Item 1. Business

General 

Corporate Structure and Business

PG&E Corporation, incorporated in California in 1995, is a holding company whose primary purpose is to hold interests in energy-based businesses.  PG&E Corporation conducts its business principally through Pacific Gas and Electric Company (“Utility”), a public utility operating in northern and central California.  The Utility engages in the businesses of electricity and natural gas distribution; electricity generation, procurement, and transmission; and natural gas procurement, transportation, and storage.  The Utility was incorporated in California in 1905.  PG&E Corporation became the holding company of the Utility and its subsidiaries on January 1, 1997.

The Utility served approximately 5.1 million electricity distribution customers and approximately 4.3 million natural gas distribution customers at December 31, 2009.  The Utility had approximately $42.7 billion in assets at December 31, 2009 and generated revenues of $13.4 billion in 2009.  Its revenues are generated mainly through the sale and delivery of electricity and natural gas.  The Utility is regulated primarily by the California Public Utilities Commission (“CPUC”) and the Federal Energy Regulatory Commission (“FERC”).  In addition, the Nuclear Regulatory Commission (“NRC”) oversees the licensing, construction, operation, and decommissioning of the Utility’s nuclear generation facilities.

Corporate and Other Information

The principal executive office of PG&E Corporation is located at One Market, Spear Tower, Suite 2400, San Francisco, California 94105, and its telephone number is (415) 267-7000.  The principal executive office of the Utility is located at 77 Beale Street, P.O. Box 770000, San Francisco, California 94177, and its telephone number is (415) 973-7000.  PG&E Corporation and the Utility file or furnish various reports with the Securities and Exchange Commission (“SEC”).  These reports, including Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and any amendments to those reports filed or furnished pursuant to Sections 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, are available free of charge on both PG&E Corporation's website, www.pgecorp.com , and the Utility's website, www.pge.com , as promptly as practicable after they are filed with, or furnished to, the SEC .  The information contained on these websites is not incorporated by reference into this Annual Report on Form 10-K and should not be considered part of this report.

Employees 

At December 31, 2009, PG&E Corporation and its subsidiaries had 19,425 regular employees, including 19,401 regular employees of the Utility.  Of the Utility’s regular employees, 12,648 are covered by collective bargaining agreements with three labor unions: the International Brotherhood of Electrical Workers, Local 1245, AFL-CIO (“IBEW”); the Engineers and Scientists of California, IFPTE Local 20, AFL-CIO and CLC (“ESC”); and the Service Employees International Union, Local 24/7 (“SEIU”).  One IBEW collective bargaining agreement expires on December 31, 2010, and the other expires on December 31, 2011.  The ESC collective bargaining agreement expires on December 31, 2011.  The SEIU collective bargaining agreement expires on July 31, 2012.

Cautionary Language Regarding Forward-Looking Statements

This combined Annual Report on Form 10-K, including the information incorporated by reference from the joint Annual Report to Shareholders for the year ended December 31, 2009 (“2009 Annual Report”) and the Joint Proxy Statement relating to the 2010 Annual Meetings of Shareholders, contains forward-looking statements that are necessarily subject to various risks and uncertainties.  These statements are based on current estimates, expectations and projections about future events, and assumptions regarding these events and management's knowledge of facts as of the date of this report.  These forward-looking statements relate to, among other matters, estimated capital expenditures, estimated Utility rate base, estimated environmental remediation liabilities, estimated tax liabilities,

the anticipated outcome of various regulatory and legal proceedings, estimated future cash flows, and the level of future equity or debt issuances, and are also identified by words such as “assume,” “expect,” “intend,” “plan,” “project,” “believe,” “estimate,” “target,” “predict,” “anticipate,” “aim, “ “may,” “might,” “should,” “would,” “could,” “goal,” “potential” and similar expressions.  PG&E Corporation and the Utility are not able to predict all the factors that may affect future results.  Some of the factors that could cause future results to differ materially from those expressed or implied by the forward-looking statements, or from historical results, include, but are not limited to:

·	the Utility’s ability to manage capital expenditures and its operating and maintenance expenses within authorized levels;
·	the outcome of pending and future regulatory proceedings and whether the Utility is able to timely recover its costs through rates;
·	the adequacy and price of electricity and natural gas supplies, and the ability of the Utility to manage and respond to the volatility of the electricity and natural gas markets, including the ability of the Utility and its counterparties to post or return collateral;
·	explosions, fires, accidents, mechanical breakdowns, the disruption of information technology and systems, and similar events that may occur while operating and maintaining an electric and natural gas system in a large service territory with varying geographic conditions, that can cause unplanned outages, reduce generating output, damage the Utility’s assets or operations, subject the Utility to third-party claims for property damage or personal injury, or result in the imposition of civil, criminal, or regulatory fines or penalties on the Utility;
·	the impact of storms, earthquakes, floods, drought, wildfires, disease and similar natural disasters, or acts of terrorism or vandalism that affect customer demand, or that damage or disrupt the facilities, operations, or information technology and systems owned by the Utility, its customers, or third parties on which the Utility relies;
·	the potential impacts of climate change on the Utility’s electricity and natural gas businesses;
·	changes in customer demand for electricity and natural gas resulting from unanticipated population growth or decline, general economic and financial market conditions, changes in technology that include the development of alternative technologies that enable customers to increase their reliance on self-generation, or other reasons;
·	the occurrence of unplanned outages at the Utility’s two nuclear generating units at the Diablo Canyon Power Plant (“Diablo Canyon”), the availability of nuclear fuel, the outcome of the Utility’s application to renew the operating licenses for Diablo Canyon, and potential changes in laws or regulations promulgated by the NRC or other environmental agencies with respect to the storage of spent nuclear fuel, security, safety, or other matters associated with the operations at Diablo Canyon;
·	whether the Utility can maintain the cost savings that it has recognized from operating efficiencies that it has achieved and identify and successfully implement additional sustainable cost-saving measures;
·	whether the Utility earns incentive revenues or incurs obligations under incentive ratemaking mechanisms, such as the CPUC’s incentive ratemaking mechanism relating to energy savings achieved through implementation of the utilities’ customer energy efficiency programs;
·	the impact of federal or state laws, or their interpretation, on energy policy and the regulation of utilities and their holding companies;
·	whether the new day-ahead, hour-ahead, and real-time wholesale electricity markets established by the California Independent System Operator (“CAISO”) that became operational on April 1, 2009 will continue to function effectively and whether the Utility can successfully implement “dynamic pricing” by offering electric rates that can vary with the customer’s time of use and are more closely aligned with wholesale electricity prices;
·	how the CPUC administers the conditions imposed on PG&E Corporation when it became the Utility’s holding company;

·	the extent to which PG&E Corporation or the Utility incurs costs and liabilities in connection with litigation that are not recoverable through rates, from insurance, or from other third parties;
·	the ability of PG&E Corporation, the Utility, and counterparties to access capital markets and other sources of credit in a timely manner on acceptable terms;
·	the impact of environmental laws and regulations and the costs of compliance and remediation;
·	the loss of customers due to municipalization of the Utility’s electric distribution facilities, the level of “direct access” by which consumers procure electricity from alternative energy providers, implementation of “ community choice aggregation,” which permits cities and counties to purchase and sell electricity for their local residents and businesses, or other forms of bypass; and
·	the outcome of federal or state tax audits and the impact of changes in federal or state tax laws, policies, or regulations.

For more information about the significant risks that could affect the outcome of these forward-looking statements and PG&E Corporation’s and the Utility’s future financial condition and results of operations, see the discussion under the heading “Risk Factors” that appears near the end of the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" (“MD&A”) in the 2009 Annual Report.  PG&E Corporation and the Utility do not undertake an obligation to update forward-looking statements, whether in response to new information, future events, or otherwise.

  PG&E Corporation's Regulatory Environment

Federal Energy Regulation

As a public utility holding company, PG&E Corporation is subject to the requirements of the Energy Policy Act of 2005 (“EPAct”), which became effective on February 8, 2006.  Among its key provisions, the EPAct repealed the Public Utility Holding Company Act of 1935 and enacted the Public Utility Holding Company Act of 2005 (“PUHCA 2005”).  Under PUHCA 2005, public utility holding companies fall principally under the regulatory oversight of the FERC, an independent agency within the U.S. Department of Energy.  PG&E Corporation and its subsidiaries are exempt from all requirements of PUHCA 2005 other than the obligation to provide access to their books and records to the FERC and the CPUC for ratemaking purposes.  These books and records provisions are largely duplicative of other provisions under the Federal Power Act of 1935 and state law.

