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Executives

Colleen Henderson – Manager of Strategic Planning & IR

Gale Klappa – Chairman, President & CEO

Rick Kuester – EVP & CFO

Steve Dickson – VP & Controller

Allen Leverett – EVP

Analysts

Andy Levi – Caris & Company

Brian Russo – Ladenburg Thalmann

Steve Fleishman – Bank of America

Michael Lapides – Goldman Sachs

Jay Dobson – Wunderlich Securities

Ted Heyn – Catapult

Sarah Akers – Wells Fargo

Dan Jenkins – State of Wisconsin Investment Board

Wisconsin Energy Corporation (WEC) Q1 2011 Earnings Call May 3, 2011 2:00 PM ET

Colleen Henderson

Good afternoon, ladies and gentlemen, and welcome to Wisconsin Energy’s Conference Call to review 2011 First Quarter Results. This conference is being recorded for rebroadcast and all participants are in a listen-only mode at this time.

Before the conference call begins, I’ll read the forward-looking language. All statements in this presentation, other than historical facts are forward-looking statements that involve risks and uncertainties, which are subject to change at any time. Such statements are made based on management’s expectations at the time they are made.

In addition to the assumptions and other factors referred to in connection with the statements, factors described in the company’s latest Form 10-K and subsequent reports filed with the Securities and Exchange Commission could cause actual results to differ materially from those contemplated. During the discussion, referenced earnings per share will be based on diluted earnings per share, unless otherwise noted. After the presentation, the conference will be open to analysts for questions and answers.

In conjunction with this call, Wisconsin Energy has posted on its Web site a package of detailed financial information on its 2011 first quarter results at www.wisconsinenergy.com. A replay of our remarks will be available approximately two hours after the conclusion of this call.

Now, I’d like to introduce Mr. Gale Klappa, Chairman of the Board, President and Chief Executive Officer of Wisconsin Energy Corporation.

Gale Klappa

Colleen, thank you. Good afternoon, everyone. We appreciate you joining us on our call to review the company's 2011 first quarter results. As always, let me begin by introducing the members of the Wisconsin Energy Management team who are here with me today. We’ve Rick Kuester, our Chief Financial Officer; Allen Leverett, President and CEO of We Generation; Jim Fleming, our venerable General Counsel; Steve Dickson, our Controller; and Pat Keyes, who has joined the company as our new Treasurer. Pat, of course, is taking the reins from Jeff West. As many of you know, Jeff retired at the end of April after 41 years of service.

Rick will review our financial results in detail in just a moment, but as you saw from our news release this morning, we reported earnings from continuing operations of $0.72 a share for the first quarter of 2011. This compares with $0.55 a share for the first quarter a year ago.

The uplift in earnings for this year’s first quarter driven by the commercial operation of the second expansion unit at Oak Creek, which as you know was placed in service in the early morning hours of January 12.

Across our utility operations, we experienced improved fuel recovery in the first quarter and colder winter weather. Overall, we’re off to a solid start for the year.

Now, I’d like to briefly touch on the state of the economy across our service areas. Overall, electric sales to large commercial and industrial customers rose just 0.4% over the first quarter of 2010, but a deeper look inside the numbers will give you a more complete picture.

First, as you may remember, a Chrysler engine plant in Kenosha, Wisconsin shut down last year, and that is a permanent shut down. This plant was one of our larger customers and we have factored this closing into our 2011 forecast.

In addition, on February 2 of this year, we experienced a blizzard that shut down much of the region for a good couple of days. If you exclude these two items growth in energy used by our large commercial and industrial customers would have been in the 2% to 3% range which is right in line with our forecast, we’re seeing strength in iron ore mining, especially steel production and printing, and we are cautiously optimistic that the recovery will continue throughout 2011.

Now, as I mentioned on our February call, we reached a milestone event in the first quarter as construction was completed on our Power the Future plan. More than 10 years ago, we developed a roadmap that we called Power the Future. It was fundamental to the principle of energy self-sufficiency.

Key components of achieving self sufficiency include investing in two combined cycled gas fired units at Port Washington, which is north of Milwaukee and the construction of two super critical pulverized coal units at Oak Creek which is south of the city and building a significant amount of renewable generation.

With the commercial operation of Unit 2 at Oak Creek, we've now completed the last of the four major units that were designed to provide our customers with a state-of-the-art generation fleet and provide clean reliable energy for many years to come.

The two natural gas fired units and the two coal fired units required a total investment of more than $2.6 billion, and we are very pleased with the efficiency and the environmental performance of these units.

Our customers are now receiving the operational benefits of these plants and our patient stockholders are beginning to realize the full benefit of their investments.

While we have largely completed our Power the Future effort there is clearly much more work to be done and more value to be created. We’ve several major projects underway and in the pipeline. To help us meet the States renewable energy standard we are building the Glacier Hills Wind Park on more than 17,000 acres of rolling farmland approximately 45 miles northeast of Madison. When completed this will be the largest wind project in the State of Wisconsin.

It will consist of 90 turbines with the total generating capacity of 162 MW or about 1.8 MW per wind site. Construction began at Glacier Hills about a year ago and we're currently on track to begin full operation by the end of 2011. The total cost of the project is expected to be approximately $360 million, excluding allowance for funds used during construction and reimbursable transmission costs.

As you know, we’ve also proposed a 50 MW cogeneration plant to be fueled with biomass at a paper mill site in Northern Wisconsin that is owned by the Domtar Corporation. This site, as I’ve mentioned, is close to significant forest lands that are harvested in a sustainable manner, yielding the wood waste that would power the land.

