BEFORE THE PUBLIC UTILITIES COMMISSION OF THE STATE OF CALIFORNIA ) ) ) )

Transcription

1 BEFORE THE PUBLIC UTILITIES COMMISSION OF THE STATE OF CALIFORNIA Order Instituting Rulemaking to Integrate Procurement Policies and Consider Long-Term Procurement Plans. ) ) ) ) Rulemaking (Filed February 16, 2006) SOUTHERN CALIFORNIA EDISON COMPANY'S (U 338-E) AMENDED OPENING BRIEF ON DEBT EQUIVALENCE ISSUES MICHAEL MONTOYA BERJ K. PARSEGHIAN Attorneys for SOUTHERN CALIFORNIA EDISON COMPANY 2244 Walnut Grove Avenue Post Office Box 800 Rosemead, California Telephone: (626) Facsimile: (626) Berj.Parseghian@SCE.com Dated: June 23, 2008 LAW-#

2 Southern California Edison Company's (U 338-E) Opening Brief TABLE OF CONTENTS Section Page I. OVERVIEW (BOADA)...1 A. Purchased Power and the Rating Agencies (ABBOTT)...3 B. Risks and Benefits of Purchased Power (ABBOTT)...6 C. Rating Methodologies (ABBOTT)...7 II. RESPONSE TO ASSUMPTIONS AND QUESTIONS...9 A. Response to Assumptions (BOADA)...9 B. Response to Questions (BOADA/ULRICH)...14 III. CONCLUSION (BOADA)...19 ATTACHMENT...21 WITNESS QUALIFICATIONS i-

3 BEFORE THE PUBLIC UTILITIES COMMISSION OF THE STATE OF CALIFORNIA Order Instituting Rulemaking to Integrate Procurement Policies and Consider Long-Term Procurement Plans. ) ) ) ) Rulemaking (Filed February 16, 2006) SOUTHERN CALIFORNIA EDISON COMPANY'S (U 338-E) AMENDED OPENING BRIEF ON DEBT EQUIVALENCE ISSUES In accordance with the May 20, 2008 Administrative Law Judge s Ruling Requesting Briefing On Debt Equivalence Issues Raised In Petitions To Modify Decision (Ruling), the Commission s Rules of Practice and Procedure, and the permission of Administrative Law Judge Econome granted by telephone on June 23, 2008, Southern California Edison Company (SCE) respectfully submits this Amended Opening Brief on Debt Equivalence Issues. This Amended Opening Brief includes an attachment that was inadvertently omitted in the original Opening Brief filed and served on June 20, I. OVERVIEW (BOADA) As SCE explained in its Petition for Modification of decision D , power purchase agreement (PPA)-related debt equivalents are a real and quantifiable cost to the utility that must be considered in evaluating PPA bids in utility solicitations. The Ruling poses assumptions and questions that appropriately focus on seeking a tangible basis for identifying and quantifying this PPA cost component. SCE supports this effort as an important step in achieving least-cost, best-fit procurement on behalf of customers

4 The Commission has been actively addressing the issue of debt equivalence in regulatory proceedings for SCE dating back to the early 1990s. Historically, the Commission has relied on the expert opinions of the credit rating agencies concerning PPA credit impacts from the existence and costs of PPA debt equivalents. More recently, this issue was prominently litigated in the 2004 Long-Term Procurement Plan proceeding and SCE s 2005 Cost of Capital proceeding. 1 In these cases, the Commission gave the expert opinions of the rating agencies great weight in deciding to adopt debt equivalent adders and specific capital structure adjustments to compensate for these costs. Recently, the subject of the existence of debt equivalents and the rating agencies views on how to evaluate purchased power obligations of utilities in rating exercises has, once again, received a good deal of attention. However, this is not a new topic for the rating agencies, and their methodological views have remained substantially consistent on this matter. Indeed, the rating agencies have been including purchased power obligations as debt equivalents for almost two decades. Moreover, the prevalence of purchased power has grown as the utility industry structure has changed (especially in California), and the imputation of purchased power as a debt equivalent on the balance sheet of the purchasing utility has come into increasing prominence, scrutiny and challenge. Many parties would like to ignore the existence of debt equivalence. However, the reality is that the rating agencies explicitly include PPAs as debt equivalent obligations of utilities and calculate the utilities financial metrics accordingly. As a result, PPAs can produce a diminution in utility credit quality and deterioration in a rating results that are not positive for either the utility or its customers. Failing to recognize the substance behind the rating agencies practices and the importance of the issue as part of the PPA evaluation process is not in the public interest. 1 See D ; D

5 A. Purchased Power and the Rating Agencies (ABBOTT) In 1995, utility generation constituted 91% of total generation in the United States. However, less than a decade after the passage of the Energy Policy Act of 1992 (EPAct), the share of non-utility generation grew from 9% to 42.5%. 2 Although the growth in non-utility generation had not yet been realized in 1990 when the rating agencies started contemplating its effect on regulated utilities, the discussions leading up to the passage of the EPAct of 1992 spurred the rating agencies to begin acting on the changes taking place in the industry. Logic dictated to them that their approach to evaluating creditworthiness of regulated electric utilities needed to change to reflect the new construct being developed within the industry. Rating agencies pursue their goals of providing objective opinions of creditworthiness to fixed income investors by examining the real economic effects of activities undertaken by the companies they rate. Accounting standards, while not ignored, are not the guiding principles by which rating agencies consider financial obligations or effects. The rating agencies regard the economic realities of any given activity on the financial flexibility of a company and include, as fixed obligations, financial transactions that they consider to be fixed, whether through business necessity, law, contract or agreement. For instance, retail companies lease stores. The leases may be short-term or long-term. However, a retail analyst views the leases as a permanent obligation, much like long-term debt, regardless of their length because without the stores, the retail operation could not continue. In similar fashion, the rating agencies consider PPAs to be fixed obligations that must be paid for the business to continue. Standard & Poor s states their view that power supply agreements... create fixed, debt-like financial obligations that represent substitutes for debt-financed capital investments in generation capacity. In a sense, a utility that has entered into a PPA has contracted with a supplier to make the financial investment on its behalf. 3 2 DOE/Energy Information Administration data. 3 Standard & Poor s Methodology for Imputing Debt for U.S. Utilities Power Purchase Agreements, Ratings Direct, Standard & Poor s, at 2 (May 7, 2007)

