SCE Agrees to Sell Transmission Assets to California

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April 11, 2001

SCE Agrees to Sell Transmission Assets to California=20

by Will McNamara=20
Director, Electric Industry Analysis

At a joint press conference with Governor Gray Davis, Edison International=
=20
Chairman, President and CEO John Bryson announced agreement on a plan to=20
restore Southern California Edison (SCE) to financial health. "The negotiat=
ed=20
resolution with the Governor is far preferable for our company, our employe=
es=20
and for our customers than is going into bankruptcy," Bryson said. The key=
=20
part of the agreement is that the state will receive a primary utility asse=
t=01*
SCE's 12,000 mile transmission system. SCE employees will operate and=20
maintain the system through a contractual arrangement with the state.=20

Analysis: Only days after Pacific Gas & Electric Co., its California utilit=
y=20
counterpart, declared bankruptcy, SCE announced what is being billed as a=
=20
pact with the State of California that should keep it out of bankruptcy=20
court. From all appearances, this seems to be a strong deal for SCE, as it=
=20
not only keeps the utility financially solvent but also removes it from a=
=20
line of business that remains rather uncertain and financially unrewarding.=
=20

First, let's establish the key aspects of the agreement. Keep in mind that=
=20
the California Legislature, the California Public Utilities Commission (CPU=
C)=20
and federal regulators must approve this deal. Edison International (NYSE:=
=20
EIX), the parent of SCE, has agreed to sell the utility's transmission asse=
ts=20
to the State of California for $2.76 billion. The confirmed price tag that=
=20
the state is paying for SCE's lines seems like a generous offer because it =
is=20
about 2.3 times the system's current book value of $1.2 billion (the origin=
al=20
cost, less any accumulated depreciation (OCLD) recorded in SCE's books).=20
Since transmission rates are based on an allowed rate of return on OCLD, it=
=20
is uncertain that SCE's current transmission rates will provide sufficient=
=20
revenues for the state to cover its purchase cost.=20

The sale includes only SCE's transmission assets. It appears that SCE will=
=20
remain in the distribution business and continue delivering power to=20
customers and running generation. Both the state and SCE have agreed to=20
commit to no less than $3 billion of capital investment in utility=20
infrastructure over the next five years, which presumably includes upgrades=
=20
to the transmission system and new generation capacity. It is not entirely=
=20
clear at this time how the $3 billion in capital investment will be shared=
=20
between the State of California and SCE.=20

Edison officials also have agreed to sell cost-based (not market-based)=20
electricity to the state from power generated at SCE plants. Edison Mission=
=20
Energy, the unregulated subsidiary of Edison International, is also obligat=
ed=20
to sell output from its Sunrise power plant exclusively to California under=
=20
cost-based pricing. Although SCE divested much of its power assets under=20
agreements with the CPUC, it still shares ownership of the San Onofre Nucle=
ar=20
Plant Units 1, 2 and 3 with San Diego Gas & Electric (SDG&E), and shares in=
=20
the Palo Verde, Mohave and Four Corners generating stations. SCE also owns=
=20
hydroelectric facilities and the Pebbly Beach generating facility. The=20
Sunrise Mission power project is a gas-fired power plant that is currently=
=20
under construction. Reportedly, the Sunrise plant is expected to provide=20
about 320 MW of electricity during peak periods of demand this summer.=20
According to the Memorandum of Understanding between SCE and the California=
=20
Department of Water Resources, "SCE's generation assets=01*including all en=
ergy,=20
capacity, ancillary services, and any combination thereof=01*will be commit=
ted=20
to cost-based ratemaking for SCE's bundled service customers." In addition,=
=20
SCE is prohibited from selling any of these generation assets until Dec. 31=
,=20
2010.=20

Also included within the agreement is SCE's commitment to dismiss all pendi=
ng=20
lawsuits against the CPUC related to market prices in California. Edison=20
International also has agreed to refund $400 million to the utility unit th=
at=20
reportedly had been paid in dividends to the parent company.=20

The $2.76 billion that the state is paying SCE for its transmission assets=
=20
can be used to pay pre-existing debt to creditors, including power generato=
rs=20
that have previously sold power to SCE. This is the essential benefit that=
=20
the utility receives in the deal and it is a considerable achievement given=
=20
that the liquid capital theoretically should stave off bankruptcy=20
proceedings. It is also important to note that this is the first revenue=20
stream that has been specifically earmarked for SCE's pre-existing debts.=
=20
Recent rate increases that have been approved by the CPUC can only be appli=
ed=20
to subsequent debts incurred by the utility. In addition, SCE will be allow=
ed=20
to issue bonds to recover a "substantial portion" of the approximate $5=20
billion in debt that the utility has accrued due to uncollected purchases o=
f=20
wholesale power. The agreement should return SCE's debt to investment grade=
,=20
making it easier for the company to raise money to fund future operations. =
By=20
reducing its debt load, Edison CEO John Bryson remains confident that SCE=
=20
"can borrow to pay out [remaining] debts."=20

