V. Credit Enhancements

SDG&E requests authority to use various forms of debt enhancements: (a) put options, (b) call options, (c) sinking funds, (d) interest rate swaps, (e) "swaptions," (f) caps and collars, (g) currency swaps, (h) credit enhancements - including letters of credit, and other features, (i) capital replacement, (j) interest deferral, (k) special-purpose entity transactions, and delayed drawdown. (See Application Section V, pp. 10 - 13.)

The Commission has previously allowed SDG&E authority to use all but (e) "swaptions," (i) capital replacement, and (j) interest deferral. (See Supplement, pp. 8 - 16.) We will again authorize SDG&E the discretion to use the previously approved forms of credit enhancement without further discussion.

SDG&E's supplemental testimony describes "swaptions":

Swaption contracts grant the right to enter a swap agreement (or to exit a swap) under specified terms and conditions. A swaption put, the instrument most relevant to SDG&E's needs, gives the buyer the right, but not the obligation, to receive floating payments and to pay a fixed interest rate based on a specified notional amount. Swaptions are an over-the-counter product: the strike price, maturity, and size can be tailored to suit an issuer's particular needs. Both American- and European-style swaptions are available. Like other types of options, the swaption involves payment of an up-front premium related to the instrument's strike price and other market variables.

Swaptions provide utility management with an additional, flexible tool for interest-risk hedging. As discussed in A.06-02-017, Section VII, SDG&E can lock in the interest rate on a future borrowing with a forward-starting swap. However, the Company may desire to preserve the opportunity for further interest savings in the event that rates decline. In such a case, SDG&E would allow the swaption to expire, thus foregoing the swap and issuing debt at a rate lower than what the swap would have locked in.

Cost impact and recovery.7 Ratemaking treatment depends on what ultimately transpires after the swaption's purchase. If the underlying debt is issued as planned and the swaption is exercised, the premium would count as an issuance cost (reduction of proceeds) in SDG&E's embedded-debt calculation. On the other hand, if the underlying debt is issued as planned and the swaption is not exercised, the premium would result in an immediate expense not recoverable as a debt-related expense. Similarly, if the underlying debt is not issued at all, the premium would result in an immediate expense not recoverable as a debt-related expense. (Supplement, p. 10. Emphasis in original.)

SDG&E would be the first utility authorized to use swaptions to hedge interest rate risk. 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 use this additional tool consistent with obtaining the best possible financial terms and conditions available at the time in the capital markets.

SDG&E's supplemental testimony describes capital replacement:

Capital replacement refers to an issuer's declaration of intent, or in some cases its covenant, to replace debt securities with new securities that receive similar or better rating-agency equity credit. An example of this feature is found in Southern California Edison's [SCE's] September 2005 prospectus for its Series B Preference Stock:

It is our intention to redeem the shares only from proceeds from the issuance of new capital offerings whose equity treatment is equal to, or greater than, the shares being redeemed. (Quote within the testimony.)

The Commission in D.05-08-008 authorized SCE to issue preferred "upon terms and conditions substantially consistent with those set forth or contemplated in Application 05-02-018." In that application SCE stated that: "SCE anticipates that the terms of the preferred stock may include, but will not be limited to: (i) restrictive redemption provisions..." - a broad category into which replacement language falls.

Since 2005, SDG&E's investment bankers have indicated that explicit capital replacement could play a role in any number of new, so-called "hybrid" securities ... . A primary benefit to SDG&E of such new securities is that they may receive more rating-agency equity credit than does ordinary debt or preferred stock. Rating agency reports make it clear that capital replacement conditions are an important consideration for improved equity credit.

Cost impact and recovery. By itself, a security's capital-replacement clause does not entail any specific cash outlays or expenses requiring recovery. However, if the specified replacement were to take place, SDG&E would appropriately reflect the substitution in its embedded debt cost calculations. (Supplement, pp. 12 - 13, emphasis in original.)

SDG&E would not be the first utility authorized to use a capital replacement tool whenever it could improve or enhance its credit rating. As with swaptions and all other capital, SDG&E must justify its costs every time the Commission examines the cost of capital. Therefore, we will allow SDG&E the discretion to use this additional tool consistent with obtaining the best possible financial terms and conditions available at the time in the capital markets.

SDG&E's supplemental testimony describes interest deferral:

The ability to defer interest on a security is defined by the security's indenture and will vary from security to security. The indenture may specify certain time periods during which deferral is allowed and may limit certain payments made on other securities. It may require certain types of payments under specific circumstances during a deferral period.

Since 2005, SDG&E's investment bankers have indicated that interest deferral on subordinated debentures could play a role in any number of new, so-called "hybrid" securities, discussed in greater detail in Question 3, below. Rating agency reports make it clear that interest deferral can lead to improved equity credit.

Cost impact and recovery. The ability to defer a particular security's interest payments will have no cost impact requiring recovery. The applicable ratemaking precedent is that of conventional preferred stock, which carries a fixed, deferrable dividend that is collected regularly in rates regardless of deferral status. (Supplement, pp. 13 - 14, emphasis in original.)

The Commission has previously authorized other California utilities to issue interest-deferrable securities: PG&E (D.95-09-023), SoCalGas (D.96-09-036) and SCE (D.05-08-008). We will grant SDG&E authority to use interest deferral, whenever appropriate as noted with the other new debt instruments credit enhancement tools.

In its application SDG&E proposed that it may wish to issue debt instruments with very long lives, up to 100 years. In its supplemental testimony SDG&E clarified that the long-lives in excess of 40 years - more typical of conventional utility long-term debt - are intended to be used with some of the more exotic forms of hybrid financing. SDG&E described hybrid debt as debt possessing many characteristics of equity but is still categorized as debt for compliance with generally accepted accounting principles. SDG&E notes in particular that these hybrids "are appealing financing vehicles, as they receive the same or higher equity credit as preferred stock, but in many cases have a lower cost because their payments are tax-deductible." (Supplement, p. 17.)

We note that in our experience the long-lives of traditional debt, often a mortgage indentured long-term bond, exhibit a life not dissimilar to the service life of many long-term utility plant items, including power plants, transmission facilities and the like. We also note there is no regulatory requirement for such symmetry, or a likely and compelling ratemaking rationale to require such symmetry. For example, we would not want a utility in times of high interest costs to unnecessarily lock in those high rates for the full service life of new plant. We will allow SDG&E the discretion it seeks for long-lived securities consistent with the desirable flexibility previously discussed for SDG&E to prudently manage its cost of capital. The life-span or duration of debt instruments is simply one of the many features that figure into SDG&E's obligation to justify the reasonableness of its capital costs.

7 The ruling required SDG&E to indicate the likely method of cost recovery and impact on ratepayers.

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