We received all the local permits necessary to move forward, and last week, the Wisconsin Public Service Commission held an open meeting on the matter. The Commission has expressed concern about the overall cost of the project and asked if Domtar would be willing to bear a greater share of the cost by paying more for the steam that the plant would produce. We and Domtar have filed a joint response actually just at noon today, and we expect the final decision from the Commission in the next week or so, and I believe that response you will find to be a very positive response.

Finally, on the construction front, we continue to make excellent progress on a major upgrade of the air quality controls for the older coal-fired units at Oak Creek. We're investing approximately $900 million.

I might add, this is the second largest construction project in the history of the company. Approximately, $900 million including allowance for funds used during construction for the installation of wet flue gas de-sulfurization and selective catalytic reduction facilities. We expect these controls to be completed in 2012. As we speak, the project is more than 75% complete, and again, we're on time and on budget.

Another development during the first quarter, we completed the sale to Allied Energy of our 25% interest in Edgewater Unit 5. Edgewater 5 is an existing 380 MW coal-fired unit in Eastern Wisconsin. We sold the 95 MW of capacity that we owned at Edgewater for approximately $38 million. The sale price reflected our net book value including working capital. So, as a result we did not record any book gain or any book loss.

Turning to regulatory matters, I'd like to briefly touch on two items for you. First, late last week the Wisconsin Public Service Commission approved a rate adjustment of less than 1% related to the higher fuel and purchase power cost that we’re incurring this year.

In our last general rate case, you may recall, we were allowed to file for our projected fuel and purchase power cost for the year 2011 and we filed for that increase back in September of 2010. Commission action on our request was delayed, but we’re pleased that an appropriate fuel recovery rate is now in place.

As a result of the delay, however, we expect to under collect our fuel cost by between $20 million and $25 million this year, but under the new fuel rules that went into effect this year, we estimate that our financial exposure will be limited to about $16 million, which should be the Wisconsin share and the $16 million is already factored into our guidance. The second regulatory matter is our upcoming rate filing. We expect to present a new rate proposal to the Wisconsin Commission within the next month.

Finally, Wisconsin Governor Scott Walker recently appointed a new Public Service Commissioner to fill a vacancy that occurred this spring when Commission Meyer’s six-year term came to an end. The new Commissioner and the new Commission’s Chairman is Phil Montgomery. Phil brings a wealth of experience to the position having worked on utility, energy, and telecommunication issues while serving for 12 years as a Wisconsin State Legislator. For a number of those 12 years, Mr. Montgomery was Chairman of the Assembly Committee on Energy and Utilities. Confirmation hearing for Commission Chairman Montgomery is expected to take place in the State Senate in May, however, he may act with full authority prior to the confirmation. Needless to say, we're pleased that the Commission is back at full strength.

In summary, with the completion of our Power the Future plan, the company is at a very positive inflection point. We expect to have approximately $600 million of free cash flow from 2011 through 2015 and that's after retirement of $450 million of holding company debt.

Along with a stronger balance sheet, we've clearly lowered the risk profile of this company. The majority of our construction risk is now behind us and when the point of each units were sold in 2007, we put nuclear operating and regulatory risk behind us as well.

We're turning our efforts now to our renewable and environmental projects and continuing to upgrade the energy infrastructure of the region. We’re planning a capital budget of up to $3.4 billion over the next five years or about $1.9 billion to $2 billion of net rate base growth after ongoing depreciation expense. By mid-year we plan to announce or revise dividend policy, debt reduction, share repurchases or a combination of all three with internally generated cash.

Now in more details on our first quarter and our outlook for the remainder of 2011, here is a familiar face but in a slightly different chair, our new Chief Financial Officer, Rick Kuester. Rick?

Rick Kuester

Thank you, Gale. Before I discuss our first quarter operating results, I’d like to remind you that our 2 for 1 stock split was effective on March 1, 2011. As a result of the split, we have changed the reporting of all prior earnings per share to reflect a new number of shares outstanding, so the $1.10 a share that we reported in the first quarter of 2010 is now $0.55 a share after the split.

As Gale mentioned, our 2011 first quarter earnings from continuing operations were $0.72 a share as compared to $0.55 a share in 2010. I’ll focus on the earnings drivers at the operating income level by segment and then touch on the other income statement items. I’ll also discuss cash flows in the quarter.

Our consolidated operating income in the first quarter of 2011 was $296 million as compared to $228 million in the 2010, an increase of $68 million. As expected, our utility operating earnings were higher because of favorable fuel recoveries as compared to 2010 and earnings from our non-utility energy segment were up with the commercial operations with a second unit at Oak Creek and a full quarter of earnings from the first Oak Creek unit. Operating income in our utility energy segment totaled $213 million, an increase of $35 million versus 2010.

On the positive side our revenues associated with the recovery of fuel and purchase power costs were up $24 million when compared to the first quarter of 2010. Last year we under collected fuel and purchase power costs by $23 million.

During the first quarter this year we were in a slightly favorable position. We also experienced a significantly colder first quarter this year and we estimate that our electric and gas margins were up $22 million as compared to last year.

On the negative side our utility O&M cost increased $10 million due to additional Power the Future costs, the timing of outages at our power plants and increased work on our distributions network.

