PG&E 2003 General Rate Case: Expert Witness Michael Phillips

May 2003

Q. What observations, if any, do you have?

A. There is evidence in the material reviewed to suggest that executive compensation is excessive.

I will explain what evidence is "suggestive" of the excessive issue, but first I want to alert the CPUC to the inadequacy of the material presented by PG&E. The CPUC should not rely solely on the material and data submitted to date.

An expert witness on executive compensation and a well informed business person in April 2003 would both be compelled by honesty to admit that the information presented by PG&E is inadequate to determine conclusively whether executive compensation is adequate or unreasonable.

There are two reasons, and both will be explained herein.

1) First, the corporate scandals in the U.S. and Europe over the past two years have alerted all expert witnesses on executive compensation and all informed business people that corporate disclosure of executive compensation can be outright deceptive to shareholders, public agencies and, on occasion, Boards of Directors.

I will cite, by name, the type of deception that could be practiced by PG&E.

A. Jack Welch type of deception. Jack Welch was the CEO of General Electric who was provided with a pension that guaranteed a rate of return of more than 12% per year.

I find in a careful revue of PG&E documents, including annual proxy statements, no disclosure about the existence or non-existence of a guaranteed rate of pension return.

B. John W. Snow type of deception. John W. Snow was CEO of CSX Corporation before becoming U.S. Treasury Secretary. His CSX employment contract contained payment provisions, based on leaving CSX for a Cabinet level job, which provided for the buyout of his life insurance policy and for a lump sum pension payment.

PG&E has provided a statement of general guidelines for executive employment contracts, but the general guidelines do not confirm nor deny the existence of specific John W. Snow type contract provisions.

C. Donald Carty type of deception. Donald Carty was CEO of American Airlines until two weeks ago when it was disclosed that he had arranged for top executives to have their pension plans guaranteed by an undisclosed trust fund that would protect executive pension funds in case of bankruptcy.

PG&E is currently in bankruptcy, so the Carty type of deception is highly relevant. No documents indicate the existence or absence of a trust fund to guarantee executive pensions.

2) There are four known harmful effects of excessive executive compensation. None of the material offered to the CPUC provides any useful information on any of these four known harmful effects of excessive executive compensation.

The four harmful effects of excessive executive compensation are:

1. Wage Creep. When executives receive increases in compensation, top management, middle management and all other salaried employees expect and often demand comparable adjustments. The net effect of increases in executive compensation is to raise the cost structure of the corporation. When executive compensation is excessive, the cost structure for the whole corporation can become excessive.

2. Buyout Vulnerability. When executive compensation is excessive, the corporation becomes more susceptible to being bought out by another corporation.

The reason that excessive executive compensation is an inducement to other businesses and corporate raiders to buy out the company is that the new post-merged company can fire the overpaid executives and immediately have a significant cost savings. This is particularly true in the case where the buying company is foreign and excessive American compensation is easily recognized. The buyout of Chrysler Corporation by Daimler-Benz is an example of this type of wage saving buyout.

3. Promotes bad employee behavior. When executive compensation is excessive, the corporate executives fail in their leadership role and occasionally employees, suppliers and customers become lax in their own moral behavior. Lower morale is associated with lower productivity, increased in-house fraud and poor work practices .

The best authority on the subject of executive compensation and employee behavior is the President of the United States:

"Everyone in a company should live up to high standards. But the burden of leadership rightly belongs to the chief executive officer. CEOs set the ethical direction for their companies. They set a moral tone by the decisions they make, the respect they show their employees, and their willingness to be held accountable for their actions.

"... one of the principal ways that CEOs set an ethical tone is through their compensation. The pay package sends a clear signal whether a business leader is committed to teamwork or personal enrichment. It tells you whether his principal goal is the creation of wealth for shareholders, or the accumulation of wealth for himself. "

4. Bad form for bad times. Excessive executive compensation sets a bad precedent for employee cooperation in bad times. Almost all businesses experience volatility in their profitability. This is particularly true when the corporation is affected by national business cycles. The example of American Airlines is the best and most recent case. American Airlines had experienced severe reduction in revenue due to industry-wide problems and a business cycle downturn. The management of American had succeeded in reaching agreements with employees to reduce staff and wages ... until the employees learned of deceptive practices involving excessive executive compensation. The staff and wage reductions were then not possible without the resignation of the CEO. Many observers believe the ill will in the American Airlines case will take many years to recover.