State Energy Regulation

PG&E Corporation is not a public utility under California law.  The CPUC has authorized the formation of public utility holding companies subject to various conditions related to finance, human resources, records and bookkeeping, and the transfer of customer information.  The financial conditions provide that:

·	the Utility cannot guarantee any obligations of PG&E Corporation without prior written consent from the CPUC;

 

·	the Utility’s dividend policy must be established by the Utility's Board of Directors as though the Utility were a stand-alone utility company;

 

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the capital requirements of the Utility, as determined to be necessary and prudent to meet the Utility's obligation to serve or to operate the Utility in a prudent and efficient manner, must be given first priority by PG&E Corporation's Board of Directors (known as the “first priority” condition); and

 

·	the Utility must maintain on average its CPUC-authorized utility capital structure, although it can request a waiver of this condition if an adverse financial event reduces the Utility's common equity component by 1% or more.

 

 

The CPUC also has adopted complex and detailed rules governing transactions between California's electricity and gas utilities and certain of their affiliates.  The rules address the use of the utilities’ names and logos by their affiliates, the separation of utilities and their affiliates, provision of utility information to affiliates, and energy procurement-related transactions between the utilities and their affiliates.  The rules also prohibit each utility from engaging in certain practices that would discriminate against energy service providers that compete with that utility's affiliates.  In December 2006, the CPUC revised its rules to, among other changes:

·	emphasize that the holding company may not aid or abet a utility's violation of the rules or act as a conduit to provide confidential utility information to an affiliate;

·	require prior CPUC approval before the utility can contract with an affiliate for resource procurement ( e.g., electricity or gas), except in blind transactions where the identity of the other party is not known until the transaction is consummated;

·	require certain key officers to provide annual certifications of compliance with the affiliate rules;

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prohibit certain key officers from serving in the same position at both the utility and the holding company (unless otherwise permitted by the CPUC), or, in the alternative, prohibit the sharing of lobbying, regulatory relations and certain legal services (except for legal services necessary to the provision of permitted shared services);

·	require the utility to obtain a “nonconsolidation opinion” indicating that it would not be consolidated into a bankruptcy of its holding company; and

·	make the CPUC's Energy Division responsible for hiring independent auditors to conduct biennial audits to verify that the utility is in compliance with the affiliate rules.

The CPUC has established specific penalties and enforcement procedures for affiliate rules violations. Utilities are required to self-report affiliate rules violations.

The Utility's Regulatory Environment 

Various aspects of the Utility's business are subject to a complex set of energy, environmental and other laws, regulations, and regulatory proceedings at the federal, state, and local levels.  In addition to enacting PUHCA 2005 to replace the Public Utility Holding Company Act of 1935, as discussed above, the EPAct significantly amended various federal energy laws applicable to electric and natural gas markets, including the Federal Power Act of 1935, the Natural Gas Act of 1938, and the Public Utility Regulatory Policies Act of 1978 (“PURPA”).

This section and the “Ratemaking Mechanisms” section below summarize some of the more significant laws, regulations, and regulatory mechanisms affecting the Utility.  These summaries are not an exhaustive description of all the laws, regulations, and regulatory proceedings that affect the Utility.  The energy laws, regulations, and regulatory proceedings may change or be implemented or applied in a way that the Utility does not currently anticipate.  For discussion of specific pending regulatory proceedings that are expected to affect the Utility, see the section of MD&A entitled “Regulatory Matters” in the 2009 Annual Report.

Federal Energy Regulation

The FERC

The FERC regulates the transmission and wholesale sales of electricity in interstate commerce and the transmission and sale of natural gas for resale in interstate commerce.  The FERC also regulates interconnections of transmission systems with other electric systems and generation facilities; tariffs and conditions of service of regional transmission organizations, including the CAISO; and the terms and rates of wholesale electricity sales.  The FERC has authority to impose penalties of up to $1,000,000 per day for violation of certain federal statutes, including the Federal Power Act of 1935 and the Natural Gas Act of 1938, and for violations of FERC-approved regulations.  The FERC has jurisdiction over the Utility's electricity transmission revenue requirements and rates, the licensing of substantially all of the Utility's hydroelectric generation facilities, and the interstate sale and transportation of natural gas.

Electric Reliability Standards; Development of Transmission Grid .  The FERC has the responsibility to approve and enforce mandatory standards governing the reliability of the nation’s electricity transmission grid, including standards to protect the nation’s bulk power system against potential disruptions from cyber and physical security breaches; to prevent market manipulation, and to supplement state transmission siting efforts in certain electric transmission corridors that are determined to be of national interest.  The FERC certified the North American Electric Reliability Corporation (“NERC”) as the nation’s Electric Reliability Organization under the EPAct of 2005.  The NERC is responsible for developing and enforcing electric reliability standards, subject to FERC approval.  The FERC also has approved a delegation agreement under which the NERC has delegated enforcement authority for the geographic area known as the Western Interconnection to the Western Electricity Coordinating Council (“WECC”).  The Utility must self-certify compliance to the WECC on an annual basis, and the compliance program encourages self-reporting of violations.  WECC staff, with participation by the NERC and the FERC, will also perform a regular compliance audit of the Utility every three years.  In addition, the WECC and the NERC may perform spot checks or other interim audits, reports, or investigations.  Under FERC authority, the WECC, NERC, and/or FERC may impose penalties up to $1,000,000 per day per violation.

The FERC also has issued rules on electric transmission pricing reforms designed to promote needed investment in energy infrastructure, to reduce transmission congestion, and to require transmission organizations with organized electricity markets to make long-term firm transmission rights available to load-serving entities, so these entities can enter into long-term transmission service arrangements without being exposed to unhedged congestion cost risk.  In addition, pursuant to FERC orders, the CAISO is responsible for providing open access electricity transmission service on a non-discriminatory basis, planning transmission system additions, and ensuring the maintenance of adequate reserves of generation capacity.

Prevention of Market Manipulation .  The FERC has broad authority to police and penalize the exercise of market power or behavior intended to manipulate prices paid in FERC-jurisdictional transactions.  The FERC has adopted rules to prohibit market manipulation, modeling its new rules on SEC Rule 10b-5, which prohibits fraud and manipulation in the purchase or sale of securities.  Under the FERC's new regulations, it is unlawful for any entity, directly or indirectly, in connection with the purchase or sale of natural gas, electric energy, or transportation/transmission services subject to the jurisdiction of the FERC (1) to use or employ any device, scheme, or artifice to defraud, (2) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (3) to engage in any act, practice, or course of business that operates or would operate as a fraud or deceit upon any person.

QF Regulation .   Under PURPA, electric utilities are required to purchase energy and capacity from independent power producers that are qualifying cogeneration facilities (“QFs”).  To implement the purchase requirements of PURPA, the CPUC required California investor-owned electric utilities to enter into long-term power purchase agreements with QFs and approved the applicable terms, conditions, prices, and eligibility requirements.  The EPAct significantly amended the purchase requirements of PURPA.  As amended, Section 210(m) of PURPA authorizes the FERC to waive the obligation of an electric utility under Section 210 of PURPA to purchase the electricity offered to it by a QF (under a new contract or obligation), if the FERC finds that the QF has nondiscriminatory access to one of three defined categories of competitive wholesale electricity markets.  The statute permits such waivers as to a particular QF or on a “service territory-wide basis.”  The Utility is assessing whether it will file a request with the FERC to terminate its obligations under PURPA to enter into new QF purchase obligations.

The Nuclear Regulatory Commission

The NRC oversees the licensing, construction, operation and decommissioning of nuclear facilities, including the two nuclear generating units at Diablo Canyon and the Utility’s retired nuclear generating unit at Humboldt Bay (“Humboldt Bay Unit 3”).  NRC regulations require extensive monitoring and review of the safety, radiological, environmental, and security aspects of these facilities.  In the event of non-compliance, the NRC has the authority to impose fines or to force a shutdown of a nuclear plant, or both. NRC safety and security

requirements have, in the past, necessitated substantial capital expenditures at Diablo Canyon, and additional significant capital expenditures could be required in the future.

In addition, as required by NRC regulations, only certain key management personnel and other designated individuals may receive information from the NRC or other government agency relating to Diablo Canyon that is deemed to be classified by the governmental agency.  In connection with this requirement, the Board of Directors of PG&E Corporation has adopted a resolution acknowledging that neither PG&E Corporation nor any director or officer of PG&E Corporation will (1) have access to such classified information or special nuclear material in the custody of the Utility, or (2) participate in any decision or matter pertaining to the protection of classified information and/or special nuclear material in the custody of the Utility.

State Energy Regulation

California Legislature. The Utility’s operations have been significantly affected by statutes passed by the California legislature, including laws related to electric industry restructuring, the 2000-2001 California energy crisis, electric resource adequacy, renewable energy resources, power plant siting and permitting, and greenhouse gas (“GHG”) emissions and other environmental matters.

