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    NORTHWESTERN CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS


    July 28, 2022 - Edgar Glimpses

     

      Non-GAAP Financial Measure

       The following discussion includes financial information prepared in accordance with GAAP, as well as another financial measure, Utility Margin, that is considered a "non-GAAP financial measure." Generally, a non-GAAP financial measure is a numerical measure of a company's financial performance, financial position or cash flows that excludes (or includes) amounts that are included in (or excluded from) the most directly comparable measure calculated and presented in accordance with GAAP. We define Utility Margin as Operating Revenues less fuel, purchased supply and direct transmission expense (exclusive of depreciation and depletion) as presented in our Condensed Consolidated Statements of Income. This measure differs from the GAAP definition of Gross Margin due to the exclusion of Operating and maintenance, Property and other taxes, and Depreciation and depletion expenses, which are presented separately in our Condensed Consolidated Statements of Income. The following discussion includes a reconciliation of Utility Margin to Gross Margin, the most directly comparable GAAP measure. We believe that Utility Margin provides a useful measure for investors and other financial statement users to analyze our financial performance in that it excludes the effect on total revenues caused by volatility in energy costs and associated regulatory mechanisms. This information is intended to enhance an investor's overall understanding of results. Under our various state regulatory mechanisms, as detailed below, our supply costs are generally collected from customers. In addition, Utility Margin is used by us to determine whether we are collecting the appropriate amount of energy costs from customers to allow recovery of operating costs, as well as to analyze how changes in loads (due to weather, economic or other conditions), rates and other factors impact our results of operations. Our Utility Margin measure may not be comparable to that of other companies' presentations or more useful than the GAAP information provided elsewhere in this report. OVERVIEW NorthWestern Corporation, doing business as NorthWestern Energy, provides electricity and/or natural gas to approximately 753,600 customers in Montana, South Dakota, Nebraska and Yellowstone National Park. For a discussion of NorthWestern's business strategy, see Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2021. We are working to deliver safe, reliable and innovative energy solutions that create value for customers, communities, employees and investors. This includes bridging our history as a regulated utility safely providing low-cost and reliable service with our future as a globally-aware company offering a broader array of services performed by highly-adaptable and skilled employees. We seek to deliver value to our customers by providing high reliability and customer service, and an environmentally sustainable generation mix at an affordable price. The energy landscape is changing and we are committed to meeting the changing demands of our customers through continued investment to enhance reliability, security and safety, grid modernization, and integration of even more renewables and energy storage, while meeting our growing demand for capacity. We are focused on delivering long-term shareholder value through: •Infrastructure investment focused on a stronger and smarter grid to improve the customer experience, while enhancing grid reliability and safety. This includes automation in customer meters, distribution and substations that enables the use of proven new technologies. 

      •Investing in and integrating supply resources that balance reliability, cost, capacity, and sustainability considerations with more predictable long-term commodity prices.

       •Continually improving our operating efficiency. Financial discipline is essential to earning our authorized return on invested capital and maintaining a strong balance sheet, stable cash flows, and quality credit ratings to continue to attract cost-effective capital for future investment. 

      We expect to pursue these investment opportunities and manage our business in a manner that allows us to be flexible in adjusting to changing economic conditions by adjusting the timing and scale of the projects.

      We are committed to providing customers with reliable and affordable electric and natural gas service while also being good stewards of the environment. Towards this end, we recently expanded and outlined our efforts towards a carbon-free future through our goal to achieve net zero carbon emissions by 2050.

       27 -------------------------------------------------------------------------------- As you read this discussion and analysis, refer to our Condensed Consolidated Statements of Income, which present the results of our operations for the three and six months ended June 30, 2022 and 2021. 28 -------------------------------------------------------------------------------- HOW WE PERFORMED AGAINST OUR SECOND QUARTER 2021 RESULTS Three Months Ended June 30, 2022 vs. 2021 Income Tax Income Before (Expense) Income Taxes Benefit Net Income (in millions) Second Quarter 2021 $ 38.6 $ (1.4) $ 37.2 Items increasing (decreasing) net income: Higher electric and natural gas volumes 6.7 (1.7) 5.0 Electric QF liability adjustment (4.1) 1.0 (3.1) Lower transmission revenue due to the prior year recognition of $4.7 million of deferred interim revenues, offset in part by higher transmission demand due to market conditions and pricing (3.9) 1.0 (2.9) CREP penalty (2.5) - (2.5) Higher operating costs impacting net income (1.4) 0.4 (1.0) Higher depreciation and depletion (1.4) 0.4 (1.0) Higher non-recoverable Montana electric supply costs (0.3) 0.1 (0.2) Other (0.5) (1.2) (1.7) Second Quarter 2022 $ 31.2 $ (1.4) $ 29.8 Change in Net Income $ (7.4) Consolidated net income for the three months ended June 30, 2022 was $29.8 million as compared with $37.2 million for the same period in 2021. This decrease was primarily due to a less favorable electric QF liability adjustment as compared to the prior period, higher operating and maintenance costs, higher administrative and general costs, recognition in the prior period of deferred transmission revenues, and higher depreciation and depletion, partly offset by higher electric and natural gas retail volumes due to favorable weather and customer growth. SIGNIFICANT TRENDS AND REGULATION 

