EIX, PCG, SRE: How California’s Cost of Capital Proceeding Will Materially Mitigate Wildfire Risk

Eric Selmon
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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

______________________________________________________________________________

April 24, 2019

EIX, PCG, SRE:

How California’s Cost of Capital Proceeding Will Materially Mitigate Wildfire Risk

In cost of capital applications filed with the CPUC on Monday, PG&E, SCE and SDG&E requested wildfire cost recovery premiums ranging from 340 to 600 on top of their base ROEs. The resulting allowed ROEs (16.0% for PG&E, 16.6% for SCE and 14.3% for SDG&E) would add over $2.0 billion annually to customer bills.

We believe the Californian utilities have a strong legal case, and that the aggressive stance of their cost of capital applications will increase the legal pressure on the CPUC to address utility concerns regarding their access to capital. They will also prod Governor Newsom and the California legislature to explore lower cost ways to do so by mitigating wildfire cost recovery risk. Either outcome would substantially enhance the equity value of California’s utilities.

  • In cost of capital applications filed with the California Public Utilities Commission (CPUC) on Monday, Pacific Gas and Electric (PG&E) requested a 500 basis point adder to its base ROE to offset wildfire cost recovery risk, Southern California Edison (SCE) requested a 600 basis point adder and San Diego Gas and Electric (SDG&E) requested a 340 basis point adder.
  • The utilities’ requests would increase PG&E’s allowed ROE to 16.0% from 10.25% previously, a 56% increase; SCE’s allowed to ROE to 16.6% from 10.3% previously, a 61% increase; and SDG&E’s allowed ROE to 14.3% from 10.2% previously, a 40% increase.
  • We believe the Californian utilities have a strong legal case, based on longstanding legal precedent: the law requires that utilities be allowed to earn a reasonable return, defined as a one that reflects the returns required by investors in companies in the same region and facing comparable risks. Moreover, the utilities’ aggressive stance in their cost of capital applications will increase the legal pressure on the CPUC to address utility concerns regarding their access to capital. They will also prod Gov. Newsom and the California legislature to explore lower cost ways to do so by mitigating wildfire cost recovery risk.
  • Citing the Supreme Court decision in Bluefield Water Works, the utilities point out that the CPUC under law must allow regulated utilities the opportunity to earn a “return to the equity owner … commensurate with returns on investments in other enterprises having corresponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and attract capital.”
  • Pointing to the bankruptcy of PG&E, the largest investor owned utility in the state, and credit downgrades at SCE and SDG&E on wildfire cost recovery concerns, the utilities argue that California has failed to meet this obligation.
  • Citing the Supreme Court decision in Hope Natural Gas, the utilities point out that, “A public utility is entitled to such rates as will permit it to earn a returnequal to that generally being made at the same time and in the same general part of the country on investments in other business undertakings which are attended by corresponding risks and uncertainties.
  • To a degree unparalleled in other states, California’s utilities are exposed to catastrophic wildfire risk. Moreover, due to climate change and other factors, the risk and size of wildfires is increasing dramatically. Given California’s unusual application of the principle of inverse condemnation to investor owned utilities, the financial consequences of such fires are borne by utility shareholders. If California’s utilities are to earn an ROE similar to that of utilities in other states, they must be granted a materially higher allowed ROE to offset these costs.
  • Finally, citing the Supreme Court decision in Duquesne Light Co., the utilities point out that the CPUC’s failure to allow such returns would constitute an unconstitutional taking: as the court’s opinion states, if “the rate does not afford sufficient compensation, the State has taken the use of utility property without paying just compensation and so violated the Fifth and Fourteenth Amendments”
  • Because utilities in other states are far less exposed to the risk of catastrophic wildfires, and as only one other state applies the inverse condemnation standard of strict liability to investor owned utilities, we believe California’s utilities can make a strong case for a sizeable ROE premium to offset these risks.
    • Absent such a premium, the utilities argue, their ability to earn their base allowed ROE will in the long term be repeatedly compromised by large, recurring wildfire liabilities.
  • Importantly, the cost of capital applications of the three electric utilities would imply significant increases in average rates, adding over $2.0 billion to annual customer bills:
  • PG&E’s cost of capital application is consistent with an $0.8 billion increase in annual revenues and would drive a 6.4% increase in its average system rate and a 7.1% increase in its average residential rate.
  • SCE’s cost of capital application is consistent with a $1.2 billion increase in annual revenues and would drive, we estimate, a 9.0% increase in its average system rate and an 11.9% increase in its average residential rate.
  • SDG&E’s cost of capital application would drive a 4.0% increase in its average system rate and a 4.5% increase in its average residential rate.
  • We believe the strength of the utilities’ legal arguments for an increase in their allowed returns, combined with consequent substantial increase in customer bills, will put significant incremental pressure on the CPUC, Governor Newsom and the California legislature to craft solutions to reduce utilities’ wildfire cost recovery risk and avoid significant rate increases.
  • Alternatives that might reduce the need for large wildfire risk premiums to be incorporated in utilities’ allowed ROE, and which therefore might avoid the consequent increase in utility rates, have been proposed by the Southern California Edison in its cost of capital application[1] and by Governor Newsom’s strike force in its April 12th report, Wildfires and Climate Change: California’s Energy Future.[2] These can be summarized as follows:
  • Changing the standard for plaintiffs to recover damages from utilities under the principle of inverse condemnation to one requiring the demonstration of utility negligence;
  • Adopting clear prudential standards for the operation of the grid which, if complied with by the utility, would constitute prima facie evidence of the absence of negligence, and establishing a regular procedure for the CPUC to make its determination of prudence in advance of, rather than subsequent to, the occurrence of wildfires; and
  • Creating a fund to bridge the gap between a utility’s payment of wildfire damages and the CPUC’s determination that the damages may be recovered from ratepayers.
  • Alternatively, if California’s over-arching objective is to ensure that the wildfire damages caused to individual property owners by utility assets are socialized among the utility’s customers generally, it would make sense to streamline the application of inverse condemnation to investor owned utilities so that these are treated just as publicly owned utilities are; this would imply that any wildfire liabilities imposed on investor owned utilities under the principle of inverse condemnation would be automatically recoverable in rates without CPUC review.
  • In summary, the cost of capital applications point to reduced risk for investors in California’s utilities. California’s utilities have a very strong legal case to support their application for substantial wildfire risk premiums to be added to their base allowed ROEs. The strength of the utilities’ legal position, we believe, will either force the CPUC to grant substantial rate relief or cause the state government to mitigate utilities’ exposure to wildfire cost recovery risk. Either outcome would substantially enhance the equity value of California’s utilities.

