UNITED STATES OF AMERICA
BEFORE THE
FEDERAL ENERGY REGULATORY COMMISSION

California Independent System )			          Docket No. ER98-___-000
Operator Corporation		  )

Prepared Written Testimony of
Sandra S. McDonald
for the California Independent System Operator Corporation

Q. 	Please state your name and business address.
A.	My name is Sandra McDonald, and my business address is 101 California Street, Suite 3700, San Francisco, California 94115.

Q. Please describe your educational and employment background.
A. 	I received a Bachelor of Science in Civil Engineering Degree from the University of Virginia in 1984.   From 1984 to 1986, I was employed by Howard Needles Tammen & Bergendoff as a structural engineer.  In 1988, I graduated from the Wharton School of the University of Pennsylvania with a Masters Degree in Business Administration.  I joined J.P. Morgan Securities in New York in 1988 as a Municipal Finance Associate and was relocated to San Francisco in 1989.  Since my relocation, I have assumed increasing responsibility and in 1992 was promoted to my current position as a Vice President in the municipal finance group.

Q.  Please describe your present responsibilities with J.P. Morgan Securities.
A. 	I am currently responsible for developing and managing client relationships with state and local governments and non-profit corporations.  I have particular responsibility for developing and executing financing plans for non-profit utility clients in California and the Pacific Northwest.   I am currently serving as J.P. Morgan’s account officer for the California Independent System Operator Corporation (“ISO”).  J.P. Morgan has been retained to develop a plan to refinance the ISO’s development expenses and to provide sufficient working capital.  

Q.  What is the purpose of your testimony?
A.	The purpose of my testimony is to describe (1) the financing requirements of the ISO; (2) the assumptions underlying the debt service requirements for the base case used in the filing, including the potential market, term of financing, and credit quality; (3) the timing of financing; and (4) the effect of the financing strategy on the Grid Management Charge.  Given the number of variables related to the financing that have yet to be determined, the ISO’s finance plan has been designed to provide the ISO sufficient flexibility to finance at or below the cost established in the base case outlined herein.

Q. 	How has the ISO been financed to date?
A.	The ISO’s start-up and development costs are currently funded by the ISO Trust.  The ISO Trust draws funds from a loan entered into between the ISO Trust and Bank of America which is guaranteed by the State’s three largest investor owned utilities, (SCE, PG&E and SDG&E).   Prior to commencement of commercial operations, the ISO Trust will transfer the assets acquired with proceeds of the ISO Trust loan to the ISO in exchange for ISO Notes.   After the commencement of operations, the Corporation will continue to draw on the Trust loan for system completion expenses until the permanent financing is executed.

Q. 	What is the ISO’s financing requirement?
A.	The total costs that will be paid from bond proceeds and interest earned on bond proceeds will be $250,858,000.   The amount financed includes:
		Project Development Costs				$178,466,000
Working Capital					    31,829,000
Capital	Expenditures					    39,002,000
Financing Costs					      1,561,000
			Total						$250,858,000

Q. 	What is included in Project Development Costs?
A.	The ISO will need to raise sufficient funds to repay all of the costs of development and start-up costs that were incurred before the commencement of commercial operation. Assuming the ISO commences operations on January 1, 1998 as currently planned, the ISO projects these costs will be approximately $155,163,000 by January 1, 1998.   It is expected that another approximately $23,303,000 of development expenses will be incurred to complete the system as contemplated in the Scope of Work, as submitted by Pacific Gas & Electric, San Diego Gas & Electric and Southern California Edison to the CPUC on July 5, 1996.   The scope of work is expected to be completed in the first quarter of 1999.

