Scientech Issue Alert: Bankruptcy May Be Unavoidable for Southern California Edison

[News item from Reuters] Edison International (NYSE:EIX) posted a second-quarter loss on July 20 and warned that its Southern California Edison (SCE) utility subsidiary will go bankrupt without immediate action from California lawmakers. "Simply put, SCE cannot avoid bankruptcy and the state cannot get out of the energy-buying business without immediate legislative intervention," Edison Senior Vice President Bob Foster said in a letter to state lawmakers. SCE accumulated billions of dollars of debt buying power at skyrocketing prices in the wholesale market. The costs could not be fully passed on to customers due to a retail price freeze imposed under the state's power deregulation laws.

Analysis: On July 21, the day after Edison International posted its 2Q financial loss and issued the dire warning about SCE's potential bankruptcy, the California Senate did pass what is attempted to be a rescue plan for the struggling utility. In exchange for allowing SCE to issue bonds to pay off its debt, the state of California would extend the timeline in which it may be able to purchase SCE's transmission assets. However, SCE quickly responded that the Senate's measure is a case of "too little, too late" and that even though many have claimed that the measure is an unwarranted bailout, it still does not offer an adequate resolution to the utility's financial problems. In addition, lawmakers continue to resist approving any measure that might be perceived as a financial bailout for SCE. Given the strong opinions on both sides of the debate, and the fact that a previously established deadline is fast approaching, SCE may soon determine that its best option is to voluntarily follow fellow utility Pacific Gas & Electric Co. into bankruptcy proceedings.

Under a 22-17 vote, the California Senate approved a modified version of an agreement between SCE and Gov. Gray Davis that had been in the works since April. Specifically, the bill allows SCE to issue up to $2.5 billion in bonds to be repaid by a mandatory charge on some customer bills. The money would be used to repay about $1.2 billion that SCE owes to financial institutions, and another $1.3 billion to qualifying facilities (smaller power plants that had provided power to the utility as a backup when larger suppliers began to grow concerned about the utility's creditworthiness). In addition, the bill would provide the state of California with a five-year option to purchase SCE's 12,000-mile transmission assets at a book value of about $1.2 billion.

There are several points about this bill that are important to note. First, SCE is getting much less (about $1 billion, in fact) than it says it needs to stave off bankruptcy proceedings. Second, whereas previously Gov. Davis was very eager to forge a deal to immediately purchase SCE's transmission assets, this aspect of the deal appears to have cooled a bit. The state still retains the option of purchasing the assets, but would have five years to finalize a decision. Also note that, in contrast to the "agreement in principle" that had been reached between Gov. Davis and SCE back in April, the state is now offering book value for the transmission assets, as opposed to the $2.76 billion that Davis had offered three months ago. At the time, legislators throughout California had balked at the high price for the transmission assets, which they believed were overvalued. In addition, some lawmakers thought that the high price that Davis offered for the transmission assets merely constituted a bailout for SCE, which gave a good number of legislators heartburn. In many ways the agreement in principle between SCE and Gov. Davis represented a sweetheart deal for the utility as it would have been paid 2.3 times above book value for its transmission grid, which does not represent a strong revenue stream for the utility. Now, of course, the offering for the assets has been cut in half, so SCE clearly is no longer as pleased with the deal.

The bill requires that SCE pay off as much of its existing debt as possible and return to creditworthiness by Jan. 1, 2003. SCE is presently under a deep-junk credit rating and consequently has turned the bulk of its power purchases over to the state of California. Obviously, a financially sound utility benefits the state's economy, so all of the stakeholders in this matter appear to be on the same page in wanting SCE to once again resume buying power for the customers it serves. The prerequisite for this, however, is getting SCE back into a financially solvent position, the method for which is something that has caused great discord among California legislators.

