Bankers probably did not think that California would be creating most of the US power market's new business in 2003. The state, since the power crisis of 2000, has been held up as an example of a regulatory compact gone horribly wrong. And uncertain offtake environments rarely make for financeable projects. The southeastern US looked far more promising, provided the incumbent villains would open up to independent power producers.

Three years later, southern IPPs are still an endangered minority, and lenders are much more happy to do business with Southern, Entergy, and FPL than those seeking to break their grip on regional power markets. Likewise, the regulatory mess of California has produced a new offtaker, one with which investors are increasingly comfortable.

The California Department of Water Resources (CDWR) is the credit behind most of the well-priced project financings to come to market this year. It has been granted to make power purchases on behalf of the State of California and the state's two largest utilities - Southern California Edison (part of Edison International) and Pacific Gas & Electric (part of PG&E Corp). The former skirted bankruptcy, the latter is under chapter 11 protection, alongside its sister company, PG&E NEG.

The CDWR existed as the only creditworthy entity capable of entering into power purchase agreements with independent power producers, and its role in the crisis was envisaged as a quick fix. It was one of the emergency measures, which included siting procedures for peaking power units, that were designed to keep the lights on.

The CDWR's role is just one of the parts of the solution that has aroused heated political opposition in the State. It highlights the continued existence of privately-held power plants, since it is on the end of power purchase agreements with merchants and IPPs. Its contracts have become the most valuable assets held by many marketers and merchants. The critics say that these were signed at too high a price - and there is some evidence that they may be right.

Contract sanctity is one of the most pressing issues in the US power market, largely because contracts are such valuable assets. There is a substantial body of case law growing up around the ability of generators and offtakers, usually bankrupt ones, to reject onerous power purchase agreements. This pits bankruptcy law against Federal energy regulation, both of which have different social imperatives to the rear.

The struggles of NRG Energy and Mirant against Connecticut Light & Power and Pepco, respectively, will have some effect upon recovery rates and the health of companies emerging from bankruptcy. But, since 12 June 2003, $2.112 billion in non-recourse debt has reached the bond markets backed by CDWR contracts, of which $1.25 billion had no generating plant behind it at all. Probable losses in the event of default will be high.

The deals generally split into two types - those that securitize the margin between the prices agreed in the CDWR contract, and the price at which the amended counterparty, in these cases an investment bank, can buy or generate power - and traditional power project bonds. The second category, supported by a power plant with a quasi-governmental offtake agreement, is familiar. The first has a more limited history - just five deals in total.

The contract monetisation structure, created by El Paso and Credit Suisse First Boston for Cedar Brakes and developed by Morgan Stanley on Utility Contract Funding, has received a new lease of life from the contracts. One key difference between the early deals, where the New Jersey PUC approved a restatement of El Paso's PPAs with PSE&G, and Calpine's PCF and Goldman's PRF, as that the transfer happened without formal PUC sanction, although the transfer to a more highly-rated entity is probably a welcome one.

The two CDWR contracts that have been monetised are both out of litigation, and settled at all levels, and have been struck at roughly $60 per MWh. Evidence from the two transactions is that Goldman Sachs' commodity arm, J Aron, and Morgan Stanley's Capital Group, both rated at A+ by S&P, can find much cheaper power. Goldman supplies PRF at $48 per MWh, while Morgan Stanley purchases power at $40.

These deals are cover power that has to be provided 24 hours a day, while there are a few events whereby either party could claim force majeure, the supply agreements are largely covered by a parental guarantee. According to Richard Ashby, managing director at Pace Global Energy Services, which has advised on all of the monetisation deals thus far, "investors are realizing the need and value for liquid forward market for power." According to Ashby, the market fundamentals are moving solidly. "Demand for power in Southern California is rising strongly, and the political risk appears to have receded. Investors should see the rewards from a long-term view in these and future transactions," he says.

This situation puts the agencies in a familiarly uncomfortable situation - one where they may be asked to issue rapid-fire downgrades and where their actions will have a material effect upon the state of the market. In the first instance, agencies have made clear, as Standard & Poor's did in its GWF Energy LLC presale report, that alterations to contractual structures will be 'credit cliff' events - those that cause rapid and large downgrades. Indeed, Fitch does not rate the Californian contract monetisation deals, for this, among other reasons, although it did rate GWF.

The second cause for agency discomfort stems from the way that the CDWR contracts have been structured. The CDWR as offtaker is a temporary solution, designed to give the troubled utilities time to recover financially. The CDWR could novate the contracts - i.e. transfer them to a third party - under certain circumstances. In theory this is any qualifying electrical utility, but in practice the successors are likely to be the restructured and restored Southern California Edison and Pacific Gas & Electric.

