CFOs speak out: Growth Strategy for the 21st Century

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For The 21st Century
Fortnightly Magazine - October 2004

For The 21st Century

Interviews by

So it begins again. After several financially tumultuous years, executives at many of the nation's top utilities can once again look to the horizon and ask the growth question worthy of a Caesar: "What worlds to conquer?"

Utility executives are emboldened by bulging free cash flows, improved credit quality, lower operations and maintenance costs, favorable regulatory treatment, growing service territories, and increasing demand for power.

But even as confidence is returning to the industry, today's utility executives say they will not venture far from their core business. Never again will they put their companies at risk or be driven by pie-in-the-sky growth fantasies that are too good to be true. Back-to-basics is where the industry has come, and back-to-basics is where it will stay, the defenders of the new orthodoxy say.

Yet, as with any orthodoxy, there are limitations. The back-to-basics mantra harks back to an earlier time in the utility industry's history, when all utilities were viewed as a low-growth, low-risk, high-yielding investment.

However, some say turning back the clock on the industry is impossible. Wall Street analysts and other investment executives wonder whether this formula is the right strategy in the 21st century, when the utility industry faces a myriad of new risks. Will back-to-basics growth be enough, they ask, to retain investors who may be attracted to higher-growth investments as the economy improves? Will the strategy be competitive with fixed-income investments as interest rates increase? Will investors gravitate toward outside growth industries that have adopted a strong dividend policy? And can utilities retain high yields when they must plan large-scale transmission and generation development programs, or meet more stringent environmental restrictions?

Without question, seeking the 21st century growth strategy will be infinitely more complex than yesteryear.

This year, annual finance issue offers exclusive interviews with four utilities that have some of the strongest free cash flows in the industry. The chief financial officers from FirstEnergy (Ticker: FE), KeySpan Energy (Ticker: KSE), PSEG (Ticker: PEG), and PG&E Corp. (Ticker: PCG) discuss how they plan to invest in growth in the coming years.

All share a common challenge. FirstEnergy's CFO shares a strategy on infrastructure and technology investment that all utilities may want to hear, particularly after last year's blackout. KeySpan Energy's financial guru shows just how good gas can be. The CFO at PSEG, with its wires business and unregulated generation business, discusses the ups and down of doing business in a deregulated market. And PG&E Corp.'s CFO talks about life after bankruptcy.

From all of us at the , we hope you enjoy this year's finance forum.

Richard Marsh, Senior Vice President and Chief Financial Officer, FirstEnergy

"At the top of my list is operational excellence. You want to avoid mistakes. You want to provide outstanding service to customers. That's how you build credibility with regulators and customers."

How do you think FirstEnergy should deploy its free cash to achieve growth?

Richard Marsh:FirstEnergy is one of the relatively few companies that has stuck with its integrated utility business model. Over the past five to six years, where other companies have been going down different paths of merchant generation or trading or so forth, we have always stuck to our guns. We believe having a foot in the generation, transmission, and distribution markets was the right spot for FirstEnergy. That is what we intend to do going forward. We have a good set of assets, we have operations in three states, and we have valuable regulatory plans that help us operate successfully in those three areas. So, we have some things going for us that other companies may not have.

In terms of growth going forward, I don't see any departures to our strategy. We are going to continue to reap additional efficiencies out of the business that exists. We are going to use the strong cash flow that we have to finish our debt repayment program. We'll be able to use some of that cash before too long to give back to shareholders in the form of a dividend increase, which will increase their total return on the stock. It's really very much an execution story. Basically doing the same things we have been doing, but continuing to do them better, more efficiently, and therefore being able to grow earnings incrementally for shareholders.

Will you look to acquire another company?

RM:We've done two mergers since 1997, each of which doubled our size. So we certainly know how mergers work, and we know the potential benefits. But it is such a specific situation. It's like marriage. You have to get two parties that come together at the right time and the right place, and that is always very difficult. You can see that there haven't been any significant transactions in our industry for several years now, so that illustrates how hard that is.

We're not banking on acquisitions. We are focused internally, growing the business and running the business more efficiently. To the degree that somewhere down the road something pops up that would be beneficial for our shareholders, certainly we're looking for that. But we're really focused internally on building value through operating the assets that we have now.

Would you be open to being acquired, or would your focus be on specific assets?

RM:I can tell you that right now the company is not for sale. We believe we are in a position to operate it successfully and produce value for our shareholders. That's the plan. However, at the end of the day we'll always do what is in the best interest of our shareholders.