Operating income in the non-utility energy segment which consists primarily of the Power the Future units was up $32 million. Unit 2 at Oak Creek was placed in service on January 12, 2011 and we realized full quarter's earnings on Unit 1. Last year we only realized partial quarter's earnings on Unit 1 as it was placed in the service on February 2, 2010.

Taking the changes for each of these segments together with a small increase in our corporate and other segment brings you back to the $68 million increase in operating income for the first quarter of 2011. During the first quarter of 2011, earnings from our investments in the American Transmission company increased just slightly over 2010.

Net interest expense increased by $14 million, primarily because of interest expense associated with Unit 2 at Oak Creek. When we placed the unit into service, we stopped capitalizing interest associated with construction of the plant.

We also issued $420 million of long-term debt and used the net proceeds to repay short-term debt incurred to finance the construction of Unit 2 and for other corporate purposes.

Consolidated income tax expense increased by approximately $18 million because of the higher pre-tax earnings offset in part by a slightly lower effective tax rate. Our effective tax rate for 2011 is expected to be between 34% and 35%. Combined all of these items brings you to $171 million of net income from continuing operations for the first quarter of 2011 or earnings of $0.72 per share.

During the first quarter we generated $391 million of cash from operations which is up $87 million from the same period in 2010. Our cash earnings, which we define as net income plus depreciation and amortization, plus deferred income taxes increased by $120 million as compared to the first quarter of 2010.

In addition to higher net income, we deferred more income tax as a result of bonus depreciation and increased depreciation expense associated with new coal units. The largest change in our uses of operating cash flows relates to our benefit plans. In the first quarter of 2011, we contributed $122 million to our qualified benefit plans no such contributions were made in 2010.

Our total capital expenditures decreased by approximately $59 million in the first quarter of 2011 as compared to first quarter of 2010 because of the completion of the Oak Creek units. However, for the year we expect to see capital expenditures of approximately $950 million which is about a $150 million more than our 2010 expenditures.

Over the next nine months we should see higher capital spending related to our air quality control system at South Oak Creek and the Glacier Hills wind farm. As Gale mentioned earlier, we received approximately $38 million from the sale of Edgewater 5 in March 2011.

We also paid $61 million in common dividends in the first quarter of 2011 which was 30% increase over the same period last year. The first quarter dividends equate to an annual dividend rate of $1.04 a share.

Our adjusted debt-to-cap ratio was 53.7% as of March 31, 2011. Our adjusted calculation treats half our hardwood securities as common equity which is consistent with past presentation. We used $223 million of cash on hand at March 31, 2011 to retire long-term debt that matured on April 1, 2011.

Adjusting for the use of cash on hand, our adjusted debt to total capital ratio was 52.5%. We’re very pleased with our efforts to strengthen our balance sheet. We’re using cash to satisfy any shares required for our 401(k) plan, options and other programs. Going forward, we do not expect to issue any additional shares. As shown in the earnings package that we posted on our Web site this morning, our actual first quarter retail sales of electricity increased 1.4% as compared to 2010.

Our residential sales were helped by a colder than normal winter, and our large commercial and industrial customers are slightly below forecast because of the February 2 closure. We see some decline in average use by our residential customers. We believe this is the result of conservation efforts, but, overall, our electric sales are in line with our annual forecast.

As we look at our natural gas sales, we saw 11.4% increase in sales, primarily because of the cold winter. We’re also seeing our weather normalize natural gas sales in line with our annual forecasts.

As we mentioned on the February call, when the second unit at Oak Creek was placed into service, we issued $420 million of senior notes in two tranches. The first tranche was a $205 million note with a coupon rate of 4.673% and the final maturity in 2031. The second tranche was a $215 million note with a coupon rate of 5.848% and the final maturity in 2041. We used the net proceeds to repay debt incurred to finance the construction of Unit 2 at Oak Creek and for other corporate purposes.

As discussed earlier, on April 1, 2011, we retired $450 million of long-term debt with $223 million of existing cash in commercial paper borrowings. Later this year, we expect Wisconsin Electric to issue approximately $300 million of long-term debt to help fund its construction program.

Our 2011 earnings guidance remains the same as what we provided to you on our February conference call. We expect our earnings for 2011 to be in the range of $2.05 to $2.10 per share. While our first quarter earnings exceeded our forecast range because of favorable weather, we still have nine more months of weather ahead of us.

Before I turn things back over to Gale, I would like to briefly discuss our earnings outlook for the second quarter. As a starting point, our 2010 second quarter earnings from continuing operations were $0.37 a share, adjusted for the 2 for 1 stock split.

When we look at our utility earnings, we expect to see a decline in operating income on a quarter-over-quarter basis because of favorable weather in 2010 and higher O&M cost in 2011.

Last year, we had an early summer and benefitted from some cooling out in June. This year our forecast assumed normal weather. However, we expect increased earnings from the second Oak Creek unit to offset the lower earnings from our utility in the second quarter.

In the past, we said that Unit 2 should contribute $0.02 a month pre-split or $0.01 a month post-split. As a result, we are expecting second quarter 2011 earnings to be in the $0.36 per share to $0.39 per share range or flat with the prior year.

With that I’ll turn things back over to Gale.

Gale Klappa

Rick, thank you very much. Overall, we're on track and focused on delivering value for our customers and our stockholders.

Question-and-Answer Session

Operator

(Operator instructions). Your first question comes from the line of Andy Levi with Caris & Company. Please state your question.

Andy Levi - Caris & Company

Gentlemen, how are you?

Gale Klappa

Fine, how are you, Andy?