These need to have a rating of BBB/Baa2 (S&P/Moody's), and therefore leave the agencies in the position of signing off on the future of these transactions. The BBB rating is therefore the ceiling for CDWR-based financings, and the rating of the revived utility could be affected by new contracts novated from the CDWR, which are likely to be treated as debt. Nevertheless, one analyst, Doug Harvin at Fitch, says that the transition from a politically insecure offtaker, the CDWR, to a regulated but commercially run utility would probably, ratings being equal, be a positive event.

The agencies stress that their role is to judge credit, and not to create policy, and are wary of entering the debate on the best form of market in the long-term for California. Moreover, contract novation, from the standpoint of the utilities to which they are assigned, will not lead to a sizeable dilution in credit quality, since there will be less and less due under the contract as the power purchase agreements near maturity.

The market is still a work in progress, and awaits the production of the California Energy Commission's Integrated Energy Policy Report. It also awaits the final passage of the Energy Bill, presently the subject of tinkering in Congressional conference. But the current political and judicial environment in the state appears positive, recall election notwithstanding. "A governor-elect that picked Warren Buffet, who runs MidAmerican Energy, as his economic advisor, is unlikely to turn against deregulated markets for power," remarked one consultant familiar with the market. The state's energy problems, moreover, while a factor in the recall, run a distant second to California's budget crisis in Arnold Schwarzenegger's list of priorities.

Nevertheless, Schwarzenegger's campaign website says that as governor he would 'explore ways to lower the cost of Gray Davis' overpriced power purchase agreements'. It also calls for plans to stimulate private investment in power generation and reform the wholesale market. How much of the above translates into executive action is in the hands of the transition committee, made up of largely of local luminaries. Absent from the list are any energy executives, although Babcock & Brown, Mayer Brown Rowe & Maw and O'Melveny & Myers all have employees present.

Sean Randolph, head of the Bay Area Economic Forum, has been charged with putting together some energy policy proposals for the transition team. He says that "reserve margin requirements [a campaign promise] are an important part of energy policy, and long-term contracts are part of the mix." Nevertheless he does not rule out reworking the contracts, saying that "we're hearing from those in the industry that they're open to revisiting, and we don't think we've had as much mileage as we could have from them." He does stress, however, that any renegotiating process would not be oppositional.

The most likely point at which the new administration could look to renegotiate settled contracts is at novation, which requires a new contract to be written. It is this probability that causes the most worry to ratings agencies, since there is no room for wiggle in the contract monetisations. More likely is that the new administration will treat those contracts, such as Sempra Energy's, which have yet to be settled, as opportunities to gain credit as and when a settlement happens. In this, it would follow the arc of the previous governor's approach.

The California Public Utilities Commission (PUC) and the state's administration initially attempted to challenge the validity of the contracts, maintaining, as do most opponents, that they were signed while market manipulation had pushed up both spot and forward prices. All of the contracts thus far financed, however, have been the subject of a settlement between the state and the generators, and have been withdrawn from consideration by FERC.

This still leaves interested, and less interested, parties with the option of turning to the courts to dispute the contracts. Schwarzenegger's erstwhile opponent, Republican state senator Tom McClintock, filed suit against the CalISO, CDWR and governor, among others, saying that the manner in which the contracts were struck, and renegotiated, was so sufficiently secret that it acted against the interests of citizens and ratepayers. This suit was folded into a similar suit, Carboneau vs. State of California, and was rejected in early November. The plaintiffs are deciding whether to pursue the case in the US Supreme Court.

A second suit, against Vikram Budhraja, a SoCal Edison official hired by Gray Davis to work on the PPAs, alleged conflicts of interest when negotiating the contracts. This suit is set for a hearing in December. A number of smaller suits were dismissed on 28 August.

Opinion in the market is divided as to how much further financing activity there will be out of the state. As one participant put it, "those that might have wanted to monetise their contracts have already done so," although those yet to settle, or those forced to sell their contracts may yet use the structure. One portfolio with a CDWR contract that is yet to refinance is InterGen's Wildflower pair of peakers. Citigroup, Scotia, Fortis and Helaba provided the 225MW venture with $110 million in September 2002, and the contract in this case is supplemented by a toll with InterGen sister company Coral Power. The long-awaited bond refinancing is most likely the result of InterGen's focusing on restructuring its three combined cycle financings, due to be completed shortly.