MGE ENERGY INC (MGEE) FY 2021 MD&A

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.

General

MGE Energy is an investor-owned public utility holding company operating through subsidiaries in five business segments:

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Regulated electric utility operations, conducted through MGE,

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Regulated gas utility operations, conducted through MGE,

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Nonregulated energy operations, conducted through MGE Power and its subsidiaries,

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Transmission investments, representing our equity investment in ATC and ATC Holdco, and

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All other, which includes corporate operations and services.

Our principal subsidiary is MGE, which generates and distributes electric energy, distributes natural gas, and represents a majority portion of our assets, liabilities, revenues, and expenses. MGE generates, purchases, and distributes electricity to approximately 159,000 customers in Dane County, Wisconsin, including the city of Madison, and purchases and distributes natural gas to approximately 169,000 customers in the Wisconsin counties of Columbia, Crawford, Dane, Iowa, Juneau, Monroe, and Vernon.

Our nonregulated energy operations own interests in electric generating capacity that is leased to MGE. The ownership/leasing structure was adopted under applicable state regulatory guidelines for MGE's participation in these generation facilities, consisting principally of a stable return on the equity investment in the new generation facilities over the term of the related leases. The nonregulated energy operations include an ownership interest in two coal-fired generating units in Oak Creek, Wisconsin and a partial ownership of a cogeneration project on the UW-Madison campus. A third party operates the units in Oak Creek, and MGE operates the cogeneration project. Due to the nature of MGE's participation in these facilities, the results of MGE Energy's nonregulated operations are also consolidated into MGE's consolidated financial position and results of operations under applicable accounting standards.

We have not included a discussion of results of operations and changes in financial position for the year ended

December 31, 2020, as compared to the year ended December 31, 2019. That discussion can be found in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations in our annual report on Form 10-K for the year ended December 31, 2020, which was filed with the SEC on February 24, 2021.

Executive Overview

Our primary focus today and for the foreseeable future is our core utility customers at MGE as well as creating long-term value for our shareholders. MGE continues to face the challenge of providing its customers with reliable power at competitive prices. MGE works on meeting this challenge by investing in more efficient generation projects, including renewable energy sources. As we work toward achieving 80% carbon reduction by 2030 (from 2005 levels), MGE continues to examine and pursue opportunities to reduce the proportion that coal generation represents in its generation mix, as evidenced by its most recent announcements of the retirement of Columbia (a coal generation plan), the change in the Elm Road Units fuel source from coal to natural gas, and its growing ownership of renewable generation sources. MGE will continue to focus on growing earnings while controlling operating and fuel costs. MGE's goal is to provide safe and efficient operations in addition to providing customer value. We believe it is critical to maintain a strong credit rating consistent with financial strength in MGE as well as the parent company in order to accomplish these goals.

We earn revenue and generate cash from operations by providing electric and natural gas utility services, including electric power generation and electric power and gas distribution. The earnings and cash flows from the utility business are sensitive to various external factors, including:

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Weather, and its impact on customer sales,

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Economic conditions, including current business activity and employment and their impact on customer demand,

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Regulation and regulatory issues, and their impact on the timing and recovery of costs,

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Energy commodity prices, including natural gas prices,

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Equity price risk pertaining to pension related assets,

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Credit market conditions, including interest rates and our debt credit rating,

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Environmental laws and regulations, including adopted and pending environmental rule changes,

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Governmental efforts to address the COVID-19 pandemic, including restrictions on activity, increased employee health and welfare costs, and precautions for dealing with members of the public, and

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Other factors listed in Item 1A. Risk Factors of this Report.

For the year ended December 31, 2021, MGE Energy's earnings were $105.8 million or $2.92 per share compared to $92.4 million or $2.60 per share for the same period in the prior year. MGE's earnings for the year ended December 31, 2021, were $78.4 million compared to $63.1 million for the same period in the prior year.

MGE Energy's net income was derived from our business segments as follows:

Our net income during 2021 compared to 2020 primarily reflects the effects of the following factors:

Electric Utility

An increase in electric investments contributed to increased earnings for 2021. The new customer information system went live in September 2021 and Badger Hollow I was completed in November 2021. MGE received approval to recover 100% AFUDC during construction of these projects.

Higher electric retail sales resulting from warmer weather in 2021 contributed to higher earnings for 2021. Cooling degree days (a measure for determining the impact of weather during the cooling season) increased from 733 days in 2020 to 846 days in 2021.

Electric commercial retail sales increased approximately 4% for 2021, compared to the same period in the prior year. The general economic recovery from the COVID-19 pandemic during 2021 contributed to higher electric commercial retail sales.

Gas Utility

An increase in gas investments contributed to increased earnings for 2021.

All Other

The decrease in all other income primarily results from a $2.5 million (pre-tax) voluntary contribution to the Madison Gas and Electric Foundation.

During 2021, the following events occurred:

2021 Rate Settlement Agreement: In December 2020, the PSCW approved a settlement agreement for MGE's 2021 rate case. The settlement agreement provided for a zero percent increase for electric rates and an approximately 4% increase for gas rates in 2021. The electric rate settlement included an increase in rate base but the associated rate increase was primarily offset by lower fuel and purchase power costs and a one-time $18.2 million return to customers of the portion of excess deferred taxes related to the 2017 Tax Act not restricted by IRS normalization rules. As part of the settlement, the fuel rules bandwidth was set at plus or minus 1% for 2021. When compared to the 2020 rate case, the settlement included lower forecasted electric sales for 2021 to reflect changes to customer usage during the COVID-19 pandemic. The gas rate increase covered infrastructure costs and technology improvements. The settlement agreement also included escrow accounting treatment for pension and other postretirement benefit costs, bad debt expense, and customer credit card fees. Escrow accounting treatment

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allows MGE to defer any difference between estimated costs in rates and actual costs incurred until its next rate case filing. Any difference would be recorded as a regulatory asset or regulatory liability.

Utility Solar: Large solar generation projects were recently completed or are under construction as shown in the following table. Incurred costs are reflected in "Property, plant, and equipment, net" for projects placed in service or "Construction work in progress" for projects under construction on the consolidated balance sheets. MGE received specific approval to recover 100% AFUDC on Badger Hollow I and II. After tax, MGE recognized $5.0 million and $0.6 million of AFUDC equity on Badger Hollow I and II, respectively, during construction.

(a)
Excluding AFUDC.

(b)
Estimated date of commercial operation.

(c)
Includes an allocation of common facilities at Badger Hollow placed in service in November 2021.

