5. Addressing Other Potential Impediments to Contract Novation/Renegotiation
5.1. Legal Authority for DWR to Enter Into a Novation Agreement
CFC claims that DWR does not have the legal authority to enter into a novation agreement. CFC interprets contract novation as being in violation of Water Code Section 80260 which specifically prohibits DWR from entering into any new contracts for the purchase of power after January 1, 2003. CFC interprets this prohibition as applying to contractual terms that would allow for the novation of a power contract to a third party. CARE makes similar arguments.
AReM/CACES and Reliant disagree with such an interpretation, arguing that the sole restriction in Section 80260 is that DWR cannot enter into a contract in which it will be purchasing electric power. Reliant argues that by entering into a novation provision or executing a replacement agreement as the novating party, DWR would not be "contracting to purchase electric power," just the opposite.
DWR likewise disagrees with CFC's and CARE's interpretation as erroneous. DWR cites Civil Code Sections 1530-1533, indicating that the Legislature recognized that both assignment and novation are permissible means for transferring contractual obligations. DWR argues that the Legislature's reference to "assignment" in Water Code Section 80102 is most reasonably construed, consistent with the normative baseline rules applicable to all contracts, to allow DWR to transfer the contracts by assignment or novation.
DWR also disagrees with CFC's claim that Section 80260 bars novation. DWR explains that in novating a contract, it is not entering into a new "contract for the purchase of electrical power." Instead, through novation, DWR is terminating such a contract. DWR views novation as a contract administration function, and notes that Section 80260 permits DWR to administer contracts entered into prior to January 1, 2003.
We conclude that the novation of DWR's contracts does not violate any provision of Water Code Section 80260. We agree with DWR that a contract novation does not mean that DWR is entering into a new "contract for the purchase of electrical power." Instead, through novation, DWR is terminating such a contract. Accordingly, we find no legal basis to preclude DWR from executing a novation of any of its existing contracts. Such action is properly within the scope of DWR's authority under AB1X.
5.2. Satisfying Minimum Credit Rating Conditions
Counterparties are legally obligated to accept novation of certain contracts only if certain conditions stated in those contracts are satisfied. For example, certain contracts impose the requirement for minimum credit ratings for any new party assuming obligations under a replacement contract. Minimum credit rating requirements apply specifically to the following contracts as a condition of their being novated or transferred: (1) High Desert: (2) CalPine; (3) PPM; and (4) Sempra.
Another restriction applies under the terms of the PG&E Bankruptcy Settlement whereby the Commission may not require PG&E "to assume or accept an assignment of legal or financial responsibility for the DWR contracts unless PG&E's Company Credit Rating, after giving effect to such assignment or assumption, shall be no less than "A" from S&P and "A2" from Moody's. PG&E's credit rating currently is A3 (Moody's) and BBB+ (S&P).
The Commission is barred from requiring PG&E to assume any of the DWR contracts as long as PG&E's credit ratings remain below this prescribed level. PG&E, however, could voluntarily waive that requirement, however, if there were significant demonstrated benefits to its customers from taking on certain contracts through novation. PG&E states that it is not willing to waive these provisions at this time, but would reconsider its position in light of the overall benefits to its customers and itself, if any, that may subsequently become available based on the circumstances at that time. Therefore, the restriction in the Bankruptcy Settlement currently poses a potential challenge to implementing a replacement agreement between PG&E and one of the current DWR suppliers.
We do not consider the restrictions on PG&E's credit ratings to be an absolute barrier precluding the possibility that PG&E may take over replacement agreements entered into as a result of a DWR contract novation or renegotiation. Instead, the prospects for PG&E to agree to voluntarily take on such a contract will depend upon the specific terms, prices, and conditions involved. If replacement agreements can be negotiated that are beneficial to PG&E and its ratepayers PG&E remains open to the possibility of voluntarily assuming responsibility for such replacement agreements. The results of such negotiations can only be determined after we move into the next phase of this proceeding.