6 Both Standard & Poor s and Moody s Investors Service (Moody s) published their first white papers on the subject of purchased power and its effects on creditworthiness in Following their historical approach to off-balance sheet obligations, they viewed purchased power in light of the economic risks involved. Off-balance sheet obligations arise [w]hen a company has retained the risks and rewards associated with certain rights and obligations that meet the definition of assets and liabilities but the accounting treatment does not fully recognize those assets and liabilities Moody s summed up its view on purchased power as follows: Moody s remains skeptical that a real transfer or reduction in economic risk has occurred simply by transferring ownership in a project to a third party... [where] any incremental risks assumed are not offset by an opportunity for the utility to earn a profit on such contracts. 5 They stated to preserve existing credit quality, utility regulators must recognize that utility managements need to offset the risks of purchased power by either earning a profit margin on the business or a higher return on rate-based assets. 6 They, in fact, downgraded four utilities, including Southern California Edison, in part because of increasing purchased power commitments without concomitant rate support. 7 While the effect of purchased power obligations is not a new topic for the rating agencies, it has been receiving more attention in recent years as utilities procure a greater proportion of power from non-utility generators. Because utilities are acutely aware of the credit impacts that result from purchasing power, they have started to calculate the costs associated with purchased power in procurement proceedings. Non-utility generators strongly object to the imputation of 4 The Analysis of Off-Balance Sheet Exposures, A Global Perspective, Moody s Investors Service, at 2 (Jul. 2004). 5 Purchase Power Commitments and Their Impact on Investor-Owned Electric Utility Credit Quality, Moody s Special Comment, Moody s Investors Service (Aug. 1992). 6 The Credit Risk of Purchased Power on Electric Utility Credit Quality, Moody s Special Comment, Moody s Investors Service, at 1 (Sep. 1992). 7 See id. at 1, 16. Moody s downgrade of SCE occurred on February 17, Standard & Poor s downgrade of SCE occurred on November 24,

7 debt equivalence costs to their offered cost of power. 8 However, Standard & Poor s has made it very clear that the policy is not going to change and that, in its view, debt equivalence is a real cost of doing business for the utilities. Whether the parties to a discussion about purchased power agree or disagree with the rating agencies about their approaches, the reality is that the rating agencies impose a cost on utilities that purchase power by computing financial metrics using higher fixed obligations than those shown on the balance sheet. This leads to a need on the part of the utilities to generate higher levels of cash flow to cover those increased obligations with funds from operations in order to maintain their rating levels. Those greater levels of cash flow can only be realized if regulators recognize the debt equivalence costs the utilities are incurring and provide the utilities with the ability to increase their cash flow generating capabilities. An example that Standard & Poor s has published to illustrate the effect of debt imputation on a company follows: 9 Debt $7.4 billion 55% Equity $6.0 billion 45% Funds from Operations Interest Expense $1.5 billion $444 million Power Purchase Payments $600,000 annually, discounted at 6% Implied Interest Expense $75,455 Implied Depreciation $74,545 Risk Factor 25% 8 See Impacts of Credit Requirements, Cost of Capital and Debt Equivalency Issues on Power Supply Acquisition, Remarks by EPSA President and CEO John E. Shelk at the Western Power Supply Forum (May 9, 2006). 9 Standard & Poor s Methodology for Imputing Debt for U.S. Utilities Power Purchase Agreements, at

8 Unadjusted Ratios Adjusted Ratios FFO/Interest 4.4x 4.0x FFO/debt 20% 18% Debt/Capitalization 55% 59% As shown above, the effect of the imputation of debt to account for purchased power obligations can have a real and deleterious effect on a company s financial metrics. If the risk factor was higher than 25%, the effect would be even greater. There is a tangible cost to ratepayers when a utility s rating deteriorates. The difference between the cost of funds for an A rated utility and a Baa rated utility is 56 basis points as of June 5, If a utility borrows $100 million for 30 years, that translates into an additional cost to ratepayers of $16,800,000 over the 30 years. Yields spreads will tend to be even greater when interest rates are higher. Further, in response to the rating agencies concerns, many utilities adjust their capital structures in order to comply with rating agency guidelines for their rating categories to avoid losing a rating. That means increasing common or preferred equity to counterbalance the additional debt the rating agencies impute. Those adjustments cost ratepayers because the cost of funding new common or preferred equity to balance imputed debt inures to the ratepayer. B. Risks and Benefits of Purchased Power (ABBOTT) The rating agencies recognize that a number of the risks associated with building power plants are diminished significantly by purchasing power. Among them are construction risk, operating risk and fuel supply risk. In addition, the advantages of purchasing power can include increased operating flexibility and profitability by relying on a portfolio of contracts that includes non-firm contracts that provide power when necessary, rather than building a plant whose output may not be needed in its entirety for some time. In addition, purchasing power avoids the rate shock associated with building power plants

