While seeking a “global” solution to its credit crunch, PG&E Corp.’s merchant energy unit Friday hit the bottom of the credit ratings as its defaulted on debt payments involving nearly $500 million and faces another $900 million of debt due in the first quarter next year that its executives say it can’t make the payments on.

Standard & Poor’s Ratings Services Thursday lowered PG&E’s National Energy Group (NEG) to its lowest non-investment-grade rating (D) from a B-, which is a multi-level plunge; and a day earlier Moody’s Investors Service lowered NEG to is next-to-the-lowest junk rating (Ca) from a B3 rating, which is a four-level drop. In addition, it dropped the ratings on NEG’s individual power plant development and natural gas interstate pipeline businesses, even though the pipeline is fully current on all of its debt payments.

Both ratings declines were tied to the company’s announcement as part of the holding company third-quarter results conference call that NEG would default Thursday on a $431 million revolving credit facility, and on Friday $52 million of interest due on senior notes. It also mentioned that it would not be able to meet a $25 million equipment revolver loan due in January 2003, and $859 million of equity contributions due at various times in early 2003 related to several new power plants under development.

“NEG’s efforts to raise cash or reduce debt have not produced sufficient results to meet the unit’s upcoming obligations,” said Peter Darbee, PG&E CFO. “The NEG’s focus is now on a global restructuring of its debt facilities and obligations, following several guiding principles: (a) seeking a consensual solution with the lenders and bondholders, (b) viewing the NEG as independent of the rest of PG&E and the utility; (c) making tax benefits an important element of the restructuring, and (d) recognizing the unique needs of each of the parties that are part of the discussions.

“A restructuring along these lines would require abandon, sell or transfer certain assets and continue to reduce energy trading operations. And any restructuring will result in substantial charges to earnings in the fourth quarter of 2002 or in 2003.”

The rating agencies downgraded all of NEG’s units and had negative outlooks for all of them except the natural gas pipeline operations in the Pacific Northwest. The spectre of bankruptcy was also raised, as it was by PG&E in its third-quarter Securities and Exchange Commission filing late last Wednesday, following its financial analysts conference call.

“The negative outlook for NEG (and its affiliates) reflects the uncertainty associated with the outcome of debt restructuring discussions between NEG and its lenders, including the possibility of a bankruptcy filing by NEG,” Moody’s wrote in its announcement of the ratings drop. (S&P’s said NEG may not be able to resolve its financial problems without bankruptcy.)

“NEG’s financial results continue to be beset by weak operating cash flows relative to debt levels, along with strained liquidity, caused in large part by low merchant wholesale power prices,” Moody’s said.

S&P’s listing of the NEG ratings changes in addition to the overall fall to D, include four other units–energy trading, USGen New England, gas transmission and Attala Generating. Except for the gas pipeline, the three others all plunged from B- (negative credit watch) to C with the same negative outlook. The gas operations started higher and didn’t fall as much (BB- to CCC), but also had a negative watch mostly because of its tie to the others.

S&P’s said that if the gas operations were assessed independently, they would not have been downgraded, nor would they carry a negative outlook.

The gas operation ratings were lowered “to reflect S&P’s maximum three-notch differential between a rating on a ring-fenced entity and its ultimate parent, in this case NEG. While the PG&E Gas Transmission Northwest (GTN) benefits from the legal protection of various structural enhancements, including an independent director, it guarantees several obligations of its energy trading affiliate, which may temper this legal protection should NEG or its creditors consider a bankruptcy filing.

“Nevertheless, GTN’s stand-alone credit quality remains considerably stronger than the current rating would indicate,” S&P’s added.

Even with solid earnings reported for the third quarter, albeit decreased from a year earlier, senior executives from NEG’s parent company, PG&E Corp., last Wednesday delivered sobering news about both of its major business units–the utility and merchant energy operations alike. The Chapter 11 bankruptcy proceeding for PG&E’s utility now is expected to run into the first half of next year.

Pacific Gas and Electric Co., the cash cow that is still providing solid earnings, is not expected to emerge from bankruptcy until “on or about May 30, 2003,” according to Robert Glynn, PG&E Corp. CEO, addressing a financial community conference call Wednesday, and that does not factor in time for legal appeals, if they materialize. It was also reported that the California Public Utilities Commission last week filed an amended alternative reorganization plan for the utility in federal bankruptcy court, but it is still “fatally flawed,” Glynn said.

Regarding specific questions about NEG’s prospects of bankruptcy if the agreement is not made with the debtholders, a corporate spokesperson said that the company’s SEC filing (Nov. 13) showed bankruptcy as one option if the financial restructuring is not completed, but it is not offered as an “either-or” proposition. The spokesperson also said there is no specified timetable by which a restructuring has to be reached, although company obviously would like to do it “as soon as possible.”

In response to a question about the option of just shutting down the NEG operations during the conference call, Glynn said there would not be corresponding capital gains to offset the loss, so it is not really an option. Current book value for the merchant energy group as a whole is slightly over $2 billion, he said, noting that more than $1 billion of that is in the unit’s Pacific Northwest-based interstate natural gas pipeline, which is fully up-to-date with all of its debt payments. There are no cross-defaults between PG&E Corp. and NEG as a whole, nor are there any between the gas pipeline unit and NEG, the PG&E executives said in response to specific questions from analysts.

There is no “exposure” of the pipeline should NEG be forced to file for Chapter 11 bankruptcy, said Thomas King, the newly named president of the NEG business unit.

“The (NEG debt) restructuring is a complex and challenging undertaking, but we very much believe there is a path to resolution that can work for all parties involved,” said Darbee, reiterating what Glynn said in his opening remarks to the conference call.

In regard to the utility bankruptcy, Glynn and others noted that the confirmation, or final “trial” phase, of the Chapter 11 process begins next Monday (Nov.18) with the CPUC putting on its case for why its alternative reorganization keeping the PG&E utility intact is the best course of action for creditors. That should last about a month, and then in mid-December, the utility puts on its case for why the utility should split off its wholesale generation, transmission and gas pipeline/storage operations into nonutility businesses and leave only the distribution operations in the utility. A judge’s decision is now expected in January, Glynn said.

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