      Electric Resource Planning - Montana

       Yellowstone County 175 MW plant - Construction at the site began in April 2022 with a current schedule that is expected to allow the plant to serve our Montana customers during the 2023-2024 winter season. On October 21, 2021, the Montana Environmental Information Center and the Sierra Club filed a lawsuit in Montana State Court, against the Montana Department of Environmental Quality (MDEQ) and us, alleging that the environmental analysis conducted prior to issuance of the Yellowstone County project's air quality permit was unlawful. The Montana District Court judge held oral argument on June 20, 2022. We expect a decision during the third quarter of 2022. An adverse decision could delay the project if the Court were to vacate the air quality permit. Beartooth Battery 50 MW project - On December 21, 2021, we filed an application with the MPSC for preapproval of the Beartooth Battery agreement as a new capacity resource. This agreement is contingent upon MPSC approval of our application. As discussed below under Risk Factors, the Montana District Court recently ruled that the Montana preapproval statute (that serves as the basis for our Beartooth Battery agreement application) is unconstitutional. The MPSC suspended the procedural deadlines in the Beartooth Battery docket and will be ruling on pending motions, including a motion to hold the docket in abeyance pending the outcome of our appeal of the Montana District Court decision and a separate motion to dismiss the docket. Future Integrated Resource Planning - To comply with statutory resource planning requirements, we expect to submit an integrated resource plan to the MPSC by the end of 2022, followed by an all-source competitive solicitation request for capacity available in 2026. Due to the significant impact of our ownership in Colstrip Unit 4 to the capacity available in our portfolio, the outcome in the arbitration amongst the co-owners (See Note 10 - Commitments and Contingencies ) may affect this plan. 29 --------------------------------------------------------------------------------

      Electric Resource Supply - South Dakota

      Our new Bob Glanzer Generating Station was operational as of May 27, 2022. The 58 MW natural gas plant is located in Huron, South Dakota. Construction was completed under budget at a total cost of approximately $83.1 million.

      Our electric supply resource plans for South Dakota continue to identify portfolio requirements including potential investments resulting from a completed competitive solicitation process. We expect to file an updated integrated resource plan in the second half of 2022.

      Regulatory Update

       Rate Review Filings - Rate reviews are necessary to recover the cost of providing safe, reliable service, while contributing to earnings growth and achieving our financial objectives. We regularly review the need for electric and natural gas rate relief in each state in which we provide service. We anticipate making a Montana electric and natural gas rate review filing (2021 test year) in August 2022. Montana Power Costs and Credits Adjustment Mechanism (PCCAM) - The current Montana PCCAM base rate (PCCAM Base), approved in 2019, no longer reflects an accurate current forecast of our normal fuel and power costs. As of June 30, 2022, we have under collected our Montana electric supply costs for the current July 2021 through June 2022 PCCAM year by approximately $56.9 million. Under the PCCAM, under and over collections of non-qualifying facility related net costs are allocated 90% to Montana customers and 10% to shareholders. The deferred costs allocated to Montana customers are not reflected in customer bills and recovered until the subsequent power cost adjustment year, adversely affecting our cash flows and liquidity. We expect to address an adjustment to the PCCAM Base in our upcoming 2022 Montana electric rate review filing. For the three and six months ended June 30, 2022, electric supply costs exceeded the PCCAM Base revenues by approximately $8.3 million and $16.2 million, respectively. As a result, during the three and six months ended June 30, 2022, we deferred $7.5 million and $14.6 million of costs, respectively, to be collected from customers (90% of the costs above base) and recorded a reduction in pre-tax earnings of $0.8 million and $1.6 million, respectively (10% of the variance). For the three and six months ended June 30, 2021, electric supply costs exceeded the PCCAM Base revenues by approximately $5.2 million and $13.5 million, respectively. As a result, during the three and six months ended June 30, 2021, we deferred $4.7 million and $12.2 million, respectively, of costs for future collection from customers and recorded a reduction in pre-tax earnings of $0.5 million and $1.3 million, respectively. Montana Fixed Cost Recovery Mechanism (FCRM) - On April 15, 2022, we requested that the MPSC continue to defer implementation of the existing FCRM pilot program currently set for July 1, 2022. The MPSC granted our request on June 9, 2022, including our intention to redesign the decoupling mechanism in our upcoming 2022 Montana electric rate review filing. Holding Company Filings - On June 1, 2022, we filed a legal corporate restructuring application (Restructuring Plan) with the state commissions in Montana, South Dakota and Nebraska and the FERC. Currently, our utility businesses are held in the same legal entity. Under the proposed Restructuring Plan, we would legally separate our Montana public utility business from our South Dakota and Nebraska public utility business and establish a holding company to hold the ownership interests of all of the subsidiaries. The purpose of the reorganization is to integrate our organizational structure to be more transparent and in line with the public utility industry. The Restructuring Plan does not propose and we do not expect any procedural or substantive change in how the state public utility commissions regulate those services. Implementation of the Restructuring Plan is subject to receipt of all regulatory approvals. On July 26, 2022, the Nebraska Public Service Commission approved our Restructuring Plan application. 