9 Nevertheless, the choice to purchase power instead of building a power plant to fulfill the obligation to serve is not a riskless activity. In 1992, Moody s explained that the build versus buy decision is not a choice between risk and absence of risk. 10 The risks the rating agencies are concerned about include the reliance on others to provide power for ratepayers, which runs the risk that the provider will not perform as expected. In addition, changing circumstances would result in a disruption in the contract if, for instance, fuel prices soared to levels the provider was unable to sustain under terms of the contract. If the provider fails to perform for either physical or commercial reasons, the utility will be left with no option except to purchase power in the open market, which can be very expensive. If those costs are not passed through to the ratepayer, the utility s cash flow and financial health is diminished. In addition, because routine purchased power costs are passed through to the ratepayer on a dollar for dollar basis, there is no cushion for the risk the utility retains by purchasing power. Because the utility retains the obligation to serve and enters into a contractual obligation that carries risks of its own, some recognition of the economic cost associated with purchased power is necessary. Moody s summed up its point of view on this issue in its 1992 report on its view of purchased power by stating, [i]t is of particular concern if, when entering into a financial commitment, the company does not at the same time increase its equity base to compensate for these risks. 11 That view has not changed. C. Rating Methodologies (ABBOTT) Moody s and Standard & Poor s have different methodologies with which they judge the effects of PPAs on a utility. Moody s approach is less well-defined and more subjective than Standard & Poor s. Standard & Poor s has a very consistent and well-publicized approach that is easy-to-follow. Therefore, most utilities rely on Standard & Poor s results to define the effects they experience from purchasing power. 10 The Credit Risk of Purchased Power on Electric Utility Credit Quality, at Id. at

10 Moody s, which has a more fluid rating process than Standard & Poor s, views the risks attendant to power purchases on a sliding scale. Moody s calculates the effect if every dollar spent on purchased power is captured in the capital structure of a company and repeats the calculation assuming nothing is captured in the capital structure. Moody s identif[ies] the extreme positions, calculate debt-protection measurements based upon those extremes, and then recognize that reality lies somewhere on a continuum in between the extremes. 12 Moody s then assesses financial, demand, supply, construction, operating, rate-base and regulatory risks associated with the PPAs. In a subjective assessment, Moody s determines where on the sliding scale between nothing and everything reality lies. In some cases, Moody s includes no debt equivalence, particularly when there are legislated or long-standing regulatory practices of capturing payments in rates on an ongoing basis. At other times, Moody s will allocate the entire debt burden of an independent power producer to the utility s balance sheet, especially if the plant in question is dedicated to that utility. Moody s takes a variety of positions in between these two bounds. Standard & Poor s uses a more methodical and transparent methodology to assess the risk of purchased power. It identifies the PPA-related fixed obligations, including those in effect and those to take effect during the forecast period, imputes an amount for implied depreciation, and calculates a net present value of the capacity payments over the life of the contract at the company s average cost of debt, net of securitized debt. Standard & Poor s then applies a risk factor to reflect regulatory and/or legislated cost recovery systems. Standard & Poor s increases debt on the balance sheet by the amount of risk-adjusted obligations resulting from the mechanics described above. Standard & Poor s also adjusts cash flow interest coverage by the imputation of the purchased power by applying the company s average cost of debt to the debt equivalence. 12 Id. at

11 Standard & Poor s risk factors typically range from between 0% and 50%, although in some cases, Standard & Poor s imputes 100% of the PPA costs. The risk factor represents Standard & Poor s view on the level of risk that has been shifted away from or maintained by the purchasing utility. For instance, a tolling arrangement entered into by an unregulated energy company, whereby a third party produces the electricity but the energy company supplies the fuel and is responsible for the demand risk, would garner a 100% risk factor. No risk has been shifted from the energy company and no regulations exist to provide for payment through fuel adjustment clauses or otherwise. On the other hand, to the extent Standard & Poor s views contractual payments as the sole responsibility of the ratepayer, it could assign a risk factor as low as 0%. Risk factors in between the extremes are the result of an assessment of regulatory and legislative mechanisms that apply to purchased power cost recovery in addition to whether and how much of the risk has been shifted to another party. II. RESPONSE TO ASSUMPTIONS AND QUESTIONS A. Response to Assumptions (BOADA) 1. Rating agencies consider many factors in determining/adjusting an IOU s credit rating. Response: SCE generally agrees with this assumption. Determining credit ratings is a complex process involving balancing financial results against qualitative risks and then placing the company being rated in the context of the corporate structure and industry in which it operates. In its 2008 Corporate Ratings Criteria, Standard & Poor s updated its methodology for evaluating corporations utilizing a grid which describes business risk as excellent, strong, satisfactory, weak, or vulnerable. Standard & Poor s assesses financial risk as minimal, modest, intermediate, aggressive, or highly leveraged. The appropriate rating at the intersection of business and financial risk carries with it an expectation for certain financial - 9 -