Andy Levi - Caris & Company

I’m doing, all right. Just two very quick questions and I may have missed the first one. O&M is down a lot for the quarter. What was the reason, why?

Gale Klappa

Actually, we can let Rick and Steve get into the mechanics if you like. So if you really look at utility O&M, it was up about $10 million in the quarter, the remaining impact of the O&M that you see on the income statement is really because of the way the mechanics of the lease payments work between the Utility and We Power. I think, because of this year, we're going to have an unusual year. The one thing you really need to focus on is the utility, O&M and the utilities. Steve, do you want to give us a color on that?

Steve Dickson

Yes, thanks, Gale. Andy, as you point out, overall in a consolidated level, O&M is down about $22 million and as Gale said that the Utility, it's up about $10 million. The difference which is about $30 million decline relates to the elimination of intercompany revenues and expense. And as I remember it We Power builds the utility for the lease payment. So We Power records revenue and the Utility records expense. This year We Power with the Unit 2 coming on line had about $30 million more of revenue and therefore, on the consolidation entries, we eliminated $30 million more revenue at We Power and $30 million more expense on a consolidated basis, so it's an accounting anomaly, which shows why the O&M is down. Does that make sense, Andy?

Andy Levi - Caris & Company

Sure, it does. Thank you very much, and then I have other quick question.

Rick Kuester

Andy, lesson for everyone here for this year if you want to look at the O&M trends really look and we'll break this out for each quarter, really look at the Utility O&M.

Andy Levi - Caris & Company

Got it. And then on the stock buyback and/or dividend increase and/or I guess was a debt pay down was that the third thing that you were talking about. Just timing on that, as far as hearing from you guys on that, will that be in the second quarter call or could that come before, what are you guys thinking?

Rick Kuester

It’ll definitely come by June and we’re working through obviously all of our final analysis. We obviously also want to have our regulatory scheduled Board meetings and so you’ll expect an answer from us by June.

Andy Levi - Caris & Company

When is your Board meeting in June, is that something you can share with us today?

Rick Kuester

We’ve a Board meeting coming up soon. We also need by the way a final decision on our proposed biomass investment in Rothschild, the Domtar investment. So that’s another factor that we’re waiting for, but you’ll be hearing from us in the not too distant future.

Andy Levi - Caris & Company

Got it, thank you.

Gale Klappa

Thanks, Andy.

Operator

Your next question comes from the line of Brian Russo with Ladenburg Thalmann.

Brian Russo - Ladenburg Thalmann

Good afternoon. Would you mind elaborating a little more on the joint filing with PSCW related to the Domtar biomass cost I apologize, business I haven’t had a chance to read the filing?

Gale Klappa

Sure. In essence the filing that we made at noon and I understand why you wouldn’t have had a chance to read it, it was noon central time. The filing in the filing Domtar has agreed to, in essence, pay more for the steam that would be produced by the unit, and for background this would be a 50 MW plant. The plant would produce both steam to power Domtar’s paper mill operations and renewable electricity for the grid.

And one of the major questions that the Commissioners had during their open meeting last week was, could there be a different allocation of cost between the cost that go to electric customers and the cost that Domtar would accept for the production of steam. And so Domtar has agreed to, what we think is, a very major price change. We’ll let Allen cover the details for you.

Allen Leverett

Yes, Brian, just to put some numbers around it. What Domtar agreed to was a 20% increase in the rate that they pay for steam. Now, when you sort of track that through the implication then for our customers that translates into about a 7% reduction in the cost of the project took to our customers.

We believe that based on the conversation at the Commission last week, we believe this puts the cost of the project as compared to a wind project within a range that at least one of the Commissioners was looking for. So, as Gale mentioned, we would expect the decision in the near future from the Commission, but from a practical standpoint, we really need a decision by May 15 if we’re going to move forward with the project. That’s a high level summary.

Gale Klappa

Allen is exactly right. We actually need an order by May 15. In that, if we’re going to go forward with this project, we have a construction schedule that we have to meet and federal production tax credits related to biomass that right now at any rate expire at the end of 2013. If we don’t qualify, if we couldn’t get the plant on line by the end of 2013, and if we couldn’t therefore qualify for the production tax credits, it obviously changes the economics of the plant and not for the better. So, we think the Commission understands that and we’re looking for a decision here in the very near future.

Brian Russo - Ladenburg Thalmann

Okay, great. And then this $600 million of cumulating free cash flow through 2014, does that assume the biomass plant moves forward and the expenditures are included in the CapEx calculation there? Or would that price of the biomass plant eat into the $600 million?

Gale Klappa

Rick?

Rick Kuester

No, Brian. The $600 million assumes that we build the biomass project. If we don't build it, that will be additional equity available. That's a total $255 million investment, so about $125 million of additional cash flow would be available.

Gale Klappa

That's because obviously of the 50-50 capital structure.

Brian Russo - Ladenburg Thalmann

Thank you very much.

Operator

Your next question comes from the line of Steve Fleishman with Bank of America.

Steve Fleishman - Bank of America

A couple of questions. First, on the Chrysler plant shut down, do you have a sense if we excluded just that plant kind of what all industrial sales would have done without that impact?

Gale Klappa

Yes. Matter of fact, I do. It's a very good question. Let me give you a little bit of analysis. The analysis I have look at the four major and not all of them are major, but we had four plant shut downs that we believe are going to be reasonably permanent shut downs. There was the Chrysler engine plant in Kenosha. And then we have the Delphi Automotive Operations in Oak Creek. We had White Pine up in the Upper Peninsula of Michigan, which was a copper refiner, and then we have the NewPage paper mills. Paper mills owned in Northern Wisconsin by NewPage. All four of those shut downs and closings we have factored into our forecast.