Tax Reform: Pursuant to the 2017 Tax Act, deferred income tax balances as of December 31, 2017, were remeasured to reflect the decrease in the corporate tax rate. The approved rate settlement agreement for 2021 included approximately $5.3 million of the benefit in base rates that was being returned to customers using a normalization method of accounting. IRS normalization rules limit the rate at which MGE can return the benefits to customers. The settlement agreement also included $18.2 million of the benefit not subject to normalization restrictions in electric base rates. The collection of the remaining portion not subject to normalization restrictions related to gas will be collected in 2022 and 2023 as approved by the PSCW in the 2022 rate case settlement.

2020 Annual Fuel Proceeding: In September 2021, the PSCW issued a final decision in the 2020 fuel rules proceedings for MGE to refund $3.2 million of additional fuel savings realized during 2020 plus accrued interest to its retail electric customers over a one-month period in October 2021. There was no change to the refund in the fuel rules proceedings from the amount MGE deferred in the previous year.

Deferred Fuel Costs: MGE under recovered fuel costs in 2021. As of December 31, 2021, MGE had deferred $3.3 million of 2021 fuel costs. These costs will be subject to the PSCW's annual review of 2021 fuel costs, expected to be completed during 2022. See Footnote 9.b. of the Notes to Consolidated Financial Statements in this Report for further information.

During 2022, several items may affect us, including:

2022/2023 Rate Case Settlement: In December 2021, the PSCW approved a settlement agreement for MGE's 2022 rate case. The settlement agreement provides for an 8.81% increase to electric rates and a 2.15% increase to gas rates for 2022. As part of the settlement agreement for 2023, the PSCW approved a 0.96% increase in gas rates and to address a potential electric rate change through a limited rate case re-opener. See "Other Matters" below for additional information on the 2022/2023 rate case settlement.

ATC Return on Equity: As discussed in "Other Matters" below, ATC's authorized ROE, which is used in calculating its rates and revenues, is the subject of a challenge before FERC. A decrease in ATC's ROE could result in lower equity earnings and distributions from ATC in the future. We derived approximately 6.7% of our net income for the year ended December 31, 2021, from our investment in ATC.

Environmental Initiatives: There are proposed legislative rules and initiatives involving matters related to air emissions, water effluent, hazardous materials, and greenhouse gases, all of which affect generation plant capital expenditures and operating costs as well as future operational planning. Legislation and rulemaking addressing climate change and related matters could significantly affect the costs of owning and operating fossil-fueled generating plants. We would expect to seek and receive recovery of any such costs in rates. However, it is difficult

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to estimate the amount of such costs due to the uncertainty as to the timing and form of the legislation and rules, and the scope and time of the recovery of costs in rates, which may lag after those costs have been incurred.

EPA's Regulation of Greenhouse Gas Emissions (GHGs) under Section 111(d) of the Clean Air Act: In January 2021, the U.S. Court of Appeals for the District of Columbia Circuit (D.C. Circuit) vacated and remanded to the EPA the ACE Rule and repealed the predecessor Clean Power Plan Rule, both of which regulated greenhouse gas emissions from existing electric generation units pursuant to Section 111(d) of the Clean Air Act. As a result of these legal proceedings, neither the CPP nor ACE rules are currently in effect. In October 2021, the EPA formally announced their intention to introduce a proposed GHG rule in July 2022. The EPA has described the pending proposed rule as guidelines for states to regulate GHGs under Section 111(d). MGE will continue to monitor and evaluate the rule development.

Future Generation - New 80% carbon reduction target by 2030: MGE has outlined initiatives to achieve our new target.

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Transitioning away from coal. Columbia: In February 2021, MGE, along with the other plant co-owners, announced plans to retire the two-unit coal-fired Columbia generating plant near Portage, Wisconsin. MGE currently owns 19% of the facility. The co-owners intend to retire Unit 1 by the end of 2023 and Unit 2 by the end of 2024. Final timing and retirement dates for Units 1 and 2 are subject to change depending on operational, regulatory, and other factors. MGE continues to evaluate additional investments to replace the generation from Columbia while maintaining electric service reliability. These investments include cost-effective, clean energy projects to help achieve MGE's carbon reduction goals.

Elm Road Units: In November 2021, MGE announced plans to end the use of coal as a primary fuel at the Elm Road Units and transition the plant to natural gas. MGE is a minority owner of Elm Road, owning 8.33%. The approximately 1,230 MW coal-fired plant is co-owned by WEC Energy Group, whose subsidiary serves as operator, and by WPPI Energy, Inc. Transition plans and costs will be subject to PSCW approval. MGE's remaining use of coal is expected to be further reduced as the Elm Road Units transition to natural gas. This transition will help MGE meet its 2030 carbon reduction goals. By 2035, MGE expects that the Elm Road Units will be fully transitioned away from coal, which will eliminate coal as an internal generation source for MGE.

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Growing renewable generation. MGE is seeking to acquire a joint interest in several renewable generation projects. See our 2022-2024 capital expenditure forecast included under "Liquidity and Capital Resources" below for information on these projects.

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Natural gas as a fuel source. West Riverside: In 2016, MGE entered into an agreement with WPL under which MGE may acquire up to 50 MW of capacity in a gas-fired generating plant constructed by WPL at its West Riverside Energy Center in Beloit, Wisconsin, during the five-year period following the in-service date of the plant. The plant was placed in service in May 2020. In January 2022, MGE, along with joint applicants, filed an application with the PSCW requesting approval for a sale and purchase of ownership interests in West Riverside. If approved, MGE's share of West Riverside will be 25 MW at a purchase price of approximately $25 million. The closing and actual transfer of ownership is expected to occur in March 2023. MGE also retains the option to purchase an additional 25 MW of capacity from West Riverside until May 2025. MGE currently expects to exercise this option in a future period. See our 2022-2024 capital expenditure forecast included under "Liquidity and Capital Resources" below for additional information.

COVID-19 Update

MGE Energy continues to provide safe and reliable service to our customers despite the challenges presented by the Coronavirus Disease 2019 (COVID-19) pandemic. We have operated continuously throughout the pandemic and suffered no material disruptions in service or employment.

We discuss various COVID-19-related events and their effects below:

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Governmental Actions. State and local governments issued orders and regulations to restrict or manage

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business and individual activity in March 2020. In June 2021, the majority of COVID-related orders were lifted, although certain counties continue to impose mask mandates. Additionally, the PSCW ordered changes to the tariff provisions on March 24, 2020, in response to the COVID-19 pandemic. All restrictions were lifted by November 1, 2020.

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Liquidity: We remain focused on maintaining strong credit quality. Subject to the duration and severity of the COVID-19 pandemic, we believe we have adequate liquidity on hand to support future operations and capital expenditures over the next twelve months. See "Liquidity and Capital Resources – Credit Facilities" below for more information about our credit facilities.

