8-K

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549

FORM 8-K

CURRENT REPORT PURSUANT TO SECTION 13 OR 15 (d) OF
THE SECURITIES EXCHANGE ACT OF 1934

Date of report (Date of earliest event reported): February 11, 2002

	Exact name of registrant as specified	I.R.S.
	in its charter, state of incorporation,	Employer
Commission	address of principal executive offices,	Identification
File Number	Telephone	Number

1-16305	PUGET ENERGY, INC.	91-1969407
	A Washington Corporation.
	411 - 108th Avenue N.E.
	Bellevue, Washington 98004-5515
	(425) 454-6363

1-4393	PUGET SOUND ENERGY, INC.	91-0374630
	A Washington Corporation
	411 - 108th Avenue N.E.
	Bellevue, Washington 98004-5515.

ITEM 5. Other Events

On December 3, 2001, Puget Sound Energy, Inc. (PSE) filed petitions for an interim electric-rate increase with the Washington Utilities and Transportation Commission (Washington Commission). The interim filing consisted of two parts: a request for deferral of projected under recovered power costs and a surcharge to rates. If approved by the Washington Commission, the surcharge of $170.7 million would remain in effect until new general rates are established in the Company’s general rate case filed November 26, 2001 (which by statute is not to exceed 11-months from the time of the filing).

On December 28, 2001, the Washington Commission authorized PSE to defer excess power costs beginning January 1, 2002 through March 31, 2002. The Washington Commission also stated that deferred power costs would be examined in the context of PSE’s request for interim rates. PSE will bear the burden to prove deferred costs should be recovered in customer rates.

On January 30, 2002, the Washington Commission’s staff (Staff) and the Washington State Attorney General’s Public Counsel section (Public Counsel) filed testimony in the interim rate proceeding. The Staff recommended an electric interim rate increase of $42 million. Public Counsel recommended denial of PSE’s request for interim rates or if the Washington Commission deemed some interim rate increase necessary, then an interim rate increase of no more than $29.3 million. Both the Staff and Public Counsel recommended the Washington Commission require Puget Energy to cut its common stock dividend as a condition of the interim rate increase.

In response to the testimony filed by the Staff and Public Counsel, PSE filed rebuttal testimony in the interim proceeding on February 11, 2002. Attached, as Exhibit 99.1 is the rebuttal testimony of Donald E. Gaines, Vice President and Treasurer, in which PSE presented a revised interim electric rate increase proposal. Under the revised proposal, PSE would recover the $170.7 million over a 19 ½-month period beginning March 15, 2002, instead of the eight-month period beginning March 1, 2002 under the original proposal. In addition, if PSE’s earns a rate of return in excess of its authorized return of 8.99% for the a 12-month period ending October 31, 2002, then the amount equal to the excess recovery will be refunded to customers. Also attached is the rebuttal testimony of William A. Gaines, Vice President Energy Supply and Gary B. Swofford, Vice President and Chief Operating Officer – Delivery as Exhibit 99.2 and Exhibit 99.3, respectively.

Hearing on PSE's interim rate increase will be held the week of February 18, 2002 with an expected decision by the Washington Commission on the interim rate increase before March 31, 2002.

Statement Regarding Forward-Looking Statements

Puget Energy and PSE are including the following cautionary statement in this Current Report on Form 8-K to make applicable and to take advantage of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 for any forward-looking statements made by or on behalf of Puget Energy or PSE.

This report contains forward-looking statements, which are statements of expectations, beliefs, plans, objectives, assumptions or future events or performance, including statements regarding the financial and other consequences to Puget Energy and PSE if PSE’s petition for interim electric-rate increase is not approved. Words or phrases such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “projects,” “will likely result,” “will continue,” or similar expressions identify forward-looking statements.

Forward-looking statements involve risks and uncertainties which could cause actual results or outcomes to differ materially from those expressed. Puget Energy’s and PSE’s expectations, beliefs and projections are expressed in good faith and are believed by Puget Energy and PSE, as applicable, to have a reasonable basis, including without limitation, management’s examination of historical operating trends, data contained in records and other data available from third parties, but there can be no assurance that Puget Energy’s and PSE’s expectations, beliefs or projections will be achieved or accomplished.

In addition to other factors and matters discussed elsewhere in this report, some important factors that could cause actual results or outcomes for Puget Energy and PSE to differ materially from those discussed in forward-looking statements include:

• the outcome and timing of general and interim rate cases filed by PSE with the Washington Commission on November 26, 2001 and December 3, 2001, respectively, which request electric and gas rate increases to address significant under-recovery of PSE’s projected power costs, among other issues;
  
• governmental policies and regulatory actions, including those of the Federal Energy Regulatory Commission (FERC) and the Washington Commission with respect to allowed rates of return, financings, industry and rate structures, acquisition and disposal of assets and facilities, operation and construction of plant facilities, recovery of purchased power and other capital investments, and present or prospective wholesale and retail competition;
  
• weather and hydroelectric conditions, which can have a potentially serious impact on PSE’s ability to procure adequate supplies of fuel or purchased power to serve its customers and on the cost of procuring such supplies;
  
• wholesale energy prices, including the effect of price controls promulgated in June 2001 by the FERC on the availability and price of wholesale power purchases and sales in the western United States;
  
• effect of wholesale and retail competition (including buy not limited to electric retail wheeling and transmission costs);
  
• changes in, and compliance with, environmental and endangered species laws and policies;
  
• industrial, commercial and residential growth and demographic patterns in the service territories of PSE;
  
• the loss of any significant customer, or changes in the business of a major customer that may result in changes in demand for services of PSE;
  
• the impact of significant events, such as the attack on September 11, 2001;
  
• the ability of Puget Energy and PSE to access the capital markets to support requirements for working capital, construction costs and the repayment of maturing debt;
  
• capital market conditions, including changes in the availability of capital or interest rate fluctuations;
  
• changes in Puget Energy’s or PSE’s credit ratings, which may have an adverse impact on the availability and cost of capital;
  
• legal and regulatory proceedings; and
  
• employee workforce factors, including strikes, work stoppages or the loss of a key executive.

Any forward-looking statement speaks only as of the date on which such statement is made, and, except as required by law, Puget Energy and PSE undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events. New factors emerge from time to time and it is not possible for management to predict all such factors, nor can it assess the impact of any such factor on the business or the extent to which any factor, or combination of factors, may cause results to differ materially from those contained in any forward-looking statement.

ITEM 7 Exhibits

Exhibit 99.1 - Rebuttal testimony of Donald E. Gaines, Vice President and Treasurer of Puget Sound Energy, Inc.

Exhibit 99.2 - Rebuttal testimony of William A. Gaines, Vice President Energy Supply of Puget Sound Energy, Inc.

Exhibit 99.3 - Rebuttal testimony of Gary B. Swofford, Vice President and Chief Operating Officer - Delivery of Puget Sound Energy, Inc.

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.

PUGET ENERGY, INC.

PUGET SOUND ENERGY, INC.

/s/ James W. Eldredge            

James W. Eldredge
Corporate Secretary and Chief Accounting Officer

Date: February 13, 2002

EX-99

EXHIBIT 99.1

EXHIBIT NO. ______ (DEG-5T)
DOCKET NO. UE-011570 (INTERIM)
WITNESS: DONALD E. GAINES

BEFORE THE
WASHINGTON UTILITIES AND TRANSPORTATION COMMISSION

WASHINGTON UTILITIES AND
AND
TRANSPORTATION COMMISSION,

           Complainant,

v.

PUGET SOUND ENERGY, INC.,

           Respondent.

REBUTTAL TESTIMONY OF DONALD E. GAINES
ON BEHALF OF PUGET SOUND ENERGY, INC.

FEBRUARY 11, 2002

PUGET SOUND ENERGY, INC.

DIRECT TESTIMONY OF DONALD E. GAINES

I. INTRODUCTION AND BACKGROUND

Q: Please state your name, business address, and position with Puget Sound Energy, Inc.

A: My name is Donald E. Gaines. My business address is P.O. Box 97034 OBC-15, Bellevue, WA 98009-9734. I am Vice President & Treasurer at Puget Sound Energy, Inc. ("PSE" or the "Company" hereinafter).

Q: Have you submitted direct testimony in this proceeding?

A: Yes, I have. I adopted the testimony of Richard L. Hawley and exhibits thereto Exhibits RLH-1T, and RLH-2 through RLH-4. I have submitted revised versions of that testimony, which include my position and background duties. My direct testimony is now found in Exhibits DEG-1T, and DEG-2 through DEG-4.

Q: How is your testimony organized?

A: Part I of my testimony responds to issues raised by Washington Utilities and Transportation Commission staff witnesses, Ms. Lisa A. Steel and Mr. Merton R. Lott (“Staff”), and by Public Counsel’s witness, Mr. Stephen G. Hill, concerning the need for and the amount of interim relief requested by the Company. Part I of my testimony also presents a revised proposal for interim relief.

        Part II of my testimony responds to a number of specific issues raised by Staff and Mr. Hill. In preparing this testimony, I sought to address all issues of consequence. Due to the volume of the testimony and exhibits presented by other parties, and the limited time available to respond, it should not be assumed or concluded that I either admit to or agree with any testimony or exhibit submitted by or on behalf of Staff, Public Counsel, or any other party due to the fact that I have not specifically addressed such testimony or exhibit in my rebuttal testimony.

        Part III of my testimony responds to specific arguments made by Staff and Mr. Hill as to the responsiveness of the evidence presented in this proceeding to the six factors to be considered in the analysis of a request for interim relief identified in WUTC v. Pacific Northwest Bell Telephone Company, Cause No. U-72-30, Second Supplemental Order Denying Petition for Emergency Rate Relief (October 1972) (the “PNB” decision).

Q: What are the primary conclusions to be drawn from your testimony?

A: The Company has requested a surcharge in an amount that is necessary to restore the Company's financial integrity for the interim period. Absent such relief:

• PSE will not be able to issue First Mortgage Bonds (April 02)
  
  
• PSE’s stock will be extremely difficult to sell in significant quantities
  
  
• at a price that would be considered fair to existing shareholders (April 02)
  
  
• PSE's credit rating will be downgraded to "junk" status (April 02)
  
  
• PSE's access to wholesale energy markets will become untenable (April 02)
  
  
• PSE will exceed its short-term borrowing limits (June 02)

Interim relief is necessary to restore the Company’s financial health and avoid the corresponding hardships and inequities to the Company, its customers, and its investors.

        To prevent these hardships and inequities from occurring, and in order to mitigate near-term rate impacts on customers, PSE has revised its interim relief proposal to spread the recovery of the $170 million over two distinct periods. During the period from March 15, 2002 through October 31, 2002, approximately $136 million of the $170 million would be recovered through a surcharge in rates. The remaining $34 million of the $170 million would be deferred and subsequently recovered over a one-year period, commencing on November 1, 2002. To be consistent with the Order Granting Accounting Petition, Docket No. UE-011600 (December 28, 2001) (“Accounting Order”) (allowing for the deferral of certain power costs), recovery of the proposed $170 million surcharge would be adjusted to reflect PSE’s actual net unrecovered power costs for the interim period. The proposal also includes a rate cap to ensure that there is no possibility for the Company to over-earn for the 12 months ending December 31, 2002.

        My testimony also responds to various arguments forwarded by the parties that the Company is not truly facing a financial crisis. In response to these arguments and the PNB analysis, the facts are:

• Interest coverage:  The Company’s pre-tax interest coverage ratio is projected to be 1.2 without interim relief, deteriorating to a level below the benchmark for a BB rated utility.
  
  
• Funds from Operations to Total Debt:   The Company’s funds from Operations to Total Debt percentage is projected to decline to 13.8% without interim relief, deteriorating to a level below the benchmark for a BB rated utility.
  
  
• Funds from Operations Interest Coverage:  The Company’s funds from operations interest coverage ratio is projected to be 2.8 without interim relief, deteriorating to a level within the range for a BB rated utility.
  
  
• Total Debt to Average Total Capital:  The Company’s Total Debt to Average Capital percentage is projected to increase to 64.2% without interim relief, deteriorating to a level below investment grade.
  
  
• Creditworthiness:  In view of these ratios, the Company is facing downgrades to "junk" status if the requested relief is not provided.
  
  
• Indenture Coverage Ratio:  The Company’s indenture coverage ratio is projected to be 1.6 without interim relief, deteriorating to a level below that required by the Company’s First Mortgage Bond covenant, prohibiting the issuance of First Mortgage Bonds.
  
  
• Rate of Return: The Company’s rate of return for the interim period will be 5.55%, well below its authorized rate of return of 8.99%. This is a 38% shortfall.
  
  
• Erosion of Equity: Investor equity in the Company is being eroded by the under-recovery of power costs at an average of nearly $13 million per month, a devastating impact to investors that will continue without interim relief. These deteriorating financial indices and eroding equity effectively preclude the Company from accessing needed capital from secured debt or equity markets and preclude the Company from accessing capital from other markets on reasonable terms.

        My testimony also responds to various arguments forwarded by the parties that the Company, its customers, and its investors will not be harmed if the requested relief is not granted. If the requested relief is not granted, there will be:

• Clear jeopardy to the utility: PSE will continue to suffer from unrecovered power costs at a rate of $625,000/day, with no offsetting revenues. The alarming erosion of equity will continue. The Company will be left in a position where it cannot issue First Mortgage Bonds and will exceed its short-term credit limits. The Company will experience further downgrades of its creditworthiness, likely to “junk” status.
  
  
• Detriment to Customers:As stated in the Direct and Rebuttal Testimony of Gary B. Swofford, customers will suffer from a reduced quality and reliability of services. As stated in the Direct and Rebuttal Testimony of William A. Gaines, if the Company’s creditworthiness falls to junk, the Company’s access to wholesale energy markets will become untenable. Further eroding the Company’s financial structure will, at a minimum, increase the cost of capital (and therefore the cost of service to our customers), deprive them of the benefit of the Company’s access to reasonably priced debt (e.g., no First Mortgage Bonds), and leave the Company with either no access to equity markets at all or limited access at an extremely high cost.
  
