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PACIFIC GAS AND ELECTRIC COMPANY

CHAPTER 6

TRANSFORMATION – EARNINGS SHARING MECHANISM

Introduction

This chapter presents Pacific Gas and Electric Company’s (PG&E or Company) testimony in support of a shared earnings adjustment mechanism as part of its 2007 General Rate Case (GRC) application. The mechanism provides a vehicle to share the financial benefits and risks of PG&E’s Business Transformation Initiatives between customers and utility investors during the period between this GRC and the next GRC. The mechanism aligns customer and utility interests, returns potential cost savings of the Business Transformation to customers more quickly than a traditional GRC cycle, and prevents the utility from realizing an unforeseen financial windfall from the Business Transformation. The chapter covers the following topics:

• Purpose of implementing a shared earnings mechanism, and its relation to other aspects of the Company’s GRC application, particularly its showing on Transformation;

• A brief review of previous regulatory experience with earnings sharing mechanisms, including the experience of this California Public Utilities Commission (CPUC or Commission) and the California energy utilities; and

• Elements of the proposed mechanism and the rationale behind its design.[[1]]

Traditional cost of service regulation with the forward looking test year revenue requirement forecasts may not provide optimum incentive or cost recovery mechanisms for the bold set of Business Transformation initiatives that are described in Chapters 2 and 5 of this exhibit. For this reason, PG&E is proposing an earnings sharing mechanism along with committed dollar reductions in the attrition years as a method for ensuring that both customers and investors share in the benefits and risks of these efforts.

Purpose of the Shared Earnings Mechanism

The proposed earnings sharing mechanism is intended to provide mutual protection to utility customers and investors during a period of substantial uncertainty regarding PG&E’s costs of doing business. This uncertainty is caused by the Company’s Business Transformation efforts. The Business Transformation initiatives are intended to fundamentally redesign PG&E’s business processes to deliver faster, better and more cost-effective customer service. This is a risky venture with uncertainty over the timing and magnitude of costs and benefits.

PG&E expects that, over time, there will be net benefits from the transformation efforts in terms of more cost-effective and higher quality customer service. However, the stream of benefits may not be uniformly positive. Some initiatives will prove far more successful than others, and PG&E will need to continually reassess and redesign initiatives to meet customers’ increasing expectations. Such flexibility is not a feature of cost of service regulation between general rate cases, which tend to take a more static view of cost trends. In traditional cost of service regulation, the filed forecast cost estimates are point estimates which do not easily permit flexibility, or ranges of costs, conditional on specified (or uncertain) events between rate cases. To illustrate the point, consider a Commission decision that would grant PG&E an average revenue requirement increase of $2x, based on the 50 percent probability that the increase needed would only be $1x (all the initiatives are winners and costs get lowered significantly) and a 50 percent probability the increase needed would be $3x (many initiatives prove to be more costly than expected). This would not be a practical decision. With a revenue requirement increase of the average or expected value, the utility would either make money (50 percent chance) or lose money (50 percent chance). Depending on the level of risk aversion, the utility would opt to take the risk or not, even though in the longer term such risk-taking may be necessary to achieve breakthrough cost efficiencies and service enhancements.

In situations like this it makes sense to adopt an alternative recovery mechanism that will preserve incentives to pursue bold innovative efforts to provide better and more cost effective customer service, while sharing the benefits from successful innovation more quickly than would typically occur over a three year GRC cycle. A useful model is some form of sharing of the costs and benefits. This aligns incentives for both the customer and the Company by sharing the rewards and risks of the Transformation initiatives. The symmetric sharing of the gains/losses preserves incentives for the utility to undertake bold, uncertain endeavors.

As described in Exhibit (PG&E-1), Chapter 2, the Company has embarked on an ambitious program to change aspects of its culture and many specific work practices and procedures. The primary goal of PG&E’s Business Transformation is to improve customer service: for example, shorter time to connect new customers; faster and easier access to information about outages or accounts; more accurate and timely billing. A secondary goal of Transformation is to achieve unit cost efficiencies so that more resources can be applied to maintaining or strengthening customer service for a given level of overall costs or mitigating inflationary pressures. As described in Chapter 5, Transformation-Benefits Realization, of this exhibit and in Chapter 1, Post Test Year Ratemaking Proposal, of Exhibit (PG&E-9), Transformation has the potential to reduce the size of attrition revenue increases after 2007. However, there is very significant uncertainty regarding the timing and scale of Transformation’s impact on PG&E’s cost structure.

There are several sources of uncertainty. Many of the Transformation initiatives require new investments, particularly in information systems and technology. The timing of implementing most initiatives is not wholly within PG&E’s control. Many initiatives will require the collaboration or acquiescence of suppliers and labor. Achieving improvements in customer service may require more resources than anticipated. Accordingly, it is quite difficult to predict the net level of cost savings from Transformation initiatives that will be available to offset projected revenue requirements using conventional PG&E practices and procedures for 2007 and subsequent attrition years. As described in Chapter 5 of this exhibit, the cumulative estimated net benefits in the form of expense and capital investment savings over the 2007-2009 rate case cycle have a range of $321 million and $235 million (nominal), respectively.

