D0209053 Interim Opinion on Procurement Issues: DWR Contract Allocation

9. Reasonableness Review Risk and Indemnification

The utilities each argue that how they administer the DWR contracts⁶⁴ is between themselves and DWR,⁶⁵ and that this commission cannot interpose itself into the assertedly exclusive DWR/utility relationship. But, that argument notwithstanding, SCE at least does accept that the Commission has some Jurisdiction to review how the utilities administer DWR contracts. As SCE summarizes its (and the other parties') arguments on this point:

"AB1X-1 makes DWR solely responsible for administration of the long term contracts. No party argues that the Commission has no authority to review the [utilities'] actions in connection with their administration of the DWR contracts. Instead, the parties object to the undefined, unbounded nature of the reasonableness review language. As currently written, the [proposed decision] arguably imposes significant disallowance risk on the [utilities] for administration actions that may be sanctioned or ordered by DWR."⁶⁶

Thus SCE at least seems to accept as a threshold matter that the Commission possesses some authority to review the justness and reasonableness of utility administration of DWR contracts.

SDG&E stakes out a different middle ground. SDG&E initially argues that: "this [reasonableness review] requirement is unlawful and overbroad under AB X1-1 and AB 57 (once it is signed by the Governor)."⁶⁷ But SDG&E then goes on to propose a framework for this Commission evaluating at least some aspects of SDG&E's contract administration practices.⁶⁸

PG&E takes a more extreme position:

"the [proposed decision] must be modified to eliminate the provisions purporting to vest the Commission with reasonableness review authority over costs that the utilities incur as agents of DWR or that DWR incurs directly as a result of utility operation of DWR's contracts. . . [t]he only remedy for the [proposed decision's] failure to reflect correctly this legal requirement of AB1X is to amend the [proposed decision] to remove Commission reasonableness review of the utilities' DWR contract administration."⁶⁹

All three utilities' arguments flow from the premise that administration of the DWR contracts impacts the DWR revenue requirement, and that this Commission has no authority to engage in reasonableness review of the DWR revenue requirement.⁷⁰ Cast slightly differently, the argument runs that this commission could not review the reasonableness of DWR's, or DWR's agents', administration of the DWR contracts, and so cannot review the utilities' administration of the DWR contracts either.⁷¹

The premise underlying this argument is one with which we do not agree. The utilities' arguments rest on Water Code Section 80110, which provides in pertinent part that: "any just and reasonable review under [Public Utilities Code] Section 451shall be conducted and determined by the department."⁷² The utilities' arguments do not account for the language in AB57, Section 1, (d) that confers responsibility upon this Commission to "assure that each electrical corporation optimizes the value of its overall supply portfolio, including Department of Water Resources contracts and procurement pursuant to Section 454.5 of the Public Utilities Code."⁷³ Section 454.5 of the PU Code, as enacted in AB57, provides in pertinent part in subsection (d)(2) that, notwithstanding language eliminating "the need for after-the-fact reasonableness reviews of an electrical corporation's actions in compliance with an approved procurement plan," the Commission "may establish a regulatory process to verify and assure that each contract was administered in accordance with the terms of the contract . . ."

SDG&E conclusorily asserts that the reasonableness review envisioned by the [proposed decision] "goes beyond the process envisioned by this provision," but does not explain how. The utilities would presumably read the word "contract" in subsection (d)(2) as referring only to a contracts to which a utility is a party, and the costs of which are included in a utility's revenue requirement.⁷⁴ This reading is impossible to square with the language in AB57, Section 1, (d), linking 454.5 to the Commission's legislative mandate to optimize "overall supply portfolio[s], including Department of Water Resources contracts."

The broader reading of "contract," however, appears to implicate AB1X and puts at issue the scope of this Commission's say over recovery of the elements of DWR's Revenue Requirement. The Commission cannot determine that some portion of DWR's Revenue Requirement is not just and reasonable and must be borne by shareholders, without running afoul of Water Code Section 80110. In fulfilling our legislative mandate to review the reasonableness of the utilities' administration of the DWR contracts (including the gas tolling provisions thereof), we are constrained by the fact that this Commission cannot deny DWR recovery of its reasonable costs.⁷⁵ Were ensuring that DWR recovers its revenue requirement the only constraint on our reasonableness review, there would be no difficulty in this Commission simply allocating the DWR Revenue Requirement between customers - who would pay only just and reasonable costs - and utility shareholders - who would bear unjust and unreasonable costs.

