DWP Debt Tops $7 Billion; City Sees Fiscal Threat

By JEFFREY L. RABIN

Nov. 16, 1997 12 AM PT

TIMES STAFF WRITER

The Los Angeles Department of Water and Power, the nation’s largest municipal utility, has amassed a staggering $7.5 billion in debt--$4.8 billion more than is shown on its books--a sum large enough to threaten the financial stability of the city.

Unless a way is found to lift this crushing burden, which came to light in a Times examination of the department’s financial documents, the DWP’s ability to compete in California’s soon-to-be-deregulated electric power market will be crippled. If that occurs, the department will no longer be able to transfer to the city’s general fund tens of millions of dollars that now go each year to pay for police, fire and other essential city services.

S. David Freeman, the veteran utility executive recruited several months ago by Mayor Richard Riordan to be the DWP’s general manager, labels the situation a “financial crisis.”

City Councilwoman Ruth Galanter, who heads the council’s ad hoc committee on DWP restructuring, describes the debt’s potential impact in equally stark terms: “In the newly competitive environment, if we are not competitive, the [utility] will fold. Those left holding the bag are the owners of the company--the people of Los Angeles.”

An analysis prepared for Riordan of the legal and financial implications of the DWP’s crisis found that--in this worst case--only the city, not the utility, could declare bankruptcy.

Freeman considers that prospect highly unlikely. “Failure is not an option,” he said.

The principle cause of the DWP’s precarious situation can be found in a lonely stretch of Utah desert, where a huge power plant with an insatiable appetite for coal cranks out much of the energy that now lights the high-rises, homes and businesses in distant Los Angeles.

This energy behemoth is both the city’s largest source of electricity and the single biggest obstacle the DWP must surmount to cope with the coming free market in power.

Situated on the outskirts of Delta, Utah, the mammoth Intermountain Power Project, which the DWP operates through a separate corporation it controls, accounts for an astonishing $3.3 billion of the DWP’s debt. Simply repaying the bonds used to build the facility accounts for nearly 60% of the cost of producing power there. That is a major reason the DWP spends twice the industry average to generate electricity.

But Freeman said he discovered that the DWP has used creative financing and accounting gimmicks to keep this whopping IOU--and nearly $1.5 billion for other power plants and electric transmission lines--off its public balance sheet.

For example, instead of carrying the Delta project’s debt on its books, the DWP pressed for formation of a Utah entity, the Intermountain Power Agency. In 1980, the agency issued the $5 billion in bonds required to build the plant. Those bonds come with an unconventional guarantee, because the DWP--with the approval of the City Council and then-Mayor Tom Bradley--contractually agreed to buy most of the plant’s electricity until 2027--regardless of whether the power is needed.

Similarly, by establishing a little-known consortium with other municipal utilities--the Southern California Public Power Authority--the DWP financed a small share of the Palo Verde nuclear power plant in Arizona plus a network of transmission lines. Investors in that entity include the civic utilities of Burbank, Glendale, Pasadena, Anaheim and Riverside.

The $2.7 billion debt that appears on the DWP’s balance sheet includes investments in four natural gas-fired power plants in the Los Angeles basin, two coal-fired plants in southern Nevada and northern Arizona, and the department’s own share of the Palo Verde nuclear plant.

The full amount of the DWP’s power system debt--$7.5 billion at the end of June--has remained largely hidden from the public, buried in a footnote to its complex financial statements.

Today, all these arrangements might look shrewd, if they had produced prudent, far-sighted investments. But in the view of Freeman and other utility and financial experts, these gargantuan investments are neither.

For instance, when the DWP and its customers finally pay off the cost of the Intermountain Power Project, the Utah agency will own the huge facility. Los Angeles’ taxpayers will retain not one cent of equity for their investment.

And then there’s the coal problem.

Like the “take or pay” power contracts, the DWP negotiated long-term contracts to buy millions of tons of low-sulfur coal each year from Utah mines. Those contracts have fixed prices that now run as much as 50% higher than low-sulfur coal’s price on the spot market, where surplus coal is available for purchase. Those inflated coal costs alone add tens of millions of dollars a year to Angelenos’ electric bills.

To fuel its boilers and create the steam that turns its turbines and produces electricity, the plant consumes an enormous amount of coal--nearly 14,000 tons--a day. Specially designed coal trains--85 cars long--arrive regularly to feed the plant.