12 metrics. For example, a utility with a strong business risk profile and an intermediate financial risk profile should qualify for an A-rating from Standard & Poor s and should have funds flow from operations interest coverage of between 3x and 4.5x. If a company s financial metrics change or fall below or above the expected outcomes for a company in that rating category, the rating agencies will change the rating to reflect a different level of creditworthiness S&P calculates an explicit value for the debt equivalency of PPAs in its methodology, the other two primary rating agencies (Moody s and Fitch) consider DE in a more implicit manner Response: SCE agrees with the first part of this statement. Standard & Poor s has an explicit calculation for debt imputation that it applies uniformly in a clear and quantifiable framework; Moody s also has an explicit approach comprised of a continuum of potential treatment of PPAs ranging from treating the PPA as a debt obligation to treating the PPA as an operating cost. Moody s has six different methods with which it assesses the obligations associated with purchased power, some of which have explicit quantitative calculations associated with them. Moody s methods treat PPA obligations as: 1) Operating Costs; 2) Annual Obligations x 8 (lease approach); 3) the Net Present Value of the obligation; 4) Debt Look-Through, which concludes that the debt of the IPP is actually debt of the utility; 5) Markto-Market, which assesses contracts that are above-market as liabilities; and 6) Consolidation, wherein both the debt and the cash flow of the IPP is attributed to the utility. While the current method that Moody s uses for SCE treats PPA obligations as an operating cost (no explicit debt imputation), Moody s states that in some circumstances, Moody s will adopt more than one method to estimate the potential obligations imposed by the PPA. This approach recognizes the 13 See Corporate Ratings Criteria 2008, Standard & Poor s (Apr. 15, 2008)

13 subjective nature of analyzing agreements that can extend over a long period of time and can have a different impact when regulatory or market conditions change. 14 In some ways, the subjective nature of Moody s approach poses greater risks to SCE as compared to the Standard & Poor s approach because debt equivalence of a PPA portfolio can drastically change based on Moody s assessment of regulatory and market conditions and contract economics. This springing lien risk is substantially what occurred in the early 1990s, when Moody s reassessed the risks from PPAs, attributed debt-like features to SCE s abovemarket QF contract portfolio and rapidly downgraded the utility. Finally, Fitch does consider debt equivalence in a more implicit manner and it rates SCE s credit higher that the other two rating agencies. Unfortunately, if there is a disagreement among the rating agencies about creditworthiness, fixed-income investors give more weight to the lower rating. As a result, the market gives Standard & Poor s and Moody s lower ratings greater significance than Fitch s higher rating in determining a utility s credit risk. There is another way to look at the different methodologies used by the rating agencies that is pertinent to informing the decision on the appropriate debt equivalence bid adder to use in evaluating PPA bids. Standard & Poor s upfront risk factor approach (e.g., 25%, as used for SCE) is an ex ante criteria to evaluate the financial risk of a PPA and therefore best matches the utility s PPA decision process framework. Standard & Poor s approach is forward-looking, in that it attempts to incorporate the risks from long-term agreements in its current ratings. Thus, it is consistent with a decision-making process that compares projected costs for alternative contracts. Although the other two rating agencies are also in the business of risk and credit evaluation, their methodologies are more characteristic of an ex post evaluation tool. Moody s, for example, may drastically change its assessment of debt equivalence in response to changing conditions. Such ex post changes cannot be assessed and incorporated into PPA bid evaluations, even though such changes may have a substantial impact on the future costs of PPAs. 14 Moody s Rating Methodology: Global Regulated Electric Utilities, Moody s Investors Service, at 10 (Mar. 2005)

14 Consequently, the Standard & Poor s approach best fits SCE s need to compare competing PPA options and select the ones that are in the best interests of its customers. 3. Ratings adjustments are based on a number of metrics, some of which are somewhat subjective, and the adjustments are stepfunctions that result from the combination of all of the inputs. Response: SCE agrees with this statement with the exception of the ambiguous use of the term stepfunction. Ratings are changed when combinations of circumstances converge to change the likelihood that a company can or will pay its fixed obligations in a timely manner. Rarely does one circumstance change a rating, but it does happen when the situation has a large enough effect on a company. If a utility suffers an adverse regulatory decision that diminishes either its actual or perceived ability to generate sufficient cash flow to qualify for its rating, rating agencies will have a negative reaction and either put the company s rating on review or downgrade the company outright. If a company has been paying down its debt over a period of years and its financial metrics have improved enough to alleviate concerns about the company being able to service its debt at a certain level, the rating agency might upgrade the company. A change in regulatory or legislative environment can affect a rating, as can a change in management or strategy. What is important to understand is that some risk categories assessed by the rating agencies are not subject to quantification. Despite the lack of ready measures, such as debt ratios, such risks are pivotal to a utility s financial flexibility and must be assessed. For example, changes in regulation are clearly an element that rating agencies must consider even though that issue does not lend itself to quantification

15 4. To determine a DE adder, the IOUs calculate the net present value of the cost of carrying the additional equity needed to rebalance the utility's current debt/equity ratio for the DE of the fixed costs associated with the PPA, using the S&P risk factor (or in our case, the CPUC's mandated DE percentage). In this way, assigning a DE adder to each PPA attempts to make the IOU s balance sheet indifferent to its existence. Response: SCE agrees with the first part of this assumption. The debt equivalence adder calculates the cost of rebalancing the capital structure to authorized levels after accounting for debt imputation. SCE does not agree that the bid adder, in and of itself, makes the utility s balance sheet indifferent. The adder is merely an ex ante estimate of the debt equivalence cost associated with the PPA. The actual ex post mitigation would need to be accomplished in the cost of capital proceedings. 5. On the other hand, when a utility develops or evaluates a UOG bid, it structures the financing of the deal according to its debt/equity ratio, so the cost of acquiring the sufficient equity to finance the appropriate portion of the fixed cost components of the project is already built into the bid price, and there is no need for an additional "debt adder." Response: Although SCE does not believe that utility-owned generation should be compared head-to-head with PPA bids in solicitations, SCE agrees with the statement. Unlike a PPA, which appears strictly as a liability, a utility built project appears on the balance sheet at the same capitalization as is authorized by the Commission. No further debt adder is appropriate. Standard & Poor s explains this view as follows: Utilities that build typically finance construction with a mix of debt and equity. A utility that leases a power plant has entered into a debt transaction for that facility; a capital lease appears on the utility s balance sheet as debt. A PPA is a similar fixed commitment. When a utility enters into a long-term PPA with a fixed-cost component, it takes on financial risk. Furthermore,

