NW Natural 220 NW Second Avenue Portland, Oregon 97209 www.nwnatural.com Serving Serving with Pride with Pride 2002 Annual Report 2002 Annual Report Corporate Profile Financial Briefs 2002 2001 Percent increase (decrease) Corporate Information NW Natural is a 144-year-old natural gas local distribution company headquartered in Portland, Oregon. For more than a decade, it has grown at two to three times the national average for natural gas LDCs. The Company serves more than 560,000 customers in northwest Oregon and southwest Washington, including the Portland-Vancouver metropolitan area, the Willamette Valley, the northern Oregon coast and the Columbia River Gorge. More than 200,000 customers have been added to NW Natural’s distribution system in the past 10 years. In keeping with its steady growth, the Company has increased annual dividends paid to shareholders every year for 47 consecutive years. NW Natural purchases natural gas for its core market from a variety of suppliers in the western United States and Canada. In addition, the Company operates an un- derground gas storage facility in Columbia County, Oregon, and leases additional gas storage outside its service area. NW Natural also operates two liquefied natural gas plants in its service area. Astoria Mist Vancouver Portland Molalla The Dalles Salem Lincoln City Newport Eugene Coos Bay Albany Legend Williams Northwest Pipeline NW Natural gas transmission line Kelso Beaver (KB) Pipeline Proposed pipelines to Molalla and Coos Bay Service territory LNG plant District offices Mist underground storage Propane system Earnings Financial facts ($000): Net operating revenues Net income Earnings applicable to common stock 287,544 43,792 41,512 276,011 50,187 47,786 Financial ratios (%): Return on average common equity Capital structure at year-end Long-term debt Preferred and preference stock Common stock equity Common stock Shareholder data: Common shareholders Average shares outstanding (000) Per share data ($): Basic earnings Diluted earnings Dividends paid on common stock Book value at year-end Market value at year-end Operating highlights 8.7 47.6 0.9 51.5 10,026 25,431 1.63 1.62 1.260 18.88 27.06 10.4 43.0 3.8 53.2 10,359 25,159 1.90 1.88 1.245 18.56 25.50 Gas sales and transportation deliveries (000 therms): Degree days (20-year average, 4,216) Customers at year-end Number of utility employees 1,126,084 4,232 560,067 1,261 1,123,287 4,325 540,931 1,284 4 (13) (13) (16) 11 (76) (3) (3) 1 (14) (14) 1 1 6 0 (2) 4 (2) Dividends paid on common stock Payment date (per share) February 15 May 15 August 15 November 15 Total dividends paid DIVIDENDS PAID PER SHARE IN DOLLARS $1.27 $1.26 $1.25 $1.24 $1.23 $1.22 $1.21 $1.20 $1.19 $1.18 $1.17 2002 2001 $ 0.315 0.315 0.315 0.315 _________ $ 1.260 _________ _________ $ 0.310 0.310 0.310 0.315 _________ $ 1.245 _________ _________ EARNINGS PER SHARE IN DOLLARS $2.00 $1.75 $1.50 $1.25 $1.00 $0.75 $0.50 $0.25 02 98 97 99 00 01 DILUTED EARNINGS PER SHARE REDUCTION IN EARNINGS PER SHARE FROM INVESTMENT WRITEDOWNS: – 50 cents per share in 1998 due to 97 98 99 00 01 02 Annual dividends paid per share in 2002 increased for the 47th consecutive year, a growth record matched by few companies. asset impairment charges – 33 cents per share in 2002 due to a loss provision for PGE acquisition costs Diluted earnings were $1.62 per share in 2002. Results include a 33 cent per share loss provision for PGE acquisition costs. Notice of Annual Meeting The 2003 Annual Meeting will be held at 2 p.m. Thursday, May 22, at the Portland Hilton Hotel, 921 S.W. Sixth Avenue, Portland, Oregon. A meeting notice and proxy statement will be sent to all share- holders in mid-April. Form 10-K The Company will provide its shareholders, without charge, a copy of the 2002 Annual Report on Form 10-K to the Securities and Exchange Commission. Requests should be made to the Corporate Secretary. Stock Transfer Agent and Registrar For all Preferred and Common Stock Issues: NW Natural 220 N.W. Second Avenue Portland, Oregon 97209 Attention: Shareholder Services Trustee, Conversion and Interest Paying Agent For Convertible Debentures: The Bank of New York Corporate Debt Operations, Floor 7-E 101 Barclay Street New York, New York 10286 (800) 548-5075 Trustee and Bond Paying Agent For all bond issues: DB Services Tennessee Inc. Security Holder Relations P.O. Box 305050 Nashville, Tennessee 37230 (800) 735-7777 Common Stock Prices The Company’s common stock is listed and trades on the New York Stock Exchange using the symbol NWN. The quarterly high and low trading range during 2001 and 2002 was: 2002 Quarter 1 2 3 4 2001 Quarter 1 2 3 4 High 28.50 30.30 30.20 30.70 High 26.69 25.25 25.85 26.30 Low 24.20 27.60 23.46 25.50 Low 23.05 21.65 22.39 22.00 Dividend Reinvestment Plan Common shareholders of record may reinvest all or part of their dividends in additional shares under the Company’s plan. Cash purchases also may be made at the current market price under this plan, and no brokerage fees will be charged. A prospectus will be sent to any registered shareholder on request. Dividend Payment Dates February 15, 2003 May 15, 2003 August 15, 2003 November 14, 2003 Quarterly Financial Information (unaudited) Dollars (thousands except per share amounts) 2002 Operating revenues Net operating revenues Net income (loss) Basic earnings (loss) per share Diluted earnings (loss) per share 2001 Operating revenues Net operating revenues Net income (loss) Basic earnings (loss) per share Diluted earnings (loss) per share ——–––––––– Quarter ended ——–––––––– Dec. 31 March 31 Sept. 30 June 30 278,563 110,666 34,447 1.34 1.32 217,341 91,653 25,907 1.00 0.99 101,873 56,564 (2,992) (0.14) (0.14) 118,150 54,726 4,865 0.17 0.17 78,717 38,059 (6,008) (0.26) (0.26) 78,359 37,067 (4,976) (0.22) (0.22) 182,223 82,255 18,345 0.70 0.69 236,402 92,565 24,391 0.94 0.93 Total 641,376 287,544 43,792 1.63* 1.62* 650,252 276,011 50,187 1.90* 1.88* * Quarterly earnings per share are based upon the average number of common shares outstanding during each quarter. Because the average number of shares outstanding has changed in each quarter shown, the sum of quarterly earnings may not equal earnings per share for the year. Variations in earnings between quarterly periods are due primarily to the seasonal nature of the Company’s business. James R. Boehlke Investor Relations (503) 721-2451 (800) 422-4012, Ext. 2451 jrb@nwnatural.com Linda R. Williams Shareholder Services (503) 220-2590 (800) 422-4012, Ext. 3402 lrw@nwnatural.com NW Natural 220 N.W. Second Avenue Portland, Oregon 97209 (503) 226-4211 (800) 422-4012 www.nwnatural.com Forward-looking statements The Company’s future operating results will be affected by various uncertainties and risk factors, many of which are beyond the Company’s control, including governmental policy and regulatory action, the competitive environment, economic factors and weather conditions. Some statements in this annual report may be forward-looking, and actual results may differ materially as a result of these uncertainties. For a more complete description of these uncertainties and risk factors, please refer to the Company’s filings with the Securities and Exchange Commis- sion on Forms 10-K and 10-Q. n o t a e B e c u r B o t o h P 5 1 P i l e n v e L e r i a C o t o h P 2 1 P n o t a e B e c u r B s r e c i f f O & d r a o B , r e t t e L r e d l o h e r a h S / t i a r t r o P d n a l r o B e i l r a h C y h p a r g o t o h P e r u t a e F l s n o i t u o S c i h p a r G n g i s e D k c o t s d e l c y c e r n o d e t n i r P r e t n e C s t r A c i h p a r G g n i t n i r P n g i s e D n o e h p a r G n o i t c u d o r P CONTENTS Page 8 Customer Satisfaction It isn’t easy keeping customers happy as wholesale gas prices fluctuate. In 2002, NW Natural main- tained its reputation for exemplary customer ser- vice and reasonable prices, and further increased customer satisfaction. Gas Storage NW Natural’s underground and liquefied natural gas storage facilities provided both cost savings and added revenue, proving again that they are major strategic assets for the Company. Page 10 Mauricio Carcamo Customer Growth Despite a slow economy, NW Natural surpassed its customer acquisition targets for 2002, adding 19,136 customers. The Company scored gains in both the conversion and new construction markets. Page 12 Kishore Duwadi Mark Farley Safety In 2002, NW Natural stepped up its pipeline safety and system security measures to meet federal requirements and to assure safe, reliable service to customers. Page 14 Community Service The spirit of community service is alive and well at NW Natural. Employees contribute their time and resources to good causes, and the Company demonstrates a continuing commitment to good corporate citizenship. Lee Hughes Letter to Shareholders . . . . . . . . . . . . . . . . . . . . . . 2 On the cover: Page 16 Interview with the CEO . . . . . . . . . . . . . . . . . . . . . . 5 NW Natural Meter Reader Rick Corporate Governance . . . . . . . . . . . . . . . . . . . . . 18 Brady has made fast friends with Management’s Discussion & Analysis . . . . . . . . . . . 19 Cooper, one of the dogs on his Report of Independent Accountants . . . . . . . . . . . . 29 meter reading route in Southwest Financial Statements . . . . . . . . . . . . . . . . . . . . . . 30 Notes to Financial Statements . . . . . . . . . . . . . . . . 34 Portland. His secret? A friendly attitude — and Company-provided Eleven-Year Financial Review . . . . . . . . . . . . . . . . 44 dog biscuits. Says Brady: “We must Corporate Officers . . . . . . . . . . . . . . . . . . . . . . . . 52 never forget that each meter rep- Board of Directors . . . . . . . . . . . . . . . . . . . . . . . . 54 resents a customer. I try to treat Corporate Information. . . . . . . . . . . . . . . . . . . . . . 55 their pets and property with care.” Tonya Brumley 1 LETTER TO SHAREHOLDERS NW Natural President and Chief Executive Officer Mark Dodson (left) with Chairman of the Board Dick Reiten along Portland’s waterfront. The Company’s headquarters is in the background. Proud to Serve, Primed to Succeed o Our Shareholders: In any year, we would be pleased to report strong earnings, high val- ue to shareholders and excellent customer service. But we were especially proud of these results in 2002 — a tumultuous year on many fronts. Despite a weak economy and a difficult year for the energy industry, NW Natural achieved solid operating results. During the year, our customers con- tinued to receive excellent service. We also saved substantially on gas costs, providing rate relief to customers while still adding to the bottom line. At mid-year we termi- nated the Portland General Electric (PGE) acquisition to avoid major risks associated with the transaction. We provided storage services to new interstate customers. And we managed our way through some un- usually warm weather in the fourth quarter. Though the year was challenging, we stayed focused on our core business ac- tivities. At the same time, we continued our commitment to the highest standards of ethical business conduct with our cus- tomers, shareholders and business part- ners. We believe our reputation for fair- ness and honesty is a significant strength for NW Natural. A year of accomplishments In 2002, NW Natural: – Earned $1.62 a diluted share including the effects of charges related to the PGE acquisition effort, or $1.95 a share before these charges. – Added 19,136 customers, growing our customer base by more than 3 percent for the 16th consecutive year. – Gained approval from Oregon regula- tors for a conservation tariff to help sta- bilize margin revenues while better align- ing the Company’s financial interests with customers’ conservation goals. – Exceeded 2001 customer additions from residential and commercial conversions and residential new construction, despite weak economic conditions. – Expanded service in the interstate gas storage market, with earnings in this seg- ment increasing to 14 cents a share from 8 cents a share in 2001. – Refunded $33 million to customers while adding 26 cents a share to earnings from savings on the cost of purchased natural gas. – Lowered rates by an average of nearly 12 percent across all customer classes. – Elected to terminate the October 2001 contract to acquire PGE in light of the risks associated with the subsequent bankrupt- cy of PGE’s parent company, Enron Corp. – Paid dividends on common stock of 2 $1.26 a share, making 2002 the 47th con- secutive year in which the Company’s div- idend payments have increased. PGE decisions made thoughtfully, prudently Given the turmoil in the energy in- dustry, it was particularly important in 2002 that NW Natural make decisions about its future with thorough knowledge and care. Nowhere was this more evident than in the Company’s decisions regard- ing the acquisition of PGE. In October 2001, NW Natural had en- tered into a contract with Enron Corp. to purchase PGE. Two months later, Enron filed for bankruptcy, turning a sound ac- quisition opportunity into a transaction with significant unknown potential risks. Those risks threatened the benefits we had expected to achieve from the acquisition. On May 16, 2002, NW Natural and Enron jointly announced an agreement to termi- nate the purchase contract. GAS SALES AND TRANSPORTATION DELIVERIES IN MILLIONS OF THERMS 1,350 1,200 1,050 900 750 600 450 300 150 92 93 94 95 96 97 98 99 00 01 02 RESIDENTIAL, COMMERCIAL AND INDUSTRIAL FIRM SALES INDUSTRIAL INTERRUPTIBLE SALES TRANSPORTATION Gas sales and transportation deliv- eries were 1.126 billion therms in 2002, the fourth highest in NW Natural’s history. Rate proposal addresses increased costs We paid close attention in 2002 to strengthening the foundation of our busi- ness to help ensure future success. Commission (OPUC). As part of that case, we requested rate recovery for increased costs in several key areas, including: – Pension, insurance and health benefit costs, and – Costs related to new federal regulations, including pipeline integrity and operator qualifications. In addition, we asked for recovery of significant system investments planned for the next several years. These include the extension of a transmission pipeline that connects to our Mist underground storage facilities, and a new distribution system in Coos County on the southern Oregon coast. In anticipation of this filing, we set the stage for collaboration by holding work- shops with representatives of industrial, commercial and residential consumers, as well as the OPUC staff. We undertook a collaborative approach in order to eliminate surprises and pave the way for a healthy discussion of major issues. We hope to receive an OPUC deci- sion in time for new rates to take effect by Oct. 1, 2003. Tariff encourages energy efficiency We worked to stabilize our revenues in another way, as well. Our customers have seen several years of double-digit percentage energy rate increases, prompting many of them to re- duce their energy use. Meanwhile, our fixed costs were rising. In 2001, we filed for a new regulato- ry mechanism called the “conservation tariff,” aimed at addressing the price elas- ticity problem. We know that customers want to reduce their energy use when faced with higher prices. The tariff, approved by the OPUC in September 2002, protects shareholders while supporting customers’ interest in conservation. The mechanism adjusts residential and commercial rates annually so the Com- pany can recover its fixed costs in the face of variable consumption patterns. A par- tial decoupling tool based on conservation trends separates the Company’s profits from its sales volumes. In November 2002, we filed a gener- al rate case with the Oregon Public Utility With the conservation tariff in effect, NW Natural can promote energy efficien- cy while reducing margin losses from lower gas use. The Company recovered $5.2 million in the last quarter of 2002 as a result of these mechanisms. TOTAL CUSTOMERS IN THOUSANDS 600 550 500 450 400 350 300 92 93 94 95 96 97 98 99 00 01 02 NW Natural added 19,136 new customers in 2002, expanding our customer base by 3.5 percent. In the past 10 years, NW Natural has added more than 200,000 new customers. Assuring profitable growth Knowing and controlling our costs has become an ingrained part of the way we do business. NW Natural is one of the few natural gas distribution companies with great growth potential in both the new con- struction and conversion segments. Our challenge has been to add customers effi- ciently and profitably. We can say confi- dently that we are meeting that challenge. We have been very successful in re- ducing construction costs. One cost-saver is the Unity program, providing for the joint installation of gas, electric and tele- communication services. In 2002, about 70 percent of new homes in the territory served jointly by PGE and NW Natural were connected with Unity. A new con- struction hookup using Unity costs about 47 percent less than adding service to a new home using conventional techniques. On the customer acquisition side, re- search and more efficient targeted market- ing are helping NW Natural add conver- sion customers more cost-effectively. As a result of new construction and marketing strategies, average construction cost per meter dropped from $1,136 in 2000 to $885 in 2002, a reduction of about 22 percent. 3 Customer service is key Adding customers profitably is critical to us — but so is keeping them satisfied. Through monthly surveys, we keep close tabs on customer satisfaction. In re- sponse to customer comments, employee teams work continuously to improve serv- ice. In 2002, our service technicians and customer account representatives (phone reps) received the highest satisfaction rat- ings since the surveys began. Last fall, all phone reps participated in a training program focused on working with customers on the most difficult is- sues, such as credit problems and high bills. Although the on-hold times were longer than in past years, customer satis- faction increased. NUMBER OF CUSTOMERS SERVED BY EACH OPERATING EMPLOYEE 800 700 600 500 400 300 200 100 92 93 94 95 96 97 98 99 00 01 02 Each operating employee served an average 714 customers in 2002, a 63 percent increase from 437 customers served in 1992. Service technicians routinely earn high customer satisfaction marks, but they were particularly high in 2002. Eighty percent of respondents gave them “excellent” ratings. We attribute these high scores to increased customer service training and a computer- based scheduling system that improved service techs’ ability to reach customers’ homes within scheduled time windows. Opportunities for the future With the basics of our Company in excellent shape, we have the opportunity to grow in our core business while explor- ing new ventures that complement the dis- tribution business. As always, our future success will depend on our ability to an- ticipate and manage change. 4 Mist. Since 1989, when NW Natural began storing natural gas in depleted gas reservoirs at Mist, Ore., the storage field has proven its value. Today, Mist’s pools help the Company keep down commodity and transportation costs. Last year, sales of in- terstate storage services and related activ- ities added 14 cents a share to earnings — up from 8 cents a share the previous year. NW Natural is expanding Mist to provide more storage for core utility cus- tomers, and in the process will add to Mist’s potential in the interstate storage market. We will double daily deliverabil- ity while augmenting capacity for work- ing gas from 11 billion cubic feet (Bcf) to 17 Bcf by 2008. As natural gas demand grows and prices fluctuate, storage will continue to help NW Natural stabilize rates and guar- antee supply while generating income. Distributed generation. The energy industry has long discussed natural gas- fueled distributed generation. Today, the conditions exist to move theory into prac- tice. NW Natural is already leading the charge. In December 2001, NW Natural in- stalled a distributed generation pilot proj- ect — a gas-fired microturbine providing electricity and waste heat to a downtown Portland office building. The project at- tracted national attention to the potential for distributed generation. In 2002, NW Natural and its consortium partners lined up 15 prospective projects featuring mi- croturbines and fuel cells. At this writing, a 5 kilowatt gas-pow- ered fuel cell is ready to start operating at a juvenile detention center. A local college wants a microturbine to generate electric- ity and waste heat. And an aquatics center is considering a combined solar/microtur- bine system to help cut its energy costs. Many similar projects are in the wings. Pipeline integrity. In the last days of the 2002 session of Congress, lawmakers passed the Pipeline Safety Improvement Act. The Act directs pipeline owners to monitor transmission pipelines aggres- sively for corrosion and other potential safety hazards. NW Natural will have up to 10 years to inspect transmission pipelines that fall in “high-consequence areas,” as defined by the Act. The Company expects to spend more than $100 million over 10 years to comply. Much of that will be spent mod- ifying pipelines to allow the passage of “smart pigs”— sophisticated monitor- ing equipment that travels through the pipelines. NW Natural has a superb safety re- cord. In every aspect of pipeline safety, we meet or exceed safety guidelines. As the Company gears up to respond to new fed- eral expectations, we believe that state regulators will support our pipeline in- tegrity program by granting rate recovery for these expensive federal mandates. The first and last word This annual report marks a transition at NW Natural from one CEO to another. Both of us have been honored to be select- ed to serve in that capacity. We are proud of what the Company has accomplished and humbled by the faith that has been placed in us to keep the legacy intact. That legacy is due in large part to NW Natural’s employees. Their performance in 2002, as in previous years, was stellar — controlling costs while achieving excellent customer service ratings, demonstrating their qualifications for ensuring pipeline safety — and much more. Our greatest pride comes from the privilege of working with this remarkable group of men and women. Their hard work, dedication and integrity ensure a bright future for NW Natural. We look forward to continuing to serve you in the years ahead. Thank you for your confidence in us and for sharing our pride in NW Natural. Richard G. Reiten Chairman of the Board Mark S. Dodson President and Chief Executive Officer March 24, 2003 Interview with the CEO It’s All About Value How does NW Natural provide value to its shareholders? Mr. Dodson: Our goal is to provide incompara- ble value to our shareholders as well as to the customers and communities we serve. We are both a growth company and a value-based stock. That means we can offer our shareholders earn- ings growth as well as a stable investment. We’ve faced some significant challenges in the past several years, as have most companies in our industry. Yet we’ve al- ways come through with strong earnings, a positive growth record and, perhaps as important as anything, our integrity. Shareholders benefit from our strong stock price, reliable dividend payments which have increased every year for 47 consecutive years, and the fact that we are adding customers at a pace more than twice the na- tional average. Company President and CEO Mark Dodson (right) talks with employ- ees in the Customer Call Center in Portland. From foreground to background are Brian Cunnington, customer service representative; Judi Hall, supervisor of customer communications; and Pat Elmore, customer service representative. Q. What are the Company’s growth prospects? Mr. Dodson: Unlike most natural gas distribution companies, we have relatively low market share. At the same time, natural gas con- tinues to be the preferred fuel for energy consumers. So in our core business, the customer growth prospects are excellent. Beyond that, we are exploring possibilities in distributed generation and other ventures that build on what we know how to do. We will consider new ventures only if they fit well with our core competencies. The growth opportunities in interstate gas storage are especially exciting. As the pressures on gas supplies increase, storage be- comes all the more valuable. This year we nearly doubled our earnings from interstate storage services, and there is room for more. Of course, we remain alert to possibilities for acquiring additional assets. But we won’t get involved in anything unless we are absolutely sure the financials are solid and that it makes good sense for our shareholders and customers. Q. How are you helped or hindered by regulation? Mr. Dodson: We are fortunate at NW Natural that we enjoy positive and productive relationships with regulatory agencies in both Oregon and Washington. Even though we sometimes see things differently, we trust and respect one another enough to be able to work together and negotiate fairly and openly. A good example of this relationship is the way we prepared for the filing of our Oregon general rate case in November. Prior to the filing, we held discussions with regulatory staff as well as various customer interest groups. We wanted to establish good com- munication and a collaborative approach so there would be no surprises when we made the filing, and so the case could proceed as smoothly as possible. Q. Why is the Oregon rate case important to you, and what are you expecting from it? Mr. Dodson: The rate case is extremely important because, among other things, it requests rate recovery for some major investments we feel are critical to NW Natural’s future and to serving our customers. Among these are investments totaling about $90 million to extend our South Mist pipeline to connect with the interstate pipeline, which will help assure reliable supplies for customers in the fast-growing parts of our region. We are also seeking rate recovery for a $12 million project to build a new distribution system in Coos County — an area that desperately needs economic development. And we have requested a regulatory mechanism to recover the significant costs involved in complying with the new federal pipeline integrity act. NW Natural has been running extremely lean over the past several years. We want to keep our standing as one of the most ef- ficient natural gas utilities in the nation — but we don’t want to be so bare bones that we risk either safety or reliability. 5 Going Above and Beyond There’s a special spirit at NW Natural.You see it in the way employees care about each other, the way they serve customers and the way they help their communities. It is a spirit borne of pride — the pride that comes from working for a 144-year-old company known for its high values and integrity, its outstanding customer service and its good corporate citizenship. NW Natural could not succeed without the people of the Northwest. For that reason, the Company and its employees seek ways to give back — whether through a friendly voice on the phone, expert technical help or corporate support for a com- munity event. We’re here to serve. NW Natural tents add a glow to the summertime gathering of about 15,000 people at Portland’s annual Waterfront Classics performance. NW Natural co-sponsors the event, which features the Oregon Symphony and fireworks along the Willamette River. CUSTOMER SATISFACTION Name: Location: Job title: NWN service: Mauricio Carcamo Eugene, OR Service Technician 11 years Eugene Service Technician Mauricio Carcamo frequently receives customer commendations for his superlative service. Above, he arrives at the home of customer Debbie Steinman to check her gas equipment. “I just go by the Golden Rule,” says Carcamo. “Do unto others the way you would have them do unto you. I try to treat the customer the way I would like to be treated.” 