ML032521349

Declaration of Michael J. Donnelly in Support of Motion for Authority to Enter Into Certain Hedging Transactions in Connection with Financing Under Proposed Plan of Reorganization, and to Incur Secured Debt Related Thereto

ML032521349
Person / Time
Site:	Diablo Canyon
Issue date:	08/29/2003
From:	Donnelly M Howard, Rice, Nemerovski, Canady, Falk & Rabkin, Pacific Gas & Electric Co
To:	Office of Nuclear Reactor Regulation, US Federal Judiciary, Bankruptcy Court, Northern District of California
References
01-30923 DM, 94-0742640
Download: ML032521349 (19)

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9 10 I1I JAMES L. LOPES (No. 63678)

-JEFFREY L. SCHAFFER (No. 91404)

GARY M. KAPLAN (No. 155530)

HOWARD, RICE, NEMEROVSKI, CANADY, FALK & RABKIN A Professional Corporation Three Embarcadero Center, 7th Floor San Francisco, California 94111-4065 Telephone:

415/434-1600 Facsimile:

415/217-5910 Attorneys for Debtor and Debtor in Possession PACIFIC GAS AND ELECTRIC COMPANY UNITED STATES BANKRUPTCY COURT NORTHERN DISTRICT OF CALIFORNIA SAN FRANCISCO DIVISION 12 sHow 13

'Iw 14 A

15 16 17 18 In re PACIFIC GAS AND ELECTRIC COMPANY, a California corporation, Debtor.

Federal I.D. No. 94-0742640 Case No. 01-30923 DM Chapter 11 Case Date:

Time:

Place:

Judge:

September 26,2003 10:30 a.m.

235 Pine Street, 22nd Floor San Francisco, California Hon. Dennis Montali 19 20 21 22 23 24 25 26 27 28 DECLARATION OF MICHAEL J. DONNELLY IN SUPPORT OF MOTION FOR AUTHORITY TO ENTER INTO CERTAIN HEDGING TRANSACTIONS IN CONNECTION WITH FINANCING UNDER PROPOSED PLAN OF REORGANIZATION. AND TO INCUR SECURED DEBT RELATED THERETO

1 I, Michael J. Donnelly, declare:

2

1. I am the Assistant Treasurer of the debtor Pacific Gas and Electric Company 3

("PG&E"), a position that I have held since September of 2000. I also am the Assistant 4

Treasurer of PG&E's parent, PG&E Corporation (the "Parent"), which reflects the fact that 5

the treasury functions of the two companies are handled through one treasury unit for 6

efficiency purposes. Except as otherwise indicated, I make this declaration based upon my 7

personal knowledge, except as to any matters stated on information and belief, as to which 8

matters I am informed and believe they are true. If called as a witness, I could and would 9

testify competently to the facts stated herein.

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2. I make this declaration in support of PG&E's Motion For Authority To Enter Into 11 Certain Hedging Transactions In Connection With Financing Under Proposed Plan Of 12 Reorganization, And To Incur Secured Debt Related Thereto (the "Motion'). Except as 13 otherwise expressly stated herein, all capitalized words or terms used in this declaration have 14 the meanings ascribed to them in the Motion. I have reviewed the Motion and am well 15 familiar with it. In my capacity as Assistant Treasurer, and working under the supervision of 16 Leroy Barnes (the Vice President and Treasurer of the Parent) and Kent M. Harvey (the 17 Senior Vice President, Chief Financial Officer and Treasurer of PG&E), I have been 18 extensively involved in the consideration of the Interest Rates Hedges and Hedge 19 Agreements described in the Motion.

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3. Pursuant to the Motion, PG&E seeks authority to enter into Interest Rate Hedges 21 and Hedge Agreements with maturity dates (in the case of Performance Interest Rate 22 Hedges) or expiration dates (in the case of Straight Option Transactions) through June 30, 23 2004.1 PG&E reserves the right to seek further authority with respect to any Interest Rate 24 l PG&E anticipates a March 31, 2004 Effective Date for the currently pending Plan 25 of Reorganization under Chapter 1 of the Bankruptcy Code for Pacific Gas and Electric Company Proposed By Pacific Gas and Electric Company, PG&E Corporation, and the Official Committee of Unsecured Creditors Dated Juy 31, 2003 (the "PG&E Plan"). (By its Order dated July 31, 2003, the Bankruptcy Court approved the Disclosure Statement with 27 respect to the PG&E Plan and scheduled a confirmation hearing on the PG&E Plan to 28 commence on November 3, 2003.) However, PG&E believes it is prudent to provide for (continued...

) DECLARATION OF MICEIAEL J. DONNELLY

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1 Hedges and Hedge Agreements as appropriate, including, without limitation, in the event 2

that the PG&E Plan fails to be confirmed and become effective before the settlement dates 3

of any Performance Interest Rate Hedges and corresponding Hedge Agreements entered into 4

pursuant to the Motion, or in connection with an alternative reorganization plan for PG&E.2 5

4. The relief sought by the Motion reflects the fact that market interest rates are near 6

(...continued) some flexibility in the event this anticipated effective date of a plan of reorganization is delayed for any reason. PG&E believes that obtaining authorization to enter into Interest 8

Rate Hedges with a settlement or exercise date of up to June 30, 2004 provides PG&E with adequate and reasonable flexibility, for the following reasons:

9 In the case of a Straight Option Transaction, the longer the period before the option expiration date the greater the cost of the option. The reason for this increased cost is that 10 the longer exercise period ncreases the timeframe during which market movements can occur. As a result, the amount of risk protection provided by the option increases, since the 11 probability that an option might be exercised increases, and the cost of obtaining such increased protection correspondingly increases. In short, a Straight Option (as defined 12 below) with an expiration date of June 30, 2004 necessarily will cost more than a Straight Option with an expiration date of March 31, 2004.

