What happens if the state's two largest electric utilities seek bankruptcy protection?

No one really knows, but it could be messy.

If the parent companies of Southern California Edison and Pacific Gas & Electric Co. file for protection under bankruptcy laws--as they have threatened to do if the Public Utilities Commission fails this week to approve huge consumer rate increases--those actions could start a chain of events whose outcome would be difficult to predict, much less control.

All the ingredients seem present for a legal, economic and political morass of unprecedented complexity.

The utilities owe billions of dollars to two entities: the California Power Exchange, the wholesale market in which most of the state's electricity is bought and sold, and the Independent System Operator, which maintains the electricity grid and buys emergency power when supplies reach dangerously low levels.

A bankruptcy filing would threaten the solvency of those two agencies and raise grave problems that could undermine the foundation of the state's electricity system.

The agencies are scheduled to make huge payments to power generators over the next two months for electricity distributed last year by Edison and PG & E. If a utility bankruptcy filing leaves them unable to fulfill those commitments, their ability to continue supplying power would be in doubt.

While state law would see to it that lights would stay on, other key questions remain unresolved: What unilateral actions would a bankruptcy judge take, such as possible rate increases? And who would be stuck with the billions of dollars utilities now owe the state electricity market for unpaid wholesale power?

In testimony this past week before the state Public Utilities Commission, executives of both utilities painted the grimmest possible scenario, warning that bankruptcy would lead to widespread economic dislocation in the form of higher rates, job cuts and service reductions. To bolster their case, they cited dire warnings from Wall Street of impending debt downgrades and defaults.

"The utilities are saying that if they go into bankruptcy, they will have to lay off employees, and that the quality of service will go down, that there will be a ripple effect of degradation of every aspect of business. That's the worst-case scenario," said Robert Kinosian, senior analyst with the utility commission's office of ratepayer advocates.

Opponents of rate increases say the utilities are using the bankruptcy threat as a scare tactic. Many, including public utilities panel commissioners and staff members, have been openly skeptical about whether the utilities' financial condition is serious enough to warrant such drastic action.

The wide gulf between the utilities and their opponents leads UCLA law professor and bankruptcy specialist Kenneth Klee to predict that bankruptcy is almost inevitable.

"The utilities could well get a rate increase and file for bankruptcy. This is an extremely political process and I don't see any realistic possibility that the state PUC or any other political body will give the utilities the magnitude of rate increase they say they need," said Klee, who helped rewrite federal bankruptcy laws in the 1980s.

No one expects a bankruptcy to halt the delivery of electricity, because state law expressly forbids it. But consumers may end up paying more for power if a bankruptcy judge demands that the utilities commission or state legislators raise consumer rates closer to wholesale costs. Last month those costs averaged four times the amount charged to consumers, whose rates are frozen.

Although a judge could not order rate increases, he or she could use the threat of throwing the case out of bankruptcy court if the state declines to act, attorneys say.

"A judge would take over day-to-day administration of the utility and the state might lose control over setting rates," said Barry Abramson, senior analyst with UBS Warburg in New York.

Utility employees could be let go, although the cost savings from staff cuts would be tiny in relation to the $11 billion that Edison and PG & E say they have racked up in unrecovered electricity costs.

PG & E owes $3 billion to the California Power Exchange. If the utilities go belly up and creditors are forced to cool their heels, Power Exchange rules indicate that all market participants must share the losses--meaning all buyers and sellers of power.

It therefore seems likely that the California Power Exchange, and possibly the Independent System Operator, would be major creditors of either company, with billions of dollars in unpaid bills outstanding.

The Power Exchange serves as the clearing agent for purchases of out-of-state power, meaning it is the buyer to every seller and the seller to every buyer. In other words, if Edison buys kilowatts from Duke Energy, what actually happens is that Duke sells the power to the Power Exchange and Edison buys it from the Power Exchange.

Exchange spokesman Jesus Arredondo acknowledged that the Power Exchange does not have the full faith and credit of the state behind it. This raises the question of what might happen if the Power Exchange were left with a multibillion-dollar hole in its clearing accounts as the result of a bankruptcy freeze on Edison or PG & E obligations.

Would it be unable to purchase power from anyone else? Would it default on its own obligations? Would that provoke a financial crisis for any other participant in the Power Exchange?

"We've certainly started thinking about" the implications of a utility bankruptcy, said Scott Rasmussen, the Power Exchange general counsel and corporate secretary. He acknowledged that it is "certainly possible" that the Power Exchange would be a creditor in bankruptcy. "To the extent we're owed money, we're a creditor," he said, adding that the situation is "extremely sensitive."

In testimony before the utilities commission last week, PG & E said it was anticipating payments due to the Independent System Operator totaling $2.7 billion between now and March 2 and $431 million more to the Power Exchange in mid-February. Edison declined to break out its debts to either the Power Exchange or the Independent System Operator.

The course of a California utility bankruptcy proceeding is difficult to predict because there has been no close parallel filing elsewhere in the U.S. Two other investor owned utilities--Public Service Co. of New Hampshire and El Paso Electric in Texas--have gone bankrupt in the last 15 years, but their cases bear little resemblance to the problems now faced by the much larger Edison and PG & E.

Edison and PG & E are reeling under the weight of $11 billion in accumulated "undercollections," as well as continuing fuel costs from which no relief is forthcoming, said Rich Levin, a bankruptcy specialist with Skadden, Arps, Slate, Meagher & Flom in Los Angeles. In fact, wholesale fuel costs are likely to increase in coming months.

If Wall Street credit-rating agencies are dissatisfied with the utilities commission rate increases and carry out their threat to downgrade utility debt to junk-bond status immediately after a commission decision, the utilities may be forced into filing for Chapter 11 immediately.

That is because such a downgrade would put the utilities in technical default on billions of dollars of outstanding debt, hamstring their ability to buy electricity, and close the door on any possibility that they could borrow money on the huge debts.

"We view it as a dire situation. I think there will be some rate increase on Jan. 4. But we will also be looking at what the politicians say about reordering the whole scheme. Doing the first step without the second would simply be a stopgap measure," said Fitch managing director Steven Fetter, who is also a former Michigan utilities regulator. * * *