The CPUC . The CPUC consists of five members appointed by the Governor of California and confirmed by the California State Senate for staggered six-year terms.  The CPUC has jurisdiction to set the rates, terms, and conditions of service for the Utility's electricity distribution, electricity generation, natural gas distribution, and natural gas transportation and storage services in California.  The CPUC also has jurisdiction over the Utility's issuances of securities, dispositions of utility assets and facilities, energy purchases on behalf of the Utility's electricity and natural gas retail customers, rate of return, rates of depreciation, aspects of the siting and operation of natural gas transportation assets, oversight of nuclear decommissioning, and aspects of the siting of the electricity transmission system.  Ratemaking for retail sales from the Utility's generation facilities is under the jurisdiction of the CPUC.  To the extent that this electricity is sold for resale into wholesale markets, however, it is under the ratemaking jurisdiction of the FERC.  In addition, the CPUC has general jurisdiction over most of the Utility’s operations, and regularly reviews the Utility’s performance, using measures such as the frequency and duration of outages.  The CPUC also conducts investigations into various matters, such as deregulation, competition, and the environment, in order to determine its future policies.

PG&E Corporation and the Utility entered into a settlement agreement with the CPUC on December 19, 2003, to resolve the Utility's proceeding filed under Chapter 11 of the U.S. Bankruptcy Code that had been pending in the U.S. Bankruptcy Court for the Northern District of California (“Bankruptcy Court”) since April 2001, referred to as the Chapter 11 Settlement Agreement.  The nine-year Chapter 11 Settlement Agreement established certain regulatory assets and addressed various ratemaking matters to restore the Utility’s financial health and enable it to emerge from Chapter 11.  The terms of the Chapter 11 Settlement Agreement were incorporated into the Utility’s plan of reorganization under Chapter 11, which became effective on April 12, 2004.  The Bankruptcy Court retains jurisdiction to hear and determine disputes arising in connection with the interpretation, implementation, or enforcement of the Chapter 11 Settlement Agreement, in addition to other matters. (For more information, see Note 14 of the Notes to the Consolidated Financial Statements included in the 2009 Annual Report.)

The California Energy Resources Conservation and Development Commission

The California Energy Resources Conservation and Development Commission, commonly called the California Energy Commission (“CEC”), is the state's primary energy policy and planning agency.  The CEC is responsible for licensing of all thermal power plants over 50 MW; overseeing funding programs that support public interest energy research; advancing energy science and technology through research, development and demonstration; and providing market support to existing, new, and emerging renewable technologies.  In addition, the CEC is responsible for forecasting future energy needs used by the CPUC in determining the adequacy of the utilities' electricity procurement plans.

Other Regulation

The Utility obtains permits, authorizations, and licenses in connection with the construction and operation of the Utility's generation facilities, electricity transmission lines, natural gas transportation pipelines, and gas compressor station facilities.  Discharge permits, various Air Pollution Control District permits, U.S. Department of Agriculture-Forest Service permits, FERC hydroelectric generation facility and transmission line licenses, and NRC licenses are some of the more significant examples.  Some licenses and permits may be revoked or modified by the granting agency if facts develop or events occur that differ significantly from the facts and projections assumed in granting the approval.  Furthermore, discharge permits and other approvals and licenses are granted for a term less than the expected life of the associated facility.  Licenses and permits may require periodic renewal, which may result in additional requirements being imposed by the granting agency.  (For more information, see “Environmental Matters — Water Quality” below.)  In addition, the Utility must comply with regulations to be issued by the California Air Resources Board (“CARB”) relating to GHG emissions.  (For more information see “Environmental Matters — Air Quality and Climate Change” below.)

The Utility has over 520 franchise agreements with various cities and counties that permit the Utility to install, operate, and maintain the Utility's electric and natural gas facilities in the public streets and roads.  In exchange for the right to use public streets and roads, the Utility pays annual fees to the cities and counties.  Franchise fees are computed pursuant to statute under either the Broughton Act or the Franchise Act of 1937.  In addition, charter cities can negotiate their fees.  In most cases, the Utility’s franchise agreements are for an indeterminate term, with no expiration date.  The Utility has several franchise agreements that have a specified term, including an agreement with a large charter city.  The franchise agreements generally require that the Utility install and maintain the electric and gas facilities in compliance with regulations adopted by cities and counties in the exercise of their police powers relating to the use of the public streets.  The Utility also periodically obtains permits, authorizations, and licenses in connection with distribution of electricity and natural gas.  Under these permits, authorizations, and licenses, the Utility has rights to occupy and/or use public property for the operation of the Utility's business and to conduct certain related operations.

Competition

Historically, energy utilities operated as regulated monopolies within service territories in which they were essentially the sole suppliers of natural gas and electricity services.  These utilities owned and operated all of the businesses and facilities necessary to generate, transport, and distribute energy.  Services were priced on a combined, or bundled, basis, with rates charged by the energy companies designed to include all the costs of providing these services.  Under traditional cost-of-service regulation, the utilities undertook a continuing obligation to serve their customers, in return for which the utilities were authorized to charge regulated rates sufficient to recover their costs of service, including timely recovery of their operating expenses and a reasonable return on their invested capital.  The objective of this regulatory policy was to provide universal access to safe and reliable utility services.  Regulation was designed in part to take the place of competition and ensure that these services were provided at fair prices.

In recent years, energy utilities have faced intensifying pressures to unbundle, or price separately, those services that are no longer considered natural monopolies.  The most significant of these services are the commodity components—the supply of electricity and natural gas.  The driving forces behind these competitive pressures have been customers who believe that they can obtain energy at lower unit prices and competitors who want access to those customers.  Regulators and legislators responded to these forces by providing for more competition in the energy industry.  Regulators and legislators, to varying degrees, have required utilities to unbundle rates in order to allow customers to compare unit prices of the utilities and other providers when selecting their energy service provider.

Competition in the Electricity Industry

Federal .  At the federal level, many provisions of the EPAct support the development of competition in the wholesale electric market.  The EPAct has directed the FERC to develop rules to encourage fair and efficient competitive markets by employing best practices in market rules and reducing barriers to trade between markets and

among regions.  The EPAct also gives the FERC authority to prevent accumulation and exercise of market power by assuring that proposed mergers and acquisitions of public utility companies and their holding companies are in the public interest and by addressing market power in jurisdictional wholesale markets through its new powers to establish and enforce rules prohibiting market manipulation.

Even before the passage of the EPAct, the FERC's policies supported the development of a competitive electricity generation industry.  FERC Order 888, issued in 1996, established standard terms and conditions for parties seeking access to regulated utilities' transmission grids.  Order 888 requires all public utilities that own, control, or operate facilities used for transmitting electric energy in interstate commerce to have on file an open access non-discriminatory transmission tariff (“OATT”) that contains minimum terms and conditions of non-discriminatory service.  The FERC's subsequent Order 2000, issued in late 1999, established national standards for regional transmission organizations, and advanced the view that a regulated unbundled transmission sector should facilitate competition in both wholesale electricity generation and retail electricity markets.  On February 16, 2007, the FERC issued Order 890, which is designed to: (1) strengthen the form of the OATT adopted in Order 888 to ensure that tariffs achieve their original purpose of remedying undue discrimination; (2) provide greater specificity in the form of the OATT to reduce opportunities for undue discrimination and facilitate the FERC’s enforcement; and (3) increase transparency in the rules applicable to planning and use of the transmission system.

The FERC also has issued rules on the interconnection of generators to require regulated transmission providers, such as the Utility or the CAISO, to use standard interconnection procedures and a standard agreement for generator interconnections.  These rules are intended to limit opportunities for transmission providers to favor their own generation, facilitate market entry for generation competitors by streamlining and standardizing interconnection procedures, and encourage needed investment in generation and transmission.  Under the rules and associated tariffs, a new generator is required to pay for the transmission system upgrades needed in order to interconnect the generator.  The generator will be reimbursed over a five-year period after the power plant achieves commercial operation.  The cost of the network upgrades is then recovered by the regulated transmission provider in its overall transmission rates.

State.   At the state level, California Assembly Bill 1890, enacted in 1996, mandated the restructuring of the California electricity industry beginning in 1998 to allow customers of the California investor-owned electric utilities to purchase energy from a service provider other than the regulated utilities (the ability to choose an energy provider is referred to as “direct access”).  Assembly Bill 1890 established a market framework for electricity generation in which generators and other electricity providers were permitted to charge market-based prices for wholesale electricity through transactions conducted through the Power Exchange (“PX”).  Following the 2000-2001 California energy crisis, the PX filed a petition for bankruptcy protection and now operates solely to reconcile remaining refund amounts owed and to make compliance filings as required by the FERC in the California refund proceeding, which is still pending at the FERC.  (For information about the status of the California refund proceeding and the remaining disputed claims made by power suppliers in the Utility’s Chapter 11 proceeding, see Note 14 of the Notes to the Consolidated Financial Statements in the 2009 Annual Report.)