Details

Summary of Proposals

Complying with the CPUC’s decision in 2017 to postpone review of the cost of capital for California’s gas and electric utilities, on Monday California’s three principal investor owned electric utilities, Pacific Gas & Electric (PG&E), Southern California Edison (SCE) and San Diego Gas & Electric (SDG&E) filed cost of capital applications with California Public Utilities Commission (CPUC) requesting aggregate revenue increases of over $2.0 billion annually until such time as their exposure to wildfire cost recovery risk is a materially mitigated by regulatory or legislative changes. We summarize the utilities’ requests below and in Exhibits 1-3.

Exhibit 1: Cost of Capital Applications Made by PG&E, SCE and SDG&E

 Source: Company filings, SSR analysis

Exhibit 2: Current & Proposed Allowed Exhibit 3: Requested Increases in Average

ROEs Rates

 

Source: Company filings, SSR analysis Source: Company filings, SSR analysis

Pacific Gas & Electric

  • PG&E requests an increase of 56% in its allowed ROE, from 10.25% currently to 16.0% in 2020. PG&E breaks down its requested allowed ROE of 16.0% into a base ROE of 11.0% and an additional charge of 5.0% to offset wildfire cost recovery risk. PG&E characterizes the latter charge as temporary, stating, “If the Commission and the Legislature implement meaningful and effective actions to reduce the extent of the wildfire risk-related challenges and structural problems facing customers, the Company, and its shareholders, PG&E proposes to amend this application with an updated cost of capital.”
  • PG&E does not seek an adjustment to its allowed ratio of common equity to rate base, proposing that this remain at 52%. Noting that its GAAP equity has fallen below this level, due to non-cash charges attributable to damage claims against it arising from the 2017-2018 northern California wildfires, PG&E requests that the CPUC “exclude the non-cash charges in determining PG&E’s capital structure for ratemaking purposes.”
  • Based on its requested increases in allowed ROE and unchanged equity ratio, PG&E is targeting an increased in allowed earnings as a percentage of rate base (equity ratio x allowed ROE) from 5.3% of rate base currently to 8.3% in 2020, an increase of 56%.

