4. Description of the Approved Energy Recovery Bonds

We next describe the Energy Recovery Bonds authorized by this Financing Order. The authorized Bonds are identical to those described in A.04-07-032 and consistent with SB 772 and D.03-12-035. Where appropriate, we adopt additional conditions and restrictions applicable to the Bonds.

A. No Recourse to the State

Pursuant to Section 848.1(h), the Energy Recovery Bonds authorized by this Financing Order do not constitute a debt or liability of the State of California or any political subdivision thereof; nor do the Bonds constitute a pledge of the full faith and credit of the State or any political subdivisions. In addition, the issuance of the Energy Recovery Bonds shall not directly, indirectly, or contingently obligate the State of any political subdivision to levy or to pledge any form of taxation to pay any obligations associated with the Bonds or to make any appropriations for their payment.

As required by Section 848.1(h), all Energy Recovery Bonds shall have written on them a statement to the following effect: "Neither the full faith and credit nor the taxing power of the State of California is pledged to the payment of the principal of, or interest on, this bond."

B. Two Series of Energy Recovery Bonds

Decision 03-12-035 authorizes the issuance of two series of Energy Recovery Bonds up to one year apart.³⁰ SB 772 states that the Energy Recovery Bonds may be issued in one or more series on or before December 31, 2006.³¹ This Financing Order authorizes two series of Bonds. The first series shall be issued in December 2004 or as soon possible thereafter. The second series shall be issued within one year of the first series, and no later than December 31, 2006.

To attract a broad range of investors, each series of Energy Recovery Bonds may be divided into several classes. Each class may have a different maturity date. The Financing Entity as defined by Section 848(b) shall select the final number, type, and size of bond classes to achieve the lowest average interest cost. In addition, the revenue requirement for the different classes for each series shall sum to an annual amount that closely approximates what the SPE would pay if only one class of Bonds were issued that is amortized on a level, mortgage style basis over the life of the series.

The first series of Energy Recovery Bonds shall consist of one or more classes with scheduled maturities of approximately eight years, and legal final maturities of approximately ten years. PG&E states that a legal final maturity longer than the scheduled maturity is a standard feature that allows for delays in scheduled principal payments due to variations in the cash flows from the securitized assets. The second series of Bonds shall consist of one or more classes with scheduled and legal final maturities of approximately seven and nine years, respectively. The scheduled maturities for the first and second series are similar to the remaining term of the Regulatory Asset. This avoids increasing the burden of the Energy Recovery Bonds on future ratepayers beyond what they are already obligated to pay on the Regulatory Asset.

The Energy Recovery Bonds may have fixed or floating interest rates as determined at the time of issuance to provide the lowest all-in cost of Bonds. The SPE or Bond Trustee will convert any floating rate to a synthetic fixed rate with interest-rate swaps so ratepayers will not have any significant floating-rate risk. The interest costs recovered in the rates shall be based on the resulting synthetic fixed rate. We authorize floating-rate Bonds only if the all-in cost of the Bonds, including the cost of creating a synthetic fixed rate, is less than what is available for comparable maturities in the fixed-rate market. Furthermore, as proposed by PG&E, we will require the swap counterparty that is responsible for paying the floating interest rate to have credit ratings that are sufficient to ensure that the swap does not reduce in any way the overall credit rating for the Energy Recovery Bonds. Finally, consistent with previous decisions,³² any interest-rate swaps will be subject to the following conditions:

1. PG&E, on behalf of the SPE, shall separately report all interest income and expense arising from interest-rate swaps in its regular report to the Commission.

2. PG&E, on behalf of the SPE, shall make the following available to Commission staff within 30 days of request: (i) all terms, conditions, and other details of swap transactions; (ii) the rationale for the swap transactions; (iii) the estimated costs for the "alternative" or unswapped transactions; and (iv) copy of the swap agreements and associated documentation.