  
• Detriment to Investors: As stated in my direct testimony, Exhibit DEG-1T at pages 4-5, each month of under-recovery of power costs confiscates huge amounts of our equity investors’ existing investment in the Company, averaging nearly $13 million per month and totaling $179 million over the period on an after-taxes basis. This confiscation in book equity is in addition to the market losses which equity investors have suffered. Bondholders have also been harmed with a loss in value of their investments and will lose more value if the Company’s credit rating is downgraded to junk status.

        The “public interest” is, to my understanding, the overriding factor to be considered in an interim case. Preventing the above-described hardships and detriments to the Company, its customers, and its investors is in the public interest. To prevent these things from occurring, the Company needs cash and earnings that will restore its financial health. PSE needs the relief that it has requested.

II. PSE NEEDS INTERIM RELIEF IN ORDER TO
RESTORE AND PRESERVE FINANCIAL INTEGRITY

Q: How do you respond to the allegation that the Company "ties its entire surcharge to full recovery of a single item: power supply costs in excess of the costs the Company states are embedded in its general rates"? Exhibit LAS-1T) at page 6, --------------- lines 15-16.

A: This allegation misinterprets the Company’s request for interim relief. The Company has requested a surcharge in an amount that is necessary to restore the Company’s financial integrity for the interim period. Staff has confused the source of the problem (near-term power costs) with the consequences of the problem (impending financial disaster). Identification of under-recovered power costs as the root cause of the problem spotlights the driver of the current financial condition that, based upon short-term financial forecasts, places the Company at the brink of financial disaster. Characterizing the Company’s evidence as just a presentation of power cost issues overlooks the substantial evidence the Company has presented showing its rapidly deteriorating financial condition and the consequences thereof to the Company, its customers, and its investors. This evidence presents the entire cost structure and shows that there are no offsetting current or projected savings in other areas that can meaningfully address the Company’s financial crisis.

Q: How do you respond to the allegation that “[t]he Company does not tie its surcharge to a specific measure of the Company’s overall financial health, or to a measure required for the Company to continue to issue debt necessary to carry out its public service obligations”? Exhibit LAS-1T at page 6, lines 16-19.

A: The requested surcharge amount ($170 million) is tied directly to the need to restore the Company’s financial integrity and thereby avoid hardships and inequities to the Company, its customers, and its investors. The sources and uses of capital during the interim period, as discussed in the Company proposal, are summarized in Table I below:

Table I
(Dollars in Thousands)

	2002 (without relief)	2002 (with relief)
Sources:     Internal Cash     Outside Financing     Total Sources	$348 $282 $630	$456 $174 $630
Uses:     Redemptions     Construction     Preferred Dvds     Common Dvds     Total Uses	$205 $256 $8 $161 $630	$205 $256 $8 $161 $630

As shown in Table I, the Company needs additional revenues in the amount requested to cover net power costs and reduce its outside financing needs. Table II relates this amount to specific measures of the Company’s overall financial health:

Table II
(Dollars in Thousands)

	No Relief	Relief
Interim Relief Capital Needs Short-Term Debt (10/02) Issue Secured Bonds Credit Rating Debt Ratio (10/02)	0 $282 $518 ($143 over limit) No Junk ("BB+" or less) 64.2%	$170 $174 $397 ($26 over limit) Yes "BBB-" 61.5%

If the relief requested is not provided, I anticipate the following consequences will occur:

• PSE will not be able to issue First Mortgage Bonds (April 02)
  
  
• PSE's stock would be extremely difficult to sell in significant quantities at a price that would be considered fair to existing shareholders (April 02)
  
  
• PSE's credit rating will be downgraded to "junk" status (April 02)
  
  
• PSE's access to wholesale energy markets will become untenable (April 02)
  
  
• PSE will exceed its short-term borrowing limits (June 02)

Q: Does PSE have any adjustments to its request for interim relief?

A: Yes. Concerns were raised regarding the near-term rate impacts on customers. Exhibit DWS-1T at page 22. In order to mitigate near-term rate impacts on customers, PSE revised its interim relief proposal to spread the recovery of the $170 million over two distinct periods. During the period from March 15, 2002 through October 31, 2002, approximately $136 million of the $170 million would be recovered through a surcharge in rates. The remaining $34 million of the $170 million would be deferred and subsequently recovered over a one-year period, commencing on November 1, 2002. To be consistent with the Accounting Order, recovery of the proposed $170 million surcharge would be adjusted to reflect PSE's actual net unrecovered power costs for the interim period. If, however, the Commission determines that a fixed surcharge of $170 million is appropriate, the fixed surcharge may be determined on the basis of the power cost forecast initially provided in the Direct Testimony of William A. Gaines.1 The proposal includes a rate cap to ensure that there is no possibility for the Company to over-earn for the 12 months ending December 31, 2002.

         This proposal levels the rate impacts of proposed interim and general rate increases to customers. Specifically, recovery of the $136 million over the March 15 -- October 31 period results in an approximately 20% overall rate impact. Recovery of the $34 million over the November 1, 2002 -- October 31, 2003 period, when combined with the proposed general rate increase of 16.5%, also produces an overall impact on rates for this time period of approximately 20%. Thus, if adopted, customers' rates are expected to be relatively level over the 19-1/2 month period for recovery of interim relief. The mechanics of this proposal are described in the Rebuttal Testimony of Barbara Luscier.

Q: How does this adjusted proposal address PSE's financial problems?

A: The proposal addresses the Company's near-term cash needs, as explained in more detail below. The proposal also addresses the Company's immediate financial needs by stopping the erosion of earnings through the deferral mechanism. In order to achieve this objective, the recovery of these deferred dollars would need to be assured, so that the Company can book earnings and thereby stop the erosion of equity.

         The revised proposal also takes account of an $80 million reduction in the need for external capital by foregoing elective redemptions of debt. The effects of the proposal on the Company's financial condition are set forth in Tables III and IV below:

Table III
(Dollars in Thousands)

	2002 (without relief)	2002 (with relief)	2002 (revised)
Sources:     Internal Cash     Outside Financing     Total Sources	$348 $282 $630	$456 $174 $630	$423 $127 $550
Uses:     Redemptions     Construction     Preferred Dvds     Common Dvds     Total Uses	$205 $256 $8 $161 $630	$205 $256 $8 $161 $630	$125 $256 $8 $161 $550

Table IV
(Dollars in Millions)

	No Relief	Full Relief	Revised Relief
Interim Relief Capital Needs Short-Term Debt (10/02) Issue Secured Bonds Credit Rating Debt Ratio (10/02)	0 $282 $518 ($143 over limit) No Junk ("BB+" or less) 64.2%	$170 $174 $397 ($26 over limit) Yes "BBB-" 61.5%	$136 ($34 deferred) $127 $350 ($25 under limit) Yes "BBB-" 61.8%

Q: How do you respond to some of the specific recalculations performed by Staff and Public Counsel? Exhibit LAS-4C; Exhibit LAS-3; Exhibit LAS-14; Exhibit LAS-15C; Exhibit SGH-T-C at pages 12, 31-32.

A: Ms. Steel’s calculation is primarily focused on PSE’s short-term credit capacity as a means of providing additional sources of funds for the uses identified above. This overlooks the consequences of such additional borrowing upon the ongoing erosion of equity. However, even if you focus on short-term debt as the primary source of funds to be applied to financial needs during the interim period, Ms. Steel’s calculation misstates the amount of relief needed due to the following errors. With respect to Ms. Steel’s calculations on Exhibit LAS-14, she has: (1) started with the incorrect short-term debt balance; (2) inappropriately deducted current maturities from long-term debt; (3) neglected to gross up her calculation of recommended interim relief for taxes; and (4) drawn upon unregulated capital to fund utility operations. Adjusting for the first three of these errors, her level of recommended relief increases from $42.3 million to $159.6 million, as can be seen in Exhibit DEG-6.

        Mr. Hill’s calculation of recommended interim relief is also flawed. Exhibit SGH-T at page 12. Like Ms. Steel’s recommendation, Mr. Hill overlooks the consequences of additional borrowing upon the ongoing erosion of equity. He purports to provide only that amount of interim relief needed for the Company to maintain a 2.0 times indenture coverage ratio. His calculation inappropriately uses operating income as the numerator for this ratio, rather than net earnings available for interest. In addition, the October 2002 operating income figure is misstated by $10 million and Mr. Hill neglects to adjust for revenue-sensitive items. Adjusting for these errors, Mr. Hill’s recommended level of relief would move from $29.3 million (30.1 as revised by Public Counsel responses to PSE-18-I) to $70.5 million, as can be seen in Exhibit DEG-7. Mr. Hill does not show how his recommended level of relief would result in the Company having the ability to finance.

Q: What is the relevance to your interim request of the financial ratios you have presented?

A: As noted above, Staff argues that the Company ties its entire surcharge to full recovery of a single item (power supply costs) and asserts that the Company does not volunteer cost saving offsets in other areas. Exhibit LAS-1T at pages 6-7. The Company has included a review of these financial ratios in support of this filing for three reasons. First, maintaining an indenture coverage ratio of 2.0 times coverage is strictly required in order to issue additional first mortgage bonds. Second, financial ratios are considered by rating agencies along with qualitative factors in determining the Company’s credit rating. As stated in my direct testimony, PSE is facing further downgrades if adequate interim relief is not provided. Looking forward, the Company’s financial ratios tell a dismal financial story as to key quantitative criteria of importance to rating agencies. Third, financial ratios are indicators of overall financial health called out in the PNB standard.

Q: Do you agree with Staff and Mr. Hill's assessment of these ratios? Exhibit LAS-1TC at pages 31-33; Exhibit SGH-T pages 25-26.

A: No. Although Staff and Mr. Hill do not dispute the calculation of these ratios, they contend that these ratios do not meaningfully support the Company’s request for relief. Exhibit LAS-1T at page 7, lines 7-14; Exhibit SGH-T at pages 24-26. Mr. Hill expects that, based on these ratios, the Company will not have its credit ratings downgraded below investment grade. Exhibit SGH-T at page 8, lines 11-24, and pages 25-26. Ms. Steel cannot predict. Exhibit LAS-1T at page 31, lines 3-4. Both Staff and Mr. Hill provide financial analysis that implies that even if a downgrade to “junk” status occurs, the financial consequences of such a downgrade (e.g., interest cost equivalent to junk) would not support interim relief. Exhibit LAS-13; Exhibit SGH-T at pages 8, 22, lines 14-19, and pages 25-29, Downgrade of the Company’s corporate credit rating to “junk” status would be disastrous and a very likely outcome if interim relief were only granted at the levels recommended by Staff and Mr. Hill.

        Staff and Mr. Hill also contend that breaking the Company’s First Mortgage Bond covenant is not relevant because the Company is not planning to issue First Mortgage Bonds during the interim period. Exhibit LAS-1T at page 17, lines 14-18, and page 38, lines 15-17; Exhibit SGH-T-C at pages 30-31. This overlooks the fact that the Company needs the ability to issue First Mortgage Bonds at all times to meet its financial needs, especially in times of fluctuating power costs and when facing financial crisis. It is appropriate to reduce debt when the Company’s financial strength is being rapidly eroded by costs over which it has no control. It does not make sense to allow one of the Company’s critical financing options to be lost and thereby eliminate needed financial flexibility.

        Finally, by examining these ratios in such a narrow context, Staff and Mr. Hill overlook the importance of the presentation of the overall financial health of the Company that these ratios provide. In sharp contrast, the PNB standard looks to these ratios for this very purpose.

Q: How do you respond to Mr. Hill's statement that a downgrade of the Company's Senior Securities to below investment grade status would not constitute clear jeopardy to the Company? Exhibit SGH-T at pages 9, 29.

A: I strongly disagree. Financing at a junk rating exposes customers to the vagaries and increased costs of the junk bond market. Mr. Hill inappropriately focuses on the Company’s bond rating while ignoring the detrimental impacts to its overall corporate credit rating. The Company’s senior securities bond rating is not the exclusive benchmark for determining the Company’s creditworthiness.

        The greater issue is the contention that junk status is acceptable for utilities providing essential public services in the State of Washington. PSE risks loss of access to debt capital if it is downgraded to junk because it may not always be able to market its bonds with that rating. Investors would prefer safer investments and, therefore, would be less inclined to invest in junk bonds.

        Second, the cost of junk bonds is excessive and unpredictable. As shown in the table on page 12 of my direct testimony in the general rate proceeding, Exhibit DEG-1T, the spread over treasuries of “BB” (junk) bonds has averaged 337 basis points since January 1993. The testimony of Mr. Hill states in footnote 9 at page 9 of Exhibit SGH-T that the current spread over treasuries of “BB+” (junk) rated debt is 445 basis points. To put these unreasonable costs in perspective, the spread over treasuries for “A” rated debt has averaged 87 basis points since January 1993. In other words, the cost of junk debt is more than four times that of “A” rated bonds.

        Third, at a time when it is critical to rebuild the Company’s equity, a downgrade to junk status will have a chilling effect on the cost and availability of equity capital. A junk bond rating means that investors project a much greater risk that the utility will default on its obligations to repay principal and interest to bondholders. Bondholders, of course, have a senior claim to shareholders on the assets of the company. As the risk of bond defaults rise, so do risks to the value of shareholder investments. As those risks rise, so do the equity returns required by investors.

        Fourth, as discussed in the Direct and Rebuttal Testimony of William A. Gaines, as a junk utility, PSE’s access to wholesale energy markets will become untenable. Impaired access to wholesale markets means that PSE will be constrained in its efforts to buy the power and gas that it needs to serve customers.

        Fifth, it is not good public policy to have two Washington-headquartered, investor-owned utilities regulated by this Commission operating at junk credit levels when the public utilities in the state operate with “A” ratings on average. This is bad policy and puts Washington state in a dim light in the eyes of investors.

Q: Do you agree with Staff and Mr. Hill's assertion that if less than the full amount of interim relief is granted, PSE will not be downgraded to junk?

A: No. Staff notes the risk of potential downgrades but falls short of making a specific prediction. Exhibit LAS-1T at page 31, lines 3-4. Staff acknowledges that credit ratings are based upon both quantitative and qualitative measures of a company’s financial health. Exhibit LAS-1T at page 30, line 18. Staff also notes that, for some time, the quantitative indicators of the Company’s creditworthiness have been below certain benchmarks. Exhibit LAS-1T at page 31, lines 8-10; Exhibit LAS-7C. As such, the Company was maintaining its “A”- credit rating (until October 2001) by reason of qualitative measures, such as good management and a supportive regulatory climate. If regulatory support in the way of adequate interim relief is not provided in this case, there is very little, if anything, in the way of quantitative or qualitative support for the Company’s financial integrity that would prevent multiple downgrades.

