4. Discussion

PG&E and SDG&E request that the Commission approve the Agreements on the basis that they represent a " commercially acceptable and mutually agreed upon relationship" between the Utilities and DWR. We have reviewed the Agreements in light of the relevant Commission decisions, the positions of the parties, and our statutory responsibilities. Although an agreement is our preference, we are not in a position to adopt the Agreements on the basis that they were negotiated like a contract. The Commission has long held that it cannot approve settlements or agreements unless they are lawful, in the public interest, and consistent with current Commission policy. To do otherwise would amount to abandoning our statutory obligations to protect ratepayers.

Our review of the utilities' filings shows that while many of the changes in the Agreements filed by PG&E and SDG&E fit these requirements, certain provisions in the Agreements are fundamentally inconsistent with the goals expressed by the Commission in D.02-09-053 and D.02-12-069 and do not meet these requirements.

In D.02-12-069, we stated that one of the Commission's fundamental short-term goals is to transition full responsibility for energy market related activities back to the utilities as soon as possible. We noted that this goal is consistent with the fact that the utilities, not DWR, continue to have statutory responsibility to serve their customers. This goal is also consistent with the fact that DWR's contracting authority expired on January 1, 2003.

We find that the changes to Sections 2.02, Articles III through VI, Article X, Article XII, and Exhibit D of the Agreements meet these requirements and should be approved. Areas subject to modifications include Section 7.03, Article VIII, Article XIII, and Exhibits A, B and C. Certain of the approved changes warrant further discussion. The areas subject to modification warrant further discussion as well.

Areas of Agreement

PG&E and SDG&E have modified Section 2.02¹ to address their concern that performance under the Operating Order might create a conflict between their limited agency duties to DWR and their obligations to electric customers. The utilities have revised Section 2.02 to state that, in addition to performing the required functions in a commercially reasonable manner, exercising good utility practice, the utilities are also required to perform " in a fashion designed to serve the best overall interests of all retail electric customers, whether the utility's or DWR's retail electric customers." While we do not take issue with this objective, we do question the ability of PG&E and SDG&E to discern the difference between the interests of their own retail customers and the interests of DWR's retail customers. As we see it, DWR's "retail customers" consist of the aggregate of the retail customers of the three major electric utilities. In this sense, DWR does not have "retail customers" of its own, separate and apart from the retail customers of the three major electric utilities, and, as such, is not in a position to assess the best interests of SDG&E's retail customers, separate and apart from DWR's retail customers, nor is SDG&E in a position to determine the best overall interests of DWR's "retail electric customers."

The utilities also revised Section 2.02 to reinstate the provision that DWR will provide evidence in Commission proceedings describing the utility's and DWR's performance under the Agreements if so requested by the utilities. Although we accept this provision, we find it unnecessary, since we would expect DWR to participate in our proceedings in any event. In addition, the utilities revised Section 2.02 to expressly acknowledge the Commission's exclusive authority over whether the utility has managed allocated power available under the Contracts in a just and reasonable manner and that nothing in the Agreements shall be interpreted to "reduce, diminish, or otherwise limit the scope" of such Commission authority or give DWR any authority over such matters. Although a similar provision already exists in the Operating Order, we are not opposed to this revision. We are also not opposed to the change to Section 2.02(d) acknowledging DWR's separate and independent right to evaluate and enforce the utilities' commercial performance within the scope of DWR's authority.

The utilities revised Section 7.01 to clarify that DWR can apply in an "appropriate forum" for sequestration and payment in the event of Utility default, rather than specifying the Commission or a court, noting that this change does not effect the Commission's role should any order pertaining to sequestration and payment be required. We agree. DWR retains the right to apply in whatever forum it deems appropriate and this right does not affect the Commission's duty to regulate the business practices of jurisdictional utilities.

