The California Public Utilities Commission wrestled this week with how to treat on- and off-balance-sheet debt associated with power plants that investor-owned utilities build and their long-term power deals. A central issue is whether the commission decides to give the investor-owned utilities additional cash to compensate for the debt on their books. Secondly, the commission is grappling with how credit-rating agencies characterize utility debt?be it on or off the books?known as ?debt equivalence.? A regulatory decision on the issue will influence which sector builds power projects: investor-owned utilities and\/or merchant generators. How prominent a role debt equivalence?in essence making all debt equal?will play remains to be seen. ?Debt equivalence is of course an important issue, but I think it?s been overblown in terms of its importance,? Gary Ackerman, Western Power Trading Forum director, stated at a September 20 CPUC hearing. He added that the three major rating agencies look at the issue in different ways. ?S&P is the most analytical; Moody?s the most black-box . . . and Fitch somewhere in the middle.? Utilities want to lower their debt levels on the books and raise their equity ratios to keep their bondholders and preferred shareholders happy and their costs of borrowing down. Rating agencies, particularly S&P, however, have been taking a closer look. For them, utility debt?on and off book?is still a financial liability. ?We don?t think the right comparison is the debt-to-equity ratio,? said Swami Venkataraman, S&P?s director of corporate and government ratings. The rating agency looks beyond the characterization of the financial obligation and assigns it a present net value for rating purposes. As long as there are existing power-purchase agreements (PPAs), the agency will add debt to the books, according to Venkataraman. This PPA debt equivalent ?will be an important credit factor,? particularly as Department of Water Resources long-term contracts expire, which are then expected to be replaced with new deals, he said. A concern for lenders, which today are often the new owners of distressed generation assets, is the expiring DWR contracts, said Ed Feo, partner at Milbank Tweed, during a September 16-17 Law Seminars International conference. There were concerns about shifting the DWR deals, considered the ?gold standard,? back to the utilities, he added. For rating agencies, another market uncertainty looming over investor-owned utility ratings is the potential sunset of a provision in AB 57 that limits undercollections and requires full recovery of power costs on a ?timely basis.? If investor-owned utility power costs exceed 5 percent of the previous year?s revenue, then a rate increase is mandatory, according to a section of the law that is set to expire January 1, 2006.