8 Satisfying our customers with exemplary service side from safe and reliable service, two things mat- ter most to NW Natural customers: being charged a reasonable price and receiving good service. In customer satisfaction surveys, NW Natural consistently outranks its competitors on both fronts. Gas prices a factor In recent years, overall customer satisfaction declined a few percentage points mainly due to price increases from higher wholesale gas costs. However, in 2002, those ratings improved as the year went on. NW Natural finished the year with customer satisfac- tion ratings of “excellent” (i.e., overall service ratings of 9 or 10 on a scale of 1 to 10, with 10 being the highest) from 58.3 percent of customers surveyed, up from 57.8 percent in 2001. The percentage of “satisfied” NW Natural cus- tomers, which includes ratings of 7 through 10, exceeded 86 percent. Two factors in particular contributed to the higher lev- els of customer satisfaction: gas price reductions and im- proved service. Thanks to reductions in wholesale gas costs, NW Natural was able to refund $30 million in gas cost savings to its Oregon customers. The refund was accomplished through a credit on customers’ June bills. Thank-you notes flood- ed into the Company, with customers expressing senti- ments such as: “I wish all utilities were as nice as you,” and “Thank you for always looking out for our best interests!” In October, the Company went further and reduced its rates for both Oregon and Washington customers. Employees shine in service ratings NW Natural’s monthly customer surveys showed that customers’ ratings of their interactions with NW Natural employees improved even when prices were up. Customer service ratings reached record highs in 2002 as prices came down. Customers’ ratings of their interactions with NW Natural’s customer service representatives, who provide telephone service, improved from 72 percent “excellent” at the start of the year to 75 percent by year-end, also a record high. Customers’ ratings of their interactions with the Com- pany’s customer service technicians, who conduct onsite visits to help customers with equipment or service needs, reached an all-time high of 84 percent “excellent” in 2002. Outshining the competition Since NW Natural began Customer satisfaction improved as gas prices came down. Company employees also received record- high ratings for their customer service. tracking customer satisfaction, the Company has consis- tently outperformed its competition — specifically, electric utilities — in satisfaction surveys. Last year, the satisfac- tion gap widened between the “excellent” ratings for NW Natural and the average for all electric providers in the Company’s service area. The variance grew from a 13 per- centage point advantage for NW Natural in 2001 to a 16.6 percentage point advantage in 2002. Of the 16 electric providers in the Company’s service territory, only one earned higher customer satisfaction ratings than NW Natural in 2002. Surveys in 2002 also showed that some 60 percent of customers still consider natural gas to be the home ener- gy source with the best overall value. Electricity was the second choice at 12 percent. Partnering to Meet Customer Needs NW Natural’s Lincoln City Utility Coordinator Judy Thompson reviews building plans for the new Summit Ridge subdivision with Dan James, owner of Northwest Homes. NW Natural works closely with builders to coordinate construction and ensure the smooth installation of natural gas service. 9 Storing valuable resources for customers and the region NW Natural is achieving cost savings and additional revenues by expanding its under- ground and liquefied natural gas storage activities. ith today’s price vola- tility and competition for interstate pipeline space, storage is a crit- ical asset in the natural gas industry. NW Natural’s underground storage and liquefied natural gas (LNG) plants help the Company keep down gas costs while generating additional revenue. Pipeline project moves forward NW Natural is in the process of extending the transmis- sion pipeline that connects the Mist underground gas storage field to the Company’s distribution system west and south of Portland. The South Mist Pipeline Extension (SMPE) will The Added Value of LNG NW Natural sells liquefied natural gas to other local gas dis- tributors to supplement their supplies. Above, Portland LNG Plant Operator Teri Carl adjusts the pressure that delivers LNG from the trailer into the ambient vaporizing unit. The vaporizer warms the LNG back into gaseous form for use in the distribution system. 10 serve some of the state’s fastest growing communities as well as connecting to the interstate pipeline system. The SMPE project involved one of the most complicat- ed energy siting proceedings ever conducted by Oregon’s Energy Facility Siting Council (EFSC). Following two years of review of NW Natural’s application, including extensive public involvement, the EFSC granted a permit for the project, with conditions, on March 13, 2003. The Company hopes to begin construction in the summer of 2003 and to have the entire pipeline extension in service in time for the winter of 2004-05. Interstate storage attracts customers In 2002, NW Natural increased the number of interstate storage customers to six firm and two interruptible cus- tomers. The Company began interstate storage sales in 2001 with four firm customers. In 2002, NW Natural marketed about one Bcf of new working gas capacity to new and existing customers. NW Natural signed a contract with Entergy-Koch Trad- ing, LP, to trade temporarily available storage and trans- portation capacity in the interstate market. Aquila Energy had performed this “optimization” service for NW Natural before leaving the trading business. Interstate storage and op- timization services contributed 14 cents a share to the Com- pany’s 2002 earnings compared to 8 cents a share in 2001. LNG — a versatile commodity NW Natural built its two LNG plants to ensure a sup- ply cushion in the event of pipeline disruptions or extremely cold weather. But liquefied natural gas — coupled with spe- cialized transport vehicles — is both versatile and valuable. In 2002, BC Gas in Vancouver, British Columbia, need- ed a supply of LNG to fuel a remote lumber mill when its own LNG plant closed for maintenance. NW Natural sold LNG and leased its 10,000-gallon trailer to the Canadian company, which purchased more than 130 trailer loads over eight months. NW Natural also uses LNG trailers to keep natural gas flowing to customers during transmission line repairs. The Company has used a 500-gallon trailer to allow industrial customers a chance to test natural gas before switching fuels for their plants, resulting in added year-round load. GAS STORAGE Name: Location: Job title: NWN service: Kishore Duwadi Miller Station, Mist, OR Supervising Engineer, Gas Storage 11 years Kishore Duwadi supervises operations at NW Natural’s underground gas storage facilities at Mist to help assure reliable gas supplies to customers. Mist is the only commercial gas-producing field in the Pacific Northwest, and its gas resources continue to be explored and developed. “The employees here are all very helpful and team-oriented,” says Duwadi. “We take pride in running the plant without any significant down time. When the demand is there, we do everything we can to meet the customers’ needs.” 11 Growing our customer base through targeted efforts The Company exceeded most of its customer growth targets for 2002, with particularly strong growth in residential conversions. W Natural added 19,136 cus- tomers in 2002, some 18 per- cent more than projected at the start of the year. Solid results in new construction New residential construction got a boost from low interest rates. Natural gas typically captures 90-plus percent of the new construction market. The Company exceeded its residential new construction targets by 24 percent. New construction in the commercial sector grew at a slower pace, reflecting a slower economy. However, NW Natural still reached 97 percent of its target for new con- struction commercial customers. The Company achieved its growth goals in multifam- ily housing. Although new construction of multifamily units was slower than 2001, NW Natural attracted a high- er share of that market. The shift was attributed to NW Natural’s targeted work with architects and engineers ear- Rewarding Builders for Going Gas NW Natural employees (standing) Kathy Dolezal and Paul Corso serve real estate agents at a Company-sponsored open house lunch in Vancouver, Washington. NW Natural sponsors the builder/real estate agent open houses for new homes that feature natural gas dryer stubs in addition to natural gas heat- ing, water heating, ranges and hearth products. The program is intended to increase awareness about the advantages of building homes ready for natural gas dryers. 12 ly in their design of multifamily projects. Conversions come on strong While new construction results were favorable in 2002, it was residential conversions that stole the show. The number of residents who converted to natural gas was 29 percent higher than had been projected. Consumer Services General Manager Grant Yoshihara said the dramatic increase in conversions was due to three factors: 1) a targeted approach for identifying and mar- keting to customers who live on existing mains, who can be acquired profitably and who have a high likelihood of converting; 2) a successful partnership with heating, ven- tilation and air conditioning (HVAC) distributors and dealers; and 3) a widening price advantage for natural gas vs. electricity. NW Natural is using an updated financial model to ensure that customer growth is profitable. The model is based on cash flow and includes a probabilities analysis that provides the Company with better estimates of con- version potential. “The result is that we are achieving strong customer growth that is meeting our requirements for return on equity invested,” said Yoshihara. Partnership pays off NW Natural is partnering with HVAC distributors and dealers for advertising and promotion. NW Natural dis- tributes sales leads based on a performance-tracking model that rewards dealers for closing sales and meeting customer expectations. The result has been an increase in the sales-to-lead ratio and a reduction in the costs of gen- erating a sales lead. Commercial customers also switched to natural gas in 2002, largely because of its price advantages. Gas prices came down while electricity prices remained high. The Company exceeded its target for commercial conversions by 7 percent. Customers in two areas within NW Natural’s service territory — Vancouver, Washington and Eugene, Oregon — were particularly influenced by the widening price advan- tage of natural gas. In Vancouver, for example, the cost of heating a home with electricity was 58 percent higher than the cost of heating with natural gas. CUSTOMER GROWTH Name: Location: Job title: NWN service: Mark Farley Portland, OR Main Crew Leader 14 years Construction employees who connect conversion customers to NW Natural’s distribution system are committed to leaving the customer’s property looking at least as good as they found it. “When we leave a job, hopefully people won’t even know we’ve been there,” says Crew Leader Mark Farley, shown above restoring landscaping after a con- version service installation in east Portland. 13 SAFETY Name: Location: Job Title: NWN service: Lee Hughes Salem, OR Distribution Crew Leader 25 years Distribution Crew Leader Lee Hughes works with fellow Salem crew members Ron Brown and Foo Ma (back- ground, left to right) to replace old bare steel pipe along Highway 99E with new polyethylene or coated steel pipe. “The new pipe eliminates leakage and increases transmission capacity,” said Hughes. “We can run higher pres- sure gas through it, and it has a larger diameter. So it is not only safer, but also allows us to serve more customers.” 14 Protecting pipelines, employees and the public afety remained a NW Natural priority in 2002, as the Company continued improving its infrastruc- ture and construction practices. The Company’s safety experts also tightened security, as the nation’s utilities responded to the threat of terrorism. Retrofitting for safety In 2002, NW Natural replaced more than five miles of bare steel pipelines, ranging from 3/4-inch service lines to 8-inch mains, with coated steel or polyethylene pipe. This began the second phase of an ongoing effort to replace aging pipelines. The Company eliminated all of its origi- nal cast iron pipes, some of them nearly 100 years old, in a 15-year project completed in 2000. An agreement with the Oregon Public Utility Commis- sion allowed the Company to recover about $3 million of its 2002 bare steel replacement costs. In addition, NW Natural is allowed to recover costs for its aggressive geohazard program. In 2002, the Company spent about $1.5 million inspecting, analyzing and protecting transmission lines from landslides and other potential geological hazards. Employees demonstrate safety qualifications In 1999, the U.S. Department of Transportation adopt- ed the Operator Qualification (OQ) Rule. The regulation calls for pipeline operators to demonstrate that their em- ployees and contractors are qualified to perform certain tasks affecting pipeline safety. Over the next three years, NW Natural involved em- ployees and supervisors in identifying 220 “covered tasks” under the OQ Rule. The Company then administered 22,000 individual assessments (written tests and performance evaluations) to 695 employees. All employees and con- tractors who perform covered tasks qualified under the federal rule by the Oct. 28, 2002 deadline. NW Natural will assess the skills of new employees and routinely re-qualify current employees. In addition, covered tasks will be added, deleted or modified as con- struction processes evolve. Responding to a post-9/11 world Shortly after Sept. 11, 2001, NW Natural created a Homeland Security Committee to review and improve security procedures at NW Natural facilities. From replacing old pipe to strengthening security, NW Natural provides for the safety of its customers, employees and local communities. One of the committee’s first actions was to contract with an experienced security specialist who assessed security at the Company’s headquarters, serv- ice centers, district offices and other facilities. In 2002, the Company started imple- menting the consultant’s recommendations, which in- cluded strengthening security protocol and making physical changes at key facilities. These efforts will con- tinue in 2003. NW Natural invested in new gates, fencing and control monitors at critical locations. Management established and trained employees in new measures for restricting access to Company facilities. The Homeland Security Committee kept employees informed of national security alerts and raised employee awareness of security concerns at all levels of the Company. Inspecting the Pipe Federal and state regulators work with NW Natural to inspect pipelines for safety. Above (left to right) are Al Jones, pipeline safety engineer with the Washington Utilities and Transporta- tion Commission; NW Natural Design Engineer Jodi Wright and Chief Engineer Bruce Paskett; and Steve Rieger, engineer with the U.S. Department of Transportation, Office of Pipeline Safety. 15 COMMUNITY SERVICE Names: Location: Job Titles: NWN service: Tonya Brumley (front); Mindi Thayer (background) The Dalles, OR Customer Acquisition Coordinator; District Manager 5 years; 8 years The spirit of community service is strong and ever-present at NW Natural. Above, Tonya Brumley and Mindi Thayer of the Company’s office in The Dalles supervise flower planting in a city park with the Brownie Scout Troop they co-lead. “My goal is to teach the girls the importance of giving,” says Brumley. “Whether it be in time, money or sharing, we can have fun together when we give to others.” 16 Serving our communities, for today and the future or NW Natural and its employees, the idea of serv- ice goes beyond supplying a safe, reliable fuel. The Company builds community involvement into its programs and budgets. Individual employees show dedication to their communities by contributing time to causes important to them. Volunteerism encouraged NW Natural employees love to volunteer for good causes. Company employees serve as volunteer mentors, theater board members, Special Olympics coaches, tutors and much more. Employees are equally generous financial supporters of programs they care about. To support and encourage community involvement, NW Natural invites employees to participate in the Dollars for Doers program. Applicants submit entries describing the organizations to which they contribute either time or money. The Company responds with cash contributions. Contributions support community programs Each year, NW Natural contributes one percent of net earnings to charity. In 2002, philanthropic priorities in- cluded three sectors that are critical to Northwest commu- nities: affordable housing, education and quality of life/ environmental protection. While most of the Company’s contributions are made at the corporate level, NW Natural sets aside individual funds for district managers to support local community activities. In addition to cash, NW Natural’s contributions of per- sonnel and products support community organizations. The Company’s cook wagons are visible at fund-raisers and other charitable activities year-round. Canopies with the Company logo can be seen at concerts, athletic events and warm-weather festivals. As in previous years, the Company’s 2002 annual charitable campaign proved to be a successful way to en- courage employee philanthropy. Last year, employees gave $181,000 to the United Way, Black United Fund and Earth Share of Oregon. Company demonstrates community leadership NW Natural takes its responsibilities to Northwest communities seriously. That’s why executives and other employees share expertise with governments at all levels on crit- ical policy issues and projects. The Company and its employees reach out to meet community needs. In 2002, NW Natural managers helped the City of Portland in efforts to address problems such as a trouble- some computer system and a development permitting process that needed to be more user-friendly. Also in 2002, Chairman and CEO Dick Reiten chaired the Oregon Business Plan Committee, a group of business people eager to help the state find the most direct way out of its economic slump. The planning effort culminat- ed in a December conference sponsored by Oregon’s gov- ernor-elect and two U.S. senators, moderated by Reiten and attended by 1,300 business and government leaders. Helping Those in Need Volunteers provide meals to clients at Transition Projects, which helps Multnomah County residents meet their basic needs for shelter, food, clothing and physical and emotional health. Serving residents at the agency’s Clark Center facili- ty in Portland are (left to right) TPI Executive Director Doreen Binder; TPI Board Member and NW Natural Residential Consumer Services Manager Mark Forker; and TPI Volunteer Coordinator Beth Gergick. Residents being served are (left to right) Allan Williams, Ronald Barr and Brad Brotherton. 17 Governance by NW Natural Board members Board creates new committees to assure NW Natural’s compliance with governance and ethics requirements. W Natural’s Board of Direc- tors took steps in 2002 to improve its effectiveness in guiding the Company. It re- structured its Executive Committee to become the Governance Committee and created the new Public Affairs Committee. These committees, together with the Audit Committee, will help carry out the Board’s and Company’s responsibilities under new federal mandates. The Governance Committee, composed entirely of in- dependent directors, establishes criteria for Board and com- mittee membership; establishes policies that govern the Board’s activities, including meeting structure and content; and evaluates the Board, committees and individual direc- tor performance. It also reviews annually the performance of the CEO and considers any questions of possible con- flicts of interest of Board members and senior executives. The Audit Committee, also composed entirely of inde- pendent directors, is responsible for overseeing matters related to accounting, financial reporting, internal control, auditing and regulatory compliance. During 2002, the Audit Committee expanded its meeting schedule and established new procedures to ensure the continuing integrity of the Company’s financial reports. The Public Affairs Committee is responsible for review- ing NW Natural’s policies and practices relating to signifi- cant public and political issues that may have an impact on the Company’s business operations, financial performance or public image. It oversees NW Natural’s programs and policies relating to civic, charitable and community affairs, safety and health, and equal employment opportunity. The Committee makes recommendations to the Board to ensure that the Company fulfills its objectives in a manner consis- tent with the responsibilities of good corporate citizenship. By reviewing its existing practices, examining and adopting the best practices of other companies and chal- lenging the Company to meet the highest standards of con- duct, the Board has actively responded to rapid changes in the corporate environment. Overseeing Corporate Governance Governance Committee members Randy Papé, Melody Teppola, Wayne Kuni (chair), Dick Woolworth, Russ Tromley and Tod Hamachek are responsible for matters of corporate governance, including Board membership, meeting structure and content, and Board and director performance. 18 MANAGEMENT’S DISCUSSION AND ANALYSIS T he following is management’s assessment of Northwest Natural Gas Company’s financial condition including the principal factors that affect results of operations. The discussion refers to the consolidated activities of the Company for the three years ended Dec. 31, 2002. References in this discussion to “Notes” are to the notes to the con- solidated financial statements. The consolidated financial statements include: Regulated utility: ■ Northwest Natural Gas Company (NW Natural) Non-regulated wholly-owned subsidiary businesses: ■ NNG Financial Corporation (Financial Corporation), and its wholly-owned subsidiaries ■ Northwest Energy Corporation (Northwest Energy), and its wholly-owned subsidiary Non-regulated majority-owned subsidiary business: ■ Canor Energy, Ltd. (Canor), sold in 2000 Together these businesses are referred to herein as the “Company” (see “Non-utility Operations,” below, and Note 2). HIGHLIGHTS Among its accomplishments in 2002, the Company: ■ grew the utility customer base by more than 3 percent for the 16th year in a row, adding 19,136 customers to NW Natural’s gas distri- bution system during the year; ■ exceeded the prior year’s customer additions from residential and commercial conversions and residential new construction, despite weaker economic conditions; reduced rates for NW Natural’s customers in Oregon and Washington due to lower purchased gas costs, and refunded $33 million to cus- tomers from its savings on gas purchases in the past year; ■ expanded service in the interstate market for gas storage services, increasing earnings from this business segment from 8 cents a share in 2001 to 14 cents a share in 2002; received approval from the Oregon Public Utility Commission (OPUC) for rate adjustments and a partial decoupling mechanism that will help stabilize margin revenues while better aligning NW Natural’s financial interests with customers’ interests in conserving energy; tested and successfully qualified, under a federally-mandated Operator Qualification rule, all 695 NW Natural employees who work on natural gas pipelines; ■ elected to terminate the October 2001 contract to acquire Portland General Electric Company (PGE) in light of the risks associated with the bankruptcy of PGE’s parent company, Enron Corp. (Enron); and ■ paid dividends on common stock of $1.26 a share, making 2002 the 47th consecutive year in which the Company’s dividend payments have increased. ISSUES AND CHALLENGES Issues and challenges the Company expects to face in 2003, as dis- cussed below, include the effects and uncertainties relating to a gen- eral rate case in Oregon, volatile gas commodity prices, unusually warm temperatures in the winter of 2002-03, continuing weak eco- nomic conditions in Oregon and Washington, higher costs for pen- sions, health benefits and insurance, uncertainties relating to the per- mits and rights-of-way necessary for the planned extension of the pipeline from NW Natural’s Mist gas storage field, and higher cap- ital and maintenance costs due to federal mandates in the area of pipeline integrity. EARNINGS AND DIVIDENDS The Company’s earnings applicable to common stock in 2002 were $41.5 million, down from $47.8 million in both 2001 and 2000. Earn- ings for 2002 were reduced by a loss provision of $8.4 million after tax, representing the Company’s costs incurred in its effort to acquire PGE from Enron. Diluted earnings per share from consolidated operations were $1.62 a share in 2002, down from $1.88 a share in both 2001 and 2000. Excluding the charges relating to the acquisition effort, dilut- ed earnings per share from consolidated operations in 2002 would have been $1.95 a share. Earnings for 2001 and 2000 were the high- est and second highest on record for the Company. Earnings in 2000 included a gain of 9 cents a share from the sale of Canor. NW Natural earned $1.76 a diluted share from gas utility opera- tions in 2002, the same as the result from utility operations in 2001, compared to $1.78 a share in 2000. Weather conditions in its service territory in 2002 were very close to average for the year as a whole but were 2 percent warmer than 2001. Temperatures in 2001 were 2 per- cent warmer than 2000 and 3 percent colder than the 20-year average. Weather in 2000 was 5 percent colder than the 20-year average. Results in 2002 from the Company’s non-utility operations were a loss of 14 cents a share, including earnings of 14 cents a share from gas storage operations, charges equivalent to 33 cents a share relating to the effort to purchase PGE, and earnings of 5 cents a share from other subsidiary and non-utility operations. The charges relating to the PGE transaction resulted from the termination effective July 1, 2002 of the Company’s contract to purchase PGE. Non-utility operating results for 2001 were earnings of 12 cents a share, including 8 cents a share from gas storage operations. Non-utility operating results for 2000 were earnings of 10 cents a share, including a gain of 9 cents a share from the sale of Canor (see “Non-utility Operations,” below). Dividends paid on common stock were $1.26 a share in 2002 com- pared to $1.245 a share in 2001 and $1.24 a share in 2000. APPLICATION OF CRITICAL ACCOUNTING POLICIES In preparing the Company’s financial statements using generally accepted accounting principles in the United States of America (GAAP), management exercises judgment in the selection and appli- cation of accounting principles, including making estimates and assumptions. Management considers its critical accounting policies to be those which are most important to the representation of the Company’s financial condition and results of operations and which require management’s most difficult and subjective or complex judg- ments, including those that could result in materially different amounts if the Company reported under different conditions or using different assumptions. The Company’s critical accounting policies are described below. Other significant accounting policies and recent accounting pro- nouncements are discussed in Note 1. Regulatory Accounting NW Natural generally uses the same accounting policies and prac- tices used by unregulated companies for financial reporting under GAAP. However, sometimes these principles, such as Statement of Financial Accounting Standards (SFAS) No. 71, “Accounting for the Effects of Certain Types of Regulation,” require different accounting treatment for regulated companies to show the effects of regulation. For example, in setting NW Natural’s retail rates, the OPUC may not allow NW Natural to charge its customers currently to recover certain expenses, but instead may require that these expenses be charged to cus- tomers in the future. In this situation, SFAS No. 71 requires NW Natural N W N A T U R A L 19 ■ ■ ■ MANAGEMENT’S DISCUSSION AND ANALYSIS to defer these items and show them as regulatory assets on the bal- ance sheet until NW Natural is allowed to charge its customers. NW Natural then amortizes these items as expense to the income state- ment as the charges are recovered from customers. Similarly, certain revenue items may be deferred as regulatory liabilities, which are also eventually amortized to the income statement as rates to cus- tomers are reduced. The conditions a regulated company must satisfy to apply the accounting policies and practices of SFAS No. 71 include: ■ an independent regulator sets rates; the regulator sets the rates to cover specific costs of delivering serv- ice; and the service territory lacks competitive pressures to reduce rates below the rates set by the regulator. NW Natural applies SFAS No. 71 in accounting for its regulated operations. The Company periodically assesses whether it can continue to apply SFAS No. 71. If NW Natural should determine in the future that all or a portion of its regulatory assets and liabilities no longer meet the criteria for continued application of SFAS No. 71, then it would be required to write off the net unrecoverable balances of its regula- tory assets and liabilities as a charge to income. Revenue Recognition Utility revenues are derived primarily from the sale and transpor- tation of natural gas. Utility revenue from gas sales and transporta- tion is recognized when the gas is delivered to and received by the cus- tomer. Estimated revenues are accrued for gas deliveries not billed to customers from meter reading dates to month end (unbilled revenue) and are reversed the following month when actual billings occur. Revenues from non-utility services, including gas storage, are recognized upon delivery of the service to customers. Revenues from non-utility optimization contracts are recognized, after deducting for regulatory revenue sharing, over the life of the contract for amounts guaranteed under the contract, or as amounts are earned and rea- sonably estimable for amounts above the guaranteed value. Accounting for Derivative Instruments and Hedging Activities The Company adopted SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” on Jan. 1, 2001. This statement established accounting and reporting standards for derivative instru- ments, including certain derivative instruments embedded in other contracts, and for hedging activities. SFAS No. 133 requires that an entity recognize derivatives as either assets or liabilities on the bal- ance sheet and measure those instruments at fair value. SFAS No. 133 also requires that changes in the fair