PG&E: Valued Across a Range of Scenarios, We See Significant Upside & Little Downside; Insights from Simple and Complex Valuation Models

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Eric Selmon                                                          Hugh Wynne

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

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

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

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February 11, 2019

PG&E: Valued Across a Range of Scenarios, We See Significant Upside & Little Downside;  

Insights from Simple and Complex Valuation Models

In this note, we assess the potential value of PG&E upon exiting bankruptcy across a range of scenarios, including cases contemplating no recovery of 2017-2018 wildfire liabilities, a further 50% increase in unrecoverable wildfire costs, and a state takeover of PG&E’s electric grid. We do so on the basis of (i) a simple sum of the parts analysis, reflecting the assumption that the company will be broken up and its component businesses sold, and (ii) a more complex valuation that assumes the company maintains its current business mix. Our scenario analysis suggests that PG&E stock offers a highly asymmetric set of prospective investment returns, with little downside from the current share price and enormous upside potential (see Exhibits 2, 3 and 4).

Portfolio Manager’s Summary

  • Critically, PG&E is solvent and we expect it to remain solvent through the bankruptcy proceeding, meaning that no creditors or contract counterparties will be impaired, shareholders will remain the owners of the company, and they will retain the value of PG&E in excess of its liabilities.
  • However, the duration of the bankruptcy proceeding will extend the term over which this value can be realized.Driven by the time it will take the bankruptcy court to adjudicate the wildfire claims and establish their value, we estimate the duration of the bankruptcy proceeding at 3-4 years.

Sum of the Parts Valuation

  • Our sum of the parts analysis suggests that PG&E stock offers a highly asymmetric set of prospective investment returns, with little downside from the current share price and enormous upside potential – even assuming no recovery of past wildfire costs.
  • In Exhibit 2, we value PG&E’s electric and gas businesses across a range of scenarios based on comparable companies and transactions. We estimate PG&E’s equity in its utility assets, net of wildfire liabilities, to be worth $13.30 per share in our low case, some 5.5% below Friday’s close; $29 per share in our mid case, or over 100% above Friday’s close; and $41 per share in our high case, to which we assign the highest probability, or 190% above Friday’s close.
  • Our high case assumes that a settlement is reached between PG&E, its creditors, regulators and plaintiffs, that permits the sale of PG&E’s electric and gas assets.
    • Driving such settlement, we believe, is the critical importance to the state, the utility, and its stakeholders of materially and rapidly reducing future wildfire risk. To achieve this, the state could require a transfer of ownership of PG&E’s power grid to a more reliable and trusted operator prepared to commit the capital necessary to fire harden the grid. In turn, any purchaser would likely demand support from the CPUC and the state to limit the scale of future, unrecoverable wildfire liabilities.
    • In this context, we believe PG&E’s equity in its electric T&D network could be valued by reference to the price to tangible net worth ratio of Edison International (EIX), which shares PG&E’s exposure to wildfire risk, inverse condemnation and CPUC regulation.
    • To value the equity in PG&E’s gas T&D network, we have chosen NiSouce (NI) as a comparable company, reflecting not only the predominant contribution of its gas utility operations to its financial results, but also NI’s checkered safety record which, following a series of explosions in Massachusetts, has brought the company under federal criminal investigation.
    • We estimated the market value of PG&E’s combined cycle gas turbine, pumped storage and conventional hydroelectric assets by reference to the average prices in $/kW of three different sets of comparable transactions, one for each class of power plant. We then subtracted the debt corresponding to these assets in PG&E’s rate base to calculate the value of PG&E’s equity in its generation fleet.
    • In this scenario, the implied equity value of PG&E’s asset portfolio is $40.4 billion. Net of (i) wildfire liability and bankruptcy costs (~$18.5 billion pre-tax), (ii) the tax benefit of these losses, offset by taxable gains on the sale of assets (~$0.2 billion), and (iii) borrowings not associated with regulated activities (~$0.9 billion), we estimate the equity value of PG&E at $21.2 billion, or 2.9x PG&E’s current market capitalization of $7.3 billion (Exhibit 2).
  • Our second scenario adopts the same assumptions with respect to PG&E’s gas and generation assets, but we assume PG&E’s electric grid is municipalized by the state or local governments, and that PG&E is paid compensation equal to the net book value of these assets.
    • In this case, the value of PG&E’s equity in its regulated rate base falls to $33.7 billion. Net of the $18.5 billion in wildfire liability and bankruptcy costs, the tax benefit of these losses, and debt not associated with regulated activities, this implies a net equity value of $15.2 billion, or 2.1x PG&E’s current market capitalization of $7.3 billion (Exhibit 2).
  • Our low case assumes a state takeover of PG&E’s electric grid plus a 50% increase to $27.8 billion in PG&E’s unrecoverable wildfire liability and bankruptcy costs. This outcome could reflect some combination of additional fires and/or a mandatory, unrecoverable investment to harden the grid.
    • In this case, the value of PG&E’s equity in its regulated rate base remains $33.3 billion; net of $27.8 billion in unrecoverable costs, however, our estimate of PG&E’s net value falls to $6.9 billion, or 94% of PG&E’s current market capitalization of $7.3 billion (Exhibit 2).
  • Each of the above scenarios assumes that PG&E was negligent in causing the Camp fire and all of the 2017 fires excluding Tubbs, and that PG&E is allowed no recovery whatsoever of wildfire liabilities. In light of SB 901, we believe these to be unrealistically conservative assumptions.
    • In Exhibit 3, we quantify the potential upside were PG&E allowed to recover a portion of its wildfire liabilities, as a result, for example, of the stress test to be applied by the CPUC in respect of the 2017 wildfires under SB 901.For every 10% of its estimated wildfire liability that PG&E is allowed to recover, the company’s value rises in our mid and high cases by $1.4 billion, or ~20% of its current market capitalization. In our low case, which assumes a 50% increase in PG&E’s wildfire liabilities, 10% recovery increases PG&E’s value by $2.0 billion or ~30% of its current market capitalization.

