PG&E Corporation's other significant subsidiary, National Energy & Gas Transmission, Inc., or NEGT, formerly known as PG&E National Energy Group, Inc., headquartered in Bethesda, Maryland, was incorporated on December 18, 1998, as a wholly owned subsidiary of PG&E Corporation. On July 8, 2003, NEGT filed a voluntary petition for relief under Chapter 11. For the reasons described below in Note 4, PG&E Corporation considers NEGT to be an abandoned asset under Statement of Financial Accounting Standards, or SFAS, "Accounting for Impairment or Disposal of Long-Lived Assets," or SFAS No. 144, and, as a result, the operations of NEGT prior to July 8, 2003 and for all prior periods, are reflected as discontinued operations in the Consolidated Financial Statements. In addition, as discussed in Note 4, effective July 8, 2003, PG&E Corporation no longer consolidates the earnings and losses of NEGT or its subsidiaries and began accounting for its ownership interest in NEGT using the cost method, under which PG&E Corporation's investment in NEGT is reflected as a single amount on the Condensed Consolidated Balance Sheet of PG&E Corporation. On October 29, 2004, NEGT's plan of reorganization became effective and NEGT emerged from Chapter 11, at which time PG&E Corporation's equity interest in NEGT was cancelled.

               This Quarterly Report on Form 10-Q is a combined report of PG&E Corporation and the Utility. Therefore, the Notes to the unaudited Consolidated Financial Statements apply to both PG&E Corporation and the Utility. PG&E Corporation's Condensed Consolidated Financial Statements include the accounts of PG&E Corporation, the Utility, and other wholly owned and controlled subsidiaries. The Utility's Condensed Consolidated Financial Statements include its accounts and those of its wholly owned and controlled subsidiaries, and variable interest entities for which it is subject to a majority of the risk of loss or gain.

               The accompanying interim unaudited Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP, for interim financial information and in accordance with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they may not contain all of the information and footnotes required by GAAP for complete financial statements. Both PG&E Corporation's and the Utility's Consolidated Balance Sheets at December 31, 2003, were derived from the audited Consolidated Balance Sheets included in the Current Report on Form 8-K dated June 18, 2004 (which supercedes the information included in the combined 2003 Annual Report). Certain reclassifications of the 2003 amounts have been made to conform to the 2004 presentation.

               The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of revenues, expenses, assets and liabilities and the disclosure of contingencies, and include, but are not limited to, estimates in determining the Utility's regulatory asset and liability balances based on probability assessments, revenues earned but not yet billed (including delayed billings), asset retirement obligations, allowance for doubtful accounts receivable, provisions for losses that are deemed probable from environmental remediation liabilities, pension liabilities, mark-to-market accounting under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended, or SFAS No. 133, income taxes, litigation, and in the Utility's review for impairment of long-lived assets and certain identifiable intangibles to be held and used whenever events or changes in circumstances indicate that the carrying amount of its assets might not be recoverable. As these estimates involve judgments on a wide range of factors, including future economic conditions that are difficult to predict, actual results could differ from these estimates. PG&E Corporation's and the Utility's Consolidated Financial Statements reflect all adjustments that management believes are necessary for the fair presentation of the financial position and results of operations for the interim periods presented. These adjustments are of a normal recurring nature.

               During the period that the Utility was in Chapter 11, the Utility's Consolidated Financial Statements were prepared in accordance with the American Institute of Certified Public Accountants' Statement of Position 90-7, "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code," or SOP 90-7. Under SOP 90-7, certain claims against the Utility existing before the Utility's Chapter 11 filing were classified as liabilities subject to compromise on PG&E Corporation's and the Utility's Consolidated Balance Sheets. Additionally, professional fees and expenses directly related to the Utility's Chapter 11 proceeding and interest income on funds accumulated during the Chapter 11 proceedings were reported separately as reorganization items.

               The Utility discontinued the application of SOP 90-7 upon its emergence from Chapter 11 on April 12, 2004. The Consolidated Financial Statements as of and for the periods ending September 30, 2003 and December 31, 2003, have been presented in accordance with SOP 90-7. Although the Utility emerged from Chapter 11 on April 12, 2004, the bankruptcy court retained jurisdiction, among other things, to resolve disputed claims made in the Chapter 11 case. Upon the effective date of the Utility's Plan of Reorganization, $1.8 billion was deposited into escrow, pending the resolution of disputed claims, and has been classified as restricted cash in current assets on PG&E Corporation's and the Utility's September 30, 2004 Consolidated Balance Sheets. The related remaining pre-petition claims are subject to resolution by the bankruptcy court.

