Financial Times (London)

Energy politics in America took a crucial turn in favour of debt holders and generators last week, with implications that are not yet fully priced in by capital markets. Talks between the representatives for the official creditors’ committee of Pacific Gas and Electric and the California Public Utilities Commission have resulted in a flat-out win by the money people.

The Foundation for Taxpayer and Consumer Rights, a leftwing activist group, accurately stated that the outcome “essentially guarantees that ratepayers will be forced to pay off the utility’s debts”. But unlike bondholders and PG&E stockholders, they do not think that’s a good thing.

PG&E, a subsidiary of PG&E Corp, filed for bankruptcy protection on April 6. It was unable to service its $13 billion of debt because it could not pass through to consumers all the costs of buying electricity on the wholesale market. This was caused partly by the company’s own ineptitude in helping formulate California’s deregulation plan, partly by the other commercial participants in the California market and partly by the state’s incompetence in planning and executing energy policy.

At the time of the filing, no one, at least no one in the know, would have thought it possible to unwind the bankruptcy in less than three or four years. Most of the smart money figured the college tuition bills of at least two generations of lawyers’ children would be paid by the bankruptcy.

The last big utility bankruptcy on the West Coast, the Washington Public Power Supply System in the 1980s, took more than four years to resolve, and litigation has not become easier since then. Politically, the California electricity mess is as appealing as a plutonium cocktail. Adding to the intrigue, PG&E and the California PUC detest each other.

PG&E‘s own reorganisation plan, which it filed last September, entailed a split into three companies – one each for power generation, transmission and retail distribution. The key was that power generation and much, if not all, transmission would come under the jurisdiction of the Federal Energy Regulatory Commission, which is an institutional proponent of a market model for energy organisation. The California PUC, in contrast, is basically a bastion of New Deal-style regulation. The PG&E plan was really a jailbreak from state control by shareholders and management.

It has been clear for a long time that there will have to be a showdown between states and Federal regulators over who controls the electricity industry. The state role is really a historical anomaly. When electric utilities were first built, they only served in-state customers and were regulated by the states. Interstate transmission of power was laid on to an existing system of regulation, so the Federal regulators were awkwardly put together with their state counterparts. As long as both were using similar economic models and regulatory philosophies, it sort of worked.

With the post-Enron collapse of the 1990s’ version of the market model for pricing and financing electricity, any hope of a consensus-based solution is quite forlorn. There will be a power struggle and, given the Fed’s Constitutional authority over interstate commerce, the states are on track to lose much of their authority. That won’t happen overnight but it will happen.

This struggle might have been the background for a long fight in bankruptcy court. However, the lawyers and financial advisers for the official creditors committee executed a clever strategy. They decided to do a deal with the California PUC, rather than support the reorganisation plan.

Both PG&E‘s plan and the PUC‘s plan promised a pay-off to creditors of 100 cents on the dollar. However Milbank Tweed, the lawyers, and Saybrook Capital, the advisers, recognised that only the PUC could deliver. Furthermore, as one of the professionals involved says: “We had to convince the PUC that nobody in the financial markets likes them or trusts them and that therefore they had to provide buyers of bonds with a rate agreement that would support an investment grade rating for the life of the securities.”

Or as Paul Aronzon of Milbank puts it: “The company’s idea of being more directly regulated by Ferc was a good idea and a valuable idea if you didn’t mind litigating all the way to the Supreme Court several times, with a very protracted and delayed settling of the case.” Instead of directly siding with the company against the state, the creditors’ advisers used the PUC‘s fear of defeat by the Feds to get an order that would lock in the cash flow to pay off debtors. They got the PUC to commit to rates guaranteeing an investment-grade rating for the $3 billion in new debt along with rich dividends for $1.75 billion in new preferred stock.

All that made it possible to execute a workout plan in what should be less than two years – an amazing achievement and one reflected in a PG&E stock price rise from just over $8 to more than $11 this month.

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