Nevertheless, PG&E is proposing two means of delivering the benefits of Transformation cost savings to its customers. First, the Company is projecting a reasonable estimated level of savings to be used to reduce its conventionally derived base revenue requirement estimates in light of the overall uncertainties regarding future Transformation costs and savings. Even this estimated level of expense and capital-related savings is not certain. Despite the fact that this estimate of Transformation initiative savings shows net costs during 2007, the Company is waiving recovery of these costs and committing to use its conventionally derived revenue requirement estimate for 2007 without adding these net costs to this GRC request. In addition, the Company will commit to pass on estimated Transformation net cost reductions for the 2008-2009 attrition years in order to reduce the Company’s attrition requests.

The second means of delivering Transformation net cost savings to customers is through the proposed earnings sharing mechanism, using earned return on rate base equity (ROE) for GRC jurisdictional operations. The intent of the mechanism is to provide a mechanical “feedback loop” to return a portion of incremental Transformation net cost savings back to customers, yet retain sufficient financial “upside” for investors to provide management a strong incentive to pursue such savings. Such a mechanism is a significant departure from PG&E’s past practices, but not Commission practices.

In its current 2003 General Rate Case cycle, PG&E does not have an earnings sharing mechanism. In fact, PG&E has never had an earnings sharing mechanism applied to any of its base costs.[[2]] Between GRCs, PG&E has been free to retain 100 percent of any cost efficiencies it can achieve. In practice, as described in Exhibit (PG&E-1), Chapter 3, the Company budgets on the assumption that it will earn its authorized ROE on rate base assets. Incremental cost efficiencies have generally been used to mitigate inflationary pressures on other parts of the Company’s operations. This will generally continue to be the case over this rate case cycle. However, Business Transformation has the potential to provide breakthrough levels of net benefits that reduce the Company’s total costs below those projected using conventional estimates, while still improving customer service. An earnings sharing mechanism is a reasonable tool at this time to balance the interests of utility customers and shareholders in light of the significant uncertainty regarding the net cost benefits of Business Transformation.

Regulatory Experience With Earnings Sharing Mechanisms

Although PG&E has not previously had an earnings sharing mechanism, such mechanisms are not a novelty in regulatory practice.[[3]] Indeed, this Commission has authorized such mechanisms for the other major California energy utilities at one time or another.

Regulatory experience with earnings sharing mechanisms is almost as old as the industry’s regulation. The earliest example was gas utility regulation in England in the mid-19th century. Earnings sharing mechanisms have been applied to energy utilities under conventional and performance-based ratemaking (PBR) regulatory frameworks.[[4]]

This Commission’s experience with applying earnings sharing mechanisms began with San Diego Gas and Electric Company’s (SDG&E) PBR in 1994 (D.94-08-023). The Commission adopted a symmetric earnings sharing mechanism for Southern California Edison’s (SCE) distribution PBR (D.96-09-092). It adopted an asymmetric earnings sharing mechanism as part of Southern California Gas Company’s PBR in Decision 97-07-054, and renewed it for SoCal and SDG&E in Decision 05-03-023.

These mechanisms use either rate of return on rate base (ROR) or rate of return on equity (ROE) as a measure of financial performance. Despite utility proposals to the contrary, only one of the adopted mechanisms has provided any “downside” sharing to protect utility investors. This asymmetric treatment of risk and return for the utilities means that utility investors end up surrendering a share of upside with no corresponding downside risk reduction. This skews incentives for innovation, since the utility investor only gains some fraction of the upside return and has to absorb all downside. Clearly, under such outcomes, the rational manager will only be willing to assume very certain or sure bets on behalf of shareholders. In general, asymmetric earnings sharing substantially dilutes incentives to pursue ambitious ventures which could lead to significant cost savings. The progressive nature of the sharing mechanisms adopted by this Commission simply exacerbates this asymmetry. Outside a “deadband” (e.g., 50 basis points ROR), customers receive a disproportionate share of early savings, then decreasing proportions as returns increased. The intent would appear to be that utility management should be inspired to heroic achievements. Rather, earning such high rates of return would seem to be like winning a lottery—a low probability random event.

Actual results for these mechanisms have been unspectacular and this could reflect the preponderance of the asymmetric sharing which dilutes incentives. Southern California Gas Company has returned earnings to its customers in several years. The economic realities of operating a utility business appear to undermine the notion that a progressive sharing mechanism can inspire managerial heroics.

PG&E proposes a nearly-symmetrical sharing system but with a relatively narrow dead band. The mechanism is described in the following section.

PG&E’S Proposed Earnings Sharing Mechanism

PG&E is proposing an earnings sharing mechanism using recorded ROE for jurisdictional operations, a relatively narrow deadband, and symmetrical upside and downside sharing up to an earnings “cap” significantly above the authorized ROE. This design enables customers to benefit quickly should Transformation benefits prove to be significantly greater than the Company is estimating for purposes of adjusting its Attrition mechanism. At the same time, the downside protection mitigates the impact on the Company’s financial risk profile of pursuing Transformation initiatives. The key elements of the proposal follow:

• Return on Equity (ROE). PG&E’s proposal utilizes return on equity. ROE entails minimal additional complication compared to return on rate base, but has the potential for customers to benefit from unforeseen reductions in the forecast cost of debt and preferred stock, and gives some risk mitigation to the Company should those costs rise between annual rate of return cases.