It could very well be that we would buy select assets at some point in the future. We have talked a lot about our interest in a certain type of generating facility in the PJM marketplace that would help us improve the margin on our Pennsylvania Provider-of-Last-Resort (POLR) obligation. I would expect that there could be transactions like that-limited, small scale, and very specific. We'll have to see what the dynamics are in the larger marketplace.

What growth levels do you believe your business can achieve?

RM:You see a lot of integrated utilities like us, if you are talking earnings-per-share growth, clustering around the 4-percent-per-year range. There has been a migration back to the basics and away from some of the higher-growth promises we saw with merchant generation trading and so forth, although many of those were not sustained for any period of time.

I think that is probably going to be typical of a lot of companies, and probably typical of FirstEnergy as well. You have to couple that with the dividend yield. … FirstEnergy has said that when we finish our debt retirement program, which will largely be done by the end of next year, we'll be in a position to use our favorable cash flow to grow the dividend. In fact, we don't think we have to wait until we are entirely done with that program. We just need to be on a good trajectory. That will enhance the overall return to investors and make a risk-adjusted return that is very competitive with anything else for people to get in the market.

What are your projected free cash flows?

RM:This year we had told the Street that we would have free cash flows of at least $825 million, and we are on track to meet or exceed that.

How have you been deploying your free cash flows?

RM:For the last several years, a large chunk of our free cash has been devoted to cleaning up the balance sheet and paying down debt. As a result of the two mergers that we did, and as a result of the nuclear building program the company was on in the 1980s primarily, we did end up with a lot of debt. We believed and continue to believe that paying down the debt and cleaning up the balance sheet is a great use of our cash. So, last year we paid off $1.9 billion of debt. This year we will be trying to pay off an additional $1 billion. That will move us back to a position where we can make a strong case to the ratings agencies-Standard & Poor's in particular-that we are an investment-grade company. Our goal is to get down to where we have the balance sheet and our credit metrics at the median for the S&P credit metrics. We think by the end of next year, we'll be there.

How will you apply those cash flows in the future to specific planned projects?

RM:Going forward, once the debt-repayment program is done, we'll be using at least a significant portion of our cash to reinvest in the business, particularly within the energy delivery or wires business. We plan to rebuild some of the rate base that hasn't been built for a period of time. We'll be investing to increase reliability to our customers, particularly in the transmission and the distribution system, and to really take our reliability to another level. We are working hard to prioritize the use of cash and those projects so we get the most bang for the buck. Looking at it in several pieces, some of it is going to pay down debt, some of it is to grow the dividend, some of it is going to reinvest in the business, and some of that will go to environmental controls in the future.

Some experts believe that some utilities are pursuing the dividend at their peril, sinking more and more money into it, at the expense of growth. Do you think investors down the road will penalize these companies?

RM:I think just the opposite. I think investors are beginning to appreciate where utility stocks fit in to the risk/reward spectrum. I think they learn that utility stocks are not necessarily always going to be growth stocks, but there is a place for a more conservative, lower-risk, higher-yielding kind of investment. I don't think investors will penalize utilities, I think they will reward them. I think you'll see a lot of money flow into utilities, as once again investors understand where they stack up in the overall investment arena.

Are you concerned about competing with fixed-income securities, as interest rates are forecasted to increase?

RM:To the degree that interest rates do continue to rise, that historically has put pressure on utility prices. So, if interest rates continue to climb, I think the group as a whole will see some pricing pressure. To the degree you have a healthy and growing dividend, that certainly offsets that somewhat. … I still think that even if rates rise there will be a small number of companies that can differentiate themselves successfully and carry a premium valuation to the overall utility market, and that's what we are trying to do.

Many utilities have been confronted with a situation where they must control O&M spending on an infrastructure that continues to age. You undertook a significant technology spend for obvious reasons. How is it affecting your bottom line? How would you recommend other utilities go about it?

RM:The biggest technology spend we have had is our implementation of SAP, which is a very large enterprise resource management program. We implemented that in July of 2003. That was a big, big project. That was probably a $90 million investment. It had a big payback as well. We are now on a common platform across the entire organization. FirstEnergy companies were on Oracle. Therefore, it really impeded our ability getting more efficiencies out of the business. Putting that common platform across the company was a priority for us. While there was a big upfront technology investment, it's already paying benefits for us.