      Supply Chain and Inflation Challenges

       We place significant reliance on our third-party business partners to supply materials, equipment and labor necessary for us to operate our utility and reliably serve current customers and future customers. As a result of current macroeconomic conditions, both nationally and globally, we have recently experienced issues with our supply chain for materials and components used in our operations and capital project construction activities. Issues include higher prices, scarcities/shortages, longer fulfillment times for orders from our suppliers, workforce availability, and wage increases. Should these conditions continue, we could have difficulty completing the operations activities necessary to serve our customers safely and reliably, and/or achieving our capital investment program, which ultimately could result in higher customer utility rates, longer outages, and could have a material adverse impact on our business, financial condition and operations. During the third quarter of 2021, we decided to discontinue our plans to build a 30-40 MW electric generation plant near Aberdeen, South Dakota as a result of significant increases in estimated construction cost as a result of global supply chain 30 -------------------------------------------------------------------------------- challenges. Also, as we developed our forecast of capital expenditures, we estimate that these supply chain and inflation challenges increased our forecasted 2022 capital spend by approximately 2 percent. Further challenges with product and services availability and price inflation could increase this impact on our capital spend forecasts or could cause us to experience delays. 

      Fire Mitigation

       With changing weather conditions which include more significant wind events, drought conditions, and warmer air temperatures, we do not consider the fire season specific to a time of year, but rather a condition that may exist at any time of year. Each year's weather conditions impact these situations differently: early season rains encourage plant growth which fuels fires later in the growing season, and winters with little snow leave dry plant material available for late season fires. The threat is not only in forested areas, where insect infestations and resulting tree death has been severe, but across the entire system including rural areas where grassland fires could be ignited, along with urban areas where extreme weather conditions pose a great risk to heavily populated areas. Recognizing the risk of significant wildfires in Montana, we continue to proactively seek to mitigate wildfire risk. We have developed an Enhanced Fire Mitigation Plan addressing five key areas: situational awareness, operational practices, system preparedness, vegetation management, and public communications and outreach. This plan builds upon several key initiatives that were initiated and executed over the past decade including nearly $80 million spent on vegetation management and hazard tree removal programs and our growing annual investment to harden our transmission and distribution system infrastructure. Because of ever-increasing wildfire risk, our plan includes greater focus on situational awareness to monitor changing environmental conditions, operational practices that are more reactive to changing conditions, increased frequency of patrol and repairs, and more robust system hardening programs that target higher risk segments in our transmission and distribution systems. We expect to include a request for expected costs associated with the mitigation plan in our 2022 Montana electric rate review. RESULTS OF OPERATIONS Our consolidated results include the results of our divisions and subsidiaries constituting each of our business segments. The overall consolidated discussion is followed by a detailed discussion of utility margin by segment. 

      Factors Affecting Results of Operations

       Our revenues may fluctuate substantially with changes in supply costs, which are generally collected in rates from customers. In addition, various regulatory agencies approve the prices for electric and natural gas utility service within their respective jurisdictions and regulate our ability to recover costs from customers. Revenues are also impacted by customer growth and usage, the latter of which is primarily affected by weather. Very cold winters increase demand for natural gas and to a lesser extent, electricity, while warmer than normal summers increase demand for electricity, especially among our residential and commercial customers. We measure this effect using degree-days, which is the difference between the average daily actual temperature and a baseline temperature of 65 degrees. Heating degree-days result when the average daily temperature is less than the baseline. Cooling degree-days result when the average daily temperature is greater than the baseline. The statistical weather information in our regulated segments represents a comparison of this data. Fuel, purchased supply and direct transmission expenses are costs directly associated with the generation and procurement of electricity and natural gas. Among the most significant of these costs are those associated with fuel, purchased power, natural gas supply, and transmission expense. These costs are generally collected in rates from customers and may fluctuate substantially with market prices and customer usage. Operating and maintenance expenses are costs associated with the ongoing operation of our vertically-integrated utility facilities which provide electric and natural gas utility products and services to our customers. Among the most significant of these costs are those associated with direct labor and supervision, repair and maintenance expenses, and contract services. These costs are normally fairly stable across broad volume ranges and therefore do not normally increase or decrease significantly in the short term with increases or decreases in volumes. 31 --------------------------------------------------------------------------------

