Table of Contents

CONFORMED

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Form 10-K

Commission file number 1-3701

AVISTA CORPORATION

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

Title of Class

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days:

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  [  ]

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act):

The aggregate market value of the Registrant’s outstanding Common Stock, no par value (the only class of voting stock), held by non-affiliates is $660,054,800, based on the last reported sale price thereof on the consolidated tape on June 28, 2002.

As of February 28, 2003, 48,118,294 shares of Registrant’s Common Stock, no par value (the only class of common stock), were outstanding.

Documents Incorporated By Reference

AVISTA CORPORATION

Table of Contents

INDEX

ii

Table of Contents

AVISTA CORPORATION

* = not an applicable item in the 2002 calendar year for the Company

iii

Table of Contents

AVISTA CORPORATION

ACRONYMS AND TERMS
(The following acronyms and terms are found in multiple locations within the document)

iv

Table of Contents

AVISTA CORPORATION

v

Table of Contents

AVISTA CORPORATION

PART I

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. Forward-looking statements should be read with the cautionary statements and important factors included in this Annual Report on Form 10-K at Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Safe Harbor for Forward-Looking Statements.” Forward-looking statements are all statements other than statements of historical fact, including without limitation those that are identified by the use of words such as, but not limited to, “will,” “anticipates,” “seeks to,” “estimates,” “expects,” “intends,” “plans,” “predicts,” and similar expressions. Such statements are inherently subject to a variety of risks and uncertainties that could cause actual results to differ materially from those expressed. Most of these risks and uncertainties are beyond the Company’s control.

Available Information

The Web site address of Avista Corporation (Avista Corp. or the Company) is http://www.avistacorp.com. Avista Corp. makes available free of charge, on or through its Web site, its annual, quarterly and current reports, and any amendments to those reports, as soon as reasonably practicable after electronically filing such reports with the Securities and Exchange Commission. Information contained on Avista Corp.’s Web site is not part of this report.

Item 1. Business

Company Overview

Avista Corp. was incorporated in the State of Washington in 1889. Avista Corp. is an energy company engaged in the generation, transmission and distribution of energy as well as other energy-related businesses. As of December 31, 2002, the Company’s employees included approximately 1,410 people in its utility operations and approximately 540 people in its subsidiary businesses. The Company’s corporate headquarters are in Spokane, Washington, which serves as the Inland Northwest center for manufacturing, transportation, health care, education, communication, agricultural, financial and service businesses.

The Company’s operations are exposed to risks, including, but not limited to, the price and supply of purchased power, fuel and natural gas, recoverability of power and natural gas costs, streamflow and weather conditions, the effects of changes in legislative and governmental regulations, availability of generation facilities, competition, technology and availability of funding. Also, like other utilities, the Company’s facilities and operations may be exposed to terrorism risks. In addition, the energy business exposes the Company to the financial, liquidity, credit and commodity price risks associated with wholesale purchases and sales.

The Company is organized into four lines of business – Avista Utilities, Energy Trading and Marketing, Information and Technology, and Other. Avista Capital, a wholly owned subsidiary of Avista Corp., is the parent company of all of the subsidiary companies engaged in the non-utility lines of business. As of December 31, 2002, the Company had common equity investments of $457.6 million and $255.2 million in Avista Utilities and Avista Capital, respectively.

Avista Utilities, an operating division of Avista Corp. and not a separate entity, represents the regulated utility operations. Avista Utilities generates, transmits and distributes electricity and distributes natural gas. Avista Utilities also engages in wholesale purchases and sales of electric capacity and energy. Avista Utilities seeks to maintain a strong, low-cost and efficient electric and natural gas utility business focused on providing reliable, high quality service to its customers. The utility business is expected to grow modestly, consistent with historical trends. Expansion is expected to result primarily from economic growth in its service territory. It is Avista Utilities’ strategy to own or control a sufficient amount of resources to meet its retail and wholesale energy requirements on an average annual basis.