Q. What additional Capital Expenditures will the ISO need to finance?
A.  The ISO management has identified $39,002,000 of capital expenditures that were not identified as initial development or start-up costs but will be necessary for the ISO to operate efficiently.  These capital expenditures, which are described in Mr. Charles Smart’s testimony, are expected to be made in 1998 and 1999.  CAS-2 at 2.  As these expenditures will be made over time, they will be funded with $37,500,000 of initial bond proceeds and $1,502,000 of projected interest earnings.  See SSM-2.
Q.	What is the ISO’s Working Capital requirement?
A.	The ISO will require at least 105 days of start-up working capital. These funds will pay for salaries and customary operating expenses for the period from January 1 through the first GMC collection date, April 5, 1998, and provide an additional 10 days of working capital.  The additional 10 days of working capital is necessary to avoid liquidity problems arising from possible delays in the settlement and billing processes and the cash flow variability associated with the seasonality of the ISO revenue stream.  Based on the ISO’s 1998 operating expense budget of $109,129,000 included in Mr. Smart’s testimony, and assuming an equal distribution of operating fund requirements throughout the year, the ISO’s initial working capital requirement will be $31,829,000. The start-up working capital will be borrowed from the ISO Trust until the financing is complete and will be repaid to the Trust at the time of closing.
Q.  Are there any other costs to be included in the initial financing?
A.	The ISO will pay customary costs of issuance.  These expenses include fees paid to underwriters, attorneys, consultants, rating agencies, trustees and miscellaneous expenses for printing, investor meetings and out-of pocket expenses.  The ISO’s total costs of issuance are expected to be approximately $1,561,000.  These costs will be paid out of proceeds of the bond issuance and are included in the ISO’s financing requirement of $250.9 million.
Q.  What is the source of repayment of the ISO’s permanent financing?
A. 	The ISO intends to sell bonds that will be secured by a claim on Net Operating Revenues and any other funds specifically pledged to bondholders pursuant to an indenture of trust.  Net Operating Revenues will be defined in the Trust Indenture as Total Revenues from Operations less Operating Expenses.  It is not currently contemplated that the ISO’s physical assets will be pledged to bondholders.  

Q.  Will the interest paid on the ISO bonds be exempt from State and Federal income taxes?
A.  The ISO has submitted a request to the Internal Revenue Service to recognize the ISO as a tax-exempt Section 501(c)(3) organization.  A positive determination from the IRS on the Section 501(c)(3) question, favorable treatment in pending private use Treasury Regulations and an opinion from the ISO’s bond counsel will be required for the ISO to issue tax-exempt bonds.  If available, such tax-exempt bonds may be limited to the financing, or refinancing of capital facilities.  A determination on the ISO’s ability to issue tax-exempt securities is expected in the first half of 1998.  
Q.  How will the ISO’s initial financing be structured?
A. 	At this time, we must conservatively assume that the ISO will not be in a position to utilize tax-exempt financing and will not be exempt from SEC registration.  As an infrequent borrower, with relatively modest on-going capital needs, it will be in the ISO’s interest to avoid the additional costs and time required for registration.  For this filing, we have assumed that the ISO will issue unregistered taxable securities using the private placement exemption provided under Section 4(2) of the Securities Act of 1933, as amended, as it is a conservative financing approach.  J.P. Morgan Securities will re-offer the ISO’s securities to a limited number of qualified investors using Rule 144A under Section 4(2) of the 1933 Act.  This approach will not require final determination of the ISO’s ability to utilize tax-exempt debt or registration with the Securities and Exchange Commission.

Q. 	Does the ISO have other financing alternatives?
A.  Yes, the ISO financing can be accomplished in a number of different markets.  If the ISO qualifies as a 501(c)(3) organization, it is likely that the financing will qualify for an exemption from registration with the Securities and Exchange Commission as well and will be sold in the municipal market on either a tax-exempt or taxable basis.  If it is deemed that the securities are not exempt from registration, other exempt alternatives include a commercial paper issuance or a bank enhanced public offering.   The ISO’s Grid Management Charge Formula and its finance plan are designed to be sufficiently flexible to achieve the lowest possible cost of funds at the time the permanent financing is executed.  J.P. Morgan will determine the most advantageous market and structure as various issues are resolved.  The final bond documents will be submitted to the ISO Board of Governors for approval.
Q.  In your opinion, should the ISO consider variable rate securities for its permanent financing?
A. 	No.  The ISO is a start-up corporation and as such will face natural budgetary uncertainty over the next few years.  With interest rates at historically low levels, it is appropriate for the ISO to arrange fixed-rate financing at this time.  We presume that if commercial paper is issued, an amortizing interest rate swap will be simultaneously executed.  An interest rate swap is an agreement to exchange interest payment cash flows on a specified notional amount.  The ISO would effectively fix its borrowing rate by paying a fixed rate to its swap counterparty and receiving a commercial paper rate from its counterparty.  The swap would be executed with a highly rated financial institution and would have the effect of fixing the rate on the ISO’s debt.  The commercial paper would be paid down according to a level amortization schedule and the notional amount of the swap would be reduced in equal amounts.
A 144-A offering and a hedged commercial paper program are comparably priced in the current market, however, the amortizing swap involves numerous credit issues that are typically negotiated at the time of execution.  If credit and collateral issues can be favorably negotiated and market conditions warrant, the hedged commercial paper program remains a viable alternative as it would provide flexibility to efficiently refinance the taxable debt with tax-exempt securities if the ISO is deemed to have tax-exempt financing capability.  

