Report on the Los Angeles

Department of Water and Power’s

April 5, 2010 Letter Regarding the

Feasibility for Transfer of Surplus

Power Revenue Funds

June 10, 2010

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Report on the Los Angeles Department of Water and Power’s April 5, 2010 Letter Regarding the Feasibility for Transfer of Surplus Power Revenue Funds

Table of Contents

EXECUTIVE SUMMARY .................................................................................................................................................................. 2

BACKGROUND ............................................................................................................................................................................... 5 Surplus Funds Transfer ............................................................................................................................................................................... 5 Energy Cost Adjustment Factor (ECAF) ................................................................................................................................................... 6

STATEMENT ONE ........................................................................................................................................................................... 8 Background ................................................................................................................................................................................................... 8 Resources ....................................................................................................................................................................................................... 8 Analysis ......................................................................................................................................................................................................... 9 Conclusion .................................................................................................................................................................................................. 18

STATEMENT TWO ........................................................................................................................................................................ 20 Background ................................................................................................................................................................................................. 20 Resources ..................................................................................................................................................................................................... 20 Analysis ....................................................................................................................................................................................................... 21 Conclusion .................................................................................................................................................................................................. 23

STATEMENT THREE ..................................................................................................................................................................... 25 Background ................................................................................................................................................................................................. 25 Resources ..................................................................................................................................................................................................... 25 Analysis ....................................................................................................................................................................................................... 26 Conclusion .................................................................................................................................................................................................. 28

STATEMENT FOUR ....................................................................................................................................................................... 29 Background ................................................................................................................................................................................................. 29 Resources ..................................................................................................................................................................................................... 29 Analysis ....................................................................................................................................................................................................... 29 Conclusion .................................................................................................................................................................................................. 30

STATEMENT FIVE ......................................................................................................................................................................... 32 Background ................................................................................................................................................................................................. 32 Resources ..................................................................................................................................................................................................... 32 Analysis ....................................................................................................................................................................................................... 32 Conclusion .................................................................................................................................................................................................. 34

APPENDIX A ......................................................................................................................................................... A-1

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Executive Summary

The City of Los Angeles’ Controller’s Office (“Controller”) has engaged Crowe Horwath LLP (“Crowe”) to conduct an evaluation of the Los Angeles Department of Water and Power (LADWP) Power System’s (“Power System”) April 5, 2010 letter to the Controller (“Letter”). The Letter is attached as Appendix A of this Report. Specifically, Crowe has been asked to evaluate five statements made by the LADWP in the Letter regarding the feasibility for transfer of surplus power revenue funds to the City’s Reserve Fund. The results of our evaluation are contained in the attached Report on the Los Angeles Department of Water and Power’s April 5, 2010 Letter Regarding the Feasibility for Transfer of Surplus Power Revenue Funds (“Report”). This Executive Summary highlights key findings of the Report and should be considered in association with the full Report.

In the Letter, LADWP provides its justifications for why it would not be able to make a transfer of $73.5 million to the City’s Reserve Fund as originally anticipated. This transfer amount represents the remainder of the calculated surplus funds transfer that LADWP makes to the City on an annual basis, based on an agreed-upon calculation method.

Based on our findings for each of the five statements, when taken as a whole, we find that the assertion made by LADWP in the Letter that it did not have the ability to transfer the remaining $73.5 million of calculated surplus funds to be unsubstantiated. While LADWP has made certain financial commitments, based on the information provided, we do not agree that these commitments would prevent LADWP from upholding its agreement with the City regarding the surplus funds transfer. The documentation provided does not support a definitive conclusion regarding a lack of funds on the part of LADWP as suggested in the Letter. For example:

LADWP has committed to maintain an operating cash balance of $300 million as a method for maintaining LADWP’s current credit ratings. However, this amount was a self-imposed target and not based on guidance from the rating agencies.

Also, the rating agencies utilize the $500 million balance of the Debt Reduction Trust Fund (DRTF) in addition to the $300 million in operating cash balance in their calculations of days cash on hand. This allows for greater flexibility in the overall operating cash balance.

Finally, based on an evaluation of spending by LADWP in 2010, LADWP has been spending down its operating fund cash balance by paying for significant capital improvements that would normally be funded through a bond issuance. In doing so, LADWP has placed their targeted operating balance, and potentially their credit ratings, in jeopardy.

The following is a summary of our findings on each of the five statements.

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“LADWP stated at Committee that we expected to make the additional transfer of $73.5 million. This statement was based on the assumption that the ECAF (Energy Cost Adjustment Factor) increases needed…would be approved. This is documented in our financial plan.”

While LADWP has been discussing an increase to the ECAF cap through Fiscal Year 2010, they have run various projections both with and without ECAF cap increases. All of these projections included a full transfer of at least $220 million of surplus funds to the City, indicating that the ECAF cap increase was not an assumption that was required to be met in order for the transfer to occur.

“Since rate relief has not occurred1, LADWP will be forced to use all funds to pay for energy costs that should otherwise be fully recovered through the ECAF mechanism. There is no surplus money to transfer at this time.”

LADWP has had an ECAF expense undercollection issue for a number of years. LADWP has not provided documentation to indicate why this issue must be immediately addressed through the use of “all” available funds. We also find that even with LADWP’s proposed ECAF cap increases, an undercollection issue remains. Lastly, based on both financial projections provided by LADWP and the actual cash balance of the Power Revenue Fund as of March 31, 2010, we calculate that the Power Revenue Fund had sufficient funds to offset the undercollection and make the transfer to the City, while maintaining LADWP’s targeted fund balance.

“…the LADWP had planned to sell over the next 60 to 90 days…a total of $1.21 billion bond sales. In order to maintain an “AA” rating for the sale of the bonds, it is imperative that the rating agencies, underwriters, and prospective bonds buyers see a plan that provides for the solid funding of these bonds into the future. If there is no bond sale by May 2010, cash levels are projected to drop below the required amount.”

We agree that being able to present a sound financial plan is important when selling bonds. However, LADWP appears to be at risk of their cash levels dropping below a certain amount due to an internal practice of using their fund balance to pay for expenditures and significant capital improvements and using bond proceeds to reimburse themselves. In doing so, LADWP risks a more permanent drain on their fund balance should LADWP experience difficulties in securing financing.

“The Board…unanimously resolved to increase and set the Power System’s minimum operating cash target in its Power Revenue Fund from $150 million to $300 million in order to maintain an “AA” bond rating…The unrestricted cash reserve amount of $300 million was recommended by the LADWP’s financial advisors as a minimum target necessary to support the Power System’s current operation as well as align its cash reserves with similarly AA-rated public power organizations.”

Through a review of credit rating analyses and various documents provided by LADWP from both LADWP’s financial advisor and a financial advisor hired by the City, we do not agree

1 As of the date of the Letter.

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that the maintenance of a $300 million minimum operating cash target will result in LADWP maintaining its credit rating. The methodology by which credit ratings are assigned includes a wide range of factors to be considered, and the rating is not likely to hinge on only one specific criteria. LADWP has not provided us documentation in which its financial advisor recommends $300 million as the appropriate target. In addition, the rating agencies have historically included LADWP’s DRTF in the calculation of liquidity, so this fund should be considered in discussions regarding appropriate levels of cash balances. Based on our evaluation of provided financial projections, we do not agree that $300 million is the only operating cash balance target that would achieve LADWP’s objectives in relation to its credit ratings.

“…any material changes to the level of the funds and restrictions in the DRTF (Debt Reduction Trust Fund) will have a negative impact on the Power System’s credit ratings and could trigger a material event disclosure as ruled by the Securities Exchange Commission, in addition to the potential for accrual of arbitrage liabilities and other tax penalties.”

After reviewing the legal documents which established the DRTF and by which the DRTF is maintained, we do not believe that “any” material change to the level of funds and restrictions in the DRTF would require a material event disclosure. In addition, as LADWP has not provided documentation to indicate that ”new” arbitrage and tax liabilities would be created above what is already existing on the DRTF balance.

This Executive Summary highlights certain key findings from our limited scope review. The data and analysis supporting these findings are included in the attached Report. The Report should be reviewed in full to gain a complete understanding of our analysis of the statements made by LADWP.

In preparing this Report, we have utilized financial statements and projections provided by LADWP, other schedules prepared by LADWP, reports prepared by both LADWP’s and the City’s financial advisors, presentations made by LADWP representatives and bond counsel for LADWP, and various ordinances and resolutions of the City and LADWP. In addition, we have consulted information from credit ratings agencies and other public utilities in order to substantiate the assertions made by LADWP regarding the impact of financial condition on credit ratings. Our conclusions have been drawn from the information specifically identified in this Report. The presence of other documentation could have resulted in conclusions other than what are stated in this Report.

The engagement was performed in accordance with consulting standards issued by the American Institute of Certified Public Accountants and this report has been issued in accordance with these standards. Therefore, we have not conducted an audit or an examination, the objective of which would be the expression of an opinion of any financial or supplemental data or any of the assumptions identified in this Report. Accordingly, we do not express such an opinion. We have no responsibility to update this Report for events and circumstances occurring after the date of this Report.

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Background

Surplus Funds Transfer

Section 344 of the City Charter (“Charter”) states, “The Council may, by ordinance, direct that surplus money in the…Power Revenue Fund…be transferred to the Reserve Fund with the consent of the board in charge of the fund, but not otherwise.” Historically the calculation of surplus funds available in any fiscal year has ranged from five percent (5%) to its current eight percent (8%) of the Power System’s gross operating revenues from the prior fiscal year as identified in the annual audit for LADWP. Once audited financial statements are available, the Board of Water and Power Commissioners (“Board”) would typically review the recommended amount of surplus funds transfer and approve the transfer of the surplus funds. As part of the recommendation and approval process, the Board reviews the calculation for compliance with bond covenants. The covenants used are as follows:

1. No transfer may exceed the prior fiscal year’s net income; and 2. No transfer may result in prior year's surplus less the agreed-upon transfer amount being

less than 33.3% of the total indebtedness (including current portion) outstanding, not more than 10 days prior to the date of such transfer.

Once the Board approves the transfer and the related resolutions and ordinances are completed, an initial, partial amount is transferred, prorated by the number of months that has transpired since the close of the prior fiscal year. Therefore if the transfer was approved in March, nine twelfths of the total would be transferred. The remaining amount would be submitted in equal installments over the following three months so that by the end of June 30, the full amount would have been transferred.