      OVERALL CONSOLIDATED RESULTS

      Three Months Ended June 30, 2022 Compared with the Three Months Ended June 30, 2021

       Consolidated net income for the three months ended June 30, 2022 was $29.8 million as compared with $37.2 million for the same period in 2021. This decrease was primarily due to a less favorable electric QF liability adjustment as compared to the prior period, higher operating and maintenance costs, higher administrative and general costs, recognition in the prior period of deferred transmission revenues, and higher depreciation and depletion, partly offset by higher electric and natural gas retail volumes due to favorable weather and customer growth. Consolidated gross margin for the three months ended June 30, 2022 was $79.6 million as compared with $84.7 million in 2021, a decrease of $5.1 million, or 6.0 percent. This decrease was primarily due to a less favorable electric QF liability adjustment as compared to the prior period, recognition in the prior period of deferred transmission revenues, and higher depreciation and depletion costs, partly offset by higher electric and natural gas retail volumes due to favorable weather and customer growth. Electric Natural Gas Total 2022 2021 2022 2021 2022 2021 (in millions) Reconciliation of gross margin to utility margin: Operating Revenues $ 243.4 $ 241.4 $ 79.6 $ 56.8 $ 323.0 $ 298.2 Less: Fuel, purchased supply and direct transmission expense (exclusive of depreciation and depletion shown separately below) 57.7 49.2 37.3 18.7 95.0 67.9 Less: Operating and maintenance 40.8 39.5 12.5 12.0 53.3 51.5 Less: Property and other taxes 36.4 37.0 10.5 10.3 46.9 47.3 Less: Depreciation and depletion 40.2 38.5 8.0 8.3 48.2 46.8 Gross Margin 68.3 77.2 11.3 7.5 79.6 84.7 Operating and maintenance 40.8 39.5 12.5 12.0 53.3 51.5 Property and other taxes 36.4 37.0 10.5 10.3 46.9 47.3 Depreciation and depletion 40.2 38.5 8.0 8.3 48.2 46.8 Utility Margin(1) $ 185.7 $ 192.2 $ 42.3 $ 38.1 $ 228.0 $ 230.3 

      (1) Non-GAAP financial measure. See "Non-GAAP Financial Measure" above.

       Three Months Ended June 30, 2022 2021 Change % Change (dollars in millions) Utility Margin Electric $ 185.7 $ 192.2 $ (6.5) (3.4) % Natural Gas 42.3 38.1 4.2 11.0 Total Utility Margin(1) $ 228.0 $ 230.3 $ (2.3) (1.0) % 

      (1) Non-GAAP financial measure. See "Non-GAAP Financial Measure" above.

       Consolidated utility margin for the three months ended June 30, 2022 was $228.0 million as compared with $230.3 million for the same period in 2021, a decrease of $2.3 million, or 1.0 percent. 

      Primary components of the change in utility margin include the following (in millions):

       32 -------------------------------------------------------------------------------- Utility Margin 2022 vs. 2021 Utility Margin Items Impacting Net Income Electric QF liability adjustment $ (4.1) 

      Lower transmission revenue due to the prior year recognition of $4.7 million of deferred interim revenues, offset in part by higher transmission demand due to market conditions and pricing

       (3.9) Higher non-recoverable Montana electric supply costs (0.3) 

      Reduction of rates from the step down of our Montana gas production assets

       (0.2) Higher natural gas retail volumes 3.9 Higher electric retail volumes 2.8 Other (0.2) Change in Utility Margin Items Impacting Net Income (2.0) 

      Utility Margin Items Offset Within Net Income Lower revenue from higher production tax credits, offset in income tax expense

       (0.7) 

      Lower property taxes recovered in revenue, offset in property tax expense

       (0.4) 

      Higher operating expenses recovered in revenue, offset in operating and maintenance expense

       0.5 

      Higher gas production taxes recovered in revenue, offset in property and other taxes

       0.3 Change in Utility Margin Items Offset Within Net Income (0.3) Decrease in Consolidated Utility Margin(1) $ (2.3) 

      (1) Non-GAAP financial measure. See "Non-GAAP Financial Measure" above.

