5. Cost of Capital Mechanism

Differences in the CCM proposals of SCE, SDG&E, PG&E, ATU, and DRA occurred in (1) duration, (2) capital structure, (3) debt and preferred stock, (4) dead band, and (5) adjustment ratio as addressed below.

5.1. Duration

Except for PG&E, the parties recommended that a CCM should be effective for a two to three year period prior to requiring the utilities to file complete cost of capital applications. PG&E proposed a five-year period based on experience with SDG&E's MICAM, in place since 1988, and its similarity in design to PG&E's proposal.¹⁰

DRA recommended a two-year cycle. However, that limited duration would not enable us to gather meaningful results or experience with the mechanism. PG&E's proposal, similar to SDG&E's MICAM that has been in existence for approximately 10 years, could provide us with meaningful results and experience. However, recent experience has shown that SDG&E's MICAM may not be working as designed because SDG&E opted to participate in the last four annual cost of capital proceedings as an active party to litigate its authorized cost of capital. Absent meaningful long-term experience it would behoove us to proceed with caution and gain results and experience with a shorter-term mechanism prior to adopting a longer-term mechanism.

We opt for a three-year cycle. Consistent with a majority of the parties, complete cost of capital applications should be required for every third test year. Consistent with DRA and SCE's proposal for an earlier filing date for full cost of capital applications and given a two year hiatus from required cost of capital applications, the current May 8 filing date should be moved back to April 20. The utilities should file their first complete cost of capital applications for test year 2011 on April 20, 2010.¹¹ That first complete filing under the CCM should address the parties' experience with the CCM and whether modifications to the mechanism are warranted.

5.2. Capital Structure

SCE was the only party seeking capital flexibility in the CCM. It proposed to accomplish automatic capital structure flexibility through the use of an actual ratemaking equity ratio, calculated as a 13-month average, which could vary by up to three percentage points in either direction of its authorized equity ratio. It would also be accomplished through the filing of one application between the utility's full cost of capital applications for authority to adjust its capital structure for changes in factors, such as debt equivalence, that may impact utility credit ratings.

ATU opposed any capital structure flexibility in the CCM on the basis that changes to the capital structure should be considered in cost of capital proceedings, where all factors that determine a utility's overall costs of capital are considered.

Capital structure is but one component of determining a fair and reasonable ROE. We addressed the reasonableness of the utilities capital structures in the first phase of this proceeding and balanced the impact of debt equivalence and other factors that impact utility credit ratings in both the adopted capital structures and ROEs. There was no evidence on how this automatic capital structure adjustment would impact ratepayers. Further, capital structure and ROE cannot, and should not, be assessed independently.

Authorized capital structures should continue to be recalibrated in full cost of capital proceedings. However, while there will be a three-year interval between full cost of capital applications, we recognize that changes in credit ratings may require an adjustment to the utilities' capital structure within that time period. Hence, a provision should be included in the CCM for utilities to file a capital structure adjustment application that addresses ratepayer impacts within that time period.

ATU sought to require PG&E to file an application for review of its capital structure for the calendar year following the year in which it reaches an A level credit rating. Shortly after the issuance of a decision on the first phase of this proceeding PG&E attained that level of credit rating.¹² With that credit rating upgrade, Moody's noted the possibility of a future downgrade if the current trend on increased regulatory support were reversed, and the utility's ratio of cash flow to total debt fell below 22% or the ratio of the utility's cash flow to total interest fell below 4.5 times on a sustainable basis.¹³ With PG&E only just attaining an A credit rating, Moody's subsequent downgrading discussion, and lack of history under an A credit rating, there is no basis for requiring PG&E to file an application for review of its capital structure at this time. Consistent with our prior capital structure adjustment discussion, any change to authorized capital structure should be addressed in PG&E's next full ROE proceeding scheduled for April 20, 2010.

5.3. Long-Term Debt and Preferred Stock

The utilities recommended adjustments to long-term debt and preferred stock costs. SDG&E sought to include an adjustment to long-term debt only if the tax exempt status for its industrial development bonds (IDB) were questioned by the Internal Revenue Service and SDG&E was required to effectively retire or refinance its low interest IDB bonds.¹⁴

SDG&E's concern on a potential loss of tax exempt bond status is premature. Any such refinancing should trigger an application pursuant to Public Utilities Code Section 818, to approve the issuance of new debt. Because a loss of IDB tax exempt status of issued and outstanding bonds may disproportionally impact SDG&E's common equity risk, SDG&E should address that impact as part of its application for authority to replace its IDB bonds.

SCE recommended that the embedded cost of debt and preferred equity be revised when the deadband is triggered as discussed below. Upon a trigger event the embedded cost of debt and preferred equity would be revised to reflect the latest available information and forecasted interest rates for the following year. We concur and will use August month-end data for the embedded measurement and forecasted interest rates for embedded variable debt and new debt issuance scheduled to be issued in the next year.

