21. Performance Incentives for SONGS

The Commission sets both SCE's and SDG&E's revenue requirement for SONGS on a forecast basis. Under the operating agreement, SCE bills SDG&E a proportionate share of actual costs, regardless of the Commission's adopted forecast of these costs. Thus, SCE shareholders are at risk/reward for any difference between the Commission-adopted forecast for SCE's share of the plant costs and SCE's share of the actual costs, and SDG&E shareholders are at risk/reward for any difference between the Commission-adopted forecast for SDG&E's share of the plant costs and SDG&E's share of the actual costs.

SDG&E now proposes a new ratemaking mechanism with respect to the recovery of SONGS costs by SCE from its customers, which SDG&E refers to as the Cost Control Incentive Mechanism (CCIM). The intent of the proposed mechanism is to give SCE a greater incentive to manage effectively the capital and O&M for SONGS. SDG&E states that the record shows that SCE managed these costs much more effectively when it was subject to the ICIP incentive mechanism than in periods when it has been subject to traditional ratemaking. SDG&E is proposing that its recovery of SONGS costs billed to it by SCE be placed on a recorded basis rather than the traditional forecast basis. If SCE reduces the total costs of operating SONGS under the incentive of CCIM, its billings to SDG&E will decline proportionately, and the SDG&E's full share of the savings will be passed through on a recorded basis to SDG&E's customers. SDG&E argues that under the CCIM, both SCE's customers and SDG&E's customers would benefit from improved cost control and greater plant output as a result of an incentive mechanism.

SDG&E states that its preferred choice is to sell its ownership interest in SONGS to SCE and enter into a purchased power agreement (PPA) with SCE for the same amount of capacity that SDG&E currently owns in the plant. SDG&E presented this approach in SCE's A.04-02-026 for authorization to replace the SONGS Units 2 & 3 Steam Generators. It has not done so in this proceeding and, thus, is not here at issue. SDG&E states that if the Commission concludes in the steam generator proceeding that the buyout/PPA option is the best alternative, the SDG&E's CCIM proposed in this proceeding will not be required. SDG&E states that the buyout/PPA has its own incentive provisions that will serve to keep SCE's SONGS costs in check to the benefit of both SCE's customers and customers served by SDG&E.

SDG&E indicates that it is extremely disturbed with SCE's historic inability, as the Operating Agent under the SONGS Operating Agreement, to manage SONGS 2 & 3 costs, as demonstrated over time by the fact that SCE routinely spends considerably more on both O&M and capital related costs than it forecasts. SDG&E further states that this history of substantial cost increases over forecasts is in marked contrast to the cost reductions that SCE was able to achieve during the Incremental Cost Incentive Pricing (ICIP) period of 1996 through 2003. In this proceeding SDG&E introduced a benchmarking study of SONGS performance during Pre-ICIP, ICIP and Post-ICIP years as well as against other nuclear facilities in the United States. This benchmarking study is intended to show that SCE can do considerably better in its efforts to manage SONGS costs when provided with the right incentives.

SDG&E states that as a co-owner of SONGS, SDG&E has come to realize that SCE's projections of the costs for SONGS -- capital, operation and maintenance, administrative and general, or any other cost - can not be trusted, whether on a "next year" budget basis, a general rate case test year basis or on a forecast basis over a five year period of cost forecast presented to the Board of Review (BOR), which is the governing committed for SONGS under the Operating Agreement. It is SDG&E's position that SCE has not been able to control SONGS costs other than during those years when the ICIP was in place. In its testimony, SDG&E presented information showing that, during the pre-ICIP years, recorded capital additions were 571% higher than preliminary budget estimates provided at BOR meetings. For the post-ICIP years, recorded and GRC forecasted additions are 130% higher than that provided in prior BOR meetings. However, during the ICIP years, there was a 46% decrease in the recorded capital expenditures when compared to the preliminary BOR budgets.