        Mr. Hill predicts that the Company will not be downgraded to junk status. Exhibit SGH-T at pages 8-9, 12. For the reasons noted above, this risky gamble is too optimistic at best and, given the writings of S&P and Moody’s, is probably wrong. Moreover, if such a downgrade were to occur, Staff states, “. . . ratings seem to fall faster than they rise,” Exhibit LAS-1T at page 30, line 21, a statement with which I agree. Therefore, the impact of downgrades to the Company and its ability to provide essential public service would likely extend well beyond the end of the interim period -- ramifications not taken into account by Staff and Mr. Hill.

Q: Staff and Mr. Hill both recommend lesser amounts of interim relief, and both recognize the need for the Company to strengthen its capital structure. Do you agree with these recommendations? Exhibit LAS-1T at page 43; Exhibit SGH-T at pages 50-51.

A: No, I strongly disagree with their recommended amounts of interim relief. In fact those recommendations are inconsistent. The recommendation that the amount of interim relief be limited so as to force the Company to incur greater debt is inconsistent with the important objective of restoring and rebuilding equity (which I do agree with). A recommendation that forces the Company to issue more debt may also be impossible to implement. As Staff and Mr. Hill acknowledge, the Company would not be able to issue First Mortgage Bonds. Even with their recommended relief, the Company’s existing short-term credit facility would be exhausted and the parties’ implications that the Company can raise those unsecured credit limits or attract other lenders lacks any substantiation.

        Even if additional debt could be incurred by the Company, this would exacerbate the erosion of equity. The Company’s revenues would still be significantly less than its costs, such that retained earnings would continue to rapidly erode. Increasing short-term borrowing adds debt to the capital structure, increasing the Company’s debt to equity balance. Credit ratings would be further downgraded. In light of these circumstances, the stock price will likely fall, especially if these circumstances are combined with Staff and Mr. Hill’s recommendation of a reduction in the dividend.

        Under these circumstances, equity investment would be unlikely. Exhibit DEG-8. If some level of equity investment could be procured, it would be at a very depressed stock price reflective of the risk premium attached to the stock. Forcing the Company to issue stock without adequate interim relief in this context to achieve an equity component of the capital structure 36% (in the case of Staff) or 40% (in the case of Mr. Hill) is a potential death spiral, eventually driving the Company’s debt higher and its equity lower, pushing the Company toward insolvency.

Q: How is this “death spiral” prevented?

A: By providing an appropriate amount of interim relief. This will allow the Company to fulfill the capital needs necessary to discharge its public service obligations during the interim period, stop the erosion of equity by reducing debt, increase retained earnings, and maintain an investment grade credit rating.

II. SPECIFIC ISSUES FOR REBUTTAL

Q: How do you respond to Staff's statement that, "The Company's projections show sufficient cash flow internally to cover necessary near- term expenses for ongoing operations"? Exhibit LAS-1TC at page 16, lines 14-16.

A: The purpose of interim relief is to support the Company’s financial health, which is a matter that considers many factors, not just cash flow. Further, the ratios relied upon by Staff as evidence for this statement inaccurately portray the Company’s cash position. Cash to construction ratios presume redemptions can be refinanced as a matter of course. As stated above, absent interim relief, the Company cannot issue First Mortgage Bonds to complete these redemptions. To avoid default, the Company must first fund redemptions. When that is complete, as Table I above shows, the Company has insufficient internally-generated cash flow to fund capital expenditures.

Q: How do you respond to the contention made by Staff and Mr. Hill that the requested relief is not cost-justified? Exhibit LAS-1T at pages 26-27; Exhibit SGH-T at page 10.

A: Staff and Mr. Hill assume continued access to capital markets without interim relief. This is not an assumption that can be made, nor, as noted above, is it an assumption that has been substantiated with evidence. Their analysis considers interest costs, on an incremental basis, as the only negative consequence of no interim relief. Their analysis fails to take into consideration significant costs associated with incurring further short-term debt in lieu of interim relief while equity continues to erode. Their analysis overlooks the fact that a cost of such financing, in addition to incremental interest costs, includes repayment of the principal.

        Increasing debt (without addressing the erosion of equity) by increasing revenues will exacerbate the consequences of under-recovery of power costs and put the Company into a financial “death spiral.” As discussed in the Direct and Rebuttal Testimony of William A. Gaines, further downgrades of the Company’s creditworthiness will result in impaired access to wholesale energy markets. As discussed in the Direct and Rebuttal Testimony of Gary B. Swofford, no relief will necessitate reductions in capital and O&M expenditures that will diminish the quality and reliability of service. The analysis of Staff and Mr. Hill also fails to consider the substantial loss in value of investments made by existing bondholders and stockholders. Depriving the Company of needed revenues -- thereby forcing the Company to pursue expensive short-term debt and degrade its creditworthiness -- is not consistent with the public policy objective of supporting a strong and healthy utilities.

Q: How do you respond to Hill’s statement that, “had the Company been capitalized in a manner envisioned by this Commission when it last set rates, its (sic) is reasonable to believe that an interim rate request would be unnecessary”? Exhibit SGH-T at page 4, lines 14-16.

A: I disagree with this statement. Until October 2001, the Company was able to maintain an “A”- bond rating. The Company maintained this credit rating after falling below quantitative benchmarks. The Company was able to maintain its ratings because rating agencies recognized the qualitative aspects of the Company’s business and regulatory position. What tipped the scale was the ongoing erosion of equity caused by the $625,000 per day under-recovery of power costs that is driving the need for interim relief.

        Further, under the PNB standard, it is inappropriate to “look back” to events, as Mr. Hill does, as opposed to looking forward. Interim relief is granted based upon a forward-looking perspective of the Company’s financial health. What may or may not have caused historical increases in debt is irrelevant to the Company’s request for interim relief. For the relevant time period, and looking forward, the enormous drain on the Company’s equity is its inability to recover its power costs, and this is the problem that must be addressed.

        Additionally, Mr. Hill’s argument boils down to an assertion that the ongoing erosion of equity would not be a problem if the Company were facing the current power cost crisis with a stronger capital structure. This is not so; equity would still be rapidly eroding. It is incorrect to argue that had the Company simply had more equity to erode, somehow interim relief would not be required. The argument rests on an unsubstantiated contention that if the Company could bleed longer, before bleeding to death, it should be left to bleed.

Q: How do you respond to Mr. Hill's contention that the erosion of the Company's capital structure is due to "bad management"? Exhibit SGH-T at page 4, lines 11-20, and pages 18-20.

A: I disagree. The Company managed its affairs throughout a Rate Plan period in a manner that, among other accomplishments, has significantly reduced costs, secured substantial benefits from BPA for our residential and small farm customers, substantially complied with Service Quality Indices, and utilized a diverse resource portfolio in a manner that, until recently, insulated our customers from impacts of wholesale energy markets. As noted above, during the Rate Plan, and until October 2001, the Company achieved and maintained an “A”- senior secured debt rating, notwithstanding some quantitative indicators of creditworthiness that were below benchmarks for “A”- rated utilities. It was the qualitative factors (such as good management and regulatory climate) that made up for shortfalls in quantitative benchmarks. It is also unfair to label a company as having been poorly managed when it has the second lowest non-production operating costs per customer in the nation, has preformed admirably with respect to the service quality indices to which both this Commission and the Company agreed, has won the coveted Edison award, and was pronounced “Utility of the Year” by Electric Light and Power.

Q: How do you respond to Staff and Mr. Hill's recommendations to reduce the dividend? Exhibit LAS-1T at pages 24-25, 43; Exhibit SGH-T at pages 39-44.

A: A dividend reduction does not address the underlying problem of rapid erosion of equity in the near-term due to the significant under-recovery of power costs. Cutting the dividend will further jeopardize the ability to issue equity at a time when the Company needs to build equity. A reduction in the dividend would further deflate investor interest in equity, thereby making it extremely difficult for the utility to issue additional equity. Exhibit DEG-4.

        Staff and Mr. Hill argue to increase retained earnings with a dividend reduction, thereby reducing debt leverage. Yet, they would also have the Company increase debt during the interim period to provide the cash necessary for the Company to operate. These recommendations are at cross purposes. The critical first step is to stop the erosion of equity by increasing revenues (and thereby create a potential for increasing retained earnings). Nor can a company increase equity when it is extremely difficult to sell stock in significant quantities at a price that would be considered fair to existing shareholders. The risk premium of such stock makes it unattractive to investors. Under the circumstances facing the Company, there is a risk that PSE’s stock price will decline to a level below book value. Exhibit DEG-4.

Q: How do you respond to Staff's and Mr. Hill's contention that financing options exist that the Company has not investigated? Exhibit LAS-1T at page 16, lines 18-20, and pages 22, 23, 41, lines 18-20.

A: The Company has completed substantial efforts to reduce its ongoing financing needed and to provide additional sources of liquidity. Specifically, the Company has: (1) issued $40 million of two-year notes, reducing its need for liquidity by a like amount; (2) deferred all of the elective redemptions callable to date -- $10 million (the $40 million issue utilized the remainder of the Series C $500 million shelf registration and, as a result, PSE is in the process of filing a new shelf); and (3) increased the size of its commercial paper program from $75 million to $125 million (a $50 million increase). While the Company is still limited to issuing $375 million in commercial paper and credit line borrowings, the additional $50 million capability with U.S. Bank helps mitigate the loss of two other programs.

Q: Specifically, what financing options has the Company explored?

A: The Company has diligently explored additional financing options. In doing so, however, the Company discovered: (1) Banca Di Roma has cut the Company’s uncommitted line from $20 million to $10 million and limited the Company’s maturities to one week in duration; (2) J.P. Morgan has cut the Company’s uncommitted line from $100 million to $5 million and limited the Company’s maturities to an overnight basis; (3) First Union Bank and Fleet Bank have quit lending to the Company altogether; (4) the Company’s East Coast commercial paper dealers (J.P. Morgan and Banc One) are no longer able to sell the Company’s commercial paper; (5) AMBAC, the firm that insures the Company’s existing pollution control bonds, is unwilling to provide insurance to refinance these securities or to enter into any other financial transactions with the Company; (6) the agent for the Company’s $375 million credit agreement, Bank of America, on behalf of themselves and all other banks party to the agreement, requested detailed projected financial statements delineating the Company’s cash position through the duration of the interim period -- an unprecedented request in the Company’s history; and (7) as a result of the recent downgrades of the Company’s credit ratings, the reputable firms with whom the Company asked to sell its remaining bonds refused to buy them for their own account and would only agree to sell the bonds if and when committed investors were found, a highly unusual practice. This resulted in extending a process that would normally take four hours into four weeks.

        It is important to keep in mind that these firms have established a long-term business relationship with the Company. To the extent financial institutions can be expected to extend credit to an entity experiencing short-term financial distress, institutions with an established long-term relationship are most likely to do so.

        Staff implies that there are financing options available to the Company that the Company is not pursuing. Exhibit LAS-1T at page 16, lines 18-20, and pages 22, 23, 41. Staff presents no evidence in support of these implications. Staff also states that the Company’s universal shelf registration “could be used for equity and debt issuances, or a combination of equity and debt issuances.” Exhibit LAS-1TC at page 13, lines 13-14. The implication is that the shelf registration evidences an ability to finance, which it does not. Shelf registrations are SEC compliance documents and have nothing to do with access to capital, the reasonableness of the terms of financing, or the degree to which investors may, or may not, be interested in investing.

        In reaching its conclusion, Staff appears to rely solely on findings such as, “[t]he Company has not presented evidence that it has fully investigated its financing possibilities. Staff has not discovered any documented evidence that the Company’s attempts to issue additional debt have been rebuffed by arrangers and investors.” Exhibit LAS-1T at page 22, lines 13-16. The question before the Commission is financing options looking forward, not looking backward. Looking forward, the Company’s ability to finance is jeopardized. Without interim relief, the Company will exceed its unsecured credit facility (prohibiting unsecured short-term debt issuances) and violate its first mortgage bond indenture regarding interest coverage (prohibiting issuance of first mortgage bonds). Equity issuance then becomes the remaining option. Absent interim relief, however, the availability of equity would be a gamble and its costs would be excessive.

Q: As a follow-up to the prior question, do you understand the PNB standard as requiring a utility to show that there are absolutely no financing options available to it?

A: No. The existence of financing options, at any price, is not the question presented in an interim relief case. The question, based upon the interim cases that I have reviewed, is the availability of financing on reasonable terms. For example, in WUTC v. Washington Water Power Co., Cause No. U-80-13, 1980 Wash. UTC LEXIS 6 (June 2, 1980), the Commission stated:

The Commission reiterates that interim rate relief should be granted only upon a reasonable showing that an emergent conditions exists and that without affirmative relief the financial integrity and ability of the company to continue to obtain financing at reasonable costs will be compromised and placed in jeopardy.

(Emphasis added.) In WUTC v. Washington Water Power Co., Cause No. U-77-53, 1977 Wash. UTC LEXIS 3 (September 23, 1977), in commenting on the financial situation, the Commission stated:

[W]e believe that earnings under current tariffs will be inadequate to allow the respondent successfully to market its debt issues and its securities at reasonable rates. If this were to occur, detriment would result not only to the respondent and to its stockholders, but also to its ratepayers.

(Emphasis added.) Further, in WUTC v. Cascade Natural Gas Corp., Cause No. U-74-20, 1974 Wash. UTC LEXIS 5 (July 23, 1974), the Commission said:

The Commission concludes that the company has established an immediate and extraordinary need to accumulate additional earnings, which need justifies allowance of interim relief. The public interest would not be served by the company’s inability to obtain reasonable debt and equity financing … and such reasonable financing does not appear possible absent immediate upward rate adjustment.

        (Emphasis added.) Thus, the ability to obtain any financing, at any cost, from any lender, is simply not the test.

Q: How do you respond to the allegations of Staff and Public Counsel that the Company's investment in unregulated subsidiaries mitigate against granting interim relief? Exhibit LAS-1T at pages 21-22; Exhibit SGH-T at pages 36-38.

