4. Next Steps: Proceeding to Phase II
of this Rulemaking

While we conclude that the Commission cannot currently lift the suspension of direct access, there is still merit in proceeding forward expeditiously with Phase II of this rulemaking Consistent with the scope of issues previously designated for this phase of the rulemaking, we address herein the legal considerations relating to possible measures to facilitate removal of DWR from its role as supplier of power under AB1X.²² Even though conditions in effect today require that the suspension continue in effect, we will move ahead to consider permissible steps whereby DWR could be removed from its role as power supplier under AB1X on an expedited basis. Exploring a plan to accelerate the timeframe to remove DWR from supplying power under AB1X is consistent with the policy that we previously articulated as noted below in D.02-12-069.

Under ABX1-1, DWR's authority is not perpetual. Water Code Section 80260 provides that DWR's authority to contract for such purchases expired on January 1, 2003. Water Code § 80000 and 80003 further demonstrate that DWR's authority was an emergency measure designed to stabilize a crisis. Both the Commission and the Legislature have expressed their intent to eliminate the need for DWR to continue procuring power for the utilities after January 1, 2003, consistent with the utilities' statutory obligation to serve their customers.

Consistent with the intent of ABIX, one of this Commission's fundamental short-term goals is to transition full responsibility for energy market related activities back to the utilities as soon as possible. We should therefore make every effort to relieve DWR from the responsibility to perform any functions that should be performed in the long term by regular market participants. We note that this direction is consistent with the fact that the utility, and not DWR, continues to have a statutory responsibility to serve its customers. The utilities' obligation to serve their customers is mandated by state law and is part and parcel of the entire regulatory scheme under which the utilities received a franchise and under which the Commission regulates utilities under the Public Utilities Act. (See, e.g., Pub. Util. Code §§ 451, 761, 762, 768, and 770.) [Footnote omitted] (D.02-12-069 at 7-8.)

Consistent with D.02-12-069, alternative approaches should therefore be considered to remove DWR from the role of supplying power to retail customers under AB1X on an expedited basis. We will consider in Phase II the most appropriate process and timing considerations to examine alternative approaches, and whether such approaches would be in the public interest.

CACES offers two possible approaches for accelerating the timeframe in which DWR no longer supplies power under AB1X. One approach would be through the novation and assignment of existing DWR contracts, as suggested in the OIR, whereby DWR would be taken out of the power supply chain entirely. Alternatives may be available whereby DWR could terminate its ownership interests earlier than the current contract expiration dates. If its ownership interests were to be terminated, the condition that DWR no longer "supplied power" would be satisfied. The Commission would then be legally permitted to lift the suspension on direct access subject to further findings in Phases II and III concerning the public policy merits and manner of doing so. Another possible approach suggested by CACES is to alter the flow of power from the DWR contracts whereby title to the power would move to a third party before any possible resale to retail customers. As a strategy to accomplish such a goal, CACES points to the approach applied in D.06-07-029, where the utilities secure resources for system need rather than for bundled retail customers.

Under such an approach, DWR would no longer sell power directly to retail customers, but would make the power available to the wholesale power market. CACES argues that the following advantages could be realized through this approach:

(1) DWR would no longer directly provide power to retail customers because the IOUs could assume the contracts;

(2) The IOUs would not need to operate as "limited agents" of DWR under the Rate Agreement and Operating Agreements;

(3) An energy auction could open up access to the DWR contract power to all load serving entities and the regional markets in a way that would negate the need for new or more complex non-bypassable charges, and

(4) The utilization of power under the DWR contracts could be better optimized as the contracts were secured for statewide loads rather than any specific IOU residual net short that existed at the time the contract was executed.

According to CACES, DWR would continue to own the power delivered under the contracts, but the flow of power could be altered in a way that would keep DWR whole while having legal title to the power move to a third party before any possible sale to retail customers. By treating DWR contracts in the same manner as other resources procured for system needs, CACES argues, the revenue stream to pay for the DWR contracts would be protected, and the IOUs would be indifferent to load migration that could occur with the reopening of direct access. CACES contends that the IOUs could make the DWR power available to the system by simply bidding the power into the California Independent System Operator integrated forward market based on each contract's underlying economics, rather than self-scheduling it without economic bids.