Regarding SCE's rebuttal which presented an alternate analysis that derived a variance as a percent of forecasted capital expenditures of 25%, SDG&E notes SCE's acknowledgement that the correct calculation was 27% and if the years were disaggregated by pre-ICIP, ICIP, and post- ICIP periods, the variance for the 1987 through 1995 period was 126%; for the 1996 through 2003 period was negative 53%; and the variance for the post-ICIP period of 2004 was 288%. SDG&E points out that the different method of calculating a variance cannot obscure the purpose of SDG&E's analysis, which was to demonstrate that SCE's cost control performance during the ICIP years was substantially better than in non-ICIP years.

While stating that it is accurate that SCE generally adheres to the annual budgets that are presented to the BOR each January for approval, SDG&E states that the "budget" that SCE will manage toward for 2006 is not the one presented in this General Rate Case. According to SDG&E, SCE will adopt its real 2006 budget next January, which may be very different from the cost estimates SCE presents to the Commission in this proceeding.

SDG&E acknowledges that some of the cost increases from the initial budget throughout this period of 1985 to 1995 and 2004 through 2005 resulted from events beyond SCE's control, such as the events of September 11, 2001, or events that occurred at other nuclear facilities, such as Davis Besse. However, SDG&E asserts that these substantial actual capital cost variances from the initial forecast of each year's capital budget are nonetheless reflective of SCE's inability to forecast capital costs at a SONGS because these costs are inherently uncertain with a high likelihood of very large increases in capital cost exposure, including exposure from events beyond the control of the utility.

SDG&E indicates that this problem of actual costs exceeding forecasts and budgets by substantial amounts during periods when SCE is subject to traditional cost of service regulation is compounded for SDG&E since it has no role to play in developing or influencing the budget. The Operating Agreement contemplates that SDG&E and the other minority owners have certain rights, e.g. to approve budgets, which must be done on a unanimous basis. A dispute involving a budget requires the owners to continue to advance funds and proceed through an arbitration process. SDG&E points out that this arbitration process, including the standards that would govern an arbitrator's awards, allows SCE to continue operating under proposed budgets and requires an expensive, lengthy and risky process for SDG&E to contest SCE's expenditures after the fact. Moreover, as a minority owner, SDG&E states that it has no control over the actual expenditures made by SCE.

SDG&E provided a statistical comparison for the cost impact of ICIP by comparing the average of the annual benchmarking results as measured against a sample of 31 utilities that own and operate nuclear plants for the ICIP years to the average of the annual benchmarking results for a limited period of the non-ICIP historical years (1993-95 and 2004) and the three forecast years. SDG&E finds that in both periods in which SCE was not under ICIP it was a inferior cost performer at a 90% confidence level. For the 2005-2007 forecast period SCE's forecasted costs exceeded the model's prediction by 22.2% on average. During the ICIP years, in contrast, SCE's cost was a little below the model's prediction, although not significantly below it in the statistical sense. Statistical tests were conducted of the hypothesis that performance in the ICIP years was equal or inferior to that in each of the two non-ICIP periods. According to SDG&E, these hypotheses were rejected in both cases, providing corroboration that the ICIP had its intended effect of causing SCE to be more efficient in its control over SONGS capital costs, which not inconsequentially also caused improved plant performance.

SDG&E concludes that SCE's cost control management track record during non-ICIP years provides compelling evidence that the Commission must adopt an effective PBR-type mechanism to encourage efficiency, like the PBR it approved for SCE in D.96-09-092. SCE states that such a new PBR mechanism applicable only to SONGS must include appropriate standards for service and safety and ensure fairness to ratepayers, employees and shareholders by balancing potentially conflicting interests.

SDG&E recommends that the Commission adopt the CCIM for an eight year-period (2006-2013). The CCIM would incorporate the expenditures approved by the Commission in this proceeding and those expenditures approved by the Commission in subsequent SCE general rate cases.117

The proposed CCIM would be applicable only to SCE, since SCE is the SONGS Operating Agent under the Operating Agreement for SONGS. SDG&E would be subject to a two-way balancing account with its customers incurring only those SONGS costs billed by SCE to SDG&E plus SDG&E's direct SONGS related costs. Thus, SDG&E's shareholders will not benefit from any SONGS cost savings generated by SCE under the CCIM.