Now, looking at how that relates, about 25% of our industrial demand and some of our largest customers are in the first quarter of this year their usage is above prerecession levels. The remaining 75% of our industrial grouping of customers, if you take out those four shutdowns, they are about 5% below, as a group about 5% below precession levels. But that's kind of the picture. We’ve, obviously, factored in these shutdowns in our 2011 forecast.

Steve Fleishman - Bank of America

A couple of other questions. The $16 million of net drag on fuel from the delay on the fuel case, was that in your initial guidance or is that kind of incremental to your initial guidance?

Gale Klappa

We had assumed there would be some drag because of the delay in getting an order from the Commission. So, it's really not incremental.

Steve Fleishman - Bank of America

And then I know you had mentioned one potential use of cash might be, for example, the fact that the state may be looking to sell some of their power assets?

Gale Klappa

Yes.

Steve Fleishman - Bank of America

Is there any update on that issue?

Gale Klappa

Very good question, Steve, and that is the potential use of cash. The State of Wisconsin or the Walker administration has expressed an interest in selling a number of the plants and steam heating power islands that currently are operated by the State of Wisconsin across college campuses and the biggest, obviously, would be the UW campus in Madison. It will require for the state to move forward with any sale.

A piece of legislation would be required to be passed by both the State Senate and the assembly, and my understanding is that the Walker administration is hoping to introduce that legislation sometime this summer. So, there won't be any immediate movement until a piece of legislation is passed and signed by the governor, but our understanding is the Walker administration would like to move forward with the sale of those assets.

Steve Fleishman - Bank of America

One last question, just your take on the EPA proposed air toxics rules and how that affects your capital plan for the remaining non-cleaned up coal plants and the like?

Gale Klappa

Sure, absolutely. I'll ask Allen to add his thoughts on this as well. Some background, Steve, might be very helpful. We really see very little impact on customer electric rates or our capital plan between now and 2015 as a result of all the new EPA regulations that have been proposed. That may surprise you because so many utilities are indicating that they are going to see huge capital increases and huge cost increases from the need to comply with these proposed rules, but there are three very good reasons why we do not see that kind of impact. Allen?

Allen Leverett

Yes. Just as background Steve. Of course, the first reason is, 10 years ago, the company made the decision to retire old coal, build new natural gas plants, build new coal plants. So, of course, those are the Port Washington plants and the Oak Creek plants. So, that's the first driver of why we are where we are. Second, you may remember in 2003, we entered into a consent decree with EPA, which drove controls at many of our other major plants.

And then, finally, we as a company unlike many others, we don't have ash impoundments. We’ve 100% beneficial reuse of the ash that comes from the combustion of the coal. So, we don't really see much many impact from EGU MACT or IB MACT on the company. The only three plants that we see they are mainly impacts on down the road, you have heard us talk about our Valley and our Milwaukee County power plants which are actually CoGen plants that produce steam as well as electricity and an electric plant that we have in the UP.

We see little impact on those units there could be a small amount of investment of those units because of EGU and or IB MACT, but the bigger impacts if there are going to be impacts than those plants would be out in the 2017 timeframe. They wouldn’t be driven by MACT, they would be driven by NAAQS, the National Ambient Air Quality Standard for SO2 in particular now, but again, we wouldn’t see impacts there if any until 2017. So it’s probably more than you wanted to know, but that’s kind of where we see ourselves positioned.

Gale Klappa

Steve, speaking more than you wanted to know you are probably seeing some of the national studies that have been done now that would indicate that the average price of electricity in the country maybe going up by as much as 20%, because of these proposed EPA rules. We might see 1% to 2% increase our best guess. So that gives you an example of how well we are positioned from the environmental standpoint in terms of complying with even the new proposed rule. So I think, this is going to materially help our competitive position.

Steve Fleishman - Bank of America

Great, thank you.

Operator

Your next question comes from the line of Michael Lapides with Goldman Sachs.

Michael Lapides - Goldman Sachs

The return on capital, you are waiting on Domtar and we are in a kind of a period where things are getting better but things aren’t perfect. I’m going to ask a question I think, your entire investor base probably won’t love which is what’s the rush?

Rick Kuester

Well I don’t feel like we are in a rush, I really don’t. We've taken I think,, very good time to do the proper analysis, we will have sooner or later within the next week or two I believe a decision from the Wisconsin Commission on Domtar, we’ve laid out $3.4 billion or up to $3.4 billion capital plan for the next five years. So, Michael, I think, all of the elements are in place for us to really have a very good understand of what our earnings potential, our investment opportunities and our cash flows look like. So, I don’t sense that we’re in a rush at all.

Allen Leverett

I’d just add onto that Michael, in other way to interpret your question would be, why now and what's happened in the first part of this year, is that we’ve gotten more clarity on the EPA rule, so we kind of know what the exposure is there. We sold Edgewater 5 which was going to be an investment that those are going to be required to make from an air quality control standpoint. So, that’s no longer an uncertainty out there, and we finished the last unit at Oak Creek, so we’ve got a number of things resolved. So, I think, the timing actually is pretty good, if you look at the issues that we were facing a few months ago versus the issues that we’re facing now in terms of capital expenditure.