13 Notwithstanding this increased cost, PG&E believes it is good business udgment to 14 purchase an o tion with an expiration date that allows for some slippage in the Effective Date of the P &E Plan, because the price of the option is based in part on current interest rate parameters as of the option purchase date and the premium for the longer period is 15 therefore fixed and known at the time of purchase. If, on the other hand, PG&E were to purchase a Straight Option with an expiration date of March 31, 2004 and there were some slippage in the Effective Date of the PG&E Plan, PG&E at that time would have to purchase 1 7 a new Straight Option with a new expiration date the price of which is unknowable at the present time because the second option necessarily would be priced based on interest rate parameters at the time of such future purchase. This is not a presently auantifiable risk.

Accordingly, if PG&E determines to purchase a Straight Option, PG&E believes that it 19 generally makes better business sense to purchase a Straight Option with an expiration date allowing for some flexibility, with a cost that is fully determinable and known at the time of 20 purchase.

In the case of Interest Rate Hedges that combine one or more of the non-option 21 hedging devices with an option hedging device, the same reasoning applies. Because virtually any Interest Rate Hedges entered into by PG&E pursuant to the Motion beyond a 22 Straight Option Transaction will involve a combination of one or more non-option hedging devices with an option hedging device, PG&E by the Motion seeks authority to enter into 23 Interest Rate Hedges with a settlement date of up to June 30, 2004.

2 On July 25, 2003, PG&E petitioned the California Public Utilities Commission (the 24 "Commission') for authorization to hedge interest rates for fixed rate long-term debt 25 anticipated as part of the financing to implement a confirmed plan of reorganization in 25 anicpae aspr ftefnnigt mlmn ofre pla ofroraizatini PG&E's bankruptcy case, prior to confirmation of a reorganization plan. PG&E's July 25 2003 petition to the Commission builds on the Commission's prior decision (D.02-11-0305 26 and seeks to modify that decision to expand the types of hedges and plans of reorganization covered by the Commission's authorization for pre-confirmation hedging. PG&E's ability to 27 engage in the Interest Rate Hedges will be contingent upon receipt of appropriate approval 28 from the Commission. DECLARATION OF MICHAEL J. DONNELLY

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1 historically low levels when viewed over the last 30 years. Securing the benefits of these 2

low rates for the debt contemplated to be issued by PG&E under its reorganization plan will 3

enhance the efficiency of such plan and will be beneficial to the estate and interested parties.

4 Authorizing PG&E to enter into the Interest Rate Hedges and Hedge Agreements while 5

forward interest rates are relatively low will provide a tool to help protect against potential 6

significant increases in interest rates that might occur before its reorganization plan is 7

implemented, thereby mitigating against potentially higher borrowing costs that may prevail 8

when debt is issued as anticipated under PG&E's reorganization plan. PG&E believes that 9

this is in the interests of PG&E, its creditors and ratepayers alike.

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5. PG&E will be required to issue and/or reinstate significant amounts of long-term 11 debt as part of its implementation financing under virtually any reorganization plan that will 12 resolve this Chapter 11 case. Under the PG&E Plan, such long-term debt is anticipated to 13 aggregate $8.8 billion, although contingencies could increase the amount to approximately 14

$10.5 billion. Of the $8.8 billion, approximately $7.7 billion is estimated to be new long-1;5 term debt, of which approximately $7.4 billion is anticipated to be fixed-rate, long-term 16 debt.3 Entering into agreements to preserve the benefits of the currently low market interest 17 rates is anticipated to provide long-lasting benefits to the estate and interested parties.4 18 Because the window of opportunity to secure the benefits of current low forward. interest 19 rates is uncertain, PG&E seeks authorization to promptly enter into the Interest Rate Hedges 20 and Hedge Agreements pursuant to the Motion.

21 22 3 Similar amounts of debt would be required under each of the reorganization plans previously proposed by (i) PG&E and PG&E Corporation (the "Original PG&E Plan '), and 23 (ii) the California Public Utilities Commission and the Official Committee of Unsecured Creitors (the "Commission Plan'). PG&E anticipates that regardless of which 24 reorganization plan is confirmed in this case, PG&E will be required to issue significant amounts of long-term debt to implement such plan.

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'Generally speaking, PG&E's borrowing costs are recoverable in retail gas and 26 electric rates (see Commission Decision 02-11-027, 2002 Cal. PUC LEXIS 718), so controlling those costs is in the interest of ratepayers. The Settlement Agreement that is the basis for the PG&E Plan expressly provides that the actual reasonable cost of PG&E's interest rate heding activities with respect to the financing necessary for the PG&E Plan shall be reflected and recoverable in PG&E's retail gas and electric rates.

28 tail gas an DECLARATION OF MICHAEL J. DONNELLY

1 Interest Rates and Risk 2

6.

