3. Approval of PG&E's Application to Issue Energy Recovery Bonds
In A.04-07-032, PG&E requests authority under SB 772 and D.03-12-035 for a legally separate SPE to issue up to $3.0 billion of Energy Recovery Bonds in two separate series up to one year apart. The Bonds would be secured by, and repaid with, a new and nonbypassable surcharge known as the DRC.
PG&E proposes that the Energy Recovery Bonds be repaid on a level, mortgage style basis, with full repayment in 2012. PG&E estimates that issuing the Bonds will save ratepayers $694 million on a net present value basis and $1.026 billion on a nominal basis. PG&E expects these savings to be achieved without jeopardizing the fiscal soundness and creditworthiness of PG&E.
SB 772 and D.03-12-035 contemplate that A.04-07-032 should be approved if the following conditions are satisfied:
1. Legislation authorizing the issuance of Energy Recovery Bonds is enacted that is satisfactory to PG&E, TURN, and the Commission. (D.03-12-035, OP 9.)
2. The Energy Recovery Bonds provide savings to PG&E's ratepayers, on a net present value basis, over the life of the Bonds. (Section 848.1(a) and D.03-12-035, OP 9.)
3. The issuance of the Energy Recovery Bonds does not adversely affect the credit ratings of PG&E or PG&E's debt. (D.03-12-035, OP 9.)
4. The Energy Recovery Bonds comply, as necessary, with Sections 701.5 and 816, et seq. (Section 848.2(d).)
5. PG&E obtains, or determines that it does not need, a private letter ruling from the Internal Revenue Service (IRS) that states neither the refinancing of the Regulatory Asset nor the issuance of the Bonds is a presently taxable event. (Section 848.1(a) and D.03-12-035, OP 9.)
Each of these conditions is addressed below.
A. Satisfactory Legislation
The first condition is that legislation satisfactory to PG&E, TURN, and the Commission must be enacted that allows the Energy Recovery Bonds to be issued. PG&E and TURN have indicated in this proceeding that they find SB 772 to be satisfactory. We agree. Therefore, this condition is satisfied.
B. Ratepayer Benefits
The second condition is that the Energy Recovery Bonds must reduce rates on a net present value (NPV) basis.15 In A.04-07-032, PG&E compares the projected revenue requirement for the bankruptcy Regulatory Asset to the projected revenue requirement for the Energy Recovery Bonds. PG&E's comparison shows that the Energy Recovery Bonds will save ratepayers $694 million on a NPV basis.
We find PG&E's comparison to be a reasonable starting point for analyzing the benefits of the Energy Recovery Bonds. We will utilize PG&E's analytical framework with two changes. First, one of the key variables for projecting the revenue requirement for the Regulatory Asset and the Energy Recovery Bonds is PG&E's authorized return on equity (ROE). PG&E assumes in its analysis that its authorized ROE will be 11.66%. We will use the more conservative assumption that PG&E's ROE will be 11.22%, the lowest allowed by the Modified Settlement Agreement (MSA) adopted by D.03-12-035.16
Appendix A of this Financing Order shows the projected revenue requirement for the Regulatory Asset and the Energy Recovery Bonds. Appendix A uses the same method and parameters as PG&E, except that Appendix A uses an ROE of 11.22% and slightly higher Bond issuance costs.17 The specific parameters used by Appendix A, which are based on the MSA, are as follows:
1. The Regulatory Asset is amortized over a nine-year period on a level, mortgage-style basis beginning on January 1, 2004.
2. The amortization of the Regulatory Asset is "grossed up" for federal income taxes and State franchise taxes.
3. The unamortized portion of the Regulatory Asset remains in PG&E's rate base and receives PG&E's authorized rate of return, including an authorized ROE of 11.22%. The ROE is grossed up for federal income taxes and State franchise taxes.
4. The revenue requirement for the Regulatory Asset is grossed up for uncollectibles and local franchise fees.
5. The after-tax balance of the Regulatory Asset on January 1, 2005, is estimated to be $1.813 billion.
6. Two series of Energy Recovery Bonds are issued. The principal and interest on the Bonds are paid on a level, mortgage-style basis.
7. The first series of Bonds is issued on January 1, 2005, in the amount of $1.813 billion to exactly cover the estimated remaining balance of the Regulatory Asset on that date.