Michael Lapides - Goldman Sachs

Got it. One other…

Gale Klappa

Michael, one other point to add onto what Rick said, I personally think it’s important for our investor base to understand, it’s very clearly where what our philosophy is on our dividend payout ratio as well. I mean, we’re entering, as I mentioned in the earlier comments, I think, the company is at a very positive inflection point, but clearly our dividend payout ratio is below our peers, and I think, it’s important to clarify for our investors going forward at a minimum what our goals are related to our dividend payout ratio.

Michael Lapides - Goldman Sachs

No, and that’s makes it understand synonymously over the last 5 to 7, 5 to 10 years, you guys have been among the best in terms of stewards of shareholder and bondholder capital. One follow-up related to capital structure, but just in general in your discussions with the new Chairman, what are you getting in terms of potential direction for state energy policy in Wisconsin for the next 3 to 5 years?

Gale Klappa

Really, Phil has just gotten in the chair. I think, he has been pretty busy trying with the other Commissioners to work off the backlog of items that they had really built up when they were short of Commissioner. So I don't think Phil has had a great opportunity yet to sit down and think about energy policy for the state. He did say though during the last open meeting that he was part of the crafting of the renewable energy standard for 2015 and supports that standard. So, I think, the first and only comment that we've really seen from Phil so far is his support for the 2015 energy standard, renewable energy standard.

Michael Lapides - Goldman Sachs

What does that then mean if Domtar doesn't get approved?

Gale Klappa

That's when we will have some conversations and try to seek some guidance from the Commissioners, because the truth of the matter is, if Domtar is approved it will get us to where we need to be for 2015 and 2016. I mean, that would be the last major investment we would need to make in the near-term in renewables to meet that 2015 and 2016 standard. Without that then we've got some decisions to make and in our first step if they decide that Domtar is just too expensive a proposal, our next step would be to sit down and work with the Commissioners and get some guidance, and frankly work with the Walker administration as well. I know that the governor would want to have some say in that thinking.

Michael Lapides - Goldman Sachs

Got it, okay, thank you, guys, much appreciate it.

Gale Klappa

You’re more than welcome, Michael. Take care.

Operator

Your next question comes from the line of Jay Dobson with Wunderlich Securities.

Jay Dobson - Wunderlich Securities

I was hoping we could continue on the Domtar topic. I know it's timely we’ll have a decision here shortly, but I didn’t hear the commentary that the PSC made but just judging from your reaction you took some solace in the fact that with the price cut they would compare that or would look economically similar to a wind asset. I was just hoping you could elaborate on that solace, simply because it seemed as if a lot of the desire for wind in the state quite frankly lost a lot of its backing with the new governor. So I'm just wondering if that's economic we would feel more comfortable with or that’s something that obviously will be determined in the ultimate decision, but just tell us how the wind economics or the comparison with wind economics makes you feel more comfortable?

Gale Klappa

I think, there is one very clear reason why it makes me feel more comfortable and that is the former Chairman and current Commissioner Eric Callisto during the open discussions with the other commissioners said that he would like to be able to see this renewable alternative, meaning the Domtar co-generation plant that we are proposing. He was concerned that it looked like based on staff analysis that this proposal was more expensive than generic wind. He said gosh, he would feel comfortable he said, if we could have some kind of, as he put it wind bogie against which to compare.

Now, when we look at the staff assumption on generic wind and the cost of generic wind, there are a couple of items here that I think, are worth pointing out. The staff's analysis on the cost of generic wind assumed that the federal production tax credit for wind would go on for a very long time. We don't think it's prudent to make that assumption because under the current law the federal production tax credit for wind expires at the end of 2012.

And then when you factor that into the fact that generic wind may not represent the real cost of building wind in Wisconsin in light of the flux that the state is in regarding the citing rules. I mean, we think the real generic cost of wind can be materially higher than what the staff indicated. And then if you couple that with price reduction that Allen described from what Domtar and we filed at noon today, you get much, much closer. In fact, we think and hope we’ve achieved what Commissioner Callisto was looking for which was a proposal that would be quite close to the cost of generic wind. Guys, would you like to add anything?

Rick Kuester

No. I think you've covered it Gale. If you kind of stand back and look at it, it’s not really possible to build the generic wind project that would be compared to because if it’s a Greenfield project, because one, citing rules aren’t clear, two, the production tax credit expires one year early than biomass. So, I think, by bringing the numbers closer we’ve been responsive to the Commission.

Gale Klappa

There’s another factor here, the area where we’re proposing to build the biomass plant, which is a suburb of Wausau in Northern Wisconsin. Like all areas, that area can benefit from jobs and there is a very strong job protection and job creation story associated with this plant that we think should also play into the mix here.

Jay Dobson - Wunderlich Securities

No. That’s very helpful. Maybe seizing on the national question, from where you indicated if it doesn’t go forward you’d like to have discussions with the Walker administration. Where do you think their desires might be on where you might fill if need be, and you certainly would have to under the renewable standard where he would like you to sort of focus?

Gale Klappa

I'd hate to pre-judge what the Governor might say on this, but clearly in the past particularly in this kind of economic climate, he has focused on near-term cost to the customer. So one option and I'm not suggesting this would be the option, we would have to get the proper inputs, but one option which is allowed under the law is the filing of RAM. The law says that if it is not practical or if it is excessive in cost to meet the 2015 standard, then a utility could file for an of RAM. None have done so at this point and we certainly would not need to do so assuming we could move forward with the Rothschild of Domtar biomass project.

