Adobe Photoshop is a professional image editing software. It can be used to manipulate real-life photographs, draw and design textures, setup background and artwork and much more. It's an extremely useful tool for working with game graphics. Photoshop is available for both Windows and Macintosh.
Adobe Photoshop CS for Windows was used during Penumbra's development but has since been deprecated due to it's old release (2003).
There are of course alternatives to Photoshop, for example GIMP (multiplatform) and Paint.NET (Windows only).
If you're an archivist like me, then you might have a legitimate copy of Photoshop laying around as well - modern versions of Photoshop might work, but for documentation purposes I will be using Adobe Photoshop CS (2003).
First off, you gotta install the Nvidia Photoshop tools from the official Nvidia website.
Here you can choose a variety of settings that'll make your texture stand out more and look good, I will be saving the bump map for this texture as a 32 bit Targa since the alpha channel can be used later on. You can also preview your texture by clicking the little 3D Preview button. (Pretty cool huh?)
You can read a more detailed explanation on how these things work here, this was just a brief tutorial on how to use Photoshop with the HPL1 engine.
The material file (.mat) is an XML file that contains information on what images is used in the material to create the texture and other properties. Unlike it's successors, the HPL1 engine does NOT generate material files automatically. Instead you will have to create them manually by using the HplHelper program.
You can download the tools here if you haven't already.