III. Capital Structure

Capital structure consists of long-term debt, preferred stock, and common equity.⁴ Because the level of financial risk that the utilities face is determined in part by the proportion of their debt to permanent capital, or leverage, we must ensure that the utilities' adopted equity ratios are sufficient to maintain reasonable credit ratings and to attract capital. The Office of Ratepayer Advocates (ORA) has recommended an optimum capital structure for the utilities, which we discuss below. No other interested party opposes the utilities' proposed capital structures.

A. Optimum Structure

ORA conducted a study to determine the optimum capital structure for each of the utilities. ORA defined an optimum capital structure, from the ratepayers' point of view, to be a capital structure in which costs are minimized and both profits and share price are maximized given the constraint of cost minimization. ORA used the average debt weight of a group of 20 to 40 companies similar to each of the utilities in terms of underlying characteristics such as risk, growth, and cash flow patterns. The comparable electric groups were selected so that the average revenue of a firm in the group was approximately equal to the revenue of the holding company of a specific regulated utility. For example, the comparable group for SDG&E consists of firms with average 2001 gross revenues of $8.47 billion compared to gross revenues of $8.03 billion for Sempra Energy, SDG&E's holding company. The comparable gas group consists of 17 companies covered by Value Line in the natural gas distribution industry and three diversified gas companies. ORA's modeling results for PG&E and SDG&E reflect the use of two comparable groups, electric and gas, because these utilities have both electric and gas customers.

ORA's study results show that its optimum capital structure proposal would require PG&E, SCE, and SDG&E to increase their long-term debt ratio with a corresponding decrease in the recommended common equity ratio. Specifically, (1) PG&E would need to increase its long-term debt ratio to 49.00% from 46.20% with a corresponding decrease in its recommended 48.00% common equity ratio; (2) SCE would increase its long-term debt ratio to 49.15% from 47.00% with a corresponding decrease in its recommended 48.00% common equity ratio; and (3) SDG&E would increase its long-term debt ratio to 47.70% from 45.25% with a corresponding decrease in its recommended 49.00% common equity ratio. Also, Sierra would need to decrease its long-term debt ratio to 48.60% from 57.94% with a corresponding increase in its 38.93% common equity ratio.

ORA acknowledges that it cannot affirm that its study results produce an optimum capital structure for the utilities.⁵ Even so, ORA recommends that its study result for each of the utilities be adopted, except Sierra. ORA exempts Sierra because it believes that its result for that utility is unrealistic because it would be costly for Sierra and its customers, if implemented. ORA, instead, recommends that Sierra's capital structure should be consistent with Sierra's 42.00% minimum long-term common equity target.

The energy utilities oppose ORA's study and recommendations. The utilities question whether the comparable groups used in ORA's study have optimum capital structures and even if they do, question whether ORA's recommended optimum capital structures are attainable. The utilities also question ORA's establishment of test year 2003 optimum capital structures on the comparable groups' estimated 2005 to 2007 capital structures. The utilities further question ORA's inconsistent treatment of including stranded-cost securitization bonds as a component of the comparable groups' long-term debt while the Commission excludes such bonds in establishing ratemaking capital structures for California utilities.

This is not a new issue. In Decision (D.) 89-11-068, the Commission reasoned that the utilities should be given some discretion to manage their capitalization with a view towards a balance between shareholders' interests, regulatory requirements, and ratepayers' interests.⁶ The Commission also concluded that the energy utilities' capital structures should continue to be evaluated on a case-by-case basis in proceedings such as this.

While it may be a desired goal, we are not prepared to adopt a specific optimum capital structure, let alone an optimum range, without some assurance that the adopted capital structure is reasonably attainable by the utilities and in the public interest, neither of which has been substantiated in this proceeding. Thus, we conclude that the utilities should be given some discretion to manage their capital structures.

B. PG&E

PG&E seeks a capital structure consisting of 46.20% long-term debt, 5.80% preferred stock, and 48.00% common equity. This is the capital structure that is currently authorized, with the same proportion of debt and equity used to finance assets in rate base over most of the last decade, and the basis for managing its finances and obtaining a Standard and Poor's (S&P) investment grade Single-A credit rating.⁷ At the same time, PG&E expresses its intent to seek additional rate relief to reflect any financial distress it continues to incur if its investment grade credit rating and financial health are not restored at the beginning of 2003, the test year for its next General Rate Case (GRC).

On April 6, 2001, PG&E filed a voluntary petition for relief under 1.c. Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court of the Northern District of California (Bankruptcy Court). Subsequently, PG&E filed a September 20, 2001 Plan of Reorganization (Plan) with the Bankruptcy Court, as amended on April 19, 2002, that provides for, among other matters, $5.4 billion in new debt, $2.7 billion in debt to certain creditors in satisfaction of their allowed claims, and $345 million of refinanced debt to be issued to certain creditors.

In response to PG&E's plan, the Commission filed an April 15, 2002 alternative plan (Commission's initial plan) with the Bankruptcy Court providing for, among other matters, PG&E to issue approximately $3.86 billion in new debt securities and $1.75 billion in common stock.

