V. Whether the Proposed Settlement Agreement Is
in the Public Interest

A. Adequacy of a Settlement Proposal in Achieving
Feasible Plan of Reorganization

The Bankruptcy Code requires any plan of reorganization to be feasible - to allow a debtor to successfully emerge from bankruptcy. To be feasible, a proposed plan must be such that if implemented it will leave the debtor in a situation where it is not likely that the reorganization will be followed by unanticipated liquidation or further reorganization:

Before the bankruptcy court may confirm a plan of reorganization, 11 U.S.C. § 1129(a)(11) requires that it find that the plan is not likely to be followed by unanticipated liquidation or further reorganization. In other words, the plan must be feasible. Under this feasibility test, the bankruptcy court must look to the plan's projected income, expenses, assets and liabilities and determine whether the plan will leave the estate financially stable. In re Pizza of Hawaii, Inc., 40 B.R. 1014, 1017 (D. Hawaii 1984).

A necessary corollary of this requirement is the requirement that the provisions of any proposed plan of reorganization can, in fact, be implemented:

[T]he feasibility test contemplates the probability of actual performance of the provisions of the plan. Sincerity, honesty, and willingness are not sufficient to make the plan feasible, and neither are any visionary promises. The test is whether the things which are to be done after confirmation can be done as a practical matter under the facts. In re Clarkson, 767 F.2d 417, 420 (8^th Cir. 1985).

It is the Bankruptcy Court which ultimately will determine whether any given proposed plan is feasible. And it is clear that the Commission should not authorize any settlement unless the Commission believes that the settlement is likely to result in a feasible plan. For the reasons detailed below, the MSA satisfies this requirement.

1. The MSA Will Allow PG&E to Emerge Promptly From Bankruptcy

The MSA¹⁴ is fair, just and reasonable and in the public interest. First, it adopts the regulatory asset structure of the PSA, and therefore will pay creditors in full, and improve PG&E's credit metrics. Second, the MSA calls for the amortization of the regulatory asset "mortgage style" over five years. Third, it offers the state significant environmental benefits.¹⁵ Fourth, it provides for reduction of the regulatory asset on account of any refunds obtained from energy suppliers. Finally, it contains PG&E's commitment not to unilaterally attempt to disaggregate for the life of the plan.¹⁶

There are provisions in both the PSA and the MSA that enhance PG&E's fiscal soundness. These elements are: the ratemaking treatment associated with the regulatory asset;¹⁷ the assurances of recovery of headroom in 2003; acknowledgement by the Commission that the URG rate base established by D.02-04-016 shall be deemed just and reasonable and not subject to modification;¹⁸ imputation of a capital structure to PG&E;¹⁹ and a Commission commitment not to discriminate against PG&E as compared with other utilities.²⁰ Further elements of both the PSA and the MSA enhancing the attractiveness of the Settlement Plan to rating agencies are the assured recovery of the full amount that PG&E sought in the ATCP,²¹ and the dismissal with prejudice of PG&E Corporation (PG&E's parent) from the Commission's Holding Company OII as to past practices.²² With those financial and regulatory benefits in place we are confident PG&E will be able to emerge from bankruptcy and continue to provide safe, reliable service.

2. The Rating Agencies (S&P and Moody's)

PG&E says that it is essential that PG&E's credit be rated investment-grade upon emergence from bankruptcy. It believes that these entities' blessing of the plan, through the assignment of investment-grade credit ratings, is crucial to feasibility. PG&E's witnesses testified: "It is critical for PG&E to meet at least minimum investment-grade ratings"²³ if emergence is to take place at all. "PG&E needs access to the liquidity and efficiency of the investment grade debt market in order to raise the approximately $8 billion required to emerge from Chapter 11."²⁴

Investment-grade credit ratings are important not only to achieving a feasible plan of reorganization, but also to ensuring on an ongoing basis that PG&E can reliably and efficiently raise capital to finance construction of new infrastructure, accommodate seasonal fluctuations in cash collections and disbursements, and meet its obligations to serve customers.²⁵ "Continuous access to the capital markets and access to low cost capital facilitates the funding of power procurement activities as well as the capital expenditures necessary to sustain the safety and reliability of a utility's operations."²⁶

Among the important longer-term benefits PG&E and ratepayers can expect from PG&E obtaining creditworthy status are a lower cost of debt.²⁷ Because there would be a greater amount of capital available and a lower risk associated with investment grade debt compared to junk-rated debt, the cost of investment grade debt is considerably less. As shown in the testimony of Paul J. Murphy (Chapter 7), PG&E's ability to issue investment grade debt under the Settlement Plan saves ratepayers approximately $2.1 billion in interest costs over 10 years (compared to junk-rated debt)."²⁸ Thus the lower cost of a utility's debt translates into lower rates, all else being equal.²⁹

There would also be lower transaction costs associated with an investment grade rating.³⁰ A company that is non-investment grade must generally post collateral to engage in purchase transactions. "Investment grade credit ratings are critical for activities such as power procurement; without investment grade ratings, PG&E would need to post additional collateral, further increasing its cost of operations."³¹ "To acquire firm pipeline capacity, PG&E recently had to post nearly $20 million of collateral, representing three months of payments. Had PG&E been investment grade, it would not have had to post collateral." Moreover, a utility with a "junk bond" rating would likely have to provide security or put up cash as collateral in various contracts (such as for energy supply) or to meet certain regulatory commitments (such as environmental remediation requirements). "Indeed, under such conditions, energy procurement through long-term contracts, even if accessible to a weak utility, creates a new set of problems. If they include mark-to-market provisions, periodic market swings could jeopardize the utility's remaining but limited credit capacity. In addition, a financially-weak utility would inevitably face less favorable terms at higher cost and for a more limited duration."³²

