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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

(Mark One)

OR

Commission file number 1-3701

AVISTA CORPORATION

(Exact name of Registrant as specified in its charter)

Registrant’s telephone number, including area code: 509-489-0500

Web site: http://www.avistacorp.com

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

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

Title of Class

Preferred Stock, Cumulative, Without Par Value

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes  x    No  ¨

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.

Yes  ¨    No  x

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:

Yes  x    No  ¨

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.  x

Indicate by check mark whether the registrant is a large accelerated filer, accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):

Yes  ¨    No  x

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 $902,211,367 based on the last reported sale price thereof on the consolidated tape on June 30, 2005.

As of February 28, 2006, 48,617,354 shares of Registrant’s Common Stock, no par value (the only class of common stock), were outstanding.

Documents Incorporated By Reference

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INDEX

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* = not an applicable item in the 2005 calendar year for the Company

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ACRONYMS AND TERMS

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

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PART I

This Annual Report on Form 10-K contains forward-looking statements, which 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 - 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,” “may,” “could,” “should,” “intends,” “plans,” “seeks,” “anticipates,” “estimates,” “expects,” “forecasts,” “projects,” “predicts,” and similar expressions. All forward-looking statements are subject to a variety of risks and uncertainties and other factors, most of which are beyond the control of Avista Corporation and many of which could have a significant effect on Avista Corporation’s operations, results of operations, financial condition or cash flows and could cause actual results to differ materially from those anticipated in such statements.

Available Information

The Web site address of Avista Corporation (Avista Corp. or the Company) is 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.

Company Overview

Avista Corp., incorporated in the State of Washington in 1889, is an energy company engaged in the generation, transmission and distribution of energy as well as other energy-related businesses. As of December 31, 2005, the Company employed approximately 1,435 people in its utility operations and approximately 550 people in its subsidiary businesses. The Company’s corporate headquarters are in Spokane, Washington, center of the Inland Northwest geographic region. Agriculture, mining and lumber were the primary industries in the Inland Northwest for many years; today health care, education, finance, electronic and other manufacturing, tourism and the service sectors are growing in importance.

The Company has four business segments – Avista Utilities, Energy Marketing and Resource Management, Avista Advantage and Other. Avista Capital, a wholly owned subsidiary of Avista Corp., is the parent company of all of the subsidiary companies in the non-utility business segments. The Company’s total common stockholders’ equity was $771.1 million as of December 31, 2005 of which $237.7 million represented its investment in Avista Capital.

Avista Utilities is an operating division of Avista Corp. comprising the regulated utility operations that started in 1889. Avista Utilities generates, transmits and distributes electricity and distributes natural gas. Avista Utilities also engages in wholesale purchases and sales of electricity and natural gas. Avista Utilities expects to continue to be among the industry leaders in performance, value and service in its electric and natural gas utility businesses. Based on Avista Utilities’ forecast for electric customer growth of 2.5 percent and natural gas customer growth of 4 percent within its service area, Avista Utilities anticipates retail electric and natural gas load growth will average between 3 and 3.5 percent annually for the next four years. As part of Avista Utilities’ strategy to focus on its business in the northwestern United States, in April 2005, the Company completed the sale of its natural gas properties in South Lake Tahoe, California (see “Note 28 of the Notes to Consolidated Financial Statements”). This was the Company’s only regulated utility operation in California.

The Energy Marketing and Resource Management business segment is comprised of Avista Energy, Inc. (Avista Energy) and Avista Power, LLC (Avista Power). Avista Energy, which commenced operations in 1997, is an electricity and natural gas marketing, trading and resource management business, operating primarily in the Western Electricity Coordinating Council (WECC) geographical area, which is comprised of eleven Western states and the provinces of British Columbia and Alberta, Canada. Avista Energy focuses on optimization of generation assets owned by other entities, long-term electric supply contracts, natural gas storage, and electric transmission and natural gas transportation arrangements. Avista Energy is also involved in trading electricity and natural gas, including derivative commodity instruments. Avista Energy Canada, Ltd. (Avista Energy Canada) is a wholly owned subsidiary of Avista Energy that provides natural gas services to end-user industrial and commercial customers in British Columbia, Canada. In addition to earnings and resulting cash flows from settled or realized transactions, Avista Energy records unrealized or mark-to-market adjustments for the change in the value of derivative commodity instruments. Avista Energy continues to seek opportunities to expand its business of optimizing generation assets

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owned by other entities and has expanded its natural gas end-user business to industrial and commercial customers in Montana. Avista Power’s primary asset is its 49 percent interest in a 270 megawatt (MW) natural gas-fired combined cycle combustion turbine plant in northern Idaho (Lancaster Project).

Avista Advantage, Inc. (Avista Advantage) is a provider of facility information and cost management services for multi-site customers throughout North America. Its primary product lines include consolidated billing, resource accounting, energy analysis and load profiling services. Avista Advantage remains focused on increasing revenues, controlling operating expenses, continuously enhancing client satisfaction and developing complementary value-added services in a competitive market. During the first quarter of 2005, Avista Advantage acquired TelAssess, Inc. Although not a significant financial transaction, this acquisition provides Avista Advantage a foundation on which to expand beyond utility bill information services to provide similar services relating to telecom expense management.

The Other business segment includes Avista Ventures, Inc. (Avista Ventures), Pentzer Corporation (Pentzer), Avista Development, Advanced Manufacturing and Development (AM&D) and certain other operations of Avista Capital. The Company continues to limit its future investment in the Other business segment.

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

See “Item 6. Selected Financial Data” and “Note 29 of the Notes to Consolidated Financial Statements” for information with respect to the operating performance of each business segment.

In February 2006, the Board of Directors of Avista Corp. made the decision to ask shareholders to approve a change in the Company’s organization, which would result in the formation of a holding company. See further information at “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Potential Holding Company Formation.”

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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 electricity and natural gas as part of its resource management and load-serving obligations.

Avista Utilities provides electric distribution and transmission as well as natural gas distribution services in parts of eastern Washington and northern Idaho with a population of approximately 865,000. It also provides natural gas distribution service in parts of northeast and southwest Oregon with a population of approximately 470,000. At the end of 2005, Avista Utilities supplied retail electric service to a total of 338,000 customers and retail natural gas service to a total of 297,000 customers across its entire service territory. As part of Avista Utilities’ strategy to focus on its business in the northwestern United States, in April 2005, the Company completed the sale of its natural gas properties in South Lake Tahoe, California (see “Note 28 of the Notes to Consolidated Financial Statements”). This was the Company’s only regulated utility operation in California. See “Item 2. Properties” for further information with respect to Avista Utilities’ electric distribution and transmission assets, as well as natural gas distribution assets.

See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Economic and Load Growth” for information with respect to projected load growth in Avista Utilities’ service territory.

Electric Operations

In addition to providing electric distribution and transmission services, Avista Utilities generates electricity from facilities that it owns. It is Avista Utilities’ strategy to own or to have contracts that provide a sufficient amount of electric resources to meet its retail and wholesale energy requirements under a range of operating conditions. In addition to company-owned resources, Avista Utilities has a number of long-term power purchase and exchange contracts that increase its available resources.

Avista Utilities engages in an ongoing process of resource optimization, which involves the pursuit of economic resources to serve load obligations and using existing resources to capture available economic value. Avista Utilities sells and purchases wholesale electric capacity and energy to and from utilities and other entities as part of the process of acquiring resources to serve its retail and wholesale load obligations. These transactions range from a term as short as one hour up to long-term contracts that extend beyond one year. 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 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 expected resources to expected energy requirements. Resource optimization also includes transactions such as purchasing fuel to run thermal generation and, when economic, selling fuel and substituting electric wholesale market purchases for the operation of Avista Utilities’ own resources, as well as other wholesale transactions to capture the value of available generation and transmission resources. This optimization process includes entering into financial and physical hedging transactions as a means of managing risks.