PG&E and SDG&E have added Section 10.04 to the Agreements, to limit the commercial liability that the utility may owe to DWR as a result of a breach of the Agreements. The utilities argue that in other commercial contexts involving the performance of services for a cost-based fee, similar concerns over the unbalanced nature of risks and rewards led parties to agree upon caps on liability. They believe that in the absence of such a cap the financial community could view this unbalanced exposure quite negatively and this could potentially hinder or impair the ability of the utilities to regain or maintain sustainable financial health. The utilities state that this cap on liability is not intended to deprive the Commission of the ability to exercise its regulatory authority over the utilities.

SCE disagrees with general premise that the utilities have assumed liability to DWR as to their performance of their duties under the Operating Order. SCE asserts that its obligations are to its ratepayers as determined by the Commission and that any liability that such performance may engender can only be determined by the Commission.

As we have stated earlier, DWR is not subject to Commission jurisdiction, therefore, if DWR agrees to cap the utility's liability to DWR, we will not object. We do not interpret this agreement between DWR and the utilities to affect in any way, the Commission's ability to exercise its regulatory authority through compliance reviews and any necessary disallowances or sanctions. We agree with SCE that this limitation on liability shall not apply to the utilities' responsibilities to its ratepayers, shareholders, or the Commission.

The Agreements also include minor modifications to Exhibit D, which pertains to ISO Scheduling Coordinator Charges. Consistent with the Operating Order, the obligation for ISO charges incurred after the Effective Date of the Agreement is allocated to the Utility. The modifications to Exhibit D clarify that any refunds, reruns, charges or credits through the ISO attributable to costs incurred by DWR for trade dates beginning on January 17, 2001 for PG&E and February 7, 2001 for SDG&E (the dates when DWR began providing for each utility's net short requirements) up to the Effective Date belong to DWR. The modifications also reflect a commitment by DWR to take appropriate action to avoid double recovery of such refunds or credits.

The Agreements are also revised to add Section 14.16, a "most favored nations clause", allowing either utility to take advantage of any later Operating Agreements that DWR may file and that might be approved.

Areas Subject to Modification

4.2.1 Termination Rights

Contrary to the express language of D.02-09-053, the proposed Agreements reinstate Section 2.05 (b) and Section 7.03 to provide PG&E and SDG&E with the ability to terminate the Agreements in certain situations. In Section 2.05 (b), the parties have agreed that if an event occurs that materially and adversely impacts the economic position of the parties, the affected party may request an amendment to the Agreement within 180 days after notice, failing which the affected party may terminate the Agreement immediately. PG&E and SDG&E state that such clauses are typical in complex commercial arrangements to provide economic protection to an affected party should a mutually agreeable modification of the underlying contract not be reached. Similarly, Section 7.03 of the proposed Agreements would allow the utilities, upon an event of default by DWR, to terminate the Agreement after providing notice to DWR.

Although DWR is agreeable to the revisions allowing termination of the Agreement, we do not believe that utility termination rights are appropriate in this situation. We note that the Agreements are not analogous to commercial arrangements that are voluntarily entered into; the utilities are subject to the jurisdiction of the Commission and are entering into these arrangements at the direction of the Commission. In D.02-09-053, the Commission operationally allocated specific DWR Contracts to PG&E and SDG&E and directed PG&E and SDG&E to enter into operating agreements with DWR to effectuate that order. If these Agreements were indeed analogous to the complex commercial arrangements cited by PG&E and SDG&E, the utilities would not require Commission approval to enter into them. In addition, PG&E and SDG&E have filed applications for rehearing of D.02-09-053 and continue to challenge the Commission's authority in this regard. Given the circumstances, we do not believe it is appropriate for the utilities to independently determine when the Agreements should be terminated.

We recognize that DWR is not subject to Commission jurisdiction and retains the right to terminate the Agreements at its sole discretion, therefore, we modify Section 2.05 (b) of the Agreements to reflect that DWR may terminate the Agreements under the agreed-upon terms, but that the utilities shall have no right to terminate the Agreements either in whole or in part. We also modify Section 7.03 to state that, in the event of DWR default, the utilities may request Commission approval to terminate the Agreements.