8. The recovery of Bond principal on the first and second series of Bonds via the DRC results in taxable income.
9. The second series of Bonds is issued on January 1, 2006, in the amount of $1.116 billion to exactly cover all future federal income taxes and State franchise taxes due on the recovery of the remaining principal on the first and second series of Bonds. The total future revenue requirement for federal income taxes and State franchise taxes for both series of Bonds is equal to the "tax gross up" on remaining principal on the first series of Bonds.
10. The proceeds from the second series reduce PG&E's rate base. The "negative rate base" is amortized as the proceeds from the second series are used to pay the federal income taxes and State franchise taxes due on the Bond principal recovered from ratepayers on the first and second series.
11. Ratepayers receive a "Carrying Cost Credit" equal to PG&E's authorized rate of return on the negative rate base.
12. The annual interest rate is assumed to be 4.98% for the first series of Bonds and 5.58% for the second series of Bonds. These rates are based on the forward curve of AAA-rated, securitized debt.
13. There is no reduction to the principal amount of the first or second series of Bonds for energy supplier refunds.
14. The net revenue requirement for both series of Bonds is grossed up for uncollectibles and local franchise fees, which will be recovered via the Energy Recovery Bond Balancing Account.
15. Both series of Bonds are repaid at the end of 2012.
Using the above parameters, Table 1 in Appendix A shows that the total revenue requirement for the Regulatory Asset will be $4.167 billion during the period of 2005 through 2012. Table 2 shows that the total revenue requirement for the first series of Energy Recovery Bonds will be $3.502 billion during the same period. Although the principal amount of the Regulatory Asset and the first series of Bonds is the same, the first series of Bonds has a lower revenue requirement compared to the Regulatory Asset because the assumed interest rate of 4.98% for the Bonds is lower than the assumed pre-tax rate of return of 12.2% to 12.8% during 2005 - 2012 for the Regulatory Asset.18
Table 3 in Appendix A shows that the total revenue requirement for the second series of Bonds will be negative $278 million during 2006 - 2012. The revenue requirement is negative because the proceeds from the second series of Bonds are used to reduce PG&E's rate base. The reduced rate base results in savings to ratepayers equal to the avoided rate of return of 12.2% to 12.8% on the reduced rate base. PG&E calls these savings the "Carrying Cost Credit." The net savings to ratepayers is equal to the difference between the Carrying Cost Credit of 12.2% to 12.8% and the assumed interest rate of 5.58% for the second series of Bonds. Table 3 shows that the annual savings decline over time as the proceeds from the second series of Bonds are used to offset the federal income taxes and State franchise taxes due on the amounts collected from PG&E's ratepayers for the principal payments on the first series of Bonds.
The net savings from both series of Energy Recovery Bonds is equal to the revenue requirement for the Regulatory Asset (Table 1 in Appendix A) less the revenue requirement for both series of Bonds (Tables 2 and 3 in Appendix A). Table 4 in Appendix A shows that the net savings to ratepayers will be $943 million on a nominal dollar basis during 2005 - 2012. Using a discount rate of 9 percent, the present value of these savings is $634 million.
The previously identified savings do not take into account other costs associated with the Energy Recovery Bonds. Therefore, the second major revision we make to PG&E's analytical framework is to incorporate those other costs that we can quantify. Table 5 in Appendix A shows that after taking into account Bond issuance costs, servicing fees, and Bond trustee fees, the Bonds will save ratepayers an estimated $447 million to $624 million on a NPV basis, and $685 million to $931 million on a nominal basis.19 These estimated savings assume the Bond transaction receives favorable tax treatment as discussed, infra. However, if it is ultimately determined that the Bond transaction results in immediate taxable income for PG&E, Table 9 in Appendix A shows that the Bond transaction would still save ratepayers an estimated $25 million to $201 million on a NPV basis, and $105 million to $351 on a nominal basis. Thus, the Bond transaction will provide savings to ratepayers under all tax scenarios.
We emphasize that the projected savings are estimates. The actual amount of savings will depend on a number of factors, such as when the Bonds are issued, the interest rate on the Bonds, and the ultimate resolution of tax issues. Although we cannot determine the precise amount of ratepayer savings at this time, we are confident that ratepayers will benefit from the issuance of the Energy Recovery Bonds.20 Therefore, the second condition is satisfied.