As a result, we recognize the provisions of the PG&E Bankruptcy Settlement as a relevant factor to be addressed in considering PG&E's role in taking over any replacement contracts. Since PG&E is agreeable to participating in the contract negotiation process and to considering any benefits that may be achieved, however, we do not consider the PG&E Bankruptcy Settlement to constitute a bar to moving forward with further efforts toward novation of DWR contracts.
5.3. DWR Contract Novation and Long Term Procurement Planning
DRA argues that renegotiation of the DWR contracts would conflict with the statutorily required competitive procurement planning process as prescribed by Public Utilities Code Section 454.5. Pursuant to Section 454.5, the Commission is required to evaluate and approve jurisdictional load-serving entities plans for procurement of resources to meet their customers' long-term energy supply needs pursuant to specified criteria. DRA believes that it would constitute a violation of this statute if a utility was required to "step into the shoes" of DWR without allowing other suppliers to compete to provide the energy needs currently provided by the DWR contracts at more competitive prices than those renegotiated with a counterparty to an existing DWR contract.
DRA argues that renegotiation of the DWR contracts outside of any competitive Request for Offer (RFO) process would prevent the statutorily required competition between suppliers of the capacity in question. DRA further argues that by [c]hanging the cost versus benefits analysis with respect to the DWR contracts," novation of the DWR contracts "could effectively unwind" the IOU procurement process which calculates the net short generation capacity to meet California load over a 10-year period, and could result in duplicative procurement.
DRA further argues that novation of the DWR contracts could disrupt the Long-Term Procurement Planning (LTPP) process which includes a mechanism to calculate the net short generation capacity required over a 10-year period.
A spokesperson for CalPeak Power L.L.C, one of the DWR counterparties, has said that CalPeak would consider novation of its DWR contract on the condition that its contract is extended for a multi-year term, and would oppose novation of the contracts "as is."23 DRA believes that other generators may seek a similar benefit in negotiations over replacement contracts. At the July 2, 2008 workshop in this proceeding, CalPeak declined to answer why its generation had not been accepted in the IOUs' all-source RFOs issued as part of the LTPP process.24 DRA infers, however, that the types of resources committed to the state by the DWR contracts do not necessarily fulfill the state's long-term needs as identified through the Commission's LTPP process. DRA contends that those long-term needs, however, must still be met through other contracts to fulfill long-term operational needs (and at the same time meet the objectives set forth in Section 454.5.) DRA believes that such other contracts would in effect render the extended DWR contract superfluous, and a waste of ratepayer money. DRA thus argues that extension of the DWR contracts could fail the least cost/best fit analysis undertaken by this Commission.
Reliant states, however, that because the DWR contracts are already part of the IOUs' portfolios, the IOUs have been incorporating such contracts into their long-term procurement plans since the LTPP process began pursuant to Section 454.5. For that reason, Reliant argues that there is no basis for DRA's claim that the act of novation will result in any duplicative procurement.
AReM/CACES agree with DRA that the novation of DWR contracts must not confer on the IOUs an opportunity to circumvent the procurement requirements embedded in their LTPP authority. AReM/CACES propose a competitive auction bidding process as one way to address this concern. AReM/CACES further argue that even absent auction process, the Commission can still exercise appropriate oversight of any renegotiated contract terms, and limit cost recovery of any excess costs deemed not to be competitive.
We conclude that the process of implementing novation does not conflict with the statutorily required procurement planning process as prescribed by Pub. Util. Code § 454.5. Pursuant to Pub. Util. Code § 454.5, the Commission must review and approve IOU procurement plans, establish policies and cost-recovery mechanisms for energy procurement, ensure that the utilities maintain an adequate reserve requirement, implement a long-term resource planning process, and implement a Renewables Portfolio Standard (RPS) program. Pub. Util. Code § 454.5(b) specifically enumerates the required elements of a utility procurement plan, and these elements are required to be in the plans filed by the IOUs at the Commission.
One required element of the procurement plan must include "a competitive procurement process under which the electrical corporation may request bids for procurement-related services, including the format and criteria of that procurement process."25 Additionally, these plans must include "a definition of each electricity product, including support and justification for the product type and amount to be procured under the plan ... the duration, timing, and range of quantities of each product to be procured."26 Therefore, the commission-approved procurement plans under which the IOU will operate do not require procurement to come solely via competitive request for offers.
