PCG, EIX, SRE: Why California Will Engage with the State’s Utilities to Contain Wildfire Risk & Restore Utility Credit

gcopley
Print Friendly
Share on LinkedIn0Tweet about this on Twitter0Share on Facebook0

______________________________________________________________________________

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

______________________________________________________________________________

February 28, 2018

PCG, EIX, SRE:

Why California Will Engage with the State’s Utilities to Contain Wildfire Risk & Restore Utility Credit

Our fundamentally positive view of the value of PG&E (set out in our research report of Feb. 11, PG&E: Valued Across a Range of Scenarios, We See Significant Upside & Little Downside) reflects our opinion that California must act (i) to contain the risk of future catastrophic wildfires and (ii) to ensure that the state’s utilities have access to the capital they need to operate, maintain and harden California’s energy delivery infrastructure. In this note we explain why we hold this view, describe its implications for the likely direction of state policy, and assess the impact on the value of PG&E’s utility assets. We also explain the limits on state action imposed by the PG&E’s bankruptcy proceeding and the regulatory compact between utility and state.

Portfolio Manager’s Summary

  • Our positive assessment of the long term value of PG&E Corp. reflects our view that California cannot tolerate a recurrence of the catastrophic wildfire damage it has suffered over the last two years, and that the state will act, in tandem with the state’s investor owned utilities, to bring this risk under control.
  • In addition, California cannot long endure a situation where the state’s utilities lack access to the capital they require to operate, maintain and harden California’s energy delivery infrastructure.
  • We believe it inevitable, therefore, that California will act (i) to contain the risk of future catastrophic wildfires and (ii) to ensure that all the state’s investor owned utilities have access to the capital markets.
  • This view reflects:
  • the pressing need to contain the risk catastrophic wildfires, whose cost, if recurring, exceeds the capacity of the state’s utilities, ratepayers and taxpayers to absorb;
  • the financial vulnerability of the state’s investor owned utilities to wildfire risk, given the scale of the damages and utilities’ strict liability for property damages from wildfires under California’s principle of inverse condemnation;
  • the critical importance of California’s electric and gas transmission and distribution systems;
  • the risk to this energy infrastructure that wildfire risk will limit utilities’ access to the capital market, starving the state’s energy delivery system of the capital investment it requires;
  • the reluctance of the state to assume the responsibility and risk of managing the power grid itself, and its desire to avoid the high price of municipalization, and
  • the high probability, therefore, of an agreement that commits the state’s utilities to fire harden their electricity grids in exchange for the state providing the regulatory or financial support these utilities require to meet their capital needs.
  • In the case of PG&E, such an agreement could include:
  • the sale (or segregation into distinct subsidiaries) of those of PG&E’s assets that historically have not caused wildfires, including PG&E’s gas utility and power generation assets, thereby insulating these assets from the financial consequences of any fire caused by PG&E’s electricity grid;
  • increased and accelerated investment by PG&E in wildfire mitigation, and the definition of objective metrics to monitor PG&E’s progress in reducing wildfire risk;
  • a commitment by the CPUC to use the power granted it by Senate Bill 901 to limit the scale of PG&E’s future, unrecoverable wildfire liabilities; and
  • the sale of PG&E’s electric transmission and distribution assets to a more reliable and trusted operator prepared to commit the capital necessary to fire harden the grid or, alternatively, a radical restructuring of PG&E’s board, senior management and asset portfolio so as to enable the company’s re-entry into the capital markets.
  • By contrast, PG&E’s current share price appears to assign higher probabilities to fundamentally different and highly unfavorable outcomes, including the government’s failure to address wildfire risk and its implications for utilities access’ to capital, or the government addressing these risks through the confiscatory municipalization of utility assets.
  • We place very low probability on California confiscating PG&E’s utility assets. While in a regular takings case compensation is based on fair market value, utilities enjoy additional protections due to their status as “public utilities,” regulated monopolies with an obligation to serve all comers at fair and reasonable rates. In setting utility rates, public utility commissions must allow utilities the opportunity to recover their prudently incurred operating costs and capital investments, with a reasonable return thereon. Since the capital invested in PG&E’s T&D business has already been determined to be prudent, PG&E must be allowed to recover that investment if the state should choose to seize it. Otherwise, municipalization becomes an end run around the state’s obligations to the utility under the regulatory compact.
  • Similarly, the failure to address wildfire risk and its implications for utilities’ access to capital is an untenable strategy if the state wishes to ensure the reliable delivery of energy to the 16 million people living in PG&E’s service territory, let alone achieve the public policy goals around climate change that rely on utility action.  The physical integrity of northern California’s energy delivery system must be maintained; absent municipalization, the utility that owns these assets (or its successors) must have access to the capital required to operate, maintain and harden its electric and gas delivery networks.
    • Furthermore, state inaction on wildfire risk would carry a material political cost, due not only to the extent of wildfire damage but also to required increases in electricity rates, as utilities’ allowed returns on capital would have to rise dramatically to reflect the risk to investors, and utilities would seek to recover from ratepayers the cost of wildfire damages not attributable to their negligence.
  • Given these considerations, we assign a very low probability to the more negative scenarios that appear to inform the consensus view implied in the share price, while assigning a much higher probability to the scenarios that restore the financial stability of PG&E and the rest of California’s investor owned utilities.

