Other Revisions to the PPA

FIN 46(R)

With the addition of the Put and Call Options to the PPA, SDG&E opines that it now has additional filing and reporting requirements with the Securities and Exchange Commission (SEC). In December 2003, FASB issued FIN 46(R) to provide guidance on the identification of and financial reporting for entities over which control is achieved through means other than voting rights. Such entities are called variable-interest entities (VIE). SDG&E reads FIN 46(R) as applying to the Put and Call Options it has with OMEC. FIN 46(R) stipulates that a contract to purchase the entire output of a single plant entity at something other than a fixed price constitutes a "variable interest" in that entity. Furthermore, the "primary beneficiary" of a VIE's activities must consolidate the financial statements of the VIE when issuing the primary beneficiary's financial statements.

Based on a litany of factors, SDG&E reads FIN 46(R) as characterizing OMEC as a VIE. According to that interpretation, SDG&E believes that since it may likely be the owner of the power plant after the term of the Revised PPA, it will be the Primary Beneficiary of OMEC, and it will be required to consolidate the financial statements of OMEC. After consolidation, SDG&E's capital structure will have much higher leverage. Therefore, SDG&E believes it will have to increase the amount of equity in its capital structure to keep it in line with what the Commission authorized in SDG&E's Cost of Capital decision, D.05-12-053. SDG&E is requesting rate recovery to cover this cost.

DRA, TURN, and UCAN do not take a position on SDG&E's analysis of FIN 46(R) because there has not been enough time to see how the SEC applies this new regulation. In order not to have this issue impede all the parties from supporting the Joint Petition, the parties have agreed to maximum amounts eligible for recovery pursuant to SDG&E's proposed FIN 46(R) treatment, as set forth in the Joint Petition. If future evidence suggests that SDG&E does not have to increase its equity to comply with FIN 46(R), DRA, TURN, and UCAN reserve the right to petition the Commission to adjust SDG&E's capital structure accordingly.

TURN, UCAN, and DRA caution that their position on the FIN 46(R) issue should not be regarded as a precedent for any future similar transaction. The agreed-upon caps (in nominal dollars) are as follows:

2009 - $16.0 million // 2010 - $15.5 million // 2011 - $15.0 million // 2012 - $14.4 million // 2013 - $13.9 million // 2014 - $13.4 million // 2015 - $12.8 million // 2016 - $12.3 million // 2017 - $11.8 million // 2018 - $11.2 million.

Incentive Mechanisms

The first incentive mechanism covers the incremental output capacity of the plant and the second covers the heat-rate. In order to ensure that OMEC designs, builds and then operates the plant under good industry standards throughout the ten-year delivery term, SDG&E designed a performance incentive that would compensate OMEC if and only if the plant maintains a designated output capacity.⁴ The incentive mechanism is spread over the ten-year delivery term to ensure that OMEC maintained this peak performance throughout the ten-year delivery term.

With respect to the heat-rate, the Otay Mesa plant is designed to utilize dry cooling instead of the wet cooling system used at Palomar. SDG&E's customers will therefore save in operation and maintenance (O&M) charges since the plant will not require the high levels of make-up water used for wet cooling. However, dry cooling technology typically uses more ancillary loading at the plant site, which reduces the net effective heat-rate of the plant. SDG&E therefore designed a performance incentive mechanism that will provide an incentive for OMEC to design, build and operate the project at the lowest possible heat-rate. The incentive is crafted to compensate OMEC for the savings that will be realized by utilizing dry cooling technology that could match the heat-rate performance of a power plant that employs wet cooling. This heat-rate incentive is also spread out over the ten-year term.

To address concerns that the consumer intervenors had regarding the additional costs for these incentive payments, SDG&E agreed to caps for both the performance and the heat-rate incentive mechanisms. In addition, if OMEC does not meet the performance thresholds, no payments will be made. SDG&E believes that the savings achieved by the increased performance and lower heat-rate will exceed the performance incentive payments, netting a benefit to ratepayers.

Local Area Reliability Costs

SDG&E, and the other Joint Parties, ask that the Commission allocate a portion of the local area reliability costs of the Revised PPA to all customers in SDG&E's service territory who benefit from the addition of the Otay Mesa plant, not just to the utility's bundled customers. Thus far, SDG&E has generally been able to accomplish such an equitable cost allocation through a reliability-must-run agreement (RMR) for Palomar, and proposes the same treatment for Otay Mesa.

Since the Joint Petition was filed on July 3, 2006, the Commission issued a decision on July 20, 2006, D.06-07-029, that established a cost sharing mechanism for utilities' to spread the benefits and costs of new generation throughout their service territory. The Joint Parties ask that the Commission provide the option for SDG&E to seek cost recovery for the Otay Mesa plant under this new cost sharing mechanism, rather than RMR. The Joint Parties do not view RMR as a long-term solution, nor a superior solution, but SDG&E believes otherwise.

However, we specifically declined to extend the new cost allocation mechanism to SDG&E's Otay Mesa facility in D.06-07-029.⁵ The Otay Mesa resource was chosen by SDG&E in its 2003 Grid Reliability RFP, and based on the assets chosen from that RFP, SDG&E made no showing of need in its 2004 long-term procurement proceeding (LTPP) filing. In D.06-07-029, we limited the application of the new cost allocation mechanism to the need findings of the LTPP proceeding, D.04-12-048. No need was found for SDG&E.

Therefore, the new cost allocation mechanism is not available to SDG&E for Otay Mesa during the PPA period. Furthermore, pursuant to D.06-07-029, if Otay Mesa does become a utility-owned asset of SDG&E at the expiration of the ten-year PPA, it would not be eligible for the new cost allocation mechanism since utility-owned assets are excluded.

SDG&E always assumed that the Otay Mesa would receive RMR treatment. SDG&E has the option of utilizing RMR treatment, or the cost sharing mechanism established in D.04-12-048, whichever option is in the best interest of its ratepayers.

⁴ SDG&E filed the specifics of the incentives under a Protective Order (PO) adopted on January 14, 2004, as part of R.01-10-024, the docket under which SDG&E originally filed its motion for approval of its new electric resource contracts. SDG&E asserts the position that materials submitted in this docket that pertain to its Procurement Plans are covered by this PO.

⁵ D.06-07-029, mimeo., p. 46.