July 31, 2001

California’s Next Test in Its Power Crisis: Selling $12.5 Billion of Electricity Bonds

By Mitchel Benson and Gregory Zuckerman Staff Reporters of The Wall Street Journal

SACRAMENTO, Calif. — For the past seven months, Gov. Gray Davis has begged, cajoled and even threatened legislators and regulators, to lay the groundwork for a $12.5 billion bond issue California needs to cover the cost of keeping its lights on.

Now comes the tough part: persuading investors that the bond is an attractive investment. On that score, Mr. Davis’s team, whose credibility has been battered by California’s months-long electricity crisis, is hoping to bounce back from a rocky start.

This week, a delegation headed by state Treasurer Philip Angelides is scheduled to visit Wall Street to pitch the municipal debt offering, which would be the largest in U.S. history by a factor of nearly four. To succeed, Mr. Angelides will have to allay investors’ fears of the kind of political infighting that already has delayed the issue several times. He will have to satisfy bond-rating agencies that the bond is safe enough to merit a top-tier investment-grade rating. And he’ll have to make investors want to buy it without demanding costly inducements that would give California financial headaches for decades to come.

“This isn’t building the Panama Canal. It’s not Apollo 11,” says Mr. Angelides. But, he concedes, the bond sale will be “uniquely challenging.”

That is because this giant bond issue won’t be backed by the full faith and credit of the state or by tax dollars — the types of guarantees public-debt investors often prefer. Instead, the bonds, which will have maturities of as long as 15 years, are to be paid off by the state’s electricity ratepayers from their monthly bills, which some view as a riskier source of cash flow. Moreover, there is still a question as to whether the issue’s proceeds will be adequate to repay the bonds, restore the state’s financially troubled private utilities to health and finance future electricity purchases.

Despite these hurdles, many analysts predict California will eventually succeed in pulling off the bond deal, though at a cost far higher than originally anticipated. In fact, the apparent easing of the state’s energy crunch may make its marketing job a bit less difficult. A recent drop in the price of natural gas, which fuels many California power plants, a mild summer in the West and a June decision by the Federal Energy Regulatory Commission to impose electricity price caps in the region have helped avert the rolling blackouts that roiled the state earlier this year.

Still, the specter of history overhangs the bond offering. Rating agencies are haunted by having failed to warn investors of such public-finance disasters as the 1983 default of the Washington Public Power Supply System and the 1994 bankruptcy of Orange County, Calif. Moreover, Moody’s Investors Service and Standard & Poor’s assigned investment-grade ratings as recently as early January to debt issued by Pacific Gas & Electric Co., just three months before the California utility sought Chapter 11 bankruptcy-court protection.

By the time California hopes to sell its bonds, in October or early November, the state’s electrical-power purchases are expected to leave it owing a total of about $10 billion to its lenders and its own general fund. If the bond issue is delayed beyond that, or canceled, or if the offering flops, California could be forced to make billions of dollars in spending cuts, raise taxes or increase electricity rates for the third time in the past year to pay back what it owes.

If the bond sale fails “the state of California will be in deep trouble,” says Mr. Angelides. “The state general fund must be repaid so money for education, health care and children’s services can be safe.”

California’s need for the bonds — like most of the state’s energy woes — stems from its troubled 1996 electricity-deregulation plan. Under the plan, the state’s investor-owned utilities were obliged to sell many of their power plants to other companies and purchase electricity through a state-sponsored power auction. Consumer rates were frozen, but wholesale rates weren’t.

The system worked fairly well until May 2000, when wholesale rates began soaring amid tight electricity supplies and stronger-than-expected demand. Last year, the state’s cost of wholesale power climbed to $27 billion from $7 billion in 1999. In the first six months of this year, that sum hit $20 billion.

With retail rates frozen, Pacific Gas & Electric, a unit of PG&E Corp., and Edison International’s Southern California Edison racked up billions of dollars of debts. In January, after power generators stopped doing business with the utilities, the state began buying power on their behalf. It borrowed the money from its general fund, normally used to pay for everything from public safety and environmental programs to social services and education, at a pace of more than $1 billion a month.