Q. What is the expected term of the ISO’s financing?
A.  It is expected that the ISO bonds will have a final maturity of 10 years.  The term of the financing is intended to balance the following goals: (a) to reasonably match the expected useful life of the assets financed, (b) to amortize the bonds over a period that is both financially prudent for the ISO and will minimize the effect on the GMC, (c) to attract broad investor demand and achieve a lower borrowing cost, and (d) to provide sufficient flexibility to issue additional debt in the future to finance system enhancements, upgrades and improvements.  A 10-year final maturity with a level amortization structure will produce a weighted average maturity of 6.2 years, which is slightly longer than the ISO’s estimated weighted average useful life of approximately 5 years for the assets placed in service.  Pursuing significantly longer financing for hardware, software and working capital would have a negative impact on the rating, market acceptance since rating analysts and investors will recognize the ISO’s need to replace and upgrade existing systems before the initial debt is retired.  Layering on additional borrowings will increase the ISO’s costs in later years which, if not controlled, could lead to reduced demand.  Longer financing would also be more expensive, due to the upward sloping yield curve and higher underwriting fees.

Q. What is the expected cost of the ISO’s debt?
A.  In the current market, the ISO will be able to borrow in the 144-A market at an all-in yield of approximately 6.82% for 10 years. This rate assumes that the Commission approved ISO tariff is satisfactory to achieve a rating in the high A category.  The rate also assumes that the tariff rates are not subject to refund.

Q. What will be required to achieve the desired rating?
A.  To achieve a rating in the high A category, we anticipate that the GMC formula must result in Net Revenues (defined as Total Revenues less Operating Expenses) that cover Debt Service (defined as principal and interest due in any twelve month period) by a minimum of 1.25X.  In addition, the ISO must be able to accumulate operating and capital reserves of at least 15% of the annual operating expenses before any excess funds are used to reduce the GMC in subsequent years, as provided in Section 8.5 of the Restated and Amended Tariff.

Q. When will the ISO’s permanent financing be completed and what factors will affect the timing?
A. 	The ISO’s ability to finance, and cost of financing, is directly related to the Commission’s approval of a GMC tariff that is not subject to refund.  The ISO is a start-up corporation that is, and will continue to be, entirely debt financed.  The ISO has no cash to repay investors if the tariff is subject to refund.   Investors will have a security interest only in future revenues.  To make an informed investment decision, investors will need to know (1) the costs FERC will permit the ISO to recover in the GMC, (2) the amount by which projected Net Revenues will cover debt service, (3) the ISO’s ability to adjust charges, as necessary, and (4) the amount of reserves the ISO will have to maintain an efficient, operational system.  Without this information, the ISO’s initial lenders will face substantial risk and will demand a market premium.
Assuming the rates are approved as filed, permanent financing could be completed by mid-February, 1998.  The ISO may delay permanent financing if it is deemed more efficient to wait for a final determination from the IRS regarding the ISO’s ability to utilize tax-exempt bonds.
Q.  What impact will a GMC tariff subject to refund have on the financing?
A.  A GMC tariff subject to refund would reduce the amount of debt that can be placed with permanent investors.  As a result, the ISO Trust would to continue to hold a portion of the ISO notes and the interim loan, which is guaranteed by the IOUs, would remain in place.  The ISO Notes and the IOU guaranteed loan cannot be fully repaid until a tariff that is not subject to refund is approved and all of the permanent financing can be completed. 

