With the shadow of one major utility’s bankruptcy barely cast, California Gov. Gray Davis late Monday announced a “memorandum of agreement” with the state’s other major financially wounded investor-owned utility, Southern California Edison Co. in which the state will purchase the Edison transmission grid assets in return for a way out of its credit crunch and back to solvency.

Edison International CEO John Bryson, a former state regulatory official in the same past gubernatorial administration in which Davis served, sealed the deal with the governor late Monday afternoon, the same day that Pacific Gas & Electric, the other major victim of the state’s power crisis, was in its first bankruptcy court session.

Announced in February as an “agreement in principal,” the governor finally delivered a long-sought deal, and one in which he hopes to build political and regulatory momentum for resolving the very long, tough electricity crisis gripping the state. He said the Edison deal can serve as a basis for separate agreements with San Diego Gas and Electric, and eventually Pacific Gas and Electric, if they choose to come back to the negotiating table.

With very critical comments directed at PG&E utility for choosing to file bankruptcy, the governor called the Edison pact a “balanced agreement.” It includes; sale of Edison’s transmission for $2.76 billion, a commitment to sell all of its own generation power below market prices to the state and a 10-year agreement with one of its non-utility facilities for below-market power.

The transmission deal has to be completed in two years, after which the state has the right to take the Edison hydroelectric facilities.

“It is a challenging one for us, but we can implement it,” Bryson said. “We can borrow to pay out debts with the implementation of this agreement. Overall the debt is $5 billion, but the amounts due and payable now are something less, and we will borrow to pay that as soon as we complete this agreement.” Although the governor called this a critical step, he and Bryson said it still requires actions by state regulators and legislators, and additional due diligence by attorneys.

“The important thing is that Edison stayed at the bargaining table and allowed a positive result,” Davis said.

Meanwhile, U.S. Northern California District Judge Dennis Montali, began what may rate as the most complicated bankruptcy case in history. The judge will be venturing into uncharted territory, and already Monday there were signs that the oil-and-water mixture of San Francisco bankruptcy court and the California Public Utilities Commission (CPUC) was getting stirred up for the first time.

Pacific Gas and Electric is pushing for a temporary restraining order against the CPUC’s mandate that it make accounting changes that would take back billions of dollars in past payments to parent company PG&E Corp. The parties reconvene before the judge this morning to first lay out the procedure for the Chapter 11 process.

“I think there is going to be some tension [between the utility and regulators] there in bankruptcy court,” said John T. Hansen, a bankruptcy attorney with Nossaman, Guthner, Knox & Elliott LLP, San Francisco, who attended the opening PG&E hearing. “Hopefully, before long the parties will begin talking to one another, seeing if they can negotiate something. There is a lot of dancing around at this point.”

Ultimately, how the case is laid out by the bankruptcy judge will determine what sort of interface there is with the regulators and legislators. Currently there are far more unknowns than known factors in this affair. Most observers agree the proceeding will be measured in years rather than months or weeks.

Pacific Gas & Electric, which has built up more than $9 billion in unrecovered power costs, is only the third utility ever to file for bankruptcy and is by far the largest. One of the first chores for Montali probably will be attempting to focus on the utility’s massive operating cost problem, noted Merrill Lynch analyst Steven Fleishman.

Unlike most companies that file for bankruptcy, PG&E’s case isn’t one of over-indebtedness, but of high operating costs. The judge will have to attempt to balance revenues and expenses, but to do that, he will have to adjust the utility’s rates and wholesale costs probably by overseeing lengthy negotiations with the CPUC over further rate increases and with wholesale suppliers over power supply prices.

“In the end we expect rate increases and some power cost reduction to be negotiated to help solve the revenue/cost disparity,” said Fleishman. “However, there could be ongoing losses in the meantime, which could further squeeze existing creditors.”

Regarding possible liquidation of PG&E assets to cover past bills, several analysts agreed the assets of the company’s unregulated affiliates have been adequately protected. Although he expects creditors to “aggressively argue” the parent company illegally shielded its unregulated affiliates from the utility’s financial trouble by forming a separate limited liability structure and separate boards, Fleishman believes the corporate barriers will hold. “Bankruptcy judges have wide latitude on these issues and can be unpredictable,” he noted. “We believe PG&E has a reasonable chance of succeeding on this issue, which is the main reason we maintain our accumulate rating [on PG&E Corp.].”

One of the risks for the utility, however, and potential advantages for creditors, is that by filing for Chapter 11, the PG&E utility has to open its books to all of its creditors, including the records on how it has channeled billions of dollars to the parent company over the past few years. The bankruptcy judge could reverse some of these payments to the holding company, PG&E Corp., ordering the monies sent back to the utility.

If asset liquidation is required, the utility has significant asset value, including 3,900 MW of hydroelectric generation assets and 2,160 MW of nuclear generation. It also has one of the largest electric and gas transmission and distribution businesses in the country, serving 70,000 square miles with a population of about 13 million.

Another key asset, Fleishman noted, is a pending federal court case against the CPUC. The case claims that the CPUC must pass wholesale power costs through retail rates under the filed rate doctrine. “Dropping this case was a condition of a deal with the state, but we expect PG&E and the bankruptcy judge to aggressively pursue it. We believe the company has a reasonable chance of succeeding.”

Other key issues include what the bankruptcy will mean to the recently adopted rate increases, to the CPUC order on paying qualifying facility companies, to the utility holding company investigations by the CPUC and to the state’s new energy proposal, which was supposed to include purchase the transmission system. What impact will it have on the state’s pending bond sale? Does it have any impact on the long-term contracts signed by the state Department of Water Resources with power suppliers?

“The bankruptcy court does not have to deal with political realities,” noted Barry Abramson, electric utility analyst at UBS Warburg. “The bankruptcy court does not have to run for re-election. The bankruptcy court does not have to worry about whether its decisions are the most popular with the most people in California. The bankruptcy court should only have to look at the facts, the financial records, projections and the laws,” he noted.

“Dealing with the bankruptcy court might be faster than trying to negotiate a broad settlement that satisfies the needs of all constituencies,” said Abramson. “The bankruptcy court can impose resolutions. If parties cannot reach agreements, the court can enforce its own opinions upon the parties.”

Another factor to consider is what affect the bankruptcy might have on the utility’s relationship with the governor, whose reputation may be seriously tarnished after this affair. “Filing for bankruptcy is a big blow to the governor’s efforts to try to achieve a broad settlement,” Abramson noted. “The governor has invested a great amount of time and political capital in the process of trying to solve the state’s electricity crisis. He wanted all of the state’s utilities to agree to similar plans that included the state’s purchase of nearly the entire electric transmission grid in California. The PG&E bankruptcy might make it impossible for the state to acquire the transmission systems.”

The leading rating agencies gave a thumbs down Monday to the bankruptcy filing. S&P affirmed its “CCC” rating on that debt, while Moody’s rates it “B-minus,” roughly two notches higher. Standard & Poor’s cut its unsecured debt rating for the utility two notches to “D,” or “default,” from “CC.” Moody’s warned it may still cut its “Caa2” rating, roughly two notches higher than Standard & Poor’s “CC” rating, for the debt. The utility’s secured bondholders, who would be paid first in bankruptcy, are in relatively better shape, the agencies said.

Calpine Corp., California’s major power plant developer and qualifying facility operator, on Monday expressed confidence it will get paid “100 cents on the dollar” for QF contracts with the bankrupt utility, and it will not have to take reserves in anticipation of writing off some or all of the more than $300 million it is owed.

Throughout the growing crisis, Calpine has set itself apart from the rest of the energy suppliers that have sought court action or withheld power in the face of mounting multi-billion-dollar debts owed by the state’s two largest investor-owned utilities. Calpine characterizes its QF contracts as being legally different than other unpaid suppliers to PG&E’s utility.

“We’ve been planning for this event for several months now,” said Calpine CEO Peter Cartwright, noting that he remains “very confident” the company will achieve its earnings targets. “We feel this [bankruptcy] filing will actually help find a solution, and we are confident we will receive payment for all past and future payments from PG&E.”

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