CPUC Ruling Denying SRE Recovery of Forest Fire Costs Does Not Increase the Risks for California 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



December 5, 2017

CPUC Ruling Denying SRE Recovery of Forest Fire Costs

Does Not Increase the Risks for California Utilities

Portfolio Manager’s Summary

On Thursday, November 30, the California Public Utility Commission (CPUC) denied the application of SRE’s electric utility subsidiary, San Diego Gas & Electric, to recover costs incurred in settlements with plaintiffs in cases stemming from wildfires in 2007. The CPUC’s decision has been portrayed as imposing an asymmetrical risk on California’s utilities, requiring them to pay potentially unlimited damages under the principle of inverse condemnation, regardless of whether the utility was at fault, while denying them the ability to recover these damages from ratepayers.

We believe that this view reflects an incorrect understanding of the application of inverse condemnation to utilities in California. First, the strict liability of California’s utilities under the principle of inverse condemnation only applies in respect of property damage, and not to damages for injury or death or for lost wages or business revenues. Inverse condemnation does not create the potential, therefore, for unlimited liability. As in other states, plaintiffs in California may seek damages for injury or death, and lost wages or business revenues, but must do so by filing a lawsuit for negligent tort.

Second, California case law stipulates the conditions under which a utility may recover from ratepayers the damages paid for property losses under the principle of inverse condemnation. A utility found liable for property losses under the principle of inverse condemnation, but which was not negligent and operated its assets prudently, is allowed recovery from ratepayers of any damages paid in excess of its insurance. Even for property damage, therefore, the net exposure of a prudently managed utility under the principle of inverse condemnation is in fact highly limited.

Third, the CPUC’s decision in the 2007 wildfire case was consistent with California’s case law and regulatory principles: San Diego Gas & Electric, was found to have contributed through its negligence to the property losses for which it was settled under the principle of inverse condemnation and therefore was not allowed recovery from ratepayers. The decision does not alter the business risk of California’s utilities, or that of investors in holding their stock. Because the CPUC’s decision is consistent with prior law, it does not affect our view of the attractiveness of PCG at current prices. (For additional information and analysis of PCG’s exposure to the California wildfires and its current valuation, please see our notes of October 17, Upgrading PCG to Our List of Most Preferred Regulated Utility Stocks: The Stock Now Fully Discounts the Sonoma County Fires, and of November 27, Portfolio Changes: EXC, FE Added to Our Preferred List, XEL Removed; POR and SO Added to Concerns List, SCG Removed.)


Inverse Condemnation vs. Negligent Torts: A Brief Explanation

  • Inverse condemnation is a widely accepted principle applied to government entities, but in California, state courts have also applied inverse condemnation to investor owned public utilities.
    • This legal precedent having been established by the California courts, the CPUC must take the law as it is and apply inverse condemnation to regulated utilities.
    • The CPUC has no authority to change the law; this would require action by California’s state legislature or a decision by the California Supreme Court.
  • Inverse condemnation stems from the U.S. Constitution’s 5th Amendment, which protects citizens from “takings” by the government without compensation.
    • A taking is traditionally a seizure of private property by the government.
    • When a government entity damages property of a private citizen while acting on behalf of the public, the government has effectively “seized” private property.
      • An example of this occurred recently during Hurricane Harvey, when the U.S. Army Corp of Engineers released water from reservoirs, flooding homes nearby, in order to prevent greater harm if the reservoirs overflowed in an uncontrolled manner.
    • The principle of inverse condemnation was created by the courts to protect private citizens from such “takings” by requiring that the government entity compensate the private citizen for the damages to property.
  • Inverse condemnation is based on the principle that a private citizen should not bear the cost of damages that result from a service provided for the benefit of the public.
    • Under California law, utilities are allowed to recover from ratepayers damages paid in a lawsuit where the utilities were not at fault, but liable only due to the principle of inverse condemnation.
    • However, California’s utilities are not allowed to recover from ratepayers damages paid in a lawsuit in which the utilities were determined to be at fault, even if these damages were awarded under the principle of inverse condemnation.
  • To recover under an inverse condemnation claim, the plaintiff need only show that:
    • a) a government entity was the actor (or, in California, a public utility);
    • b) the actions of the government entity or California utility were the actual and proximate causes of the plaintiff’s injury; and
    • c) the plaintiff’s injury includes damage to property.
      • The principle of inverse condemnation applies only to the recovery of damages to property, and is not applicable to damages claimed for pain, suffering, injuries or death, nor to economic losses such as lost wages or business revenues.
  • In contrast, a regular lawsuit for a negligent tort requires the plaintiff to show:
    • a) a duty of care was required on the part of the defendant towards the plaintiff;
    • b) the defendant breached its duty towards the defendant – in other words, the defendant was negligent in exercising its duty of care (i.e. the defendant was at fault);
    • c) the defendant was the actual and proximate cause of the injury;
    • d) there was damage to the person or property of the plaintiff.
      • A lawsuit for negligent tort may seek recovery of all damages to the plaintiff, including property, as well as pain, suffering, injury, or death, and lost wages or revenues.
    • Note that many states require a showing of gross negligence by utilities before allowing recovery of damages, so California is less protective than other states even in regular damage claims, but that has always been the case.
  • Generally, plaintiffs will state all available claims when filing suit, including negligent tort and inverse condemnation.
    • All of the lawsuits filed against SDG&E in the 2007 wildfires likely contained claims of both negligence and inverse condemnation, and we would expect that claims filed against PG&E for the recent wildfires in Sonoma County to do so as well.

