Upgrading PCG to Our List of Most Preferred Regulated Utility Stocks: The Stock Now Fully Discounts the Sonoma County Fires

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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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October 16 , 2017

Upgrading PCG to Our List of Most Preferred Regulated Utility Stocks:

The Stock Now Fully Discounts the Sonoma County Fires

Over the last three trading days, PG&E (PCG) stock has dropped by 22%, erasing $7.8 billion in market value. If we assume this reflects the market’s estimate of the after-tax cost to PCG of the Sonoma County fires, the pre-tax and pre-insurance cost must be estimated to be ~$13.0 billion. By contrast, the estimates of property damage released by public officials to date total some $3.2 billion, with forecasts ranging up to $6.0 billion. In this note, therefore, we argue that PCG’s drop in market value capitalizes losses from the Sonoma County fires that are unrealistically high. Our analysis suggests that PCG’s $54 share price at Monday’s close represents an attractive entry point for the stock, offering protection against a worst case scenario and 14% to 27% upside depending on the final level of fire losses.

Portfolio Manager’s Summary

  • Categories of Potential Loses. The losses that PCG may incur as a result of the Sonoma County fires can be categorized as follows: (i) penalties, including fines and unrecoverable capital expenditures, imposed by the California Public Utility Commission (CPUC), (ii) third party liability claims for deaths, injuries and property damage caused by the fires, and (iii) punitive damages, either awarded by the courts or implicit in settlements negotiated by PCG with victims of the fires. Below we estimate the potential scale of the losses that could be suffered by PCG in each of these three categories, and, on this basis, assess the maximum probable loss from the Sonoma fires in both an adverse and a worst case scenario (see Exhibit 1).
  • Scale of Potential Loses. We estimate that PCG’s maximum potential losses for CPUC penalties, third party liability claims and punitive damages could range from ~$6.8 billion in an adverse scenario to ~$12.4 billion in a worst case scenario. Adjusted for insurance recoveries and PCG’s ability to tax deduct the cost of third party liability claims and punitive damages, we estimate the net cost to PCG at $3.6 to $7.0 billion in these scenarios, or the equivalent of ~$7.00 to $13.55 per share. Assuming that PCG’s Oct. 11 close of $69.15 represents the market’s assessment of the company’s value in the absence of Sonoma County losses, our analysis suggests that a share price of up to $55.60 would offer protection against a worst case scenario. Even in a materially adverse scenario, we see 15% upside from Monday’s close of $54 per share. In a range of more favorable scenarios, we estimate that upsides of 16% to 27% are possible (see Exhibit 1).