PG&E expects to emerge from bankruptcy at the beginning of its test year. Whether under PG&E's Plan or the Commission's initial plan, PG&E expects that its capital structure would be nearly the same as that being requested in this application.⁸ PG&E assumes that it will not issue any new debt, make any distribution of capital, and make no debt service payments except those permitted by the Bankruptcy Court. In addition, the Commission's initial plan provided for a 48.13% equity ratio, which approximates the 48% equity structure being proposed in this proceeding.

Subsequently, on August 30, 2002, the Commission and the Official Committee of Unsecured Creditors jointly filed an amended Commission plan that replaces the common stock component of the Commission's plan with preferred stock. Under the amended Commission's plan, PG&E's common equity ratio would decrease to 37.00% from 48.13% and its preferred stock ratio would increase to 13.88% from 2.74%. It also provides for the Commission to establish retail electric rates for PG&E's customers sufficient to pay interest and dividends, fund required reserves for, and allow PG&E to meet its obligations with respect to scheduled amortization and redemption of the securities to be issued under the amended plan. It further provides for PG&E to recover prudently incurred costs and for the Commission to facilitate PG&E's achievement and maintenance of investment grade credit ratings.

Although PG&E believes that its proposed plan will enable it to obtain an investment grade credit rating, it may seek additional rate relief in the GRC. PG&E does not believe that either of the Commission's plans will enable it to achieve an investment grade credit rating.

Should the Commission's initial plan be implemented, PG&E foresees a need to increase its ROE in the area of 30%. PG&E attributes that substantial ROE change as being necessary to compensate its shareholders for additional risks due to the issuance of speculative grade debt requiring a 10% to 17% interest rate resulting in a minimum of 100 basis points increase in its long-term debt costs. Should the Commission's amended plan be implemented, PG&E contends that its risk would further increase because the substitution of preferred stock in place of common stock would substantially impact its preferred stock costs and capital structure, and require its new debt to carry an even higher interest rate under the Commission's initial plan.

ORA acknowledges that the Commission's plans would impact PG&E through higher debt costs and, if the Commission's alternative plan were adopted, higher preferred stock costs. However, it sees no effect on PG&E's ROE because PG&E's ROE is "estimated from market models using a group of comparable companies."⁹ ORA concludes that even if the Commission's plan were to enable PG&E to achieve an investment grade credit rating there would be no impact on PG&E's ROE. ORA contends that the credit quality of a particular firm is a firm-specific risk that can be diversified away by investors.

We find that any adjustment to PG&E's capital structure at this time is purely speculative. With PG&E expecting to emerge from Chapter 11 at the beginning of its test year, the capital structure being adopted by this decision may become obsolete in a very short time. Absent an adjustment to its capital structure and associated costs, PG&E may not have a sufficient margin of safety for payment of interest, preferred dividends, reasonable common dividends, or ability to keep some money in the business as retained earnings to fulfill its public utility service obligation. Therefore, irrespective of which plan the Bankruptcy Court adopts, at the very least, an adjustment to PG&E's capital structure and costs would be necessary to assist PG&E in maintaining investment-grade creditworthiness.

It is appropriate and necessary to retain PG&E's currently authorized capital structure and to keep its application open to true up that capital structure and associated costs with changes resulting from it implementing the financing contemplated by the Chapter 11 plan approved by the Bankruptcy Court.

C. SCE

SCE also seeks the same capital structure that it is currently authorized. That target capital structure is 47.00% long-term debt, 5.00% preferred stock, and 48.00% common equity. SCE recommends no change and maintains that its capital structure will enable SCE to restore its financial strength and return it to an investment grade Triple-B rating from its speculative grade Double-B credit rating.

D. Sierra

Sierra seeks a capital structure consisting of 54.87% long-term debt, 3.13% preferred stock, and 42.00% common equity. This is a change from its 57.94% long-term debt, 3.13% preferred stock, and 38.93% common equity request set forth in its application

Sierra explains that the capital structure in its application was its best estimate at that time. However, based on recent financial projections supporting its ability to attain at least a minimum 42.00% common equity ratio, Sierra has modified its request. Sierra believes this revised capital structure is necessary to move its credit rating from speculative grade Double-B to investment grade Single-A. The revised capital structure is consistent with ORA's recommendation.

E. SDG&E

SDG&E, the only utility in this proceeding with an investment grade credit rating (Single-A), also seeks no change in its authorized capital structure. SDG&E contends that its current capital structure is attainable under its current business plan. That capital structure is 45.25% long-term debt, 5.75% preferred stock, and 49.00% common equity.

F. Conclusion

We reject ORA's optimum capital structure study. As ORA admits, it is not clear that the study produces an optimum capital structure that is attainable for each utility. On the other hand, the capital structures being proposed by the utilities are balanced, attainable, intended to either return their credit ratings to investment grade from a speculative grade or to maintain an investment grade rating. The utilities' proposed structures are also designed to attract capital. For these reasons, we find that the utilities' proposed capital structures are fair. The following capital structures for the utilities are consistent with the law, in the public interest, and should be adopted for test year 2003. As stated previously, we intend to update PG&E's capital structure when we are certain of the outcome in Bankruptcy Court.

PG&E SCE SIERRA SDG&E

Long-Term Debt 46.20% 47.00% 54.87% 45.25%

Preferred Stock 5.80% 5.00% 3.13% 5.75%

Common Equity 48.00% 48.00% 42.00% 49.00%

The next step in determining a fair ROE is to establish reasonable long-term debt and preferred stock costs.