C. Authorized Amount of Energy Recovery Bonds

SB 772 and D.03-12-035 strictly limit the amount of Bonds that can be issued. In particular, SB 772 and D.03-12-035 authorize Energy Recovery Bonds in an amount equal to the lesser of the following: (1) $3.0 billion, or (2) the sum of the unamortized portion of the Regulatory Asset, plus the federal income taxes and State franchise taxes associated with the unamortized portion of the Regulatory Asset, plus the cost of the issuing the Bonds, less any energy supplier refunds received prior to the issuance of the Bonds.³³

In accordance with SB 772 and D.03-12-035, the aggregate principal amount of the first series of Bonds shall equal the sum of the estimated after-tax unamortized portion of the Regulatory Asset at the time the Bonds are issued,³⁴ plus the estimated cost of issuing the first series of Bonds, less the after-tax amount of any energy supplier refunds expected to be received by PG&E prior to the issuance of the first series of Bonds. The aggregate principal amount of the second series shall equal the lesser of (1) $3.0 billion minus the aggregate principal amount of the first series, or (2) the sum of the estimated remaining federal income taxes and State franchise taxes³⁵ owed on the first and second series,³⁶ plus the cost of issuing the second series of Bonds, less the pre-tax amount of any energy supplier refunds expected to be received after the first series of Bonds is issued but prior to the date the second series is issued.

SB 772 and D.03-12-035 do not address the treatment of energy supplier refunds received after the Bonds are issued. Therefore, consistent with PG&E's unopposed proposal, any energy supplier refunds received after the second series is issued shall be refunded to ratepayers via the Energy Recovery Bonds Balancing Account (ERRBA) described later in this Financing Order.

D. The Bond Transaction

In accordance with SB 772 and D.03-12-035, the Energy Recovery Bonds will be issued by a Special Purpose Entity (SPE) that is owned by PG&E.³⁷ The Bonds will be secured by "Recovery Property," which SB 772 defines as the right to receive revenues from nonbypassable electric rates that SB 772 calls the "Fixed Recovery Amounts.³⁸" SB 772 requires the Commission to set these rates at a level that provides sufficient funds to timely pay Bond principal, interest, and other "Recovery Costs.³⁹"

PG&E shall transfer the Recovery Property to a SPE that is legally separate and bankruptcy remote from PG&E. This ensures that if PG&E ever becomes bankrupt, the Recovery Property will not be included in PG&E's bankruptcy estate. Rather, the revenues from the Recovery Property will continue to be available to pay the debt service on the Energy Recovery Bonds. In addition, as is required for asset-backed securities, a Bond Trustee will be chosen. The Bond Trustee will be responsible for holding all of the SPE's funds.

PG&E shall contribute equity to the SPE equal to at least 0.50 percent of the total Bond principal. The SPE equity will be pledged to secure the Energy Recovery Bonds and will be deposited into an account held by the Bond Trustee. PG&E adds that the IRS requires an equity contribution (i.e., credit enhancement) of at least 0.50 percent in order to characterize asset-backed securities as debt for tax purposes. PG&E notes that the required amount of equity could be increased by the IRS before the Energy Recovery Bonds are issued.⁴⁰

To fund the acquisition of the Recovery Property, the SPE will issue Energy Recovery Bonds to investors. The Bonds will be secured by the Recovery Property, the SPE equity, and other funds held by the Bond Trustee. Parties secured by this collateral may exercise all remedies pursuant to this security interest if there is a default. The proceeds (net of issuance costs) from the Energy Recovery Bonds will be transferred from the SPE to PG&E in partial payment of the purchase price for the Recovery Property. The small remaining balance of the purchase price will be paid from the SPE's equity funds.

The following diagram illustrates the Bond transaction structure approved by this Financing Order:

Bond Transaction Structure



The Commission shall have full access to the books and records of the SPE. PG&E shall not make any profit from the SPE, except for an authorized return on PG&E's equity investment in the SPE.