PG&E proposed to annually update long-term debt and preferred stock costs to the most recent recorded costs in September of each year. The update would be independent of a deadband adjustment mechanism applicable to ROE described in the following deadband discussion. PG&E proposed this annual update on the basis that the costs of debt and preferred stock are readily ascertainable from recorded costs.

In a full cost of capital proceeding, such as the first phase of this proceeding, adopted long-term debt and preferred stock costs are based on historical and forecasted interest rates. Historical rates are used for long-term debt and preferred stock actually issued. Changes in long-term debt and preferred stock costs result from new issuances and a change in the interest rate on variable long-term debt. Forecasted rates are applied to those new and variable rate issuances based on Global Insight forecasts that are updated just prior to issuance of a proposed decision. For the short-term interval where utilities are exempt from filing full cost of capital applications, the overall long-term debt and preferred stock costs should not materially change. Non-material changes in costs should not warrant a change in a utility's overall return on rate base. To the extent that it does materially change, a CCM deadband would be applicable as addressed in the following discussion. If we had adopted a longer interval between the times utilities are required to file full cost of capital applications, a procedure would have been appropriate for updating costs as well as reflecting a proportionate change in the ROE.

5.4. Deadband

A deadband is a range of change in interest rates than may occur without automatically triggering a change in embedded long-term debt and preferred stock costs and ROEs. The size of a deadband affects the rate at which an adjustment mechanism is activated. A deadband that is overly sensitive to interest rates cause needless volatility in revenues and rates. Conversely, a deadband that never triggers can impose unnecessary costs on shareholders or ratepayers, depending on which direction interest rates move.

PG&E proposed a 75-basis point deadband. Based on its proposed April through September average six-month interest rate measurement period the deadband would have triggered about half of the years between 1998 and 2006, four of which would have resulted in a reduction and one an increase in its authorized ROE. Those same results would have occurred under an 85-basis point deadband. Under a 100-basis point deadband it would have triggered twice, once to reduce and once to increase its authorized ROE.

SDG&E recommended that the 100-basis point deadband being used for its MICAM since 1998 continue to be used for a CCM deadband. That deadband, based on a March through August average six-month interest rate measurement, triggered only once during that 10-year period. ATU also proposed a 100-basis point deadband. However, it recommended a 12-month average measurement period ending September and clarified under examination that it considered a substantial change in interest rates to be in the 75 to 100-basis point range.¹⁵ SCE also recommended a 100-basis point deadband with a 12-month average measurement period ending September. Under SCE's proposed features, including a 12-month measurement period, the deadband would have triggered five times between a 1986 and 2006, a 20-year period.¹⁶

A deadband needs to strike a reasonable balance between triggering too often and not triggering often enough. The 75-basis point trigger under PG&E's six-month average measurement scenario would trigger too often and the 100-basis point trigger under SDG&E's average six-month scenario would not trigger often enough. However, a 100-basis point deadband under a 12-month average measurement period as proposed by SCE mitigates volatility of interest rates. Therefore, a 100-basis point deadband is adopted, having a 12-month ended September average measurement period. A rolling average index is not adopted.

Having resolved a deadband and measurement period we need to address the appropriate deadband index and data source.

5.4.1. Index

Two indices were proposed by the parties, 10-year Treasuries and Moody's utility bonds. ATU proposed 10-year Treasuries on the basis that Treasuries measure the general state of interest rates in the U.S. economy, do not reflect utility-specific business risks, and are used in conventional financial models such as the Capital Asset Pricing Model. PG&E proposed utility bonds on the basis of a Commission history of relying on utility bond rates to reflect current interest rates in arriving at a reasonable level of ROE and as a benchmark interest rate for the previously adopted performance-based ratemaking mechanism (PBR) for SCE and MICAM for SDG&E.

The purpose of an interest rate benchmark is to gauge changes in interest rates that also indicate changes in the equity costs of utilities. U.S. Treasuries are more sensitive to economic changes and risks in the international capital markets than utility bonds because they are bought and sold globally.¹⁷ However, U.S. utility bonds are generally affected less than Treasuries as a result of major shifts of international capital because a majority of U.S. utility bonds are traded within the U.S.¹⁸

Consistent with our use of utility bond interest rates in ROE, PBR, and MICAM proceedings and desire to use an index that more likely correlates and moves with utility industry risk, utility bonds should be adopted for the CCM index. In this regard, the Moody's Aa utility bond index rates should be used for those utilities having an AA credit rating or higher and Moody's Baa utility bond interest rates for utilities having a BBB credit rating or lower. The initial Moody's AA benchmark is 5.87% and Baa benchmark is 6.26%.