Avista Utilities’ generation assets are interconnected through its transmission system and are operated on a coordinated basis to achieve a high level of load-serving capability and reliability. Avista Utilities offers transmission and ancillary services in eastern Washington, northern Idaho and western Montana. Avista Utilities’ Open Access Same-Time Information System (OASIS) is part of the Joint Transmission Services Information Network that covers much of the United States. Transmission revenues, which are included in Other Electric Revenues at “Avista Utilities Operating Statistics – Electric Operations,” totaled $11.0 million, $13.9 million and $11.6 million for 2005, 2004 and 2003, respectively. Avista Utilities is currently in the process of enhancing its transmission system. The transmission system project is expected to cost approximately $115 million, of which $67 million has been incurred as of December 31, 2005.

Challenges facing Avista Utilities’ electric operations include, among other things, streamflows to hydroelectric generating facilities, weather conditions, changes in the availability of and volatility in the prices of power and fuel, the timing and approval of the recovery of deferred power costs, generating unit availability, legislative and governmental regulations, potential tax law changes, and customer response to price increases and surcharges. See “Industry Restructuring,” “Item 1A. Risk Factors,” “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Business Risk and – Risk Management” and “Note 1 of Notes to Consolidated Financial Statements” for additional information.

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Electric Requirements

The peak electric native load requirement for 2005 occurred on December 8, 2005 at which time native load was 1,660 MW, long-term wholesale obligations were 172 MW and short-term wholesale obligations were 110 MW. At that time the maximum resource capacity available from Avista Utilities was 2,556 MW, which included 1,816 MW of company-owned electric generation, 70 MW of long-term hydroelectric contracts, 316 MW of other long-term wholesale purchases and 354 MW of short-term wholesale purchases. Variations in energy usage by Avista Utilities’ customers occur as a result of varying weather conditions and other energy usage behaviors. This necessitates a continual balancing of loads and resources, and requires both wholesale 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 has a diverse electric resource mix of hydroelectric projects, thermal generating facilities, and power purchases and exchanges. At the end of 2005, Avista Utilities’ owned facilities had a total net capability of approximately 1,800 MW, of which 54 percent was hydroelectric and 46 percent was thermal. See “Item 2. Properties” for detailed information with respect to generating facilities.

Hydroelectric Resources Avista Utilities owns and operates six hydroelectric projects on the Spokane River and two hydroelectric projects on the Clark Fork River. Hydroelectric generation is Avista Utilities’ lowest cost source per megawatt-hour (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 average electric requirements (both retail and long-term wholesale) with the combination of its own hydroelectric generation and long-term hydroelectric purchase contracts with certain Public Utility Districts (PUDs) in Washington state. Avista Utilities estimates that normal annual hydroelectric generation (including resources purchased under long-term hydroelectric contracts with certain PUDs) is 538 average megawatts (aMW) (or 4.7 million MWhs). This is a decrease from previous estimates of normal annual hydroelectric generation of 550 aMW (or 4.8 million MWhs) primarily due to changes in long-term hydroelectric contracts with certain PUDs during 2005. Hydroelectric resources generated 511 aMW, 523 aMW and 492 aMW during 2005, 2004 and 2003, respectively. Hydroelectric generation has been below normal (based on a 70-year average) for 5 of the past 6 years. Avista Utilities cannot determine if this trend of lower than normal hydroelectric generation will continue in future years.

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

Thermal Resources Since January 2005, Avista Utilities has owned 100 percent of the combined cycle natural gas-fired Coyote Springs 2 Generation Project (Coyote Springs 2) located near Boardman, Oregon. Prior to January 2005, Avista Utilities owned 50 percent of Coyote Springs 2. 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. Avista Utilities owns a wood-waste-fired generating facility known as the Kettle Falls Generating Station (Kettle Falls GS) in northeastern Washington and a two-unit natural gas-fired CT generating facility, located in northeast Spokane (Northeast CT). Avista Utilities also owns a two-unit natural gas-fired CT generating facility in northern Idaho (Rathdrum CT). In 2005, Avista Utilities acquired the Rathdrum CT from WP Funding LP, an entity that was included in Avista Corp.’s consolidated financial statements and included in the Avista Utilities business segment. In addition, Avista Utilities owns two small generating facilities (Boulder Park and Kettle Falls CT).

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Fuel Supply for Thermal Resources Coyote Springs 2, which is operated by Portland General Electric Corporation, is supplied with natural gas under both term contracts and spot market purchases, and has transportation agreements with unilateral renewal rights in place.

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

The primary fuel for the Kettle Falls GS is wood-waste generated as a by-product and delivered by trucks 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 and spot purchases have provided and are expected to meet, future fuel requirements for the Kettle Falls GS.

The Northeast CT, Rathdrum CT, Boulder Park and Kettle Falls CT generating units are primarily used for peaking electric requirements and are also operated when marginal costs are below prevailing wholesale electric prices. These generating units have not been operated significantly in 2005, 2004 and 2003. These generating facilities have access to natural gas supplies that are adequate to meet their respective operating needs.

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 and sells power under various long-term contracts. Avista Utilities also enters into a significant number of short-term purchases and sales with terms of up to one year. See “Electric Operations” for additional information with respect to Avista Utilities’ use of wholesale purchases and sales as part of its resource optimization process.

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 between 2015 and 2022. In February 2006, the PURPA was amended by the Federal Energy Regulatory Commission (FERC) as required by the Energy Policy Act of 2005. These amendments are not expected to have an effect on Avista Utilities’ current PURPA-related contracts.

See “Avista Utilities Operating Statistics – Electric Operations – Electric Energy Resources” for annual quantities of purchased power, wholesale power sales and power from exchanges in 2005, 2004 and 2003.

Hydroelectric Relicensing

Avista Corp. is a licensee under the Federal Power Act as administered by the FERC, which includes regulation of hydroelectric generation resources. Except for the Little Falls Plant, all of the Company’s hydroelectric plants are regulated by the FERC through project licenses issued for 30 to 50 year periods. 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.

In March 2001, Avista Utilities received a 45-year operating license from the FERC for the Cabinet Gorge Hydroelectric Generating Project (Cabinet Gorge) and the Noxon Rapids Hydroelectric Generating Project (Noxon Rapids). 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

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agreement address issues related to fisheries, water quality, wildlife, recreation, land use, cultural resources and erosion. 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 recovery through retail rates.

See “Clark Fork Settlement Agreement” in “Note 26 of the Notes to Consolidated Financial Statements” for disclosure of dissolved atmospheric gas levels that exceed state of Idaho and federal water quality standards downstream of the Cabinet Gorge during periods when excess river flows must be diverted over the spillway and the Company’s mitigation plans and efforts.

The Company owns and 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 are referred to, collectively, as the Spokane River Project. The sixth, Little Falls, is operated under separate Congressional authority and is not licensed by the FERC. The license for the Spokane River Project expires on August 1, 2007; the Company filed a Notice of Intent to Relicense in July 2002. The formal consultation process involving planning and information gathering with stakeholder groups has been underway since that time. The Company filed its license application with the FERC in July 2005. The Company has requested the FERC to consider a license for Post Falls that is separate from the other four hydroelectric plants. This is due to the fact that Post Falls presents more complex issues that may take longer to resolve than those dealing with the rest of the Spokane River Project. If granted, new licenses would have a term of 30 to 50 years. In the license application, the Company has proposed a number of measures intended to address the impact of the Spokane River Project and enhance resources associated with the Spokane River. Currently, certain environmental measures in the Company’s license application have estimated costs of $3.2 million per year. For certain items, costs cannot be reasonably estimated at this time. The total annual operating and capitalized costs associated with the relicensing of the Spokane River Project will become better known and estimable as the process continues through July 2007. The Company intends to seek recovery of relicensing costs through the rate making process.

