(8)     New Accounting Pronouncements

        In January 2003, the Financial Accounting Standards Board issued Interpretation No. 46 – “Consolidation of Variable Interest Entities” (FIN 46). FIN 46 clarifies the application of Accounting Research Bulletin No. 51 – “Consolidated Financial Statements” to certain entities in which equity investors do not have controlling interest or sufficient equity at risk for the entity to finance its activities without additional financial support. This Interpretation requires that if a business entity has a controlling financial interest in a variable interest entity the financial statements must be included in the consolidated financial statements of the business entity. The adoption of this Interpretation for all interests in variable interest entities created after January 31, 2003 is effective immediately. For variable interest entities created before February 1, 2003, it is effective June 15, 2003. The Company is in the process of determining the impacts of this Interpretation but does not anticipate any material change as a result of the new Interpretation.
        The Emerging Issues Task Force of the Financial Accounting Standards Board (EITF or Task Force) at its June 2002 meeting came to a consensus on one of three items included in EITF Issue 02-3 “Accounting for Contracts Involved in Energy Trading and Risk Management Activities”. The Task Force has agreed that all mark-to-market gains and losses on energy trading contracts whether realized or unrealized will be shown net in the income statement (costs offset against revenues), irrespective of whether the contract is physically settled. The presentation is applicable to financial statements for periods ending after July 15, 2002. The Company performs risk management activities to optimize the value of energy supply and transmission assets and to ensure that physical energy supply is available to meet the customer demand loads. The Company also purchases energy when demand exceeds available supplies in its portfolio; likewise the Company makes sales to other utilities and marketers when surplus energy is available. These transactions are part of the Company’s normal operations to meet retail load. The Company has reclassified all settled transactions that meet the definition of optimization (trading transactions that optimize hydro resources, and purchases and sales between trading points) net in the income statement to conform to the new presentation required under EITF 02-3. The Company previously reported these transactions when settled in a gross manner in the income statement in electric operating revenue and purchased electricity expense. Unrealized gains or losses on derivative instruments that are required to be marked-to-market remain reflected in unrealized (gain) loss on derivative instruments on Puget Energy’s and PSE’s income statement as required by SFAS No. 133. The adoption of EITF 02-3 does not have any impact on the previously reported net income of the Company.

(9)     Other

        On April 9, 2003, the Washington Commission approved an increase in the Purchased Gas Adjustment (PGA) gas rates of approximately $103.6 million annually or 20.1%. The PGA mechanism passes through to customers increases or decreases in the gas supply portion of the natural gas service rates based upon changes in gas prices. PSE’s gas margin and net income is not affected by the change in the PGA rates. The PGA increase became effective April 10, 2003.

Item 2.      Management's Discussion and Analysis of Financial Condition and Results of Operations

        The following discussion of the Company’s financial condition and results of operations contains forward-looking statements that involve risks and uncertainties, such as statements of the Company’s plans, objectives, expectations and intentions. Words such as “anticipate,” “believe,” “expect,” “future” and “intend” and similar expressions are used to identify forward-looking statements. However, these words are not the exclusive means of identifying such statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. The Company’s actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the factors described below and under the caption “Forward-Looking Statements” at the beginning of this report. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Form 10-Q.

Results of Operations

Puget Energy
        All of the operations of Puget Energy are conducted through its subsidiaries, PSE and InfrastruX. Puget Energy’s net income for the three months ended March 31, 2003 was $44.6 million on operating revenues of $676.0 million, compared with net income of $26.5 million on operating revenues of $739.1 million for the same period in 2002. Net income for common stock was $42.7 million for the first quarter of 2003 compared to $24.5 million for the first quarter of 2002. Basic and diluted earnings per share were $0.46 and $0.45, respectively, for the first quarter of 2003 compared to $0.28 for the first quarter of 2002.
        Net income for common stock was positively impacted by an increase in PSE’s net income for common stock of $22.5 million for the three months ended March 31, 2003 compared to the same period in 2002, due primarily to the favorable impact of general tariff rate increases that became effective on July 1, 2002 for PSE’s electric customers and September 1, 2002 for PSE’s gas customers. PSE also incurred a significant under-recovery of electric power supply costs from customers in the first quarter of 2002. Net income for common stock was negatively impacted by a decrease in InfrastruX’s net income for common stock (net of minority interest) of $4.4 million for the three months ended March 31, 2003 compared to the same period in 2002 due to severe winter weather and snow accumulation in the Northeast and Midwest and extremely wet winter conditions in the South, resulting in a significant slowdown in construction work.

Puget Sound Energy
        The table below sets forth changes in the results of operations for Puget Sound Energy and its subsidiaries.