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

Source: SSR research and analysis

Details

Why California Must Engage with Its Utilities to Contain Wildfire Risk

Our positive assessment of the long term value of PG&E Corp. (PCG) reflects our view that California cannot tolerate a recurrence of the catastrophic wildfire damage it has suffered over the last two years, and that the state will act, in tandem with the state’s investor owned utilities, to bring this risk under control. In addition, California cannot long endure for any extended period a situation where the state’s utilities lack access to the capital they require to operate, maintain and harden California’s energy delivery infrastructure. We believe it inevitable, therefore, that California will act (i) to contain the risk of future catastrophic wildfires and (ii) to ensure that all the state’s investor owned utilities have access to the capital markets.

This view reflects:

  • the pressing need to contain the risk catastrophic wildfires, whose cost, if recurring, exceeds the capacity of the state’s utilities, ratepayers and taxpayers to absorb;
  • the financial vulnerability of the state’s investor owned utilities to wildfire risk, given the scale of the damages and utilities’ strict liability for property damages from wildfires under California’s principle of inverse condemnation;
  • the critical importance of California’s electric and gas transmission and distribution systems;
  • the risk to this energy infrastructure that wildfire risk will limit utilities’ access to the capital market, starving the state’s energy delivery system of the capital investment it requires;
  • the reluctance of the state to assume the responsibility and risk of managing the power grid itself, and its desire to avoid the high price of municipalization, and
  • the high probability, therefore, of an agreement that commits the state’s utilities to fire harden their electricity grids in exchange for the state providing the regulatory or financial support these utilities require to meet their capital needs.

Given the above, we retain high confidence that an agreement will be reached between PG&E, politicians and regulators that restores the utility’s access to the capital markets and protects the integrity of its electric and gas delivery networks.  A similar resolution, we believe, is likely to be reached with California’s investor owned utilities generally. In the case of PG&E, this agreement could include:

  • the sale (or segregation into distinct subsidiaries) of those of PG&E’s assets that historically have not caused wildfires, including the utility’s underground gas transmission and distribution network and its power generation assets, thereby insulating these assets from the financial consequences of any fire caused by PG&E’s electricity grid;
  • increased and accelerated investment by PG&E in wildfire mitigation, and the definition of objective metrics to monitor PG&E’s progress in reducing wildfire risk;
  • a commitment by the CPUC to use the power granted it by Senate Bill 901 to limit the scale of PG&E’s future, unrecoverable wildfire liabilities; and
  • the sale of PG&E’s electric transmission and distribution assets to a more reliable and trusted operator prepared to commit the capital necessary to fire harden the grid or, alternatively, a radical restructuring of PG&E’s board, senior management and asset portfolio so as to enable the company’s re-entry into the capital markets.

A worst case scenario exists, in which there is no change to state wildfire policy or utility regulation, and PG&E is forced undertake the investment required to fire harden its electric grid while facing the risk of recurring wildfires and catastrophic wildfire damage. We believe this to be a low probability outcome, however, and if it materializes it will be of short duration. Due to its continued exposure to wildfire risk, PG&E in this scenario would be unlikely to secure access to the capital it needs to operate, maintain and harden its grid. Bear in mind that the damage caused by the 2017-2018 wildfires attributable to PG&E equipment is estimated at some $25 billion, more than the net book value PG&E’s of electric transmission and distribution rate base; what allowed rate of return on rate base what compensate for this outsized risk?