SCE's annual SONGS revenue requirement would reflect existing capital, O&M, property taxes, franchise fees, depreciation of existing capital, and rate of return on SONGS related ratebase as of the end of 2005. New capital improvements in 2006 and thereafter would be expensed over a twelve month period commencing with the in-service date of the improvement, using Commission adopted forecasts of the costs for such improvements. Not included, nor subject to the CCIM, would be SCE's nuclear decommissioning costs and its nuclear fuel costs.

Under the proposed CCIM the annual revenue requirement for the years 2006 through 2013, adjusted for inflation, would be divided by the CPUC-adopted forecast capacity factor for the years 2006 through 2013 to determine a cents per kWh price that SCE will be allowed to charge its customers in each year for its share of the actual output that SONGS produces. Both the cost forecast and the capacity factor forecast would be addressed in a separate phase of this proceeding.

Embedded within the annual authorized revenue requirement would be SCE's authorized return on ratebase. The proposed cost control incentive mechanism should also have a sharing feature based on SCE's actual earned rate of return for SONGS operations. Again, specific sharing mechanisms would be addressed in a separate phase.

SDG&E's annual SONGS revenue requirement would reflect existing capital, O&M, property taxes, franchise fees, depreciation of existing capital, rate of return on SONGS related ratebase as of the end of 2005, nuclear decommissioning costs and its share of nuclear fuel costs. New capital improvements in 2006 and thereafter would be expensed over a twelve month period commencing with the in-service date of the improvement, using Commission adopted forecasts of the costs for such improvements.

SDG&E would be subject to a two-way balancing account with its customers incurring only those SONGS costs billed by SCE to SDG&E plus SDG&E's direct SONGS related costs. Thus, SDG&E would initially charge its customers its 20% share of the SONGS revenue requirement established in this proceeding plus SDG&E's direct SONGS related costs. The two-way balancing account would track only SDG&E's actual SONGS costs billed by SCE against the revenue requirement adopted for SDG&E in this proceeding. The following year SDG&E would be authorized to recover the inflation adjusted revenue requirement for the next year adjusted to reflect any over-collection or under-collection from the previous year.

SDG&E makes the following observations:

· Because of SCE's cost over-runs associated with SONGS since the expiration of the ICIP in 2003, SDG&E desires to hold SCE accountable for this inability to control expenditures at SONGS. The proposed CCIM will accomplish this result. However, if SCE strives to control its SONGS related costs and is able to operate SONGS at a lower cost than incorporated into the rates from this proceeding, SDG&E believes a reward for this effort is justified. The proposed CCIM will provide SCE with this reward and furthermore benefit SCE's customers. It will also benefit SDG&E's customers because the lower SONGS costs and better plant performance will flow through to these customers as well as SCE's customers.

· It is anticipated that under the CCIM SCE's shareholders will benefit if it keeps its costs in check. But foremost, SCE's ratepayers will benefit as well when SCE is able to reduce its costs by sharing in any additional earnings that SCE is able to achieve by reducing costs and improving plant performance. Conversely, if SCE is not able to control its costs and exceeds the CCIM cents per kWh price target approved by the Commission in this case, SCE's actual earned ROR for its SONGS operations will fall and SCE's shareholders will take share in the resulting economic penalty.

· Treating new non-major capital additions as expense under the proposed CCIM will provide greater incentives for good management by SCE of capital costs than under traditional ratemaking. Under traditional ratemaking, if the amount of capital additions exceed the Commission-allowed level for the rate case cycle, the utility shareholders do not recover return (and taxes) and depreciation on the excess capital spending for the term of the rate case cycle. However, as of the next rate case test year, the utility may then be able to earn a return on and of the remaining undepreciated amount of capital spending in excess of the previous allowed level. Under the proposed CCIM, there will be a greater incentive because if capital additions exceed the allowed level, SCE will never recover the excess in rates. Similarly, the benefit from managing capital spending below allowed levels will also be greater under CCIM than traditional ratemaking.

· The proposed earnings sharing mechanism also provides incentives for effectively managing expenses. The proposed earnings sharing feature, applicable to the effects of both recorded expense and capital additions, ensures a fair sharing with ratepayers of benefits if SCE manages SONGS in a superior manner.