A: The Order Accepting Stipulation and Approving Corporate Reorganization To Create a Holding Company, With Conditions, Cause No. UE-991779 (August 2000) (“Holding Company Order”) separates regulated from non-regulated activities, a key interest of both the Company and the Commission. The purpose of this order, among other things, is to insulate utility customers from the risks of unregulated businesses. The Company conducts its business in compliance with this order.

        With respect to the initial equity investment made to capitalize InfrastruX, this investment was made from unregulated (non-utility) funds in 2000, many months before the circumstances described in the Testimony of William A. Gaines that gave rise to the rapid escalation of the Company’s power costs. All subsequent acquisitions by InfrastruX were made using this initial equity investment, stock of InfrastruX, and/or draws under InfrastruX’s $150 million line of credit. Also, for a sense of context, PSE’s size ($5.3 billion in asset value as of 12/31/01) greatly overshadows an $86 million investment by the parent corporation in a non-regulated subsidiary. It is appropriate for the Board of Directors to provide the Company’s investors with growth potential associated with such an investment, in addition to that provided by the regulated utility.

        The $150 million guarantee of InfrastruX line of credit by the holding company is fully compliant with the holding company order and does not expose PSE or its customers to financial risk.² Additionally, all InfrastruX operating subsidiaries back the line of credit. If InfrastruX were to default, and the parent company were called upon to fund InfrastruX’s debt, there are assets in other unregulated subsidiaries that could be used to minimize the impact on shareholders and the capital of the utility.

Q: Do you agree with Staff’s assertion that the “Company does not volunteer cost savings offsets in other areas that could mitigate higher power supply costs”? Exhibit LAS-1T at page 7, lines 18-19.

A: No. Moreover, Staff's assertion is unclear. The financial information presented by PSE addresses all costs and expenses, as well as all revenues and savings, such that there are no "offsets" that are excluded from the analysis. If the question is to what extent PSE can further reduce costs prospectively, this is addressed in the Direct and Rebuttal Testimony of Gary B. Swofford.

Q: Staff witness Lott says, "[t]he Company's proposal to recover its deferred power supply costs through interim relief is inappropriate single issue ratemaking." Do you agree? Exhibit MRL-1T at page 4, lines 10-11.

A: No. As noted above, this allegation misinterprets the Company’s request for interim relief. The Company has requested a surcharge in an amount that is necessary to restore the Company’s financial integrity for the interim period. The requested surcharge amount is tied directly to the hardships and inequities to be addressed with interim relief. The under-recovery of power costs is the root cause of the financial distress, and the time frame within which this consequence of market volatility has occurred presents the imminent threat of financial disaster if appropriate relief is not granted.

Q: Mr. Hill alleges that the Board of Directors was not properly informed of the impact on the Company's capital structure of its dividend policy. What is the Company's response? Exhibit SGH-T at page 12, lines 27-28, and page 13, lines 1-2.

A: The Board is fully informed of the financial conditions of the Company and makes dividend decisions in this context.

Q: Mr. Hill points out that rating agency presentations made in April differ from financial information filed in December in support of the Company's request for interim relief. How to you respond to this observation? Exhibit SGH-T-C at page 48 lines 24-28, and page 49, line 1.

A: The rating agency presentation was prepared and made in April 2001 before the wholesale market collapse in August 2001. The subsequent rapid and significant erosion of the Company’s financial health occurred thereafter and was reflected in the December filing.

Q: Mr. Hill states, "the average bond rating of the industrial firms in the U.S. is 'BB'." Is this indicative of utility credit ratings? Exhibit SGH-T, page 9, lines 10-11.

A: No. Unlike industrial firms, utility debt has not averaged junk ratings or even close to junk ratings. For example, Moody’s October 2001 Power and Energy Company Sourcebook shows the credit rating of the electric utility industry has averaged between “A2” and “A3” over the last eight years. By way of contrast, that average rating is much higher than the Company’s current Moody’s bond rating of “Baa1,” which is subject to downgrades without interim relief.

III. THE PNB STANDARD

Q: Are you familiar with the factors identified in the PNB case for evaluating a request for interim relief?

A: Yes, I am. The PNB case identifies six factors for analyzing interim relief requests. These are:

1. The Commission has the authority, in proper circumstances, to grant interim relief to a regulated utility, but this should be done only after an opportunity for adequate hearing.
   
   
2. An interim rate increase is an extraordinary measure and should be granted only where an actual emergency exists or where the relief is necessary to prevent gross hardship or gross inequity.
   
   
3. The mere failure of a utility's currently-realized rate of return to equal the rate of return previously authorized to the utility by this Commission as adequate is not sufficient, standing alone, to justify a grant of interim relief.
   
   
4. The Commission should review all financial indices as they concern the applicant, including rate of return, interest coverage, earnings coverage, and the growth, stability, or deterioration of each, together with the immediate and short-term demands for new financing and whether the grant or denial of interim relief will have such an effect on financing demands as to substantially affect the public interest.
   
   
5. In the current economic climate, the financial health of a utility may decline very swiftly, and interim relief stands as a useful tool in an appropriate case to stave off impending disaster. This tool, however, must be used with caution, and it must be applied only in cases where the denial of interim relief would cause clear jeopardy to the utility and detriment to its ratepayers and its stockholders. This is not to say that interim relief should be granted only after disaster has struck or is imminent, but neither should interim relief be granted in any case where full hearing can be accomplished and the case in chief resolved without clear jeopardy to the utility.
   
   
6. As in all matters before the Commission, we must reach our conclusion while keeping in mind the statutory charge to this Commission that we must “regulate in the public interest.” This is [the Commission’s] ultimate responsibility, and a reasoned judgment must give appropriate weight to all relevant factors.

Q: In your opinion, does the evidence submitted by PSE satisfy the first factor of the PNB analysis?

A: The first factor relates to the requirement of an adequate hearing. I understand this to be a legal requirement of a procedural nature, and therefore I am not in a position to offer an opinion.

Q: In your opinion, does the evidence submitted by PSE satisfy the second factor of the PNB analysis?

A: Yes. In my opinion, the evidence presented in this case demonstrates that an actual emergency exists. As Mr. Hill notes in his testimony, the events in the western wholesale power markets “must be characterized as extraordinary during the past eighteen months.” Exhibit SGH-T at page 4, line 12. As explained in the Direct Testimony of William A. Gaines, “[t]he cumulative effect of these extraordinary circumstances has been to undermine the Company’s ability to offset escalating basic power supply costs with margins from wholesale power sales.” Exhibit WAG-1T at page 3. The emergency resulting from these unforeseeable circumstances is a $625,000/day drain on the Company resources that is driving the Company to financial ruin.

        The evidence presented in this case also shows that relief is necessary to prevent gross hardship or gross inequity to the Company, its customers, and its investors. As noted above, absent relief:

• PSE will not be able to issue First Mortgage Bonds (April 02)
  
  
• PSE’s stock would be extremely difficult to sell in significant quantities at a price that would be considered fair to existing shareholders (April 02)
  
  
• PSE's credit rating will be downgraded to "junk" status (April 02)
  
  
• PSE's access to wholesale energy markets will become untenable (April 02)
  
  
• PSE will exceed its short-term borrowing limits (June 02)

These hardships and inequities result in jeopardy to PSE and are detrimental to customers and investors, the consequences of which are addressed below in my discussion of the fifth factor of the PNB analysis.

Q: In your opinion, does the evidence submitted by PSE satisfy the third factor of the PNB analysis?

A: Yes. The evidence submitted by PSE addresses all aspects of the Company’s financial condition. Moreover, unlike much of the testimony submitted by Staff and on behalf of Public Counsel, the financial information submitted by the Company is forward-looking, not historical. In this regard, I understand that the Commission considers evidence of existing and actual conditions and short-range projections in its consideration of requests for interim relief. WUTC v. Washington Water Power, Cause No. U-80-13, Second Supplemental Order Granting Petition For Emergency Rate Relief in Part (June 1980).

        PSE does not solely rely upon the Company’s failure to earn its authorized rate of return. However, the Company’s actual rate of return relative to its authorized rate of return is relevant. In my direct testimony, I point out that the Company’s rate of return for the interim period will be 5.55%, well below its authorized rate of return of 8.99%. This is a 38% shortfall. In comparison to a 1980 interim case where the Company was granted relief, the Company’s authorized was 9.8% and the actual was 8.65%. This shortfall was approximately 12% (as compared to 38% in this case). In a 1973 interim case, the Company’s authorized was 7.7% and the actual was 6.8%. This was a shortfall of approximately 10% (as compared to 38% in this case). The Company’s dismal rate of return for the interim period is relevant and is strongly supportive of its request for interim relief. This is particularly true when rate of return is considered alongside the many other indicators of financial distress discussed in my testimony that reveal a state of clear jeopardy to the Company, its customers and investors.

Q: In your opinion, does the evidence submitted by PSE satisfy the fourth factor of the PNB analysis?

A: Yes. The Company has presented information and analysis that meets and exceeds the requirements of this element of the standard. Speaking directly to the financial indices, my testimony shows, among other things:

        • Interest coverage: The Company’s pre-tax interest coverage ratio is projected to be 1.2 without interim relief, deteriorating to a level below the benchmark for a BB rated utility.

• Funds from Operations to Total Debt:  The Company’s funds from Operations to Total Debt percentage is projected to decline to 13.8% without interim relief, deteriorating to a level below the benchmark for a BB rated utility.

• Funds from Operations Interest Coverage:  The Company’s funds from operations interest coverage ratio is projected to be 2.8 without interim relief, deteriorating to a level within the range for a BB rated utility.

• Total Debt to Average Total Capital:   The Company’s Total Debt to Average Capital percentage is projected to increase to 64.2% without interim relief, deteriorating to a level below investment grade.

• Creditworthiness:  In view of these ratios, the Company is facing multiple downgrades, to "junk" status, if the requested relief is not provided.

• Indenture Coverage Ratio:   The Company’s indenture coverage ratio is projected to be 1.6 without interim relief, deteriorating to a level below that required by the Company’s First Mortgage Bond covenant, prohibiting the issuance of First Mortgage Bonds.

• Rate of Return:   The Company’s rate of return for the interim period will be 5.55%, well below its authorized rate of return of 8.99%. This is a 38% shortfall.

• Erosion of Equity:  Investor equity in the Company is being eroded at an average of nearly $13 million per month, a devastating impact to investors that will continue absent interim relief.

Q: In your opinion, does the evidence submitted by PSE satisfy the fifth factor of the PNB analysis?

A: Yes. There is, to my reading, a temporal aspect to this factor of the analysis as well as a need to show “clear jeopardy to the utility and detriment to its ratepayers and its stockholders.” The temporal aspect is stated as follows: “This is not to say that interim relief should be granted only after disaster has struck or is imminent, but neither should interim relief be granted in any case where full hearing can be accomplished and the case in chief resolved without clear jeopardy to the utility.”

        The enormous under-recovery of power costs that is the root cause of the financial distress facing the Company, and the rapid time frame within which this consequence of market volatility has occurred, presents the imminent threat of financial disaster if appropriate relief is not granted. No one contests the fact that the Company’s net power costs have dramatically increased since August of 2001, and no one contests the devastation this ongoing $625,000/day drain is causing to the Company’s financial integrity. Rather, the arguments raised by the parties try to redirect the Commission’s attention to matters such as blame (allegations of bad management) or suggest that no financial crisis is presented until the utility is in financial ruin. The bottom line, in my opinion, is that all of the evidence before the Commission shows immediate relief is needed.

         The question then becomes who gets hurt if relief is not granted, or, in the words of the PNB decision, what will be the "clear jeopardy to the utility and detriment to its ratepayers and its stockholders." To summarize what I have stated above:

• Clear jeopardy to the utility if relief is not granted:  PSE will continue to suffer from unrecovered power costs at a rate of $625,000/day, with no offsetting revenues. The alarming erosion of equity will continue. The Company will be left in a position where it cannot issue First Mortgage Bonds and will exceed its short-term credit limits. The Company will experience further downgrades of its creditworthiness, likely to “junk” status.
  
  
• Detriment to Customers:  As stated in the Direct and Rebuttal Testimony of Gary Swofford, customers will suffer from a reduced quality and reliability of service. As stated in the Direct and Rebuttal Testimony of William A. Gaines, if the Company’s creditworthiness falls to junk, the Company’s access to wholesale energy markets will become untenable. Further erosion of the Company’s financial structure will, at a minimum, increase the cost of capital (and therefore the cost of service to our customers), deprive them of the benefit of the Company’s access to reasonably priced debt (e.g., no First Mortgage Bonds), and leave the Company with either no access to equity markets at all or limited access at an extremely high price.
  
  
• Detriment to Investors:   Each month of under-recovery of power costs confiscates huge amounts of our equity investors’ existing investment in the Company, averaging nearly $13 million per month and totaling $179 million over the period on an after-taxes basis. This confiscation in book equity is in addition to the market losses which equity investors have suffered. Absent a clear demonstration of support for equity investment through approval of the interim relief requested by the Company, equity investors would view the Company as simply a place to lose money both at the book level and the market level and will put no new money into it except at extremely discounted values. Bondholders have also been harmed with a loss in value of their investments and will lose more value if the Company’s credit rating is downgraded to junk status.

Q: In your opinion, does the evidence submitted by PSE satisfy the sixth factor of the PNB analysis?

A: Yes. The "public interest" is, to my reading, the overriding factor to be considered in an interim case. Preventing the above-described hardships and detriments to the Company, its customers, and its investors is in the public interest. To prevent these things from occurring, the Company needs cash and earnings that will restore its financial health. PSE needs the relief it has requested and granting such relief is in the pubic interest.

Q: Does that conclude your testimony?

A: Yes, it does.

        ¹ There are variants the Commission could consider to this proposal, including a surcharge based upon actuals for the January 1, 2002 through March 31, 2002 deferral period, plus PSE’s forecast for the remainder of the interim period. This amount could be spread over the two recovery periods, as suggested above. If the Commission determines that less than the full amount of interim relief is warranted, the Commission would in effect determine that such under-recovery of power costs is not directly related to the amount of relief required to restore the Company’s financial integrity (even though the unrecovery of power costs would continue to be the root cause of the need for relief). In such event, there would be no reason to adjust the amount of relief granted by an adjustment to PSE’s actual power costs.

         ² The Stipulation approved in the Holding Company Order holds PSE customers harmless against such risks. Stipulation,P. 4, pg. 2.