value of a derivative be rec- ognized currently in earnings unless specific hedge accounting criteria are met. NW Natural’s Derivatives Policy sets forth the guidelines for using selected financial derivative products to support prudent risk man- agement strategies within designated parameters (see Note 1). NW Natural’s primary hedging activities, consisting of natural gas com- modity price and foreign currency exchange rate hedges, are princi- pally accounted for as cash flow hedges under SFAS No. 133 and sub- ject to regulatory deferral pursuant to SFAS No. 71. Unrealized gains and losses from mark-to-market valuations of these contracts are not recognized in current income but are reported as non-trading deriva- tive assets or liabilities and offset by a corresponding deferred account balance included under “Regulatory liabilities” or “Regulatory assets.” At Dec. 31, 2002, NW Natural had derivatives outstanding cover- ing its exposures to commodity and foreign currency prices (see Note 11). The fair value of the hedge derivatives outstanding on that date 20 N W N A T U R A L was a net gain of $12.4 million, compared to a net loss of $111.9 mil- lion at Dec. 31, 2001. NW Natural had two natural gas price swap con- tracts extending beyond Dec. 31, 2003, but none extends beyond Oct. 31, 2004. None of the natural gas call option contracts extends beyond March 31, 2003. In 2002, NW Natural recorded net losses from commodity swap and call option contracts of $75.5 million, compared to net gains of $57.6 million and $56.2 million during 2001 and 2000, respectively. Gains (losses) from commodity hedges are recorded as reductions (increases) to the cost of gas and are included in the calculation of annu- al Purchased Gas Adjustment (PGA) rate changes. The gain or loss on all foreign currency forward purchase contracts relating to gas purchase obligations is included in NW Natural’s cost of gas. The fair value of derivative instruments at Dec. 31, 2002 and 2001 was determined using estimated or quoted market prices for the peri- ods covered by the contracts. Market prices for the natural gas swap and call option contracts were obtained from external sources. These third-party valuations are reviewed for reasonableness by the Company using fair value calculations for other contracts with similar terms and conditions. The market prices for the foreign currency forward contracts are based on currency exchange rates quoted by The Bank of Canada. Accounting for Pensions NW Natural has two qualified non-contributory defined benefit pension plans that cover all regular employees with more than one year of service. These plans are funded through a trust dedicated to pro- viding the benefits. Net periodic pension costs are determined in accordance with SFAS No. 87, “Employers’Accounting for Pensions” (see “Financial Condition – Pension Cost (Income) and Funding Status,” below). NW Natural’s pension cost consists of service costs, interest costs, the amortization of actuarial gains and losses, and expected long-term returns on plan assets, and is based in part on a market-relat- ed valuation of assets. Variances between actual investment gains or losses and expected returns on plan assets are recognized over a three- year period from the year in which they occur, thereby reducing year- to-year volatility. NW Natural’s accumulated benefit obligation, the fair value of plan assets and the amount of annual pension cost are calculated based on a number of actuarial assumptions including an expected long- term return on plan assets, assumed rates of compensation increase and a discount rate (see Note 7). In developing these assumptions, NW Natural evaluates input from its actuaries as well as information avail- able from the securities markets. The actuarial assumptions are eval- uated annually and adjusted as necessary. Based on information from its actuaries and investment advisors, NW Natural reduced its expected long-term return on plan assets from 9 percent to 8 percent, and reduced the discount rate used in calculating benefit obligations from 7.25 percent to 6.75 percent, both effective as of Jan. 1, 2003. Had these assumptions been in effect a year earlier, NW Natural would have recorded net periodic pension cost of $2.2 million for the year, rather than pension income of $0.1 million, and the Company’s net income would have been lower by $0.8 million. Contingencies The Company records loss contingencies when it is probable that a loss has been incurred and the amount of the loss is reasonably estimable. Estimating probable losses requires analysis of uncer- tainties that often depend upon judgments about potential actions by third parties. In the normal course of business, NW Natural records accruals for loss contingencies including allowances for uncollectible ■ ■ accounts receivable, environmental claims and property damage and personal injury claims. NW Natural records receivables for anticipated recoveries under insurance contracts when recovery is probable. RESULTS OF OPERATIONS Regulatory Matters NW Natural provides gas utility service in Oregon and Washington, with Oregon representing over 90 percent of its revenues. Future earn- ings and cash flows from utility operations will be determined large- ly by the pace of continued growth in the residential and commercial markets and by the ability to remain price competitive in the large in- dustrial market, to control expenses, and to obtain reasonable and timely regulatory ratemaking treatment for investments made in util- ity plant. NW Natural’s most recent general rate increase in Oregon, which was effective Dec. 1, 1999, authorized rates designed to produce a re- turn on common shareholders’ equity (ROE) of 10.25 percent. The OPUC approved a revenue increase of $0.2 million per year, or 0.1 percent of Oregon revenues. On Nov. 29, 2002, NW Natural filed a new general rate case in Oregon. The filing proposes a revenue increase of $38 million per year from Oregon operations through rate increases averaging 6.8 percent. If the increase were approved as proposed, residential customer rates would increase by 8.9 percent and commercial rates by 4.6 percent; there would be no changes for industrial firm or interruptible cus- tomer rates. The proposed rates are designed to produce an ROE of 11.3 percent and to recover increases in NW Natural’s cost of serv- ice including the costs of complying with new federal regulations regarding pipeline safety and integrity; expanding the Company’s underground storage facilities to meet customer growth; commenc- ing service to Coos County, Oregon; improving customer service; and providing for system security, insurance coverage and employee benefits. The schedule for the case provides for settlement confer- ences in March 2003, the filing of OPUC staff and intervenor testi- mony in late April, hearings in August and a decision by the OPUC determining new rates by Oct. 1. The Company is unable to determine the extent to which its proposals will be accepted by the OPUC. In October 2000, the Washington Utilities and Transportation Com- mission (WUTC) authorized a general rate increase totaling $4.3 mil- lion per year, or 12.1 percent. The first $3.0 million per year of the revenue increase, relating to costs allocated to Washington under a cost allocation study approved by the WUTC and the OPUC, was effec- tive on Nov. 1, 2000. The remaining increase of $1.3 million per year was effective on Oct. 1, 2001. The WUTC authorized and based rates on an ROE of 10.8 percent. NW Natural applies rate changes each year under the PGA mech- anisms in its tariffs in Oregon and Washington. The rate increases or decreases reflect changes in the costs of natural gas commodity pur- chased under contracts with gas producers (see “Comparison of Gas Operations – Cost of Gas,” below), the application of temporary rate adjustments to amortize balances in regulatory asset or liability accounts and the removal of temporary rate adjustments effective the previous year. In 2002, the OPUC approved rate decreases averaging 14 percent for NW Natural’s Oregon sales customers and the WUTC approved rate decreases averaging 25 percent for NW Natural’s Washington sales customers, both effective on Oct. 1, 2002. In 2001, the OPUC approved rate increases averaging 22 percent for Oregon sales customers and the WUTC approved rate increases averaging 21 percent for Washington sales customers, both effective on Oct. 1, 2001. In 2000, the OPUC approved rate increases averaging 23 per- cent for Oregon sales customers effective on Oct. 1, 2000 and the WUTC approved rate increases averaging 23 percent for Washington sales customers effective on Aug. 1, 2000. In an order issued in 1999, the OPUC formalized a process that tests for excessive earnings in connection with gas utilities’ annual filings under their PGA mechanisms. The OPUC confirmed NW Natural’s ability to pass through 100 percent of its prudently incurred gas costs into rates. Under this order, NW Natural is authorized to retain all of its earnings up to a threshold level equal to its authorized ROE plus 300 basis points. One-third of any earnings above that level will be refunded to customers. The excess earnings threshold is subject to adjustment up or down each year depending on movements in inter- est rates. There were no amounts identified in this process for refund to customers with respect to NW Natural’s earnings results in 2000 or 2001. NW Natural does not expect there will be amounts identi- fied for refund with respect to its earnings in 2002, which will be reviewed by the OPUC in the second quarter of 2003. In 2002, the OPUC approved a settlement in a proceeding NW Natural initiated in 2001 with a goal of stabilizing margin revenues in the face of above- or below-normal consumption patterns. NW Natural believes that reductions in recent years in its customers’ gas consumptions per degree day (see “Comparison of Gas Operations – Residential and Commercial,” below) were caused by increases in the cost of purchased gas that were passed on to customers as rate increas- es, and to efforts throughout the region to conserve energy. NW Natural estimates that lower average consumptions per degree day reduced mar- gin from residential and commercial sales by $11 million, equivalent to 26 cents a share, in 2001, and by $10.7 million, equivalent to 25 cents a share, in the first nine months of 2002. Pursuant to the settle- ment, the OPUC authorized a mechanism for rate changes relating to the impact of price elasticity, starting with small increases to resi- dential and commercial rates that became effective on Oct. 1, 2002. These rate changes contributed an estimated $3.5 million of margin during the fourth quarter of 2002, equivalent to 8 cents a share. Also under the settlement, the OPUC authorized NW Natural to implement a partial decoupling mechanism effective Oct. 1, 2002. Decoupling mechanisms are used to break the link between a utility’s earnings and the energy consumed by its customers so the utility does not have an incentive to discourage customers’ conservation efforts. The decoupling mechanism works by adding margin revenues during periods when customer consumptions are lower than baseline con- sumption or by deducting margin revenues when consumptions are higher than the baseline. Under the partial decoupling mechanism, NW Natural uses a balancing account to defer and subsequently amortize 90 percent of the margin differentials between baseline usage by its residential and commercial customers and weather-normalized actu- al usage by these customers. The deferred amounts are treated as adjustments to be refunded or collected in future periods. Baseline con- sumption is based on current customer consumption patterns, adjust- ed for consumptions resulting from new customers. NW Natural con- tinues to bear the risk of weather-related variations in customer usage. The partial decoupling mechanism will expire at the end of September 2005 unless the OPUC approves an extension based on the results of an independent study to measure the mechanism’s effectiveness. Also under the settlement, NW Natural agreed to adopt certain service quality measures that establish the Company’s performance goal for minimizing complaints by customers where the Company is determined to be at fault. If NW Natural exceeds the prescribed lev- el of at-fault complaints, it will be subject to penalties. N W N A T U R A L 21 MANAGEMENT’S DISCUSSION AND ANALYSIS Comparison of Gas Operations The following table summarizes the composition of gas utility vol- umes and revenues for the three years ended Dec. 31: (Thousands, except customers and degree days) 2001 2002 2000 Utility Gas Sales and Transportation Volumes – Therms: Residential and commercial sales Unbilled volumes 597,246 (6,617) ________ 592,358 1,771 ________ 606,755 8,691 ________ Industrial firm sales Industrial interruptible sales Weather-sensitive volumes 590,629 52% 594,129 53% 615,446 52% 6% 63,215 5% 26,241 ________ _____ ________ _____ ________ _____ 680,085 60% 737,504 66% 748,637 63% 445,999 40% 385,783 34% 431,136 37% ________ _____ ________ _____ ________ _____ 6% 79,778 2% 63,597 7% 76,559 6% 56,632 Total gas sales Transportation deliveries Total volumes sold and delivered 1,126,084 100% 1,123,287 100% 1,179,773 100% ________ _____ ________ _____ ________ _____ ________ _____ ________ _____ ________ _____ Utility Operating Revenues – Dollars: Residential and commercial sales Unbilled revenues $ 556,210 (12,702) ________ $ 520,141 13,774 ________ $ 440,302 12,661 ________ Weather-sensitive revenues Industrial firm sales Industrial interruptible sales Total gas sales Transportation revenues Other revenues Total utility operating revenues Cost of gas sold Net operating revenues (utility margin) Total number of customers (end of period) Actual degree days 20-year average degree days 7% 49,662 2% 34,283 543,508 86% 533,915 84% 452,963 85% 7% 42,965 15,937 5% ________ _____ ________ _____ ________ _____ 602,410 95% 617,860 97% 513,824 97% 4% 26,020 (1%) 4,018 ________ _____ ________ _____ ________ _____ 4% 20,637 1% (2,325) 3% 21,491 (3,976) 8% 37,378 5% 23,483 – $ 632,448 100% $ 636,172 100% $ 531,339 100% ________ _____ ________ _____ ________ _____ ________ _____ ________ _____ ________ _____ $ 353,034 ________ ________ $ 273,978 ________ ________ $ 364,699 ________ ________ $ 279,414 ________ ________ $ 271,473 ________ ________ $ 257,361 ________ ________ 560,067 ________ ________ 4,232 ________ ________ 4,216 ________ ________ 540,931 ________ ________ 4,325 ________ ________ 4,202 ________ ________ 523,406 ________ ________ 4,418 ________ ________ 4,197 ________ ________ NW Natural refunded deferred gas cost savings to its Oregon cus- tomers through billing credits in June 2002. The refunds were the customers’ 67 percent portion of gas cost savings realized between October 2001 and March 2002, which had been deferred, with inter- est, pursuant to NW Natural’s PGA tariff in Oregon (see “Cost of Gas,” below). The refunds reduced total gas sales and total utility operating revenues for 2002 by $30.2 million and cost of gas sold by $29.5 mil- lion. The refunds also reduced utility margin by about $0.9 million, but this amount was largely offset by corresponding reductions in franchise tax expense and uncollectible expense with the result that the effect of the refunds on net income was negligible. Residential and Commercial NW Natural continued to grow its customer base, with 19,136 customers added during 2002. This represents a growth rate of 3.5 percent, compared to 3.3 percent in 2001 and 4.4 percent in 2000. In the three years ended Dec. 31, 2002, more than 58,000 customers were added to the system, representing an average annual growth rate of 3.9 percent. Typically, 80 percent or more of NW Natural’s annual operating revenues are derived from gas sales to weather-sensitive residential and commercial customers. Accordingly, variations in temperatures between periods affect volumes of gas sold to these customers. Weather conditions in 2002 were very close to average for the year. Temperatures were 3 percent colder than average in 2001 and 5 percent colder than average in 2000. Weather in 2002 was 2 percent warmer than 2001 and 2001 was 2 percent warmer than 2000. Average weather conditions are calculated from the most recent 20 years of tem- perature data measured by heating degree-days. 22 N W N A T U R A L The volumes of gas sold to residential and commercial customers were 1 percent lower in 2002 than in 2001 and 3 percent lower in 2001 than in 2000, reflecting warmer weather as well as lower con- sumption patterns by customers due to higher gas commodity prices included in rates in previous years. Effective Oct. 1, 2002, the Com- pany implemented rate increases designed to recover the margin lost due to the changes in consumption patterns. Excluding the impact of the refunds to Oregon customers during 2002, in- related revenues creased $40 million, or 7 percent, primarily due to PGA tariff rate in- creases effective Oct. 1, 2001 (see “Regulatory Matters,” above). Rev- enue from residential and commercial cus- tomers was 18 percent higher in 2001 than in 2000 due to rate increas- es effective in 2000 and 2001. WEATHER-SENSITIVE OPERATING REVENUES AND DEGREE DAYS IN MILLIONS OF DOLLARS 4,418 degree days 4,232 degree days 4,325 degree days $575 $550 $525 $500 $475 $450 $425 $400 $534 $453 $544 01 00 02 WEATHER-SENSITIVE REVENUES DEGREE DAYS Weather-sensitive operating revenues have been at record levels during the past three years. Weather condi- tions in 2002 were comparable to the 20-year average. In order to match revenues with related purchased gas costs, NW Natural records unbilled revenues for gas deliv- ered and sold to cus- tomers, but not yet billed, through the end of the period. Amounts report- ed as unbilled revenues reflect the increase or decrease in the balance of unbilled revenues over the prior year-end. Weather conditions, rate changes and customer billing dates from one period to the next affect year-end balances. Industrial Sales, Transportation and Other Revenues The following table summarizes the delivered volumes and mar- gin by market segment in the industrial market: 2002 (Thousands) 2001 2000 Delivered volumes by market segment (therms): Electric generation Industrial sales and transportation Total volumes Margin by market segment (dollars): Electric generation Industrial sales and transportation Total margin 3,400 531,195 534,595 3,798 42,867 560,675 486,116 ________ ________ ________ 564,473 528,983 ________ ________ ________ ________ ________ ________ $ 4,584 $ 4,721 $ 71 46,683 ________ ________ ________ $ 45,250 $ 47,972 $ 46,754 ________ ________ ________ ________ ________ ________ 43,251 40,666 Total volumes delivered to industrial and electric generation cus- tomers were 1 percent higher in 2002 than in 2001 and 6 percent low- er in 2001 than in 2000. Combined margins from these customers were 6 percent lower in 2002 than in 2001 and 3 percent higher in 2001 than in 2000. Excluding electric generation customers, volumes delivered to end-use industrial sales and transportation customers were 9 percent higher in 2002 than in 2001 and 13 percent lower in 2001 than in 2000. Margin from these customers was 6 percent lower in 2002 than in 2001 and 7 percent lower in 2001 than in 2000. The decline in mar- gin from these customers was due to migrations of some industrial cus- tomers from higher margin firm service to lower margin interruptible service and to plant shut-downs or cut-backs in the manufacturing sector because of economic conditions. In the electric generation market segment, margin was $4.6 mil- lion and $4.7 million in 2002 and 2001, respectively, equivalent to 11 cents a share in each year. More than 90 percent of the margin but only about 14 percent of the gas deliveries in each of these years was from two customers that were served under contracts that went into effect in the second half of 2001 and expired at the end of the second quar- ter of 2002. Most of the margin from these contracts was from fixed charges. A third electric generation customer used 3.0 million therms in 2002, 36.8 million therms in 2001 and 3.8 million therms in 2000 under contracts with low volumetric charges. Margin in the electric generation market segment in 2000 was negligible. Other revenues include amortizations of regulatory accounts and miscellaneous fee income. In 2002, other revenues increased net util- ity operating revenues by $4.0 million. Other revenues in 2002 includ- ed customer late payment and collection fees ($3.1 million), amor- tizations of regulatory accounts covering customer consumption under NW Natural’s decoupling mechanism ($1.7 million) (see “Reg- ulatory Matters,” above), miscellaneous revenues ($1.6 million) and refunds due to sharing of income from interstate gas storage servic- es ($1.2 million), partially offset by amortizations from regulatory accounts covering conservation programs ($2.1 million) and Year 2000 costs ($1.5 million). In 2001, other revenues reduced net utility operating revenues by $2.3 million. Other revenues in 2001 included expense amortizations of regulatory accounts covering conservation programs ($4.9 mil- lion), Year 2000 costs ($1.2 million) and property taxes ($0.2 million), partially offset by revenues from customer late payment and collec- tion fees ($2.9 million) and miscellaneous revenues ($1.3 million). Cost of Gas The cost per therm of gas sold was 5 percent higher in 2002 than in 2001 and 35 percent higher in 2001 than in 2000. The cost per therm of gas sold includes current gas purchases, gas drawn from storage inventory, gains or losses from commodity hedges, margin from off- system gas sales, demand cost equalization, regulatory deferrals and company use. Results for 2002 include an adjustment reducing cost of gas by $29.5 million (see “Comparison of Gas Operations,” above). Excluding the impact of this adjustment, the cost per therm of gas sold was 14 percent higher in 2002 than in 2001, primarily due to higher prices in the natural gas commodity market. Results for 2002 also include adjustments reducing cost of gas by $2.9 million to correct the amount of deferred expenses related to the recovery of pipeline demand charges under NW Natural’s Oregon PGA mechanism. These adjust- ments contributed 7 cents a share to earnings during 2002. The cor- rected methodology will continue to be applied in the future. NW Natural uses a natural gas commodity-price hedge program under the terms of its Derivatives Policy (see Note 1) to help manage its variable price gas commodity contracts. NW Natural recorded net losses from commodity swap and call option contracts of $75.5 mil- lion during 2002, compared to net gains of $57.6 million and $56.2 million in 2001 and 2000, respectively. Gains (losses) from com- modity hedges are recorded as reductions (increases) to the cost of gas and the majority of such gains and losses are included in annual PGA rate adjustments. Under NW Natural’s PGA tariff in Oregon, net income from Oregon operations is affected within defined limits by changes in purchased gas costs. NW Natural absorbs 33 percent of the higher cost of gas sold, or retains 33 percent of the lower cost, in either case as compared to projected costs built into rates. The remaining 67 percent of the high- er or lower gas costs is recorded as deferred debits or credits (regu- latory assets or liabilities) for recovery from or refund to customers in future rates. Net savings realized from gas commodity purchases in 2002 contributed $10.8 million of margin, equivalent to 26 cents a share of earnings. Net savings realized from gas purchases in 2001 totaled $12.3 million, of which $8.2 million was deferred for refund to customers and $4.1 million was reflected as an increase in margin. These gas cost savings contributed 10 cents a share to earnings in 2001, while excess gas costs in 2000 reduced earnings by 7 cents a share. Under an agreement with the OPUC, margin from off-system gas sales is treated as a reduction of gas costs. These sales reduced the cost of gas sold by $2.8 million in 2002, $2.6 million in 2001 and $3.0 mil- lion in 2000. Natural gas commodity prices have fluctuated dramatically in recent years. NW Natural has sought to mitigate the effect of price volatility on core utility customers through the use of its underground storage facilities, by entering into gas commodity-based financial hedge contracts, and by crediting gas costs with margin revenues derived from off-system sales of commodity and released trans- portation capacity in periods when core utility customers do not ful- ly utilize firm pipeline capacity and gas supplies. Non-utility Operations At Dec. 31, 2002 and 2001, the Company’s non-utility operations consisted of two direct wholly-owned subsidiaries, Financial Corpor- ation and Northwest Energy, and gas storage operations. One dis- continued segment, Canor, a majority-owned subsidiary, was sold in 2000 (see “Discontinued Segment,” below). Financial Corporation Financial Corporation’s operating results in 2002 were net income of $1.2 million, compared to $0.7 million in 2001 and $0.1 million in 2000. The increases in net income from 2001 to 2002, and from 2000 to 2001, were due to improved operating results from Financial Cor- poration’s investments in limited partnerships in wind and solar elec- tric generation projects in California. The Company’s investment in Financial Corporation at Dec. 31, 2002, was $9.1 million, compared to $7.9 million and $7.2 million at Dec. 31, 2001 and 2000, respectively. Northwest Energy Northwest Energy was formed in 2001 to serve as the holding com- pany for NW Natural and PGE if the acquisition of PGE had been com- pleted. Northwest Energy recorded a loss provision totaling $13.9 million (before tax) in 2002 for the transaction costs incurred in con- nection with the effort to acquire PGE. These charges, equivalent to 33 cents a diluted share, were based upon the Company’s judgment that the acquisition was no longer probable. Discontinued Segment During 2000, the Company sold its interest in Canor at a gain of $2.4 million, equivalent to 9 cents a share (see Note 2). Gas Storage NW Natural realized net income from its non-utility gas storage business segment in 2002, after regulatory sharing and income tax- es, of $3.6 million or 14 cents a share, up from $2.1 million or 8 cents a share in 2001 and $0.1 million or negligible earnings per share in 2000. Gas storage services are provided to upstream interstate cus- tomers using storage capacity that has been developed in advance of core utility customers’ requirements. NW Natural retains 80 percent of the income before tax from gas storage services and credits the re- N W N A T U R A L 23 MANAGEMENT’S DISCUSSION AND ANALYSIS maining 20 percent to a deferred regulatory account for sharing with its core utility customers. Results for the gas storage business segment also include rev- enues, net of amounts shared with core utility customers, from a con- tract with an independent energy trading company that seeks to opti- mize the use of NW Natural’s assets by trading temporarily unused portions of its gas storage capacity and upstream pipeline trans- portation capacity. Operating Expenses Operations and Maintenance Consolidated operations and maintenance expenses were $1.2 mil- lion, or 1 percent, higher in 2002 than in 2001. The increase was caused primarily by higher payroll costs due to wage and salary in- creases ($1.3 million) and higher expenses for pension ($2.5 mil- lion) (see “Financial Condition – Pension Cost (Income) and Funding Status,” below) and health benefits ($1.2 million), partially offset by an amount charged to a litigation reserve in 2001 ($1.7 million), low- er information technology expenses ($1.0 million) and lower uncol- lectible accounts expense ($0.5 million). Consolidated operations and maintenance expenses were $6.1 mil- lion, or 8 percent, higher in 2001 than in 2000. The increase resulted primarily from higher payroll costs due to wage and salary increases ($1.9 million), higher costs for employees’ health and pension bene- fits ($1.9 million), a charge to a litigation reserve resulting from an unfavorable decision by the Oregon Supreme Court in a case involv- ing a claim by a commercial customer ($1.7 million) and higher uncol- lectible accounts expense ($1.0 million). Taxes Other Than Income Taxes Taxes other than income taxes, which are principally comprised of property, franchise and payroll taxes, increased $1.8 million, or 6 per- cent, in 2002. Property taxes increased $1.6 million, or 13 percent, due to higher property tax rates and utility plant additions. Franchise tax- es, regulatory fees and payroll tax expenses accounted for the remain- ing $0.2 million increase in 2002. Taxes other than income taxes increased $3.9 million, or 14 per- cent, in 2001. Property taxes increased $1.8 million, or 18 percent, due to higher property tax rates and utility plant additions. Franchise taxes, which are based on gross revenues, increased $1.5 million, or 12 per- cent, reflecting higher revenues due to NW Natural’s growing customer base and rate increases effective in late 2000 and 2001. Regulatory fees and payroll tax expenses accounted for the remaining $0.6 million increase in 2001. Depreciation and Amortization The Company’s depreciation and amortization expense increased by $2.5 million in 2002 and by $2.2 million in 2001, or about 5 per- cent in each of these years, primarily due to corresponding increases in utility plant and non-utility plant in service. Depreciation and amortization expense was $3.6 million or about 7 percent lower in 2000 than in 1999, primarily due to charges to depreciation expense in 1999 to write down NW Natural’s customer information system pursuant to the OPUC’s order in its Oregon gen- eral rate case concluded in 1999. As a percentage of average plant and property, depreciation and amortization expense was 3.5 percent in each of 2002, 2001 and 2000. Other Income (Expense) The Company’s other income (expense) decreased $16.2 million in 2002, primarily due to a $13.9 million charge to a loss provision for costs incurred in the effort to acquire PGE. Excluding the provi- sion for PGE acquisition costs, other income (expense) decreased $2.3 million, primarily due to higher interest accrued on deferred regula- tory account balances ($2.6 million), an increase in miscellaneous non-operating expenses ($0.6 million) and a decrease in miscellaneous non-operating income ($0.3 million), partially offset by an increase in earnings from investments ($1.3 million). Other income in 2001 was $1.3 million, or $2.5 million lower than in 2000, primarily due to lower interest income accrued on deferred regulatory account balances ($1.9 million) and lower miscellaneous non-operating income ($0.6 million). Interest Charges – Net The Company’s net interest expense in 2002 was $0.3 million, or 1 percent, higher than in 2001, primarily due to higher average bal- ances of long-term debt outstanding. Net interest expense in 2001 was $0.2 million higher than in 2000. Excluding a $1.0 million charge to interest expense due to an unfa- vorable litigation decision, interest expense decreased $0.8 million in 2001 due to lower average interest rates. Allowance for Funds Used During Construction (AFUDC) repre- sents the cost of funds used during the construction of utility plant (see Note 1). In 2002, AFUDC reduced interest expense by $0.6 million compared to $1.0 million in 2001 and $0.8 million in 2000. AFUDC was calculated using weighted average rates of 2.8 percent in 2002, 6.2 percent in 2001 and 6.0 percent in 2000 (see “Financial Condition – Cash Flows – Financing Activities,” below). Income Taxes The effective income tax rate of 34.9 percent in 2002 includes the effect of the tax benefit from the $13.9 million charge for costs incurred in the effort to acquire PGE. Absent this charge, the effective tax rate for 2002 would have been 35.6 percent, compared to 35.4 percent for 2001 and 35.9 percent for 2000 (see Note 8). Redeemable Preferred and Preference Stock Dividend Requirements Redeemable preferred and preference stock dividend requirements for 2002, 2001 and 2000 were lower by $0.1 million in each year com- pared to the prior year due to annual sinking fund redemptions. On Dec. 31, 2002, NW Natural redeemed in its entirety the $6.95 Series of Redeemable Preference Stock pursuant to the mandatory redemp- tion provisions applicable to that Series. FINANCIAL CONDITION Capital Structure The Company’s goal is to maintain a capital structure comprised of 45 to 50 percent common stock equity, up to 10 percent preferred stock and 45 to 50 percent short-term and long-term debt. When addi- tional capital is required, debt or equity securities are issued depending upon both the target capital structure and market conditions. These sources also are used to meet long-term debt and preferred stock redemption requirements (see Notes 3 and 5). Liquidity and Capital Resources At Dec. 31, 2002, the Company had $7.3 million in cash and cash equivalents compared to $10.4 million at Dec. 31, 2001. Short-term liquidity is provided by cash from operations and from the sale of the Company’s commercial paper notes, which are supported by com- mercial bank lines of credit (see Note 6). The Company has available through Sept. 30, 2004, committed lines of credit with four commer- cial banks (see “Lines of Credit,” below). On Dec. 31, 2002, NW Natural redeemed all 250,000 shares of its $6.95 Series of Redeemable Preference Stock with proceeds from the sale of commercial paper. 