Through this approach, CACES argues, there would be no need for multiple contract negotiations with DWR suppliers as would be the case with assignment and novation, because there is no change in the underlying existing commercial arrangements. CACES argues that this approach offers an additional tool should the IOUs decline to pick up the DWR contracts through assignment/novation, either because they do not fit well into the IOUs resource portfolios, or due to financial implications, such as debt equivalency.

CACES notes that Water Code § 80116 specifically permits DWR to direct the output of its contracts to entities other than retail customers when there is a sufficiency of resources, stating:

However, to the extent that any acquired power that is not required for use within the state, if it is otherwise advantageous and necessary, the power may be sold, transferred, or otherwise disposed of, or an option may be granted with respect to the power, to any person or public or private entity." (Sec. 80116, emphasis added by CACES.)

CACES argues that this provision allows for the assignment of the contracts to the IOUs through novation, or by treating the power in the same manner as other IOU-procured system resources. Alternatively, CACES argues, DWR could auction off the rights to the contract output in a manner similar to that contemplated for the IOUs.

In its comments on the Proposed Decision, TURN contends that any arrangement to redirect the flow of DWR power to the wholesale market, as suggested by CACES, such as through an energy auction, would likely be unlawful because it would violate the purposes for which DWR was directed to enter into the electricity market in the first instance. SCE likewise argues in its comments on the Proposed Decision, that there is nothing in the record to indicate how such an energy auction would be implemented and whether its implementation would meet the legal requirements for ending the Direct Access suspension.

In Phase II, we shall consider the merits of possible approaches to facilitating the removal of DWR from its role of supplying power under AB1X, including whether the CACES concept of redirecting the flow of DWR power to the wholesale market has merit from a legal as well as an operational perspective. Concurrently we also shall explore whether, in order to satisfy legal requirements, it may be appropriate for DWR to terminate its ownership interests in its existing contracts and transfer them to one or more of the IOUs, or other credit-worthy third parties through novation or assignment. Such possible approaches are not necessarily mutually exclusive, but may also be explored as complementary options.

If we deem an option to have potential merit, we shall further consider how implementing such an option could affect various interests. In addition to the contracting parties, other relevant interests include those of bundled and direct access customers, the IOUs, and the DWR bondholders. We shall provide parties an opportunity to address such impacts on the relevant affected interests in Phase II of this proceeding.

We would need to consider whether or to what extent, power costs charged to retail electric customers, or service reliability, would be affected as a result of assignments of DWR contracts. We also would consider whether, or to what extent, the IOU assumption of additional financial obligations of the DWR Contracts could adversely affect their debt equivalence, credit ratings, or costs of capital. The potential effects on utility procurement planning would also be considered.

We also recognize the necessity to protect the interests of DWR Bondholders as required by the "Rate Agreement" adopted in D.02-02-051. Water Code § 80110 expressly entitles DWR to recover in electricity charges amounts sufficient to enable it to comply with Water Code § 80134, which provides for the revenues necessary, inter alia, to support the bonds that DWR was authorized to issue pursuant to Water Code § 80130. Bond proceeds were used to repay the debt that DWR incurred to finance power purchases during the electricity crisis, including amounts owed to the State of California General Fund. D.02-02-051 prescribed the terms and conditions for the recovery of DWR's revenue requirements including the sums necessary, to pay the DWR bonds,
as set forth in the "Rate Agreement" adopted therein. The provisions of the "Rate Agreement" do not terminate until the bonds and associated financial obligations have been paid or otherwise funded.²³

As explained in D.02-02-051, the DWR receives two revenue streams: (a) a revenue stream from Bond Charges imposed on electric customers, designed to pay for bond-related costs, and (b) a second revenue stream from DWR Power Charges imposed on electric customers, designed to pay the commodity costs of DWR power. Both streams of revenue provided necessary support for DWR to issue bonds with investment-grade ratings.

According to DWR, the DWR bonds were marketed and sold based in part on representations regarding the suspension of direct access and the reserves that DWR would maintain for operating expenses and debt service. DWR states that if, or to the extent, that lifting the direct access suspension could create a material shift in the sources of DWR's revenue streams, it could require changes in the amount of DWR reserves. Such changes could be required to protect against the risk of significant load migration from bundled service to direct access, as well as any other relevant risks. Any possible contract assignment would need to consider the effects on the DWR bonds and bondholders, including reserve requirements, bond ratings, interest charges, and any other relevant concerns.

