COM/GFB/ccv Mailed 9/8/2004

BEFORE THE PUBLIC UTILITIES COMMISSION OF THE STATE OF CALIFORNIA

Order Instituting Rulemaking on the Commission's own motion for the purpose of considering policies and guidelines regarding the allocation of gains from sales of energy, telecommunications, and water utility assets.

FILED

PUBLIC UTILITIES COMMISSION

September 2, 2004

SAN FRANCISCO, CALIFORNIA

RULEMAKING 04-09-003

ORDER INSTITUTING RULEMAKING REGARDING ALLOCATION OF GAINS ON SALE BY ENERGY UTILITIES, INCUMBENT LOCAL TELECOMMUNICATIONS CARRIERS AND WATER COMPANIES

Table of Contents

Title Pages

ORDER INSTITUTING RULEMAKING REGARDING ALLOCATION OF GAINS ON SALE BY ENERGY UTILITIES, INCUMBENT LOCAL TELECOMMUNICATIONS CARRIERS AND WATER COMPANIES 1 1

I. Summary 2 2

II. Recent Commission Treatment of Gain on Sale 5 5

III. Fundamental Concepts 8 8

IV. The Treatment of Gains by other States 13 13

V. Important Prior Commission Decisions 20 20

VII. Discussion 36 36

VIII. Proposed guidelines for allocation of the gains. 39 39

IX. P.U. Code §455.5. 40 40

X. Preliminary Scoping Memo 42 42

XI. Category of Proceeding 43 43

XII. Respondents 43 43

XIII. Parties and Service List 43 43

XIV. Schedule 45 45

XV. Public Advisor 45 45

XVI. Ex Parte Communications 46 46

Findings of Fact 46 46

ORDER 51 51

Appendix A ELECTRONIC SERVICE PROTOCOLS

Appendix B List of Cases in Which Gain on Sale Question Deferred to This Proceeding

I. Summary

By this order, we initiate an Order Instituting Rulemaking on our own motion to consider policies and guidelines regarding the allocation of the gains from sales of utility assets. The primary purpose of this proceeding is to set forth clear guidelines regarding the disposition of the capital gains realized upon the sale of utility property. We will consider in this Rulemaking assets sold by electric and gas utilities, certain telecommunications carriers, and water utilities.¹

The goal of this Rulemaking is to ensure that our guidelines related to gain on sale of public utility property are easy to follow, properly allocate gains and losses based on financial risks, provide incentives for prudent investment in and continued ownership of property necessary for service to utility customers, and do not provide utilities any unreasonable incentives for unnecessary and speculative investment to profit from gains on sale. We also seek to ensure that the guidelines provide the utilities with necessary incentives to dispose of properties that have been rendered unnecessary by change of circumstances. We tentatively conclude that utilities be allocated no more than 50% and no less than 5% of the gain on sale of land or non-land assets. We intend to establish a specific percentage allocation of gain on sale (e.g., 20%) that would give utilities between 5% and 50% of the gain on sale under normal circumstances and with the remainder allocated to ratepayers. In unusual circumstances, we would consider the issue on a case-by-case basis.

We invite comment from utility respondents and other interest parties on the proposed guidelines, the proposed allocation of gains and losses and other related topics discussed herein.

In general, the utilities should invest in real estate and plant only to the extent that it is needed to serve their customers. Such investments should be included in ratebase. When these assets are no longer needed to provide utility service, the utilities should so notify the Commission, the assets should be removed from ratebase and disposed of pursuant to Pub. Util. Code § 851, and their costs should no longer be paid by ratepayers. Our rules should provide incentives to promote these goals.

If shareholders receive a portion of the gain on sale that is too large, they may have an incentive to add properties that are not really needed for service to customers but have the potential to bring them high profit at some later date when sold. On the other hand, it may be necessary to provide shareholders with enough of the gain to encourage the utilities to sell properties that are no longer needed. Proper gain on sale guidelines should result in the right kind and level of investment and divestiture, as well as reflect the relative risks borne by shareholders and ratepayers.

Our preference is to create guidelines and a specific rule on allocation of the gain on sale between shareholders and ratepayers, so that the determination of the proper gain on sale for a specific sale is easy and clear-cut. Only where the sale is unusual or especially complex should the guidelines be more open-ended. To date, most of our determinations of how to allocate gains on sale have been conducted on a case-by-case basis. This case-by-case analysis is cumbersome for the Commission and for parties, and often does not provide clear guidance for future cases on how to allocate gains. This lack of clarity promotes inefficiency and inconsistency.

We deferred such determination in several recent cases because the guidelines for determining how to allocate the gain were difficult to follow. The guidelines we develop in this proceeding will also provide direction for how to allocate the gains - currently held by the utilities in memorandum accounts or otherwise in suspense - in those cases. We identify the cases in which we deferred the gain on sale allocation determination in Appendix B to this decision. We will also require the utilities named as Respondents to supplement the list in Appendix B if they are aware of other cases - whether or not they affect that Respondent - in which we deferred the question.

In summary, the guidelines proposed in this Order are as follows:

1. These guidelines should apply to the allocation of both gains and losses upon the sale of a capital asset.

2. The allocation should vary directly, holding everything else constant, with the assumption of the financial risk of the investment.

3. While it is important to ensure that ratepayers are not harmed by the sale of the asset, or that they are compensated if they are, it is equally important to recognize who has borne the burden of the financial risk of the investment.

4. For the majority of cases, ratepayers have borne most of the financial risk and have paid for the asset. Thus it will be typical for most of the gain to be allocated to the ratepayer. The burden of the financial risk should be a primary consideration whenever the gain is allocated between ratepayer and shareholder.

5. There should be no difference in the treatment of depreciable and nondepreciable assets (land) for the purpose of allocating the gain. If land that has been taken out of ratebase is sold, an allocation of the gain or loss should be assessed consistent with the risk that has been shared between the ratepayer and shareholder.

6. The Uniform System of Accounts is useful for the accounting and recording of a transaction, but it is not useful in the determination of how the gain is to be allocated.

7. The allocation of the gain on sale standards should provide an incentive to encourage prudent management of utility assets.

8. The allocation should be applied to after-tax gains only.

¹ Pub. Util. Code §§ 789 et seq. gives guidance regarding the disposition of the gains from the sale of real property by water utilities. Upon review of this statute, it appears that, as explained more thoroughly below, the Commission will need to interpret that statute to reconcile its impact with the requirements of Pub. Util. Code § 451 and 454 that water utilities' rates be just and reasonable.