The utilities argument, as elaborated earlier, rests on a misreading of Water Code Section 80110. Water Code Section 80110 vests DWR with responsibility for "any just and reasonable review under Section 451 . . ." The review of the contracts, as we have explained above, will be "pursuant to Section 454.5 . . ."⁷⁶ and not pursuant to Section 451. Water Code Section 80110 is quite narrow in its delegation. Unsurprisingly, it makes no mention whatsoever of Public Utilities Code Section 454.5, a law that is both more recent than AB1X (which codified Water Code Section 80110), and a law that is more specific than AB1X insofar as it directly addresses this Commission's review of utility contract administration. AB1 X1 addresses DWR's role with respect to its revenue requirement but does not limit the Commission's ability to regulate utilities.

We note parenthetically that the review described here would not impact DWR's revenue requirement. DWR will continue to review its revenue requirement per Water Code Section 80110 and Public Utilities section 451, and will continue to submit its revenue requirement to this Commission and recover that revenue requirement per the Rate Agreement Decision. The Public Utilities Code Section 454.5 process established by this Decision will be devoted to allocating costs between ratepayers and shareholders, without impacting DWR revenues.

Once the threshold legal issue of whether the CPUC may review the reasonableness of utility administration of DWR contracts is disposed of, the question becomes one of policy: should the Commission exercise its jurisdiction over contract administration? SCE argues "no," lest "the [utilities] have two masters with potentially quite different agendas," which results in "significant disallowance risk on the [utilities] for administration actions that may be sanctioned or ordered by DWR."⁷⁷ DWR, in its comments, identifies two scenarios that "could exist where the utility would not be allowed to recover such costs under the Commission's determination but DWR may or could include such costs in its own revenue requirement."⁷⁸ SDG&E makes an argument (albeit in the context of arguing that no reasonableness review is appropriate) that: "there is no need or legitimate basis to impose hindsight reasonableness review burdens on the utilities. There are simply too many variables and moving parts to justify this approach, particularly when the utilities did not negotiate or structure these contracts, nor do they retain ultimate financial and legal responsibility for them."⁷⁹ SDG&E proffers alternative approaches, as note above, to ensuring that they administer DWR contracts in a just and reasonable fashion.

We do not find these arguments compelling. We are hard pressed to imagine a scenario in which DWR orders a utility to take some action, only to have this Commission find that the utility acted unreasonably. The need for some review is clear, given that the utilities will be playing with other peoples' money, and, as noted earlier, divorcing decision-making from financial responsibility is an invitation to disaster. Finally, as already noted, this Commission has a legislative mandate under AB57 to ensure that the utilities' contract management costs are just and reasonable.

SCE raises a due-process argument. SCE states in its Opening Comments that: ·"parties were not afforded an opportunity to address the legality of Commission review of administration of the DWR contracts," and in its Reply Comments that "parties were not afforded an opportunity to comment on the legality and appropriateness of the reasonableness review requirement before the [proposed decision] was issued. For this reason, the reasonableness review requirement should be removed from the [proposed decision]." A party that has been able to brief a legal issue twice prior to issuance of a decision has had its opportunity to be heard, and these arguments are not meritorious. SCE has long been on notice that reasonableness review was an issue in the broader Procurement OIR, and can hardly be surprised to see the issue rear its head in miniature in this phase of the proceeding. SCE itself introduced the issue of reasonableness review into the proceeding at the PHC, as noted in the Scoping Memorandum: "At the PHC, PG&E, Edison, the Independent Energy Producers Association, and Dynegy Marketing and Trade ask that the Commission consider adopting here policy framework statements on timely recovery of costs and limiting the risk associated with after-the-fact reasonableness review . . . Parties may propose specific language that addresses this concern in their testimony." SCE may fairly claim that we did not see things their way, but SCE should not be heard today to complain of being ambushed.

Moreover, we do not decide today the level of review that we will apply to a review of utility contract administration. It is sufficient for the moment to conclude that this Commission will review utility contract administration practices for their reasonableness, while deferring our enunciation of the applicable standard of review to some time prior to January 1, 2003.

Ironically, SCE contends that this - our failure to go far enough down a road SCE first says we ought not tread at all - is itself legal error. The only legal argument proffered by SCE is that "to allow unlimited financial exposure is tantamount to assigning financial responsibility for the contracts to the utilities in violation of AB 1X-1's requirements that DWR remain liable for the financial impacts of the contracts."⁸⁰ We reject both the equation of "unlimited financial exposure" with "financial responsibility for the contracts" and the assertion that ABX1-1 requires that "DWR remain liable for the financial impacts of the contracts." The former is simply hyperbole, while the latter is unsupported by anything more than a generic citation to the testimony of a DWR witness, whose interpretation of the law (even if as SCE claims) is not binding on this Commission. SCE cites to no portion of ABX1-1 that requires DWR to remain liable for "financial impacts of the contracts," and we are aware of none.