               The accounting policies used by the Utility include those necessary for rate-regulated enterprises, which reflect the ratemaking policies of the California Public Utilities Commission, or the CPUC, and the Federal Energy Regulatory Commission, or the FERC. Except as disclosed below, PG&E Corporation and the Utility are following the same accounting policies discussed in their Current Report on Form 8-K dated June 18, 2004 (which supercedes the information included in the combined 2003 Annual Report).

               In May 2004, the Financial Accounting Standards Board, or the FASB, issued Staff Position SFAS No. 106-2, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003," or FSP 106-2. FSP 106-2 supersedes FSP 106-1, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003," and provides guidance on the accounting, disclosure, effective date, and transition requirements related to the Medicare Prescription Drug Act. FSP 106-2 is effective for the third quarter of 2004. The companies have determined that the Utility's postretirement medical plan, or the Plan, the only benefit plan potentially affected by the Medicare Prescription Drug Act (and FSP 106-2), does not qualify for the federal subsidy under the terms of the Medicare Prescription Drug Act. The adoption of FSP 106-2 did not have any impact on the Consolidated Financial Statements of PG&E Corporation or the Utility. The Medicare Prescription Drug Act could subsequently affect the Plan in terms of lower participation rates, which would lower the Plan's benefit obligation and related expenses.

               In December 2003, the FASB issued Interpretation No. 46 (revised December 2003), "Consolidation of Variable Interest Entities," or FIN 46R. FIN 46R provides that an entity is a variable interest entity, or VIE, if it does not have sufficient equity investment at risk, or if the holders of the entity's equity instruments lack the essential characteristics of a controlling financial interest. FIN 46R requires that the company that is subject to a majority of the risk of loss from a VIE's activities, or is entitled to receive a majority of the entity's residual returns, or both, consolidate the VIE. A company that consolidates a VIE is called the primary beneficiary.

               PG&E Corporation and the Utility adopted FIN 46R on January 1, 2004. The adoption of FIN 46R did not have any impact on net income.

               The Utility invests in low-income housing partnerships, or LIHPs. The entities were formed to invest in low-income housing projects sponsored by non-profit organizations in the state of California. The Utility determined that it was the primary beneficiary of one LIHP, resulting in its consolidation. Accordingly, total assets and total liabilities of $14 million for the LIHP have been included in the Utility's Consolidated Balance Sheets. The consolidated LIHP has issued debt in the amount of $6 million, which is secured by assets of the partnership, totaling $27 million, and the Utility's commitment to make capital infusions of approximately $13 million over the next five years.

               The Utility is not considered to be the primary beneficiary of any other LIHPs. The maximum exposure to loss from its investment in unconsolidated LIHPs is the Utility's investment of $6 million.

               The nature of power purchase agreements is such that the Utility could have a significant variable interest in a power purchase agreement counterparty if that entity is a VIE owning one plant that sells substantially all of its output to the Utility, and the contract price for power is correlated with the plant's variable costs of production. Previously, the Utility was not able to determine whether certain power purchase contracts represented variable interests in VIEs. During the third quarter, the Utility determined that none of its current power purchase agreements represent significant variable interests. The Emerging Issues Taskforce, or the EITF, continues to review how companies determine whether an arrangement is a variable interest. Their findings could impact how the determination is applied to the Utility's power purchase agreements in the future.

               In November 2003, the FASB approved an amendment to an interpretation issued by the Derivatives Implementation Group C15, or DIG C15, as previously amended in October 2001 and December 2001, that changed the definition of normal purchases and sales for certain power contracts that contain option-like features.

               PG&E Corporation and the Utility had previously adopted the new DIG C15 guidelines prospectively for new derivative instruments entered into after June 30, 2003. On January 1, 2004, PG&E Corporation and the Utility adopted the new DIG C15 guidelines for certain power contracts that contain option-like features that existed prior to July 1, 2003. The adoption of DIG C15 did not have any impact on the Consolidated Financial Statements of PG&E Corporation or the Utility.

               PG&E Corporation and the Utility account for the financial effects of regulation in accordance with "Accounting for the Effects of Certain Types of Regulation," as amended, or SFAS No. 71. SFAS No. 71 applies to regulated entities whose rates are designed to recover the costs of providing service. The Utility is regulated by the CPUC, the FERC and the Nuclear Regulatory Commission, or the NRC, among others. As discussed further in Note 2, during the first quarter of 2004, the Utility began reapplying SFAS No. 71 to its generation operations. As a result, as of March 31, 2004, the Utility recorded a generation regulatory asset of approximately $1.2 billion. SFAS No. 71 now applies to all of the Utility's operations except for the operations of a natural gas pipeline.

               SFAS No. 71 provides for recording regulatory assets and liabilities when certain conditions are met. Regulatory assets represent the capitalization of incurred costs that would otherwise be charged to expense when it is probable that the incurred costs would be included for ratemaking purposes in the future. Regulatory liabilities represent rate actions of a regulator that will result in amounts that are to be credited to customers through the ratemaking process.