Southern California Edison

  • SCE requests an increase of 61% in its allowed ROE, from 10.3% currently to 16.6% in 2020. SCE breaks down its requested allowed ROE of 16.6% into a base ROE of 10.6% and an additional charge of 6.0% to offset wildfire cost recovery risk. Like PG&E, SCE characterizes the latter charge as temporary, stating “that SCE would seek to modify or remove [it] upon a material change in SCE’s wildfire cost recovery risk due to mitigating regulatory or legislative changes.”
  • SCE is also seeking a 400 basis point increase in its allowed ratio of common equity to rate base from 48% currently to 52%, “in order to improve the credit metrics used by the credit rating agencies to assess SCE’s financial health.” SCE was downgraded by both Standard & Poor’s and Moody’s in the first quarter and is now rated BBB/Baa2.
  • Based on its requested increases in both allowed ROE and equity ratio, SCE is targeting an increased in allowed earnings as a percentage of rate base (equity ratio x allowed ROE) from 4.9% of rate base currently to 8.6% in 2020, an increase of 75%.

San Diego Gas & Electric

  • SDG&E requests an increase of 40% in its allowed ROE, from 10.2% currently to 14.3% in 2020. SDG&E breaks down its requested allowed ROE of 14.3% into a base ROE of 10.9% and an additional charge of 3.4% to offset wildfire cost recovery risk.
  • SDG&E is also seeking a 400 basis point increase in its allowed ratio of common equity to rate base from 52% currently to 56%, to better reflect the average of “its actual capital ratios since 2013.”
  • Based on its requested increases in both allowed ROE and equity ratio, SDG&E is targeting an increased in allowed earnings as a percentage of rate base (equity ratio x allowed ROE) from 5.3% of rate base currently to 8.0% in 2020, an increase of 51%.

The cost of capital applications of the three electric utilities would imply significant increases in average rates:

  • PG&E’s cost of capital application is consistent with an $0.8 billion increase in annual revenues and would drive a 6.4% increase in its average system rate and a 7.1% increase in its average residential rate.
  • SCE’s cost of capital application is consistent with a $1.2 billion increase in annual revenues and would drive, we estimate, a 9.0% increase in its average system rate and an 11.9% increase in its average residential rate.
  • SDG&E’s cost of capital application would drive a 4.0% increase in its average system rate and a 4.5% increase in its average residential rate.

Legal Basis of Proposals

The utilities’ request for higher allowed ROEs and equity ratios rests on firm legal ground and is likely to put significant incremental pressure on the CPUC, Governor Newsom and the California legislature to craft solutions to reduce the wildfire risk faced by the utilities.

Each of PG&E’s, SCE’s and SDG&E’s cost of capital applications cites three key Supreme Court cases that establish the legal standards for setting a reasonable rate of return in regulated utility rate cases. SDG&E’s filing provides the most complete summary, first citing Bluefield Water Works v. Public Service Commission of West Virginia as setting for the standard for measuring just and reasonable rates:

“A public utility is entitled to such rates as will permit it to earn a return upon the value of the property which it employs for the convenience of the public equal to that generally being made at the same time and in the same general part of the country on investments in other business undertakings which are attended by corresponding risks and uncertainties . . . The return should be reasonably sufficient to assure confidence in the financial soundness of the utility, and should be adequate, under efficient and economical management, to maintain and support its credit, and enable it to raise the money necessary for the proper discharge of its public duties.” [Emphasis added]

(Bluefield Water Works v. Public Service Comm’n, 262 US 679 (1923))

SDG&E then cites Fed. Power Commission v. Hope Natural Gas as reinforcing the financial soundness and capital attraction principles of the Bluefield decision and setting the standard for determining whether set rates satisfy utility investors’ constitutional interests:

“From the investor or company point of view it is important that there be enough revenue not only for operating expenses but also for the capital costs of the business. These include service on the debt and dividends on the stock . . . By that standard the return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and attract capital.” [Emphasis added]

