Pacific Gas & Electric (PCG)

PG&E Corporation’s and the Utility’s financial viability depends upon the Utility’s ability to recover its costs in a timely manner from the Utility’s customers through regulated rates and otherwise execute its business strategy.

The Utility is a regulated entity subject to CPUC jurisdiction in almost all aspects of its business, including the rates, terms and conditions of its services, procurement of electricity and natural gas for its customers, issuance of securities, dispositions of utility assets and facilities and aspects of the siting and operation of its electricity and natural gas distribution systems. Executing the Utility’s business strategy depends on periodic CPUC approvals of these and related matters. The Utility’s ongoing financial viability depends on its ability to recover from its customers in a timely manner the Utility’s costs, including the costs of electricity and natural gas purchased by it for its customers, in the Utility’s CPUC-approved rates and its ability to pass through to its customers in rates the Utility’s FERC-authorized revenue requirements.

The Utility’s financial viability also depends on its ability to recover in rates an adequate return on its capital structure, including long-term debt and equity. During the California energy crisis, the high price the Utility had to pay for electricity on the wholesale market, coupled with its inability to fully recover its costs in retail rates, caused the Utility’s costs to significantly exceed its revenues and ultimately caused the Utility to file a petition under Chapter 11. Even though the Settlement Agreement and current regulatory mechanisms contemplate that the CPUC will give the Utility the opportunity to recover its reasonable and prudent future costs in its rates, there can be no assurance that the CPUC will find that all of the Utility’s costs are reasonable and prudent or will not otherwise take or fail to take actions to the Utility’s detriment.

In addition, there can be no assurance that the bankruptcy court or other courts will implement and enforce the terms of the Settlement Agreement and the Utility’s plan of reorganization in a manner that would produce the economic results that PG&E Corporation and the Utility intend or anticipate. Further, there can be no assurance that FERC-authorized tariffs will be adequate to cover the related costs. If the Utility is unable to recover any material amount of its costs through its rates in a timely manner, PG&E Corporation’s and the Utility’s financial condition and results of operations would be materially adversely affected.

The Utility may be unable to purchase electricity in the wholesale market or to increase its generating capacity in a manner that the CPUC will find reasonable or in amounts sufficient to satisfy the Utility’s obligation to meet the electricity needs of its customers and the CPUC’s electricity resource adequacy requirements.

The Utility’s residual net open position (i.e., that portion of the Utility’s electricity customers’ demand not satisfied by electricity that the Utility generates or has under contract, or by electricity provided under the DWR allocated contracts) is expected to grow over time, as discussed in the “Risk Management” section of this MD&A above. In addition, unexpected outages at the Utility’s Diablo Canyon power plant or any of its other significant generation facilities, or a failure to perform by any of the counterparties to the Utility’s electricity purchase contracts or the DWR allocated contracts, would immediately increase the Utility’s residual net open position.

As existing electricity purchase contracts expire, sources of electricity otherwise become unavailable or demand increases, the Utility will purchase electricity in the wholesale market. These purchases will be made under contracts priced at the time of execution or, if made in the spot market, at the then-current market price of wholesale electricity. There can be no assurance that sufficient replacement electricity will be available at prices and on terms that the CPUC will find reasonable, or at all. The Utility’s financial condition and results of operations would be materially adversely affected if it is unable to purchase electricity in the wholesale market at prices or on terms the CPUC finds reasonable or in quantities sufficient to satisfy the Utility’s residual net open position.

California investor-owned electric utilities are required to achieve an electricity planning reserve margin of 15% to 17% in excess of peak capacity electricity requirements by June 1, 2006. In order to meet electricity resource adequacy requirements, the Utility may develop or acquire new generation facilities. The development or acquisition of additional generation facilities would require the Utility to incur significant additional capital expenditures or other costs and may require the Utility to issue additional debt, which it may not be able to issue on reasonable terms, or at all. The CPUC’s December 16, 2004 decision approving the Utility’s LTPP prohibits the Utility from recovering costs in excess of the Utility’s projection of its initial capital costs included in the Utility’s bid for Utility-owned generation. If the Utility is not able to recover a material part of the cost of developing or acquiring additional generation facilities in the Utility’s rates in a timely manner, PG&E Corporation’s and the Utility’s financial condition and results of operations would be materially adversely affected.