Finally, the utilities contend that DWR will need to indemnify them for any claims that might arise out of the administration of the contracts. For example, if a supplier does not perform as required under a DWR contract, SDG&E argues that the utility should not be liable for that supplier's failure to perform.⁸¹ There may be certain types of "failure to perform" claims for which DWR indemnification is appropriate, as the utilities suggest. These circumstances should be considered in the development of the operating agreements discussed above. However, DWR indemnification should not relieve the utilities from the responsibility of implementing the terms of the contract in good faith, so that the supplier has a reasonable opportunity to perform under those terms.

⁶⁴ In its comments on the proposed decision, Aglet Consumer Alliance ("Aglet") has sought clarification that the reasonableness review at issue today does not reach the "the reasonableness of DWR contract terms, quantities and prices." (Aglet Comments, p. 2. We confirm that the reasonableness of DWR contract terms, quantities and prices are not subject to reasonableness review by this Commission, but regard this as sufficiently apparent from the draft of the decision as to make the modifications that Aglet requests unnecessary. ⁶⁵Opening Comments of PG&E on Proposed Decision, p. 3: "the [proposed decision] must be modified to state that DWR, not the Commission, is responsible under AB1X for ensuring that the DWR contracts are administered reasonably by the utilities consistent with the direction and guidance DWR provides and that the Commission lacks authority to conduct a prudence review of the utilities' performance of these duties on behalf of DWR."

Reply Comments of SCE on Proposed Decision: "the [proposed decision]'s reasonableness review requirement exceeds the Commission's jurisdiction because AB1X-1 makes DWR solely responsible for management and administration of the contracts at issue."

⁶⁶ Reply Comments of SCE on Proposed Decision, p. 4 (emphasis added). ⁶⁷ Reply Comments of SDG&E on Proposed Decision, p. 2. ⁶⁸ Opening Comments of SDG&E on Proposed Decision, p. 5: "For example, the Commission could audit the utilities' administration of the contracts according to either a pre-determined or random schedule. The Commission could also require periodic reports from the utilities regarding the administration of the contracts." The former approach sounds very close to traditional reasonableness review. SDG&E also proposes that the Commission rely on the proposed "Operational Functional Agreement" to delineate reasonable behavior "up front." Id. Finally, SDG&E proposes informal meetings amongst its representatives, DWR representatives, and CPUC staff. ⁶⁹ Reply Comments of PG&E on Proposed Decision, p.3. See also Opening Comments of PG&E on Proposed Decision, p. 3, quoted above. ⁷⁰ See Opening Comments of PG&E on Proposed Decision, p. 9: "under no circumstances would DWR contract costs in DWR's revenue requirement be subject to the Commission's reasonableness review under AB1X, whether the contracts are managed by DWR or the utilities." See also SDG&E Opening Comments, pp. 4-5. ⁷¹ See Opening Comments of SCE on Proposed Decision, p.2, n.1. See also Opening Comments of SDG&E on Proposed Decision, p. 2: "there is no legitimate basis to impose reasonableness review burdens on the utilities based on their administration of the contracts when CDWR was itself immune from such risk pursuant to Assembly Bill (AB) X1-1." For a further gloss on the argument, see Opening Comments of PG&E on Proposed Decision, p. 7: "If DWR should choose instead to have another agent or agents manage its contracts, those costs and the decisions of those agents would not be subject to review by this Commission." ⁷² Water Code Section 80110. ⁷³ Public Utilities Code Section 454.5. ⁷⁴ Such an argument is apparent in PG&E's assertion that: "the scope of prudence review and `disallowance risk' that the Commission is empowered to exercise is explicitly limited to actions undertaken by the utilities in dispatch and operation of their own resources as those actions affect their own costs and services," even though PG&E does not cite to AB57 by name. Opening Comments of PG&E on Proposed Decision, p. 3. ⁷⁵ See D.02-02-051 ("Rate Agreement Decision"), rehearing denied in D.02-03-063. ⁷⁶ AB57, Section 1(d). ⁷⁷ Reply Comments of SCE on Proposed Decision, p. 4. ⁷⁸ Opening Comments of DWR on Proposed Decision, p. 7. ⁷⁹ Reply Comments of SDG&E on Proposed Decision, p. 2. ⁸⁰ Opening Comments of SCE on Proposed Decision, p. 3. ⁸¹ July 30, 2002 Comments of SDG&E, p. 13.