The Energy Trading and Marketing line of business includes Avista Energy, Inc. (Avista Energy) and Avista Power, LLC (Avista Power). Avista Energy is an electricity and natural gas marketing and trading business, operating primarily within the Western Electricity Coordinating Council (WECC) geographical area, which is comprised of eleven Western states. Avista Energy focuses on asset-backed optimization of combustion turbines and hydroelectric assets owned by other entities, long-term electric supply contracts, natural gas storage, and electric and natural gas transmission and transportation arrangements. Avista Energy’s marketing efforts are driven by its base of knowledge and experience in the operation of both electric energy and natural gas physical systems in the WECC, as well as its relationship-focused approach with its customers. Avista Power was originally formed to develop and own

1

Table of Contents

AVISTA CORPORATION

generation assets. During 2001, the Company decided that Avista Power would no longer pursue the development of additional non-regulated generation projects. Avista Power continues to manage the generation assets it currently owns, primarily its 49 percent interest in a 270 megawatt (MW) natural gas-fired combustion turbine plant in northern Idaho (Lancaster Project), which commenced commercial operation in September 2001.

The Information and Technology line of business includes Avista Advantage, Inc. (Avista Advantage) and Avista Laboratories, Inc. (Avista Labs). Avista Advantage is a provider of internet-based facility intelligence, cost management, billing and information services to retail customers throughout North America. Avista Advantage remains focused on growing revenue, improving margins, reducing fixed and variable costs and improving client satisfaction. Avista Labs has patented and developed a modular air-cooled, self-hydrating Proton Exchange Membrane (PEM) fuel cell that delivers reliable and clean distributed power solutions. In addition to developing its modular fuel cell products, Avista Labs is contracting with selected market channels to deliver system solutions to industrial, commercial and residential markets. Avista Labs holds a 70 percent equity interest in H2fuel, LLC, a developer of fuel processors for the production of hydrogen. Avista Corp. continues discussions with selected companies in its search for a financial partner for Avista Labs with the goal of owning less than 20 percent of this company.

The Other line of business includes Avista Ventures, Inc. (Avista Ventures), Avista Capital (parent company only amounts), Pentzer Corporation (Pentzer) and several other subsidiaries. The Company continues to limit its future investment in this line of business.

The Company’s current lines of business, and the companies included within them, are illustrated below:

      o - denotes a business entity.

      O  - denotes an operating division or line of business.

See “Item 6. Selected Financial Data” and “Schedule of Information by Business Segments in the Consolidated Financial Statements” for information with respect to the operating performance of each business segment.

2

Table of Contents

AVISTA CORPORATION

Avista Utilities

General

Avista Utilities generates, transmits and distributes electricity and distributes natural gas. Retail electric and natural gas customers include residential, commercial and industrial classifications. Avista Utilities also engages in wholesale purchases and sales of electric capacity and energy as part of its resource management and load-serving obligations.

Avista Utilities provides electric and natural gas distribution and transmission services in a 26,000 square mile area in eastern Washington and northern Idaho with a population of approximately 813,000. It also provides natural gas distribution service in a 4,000 square mile area in northeast and southwest Oregon and in the South Lake Tahoe region of California, with the population in these areas approximating 611,000. At the end of 2002, Avista Utilities supplied retail electric service to approximately 320,000 customers in eastern Washington and northern Idaho and retail natural gas service to approximately 290,000 customers in parts of Washington, Idaho, Oregon and California.

Avista Utilities anticipates residential and commercial electric load growth to average between 2.5 and 3.5 percent annually for the next four years, primarily due to expected increases in both population and the number of businesses in its service territory. The number of electric customers is expected to increase; however, the average annual usage by residential customers is not expected to change significantly. For the next four years, Avista Utilities expects natural gas load growth to average between 3.0 and 4.0 percent annually in its service territory. The natural gas load growth is primarily due to expected conversions from electric space, oil space and electric water heating to natural gas, and increases in both population and the number of businesses in Avista Utilities’ service territories. These electric and natural gas load growth projections are based on purchased economic forecasts, publicly available studies, and internal analysis of company-specific data, such as energy consumption patterns and internal business plans. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Future Outlook” for additional information.