The attractiveness of current market interest rates is exemplified by the 3

closing yields on 5-year and 10-year U.S. Treasury notes, which were 3.34% and 4.48% per 4

annum, respectively, as of August 26, 2003. These U.S. Treasury note rates, which are 5

illustrative of similar trends in other interest rate benchmarks, are at levels close to the 6

lowest rates seen in decades. On August 26,2003, the 30-year U.S. Treasury bond yield was 7

5.27% per annum, which again is among the lowest rates prevailing since the United States 8

Treasury began issuing 30-year bonds on a regular basis.

9

7.

As is typical with corporate long-term debt, the interest rate on PG&E's 10 anticipated long-term debt issuances under its reorganization plan will be based on a 11 combination of the yield on a comparable maturity U.S. Treasury note or bond, which 12 reflects the time-value of money (referred to as the "risk-free" rate), and a credit-spread, 13 which reflects a premium for PG&E's credit risk. The financial markets offer various 14 mechanisms for PG&E to hedge the U.S. Treasury yield portion of the interest rate on its 15 future long-term debt. However, these markets do not offer instruments that would allow 16 PG&E to hedge the credit-spread portion of the debt Thus, PG&E could only hedge for the 17 impact of changes on a component of the interest rates on PG&E debt to be issued in the 18 future. Financial market instruments appropriate for that purpose would enable the Debtor 19 to hedge rates related to U.S. Treasury yields for such a future date (which is referred to as 20 the "forward yield"), although it is not possible to lock in today's current yields (referred to 21 as the "spot yield") for debt that will be issued in the future.

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8.

Under most circumstances, forward U.S. Treasury yields are higher than 23 current spot U.S. Treasury yields. As of August 26, 2003, the market's expectation of the 24 yield of a 10-year U.S. Treasury note on March 31, 2004 was approximately 0.35% above 25 the current spot yield, and for January 1, 2005, the market expectation of the yield was 26 approximately 0.75% above the current spot yield. These expected rates could change 27 dramatically if market rates and expectations of future U.S. Treasury rates change.

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9.

Although it would be difficult to project with any certainty the movement of DECLARATION OF MICHAEL J. DONNELLY

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U.S. Treasury yields in the next year, the current levels are among the lowest in decades.

2 Since there is a general belief that interest rates normally increase in a growing or recovering 3

economy, should the U.S. economy rebound from its current slump, interest rates are likely 4

to increase further. Hedging interest rates at or near levels expected in the near term will 5

partially reduce the exposure to higher debt costs faced byPG&E's estate and its 6

constituents at the time that the long-term debt is anticipated to be issued.

7 Interest Rate Hedge Descriptions 8

10.

PG&E proposes to manage its exposure to potential future interest rate 9

increases by using the Interest Rate Hedges to hedge, in part, its cost of long-term debt 10 financing upon implementation of a confirmed reorganization plan. By the Motion, PG&E 11 requests authority to enter into Hedge Agreements to engage in the following types of 12 Interest Rate Hedges: interest rate swaps, caps, floors, collars, forward rate agreements and 13 options, each of which is described below.

14 Interest Rate Swaps 15

11.

An interest rate swap is an agreement between two parties in which one party 16 agrees to pay the other party a certain fixed rate of interest, and the other party agrees to pay 17 the first party a certain variable (or "floating") rate of interest for a specified time period.

18 PG&E would make or receive cash payments that reflect the difference between the fixed 19 and floating rates for the applicable time period. For example, if PG&E agrees to pay the 20 fixed rate and receive the floating rate and interest rates increase beyond the fixed rate 21 during the applicable time, then the counterparty would pay PG&E the difference between 22 the floating and fixed rates. Conversely, if PG&E agrees to pay the fixed rate and receive 23 the floating rate and interest rates decrease, then PG&E would pay the counterparty the 24 difference. Interest rate swaps can also involve parties who both pay floating rates, but 25 based on different indexes.

26 Interest Rate Cans. Floors and Collars 27

12.

An interest-rate cap is a financial instrument that sets a maximum rate of 28 interest on variable-rate obligations. An interest-rate floor sets a minimum rate of interest on DECLARATION OF MICHAEL J. DONNELLY

I variable-rate obligations. An interest rate collar is a financial instrument that sets both 2

minimum and maximum rates of interest on variable-rate obligations.

3 Forward Rate Agreements 4

13.

PG&E may choose to enter into forward contracts with respect to U.S.

5 Treasury securities and/or interest rate swaps. A forward contract with respect to U.S.

6 Treasury securities is an agreement between two parties to buy and sell a specific U.S.

7 Treasury note or bond at a specified price on a forward basis (at the settlement date). On the 8

settlement date, PG&E would either make or receive a cash payment that reflects the 9

difference between the expectation of rates at the time of the agreement (the contractual 10 rate), and the actual level of rates on the date of settlement (the market rate). If PG&E 11 agrees to sell a specified U.S. Treasury security and the market price for the particular 12 security is above the specified contractual price on the settlement date (ie., market interest 13 rates for Treasury notes have increased above the contractual rate), then the counterparty 14 would pay PG&E the difference. Conversely, if PG&E agrees to sell a specified U.S.

15 Treasury security and the applicable U.S. Treasury security market price on the settlement 16 date is above the specified contractual price (i market interest rates have decreased below 17 the contractual rate), then PG&E would pay the counterparty the difference.

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14.

