wholly owned subsidiary of The AES Corporation)and its subsidiaries (the Company) as of December 31, 2004 and 2003. Thesefinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits.

 

We conducted our audits in accordance with the standards ofthe Public Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement. The Companyis not required to have, nor were we engaged to perform, an audit of itsinternal control over financial reporting. Our audit included consideration ofinternal control over financial reporting as a basis for designing auditprocedures that are appropriate in the circumstances, but not for the purposeof expressing an opinion on the effectiveness of the Company’s internal controlover financial reporting.  Accordingly,we express no such opinion.  An auditalso includes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, as well as evaluating theoverall financial statement presentation. We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, such consolidated balance sheets presentfairly, in all material respects, the financial position of AES NY, L.L.C. andits subsidiaries as of December 31, 2004 and 2003, in conformity withaccounting principles generally accepted in the United States of America.

 

Asdiscussed in Note 2 to the consolidated financial statements, January 1,2004, the Company adopted Financial Accounting Standards Board Interpretation No. 46(R),“Consolidation of Variable Interest Entities” and prospectively changed itsmethod of accounting for special purpose entities.

 

As discussed in Note 2 to the consolidated financialstatements, on January 1, 2003, the Company adopted Statement of FinancialAccounting Standard No. 143, “Accounting for Asset Retirement Obligations.”

 
| /s/Deloitte & Touche LLP |   |
|-----------------------------------|--------|
|                              |
|                              |
| McLean, Virginia                  |
| March 31, 2005               |

 

62

----

 

**AES NY, L.L.C.**

**CONSOLIDATEDBALANCE SHEETS,**

**DECEMBER 31, 2004 and DECEMBER 31,2003**

 

***(Amounts in Thousands*****)**

 
| **December 31,**                                                                | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| **ASSETS**                                                                           |       |     |       |     |       |
| Current  Assets:                                                                     |       |     |       |     |       |
| Restricted  cash:                                                                    |       |     |       |     |       |
| Operating -  cash and cash equivalents                                               |       | $        | 2,431      |     | $          | 2,932 |   |
| Revenue  account                                                                     |       | 59,218   |       | 85,231   |       |
| Accounts  receivable - trade                                                         |       | 42,112   |       | 34,883   |       |
| Accounts  receivable - affiliates                                                    |       | 3,717    |       | 2,969    |       |
| Accounts  receivable - other                                                         |       | 872      |       | 1,280    |       |
| Derivative  valuation asset - current                                                |       | 1,239    |       | 8,153    |       |
| Inventory                                                                            |       | 38,317   |       | 27,700   |       |
| Prepaid  expenses                                                                    |       | 8,360    |       | 8,117    |       |
| Total current assets                                                                 |       | 156,266  |       | 171,265  |       |
| PROPERTY,  PLANT, EQUIPMENT, AND RELATED ASSETS:                                     |       |     |       |     |       |
| Land                                                                                 |       | 8,748    |       | 7,503    |       |
| Electric  generation assets-net of accumulated depreciation of $247,632 and $161,784 |       | 904,218  |       | 902,663  |       |
| Total  property, plant, equipment and related assets                                 |       | 912,966  |       | 910,166  |       |
| OTHER  ASSETS:                                                                       |       |     |       |     |       |
| Deferred  financing -net of accumulated amortization of $892 and $328                |       | 2,090    |       | 303      |       |
| Derivative  valuation                                                                |       | 2,773    |       | 7,990    |       |
| Credit  reserves                                                                     |       | 1,494    |       | —   |       |
| Rent reserve  account                                                                |       | 31,717   |       | 31,717   |       |
| TOTAL ASSETS                                                                         |       | $        | 1,107,306  |     | $          | 1,121,441 |   |
| LIABILITIES  AND MEMBERS’ CAPITAL                                               |       |     |       |     |       |
|                                                                                 |       |     |       |     |       |
| CURRENT  LIABILITIES:                                                                |       |     |       |     |       |
| Accounts  payable                                                                    |       | $        | 1,653      |     | $          | 833 |   |
| Lease financing  - current                                                           |       | 4,411    |       | 7,846    |       |
| Other  long-term debt - current                                                      |       | 2,459    |       | 347      |       |
| Accrued  interest expense                                                            |       | 27,663   |       | 28,004   |       |
| Derivative  valuation liability - current                                            |       | 82,125   |       | 26,043   |       |
| Transmission  congestion contract                                                    |       | —   |       | 359      |       |
| Due to The  AES Corporation and affiliates                                           |       | 13,092   |       | 9,096    |       |
| Accrued coal  and rail expense                                                       |       | 7,431    |       | 6,456    |       |
| Environmental  remediation                                                           |       | 332      |       | —   |       |
| Loss  contingency                                                                    |       | 1,700    |       | —   |       |
| Other  accrued expenses and liabilities                                              |       | 16,900   |       | 9,787    |       |
| Total  current liabilities                                                           |       | 157,766  |       | 88,771   |       |
| LONG-TERM  LIABILITIES:                                                              |       |     |       |     |       |
| Lease  financing - long term                                                         |       | 625,404  |       | 629,815  |       |
| Other  long-term debt - non-current                                                  |       | 16,411   |       | 744      |       |
| Environmental  remediation                                                           |       | 6,528    |       | 6,800    |       |
| Defined  benefit plan obligation                                                     |       | 13,920   |       | 17,238   |       |
| Derivative  valuation liability - non-current                                        |       | 38,151   |       | 17,581   |       |
| Asset  retirement obligation                                                         |       | 11,845   |       | 10,299   |       |
| Other  liabilities                                                                   |       | 1,907    |       | 1,944    |       |
| Total  long-term liabilities                                                         |       | 714,166  |       | 684,421  |       |
| TOTAL  LIABILITIES                                                                   |       | 871,932  |       | 773,192  |       |
|                                                                                 |       |     |       |     |       |
| COMMITMENTS  AND CONTINGENCIES (Note 6)                                              |       |     |       |     |       |
|                                                                                 |       |     |       |     |       |
| MINORITY  INTEREST                                                                   |       | 233,020  |       | 344,767  |       |
| MEMBER’S  EQUITY                                                                |       | 2,354    |       | 3,482    |       |
| TOTAL  LIABILITIES AND MEMBERS’ CAPITAL                                         |       | $        | 1,107,306  |     | $          | 1,121,441 |   |

 

The notes are an integral part of theconsolidated Balance Sheets

 

63

----

 

AES NY,L.L.C

NOTES TO CONSOLIDATED BALANCE SHEETS

YEARS ENDED DECEMBER 31, 2004 AND 2003

 

1.             GENERAL

 

AES NY, L.L.C. (theCompany), a Delaware limited liability company, was formed on December 2,1998. The Company is the sole general partner of AES Eastern Energy, L.P.(AEE), owning a one percent interest in AEE. The Company is also the solegeneral partner of AES Creative Resources, L.P.(ACR), owning a one percentinterest in ACR. AES NY Holdings, L.L.C. is the sole member of the Company. TheCompany is an indirect wholly owned subsidiary of The AES Corporation (AES).The Company began operations on May 14, 1999. Prior to that date, theCompany had no operations. 

 

The Company was establishedfor the purpose of acting as the general partner of both AEE and ACR. In thiscapacity, the Company is responsible for the day-to-day management of AEE andACR and their operations and affairs, and is responsible for all liabilitiesand obligations of both entities.

 

AEE, a Delaware limitedpartnership, was formed on December 2, 1998. AEE’s wholly owned subsidiariesare AES Somerset, L.L.C., AES Cayuga, L.L.C., and AEE2, L.L.C., (which whollyowns AES Westover, L.L.C. and AES Greenidge, L.L.C.). AEE began operations on May 14,1999. Prior to that date, AEE had no operations. AEE was established for thepurpose of owning and operating four coal-fired electric generating stations(the AEE Plants) with a total combined capacity of 1,268 MW. Two of the plantsare owned by AEE and two of the plants are leased by AEE (see Note 5), and areoperated by AEE’s wholly owned subsidiaries in the State of New York, pursuantto operation and maintenance agreements with AEE. The limited partner of AEE isAES NY 2, L.L.C. (the Limited Partner), which is also an indirect wholly ownedsubsidiary of AES.

 

ACR, a Delaware limitedpartnership, was formed on December 3, 1998. ACR’s wholly ownedsubsidiaries are AES Jennison, L.L.C. and AES Hickling, L.L.C., which each ownsa coal-fired electric generating station (the ACR Plants) with a combinedcapacity of 156 MW. ACR began operations on May 14, 1999. Prior to thatdate ACR had no operations. The limited partner of ACR is AES NY 2, L.L.C. TheAEE Plants and the ACR Plants are hereinafter referred to collectively as “thePlants.”

 

AES NY3, L.L.C., an indirectwholly owned subsidiary of AES acquired the stock of the Somerset RailroadCorporation (SRC), which owns short line railroad assets used to transport coaland limestone. AEE has entered into a contract with SRC pursuant to which SRCwill haul coal and limestone to the Somerset Plant and make its rail carsavailable to transport coal to the Cayuga Plant. AEE will pay amountssufficient to enable SRC to pay all of its operating and other expenses,including all out-of-pocket expenses, taxes, interest on and principal of SRC’soutstanding indebtedness, and all capital expenditures necessary to permit SRCto continue to provide rail service to the Somerset and Cayuga Plants. AEE hasconcluded that under the revised Financial Accounting Standards Board (FASB)interpretation No. 46(R)”Consolidation of Variable Interest Entities”, AEEneeds to consolidate SRC into its consolidated financial statements as of January 1,2004. (See Note 2)

 

In November 2000, AEEand ACR entered into a three-year agreement for energy marketing services withAES Odyssey, L.L.C. (“Odyssey”), a direct wholly-owned subsidiary of AES. In March 2002,a new agreement was reached, for a term of five years through February 28,2007, pursuant to which Odyssey provides data management, marketing,scheduling, invoicing and risk management services for a fee of $300,000 permonth. On September 4, 2003, AEE signed an amendment to their March 2002agreement. Odyssey will manage the AEE coal and environmental emission creditpositions for an additional fee of $100,000 per month. Odyssey acts as agent onbehalf of AEE and ACR in the over-the-counter and New York Independent SystemOperator(NYISO) markets. (see Note 7)

 

The AEE Plants sellgenerated electricity, as well as unforced capacity and ancillary services,directly into the markets operated by the NYISO system, Pennsylvania, NewJersey, Maryland (PJM) Interconnection and ISO New England. For Federalregulatory purposes, AEE and ACR are exempt wholesale generators (EWGs). AsEWGs, AEE and ACR cannot make retail sales of electricity, and can only makewholesale sales of electricity, unforced capacity, and ancillary services intowholesale power markets.