What is your overall view of the deregulation and how it has affected FirstEnergy's business?

RM:It's a little bit different story in the three states that we operate. In New Jersey, generation has been deregulated successfully. We have only a distribution company in New Jersey. Every year there is an auction for generation service. That process in many respects has gone well. It hasn't necessarily produced lower prices for generation service for customers, but it has certainly worked from a fundamental standpoint.

Pennsylvania and Ohio are a little bit more of a hybrid model right now in theory. Those states have deregulated generation, but competitive generation markets have not really developed in those states to the degree that some of the regulators and companies had hoped. In Ohio, under the original rate plan we put in place several years ago, there were a number of incentives for us to achieve 20 percent shopping levels by customer and by class. We've been able to do that in Ohio, although it has taken some artificial incentives and some governmental aggregation mechanisms to get there. But we have achieved 20 percent shopping across our customer base.

In 2003, the Ohio commission came out and said that because the competitive generation market had not fully developed they were concerned that when rate freezes for the various companies started to drop off-for FirstEnergy, that was at the end of 2005-customers would be exposed to potentially higher prices and price volatility. So they asked the companies to come back and propose a rate freeze to extend the existing rate structure for a period of time.

Approved by the commission earlier this year, [FirstEnergy] rates will be frozen between 2006 through 2008, with some limited exceptions, one of which is our ability to pass through fuel increases to customers under certain circumstances.

What are the three top concerns on your mind in terms of finances?

RM:At the top of my list is operational excellence. You want to avoid mistakes. You want to provide outstanding service to customers. That's how you build credibility with regulators and customers. Being able to take costs and efficiencies out of the business is important-the ability to consistently grow earnings for shareholders that have predictable rates. Long-term consistency of regulations is key for any company that has coal generation like FirstEnergy does.

Where do you draw the line in terms of outsourcing utility functions?

RM:We've looked at the whole range of potential opportunities to save costs, including outsourcing. There are pros and cons. At this point, we have not outsourced a significant part of our business, but we'll continue to track that. Certainly, TXU made a big splash earlier this year when they announced they were going to outsource a large part of their shared service and some of their customer service functions. I think people in the industry will be tracking that very closely. The concern that you always have when you outsource is a loss in control, obviously. You have to have a superior partner, and sometimes the initial promises are not fulfilled. So, it's a very interesting alternative. We are going to continue to track it, but at this point it has not been right for us.

Gerald Luterman, Executive Vice President and Chief Financial Officer, KeySpan Energy

"To remain competitive it will be necessary for us and others in our industry to match or increase the dividend while maintaining the security of our credit rating and maintaining our capital expenditure."

How do you think utilities should deploy their free cash to achieve meaningful growth?

Gerald Luterman: KeySpan finds itself in a unique and enviable position. To begin with, we have a very strong organic growth situation in our core local distribution company (LDC) business. The markets that we participate in are under-saturated from a gas point of view; in the New England area it is something on the order of 50 percent. In the Long Island area it is something on the order of 40 percent. In the Brooklyn and New York area it is up around 80 percent, which was the core or starting point.

If you look at our growth rate, a good part of the growth is coming from the organic growth inherent in these markets and in the excellent demographics of these markets, which have the ability to convert from oil to gas. We estimate that we can virtually double our gross profit margin by the full conversion (which is highly unlikely) of all potential customers from oil to gas. So we have a very strong organic growth composition underpinning our growth strategy. … In addition, like many other companies, we will surround the [LDC] business with additional investments that are complementary, in pipelines, in storage, etc. The third leg is our electric business-the additional investments in facilities like our 250-MW Ravenswood power plant, which was added to our fleet and continues the growth in the electric component. So it will be investments in our core businesses plus the organic growth inherent in our marketplace.

Do you feel limited in any way as to how you can deploy capital?

GL: We have very strict criteria that we like to follow in terms of our investment policies. We are very disciplined in that sense. In the electric area, we have always made it clear that we will not invest in merchant plants, that we will invest only in properties that have either purchased power agreements or located, like our Ravenswood plant, in a load pocket. We will not invest in assets outside of our footprint. We are going to invest in assets that generate additional cash flow and/or are located in our [Northeastern] footprint.

How do you view being acquired or acquiring a company in a merger or acquisition?

GL: We have the size and scale today from a core business point of view that we don't see any need for any type of merger or acquisition in our businesses. In terms of being acquired by somebody else, there is nothing on the horizon, and we are certainly not sending any welcome invitations.