Further, in D.03-12-062, the Commission authorized IOUs to enter into negotiated bilateral contracts for short term transactions of less than 90 days duration and with delivery beginning less than 90 days forward and negotiated bilateral contracts for longer-term products provided the IOU include justification in quarterly compliance filings. Therefore, as the Commission has implemented Pub. Util. Code § 454.5, it has given each IOU explicit authority, subject to proper conditions and justifications, to contract on a bilateral basis. As the Commission stated in D.07-12-052, it prefers that long term procurement be conducted via competitive procurement mechanisms, however it by no means removes bilateral contracts from the IOUs' options to meet its residual net short positions. In addition, nothing in this process prohibits an IOU from utilizing market benchmarks - including conducting an RFO - to determine whether the renegotiated contract is, indeed, competitive with other options.
Until a renegotiated contract has been presented to us for approval under the "just and reasonable" standards of Section 454, we cannot speculate as to how such a contract would compare with other IOU contracts, or contracting options. Parties will have the opportunity to raise such issues at the appropriate time in connection with the "just and reasonable" review process. At this early point in the process, however, DRA's objections are premature.
As a priority matter in Phase II(a)(2) of this proceeding, we shall provide guidance on appropriate "just and reasonable" standards to be used in the review and approval of any replacement agreements in order to ensure consistency with the applicable requirements of Section 454.5.
5.4. Effects on Resource Adequacy Requirements
DRA argues that under current resource adequacy rules, DWR contracts may count for resource adequacy and are exempted from Commission rules that do not allow for new Liquated Damages (LD) contracts to count for RA capacity. Currently, DWR has several LD contracts in its portfolio and it is unclear as to whether novation or replacement of those contracts entered into as a result of a DWR contract novation would qualify as meeting resource adequacy requirements.
The Commission decided in D.04-10-035 that DWR contracts should fully count for purposes of resource adequacy showings. In D.05-10-042, the Commission determined that the sunset date as well as the adopted portfolio limitations adopted related to LD contracts shall not apply to DWR contracts. Consequently, the IOUs currently are able to count the DWR contracts towards their resource adequacy requirements, regardless of whether the DWR contract is generator-specific or market-sourced. SCE argues that unless the Commission allows the novated DWR contracts, as well as any other replacement contracts, to count towards the IOUs' resource adequacy requirements at least through the current DWR contract expiration dates, the IOUs stand to lose a sizeable amount of eligible capacity from the novation process.
We shall adopt the proposal of SCE to allow novated DWR contracts, as well as any other replacement contracts, to count towards the IOUs' resource adequacy requirements, at least for equivalent power quantities through the current DWR contract expiration dates, including those contracts currently exempt from the Commission's LD rules. We agree that imposing this requirement is necessary so that the IOUs do not lose a sizeable amount of eligible capacity for resource adequacy from the novation process. We believe that adopting this condition on the Commission's approval of any replacement agreements adequately addresses the concern raised by DRA.
5.5. Effects of Novation on Cost Allocation Among IOUs
Parties generally agree that an impediment to the IOUs entering into negotiations to execute a new contract to replace a novated DWR contract up until now has been how the resulting contract costs could be allocated among the IOUs and their customers in an equitable manner. Accordingly, as a prerequisite to the IOUs moving forward with contract negotiations, the manner in which the associated contract costs are to be allocated among IOU customers must first be addressed.
Parties submitted proposals as to the principles, protocols, and processes that the Commission should adopt as necessary for the IOUs to enter into negotiations with power suppliers to arrange to take over DWR contracts pursuant to novation or through renegotiation.
PG&E submitted two alternative proposals addressing the inter-utility allocation issues. Under its first alternative, PG&E proposes that DWR contract benefits and costs be borne fully by the customers of the utility that either receives the contract through novation or assignment, or that continues to administer the contract after a designated date. There would be no allocation of contract costs among the utilities after the designated date. There would be no taking into account the proportion of DWR contract costs paid by the customers of each IOU prior to the designated date, and no attempt to preserve (by inter-utility payments or other means) the "equitable" formula for the life of the contracts adopted in D.05-06-060. Thus, this proposal would entail a revision to the Commission's "permanent" cost allocation decision.
