Are PCG & EIX Still Hot Stocks? We Assess the Risk of Repeated Catastrophic Wildfires & Its Implications for Valuation; Maintain PCG & EIX on Our List of Preferred Utilities

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Eric Selmon Hugh Wynne

Office: +1-646-843-7200 Office: +1-917-999-8556

Email: eselmon@ssrllc.com Email: hwynne@ssrllc.com

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

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December 3, 2018

Are PCG & EIX Still Hot Stocks?

We Assess the Risk of Repeated Catastrophic Wildfires & Its Implications for Valuation;

Maintain PCG & EIX on Our List of Preferred Utilities

The damage caused by California’s 2017-2018 wildfires dwarfs the revenues of the state’s electric utilities and property and casualty insurers, and are substantial even compared to the fiscal revenues of the state. Based on data from the California Department of Insurance, we estimate that the property and other damage caused by the fires exceeds the combined annual electricity revenues of all the utilities in California, both private and municipal. The property damage alone is equivalent to 3.0x the total residential insurance premiums collected annually in California. Even the state of California would be challenged to absorb the risk of recurring fires of this magnitude; our estimate of the property and other damage caused by the fires is equivalent to a third of the state’s annual tax receipts.

Of California’s utilities, PCG faces the highest risk of the devastating wildfires. California’s high fire risk areas are concentrated in PCG’s service territory; PCG serves many more communities in high fire risk areas that its southern peers; and it reports by far the most incidents of fire. The financial risk to PCG is massive: even if we allow for insurance recoveries, the tax deductibility of losses and the possibility that third party liability claims may be settled by the utility at a significant discount to their face value, we estimate that the cost to PCG of the 2017-2018 wildfires could, in a worst case, be equivalent to 80% of its electric rate base and almost twice its annual electricity revenues.

In our view, these facts have several important implications for investors. First, if PCG is liable for all the damage claims arising from the 2017-2018 northern California wildfires, the full recovery of these losses from ratepayers may be politically infeasible, especially if fires of similar magnitude recur in future years. Second, even the state of California lacks the fiscal resources to absorb repeated losses on the scale of those caused by the wildfires of 2017-2018. Third, as a consequence, California’s state and municipal governments, public utilities, insurance companies and residents will be compelled to take a range of actions to materially reduce wildfire risk, well beyond the steps initiated in the wildfire legislation signed into law in September (Senate Bill 901). In addition to improving the management of the state’s privately and publicly owned forest land, other necessary measures include imposing, and enforcing, stricter building codes and standards for the clearance of vegetation in residential areas, hardening or undergrounding utility distribution networks in fire prone areas, and requiring more conservative underwriting of property and casualty risk in these regions. Fourth, while we expect concerted public and private action to significantly reduce wildfire risk over the next decade, in the interim the shareholders of the state’s utilities, and particularly PCG, remain at risk that future catastrophic fires could erase the market value of their investments. Finally, because extensive investment in grid upgrades is critical to curtailing the risk of wildfires in northern California, we believe the state will be forced to sustain PCG’s financial health by mitigating its wildfire losses until this risk is contained.

In this research report, we analyze the differentiated impact of wildfire risk on EIX and PCG, and assess how it should be reflected in the valuation of their stocks. We conclude that EIX and PCG both remain attractive long term investments, although PCG entails much higher volatility and significant downside risk.

Portfolio Manager’s Summary

  • The damage caused by California’s 2017-2018 wildfires dwarfs the revenues of the state’s electric utilities and property and casualty insurers, and are substantial even compared to the fiscal revenues of the state (see Exhibit 2).
  • Our estimate of the property and other damage caused by the fires exceeds the combined annual electricity revenues of all the utilities in California, both private and municipal.
  • The property damage alone is equivalent to 3.0x the total residential insurance premiums collected annually in the state.
  • Our estimate of the property and other damage caused by the fires is equivalent to a third of the state’s annual tax receipts.
  • The risk of devastating wildfires is disproportionately born by PCG, which serves many more communities in high fire risk areas than its southern peers (see Exhibits 3-5).
  • Even allowing for insurance recoveries, the tax deductibility of losses and the possibility that third party liability claims may be settled by the utility at a significant discount to their face value, we estimate that the cost to PCG of the 2017-2018 wildfires could, in a worst case, be equivalent to 80% of its electric rate base and almost twice its annual electricity revenues.
  • If PCG is liable for all the losses claimed, the full recovery of these losses from PCG’s ratepayers may be politically infeasible, especially if fires of similar magnitude recur in future years.
  • The recovery from ratepayers of PCG’s $26.5 billion of net wildfire losses would require each its 5.5 million customers to pay, on average, $4,800 to the utility – twice the average annual customer bill.
  • If all of PCG’s potential 2017-2018 wildfire losses were to be securitized, and recovered over 15 years at a 4.0% interest rate, the debt service cost, assuming mortgage style amortization, would increase the utility’s average rates and customer bills by some 17%.
  • Given our view that it is politically infeasible to recover the cost of recurrent catastrophic wildfires from ratepayers or taxpayers, we believe that California’s state and municipal governments, utilities and insurers will be compelled to implement a range of policy actions to materially curtail the number and extent of future wildfires, well beyond the steps initiated in the wildfire legislation signed into law in September (Senate Bill 901).
  • In addition to improving the management of the state’s privately and publicly owned forest land, other necessary measures include imposing, and enforcing, stricter building codes and standards for the clearance of vegetation in residential areas, hardening or undergrounding utility distribution networks in fire prone areas and tightening insurance underwriting standards.
  • Because extensive investment in grid upgrades is critical to curtailing the risk of wildfires in northern California, we believe the state will be forced to sustain PCG’s financial health by mitigating its wildfire losses until this risk is contained.
  • While concerted action on all these fronts could significantly reduce wildfire risk over the next decade, in the interim the shareholders of the state’s utilities, and particularly PCG, must continue to shoulder significant wildfire risk. Recognizing this, our valuation model (set out on pages 13-15) estimates:
  • The potential losses faced by each utility as a result of the 2017-2018 wildfires, as well as any material offsets to those losses (see Exhibit 6 and Appendix 1); and
  • The level and frequency of future wildfire losses, at least until the risk of catastrophic wildfires can be contained through the above policies.
    • CalFire data show a rising trend over the last 20 years in the number of acres burned by wildfires in California, and also in the occurrence of highly destructive fires. Critically for our assessment of wildfire risk, the data also show that the occurrence of two catastrophic wildfires back-to-back in 2017 and 2018 is not unprecedented, with a similar double year spike in 2007-2008 (see Exhibit 9). The data suggest to us that the recurrence of two years of back-to-back catastrophic fires similar to 2017-18 is possible every 10 years, and that single year spikes in the number of acres burned can occur every three to five years.
  • Finally, as explained below, we consider a range of scenarios for the partial recovery by PCG of its wildfire losses from ratepayers.
  • On this basis, we find EIX stock to be significantly undervalued across a range of scenarios (Exhibit 11). We estimate the net cost to EIX (after insurance and taxes) of the 2017-2018 wildfires and mudslides to be only $3.0 billion (see Exhibit 6). Assuming no recovery from ratepayers, this figure is consistent with a fair market value of $72 per fully diluted share (i.e., including the dilutive impact of the equity issuance required to offset wildfire losses), suggesting ~30% upside from the current price.
  • We have valued PCG using the same set of assumptions. However, given the much larger scale of PCG’s potential net losses ($26.5 billion; see Exhibit 6), we have also run a series of scenarios that reflect the provisions of Senate Bill 901 regarding the recovery of catastrophic wildfire losses from ratepayers.
  • This analysis illustrates the critical importance to PCG of recovering, or avoiding liability for, a substantial portion of the damage claims arising from the 2017-2018 northern California wildfires:
  • Absent recovery or avoidance of at least 35% of these losses, the upside in PCG stock is unattractive.
  • By contrast, if PCG is allowed recovery of, or is able to avoid, 50% or more of its 2017-2018 losses, our estimate of the fair market value of the stock suggests it is significantly undervalued (Exhibit 12).
  • In assessing the possibility that PCG may be allowed recovery of 50% or more of its losses stemming from the 2017-2018 wildfires, we believe it is important to weigh the following considerations:
  • PCG has a critical role to play in containing the risk of future devastating fires in northern California. The only alternative to PCG hardening the electricity grid in California’s most fire prone areas is state ownership of the region’s transmission and distribution network, implying state responsibility for the damage caused by future catastrophic fires.
  • Senate Bill 901 requires the CPUC to authorize recovery from ratepayers of costs arising from the 2017 wildfires to the extent these exceed “the maximum amount the corporation can pay without harming ratepayers or materially impacting its ability to provide adequate and safe service.”
  • While our analysis assumes that PCG will ultimately be found liable for all the property and other damage caused by the 2017-2018 wildfires in its service territory, this may not be the case. CalFire has yet to issue its report with respect to the causes of the Tubbs fire, which alone accounts for over 20% of the structures destroyed by the 2017-2018 northern California wildfires, nor its report on the causes of the 2018 Camp fire.
  • Under the principle of inverse condemnation, PCG is financially liable for property damaged by its equipment, even if the utility is demonstrably prudent in the operation and maintenance of these assets. This is not the case, however, with respect to other forms of damage, such as loss of life or limb or foregone business revenues or wages, where the plaintiff is required to prove in court that the utility was negligent in causing the fires. Because such claims account for just over half of the total estimated damage caused by the 2017-2018 northern California wildfires, this higher standard for determining liability could materially reduce PCG’s financial exposure.
  • Even in cases where PCG is financially liable, it is possible that extenuating circumstances, or the contributory negligence of others, could reduce the scale of its financial liability.
    • Senate Bill 901 requires the CPUC, in allocating future wildfire costs between ratepayers and shareholders, to consider such factors, and the CPUC has made statements asserting that is has the authority to do so for the 2017-2018 wildfires, as well.
  • In contrast to EIX stock, which we perceive to carry little downside risk, there is clearly a wide dispersion of potential returns on PCG. This uncertainty will likely deter the risk adverse investor in utility stocks, but may offer an attractive opportunity for deep value investors with an investment horizon of three years or more. Taking into account the mitigating factors discussed above, we find the upside potential in the stock attractive relative to the far more limited downside risk (see Exhibit 12).