24 N W N A T U R A L The following table shows NW Natural’s contractual commitments by maturity and type of commitment: Long-term Gas Supply Commitments $ 78,810 47,600 43,583 39,147 37,472 _________ 246,612 160,140 (96,817) _________ $ 309,935 _________ _________ (Thousands) Payments Due in Years Ending Dec. 31, 2003 2004 2005 2006 2007 Total 2003 – 2007 Thereafter Less: imputed interest Total Capital Leases $ 180 20 1 1 – _________ 202 – (8) _________ $ 194 _________ _________ Long-term Debt $ 20,000 – 15,000 8,000 29,500 _________ 72,500 393,445 – _________ $ 465,945 _________ _________ Operating Leases $ 2,943 2,675 2,597 1,003 301 _________ 9,519 4,266 – _________ $ 13,785 _________ _________ Commercial Paper $ 69,802 – – – – _________ 69,802 – – _________ $ 69,802 _________ _________ Preferred Stock $ 750 750 750 750 750 _________ 3,750 4,500 – _________ $ 8,250 _________ _________ Other Purchase Commitments $ 10,082 – – – – _________ 10,082 – – _________ $ 10,082 _________ _________ Total $ 182,567 51,045 61,931 48,901 68,023 _________ 412,467 562,351 (96,825) _________ $ 877,993 _________ _________ NW Natural’s capital expenditures are primarily related to utility construction resulting from customer growth and system improve- ments (see “Cash Flows – Investing Activities,” below). In addition, NW Natural has certain long-term contractual commitments under cap- ital leases, operating leases and long-term gas supply purchase con- tracts that require an adequate source of funding. NW Natural also has a contract commitment to purchase about $10.1 million in gas trans- mission pipe in 2003 for use in constructing an extension of the pipeline from its Mist storage field. These capital and contractual expenditures are financed through cash from operations and from the issuance of short-term debt, which is periodical- ly refinanced through the sale of long-term debt or equity securities. CAPITAL STRUCTURE IN MILLIONS OF DOLLARS $1,200 $1,000 $600 $400 $800 47% 52% 51% 47% 46% 49% 1% 3% 4% 01 02 00 COMMON EQUITY PREFERRED AND PREFERENCE STOCK SHORT-TERM AND LONG-TERM DEBT The Company’s long-term goal is to maintain a capital structure of 45 to 50 percent common stock equity. There are no credit rating triggers or stock price provisions that require the acceleration of debt repayment under NW Natural’s Mortgage and Deed of Trust or oth- er long-term indebted- ness. Also, there are no rating triggers or stock price provisions contained in contracts or other agreements with third parties, except for agreements with certain counter-parties under NW Natural’s Derivatives Policy, which require the affected party to provide substitute collateral such as cash, guaranty or letter of credit if cred- it ratings are lowered to non-investment grade, or in some cases if the mark-to-market value exceeds a certain threshold. At Dec. 31, 2002, the Company had three commodity-price swap agreements outstanding with one counter-party which was subject to a below investment grade ratings trigger. The Company has no other material off-balance sheet obligations, except for certain lease and purchase commitments (see table above and Note 12). Commercial Paper $200 The Company’s primary source of short-term funds is commercial paper notes payable. Both NW Natural and Financial Corporation issue commercial paper under agency agreements with a commercial bank. NW Natural’s commercial paper is supported by its committed bank lines of credit (see “Lines of Credit,” below), while Financial Cor- poration’s commercial paper is supported by committed bank lines of credit and the guaranty of NW Natural (see Note 6). NW Natural had $69.8 million of commercial paper notes outstanding at Dec. 31, 2002, compared to $108.3 million at Dec. 31, 2001. Financial Corporation had no commercial paper notes outstanding at Dec. 31, 2002 or 2001. Lines of Credit NW Natural has lines of credit with four commercial banks total- ing $150 million. Half of the credit with each bank, totaling $75 mil- lion, is committed and available through Sept. 30, 2003, and the oth- er $75 million is committed and available through Sept. 30, 2004. In addition, Financial Corporation has available through Sept. 30, 2003, committed lines of credit with two commercial banks totaling $20 million. Financial Corporation’s lines are supported by the guaranty of NW Natural. Under the terms of these lines of credit, NW Natural and Financial Corporation pay commitment fees but are not required to maintain compensating bank balances. The interest rates on borrowings under these lines of credit, if any, are based on current market rates. There were no outstanding balances under either NW Natural’s or Financial Corporation’s lines of credit at Dec. 31, 2002 or 2001. NW Natural’s lines of credit require that credit ratings be maintained in effect at all times and that notice be given of any change in its sen- ior unsecured debt ratings. A change in NW Natural’s credit rating is not an event of default, nor is the maintenance of a specific mini- mum level of credit rating a condition to drawing upon the lines of cred- it. However, interest rates on any loans outstanding under NW Natural’s bank lines are tied to credit ratings, which would increase or decrease the cost of bank debt, if any, when ratings are changed. The lines of credit require the Company to maintain an indebted- ness to total capitalization ratio of 65 percent or less and to maintain a net worth at least equal to 80 percent of its net worth at Sept. 30, 2002, plus 50 percent of the Company’s net income for each subsequent fiscal quarter. Failure to comply with either of these covenants would entitle the banks to terminate their lending commitments and to accel- erate the maturity of all amounts outstanding. At Dec. 31, 2002, the Company was in compliance with both of these covenants. The banks have waived through Sept. 30, 2003, a requirement that NW Natural represent that the assets dedicated to its qualified pension plans exceed the unfunded liabilities of the plans before it may draw upon the lines of credit. NW Natural may be unable to draw upon the two-year portions of the credit lines, totaling $75 million, until its notes relating to the two-year commitments are approved by the OPUC or the WUTC, or both. NW Natural expects that it will be able to secure such approvals, if required. N W N A T U R A L 25 MANAGEMENT’S DISCUSSION AND ANALYSIS Cash Flows Operating Activities Continuing operations provided net cash of $124 million in 2002 compared to $72 million in 2001. The 73 percent increase was due to increased cash from operations before working capital changes ($5.7 million) and lower working capital requirements ($47 million). The increase in cash from continuing operations before working capital changes was due to an increase in deferred income taxes and invest- ment tax credits in 2002 compared to a reduction in 2001 ($22.5 mil- lion), the loss provision for the PGE transaction costs ($13.9 million) and higher depreciation and amortization ($2.4 million), largely off- set by a small increase in deferred gas cost payables in 2002 compared to a large swing from net gas cost receivables to payables in 2001 ($26.5 million), and lower net income in 2002 ($6.4 million). The decrease in working capital requirements was due to an increase in accounts payable in 2002 compared to a decrease in 2001 ($44 mil- lion), a decrease in accrued unbilled revenue in 2002 compared to an increase in 2001 ($26 million), and a decrease in accounts receivable in 2002 compared to an increase in 2001 ($22 million), partially off- set by a decrease in accrued interest and taxes in 2002 compared to an increase in 2001 ($40 million) and a larger increase in inventories in 2002 ($6.2 million). NW Natural’s refunds to customers of approximately $30.2 mil- lion of deferred gas cost savings in 2002 (see “Results of Operations – Comparison of Gas Operations,” above) reduced cash flows from operations by that amount, but the reduction was more than offset by the other factors affecting cash flows cited above. The Job Creation and Worker Assistance Act of 2002 (the Assist- ance Act), enacted on March 9, 2002, allows an additional first-year tax deduction for depreciation equal to 30 percent of the adjusted basis of “qualified property.” The extra 30 percent depreciation deduc- tion in the first year is an acceleration of depreciation deductions that otherwise would have been taken in the later years of an asset’s recov- ery period. In general, the extra 30 percent depreciation deduction is available for most personal property acquired after Sept. 10, 2001, and before Sept. 11, 2004. The Company anticipates enhanced cash flow from reduced income taxes, totaling an estimated $25 million to $30 million, during the effective period of the Assistance Act, based on actual and projected plant investments between Sept. 11, 2001 and Sept. 10, 2004. Continuing operations provided net cash of $72 million in 2001 compared to $87 million in 2000. The 18 percent decrease was due to increased cash from operations before working capital changes ($8 million), offset by higher working capital requirements ($24 million). The increase in cash from continuing operations before working cap- ital changes was due to a larger decrease in deferred gas costs ($23 million), an increase in income from continuing operations ($2.4 mil- lion) and an increase in depreciation and amortization in 2001 ($2.2 million), partially offset by a decrease in deferred investment tax cred- its and income taxes ($17 million) and a smaller decrease in regula- tory accounts and other ($3 million). The increase in working capital requirements was due to a decrease in accounts payable ($82.5 mil- lion), partially offset by smaller increases in other current assets and liabilities ($19.5 million), accounts receivable ($13 million), inven- tories ($10.5 million), accrued unbilled revenues ($2 million), and a larger increase in accrued interest and taxes ($13 million). The Company has lease and purchase commitments relating to its operating activities that are financed with cash flows from operations (see “Liquidity and Capital Resources,” above, and Note 12). 26 N W N A T U R A L Investing Activities Cash requirements for investing activities in 2002 totaled $84 million, down from $87 million in 2001, primarily due to lower amounts of cash used for investments in non-utility property ($6.9 million) and for the PGE transaction ($5.2 million), partially offset by higher amounts of cash used for the construction of utility plant ($7.6 mil- lion) and lower cash proceeds from the sale of assets ($2.8 million). Cash requirements for utility construction in 2002 totaled $80 mil- lion, up from $72 million in 2001, primarily as a result of capital expenditures related to NW Natural’s pipeline safety program ($4.7 million) and special projects expanding service into new service areas ($3.4 million). Cash requirements for investing activities in 2001 totaled $87 mil- lion, up from $31 million in 2000, primarily due to proceeds from the sales in 2000 of Canor ($35 million) and a building constructed for the Port of Portland ($20 million). Cash requirements for utility con- struction in 2001 totaled $72 million, down $8.5 million from 2000. The decrease in cash requirements for utility construction in 2001 resulted primarily from the completion of another phase in the expan- sion of NW Natural’s Mist gas storage system in 2000 ($8.7 million). Investments in non-utility property in 2002 ($2.6 million) and 2001 ($9.6 million) included expenditures for certain improvements to the Company’s Mist gas storage system that were primarily relat- ed to interstate storage services. During the five-year period 2003 through 2007, utility construc- tion expenditures are estimated at between $500 million and $600 million. The level of capital expenditures over the next five years reflects projected customer growth, system improvement projects resulting in part from requirements under the Pipeline Safety Act (see below), and a project estimated to cost $93 million to extend the pipeline that moves gas from NW Natural’s Mist gas storage field into growing portions of its service area. An estimated 60 percent of the required funds are expected to be internally generated over the five- year period; the remainder will be funded through a combination of long-term debt and equity securities with short-term debt providing liquidity and bridge financing. NW Natural’s utility construction expenditures in 2003 are esti- mated to total $148 million, up from $85 million in 2002. Projected utility construction in 2003 includes $31 million for customer growth, up from $29 million in 2002; $36 million for system improvement and support, up from $25 million in 2002; $55 million for the extension of the Mist pipeline and related gas storage projects, up from $9 mil- lion in 2002; and $6 million for the construction of a gas distribution system in Coos County, Oregon, up from $1 million in 2002. The project for the extension of the Mist pipeline has a scheduled completion date in late 2004 or 2005. Following two years of review of NW Natural’s application, including extensive public involvement, the Oregon Energy Facility Siting Council granted a permit for the project, with conditions, on March 13, 2003. The issuance of this per- mit potentially could be appealed under current law. NW Natural also must obtain easements and rights-of-way for the construction of the pipeline and may need to use condemnation proceedings to secure some of them. The Company entered into a stipulation with the OPUC in 2001 for an enhanced pipeline safety program that includes an accelerated bare steel replacement program and a geo-hazard safety program. The bare steel replacement program accelerates the replacement of the Company’s bare steel piping over 20 years instead of 40 years. The geo- hazard safety program includes the identification, assessment and remediation of risks to the Company’s piping infrastructure created by landslides, washouts, earthquakes or similar occurrences. The stip- ulation allowed the Company to receive deferred accounting rate treat- ment commencing Oct. 1, 2002, for costs associated with the pro- grams, expected to be approximately $1.5 million annually. On Nov. 15, 2002, Congress passed the Pipeline Safety Improve- ment Act of 2002 (Pipeline Safety Act) and the legislation was signed into law by President Bush on Dec. 17, 2002. The Pipeline Safety Act requires operators of gas transmission pipelines to identify lines located in High Consequence Areas (HCAs) and develop Integrity Management Programs (IMPs) to periodically inspect the integrity of the pipelines and make repairs or replacements as necessary to ensure the ongoing integrity of the pipelines. The legislation requires NW Natural to complete inspection of the 50 percent highest risk pipelines located in its HCAs within the first five years, and the remaining covered pipelines within 10 years of the date of the enact- ment. The Pipeline Safety Act also requires re-inspections of the cov- ered pipelines every seven years thereafter for the life of the pipelines. On Jan. 28, 2003, the U.S. Department of Transportation issued pro- posed rules that may impose additional requirements on pipeline operators that could result in shorter time periods for compliance and require additional capital investment by the Company. The cost of compliance with the legislation and rules is uncertain; however, NW Natural’s IMP is expected to cost approximately $5 million to $10 million per year beginning in 2004, and more than $100 million over the next 10 years. Financing Activities Cash used in financing activities in 2002 totaled $43 million, com- pared to cash provided by financing activities in 2001 of $15 million. Factors contributing to the $58 million difference were a reduction in short-term debt in 2002 ($38 million) compared to an increase in 2001 ($52 million), the redemption of the $6.95 Series of Preference Stock in 2002 ($25 million), and a higher amount used for the retire- ment of long-term debt ($40.5 million in 2002 compared to $20 mil- lion in 2001), partially offset by an increase in long-term debt issued ($90 million in 2002 compared to $18 million in 2001) and a reduc- tion in common stock repurchased ($5.8 million). Cash provided by financing activities in 2001 totaled $15 million, compared to cash used in financing activities in 2000 of $55 million. Factors contributing to the $70 million difference were a lower amount used for the retirement of long-term debt ($20 million in 2001 com- pared to $60 million in 2000) and an increase in short-term debt in 2001 ($52 million) compared to a reduction in short-term debt in 2000 ($38 million), partially offset by a reduction in long-term debt issued ($18 million in 2001 compared to $75 million in 2000). NW Natural sold $90 million of its secured Medium-Term Notes, Series B (MTNs), in 2002 and used the proceeds to reduce long-term debt ($40.5 million), provide cash for investments in utility plant and reduce short-term borrowings. NW Natural sold $18 million of its secured MTNs in 2001 and used the proceeds, together with a $52 million increase in short-term bor- rowings, to reduce long-term debt ($20 million) and provide cash for investments in utility plant. In 2000, NW Natural commenced a program to repurchase up to 2 million shares, or up to $35 million in value, of NW Natural’s com- mon stock through a repurchase program that has been extended through May 2003. The purchases are made in the open market or through privately negotiated transactions. The Company used $5.8 million for the repurchase of 246,700 shares under the program in 2001. No shares were repurchased in 2002. Since the program’s incep- tion the Company has repurchased 355,400 shares of common stock at a total cost of $8.2 million. Pension Cost (Income) and Funding Status Net periodic pension costs are determined in accordance with SFAS No. 87, “Employers’Accounting for Pensions” (see “Application of Critical Accounting Policies – Accounting for Pensions,” above). The annual pension cost or income is allocated between operations and maintenance expense and construction overhead. Net periodic pension income was $0.1 million, $4.1 million and $5.4 million in 2002, 2001 and 2000, respectively. No cash contribu- tions to NW Natural’s qualified defined benefit pension plans were required for the 2002 plan year. The fair value of the plan assets declined from $169 million at Dec. 31, 2001, to $143 million at Dec. 31, 2002, including $15 million in investment losses, $10 million in withdrawals to pay benefits and $1 million in eligible expenses of the plans. The present value of benefit obligations under the plans increased from an estimated $156 million to $172 million over that period. Despite the reduced pension income in 2002 and 2001, and the recent reductions in the funded status of the plans, NW Natural believes it will be able to maintain well-funded pension plans. NW Natural expects to be required to make cash contributions estimated at $1.9 million to the plans for the 2003 plan year, payable by September 2004, but it does not expect these or future cash contributions to have a material adverse effect on its liquidity or financial condition. Ratios of Earnings to Fixed Charges For the years ended Dec. 31, 2002, 2001 and 2000, the Company’s ratios of earnings to fixed charges, computed using the Securities and Exchange Commission method, were 2.85, 3.14 and 3.14, respec- tively. For this purpose, earnings consist of net income before taxes plus fixed charges, and fixed charges consist of interest on all indebt- edness, the amortization of debt expense and discount or premium and the estimated interest portion of rentals charged to income. CONTINGENT LIABILITIES Environmental Matters NW Natural owns property in Multnomah County, Oregon that is the site of a former gas manufacturing plant that was closed in 1956 (the Gasco site). The Gasco site has been under investigation by NW Natural for environmental contamination under the Oregon Department of Environmental Quality’s (ODEQ) Voluntary Clean-Up Program. NW Natural has recorded liabilities totaling $4.0 million for the esti- mated costs of investigation and interim remediation at the Gasco site, including consultants’ fees, ODEQ oversight reimbursement and legal fees, of which $3.2 million had been spent as of Dec. 31, 2002. NW Natural previously owned property adjacent to the Gasco site that now is the location of a manufacturing plant owned by Wacker Siltronic Corporation (the Wacker site). In 2000, the ODEQ issued an order requiring Wacker and NW Natural to determine the nature and extent of releases of hazardous substances to Willamette River sedi- ments from the Wacker site. NW Natural has completed the majori- ty of the studies required under the ODEQ work plan and the agency is reviewing data generated by the studies. NW Natural has recorded a liability of $0.3 million for its estimated costs of the investigation and initial remediation on the Wacker site, of which $0.2 million had been spent as of Dec. 31, 2002. In 1998, the ODEQ and the U.S. Environmental Protection Agency (EPA) completed a study of sediments in a 5.5-mile segment of the Willamette River (the Portland Harbor) that includes the area adjacent N W N A T U R A L 27 MANAGEMENT’S DISCUSSION AND ANALYSIS to the Gasco site and the Wacker site. In 2000, the EPA listed the Portland Harbor as a Superfund site and notified the Company that it is a poten- tially responsible party. NW Natural recorded liabilities totaling $2.3 million between 2000 and 2002, of which $1.1 million had been spent as of Dec. 31, 2002. The amount of NW Natural’s liability is based on estimates of the Company’s share of the lower end of a range of probable liability for the costs of the Remedial Investigation/Feasibility Study for the Portland Harbor. Available information is insufficient to determine either the total amount of liability for investigation and remediation of the Portland Harbor or the higher end of a range for NW Natural’s estimated share of that liability. The City of Portland has notified NW Natural that it is planning a sewer improvement project that would include excavation within the former site of a gas manufacturing plant (the Portland Gas site) that was owned and operated by a predecessor of the Company between 1860 and 1913. The preliminary assessment of this site performed by a consultant for the EPA in 1987 indicated that it could be assumed that by-product tars may have been disposed of on site. The report con- cluded, however, that it is likely that waste residues from the plant, if present on the site, were covered by deep fill during construction of the nearby seawall bordering the Willamette River and probably have stabilized due to physical and chemical processes. Neither the City of Portland nor the ODEQ has notified NW Natural whether a further investigation or potential remediation might be required on the site in connection with the sewer project. Available information is insufficient to determine either the total amount of liability or a probable range, if any, of potential liability. NW Natural has accrued all material loss contingencies relating to environmental matters that it believes to be probable of assertion and reasonably estimable. Due to the preliminary nature of these envi- ronmental investigations, the range of any additional possible loss contingency cannot be currently estimated. NW Natural expects that its costs of further investigation and remediation for which it may be responsible with respect to the Gasco site, the Wacker site, the Portland Harbor site and the Portland Gas site, if any, should be recoverable, in large part, from insurance. At Dec. 31, 2002, NW Natural had a $2.5 million receivable representing an estimate of the environmental costs NW Natural expects to recover from insurance, including $1.4 mil- lion that was recorded in 2000 for costs relating to the Gasco site and $1.1 million that was recorded in 2002 for costs relating to the Portland Harbor site. In the event these costs are not recovered from insur- ance, NW Natural will seek recovery through future rates. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company’s primary market risk exposures associated with activities involving derivative financial instruments and other finan- cial instruments are natural gas commodity price risk, foreign currency exchange risk and interest rate risk. Derivative financial instruments are used as tools to mitigate certain of these market risks (see Note 11). Such instruments are used for hedging purposes, not for trading purposes. Market risks associated with the derivative financial instru- ments are monitored by management personnel who do not directly enter into these contracts and by the Audit Committee of the Board of Directors. Physical and Financial Commodity, Foreign Currency and Interest Rate Transactions NW Natural enters into short-term and long-term natural gas pur- chase contracts with demand and commodity fixed-price and float- 28 N W N A T U R A L ing-price components, along with associated short-term and long- term natural gas transportation contracts. Foreign currency forward contracts are used to hedge against foreign exchange rate fluctuations on purchases made under these contracts that are denominated in Canadian dollars. Historically, NW Natural has taken physical delivery of at least the minimum quantities specified in its natural gas purchase contracts. The contracts are subject to annual re-pricing, a process that is intended to reflect anticipated market price trends during the next year. NW Natural’s PGA mechanism in Oregon provides for the recovery from customers of actual commodity costs in comparison with established benchmark costs, except that NW Natural absorbs 33 percent of the higher cost of gas sold, or retains 33 percent of the lower cost, in either case as compared to projections. At Dec. 31, 2002, differences between notional values and fair values with respect to NW Natural’s open positions in derivative finan- cial instruments were not material to the Company’s financial posi- tion or results of operations because of the treatment of these instru- ments in regulatory mechanisms relating to gas costs (see “Results of Operations – Comparison of Gas Operations – Cost of Gas,” above, and Notes 1 and 11). However, to the degree that market risks exist due to potential adverse changes in commodity prices and foreign exchange rates in relation to these financial and physical contracts, the Company considers the risks to be: Commodity Price Risk The prices of natural gas commodity are subject to fluctuations due to unpredictable factors including weather, pipeline transportation congestion and other factors that affect short-term supply and demand. Natural gas commodity swaps and call option contracts are used to con- vert certain long-term gas purchase contracts from floating prices to fixed prices. At Dec. 31, 2002 and 2001, notional amounts under nat- ural gas commodity swaps and call option contracts totaled $180.6 mil- lion and $260.6 million, respectively. As of Dec. 31, 2002, two com- modity agreements extended beyond Dec. 31, 2003. If all of the commodity swaps and call option contracts had been settled on Dec. 31, 2002, a gain of $12.6 million would have been realized (see Note 11). Foreign Currency Risk The costs of natural gas commodity and certain pipeline services purchased from Canadian suppliers are subject to changes in the val- ue of Canadian currency in relation to U.S. currency. Foreign cur- rency forward contracts are used to hedge against fluctuations in exchange rates with respect to purchases of natural gas from Canadian suppliers. At Dec. 31, 2002 and 2001, notional amounts under foreign currency forward contracts totaled $15.5 million and $10.2 million, respectively. As of Dec. 31, 2002, no foreign currency forward con- tracts extended beyond Dec. 31, 2003. If all of the foreign currency forward contracts had been settled on Dec. 31, 2002, a loss of $0.2 million would have been realized (see Note 11). Interest Rate Risk Interest rate risk relates to new debt financing needed to fund cap- ital requirements, including maturing debt securities, and to the issuance of commercial paper. Interest rate risk is managed through the issuance of fixed-rate debt with varying maturities and the reduc- tion of debt through optional redemption when interest rates are favor- able. No derivative financial instruments to hedge interest rates were in place at Dec. 31, 2002 or 2001. MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL STATEMENTS The financial statements in this report were prepared by manage- ment, which is responsible for their objectivity and integrity. The statements have been prepared in conformity with generally accept- ed accounting principles in the United States of America and, where appropriate, reflect informed estimates based on judgments of man- agement. The responsibility of the Company’s independent account- ants is to render an independent report on the financial statements. The Company’s system of internal accounting controls is designed to provide reasonable assurance that assets are safeguarded and trans- actions are executed in accordance with management’s authoriza- tions, that transactions are recorded to permit the preparation of finan- cial statements in conformity with orders of regulatory authorities and generally accepted accounting principles in the United States of America and that accountability for assets is maintained. The Com- pany’s system of internal controls has provided such reasonable assur- ances during the periods reported herein. The system includes writ- ten policies, procedures and guidelines, an organization structure that segregates duties and an established program for monitoring the sys- tem by internal auditors. In addition, the Company has prepared and annually distributes to its employees a Code of Ethics covering its policies for conducting business affairs in a lawful and ethical man- ner. In February 2003, the Board of Directors approved a Financial Code of Ethics covering all senior financial executives and managers. Ongoing review programs are carried out to ensure compliance with these policies. The Board of Directors, through its Audit Committee (the Com- mittee), oversees management’s financial reporting responsibilities. The Committee meets regularly with management, the internal audi- tors, and representatives of the Company’s independent accountants. Both internal auditors and independent accountants have free and independent access to the Committee and the Board of Directors. Each member of the Committee meets the requirements of “inde- pendent director” as defined by New York Stock Exchange Listing Standards. The Committee reports the results of its activities to the full Board of Directors. Annually, the Committee selects the inde- pendent accountants. Mark S. Dodson President and Chief Executive Officer Bruce R. DeBolt Senior Vice President, Finance, and Chief Financial Officer REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Northwest Natural Gas Company: In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, of earnings invested in the business, of cash flows and of capitalization present fairly, in all material respects, the financial position of Northwest Natural Gas Company (doing business as NW Natural) and its subsidiaries (the “Company”) at December 31, 2002 and 2001, and the results of their oper- ations and their cash flows for each of the three years in the period ended December 31, 2002 in conformity with accounting principles gen- erally accepted in the United States of America. These financial statements are the responsibility of the Company’s management; our respon- sibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain rea- sonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evi- dence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Notes 1 and 11 to the consolidated financial statements, the Company changed its method of accounting for derivative instruments as of January 1, 2001. Portland, Oregon February 14, 2003 N W N A T U R A L 29 Thousands, except per share amounts (year ended December 31) 2002 2001 2000 CONSOLIDATED STATEMENTS OF INCOME Operating revenues: Gross operating revenues Cost of sales Net operating revenues Operating expenses: Operations and maintenance Taxes other than income taxes Depreciation and amortization Total operating expenses Income from continuing operations Other income (expense) Interest charges – net Income before income taxes Income taxes Net income from continuing operations Discontinued segment: Gain on sale of discontinued segment – net of tax Net income Redeemable preferred and preference stock dividend requirements Earnings applicable to common stock Average common shares outstanding Basic earnings per share of common stock: From continuing operations From gain on sale of discontinued segment Total basic earnings per share Diluted earnings per share of common stock: From continuing operations From gain on sale of discontinued segment Total diluted earnings per share Dividends per share of common stock See Notes to Consolidated Financial Statements. CONSOLIDATED STATEMENTS OF EARNINGS INVESTED IN THE BUSINESS $ 641,376 353,832 _________ 287,544 $ 650,252 374,241 _________ 276,011 $ 532,110 274,160 _________ 257,950 85,120 34,076 52,090 _________ 171,286 _________ 116,258 (14,890) 34,132 _________ 67,236 23,444 _________ 83,920 32,240 49,640 _________ 165,800 _________ 110,211 1,334 33,805 _________ 77,740 27,553 _________ 77,817 28,351 47,440 _________ 153,608 _________ 104,342 3,860 33,561 _________ 74,641 26,829 _________ 43,792 50,187 47,812 – _________ 43,792 2,280 _________ $ 41,512 _________ _________ – _________ 50,187 2,401 _________ $ 47,786 _________ _________ 2,412 _________ 50,224 2,456 _________ $ 47,768 _________ _________ 25,431 25,159 25,183 $ 1.63 – _________ $ 1.63 _________ _________ $ 1.62 – _________ $ 1.62 _________ _________ $ 1.26 _________ _________ $ 1.90 – _________ $ 1.90 _________ _________ $ 1.88 – _________ $ 1.88 _________ _________ $ 1.245 _________ _________ $ 1.80 0.10 _________ $ 1.90 _________ _________ $ 1.79 0.09 _________ $ 1.88 _________ _________ $ 1.24 _________ _________ Thousands (year ended December 31) Earnings invested in the business: Balance at beginning of year Net income Cash dividends paid: Redeemable preferred and preference stock Common stock Common stock repurchased Common stock expense Balance at end of year Accumulated other comprehensive income (loss): Balance at beginning of year Other comprehensive income (loss) – net of tax: Recognition of foreign currency translation adjustment included in gain on sale of discontinued segment Minimum pension liability adjustment Change in unrealized loss from price risk management activities – (2,936) 227 ________ Comprehensive income Balance at end of year See Notes to Consolidated Financial Statements. 30 N W N A T U R A L $ (3,084) ________ ________ 2002 2001 2000 $ 147,950 43,792 (2,579) (32,024) – (3) ________ $ 157,136 ________ ________ $ (375) $ 43,792 – (2,936) 227 ________ $ 41,083 ________ ________ $ 134,189 50,187 (2,410) (31,307) (2,688) (21) ________ $ 147,950 ________ ________ $ – – (148) (227) ________ $ (375) ________ ________ $ 50,187 $ 50,224 $ 118,711 50,224 (2,466) (31,198) (1,080) (2) ________ $ 134,189 ________ ________ $ (3,181) – (148) (227) ________ $ 49,812 ________ ________ 3,181 – – ________ $ – ________ ________ 3,181 – – ________ $ 53,405 ________ ________ CONSOLIDATED BALANCE SHEETS Thousands (December 31) Assets: Plant and property: Utility plant Less accumulated depreciation Utility plant – net Non-utility property Less accumulated depreciation and amortization Non-utility property – net Total plant and property Other investments Current assets: Cash and cash equivalents Accounts receivable, less allowance for uncollectible accounts of $1,815 in 2002 and $1,962 in 2001 Accrued unbilled revenue Inventories of gas, materials and supplies Prepayments and other current assets Total current assets Regulatory assets: Income tax asset Unamortized loss on debt redemption Unrealized loss on non-trading derivatives Other Total regulatory assets Other assets: Investment in life insurance Fair value of non-trading derivatives Other Total other assets Total assets Capitalization and liabilities: Capitalization (see Consolidated Statements of Capitalization): Common stock Premium on common stock Earnings invested in the business Accumulated other comprehensive income (loss) Total common stock equity Redeemable preference stock Redeemable preferred stock Long-term debt Total capitalization Current liabilities: Notes payable Accounts payable Long-term debt due within one year Taxes accrued Interest accrued Other current and accrued liabilities Total current liabilities Regulatory liabilities: Customer advances Deferred gas costs payable Unrealized gain on non-trading derivatives Total regulatory liabilities Other liabilities: Deferred income taxes Deferred investment tax credits Fair value of non-trading derivatives Other Total other liabilities Commitments and contingencies (see Note 12) Total capitalization and liabilities See Notes to Consolidated Financial Statements. 2002 2001 $ 1,539,965 560,798 __________ 979,167 __________ 20,832 4,404 __________ 16,428 __________ 995,595 __________ 12,703 __________ 7,328 46,936 44,069 58,030 37,645 __________ 194,008 __________ 47,975 6,508 – 7,040 __________ 61,523 __________ 54,916 12,426 11,620 __________ 78,962 __________ $ 1,342,791 __________ __________ $ 81,023 248,028 157,136 (3,084) __________ 483,103 – 8,250 445,945 __________ 937,298 __________ 69,802 74,436 20,000 7,822 2,902 30,045 __________ 205,007 __________ $ 1,465,079 514,299 __________ 950,780 __________ 18,203 4,007 __________ 14,196 __________ 964,976 __________ 23,233 __________ 10,440 64,722 57,749 49,337 28,086 __________ 210,334 __________ 48,469 6,970 111,641 5,302 __________ 172,382 __________ 53,033 – 11,064 __________ 64,097 __________ $ 1,435,022 __________ __________ $ 79,889 240,697 147,950 (375) __________ 468,161 25,000 9,000 378,377 __________ 880,538 __________ 108,291 70,698 40,000 22,539 3,658 28,396 __________ 273,582 __________ 1,791 10,635 12,426 __________ 24,852 __________ 1,985 10,089 – __________ 12,074 __________ 141,732 7,824 – 26,078 __________ 175,634 __________ – __________ $ 1,342,791 __________ __________ 130,424 8,682 111,868 17,854 __________ 268,828 __________ – __________ $ 1,435,022 __________ __________ N W N A T U R A L 31 CONSOLIDATED STATEMENTS OF CASH FLOWS Thousands (year ended December 31) Operating activities: 2002 2001 2000 Net income from continuing operations Adjustments to reconcile net income to cash provided by continuing operations: $ 43,792 $ 50,187 $ 47,812 Depreciation and amortization Gain on sale of assets Loss provision for PGE acquisition costs Minimum pension liability adjustment Unrealized gain (loss) from price risk management activities Deferred income taxes and investment tax credits Equity in (earnings) losses of investments Allowance for funds used during construction Deferred gas costs – net Other Cash from continuing operations before working capital changes Changes in operating assets and liabilities: Accounts receivable – net of uncollectible accounts Accrued unbilled revenue Inventories of gas, materials and supplies Accounts payable Accrued interest and taxes Other current assets and liabilities Cash provided by continuing operating activities Investing activities: Acquisition and construction of utility plant assets Investment in non-utility property PGE acquisition costs Proceeds from sale of discontinued segment Proceeds from sale of assets Other investments Cash used in investing activities Financing activities: Common stock issued Common stock repurchased Redeemable preferred stock retired Redeemable preference stock retired Long-term debt issued Long-term debt retired Change in short-term debt Cash dividend payments: Redeemable preferred and preference stock Common stock Common stock expense Cash provided by (used in) financing activities Increase (decrease) in cash and cash equivalents Cash and cash equivalents – beginning of year Cash and cash equivalents – end of year Supplemental disclosure of cash flow information: Cash paid during the period for: Interest Income taxes Supplemental disclosure of non-cash financing activities: Conversion to common stock: 7-1/4 % Series of Convertible Debentures See Notes to Consolidated Financial Statements. 32 N W N A T U R A L 52,090 (221) 13,873 (2,936) 227 10,450 (988) (550) 546 4,582 _________ 120,865 17,786 13,680 (8,693) 3,738 (24,725) 1,176 _________ 123,827 (79,530) (2,629) (4,316) – 500 1,848 _________ (84,127) 6,533 – (750) (25,000) 90,000 (40,500) (38,489) 49,640 – – (148) (227) (12,088) 321 (959) 27,062 1,345 _________ 115,133 (3,969) (12,130) (2,454) (40,000) 15,435 (494) _________ 71,521 (71,943) (9,554) (9,557) – 3,256 529 _________ (87,269) 5,157 (5,792) (750) – 18,000 (20,000) 52,028 47,440 (491) – – – 4,651 221 (789) 3,977 4,333 _________ 107,154 (17,404) (14,069) (12,964) 42,535 1,988 (20,000) _________ 87,240 (80,444) (6,923) – 34,756 21,012 610 _________ (30,989) 4,826 (2,441) (814) – 75,000 (60,000) (37,886) (2,579) (32,024) (3) _________ (42,812) (3,112) 10,440 _________ $ 7,328 _________ _________ (2,410) (31,307) (21) _________ 14,905 (843) 11,283 _________ $ 10,440 _________ _________ (2,466) (31,198) (2) _________ (54,981) 1,270 10,013 _________ $ 11,283 _________ _________ $ 34,640 $ 33,474 $ 33,034 $ 25,201 $ 35,592 $ 22,552 $ 1,932 $ 413 $ 589 CONSOLIDATED STATEMENTS OF CAPITALIZATION Thousands, except share amounts (December 31) 2002 2001 Common stock equity: Common stock – par value $3-1/6 per share, authorized 60,000,000 shares: outstanding – 2002, 25,586,313 shares; 2001, 25,228,074 shares Premium on common stock Earnings invested in the business Accumulated other comprehensive income (loss) Total common stock equity $ 81,023 248,028 157,136 (3,084) _________ 483,103 _________ $ 79,889 240,697 147,950 (375) _________ 468,161 _________ 51% Redeemable preference stock, authorized 2,000,000 shares; $6.95 Series, stated value $100 per share: outstanding – 2002, none; 2001, 250,000 shares Redeemable preferred stock, authorized 1,500,000 shares; $7.125 Series, stated value $100 per share: outstanding – 2002, 82,500 shares; 2001, 90,000 shares Long-term debt: Medium-Term Notes First Mortgage Debt: – – 25,000 8,250 1% 9,000 53% 3% 1% 8.050% Series A due 2002 6.750% Series B due 2002 5.550% Series B due 2002 6.400% Series B due 2003 6.340% Series B due 2005 6.380% Series B due 2005 6.450% Series B due 2005 6.050% Series B due 2006 6.310% Series B due 2007 6.800% Series B due 2007 6.500% Series B due 2008 7.450% Series B due 2010 6.665% Series B due 2011 7.130% Series B due 2012 8.260% Series B due 2014 7.000% Series B due 2017 6.600% Series B due 2018 8.310% Series B due 2019 7.630% Series B due 2019 9.050% Series A due 2021 7.250% Series B due 2023 7.500% Series B due 2023 7.520% Series B due 2023 7.720% Series B due 2025 6.520% Series B due 2025 7.050% Series B due 2026 7.000% Series B due 2027 6.650% Series B due 2027 6.650% Series B due 2028 7.740% Series B due 2030 7.850% Series B due 2030 5.820% Series B due 2032 Convertible Debentures 7-1/4% Series due 2012 Less long-term debt due within one year Total long-term debt Total capitalization See Notes to Consolidated Financial Statements. – – – 20,000 5,000 5,000 5,000 8,000 20,000 9,500 5,000 25,000 10,000 40,000 10,000 40,000 22,000 10,000 20,000 10,000 20,000 4,000 11,000 20,000 10,000 20,000 20,000 20,000 10,000 20,000 10,000 30,000 10,000 10,000 20,000 20,000 5,000 5,000 5,000 8,000 – 10,000 5,000 25,000 10,000 – 10,000 40,000 22,000 10,000 20,000 10,000 20,000 4,000 11,000 20,000 10,000 20,000 20,000 20,000 10,000 20,000 10,000 – 6,445 _________ 465,945 20,000 _________ 445,945 _________ $ 937,298 _________ _________ 8,377 _________ 418,377 40,000 _________ 378,377 _________ 48% ______ 100% $ 880,538 _________ ______ _________ ______ 43% ______ 100% ______ ______ N W N A T U R A L 33 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Recent Accounting Pronouncements NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Organization and Principles of Consolidation The consolidated financial statements include: Regulated utility: ■ Northwest Natural Gas Company (NW Natural) Non-regulated wholly-owned subsidiary businesses: ■ NNG Financial Corporation (Financial Corporation), and its wholly-owned subsidiaries ■ Northwest Energy Corporation (Northwest Energy), and its wholly-owned subsidiary Non-regulated majority-owned subsidiary business: ■ Canor Energy, Ltd. (Canor), sold in 2000 Together these businesses are referred to herein as the “Company.” Intercompany accounts and transactions have been eliminated. Investments in corporate joint ventures and partnerships in which the Company’s ownership interest is 50 percent or less and over which the Company does not exercise control are accounted for by the equi- ty method or the cost method (see Note 9). Certain amounts from prior years have been reclassified to con- form with the 2002 presentation. These reclassifications had no impact on prior year results of operations. Use of Estimates The preparation of financial statements in conformity with gen- erally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect reported amounts in the consolidated financial statements and accom- panying notes. Actual amounts could differ from those estimates and changes would be reported in future periods. Management believes that the estimates used are reasonable. Industry Regulation The Company’s principal business is the distribution of natural gas which is regulated by the Oregon Public Utility Commission (OPUC) and the Washington Utilities and Transportation Commission (WUTC). Accounting records and practices conform to the require- ments and uniform system of accounts prescribed by these regulato- ry authorities in accordance with Statement of Financial Accounting Standards (SFAS) No. 71, “Accounting for the Effects of Certain Types of Regulation.” In applying SFAS No. 71, NW Natural has capitalized certain costs and benefits as regulatory assets and liabilities pursuant to orders of the OPUC or WUTC in general rate or expense deferral proceed- ings, to provide for recovery of revenues or expenses from, or refunds to, utility customers in future periods. At Dec. 31, 2002 and 2001, reg- ulatory tax assets were $48.0 million and $48.5 million, respective- ly, while other regulatory assets and liabilities (net) were net liabili- ties of $11.3 million and net assets of $111.8 million, respectively. If NW Natural should determine in the future that all or a portion of these regulatory assets and liabilities no longer meet the criteria for continued application of SFAS No. 71, then it would be required to write off the net unrecoverable balances of its regulatory assets and liabilities as a charge to income. 34 N W N A T U R A L In August 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 143, “Accounting for Asset Retirement Obligations.” SFAS No. 143, which is effective for fiscal years beginning after June 15, 2002, requires that obligations associated with the retirement of a tangible long-lived asset be recorded as a liability when those obli- gations are incurred, with the amount of the liability initially meas- ured at fair value. The liability for the asset retirement obligation is recorded as a capitalized cost increasing the carrying amount of the related long-lived asset. Over time, the liability is accreted to its pres- ent value each period and the capitalized cost is depreciated over the useful life of the related asset. In April 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statement Nos. 4, 44 and 64, Amendment of FASB Statement No. 13 and Technical Corrections,” effective for financial statements issued for fiscal years beginning after May 15, 2002. SFAS No. 145, which updates, clarifies and simplifies existing accounting pro- nouncements, addresses the reporting of debt extinguishments and accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which replaces Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” SFAS No. 146 requires companies to recognize costs associated with exit or disposal activities, such as lease termination costs and certain employ- ee severance costs, when they are incurred rather than at the date of a commitment to an exit or disposal plan. The primary effect of apply- ing SFAS No. 146, which is effective for all exit or disposal activities initiated after Dec. 31, 2002, will be on the timing of recognition of costs associated with exit or disposal activities. The Company is currently evaluating the impact of the adoption of SFAS Nos. 143, 145 and 146 upon its financial condition and re- sults of operations. Adoption of New Accounting Standards Effective Jan. 1, 2002, the Company adopted SFAS No. 141, “Business Combinations,” and SFAS No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 141 requires business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting. It also specifies the types of acquired intan- gible assets that are required to be recognized and reported sepa- rately from goodwill. SFAS No. 142 requires goodwill, of which the Company had none as of Dec. 31, 2002, and other intangibles with indefinite lives to be tested for impairment at least annually rather than being amortized as previously required. The adoption of SFAS No. 141 and SFAS No. 142 had no impact on the Company’s financial con- dition or results of operations. The Company also adopted SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” effective Jan. 1, 2002. SFAS No. 144 establishes a single accounting model for recognition and measurement of the impairment of long-lived assets to be held and used, the measurement of long-lived assets to be disposed of by sale and for segments of a business to be disposed of. SFAS No. 144 also expands the scope of discontinued operations to include all compo- nents of an entity that can be distinguished from the rest of the enti- ty and will be eliminated from the ongoing operations of the entity in a disposal transaction. The adoption of SFAS No. 144 had no impact on the Company’s financial condition or results of operations. On Dec. 31, 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” SFAS No. 148 amends FASB No. 123, “Accounting for Stock-Based Com- pensation,” to provide alternative methods of transition for companies that voluntarily change to the fair-value-based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require promi- nent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company has adopted the SFAS No. 148 disclosure requirements but continues to apply Accounting Principles Board (APB) Opinion No. 25, “Account- ing for Stock Issued to Employees,” to account for its stock-based compensation plans (see Note 4). Utility Plant and Depreciation Utility plant for NW Natural is stated at cost (see Note 9). When a depreciable unit of utility plant is retired, the cost is removed from both utility plant and accumulated depreciation together with the cost of removal, less any salvage. No gain or loss is recognized upon nor- mal retirement. NW Natural’s provision for depreciation of utility property, which is computed under the straight-line, age-life method in accordance with independent engineering studies and as approved by regulatory author- ities, approximated 3.5 percent of average depreciable plant in each of 2002, 2001 and 2000. The depreciation rate approximates the eco- nomic life of the utility property. Allowance for Funds Used During Construction Certain additions to utility plant include an allowance for funds used during construction (AFUDC). AFUDC represents the cost of funds borrowed during construction and is calculated using actual com- mercial paper interest rates. If commercial paper borrowings are less than the total costs of construction work in progress, then a compos- ite rate of interest on all debt, shown as a reduction to interest charges, and a return on equity funds, shown as other income, is used to com- pute AFUDC. While cash is not realized currently from AFUDC, it is realized in the ratemaking process over the service life of the relat- ed property through increased revenues resulting from higher rate base and higher depreciation expense. NW Natural’s weighted aver- age AFUDC rates were 2.8 percent in 2002, 6.2 percent in 2001 and 6.0 percent in 2000. Cash and Cash Equivalents For purposes of reporting cash flows, cash and cash equivalents include cash on hand and highly liquid temporary investments with original maturity dates of three months or less. Revenue Recognition Utility revenues are derived primarily from the sale and transporta- tion of natural gas. Utility revenue from gas sales and transportation is recognized when the gas is delivered to and received by the customer. Estimated revenues are accrued for gas deliveries not billed to cus- tomers from meter reading dates to month end (unbilled revenue) and are reversed the following month when actual billings occur. Revenues from non-utility services, including gas storage, are rec- ognized upon delivery of the service to customers. Revenues from non- utility optimization contracts are recognized, after deducting for reg- ulatory revenue sharing, over the life of the contract for amounts guaranteed under the contract, or as amounts are earned and reason- ably estimable for amounts above the guaranteed value. Inventories Inventories, consisting primarily of natural gas in storage, are stat- ed at the lower of average cost or net realizable value. Derivatives Policy NW Natural’s Derivatives Policy sets forth the guidelines for using selected financial derivative products to support prudent risk man- agement strategies within designated parameters. The Policy allows for the use of derivatives to manage commodity prices related to nat- ural gas purchases, foreign currency prices related to gas purchase com- mitments from Canada, oil or propane commodity prices related to gas sales and transportation services under rate schedules pegged to oth- er commodities, and interest rates related to long-term debt maturing in less than five years or expected to be issued in future periods. NW Natural’s objectives for using derivatives are to decrease the volatili- ty of earnings and cash flows associated with changes in commodity prices, foreign currency prices and interest rates. Use of derivatives is permitted only after the commodity price, exchange rate, and inter- est rate exposures have been identified, are determined to exceed defined tolerance levels and are considered to be unavoidable because they are necessary to support normal business activities (see Note 11). The Policy is intended to prevent speculative risk. NW Natural does not enter into derivative instruments for trading purposes