Please do not hesitate to contact Robert Johnston (x39934) or Kristin Walsh 
(x39510) with additional questions.

Executive Summary
An announcement could be made as early as today regarding the first wave of 
long-term contracts (price and term).
The threat of bankruptcy is significantly diminishing as Davis hatches a plan 
to 1) pass on "court ordered rate increases" and 2) issue revenue bonds.
Audit results are in and questions loom about the amount of funds transferred 
to parent companies.  Davis is expected to use the threat of "endless 
appeals" in courts and a possible ballot initiative in November to keep the 
pressure on the parent companies to pay a share of the utility debt, as well 
as to limit the scope of the rate hikes.
Davis hopes that a court ruling in favor of the utilities would provide him 
with the political cover he needs to pass on rate hikes to California 
consumers and avoid utility bankruptcy.
Davis walking a fine line with consumer advocacy groups.  If there is a 
ballot initiative in November to challenge the expected court-ordered rate 
hikes, it could be disastrous for investor confidence in the state.

Legislation and Bail Out
Bill AB1X was heard for several hours in the Senate Appropriations 
yesterday.  Issues still remain regarding the tiered rate structure, 
specifically for communities that have harsh climates.  However, the bill has 
received support from almost everyone including consumer groups.   The bill 
is expected to pass sometime today.  Tim Gage, CA Director of Finance said 
Davis supports all the provisions in AB1X and expected to sign.  

Bill AB18X was not heard in the Assembly yesterday but is expected to be hear 
today.  In committee hearings Monday, the DWR testified it is spent all of 
the $400M and were spending $45M/day in the spot market to buy power.

According to sources with direct access to Governor Davis, the on-going court 
battle, as discussed below, is viewed as an excellent opportunity for a 
settlement.  Davis recognizes that 1) the expected court ruling in the CPUC 
case will likely authorize the utilities to increase rates charged to 
California rate payers; 2) despite that ruling, the state government has the 
ability to delay the eventual reward of that order long enough to cripple the 
two utilities unless they come to terms.  Thus, Davis believes that 
California consumers cannot avoid getting  hit with higher electricity 
charges, but he plans to use the threat of an appeal (and a possible ballot 
initiative) to limit the amount of the rate hikes.  

A plan to exempt the lowest income, smallest consumers from any rate increase 
and to concentrate rate increases among consumers using 130% of a baseline 
usage rate was gaining serious momentum last night in Sacramento.  That would 
still hit about one half of all consumers (since the "baseline" is set at 60% 
of average consumption), but it is "progressive" in a politically important 
sense. 

Making this work would require solving a minor crisis that erupted last night 
when PG&E admitted they had stopped reading electricity meters for many 
customers and were estimating their bills based on previous usage rates.   
The company's defense (they had laid off meter readers to conserve cash) was 
met with widespread derision as consumer advocates pointed out the estimation 
policy conveniently allowed the company to charge more despite serious 
efforts by Californians to use less electricity.   "Every time you think 
there's a moment when these utilities will not embarrass themselves, 
something like this happens," one legislator moaned.

Long-Term Contracts

A second key to keeping the eventual rate increases down lies in the 
negotiations now almost complete for the first wave of long-term power buying 
contracts Davis initiated earlier this month.  The first wave of those 
contracts will be announced perhaps as early as today and they will be 
surprisingly positive, according to officials in the talks.  "We got a series 
of good offers in those initial proposals.   And some not so good ones," one 
official told our source.   "The idea is to announce the results of the first 
contract talks with the good guys and then go back to the others and say, 
'you want in on this with these terms?'   We think we'll eventually shake 
loose a lot of supply with this strategy."

Bankruptcy

Because of these new dynamics, there is improved market confidence that 
California will emerge from the current energy crisis without bankruptcy for 
SoCal Edison and PG&E, even as they are set to miss another round of payments 
to creditors and suppliers today (remember, there is a standstill agreement 
among creditors not to ask for accelerated payment until Feb. 13).

We believe that sense of optimism will be given an even more credible boost 
by the court case in front of US District Judge Ronald S.W. Lew in Los 
Angeles, which is likely to mushroom into the kind of political cover for 
elected officials that make a settlement possible by the end of next week, at 
the latest.  In fact, without that political cover it would be impossible to 
square all the various circles of this crisis. 