During 2001 and 2002, Avista Utilities experienced decreased loads and decreased use per customer with respect to both electric and natural gas retail sales. The decrease in use per customer appears to be primarily due to a response to the increase in rates and the resulting conservation efforts of individual customers. The decrease in use per customer in 2002 and 2001 as compared to 2000 also appears to reflect milder weather in 2002 and 2001 as compared to 2000. The decrease in total kilowatt-hours (kWhs) and therms sold primarily relates to industrial customers and appears to reflect a general downturn in the economy of Avista Utilities’ service territory. However, as described above, based on economic forecasts, publicly available studies and internal analysis of company-specific data, the Company does not expect the trend of declining loads to continue over the next four years.

Electric Operations

In addition to providing electric transmission and distribution services, Avista Utilities generates electricity for sales to customers. Avista Utilities owns and operates eight hydroelectric projects, a wood-waste fueled generating station, a two-unit natural gas-fired combustion turbine (CT) generating facility and two small generating facilities. It also owns a 15 percent share in a two-unit coal-fired generating facility and leases and operates a two-unit natural gas-fired CT generating facility. In mid-2003, it is expected that the natural gas-fired Coyote Springs 2 Generation Project (Coyote Springs 2) will be placed into operation. Avista Utilities has a 50 percent ownership interest (140 MW) in Coyote Springs 2. In addition to company-owned resources, Avista Utilities has a number of long-term power purchase and exchange contracts that increase its available resources. See “Item 2. Properties” for further information with respect to generation properties.

Historically, Avista Utilities’ electric rates to retail customers have been among the lowest of investor-owned utilities in the United States, due primarily to its large proportion of hydroelectric resources as compared to other investor-owned utilities. Retail electric rates remain low, relative to other investor-owned utilities in the United States, even after the enactment of rate increases in 2001 and 2002. See “Regulatory Issues-Power Cost Deferrals” and “Regulatory Issues-General Rate Cases” for further information.

Avista Utilities sells and purchases electric capacity and energy to and from utilities and other entities in the wholesale market under long-term contracts having terms of more than one year. In addition, Avista Utilities engages in an ongoing process of resource optimization which involves short-term purchases and sales in the wholesale market in pursuit of an economic selection of resources to serve retail and wholesale loads. Avista Utilities makes continuing projections of (1) future retail and wholesale loads based on, among other things, forward estimates of factors such as customer usage and weather as well as historical data and contract terms and (2) resource availability based on, among other things, estimates of streamflows, generating unit availability, historic and forward market information and

3

Table of Contents

AVISTA CORPORATION

experience. On the basis of these continuing projections, Avista Utilities makes purchases and sales of energy on an annual, quarterly, monthly, daily and hourly basis to match actual resources to actual energy requirements. This process includes hedging transactions.

Participants in the electric wholesale market include other utilities, federal marketing agencies and power marketers. The electric wholesale market has changed significantly over the last few years with respect to market participants involved, level of activity, variability in market prices, liquidity, Federal Energy Regulatory Commission (FERC)-imposed price caps and counterparty credit issues. During 2000 and the first half of 2001, the electric wholesale market in the WECC region was more turbulent than previously experienced and marked by significant volatility, service disruptions and defaults by certain participants. During the second half of 2001 and 2002 wholesale market prices and volatility both decreased to levels similar to those experienced before 2000. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Power Market Issues” for more information.

Challenges facing Avista Utilities’ electric operations include, among other things, the timing of the recovery of deferred power supply costs, changes in the availability of and volatility in the prices of power and fuel, generating unit availability, legislative and governmental regulations, potential tax law changes, customer response to price increases and surcharges, streamflows and weather conditions. Avista Utilities may also be exposed to refunds for wholesale power sales depending on the outcome of the FERC’s retroactive price cap proceeding for the Pacific Northwest; however, Avista Utilities would have the opportunity to assert offsetting claims. See “Industry Restructuring,” “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Power Market Issues” and “Note 1 of Notes to Consolidated Financial Statements” for additional information.