For FY 2009, the Power System’s gross operating revenues were $2.756 billion, which would yield a surplus funds amount for payment in FY 2010 of roughly $220.5 million. However, as the Charter states, the board in charge of the Power Revenue Fund must consent to this transfer. The board with oversight of the Power Revenue Fund is the Board of Water and Power Commissioners (“Board”).

In February 2010, the Board provided a report to the City Council (“Council”) regarding the Power Revenue Fund Transfer. The Board indicated in that report there is a surplus of money in the Power Revenue Fund as of the close of FY 2009, and the Board consents to the transfer of $147 million of said surplus money to the Reserve Fund of the City during FY 2010. The Board acknowledges that this recommendation does not follow the historical methodology for calculation of the surplus and states that “to ensure operational needs are met in the current fiscal environment it is not prudent to follow this past methodology.” The Board also indicates that there may be an opportunity for an additional surplus to be declared during FY 2010. Based on the Board’s recommendation, the Council approved, by ordinance, a surplus funds transfer of $147 million on March 4, 2010.

During the Council meeting on April 6, 2010, a motion was made and adopted that the Board be requested to honor its commitment of an additional $73.5 million transfer. According to the motion, during the March 1, 2010 Council Budget and Finance Committee meeting, a representative from LADWP reported that LADWP planned to approve a transfer for an additional amount of surplus funds, estimated at $73.5 million, within two months. The LADWP representative stated that the surplus funds transfer was being done in segments because of reduced consumption and therefore reduced revenues in FY 2010, the application of a rate restructuring program, and escalating power

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costs. The LADWP representative indicated that the remaining cash transfer was tied to cash levels, with a specific comment on the $300 million in operating cash reserves. However, according to the motion, no mention was made at that time that the remaining transfer was contingent on approval of the Energy Cost Adjustment Factor (ECAF) cap increase.

On May 4, 2010, the Board adopted a resolution consenting to the transfer of an additional $73.475 million in surplus revenues to the Reserve Fund.

Energy Cost Adjustment Factor (ECAF)

LADWP’s rate structure for its Power System allows for the addition of an ECAF to the electric bills. The ECAF is an additional charge to the customers over and above the base rate charges and is based on consumption. Originally designed to allow LADWP to recapture costs associated with volatile energy costs, the ECAF has since evolved to include other expenses as well. The ECAF is currently based on the following items:

Fuel expense, estimated for the twelve months following the effective date of the ECAF;

Purchased power expense, estimated for the twelve months following the effective date of the ECAF;

Expenses associated with the procurement and acquisition of renewable portfolio standard (RPS), estimated for the twelve months following the effective date of the ECAF;

Demand-Side Management cost, estimated for the twelve months following the effective date of the ECAF, provided that such costs may not exceed ten percent of the other expenses identified above;

The Board’s approved cumulative energy efficiency savings multiplied by a factor, currently $0.05513 per kilowatt hour;

An amount equal to the City transfer percentage for surplus funds, currently eight percent (8%), times the sum of the expenses identified above;

The balance in the Energy Cost Adjustment (ECA) Account;

Retail energy sales, estimated for the twelve months following the effective date of the ECAF; and

A set adjustment amount, currently $0.0125 per kilowatt hour, to reflect a portion of the ECAF charge that is included in the base rates.

The ECAF is adjusted on a quarterly basis, effective January 1, April 1, July 1 and October 1. While the ECAF’s theoretical design is to allow LADWP to pass through volatile energy expenses to the customers, increases to the ECAF are currently capped at $0.001 per kilowatt hour each quarter.

In September 2009, the Board approved a resolution that would allow for an increase in the ECAF cap as a way to limit LADWP’s exposure to undercollection and to help maintain LADWP’s financial condition. The Board approved a $0.005 per kilowatt hour cap for ECAF expenses and an additional $0.001 per kilowatt hour cap for RPS funding, totaling a cap of ECAF increases at $0.006 per kilowatt hour per quarter.

In response to this action, the Council, through the Los Angeles Chief Legislative Analyst and the City Administrative Officer, engaged PA Consulting to provide an independent fiscal review of the ECAF and other rate design issues. PA Consulting provided their report to the City on February 25, 2010 (“PA Consulting ECAF Report”). In their report, PA Consulting recommended an increase in the ECAF cap to $0.008 per kilowatt hour per quarter.

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On March 18, 2010, the Board passed a resolution authorizing an increase in the ECAF cap up to $0.008 per kilowatt hour. The Council elected to assert its jurisdiction over this matter and, on March 26, 2010, rejected the resolution made by the Board, thereby vetoing the action. The Board again approved an ECAF cap increase through a verbal resolution on March 31, 2010. That same day, Council again asserted its jurisdiction and rejected the Board’s new resolution. Therefore, as of the date of the Letter, changes to the ECAF cap had not yet been approved.

On April 15, 2010, the Board approved a resolution which authorized the ECAF increase to go up by $0.006 per kilowatt hour for the quarter starting July 1, 2010. At the end of that quarter, the ECAF rate would not decrease down to its prior level, but the amount the ECAF would be allowed to increase would return to $0.001 per kilowatt hour. The Energy and Environment Committee of the Council considered this action and presented it to the Council on April 27, 2010. The Council approved the increase to the ECAF cap and requested that the Board report back to Council on or before September 7, 2010, regarding any proposed changes for the quarter starting October 1, 2010.

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Statement One

“The Board…unanimously resolved to increase and set the Power System’s minimum operating cash target in its Power Revenue Fund from $150 million to $300 million in order to maintain an “AA” bond rating…The unrestricted cash reserve amount of $300 million was recommended by the LADWP’s financial advisors as a minimum target necessary to support the Power System’s current

operations as well as align it cash reserves with similarly AA-rated public power organizations.”

Background

The Letter states that “the rating agencies have consistently identified the inadequacy of the LADWP’s cash reserves relative to its current level of operations.” According to the Letter, on May 21, 2009, the Board unanimously resolved to increase and set the Power System’s minimum operating cash target in its Power Revenue Fund from $150 million to $300 million in order to maintain an AA bond rating and ensure its ability to access low-cost borrowing for its planned level of infrastructure investments. The Letter states that the $300 million amount for unrestricted cash reserve was recommended by LADWP’s financial advisors as “a minimum target necessary to support the Power System’s current operations as well as align its cash reserves with similarly AA-rated public power organizations.” The Letter states that “similar AA- rated public power organizations maintain roughly 102 to 108 days of operating cash. If the LADWP Power System were to maintain this level of cash, the unrestricted cash level would be over $800 million.”

Resources

We evaluated the following documents provided by LADWP or gathered by Crowe to analyze this assertion as stated in the Letter:

The PA Consulting ECAF Report. Specifically, Section Two of the PA Consulting ECAF

Report discusses LADWP’s Financial Objectives.

Moody’s Investors Services (“Moody’s”) Rating Report dated March 19, 2010 providing a

rating of “Aa3” to LADWP.

Standard & Poor’s Rating Report dated March 22, 2010 providing a rating of “AA-” to

LADWP.

Fitch Ratings’ (“Fitch”) Rating Report dated March 18, 2010 providing a rating of “AA-” to

LADWP.

Moody’s Rating Methodology Report for U.S. Public Power Electric Utilities dated April 2008.

Standard & Poor’s Electric Utility Ratings criteria report dated June 15, 2007.

Fitch’s Public Power Rating Guidelines dated June 11, 2009.

Fitch Ratings U.S. Public Power Peer Study dated June 2009.

Memorandum prepared by LADWP’s financial advisor Gardner, Underwood & Bacon LLC

(“GUB”) dated May 11, 2009 (“GUB Memorandum”).

LADWP’s calculation of 100 days unrestricted cash and investments for 2010 through 2014.

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In addition to the resources identified above, we have also reviewed a ratings report released by Fitch on May 18, 2010. This rating replaced the March 18, 2010 rating, which was subsequently withdrawn on April 5, 2010. For the purposes of our analysis, we have limited our discussion to information that would have been available as of the date of the Letter.

Analysis

Throughout LADWP’s discussion on its financial condition, it is apparent how important the maintenance of the AA credit rating is to the Power System. In particular, as the LADWP is initiating a significant capital improvement plan that will require bond financing and as the Power System has over $1 billion in variable rate debt outstanding, the maintenance of its credit rating will have a direct impact on its ability to access a favorable bond market and the costs associated with interest for these bonds. As the PA Consulting ECAF Report states, LADWP “has identified maintaining its AA debt rating as a core business objective…Strategic objectives such as meeting renewable portfolio standards and other large scale capital improvement programs are therefore evaluated in the context of this broader objective.”

Current Credit Ratings and Methodologies for Ratings

The discussion below focuses on the recent credit ratings obtained by LADWP in preparation for their sale of up to $616 million Power System Revenue Bonds, 2010 Series A (Federally Taxable-Direct Payment-Build America Bonds) and up to $104 million Power System Revenue Bonds, 2010 Series B (collectively, “2010 Bonds”). In addition, the rating agencies reaffirmed the ratings assigned to prior bond issuances. For each rating agency, we have pulled key statements from the ratings report in order to capture the general conclusions made by the rating agencies in regard to the Power System’s cash balances.

Moody’s Investors Service – Report released March 19, 2010; Rating: Aa3

“The Aa3 rating considers LADWP’s continued sound financial management and its favorable comparison to financial metrics of other Aa rated municipal electric utilities.”

“The credit rating could be lowered should LADWP’s anticipated debt service coverage ratios fall to a level below the median for Aa rated electric utilities or should the city pressure the utility for additional General Fund transfers.”

“The credit rating could increase if LADWP exhibits consistently stronger debt service coverage ratios while managing its capital improvement program.”

Strength: “Strong LADWP financial liquidity including maintenance of unrestricted debt reduction fund balance in excess of $500 million forecasted through 2014.”

Challenge: “Fiscal pressures from recession on city remains a potential challenge for LADWP since general fund transfers could be increased; the general fund transfer is currently at 8% of utility revenues, which is the median for a municipal electric utility.”

“The utility’s unrestricted Debt Reduction Trust Fund balance was in excess of $500 million in 2009 and is forecasted to remain in the $500 million range through 2014…LADWP’s days cash on hand (including the unrestricted trust fund balance) remains strong at 188 days and is consistent with other Aa rated public power utilities.”

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“Debt service coverage as calculated by Moody’s from audited financial statements has been on average more than two times during the prior five year period. FY 2009 debt service coverage was 2.34x. This calculation includes General Fund transfers as an operating expense…Forecasted financial results through 2014 show the debt service coverage ratio to remain in generally the same two times range.”

