Would Splitting PG&E Create Value for Shareholders? Why Municipalization Might Make Sense

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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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December 11, 2018

Would Splitting PG&E Create Value for Shareholders?

Why Municipalization Might Make Sense

Last month, President Picker of the California Public Utilities Commission (CPUC) announced the opening of new phase in the Commission’s existing investigation into the safety culture of Pacific Gas & Electric, widening its scope to examine the corporate governance, structure and operation of the utility. In particular, Picker explained, the proceeding will examine the best path forward for northern Californians to receive safe electric and gas service. PG&E management has sought to engage with the Commission’s investigation by exploring, among other alternatives, the possibility of allowing the state of California or local governments to acquire its power transmission and distribution assets in the most fire-prone regions of the state north of San Francisco Bay. Such a sale would significantly reduce PG&E’s exposure to the risk of future catastrophic wildfires similar to those of 2017-2018, materially enhancing the value of PG&E’s remaining utility franchise in the central portion of the state. Moreover, with PG&E stock now trading at a 30% discount to book value, the sale of assets to the state at their net book value would be accretive to book value per share.

We outline below the financial arithmetic of such a transaction, and assess the pros and cons from the perspective of the utility and the state. We find that PG&E’s value is enhanced by the divestiture of its northern California T&D assets under the following circumstances: (i) if the deal increases the odds of higher recovery of 2017-18 damages from ratepayers, (ii) if PG&E fears that the risk of future catastrophic wildfires cannot be materially reduced, or (iii) if the scale of future wildfire losses, absent divestiture, would be so high that the utility would expect to recover less than half of the of losses from ratepayers. Conversely, if PG&E is confident the risk of future fires, and investors’ perception of such risk, can be reduced, and it can therefore recover more than half of its future wildfire losses without divestiture of its northern California T&D assets, such a deal would have limited value.