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Customer Impacts: Governmental regulations limiting community activity began impacting customer sales in late March 2020. While the total expected impact of COVID-19 on future sales is currently unknown, MGE experienced higher electric residential sales and lower electric commercial and industrial sales due to pandemic-related regulations. The general economic recovery that followed the lifting of these regulations during the second quarter of 2021 contributed to higher electric commercial and industrial sales.

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Capital Expenditures: Badger Hollow II was expected to be completed in December 2022. Due to supply chain constraints, Badger Hollow II is now expected to be completed in March 2023. These updates have been reflected in our capital expenditure forecast. We continue to monitor potential impacts on an ongoing basis. See our 2022-2024 capital expenditure forecast included under "Liquidity and Capital Resources" below.

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Operations: To date, MGE Energy has experienced no material disruptions in utility operations. Our administrative personnel have been working largely remotely, and our field operations have not been materially affected. We continue to monitor potential disruptions or constraints in materials and supplies from key suppliers. We could experience delays in our ability to perform certain maintenance and capital project activities.

We cannot reasonably estimate with any degree of certainty the actual impact of COVID-19 and associated governmental regulations may have on future results of operations, financial position, and liquidity. See Part II, Item 1A. "Risk Factors" "Pandemic virus or diseases, including COVID-19, could have a material adverse effect on our business, financial condition and liquidity."

The following discussion is based on the business segments as discussed in Footnote 22 of the Notes to Consolidated Financial Statements in this Report.

Results of Operations

Results of operations include financial information prepared in accordance with GAAP and electric and gas margins, both which are non-GAAP measures. Electric margin (electric revenues less fuel for electric generation and purchase power costs) and gas margin (gas revenues less cost of gas sold) are non-GAAP measures because they exclude items used in the calculation of the most comparable GAAP measure, operating income. These exclusions consist of nonregulated operating revenues, other operations and maintenance expense, depreciation and amortization expense, and other general taxes expense. Thus, electric and gas margin are not measures determined in accordance with GAAP.

Management believes that electric and gas margins provide a meaningful basis for evaluating and managing utility operations since fuel for electric generation, purchase power costs, and cost of gas sold are passed through without mark-up to customers in current rates. As a result, management uses electric and gas margins internally when assessing the operating performance of our segments. The presentation of utility electric and gas margins herein is intended to provide supplemental information for investors regarding operating performance. These electric and gas margins may not be comparable to how other entities calculate utility electric and gas margin or similar measures. Furthermore, these measures are not intended to replace operating income as determined in accordance with GAAP as an indicator of operating performance.

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Year Ended December 31, 2021, Versus the Year Ended December 31, 2020

Operating income for 2021 compared to 2020 primarily reflects the effects of the following factors:

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Electric revenues and fuel costs

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A $26.6 million increase in electric revenues primarily driven by an increase in electric retail sales due to warmer weather and economic recovery in MGE's service territory from the COVID-19 pandemic.

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A $12.9 million increase in fuel for electric generation reflecting higher internal generation and market costs.

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A $3.5 million decrease in purchased power costs driven by lower market purchases as a result of higher internal generation.

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Gas revenues and cost of gas sold

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A $41.3 million increase in gas revenue driven by higher rates to cover infrastructure costs and technology improvements. Also increasing gas rates is the cost of gas, which is recovered on a pass-through basis in revenues. See explanation below regarding the increase in gas costs.

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A $36.0 million increase in cost of gas sold driven by higher cost per therm of gas. Average cost per therm increased approximately 56%. Payments for natural gas increased due to a significant increase in the price of natural gas. The increase in the price of natural gas is partially related to extreme weather conditions in February 2021 increasing costs approximately $15 million. These costs were recovered by the end of 2021 through our existing recovery mechanism (pass-through basis in customer rates).

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A $12.9 million increase in other operations and maintenance. See "Consolidated operations and maintenance expenses" section below for a description of the factors contributing to the increase.

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A $2.8 million increase in depreciation and amortization expense driven by the timing of the completion of the implementation of the customer information system that went live in September 2021 and commercial operation of Two Creeks in November 2020 and Badger Hollow I that took place in November 2021 as discussed in the "Consolidated depreciation expense" section below.

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Electric sales and revenues

The following table compares MGE's electric revenues and electric kWh sales by customer class for each of the years indicated:

Electric Margin

Electric margin, a non-GAAP measure, increased $17.2 million during 2021 compared to 2020, due to the following:

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Revenue subject to refund. For cost recovery mechanisms, any over-collection of revenues resulting from the amount of costs authorized to be collected from customers in rates exceeding actual costs is recorded as a reduction of revenue in the period incurred, as the over-collection is expected to be refunded to customers in a subsequent period. In the year the over-collection is refunded, rates are reduced and offset as revenue subject to refund. There is no margin impact in the year the costs are refunded. The largest driver is related to return of excess deferred taxes related to the 2017 Tax Act in 2021. See Footnote 10 of the Notes to Consolidated Financial Statements in this Report for additional information.

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Commercial, industrial, and other-retail/municipal volume. During 2021, there was an approximately 4% increase in commercial sales compared to the same period in the prior year. This increase was driven by economic recovery from the COVID-19 pandemic and the lifting of associated governmental regulations and restrictions on activity.

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Rate changes. MGE's PSCW-approved 2020 Fuel Cost Plan resulted in a fuel credit that decreased rates by 0.84% in 2020. Rates charged to retail customers during 2021 were $3.6 million higher than those charged during the same period in the prior year as a result of the fuel credit from 2020 ending.

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Residential volume. During 2021, there was an approximately 2% increase in residential sales driven by favorable weather conditions in the first half of 2021. The weather impact was partially offset by a decrease in residential usage associated with the recovery from the COVID-19 pandemic and a return to traditional work environments, which has occurred throughout 2021.

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Fuel costs. Fuel costs increased during 2021, primarily as a result of higher costs to generate and purchase electricity in the market. Renewable owned resources have no generation costs and the delay in the

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commercial operation of Badger Hollow I solar farm has contributed to higher replacement energy costs for MGE.

Gas deliveries and revenues

The following table compares MGE's gas revenues and gas therms delivered by customer class during each of the years indicated:

Gas Margin

Gas margin, a non-GAAP measure, increased $5.3 million during 2021 compared to 2020, due to the following:


Rate changes. In December 2020, the PSCW authorized MGE to increase 2021 rates for retail gas customers by 4.0%. MGE recovers the cost of natural gas in its gas segment through the purchased gas adjustment clause (PGA). Under the PGA, MGE is able to pass through to its gas customers the cost of gas. Changes in PGA recoveries affect revenues but do not change net income. Payments for natural gas increased due to a significant increase in the price of natural gas. The increase in the price of natural gas is partially related to extreme weather conditions in February 2021 increasing costs approximately $15 million. These costs were recovered by the end of 2021 through our existing recovery mechanism (costs are passed-through in customer rates).