Exhibit 1: Heat Map: Preferences Among Utilities, IPP and Clean Technology

Details

Are Losses of the Scale Incurred by California’s Utilities in Fact Recoverable?

The damage caused by California’s 2017-2018 wildfires dwarfs the revenues of the state’s electric utilities and property and casualty insurers, and are substantial even compared to the fiscal revenues of the state. The $44 billion of property and other damage that we estimate were caused by the fires exceeds the combined annual electricity revenues of all the utilities in California, both private and municipal ($41 billion). At some $21 billion, the property damage caused by the fires is equivalent to 3.0x the total residential insurance premiums collected annually in California ($8 billion). Even the state of California’s ability to absorb the risk is constrained by the scale of the losses; the $44 billion of property and other damage caused by the fires is equivalent to a third of the state of California’s annual tax receipts ($135 billion). (See Exhibit 2).

Exhibit 2: Estimated Losses Attributable to the 2017-2018 Wildfires & Mudslides Compared to Utility Revenues, Real Estate Taxes and State Income and Other Taxes (1)

 

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1. Gross 2017-2018 wildfire and mudslide losses of $43.8 billion represent the sum of estimated property and other damages across the state, plus estimated legal costs (see Exhibit 6). Retail electric revenues represent each utility’s total retail electric revenues in California during calendar year 2017. California residential insurance premiums represent all residential insurance premiums paid by California residents in calendar year 2015; these should be compared to the estimated property damages caused by the 2017-2018 fires of $21 billion. California real estate taxes, state income taxes and total state taxes represent all such taxes paid by California residents in fiscal year 2017-2018, which ran from July 1,2 017 through June 30, 2018.

Source: SSR research and analysis, company reports including FERC Form 1, S&P Global Market Intelligence, California Department of Insurance, State of California Fiscal Year 2017-2018 Property Tax Collections Statistical Report, and Betty Yee, California State Controller, Statement of General Fund Cash Receipts and Disbursements for the period July 1, 2017 through June 30, 2018.

Critically, however, the risk of unrecoverable wildfire losses is materially mitigated in the cases of EIX and Sempra Energy (SRE) by the lower frequency and less destructive nature of wildfires in their service territories. PCG, by contrast, is disproportionately at risk for recurring wildfire losses beyond the capability of its ratepayers to absorb.

As can be seen in Exhibit 3, some 74,000 square miles of PCG’s service territory are in counties designated by CalFire (the California Department of Forestry and Fire Protection) to be at high risk of fire, and PCG serves 793 communities in these high-risk zones. By contrast, only some 46,000 square miles of EIX’ service territory are in counties with high risk of fire and EIX serves just 336 communities in these high risk zones — equivalent to 72% of the square miles and 42% of the communities served by PCG in high fire risk areas. The square miles in SRE’s service territory that are at high risk of fire are equivalent to only 6% of those served by PCG, and the number of communities served by SRE in these high risk zones is only 11% of those served by PCG.

Exhibit 3: Exposure of California’s Utilities to Areas of High Wild Fire Risk, per CalFire

Square Miles of Service Territory in High Fire Risk Counties Number of Communities Served in High Risk Counties

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Source: California Department of Forestry and Fire Protection (CalFire), SSR analysis

The number of fire incidents reported by the three utilities to the California Public Utilities Commission (CPUC) over the last four years is even more skewed against PCG. According to CPUC data compiled by the Sacramento Bee, PCG reported 1552 fire incidents to the CPUC over the period 2014-2017, EIX 347 (22% of PCG’s total) and SRE 110 (7% of PCG’s total) (see Exhibit 4).

Finally, we estimate the property and other damage attributable to wildfires originating in PCG’s service territory over 2017-2018 at some $44 billion, in contrast to $9 billion in losses arising from the 2017-2018 wildfires and mudslides in EIX’ service territory (21% of PCG’s total) and no material wildfire losses at SRE (see Exhibit 5). Although not in itself evidence for the recurrence of wildfires in the future, the distribution of historical wildfire losses is certainly consistent with the other indicators of much higher wildfire risk in northern California.

Exhibit 4: Fire Incidents Reported to the CPUC per Utility

Exhibit 5: Estimated Losses Attributable to

2014-2017 Fires Originating in Service Territory, 2017-18

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Source: California Public Utility Commission, California Department of Insurance, company reports. Fire incident data compiled from CPUC sources by Michael Finch II of the Sacramento Bee.

The concentration of high fire risk areas in PCG’s service territory, the much higher number of communities served by PCG in these areas, and the prevalence of reported fired incidents on PCG’s grid, all suggest that PCG faces significantly higher wildfire risk than EIX or SRE.