C. Effect of the Bonds on PG&E's Credit Ratings
The third condition is that the Energy Recovery Bonds must not adversely affect the credit ratings of PG&E or PG&E's debt.21 We find that the Energy Recovery Bonds satisfy this condition because (1) the Bond transaction will provide PG&E with nearly $2 billion of cash to restore its financial health, (2) the Bonds will be non-recourse to PG&E,22 and (3) this Financing Order obligates the Commission to set the DRC at a level that provides sufficient funds to pay Bond principal and interest on a timely basis.
D. Compliance with Sections 701.5 and 816, et seq.
The fourth condition that must be satisfied is set forth in Section 848.2(d), which states, in relevant part, as follows:
The approval by the commission in a financing order of...[Energy Recovery Bonds] shall include the approvals, if any, as may be required by Article 5 (commencing with Section 816) and Section 701.5...Section 851 is not applicable to the transfer or pledge of Recovery Property, the issuance of [Energy Recovery Bonds], or related transactions approved in a financing order.
We interpret Section 848.2(d) as requiring this Financing Order to include the approvals, if any, as may be required by Sections 701.5 and 816, et seq. These statutes state, in relevant part, as follows:
Section 701.5: [N]o electrical, gas, or telephone corporation, whose rates are set by the commission on a cost-of-service basis, shall issue any bond, note, lien, guarantee, or indebtedness of any kind pledging the utility assets or credit for or on behalf of any subsidiary or affiliate...The commission may, however, authorize an electrical, gas, or telephone corporation to issue any bond, note, lien, guarantee, or indebtedness pledging the utility assets or credit...[for] or on behalf of a subsidiary or affiliate if it engages in activities which support the electric, gas, or telephone corporation in its operations or service, these activities are, or will be, regulated either by the commission or a comparable federal agency, and the issuance of the bond, note, lien, guarantee, or indebtedness is specifically approved in advance by the commission....
Section 817: A public utility may issue . . . bonds, notes, and other evidence of indebtedness payable at periods of more than 12 months after the date thereof for any of the following purposes and no others . . . (f) For the reorganization or readjustment of its indebtedness or capitalization upon a merger, consolidation, or other reorganization.
Section 818: No public utility may issue [debt]...unless...it shall first have secured from the commission an order authorizing the issue, stating the amount thereof and the purposes to which the...proceeds thereof are to be applied, and that, in the opinion of the commission, the money, property, or labor to be procured or paid for by the issue is reasonably required for the purposes specified in the order, and that...such purposes are not, in whole or in part, reasonably chargeable to operating expenses or to income.
We conclude that the Energy Recovery Bonds do not require the Commission's approval pursuant to Section 701.5, as PG&E will "not issue any bond, note, lien, guarantee, or indebtedness of any kind pledging the utility assets or credit for or on behalf of any subsidiary or affiliate." Rather, the SPE will issue the Energy Recovery Bonds, and the Bond investors will have no recourse to PG&E. The Bonds will be secured by the DRC, and it will be the Commission's duty under SB 772 to set the DRC at a level sufficient to timely pay the principal, interest, and certain other Bond-related costs identified, infra.
The Energy Recovery Bonds approved by this Financing Order comply with Section 817(f). The fundamental purpose of the Bonds is to refinance PG&E's bankruptcy Regulatory Asset that enabled PG&E to reorganize and emerge from bankruptcy.23 Section 817(f) provides that the Commission may authorize a utility to issue debt for the "readjustment of its indebtedness or capitalization upon a merger, consolidation, or other reorganization.24" The Bond transaction also complies with Section 818 because issuance of the Bonds for the purpose of refinancing PG&E's bankruptcy Regulatory Asset will save PG&E's ratepayers between $25 million to $624 million on a NPV basis, and this purpose is not reasonably chargeable to operating expenses or income.
E. IRS Private Letter Ruling
The final condition is that PG&E must obtain, or determine that it does not need, a private letter ruling from the IRS which states that neither the refinancing of the Regulatory Asset nor the issuance of the Energy Recovery Bonds is a presently taxable event.25 PG&E expects that the issuance of the Energy Recovery Bonds and the refinancing of the Regulatory Asset will not result in presently taxable income to PG&E.26 Rather, PG&E expects to recognize taxable income over the life of the first and second series of Bonds as PG&E collects the principal on both series of Bonds from ratepayers.