Alternative Valuation Methodology: No Breakup

  • Our second valuation methodology values PG&E as an ongoing enterprise holding its existing portfolio of assets. Our analysis attempts to quantify not only the damage claims arising from the 2017-2018 wildfires, but the potential scale of future wildfire liabilities as well. This alternative valuation model is based on the following assumptions:
  • Wildfires on the scale of 2017-2018 recur roughly once every ten years, implying a risk of ~10% in each year of the coming decade of similar catastrophic losses ($18.5 billion pre-tax).
  • However, we see California bringing catastrophic wildfires under control over the coming decade through the hardening of electricity grids, improved forest management, and stricter vegetation management and building codes in residential areas. We therefore assume that the probability of catastrophic wildfires gradually declines, falling to 9% in year two, 8% in year three and so forth.
  • The discount rate to be applied to these expected wildfire losses is roughly 15%, reflecting the sum of (i) the forward earnings yield of Edison International (EIX) stock, calculated using the current share price and consensus 2019 earnings per share, plus (ii) the expected rate of growth in its normalized earnings per share, as reflected in the consensus estimates for EIX in 2018 and 2021.
  • PG&E is not broken up and its component businesses are not sold off as separate utilities. Rather, we assume that PG&E’s current corporate structure and asset portfolio remain unchanged.
  • Through a ten year program of investment and operational reforms, PG&E gradually controls wildfire risk, and recovers the relative PE multiple at which it traded prior to October 2017, a discount of ~5% to the average PE of the U.S. regulated utilities as a group.
  • We make no explicit assumption as to the portion of past and future wildfire damage claims that the CPUC will allow PG&E to recover in rates. Rather, we present the results of our valuation analysis across a range of recovery scenarios for both the 2017-2018 and potential future wildfires.
  • The results of our valuation analysis are presented in Exhibit 4.[1] Assuming between 20% and 50% recovery of the utility’s past and potential future wildfire losses, our estimate of PG&E’s value is $40 to $51 per share, or some 2.8-3.6x its price at Friday’s close.

The Impact of Chapter 11 and Other Regulatory Proceedings

  • We expect PG&E’s bankruptcy proceeding to preserve and enhance shareholder value, allowing PG&E:
    • to consolidate all the damage claims arising from the 2017 and 2018 wildfires into a single proceeding to be adjudicated in front of the bankruptcy judge, and
    • to prepare a comprehensive plan of reorganization that simultaneously addresses the damage payments to the plaintiffs, PG&E’s existing debts, the capital needs of the utility and the exposure of its assets to wildfire risk.
  • Consolidating all of the wildfire claims and adjudicating them in a single bankruptcy proceeding could materially reduce the cost to PG&E of litigating and settling these claims. The application of consistent standards across all the wildfire damage proceedings will reduce the time and cost to litigate them, limit the potential for unreasonable damage awards in particular cases, and allow the bankruptcy judge to create incentives for plaintiffs to settle or submit to arbitration.
  • To the extent PG&E plans to sell assets or the component parts of its business, and apply the proceeds to pay third party damage claims, bankruptcy permits these assets or businesses to be sold free and clear of any liens or wildfire liabilities. Such sales would be virtually impossible outside of bankruptcy due the risk buyers would face from wildfire claims.
  • By making a voluntary filing for bankruptcy under Chapter 11 of the U.S. Bankruptcy Code, PG&E will secure protection from its creditors while maintaining control of its assets as a “debtor in possession.” This will allow the company to apply its internally generated cash exclusively to fund its capital expenditures, facilitating ongoing investment in wildfire mitigation.
  • Furthermore, bankruptcy likely enhances PG&E’s leverage with legislators and regulators to ensure that its power transmission and distribution system, the portion of its asset portfolio most vulnerable to wildfire risk, enjoys the regulatory and legislative protections required to ensure continued access to debt and equity capital, either as an independent company or as the subsidiary of acquiring utility.
  • Finally, as noted earlier, we estimate the duration of the bankruptcy proceeding at 3-4 years, which means that there may be significant volatility in PG&E’s stock price over this timeframe driven by events in bankruptcy proceeding, as well as outcomes from a number of other regulatory proceedings at the CPUC and elsewhere including:
    • Criminal Probation: PG&E is serving five years’ probation through early 2022 and is subject to oversight by Judge Alsup of the Federal District Court of Northern California. If Judge Alsup finds PG&E to be in violation of its probation or that PG&E poses a risk to public safety he can take wide ranging actions to penalize and force change at PG&E.
      • Moreover, because the bankruptcy court where PG&E filed in is in Judge Alsup’s district court, the judge has wide discretion to intervene directly in the bankruptcy proceedings.
    • Safety Culture and Governance OII: Due to PG&E’s actions related to San Bruno and several other safety incidents since then, the CPUC has instituted a proceeding to improve PG&E’s safety culture. This proceeding will address corporate structure, governance and management, and return on equity, among other issues.
      • Potential outcomes include changes to the board and management, separation of gas and electric utilities, division into regional subsidiaries, divestiture of generation, public ownership/municipalization, and ROE conditioned on safety performance.
      • While this remedy phase will likely be completed in the next 12 months, it will be impacted by findings from CalFire investigations and could take longer.
    • Wildfire Cost Recovery OIR: This will set the criteria for the stress tests for the 2017 wildfires, and determinations in this proceeding could serve as general principles for recovery of future wildfire costs from ratepayers, as well.
      • The scoping memo for the proceeding is due in March, but there is no timeline for a final decision.
      • Furthermore, the CPUC has stated that it will not make a decision on actual amounts until it is faced by a request from PG&E to recover actual expenditures, so this proceeding may not be resolved until after the bankruptcy.
    • Wildfire Mitigation Plans: PG&E filed its proposed plan last week, comments are due over the next month, and the final decision on the plans is due in May, although this can be delayed by the CPUC.
    • Cost of Capital Proceeding: The three main investor owned utilities in California are supposed to file their cost of capital requests on April 19. This is part of the cost of capital process the CPUC established in 2012.
      • We view this as a potential positive for PG&E as its filing should include a much higher cost of debt and equity than the current levels and than any other utility in the country.
      • This will serve as a reminder to regulators and politicians that, in the absence of any malicious intent, if PG&E is not allowed to recover wildfire costs and there is no change to the legal and regulatory framework for addressing wildfires, ratepayers will still need to bear higher costs in order to compensate credit and equity investors for the higher risks they face.