Future Resource Needs

Avista Utilities has operational strategies to have available resources sufficient to meet its energy requirements under a range of operating conditions. These operational strategies consider the amount of energy needed over hourly, daily, monthly and annual durations, which vary widely because of the factors that influence demand. The following is a forecast of Avista Utilities’ average annual energy requirements and resources for 2006, 2007, 2008 and 2009:

Forecasted Electric Energy Requirements and Resources

(aMW)

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In October 2005, Avista Utilities submitted its 2005 Electric Integrated Resource Plan (IRP) to the WUTC and the IPUC. The IRP identifies a strategic resource portfolio that meets future electric load requirements, promotes environmental stewardship and meets Avista Utilities’ obligation to provide reliable electric service to customers at rates, terms and conditions that are fair, just and reasonable and sufficient. Avista Utilities regards the IRP as a tool for resource evaluation, rather than an acquisition plan for a particular project. Based on the assumptions in the IRP, Avista Utilities forecasts that quarterly energy deficits will begin in 2007 and annual energy deficits will begin in 2010. In order to meet these increased demands, Avista Utilities’ preferred resource plan, which is part of the IRP, includes 400 MW of wind power, 250 MW of coal-based generation, 80 MW of biomass, 52 MW of generation plant upgrades and 69 MW of conservation by 2016. In January 2006, Avista Utilities issued a request for proposals (RFP) to consider adding approximately 35 average megawatts of long-term renewable energy supplies. It is expected that deliveries of any energy supplies from this RFP would begin in the fourth quarter of 2007. In early 2006, Avista Utilities has also entered into an agreement with Idaho Power to jointly investigate possible future coal-based generation resources.

Natural Gas Operations

General Avista Utilities provides natural gas distribution services to retail customers in parts of eastern Washington, northern Idaho, as well as parts of northeast and southwest Oregon. Natural gas commodity costs in excess of, or which fall below, the amount recovered in current retail rates are deferred and recovered or refunded as a pass-through to customers in future periods with applicable regulatory approval through adjustments to rates.

During recent years, natural gas prices have been volatile with a general upward trend. Avista Utilities’ average prices per dekatherm were $8.13, $6.62 and $5.50 in 2005, 2004 and 2003, respectively. This continued upward price trend has resulted in increased rates for customers and lengthened the recovery period for deferred natural gas costs. Market prices for natural gas continue to be competitive compared to alternative fuel sources for residential, commercial and industrial customers, and Avista Utilities believes that natural gas should sustain its long-term market advantage over competing energy sources based on the levels of existing reserves and potential natural gas development in the future. In order to maintain that competitive advantage and to offset increasing demand, natural gas must be used more efficiently. Avista Utilities is committed to encouraging efficient use of natural gas and has several incentive programs available to its customers.

Challenges facing Avista Utilities’ natural gas operations include, among other things, volatility in the price of natural gas, increases in the price of natural gas, changes in the availability of natural gas, legislative and governmental regulations, weather conditions and the timing and approval of recovery for increased natural gas costs.

Avista Utilities offers natural gas sales and transportation service to large natural gas customers. The majority of Avista Utilities’ large industrial customers purchase natural gas through marketers. For these customers, Avista Utilities provides transportation services for a fee to move the customers’ natural gas through Avista Utilities’ distribution system from the natural gas transmission pipeline delivery points to the customers’ premises. Several of Avista Utilities’ largest natural gas customers are provided natural gas transportation service under individual contracts. All individual contracts are subject to regulatory review and approval. The total volume transported on behalf of transportation customers for 2005, 2004 and 2003 was 153.0, 154.4 and 153.4 million therms, which represented approximately 27 percent, 31 percent and 31 percent of Avista Utilities’ total system deliveries, respectively.

As part of the process of balancing natural gas retail load requirements and resources obtained through wholesale purchases, Avista Utilities engages in wholesale sales of natural gas. This activity has increased significantly in 2005 due to the transition of natural gas procurement activities from Avista Energy to Avista Utilities with the termination of the Agency Agreement (see discussion below).

Natural Gas Supply Avista Utilities does not have any natural gas reserves and purchases all of its natural gas in the wholesale market. Avista Utilities is connected to multiple supply basins in the western United States and western Canada and believes there will be sufficient supplies of natural gas to meet its customers’ needs. Natural gas prices in the Pacific Northwest are affected by global energy markets, as well as supply and demand factors in other regions of the United States and Canada. Avista Utilities has capacity delivery rights on six pipelines and owns natural gas storage facilities. Access to a diverse portfolio of natural gas resources allows Avista Utilities to make natural gas procurement decisions that benefit its natural gas customers. Approximately 25 percent of Avista Utilities’ natural gas supplies are obtained from domestic sources, with the remaining 75 percent from Canadian sources.

From 1999 through March 31, 2005, the Company’s energy marketing, trading and resource management subsidiary, Avista Energy, was responsible for natural gas procurement functions, including the daily management and optimization of these natural gas resources for the requirements of customers in the states of Washington, Idaho and Oregon under the Natural Gas Benchmark Mechanism and related Agency Agreement with Avista Utilities. Effective April 1, 2005, the Natural Gas Benchmark Mechanism and related Agency Agreement were terminated and the management of natural gas

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procurement functions was moved from Avista Energy back to Avista Utilities. This was required for Washington customers by WUTC orders issued in February 2004, and Avista Utilities’ resulting transition plan approved by the WUTC in April 2004. The Company also elected to move these functions back to Avista Utilities for Idaho and Oregon natural gas customers.

Natural Gas Storage Avista Utilities owns a one-third interest in the Jackson Prairie Natural Gas Storage Project (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 221.4 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. Avista Energy controls a portion of the capacity at Jackson Prairie for a ten-year period ending in 2009. 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.

Regulatory Issues

General Avista Corp., as a regulated public utility, is currently subject to regulation by state utility commissions with respect to prices, accounting, the issuance of securities, and other matters. The retail electric and natural gas operations are subject to the jurisdiction of the WUTC, the IPUC, the Oregon Public Utility Commission (OPUC), and the Public Service Commission of the State of Montana (Montana Commission). Approval of the issuance of securities is not required from the Montana Commission. The Company is also subject to the jurisdiction of the FERC for its wholesale natural gas rates charged for the release of capacity from Jackson Prairie, licensing of hydroelectric generation resources, and for electric transmission service and wholesale sales.

In each regulatory jurisdiction, rates for retail electric and natural gas services (other than specially negotiated retail rates for industrial or large commercial customers, which are subject to regulatory review and approval) are determined on a “cost of service” basis and are designed to provide, after recovery of allowable operating expenses, an opportunity to earn a reasonable return on “rate base.” “Rate base” is generally determined by reference to the original cost (net of accumulated depreciation) of utility plant in service, subject to various adjustments for deferred taxes and other items. Over time, rate base is increased by additions to utility plant in service and reduced by depreciation and retirement of utility plant and write-offs as determined by the utility commissions. Rates for wholesale electric and natural gas transmission services are based on either “cost of service” principles or market-based rates as set forth by the FERC. See “Note 1 of Notes to Consolidated Financial Statements” for additional information about regulation, depreciation and deferred income taxes. See “Industry Restructuring” for additional information about deregulation, as well as changes with respect to transmission and wholesale electricity markets. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Energy Policy Act of 2005” for information on the Energy Policy Act.

General Rate Cases Avista Utilities regularly reviews the need for electric and natural gas rate changes in each state in which it provides service. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Avista Utilities – Regulatory Matters – General Rate Cases” for information on general rate case activity.