4.2.2 Transition Period

The Utilities and DWR have added Section 5.01(f) to the Agreements, which states:

"In the event (1) Utility determines that it can perform its obligations under the Agreement by following more than one course of action, (2) Utility develops recommended protocols for implementing its obligations under the Agreement or (3) Utility is uncertain how to perform its obligations under the Agreement. Utility may, at its sole discretion, present the various options (including advantages or disadvantages), protocols, or proposed actions to DWR for directions, instructions or approvals and DWR will provide timely guidance to Utility. Utility action in compliance with instructions, directions or approvals provided by DWR, or, in the event DWR refuses to provide guidance, in compliance with Utility's recommendation shall be deemed in compliance with the Agreement for all purposes under the Agreement and shall not be an Event of Default under Section 7.01 or subject to indemnification under Section 14.11 . . . " (PG&E Agreement, p.14)

According to PG&E, under this provision, "if the utilities were uncertain as to how the parties to an Allocated Contract contemplated the working of its dispatch terms, the Utility would develop options to take to DWR for guidance as to how to proceed."

We recognize that there may be situations in which the utilities may find it useful to ask questions of DWR, but we do not see the need to incorporate this into the Agreement as one of DWR's "duties". We believe that the Operating Agreement already provides sufficient direction to guide the utilities in their administration of the DWR contracts. Section 2.02 of the Operating Agreement requires the utilities to administer the contracts in a "commercially reasonable manner, consistent with good utility practice", and Section 13.04 provides the utilities with procedures for negotiating in good faith with DWR, should disagreements arise.

We also find that the language in Section 5.01 (f) conflicts with Section 2.02(c), which states:

"DWR acknowledges the Commission's exclusive authority over whether the Utility has managed Allocated Power available under the Contracts in a just and reasonable manner and DWR and Utility each agrees that none of the provisions of this Agreement shall be interpreted to reduce, diminish, or otherwise limit the scope of any Commission authority or to give DWR any authority over such matters."(PG&E Agreement, p. 8.)

By seeking and acquiring DWR's "directions, instructions or approvals" regarding various dispatch or operational options, the Agreements would essentially delegate dispatch and operational decision making to DWR. SDG&E's comments confirm our understanding of Section 5.01(f) stating that it "provides a mechanism for utilities to obtain instructions from DWR on how to administer DWR contracts where there are several choices available."

Finally, we are concerned that this provision would effectively extend the "transition period" incorporated in Exhibit A, Section VI, from a six-month period to the entire term of the contract. In D.02-12-069, we rejected this provision citing concerns regarding the unnecessary expense associated with the six- month transition period. Section 5.01(f) would only exacerbate these concerns. For the above reasons, we modify the Operating Agreements to delete Section 5.01(f).

4.2.3 Utility Fees and Charges

The utilities have revised Section 8.01 of the Agreements to provide an alternate option concerning reimbursement for the utilities' costs associated with administering the DWR Contracts. This option would treat reimbursement in a manner similar to the reimbursement arrangements set forth in the existing Servicing Agreement. Under this option DWR would agree to pay the utilities a "fee" in order to cover the costs associated with administering the DWR contracts. These "fees" would be billed and reimbursed in conjunction with Section 7 of the Servicing Agreement. Under this option, the utility would first estimate its costs of administering the DWR contracts and provide this estimate to DWR. To the extent these costs are "administrative costs," they will require annual appropriation by the Legislature. DWR would then forecast the amount necessary to recover the amounts paid to the utilities, and its own administrative costs, and this combined amount would be included in DWR's revenue requirement for allocation among the three electric utilities. The combined administrative costs would be paid to DWR as part of each utility's "remittance rate" paid for by retail customers.

To further complicate matters, under current processes, the utilities' "fees" would not have been subject to review by either the Commission or DWR. In fact, once the utilities have been reimbursed by DWR for the estimated costs, those costs would become part of DWR's Revenue Requirement and would no longer be subject to review by this Commission. Furthermore, although it is possible for the Commission to undertake a review of the estimated "fees" prior to the utilities' forwarding them to DWR for payment, this step is not contemplated by our current ratemaking processes and would be an added burden on this Commission's time and resources.