       Higher electric retail volumes were driven by increased residential and commercial demand and customer growth, partly offset by cooler spring weather. Higher natural gas retail volumes were driven by colder spring weather in all jurisdictions and customer growth. The less favorable adjustment to our electric QF liability (unrecoverable costs associated with contracts covered by the Public Utility Regulatory Policies Act of 1978 (PURPA) as part of a 2002 stipulation with the MPSC and other parties) reflects a $5.1 million gain in 2022, as compared with a $9.2 million gain for the same period in 2021, due to the combination of: •A $1.8 million favorable reduction in costs for the current contract year to record the annual adjustment for actual output and pricing as compared with a $2.6 million favorable reduction in costs in the prior period; •A favorable adjustment, decreasing the QF liability by $3.3 million, reflecting annual actual contract price escalation for the 2023-2024 contract year, which was less than previously estimated, partly offset by an increase in estimated contract prices for the 2023-2024 contract year, which is the last year of the contract that contains variable pricing terms. See Critical Accounting Policies and Estimates below for further information regarding our process of estimating the contract price for this 2023-2024 contract year. This is compared to an unfavorable adjustment of $2.1 million in the prior year due to higher actual price escalation; and •A favorable adjustment in the prior year, decreasing the QF liability by approximately $8.7 million, associated with a one-time clarification in contract term. 

      Three Months Ended June 30,

       2022 2021 Change % Change (dollars in millions) Operating Expenses (excluding fuel, purchased supply and direct transmission expense) Operating and maintenance $ 53.3 $ 51.5 $ 1.8 3.5 % Administrative and general 27.2 25.6 1.6 6.3 Property and other taxes 46.9 47.3 (0.4) (0.8) Depreciation and depletion 48.2 46.8 1.4 3.0

      Total Operating Expenses (excluding fuel, purchased supply and direct transmission expense)

       $ 175.6 $ 171.2 $ 4.4 2.6 % 33 -------------------------------------------------------------------------------- Consolidated operating expenses, excluding fuel, purchased supply and direct transmission expense, were $175.6 million for the three months ended June 30, 2022, as compared with $171.2 million for the three months ended June 30, 2021. Primary components of the change include the following (in millions): 

      Operating Expenses

       2022 vs. 2021 Operating Expenses (excluding fuel, purchased supply and direct transmission expense) Impacting Net Income Higher insurance expense $ 1.6 Higher depreciation expense due to plant additions 1.4 Higher technology implementation and maintenance expenses 0.5 

      Increase in uncollectible accounts due to the prior year collection of previously written off balances

       0.4 Decrease in expenses at our generation facilities (0.4) 

      Lower property tax expenses due to a decrease in estimated state and local taxes

       (0.4) Lower labor and benefits(1) (0.1) Other (0.2) Change in Items Impacting Net Income 2.8 Operating Expenses Offset Within Net Income Higher pension and other postretirement benefits, offset in other income(1) 1.3 

      Higher operating and maintenance expenses recovered in trackers, offset in revenue

       0.5 

      Higher non-employee directors deferred compensation recorded within administrative and general expense, offset in other income

       0.2 

      Lower property and other taxes recovered in trackers, offset in revenue

       (0.4) Change in Items Offset Within Net Income 1.6 

      Increase in Operating Expenses (excluding fuel, purchased supply and direct transmission expense)

       $ 4.4 (1) In order to present the total change in labor and benefits, we have included the change in the non-service cost component of our pension and other postretirement benefits, which is recorded within other income on our Condensed Consolidated Statements of Income. This change is offset within this table as it does not affect our operating expenses. We estimate property taxes throughout each year, and update those estimates based on valuation reports received from the Montana Department of Revenue. Under Montana law, we are allowed to track the increases and decreases in the actual level of state and local taxes and fees and adjust our rates to recover the increase or decrease between rate cases less the amount allocated to FERC-jurisdictional customers and net of the associated income tax benefit. Consolidated operating income for the three months ended June 30, 2022 was $52.3 million as compared with $59.0 million in the same period of 2021. This decrease was primarily driven by lower utility margin, higher operating and maintenance costs, higher administrative and general costs and higher depreciation and depletion, partly offset by higher electric and natural gas retail volumes. Consolidated interest expense was $24.0 million for the three months ended June 30, 2022 as compared with $23.5 million for the same period of 2021. This increase was primarily due to higher interest on borrowings under our revolving credit facilities partly offset by higher capitalization of AFUDC. Consolidated other income was $2.9 million for the three months ended June 30, 2022 as compared to $3.0 million during the same period of 2021. This includes the $2.5 million CREP penalty, which relates to litigation we have been involved in associated with our past progress towards meeting obligations to acquire renewable energy projects, as mandated by the recently repealed Montana CREP requirement. This is partly offset by a decrease in the non-service cost component of pension expense of $1.3 million and higher capitalization of AFUDC. Consolidated income tax expense for the three months ended June 30, 2022 and 2021 was $1.4 million. Our effective tax rate for the three months ended June 30, 2022 was 4.6% as compared with 3.4% for the same period in 2021. We expect our effective tax rate to range between 0% to 3% in 2022. 34 --------------------------------------------------------------------------------