5.4.2. Data Source

Historical Moody's monthly utility bond interest rate averages are available through subscription services from Moody's and Bloomberg. The same historical Moody's bond interest rates are available from Mergent Bond Record at no cost at some public libraries. To the extent that interested parties may not be able to access historical Moody's monthly utility bond interest rate averages from their local libraries or from Moody's and Bloomberg without paying a fee, the utilities shall make available and provide those monthly averages to DRA and interested parties upon request at no cost.

5.5. Adjustment Ratio

An equity adjustment ratio is a percentage that is based on interest rate changes. That percentage is automatically applied to the utilities' authorized ROE in the same direction as the interest rate changes.

SCE proposed a 70% equity adjustment ratio, 20 percentage points higher than the 50% ratio that was authorized for its PBR. It proposed a 70% ratio on the basis that it is a closer match to a one-for-one sensitivity of equity returns to sustained long-run movements in interest rates, all else equal. Also, it is just above the one-half to two-thirds range normally used to adjust authorized ROEs in response to updated interest rate projections.

A majority of the parties, SDG&E, PG&E, and ATU recommended a 50% equity adjustment. Those recommendations were based on a consistent practice of only adjusting ROEs by one-half to two-thirds of the change in updated interest rate projections.

All of the parties that recommended an adjustment ratio used the same basis of one-half to two-thirds range normally used to adjust authorized ROEs in response to updated interest rate projections, in arriving at their respective adjustment ratio. As testified to by SDG&E, a 100-basis point change in bond rates correlated to changes in equity.¹⁹ Hence, a major change in bond rates impacts equity investments. An adjustment ratio should be set at a point where a utility's debt cost and equity investment becomes volatile. Minor changes in debt cost and equity investment should not warrant any adjustment. Consistent with the majority consensus and goal of balancing shareholder and ratepayer interests, a 50% adjustment ratio should be adopted. This adjustment ratio should be applicable only when the 100-basis point deadband is exceeded and applied to the total basis point difference between the old interest rate benchmark and new interest rate benchmark.²⁰

5.6. Summary

A uniform CCM shall be adopted for SCE, SDG&E, and PG&E. The CCM shall be based on:

a. A full cost of capital application due April 20 of every third year for the following test year.

b. Capital structure is the most recently adopted.

c. Long-term debt and preferred stock cost is the most recently adopted.

d. Deadband is equal to 100-basis points.

e. Index is Moody's Aa utility bonds for AA credit-rated utilities or higher and Moody's Baa utility bonds for BBB credit-rated utilities or lower.

f. Adjustment ratio is 50%.

In any year where the difference between the current 12-month October through September average Moody's utility bond rates and the benchmark exceeds a 100-basis point trigger, an automatic adjustment to the utilities' returns on equity (ROE) shall be made by an October 15 advice letter to become effective on January 1 of the next year as follows:

a. ROE is adjusted by one-half of the difference between the Aa utility bond average for AA credit-rated utilities or higher and Baa utility bond average for BBB credit-rated utilities or lower and the benchmark.

b. Long-term debt and preferred stock costs are updated to reflect actual August month-end embedded costs in that year and forecasted interest rates for variable long-term debt and new long-term debt and preferred stock scheduled to be issued.

c. The 12-month October through September average that triggered an ROE adjustment becomes the new benchmark.

This CCM streamlines the major energy utilities' cost of capital process while providing greater predictability of the utilities' cost of capital by eliminating the use of interest rate forecasts and disputes concerning interest rate levels and trends, as well as uncertainties associated with conflicting perceptions of financial markets and the return requirements of investors. The CCM also enables the utilities, interested parties, and Commission staff to reduce and reallocate their respective workload requirements for litigating annual cost of capital proceedings.

While streamlining the cost of capital process, the utilities have a right to file a cost of capital application outside of the CCM process upon an extraordinary or catastrophic event that materially impacts their respective cost of capital and/or capital structure and affects them differently than the overall financial markets.

¹⁰ Exhibit 70, p. 6.

¹¹ To the extent that April 20^th occurs on a Saturday, Sunday or holiday, the filing date shall be on the first business day after April 20^th.

¹² On December 27, 2007, Moody's upgraded PG&E's credit rating from Baa1 to A3.

¹³ Exhibit 70, p. 10.

¹⁴ IDB are tax exempt bonds applicable to a two-county entity issued at a 100 to 130-basis point discount from traditional bonds, as discussed in reporter's Transcript Vol. 7, p. 859.

¹⁵ Reporter's Transcript Vol. 7, p. 732.

¹⁶ Exhibit 4, p. 46.

¹⁷ Exhibit 70, p. 5.

¹⁸ Id.

¹⁹ Reporter's Transcript Vol. 7, p. 838.

²⁰ An application of the equity adjustment rate on only the basis points that exceeded a 100-basis point deadband would not reasonably reflect the volatility impact of interest rate changes on an equity investment. Such an application would also reverse the Commission's long-standing practice of changing authorized ROEs by one-half to two-thirds of the change in interest rates.