Electric Requirements

The peak electric load requirement for 2002 was 1,855 MW (including retail native load of 1,389 MW, long-term wholesale obligations of 320 MW and short-term wholesale obligations of 146 MW). This peak occurred on July 12, 2002 at which time the maximum resource capacity available from Avista Utilities was 2,287 MW. The maximum resource capacity included 1,362 MW of company-owned electric generation, 119 MW of long-term hydroelectric contracts, 210 MW of other long-term wholesale purchases and 596 MW of short-term wholesale purchases. Variations in energy usage by Avista Utilities’ customers occur from year to year, from season to season and hour to hour as a result of varying weather conditions and other energy usage behaviors. This necessitates a continual balancing of loads and resources, and requires both purchases and sales of energy for annual, quarterly, monthly, daily and hourly periods in order to meet electric requirements and to prudently manage and optimize available resources.

Electric Resources

General Avista Utilities’ diverse electric resource mix of hydroelectric projects, thermal generating facilities, and power purchases and exchanges, enables it to remain a low-cost and reliable provider of electric energy. At the end of 2002, Avista Utilities’ facilities had a total net capability of approximately 1,511 MW, of which 64 percent was hydroelectric and 36 percent was thermal. See “Avista Utilities Operating Statistics – Electric Operations” for energy resource statistics.

Hydroelectric Resources Hydroelectric generation is Avista Utilities’ lowest cost source per MWh of electricity and the availability of hydroelectric generation has a significant effect on its total power supply costs. Under normal streamflow and operating conditions, Avista Utilities projects that it would be able to meet approximately one-half of its total electric requirements (both retail and long-term wholesale) with its own hydroelectric generation and long-term hydroelectric contracts with certain Public Utility Districts in Washington state. Total hydroelectric resource generation (both company-owned and purchased under long-term hydroelectric contracts) was 4.8 million MWhs in 2002, compared to 3.2 million MWhs in 2001 and 4.7 million MWhs in 2000.

Total hydroelectric resources (including resources purchased under long-term hydroelectric contracts) generate 550 average megawatts (aMW) (or 4.8 million MWhs) annually under normal streamflow conditions. Hydroelectric resources generated 553 aMW during 2002. The streamflows to company-owned hydroelectric projects were 112 percent, 56 percent and 86 percent of normal in 2002, 2001 and 2000, respectively. In a “critical water” year (defined by the Northwest Power Pool as the worst water conditions on record), Avista Utilities would expect hydroelectric generation of 400 aMW, 150 aMW below normal. Hydroelectric generation for the year 2001 was 369 aMW, which was 181 aMW below normal and the lowest level in the 73 years in which records have been kept. The combination of low hydroelectric production and other factors resulted in Avista Utilities incurring power supply costs during the second half of 2000 and the year 2001 significantly in excess of the amount of power supply costs recovered through retail rates in effect at the time. See “Regulatory Issues – Power Cost Deferrals” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Avista Utilities-Regulatory Matters” for more information.

4

Table of Contents

AVISTA CORPORATION

The following table shows Avista Utilities’ hydroelectric generation (in thousands of MWhs) during the years ended December 31:

Thermal Resources Avista Utilities owns a 15 percent interest in a twin-unit, coal-fired generating facility, the Colstrip 3 & 4 Generating Project (Colstrip) in southeastern Montana. Additionally, Avista Utilities owns a wood-waste-fired generating facility known as the Kettle Falls Generating Station (Kettle Falls) in northeastern Washington and a two-unit natural gas-fired CT generating facility, located in northeast Spokane (Northeast CT). Avista Utilities also leases and operates a two-unit natural gas-fired CT generating facility in northern Idaho (Rathdrum CT). In addition, Avista Utilities owns two small generating facilities (Boulder Park and Kettle Falls CT) that were placed into service in 2002.

Avista Utilities owns a 50 percent interest in the natural gas-fired Coyote Springs 2 located near Boardman, Oregon. It is expected that Coyote Springs 2 will be placed into operation in the middle of 2003. In January 2003, Avista Power’s 50 percent ownership interest in Coyote Springs 2 was transferred to Avista Corp. for inclusion in Avista Utilities’ power generation resource portfolio. In May 2002, a transformer at Coyote Springs 2 failed and caught fire resulting in the release of an estimated 17,000 gallons of coolant oil. The Company worked closely with the appropriate environmental agencies to complete a satisfactory cleanup of the oil. In December 2002, the replacement transformer was received, but it was determined to be damaged. The problems with the transformer have delayed the scheduled completion of Coyote Springs 2 from the third quarter of 2002 to the middle of 2003.