 

During the fourth quarter of2000, ACR placed the ACR Plants on long-term cold standby. The long-term coldstandby designation means that these Plants require more than 14 days to bebrought on-line. The Company is currently evaluating the future of thesePlants.

 

2.             SIGNIFICANTACCOUNTING POLICIES

 

Principles of Consolidation- The consolidated balance sheets include the accounts of the Company, AEE, SRCand ACR (including all subsidiaries). The balance sheets are presented on aconsolidated basis because the Company, as general partner, controls the operationsof AEE and ACR (Note 1). All material intercompany transactions have beeneliminated. The 99% limited partner ownerships of AEE and ACR are presented asminority interest.

 

The assets of the Company ona stand-alone basis at December 31, 2004 and 2003 (using the equity methodof accounting) consist only of the 1% ownership interest in AEE ($4,330,000 and$4,330,000,

 

64

----

 

respectively) and the 1%ownership interest in ACR ($32,000 and $32,000, respectively). The Company hadno liabilities as of December 31, 2004 and 2003, other than liabilities ofAEE, SRC and ACR for which it is responsible as General Partner of AEE and ACR.

 

Restricted Cash - Under theterms of the deposit and disbursement agreement entered into by AEE inconnection with the lease of two AEE plants (see Note 5), all revenues of AEEand its subsidiaries are deposited into a revenue account administered byDeutsche Bank (formerly Bankers Trust Company), as depositary agent. On requestof AEE and in accordance with the terms of the deposit and disbursementagreement, funds are transferred from the revenue account to other operatingaccounts administered by the depositary agent for payment of operating andmaintenance costs, lease obligations, debt service, reserve requirements, anddistributions. Payment of operating and maintenance costs (other than actualfuel costs) in excess of 125% of the annual operating budget is not permittedunder the terms of the lease documents. Amendments, modifications orreallocations of the annual operating budget that result in changes of 25%(positive or negative) in the amounts set forth in the annual operating budgetrequire confirmation from an independent engineer that such payment is based onreasonable assumptions.

 

Inventory - Inventory isvalued at the lower of cost (average cost basis) or market, and consists ofcoal and other raw materials used in generating electricity, and spare parts,materials, and supplies.

 

Inventory, as of December 31consisted of the following (in thousands):

 
| ** **                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|
| Coal and  other raw materials         |       | $        | 23,613     |     | $          | 12,329 |   |
| Spare parts,  materials, and supplies |       | 14,704   |       | 15,371   |       |
|                                  |       |     |       |     |       |
| Total                                 |       | $        | 38,317     |     | $          | 27,700 |   |

 

Property, Plant, Equipment,and Related Assets - Electric generation assets that existed at the date ofacquisition (see Note 3) were recorded at fair market value. The Somerset(formerly known as Kintigh) and Cayuga (formerly known as Milliken) Plants,which represent $650 million of the electric generation assets, are subject toa leasing arrangement accounted for as a financing (see Note 5). Additions orimprovements thereafter are recorded at cost. Depreciation is computed usingthe straight-line method over the 34-year and 28.5-year lease termsfor the Somerset and Cayuga Plants, respectively, and over the estimated usefullives for the other fixed assets, which range from 7 to 35 years. Maintenanceand repairs are charged to expense as incurred.

 

The Company is evaluatingthe future of the Jennison and Hickling plants and may dispose or shut downthese plants. As such, the electric generation assets of these two plants weredepreciated over two years (2001 and 2002) using the straight-line method. Maintenanceand repairs are charged to expense as incurred. During the fourth quarter of 2000, ACR placed the ACR Plants onlong-term cold standby. The long-term cold standby designation means that theseplants require more than 14 days to be brought on-line. The ACR Plants continueto generate revenue from the sales of environmental allowances which theyreceive from regulatory authorities.

 

Electric generation assetsas of December 31 consisted of the following:

 
| **Description of Asset**        | ** ** | **Depreciable Life** | ** ** | **Net Book Value  at December 31,  2004** | ** ** | **Net Book Value  at December 31,  2003** | ** ** |
|---------------------------------|------------|----------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                      | ** ** | ** **           | ** ** | **(in thousands)**                             | ** ** | **(in thousands)**                             | ** ** |
| Buildings                       |       | 35                   |       | $                                              | 2,488      |                                           | $          | 2,612 |   |
| Landfills                       |       | 5                    |       | 7,129                                          |       | 3,095                                          |       |
| General  Plant                  |       | 5-35                 |       | 830,848                                        |       | 859,970                                        |       |
| Office  Equipment               |       | 7                    |       | 339                                            |       | 183                                            |       |
| Leasehold  Improvements         |       | 5-34                 |       | 36,878                                         |       | 34,046                                         |       |
| Asset Retirement  Obligations   |       | 3-30                 |       | 2,962                                          |       | 2,757                                          |       |
| SRC Track &  Structure |       | 30                   |       | 18,363                                         |       | —                                         |       |
| SRC Freight  Cars               |       | 15                   |       | 5,211                                          |       | —                                         |       |
|                            |       |                 |       | $                                              | 904,218    |                                           | $          | 902,662 |   |

 

Rent Reserve Account - Aspart of AEE’s lease obligation (see Note 5), AEE is required to maintain a rentreserve account equal to the maximum semiannual payment with respect to the sumof basic rent (other than deferrable payments) and fixed charges expected tobecome due on any one basic rent payment date in the immediately succeedingthree-year period. As of December 31, 2004 and 2003, AEE had fulfilledthis obligation by entering into a Payment Undertaking Agreement, dated as of May 1,1999, among AEE, each Owner Trust (see Note 3) and Morgan Guaranty TrustCompany of New York (the Payment Undertaking Agreement). On May 14, 1999,AEE deposited with Morgan Guaranty Trust Company of New York approximately$28.7 million pursuant to the Payment Undertaking Agreement. The accreted valueof the Payment Undertaking Agreement at any time includes interest earned

 

65

----

 

thereunder at an interestrate of 4.79% per annum. Interest earnings as of December 31, 2004, 2003,and 2002 were approximately $1.5 million for each year, respectively, and areincluded in the rent reserve account balance. At December 31, 2004 and2003, the accreted value of the Payment Undertaking Agreement exceeded therequired balance of the rent reserve account. This amount is being accountedfor as a restricted cash balance and is included within the rent reserveaccount on the accompanying balance sheets, as it can only be utilized tosatisfy lease obligations. In the future, AEE may fulfill its obligation tomaintain the required balance of the rent reserve account either by depositsinto the rent reserve account or by making amounts available under the PaymentUndertaking Agreement, such that the aggregate amount of such deposits in therent reserve account and amounts available to be paid under the PaymentUndertaking Agreement are equal to the required balance of the rent reserveaccount.

 

Income Taxes - A provisionfor Federal and state income taxes has not been made in the accompanyingfinancial statements since the Company, AEE and ACR do not pay income taxes butrather allocate their revenues and expenses to the individual partners.

 

Use of Estimates - Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires the Company to makeestimates and assumptions that affect reported amounts of assets andliabilities and disclosures of contingent assets and liabilities at the date ofthe financial statements, as well as the reported amounts of revenues andexpenses during the reporting period. Actual results could differ from thoseestimates.

 

Derivative Instruments andHedging Activities - The Company accounts for derivative instruments andhedging activities in accordance with SFAS No. 133, “Accounting forDerivative Instruments and Hedging Activities”. The Statement requires that theCompany recognize all derivatives, as defined in the Statement, on the balancesheet at fair value. As of December 31, 2004, the Company has recorded$116.4 million in accumulated other comprehensive loss due to hedgingactivities.

 

AEE utilizesderivative financial instruments to hedge commodity price risk. AEE utilizeselectric derivative instruments, including swaps and forwards, to hedge therisk related to forecasted electricity sales over the next two years. Themajority of AEE’s electric derivatives are designated and qualify as cash flowhedges. AEEhas chosen to use the hypothetical derivative methodology for testing whetherits hedges meet the criteria to qualify for cash flow hedge accountingtreatment. A historical regression is performed between the AEE Plants’delivery points into the NYISO and the NYISO zones in which the hedges aresettled. Comparing the results of the historical regression and the actualchanges in the market value of the hedges determines if the hedges qualify forhedge accounting criteria treatment. No hedges were derecognized ordiscontinued during the year ended December 31, 2004. Hedgeineffectiveness is recognized in current period earnings during the year ended December 31,2004.

 

Approximately $80.9million of other comprehensive income is expected to be recognized as areduction to earnings over the next twelve months. Amounts recorded inAccumulated Other Comprehensive Income during the year ended December 31,2004, were as follows (in millions):

 
| Beginning Balance on January 1, 2004 |   | $      | (27.6  | ) |
|-------------------------------------------|--------|--------|--------|---|
| Reclassified  to earnings                 |   | 29.3   |   |
| Change in  fair value                     |   | (118.1 | )      |
| Balance, December 31,  2004          |   | $      | (116.4 | ) |

 

In addition tothe electric derivatives classified as cash flow hedge contracts, AEE had aTransmission Congestion Contract that was a derivative under the definition ofSFAS No. 133, but did not qualify for hedge accounting. Thiscontract, which expired in October 2004 and was not renewed, was recordedat fair value on the balance sheet with changes in the fair value recognizedthrough earnings. (See Note 6 - Transmission Agreements)

 

Revenue Recognition -Revenues from the sale of electricity are recorded based upon output deliveredand rates specified under contract terms. Gains and losses, generated from thehedging of future sales using commodity forwards, swaps and options, reportedin other comprehensive income, are reclassified to earnings in the periods inwhich earnings are impacted by the variability of the cash flows of the hedgeditem. The ineffective portions of the change in fair value of derivatives andthe change in the fair value of derivatives not designated as hedges foraccounting purposes are recognized in current period earnings. Revenues forancillary and other services are recorded when the services are rendered.