To obtain certainty regarding the tax treatment, PG&E submitted a request for a private letter ruling to the IRS in June 2004. PG&E anticipates the IRS will respond in December 2004. However, the IRS might not respond until after December 2004, or not at all. If the IRS issues a private ruling, PG&E shall file a copy of the ruling at the Docket Office27 and provide a copy to the Commission`s Financing Team established by this Financing Order, infra, no later than 5 days after the IRS issues the ruling.
It is not certain if and when the IRS will issue a private letter ruling. We believe the Bonds should be issued as soon as possible in order to take advantage of historically low interest rates and to flow through the Bond-related benefits to ratepayers as soon as possible. We also believe that PG&E correctly anticipates the Bond transaction will not be deemed a presently taxable event. Therefore, so the Bond transaction can proceed without the private letter ruling, if it is not timely received, PG&E shall file and serve a compliance report that states whether PG&E believes a private letter ruling is needed. This compliance report shall be due no later than 10 days before the first series of Bonds is issued.28 If PG&E determines that it does not need a private letter ruling, this compliance report will satisfy the final condition.29
If PG&E determines that an IRS private letter ruling is not needed, it may increase the amount of overcollateralization of the Bonds and the equity contributed to the SPE in order to strengthen the position that PG&E will take in its income tax returns that the Bond transaction is not a presently taxable event. As requested by PG&E, the maximum amount of overcollateralization and equity contribution may each be no more than 1.5 percent of the Bond principal amount.
F. Approval of the Energy Recovery Bonds
We conclude for the previously stated reasons that the Energy Recovery Bonds proposed by PG&E in A.04-07-032 satisfy all the conditions for approval established by SB 772 and D.03-12-035, except for the condition that PG&E obtain, or determine that it does not need, a private letter ruling from the IRS that states neither the refinancing of the Regulatory Asset nor the issuance of the Energy Recovery Bonds is a presently taxable event. This condition must be satisfied before the Bonds are issued. Because issuance of the Energy Recovery Bonds will provide substantial benefits to PG&E's ratepayers, we will authorize the SPE to issue the Energy Recovery Bonds if and when the final condition is satisfied.
15 Section 848.1(a) and D.03-12-035, OP 9.
16 D.03-12-035, Appendix C, Section 2.b. Using a lower ROE is more conservative in that it reduces the projected benefits of the Energy Recovery Bonds.
17 PG&E assumed total issuance costs would be $21.6 million. Appendix A of this Financing Order assumes total issuance costs will be $25 million, the maximum amount allowed by this Financing Order (not including costs incurred by the Commission's Financing Team).
18 Table 1 shows the after-tax rate of return ranges from 8.3% to 8.8% during 2005 - 2012.
19 The estimated savings do not include unquantified incremental costs, such as a return on PG&E's equity investment in the SPE and overcollateralization. We estimate that the total amount of all other costs to be between $5 million and $15 million on a NPV basis. The unquantified incremental costs could be higher if the IRS determines that the Bond transaction is a presently taxable event and imposes interest on any past due taxes.
20 We believe that it is likely that the NPV of the actual savings that will ultimately be realized by ratepayers from the issuance of the Bonds will be in the upper end of the range of $25 million - $624 million estimated by this Financing Order.
21 D.03-12-035, OP 9.
22 See A.04-07-032, pp. 2-3, Chapter 1, p 1-1, and Chapter 3, pp. 3-2, 3-20, and 3-21.
23 D.03-12-035, Findings of Fact 15, 16, 20, 21, and 30; Conclusions of Law 13 and 21; and OPs 2 and 9.
24 PG&E intends to use the proceeds from the Bond transaction to fund capital expenditures and to retire debt and equity. The issuance of debt for these purposes is authorized by Sections 817(b) and (g).
25 D.03-12-035, OP 9.
26 A.04-07-032, Chapter 3, pp. 3-19 and 3-20.
27 PG&E may file a concurrent motion to place the ruling under seal.
28 There is no need to file the compliance report if the IRS issues a favorable private letter ruling prior to the date the compliance report is due.
29 We expect PG&E to advocate for favorable tax treatment regardless of whether PG&E receives the Private Letter Ruling or determines that it no longer needs it.
