Pacific Gas & Electric (PCG)

The FERC

        The FERC is an independent agency within the U.S. Department of Energy, or DOE, that regulates the transmission of electricity in interstate commerce and the sale for resale of electricity in interstate commerce. The FERC regulates electricity transmission, interconnections, tariffs and conditions of service of the ISO and the terms and rates of wholesale electricity sales. The ISO is responsible for providing open access transmission service on a non-discriminatory basis, meeting applicable reliability criteria, planning transmission system additions and assuring the maintenance of adequate reserves of generation capacity. In addition, the FERC has jurisdiction over the Utility's electricity transmission revenue requirements and rates, the licensing of substantially all of the Utility's hydroelectric generation facilities and the interstate sale and transportation of natural gas.

        In response to the California energy crisis, the FERC issued a series of orders in the spring and summer of 2001 and July 2002 aimed at prospectively mitigating extreme wholesale energy prices like those that prevailed in 2000 and 2001. These orders established a cap on bids for real-time electricity and ancillary services of $250 per MWh (unless a generator could demonstrate that its costs justified a rate in excess of $250 per MWh) and established various automatic mitigation procedures. As of December 2003, all sellers with market-based rate authority became subject to, and incorporated in their market-based rate tariffs, behavioral conditions designed to prevent market manipulation.

        In 2005, the FERC is expected to consider ISO market monitoring and oversight in connection with the FERC's review of the ISO's market design proposals. Market monitoring and mitigation also may be affected by any energy legislation Congress may pass.

        Various entities, including the Utility and the state of California are seeking up to $8.9 billion in refunds for electricity overcharges on behalf of California electricity purchasers from May 2000 to June 2001 through a proceeding pending at the FERC. This FERC proceeding, the "Refund Proceeding," commenced on August 2, 2000 when a complaint was filed against all suppliers in the ISO and PX markets. On July 25, 2001, the FERC held that refunds would be available for certain overcharges, and established a process to determine the amount of the overcharges that will be refunded. The FERC asserted that it would not order market-wide refunds for periods before October 2, 2000, because under a federal statute it can only order refunds beginning 60 days after a complaint for overcharges was filed and the first complaint for overcharges was not filed with the FERC until August 2, 2000. In December 2002, a FERC ALJ issued an initial decision in the Refund Proceeding finding that power suppliers overcharged the utilities, the state of California and other buyers approximately $1.8 billion from October 2, 2000 to June 20, 2001, but that California buyers still owe the power suppliers approximately $3.0 billion, leaving approximately $1.2 billion in net unpaid bills.

        In March 2003, the FERC confirmed most of the ALJ's findings in the Refund Proceeding, but partially modified the refund methodology to include use of a new natural gas price methodology as the basis for mitigated prices. The FERC indicated that it would consider later allowances claimed by sellers for natural gas costs above the natural gas prices in the refund methodology. In addition, the FERC directed the ISO and the PX (which operates solely to reconcile remaining refund amounts owed) to make compliance filings establishing refund amounts by March 2004. The ISO calculation process has been continuing, and the ISO has indicated that it plans to make its compliance filing by the first half of 2005. The PX cannot make its compliance filing until after the ISO has made its filing. In October 2003, the FERC affirmed its March 2003 decision. Various parties have filed appeals with the U.S. Court of Appeals for the Ninth Circuit, or Ninth Circuit, of the various FERC orders in the

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Refund Proceeding. Although the Ninth Circuit originally held those appeals in abeyance while the FERC process continued, on October 22, 2004, the Ninth Circuit ordered that the appeals should proceed. According to a schedule developed by the Ninth Circuit, the parties are required to submit all briefs by March 2005 to address the issues of which power suppliers are subject to refunds, the appropriate time period for which refunds can be ordered, and which transactions are subject to refunds. These matters will be considered at oral argument before the Ninth Circuit on April 12 and 13, 2005, and a decision is expected in the following months.

        The final refunds will not be determined until the FERC issues a final decision in the Refund Proceeding, following the ISO and PX compliance filings and the resolution of the appeals of the FERC's orders. The FERC is uncertain when it will issue a final decision in the Refund Proceeding, after which further appellate review is expected. In addition, future refunds could increase or decrease as a result of retroactive adjustments proposed by the ISO, which incorporate revised data provided by the Utility and other entities.

        As noted above, the FERC asserted in the Refund Proceeding that it does not have the power to direct the power suppliers to make comprehensive market-wide refunds to customers for the period before October 2, 2000. However, in the FERC's separate proceedings to investigate whether tariff violations occurred in the period before October 2, 2000, the FERC has asserted that it has the power to order power suppliers to disgorge any profits if the FERC finds that the tariffs in force at that time were violated or subject to manipulation. In addition, in September 2004, acting in a separate case from the Refund Proceeding and the FERC's investigative proceedings, the Ninth Circuit found that the FERC has the authority to provide refunds for tariff violations involving inadequate transaction reporting for sales into the California spot markets throughout the period before October 2, 2000. The Ninth Circuit remanded the case to the FERC to determine the appropriate remedy. Pending a decision on the suppliers' request for a rehearing of this Ninth Circuit decision, the FERC has not yet acted on the September 2004 remand order. It is uncertain whether the Ninth Circuit's decision interpreting the FERC's power to order refunds will be upheld and how it will be applied by the FERC.

        The Utility recorded approximately $1.8 billion of claims filed by various electricity generators in its Chapter 11 proceeding as liabilities subject to compromise. This amount is subject to a pre-petition offset of approximately $200 million, reducing the net liability recorded to approximately $1.6 billion. Under a bankruptcy court order, the aggregate allowable amount of ISO, PX and generator claims was limited to approximately $1.6 billion. The Utility currently estimates that the claims would have been reduced to approximately $1.0 billion based on the refund methodology recommended in the FERC ALJ's initial decision. The recalculation of market prices according to the revised methodology adopted by the FERC in its March 2003 decision could further reduce the amount of the suppliers' claims by several hundred million dollars. This reduction could be offset by the amount of any additional fuel cost allowance for suppliers if they demonstrate that natural gas prices were higher than the natural gas prices assumed in the refund methodology. The FERC has directed that sellers claiming a fuel cost allowance should submit their claims to an independent auditor before inclusion of any amounts in an ISO calculation of refunds and offsets for such fuel costs.

        The Utility has entered into various settlements with power suppliers resolving the Utility's claims against these power suppliers. Although settlement discussions with a number of other major sellers and other market participants are continuing, the Utility cannot predict whether these settlement negotiations will be successful. The net after-tax amounts received by the Utility under settlements reduced the amount of the Settlement Regulatory Asset. Customers also will receive the benefit of any future energy supplier refunds received by the Utility. See discussion entitled "Contingencies" in MD&A.

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        On November 25, 2003, the FERC issued Order No. 2004, its final rule on standards of conduct for interstate natural gas pipelines and public utilities (jointly referred to as transmission providers). The standards of conduct are designed to ensure that transmission providers do not provide affiliated market participants with preferential access to service or information. In Order No. 2004, the FERC consolidated the previously separate standards of conduct for interstate natural gas pipelines and electric transmission providers and expanded the range of affiliates covered by the standards. In accordance with Order No. 2004, on September 22, 2004, the Utility posted its plan for compliance with the standards of conduct on its internet website, www.pge.com.