Exhibit 1: Scenario Analysis of PCG’s Potential Losses from Sonoma County Fires

Source: Company and press reports, SSR analysis

Exhibit 2: Heat Map: Preferences Among Utilities, IPP and Clean Technology

Source: SSR analysis

Details

  • As noted above, the losses that PCG may incur as a result of the Sonoma County fires can be categorized as follows: (i) penalties, including fines and unrecoverable capital expenditures, imposed by the California Public Utility Commission (CPUC), (ii) third party liability claims for deaths, injuries and property damage caused by the fires, and (iii) punitive damages, either awarded by the courts or implicit in settlements negotiated by PCG with victims of the fires. Below, we estimate the range of PCG’s potential losses in each of these categories.
  • CPUC Penalties. Historically, the CPUC has levied relatively modest penalties on PCG and other California 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 2017 dollars.
  • Note that even the largest of the penalties listed above is only one fortieth of the $2.2 billion in fines, penalties and unrecovered costs imposed by the CPUC on PCG for the 2010 explosion of its gas transmission line at San Bruno. This difference reflects (i) the scale of PCG’s violations in that case (a total of 2,425 violations of federal and state laws and regulations), (ii) the fact that these violations persisted over five decades (resulting in 18,447,803 days in violation), and (iii) the Commission’s practice of levying fines based on days in violation.
    • The likelihood that the Sonoma County fires might reflect a similar number of days in violation is very low, if only because vegetation management around power lines requires annual if not more frequent inspections. As the risk of brush fires worsened as a result of California’s 2011-2016 drought, PCG has begun inspecting power lines in high risk areas twice annually.
    • Nor is it likely that the pattern of criminal negligence that characterized the maintenance of PCG’s gas pipeline system will be found to recur in connection with the Sonoma County fires. In 2016, PCG reports having inspected all its overhead power lines, as well as 170,000 utility poles, and pruning 236,000 trees near its power lines – at a total cost $198 million.
    • Absent a similar number and duration of violations as preceded the San Bruno explosion, the scale of the penalties imposed in that case are a poor benchmark to evaluate shareholder risk in connection with the Sonoma County fires.
  • Third Party Liability. In our view, third party liability claims constitute the critical risk to PCG, reflecting both their potential scale and the relative ease of winning awards in court. In connection with the 2015 Butte Fire and the 2007 brush fires in Southern California, plaintiffs were successful in court in winning damage awards against PCG and SDG&E based on the principle of “inverse condemnation.” Exercising the right of eminent domain, state authorities and public utilities may condemn private property for the construction of facilities deemed to be in the public interest, provided they compensate the owners. Under California law, the principle of inverse condemnation allows parties whose property has been damaged by the assets or operations of a regulated utility to argue that, in effect, their property has been condemned and they are due compensation. The plaintiffs have no obligation under this principle to prove negligence on the part of the utility. However, if PCG was not negligent in its grid maintenance and tree trimming activities it should be allowed to recover from ratepayers the cost of any compensation paid.
    • Recovery from Ratepayers. 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, this principle has been extended to cover public utilities operating under state regulation, even if these are private companies, and holds that the taking of or damage to property caused by the assets or operation of public utilities must therefore be compensated. Second, because these assets and operations serve the public interest, the principle holds that the cost of such compensation should be borne by the public. The court in the Butte decision specifically noted that PCG could file to recover the costs of compensation from ratepayers. However, at this time the ability to do so is not clear and is being litigated by San Diego Gas and Electric in an earlier case.
    • We believe that there is a strong federal constitutional claim to be made that, in the absence of negligence by the utility, the utility should have the right to recover from ratepayers the costs paid for compensation under inverse condemnation cases. The argument is that the utility has an obligation to serve, that it makes investments therefore to serve the public, and it has a right to earn a reasonable return on these investments. The obligation to provide compensation for damages caused by a utility’s investments caused solely through their operation in their intended purpose would undermine the utility’s ability to earn a reasonable return.
  • Punitive Damages. The risk to PCG of punitive damages is limited by the much stricter legal standard for their award. Under the Public Utilities Code section of California law, plaintiffs seeking punitive damages from PCG would be required to prove that PCG not only behaved negligently but that it acted “willfully.” While specific definitions of “willful” vary, the common theme is that it requires a conscious disregard of probable harm. Given the effort that PCG has put into improving its safety culture, and in particular the company’s increased focus on vegetation management as California’s drought has worsened, proving conscious disregard of probable harm may be a challenge for plaintiffs.
    • Courts may limit punitive damages even for willful misconduct. Even if PCG were to have engaged in willful misconduct, courts may be hesitant to impose punitive damages on the company if its conduct was not specific to any customer, but rather represented general misconduct in maintaining its transmission lines. The California Public Utilities Code, while allowing courts to impose punitive damages on utilities, also instructs the courts not to interfere with the CPUC’s performance of its duties. When the willful misconduct is a widespread problem affecting the operation of the grid, courts would likely reason that imposing significant punitive damages would interfere with the CPUC’s ability to impose appropriate penalties that encourage the desired change in utility practices.