Comparative Three Months Ended
March 31, 2003 vs. March 31, 2002
Increase (Decrease)
(Dollars in Millions)

        PSE’s operating revenues and associated expenses are not generated evenly during the year. Variations in energy usage by consumers occur from season to season and from month to month within a season, primarily as a result of weather conditions. PSE normally experiences its highest retail energy sales in the first and fourth quarters of the year. Varying wholesale electric prices and the amount of hydroelectric energy supplies available to PSE also make quarter-to-quarter comparisons difficult. The following is additional information pertaining to the changes outlined in the above table.

Operating Revenues — Electric
        Electric operating revenues for the three months ended March 31, 2003 were $417.0 million, an increase of $53.7 million compared to the same period in 2002 due primarily to wholesale electric sales to other utilities and marketers which increased $40.2 million due to higher surplus volumes and higher prices in the wholesale electricity market. Wholesale sales volumes increased by 712.5 million kWh or 125.3% to 1.3 billion kWh as a result of warmer-than-normal temperatures in the Pacific Northwest which provided excess electric energy supplies for sales to the wholesale market as a result of reduction in retail sales. Temperatures based on heating-degree-days measured at Seattle-Tacoma airport during the three month period ended March 31, 2003 were 10.7% warmer than normal as compared to heating-degree-days being 4.3% cooler than normal during the three month period ended March 31, 2002. Retail sales revenue decreased $7.2 million which included the effect of a 4.6% electric general rate increase effective July 1, 2002 that increased electric revenue by approximately $10.6 million in 2003. Retail sales volume decreased 2.8% to 5.3 billion kWh from 5.5 billion kWh for the same period in 2002.
        On June 20, 2002, the Washington Commission approved and adopted the settlement stipulation in the general rate case, putting new rates into effect on July 1, 2002. PSE established a PCA mechanism in the rate case settlement. The PCA mechanism will account for differences in PSE’s modified actual power costs relative to a power cost baseline. The mechanism will account for a sharing of costs and benefits that are graduated over four levels of power cost variances, with an overall cap of $40 million (+/-) over the four year period July 1, 2002 through June 30, 2006 plus 1% of the excess over $40 million. PSE’s share of the cost through March 31, 2003 was $16.7 million, $11.6 million of which was incurred in the first quarter of 2003. The factors influencing the variability of power costs included in the proposal are primarily weather and market related.
        On June 11, 2001, PSE and the BPA entered into an amended settlement agreement regarding the Residential Purchase and Sale Program, under which PSE’s residential and small farm customers would continue to receive benefits of federal power. Completion of this agreement enabled PSE to continue to provide a Residential and Farm Energy Exchange Credit to residential and small farm customers. The amended settlement agreement provides that, for its residential and small farm customers, PSE will receive (a) cash payment benefits during the period July 1, 2001 through September 30, 2006 and (b) benefits in the form of power or cash payments during the period October 1, 2006 through September 30, 2011.
        Under the Residential Purchase and Sale Program, PSE reduces residential and small farm customers revenue on a per kWh basis through the Residential and Farm Energy Exchange Credit. The credit has no impact on PSE’s electric margin or net income as a corresponding reduction is included in purchased electricity expenses. The Residential Purchase and Sale Program provides PSE’s residential and small farm customers benefits of lower-cost federal power.
        On June 17, 2002, PSE entered into an agreement with the BPA which amended the payment provisions of the amended settlement agreement to provide for conditional deferral of payment by BPA of certain amounts to be paid under the original agreement. Under the modified agreement, BPA will defer paying a portion of the benefits it would have otherwise paid. The amount of benefits deferred will be $3.5 million each month for the eight-month period beginning February 2003, for a total deferral of $27.7 million. Contemporaneously with entering into this agreement with PSE, BPA is entering into other agreements similar to the agreement with PSE through which other investor-owned utilities and BPA are agreeing to BPA’s deferral of payments in their fiscal year 2003. The total cumulative amount to be deferred under the agreement with PSE and other such agreements equals $55 million, an amount that will help BPA address its current financial difficulties. Absent certain adjustments, BPA will begin paying back the amount deferred with interest over the sixty-month period beginning October 2006. In January 2003, PSE filed revised tariff sheets with the Washington Commission to reflect this modification to the agreement between PSE and the BPA. The Washington Commission accepted the tariff changes and the Rider credit was changed to $0.01740 per kWh, from $0.01817 per kWh, for the period February 15, 2003 through September 30, 2006. In February 2003, BPA commenced a rate case that may affect the level of residential exchange benefits for PSE’s customers.
        For the three months ended March 31, 2003, the benefits of the Residential and Farm Energy Exchange credited to customers were $55.1 million with a related offset to power costs. PSE received payments from BPA in the amount of $37.0 million during the three months ended March 31, 2003. The difference between the customers’ credit and the amount received from BPA reduces the previously deferred amount owed to customers. The aggregated deferred amount is recorded on PSE’s balance sheet as restricted cash. Absent certain adjustments, the modified amended settlement agreement will provide for payments from BPA in the amount of $630.6 million for the period January 2003 through September 2006 and for pass-through to eligible residential and farm customers of the same amount.
        There are several actions in the U.S. Ninth Circuit Court of Appeals against BPA, in which the petitioners assert that BPA acted contrary to law or without authority in deciding to enter into, or in entering into or performing, a number of contracts, including the contract between BPA and PSE. BPA rates used in such contract between BPA and PSE for determining the amounts of money to be paid to PSE as residential exchange benefits during the period October 1, 2001 through September 30, 2006 have been confirmed, approved and allowed to go into effect by FERC on an interim basis, subject to refund with interest. It is not clear what impact, if any, review of such rates and the above-described U.S. Ninth Circuit Court of Appeals actions may have on PSE. PSE and other investor owned utilities are presently negotiating a potential settlement of the U.S. Ninth Circuit actions, whereby the litigation would be dismissed and BPA’s discretion over the level of 2007-2011 benefits would be reduced in consideration of a reduction in current period benefits. PSE cannot presently predict the outcome of the settlement negotiations.
        To meet customer demand, PSE dispatches resources in its power supply portfolio such as fossil-fuel generation, owned and contracted hydro capacity and energy, and long-term contracted power. However, depending principally upon availability of hydroelectric energy, plant availability, fuel prices and/or changing load as a result of weather, PSE may sell surplus power or purchase deficit power in the wholesale market. PSE manages its core energy portfolio through short and intermediate-term off-system physical purchases and sales, and through other risk management techniques. PSE’s Risk Management Committee oversees energy portfolio exposures.
        During the three months ended March 31, 2003, PSE collected and remitted to a grantor trust $3.9 million as compared to $3.1 million for the same period in 2002 as a result of PSE’s 1995 sale of future electric revenues associated with its investment in conservation assets in its electric general rate tariff. The impact of the sale of revenue was offset by reductions in conservation amortization and interest expenses. The principal amount owed by the trust to its bondholders was $15.2 million at March 31, 2003.
        PSE operates within the western wholesale market and has made sales into the California energy market. During the fourth quarter of 2000, PSE made such sales to the California energy market on which the receivable amount is still outstanding. At March 31, 2003, PSE’s receivable from the California Independent System Operators (CAISO) and other counter-parties, net of reserves, was $25.3 million.

