IV. Current Regulatory Accounting Mechanisms Overstate Power Purchase Liabilities Which Should Be Netted Against Power Sales Revenues

The "rate freeze" created by AB 1890 refers to a specific term of art. The AB 1890 rate freeze constitutes controls on rates to be filed with the Commission during a transition period from historic methods or rate regulation to a post-transition period. At its essence, the rate freeze allowed rates to remain higher than would have been justified in cost-based rates in order to allow the utilities the opportunity to recover costs associated with moving from cost-of-service regulation to a competitive regulatory scheme. The "AB 1890 rate freeze" is shorthand for a set of specific accounting and cost recovery triggers that could operate to induce market-based rates. The imposition of AB 1890's consumer protections, commonly called the rate freeze, ends when the utilities collect their remaining capital costs which were assumed at the time to be uneconomic or stranded. The utility reduces these generation asset capital costs after accounting for all other authorized costs (which can be analogized to operating costs, such as those associated with distribution, transmission and energy procurement).

A. Current Regulatory Accounting Mechanisms Fail to Match Operating Costs Against Operating Revenues

The Commission established two accounts to track costs and revenues: the Transition Cost Balancing Account (TCBA) and the Transition Revenue Account (TRA) established by D.97-10-057. Three sources of revenue originally flowed into and were tracked by the TCBA account:

1. "headroom," or the revenues remaining from customers' bill payments after a utility's authorized operating costs were paid;

2. revenue from sales of utility power plants to private owners, and

3. revenues from the sales of electric power provided by remaining utility-owned generation.

The TCBA tracks accelerated depreciation of all the undepreciated capital costs from the utilities' power plants. These amounts, along with costs of above-market QF contracts and other specific costs, were added together to produce the TCBA balance. When that balance dropped or was paid down to zero, that zeroing out triggers the lifting of the AB 1890 rate controls.⁹ The TCBA balance is reduced when generation assets are sold for greater than net book value. The Commission also established generation memorandum accounts that track the costs and revenues of operating in the marketplace. Prior to D.01-01-018, revenues in excess of costs from these accounts were credited to the TCBA annually.

A second account, the TRA, tracks a utility's operating costs and revenues. The operation of this account permits calculation of headroom revenues remaining after operating costs are paid out of customer bill revenues. The purpose of the TRA is to match the amount of billed revenues against the amount of the separated revenue requirement and Commission-approved obligations. Separated revenue requirements include transmission, distribution, public purpose programs, and nuclear decommissioning. Commission-approved obligations include of Independent System Operator (ISO) charges and Power Exchange (PX) charges. For PG&E, Commission-approved obligations also include Diablo Canyon-related ICIP exclusions. The TRA assures that PG&E recovers all approved costs for distribution operations, nuclear decommissioning and public purpose programs. Edison's distribution revenues fluctuate according to sales. The TRA ensures Edison recovers nuclear decommissioning and public purpose costs.

The TRA and TCBA interact because headroom is calculated through the TRA and credited monthly to the TCBA. The Commission has recognized that there may be months where operating costs exceed revenues, because the costs of energy vary on an hourly basis.¹⁰ The Commission allowed these unrecovered costs to be carried over in the TRA from month to month, and allowed revenues to be applied to these accumulated undercollections first before being transferred to the TCBA. When the AB 1890 rate controls expire, any undercollection in the TRA cannot be thereafter recovered. (D.99-10-057 and D.00-03-058.)

B. TURN's Petition to Modify the TRA and TCBA Accounting Mechanisms Accurately Reflects True Costs and Profits

The current accounting rules under Resolution E-3527 prohibit the transfer of TRA liabilities to the TCBA. TURN asserts that this rule is inconsistent with the intent of AB 1890.

TURN proposes that we modify the current accounting rules to require that each month the balance in each utility whether negative or positive, be transferred to the TCBA. The effective date of the proposed accounting changes would be January 1, 1998, when Resolution E-3527 took effect. The TURN proposal would require reconciliation or a "true-up" of utility operating costs and profits for the AB 1890 rate control period, otherwise known as the rate freeze.

