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Rating Action:

MOODY'S ASSIGNS Baa3 RATING TO CAITHNESS COSO FUNDING CORP.'S (CAITHNESS COSO) PROPOSED ISSUE OF SENIOR SECURED BONDS AND ASSIGNS Ba2 RATING TO CAITHNESS COSO'S PROPOSED ISSUE OF SUBORDINATED SECURED NOTES; OUTLOOK STABLE

21 Jul 2005
MOODY'S ASSIGNS Baa3 RATING TO CAITHNESS COSO FUNDING CORP.'S (CAITHNESS COSO) PROPOSED ISSUE OF SENIOR SECURED BONDS AND ASSIGNS Ba2 RATING TO CAITHNESS COSO'S PROPOSED ISSUE OF SUBORDINATED SECURED NOTES; OUTLOOK STABLE

Approximately $465 Million of Debt Securities Affected

New York, July 21, 2005 -- Moody's Investors Service has assigned a Baa3 rating to approximately $375 million of senior secured bonds due 2019 and assigned a Ba2 rating to $90 million of subordinated secured notes due 2014 to be issued by Caithness Coso Funding Corp. (Caithness Coso). The rating outlook is stable.

Proceeds from the offering, along with cash on hand of around $31 million, will be used to repay approximately $208 million of existing Caithness Coso Series B 9.05% notes, rated Baa3; to pay about $27.5 million of accrued interest and the make-whole amount related to the existing Series B notes; to fund about $27 million in debt service and capital expenditure reserve accounts; to pay transaction costs of around $7 million and to make distributions of about $230 million to the owners.

The Caithness Coso Baa3 rating considers the following supportive factors:

1. A high degree of cash flow predictability, as contracted cash flows with Southern California Edison Company (SCE: Baa1 senior unsecured debt: stable outlook) provide the primary source of debt repayment through three separate power purchase agreements (PPA) that expire at varying times through 2019;

2. While two of the PPA's with SCE expire before the term of the bonds, contract extension risk is viewed as being low given the relatively large size of this existing geothermal resource, its successful operating history, its low operating costs, the must-take requirement for a Qualifying Facility (QF) under the Public Utility Regulatory Policies Act of 1978 (PURPA), and the importance of renewable resources to California's energy policy;

3. Coso Operating Company (COC), the operator, has a very strong track record in operating geothermal assets, as demonstrated by a capacity factor of 102.4% for the five year period ending 2004;

4. Extension of the US Navy I and US Navy II resource contract through 2034 lowers Caithness' cost structure, enhances the long-term value of the plants, and provides greater incentive for reinvestment of project cash flow back into the geothermal resource;

5. Historically, the Caithness Coso partnerships have demonstrated very predictable financial metrics. For each of the 12-month periods ending March 31, 2005, December 31, 2004 and December 31, 2003, revenues, operating income, and cash from operations were virtually unchanged at $153 million, $66 million and $76 million, respectively. Likewise, Caithness Coso's annual debt service coverage ratios (DSCR) for these three periods were in excess of 1.60x;

6. Prospectively, the Caithness Coso partnerships are expected to continue to demonstrate fairly robust and predictable DSCR. Under the project's base case assumptions, DSCR for senior debt is expected to average 2.41x, with a minimum DSCR of 1.55x, while the consolidated base case DSCR, which incorporates annual debt service on the subordinated notes, is expected to average 1.95x with a minimum of 1.27x. The minimum DSCR for both senior debt and subordinated debt occurs in 2006, when the potential for cash flow volatility will be low, since the project is scheduled to receive fixed energy payments of 5.37 cents/kwh.

7. Low operating costs, as the average all-in breakeven short run avoided cost (SRAC) rate needed to cover all costs, including the payment of debt service on senior and subordinated debt, is around 3.3 cents/kwh, which would be consistent with an average natural gas price that is below $2.50/MMbtu;

8. According to reports prepared by the independent geothermal engineer, the geothermal resource assets are expected to have a reserve life that is well in excess of the term of the financing. With effective stewardship of the resource and successful implementation of various capital programs, the reservoir engineer believes that the reserves should not experience a material decline over the period of the financing.

The supportive factors are balanced against the following risks:

1. The proposed transaction will result in a substantial increase in consolidated leverage. Total consolidated debt will increase by around $257 million, the bulk of which will be returned to the owners in the form of a dividend that may approximate $230 million and will result in negative shareholder's equity on a GAAP balance sheet basis at closing;

2. Single resource risk and reliance upon one off-taker, SCE as the source of revenue;

3. California regulatory decisions surrounding SRAC are likely to be highly contentious;

4. While operating and financial results have been stable in recent times, geothermal resources can experience greater year-over-year changes in electric output, operating expenses and in capital expenditures relative to other fuel sources;

5. The Caithness Coso partnerships' future revenues may exhibit greater revenue volatility after April 2007 when the energy compensation reverts to SRAC. This risk is significantly mitigated by Caithness' low operating costs and an expectation that natural gas prices will remain at levels that are well above the historic average.