Details

We have valued PG&E using two alternative methodologies:

  • First, by estimating the value of PG&E on the assumption that it maintains its existing asset portfolio, that the company invests heavily in upgrading its power grid over the coming decade to minimize the risk of future wildfires, but that until this upgrade is complete it remains exposed to the risk of future catastrophic wildfires similar to those of 2017-2018, and that the legal and regulatory context for dealing with wildfire liabilities remains unchanged; and
  • Second, on the basis of a sum of the parts analysis, where we value PG&E’s various business segments by reference to comparable companies or transactions in these segments, and test the sensitivity of this valuation to various downside scenarios for PG&E’s fire vulnerable electric grid.

Sum of the Parts Valuation

Our sum of the parts analysis considers three alternative scenarios for PG&E’s power transmission and distribution grid:

  • A high case, to which we also assign the highest probability, where a settlement is reached between PG&E, its creditors, regulators and plaintiffs, that permits the sale of PG&E’s electric and gas assets. Driving such a settlement, we believe, is the critical importance to the state, the utility, and its stakeholders, of materially and rapidly reducing future wildfire risk. To achieve this, the state could require a transfer of ownership of PG&E’s power grid to a more reliable and trusted operator prepared to commit the capital necessary to fire harden the grid. In turn, the purchaser would likely demand support from the CPUC and the state to limit the scale of future, unrecoverable wildfire liabilities. Given PG&E’s seemingly unending list of safety and record keeping violations with respect to its gas transmission and distribution network, we assume these assets also are sold.
      • In this context, we believe PG&E’s transmission and distribution network could be valued by reference to the price to tangible net worth ratio of Edison International (EIX), which shares PG&E’s exposure to wildfire risk, inverse condemnation and CPUC regulation.
      • To value the equity in PG&E’s gas T&D network, we have chosen NiSouce (NI) as a comparable company, reflecting not only the predominant contribution of its gas utility operations to its financial results, but also NI’s checkered safety record which, following a series of explosions in Massachusetts, has brought the company under federal criminal investigation.
      • We estimate the market value of PG&E’s combined cycle gas turbine, pumped storage and conventional hydroelectric assets by reference to the average prices in $/kW of three different sets of comparable transactions, one for each class of power plant. (We provide a detailed description of these transactions, and an explanation of our methodology, in Appendix 2.) We then subtract the debt corresponding to these assets in PG&E’s rate base to calculate the market value of PG&E’s equity in its generation fleet
  • A mid case where PG&E’s electric transmission and distribution grid is seized by the state or local governments, and PG&E is paid compensation equal to the net book value of these assets.[2] As in the high case, however, we assume PG&E’s power generation and gas transmission and distribution assets are sold, and we value them as described above.
  • A low case that adopts the same assumptions as the mid case, but which assumes a 50% increase to $27.8 billion in PG&E’s unrecoverable wildfire and bankruptcy costs. This outcome could reflect some combination of additional fires and/or mandatory, unrecoverable investments to harden the grid.

Our sum of the parts analysis assigns a value to:

  • PG&E’s equity in gas transmission and distribution assets of $17.5 billion,
  • PG&E’s equity in its non-nuclear generation assets of $4.2 billion , and
  • PG&E’s equity in its electric transmission and distribution grid of $11.9 billion, if municipalized at its book value, or $18.6 billion if sold at a price to tangible book value multiple comparable to that of Edison International.

From this estimate of the value of PG&E’s equity in its electric and gas utility assets we must subtract the net cost to PG&E of the wildfire damage claims made against it arising from the 2017-2018 wildfires. In Exhibit 1, we present our estimate of the maximum potential liability PG&E could face for the 2017-2018 northern California wildfires, assuming no recovery from ratepayers. Please see Appendix 1 for a detailed explanation of our underlying assumptions.

Exhibit 1: PG&E’s Maximum Potential Liability for Wildfire Damages Arising from the 2017-2018 Northern California Wildfires

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1. Excludes damage claims arising from the Tubbs fire, where CalFire has found no evidence that PG&E equipment caused the fire.

2. Assumes that PG&E settles the property damage claims against it at 60% of the claimed amount, as SDG&E did in respect of the 2007 Guejito, Rice and Witch Creek fires.

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

Our estimates of the claims for property damage arising from the wildfires reflect data from the California Department of Insurance on the insured property losses caused by these fires. To estimate PG&E’s liability for other damage caused by the 2017-2018 wildfires (for example, injury or death, loss of wages or business profit, or uninsured property damage), we relied upon (i) disclosures made by San Diego Gas & Electric in respect of the damage claims against it arising from the 2007 Guejito, Rice and Witch Creek fires and (ii) data on the number of structures destroyed by these fires compiled by the California Department of Forestry and Fire Prevention (CalFire). We used these disclosures to calculate the ratio of non-property damage claims per structure destroyed in the 2007 wildfires; adjusted these estimates to reflect the increase in the general price level in the intervening years; and, based on the number of structures destroyed by the 2017-2018 northern California wildfires, used this revised ratio to estimate the non-property damage caused by these fires. Importantly, we have excluded the 2017 Tubbs fire from our estimate, reflecting CalFire’s finding that PG&E equipment did not contribute to that fire. (For a more complete description of the assumptions underlying our estimates, please see Appendix 1 of this report).

On this basis, our estimate of the maximum potential wildfire liabilities arising from the 2107-2018 wildfires is $25.2 billion (see the first line of Exhibit 1). However, we believe this estimate of PG&E’s wildfire liabilities materially exceeds what the utility is likely to pay to settle the claims against it. San Diego Gas & Electric, in settling the property damage claims arising from the 2007 Guejito, Rice and Witch Creek fires, paid only 60 cents on the dollar, and the utility was not in bankruptcy at the time. We assume therefore that PG&E can also settle the property damage claims against it at 60% of the claimed amount. Taking into account PG&E’s $2.2 billion of liability insurance, we estimate the net pre-tax cost to PG&E of the 2017-2018 wildfire liabilities at $18.5 billion (see penultimate line of Exhibit 1). Although we estimate the net, after-insurance, after-tax cost of settling the damage claims arising from 2017-2018 northern California fires at only $14.6 billion (see final line of Exhibit 1), given the scale of the losses, we have assumed PG&E is not immediately able to tax deduct its unrecovered losses. We have therefore used a more conservative methodology for estimating the tax value of these losses, as discussed below.