TURN and several other parties¹¹ maintain that this simple change will properly capture the concept of "headroom" over the entire rate-control period. This true-up allows the Commission to accurately capture the "rate freeze compact"and assess the recovery of transition costs over the entire rate control period, as was intended by the Legislature.

TURN believes that this change will recognize the billions of dollars the utilities have realized both on their sales of capital assets and in revenues from selling electricity generated by their own plants.¹² This true-up is necessary to correct inequities in the current accounting rules which make it appear that the utilities have fully collected their stranded capital costs, while at the same time recording monthly liabilities of billions of dollars in operating costs.

TURN also asserts that its proposed accounting change will correct the erroneous treatment of revenues associated with the rate reduction bonds (RRBs) authorized by AB 1890. TURN observes that the Commission's current accounting treatment does not achieve the "indifference" outcome reflected in the Commission's decisions on Rate Reduction Bonds when TRA undercollections are accumulating. TURN contends that allowing the transfer of TRA undercollections merely reduces prior revenues recorded in the TCBA, thereby affecting only the amount of transition cost recovery achieved to date, not the amount of actual transition costs recorded in the TCBA.

In addition, TURN and the non-utility parties urge the Commission to true-up the accounting practices that track the costs and revenues from the utilities' fossil and hydroelectric generating plants in separate memorandum accounts until the end of the year. These parties point out that rising revenues reflected in these memo accounts are directly attributable to the same high-energy prices that have resulted to the growing TRA undecollections.

PG&E and Edison contend that this true-up is unlawful and would artificially extend the transition period. The utilities argue that such a true-up would force them to absorb the operating expenses incurred to provide service to their customers and would require the utilities to write off billions of dollars of transition costs. In essence, the utilities maintain that this (1) true-up would result in operating expenses being transformed into transition costs; (2) AB 1890 did not subject the utilities to the risk of non-recovery of FERC and CPUC-approved costs of providing service to their customers; (3) the accounting changes would be tantamount to retroactive ratemaking; and (4) the changes could deprive the utilities of a fair rate of return and result in confiscating rates. Edison states that the true-up would have a material impact on a case now pending before a federal court.

We disagree. We believe this true-up is critical in correcting an accounting anomaly.¹³ As EPUC, CMTA, WPTF, CIU, Enron, and ORA point out, the utilities are wrong in claiming that the filed rate doctrine would be violated if the relief they seek were not granted.

FERC was aware of the "AB 1890 rate freeze" concept when it approved California's restructuring plan. In fact, FERC authorized market-based rates based on utilities' claims that the California "rate freeze" would mitigate the utilities' incentive to raise PX prices.

PG&E and Edison understood that their ability to collect their transition costs was tied directly to their operating costs, including wholesale electricity costs.

By adopting this true-up, i.e., by requiring that either the debit or credit balance determined through the TRA calculation be recorded in the TCBA, we give full effect to the "rate freeze" principle, properly apply the matching principle, and adhere to the requirements of Public Utilities Code § 368(a).

It is inconsistent with the intent of AB 1890 to continue to allow the utilities to appear to incur substantial liabilities in their operating costs on the one hand, while they continue to recover substantial amounts for accelerated capital costs on the other. The utilities insist that shareholders have achieved full recovery of transition costs and are therefore not at any risk. At the same time, the utilities demand that ratepayers now be required to reimburse the utilities for energy procurement costs, even while recognizing that rates were "frozen" at an artificially high level to ensure that the utilities recover their prior transition costs. The true-up we adopt today corrects this inequity.