E. Credit Rating Issues

To obtain the highest possible credit ratings, the Recovery Property must be legally separate from PG&E's bankruptcy estate. To ensure legal separation, the SPE may (1) include one or more independent members on its board of directors in the case of a corporation or a limited liability company, or an independent trustee in the case of a trust; (2) restrict its ability to declare bankruptcy or to engage in corporate reorganizations; and (3) limit its activities to those related to the Energy Recovery Bonds.

PG&E will have to provide to the credit rating agencies an opinion from its legal counsel that (1) the transfer of the Recovery Property from PG&E to the SPE constitutes a "true sale" for bankruptcy purposes, and (2) the SPE will not be substantively consolidated for bankruptcy purposes. This legal opinion will provide assurance to the credit rating agencies that the SPE's assets (including Recovery Property) will not be part of PG&E's bankruptcy estate, and thus not available to creditors, should PG&E again enter into bankruptcy.

The SPE may obtain credit enhancements for the Energy Recovery Bonds in the form of overcollateralization if (1) required for tax purposes, or (2) the credit rating agencies require overcollateralization to receive the highest credit rating on the Bonds, and the all-in cost of the Bonds with the overcollateralization is less than without.⁴¹ The overcollateralization may be obtained via the DRC. The exact amount and timing of its collection via the DRC will be determined before each series of Bonds is issued.

The overcollateralization requirement will be sized by the rating agencies based on the amount of interest and principal which would otherwise remain unpaid on the debt service payment dates and the legal final maturity dates under the rating agencies' worst case scenario. The IRS may also set overcollateralization requirements in conjunction with the private letter ruling discussed, supra.⁴² Any overcollateralization that is collected from ratepayers in excess of total debt service and other Bond costs will be the property of the SPE. After the Energy Recovery Bonds are repaid, the increase in value of PG&E's equity interest in the SPE related to the balance in the overcolleratization subaccount or any other subaccount maintained by the SPE shall be returned to ratepayers through the ERBBA.

PG&E may also obtain the following types of credit enhancements, but only if the all-in cost of the Energy Recovery Bonds with these other credit enhancements is less than without the enhancements: bond insurance, letters of credit, and similar instruments.⁴³ In addition, the SPE's equity and other funds held by the Bond Trustee will be available as a credit enhancement. If the equity capital is drawn upon, it may be replenished from future DRC collections. Investment earnings on the equity contribution will also be available to pay for Bond principal, interest, fees and expenses.

F. Bond Issuance Costs

PG&E estimates the issuance costs for the two series of Energy Recovery Bonds, excluding servicing fees and other ongoing costs, will be $21.663 million.⁴⁴ An itemization of the estimated issuance costs is provided in the following table.

The above table does not include any costs for PG&E's employees or the Commission's Financing Team. PG&E proposes to cap the Bond issuance costs at $25 million, which is 0.83 percent of the $3.0 billion maximum Energy Recovery Bond transaction size. Costs for the Commission's Financing Team are not included in the cap.

We adopt PG&E's unopposed proposal to cap Bond issuance costs at $25 million, plus costs for the Commission's Financing Team. When the SPE issues each series of Energy Recovery Bonds, PG&E shall estimate the issuance costs. The estimated issuance costs shall be financed and included in the Energy Recovery Bonds in accordance with Section 848(d). Elsewhere in this Financing Order, we establish a Commission Financing Team, which will review the proposed costs before issuance. After the Bonds are issued and all issuance costs have been paid by the SPE, any Bond proceeds not used for issuance costs shall be used to offset the revenue requirement in the next DRC true-up calculation.

G. Tax Issues

The authorized Bond transaction is structured to achieve two important tax objectives. First, to lower overall taxes, the SPE will be treated as part of PG&E for tax purposes, and not as a separate entity responsible for paying its own taxes. Second, to avoid an immediate taxable gain when PG&E transfers the Recovery Property to the SPE, the transfer will not be treated as a sale for tax purposes. Instead, the Energy Recovery Bonds will be treated as PG&E's own debt for tax purposes. If the IRS accepts this treatment, PG&E will report taxable income over time as income is generated by the Recovery Property, and PG&E will deduct interest expense when it is accrued.