To ensure that we are capturing the tax impact of these losses in our valuation appropriately, we have in each our three scenarios netted (i) the tax deductible losses arising from PG&E’s wildfire liabilities and bankruptcy costs against (ii) the taxable gains from the sale of its component businesses. We have added the resulting net losses to PG&E’s existing net operating loss carryforward, and assumed that these tax losses are applied against taxable income over the next ten years. We have calculated the present value of these future tax benefits, and added it to our estimate of the value of PG&E. We used a discount rate of 15% in our present value calculation, reflecting the sum of (i) the forward earnings yield of Edison International (EIX) stock, calculated using the current share price and consensus 2019 earnings per share, plus (ii) the expected rate of growth in its normalized earnings, reflecting the compound annual growth rate implied by the consensus earnings estimates for EIX in 2018 and 2021.

Finally, we have deducted from our estimate of the value of PG&E any debt not attributable to its regulated utility businesses, the cost of which may therefore not be recoverable in rates. To estimate the amount of such debt, we have compared (i) PG&E Corp.’s consolidated debt outstanding as of September 30, 2018, plus assumed 2019 borrowings of $1.6 billion under PG&E’s debtor in possession financing, to (ii) the level of debt allowed against Pacific Gas & Electric Company’s 2019 regulated rate base, assuming a 47% ratio of debt to rate base, as authorized in the CPUC’s 2012 cost of capital decision. Our estimate of 2019 rate base is $39.4 billion, to which we added an estimated $2.5 billion in construction work in progress. On this basis, our estimate of the excess of PG&E’s 2019 debt over the authorized level is $0.9 billion.[3]

Scenario Analysis

Our scenario analysis suggests that PG&E stock offers a highly asymmetric set of prospective investment returns, with little downside from the current share price and enormous upside potential – even assuming no recovery of past wildfire costs (see Exhibit 2.) Recovery of any wildfire damages paid would add significant, additional upside (see Exhibit 3).

Low Case

Our low case assumes a state takeover of PG&E’s electric grid with compensation at 1.0x book, but the sale of PG&E’s power generation and gas transmission and distribution assets at their market value. Given these assumptions, we estimate of the value of PG&E’s equity in electric and gas utility assets at $33.7 billion (see the bottom section of Exhibit 2).

From this we deduct:

  • our estimate of the cost to shareholders of PG&E’s liability for damages arising from the 2017-2018 wildfires, plus the legal costs arising from its bankruptcy (~$18.5 billion; see Exhibit 1 for a breakdown of these costs and Appendix 1 for a detailed explanation of our underlying assumptions);
  • an assumed 50% increase in these costs attributable to a third fire or a mandatory, unrecoverable investment of $9.3 billion to harden the grid and minimize wildfire risk; and
  • borrowings not associated with regulated activities (~$0.9 billion), and whose cost therefore is not recoverable in rates.
  • Finally, we add back the tax benefit of these losses, offset by taxable gains on the sale of assets. Assuming these tax benefits are realized over the next ten years, we estimate PG&E’s net tax savings to have a present value of ~$1.9 billion.

In summary, in our low case our sum of the parts valuation estimates that the market value of PG&E’s equity in its regulated rate base is $33.7 billion, from which we deduct $27.8 billion in pre-tax, after-insurance wildfire liabilities and bankruptcy costs. In addition, we subtract an estimated $0.9 billion in debt not attributable to PG&E’s regulated utility business, and add back our estimate ($1.9 billion) of the present value of PG&E’s future tax savings from its tax loss carryforwards. On this basis, we estimate PG&E’s net value to shareholders at $6.9 billion, some 5.5% below PG&E’s market capitalization of $7.3 billionat the close of trading on Friday, February 8th (see Exhibit 2).

Exhibit 2: Sum of the Parts Valuation of PG&E Corp. in Three Different Scenarios

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1. We have estimated the market value of PG&E’s combined cycle gas turbine, pumped storage and conventional hydroelectric assets by reference to the average prices in $/kW of three different sets of comparable transactions, one for each class of power plant. We provide a detailed description of these transactions, and an explanation of our methodology, in Appendix 2. We then subtracted from the estimated market value of PG&E’s generation assets the debt corresponding to these assets in PG&E’s rate base (i.e., 48% of the rate base value of these assets, or .48 x $2.0 billion = $960 million).

2. Our $18.5 billion estimate of wildfire losses represents the pre-tax, after-insurance cost to PG&E of damage claims arising from the 2017-2018 wildfires, excluding the Tubbs fire, as well as the legal costs to PG&E of its resulting bankruptcy. A breakdown of these estimated losses is presented in Exhibit 1, and a detailed explanation of our assumptions appears in Appendix 2. Our third, low case assumes a 50% increase in our estimate of PG&E’s wildfire and bankruptcy costs to $27.8 billion. In none of the three cases do we assume any recovery of wildfire losses from ratepayers. However, we assume that PG&E can settle the property damage claims against it at 60% of face value, as SDG&E did in respect of the 2007 Guejito, Rice and Witch Creek fires.

3. We have compared PG&E Corp.’s debt outstanding as of September 30, 2018, plus assumed 2019 borrowings of $1.6 billion under PG&E’s debtor in possession financing, to the level of debt allowed against Pacific Gas & Electric Company’s 2019 regulated rate base, assuming a 47% ratio of debt to rate base. Our estimate of the excess of PG&E’s 2019 debt over the authorized level is $0.9 billion. Our estimate of 2019 rate base is $39.4 billion, to which we added an estimated $2.5 billion in construction work in progress. Our 2019 rate base estimate is taken from Attachment B of the Petition for Modification of Decision 16-06-056 of Pacific Gas and Electric Company to Reflect Tax Changes.

4. We have netted the tax deductible losses arising from PG&E’s wildfire liabilities and bankruptcy costs against the taxable gains from the sale of its component businesses, and added the resulting net losses to PG&E’s existing net operating loss carryforward. We have assumed that these tax losses are applied against taxable income over the next ten years. We have calculated the present value to the resulting tax savings at a discount rate of 15%.

Source: Company reports, S&P Global, SSR research and analysis.

