MGEE

Business Context and Reporting Period

This Form 10-K covers the fiscal year ended December 31, 2008, for MGE Energy, Inc. (MGE Energy) and its principal subsidiary, Madison Gas and Electric Company (MGE). MGE Energy is a holding company operating in Wisconsin through five segments: electric utility operations, gas utility operations, nonregulated energy operations, transmission investments, and corporate functions. MGE serves approximately 137,000 electric customers and 141,000 gas customers in Dane County and surrounding areas. The company is regulated by the Public Service Commission of Wisconsin (PSCW) and the Federal Energy Regulatory Commission (FERC).

Key Financial Metrics

Note: MGE Energy's effective income tax rate was 35.5% in 2008 compared to 36.3% in 2007, largely due to increased wind energy tax credits.

Material Changes Versus Prior Period

• Revenue Growth: Total operating revenues increased 10.9% to $595.99 million. Electric revenues rose 3.4% due to a 4.8% rate increase approved by the PSCW, partially offset by lower demand from cooler summer weather. Gas revenues surged 22.6% driven by a 14.8% increase in delivered volumes due to colder winter weather and a 2.8% rate increase.
• Profitability: Net income increased 8.1% to $52.77 million. Segment earnings were driven by higher nonregulated energy revenues (due to Elm Road carrying costs) and increased gas utility earnings.
• Weather Impact: A $1.5 million expense was recorded in 2008 related to a heating degree day (HDD) collar settlement due to colder-than-expected weather.
• Capital Spending: Capital expenditures decreased 22.4% to $105.78 million, primarily due to the completion of the Top of Iowa III wind project and reduced construction activity on the Elm Road project compared to 2007.
• Debt Structure: Short-term debt increased to $124.5 million, reflecting the funding of capital commitments for the Elm Road project. MGE Energy issued $40 million in long-term senior notes in September 2008 to refinance maturing debt.

Guidance, Outlook, Risks, and Unusual Items

Management Commentary and Outlook

Management expects to continue focusing on core utility customers and creating long-term value. The company anticipates maintaining a strong credit standing. For 2009, the PSCW authorized a 0.74% decrease in retail electric rates, driven by lower fuel and purchased power costs. The company does not anticipate a need for further long-term financing until the third quarter of 2009.

Key Risks and Contingencies

• Elm Road Construction Claims: The contractor, Bechtel Power Corporation, has filed formal claims for schedule and cost relief totaling approximately $485 million (MGE Energy's share estimated at $40.4 million). The claims cite severe weather and labor conditions. The dispute is in the mediation phase, and the outcome is uncertain. If costs exceed the PSCW authorized cap, recovery from customers may be limited.
• Environmental Regulations: Significant uncertainty exists regarding compliance costs for the Clean Air Interstate Rule (CAIR), Clean Air Mercury Rule (CAMR), and new ozone/PM2.5 standards. Estimated capital expenditures for Columbia plant compliance range from $130 million to $170 million. The company expects these costs to be recoverable through rates.
• Pension Funding: The market value of pension plan assets declined approximately 27.5% in 2008. This may increase future funding requirements. A discretionary contribution of $6.0 million was made in January 2009.
• Regulatory Risk: The company faces risks regarding the recovery of fuel and purchased power costs if they exceed base rates. Dividend payments from MGE to MGE Energy are restricted if the common equity ratio falls below 55% (currently estimated at 50.4%).

Important Facts for Investor Verification

• Elm Road Cost Cap: Verify the status of the Bechtel construction claims and the likelihood of the PSCW allowing cost recovery above the authorized cap.
• Environmental Compliance Costs: Monitor the finalization of CAIR and CAMR regulations and the specific capital expenditure requirements for the Columbia and Blount plants.
• Pension Asset Volatility: Assess the impact of the 27.5% decline in pension assets on future cash contributions and operating expenses.
• Dividend Restrictions: Confirm the 13-month rolling average common equity ratio for MGE to ensure compliance with PSCW dividend restrictions.
• Weather Derivatives: Review the exposure to weather derivatives (HDD collars) and their potential impact on earnings in future volatile weather years.