Under these circumstances, we believe it more likely that PG&E’s electricity grid (or, possibly, those sections most vulnerable to wildfires) would be taken over by the state of California. Regulatory law and applicable precedents suggest that the compensation to PG&E’s shareholders in the event of municipalization would be set at the net book value of the assets taken over by the state. State ownership would ensure access to the capital required to maintain and fire harden the network, while the state could contract with a reputable utility to maintain and operate the system, much as PSE&G has been contracted by New York’s Long Island Power Authority to manage Long Island’s power grid.

By contrast, PG&E’s current share price appears to assign higher probabilities to fundamentally different and highly unfavorable outcomes, including the government’s failure to address wildfire risk and its implications for utilities access’ to capital, or the government addressing these risks through the confiscatory municipalization of utility assets.

We place very low probability on California confiscating PG&E’s utility assets. While in a regular takings case compensation is based on fair market value, utilities enjoy additional protections due to their status as “public utilities,” regulated monopolies with an obligation to serve all comers at fair and reasonable rates. In setting utility rates, public utility commissions must allow utilities the opportunity to recover their prudently incurred operating costs and capital investments, with a reasonable return thereon. Since the capital invested in PG&E’s T&D business has already been determined to be prudent, PG&E must be allowed to recover that investment if the state should choose to seize it. Otherwise, municipalization becomes an end run around the state’s obligations to the utility under the regulatory compact.

Similarly, the failure to address wildfire risk and its implications for utilities’ access to capital is an untenable strategy if the state’s objective is to ensure the reliable delivery of energy to 16 million people living in PG&E’s service territory, let alone achieve the public policy goals around climate change that rely on utility action.  The physical integrity of northern California’s energy delivery system must be maintained; consequently, in the absence of municipalization, the utility that owns these assets (or its successors) must have access to the capital required to operate, maintain and harden its electric and gas delivery networks.

Given these considerations, we assign a very low probability to the more negative scenarios that appear to inform the consensus view implied in the share price, while assigning a much higher probability to the scenarios that restore the financial stability of PG&E and the rest of California’s investor owned utilities.

The Facts Behind Our Assumptions

 

The views set out above reflect the following facts:

 

First, California cannot long endure the economic, social and environmental cost of recurring wildfires similar in magnitude to those of 2017-2018, which burned over 775,000 acres, destroyed over 30,000 structures, killed 133 people and caused property and other damages estimated at some $40 billion over two years.  To place the scale of these losses in context, Exhibit 2 compares the estimated property and other damages caused by California’s 2017-2018 wildfires, net of federal tax savings and insurance proceeds, to (i) the annual retail electricity revenues of all the electric utilities in the state, and (ii) California’s annual receipts from real estate taxes, income taxes and all sources of tax revenue. As this comparison illustrates, if wildfire losses of the magnitude of 2017-2018 recur on an ongoing basis, passing these losses on to ratepayers or taxpayers is not, in the long term, a tenable option: recurrent wildfire losses of the scale California has suffered over the last two years are not, in any practical sense, recoverable. California has no choice but to contain wildfire risk and reduce the attendant losses to a manageable level.

Exhibit 2: 2017-2018 Wildfire Losses, After Federal Taxes & Insurance, Compared to California’s Retail Electric Revenues and Real Estate, Income and Total Taxes (1)

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, after taxes and insurance. 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.

Second, wildfires caused by utility power lines are a risk that can be and has been contained, notably in California by San Diego Gas & Electric (SDG&E).  In 2007, SDG&E was the subject of some $3.0 billion in wildfire damage claims due to the role its power lines played in igniting the Guejito, Rice and Witch Creek fires. In the years since the 2007 fires, SDG&E has spent over $1.0 billion to fire harden its grid, replacing 16,000 wood poles with steel poles, selectively insulating power lines, and widening the gaps between wires, with the objective of upgrading its distribution system to withstand 85 mile-an-hour winds. In addition, the utility installed weather stations to track regional wind conditions and now pro-actively de-energizes electrical circuits when wind speeds or other conditions elevate the risk of fire. Following a decade of such network upgrades, SDG&E faced no significant wildfire damage claims in 2017 or 2018 (see Exhibit 3).