Exhibit 6 presents our estimates of the potential costs, including liability for third party property and other damages, legal expenses and CPUC penalties, that could be faced by PCG and Edison International (EIX) in respect of the 2017-2018 northern and southern California wildfires and Montecito mudslides. In estimating the costs that could be borne by the two utilities we have modeled two different scenarios. In the first (labelled “Full Claims Paid” in Exhibit 6), we have assumed that the utilities are liable for and pay in full (i) all property damage claims brought against them, reflecting the standard of strict liability under California’s principle of inverse condemnation, and (ii) all other damage claims as well (e.g., for lost revenue or wages, or the loss of life or limb), even though these would require the plaintiff to prove in court that the utilities had been negligent in causing the fires. Our second, less conservative scenario (labelled “Settlements” in Exhibit 6) assumes the utilities settle all the property damage claims against them by agreeing to pay 60% of the face value of these claims, reflecting the average ratio at which San Diego Gas & Electric settled the property damage claims against it arising from the 2007 Guejito, Rice and Witch Creek fires. In both scenarios, we have assumed that the utilities’ gross costs are offset by (i) the two utilities’ respective third party liability insurance policies, and (ii) the utilities’ ability to deduct any costs that are not recovered under these policies (with the exception of the CPUC penalties) from their taxable income. The sources and methodology used to estimate third party damage claims, legal expenses and CPUC penalties are explained in detail in Appendix 1 to this research report.

Exhibit 6: Potential 2017-2018 Wildfire Liability, Legal Costs & CPUC Penalties ($ Billions)

PCG EIX

 

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1. Our settlements scenario assumes that the utilities settle all the property damage claims arising from the 2017-2018 wildfires and mudslides by agreeing to pay 60% of the face value of these claims, reflecting the average ratio at which San Diego Gas & Electric settled the claims against it arising from the 2007 Guejito, Rice and Witch Creek fires.

Source: SSR research and analysis, California Department of Insurance and company reports.

Even if we take into account the offsetting factors described above that could mitigate PCG’s exposure to damage claims arising from the 2017-2018 wildfires (i.e., PCG’s third party liability insurance, the company’s ability to deduct its unrecovered losses for federal tax purposes, and the possibility that PCG could settle the property damage claims against it at only 60% of their face value) we estimate that PCG still faces maximum potential losses of some $26 billion (see the bottom line of Exhibit 6). Losses of this magnitude are equivalent to 80% of PCG’s forecast 2018 electric rate base of $33 billion and 190% of its 2017 retail electric revenues of $13.9 billion (see Exhibit 7).

By contrast, under the same assumptions, we estimate EIX’ net potential losses from the 2017-2018 wildfires and Montecito mudslide at only $3.0 billion (see Exhibit 6). Losses of this magnitude would be equivalent to only 10% of its forecast 2018 rate base of $29 billion, and 26% of its 2017 retail electric revenues of $11.5 billion (see Exhibit 7).

Exhibit 7: Estimated Net1 Wildfire Losses of EIX and PCG Over 2017-2018 Compared to the Utilities’ Forecast 2018 Electric Rate Base and 2017 Retail Electric Revenues

$ Billions %

 

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1. Estimated losses are net of the proceeds of each utility’s third party liability insurance policies and reflect the utilities’ ability to deduct any unrecovered losses for federal tax purposes. Our estimate of losses further assumes that both utilities settle the property damage claims against them at only 60% of their face value, as SRE settled the claims against it arising from the 2007 Guejito, Rice and Witch Creek fires.

Source: California Department of Insurance, company reports, including FERC Form 1, S&P Global Market Intelligence and SSR analysis and estimates.

To mitigate the financial burden on PCG of its 2017 wildfire losses, legislation signed into law in September (Senate Bill 901) requires the CPUC to estimate “the maximum amount the corporation can pay without harming ratepayers or materially impacting its ability to provide adequate and safe service,” to allocate the excess costs to ratepayers, and to authorize the securitization of these future revenues. Following the Camp fire, there is discussion of new legislation to be introduced in the California Assembly, most likely in the next session starting in January, 2019, to extend these provisions of Senate Bill 901 to 2018 wildfire losses as well. In addition, the CPUC has recently asserted that is has the authority to allocate wildfire costs between shareholders and ratepayers based on the proportion of losses that were caused by the utility’s negligence and those that were due to exacerbating factors outside of the utility’s control, such as weather and the failure of property owners to take required preventative measures.

Given their scale, however, we fear that full recovery from ratepayers of PCG’s 2017 and 2018 wildfire losses will not be politically feasible for the CPUC. We are also skeptical, given the magnitude of the rate impacts, that such recovery is possible for future wildfires.

    • The recovery from ratepayers of PCG’s $26.5 billion of net 2017-2018 wildfire losses would require each of its 5.5 million customers to pay, on average, $4,800 to the utility – almost twice the average annual customer bill.
    • If all of PCG’s potential 2017-2018 wildfire losses were to be securitized, and recovered over 15 years at a 4.0% interest rate, the debt service cost, assuming mortgage style amortization, would increase the utility’s average rates and customer bills by some 17%. For purposes of comparison, the average annual increase in PCG’s revenue per customer in the 15 years since it emerged from bankruptcy has been only 2.5% p.a.
    • Even if the 17% increase in average customer bills required to recover PCG’s 2017-2018 wildfire losses were to prove acceptable to California regulators and politicians, PCG’s ability to recover its future wildfire losses from ratepayers would diminish with each subsequent fire: every future fire that causes damage comparable to that caused by just the 2017 northern California fires could require a further 8% increase in PCG’s customer bills.
    • Even if PCG is found not to have been negligent in causing the wildfires, and thus to be responsible only for property losses due to inverse condemnation, the burden on ratepayers of recurring wildfires would still be difficult to bear. We estimate the potential property losses in PCG’s service territory from the 2017-18 wildfires to be ~$14.5 billion, net of insurance and taxes, or 103% of PCG’s annual electric revenues. If securitized over 15 years at 4.0% interest, this would result in a 9.3% rate and bill increase. Each additional fire causing property damage of a magnitude comparable to just the 2017 northern California wildfires, if borne by ratepayers through securitization, would increase rates by an additional 4.4%.
    • If recovering the cost of future fires from ratepayers becomes politically untenable, the solvency of PCG would be at risk. A single future fire causing damage of a magnitude comparable to the 2017 northern California wildfires, which we estimate at $12.5 billion after insurance and taxes, would come close to wiping out PCG’s current market capitalization of $13.7 billion.

We do not believe this would be an acceptable outcome for the CPUC, the California legislature or the incoming governor. Significant investment by the utilities in grid upgrades and management focus on operational improvements will be necessary to reduce the risk of recurrence of the catastrophic wildfires of 2017-18. But private utilities cannot be forced to invest without the potential for full recovery, nor must creditors and equity investors offer them capital on reasonable terms. The alternative of municipalizing PG&E would be an even worse outcome for the state, as all future investment, losses and blame would then be the state’s responsibility.

The authors of Senate Bill 901, wishing to preserve the solvency of investor owned utilities while anticipating the difficulty of implementing the bill’s securitization provisions, foresaw the need to consider alternative approaches to protect utility shareholders from wildfire risk. Accordingly, Senate Bill 901 establishes an expert commission to determine how California should allocate the costs of catastrophic wildfires associated with utility infrastructure, and charges the commission to submit its recommendations by July 1, 2019. Specifically, the bill requires the commission “to examine issues related to catastrophic wildfires associated with utility infrastructure” and to make “recommendations as to changes to law that would ensure equitable distribution of costs among the affected parties.”

Given the difficulty of securing from ratepayers the resources required to pay for catastrophic wildfires, we expect the expert commission will consider transferring this cost to the state’s taxpayers or building owners.

    • While PCG’s estimated net losses from the 2017-2018 fires are equivalent to 190% of its retail electric revenues, they are equivalent to just 36% of the real estate taxes collected annually in the state of California, to 28% of California’s annual income tax receipts, and to 20% of California’s total annual tax receipts. (See top table of Exhibit 8.)
    • If PCG’s maximum potential losses from the 2017-2018 wildfires were to be recovered from taxpayers over 15 years, at an assumed annual interest rate of 4.0%, we calculate that annual recoveries would represent just 3.2% of the real estate taxes collected annually in the state, 2.5% of California’s annual income tax receipts and 1.8% of California’s total annual tax receipts.(See bottom table of Exhibit 8.)
    • Tax increases of this magnitude could be politically feasible. They would certainly be unpopular, particularly given their purpose of ensuring that the shareholders of the utility that caused the fires achieve their expected returns. Repeated increases of a similar magnitude, to cover the losses from future fires, would of course exacerbate the political opposition.
    • Most importantly, under California’s constitution, any increase in state taxes requires a two thirds vote of both houses of the state legislature. This is a high hurdle, and one rendered more difficult to achieve by the heavy concentration of losses in areas well north of the major population centers of San Diego, Los Angeles, San Jose and San Francisco.