      The following table summarizes the differences between our effective tax rate and the federal statutory rate (in millions):

       Three Months Ended June 30, 2022 2021 Income Before Income Taxes $ 31.2 $ 38.6 Income tax calculated at federal statutory rate 6.6 21.0 % 8.1 21.0 % Permanent or flow-through adjustments: State income tax, net of federal provisions 0.4 1.4 0.2 0.6 Flow-through repairs deductions (3.3) (10.6) (4.2) (11.0) Production tax credits (2.6) (8.2) (2.3) (5.9) Amortization of excess deferred income tax (0.2) (0.5) (0.1) (0.4) Plant and depreciation of flow-through items 0.4 1.3 (0.2) (0.5) Other, net 0.1 0.2 (0.1) (0.4) (5.2) (16.4) (6.7) (17.6) Income tax expense $ 1.4 4.6 % $ 1.4 3.4 % We compute income tax expense for each quarter based on the estimated annual effective tax rate for the year, adjusted for certain discrete items. Our effective tax rate typically differs from the federal statutory tax rate primarily due to the regulatory impact of flowing through federal and state tax benefits of repairs deductions, state tax benefit of accelerated tax depreciation deductions (including bonus depreciation when applicable) and production tax credits. 35 --------------------------------------------------------------------------------

      Six Months Ended June 30, 2022 Compared with the Six Months Ended June 30, 2021

       Consolidated net income for the six months ended June 30, 2022 was $88.9 million as compared with $100.3 million for the same period in 2021. This decrease was primarily due to a less favorable electric QF liability adjustment as compared to the prior period, higher operating and maintenance costs, higher administrative and general costs and higher income tax expense, partly offset by higher electric and natural gas retail volumes due to favorable weather and customer growth. Consolidated gross margin for the six months ended June 30, 2022 was $190.3 million as compared with $194.6 million in 2021, a decrease of $4.3 million, or 2 percent. This decrease was primarily due to a less favorable QF liability adjustment as compared to the prior period, recognition in the prior period of deferred transmission revenues, higher operating and maintenance costs, and higher depreciation and depletion costs, partly offset by higher electric and natural gas retail volumes due to favorable weather and customer growth. Electric Natural Gas Total 2022 2021 2022 2021 2022 2021 (in millions) Reconciliation of gross margin to utility margin: Operating Revenues $ 515.1 $ 511.5 $ 202.3 $ 187.5 $ 717.4 $ 699.0 Less: Fuel, purchased supply and direct transmission expense (exclusive of depreciation and depletion shown separately below) 135.3 129.4 94.8 83.1 230.1 212.5 Less: Operating and maintenance 80.3 77.7 25.8 25.6 106.1 103.3 Less: Property and other taxes 72.9 74.0 20.9 20.8 93.8 94.8 Less: Depreciation and depletion 80.6 77.2 16.5 16.6 97.1 93.8 Gross Margin 146.0 153.2 44.3 41.4 190.3 194.6 Operating and maintenance 80.3 77.7 25.8 25.6 106.1 103.3 Property and other taxes 72.9 74.0 20.9 20.8 93.8 94.8 Depreciation and depletion 80.6 77.2 16.5 16.6 97.1 93.8 Utility Margin(1) $ 379.8 $ 382.1 $ 107.5 $ 104.4 $ 487.3 $ 486.5 

      (1) Non-GAAP financial measure. See "Non-GAAP Financial Measure" above.

       Six Months Ended June 30, 2022 2021 Change % Change (dollars in millions) Utility Margin Electric $ 379.8 $ 382.1 $ (2.3) (0.6) % Natural Gas 107.5 104.4 3.1 3.0 Total Utility Margin(1) $ 487.3 $ 486.5 $ 0.8 0.2 % 

      (1) Non-GAAP financial measure. See "Non-GAAP Financial Measure" above.

       Consolidated utility margin for the six months ended June 30, 2022 was $487.3 million as compared with $486.5 million for the same period in 2021, an increase of $0.8 million, or 0.2 percent. 

