ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with our Form 10-K. This includes non-GAAP financial measures, which are not standardized; therefore it may not be possible to compare these financial measures with other companies' non-GAAP financial measures having the same or similar names. These non-GAAP financial measures, which are discussed further in "-Consolidated Results of Operations," reflect an additional way of viewing aspects of our operations that, when viewed with our GAAP results, may provide a more complete understanding of factors and trends affecting our business segments. Investors should review our consolidated financial statements and publicly filed reports in their entirety and not rely on any single financial measure.

Business Overview We provide electricity and energy services to retail and wholesale customers through two business segments.
• Retail energy - provides electricity and energy services to approximately 1.8 million retail electricity customers in Texas, including residential and small business customers and commercial, industrial and governmental/institutional customers. Our next largest market is the PJM Market, where we serve commercial, industrial and governmental/institutional customers.

• Wholesale energy - provides electricity and energy services in the competitive wholesale energy markets in the United States through our ownership and operation or contracting for power generation capacity. We have approximately 15,000 megawatts of power generation capacity.

See discussions below under "- Liquidity and Capital Resources" regarding changes to our business and possible changes to our capital structure. Key Earnings Drivers.
Retail Energy. The retail energy segment is an electricity resale business. We earn a margin by selling electricity to end-use customers and acquiring supply for the estimated demand. The key earnings drivers in the retail energy segment are the volume of electricity we sell to customers, the unit margins received on those sales and the cost of acquiring and serving those customers (operating costs). These earnings drivers are impacted by various factors including:
Volume of electricity sales
• Local weather patterns

• Number and type of customers

• Energy efficiency behaviors

• Expansion into new markets

Unit margins
• Revenue rate charged compared to cost of supply, which includes

• Commodity price volatility when actual and estimated demand differ

• Load-related charges

• Transmission congestion

• Hedging costs

• Competitive tactics of other retailers in the market

• Incremental value-added services

Operating costs
• Collateral costs

• Operating efficiencies

• Cost to acquire and retain customers

• Ability to collect

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Wholesale Energy. The wholesale energy segment is a capital-intensive, cyclical business. Earnings are significantly impacted by spark and dark spreads and capacity prices. Spark and dark spreads are driven by a number of factors, including the prices of natural gas, coal and fuel oil, the cost of emissions, transmission, weather and global macro-economic factors, none of which we control and many of which are volatile. The factor that we have the most control over is the percentage of time that our generating assets are available to run when it is economical for them to do so (commercial capacity factor). The key earnings drivers in the wholesale energy segment are the amount of time our power plants are economical to operate (economic generation) and commercial capacity factor, which both determine the amount of electricity we generate, the margin we earn for each unit of electricity sold, the availability of our generating assets to meet demand (other margin) and operating costs. These earnings drivers are impacted by various factors including:
Economic generation
• Supply and demand fundamentals

• Spark spreads (difference between power prices and natural gas fuel costs)

• Dark spreads (difference between power prices and coal fuel costs)

• Generation asset fuel type and efficiency

Commercial capacity factor
• Operations excellence

• Maintenance practices

Unit margin
• Supply and demand fundamentals

• Commodity prices

• Generation asset fuel type and efficiency

Other margin
• Capacity prices

• Power purchase agreements sold to others

• Ancillary services

Operating costs
• Operating efficiencies

• Maintenance practices

• Generation asset fuel type

Liquidity and Capital Resources Merrill Lynch Unwind. The results in our retail energy segment in 2008 have been substantially below our expectations as a result of a variety of factors, including the record heat in the Houston area and ERCOT transmission constraints experienced in late May and early June, the devastating impact of Hurricane Ike on the Gulf Coast and the significant volatility in commodity prices experienced in 2008. As a consequence, we concluded that amending or terminating our $300 million working capital facility agreement with Merrill Lynch could be appropriate in order to address any issue that might be raised regarding the minimum adjusted retail EBITDA covenant in that facility. We believe that we have the right to terminate the working capital facility under the terms of the facility. Merrill Lynch has reserved its right to dispute our right to terminate the facility.
In addition, the ongoing turmoil in the financial markets and uncertainty in the overall economic outlook has resulted in a significant increase in the cost of capital generally and constraints in the availability of capital. The impact of this turmoil and uncertainty has been to increase Merrill Lynch's cost to perform under the credit-enhanced retail structure. From our perspective, the credit-enhanced retail structure represents a significant concentration of credit support for us with Merrill Lynch.
As a result of the factors described above, in September 2008, we and Merrill Lynch determined that pursuing an orderly unwind of the credit-enhanced retail structure was in our mutual best interests. Accordingly, on September 29, 2008, we entered into a letter agreement with Merrill Lynch providing that:
• the parties would use their commercially reasonable efforts to negotiate a definitive agreement before October 31, 2008 to unwind the structure by April 1, 2009;

• Merrill Lynch would waive compliance with the minimum adjusted EBITDA covenant in the $300 million retail working capital facility through October 31, 2008, so long as all other covenants were complied with; and

• we would not draw on the retail working capital facility.