Exhibit 8: Estimated 2017-2018 Wildfire Losses, After Taxes & Insurance, Compared to Retail Electric Revenues, Residential Insurance Premiums and California’s Taxes (1)

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1. Wildfire losses represent the sum of each utility’s gross potential wildfire liability for property and other damages, estimated legal costs and CPUC penalties (see Exhibit 6), after taxes and insurance. The bottom table assumes wildfire losses are recovered over 15 years using mortgage style amortization at a fixed rate of 4.0%. Retail electric revenues represent each utility’s total retail electric revenues in calendar year 2017. California residential insurance premiums represent all residential insurance premiums paid by California residents in calendar year 2015. California real estate taxes, state income taxes and total state taxes represent all such taxes paid by California residents in fiscal year 2017-2018, which ran from July 1,2 017 through June 30, 2018.

Source: SSR research and analysis, company reports including FERC Form 1, S&P Global Market Intelligence, California Department of Insurance, State of California Fiscal Year 2017-2018 Property Tax Collections Statistical Report, and Betty Yee, California State Controller, Statement of General Fund Cash Receipts and Disbursements for the period July 1, 2017 through June 30, 2018.

A final possibility is that California’s politicians may determine that wildfire costs are too large to socialize, and that citizens living in wildfire prone areas should bear the corresponding risk. This would require the elimination of the principle of inverse condemnation, derived over several decades of court precedent from the California constitution’s requirement that compensation be paid when private property is taken or damaged for public use. At a minimum, legislation would be required to stop the application of inverse condemnation to investor owned utilities. Any such legislation would be challenged in court, however, and the courts may decide that a constitutional amendment is required. Amending the California constitution requires a two-thirds vote in both chambers of the state legislature and ratification by voters in a statewide referendum.

Ending the application of inverse condemnation to investor owned utilities would weigh heavily on California’s property and casualty insurers and, ultimately, on the residents of California’s wildfire prone regions. We would expect these groups to lobby strongly against it. We calculate that the damage to property caused by the 2017-2018 wildfires and mudslides is equivalent to ~3.0x the total residential insurance premiums collected in the state of California in 2016. If the elimination of inverse condemnation were to prevent insurers from recovering their losses from the utilities whose equipment started the fires, insurance companies may exclude wildfire risk from future homeowner policies, or make wildfire coverage conditional on massive premium increases, depending on how frequently insurers expect catastrophic fires to recur.

In summary, the state requires financially viable electric utilities to make the investments necessary to harden the grid and curtail the risk of repeated catastrophic wildfires. But the full recovery from ratepayers of PCG’s 2017-2018 wildfire losses may be politically infeasible, and will only become more so if fires of similar magnitude recur in future years. Even the state of California lacks the fiscal resources to absorb repeated losses on the scale of those caused by the wildfires of 2017-2018. Finally, limiting utility exposure to wildfire risk by ending the application of inverse condemnation to investor owned utilities would be strongly opposed by the state’s insurers and by residents of the state’s fire prone areas, and may require a constitutional amendment to implement.

We believe, therefore, that California’s state and municipal governments will be compelled to implement a range of policy actions to curtail the number and extent of future wildfires, well beyond the steps initiated in the wildfire legislation signed into law in September (Senate Bill 901). In addition to improving the management of the state’s privately and publicly owned forest land, other necessary measures include imposing, and enforcing, stricter building codes and standards for the clearance of vegetation in residential areas, hardening or undergrounding utility distribution networks in fire prone areas so as to minimize wildfire risk, and more conservative underwriting of property and casualty risk in these regions.

While concerted action on all these fronts could significantly reduce wildfire risk over the next decade, in the interim the shareholders of the state’s utilities, and particularly PCG, are at risk that future catastrophic fires could erase the market value of their investments. Rather than allow this to occur, we expect that policymakers in California will allow utilities partial recovery of catastrophic wildfire losses during this interim period, from ratepayers or taxpayers or both.

In the sections that follow we discuss how the risk of future catastrophic wildfires, and the recovery of their costs, should be assessed in the valuation of California’s utilities, and the implications for the value of EIX and PCG.

The Biggest Question Facing California and its Utilities: How Frequently Will Similar Wildfires Recur in the Future?

A key assumption of our analysis so far has been that catastrophic wildfires, similar in scale to those of 2017-2018, will recur in future years. If this assumption is correct, we have argued, the cumulative cost of future catastrophic wildfires will undermine the effort to insulate utility shareholders from wildfire risk by recovering their cost from ratepayers or taxpayers. What is the evidence for this assumption, and what does this evidence imply for the valuation of California’s utilities?

Fortunately, a long time series of data on California wildfires is available from the California Department of Forestry and Fire Protection (CalFire). CalFire is responsible for fire protection and resource management on 31 million acres of wildlands throughout California, known as the State Responsibility Area. The State Responsibility Area comprises all publicly and privately owned woodlands and shrublands in the state of California, with the exception of land owned by the federal government or contained within city boundaries. CalFire provides data on the total number of acres burned in the State Responsibility Area back to 1933. Exhibit 9 presents acres burned in the State Responsibility Area in each year since 1951, corresponding to a period during which modern fire prevention and containment techniques have been in use.

Exhibit 9: Acres Burned in the State Responsibility Area Only (Excludes Federal Lands and Land Within City Boundaries)

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Source: California Department of Forestry and Fire Protection (CalFire), SSR analysis

CalFire also provides data on the number of structures destroyed each year by fire, which we have used to assess the destructiveness of the fires by calculating the number of structures destroyed per acre burned. We have found that the that the number of acres burned in the State Responsibility Area is strongly correlated (R^2=0.67) with the destructiveness of the fires: as can be seen in Exhibit 10, the number of structures destroyed per acreburned rises as the number of acres burned increases. We believe this is attributable to the fact that the very largest fires are the ones most likely to encroach on more heavily populated areas and, once populated areas are reached, fewer resources are available to contain the other parts of the fire until the threat to populated areas is contained. As a result, it appears that the greatest destruction, when more than 1,000 structures are destroyed, occurs when the area burned by the fire exceeds 250,000 acres.

Exhibit 10: Structures Destroyed per Acre Burned of State Responsibility Area

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1. The State Responsibility Area comprises all publicly and privately owned woodlands and shrublands in the state of California, with the exception of land owned by the federal government or contained within city boundaries.

Source: California Department of Forestry and Fire Protection (CalFire), SSR analysis

The CalFire data appear to show a rising trend over the last 20 years in the number of acres burned, and also in the occurrence of highly destructive fires. Throughout the time series, the data seem to show a certain cyclicality in the occurrence of major wildfires, with periodic spikes and troughs in acres burned. Over the last 20 years, however, the scale of these spikes has increased dramatically: only since 1999 have there been years when wildfires have burned more than 250,000 acres. Finally, and critically for our assessment of wildfire risk, the data show that the occurrence of two catastrophic wildfires back-to-back in 2017 and 2018 is not unprecedented, with a similar double year spike in 2007-2008 (see Exhibit 9). The data suggest to us that the recurrence of two years of back-to-back catastrophic fires similar to 2017-18 is possible every 10 years, and that single year spikes in the number of acres burned can occur every three to five years.

How Should California’s Utilities Be Valued?

