Rooted in the US Constitution, the power of eminent domain is being invoked by cities and towns in attempts to ?municipalise? private utilities. It is a small but growing source of lending business for US bankers.

Eminent domain allows government agencies ? with the blessing of the US court system ? to condemn and appropriate private property for public use as long as ?just compensation? is paid.

Paul Neuehedel, director in Fitch's utilities group, says, much of the interest in municipalisation is driven by politics. ?When a public official looks at a neighbouring city or state and notices that rates are significantly lower, it makes sense to ask why this is the case.? With deregulation spreading and theoretical benefits being touted, more cities will look to municipalisation as a panacea. But for every 25 possible municipalisations, only one is potentially viable.?

Literally hundreds of US cities and towns have begun exploring options as long-term electrical power franchises wind down or high power prices coupled with deteriorating service force politicians to seek drastic remedies. A key attribute of eminent domain is that the government can exercise its power of eminent domain even if the owner does not wish to sell the property.

Most municipalisation attempts in advanced stages include smaller cities. However, efforts also are underway in Laguna, California and Wichita, Kansas. Attempts to municipalise in San Francisco and Davis, California, recently were rejected although those efforts demonstrated strong local support. And Las Cruces, New Mexico, just reached agreement with El Paso Electric after protracted threats to municipalise. Larger cities will continue exploring the tactic, particularly as utility costs are expected to rise, reflecting higher fuel costs.

A New York banker notes that the small size of many potential deals is not a deterrent for banks looking to get in on the bottom rung of a trend. ?However, a first time issuer probably would not jump out at you as a stellar credit.?

The City of Hermiston, Oregon, is battling with Pacific Power, a unit of global energy supplier Scottish Power, in a classic David vs Goliath scenario. In late June 1999, Pacific Power rejected a $3.2 million offer by Hermiston to buy out its local system. Hermiston officials had expected the utility to turn down its offer. The city is now in the process of initiating condemnation proceedings against the utility. Pacific Power has been down this path before, fighting off condemnation efforts in Alturas, California, and Eugene, Oregon. Unsuccessfully taking on the utility in Alturas proved costly, with the local government spending millions of taxpayer dollars.

The genesis of the issue goes back about two years when ? anticipating deregulation ? the city asked Pacific Power and Umatilla Electric to bid for the city system. Absent a specific rate and service plan from Pacific Power, voters gave Umatilla the nod. However, Umatilla's mandate was challenged by Pacific Power before the state Public Utilities Commission (PUC). The complaint filed by Pacific Power charges that condemnation is an attempt to circumvent a 1963 state territorial allocation law, which assigns specific service areas to all electric utilities operating in the state. That law states that the allocation can only be transferred or reassigned if the PUC determines that the original assignment does not serve the public interest.

A petition by the City of Alma, Michigan, to the Federal Energy Regulatory Commission is testing arguments by Consumers Power Co. (CPCo). In its petition, the city challenged the utility's claim for recovery of $56.1 million in stranded costs over 30 years from utility customers in Alma, if Alma develops a municipal electric system that competes head-to-head with CPCo. Alma officials are awaiting for FERC to determine whether CPCo, under certain indisputable facts, has or will have any unrecoverable fixed costs as a result of the gradual departure of individual customers from CPCo to a competitive municipal electric system.

If FERC looks to a March 1999 NY Supreme Court decision for guidance, the City of Alma may be displeased. The court rejected a challenge by the Alliance for Municipal Power (AMP) to the New York Public Service Commission (PSC) against electrical power provider Niagara Mohawk. AMP unsuccessfully tried to persuade the court to overturn the PSC's decision to establish an exit fee applicable to new municipal utilities formed to serve customers in Niagara Mohawk's service territory. Exit fees are a mechanism for recovering stranded costs from customers who depart the electric system, such as new municipal power companies.

Earlier this year, Pittsburgh-based Strategic Energy LLC (SEL) completed a preliminary economic feasibility study outlining options for the Florida City of Dunedin and the Town of Belleair to develop a municipal electric system. SEL estimates that Belleair would save 12.4% and Dunedin would save 12.8% from their respective 1998 rates which were paid to Florida Power Corporation (FPC), if they formed a municipal electric system. This equates to savings of approximately $552,000 for Belleair and $3,578,000 for Dunedin. SEL estimates do not include stranded costs charges, which could be assessed by the Federal Energy Regulatory Commission (FERC).

Steve Speicher, consultant at SEC, says: ?We advised that municipalisation might be feasible and that they shouldn't necessarily abandon the idea. The utility has a limited length on its franchise, which is coming to an end. So the town has to decide how to proceed.? Dunedin's franchise expires January 2002 while Belleair's expires December 2001. No decision has been made on whether to proceed with municipalisation.

The city council in Lakewood, Washington, recently voted to rescind a planned September vote on whether to attempt a municipal takeover ? so-called ?municipalisation? ? of Puget Sound Energy's (PSE) Lakewood electric system. PSE is one of three power companies in the area and serves some nine thousand homes and businesses in Lakewood. The other two suppliers are Tacoma Public Utilities and Lakewood Light & Power. Representatives of the city and the utility agreed to work cooperatively to improve utility service. Deborah Penn, an attorney with the American Public Power Association, says, ?Sometimes after analysing the costs of municipalisation, the issue is dropped.? However, she added that there have been instances in which the incumbent utility has spent more defending its position in the market than the company's book value.