That’s 5.1 million tons a year at an average cost of $36 a ton delivered to the plant, according to DWP officials; the spot market for Utah coal, when available, is $22 to $26 a ton delivered.

Coincidentally, the single largest supplier of the coal at prices far above market now is Arco, the Los Angeles-based corporation that last year teamed up with a Japanese partner to buy the coal holdings of Coastal Corp. for $615 million.

Arco is the biggest of four major suppliers of coal to the plant, providing about 28% of its total needs, according to Reed T. Searle, general manager of the Intermountain Power Agency. It is also the most expensive.

“They are overcharging us substantially,” Searle said. “Every other coal company that we have contracts with has negotiated reductions.”

Believing that the coal price amounts to a gross inequity, Searle said the Utah agency has been pursuing administrative remedies, a requirement before filing suit against Arco.

An Arco spokesman had no immediate comment. DWP officials, who Searle said drafted and negotiated the original contracts, refused to release details, citing a confidentiality clause in the agreements.

And that’s only part of the department’s increasingly dark picture.

Freeman, who has run major utilities from coast to coast, including the giant Tennessee Valley Authority, arrived in Los Angeles several months ago and didn’t like what he found: The DWP is woefully unprepared to compete in the emerging free market for electric energy.

According to Freeman, the biggest reasons are the debt on the Intermountain Power Project, the long-term power purchase contracts, and the price of coal.

“I intend to take a real hard and mean look at this deal. I don’t like it at all. I think we’re being ripped off real badly,” Freeman said in an interview. “Nobody with the benefit of 20-20 hindsight would have come within 10 feet of a deal like that.”

So long as the DWP maintained its monopoly in the nation’s second-largest city, it was able to operate profitably despite the debt burden, a huge work force and a host of inefficiencies that make its cost of producing electricity higher than the regional average for other utilities.

This monopoly protection will end once the doors of the electric power business fully open to competition over the next few years.

Unless the DWP soon lowers its operating costs and reduces its debt load, the utility could watch as its biggest industrial customers, which now pay its highest rates, switch to cheaper suppliers.

Such a move could trigger what utility analysts call a “death spiral,” which would increase the financial burden on the utility’s residential and commercial customers at precisely the same time that California’s private utilities and out-of-state companies are undercutting the DWP’s energy prices.

So, in a bold move, Freeman recently unveiled a sweeping plan to make the DWP more competitive in the rapidly changing electric utility business.

The Times reported two weeks ago that he wants to lay off 2,000 engineers and managers--eliminating more than one out of five jobs in the department, which employs just under 9,000 people. If the City Council approves, it will be the biggest municipal layoff in the city’s history.

Before the council can act, however, the Board of Water and Power Commissioners must discuss the plan in public and private meetings this week.

Freeman wants to slash at least $400 million from an annual budget of $2.4 billion.

Using, in part, the savings from a much smaller work force, Freeman wants to embark on an aggressive program to eliminate $4 billion of the utility’s mountain of debt before all DWP customers are given a choice of power suppliers in January 2003.

Private utilities in California will begin opening their territory to competitors on the coming New Year’s Day, but municipal utilities have the option to maintain their monopoly for longer periods. Out-of-state energy suppliers are already clamoring for a piece of the California action.

Freeman sums up the threat that the DWP faces: “The wolves are not at the door; they are in the kitchen,” he said. “I assume we are in a fight for every customer.”

In advance of deregulation, the DWP’s credit rating has fallen a notch from AA-. And Wall Street bond rating agencies, mindful of the long-range risks facing the giant utility, have signaled that a further downgrade in its lower A+ bond rating is possible.

“The challenge is quite significant,” said William Cox, a utility analyst for Standard & Poor’s in New York. “Some of its debt and some of its operations need to be reduced. . . . Significant changes are needed, and they have not made it through the City Council in a timely and unpoliticized way.”

The rating agency recently issued a statement calling Freeman’s plan “an encouraging step toward addressing the utility’s uncompetitive electric rates.”

But Standard & Poor’s said its concern is “principally premised upon whether [the DWP] is capable of executing a timely and viable plan, because it has not been able to do so previously.”

Likewise, Moody’s Investors Service also has downgraded the DWP’s credit rating and signaled that another reduction may occur. “The negative outlook is based on the uncertainty about the willingness of the Los Angeles City Council to make the decisions needed to move the municipal utility into a more competitive . . . marketplace.”