Until May 2000, Avista Utilities had a 15 percent interest in a twin-unit, coal-fired generating facility, the Centralia Power Plant (Centralia) in western Washington. In May 2000, the owners of Centralia sold the plant to TransAlta. Avista Utilities is purchasing energy from TransAlta to replace the output from Centralia for the period from July 1, 2000 through December 31, 2003, excluding April, May and June of each year. Avista Utilities receives approximately 200 megawatts per hour during the term of the contract.

Fuel Supply for Thermal Resources Coyote Springs 2, which will be operated by Portland General Electric, will be supplied with natural gas under natural gas supply contracts through October 2004, and transportation agreements with unilateral renewal rights are in place.

Colstrip, which is operated by PPL Global, Inc., is supplied with fuel from adjacent coal reserves under coal supply and transportation agreements in effect through December 2019.

Kettle Falls’ primary fuel is wood-waste generated as a by-product from forest industry operations within 100 miles of the plant. Natural gas may be used as an alternate fuel. A combination of long-term contracts plus spot purchases provides Avista Utilities the flexibility to meet expected future fuel requirements for the plant.

The Northeast CT, Rathdrum CT, Boulder Park and Kettle Falls CT are generating units that are primarily used for peaking electric requirements. Due to the shortage of hydroelectric generation during 2000 and 2001 and the relative operating cost compared to higher wholesale market prices, the Northeast CT and Rathdrum CT units were operated on a more frequent basis. These generating facilities have access to natural gas supplies that are adequate to meet their respective operating needs.

5

Table of Contents

AVISTA CORPORATION

The following table shows Avista Utilities’ thermal generation (in thousands of MWhs) during the years ended December 31:

Purchases, Exchanges and Sales Avista Utilities purchases power under various long-term contracts. Avista Utilities also enters into a significant number of short-term sales and purchases with terms of up to one year.

Under the Public Utility Regulatory Policies Act of 1978 (PURPA), Avista Utilities is required to purchase generation from qualifying facilities, including small hydroelectric and cogeneration projects, at rates approved by the Washington Utilities and Transportation Commission (WUTC) and the Idaho Public Utilities Commission (IPUC). These contracts expire at various times through 2022.

See “Avista Utilities Operating Statistics – Electric Operations - Electric Energy Resources” for more detailed information with respect to purchased power and power from exchanges in 2002, 2001 and 2000.

Future Resource Needs

Avista Utilities has operational strategies to ensure that it has available resources sufficient to meet the increased demand for energy. The following is a forecast of Avista Utilities’ average energy requirements and resources for the period 2003 through 2005:

Forecasted Electric Energy Requirements and Resources
(aMW)

(1)		Preliminary forecasts and snowpack conditions indicate streamflows are expected to be approximately 70 percent of normal in 2003. Avista Utilities currently estimates that hydroelectric generation will be 458 aMW in 2003, which is 92 aMW below normal. The forecasts for 2004 and 2005 assume normal water conditions, which is the mean of the 60 years between 1928 and 1988.
(2)		Forecast assumes that Coyote Springs 2 will be placed in operation in mid-2003.
(3)		Forecast assumes no generation from the Northeast CT, Rathdrum CT, Kettle Falls CT and Boulder Park, which are generally only used to meet electric load requirements due to either below normal hydroelectric generation and increased loads, and/or when operating costs are lower than short-term wholesale market prices. The combined maximum capacity of the Northeast CT, Rathdrum CT, Kettle Falls CT and Boulder Park is 274 MW.

Significant Customer A contract with Potlatch Corporation (Potlatch), expired on December 31, 2001. Potlatch’s Lewiston, Idaho facility has electric requirements of about 100 aMW. The facility also produces approximately 60 aMW of self-generation. The parties have agreed that Potlatch will receive electric service from Avista at the retail tariff rates established for large industrial customers. Potlatch is currently using its generation for its own electric requirements,

6

Table of Contents

AVISTA CORPORATION

which results in a net electric requirement on Avista Utilities’ system of approximately 40 aMW. In December 2002, Potlatch filed a complaint with the IPUC requesting that Avista Utilities be required to purchase its self-generation at a rate equivalent to Avista Utilities’ avoided costs. Hearings before the IPUC are currently scheduled for June 2003.