Mid Case

Our mid case scenario adopts the principal assumptions of our low case, including a state or municipal takeover of PG&E’s electric transmission and distribution grid with compensation at 1.0x book. Given these assumptions, our sum of the parts valuation estimates that the market value of PG&E’s equity in its regulated rate base at $33.7 billion (see the middle section of Exhibit 2).

In our mid case, however, we assume that PG&E’s wildfire-related costs are limited to the pre-tax, after-insurance cost of settling the damage claims against it arising from the 2017-2018 wildfires. Adding PG&E’s bankruptcy-related costs, we estimate its total unrecoverable losses at $18.5 billion (see the penultimate line of Exhibit 1). We estimate the tax benefit of these losses, offset by taxable gains on the sale of assets, to have a present value of ~$0.9 billion, assuming they are realized over the next ten years. Finally, we subtract an estimated $0.9 billion in debt not attributable to PG&E’s regulated utility business and whose cost therefore is not recoverable in rates.

On this basis, we calculate PG&E’s net value to shareholders at $15.2 billion (Exhibit 2), or some 2.1x PG&E’s current market capitalization of $7.3 billion.

High Case

Our high case assumes that a settlement is reached between PG&E, its creditors, regulators and plaintiffs, that permits the sale of PG&E’s electric and gas assets. Driving such settlement, we believe, is the critical importance to the state, the utility, and its stakeholders of materially and rapidly reducing future wildfire risk. To achieve this, the state could require a transfer of ownership of PG&E’s power grid to a more reliable and trusted operator prepared to commit the capital necessary to fire harden the grid. In turn, the purchaser would likely demand support from the CPUC and the state to limit the scale of future, unrecoverable wildfire liabilities.

We believe that concerted public/private effort to mitigate wildfire risk, which would likely extend over a five to ten year period, could be successful were it to include:

  • Widespread hardening of utility distribution networks by:
    • replacing wooden power poles with cement ones,
    • reinforcing and insulating overhead power lines,
    • undergrounding power lines in the most fire prone areas,
    • remote monitoring of wind and weather conditions affecting wildfire risk,
    • increased reliance on de-energizing lines as a means of preventing wildfires, and
    • significantly more aggressive vegetation management;
  • Improving the management of the state’s privately and publicly owned forests;
  • More consistent enforcement of standards for the clearance of vegetation in residential areas;
  • Building codes requiring fire resistant roofs and other prudential design features;
  • More conservative underwriting of property and casualty risk in fire prone regions

In this context, we believe it plausible to assume that PG&E’s entire transmission and distribution network could be valued by reference to the price to tangible net worth ratio of Edison International, whose utility subsidiary, Southern California Edison, also faces the risk of wildfire damage claims under California’s principle of inverse condemnation and, like PG&E, is regulated by the CPUC and FERC.

If so, the implied market value of PG&E’s asset portfolio rises to $40.4 billion. We subtract our estimate of PG&E’s pre-tax wildfire and bankruptcy-related costs of $18.5 billion (Exhibit 1). As in the Low and Mid Case scenarios, we further subtract an estimated $0.9 billion in debt not attributable to PG&E’s regulated utility business, and add back our estimate ($0.2 billion) of the present value of PG&E’s future tax savings from its tax loss carryforwards. We thus calculate PG&E’s net value to shareholders to be $21.2 billion (Exhibit 2), or some 2.9x PG&E’s current market capitalization of $7.3 billion.

Sum of the Parts Analysis: Upside from the Recovery of Wildfire Losses

A very conservative aspect of the above valuation analysis is that in all cases it assumes that PG&E (i) was negligent in causing the Camp fire and all of the 2017 fires excluding Tubbs and (ii) is allowed no recovery whatsoever of its wildfire liabilities. In light of Senate Bill 901, we believe these to be unrealistically conservative assumptions.

In Exhibit 3, therefore, we present the potential upside to our valuation of PG&E were the utility allowed to recover a portion of these damage payments. Under California’s utility regulatory framework, as modified by Senate Bill 901, this would correspond to a scenario where:

  • PG&E was found to have acted prudently in the management of its electric grid and, because the utility’s negligence did not contribute to the wildfires that caused the damages, PG&E is allowed to seek recovery from the CPUC of its wildfire losses;
  • PG&E negligence contributed to the fires, but other factors (such as drought and high winds, or violations of municipal building or vegetation management codes) contributed as well, causing the CPUC to allow PG&E recovery of some portion of the losses; or
  • PG&E’s negligence caused the losses but the utility’s unrecoverable losses exceed “the maximum amount the corporation can pay without harming ratepayers or materially impacting its ability to provide adequate and safe service,” in which case the CPUC has the authority under Senate Bill 901 to cap PG&E’s unrecovered losses for 2017.

For every 10% of PG&E’s maximum potential wildfire liability that PG&E is allowed to recover, the utility’s after-tax, after-insurance cost is reduced by $1.4 billion in our high and mid cases, equivalent to almost 20% of PG&E’s current market cap of $7.3 billion. In our low case, with its assumption of a 50% increase in PG&E’s wildfire liability, 10% recovery reduces the utility’s unrecoverable costs by $2.0 billion, or almost 30% of PG&E’s current market cap. We note that these potential upsides are not improbable; in our high and mid cases, for example, a 10% reduction in PG&E’s wildfire liability might occur if PG&E were found not to be responsible for the 2017 Atlas fire, for which we estimate that property and other damages will total $2.7 billion, but in respect of which the company has not felt compelled to book reserves in accordance with GAAP.

Exhibit 3: Upside to Our Sum of the Parts Valuation of PG&E Assuming Various Levels of Recovery of Damage Payments Made by the Utility in Respect of the 2017-2018 Wildfires (1)

_____________________________________________________________________________

1. Assumes the net cost to PG&E of the wildfire damage liabilities arising from the 2017-2018 wildfires is $14.2 billion, after settlements, insurance and taxes (see Exhibit 2). Assumes that property damage claims are settled at 60% of face value, as SDG&E did in respect of the 2007 Guejito, Rice and Witch Creek fires. Excludes damage claims arising from the Tubbs fire, where CalFire has found no evidence that PG&E equipment caused the fire.

