Part of Utilities’ Windfall Went to Dividends, Parent Firms

In the debate over how deregulation has brought California’s two largest utilities to the brink of bankruptcy, one question is beginning to move to center stage:

What did they do with the money?

The money in question is an estimated $10-billion windfall that Southern California Edison and Pacific Gas & Electric each reaped in the early stages of deregulation, from early 1998 through April 2000, the last month in which revenue from frozen electrical rates covered their cost of buying power.

Since May, the two utilities have gone almost $12 billion in the red buying high-priced electricity.

Determining exactly how that early windfall was spent is made more difficult by the notoriously complex finances of the utilities. State authorities already have taken steps to examine how the utilities spent the money, especially whether they spent it to benefit shareholders rather than customers.

Whether the utilities disbursed the windfall to cover liabilities that should remain the obligations of shareholders rather than customers will be critical to any future bailout or restructuring to save the companies from bankruptcy.

What is known is that some of this money went to pay for power from such alternative producers as wind and geothermal generating companies. But some also flowed to the utilities’ parents, PG&E; Corp. and Edison International.

The two utilities received more than $10 billion each over and above their cost of procuring conventional power for customers in the first two years of deregulation, according to financial documents and interviews with utility executives, officials of the California Public Utilities Commission and consumer advocates.

The revenue came from money collected from customers under a rate freeze that to most observers, ironically, seemed set at a level overly generous to the utilities; profit from generating plants they owned; gains from plants they sold; and the proceeds of a special bond issue.

The parent companies passed on some of the money to their bondholders and shareholders and may also have used it to buy assets they say should be immune from attachment to cover their growing debts.

Nobody is accusing the utilities of transferring money illegally or of concealing the transfers, which were disclosed to federal regulators in public statements and filings.

Moreover, the utilities’ disbursement of the money was considered normal, even mandatory, at the time. Because deregulation forced them to downsize by selling off most of their generating plants, it made perfect fiscal sense for them to shrink the amount of stock and debt they had outstanding by repurchasing shares and retiring bonds.

“These are not normal times,” said Richard W. Cortright Jr., a utilities analyst at Standard & Poor’s. “But normally the utilities keep as little cash as possible on their balance sheets” because it pays little interest.

Nor does anybody believe that resolving questions about the first two years’ gains will rescue the utilities from their financial crisis.

“We know they don’t have a bank account with all that money in it,” said Robert E. Finkelstein, a lawyer for the Utility Reform Network, a consumer advocacy group.

Edison does, however, acknowledge that of the $4.5 billion in power costs it claims to have “under-collected” from customer rates since May, $2 billion represents money it owes to itself for power from its own generators and other gains.

The utility reform group has asked the Public Utilities Commission to order Edison to apply that sum to the deficit, meaning the utility may be only $2.5 billion in the red. The commission has ordered Edison to hold the $2 billion in reserve, pending its ruling on the reform group’s proposal.

In a larger sense, the money flow raises questions about whether the companies’ shareholders and bondholders will fully share the burden of what has evolved into a massive miscalculation by the state and the utilities of the course of deregulation.

The issue could affect the terms of any state bailout. To the extent the parent companies have spent the utility funds to buy unregulated assets--such as power plants acquired in the U.S., Europe and Asia by Edison’s subsidiary, Edison Mission Energy--the state could conceivably require the parents to sell those assets as a condition of receiving a bailout on power costs.

But that would raise thorny financial and philosophical issues. “Unless you could show definitively that the [utility] ratepayers had paid for those assets around the world, you have to ask if it’s appropriate to sell them,” Standard & Poor’s Cortright said.

In fact, utility officials say they expect the audits ordered by the utilities commission to support their contention that they spent the money appropriately.

“We can’t wait for that audit report to come out,” said Donald A. Fellows, director of revenue and tariffs for Southern California Edison.

Another issue raised by the commission is whether the utilities could have managed their cash better as the energy crisis gathered momentum this year.

In approving a temporary rate increase for the utilities Jan. 4, the commission implicitly criticized PG&E; for declaring a third-quarter dividend in August--a payout to its parent company--a month after problems in the wholesale electricity market in California emerged. Instead, the utility might have considered “establishing a contingency fund or retaining cash to cushion its risk,” the commission said.

The dividend came to nearly $100 million and helped fund the parent’s subsequent dividend to shareholders of $116.1 million. Around the same time, Southern California Edison also declared a third-quarter dividend, payable to Edison International, of $97 million. The parent subsequently declared a quarterly dividend worth $91 million to its own shareholders.

Utility officials respond that it would have been unprecedented for the companies to hold millions of dollars in the bank to cover an eventuality no one had forecast. That’s especially so given that utility stocks are traditionally valued for their large dividend streams.

As it happens, after the full dimensions of the crisis became clear this fall, both companies did suspend their fourth-quarter dividends, which would have been payable to shareholders this month.

Critics contend, however, that the utilities knew enough about the deterioration in the wholesale electricity market to foresee the need to conserve cash earlier. By the end of the summer, their cost of procuring power had exceeded revenue available from the frozen rates for four months in a row--an event that was never expected to happen even once.

“Maybe in June you get taken by surprise,” the Utility Reform Network’s Finkelstein said. “But when it gets worse in July, maybe you as a utility have to respond to what’s turning into a pattern.”

The dividends are only one way the shareholders benefited from the utilities’ healthy cash flow in the first stage of deregulation. The utilities also repurchased hundreds of millions of dollars worth of stock, a process that tends to support share prices by providing demand into which shareholders can liquidate their stakes.

At issue in the controversy is so-called headroom--money the utilities collected from various sources in excess of their cost of buying power. When deregulation was launched March 31, 1998, electric rates charged by SCE and PG&E; were frozen until March 2002 or until they had paid off their so-called stranded costs, whichever came first.

The stranded costs were those associated with contracts with alternative-power producers--including wind, geothermal and solar plants--and cost overruns in their nuclear construction programs. Because electricity from those sources cost much more than conventional power at the time, those costs for Edison alone were calculated to be about $10 billion.

Every month, the utilities calculated their revenue under the rate freeze and added any profit they made from the state-mandated sale of the generating plants and the sale of electricity from plants they kept. Whatever was left over from the sum after they subtracted the costs of conventional power could be devoted to paying off the stranded costs. If nothing was left over, the stranded costs would have been unpaid--in practical terms, they would remain costs to be borne by shareholders.

The utilities explicitly acknowledged that their shareholders were to carry the risk that power prices would rise. But the monthly transfers meant that no money was held in reserve against the worst-case scenario, in which power costs would actually exceed the frozen rates and start draining the utilities’ resources.

Indeed, that scenario never arose--until last May. Before May, the utilities recorded billions of dollars in headroom. In Southern California Edison’s case, the utilities commission said, the headroom added up to $7.8 billion through April. SCE received an additional $2.5 billion from bonds it was permitted to sell to cover a 10% rollback in residential rates ordered by the state Legislature.

But then the scenario came true with a vengeance.

“The world got turned on its head, and they were paying an energy cost far in excess of rates,” Finkelstein said. “Our position is that the risk is coming home to roost, but it’s exactly the risk they undertook to assume.”

In Edison’s case, whether it is genuinely assuming that risk depends in part on what it did with its $10.3 billion in revenue through April.

Edison International has disclosed that it spent the $2.5-billion proceeds of the rate rollback bonds on retiring long-term debt and repurchasing stock--in other words, the money was paid out to bondholders and shareholders.

How it disposed of the remaining $7.8 billion is less clear. Utility officials contend that 90% of it went to buy energy from alternative producers, a figure that some officials at the utilities commission believe is unrealistically high. That point may be clarified in the commission’s audit, which may be released as early as this week.

But it is known that from 1998 through the third quarter of 2000, the utility provided a healthy cash flow to the parent company, sending nearly $2.1 billion in dividends upstream. Using that money in part, the parent paid out just more than $1 billion in dividends in the same period and repurchased nearly $1.2 billion in shares, according to its annual and quarterly reports to the Securities and Exchange Commission.

PG&E; was similarly flush, according to Public Utilities Commission documents, which state that starting in January 1998 Pacific Gas & Electric disbursed $9.6 billion to its parent, PG&E; Corp. Out of that, the parent issued shareholder dividends of about $1.5 billion, repurchased $2.8 billion in shares and retired $2.8 billion in debt.

Given these figures, the commission observed in granting a temporary 7% to 15% rate increase this month, the utilities and the state have “only just begun to explore the ability of [the parents] to participate in the solution” to the crisis.

Throughout deregulation, the parents not only spent money on dividends, but both also embarked on a buying spree of power plants and other assets, much of it outside California. Edison, for example, built its subsidiary Edison Mission Energy into an independent power company with $15 billion in assets. A considerable portion of Edison Mission’s assets were purchased with Edison International cash and equity, at least some of which was derived presumably from SCE.

Edison has taken steps, however, to shield Edison Mission’s assets from being used to cover its utility cousin’s red ink, a process known as ring-fencing. Although the step has succeeded in bolstering Edison Mission’s credit rating as its parent’s crumbles, it has raised protests from consumer advocates.

“They ought to be embarrassed by walling off” Edison Mission, Finkelstein said. “They’re saying they’re going to put the utility out there for a bailout, but insulate their own resources. It’s a craven act.”

Instead, he contended, Edison should be forced to consider selling Edison Mission to help cover SCE’s deficit.

Others observe that selling Edison Mission or other assets might not have much more than symbolic value. Edison Mission’s plants, for one thing, are heavily encumbered with debt, and a sale could take months or years.

“What they have is a severe immediate cash crunch,” Cortright said. “How much you could generate from a sale would be a pittance compared to the enormous amount they need.”