In February, Mr. Davis’s allies in the state Legislature helped him pass a bill authorizing the state to sell bonds to replenish the fund and to continue making power purchases. But legislators cautiously capped the size of the borrowing, using a complex formula. Under the new law, the formula would allow only for a bond sale of less than $1 billion.

Realizing that wasn’t sufficient, the governor and the assembly drafted another bill that scrapped the formula and allowed the state to sell up to $13.4 billion of bonds. But, in a setback for Mr. Davis, Republican lawmakers banded together to deny him the two-thirds majority needed for the bill to immediately become law. As a result, the law won’t take effect until mid-August, when the public-finance market is all but moribund.

In the meantime, Mr. Angelides moved to hire underwriters. After receiving four dozen bids from Wall Street investment bankers in February, he retained a team led by J.P. Morgan Chase & Co. But under pressure to get the financing moving, the treasurer didn’t negotiate firm underwriting fees on the deal.

At the time, Mr. Angelides said he expected the underwriters to “skinny down” their fees given the enormous size of the offering. But Morgan, representing a team of underwriters that includes Lehman Brothers Holdings Inc., Citgroup Inc.’s Salomon Smith Barney unit and Bear, Stearns & Co., says it expects to charge standard fees, given the significant challenges presented by the issue’s size. In the case of a $12.5 billion sale, that amounts to around $56 million. J.P. Morgan and the California treasurer’s office now say the fees won’t be decided until they determine the bond issue’s final size and structure.

From the start, relations between California officials and Wall Street seemed fraught with miscommunication. In February, Mr. Davis called a meeting to explain to institutional investors, analysts and rating-agency executives his blueprint for getting a grip on California’s energy crisis. The session, his only face-to-face meeting with investors to date, was held at Manhattan’s Cornell Club. Attendees say the governor kept them waiting for 20 minutes before breezing into the room and giving them only a general overview of the state’s energy plan, which left investors grumbling.

During the discussion, Mr. Davis, a Bronx, N.Y., native, made light of a conversation he had had with Richard Cortright Jr., a Standard & Poor’s director. “I told him: `You’re from Indiana, that explains why you’re not getting it,'” the governor said, according to several people present.

“It was intended as a joke, but no one was laughing,” says A.J. Sabatelle, a Moody’s vice president. A spokesman for Mr. Davis says the governor doesn’t recall the exchange; Mr. Davis is frequently late for public engagements. A spokesman for Mr. Cortright wouldn’t comment.

Then, in March, the governor’s office set up a conference call to update investors. Figuring they wouldn’t get a big turnout, they used an open-mike system that allowed each investor’s comments to be heard by everyone else. But with around 100 investors taking part, the presentation by Joseph Fichera, a paid consultant who is one of Mr. Davis’s top financial advisers, turned into a free-for-all, with one caller cursing Mr. Fichera in response to one of his answers.

Infighting among California politicians hasn’t helped. Earlier this year, for example, state Controller Kathleen Connell criticized the way her fellow Democrats, Messrs. Davis and Angelides, were handling the bond sale. Unless it was far bigger, she warned, the state would face a “cash-flow crunch” by February or March of 2002. The governor’s office fired back, calling her claims “completely” political.

California policy makers have “spent most of the year bickering and finger pointing,” Standard & Poor’s director Peter Rigby said in a recent report, “and that will raise some uncertainty among lenders.” Moreover, investors know the state needs the money, and so “it’s a buyer’s market,” Mr. Rigby added.

Aware that it needed a financial pro to make its case to Wall Street, the Davis Administration pushed Mr. Fichera to the forefront. Since May, the former Prudential Securities investment banker has spent hours on conference calls with Wall Street explaining the state’s strategy. That and a sense that California has gotten a better grip on its electricity woes indicates that “the governor’s staff is far higher on the learning curve than just a few months ago,” says Paul Patterson, an electric-power analyst at ABN Amro Inc.