The CPUC’s Decision in the SDG&E Wildfire Case

  • On November 30th, the CPUC denied the application of SRE’s electric utility subsidiary, San Diego Gas and Electric (SDG&E), to recover from ratepayers $379 million of wildfire-related costs that exceed the utility’s insurance coverage.
    • SRE and the other California utilities, EIX and PCG, argued that because the recovery of damages under inverse condemnation does not require a demonstration of fault by the utilities, the utilities should be able to pass on the costs of any damages paid to ratepayers.
    • Disagreeing, the CPUC found that SRE was negligent in causing the fires and the resulting damages and, therefore, is not allowed to recover these damages from ratepayers.
  • In California, the CPUC has held that only “reasonable” costs may be passed onto ratepayers. Reasonable costs are only those that were “prudently incurred by competent management exercising the best practices of the era, and using well-trained, well-informed and conscientious employees who are performing their jobs properly.”
    • In other words, costs that result from a lack of reasonable care, or negligence, are not reasonable and may not be passed on to ratepayers.
  • Because SDG&E settled the claims arising from the 2007 fires, no determination of the prudency of the utility’s actions was ever made. The CPUC proceedings, therefore, made a determination of the reasonableness of the utility actions that led to the 2007 wildfires.
    • The proceedings allowed the utility and other intervenors to present evidence as to the cause of the fires and the role of the utility’s actions and behavior in causing the fire.
    • The burden of proof was on SDG&E to prove by a “preponderance of the evidence” that their actions were prudent.
    • The CPUC determined that SDG&E was negligent in causing the fire and it would not be allowed to recover the excess expenses from ratepayers.
  • We believe this decision is correct as a matter of policy: approving recovery for settlements under inverse condemnation without a determination of fault would encourage utilities to settle cases under the principle of inverse condemnation even when they are at fault in order to pass costs onto ratepayers.
  • More importantly, we believe the decision is consistent with California’s prior case law with respect to inverse condemnation, and therefore do not see it as increasing the risk to California utilities from wildfires.
    • A utility can still protect itself when it believes that it was not negligent by fully litigating those cases in court to reach a determination of fault.
    • In court, the burden of proof is on the plaintiff to prove negligence, rather than on the utility in a CPUC proceeding to recover from ratepayers, so utilities that believe they are not at fault are better off fully litigating claims in court.
    • If a determination is made in court that the utility was not negligent and damages were only rewarded due to inverse condemnation, the CPUC will allow recovery of the costs from ratepayers.
  • As a result of this CPUC decision, we expect PCG will be more willing to fully litigate lawsuits resulting from the recent wildfires, so as to reach a determination of fault.

The Investment Case for PCG

  • The drop in PCG’s market cap since the Sonoma fires far outweighs their potential impact on the value of the stock, even in the worst case.
    • PCG’s loss in market cap of ~$8.5 billion would imply the market is expecting $13 billion in pre-tax losses stemming from the fire.
    • We estimate PCG’s maximum exposure from all fires, including property and economic losses, life and limb and the cost of the firefighting to be ~$7.5-$9.5 billion pre-tax.
    • After insurance recoveries and tax deductions, we estimate that these damages might cost PCG ~$4-$5 billion.
    • This would suggest the potential for ~13% to 16% upside on PCG’s current market cap of $27.8 billion, even in a worst-case scenario.
  • In fact, the worst case is unlikely, implying higher probable upside. 
    • While PCG may be held liable for property damage caused by its equipment under the strict liability standard of California’s inverse condemnation principle, it will only be held liable for consequential damages – economic losses and loss of life and limb – if it was negligent.
    • PCG would thus face the maximum loss of $7.5-9.5billion only if PCG caused all 25 fires and was negligent in all 25 cases.
    • If PCG was not negligent, and had to pay only $5 billion for property damage, after insurance coverage and tax deductions, we estimate there would be ~20% upside in the stock.
  • If PG&E was not negligent, it may be capable of recovering a much larger portion of any damages than the market expects.
    • As noted above, in cases where PCG’s equipment caused a fire, PCG could be held liable for property damages under California’s legal principle of inverse condemnation regardless of whether the company was negligent.
    • But if a court or the CPUC makes a finding that PCG was not negligent, the principle of inverse condemnation implies that PCG would be able to recover from ratepayers the damages paid out.
  • PCG’s is a fundamentally attractive franchise with some of the strongest prospective rate base growth in the country and a regulatory framework that minimizes regulatory lag.  
    • We expect PCG to realize ~9.5% compound annual growth in electric plant rate base over 2016-2021, as against an industry average of only 6.5% — suggesting the potential for above-average long run returns even if the stock recover were to recover its pre-fire valuation.
    • Furthermore, should tax reform pass in a form similar to what passed both of the houses of Congress, PCG would be one of the biggest beneficiaries among regulated utilities, with a 4.5-5% boost to rate base growth through 2019 versus the status quo. See our note from December 4, Tax Reform and Rate Base Growth: Which Utilities Benefit Most?.

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

Source: SSR analysis

©2017, 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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