 

AssetRetirement Obligations - On January 1, 2003 the Company adopted SFAS No. 143,“Accounting for Asset Retirement Obligations”. SFAS No. 143, requiresentities to record the fair value of a legal liability for an asset retirementobligation in the period in which it is incurred.  The Company capitalized the costs of theliability by increasing the carrying amount of the related long-lived asset.The liability is accreted to its present value each period, and the capitalizedcost is depreciated over the useful life of the related asset. Upon settlementof the liability, the Company will settle the obligation for its recordedamount or incur a gain or loss upon settlement.

 

66

----

 

The Company’sasset retirement obligations’ primarily consist of active ash landfills andwater treatment basins. Upon adoption of SFAS No. 143, the Companyrecorded a liability of approximately $9.6 million and a net asset ofapproximately $3.3 million, which is included in electrical generation assets,and reversed a $4.2 million environmental remediation liability previouslyrecorded (see Note 3). The difference of the amounts previously recorded andthe net SFAS 143 liability is a loss recorded as the cumulative effect of achange in accounting principle of $2.2 million. Reconciliation of the assetretirement obligation liability for the year ending December 31, 2004 wasas follows (in millions):

 
| ** **                    | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Balance as  of January 1 |       | $        | 10.3       |     | $          | 9.6 |   |
| Accretion                     |       | 0.8      |       | 0.7      |       |
| Revision to  cash flow        |       | 0.8      |       | —   |       |
| Balance, December 31     |       | $        | 11.9       |     |       | 10.3 |   |

 

Stock-Based Compensation -In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-BasedCompensation - Transition and Disclosure.” SFAS No. 148 amends SFAS No. 123,“Accounting for Stock-Based Compensation” to provide alternative methods oftransition for a voluntary change to the fair value based method of accountingfor stock-based employee compensation. In addition, this Statement amends thedisclosure requirements of SFAS No. 123 to require prominent disclosuresin both annual and interim financial statements about the method of accountingfor stock-based employee compensation and the effect of the method used onreported results. The Partnership expects to use the prospective method totransition to the fair value based method of accounting for stock-basedemployee compensation. All employee awards granted, modified, or settledafter January 1, 2003, will be recorded using the fair value based methodof accounting (See Note 9). The Company’s adoption of the prospective method ofaccounting for stock-based employee compensation did not have any material impacton its financial position or results of operations. 

 

New AccountingPronouncements

 

Variable InterestEntities - In January 2003, the FASB issued FASB Interpretation No. (FIN)46, “Consolidation of Variable Interest Entities” which provides guidance onhow to identify a variable interest entity (VIE), and when the assets,liabilities, noncontrolling interests and results of operations of a VIE needto be included in a company’s consolidated financial statements. Thisinterpretation was revised in December 2003 with the issuance of FIN46(R), “Consolidation of Variable Interest Entities”.

 

In general, a VIE is anentity that lacks sufficient equity or its equity holders lack adequatedecision making ability. If either of these characteristics is present, theentity is subject to a variable interests consolidation model, andconsolidation is based on variable interests, not on ownership of the entity’soutstanding voting stock. Variable interests are defined as contractual,ownership, or other money interests in an entity that change with fluctuationsin the entity’s net asset value. The primary beneficiary consolidates the VIE;the primary beneficiary is defined as the enterprise that absorbs a majority ofexpected losses or receives a majority of residual returns (if the losses orreturns occur), or both.

 

On January 1, 2004, AEEadopted FIN 46(R) and concluded that under FIN 46(R) AEE needs to consolidateSRC into its consolidated financial statements. AEE’s consolidated balancesheet as of December 31, 2004 reflects additional assets of approximately$25.6 million and liabilities of approximately $17.3 million as a result ofthis consolidation. Since SRC is owned by another affiliate of AES, the Company’sconsolidated balance sheets show such ownership as minority interest.

 

Share-BasedPayment - In December 2004,the FASB issued a revised SFAS No.123 (“SFAS No. 123R”), “Share-BasedPayment”, which is a revision of SFAS No. 123. SFAS No. 123Reliminates the intrinsic value method under APB 25 as an alternative method ofaccounting for stock-based awards by requiring that all share-based payments toemployees, including grants of stock options for all outstanding years berecognized in the financial statements based on their fair values. It alsorevises the fair-value based method of accounting for share-based paymentliabilities, forfeitures and modifications of stock-based awards and clarifiesSFAS No. 123’s guidance related to measurement of fair value, classifyingan award as equity or as a liability and attributing compensation to reportingperiods.  In addition, SFAS No. 123R amends SFAS No. 95, “Statementof Cash Flows”, to require that excess tax benefits be reported as a financingcash flow rather than as an operating cash flow.

 

The Company is required toadopt SFAS No. 123R for the interim period beginning July 1, 2005using a modified version of prospective application.  The Company mayapply a modified retrospective application to periods before the requiredeffective date.  The Company plans to adopt SFAS No. 123R no laterthan July 1, 2005, but has not determined what method it willuse. The Company is currently evaluating the effect of adoption of SFAS No. 123R,but does not expect the adoption to have a material effect on our financialcondition, results of operations or cash flows, as the Company had previouslyadopted income statement treatment for compensation related to share-basedpayments under SFAS No. 123.

 

Reclassifications - Certainprior period amounts have been reclassified on the consolidated financialstatements to conform with the 2004 presentation.  This includes a reclass of amounts related tothe Transmission Congestion Contract and Derivatives from Long-term to currentliabilities at December 31, 2003.

 

67

----

 

3.             ACQUISITION

 

On May 14, 1999, AEE’sfour Plants were acquired from NYSEG for approximately $914 million. AEEacquired ownership of two of the Plants, Westover and Greenidge. The other twoPlants, Somerset and Cayuga, were acquired for $650 million by twelve unrelatedthird-party owner trusts (collectively, the Owner Trusts) organized by threeunrelated institutional investors. Simultaneously, AEE entered into separateleasing agreements for the Somerset and Cayuga Plants with the Owner Trusts.The Company accounts for these leases as a financing (see Note 5).

 

The acquisition of the AEEPlants was financed by capital contributions from the Company and the LimitedPartner in an aggregate amount equal to the purchase price for the Plants,certain associated costs and expenses, and certain amounts for working capitalless the net proceeds from the leasing transactions with respect to theSomerset and Cayuga Plants described above. The acquisition has been accountedfor as an asset purchase.

 

In connection with theacquisition of the AEE Plants, NYSEG engaged an environmental consulting firmto perform an environmental analysis of the potential required remediations forsoil and ground water contamination. AEE engaged another environmentalconsulting firm to evaluate the costs estimated by NYSEG’s consultants. Theenvironmental analysis and AEE’s estimate of other environmental remediationcosts indicated that there existed a range of potential remediation costs ofbetween $8.5 million and $19.7 million, with a most probable liability ofapproximately $12.2 million. AEE recorded $12.2 million as an undiscountedliability under purchase accounting for the projected remediation cost. In 2001and 2002, AEE reduced its undiscounted liability by approximately $587,000 and$2.2 million, respectively, as remediation was completed or more currentestimates were received for lower than the amounts previously estimated. On January 1,2003, $4.2 million of this environmental remediation liability was reclassifiedinto the asset liability obligation in accordance with SFAS No. 143. As ofDecember 31, 2004, $332,000 of the liability which pertains to the pendingNYSDEC opacity consent (Note 6) order is classified as a current liability, theremaining $4.8 million is classified as long-term.

 

Also, in connection withthis transaction, ACR acquired from NYSEG two older coal-fired plants, Jennisonand Hickling (Note 1). An environmental liability of $2.6 million was recordedin connection with this acquisition, which represented the most probableliability based on a range calculated by NYSEG’s environmental consultants andreviewed by other environmental consultants hired by ACR. In 2002, ACR reducedits undiscounted liability by $900,000 as remediation was completed. As of December 31,2004, none of the liability was classified as a current liability, theremaining $1.7 million is classified as longterm.

 

4.             CAPITALIZATION

 

The Company is indirectlyowned by AES New York Funding, L.L.C. (AES Funding), which is a special purposefinancing vehicle established to raise a portion of the capital contributed toAEE and ACR through the Company and the Limited Partner. AES Funding is adirect wholly owned subsidiary of AES.

 

On November 30, 2001,AES Funding entered into a thirty-nine month loan agreement with a syndicate offinancial institutions and institutional lenders, with Citibank, N.A. as Agent,in the amount of $300 million.  Theproceeds were used to refinance in full the debt outstanding under the originalLoan Agreement dated May 11, 1999. Collateral for the loan includes apledge of AES common stock.

 

On July 23, 2002, AESannounced that AES Funding had amended the thirty-nine month loan agreement inthe amount of $300 million. The amendment capped the number of shares of AEScommon stock required to be pledged to secure the loan. The amendment also providesthat the loan will be prepaid in part ($75 million) no later than December 15,2002. The prepayment was paid on September 9, 2002.

 

On July 29, 2003, AESamended and restated its senior secured bank credit facilities.  Asamended and restated, the credit facilities provide for a $250 millionrevolving loan and letter of credit facility and a $700 million term loanfacility. The total amount of credit available under the amendedfacilities was increased by $135 million.  This increase, together with cashon hand, was used to repay in full the outstanding balance of the AES Fundingloan, resulting in the release of the unregistered common stock of AES andother collateral that secured such loan.

 

Collateral for the loan alsoincluded a pledge of the membership interests of AES New York Holdings, L.L.C.,a direct wholly owned subsidiary of AES Funding, which is the 100% direct ownerof both the General Partner and the Limited Partner.