Standard & Poor’s – Report released March 22, 2010; Rating: AA-

“LADWP exhibits, in our view, sound financial metrics after accounting for direct debt and off-balance-sheet financial commitment.”

“However, the utility is projecting that $5.1 billion of 2010-2014 capital needs and rising operating costs will place pressure on financial margins….we believe moderate additional rate increases could preserve financial metrics.”

“The department projects that substantial additional debt and fixed contractual commitments needed to meet generation and system capital needs will continue to pose a challenge to maintaining historically strong financial margins at levels that we believe are only adequate for the rating.”

Fitch Ratings (“Fitch”) – Report released March 18, 2010; Rating: AA-

“LADWP appears to have the debt capacity to absorb the additional $2.5 billion in debt expected over the next five years. Debt service coverage is projected to remain above of 2.25 times (x).”

“Liquidity levels are healthy and following adoption of formal financial policies in June 2009, LADWP no longer expects to draw down its unrestricted cash reserve to fund its capital spending, mitigating Fitch’s previous credit concerns regarding liquidity.”

“Positive credit developments have occurred since Fitch’s last credit review. The Board of Commissioners, the governing body of the utility, approved formal financial policies in 2009 that include a debt service coverage target of 2.25x, a minimum unrestricted cash reserve of $300 million, and a debt to capitalization of less than 60%. The reserve level of $300 million, when combined with the debt reduction fund of over $500 million, is expected to provide healthy liquidity as LADWP executes its large capital plan.”

“Financial performance has been consistently strong. Debt service coverage of fiscal year-end 2009 was 3.1x, or 2.3x after the general fund transfer. Debt service coverage is projected to decline closer to LADWP’s minimum target of 2.25x as new debt is issued to finance a large portion (approximately two-thirds) of the capital plan.”

“LADWP’s liquidity was strong with $445 million in unrestricted operating cash and $547 million in the debt reduction fund, which acts as a hedge for the utility’s variable-rate debt exposure and can be used in the future to economically defease debt or to pay current debt service costs. The combined liquidity resulted in just under $1 billion in reserves, or 177 days cash.”

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» Based on this analysis, the days cash on hand based solely on the unrestricted operating cash would be approximately 79 days.

In addition to the actual ratings reports for LADWP, we have also researched the credit rating agencies’ rating methodologies for U.S. public power electric utilities. Each of the credit rating agencies has released a report which describes the criteria being evaluated when assigning a credit rating to a U.S. public power utility. Below are synopses of these methodologies in order to provide a better understanding of how cash balances are factored into the rating.

Moody’s Investors Service – Report released April 2008

Moody’s identifies the following six drivers being considered when assigning a credit rating to a U.S. public power electric utility. Within each of these drivers, Moody’s has also identified sub-factors to better describe what is being considered in the rating.

1. Market Position

a. Competitiveness b. Service territory credit characteristics and demand c. Scope and reliability of power supply, transmission and distribution

2. Local Government Credit Characteristics

a. Degree of legal and financial relationship of utility with local government b. General obligation credit quality of local government c. General Fund Transfer (GFT)

i. In regard to the GFT, Moody’s states that this transfer can be significant both directly and indirectly. “If transfers from the utility represent a large part of the city’s overall operating revenues, then there is a greater likelihood that the city will ensure the electric enterprise remains healthy. However, when the transfer represents a substantial portion of the utility’s own resources, this could have a negative rating impact.” Moody’s states that the median GFT as a percent of utility gross revenues in the U.S. is 7%. (This contradicts a statement made by Moody’s in LADWP’s ratings letter which states that LADWP’s GFT percentage of 8% is the median for a municipal electric utility.) Moody’s also gives better consideration to GFT policies that are in place and accepted by both the city and the utility versus GFT policies which allow the city to set the transfer amount on an annual basis.

3. Governance and Management

a. Governance b. Cost recovery process/rate setting c. Management d. Regulatory compliance

4. Financial Position and Performance

a. Operating performance b. Debt service coverage

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i. Moody’s provides a table which indicates that Aaa or Aa rated utilities would be expected to have strong debt service coverage with a stable trend. The three year average debt service coverage ratio would typically be between 2.25x and 3.00x or 2.00x and 2.50x when including the GFT as an operating expense.

c. Financial liquidity i. In discussing financial liquidity, Moody’s focuses largely on days cash on

hand. For this metric, Moody’s states, “While days cash on hand is a useful ratio for measuring the relative strength of a utility’s liquidity, the level of cash must be evaluated in conjunction with identified immediate risks to cash flow.” In addition, Moody’s discusses that the days cash on hand metric can be directly relatable to the number of days it takes for the utility to raise its rates and begin to receive additional revenue. “If a utility has a pass-through mechanism that permits monthly adjustments to customer’s bills for fuel price increases it may mitigate the need for a higher level of available cash on hand.” As a general guideline, Moody’s suggests that Aaa or Aa rated public power utilities should have more than 125 days cash on hand.

d. Leverage e. Operating ratios

5. Debt and Capital Plan

a. Power supply and capital plan b. Debt management c. Construction risk

6. Covenants and Legal Framework

a. Bond security b. Rate covenant c. Additional bonds test d. Debt service reserve and other required reserves

Standard & Poor’s – Report released June 15, 2007

Standard & Poor’s identifies twelve criteria used in evaluating a U.S. public electric utility. These criteria are as follows:

1. Management 2. Operations 3. Competitive Position 4. Service Area 5. Regulation 6. Finances

a. Within this category, Standard & Poor’s looks at many key financial ratios including debt service coverage, fixed charge coverage, unrestricted cash as a percentage of total

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expenditures and debt to equity, in addition to other ratios. For debt service coverage, Standard & Poor’s acknowledges its importance, but also states that “reduced coverage and reserves may be appropriate for some utilities but not for others, depending upon the degree to which competitiveness can be enhanced and also the operational and competitive challenges that each utility faces.” In regards to cash balances, Standard & Poor’s finds that utilities with adequate cash balances have important flexibility in dealing with future challenges. However, Standard & Poor’s also goes on to say that “some systems with strong business fundamentals could reduce their cash balances without impacting their credit ratings.”

7. Legal Provisions of Retail Electric Systems 8. Security 9. Rate Covenant 10. Flow of Funds 11. Additional Bonds Test 12. Reserves

a. This section deals largely with debt service reserve funds. Historically, LADWP has not been required to fund debt service reserve funds when issuing bonds.

Fitch Ratings – Report released June 11, 2009

Fitch’s rating methodology for public power utilities focuses on five main criteria as follows:

1. Management, governance and business strategy 2. Service area 3. Asset operations 4. Cost structure 5. Financial performance and legal considerations

a. “Fitch focuses on the adequacy of the utility’s cash flow relative to expenses and financial obligations, as well as its capital structure, liquidity and ability to fund capital expenditures.” In regards to debt service coverage, Fitch provides 2.00x as a general guideline for AA rated public power utilities but notes that “other key credit factors can affect the ultimate level of coverage necessary for a system to reach a given rating category.”

In addition to its ratings methodology, Fitch has also released a peer study on U.S. public power utilities. This peer study provides detail on various financial ratios utilized by Fitch in assigning credit ratings. These ratios include various calculations for debt service coverage, debt to customer, days cash on hand, variable rate exposure to capitalization, general fund transfer to total operating revenues and other identified ratios. However, when taken with the ratings methodology, it is important to note that these ratios would be considered within the financial performance criteria and would be considered in association with the other criteria considered by Fitch.

As can be seen, the credit rating agencies are reviewing a wide range of factors in assigning a credit rating. While in many instances the rating agencies may provide some guidelines for where they would anticipate an AA rated public power utility to be in terms of debt service coverage and days cash on hand, these guidelines often include additional comments that these metrics need to be reviewed in the context of other criteria.

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GUB Memorandum

Prior to the Board’s adoption of a policy targeting a Power Revenue Fund minimum operating balance of $300 million on May 21, 2009, LADWP received a memorandum from its financial advisor, Gardner, Underwood & Bacon LLC (“GUB”) on May 11, 2009. This memorandum (“GUB Memorandum”) provided a peer analysis of the Power System’s financial condition in relation to other similarly rated public power utilities. The discussion below reviews the GUB Memorandum in the context of the credit rating guidelines discussed above and the action ultimately taken by the Board.

In order to provide a picture of how the Power System’s financial condition compared to its peers, GUB identified seven peers, while acknowledging that given LADWP’s size and services, there were few comparable peers. The selected peers were based on having at least an Aa3/AA- rating and a sizeable service population. Table 1 below restates the data provided in the GUB Memorandum regarding LADWP and the selected peers. Bold font has been added in certain instances to highlight key statistics which will be discussed below.

The GUB Memorandum uses the information noted in Table 1 to provide analysis regarding both debt service coverage and days cash on hand. In regards to debt service coverage, GUB notes that if the transfer to the City is included as an operating expense, LADWP’s debt service coverage drops to 2.56x, making it more in line with its peers. Based on this GUB concludes, “We believe the targeted minimum debt service coverage of 2.25x is a prudent policy and is consistent with the level of LADWP’s peers.” While this conclusion mostly plays out in the provided table, it is interesting to note that Anaheim has the same credit ratings as LADWP but has debt service coverage of 1.68x.

In regard to days cash on hand, GUB notes that the liquidity position of the Power System is “fairly weak given the size of its operations and debt burden.” This is largely based on a calculation of days cash on hand. For the purposes of the GUB Memorandum, GUB has computed days cash on hand based on operating expenses less depreciation and amortization expenses, unrestricted cash and investments and a 365-day year. The GUB Memorandum also notes that the forecasted Financial Plan shows this metric dropping to 33 days for FY 2010 and down to 26 days by FY 2014 based on the Power System’s projected unrestricted cash balance. GUB’s analysis does not take into consideration the fund balance of the DRTF. GUB concludes that “LADWP should consider increasing its liquidity position both as a defensive strategy and potentially as an argument for a positive rating action.” GUB does not make any statements in the GUB Memorandum regarding the appropriate amount of days cash on hand for LADWP or appropriate level of unrestricted cash balances.