  • Estimating the Scale of PCG’s Potential Losses. It is too early to know the full scale of property damage caused by the Sonoma County fires, but two public officials have offered estimates. The mayor of the principal city in the county, Santa Rosa, has estimated that the fire destroyed nearly 5 percent of the city’s housing stock, causing at least $1.2 billion in damage. State Senator Mike McGuire has offered a separate assessment of $2.0 billion for the unincorporated portions of Sonoma County. The sum of these two estimates is $3.2 billion. However, other, private estimates of total property damage from the Sonoma County fires range as high as $6 billion. We will use the lower end of this $3.2 to $6.0 billion range of potential property damage to estimate the cost to PCG of the Sonoma County fires in an adverse scenario and the upper end to calculate the consequences of a worst case scenario.
    • 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 face $50 million in CPUC fines and penalties for the Sonoma County fires.
    • Third Party Liability. We assume that, under California’s principle of inverse condemnation, PCG is found to be liable for the full amount of the property damage caused by the Sonoma County fires, estimated at $3.2 billion in our adverse scenario and $6.0 billion in our worst case scenario. We further assume that PCG is not allowed recovery of these damages from ratepayers, despite the strong legal argument to the contrary.
    • Punitive Damages. While we believe it improbable that plaintiffs can meet California’s high standard of willful disregard of probable harm for the award of punitive damages, we nonetheless assume that PCG is required to pay punitive damages equal to our estimate of property losses, or $3.2 billion in our adverse scenario and $6.0 billion in our worst case scenario. These punitive damages could be paid out explicitly, in response to litigation and an adverse court decision, or implicitly, through settlements individually negotiated with the plaintiffs.
    • Legal Fees. We estimate that in all scenarios PCG will face significant legal costs defending itself over the next few years. We use $300 million as our estimate of legal costs.
    • Total Estimated Pre-Tax Losses. In our adverse scenario, we estimate PGG pre-tax losses at some $6.75 billion, comprising $3.2 billion in third party liability claims, $3.2 billion in punitive damages, $300 million in legal costs and $50 million in CPUC fines and penalties. In our worst case scenario, which is based upon $6.0 billion in third party liability claims and $6.0 billion in punitive damages, we estimate that PCG’s pre-tax losses could range as high as $12.35 billion.
  • The Offsets: Insurance and Taxes. PCG has disclosed that it has $800 million of third party liability insurance available to it to cover losses from the Sonoma County fires. This would reduce our estimate of PCG’s out-of-pocket losses to ~$6.0 billion in our adverse case and to ~$11.6 billion in our worst case. We note, moreover, that payments in respect of third party liability claims and punitive damages are tax deductible, reducing the after-tax cost of these loses to ~$3.6 billion in our adverse scenario and $7.0 billion in the worst case.
  • Net impact on PCG’s value. Spread across PCG’s 513 million shares outstanding, our worst case estimate of $7.0 billion in after-tax losses is equivalent to $13.55 per share, less than the $15.15 drop in PCG’s share price over the last three trading days. Our adverse scenario of $3.6 billion in after-tax losses is equivalent to ~$7.00 per share, or less than half the $15.15 drop. PCG’s shares closed at $69.15 on Wednesday, October 11, not far from its 52-week high of $71.57. If we accept $69.15 as the market’s estimate of PCG’s value in the absence of material losses from the Sonoma County fire, our calculation that PCG’s losses could total $13.55 per share in a worst case scenario suggests that the stock price could return to $55.60 per share, or 3.0% above Monday’s close of $54 per share. In our adverse scenario, the stock might bounce back to $62, or 15% above Monday’s close (see Exhibit 1).
    • In a more positive scenario, where courts rule that the legal standard for punitive damages has not been met, the pre-tax cost of the Sonoma County fires might fall to a range of $3.26 to $6.53 billion ($50 million in CPUC penalties plus $300 million in legal fees plus $3.0 to $6.0 billion for third party liability claims). Net of insurance proceeds of $800 million, these losses would be reduced to a range of $2.55 to $5.55 billion; after these losses are deducted from PGC’s taxes, the net cost falls to ~$1.6 to ~$3.4 billion or $3.00 to $6.50 per share. In this scenario, and again assuming a market value for PCG of $69.15 per share in the absence of fire losses, fair value for the stock would fall in a range of ~$62 to $66, or ~16% to 22% above Monday’s close (see Exhibit 1).
    • Finally, if PCG were allowed recovery of the compensation it pays for third party liability claims under California’s principle of inverse condemnation, the pre-tax cost to PCG could be reduced to only $350 million ($50 million in CPUC penalties plus $300 million in legal fees), or just $0.45 per share after tax – consistent with a share price of $68.70, some 27% above Monday’s close.
  • Conclusion. Our analysis suggests that PCG’s $54 share price at Monday’s close represents an attractive entry point for the stock, offering protection against a worst case scenario and 15% to 27% upside depending on the final level of fire-related property losses, whether punitive damages are awarded, and whether the recovery of third party liability claims is allowed. On a fundamental basis, moreover, we note that a 14.1x multiple of 2017 consensus eps, PCG is now cheaper than any other primarily regulated electric utility, while offering one the sector’s fastest expected rates of rate base growth (8.6% p.a. over 2016-2021). [1] We believe the potential upside now far outweighs the potential downside risk from the 2019 cost of capital proceeding that caused us to remove PCG from our list of most preferred regulated

utility stocks in May (see our note of May 12, California Cost of Capital Proposed Decision: A Year’s Reprieve Before ROEs Drop for EIX and PCG.

 

©2017, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

  1. See our note of October 2, If This Is the Golden Age of Electric Utilities, What’s Next? Or, How Fast Can Rate Base Grow in the Long Term and on What Will Utilities Spend?
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