Also investment grade credit ratings for PG&E should require lower working capital requirements,³³ should facilitate the construction of new power supplies for its customers,³⁴ and are crucial in order for PG&E to carry out its public purpose responsibilities in an appropriate manner in the future."³⁵ And, as witness Murphy notes: "[t]he utility industry is capital-intensive. PG&E's financial forecast highlights this fact with regard to PG&E: over $8 billion of capital expenditures are expected during the next five years. Ease of access to the debt market on reasonable terms to fund such expenditures serves the interests of customers as well, since investment-grade debt is significantly more economical than non-investment-grade debt."³⁶ Staff Witness Paul Clanon concurred, concluding that "[n]on-investment grade credit ratings are bad for ratepayers."³⁷ Thus adopting a long-term goal of maintaining and improving PG&E's credit ratings is good public policy and indeed it is the Commission's "duty and authority to guarantee that the electric utilities would have the capacity and financial viability to provide power to California consumers." Southern California Edison Co. v. Peevey, supra, 31 Cal. 4^th at 793.

B. Fairness and Reasonableness

1. Relationship of Settlement to Parties' Risks of Achieving Desired Results

For more than three years, the Commission and PG&E have been in continuous litigation against each other before the state appellate courts, the federal courts, and the Bankruptcy Court. A settlement between PG&E and the Commission would end this litigation and resolve claims totaling billions of dollars made by PG&E against the Commission and ratepayers.

Prior to the settlement, both the Commission and PG&E faced risks and consequences depending on the outcome of PG&E's litigation claims and proposal to disaggregate itself through the asserted preemptive authority of the Bankruptcy Court. On the one hand, PG&E filed a complaint in federal court seeking authority to recover billions of dollars of undercollected costs (which PG&E now estimates at $11.8 billion) from retail ratepayers and to transfer its assets outside the regulatory reach of the State of California. On the other hand, the Commission and other agencies of the State, including the State Attorney General, continue to fight PG&E's proposals, vowing to carry their opposition beyond the federal trial court and Bankruptcy Court to the highest appellate levels. In addition, the Commission had proposed an alternative plan of reorganization in the Bankruptcy Court, and had obtained the support of the OCC for its alternative plan. PG&E just as vigorously opposed the Joint Amended Plan, and threatened to carry its opposition to the highest appellate levels. There was skepticism regarding the feasibility of either plan of reorganization. The litigation costs incurred by both sides were enormous, and threatened to mount to even higher levels, given the likelihood of additional appellate litigation. In short, both parties faced enormous risks that they would fail to achieve their desired results unless they reached a settlement.

2. The Risk, Expense, Complexity, and Likely Duration of Further Bankruptcy Litigation

From the perspective of the Commission and ratepayers, the risks of continued litigation in PG&E's bankruptcy proceeding and the federal court are that some combination of the Bankruptcy Court and federal district and/or appellate courts ultimately may approve PG&E's request for injunctive relief, as well as its proposal to disaggregate its traditional utility business into four separate entities, three of which would be permanently outside the jurisdiction of the Commission. The U.S. Court of Appeals for the Ninth Circuit of the U.S. has decided the express preemption issues in the Commission's favor on November 19, 2003.

The 9^th Circuit held that the only state laws pre-empted by the bankruptcy code would be " otherwise applicable nonbankruptcy law, rule or regulation relating to financial condition..." under Section 1142(a) of the Bankruptcy Code. This reasoning necessarily excludes the nonbankruptcy provisions of the Public Utilities Code relating to rates, service, transfers and encumbrances of property, security issuances, corporate structure, etc.

The decision of the Bankruptcy Court on implied pre-emption also utilized an approach inconsistent with the Ninth Circuit's reasoning. Memorandum Decision Regarding Preemption and Sovereign Immunity, February 7, 2002, In Re. Pacific Gas and Electric Company, Bankruptcy Case No. 01-30923DM, United States Bankruptcy Court, Northern District of California.³⁸ As interpreted by the 9^th Circuit, the Bankruptcy Code does expressly pre-empt within the narrow scope described by BC 1142(a). This narrow scope is, however, consistent with the position frequency articulated by Judge Montali that normal state utility regulation processes ought not be interfered with by the federal courts.

The concern that the Commission's costs and delays of further litigating against PG&E are likely to be massive, given the possibility of appeals through several layers of the federal court system, possibly all the way to the U.S. Supreme Court, is somewhat mitigated by this ruling. On the other hand, PG&E's risks, expenses, and delays are increased by the 9^th Circuit ruling. Even if it were to prevail in persuading the Bankruptcy Court to impliedly or expressly preempt state law and in so doing limit the Commission's jurisdiction, the Commission has vowed to appeal and further challenge PG&E's plan through the courts. The mutually cooperative approach to rehabilitation of PG&E's credit evinced by the PSA enables both PG&E and the Commission to return to the business of serving the people of California.

In short, further litigation between PG&E and the Commission in and beyond the Bankruptcy Court could be costly, complex and lengthy, potentially delaying any resolution as the case winds its way through the federal appellate court system, no matter who prevails at the trial court level.

3. Reasonableness of Settlement of Other
Claims and Litigation

PG&E presented testimony that identified $11.8 billion in unrecovered costs of utility service which it claims are to be recoverable from retail electric ratepayers. (Exs. 120 and 120c, PG&E/McManus.) PG&E asserts that it is likely to prevail on its claims before the Commission and/or the state and federal courts. (Exs. 120, 120c, 121, PG&E/McManus.) PG&E cites the ruling of Judge Walker in PG&E v. Lynch, which held that the "cost of wholesale energy, incurred pursuant to rate tariffs filed with FERC, whether these rates are market-based or cost-based, must be recognized as recoverable costs by state regulators and may not be trapped by excessively low retail rates or other limitations imposed at the state level." (Ex. 120 and 120c, PG&E/McManus.) PG&E also presented testimony on its claims for cost recovery under state law. (Ex. 120 and 120c, PG&E/McManus.) This testimony asserts that even if its undercollected costs are not classified as wholesale costs protected by the Filed Rate Doctrine under federal law, the costs are still legitimate costs of utility service that PG&E is legally entitled to recover in full from retail ratepayers under California state law.