For this reason, the Commission, in D.02-09-053 and D.02-12-074 found that recovery of the utilities' administrative costs associated with DWR contract should be addressed in each utility's general rate case (GRC), where we also consider the administrative costs associated with non-DWR contracts (D.02-09-053). As we stated in D.02-09-053, "having the utilities account for the administrative costs associated with DWR contracts in the same manner as the administrative costs associated with other procurement contracts (i.e., in each utility's general rate case), will enable the Commission to review them in the context of overall administrative cost level to determine the need for any rate increases to base rates."

We note that in filings leading up to D.02-12-074, PG&E recommended that these costs should be reviewed and set on a forecast basis in the GRC. TURN and ORA supported this recommendation, and SDG&E and SCE agreed that in the future administrative costs should be included in base rates established in the GRCs (D.02-12-074, page 38).

At best, the alternative option proposed by the utilities would make it more difficult, if not impossible, for the Commission to adequately review the utilities' cost of administering the DWR Contracts. Removing an additional cost category from Commission review will also make it difficult to get a complete picture of the utilities' cost of service. At worst, the alternative option would substitute a system with additional costs and complexities for a fairly straightforward, existing system. The option would also require DWR to approach the legislature to appropriate funds to increase its administrative budget at a time when the State's budget is already stretched thin. We believe that DWR's role in generation procurement should result in the least possible increase in the total cost that electric end-users pay for procurement-related services. We find that the alternate option produces a distinctly more costly option for end-users. Since the alternate option is neither more cost effective nor more efficient, it should be rejected.

4.2.4 Binding Arbitration

The utilities have revised Sections 13.04 (Good-Faith Negotiations) and 14.10 (Amendment upon Changed Circumstances) of the Agreements to require that disputes and disagreements between the utilities and DWR be subject to binding arbitration. We do not believe it is wise or lawful for the Commission to cede its regulatory authority to an arbitrator. The Operating Order is designed to implement and effectuate legislation of the State of California as well as prior Commission decisions. No party other than the Commission can settle disputes regarding compliance with Commission decisions. Sections 13.04 and 14.10 should be modified to state that if the parties are unable to resolve a dispute or agree on necessary amendments, either party may, at its sole discretion, submit the dispute to the Commission for final resolution.

4.2.5 Operating Protocols

The Agreements include several revisions to Exhibit A, addressing Operating Protocols. According to PG&E and SDG&E, the revisions are designed to eliminate concerns that they might be "caught" in a conflict between their fiduciary duty owed to DWR as a limited agent and their fiduciary duty to retail customers. The utilities have revised Article I of Exhibit A to state:

"Utility shall undertake these least cost dispatch functions both of Allocated Contracts and URG so as to minimize the cost of service to retail customers based on circumstances known or that reasonable could have been known at the time dispatch decisions are made. DWR shall have no role in enforcement or review of Utility least cost dispatch under this Agreement and all issues of Utility compliance with least cost dispatch shall be within the sole review of the Commission."

The changes to the remaining sections of Exhibit A, however, belie the stated intent and the express language of Article I. For example, the utility must develop pay-for-curtailment protocols that will enable the utility to instruct a must-take resource not to deliver energy under specified conditions, and submit such protocols and procedures to DWR for approval. Similarly, under Part IV of Article I, the utilities would submit monthly sales plans addressing all surplus sales, for review and approval by DWR. The Agreements also include a provision rejected by the Commission in D.02-12-069 providing that DWR will, during a six-month transition period, facilitate, assist and cooperate with utility in the transition from DWR to utility performance of the operational, dispatch, and administrative functions as provided under the Agreement. The utilities claim that this feature would take advantage of the experience gained by DWR personnel whom will remain with DWR in any event, and will permit the transition to the utilities to be as smooth and least costly as possible, however, the utilities also state that this provision is complementary to the process contemplated by Section 5.01(f), described above, in which DWR would be available to review and approve alternate methods of dispatching DWR Contracts for the duration of the contract term.