While a strong liquidity position is certainly a good indicator of financial health of an electric utility, it is clearly not the only determinant. As the table shows, three of the selected peers have days cash on hand less than the calculated days cash on hand for LADWP. At the same time, these three utilities (JEA, Nashville Electric System and Omaha Public Power) have a higher credit rating than LADWP by at least one of the rating agencies, with the Nashville Electric System and Omaha Public Power having higher credit ratings than LADWP as assigned by all three credit rating agencies. This indicates that other factors must also be included in the consideration of these ratings.

This information is also confirmed within the Fitch peer study. In that study, Fitch provides tables which detail ratios for various utilities throughout the United States. In regards to days cash on hand, Fitch identifies the median days cash on hand for AA- rated retail systems in FY 2008 to be 135 days. However, individual utility ratios show that within the AA- credit rating, this ratio varies from 33

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TABLE 1 SOURCE: Gardner, Underwood & Bacon LLC Memorandum dated May 11, 2009

Tallahassee

Electric

Aa2/

AA/

AA-

403,379

4,093

326,715

80,757

33,695

2.40

500,545

87,466

108

Sources of Data: Published annual reports, comprehensive annual financial reports, disclosure filings and other publicly available data on issuers’

websites, Bloomberg and through financial subscription services. 1Includes investment income, rent and other sources of income. 2Revenue available for debt service coverage calculation may include rate stabilization funds and other sources while excluding depreciation and

interest and amortization expenses. 3Calculation based on unrestricted cash and investments and assumes a 365 day fiscal year calendar. The rating agencies may have differing methods

and/or may include other funds into their calculation.

San

Antonio

Aa1/

AA/

AA+

1,860,677

95,728

1,460,767

495,638

322,706

2.36

3,327,551

795,347

243

Orlando

Utilities

Commission

Aa1/

AA/

AA

844,182

23,099

582,074

285,207

116,220

2.45

1,352,397

232,727

176

Omaha

Public

Power

Aa1/

AA/

AA

787,973

20,152

687,620

120,505

85,184

2.90

1,853,433

71,504

46

Nashville

Electric

System

Aa3/

AA+/

AA

1,030,953

5,736

980,280

56,409

44,400

2.19

524,099

94,776

37

JEA

Aa2/

AA-/

AA-

1,247,324

32,601

1,114,703

165,222

140,753

2.40

2,555,787

167,382

65

Anaheim

Aa3/

AA-/

AA-

351,160

22,682

327,725

46,117

44,140

1.68

614,821

121,958

149

LADWP

Aa3/

AA-/

AA-

2,781,324

175,906

2,457,597

499,633

227,359

3.44

4,977,183

389,529

65

Selected Financials (FY 2008)

Senior Most Rating

Operating Revenues ($000)

Other Income ($000)1

Total O&M Expenses ($000)

Net Revenues ($000)

Total Annual Debt Service ($000)

Total Annual Debt Service Coverage (x)2

Total Long Term Debt ($000)

Unrestricted Cash and Investments ($000)3

Days Cash on Hand3

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days up to 376 days. For AA rated systems, which is a higher credit rating than what LADWP currently has, this ratio ranges from 25 days up to 331 days. Going the other direction, A+ rated utilities have days cash on hand ranging from 19 up to 875 days. This data provides further recognition that the rating agencies consider a wide range of criteria in evaluating utilities.

PA Consulting ECAF Report

PA Consulting also provided an analysis of LADWP’s financial condition in its PA Consulting ECAF Report released in February 2010. PA Consulting focused on the three financial targets identified by the Board:

Debt service coverage ratio of 2.25x

Unrestricted cash balance of $300 million

Capitalization ratio of no more than 60% debt

For the purposes of this Report, we will focus our analysis on the debt service coverage ratio and unrestricted cash balance metrics as these are the same metrics discussed in the credit rating analysis and GUB Memorandum analysis above.

PA Consulting identifies three debt service coverage ratios commonly used in financial analysis. The first is the typical Debt Service Coverage ratio which excludes fixed charge obligations (“off-balance-sheet” debt) and the general fund transfer from consideration. The second metric is the Adjusted Debt Service Coverage Ratio which takes into account the fixed charge obligations. Finally, the Coverage of Full Obligations ratio takes into account all long-term debt and fixed charge obligations while considering the general fund transfer to be an operating expense. PA Consulting provides the following table in the PA Consulting ECAF Report.

TABLE 2 SOURCE: PA Consulting ECAF Report

Peer group defined as Retail municipal utilities, AA+/AA/AA- Ratings, >100,000 meters served

FY2008 data, median vales shown

Debt Service Coverage

Adjusted Debt Service Coverage

Coverage of Full Obligations

Peers 2.31 1.63 1.44

LADWP Target 2.25 ~1.75 (implied) ~1.4 (implied)

PA Consulting’s Source: Fitch Ratings U.S. Public Power Peer Study, June 2009

Based on this peer analysis (for which specific peers used are not identified), PA Consulting concludes, “that LADWP’s target of 2.25x, while slightly below the median of other companies, is reasonable.”

PA Consulting also provides an analysis of liquidity measures, starting from LADWP’s minimum target of $300 million for operating cash reserves. PA Consulting indicates that “this level of liquidity corresponds to slightly less than 50 days of cash given projected 2010 expenses, and can be compared to a median of 102 days for the peers considered by PA and 108 days for the peers considered in a recent analysis by LADWP’s financial advisor.” (According to a footnote, the analysis being referred to is the GUB Memorandum.) The method by which PA Consulting is calculating days cash on hand

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cannot be determined based on the analysis provided in the PA Consulting ECAF Report. PA Consulting notes that with the addition of the debt reduction trust funds, LADWP’s liquidity levels increase to well over 100 days, making it more in line with comparable peers. PA Consulting concludes by stating that “LADWP’s minimum cash target of $300 million appears to be adequate to maintain its AA rating.” PA Consulting does not make its own recommendation as to the appropriate level of operating cash but rather focuses on the LADWP’s stated minimum target.

LADWP’s Calculation of Days Cash on Hand

In addition to the commentary provided by GUB and PA Consulting, LADWP has also provided their own calculation of days cash on hand. Table 3 below restates the calculation as provided by LADWP. The numbers in this calculation are based on the FY 2010 Financial Model approved with the FY 2010 budget and are in millions of dollars.

TABLE 3 SOURCE: LADWP

Fiscal Year Ended June 30,

Description 2010 2011 2012 2013 2014

Total Operating Expenses $ 2,704 $ 2,996 $ 3,163 $ 3,300 $ 3,418 Less Depreciation (319) (361) (385) (411) (440) Interest on Fixed Rate Bonds 196 247 299 342 378 Interest on Variable Rate Bonds 56 56 56 56 56 Principal Payments on Debt 101 121 135 142 148 City Transfer 232 259 287 310 331

Total Planned Cash Disbursements $ 2,970 $ 3,318 $ 3,555 $ 3,739 $ 3,891

Average Cash Spent Per Day $ 8.14 $ 9.09 $ 9.74 $ 10.24 $ 10.66

At $300 Million (Unrestricted Cash Balance), Days Cash on Hand

37 33 31 29 28

At $300 Million (Unrestricted Cash Balance) plus Debt Reduction Fund of $546 Million, Days Cash on Hand

104 93 87 83 79

As noted in Table 3, LADWP’s calculation of days cash on hand shows that LADWP’s liquidity position is low, even at the $300 million in unrestricted cash balance. This calculation shows a much different, more conservative picture than other calculations of days cash on hand due to the inclusion of a number of other non-operating expenditures, such as interest and principal payments and the transfer to the City. While PA Consulting’s calculation of days cash on hand could not be verified, the GUB calculation of days cash on hand did not include these other extraneous disbursements. As GUB’s results seem to be more in line with the days cash on hand analysis documented in the ratings reports, we believe the rating agencies also do not include these extraneous expenses in their calculation of days cash on hand. As shown in the table below, if these items were removed from consideration, the days cash on hand based solely on the $300 million unrestricted cash balance target would range from 46 days in 2010 to 37 days in 2014. When including a Debt Reduction Trust Fund balance of $546 million, these days climb to 129 days in 2010 down to 104 days in 2014.

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TABLE 4 SOURCE: Revised from Table 3 above

Fiscal Year Ended June 30,

Description 2010 2011 2012 2013 2014

Total Operating Expenses $ 2,704 $ 2,996 $ 3,163 $ 3,300 $ 3,418 Less Depreciation (319) (361) (385) (411) (440) Interest on Fixed Rate Bonds ----------------------------------EXCLUDED----------------------------------- Interest on Variable Rate Bonds ----------------------------------EXCLUDED----------------------------------- Principal Payments on Debt ----------------------------------EXCLUDED----------------------------------- City Transfer ----------------------------------EXCLUDED-----------------------------------

Total Planned Cash Disbursements $ 2,385 $ 2,635 $ 2,778 $ 2,889 $ 2,978

Average Cash Spent Per Day $ 6.53 $ 7.22 $ 7.61 $ 7.92 $ 8.16

At $300 Million (Unrestricted Cash Balance), Days Cash on Hand

46 42 39 38 37

At $300 Million (Unrestricted Cash Balance) plus Debt Reduction Fund of $546 Million, Days Cash on Hand

129 117 111 107 104

Conclusion

As the analysis above identifies, two key metrics used in evaluating financial condition are debt service coverage ratios and days cash on hand. All parties identified above, including the credit rating agencies, GUB and PA Consulting, agree that these are valuable metrics. Being able to show strong and consistent results in these metrics will clearly be of benefit to an electric utility for the purposes of credit ratings and bond market presence.

LADWP has indicated its commitment to achieving a minimum of 2.25x debt service coverage and $300 million in unrestricted operating cash balances in order to maintain its AA credit rating. However, our analysis of the rating agencies’ evaluation methodology and the peer comparables provided by GUB and PA Consulting demonstrate that these commitments alone would not necessarily result in LADWP maintaining its current AA rating. As discussed above, the credit rating agencies have historically considered a wide range of criteria in order to establish a credit rating and will continue to use this approach according to the publicized methodologies. It would be inaccurate to state that one or two particular metrics would be the sole indicators of financial health and therefore credit worthiness. Even as the methodologies state, in many cases there are caveats associated with particular metrics as in some instances lower metrics may be appropriate within the context of the utility being evaluated.

Prior to the establishment of the 2.25x debt service coverage policy, the Board received a recommendation from LADWP’s financial advisor, GUB, indicating that 2.25x debt service coverage would be an appropriate targeted coverage. However, it is important to note two key aspects of the calculation of debt service coverage in relation to the Letter. First, the calculation of debt service coverage is based on operating revenues compared to operating expenses. It would not include consideration of the fund balance in the Power Revenue Fund. Secondly, the calculation of debt service coverage does not consider the transfer to the City as an operating expense. Therefore, the

19

transfer of the surplus funds would have no bearing on LADWP’s ability to meet its debt service coverage policy.