Utilities’ exposure to wildfire damage claims, however, is to a significant degree a function of the geography they serve: SDG&E supplies electricity to only 87 communities in high fire risk areas, as against 336 served by SCE and 793 served by PG&E. Nonetheless, other performance metrics also suggest that SDG&E and SCE are much more effective at preventing fires than PG&E. Michael Finch of the Sacramento Bee has compiled data on the number of fires involving utility power lines that were reported by the state’s utilities to the California Public Utility Commission (CPUC) over the four year period from 2014 through 2017. Dividing the number of these fires by each utility’s miles of power lines, we find that PG&E reported 13.3 fires per thousand miles of line over this period, while SDG&E reported 4.3 and SCE 2.9, or 32% and 22%, respectively, the number reported by PG&E (see Exhibit 4).

Exhibit 3: Estimated Damage due to Fires Exhibit 4: Fire Incidents Reported to the

Attributed to Utility Equipment, 2017-18 CPUC per Thousand Miles of Line, 2014-2017

 

______________________________________________

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 California Public Utilities Commission is pushing the state’s investor owned utilities to do more. In compliance with legislation passed in 2018 by the California legislature and signed by then Gov. Brown (Senate Bill 901),  California’s investor owned utilities have each filed with the CPUC this month their wildfire mitigation plans, backed by proposed capital expenditures of some $4.0 billion in aggregate. In these plans, the utilities undertake to contain wildfire risk by:

(i) fire hardening their electric grids (including replacing wooden power poles with steel or cement ones, insulating power lines, and undergrounding particularly fire prone circuits) and

(ii) adopting operating procedures to ensure the safety of the grid (including de-energizing power lines during periods of high fire risk to prevent these from causing fires, far more aggressive vegetation management, and enhanced system control and data acquisition to monitor the status of the grid as well as evolving wind and weather conditions).

Critically, the annual capital expenditures proposed by the state’s utilities to achieve these goals are equivalent to approximately one tenth of the property and other damages caused by the 2017-2018 wildfires.

Third, were California to fail to control wildfire risk, the consequence would be an unacceptable degradation of the electric and gas delivery systems that supply the state’s population. Unless the risk of future wildfires can be contained, PG&E will remain blocked from the capital markets, threatening the capital investment required to maintain and expand the electricity grid that supplies the population centers of San Francisco, San Jose, Silicon Valley and the Central Valley.  Nor is this risk limited to northern California: on February 19th, S&P Global Ratings warned that PG&E’s bankruptcy filing could portend similar actions by California’s other investor owned utilities if their equipment were to cause similarly devastating wildfires and the utilities faced the prospect of strict liability for the resulting damages under California’s principle of inverse condemnation.  Utilities operating under bankruptcy protection, S&P warned, will be challenged to meet the huge capital requirements of California’s energy delivery network, whose operation and maintenance depends on “consistent access to the capital markets” as a steady source of affordable capital.

State inaction on wildfire risk would also carry a material political cost, due not only to the extent of wildfire damage, but also to required increases in electricity rates, as utilities’ allowed returns on capital would have to rise dramatically to reflect the risk to investors, and utilities would seek to recover from ratepayers the cost of wildfire damages not attributable to their negligence.

How Accurate Has Our Assessment Proved So Far?

While California’s elected and appointed government officials are among the most left-leaning in the nation, and popular opinion is virulently opposed to PG&E, the actions of the state’s legislature, governors and utility regulators have to date been surprisingly thoughtful and constructive, simultaneously attempting to mitigate wildfire risk and while shielding the state’s utilities’ from financial liability for the damage they cause. As examples of this constructive response, in this section we describe Senate Bill 901, signed into law in September last year; the statements and actions of California’s new Governor, Gavin Newsom, and in particular his appointments to the blue ribbon Commission on Catastrophic Wildfire Cost and Recovery mandated by S.B. 901; and the several CPUC proceedings involving PG&E.

Senate Bill 901

The most important element of California’s response to the 2017-2018 wildfires is Senate Bill 901, which stipulates more stringent requirements for the design, implementation and enforcement of utilities’ wildfire mitigation plans, while also establishing a far more constructive regulatory framework for assessing utilities’ responsibility for wildfire damages.