The Commission staff presented testimony arguing that PG&E was unlikely to prevail in PG&E v. Lynch. (Ex. 122, p. 17, CPUC Staff/Clanon.) The staff relied on the testimony of an expert who argued that Judge Walker's ruling was incorrect. The Commission staff estimated that the net present value of the estimated ratepayer contribution to the settlement would be $7.129 to $7.229 billion. (Ex.122, p. 9, CPUC Staff/Clanon.)³⁹ The components of these ratepayer contributions use the same time frames and components that PG&E used to estimate its claims, i.e. the period from the beginning of the energy crisis to the present. This period treats PG&E's 2001 and 2002 pre-tax headroom revenues under the Commission's surcharge revenue decisions as a ratepayer contribution under the settlement. The Commission staff then quantified the net present value of the regulatory asset, including the costs of taxes and return on the asset.

Using the Commission staff's estimate of ratepayer contributions, the proposed settlement would allow ratepayers to settle PG&E's $11.8 billion in pre-settlement claims at a cost of $7.1 to 7.2 billion, or about 60 cents on the dollar, with PG&E giving up $4.6 billion in claims. However, the PSA also allows PG&E to keep revenues the Commission has already authorized PG&E to collect from ratepayers to pay down it's undercollection, including overcollections in a number of regulatory accounts such as the generation memorandum account, and the over $1 billion increase in ratebase the Commission approved for PG&E in 2001. With these additional offsets included along with the PSA amounts, PG&E will recover 100% of its litigation claims from ratepayers as well as obtaining additional money related to PG&E's claims for a retroactive increase in their authorized 2001 return on equity for URG, interest costs, litigation costs, and other items.

In its testimony, ORA questioned the accuracy of PG&E's calculation of undercollected costs in light of headroom revenues reported in PG&E's regulatory balancing accounts. (Ex. 139, ORA/Reid, Danforth; Ex. 187, ORA/Bumgardner.) By ORA's calculation, PG&E had collected $694 million more in headroom revenues during 2001- 2002 than PG&E estimated in its testimony. (Ex. 187, ORA/Bumgardner.) In response, PG&E said that the difference between ORA and PG&E was that ORA did not take into account anticipated additional costs or reductions in revenue that PG&E had accrued and reported in its SEC financial reports under generally accepted accounting principles (GAAP), but that had not yet flowed through PG&E's regulatory balancing accounts.

ORA estimated the ratepayer contribution under the settlement using the same time frame and components as Commission staff, to be in the range of $9.0 to $9.1 billion, $1.9 billion higher than Commission staff. (Ex. 139, ORA/Reid, Bumgardner; Ex. 187, ORA/Bumgardner.) ORA estimated the amount of headroom received by PG&E in 2001 and 2002 to be $694 million more than PG&E's estimate. In a joint comparison exhibit, ORA and PG&E indicate that the difference in headroom for these years is largely due to PG&E's use of GAAP versus regulatory accounting. We will rely on the use of regulatory accounting, as PG&E contends that with the appropriate adjustments, the two approaches should reach the same result. Despite our use of regulatory accounting, we do allow for the utility's cost of bankruptcy litigation to be recovered from ratepayers as is contemplated in the PSA.

PG&E includes in its $1.8 billion claim amounts totaling nearly $450 million for the cost of the bankruptcy litigation, of which roughly half was costs incurred by Corp. PG&E and Corp decided to undertake bankruptcy litigation rather than continuing to work with the Commission to achieve a discipline workout of its debts using its revenues from the high rates that the Commission approved in March 2001, as Edison did. The decision to take Chapter 11 while still solvent and to attempt to use Chapter 11 to achieve regulatory and political objectives that it could not achieve under state law was a risky and ultimately futile action undertaken by PG&E's management when other less destruction and aggressive measures were available. Ratepayers ought not pay the cost of PG&E Corp's imprudent action.

The PSA states in Section 15 (Fees and Expenses): "PG&E shall not recover any portion of the amounts so paid or reimbursed to PG&E Corporation in retail rates; rather, such costs shall be borne solely by shareholders through a reduction in reduced earnings." To the extent that PG&E's cash on hand reflects any amounts to be paid to the Holding Company (i.e, PG&E Corp) for Corp's Bankruptcy related costs related to litigation and consulting (referred to in the PSA Section 15 as "professional fees and expenses incurred in connection with the Chapter 11 Case"), PG&E shall adjust its cash on hand to eliminate any such amounts. Alternatively, if PG&E includes Corp's costs as part of unrecovered costs (such as discussed in Exhibit 184, Table A, line 6), and these costs supported either PG&E's cash on hand calculation or the size of its regulatory asset, these costs should be deducted and PG&E should file an Advice Letter to propose how to return this amount to ratepayers.

The sole other adjustment we make is in regards to PG&E's claim that ratepayers should reimburse Corp for $96 million in net costs incurred regarding a gas hedging contract that was prematurely cancelled due to PG&E's inability to maintain creditworthiness. It is not appropriate to have ratepayers reimburse Corp for costs relating to a shareholder contract that was not used to serve utility customers.

This $96 million present value reduction could be implemented in a number of ways. We shall require PG&E to submit an advice letter identifying PG&E's preferred means of removing this amount from the revenues it will be obtaining under the MSA. PG&E may propose a reduction in the size of the Regulatory asset or a reduction in rates over a period from one to five years, as long as ratepayers receive the same present value of this reductions. Should PG&E propose to spread this reduction over time, the present value of the reduction should be equal to the value of an immediate reduction in ratepayer costs, using the utility's weighted average cost of capital as the discount rate to calculate the present value.

The only other parties presenting any detailed testimony on the strength and quantification of PG&E's claims were The Utility Reform Network (TURN) and the City and County of San Francisco (CCSF). TURN's testimony relied primarily on the legal position taken by the Commission staff's outside expert as well as the position TURN itself took before the California Supreme Court in the SCE case. TURN also alleged that PG&E's estimate of undercollected costs was inflated. CCSF assumed that PG&E's undercollected procurement costs should be netted against $2.5 billion in power generation revenues identified in the same exhibit. (Ex. 138, p. 6, CCSF/Barkovich.)

PG&E argues that although it is possible for the Commission to quantify the amount of PG&E's various claims that the utility would be giving up under the settlement, it is not so easy to compare those claims to the costs ratepayers would bear under the settlement. This is primarily because before any comparison can be done, the costs of the settlement to ratepayers must be netted against the quantifiable and unquantifiable benefits that ratepayers will receive directly from the settlement itself. In this regard, one of the direct and quantifiable benefits to ratepayers under the settlement is that they receive over $670 million a year in estimated rate relief effective January 1, 2004, and as much as $2.1 billion in interest cost savings over the next ten years.

4. Reasonableness of Rates

Analysis of the reasonableness of the settlement must begin with the rates themselves. The proposed rates under the PSA were originally forecasted to be:⁴⁰

	Current	2004	2005	2006	2007	2008
Bundled Rate (cents/Kwh)	13.87	13.36	13.32	13.16	13.18	12.92

The initial revenue reduction in 2004 was updated by PG&E, which more recently forecast the revenue reduction in 2004 to be approximately $670 million, resulting in a projected 12.91 cents per kWh rate for 2004. (Ex. 117b, p.10-3.)

While this information is interesting, it is important to bear in mind that the ratemaking process contains significant elements of art as well as science. Further, the Scoping Memo in this proceeding excluded any detailed examination of rates and ratemaking, except that which is necessary to raise the cash to implement the Settlement Plan. All ratemaking proceedings are inherently complex undertakings that require many judgment calls. Projected system average rates under the settlement are expected to be lower than current rates. Rates under the settlement agreement lie between the rates ratepayers would have seen under PG&E's disaggregation plan and the Joint Amended Plan were either to be implemented. (Ex. 122, p. 10, Staff/Clanon) Accordingly, as to anticipated rates, the MSA satisfies our concern that the settlement fall within the "reasonable range of outcomes" that would result had the case proceeded to trial. (See, Southern Calif. Edison Co., D.02-06-074.)

In any case, the MSA will not be a major driver of PG&E's rates in the near term. The costs associated with the MSA - principally the costs associated with the regulatory asset - are only a small share of PG&E's total costs, and are dwarfed even by such relatively small cost components as transmission costs.

The selection of a five year amortization period and amortization method will result in significantly lower rates than current levels over the five year period. Rates will then fall substantially after the expiration of the five-year period as the regulatory asset is fully amortized. While rates during the five-year period will be higher on average than under the PSA, ratepayers will save nearly a billion dollars under the MSA as compared to the PSA owing to a $741 million reduction in interest payments, the $100 million reduction in 2003 allowable headroom, and a $97 million reduction from elimination of gas hedging costs rightfully borne by shareholders. If reimbursement of Corp professional fees and expenses related to bankruptcy are improperly included in PG&E's costs, ratepayers will see further reductions, relative to PSA.

5. Adequacy of Representation In the Settlement Process

Adequacy of representation is a legal requirement for approval of a settlement, under the Commission's precedents. Re Pacific Gas and Electric Company, 30 CPUC 2d 189, 222 (D.88-12-083, 1988)(Diablo Canyon)); Rule 51.1. The Commission evaluates this issue utilizing legal concepts developed for use in class actions under Rule 23, Federal Rules of Civil Procedure, where the legal interests of persons are decided despite their absence. Id. at 221-23.

The PSA was negotiated without the presence of any consumer representatives or advocates, a peculiarity largely borne of the bankruptcy court forum. The proceedings in this docket to enable us to evaluate the merits of the settlement are therefore critical, and enables us to "delve" more deeply than we otherwise might, to satisfy ourselves that the previously unrepresented consumer interests are in fact adequately represented. The MSA is the result of that scrutiny.

The PSA was negotiated by staff of the Commission, under the judicial supervision and mediation of a United States Bankruptcy Court Judge. According to Judge Newsome, "...[Y]ou should know that the staff of the Public Utilities Commission, who participated in the settlement process, in my opinion, displayed diligence, competence and professionalism. I do not believe that they overlooked opportunities to reduce costs to ratepayers, even as they agreed that the company should be restored to financial health." (Ex. 146, p.2.) Unfortunately, if understandably, the same Judge's "gag order" prevents us from independently evaluating that assertion.

The presence and involvement of Commission staff was adequate for three reasons. First, there is no question regarding the motives, independence, or professional competence of the governmental representatives in the negotiations. Second, the Commission staff has represented the Commission in the Bankruptcy Court on the Commission's own plans of reorganization for PG&E. Finally, the Commission staff has played a prominent role in representing the Commission before the Legislature, the investment community, the rating agencies, and other constituent groups throughout the California energy crisis. We do not doubt the technical, financial, and ratemaking expertise of the Commission staff.

PG&E argues that the active participation of an independent, competent Commission staff in the settlement is a significant indication of the overall reasonableness and fairness of the PSA. In addition to the Commission staff, other governmental participants have endorsed the environmental provisions of the PSA, particularly the Land Conservation Commitment. (Ex. 181.)

Considering adequacy of representation from a different perspective, whether or not representation was adequate in the bankruptcy settlement negotiations is now moot because the fairness of the PSA has been examined in this proceeding. In this investigation, where we approve the MSA, it is clear that ratepayers have been adequately represented by, among others, ORA, TURN, Aglet, and CCSF. We find that the Commission and ratepayers had adequate representation in the settlement process.

6. Release of PG&E Corporation

Paragraph 10 of the PSA states in part: "PG&E and PG&E Corporation, on the one hand, and the Commission on the other, will execute full mutual releases and dismissals with prejudice of all claims, actions or regulatory proceedings arising out of or related in any way to the energy crisis or the implementation of AB 1890 listed on Appendix C hereto." CCSF says the release language should be modified to exclude Corp. It believes there is no need for any release of claims against PG&E Corporation in this proceeding, because such claims have nothing to do with helping PG&E resolve its bankruptcy. More importantly, it contends, the Commission currently has no pending proceedings against Corp. and certainly none that are listed in Appendix C. Nor has Corp. any claims against the Commission. CCSF argues that this release goes not to the Commission's claims, but to the pending actions against PG&E Corporation brought by the California Attorney General and the City and County of San Francisco in the Superior Court. The Commission, CCSF maintains, should not provide Corp. with this very significant release as Corp. is not providing any consideration for the proposed release. The California Attorney General joins in this request. We accede to it.

C. Public Interest

1. The Regulatory Asset

Rate treatment of the regulatory asset should preserve the transparency of cost of service ratemaking for PG&E's normal operations. The regulatory asset should be amortized through a surcharge whose duration is as short as possible, in order to be consistent with the Edison settlement approach and in order to minimize the duration of federal court supervision after PG&E has emerged from bankruptcy to the payment of its debts.

The regulatory asset represents income to PG&E contributed by ratepayers to support additional debt and equity in PG&E's capital structure needed to pay its debts and emerge from bankruptcy. The net amount of the regulatory asset therefore must to be grossed up for taxes, and that amount amortized over a period of five (5) years or less. Achieving these objectives requires that the regulatory asset be appropriately sized to achieve the objective of raising cash to end the bankruptcy. The amortization period is also important to ensure that PG&E's cash flows are sufficient to be creditworthy, and also to minimize the time that ratepayers need to bear these high costs. We determine that a five year amortization period is the better than the nine year period proposed in the PSA. A five year period will greatly reduce the nominal amount of interest paid by ratepayers, and will give the ratepayers a reasonable end date to the high rates. It also increase PG&E's revenues in the early years compared to the PSA, further improving PG&E's creditworthiness during this period.

This objective is made more difficult by the fact that there are significant uncertainties in the exact amount of cash on hand PG&E will have at the time the plan is consummated. Currently the size of the regulatory asset is based in part on forecasts of PG&E's cash on hand. In order to protect PG&E should there be a significant shortfall in actual cash on hand compared to the current estimate, and to provide ratepayers with protection should more cash on hand be available (and thus less need for additional funds), we will update the forecast of cash on hand to reflect actual amounts. PG&E shall be required to file an advice letter which will detail their actual cash on hand (including any necessary adjustment to ensure PG&E Corp for Corp's bankruptcy-related litigation and consulting costs) as compared to the forecasts, and any subsequent adjustments that are warranted to the other PSA terms due to any differences between the actuals and the forecasted values.

The regulatory asset has been described above. It is $2.21 billion, amortized over not more than five (5) years. It has been sized to provide for the revenue, cash flow, and capital structure requirements that will enable PG&E to emerge from bankruptcy as an investment grade company. This asset, when combined with the headroom, provides a $7 billion ratepayer financial contribution (Ex. 122, p. 8.) By continuing to allow PG&E to keep monies that have already been approved and implemented by the Commission to offset PG&E's undercollections (including funds from generation memorandum accounts, transition revenue account overcollections, increases in the ratebase of PG&E's utility retained generation), the net result is that ratepayers are paying all of PG&E's over $11 billion claim in the filed rate case litigation, plus other costs identified by PG&E.

As discussed above, the only costs claimed by PG&E which are not allowed to recover from ratepayers are Corp's litigation costs, and costs PG&E claims were incurred due to the termination of a gas hedging contract. 100% of all other costs claimed by PG&E will be recovered from ratepayers under the MSA.

As we have discussed above, this is a reasonable compromise of the economic differences of the proponents of the PSA. We also recognize that the settlement provides for net-of-tax generator refunds or offsets received by PG&E in 2003 or thereafter, which may offset dollar for dollar the amount of the regulatory asset.  (PSA ¶ 2d) This is a further potential benefit for ratepayers.  We understand that these generator refunds or offsets are not "headroom" under the settlement and will applied solely to reduce the regulatory asset.  This further feature of the design of the regulatory asset is also in the public interest.

Resolving PG&E's bankruptcy, even at the expense of an additional $2.21 billion ratepayer contribution in the form of a regulatory asset advances the state's overall goal of restoring stability to the commercial and institutional infrastructure by which we provide essential services to Californians. Although PG&E has demonstrated the ability to operate over the past 2 ½ years in bankruptcy as debtor in possession, we are determined to achieve normalcy even at additional cost.

2. Headroom

The PSA's definition of headroom is:

"PG&E's total net after-tax income reported under Generally Accepted Accounting Principles, less earnings from operations, plus after-tax amounts accrued for bankruptcy-related administration and bankruptcy - related interest costs, all multiplied by 1.67, provided that the calculation will reflect the outcome of PG&E's 2003 general rate case (A.02-09-005 and A.02-11-067)."

The Commission's definition of headroom is found in Re Proposed Policies, etc., (1996) D.96-12-076, 70 CPUC 2d 207:

"Freezing rates stabilizes collected revenues (subject to sales variation), and declining costs create "headroom," i.e., revenues beyond those required to provide service, that can be applied to offset transition costs. The utilities' reasonable costs of providing service are currently identified as their authorized revenue requirements. (70 CPUC 2d at 219.)