· The average capacity factor for the SONGS units during the eight-year period that ICIP in effect (1996-3003) was 89.6%, the highest of any eight-year period in the plant's history. Since under the CCIM SCE will recover a fixed cent per kWh price for its share of actual SONGS generation, its ROR for its SONGS operations will be influenced by plant output as well as by cost control. Thus, under the CCIM, SCE's shareholders will benefit if SCE achieves high plant capacity factors. Because the cost of incremental power output from SONGS is so much less than the cost of obtaining the same amount of power from any other higher priced resource, there is a large benefit for ratepayers from achieving an increased capacity factor. Conversely, if SCE is not able achieve high plant capacity factors and as a result exceeds the CCIM cents per kWh price target approved by the Commission in this case, SCE's actual earned ROR for its SONGS operations will fall and SCE's shareholders will share in the resulting economic penalty.

SDG&E acknowledges that its proposed CCIM will require considerable further scrutiny and in all likelihood revision to accomplish the objectives of including appropriate service and safety standards and ensuring fairness of affected stakeholders. It was for this reason that SDG&E's proposal included a request that, if the Commission concludes that such PBR mechanism could better serve to cause SCE to become more efficient in managing costs at SONGS, a second phase of this proceeding immediately be commenced to take up this subject in great detail to determine whether such a mechanism could be structured to meet competing objectives.

SCE asserts that SDG&E's proposed CCIM is seriously flawed and should be rejected in this phase of the proceeding as well as for further review in a later phase. SCE argues that the proponent of an incentive ratemaking mechanism must show why the proposed rewards/penalties provide improved service as compared to traditional cost-of-service ratemaking. SCE claims that SDG&E did not show that its CCIM would result in better service for ratepayers than traditional cost-of-service ratemaking for SONGS 2 & 3. SCE also claims that adoption of CCIM could ultimately deprive ratepayers of the benefits of power from SONGS 2 & 3.

SCE is concerned that CCIM would apply incentives/penalties only to SCE and would allow use of a two-way balancing account for recovery of SDG&E's SONGS 2 & 3 operating costs. According to SCE, this would transfer all SONGS 2 & 3 operating risk from SDG&E's shareholders to its ratepayers. However, SCE does not necessarily oppose Commission adoption of different types of ratemaking for SCE's and SDG&E's SONGS 2 & 3 operating costs, if such ratemaking appropriately balances incentives/penalties for both utilities. For example, SCE states that it would not oppose use of traditional cost-of-service ratemaking for recovery of its SONGS 2 & 3 operating costs and appropriately designed balancing account treatment for recovery of SDG&E's SONGS 2 & 3 operating costs.118 However, according to SCE, the aspects of the CCIM that would apply to it are so seriously flawed that the Commission should not adopt it under any circumstances.

SCE argues that SDG&E's proposal that none of the penalties or benefits should apply to SDG&E inappropriately ignores the fact that SDG&E can influence management of SONGS 2 & 3. SCE states that SDG&E has the right to not approve a budget that it reasonably disagrees with and refers to SDG&E's statement that: "[t]he Operating Agreement contemplates that SDG&E and the other minority owners have certain rights, e.g., to approve budgets, which must be done on a unanimous basis."119 SDG&E can request information concerning costs at SONGS 2 & 3, and SCE indicates that it welcomes such requests and works hard to try to respond to them. It is SCE's position that, even though SDG&E is not the Operating Agent for SONGS 2 & 3, it does have input to SONGS 2 & 3 management and its incentives/penalties for safe, reliable, and compliant operation of SONGS 2 & 3 should be aligned with SCE's incentives/penalties.

