3. Details of DWR's Proposed Bond Sale

DWR, the State Treasurer's Office, and their combined financing team of underwriters, financial and legal advisors began in early 2001 the process of structuring a power supply revenue bond credit that would comply with the provisions of AB1X and receive investment-grade ratings. This group faced a formidable task. The proposed sale of bonds at close to $12 billion will be "the largest municipal bond sale in history."¹⁴ In addition, there are several aspects of this financing, as well as of AB 1X and DWR's power supply program, that make this bond deal complex and unusual:

· DWR entered into certain contracts for power (called priority contracts) that have a higher priority for payment than bond costs.

· Because several contracts include terms that pass through the costs of natural gas, fluctuations in gas prices will lead to fluctuations in the price paid by DWR for power.

· Unlike a typical municipal bond offering, where the borrowing entity has the power to provide a dedicated stream of revenues, in this particular situation, the Commission must impose bond and power charges on IOU customers.

These characteristics serve to complicate the credit structure of DWR's indenture. DWR, working with rating agencies, has developed an elaborate credit structure that is described in Exhibit 1, pp. 6-13. We will not describe the detailed features of the credit structure or the elaborate flow of funds between the multiple reserve accounts, but will focus on the key features of the financing that drive the costs of the funds.

The most unusual element of the credit structure is the large size of reserve and similar accounts. The balances deposited in these accounts will comprise a significant percentage of total borrowing. The purposes of these reserves, however, are readily described:

· The reserves provide bondholders with additional security in covering the contingency that the revenues designated for repayment of bonds are needed to pay "priority contracts;"

· The reserves help maintain a quality investment-grade credit rating for DWR's bonds, as required by the Act;

· As a result of the additional security and higher credit rating the reserves produce, the reserves can help to lower overall costs of the bonds.

The exact annual revenue requirement needed to support the bonds will not be known until the bond placement is complete. To support this Commission's development of a bond charge methodology, DWR's Exhibit 1 does provide the best estimates of the credit structure and costs as of July 9, 2002. At that date, DWR estimated that a bond issuance of $11.1 billion would lead to a 2003 revenue requirement in respect to bond costs of $841,965,794, which will rise to $971,256,477 in 2004 and remain at that level through the repayment period.

In Exhibit 1, DWR's estimate anticipates an "A-level" rating, which will then lead to an "all-in average" interest rate of 5.24% for the 20 year bonds.¹⁵ This also includes tax exempt variable rate bonds at 4.61% and tax exempt hedged variable rate bonds at 5.18%.¹⁶

DWR's Reference Exhibit 1-a contains substantial revisions to Exhibit 1. It increases the size of the bond offering from $11.1 billion to $11.95 billion. DWR states that "The rating agencies are concerned that the Department may be obligated to purchase the Residual Net Short beyond the December 31, 2002 deadline for such purchases contained in Assembly Bill 1X."¹⁷ In addition, DWR proposes a different schedule of debt service payments, resulting in a bond charge revenue requirement of $1.140 billion in 2003, but decreasing to $784 million in 2004. DWR notes that its estimate anticipates an "A-level" rating, which will lead to an "all-in average" interest rate of 5.38%.¹⁸

A. Discussion: Major Changes between Exhibit 1 and Reference Exhibit 1-a

DWR's estimated 2003 revenue requirement for bond-related costs in its Reference Exhibit 1-a is almost $300 million higher than that contained in its initial testimony (Exhibit 1). In its October 15, 2002 memorandum, DWR explains this increase as resulting from changes in assumptions concerning the receipt of revenues and the uses of funds. In particular, concerning the specific use of funds, DWR states:

". . . in the June 14, 2002 Proposed Determination of Revenue Requirements [Exhibit 1], the Department made an assumption that Bond Charge Revenues would not be adequate to fund ongoing debt service (as provided by the Summary of Material Terms) until mid-2003, and that power charge revenues would be used to supplement Bond Charge revenues until that time. The August 13, 2002 supplemental testimony [Reference Exhibit 1-a] revised this assumption to provide for the full finding of bond related costs from Bond Charges in 2003."¹⁹

We note that California law assigns responsibility for determining a reasonable revenue requirement, including the bond-related costs, to DWR.²⁰ In summary, DWR plans to borrow up to $11.95 billion to repay the $6.6 billion to California's General Fund and $3.5 billion to retire an Interim Loan. The exact costs of retiring these bonds, the establishment of annual revenue requirements, and the determination of its reasonableness are, under the provisions of AB1X, the responsibility of DWR. We note that Reference Exhibit 1-a was also filed in DWR's own administrative process; DWR has the statutory authority to determine the reasonableness of the bond-related revenue requirement and has created a separate opportunity for parties to file comments. Moreover, we note that DWR will present this Commission with its more precise 2003 bond revenue requirements following its placement of the bonds according to the implementation procedures described in Section 8 below. Because DWR's August 13, 2002 filing does not constitute a final 2003 revenue requirement, we consider it only as illustrative of DWR's ongoing work in placing the bonds and estimating their costs and identify it as Reference Exhibit 1-a. We stress that we do not use this reference material as probative evidence to determine the reasonableness of the bond-related costs, which is DWR's responsibility. Instead we use these figures to help illustrate the applicability of our bond charge methodology over a range of financing possibilities.