To provide certainty on the tax treatment, PG&E submitted a request for a private letter ruling to the IRS on June 8, 2004. PG&E's request asks the IRS to rule on three issues: (1) whether the Commission's establishment of the Regulatory Asset, the Commission's Financing Order, or the Commission's establishment of Recovery Property (in place of some or all of the Regulatory Asset) will result in taxable income to PG&E; (2) whether the issuance of Energy Recovery Bonds and the transfer of Bond proceeds to PG&E will result in taxable income to PG&E; and (3) whether the Energy Recovery Bonds will be treated as obligations of PG&E. PG&E anticipates the IRS will respond in December 2004, but the IRS may not respond until after December 2004 or not at all. Elsewhere in this Financing Order, we make the SPE's authority to issue Energy Recovery Bonds contingent on PG&E obtaining a favorable private letter ruling from the IRS or advising the Commission that PG&E has determined that it does not need a private letter ruling.

H. Use of Bond Proceeds

Decision 03-12-035 directs PG&E to use the proceeds from the Energy Recovery Bonds "to rebalance its capital structure to maintain the capital structure provided for under the [Modified] Settlement Agreement [adopted by D.03-12-035].⁴⁵" The Modified Settlement Agreement (MSA) requires the percentage of equity in PG&E's capital structure to be at least 52% in 2006 and equal to the "Forecast Average Equity Ratio" in 2004 and 2005.⁴⁶ The MSA defines the "Forecast Average Equity Ratio" as the "proportion of equity in the forecast of PG&E's average capital structure for calendar year 2004 and 2005 to be filed by PG&E in its 2003 cost of capital proceeding, Application No. 02-05-022, and its 2005 cost of capital proceeding, respectively, or such other [Commission] proceedings as may be appropriate.⁴⁷"

SB 772 requires PG&E to use the Bond proceeds to recover, finance, or refinance the following: (1) the unamortized balance of the Regulatory Asset, (2) the federal income taxes and State franchise taxes on the unamortized balance of the Regulatory Asset, (3) the cost of issuing the Bonds, and (4) the costs incurred by PG&E to acquire outstanding securities.⁴⁸

In A.04-07-032, as supplemented, PG&E projects that it will use the proceeds from the Bond transaction as set forth in the following table:

PG&E's proposed uses of the Bond proceeds will result in a capital structure that complies with the MSA.⁴⁹ The proposed uses are also consistent with SB 772, which requires PG&E to use Bond proceeds for, among other things, to finance the federal income taxes and State franchise taxes associated with the refinancing of the Regulatory Asset.⁵⁰ Therefore, PG&E may use the Bond proceeds as described previously. PG&E may reallocate the Bond proceeds among the authorized uses, subject to the condition that the percentage of common equity in PG&E's capital structure must comply with the MSA.

I. Exemption from the Competitive Bidding Rule

Resolution F-616, issued on October 1, 1986, requires utilities to issue debt using competitive bids. The purpose of this requirement, known as the Competitive Bidding Rule, is to reduce the cost of debt. The Resolution also provides that requests for an exemption from the Competitive Bidding Rule will be "entertained for debt issues in excess of $200 million, and will only be granted upon a compelling showing by a utility that because of the size of the issues, an exemption is warranted."

PG&E submits that the Energy Recovery Bonds issued by the SPE should be exempted from the Competitive Bidding Rule because the Bonds will have to be issued on a negotiated basis. PG&E represents that competitive bidding is not commonly used for highly structured asset-backed securitization transactions such as the Energy Recovery Bonds. PG&E adds that the interest cost of the Bonds will be minimized if underwriters can adjust the size, structure, and interest rate of particular classes of Energy Recovery Bonds to meet actual investor demand at the time the Bonds are marketed and priced. PG&E asserts that the ability to quickly adjust the Bonds to respond to investor demand is only available through a negotiated underwriting process.