A forward interest rate swap is an agreement between two parties to enter into 19 an interest rate swap at a later settlement date. As with a forward contract with respect to 20 U.S. Treasury securities, on the settlement date, the parties cash settle the difference between 21 the contractual rate and the actual (market) interest rate, instead of actually entering into the 22 interest rate swap. If the swap provided for PG&E to pay a fixed interest rate and receive a 23 floating rate from the counterparty and the applicable market interest rate is above the fixed 24 contractual rate, then the counterparty would pay PG&E the difference. On the other hand, 25 if the applicable market interest rate is below the fixed contractual rate, then PG&E would 26 pay the counterparty the difference.

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15.

In either of the forward rate agreements described above, a payment to PG&E 28 would offset the higher interest expense resulting from an increase in the risk-free rate DECLARATION OF MICHAEL J. DONNELLY

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1 component of the long-term debt to be issued under its reorganization plan, and a payment 2

by PG&E to the counterparty would be offset by the lower interest expense resulting from a 3

decrease in the risk-free rate component of such long-term debt. The net result under either 4

arrangement is management of the risk-free interest rate applicable to the portion of PG&E's 5

anticipated debt issuance that is hedged.

6 Option Contracts 7

16.

In general, an option contract is an agreement giving the purchaser the right, 8

but not the obligation, to buy (call) or sell (put) an asset at a given price (referred to as the 9

"strike price"). The optionis strike price and maturity date are determined when the contract 10L is entered into, and an "upfront premium" or purchase price is established for payment from 11 the purchaser to the seller.

12

17.

PG&E may choose to purchase a floor or a cap, which may be in the form of a 13 single put or call option or a series of put or call options on a specified financial instrument, 14 such as a U.S. Treasury security or an interest rate swap. Used in this way, options may be 15 thought of as analogous to an insurance policy, in that an upfront premium is paid in order to 16 limit total payments. In the case of a put option, PG&E would be purchasing the right to sell 17 the underlying asset to the counterparty at the strike price; therefore, if interest rates 18 increase, thereby decreasing the price of the asset below the put option's strike price, PG&E 19 would exercise the put option and receive from the counterparty a payment based on the 20 difference between the market price and the strike price. Conversely, if interest rates 21 decrease, thereby increasing the market price of the asset above the strike price, PG&E 22 would not exercise the put option and no payment would be exchanged. In such a case, 23 PG&E would have paid the upfront premium but would receive no offsetting payment. Call 24 options offer analogous protection against falling interest rates and rising asset prices. The 25 purchase of only an option hedging device as described in this paragraph, whereby PG&E 26 pays the purchase price upfront at the time of purchase and has no future payment 27 obligations to the counterparty, is referred to herein and in the Motion as a "Straight Option 28 Transaction", and the product so purchased is referred to as a "Straight Option". DECLARATION OF MICHAEL J. DONNELLY

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1 Combination. Notional Amount and Timing of Interest Rate Hedges 2

18.

PG&E may choose to enter into combinations of the above-described Interest 3

Rate Hedges. For example, PG&E may purchase a floor in combination with a forward rate 4

agreement to limit to a defined dollar amount any potential settlement payment to the 5

counterparty that would be required. In this scenario, if interest rates were to decrease, the 6

floor would protect against the significant settlement payment that would otherwise be 7

required as a result of a precipitous interest rate drop. The premium on the floor would 8

either be paid upfront or embedded into the forward rate agreement by increasing its fixed 9

contractual rate. Additionally, PG&E might utilize a combination of floors and caps to 10 create a collar-a limitation on interest costs to a pre-defined range.

11

19.

PG&E is seeking approval to transact up to $7.4 billion in notional amount of 12 Interest Rate Hedges, although the notional amount of the actual Interest Rate Hedges may 13 be less. This maximum $7.4 billion in notional amount would cover all or a substantial 14 portion of the principal amount of long-term fixed rate debt anticipated to be issued by 15 PG&E under its reorganization plan.

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20.

Other than a Straight Option Transaction, for all other types of Interest Rate 17 Hedges a payment may be due from either party to the other upon the settlement/maturity 18 date of the transactions (all such other types of Interest Rate Hedges being referred to in the 19 Motion and herein as 4'Performance Interest Rate Hedges").5 To maximize the benefits to 20 PG&E from any Performance Interest Rate Hedges, the ending date should be selected with 21 reference to the anticipated time of issuance of the implementation financing for PG&E's 22 reorganization plan, but with some reasonable flexibility for slippage.6 While the precise 23 51t is critical to this definition of "Performance Interest Rate Hedges" that a payment 24 may be due from either party to the other upon the maturity or earlier termination of the hedge. Accordingly, a Straight Option Transaction is not a Performance Interest Rate Hedge 25 because although PG&E's counterparty to a Straight Option Transaction may have a payment obligation to PG&E upon the exercise o the option, PG&E would not have any 26 potential payment obligation to the counterparty beyond the purchase price that is paid in full by PG&E "up front" at the time the Straight Option is purchased.

27 6See footnote 1 above for an explanation of the justification for permittin PG&E to 28 enter into Interest Rate Hedges and Hedge Agreements with settlement (and, in e case of (continued... DECLARATION OF MICHAEL J. DONNELLY

1 date of such financing implementation is uncertain, PG&E belives that the relatively low 2

forward interest rates available today with respect to the approximate period when PG&E 3

expects to implement financing under its reorganization plan, coupled with the risk of 4

increasing interest rates, justify entering into any Performance Interest Rate Hedges and 5

corresponding Hedge Agreements before the precise reorganization plan financing 6

implementation date is determined.

