Transmittal Letter

Interim Findings

From:

Brian Browne

Email - brian@h2oecon.com

San Francisco Public Utilities Infrastructure Task Force

To:

Richard Bodisco

Chair San Francisco Public Utilities Commission Infrastructure Task Force

Date: September 7, 2001

Dear Rich,

As requested, I enclose here my interim report - emphasis on "interim". The final report for the Task Force will incorporate additional findings and the whole presented in a more systematic fashion, enhanced with greater detail and comments, where appropriate. The aim is to develop a comprehensive review, from my perspective, of the problems facing the PUC and proposed remedies; we can view this as a milestone in its evolution. As a nascent effort, it begs your forbearance.

• Develop a Long Term Strategic Plan, reflective of an efficient and responsive business model
• Integrate the PUC Long Term Strategic Plan (LTSP) into the overall City LTSP.
• Unbundle (transfer) the traditional PUC planning and engineering functions from financial transactions
• Investigate methods for increasing revenues as a substitute for borrowing. All residential dwellings in San Francisco receive 300 cubic ft. of wastewater at a lifeline rate. The lifeline rate criteria should be modified. Dwellings formerly deemed residential and now in commercial, corporate, or hotel type use should be monitored and charged the commercial rate.
• Increase the sale of PUC (HH) public power to the private sector. Do not create a monopoly service area for any single power provider in San Francisco.
• Hire people with skills and educational backgrounds that fit the PUC job descriptions.
• Specify the projected date when revenues will exceed costs and the PUC will be weaned of borrowing
• Focus on running a utility. Unbundle functions relating to major financial market transactions.
• Full cost all technologies. Planners must also calculate the external effects associated with various technologies, especially digester and power plant operations. Plans must consider both explicit (actual dollar value of owning and operating) and implicit (impact on workers and the environment) costs; to wit, a "cheaper" technology with greater negative external effects may prove more costly to the entire community because of adverse environmental impact. Planners must carefully weigh and calculate these effects, as the PUC plans have not, and the community must be reassured.
• Do not change the current system of requiring that the SF voters must approve revenue bond issues.

Sincerely,

Brian Browne

Interim Findings

This report is loosely divided into three sections.

I --- Long Term Strategic Planning.

II --- Finances - Revenue Bonds Issue and Rate Increases.

III --- Power -- Policy Issues

As noted in the transmittal letter, this is an interim study. It represents an eclectic organization of issues, which have emerged during my tenure on the San Francisco Public Utilities Task Force Infrastructure. A final report will be more comprehensive and fully documented. However, all documents are available in my source files and on the recorded minutes of the Task Force meetings.

I Long Term Strategic Plan (LTSP)

The PUC does not have a viable long-term strategic plan. An LTSP defines the goals and objectives of an enterprise, and dynamic plans for achieving these goals. An LTSP reflects the unique soul of the business model from which it was developed. An LTSP must incorporate the coordinated efforts of every department in the enterprise. The overriding goals of the plan are to ensure a continuation of the entity, while delivering the highest quality, most cost effective products to the public. Risk and asset management decisions must be decided in the context of demographics, economics, budgetary constraints, and the impact on the environment.

A LTSP for an in perpetuity enterprise such as the PUC cannot be limited to a 10-year reconstruction cycle and an ad infinitum horizon of debt financing. Planners must develop a scenario, which forecasts a crossover point when the enterprise will be self-sustaining. The TF does not believe that that the Mayor, Board of Supervisors, and taxpayers of San Francisco intend for the PUC to continually shift the debt of prior decision makers forward to their grandchildren.

Since the inception of the TF, three "plans" have been given to the members. These plans have all been for a ten-year capital improvement program (CIP), requiring upwards of 30 years of rate increase to fund bond indebtedness. The CIP approach is flawed and incomplete. It should be part of a PUC-LTSP. Expenditures of the magnitude suggested by the PUC in the 10-year CIP of $5.2 billion cannot be considered in isolation from San Francisco's other financial resource requirements. A debt of one billion dollars at the proposed interest payment of 6.5 percent over a 30-year period requires an increase in annual revenues of approximately $77,000,000. Funding the complete CIP of $5.2 billion will mean an increase in revenue requirements through rate hikes of approximately $400,000,000. This $400,000,000 almost doubles the current revenue requirements through rate hikes.