The utilities have also revised Article II of the Agreements to allow the utilities to develop protocols or procedures for using DWR resources to bid into the ISO's Ancillary Services (AS) market or for the self-provision of AS. Article II of the Agreement states that these protocols and procedures would be subject to review and approval by DWR "solely for compliance with the terms and conditions of the Allocated Contracts." The Agreements also state that the: "Utility shall, upon DWR's request, provide to DWR such information concerning Utility's intended use of DWR resources for AS as DWR may reasonably request for planning and revenue requirement purposes."

It is difficult to reconcile the approvals required in the above sections with the claim that "DWR shall have no role in enforcement or review of Utility least cost dispatch under this Agreement and all issues of Utility compliance with least cost dispatch shall be within the sole review of the Commission." The activities contemplated in Articles II, III and IV require the utilities to engage in least cost dispatch. If DWR is involved in the review and approval of the utilities' decision-making processes, DWR is involved in the review of utility least cost dispatch. The fact that DWR's approval would occur in advance of the actual physical dispatch of the energy is irrelevant.

While we believe it is appropriate for the utilities to submit protocols and sales plans to DWR for forecasting and reporting purposes, we do not believe it is appropriate for DWR to "review and approve" such sales protocols or sales plans. With respect to Articles II, III, and IV, the Operating Agreements is modified to eliminate the requirement that DWR "review and approve" the utilities dispatch decision protocols and procedures.

We understand DWR's concern that the use of Allocated Contracts for AS may affect DWR's revenues, nonetheless, we believe that the utilities should be solely responsible for all least cost dispatch decisions concerning the Allocated contracts, including the use or non-use of contract resources for AS. If DWR is concerned that one of the utilities' protocols would resulting a breach of contract, DWR should notify the utility.

4.2.6 Fuel Management Protocols

With respect to fuel management for DWR Contracts, we find ourselves in an undesirable situation. At this time we are unable to fully assign the legal and financial responsibility for the DWR Contracts to the utilities. In D.02-09-053, we found that since the utilities are not signatories to the contracts containing the gas tolling provisions, ending DWR involvement in gas procurement entirely may be impossible, insofar as the contracts prohibit assignment of DWR's rights (e.g., the right to procure gas). We also found that making the utilities financially responsible for gas purchases under the gas tolling provisions while DWR retained the financially responsibility for the electricity purchases would lead to an asymmetry in cost allocation.

However, as discussed in D.02-09-053, we distinguished between administrative responsibilities (e.g., choosing to buy gas, contacting gas suppliers, entering into agreements to buy gas) and financial responsibilities (i.e., responsibility for paying from a utility revenue requirement for gas procured for DWR contracts). We determined that the utility, and not DWR, should assume the administrative responsibility of procuring gas because it goes hand in hand with the responsibility to minimize operating costs associated with the DWR contracts. Moreover, we found that requiring DWR to continue in this role ignores that fact that it is exiting the electric procurement business in all other respects. At the same time, we also acknowledged that divorcing decision-making responsibility from financial responsibility is an invitation to disaster.

The fuel management protocols in Exhibit B of the Operating Order are designed to provide the necessary link between the administrative decision-making responsibility and the financial responsibility. DWR would retain legal and financial responsibility for gas and related services, while the utilities would, as a limited agent acting for DWR, perform the administrative and operational activities required to ensure adequate gas supplies consistent with the tolling agreements in the contracts. The Operating Order requires the utilities to prepare Gas Supply Plans, which would be reviewed by the Commission and DWR. Subsequent to approval of the Gas Supply Plans, the utilities would act within the parameters of the Gas Supply Plans without further DWR involvement.