               To the extent that portions of the Utility's operations cease to be subject to SFAS No. 71 or recovery is no longer probable as a result of changes in regulation or the Utility's competitive position, the related regulatory assets and liabilities are written off.

               Regulatory assets comprise the following:

               Regulatory liabilities comprise the following:

               Sales balancing accounts accumulate differences between revenues and the Utility's authorized revenue requirements. Cost balancing accounts accumulate differences between incurred costs and authorized revenue requirements. Under-collections that are probable of recovery through regulated rates are recorded as regulatory balancing account assets. Over-collections that are probable of being credited to customers are recorded as regulatory balancing account liabilities. The Utility's regulatory balancing accounts accumulate balances until they are refunded to or received from the Utility's customers through authorized rate adjustments.

               Earnings (loss) per share is calculated utilizing the "two-class" method by dividing earnings (loss) allocated to common shareholders by the weighted average number of common shares outstanding during the period.

               On March 31, 2004, the FASB ratified the consensus reached by the EITF, on EITF Issue 03-06, "Participating Securities and the Two-Class Method under FASB Statement No. 128," or EITF 03-06. EITF 03-06 provides additional guidance related to the calculation of earnings per share under SFAS No. 128, "Earnings per Share," or SFAS No. 128, which includes application of the "two-class" method in computing earnings per share, identification of participating securities, and requirements for the allocation of undistributed earnings (and losses) to participating securities.

               PG&E Corporation currently has outstanding $280 million in convertible subordinated 9.50% notes due 2010, or Convertible Notes, that are entitled to receive (non-cumulative) dividend payments without exercising the conversion option. These Convertible Notes meet the criteria of a participating security in the calculation of basic earnings per share using the "two-class" method of SFAS No. 128. Therefore, EITF 03-06 requires that earnings be allocated between common stock and the participating security. PG&E Corporation adopted EITF 03-06 in the first quarter of 2004 and for all subsequent and all prior periods presented.

               In applying the "two-class" method, the following reflects the earnings (loss) allocated to common shareholders after the inclusion of participation rights related to PG&E Corporation's 9.50% Convertible Notes in the allocation of earnings. The 9.50% Convertible Notes are convertible at the option of the holders into 18,558,655 common shares. All PG&E Corporation's participating securities participate on a 1:1 basis in dividends with common shareholders.

               The following options to purchase PG&E Corporation common shares were outstanding, but not included in the computation of diluted earnings per share because the option exercise prices were greater than the average market price: nine months ended September 30, 2004 - 8,045,805, nine months ended September 30, 2003 - 17,687,167, three months ended September 30, 2004 - 7,705,881, and three months ended September 30, 2003 - 11,130,315.

               PG&E Corporation reflects the preferred dividends of subsidiaries as other expense for computation of both basic and diluted earnings per share.

               PG&E Corporation and the Utility apply the intrinsic-value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," in accounting for employee stock-based compensation, as allowed by SFAS No. 123, "Accounting for Stock-Based Compensation," or SFAS No. 123, as amended by SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure, an Amendment of FASB Statement No. 123," or SFAS No. 148. Under the intrinsic value method, PG&E Corporation and the Utility do not recognize any compensation expense for stock options, as the exercise price is equal to the fair market value of a share of PG&E Corporation common stock at the time the options are granted.

               The tables below show the effect on net income and earnings per share for PG&E Corporation and the Utility had it elected to account for its stock-based compensation plans using the fair-value method under SFAS No. 123 for the three and nine months ended September 30, 2004 and 2003:

               If compensation expense had been recognized using the fair value-based method under SFAS No. 123, the Utility's pro forma consolidated earnings would have been as follows:

               At September 30, 2004, a total of 2,088,920 shares of restricted PG&E Corporation common stock had been awarded to eligible employees of PG&E Corporation and its subsidiaries, of which 1,280,000 shares were granted to Utility employees. At September 30, 2004, approximately 1,613,427 shares of restricted stock awarded to eligible employees of PG&E Corporation and its subsidiaries were outstanding, of which 1,062,697 shares were granted to Utility employees. The shares were granted with restrictions and are subject to forfeiture unless certain conditions are met.