 

5.             DEBT

 

AEE’s leases for theSomerset and Cayuga Plants are accounted for as a financing (see Note 3).Minimum lease payments and the present value of the lease obligations are as follows(in thousands):

 

68

----

 
| **Fiscal Years ending December 31,** | ** ** | **Principal  Portion** | ** ** | **Interest  Imputed** | ** ** | **Lease  Payments** | ** ** |
|-------------------------------------------|------------|------------------------|------------|-----------------------|------------|---------------------|------------|
|                                      |       |                   |       |                  |       |                |       |
| 2005                                      |       | $                      | 4,411      |                  | $          | 55,039              |       | $ | 59,450 |   |
| 2006                                      |       | 6,898                  |       | 54,652                |       | 61,550              |       |
| 2007                                      |       | 8,495                  |       | 54,005                |       | 62,500              |       |
| 2008                                      |       | 9,256                  |       | 53,244                |       | 62,500              |       |
| 2009                                      |       | 10,086                 |       | 52,414                |       | 62,500              |       |
| Thereafter                                |       | 590,669                |       | 536,504               |       | 1,127,173           |       |
| Total minimum  lease payments             |       | 629,815                |       | 805,858               |       | 1,435,673           |       |
|                                      |       |                   |       |                  |       |                |       |
| Less imputed  interest                    |       |                   |       |                  |       | (805,858            | )          |
|                                      |       |                   |       |                  |       |                |       |
| Present  value of minimum lease payments  |       |                   |       |                  |       | $                   | 629,815    |   |
|                                      |       |                   |       |                  |       |                |       |
| Less current  portion                     |       |                   |       |                  |       | (4,411              | )          |
| Lease  financing - long term              |       |                   |       |                  |       | $                   | 625,404    |   |
|                                           |            |                        |            |                       |            |                     |            |  |  |  |

 

Through July 2, 2020,and so long as no lease event of default exists, a portion of the rent payableunder each lease may be deferred until after the final scheduled payment of thedebt incurred by the Owner Trusts to acquire the Somerset and Cayuga Plants. Asof December 31, 2004, AEE has not deferred any portion of the leaseobligations.

 

The lease obligations arepayable to the Owner Trusts. These obligations bear imputed interest at 9.252%and 9.024% for the Somerset and Cayuga Plants, respectively. Total assets underthe leases of these two Plants were $650 million at December 31, 2004.These amounts are included in electric generation assets.  The related accumulated depreciation,combined for both leased Plants, as of December 31, 2004 and 2003, wasapproximately $113.3 million and $92.9 million, respectively.  The agreements governing the leases restrictAEE’s ability to incur additional indebtedness, engage in other businesses,sell its assets, or merge with another entity. The ability of AEE to makedistributions to its partners is restricted unless certain covenants, includingthe maintenance of certain coverage ratios, are met. In connection with thelease agreements, AEE is required to maintain an additional liquidity account.The required balance in the additional liquidity account was initially equal tothe greater of $65 million less the balance in the rent reserve account on May 14,1999 (see Note 2) or $29 million. As of December 31, 2004, AEE hadfulfilled its obligation to fund the additional liquidity account byestablishing a letter of credit, issued by Bank of America (formerly FleetBank) dated May 14, 1999, in the stated amount of approximately $36million (the Additional Liquidity Letter of Credit). This letter of credit wasestablished by AES for the benefit of AEE. However, AEE is obligated toreplenish or replace this letter of credit in the event it is drawn upon orneeds to be replaced.

 

An aggregate amount inexcess of $65 million is available to be drawn under the Payment UndertakingAgreement (see Note 2) and the Additional Liquidity Letter of Credit for makingrental payments. In the event sufficient amounts to make rental payments arenot available from other sources, a withdrawal from the additional liquidityaccount (which may include making a drawing under the Additional LiquidityLetter of Credit) and from the rent reserve account (which may include making ademand under the Payment Undertaking Agreement) may be made for rentalpayments.

 

The leases for Somerset andCayuga expire on February 13, 2033 and November 13, 2027,respectively.

 

On August 14,2000, SRC entered into a $26 million credit facility with Fortis Capital Corp. whichreplaced in its entirety a credit facility for the same amount previously providedto SRC by an affiliate of CIBC World Markets. The new credit facility providedby Fortis Capital Corp. consists of a 14-year term note (maturing on May 6,2014), with principal and interest payments due quarterly. (inthousands):

 
| **Fiscal Years ending December 31,** | ** ** | **Principal  Portion** | ** ** |
|-------------------------------------------|------------|------------------------|------------|
|                                      |       |                   |       |
| 2005                                      |       | $                      | 1,857      |   |
| 2006                                      |       | 1,857                  |       |
| 2007                                      |       | 1,857                  |       |
| 2008                                      |       | 1,857                  |       |
| 2009                                      |       | 1,857                  |       |
| Thereafter                                |       | 8,358                  |       |
| Total  minimum lease payments             |       | 17,643                 |       |
|                                      |       |                   |       |
| Less current  portion                     |       | 1,857                  |       |
| Lease  financing - long term              |       | $                      | 15,786     |   |

 

69

----

 

6.             COMMITMENTSAND CONTINGENCIES

 

Coal Purchases - Inconnection with the acquisition of AEE’s four Plants, AEE assumed from NYSEG anagreement to purchase the coal required by the Somerset and Cayuga Plants. Thetermination date for the contract was December 31, 2003. The agreement wasnot extended.

 

As of the acquisition dateof the Plants, the contract prices for the coal purchased through 2002 wereabove the market price, and AEE recorded a purchase accounting liability forapproximately $15.7 million related to the fulfillment of its obligation topurchase coal under this agreement.  Thepurchase accounting liability was amortized as a reduction to coal expense overthe life of the contract. As of December 31, 2002, the purchase accountingliability was fully amortized.

 

AEE has expected coalpurchases, composed of short and medium term contracts with various suppliers,ranging between $100.1 million and $110.4 million and $78.8 million and $86.9 millionfor 2005 and 2006, respectively.

 

Transmission Agreements - OnAugust 3, 1998, the Company entered into an agreement for the purpose oftransferring certain rights and obligations from NYSEG to the Company under anexisting transmission agreement among Niagara Mohawk Power Corporation (NIMO),the New York Power Authority, NYSEG, and Rochester Gas & ElectricCorporation, and an existing transmission agreement between NYSEG and NIMO.This agreement provides for the assignment of rights to transmit energy fromthe Somerset Plant and other sources to remote load areas and other deliverypoints, and was assumed by AEE on the date of acquisition of the Plants. Inaccordance with its plan as of the acquisition date, AEE discontinued usingthis service. AEE did not intend to transmit over these lines and was requiredto pay the current fees until the effective cancellation date, November 19,1999.

 

AEE was informed by NIMOthat AEE would be responsible for the monthly fees of $500,640 under theexisting transmission agreement to the originally scheduled termination date ofOctober 1, 2004. On October 5, 1999, AEE filed a complaint againstNIMO alleging that AEE has a right to non-firm transmission service upon sixmonths prior notice without payment of $500,640 in monthly fees subsequent tothe cancellation date of November 19, 1999. On March 9, 2000, asettlement was reached between AEE and NIMO, which was subsequently approved bythe Federal Energy Regulatory Commission (FERC). According to the settlement,AEE paid NIMO a fixed rate of $500,640 per month during the period of November 20,1999 to October 1, 2004, and in turn, received a form of transmissionservice commencing on May 1, 2000. AEE had the right under a Remote LoadWheeling Agreement (RLWA) to transmit 298 MW over firm transmission lines fromthe Somerset Plant. AEE had the right to designate alternate points of deliveryon NIMO’s transmission system provided that AEE was not entitled to receive anytransmission service charge credit on the NIMO system.

 

The contractwas accounted for as a derivative under SFAS No. 133. The transmissioncontract was entered into because it provided a reasonable settlement forresolving a FERC issue. The agreement was essentially a swap between thecongestion component of the locational prices posted daily by the NYISO inwestern New York and the more heavily populated areas in eastern New York. Theagreement was a financially settled contract since there was no requirement toflow power under this agreement.  Theagreement generated gains or losses from exposure to shifts or changes inmarket prices. AEE recorded losses of approximately $3.8 million and $6.2million and a gain of $8.9 million for the years ended December 31, 2004,2003 and 2002, respectively, related to this contract.

 

On June 25, 2003, AESSomerset L.L.C. filed a complaint against NIMO with the FERC. The complaintinvolved outstanding station service charges for the period April 2000 to May 2003.The Plant calculated that the outstanding charges owed were $290,000, whileNIMO calculated that the outstanding charges were $3.6 million. In December 2003,FERC reiterated its 2001 ruling that independent power plants can net stationservice power, in the Somerset and Nine Mile orders. NIMO is appealing the ruling.As of December 31, 2004, AES Somerset had accrued approximately $1.6million for these charges.

 

Line of CreditAgreement - In April 2001, AEE entered into a $35 million securedrevolving working capital and letter of credit facility with Union Bank ofCalifornia, N.A. This facility had a term of approximately twenty-one months.AEE could borrow up to $35 million for working capital purposes under thisfacility. In addition, AEE could have letters of credit issued under thisfacility up to $25 million, provided that the total amount of working capitalborrowings and letters of credit issuances could not exceed the $35 millionlimit on the entire facility. Through December 31, 2003, there were threeborrowings under this facility. The first borrowing was for $7 million on July 13,2001 at an interest rate of 8.125%. The borrowing was repaid in full on July 31,2001. The second borrowing was for $8.5 million on January 11, 2002 at aninterest rate of 6.125%. The borrowing was repaid in full on February 28,2002. The third borrowing was for $14.0 million on July 9, 2002, at aninterest rate of 6.125%.  AEE repaid theborrowing in two installments: $7.2 million on July 31, 2002 and $6.8million on August 28, 2002.

 

On November 20, 2002,AEE signed an agreement with Union Bank of California, N.A. for a one- yearextension of the working capital and letter of credit facility. On April 16,2003, AEE signed an amendment to its November 20, 2002 credit agreementwith Union Bank of California, N.A. The amendment included another one-yearextension of the current facility, which extended the maturity date of theworking capital and letter of credit facility to January 2, 2005. The amendmentalso increased Union Bank of California’s commitment from $15 million to $20million. On

 

70

----

 

April 25, 2003, AEEfurther amended its November 20, 2002 credit agreement with Union Bank of California,N.A. The amendment included a commitment from Citibank, N.A. for the remaining$15 million of the facility.  There werefour borrowings under this facility. The first borrowing was for $9.7 millionon January 10, 2003 at an interest rate of 5.75%. This borrowing wasrepaid in full on January 28, 2003. The second borrowing was for $9.7 millionon July 9, 2003 at an interest rate of 5.5%. This borrowing was repaid infull on July 25, 2003. The third borrowing was for $12.9 million and anadditional $1 million on January 9, 2004 and February 20, 2004, respectively,at an interest rate of 5.5%. This borrowing was repaid in two payments, $6.2million on January 27, 2004 and the remaining balance of $7.7 million wasrepaid on February 26, 2004. The fourth borrowing was for $14.3 million onJuly 9, 2004 at an interest rate of 5.75%. This borrowing was repaid infull on July 26, 2004.