EX-99

EXHIBIT 99.2

EXHIBIT NO. ______ (WAG-5T)
DOCKET NO. UE-011570 (INTERIM)
WITNESS: WILLIAM A. GAINES

BEFORE THE
WASHINGTON UTILITIES AND TRANSPORTATION COMMISSION

WASHINGTON UTILITIES AND
AND
TRANSPORTATION COMMISSION,

           Complainant,

v.

PUGET SOUND ENERGY, INC.,

           Respondent.

REBUTTAL TESTIMONY OF WILLIAM A. GAINES
ON BEHALF OF PUGET SOUND ENERGY, INC.

FEBRUARY 11, 2002

PUGET SOUND ENERGY, INC.

REBUTTAL TESTIMONY OF WILLIAM A. GAINES

I. INTRODUCTION

Q: Please state your name, business address, and position with Puget Sound Energy, Inc.?

A: My name is William A. Gaines. My business address is 411 108th Avenue N.E., Bellevue, Washington 98004. I am Vice President Energy Supply for Puget Sound Energy, Inc. ("PSE" or the "Company").

Q: Have you presented direct testimony in this proceeding?

A: Yes, I have, in Exhibits WAG-1T and WAG-2 through WAG-4.

II. SUMMARY OF TESTIMONY

Q: Please summarize the contents of your testimony?

A: The following is a summary of the contents of my testimony:
Section I -- Introduction

Section II -- Summary of Testimony

Section III -- The Company Is Seeking Interim Relief Under the PNB Standard to Restore Financial Integrity

Section IV -- Intervenors Misunderstand the Company's Financial Situation and Its Cause

Section V -- The Criticism In This Proceeding of the Company's Hedge Costs Relies On Hindsight and Ignores the Context In Which Hedging Decisions Were Made

Section VI -- Other Criticism By Parties of the Company's Hedging Decisions -- As Uneconomic, Unjustified, Unique, or Primarily to Support Wholesale Transactions -- Are Unfounded

Section VII -- Mr. Schoenbeck Erroneously Accuses the Company of Hiding the Ball with Respect to Gas Financial Hedge Transactions

Section VIII -- Parties Have Not Recognized the Adverse Impacts of Reduced Creditworthiness on Power Supply

III. THE COMPANY IS SEEKING INTERIM RELIEF UNDER THE PNB STANDARD TO RESTORE FINANCIAL INTEGRITY

Q: How does the Company's proposal for relief under the PNB standard relate to its power costs?

A: As Mr. Donald E. Gaines discusses in Exhibit DEG-5T, the Company has requested interim relief in an amount necessary to restore the Company’s financial integrity. As he also discusses, the requested surcharge amount is (i) tied directly to the hardships and inequities to be mitigated with interim relief and (ii) an amount of interim relief necessary to satisfy the PNB standard.

        The requested surcharge amount reflects a projection that actual power costs will exceed power costs included in rates. If the Commission recognizes that the full amount of requested interim relief is needed to satisfy the PNB standard, then it would be appropriate to adjust the amount of interim relief afforded in an amount equal to the amount by which actual power costs are greater or lesser than projected power costs. Otherwise, the Company could exceed or fall short of the relief required by the PNB standard.

Q: Do the recommendations of Mr. Schoenbeck (Exhibit DWS-1T) and Mr. Lott (Exhibit MRL-1T) with respect to the Company's power costs reflect application of the PNB standard for interim relief?

A. Mr. Schoenbeck ignores and fails to apply the PNB standard for interim relief in making his proposals. Mr. Lott does state at page 8, lines 7-9, of Exhibit MRL-1T that any interim relief should attempt to maintain the Company’s overall financial viability. However, they both propose power cost adjustments that would impact interim relief. In doing so, they do not address the impact that those adjustments would have on the financial integrity of the Company.

Q: Is it appropriate to make adjustments to the amount of interim relief provided to the Company based on adjustments, such as those proposed by Mr. Schoenbeck and Mr. Lott, of the Company's projected power costs?

A. No. Because grant of interim relief is based on the need to maintain the Company's financial integrity, adjustments of the Company's power costs such as those proposed by Mr. Schoenbeck and Mr. Lott to remove hedging costs or to remove an allowance for hydroelectric generation and market risk are inappropriate in this interim relief proceeding. They are inconsistent with application of the PNB standard and are otherwise flawed, as discussed later in my testimony. As an additional matter, Mr. Schoenbeck and Mr. Lott do not address their proposals from the perspective of the Company's situation at the time decisions were made.

Q: Should the interim relief received by the Company be reduced by an allowance for & market/hydro risk that might be subtracted from projected power costs based on a general rate case normalized power cost study?

A: No. Reduction of interim relief provided to the Company based on power cost adjustments proposed by Staff and intervenors is unwarranted. Mr. Lott suggests in Exhibit MRL-1T, at page 24, that the amount of interim relief provided to the Company should be reduced by a dead-band around long-term normalized power costs. Mr. Schoenbeck makes a similar suggestion in Exhibit DWS-1T, at pages 19-21. Again, as discussed by Mr. Donald E. Gaines in Exhibit DEG-5T, the Company has requested an amount that is necessary as interim relief to restore the Company's financial integrity. As pointed out below, one of the factors contributing to the root cause of the Company's need for interim relief is market and hydroelectric volatility. For example, the Company absorbed a significant amount of hydro risk in 2001, one of the driest years on record. This is a significant contributor to the Company's current financial situation for which it needs interim relief.

IV. INTERVENORS MISUNDERSTAND THE COMPANY'S FINANCIAL SITUATION AND ITS CAUSE

Q: Mr. Schoenbeck asserts at page 8, lines 15-18, of Exhibit DWS-1T that Puget claims that their high power expenses are a result of high market prices of electricity and their reliance on purchased power for a substantial amount of the power supply. Is this an accurate characterization of PSE's position?

A. No. As described in Exhibit WAG-1T, at page3, lines 3-5, the cumulative impact of the energy market price increases in 2000, and the subsequent dramatic collapse of those prices in the summer of 2001, has been to undermine the Company's ability to offset escalating basic power supply costs with margins from wholesale power sales. Indeed, Exhibit WAG-1T, at page 4, lines 3-6, specifically contrasts the Company's situation with a number of other utilities [that] were forced to seek substantial rate increases during that period, often caused in substantial part by reliance on the spot power markets for a portion of their power supply needs. Thus, Mr. Schoenbeck misunderstands the root cause of the Company's need for interim relief to restore financial integrity and confuses the Company's situation with that of such other utilities. The Company's actual situation is that, due to market prices and other factors, it no longer has the ability to offset escalating basic power supply costs with margins from wholesale power sales.

Q: Mr. Schoenbeck asserts at page 9, lines 13-14, of Exhibit DWS-1T that the "single most important factor impacting the Company's current financial situation is a series of gas hedging transactions." Is it meaningful to compare a mark-to-market value of gas financial hedge transactions with the amount of relief requested by the Company in this proceeding?

A. No. Mr. Schoenbeck looks at only one, currently out-of-the-market (on a mark-to-market basis) piece of the portfolio. He then attempts to compare that value to the increase (not on a mark-to-market basis) in the Company's net power costs since its last rate proceedings. This ignores the many other changes in the Company's supply portfolio, does not take into consideration the mark-to-market value of the other components of the Company's supply portfolio, and is an apples-to-oranges comparison.

         There is another flaw in Mr. Schoenbeck's attempted comparison. He asserts that gas hedging transactions are the single most important factor impacting the Company's current financial situation.” Exhibit DWS-1T at page 9, line 13. In fact, as indicated in Exhibit WAG-1T, the root cause of the Company's current financial condition is substantial increases in the Company's basic power supply costs combined with an inability to offset those costs with healthy margins in the wholesale market.

Q: Are there other indications that parties misunderstand the root cause of the Company's need for interim relief?

A. Yes. For example, Mr. Schoenbeck states at page 12, lines 3-4, of Exhibit DWS-1T that the higher power costs for these months [January through October 2002] is not due to current unprecedented market conditions. Again, this statement ignores the continuing effect of the rapid decline in power prices from unprecedented levels that decreases the Company's wholesale margins. These margins had been offsetting the Company's escalating basic power supply costs.

Q: Mr. Hill, at page 45, lines 3-4, of Exhibit SGH-T-C, asserts that "the Company's 2002 net fuel costs are not substantially different from the levels established in 1998 and 1999." Is his comparison valid?

A. No. Mr. Hill's analysis is flawed. His comparison erroneously (i) includes the Company's gas retail load revenues (and associated costs), (ii) does not properly adjust for the Company's revenues and expenditures in 1998 and 1999 with respect to the Residential Exchange, and (iii) fails to account for increased wholesale electricity revenues (and associated costs) associated with balancing load to resources.

        Mr. Hill, at page, lines 3-4, of Exhibit SGH-T-C erroneously asserts that the Company's 2002 net fuel costs [from PSE's projected 2002 income statement] are not substantially different from the levels established in 1998 and 1999 [from PSE's actual income statements]. (In fact, what Mr. Hill calculates as net fuel costs also includes purchased power costs.) A comparison of Mr. Hill’s calculation of the ratio of these power costs to electric revenues for 1998 and 1999 with a corrected calculation of such ratio is shown below:

	1998	1999	2002
Mr. Hill's Ratio Calculation	0.491	0.499	0.504
Corrected Ratio Calculation	0.511	0.503	0.579

Thus, Mr. Hill’s assertion that power costs are not a substantial driver of the Company’s need for relief is erroneous. Exhibit WAG-6 describes the calculation of the corrected ratios.

Q: Mr. Hill asserts at page 48, lines 20-27, of Exhibit SGH-T-C that his analysis has revealed inconsistencies in the Company's off-system sales revenues for 2002 as compared with off-system sales revenues for 2001. Do you agree?

A: No. Mr. Hill compares (i) projected off-system sales revenues for 2002 of $66 million with (ii) nine months of actual and three months of projected off-system sales revenues for 2001 of approximately $1 billion. He is comparing apples and oranges. The $66 million projection is an output from AURORA modeling. It does not reflect the revenues from the multiple sales and purchases conducted in reality to balance load and resources, as discussed in Exhibit WAG-6.

        Moreover, Mr. Hill ignores the fact that projected purchased electricity costs for 2002 decrease by approximately $800 million when the revenues decrease by the same order of magnitude. (Information that would permit consideration of both costs and revenues was provided by the Company in its response to Public Counsel Data Request No. PC-62, the same response used by Mr. Hill to calculate his difference in off-system sales revenues.)

V. THE CRITICISM IN THIS PROCEEDING OF THE COMPANY'S HEDGE COSTS RELIES ON HINDSIGHT AND IGNORES THE CONTEXT IN WHICH HEDGING DECISIONS WERE MADE

Q: Could you give examples of the use of hindsight by other parties to criticize or otherwise question the Company's hedge costs?

A: Yes. Mr. Schoenbeck criticizes, at pages 10 and 11 of Exhibit DWS-1T, gas financial hedges entered into by the Company before mid-year 2001 for the period June 2001 through December 2001. Exercising hindsight, he characterizes them as being & out of the money or Above Market Hedges. Mr. Schoenbeck erroneously bases his criticism on perfect hindsight, ignoring conditions at the time the hedges were entered into. (Moreover, Mr. Schoenbeck's criticism is aimed in part at hedges for 2001 -- which is a period prior to the January through October 2002 interim period in this proceeding.) This use of hindsight continues, for example, on Exhibit DWS-10, Chart 3, where Mr. Schoenbeck depicts the timing of some (and only some) of the Company's hedging decisions as compared with the actual spot market price of gas both before and after those decisions were made. Similarly, Mr. Lott, at Exhibit MRL-1TC, page 26, lines 5-6, compares the prices reflected in some of the Company's gas financial hedges with today's market price of gas. Again, care must be taken to examine hedging decisions in the context of circumstances that existed at the time and to avoid looking at the Company's hedging decisions with hindsight.

        A comparison of the prices at which the Company entered into its gas financial transactions to the forward market prices at the time shows that the prices paid by the Company were typically lower than the generally prevailing forward prices at the time. See Exhibit WAG-7, which depicts the Company’s forward gas financial transactions (time of decision, price, volume, and term) and the forward market prices at the time the Company's decisions regarding such transactions were made. In short, those purchases in 2001 for 2002 were in fact not uneconomic at the time they were made. A transaction to obtain a fixed price for power or fuel (whether a physical or financial transaction) that was economic and for which there was a need at the time it was entered into should not be criticized merely because it subsequently turns out in hindsight that future market conditions (which were unknowable at the time the transaction was entered into) differ from and are less than the fixed price.

Q: Could you please describe the context in which gas financial hedging decisions were made?

A Period of Tight Supplies and High Market Prices in the West

        As the Company was entering into gas hedging transactions, power supply deficits were a distinct possibility and prices in the wholesale gas and electric markets were high and volatile. For example, the Northwest Power Planning Council was predicting that the region could face a deficit of 8,000 megawatt-months that spring and summer, warning that it is likely that this summer will be a period of tight supplies and continued high market prices. (March 26, 2001 Clearing Up, p. 3.)

        The testimony of Tom Karier, Council Member, Northwest Power Planning Council, at a U.S. Senate Energy Committee hearing on January 31, 2001 (“Karier Testimony”), described what he called “the current power crisis in the West.” He pointed out, for example, that

1. snow pack runoff was predicted to be only 68% of normal for the year, with the elevation of Lake Roosevelt behind Grand Coulee Dam being the lowest in 25 years,
   
2. conditions may well be dangerously close to the driest on record, which would reduce BPA generation about 4,000 megawatts below average,
3. (iii) the price of natural gas had doubled last summer and was then three times the price it had been the previous year, and (iv) the loss of flexibility in the hydroelectric system due to Endangered Species Act requirements had de-rated the system by more than 1,000 megawatts. A copy of the Karier Testimony is provided as Exhibit WAG-8.

         Moreover, the power shortage was not limited to the Pacific Northwest. The April 10, 2001 Statement of Terry Winter, President and Chief Executive Officer, California Independent System Operator Corporation, before the House Committee on Government Reform, Sacramento, California Field Hearing, indicated at page 6 that “we expect ‘an electricity shortage of unprecedented proportions’ and that the ‘forecast deficiency suggests that California will experience rotating blackouts for periods this summer.

Utilities Relying on Spot Market Suffer Large Cost Increases as Prices Rise

        The January 15, 2001 Clearing Up reported at pages 8-9 that adverse hydro generating conditions caused increased market exposure, which coupled with sky-rocketing power prices have combined to leave [Seattle] City Light with projected deficits of $111 million for 2000, and another $228 million for 2001. The March 26, 2001 Clearing Up reported at page 3 that Seattle City Light needed an additional $185 million in bonds to cover deficits from buying power on the open market.

        The December 18, 2000 Clearing Up reported at page 11 that Snohomish PUD last Wednesday joined the parade of Northwest utilities -- public and private -- putting in place rate hikes as the result of recent power market conditions. The Snohomish board on Dec. 13 passed a resolution raising its revenues by 35 percent, effective Jan. 1, 2001. The PUD said that colder temperatures and under-production of energy in the Northwest have forced it to increase the typically small amount of power it buys at market and to spend a considerable portion of its budget reserves.

Utilities With Hedged and Locked-In Power Supply Prices Suffer Mark-to-Market Losses as Prices Fall

        However, after many utilities locked in longer term power or fuel supplies, FERC on June 19, 2001 imposed Westwide price caps on spot market sales. At about the same time, wholesale natural gas and electricity spot market prices dropped dramatically. This sequence of event has been recently described in The Spokesman-Review:

FERC not only resisted caps, he [PacifiCorp spokesman Dave Kvamme] said, the agency also urged the utilities to go long by buying enough power to meet all their needs for months or years ahead.

That's what the utilities did despite high prices, he said.

They were saying Read my lips, no price caps, said Dave Danner, who advises Locke on energy policy.

        When FERC reversed course, Kvamme said, utilities suddenly found themselves with a lot of expensive electricity, and a market that would pay them only a fraction of their original cost for any surplus they had to sell.

        If FERC had acted months sooner, utility planners would not have been forced to commit their companies to expensive long-term contracts, he said.

(Bert Caldwell, Officials deride FERC analysis: Report On Effects Of Price Caps Misses The Big Picture, They Say, The Spokesman-Review, February 5, 2002, at A6.) Similarly, The Oregonian recently reported as follows:

Oregon's two biggest investor-owned utilities, Portland General Electric and PacifiCorp, have requests pending with regulators to recoup $93 million and $136 million, respectively, in extraordinary costs of purchased power.

After months of surging power prices, federal regulators last year chastised utilities for filling their wholesale power needs in the pricey, day-ahead spot markets instead of looking to cheaper, longer-term contracts.

        Many utilities obliged, making deals for $200 or $300 per megawatt hour or higher, prices that seemed reasonable compared with spot rates.

        Then, in early summer, the Federal Energy Regulatory Commission adopted Westwide price controls. Supply problems also ebbed in California, and prices dropped. Utilities that bought long-term contracts in the higher markets were trapped. Some also had to take surplus power they have to sell at a loss.

(Tom Detzel, BPA Sees Red, May Raise Rates, The Oregonian, February 4, 2002, at D1.) In sum, regardless of the degree to which fixed-price power and fuel financial and physical purchase transactions were relied upon, load serving utilities were harmed by the sudden drop of wholesale prices. It should be noted that many other load serving entities did not as fully enter into fixed-price power and fuel financial and physical purchase transactions. They suffered as great and probably greater financial harm. For example, the Karier Testimony stated that “Tacoma Public Utilities implemented a 50-percent surcharge. Dry weather is impacting Tacoma's hydropower operations, forcing the utility to make purchases in the spot market. Tacoma spent $60 million for power in December and is facing continuing high prices with cash reserves of only $130 million. The utility has secured diesel generators with 50 megawatts of capacity, called for conservation, imposed the rate surcharge, and is also planning to take on $100 million in debt to get through the rest of the winter.

VI. OTHER CRITICISM BY PARTIES OF THE COMPANY'S HEDGING DECISIONS -- AS UNECONOMIC, UNJUSTIFIED, UNIQUE, OR PRIMARILY TO SUPPORT WHOLESALE TRANSACTIONS -- ARE UNFOUNDED

Q: Are the mark-to-market losses and gains of the Company's gas financial hedge transactions one time costs or somehow unique to the interim/deferral period as asserted for example by Mr. Schoenbeck at page 5, lines 5-9, of Exhibit DWS-1T?

A: No. Fixed price arrangements for securing power or coal, natural gas, or other fuel for the Company’s generation represent a “hedge” against fluctuations and uncertainty in the prices for power or fuel. Financial hedges for power or fuel, like fixed price arrangements for physical procurements, guarantee the price at which power or fuel may be secured. The Company relies on a mix of fixed price resources, financial hedges, and market purchases to meet its retail loads while attempting to avoid excessive exposure to market price fluctuations.

Q: Can you describe some of the benefits to load-serving entities of using hedge transactions?

A: It is particularly desirable to avoid undue exposure to spot market prices in periods for which spot market prices are projected to be volatile and high. This has been particularly true in recent years. Load-serving entities, such as the Company, routinely must address exposure to spot market prices that is due to variations in supply and fixed price retail load. Examples of uncertainty in the output of the Company's resources include hydroelectric generation variability and thermal unit outage -- an outage at a single Colstrip unit (as occurred during most of January 2002) can decrease the Company's power supply by 225 average megawatts. Uncertainty in the Company's retail loads is demonstrated by the fact that it is possible for the Company's retail load to vary from normal by greater than 50 average megawatts in a summer month and 200 average megawatts in a winter month. Hedging acts like insurance in that it reduces exposure to spot market price volatility.

        The regulatory community has recognized that hedging against wholesale price volatility may help to mitigate the effect of market volatility on consumers by providing greater price predictability but not necessarily at the lowest cost:

WHEREAS, Wholesale electricity and natural gas markets have recently proven to be highly volatile; and

WHEREAS, Consumers and utilities are impacted by energy market volatility through both high and uncertain prices; and

WHEREAS, The use of financial mechanisms, such as derivatives and insurance products, and the use of physical products such as natural gas storage and the storage of fuels to generate electricity are a component of a comprehensive energy procurement program; and

WHEREAS, Market conditions appear to be poised for some continued degree of volatility; and

WHEREAS, Purchasing financial instruments such as derivatives and insurance to hedge against wholesale price volatility may help to mitigate the effect of market volatility on consumers by providing greater priced predictability but not necessarily at the lowest cost; and WHEREAS, The National Regulatory Research Institute (NRRI) issues its report on May 2, 2001 entitled, Use of Hedging By Local Gas Distribution Companies: Basis Considerations and Regulatory Issues” which provides an important perspective on hedging instruments; now therefore be it

RESOLVED. That the Board of Directors of the National Association of Regulatory Utility Commissioners (NARUC), convened in its 2001 Summer Committee Meetings in Seattle, Washington, urges each State commission to explore and examine the potential benefits to consumers and distribution utilities of using financial and physical mechanisms to hedge against market volatility in wholesale electric and gas markets.

(Resolution Recognizing the Important Use of Financial and Physical Mechanisms to Reduce Electricity and Natural Gas Market Volatility adopted by the National Association of Regulatory Utility Commissioners at its July 18, 2001 meeting in Seattle, Washington.)

The following basic facts were recognized in the report on Use of Hedging By Local Gas Distribution Companies: Basic Considerations and Regulatory Issues, dated May 2001, prepared by The National Regulatory Research Institute (NRRI):

• Hedging may result in the utility locking in a price that turns out to be higher than the subsequent prevailing market price.
  
• Hedging is designed to reduce exposure to price volatility but should not be expected to produce the lowest average costs over time.
  
• Hedging does not provide a means to reduce the expected price of energy for a utility. Rather, from a consumer’s perspective, its primary function is to stabilize prices.

        The Federal Energy Regulatory Commission (FERC) recognized in its discussion of the California electric spot market that [m]any of the market dysfunctions in California and the exposure of California consumers to high prices can be traced directly to an over reliance on spot markets. Industries that are either capital intensive or that have a lack of demand response do not rely solely on spot markets where volatility is to be expected. Because the price risks inherent in spot markets are too great for both suppliers and consumers, these market sectors will prefer to manage their risk profiles through forward contracts. San Diego Gas & Electric Co. et al., 93 F.E.R.C. 61,121, at 61,359 (2000).

        Similarly, the Karier Testimony strongly endorsed financial hedging mechanisms, while recognizing the risk that they may prove more costly than the spot market:

One of the characteristics of a commodity market is the emergence of mechanisms to manage risk, and electricity is rapidly becoming a commodity market. These mechanisms include actual physical forward contracts for supply, futures contracts, financial hedging mechanisms, and so on. These mechanisms can limit exposure to high prices. At the same time, however, there is always the risk that they will prove more costly than the spot market. As noted earlier, we believe the limitations on forward contracting by California utilities was a contributing factor to the price extremes of this summer and fall.

     We believe the same is true of other market participants in the Northwest and elsewhere. While opportunities to enter into forward contracts and other hedging arrangements have existed, it may be that the protracted period of low market prices for electricity lulled some market participants into believing they had no need for such mechanisms. The extreme volatility of the market has been revealed. We believe this will spur the development and use of risk mitigation tools. Every effort should be made to encourage their development and use.

     Had more market participants been able to take steps to protect against risk, it is likely that the price volatility impacts would have been moderated. Forward contracting is also a vehicle by which new entrants in the generation market can limit their downside risk, thereby facilitating the development of new generation.

Karier Testimony, Exhibit WAG-8, at pages 7-8 (emphasis added).

Q: Were the Company's gas hedges uneconomic, unjustified, or primarily to support wholesale transactions?

A: No. Mr. Schoenbeck, in Exhibit DWS-1T (e.g., page 19, lines 9-11) criticizes the Company's gas financial hedge transactions as unjustified and uneconomic. It is illogical to single out limited examples of the Company’s use of one of the tools (i.e., gas financial hedges) that protects against undue exposure to market price fluctuations in a period of unprecedented price volatility and assert in hindsight that they are uneconomic or unjustified. This is particularly true of gas financial hedges such as those entered into by the Company -- at or below then-prevailing future market prices for hedges (as discussed earlier) -- in light of:

1. state and federal officials underscoring the importance of avoiding undue reliance on spot market prices;
   
2. other utilities experiencing dramatic retail electric rate increases as a result of their reliance on purchases at spot market prices to meet retail load;
3. projections that the amount of power available for purchases from others was unusually low; and
   
4. projections that the amount of power that would be available from the Company's hydro resources was highly uncertain and unusually low.

        Mr. Schoenbeck in Exhibit DWS-1T criticizes the Company's gas financial hedges entered into during the period April 2001 through October 2001 for generation needed during the period January through October 2002. He does this with perfect hindsight and ignores the fact that the Company had to use forward price curves and projections of fixed price retail load (i.e., retail load not being sold at a price tied to index) to assess the need for and economics of the transactions at the time the Company entered into them.

        Moreover, Mr. Schoenbeck erroneously asserts at page 18, lines 18-23, of Exhibit DWS-1T, that the April 2001 credit rating agency presentation contained as part of the Company's response to Staff data Request No. 43-I (April 2001 materials included in Confidential Exhibit DWS-5C) and the Company's confidential response to Public Counsel Data Request No. 138-I suggests the majority of the hedges were done to support wholesale activity (included in Confidential Exhibit DWS-5C).

        Mr. Schoenbeck's assertion is wrong. The materials relating to hedging included in Exhibit DWS-5C (which focus on hedging decisions in late 2000 and early 2001) do not suggest that the Company's gas financial hedges were done to support wholesale activity. For example, the Overview of PSE Loads and Resources 2000-2008 presentation for the Company's load-resource strategy meeting of November 9, 2000, stresses variability and uncertainty in the Company's retail electric loads. Review of the resources and fixed price loads in that presentation shows that the Company needed additional gas to meet fixed price load in all months for which gas financial hedges were purchased (except for a few months, in the spring of 2001, which do not impact the power cost projections presented by the Company in this proceeding and do not detract from the Company's need for interim relief in this proceeding). This need was shown even if one assumes that retail load would be no higher than projected and that all the Company's non-gas resources would operate at projected levels.

        The Company also entered into some gas financial transactions for certain months in 2001 associated with forward power sale transactions using Company gas-fired generation in amounts and at times that was not reasonably expected to be needed to be available for the Company's retail load. These transactions in effect locked in the spark spread and produced net margins of the type that over time have helped to keep the Company's retail electric rates lower than they would otherwise have been. It is certainly neither accurate nor fair to characterize such transactions as for aggressive wholesale market sales, or mostly to benefit shareholders as asserted by Mr. Schoenbeck at pages #160;18-19 of Exhibit DWS-1T.

        Also, the Hedge Strategy to Meet CT Gas/Oil Needs for Fixed Price Load” presentation for the Company's risk management committee meeting of April 2, 2001, reflects a fuel hedging strategy based on meeting fixed price retail electric load. That presentation stated that PSE staff recommends hedging winter fuel requirements to cover fixed price loads. Exhibit DWS-5C, Slide 2, page 120. Page 118 of that same exhibit indicates that this recommendation was approved by the Company's risk management committee.

        Exhibit WAG-7, which uses the same data provided by the Company to Mr. Schoenbeck and other parties, depicts (i) a timeline of gas financial hedge decisions and transactions by the Company, (ii) a summary of forward price curves, and (iii) because Mr. Schoenbeck focuses on gas financial hedge decisions of the Company in April 2001 (see Exhibit DWS-10, Chart 3), a summary of the Company's load-resource position upon which the Company based its decisions in April 2001. Exhibit WAG-7 shows that the Company did not have sufficient fixed price gas for core load in the January through April and August through December periods of 2002. This was true even if one assumes that retail load would be no higher than projected and that all the Company's non-gas resources would operate at projected levels.