Subsequently, we agreed with Merrill Lynch to extend the time period for the negotiation of the definitive agreement and the waiver of the minimum adjusted EBITDA covenant until December 5, 2008.
To provide us with sufficient capital to be able to operate our retail business without the benefit of the credit-enhanced retail structure, on September 29, 2008, we also entered into a commitment letter with GS Loan Partners (an affiliate of Goldman Sachs) for $650 million in senior secured term loans and a commitment letter with First Reserve to issue $350 million of participating convertible preferred stock, the latter of which became a definitive agreement on October 10, 2008. We are presently negotiating the definitive agreement with GS Loan Partners. Each of these financing arrangements is contingent upon each other and on our entry into the definitive agreement with Merrill Lynch described above.
If completed, we believe that these contingent capital arrangements, combined with our existing available liquidity, would provide us with adequate liquidity to facilitate the orderly unwind of the credit-enhanced retail structure and to operate our retail business in the current environment. There can be no assurance, however, that we will be able to reach definitive agreements with Merrill Lynch or GS Loan Partners, or that the other conditions to these arrangements or the First Reserve investment will be satisfied.
In the event that we are unable to reach a definitive agreement with GS Loan Partners or are unable to complete either the First Reserve or GS Loan Partners transactions for any reason, our ability to complete the Merrill Lynch unwind on the terms outlined in the September 29, 2008 letter agreement, as amended, could be impacted. In that event, we would, however, intend to pursue the Merrill Lynch unwind on alternative terms and, as discussed below, complete our exit of the C&I portion of our retail business.
In the event that we are unable to reach a definitive agreement with Merrill Lynch, as noted above we may terminate the $300 million retail working capital facility. In that event, Merrill Lynch may dispute our right to terminate the retail working capital facility and, accordingly, could seek to exercise remedies under the credit-enhanced retail structure, including seeking to foreclose on its collateral under that arrangement. We believe that such actions by Merrill Lynch, even if successful, would not have a material impact on our wholesale business and that we have sufficient available liquidity to continue to operate our wholesale business.
Strategic Alternatives Process. On October 6, 2008, our Board of Directors concluded that it would be prudent to initiate a formal process to explore other strategic alternatives prior to the funding of the financing commitments with First Reserve and GS Loan Partners and formed a special committee to oversee this process. The strategic alternatives process is intended to explore the full range of options to enhance stockholder value, including determining whether better value creation alternatives exist to closing on the new capital commitments and completing the unwind of the credit-enhanced retail structure on the terms outlined in the September 29, 2008 letter agreement with Merrill Lynch. The possible strategic actions include, among other possibilities, the sale of all or substantially all of Reliant Energy as well as the sale of some or all of our retail business.
Wind Down of C&I Portion of Our Retail Business. As of October 31, 2008, if Merrill Lynch were no longer providing credit support for our retail business, our collateral posting obligations for our retail business would be approximately $1.5 to $2.0 billion. We do not expect to assume this collateral posting obligation immediately, but rather over time, and required collateral postings will likely decrease as underlying positions roll off.
We estimate that roughly 70% of the retail collateral posting obligations is associated with C&I. In contrast, C&I represents only approximately 30% of the contribution margin associated with the retail business. Without the Merrill Lynch credit support, we do not believe that the C&I margins cover our cost of capital associated with this business. As a result we have concluded that it is appropriate for us to wind down the C&I portion of our retail business and we are, except in certain limited instances, no longer entering into contracts with new C&I customers and we do not expect to renew contracts with our current customers. As part of the strategic alternatives process, we are also exploring ways to accelerate this wind down, including a possible disposition of all or part of the C&I portion of our retail business. In addition, we are considering other methods to reduce collateral requirements, including an alternative credit support vehicle, additional internal hedges with our wholesale energy segment and commodity options to replace fixed price retail supply positions. Available Liquidity. As of October 31, 2008, and including the $500 million in proceeds from the sale of our Bighorn plant, we had total available liquidity of $1.7 billion, comprised of unused borrowing capacity, letters of credit capacity and cash and cash equivalents. This amount includes $150 million in cash and cash equivalents related to our retail business and excludes the $300 million from the retail working capital facility.
Contingent Uses of Liquidity. The preferred stock will pay cumulative quarterly cash dividends of 14% per year compounded quarterly or $49 million per year. In connection with our $650 million senior secured term loans commitment, we expect our interest expense and payments to increase approximately $55 million per year. As a result of the extension of the deadline for negotiating the definitive agreement with Merrill Lynch to December 5, 2008, we will be required to pay a $35 million termination fee to First Reserve if the First Reserve transaction does not close for any reason other than a default by First Reserve. See "-Recent Events'', "Risk Factors" in Item 1A of this Form 10-Q and "Risk Factors" in Item 1A and "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" in Item 7 of our Form 10-K and note 6 to our consolidated financial statements in our Form 10-K.