 

AES on January 6,2003 and February 25, 2003 authorized AEE to issue letters of credit tocounter-parties on its $350 million senior secured revolving credit facility tothe amount of $25 million and $35 million for the years of 2003 and 2004,respectively.

 

On February 12,2004, AEE signed a two-year agreement, effective January 1, 2004 (AESLetter of Credit Agreement), with AES to obtain up to $35 million and $25million of letters of credit or cash collateral for 2004 and 2005,respectively. This agreement superseded the authorization of AES on February 25,2003. The agreement limited the letters of credit amounts and cash collateralto the stated amounts and set into place a fee structure and repayment terms.As of December 31, 2003, AEE had obtained letters of credit in the amountof $4.6 million, which have been provided as additional margin to supportnormal, ongoing hedging activities with a number of counterparties.

 

On October 26, 2004,AEE and AES agreed to terminate the commitment of AES to provide letters ofcredit and cash collateral for the benefit of AEE under the AES Letter ofCredit Agreement.

 

Pursuant to the AES Letterof Credit Agreement, AES had agreed to provide, or cause to be provided, to AEEletters of credit and cash collateral to counterparties to support AEE’sobligations arising in connection with AEE’s sale of electricity. AES agreedthat the maximum amount of letters of credit and cash collateral that AES wouldprovide, or cause to be provided, pursuant to the AES Letter of CreditAgreement would be $95 million from April 28, 2004 until December 31,2004 and $60 million from January 1, 2005 until December 30, 2005. OnOctober 14, 2004, the AES Board of Directors passed a resolution regardingextension of authorized credit support for AEE. The Board of Directors resolvedto authorize AES to extend AEE use of $95 million in letter of credit capacitythrough December 31, 2006. As of December 31, 2004, AEE had obtainedletters of credit in the amount of $58.9 million, which have been provided asadditional margin to support normal, ongoing hedging activities with a numberof counterparties.

 

The termination of AES’scommitment under the AES Letter of Credit Agreement does not affect outstandingauthorizations of letters of credit or cash collateral. AEE remains obligatedto perform its responsibilities under the AES Letter of Credit Agreement withrespect to any outstanding letters of credit or cash collateral agreementsuntil the earlier of such time as AEE replaces such outstanding letters ofcredit or cash collateral agreements or the stated expiration date of suchletters of credit or cash collateral agreements shall occur.

 

AES is not obligated toprovide any such letters of credit in the future and will review any requestfor the issuance of an authorization for such letters of credit on a case bycase basis and may refuse any request for the issuance of such letters ofcredit for any reason, or for no reason.

 

On October 26, 2004,AEE entered into an Amended and Restated Credit Agreement with Calyon New YorkBranch and the Banks and the Issuing Banks named therein (the Calyon CreditFacility). Also on October 26, 2004, Calyon New York Branch purchased theoutstanding loans made under AEE’s existing $35,000,000 credit facility, datedas of April 10, 2001, as amended, and the unreimbursed drawings underletters of credit issued under the existing credit facility.  In addition, Calyon New York Branch assumedall of the rights and obligations of the banks under the existing creditfacility including the commitments of such banks to make loans and issueletters of credit.

 

Under the Calyon CreditFacility, the Banks have agreed, from time to time until January 28, 2008,to make loans to and issue letters of credit on behalf of AEE.  The maximum aggregate principal amount ofloans, outstanding letters of credit and unreimbursed drawings under letters ofcredit issued under the Calyon Credit Facility which may be at any one timeoutstanding initially was $35 million (and was increased to $75 million whensubsequent approval by the New York State Public Service Commission wasobtained on November 10, 2004).  AEEmay borrow, pay or prepay and reborrow loans.

 

Loans may, at the option ofAEE, be made under the Calyon Credit Facility as Base Rate Loans or EurodollarRate Loans or any combination thereof. Base Rate Loans bear interest at aninterest rate per annum equal to the sum of (1) the higher of (a) thePrime Rate announced by Calyon New York Branch from time to time in effect and (b) thesum of the Federal Funds Rate in effect plus 0.50%, plus (2) an applicablemargin of 0.75% until October 26, 2006 and 1% thereafter. Eurodollar RateLoans bear interest at an interest rate per annum (rounded upwards, if necessary,to the nearest whole multiple of 1/100 of 1%) equal to the sum of (1) theLondon interbank offered rate for deposits in Dollars two business days priorto the first day of an Interest Period (a period of one, two, three or sixmonths selected by AEE) for a term comparable to such Interest Period, plus

 

71

----

 

(2) an applicablemargin of 1.75% until October 26, 2006 and 2% thereafter. As of December 31,2004, of the $75 million committed, AEE had obtained letters of credit of $51.6million, which have been provided as additional margin to support normal,ongoing hedging activities with a number of counterparties.

 

The obligations of AEE underthe Calyon Credit Facility are secured by AEE’s pledge of the membershipinterests in AEE’s wholly owned subsidiary, AEE2, L.L.C. (which owns theWestover and Greenidge Plants), as well as AEE2, L.L.C.’s wholly ownedsubsidiaries, AES Westover, L.L.C. (which operates the Westover Plant) and AESGreenidge, L.L.C. (which operates the Greenidge plant).

 

On October 3, 2002,Standard & Poor’s lowered its rating on AEE’s $550 million passthrough trust certificates and $35 million working capital and letter of creditfacility to BB+ from BBB-  solely due toAEE’s rating linkage to AES. The rating was also placed on CreditWatch withnegative implications. (see Note 3)

 

Environmental- The Company has recorded a liability for environmental remediation associatedwith the acquisition of the Plants (see Note 3). On an ongoing basis, theCompany monitors its compliance with environmental laws. Because of theuncertainties associated with environmental compliance and remediationactivities, future costs of compliance or remediation could be higher or lowerthan the amount currently accrued.

 

AEE received an informationrequest letter dated October 12, 1999 from the New York Attorney General,which sought detailed operating and maintenance history for the Westover andGreenidge Plants. On January 13, 2000, AEE received a subpoena from NewYork State Department of Environmental Conservation (NYSDEC) seeking similaroperating and maintenance history from the Plants. This information was soughtin connection with the Attorney General’s and the NYSDEC’s investigations ofseveral electricity generating stations in New York that were suspected ofundertaking modifications in the past without undergoing an air permittingreview.

 

On April 14, 2000, AEEreceived a request for information pursuant to Section 114 of the CleanAir Act from the U.S. Environmental Protection Agency (EPA) seeking detailedoperating and maintenance history data for the Cayuga and Somerset Plants. TheEPA has commenced an industry-wide investigation of coal-fired electric powergenerators to determine compliance with environmental requirements under theClean Air Act associated with repairs, maintenance, modifications andoperational changes made to coal-fired facilities over the years. The EPA’sfocus is on whether the changes were subject to new source review or new sourceperformance standards, and whether best available control technology was orshould have been used. AEE has provided the requested documentation.

 

By letter dated May 25,2000, the NYSDEC issued a Notice of Violation (NOV) to NYSEG for violations ofthe Clean Air Act and the New York Environmental Conservation Law at theGreenidge and Westover Plants related to NYSEG’s alleged failure to obtain anair permitting review for repairs and improvements made during the 1980s and1990s, which was prior to the acquisition of the Plants by AEE. Pursuant to thepurchase agreement relating to the acquisition of the Plants from NYSEG, AEEagreed to assume responsibility for environmental liabilities that arose whileNYSEG owned the Plants. On September 12, 2000, AEE agreed with NYSEG thatAEE would assume the defense of and responsibility for the NOV, subject to areservation of its right to assert applicable exceptions to its contractualundertaking to assume preexisting environmental liabilities.

 

On January 11, 2005,three subsidiaries which AEE controls and two subsidiaries controlled by ACR (AESEntities) entered into a consent agreement to settle all outstanding NOVs andcivil claims that could have been brought by the State of New York against theAES Entities and NYSEG for the alleged violations of the new source review andnew source performance standard provisions of the Clean Air Act and itsapplicable regulations, similar provisions under the New York Environmental ConservationLaw and its applicable regulations, common law, and State Executive Law(Consent Decree). The Consent Decree is expected to be entered by the UnitedStates District Court for the Western District of New York after completion ofa public comment period and a separate 45 day period in which the FederalGovernment may submit comments.  TheFederal Government also has the opportunity to intervene in the case. TheConsent Decree will become effective when it is entered by the Court. Under theterms and conditions of the Consent Decree, upon entering into effect, theState of New York covenants not to sue and releases the AES Entities and NYSEGfrom alleged violations under the Clean Air Act and regulations and alsocovenants not to sue or bring any administrative enforcement actions against theparticipating subsidiaries for claims under the above-mentioned air emissionlaws and regulations associated with work required pursuant to the ConsentDecree or other changes at the Plants commenced after entry of the ConsentDecree, but prior to December 31, 2009 and completed by December 31,2010.  Under the Consent Decree, the AESEntities have agreed to pay a $700,000 civil penalty for the violationsassessed to NYSEG and will deposit $1,000,000 in an AES Environmental MitigationProject Account that will be used to carry out one or more projects pertainingto energy efficiency, renewable energy and/or clean air projects that areapproved by the NYSDEC and the Office of the Attorney General. The ConsentDecree does not address the Somerset and Cayuga Plants, and it is possible thatthese two Plants may be subject to a separate enforcement action filed eitherby the United States Environmental Protection Agency, NYSDEC, or the New YorkState Attorney General.