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Other. During 2021, other charges primarily increased as a result of increased revenue from gas transportation customers.

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Revenue subject to refund. For cost recovery mechanisms, any over-collection of revenues resulting from the amount of costs authorized to be collected from customers in rates exceeding actual costs is recorded as a reduction of revenue in the period incurred, as the over-collection is expected to be refunded to customers in a subsequent period.

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Consolidated operations and maintenance expenses

For 2021, operations and maintenance expenses increased $12.9 million, compared to the same period in the prior year. The following contributed to the net change:

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Increased electric production expenses are related to increased maintenance costs for Saratoga, Two Creeks, and Columbia. Also contributing to the increase is $2.5 million additional expense recorded for Columbia inventory obsolescence and employee severance reserves. MGE anticipates requesting PSCW approval for regulatory recovery of these costs at a future date.

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Increased transmission costs are related to higher transmission rates in 2021 compared to rates in 2020. The 2020 transmission rates reflect adjustments from a lower return on equity, ordered in FERC proceedings, for prior year rates.

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Increased customer accounts and services costs are primarily related to increased operation costs associated with the new customer information system, which went live in September 2021.

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Decreased electric distribution expenses are primarily related to a decrease in locating services.

Consolidated depreciation expense

Electric depreciation expense increased $2.0 million and gas depreciation expense increased $0.8 million for 2021, compared to the same period in the prior year. MGE placed Two Creeks in service in November 2020 and Badger Hollow I in November 2021. Timing of the in-service date contributed to the increase in electric depreciation expense. The new customer information system went live in September 2021 increasing deprecation costs for both electric and gas in 2021.

Electric and gas other income

Electric and gas other income decreased $1.8 million and $4.1 million, respectively, during the twelve months ended December 31, 2021, compared to the same period in the prior year, primarily related to the collection of the deferred pension and other postretirement other than service costs from 2019.

Nonregulated Energy Operations - MGE Energy and MGE

The nonregulated energy operations are conducted through MGE Energy's subsidiaries: MGE Power Elm Road (the Elm Road Units) and MGE Power West Campus (WCCF), which have been formed to own and lease electric generating capacity to assist MGE. For 2021 and 2020, net income at the nonregulated energy operations segment was $21.4 million and $20.8 million, respectively.

Transmission Investment Operations - MGE Energy

The transmission investment segment holds our interest in ATC and ATC Holdco, and its income reflects our equity in the earnings of those investments. ATC Holdco was formed in December 2016 to pursue transmission development opportunities that typically have long development and investment lead times before becoming operational. ATC Holdco's transmission development activities have been suspended for the near term. During 2021 and 2020, other income at the transmission investment segment primarily reflects ATC's operations and was

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$9.3 million and $10.2 million, respectively. In May 2020, the FERC issued an opinion further refining the methodology for setting the ROE that electric utilities are authorized to earn, which adjusted ATC's ROE to 10.02%. See Footnote 7.b. of the Notes to Consolidated Financial Statements in this Report and "Other Matters" below for additional information concerning ATC and summarized financial information regarding ATC.

Consolidated Income Taxes - MGE Energy and MGE

In 2021, the effective electric tax rate decreased as a result of the return of electric excess deferred taxes related to the 2017 Tax Act not governed by IRS normalization rules in 2021. These costs were recorded as a regulatory liability in the year of remeasurement. See Footnote 10 of the Notes to Consolidated Financial Statements in this Report for details of effective income tax rates for continuing operations.

Noncontrolling Interest, Net of Tax - MGE

The noncontrolling interest, net of tax, reflects the accounting required for MGE Energy's interest in MGE Power Elm Road (the Elm Road Units) and MGE Power West Campus (WCCF). MGE Energy owns 100% of MGE Power Elm Road and MGE Power West Campus; however, due to the contractual agreements for these projects with MGE, the entities are considered VIEs with respect to MGE and their results are consolidated with those of MGE, the primary beneficiary of the VIEs. The following table shows MGE Energy's noncontrolling interest, net of tax, reflected on MGE's consolidated statement of income:

Liquidity and Capital Resources

Subject to the duration and severity of the COVID-19 pandemic, MGE Energy and MGE expect to have adequate liquidity to support future operations and capital expenditures over the next twelve months. Available resources include cash and cash equivalents, operating cash flows, liquid assets, borrowing working capacity under revolving credit facilities, and access to equity and debt capital markets. MGE Energy expects to generate funds from both long-term debt financing, short-term debt financing, and if needed, could issue new shares through our Direct Stock Purchase and Dividend Reinvestment Plan.

Cash Flows

The following summarizes cash flows for MGE Energy and MGE during 2021 and 2020:

Cash Provided by Operating Activities

MGE Energy

MGE Energy's consolidated net cash provided by operating activities is derived mainly from the electric and gas operations of its principal subsidiary, MGE.

Cash provided by operating activities for 2021 was $137.5 million, a decrease of $34.9 million when compared to the prior year.

MGE Energy's net income increased $13.3 million for 2021 when compared to the prior year.

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MGE Energy's federal and state taxes paid decreased $4.1 million during 2021, when compared to the prior year. The decrease in taxes paid is primarily related to increased production and investment tax credits.

Working capital accounts (excluding prepaid and accrued taxes) resulted in $36.5 million in cash used for operating activities for 2021, primarily due to increased accounts receivable, increased other receivables, increased unbilled revenues, increase in gas inventory, and decrease in other current liabilities. Natural gas costs increased significantly throughout the central part of the country in February 2021 related to extreme weather conditions. In addition to those increased natural gas costs, we incurred higher natural gas costs throughout 2021, as a result of an increase in the price of natural gas. The decrease in other current liabilities is attributable to a $3.2 million one-time fuel credit returned to retail customers in 2021. These increases in cash used for operations were partially offset by an increase in accounts payable.

Working capital accounts (excluding prepaid and accrued taxes) resulted in $0.1 million in cash used for operating activities for 2020, primarily due to decreased current liabilities, increased accounts receivable, and increased unbilled revenues, partially offset by increased accounts payable.

Hosted software asset expenditures during 2021 were $3.4 million. This amount represents an increase of $1.0 million in cash used when compared to the prior year.

MGE

Cash provided by operating activities for 2021 was $130.2 million, a decrease of $36.1 million when compared to the prior year.

Net income increased $15.3 million for 2021 when compared to the prior year.