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

To assist the reader in assessing the probability of recovery of PG&E’s wildfire losses, it may be helpful to summarize the provisions of Senate Bill 901, which was passed by the California legislature and signed by Governor Brown last year.

Senate Bill 901 requires the California Public Utility Commission to authorize recovery from ratepayers of otherwise unrecoverable costs arising from the 2017 wildfires to the extent these exceed “the maximum amount the corporation can pay without harming ratepayers or materially impacting its ability to provide adequate and safe service.” To frame the potential value of this provision, we estimate PG&E’s potential liability for property and other damages arising from the 2017 wildfires, net of settlements, insurance and taxes, at ~$4.8 billion, or 20% of our estimated $23.9 billion total. (Future wildfires are also covered by this provision, but 2018 wildfires are not.)

A second key provision of Senate Bill 901 allows the Commission, when “evaluating the reasonableness of the costs and expenses” incurred by utilities due to wildfires occurring in 2019 or later, including damages paid by the utilities to third parties in compensation for their losses, to consider exculpating factors, such as:

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

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. Although this provision of Senate Bill 901 does not apply to the 2017 and 2018 fires, the president of the CPUC has stated that the CPUC already has such authority under pre-existing law and could thus apply a similar standard when assessing the recovery of 2017-2018 wildfire costs.

For a more detailed summary of the provisions of Senate Bill 901, please see Appendix 3 of this research report.

Alternative Valuation Analysis: No Breakup

Our second valuation methodology values PG&E as an ongoing enterprise holding its existing portfolio of assets. A unique challenge of valuing PG&E is the need to assess not only the scale of the damage claims arising from the 2017-2018 wildfires for which the utility will be held responsible, but the potential scale of future wildfire liabilities as well.[4] Looking backwards, our valuation model estimates the potential losses faced by PG&E as a result of the 2017-2018 wildfires, as well as any material offsets to those losses. Looking forward, the model estimates the cost of potential future wildfire losses, at least until the risk of catastrophic wildfires can be contained. A critical assumption underlying this assessment is that the utility and the state commit to a concerted program of action to significantly reduce future wildfire risk.

More specifically, our model estimates:

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

In applying this model to PG&E, we have assumed the following:

  • PG&E is not broken up in bankruptcy and its component business sold off as separate utilities. Rather, we assume that PG&E’s current corporate structure and asset portfolio remain unchanged.
  • The scale of PG&E’s potential liability for future catastrophic wildfire losses will be equivalent to its estimated liability for the 2017-2018 wildfires, as set out in Exhibit 2. The assumptions and methodology underpinning the estimates in Exhibit 2 are set out in the Appendix 1 to this report.
  • The periodicity of catastrophic wildfires similar in scale to those of 2017-2018 is roughly ten years, implying an initial risk of 10% in each year of catastrophic losses similar to those set out in Exhibit 2.
  • Consistent with our assumption that California can bring catastrophic wildfires under control over the coming decade through the policy initiatives described above,[5] we assume that the probability of catastrophic wildfires gradually declines over time, falling to 9% in year two, 8% in year three and so forth.
  • The discount rate to be applied to these expected wildfire losses is roughly 15%, reflecting the sum of (i) the forward earnings yield of Edison International (EIX) stock, calculated using the current share price and consensus 2019 earnings per share, plus (ii) the expected rate of growth in its normalized earnings, reflecting the compound annual growth rate implied by the consensus earnings estimates for EIX in 2018 and 2021.
  • PG&E’s potential liability for past and future fires will be reduced by three principal offsets: (i) the settlement of third party property damage claims at 60 cents on the dollar (as San Diego Gas & Electric was able to do in settling the property damage claims against it arising from the 2007 Guejito, Rice and Witch Creek fires); (ii) the proceeds of third party liability insurance policies, of a size comparable to those maintained by PCG over 2017-2018; and (iii) the utility’s right to deduct unrecovered losses in the calculation of its federal taxes.
  • In the long term, PCG will recover the relative PE multiple at which it traded prior to October 2017, a discount of ~5% to the average PE of the U.S. regulated utilities as a group.
  • Finally, we make no explicit assumption as to the portion of its past and future wildfire damage claims that the CPUC will allow PG&E to recover in rates. Rather, we present the results of our valuation analysis across a range of recovery scenarios for both the 2017-2018 and potential future wildfires.

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

We present the results of our valuation analysis below. Based on our subjective assessment of PG&E’s probable recovery of wildfire losses, we have highlighted those valuations that reflect between 20% and 50% recovery of the utility’s past and potential future wildfire losses. Within this range of potential recoveries, our estimate of PG&E’s value is $40 to $51 per share, or 2.8-3.6x its price of $14.06 per share at the close of trading on Friday, February 8th.

Exhibit 4: Estimated Fair Value of PCG Stock (1)

________________________________________________

1. Our estimate of PG&E’s maximum potential 2017-2018 wildfire losses is $14.2 billion. This estimate excludes damage claims arising from the Tubbs fire, where CalFire has found no evidence that PG&E equipment caused the fire.

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

Appendix 1: Methodology for the Estimation of Wildfire Liabilities

  • The losses that PCG may incur as a result of the 2017-2018 California wildfires can be categorized as follows:
    • penalties, including fines and unrecoverable capital expenditures, imposed by the California Public Utility Commission (CPUC);
    • third party liability claims for deaths, injuries, property damage and consequential damage (e.g., loss of wages or profit);[6]
    • punitive damages, either awarded by the courts or implicit in settlements negotiated by the utilities with victims of the fires;[7] and
    • legal costs for the litigation and CPUC proceedings.