As stated in Resolution E-3527, Edison has previously proposed the approach we now take:

Edison finds the ED's proposed approach inequitable because `at the same time that the payments to the ISO and PX are increasing, potentially making the TRA balance negative, additional funds from the sales of Edison's generation output to the PX are being directly credited to the TCBA which will result in a direct benefit to the customers by immediately reducing transition costs recorded in the TCBA.' Edison argues that with an increase in the PX price, the ED's proposal results in the utilities bearing the risk of debit balances in the TRA while the benefits of the increased in the market price related to sale of their generation output to the PX are entirely reflected in the TCBA. (Resolution E-3527, mimeo at p. 5.)

Resolution E-3527 rejected Edison's arguments by stating that such treatment would be equivalent to treating the TRA debits as transition costs, which would be unlawful pursuant to § 367(a). The Resolution also declined to address the disposition of debits remaining in the TRA at the end of the transition period, as being beyond the scope of the Resolution.

In retrospect, Edison was correct in noting how E-3527 negated the matching principle. We believe the Resolution prematurely characterized the nature of TRA debit transfers. Applying the principles set forth in D.99-10-057 and upheld in D.00-03-058 requires that we take a closer look at the accounting anomalies caused by the treatment established by Resolution E-3527. We do not intend to further foster such inequities. As we have previously stated, the Commission has devised the TCBA and TRA accounting mechanisms and it is within our purview to change these mechanisms when inequities in accounting treatment become apparent.

Moreover, this true-up does not have the effect of treating TRA undercollections as an additional category of transition costs. Instead, it merely reduces prior revenues recorded in the TCBA, thereby affecting only the amount of transition cost recovery achieved to date. It does not affect the amount of transition costs recorded in the TCBA.¹⁴ Aglet also correctly points out that debits in the TCBA include many non-transition costs.¹⁵

In D.97-11-074, the Commission determined the costs and categories of costs for generation-related capital costs and obligations that had the potential of becoming uneconomic as a result of transitioning in to a competitive generation market. These Commission-authorized costs and obligations will not increase, except as they may have been modified by other Commission decisions. Instead, transferring the TRA balance to the TCBA on a monthly basis, whether that balance is an under- or overcollection, simply matches operating costs and revenues appropriately. The effect of this true-up is fully consistent with AB 1890 and several prior Commission decisions, including D.97-10-057, D.99-10-057, and D.00-03-058.

In other proceedings at this Commission and before FERC, PG&E and Edison have long recognized the risk that the variable energy costs may create. For example, in early 1997, PG&E and Edison asserted to FERC that market-based rates were appropriate because they had no incentive to exercise market power. The utilities recognized that any increase in revenues obtained as a seller of energy in the PX would be offset by a greater loss in headroom revenues.¹⁶ In its order conditionally approving the ISO and PX, FERC adopted market-based wholesale rates and confirmed that the existence of the "AB 1890 rate freeze," the fixed transition cost recovery period, and the mandatory sale of energy by the utilities into the PX helped to mitigate market power concerns. (Order Conditionally Authorizing Limited Operation of an Independent System Operator and Power Exchange, Pacific Gas and Electric Company, et al., Docket No. EC96-19-001, et al; 81 FERC ¶ 61,546, October 30, 1997.)

It is true that adopting this accounting true-up will increase the remaining level of unrecovered capital costs relating to generation assets. This is appropriate: the level of recorded transition cost recovery at any given time should reflect the fact that the utilities must first pay off operating costs incurred in providing service during the rate freeze and then may apply any remaining revenues to capital or stranded cost recovery.

PG&E now contends that while AB 1890 exposed them to the risk of recovering its transition costs, it did not subject them to the risk of not recovering of FERC-approved costs. PG&E argues that adopting TURN's proposal would do exactly that and is therefore unlawful. Similarly, Edison contends that federal law requires states to pass through to retail customers federally tariffed charges and, to the extent that TURN's proposal denies Edison the ability to recover procurement costs, it would contravene against the filed rate doctrine.

As stated above, we reject the utilities' contention that allowing the transfer of the TRA undercollections will somehow transform energy procurement costs into transition costs. In adopting this accounting true-up, we merely reduce prior revenues recorded in the TCBA, thereby affecting only the amount of stranded cost recovery achieved to date. Under TURN's proposed accounting mechanism, the utilities will achieve full recovery of their PX costs and any other FERC-approved costs incurred during the rate control period.