MGE's federal and state taxes paid decreased $3.7 million during 2021, when compared to the prior year. The decrease in taxes paid is primarily related to increased production and investment tax credits.

Working capital accounts (excluding prepaid and accrued taxes) resulted in $39.0 million in cash used for operating activities for 2021, primarily due to increased accounts receivable, increased other receivables, increased unbilled revenues, increase in gas inventory, and decreased other current liabilities. Natural gas costs increased significantly throughout the central part of the country in February 2021 related to extreme weather conditions. In addition to those increased natural gas costs, we incurred higher natural gas costs throughout 2021, as a result of an increase in the price of natural gas. The decrease in other current liabilities is attributable to a $3.2 million one-time fuel credit returned to retail customers in 2021. These increases in cash used for operations were partially offset by an increase in accounts payable.

Working capital accounts (excluding prepaid and accrued taxes) resulted in $2.1 million in cash provided by operating activities for 2020, primarily due to increased accounts payable, partially offset by decreased current liabilities, increased accounts receivable, and increased unbilled revenues.

Hosted software asset expenditures during 2021 were $3.4 million. This amount represents an increase of $1.0 million in cash used when compared to the prior year.

Capital Requirements and Investing Activities

MGE Energy

MGE Energy's cash used for investing activities decreased $53.4 million for 2021 when compared to the prior year.

Capital expenditures for 2021 were $153.2 million. This amount represents a decrease of $50.0 million from the expenditures made in the prior year. This decrease primarily reflects the reduction of expenditures on the construction of Badger Hollow I due to timing of expenditures.

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Capital contributions in ATC and other investments decreased $1.6 million for 2021 when compared to the prior year.

Proceeds from the sale of investments increased $1.1 million during 2021, when compared to the same period in the prior year.

MGE

MGE's cash used for investing activities decreased $50.4 million for 2021 when compared to the prior year.

Capital expenditures for 2021 were $153.2 million. This amount represents a decrease of $50.0 million from the expenditures made in the prior year. This decrease primarily reflects the reduction of expenditures on the construction of Badger Hollow I due to timing of expenditures.

Capital expenditures

The following table shows MGE Energy's actual capital expenditures for both 2021 and 2020, and forecasted capital expenditures for 2022 through 2024:

Forecasted capital expenditures are based upon management's assumptions with respect to future events, including the timing and amount of expenditures associated with environmental compliance initiatives, legislative and regulatory action, the continued effect of the COVID-19 pandemic, customer demand and support for electrification and renewable energy resources, energy conservation programs, load growth, the timing of any required regulatory approvals, and the adequacy of rate recovery. Actual events may differ materially from these assumptions and result in material changes to those forecasted amounts.

MGE is targeting at least 80% carbon reduction from electric generation by 2030 (from 2005 levels) and net-zero carbon electricity by 2050. Solar, wind, and battery storage projects are a major step toward deep decarbonization and greater use of clean energy sources in pursuit of our goal. MGE continues to evaluate solar, wind, and battery storage projects that align with its goals as legacy fossil fuel-fired facilities are retired. In February 2021, MGE, along with its co-owners, announced plans to retire Columbia Unit 1 by the end of 2023 and Unit 2 by the end of 2024. MGE has included forecasted capital expenditures for the years 2022 through 2024 for projects to replace Columbia's generation. Additional replacement capital expenditures are expected to continue beyond 2024.

In November 2021, construction of the Badger Hollow I solar project was completed. Total cost of the project excluding AFUDC was approximately $60 million. O'Brien, an approximately $29 million RER solar project, was completed in May 2021.

The following table provides further detail of MGE Energy's forecasted capital expenditures, separating spending into capital project categories for 2022 through 2024:

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Our forecasted capital expenditures reflect the following significant renewable projects that are proposed or currently under construction:

(a)
Approved by the PSCW in February 2022.

(b)
Pending approval by the PSCW. There is no certainty that this project will be approved by the PSCW.

(c)
Excluding AFUDC.

(d)
Requested, in the case of projects pending PSCW approval, or received, in the case of Badger Hollow II, approval to recover 100% AFUDC.

(e)
$21.2 million of costs incurred, including an allocation of common facilities at Badger Hollow as of December 31, 2021.

(f)
Construction of the project is expected to be completed in phases ranging from May 2024 through December 2024.

These renewable generation projects, along with our existing renewable generation, represent progress towards our goal of net-zero carbon emissions from electrical generation by 2050.

West Riverside: In January 2022, MGE, along with joint applicants, filed an application with the PSCW requesting approval for a sale and purchase of ownership interests in the West Riverside Energy Center, a highly efficient, state-of-the-art natural gas-fired plant in Beloit, Wis. If approved, MGE's share of West Riverside will be 25 MW at a purchase price of approximately $25 million. The closing and actual transfer of ownership is expected to occur in March 2023. MGE also retains the option to purchase an additional 25 MW of capacity from West Riverside until May 2025. MGE currently expects to exercise this option in a future period. Natural gas has much lower carbon emission rates compared to coal-fired generation. The investment in the West Riverside plant will help MGE to retire Columbia ahead of schedule in order to dramatically increase the amount of clean energy in our generating mix.

Electric and Gas Distribution: In 2022 through 2024, electric and gas capital expenditures include investment in enhanced metering solutions to provide customers with more timely and detailed energy use information. Investments in advanced metering infrastructure will provide additional benefits including outage and demand response and automated meter reading capabilities. Forecasted capital expenditures in those years is approximately $14 million.

Enterprise Forward: Enterprise Forward is a multi-year information technology project, which includes implementation of a new customer information system and other applications. MGE is entering the final phase of this transformational program. There is approximately $21 million of forecasted capital expenditures in total for 2022 and 2023.

Internal use software incurred in a hosting arrangement and preliminary construction costs related to renewable generation assets pending regulatory approvals are accounted for as an operating cash flow in accordance with applicable accounting policies. These costs are therefore excluded from the table above. For ratemaking purposes, they are included in forecasted utility capital expenditures. These costs are forecasted to be $3 million and $1 million for 2022 and 2023, respectively.

Financing Activities

MGE Energy

Cash used for MGE Energy's financing activities was $8.8 million for 2021, compared to $59.2 million of cash provided by financing activities in 2020.

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For 2021, cash dividends paid were $54.8 million compared to $51.7 million in the prior year. This increase reflected a higher dividend per share ($1.52 vs. $1.45) and a greater number of outstanding shares since the completion of the public offering of shares in May 2020.

During 2020, MGE Energy issued common stock for net proceeds of $79.6 million, which were used for general corporate purposes including funding capital expenditures at MGE, such as Two Creeks, Badger Hollow I and II, Renewable Energy Rider solar projects, and other capital projects.