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Recent Events Strategic Updates. For updates related to strategic events, including our credit-enhanced retail structure with Merrill Lynch, see "- Liquidity and Capital Resources" above.
Hurricane Ike. In September 2008, Hurricane Ike struck the upper Texas coast, which left over 2.1 million electric consumers (more than 90 percent of the metered electric consumers in the Houston-Galveston area) without power. More than 1.0 million electric consumers were without power for at least six days and more than 500,000 customers remained without power ten days after the storm. We currently estimate our contribution margin will be negatively impacted for all of 2008 by approximately $200 million (with approximately $75-$100 million during the third quarter) as a result of the effects of Hurricane Ike, including reduced sales volumes, the sale of excess supply at a loss, cancellation of planned price increases and increased storm-related operating costs. The full extent of the loss will not be known until later this year.
ERCOT. In addition, the Houston area experienced thirty-year record heat in late May and early June 2008. As a result, load demand in Houston and south Texas was greater than we expected. Additionally, transmission constraints limited the ability to move power into the Houston and south Texas zones, which caused some of our power supply to be unavailable to meet expected demand. In response, we purchased power in Houston and south Texas to meet our increased load at market prices, which resulted in negative retail contribution margin in our retail energy segment. We have secured retail supply for the remainder of 2008 and beyond from sources in Houston and south Texas for our expected load. To reduce earnings variability in our retail energy segment, we are designing and implementing changes in our hedging approach such as matching supply and load by zone, buying heat rate for volumes above two standard deviations in some months and considering the use of gas and weather options to mitigate extreme events. These changes will result in higher expected supply costs over time, which we do not plan to pass through to customers. We are reviewing our core processes that support the business to ensure that we have the right people, skills and systems.
Bighorn Plant. In October 2008, we sold our Bighorn natural gas-fired combined-cycle electric generation facility for approximately $500 million. See note 15 to our interim financial statements.
Channelview. In July 2008, Channelview completed the sale of its plant for $500 million. See note 14 to our interim financial statements.
Environmental Matters. In July 2008, the District of Columbia Circuit Court of Appeals vacated the EPA's Clean Air Interstate Rule (CAIR) and remanded it to the EPA. In September 2008, the EPA and three other petitioners filed petitions for the court to rehear the decision. We do not know if the court will approve or deny the petitions or if any of the parties will appeal any denial. In October 2008, the court indicated it was considering leaving CAIR in effect while the EPA works to cure defects in the rule. The court's decision to vacate CAIR raises questions as to whether the EPA can design new cap-and-trade programs for nitrogen oxides (NOx) and sulfur dioxide (SO2) that are consistent with the Clean Air Act provisions that address upwind contributions to downwind states' noncompliance with national ambient air quality standards for ozone and fine particulate matter. The decision to vacate would set aside CAIR's proposed annual allowance-based NOx program and the increased surrender rate for SO2allowances. The existing ozone season NOx program and the SO2 allowance requirements under the Clean Air Act's acid rain program will continue. We cannot reasonably estimate changes, if any, to our capital expenditures or operating costs for this ruling or any additional regulations that may be enacted.
In June 2008, we revised our estimated capital expenditures for compliance with the first phase of Pennsylvania's mercury control program to approximately $50 million. This amount is adjusted from our preliminary estimate for the first phase of the program of $88 million to $103 million as a result of refined site-specific engineering and technology evaluations.
See "Risk Factors" in Item 1A, "- Liquidity and Capital Resources" and note 17 to our interim financial statements in this Form 10-Q and "Risk Factors" in Item 1A of our Form 10-K.

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