16 utilities are typically not financially compensated for the risks they assume in purchasing power, as purchased power is usually recovered on a dollar-for-dollar basis. 15 B. Response to Questions (BOADA/ULRICH) 1. Is the value (in the California market) of the RA capacity product associated with the PPA understood by rating agencies and included somehow on the plus side of the rating agencies credit analysis (and therefore not captured within the DE metric)? (BOADA) Response: The value of the resource adequacy capacity product of any PPA the utility signs is understood by the rating agencies. However, the debt equivalence methodology is intended to recognize the extent of the fixed obligation the utility has taken on by signing a PPA. Rating agency methodologies are designed to capture the financial risk aspects of PPAs. Standard & Poor s has assessed the benefits and costs of PPAs as a whole and, for these reasons, applies a risk factor of less that 100%. Moody s recognizes contracts that are uneconomic by marking them to market. 2. How does a new rate-based UOG project affect the rating agencies credit analysis? For example, if a service area is resource-rich, and an IOU is procuring additional new UOG, does this factor negatively in the rating agencies analysis? Or do other ownership risks such as technological obsolescence or the potential for non-recovery if a project runs over-budget or underperforms factored into the credit analysis? (BOADA) Response: Rating agencies recognize and examine the risks associated with any construction project a utility undertakes. Based on recent reports, the rating agencies have not singled out the risk of utility-owned generation as being any different from the risk associated 15 Buy Versus Build: Debt Aspects of Purchased Power Agreements, Standard & Poor s, at 1 (May 8, 2003)

17 with any other type of utility capital expenditures. How any capital expenditure affects the rating depends on the level of regulatory support for the utility s credit quality. Rating agencies may be concerned about the stress created by any construction project. Rating agencies would be less concerned about geographic location of a power plant owned by a regulated utility in a resource-rich service area as long as the power could be sold in interconnected power markets, making the plant location not particularly significant. In regard to how rating agencies view utility-owned generation, a recent Moody s report grouped utility-owned generation in with other types of capital expenditures, stating Longer-term, investments for new generation supplies, new transmission lines, environmental compliance costs and distribution enhancements should help grow rate base, a ratings positive. 16 In their December 2007 report on SCE, Standard & Poor s raises an issue relating to the lack of utility-owned generation: owned generation accounts for very little of SCE's power portfolio needed to serve retail load, as most of SCE's assets were divested as part of the restructuring effort in the late 1990s. While SCE is not prohibited from owning power generation, it has no near-term plans to build new generation. As a result, a second risk that is growing for the utility is related to its reliance on purchased power. As shown in the chart below, based on 2007 data SCE contracts to meet all but 38% of its power supply needs. SCE's projected net open position is expected to rise over time as the utility's load grows, CDWR and qualifying facilities (QF) contracts expire, as well as its needs to meet CPUC resource adequacy and renewable directives. 17 Based on the foregoing reference, SCE s smaller percentage of power supply from utility-owned generation creates a concern for Standard & Poor s about an increasing reliance on purchased power agreements to meet resource needs. This issue is very relevant in California because the percentage of purchased power in the California utilities respective energy supplies 16 Industry Outlook: US Electric Utility Sector, Moody s Corporate Finance, at 10 (Jan. 2008). 17 SCE Credit Opinion, Standard & Poor s, at 4 (Dec. 18, 2007)

18 is approximately 1.5 to 2 times the national average; this creates a heavy burden for getting this PPA bid adder issue right. 3. If the answer to the questions #2 above is yes, is a UOG-adder also required to maintain indifference to additional UOGs? (BOADA) Response: As discussed above, SCE does not believe that utility-owned generation should be compared head-to-head with PPA bids in solicitations. If, however, one were to make such a comparison, SCE does not believe that an adder would be necessary for utility-owned generation. For purposes of assessing creditworthiness, the rating agencies have developed debt equivalence methodologies that attempts to equalize utility-owned generation and PPAs in order to reflect the risks utilities incur by selecting either strategy to fulfill their obligation to serve. A utility-owned generation strategy provides appropriate support through additional equity to cushion against risk and a financial return to reflect the cost of that equity and associated rate base. A PPA strategy does not. It includes the assumption of a fixed obligation, like debt, but is not balanced by equity or a financial return associated with the PPA. Therefore, in order to equalize PPAs with utility-owned generation, the PPA needs an adder. The utility-owned generation already has the support it needs