During 2021, MGE issued $100.0 million of senior unsecured notes whose proceeds were used to assist with the payment of additional capital expenditures and other corporate obligations. During 2020, MGE refinanced $19.3 million of existing Industrial Development Revenue Refunding Bonds through the issuance of an equivalent amount of Industrial Development Revenue Refunding Bonds at a lower interest rate. During 2020, MGE made repayments of $15.0 million for a maturing long-term note.

For 2021, net short-term debt repayments were $47.0 million compared to net short-term debt borrowings of $52.5 million in the prior year.

MGE

During 2021, cash provided by MGE's financing activities was $26.0 million, compared to $39.8 million of cash provided by financing activities in 2020.

Capital contributions made by MGE Energy to MGE were $30.0 million in 2020. Cash dividends to parent (MGE Energy) were $5.0 million in 2021.

Distributions to parent (MGE Energy) from noncontrolling interest, which represent distributions from MGE Power Elm Road and MGE Power West Campus, were $15.0 million for 2021, compared to $21.5 million in the prior year. The noncontrolling interest arises from the accounting required for the entities, which are not owned by MGE but are consolidated as VIEs.

During 2021, MGE issued $100.0 million of senior unsecured notes whose proceeds were used to assist with the payment of additional capital expenditures and other corporate obligations. During 2020, MGE refinanced $19.3 million of existing Industrial Development Revenue Refunding Bonds through the issuance of an equivalent amount of Industrial Development Revenue Refunding Bonds at a lower interest rate. During 2020, MGE made repayments of $15.0 million for a maturing long-term note.

For 2021, net short-term debt repayments were $47.0 million compared to net short-term debt borrowings of $52.5 million in the prior year.

Dividend Restrictions

Dividend payments by MGE to MGE Energy are subject to restrictions arising under a PSCW rate order and, to a lesser degree, MGE's first mortgage bonds. The PSCW order restricts any dividends that MGE may pay MGE Energy if its common equity ratio, calculated in the manner used in the rate proceeding, is less than 55%. MGE's thirteen month rolling average common equity ratio as of December 31, 2021, is 60.7%, as determined under the calculation used in the rate proceeding. This restriction did not restrict MGE's payment of dividends in 2021. Cash dividends of $5.0 million were paid by MGE to MGE Energy in 2021. No cash dividends were paid by MGE to MGE Energy in 2020 in light of the desire to fund planned capital expenditures with internally generated cash. The rate proceeding calculation includes indebtedness imputed amounts for MGE's outstanding purchase power capacity payments and other PSCW adjustments but does not include the indebtedness associated with MGE Power Elm Road and MGE Power West Campus, which are consolidated into MGE's financial statements but are not direct obligations of MGE.

MGE has covenanted with the holders of its first mortgage bonds not to declare or pay any dividend or make any other distribution on or purchase any shares of its common stock unless, after giving effect thereto, the aggregate amount of all such dividends and distributions and all amounts applied to such purchases, after December 31, 1945, shall not exceed the earned surplus (retained earnings) accumulated subsequent to December 31, 1945. As

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of December 31, 2021, approximately $604.3 million was available for the payment of dividends under this covenant.

MGE Power West Campus has covenanted with the holders of its outstanding senior secured notes not to declare or make distributions to us in the event that, both before and after giving effect to such distribution, its total debt to total capitalization would exceed .65 to 1.00 or its projected debt service coverage ratio for the following four fiscal quarters would be less than 1.25 to 1.00. Projected debt service coverage considers the projected revenues available for debt service, after deducting expenses other than debt service, in relation to projected debt service on indebtedness.

MGE Power Elm Road has covenanted with the holders of its outstanding senior secured notes not to declare or make distributions to us in the event that, both before and after giving effect to such distribution, its projected debt service coverage ratio for the following four fiscal quarters would be less than 1.25 to 1.00. Projected debt service coverage considers the projected revenues available for debt service, after deducting expenses other than debt service, in relation to projected debt service on indebtedness.

Credit Facilities

As of December 31, 2021, MGE Energy and MGE had the following aggregate bank commitments and available capacity under their credit agreements:

Borrowings under the Credit Agreements may bear interest at a rate based upon either a "floating rate" or a "Eurodollar Rate" adjusted for statutory reserve requirements, plus an adder based upon the credit ratings assigned to MGE's senior unsecured long-term debt securities. The "floating rate" is calculated on a daily basis as the highest of a prime rate, a Federal Funds effective rate plus 0.5% per annum, or a Eurodollar Rate for a one-month interest period plus 1%. The "floating rate" adder ranges from zero to 0.125%. The "Eurodollar Rate" is calculated as provided in the Credit Agreements. The "Eurodollar Rate" adder ranges from 0.625% to 1.125%.

The credit agreements require the borrower to maintain a ratio of consolidated debt to consolidated total capitalization not to exceed a maximum of 65%. In the case of MGE, the ratio calculation excludes assets, liabilities, revenues, and expenses included in MGE's financial statements as a result of the consolidation of VIEs, such as MGE Power Elm Road and MGE Power West Campus. As of December 31, 2021, the ratio of consolidated debt to consolidated total capitalization for each of MGE Energy and MGE, as calculated under the credit agreements' covenant, were 37.8% and 40.2%, respectively. See Footnote 13 of the Notes to Consolidated Financial Statements in this Report for additional information regarding the credit facilities.

Capitalization Ratios

MGE Energy's capitalization ratios were as follows:

(a)
Includes the current portion of long-term debt.

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Credit Ratings

MGE Energy's and MGE's access to the capital markets, including, in the case of MGE, the commercial paper market, and their respective financing costs in those markets, may depend on the credit ratings of the entity that is accessing the capital markets.

None of MGE Energy's or MGE's borrowing is subject to default or prepayment as a result of a downgrading of credit ratings, although a downgrading of MGE's credit ratings would increase fees and interest charges under both MGE Energy's and MGE's credit agreements.

Contractual Obligations and Commercial Commitments for MGE Energy and MGE

MGE Energy's and MGE's contractual obligations as of December 31, 2021, representing cash obligations that are considered to be firm commitments, are as follows:

(a)
Long-term debt consisting of secured first mortgage bonds, unsecured medium-term notes, and Industrial Development Revenue Bonds issued by MGE, and private placement debt issued by MGE, MGE Power Elm Road, and MGE Power West Campus.

(b)
Short-term debt consisting of commercial paper for MGE. See Footnote 13 of the Notes to Consolidated Financial Statements in this Report.

(c)
Amount represents interest expense on long-term debt. See Footnote 14 of the Notes to Consolidated Financial Statements in this Report for further discussion of the long-term debt outstanding as of December 31, 2021.