VII. MR. SCHOENBECK ERRONEOUSLY ACCUSES THE COMPANY OF HIDING THE BALL WITH RESPECT TO GAS FINANCIAL HEDGE TRANSACTIONS

Q: Is Mr. Schoenbeck's conclusion that the Company "hid[]-the-ball" with respect to gas financial hedge transactions correct? [Exhibit DWS-1T, pages 12-14]

A: No. Mr. Schoenbeck's conclusion that the Company tried to "hide-the-ball" with respect to gas financial hedge transactions is surprising, in light of the extensive information provided to him in response to numerous data requests and his discussions with knowledgeable Company personnel -- initiated at his request -- to clarify these matters. That information is described in some detail in Exhibit WAG-9C and included the Company's responses to the following data requests:

                       FEA Data Request                          WUTC Staff Data Request
                              7-I                                          9-I
                                                                           74-I
                       ICNU Data Request                                   75-I
                            2.1(I)                                         76-I
                            2.2(I)                                         80-I
                            2.3(I)                                         88-I
                            2.4(I)                                         89-I
                            4.1(I)                                         90-I
                                                                           91-I
                        Public Counsel                                    108-I
                             PC-60
                             PC-61
                            PC-138I

VIII. PARTIES HAVE NOT RECOGNIZED THE ADVERSE IMPACTS OF REDUCED CREDITWORTHINESS ON POWER SUPPLY

Q: Have other parties recognized the impact of the Company's financial condition on its ability to participate in the wholesale markets and use those markets to balance its loads and resources in meeting retail loads?

A: No. The other parties miss the issue or wholly ignore the impact of the Company's financial condition on its ability to participate in wholesale markets. For example, Ms. Steel, in responding to a question regarding evidence of emergency on an historical basis, states at page 10, lines 10-11, of Exhibit LAS-1T that [s]everal trade creditors re-examined the Company's creditworthiness without a significant negative outcome. She further states at pages 12-13 of Exhibit LAS-1T:

[t]he Company identified several potential suppliers who base trade credit extensions on corporate credit ratings. The inquiries reflect differences of opinion about [the Company's] actual credit ratings and the definition of investment grade. The effect of the Company's October 2001 ratings downgrades are limited to notices and reviews of trade credit extensions by a few counterparties. Indeed, [the Company] itself has placed a cash and financial exposure credit limits [sic] on all its counterparties since 1997. Response to Staff Data Request 86-I. Enron's collapse and the economic recession are factors that could have prompted counterparty reviews. The only independent assessment provided, PG&E's review, was favorable and has resulted in resumption of trading on the same terms. Response to Staff Data Request 81-I.

Ms. Steel's statements simply observe certain events that occurred before the statements were made, but, as will be discussed later in this testimony, they miss the point of counterparties contractual rights under wholesale market transactions and the counterparties; willingness to exercise such rights.

        Moreover, Ms. Steel's reference to WUTC Staff Data Request 86-I confuses the setting of credit limits (addressed in Section 3.4 of that Data Request), as is routinely done in the industry, with the effects of exceeding those credit limits. The relevant issue, of course, is the effect on the Company's participation in wholesale markets when its debt rating is downgraded and its credit limits are exceeded.

        More fundamentally, in response to questions at page 16, line 6, of Exhibit LAS-1T, at page 19, line 8, of such exhibit, and at page 20, line 7, of such exhibit, regarding evidence of an imminent emergency, Ms. Steel does not address the impact of a downgrade below investment grade on the Company's ability to participate in the wholesale gas and electric physical and financial forward markets. Instead, without explanation, she reaches the erroneous conclusion at page16, lines 7-9, of such exhibit that the Company is not facing clear jeopardy to the utility or its ratepayers.

        Mr. Schoenbeck and Mr. Hill do not address at all what could happen to the Company's ability to access the wholesale power and gas markets if its senior securities were downgraded to below investment grade. In remarking on the effects of such a downgrade, Mr. Hill focuses exclusively on the Company s ability to borrow money. See Exhibit SGH-T, page 9, lines 8-25. However, he altogether ignores the consequences of a downgrade under the standard agreements (WSPP agreement, GISB agreement, and ISDA agreement) that are commonly used in the energy industry to participate in the wholesale energy physical and derivative forward markets. Indeed, Mr. Hill is not aware of the terms and conditions under which the Company accomplishes its power purchase and financial hedge transactions. In his response to PSE Request No. ;10-I to Public Counsel, Mr. Hill states: Mr. Hill has not reviewed any documents regarding the ability of a utility to purchase wholesale power under the WSPP Agreement if it is rated below investment grade. Similarly, in his response to PSE Request No. 11-I to Public Counsel, Mr. Hill states: Mr. Hill has not reviewed any documents that address the ability of a utility to trade in energy financials if the utility is rated below investment grade. Moreover, while Mr. Hill does assert at page 9 of Exhibit SGH-T, lines 8-9, that the Company would not be shut out of the financial markets if [its] bond ratings fell below investment grade, he, like the other parties, ignores the adverse effects of increased borrowings on the Company under its agreements for participation in the wholesale energy physical and derivative forward markets (e.g., the Company's increased capital needs to prepay or provide security under these agreements).

Q: How would the Company's access to power, gas and financial markets be impaired by a downgrade of the Company's debt to below investment grade?

A: As I stated in my direct testimony, counterparties in power, gas, and related financial transactions routinely review a company’s financial health -- as indicated by its rating by major bond rating agencies and other creditworthiness indicators -- to determine whether and on what terms to enter into or continue such transactions with such company. A de-rating of the Company's senior securities to below investment grade would, under each of the standard agreements through which the Company commonly participates in wholesale power, wholesale gas, and financial derivative markets, trigger a requirement (in some instances to avoid termination of such agreement) for the Company to post cash collateral up to the amount of its forward obligations or other expensive security.

        The WSPP Agreement provides for such security requirement in Section 27 (Creditworthiness), stating that:

[s]hould a Party's creditworthiness, financial responsibility, or performance viability become unsatisfactory to the other Party in such other Party’s reasonably exercised discretion ... the dissatisfied Party ... may require the other Party ... to provide either (1) the posting of a Letter of Credit, (2) a cash prepayment, (3) the posting of other acceptable collateral or security , (4) a Guarantee Agreement executed by a creditworthy entity; or (5) some other mutually agreeable method ...

There is no doubt that if the Company's senior securities were downgraded to junk bond status, a counterparty to any WSPP transaction would have the basis to assert that it is reasonably dissatisfied with the Company's creditworthiness, financial responsibility, or performance viability. The counterparty could, and in all likelihood would, demand that the Company provide the required security. This would further impact the Company's cash flow and may necessitate further borrowings by the Company, thus exacerbating the Company's capitalization difficulties.

The GISB Agreement provides that:

[w]hen reasonable grounds for insecurity of payment... arise, either party may demand adequate assurance of performance. Adequate assurance shall mean sufficient security in the form and for the term reasonably specified by the party demanding assurance...

By amendment to the GISB provisions, parties often specify the form of security to include a standby irrevocable letter of credit, an agreed-upon company asset, or a performance bond or guaranty by a creditworthy entity.

        As with the WSPP Agreement, if the Company’s debt were downgraded to junk bond status, a counterparty to any GISB transaction would have the basis to assert that reasonable grounds for insecurity of payment exist. The counterparty could, and in all likelihood would, demand that the Company provide the required security, with the same effect on the Company's cash flow and capitalization difficulties.

        Indeed, GISB counterparties are not reluctant to exercise their contractual rights. By letter dated December 21, 2001, Engage Energy Canada, L.P., one of the Company’s major gas trading partners, notified the Company that:

[i]n the event [the Company] loses its investment-grade status, Engage Energy will be considering various options to shore up its credit risk exposure in accordance with our contractual rights [under our GISB agreement]. It is possible that these options will cause Engage Energy to request further securitization in the form of a letter of credit or other measures considered appropriate in the circumstances.

Loss of the ability to trade with Engage Energy Canada would severely limit the Company’s opportunities to procure gas for its LDC customers.

        The Company's Master Purchase and Sale Agreement for gas transactions (which has terms and conditions similar to the GISB agreement) provides that if a party has long-term debt unsupported by third party credit enhancement that (a) if rated by Standard & Poor's, is rated by Standard & Poor's below BBB-, or (b) if not rated by Standard & Poor's, has a debt coverage ratio or a cash flow ratio that would reasonably be determined to be the equivalent of a rating by Standard& Poor's below BBB-, the counterparty may terminate any or all transactions under such agreement unless the party provides (i) a letter of credit in an amount equal to the greater of the party's forward obligations under the agreement from time to time, (ii) cash prepayments with respect to any outstanding transactions, or (iii) other security in form and substance acceptable to the counterparty. Thus, if the Company's debt were downgraded to junk bond status, a counterparty to any such gas purchase and sale agreement would have a termination right, which the Company could avoid only by providing the required security. Posting such security would, as in other wholesale market arrangements, adversely affect the Company's cash flow and exacerbate the Company's capitalization difficulties.

        The ISDA Agreement is often used by the Company to hedge its floating price risk in volatile wholesale markets. The Company's existing ISDA agreements provide for the posting of collateral, most often in the form of cash or letter of credit, depending on the party's debt rating. Thus, if the Company's debt is rated below investment grade, the Company must provide such security in the entire amount of its then-current forward obligations. Providing such security would, again, adversely affect the Company's cash flow and exacerbate the Company's capitalization difficulties. In addition, at such credit rating, the Company is likely to be precluded from entering into new unsecured derivative transactions with financial counterparties.

Q: Are there any other adverse effects related to the wholesale market and financial agreements referred to above if the Company's debt were to be downgraded to below investment grade?

A: Yes. Under the WSPP Agreement, the GISB Agreement, the Company Master Purchase and Sale Agreement and the ISDA Agreement, the counterparty has the right to terminate or suspend any or all transactions under such agreements if the required security is not posted. Upon termination, the Company would be required to immediately pay to the counterparty all of its forward obligations under the terminated transactions. Thus, the downgrade of the Company's debt immediately puts the Company in one of two positions, each equally untenable: (i) the Company would have to provide security to cover forward obligations under its long-term wholesale power and gas contracts and hedge transactions or (ii) the Company would have to liquidate its forward obligations under its long-term wholesale power and gas contracts and hedge transactions. Borrowings by the Company to cover these obligations would only exacerbate the Company's capitalization difficulties.

        Moreover,

the Company’s ability to enter into market transactions to cover the terminated power and gas transaction purchases would be severely constrained by the financial condition produced by these events. Indeed, even without its senior securities being rated at junk bond status, the Company’s current credit status has begun to adversely affect its ability to deal in the power market. On February 1, 2002, Engage Energy America Corporation, an Engage affiliate dealing in power transactions, refused to enter into unsecured trades with the Company due to the Company’s current credit rating.

        Mr. Hill does not address any of the foregoing points when he asserts without explanation at page 29, lines 6-10, of Exhibit SGH-T that reduction of the Company's senior secured debt to a level below investment grade does not mean the Company would be able [sic] to continue to meet its public service obligations. As a result of a reduction of the Company’s debt to below investment grade, the Company may well lack the creditworthiness and the cash flow to continue to serve its loads. Enron's case illustrates how quickly the physical and financial markets can close on parties lacking creditworthiness or even perceived to be lacking creditworthiness, as recognized in my direct testimony.

Q: Is the adverse effect of a debt rating below investment grade on a utility's ability to participate in the wholesale markets unique to the Company

A: No. Avista Corporation has testified before the Commission regarding the adverse impact of its debt rating on its ability to participate in wholesale markets.

        At page 12, lines 11-22, and page 13, lines 1-2, in his pre-filed direct testimony in Docket No. UE-011514 in response to a question regarding the impacts of Avista’s credit rating below investment grade, Mr. Jon Eliassen stated:

The Company relies on many suppliers and contractors for day-to-day operations. As an active participant in regional power markets, in order to assure power and natural gas supplies and to effectively manage energy resources, Avista routinely buys and sells energy by transacting with other parties. Many of these parties monitor credit quality at least in part on the basis of rating agency reports. Avista has traditionally enjoyed the ability to conduct transactions in these markets with unsecured credit terms. A deteriorating credit rating, however, can trigger counterparties to reduce open credit limits, to require enhanced credit terms, or to simply curtail new transactions with Avista. As of November 8, 2001, Avista had $3.8 million of collateral posted to energy suppliers to satisfy their requests for adequate assurance as a result of the Company’s lowered credit ratings, which reduces the amount of cash borrowing capacity under our credit line. In addition, several energy companies have suspended authority to do business with Avista. To avoid collateral posting, we have flattened our positions by buying and selling energy very selectively to stay within tighter credit limits, and we continue to negotiate with other parties who have made adequate assurance inquiries.

At page 9, lines 17-21, in his rebuttal testimony in Docket No. UE-010395 in response to a question regarding the immediate impacts of Avista's August 2, 2001 Standard & Poor's rating downgrade, Mr. Eliassen stated:

Several counterparties that the Company relies upon to provide short-term and real-time energy suspended their authority to transact with Avista. We were precluded from buying energy from those parties absent prepayments or other unusual terms. The obvious and acknowledged cause for suspending their authority to transact with Avista was the concerns expressed by S&P in their downgrade, including S&P's continued negative outlook.

At page 12, lines 10-23, and page 13, lines 1-4, in his pre-filed rebuttal testimony in Docket No. UE-010395 in response to a question regarding the likely power supply-related impacts of a drop in credit rating, Mr. Kelly Norwood stated:

If the Company's credit rating were to drop below investment grade, it would likely place Avista in a similar position to the utilities in California (PG&E and So. Cal. Edison) with regard to its ability to purchase power from the wholesale market to serve its system load requirements. Many counterparties would refuse to sell power to Avista or grant a credit line for money that would be owed related to a transaction. This would force Avista to prepay for power purchases, and/or post cash collateral margins, at a time when the utility would have limited cash available. Several counterparties have already cut off transactions with Avista, or have limited transactions with Avista, as a result of the most recent downgrade that occurred.

        Furthermore, the majority of Avista's short-term wholesale market purchases are conducted under the Western Systems Power Pool (WSPP) Agreement. The WSPP Agreement includes a creditworthiness section, that states in general terms, that should a party’s creditworthiness become unsatisfactory to the other party, the dissatisfied party may require the counterparty to make a prepayment of cash, or use some other mutually agreeable method to satisfy the party. Under the Agreement, a downgrade to below investment grade could result in substantial margin calls to Avista that would require Avista to make immediate cash payments or post collateral for existing transactions already entered into by Avista to serve system load requirements. Mr. Eliassen addresses the financial difficulties that would be associated with these margin calls.

Thus, the adverse effect that would result from a below-investment-grade debt rating on a utility’s ability to participate in wholesale markets is recognized by both of the largest investor-owned utilities in this state.