We find PG&E's uncontested request to exempt the Energy Recovery Bonds from the Competitive Bidding Rule to be reasonable. Therefore, we will grant the request. However, to ensure that the Bond transaction is structured in a reasonable manner, and consistent with the authority set forth in Decisions 02-11-030, 03-04-035, 03-09-020 and 04-01-024, we will require the transaction for each series of Bonds to be reviewed and approved by a Commission Financing Team consisting of the General Counsel, the Director of the Energy Division, other Commission staff, outside bond counsel, and any other outside expertise deemed necessary by the Financing Team. The outside expertise may include, for example, an independent financial advisor to assist the Financing Team in overseeing and reviewing the issuance of each series of Bonds. The Financing Team's approval, if any, of the Bond transaction for each series of Bonds should be provided in the form of a letter from the Financing Team to PG&E.

PG&E shall reimburse the Financing Team for the costs that the Team incurs for outside bond counsel and consultants. PG&E may recover these costs as part of the issuance costs of the Bonds. Such costs will not count against the $25 million cap on issuance costs adopted elsewhere in this Financing Order.

³⁰ D.03-12-035, OP 9.

³¹ Section 848.1(e).

³² See, for example, D.95-09-023, D.96-05-066, and D.03-12-004.

³³ Section 848.7; D.03-12-035, Finding of Fact 21 and OP 3.

³⁴ PG&E estimates that the balance of the Regulatory Asset will be approximately $1.8 billion on January 1, 2005.

³⁵ SB 772 does not provide that local franchise fees will be financed with Energy Recovery Bonds. Thus, this Financing Order does not authorize the inclusion of local franchise fees in the second series of Energy Recovery Bonds.

³⁶ PG&E estimates the aggregate principal amount of both series of Bonds will be approximately $2.9 billion.

³⁷ SB 772 authorizes the use of a subsidiary SPE to issue the Energy Recovery Bonds. (See, e.g., Sections 848(b), 848.2(a) and (b), 848.4(a), (b), (c).) D.03-12-035 contemplates that the Energy Recovery Bonds will be issued by a SPE. (See, e.g., D.03-12-035, mimeo., p. 68.)

³⁸ Sections 848(d) and (j).

³⁹ Section 848.1(g). The definition of "Recovery Costs" is set forth in Section 848(i).

⁴⁰ If PG&E determines that an IRS private letter ruling is not necessary, PG&E may contribute an amount of equity of up to 1.5% of the total initial principal amount of the Bonds.

⁴¹ To overcollateralize the Bonds means to secure them with Recovery Property or other assets in an amount larger than the total principal amount of the Bonds. Overcollateralization provides assurance that bondholders will receive all principal and interest due them.

⁴² If PG&E determines that is not necessary to obtain an IRS private letter ruling, the SPE may obtain over-collateralization of up to 1.5% of the total initial Bond principal amount.

⁴³ Those providing other forms of credit enhancements should approve the level of overcollateralization, if any.

⁴⁴ PG&E Supplement filed on September 3, 2004, response to Question 3.

⁴⁵ D.03-12-035, OP 9.

⁴⁶ MSA, Section 3.b.

⁴⁷ MSA, Section 1.y.

⁴⁸ Sections 848(g) and (i).

⁴⁹ PG&E Supplements filed on September 8 and September 22, 2004.

⁵⁰ As shown in Appendix A, Table 3, of this Financing Order, the proceeds from the second series of Bonds will be recorded as a deferred tax credit for regulatory accounting purposes, which has the effect of reducing PG&E's rate base. Each year, the deferred tax credit will be amortized in an amount sufficient to "pay" the federal income taxes and State franchise taxes due on the principal payments recovered in the DRC for each series of Bonds.