Calpine Corporation's metamorphosis from cheerleader of flexible finance to contractually-bound workout subject would be cheering to those project bankers it dismissed on the way up. However, few of these naysayers are now in work, and Calpine, like NRG before it, has turned to an investment bank for rescue finance. And it has used the contract monetisation template, developed by El Paso, to raise the cash.

Contract monetisation involves the raising of money against the margin between a high-priced utility contract and that between a merchant generator and a special purpose vehicle formed issue debt. The earliest example, El Paso's first Cedar Brakes deal, used a contract between PSE&G and the Cedar Brakes vehicle, and between El Paso and Cedar Brakes, and even included a rebate to the offtaker to compensate for the change in supplier.

The deal, led by Credit Suisse First Boston in September 2000, and was followed up with a larger issue in December 2001. Both deals allowed El Paso to source its power to honour power purchase agreements (PPAs) where it saw fit. As such it was hailed as a useful tool to enable merchant suppliers to realise the value of contracted plants and replace an asset-based credit with a corporate one.

The second deal closed in the aftermath of Enron's implosion, and priced wide. El Paso attempted a third deal, Utility Contract Funding (UCF), in June 2002. By this time, however, the original template, whose credit rested to a large degree on the blended qualities of the supplier and offtaker, was not sufficiently robust. El Paso brought in Morgan Stanley to bolster the credit by acting as intermediary, supplying the power to the UCF vehicle under a mirror PPA.

Morgan Stanley is now attempting to adapt the template to Calpines needs. The offtaker? The California Department of Water Resources (CDWR). The CDWR, charged by the California legislature with acting as proxy offtaker for the state's troubled utilities, was the short-term fix to the state's power crisis. A political creation, its moves have been questioned by critics in the state since its inception.

Neverthelesss, the CDWR has a rating, since an issue of $11.9 billion, led by JP Morgan, gained a BBB+ from Standard & Poor's, while Fitch has it at A-. The CDWR's bonds are paid after power producers (including PCF) and it has made its own spot purchases. A major factor in the rating was the potential for litigation ? the department has 10 million customers, but a number of them are very litigious.

Calpine signed four contracts with the department in the aftermath of the power crisis, and restated them in April 2002. Two are agreements for the purchase of 1000MW of baseload capacity, 24 hours a day at a fixed price, with a further two are related to peaking capacity. The contract monetised here is the first, and has a price of $58.60 per MWh. This contract runs till 2008, although Calpine only provides 600MW until 2004. Calpine has said that it expects to earn $3.7 billion under this contract.

The mirror power purchase agreement with Morgan Stanley is even more telling ? it assumes that Morgan Stanley can supply at $38.50. This will provide ammunition to critics of the CDWR contracts, who argued that the department had massively overpaid. Morgan Stanley Capital Group will source some of its power from Calpine (its own risk management would prevent it buying the lot), and the rest from elsewhere in its substantial book. PCF also benefits from a $12.50/kWmonth payment for making 400MW capacity available to the department.

The $87 million per year in profit is used by Power Contract Financing, a wholly-owned but independently directed subsidiary of Calpine Energy Services to service its $802 million issue. The bonds, underwritten by Morgan Stanley, are split into two tranches ? $340 million of 2006 notes, which priced at 5.2%, and a $462 million 2010 issue with a 6.256% coupon. The pricing is impressive, given the performance of the Cedar Brakes bonds, although the bond market has been extremely lenient in recent months, especially for energy deals.

The coverages are tight, but are based on two theoretically watertight contracts ? the Morgan Stanley Capital Group agreement, which carries an A+ parental guarantee, and the DWR agreement. The second is probably still the greatest cause for concern. Many power bankers are still wary of lending to Californian deals because political risk is too high.

In this instance, Governor Gray Davis is fighting for his political life, facing a recall from voters, and likely to take a strongly consumer-friendly stance over energy issues. While the power crisis has faded into the background a little, or been forced into the background by the state's worsening economic and fiscal situation. Davis has already put a request to the California Public Utilities Commission for a $1 billion rate decrease. S&P promptly put the CDWR bonds on CreditWatch.

S&P gave the deal a BBB rating, while Moody's gave it a Baa2 rating. Fitch did not assign a rating. One key concern for the agencies will have been the possibility, that CDWR, as it has stated, will assign the contract to another entity rated BBB/Baa2 or higher. This counterparty would most probably be a recovered Southern California Edison or Pacific Gas & Electric, although any recovery would be some way off.

Moreover, since the power must always be running, there is very little wriggle room in the contract for unforeseen outages ? in which case bondholders do not get paid. A six-month debt service reserve account mitigates some of this risk, since outages should not be that long, and Capital Group will be able to source its power from anywhere inside the WECC.

Calpine is not the only producer with a CDWR contract that is in financial difficulties, although it is the one with the most obvious roots and presence in the state. Ratings agencies have certainly be fielding inquiries, and other investment banks with trading operations may be tempted to follow suit. Given California's peculiarities, they may take their time in following suit.

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Status: Priced June 12 2003

Size: $802 million

Description: Monetisation of a contract between the CDWR and Calpine

Sponsor: Calpine

Bookrunner: Morgan Stanley

Maturity: $340 million is due 2006, $462 million due 2010

Coupon: 5.2% and 6.256%, respectively

Lawyers to the borrower: Covington & Burling, Thelen Reid & Priest

Lawyers to the underwriter: Skadden Arps Slate Meagher & Flom, Latham

Lawyers to MSCG: McDermott Will & Emery

Market consultant: Pace Global