Pacific Gas & Electric (PCG)

Accounting for Price Risk Management Activities

PG&E Corporation, through the Utility, engages in price risk management activities for non-trading purposes. Price risk management activities include the continuation of power forward contracts that were in existence before the Utility’s Chapter 11 proceeding, new power contracts entered into since January 1, 2003 when the Utility resumed procurement of electricity, contracts related to the natural gas and nuclear fuel portfolio, and interest rate hedges related to the issuance of debt under the Utility’s plan of reorganization.

Derivative instruments include most forward contracts, futures, swaps, options and other contracts. (Some contracts are accounted for as leases.) Derivative instruments designated as cash flow hedges are entered into to hedge variable price risk associated with the purchase and sale of commodities or to hedge variable interest rates on long-term debt. Additionally, derivative instruments may be eligible for a scope exclusion as further discussed below. For derivative instruments that are not designated as hedges or that are not eligible for a scope exclusion, they are adjusted to fair value through income.

Derivative instruments recorded on PG&E Corporation’s and the Utility’s Consolidated Balance Sheets are presented in other current assets or other current liabilities. For derivative instruments designated as cash flow hedges associated with non-regulated operations, unrealized gains or losses related to the effective portion of the change in the fair value of the derivative instrument are recorded in accumulated other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of the change in the fair value of the derivative instrument is recognized immediately in earnings. For derivative instruments designated as cash flow hedges associated with the Utility’s regulated operations, unrealized gains and losses related to the effective and ineffective portions of the change in the fair value of the derivative instrument to the extent they are recoverable through regulated rates, are deferred and recorded in regulatory accounts.

Hedge accounting is discontinued prospectively if it is determined that the derivative instrument no longer qualifies as an effective hedge, or when the forecasted transaction is no longer probable of occurring. If hedge accounting is discontinued the derivative instrument continues to be reflected at fair value, with any subsequent changes in fair value recognized immediately in earnings. Gains and losses related to a derivative instrument that were previously recorded in accumulated other comprehensive income will remain there until the hedged item is recognized in earnings, unless the forecasted transaction is probable of not occurring, whereupon the gains and losses from the derivative instrument will be immediately recognized in earnings. The gains and losses deferred in accumulated other comprehensive income are recognized in earnings when the hedged item matures or is exercised.

Net realized and unrealized gains or losses on derivative instruments are included in various lines on PG&E Corporation’s and the Utility’s Consolidated Statements of Operations, including cost of electricity, cost of natural gas and interest expense. Cash inflows and outflows associated with the settlement of price risk management activities are recognized in operating cash flows on PG&E Corporation’s and the Utility’s Consolidated Statements of Cash Flows.

Accounting for Price Risk Management Activities

        PG&E Corporation, through the Utility, engages in price risk management activities for non-trading purposes. Price risk management activities include the continuation of power forward contracts that were in existence before the Utility's Chapter 11 proceeding, new power contracts entered into since January 1, 2003 when the Utility resumed procurement of electricity, contracts related to the natural gas and nuclear fuel portfolio, and interest rate hedges related to the issuance of debt under the Utility's plan of reorganization.

        Derivative instruments include most forward contracts, futures, swaps, options and other contracts. (Some contracts are accounted for as leases.) Derivative instruments designated as cash flow hedges are entered into to hedge variable price risk associated with the purchase and sale of commodities or to hedge variable interest rates on long-term debt. Additionally, derivative instruments may be eligible for a scope exclusion as further discussed below. For derivative instruments that are not designated as hedges or that are not eligible for a scope exclusion, they are adjusted to fair value through income.

        Derivative instruments recorded on PG&E Corporation's and the Utility's Consolidated Balance Sheets are presented in other current assets or other current liabilities. For derivative instruments designated as cash flow hedges associated with non-regulated operations, unrealized gains or losses related to the effective portion of the change in the fair value of the derivative instrument are recorded in accumulated other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of the change in the fair value of the derivative instrument is recognized immediately in earnings. For derivative instruments designated as cash flow hedges associated with the Utility's regulated operations, unrealized gains and losses related to the effective and ineffective portions of the change in the fair value of the derivative instrument to the extent they are recoverable through regulated rates, are deferred and recorded in regulatory accounts.

        Hedge accounting is discontinued prospectively if it is determined that the derivative instrument no longer qualifies as an effective hedge, or when the forecasted transaction is no longer probable of occurring. If hedge accounting is discontinued the derivative instrument continues to be reflected at fair value, with any subsequent changes in fair value recognized immediately in earnings. Gains and losses related to a derivative instrument that were previously recorded in accumulated other comprehensive income will remain there until the hedged item is recognized in earnings, unless the forecasted

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transaction is probable of not occurring, whereupon the gains and losses from the derivative instrument will be immediately recognized in earnings. The gains and losses deferred in accumulated other comprehensive income are recognized in earnings when the hedged item matures or is exercised.

        Net realized and unrealized gains or losses on derivative instruments are included in various lines on PG&E Corporation's and the Utility's Consolidated Statements of Operations, including cost of electricity, cost of natural gas and interest expense. Cash inflows and outflows associated with the settlement of price risk management activities are recognized in operating cash flows on PG&E Corporation's and the Utility's Consolidated Statements of Cash Flows.

        The fair value of contracts is estimated using the mid-point of quoted bid and ask forward prices, including quotes from counterparties, brokers, electronic exchanges and published indices, supplemented by online price information from news services. When market data is not available, models are used to estimate fair value.

        The Utility has derivative instruments for the physical delivery of commodities transacted in the normal course of business as well as non-financial assets that are not exchange-traded. These derivative instruments are exempt from the requirements of SFAS No. 133 under the normal purchase and sales and non-exchange traded contract exceptions, and are not reflected on the balance sheet at fair value. They are recorded and recognized in income using accrual accounting. Therefore, revenues are recognized as earned and expenses are recognized as incurred.

        The Utility has certain commodity contracts for the purchase of nuclear fuel and core gas transportation and storage contracts that are not derivative instruments and are not reflected on the balance sheet at fair value. Revenues are recorded as earned and expenses are recognized as incurred.