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

  • CPUC Penalties. Historically, the CPUC has levied relatively modest penalties on the state’s electric utilities for regulatory violations contributing to brush fires.
    • In September, 2015, the Butte Fire in Amador County burned 71,000 acres, destroyed 549 homes and killed two people. The CPUC found that PCG’s negligence in pruning trees nears its lines had contributed to the fire and fined the utility $8.3 million.
    • In 2013, Southern California Edison (SCE) agreed with the CPUC to a $37 million settlement in connection with the 2007 Malibu Canyon fire, paying a $20 million fine to the State of California and absorbing $17 million in costs to assess the safety of utility poles. SCE admitted having overloaded its power poles in violation of CPUC rules and having withheld pertinent information from the CPUC.
    • In 2010, San Diego Gas & Electric (SDG&E) agreed to pay $21 million to settle allegations that its mismanagement led to the 2007 Guejito, Rice and Witch Creek fires and that SDG&E hampered investigators. SDG&E paid $14.35 million in fines to the State of California and absorbed $6.75 million in costs incurred as a result of the 2007 fires.
    • In 1994, PCG was found guilty of 739 counts of negligence in connection with a fire in the Sierra foothills that destroyed twelve homes.  PCG was fined $30 million by state regulators, or the equivalent of ~$50 million in 2018 dollars.
    • To be conservative, we have used the largest of these historical penalties, that levied in the Sierra foothills fire, as the basis for our estimate of CPUC penalties in respect of the 2017-2018 California wildfires.
  • Third Party Liability. PCG face the risk of liability for property damages under the principle of inverse condemnation, and the risk of liability for property damages plus personal injury, pain and suffering and incidental damages under the principle of tort liability.
    • Inverse condemnation. Inverse condemnation is based upon the fifth amendment of the U.S. constitution, which stipulates that private property may not be taken for public use without just compensation. Under California state law, inverse condemnation, a principle that requires compensation for damage to property caused by government property, has been extended based on the state constitution to cover investor owned utilities operating under state regulation. The principle stipulates that a utility must compensate property owners for damage to their property caused by a utility’s assets, whether or not the utility was negligent in the operation or maintenance of those assets. If the utility was not negligent in causing the damage, the CPUC should allow recovery of the damages from ratepayers. The principle of inverse condemnation does not extend to third party liability claims for death, injury, and consequential damages (e.g., loss of wages or profits); these must be pursued under the principle of tort liability.[8]
    • Tort liability. Third party liability claims for property damage could also be brought against PCG under the principle of tort liability in suits filed in state courts. Under the principle of tort liability. Plaintiffs may also seek compensation for death, injury, and consequential damages (e.g., loss of wages or profits). Under the principle of tort liability, however, the utility would be liable for property and other damages if the plaintiff could prove that the damages suffered were caused by the utility’s negligence. Plaintiffs can, and have, filed claims for both inverse condemnation and negligence at the same time, collecting the greater of the two liabilities they can prove in court.
      • Negligence. Whether a utility has been negligent in the operation or maintenance of its assets is of far greater consequence than whether a claim is pursued under the principle of inverse condemnation or tort liability. A finding of negligence is what determines if the utility suffers an economic loss or not. If a utility is not found to have been negligent, then, under the principle of inverse condemnation, it is to be allowed to recover from ratepayers any damages paid, implying minimal economic loss; under the principle of tort liability, it would not be liable for damages in the first place and thus, similarly, would suffer no loss. Conversely, if a utility is found to have been negligent, under CPUC rules, no recovery is allowed from ratepayers (regardless of whether the damage was awarded under the principle of inverse condemnation or of tort liability), implying that shareholders must absorb the cost of any damages paid.
    • Consequences. If a utility’s assets are found to be the cause of a fire, and it is determined that the negligence of the utility in maintaining or operating its equipment caused the fire, then the utility will be liable for all damage resulting from the fire, including property, death, injury, pain and suffering and consequential damages such as the loss of wages or profits.
  • Punitive Damages. We view the odds of an award of punitive damages to be very low and have excluded it from our analysis of potential impacts. In punitive damages cases, the burden of proof is on the plaintiff, who must demonstrate that the defendant engaged in “willful misconduct,” a higher legal standard of negligence which has generally been defined as a conscious disregard of probable harm. Given the absence to date of any physical evidence suggesting such egregious misconduct by the utilities, and their significantly increased focus on vegetation management and fire prevention as California’s drought worsened over the last several years, proving conscious disregard of probable harm will be a challenge for plaintiffs.
  • Estimating the Scale of Potential Losses. It is too early to know the full scale of damage caused by the 2017-2018 California wildfires. It is possible to estimate the scale of damage, however, by reference the damage caused by past fires, such as the 2007 Witch/Rice fires, the 2015 Butte fire and the fires in Northern California in October 2017.
    • Property Damage. Based on the insurance claims brought in connection with past fires, and the number of structures destroyed by these fires, it is possible to arrive at an estimated ratio of insured damage per structure, which we use as a proxy for property damage.[9] Adjusting for inflation, we found that the highest value of insurance claims per structure destroyed was registered in connection with 2017 northern California fires. Dividing the $9.4 billion in property damage claims arising from these fires across the ~8,600 structures destroyed results in a ratio of ~$1.2 million per structure destroyed in 2017. For the 2018 Camp fire the insured damage totaled $8.4 billion, but that was across ~18,800 structures, resulting in a much lower damage per structure of ~$0.45 million. To estimate the total property damage caused by the 2017-2018 California wildfires, we have multiplied the 2017 ratio of $1.2 million in property damage per structure destroyed by the total number of structures destroyed in the Nuns, Atlas and Redwood Valley fires (~$2.4 billion) and we added the $8.4 billion of insured damage for the Camp fire.
    • Other Third Party Liabilities. PCG will likely also face other third party liabilities, including claims for damages arising from death and personal injury, consequential damages, such a loss of wages or profit, damage to governmental property, and firefighting costs. In the Witch/Rice fire, San Diego Gas & Electric (SDG&E) recorded total costs of $1.3 billion for all third party claims excluding insured claims. Calculated per structure destroyed, and adjusted for inflation since 2007, the losses from the Witch/Rice fire work out to ~$850,000 per structure. For the 2017 wildfires, again, we have multiplied this ratio in other third party liabilities per structure destroyed by the total number of structures destroyed in each wildfire to estimate the total cost of these claims to PCG. For the Camp wildfire, given the poorer economic conditions of the area compared to the previous fires, we reduce the non-property damages by one third to ~$570,000 per structure[10] and multiplied it by the number of structures destroyed.
    • CPUC Penalties. Reflecting the penalty imposed on PCG by the CPUC for the Sierra foothills fire of 1994 — the largest penalty imposed by the Commission over the last 25 years in respect of a brush fire – we assume that PCG will each face $50 million in CPUC fines and penalties for each major fire in their service territories, or a total of $100 million each across 2017-2018.
    • Legal Fees. We estimated the legal fees for the bankruptcy filing and the wildfire claims litigation within the bankruptcy filing separately. Based on the legal costs incurred by PCG in connection with the San Bruno gas pipeline explosion, we estimate that PCG will incur $300 million in legal costs in connection with the claims arising from each of the 2017 and 2018 northern California wildfires, for a total of $600 million. We added an additional $600 million reflecting the legal fees for Energy Future Holdings bankruptcy.
  • The Offsets: Insurance and Taxes. PCG had $2.2 billion of third party liability insurance available to them to cover losses from the 2017-2018 wildfires. Importantly, payments of third party liability claims in excess of these amounts are tax deductible, as are legal expense. CPUC penalties, however, are not. We have assumed, therefore, that both PCG can deduct their legal costs and payments of third party liability claims, net of insurance proceeds, from their taxable income in the calculation of their federal income taxes.