California Assembly Bill 1X authorized the California Department of Water Resources (“DWR”), beginning in February 1, 2001, to purchase electricity and sell that electricity directly to the utilities' retail customers.  Assembly Bill 1X requires the utilities to deliver electricity purchased by the DWR under the contracts and to act as the DWR’s billing and collection agent.  To ensure that the DWR recovers the costs that it incurs under its power purchase contracts, the CPUC suspended direct access on September 20, 2001, but allowed existing direct access customers to continue being served by alternative energy service providers.  California Senate Bill 695, enacted on October 11, 2009, requires the CPUC to adopt and implement a schedule by April 11, 2010 to reopen direct access on a gradual basis over a period of not less than three years and not more than five years.  The statute imposes an annual limit on the amount of electricity that can be purchased by direct access customers of a particular utility.  The annual limit for each utility is increased each year until it reaches an amount equal to each utility’s historical maximum amount of energy provided by other service providers in that utility’s service territory during any one-year period.  Further legislative action is required to exceed these limits.

Assembly Bill 1890 also provided for the establishment of the CAISO, as a nonprofit public benefit corporation, to operate and control the state-wide electricity transmission grid and ensure efficient use and reliable operation of the transmission grid.  On April 1, 2009, the CAISO implemented new day-ahead, hour-ahead, and

real-time wholesale electricity markets subject to bid caps that increase over time, as part of the implementation of the CAISO’s Market Redesign and Technology Upgrade initiative (“MRTU”).  Market participants, including load-serving entities like the Utility, are permitted to hedge the financial risk of CAISO-imposed congestion charges in the MRTU day-ahead market by acquiring congestion revenue rights.  Also, in January 2008, the CPUC staff issued its recommendation to establish a statewide wholesale electric capacity market to replace the current resource adequacy program.  Any changes that the CPUC adopts would be subject to FERC approval.  On October 29, 2009, the CPUC opened a new rulemaking proceeding to continue oversight of the current resource adequacy program, consider program refinements, and establish annual local procurement obligations.

In addition, the Utility’s customers may, under certain circumstances, obtain power from a “community choice aggregator” instead of from the Utility.  California Assembly Bill 117, enacted in 2002, permits cities and counties to purchase and sell electricity for their local residents and businesses once they have registered as community choice aggregators.  Under Assembly Bill 117, the Utility would continue to provide distribution, metering, and billing services to the community choice aggregators' customers and would be those customers' electricity provider of last resort.  Assembly Bill 117 provides that a community choice aggregator can procure electricity for all of its residents who do not affirmatively elect to continue to receive electricity from the Utility.  The CPUC has adopted rules to implement community choice aggregation, including the imposition of a surcharge on retail end-users of the community choice aggregator to prevent a shifting of costs to customers of a utility who receive bundled services and allowing a community choice aggregator to start service in phases.  Assembly Bill 117 also authorized the Utility to recover from each community choice aggregator any costs of implementing the program that are reasonably attributable to the community choice aggregator, and to recover from customers any costs of implementing the program not reasonably attributable to a community choice aggregator.

Competition in the Natural Gas Industry

FERC Order 636, issued in 1992, required interstate natural gas pipeline companies to divide their services into separate gas commodity sales, transportation, and storage services.  Under Order 636, interstate natural gas pipeline companies must provide transportation service whether or not the customer (often a local gas distribution company) buys the natural gas commodity from these companies.  The Utility’s natural gas pipelines are located within the State of California and are exempt from the FERC’s rules and regulations applicable to interstate pipelines; the Utility’s pipeline operations are instead subject to the jurisdiction of the CPUC.

The Utility’s gas transmission and storage system has operated under the CPUC-approved “Gas Accord” market structure since 1998.  This market structure largely mimics the regulatory framework required by the FERC for interstate gas pipelines.  The CPUC divides the Utility's natural gas customers into two categories: “core” customers, which are primarily small commercial and residential customers, and “non-core” customers, which are primarily industrial, large commercial, and electric generation customers.  Under the Gas Accord structure, non-core customers have access to capacity rights for firm service, as well as interruptible (or “as-available”) services.  All services are offered on a nondiscriminatory basis to any creditworthy customer.  The Gas Accord market structure has resulted in a robust wholesale gas commodity market at the Utility’s “citygate,” which refers to the interconnection between the big “backbone” gas transmission system and the smaller downstream local transmission systems.

The Gas Accord separated the Utility’s natural gas transmission and storage rates from its distribution services and rates.  The Gas Accord also changed the nature of the Utility’s transmission and storage services by creating path-specific transmission services, firm and interruptible service offerings, standard and negotiated rate options, and a secondary market for trading of firm capacity rights.  Additionally, the Gas Accord eliminated balancing account protection for some services, increasing the Utility’s risk/reward potential.  The Utility’s first Gas Accord, a settlement agreement reached among the Utility and many interested parties, was approved by the CPUC in 1997, took effect on March 1, 1998, and was renewed, with slight modifications, for various successive periods.  In September 2007, the CPUC approved the Gas Accord IV covering 2008 through 2010. In September 2009, the Utility filed an application with the CPUC to continue a majority of the Gas Accord IV’s terms and conditions for the Utility’s natural gas transportation and storage services from 2011 through 2014.

The Utility competes with other natural gas pipeline companies for customers transporting natural gas into the southern California market on the basis of transportation rates, access to competitively priced supplies of natural

gas, and the quality and reliability of transportation services. The most important competitive factor affecting the Utility's market share for transportation of natural gas to the southern California market is the total delivered cost of western Canadian natural gas relative to the total delivered cost of natural gas from the southwestern United States. The total delivered cost of natural gas includes, in addition to the commodity cost, transportation costs on all pipelines that are used to deliver the natural gas, which, in the Utility's case, includes the cost of transportation of the natural gas from Canada to the California border and the amount that the Utility charges for transportation from the border to southern California. In general, when the total cost of western Canadian natural gas increases relative to other competing natural gas sources, the Utility's market share of transportation services into southern California decreases.  The Utility also competes for storage services with other third-party storage providers, primarily in northern California.

PG&E Corporation, through its subsidiary, PG&E Strategic Capital, Inc., along with Fort Chicago Energy Partners, L.P. and Williams Gas Pipeline Company, LLC, have been jointly pursuing the development of a new 234-mile interstate gas transmission pipeline that would increase natural gas supplies for the West Coast region of the United States. The proposed Pacific Connector Gas Pipeline, together with the proposed Jordan Cove liquefied natural gas (“LNG”) terminal in Coos Bay, Oregon, being developed by Fort Chicago Energy Partners, L.P., as lead investor, would open growing West Coast natural gas markets to diverse worldwide natural gas supply sources, providing additional alternatives to traditional Canadian, Southwest, and Rocky Mountain supplies and increasing supply options and reliability. The proposed Pacific Connector Gas Pipeline would be capable of delivering 1 Bcf per day. On December 17, 2009, the FERC issued an order to authorize construction and operation of the LNG terminal and the Pacific Connector Gas Pipeline.

The development and construction of the Pacific Connector Gas Pipeline and the proposed LNG terminal are subject to obtaining all remaining required federal, state and local permits and authorizations, as well as commitments under long-term capacity contracts of sufficient volumes to justify moving forward with construction of the terminal and the pipeline.  Assuming these are obtained and other conditions are timely satisfied, the proposed Pacific Connector Gas Pipeline and LNG terminal could begin commercial operation by late 2014.  However, PG&E Corporation cannot predict whether such conditions will be met and whether the construction of the proposed LNG terminal and associated pipeline will occur.

Ratemaking Mechanisms

Overview

The Utility’s rates for electricity and natural gas utility services are based on its costs of providing service (“cost-of-service ratemaking”).  Before setting rates, the CPUC and the FERC determine the annual amount of revenue (“revenue requirements”) that the Utility is authorized to collect from its customers.  The CPUC determines the Utility’s revenue requirements associated with electricity and gas distribution operations, electricity generation, and natural gas transportation and storage.  The FERC determines the Utility’s revenue requirements associated with its electricity transmission operations.

Revenue requirements are designed to allow a utility an opportunity to recover its reasonable operating and capital costs of providing utility services as well as a return of, and a fair rate of return on, its investment in utility facilities (“rate base”).  Revenue requirements are primarily determined based on the Utility’s forecast of future costs.  These costs include the Utility’s costs of electricity and natural gas purchased for its customers, operating expenses, administrative and general expenses, depreciation, taxes, and public purpose programs.

Regulatory balancing accounts are used to adjust the Utility’s revenue requirements.  Sales balancing accounts track differences between the Utility’s recorded revenues and its authorized revenue requirements, due primarily to sales fluctuations.  In general, electricity sales are higher in the summer months and natural gas sales are higher in the winter months.  Cost balancing accounts track differences between the Utility’s incurred costs and its authorized revenue requirements, most importantly for energy commodity costs and volumes that can be affected by seasonal demand, weather, and other factors.  Balances in all CPUC-authorized accounts are subject to review, verification audit, and adjustment, if necessary, by the CPUC.

