8. Economic Need

Because we find that SDG&E does not have a capacity deficiency in the relevant planning horizon and cannot be justified as a reliability project, we next look at whether the Valley-Rainbow Project provides economic benefits to SDG&E ratepayers and California and should be pursued as an economic project.²¹ SDG&E submitted a report to quantify some of the likely economic benefits. (Exhibit 1, Chapter IV and Exhibit 4, Chapter IV.) The report was prepared by Henwood Energy Services, Inc. and is sometimes referred to by the parties as the Henwood Report. This report looked at the impact of the Valley-Rainbow Project on electricity market prices by modeling the difference in hourly market clearing prices in load areas with and without the project under various water scenarios, assumptions about a Path 15 transmission expansion, and new generation scenarios.

8.1. Estimated Project Costs

SDG&E originally estimated the total cost of the Valley-Rainbow Project, including necessary upgrades to its existing 230 kV system and substations to accommodate a 500 kV interconnection, to be $270,963,765. (SDG&E April 26, 2001 filing.) This figure was subsequently updated by SDG&E to $289,746,381 in 2001 dollars and $301,882,646 escalated to 2005 dollars. (Exhibit 5 at IV-6.) These figures do not include allowance for funds used during construction (AFUDC). Utilizing SDG&E's current AFUDC assumption of 8.8%, the current cost estimate for the Valley-Rainbow Project is $341,068,297 in 2005 dollars. (Exhibit 5 at IV-6.) SSRC estimated that the annual carrying charge for the project would be in the range of $50 and $60 million, depending on whether the cost included AFUDC and the specific rate used to annualize costs. (Exhibit 300 at III-5.) SDG&E estimates the annual carrying charge to be $60.7 million in 2005 dollars, assuming a 17.8% fixed charge rate. (Exhibit 5 at IV-11.) To allow for a one-to-one comparison to project benefits, which are calculated in 2001 dollars, we have converted the total cost to $318.9 million in 2001 dollars.²² This results in an annual carrying charge of $56.8 million in 2001 dollars, assuming SDG&E's fixed charge rate of 17.8%.

SSRC and Centex Homes dispute the accuracy of SDG&E's cost estimate for the Valley-Rainbow Project. They argue that SDG&E has underestimated land acquisition and rights-of-way costs, resulting in overstatement of net project benefits.

This phase of the proceeding is not the place to establish a definitive cost estimate for the project, so we do not attempt to determine whether SDG&E's cost estimate over- or underestimates the actual project cost. For purposes of this decision, we use $56.8 million/year (in 2001 dollars) as an approximate cost against which to measure the forecasted benefits of the project and to calculate net project benefits. We view this estimate as a placeholder during this phase of the proceeding.

8.2. SDG&E's Economic Analysis

SDG&E describes its economic analysis as conservative because it does not assess the project's value as a hedge against market power. Likewise, the analysis assumes that generators will operate if their variable cost is covered, which results in lower market clearing prices. In essence, the model simulates cost-based bidding based on individual power plant characteristics, forecasted fuel prices, and variable operation and maintenance costs.

For each scenario analyzed, SDG&E compared the system electricity costs before and after construction of a Valley-Rainbow Project under three sets of generation assumptions (Case A; Cases B and C; Cases D and E), two sets of hydro assumptions (Cases A, B, and D; Cases C and E), and with (Cases 2 and 4) and without (Cases 1 and 3) construction of a Path 15 transmission expansion. Cases 1 and 2 assumed that the Valley-Rainbow Project (or a project like it) was not constructed; Cases 3 and 4 assumed that the Valley-Rainbow Project was constructed. All scenarios already include 1308 MW of new generation in SDG&E's service territory, 558 MW from Otay Mesa, and 750 MW from La Rosita Power Plant in Mexico. (RT 720:10-12.) All cases also include generation that is permitted or under construction in the rest of California, 3347.5 MW in Northern California and 5307.4 MW in SCE/Zone 26. (RT 778:16-780:2.) SDG&E's scenarios for dry hydro conditions assumed that there would be six consecutive years of extreme drought, with water conditions expected to occur only once in 35 years. The premise is that by reducing congestion, new transmission capacity allows for a more efficient dispatch of generation resources, thereby lowering market clearing prices and producing project benefits.