In regard to LADWP’s statement in the Letter that the unrestricted cash reserve amount of $300 million was recommended by the LADWP’s financial advisors as a minimum target necessary to support current operations and align the Power System with other similarly rated utilities, the documentation provided to us by LADWP does not include a recommendation from GUB that $300 million is the appropriate level of reserves. GUB does not comment on specific levels of cash balances or days cash on hand that would be necessary. PA Consulting also did not make an independent recommendation as to level of operating cash balance, but rather utilizes LADWP’s stated target. In addition, in the Letter, LADWP states that similar AA- rated public power organizations maintain 102 to 108 days of operating cash. As the GUB Memorandum and the Fitch peer study demonstrate, this is not a hard and fast rule, as in some instances, public power utilities with ratings higher than AA- had operating cash balances which yielded much less than 102 to 108 days cash on hand and utilities with ratings lower than AA- may have days cash on hand higher than these identified targets. Again, this supports the conclusion that credit ratings are not based solely on one or two metrics but rather on the complete picture of the entity being evaluated.

We also disagree with LADWP’s implied assertion that the target $300 million minimum cash balance is needed to achieve 100 days of cash on hand. In calculating days cash on hand, the fund balance of the Debt Reduction Trust Fund (DRTF) is regularly included by both the rating agencies and the financial advisors to calculate days cash on hand. Using the budgeted numbers presented by LADWP in its calculation of days cash on hand, the DRTF balance is forecasted to be $546 million for FY 2010 and forward. Assuming this balance and assuming the operating and depreciation expenses identified by the LADWP for the FY 2010 budget to be accurate, unrestricted cash balances would need to equal only approximately $107 million in order to achieve 100 days cash on hand. Under this calculation, even LADWP’s original minimum target of $150 million would be sufficient to achieve 100 days of cash on hand for FY 2010.

We agree with the concept of setting targeted minimum debt service coverage ratios and cash balances, in addition to a multitude of other possible metrics, as a matter of sound fiscal policy. However, we conclude that LADWP’s statement that it “must” increase the minimum target operating balance from $150 million to $300 million is not supported by documentation provided by LADWP or our analysis of credit rating methodology as a guaranteed method for maintaining LADWP’s AA- credit rating.

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Statement Two

“…any material changes to the level of the funds and restrictions in the DRTF (Debt Reduction Trust Fund) will have a negative impact on the Power System’s

credit ratings and could trigger a material event disclosure as ruled by the Securities Exchange Commission, in addition to the potential for accrual of

arbitrage liabilities and other tax penalties.”

Background

The April 5, 2010 letter from LADWP stated that “rating agencies include the $500+ million of funds in the Debt Reduction Trust Fund (DRTF), albeit restricted, when assessing the Power System’s total liquidity.” The letter goes on to state that “for more than a decade, the rating agencies, bondholders, and potential investors have relied on the DRTF both as a source of liquidity as well as a back stop for future debt service payments. The DRTF also acts as an interest rate hedge for the Power System’s variable rate debt obligations totaling over $1.2 billion.” Based on statements made by LADWP’s financial advisor and bond/tax and disclosure counsel, LADWP concludes that reductions in the DRTF cash balance could trigger a material event disclosure and place the LADWP at risk for arbitrage and other tax penalties.

Resources

We evaluated the following documents provided by LADWP or gathered by Crowe to analyze this assertion as stated in the Letter:

Resolution No. 97-116 authorizing the establishment of the Electric Plant Revenue Bond

Reduction Escrow Fund (“DRTF Resolution”).

Electric Plant Revenue Bond Reduction Escrow Fund, Trust Agreement by and between Los

Angeles Department of Water and Power and First Trust of California, National Association

as Trustee, Dated as of June 25, 1997 (“Trust Agreement”).

Master Bond Resolution of the Board of Water and Power Commissioners of the City of Los

Angeles Establishing the Terms and Conditions of Department of Water and Power of the

City of Los Angeles Power System Revenue Bonds, Resolution No. 4596 (“Master Bond

Resolution”).

Memorandum prepared by GUB dated March 31, 2010 (“GUB DRTF Memorandum”) that

discusses the City Council Motion on Feasibility of Removing Existing Restrictions on Power

System’s Debt Reduction Trust Fund.

Audio Transcript from the Board meeting on March 31, 2010 in which Gene Carron from

Orrick, Herrington & Sutcliffe LLP, Bond Counsel and Disclosure Counsel, verbally discussed

the arbitrage and material event disclosure.

21

Analysis

In order to understand the potential implications associated with changes to the DRTF, we have first studied the DRTF Resolution which authorizes the establishment of the DRTF. The bullet points below identify key sections of DRTF Resolution in relation to LADWP’s statement.

Section 1 of the DRTF Resolution discusses the fact that the DRTF was established:

“To maintain and improve the competitive position of the Electric Works and to provide the Department with flexibility in establishing rates and charges and providing alternatives in the purchase of Bonds or the payment, when due and payable, whether at maturity or upon redemption , of the principal and interest on the Bonds,…”

Section 2 of the DRTF Resolution states that “Deposits to the Fund”:

“Funds dedicated solely for debt reduction from rates or any other revenue generating sources may be deposited upon receipt or at the end of each month.” (Page 2 of Trust Agreement)

Also, Section 3 of the DRTF Resolution gives definition as to the “Application of Moneys in the Fund”:

“Amounts on deposit in the Fund shall be applied at such time or times and for any of the following purposes as shall be determined by the Chief Financial Officer: (i) to the payment when due of principal or of interest on Bonds; (ii) to the purchase of Bonds, including the payment of accrued interest thereon; (iii) to the redemption of Bonds; (iv) to making provisions for the payment of Bonds in accordance with the provisions of the resolution authorizing such bonds such that such Bonds are defeased and deemed paid for purposes of such resolution; (v) to redeem commercial paper issued to purchase such Bonds; or (vi) to making provision for the payment of Bonds in a manner that such Bonds continue to be outstanding under the resolution authorizing such Bonds.”

The language of the Trust Agreement also gives some insight into the purpose for the establishment of the DRTF and the use of any moneys being held within the DRTF:

“Whereas, the purpose of the Debt Reduction Fund is to serve as a depository for funds accumulated for debt reduction in order in improve LADWP’s competitive position in a deregulated electric industry and potential sources will come from contributions for operating revenues, transfers from stabilization account, revenue from competitive transition charge, and budget savings from Joint Power Agencies;” (Page 1 of Trust Agreement)

“Whereas, moneys in the Debt Reduction Fund will be used to (1) purchase bonds in the open market or make tender offers, (2) establish escrow funds to defease certain high coupon bonds, (3) perform current refundings, (4) retire commercial paper issued to purchase or call long-term bonds, (5) offset debt service payments, and (6) generate

22

investment earnings to accomplish the above mentioned purposes;” (Page 1 of Trust Agreement)

Other sections of the Trust Agreement also discuss the DRTF and LADWP’s rights in relation to the DRTF.

The following provisions are found within the “Dispositive Provisions” section (Section II) of the Trust Agreement:

“2.04 Termination of Fund. The Fund may be terminated at any time upon thirty (30) days written notice by LADWP to the Trustee.”

“2.05 Distribution of Fund Upon Termination. Upon the termination of the Fund, the Trustee shall, at the written direction of LADWP, (a) immediately transfer all or any portion of the remaining monies and assets in the Fund to or as Directed by LADWP, or (b) liquidate all or any portion of the assets of the Fund and immediately distribute the proceeds of such liquidation(s) to or as directed by LADWP.”

“2.06 Alterations and Amendments. The Trustee and LADWP understand and agree that modifications or amendments may be required to the Agreement from time to time to effectuate the purpose of the Fund. No amendment to the Agreement shall be effective unless it has been signed by the Trustee and LADWP.”

The following statement is found within Section VIII “Miscellaneous” of the Trust Agreement”:

“Parties Interested Herein. Nothing expressed or implied in this Agreement is intended or shall be construed to confer upon, or to give to, any person or corporation, other than LADWP and the Trustee, any right, remedy or claim under or by reason of this Agreement, or any covenant, condition or stipulation contained herein.”

The Master Bond Resolution, which was adopted at the Board’s meeting on February 6, 2001, makes no specific mention of: (a) the DRTF Resolution, which was adopted at the Board’s meeting on November 19, 1996; (b) the Trust Agreement which is dated as of June 25, 1997; or (c) the existence of monies in the DRTF.

LADWP’s financial advisor addressed the DRTF in a memo to the Assistant Chief Financial Officer and Treasurer for LADWP on March 31, 2010. The GUB DRTF Memorandum makes the following comments about the DRTF:

“Given this context, changes to the DRTF would have a negative impact on the Department’s credit ratings from Fitch Ratings, Moody’s Investors Service and Standard & Poor’s. This impact could range from a move to “negative outlook/watch” to a downgrade of the Department’s ratings.”

The GUB DRTF Memorandum also lists the following comments from the rating agencies discussed above:

23

“Fitch Ratings: “The reserve level of $300 million, when combined with the debt reduction fund of over $500 million, is expected to provide healthy liquidity as LADWP executes its large capital plan.””

“Moody’s Investors Service: “Strong LADWP financial liquidity including maintenance of unrestricted debt reduction fund balance in excess of $500 million forecasted through 2014.””

“Standard & Poor’s: “The utility’s strong liquidity in the form of a $540 million debt reduction trust fund. The utility forecasts that it will maintain this fund with a balance of $500 million - $600 million during the next five years.””

Conclusion

The Letter’s statement that “…any material changes to the level of the funds and restrictions in the DRTF…will have a negative impact on the Power System’s credit ratings…” (emphasis added) does not appear to be supported by the analysis of the documents provided. For example, Moody’s Investors Service refers to the DRTF as “unrestricted” and all three rating agencies refer to the DRTF as part of LADWP’s overall “liquidity”. It would appear that any current restrictions on the DRTF were not an important part of the analysis performed by the rating agencies. Therefore, it is very possible that changes to remove existing restrictions on the DRTF could have no effect on LADWP’s credit ratings.