Each and all of the four types of harmful effects of excessive executive compensation can be detrimental to the operation and management of a corporation.

It is important that a regulatory body as well as shareholders and Boards of Directors have adequate information on each type of harmful effect that can result from excessive executive compensation.

Such adequate information is not made available to the CPUC in the material presented by PG&E in this rate proceeding.

Q. You mention in the beginning of your testimony that, "There is evidence in the material reviewed to suggest that executive compensation is excessive." Could you return to this subject?

A. There are two disturbingg elements in the documents I have reviewed. The first is the membership of the Board's Nominating and Compensation Committee.

The second disturbing element is what I refer to as the Enron Effect on PG&E Compensation.

1. The Nominating and Compensation Committee has the responsibility to carefully review executive compensation proposals and make recommendations to the full board on such matters. The committee has four members including David A. Coulter. The committee membership has remained the same for a number of years.

Mr. Coulter was CEO of Bank of America for a few years in the mid 1990's. Mr. Coulter is called upon in his paid position on the Nominating and Compensation Committee to contribute expertise to the committee in matters of executive leadership, ethical executive standards and general business ethics.

My concern is that the Nominating and Compensation Committee of the PG&E Board may not be advised at the highest level of expertise on these matters by Mr. Coulter. I have no personal nor direct knowledge of Mr. Coulter's role on the Committee. My concern arises from the public evidence of Mr. Coulter's previous business experience.

In 1996, Mr. Coulter became CEO of Bank of America, the largest bank in California, the largest populated state in the U.S., and the third largest bank in the United States by assets. After less than three years in the CEO position at Bank of America, Mr. Coulter actively participated in merging Bank of America with NationsBank, a bank headquartered in Charleston, North Carolina. Shortly after the merger was completed, Mr. Coulter was awarded an executive compensation departure bonus of a reported $100 million. He left the bank to join an investment banking firm.

This may or may not have a bearing on the type of advice the Board of PG&E received on matters of executive compensation. The quality of Mr. Coulter's advice should be reviewed.

2. The Enron Effect on PG&E Compensation.

The Nominating and Compensation Committee used the Hewitt Associates company survey of what it calls "market comparator data" to help establish executive compensation for PG&E executives.

Beginning with data supplied for the year 1996 and continuing to 2002, Enron Corporation was one of twelve utility company executive compensation benchmarks used in the "market comparator data" for PG&E executives.

The actual comparator data used by PG&E in establishing compensation is only provided to me for one year, 2002. For that year, Enron Chairman Kenneth Lay's total executive compensation of $31 million is used as a basis for PG&E Chairman Robert D. Glynn Jr.'s compensation. Having Chairman Lay's compensation in the benchmark data raises the comparator average from $6.3 million to $8.5 million, an increase of 35%.

For the same year, Enron President and CEO Jeffrey K. Skilling's total executive compensation of $30.6 million was used in the basis for the compensation of PG&E EVPs Thomas Boren and Gordon Smith. Having Enron President and CEO Jeffrey K. Skilling's compensation in the benchmark data raises the comparator average from $3.8 million to $6.2 million, an increase of 63%.

I have no reason to believe that the data for executive compensation in 2002 was significantly different from the type of data used in previous years. I therefore conclude that some evidence exists that the unique executive compensation practices used at Enron over the recent past have had an effect on the executive compensation for PG&E.

Q. Have you any suggestions for the CPUC regarding a method to obtain reliable data on whether PG&E executive compensation is excessive?

The CPUC could have significantly more reliable information with which to judge excessive executive compensation if it hired an outside audit consulting group directed to:

1) Examine and report back the completion of an audit to determine whether practices described as the Welch, Snow and Carty deceptions were or are practiced at PG&E.

2) Examine and report back the completion of an audit to determine the magnitude of the Four Harmful Effects of Executive Compensation at PG&E. The audit group could rate PG&E executive compensation on a scale from 1 to 10 for each of the four harmful effects.

Strictly as an example, the audit group might determine that PG&E had a high risk of Type 1 Harmful Effect of Executive Compensation (Wage Creep) with a rating of 8 on a 1-10 scale, but has a lower risk of Type 3 Harmful Effect of Executive Compensation (Promotes Bad Employee Behavior) with a rating of 3 on a 1-10 scale.

Such an outside audit could inform the CPUC on the merit of current PG&E executive compensation practices.