The Baa3 Caithness Coso rating reflects the predictable source of cash flow expected to be generated from energy and capacity payments received under three PPAs that expire at varying times though 2019 with SCE, an investment grade rated California based load-serving utility. The rating also incorporates the strong operating history of these plants, as demonstrated by the plants' average capacity factor of 102.4% over the past five years and by the partnerships' stable financial performance over the past few years as annual revenues, operating income and cash from operations have been virtually unchanged since 2002. The rating considers the experience of the operator, COC, which has operated these plants since their inception in the 1980's and the experience of Caithness Energy, COC's parent, which obtained a controlling interest in these plants in 1999 and owns other geothermal plants.

The rating also reflects the importance of these existing geothermal assets to the California electric market, given the state's focus on renewable resources as a core component of their energy policy. The higher level of debt under the proposed financing is balanced against the benefits resulting from the recent signing of a new agreement between two of the Caithness Coso partnerships and the U.S. Navy, which extended the partnerships' exclusive right to the geothermal resources through October 31, 2034. This new agreement modestly lowers the Caithness Coso partnerships' operating costs, reduces uncertainties about future fuel supply, and provides the project with a long-term incentive to continue exploring and developing these geothermal resources and making the related capital investments.

The rating further considers the long-term favorable characteristics of these geothermal resources, which are expected to have a reserve life that is longer than the term of the financing, and have experienced a relatively flat reserve decline, due in part, to a combination of make-up drilling and improvements in surface facilities by COC. Caithness Coso's plans to spend about $11.4 million in capital expenditures during 2006 to build a system to supplement water injection from the Hay Ranch that is part of a planned strategy to maintain or increase reserve levels over an extended period of time.

The rating acknowledges the plants' very competitive operating cost profile relative to other generating resources within the region. Caithness Coso's variable costs of 1.4 cents/kwh are below all fossil-fuel options in the western US, including base load coal. This competitive position helps to mitigate future cash flow concerns for the period when changes to the energy payment are expected to occur. Under the current tariff arrangement with SCE, the utility pays the Caithness Coso partnerships a capacity payment and an energy payment of 5.37 cents/kWh. The energy payment arrangement expires at the end of April 2007. Thereafter, the Caithness Coso partnerships are expected to receive compensation for energy based upon SCE's short-run avoided costs (SRAC), an amount which is indexed to natural gas prices. While uncertainty exists concerning the outcome of SRAC compensation, the Caithness Coso partnerships' low operating costs, coupled with the expectation of relatively high natural gas prices, position the Caithness Coso partnership reasonably well to manage this risk. Break-even analyses under assumptions that otherwise reflect the project's base case conditions, indicate that the average SRAC energy price could decline to around 2.8 cents/kwh and the Caithness partnerships would have sufficient cash flow to service senior debt on a 1:1 basis.

Notwithstanding Caithness Coso's competitive position, Moody's expects the SRAC process to be contentious, with the utilities seeking to lower the compensation paid for energy under SRAC compensated contracts to the lowest possible level and the QFs seeking to have an energy price mechanism that minimizes any margin compression. An overriding theme that should benefit the QFs position is the importance of QFs assets to the overall resource supply mix in California, given the relatively tight regional supply and the challenges to building additional energy infrastructure in the state. However, Moody's believes that the compensation scheme that ultimately results from the SRAC negotiations is likely to compress over time as more efficient, lower heat rate generating units are brought on-line.

The Baa3 rating incorporates the substantially higher leverage that will exist at the Caithness Coso partnerships following the completion of this financing. In addition to increasing total debt by about $257 million, approximately $230 million of the net proceeds will be paid to the partners as a distribution at closing. As a result, the Caithness Coso partnerships' balance sheet is expected to show negative GAAP equity of approximately $7 million at closing.

The rating further incorporates the fact that two (Navy I partnership and Navy II partnership) of the three PPA's with SCE expire in 2010 and 2011, respectively, well before the maturity date of the senior bonds. This re-contracting risk is considered to be low given the importance of this existing, dependable, and low-cost renewable resource, the California PUC requirement that renewable resources represent 20% of a utility's generation resources by 2017, and the plants' status as a QF, which under PURPA, requires SCE to take output from the Navy I and Navy II partnerships at the utility's SRAC after the respective PPA expires. Moreover, the debt and the amortization schedule have been sized to try to address this risk, as the debt allocated to the Navy I and Navy partnerships fully amortizes during the term of their PPAs expiring in 2010 and 2011, respectively, resulting in the majority of the debt being allocated to the BLM partnership, which has a PPA expiry date of 2019.