This would also appear to be supported by the fact that the Dispositive Provisions for the Trust Agreement allow for the termination of the fund “…at any time upon thirty (30) days written notice by LADWP to the Trustee.” The current Trust Agreement does not require any notice to LADWP’s bondholders or creditors if a decision is made to terminate the fund that is being held as part of the Trust Agreement. Section 2.05 of the Trust Agreement makes it clear that, upon termination of the fund, the monies within the fund will be transferred or distributed as “…directed by LADWP.”

Finally, with regard to the flexibility to modify any of the current restrictions on the DRTF, the Trust Agreement makes it clear that no outside parties have any rights or claims being conferred on them as part of the trust arraignments. Therefore, changing the restrictions on the DRTF, the DRTF Resolution or the Trust Agreement would not appear to impact the position of any outside parties with respect to any claims of the monies in the DRTF. Again, this flexibility would support the rating agencies’ view of the DRTF as either unrestricted or part of the overall liquidity.

With regard to the impact that “…any material changes to the level of the funds … in the DRTF…” would have on LADWP’s credit ratings, this has been discussed in the previous section of the report. As mentioned in the Statement One, the rating agencies review an issuer’s creditworthiness based on a variety of areas that are analyzed. The overall cash or liquidity position of an issuer is just one of the areas that would be examined. The rating agencies have not given a specific amount that an issuer is required to keep in a specific fund in order to achieve a desired rating.

It is clear from the analysis provided in the previous section that LADWP could experience a reduction in the level of its overall liquidity (which would include the DRTF and the Power Revenue Fund) and still be in a better “cash position” than some of the other issuers in the peer group that was provided. Therefore, the statement in the GUB DRTF Memorandum that states: “Given this context, changes to the DRTF would have a negative impact on the Department’s credit ratings from Fitch

24

Ratings, Moody’s Investors Service and Standard & Poor’s” (emphasis added) does not appear to be accurate. Where the GUB DRTF Memorandum goes on to state that: “This impact could range from a move to “negative outlook/watch” to a downgrade of the Department’s ratings.”, it would be more accurate to state that: “The impact of a change in the balance of monies in the DRTF could range from maintaining LADWP’s current credit rating to a change in the ratings depending on a variety of other factors affecting LADWP’s credit ratings.” A less definitive statement would better account for all of the various factors that may influence a credit rating.

With regard to the statement that “…any material changes to the level of the funds and restrictions in the DRTF… could trigger a material event disclosure as ruled by the Securities Exchange Commission, …”, this also does not appear to be supported by the documentation provided by LADWP. While the decision to report a material event is at discretion of the issuer and it is usually based on advice from the issuer’s bond counsel and / or financial advisors, that disclosure is usually guided by the covenants provided within the legal documents governing the outstanding bond issues as well as the outstanding fund balances. Material event disclosures are issued with the intent of notifying the bondholders or the bond market of specific events that may have occurred within clearly defined areas. It is clear from the language regarding the original purpose of the DRTF and the application of the monies that bondholders have no specific rights or claims to the DRTF. In addition, the description of the “Application of Moneys in the Fund” as provided in the DRTF Resolution provides that the balance in the DRTF will be used from time to time to: make principal and interest payments; retire, purchase, redeem or defease outstanding bonds; or redeeming commercial paper. A material event disclosure is normally not required when the monies within a fund are used for the purpose provided for within the enabling resolution or authorizing document. Therefore, we do not believe that utilizing the DRTF to make debt service payments, even if this action resulted in a material change in the fund balance, would necessarily trigger a material event disclosure.

Finally, it is unclear from the documents provided by LADWP how “…any material changes to the level of the funds and restrictions in the DRTF …could trigger …the potential for accrual of arbitrage liabilities and other tax penalties.” The Letter leaves the impression that any material changes to the level of funds in the DRTF would “trigger” an arbitrage or tax liability that would be out of the ordinary course of business. From information provided by LADWP, the potential for arbitrage or tax penalties already exists because the DRTF has been treated as “replacement proceeds” under Treasury Regulation Section 1.148-1(c)(1) since the fund was first established. Arbitrage and tax penalty calculations are accomplished as part of the normal course of making any distribution from the DRTF. Therefore, the inference in the letter that “new” tax issues would be raised by a material change to the level of funds in the DRTF is unsupported by the documents that have been provided.

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Statement Three

“…the LADWP had planned to sell over the next 60 to 90 days…a total of $1.21 billion bond sales. In order to maintain an “AA” rating for the sale of the bonds, it is imperative that the rating agencies, underwriters, and prospective bonds buyers

see a plan that provides for the solid funding of these bonds into the future. If there is no bond sale by May 2010, cash levels are projected to drop below the

required amount.”

Background

The Power System has established a significant capital improvement plan for the next five years and forward, mainly including investments to replace aging infrastructure and add new renewable generation resources as part of the RPS. In order to fund these improvements, LADWP anticipated selling $720 million in Power Revenue Bonds and $473 million in Southern California Public Power Authority prepayment bonds between the date of the Letter (April 5, 2010) and roughly the end of June 2010. The Letter states, “If there is no bond sale by May 2010, cash levels are projected to drop below the required amount.”

Resources

We evaluated the following documents provided by LADWP or gathered by Crowe to analyze this assertion as stated in the Letter:

Draft Preliminary Official Statement for the Department of Water and Power of the City of

Los Angeles Power System Revenue Bonds, 2010 Series A (Federally Taxable – Direct

Payment – Build America Bonds) and 2010 Series B.

LADWP’s FY 2010 Fiscal Year Financial Plan Presentation dated May 19, 2009.

Financial projections prepared by LADWP dated May 29, 2009.

LADWP’s Power System Presentation to Standard & Poor’s dated March 8, 2010.

Financial projections prepared by LADWP dated March 3, 2010.

Moody’s Investors Services (“Moody’s”) Rating Report dated March 19, 2010 providing a

rating of “Aa3” to LADWP.

Standard & Poor’s Rating Report dated March 22, 2010 providing a rating of “AA-” to

LADWP.

Fitch Ratings’ (“Fitch”) Rating Report dated March 18, 2010 providing a rating of “AA-” to

LADWP.

Moody’s Rating Methodology Report for U.S. Public Power Electric Utilities dated April 2008.

Standard & Poor’s Electric Utility Ratings criteria report dated June 15, 2007.

Fitch’s Public Power Rating Guidelines dated June 11, 2009.

LADWP Cash Position as of March 31, 2010 prepared by LADWP Controller.

LADWP Cash Projections for FY 2010 prepared by LADWP Controller.

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Analysis

In the Letter, LADWP identifies its plan to issue $1.21 billion in bonds “over the next 60 to 90 days”. The $1.21 billion in bonds is composed of two parts, according to LADWP. The first part is the issuance of $720 million in Power Revenue bonds and the remainder ($473 million) would be issued as Southern California Public Power Authority (SCPPA) prepayment bonds. Based on a review of the ratings letters, we would further breakdown these amounts into three categories. The first would be a new money bond issuance of $616 million. This bond issue has been proposed as the 2010 Series A Bonds. The second component would be up to $104 million in advance refunding bonds. These bonds, 2010 Series B Bonds, would advance refund the Department of Water and Power of the City of Los Angeles Power System Revenue Bonds, 2001 Series A, Subseries A-1 and the Department of Water and Power of the City of Los Angeles Power System Revenue Bonds, 2003 Series B. According to LADWP’s Draft Preliminary Official Statement for the 2010 Series A and 2010 Series B Bonds, the 2010 Series B Bonds will also generate new money project funds. The final portion of the $1.21 billion in bond issuance would be the SCPPA Bonds as proposed.

We distinguish between these bond issues in such a manner for the following reasons. Of the $1.21 billion, less than $720 million is new money issued in the name of LADWP. A portion of the 2010 Series B Bonds are refunding bonds and therefore would supersede debt currently on the Power System’s balance sheet. This is not to say that the AA rating is not important to the issuance of the refunding bonds, but it helps to clarify the funding to be received by LADWP for new capital improvements. The most recent rating agency actions, as summarized in the discussion for Statement One, applied to both the 2010 Series A Bonds and the 2010 Series B Bonds.

The SCPPA prepayment bonds proposed to be issued would not be a direct obligation of the LADWP. These bonds would be issued by SCPPA, not LADWP. While LADWP would make a commitment as to its portion of the potential payment towards these bonds through its payments to SCPPA for the services provided, these bonds (as with other SCPPA bonds issued prior) would not show up on LADWP’s balance sheet. SCPPA receives its own credit rating when issuing bonds. It is logical to consider that LADWP’s credit worthiness may be evaluated as a participant in this transaction; however, LADWP’s rating would not be directly applied to this transaction.

As of the date of this report, the bonds identified above have been issued.

In discussing the issuance of $1.21 billion in bonds, LADWP indicates that the rating agencies, underwriters and prospective bond buyers need to see a plan for solid funding of the bonds into the future. This is certainly a true statement, as each stakeholder involved in the bond market for these bonds would conduct an evaluation of the ability of LADWP to repay these bonds in the future. Oftentimes, the ability to repay bonds into the future can be established through the preparation of a consultant’s report or a parity report. Both reports would demonstrate that the LADWP has, based on financial circumstances at the time of bond issuance, sufficient funds to pay both the bonds being issued and all parity bonds. To do this, these reports would calculate a debt service coverage ratio on all parity bonds. However, even as the LADWP may prepare or cause to be prepared one or both of these reports, many times, the stakeholders will also conduct their own analysis and draw their own conclusions.

This is particularly true in the case of the rating agencies. As detailed in the discussion for Statement One, each rating agency has its own methodology for reviewing credit worthiness. These methodologies focus on a wide range of criteria. While financial performance and a sound financial

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plan are key factors in a credit rating, as discussed above, they are not the only factors and are typically considered in the wider context of the issuer’s circumstances.

The last assertion made by LADWP in this statement is that its cash balances would drop below required amounts if the bond sale did not occur by May 2010. In addition, LADWP did not provide an indication in the Letter of the “required amount” being referred to in this statement. Based on other statements made in the Letter, we assume that this amount may be the minimum target of $300 million in unrestricted cash balance, but this is not explicitly stated in the Letter.

To analyze this statement, we reviewed financial projections prepared by LADWP in March 2010 for their rating agency presentations. These projections include actual data through the end of January 2010 and include an FY 2010 transfer to the City of the full amount of $220 million. In addition, these projections include bond proceeds of $600 million. Based on these projections, LADWP was estimating that the Revenue Fund would end FY 2010 with a cash balance of $746 million. This scenario assumes an increase in revenue of $45 million due to the assumed increase in the ECAF cap. As the ECAF cap had not been raised as of the date of the Letter, we have removed these additional revenues. By removing the effect of these revenues, the year-end projection is assumed to drop to roughly $701 million. This projected fund balance is more than double the Board’s minimum target of $300 million. However, as mentioned above, this includes $600 million in bond proceeds.

