IV. Types of Debt Securities

SDG&E seeks authority to issue: (a) secured debt, (b) unsecured debt or debentures, (c) debt in foreign capital markets in U.S. or other currency denomination and proceeds in U.S. or other currency possibly with currency swaps, (d) medium-term notes with maturity of generally 9 months to 15 years, but authority for up to 40 years, (e) direct long-term loans greater than one year pursuant to lines of credit with various institutions, (f) accounts receivable financing by pledging, selling, or assigning the accounts receivable of the company, (g) tax exempt debt, (h) variable rate debt of various possible forms, (i) "fall-away" mortgage bonds that are initially secured debt and later convertible into unsecured debt, and (j) subordinated debt, junior in its right of payment to senior secured and unsecured indebtedness. (See Application Section IV, pp. 6 - 10.)

The Commission has previously allowed SDG&E to issue all of the above types of debt except for the last two, "fall-away" mortgage bonds and subordinated debt. (See Supplement, pp. 2 - 7.) We will again authorize SDG&E the discretion to use these previously approved forms of debt without further discussion, except to further examine accounts receivable financing, as discussed below. We also discuss the two new forms of debt instruments in more detail below.

SDG&E's supplemental testimony describes "fall-away" mortgage bonds (FMB):

The purpose of "fall away" FMBs is to ultimately replace an existing first mortgage indenture with an unsecured note financing program or a modernized first mortgage indenture. Generally, "fall away" bonds are used in the following fashion: new, unsecured senior notes are issued under a senior note indenture and are initially secured by mirror FMBs issued under the first mortgage indenture and delivered to the senior note trustee. These mirror FMBs will have the same interest rate, maturity date, and other terms of the senior notes and will rank equally with all other outstanding FMBs. The senior note indenture provides that on the earlier of (i) the date that all FMBs (other than the mirror bonds) have been retired or (ii) the date upon which some other condition has been met (e.g., a ratings threshold has been crossed, certain financial ratios have been exceeded, a certain percentage of outstanding FMBs have been delivered to the senior note trustee, etc.) the mirror bonds will be canceled and cease to secure the senior notes (i.e., they "fall away") and the senior notes become unsecured general obligations of the company.

The use of "fall-away" bonds offers certain benefits to a utility issuer like SDG&E. First, it allows the firm to launch an unsecured note program with a rating comparable to that of its first mortgage bonds. Second, once the company's first mortgage debt has fallen away and the new senior notes are no longer subordinate to the former FMBs, additional senior notes can be later sold at interest rates essentially equivalent to those which could have been obtainable for secured debt. Finally, the issuance of senior notes under a streamlined, twenty-first century indenture eliminates the administrative costs and burdens associated with a vintage-1930 first mortgage indenture. (Supplement, pp. 5 - 6.)

SDG&E further points out that the Commission authorized Pacific Gas and Electric Company (PG&E) to issue "fall-away" mortgage bonds in D.04-10-037.1 We find that SDG&E has the burden of proof to justify its underlying cost of debt whenever the Commission adopts a reasonable cost of capital. Further, we expect SDG&E to act prudently at all times and use its best professional judgment and best available information at the time it enters into financing transactions. Therefore, we will allow SDG&E the discretion to include this new form of debt and we will grant SDG&E the requested authority for this new type of debt instrument.

SDG&E's supplemental testimony describes subordinated debt:

Subordinated debt is a key component of trust-preferred securities, a conventional security that has been recognized by the Commission for over ten years. A typical trust-preferred structure works in the following manner: a company seeking to raise cash forms a wholly owned trust that issues preferred stock. The parent company in turn simultaneously issues deeply subordinated debentures to the trust. The debentures have "back-to-back" terms with the trust's preferred securities, meaning that the interest, redemption and other payments on the subordinated debt correspond to those on the preferred. In addition, the parent company may guarantee the trust's securities.

The typical benefit to an issuer like SDG&E of a trust-preferred security is the tax treatment: on a consolidated basis, the dividends paid to investors are tax-deductible due to the presence of subordinated debt in the structure. This lower preferred cost is a direct benefit to ratepayers.