Audit Results and Ballot Initiatives
Markets, Bush administration officials, and perhaps utility companies 
themselves are underweighting the possibility that citizens groups will 
launch a successful ballot initiative in the fall of 200l to bring all 
electricity generation back under state control.  The threat of a proposition 
initiative mounted as the two audits of the utility companies ordered by the 
California Public Utilities Commission released in the last 48 hours 
confirmed two seriously damaging points we have been warning about since 
mid-January.  First, the audit of SoCal Edison confirmed that $2 billion of 
the debt the utility claims it owes to energy suppliers is actually owed to 
itself through its corporate holding structure that generates and sells 
power.  Second, it confirmed that Edison electric paid nearly $5 billion in 
profits to the holding company which then used that money to buy back its 
stock and increase dividends in an effort to keep its stock price up even 
while it was going on a debt-issuing binge. 

The audit of PG&E released late last night was even more damaging: PG&E 
management was sharply criticized for poor decisions in failing to react to 
"clear warning signs of an approaching energy crisis" by not making deep 
spending cuts, "including scaling back management salaries."  The auditors 
also questioned the utility's decision to funnel some $4.7 billion of its 
profits since deregulation into the coffers of its parent holding company, 
which then used the cash mostly to pay dividends and buy back stocks.  
"Basically, they took the money and ran," as State Senate Speaker Burton put 
it yesterday.

What appears to be Governor Gray Davis' grudging acceptance of reality is 
actually a highly evolved effort to produce a solution that provides enough 
rate hikes/taxpayer subsidy to help solve the current crisis without 
triggering a new -- and far more damaging -- burst of populist outrage among 
a voter base that still thinks the utility companies are basically making 
this all up.  There is no doubt that this use of money by SoCal Edison and 
the debts it owes to itself are perfectly legal and in keeping with the 
spirit of the 1996 deregulation law, but that is irrelevant in popular 
political terms.  Were it not for the political cover potentially afforded by 
the court case discussed below, these audits would make settlement extremely 
difficult.

Keeping that anger from exploding into a ballot initiative this fall is key 
to understanding the very complex game that Davis, his advisers and senior 
legislators are now playing.   A ballot initiative would be a potential 
disaster since it would almost certainly be aimed at re-establishing full 
public control over the electric utilities.  Even if the state and utilities 
successfully challenged such an initiative in court it would be years before 
that victory was clear and it would freeze all new private investment during 
that prolonged period.   That's something California cannot afford as 
businesses would be moving out and new ones failing to relocate. 

Court Battle
Thus, legislators are listening in horror as they hear the ugly details of 
the court case in Los Angeles that SoCal Edison and PG&E are likely to win in 
mid-February.  The court will most likely grant the two utilities $12.7 
billion in relief and that the cost would fall immediately on the shoulders 
of consumers who would see bills rise by at least 30%, California politicians 
could see the emergence of the one thing everyone has needed since the start 
of this extended drama: political cover. Davis will then have to rely on his 
political and negotiating skills to pressure the parent companies of the 
utilities to pass on something less than the full $12.7 billion debt.

PG&E and SoCal Edison have already won round one of a legal battle designed 
to let them raise electricity rates enough to recover all of the debt they 
have accumulated since August last year when the PUC refused to let them 
raise prices even as electricity prices soared.  The court said the 1996 
deregulation law was crystal clear -- when the two utilities had repaid 
so-called "stranded costs," they were free to begin charging whatever they 
needed to charge consumers to cover their cost of acquiring power. 

Although the utilities won this case, the Judge stayed his order until 
February 14th at the state government's request.  As that deadline 
approaches, an intense new negotiating round is under way.  On the one hand, 
political officials know they have the ultimate political cover for higher 
electric prices ("the courts made me do it"), but on the other hand, they 
also know that immediate and full compliance with that court order would 
force electricity rates up by about 40% on top of natural gas bills that have 
soared by about 300% since last year.  Utility companies are playing this 
card aggressively in negotiations about the scope and shape of the final 
bailout.  "We'll just wait until the court puts the order into effect in 
mid-February then even if we are in bankruptcy we will emerge quickly and 
easily."

One tactic the state political officials are using, in order to force a 
settlement, is the threat of keeping the law suit tied up in court for the 
next couple of years.  One political official pointed out that they could 
keep the utilities from receiving their money this year, next year or perhaps 
even the year after. "Sure, we tell them, they will probably win in court and 
get that money.  Eventually.  We are making them well aware that unless we 
have a settlement we will appeal that court ruling all the way to the Supreme 
Court and keep them tied up for the next two years at least.  We don't think 
the creditors will be quite that patient."