The utilities' revisions to Exhibit B of the Agreements would eliminate the Commission's role in reviewing the Gas Supply Plans and would allow DWR to provide additional up-front guidance to the utilities in their implementation of the Gas Supply Plans. Under Exhibit B, DWR would provide information to the utilities regarding gas providers that are acceptable and any limitations or terms that may need to be inserted into gas purchase, transportation, and storage contracts. The Agreements also require DWR's advance review and approval where a utility negotiates gas contracts of a total value exceeding $10 million or a term exceeding 3 months. The Agreements also clarify that final decisions relating to the use or non-use of financial tools such as futures, options, and swaps to hedge future gas price exposure on any gas volumes not hedged by the Utility under the utility Gas Supply Plan shall be made and implemented by DWR, and any such DWR hedge contract shall be provided to the Utility for use in calculating the cost of gas for use in making dispatch decisions.

SCE is concerned that the Agreements substantially reduce the utilities' role and discretion with regard to fuel management. SCE strongly opposes the terms of Exhibit B which would allow DWR, in addition to approving the utilities' Gas Supply Plans, to supply a list of approved suppliers from whom the utility shall purchase gas, determine how such supplies will be delivered, determine whether such gas should be used for storage capacity that DWR will direct, direct what provisions should be included in the contracts, and determine to what extent the utilities should hedge the risk of such supply costs. SCE believes these requirements would unnecessarily complicate its ability to manage its resources in an efficient manner.

Notwithstanding our policy preference that DWR be allowed to end its involvement in gas purchasing, we will approve the provisions requiring DWR to participate in the fuel management activities as contemplated by the Agreements. We recognize that under the current situation, DWR retains financial and legal responsibility for the contracts, including the right to implement the gas tolling provisions of the contracts. The revisions allow DWR to provide the utilities with additional up-front information regarding contract limits, and approved suppliers, which the utilities will then incorporate into their Gas Supply Plans and gas procurement activities. We view these requirements as relatively minor clarifications designed to streamline the utilities' gas purchasing activities and increase the likelihood that DWR will sign gas contracts presented to it in a timely manner. We modify the Agreements to reinstate the requirement that the Gas Supply Plans be subject to Commission review and approval. We direct the utilities to file initial Gas Supply Plans with the Commission and DWR within 30 days of this decision and then every six months thereafter for the term of the Agreement.

We note that D.02-09-053 determined that while it is possible to make an argument that ABX1-1, as codified in Water Code § 80260, bars DWR from having any responsibility for gas procurement, this argument ultimately fails. In the event that the legislature or a court of competent jurisdiction determines that DWR is not or should not be authorized to continue entering into contracts for gas supplies, transportation, etc., we will revisit this arrangement.

4.2.7 Settlement Principles for Remittances
and Surplus Revenues

As discussed in D.02-09-053, we adopted a pro rata approach to calculating surplus sales and revenues, based on dispatched quantities of energy. D.02-12-069 further defined this policy, finding that revenues should be allocated for both surplus sales and retail customer deliveries, and that surplus sales quantities should be calculated as the difference between the utility's Energy Delivery Obligations (EDOs) and the combination of energy from URG and energy dispatched from DWR contracts.

The Agreements filed by PG&E and SDG&E each contain several revisions to Exhibit C addressing Settlement Principles for Remittances and Surplus Revenues. Several of the changes are relatively minor. We address these changes first, and then turn to the more substantive changes. The first minor change is that both Agreements define the term "Over-Generation" as a condition announced by the ISO in which total supply exceeds total load in the ISO control area and revised the discussion of "Over-Generation" to clarify that revenues or costs associated with delivering surplus energy during Over-Generation periods will not be distributed until the final monthly invoice from the ISO. The utilities also agree to place revenues from Surplus Sales into a separate account, a "Surplus Sales Fund", to be held in trust and to be disbursed by the utility to DWR consistent with the pro rata sharing policy.