19 4. All else equal, in order to maintain its current credit rating, does an IOU need to increase its proportion of equity to debt as it increases the amount of PPAs in its portfolio (i.e., would an IOU s credit rating definitely decrease if it did not take this step in response to increased PPAs with fixed cost payment streams)? (BOADA) Response: All else equal, increasing debt equivalence will negatively affect a utility s credit metrics and, if sizeable enough, will reduce its credit rating. 18 SCE believes that an increase in the equity ratio is the most straightforward way to mitigate the increased amount of debt equivalents from PPAs. Standard & Poor s has similarly identified increases to the equity ratio as the method for offsetting financial adjustments from debt equivalents. 19 Historically, SCE has adjusted its equity ratio in prior cost of capital proceedings with the purpose of mitigating debt equivalence. In 1992, both Moody s and Standard & Poor s downgraded SCE s credit primarily due to debt equivalence. 20 SCE requested an increase in common equity to 48% from 46% in the mid-1990s as mitigation for the increased debt imputation by the rating agencies. 21 In its 2005 cost of capital application, SCE requested an increase in the authorized preferred equity capitalization to mitigate further debt equivalence from PPAs. D authorized the requested increase in the ratio of preferred equity in SCE's authorized ratemaking capital structure to 9%. It is important to recognize that SCE s affirmative response to this question hinges on the term all else equal. This condition means SCE s financial ratios and risk characteristics are unchanged but for the impact of debt equivalence. For PPA bid evaluations, it is proper to isolate the impact of debt equivalence on the cost of capital in an all-else-equal framework. In so 18 The extent of debt equivalence necessary to reduce credit quality will depend on the utility s starting credit position; however, its impact on Standard & Poor s credit metrics is undeniable. 19 See Buy Versus Build: Debt Aspects of Purchased Power Agreements, at The Credit Risk of Purchased Power on Electric Utility Credit Quality, at 1, See D , 1992 Cal. PUC LEXIS 798 *

20 doing, customers can have confidence that the winning PPAs will have the lowest overall cost, including the costs of supporting utility credit quality with appropriate debt and equity ratios. In reality, many factors will affect the company s financial ratios, among them, depreciation, interest rates, return on equity and asset growth. Furthermore, the rating agencies assessments of risk may change based upon a variety of qualitative factors, including industry and regulatory conditions. As a result, assessing the appropriate capital structure is a very different exercise from evaluating alternative PPA bids. If credit quality is improving due to other factors, a utility will not necessarily need to increase the percentage of equity in its authorized capital structure to counter increasing debt equivalence. Although these other factors will allow a utility to maintain its current capital structure, this does not mean that debt equivalence has no cost impact. To the contrary, increasing debt equivalence imposes costs even though other factors may mask those costs. Without the increased debt equivalence, those factors would result in higher credit ratios, with ramifications for both credit rating and the cost of capital. 5. For illustrative purposes, would it be possible and useful to explicitly calculate the cost of the equity used to balance the debt in UOG bids and identify this cost as the debt-adder in the bid comparison process? (BOADA) Response: No. The cost of equity is already included in the costs of utility-owned generation projects. To account for equity twice in some type of debt-adder would be inappropriate

21 6. (For parties requesting the use of the DE adder for RFOs that exclude UOG bids.) Please provide some numeric examples of how the DE adder would be used to evaluate two bids with different fixed costs. Please include one example in which a bid with higher fixed costs, but lower total costs, wins the RFO (all else equal), as a result of the use of a DE adder. (ULRICH) Response: SCE interprets this question as seeking whether the ranking of resources in an RFO could change based on whether or not a debt equivalence adder is used. SCE has multiple real-world examples in which this has occurred and can confirm positively that PPA projects, in fact, change order in the ranking depending on the use of a debt equivalence adder. This makes sense because different PPAs can impute different levels of debt on SCE s balance sheet. Please see the attached hypothetical example that compares offers of equal total costs but one with higher fixed costs and their imputed debt equivalence adders. III. CONCLUSION (BOADA) As discussed above, debt equivalence costs associated with PPAs are real and quantifiable costs to the utility that must be considered in evaluating PPA bids in utility solicitations. The Commission has a history of recognizing impacts of debt equivalence and has properly relied on the expert opinions of the credit rating agencies in doing so. Although the rating agencies use different methodologies for evaluating the impacts of PPAs on the utility balance sheet, it is indisputable that they do, in fact, explicitly include PPAs as debt equivalent obligations of the utilities and calculate the utilities financial metrics accordingly. The record in this and prior proceedings soundly demonstrates that the Standard & Poor s-based methodology previously approved by the Commission continues to represent an appropriate methodology for calculating the debt imputation costs of PPAs. The Standard & Poor s-based methodology is consistent, well-publicized and easy-to-follow and is widely relied on by other utilities to evaluate the credit effects of PPAs. Therefore, the Commission should

22 find that the utilities should continue to use debt equivalence bid adders, as previously approved by the Commission, in their evaluation of PPA bids. Respectfully submitted, MICHAEL MONTOYA BERJ K. PARSEGHIAN /s/ Berj K. Parseghian By: Berj K. Parseghian Attorneys for SOUTHERN CALIFORNIA EDISON COMPANY 2244 Walnut Grove Avenue Post Office Box 800 Rosemead, California Telephone: (626) Facsimile: (626) June 23,

23 ATTACHMENT

24 Assumptions Discount Rate 7.3% Risk Factor 20% Cost of Capital 2 1 = Authorized 2 = Incremental DE Formula Present Value of Capacity Payments X Risk Factor Cost of Mitigation [We x Ke x Tax Gross-up x DE] + [Wp x Kp x Tax Gross-up x DE] - [(1 - Wd) x Kd x DE] Where: We = Weight of Equity Ke = Cost of Equity Wp = Weight of Preferred Kp = Cost of Preferred Wd = Weight of Debt Kd = Cost of Debt DE = Debt Equivalence