 

The Consent Decree setsforth mandated emission reductions and requires the installation of new emissioncontrol technologies on certain units or the repowering of or the ceasing ofoperations of such units. On Greenidge Unit 4, we are obligated to controlsulfur dioxide (SO2) and nitrogen oxide (NOx) emissions through amulti-pollutant control clean coal project (“MCP Project”). This

 

72

----

 

obligation is subject to thepartial funding of the MCP Project by the U.S. Department of Energy and theabsence of any force majeure event or material adverse change in circumstancesthat affects the economic viability of the MCP Project. The AES Entities arerequired to commence initial operation of the MCP Project by September 1,2006 or a date eighteen months after entry of the Consent Decree, whichever islater.  The AES Entities are alsoobligated to use good faith efforts to meet certain NOx emission rates andachieve a certain SO2 removal efficiency during normal operations on GreenidgeUnit 4. If the MCP Project on Greenidge Unit 4 is discontinued, the AESEntities are required by December 31, 2009 either to (i) installcontrol technology that will meet the Consent Decree emission limits, (ii) repowerwith a non-coal fuel source or (iii) cease operations.

 

On Westover Unit 8, the AESEntities are obligated under the Consent Decree to take one of the followingthree actions by December 31, 2009 and to notify the NYSDEC of whichaction they elect to take by June 1, 2007: (i) control NOx and SO2 using technology similar to the MCP Projecton Greenidge Unit 4, (ii) repower with a non-coal fuel source or (iii) ceaseoperations.  Beginning in 2005 andlasting through 2009, Westover Unit 8 is subject to a declining SO2 emissionscap that starts with a cap in 2005 and declines per year until 2009.  Should they elect to install emission controltechnology on Westover Unit 8 by December 31, 2009, then they areobligated under the Consent Decree to use good faith efforts to meet a certainNOx emissions rate and a certain SO2 removal efficiency.

 

Under the Consent Decree,Greenidge Unit 3 and Westover Unit 7 are required either to (i) install controltechnology equivalent to Best Available Control Technology or BACT, (ii) berepowered with a non-coal fuel, or (iii) cease operations, no later than December 31,2009.  During the years 2007, 2008, and2009, these two units will be subject to an annual operating limit of 1,400hours with an SO2 emission rate of 3.0 lb/mmBtu. Hickling Units 1 and 2 andJennison Units 1 and 2 are each required either to (i) install BACT-equivalentcontrol technology, (ii) repower using a non-coal fuel or (iii) ceaseoperations no later than May 1, 2007. The Consent Decree does allow the AESEntities to use up to a 30% blend of sub-bituminous (reduced sulfur) coal ateither the Greenidge or Westover Plants.

 

The Consent Decree alsorequires the surrender of federal Acid Rain Program SO2 allowances for GreenidgeUnits 3 and 4 and Westover Units 7 and 8 starting in the year 2012.  The amount of allowances that will besurrendered depends on which compliance option we ultimately select for theseunits.

 

In the event that the AESEntities fail to comply with one or more terms of the Consent Decree, the AESEntities are obligated to pay stipulated penalties that are set forth in theConsent Decree with the exception of noncompliance due to force majeure eventsor certain material adverse conditions affecting the economic viability of theMCP Project.  Upon achieving compliancewith the material requirements of the Consent Decree, then the parties to thesettlement may petition the court for termination of the Consent Decree.  The Company expects that the emissionreduction and control technology requirements set forth in the Consent Decreewill be incorporated into each Plant’s Title V air operating permit.

 

AEE has projected that itsshare of the capital costs to install the MCP Project at Greenidge Unit 4 willbe approximately $29 million, however, there can be no assurance that this willbe the actual cost since AEE has not entered into an agreement for engineering,procurement and construction of the MCP Project at Greenidge Unit 4.

 

At this time, the Companyhas not made decisions regarding the options of either installing pollutioncontrol technology, repowering or ceasing operations at the other units subjectto the terms of the Consent Decree, and thus the Company is unable to projectthe potential costs associated with complying with the other provisions of theConsent Decree its financial condition or the effect on future operations.

 

The EPA is not a signatoryto the Consent Decree, and it is possible that EPA could separately issue us aNOV for alleged violations of the federal Clean Air Act and federallyenforceable New York air regulations associated with suspected pastmodifications of plant equipment without undergoing an air permittingreview.  If EPA does file an enforcementaction against Greenidge, Westover, Hickling or Jennison, then penalties may beasserted and further emission reductions might be necessary which could requireus to make substantial expenditures. The Company is unable to estimate theeffect of any EPA-issued NOV on its financial condition or results of future operations.

 

Nitrogen Oxide and SulfurDioxide Emission Allowances -The AEE and ACR Plants emit NOx and SO2 as aresult of burning coal to produce electricity.

 

The six Plants have beenallocated allowances by the NYSDEC to emit NOx during the ozone season, whichruns from May 1 to September 30. Each NOx allowance authorizes theemission of one ton of NOx during the ozone season. If NOx emissions exceed theallowance amounts allocated to the six Plants, then the Company may need topurchase additional allowances on the open market or otherwise reduce itsproduction of electricity to stay within the allocated amounts. New York Stateand the other states in the Mid-Atlantic and Northeast region are classified asthe Ozone Transport Region in the federal Clean Air Act, which designates theOzone Transport Region as not being in compliance with the ozone NationalAmbient Air Quality Standard. The states in the Ozone Transport Region haveagreed to implement a three phase process to reduce NOx emissions in the regionin order to comply with the federal Clean Air Act Title I requirements forozone non-compliance areas. Implementation of Phase III emission rules commencedon May 1, 2003. The Phase III emission rules have

 

73

----

 

been superseded by thetransition to the federal NOx SIP Call rule, which imposes NOx ozone seasonemission reduction requirements through an allowance system similar to thePhase III emission rules.  Under the NOxSIP Call rule, electric generating facilities in 21 Northeast and Mid-Atlanticstates and the District of Columbia are required to hold allowances sufficientto cover the ozone season NOx emissions emitted by such facilities.  Each of the Plants is subject to the NOx SIPCall rule, and the six Plants have been allocated 2,492 NOx allowances for the2005 ozone season.  The NOx SIP Callprogram commenced on May 31, 2004. The six Plants were net sellers of NOxallowances in 2002. The six Plants had shortfalls of approximately 1,020 and1,200 NOx allowances in 2004 and 2003, respectively. The 2003 shortfall wascovered by purchasing 70 NOx allowances from AES Ironwood, an indirect whollyowned subsidiary of the AES Corporation, at market prices and the remainder of2003 and 2004 shortfall NOx allowances were purchased from unrelated companiesin the open market at market price.

 

The six Plants are alsosubject to SO2 emission allowance requirements imposed by the EPA. Each SO2allowance authorizes the emission of one ton of SO2 during the calendar year.SO2 allowances may be bought, sold, or traded. If SO2 emissions exceed theallowance amounts allocated to the six Plants, then the Company may need topurchase additional allowances on the open market or otherwise reduce itsproduction of electricity to stay within the allocated amounts. The six Plantshad shortfalls of approximately 600, 10,000 and 1,000 SO2 allowances in 2002,2003 and 2004, respectively. In 2002, ACR sold approximately 6,000 SO2allowances to the AEE Plants at market prices, then sold on the open market,the remaining SO2 allowances through 2009. The 2003 and 2004 allowanceshortfall was covered by purchasing SO2 allowances at market prices fromunrelated companies in the open market.

 

In October 1999, NewYork State Governor Pataki announced an executive order mandating additional emissionreductions from New York State power plants. The Governor’s initiative requiresnon-ozone season NOx emission reductions based on an emission rate of 0.15lbs/Mmbtu starting in 2004, and a 50% reduction from the power plants’ Title IVSO2 emissions being phased in from 2005 to 2008. The program will beimplemented through a market-based mechanism. The rules implementing theGovernor’s initiative (6 NYCRR Parts 237 and 238) were adopted in March 2003.

 

In September 2003, NewYork State determined the amount of NOx emissions allowances that would be allocatedto the six Plants. The allocation is hundred thousand tons short of the Company’saverage historical NOx emissions for the Plants during the control period.

 

In January 2004, NYSDECdetermined the amount of SO2 emissions allowances that would be allocated tothe Plants. The allocation is approximately the Company’s average historicalSO2 emissions for the Plants.

 

On May 26, 2004, theNew York Supreme Court struck down the Acid Deposition Reduction Program regulations(6 NYCRR 237 and 238). The Court ruled that the regulations had been adoptedimproperly after the State missed a deadline for publication of a notice toinform the public of proposed changes in the regulations. On July 1, 2004,NYSDEC appealed the Court’s ruling.

 

On August 17, 2004, theNYSDEC announced the adoption of emergency regulations to implement the AcidDeposition Reduction Program as originally scheduled. A number of entitieschallenged the adoption of the emergency regulations. On October 19, 2004,a State Supreme Court Judge dismissed the petition challenging New York State’sadoption of emergency regulations to implement the Acid Deposition ReductionProgram as originally scheduled.

 

The new NOxregulations became effective October 1, 2004, and the new SO2 regulationswill be phased in starting January 1, 2005, with full implementationcomplete by January 1, 2008. AEE’s compliance strategy involves reduced operations from the Plants’non-reheat units, reducing emission rates and/or the selling/buying or tradingof New York State SO2 and NOx allowances.

 

On March 10, 2005, theEPA Acting Administrator signed the final Clear Air Interstate Rule thatwill require further emission reductions in NOx and SO2 emitted from powerplants and other sources that significantly contribute to fine particulate (“PM2.5”)and ozone pollution in downwind states. NOx and SO2 are precursors of PM2.5, and NOx is a precursor ofozone.  The final rule directs 28 states, including New York, toissue new regulations that will require major SO2 and NOx reductions by2015. States must achieve the required NOx and SO2 reductions by meeting astate-specific emissions budget through one of two compliance methods: (i) requiringelectric generating facilities in the state to participate in anEPA-administered cap and trade regime that caps emissions in two phasesstarting with a first phase in 2010 and a second phase commencing in 2015, or (ii) meetingthe budget levels through measures selected by a particular state that areapproved by EPA. States are encouraged to use a cap and emission tradingapproach.  At this point, the Company cannot determine what the costswould be to comply with new federal SO2 and NOx emission reductionrequirements.

 

On March 15, 2005, theEPA Acting Administrator signed the final Clear Air Mercury Rule that willregulate mercury emissions from existing and new coal-fired powerplants. The final rule requires the reduction of mercury emissions tobe achieved through a cap and emission trading program with the first phasecommencing in 2010 and the second phase starting in 2018. At this point, theCompany cannot determine what the costs would be to comply with the new federalmercury emission reductions requirements.

 

74

----

 

AEE voluntarily disclosed tothe NYSDEC and EPA on November 27, 2002 that NOx exceedences appear tohave occurred on October 30 and 31 and November 1-8 and 10 of2002. The exceedences were discovered through an audit by plant personnel ofthe Plant’s NOx RACT tracking system. The Company believes that it has takenall reasonable, good faith efforts to assess and correct the exceedences.  Immediately upon the discovery of theexceedences, the SCR at the Somerset Plant was activated to reduce NOxemissions. Emission data indicates that the system had already returned to acompliant operation by the time the exceedences were discovered. The EPA hasdecided to defer to the NYSDEC for review of the self-disclosure letter andtechnical issues. Recently, the Company learned of a Notice of Violation issuedby the NYSDEC for the NOx RACT exceedances through a review of the November 2004release of the EPA’s Enforcement and Compliance History “ECHO” database. TheCompany has not yet seen the NOV from the NYSDEC. The Company is unable topredict any potential actions or fines the NYSDEC may require, if any.

 

AEEvoluntarily disclosed to the NYSDEC in January 2003 that the Cayuga Planthad inadvertently burned synfuel (coal with a latex binder applied), which itis not permitted to burn. AEE had entered into an agreement with a supplier topurchase coal. It received approximately one 9000-ton trainshipment per month from April 24, 2001 to December 27, 2002. In January 2003,AEE became aware that the product the Cayuga Plant was receiving was synfuel.AEE suspended all shipments from that supplier until a resolution was reached.AEE reviewed the emission and operation data which showed there was no adverseeffect to air quality with respect to applicable permit emissions limitsattributable to burning the material. The Company is unable to predict anypotential actions or fines the NYSDEC may require, if any. In July 2003,AEE reached an agreement with the supplier to resume shipment of coal in orderto satisfy contractual obligations. As part of this agreement, the supplier hasprovided a written guarantee stating that all fuel shipments will be coal.

 

In July 2004, the EPAfinal rule for regulating existing power plants under Section 316(b) ofthe Clean Water Act was published in the Federal Register. This rule becameeffective on September 7, 2004. This new rule will impose newcompliance requirements, with potentially significant costs, on operatingplants across the nation with cooling water intake structures. Cost itemsinclude various environmental and engineering studies and potential capital andmaintenance costs. The Partnership has not yet determined the effects of this rule onits financial condition or results of operations.

 

In October 1999, ACRentered into a consent order with the NYSDEC to resolve alleged violations ofthe water quality standards in the groundwater downgradient of an ash disposalsite. As a result, the site was closed. AEE2, L.L.C. contributed one-half ofthe costs to close the landfill, which were approximately $2 million, and itwill contribute additional costs for long-term groundwater monitoring.Nevertheless, if a groundwater remediation is required, AEE2, L.L.C. may beresponsible for a portion of such costs.

 

ACR reported thatconcentrations of a number of chemicals in a few groundwater wells increased inthe year ending December 31, 2001, since the Jennison and Hickling Plantswere placed on long-term cold standby. A consultant was retained to helpevaluate the source of the chemicals and provide recommendations forremediation. The consultant concluded that the cause of the problem was coarsebottom ash with pyrites that has been exposed to air since sluicing of water tothe bottom ash ponds has been terminated. ACR notified NYSDEC that at Jennison,where the elevated concentrations are the highest, that ACR is removing thesuspect material and anticipate that over time concentrations willsubside.  ACR has asked NYSDEC for approvalof a plan to add additional monitoring wells at Hickling to allow ACR to assesschanges in the groundwater that have occurred since use of its pond wasterminated. On March 19, 2004, the NYSDEC approved the plan, the additionalwells have been installed and monitoring initiated.

 

ACR voluntarily disclosed tothe NYSDEC and EPA that ACR is conducting an investigation based on conflictingreports of suspected materials buried at the Hickling Plant. Field andlaboratory studies have not indicated any evidence of waste disposal that posesa serious risk to potential receptors. ACR has notified both the NYSDEC and EPAof these studies and believes that no further action is required.

 

Northeastern U.S. states(including New York) have agreed to work to develop a regional market- basedemissions trading system to reduce power plants’ carbon dioxide emissions. Thegoal is to reach an agreement by April 2005 on a cap and emission tradingprogram. Until such time as the rules are developed to implement such aprogram the Company cannot determine what its impact would be on the Company’sfinancial position or results of operations.

 

7.             RELATEDPARTY TRANSACTIONS

 

AEE has entered into acontract with Somerset Railroad Corporation (SRC), a wholly owned subsidiary ofAES NY3, L.L.C., which is an indirect wholly owned subsidiary of AES, pursuantto which SRC will haul coal and limestone to the Somerset Plant and make itsrail cars available to transport coal to the Cayuga Plant. Through thisagreement, AEE has, in effect, guaranteed interest on and principal of SRC’soutstanding indebtedness, and will pay amounts sufficient to enable SRC to payall of its operating and other expenses, including all out-of-pocket expenses,taxes, and all capital expenditures necessary to permit SRC to continue toprovide rail service to the Somerset and Cayuga Plants. As of December 31,2003 and 2002, $3.1 million and $3.8 million, respectively, has been recordedby AEE as operating expenses and other accrued liabilities under thisagreement.

 

In November 2000, AEEand ACR entered into a three-year agreement for energy marketing services with

 

75

----

 

Odyssey, a wholly ownedsubsidiary of AES. In March 2002, a new agreement was reached. The new agreementis for a term of five years through February 28, 2007 pursuant to whichOdyssey provides data management, marketing, scheduling, invoicing and riskmanagement services for a fee of $300,000 per month. On September 4, 2003,AEE and ACR signed an amendment to their March 2002 agreement. Odysseywill also manage the AEE and ACR coal and environmental emission creditpositions for an additional fee of $100,000 per month. Odyssey acts as agent onbehalf of AEE and ACR in the over-the- counter and NYISO markets.

 

As agent, Odyssey managesall energy transactions under AEE and ACR’s name including (i) preparingconfirmations for AEE and ACR and approving confirmations with counterparties, (ii) conductingmonthly check-outs with counterparties as appropriate before the preparation ofinvoices, (iii) invoicing counterparties for the term of the transactionsand (iv) otherwise managing and executing the terms of the transactions inaccordance with their provisions.

 

Odyssey provides datamanagement services for AEE and ACR by maintaining databases of pricing, load,transmission, weather and generation data to aid in analysis to optimize thevalue of AEE and ACR’s assets. Odyssey maintains a transaction managementsystem to manage day-ahead commitments with the NYISO and swap and physicalvalues with counterparties and to provide daily financial reporting and end ofday budget variance, forward mark-to-market and commercially accepted riskanalysis.

 

Odyssey also managesenvironmental emission credit positions for other AES facilities. Theseallowances were purchased on the open market at market prices. From time totime the allowances will be temporarily placed into the Somerset Plant’sallowance account while awaiting transfer to the purchasing facility. In 2003,allowances were purchased and sold in this manner for AES Deepwater, AES RedOak and AES Ironwood, all indirect wholly owned subsidiaries of AES.

 

For the year ended December 31,2002, ACR sold approximately 6,000 SO2 allowances to the AEE Plants forapproximately $843,000 at quoted market prices.

 

For the year ended December 21,2004, Odyssey purchased for AEE’s account 70 NOx allowances for approximately$322,000 at market prices from AES Ironwood, a wholly owned subsidiary of AES.

 

Until the sale of AES NewEnergy in the third quarter of 2002, AEE entered into bilateral contracttransactions with AES New Energy, a wholly owned subsidiary of AES.  These transactions included forward sales ofelectric energy and unforced capacity at market based rates. For the year endedDecember 31, 2002, AEE recognized revenues of approximately $13.9 millionrelated to the physical delivery of electricity or unforced capacity and thesubsequent change in the market value of these contracts. AES New Energy wassold in the third quarter of 2002. As of December 31, 2002, the relatedaccount receivable - trade between AES New Energy and AEE was zero. Theexposure at December 31, 2002 related to these contract transactions wasless than 10% of AEE’s estimated cash revenues for the year then ended.

 

AEScontributed approximately $415,000 and $162,000 to AEE in 2004 and 2003,respectively, related to the cost of stock options compensation expense. Also,AES contributed approximately $1.5 million to AEE in 2002 related to theconstruction of the SCR on Unit 1 of the Cayuga Plant, which became operationalon June 7, 2001.

 

8.             BENEFITPLANS

 

Effective May 14, 1999,the Company adopted The Retirement Plan for Employees of AES NY, L.L.C. (thePlan), a defined benefit pension plan. The Plan covers people employed bothunder collectively bargained and non-collectively bargained arrangements.Certain people formerly employed by NYSEG (the Transferred Persons) receivecredit under the Plan for compensation and service earned while employed byNYSEG. The amount of any benefit payable under the Plan to a Transferred Personwill be offset by the amount of any benefit payable to such Transferred Personunder the Retirement Plan for Employees of NYSEG. Effective May 29, 1999,the ability to commence participation in the Plan and the accrual of benefitsunder the Plan ceased with respect to non-collectively bargained people and theaccrued benefits of any such participant were fixed as of such date. As of December 31,2003, the Plan was funded at least to the extent required by Internal RevenueCode (IRC) Section 412 minimum funding and not more than the requirementof IRC Section 404, maximum contribution limits. The Company will make therequired minimum contribution within the Employee Retirement Income SecurityAct (ERISA) guidelines. Pension benefits are based on years of creditedservice, age of the participant, and average earnings. During 2004, 2003 and2002, collectively bargained people were offered the opportunity to freezetheir accrued benefit payable under the Plan and opt into the AES ProfitSharing and Stock Ownership Plans.

 

The assets and liabilitiesof the Plan were valued as of October 31, 2004 and 2003.  The values of the assets and liabilities asof October 31, 2004 and 2003 were not materially different than the valuesas of December 31, 2004 and 2003.