Q. 	What is the ISO’s projected Debt Service revenue requirement?
A.  We have assumed that the ISO borrowing cost may increase by as much as .10%, due to upward pressure on interest rates.  This forward premium is the difference between the current ten year U.S. Treasury rate and the rate on a ten year U.S. Treasury bond to be purchased four months in the future.  At an all-in assumed rate of 6.92%, the ISO’s annual debt service cost is projected to be approximately $35,730,000 per year.  We have assumed that the bond structure is made up of serial maturities with debt becoming due in each year.  The overall structure is designed to achieve level debt service in each year.

From time to time it is advantageous to issue “bullet” maturities, or to aggregate several years of principal payments into a single maturity.  This is done to enhance investor demand.  If the actual ISO bond structure includes bullet maturities, the ISO will be required to make monthly principal and interest payments into debt service funds so that sufficient funds will be available to make principal and interest payments when due.  Principal payments will be held in an internal sinking fund until the next principal payment date.   Required sinking fund payments will be a component of “Debt Service” in the calculation of the GMC.  

Principal payments will be due on April 15th of each year, and interest will be due each October 15th and April 15th.  The ISO’s cash revenues will lag the period during which revenues are earned by at least 95 days.  For this reason, principal and interest due each April 15th must be considered Debt Service in the GMC revenue requirement formula in the prior calendar year.  This practice will ensure that revenues earned in any fiscal year will be received in sufficient time to make debt service payments when due.

The following amounts of principal and interest must be included in the GMC revenue requirement over the next two years:
Debt Service Component of the GMC Revenue Requirement
	1998	1999	
Interest	$20,370,000	$15,767,000	
Principal or Sinking Fund Requirement	$18,360,000	$19,960,000	
Total	$38,730,000	$35,727,000	

Q. 	Why is the debt service component of the GMC revenue requirement greater in 1998 than 1999?
A.	We have assumed that the ISO will issue bonds on February 15, 1998.  The bonds will be dated February 1 and will begin to accrue interest from such date.  The ISO will receive $657,100 of accrued interest for the period from February 1 to February 15 on the date of closing.  In addition, interest will need to be capitalized from the date of issuance to April 5, 1998, when the ISO will begin to receive operating revenues.  The bond issue will include $2,256,000 of capitalized interest for this period.  In addition to these amounts, $90,690 of interest on the capitalized interest portion of the bond proceeds, will be used by the ISO to pay interest for the period from February 1 to April 15, 1998.

Q.  Will the ISO have any bank lines separate from the initial financing?
A.  The ISO may require an external liquidity facility to ensure that all settlements will clear on a timely basis.  If there is a failed settlement, the ISO would activate its own facility and immediately recover funds from the security deposit of the defaulting participant.  For purposes of this filing, we have assumed that all ISO participants will make timely payments and that the ISO will not be required to draw on external liquidity facilities.  The cost of the facility is estimated to be .10% of the amount committed and is considered as an ongoing operating expense.

Q.  What effect will the financing plan have on the ISO’s GMC Revenue Requirement?
A.  The financing plan assumes that the GMC formula will result in satisfactory coverage of principal and interest payments after operating expenses have been paid.  The financing plan also requires the ISO to accumulate satisfactory reserves to handle seasonal cash flow volatility, unanticipated expenditures or reductions in energy demand.  

Based upon the testimony of Mr. Charles Smart regarding the ISO’s projected operating expenses, the ISO’s GMC revenue requirement will be $152,710,000 in 1998 and $150,165,000 in 1999. 
Annual GMC Revenue Requirement
(in thousands)

	1998	1999(2)	
Grid Management Charge Revenue	$152,710	$150,165	
Connection and Application Fees	778	778	
Interest Earned on Operating Funds	299	491	
Reserve Fund Transfers	              0	             0	
      Total Revenues	$153,787	$151,434	
			
Operating Expenses	($109,129)	($106,775)	
			
Net Revenues	$44,658	$44,659	
			
Debt Service (1)	($35,726)	($35,727)	
Debt Service Coverage	1.25X	1.25X	

(1) 	Debt service for the twelve month period beginning April 15, 1998.  Interest due between the sale of the ISO’s bonds and April 15, 1998 will be capitalized.
(2) 	1999 Operating projections are preliminary and are used here solely for illustrative purposes.