To be clear, the true-up we adopt today does not disallow the utilities' recovery of the cost of procuring and transmitting electricity in retail rates. Since the true-up alone does not disallow FERC-approved costs, there can be no violation of the filed rate doctrine in our adoption of the true-up accounting method.

PG&E and Edison assert that the true-up accounting method will deny them the ability to recover the TRA undercollections and that this would result in a "taking" under the California and United States Constitutions. Edison argues that nothing in AB 1890 changes the principle that a regulated company is entitled to a fair opportunity to recover its just and reasonable cost of operation. Both utilities claim constitutional right to retail rates that are not confiscatory.

PG&E maintains that any change of Commission's rules that would result in an indirect disallowance of PG&E's reasonable utility costs of service, whether the costs are operating costs or transition costs, is unlawful. According to Edison, TURN proposes that the TRA undercollection be transferred to the TCBA, where generation revenues are to offset them. Edison argues that TURN's proposal would deny Edison the ability to recover its procurement costs, and is therefore confiscatory.

These assertions are not persuasive. Under AB 1890, the utilities are at risk for the recovery of transition costs. Accordingly, the fact that this risk has now come to pass does not mean that there has been an unconstitutional taking. In short, the utilities' argument is premature. The AB 1890 rate controls are not over yet. Although the true-up accounting method will reduce prior transition cost recovery, no definitive landscape yet exists in which to ascertain the existence or extent of unrecovered costs.

Edison's argument about procurement costs adds nothing to PG&E's argument. Furthermore, in prior decisions we have consistently stressed that if we were to allow the utilities to recover procurement costs incurred during the rate-control period after rate controls end, the utilities' rates during the rate-control period would be made - retroactively - to exceed those in effect on June 10, 1996. This action would result in a recovery exceeding transition costs, an outcome inconsistent with AB 1890.

PG&E contends that the proposed true-up is illegal retroactive ratemaking because it changes the "rules of the game" after the fact. However, PG&E construes this prohibition too broadly. Even if this accounting change were a change in the rules of the game, it would not constitute prohibited retroactive ratemaking. As the California Supreme Court explained in Southern California Edison Company v. Public Utilities Commission (1978) 20 Cal.3d 813 (Edison), not every order involving rates that has a retroactive effect is prohibited retroactive ratemaking.

In Edison, the Court concluded that an adjustment of rate that does not involve general ratemaking may have a retroactive effect without violating the rule against retroactive ratemaking. Here, as in Edison, the accounting change at issue does not involve general ratemaking. In Edison, while the accounting rules changed in a way that Edison argued was detrimental, the changed rules, together with the required refund, simply carried out the Commission's original intent to allow Edison to recover its increased fuel costs on a dollar-for-dollar basis. Similarly, here, the effect of this accounting change is to carry out the original intent of AB 1890, i.e., that the utilities be at risk for recovery of transition costs during the transition period.

There are additional related reasons why TURN's proposal does not constitute prohibited retroactive ratemaking. First, no rates are being changed here. Unlike the situation in Edison, where refunds were ordered, here the utilities' rates remain frozen at the same level both before and after implementation of TURN's proposal. Second, the prohibition on retroactive ratemaking is a general statutory prohibition imposed by § 728. (See Edison, 20 Cal.3d at 816.) The accounting changes we adopt here are required to carry out a more specific and more recently enacted statute, AB 1890. Thus, even if there were a conflict between the retroactive ratemaking prohibition imposed by section 728 and the requirement of AB 1890 that the utilities be at risk for recovery of transition costs during the transition period, the more recently enacted and more specific requirements of AB 1890 would control.