7

21.

If the implementation financing occurs prior to a Performance Interest Rate 8

Hedge's settlement date, the Performance Interest Rate Hedge can be unwound early or sold.

9 In the case of a forward rate agreement, the settlement amount would then be based upon the 10 difference between the Performance Interest Rate Hedge's contractual interest rate and the 11 then-effective forward rate as determined by the capital markets. For example, if the 12 implementation financing occurred three months prior to the Performance Interest Rate 13 Hedge's settlement date, then the settlement amount would be based on the difference 14 between the contractual interest rate and the three-month forward interest rate at the time of 15 the unwind.

16

22.

PG&E seeks authority to enter into Interest Rate Hedges and corresponding 17 Hedge Agreements with settlement dates (in the case of Performance Interest Rate Hedges) 18 and expirations dates (in the case of Straight Option Transactions) through June 30, 2004, 19 while reserving all rights to seek additional authority with respect to the Interest Rate 20 Hedges and corresponding Hedge Agreements, as appropriate. For example, if it becomes 21 clear that the PG&E Plan is not likely to be confirmed and become effective by June 30, 22 2004, PG&E expects to seek authority to enter into one or more new Interest Rate Hedges 23 and corresponding Hedge Agreements with a new settlement/maturity date (in the case of a 24 Performance Interest Rate Hedge) or expiration date (in the case of a Straight Option 25 Transaction), depending on market conditions at that time. Alternatively, if it is determined 26

(... continued) 27 Straight Option Transactions, expiration) dates a modest period beyond the anticipated 28 Effective Date of the PG&E Plan. DECLARATION OF MICHAEL J. DONNELLY

1 that it is appropriate to terminate a Performance Interest Rate Hedge, then such Performance 2

Interest Rate Hedge could be unwound prior to its original maturity date.

3 4

Sensitivity Analysis With Respect To The Interest Rate Hedges Based on Changes in Market Rates

23.

On the settlement date of a Performance Interest Rate Hedge, one party 6

typically pays the other party a certain amount pursuant to the agreement based on the difference between the contract and market rates of interest. If the market interest rate fell 8

below the Performance Interest Rate Hedge contract rate, PG&E would make an appropriate 9

payment to the counterparty out of cash on hand and issue additional debt pursuant to its 10 reorganization plan. The cost of this additional debt would be expected to be effectively 11 offset by the lower interest rate on the long-term debt to be issued by PG&E pursuant to its 12 reorganization plan. Conversely, if the market interest rate increased above an Interest Rate 13 Hedge contract rate (including either a Performance Interest Rate Hedge or a Straight 14 Option), the counterparty would make appropriate payment to PG&E, thereby increasing 15 PG&E's cash on hand and presumably decreasing the amount of debt to be issued pursuant 16 to the reorganization plan, which would be expected to reduce the overall interest expense 17 on such debt issued at the then-applicable market rate.

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24.

PG&E's potential risk and liability with respect to any Performance Interest 19 Rate Hedges and corresponding Hedge Agreements will necessarily be based on current 20 forward interest rates and volatility at the time that the Performance Interest Rate Hedge is 21 commenced. Under recent market conditions, for a $1 billion forward contract on a 10-year 22 interest rate swap (designed to hedge against changes in the interest rate of securities with a 23 10-year maturity) at a fixed contractual rate of 5.27%, a decline in the swap rate to 4.27%

24 would result in PG&E paying approximately $80.7 million to the counterparty. Conversely, 25 an increase of in the swap rate from 5.27% to 6.27% would result in the counterparty paying 26 approximately $73.5 million to PG&E.

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25.

This would indicate that if PG&E were to enter into comparable hedging 28 DECLARATION OF MICHAEL J. DONNELLY

1 transactions with a notional amount aggregating approximately $7.4 billion (the maximum 2

authority sought by the Motion), its potential liability would amount to close to $600 million 3

for a decline in interest rates of 100 basis points.7 However remote the possibility of such a 4

decline in interest rates when rates are already near historic lows, PG&E would not be 5

comfortable undertaking anywhere near this level of risk. Accordingly, PG&E intends to 6

engage in transactions which would limit its potential liabilities under any and all Interest 7

Rate Hedges to no more than $90 million in the aggregate, and PG&E by the Motion 8

therefore seeks authority to enter into Interest Rate Hedges and Hedge Agreements in a 9

-notional amount of up to $7.4 billion outstanding at one time, provided that PG&E in so 10 doing uses devices that limit its maximum liability to an aggregate of $90 million. P&E 11 believes that this $90 million maximum liability amount provides PG&E with adequate 12 authority to carry out a reasonable hedging program to carry out the objectives of the 13 Motion.9 14

26.

In addition to considering PG&E's maximum potential liability under the 15 proposed Interest Rate Hedges, it is important to consider the potential impact of not 16 17 rate.For technical reasons, the impact is not completely proportional to the change in rates. For example, a decline in interest rates of 50 basis points would result in a potential liability of approximately $290 million, and decline in interest rates of two hundred basis 18 points would result in a potential liability of aproximately $1.25 billion. In any event, the exact nature and structure of the Interest Rate~edges that PG&E enters into may be 19 different from the examples contained in the Motion.