Operating Revenues— Gas
        Retail gas revenue for the three months ended March 31, 2003 decreased by $127.4 million from the same period in 2002, which included the effect of a 5.8% gas general rate increase effective September 1, 2002 that increased gas revenue by approximately $14.8 million in 2003. Retail gas sales volumes decreased 15.5% from 346.9 million therms in 2002 to 293.1 million therms in 2003 due primarily to warmer temperatures in the Pacific Northwest.
        Purchased Gas Adjustment (PGA) rates charged to customers were lower in the three months ended March 31, 2003 compared to the same period in 2002 as a result of rate decreases of 7.3% and 12.5%, which took effect September 1, 2002 and November 1, 2002, respectively. Gas supply costs are passed through to customers in the PGA. The PGA mechanism passes through to customers increases or decreases in the gas supply portion of the natural gas service rates based upon changes in the price of natural gas purchased from producers and wholesale marketers or changes in gas pipeline transportation costs. On April 9, 2003, the Washington Commission approved an increase in natural gas supply rates under the PGA mechanism. The increase of approximately $103.6 million or 20.1% on overall revenues became effective April 10, 2003.

        PSE’s gas margin (gas sales to retail and transportation customers less the cost of gas purchased, including gas transportation costs to bring gas to PSE’s service territory) and net income are not affected by changes under the PGA.