Senate Bill 901 imposes important new requirements on California’s investor-owned utilities, the California Public Utilities Commission, and the California Department of Forestry and Fire Protection (CalFire) and California’s state government, in each case designed to mitigate the risk of future wildfires ignited by utility equipment. Specifically, the bill:

  • requires each wildfire mitigation plan developed by an electrical utility to include important new elements, including protocols for deenergizing portions of the electrical distribution system when fire risk is high, inspections of electrical infrastructure, plans to modernize and harden this infrastructure, plans for vegetation management, and other actions to ensure that utilities’ electric transmission and distribution systems achieve higher levels of safety, reliability, and resilience;
  • requires utilities to hire independent experts to evaluate their wildfire mitigation plans, and requires the CPUC to consider these independent evaluations before approving the plans;
  • requires the CPUC to impose penalties on utilities that fail to comply with their wildfire mitigation plans, and doubles the maximum penalties the CPUC can assess on utilities for violations of law and CPUC regulations from $50,000 to $100,000 per violation per day;
  • requires the CPUC to coordinate with CalFire in developing a consistent approach to fire prevention, vegetation management and monitoring the safety of electricity grids;
  • requires CalFire 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 all residential, commercial and industrial building construction within such zones after July 1, 2021 — helping to address the growing risk to utilities caused by expansion of settlements in areas of high wildfire risk.

At the same time, S.B. 901 takes important, forward-looking steps to reform California’s regulatory framework for assessing utilities’ responsibility for future wildfire damages, allowing the recovery of prudently incurred costs (including any liability for wildfire damages), and mitigating the impact of this recovery on ratepayers. Specifically, the law:

  • authorizes the CPUC to permit 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;”
  • authorizes the CPUC “in evaluating the reasonableness of the costs and expenses” to consider exculpating factors, including the extent to which the costs and expenses were caused by circumstances beyond the utility’s control, whether extreme climate conditions contributed to the fire’s ignition or the extent of the damages, the utility’s compliance with applicable laws, regulations, and its own wildfire mitigation plan, and any violations of law or regulation by third parties that contributed to the damages;
  • authorizes the CPUC to make a balanced assessment of the utility’s responsibility for the wildfire and the damage it caused, and permits the CPUC to allocate these wildfire-related costs to ratepayers or shareholders in a manner that reflects the relative prudence or negligence or the utility’s actions; and
  • permits utilities to apply to the CPUC for recovery of their prudently incurred costs through fixed recovery charges imposed on ratepayers, and allowing the securitization of these charges to raise the funds required to defray these costs in the capital market.

Finally, S.B. 901creates an expert Commission on Catastrophic Wildfire Cost and Recovery and charges it, in consultation with the CPUC and California’s Insurance Commissioner, to present by July 1, 2019 “recommendations as to changes to law that would ensure equitable distribution of costs among the affected parties” — opening the door to a cost recovery mechanism that ensures that wildfire-related costs are not borne exclusively by utility shareholders but rather are shared among property owners, utility ratepayers, commercial or government insurers, or state taxpayers.

The Statements and Actions of Governor Gavin Newsom

Since taking office on January 7th, California’s new governor, Gavin Newsom, has given his focused attention to the issue of wildfire risk and its implications for the state’s utilities. By January 22nd, he had appointed the three commissioners it was his prerogative to appoint to the Commission on Catastrophic Wildfire Cost and Recovery. As we discuss below, the quality of these three commissioners, as well as that of the other two commissioners, appointed severally by Senate President Pro Tempore Toni Atkins and Assembly Speaker Anthony Rendon, speak to the seriousness of Newsom’s concern and suggest that this concern is shared by the most senior member of California’s legislature.

Newsom gave high priority to the issue of wildfires, California’s energy infrastructure, and utility’s access to capital, in his state of the state speech, delivered on February 12th. While Senate Bill 901 stipulates that the wildfire commission must deliver its recommendations before July 1, 2019, Newsom in his state of the state speech set a tighter deadline, indicating that he would present a “comprehensive strategy” to address these issues within 60 days (April 13). Newsom explained that his staff would be assisted by a team of “the nation’s best bankruptcy lawyers and financial experts from the energy sector.” Importantly, Governor Newsom comments suggest that he understands that the quality of the state’s energy delivery infrastructure is a function of utilities’ access to capital, and that this is a larger issue that PG&E’s bankruptcy alone. In his words:

We will ensure continued access to safe, affordable power…We will continue to invest in safety, and we will never waver on achieving the nation’s most ambitious clean energy goals.