The other pressure on this deal making is time, and the clock keeps ticking away. For starters, the agreement in principle reached between SCE and Gov. Davis has a deadline of Aug. 15. Unless an acceptable deal is reached between the two parties by that date, all bets are off. Compounding the problem is that California lawmakers began a 30-day recess as of July 20. The lawmakers will continue to attempt to reach a compromise during this break, but realize that presently it will be very difficult to gain support for the rescue plan in the California Assembly. In fact, even though the Senate bill includes a financial offering that is significantly less than Davis' original offer, some California legislators still consider the bill to be "corporate welfare" for SCE and may block voting on the measure once it reaches the Assembly. Keep in mind that competing bills have also surfaced in the Assembly, which could drag out the debate on the issue. Davis has established that Aug. 15 is a firm deadline and that the issue must be fully resolved before the end of the legislative recess.

All of which still leaves SCE in a very precarious state. SCE representatives warned that the Senate plan was inadequate and would leave the utility about $1 billion short of the amount it needs to become creditworthy again. Although the measure might enable SCE to pay some of the smaller generators and lenders that it owes, outstanding bills that the utility owes to larger power suppliers would remain intact. Thus, SCE representatives do not appear to support the Senate-approved bill because it does not fully restore the utility to creditworthy status. Moreover, in the event that no acceptable resolution can be reached by Aug. 15, it appears increasingly likely that SCE will follow similar action taken by Pacific Gas & Electric Co., California's largest IOU, and file for bankruptcy status.

Financial numbers reported by Edison International last week validate the severity of the company's problems. For 2Q 2001, Edison International reported a $102-million loss, which amounted to 31 cents a share. The loss includes $63 million, or 19 cents per share, in unrecovered power purchases that SCE made before the Department of Water Resources began buying power for the cash-strapped utilities earlier this year. Due to a retail rate freeze in California, SCE was unable to recover the high costs it incurred for purchasing power in wholesale contracts and on the spot market. Also taking a toll on SCE's financials were problems associated with the San Onofre nuclear plant in Southern California, in which SCE still owns a 75-percent stake. Due to a fire that caused extensive damage, the plant was shut down from early February to June of this year, which made for a one-time loss of $117 million for SCE.

The current financial report is in marked contrast from Edison International's position one year ago, when it posted a profit of $137 million, or 41 cents a share, in 2Q 2000. In fact, SCE's earnings have sunk 82 percent from 2Q 2000 to 2Q 2001, even though some larger market conditions have improved. Despite the fact that wholesale prices have dropped and SCE actually has put into place several retail rate increases, these improvements have not restored the utility to a financially solvent position. In fact, the rate increases put into place this year must be used to support the power purchases made by the Department of Water Resources before they can be applied to SCE's outstanding debt. At the end of the most recent quarter, SCE reportedly had about $1.9 to $2 billion in cash. However, considering that the utility still faces about $3.5 billion in unpaid bills and defaults, its negative balance is still in the range of about $2 billion plus.

The fact that the state's proposed purchase of SCE's transmission lines has been put on the backburner may give this measure a slightly greater chance of getting passed in the California Assembly. The purchase of the transmission lines was clearly one of the most contentious parts of the agreement between SCE and Gov. Davis. However, lawmakers are extremely reticent to approve any measure that could be perceived by the public as a financial bailout for SCE, and thus the issue of bonds used to pay off some of SCE's debts has also become very polarized. Consequently, I doubt that any acceptable resolution can be reached by the firm deadline of Aug. 15, and it is also unlikely that the amount of the bonds would be increased by another $1 billion (the amount that SCE claims it needs). What this means is that a bankruptcy filing for SCE could come as early as late August or September. As I've said before, bankruptcy is not always the end of the game for utilities following this path. Pacific Gas & Electric Co., for instance, could emerge as a stronger and more streamlined company after using the next few years to resolve its credit problems. By the same token, SCE may determine that declaring bankruptcy, instead of accepting what it deems to be an insufficient offer, marks the best strategic move at this juncture.

SCIENTECH's IssueAlerts^(SM) are compiled based on the independent analysis of SCIENTECH consultants. The opinions expressed in SCIENTECH's IssueAlerts are not intended to predict financial performance of companies discussed, or to be the basis for investment decisions of any kind. SCIENTECH's sole purpose in publishing its IssueAlerts is to offer an independent perspective regarding the key events occurring in the energy industry, based on its long-standing reputation as an expert on energy issues.

Copyright 2001. SCIENTECH, Inc. All rights reserved.

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