Power Cost Deferrals Avista Utilities defers the recognition in the income statement of certain power supply costs that are in excess of the level currently recovered from retail customers as authorized by the WUTC and the IPUC. A portion of power supply costs are recorded as a deferred charge on the balance sheet for future review and the opportunity for recovery through retail rates. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Avista Utilities – Regulatory Matters – Power Cost Deferrals and Recovery Mechanisms” and “Note 1 - Power Cost Deferrals and Recovery Mechanisms of the Notes to Consolidated Financial Statements” for detailed information on Avista Utilities’ power cost deferrals and recovery mechanisms in Washington and Idaho.

Purchased Gas Adjustment (PGA or Natural Gas Trackers) Under established regulatory practices in each respective state, Avista Utilities is allowed to adjust its natural gas rates periodically (with regulatory approval) to reflect increases or decreases in the cost of natural gas purchased. Differences between actual natural gas costs and the natural gas costs included in retail rates are deferred and charged or credited to expense when regulators approve inclusion of the cost changes in rates. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Avista Utilities – Regulatory Matters – Purchased Gas Adjustments” for information on natural gas rate increases to recover increased natural gas costs.

Residential Exchange Program The Residential Exchange Program provides access to the benefits of low-cost federal hydroelectricity to residential and small-farm customers of the region’s investor-owned utilities. The Bonneville Power Administration (BPA) administers the Residential Exchange Program. Avista Corp. has executed an agreement with the BPA in settlement of each party’s rights and obligations related to the Residential Exchange Program for the period

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October 1, 2001 through September 30, 2011. The benefits that Avista Corp. receives under the agreement with the BPA are passed through directly to residential and small-farm customers via a credit to their monthly electric bills. The current BPA rate period began on October 1, 2001 and continues through September 30, 2006. In 2004, Avista Corp. and other investor-owned utilities entered into amended agreements to provide benefits to customers during the rate period from October 1, 2006 through September 30, 2011.

Numerous parties have filed Petitions for Review in the Ninth Circuit Court of Appeals challenging the agreements between Avista Corp. and the BPA, as well as the BPA’s agreements with other investor-owned utilities. These challenges could possibly affect the amount of benefits paid by the BPA to Avista Corp. However, since these benefits are passed through to customers as adjustments to electric rates, which must be approved by the WUTC and the IPUC, the outcome of these Petitions for Review is not expected to have a significant effect on Avista Corp.’s financial condition or results of operations.

Industry Restructuring

Energy Policy Act of 2005 In August 2005, the Energy Policy Act of 2005 (Energy Policy Act) was passed into law. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Energy Policy Act of 2005” for information on the Energy Policy Act.

Federal Level Industry restructuring to open the electric wholesale energy market to competition was initially promoted by federal legislation. The Energy Policy Act of 1992 (1992 Energy Act) expanded the authority of the FERC to issue orders requiring electric utilities to transmit power and energy to or for wholesale purchasers and sellers, and to require electric utilities to enlarge or construct additional transmission capacity for the purpose of providing these services. It also created “exempt wholesale generators,” a class of independent power plant owners that are able to sell generation only at the wholesale level. This permits public utilities and other entities to participate through subsidiaries in the development of independent electric generating plants for sales to wholesale customers.

FERC orders issued in the mid-1990s require public utilities operating under the Federal Power Act to provide access to their transmission systems to third parties and establish an OASIS to provide transmission customers with information about available transmission capacity and other information by electronic means. FERC orders also require each public utility subject to the rule to functionally separate its transmission and wholesale power merchant functions.

In November 2003, the FERC issued a final rule (FERC Order No. 2004) revising the standards of conduct applicable to jurisdictional electric transmission providers and natural gas pipelines (collectively defined by the rule as “transmission providers”) and their “energy affiliates.” FERC Order No. 2004 replaces the previous natural gas and electricity standards of conduct with new unified standards of conduct applicable to both electric and natural gas transmission providers, and dramatically expands the range of affiliated entities covered by the standards. The standards of conduct are designed to ensure that transmission providers do not provide preferential access to service or information to affiliated entities. FERC Order No. 2004 became effective in February 2004 upon each transmission provider completing its filing with the FERC and posting on its OASIS or its Internet Web site its plan for implementing the revised standards of conduct. By June 2004, each transmission provider was required to comply with the new rule’s requirements and post procedures enabling customers and the FERC to determine whether the transmission provider complies with the new standards. Avista Utilities has complied with the revised standards, which have not had any substantive impact on the operation, maintenance and marketing of its transmission system or Avista Utilities’ ability to provide service to its customers.

The North American Electric Reliability Council (NERC) and the WECC have undertaken initiatives to establish a series of security coordinators to oversee the reliable operation of the regional transmission system. Accordingly, Avista Utilities, in cooperation with other utilities in the Pacific Northwest, established the Pacific Northwest Security Coordinator (PNSC) in the late-1990s, which oversees daily and short-term operations of the Northwest sub-regional transmission grid and has limited authority to direct certain actions of control area operators in the case of a pending transmission system emergency.

The utility industry experienced a significant blackout in August 2003, when 50 million people lost power in the northeastern United States and eastern Canadian provinces. As a result of this outage, the NERC, in conjunction with the FERC, conducted a comprehensive investigation of the outage and issued certain reliability related recommendations. These recommendations addressed compliance with existing national and regional standards and initiatives to prevent or mitigate future blackouts. Utilities in the western United States, including Avista Utilities, had already been following the provisions of approximately half of these NERC recommendations and Avista Utilities already complies with many of the remaining NERC recommendations.

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In February 2005, the NERC Board of Trustees approved reliability standards with the goal of restating existing standards in a manner that is clear, unambiguous, measurable and enforceable. These reliability standards became effective April 1, 2005. Also in February 2005, the FERC issued an order to supplement its April 2004 policy statement, which interprets the term “Good Utility Practice” as that term is used in the Open Access Transmission Tariff, to include compliance with reliability standards developed by the NERC. To comply with applicable standards, Avista Utilities submits annual reliability compliance reports to the NERC.

In February 2006, the FERC issued its final rule on the certification rules for a single Electric Reliability Organization (ERO). This organization, once certified, will have the authority to establish and enforce reliability standards, and will have the ability to delegate authority to regional entities for the purpose of establishing and enforcing reliability standards. The FERC intends to provide adequate time to transition from the current system of voluntary reliability standards to mandatory standards under the ERO. The Company continues with its involvement in the NERC compliance process and expects to be involved in the transition to the ERO or regional compliance process.

Regional Transmission Organizations FERC Order No. 2000 required all utilities subject to FERC regulation to file a proposal to form a Regional Transmission Organization (RTO), or a description of efforts to participate in an RTO, and any existing obstacles to RTO participation. FERC Order No. 2000 is a follow-up to FERC Orders No. 888 and No. 889 issued in 1996, which required transmission owners to provide non-discriminatory transmission service to third parties. While it has not formally withdrawn Order No. 2000, the FERC has issued orders and made public policy statements indicating its support for the development and formation of regional independently-governed transmission organizations that is developed by the region and that does not necessarily meet all of the functions and characteristics of an RTO outlined in Order No. 2000.

Since prior to the FERC’s Order No. 2000, Avista Utilities has been participating in discussions with utilities and others in the Pacific Northwest to develop the structure of an independently-governed transmission organization for the region. Interim bylaws governing continuing developmental activities for a non-profit membership corporation, Grid West, were adopted in December 2004. During 2005, certain regional parties explored an alternative structure that did not involve creation of an independently-governed organization. In September 2005, a proposal to converge the two alternatives under the Grid West organization emerged; however, a consensus was not achieved. As a result, Grid West was restructured into a non-member organization in November of 2005, with fewer participating transmission owners, and has been evaluating alternative implementation plans, which work is now in progress. Avista Utilities continues in these discussions regarding a reduced set of initial functions and geographical scope for Grid West, and will participate in discussions regarding other structural approaches that include those regional transmission provider systems currently not participating in the Grid West organization.