The PUC Infrastructure Task Force (TF), from its inception, has asked the PUC to present a viable LTSP that shows:

• Where it has been
• Where it is today
• Where it plans to go

All requests have been met with another version of the original 10-year CIP, albeit sometimes the name (e.g. co-appearance of Task Force member and representative of the SFPUC on May 22, 2001) has been changed to say long-term strategic plan. However, the documents presented to this point have been for 10-year work/expenditure cycles with considerably longer periods (30 years) of correlative debt being internalized by the ratepayers. As stated previously, there is no benchmarking or economic forecasting and no quantifying the trade-off between risk and cost. Further, there is no crossover point when revenues will exceed costs and the PUC will become independent from borrowing against future generations.

TF members have reviewed the various plans, financing, and costs estimates. The process has proved difficult and frustrating. Staff is not uniformly cooperative. Some staff members were open and forthright, while others acted as if the TF did not exist. The latter approach made the process of discovery tedious and the path often littered with obstacles. If the PUC had a viable LTSP with a clear and concise executive summary, aimed at the non-technical stakeholder, then the TF would have been able to comprehend their past, current and proposed business model and how it plans to execute its LTSP. Failure to create such a document, often requested by the TF, has bogged the entire process down.

Questions posed by PUC staff suggest that it doesn’t know what a LTSP should be. This is a sad commentary. It is not the function of the TF to provide micro details on how to develop such a plan. However, the TF recommended that staff define a business model and correlative LTSP for the PUC incorporating many of the following elements. The PUC must make this plan dynamic and flexible so that overall strategic goals can be achieved through shorter-term tactical dynamics, long-term asset management and eventually self-sustainability.

Process --

The PUC might consider forming a LTSP committee. This committee should comprise Commission and staff members, legislators, City officials (finance, other departments), disaster relief specialists, stakeholders, environmentalist, the public and other concerned citizens (etc.) and meet annually. A LTSP should be developed with established goals and milestones. To ensure that these goals remain in sight, the PUC should establish a shot-term working committee that meets on a monthly basis to evaluate progress. There should be a strong link between the committees, the overall City planners, and the plan implementers. Special emphasis should be placed on disaster response. This approach should be well integrated into the PUC business model.

Elements to Consider for a Business model - clarify purpose and function of the PUC

• The PUC business model must explain and make a case why taxpayers should lend the PUC $5.2 billion. The agency has to demonstrate how it will be held accountable. There has to be a system in place at the PUC to ensure a nexus between decision-makers and economic outcomes? In private enterprise bad outcomes are internalized by the decision-maker. This outcome should be more significant than merely rearranging the deck chairs on the Titanic (dismissal). The PUC has to explain how it inculcates and monitor this accountability ethic. The PUC should describe how it perceives its role in the overall San Francisco and Bay Area region. It’s important to know how it assesses the impact of its huge expenditure project into the overall economic environment. Mission and goals must be stated such that stakeholders can hold the Commission accountable. Attach resumes of key players and make them available to the public. Stress how academic and career experiences correlate with the specific job descriptions required to operate this vast multi-utility. The business plan should be a confidence builder -- or reveal weakness -- wherein the stakeholder understands the PUC way of doing business.

Elements to Consider and Discussion Points for a Long Term Strategic Plan (LTSP) --

• Executive summary. Make sure, in clear non-jargon that the citizen-reader, the Mayor and the Board of Supervisors understand where the PUC has been, where it is now, and where it’s going. It must encapsulate everything that is presented in the plan. All assumptions must be clearly stated.

The PUC is the creation of the federal, state, and City of San Francisco governments. The federal government under the Raker Act of 1913 endowed San Francisco with the Hetch Hetchy water and power resources. The City combined power, water, and wastewater into multi-utility now known as the PUC. Currently the PUC is divided into three enterprises - Hetch Hetchy, water and cleanwater (sewerage). The Hetch Hetchy power division produces, aggregates (buys electric power in bulk), transports and distributes power to governmental agencies and some private sector customers. The water division distributes water to governmental agencies, the City of San Francisco, and Bay Area water districts. The cleanwater division collects and treats wastewater for San Francisco.

The PUC has monopoly service area rights in the sale, distribution, and collection of water and wastewater in San Francisco. Hetch Hetchy provides power, when possible, to governmental agencies, Turlock and Modesto Irrigation Districts (TID/MID) and certain non-governmental entities, mainly those that are tenants of City owned facilities.

Municipalities in California with monopoly service areas are self-regulating with regard to rates and service conditions. The California Public Utilities Commission (CPUC) regulates investor owned utilities (IOUs) that have exclusive service areas as to ratemaking and conditions of service. CPUC hearings are quasi-judicial and open. The PUC as a municipality is a self-regulating utility.