Regarding SDG&E's analysis that supports its CCIM proposal, SCE makes the following arguments:

· In the Test Year 2006 GRC, the Commission will set cost recovery ratemaking for SONGS 2 & 3 O&M and capital expenditures for 2006-2008. In 2006, SCE forecasts $234.9 million (2003 $, 100 percent share) of Base O&M expenses and $61.2 million of RFO expenses per unit per outage for SONGS 2 & 3. These O&M expenses are not subject to a later true-up. They will set SCE's recovery of SONGS 2&3 O&M expenses for the years 2006-2008. Correctly forecasting O&M expenses is critical to match operating costs with authorized revenues. SDG&E offers no evidence on SCE's ability to forecast SONGS 2 & 3 O&M expenses other than noting that "SCE generally adheres to the annual budgets that are presented to the Board of Review (BOR) each January for approval."120

· SDG&E's focus on SCE's ability to forecast capital expenditures at SONGS 2 & 3 five years in the future is misplaced. As SCE also stated in its Rebuttal Testimony, Exhibit 89, "[n]uclear power plant capital costs are particularly uncertain because events beyond the control of the utility affect the need to complete capital projects at a nuclear power plant."1149 As SCE noted in its Rebuttal Testimony, Exhibit 89, SDG&E's testimony acknowledges that SCE could not reasonably foresee events beyond its control and their effects on SONGS 2 & 3 costs.1150. In this docket, SCE forecasts capital expenditures for years 2004-2008. None of the SDG&E materials demonstrate that SCE's capital expenditures forecast in this docket is wrong. If SCE's forecast is necessarily wrong, SDG&E offers no other forecast that it argues is more correct, only a punitive performance-based ratemaking mechanism from which it proposes to exempt itself.

· SDG&E's benchmarking study is based on FERC Form 1 data from other utilities for 1990-2003 and observations from SONGS 2&3 for 1993-2004. Most of this data is for years prior to 2000. The September 11, 2001 terrorist attacks significantly increased security costs at SONGS 2 & 3 and at nuclear plants throughout the United States. SDG&E's benchmarking study does not fully take into account Nuclear Regulatory Commission (NRC) orders on nuclear security issued in 2003 requiring full compliance by October 2004. Therefore, they cannot provide an effective benchmark for SONGS 2 & 3 costs in 2006-2008.

· SDG&E's benchmarking study contains serious flaws in its measurement of costs and cannot be relied upon to assess the cost performance of SONGS 2 & 3. First, Dr. Lowry's study in this docket "commingles the costs of items, which are consumed at or near the time of purchase, such as labor and materials included in Operation and Maintenance expense, with the cost of long-lived capital assets." Second, Dr. Lowry's previous benchmarking study, submitted to this Commission on behalf of SDG&E and its affiliate Southern California Gas Company, calculated the cost of capital used in production as the product of capital quantity index multiplied by a rental rate, which includes factors for depreciation, return and taxes. In contrast, Dr. Lowry's benchmarking study in this application uses only an incremental capital cost measure. Incremental costs in any given year only take account of capital additions in that year, and completely ignore the cost associated with all capital additions from prior periods, including the capital installed when the plant was originally completed.

· SDG&E's benchmarking study compares costs of utilities with portfolios of nuclear plants to SONGS 2 & 3, which is a single plant site. SCE has ownership interests in SONGS 2 & 3 and Palo Verde. SDG&E should have compared (1) SCE's nuclear plant portfolio to those of other utilities, or (2) costs of individual nuclear plant sites with SONGS 2 & 3 costs. SONGS 2 & 3 cannot be appropriately compared to other utilities with nuclear plant portfolios included in SDG&E's sample group. In addition, costs from a portfolio would reflect an optimization decision that is not available for a single plant.

· Finally, and more generally, SDG&E still had data errors in its last errata with the following variables: (1) plant age; (2) percentage of plant owned; and (3) acreage.

SCE states that the proposed CCIM could increasingly constrict its ability to earn its authorized return on SONGS 2 & 3 investment. According to SCE, earnings on rate base will dwindle while incentive ratemaking opportunities to realize earnings through O&M cost savings compared to O&M forecasts adopted by the Commission are limited by resetting rates every three-years. Also, the CCIM would place the burden of carrying costs on SCE's shareholders for capital additions which may not go into service for several years, such as reactor pressure vessel head replacements. SCE also states that the purpose of CCIM sharing bands is unclear and the CCIM penalizes SCE for fluctuations in cost that could be caused by such normal events as simply having two refueling outages in a single year.