As noted in its 2007 Revenue Requirement Determination,²⁴ DWR has renegotiated 19 of the original contracts from 2001 that currently remain in effect, and has terminated five additional contracts for cause. DWR has continued efforts to renegotiate additional contracts, and regularly monitors its contracts to determine if there are opportunities for bilateral negotiation which could lead to more favorable terms and costs.

A number of the renegotiated DWR contracts contain novation clauses which may be exercised at the discretion of DWR. Under a novation clause, upon a written request by DWR, the counterparty to a contract must enter into a replacement agreement with one or more qualified electric suppliers.²⁵ The execution of such a replacement agreement would thereby constitute a novation that would relieve DWR of any liability or obligation arising under the new agreement.

For DWR contracts that do not contain novation clauses, the contracting parties may still negotiate contract assignment, but DWR may not unilaterally require the counterparty to enter into a replacement agreement. As a vehicle for relieving DWR of all ownership obligations under the power contracts so that the direct access suspension can be lifted, we will consider measures to facilitate contract novation or assignments to a third party.

Assuming that DWR were to proceed with the assignment of DWR Power Contracts, we envision the following steps:

(1) The Commission may request that DWR enter into discussions with qualified entities regarding a process to assign its DWR contract interests.

(2) Upon reaching agreement with one or more qualified entities for the assignment of rights and obligations, DWR provides written request to counterparties to contracts with novation or assignment clauses to enter into a replacement agreement with one or more of the designated entities.

(3) Since DWR may not have unilateral discretion to require counterparties to enter into replacement contracts for contracts without novation clauses, DWR would enter into negotiations with the counterparties for such contracts to adopt amendments to allow the substitution of another credit-worthy entity to assume the rights and obligations of DWR under such contracts, and

(4) Replacement contracts with the applicable entities are executed where novation or assignment clauses apply.

As noted previously, by 2010, the remaining long-term DWR contracts are expected to cover only 15% of the IOU requirements. The vast majority of DWR contracts are scheduled to expire by 2011.²⁶ Therefore, depending on the time table for the lifting of direct access, the number of remaining power contracts (and associated capacity) that would require reassignment may be substantially less than what exists today. The task of DWR assigning its remaining contract interests may become more manageable as a result.

In its comments on the Proposed Decision, SDG&E agrees that novation or assignment of DWR contracts would constitute one means of meeting the condition that DWR "no longer supply power" under AB1X. SDG&E, however, argues that any novation or assignment of DWR contracts to a party other than DWR should occur only after certain prescribed conditions are met, as enumerated in SDG&E's comments. The question of the time frame within which any DWR contract novation or assignment may occur, and its sequencing relative to other conditions, are issues for Phase II of this proceeding. We make no prejudgment concerning what timing considerations may be involved, or what conditions should be met or addressed before steps would be undertaken to implement or facilitate novation or assignment of DWR contracts. Parties will be provided with the opportunity to comment on such issues in Phase II of this proceeding.

Consistent with the directives herein, a scoping memo will provide guidance regarding the development of issues designated for Phase II of this proceeding, as previously outlined in the OIR.

²² We previously outlined in broad fashion the scope of issues to be addressed in each of the phases of this proceeding in the OIR issued on May 24, 2007, as further clarified by the Assigned Commissioner's Ruling dated July 19, 2007.

²³ Sections 5.1(a) and 5.1(b) of the Rate Agreement have the force and effect of an irrevocable financing order issued by the Commission pursuant to Pub. Util. Code § 840 et seq., and these sections may not be amended after the bonds have been issued.

²⁴ See the DWR Revenue Requirement Determination for 2007, submitted to the Commission on August 2, 2006, pursuant to §§ 80110 and 80134 of the Water Code.

²⁵ In order to be qualified to take over the rights and obligations of a DWR contract, the supplier's long-term unsecured senior debt must meet specified minimum credit rating standards.

²⁶ See the DWR Revenue Requirement Determination for 2007, submitted to the Commission on August 2, 2006, pursuant to Sec. 80110 and 80134 of the Water Code, pp. 22-24, TABLE D-5 LONG-TERM POWER CONTRACT LISTING.