• The PUC regulatory system. Let people know how the PUC regulates its levels of service (environmental considerations) and ratemaking. The PUC, excluding power, has a monopoly service area and is self-regulating. Define enterprise goals now and in the future (rates, quality, conditions of service). The reader must understand this. It should be stated how rates are being assessed and used and what is expected in return for these rates Ratepayers are the customers.
• Benchmark. How do the PUC compare with other public and private utility systems in California and other parts of the US? Historical, present and projected benchmarking is required. Projected benchmarking can be used as an evaluative tool in holding the PUC accountable. Benchmarking is not the answer per se in evaluating performance, but in conjunction with other engineering, financial, social, and economic indicators produces a solid basis for assessing relative efficiencies over a broad range of industry standards.
• Past, present and projected finance requirements need to be stated in clear language.
• Decision models for evaluating competing wants in a budget-constrained environment must be explained in quantitative as well as qualitative terms.
• Forecasting and sensitivity testing. Use standard orthodox forecasting techniques to assess future macro and micro economic, financial, technological and social variables, which will determine a specific market. Clearly state all assumptions.

• Though the established process (see above) ensure that public comment is always highly visible

II - Finances -- Revenue Bonds Issue and Rate Increases

San Francisco has a unique relationship between its government and citizenry. The citizens must approve revenue bonds (excluding SFO). Revenue bonds are bonds which will be paid back from revenues collected. This is a unique system of checks and balances. The bond requester must state what the bond funds will be used for and how the bonds will be repaid. This might be perceived as a contract between the entity issuing the bonds and the stakeholders. Many of the TF members view the execution of the contract as it is written as pivotal to the PUC in sustaining a line of credit with the voters. With the PUC proposing a CIP requiring additional expenditures of $5.2 billion this "credit-line confidence" factor becomes critical.

• The PUC is as mentioned a self-regulating utility entrusted under statute with a monopoly service area. The PUC rates are set to cover its revenue requirements. Revenues must cover operation & maintenance expenses, debt-service payments, and capital expenditures not financed by debt. The PUC does not have a funded depreciation or capital replacement account. PUC uses cash needs approach for funding capital expenditures by debt service and direct capital expenditure components out from revenues.

Debt service is created when the PUC causes bonds to be issued on its behalf. The PUC issues both serial and term bonds. In developing forecasts the PUC assumes these bonds will be amortized in a manner similar to a mortgage payment. Planners take the present value of the bonds and apply a level annualized factor that is calculated using interest and repayment period. This approach generates an annual dollar repayment amount which is allocated as rates over the customer base on a $/hundred cubic ft. (CCF) basis. The customers, through the increased rates, are in effect paying off both the interest and principle component of the IOU. Ultimately, the debt is passed through to PUC customers.

If the above process happens, as explained above, rate changes pursuant to a bond issue would be unchanged. However, the Commission has financial advisors who advise on their perception of optimal timing and structure of issues. This market participation, according to staff, can course a divergence between forecast and actual rates as a function of the prevailing bond market. The Commission advises that financial intermediaries be chosen in a competitive process.

To make the payments associated with the bond issuance the PUC has established two accounts with a fiscal agent:

• Interest fund --- Revenues are transferred into this account sufficient to cover twice a year interest payments on the bond debt
• Principle fund -- Revenues are transferred into this account sufficient to cover a once a year payment on debt principle

These two funds do not exceed the total required to cover both interest and principal requirements on a yearly basis. Surpluses are transferred back into the CIP. These funds cover interest charges and pay to retire bonds expiring during the year.

As an additional security for bondholders a Bond Reserve Account (BRA) is created. This is equal to one year of principle and interest payments. For the proposed CIP this will be approximately $345,000,000. This is an interest bearing account. If the BRA exceeds the pre-ordained level, the funds are returned to the CIP. When the debt is finally being retired and this reserve is not needed, it is used to offset the remaining amount outstanding.

The Commission might consider a business model, which focuses on planning, ratemaking, service conditions and ensuring a reliable supply of power, water and wastewater and unbundle its market activities. These are all specialized functions. The PUC has a long history of supplying power, water, and wastewater services and hence have developed specialized skills in these fields. However, in the new market dynamic, a number of TF members, especially after the A&B Bond situation, as discussed below, question the efficacy of internalizing very specialized market transaction functions within the Commission. This City might best be served by moving this function to a centralized/specialized entity within the City governance.