The problems we face are far greater than PG&E. Climate change is putting pressure on all of our utilities—public and private, north and south. Edison and San Diego Gas & Electric both recently had their credit ratings downgraded.

Newsom’s comments suggest to us that he is seeking to frame a set of policies that will maintain utilities’ access to capital and safeguard the reliable supply of energy to the state. In support of this view, we would cite as evidence the experience and expertise of the individuals appointed to the Commission on Catastrophic Wildfire Cost and Recovery by Governor Newsom, Senate President Atkins and Assembly Speaker Rendon. We summarize the credentials of the five commissioners below.

Governor Newsom’s appointees are:

  • Michael A. Kahn, 69. An attorney currently of counsel at Crowell & Moring, Mr. Kahn was Chair of the Board of Governors of the California Independent System Operator from 2001 to 2005, Chair of the California Electricity Oversight Board from 2000 to 2001, a member of the California State Insurance Commissioner Task Force on Environmental Liability Insurance from 1993 to 1994, a member of the California State Insurance Commissioner Task Force on Insurance Industry Practices in 1993, and Commissioner on the California State Senate Commission on Property Tax Equity and Revenue in 1990.
  • Dave Jones, 57. An attorney, Mr. Jones served as the California Insurance Commissioner from 2011 to 2019. Previously, he was a member of the California State Assembly from 2001 to 2010 and of the Sacramento City Council from 1999 to 2001. Mr. Jones was Counsel to U.S. Attorney General Janet Reno from 1996 to 1998, as well as White House Fellow to the U.S. Attorney General from 1995 to 1996.
  • Carla Peterman, 40. Ms. Peterman served as a member of the California Public Utilities Commission from 2013 to 2018, and as a member of the California Energy Commission from 2011 to 2012. A Ph.D. in energy and resources from the University of California, Berkeley Ms. Peterman also holds an M.B.A. from the University of Oxford.

Senate President Atkin’s appointee is:

  • Michael Wara, 44. An attorney and expert on environmental law, Mr. Wara is currently a Research Fellow at Stanford University’s Steyer-Taylor Center for Energy Policy and Finance. Mr. Wara was an Assistant and then Associate Professor of Law at Stanford Law School from 2007 to 2015. He received his J.D. from Stanford Law School and holds a Ph.D. in Ocean Sciences from the University of California at Santa Cruz.

Assembly Speaker Rendon’s appointee is:

  • Pedro Nava, 70. An attorney and civil litigator, Mr. Nava has served as Chair of California’s Little Hoover Commission, an independent state oversight agency, since 2010. From 2004 to 2010, he was a  member of the California State Assembly, where he was Chair of the Banking and Finance Committee and a member of the Insurance Committee, Health Committee, and Business and Professions Committee.

The Impact of the CPUC’s Regulatory Proceedings

Importantly, in the context of PG&E’s Chapter 11 bankruptcy filing, we believe that current and upcoming CPUC proceedings could significantly enhance the access to capital of California’s investor owned utilities and create significant value for the shareholders of PCG, EIX and SRE.

In particular, the CPUC’s investigation into PG&E’s safety culture and governance puts intense pressure on PG&E to upgrade its board of directors, replace key members of its senior management, and possibly divest its component businesses – all actions that could materially enhance shareholder value but which the utility would be less likely to take on its own. Second, California’s upcoming cost of capital proceeding, which commences on April 19 and will likely run through the end of year, will take place coincident with PG&E’s bankruptcy proceeding – strengthening the hand of California’s investor owned utilities, whose case for higher allowed ROEs is evidently supported by the financial risk arising from catastrophic wildfires and the principle of inverse condemnation. A third proceeding, in which the CPUC is assessing the proper procedures to follow in determining utilities’ recovery from ratepayers of wildfire related costs, will be critical to the long run value of the state’s investor owned utilities. Here too, the coincidence of the CPUC’s investigation with PG&E’s bankruptcy proceeding strengthens the hand of the utilities in securing fair treatment from regulators.