Appendix 2: Comparable Transactions Valuation of PG&E’s Generating Fleet

First. we have valued PG&E’s 1,203 MW of CCGT capacity at $574/kW, by reference to the $300 million price paid by Avenue Capital in November 2018 for AltaGas’ three gas fired power plants, totaling 523 MW of operating capacity (330 MW CCGT, 193 MW GT) in California’s San Joaquin and Kings counties. All three plants are in PG&E’s service territory and have PPAs with the utility through 2022. (We believe the AltaGas sale to be a conservative benchmark by which to value PG&E’s CCGT capacity, given the relatively high proportion of open cycle gas turbine capacity (37%) in AltaGas’ Californian fleet.)

Second, we have valued PG&E’s 1,212 MW of pumped storage capacity at $790/KW by reference to the average price set in two recent sales of pumped storage facilities. The first of these was the sale by Engie Group to PSP Investments in November 2016 of 1,168 MW of pumped storage capacity and 232 MW of conventional hydroelectric capacity in Massachusetts and Connecticut (like California, states where gas fired generators tend to be the price setting units) for a price of $1.2 billion, or $857/kW. The second was the sale by Allegheny Energy to LS Power in July 2018 of 421 MW of capacity at the Bath County, Virginia pumped storage facility, plus 881 MW of open cycle gas turbine capacity. If we value the open cycle gas turbine capacity (generously, in our view) at $592/kW, by reference to three sales of CCGT capacity that also closed in the second half of 2018, the implied valuation of the pumped storage capacity is $722/kW.

Third, we have valued PG&E’s 2,685 MW of conventional hydroelectric capacity at $1,623/kW, reflecting the average of two sales of comparable fleets of hydroelectric assets. The first of these was the sale by PPL to NorthWest Energy in November 2014 of 633 MW of capacity at 11 hydroelectric plants in Montana for $900 million, or $1,422/kW. The second was the sale by TransCanada to ArcLight Capital in April 2017 of 584 MW of capacity at 13 hydroelectric facilities in Vermont, New Hampshire and Massachusetts for $1.065 billion, or $1,824/kW.

Appendix 3: A Summary of the Provisions of Senate Bill 901

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

©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 also our research report of Dec. 3, 2018, Are PCG & EIX Still Hot Stocks? We Assess the Risk of Repeated Catastrophic Wildfires & Its Implications for Valuation; Maintain PCG & EIX on Our List of Preferred Utilities, available at http://www.ssrllc.com/publication/are-pcg-maintain-pcg-eix-on-our-list-of-preferred-utilities/ 
  2. We assume a minimum of net book value because, unlike a regular takings case, in which compensation is based on fair market value, utilities have additional protections due to their status as “public utilities” with an obligation to serve all comers at fair and reasonable prices. In particular, utilities must be allowed the opportunity to earn a reasonable return on their investments. Since all of the existing investment in PG&E’s T&D business has already been determined to be prudent, they 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. This does not preclude the state from imposing fines and penalties on PG&E for its behavior in causing the wildfires, but those would have to be authorized under other provisions of the law. 
  3. Our 2019 rate base estimate is taken from Attachment B of the Petition for Modification of Decision 16-06-056 of Pacific Gas and Electric Company to Reflect Tax Changes. 
  4. See our research report of Dec. 3, 2018, Are PCG & EIX Still Hot Stocks? We Assess the Risk of Repeated Catastrophic Wildfires & Its Implications for Valuation; Maintain PCG & EIX on Our List of Preferred Utilities, available at http://www.ssrllc.com/publication/are-pcg-maintain-pcg-eix-on-our-list-of-preferred-utilities/ 
  5. See “Sum of the Parts Analysis: Base Case” above. 
  6. Third party liability claims for property damage could be brought against EIX under (i) California’s principle of inverse condemnation, which stipulates that a utility must compensate property owners for damage to their property caused by a utility’s assets, whether or not the utility was negligent in the operation or maintenance of those assets, or (ii) under the principle of tort liability in suits filed in state courts, in which case the utility would be liable for damages only if the plaintiff could prove that the damages suffered were caused by the utility’s negligence. The principle of inverse condemnation does not extend to third party liability claims for death, injury, and consequential damages (e.g., loss of wages or profits); these must be pursued under the principle of tort liability, requiring the plaintiff to prove negligence. 
  7. The principle of inverse condemnation does not extend to punitive damages; these must be pursued under the principle of tort liability. In punitive damages cases, the burden of proof is on the plaintiff, who must demonstrate that the defendant engaged in “willful misconduct,” a higher legal standard of negligence which has generally been defined as a conscious disregard of probable harm. 
  8. For a much more thorough discussion of inverse condemnation and the risk it poses for utilities, please see our note from December 5, 2017 CPUC Ruling Denying SRE Recovery of Forest Fire Costs Does Not Increase the Risks for California Utilities
  9. We used the insurance claims as an estimate of total property damage. While there are uninsured property damages, the vast majority of structures destroyed in the past fires were insured. Furthermore, the insurance claims include non-property damages, such as business interruption and the cost of replacement housing. We assuming the non-property portion of the insured damages is similar in size to the value of the uninsured property. 
  10. We did not reduce the non-property damages in line with the lower value of the property damages per structure because much of the non-property damage, such as injury, death and pain and suffering, is not related to the regional economic differences. 
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