      Primary components of the change in utility margin include the following (in millions):

       36 -------------------------------------------------------------------------------- Utility Margin 2022 vs. 2021 Utility Margin Items Impacting Net Income Higher electric retail volumes $ 3.5 Higher natural gas retail volumes 2.9 Electric QF liability adjustment (4.1) 

      Lower transmission revenue due to the prior year recognition of $4.7 million of deferred interim revenues, offset in part by higher transmission demand due to market conditions and pricing

       (0.9) 

      Reduction of rates from the step down of our Montana gas production assets

       (0.7) Higher non-recoverable Montana electric supply costs (0.3) Other 0.4 Change in Utility Margin Items Impacting Net Income 0.8 

      Utility Margin Items Offset Within Net Income Higher operating expenses recovered in revenue, offset in operating and maintenance expense

       2.1 

      Higher gas production taxes recovered in revenue, offset in property and other taxes

       0.3 

      Lower revenue from higher production tax credits, offset in income tax expense

       (2.1) 

      Lower property taxes recovered in revenue, offset in property tax expense

       (0.3) Change in Utility Margin Items Offset Within Net Income - Increase in Consolidated Utility Margin(1) $ 0.8 

      (1) Non-GAAP financial measure. See "Non-GAAP Financial Measure" above.

       Higher electric retail volumes were driven by colder winter weather in South Dakota, customer growth, and increased residential and commercial demand as compared to the prior year, partly offset by warmer winter weather in our Montana electric service territory and cooler spring weather in both Montana and South Dakota. Higher natural gas retail volumes were driven by colder winter weather in Montana and South Dakota, colder spring weather in all jurisdictions, and customer growth, partly offset by warmer winter weather in Nebraska. The less favorable adjustment to our electric QF liability (unrecoverable costs associated with PURPA contracts as part of a 2002 stipulation with the MPSC and other parties) reflects a $5.1 million gain in 2022, as compared with a $9.2 million gain for the same period in 2021, due to the combination of: •A $1.8 million favorable reduction in costs for the current contract year to record the annual adjustment for actual output and pricing as compared with a $2.6 million favorable reduction in costs in the prior period; •A favorable adjustment, decreasing the QF liability by $3.3 million, reflecting annual actual contract price escalation for the 2023-2024 contract year, which was less than previously estimated, partly offset by an increase in estimated contract prices for the 2023-2024 contract year, which is the last year of the contract that contains variable pricing terms. See Critical Accounting Policies and Estimates below for further information regarding our process of estimating the contract price for this 2023-2024 contract year. This is compared to an unfavorable adjustment of $2.1 million in the prior year due to higher actual price escalation; and •A favorable adjustment in the prior year, decreasing the QF liability by approximately $8.7 million, associated with a one-time clarification in contract term. 37 --------------------------------------------------------------------------------
       Six Months Ended June 30, 2022 2021 Change % Change (dollars in millions) Operating Expenses (excluding fuel, purchased supply and direct transmission expense) Operating and maintenance $ 106.1 $ 103.3 $ 2.8 2.7 % Administrative and general 58.9 54.7 4.2 7.7 Property and other taxes 93.7 94.8 (1.1) (1.2) Depreciation and depletion 97.1 93.8 3.3 3.5 

      Total Operating Expenses (excluding fuel, purchased supply and direct transmission expense)

       $ 355.8 $ 346.6 $ 9.2 2.7 % Consolidated operating expenses, excluding fuel, purchased supply and direct transmission expense, were $355.8 for the six months ended June 30, 2022, as compared with $346.6 for the six months ended June 30, 2021. Primary components of the change include the following (in millions): 

      Operating Expenses

       2022 vs. 2021 Operating Expenses (excluding fuel, purchased supply and direct transmission expense) Impacting Net Income Higher depreciation expense due to plant additions $ 3.3 Higher insurance expense 2.2 Higher technology implementation and maintenance expenses 1.8 

      Increase in uncollectible accounts due to the prior year collection of previously written off balances

       1.7 Higher labor and benefits(1) 0.8 Higher line clearing expenses 0.4 

      Lower property tax expenses due to a decrease in estimated state and local taxes

       (1.1) Lower expenses at our electric generation facilities (0.4) Other (0.1) Change in Items Impacting Net Income 8.6 

      Operating Expenses Offset Within Net Income Higher operating and maintenance expenses recovered in trackers, offset in revenue

       2.1 

      Higher pension and other postretirement benefits, offset in other income(1)

       0.2 

      Lower non-employee directors deferred compensation recorded within administrative and general expense, offset in other income

       (1.4) 

      Lower property and other taxes recovered in trackers, offset in revenue

       (0.3) Change in Items Offset Within Net Income 0.6 

      Increase in Operating Expenses (excluding fuel, purchased supply and direct transmission expense)