Critical barriers remain. The state’s Public Utilities Commission has yet to make key decisions intended to ensure that there’s enough ratepayer revenue set aside to guarantee that bondholders get paid. On Aug. 23, for example, the PUC is expected to take up a rate agreement giving the state’s power purchaser, the Department of Water Resources, unprecedented authority to raise rates without a public hearing. The commission also is expected to decide how to divvy up current ratepayer revenue among state and private utilities and to take up a measure that would prohibit large industrial consumers from, in effect, bypassing the utilities and buying their juice directly from generators or traders.

But opponents of those controversial measures are expected to put up a fight. Businesses and consumer groups are particularly upset that the state might get carte blanche to raise rates and are threatening to sue to block the PUC decision before the state Supreme Court.

California already has some of the highest electricity rates in the nation. Residential consumers in San Francisco, for instance, pay around 14 cents per kilowatt hour for power, up from about 10 cents in December. That compares with around seven cents per kilowatt hour in Atlanta and 10 cents in Chicago, but it is still lower than the nearly 23 cents charged in New York City.

High costs are a big reason businesses think they ought to be free to buy electricity directly. It’s not “in the best interest of consumers to eliminate direct access in order to market bonds that will keep the price of electricity in California higher than necessary for at least 10 years,” says Allan Zaremberg, president of the California Chamber of Commerce.

The state’s three largest investor-owned utilities, PG&E, SoCalEd and Sempra Energy’s San Diego Gas & Electric Co., are expected to demand the largest possible share of the revenues they collect from ratepayers. PG&E, for example, has already asked for a public hearing to examine the state’s claim that it needs so much money. The pressure to allocate more cash to the utilities could also rise if a state-sponsored bailout plan for SoCalEd fails and the utility joins PG&E in bankruptcy proceedings.

Sorting all these issues out before the PUC may lead to legal challenges that could delay the bond issuance for months. And potential investors face another nagging concern: Under a $43 billion series of long-term power contracts signed by the state, electricity generators and traders involved get first call on revenue from ratepayers. Only then would bondholders, who are accustomed to being first in line, get paid.

In fact, some investors who were initially enthusiastic about a bond that is expected to pay more than half a percentage point above other municipal issues in the market are starting to have doubts. Marilyn Cohen, president of Envision Capital in Los Angeles, a firm that manages bond portfolios for individual investors, says she spent several months setting aside money to participate in the deal. Now, she says, she is starting to look elsewhere. “I don’t have confidence that it will get done,” she adds.

Many investors are concerned the state hasn’t proved it can overcome its energy crisis. “These are the same guys who told us energy prices were going south five years ago, they’re trying to gloss over the potential problems,” says Kelly Mainelli, a portfolio manager at Montgomery Asset Management in San Francisco, who is considering investing in the bonds. He says he also worries about a spike in natural gas prices ahead of the offering.

To reassure potential investors, the state now is offering to amass a $3 billion reserve — from bond proceeds and ratepayer revenues — to ensure that bondholders would get paid in the event of any unforeseen developments in the power market. In addition, California lawmakers are moving a bill through the Legislature that would set aside a specific portion of revenues from ratepayers solely to pay bondholders. Such an approach could help the bond issue “to get a higher rating,” says David Hitchcock, director of Standard & Poor’s state and local government group.

It might not, however. It isn’t clear whether bankruptcy courts can overrule state government. So, some investors worry that PG&E’s bankruptcy judge could rule that money collected by the utility should go to the company’s creditors, and not to paying investors in the coming bond deal, throwing a wrench into the offering. The same would be true in the case of SoCalEd if it ended up filing for Chapter 11 protection.

Underwriters are moving to broaden the appeal of the planned issue by chopping it into small slices aimed at different types of investors. There will be taxable, tax-free, variable-interest, fixed-interest, short-term and long-term bonds. State Finance Director Tim Gage says the state is assuming a rating “in the range of single-A” on the power bonds and thus expects to pay an average annual interest rate of 5.77% on the tax-exempt issue and 7.77% on the taxable bonds.

Investors and analysts “may think we’re crazy,” says Guy Phillips, one of the state’s top legislative aides on energy matters, “But in the end, the decision for them is: `Do we see a path to get our money.'”