Example - 1997 A&B Bonds and Proposition H

In 1997 voters of San Francisco passed A&B bonds allowing the SFPUC to issue $304 million in bonds to finance reliability and seismic safety improvements and safe drinking water improvements.

In 1998 voters of San Francisco passed Proposition H, which froze water and wastewater rates at the level in effect on January 1, 1998 until July 1, 2006. There were limited exceptions such as to cover the debt service for the 1997 Revenue Bonds approved by the voters.

In Text of Ordinance Authorizing Bond Election - Proposition A. (p33) it is stated:

In Text of Ordinance Authorizing Bond Election - Proposition B. (p41) it is stated:

The text authorizing both A & B also called for any "substitute work" to be performed only after it went through the same rigorous independent certification process as dictated at the ballot box.

Many members of the Task Force interpreted the text of the ordinances authorizing the Bond election to mean that the PUC should have followed specific steps; namely,

1. Have work-scope developed for initiatives certified by independent engineering entity. The TF members interpreted "independent" to mean as in the Declaration of Independence and not consultants working for the PUC.

2. Issue revenue bonds

3. Sequence debt service payment with rate increases

4. Perform certified work using funds generated from bond issuance.

The PUC followed a different approach. The Commission used commercial paper to fund A&B work. The first 1997 Bonds were not issued until July 25, 2001.

On February 28, 2001 the PUC produced a document entitled: "San Francisco Public Utilities Commission -- Capital Improvement Program - Long-Range Financial Plan. This document was presented to the public on May 22, 2001 as the SFPUC LTSP. In this document, the PUC described 1997 A&B Revenue Bond and their commercial paper program

The history of this commercial paper/Bond Issuance (incomplete as of writing) program is summarized in the following steps.

1. During the spring of 1999 the PUC requested and had passed by the Board of Supervisors an ordinance allowing for commercial payment to be used prior to actual bond issuance.

2. In July 1999 the PUC commenced issuing commercial paper, thereby, as noted by the TF, necessitating a two versus one step approach to funding A&B work. The first step was not presented to the voters as an option.

3. On May 22, 2001 SFPUC representative, Dr. Phil Arnold, announced that A&B work had been certified and confirmed to that the Alliance had issued the certification. Task Force members question the PUC as to what was specifically was certified and whether The Alliance could be considered independent.

4. July 1, 2001 water rate increase of 8.69%, announced by PUC. This increase overrode Proposition H freeze in that PUC stated it was required for debt service pursuant to issuing A&B bonds.

5. On August 27, 01 staff of PUC responded to a TF request for additional clarification regarding work-scope certification:

6 July 25, Bonds issued for $140,000,000.

7. As of August 15, 2001 - TF advised that as of now $226 million dollars have been appropriated or spent and that the remaining $78 million has been "identified." The $226 million is divided into three categories by the PUC

• $28 million spent
• $66 million encumbered -- contracted for but not paid
• $82 million Available for specific projects

TF members believe that Propositions A&B did not permit a commercial paper program and that certification was done after the fact and possibly not by an independent engineering entity. The TF believes that A&B work should have been completed. These type of factors raise concerns as to accountability and confidence in future revenue bond request.

Examples - Revenue from Customers v Debt Financing

Lifeline Rates and Revenue Requirements

The TF has requested that the PUC consider equating like customers with equal rates. Commercial and hotel customers do not receive any lifeline wastewater rates. Commercial and industrial customer rates are higher than the lifeline rate. These rates also include discharge costs.

Residential customers in San Francisco receive 300 cubic ft. of wastewater each month at a discount ($1.8623 per 100 cubic feet of water consumption). This rate is known as a lifeline rate. All wastewater use in excess of 300 cubic feet per residential dwelling per month is charged $4.8334 per 100 cubic feet. TF members asked if a building went from residential use to a hotel/corporate type use, should the lifeline rates still be applicable? The PUC stated that the administrative costs associated with redefining use would be too high to merit such a change. TF members suggested that these administrative costs would be less than the increased revenues and asked the PUC to investigate this matter further.