20 8This maximum $90 million amount includes the aggregate of (a) the costs of the hedging devices that PG&E may utilize to limits its potential liability under the Interest Rate 21 Hedges, (b) PG&E's potential liability to counterparties under the Interest Rate Hedges and corresponding Hedge Agreements resulting from changes in applicable interest rates, and 22 (c) the purchase price for any Straight Options).

9Using a $7.4 billion aregate notional amount of comparable hedging transactions, an increase in interest rates of basis points above a locked-in rate for a Performance 24 Interest Rate Hedge or a strike rate in a Straight Option Transaction would result in the hedging counterparties having payment obligations to PG&E aggregating approximately 25

$500 million. Because, theoretically, there is no limit to the amount that interest rates can increase, there is no upper limit to the hedging counterparties' potential obligations to 26 PG&E. For this reason, and in order to the address and mitigate the risk of any counterparty not being able to perform its obligations upon the settlement of any interest rate hedge transaction, PG&E is requiring that, subject to negotiated uncollateralized thresholds, each 27 hedging counterparty's potential obligations to PG&E under the Interest Rate Hedges be 28 secured by collateral consisting of cash or relatively liquid securities. DECLARATION OF MICHAEL J. DONNELLY

1 entering into Interest Rate Hedges in the current favorable interest rate environment. If 2

PG&E does not enter into any Interest Rate Hedges and PG&E issues the maximum 3

potential $7.4 billion amount of fixed-rate debt anticipated under the PG&E Plan; each 4

increase of 200 basis points in interest rates would increase PG&E's annual pre-tax interest 5

expense by $148 million. Assuming (for illustration purposes only) that the maturities of all 6

fixed-rate debt issued under the PG&E Plan were 10 years, such an unhedged 200-basis-7 points increase in interest rates would amount to additional interest expense to PG&E with a 8

present value of approximately $1 billion. Under any reasoned analysis, PG&E believes 9

that it is sound business judgment to use the available financial tools to hedge against this 10 interest rate risk, particularly in view of the currently low market interest rates. PG&E 11 believes that this risk mitigation benefits the bankruptcy estate and interested parties alike.

12 Counterparties for the Interest Rate Hedges and Hedge Agreements 13

27.

Consistent with the Settlement Agreement that is the basis for the PG&E Plan 14 (a copy of which is attached as Exhibit D to the PG&E Plan), PG&E has agreed to name 15 UBS Securities LLC and Lehman Brothers Inc. as exclusive book runners, lead managers 16 and hedging providers of all financings pursuant to the PG&E Plan with equal economics for 17 80 percent of the aggregate total fees and commissions payable on such financings.' 0 18 Accordingly, PG&E anticipates that Lehman Brothers Special Financing Inc., together with 19 Lehman Brothers Holdings Inc., as guarantor, or any affiliates thereof agreed to in writing 20 by PG&E (collectively, "Lehman") and/or UBS AG or any affiliates thereof agreed to in 21 writing by PG&E (colleedtively, "UBS") will be PG&E's counterparties with respect to 80 22 percent of the Interest Rate Hedges, provided that such Interest Rate Hedges and 23 corresponding Hedge Agreements are on commercially reasonable terms and rates. PG&E 24 under all circumstances may enter into Interest Rate Hedges and Hedge Agreements with 25 any institutional counterparties for the remaining 20 percent of the hedging transactions.

26 27 10PG&E also has been directed by the Commission to work with UBS Securities LLC in Commission Decision 02-11-030 on implementation financing for PG&E's 28 emergence from Chapter 11. DECLARATION OF MICHAEL J. DONNELLY

of~~~~

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1 ^

28.

To the extent that PG&E enters into Interest Rate Hedges and Hedge 2

Agreements with Lehman and/or UBS, PG&E notes that affiliates of such parties (iLe.,

3 Lehman Brothers Inc. and UBS Securities LLC) are acting as the financial advisor and 4

capital markets arranger to PG&E and the Commission, respectively. PG&E also notes that 5

it anticipates that the function of "Calculation Agent" under any Interest Rate Hedge and 6

Hedge Agreement that PG&E enters into - i.e., the agent that performs certain settlement 7

calculations under a Hedge Agreement, except if a defined "Event of Default" or 8

"Termination Event" occurs, in which case the calculations are performed by the non-9 defaulting party (in the case of an Event of Default) or the non-affected party (in the case of 10 certain Termination Events) under the applicable Hedge Agreement -

may be performed by 11 one of the parties to the Hedge Agreement or an independent third party. These matters are 12 still under discussion and have not been finally determined. Thus, it is possible that under 13 certain circumstances Lehman, UBS, or other counterparties may act as the Calculation 14 Agent under one or more Hedge Agreements pertaining to one or more Interest Rate Hedges, 15 and in such role would be responsible for the calculation of certain settlement amounts with 16 respect to those Interest Rate Hedges. In any event, each counterparty acting as a 17 Calculation Agent is obligated to perform its calculations in good faith and in a 18 commercially reasonable manner.

19

29.