The final proposal for any RTO must be filed with the FERC and approved by the boards of directors of the filing companies and regulators in various states. The Company’s decision to move forward with the formation of any RTO serving the Pacific Northwest region, as well as the legal, financial and operating implications of such decisions, will ultimately depend on the terms and conditions related to the formation of the entities and conditions established in the regulatory approval process. The Company cannot predict these implications.

State Level While the 1992 Energy Act precludes the FERC from mandating retail wheeling, state regulators and legislators could open service territories to full competition at the retail level. Legislative action at the state level would be required for full retail wheeling and customer choice to occur in Washington and Idaho. Public policy makers in Washington and Idaho continue to examine other states’ experiences with restructuring, while cognizant that the Pacific Northwest generally benefits from electric rates that are among the lowest in the country. There is currently no movement toward deregulation in Washington or Idaho.

Environmental Issues

General The Company is subject to environmental regulation by federal, state and local authorities. The generation, transmission, distribution, service and storage facilities in which Avista Utilities has an ownership interest were designed to comply with all applicable environmental laws. Furthermore, the Company conducts periodic reviews of all its facilities and operations to respond to or to anticipate emerging environmental issues. The Company’s Board of Directors has a committee to oversee environmental issues.

Since December 1991, a number of species of fish in the Northwest, including the Snake River sockeye salmon and fall chinook salmon, the Kootenai River white sturgeon, the upper Columbia River steelhead, the upper Columbia River spring chinook salmon and the bull trout, have been listed as threatened or endangered under the Federal Endangered Species Act. Thus far, measures that were adopted and implemented to save the Snake River sockeye salmon and fall chinook salmon have not directly impacted generation levels at any of Avista Utilities’ hydroelectric facilities. Avista

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Utilities does, however, purchase power under long-term contracts with PUDs on the Columbia River that are directly impacted by ongoing mitigation measures for salmon and steelhead. The reduction in generation at these projects is relatively minor, resulting in minimal economic impact on Avista Utilities at this time. It is currently not possible to accurately predict the likely economic costs to the Company resulting from future actions. The Company received a 45-year FERC operating license for Cabinet Gorge and Noxon Rapids in March 2001 that incorporates a comprehensive settlement agreement. The restoration of native salmonid fish, particularly bull trout, is a key part of the agreement. The result is a collaborative bull trout recovery program with the U.S. Fish and Wildlife Service, Native American tribes and the states of Idaho and Montana on the lower Clark Fork River, consistent with requirements of the FERC license. See “Hydroelectric Relicensing” for further information.

Air Quality The most significant impact on the Company related to the Clean Air Act (CAA) and the 1990 Clear Air Act Amendments (CAAA) pertains to Colstrip, which is a “Phase II” coal-fired plant under the CAAA. Avista Utilities does not expect Colstrip to be required to implement any additional sulfur dioxide (SO2) mitigation in the foreseeable future in order to continue operations. Avista Utilities’ other thermal projects are subject to various CAAA standards. Every five years each of the other thermal projects requires an updated operating permit (known as a Title V permit), which addresses, among other things, the compliance of the plant with the CAAA. The operating permit for the Rathdrum CT was renewed in 2001 (expires in 2006 and the Company has applied for renewal) and the operating permit for the Kettle Falls GS was renewed in 2002 (expires in 2007). The Northeast CT was issued a Title V permit in February 2004 (expires in 2009). Boulder Park does not require a Title V permit based on its limited output and instead has a synthetic minor permit that does not expire. Coyote Springs 2 has a Title V permit that was issued in 2003 (expires in 2008).

In 1999, the Environmental Protection Agency (EPA) initiated enforcement actions against several utilities, asserting that older, coal-fired power plants operated by those utilities have, over the years, been modified in ways that subject them to more stringent requirements under the CAA. The EPA has since issued notices of violation and commenced enforcement activities against other utilities. The future direction of the EPA’s enforcement initiative is presently unclear. Therefore, at this time, Avista Utilities is unable to predict whether such EPA enforcement actions will be made against Colstrip. However, the EPA regional office that regulates plants in Montana has indicated an intention to issue information requests to all utilities in their jurisdiction and issued such a request to Colstrip in 2003. The owners of Colstrip began the process of responding to this information request. However, the EPA has stayed further production of Colstrip documents pending discussion among the Colstrip owners and the EPA. Avista Utilities cannot presently predict what action, if any, the EPA might take in this matter.

See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Environmental Issues and Other Contingencies “ for further information.

Water Quality See “Clark Fork Settlement Agreement” in “Note 26 of the Notes to Consolidated Financial Statements” regarding dissolved atmospheric gas levels that exceed state of Idaho and federal water quality standards downstream of the Cabinet Gorge.

Other Environmental Issues See “Colstrip Generating Project Complaint,” “Environmental Protection Agency Administrative Compliance Order,” “Hamilton Street Bridge,” “Spokane River,” “Harbor Oil Inc. Site,” “Northeast Combustion Turbine Site” and “Other Contingencies” in “Note 26 of the Notes to Consolidated Financial Statements” for information with respect to additional environmental issues.

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AVISTA UTILITIES OPERATING STATISTICS

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AVISTA UTILITIES OPERATING STATISTICS

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Energy Marketing and Resource Management

The Energy Marketing and Resource Management business segment includes Avista Energy and Avista Power, both subsidiaries of Avista Capital.

Avista Energy

Avista Energy is an electricity and natural gas marketing, trading and resource management business, operating primarily within the WECC. Avista Energy’s headquarters are in Spokane, Washington, and it also has natural gas marketing offices in Vancouver, British Columbia, Canada and Great Falls, Montana (which opened in early 2006). Avista Energy focuses on optimization of generation assets owned by other entities, long-term electric supply contracts, natural gas storage, and electric transmission and natural gas transportation arrangements. Avista Energy is also involved in trading electricity and natural gas, including derivative commodity instruments. Avista Energy Canada, Ltd. (Avista Energy Canada) is a wholly owned subsidiary of Avista Energy that provides natural gas services to approximately 200 end-user industrial and commercial customers that represent approximately 400 sites in British Columbia, Canada. Avista Energy’s marketing, trading and resource management activities 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 Energy continues to seek opportunities to expand its business of optimizing generation assets owned by other entities and has expanded its natural gas end-user business to industrial and commercial customers in Montana. Avista Energy’s earnings are primarily derived from the following activities:

Avista Energy trades electricity and natural gas, along with derivative commodity instruments including futures, options, swaps and other contractual arrangements. Most transactions are conducted on an “over-the-counter” basis. Avista Energy’s trading operations are affected by, among other things, volatility of prices within the electric energy and natural gas markets, the demand for and availability of energy, changing regulation of the electric and natural gas industries, the creditworthiness of counterparties and variations in liquidity in energy markets. See “Item 1A. Risk Factors,” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Business Risk and – Risk Management” for further information.

In addition to its trading activities, a fundamental component of Avista Energy’s business strategy is having asset management and optimization agreements with other entities, which helps create synergies within its entire portfolio. Under this strategy, Avista Energy does not have ownership of the physical energy assets, which allows Avista Energy to focus on commodity management while minimizing responsibilities and risks associated with actual ownership. Avista Energy assists the asset owner with decisions regarding the operation of their generation assets to capture available economic value and shares in the benefits derived from optimization. This process includes transactions such as purchasing fuel to run thermal generation and, when economic, selling fuel and substituting market purchases for the operation of the generating asset. Optimization also includes other transactions to capture the value of available generation, transmission and transportation resources. This optimization process is combined with other portions of Avista Energy’s business, including electric and natural gas trading, to maximize the value of Avista Energy’s entire portfolio, within established risk management policies.