(Fed. Power Comm’n v. Hope Natural Gas, 320 US 591 (1944)

These two decisions have formed the legal basis of ratemaking decisions throughout the U.S. over the past 75 years. They have been reaffirmed multiple times, with notably strong language in Duquesne Light Co. v. Barasch in 1989, where the Supreme Court stated that a utility cannot be limited to a charge for the use of its property that is so low that it is considered “confiscatory” and an unconstitutional taking. If “the rate does not afford sufficient compensation, the State has taken the use of utility property without paying just compensation and so violated the Fifth and Fourteenth Amendments” (Duquesne Light Co. v. Barasch488 U.S. 299, 307-312 (1989).

What Will Be the Impact of the Utilities’ Cost of Capital Proposals?

The utilities’ proposed increases in allowed ROE serve to mitigate the risk of wildfire cost recovery. This risk arises from the combination of (i) the frequency of catastrophic wildfires in California and (ii) California’s legal and regulatory framework for determining utilities’ liability for property damage caused by their power grids. Currently, this framework has the following critical features:

  1. Utilities’ strict liability (i.e., regardless of utility fault) for property damage caused by utility equipment or operations (“inverse condemnation”);
  2. Utilities’ right to recover damages paid under the principle of inverse condemnation only following a separate CPUC determination of prudency.
  3. The differing standard for liability and recovery expose utilities to the following risks:
    • Recovery of wildfire liabilities will be delayed until all liability claims have been paid and the CPUC has delivered its decision on recoverability – a process that can take years
    • Wildfire liabilities will be unrecoverable if the CPUC determines with 20-20 hindsight that the utility’s imprudent management of its assets or operations contributed to the fire, or allows its decision to be influenced by the political cost of allowing recovery from ratepayers.
    • Catastrophic wildfire costs will be unrecoverable if they stem from a wildfire where the utility was indeed at fault – even if the failure to recover such costs should undermine the financial stability of the utility.

These features, when combined with the rising risk of wildfires and the increasing size of the damages caused by these fires, imply massive financial risks to utilities. An increase in utilities’ allowed earnings sufficient to offset expected future wildfire liabilities would materially mitigate the risks set out in point 3 above: the risk of delay in the recovery of wildfire liabilities, and the risk that recovery will be denied altogether. Both are mitigated by the cushion of incremental earnings designed to offset in the long run the expected amount of such liabilities. The residual risk borne by utilities would be that of illiquidity, caused by catastrophic wildfire losses occurring before the accumulation of the incremental earnings would have created a capital buffer to absorb the losses. The ability of utilities to borrow against the future stream of incremental earnings might allow them to absorb the growing risk.

While increased allowed ROEs would succeed in compensating utility investors for the increased risks they face, as public policy the utilities’ proposals suffer from important weaknesses. First, the utilities’ requested ROE increases would raise customer bills by over $2.0 billion annually. Second, because the incremental cash flow to absorb wildfire losses is to be collected in the form of allowed earnings, taxes must be paid on these earnings. This would not be the case, for example, if a wildfire cost recovery charge were collected from ratepayers to fund a prudential reserve against future wildfire losses. Third, no assurance is provided that the incremental earnings requested by the utilities will be retained as a buffer against future losses, rather than paid out as dividends. Finally, no mechanism exists to pool the additional collections, as might be desirable if utilities in different regions were subject to increased wildfire risk at different times.

We believe the strength of the utilities’ legal arguments for an increase in their allowed returns, combined with consequent substantial increase in customer bills, will put significant incremental pressure on the CPUC, Governor Newsom and the California legislature to craft alternative solutions to reduce utilities’ wildfire cost recovery risk and avoid significant rate increases.

One such option is to adopt a combination of proposals put forth by the Southern California Edison in its cost of capital application[3] and by Governor Newsom’s strike force in its April 12th report, Wildfires and Climate Change: California’s Energy Future.[4] These can be summarized as follows:

    • Changing the standard for plaintiffs to recover damages from utilities under the principle of inverse condemnation to one requiring the demonstration of utility negligence;
    • Adopting clear prudential standards for the operation of the grid which, if complied with by the utility, would constitute prima facie evidence of the absence of negligence, and establishing a regular procedure for the CPUC to make its determination of prudence in advance of, rather than subsequent to, the occurrence of wildfires; and
    • Creating a fund to bridge the gap between a utility’s payment of wildfire damages and the CPUC’s determination that the damages may be recovered from ratepayers.