To develop retail rates, the revenue requirements are allocated among customer classes (mainly residential, commercial, industrial, and agricultural) and to various service components (mainly customer, demand, and energy).  Specific rate components are designed to produce the required revenue.  Rate changes become effective prospectively on or after the date of CPUC or FERC decisions.  Most rate changes approved by the CPUC throughout the year are consolidated to take effect on the first day of the following year.

Through cost-of-service ratemaking, rates are developed to produce the revenue requirements, including the authorized return on rate base.  The Utility may be unable to earn its authorized rate of return because the CPUC or the FERC excludes some of the Utility’s actual costs from the revenue requirements or because the Utility’s actual costs are higher than those reflected in the revenue requirements.

While the CPUC generally uses cost-of-service ratemaking to develop revenue requirements and rates, it selectively uses incentive ratemaking, which bases rates on the extent to which the utilities meet objective or fixed standards or goals, such as reliability standards or energy efficiency goals, instead of on the cost of providing service.

Electricity and Natural Gas Distribution and Electricity Generation Operations

General Rate Cases

The General Rate Case (“GRC”) is the primary proceeding in which the CPUC determines the amount of revenue requirements that the Utility is authorized to collect from customers to recover the Utility’s basic business and operational costs related to its electricity and natural gas distribution and electricity generation operations.  The CPUC generally conducts a GRC every three years.  The CPUC sets revenue requirement levels for a three-year rate period based on a forecast of costs for the first or “test” year.  Typical interveners in the Utility's GRC include the CPUC’s Division of Ratepayer Advocates and The Utility Reform Network.  On March 15, 2007, the CPUC approved a multi-party settlement agreement to resolve the Utility’s 2007 GRC.  The decision set the Utility’s electricity and natural gas distribution and electricity generation revenue requirements for a four-year period, from 2007 through 2010, rather than for a typical three-year period.  On December 21, 2009, the Utility filed its application for the next GRC to establish revenue requirements for 2011 through 2013.  For more information, see the section of MD&A entitled “Regulatory Matters” in the 2009 Annual Report.

Attrition Rate Adjustments

The CPUC may authorize the Utility to receive annual increases for the years between GRCs in the base revenues authorized for the test year of a GRC in order to avoid a reduction in earnings in those years due to, among other things, inflation and increases in invested capital. These adjustments are known as attrition rate adjustments. Attrition rate adjustments provide increases in the revenue requirements that the Utility is authorized to collect in rates for electricity and natural gas distribution and electricity generation operations.  The CPUC’s decision in the Utility’s 2007 GRC provided for attrition adjustments for 2008, 2009, and 2010.  For more information, see the section of MD&A entitled “Results of Operations” in the 2009 Annual Report.

Cost of Capital Proceedings

The CPUC authorizes the Utility's capital structure (i.e., the relative weightings of common equity, preferred equity, and debt) and the authorized rates of return on each component that the Utility may earn on its electricity and natural gas distribution and electricity generation assets.  The current authorized capital structure, consisting of 52% equity, 46% long-term debt, and 2% preferred stock, will be maintained through 2012 unless the automatic adjustment mechanism described below is triggered.  The Utility’s current authorized rates of return that the Utility may earn on its electricity and natural gas distribution and electricity generation rate base are 6.05% for long-term debt, 5.68% for preferred stock, and 11.35% for common equity, resulting in an overall rate of return on rate base of 8.79%.  The CPUC has authorized the Utility to maintain these rates through 2010.

The CPUC’s cost of capital mechanism uses an interest rate index (the 12-month October through September average of the Moody's Investors Service utility bond index) to trigger changes in the authorized cost of

debt, preferred stock, and equity.  In any year in which the 12-month October through September average for the index increases or decreases by more than 100 basis points (“deadband”) from the benchmark, the cost of equity will be adjusted by one-half of the difference between the 12-month average and the benchmark.  In addition, if the mechanism is triggered, the costs of long-term debt and preferred stock will be adjusted to reflect the actual August month-end embedded costs in that year and forecasted interest rates for variable long-term debt and any new long-term debt and preferred stock forecasted to be issued in the coming year.  The Utility may apply for an adjustment to either the cost of capital or the capital structure sooner based on extraordinary circumstances.  The Utility’s next full cost of capital application must be filed by April 20, 2012, so that any resulting changes would become effective on January 1, 2013.

Although the FERC has authority to set the Utility’s rate of return for its electricity transmission operations, the rate of return is often unspecified if the Utility's transmission rates are determined through a negotiated rate settlement.

Baseline Allowance

The CPUC sets and periodically revises a baseline allowance for the Utility's residential gas and electricity customers. A customer's baseline allowance is the amount of its monthly usage that is covered under the lowest possible natural gas or electric rate. Natural gas or electricity usage in excess of the baseline allowance is covered by higher rates that increase with usage.

Rate Recovery of Costs of New Electricity Generation Resources

Overview

Each California investor-owned electric utility is responsible for procuring electricity to meet customer demand, plus applicable reserve margins, not satisfied from that utility's own generation facilities and existing electricity contracts (including DWR contracts allocated to the Utility under Assembly Bill 1X).  To accomplish this, each utility must submit a long-term procurement plan covering a 10-year period to the CPUC for approval.  Each long-term procurement plan must be designed to reduce GHG emissions and use the State of California’s preferred loading order to meet forecasted demand (i.e., increases in future demand will be offset through energy efficiency programs, demand response programs, renewable generation resources, distributed generation resources, and new conventional generation).  In December 2007, the CPUC approved the utilities’ long-term electricity procurement plans, covering 2007 through 2016, subject to certain required modifications.  California legislation, Assembly Bill 57, allows the utilities to recover the costs incurred in compliance with their CPUC-approved procurement plans without further after-the-fact reasonableness review.  Each utility may, if appropriate, conduct a competitive request for offers (“RFO”) within the parameters permitted in its approved plan to meet the utility’s projected need for electricity resources.  Contracts that are entered into after the RFO process are submitted to the CPUC for approval, along with a request for the CPUC to authorize revenue requirements to recover the associated costs.  The utilities conduct separate competitive solicitations to meet their renewable energy resource requirements. The utilities submit the renewable energy contracts after the conclusion of these solicitations to the CPUC for approval and authorization of the associated revenue requirements.  For more information about the Utility’s approved long-term procurement plan covering 2007 through 2016, see “Electric Utility Operations — Electricity Resources — Future Long-Term Generation Resources” below.

The Utility recovers its electricity procurement costs and the fuel costs for the Utility’s own generation facilities (but excluding the costs of electricity allocated to the Utility’s customers under DWR contracts) through the Energy Resource Recovery Account (“ERRA”), a balancing account authorized by the CPUC in accordance with Assembly Bill 57.  The ERRA tracks the difference between the authorized revenue requirement and actual costs incurred under the Utility's authorized procurement plans and contracts.  To determine the authorized revenue requirement recorded in the ERRA, each year the CPUC reviews the Utility’s forecasted costs under power purchase agreements and fuel costs.  Although California legislation requiring the CPUC to adjust a utility’s retail electricity rates when the forecast aggregate over-collections or under-collections in the ERRA exceed 5% of a utility's prior year electricity procurement revenues (excluding amounts collected for the DWR contracts) expired on January 1, 2006, the

CPUC has extended this mandatory rate adjustment mechanism for the length of a utility’s resource commitment or 10 years, whichever is longer.  The CPUC also performs compliance reviews of the procurement activities recorded in the ERRA to ensure that the Utility’s procurement activities are in compliance with its approved procurement plans. The Chapter 11 Settlement Agreement also provides that the Utility will recover its reasonable costs of providing utility service, including power purchase costs.

Costs Incurred Under New Power Purchase Agreements

The CPUC has approved various power purchase agreements that the Utility has entered into with third parties in accordance with the Utility’s CPUC-approved long-term procurement plan and to meet renewable energy and resource adequacy requirements.  The CPUC also authorized the Utility to recover fixed and variable costs associated with these contracts through the ERRA.

For new non-renewable generation purchased from third parties under power purchase agreements, the Utility may elect to recover any above-market costs through either (1) the imposition of a non-bypassable charge on bundled and departing customers only, or (2) the allocation of the “net capacity costs” (i.e., contract price less energy revenues) to all “benefiting customers” in the utilities’ service territory, including existing direct access customers and community choice aggregation customers.  (For information about the status of direct access and community choice aggregation, see the section above entitled “Competition in the Electricity Industry.”)

The non-bypassable charge can be imposed from the date of signing a power purchase agreement and can last for 10 years from the date the new generation unit comes on line or for the term of the contract, whichever is less.  Utilities are allowed to justify a cost recovery period longer than 10 years on a case-by-case basis.  If a utility elects to use the net capacity cost allocation method, the net capacity costs are allocated for the term of the contract or 10 years, whichever is shorter, starting on the date the new generation unit comes on line.  Under this allocation mechanism, the energy rights to the contract are auctioned off to maximize the energy revenues and minimize the net capacity costs subject to allocation.  If no bids are accepted for the energy rights, the Utility would retain the rights to the energy and would value it at market prices for the purposes of determining the net capacity costs to be allocated until the next periodic auction.