The following table provides operating statistics for Avista Energy for the years ended December 31:

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Avista Energy managed Avista Utilities’ natural gas storage assets, transportation contracts and natural gas purchasing operations from 1999 through March 31, 2005 under an Agency Agreement. Under that agreement, Avista Energy served as the natural gas supply agent for Avista Utilities, including purchasing natural gas for Avista Utilities’ retail customers. Effective April 1, 2005, the Agency Agreement was terminated and the management of natural gas procurement functions was moved from Avista Energy back to Avista Utilities. The termination of the Agency Agreement was required for Washington customers by WUTC orders issued in February 2004, and Avista Utilities’ resulting transition plan was approved by the WUTC in April 2004. The Company also elected to move these functions back to Avista Utilities for Idaho and Oregon natural gas customers.

Avista Power

Avista Power’s primary asset is its 49 percent ownership interest in the Lancaster Project. The Lancaster Project capacity is contracted to Avista Energy through 2026 through a power purchase agreement. The power purchase agreement gives Avista Energy the right to purchase natural gas for generation, and convert to electricity for a fixed fee. Avista Power is not seeking additional investment opportunities.

Avista Advantage

Avista Advantage is a provider of facility information and cost management services for multi-site customers throughout North America. Through invoice processing, auditing, payment services and comprehensive reporting, Avista Advantage’s solutions are designed to provide companies with critical and easy-to-access information that enables them to proactively manage and reduce their utility, telecom and waste management expenses.

As part of their process, Avista Advantage analyzes and audits invoices, then presents consolidated bills on-line, as well as processes payments for these expenses. Information gathered from invoices, providers and other customer-specific data allows Avista Advantage to provide its clients with in-depth analytical support, real-time reporting and consulting services.

Avista Advantage has secured five patents on its two critical business systems: the Facility IQ^™ system, which provides operational information drawn from facility bills, and the AviTrack^™ database, which processes and reports on information gathered from service providers to ensure customers are receiving the most effective services at the proper price. Avista Advantage is not aware of any claimed or threatened infringement on any of its patents issued to date and will continue to expand and protect its existing patents, as well as file additional patent applications for new products, services and process enhancements.

As of December 31, 2005, Avista Advantage serviced 348 customers, having 174,910 billed sites throughout North America. This is an increase from 323 customers and 141,442 billed sites as of December 31, 2004. As of December 31, 2003, Avista Advantage serviced 292 customers and 109,583 billed sites. During 2005, Avista Advantage processed $9.3 billion of bills, an increase from $7.6 billion in 2004 and $6.4 billion in 2003.

Other

The Other business segment includes Avista Ventures, Pentzer, Avista Development and certain other operations of Avista Capital. Included in this business segment is AM&D doing business as METALfx, a subsidiary of Avista Ventures that performs custom sheet metal fabrication of electronic enclosures, parts and systems for the computer, telecom and medical industries. AM&D also performs contract assembly for radiant floor heating systems. Other significant investments in this segment include commercial office buildings, investments in low income housing and venture capital partnerships, the remaining investment in a previous fuel cell subsidiary of the Company, and notes receivable from the sale of property and investments. Over time as opportunities arise, the Company plans to continue to dispose of assets and phase out operations in the Other business segment. However, the Company may, from time to time, invest incremental funds in these businesses to protect its existing investments.

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Risk Factors

The following are factors that could have a significant impact on the operations, results of operations, financial condition or cash flows of Avista Corp. and could cause actual results or outcomes to differ materially from those discussed in Avista Corp.’s reports filed with the Securities and Exchange Commission (including this Annual Report on Form 10-K), and elsewhere. In addition to these risk factors, please also see the “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Forward-Looking Statements” for additional factors which could have a significant impact on Avista Corp.’s operations, results of operations, financial condition or cash flows and could cause actual results to differ materially from those anticipated in such statements.

Avista Corp.’s results of operations, financial condition and cash flows can be significantly affected by weather.

Weather has a significant effect on Avista Utilities’ operations, both with respect to customer demand and resulting operating revenues (primarily heating requirements in the winter and cooling requirements in the summer) and electric resource costs (primarily the availability of hydroelectric generation and the tendency for high demand to increase the cost of fuel for electric generation and wholesale electric market prices). Avista Utilities normally experiences its highest retail (electric and natural gas) energy sales during the heating season in the first and fourth quarters of the year. Avista Utilities also experiences high electricity demand for air conditioning during the summer (third quarter). In general, warmer weather in the heating season and colder weather in the cooling season will have a negative effect on Avista Utilities’ operating revenues. In addition, a reduction in precipitation (particularly snowpack) will decrease hydroelectric generation capability and increase resource costs and cash outflows to purchase electric resources. Hydroelectric generation has been below normal (based on a 70-year average) for 5 of the past 6 years. Avista Corp. has no way to predict whether this trend of lower than normal hydroelectric generation will continue in the future. Regional precipitation and snowpack conditions can also have a significant effect on the wholesale price of electricity.

Avista Corp. is subject to commodity price risk.

Both Avista Utilities and Avista Energy are subject to electric and natural gas commodity price risk. Price risk is, in general, the risk of fluctuation in the market price of the commodity needed, held or traded. Changes in wholesale energy prices can affect, among other things, the cash requirements to purchase electricity and natural gas for retail customers or wholesale obligations, as well as the market value of derivative assets and liabilities and unrealized gains and losses. In the case of electricity, prices can be affected by the adequacy of generating reserve margins, scheduled and unscheduled outages of generating facilities, availability of streamflows for hydroelectric generation on a regional basis, the price and availability of fuel for thermal generating plants, and disruptions of or constraints on transmission facilities, among other things. Natural gas prices are affected by a number of factors, including but not limited to, the adequacy of North American production, the level of imports, the level of inventories, the demand for natural gas as fuel for electric generation, global energy markets, and the availability of pipeline capacity to transport natural gas from region to region. In addition, oil prices can influence natural gas and electricity prices, because of the fuel-switching capabilities of certain energy users. Demand changes caused by variations in the weather and other factors can also affect market prices for electricity and natural gas. Any combination of these factors that results in a shortage of energy generally causes the market price to move upward.

Increasing energy commodity prices have a significant effect on liquidity for both Avista Utilities and Avista Energy. Avista Utilities has regulatory mechanisms in place that provide for the deferral and recovery of the majority of its power and natural gas supply costs. However, if prices increase, deferral balances will increase, which will negatively affect Avista Corp.’s operating cash flow and liquidity until such costs, with interest, are recovered from customers.

Avista Utilities’ deferred power and natural gas costs are subject to regulatory review; costs in excess of levels recovered in base rates reduce cash flows and it may take several years to recover current balances of deferred costs.

Avista Utilities defers the recognition in the income statement of certain power and natural gas costs that are in excess of the level currently recovered from its retail customers as authorized by the WUTC, the IPUC and the OPUC. These excess power and natural gas costs are recorded as deferred charges on the Consolidated Balance Sheet with the opportunity for recovery through future retail rates. These deferred power and natural gas costs are

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subject to review by the WUTC, IPUC and OPUC, as applicable, for prudence and as such certain deferred costs may be disallowed by the respective regulatory agencies.

Despite the opportunity to eventually recover a substantial portion of power and natural gas costs in excess of the levels currently recovered from retail customers, Avista Utilities’ operating cash flows are negatively affected in the periods in which these costs are paid. Factors that could cause costs to exceed the levels currently recovered from Avista Utilities’ customers include, but are not limited to, higher prices in wholesale markets combined with an increased need to purchase energy in the wholesale markets. Factors beyond Avista Utilities’ control that could result in an increased need to purchase energy in the wholesale markets include, but are not limited to, increases in demand (either due to weather or customer growth), low availability of hydroelectric resources, outages at generating facilities and failure of third parties to deliver on energy or capacity contracts.