Alternatively, if California’s over-arching objective is to ensure that the wildfire damages caused to individual property owners by utility assets are socialized among the utility’s customers generally, it would make sense to streamline the application of inverse condemnation to investor owned utilities so that these are treated just as publicly owned utilities are; this would imply that any wildfire liabilities imposed on investor owned utilities under the principle of inverse condemnation would be automatically recoverable in rates without CPUC review.

In summary, the cost of capital applications point to reduced risk for investors in California’s utilities. California’s utilities have a very strong legal case to support their application for substantial wildfire risk premiums to be added to their base allowed ROEs. The strength of the utilities’ legal position, we believe, will either force the CPUC to grant substantial rate relief or cause the state government to mitigate utilities’ exposure to wildfire cost recovery risk. Either outcome would substantially enhance the equity value of California’s utilities.

Exhibit 4: Heat Map: Preferences Among Utilities, IPP and Clean Technology

Source: SSR analysis

©2019, 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. See Testimony Supporting Southern California Edison’s Application for Authority to Establish Its Authorized Cost of Capital for Utility Operations for 2020 and to Reset the Annual Cost of Capital Adjustment Mechanism, pages 44-45, available at http://www3.sce.com/sscc/law/dis/dbattach5e.nsf/0/B5B462A79CF49F4D882583E4006F8BD4/$FILE/A1904XXX-SCE 2020 COC EXH. SCE-01 Testimony-Various SCE Witnesses.pdf. There Southern California Edison states that, “One of the most important things that the Commission can do is to establish a clear, durable, and repeatable process for assessing the prudency of IOU wildfire operations that enables timely cost recovery of prudently-incurred, wildfire-related expenses. This includes payments to settle claims where utility facilities are alleged to be a significant cause of a wildfire ignition when those payments exceed the limits of the utility’s insurance. The Commission has the authority to address the continuing wildfire crisis by implementing a cost recovery framework that is more aligned with the proven model adopted in AB 57,” legislation adopted by California to clarify the criteria for utilities’ recovery of energy procurement costs following the California energy crisis of 2000-2001. As SCE explains, “The Assembly Bill (AB) 57 energy procurement process successfully restored confidence in the regulatory construct that was fractured during the Energy Crisis, by providing for Commission approved energy procurement plans with upfront, achievable standards and timely, robust reviews to ensure compliance with those approved plans.” 
  2. Governor Newsom’s strike force, Wildfires and Climate Change: California’s Energy Future, pages 34-39. 
  3. See Testimony Supporting Southern California Edison’s Application for Authority to Establish Its Authorized Cost of Capital for Utility Operations for 2020 and to Reset the Annual Cost of Capital Adjustment Mechanism, pages 44-45, available at http://www3.sce.com/sscc/law/dis/dbattach5e.nsf/0/B5B462A79CF49F4D882583E4006F8BD4/$FILE/A1904XXX-SCE 2020 COC EXH. SCE-01 Testimony-Various SCE Witnesses.pdf. There Southern California Edison states that, “One of the most important things that the Commission can do is to establish a clear, durable, and repeatable process for assessing the prudency of IOU wildfire operations that enables timely cost recovery of prudently-incurred, wildfire-related expenses. This includes payments to settle claims where utility facilities are alleged to be a significant cause of a wildfire ignition when those payments exceed the limits of the utility’s insurance. The Commission has the authority to address the continuing wildfire crisis by implementing a cost recovery framework that is more aligned with the proven model adopted in AB 57,” legislation adopted by California to clarify the criteria for utilities’ recovery of energy procurement costs following the California energy crisis of 2000-2001. As SCE explains, “The Assembly Bill (AB) 57 energy procurement process successfully restored confidence in the regulatory construct that was fractured during the Energy Crisis, by providing for Commission approved energy procurement plans with upfront, achievable standards and timely, robust reviews to ensure compliance with those approved plans.” 
  4. Governor Newsom’s strike force, Wildfires and Climate Change: California’s Energy Future, pages 34-39. 
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