Jay Dobson - Wunderlich Securities

Last question on Domtar, how much is in the CapEx budget for '11? I think, you answered that question and it just went by me too quick.

Rick Kuester

About $100 million this year.

Jay Dobson - Wunderlich Securities

About $100 million this year?

Rick Kuester

$255 million.

Jay Dobson - Wunderlich Securities

Great. And my last question, on the under collection, the fuel under recoveries for the balance of this year, how do they flow over the remaining three quarters, understanding it's just about $16 million of financial exposure?

Gale Klappa

Right, we're about even now on fuel recovery going into Q2. Steve or Rick, do you have that flow for the final three quarters?

Rick Kuester

As Gale said, basically our cost of fuel was right on top of our collection rate in the first quarter. As Gale said, we expect to be $16 million. We expect to hit the threshold. If you look in the next couple of quarters, we expect to under recovering the second, but most of it would be in the third quarter. That's probably when we would exceed the $16 million amount and start to edge up toward the $20 million to $25 million that Gale mentioned.

And then in the fourth quarter, we typically claw back some of that that we’ve lost in the third quarter because of the higher cost of power during the summer. So at the end of the year we expect to be in that $20 million to $25 million under collected, but we're capped at $16 million based on how the fuel rules work.

Jay Dobson - Wunderlich Securities

How much would be in that 36 to 39 you gave Rick for the second quarter, it’s probably pretty small number I know but…

Steve Dickson

Basically, on the fuel recoveries, we'll under collect anywhere from $5 million to $7 million in the second quarter and that amount is comparable to 2010. So we don't expect earnings varying in some 2010 to 2011 related to fuel in Q2.

Jay Dobson - Wunderlich Securities

Great, perfect, thank you so much.

Operator

Your next question comes from the line of Ted Heyn with Catapult.

Ted Heyn - Catapult

I had a few quick questions, first on just on the under recoveries, so the $16 million represents basically the 2% bandwidth, the 16 is cap of the earnings exposure?

Gale Klappa

You've nailed it.

Ted Heyn - Catapult

Just quickly on weather, how much above normal was at this quarter and how much does it contribute?

Gale Klappa

In terms of average temperatures Q1 was about 10% colder than last year and Steve how much colder than normal?

Steve Dickson

6%, colder than normal, last year it was 4% warmer than normal.

Ted Heyn - Catapult

Do you have a dollar impact or gross margin impact from being above normal?

Steve Dickson

On electric side we think that compared to normal our electric margins which is revenues minus fuel were helped by about $7 million and on the gas side, our gas margins were held at about $8 million, so in total about $15 million.

Ted Heyn - Catapult

So, 15 ahead but you also have the 16 of fuel under recovery so kind of net-net on a normalized basis you are kind of…

Gale Klappa

No. The 16 of fuel under recovery was already in our guidance

Rick Kuester

We fully collected on fuel this quarter. That 16 actually fell through till third quarter.

Ted Heyn - Catapult

I guess I was thinking as when I do a bridge from '11 to '12 those two things should wash each other out?

Gale Klappa

Yes from '11 and '12, yes exactly.

Ted Heyn - Catapult

And then on the Domtar, the filing mentioned that they increased their capital allocation by $22 million. Does that change the amount of dollars you would spend or is that…..

Gale Klappa

No. All it does and again you need to think about this as about $255 million capital investment and then the questions becomes what share of the cost of that investment and what share of the operating costs would be allocated to Domtar for taking the steam for their paper mill operations and what share would go to electric customers for the renewable electricity that would go to the grid? This is all a question about allocation of the total cost not about change of total cost.

Ted Heyn - Catapult

So, if your revised proposal was approved, the spend would still be $255 million?

Gale Klappa

You got it.

Rick Kuester

It's just the rate that they pay for the steam.

Ted Heyn - Catapult

It's just the rate. And then just finally I think, that there is some movement to try to change the RPS standard to allow hydropower for Manitoba to potentially count. If that were to happen could you talk maybe about how – what the investment opportunities would be for you there?

Gale Klappa

I'm not sure there is an investment opportunity there in terms of that change or any Wisconsin utility because what is being proposed is particularly if I want other Wisconsin utilities is that, in essence they would sign a purchase power agreement for new hydro power that would be developed in Canada to be imported into Wisconsin. So, there is no real construction investment opportunity there for the hydropower itself, but as Rick is pointing out, there may be a transmission in this.

Ted Heyn - Catapult

Okay. So, maybe ATC would have some opportunity?

Gale Klappa

That is entirely possible.

Ted Heyn - Catapult

But that’s probably longer term in nature.

Gale Klappa

Ted, I would be thinking this is a post 2015 type of matter, because first of all the new hydro facilities aren’t even built yet.

Ted Heyn - Catapult

Got you. Okay. Thanks a lot for all the help.

Gale Klappa

Thank you, Take care, Ted.

Ted Heyn - Catapult

You too. Bye-bye.

Operator

Your next question comes from the line of Sarah Akers with Wells Fargo.

Sarah Akers - Wells Fargo

Hey, good afternoon. I just had a quick clarification question on the $600 million of free cash flow. First, does that include the sale proceeds from Edgewater 5 and second, does it include the impact of the DOE settlement, which I believe was about $45 million?

Gale Klappa

Yes and no. It includes the Edgewater 5 sale proceeds, but the proceeds from our settlement with the federal government regarding the extra cost we incurred at Point Beach on spent nuclear fuel, those dollars are in an Al Gore lock-box down the street in a bank and those dollars will be completely returned to customers overtime, and so they’re not counted in our cash flow assumptions.

Sarah Akers - Wells Fargo

Got it, okay, thank you very much.

Gale Klappa

You’re welcome, Sarah.

Operator

Your next question comes from the line of Dan Jenkins with State of Wisconsin Investment Board.

Dan Jenkins - State of Wisconsin Investment Board

Hi, good afternoon. Just to follow-up on what you just talked about with further, so is that the $45 million of restricted cash then that we're seeing on the balance sheet?

Gale Klappa

Yes, $45 million.

Dan Jenkins - State of Wisconsin Investment Board

And then lower on the balance sheet, I noticed the material supplies inventories are about $100 million lower which I assume it’s also been part of the working capital gain that we're seeing on the cash flow statement. I just wondered if you could talk about what is going on with that.

Allen Leverett

Yes, its gas and coal inventories that Steve can talk about that.

Steve Dickson

Yes, the balance sheet is comparing December 31st to March 31st and at the end of December we had a significant amount of gas in storage and we pulled that out at the end of the year. So, we had the same decline last year. The number this year is about $50 million more because March was significantly coldish so we would show more in gas and storage. In addition we were able to reduce coal inventories down and so those are the two big drivers.

Dan Jenkins - State of Wisconsin Investment Board

Is there anything else then that's driving that working capital gain $150 million on the cash flow statement?

Gale Klappa

Well, the balance depreciation is having an effect on that Dan.

Allen Leverett

Yes, the increase in the deferred taxes.

Gale Klappa

Yes.

Dan Jenkins - State of Wisconsin Investment Board

Was that 60 odd million you see?

Allen Leverett

Yes

Dan Jenkins - State of Wisconsin Investment Board

And then I think, you mentioned you're expecting to file for a rate increase in the next month or so.

Gale Klappa

That is correct.

Dan Jenkins - State of Wisconsin Investment Board

I was curious what your current ROE, earned ROE is and then are there any other items driving that, that you expect that'll drive that request beyond ROE impact?

Gale Klappa

Well, for all of 2010, our earned ROE was very close to the allowed ROE at the utility. So, again, we performed very close to the allowed ROE at the utility last year. Of course, the way Wisconsin regulation works, the Commission uses and ask us to file a two-year forward-looking test year. We project our expenses, our O&M expense, our fuel expenses, our capital costs for, in this case, 2012 and 2013. The big driver of the rate proposal that we will file is really completing construction and placing into service about $1.2 billion of new assets that have already been approved by the Commission.

In specific, the two large projects that would be the big drivers would be the completion of the air quality controls of the older existing Oak Creek units. Remember, I mentioned that's a $900 million capital expenditure, and then the completion later this year we believe of the Glacier Hills Wind Park, which is another $360-ish million.

Rick Kuester

$360 million and $370 million.

Gale Klappa

You put those two together and that's $1.2 billion of new capital that once placed into service needs to be reflected in customer rates. So that would be the big driver of our rate proposal that we expect to file in the next few weeks.

Dan Jenkins - State of Wisconsin Investment Board

And then the last thing I was curious is, it looks like the residential usage was up about 1.5% and the small commercial was up about 2.5%. If you strip out the weather impact, what would those have looked like?

Gale Klappa

You strip out the weather impact, against 20-year average weather, you would see residential actually being down slightly. You would see small commercial and industrial up about 0.5%. You would see large commercial and industrial about flat, and total large commercial and industrial up about four-tenth of one percent.

Rick Kuester

Dan, one other thing, on the $45 million that restricted cash in the DoD settlement that would be returned to customers net of the cost to achieve. That was about a 10-year process where we were suing the federal government. So, there are costs associated with that. So, just point of clarification.

Dan Jenkins - State of Wisconsin Investment Board

What's the timeframe for returning there?

Gale Klappa

Actually, it's certainly up to the Commission when they would like to have and over what timeframe they would like to have those dollars flow back to customers, but we will propose an option for the Commission in the (inaudible) filing.

Dan Jenkins - State of Wisconsin Investment Board

Okay, thank you.

Gale Klappa

You’re more than welcome, Dan.

Operator

Your next question comes from the line of Michael Lapides with Goldman Sachs.

Michael Lapides - Goldman Sachs

Hey, guys, Rick, a modeling question real quickly. What is left in 2011 in terms of deferred income tax or really bonus depreciation for you to take and even deferred income taxes separate from bonus depreciation, meaning the deferred income tax benefit you get from Oak Creek?

Rick Kuester

We said all along we’ve got about $100 million worth of bonus depreciation impacts in 2011.

Gale Klappa

Most of that's to come this year yet.

Michael Lapides - Goldman Sachs

Meaning very little of that is what showed in the first quarter?

Rick Kuester

About $60 million showed in the first quarter I believe.

Michael Lapides - Goldman Sachs

So, another $40 million for the rest of the year?

Gale Klappa

All right, Michael, thank you.

Michael Lapides - Goldman Sachs

Thanks, guys. Much appreciate it.

Gale Klappa

You’re more than welcome.

Operator

At this time, there are no further questions.

Gale Klappa

Very good, well, that concludes our conference call for today. We really appreciate you taking part and all the great questions you asked today. If you have any other questions, Colleen Henderson is ready and waiting at our Investor Relations office, and that number is 414-221-2592. Thank you very much. Have a good day, everybody.

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