Avista Utilities currently expects that the recovery of current balances of deferred power and natural gas costs may take several years.

Avista Utilities is subject to the risk that regulators will not grant sufficient recovery of its costs and not provide a reasonable rate of return for Avista Corp.’s shareholders.

Avista Utilities regularly reviews the need for electric and natural gas rate changes in each state in which it provides service. General rate increases granted since 2002 have been important steps in Avista Corp.’s financial recovery primarily through increased operating revenues and operating cash flows. Avista Utilities anticipates that it will continue to periodically file for general rate increases with regulatory agencies to recover its costs and provide a reasonable return to Avista Corp.’s shareholders. If regulators were to grant substantially lower rate increases than Avista Utilities requests in the future, it could have a negative effect on operating revenues and cash flows, which could result in future downgrades to its credit ratings or prevent Avista Corp. from improving its credit ratings.

Avista Corp. is subject to credit risk.

Avista Utilities and Avista Energy are subject to credit risk. Credit risk relates to the losses that Avista Utilities and/or Avista Energy would incur as a result of non-performance by counterparties of their contractual obligations to deliver energy or make financial settlements. Avista Utilities and Avista Energy often extend credit to counterparties and customers and are exposed to the risk that they may not be able to collect amounts owed to them. Changes in market prices may dramatically alter the size of credit risk with counterparties, even when conservative credit limits have been established. Credit risk includes the risk that a counterparty may default due to circumstances relating directly to it, circumstances caused by market price changes and also the risk that a counterparty may default due to circumstances that relate to other market participants that have a direct or indirect relationship with such counterparty. Should a counterparty, customer or supplier fail to perform, Avista Utilities and/or Avista Energy may be required to replace existing contracts with contracts at then-current market prices or to honor the underlying commitment.

Avista Energy has concentrations of suppliers and customers in the electric and natural gas industries including but not limited to, electric utilities, natural gas distribution companies, and other energy marketing and trading companies. In addition, Avista Energy has concentrations of credit risk related to geographic location, as Avista Energy operates in the western United States and western Canada. These concentrations of counterparties and concentrations of geographic location may negatively affect Avista Energy’s overall exposure to credit risk, because the counterparties may be similarly affected by changes in economic, regulatory or other conditions.

Credit risk also involves the exposure that counterparties perceive related to the ability of Avista Utilities and Avista Energy to perform deliveries and settlement under physical and financial energy contracts. These counterparties may seek assurances of performance in the form of letters of credit, prepayment or cash deposits, and, in the case of Avista Energy, parent company (Avista Capital) performance guarantees. In periods of price volatility, the level of exposure can change significantly, with the result that sudden and significant demands may be made against the Company’s capital resource reserves (credit facilities and cash).

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Avista Corp.’s commodity trading, marketing and resource management activities may increase the volatility in its results of operations; Avista Corp. cannot, and does not attempt to, fully hedge its assets or positions against changes in commodity prices, and its hedging procedures may not fully match the corresponding purchase or sale.

Avista Energy engages in commodity trading and marketing, as well as resource management activities. These activities include entering into financial and physical derivative transactions, and taking speculative positions on future price movements, within established risk management policies. Avista Energy is required by applicable accounting principles to record all derivatives on the Consolidated Balance Sheet at estimated fair value. Changes in the estimated fair value of derivatives are immediately recognized in earnings unless they are designated as cash flow hedges of forecasted transactions. Changes in the estimated fair value of derivatives accounted for as cash flow hedges of forecasted transactions are deferred and recorded as a component of accumulated other comprehensive income (loss) until the hedged transactions occur and are recognized in earnings. Most of Avista Energy’s derivative contracts are marked-to-market and changes in their value caused by fluctuations in the underlying commodity prices, flow through Avista Corp.’s Consolidated Statements of Income. As a result, fluctuations in commodity prices and the corresponding effect on the market value of derivative instruments could have a significant effect on Avista Corp.’s operating revenues, resource costs, derivative assets and liabilities, and operating cash flows.

To reduce financial and economic exposure related to commodity price fluctuations, Avista Utilities and Avista Energy routinely enter into contracts to hedge a portion of their purchase and sale commitments for electricity and natural gas, as well as inventories of natural gas. As part of this strategy, Avista Utilities and Avista Energy routinely utilize derivative instruments, such as forwards, futures, swaps and options traded in the over-the-counter markets or on exchanges. However, Avista Utilities and Avista Energy do not always cover the entire exposure of assets or positions to market price volatility and the coverage will vary over time. To the extent Avista Utilities or Avista Energy have unhedged positions, or if hedging positions do not fully match the corresponding purchase or sale, fluctuating commodity prices could have a material adverse effect on Avista Corp.’s operating revenues, resource costs, derivative assets and liabilities, and operating cash flows.

Avista Corp.’s risk management procedures may not prevent losses.

Avista Utilities and Avista Energy have risk management policies and control procedures designed to measure and mitigate energy market risks. However, these policies and procedures cannot prevent material losses in all possible situations or from all potential causes. Included in Avista Energy’s risk management policies are value-at-risk (VAR) limits and systematic measurement procedures derived from historic price behavior. VAR measures the expected portfolio loss under hypothetical adverse price movements over a given time interval within a given confidence level. Losses could exceed the VAR predictive amounts if prices deviate significantly from their historic patterns and in cases when actual events fall into the extreme end of the VAR confidence interval. In addition, continuing trends of small losses that may be individually less than VAR limits may cumulatively become significant. As a result of these and other factors, there can be no assurance that Avista Utilities’ and Avista Energy’s risk management procedures will prevent losses that could negatively affect its operating revenues, resource costs, derivative assets and liabilities, and operating cash flows.

Avista Corp. relies on access to credit from banks.

Avista Corp. needs to maintain access to adequate levels of credit with its banks. Avista Corp. has in place a committed line of credit in the amount of $350 million, which is scheduled to expire in December 2009. Avista Corp. cannot predict whether it will have access to credit beyond the expiration date. The line of credit contains customary covenants and default provisions. In the event of default, it would be difficult for Avista Corp. to obtain financing on any reasonable terms to pay creditors or fund operations, and Avista Corp. would likely be prohibited from paying dividends on its common stock.

Avista Energy also needs access to adequate levels of credit from banks and currently has a $145 million committed line of credit, which is scheduled to expire in July 2007. Avista Corp. cannot predict whether Avista Energy will have access to credit after the expiration of its current line of credit. Avista Energy’s credit agreement contains customary covenants and default provisions, including but not limited to, covenants to maintain “minimum net working capital” and “minimum net worth”, as well as a covenant limiting the amount of indebtedness that the co-borrowers (Avista Energy and Avista Energy Canada) may incur. The credit agreement also contains covenants and other restrictions related to Avista Energy’s trading limits and positions, including but not limited to, VAR limits, restrictions with respect to changes in risk management policies or volumetric limits, and limits on exposure related to hourly and daily trading of electricity. These covenants, certain counterparty agreements and market liquidity conditions result in Avista Energy maintaining certain levels of cash and therefore effectively limit the amount of cash dividends that are available for distribution to Avista Capital and ultimately Avista Corp. If Avista Energy were

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unable to continue to obtain credit from banks or other lenders, Avista Energy would likely not have sufficient liquidity to meet its obligations.

Any default on the line of credit or other financing arrangements of Avista Corp. or any of its significant subsidiaries (including Avista Energy) could result in cross-defaults to other agreements of such entity, and/or to the line of credit or other financing arrangements of any other of such entities, and could induce vendors and other counterparties to demand collateral.