25 DE Example #1 - Tolling Contract Year 1 Year 2 Year 3 Year 4 Year 5 Capacity Cost 6,000,000 6,000,000 6,000,000 6,000,000 6,000,000 Energy Cost 39,945,600 39,945,600 39,945,600 39,945,600 39,945,600 Total Cost 45,945,600 45,945,600 45,945,600 45,945,600 45,945,600 PV Total Cost 174,164,633 Debt Equivalence $4,880,966 $4,037,276 $3,131,998 $2,160,633 $1,118,360 Cost of Mitigation Increase in Equity 498, , , , ,260 Increase in Preferred 60,916 50,386 39,088 26,965 13,957 Decrease in Debt (203,097) (167,991) (130,322) (89,904) (46,535) Annual DE Cost 356, , , ,809 81,683 PV Cost of Mitigation 921,170 PV Cost with DE Mitigation 175,085,804 Assumptions Contract Term 5 Quantity (MW) 100 $/kw-mo 5.00 Gas Price Heat Rate 8.00 Capacity Factor 0.57

26 DE Example #2 - Must-Take Contract Year 1 Year 2 Year 3 Year 4 Year 5 Energy Cost 45,945,600 45,945,600 45,945,600 45,945,600 45,945,600 Total Cost 45,945,600 45,945,600 45,945,600 45,945,600 45,945,600 PV Total Cost 174,164,633 Debt Equivalence $18,688,242 $15,457,924 $11,991,793 $8,272,634 $4,281,976 Cost of Mitigation Increase in Equity 1,909,339 1,579,304 1,225, , ,481 Increase in Preferred 233, , , ,245 53,440 Decrease in Debt (777,618) (643,204) (498,978) (344,224) (178,173) Annual DE Cost 1,364,956 1,129, , , ,748 PV Cost of Mitigation 3,526,977 PV Cost with DE Mitigation 177,691,610 Assumptions Contract Term 5 Quantity (MW) 100 $/MWh Contract Output 6 x 16 Capacity Proxy 50%

27 Default Cost of Capital for Revenue Requirement 2007 Authorized Cost of Capital Pre-tax Net - To - Weighted COC with Capital Capital Weighted Gross Cost Incl. After-tax Component Ratio Cost Cost of Capital Multiplier Income Tax Cost of Debt o Debt 43.0% 6.17% 2.65% % 1.59% o Preferred 9.0% 6.09% 0.55% % 0.55% o Common 48.0% 11.60% 5.57% % 5.57% TOTAL 100.0% 8.77% 12.87% 7.70% Incremental Cost of Capital Pre-tax Net - To - Weighted COC with Capital Capital Weighted Gross Cost Incl. After-tax Component Ratio Cost Cost of Capital Multiplier Income Tax Cost of Debt o Debt 43.0% 7.30% 3.14% % 1.88% o Preferred 9.0% 8.30% 0.75% % 0.75% o Common 48.0% 12.74% 6.12% % 6.12% TOTAL 100.0% 10.00% 14.60% 8.74%

28 WITNESS QUALIFICATIONS

29 SOUTHERN CALIFORNIA EDISON COMPANY QUALIFICATIONS AND PREPARED TESTIMONY OF ROBERT C. BOADA Q. Please state your name and business address for the record. A. My name is Robert C. Boada, and my business address is 2244 Walnut Grove Avenue, Rosemead, California Q. Briefly describe your present responsibilities at the Southern California Edison Company. A. I am Vice President and Treasurer of the Southern California Edison Company. In this capacity, I am responsible for managing and directing the Treasury functions for the Company. Q. Briefly describe your educational and professional background. A. I have a Bachelor's Degree (1980) in Economics and Biology from the University of California at Los Angeles. I also have a Master's Degree (1984) in Business Administration, specializing in Finance and Corporate Accounting, from the William E. Simon Graduate School of Management at the University of Rochester. I also hold a Chartered Financial Analyst (CFA) designation conferred in I joined Southern California Edison Company in 1984 as an Assistant Financial Analyst in the Financial Planning Division. I have held various progressive assignments in the division until In June 1989, I was promoted to Supervising Financial Analyst for the division. In June 1991, I was promoted to Manager of Financial Planning. In 1996, I was promoted to Director of Financial Planning. In 2000, I was promoted to Treasurer of the SCE. In 2001, I was promoted to Vice President and Treasurer. Q. What is the purpose of your testimony in this proceeding? A. The purpose of my testimony in this proceeding is to sponsor those portions of Southern California Edison Company s Opening Brief On Debt Equivalence Issues, as identified in the Table of Contents and section headings therein

30 Q. Was this material prepared by you or under your supervision? A. Yes, it was. Q. Insofar as this material is factual in nature, do you believe it to be correct? A. Yes, I do. Q. Insofar as this material is in the nature of opinion or judgment, does it represent your best judgment? A. Yes, it does. Q. Does this conclude your qualifications and prepared testimony? A. Yes, it does

