Legal challenges to California?s deficit financing instruments threaten to blow away the bipartisan budget deal struck less than two months ago and to force deep midyear cuts and tax increases. As a result, energy agencies may suffer further operational cuts. However, energy programs and projects financed through revenue bonds and dedicated revenue streams are unlikely to be affected, according to attorneys involved in the litigation. At issue are two suits challenging the constitutionality of about $13 billion worth of bonds that the state plans to issue under the 2003-04 budget passed by the legislature in August. These include $2 billion in bonds to fund the state employees? pension fund and almost $11 billion worth of ?deficit financing bonds? to roll over short-term borrowing to fund state operations through the final months of the 2002-03 budget year when California?s budget crisis exploded. ?There is no contingency plan in place,? said Anita Gore, assistant director of the California Department of Finance. ?If we lose the litigation we?re back to square one with the budget. We?ll have to consider taxes and cuts.? State energy agencies?such as the California Public Utilities Commission and the California Energy Commission?likely would share the pain, state officials say, with potentially significant cuts in their budgets. ?It?s pretty much unprecedented to go to the bond market to pay for operations,? as this budget fix has, said Harold Johnson, attorney for the Pacific Legal Foundation, which challenged the constitutionality of the ?deficit finance bonds? in Sacramento Superior Court. ?The state constitution has an exceeding bias in favor of balanced budgets.? The conservative legal action group contends that the state constitution prohibits bonded indebtedness for operations, particularly when the debt is to be paid off with general fund revenues. Moreover, Johnson noted that bond issues are to be approved by the voters. A decision on the lawsuit is expected by year-end, and?regardless of the outcome?will be appealed to the state supreme court under an expedited review procedure outlined in the budget itself. The foundation, however, is not challenging the ability of the state to issue revenue bonds for energy infrastructure, conservation programs, renewable resources, or other infrastructure projects paid off by dedicated revenue streams, according to Johnson. State officials concur that the litigation will not affect revenue bonds or the rating of those bonds. Moreover, it will not affect bonds outstanding, such as those floated to pay for electricity purchases during the height of the power crisis. However, should the suit succeed, it will cloud the ability of the state to pay off some $11 billion in short-term debt incurred in the final quarter of fiscal 2002-03 to keep state offices open in the midst of a cash-flow crunch. That debt is due in the final quarter of the current fiscal year. ?In April, we said we don?t have enough cash to operate through the fiscal year,? said Rick Chivaro, chief counsel for the Controller?s Office. To generate cash, the office issued revenue anticipation warrants, a type of financial instrument that allows the state to borrow money on a short-term basis in one fiscal year and pay it back in the next. ?There has been an improvement in receipts, but not enough to meet the level of expenditures approved by the legislature,? said Chivaro. ?A loss [of the lawsuit] would put us back to January of 2003 when the legislature faced a $20 billion hole.? Other bonds should remain unscathed. For instance, the California Power Authority plans to issue $280 million in bonds to finance construction of 300 MW of peak generating units near San Francisco, according to authority spokesperson Linda Chou. The state will own and operate the units and pay off the bonds with the proceeds from the sale of power, mostly to Pacific Gas & Electric under an expected purchase agreement. In addition, Chou said, the authority may issue bonds totaling ?several hundred million dollars? to provide a loan to Calpine to complete construction of its 510 MW Otay Mesa plant just south of San Diego near the Mexican border. Agency budgets are at the whim of the new governor, who controls the Department of Finance, and when governor-elect Arnold Schwarzenegger takes office he will face an immediate $8 billion projected deficit. In addition, unless the state wins an appeal of a recent decision by a state trial court that prevents issuance of $2 billion in pension bonds, the shortfall will reach $10 billion. Repeal of the vehicle license fee will add another $4 billion to the shortfall, and if the state loses the $11 billion deficit financing bond case, the total shortfall could reach as high as $25 billion, according to Chivaro. This would equal a whopping 35 percent of the current year?s $71 billion in budgeted general fund expenditures.