California Senate Bill 695, enacted on October 11, 2009, also includes a mechanism for recovery of above-market costs from direct access and community choice aggregation customers.  The CPUC has not yet implemented this portion of Senate Bill 695.

Costs of Utility-Owned Generation Resource Projects

The CPUC-authorized revenue requirements for capital costs and non-fuel operating and maintenance costs for operating Utility-owned generation facilities are addressed in the Utility’s GRC.  The CPUC-authorized revenue requirements to recover the initial capital costs for utility-owned generation projects are recovered through a balancing account, the Utility Generation Balancing Account (“UGBA”), which tracks the difference between the CPUC-approved forecast of initial capital costs, adjusted from time to time as permitted by the CPUC, and actual costs.  The initial revenue requirement for Utility-owned projects generally would begin to accrue in the UGBA as of the new facility’s commercial operation date or the date a completed facility is transferred to the Utility, and would be included in rates on January 1 of the following year.  For more information, see the section of MD&A entitled “Capital Expenditures — Proposed New Generation Facilities” in the 2009 Annual Report.

DWR Electricity and DWR Revenue Requirements

 

During the 2000-2001 California energy crisis, the DWR entered into long-term contracts to purchase electricity from third parties.  The electricity provided under these contracts has been allocated to the electric customers of the three California investor-owned electric utilities.  The DWR pays for its costs of purchasing electricity from a revenue requirement collected from these customers through a rate component called the DWR “power charge.”  The rates that these customers pay also include a “bond charge” to pay a share of the DWR’s revenue requirements to recover costs associated with the DWR's $11.3 billion bond offering completed in November 2002.  The proceeds of this bond offering were used to repay the State of California and lenders to the DWR for electricity purchases made before the implementation of the DWR's revenue requirement and to provide

 

 

the DWR with funds to make its electricity purchases.  The Utility acts as a billing and collection agent for the DWR for these amounts; however, amounts collected for the DWR and any adjustments are not included in the Utility's revenues.

 

Electricity Transmission 

The Utility's electricity transmission revenue requirements and its wholesale and retail transmission rates are subject to authorization by the FERC. The Utility has two main sources of transmission revenues (1) charges under the Utility's transmission owner tariff, and (2) charges under specific contracts with wholesale transmission customers that the Utility entered into before the CAISO began its operations in March 1998.  These wholesale customers are referred to as existing transmission contract customers and are charged individualized rates based on the terms of their contracts.  Other customers pay transmission rates that are established by the FERC in the Utility's transmission owner tariff rate cases.  These FERC-approved rates are included by the CPUC in the Utility's retail electric rates, consistent with the federal filed rate doctrine, and are collected from retail electric customers receiving bundled service.

Transmission Owner Rate Cases

The primary FERC ratemaking proceeding to determine the amount of revenue requirements that the Utility is authorized to recover for its electric transmission costs and to earn its return on equity is the transmission owner rate case (“TO rate case”).  The Utility generally files a TO rate case every year, setting rates for a one-year period.  The Utility is typically able to charge new rates, subject to refund, before the outcome of the FERC ratemaking review process.  For more information about the Utility’s TO rate cases, see the section of MD&A entitled “Regulatory Matters — Electric Transmission Owner Rate Cases” in the 2009 Annual Report.

The Utility's transmission owner tariff includes two rate components.  The primary component consists of base transmission rates intended to recover the Utility's operating and maintenance expenses, depreciation and amortization expenses, interest expense, tax expense, and return on equity.  The Utility derives the majority of the Utility's transmission revenue from base transmission rates.

The other component consists of rates intended to reflect credits and charges from the CAISO.  The CAISO credits the Utility for transmission revenues received by the CAISO.  These revenues include:

·	the proceeds received from the CAISO for wholesale wheeling service (i.e., the transfer of electricity that is being sold in the wholesale market) that the CAISO provides to third parties using the Utility’s transmission facilities, and

·

revenues that the CAISO collects from transmission users to relieve congestion on the Utility’s transmission line (either in the form of financial hedges, such as firm transmission rights relating to future deliveries of electricity, or in the form of a usage charge to manage congestion relating to real-time delivery of electricity).

These revenues are adjusted by the shortfall or surplus resulting from any cost differences between the amount that the Utility is entitled to receive from existing transmission contract customers under specific contracts and the amount that the Utility is entitled to receive or be charged for scheduling services under the CAISO’s rules and protocols.

The CAISO also charges the Utility for reliability service costs and imposes a transmission access charge on the Utility for the use of the CAISO-controlled electric transmission grid in serving its customers.  The CAISO's transmission access charge methodology, approved by the FERC in December 2004, provided for a transition over a 10-year period, from 2001 to2010, to a uniform statewide high-voltage transmission rate.  This rate is based on the revenue requirements associated with facilities operated at 200 kV and above of all transmission-owning entities that become participating transmission owners under the CAISO tariff.  The transmission access charge methodology results in a cost shift from transmission owners, whose costs for existing transmission facilities at 200 kV and above are higher than that embedded in the uniform transmission access charge rate, to transmission owners with lower embedded costs for existing high voltage transmission, such as the Utility. The Utility's obligation for this cost

differential, which is capped at $32 million per year during the 10-year transition period, is recovered in retail transmission rates.

Natural Gas

The Gas Accord

The Utility’s authorized natural gas transmission and storage rates and associated revenue requirements from January 1, 2008 through December 31, 2010 have been set in accordance with the CPUC-approved settlement agreement known as the Gas Accord IV.  On September 18, 2009, the Utility filed an application with the CPUC to establish the Utility’s natural gas transmission and storage revenue requirements from January 1, 2011 through 2014 and to continue a majority of the terms and conditions of the Gas Accord IV.  A decision on the Utility’s application, known as the Gas Accord V, is expected by the end of 2010.  A substantial portion of the authorized revenue requirements, primarily those costs allocated to core customers, would continue to be assured of recovery through balancing account mechanisms and/or fixed reservation charges.  The Utility’s ability to recover the remaining revenue requirements would continue to depend on throughput volumes, gas prices, and the extent to which non-core customers and other shippers contract for firm transmission services. This volumetric cost recovery risk associated with each function (backbone transmission, local transmission, and storage) is summarized below:

Backbone Transmission.   The backbone transmission revenue requirement is recovered through a combination of firm two-part rates (consisting of fixed monthly reservation charges and volumetric usage charges) and as-available one-part rates (consisting only of volumetric usage charges).  The mix of firm and as-available backbone services provided by the Utility continually changes.  As a result, the Utility’s recovery of its backbone transmission costs is subject to volumetric and price risk to the extent that backbone capacity is sold on an as-available basis.  Core procurement entities (including core customers served by the Utility) are the primary long-term subscribers to backbone capacity.  Core customers are allocated approximately 36% of the total backbone capacity on the Utility’s system. Core customers pay approximately 72% of the costs of the backbone capacity that is allocated to them through fixed reservation charges.

Local Transmission.   The local transmission revenue requirement is allocated approximately 71% to core customers and 29% to non-core customers.  The Utility recovers the portion allocated to core customers through a balancing account, but the Utility’s recovery of the portion allocated to non-core customers is subject to volumetric and price risk.

Storage.   The storage revenue requirement is allocated approximately 71% to core customers, 12% to non-core storage service, and 17% to pipeline load balancing service.  The Utility recovers the portion allocated to core customers through a balancing account, but the Utility’s recovery of the portion allocated to non-core customers is subject to volumetric and price risk.  The revenue requirement for pipeline load balancing service is recovered in backbone transmission rates and is subject to the same cost recovery risks described above for backbone transmission.

Biennial Cost Allocation Proceeding

Certain of the Utility's natural gas distribution costs and balancing account balances are allocated to customers in the CPUC’s Biennial Cost Allocation Proceeding. This proceeding normally occurs every two years and is updated in the interim year for purposes of adjusting natural gas rates to recover from customers any under-collection, or refund to customers any over-collection, in the balancing accounts. Balancing accounts for gas distribution and other authorized expenses accumulate differences between authorized amounts and actual revenues.

Natural Gas Procurement

The Utility sets the natural gas procurement rate for core customers monthly, based on the forecasted costs of natural gas, core pipeline capacity and storage costs. The Utility reflects the difference between actual natural gas purchase costs and forecasted natural gas purchase costs in several natural gas balancing accounts, with under-collections and over-collections taken into account in subsequent monthly rates.