"In general, headroom revenues consist of the difference between recovered revenues at the frozen rate levels (including the reduced rate levels for residential and small commercial customers beginning in 1998) and the reasonable costs of providing utility services, which for convenience we refer to as the authorized revenue requirement." (70 CPUC 2d at 223.)

Clearly, the PSA definition is not the same as the Commission's definition. Nevertheless, the Commission will adopt the definition in the PSA. When PG&E submits its filing to the Commission to implement the MSA, PG&E must demonstrate to the satisfaction of the Commission that PG&E has fairly and accurately accounted for the headroom. Any headroom revenues in excess of the $775 million cap for 2003 are credited to PG&E's ratepayers. Rather than attempt here to resolve potential disputes about headroom calculations, as ORA suggests, the Commission can address the disputes, if any, at the time of PG&E's filing.

3. Dividends

6. Dividend Payments and Stock Repurchases. The Parties acknowledge that, for the Parent, as PG&E's shareholder, to receive the benefit of this Agreement, both PG&E and its Parent must be able to pay dividends and repurchase common stock when appropriate. Accordingly, the Parties agree that, other than the capital structure and stand-alone dividend conditions contained in the PG&E holding company decisions (D.96-11-017 and D.99-04-068), the Commission shall not restrict the ability of the boards of directors of either PG&E or PG&E Corporation to declare and pay dividends or repurchase common stock.

This paragraph is not in the public interest and is stricken. It says the Commission "shall not restrict" PG&E from paying dividends or repurchasing common stock. There are numerous possibilities during the next nine years as to reasons why parties could challenge the reasonableness of PG&E's dividend practices or PG&E's rates. For example, it is possible that during the next nine years, PG&E may engage in unreasonable and imprudent conduct. Depending upon the size of the disallowance of costs, this could limit PG&E's ability to collect revenues from its ratepayers that would be necessary for dividend payments. PG&E also may be financially unable to perform all of its public service obligations under section 761 of the Public Utilities Code if it paid unreasonably high dividends. Under either of these examples, Paragraph 6 of the PSA could restrict the Commission from ruling against PG&E concerning any allegations of unreasonable dividend practices. There are many other possibilities where this issue could arise during the nine years.

Paragraph 6 is not reasonable and is not in the public interest, because it is unreasonable to expect the Commission to agree blindly (i.e, without knowing all future circumstances) to preclude future Commissions from deciding potential issues, if any. We do not have a record in this proceeding to support whether future dividend practices or stock repurchasing practices are reasonable or unreasonable. Further, the Commission cannot know at this time if, in the future, parties will raise issues relating to the reasonableness of PG&E's dividend practices or PG&E's rates, or the prudency or legality of PG&E's conduct which could limit PG&E's ability to collect revenues necessary for dividends. We cannot know if due to its dividend practices in the future, PG&E were to have insufficient funds to perform its public service obligations. It is therefore unreasonable and not in the public interest to have a provision in the PSA for the Commission to effectively decide these future hypothetical issues in PG&E's favor without any record to support it.

As discussed above, under traditional cost-of-service ratemaking PG&E should be able to provide dividends or repurchase common stock. PG&E and SCE lost their creditworthiness and stopped paying dividends during the energy crisis due to skyrocketing wholesale procurement costs and the uncertainty caused by AB 1890's deviation from cost-of-service ratemaking. However, as the California Supreme Court explained in Southern California Edison Co. v. Peevey, supra, 31 Cal.4^th at 795, the passage of AB 6X in January 2001 "allowed PUC to regulate the rates for power so generated pursuant to ordinary `cost-of-service' ratemaking. PUC was thus authorized to permit SCE such recovery of past costs as necessary to render the utility financially viable and to ensure SCE would be able to continue serving its customers through electricity generated in its retained plants." The Court contrasted the "competitive price-reduction approach" of AB 1890 with the cost-of-service rate regulation restored by AB 6X, which reemphasized the Commission's "duty and authority to guarantee that the electric utilities would have the capacity and financial viability to provide power to California consumers." Id. at 793.

Therefore, we have every reason to believe that in all likelihood, under our cost-of-service ratemaking authority, PG&E will be able to declare and pay dividends and maintain investment grade credit ratings. That being said, we cannot predict the future, and we find it unreasonable for a settlement provision to preclude the Commission from deciding in the future whether or not PG&E's dividend or common stock repurchase practices are reasonable.

4. Credit Rating

PSA paragraph 2g. states:

g. The Commission recognizes that the establishment, maintenance and improvement of Investment Grade Company Credit Ratings is vital for PG&E to be able to continue to provide safe and reliable service to its customers. The Commission further recognizes that the establishment, maintenance and improvement of PG&E's Investment Grade Company Credit Ratings directly benefits PG&E's ratepayers by reducing PG&E's immediate and future borrowing costs, which, in turn, will allow PG&E to finance its operations and make capital expenditures on its distribution, transmission, and generation assets at a lower cost to its ratepayers. In furtherance of these objectives, the Commission agrees to act to facilitate and maintain Investment Grade Company Credit Ratings for PG&E.

The commitment in Paragraph 2g must be modified to provide an explicit commitment by PG&E's management that mirrors the Commission's commitment. As discussed above, we agree that it is in the public interest for PG&E to achieve and maintain an investment grade credit rating. Therefore, the Commission will act to facilitate and maintain such an investment grade credit rating for PG&E, which is part of the Commission's task in setting rates that are just and reasonable. Quoting FPC v. Hope Natural Gas Co., supra, 320 U.S. at 603, the California Supreme Court in 20th Century Insurance Company v. Garamendi (1994) 8 Cal.4^th 216, 294 stated that the regulated entity has a legitimate concern that "there be enough revenue not only for operating expenses but also for the capital costs of the business. These include service on the debt and dividends on the stock...[The return on equity] should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and to attract capital."