It is SCE's position that it will not operate SONGS 2 & 3 unless it is assured it has an opportunity to access adequate resources to ensure public safety, compliance with regulatory requirements, and adequate reliability. SCE argues that SDG&E's proposed CCIM does not help SCE further those goals. If SCE has no opportunity to ensure access to adequate resources for public safety, compliance with regulatory requirements and adequate reliability, it states that it would have to close SONGS 2 & 3 and deprive ratepayers of both utilities of low cost power from SONGS 2 & 3.

Whether SDG&E has any influence in controlling spending at SONGS is debatable - SCE says yes; SDG&E says no. We would however agree that SDG&E has less control than they would if they operated the plant. It is similar to SCE's position as minority owner of the PVNGS 1-3. However, as discussed below, we are not convinced that an incentive mechanism at this time will necessarily lead to lower costs, over the long term, than would occur under normal cost of service ratemaking. While somewhat sympathetic to SDG&E's situation, we decline its request to adopt the concept of its proposed CCIM. We will continue to evaluate and set authorized levels of rate recovery for SONGS on a cost of service ratemaking basis.

Regarding SDG&E's benchmarking study, while such information would be helpful in our decision making, consideration of SCE's criticisms reduces our confidence in the study to the extent that we do not feel comfortable in making wide-ranging decisions based on the results. It is reasonable that the study should correctly reflect such factors as plant age, percentage of plant owned and acreage. Also SCE reasonably argues that SONGS 2&3 should be compared to costs of nuclear plant sites, not nuclear portfolios of other utilities. Possible commingling of O&M and capital costs and use of incremental plant additions rather than also considering costs of embedded plant also are concerns.

SDG&E's analysis of the ICIP benefits focused on capital expenditures. Data presented clearly shows that during the ICIP years, SONGS capital expenditures were lower than in the pre-ICIP and post-ICIP years. What is not clear is why expenditures were so much lower in the ICIP years. SDG&E shows that in the pre-ICIP years, annual capital expenditures ranged from approximately $50 million to approximately $160 million. During the ICIP years annual capital expenditures ranged from approximately $18 million to approximately $57 million. In 2004 the recorded capital expenditures were $143 million, and the forecasts for 2005 to 2007 are between $100 million and $120 million per year. We are less concerned about the differences between preliminary budgets and recorded costs than we are about the variance in the magnitude of the recorded capital costs over time. If we felt certain that an incentive mechanism would somehow reduce the capital expenditure levels to those experienced during the ICIP years, it would be foolish not to adopt a mechanism which reflects that reduced spending in the base amount. However, even though SDG&E is concerned that recorded/forecasted costs have increased over preliminary budget amounts, it does not assert that any of the recorded or forecasted expenditures costs are unnecessary or unreasonable. In fact, at this point in this GRC, there is only one issue related to SCE's forecasts for specific SONGS capital projects even though the forecasted expenditures are significantly higher than that experienced during the ICIP years.

SDG&E acknowledges there may be cost increases related to events, such as that of September 11, 2001, that are beyond SCE's control. However, SDG&E sees the increased costs of such events as reflective of SCE's inability to forecast costs at SONGS's because these costs are inherently uncertain with a high likelihood of very large increase in capital cost exposure, including exposure from events beyond the control of the utility. Such exposure may be exasperated by SDG&E's proposal to expense the costs over one year. While unanticipated costs are also not reflected in cost of service ratemaking, the utility is only denied cost recovery until the next GRC. At that point, assuming reasonableness, the utility can recover costs relate to the undepreciated amount over the life of the asset. From SDG&E's explanations, it appears that if feels it is more likely that capital expenditures will increase rather than decrease. In that sense, the proposal does not appear balanced. Without providing some offsetting benefit to SCE, it is not reasonable or fair to establish an incentive mechanism that is developed to expose SCE to the effects of acknowledged potential unknown cost increases, especially those that are beyond its control.