Could you put a number on the percentage growth in the coming years?

GL: We have always said that somewhere on the order of 5- to 6-percent earnings growth per year is consistent with what we see as the potential for our business. Given the low-risk nature of our business and the fact that we are a very strong regional company with a very strong regional presence, 5 to 6 percent is something that we will strive to accomplish. Given our 5-percent yield, when you add those pieces together, we should be able to provide our shareholders with very low-risk 10- to 11-percent total return.

Have you provided any guidance on whether you are going to raise the dividend?

GL: Since we earn 95 percent of our earnings in the first and fourth quarter, we'll probably take a look at the fourth quarter and see how that is faring, then make a recommendation to our board.

How will liquefied natural gas issues factor into the company's growth strategy?

GL: We have always had a small percentage of LNG used in the New England area. In fact, we invested in the facility and hope to convert it to a full-scale LNG facility going forward. LNG increasingly will play an important role in our area and in others around the country. …We have already announced a venture together with British Gas to expand our Providence, R.I., facility to receive marine deliveries. It is relatively small and will serve the Northeast.

There has been talk in the investment community of KeySpan buying LIPA's transmission assets. Would you be interested?

GL: We are the provider of service and electricity to the Long Island Power Authority under long-term contracts. They have recently stated that they are re-evaluating their strategy going forward, and they have used the word privatization. Clearly, we have a very large relationship with them. We provide virtually all their power on Long Island. We own 4,000 MW of electricity on Long Island. So, obviously … we would be very interested. It would be a low-risk business and would be consistent with our existing structure and policy, and we certainly have the financial wherewithal. But this is all premature; they are just starting their strategic review.

How do your different businesses contribute to your bottom line?

GL: The LDC is about 65 percent to 70 percent of our bottom line. All the electric businesses contribute 25 percent to operating income. [Breaking it down], electric generation and the Ravenswood complex is a major contributor. Thereafter, the Long Island Power Authority relationship. We have three long-term contracts with them, and we own 4,000 MW of generation fully contracted to them. Those are the three major generators of operating income to the corporation.

What are the three concerns on your mind in terms of the financial environment for utilities? Are you concerned that a new administration might reinstate the dividend tax?

GL: We are a yield stock and are very much committed to our dividend. So, anything that would change that environment would be of concern. High gas prices are a factor to be concerned with as well.

Will we be able to get enough gas to the United States in time to stem a massive gas price shock?

GL: We are clearly the largest gas user in our region, and gas supply is not a concern. But it will clearly demand additions to the infrastructure, such as pipelines and storage, to accommodate the organic growth that I talked about.

Are you concerned about competing with fixed income securities, as interest rates are forecasted to increase?

GL: If Treasuries start to move up, I think that would put pressure on utilities, including KeySpan, to increase their dividend so that they are competitive. It will be important for yield-orientated securities to manage their free cash flow ... to remain competitive against alternative investment vehicles, if they want their stock price to be sustained. ... To remain competitive it will be necessary for us and others in our industry to step up and match or increase the dividend while maintaining the security of our credit rating and maintaining our capital expenditure, which is a big part of all utilities' financial profile.

Thomas O'Flynn, Executive Vice President and Chief Financial Officer, Public Service Enterprise Group, Inc.

"We obviously look at M&A opportunities, but they are hard to do. I think it is a tough time in the market to be doing large M&A deals."

How do you think utilities should deploy their free cash?

Thomas O'Flynn: We have a very strong cash flow story that is an improving story. Bottom line: We are using it to improve the balance sheet, pay down debt, and ensure we continue to pay the dividend with some modest growth potential. Last year was the first in 10-plus years that we raised the dividend. We raised it about 2 percent, and we hope to be able to continue that. But we have reduced our debt-to-cap about 5 percent over the last year and a half. It stands at about 57 percent, as our lenders calculate it. In the next year we are looking to bring it down to the low 50s.

If mergers and acquisitions are part of the growth plan, do you think you would be an acquirer or be acquired? Why or why not?

TO: Our primary focus is to run the business and have safe, reliable, cost-effective operations, and to use our cash to improve the balance sheet to strengthen ourselves and improve our financial flexibility. We obviously look at M&A opportunities, but they are hard to do. … I think it is a tough time in the market to be doing large M&A deals.

How does PSEG see itself as pursuing growth?