• Jurisdictional Operations. The ROE will be measured for CPUC jurisdictional operations excluding the CPUC-regulated California Gas Transmission and Federal Energy Regulatory Commission (FERC)—regulated electric transmission operations. Revenues and expenses for certain distribution and retained generation investments such as Advanced Metering Infrastructure (AMI) and any new utility owned generation assets (e.g., Contra Costa Unit 8), will be included in the mechanism, although during this general rate case cycle they may receive separate interim ratemaking treatment.

• Below-The-Line Exclusions. The ROE will be measured excluding below-the-line items traditionally excluded from estimates of utility rate of return (e.g., excluded costs such as advertising and lobbying expenses, allowance for funds used during construction, etc.).

• Other Exclusions. A few above-the-line items, positive or negative, will be excluded from the mechanism. These are items which are included above-the-line as part of utility operations under FERC accounting rules, but represent items of income or loss which should be treated as separate incentives (to avoid double-counting) or which represent unusual timing items. For example, these would include incentive earnings under the Core Procurement Incentive Mechanism or revenues returned to, or recovered from, customers under the proposed ROE sharing mechanism.

• Recorded Rate Base. The denominator will use weighted average recorded rate base for all distribution and utility retained generation. This rate base will be reduced by the average balance of items used to calculate carrying cost credits associated with the Rate Reduction Bond and Energy Recovery Bond financings.

• Authorized Capital Structure. The equity denominator will equal average recorded rate base times the authorized common equity ratio. The authorized common equity ratio is used to avoid perverse incentives such as decreasing ROE from the mechanism simply by increasing book equity or by increasing ROE due to a below-the-line accounting event such as a reserve.

• A +/- 50 Basis Point Dead Band. The mechanism will utilize a dead band of +/- 50 basis points around the authorized ROE, for a total 100 basis point deadband. This provides for regulatory simplification if actual results are close to authorized returns. As noted above, however, this dead band is at the tight end of ranges adopted for other utilities, which have had 50 to 100 basis point dead bands for rate of return on equity or rate base. It will enable customers to share relatively quickly in upside net benefits from Transformation initiatives. Table 6-1 illustrates the sharing bands.

• Symmetrical Sharing. The mechanism will split earnings results outside the dead band—upside or downside—50/50. The 50/50 sharing is straightforward: utility investors and managers retain a meaningful incentive to enhance cost performance while adhering to the first priority of the Business Transformation—improving customer service.

• Shared Earnings Tax Treatment. All earnings to be shared will be treated as a one-time adjustment to base revenues, grossed up for income taxes, franchise fees, and uncollectibles, and credited to the appropriate balancing accounts to return to customers. The return of shared earnings from the mechanism as a revenue reduction will be excluded from the calculation of ROE for the year in which the revenues are returned to customers. Adjustments to billed revenues will need to occur during a calendar year subsequent to the calendar year of measured performance since sharing will be calculated as part of the process of preparing the Company’s annual financial statements. Consistent with other rate adjustments based on calendar year performance, this would occur on an annual basis through the routine true-up of PG&E’s balancing accounts.

• Earnings Cap but No Floor. The mechanism will retain the 50/50 sharing up to 300 basis points above the authorized ROE. Earnings above that level will be returned 100 percent to customers. Though not strictly symmetrical, this still provides substantial upside to utility investors to offset downside risk. The probability that the Company would achieve this level of performance during this rate case cycle is remote. There is no corresponding “floor” that would provide a guaranteed minimum level of earnings.

In conclusion, the ROE sharing mechanism is intended to align utility and customer incentives. It provides PG&E meaningful upside if the Company’s Business Transformation initiatives are highly successful at achieving cost efficiencies, but enables customers to begin receiving those benefits more quickly than they would by waiting until the next general rate case. It also protects customers against an unforeseen financial windfall for PG&E.

table 6-1

PACIFIC GAS AND ELECTRIC COMPANY

Customer/Shareholder Sharing Percentages

|Line No. |ROE |Customer |Shareholder |

|1 |Below 10.72% |50% |50% |

|2 |10.72% – 11.72% |0% |100% |

|3 |11.73% – 14.22% |50% |50% |

|4 |Above 14.22% |100% |0% |

| | | | |

|Based on 2005 authorized ROE of 11.22%. |

| |

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[[1]] Exhibit (PG&E-1), Chapter 2, identifies the ratemaking mechanisms for implementing the proposed sharing mechanism.

[[2]] The incentive ratemaking mechanisms applied to the Diablo Canyon power plant from the late 1980s through 2000 were based on operating performance, not earnings.

[[3]] The Commission has authorized sharing mechanisms for PG&E that provide incentive earnings for customer energy efficiency programs and core gas procurement.

[[4]] See “Performance-Based Regulation of Utilities,” Lowry and Kaufmann, Energy Law Journal, Volume 23, No. 2, 2002, pp. 399-457.

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