SCE Chairman and CEO Stephen Frank expressed confidence that a final=20
agreement could be reached "before the end of the year," although the=20
California Legislature reportedly has agreed to expedite its own review of=
=20
the agreement and provide approval before summer temperatures begin to wrea=
k=20
havoc on the California market. If for any reason the sale of the=20
transmission assets has not been completed within two years, SCE is obligat=
ed=20
to sell to the state its hydroelectric generation facilities instead (at a=
=20
to-be-determined price). Although the deal is expected to proceed, some=20
concerns have been raised about federal issues related to interstate=20
commerce. In addition, the fact that Pacific Gas & Electric Co.=01*with whi=
ch=20
SCE has often been intertwined=01*remains in bankruptcy court could also=20
complicate the agreement between SCE and the state. =20

News of the agreement immediately caused Edison shares to increase by about=
=20
$2.16, or 24 percent, to $11.08 on April 9. As of the close of trading on=
=20
April 10, Edison shares were priced at about $11.38. =20

For its part, SCE said that it was "racing toward" an agreement with the=20
governor to avoid being forced into an involuntary bankruptcy. Yet, for som=
e=20
time, SCE has been more willing to sell its transmission assets than PGOeve=
r=20
appeared to be. In fact, I wrote in the 2/26/01 IssueAlert that Gov. Davis=
=20
had reached an "agreement in principle" with SCE regarding the sale of the=
=20
transmission lines. Most of the key elements of the agreement that has been=
=20
agreed to by both parties have been in the works for over two months. =20

PGOCorp. issued a statement that it was pleased that SCE had been able to=
=20
reach an agreement with Gov. Davis, but said that the agreement did not=20
change its own direction toward bankruptcy court. According to a report on=
=20
CBS.MarketWatch.com, Fitch analysts have suggested that the sale of SCE's=
=20
transmission assets to the state of California could in fact lend a=20
"framework" that might be used in Pacific Gas & Electric Co.'s bankruptcy=
=20
proceedings. What this might mean is that Federal Judge Dennis Montali, the=
=20
official overseeing Pacific Gas & Electric Co.'s bankruptcy, might rely upo=
n=20
the agreement between SCE and the State of California to mandate a similar=
=20
deal for PG&E. Gov. Davis commented that the SCE deal could serve as a bas=
is=20
for separate agreements with SDG&E, and eventually PG&E, if they choose to=
=20
come back to the negotiating table. In fact, the state could submit a plan =
to=20
Judge Montali outlining a purchase of PG&E's transmission assets, which the=
=20
judge could ultimately enforce.=20

An argument could be made that the agreement SCE has reached with the State=
=20
of the California provides benefits to the utility that go beyond protectin=
g=20
it from bankruptcy. One could argue that SCE benefits by being able to exit=
=20
the transmission business altogether, which in many ways can cause tremendo=
us=20
problems for the companies that choose to remain in this business.=20
Transmission operations also typically offer a low rate of return; in SCE's=
=20
case, according to its most recent 10K filing, its transmission business=20
resulted in a return on equity of 9.68 percent. SCE had proposed that the=
=20
return on equity for its transmission assets be set at 11.6 percent, which=
=20
FERC rejected (FERC has ultimate authority over transmission service=20
pricing). Thus, the question could be raised of why SCE would even want to=
=20
remain in the transmission business, given this low return on equity. Behin=
d=20
the scenes, SCE could very well have previously made the determination that=
=20
its transmission business was not a valuable part of its overall operation.=
=20
This could be representative of an international trend, as regulatory=20
agencies in Australia and Great Britain have also set lower limits on the=
=20
average transmission network charges that utilities can implement.=20

Moreover, the State of California does not bring extensive operational=20
expertise to its new role as a transmission owner. Thus, the state is wise =
to=20
keep SCE employees in charge of the operation and maintenance of the=20
transmission system. This substantially reduces the risk for the state, whi=
ch=20
is a prudent move. From the state's perspective, it gets an asset in exchan=
ge=20
for a bailout, which makes its investment in SCE beneficial. However, the=
=20
transmission business will present unique challenges for the state, such as=
=20
raising capital for transmission improvements and siting procedures. The=20
state may quickly learn why the transmission business is perceived as being=
=20
so challenging, and why it is difficult to entice companies to build new=20
transmission lines (especially considering the low rate of return that the=
=20
transmission business offers). On the other hand, by assuming the role of a=
=20
transmission system owner, the State of California will be in a position to=
=20
obtain competitive information about the activities of power generators in=
=20
the state. This could result in a significant advantage for the State of=20
California if it remains in its current power-buying role. =20

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