TO: I think the primary of the three businesses that we have, PSEG Power, would be our primary growth vehicle. Of the three arms that we have, PSE&G is a very strong transmission and distribution utility but with modest growth in our region here in New Jersey.

There are modest expectations we can have with a very sound, solid, safe, reliable, strong cash-flow-generating company. The other company is PSEG Holdings, and international and non-Northeast business. We have said for the last couple of years that we are not going to be putting new capital into the [international] business. It is a solid business but with a more stable, flat earnings-growth outlook.

PSEG Power is about 40 percent of our earnings. We would expect to have some reasonable, organic growth with the completion of construction on a couple of plants that are coming on line in 2005 and 2006, and also some improvement in the markets. PSEG Power is in our unregulated generation company-about 14,000 MW. All of our generation is unregulated and was separated out back in 1999. Our vertically integrated utility was divided in two. The transmission and distribution went to PSE&G, our regulated company, and all of the generation went to an unregulated wholesale company, PSEG Power, which is primarily in the Pennsylvania-New Jersey-Maryland market, with a few thousand megawatts in surrounding regions.

How do you view the dividend?

TO: We think a solid dividend with modest growth is at the core of a utility investment profile. For us, our yield is about 5.25, and our payout based on our guidance will be mid to high 60s this year (that's dividend over earnings). We have very strong cash flows, which should improve quite a bit in 2005 as our capital expenditure program in power gets cut by one-half or more.

What do you think of the energy trading business?

TO: We do not have aspirations of broadening energy trading beyond our core PJM and surrounding regions. We don't want to go national. We don't want to go international. We want to trade in energy commodities in PJM and the surrounding areas where we already have an active portfolio. That may include electric, gas, emissions, transmission rights or fixed transmission rights [FTRs]. It may include a broad set, but that is all in the sandbox in which we currently play.

Is energy trading today the moneymaker that it was marketed as in the late 1990s?

TO: We never marketed [ER&T] in that way. I will say that we have seen some reduced volumes and reduced number of participants in some of the commodities that we participate in. We are seeing some financial firms come in. We think our trading business will make the same amount this year as it did last year. Incremental value of our ER&T unit in 2004 is $150 million, which includes transmission rights, the BGS auction, and trading, among other things. This figure is about 10 cents less per share than we had expected in 2004. So, from 2003 to 2004 it was basically flat. In prior years we had seen a modest year-over-year increase.

S&P recently revised your company's outlook to negative from stable, citing "erratic performance at the nuclear fleet over the past few months and a protracted maintenance outage at the Mercer coal-fired plant that diminished availability, transmission constraints that have dispatch and cost implications, and expectation that trading revenues will not be robust as expected." Do you agree with S&P's position and how does the company hope to rectify the situation?

TO: We are disappointed that S&P did that but we understand that they had to take a view. The primary focus has been the availability of our nuclear plant. We had targeted our capacity factor this year for 90 percent. Now we expect it to be about 86 percent. This year and next we will see investment into our nuclear facilities. So, the bulk of that availability reduction has been from having the plants off line to do some maintenance work that is costly in the near term and fruitful and beneficial in the long term. As for the other items you mentioned, the Mercer outage was a result of problems with new pollution control equipment being installed there. Those problems have been tackled, and Mercer is now operating well. The transmission constraints were the result of a down-rating of a transformer that will take us until the middle of 2005 to replace.

Peter A. Darbee, Senior Vice President and Chief Financial Officer, PG&E Corp.

"We are pro-choice. But there are three requirements that are essential that we really feel the state has to embrace if it were to move forward with choice."

What are PG&E's future growth strategies?

Peter Darbee: We will be throwing off a very substantial amount of cash … because we anticipate a securitization of our regulatory assets, the first tranche of which would occur in the early part of 2005.

We expect that, for the period through the end of 2005, we will generate about $1.55 billion of cash. Then, looking through 2008, we will probably total about $3.3 billion. So, we have a lot of cash going forward, which is the source of what we would use to invest in growth. We are in a unique situation given our regulatory assets and the immense restructuring that the company went through coming out of the California energy crisis.

The first tranche of cash will be utilized for retiring debt and then retiring equity. We have about $1.2 billion that will be paid up from the utility to the holding company, and that could be combined with cash. For the first round, that is going to be used for share repurchase. That will grow earnings per share, but it isn't growth in the classic sense of creating new businesses going forward. We recognize that. We anticipate a second securitization within 12 months that will provide dollars we might use for either share repurchase, or in the alternative, generation opportunities and electric transmission opportunities, as well as advanced metering opportunities and other systems improvements in our business.