The bond rating agency in particular has raised concerns about the utility’s long-term power purchase contracts with the Intermountain Power Authority and the Southern California Public Power Authority.

How the DWP ended up orchestrating the building of a mega-power plant in the Utah desert is a tale of intrigue that would warm the heart of the department’s legendary chief engineer, William Mulholland, who secured a source of water for a growing Los Angeles by secretly buying up much of the Owens Valley.

The seeds were sown in the early 1970s, when the Arab oil embargo sent shock waves rolling through an industrial world long accustomed to cheap energy. Shortages of imported oil sparked lines at gas stations and sent energy prices skyrocketing.

For utility planners, the world was turned upside down, almost overnight.

Eldon A. Cotton, the DWP’s assistant general manager of external assets, recalls that the price of oil was soaring and the utility’s planners saw a future of steadily increasing energy prices.

Under pressure to reduce emissions from oil-fired power plants that were polluting the air in the smog-plagued Los Angeles Basin, the DWP and its private counterpart, Southern California Edison, began searching for places to build power plants. The desert Southwest was a natural destination.

As early as 1974, a group of Southern California cities with municipal utilities, led by Los Angeles and including Burbank, Glendale, Pasadena, Anaheim and Riverside, set their sights on Utah.

Early efforts to locate the huge coal-fired plant at two sites in southern Utah were blocked by environmental concerns, particularly the prospect of air pollution in the Grand Canyon.

In December 1979, then-U.S. Interior Secretary Cecil Andrus gave approval to construction of the plant outside the small town of Delta, about 100 miles south of Salt Lake City.

In May 1980, the Los Angeles City Council, without any discussion, swiftly and unanimously approved the city’s participation in the power plant project, including the long-term power purchase contracts with the Utah agency.

“We got into some deals that are painful today,” said City Council President John Ferraro. He recalled that the city was growing rapidly and so was the demand for energy. The assumption was “the growth was going to continue. We got caught up in the same thing.”

At the DWP, Freeman said the mind-set was that the price of oil was going to $40 a barrel, then higher, and the utility had to ensure it had enough power to meet the demand. “They were playing Monopoly,” Freeman said. “If you’re playing Monopoly, the worst thing that can happen is to be short of power.”

He said the DWP was being run by “people who felt they knew the future and essentially tried to lock it in. They made an error in judgment. It turned out to be wrong, real wrong.”

To make matters worse, “nobody dreamed that this utility would have to go head to head with other utilities.”

Now, the city faces a double-barreled threat--from the utility’s problems and from the coming of energy deregulation.

Freeman, however, is confident that after a long, difficult and painful period of adjustment, the municipal utility will not only survive, but compete.

“We’re in a hole. It’s not going to go away. It’ll cave in on us if we don’t jump out of it.” But, Freeman said, “it’s not mission impossible.”

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Hungry for Coal

Utah power plant burned 5.1 million tons of coal in 1996-97 at an average cost of $35 per ton--far higher than the spot market price of $22-$26 per ton.

A mountain of debt

* On DWP’s balance sheet: $2.7 Billion

* Off DWP’s balance sheet: $4.8 Billion

* Total power system debt (as of June 30, 1997): $7.51 Billion

Biggest debt source

* Intermountain Power Project: $3.3 Billion

Sources: Los Angeles Department of Water and Power, International Power Agency

Researched by JEFFREY L. RABIN / Los Angeles Times

Department of Water and Power Blues

In the early 1980s, the Los Angeles Department of Water and Power signed a number of long-term agreements related to Utah’s Innermountain Power Project that have since proved costly. The DWP is committed to purchase electricity--regardless of price--from the plant through 2027. These commitments include $3.3 billion in debt still owned for construction of the plant. The DWP also pays far above the current market price for the coal that fuels the facility. Contracts with coal companies do not expire until 2000 to 2008.

Largest Coal Suppliers to Utah Plant:

1) ARCO

2) Cyprus AMAX Minerals Corp.

3) Andalex Resources Inc.

4) Genwal Coal Co.

Los Angeles peak demand for electricity

In Megawatts

1970: 3,107

1980: 4,070

1990: 5,312

Sept 4, 1997: 5,517

Power lines: where L.A. gets its electricity