PG&E has been advised by Lehman Brothers that, consistent with what the 20 financial markets would require for financial institutions to enter into these types of complex 21 finance-related-agreements with a Chapter 11 debtor, the Hedge Agreements pertaining to 22 one or more Interest Rate Hedges will require the Bankruptcy Court to have entered a final 23 order (in form and substance satisfactory to the institutional counterparty):

24 (1) Authorizing PG&E to enter into the Interest Rate Hedges and the 25 corresponding Hedge Agreements, and, with respect to any Performance Interest Rate Hedge 26 and corresponding Hedge Agreements, to incur secured debt pursuant to Bankruptcy Code 27 Section 364(d);

28 (2) Finding that the counterparty to each Hedge Agreement pertaining to a DECLARATION OF MICHAEL J. DONNELLY

1 Performance Interest Rate Hedge is extending credit to PG&E in good faith within the 2

meaning of Bankruptcy Code Section 364(e);'1 and 3

(3) Authorizing the counterparty to each Hedge Agreement to exercise its rights 4

and remedies under the Hedge Agreement(s) with such counterparty, notwithstanding the 5

automatic stay provisions of Bankruptcy Code Section 362.12 6

Secured Debt Requirements Related to the Interest Rate Hedges 7

30.

As a matter of prudent business practice, and consistent with PG&E's risk 8

management policies and practices with respect to hedge counterparties, PG&E expects to 9

require its counterparties to post collateral to secure their potential payment obligations to 10 PG&E with respect to certain Interest Rate Hedges based on market movements adverse to 1 1 the counterparty's position, which obligations may be quite substantial. PG&E believes and 12 represents that if PG&E so requires its hedge counterparties to post collateral, the 13 counterparties will require PG&E to post collateral to secure PG&E's potential payment 14 obligations to the counterparty with respect to Performance Interest Rate Hedges based on 15 market movements adverse to PG&E's position.

16

31.

For example, in the situation where the market interest rate rises above the 17 rate used in a Performance Interest Rate Hedge, the counterparty may need to post collateral 18 in an amount that represents all or a portion of the payment to PG&E that would be due if 19 20 "As discussed above, PG&E also may enter into Interest Rate Hedges and Hedge Agreements with other institutional counterparties (each an "other institutional 21 counterpart?'). PG&E understands that any such other institutional counterparty, like Lehman and UBS, will require a "good faith" determination pursuant to Baptcy Code 22 Section 364(e) as a condition to entering into any Performance Interest Rate Hede and corresponding Hedge Agreement with PG&E. Because all such other institutional 23 counterparties have not yet been selected, to facilitate such other counterparties entering into Hedge Agreements with PG&E consistent with the Motion, PG&E as part of the Motion has 24 proposed a streamlined procedure for such proposed other counterparties to seek and obtain a good faith determination pursuant to Barptcy Code Section 364(e).

25 12 As will be provided in the Hedge Agreements pertaining to any Performance Interest Rate Hedges, time is of the essence in respect of any payment or collateral-posting 26 obligations due from PG&E or any applicable counterparty. Accordingly, each of PG&E aid any applicable counterparty shall be entitled to demand and receive prompt pa ent of 27 collateral calls and termination payments in accordance with the provisions o the edge 28 Agreements pertaining to Performance Interest Rate Hedges. DECLARATION OF MICHAEL J. DONNELLY

1 the hedge were to cash settle on the exposure measurement date. Conversely, in the 2

situation where the forward interest rate curve drops below the forward rate used in a 3

Performance Interest Rate Hedge, PG&E may be required to post collateral that represents 4

the payment to the counterparty that would be required if the hedge were to cash settle on 5

the exposure measurement date.

6

32.

As part of the Motion, PG&E seeks authorization to enter into Performance 7

Interest Rate Hedges and corresponding Hedge Agreements with collateral-posting 8

requirements, granting liens on collateral in favor of the counterparties, and obtaining liens 9

-on collateral from the counterparties (and, with respect to Straight Option Transactions, 10 obtaining liens on collateral from the counterparties), as follows: PG&E would be required 11 to post collateral from time to time to the extent of PG&E's potential payment obligations as 12 a result of changes in applicable market interest rate parameters in any Performance Interest 13 Rate Hedges, and would be entitled to the return of collateral from time to time to the extent 14 that PG&E potential payment obligations dropped below the amount of collateral then 15 posted as a result of changes in applicable market interest paramters.

16

33.

Lehman, UBS and any other counterparty under any Interest Rate Hedge and 17 corresponding Hedge Agreement would each have an uncollateralized exposure threshold 18 (the "Counterparty Collateral Threshold"), as follows: if a counterparty or the guarantor of 19 such counterparty's obligations under the Hedge Agreements(s) with such counterparty (a 20 "Guarantor") has a long-term senior unsecured debt rating (a "Rating") of at least "AAA" 21 from Standard & Poor's ("S&P") and "Aaa" from Moody's Investor's Service Inc.

22

('Moody's"), the Counterparty Collateral Threshold for such counterparty shall be $60 23 million; if a counterparty or its Guarantor has a Rating of (or, after entering into a Hedge 24 Agreement with PG&E, such counterparty's or such Guarantor's Rating is reduced to) 25 anywhere from "AA+" through "AA-" from S&P and anywhere from "Aal" through "Aa3" 26 from Moody's, then the Counterparty Collateral Threshold for such counterparty shall be 27

$40 million; if a counterparty or its Guarantor has a Rating of (or, after entering into a Hedge 28 Agreement with PG&E, such counterparty's or its Guarantor's Rating is reduced to) DECLARATION OF MICHAEL J. DONNELLY

)

1 anywhere from "A+" through "A-" from S&P a anywhere from "Al" through "A3" from 2

Moody's, then the Counterparty Collateral Threshold for such counterparty shall be $20 3

million; and if a counterparty and its Guarantor has a Rating of (or, after entering into a 4

Hedge Agreement with PG&E, such counterparty's or its Guarantor's Rating is reduced to) 5 below "A-" from S&P or below "A3" from Moody's, the Counterparty Collateral Threshold 6

for such counterparty shall be zero.13 7

34.