 

76

----

 
| ** **                                              | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------------|------------|----------|------------|----------|------------|
| Projected  Benefit Obligation                           |       |     |       |     |       |
| Change in  projected benefit obligation (in thousands): |       |     |       |     |       |
| Projected  benefit obligation, beginning of period      |       | $        | 26,375     |     | $          | 26,780 |   |
| Service cost                                            |       | 683      |       | 375      |       |
| Interest  cost                                          |       | 1,629    |       | 1,585    |       |
| Actuarial  (gain) loss                                  |       | 1,530    |       | (1,410   | )          |
| Benefits  paid                                          |       | (876     | )          | (955     | )          |
| Curtailment                                             |       | —   |       | —   |       |
| Special  Termination Loss                               |       | —   |       | —   |       |
| Projected  benefit obligation, end of period            |       | $        | 29,341     |     | $          | 26,375 |   |
| Plan Assets:                                            |       |     |       |     |       |
| Change in  plan assets (in thousands):                  |       |     |       |     |       |
| Fair value  of plan assets (in thousands):              |       | $        | 11,009     |     | $          | 8,711 |   |
| Actual  return on plan assets                           |       | 502      |       | 1,092    |       |
| Employer  contributions                                 |       | 4,571    |       | 2,161    |       |
| Benefits  paid                                          |       | (876     | )          | (955     | )          |
| Fair value  of plan assets, end of period               |       | $        | 15,206     |     | $          | 11,009 |   |
| Funded  status/accrued benefit liability                |       | $        | (14,135    | )        | $          | (15,366 | ) |
| Unrecognized  Net (Gain)                                |       | 215      |       | (1,872   | )          |
|                                                    |       |     |       |     |       |
| (Accrued)/Prepaid  Pension Cost, end of period          |       | $        | (13,920    | )        | $          | (17,238 | ) |
|                                                    |       |     |       |     |       |
| Defined  Benefit Pension Plan Costs:                    |       |     |       |     |       |
| Components  of net periodic benefit cost (in thousands) |       |     |       |     |       |
| Service cost                                            |       | $        | 683        |     | $          | 367 |   |
| Interest  cost                                          |       | 1,629    |       | 1,611    |       |
| Expected  return on plan assets                         |       | (1,059   | )          | (726     | )          |
| Curtailment  gain                                       |       | —   |       | —   |       |
| Net periodic  benefit cost                              |       | $        | 1,253      |     | $          | 1,252 |   |

 

The discount rate utilizedfor determining future pension obligations is based on a review of long-termbond rates. The discount rate was reduced to 5.75% to reflect current long-termbond rates. Future actual pension obligations will depend on future investmentperformance, changes in future discount rates and various other factors relatedto the populations participating in the Company’s pension plans.

 
| ** **                                        | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|
|                                              |       |     |       |     |       |
| Discount  rate                                    |       | 5.75     | %          | 6.25     | %          |
| Expected  long-term rate of return on plan assets |       | 8.00     | %          | 8.00     | %          |
| Rate of  compensation increase                    |       | 4.75     | %          | 4.75     | %          |

 

The accumulated benefitobligation was approximately $25.5 million and $23.3 million as of December 31,2004 and 2003, respectively.

 

Significant assumptions wereused in the calculations of the net benefit cost and projected benefitobligation for the periods ending October 31, 2004, 2003 and 2002. Indeveloping the Company’s expected long-term rate of return assumption, theCompany evaluated input from its actuaries and plan asset manager. Projectedreturns are based on a broad range of equity and bond indices. The Company’sexpected 8% long-term rate of return on Qualified Plan assets is based on theallocation assumption of 60% equities (50% growth and 50% value), with a 10%long-term rate of return, and 40% in fixed income investments, with a 5.5%long-term rate of return. Because of market fluctuation, its actual allocationwas 54% and 58% equities and 46% and 42% in fixed income investments as of October 31,2004 and 2003, respectively. However, the Company believes that its long-termasset allocation on average will approximate 60% equities and 40% fixed incomeinvestments. The Company regularly reviews the asset allocation with the assetmanager and periodically rebalance the Plan’s investments to its targetedallocation when appropriate.  The Companycontinues to believe that 8% is a reasonable long-term rate of return on itsqualified plan assets, despite the market downturn. The Company will continueto evaluate its actuarial assumptions, including its expected rate of return,at least annually, and will adjust as necessary.

 

As of December 31,2004, the Plan had 260 active participants.

 

Plan Assets

 

The overall expectedlong-term rate-of-return-on-assets assumption is based upon a building-block method,whereby the expected rate of return on each asset class is broken down intothree

 

77

----

 

components: (1) inflation,(2) the real risk-free rate of return (i.e., the long-term estimate of futurereturns on default-free U.S. government securities), and (3) the riskpremium for each asset class (i.e., the expected return in excess of therisk-free rate).

 

All three components arebased primarily on historical data, with modest adjustments to take into accountadditional relevant information that is currently available. For the inflationand risk-free return components, the most significant additional information isthat provided by the market for nominal and inflation-indexed U.S. Treasurysecurities.  That market provides implied forecasts of both the inflationrate and risk-free rate for the period over which currently-availablesecurities mature.  The historical data on risk premiums for each assetclass is adjusted to reflect any systemic changes that have occurred in therelevant markets; e.g., the higher current valuations for equities, as amultiple of earnings, relative to the longer-term average for such valuations.

 

Cash Flows

 

The Company expects tocontribute $4.1 million to its pension plan in 2005.

 

Estimated Future Benefits

 

The followingbenefit payments, which reflect expected future service, as appropriate, areexpected to be paid:

 
| **Fiscal Years ending December 31,** | ** ** | **Payments** | ** ** |
|-------------------------------------------|------------|--------------|------------|
| 2005                                      |       | $            | 979        |   |
| 2006                                      |       | 1,075        |       |
| 2007                                      |       | 1,210        |       |
| 2008                                      |       | 1,354        |       |
| 2009                                      |       | 1,511        |       |
| Thereafter                                |       | 9,907        |       |
| Total  Estimated Future Benefits          |       | $            | 16,036     |   |

 

Additionally, people of theCompany and its subsidiaries participate in the AES Profit Sharing and StockOwnership Plans. The plans provide employer matching contributions.Participants are fully vested in their own contributions and the employer’smatching contributions. The Company contributed to AES Profit Sharing and StockOwnership Plans approximately $899,000, $885,000 and $809,000 in 2004, 2003 and2002, respectively.

 

OtherPostretirement Benefit Plan

 

On July 1,2000, AES Greenidge adopted SFAS No. 106 “Employees’ Accounting forPostretirement Benefit Other Than Pension.” Prior years cost were deemedimmaterial for presentation purposes. The net periodic cost was $231,000 forthe year ended December 31, 2002. On July 1, 2003, as part of AESGreenidge’s collective bargaining agreement with the International Brotherhoodof Electrical workers, AES Greenidge established a VoluntaryEmployees’ Beneficiary Association (“VEBA”) to fund their retired union members’,spouses’ and dependents’ medical expenses.

 

The Plants also havecreated separate VEBAs to fund their retiree medical expenses. Employercontributions to pay the claims of the employees are deposited in the VEBATrusts. Currently, the VEBA Trusts are to pay the medical claims of theemployees who are union members and who retire from AEE and the medical claimsof their spouses and dependants. Some of the VEBA trusts offer supplementalMedicare benefits, the other Trusts’ coverage end when the employee is Medicareeligible. The AES Somerset, AES Cayuga and AES Westover VEBA trusts werecreated in 2002, and the AES Greenidge VEBA trust was created in 2003. The fundingschedule for the trusts are as follows: (in thousands)

 
| **Fiscal Years ending December 31,** | ** ** | **Payments** | ** ** |
|-------------------------------------------|------------|--------------|------------|
| 2005                                      |       | $            | 534        |   |
| 2006                                      |       | 434          |       |
| 2007                                      |       | 172          |       |
| 2008                                      |       | 172          |       |
| 2009                                      |       | —       |       |
| Total  funding payments                   |       | $            | 1,312      |   |

 

9.             LONG-TERMINCENTIVE PROGRAM

 

Stock Option Plan -Employees of the Company participate in the AES Stock Option Plan (the SOP)that provides for grants of stock options to eligible participants. Prior to2003, the Company accounted for the SOP under the recognition and measurementprovisions of APB Opinion No. 25, “Accounting for Stock Issued toEmployees,” and related Interpretations. No stock-based employee compensation cost is reflected in 2002 and 2001net income, as all options granted under the SOP in those years had an exerciseprice equal to the market value of the underlying common stock on the

 

78

----

 

date of grant.  Effective January 1, 2003, the Companyadopted the fair value recognition provisions of SFAS No. 123, “Accountingfor Stock-Based Compensation”, prospectively to all employee awards granted,modified or settled after January 1, 2003. Awards under the SOP vest overperiods ranging from two to five years. Therefore, the cost related tostock-based employee compensation included in the determination of net incomefor 2003 is less than that which would have been recognized if the fair valuebased method had been applied to all awards from the inception of the Company.The expense recognized under the prospective method for the year ended December 31,2003 and 2004 is approximately $162,000 and $415,000, respectively.

 

10.           FAIR VALUEOF FINANCIAL INSTRUMENTS

 

The fair value of the Company’s current financialassets and liabilities approximate their carrying values. The fair valueestimates are based on pertinent information available as of December 31,2003. The Company is not aware of any factors that would significantly affectthe estimated fair value amounts since that date. The fair value of thelong-term debt (the leasing debt) would not be at the carrying value. The fairvalue of the long-term debt is $680.6 million.

 

11.           SEGMENTINFORMATION

 

Under the provisions of SFAS No. 131,“Disclosures About Segments of an Enterprise and Related Information”, theCompany’s business is expected to be operated as one reportable segment, withoperating income or loss being the measure of performance measured by the chiefoperating decision-maker.

 

12.           SUBSEQUENT EVENTS

 

Cash flow from AEE’soperations during the second half of 2004 was sufficient to cover the aggregaterental payments under the leases on the Somerset and Cayuga Plants due January 2,2005. On this date, rental payments were made in the amount of $31.7 million.

 

Cash flow from operations inexcess of the aggregate rental payments under the AEE’s leases may be distributedto its partners if certain criteria are met. On January 7, 2005, AEE madea distribution payment of $25 million.

 

AEE borrowed $21 million on January 10, 2005, and a additional $750,000 million on February 9, 2005, for working capital purposes under the $75 million Calyon Credit Facility. The borrowing was at an interest rate of 6%.  A partial repayment of $4.6 million was made on January 27, 2005, and the remaining balance of $17.2 million was repaid on February 28, 2005.

 

79

----