III - Power -- Policy Issues

AB1890 the power deregulation legislation was market-perverse. It created an environment whereby producers could act in an opportunistic manner toward consumers. At the time AB1890 was passed PUC (Hetch Hetchy) was producing, aggregating, transmitting, and selling power to both public and private sector customers. TF members believed that with a LTSP it would have been obvious to PUC management that a more dynamic approach should have been adopted. Some suggestions made during the course of meetings with the PUC are shown below:

• Creeping municipalization - PUC should have offered all residents a chance to sign up for PUC power. This type of approach is permitted under the San Francisco charter and was encouraged under AB1890.
• PUC should have used its low marginal cost of hydropower (Hetch Hetchy) to sell into high California Independent System Operator (CAISO) auctions to offset lower contractual irrigation district contractual prices. Sold high and bought low philosophy.
• PUC should have revisited the Turlock and Modesto irrigation district contracts immediately. These contracts were priced well below the market clearing price of power and the clause allowing right of first refusal over base load was a constraint on increasing Hetch Hetchy power generating capacity.
• PUC while providing public power to citizens of San Francisco should not increase its debt to buy PG&E intra-city wires, but rather negotiate favorable wheeling contracts.
• PUC should work with the state in acquiring low cost contractual power which is being purchased and sold by the DWR. The current 24/7/5-year contract with Calpine to purchase 50 MWH power with an average price of $86.90 over the 5-year contract period beginning July 1, 2001-- exceeds the current market rate. Mention was not made of this contract by the PUC on May 22, 01, when they presented the LTSP and announced certification of 1997- A&B Bonds or at any TF meeting or to any TF member working with staff on power issues.
• Hetch Hetchy revenues must be internalized for the entire system. For example during the period 1992-2000, SFPUC transferred $339,150,972 from Hetch Hetchy to the general fund. The present (appreciated) value of these funds, if available in a depreciation account (asset management) today, would approximate $1 billion. A systems approach to maintaining the entire system will ensure intra-utility synergism. Engineering and economic criteria must override any parochial attempts to dilute by political fiat the way the various functions of the current system complement each other. The current SFPUC business model may require overhauling and streamlining, but the conceptual approach of an integrated system controlled by San Francisco must not be changed.

One advantage of having San Francisco as a player in the energy markets is that it will restrain "gaming" (withholding power to spike prices) by producers. San Francisco as a strong political entity will lend additional policing powers into a market that has been perversely redesigned (AB1890) by fiat to favor rather than dissuade cartel type behavior by power producers. This weakness in the law is gradually being addressed.

The TF members, while strongly supporting public power participation by the PUC in the overall San Francisco electric marketplace, do not believe any single power supplier should be granted sole monopoly rights to sell power in San Francisco. The public must have choices and a leading option must be the PUC. Acquisition of PG&E's aging intra-city wires is not encouraged. This would generate an additional debt burden on the City and straddle the City with a high learning curve in operating, maintaining, and running a "wires" (PG&E distribution lines) business. The PG& E wires acquisition could increase the proposed $5.2 billion debt issuance to possibly over $7 billion.

Endnotes

August 27, 01 email to Rich Bodisco ---- SFPUC (lack of) Planning Process

Rich the Briefing Paper "An Earthquake Vulnerable, Aging System Could Leave
2.4 Million Bay Area Customers With Little or No Water for Up to 60 Days"
highlights an old and well known problem associated with living in an area
of geological instability. Three things come to mind: (1) Why were these
assets allowed to degrade to a point supposedly requiring billions now? (2)
Haste makes waste (going ahead without a LTSP), and (3) Don't shoot the
messenger (Task Force). Since sunk costs are sunk costs (irrelevant), we
must seek an answer to question 1, while moving forward with the real task
at hand -- ensuring our infrastructure be restored and enhanced and that
this type crisis situation never again arises. This can be done by a
disciplined and planned approach to asset management. As noted below,
this "crisis" needs to be properly quantified - the cost, timing, and risk
calculations have yet to pass consensus TF scrutiny.

For over 15 months we have failed in our entreaties to the PUC to have
them generate a viable long term strategic plan (LTSP) that will guarantee
the public will have complete confidence in granting PUC a line of credit
(revenue bonds), apparently in the billions. This credit line cannot be
considered in isolation from SF's other present and future financial goals.
Our ability to issue paper is NOT infinite. We must live within overall
budgetary constraints. This plan must tell us why we are at this perceived
crisis point now and how we can avoid this situation in the future. It must
look beyond 10 years - this must not be the planning horizon for an in
perpetuity conurbation such as the bay Area. It must involve the public,
especially in risk (risk reduction is not a free good) and financial
management. The trade-off with the environment cannot be ignored. In this
regard, both explicit (actual) and implicit (internalizing externalities)
must be considered. Brian Browne
EOM---------------------------------

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Benchmarking -- Questions requested by Member Browne - from an XLS sheet

---- This report should be benchmarked against other similar systems to compare operating statistics. (July 01)