A downgrade in Avista Corp.’s credit rating could limit its ability to obtain financing or adversely affect the terms of financing.

Avista Corp.’s credit ratings were downgraded during the fourth quarter of 2001 resulting in an overall corporate credit rating that is below investment grade. The downgrades were due to liquidity concerns primarily related to the significant amount of purchased power and natural gas costs incurred and the resulting increase in debt levels and debt service costs. Avista Corp. continues to work towards restoring an overall corporate investment grade credit rating. However, any future downgrades could limit Avista Corp.’s ability to issue debt securities or obtain other financing at reasonable interest rates. In addition, future downgrades could require Avista Corp. to provide letters of credit and/or collateral to lenders and counterparties.

An increase in interest rates could negatively affect Avista Corp.’s future results of operations and cash flows.

During the years 2006 through 2008, utility capital expenditures are currently expected to be in the range of $160 million to $175 million per year. In addition to continuing needs for Avista Utilities’ distribution system, significant projects include the continued enhancement of Avista Utilities’ transmission system and upgrades to generating facilities. Avista Corp. also has approximately $567 million of long-term debt maturities and mandatory preferred stock redemptions between 2006 and 2008, with the majority occurring in 2007 and 2008. Avista Corp.’s forecasts indicate that it will need to issue new securities to fund a significant portion of these requirements. In 2004, Avista Corp. entered into forward-starting interest rate swap agreements to effectively lock in market fixed interest rates, which are relatively low compared to historical interest rates, for $200 million of forecasted debt issuances. However, with respect to the remaining debt that Avista Corp. expects to issue, rising interest rates could increase Avista Corp.’s future debt service costs and decrease operating cash flows.

Avista Corp. is subject to various operational and event risks, which are common to the utility industry.

Avista Utilities, Avista Corp.’s regulated utility operation, is subject to operational and event risks including, among others, increases or decreases in load demand, blackouts or disruptions to transmission or transportation systems, fuel quality, forced outages at generating plants and disruptions to information systems and other administrative tools required for normal operations.

Avista Utilities also has exposure to natural disasters and terrorism threats that can cause physical damage to its property, requiring repairs to restore utility service.

Avista Corp. may not be able to relicense its hydroelectric facilities located on the Spokane River at a cost-effective level with reasonable terms and conditions.

Avista Corp. owns and 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 Federal Energy Regulatory Commission (FERC) license and are referred to as the Spokane River Project. The sixth, Little Falls, is operated under separate Congressional authority and is not licensed by the FERC. The license for the Spokane River Project expires on August 1, 2007; Avista Corp. filed its license application with the FERC in July 2005. Avista Corp. has requested the FERC to consider a license for Post Falls that is separate from the other four hydroelectric plants. This is due to the fact that Post Falls presents more complex issues that may take longer to resolve than those dealing with the rest of the Spokane River Project. The FERC may impose certain environmental, operating and other conditions in connection with the new licenses that could result in significant capital expenditures, higher operating costs and/or reduced hydroelectric generation capability. Avista Corp. plans to request regulatory approval to recover these costs. However, Avista Corp. cannot estimate the magnitude of these costs or provide certainty that they will be recovered through the rate making process.

In 2001, Avista Corp. received a 45-year operating license from the FERC for the Cabinet Gorge Hydroelectric Generating Project and the Noxon Rapids Hydroelectric Generating Project, which represent approximately 80 percent of Avista Corp.’s current hydroelectric generating capability. The Spokane River facilities represent approximately 20 percent of Avista Corp.’s current hydroelectric generating capability.

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Avista Corp. is currently the subject of several regulatory proceedings and named in multiple lawsuits with respect to its participation in Western energy markets as disclosed in “Note 26 of the Notes to Consolidated Financial Statements.”

Avista Energy and Avista Utilities are involved in a number of legal and regulatory proceedings and complaints with respect to power markets in the western United States. Most of these proceedings and complaints relate to the significant increase in the spot market price of energy in western power markets in 2000 and 2001, which allegedly contributed to or caused unjust and unreasonable prices. These proceedings and complaints include, but are not limited to, refund proceedings and hearings in California and the Pacific Northwest, market conduct investigations by the FERC, and complaints and cross-complaints filed by various parties with respect to alleged misconduct by other parties in western power markets. In addition, a class action shareholder complaint has been filed against Avista Corp. and certain current and former executive officers based on alleged misconduct in western power markets. As a result of these proceedings and complaints, certain parties have asserted claims for significant refunds and damages from Avista Corp. and its subsidiaries, which could result in a negative effect on Avista Corp.’s results of operations and cash flows. See “Note 26 of the Notes to Consolidated Financial Statements” for further information.

Avista Corp. has contingent liabilities as disclosed in “Note 26 of the Notes to Consolidated Financial Statements.” Avista Corp. cannot predict the outcome of these matters.

Avista Corp. has multiple matters that are the subject of ongoing litigation, mediation, investigation and/or negotiation. Avista Corp. cannot predict the ultimate outcome or potential impact of any particular issue, including the extent, if any, of insurance coverage or the extent, if any, that amounts payable by Avista Corp. may be recoverable through the rate making process. See “Note 26 of the Notes to Consolidated Financial Statements” for further details of these matters.

Lake Coeur d’Alene Matter

Avista Corp. is liable for compensation (not yet determined as to amount) for the use of portions of the bed and banks of Lake Coeur d’Alene and the St. Joe River, which were determined to be property of the Coeur d’Alene Tribe of Idaho. Avista Corp. is engaged with the Tribe in discussions with respect to past and future compensation (which may include interest) for use of the portions of the bed and banks of the Lake that are owned by the Tribe. If the parties cannot agree on the amount of compensation, the matter could result in litigation.

Montana Hydroelectric Litigation

A lawsuit was filed in Montana against all private owners of hydroelectric dams in Montana, including Avista Corp., alleging that the hydroelectric facilities are located on state-owned riverbeds and the owners have never paid compensation to the state’s public school trust fund. The lawsuit was originally filed by private parties and was subsequently joined by other public parties, including the Attorney General of the State of Montana. Various motions for summary judgment and counter claims are pending in federal and state courts.

Environmental Matters

Avista Corp. is subject to environmental regulation by federal, state and local authorities with respect to its past, present and future operations. Environmental issues include, but are not limited to, contamination of certain parcels of land that Avista Corp. currently owns, has formerly owned or has used as a customer, contamination of certain parcels of land and waters adjacent to Avista Corp.’s property, contamination of certain portions of the Spokane River as well as the levels of dissolved gas in waters downstream of Avista Corp.’s hydroelectric facilities and the resulting impact on free ranging fish.

Avista Corp. is subject to the risk from the potential effects of any legislation or administrative rulemaking.

Avista Corp. has been and is expected to continue to be impacted by legislation at the national and state level, as well as by administrative rules promulgated by government agencies, such as the FERC, NERC and the EPA. Future legislation or administrative rules could have a material adverse effect on Avista Corp.’s operations, results of operations, financial condition and cash flows.

As of the filing date of this Annual Report on Form 10-K, Avista Corp. does not have any unresolved comments from the staff of the Securities and Exchange Commission.

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Avista Utilities

Avista Utilities’ electric properties, located in the states of Washington, Idaho, Montana and Oregon, include the following:

Generation Properties

Electric Distribution and Transmission Plant

Avista Utilities operates approximately 17,000 miles of primary and secondary electric distribution lines. Avista Utilities has an electric transmission system of approximately 625 miles of 230 kV line and 1,539 miles of 115 kV line. Avista Utilities also owns an 11 percent interest (representing 465 MW capacity) in 495 miles of a 500 kV line between Colstrip, Montana and Townsend, Montana. The transmission and distribution system also includes numerous substations with transformers, switches, monitoring and metering devices, and other equipment related to its operation.