31 SOUTHERN CALIFORNIA EDISON COMPANY QUALIFICATIONS AND PREPARED TESTIMONY OF MARC L. ULRICH Q. Please state your name and business address for the record. A. My name is Marc L. Ulrich, and my business address is 2244 Walnut Grove Avenue, Rosemead, California Q. Briefly describe your present responsibilities at the Southern California Edison Company (SCE). A. I am the Director of Energy Planning Division in SCE s Energy Supply and Management (ES&M) Department. My organization s responsibilities include electric generation unit commitment and dispatch planning, generation and power contract bid development, power and natural gas procurement planning, contract valuation and analysis, and power and natural gas price forecasting. Our planning efforts include analytical support for realtime ancillary services markets all the way out to ten years regarding portfolio development. Q. Briefly describe your educational and professional background. A. In 1992, I earned a Bachelor of Science degree in Economics, and in 1995, a Master of Science degree in Economics, both from San Jose State University. Subsequently, I earned a Doctorate in Economics from Auburn University in In 1998, I began working for Southern Company Services in Atlanta and later took a supervisory role in load forecasting and general quantitative analytics for Georgia Power, a subsidiary of Southern Company. In 2001, I joined Enron Energy Services, in Utility Risk Management and developed extensive forecasts and risk management hedging strategies for various retail tariffs across the nation. Subsequent to Enron, I spent a year at Econ One Research, Inc. establishing an energy consulting practice until I joined SCE. In December 2002, I took the role of ES&M Risk Control manager and created a group responsible for forward curve development, mark-to-market valuation, deal

32 confirmations, and risk reporting. In December 2004, I assumed my current position as Director of Energy Planning. Q. What is the purpose of your testimony in this proceeding? A. The purpose of my testimony in this proceeding is to sponsor those portions of Southern California Edison Company s Opening Brief On Debt Equivalence Issues, as identified in the Table of Contents and section headings therein. Q. Was this material prepared by you or under your supervision? A. Yes, it was. Q. Insofar as this material is factual in nature, do you believe it to be correct? A. Yes, I do. Q. Insofar as this material is in the nature of opinion or judgment, does it represent your best judgment? A. Yes, it does. Q. Does this conclude your qualifications and prepared testimony? A. Yes, it does

33 SOUTHERN CALIFORNIA EDISON COMPANY QUALIFICATIONS AND PREPARED TESTIMONY OF SUSAN D. ABBOTT Q. Please state your name and business address for the record. A. My name is Susan D. Abbott, and my business address is 143 Imperial Avenue, Westport, Connecticut Q. Briefly describe your present job responsibilities. A. I am Managing Director of New Harbor, Incorporated an investment bank that specializes in financial advisory services for the electric, gas and water industries. Q. Briefly describe your educational and professional background. A. I have a Bachelor's Degree in Literature from Syracuse University. I also have a Master's Degree in Business Administration from the University of Connecticut. I was a faculty member of the University of Idaho s Public Utilities Executive Course for 9 years. Prior to joining New Harbor, I worked for Moody s Investors Service for 20 years and was the Managing Director of the Power and Project Finance Groups at Moody s for 10 years. At Moody s, I was responsible for the ratings of all investor-owned, regulated electric and combination utilities, electric generating companies, water companies and electric coops in the Americas. A copy of my resume and prior expert witness experience is attached hereto. Q. What is the purpose of your testimony in this proceeding? A. The purpose of my testimony in this proceeding is to sponsor those portions of Southern California Edison Company s Opening Brief On Debt Equivalence Issues, as identified in the Table of Contents and section headings therein. Q. Was this material prepared by you or under your supervision? A. Yes, it was. Q. Insofar as this material is factual in nature, do you believe it to be correct? A. Yes, I do

34 Q. Insofar as this material is in the nature of opinion or judgment, does it represent your best judgment? A. Yes, it does. Q. Does this conclude your qualifications and prepared testimony? A. Yes, it does

35 SUSAN D. ABBOTT 143 Imperial Avenue, Westport, CT (business) (home) Highly experienced financial professional with excellent oral and written communication skills, interpersonal relationship strengths, project and people management capabilities, analytical mind-set, and an aptitude for creative problem-solving. Internationally experienced, and a good team player that relishes the richness of group efforts, and is flexible enough to apply skills in a variety of ways to meet objectives. Desirous of position within a team environment that will utilize best developed skills to mutual benefit. PROFESSIONAL EXPERIENCE NEW HARBOR, INC to present MANAGING DIRECTOR Source and execute strategic business assignments including strategic advisory, private placement financing, mergers and acquisitions and expert witness testimony. MOODY S INVESTORS SERVICE, INC. MANAGING DIRECTOR,PROJECT AND INFRASTRUCTURE FINANCE Managed a staff of 9 analysts specializing in project and infrastructure finance including toll roads, power projects, oil and gas projects and airports MANAGING DIRECTOR, POWER GROUP Managed a group of 15 analysts and support staff generating $20 million in rating revenues. VICE PRESIDENT,ASSOCIATE DIRECTOR,INTERNATIONAL GROUP (LONDON & NY) Responsible for marketing, administration, human resources, intermediary relationships and ratings backup for London office that was at the time limited to 15 people. VICE PRESIDENT,CORPORATE DEPARTMENT Leading a staff of 9, was responsible for corporate functions such as publishing, billing, statistics, strategy, ex-patriot deployment and human resource management. ASSOCIATE DIRECTOR,FINANCIAL INSTITUTIONS GROUP Managed a group of bank and insurance company analysts. ASSOCIATE DIRECTOR,BASIC INDUSTRIES,CORPORATE FINANCE Managed analysts following basic industrial concerns such as wood and paper, real estate, chemicals, and pharmaceuticals. Senior Analyst, Electric Utilities Group Followed electric and gas utilities in the Western half of the United States. AETNA LIFE AND CASUALTY CO. Senior Analyst, Private Placements Responsible for analyzing and recommending private and public placement of investment funds EDUCATION MBA, Finance, University of Connecticut, 1981 BA, Literature, Syracuse University