Consequently, the Commission is already obligated in setting just and reasonable rates to authorize a sufficient return on equity for the utility to maintain its creditworthiness. To commit to act to maintain PG&E's creditworthiness, as provided in this paragraph 2.g., is consistent with the law. However, as discussed above, we feel compelled to clarify that the Commission's commitment does not require the Commission to guarantee such creditworthiness when there are factors threatening PG&E's investment grade credit rating besides the Commission's actions. The commitment to maintain investment grade is equally a responsibility of PG&E's management. We may authorize a sufficient return on equity, but imprudence or unreasonable conduct by PG&E or Corp. may be the cause of PG&E not maintaining its creditworthiness. For example, we must take into account the imprudence or unreasonable costs of a utility when we set rates. See City and County of San Francisco v. PUC (1971) 6 Cal.3d 119, 129. If PG&E's own imprudence were to result in a disallowance that threatened PG&E's investment grade credit rating, it is PG&E's actions that would be responsible for this threat. External forces in the marketplace may also threaten PG&E's creditworthiness. We reiterate that this paragraph as modified does not mean that the ratepayers will always have to pay higher rates to guarantee PG&E's investment grade credit rating.

As discussed above, however, we do not foresee this being a realistic problem in light of the decades in which PG&E and the other California utilities have had outstanding credit ratings, even when the Commission has on occasion disallowed imprudently incurred costs.

5. Assignability of DWR Contracts

Section 7 of the PSA provides for PG&E's agreement to the assignment and legal and financial responsibility for the DWR Contracts, subject to certain conditions precedent, as discussed earlier. Staff Witness Clanon testified that PG&E is currently dispatching most of these contracts and that it made sense from a policy perspective to put financial responsibility in with operational responsibility. Inasmuch as DWR's presence in the electricity power procurement business was an emergency measure, he further testified that such assignment was consistent with the Commission's policy of getting DWR out of the business as quickly as possible. (RT: 424: 2-19) We conclude that it is in the public interest for DWR to get out of the business as quickly as possible, consistent with the conditions for assignment set forth in this provision.

6. Environmental Matters

The Land Conservation Commitment (LLC)

The PSA gives the people of California control over, and access to, 140,000 acres of land associated with PG&E's hydroelectric facilities (PSA ¶ 17), without compromising the ability of PG&E to generate electricity from those facilities. In 1999 PG&E proposed to sell these lands to the highest bidder. The PSA would remove forever that possibility, and replace the spectre of loss of public control with the promise of perpetual public access. The PSA's provisions for PG&E's either donating the land or granting conservation easements go much further than simply maintaining the status quo - the people of California can look to a partnership of the environmental community, state and local governments, and environmental stewardship organizations to preserve the lands and improve public access where desirable.

The proposed corporation and its governing board established in the PSA will ensure that PG&E complies with the requirement to donate the lands or grant conservation easements and will provide significant public (and Commission) oversight and participation into improvements made to the lands and the lands' ultimate disposition. Membership of the governing board would include representatives from PG&E, the Commission, the California Department of Fish and Game, the State Water Resources Control Board, the California Farm Bureau Federation, and three public members to be named by the Commission, plus others. This board should play an historic role in the protection of California's environment. The PSA expressly provides that enhancements to the lands not interfere with PG&E's hydroelectric operations, maintenance, or capital improvements. Funding is provided by $70 million to be paid over ten years, to be recovered in retail rates.

(a) The Stewardship Council

Fourteen parties served testimony regarding the land conservation commitment taking a diversity of positions and making numerous suggestions for improvement. Consequently, the presiding Administrative Law Judge (ALJ) encouraged the parties to resolve their differences through a stipulation. The ALJ waived the notice requirements of Rule 51 (Stipulations).

On September 25, 2003, Association of California Water Agencies, California Farm Bureau Federation, California Hydropower Reform Coalition, California Resources Agency, ORA, Regional Council of Rural Counties, State Water Resources Control Board, Tuolumne Utility District, U.S. Department of Agriculture-Forest Service, which are parties, and non-parties California Forestry Association, California Wilderness Coalition, Central Valley Regional Water Control Board, Mountain Meadows Conservancy, Natural Resources Defense Council, Northern California Council Federation of Fly Fishers, The Pacific Forest Trust, Inc., Planning and Conservation League, Sierra Club California, Sierra Foothills Audobon Society, Sierra Nevada Alliance, Trust for Public Land and U.S. Department of Interior-Bureau of Land Management presented to the Commission a "Stipulation Resolving Issues Regarding The Land Conservation Commitment" (the Land Conservation Commitment Stipulation (Ex. 181)), that implements Paragraph 17 and Appendix E of the Settlement Agreement and constitutes an enforceable contract among those parties.

Several parties had indicated that the governing board of the Stewardship Council,⁴¹ as proposed in the PSA, would be more effective and representative if it was expanded to include the fuller array of interests and expertise of the public agencies, local government and trade associations, environmental organizations, and ratepayer organizations who have worked on the watershed land protection issue. The stipulation provides that, after its formation, the by-laws will be amended to provide that, in addition to the five members provided for in the PSA, the governing board will include one representative each from the California Resources Agency, the Central Valley Regional Water Quality Control Board, Association of California Water Agencies, Regional Council of Rural Counties, California Hydropower Reform Coalition, The Trust for Public Land, ORA, and California Forestry Association. (Ex. 181 ¶ 10(a).) In addition, the U.S. Department of Agriculture-Forest Service and U.S. Department of Interior-Bureau of Land Management will together designate a federal liaison who will participate in an advisory and non-voting capacity. The Commission will name three additional board members to further provide for public representation. This board ensures that all of the key constituencies are represented in the development and implementation of the land conservation plan.