To corroborate the projections, we received from LADWP its fund balances as of March 31, 2010. As of this date, the Power Revenue Fund had a cash balance of over $744 million. In addition, we also received a monthly cash flow projection for FY 2010. Based on this cash flow projection, LADWP is estimating an ending fund balance of $385.7 million at the end of June 2010. However, as LADWP points out, this assumes the issuance of bonds and the contribution of $300 million of bond proceeds to a construction fund. This number is significantly different from what LADWP was predicting as of the date of the Letter, as the projections used in the Letter assumed $600 million in bond sales. Assuming the $600 million to be accurate, the projected ending balance would be $685 million, much higher than the LADWP’s targeted fund balance.

LADWP has indicated that the proposed bond sales would reimburse expenditures within the Power Revenue Fund, yielding the projected year-end balance. Neither the ratings presentation given to Standard & Poor’s on March 8, 2010 nor the draft preliminary official statement for the 2010 Series A and 2010 Series B Bonds indicate that bond proceeds would be used for reimbursements of expenditures. LADWP indicated that it was necessary to fund capital improvements prior to the issuance of the bonds because the bond sales could not be conducted prior to ECAF rate relief being approved. This assertion is discussed further in Statement Four. In general, we question the soundness of utilizing bond proceeds to reimburse expenditures in regards to the overall financial plan of LADWP. While many jurisdictions allow for bond proceeds to be utilized for reimbursements, these reimbursements are often associated with the professional services required to plan the proposed capital improvements or to issue the bonds. This would normally not include reimbursement for significant capital expenditures made prior to the issuance of the bonds. Oftentimes, municipalities or their subsidiaries would not let contracts for or begin the construction of significant capital improvements until the project funding is in place. This is done to ensure that the entity will be able to fully fund the project prior to its initiation. By doing this, the entity can reduce its risk associated with difficulties in securing financing.

LADWP’s approach could yield a situation in which bond financing cannot be obtained, thereby creating a drain on fund balances that would need to be made up through other means, including the

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possibility of rate increases. At the same time, this practice demonstrates disregard for LADWP’s commitment to maintain an unrestricted cash balance of $300 million. Drawing down the cash balance to fund significant capital expenditures without having the bond issuance in place could result in LADWP dropping below their established minimum target. According to LADWP, this draw on the cash balance could result in potential changes to their current AA rating, the maintenance of which has been established as a core business objective. This is a particular risk to LADWP as they have utilized their commitment to the fund balance as a positive influence on their current ratings. According to Fitch, “Liquidity levels are healthy and following adoption of formal financial policies in June 2009, LADWP no longer expects to draw down its unrestricted cash reserve to fund its capital spending, mitigating Fitch’s previous credit concerns regarding liquidity.”

Conclusion

Given the significant capital improvement plan of the LADWP for FY 2010 and future years, we agree that it is important for LADWP to have a sound financial plan. LADWP needs to be able to show that it will be able to repay the bonds that it issues both in FY 2010 and going forward. However, we do not agree that the financial plan alone would be the driving factor in maintaining LADWP’s current credit ratings. As discussed in Statement One, credit rating agencies utilize many criteria in assigning credit ratings and the financial plan would be only a component of this evaluation.

Utilizing LADWP’s budget projections and given their declaration that they are utilizing their Power Revenue Fund balance to fund significant capital expenditures that will be reimbursed through the proposed bond issuances, the fund balance of the Power Revenue Fund is projected to be rapidly approaching LADWP’s minimum cash balance target as of the date of this Report. This can be attributed to LADWP’s decision to fund significant capital expenditures prior to having actual project funding in place through the bond issues. While LADWP had the money available as of March 31, 2010, to finance expenditures with cash on hand, this approach opens LADWP up to the risk that this money would not be reimbursed if bond financing cannot be obtained, thereby yielding a permanent drain on fund balances. This practice puts LADWP’s commitment to a minimum target balance and their AA credit rating at risk. While we do not necessarily agree that the minimum required cash balance is $300 million, as LADWP asserts or that the maintenance of this level of fund balance will ensure the maintenance of the AA credit rating, LADWP has used their commitment to this fund balance as a selling point in presenting to the rating agencies. By spending down the cash balance without having the reimbursement in place, LADWP runs the risk of going against the commitments they have made to the rating agencies, which could result in future ratings actions.

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Statement Four

“LADWP stated at Committee that we expected to make the additional transfer of $73.5 million. This statement was based on the assumption that the ECAF (Energy

Cost Adjustment Factor) increases needed…would be approved. This is documented in our financial plan.”

Background

The Letter addressed the LADWP representative’s statement during the March 1, 2010 Budget and Finance Committee meeting that the LADWP expected to make the additional $73.5 million transfer in FY 2010. The Letter stated that “this statement was based on the assumption that the ECAF increases needed, as confirmed by the independent review by PA Consulting Group, would be approved.” LADWP indicates that the approval of the ECAF cap increases is documented in the financial plan for the Power System.

Resources

We evaluated the following documents provided by LADWP or gathered by Crowe to analyze this assertion as stated in the Letter:

LADWP’s FY 2010 Fiscal Year Financial Plan Presentation dated May 19, 2009.

Financial projections prepared by LADWP dated May 29, 2009.

LADWP’s Power System Presentation to Standard & Poor’s dated March 8, 2010.

Financial projections prepared by LADWP dated March 3, 2010.

Financial projections prepared by LADWP dated September 8, 2009.

Moody’s Investors Services (“Moody’s”) Rating Report dated March 19, 2010 providing a

rating of “Aa3” to LADWP.

Standard & Poor’s Rating Report dated March 22, 2010 providing a rating of “AA-” to

LADWP.

Fitch Ratings’ (“Fitch”) Rating Report dated March 18, 2010 providing a rating of “AA-” to

LADWP.

LADWP Cash Position as of March 31, 2010 prepared by LADWP Controller.

LADWP’s Financial Services Organization Monthly Activity Report for February 2010.

Analysis

In order to get a complete picture of LADWP’s financial plan for FY 2010, we first analyzed LADWP’s FY 2010 Financial Plan as presented on May 19, 2009. This presentation was made during the budget process for FY 2010. In this presentation, LADWP includes a transfer to the City in the amount of

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$232 million.2 The presentation indicates that the financials presented in the plan assume an increase to the ECAF cap. At that time, the proposed increase was as follows:

If undercollection is greater than $200 million, increase the quarterly cap by $0.02 per kilowatt hours.

If undercollection is greater than $400 million, increase quarterly cap by an additional $0.02 per kilowatt hour.

For the financial projections used in ratings presentations in March 2010, LADWP’s approach to the ECAF cap increase had changed. For these presentations, LADWP assumed that the ECAF cap would be raised to $0.008 per kilowatt hour effective April 1, 2010. In these projections, LADWP is shown transferring $220 million to the City as a result of audit adjustments to FY 2009 revenues.

While these two financial projections have included proposed increases to the ECAF cap, LADWP has also prepared additional financial scenarios which have not included proposed increases to the ECAF cap. In a September 8, 2009, projection, LADWP assumed no change to the ECAF rate cap but a full transfer to the City of $220 million. In this projection, the Power Revenue Fund is projected to end FY 2010 with a fund balance of $582 million. This scenario also included additional notes regarding the credit rating being downgraded due to the $0.001 cap on ECAF increases, and accounted for an increase in the cost of LADWP’s variable rate debt financing.

Conclusion

Based on the information provided, we agree that discussions regarding proposed increases to the ECAF cap have been ongoing since before FY 2010 and that LADWP has included this in their financial plan for FY 2010. However, LADWP did not provide documentation showing that it informed Council prior to the Letter that the ECAF cap rate increase was required in order to make the full surplus funds transfer. In addition, throughout FY 2010, LADWP also made projections which assumed payment of the full transfer with no increase to the ECAF cap while still projected to meet the Board’s commitment to a $300 million unrestricted cash balance. Because of this, we do not agree that LADWP’s statement that the commitment made during the March 1, 2010, Budget and Finance Committee meeting to transfer the remaining surplus amount of $73.5 million to the City was made only under the assumption that the ECAF cap increase was approved. Throughout the year, various projections had been run both with and without ECAF cap increases, but we have not seen any projections which included less than a $220 million transfer to the City’s Reserve Fund. The ECAF cap increase, therefore, does not appear to be assumed for the purposes of projecting the transfer to the City.

While the statement being evaluated does not specifically address LADWP’s credit ratings, LADWP’s assumptions regarding the ECAF cap increases have the potential to impact LADWP’s credit rating going forward. In presenting its financial plan to rating agencies for the purposes of obtaining a credit rating on the proposed 2010 Series A and 2010 Series B bonds, LADWP provided the rating agencies with financial projections which included a $0.008 per kilowatt hour increase to the ECAF rate per quarter. In light of the Council’s rejection of this proposal on March 31, 2010, we question the use of

2 The originally calculated amount prior to finalization of the FY 2009 audit.

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proposed rate increases for the purposes of obtaining a credit rating. By utilizing assumed changes to the ECAF cap to obtain a credit rating, LADWP has created an opportunity for the rating agencies to further review LADWP’s credit and possibly take action on the credit ratings as the information on which the AA credit ratings were obtained has not occurred as LADWP anticipated.

The additional revenue generated by increasing the ECAF rate by $0.008 per kilowatt hour for each quarter going forward versus the revenue generated by an increase to the ECAF rate of $0.006 per kilowatt hour in one quarter with subsequent increases limited to $0.001 per kilowatt hour would clearly make significant changes to LADWP’s financial projections. This is particularly true as PA Consulting identifies that the ECAF represented 39% of the total revenues in 2009 and that number is projected to continue to increase. With the ECAF as such a large percentage of total revenues, significant changes to the ECAF cap increase will have significant changes on the financial projections. As the credit rating agencies based their ratings on projections that will not be realized, LADWP’s credit rating is vulnerable to further review. As noted earlier, Fitch did withdraw its credit rating issued on March 18, 2010, shortly after Council rejected the proposed ECAF cap increase and reissued its rating after the ECAF cap increase issue had been resolved in April 2010.