Using the time period of 2005-2010, SDG&E's scenarios identified cumulative gross benefits (in 2001 dollars) to California from building the Valley-Rainbow Project as described below, using the following specific assumptions:

· Case A1/A3 Gross benefits = $1,632,000: Median hydro conditions in all years, no additional generation capacity in California, Path 15 is not constructed

· Case A2/A4 Gross benefits = ($844,000): Median hydro conditions in all years, no additional generation capacity in California, Path 15 is constructed

· Case B1/B3 Gross benefits= $1,222,000: Median hydro conditions in all years, 1700 MW additional generation capacity in SDG&E/Northern Mexico, 1531 MW additional generation in SCE/Zone 26, 2578 MW additional generation in Northern California, Path 15 is not constructed

· Case B2/B4 Gross benefits= $6,130,000: Median hydro conditions in all years, 1700 MW additional generation capacity in SDG&E/Northern Mexico, 1531 MW additional generation in SCE/Zone 26, 2578 MW additional generation in Northern California, Path 15 is constructed

· Case C1/C3 Gross benefits= $93,491,000: Dry hydro conditions in all years, 1700 MW additional generation capacity in SDG&E/Northern Mexico, 1531 MW additional generation in SCE/Zone 26, 2578 MW additional generation in Northern California, Path 15 is not constructed

· Case C2/C4 Gross benefits= $8,475,000: Dry hydro conditions in all years, 1700 MW additional generation capacity in SDG&E/Northern Mexico, 1531 MW additional generation in SCE/Zone 26, 2578 MW additional generation in Northern California, Path 15 is constructed

· Case D1/D3 Gross benefits= $3,200,000: Median hydro conditions in all years, 1700 MW additional generation capacity in SDG&E/Northern Mexico, no additional generation anywhere else in California, Path 15 is not constructed

· Case D2/D4 Gross benefits= $33,199,000: Median hydro conditions in all years, 1700 MW additional generation capacity in SDG&E/Northern Mexico, no additional generation anywhere else in California, Path 15 is constructed

· Case E1/E3 Gross benefits= $340,811,000: Dry hydro conditions in all years, 1700 MW additional generation capacity in SDG&E/Northern Mexico, no additional generation anywhere else in California, Path 15 is not constructed

· Case E2/E4 Gross benefits= $504,677,000: Dry hydro conditions in all years, 1700 MW additional generation capacity in SDG&E/Northern Mexico, no additional generation anywhere else in California, Path 15 is constructed

SDG&E summarizes the results in this way:

"For the reference case scenario [A1/A3], ... existing generation, planned summer peakers [footnote omitted], and the addition of 1,308 MW of new generation is assumed. Under this reference case, the analysis shows only a small economic benefit to the consumers in the California ISO area over the period 2005-2010. However, there are numerous additional plants being proposed for the San Diego and North Baja areas, as well as the rest of the WSCC. When other scenarios of generation expansion are examined, including the impact of adverse hydroelectric conditions, the economic benefits can exceed $300,000,000 over that same 2005 - 2010 period. The value of the Valley - Rainbow Interconnect is significantly improved under the premise that as new transmission facilities are constructed and "bottlenecks" to the economic flow of electricity are reduced or eliminated, new generation is likely to be developed where it can capture the resulting market opportunities.

This analysis concludes that as more generation is built in San Diego and in Northern Baja, the economic value of the Valley - Rainbow Interconnect increases significantly. The analysis shows that ratepayers in San Diego, and within the entire area of the transmission grid controlled by the California ISO, would benefit from both the construction of more plants and the commensurate construction of the Valley - Rainbow Interconnect." (Exhibit 2, Chapter IV at 1-1 to 1-2, emphasis in original.)

Under cross-examination by SSRC and questioning by the ALJ, SDG&E witness Lauckhart indicated that he assumed various generation scenarios but had not analyzed the likelihood that the generation assumptions would come to pass. (See generally RT 728:7-735:24.) The analysis offered does not provide any position on the probability that any of the generation scenarios assumed would actually occur.

As we discussed earlier, we are using total costs of $318.9 million (or $56.8 million annualized in 2001 dollars) as a placeholder assumption. Thus, SDG&E's analysis shows that in eight of the ten scenarios studied the project costs over the 2005 through 2010 time frame exceed SDG&E's estimate of economic benefits. One scenario resulted in costs and benefits being equal. The only scenario where project benefits exceeded SDG&E's projected project costs assumes that six consecutive years of one-in-35 year drought conditions occur, all new generation in California is constructed in SDG&E's service territory, and the transmission capacity on Path 15 is expanded.

SDG&E studied six scenarios under median hydro conditions. Five of the six scenarios resulted in gross benefits of less than $9 million over the 2005 to 2010 time period. The sixth scenario resulted in gross benefits of $33.2 million over the 2005 to 2010 time period. Again, the annual project carrying cost over for a single year is projected by SDG&E to be $56.8 million, more than the six-year forecast of gross benefits.

In its Opening Brief, SDG&E argues that we should be considering the gross benefits of the project, without comparison to costs, because the economic benefits are "supplemental" to the reliability benefits provided by the project.

8.3. Critiques of SDG&E's Analysis

The ISO notes that SDG&E's economic studies did not assess the potential benefits of the Valley-Rainbow Project to mitigate market power, promote supply diversity, or provide incentive for new generation development. The ISO did not itself undertake a study to assess these potential benefits but it believe that the economic benefits are greater that SDG&E's study indicates. The ISO urges the Commission to qualitatively consider these potential benefits as further rationale to approve the Valley-Rainbow Project.

ORA argues that SDG&E's position that the Valley-Rainbow Project will be needed to transport cheap generation from San Diego and Baja to the Los Angeles basin, central and northern California is not supported by the record. ORA points out that SDG&E's argument in its economic case "assumes the opposite of what SDG&E assumes in its reliability case. Here they assume that large amounts of new generation will be built in the San Diego and north Baja region whereas in the reliability case they assume that no new generation will be built north or west of Mexicali." (ORA Opening Brief at 47.) ORA submits that generation build-out in between the low and high generation estimates relied on by SDG&E results in no need for the Valley-Rainbow Project.

ORA maintains that Valley-Rainbow should not be constructed if the annualized net present value of reduced system operating costs exceeds the annualized net present value of the Valley-Rainbow Project construction costs. ORA calculates that annualized benefits must exceed $60.7 million.

ORA states that it "looked long and hard for the economic benefit pot of gold that SDG&E describes but could not find it. In several scenarios of their economic analysis, SERA [ORA's consultant] assumed input variables that favored the project, including extreme drought years, but still could not find benefits:

`Additional runs ... increased ... Baja generation by a disproportionate 1,700 MW which tends to bias the results toward the benefits of VRTP. In these scenarios the second Mission to Miguel 230 kV line is also assumed. Further impacting these scenarios was the elimination of other generation within the region equal to the total additions made. Even with these controversial assumptions, the basic total benefits for the full six year period were forecasted to range from only 1.2 to $6 million depending upon the status of Path 15 upgrades. Even in the severe drought case the expected benefits ranged from only about $250,000 to $2.5 million for the full 6 year period.'" (ORA Reply Brief at 25-26.)

ORA argues that:

"Although both SDG&E and the CAISO alluded in their testimony to mitigation of market power as being a benefit of Valley-Rainbow, neither party presented persuasive analysis supporting this position. Neither party introduced testimony that even attempted to quantify this alleged benefit. However, they both cite this alleged benefit of the project in their briefs.

"ORA agrees that additional transmission lines have the potential to reduce market power. However, we disagree that building expensive transmission lines is the best means of controlling market power, or that construction of such lines will necessarily reduce market power substantially. If market power in 2005 and beyond is at low levels because of more new generation, increasing diversity of generation ownership, or more effective regulation, then the incremental economic benefit that would be provided by Valley-Rainbow is very small. If market power is at high levels, then construction of Valley-Rainbow is probably not enough to bring market power down to acceptable levels and other measures will need to be taken." (ORA Reply Brief at 27, emphasis in original.)

ORA disputes the ISO claim that the Valley-Rainbow Project has a market power mitigation benefit. "To claim significant market power mitigation benefits from this line the CAISO has to demonstrate that building this line really will reduce the market power of the dominant generators. The CAISO has introduced no such analysis here; it simply assumes as a matter of faith that more transmission lines will lead to more competition." (ORA Reply Brief at 29.)

SSRC argues that:

"SDG&E also seeks to distance itself from the results of the Henwood study by arguing that the study was conservative and therefore understated the potential economic benefits of the project. (Citation omitted.) The Commission should reject this argument, however, because the Henwood study was conducted for and presumably designed with the approval of SDG&E. If SDG&E felt (as it now claims) that some other approach to the economic study was appropriate in this case, it could and should have conducted such a study and submitted the results to the Commission with its opening testimony. SDG&E should not, however, be permitted to argue that some economic study that it chose not to conduct would have shown greater benefits." (SSRC Reply Brief at 48, fn. 25.)

SSRC states "[t]his argument should be recognized for what is: an acknowledgment by SDG&E of the marginal nature of the economic benefits of the project as calculated by its own study." (SSRC Reply Brief at 48.) SSRC points out that the "Valley-Rainbow Project can only be expected to produce economic benefits under a scenario (the export case) in which the project would not be needed for reliability purposes.... [A]nalysis reveals that even under the most favorable conditions and assumptions, the project offers only meager economic benefits... based on a series of unrealistic and unsupported assumptions." (SSRC Reply Brief at 49-50.) "Indeed, under most of the scenarios studied by Henwood, the project costs are between 3½ and 250 times the projected economic benefits." (SSRC Opening Brief at 99.) Under cross-examination by SSRC, SDG&E's witness clarified that, in several of the scenarios studied by SDG&E, the change in energy costs when the Valley-Rainbow Project was assumed to be built were so low as to be essentially zero. (See RT 722:224-27.)

During cross-examination of witness Lauckhart, counsel for SSRC examined the assumptions used in SDG&E's economic study.

"Q Now, Table 1-1 indicates that for the scenarios you've identified, E2, E4, you assumed dry hydro conditions; is that correct?

A Yes.

Q Okay. And when you say on this table that you assumed dry hydro conditions, does that mean you assumed dry hydro conditions in 2005, 2006, 2007, 2008, 2009 and 2010, all of those years?

A Yes.

Q Okay. And when you assume dry hydro conditions, that means that you are assuming we will experience what's referred to as a one-in-35-year drought?

A That's what we modeled here is the drought that we had in the year 2000-2001, which has been characterized as a one-in-35-year drought.

Q Meaning, statistically speaking, you would expect it to occur one year out of 35?

A Yeah, or alternatively it's the second worst in the seven[ty] years of history is what that really means.

Q Okay. So the benefit number shown here on your Table 1-1 of 504 million and some change, that's calculated assuming six years in a row of drought at a level of one -- at a level expected once every 35 years?

A Yes.

Q And in your rebuttal testimony, Exhibit 5, Chapter 5, page 25, lines 15 to 16 you state, and I quote:. . . it is very unlikely that the one-in-35-year drought would occur six years in a row. Do you see that?

A Yes." (RT 717:28-719:5.)

In testimony, SSRC's witness used the results of SDG&E's study to perform its own analysis to identify whether the source of the system energy cost benefits was a result of building transmission or generation. SSRC compared the system energy costs from SDG&E's study under various generation build out assumptions. SSRC summarizes the results of its analysis as follows:

"My analysis of the results of the Henwood study shows that between 90% and 99% of the combined benefits should actually be attributed to the existence of the additional 1700 MW of generation in San Diego/North Baja, rather than to the Valley-Rainbow Project ... [I]f Path 15 is not upgraded, Henwood's analysis shows that locating an additional 1700 MW in San Diego/North Baja provides $221.7 million of economic benefits over the 6 year study period, without the Valley-Rainbow Project. These benefits represent approximately 99% of the $224.9 million of economic benefits calculated by Henwood resulting from the combination of the additional 1700 MW and the Valley-Rainbow Project, if Path 15 is not upgraded. If Path 15 is upgraded, Henwood's analysis shows that locating an additional 1700 MW in San Diego/North Baja provides $335.3 million of economic benefits over the 6 year study period, without the Valley-Rainbow Project. These benefits represent approximately 90% of the $368.5 million of economic benefits calculated by Henwood resulting from the combination of the additional 1700 MW and the Valley-Rainbow Project, if Path 15 is upgraded.

* * *

By combining the economic benefits of these two factors considered in scenarios A1/D3 and A2/D4 (additional generation and the Valley-Rainbow Project), SDG&E has obscured the true source of the vast majority of the benefits. Given that the vast majority of the economic benefits attributed to the combination of the addition of 1700 MW of new generation and the Valley-Rainbow Project can be achieved without the additional cost of building Valley-Rainbow (whether or not Path 15 is upgraded), it is inappropriate to attribute all of the benefits to the project. Furthermore, it is implausible to assume that the presence (or absence) of the Valley-Rainbow Project would be a critical factor in a generator's decision to locate a project in San Diego/North Baja." (Exhibit 300 at III-10-III-12, emphasis in original.)

As described by SSRC:

"Henwood did not independently or otherwise predict that the significant quantities of new generation at issue would actually be built in San Diego/North Baja rather than elsewhere to respond to the market, but rather assumed that this would be the case for purposes of its work for SDG&E. (Citations omitted.) In fact, Henwood's study did not even determine the probability that new generation would actually be developed at the levels and locations assumed for purposes of its study....

The assumption that significant quantities of new generation will be built in the San Diego/North Baja area rather than elsewhere in the WECC is highly suspect and unsupported by the record. The assumption is not supported by any probability analysis and runs contrary to the conclusions Henwood reached regarding the location of new generation prior to, and independent of, its work for SDG&E." (SSRC Opening Brief at 106-107.)

8.4. Discussion

Based on our review, we conclude that the proposed project is not cost-effective to ratepayers. Our conclusion is based on the placeholder assumption that the Valley-Rainbow Project will cost $318.9 million (or approximately $56.8 million per year on an annualized basis in 2001 dollars). The analysis indicates that project costs exceed benefits in all but one scenario. That scenario assumes six consecutive years of one-in-35 year drought conditions, all new generation being built in SDG&E's service territory, and Path 15 being expanded. As SSRC and ORA point out, the generation assumptions that we must make to find any level of benefits are completely contrary to those promoted by SDG&E and the ISO in our reliability analysis. Thus, we would have to assume that all the generation that SDG&E and the ISO argue we cannot rely on for reliability purposes is already online, plus an additional 1700 MW in the San Diego basin and Northern Baja and none anywhere else in the state. This combination of assumptions is so extreme that it is totally unrealistic.

In all the scenarios where average hydro year conditions are assumed, the annual benefits of the proposed project are less than the cost, with the project costs exceeding benefits by at least $51.3 million/year or more, regardless of the level of new generation assumed.²³ The one scenario where annual benefits are greater than costs assumes one-in-35 year drought conditions for six consecutive years. As SSRC demonstrated during cross-examination of witness Lauckhart, even SDG&E's own witness does not consider it likely for this scenario to occur. SSRC also compellingly demonstrated that the vast majority of gross benefits identified by SDG&E are attributable to generation units coming online, rather than the construction of the Valley-Rainbow Project. Neither SDG&E nor the ISO attempted to quantify the market power mitigation value they claim accrues from the project.²⁴

Based on the project costs and minimal benefits presented by SDG&E in its testimony and the problems associated with the analysis, we find that the proposed Valley-Rainbow Project is not cost-effective to ratepayers.