The stipulation provides that decisions of the governing board will be made by consensus, that meetings will be public, and that there is a dispute resolution process. The stipulation delineates a planning and assessment process that will examine all of the subject lands in the context of their watershed and county. For each parcel, the plan will assess its current natural resource condition and uses, state its conservation and/or enhancement objectives, whether the parcel should be donated in fee or be subject to a conservation easement, or both, that the intended recipient has the capability to maintain the property interest so as to preserve or enhance the beneficial public values, that the donation will not adversely impact local tax revenue, assurance that known contamination be disclosed, appropriate consideration of whether to split the parcel, a strategy to undertake appropriate physical measures to enhance the beneficial public values, a plan to monitor the impacts of disposition and implementation of the plan, and an implementation schedule. Consistent with Appendix E to the PSA, the plan may also consider whether land "without significant public interest value" should be sold to private entities with few or no restrictions. The stipulation does not alter § 851 authority. Any proposed disposition will be presented to the Commission for public notice, hearing, and approval. The stipulation is expected to enhance the existing environmental and economic benefits of the Watershed Lands and Carizzo Plains on an overall basis.

We agree that the LCC as supplemented by the LCC stipulation will provide ratepayers with substantial benefits and is in the public interest. PG&E will undertake a study of all of these lands to determine current public values, and to recommend strategies and measures to preserve and enhance such values in perpetuity. PG&E will then implement such strategies and measures within six months after final receipt of all required government approvals no longer subject to appeal. The planning process, including surveys and inspections of 140,000 acres, will likely cost $20 million or less (Ex. 127a, pp. 4-5, CHRC/Sutton), and thus the balance of the $70 million will be available to implement physical measures, such as planting of trees to enhance fish and wildlife habitat and water quality, construction or improvement of recreational access, and protection of Tribal or other historical sites. The LCC limits the discretion of PG&E to take inconsistent action in future proceedings.

The State Water Resources Control Board argues that the term "beneficial public values," as used in Appendix C of the PSA, be modified to state that any agricultural, sustainable forestry and outdoor recreation uses on transferred lands "must be environmentally sensitive." (SWRCB Op. Br. at 6.) PG&E opposes this modification, it argues that the term "environmentally sensitive" is hopelessly vague and, rather than clarifying the land conservation commitment, would only result in more confusion and debate. It asserts that the language in Appendix E has been crafted to give the Stewardship Council direction and the flexibility to determine how best to preserve and enhance the beneficial public values of the lands. The combination of state agency representation on the governing board with consensus voting, as well as the Commission's § 851 approval process and CEQA review, will ensure that recreational uses that unduly harm the environment are not permitted. We agree with PG&E's reasoning.

(b) Environmental Opportunity For Urban Youth

The Greenlining Institute has asked us to expand the LCC to address the needs of low-income urban PG&E ratepayers. A majority of PG&E's ratepayers live in urban areas, not in the Sierra foothills, where the vast majority of the 140,000 acres are located. In order to ensure that environmental benefits of a substantial nature are realized by PG&E's urban ratepayers, our modified Settlement Agreement will augment the $70 million devoted to environment activities by $30 million. These additional funds shall be expended to provide a wilderness experience for urban youth, especially disadvantaged urban youth, and to acquire and maintain urban parks and recreation areas. We direct that the acquisition of such parks and recreation areas be focused on creating an environment that will particularly serve the needs of urban low-income youth.

Of the $30 million, to be expended in equal installments over 10 years, we will expect approximately 1/3 would be used to provide seed money that would establish a permanent program for young people who are least likely to enjoy the wonder of California's natural beauty. This program would allow disadvantaged, inner city youth to experience the environment in nature's own setting. The program would select young citizens in an urban setting, and provide the means to visit these watershed lands for a week or two. While there, they would be exposed to living in the outdoors and see how the actions of man interact with animal and plant life, both favorably and unfavorably. The 2/3 balance of the $30 million would be used to acquire urban parks and recreation areas for inner city youth. We will use our three appointments to the Stewardship Council to champion this $30 million allocation, among their other duties.

The Commission fully supports the intent of the LLC and believe that the structure and proposals contained in the parties stipulation are reasonable. However, notwithstanding any statements in the PSA and the stipulation that the Commission will give up it's ongoing authority and oversight of the amounts and uses of the money that are to be applied to the LLC and the urban youth program, the Commission will retain its ability to modify this program as necessary in the future. By retaining ongoing oversight, we will avoid any potential legal problem regarding the Commission ceding its authority; provide an opportunity for changes in program scope and increases in funding if those become necessary; and ensure that the LLC program will operate as intended.

(c) Clean Energy Technology Commitment

Under the PSA, PG&E will establish a shareholder-funded non-profit corporation dedicated to supporting research and investment in clean energy technologies primarily in PG&E's service territory. (PSA ¶ 18.) The non-profit corporation's governing board will include Commission-selected appointees, PG&E-selected appointees, and appointees jointly selected by the Commission and PG&E. PG&E proposes an initial endowment of the non-profit corporation at $15 million over five years (not to be recovered in rates). We view this commitment as part of the Commission's, and the State's, ongoing policies encouraging energy efficiency, demand response, renewable generation, and the entire range of more environmentally-friendly options for meeting load growth. However, $15 million is inadequate. We believe an additional $15 million (not to be recovered in rates) will assure adequate planning and funding.

39

In $Millions
2001 and 2002 Pre-Tax Headroom	$3,200
2003 Pre-Tax Headroom	$775 to $875
NPV of the Regulatory Asset	$2,210
NPV of the Tax Component of the Regulatory Asset	$944
Estimated Ratepayer Contribution	$7,129 to 7,229

⁴⁰ Exhibit 122, p. 7 (Clanon). ⁴¹ The stipulation provides that, once the PG&E Environmental Enhancement Corporation (EEC) is formed, its governing board will change its name to Pacific Forest and Watershed Lands Stewardship Council, referred to herein as the Stewardship Council.