The Utility recovers the cost of gas (subject to the ratemaking mechanism discussed below), acquired on behalf of core customers, through its retail gas rates.  The Utility is protected against after-the-fact reasonableness reviews of these gas procurement costs under the Core Procurement Incentive Mechanism (“CPIM”).  Under the CPIM, the Utility's purchase costs for a fixed 12-month period are compared to an aggregate market-based benchmark based on a weighted average of published monthly and daily natural gas price indices at the points where the Utility typically purchases natural gas.  Costs that fall within a tolerance band, which is 99% to 102% of the benchmark, are considered reasonable and are fully recovered in customers' rates. One-half of the costs above 102% of the benchmark are recoverable in customers' rates, and the Utility's customers receive in their rates 80% of any savings resulting from the Utility's cost of natural gas that is less than 99% of the benchmark. The shareholder award is capped at the lower of 1.5% of total natural gas commodity costs or $25 million.  While this incentive mechanism remains in place, changes in the price of natural gas, consistent with the market-based benchmark, are not expected to materially impact net income. The Utility also has received CPUC approval for a long-term gas hedging program through 2011 on behalf of core customers.  The costs of the hedging program are recovered directly from gas customers, outside the CPIM mechanism, and are subject only to a compliance review, not an after-the fact reasonableness review. (For more information, see Note 10: Derivatives and Hedging Activities, of the Notes to the Consolidated Financial Statements in the 2009 Annual Report).

In January 2010, the CPUC approved a joint settlement agreement among the Utility, the CPUC’s Division of Ratepayer Advocates, and The Utility Reform Network to incorporate a portion of hedging costs for core customers into the Utility’s CPIM.  The settlement agreement has an initial term of seven years, through October 2017, which can be extended by agreement of the parties.  As a result, the settlement agreement permits the Utility to develop and implement a sustained core hedging program.

Interstate and Canadian Natural Gas Transportation

The Utility's interstate and Canadian natural gas transportation agreements with third-party service providers are governed by tariffs that detail rates, rules, and terms of service for the provision of natural gas transportation services to the Utility on interstate and Canadian pipelines.  United States tariffs are approved for each pipeline for service to all of its shippers, including the Utility, by the FERC in a FERC ratemaking review process, and the applicable Canadian tariffs are approved by the Alberta Utilities Commission and the National Energy Board.  The Utility's agreements with interstate and Canadian natural gas transportation service providers are administered as part of the Utility's core natural gas procurement business.  Their purpose is to transport natural gas from the points at which the Utility takes delivery of natural gas (typically in Canada and the southwestern United States) to the points at which the Utility's natural gas transportation system begins.   For more information, see the discussion below under “Natural Gas Utility Operations — Interstate and Canadian Natural Gas Transportation Services Agreements.”

Electric Utility Operations

Electricity Resources 

The Utility is required to maintain physical generating capacity adequate to meet its customers’ demand for electricity (“load”), including peak demand and planning and operating reserves, deliverable to the locations and at times as may be necessary to provide reliable electric service.  The Utility is required to dispatch, or schedule, all of the electricity resources within its portfolio, including electricity provided under DWR contracts, in the most cost-effective way .

The following table shows the percentage of the Utility's total actual deliveries of electricity in 2009 represented by each major electricity resource:

(1)	The Gateway Generating Station became operational in January 2009.

(2)	The Humboldt Bay facilities consist of a retired nuclear generation unit, Humboldt Bay Unit 3, and two operating fossil fuel-fired plants.  As described below, the CPUC has approved the Utility’s application to re-power the two fossil fuel-fired plants.

Diablo Canyon Power Plant.   The Utility's Diablo Canyon power plant consists of two nuclear power reactor units, Units 1 and 2, with a total-plant net generation capacity of approximately 2,240 MW of electricity.  For the twelve months period ended December 31, 2009, the Utility’s Diablo Canyon power plant achieved an average overall capacity factor of approximately 83%.  The NRC operating license for Unit 1 expires in November 2024, and the NRC operating license for Unit 2 expires in August 2025.  In November 2009, the Utility filed an application at the NRC requesting that each of these licenses be renewed for 20 years.  The license renewal process is expected to take several years as the NRC holds public hearings and conducts safety and environmental analyses and site audits.  (See the discussion under the heading “Risk Factors” that appears in the MD&A section of the 2009 Annual Report.)  Under the terms of the NRC operating licenses, there must be sufficient storage capacity for the radioactive spent fuel produced by the Diablo Canyon plant.  For a discussion of the Utility’s spent fuel storage project, see “Environmental Matters — Nuclear Fuel Disposal” below.

The ability of the Utility to produce nuclear generation depends on the availability of nuclear fuel.  The Utility has entered into various purchase agreements for nuclear fuel that are intended to ensure long-term fuel supply.  For more information about these agreements, see Note 16: Commitments and Contingencies — Nuclear Fuel Agreements, of the Notes to the Consolidated Financial Statements in the 2009 Annual Report.

The following table outlines the Diablo Canyon power plant’s refueling schedule for the next five years.  The Diablo Canyon power plant refueling outages are typically scheduled every 20 months.  The average length of a refueling outage over the last five years has been approximately 51 days.  The actual refueling schedule and outage duration will depend on the scope of the work required for a particular outage and other factors.

Hydroelectric Generation Facilities.   The Utility’s hydroelectric system consists of 110 generating units at 69 powerhouses, including a pumped storage facility, with a total generating capacity of 3,896 MW.  Most of the Utility’s hydroelectric generation units are classified as “large” hydro facilities, as their unit capacity exceeds 30 MW.  The system includes 99 reservoirs, 56 diversions, 170 dams, 184 miles of canals, 44 miles of flumes, 135 miles of tunnels, 19 miles of pipe, and 5 miles of natural waterways. The system also includes water rights as specified in 90 permits or licenses and 160 statements of water diversion and use.  All of the Utility's powerhouses are licensed by the FERC (except for three small powerhouses not subject to FERC licensing requirements), with license terms between 30 and 50 years. In the last three years, the FERC renewed three hydroelectric licenses associated with a total of 435 MW of hydroelectric power.  The Utility is in the process of renewing licenses for projects associated with approximately 1,073 MW of hydroelectric power.  Although the original licenses associated with 516 MW of the 1,073 MW have expired, the licenses are automatically renewed each year until completion of the relicensing process.  Licenses associated with approximately 2,701 MW of hydroelectric power will expire between 2018 and 2043.

New Generation Facilities.   In addition to the Utility-owned resources shown in the table above, the Utility has been engaged in the development of two generation facilities to be owned and operated by the Utility.  Construction of the Colusa Generating Station, a 657 MW combined cycle generating facility to be located in Colusa County, California, began on October 1, 2008.  Subject to meeting operational performance requirements and other conditions, it is anticipated that the Colusa Generating Station will commence operations by November 2010.  Also, in December 2008, the Utility began construction of a 163 MW power plant to re-power the Utility’s existing power plant at Humboldt Bay, which is at the end of its useful life.  Subject to obtaining required permits, meeting construction schedules, operational performance requirements and other conditions, it is anticipated that the Humboldt Bay project will commence operations in September 2010.

DWR Power Purchases 

During 2009, electricity from the DWR contracts allocated to the Utility provided approximately 18.0% of the electricity delivered to the Utility’s customers.  The DWR purchased the electricity under contracts with various generators.  The Utility, as an agent, is responsible for administration and dispatch of these DWR contracts and acts as a billing and collection agent.  The DWR remains legally and financially responsible for its contracts.  The Utility expects that the amount of power supplied under the DWR’s contracts will diminish in the future as these contracts expire or are novated to the Utility.

Third-Party Power Purchase Agreements

Qualifying Facility Power Purchase Agreements.   As described above under “The Utility’s Regulatory Environment-Federal Energy Regulation,” the Utility is required to purchase energy and capacity from independent power producers that are QFs.  As of December 31, 2009, the Utility had power purchase agreements with 240 QFs for approximately 3,900 MW that are in operation.  Agreements for approximately 3,600 MW expire at various dates between 2010 and 2028.  QF power purchase agreements for approximately 300 MW have no specific expiration dates and will terminate only when the owner of the QF exercises its termination option.  The Utility also has power purchase agreements with approximately 75 inoperative QFs.  The total of approximately 3,900 MW consists of 2,500 MW from cogeneration projects, and 1,400 MW from renewable generation resources, as discussed below.  QF power purchases accounted for 18.8% of the Utility’s 2009 electricity deliveries.  No single QF accounted for more than 5% of the Utility’s 2009 electricity deliveries.

Irrigation Districts and Water Agencies.   The Utility also has entered into contracts with various irrigation districts and water agencies to purchase hydroelectric power.  These agreements are based on debt service requirements (regardless of the amount of power supplied), and include variable payments to the counterparty for operation and maintenance costs.  These contracts will expire on various dates between 2010 and 2031.  In 2009, they accounted for 3.7% of the Utility’s electricity deliveries.

Other Power Purchase Agreements.   The Utility has entered into power purchase agreements, including agreements to purchase renewable energy that were entered into following annual solicitations and separate bilateral negotiations.  In addition, in accordance with the Utility’s CPUC-approved long-term procurement plan, the Utility has entered into power purchase agreements for conventional generation resources.  During 2009, the Utility’s purchases under these agreements accounted for 9.0% of the Utility’s deliveries.  When market prices and forecasted load conditions are favorable, the Utility also has the ability to procure electricity through the spot bilateral and CAISO markets.  Electricity purchased in these markets accounted for 14.2% of the Utility’s deliveries in 2009.

For more information regarding the Utility’s power purchase contracts, see Note 16: Commitments and Contingencies — Third-Party Power Purchase Agreements, of the Notes to the Consolidated Financial Statements in the 2009 Annual Report.

Renewable Generation Resources

California law requires California retail sellers of electricity, such as the Utility, to comply with a renewable portfolio standard (“RPS”) by increasing their deliveries of renewable energy (such as biomass, small hydroelectric, wind, solar, and geothermal energy) each year, so that the amount of electricity delivered from renewable resources equals at least 20% of their total retail sales by the end of 2010.  If a retail seller is unable to meet its target for a particular year, the current CPUC “flexible compliance” rules allow the deficit to be carried forward for up to three years so that future deliveries of renewable power can be used to make up the deficit.

The amount of electricity the Utility delivered from renewable resources during 2009 equaled 14.4 % of the Utility’s total retail electricity sales at December 31, 2009.  Most renewable energy deliveries resulted from third party contracts, mainly QF agreements and bilateral contracts.  Additional renewable resources included the Utility’s small hydro and solar facilities and certain irrigation district contracts (small hydro facilities).  (Under California law only hydroelectric generation resources with a capacity of 30 MW or less can qualify as a renewable resource for purposes of meeting the RPS mandate.  Most of the Utility’s hydroelectric generating units have a capacity in excess of 30 MW and do not qualify as RPS-eligible resources.)

Total 2009 renewable deliveries are stated in the table below.

For more information regarding the Utility’s renewable energy contracts, see Note 16: Commitments and Contingencies — Third-Party Power Purchase Agreements, of the Notes to the Consolidated Financial Statements in the 2009 Annual Report.

Future Long-Term Generation Resources

In compliance with California’s Clean Energy Action Plan, the Utility plans to meet future electricity demand by focusing first on reducing consumption through energy efficiency and demand response programs, then by securing environmentally preferred energy resources, such as renewable generation and distributed generation (including solar power), and finally by relying on clean and efficient fossil-fueled generation resources.   The Utility’s CPUC-approved long-term electricity procurement plan, covering 2007-2016, forecasts that the Utility will need to obtain an additional 800 to 1,200 MW of new generation resources by 2015 above the Utility's planned additions of renewable resources, energy efficiency, demand reduction programs, and previously approved contracts for new generation resources.  Due to the cancellation of two projects selected in its 2004 RFO for new long-term generation resources, the Utility was authorized to increase the new generation resource need to obtain 1,112 to 1,512 MW.  

The CPUC allows the California investor-owned utilities to acquire ownership of new conventional generation resources only through purchase and sale agreements (“PSAs”) ( a PSA is a “turnkey” arrangement in which a new generating facility is constructed by a third party and then sold to the Utility upon satisfaction of certain contractual requirements).  The utilities are prohibited from submitting offers for utility-build generation in their respective RFOs until questions can be resolved about how to compare offers for utility-owned generation with offers from independent power producers.  The utilities are permitted to propose utility-owned generation projects through a separate application outside of the RFO process in the following circumstances: (1) to mitigate market power demonstrated by the utility to be held by others, (2) to support a use of preferred resources, such as renewable energy sources, (3) to take advantage of a unique and fleeting opportunity (such as a bankruptcy settlement), and (4) to meet unique reliability needs.

For a discussion of the Utility-owned generation projects the Utility has requested that the CPUC approve, see the section of MD&A entitled “Capital Expenditures — Proposed New Generation Facilities” in the 2009 Annual Report.

Electricity Transmission 

At December 31, 2009, the Utility owned 18,650 circuit miles of interconnected transmission lines operated at voltages of 500 kV to 60 kV and transmission substations with a capacity of 57,848 MVA. Electricity is transmitted across these lines and substations and is then distributed to customers through 141,213 circuit miles of distribution lines and substations with a capacity of 27,896 MVA.  In 2009, the Utility delivered 85,629 GWh to its customers, including 5,643 GWh delivered to direct access customers.  The Utility is interconnected with electric power systems in the WECC, which includes 14 western states, Alberta and British Columbia, Canada, and parts of Mexico.

During 1998, in connection with electric industry restructuring, the California investor-owned electric utilities relinquished control, but not ownership, of their transmission facilities to the CAISO.  The Utility entered into a Transmission Control Agreement with the CAISO and other participating transmission owners (including Southern California Edison Company, San Diego Gas & Electric Company, and several California municipal utilities) under which the transmission owners have assigned operational control of their electric transmission systems to the CAISO.  The Utility is required to give the CAISO two years notice and receive approval from the FERC if it wishes to withdraw from the Transmission Control Agreement and take back operational control of its transmission facilities.

The CAISO, which is regulated by the FERC, controls the operation of the transmission system and provides open access transmission service on a nondiscriminatory basis.  The CAISO also is responsible for ensuring that the reliability of the transmission system is maintained.  The Utility acts as a scheduling coordinator to schedule electricity deliveries to the transmission grid.  The Utility also acts as a scheduling coordinator to deliver electricity produced by several governmental entities to the transmission grid under contracts the Utility entered into with these entities before the CAISO commenced operation in 1998.  In addition, under the mandatory reliability standards implemented following the EPAct, all users, owners, and operators of the transmission system, including the Utility, are also responsible for maintaining reliability through compliance with the reliability standards.  See the discussion of reliability standards above under “The Utility’s Regulatory Environment — Federal Energy Regulation.”

The Utility expects to undertake various additional transmission projects over the next few years to upgrade and expand the Utility’s transmission system in order to accommodate system load growth, to secure access to renewable generation resources, to replace aging or obsolete equipment, to maintain system reliability,   and to reduce reliance on generation provided under reliability must run (“RMR”) agreements with the CAISO.  (RMR agreements require various power plant owners, including the Utility, to keep designated units in certain power plants, known as RMR units, available to generate electricity upon the CAISO's demand when the generation from those RMR units is needed for local transmission system reliability.)  Potential transmission projects include a high-voltage transmission line to improve regional reliability in the Fresno, California area and ultimately enable access to new renewable generation resources (referred to as the “Central California Clean Energy Transmission Project”).  A s previously disclosed, the Utility has been exploring the feasibility of obtaining regulatory approval for a potential investment in a proposed 1,000 mile high-voltage electric transmission project that would run from British Columbia, Canada to Northern California.  The project would provide access to potential new renewable generation resources, improve regional transmission reliability, and provide opportunities for other market participants to use the new facilities.  The supply of and need for new renewable generation have evolved since the Utility began exploring the feasibility of obtaining regulatory approval for the potential investment, as has the interest from potential partners.  In lieu of the 1,000 mile high-voltage transmission line ,   the Utility is in continuing discussions with various stakeholders to explore whether, in light of these changing circumstances, a different version of this project or another transmission project in this region should be pursued as part of its overall renewable energy supply strategy.  
  

Electricity Distribution Operations

The Utility's electricity distribution network extends through 47 of California’s 58 counties, comprising most of northern and central California.  The Utility's network consists of 141,213 circuit miles of distribution lines

(of which approximately 20% are underground and approximately 80% are overhead).  There are 93 transmission substations and 48 transmission-switching stations.  A transmission substation is a fenced facility where voltage is transformed from one transmission voltage level to another.  The Utility’s network includes 600 distribution substations and 118 low-voltage distribution substations.  The 53 combined transmission and distribution substations have both transmission and distribution transformers.

The Utility's distribution network interconnects to the Utility’s electricity transmission system at 1,116 points.  This interconnection between the Utility's distribution network and the transmission system typically occurs at distribution substations where transformers and switching equipment reduce the high-voltage transmission levels at which the electricity transmission system transmits electricity, ranging from 500 kV to 60 kV, to lower voltages, ranging from 44 kV to 2.4 kV, suitable for distribution to the Utility's customers.  The distribution substations serve as the central hubs of the Utility's electricity distribution network and consist of transformers, voltage regulation equipment, protective devices, and structural equipment.  Emanating from each substation are primary and secondary distribution lines connected to local transformers and switching equipment that link distribution lines and provide delivery to end-users.  In some cases, the Utility sells electricity from its distribution lines or other facilities to entities, such as municipal and other utilities, that then resell the electricity.

2009 Electricity Deliveries.   The following table shows the percentage of the Utility’s total 2009 electricity deliveries represented by each of its major customer classes.

Total 2009 Electricity Delivered: 85,629 GWh