       $ 9.2 (1) In order to present the total change in labor and benefits, we have included the change in the non-service cost component of our pension and other postretirement benefits, which is recorded within other income on our Condensed Consolidated Statements of Income. This change is offset within this table as it does not affect our operating expenses. Consolidated operating income for the six months ended June 30, 2022 was $131.6 million as compared with $140.0 million in the same period of 2021. This decrease was primarily driven by a less favorable QF liability adjustment as compared to the prior period, higher operating and maintenance costs, higher administrative and general costs and higher depreciation and depletion, partly offset by higher electric and natural gas retail demand. Consolidated interest expense was $47.7 million for the six months ended June 30, 2022 as compared with $47.0 million for the same period of 2021. This increase was primarily due to higher interest on borrowings under our revolving credit facilities partly offset by higher capitalization of AFUDC. 38 -------------------------------------------------------------------------------- Consolidated other income was $7.6 million for the six months ended June 30, 2022 as compared to $8.6 million during the same period of 2021. This decrease was primarily due to the $2.5 million CREP penalty, which relates to litigation we have been involved in associated with our past progress towards meeting obligations to acquire renewable energy projects as mandated by the recently repealed Montana CREP requirement, and a $1.4 million decrease in the value of deferred shares held in trust for non-employee directors deferred compensation, which is offset in operating expenses. These decreases are partly offset by a $0.2 million decrease in the non-service cost component of pension expense, which is offset in operating expenses, higher capitalization of AFUDC and higher interest income. Consolidated income tax expense for the six months ended June 30, 2022 was $2.5 million as compared to $1.3 million in the same period of 2021. Our effective tax rate for the six months ended June 30, 2022 was 2.8% as compared with 1.3% for the same period in 2021. We expect our effective tax rate to range between 0% to 3% in 2022. 

      The following table summarizes the differences between our effective tax rate and the federal statutory rate (in millions):

       Six Months Ended June 30, 2022 2021 Income Before Income Taxes $ 91.4 $ 101.7 Income tax calculated at federal statutory rate 19.2 21.0 % 21.3 21.0 % Permanent or flow-through adjustments: State income tax, net of federal provisions 0.8 0.9 0.3 0.3 Flow-through repairs deductions (10.1) (11.1) (12.1) (11.9) Production tax credits (6.4) (7.0) (6.6) (6.5) Amortization of excess deferred income tax (0.6) (0.6) (0.4) (0.4) Share-based compensation (0.3) (0.3) (0.3) (0.3) Plant and depreciation of flow-through items 0.1 0.2 (0.5) (0.5) Other, net (0.2) (0.3) (0.4) (0.4) (16.7) (18.2) (20.0) (19.7) Income tax expense $ 2.5 2.8 % $ 1.3 1.3 % We compute income tax expense for each quarter based on the estimated annual effective tax rate for the year, adjusted for certain discrete items. Our effective tax rate typically differs from the federal statutory tax rate primarily due to the regulatory impact of flowing through federal and state tax benefits of repairs deductions, state tax benefit of accelerated tax depreciation deductions (including bonus depreciation when applicable) and production tax credits. 39 --------------------------------------------------------------------------------

      ELECTRIC SEGMENT

      We have various classifications of electric revenues, defined as follows:

       •Retail: Sales of electricity to residential, commercial and industrial customers, and the impact of regulatory mechanisms. •Regulatory amortization: Primarily represents timing differences for electric supply costs and property taxes between when we incur these costs and when we recover these costs in rates from our customers, which is also reflected in fuel, purchased supply and direct transmission expense and therefore has minimal impact on utility margin. The amortization of these amounts are offset in retail revenue. •Transmission: Reflects transmission revenues regulated by the FERC. •Wholesale and other are largely utility margin neutral as they are offset by changes in fuel, purchased supply and direct transmission expense. Three Months Ended June 30, 2022 Compared with the Three Months Ended June 30, 2021 Revenues Change Megawatt Hours (MWH) Avg. Customer Counts 2022 2021 $ % 2022 2021 2022 2021 (in thousands) Montana $ 70,715 $ 69,884 $ 831 1.2 % 590 575 316,180 311,264 South Dakota 15,593 14,401 1,192 8.3 123 119 50,925 50,734 Residential 86,308 84,285 2,023 2.4 713 694 367,105 361,998 Montana 84,327 84,555 (228) (0.3) 772 762 72,826 71,400 South Dakota 26,445 24,053 2,392 9.9 261 252 12,882 12,805 Commercial 110,772 108,608 2,164 2.0 1,033 1,014 85,708 84,205 Industrial 8,988 9,224 (236) (2.6) 608 618 76 77 Other 8,311 9,118 (807) (8.9) 42 49 6,415 6,373

      Total Retail Electric $ 214,379 $ 211,235 $ 3,144

       1.5 % 2,396 2,375 459,304 452,653 Regulatory amortization 7,741 5,201 2,540 48.8 Transmission 20,005 23,862 (3,857) (16.2) Wholesale and Other 1,293 1,142 151 13.2 Total Revenues $ 243,418 $ 241,440 $ 1,978 
      

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