Q. How is the Debt Service Coverage component derived?
A.  The GMC will be set to satisfy bondholder covenants.  Based on a high A category rating, we anticipate the ISO will be required to set rates sufficient to maintain a coverage ratio of 1.25.  The actual bond coverage ratio, when determined, will be used in the Grid Management Charge Formula and may have an effect on future Grid Management Charge calculations.

Q. What will the excess funds generated by the debt service coverage component be used for?
A. 	Any excess funds will be deposited to an operating and capital reserve account.  The ISO Board has established a minimum operating and reserve requirement of 15% of the operating expense budget.  The bond covenants will likely require the ISO to fund the reserve over a period of no more than three years after commencement of commercial operations.  After the Corporation has several years of operating history, the Board may adjust the reserve Requirement to a level that is deemed to be appropriate, as long as bond covenants are satisfied.
Operating and Capital Reserve
(in thousands)
	
1998        	
1999(2)	
			
Net Operating Revenues	$44,658	$44,659	
Debt Service	($35,726)	($35,727)	
Capital Expenditures	         ($0)	         ($0)	
Deposit to Reserves	$8,932	$8,932	
			
Beginning Reserve Balance	$0	$8,932	
Ending Reserve Balance	$8,932	$17,864	
			
Reserve Requirement (1)	$16,369	$16,016	
Transfer to Revenue Fund	0	($1,848)	
	
(1) 	Based on Reserve Requirement initially approved by the ISO Board :  
15% of Operating Budget to be funded within a period of three years from start of operation. 
(2)	Operating projections are preliminary and are used here solely for illustrative purposes.

Q. What happens if the reserve is used?
A. 	The ISO will have to set the following year’s Grid Management Charge at a level that will provide sufficient funds to replenish the reserve over the next two years.
Q.  What if the reserve is overfunded?
A.  The ISO will take funds in excess of the reserve requirement at year end and credit them to the following year’s revenue account, which will have the effect of reducing the Grid Management Charge in the following year.  The Reserve must be fully funded before the first transfer is made.
Q.  How will capital expenditures beyond 1999 be met?
A.  Board approved capital expenditures can be made from the coverage component each year.  Alternatively, additional bonds may be issued so long as additional bond requirements, which will be included in the bond indenture, are satisfied.   If cash funded capital expenditures (pay as you go) are budgeted to exceed the coverage requirement in any year, the Grid Management Charge will need to be set high enough to cover operating expenses, principal, interest and cash funded capital expenditures. 
Q.  How will the GMC revenue requirement be adjusted in future years?
A.  The GMC revenue requirement will be established by formula.  The rate will be set by December 15 to go into effect the following January 1 of each year.

Annual Rate Adjustment Formula
GMC Revenue Requirement = Budgeted Operating Expenses + Debt Service + 
the greater of  ((Coverage Requirement x  Senior Lien Debt Service) or cash funded capital expenditures) - Interest Earnings - Other Revenues - Reserve Transfer

where, the Coverage Requirement is:

25% or such other coverage requirement as included in financing documents for senior lien bonds as approved by the ISO Board of Governors

the Debt Service is:

For any fiscal year, scheduled principal and interest payments, sinking fund payments related to balloon maturities, repayment of commercial paper notes, net payments required pursuant to a payment obligation such as an interest rate swap, or payments due on any ISO Notes.

the Senior Lien Debt Service is:

All Debt Service that has a first lien on ISO Net Operating Revenues.

the Interest Earnings are: 

Interest earnings on the ISO’s operating reserve funds.  Interest on bond proceeds specifically designated for capital projects or capitalized interest is excluded.

the Other Revenues are:

Connection fees associated with communications equipment and application fees.

the Reserve Transfer is:

The projected reserve balance for December 31 of each year less the Reserve Requirement as adopted by the Board.  If such amount is negative, the amount may be divided by two, so that the reserve is replenished within a two year period.

Q. 	How will the GMC be set?
A.	The Grid Management Charge will also be set by formula. 
      GMC =  Annual Grid Management Charge Revenue Requirement/ Projected ISO Demand

Q. 	Will the GMC be adjusted throughout the year?
A.	Yes.  The GMC will be reviewed periodically and recalculated effective as of the beginning of the following quarter if the projected volume estimate on an annualized basis changes by 5% or more.

Q. 	Does this conclude your testimony?
A.	Yes.