Today, subordinated debt may be useful in more structures than just trust-preferred securities. Since early 2005, the Company's investment bankers have indicated that subordinated debt could play a role in any number of new, so-called "hybrid" securities, ... . The benefits to SDG&E of such new securities are twofold. First, the new securities can receive more rating-agency equity credit than is currently granted to traditional trust-preferred or preferred stock. The term "equity credit" refers to how rating agencies treat securities that are neither debt nor equity when running their calculations. Moody's Investors Service describes the process like so:

The hybrid's characteristics are...scored in terms of their strength relative to common equity...[o]nce these scores have been assigned, the hybrid is compared to hybrids already on the debt-equity continuum and placed in a basket. There is a specific percentage of debt and equity associated with each basket, which is used to adjust full sets of financial statements. The hybrid is then considered within the context of each issuer's overall credit fundamentals and its impact on the rating is left to the relevant rating committee. (Quote within the testimony.)

The second benefit is that most of these new securities, like trust preferreds, feature tax-deductible periodic payments, thus reducing financing costs for ratepayers. (Supplement, pp. 6 - 7.)

SDG&E further points out that the Commission authorized subordinated debt for PG&E (D.95-09-023), Southern California Gas (SoCalGas) (D.96-09-036), and Southern California Edison (SCE) (D.05-08-008).

As already noted, SDG&E must justify its capital structure and costs in the appropriate proceedings. We will grant SDG&E authority for this additional type of debt instrument.

We want to examine more closely SDG&E's request for authority to secure its debt with its accounts receivable. SDG&E has previous authority which it has not exercised. (D.04-01-009.) There are two divergent bodies of Commission precedent relevant to SDG&E's current request. The first consists of decisions that have allowed several utilities, including SDG&E in its most recent financing decision, to use their accounts receivable as collateral to secure debt. In general, these decisions placed few, if any, restrictions or conditions on the use of accounts receivable as collateral.2 The second set is confined to PG&E. These decisions were issued shortly before and during PG&E's recent bankruptcy: they authorized PG&E to pledge its gas customer accounts receivable for the sole purpose of procuring gas supplies for PG&E's core customers, including flowing gas and storage gas.3 In D.04-10-037, the Commission found:

It was fortunate that PG&E's gas accounts receivable were available to be used as collateral for the procurement of gas for PG&E's customers during PG&E's bankruptcy. If PG&E's gas accounts receivable had already been pledged as collateral for other purposes, it is possible that PG&E would not have been able to procure adequate supplies of gas for its customers,4 thereby causing gas shortages with potentially disastrous consequences for California.5

We conclude that it is in the public interest to ensure that amounts paid by PG&E's customers will always be available to serve as collateral for the procurement of gas and electricity. Therefore, we will limit PG&E's authority to pledge its gas customer accounts receivable to the sole purpose of procuring gas supplies for PG&E's customers, including flowing gas and storage gas. Similarly, we will limit PG&E's authority to pledge its electric accounts receivable to the sole purpose of procuring electric power for PG&E's customers, including any fuels necessary for PG&E's retained generation plants. (mimeo., pp. 19 - 21.)

The Commission subsequently revoked this restriction6 in D.05-04-023, where we found:

We do so with the expectation that the modification will enable PG&E to issue debt at the lowest possible cost for its ratepayers. We also agree with PG&E that because other utilities have been authorized to use their accounts receivable to secure debt, PG&E should be granted the same authority. (Mimeo., p. 7.)

Restrictions on the use of accounts receivables could provide a significant safeguard for SDG&E's ratepayers - ensuring the availability of the receivables to finance gas and electricity purchases in a crisis - and, as SDG&E indicated, it has not previously exercised its broader authority. We therefore strongly encourage SDG&E to be very cautious in the use of accounts receivable financing - especially in light of the wide range of other tools we authorize and noting that it has not used its prior authority to date. But our current policy is to allow the utilities discretion on when, or if, to use accounts receivable for general credit enhancement purposes and we will therefore continue to allow SDG&E the same discretion.

1 D.04-10-037 dated October 28, 2004, and subsequently modified by D.05-04-023 dated April 7, 2005, in A.04-05-041, filed May 27, 2004.

2 See, e.g., D.04-01-009 (San Diego Gas & Electric Company), D.03-11-018 (Southern California Edison Company), and D.01-04-031 (Mountain Utilities).

3 See D.04-02-056, D.03-02-061, D.02-03-025, D.01-06-074, D.01-02-050, and D.01-01-062.

4 PG&E asserted at the time that its ability to procure adequate supplies of gas was dependent on its use of accounts receivable as collateral for gas purchases. (See, e.g., D.04-02-056, Finding of Fact (FOF) 2; D.03-02-061, pp. 3, 4, and FOF 2; and D.01-01-062, FOFs 6, 7, 8, & 10.)

5 D.01-01-062, FOF 9.

6 On November 29, 2004, PG&E filed a petition to modify D.04-10-037.

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