The utilities also delete language in the Operating Order differentiating between positive and negative ISO Instructed Energy. The change simplifies the description to a netted result, and the treatment of ISO Instructed Energy remains unchanged, it is still resource-specific, and is not included in the supply quantity for purposes of pro rata sharing. Similarly, although under the Operating Order regarding ISO Uninstructed Energy, Positive Load and Positive Supply is shared on a pro rata basis, and Negative Load and Negative Supply is counted as URG, the Agreements would net the load and supply deviations into a single schedule and would apply this net deviation to URG for pro rata share calculation. This change is intended to be consistent with the ISO's method of tracking and reporting ISO uninstructed energy.

Both Agreements would also modify the treatment of exchanges. While the Operating Order counts existing exchange transactions as URG-specific, but does not count future exchange transactions as URG-specific, the Agreements would count both existing and new exchange transactions as using and supplementing URG for the purposes of pro rata share calculation.

SDG&E's Agreement adjusts Utility Supply for transmission losses but deletes the adjustment for transmission losses from the definition of DWR Supply. PG&E's Agreement adjusts both DWR Supply and Utility Supply for transmission losses. We believe this revision is simply an oversight on SDG&E's part, as they do not provide an explanation for the change. Since transmission loss is defined as energy that is lost due to the process of transmitting energy from supply source to load, and supply resources from both the DWR contracts and utility supply have identifiable transmission losses, we modify SDG&E's Agreement to adjust DWR Supply for transmission losses.

The more extensive changes to Exhibit C are present only in the PG&E Agreement. The most significant revisions contained in PG&E's Agreement include an "economic stacking" protocol which would be used to calculate surplus sales revenues, and adjustment to those revenues to account for the "variable costs" associated with surplus sales quantities, and an interim resolution of the Western Area Power Administration (WAPA) quantities.

PG&E acknowledges that its approach to Exhibit C is different from that adopted in the Operating Order and agreed upon by SDG&E, but states that its refinements better implement the pro rata sharing concepts adopted in D.02-09-053 and eliminate potential perverse outcomes associated with the other approaches. As PG&E described in its reply to SCE's comments, its primary objective in making changes to Exhibit C was to eliminate what it views to be an "over-remittance" problem. PG&E states that, under Exhibit C of the Operating Order, the remittance rate will be paid for output from a portion of the DWR resources used for surplus sales. PG&E expresses concern that if such retail remittance rate were to be considered part of the variable cost of making such surplus sale, it would be unclear whether making a surplus sale from that asset would be consistent with least cost dispatch.

According to PG&E, under its version the remittance rate is paid only for DWR resources that are used to serve retail load on a least cost basis. First, PG&E would determine the specific resources that, on a least cost basis, were used to meet retail load using an "economic stacking" protocol. Next, PG&E would determine which resources were dispatched but were not needed to meet retail load; these resources would comprise the excess resources. PG&E would then subtract the variable costs associated with the excess resources (including gas, variable O&M, brokerage fees, transmission costs) from the revenues. The net revenues would be allocated between DWR and PG&E based on the relative quantities dispatched. PG&E believes that its method would clarify that surplus sales will be made when market prices are greater than the incremental dispatch costs (i.e., variable costs) of a unit and the resulting margin will reduce rates to customers.

SCE urges us to reject PG&E's method of calculating surplus sales. In particular, SCE is concerned that PG&E's proposal will result in the utilities receiving an improper price signal for sales because the protocol is based on an approximation of variable costs, rather than actual costs. SCE also argues that PG&E's method would result in differing approaches for surplus sales calculations among the utilities. As SCE points out, the Commission has not yet adopted mechanism for "truing-up" DWR's Revenue Requirement, nor has the Commission adopted an accounting treatment to insulate one utility's allocation of DWR costs from another utility's accounting practices or dispatch and sales decisions. According to SCE, these mechanisms are to be developed in the next stage of the DWR revenue requirement proceedings. SCE contends that until these mechanisms are in place, the Commission should not approve differing approaches for surplus sales calculations.