and believes that any increase in market risk created by holding derivatives should be offset by the exposures they modify. The Company adopted SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” on Jan. 1, 2001. This statement establishes accounting and reporting standards for derivative instru- ments, including certain derivative instruments embedded in other contracts, and for hedging activities. SFAS No. 133 requires that an entity recognize derivatives as either assets or liabilities on the bal- ance sheet and measure those instruments at fair value. SFAS No. 133 also requires that changes in the fair value of a derivative be rec- ognized currently in earnings unless specific hedge accounting criteria are met. NW Natural designates its derivatives as fair value or cash flow hedges based upon criteria established by SFAS No. 133. For a deriv- ative designated as a fair value hedge, the gain or loss is recognized in earnings in the period of change. For a derivative designated as a cash flow hedge, the effective portion of the derivative gain or loss is initially reported in accumulated other comprehensive income (OCI) unless the derivative is subject to deferral under NW Natural’s regu- lated tariffs with the OPUC or the WUTC. The ineffective portion of the gain or loss in a cash flow hedge is recognized in current earnings. Effectiveness is measured by comparing changes in cash flows of the hedged item to gains or losses on derivative instruments. NW Natural’s primary hedging activities, consisting of natural gas commodity price and foreign currency exchange rate hedges, are prin- cipally accounted for as cash flow hedges under SFAS No. 133 and subject to regulatory deferral pursuant to SFAS No. 71. Unrealized gains and losses from mark-to-market valuations of these contracts are not recognized in current income but are reported as derivative assets or liabilities and offset by a corresponding deferred account balance included under “Regulatory liabilities” or “Regulatory assets.” Due to their regulatory deferral treatment, effective portions of changes in the fair value of these derivatives are not recorded in OCI but are rec- ognized as a regulatory asset or liability. Ineffective portions of changes in the fair value of these contracts are recognized in current earnings. N W N A T U R A L 35 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NW Natural documents all relationships between its hedge con- tracts and hedged items, as well as its risk management objective and strategy. This process includes specific identification of the type of contract, the details of the hedge transaction, the nature of the risk being hedged and how the hedging instrument’s effectiveness will be measured. Both at the inception of the hedge and on an ongoing basis, NW Natural measures the effectiveness of the derivatives used in hedge transactions. Income Taxes NW Natural uses the balance sheet method of accounting for deferred income taxes. Deferred tax liabilities and assets reflect the expected future tax consequences, based on enacted tax law, of tem- porary differences between the tax basis of assets and liabilities and their financial reporting amounts (see Note 8). Consistent with rate and accounting orders of regulatory author- ities, deferred income taxes are not currently collected for those tem- porary income tax differences where the prescribed regulatory accounting methods do not provide for current recovery in rates. NW Natural has recorded a regulatory tax asset for amounts pending recovery from customers in future rates. These amounts are prima- rily differences between the book and tax bases of net utility plant in service. This asset balance was $48.0 million and $48.5 million at Dec. 31, 2002 and 2001, respectively. Investment tax credits on utility property additions and leveraged leases, which reduce income taxes payable, are deferred for financial statement purposes and are amortized over the life of the related prop- erty or lease. Investment and energy tax credits generated by non- regulated subsidiaries are amortized over a period of one to five years. Other Income (Expense) Other income (expense) consists of interest income, gain on sale of assets, investment income of Financial Corporation, the loss pro- vision related to costs incurred in connection with the effort to acquire Portland General Electric Company (PGE) and other miscellaneous income from merchandise sales, rents, an aircraft lease and other items. Earnings Per Share Basic earnings per share are computed based on the weighted aver- age number of common shares outstanding each year. Diluted earn- ings per share reflect the potential effects of the conversion of con- vertible debentures and the exercise of stock options. Diluted earnings are calculated as follows: Thousands, except per share amounts Earnings applicable to common stock – basic 2000 $ 41,512 $ 47,786 $ 47,768 389 ________ ________ ________ Earnings applicable to common stock – diluted $ 41,797 $ 48,156 $ 48,157 ________ ________ ________ ________ ________ ________ Average common shares outstanding – basic 25,183 13 442 ________ ________ ________ Average common shares outstanding – diluted 25,638 ________ ________ ________ ________ ________ ________ Earnings per share of common stock – basic $ 1.63 $ 1.90 $ 1.90 ________ ________ ________ ________ ________ ________ Earnings per share of common stock – diluted $ 1.62 $ 1.88 $ 1.88 ________ ________ ________ ________ ________ ________ Stock options Convertible debentures 25,431 59 324 25,814 25,159 32 421 25,612 Debenture interest less taxes 2002 2001 285 370 Stock-Based Compensation The Company applies APB Opinion No. 25, “Accounting for Stock Issued to Employees,” to account for its stock-based compensation plans. Accordingly, the Company does not recognize compensation expense for the fair value of its stock-based awards. However, the Company recognizes compensation expense for the market value of stock awards granted under its Long-Term Incentive Plan (LTIP) in the period when performance shares are earned (see Note 4). The Company has elected to continue using the intrinsic value method of accounting for its stock-based awards rather than changing to the fair value method of accounting until a uniform method of valuing and expensing stock options is promulgated by the FASB. 2. CONSOLIDATED SUBSIDIARY OPERATIONS AND SEGMENT INFORMATION: At Dec. 31, 2002, the Company had two direct wholly-owned sub- sidiaries, Financial Corporation and Northwest Energy. Northwest Energy was formed in 2001 to serve as the holding company for NW Natural and PGE if the acquisition of PGE had been completed. The Company principally operates in a segment of business, “Utility,” consisting of the distribution of natural gas. Another segment, “Gas Storage,” primarily represents natural gas storage services pro- vided to upstream interstate customers using storage capacity that has been developed in advance of core utility customers’ require- ments. The remaining segment, “Other,” primarily consists of non-reg- ulated investments in alternative energy projects in California and a Boeing 737-300 aircraft leased to Continental Airlines, and deferred costs relating to the acquisition of PGE (see Note 9). NNG Financial Corporation Financial Corporation has several financial investments, including investments as a limited partner in solar electric generating systems, windpower electric generating projects and low-income housing proj- ects. Financial Corporation disposed of its remaining interests in cer- tain gas producing properties in the western United States in 2000 and its partnership interest in a hydroelectric generating project in 2001. Gas Storage Gas storage services are provided to interstate customers using stor- age capacity that has been developed in advance of core utility cus- tomers’ requirements. NW Natural retains 80 percent of the income before tax from gas storage services and credits the remaining 20 percent to a deferred regulatory account for sharing with its core utility customers. NW Natural also receives revenues, after deducting for amounts shared with core utility customers, from a contract with an independ- ent energy trading company that seeks to optimize the use of NW Natural’s assets by trading temporarily unused portions of its gas stor- age and upstream pipeline transportation capacity. Canor Energy, Ltd. In January 2000, the Company sold its interest in Canor, an Alberta, Canada corporation that had been engaged in natural gas and oil ex- ploration, development and production in Alberta and Saskatchewan, Canada. The after-tax gain from the sale was $2.4 million, net of Canadian tax on dividends ($0.6 million) and U.S. income tax ($2.8 million), and is shown as gain on sale of discontinued segment. 36 N W N A T U R A L Segment Information Stock Repurchase Program The following table presents information about reportable segments for 2002, 2001 and 2000. Inter-segment transactions are insignificant. Utility Gas Storage Other Total $ 279,414 $ 7,944 $ 186 $ 287,544 52,090 119,196 116,258 988 51,693 118,156 109,565 – 396 962 6,586 – 1 78 107 988 – 47,336 1,308,291 – 3,646 16,403 (8,414) (8,414) (7,190) 43,792 18,097 1,342,791 $ 271,473 $ 4,368 $ 170 $ 276,011 49,640 116,160 110,211 49,413 115,708 106,352 227 489 3,652 – (37) 207 – 47,313 1,391,156 – 2,112 14,243 (321) 762 (321) 50,187 29,623 1,435,022 $ 257,361 $ 258 $ 331 $ 257,950 47,440 106,168 104,342 47,430 106,027 103,904 – 60 271 10 81 167 – 47,519 – 102 (221) (221) 191 47,812 – 1,252,747 – 4,919 2,412 2,412 21,047 1,278,713 Thousands 2002 Net operating revenues Depreciation and amortization Other operating expenses Income from operations Income from financial investments Loss provision for PGE transaction costs Net income (loss) Total assets at Dec. 31, 2002 2001 Net operating revenues Depreciation and amortization Other operating expenses (income) Income from operations Income (loss) from financial investments Net income Total assets at Dec. 31, 2001 2000 Net operating revenues Depreciation and amortization Other operating expenses Income from operations Income (loss) from financial investments Net income from continuing operations Gain on sale of discontinued segment Total assets at Dec. 31, 2000 3. CAPITAL STOCK: Common Stock At Dec. 31, 2002, NW Natural had reserved 148,415 shares of common stock for issuance under the Employee Stock Purchase Plan, 384,502 shares for future conversions of its 7-1/4% Convertible Debentures, 568,665 shares under its Dividend Reinvestment and Stock Purchase Plan, 1,892,014 shares under its Restated Stock Option Plan (see Note 4), and 3,000,000 shares under the Shareholder Rights Plan. Redeemable Preference Stock On Dec. 31, 2002, NW Natural redeemed all 250,000 shares of its $6.95 Series of Redeemable Preference Stock with proceeds from the sale of commercial paper. Redeemable Preferred Stock The mandatory preferred stock redemption requirements aggregate $0.8 million in each of 2003, 2004, 2005, 2006 and 2007. These re- quirements are non-cumulative. At any time NW Natural is in default on any of its obligations to make the prescribed sinking fund payments, it may not pay cash dividends on the common stock. Upon involun- tary liquidation, all series of redeemable preferred stock are entitled to their stated value. The redeemable preferred stock is callable at stipulated prices, plus accrued dividends. On or after May 1, 2002, shares of the $7.125 Series are redeemable at a price of $102.850 per share, decreasing each year thereafter to $100 per share on or after May 1, 2008. In May 2000, the Company commenced a program to repurchase up to 2 million shares, or up to $35 million in value, of NW Natural’s common stock through a repurchase program which has been extend- ed through May 2003. The purchases are made in the open market or through privately negotiated transactions. Since the program’s incep- tion the Company has repurchased 355,400 shares of common stock at a total cost of $8.2 million. Restated Stock Option Plan At the Company’s Annual Meeting in May 2002, the shareholders approved an amendment to the Restated Stock Option Plan that increased the total number of shares authorized for option grants from 1,200,000 to 2,400,000 shares. At Dec. 31, 2002, options on 1,428,200 shares were available for grant and options to purchase 463,814 shares were outstanding. The following table shows the changes in the number of shares of NW Natural’s capital stock and the premium on common stock for the years 2002, 2001 and 2000: Balance, Dec. 31, 1999 Sales to employees Sales to stockholders Exercise of stock options – net Conversion of convertible debentures to common Stock repurchases Sinking fund purchases Balance, Dec. 31, 2000 Sales to employees Sales to stockholders Exercise of stock options – net Conversion of convertible debentures to common Stock repurchases Sinking fund purchases Balance, Dec. 31, 2001 Sales to employees Sales to stockholders Exercise of stock options – net Conversion of convertible debentures to common Sinking fund purchases Redemption Balance, Dec. 31, 2002 Redeemable Redeemable preferred ————–— Shares ————–— Premium on common stock stock (thousands) 105,643 $ 234,608 278 3,769 81 preference stock 250,000 – – – Common stock 25,091,938 14,696 199,920 5,990 – – – 495 – 29,580 ( 1,016) – (108,700) – – – __________ ________ ________ ________ 238,215 250,000 25,233,424 498 – 30,952 3,854 – 177,624 110 – 12,289 – – (8,143) 97,500 – – – 343 – 20,485 (2,323) – (246,700) – – – __________ ________ ________ ________ 240,697 250,000 25,228,074 748 – 42,862 3,854 – 157,288 1,105 – 61,020 – – (7,500) 90,000 – – – 1,624 – 97,069 – – – (250,000) – – __________ ________ ________ ________ 82,500 $ 248,028 – 25,586,313 __________ ________ ________ ________ __________ ________ ________ ________ – (7,500) – 4. STOCK-BASED COMPENSATION: NW Natural has the following stock-based compensation plans: the Long-Term Incentive Plan (LTIP); the Restated Stock Option Plan (Restated SOP) (formerly the 1985 Stock Option Plan); the Employee Stock Purchase Plan (ESPP); and the Non-Employee Directors Stock Compensation Plan (NEDSCP). These plans are designed to promote stock ownership in NW Natural by employees, officers and directors. NW Natural’s shareholders approved the LTIP effective Jan. 1, 2001, to provide a flexible, competitive compensation program for eli- gible officers. An aggregate of 500,000 shares of common stock was authorized for grants under the LTIP as stock bonus, restricted stock or performance-based stock awards. Shares awarded under the LTIP are purchased on the open market. To date, NW Natural has granted three performance-based awards, one based on a two-year performance period (2001-02) and two based on three-year performance periods (2001-03 and 2002-04), and a restricted stock award. The aggregate N W N A T U R A L 37 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS target awards for each of the two-year (2001-02) and three-year (2001- 03) performance-based award periods were 26,000 shares and the maximum awards were 52,000 shares. The aggregate target and max- imum awards for the three-year performance-based award period (2002-04) were 29,000 and 58,000 shares, respectively. Final awards depend on the attainment of certain return on equity performance goals. At Dec. 31, 2002, the two-year performance-based award cov- ering the period 2001-02 lapsed because the performance-based meas- ures were not achieved. The restricted stock award consists of 4,500 shares granted in 2001 with a vesting period of 65 months. The LTIP stock awards are compensatory awards for which compensation expense is accrued based upon the market value of performance shares earned, or a pro rata amortization over the vesting period for restrict- ed shares. The Restated SOP authorizes an aggregate of 2,400,000 shares of common stock for issuance as incentive or non-statutory stock options. These options may be granted only to officers and key employees designated by a committee of NW Natural’s Board of Directors. All options are granted at an option price not less than the market value at the date of grant and may be exercised for a period not exceeding 10 years from the date of grant. Option holders may exchange shares they have owned for at least six months, at the current market price, to purchase shares at the option price. Since inception in 1985, options on 1,100,921 shares of common stock have been granted at prices ranging from $11.75 to $27.875 per share, and options on 129,121 shares have expired. In accordance with APB No. 25, no compensation expense is rec- ognized for the Restated SOP or the ESPP. If compensation expense for awards under the Restated SOP and the ESPP had been deter- mined based on fair value at the grant dates using the method pre- scribed by SFAS No. 123, “Accounting for Stock-Based Compensa- tion,” net income and earnings per share would have been reduced to the pro forma amounts shown below: Earnings applicable to common stock ($000): As reported Deduct: total stock-based compensation expense determined under fair value based method – net of tax Pro forma Basic earnings per share As reported Pro forma Diluted earnings per share As reported Pro forma 2002 2001 2000 $ 41,512 $ 47,786 $ 47,768 (478) (353) ________ ________ ________ $ 41,034 $ 47,448 $ 47,415 ________ ________ ________ ________ ________ ________ (338) $ 1.63 $ 1.90 $ 1.90 $ 1.61 $ 1.89 $ 1.88 $ 1.62 $ 1.88 $ 1.88 $ 1.60 $ 1.87 $ 1.86 The fair value of each stock option grant is estimated on the grant date using the Black-Scholes option pricing model with the follow- ing weighted average assumptions: 2002 4.8% 29.1% 3.6% 7 2000 4.7% 31.4% 5.2% 7 $ 20.49 $ 17.34 $ 14.18 2001 4.9% 31.0% 5.2% 7 Dividend yield Expected volatility Risk-free interest rate Expected life (years) Present value of options granted 38 N W N A T U R A L Information regarding the Restated SOP’s activity is summarized as follows: Balance, Dec. 31, 1999 Granted Exercised Expired Balance, Dec. 31, 2000 Granted Exercised Expired Balance, Dec. 31, 2001 Granted Exercised Expired Balance, Dec. 31, 2002 Shares 290,212 153,000 (14,207) (13,000) ________ 416,005 15,000 (12,289) (31,625) ________ 387,091 163,750 (68,827) (18,200) ________ 463,814 Range 20.25 – 22.875 16.59 – 24.00 20.25 – 27.875 20.17 – 27.875 24.91 ——— Price per Share ——— Weighted Average $ 16.59 – 27.875 $ 24.08 20.36 22.63 24.36 22.75 24.91 20.36 24.31 22.79 26.35 21.74 25.43 24.10 20.17 – 20.92 20.25 – 27.875 20.25 – 27.875 26.07 – 27.85 20.25 – 27.875 20.25 – 27.875 20.25 – 27.875 The weighted average characteristics of outstanding stock options at Dec. 31, 2002 were as follows: ————————– Outstanding Options ————————– Remaining Range of Life Exercise (Years) Prices 6.64 $20.25 – 27.875 Shares 463,814 – Exercisable Options – Weighted Average Price 244,864 $ 23.31 Shares The ESPP, as amended in 2000, allows employees to purchase common stock at 85 percent of the opening market price on the sub- scription date which is set annually. Each eligible employee may pur- chase up to 900 shares through payroll deduction over a six to 12- month period. Non-employee directors of the Company are awarded approxi- mately $100,000 worth of the Company’s common stock upon join- ing the Board pursuant to NW Natural’s NEDSCP. These initial awards vest in monthly installments over the five calendar years following the award. On Jan. 1 of each year thereafter, non-employee directors are awarded an additional $20,000 of common stock which vests in month- ly installments in the fifth year following the award (after the previ- ous award has fully vested). All awards vest immediately upon a change in control of the Company. Unvested shares are forfeited if the recipient ceases to be a director. The shares awarded are purchased in the open market by the Company at the time of award. Directors may elect to defer unvested shares into their stock accounts under the Directors Deferred Compensation Plan. Non-employee directors also may elect to receive shares of common stock instead of a cash pay- ment for their fees and retainers under a separate plan. 5. LONG-TERM DEBT: The issuance of first mortgage debt, including secured medium- term notes, under the Mortgage and Deed of Trust (Mortgage) is lim- ited by property additions, adjusted net earnings and other provisions of the Mortgage. The Mortgage constitutes a first mortgage lien on substantially all of NW Natural’s utility property. The 7-1/4 % Series of Convertible Debentures may be converted at any time into 50-1/4 shares of common stock for each $1,000 face value ($19.90 per share). The maturities for the five years ending Dec. 31, 2007 on the long- term debt outstanding at Dec. 31, 2002 amount to: $20 million in 2003, no maturity in 2004, $15 million in 2005, $8 million in 2006 and $29.5 million in 2007. Holders of certain medium-term notes have put options that, if exercised, would accelerate the maturity of long-term debt by $10 million and $20 million in 2005 and 2007, respectively. 6. NOTES PAYABLE AND LINES OF CREDIT: The Company’s primary source of short-term funds is commercial paper notes payable. Both NW Natural and Financial Corporation issue commercial paper under agency agreements with a commercial bank. NW Natural’s commercial paper is supported by its committed bank lines of credit (see below), while Financial Corporation’s com- mercial paper is supported by committed bank lines of credit and the guaranty of NW Natural. The amounts and average interest rates of commercial paper debt outstanding at Dec. 31 were as follows: Thousands NW Natural Financial Corporation Total –––––– 2001 –––––– –––––– 2002 –––––– Rate Amount Rate Amount 1.4% $ 108,291 $ 69,802 2.6% – – ________ ________ $ 108,291 $ 69,802 ________ ________ ________ ________ NW Natural has lines of credit with four commercial banks total- ing $150 million. Half of the credit with each bank, totaling $75 mil- lion, is committed and available through Sept. 30, 2003, and the oth- er $75 million is committed and available through Sept. 30, 2004. In addition, Financial Corporation has available through Sept. 30, 2003, committed lines of credit with two commercial banks totaling $20 million. Financial Corporation’s lines are supported by the guaranty of NW Natural. Under the terms of these lines of credit, NW Natural and Financial Corporation pay commitment fees but are not required to maintain compensating bank balances. The interest rates on borrowings under these lines of credit, if any, are based on current market rates. There were no outstanding balances on either the NW Natural or Financial Corporation lines of credit as of Dec. 31, 2002 or 2001. NW Natural’s lines of credit require that credit ratings be main- tained in effect at all times and that notice be given of any change in its senior unsecured debt ratings. A change in NW Natural’s credit rating is not an event of default, nor is the maintenance of a specif- ic minimum level of credit rating a condition to drawing upon the lines of credit. However, interest rates on any loans outstanding under NW Natural’s bank lines are tied to credit ratings, which would increase or decrease the cost of bank debt, if any, when ratings are changed. The lines of credit require that the Company maintain an indebted- ness to total capitalization ratio, as defined in the credit agreements, of 65 percent or less. Also, effective Oct. 1, 2002, the lines of cred- it require the Company to maintain a net worth at least equal to 80 percent of its net worth at Sept. 30, 2002, plus 50 percent of the Company’s net income for each subsequent fiscal quarter. Failure to comply with either of these covenants would entitle the banks to ter- minate their lending commitments and to accelerate the maturity of all amounts outstanding. At Dec. 31, 2002, the Company was in com- pliance with both the debt to total capital covenant and the minimum net worth covenant. 7. PENSION AND OTHER POSTRETIREMENT BENEFITS: NW Natural has two qualified non-contributory defined benefit pension plans covering all regular employees with more than one year of service, a non-qualified supplemental pension plan for eligible executive officers and other postretirement benefit plans for its employ- ees. The following tables provide a reconciliation of the changes in the plans’ benefit obligations and fair value of assets over the three-year period ended Dec. 31, 2002 and a statement of the funded status and amounts recognized in the consolidated balance sheets as of Dec. 31, 2002, 2001 and 2000: Thousands Change in benefit obligation: Benefit obligation at Jan. 1 Service cost Interest cost Expected benefits paid Plan amendments Net actuarial (gain) loss Benefit obligation at Dec. 31 Change in plan assets: Fair value of plan assets at Jan. 1 Actual return on plan assets Employer contributions Benefits paid Fair value of plan assets at Dec. 31 Funded status: Funded status at Dec. 31 Unrecognized transition obligation Unrecognized prior service cost Unrecognized net actuarial (gain) loss Net amount recognized Amounts recognized in the consolidated balance sheets at Dec. 31: Prepaid benefit cost Accrued benefit liability Intangible asset Other comprehensive loss Net amount recognized ––––––––––––––– Pension Benefits ––––––––––––––– 2000 2002 2001 –––––––––– Other Postretirement Benefits –––––––––– 2000 2001 2002 $ 166,751 4,637 11,807 (9,453) – 11,382 __________ 185,124 __________ 168,964 (17,082) 735 (9,453) __________ 143,164 __________ (41,960) – 7,371 42,060 __________ $ 7,471 __________ __________ $ 17,339 (18,741) 4,438 4,435 __________ $ 7,471 __________ __________ $ 146,802 3,964 11,332 (9,152) 1,838 11,967 ________ 166,751 ________ 190,451 (13,077) 742 (9,152) ________ 168,964 ________ 2,212 351 8,575 (2,956) ________ $ 8,182 ________ ________ $ 17,211 (9,346) 169 148 ________ $ 8,182 ________ ________ $ 136,198 3,475 10,312 (8,035) 12 4,840 ________ 146,802 ________ 193,427 4,351 708 (8,035) ________ 190,451 ________ 43,649 701 8,022 (47,661) ________ $ 4,711 ________ ________ $ 13,150 (8,932) 493 – ________ $ 4,711 ________ ________ $ 16,987 395 1,174 (979) (300) 1,180 ________ 18,457 ________ – – 979 (979) ________ – ________ (18,457) 4,226 – 4,437 ________ $ (9,794) ________ ________ $ – (9,794) – – ________ $ (9,794) ________ ________ $ 14,069 325 1,116 (942) – 2,419 ________ 16,987 ________ – – 942 (942) ________ – ________ (16,987) 4,795 172 3,405 ________ $ (8,615) ________ ________ $ – (8,615) – – ________ $ (8,615) ________ ________ $ 11,902 234 995 (878) – 1,816 ________ 14,069 ________ – – 878 (878) ________ – ________ (14,069) 5,232 191 1,061 ________ $ (7,585) ________ ________ $ – (7,585) – – ________ $ (7,585) ________ ________ N W N A T U R A L 39 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The Company’s qualified defined benefit pension plans had an accumulated benefit obligation in excess of plan assets at Dec. 31, 2002. The plans’ aggregate accumulated benefit obligation was $172 million, $156 million and $136 million at Dec. 31, 2002, 2001 and 2000, respectively. Plan assets were $143 million, $169 million and $190 million, respectively. The fair value of plan assets declined from Dec. 31, 2001 to Dec. 31, 2002 due to $15 million in investment losses, $9.8 million in withdrawals to pay benefits and $1.0 million in eligible expenses of the plans. The combination of investment returns and cash contributions is expected to provide sufficient funds to cover all benefit obligations of the plans; the Company expects to make cash contributions to the plans totaling $1.9 million for the 2003 plan year. The Company’s non-qualified supplemental pension plan had an accumulated benefit obligation in excess of plan assets for each of the periods presented. The plan’s aggregate accumulated benefit obliga- tion was $12.8 million, $10.7 million and $10.4 million at Dec. 31, 2002, 2001 and 2000, respectively. There were no plan assets in the non-qualified plan due to the nature of the plan, but the Company funds its obligation with trust-owned life insurance. The amount of the life insurance coverage is designed to provide sufficient returns to cover the benefit obligations and other costs of the plan. The Company’s plans for providing postretirement benefits other than pensions also have no plan assets. The aggregate benefit obligation for those plans was $18.5 million, $17.0 million and $14.1 million at Dec. 31, 2002, 2001 and 2000, respectively. The following tables provide the components of net periodic cost (benefit) for the plans for the years ended Dec. 31, 2002, 2001 and 2000, and the assumptions used in the measurement of these costs and the Company’s benefit obligations: Thousands Service cost Interest cost Expected return on plan assets Amortization of transition obligation Amortization of prior service cost Recognized actuarial (gain) loss Net periodic cost (benefit) Weighted average assumptions as of Dec. 31: Discount rate Expected return on plan assets Rate of compensation increase ––––––––––––––– Pension Benefits ––––––––––––––– 2000 $ 3,475 10,312 (16,056) 334 1,174 (3,449) ________ $ (4,210) ________ ________ 2001 $ 3,964 11,332 (17,198) 351 1,284 (2,464) ________ $ (2,731) ________ ________ 2002 $ 4,637 11,807 (16,335) 351 1,204 (216) ________ $ 1,448 ________ ________ –––––––––– Other Postretirement Benefits –––––––––– 2000 $ 234 995 – 436 19 – ________ $ 1,684 ________ ________ 2002 $ 395 1,174 – 436 6 147 ________ $ 2,158 ________ ________ 2001 $ 325 1,116 – 436 19 75 ________ $ 1,971 ________ ________ 6.75% 8.00% 4.25-5.00% 7.25% 9.00% 4.25-5.00% 7.50% 9.00% 4.25-5.00% 6.75% n/a n/a 7.25% n/a n/a 7.50% n/a n/a required to allow RKSP participants the option of receiving the div- idends paid on the Company’s common stock in the ESOP account in cash rather than having the dividends automatically reinvested (see Note 8). 