As we have argued above, we believe the risk of future wildfires similar in scale to those of 2017-2018, with the potential to cause damage beyond the capacity of ratepayers or taxpayers to absorb, will force action by California’s state and municipal governments, public utilities, insurance companies and residents to reduce both the frequency and the cost of catastrophic wildfires.

We believe that a concerted program of action could be successful, particularly if it were to include:

  • Improving the management of the state’s privately and publicly owned forests, by removing flammable debris and underbrush and using controlled burning to prevent the spread of catastrophic fires;
  • Limiting the number of structures destroyed by wildfires through stricter building codes and more consistent enforcement of standards for the clearance of vegetation in residential areas;
  • Hardening utility distribution networks, including replacing wooden power poles with cement ones, undergrounding utility lines in fire prone areas, insulating overhead lines where undergrounding is not feasible and practicing aggressive vegetation management;
  • Requiring more conservative underwriting of property and casualty risk in fire prone regions.

Even if the design and legislation of these initiatives could be completed in the next couple of years, however, their cumulative impact will only be felt over a much longer period of time, possibly extending to a decade. In the interim, we fear that the shareholders of the state’s utilities, and particularly PCG, will continue to bear the risk of future catastrophic fires. How is this risk to be quantified in the valuation of California’s utilities?

Janus, the Roman god of beginnings and endings, who lends his name to month of January, was depicted as having two faces, one looking forward and one looking back. Given the scale of California’s 2017-2018 wildfires, and the historical tendency for devastating wildfires to recur periodically over time, a similar perspective would be helpful in valuing California’s investor owned utilities. Looking backwards, our valuation must estimate the potential losses faced by the utility as a result of the 2017-2018 wildfires, as well as any material offsets to those losses. Looking forward, the model must estimate the cost of potential future wildfire losses, at least until the risk of catastrophic wildfires can be contained through policies such as those outlined above.

More specifically, we believe that a valuation model for California’s utilities must estimate:

  • The scale of a utility’s potential liability for property and other damages arising from the catastrophic wildfires of 2017-2018, as well as potential losses from similar fires in future years;
  • The value of any offsets to these potential losses, such as the settlement of third party liability claims at a discount to their face value, the proceeds from third party liability insurance, the potential recovery of losses from ratepayers, and the tax deductibility of unrecovered losses;
  • The number of years until California’s wildfire risk can be contained, representing the sum of (a) the number of years required for California to implement existing strategies and to design and legislate additional strategies to contain wildfires, and (b) the number of years required for such a strategies to be effective;
  • The probability of catastrophic fires recurring over this period, which in turn will be a function of the assumed periodicity of such fires (i.e., the period of time over which catastrophic fires similar to those of 2017-2018 can be expected to recur);
  • The discount rate to be applied to these expected wildfire losses;
  • The PE multiple that can should be used to value the utility’s earnings once wildfire risk has been contained.

More sophisticated versions of this valuation model could assign probabilities to different assumptions, such as the probability that California will design and implement an effective strategy to contain future wildfires, or that the state’s utilities will be allowed full or partial recovery of their past and future wildfire losses.

For our purposes of our analysis, we have assumed the following:

  • The scale of a utility’s potential liability for future catastrophic wildfire losses will be equivalent to its estimated liability for the 2017-2018 wildfires, as set out in Exhibit 6. The assumptions and methodology underpinning the estimates in Exhibit 6 are set out in the Appendix 1 to this report.
  • The utility’s potential liability for past and future fires will be reduced by three principal offsets: (i) the settlement of third party property damage claims at a 40% discount to their face value offset (as SRE settled the property damage claims against it arising from the 2007 Guejito, Rice and Witch Creek fires); (ii) the proceeds of third party liability insurance policies, of a size comparable to those maintained by EIX and PCG over 2017-2018; and (iii) the utility’s right to deduct unrecovered losses in the calculation of its federal taxes.
  • The periodicity of catastrophic wildfires similar in scale to those of 2017-2018 is roughly ten years, implying an initial risk of 10% in each year of the coming decade of catastrophic losses similar to those set out in Exhibit 6.
  • Consistent with our assumption that California can bring catastrophic wildfires under control over the coming decade through the policy initiatives described above, we assume that the probability of catastrophic wildfires gradually declines, falling to 9% in year two, 8% in year three and so forth.
  • The discount rate to be applied to these expected wildfire losses is roughly 15%, reflecting the sum of (i) the forward earnings yield of each of the two pure play Californian utilities (EIX and PCG), calculated using their current share price and consensus 2019 earnings per share, plus (ii) the expected rate of growth in these utilities’ normalized earnings, reflecting the compound annual growth rate implied by each utility’s normalized EPS in 2017 and the consensus estimate for 2020.
  • A long term PE multiple comparable to that at which EIX and PCG traded prior to October 2017, equivalent to an ~5% discount to the average PE of the U.S. regulated utilities as a group.

Applying these assumptions, we first calculate the fair market value of EIX and PCG and then convert this valuation to a per share amount, taking into account the scale of the equity issuance required to offset the utility’s liability for wildfire damages. In estimating the size of the utility’s equity offering, we assumed that the utility would be required by regulators to restore its ratio of owners’ equity to rate base to the level stipulated in its last cost of capital proceeding. The equity offering, in other words, must be sufficient to offset the utility’s after-tax wildfire losses, net of insurance and assumed recovery from ratepayers across a range of scenarios. To quantify the share dilution implied by the equity offering, we divided the dollar amount of the required equity offering by our estimate of the fair market value of the utility, and assumed that the resulting share of the company’s equity would be sold to new investors. We then dividend the remaining share of the company’s equity by the utility’s current number of shares outstanding to arrive at our estimate of fair market value per share.

We present the results of our valuation analysis of EIX and PCG below.

EIX

Based on the assumptions set out above, we find EIX stock to be significantly undervalued across a range of scenarios (see Exhibit 11).

Exhibit 11: Estimated Fair Value of EIX Stock

________________________________________________

Source: SSR research and analysis, California Department of Insurance and company reports.

We estimate the net cost to EIX (after insurance and taxes) of the compensation to be paid for the 2017-2018 wildfires and mudslides to be only $3.0 billion (see Exhibit 6 and Appendix 1). Assuming no recovery from ratepayers, this figure is consistent with a fair market value of $72 per fully diluted share (i.e., including the dilutive impact of the required equity issuance), suggesting ~30% upside from the current price.

We also modeled two alternative upside scenarios, one where EIX is found not be liable for damage caused by the Montecito mudslides and one where it is found not be liable for either the mudslides or the wildfires. Our corresponding estimates of the fair market value of EIX stock are $73 and $81 per share, respectively, implying potential upsides of 34% and 48% from current levels.

PCG

We have valued PCG using the same set of assumptions with respect to the recovery of past and future wildfire losses. Given the much larger scale of PCG’s potential losses, however, we have also run a series of scenarios that reflect the provisions of Senate Bill 901 regarding the recovery of catastrophic wildfire losses from ratepayers.

As a reminder, Senate Bill 901 requires the California Public Utility Commission to authorize recovery from ratepayers of otherwise unrecoverable costs arising from the 2017 wildfires to the extent these exceed “the maximum amount the corporation can pay without harming ratepayers or materially impacting its ability to provide adequate and safe service.” While the law does not include 2018 wildfire losses in the calculation of this cap, following the outbreak of the Camp fire in October 2018 a bill has been prepared for introduction in the California legislature that would cap unrecoverable losses from 2018 wildfires as well. Even if this bill does not pass, it is difficult to see how any estimate made by the CPUC of the financial sustainability of unrecoverable losses arising from the 2017 wildfires could not take into account the current financial condition of the state’s utilities, suggesting implicit recognition of the financial impact of catastrophic wildfire losses sustained in 2018.