The value of the CCIM when compared to cost of service ratemaking is also speculative. There is always an incentive for the utility to incur lesser costs than that forecasted to set rates. The utility's shareholders would benefit fully to the extent that occurred. Likewise, there is no incentive for SCE to unnecessarily spend more than authorized, since its shareholders would be responsible for all cost overruns. Under the CCIM proposal, there would be sharing bands, with details to be worked out in a subsequent phase to this proceeding. SDG&E provided an example where SCE would be responsible for 100% of the costs or the first 50 basis points around the benchmark rate of return. Between 50 and 100 basis points there would be a 50%/50% sharing with ratepayers. The shareholder share would then increase in steps back to 100% with a suspension of the mechanism if the spread is greater than 300 basis points. Regular cost of service ratemaking provides a greater incentive to control costs, because, under cost of service ratemaking, SCE would be responsible for all overruns and would keep all savings during the rate case cycle as opposed to, under the CCIM, potentially only having to absorb a portion of cost overruns and being able to only share in a portion s of cost underruns. Under typical PBR mechanisms with sharing mechanisms, a utility might pursue cost savings, because even though there may be sharing with ratepayers, the benefit of the savings would be realized over a substantially longer period than the normal GRC cycle. However, under the CCIM proposal, costs would be reevaluated in the next GRC. Realized cost savings might then be reflected on a forward looking basis in rates for the next GRC cycle. This negates some of incentive for the utility to pursue cost savings and reduce costs.

We do recognize that the CCIM proposal to expense capital additions will provide additional incentives to maintain capital spending below authorized levels, because, as SDG&E indicates, there is no future truing up of recorded costs in rates since the costs are only reflected in one year, not over the life of the asset or plant. The converse is also true, if a capital project comes in below budget, the whole benefit is reflected in one year and there is no truing up of the reduced cost in rates to be reflected over the remaining life. However, the proposal to expense capital additions may actually provide an incentive for SCE to defer projects that might otherwise be built. Some projects might be deferred for a short period to capture the differential between authorized and recorded amounts up front. Other projects based on cost benefit analyses may be deferred only because the effect of expensing the project in one year may not, from the utility's perspective, be offset by the resultant cost savings. Such cost savings may not even fully occur until the next GRC at which time, under the CCIM proposal, the savings might be then reflected in rates. Whether or not such deferrals occurred during the ICIP period is uncertain, but considering the reduced capital spending during that period when compared to the prior and subsequent periods, it is something to at least consider going forward.

It is for the reasons above that we decline to adopt SDG&E's request to establish its proposed CCIM. SCE indicated that it would not oppose the use of traditional cost-of-service ratemaking for recovery of its SONGS 2 & 3 operating costs and appropriately designed balancing account treatment for recovery of SDG&E's SONGS 2 & 3 operating costs. SDG&E indicates such a proposal would be acceptable with certain conditions. There may be merit in establishing a balancing account mechanism for SDG&E's share of SONGS costs. However, such a mechanism would transfer the cost recovery risk from SDG&E's shareholders to SDG&E's ratepayers. There would be no effect on SCE's shareholders or SCE's ratepayers. For this reason, it would be more appropriate that any consideration of such a balancing account for SDG&E be considered in the context of SDG&E's next general rate proceeding, where overall shareholder and ratepayer risks and benefits can be evaluated in a more cohesive manner.

Lastly, SDG&E's stated preference is to sell its share of SONGS to SCE and instead receive energy through a negotiated purchase power agreement. SDG&E is pursuing such a course of action in the steam generator proceeding. If unsuccessful, it might pursue this goal in other venues. SDG&E has stated that if such a proposal is adopted by the Commission, it would withdraw it CCIM proposal. It may be worthwhile to defer significant ratemaking changes, such as the proposed CCIM, until there is more certainty that such proposed changes are really necessary.

117 Major capital expenditures, such as the Steam Generator Replacement Application, would not be subject to the CCIM.

118 SCE notes that in a settlement agreement on cost recovery for its investment in Palo Verde adopted by the Commission in D.96-12-083, SCE agreed to balancing account treatment for its share of Palo Verde operating costs subject to reasonableness review if certain cost thresholds were exceeded.

119 Exhibit 721, page JA-8.

120 Exhibit 721, page JA-7.

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