(d)
Leases. See Footnote 5 of the Notes to Consolidated Financial Statements in this Report.

(e)
Purchase obligations for MGE Energy and MGE consist primarily of the purchase of electricity and natural gas, electric transmission, natural gas storage capacity, natural gas pipeline transportation, and the purchase and transport of coal. See Footnote 16.c. of the Notes to Consolidated Financial Statements in this Report.

(f)
Construction obligations consist primarily of Badger Hollow II and other renewable solar projects.

(g)
Other obligations are primarily related to investment commitments, chattel paper agreements, environmental projects, and uncertain tax positions.

The above amounts do not include any contributions for MGE's pension and postretirement plans. MGE does not expect to need to make any required contributions to the qualified plans for 2022. The contributions for years after 2022 are not yet currently estimated. Due to uncertainties in the future economic performance of plan assets, discount rates, and other key assumptions, estimated contributions are subject to change. MGE may also elect to make additional discretionary contributions to the plans.

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The above amounts do not include future capital calls by ATC and ATC Holdco. In January 2022, MGE Transco made a $1.2 million contribution to ATC. The amount and timing of future capital calls to these entities is uncertain and primarily dependent on the operations and expansion of ATC and the resumption of development activities by ATC Holdco.

MGE Energy's and MGE's commercial commitments as of December 31, 2021, representing commitments triggered by future events and including financing arrangements to secure obligations of MGE Energy and MGE, are as follows:

(a)
Amount includes the facilities discussed in (b) plus an additional line of credit. MGE Energy has available at any time a $50 million committed revolving credit agreement, expiring in February 2024. As of December 31, 2021, MGE Energy had no borrowings outstanding under this credit facility.

(b)
Amount includes two committed revolving credit agreements totaling $100 million expiring in February 2024. These credit facilities are used to support commercial paper issuances. As of December 31, 2021, MGE had $5.5 million of commercial paper outstanding backed by the facilities but no borrowings outstanding. As of December 31, 2021, MGE had $0.7 million of letters of credit issued inside credit facilities.

Other Matters

Rate Matters

In December 2021, the PSCW approved a settlement agreement for MGE's 2022 rate case. The settlement agreement provides for an 8.81% increase for electric rates and a 2.15% increase to gas rates for 2022. The electric and gas rate increases are driven by an increase in rate base including our investments in Badger Hollow I and a new customer information system. Also driving the electric increase are higher fuel and purchase power costs as well as the completion in 2021 of the one-time return of the electric excess deferred tax credit related to the 2017 Tax Act not restricted by IRS normalization rules. Included in the electric residential rate is a reduction in the customer charge. As part of the settlement agreement for 2023, the PSCW approved a 0.96% increase in gas rates and to address a potential electric rate change through a limited rate case re-opener. The return on common stock equity for 2022 and 2023 is 9.8% based on a capital structure consisting of 55.6% common equity.

Details related to MGE's 2022/2023 approved settlement agreement:

(a)
Average rate base amounts reflect MGE's allocated share of rate base and do not include construction work in progress (CWIP) or a cash working capital allowance and were calculated using a forecasted 13-month average for the test periods. The PSCW provides a return on selected CWIP and a cash working capital allowance by adjusting the percentage return on rate base.

(b)
50% of the forecasted 13-month average CWIP for the test periods which earns an AFUDC return. Projects eligible to earn 100% AFUDC are excluded from this balance and discussed further in the Management Discussion and Analysis - Executive Overview section.

(c)
Authorized returns on common equity may not be indicative of actual returns earned or projections of future returns, as actual returns will be affected by the volume of electricity or gas sold.

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Electric (2023 Test Period) average rate base will be subject to a limited reopener expected to be filed in 2022 and gas (2023 Test Period) average rate base is $312.3 million. The PSCW has approved MGE to maintain 2022 levels for return on common stock equity and capital structure for electric and gas rates in 2023.

Certain environmental groups have filed petitions against the PSCW regarding MGE's two most recent rate settlements. MGE has intervened in the petitions in cooperation with the PSCW. See Footnote 9.a. of the Notes to Consolidated Financial Statements in this Report for more information regarding this matter.

ATC

2013 FERC Complaint - In 2013, several parties filed a complaint with the FERC seeking to reduce the base return on equity (ROE) used by MISO transmission owners, including ATC. The complaint provided for a statutory refund period of November 2013 through February 2015. The complaint asserted that the MISO ROE should not exceed 9.15%, that the equity components of hypothetical capital structures should be restricted to 50%, and that the relevant incentive ROE adders should be discontinued. At the time, MISO's base ROE was 12.38% and ATC's base ROE was 12.2%. On September 28, 2016, FERC issued an order, for the period November 2013 through February 2015, reducing ATC's base ROE to 10.32%. In November 2019, FERC issued an order to further reduce ATC's base ROE to 9.88%. In May 2020, the FERC issued an order further refining the methodology for setting the ROE that electric utilities are authorized to earn. This increased the ROE from 9.88% to 10.02%. This base ROE is effective for the 2013 FERC complaint period and for all periods following September 2016.

2015 FERC Complaint - In February 2015, several parties filed a complaint with the FERC seeking to reduce the base ROE used by MISO transmission owners, including ATC, to 8.67%. The complaint provided for a statutory refund period of February 2015 through May 2016 with a refund effective date retroactive to the complaint filing date. In June 2016, an administrative law judge issued an initial decision for the complaint that would reduce the transmission owner's base ROE to 9.7%. In November 2019, FERC issued an order dismissing the complaint with the determination that the ROE was reasonable. As a result of this order and the methodology FERC used to determine the applicable ROE in the 2013 FERC complaint, several parties have requested a rehearing by FERC. If FERC denies these requests, the complainants are likely to file an appeal with the appellate court. Any downward change to ATC's ROE could result in lower equity earnings and distributions from ATC in the future.

As of December 31, 2018, our share of the estimated refund recorded was $2.5 million, including interest. Following the November 2019 FERC order, our share of ATC's earnings reflects a pre-tax adjustment of $2.0 million, including interest, related to the 2013 complaint refund period and from September 28, 2016 through December 31, 2019. As a result of the May 2020 FERC order, our share of ATC's earnings reflects a $0.6 million reduction of our reserve. Additionally, our share of ATC's earnings reflects the derecognition of a possible refund related to the 2015 complaint as ATC considers such a refund to be no longer considered probable due to FERC's November 2019 dismissal of that complaint. However, due to pending requests for rehearing, a loss related to the 2015 complaint remains possible. Our share of the estimated refund for the 2015 complaint is approximately $2.3 million. As of December 31, 2020, our share of the estimated refund amount reflected a net increase in ATC's earnings with a pre-tax adjustment of $0.6 million, inclusive of interest.

