Fitch Rts California DWR $1B Power Bonds ‘A+’; Upgrades $10.1B Outstanding to ‘A+’; Outlook Positive

Fitch assigns California Department of Water Resources’ (DWR) up to $1.025 billion, series 2008H power supply revenue bonds a rating of ‘A+’. Fitch also upgrades the underlying rating of DWR’s $10.05 billion outstanding power supply revenue bonds to ‘A+’ from ‘A’. The Rating Outlook remains Positive.

The bonds are all secured by DWR’s bond charge revenues imposed by the California Public Utilities Commission (CPUC) on all customers served by the three investor-owned utilities (IOUs) in California: Pacific Gas & Electric Company (PG&E, IDR of ‘BBB+’); San Diego Gas & Electric Company (SDG&E, IDR of ‘A+’); and the Southern California Edison Company (SCE, IDR of ‘A-’). The bonds are separately secured from any other obligations of DWR. The bonds are not obligations of the State of California (the state).

Proceeds from the fixed rate series 2008H bonds will refund certain outstanding auction rate and variable rate demand bonds (from the series 2002 and 2005 power supply bonds), that were wrapped with bond insurance from an insurer whose credit rating has been downgraded. The bond insurers’ downgrades have affected overall market demand for auction rate securities and insured floaters, and have resulted in increased interest rate exposure for municipal issuers, like DWR.

The upgrade and Positive Outlook stem from a combination of improved credit factors realized by DWR directly, as well as improving California energy market factors over the past few years. Primary drivers for the upgrade, include the following:

–Continued timely processing of DWR’s base and supplemental revenue requirements by the CPUC;

–Solid operating and debt service reserves;

–Resolution of most legal challenges to the power purchase program;

– DWR’s power supply annual cost, subject to generally greater variability than the bond charges, notably decline in 2008 and thereafter;

–Strengthened ratings for the IOUs in California since our last rating change for DWR in 2005;

– DWR’s average cost of power, at about 8 cents/kwh, is now in-line, rather than above, the market clearing price of electricity in the state (assuming $8/MMBtu natural gas price); and

–DWR is a closed power system – no longer required to enter into additional power contracts.

To attain a higher rating, DWR will need continued timely and adequate approvals of its revenue requirements by the CPUC, effective management of DWR’s significant variable rate exposure during this period of turmoil in the municipal auction rate/insured floaters’ markets, and continued maintenance of solid operating reserves. Additionally, Fitch will be monitoring the California Independent System Operator’s implementation of the Market Redesign and Technology Update (MRTU), likely in the third quarter of 2008, as it could affect DWR’s revenues from surplus offsystem sales. The MRTU does not affect DWR’s bond charges.

Other credit factors that underpin DWR’s rating include irrevocability and enforceability of the bond charges, the ability of the IOUs to service the power and bond charges, and the relative economic strength of the service territory (California GO rating at ‘A+’). Fitch’s analysis further incorporated stress case scenarios that include significant increases in natural gas costs and a spike in variable interest rates. Under these stress cases, current operating reserves remained adequate, further supporting the upgrade.

Ongoing credit concerns include risks to transaction cash flows associated with the volatility of power and fuel prices in the state, variances from expected demand for electricity, and the potential delays both in DWR arriving at the revenue requirement and/or the CPUC adopting customer rates. Additionally, approximately 67% of the bonds are in variable-rate modes; but after hedging, the ratio drops to a lower 25% of total debt.

The state entered the electric power business in January 2001 when soaring energy prices outpaced the capped rates charged by the IOUs, rendering PG&E and SCE uncreditworthy and compromising the ability of all three IOUs to deliver power. DWR began selling power to IOU retail customers at that time with power purchases from wholesale suppliers under long-term contracts through 2013. DWR’s power is delivered to customers through the transmission and distribution systems of the IOUs, and payments from the customers are collected for DWR by the IOUs, pursuant to servicing arrangements ordered by the CPUC. DWR initially financed its power purchases with advances from the state’s general fund and loans from financial institutions. The advances and loans were repaid from the proceeds of the DWR’s $11.3 billion power revenue bonds issued in October and November 2002.

Fitch’s rating definitions and the terms of use of such ratings are available on the agency’s public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch’s code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the ‘Code of Conduct’ section of this site.