8. INCOME TAXES: A reconciliation between income taxes calculated at the statutory federal tax rate and the tax provision reflected in the financial state- ments is as follows: Thousands 2001 2002 2000 Computed income taxes based on statutory federal income tax rate of 35% Increase (reduction) in taxes resulting from: Difference between book and tax depreciation Current state income tax, net of federal tax benefit Federal income tax credits Amortization of investment tax credits Gains on Company and trust-owned life insurance Removal costs Reversal of amounts provided in prior years Deduction for dividends paid on certain employer securities to an ESOP Other – net Total provision for income taxes Total income taxes paid $ 23,533 $ 27,209 $ 26,124 222 222 222 2,299 (362) (858) (487) (573) (240) 2,672 (362) (855) (576) (508) (72) 2,622 (357) (855) (611) (480) (25) – (177) (204) 114 – 189 ________ ________ ________ $ 23,444 $ 27,553 $ 26,829 ________ ________ ________ ________ ________ ________ $ 33,474 $ 25,201 $ 22,552 ________ ________ ________ ________ ________ ________ The assumed annual trend rates used in measuring postretirement benefits as of Dec. 31, 2002 were 10 percent for medical and 15 per- cent for prescription drugs. Medical costs were assumed to decrease gradually each year to a rate of 4.5 percent for 2008, while prescrip- tion drug costs were assumed to decrease gradually each year to a rate of 4.5 percent for 2013. Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one percent change in assumed health care cost trend rates would have the following effects: 1% Decrease Thousands 1% Increase Effect on the total service and interest cost components of net periodic postretirement health care benefit cost Effect on the health care component of the accumulated postretirement benefit obligation $ 45 $ (45) $ 488 $ (476) NW Natural’s Retirement K Savings Plan (RKSP) is a qualified defined contribution plan under Internal Revenue Code Section 401(k). NW Natural also has a non-qualified deferred compensation plan for eligible officers and senior managers. These plans are designed to enhance the retirement program of employees and to assist them in strengthening their financial security by providing an incentive to save and invest regularly. NW Natural’s matching contributions to these plans totaled $1.4 million in 2002 and $1.3 million in both 2001 and 2000. Effective Jan. 1, 2002, the RKSP was amended to establish an Employee Stock Ownership Plan (ESOP) within the RKSP by con- verting the existing RKSP Company Stock Fund into an ESOP. This amendment allowed the Company to claim a tax benefit of $0.2 mil- lion in 2002 for the dividends paid on the Company’s common stock held by the ESOP. In order to claim this deduction, the Company was 40 N W N A T U R A L Investment and energy tax credits restored: Total investments and other The provision for income taxes consists of the following: Thousands 2002 2001 2000 Income taxes currently payable: Federal State Total Deferred taxes – net: Federal State Total $ 9,377 $ 32,682 $ 18,228 2,444 ________ ________ ________ 20,672 ________ ________ ________ 1,239 10,616 5,912 38,594 7,495 (483) ________ ________ ________ 7,012 ________ ________ ________ (8,606) (1,580) (10,186) 11,476 2,210 13,686 From utility operations From subsidiary operations Total Total provision for income taxes Percentage of pretax income (800) (58) (858) (800) (55) (855) (800) (55) ________ ________ ________ (855) ________ ________ ________ $ 23,444 $ 27,553 $ 26,829 ________ ________ ________ ________ ________ ________ 35.9% ________ ________ ________ ________ ________ ________ 34.9% 35.4% Deferred tax assets and liabilities are comprised of the following: 2001 2002 Thousands Deferred tax liabilities: Plant and property Regulatory income tax asset Regulatory liabilities Other deferred liabilities Total Deferred tax assets: Regulatory assets Minimum pension liability Other deferred assets Total Net accumulated deferred income tax liability $ 96,525 $ 84,976 48,469 – 7,645 ________ ________ 141,090 ________ ________ 47,975 319 6,569 151,388 – 1,883 7,773 9,656 2,270 – 8,396 ________ ________ 10,666 ________ ________ $ 141,732 $ 130,424 ________ ________ ________ ________ A $1.9 million tax benefit associated with a charge related to accrual of minimum pension liability was recorded in OCI for the year ended Dec. 31, 2002. 9. PROPERTY AND INVESTMENTS: The following table sets forth the major classifications of NW Natural’s utility plant and accumulated depreciation at Dec. 31: Amount Thousands Transmission and distribution $1,254,624 Utility storage 107,110 General 83,878 Intangible and other 53,291 _________ 1,498,903 11,301 29,761 _________ 1,539,965 Gas stored long-term Construction work in progress Utility plant in service Total utility plant ––––––– 2001 ––––––– Average Depreciation Rate 3.4% 2.6% 6.0% 5.8% 3.5% ––––––– 2002 ––––––– Average Depreciation Amount Rate 3.4% $1,196,824 106,500 2.7% 80,411 6.3% 4.3% 50,274 _________ 3.5% 1,434,009 11,301 19,769 _________ 1,465,079 Less accumulated depreciation Utility plant – net 560,798 _________ $ 979,167 _________ _________ 514,299 _________ $ 950,780 _________ _________ The following table summarizes the Company’s investments in non-utility plant at Dec. 31: Thousands Non-utility storage Dock, land, oil station and other Total non-utility plant Less accumulated depreciation Non-utility plant – net 2002 2001 $ 17,037 $ 14,480 3,723 ________ ________ 18,203 4,007 ________ ________ $ 16,428 $ 14,196 ________ ________ ________ ________ 3,795 20,832 4,404 The following table summarizes the Company’s investments in entities accounted for under the equity and cost methods, and its investment in an aircraft leveraged lease at Dec. 31: Thousands Deferred costs for pending purchase of PGE, net of loss provision Aircraft leveraged lease Gas pipeline and other Electric generation Long-term notes receivable $ – $ 9,557 6,987 3,234 3,155 300 ________ ________ $ 12,703 $ 23,233 ________ ________ ________ ________ 6,489 2,950 3,264 – 2001 2002 Financial Corporation has ownership interests ranging from 4.0 to 5.3 percent in solar electric generation plants located near Barstow, California. Power generated by these plants is sold to Southern California Edison Company under long-term contracts. Financial Corporation also has ownership interests ranging from 25 to 41 percent in wind- power electric generation projects located near Livermore and Palm Springs, California. The wind-generated power is sold to Pacific Gas and Electric Company and Southern California Edison Company under long-term contracts. Financial Corporation has a 10 percent ownership interest in a 19- mile interstate natural gas pipeline. NW Natural is the operator of this pipeline. In 1987, the Company invested in a Boeing 737-300 aircraft, which is leased to Continental Airlines for 20 years under a leveraged lease agreement. 10. FAIR VALUE OF FINANCIAL INSTRUMENTS: The estimated fair values of NW Natural’s financial instruments have been determined using available market information and appro- priate valuation methodologies. The following are financial instruments whose carrying values are sensitive to market conditions: Thousands Redeemable preference stock Redeemable preferred stock Long-term debt including amount due within one year ––– Dec. 31, 2002 ––– Carrying Estimated Amount Fair Value ––– Dec. 31, 2001 ––– Estimated Carrying Fair Value Amount $ – $ – $ 25,000 $ 25,347 $ 8,250 $ 8,333 $ 9,000 $ 9,256 $ 465,945 $ 518,495 $ 418,377 $ 407,239 Fair value of the redeemable preference stock and the redeemable preferred stock was estimated using quoted market prices. Interest rates for debt with similar terms and remaining maturities were used to estimate fair value for debt issues. 11. USE OF FINANCIAL DERIVATIVES: NW Natural enters into short-term and long-term natural gas pur- chase contracts with suppliers, including contracts tied to floating prices. As such, NW Natural is exposed to changes in commodity prices. Natural gas prices are subject to fluctuations due to unpre- dictable factors including weather, inventory levels, pipeline trans- portation availability, and the economy, each of which affects short- term supply and demand. As part of its overall strategy to maintain an acceptable level of exposure to gas price fluctuations, NW Natural uses a targeted mix of fixed-rate and cap-protected derivatives to hedge the exposure under floating price gas supply contracts. Swap contracts are used to convert certain long-term gas purchase contracts from float- ing prices to fixed prices, and call option contracts are used to limit the maximum adverse impact from floating price contracts while retaining the potential favorable impact from declining gas prices. N W N A T U R A L 41 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The prices embedded in these commodity hedge contracts are incor- porated in NW Natural’s annual rate changes, pursuant to its Oregon Purchased Gas Adjustment (PGA) tariff, thereby limiting customers’ exposure to frequent changes in purchased gas costs. The estimated fair value gains and losses from commodity hedge contracts are record- ed as a derivative asset or liability, and are offset by a corresponding amount recorded to a deferred regulatory asset or liability account for the effective portion of each hedge contract. The actual gains and losses realized at settlement of the hedge contract are used to offset the actual purchase cost from NW Natural’s physical supply contract. Certain natural gas purchases from Canadian suppliers are invoiced in Canadian dollars, including both commodity and demand charges, thereby exposing NW Natural to adverse changes in foreign curren- cy rates. Foreign currency forward contracts are used to minimize the impact of fluctuations in currency rates. Foreign currency contracts for commodity costs are purchased on a month-to-month basis because the Canadian cost is priced at the average noonday exchange rate for each month. Foreign currency contracts for demand costs have terms ranging up to 24 months. The gains and losses on the shorter-term cur- rency contracts for commodity costs are recognized immediately in cost of gas. The gains and losses on the longer-term currency contracts for demand charges are subject to a regulatory deferral tariff and, as such, are recorded as a derivative asset or liability which is offset by a corresponding amount to a deferred asset or liability account. NW Natural did not use any derivative instruments to hedge oil or propane prices or interest rates during 2002 or 2001. At Dec. 31, 2002, NW Natural had the following derivatives out- standing covering its exposures to commodity and foreign currency prices: a series of 18 natural gas price swap contracts, three natural gas call option contracts, and 83 foreign currency forward contracts. Each of these contracts was designated as a cash flow hedge. NW Natural also had one physical natural gas supply contract with an embedded derivative, which did not qualify as a normal purchase or sales contract. The estimated fair values and the notional amounts of derivative instruments outstanding were as follows: Thousands Fixed-price natural gas commodity swaps Fixed-price natural gas call options Physical natural gas supply contract with embedded option Foreign currency forward purchase contracts Total ––– Dec. 31, 2001 ––– ––– Dec. 31, 2002 ––– Notional Fair Value Notional Fair Value Amount Gain (Loss) Amount Gain (Loss) $ 11,422 $ 159,724 $(110,935) $ 254,209 717 448 18,084 (832) 6,390 2,754 – – (161) 10,223 _________ ________ ________ ________ $ 12,426 $ 196,087 $(111,868) $ 270,822 _________ ________ ________ ________ _________ ________ ________ ________ 15,525 (101) In 2002, NW Natural realized net losses of $75.5 million from the settlement of natural gas commodity swap and call option contracts, which were recorded as increases to the cost of gas, compared to net gains of $57.6 million during 2001. The currency exchange rate in all foreign currency forward purchase contracts is included in NW Natural’s cost of gas at settlement; therefore, no gain or loss was recorded from the settlement of those contracts. The change in value of cash flow hedge contracts, not included in regulatory recovery, is included in OCI. In 2002 and 2001, the Company recognized a $0.2 million gain and a $0.2 million loss, respectively, in OCI from these changes in value of cash flow hedge contracts. 42 N W N A T U R A L The fair value of derivative instruments at Dec. 31, 2002 (see table above) was determined using estimated or quoted market prices for the periods covered by the contracts. Market prices for the natural gas commodity-price swap and call option contracts were obtained from external sources. NW Natural reviews these third-party valua- tions for reasonableness using fair value calculations for other con- tracts with similar terms and conditions. The market prices for the for- eign currency forward contracts were based on currency exchange rates quoted by The Bank of Canada. As of Dec. 31, 2002, NW Natural had two natural gas commodi- ty swap contracts extending beyond Dec. 31, 2003, but none extends beyond Oct. 31, 2004. None of the natural gas commodity call option contracts extends beyond March 31, 2003. 12. COMMITMENTS AND CONTINGENCIES: Lease Commitments The Company leases land, buildings and equipment under agree- ments that expire in various years through 2006. Rental expense under operating leases was $4.8 million, $4.7 million and $4.9 million for the years ended Dec. 31, 2002, 2001 and 2000, respectively. The table below reflects the future minimum lease payments due under non-can- celable leases at Dec. 31, 2002. Such payments total $13.8 million for operating leases. The net present value of payments on capital leases less imputed interest was $0.2 million. These commitments principally relate to the lease of the Company’s office headquarters, underground gas storage facilities, vehicles and computer equipment. Millions Operating leases Capital leases Minimum lease payments Purchase Commitments 2003 $ 2.9 0.2 _____ $ 3.1 _____ _____ 2004 $ 2.7 – _____ $ 2.7 _____ _____ 2005 $ 2.6 – _____ $ 2.6 _____ _____ 2006 $ 1.0 – _____ $ 1.0 _____ _____ 2007 $ 0.3 – _____ $ 0.3 _____ _____ Later years $ 4.3 – _____ $ 4.3 _____ _____ NW Natural has signed agreements providing for the availability of firm pipeline capacity under which it must make fixed monthly pay- ments for contracted capacity. The pricing component of the month- ly payment is established, subject to change, by U.S. or Canadian reg- ulatory bodies. In addition, NW Natural has entered into long-term sale agreements to release firm pipeline capacity. The aggregate amounts of these agreements were as follows at Dec. 31, 2002: Thousands 2003 2004 2005 2006 2007 2008 through 2023 Total Less: Amount representing interest Total at present value Capacity Purchase Capacity Release Agreements Agreements $ 75,112 $ 3,698 3,536 3,382 3,235 3,092 8,047 ________ ________ 24,990 4,687 ________ ________ $ 289,632 $ 20,303 ________ ________ ________ ________ 44,064 40,201 35,912 34,380 152,093 381,762 92,130 NW Natural’s total payments of fixed charges under capacity pur- chase agreements in 2002, 2001 and 2000 were $86.2 million, $86.5 million and $81.5 million, respectively. Included in the amounts for 2002, 2001 and 2000 were reductions for capacity release sales of $4.2 million, $3.8 million and $3.8 million, respectively. In addition, per- unit charges are required to be paid based on the actual quantities shipped under the agreements. In certain take-or-pay purchase com- mitments, annual deficiencies may be offset by prepayments subject to recovery over a longer term if future purchases exceed the mini- NW Natural has accrued all material loss contingencies relating to environmental matters that it believes to be probable of assertion and reasonably estimable. Due to the preliminary nature of these envi- ronmental investigations, the range of any additional possible loss contingency cannot be currently estimated. NW Natural expects that its costs of further investigation and remediation for which it may be responsible with respect to the Gasco site, the Wacker site, the Portland Harbor site and the Portland Gas site, if any, should be recoverable, in large part, from insurance. At Dec. 31, 2002, NW Natural had a $2.5 million receivable representing an estimate of the environmental costs NW Natural expects to recover from insurance, including $1.4 mil- lion that was recorded in 2000 for costs relating to the Gasco site and $1.1 million that was recorded in 2002 for costs relating to the Portland Harbor site. In the event these costs are not recovered from insur- ance, NW Natural will seek recovery through future rates. Litigation In November 2001, NW Natural commenced a lawsuit, (Northwest Natural Gas Company v. Cascade Resources Corporation and Curry, et. al.) (United States District Court for the District of Oregon, Case No. CV 01-1620 HU), alleging that the defendants violated obliga- tions regarding the use and disclosure of confidential information and used such information to solicit and secure underground gas storage leases in areas of interest to the Company. Among other remedies, the Company seeks to have a constructive trust imposed on such leases and to require the defendants to assign their interest in such leases to the Company. The defendants in this case have asserted counterclaims against the Company alleging that by asserting that the defendants have misused confidential information, the Company improperly interfered with the defendants’ business opportunities. The assertions include claims for violation of antitrust laws and the defendants seek $15 million in damages, trebled, plus punitive damages and attorneys’ fees. The Com- pany believes these counterclaims are without merit. The litigation is currently in the discovery stage. From time to time the Company is subject to other claims and lit- igation arising in the ordinary course of business. Although the final outcome of any legal proceeding cannot be predicted with certainty, the Company does not expect disposition of these matters to have a materially adverse effect on the Company’s financial position, results of operations or cash flows. mum annual requirements. NW Natural also has a contract commit- ment to purchase about $10.1 million in gas transmission pipe in 2003 for use in constructing an extension of the pipeline from its Mist storage field. Environmental Matters NW Natural owns property in Multnomah County, Oregon that is the site of a former gas manufacturing plant that was closed in 1956 (the Gasco site). The Gasco site has been under investigation by NW Natural for environmental contamination under the Oregon Department of Environmental Quality’s (ODEQ) Voluntary Clean-Up Program. NW Natural has recorded liabilities totaling $4.0 million for the esti- mated costs of investigation and interim remediation at the Gasco site, including consultants’ fees, ODEQ oversight reimbursement and legal fees, of which $3.2 million had been spent as of Dec. 31, 2002. NW Natural previously owned property adjacent to the Gasco site that now is the location of a manufacturing plant owned by Wacker Siltronic Corporation (the Wacker site). In 2000, the ODEQ issued an order requiring Wacker and NW Natural to determine the nature and extent of releases of hazardous substances to Willamette River sedi- ments from the Wacker site. NW Natural has completed the majori- ty of the studies required under the ODEQ work plan and the agency is reviewing data generated by the studies. NW Natural has recorded a liability of $0.3 million for its estimated costs of the investigation and initial remediation on the Wacker site, of which $0.2 million had been spent as of Dec. 31, 2002. In 1998, the ODEQ and the U.S. Environmental Protection Agency (EPA) completed a study of sediments in a 5.5-mile segment of the Willamette River (the Portland Harbor) that includes the area adjacent to the Gasco site and the Wacker site. In 2000, the EPA listed the Portland Harbor as a Superfund site and notified the Company that it is a potentially responsible party. NW Natural recorded liabilities totaling $2.3 million between 2000 and 2002, of which $1.1 million had been spent as of Dec. 31, 2002. The amount of NW Natural’s lia- bility is based on estimates of the Company’s share of the lower end of a range of probable liability for the costs of the Remedial Investi- gation/Feasibility Study for the Portland Harbor. Available informa- tion is insufficient to determine either the total amount of liability for investigation and remediation of the Portland Harbor or the high- er end of a range for NW Natural’s estimated share of that liability. The City of Portland has notified NW Natural that it is planning a sewer improvement project that would include excavation within the former site of a gas manufacturing plant (the Portland Gas site) that was owned and operated by a predecessor of the Company between 1860 and 1913. The preliminary assessment of this site performed by a consultant for the EPA in 1987 indicated that it could be assumed that by-product tars may have been disposed of on site. The report con- cluded, however, that it is likely that waste residues from the plant, if present on the site, were covered by deep fill during construction of the nearby seawall bordering the Willamette River and probably have stabilized due to physical and chemical processes. Neither the City of Portland nor the ODEQ has notified NW Natural whether a further investigation or potential remediation might be required on the site in connection with the sewer project. Available information is insufficient to determine either the total amount of liability or a probable range, if any, of potential liability. N W N A T U R A L 43 COMPARATIVE CONSOLIDATED INCOME STATEMENTS Thousands, except per share amounts (year ended December 31) Operating revenues: Gross operating revenues* Cost of sales* Net operating revenues* Operating expenses: Operations and maintenance Taxes other than income taxes Depreciation, depletion and amortization Loss on cogeneration facility Total operating expenses Income from continuing operations Other income (expense)* Interest charges – net Income before income taxes Income taxes Net income from continuing operations Discontinued segment: Income from discontinued segment – net of tax Gain on sale of discontinued segment – net of tax Net income Redeemable preferred and preference stock dividend requirements Earnings applicable to common stock Average common shares outstanding Basic earnings per share of common stock: From continuing operations From discontinued segment From gain on sale of discontinued segment Total basic earnings per share Diluted earnings per share of common stock: From continuing operations From discontinued segment From gain on sale of discontinued segment Total diluted earnings per share Dividends per share of common stock 2002 2001 $ 641,376 $ 650,252 374,241 ___________ ___________ 276,011 353,832 287,544 83,920 32,240 49,640 – ___________ ___________ 165,800 ___________ ___________ 110,211 85,120 34,076 52,090 – 171,286 116,258 1,334 33,805 ___________ ___________ 77,740 27,553 ___________ ___________ 50,187 (14,890) 34,132 67,236 23,444 43,792 – – ___________ ___________ 50,187 – – 43,792 2,280 2,401 ___________ ___________ $ 41,512 $ 47,786 ___________ ___________ ___________ ___________ 25,431 25,159 $ 1.63 $ 1.90 – – ___________ ___________ $ 1.63 $ 1.90 ___________ ___________ ___________ ___________ – – – – $ 1.62 $ 1.88 – – ___________ ___________ $ 1.62 $ 1.88 ___________ ___________ ___________ ___________ $ 1.26 $ 1.245 ___________ ___________ ___________ ___________ See Notes to Consolidated Financial Statements. *Interest on deferred regulatory accounts for years prior to 1998 was reclassified from gross operating revenues or cost of sales to other income (expense). UTILITY GAS REVENUES BY CUSTOMER CLASS 2002 87% 2% 11% 93% 4% 3% 1990 RESIDENTIAL, COMMERCIAL AND INDUSTRIAL FIRM INDUSTRIAL INTERRUPTIBLE TRANSPORTATION Revenues from residential, com- mercial and industrial firm sales customers have consistently exceeded 87 percent of total gas revenues since 1990. NET INCOME IN MILLIONS OF DOLLARS $70 $60 $50 $40 $30 $20 $10 92 93 94 95 96 97 98 99 00 01 02 NET INCOME REDUCTION OF NET INCOME FROM INVESTMENT WRITEDOWNS: – $2.8 million from a loss on Agrico Cogeneration Corporation in 1992 – $10.8 million loss for Financial Corporation and $1.7 million loss for Canor from asset impairment charges in 1998 – $8.4 million loss from PGE acquisition costs in 2002 The Company earned $43.8 million in net income in 2002. Net income, excluding the loss provision for PGE acquisition costs, would have been $52.2 million. 44 N W N A T U R A L 2000 1999 1998 1997 1996 1995 1994 1993 1992 $ 532,110 $ 455,834 $ 404,390 $ 351,709 $ 370,826 $ 355,627 $ 367,861 $ 358,452 $ 274,397 101,672 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 172,725 138,751 219,701 274,160 257,950 173,424 230,966 212,197 243,637 130,599 221,110 142,025 213,602 141,842 228,984 162,199 205,662 64,249 20,865 33,035 4,575 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 122,724 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 50,001 70,723 25,561 39,683 – 135,967 83,734 70,881 24,263 38,058 – 133,202 72,460 77,817 28,351 47,440 – 153,608 104,342 73,209 24,652 51,008 – 148,869 94,768 78,226 21,939 43,937 – 144,102 86,864 76,204 21,597 37,971 – 135,772 93,212 72,018 24,181 40,594 – 136,793 76,809 73,864 19,952 39,051 – 132,867 88,243 (542) 26,733 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 22,726 6,951 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 15,775 (13,723) 31,586 41,555 14,604 26,951 8,393 24,919 55,934 20,473 35,461 1,116 25,107 59,743 22,096 37,647 6,891 26,711 73,392 27,118 46,274 4,138 28,469 63,912 21,034 42,878 9,055 25,679 60,185 22,120 38,065 3,860 33,561 74,641 26,829 47,812 4,816 30,052 69,532 24,591 44,941 – – ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 15,775 350 – 27,301 181 – 43,059 – – 37,647 – – 38,065 – 2,412 50,224 355 – 45,296 – – 35,461 519 – 46,793 2,456 2,560 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ $ 47,768 $ 42,781 $ 24,724 $ 40,413 $ 44,070 $ 35,259 $ 32,478 $ 34 ,159 $ 13,215 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 2,723 2,515 3,488 2,646 2,577 2,806 2,983 25,183 24,976 24,233 22,698 22,391 21,817 19,943 19,611 17,864 $ 1.80 $ 1.70 $ 1.01 $ 1.77 $ 1.95 $ 1.62 $ 1.63 $ 1.74 $ 0.74 – – ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ $ 1.90 $ 1.71 $ 1.02 $ 1.78 $ 1.97 $ 1.62 $ 1.63 $ 1.74 $ 0.74 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 0.01 – 0.01 – 0.01 – 0.02 – – 0.10 – – – – – – – 0.09 $ 1.79 $ 1.69 $ 1.01 $ 1.75 $ 1.92 $ 1.60 $ 1.61 $ 1.72 $ 0.74 – – ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ $ 1.88 $ 1.70 $ 1.02 $ 1.76 $ 1.94 $ 1.60 $ 1.61 $ 1.72 $ 0.74 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ $ 1.24 $ 1.225 $ 1.22 $ 1.205 $ 1.20 $ 1.18 $ 1.1 73 $ 1.167 $ 1.147 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 0.01 – 0.01 – 0.01 – 0.02 – – – – – – – N W N A T U R A L 45 COMPARATIVE CONSOLIDATED BALANCE SHEETS Thousands of dollars (December 31) Assets: Plant and property: Utility plant Less accumulated depreciation Utility plant – net Non-utility property Less accumulated depreciation and depletion Non-utility property – net Total plant and property Other investments Current assets: Cash and cash equivalents Accounts receivable – net Accrued unbilled revenue Inventories of gas, materials and supplies Investment in discontinued segment Property held for sale Prepayments and other current assets Total current assets Regulatory tax assets Deferred gas costs receivable Unrealized loss on non-trading derivatives Deferred debits and other Total assets Capitalization and liabilities: Capitalization: Common stock equity Redeemable preference stock Redeemable preferred stock Total capital stock First mortgage debt Unsecured debt Total long-term debt Total capitalization Minority interest Current liabilities: Notes payable Accounts payable Long-term debt due within one year Taxes accrued Interest accrued Other current and accrued liabilities Total current liabilities Deferred investment tax credits Deferred income taxes Fair value of non-trading derivatives Deferred gas costs payable Regulatory liabilities and other Total capitalization and liabilities 2002 2001 $ 1,539,965 $ 1,465,079 514,299 ___________ ___________ 950,780 ___________ ___________ 18,203 4,007 ___________ ___________ 14,196 ___________ ___________ 964,976 ___________ ___________ 23,233 ___________ ___________ 560,798 979,167 20,832 4,404 16,428 995,595 12,703 7,328 46,936 44,069 58,030 – – 37,645 194,008 47,975 – – 92,510 10,440 64,722 57,749 49,337 – – 28,086 ___________ ___________ 210,334 ___________ ___________ 48,469 ___________ ___________ – ___________ ___________ 111,641 ___________ ___________ 76,369 ___________ ___________ $ 1,342,791 $ 1,435,022 ___________ ___________ ___________ ___________ $ 483,103 $ 468,161 25,000 9,000 ___________ ___________ 502,161 ___________ ___________ 370,000 8,377 ___________ ___________ 378,377 ___________ ___________ 880,538 ___________ ___________ – – 8,250 491,353 439,500 6,445 445,945 937,298 – 69,802 74,436 20,000 7,822 2,902 30,045 205,007 7,824 141,732 – 10,635 40,295 108,291 70,698 40,000 22,539 3,658 28,396 ___________ ___________ 273,582 ___________ ___________ 8,682 ___________ ___________ 130,424 ___________ ___________ 111,868 ___________ ___________ 10,089 ___________ ___________ 19,839 ___________ ___________ $ 1,342,791 $ 1,435,022 ___________ ___________ ___________ ___________ *Deferred gas costs were included in deferred debits or regulatory accounts prior to 1995. NET UTILITY PLANT IN MILLIONS OF DOLLARS $1,100 $1,000 $900 $800 $700 $600 $500 $400 $300 92 93 94 95 96 97 98 99 00 01 02 Utility plant continued to increase in 2002 as a result of customer growth and investments in system improve- ments and gas storage. CAPITALIZATION IN MILLIONS OF DOLLARS $1050 $900 $750 $600 $450 $300 $150 92 93 94 95 96 97 98 99 00 01 02 COMMON EQUITY PREFERRED AND PREFERENCE STOCK LONG-TERM DEBT In 2002, $32 million in cash divi- dends were paid to common share- holders, $25 million in Preference Stock was redeemed, $90 million in Medium-Term Notes were issued and $40.5 million in Medium-Term Notes were retired. 