Do you plan to build more generation into rate base?

PD: Yes. Our current focus would be to deploy the capital in rate base in our core business. There are a number of factors that are drivers behind that. We see a need for the addition of about 2,000 MW of capacity in California up to the period of 2010, and about half of that we perceive a need for before 2008. It is very important that we ensure adequate generation capacity in California so that we avoid another California energy crisis.

So, your growth strategy focuses on your regulated operations?

PD: Over the next one to two years, it is focused on the regulated utility. Once we get down the road, we'll look [whether we] should put more investment into the regulated utility. After having spent 10 years on Wall Street, I think it is important that additional investments relate to the strengths and capabilities of a company. Therefore, the idea of going into real estate, financial services, and other things far afield are not really of interest at this point. And we don't contemplate that they would be two years from now. If it is not in the core business, it would probably be along the lines of other regulated businesses that look a lot like what we do.

Some bankers have said that PG&E could be a good candidate for acquisition because of it price-to-earnings ratio and it free cash flows. How would you view overtures by other companies?

PD: This management team has demonstrated it can generate a lot of shareholder value for its stockholders. It has done a good job of doing that over the last several years. I think this management team is quite capable of continuing to generate substantial shareholder value going forward. So, we would see our future as an independent entity.

Could you put a number on the percentage growth in the coming years that you expect to deliver to shareholders?

PD: We have not done so other than provide our earnings estimates for this year, which are $2.00 to $2.10 per share and for 2005 [our earnings estimates] are $2.15-$2.25 per share. There is somewhat of an unprecedented opportunity to get insights into that question if one were to look at exhibit C that we filed as an 8K in connection with the chapter 11 bankruptcy, that required five years of financial forecasts. [But] it needs to be adjusted [because] a lot of cash comes up to the parent, and one needs to think about what we will do with that-either repurchase shares or invest in something that looks like rate base. Analysts can make judgments about those things, but the company has not put out a growth target looking out beyond 2005.

So you will not be investing in deregulated investment such as energy trading?

PD: That is correct. That is our position at this time. We have a capability in running a regulated business, running one in California particularly. When you extend out to businesses like energy trading, people in this business will come directly up against the likes of Goldman Sachs and Morgan Stanley. And I've worked for Goldman Sachs and have run groups there. They are very, very capable in the trading arena. They have developed practices, procedures, and safeguards that have been built up over decades, and I frankly think that they are better at that business than most electric utilities or energy companies.

On the other hand, I would agree that they probably would not be very good at running a regulated utility. We do not have a demonstrated track record, nor do many other energy companies that come from deregulated backgrounds.

What is the status of your bankrupt energy trading and merchant division?

PD: The bankruptcy court has approved its reorganization plan, they are trying to go through a number of milestones, many of which they have accomplished. So, we anticipate that they will emerge from Chapter 11 probably before the end of the year. When they do emerge, they will be an entirely independent entity from us and unaffiliated because our equity will have been eliminated in the course of the reorganization process. … They changed their name in part to reflect [their independence]. We really have not had any degree of control over them since they filed back in July.

As to the securitization next year of your future dividend distribution, share buyback, and infrastructure investment, do you expect any issues or obstacles?

PD: We believe that there is precedent out there for doing these securitizations, and in fact we did among the first of these securitizations years back with our rate-reduction bonds. However, there are two key milestones, at a minimum, that we have to get passed. [First,] a financing order from the California Public Utilities Commission (CPUC). We expect that in the November time frame. The second is a private letter ruling from the IRS. We expect the answer on that to be six months from the time we filed it, which was last June. So, that would suggest the December time frame in 2004. Those are the principle milestones that we need to get over in order to get the securitization done.

PG&E Corp.'s capital expenditures (cap ex) seem to be projected to fall in the coming years. How will the company manage to contain its O&M expenses?

PD: Most companies don't put out 5-year projections, but we were required to do so because of our being in bankruptcy. When emerging from bankruptcy, you have to have a multi-year plan that you present, but most other utilities don't have one.

When you look out one, two, and three years, cap ex seems to build nicely, and then it flattens out-frankly because people haven't thought through all of the requirements for years four, five, six and seven. But as you roll forward each year and people focus more and more on what was your four, five, six, and seven as they become years one, two, and three, usually cap ex builds over time. I think it is most likely that ours would build.