The majority of parties oppose PG&E's first proposal, arguing that it would be inconsistent with the intent of D.05-06-060. DRA argues that the proposed allocation could also result in a substantial and potentially inequitable shifting of costs from one group of IOU customers to another. They argue that relitigating the "permanent" cost allocation adopted in D.05-06-060 is unnecessary and would be a poor use of the Commission's and the parties' resources.
PG&E's second alternative proposal would require recalculation of the inter-utility allocation of all the DWR contract costs over the life of the contracts from 2001 through the current termination date for the last remaining contract (in 2015). A revised cost allocation among the IOUs would thereby be determined based upon a statewide average DWR contract cost on a per-megawatt-hour (MWh) basis over the life of the DWR contracts. Transfer payments would be authorized among the IOUs as necessary to reconcile any differences between the resulting average cost allocation and total costs of each contract novated to a particular IOU. Under this approach, all utility customers would pay the same average DWR contract unit cost for deliveries of power. To the extent that an IOU were to negotiate additional terms after a DWR contract had been novated, the effects of the renegotiated terms would be borne fully by that IOU's customers.
PG&E argues that its second proposal "ensures that DWR contract costs are equitably allocated for the entire contract period."27 However, the methodology proposed for determining each utility's "equitable" share is different from the methodology adopted in D.05-06-060. As with PG&E's first proposal, this approach would require modifying that decision and relitigating the cost allocation methodology. Parties generally oppose the proposal as being too complicated to implement.
Most parties oppose PG&E's proposals and argue instead that the "permanent" inter-utility cost allocation methodology adopted in D.05-06-060 should be maintained.28 Under that adopted methodology, the "unavoidable" costs of the entire portfolio of DWR contracts among the three IOUs are allocated on a fixed percentage basis, while the "avoidable" costs of the contracts are allocated to the IOUs on a "costs follow contracts" basis. The IOU that administers a given contract thereby receives whatever benefits that contract offers and is responsible for the avoidable costs associated with it. Most parties argue that it is unnecessary to revisit these percentages for purposes of allocating costs among the IOUs as a result of taking over the DWR contracts through novation or renegotiation. These parties generally agree that SCE's proposal for inter-utility transfer payments appears to be a reasonable way to meet this objective.
SCE argues that the inter-utility allocation of costs associated with contracts entered into as a result of DWR contract novation must preserve the existing inter-utility allocation equities reflected in the permanent cost allocation methodology adopted in D.05-06-060. That methodology was made effective for the allocation of DWR contract costs since 2004, with assurance that the methodology would remain in place over the life of the DWR contracts. Consistent with that assurance, SCE argues that any revised inter-utility allocation methodology must ensure no IOU customers are allocated either a greater or a lesser share of contract costs merely as a result of the novation, assignment, or renegotiation of DWR contract costs.
As a means of accommodating the IOUs' entering into replacement contracts under a DWR novation, SCE proposes a transition to a "cost-follows-contracts" allocation methodology which preserves the principles adopted in D.05-06-060. Under the current allocation methodology, DWR contract costs which are classified as "unavoidable" are allocated among the three IOUs based on fixed percentages. Under SCE's proposal, all unavoidable DWR contract costs would be allocated to the customers of the IOU that administers the subject contract. As a result of this allocation, there would be a disparity as compared with the allocation that would result under D.05-06-060. To ensure that customers are left indifferent to the cost impact of the "costs-follow-contracts" allocation, SCE proposes that the Commission authorize a schedule of indifference payments.
Except for the Coral and Sempra contracts, all DWR unavoidable contract costs are fixed. Thus, except for these two contracts, the total unavoidable contract costs can be readily calculated. For Coral and Sempra, a portion of the unavoidable contract costs are tied to the delivery of natural gas or an index of natural gas prices. Thus, to calculate the costs for Sempra and Coral, SCE recommends that an assessment of forward natural gas prices be used to determine the total unavoidable contract costs at the time that the indifference payments are calculated.
SCE proposes a two-step contract allocation process to facilitate a transition to a "cost-follows-contracts" methodology. Step 1 would establish a transfer payment schedule between the IOUs to keep their respective customers indifferent to a new "costs-follow-contracts" methodology. The transfer payments would be based on the difference between the existing cost allocation methodology adopted in D.05-06-060 and the new allocation methodology. Step 2 would be the implementation of the new "costs-follow-contracts" methodology, which SCE proposes should take effect beginning January 1, 2009. SCE proposes that a 30-day compliance period be employed for the IOUs to coordinate and calculate the transfer payment amounts. The IOUs would also use the 30-day compliance period to explore a mutually acceptable "shaping of the transfer payments, such as levelized fixed payments over a period of time to facilitate rate stabilization." Any miscellaneous DWR contract costs that are not attributable to energy deliveries shall continue to be allocated in accordance with the fixed percentage allocations adopted in D.05-06-060.
TURN suggests that the three IOUs attempt to reach a negotiated agreement on a revised cost allocation approach going forward, based on a "cost-follows-contracts" allocation "in which each utility pays the full costs of the contracts it administers . . . and bears full responsibility for the costs and benefits of any future renegotiation of the contractual terms."29 TURN believes that "equitable adjustment payments" among the IOUs would likely be a necessary component of such an agreement.30 If after a prescribed period of time (e.g., 45-60 days) the IOUs could not reach agreement, TURN suggests the unresolved issues be set for hearing, briefing, and Commission decision. 31
We conclude that the SCE proposal for inter-utility allocation offers the best solution to facilitate the transfer of contracts to the IOU, and we hereby adopt it. Adopting a mechanism that preserves the existing allocation methodology, as proposed by SCE, is consistent with past Commission policy not to revisit the fixed percentages and the methodology adopted in D.05-06-060 to allocate the unavoidable costs over the life of the contracts. The previously adopted allocation methodology was "designed to be fair over the life of the contracts."32 In the early years of the allocation period, however, SCE customers bear a disproportionate share of contract costs. Correspondingly, in the later years, PG&E customers bear a disproportionate share of costs. We expressly stated in D.05-06-060 that the adopted cost allocation approach fairly balanced the relative cost burdens, and that we did not intend to revisit the adopted methodology.
PG&E's first proposal would result in SCE customers absorbing approximately $1.4 billion more of DWR contract costs than they would under the adopted methodology. PG&E's second proposal would increase SCE customers' costs by $140 million and SDG&E customers' costs by $260 million. Accordingly, we reject PG&E's proposals for a new allocation methodology as they unfairly shift costs to SCE and SDG&E customers and are in conflict with the principles of fairness underlying the methodology adopted in D.05-06-060.
We approve SCE's proposal for indifference payments with an important exception. The example contained in Paragraph 8 of SCE's proposal would violate two key principles contained in AB 1X: first, DWR power is sold by DWR to end use customers, and second, the IOUs collect the money owed for such DWR power from their customers and hold that money in trust until they remit it to DWR. In preparing their compliance filing, the IOUs must revise the methodology for making indifference payments to be consistent with these two principles of AB 1X. In addition, the methodology for making the indifference payments must comply with the Rate Agreement. Compliance with these principles may require that an IOU that owes an indifference payment to another IOU pay that sum directly to the other IOU (to ensure that the other IOU's overall rates remain reasonable).
23 See R 07-05-025 Workshop Transcript of July 2nd Workshop in this proceeding at p. 336, lines 8 - 24, and p. 359 at lines 17-22.
24 Transcript of July 2nd Workshop in this proceeding at p. 361 at line 16 through p. 363 at line 13.
25 See, Pub. Util. Code § 454.5(b).
26 See, Pub. Util. Code § 454.5(b).
27 Id., p. 12.
28 See comments of SCE, SDG&E, DRA, TURN, CLECA, and Reliant.
29 TURN's Opening Comments on Inter-Utility/Cost Allocation Issues, p. 3.
30 Id.
31 Id. at pp. 3-4.
32 See D.05-06-060, mimeo., pp. 9-10.