We derived approximately 6.7% of our net income for 2021 and approximately 8.0% of our net income for 2020 and 2019 from our investment in ATC.

Critical Accounting Estimates - MGE Energy and MGE

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to regulatory assets and liabilities, unbilled revenues, pension obligations, and income taxes. We base our estimates on historical experience and on various assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Those values may differ from these estimates under different assumptions or conditions. We believe the following critical accounting estimates affect our more significant judgments used in the preparation of our consolidated financial statements.

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Regulatory Assets/Liabilities

Regulatory assets represent costs that have been deferred to future periods when it is probable that the regulator will allow future recovery of those costs through rates. MGE bases its assessment of recovery on precedents established by the regulatory body. Regulatory liabilities represent previous collections from customers that are expected to be refunded to customers in future periods. Regulatory assets and regulatory liabilities typically include deferral of energy costs, the normalization of income taxes, pension and other postretirement costs, the deferral of certain operating expenses, and non-ARO removal costs. The accounting for these regulatory assets and liabilities is in accordance with regulatory accounting standards.

MGE continually assesses whether the regulatory assets and liabilities meet the criteria for probability of future recovery or deferral. This assessment considers factors such as changes in the regulatory environment, recent rate orders to other regulated entities under the same jurisdiction, and the status of any pending or potential deregulation legislation. If future recovery of costs becomes no longer probable, the assets and liabilities would be recognized as current-period revenues or expenses.

Amortization of regulatory assets and liabilities is provided over the recovery or deferral period as allowed in the related regulatory agreement.

Unbilled Revenues

Revenues from the sale of electricity and gas are recorded when they are delivered to customers. Sales quantity is measured by customers' meters. Due to the large volume of those meters, it is impractical to read all of them at month end. Meters are read on a systematic basis throughout the month based on established meter-reading schedules. Consequently, at the end of any month, there exists a quantity of electricity and gas that has been delivered to customers but has not been captured by the meter readings. As a result, management must estimate revenue related to electricity and gas delivered to customers between meter-read dates and the end of the reporting period. These estimates include:

•
The amount of electricity expected to be lost in the process of its transmission and distribution to customers (referred to as line loss) and the amount of electricity actually delivered to customers.

•
The amount of gas expected to be lost in the process of distribution to customers and the amount of gas actually delivered to customers.

•
The mix of sales between customer rate classes having different rates, which is based upon historical utilization assumptions.

MGE monitors the reasonableness of the unbilled revenue estimate through the review of ratios such as unbilled electric consumption compared to billed electric sales. To confirm the reasonableness of unbilled gas, the estimated unbilled consumption is compared to various other statistics, including percent of gas available for sale, change in unbilled month-to-month and change in unbilled compared to the prior year.

Pension and Other Postretirement Benefit Plans

MGE provides employees with certain retirement (pension) and postretirement (health care and life insurance) benefits. In order to measure the expense and obligations associated with these benefits, management must make a variety of estimates, including discount rates used to value certain liabilities, the expected return on plan assets set aside to fund these costs, the rate of compensation increase, employee turnover rates, retirement rates, health care trends, mortality rates, and other factors. These accounting estimates may change due to the uncertainty attached to the estimate as well as the fact that these estimates are difficult to measure. Different estimates used could result in recognizing different amounts of expense over different periods of time. Recovery in rates is expected.

MGE uses third-party specialists to assist it in evaluating its assumptions as well as to appropriately measure the costs and obligations associated with these retirement benefits. The discount rate and expected return on plan

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assets are based primarily on available investment yields and the historical performance of plan assets. They are critical accounting estimates because they are subject to management's judgment and can materially affect financial performance.

•
Assumed return on assets. This assumption represents the rate of return on plan assets reflecting the average rate of earnings expected on the funds invested (or to be invested) to provide for the benefits included in the projected benefit obligation. For 2021, MGE used an assumed return on assets of 7.00% for pension and 6.61% for other postretirement benefits. In 2022, the pension asset assumption will decrease to 6.75% and the postretirement benefit assumption will decrease to 6.40%. The annual expected rate of return is based on projected long-term equity and bond returns, maturities and asset allocations. Holding other assumptions constant, for every 1% reduction in the expected rate of return on plan assets, annual pension and other postretirement cost would increase by approximately $4.7 million, before taxes.

•
Discount rate. The discount rate represents the rate at which pension obligations could effectively be settled on a present-value basis. MGE uses high-grade bond yields as a benchmark for determining the appropriate discount rate. MGE uses individual spot rates rather than a weighted average of the yield curve spot rates to measure the service cost and interest cost components for net periodic benefit cost. Holding other assumptions constant, a 0.5% increase in the discount rate on the obligation balance as of December 31, 2021, would decrease annual pension and other postretirement cost by approximately $0.3 million, before taxes.

•
Medical trend assumptions. The health care cost trend rate is the assumed rate of increase in per-capita health care charges.

•
Mortality rate assumption. Expected mortality rates are used in the valuation to determine the expected duration of future benefit payments to the plan participants. MGE utilizes mortality tables and projection scales developed by the society of actuaries. These tables and scales were last updated in 2021.

See Footnote 11 of the Notes to Consolidated Financial Statements in this Report for additional discussion of these plans.

Income Tax Provision

MGE Energy's and MGE's income tax provisions, including both current and deferred components, are based on estimates, assumptions, calculations, and interpretation of tax statutes for the current and future years. Determination of current-year federal and state income tax will not be settled for years.

Management regularly makes assessments of tax return outcomes relative to financial statement tax provisions and adjusts the tax provisions in the period when facts become final.

Additionally, in determining our current income tax provision, we assess temporary differences resulting from differing treatments of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are recorded in our balance sheets. When we maintain deferred tax assets, we assess the likelihood that these assets will be recovered through adjustments to future taxable income. Future tax benefits are recognized to the extent that realization of such benefits is more likely than not. A valuation allowance is recorded for those benefits that do not meet this criterion. We record an allowance reducing the asset to a value we believe will be recoverable based on our expectation of future taxable income. We believe the accounting estimate related to the valuation allowance is a critical accounting estimate because it is highly susceptible to change from period to period as it requires management to make assumptions about our future income over the lives of the deferred tax assets, and the impact of increasing or decreasing the valuation allowance is potentially material to our results of operations.

Adoption of Accounting Principles and Recently Issued Accounting Pronouncements - MGE Energy and MGE

See Footnote 2 of the Notes to Consolidated Financial Statements in this Report for discussion of new accounting pronouncements.

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