Based on PG&E's maximum obligations under the Interest Rate Hedges as 8

discussed above, PG&E by the Motion seeks authority to utilize up to $90 million in cash or 9

cash equivalents for purposes of posting collateral with counterparties in connection with the 10 Performance Interest Rate Hedges and corresponding Hedge Agreements.'4 PG&E expects 11 to fund such collateral-posting requirements under the Hedge Agreements pertaining to 12 Performance Interest Rate Hedges from its cash and cash equivalents on hand.

13 Lien Of Indenture Trustee Under 1920 Indenture 14

35.

BNY Western Trust Company has a lien on substantially all of PG&E's real 15 and personal property in its capacity as the successor trustee (the "Indenture Trustee") under 16 that certain Indenture dated December 1, 1920 as amended to date (the "1920 Indenture"),

17 which is the subject of that certain "Stipulation (I) Authorizing and Restricting Use of Cash 18 Collateral Pursuant to 11 U.S.C. §363 and Bankruptcy Rule 4001 and (II) Granting 19 Adequate Protection Pursuant to 11 U.S.C. §§361 and 363" entered into between PG&E and 20 the Trustee on May 9, 2001, as amended to date (the "Cash Collateral Stipulation") and 21 approved by the Bankruptcy Court by its Order thereon dated the same date and by 22 13PG&E as a Chapter 11 debtor does not have a credit rating that would support any 23 collateral threshold for PG&E under this collateral threshold matrix. PG&E therefore has a collateral threshold of zero and, as set forth above, must fully secure its potential payment 24 obligations under the Performance Interest Rate Hedges and corresponding Hedge Agreements it enters into pursuant to the Motion.

25

' 4Such collateral posting obligation will include an "independent amount" that will be 26 based upon assessment of risk and volatility with respect to any-erformance Interest Rate 26 Hedge and PG&E's ability to fulfill its potential payment obligations on such hedge in the 27 event of a termination or default event with respect to PG&E. Consistent with the $90 million aggregate liability limitation, in no event can the total amount of collateral posted, 28 including the_'independent amount." exceed $90 million. DECLARATION OF MICHAEL J. DONNELLY

-?

1 subsequent Orders approving the amendments to the Cash Collateral Stipulation.

2

36.

PG&E believes the interest of the Indenture Trustee is fully secured and 3

adequately protected by a substantial equity cushion, as has been repeatedly demonstrated in 4

previous motions filed by PG&E in this case. As set forth in the Debtor's Operating Report 5

filed with this Court (Docket No. 13037), as of May 31, 2003, the Debtor's total reported 6

assets exceeded $26 billion (including cash on hand of approximately $3.5 billion), while the 7

Debtor's outstanding obligations under the mortgage bond indenture, which are secured by 8

substantially all of the Debtor's assets, aggregate approximately $3 billion.

9

37.

PG&E has had discussions with the Indenture Trustee concerning the Motion 10 and the use of cash collateral that it entails in order to provide security to the hedge 11 counterparties pursuant to Bankruptcy Code Section 364(d). The Indenture Trustee has 12 indicated that it has no objection to PG&E's filing of the Motion, but at the same time, 13 pending its further consideration of the relief requested, the Indenture Trustee has reserved 14 the right to object to the use of cash collateral and to require that PG&E carry its burden of 15 establishing that the Indenture Trustee's interests are adequately protected.

16

38.

As discussed above, as a matter of prudent business practices, and consistent 17 with PG&E's risk management policies concerning the obligations of its hedge 1 8 counterparties, PG&E expects to require its counterparties to post collateral to secure at least 19 a portion of their potential payment obligations to PG&E (subject to the Counterparty 20 Collateral Threshold as described above) with respect to certain Interest Rate Hedges based 21 on market movements adverse to the counterparty's position, and the counterparties in turn 22 will demand and require PG&E to post collateral to secure its potential payment obligations 23 to the counterparty with respect to Performance Interest Rate Hedges based on market 24 movements adverse to PG&E's position. Thus, PG&E is effectively unable to engage in 25 Performance Interest Rate Hedges unless it provides credit on a senior secured basis to its 26 counterparties as described above.

27

39.

PG&E believes that sound business justifications support PG&E's decision to 28 enter into the Interest Rate Hedges, as it deems appropriate, subject to the maximum $90 DECLARATION OF MICHAEL J. DONNELLY

?

1 2

3 4

5 6

7 8

9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 million limit. As discussed above, authorizing PG&E to enter into Interest Rate Hedges (particularly while forward interest rates are relatively low) will provide a tool to help protect PG&E from potential increases in interest rates that might occur before its reorganization plan is implemented, thereby mitigating against potentially higher borrowing costs that may prevail when new debt is issued under PG&E's reorganization plan. PG&E believes this will benefit the bankruptcy estate and interested parties.

I declare under penalty of perjury under the laws of the United States of America that the foregoing is true and correct. Executed this 29th day of August, 2003, at San Francisco, California.

MIC AL J. DONNELL WD 08290311-1419911/1099085 DECLARATION OF MICHAEL J. DONNELLY