The Commission established the TRA and TCBA based on our authority to implement the provisions of AB 1890. In retrospect, the accounting treatment we adopted in Resolution E-3527 contravenes the principles promulgated in AB 1890. We therefore find it necessary to modify our accounting approach in the manner proposed by TURN. The Commission has the authority to do so, and contrary to the utilities' claims that authority is not preempted by any law.

Edison asserts that when the Commission has cited the TURN proposal as a basis for dismissing the federal lawsuit, it is inappropriate for the Commission to grant TURN's request before the federal court has ruled. This argument is not persuasive under an estoppel theory or any other analysis.

Even if this argument were colorable, it would be defeated by the fact that Edison filed its federal lawsuit after TURN filed its accounting proposal with the Commission. We agree with the non-utility parties that accepting Edison' s contention and failing to act now on TURN's proposal would deny TURN its due process rights.

Moreover, the Commission's authority and responsibility to regulate utilities does not grind to a halt just because the utilities sue it. The Commission's authority to do its job continues, and our consideration of the proposed accounting true-up is a timely exercise of our ratemaking authority.

On a technical note, we agree with TURN's contention that current accounting treatment negates the neutrality of the rate reduction bond (RRB) transactions because the utilities' TRA accounts are undercollected. The Financing Order,¹⁷ which governed the 10% rate reduction and the issuance of the RRBs, adopted a ratemaking approach designed to render the RRB transactions neutral as to when rate controls end and to prevent cost-shifting among residential customers, small commercial customers and large customers.¹⁸ Since the TRA undercollections began to accrue, there has been no transition recovery from rate revenues.¹⁹ Absent the financed 10% rate reduction, the total amount of revenues collected from residential and small commercial customers would have been applied to offset the undercollections in the TRA.²⁰ But because of the adopted RRB transactions and the Commission's current accounting mechanism, the utilities continue to impute to the TCBA revenues related to the RRBs. Consequently, residential and small commercial customers continue to contribute to transition cost recovery by the amount of the imputed revenues, despite the lack of headroom. As a result, the utilities have recorded a greater amount of transition cost recovery than they would have had absent the RRB transaction and the residential and small commercial customers are paying a disproportionate share of the utilities' transition cost recovery,²¹ an outcome that contradicts the objectives of the Financing Order. Adopting the proposed accounting true-up therefore has the additional advantage of ensuring that ratepayers are made indifferent as to how the revenues associated with the RRBs are treated.

We will also modify our approach to generation revenues tracked and recorded in the generation memorandum accounts. D.97-11-074 allowed the utilities to credit these accounts to the TCBA on an annual basis, in part to address Edison's concerns regarding the seasonal nature of its costs and revenues. TURN and other parties propose that the balance--whether overcollected or undercollected--in generation-related memorandum accounts be transferred to the TCBA monthly rather than annually. On the other hand, proposes that a portion of the retained generation revenues accruing in the TCBA accounts and generation memorandum accounts should be credited to the TRA undercollection. Enron agrees that to the extent we reject the accounting true-up, all generation revenue should first flow into the TRA to offset the utilities' operating costs on a monthly basis.

In D.01-01-018, we ordered the utilities to segregate the generation memorandum account balances, which otherwise would have been credited to the TCBA at year-end 2000. Because we are now transferring the balance in the TRA to the TCBA on a monthly basis, we will also now require the utilities to restate and record overcollected generation memorandum account balances to the TRA before any transfer to the TCBA. This should be done on a monthly basis. This is appropriate because it will match the costs of procuring power on a monthly basis with the revenues resulting from generating that power. We will consider any adjustments, including addressing monthly GMA undercollections, needed as we consider the interaction of AB6X, AB1X, and § 367(c) with regard to recording the monthly balance.

¹² As LAC/ISD and ORA point out, the November 1, 2000 FERC order (Order Proposing Remedies for California Wholesale Electric Markets, FERC Order Docket No. EL00-95-000, November 1, 2000, p. 11), recognizes that "[t]he utilities have reported about $4.6 billion in unrecovered wholesale costs of which about $2 billion reflects sales of electricity sold from generation which they still own.