While recent financial results have been stable, the rating also considers the potential for greater year-over-year volatility in financial results when operating a geothermal resource as compared to other fuel sources, particularly natural gas-fired generation. Given the possibility of year-over-year shifts in operating expenses, the ongoing need to fund capital expenditures, the ability to incur additional debt, and the uncertainty around future SRAC revenues, the projected DSCR for the Caithness Coso partnerships are appropriately stronger than most other investment grade power projects. The base case DSCR for senior debt is expected to average 2.41x, with a minimum DSCR of 1.55x, while the consolidated base case DSCR, which incorporates annual debt service on the subordinated notes, is expected to average 1.95x with a minimum of 1.27x. The minimum DSCR for both senior debt and subordinated occurs in 2006, when cash flow volatility is expected to be lowest as the project receives fixed energy payments of 5.37 cents/kwh from SCE. While the projected senior DSCR is substantially higher than is typically expected in contracted power projects, the rating contemplates the flexibility afforded to Caithness Coso through the financing documents, which allows for the incurrence of additional senior secured bonds and additional senior subordinated notes should the PPAs with the Navy I partnership and Navy II partnership be extended. Under the terms of the indentures, additional senior secured bonds and additional senior subordinated notes can be incurred if the rating is affirmed by two rating agencies, or if the minimum projected senior DSCR and consolidated DSCR for each fiscal year, after taking into account the incremental debt, is equal to or greater than 1.65x and 1.30x, respectively, based upon contractual cash flows.

Caithness Coso, which is the issuer of the proposed bonds and notes is a funding company without direct ownership of the physical assets. However, each of the three partnerships, Coso Finance Partnership (Navy I Partnership), Coso Energy Developers (BLM Partnership), and Coso Power Developers (Navy II Partnership), will provide unconditional upstream guarantees of the debt at Caithness Coso on a joint and several basis. Caithness Coso's senior debt will be secured by a first lien on all of its assets and its contracts, including the three off-take PPAs with SCE. The transaction will feature a waterfall structure for payment obligations, will require the ongoing funding of a 12-month capital expenditure reserve, and will have a six-month debt service reserve for the senior secured notes. The debt service reserve will initially be provided by the project in the form of a letter of credit available under a senior secured five year letter of credit facility. Interest payments for draws under the letter of credit reimbursement agreement will be paid on par with senior debt service while principal payments of the letter of credit reimbursement agreement will be paid after payment of senior debt service in the waterfall.

The Ba2 rating for the senior subordinated notes incorporates the depth of subordination of this debt relative to the senior debt. While holders of the subordinated debt will have a second lien interest in the collateral pledged to the senior debt, holders of the subordinated notes lack rights to take action against Caithness Coso or its partnerships if an event of default were to occur on the subordinated notes, so long as there is any senior debt outstanding. The Ba2 rating further considers the competitiveness of the Caithness parternships assets as the average all-in breakeven SRAC price needed to cover all costs, including the payment of debt service on senior and subordinated debt, is around 3.3 cents/kwh which equates to an average natural gas price that is below $2.50/MMbtu. The principal on the subordinated notes will amortize over a nine year period with final payment due in 2014, and the payment of interest and principal on the secured subordinated notes is subject to a 1.30x senior DSCR restricted payments test. Subordinated noteholders benefit from a separate six month cash funded debt service reserve, which provides some protection in the event that cash is trapped at the senior debt level.

The rating outlook is stable and incorporates the expectation of a stable operating and financial performance due to COC's history of being able to effectively manage costs at this geothermal resource, the existence of a predictable capacity payment through the life of the PPAs and a fixed energy payment through April 2007, and the belief that the Caithness Coso partnerships' exposure to SRAC risk is modest given the low operating costs and the expectation for continued high natural gas prices, a key determinant of the SRAC price. Limited upside rating potential exists in the near-term given the single asset nature of this project financing, the reliance on one source for all of Caithness Coso's revenue stream, the expectation that the project's DSCR for senior debt will remain in the 1.60x range in the near-term, and the ability of the borrower to incur additional indebtedness under both indentures. The rating could be downgraded should there be a significant deterioration in the operating performance of the three Caithness Coso partnerships or a substantial change in the credit quality at SCE, which is the sole source of cash flow for the project.

The ratings are predicated upon review of final documentation and debt sizing to meet projected debt service coverage ratios.

Caithness Coso is a special purpose corporation and a wholly owned subsidiary of the Caithness Coso partnerships: Coso Finance Partners, Coso Energy Developers, and Coso Power Developers. Caithness Coso was formed for the purpose of issuing the senior secured notes on behalf of the Coso partnerships who have jointly, severally, and unconditionally guaranteed repayment of the senior secured notes. The Coso partnerships and their affiliates own the exclusive right to explore, develop, and use a portion of the Coso Known Geothermal Resource Area in California.

Caithness Coso and the Caithness Coso partnerships are majority owned by Caithness Energy, a project developer and sponsor with ownership interest of approximately 2,500 MW of gross generating capacity in geothermal, solar, wind, and natural gas. Privately held, Caithness Energy is majority owned by Caithness Equities, which is headquartered in New York City.

New York
Daniel Gates
Managing Director
Corporate Finance Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

New York
A.J. Sabatelle
VP - Senior Credit Officer
Corporate Finance Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

No Related Data.
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