I believe that we have a commission that is very interested in having us invest in power generation in the state of California and having it be in rate base. There has been a lot of discussion across the country on the need to invest in the electric transmission infrastructure. I know that we have a president of our commission who is very intrigued and enthusiastic by advanced metering. … I think it quite possible that our capital expenditures for years four, five, and six will increase. This will be done in rate base as we see it and through a process with our CPUC of their authorization of it.

Are you concerned that your 2,000-MW generation buildout-which you've said will be financed 50 percent through rate base and 50 percent through contract-will increase your cost of capital or financing as interest rates increase during that period? Do you think it will impact the company's finances adversely?

PD: My own view is that interest rates will go up in the future, yes. However, what is most critical is that California has adequate supplies of power. What we've seen in California is that the price of power escalated from about a high two- to three-cent range to about $1.20 or $1.40 per kilowatt-hour, and therefore if there isn't enough power, prices absolutely go through the roof. So, when one thinks of the potential increase in costs because of increasing interest rates versus the cost of a shortage of power, the shortage of power costs are many times greater than anyone would experience from increased capital costs.

Are we concerned about increasing capital costs in the future relating to power generation? Yes. But what we see as a far greater concern is adequate supplies. That is why we are working very hard with the commission and a broad constituency here to help come to a resolution regarding how California will meet its future power needs.

There are utilities in the United States that are relatively strapped, whereas by contrast, we are throwing off a very substantial amount of cash, which results from our settlement and coming out of the bankruptcy. I believe that once we are at the point where we are paying a dividend, there will be adequate cash flow for paying a dividend, investing in generation, and we'll still be in a position where it is likely we will do some repurchase of shares.

We are getting the rules clarified with the commission as to what is required to get [generation] investments into rate base. I think when all is said and done, given our cash flow characteristics, we will look like a very good proposition. We are entitled to earn a minimum return on equity of 11.22 or better until such time as the utility is rated "A-" or "A3" by the ratings agencies. The approved capital structure is 52 percent. So, those protections, together with the 3-year rate case we have, provide a substantial level of certainty once assets are put into rate base.

What is your position on efforts in California to open choice to commercial and industrial customers? Will it not affect your generation development plans?

PD: We have had discussions with the governor's office and with the commission. We take the position that we don't want to get between customers and how they want to procure their power. We are pro-choice. But there are three requirements that are essential that we really feel the state has to embrace if it were to move forward with choice.

If utilities and energy providers are required to provide for peak needs and capacity needs of their customers and provide for a 15 percent surplus, then everybody has to be under the same rules and everybody has to provide that 15-percent surplus margin. The other key factors are that in the past, people who wanted choice wanted to avoid stranded costs or previous costs resulting from certain problems. In this instance, what they would be trying to avoid is the cost associated with the Department of Water Resources contracts that the state entered into during the California Energy Crisis. In effect, if they want to leave, they should have to pay their fair share of the exit tax. The other thing is, some of these people that want choice really want to be able to go back and forth between the two and take the lower of market rates or regulated rates, and that is inappropriate for several reasons. First, a utility cannot plan and procure if in fact they do not know what the demand is going to be on their resources. People really need to make a choice and stick with it. Second, it would be unfair to give a certain set of customers the ability to jump back and forth on a free option and take advantage of that while the people who support the cost are ratepayers like the everyday consumer.

When will you get finality on your long-term procurement plan?

PD: The schedule calls for the commission to come to closure on the long-term procurement at the end of the year.

What are your three top concerns in terms of the financial environment for utilities?

PD: It's very important that California come to consensus about how they are going to deal with the long-term procurement issue. … We realize we have a tremendous amount of cash flow. So, we are very focused on how we are going to use that and deliver the best value for our shareholders.

We are evaluating opportunities within the generation segment and are going to turn to electric transmission opportunities in our service territory in rate base, and potentially advanced metering opportunities, and see what the relative balance should be. In the third category, which is really more broad, we have to be concerned about the resurgence of inflation. How will people enhance shareholder value in that kind of environment? I think the answer to that question will be creating growth, but doing it in a reasonable and responsible way so that the growth in earnings actually materializes, as opposed to having some of the breakdowns that we saw previously in merchant generating, energy trading, and the like.

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"We are pro-choice. But there are three requirements that are essential that we really feel the state has to embrace if it were to move forward with choice."