Tami Davis, a spokeperson for the City of Lakewood, says: ?The takeover has been set aside for the time being. If the utility is not willing to deal with rates that are 30% in excess of the competition, I think the threat of takeover is still there.? Davis says the possibility of moves by the city against PSE are more than sabre-rattling.

Bob Bellemare, vice-president at New Mexico-based Reddy Corporation International, an engineering consulting firm which advised the city in its battle with PSE, says condemnation and purchase of the utility would have cost the city between $42 million and $60 million. The city initially estimated the condemnation and acquisition to cost $4 million but later raised the estimate to $5 million and then $8 million. Still, the high estimate did not take into account millions of additional dollars in legal and consulting fees nor did it include the cost of reconfiguring the power system.

?Utility takeovers don't have a good track record. The last successful hostile condemnation was in 1982 in Massena, NY, and the process involved a six or seven year battle.? The process resulted in creation of the Massena Electric Department (MED), a municipal consumer-owned utility.

Bellemare says the company has been involved in 18 such actions, usually on the side of the investor-owned utility.

Creation of the Long Island Power Authority (LIPA) began acrimoniously under one political regime and was resolved somewhat amicably under another governorship. LIPA was created by legislation in 1986 to resolve the controversy over the Shoreham Nuclear Power Plant and to seek lower utility rates on Long Island. LIPA was authorised under its enabling statute to acquire all or any part of the securities or assets of the Long Island Lighting Company (LILCO) on a negotiated or unilateral basis and to issue lower cost, tax-exempt debt to finance such acquisition. LILCO had among the highest utility rates in the US. Prior to any such acquisition, LIPA was required to determine that the rates for a reasonable period of time after the acquisition would be no higher than the rates would have been if LILCO's securities or assets had not been acquired. LIPA is authorised to fix its own rates and charges for utility services. The takeover was financed with $11 billion of revenue bond debt, the highest level of revenue bond debt of any municipal utility in the US. The acquisition was completed in May 1998.

LIPA's acquisition of LILCO resulted in immediate rate reductions of 20.9 percent in Nassau County and the Rockaways and 19.1 percent for Suffolk County. Residents of Nassau County and the Rockaways also received a one-time check of $232 soon after the completion of the acquisition and Suffolk County residents received a check for $101.

It's difficult to use the LIPA as a model. Fitch Vice President Steven Fetter says, ?LIPA is not only the largest utility deal financed through revenue bonds. It is the largest municipal bond issuance ? period.?

Bellemare says that a city could finance a takeover by imposing a surcharge on utility bills and securitising the future flows. However, revenues from those bonds generally is taxable, which could impact demand. And smaller cities may be hamstrung by inability to issue sufficient debt to bankroll a takeover. ?Consultants eager for business may suggest that a municipality invoke the principle of eminent domain to acquire a utility. But this is time-consuming and complex process.?

Other major hurdle to municipalisation is assumption of stranded costs and valuation, according to Bruce Fabrikant, vice-president and senior credit officer for asset-backed securities at Moody's. ?The municipality wants to acquire distribution systems based on depreciated asset value. Utilities want valuation based on replacement cost.? Moody's Analyst Dan Aschenbach says, ?Municipalities are particularly interested in municipalisation as volatility in the marketplace has tightened.? Aschenbach added that there is often distrust of utilities which have exerted a monopolistic presence in some markets for decades.

Short of going full-way with condemnation proceedings, state governments in about half of US states have allowed local governments the right to represent consumers in the power market through ?municipal aggregation?. The most prevalent form is ?opt out? aggregation, in which consumers automatically are enrolled into a programme by the municipality unless they elect to buy electricity from another source. It is not necessary for the municipality, acting as aggregator, to own physical facilities, such as distribution, generation or transmission assets. A municipal aggregator either can act as buying agent, functioning as a broker, or as a reseller, purchasing power at wholesale and selling at retail. Users of aggregated power benefit from economies of scale. Opponents of municipal aggregation see a conflict between allowing users a choice of suppliers and legislating the means for governments to represent users.

In mid-August, the Massachusetts Department of Telecommunications and Energy approved the first municipal aggregation in the US. Towns on Cape Cod and Martha's Vineyard have established a power pool that can buy electricity for all consumers in the 21 towns that make up two counties. Towns in Ohio and New Jersey are says to be creating similar power pools although similar efforts failed in Palm Springs, California. The power pool has contracted with Connecticut-based Select Energy. While savings to individual residential consumers will be a pittance ? about $5 per year ? savings of tens of thousands of dollars will accrue to local governments and larger business users. The state agency currently is studying two other proposals for power pools in Massachusetts.

Select Energy has the option of deferring the December 1 start of its contract, pending improvements in market conditions. However, the power supplier is required to release its proposed schedule by August 23. Given power shortages and escalating fuel prices, Select Energy may delay inception of its contract until officials can get a better assessment of where the market is headed ? at least over the short term.