We find that the allocation approach contemplated by PG&E requires two separate calculations: one for physical dispatch decisions and one for calculating surplus sales revenues. For physical dispatch decisions, the utilities would engage in least cost dispatch decision making, whereas for calculation of surplus sales revenues, an "economic stacking" protocol would be used. The resulting ranking of resources under least cost dispatch will change daily or hourly, depending on system conditions, while the ranking of resources under the "economic stacking" appears to remain fairly static with the exception of the addition or deletion of new resources.

Despite PG&E's assertions that its protocol would identify the specific resources used to meet retail load, and thereby eliminate any "over-remittance" problem, what the protocol would actually identify is an approximation of which resources are most likely to be dispatched first. As described on page C-10 of PG&E's Agreement, "total retail supply is determined based on the economic stacking established in Section A, commencing with must-take, then least cost heat rate and ending with the highest cost heat rate unit required to meet EDO". And, while physical least cost dispatch decisions would be based on actual variable costs, the "economic stacking" protocol is based on an estimate of variable costs.

This "economic stacking" rank of resources would be used to calculate the variable costs associated with surplus sales. Variable costs would be calculated (again, based on estimates) for each unit in the economic "stack" above the EDO. This estimate of variable costs would be subtracted from actual surplus sales revenues; the remaining "net revenues" would be allocated between DWR and the utility. As PG&E puts it, "each of DWR and PG&E will recover its transaction related costs and variable costs for each unit in the economic stacking above EDO..." However, under this approach there is no assurance that the amount remitted for variable costs will equal the amount incurred.

In support of its approach, PG&E emphasizes that the definition of "economic stacking" is not applicable to the concept of "least cost dispatch" stated in Exhibit A and that DWR will have no role in enforcement or review of utility least cost dispatch under this Agreement. As described in Section A of PG&E's Agreement, "the parties will apply the following economic stacking assumptions set forth in this paragraph solely for remittance purposes." "Utility and DWR will apply the following economic stacking of resources for Surplus Energy Sales Revenues Settlements based on economic dispatch principles at the earliest practical date after execution of this Agreement." Although the parties state that the "economic stacking" protocol is used only for calculating surplus sales and remittances and that only the Commission will be responsible for review of least cost dispatch, it does not appear that two are separable.

We find that PG&E's "economic stacking" protocol is inconsistent with the pro rata sharing policy adopted in D.02-09-053. In order to implement PG&E's method of calculating surplus sales revenues, PG&E would have to estimate the merit order of all resources, contrary to the direction in D.02-09-053. The Commission expressly rejected several proposals to adopt a specific merit order for resources, finding that "there is no need to specify a dispatch order among must-take resources or between utility resources and DWR resources."

We are also concerned that basing surplus sales revenues on an economic stacking method will reduce the utilities' incentive to conduct least cost dispatch. Once a merit order was established, the utilities incentive to make surplus sales would be reduced depending on whose resources were ranked on the margin, because all surplus sales would be resource-specific. We agree with SCE that the economic stacking would need to change to reflect actual least cost dispatch decisions in order to convey the right price signal. A ranking order based on "a reasonable approximation in lieu of actual costs" cannot convey a proper price signal.

And finally, despite the Commission's previous findings in the WAPA issue, PG&E states that the appropriate treatment of the WAPA has yet to be resolved. PG&E's Exhibit C incorporates an interim approach for the treatment of WAPA that would be subject to true-up and refund if the Commission determines this issue should be resolved differently going forward. Under this interim approach, WAPA load is not included in Retail Load or Energy Delivery Obligations, but is part of Utility Supply. Following adoption of the Agreement, PG&E would file a motion with the Commission seeking final resolution of the WAPA issue. We disagree with PG&E's contention that this issue remains unresolved. This issue has already been decided by the Commission in D.02-05-048 and D.02-12-069 and we will not revisit it in this decision.

In sum, while we approve certain of the changes to Exhibit C of the Agreements, we believe it is unwise to approved PG&E's proposed economic stacking mechanism at this time. It is incomplete, inconsistent with D.02-09-053, does not reflect least cost dispatch protocols, and has the potential to unfairly impact SCE and SDG&E. For all these reasons, we reject PG&E's "economic stacking" mechanism.