In addition, we find the actual practice to contradict statements made by LADWP representatives regarding postponing the proposed bond sales until the ECAF cap increase was in place. LADWP stated, in a separate email on May 24, 2010, that “no bond sales could be conducted until LADWP could report to the rating agencies what changes to the ECAF were approved to meet the 20% renewable energy goal by 2010.” LADWP’s actions taken to obtain ratings in March of 2010 using proposed ECAF cap increase projections and prior to official acceptance by the Council, do not agree with these further statements made by LADWP. These additional comments by LADWP seem to support our analysis and conclusions regarding the risk associated with presenting projections to rating agencies.

Finally, we also point to the cash position of LADWP as of the end of March 2010. Based on the projections provided, the cash balance in the Power Revenue Fund of over $744 million seems to be ahead of projections. Even as of the end of February 2010, prior to the March 1, 2010 Budget and Finance Committee meeting, the Power Revenue Fund had a cash balance of $720 million. Given these cash balances, we disagree with the assumption that the ECAF cap increase would be necessary in order to make the $73.5 million transfer. This assumption does not appear to be supported by the financial condition of LADWP on the date this statement was made in the Budget and Finance Committee meeting.

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Statement Five

“Since rate relief has not occurred3, LADWP will be forced to use all funds to pay for energy costs that should otherwise be fully recovered through the ECAF mechanism. There is no

surplus money to transfer at this time.”

Background

The Letter indicates that the Power System had an undercollection of $113.9 million in energy costs. The Letter also discusses that the ECAF expenditures are increasing by $550 million over the FY 2010 to FY 2011 time period. LADWP believed that, after proper vetting, an increase to the ECAF rate cap would be approved by Council, thereby providing some relief for FY 2010. Since, as of the date of the Letter (April 5, 2010), the Council had rejected the proposal to increase the ECAF rate cap, LADWP indicated that it would now “be forced to use all funds to pay for energy costs that should otherwise be fully recovered through the ECAF mechanism.” Because of this, LADWP concluded that there was no surplus money available to transfer at that time and that, “without increases, we have deficits, not surplus.”

Resources

We evaluated the following documents provided by LADWP or gathered by Crowe to analyze this assertion as stated in the Letter:

LADWP’s General Provisions regarding Electric Rates effective September 1, 2008.

Financial projections prepared by LADWP dated March 3, 2010.

The PA Consulting ECAF Report.

LADWP’s FY 2010 Fiscal Year Financial Plan Presentation dated May 19, 2009.

Financial projections prepared by LADWP dated September 8, 2009.

LADWP Energy Cost Adjustment Factor Modification Financial Impact of Council Motions

presentation dated March 31, 2010.

LADWP Cash Position as of March 31, 2010 prepared by LADWP Controller.

Analysis

In order to understand the implication of the ECAF cap to the financial condition of the Power System, we first considered the various components of the ECAF. In particular, we focused on the Energy Cost Adjustment (ECA) Account. The ECA Account is a recording mechanism for tracking revenues and expenses associated with the ECAF. Each month, ECAF expenses are recorded into the account as are ECAF collections. If, in a given month, ECAF revenues exceeded the ECAF expenses, the ECA Account would show an overcollection of ECAF revenue. If, however, ECAF expenses exceeded the ECAF revenue, then the ECA Account would show an undercollection. As of the end of

3 As of the date of the Letter.

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FY 2009, the ECA Account was showing an undercollection of approximately $114 million, as documented in the LADWP’s Letter.

As LADWP accumulates an undercollection in the ECA Account, the impact of this undercollection to ratepayers is simply delayed. As PA Consulting explains in its ECAF Report, “Ultimately, customers are responsible for paying the ECAF costs that accumulate in the undercollection balance. As this undercollection accumulates, the Department is in essence loaning these funds to the customer to be paid back at a later date when rate levels eventually catch up to and exceed cost levels.”

Since the May 19, 2009, presentation of the proposed financial plan for FY 2010, LADWP has been showing significant increases in ECAF expenses over time. Table 5 below summarizes projected ECAF expenses presented by the Board during the FY 2010 budget process.

TABLE 5 SOURCE: LADWP data

Fiscal Year 2009 2010 2011 2012 2013 2014

ECAF Expenses (Millions) $ 1,372 $ 1,670 $ 1,876 $ 1,948 $ 2,029 $ 2,106

Cumulative Increase from FY 2009 298 504 576 657 734

While these projections indicate a $500 million increase in ECAF expenses from FY 2009 to FY 2011, it is reasonable to expect that these numbers were revised from May 19, 2009 to April 5, 2010, which may account for the Letter’s assertion that ECAF expenses will increase by $550 million over that same time period. To the extent that financial projections have been updated since May 2009, we believe it is reasonable that ECAF expenses may increase by $550 million from FY 2009 to FY 2011.

In the letter, LADWP implies that because the ECAF cap increase was rejected by Council, LADWP would now need to use “all funds” to pay these ECAF expenses. LADWP has not provided documentation that would indicate why it is imperative that they address the ECAF expenses and their undercollection so aggressively at this point in time.

We have identified a number of issues which contradict this statement. The first would be the undercollection issues that LADWP has had over time. As of the end of FY 2008, LADWP had an ECAF undercollection of $187 million. This dropped in FY 2009 to $114 million. Using LADWP’s FY 2010 budget projections from May 2009, in which they were assuming the two-tier ECAF cap increase as discussed in Statement Four, LADWP was projecting an undercollection of $275 million at the end of FY 2010. This undercollection continued throughout the projection period to 2014 when the undercollection was projected to be $168 million. We therefore question the timing associated with indicating that “all” funds would be needed to pay off the undercollection when LADWP has historically had an undercollection and projected an undercollection under various ECAF cap scenarios. Even assuming the $0.008 per kilowatt hour ECAF cap increase had been approved by Council, according to the PA Consulting ECAF Report, it could take three to four quarters before the undercollection is fully addressed. During that time, LADWP would still be carrying this deficit.

While the Council and the Board took several unsuccessful actions to increase the ECAF cap, it is accurate to say that ECAF cap relief had not occurred as of the date of the Letter. We do not believe, however, that the discussion could be considered closed at that point in time. Ten days after the Letter, the Board adopted a resolution that was subsequently approved by the Council, allowing LADWP to increase the ECAF rate by $0.006 per kilowatt hour effective July 1, 2010. After the July 1, 2010 quarter, the ECAF rate will not revert back to its prior levels but LADWP’s ability to increase the ECAF rate in future quarters will again be capped at $0.001 per kilowatt hour.

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In analyzing LADWP’s statement that there is no surplus money available as of the time of the Letter, we refer back to the September 8, 2009 financial projection which assumes that the $0.001 per kilowatt hour ECAF cap remains in place. Under this scenario, LADWP is projected to have $582 million in the Power Revenue Fund at the end of FY 2010. This includes an assumption that the full transfer amount of $220 million is paid to the City. In this scenario, therefore, LADWP could offset all of the projected ECAF undercollection of $260 million and still meet its financial target of a minimum balance of $300 million in the Power Revenue Fund. In addition, the fund balance in the Power Revenue Fund as of March 31, 2010 seems to indicate the LADWP may be ahead of its projections as of the end of March, meaning LADWP would have even more access to funds, should it find it necessary to pay down the ECAF undercollection immediately.

Finally, in evaluating the statement that no surplus funds were available as of the date of the Letter, we also refer to our analysis in Statement Three. LADWP representatives have indicated that part of the reason why surplus funds would not be available is because they had been funding capital improvements since September 2009 as it was not possible to conduct bond sales prior to the ECAF cap increase being approved. As discussed in Statement Three, it is generally risky to pay for significant capital improvements anticipating reimbursement from bond proceeds if there is a possibility that bond proceeds may not be received in a timely manner. To the extent that LADWP implemented this practice, the suggested lack of surplus funds can be associated with LADWP’s internal policies to spend down cash balances without regard for the Board’s targeted minimum cash balance and generally accepted obligations such as the transfer to the City.

Conclusion

Based on the data and documentation obtained, we do not believe this to be an accurate statement. We agree that it is important to be proactive in addressing the undercollection issue and believe the subsequent adoption of a one-time increase to the ECAF cap to be a positive move in addressing this situation. However, LADWP has not provided reasons why it must address the undercollection immediately, either through a change in the ECAF cap or through payment of those expenses through available cash. LADWP has had an issue with undercollection for a number of years and has not addressed this situation in the past. In addition, even under the Board’s original March proposal of an increase in the cap to $0.008 per kilowatt hour, it could take up to a year to fully address the undercollection, meaning LADWP would still be carrying the burden of the undercollection for at least another year.

Throughout the preparation of this Report, we have evaluated various financial projections prepared by LADWP. Many of these projections included various assumptions regarding increases to the ECAF cap. However, the one projection provided by LADWP which does not include an increase to the ECAF cap still demonstrated that LADWP would have sufficient funds as of the end of FY 2010 to pay down the ECAF undercollection and meet its minimum cash balance target of $300 million. This indicates that even if the funds are diverted to fund the undercollection at this point in time, the Board would not be in a deficit situation as stated by the LADWP.

While this discussion of the ECAF focuses on its ability generate revenue and correct undercollections over time, we believe it is also important to highlight certain comments made by PA Consulting regarding the current structure of the ECAF. These comments are as follows:

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“The ECAF as currently constituted at LADWP contains several elements that typically would not be found in a cost adjustment factor.”

“…the presence of so many elements into a single cost adjustment factor reduces transparency into the cost drivers behind ECAF increases.”

“Under the current structure, commitments that are both predictable and within the Department’s control can be passed through to ratepayers without review. While this may be appropriate for market-based fuel and purchased power, major capital project commitments represent strategic and not operation decisions.”

“The current ECAF design does not provide for adequate oversight and transparency into long-term commitments made by the Department…”

These comments cause us to question what portion of the ECAF undercollection is due to the addition of these atypical expenses for this type of factor. It appears that LADWP has driven up its ECAF expenses, even as the ECAF rate has been capped during the same time period as these additional expenses have been added to the calculation of the ECAF rate. LADWP has indicated that it would be preparing proposals to reconstitute the ECAF in order to provide the Council with greater visibility of the LADWP’s cost structure. While this will help with future expenses and transparency into long-term commitments for capital projects, it does not address the current undercollection issue and how much of this may be attributable to these atypical elements of the ECAF calculation.

A - 1

APPENDIX A

Los Angeles Department of Water and Power’s April 5, 2010 Letter