Operating Expenses
        Purchased electricity expenses increased $58.4 million for the three months ended March 31, 2003 compared to the same period in 2002. PSE’s hydroelectric production and related power costs in 2003 have been negatively impacted by below normal winter precipitation and snow pack in the Pacific Northwest region associated with an El Nino weather condition. The April 17, 2003 seasonal water supply forecast published by the National Weather Service indicated that the total forecast runoff into the Grand Coulee reservoir for the period January through July 2003 would be 86% of normal. This compares to 108% of normal for the same period in 2002. The National Weather Service forecast runoff into the Grand Coulee reservoir for the later period of April through September 2003 is similar to the January through July 2003 period and is expected to be 85% of normal assuming average precipitation during the period. Primarily due to adverse hydro conditions in 2003, the Company anticipates reaching the $40 million cumulative cap under the Power Cost Adjustment (PCA) mechanism by the end of 2003. Under the PCA mechanism, further increases in variable power costs through June 30, 2006 would be apportioned 99% to customers and 1% to PSE. PSE’s share of power costs, in excess of those set in rates, through March 31, 2003 was $16.7 million.
        Purchased gas expenses decreased $117.8 million for the three months ended March 31, 2003 compared to the same period in 2002. The decrease was due to lower consumption volumes as a result of warmer than normal temperatures and the impact of decreased gas costs, which are passed through to customers through the PGA mechanism. The PGA allows PSE to recover expected gas costs. PSE defers, as a receivable or liability, any gas costs that exceed or fall short of the amount in PGA rates and accrues interest under the PGA. The PGA balance was a liability at March 31, 2002 of $56.3 million compared to a liability balance at March 31, 2003 of $33.0 million.
        Electric generation fuel expense decreased $50.1 million for the three months ended March 31, 2003 compared to the same period in 2002 due to lower fuel costs for PSE controlled gas-fired generation facilities related to the reduction of generation at those facilities.
        Residential exchange credits associated with the Residential Purchase and Sale Agreement with BPA increased $9.9 million in 2003 when compared to 2002, due to an increase in the Residential and Farm Energy Exchange credit rate as compared to 2002. For further details, see the amended Residential Purchase and Sale Agreement between PSE and BPA discussion in Operating Revenues – Electric.
        Unrealized gains on derivative instruments decreased $11.0 million in 2003 compared to 2002 as the first three months of 2002 included an $11.5 million pre-tax gain as compared to $0.5 million for the same period in 2003. The 2002 gain represented the reversal of unrealized losses on gas hedge contracts that were de-designated in the fourth quarter of 2001 and the reversal of the mark-to-market unrealized loss on physical electric contracts at December 31, 2001 that were settled in the first quarter of 2002.
        The Company has two contracts outstanding with a counterparty whose senior unsecured debt ratings are below investment grade. The first contract is a fixed for floating price natural gas swap contract for which the Company has collected a collateral deposit in the amount of $25.7 million from the counterparty to guarantee performance. The financial contract will expire in June 2008 and is accounted for as a cash flow hedge under SFAS No. 133. The second is a physical gas supply contract expiring in December 2008, which has been designated as a normal purchase under SFAS No. 133. The counterparty has continuously performed on both contracts since the contracts were entered into in 2000 and the Company believes the risk of non-performance by the counterparty to be remote. The Company will continue to monitor the performance of the counterparty.
        PSE’s Personal Energy Management^TM energy-efficiency program costs decreased $2.2 million for the three months ended March 31, 2003 compared to the same period in 2002, reflecting a decreased emphasis on the program in light of relatively moderate energy prices and cancellation of the Time of Use program in November 2002.
        A new Low-income Program approved by the Washington Commission in the general rate case settlement began in July 2002 which resulted in increased costs of $2.7 million for the three months ended March 31, 2003 compared to the same period in 2002. These costs are fully recovered in retail rates beginning at the program’s inception on July 1, 2002 for electric and September 1, 2002 for gas.
        Other utility operations and maintenance costs increased $3.4 million for the three months ended March 31, 2003 compared to the same period in 2002 due primarily to an increase of $1.6 million in electric-service restoration costs related to storm damage, $3.6 million in increased vegetation management, meter reading, customer collection and uncollectible accounts expenses and other costs, offset by PSE employee severance costs totaling $4.0 million related to strategic outsourcing of operations work to service providers in the first quarter of 2002 which did not recur in 2003. In addition, PSE recorded an estimated net curtailment gain in the first quarter of 2002 which did not recur in 2003 of $2.2 million for Statement of Financial Accounting Standards No. 88 – “Employers’ Accounting for Settlement and Curtailment of Defined Benefit Pension Plans and for Termination Benefits” and Statement of Financial Accounting Standards No. 106 – “Employers’ Accounting for Postretirement Benefits Other than Pensions” as calculated by PSE’s actuary.
        Depreciation and amortization expense for PSE increased $0.9 million for the three months ended March 31, 2003 compared to the same period in 2002 due primarily to the effects of new plant placed into service during the past year.
        Conservation amortization expense increased $5.6 million for the three months ended March 31, 2003 compared to the same period in 2002 due to increased conservation expenditures. These costs are recovered in an electric conservation rider and a gas conservation tracker mechanism with no impact to earnings.
        Taxes other than income taxes decreased $8.3 million for the three months ended March 31, 2003 compared to the same period in 2002 primarily due to lower municipal and state excise taxes which are revenue based.
        Income taxes increased $14.1 million for the three months ended March 31, 2003 compared to the same period in 2002 as a result of higher pre-tax operating income.