A second key provision of Senate Bill 901 directs the Commission, when “evaluating the reasonableness of the costs and expenses” incurred by utilities due to wildfires, including damages paid by the utilities to third parties in compensation for their losses, to consider exculpating factors, such as:

  • the extent to which the costs and expenses were in part caused by circumstances beyond the utility’s control, including extreme climate conditions;
  • The utility’s compliance with regulations, laws, commission orders and its own wildfire mitigation plans, as well as the utility’s past record of compliance; and
  • Any statutory, regulatory or ordinance violations by parties other than the utility that contributed to the extent of the damages.

Finally, if the Commission, having considered these exculpating factors, finds any of the costs and expenses incurred by the utility to be reasonable, the Commission may allow recovery of a portion these costs even while denying recovery of the remainder.

For a summary of the provisions of Senate Bill 901, please see Appendix 2 of this research report.

Given these provisions of Senate Bill 901, we have modeled a range of alternative scenarios where PCG is allowed to recover between 20% and 80% of its otherwise unrecoverable losses arising from both (i) the 2017 and 2018 wildfires in its service territory and (ii) future catastrophic wildfires that may occur over the next decade (see Exhibit 12).

Our scenario analysis illustrates the critical importance to PCG of either (i) recovering a minimum level of its 2017-2018 wildfire losses or (ii) reducing its liability for wildfire losses below the estimate of losses we have used in our analysis.

  • Absent recovering or avoiding liability for of at least 35% of its 2017-2018 losses, the potential upside in PCG stock is likely to be unattractive.
  • By contrast, if PCG is allowed recovery ofor is able to avoid exposure to, 50% or more of its maximum potential 2017-2018 losses, our estimate of the fair market value of the stock suggests it is significantly undervalued.[1] This is true even if the percentage of future wildfire losses is assumed to be relatively low (see Exhibit 12).

Exhibit 12: Estimated Fair Value of PCG Stock

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Source: SSR research and analysis, California Department of Insurance and company reports.

20% recovery is approximately in line with a cap on equity issuance due to the 2017 fires of $3 billion. 65% recovery is similar to the amount of equity required if the CPUC capped total equity issuance for 2017 and 2018 at ~$9 billion.

In assessing the possibility that PCG may be allowed recovery of, or be able to avoid liability for, 50% or more of the maximum potential losses stemming from the 2017-2018 wildfires, we believe it is important to weigh the following considerations:

  • PCG has a critical role to play in containing the risk of future devastating fires in northern California. Failure to make the investments required to harden the distribution grid and improve operations in the more fire prone areas of PCG’s service territory will arguably have much larger, more adverse and more immediate consequences than the deferral of maintenance capex elsewhere on the grid, or the failure advance the various green initiatives held dear by politicians in the state. The only alternative to PCG hardening the electricity grid in California’s most fire prone areas is state ownership of the region’s transmission and distribution network, implying full state responsibility for the cost of future catastrophic fires. transmission and distribution network, implying full state responsibility for the cost of future catastrophic fires.
  • While our sensitivity analysis assumes that PCG will ultimately be found liable for all the property and other damage caused by the 2017-2018 wildfires in its service territory, this may not be the case. CalFire has yet to issue its report with respect to the causes of the Tubbs fire, which alone accounts for over 20% of the structures destroyed by the 2017-2018 northern California wildfires, nor its report on the Camp fire. PCG has made strong arguments in court filings that the Tubbs fire ignited at multiple locations and that privately installed electrical equipment may have contributed to or caused the fire. If PCG is found not to be liable for the Tubbs fire, the impact of excluding the related losses from our analysis would be itself be equivalent to the recovery of 20% of the total damages caused by the 2017-2018 fires.
  • Under the principle of inverse condemnation, PCG is financially liable for property damaged by its equipment, even if the utility is demonstrably prudent in the operation and maintenance of these assets. This is not the case, however, with respect to other forms of damage caused by the fires, including lost profits and wages or the loss of life or limb. Such claims must be brought in state court, where the burden of proof is on the plaintiff to demonstrate that the losses for which compensation is sought were attributable to the negligence of the utility. To the extent PCG is not found to have been negligent, no compensation will be due claimants for non-property related losses. Because such claims account for just over half of the total estimated damage caused by the 2017-2018 northern California wildfires, this higher standard for determining liability could materially reduce PCG’s financial exposure.
  • Even in cases where PCG is financially liable, it is possible that extenuating circumstances, or the contributory negligence of others, could reduce the scale of its financial liability. As noted above, Senate Bill 901 requires the CPUC, when determining whether a utility should be allowed to recover wildfire losses, to consider if such costs and expenses were in part caused by circumstances beyond the utility’s control, including extreme climate conditions. If exculpating factors are present, the Commission may allow recovery of a portion these costs. A similar principle would guide state courts in assessing PCG’s liability for non-property related damages. Were PCG found to have been negligent in a damage case brought in state court, the contributory negligence of other parties could result in a reduced allocation of the compensatory damages to PCG. An example of contributory negligence might be the failure of municipalities to enforce regulations requiring the clearance of vegetation, thereby aggravating the damage caused by the fires.

In contrast to EIX stock, which we perceive to carry little downside risk, there is clearly a wide dispersion of potential returns on PCG. This uncertainty will likely deter the risk adverse investor in utility stocks, but may offer an attractive opportunity for deep value investors with an investment horizon of three years or more. Taking into account the mitigating factors discussed above, we find the upside potential in the stock attractive relative to the far more limited downside risk.

Appendix 1: Methodology for the Estimation of Wildfire Liabilities

  • The losses that EIX and PCG may incur as a result of the 2017-2018 California wildfires can be categorized as follows:
    • penalties, including fines and unrecoverable capital expenditures, imposed by the California Public Utility Commission (CPUC);
    • third party liability claims for deaths, injuries, property damage and consequential damage (e.g., loss of wages or profit);[2]
    • punitive damages, either awarded by the courts or implicit in settlements negotiated by the utilities with victims of the fires;[3] and
    • legal costs for the litigation and CPUC proceedings.

We explain below how we estimate the range of potential losses in each of these categories.