Q: Does this conclude your testimony?

A: Yes, it does.

EX-99

EXHIBIT 99.3

EXHIBIT NO. ______ (GBS-4T)
DOCKET NO. UE-011570 (INTERIM)
WITNESS: GARY B. SWOFFORD

BEFORE THE
WASHINGTON UTILITIES AND TRANSPORTATION COMMISSION

WASHINGTON UTILITIES AND
AND
TRANSPORTATION COMMISSION,

           Complainant,

v.

PUGET SOUND ENERGY, INC.,

           Respondent.

REBUTTAL TESTIMONY OF GARY B. SWOFFORD
ON BEHALF OF PUGET SOUND ENERGY, INC.

FEBRUARY 11, 2002

PUGET SOUND ENERGY, INC.

REBUTTAL TESTIMONY OF GARY B. SWOFFORD

Q: Please state your name, business address and present position with Puget Sound Energy, Inc.

A: My name is Gary B. Swofford. My business address is One Bellevue Center, Suite 1500, 411 108th Ave. N.E., Bellevue, Washington 98004. I am the Vice President and Chief Operating Officer Delivery for Puget Sound Energy, Inc. ("PSE" or "the Company").

Q: Have you presented direct testimony in this proceeding?

A: Yes, I have, in Exhibits GBS-1T, GBS-2 and GBS-3.

Q: Would you please summarize your rebuttal testimony?

A: PSE provides some of the best and lowest cost per customer services of any utility in the country, public or private, and has been recognized twice this past year for its achievements, including utility of the year honors. Our customers enjoy some of the best technology has to offer in helping them manage their energy usage, and they have had a strong, positive response to having access to these services. While PSE is proposing an increase in customer rates, our customers will be the last in the region to see an increase in electric rates, and the increase they do see will be among the lowest in the region. Until October of 2001, we maintained an A- bond rating. I conclude that these are hardly the accomplishments or the attributes of a poorly managed utility, as asserted by others in this proceeding.

      In addition, my rebuttal testimony addresses the assertion that PSE is not facing financial crisis because it has taken no dramatic actions to reduce expenditures. I describe why this conclusion is flawed, and ignores the significant actions the Company has and will take such as freezing the salaries of Officers, Directors and Managers, restricting travel, and requiring Officers to review and approve any new hires as well as the purchase of any personal computers, printers and other office equipment.

      Finally, I address Staff's suggestion that reductions to the Company's O&M and Capital budgets should be made. We have achieved our present low cost per customer levels by aggressively managing expenditures, and consequently have little flexibility to make further cuts without affecting service and reliability. I lay out a number of areas where reductions or deferrals may have to be made if interim relief is not granted, and also address the consequences of making cuts in those areas.

Q: How do you respond to the suggestion by Public Council and other parties that PSE’s “bad management decisions” are what has placed the Company in its current distressed financial condition?

A:; The management and all employees have worked diligently to make PSE one of the best utilities in the business. As of now, PSE has the second lowest non-production O&M cost per customer of all the combination gas and electric IOUs in the country. For our electric only operations, we are the lowest among all Northwest utilities, public or private. For the most part, our service levels have consistently equaled or exceeded the Service Quality Index levels established at the time of the merger. In short, today we are providing our customers with quality service at low cost.

      As a result of the technology we are now providing, our customers have access to information from which they can manage their energy use and make choices that other utilities do not provide. Of those customers on the PEM pilot program, 90% say they would recommend it to a friend or neighbor. This same technology also helps us to provide efficient, more reliable service to all of our customers.

     We have far exceeded the expectations that were set at the time of the merger with respect to achieving potential benefits that were identified at that time, and we have far exceeded the benefits derived from other mergers that have taken place over the past five years.

      PSE just this past year has received two of the energy industry's highest honors. In June, we received the Edison Award from the Edison Electric Institute. This was awarded to PSE for distinguished leadership, innovation and contribution to the advancement of the electric industry for the benefit of all. In addition to the Edison Award, we were notified in December that we were selected as the Utility of the Year by Electric Light and Power.

     Finally, as described in the rebuttal testimony of Donald Gaines, PSE was able to meet the expectations of debt and equity analysts until October of 2001 when the consequences of our inability to recover our net power costs became apparent. Until then, we maintained an A- bond rating in spite of coverage ratios that did not meet all of the quantitative requirements.

     Taken all together, these are hardly the results that would be achieved by a utility that was poorly managed.

Q: How will PSE's customers fare if the interim request is granted?

A: PSE has managed to protect its customers from rate increases longer than other utilities in the region. Although customers will experience increased electric bills, these increases will be among the lowest in the region. Comparing PSE's proposed rates to those adjacent to its service area, PSE will be second lowest. The increases will also allow the Company to continue necessary investments in infrastructure to provide the service levels that customers need and expect.

Q: Would you respond to Staff witness Lisa A. Steel's assertion that the Company has not taken "steps a utility would typically take during times of financial emergency," including hiring freezes, job cuts, discretionary Capital expenditure deferrals and bonus restructurings? [Exhibit LAS-1T, p. 14, ll. 13-18]

A: A well-managed company does not wait until a financial crisis occurs to take aggressive actions to control its costs. PSE has spent the last several years working hard to reduce its costs to the lowest possible levels.

      PSE has not announced "hiring freezes" because it already has a system in place that defers hiring as long as possible. Officer approval is required to fill any vacancy, and this decision is made with an eye on managing costs. Officers generally will not approve any hire unless it can be demonstrated that existing employees cannot cover the position, and that filling the position is necessary to PSE’s operations. This “critical hiring only” practice has recently been made a mandatory policy and has been further emphasized with direct reports.

     The result of this practice is that PSE has already reduced staffing levels to a minimum. The Company’s full-time equivalent employee (FTE) counts for the year-end 2000 (as provided in Data Request No. 193-G) were 2,723.50 while the year-end 2001 FTE counts were 2,479.61. Thus, PSE reduced or deferred staffing by 243.89 FTEs. Of those, 189 FTEs left PSE to work for our service providers. Those employees continue to perform work on PSE assets, but only on an as-needed basis. That leaves 54.89 FTE jobs that were either eliminated or that PSE has deferred filling to date. This reduction has not been offset with increased use of contract or agency personnel, as Officers manage use of such personnel in the same manner.

      PSE has not laid off employees in 2002 because PSE is managing its business to operate with the minimum number of employees. We are staffed at a level that responds to requests for services. PSE's financial emergency is not the result of a reduction in customer requests for services, which is the type of emergency facing other types of businesses in the region that are cutting jobs. PSE generally is not experiencing low demand for its services, such that it has idle workers who can be laid off. Customers continue to need gas and electric service, and demand that PSE provide services such as relocations, conversions and new construction. Although some industrial customers may need less power from PSE, PSE still needs to have the infrastructure in place and knowledgeable employees to run its operations. Our employees have been and continue to be working at maximum capacity.

      In addition to the above, the Company has frozen management salaries at its current levels by not implementing scheduled annual merit increases for officers, directors and managers. PSE has extended the same “officer review” approach it utilizes with respect to hiring decisions to the lease or purchase of personal computers, printers, copiers and other office equipment. Officer approval is also required for all out-of-state business travel.

Q: Is Ms. Steel correct that a comparison of PSE’s 2002 Capital and O&M budgets provides evidence "inconsistent with the existence of an imminent financial emergency"? [Exhibit LAS-1T, p. 19, ll. 8-9]

A: No. PSE takes an aggressive approach to budgeting, and has found that during any given year actual expenditures vary from the original budget. For example, the original 2001 O&M budget did not include a number of significant expenditures, such as costs associated with the PEM pilot, a partial year of lease expenditures associated with Fredonia turbines, and other costs. Comparison of the 2001 budget to the 2002 budget makes it appear as though O&M will increase by 20% in 2002. Comparing 2001 actual expenditures to the 2002 budget reflects only an 8% increase.

     Similarly, one should not compare PSE’s 2001 and 2002 Capital budgets to get an idea of overall Company cost increases. Comparing budget-to-budget, it appears as though Capital will increase by 2%. However, comparing 2001 actual expenditures to the 2002 budget reflects a 2% decrease. Capital expenditures are more project/program oriented than are O&M expenditures. Although Capital expenditures may sometimes be accelerated or deferred, each year tends to be unique, based upon the needs of the overall system.

     Second, comparison of budgets or actual expenditures from year to year does not take into account how an increase in O&M expenditures might produce lower costs in another area, or how a reduction in short-term spending might have the adverse impact of deteriorating customer service and system reliability while at the same time increasing costs in the longer-term. For example, long-term power supply savings are contemplated and anticipated because of PEM O&M costs. Another example, explained in my direct testimony, is the deferral of normal vegetation management actions and the higher number of outages that are accompanied with higher costs in future years. PSE has been reluctant to take reductions beyond our current levels because of the adverse impact on customers.

Q: Can PSE make cuts across all areas of its budget?

A: No. As described in my direct testimony, most of our expenditures are unavoidable because they must be made to provide services required by law or contract, including our tariffs and franchises, or because they are for public safety. For example, PSE generally must relocate its facilities or install new facilities when requested by its customers. PSE continues to invest in maintaining gas pipeline safety. We cannot make cuts that would affect public or employee safety.

      New customer construction, external commitments, non-PEM metering and billing, and “unplanned” events – customers calling with reports of gas odors that must be investigated/addressed and electric system outages, collectively represent the bulk of the Company’s anticipated combined O&M and Capital expenditures. Another significant component is “planned” safety and reliability work, which when performed, has the affect of reducing future “unplanned” expenditures. For example, failure to construct a specific gas capacity project creates higher O&M costs in the form of the purchase and manning of CNG tube trailers, which are used to inject compressed natural gas into the system in low-pressure areas during cold weather. Eventually, customers can lose service and we incur further unplanned O&M expenditures in re-lighting customer appliances when pressures are restored. Deferred expenditures on system maintenance have similar adverse consequences. Thus, as described in my direct testimony at pages 4-5, PSE has not eliminated its plans to undertake such projects in 2002.

Q: Would you please respond to Ms. Steel's proposal to adjust O&M and Capital Spending levels? [Exhibit LAS-1T, p. 36, ll. 3-5]

A: Ms. Steel has suggested an after-tax O&M cut of $9.8 million, which equates to a $15.1 million (5.25%) reduction in our 2002 budget. On the Capital-side, she suggests a $7.8 million (5.20%) reduction, which is not modified for taxes since Capital expenditures are not tax-affected until expenditures are depreciated.

      Given the Company’s efforts to date to reduce and control its O&M and Capital expenditures, we do not believe it is in our customers' interest to make additional reductions or deferrals. However, in the event that the Commission agrees with Ms. Steel, it would be important to recognize the effect of taxes, and that Ms. Steel’s proposal would result in a tax-adjusted reduction of $22.9 million rather than $17.6 million.

      In the event sufficient interim relief is not granted, then PSE would have to consider taking a number of steps such as those listed in my direct testimony and below:

1. Estimated bills. Of remaining manually read meter routes (non-AMR), PSE may estimate reads every other month rather than manually reading the route every month, as allowed by WAC 480-90-178 (gas) and 480-100-178 (electric) (“The utility may not estimate for more than four consecutive months...”) Estimated bills would be issued on months in which no read was made.

2. New customer construction. PSE may also eliminate new customer construction canvassing efforts, an activity performed after initial gas conversion inquiries are received. Canvassing an area to determine whether or not there is sufficient interest in gas conversion, to make the gas system extension cost effective, typically spreads the cost of bringing gas to an area over more parties, thus making the cost lower for each individual customer. This activity adds new gas customers who would not otherwise have taken gas service. By eliminating all canvassing efforts, an estimated 1,875 fewer new gas customers would be hooked-up, thus reducing new customer construction costs accordingly.

3. Paystations. PSE will consider eliminating pay stations. PSE handles 10.8 million bill-processing transactions each year, of which 600,000 of those transactions, or approximately 5%, are handled through paystations. Customers at risk of disconnect for non-payment, who might use a paystation, will either have to travel to the nearest business office, or be prepared to pay the Disconnect Visit Fee to have their delinquent payment picked up in-person by a Field Collector.

4. 24 by 7 Customer Access Center coverage. Although inconvenient for our customers, PSE is evaluating a change in our availability to customers by adopting the following hours Monday through Friday, 7 a.m. to 10 p.m. and Saturday 9 a.m. to 5 p.m. Emergency calls would be handled during non-business hours with a limited emergency staff. Ramping-up of staff in storm situations would take place utilizing current plans, but PSE anticipates customer frustration in trying to contact a live representative during the early hours of a storm.

5. Vegetation management. In all likelihood we would need to partially defer our normal vegetation management and TreeWatch vegetation management programs. However, that would result in decreased system reliability and increased longer term costs, as described at page 4 of my direct testimony. In addition, PSE is likely to be on the borderline of meeting its SAIDI and SAIFI service quality measures and as a consequence might need to ask the Commission to excuse any nonperformance, in order to avoid expenditures associated with a potential penalty for not meeting these measures. Additionally, proforma increases would need to be added to the general rate case request, in order to reflect the increased spending that would result during the rate year as a consequence of such deferral.

6. Gas pipeline programs. Given PSE's repaired leak performance relative to the industry and our active leak reduction actions, we will need to petition the Commission to extend the settlement periods for the cast iron replacement and critical bond programs to secure the remaining expenditure reductions, deferring our spending on these programs.

Q: Could stopping the PEM pilot reduce PSE’s 2002 O&M and Capital expenditures?

A: Yes, but PSE believes that taking such action would provide minimal assistance during the interim period and would have adverse consequences for the potential expansion of the PEM program that PSE has proposed in the general case. Because of contractual obligations with SchlumbergerSema, the earliest possible date to lower PEM costs without a significant penalty would be June 1, 2002. If the PEM/TOU program were eliminated effective June 1, 2002 and reinitiated after a decision on the general rate case, the resultant reduction in O&M and Capital would be $4.2 million.

     However, it is important to recognize the risks associated with the elimination of PEM spending. The elimination of PEM and TOU pricing would be confusing to customers who use the program. Additionally, customers who use the program may revert to pre-PEM behaviors, thus shifting usage back to more expensive periods and consuming overall higher quantities of electricity.

Q: Does this conclude your testimony?

A: Yes.