  • The risk of wildfires in PG&E’s service territory is highest in the California counties north of San Francisco Bay. Were PG&E to divest its electric transmission and distribution assets in these fire prone counties, the consequent reduction in wildfire risk would significantly enhance the value of the utility franchise that remains, with assets concentrated in the lower risk and higher growth areas south of San Francisco Bay.
    • The California Department of Forestry and Fire Protection (CalFire) has designated certain California counties to be at high risk of fire. Many of these counties are located in the region north of San Francisco Bay. Within PG&E’s service territory, 73% of the communities served in high fire risk counties are located north of the Bay.
    • Moreover, all the damage caused in PG&E’s service territory by the catastrophic 2017-2018 wildfires occurred in the counties north of San Francisco Bay.
  • PG&E’s enterprise value of $32.6 is now ~12% below the utility’s estimated 2018 rate base of $36.8 billion, while PG&E’s market capitalization of $13.4 billion is ~30% below its book value of $19.7 billion. An asset sale at book value would thus be accretive to book value per share.
  • Finally, such an asset sale might be used to fund a part of the damage claims against PG&E arising from the 2017-2018 fires, possibly facilitating an agreement with the CPUC to recover most or all of the remaining amount from PG&E’s ratepayers.
  • The cost to PG&E of such a transaction would be the loss of a material portion of its total rate base and the regulated earnings it is allowed on these assets.
        • To estimate the contribution of PG&E’s T&D assets north of San Francisco Bay to the utility’s total rate base, we have assumed that the distribution of PG&E’s T&D assets are roughly proportional to the distribution of population in its service territory.
      • The counties north of San Francisco Bay account for 20% of the population served by PG&E across its entire service territory.
      • PG&E’s power transmission and distribution network accounts for ~58% of PG&E’s total rate base of $36.8 billion.
      • We can thus estimate the book value of PG&E’s northern California T&D assets at ~$4.4 billion or 12% of PG&E’s total rate base of $36.8 billion ($36.8 billion x 58% x 20% = $4.4 billion).
      • Were PG&E’s utility franchise in California’s northern counties to be terminated, and taken over by the state or local governments, we expect the compensation due PG&E would be roughly equivalent to the book value of the acquired assets.
      • Although an acquisition of private property is generally valued at fair market value, given the high risk of future fires, the value of this utility plant would be well below that of other utility grids and possibly below book value.
      • However, due to the regulatory compact under which the PG&E made its utility investments, the state is required to allow it to recover its investment in the property, which is equal to the book value. An attempt to acquire these assets through eminent domain by the state or one of its territories would not circumvent this requirement.
          • The most important implications of such transaction, we believe, is that it would restore value to PG&E’s existing franchise, freeing investors to capitalize the future earnings stream on the remaining 88% of PG&E’s rate base without fear that their value will be wiped out by a repeat of the 2017-2018 fires.
      • Limiting wildfire risk, and thus restoring the value of PG&E’s utility franchise, is critical to restoring PG&E’s access to the capital markets, allowing it to raise the large amounts of capital required to ensure the reliable supply of electricity in its service territory.
      • Absent a significant reduction in future wildfire risk, it cannot be assumed that PG&E will regain access to the capital markets – irrespective of any settlement reached between the utility and its regulator for the recovery of losses arising from the 2017-2018 fires.
  • A second implication of the transaction would be an inflow of ~$4.4 billion pre-tax to PG&E’s utility subsidiary, Pacific Gas & Electric, in return for the T&D assets sold.
      • We would expect the after-tax proceeds of the sale to be very similar, reflecting the scale of PG&E’s existing net operating losses, its expected losses from the 2017-2018 wildfires, and the fact that the assets would be sold at their depreciated book value.
      • Of the $4.4 billion, we would expect ~$2.1 billion to flow to the holders of the Pacific Gas & Electric’s bonds, thereby maintaining the utility’s mandated ratio of debt to rate base and complying with the indenture of its first mortgage bonds.
    • We would expect PG&E to apply the remaining $2.3 billion to settle liability claims arising from the 2017-2018 fires, possibly facilitating an agreement with the CPUC for the utility to recover most or all of the remaining amount from ratepayers.
  • A final but very important implication of the deal is the latitude it might give California’s politicians to craft a financial rescue of PG&E.
        • The state of California, for economic and security reasons, has a strong interest in ensuring that PG&E regains access to the capital markets, allowing it to raise the capital required to ensure the safe and reliable supply of electricity to the residents of the state.
    • Legally, the CPUC should allow PG&E to recover from ratepayers any payments made to third parties under the principle of inverse condemnation for property damages arising from the fires, provided that the utility is found to have acted prudently in maintaining and operating its power grid.
    • Politically and economically, however, such recovery may be infeasible.
    • We estimate PG&E’s total potential losses from third party liability claims arising from the 2017-2018 wildfires, after claims settlement, insurance and taxes, to be ~$26.5 billion,[1] equivalent of 190% of PG&E’s retail electric revenues.
    • If we assume that PG&E were to recover this $26.5 billion of potential losses through a securitization, with mortgage style amortization over 15 years at a 4.0% interest rate, the debt service cost would increase PG&E’s average customer rates and bills by some 17%.
    • Moreover, absent a plan to mitigate PG&E’s exposure to future wildfire losses, this substantial increase in customer bills might only be the first of several, as losses from future fires are recovered from the same pool of ratepayers.
        • Most onerous, from the standpoint of the state’s politicians, is the prospect of transferring as much as $26.5 billion from the ratepayers to the shareholders of the company that caused the devastation so that shareholders can earn a “fair” return.
  • We believe it likely, therefore, that any settlement reached between PG&E and the CPUC regarding the recovery of wildfire losses will require a significant degree of burden sharing between PG&E’s shareholders, ratepayers and the state. The municipalization of PG&E’s assets could play an important role in structuring such an agreement.
        • For political purposes, the municipalization of PG&E’s assets in the wildfire devastated northern counties could be portrayed as a punitive action against the utility, removing 55% of its franchise territory as measured in square miles.
        • PG&E could be required, moreover, to allocate its proceeds from the sale of the assets not to shareholders but to pay damages to those who lost homes or loved ones in the fires.
        • In the context of such a deal, the recovery from ratepayers of the remaining damages paid by PG&E could be portrayed as a balanced resolution of the case.
  • What are the risks to the state of a settlement such as that envisioned in these assumptions?

First and foremost, the newly municipalized northern California utility would assume the risk that future catastrophic wildfires, caused by its power lines, would again engulf northern California. PG&E’s profit-obsessed utility management team could no longer be blamed. Rather, the opprobrium of the public would fall on state or local politicians and bureaucrats.

Second, the third party liability claims arising from future fires could cripple the new utility. Private shareholders could no longer be forced to absorb a share of the pain. Rather, the utility’s ratepayers, or the state or local governments that own the utility, would be required to absorb the loss.

Third, the new municipal utility and its ratepayers would be forced to pay for the investments required to harden the northern California grid, replacing wooden power poles with cement ones, insulating or undergrounding distribution lines in the most fire prone areas and deploying sensors and relays to cut power to vulnerable circuits.

  • We would argue, however, that the risks listed above are risks ultimately borne by ratepayers regardless of who owns the T&D system in northern California.
    • Any owner of that system, whether public or private, will require recovery of the capital invested in hardening the grid, as well as protection against the risk that catastrophic wildfires might wipe out the value of its investment.
  • We have estimated the value of PG&E following the sale of its power transmission and distribution network in the high fire risk counties north of San Francisco Bay (Exhibit 1).
    • Our estimate is based on the valuation model developed in our report of December 3, Are PCG & EIX Still Hot Stocks? We Assess the Risk of Repeated Catastrophic Wildfires & Its Implications for Valuation.[2]
    • We assume that within two to three years of municipalization of PG&E’s most vulnerable T&D assets, the valuation of PG&E stock should revert to its historical 5% discount to the forward PE multiple of the U.S. regulated utilities as a group, reflecting significantly lower geographic exposure to wildfire risk as well as measures taken by the utility and the state to contain the risk of catastrophic wildfires.
    • Over this transition period, we assume PG&E remains exposed to the risk of catastrophic wildfire losses. However, given the sale of PG&E’s T&D assets in the high fire risk counties north of San Francisco Bay, we assume the extent of the damage caused by such fires is reduced by 73% — equivalent to these counties’ share of all the communities served by PG&E in high fire risk areas.
    • We have assumed that the T&D assets are sold at a price equivalent to their depreciated book value and that the pre-tax and after-tax proceeds of the sale are equal. We have assumed that the proceeds are used first to pay back utility debt equivalent to 48% of the value of the assets sold, thereby preserving the utility’s maximum debt to capital ratio, and second to fund damage payments owed by the utility arising from the 2017-2018 wildfires.
    • Finally, we have modeled a range of alternative scenarios where PCG is allowed to recover between 20% and 80% of its otherwise unrecoverable losses arising from both (i) the 2017 and 2018 wildfires in its service territory and (ii) future catastrophic wildfires that may occur over the next decade. We have also modeled a scenario where PCG’s exposure to damages arising from the 2017-18 wildfires is limited to the proceeds from the sale of its northern California grid, with the remainder recovered from ratepayers.

Exhibit 1: Estimated Fair Value of PCG Stock Assuming the Sale of Its T&D Assets in the High Fire Risk Counties North of San Francisco Bay (1)

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1. 20% recovery is approximately in line with a cap on equity issuance due to the 2017 fires of $3 billion. 65% recovery is similar to the amount of equity required if the CPUC capped total equity issuance for 2017 and 2018 at ~$9 billion.

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

  • Our scenario analysis illustrates the critical importance to PCG of either (i) recovering a minimum level of its 2017-2018 wildfire losses or (ii) reducing its liability for wildfire losses below the estimated $26.5 billion we have used in our analysis.[3]
    • Absent recovering or avoiding liability for of at least 35% of its 2017-2018 losses, the potential upside in PCG stock is likely to be unattractive.
    • By contrast, if PCG is allowed recovery of, or is able to avoid exposure to, 50% or more of its maximum potential 2017-2018 losses, our estimate of the fair market value of the stock suggests it is significantly undervalued.[4]
  • Our analysis suggests that PG&E’s value is enhanced by the divestiture of its northern California T&D assets if:
    • the deal increases the odds of higher recovery of 2017-18 damages from ratepayers,
    • PG&E does not believe the risk of future wildfires, or investors’ perception of such risk, can be reduced significantly or
    • the scale of future wildfire losses, absent divestiture, would be so high that the utility would expect to recover less than 50% of its losses.
  • Conversely, if PG&E is confident the risk of future fires, and investors’ perception of such risk, can be reduced, and it can therefore recover more than 50% of its future wildfire losses without divestiture of its northern California T&D assets, such a deal would have limited value.

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

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Source: FERC Form 1, company reports, SNL, SSR analysis

©2018, 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 report of December 3, Are PCG & EIX Still Hot Stocks? We Assess the Risk of Repeated Catastrophic Wildfires & Its Implications for Valuation, available at www.ssrllc.com/publication/are-pcg-maintain-pcg-eix-on-our-list-of-preferred-utilities/. 
  2. Available at www.ssrllc.com/publication/are-pcg-maintain-pcg-eix-on-our-list-of-preferred-utilities/. 
  3. See our report of December 3, Are PCG & EIX Still Hot Stocks? We Assess the Risk of Repeated Catastrophic Wildfires & Its Implications for Valuation, available at www.ssrllc.com/publication/are-pcg-maintain-pcg-eix-on-our-list-of-preferred-utilities/. 
  4. A caveat, however, is that we do not know the period of time over which these potential gains will be realized. In particular, we cannot predict when PCG will eventually settle the many claims against it, persuade the CPUC to allow recovery of a portion of these losses from ratepayers, and issue equity to offset the unrecovered amount. Based on the duration of the legal and regulatory proceedings stemming from PCG’s 2010 gas pipeline explosion in San Bruno, this process could extend over the next three to five years. Investors considering PCG stock must take into account this extended period of uncertainty, during which PCG stock could trade well below our estimate of its fair market value, diluting the annual rate of return that can be expected on the stock. 
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