The CPUC’s investigation into PG&E’s safety culture and governance was the product of the utility’s repeated failure to prudently monitor, maintain and operate its gas transmission and distribution network, both before and after the San Bruno gas pipeline explosion of 2010. More recently, CalFire’s finding that PG&E equipment was the cause 16 of the 18 wildfires that erupted in PG&E’s northern California service territory in 2017 has given rise to similar concerns regarding PG&E’s management of its power transmission and distribution grid.

Despite its origins, we believe the CPUC’s safety culture investigation could be of material benefit to PG&E. The CPUC proceeding will focus on improving PG&E’s safety culture and will consider radical action to do so, including changes to PG&E’s corporate structure, governance and management. Potential outcomes include CPUC support for changes that are already in process, including upgrading PG&E’s board of directors and replacing key members of senior management. Other potential outcomes could further enhance shareholder value, including the separation of PG&E’s gas and electric networks, and the divestiture of these utilities as well as PG&E’s generation assets.

The fact that the CPUC’s safety investigation is proceeding in parallel with PG&E’s Chapter 11 bankruptcy proceeding could facilitate radical change. As a debtor in possession of its assets, PG&E is the trustee of its own estate and is charged with maximizing its value. We would expect PG&E therefore to cooperate with the CPUC in implementing those safety related reforms that could enhance the value of its assets. The fact that these reforms grew out the CPUC’s safety investigation, and thus may be viewed by politicians and the press as punitive in nature, will also facilitate their implementation.

Similarly, we see upside potential for California’s investor owned utilities in the CPUC’s 2019 cost of capital proceeding. As part of an ongoing cost of capital determination process established by the CPUC in 2012, the three main investor owned utilities in California are to file their cost of capital requests with the CPUC on April 19th. Given the adverse impact of the 2017-2018 wildfires on the prices of their debt and equity securities, all three utilities are well positioned to request higher allowed returns on equity and/or increases in their ratios of equity to rate base. In particular, we would expect PG&E to file for a much higher return on equity than it is currently allowed, and indeed expect its requested ROE to exceed that allowed any other utility in the country. Such a request would be supported not only by the depressed prices of PG&E’s own debt and equity securities, but also by the similar discounts prevailing on the securities of Edison International. This is important, in our view, because it suggests that the high cost of debt and equity to California’s investor owned utilities does not solely reflect poor management or disregard for safety, but is fundamentally attributable to the prevalence of wildfires in the state and the standard of strict liability for wildfire damages imposed on utilities by California’s principle of inverse condemnation..

Finally, the CPUC is also engaged in a third proceeding, in which it is assessing the proper procedures to follow in determining utilities’ recovery from ratepayers of wildfire related costs. As noted above, Senate Bill 901:

  • authorizes the CPUC to permit utilities to recover wildfire-related costs “if the costs and expenses are just and reasonable;”
  • authorizes the CPUC “in evaluating the reasonableness of the costs and expenses” to consider exculpating factors, including the utility’s compliance with applicable laws, regulations, and its own wildfire mitigation plan, and any violations of law or regulation by third parties that contributed to the damages;
  • authorizes the CPUC to make a balanced assessment of the utility’s responsibility for the wildfire and the damage it caused, and permits the CPUC to allocate these wildfire-related costs to ratepayers or shareholders in a manner that reflects the relative prudence or negligence or the utility’s actions.

How the CPUC implements these requirements of the law will be critical to the long run value of California’s utilities. Here too, the simultaneity of the CPUC’s investigation with PG&E’s bankruptcy proceeding strengthens the hand of the state’s utilities in seeking fair treatment from regulators.

In conclusion, the issues to be addressed in the CPUC’s several 2019 proceedings on PG&E’s safety culture and governance, the recovery of wildfire costs, and utilities’ cost of capital, will focus California’s regulators and politicians on the fact that, if utilities are not allowed to recover wildfire costs, and there is no change to the legal and regulatory framework for addressing wildfire risk, ratepayers will ultimately bear the cost to compensate debt and equity investors for the higher risks they face or taxpayers will assume the costs and risks by acquiring the electric utility. That these proceedings are taking place coincident with PG&E’s bankruptcy enhances the probability, in our view, that California’s utilities and their regulators will engage constructively with each other to address these issues. We also view positively the pressure that the CPUC’s safety investigation will place on PG&E finally to take the radical steps necessary to improve its operational performance and restructure its asset portfolio in a ways that could materially enhance shareholder value.

©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.

Print Friendly