  • CPUC Penalties. Historically, the CPUC has levied relatively modest penalties on the state’s electric utilities for regulatory violations contributing to brush fires.
    • In September, 2015, the Butte Fire in Amador County burned 71,000 acres, destroyed 549 homes and killed two people. The CPUC found that PCG’s negligence in pruning trees nears its lines had contributed to the fire and fined the utility $8.3 million.
    • In 2013, Southern California Edison (SCE) agreed with the CPUC to a $37 million settlement in connection with the 2007 Malibu Canyon fire, paying a $20 million fine to the State of California and absorbing $17 million in costs to assess the safety of utility poles. SCE admitted having overloaded its power poles in violation of CPUC rules and having withheld pertinent information from the CPUC.
    • In 2010, San Diego Gas & Electric (SDG&E) agreed to pay $21 million to settle allegations that its mismanagement led to the 2007 Guejito, Rice and Witch Creek fires and that SDG&E hampered investigators. SDG&E paid $14.35 million in fines to the State of California and absorbed $6.75 million in costs incurred as a result of the 2007 fires.
    • In 1994, PCG was found guilty of 739 counts of negligence in connection with a fire in the Sierra foothills that destroyed twelve homes.  PCG was fined $30 million by state regulators, or the equivalent of ~$50 million in 2018 dollars.
    • To be conservative, we have used the largest of these historical penalties, that levied in the Sierra foothills fire, as the basis for our estimate of CPUC penalties in respect of the 2017-2018 California wildfires.
  • Third Party Liability. EIX and PCG face the risk of liability for property damages under the principle of inverse condemnation, and the risk of liability for property damages plus personal injury, pain and suffering and incidental damages under the principle of tort liability.
    • Inverse condemnation. Inverse condemnation is based upon the fifth amendment of the U.S. constitution, which stipulates that private property may not be taken for public use without just compensation. Under California state law, inverse condemnation, a principle that requires compensation for damage to property caused by government property, has been extended to cover investor owned utilities operating under state regulation. The principle stipulates that a utility must compensate property owners for damage to their property caused by a utility’s assets, whether or not the utility was negligent in the operation or maintenance of those assets. If the utility was not negligent in causing the damage, the CPUC should allow recovery of the damages from ratepayers. The principle of inverse condemnation does not extend to third party liability claims for death, injury, and consequential damages (e.g., loss of wages or profits); these must be pursued under the principle of tort liability.[4]
    • Tort liability. Third party liability claims for property damage could also be brought against EIX and PCG under the principle of tort liability in suits filed in state courts. Under the principle of tort liability. Plaintiffs may also seek compensation for death, injury, and consequential damages (e.g., loss of wages or profits). Under the principle of tort liability, however, the utility would be liable for property and other damages if the plaintiff could prove that the damages suffered were caused by the utility’s negligence. Plaintiffs can, and have, filed claims for both inverse condemnation and negligence at the same time, collecting the greater of the two liabilities they can prove in court.
      • Negligence. Whether a utility has been negligent in the operation or maintenance of its assets is of far greater consequence than whether a claim is pursued under the principle of inverse condemnation or tort liability. A finding of negligence is what determines if the utility suffers an economic loss or not. If a utility is not found to have been negligent, then, under the principle of inverse condemnation, it is to be allowed to recover from ratepayers any damages paid, implying minimal economic loss; under the principle of tort liability, it would not be liable for damages in the first place and thus, similarly, would suffer no loss. Conversely, if a utility is found to have been negligent, under CPUC rules, no recovery is allowed from ratepayers (regardless of whether the damage was awarded under the principle of inverse condemnation or of tort liability), implying that shareholders must absorb the cost of any damages paid.
    • Consequences. If a utility’s assets are found to be the cause of a fire, and it is determined that the negligence of the utility in maintaining or operating its equipment caused the fire, then the utility will be liable for all damage resulting from the fire, including property, death, injury, pain and suffering and consequential damages such as the loss of wages or profits.
  • Punitive Damages. We view the odds of an award of punitive damages to be very low and have excluded it from our analysis of potential impacts. In punitive damages cases, the burden of proof is on the plaintiff, who must demonstrate that the defendant engaged in “willful misconduct,” a higher legal standard of negligence which has generally been defined as a conscious disregard of probable harm. Given the absence to date of any physical evidence suggesting such egregious misconduct by the utilities, and their significantly increased focus on vegetation management and fire prevention as California’s drought worsened over the last several years, proving conscious disregard of probable harm will be a challenge for plaintiffs.
  • Estimating the Scale of Potential Losses. It is too early to know the full scale of damage caused by the 2017-2018 California wildfires. It is possible to estimate the scale of damage, however, by reference the damage caused by past fires, such as the 2007 Witch/Rice fires, the 2015 Butte fire and the fires in Northern California in October 2017.
    • Property Damage. Based on the insurance claims brought in connection with past fires, and the number of structures destroyed by these fires, it is possible to arrive at an estimated ratio of insured damage per structure, which we use as a proxy for property damage.[5] Adjusting for inflation, we found that the highest value of insurance claims per structure destroyed was registered in connection with the recent northern California fires. Dividing the $9.4 billion in property damage claims arising from these fires across the ~8,600 structures destroyed results in a ratio of ~$1.2 million per structure destroyed. To estimate the total property damage caused by the 2017-2018 California wildfires, we have multiplied this ratio of $1.2 million in property damage per structure destroyed by the total number of structures destroyed in each wildfire. We have made an exception, however, for the Camp fire: to reflect the substantially lower value of the structures in the region where that fire occurred, we have applied in this case a ratio of $0.6 million in property damage per structure destroyed.
    • Other Third Party Liabilities. EIX and PCG will likely also face other third party liabilities, including claims for damages arising from death and personal injury, consequential damages, such a loss of wages or profit, damage to governmental property, and firefighting costs. In the Witch/Rice fire, San Diego Gas & Electric (SDG&E) recorded total costs of $1.3 billion for all third party claims excluding insured claims. Calculated per structure destroyed, and adjusted for inflation since 2007, the losses from the Witch/Rice fire work out to ~$850,000 per structure. Again, we have multiplied this ratio of $1.2 million in other third party liabilities per structure destroyed by the total number of structures destroyed in each wildfire to estimate the total cost of these claims to EIX and PCG.
    • CPUC Penalties. Reflecting the penalty imposed on PCG by the CPUC for the Sierra foothills fire of 1994 — the largest penalty imposed by the Commission over the last 25 years in respect of a brush fire – we assume that EIX and PCG will each face $50 million in CPUC fines and penalties for each major fire in their service territories, or a total of $100 million each across 2017-2018.
    • Legal Fees. Based on the legal costs incurred by PCG in connection with the San Bruno gas pipeline explosion, we estimate that PCG will incur $300 million in legal costs in connection with the claims arising from each of the 2017 and 2018 northern California wildfires, for a total of $600 million. We estimate EIX’s legal costs at half this level, $150 million for each of the 2017 and 2018 southern California wildfires or $300 million in total, reflecting the smaller number of events and a much smaller number of properties affected.
  • The Offsets: Insurance and Taxes. PCG and EIX had respectively $2.2. and $2.1 billion of third party liability insurance available to them to cover losses from the 2017-2018 wildfires. Importantly, payments of third party liability claims in excess of these amounts are tax deductible, as are legal expense. CPUC penalties, however, are not. We have assumed, therefore, that both EIX and PCG can deduct their legal costs and payments of third party liability claims, net of insurance proceeds, from their taxable income in the calculation of their federal income taxes.

Appendix 2: A Summary of the Provisions of Senate Bill 901

  • To frame the implications of S.B. 901, it is first helpful to summarize what the bill will not change:
    • The bill would not do away with California’s unique legal principle of applying inverse condemnation to privately owned utilities. Utilities will continue to be subject to strict liability for damages caused to third parties by utility assets or operations, relieving the injured party of any obligation to prove negligence or fault on the part of the utility.
    • Utilities seeking to recover from ratepayers the cost of damages paid to third parties will remain obligated to demonstrate to the California Public Utilities Commission (CPUC) that their actions were prudent, and that the damages did not arise due to negligence of the utility.
    • The bill would not protect California’s utilities against tort claims brought in state courts. In such cases, however, the burden of proof falls on the plaintiff, who must demonstrate that the damages were caused by the utility’s negligence.
    • The bill does not change the current law at all for non-catastrophic wildfires. What qualifies as catastrophic is not specifically defined in the bill, but it is clear from the legislative discussions that fires of a similar magnitude to the October 2017 southern California wildfires and Thomas fire in southern California would be considered catastrophic.
  • Within this ongoing framework, however, S.B. 901 would materially strengthen the position of California’s utilities in securing recovery from ratepayers of catastrophic wildfire-related expenses, reduce the cost to ratepayers of such recovery, and, for the 2017 wildfires, limit utilities’ financial exposure to unrecovered penalties and expenses.
  • First, for the 2017 wildfires, while the bill does not change the current standard of review for the recovery of costs from ratepayers, S.B. 901 would set a cap on how large a utility’s unrecoverable costs can be. Unrecoverable costs would be capped at an amount equal to “the maximum amount the corporation can pay without harming ratepayers or materially impacting its ability to provide adequate and safe service.” This amount is to be determined by the CPUC, although it is unclear how the determination is to be made.
    • This is most relevant and positive for PG&E, as the maximum potential liability for EIX for the Thomas fire likely is well below any potential limit the CPUC may set.
    • Therefore, if S.B. 901 is passed, the key controversy around PG&E will become the level at which the cap on unrecoverable 2017 wildfire expenses will be set and the timing for such a determination.
      • It can be argued that ratepayers are already being harmed because the cost of equity for PG&E is now significantly higher than its peers.
        • In 2012, Overland report, commissioned by the CPUC for the San Bruno gas explosion proceedings, determined the maximum equity PG&E could raise at that time without significant affecting its cost of capital (which would harm ratepayers) was $2.25 billion.
        • Based on that report and statements in the hearings, we believe the cap will likely be well below PG&E’s maximum potential liability of ~$15 billion.
      • On the other hand it can be argued that PG&E’s stock is already pricing in enough equity issuance to cover $15 billion in damages with no apparent impact on electric service.
    • The bill only authorizes the CPUC to determine this limit as part of a proceeding to recover costs from the 2017 fires, meaning the limit could remain unknown for an extended period of time. A strategy that could help reduce the uncertainty for investors would be for PG&E to file for recovery of even a small portion of costs as soon as practical to force a determination of the cap by the CPUC.
  • Second, for catastrophic wildfires ignited in 2019 and afterwards, the bill requires the CPUC to allow utilities to recover wildfire-related costs and expenses, including damages paid by utilities to third parties in compensation for their losses, “if the costs and expenses are just and reasonable.” In addition, the bill requires the Commission, “in evaluating the reasonableness of the costs and expenses” to consider exculpating factors, such as:
    • The extent to which the costs and expenses were in part caused by circumstances beyond the utility’s control;
    • Whether extreme climate conditions, including humidity, temperature or winds, contributed to the fire’s ignition or exacerbated the extent of the damages;
    • The utility’s compliance with regulations, laws, commission orders and its own wildfire mitigation plans, as well as the utility’s past record of compliance; and
    • Any statutory, regulatory or ordinance violations by parties other than the utility that contributed to the extent of the damages.
  • Third, if the Commission, having considered these exculpating factors, finds any of the costs and expenses incurred by the utility to be reasonable, the Commission may allow recovery of a portion these costs even while denying recovery of the remainder. Critically, therefore, the Commission’s determination of fault is thus no longer a binary, all-or-nothing decision, where any finding of negligence would deny the utility recovery of all its wildfire-related expenses for each event. Rather, the Commission is (i) instructed to make a balanced assessment of the utility’s responsibility for the wildfire and the damage it caused, and (ii) is permitted to allocate the wildfire-related expenses of the utility to ratepayers or shareholders in a manner that reflects the relative prudence or negligence or the utility’s actions.
    • It is important in this respect that the bill provides more detailed guidance to utilities as to the preparation of their annual fire mitigation plans, requires that these plans be reviewed by an independent evaluator and, finally, requires the CPUC to approve the utilities’ plans. These provisions should help utilities to demonstrate the prudence of their fire prevention measures and thus improve the odds of recovery from the CPUC of future fire costs.
  • Finally, if the Commission finds “some or all” of the costs and expenses related to a catastrophic wildfire to have been reasonably incurred by the utility, the utility may apply to the Commission for “a financing order to authorize these costs and expenses to be recovered through fixed recovery charges.” These fixed recovery charges can be assigned in turn to lenders through a securitization, allowing the utility to raise the funds required to defray these costs and expenses in the capital market.
    • The CPUC is required to respond to the utility’s application within 180 days, and to authorize the securitization if its proposed terms are just and reasonable, consistent with the public interest and capable of reducing “to the maximum degree possible” the present value of ratepayers’ future payments to the utility.
    • Historically, California and other states have excluded the proceeds of such securitizations from the calculation of a utility’s total capital, thus avoiding any required increased in the utility’s common equity. The result is that the cost to ratepayers of the capital raised reflects the interest rate on the securitization alone, which tends to be low given the collateralized nature of the obligation, and not the weighted average cost of capital to the utility, which is based on an equity ratio of close to 50% and thus is materially higher.
    • As noted above, any costs from the 2017 wildfires allowed for recovery or exceeding the financial impact cap set by the CPUC can also be securitized under this provision.
    • The one glaring fault with the bill is that any catastrophic fires in 2018 are not addressed at all. While no fires this year have yet been attributed to utilities, there are still several months remaining in the year.
    • Two other provisions of S.B. 901, although they will not have an immediate impact, could in the long run materially reduce the financial risk to California utilities of future wildfires.
  • First, the bill establishes an expert commission to determine how California should allocate the costs of catastrophic wildfires associated with utility infrastructure, and charges the commission to submit its recommendations by July 1, 2019. Specifically, the bill would require the commission “to examine issues related to catastrophic wildfires associated with utility infrastructure” and to make “recommendations as to changes to law that would ensure equitable distribution of costs among the affected parties.” The implication of this provision is that the legislature is seeking a permanent mechanism to ensure that wildfire-related costs are not borne exclusively by utility shareholders but rather are borne at least in part by commercial or government insurers, utility ratepayers or state taxpayers.
  • Second, the bill would require the state forestry board to adopt regulations implementing minimum fire safety standards applicable to lands designated as very high fire hazard severity zones, and would require the regulations to apply to the perimeters and access to all residential, commercial and industrial building construction within such zones after July 1, 2021. The provision could help to address the growing risk to utilities caused by expansion of settlements in areas of high wildfire risk.
  • Other provisions of S.B. 901 are far less material in their impact on the valuation of California’s utilities, but will nonetheless be of interest to investors. These include:
  • A prohibition on utilities recovering from ratepayers the compensation of their corporate officers.
  • A prohibition on electric utilities recovering from ratepayers the cost of penalties or fines (a similar ban was imposed on gas utilities following the San Bruno gas pipeline explosion).
  • A requirement that utilities conduct a safety culture review every five years.
  • A push to minimize outside contractors for fire prevention, mitigation and defense, favoring utility employees instead.
  • Certain limits imposed on companies acquiring California utilities, in particular limits on firing employees or reducing their compensation in the first 180 days following an acquisition.

©2018, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

  1. A caveat, however, is that we do not know the period of time over which these potential gains will be realized. In particular, we cannot predict when PCG will eventually settle the many claims against it, persuade the CPUC to allow recovery of a portion of these losses from ratepayers, and issue equity to offset the unrecovered amount. Based on the duration of the legal and regulatory proceedings stemming from PCG’s 2010 gas pipeline explosion in San Bruno, this process could extend over the next three to five years. Investors considering PCG stock must take into account this extended period of uncertainty, during which PCG stock could trade well below our estimate of its fair market value, diluting the annual rate of return that can be expected on the stock. 
  2. Third party liability claims for property damage could be brought against EIX under (i) California’s principle of inverse condemnation, which stipulates that a utility must compensate property owners for damage to their property caused by a utility’s assets, whether or not the utility was negligent in the operation or maintenance of those assets, or (ii) under the principle of tort liability in suits filed in state courts, in which case the utility would be liable for damages only if the plaintiff could prove that the damages suffered were caused by the utility’s negligence. The principle of inverse condemnation does not extend to third party liability claims for death, injury, and consequential damages (e.g., loss of wages or profits); these must be pursued under the principle of tort liability, requiring the plaintiff to prove negligence. 
  3. The principle of inverse condemnation does not extend to punitive damages; these must be pursued under the principle of tort liability. In punitive damages cases, the burden of proof is on the plaintiff, who must demonstrate that the defendant engaged in “willful misconduct,” a higher legal standard of negligence which has generally been defined as a conscious disregard of probable harm. 
  4. For a much more thorough discussion of inverse condemnation and the risk it poses for utilities, please see our note from December 5, CPUC Ruling Denying SRE Recovery of Forest Fire Costs Does Not Increase the Risks for California Utilities
  5. We used the insurance claims as an estimate of total property damage. While there are uninsured property damages, the vast majority of structures destroyed in the past fires were insured. Furthermore, the insurance claims include non-property damages, such as business interruption and the cost of replacement housing. We assuming the non-property portion of the insured damages is similar in size to the value of the uninsured property. 
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