Hydroelectric Relicensing

Avista Corp. is a licensee under the Federal Power Act, which regulates certain of its hydroelectric generation resources, as administered by the FERC. Avista Corp.’s licensed projects are subject to the provisions of Part I of the Federal Power Act. These provisions include payment for headwater benefits, condemnation of licensed projects upon payment of just compensation, and take-over of such projects after the expiration of the license upon payment of the lesser of “net investment” or “fair value” of the project, in either case, plus severance damages. All but the Little Falls Plant of the Company’s hydroelectric plants are regulated by the FERC through project licenses issued for 30-50 year periods.

In February 2000, Avista Utilities received a 45-year operating license from the FERC for the Cabinet Gorge and Noxon Rapids Hydroelectric Generating Projects. The Clark Fork Settlement Agreement that was entered into during 1999 and incorporated into the FERC license, preserved the projects’ economic peaking and load following operations. Also, as part of the Clark Fork Settlement Agreement, Avista Utilities initiated implementation of protection, mitigation and enhancement measures in March 1999. Measures in the agreement, which cost approximately $4.7 million annually, address issues related to fisheries, water quality, wildlife, recreation, land use, cultural resources and erosion. Recovery of previously deferred hydroelectric relicensing costs, as well as estimated levels of ongoing costs associated with implementation of the Clark Fork Settlement Agreement, were addressed by both the WUTC and IPUC and received favorable regulatory recovery treatment. Costs of approximately $15 million deferred during the licensing phase were allowed in rate base and are being amortized over the 45-year license term. See “Item 2. Properties - Avista Utilities” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Future Outlook” for additional information.

The issue of high levels of dissolved gas which exceed Idaho and federal water quality standards downstream of the Cabinet Gorge Hydroelectric Generating Project (Cabinet Gorge) during spill periods continues to be studied, as agreed to in the Clark Fork Settlement Agreement and incorporated in the renewed FERC license. To date, intensive biological studies in the lower Clark Fork River and Lake Pend Oreille have documented minimal biological effects of high dissolved gas levels on free ranging fish. Under the terms of the Clark Fork Settlement Agreement, the Company developed an abatement and mitigation strategy during 2002 with the other signatories to the agreement. In December 2002, the Company submitted its plan for review and approval by the other signatories as well as the FERC. The structural alternative proposed in the plan provides for the modification of the two existing diversion tunnels built when Cabinet Gorge was originally constructed. The costs of modifications to the first tunnel are currently estimated to be $37 million (including allowance for funds used during construction (AFUDC) and inflation) and would be incurred between 2004 and 2009. The second tunnel would be modified only after evaluation of the performance of the first tunnel and such modifications would commence no later than 10 years following the completion of the first tunnel. It is currently estimated that the costs to modify the second tunnel would be $23 million (including AFUDC and inflation). As part of the plan, the Company will also provide $0.5 million annually commencing as early as 2004, as mitigation for aquatic resources that might be adversely affected by high dissolved gas levels. Mitigation funds will continue until the modification of the second tunnel commences or if the second tunnel is not modified to an agreed upon point in time commensurate with the biological effects of high dissolved gas levels. The Company will seek regulatory recovery of the costs for the modification of Cabinet Gorge and the mitigation payments.

The Company operates six hydroelectric plants on the Spokane River, and five of these (Long Lake, Nine Mile, Upper Falls, Monroe Street and Post Falls) are under one FERC license and referred to herein as the Spokane River Project. The sixth, Little Falls, operates under separate Congressional authorization and is not licensed by the FERC. The license for the Spokane River Project expires in August 2007; the Company filed a Notice of Intent to Relicense on July 29, 2002. The formal consultation process involving planning and information gathering with stakeholder groups is underway. The Company’s goal is to develop with the stakeholders a comprehensive and cost-effective settlement agreement to be filed as part of the Company’s license application to the FERC in July 2005.