               The restricted shares are held in an escrow account. The shares become available to the employees as the restrictions lapse. In general, for shares granted in 2003, the restrictions on 80% of the shares lapse automatically over a period of four years at the rate of 20% per year. The compensation expense for these shares remains fixed at the value of the stock at grant date. Restrictions on the remaining 20% of the shares will lapse at a rate of 5% per year if PG&E Corporation is in the top quartile of its comparator group as measured by annual total shareholder return for each year ending immediately before each annual lapse date. The compensation expense recognized for these shares is variable, and changes with the common stock share price. For shares granted in 2004, the restrictions lapse automatically over a period of four years at the rate of 25% per year, and the compensation expense remains fixed at the value of the stock at grant date. Compensation expense associated with all restricted stock is recognized on a quarterly basis by amortizing the unearned compensation related to that period. Total compensation expense resulting from the restricted stock issuances reflected in PG&E Corporation's Consolidated Statements of Income was approximately $3.1 million for the three-month period ended September 30, 2004 and $6.2 million for the nine-month period ended September 30, 2004, of which approximately $1.8 million for the three-month period ended September 30, 2004 and $3.8 million for the nine-month period ended September 30, 2004 was recognized by the Utility. The total unamortized balance of unearned compensation resulting from the restricted stock issuances reflected in PG&E Corporation's Consolidated Balance Sheet at September 30, 2004 was approximately $25 million.

               PG&E Corporation's and the Utility's comprehensive income (loss) consists principally of changes in the market value of certain cash flow hedges under SFAS No. 133, and the effects of the remeasurement of the defined benefit pension plan.

               The above changes to other comprehensive income, or OCI, are stated net of income tax expense (benefit) of $2 million for the nine-month period ended September 30, 2004, and $1 million for the three-month and ($46) million for the nine-month periods ended September 30, 2003.

               Accumulated other comprehensive income (loss) reports a measure for accumulated changes in equity of an enterprise that results from transactions and other economic events other than transactions with shareholders. The following table sets forth the changes in each component of accumulated other comprehensive income (loss):

               There was no movement in the component balances of accumulated other comprehensive income (loss) during the third quarter of 2004. An amount of $77 million is included in accumulated other comprehensive income (loss) related to discontinued operations at September 30, 2004, and at September 30, 2003. This amount will be recognized in connection with PG&E Corporation's elimination of its equity interest in NEGT in the fourth quarter of 2004 (see further discussion in Note 4, Discontinued Operations).

               In accordance with various agreements, the Utility and other subsidiaries provide and receive various services to and from their parent, PG&E Corporation, and among themselves. The Utility and PG&E Corporation exchange administrative and professional support services in support of operations. These services are priced either at the fully loaded cost ( i.e ., direct costs and allocation of overhead costs) or at the higher of fully loaded cost or fair market value, depending on the nature of the services. PG&E Corporation also allocates certain other corporate administrative and general costs to the Utility and other subsidiaries using a variety of factors, including the number of employees, operating expenses excluding fuel purchases, total assets and other cost-causal methods. The Utility purchases natural gas transportation services from Gas Transmission Northwest Corporation, or GTNW, formerly known as PG&E Gas Transmission, Northwest Corporation. Effective April 1, 2003, the Utility no longer purchases natural gas from NEGT Energy Trading Holdings Corporation, or NEGT ET, formerly known as PG&E Energy Trading Holdings Corporation. Both GTNW and NEGT ET are subsidiaries of NEGT. The Utility sold natural gas transportation capacity and other ancillary services to NEGT ET until NEGT's Chapter 11 proceeding was imminent. These services were priced at either tariff rates or fair market value, depending on the nature of the services provided. Through July 7, 2003, all significant intercompany transactions are eliminated in consolidation; therefore, no profit or loss resulted from these transactions. Beginning July 8, 2003, the Utility's transactions with NEGT are no longer eliminated in consolidation. The Utility's significant related party transactions and related receivable (payable) balances were as follows:

               As discussed further in Note 2, as of March 31, 2004, PG&E Corporation recorded the impact of the Settlement Agreement entered into on December 19, 2003, among PG&E Corporation, the Utility and the CPUC to resolve the Utility's Chapter 11 case. The Settlement Agreement precluded the Utility from reimbursing PG&E Corporation for certain Chapter 11 related costs. As such, PG&E Corporation reduced its receivable from the Utility, and the Utility reduced its payable to PG&E Corporation by $128 million. The transactions were recorded as a contribution of equity to the Utility by PG&E Corporation, net of taxes of $52 million, and an increase to additional paid-in capital by the Utility in the first quarter of 2004.

               PG&E Corporation and its subsidiaries provide non-contributory defined benefit pension plans for certain of their employees and retirees (referred to collectively as pension benefits), contributory postretirement medical plans for certain of their employees and retirees and their eligible dependents, and non-contributory postretirement life insurance plans for certain of their employees and retirees (referred to collectively as other benefits). PG&E Corporation and its subsidiaries use a December 31 measurement date for all of its plans and use publicly quoted market values and independent pricing services depending on the nature of the assets, as reported by the trustee, to determine the fair value of the plan assets.

               Net periodic benefit cost as reflected in PG&E Corporation's and the Utility's Statements of Income for the three and nine-month periods ended September 30, 2004 and September 30, 2003 are as follows: