California’s Senate Bill 901 Could Materially Reduce Shareholder Exposure to Wildfire Risk, but 2017 Exposure for PCG is All About the Cap

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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

______________________________________________________________________________

August 29, 2018

California’s Senate Bill 901 Could Materially Reduce Shareholder Exposure to Wildfire Risk, but 2017 Exposure for PCG is All About the Cap

The Wildfire Preparedness and Response Conference Committee of the California State Legislature was established in July at the instigation of Governor Brown and the state’s legislative leaders to strengthen wildfire prevention efforts, establish a framework for determining responsibility for catastrophic wildfires, and fairly allocate their cost. Late on August 28th, the Committee released the final version of Senate Bill 901, the legislative vehicle for these proposed reforms. If passed by the Legislature before the current legislative session ends on August 31st, Senate Bill 901 would materially strengthen the position of California’s utilities in securing recovery from ratepayers of catastrophic wildfire-related costs, including damages paid by utilities to third parties in compensation for their losses. This note summarizes the key provisions of the revised bill and assesses their implications. We believe the bill is especially positive for PCG due to the cap it would set on the unrecoverable 2017 wildfire expenses, although the exact limit is yet to be determined. The bill should also reduce the valuation discount being applied to the California utilities for future catastrophic wildfire risk as it increases the probability of at least partial recovery of future wildfire costs and allows for the securitization of those costs.

  • To frame the implications of S.B. 901, it is 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 PCG, 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 PCG 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 PCG 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 the 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 this could remain as an unknown for an extended period of time. A strategy that could help reduce the uncertainty for investors would be for PCG file for recovery of even a small portion of costs as soon as practical to force a determination of the cap by the CPUC.
      • Despite this ambiguity, the existence of a legal limit on unrecoverable costs for the 2017 fires, established with the intent of preserving a utility’s ability “to provide adequate and safe service,” is itself an important safeguard against the more extreme positions taken by California’s ratepayer advocates.
  • 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.
  • To help frame how Senate Bill 901 would change the risks facing utilities for fires in 2019 and beyond in comparison to current law, we provide below an assessment of three different scenarios:
  • Scenario 1: A utility is liable for wildfire damage under inverse condemnation, but a court in a tort liability case determines that this damage was not caused by the utility’s negligence.
    • Current law: all damages likely recoverable
    • S.B. 901: all damages likely recoverable, but there could be some disallowances if the utility was deemed to be partly responsible in any way. Any recoverable damages could be recovered through securitization with minimal delay.
  • Scenario 2: Utility settles damage claims out of court; no determination is made by a court as to the utility’s negligence.
  • Current law: the utility may recover its costs from ratepayers if it can demonstrate to the CPUC that its actions were consistently prudent. Failure to do so may result in the CPUC’s denial of any recovery. The utility thus faces a binary, all-or-nothing risk.
  • S.B. 901: the utility could recover as much as all its costs, but more likely will be allocated some of the blame and thus denied recovery of some of its costs. How much blame would depend on the extent of the utility’s negligence and regulatory violations, offset by exculpating factors such weather and third-party actions.
  • Scenario 3: Utility found negligent in court.
    • Current law: no recovery.
    • S.B. 901: the utility could still receive partial recovery if factors beyond the utility’s control, such as the weather or third-party actions, contributed to the wildfire damage, or if the negligence of the utility was minor or an isolated incident.

©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.

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