Natural Gas Operations

Avista Utilities provides natural gas distribution services to retail customers in parts of Washington, Idaho, Oregon and California. Natural gas commodity costs in excess of the amount recovered in current rates are deferred and recovered in future periods with applicable regulatory approval through adjustments to rates. Market prices for natural gas continue to be competitive compared to alternative fuel sources for residential, commercial and industrial customers. Avista Utilities believes that natural gas should sustain its market advantage based on the levels of existing reserves and potential natural gas development in the future. Growth has occurred in the natural gas business in recent years due to

7

Table of Contents

AVISTA CORPORATION

increased demand for natural gas in new construction, as well as conversions from electric space, oil space and electric water heating to natural gas.

Avista Utilities makes sales and provides transportation service directly to large natural gas customers. The majority of Avista Utilities’ large industrial customers purchase their own natural gas requirements through natural gas marketers. For these customers, Avista Utilities provides transportation from its pipeline interconnection to the customers’ premises. Thirteen of Avista Utilities’ largest natural gas customers are provided natural gas transportation service under individual contracts. These negotiated contracts were entered into to retain these customers who can either by-pass Avista Utilities’ distribution system or have competitive alternative fuel capability. All individual contracts are subject to regulatory review and approval. The competitive nature of the natural gas spot market results in savings in the cost of purchased natural gas, which encourages large customers with fuel-switching capabilities to continue to utilize natural gas for their energy needs when economic. The total volume transported on behalf of transportation customers for 2002, 2001 and 2000 was 174.9, 180.9 and 224.8 million therms, which represented approximately 34 percent, 33 percent and 38 percent of Avista Utilities’ total system deliveries, respectively.

Challenges facing Avista Utilities’ natural gas operations include, among other things, volatility in the price of natural gas, the timing of recovery of increased commodity costs, customer response to changes in prices, changes in the availability of natural gas, legislative and governmental regulations and weather conditions.

Natural Gas Resources

Natural Gas Supply Natural gas supplies are available from domestic and Canadian sources through both long- and short-term, or spot market, purchases. Avista Utilities has capacity delivery rights on seven pipelines and owns natural gas storage facilities. A diverse portfolio of natural gas resources allows Avista Utilities to capture market opportunities that benefit its natural gas customers.

The Company’s energy trading and marketing subsidiary, Avista Energy, is responsible for the daily management and optimization of these resources for the requirements of customers in the states of Washington, Idaho and Oregon under an agreement with Avista Utilities. Under this relationship, Avista Utilities retains ownership of its transportation, storage and long-term contracts and Avista Energy acts as an agent to optimize these important resources. See “Regulatory Issues: Natural Gas Benchmark Mechanism” and “Note 1 of Notes to Consolidated Financial Statements” for additional information.

Approximately 25 percent of Avista Utilities’ natural gas supplies are obtained from domestic sources, with the remaining 75 percent from Canadian sources. Nearly all natural gas purchased from Canadian sources is contracted in U.S. dollars, limiting any foreign currency exchange exposure. Canadian natural gas supplies are not considered to be at greater risk of non-delivery than supplies from the United States.

Jackson Prairie Natural Gas Storage Project (Jackson Prairie) Avista Utilities owns a one-third interest in Jackson Prairie, an underground natural gas storage field located near Chehalis, Washington. Jackson Prairie has a total peak day deliverability of 8.8 million therms, with a total working natural gas inventory of 190.3 million therms. The role of Jackson Prairie in providing flexible natural gas supplies is important to Avista Utilities’ natural gas operations. It enables Avista Utilities to place natural gas into storage when prices are low or to meet minimum natural gas purchasing requirements, as well as to meet high demand periods or to withdraw natural gas from storage when spot prices are high. During 1999, the capacity at Jackson Prairie was increased. This increased capacity is being operated and managed by Avista Energy for a ten-year period with Avista Energy incurring the associated costs of the increased capacity. During 2002, a multi-year project to further increase the capacity at Jackson Prairie commenced. Avista Utilities has contracted to release a total of approximately 37 percent of its Jackson Prairie capacity to two other utilities. One of these contracts requires two-years notice for termination and one contract is renewed on a year-to-year basis.