46 N W N A T U R A L 2000 1999 1998 1997 1996 1995 1994 1993 1992 $ 1,406,970 $ 1,331,415 $ 1,239,690 $ 1,164,499 $ 1,055,112 $ 969,075 $ 908,238 $ 840,030 $ 779,274 233,385 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 545,889 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 44,629 15,480 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 29,149 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 575,038 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 40,336 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 279,112 629,126 49,586 24,456 25,130 654,256 37,097 255,282 584,748 42,764 20,646 22,118 606,866 34,574 436,386 895,029 8,548 7,654 894 895,923 16,557 478,138 928,832 8,649 3,451 5,198 934,030 14,526 404,117 835,573 89,050 29,927 59,123 894,696 16,714 308,702 660,373 53,807 16,997 36,810 697,183 37,882 366,607 797,892 52,422 22,843 29,579 827,471 35,126 336,141 718,971 45,689 19,388 26,301 745,272 34,723 11,283 60,753 45,619 46,883 – – 22,834 187,372 49,515 16,973 – 76,297 7,537 33,008 20,738 15,797 – – 8,220 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 85,300 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ – ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ * ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ – ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 31,160 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ $ 1,278,713 $ 1,244,423 $ 1,191,736 $ 1,111,617 $ 988,869 $ 929,277 $ 889,304 $ 849,036 $ 731,834 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 7,383 47,476 34,258 21,258 – – 16,105 126,480 56,860 27,795 – 69,191 4,198 43,972 25,890 16,838 – – 16,412 107,310 62,130 * – 38,156 6,731 39,420 23,911 17,385 – – 17,226 104,673 56,860 28,628 – 58,859 10,013 43,349 31,550 33,919 29,163 16,712 18,349 183,055 51,060 20,950 – 76,878 8,068 42,152 20,320 14,958 – – 10,041 95,539 60,430 * – 41,982 7,782 34,385 21,493 14,254 – – 12,396 90,310 60,430 – – 43,472 8,219 40,833 22,340 14,439 – – 12,483 98,314 57,940 – – 52,620 $ 452,309 $ 429,596 $ 412,404 $ 366,265 $ 346,778 $ 323,552 $ 274,408 $ 258,565 $ 241,538 26,766 28,218 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 296,522 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 205,458 48,308 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 253,766 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 550,288 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ – 26,252 15,950 316,610 234,000 57,076 291,076 607,686 – 26,633 17,041 302,239 215,000 57,931 272,931 575,170 – 25,000 9,750 487,059 382,000 18,790 400,790 887,849 – 25,000 10,564 465,160 377,000 19,379 396,379 861,539 – 25,000 11,499 448,903 347,000 19,738 366,738 815,641 16,322 25,000 13,749 385,527 236,000 35,838 271,838 657,365 – 25,000 14,840 363,392 238,000 41,945 279,945 643,337 – 25,000 12,429 403,694 324,000 20,303 344,303 747,997 – 56,263 110,698 20,000 8,066 2,696 23,638 221,361 9,538 141,656 – – 18,309 47,109 40,282 2,138 4,790 6,792 9,387 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 110,498 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 15,603 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 34,929 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ – ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ * ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 20,516 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ $ 1,278,713 $ 1,244,423 $ 1,191,736 $ 1,111,617 $ 988,869 $ 929,277 $ 889,304 $ 849,036 $ 731,834 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 72,548 44,318 – 6,757 4,438 10,180 138,241 14,567 104,300 – * 16,758 53,654 48,517 1,000 6,584 4,570 11,757 126,082 13,530 112,433 – * 29,573 94,149 68,163 10,000 4,101 4,673 39,153 220,239 10,393 136,150 – – 16,102 87,264 56,039 10,000 7,486 6,204 23,477 190,470 11,248 140,310 – – 17,745 50,058 64,795 26,000 3,196 5,396 19,418 168,863 11,668 123,625 – 8,058 19,290 28,832 41,784 21,000 10,281 4,617 13,204 119,718 12,493 118,692 – 19,914 15,123 89,317 58,775 16,000 4,656 6,058 21,390 196,196 11,949 139,953 – – 15,522 N W N A T U R A L 47 COMPARATIVE FINANCIAL STATISTICS EARNINGS PER SHARE IN DOLLARS Common stock Ratios – year-end: Price/earnings ratio Dividend yield at year-end rate – % Dividend payout – % Return on average common equity – % Per share data – ($): Basic earnings Diluted earnings Dividends paid Dividend rate at year-end Book value at year-end Market price: High Low Year-end Average Number of shares of common stock outstanding (000): Year-end Average Coverage data – times earned Fixed charges – Securities and Exchange Commission Fixed charges – Standard & Poor’s Utility plant Capital expenditures (000) Depreciation – % of average depreciable utility plant Accumulated depreciation – % of depreciable utility plant Capital structure – year-end (%) (Exclusive of current portion of long-term debt) First mortgage debt Unsecured debt Total long-term debt Redeemable preferred stock Redeemable preference stock Common stock equity Total capital stock Total capital structure Effective tax rate Effective tax rate – % of pretax income 2002 2001 16.6* 4.7 77.3* 8.7* 1.63* 1.62* 1.26 1.26 18.88* 30.70 23.46 27.06 27.577 25,586 25,431 13.4 4.9 65.5 10.4 1.90 1.88 1.245 1.26 18.56 26.69 21.65 25.50 23.666 25,228 25,159 2.85* 3.29 3.14 3.30 $ 79,530 $ 71,943 3.5 37.3 3.5 35.8 42.0 1.0 ___________ ___________ 43.0 ___________ ___________ 1.0 2.8 53.2 ___________ ___________ 57.0 ___________ ___________ 100.0 ___________ ___________ ___________ ___________ 46.9 0.7 47.6 0.9 – 51.5 52.4 100.0 35 35 *Includes loss of $0.16 per share in 1992 on Agrico Cogeneration Corporation, losses of $0.50 per share in 1998 due to asset write-downs for Financial Corporation and Canor, and loss of $0.33 per share in 2002 for PGE acquisition costs. $2.00 $1.75 $1.50 $1.25 $1.00 $0.75 $0.50 $0.25 92 93 94 95 96 97 98 99 00 01 02 DILUTED EARNINGS PER SHARE REDUCTION IN EARNINGS PER SHARE FROM INVESTMENT WRITEDOWNS: – 16 cents per share in 1992 from a loss on Agrico Cogeneration Corporation – 50 cents per share in 1998 due to asset impairment charges – 33 cents per share in 2002 due to a loss provision for PGE acquisition costs Diluted earnings were $1.62 per share in 2002. Results include a 33 cent per share loss provision for PGE acquisition costs. YEAR-END MARKET PRICE & BOOK VALUE PER SHARE IN DOLLARS $35 $30 $25 $20 $15 $10 92 93 94 95 96 97 98 99 00 01 02 BOOK VALUE PER SHARE EXCESS OF MARKET PRICE OVER BOOK VALUE PER SHARE The year-end market-to-book ratio averaged 1.53x over the past 10 years. Total return to shareholders from dividends paid and market appreciation averaged 9.0 percent per year for this period. 48 N W N A T U R A L 2000 1999 1998 1997 1996 1995 1994 1993 1992 13.9 4.7 65.3 10.8 1.90 1.88 1.240 1.24 17.93 27.50 17.75 26.50 22.147 25,233 25,183 12.9 5.6 71.6 10.2 1.71 1.70 1.225 1.24 17.12 27.875 19.50 21.938 24.629 25,092 24,976 25.4* 4.7 119.6* 6.4* 1.02* 1.02* 1.22 1.22 16.59* 30.75 24.25 25.875 27.248 24,853 24,233 17.4 3.9 67.7 11.3 1.78 1.76 1.205 1.22 16.02 31.25 23.125 31.00 25.292 22,864 22,698 12.2 5.0 60.9 13.0 1.97 1.94 1.20 1.20 15.37 25.75 20.833 24.00 23.054 22,555 22,391 13.6 5.5 73.1 11.8 1.62 1.60 1.18 1.20 14.55 22.667 18.667 22.00 20.75 22,243 21,817 12.1 6.0 72.1 12.2 1.63 1.61 1.173 1.173 13.63 24.333 19.00 19.667 21.25 20,129 19,943 13.1 5.1 67.0 13.7 1.74 1.72 1.167 1.173 13.08 25.333 19.00 22.833 22.167 19,766 19,611 25.7* 6.0 155.0* 5.8* 0.74* 0.74* 1.147 1.147 12.41* 22.50 17.667 19.00 20.00 19,460 17,864 3.14 3.16 3.12 3.19 2.20* 2.72 2.99 3.05 3.53 3.71 3.15 2.87 3.08 2.98 3.22 3.47 1.81* 2.08 $ 80,444 $ 109,144 $ 80,022 $ 115,886 $ 83,400 $ 67,163 $ 77,668 $ 70,404 $ 60,709 3.5 34.9 4.0 33.4 3.9 33.2 3.8 32.6 3.8 33.2 4.2 32.8 4.1 31.7 4.1 31.1 4.0 30.4 37.3 8.8 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 46.1 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 5.1 4.9 43.9 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 53.9 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 100.0 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 37.4 10.1 47.5 3.0 4.6 44.9 52.5 100.0 43.6 2.3 45.9 1.2 2.9 50.0 54.1 100.0 44.1 1.0 45.1 1.1 2.8 51.0 54.9 100.0 42.6 2.4 45.0 1.4 3.1 50.5 55.0 100.0 43.3 2.7 46.0 1.7 3.3 49.0 54.0 100.0 37.0 6.5 43.5 2.3 3.9 50.3 56.5 100.0 38.5 9.4 47.9 2.6 4.3 45.2 52.1 100.0 35.9 5.5 41.4 2.1 3.8 52.7 58.6 100.0 36 35 35 33 37 37 37 37 31 N W N A T U R A L 49 COMPARATIVE OPERATING STATISTICS Selected utility data Customers at year-end Residential Commercial Industrial firm Industrial interruptible Total sales customers Transportation customers Total customers Gas sales and transportation deliveries (000 therms) Residential Commercial Industrial firm Industrial interruptible Total gas sales Transportation Unbilled therms Total volumes delivered Operating revenues and cost of sales (000) Sales revenues: Residential Commercial Industrial firm Industrial interruptible Total gas sales revenues Transportation Unbilled revenues Other Total utility operating revenues Cost of gas Net utility operating revenues Non-utility net operating revenues Net operating revenues Customer data Heat requirements: Actual degree days 20-year average degree days Average use per customer in therms: Residential Commercial Average rate per therm (cents): Residential Commercial Industrial firm Industrial interruptible Total sales Gas purchases (000 therms) Gas purchased cost per therm – net (cents) Average sendout cost of gas (cents) Maximum day firm sendout (000 therms) Maximum day total sendout (000 therms) Payroll (000) Operating Construction and other Total Utility employees Number of customers served by each operating employee CUSTOMER GROWTH IN THOUSANDS 30 25 20 15 10 5 92 93 94 95 96 97 98 99 00 01 02 The Company added 19,136 new customers in 2002. The customer base has grown at a compound annual rate of 4.3 percent over the past 10 years. COST OF PURCHASED GAS IN CENTS PER THERM $0.55 $0.50 $0.45 $0.40 $0.35 $0.30 $0.25 $0.20 $0.15 $0.10 $0.05 92 93 94 95 96 97 98 99 00 01 02 Cost of purchased gas, including demand charges, increased 8 percent in 2002 and was 115 percent higher than 10 years ago. HEAT REQUIREMENTS IN HEATING DEGREE DAYS 4,700 4,500 4,300 4,100 3,900 3,700 3,500 92 93 94 95 96 97 98 99 00 01 02 DEGREE DAYS 20-YEAR AVERAGE DEGREE DAYS Weather conditions in NW Natural’s service area were about average in 2002 but were considerably warmer than average in five of the previous 10 years. 50 N W N A T U R A L 2002 2001 485,207 55,096 383 148 ___________ ___________ 540,834 97 ___________ ___________ 540,931 ___________ ___________ ___________ ___________ 503,402 56,087 306 31 559,826 241 560,067 350,065 242,293 79,778 63,597 ___________ ___________ 735,733 385,783 1,771 ___________ ___________ 1,123,287 ___________ ___________ ___________ ___________ 357,091 240,155 63,215 26,241 686,702 445,999 (6,617) 1,126,084 $ 354,735 $ 329,905 190,236 49,662 34,283 ___________ ___________ 604,086 20,637 13,774 (2,325) ___________ ___________ 636,172 364,699 ___________ ___________ 271,473 4,538 ___________ ___________ $ 279,414 $ 276,011 ___________ ___________ ___________ ___________ 201,475 42,965 15,937 615,112 26,020 (12,702) 4,018 632,448 353,034 279,414 – 4,232 4,216 725 4,334 99.3 83.9 68.0 61.7 89.6 708,796 51.07 51.91 4,278 6,172 4,325 4,202 738 4,435 94.2 78.5 62.2 54.0 82.1 739,620 47.19 49.45 4,247 5,996 26,044 $ 42,168 $ 40,856 25,626 ___________ ___________ $ 68,212 $ 66,482 ___________ ___________ ___________ ___________ 1,284 671 1,261 714 2000 1999 1998 1997 1996 1995 1994 1993 1992 311,216 41,156 381 90 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 352,843 135 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 352,978 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 407,061 50,315 403 122 457,901 120 458,021 346,950 44,078 401 142 391,571 67 391,638 329,157 42,657 396 153 372,363 64 372,427 447,659 52,870 388 115 501,032 131 501,163 468,087 54,684 384 126 523,281 125 523,406 425,606 51,159 411 108 477,284 123 477,407 385,213 47,309 407 119 433,048 121 433,169 363,903 45,402 410 143 409,858 91 409,949 206,131 169,406 67,847 22,399 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 465,783 595,397 4,163 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 1,065,343 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 352,969 252,382 84,630 52,938 742,919 480,570 (9,343) 1,214,146 267,818 209,642 80,588 66,370 624,418 415,367 3,844 1,043,629 306,310 225,115 91,122 63,261 685,808 410,062 3,759 1,099,629 315,686 229,124 87,275 51,521 683,606 446,165 8,645 1,138,416 256,462 196,723 82,958 84,173 620,316 379,116 4,946 1,004,378 306,356 225,249 84,523 53,929 670,057 440,452 3,615 1,114,124 356,375 250,380 76,559 56,632 739,946 431,136 8,691 1,179,773 260,218 201,925 81,348 89,899 633,390 364,461 (7,519) 990,332 $ 280,642 $ 242,952 $ 205,388 $ 177,835 $ 183,802 $ 165,662 $ 176,510 $ 168,217 $ 124,834 78,614 24,867 6,920 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 235,235 25,564 2,603 2,812 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 266,214 101,489 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 164,725 8,000 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ $ 257,950 $ 243,637 $ 230,966 $ 221,110 $ 228,984 $ 213,602 $ 205,662 $ 219,701 $ 172,725 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 108,452 34,443 27,361 346,766 14,702 (5,571) 429 356,326 162,437 193,889 11,773 159,660 37,378 23,483 501,163 21,491 12,661 (3,976) 531,339 273,978 257,361 589 139,425 35,857 17,182 435,416 21,351 (2,671) 1,194 455,290 212,021 243,269 368 103,476 31,340 18,884 321,917 17,892 5,153 2,625 347,587 138,751 208,836 10,865 117,889 34,303 15,337 372,917 19,958 8,314 2,617 403,806 173,242 230,564 402 100,677 27,025 13,944 319,481 22,029 1,647 7,884 351,041 130,381 220,660 450 99,079 31,268 24,113 320,122 16,650 1,173 9,411 347,356 142,025 205,331 8,271 104,582 30,672 17,097 336,153 22,533 1,627 9,824 370,137 141,789 228,348 636 4,418 4,197 781 4,670 78.7 63.8 48.8 41.5 67.7 745,582 37.68 36.60 4,071 5,759 4,256 4,193 810 4,851 68.8 55.2 42.4 32.5 58.6 773,258 27.85 28.90 4,170 6,211 4,011 4,234 749 4,540 65.1 51.5 39.3 29.6 54.6 712,602 25.09 25.03 6,260 7,526 4,092 4,264 777 4,670 58.0 44.7 32.0 25.9 47.7 702,820 24.05 19.35 4,450 5,746 4,427 4,273 823 4,874 60.0 46.5 33.7 27.0 49.0 692,894 22.25 20.56 6,020 7,446 3,779 4,306 726 4,420 64.6 50.4 37.7 28.6 51.6 640,976 20.67 22.71 4,359 5,701 4,020 4,324 776 4,680 67.8 53.7 42.3 30.4 54.7 642,607 23.44 25.95 3,913 5,285 4,452 4,313 844 5,029 62.8 49.4 38.9 28.5 51.6 628,172 23.11 22.08 4,047 5,479 3,662 4,354 685 4,214 60.6 46.4 36.7 30.9 50.5 455,343 23.76 21.60 3,432 5,300 24,756 $ 38,979 $ 38,066 $ 37,573 $ 35,669 $ 34,037 $ 33,669 $ 33,888 $ 33,539 $ 30,398 19,802 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ $ 63,735 $ 62,388 $ 62,198 $ 60,299 $ 56,957 $ 55,743 $ 54,683 $ 54,595 $ 50,200 ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ ___________ 1,328 437 1,275 643 1,293 469 1,315 646 1,303 611 1,337 583 1,288 533 1,338 478 1,304 560 21,056 20,795 24,625 22,920 24,630 24,322 22,074 N W N A T U R A L 51 CORPORATE OFFICERS The officers of NW Natural gather in front of Pearl Court Apartments, a gas-heated complex of affordable multifamily housing in Portland’s fast-growing Pearl District. From left to right in foreground are Bruce DeBolt, Dick Reiten, C.J. Rue, Mark Dodson and Mike McCoy. In background are (left to right) Lea Anne Doolittle, Gregg Kantor and Steve Feltz. Not pictured are Richelle Luther and Beth Ugoretz. 52 Bruce R. DeBolt, 55 [1980] Senior Vice President, Finance, and Chief Financial Officer (1990- ) Senior Vice President, Finance and Administration and General Counsel (1987-1990) Vice President and General Counsel (1983-1987) Mark S. Dodson, 58 [1997] President, Chief Executive Officer (2003- ) President, Chief Operating Officer (2001- 2002) General Counsel (1997-2002) Senior Vice President, Public Affairs (1997-2001) Richelle T. Luther, 34 [2002] Assistant Secretary (2002- ) Associate, Stoel Rives LLP (1997-2002) Michael S. McCoy, 59 [1969] Executive Vice President, Customer and Utility Operations (2000- ) Senior Vice President, Customer and Utility Operations (1999-2000) Senior Vice President, Customer Services (1992-1999) Richard G. Reiten, 63 [1995] Chairman of the Board (2000- ) Chief Executive Officer (1997-2002) President (1996-2001) Lea Anne Doolittle, 47 [2000] Vice President, Human Resources (2000- ) Director of Compensation, PacifiCorp (1993-2000) C. J. Rue, 57 [1974] Secretary (1982- ) Assistant Treasurer (1987- ) Stephen P. Feltz, 47 [1982] Treasurer and Controller (1999- ) Assistant Treasurer and Manager, General Accounting (1996-1999) Gregg S. Kantor, 45 [1996] Senior Vice President, Public and Regulatory Affairs (2003- ) Vice President, Public Affairs and Communications (1998-2002) Director, Public Affairs and Communications (1996-1997) Beth A. Ugoretz, 47 [2002] Senior Vice President, General Counsel (2003- ) Executive Vice President, KinderCare Learning Centers, Inc. (1997-2000) Senior Vice President, General Counsel and Secretary, Red Lion Hotels, Inc. (1993-1996) [Date joined NW Natural] In June 2002, NW Natural formed a cross-functional task force to review the Company’s 1997 Community Relations Plan. The group was charged with updating the plan to reflect changing needs and oppor- tunities in the communities served by NW Natural. The task force, which included rep- resentatives from every part of the Company, developed its recommendations over a six- month period. Following is the policy state- ment that was approved as part of the updated plan. Community Involvement Policy NW Natural is committed to being a good corporate citizen and to giving back to the communities that have contributed to its success for more than 140 years. Through its community involvement programs, NW Natural is actively involved in working with communities, organiza- tions and individuals to solve social prob- lems and improve the quality of life in the Northwest. The Company fully encourages and supports employee participation in groups and activities that help communities thrive and grow. NW Natural also demonstrates philan- thropic leadership through its charitable giving program, aimed at organizations and causes that meet local needs and enhance livability in the Pacific Northwest. Employee Volunteerism NW Natural is actively involved in mak- ing a difference and solving community problems through a strong, proactive pro- gram of volunteering. The Company believes employee volunteerism fosters teamwork, helps develop new skills and promotes civic responsibility — to the advantage of the in- dividual, the Company and the community. Approved by Public Affairs Committee, NW Natural Board of Directors December 2002 53 BOARD OF DIRECTORS Richard G. Reiten, 63 Chairman of the Board NW Natural Portland, Oregon [1996] Robert L. Ridgley, 69 Retired Chairman of the Board NW Natural Vancouver, Washington [1984] (4) (5) (6) Dwight A. Sangrey, 62 Business Development Consultant (Information technology, engineering and health care) Portland, Oregon [1992] (2) (4) (5) Melody C. Teppola, 60 Managing Partner National Builders Hardware Company (Regional and national distributor of builders hardware, decorative plumbing and woodworking machinery) Portland, Oregon [1987] (1) (4) (5) Russell F. Tromley, 63 President and Chief Executive Officer Tromley Industrial Holdings, Inc. (Manufacturer of foundry equipment and distribution of nonferrous metals) Tualatin, Oregon [1994] (1) (2) (3) Richard L. Woolworth, 61 Chairman and CEO The Regence Group (Regional affiliation of health plans) Portland, Oregon [2000] (1) (4) (6) [Year elected to the Board] (1) Governance Committee (2) Audit Committee (3) Organization and Executive Compensation Committee (4) Public Affairs Committee (5) Environmental Policy Committee (6) Finance Committee John D. Carter, 57 Principal Goldschmidt, Imeson, Carter (Strategic planning and public affairs consulting) Portland, Oregon [2002] (2) (6) Thomas E. Dewey, Jr., 70 Member McFarland Dewey & Co., LLC (Investment banking firm) New York, N.Y. [1986] (2) (6) Mark S. Dodson, 58 President and Chief Executive Officer NW Natural Portland, Oregon [2003] C. Scott Gibson, 50 President Gibson Enterprises (Venture capital firm) Lake Oswego, Oregon [2002] (3) (4) (5) Tod R. Hamachek, 57 Chairman and Chief Executive Officer Penwest Pharmaceuticals Company (Development of pharmaceutical drug delivery products and technologies) Patterson, New York [1986] (1) (2) (3) Wayne D. Kuni, 72 Chairman Kuni Enterprises (Automobile dealerships) Beaverton, Oregon [1980] (1) (2) (3) Randall C. Papé, 52 President and Chief Executive Officer The Papé Group, Inc. (Sales and service of capital equipment) Eugene, Oregon [1996] (1) (3) (6) 54 Corporate Profile Financial Briefs 2002 2001 Percent increase (decrease) Corporate Information NW Natural is a 144-year-old natural gas local distribution company headquartered in Portland, Oregon. For more than a decade, it has grown at two to three times the national average for natural gas LDCs. The Company serves more than 560,000 customers in northwest Oregon and southwest Washington, including the Portland-Vancouver metropolitan area, the Willamette Valley, the northern Oregon coast and the Columbia River Gorge. More than 200,000 customers have been added to NW Natural’s distribution system in the past 10 years. In keeping with its steady growth, the Company has increased annual dividends paid to shareholders every year for 47 consecutive years. NW Natural purchases natural gas for its core market from a variety of suppliers in the western United States and Canada. In addition, the Company operates an un- derground gas storage facility in Columbia County, Oregon, and leases additional gas storage outside its service area. NW Natural also operates two liquefied natural gas plants in its service area. Astoria Mist Vancouver Portland Molalla The Dalles Salem Lincoln City Newport Eugene Coos Bay Albany Legend Williams Northwest Pipeline NW Natural gas transmission line Kelso Beaver (KB) Pipeline Proposed pipelines to Molalla and Coos Bay Service territory LNG plant District offices Mist underground storage Propane system Earnings Financial facts ($000): Net operating revenues Net income Earnings applicable to common stock 287,544 43,792 41,512 276,011 50,187 47,786 Financial ratios (%): Return on average common equity Capital structure at year-end Long-term debt Preferred and preference stock Common stock equity Common stock Shareholder data: Common shareholders Average shares outstanding (000) Per share data ($): Basic earnings Diluted earnings Dividends paid on common stock Book value at year-end Market value at year-end Operating highlights 8.7 47.6 0.9 51.5 10,026 25,431 1.63 1.62 1.260 18.88 27.06 10.4 43.0 3.8 53.2 10,359 25,159 1.90 1.88 1.245 18.56 25.50 Gas sales and transportation deliveries (000 therms): Degree days (20-year average, 4,216) Customers at year-end Number of utility employees 1,126,084 4,232 560,067 1,261 1,123,287 4,325 540,931 1,284 4 (13) (13) (16) 11 (76) (3) (3) 1 (14) (14) 1 1 6 0 (2) 4 (2) Dividends paid on common stock Payment date (per share) February 15 May 15 August 15 November 15 Total dividends paid DIVIDENDS PAID PER SHARE IN DOLLARS $1.27 $1.26 $1.25 $1.24 $1.23 $1.22 $1.21 $1.20 $1.19 $1.18 $1.17 2002 2001 $ 0.315 0.315 0.315 0.315 _________ $ 1.260 _________ _________ $ 0.310 0.310 0.310 0.315 _________ $ 1.245 _________ _________ EARNINGS PER SHARE IN DOLLARS $2.00 $1.75 $1.50 $1.25 $1.00 $0.75 $0.50 $0.25 02 99 98 97 00 01 DILUTED EARNINGS PER SHARE REDUCTION IN EARNINGS PER SHARE FROM INVESTMENT WRITEDOWNS: – 50 cents per share in 1998 due to 97 98 99 00 01 02 Annual dividends paid per share in 2002 increased for the 47th consecutive year, a growth record matched by few companies. asset impairment charges – 33 cents per share in 2002 due to a loss provision for PGE acquisition costs Diluted earnings were $1.62 per share in 2002. Results include a 33 cent per share loss provision for PGE acquisition costs. Notice of Annual Meeting The 2003 Annual Meeting will be held at 2 p.m. Thursday, May 22, at the Portland Hilton Hotel, 921 S.W. Sixth Avenue, Portland, Oregon. A meeting notice and proxy statement will be sent to all share- holders in mid-April. Form 10-K The Company will provide its shareholders, without charge, a copy of the 2002 Annual Report on Form 10-K to the Securities and Exchange Commission. Requests should be made to the Corporate Secretary. Stock Transfer Agent and Registrar For all Preferred and Common Stock Issues: NW Natural 220 N.W. Second Avenue Portland, Oregon 97209 Attention: Shareholder Services Trustee, Conversion and Interest Paying Agent For Convertible Debentures: The Bank of New York Corporate Debt Operations, Floor 7-E 101 Barclay Street New York, New York 10286 (800) 548-5075 Trustee and Bond Paying Agent For all bond issues: DB Services Tennessee Inc. Security Holder Relations P.O. Box 305050 Nashville, Tennessee 37230 (800) 735-7777 Common Stock Prices The Company’s common stock is listed and trades on the New York Stock Exchange using the symbol NWN. The quarterly high and low trading range during 2001 and 2002 was: 2002 Quarter 1 2 3 4 2001 Quarter 1 2 3 4 High 28.50 30.30 30.20 30.70 High 26.69 25.25 25.85 26.30 Low 24.20 27.60 23.46 25.50 Low 23.05 21.65 22.39 22.00 Dividend Reinvestment Plan Common shareholders of record may reinvest all or part of their dividends in additional shares under the Company’s plan. Cash purchases also may be made at the current market price under this plan, and no brokerage fees will be charged. A prospectus will be sent to any registered shareholder on request. Dividend Payment Dates February 15, 2003 May 15, 2003 August 15, 2003 November 14, 2003 Quarterly Financial Information (unaudited) Dollars (thousands except per share amounts) 2002 Operating revenues Net operating revenues Net income (loss) Basic earnings (loss) per share Diluted earnings (loss) per share 2001 Operating revenues Net operating revenues Net income (loss) Basic earnings (loss) per share Diluted earnings (loss) per share ——–––––––– Quarter ended ——–––––––– Dec. 31 March 31 Sept. 30 June 30 278,563 110,666 34,447 1.34 1.32 217,341 91,653 25,907 1.00 0.99 101,873 56,564 (2,992) (0.14) (0.14) 118,150 54,726 4,865 0.17 0.17 78,717 38,059 (6,008) (0.26) (0.26) 78,359 37,067 (4,976) (0.22) (0.22) 182,223 82,255 18,345 0.70 0.69 236,402 92,565 24,391 0.94 0.93 Total 641,376 287,544 43,792 1.63* 1.62* 650,252 276,011 50,187 1.90* 1.88* * Quarterly earnings per share are based upon the average number of common shares outstanding during each quarter. Because the average number of shares outstanding has changed in each quarter shown, the sum of quarterly earnings may not equal earnings per share for the year. Variations in earnings between quarterly periods are due primarily to the seasonal nature of the Company’s business. James R. Boehlke Investor Relations (503) 721-2451 (800) 422-4012, Ext. 2451 jrb@nwnatural.com Linda R. Williams Shareholder Services (503) 220-2590 (800) 422-4012, Ext. 3402 lrw@nwnatural.com NW Natural 220 N.W. Second Avenue Portland, Oregon 97209 (503) 226-4211 (800) 422-4012 www.nwnatural.com Forward-looking statements The Company’s future operating results will be affected by various uncertainties and risk factors, many of which are beyond the Company’s control, including governmental policy and regulatory action, the competitive environment, economic factors and weather conditions. Some statements in this annual report may be forward-looking, and actual results may differ materially as a result of these uncertainties. For a more complete description of these uncertainties and risk factors, please refer to the Company’s filings with the Securities and Exchange Commis- sion on Forms 10-K and 10-Q. n o t a e B e c u r B o t o h P 5 1 P i l e n v e L e r i a C o t o h P 2 1 P n o t a e B e c u r B s r e c i f f O & d r a o B , r e t t e L r e d l o h e r a h S / t i a r t r o P d n a l r o B e i l r a h C y h p a r g o t o h P e r u t a e F l s n o i t u o S c i h p a r G n g i s e D k c o t s d e l c y c e r n o d e t n i r P r e t n e C s t r A c i h p a r G g n i t n i r P n g i s e D n o e h p a r G n o i t c u d o r P NW Natural 220 NW Second Avenue Portland, Oregon 97209 www.nwnatural.com 2002 Annual Report