There’s been no shortage of skeptics, including all three major credit raters Moody’s, Fitch and S&P. But California has delivered on Governor Gavin Newsom’s pledge for a legislative fix to state utilities’ bottomless liability for wildfire damages.
The cornerstone of AB 1054 is a wildfire fund that will take one of two forms. Favored by credit raters is a $21 billion “insurance fund” financed by utilities and the state. The insurance fund includes a “disallowance cap” not to exceed 20 percent of companies’ transmission and distribution equity.
The other choice is a “liquidity fund.” This would start with a much smaller balance for utilities to fund but would be replenished over time. It would not include a cap on disallowances.
The insurance option would also dramatically change the state’s prudency standard for recovering wildfire costs in electricity rates. Currently, the California Public Utility Commission disallows costs, even if utilities follow best practices to prevent wildfires. The new standard would follow Federal Energy Regulatory Commission rules, which allow recovery if prevention protocols have been followed.
Gov. Gavin Newsom signs a measure aimed at stabilizing the state’s electric utilities in the face of devastating wildfires caused by their equipment, as the bills author, Assemblyman Chris Holden, D-Pasadena, left, Thom Porter, the director for the California Department of Forestry and Fire Protection, center, and Mark Ghilarducci, the director of the California Governor’s Office Emergency Services, right, look on in Sacramento, Calif., Friday, July 12, 2019. (AP Photo/Rich Pedroncelli)
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Notably, the new legislation does not address wildfire costs for previous years. Nor does it end the doctrine of “inverse condemnation,” under which utilities are ultimately liable for the cost of wildfires in which power lines are involved.
That means power companies will continue to be under scrutiny during the state’s increasingly long dry season. Risk has already resulted in
It also remains to be seen just how various state agencies will respond when there are future wildfires, and how rigorously utilities will be judged on the prudency standard. These decisions will have a major impact on how quickly the wildfire fund utilities choose is exhausted.
By early August, we’ll find out the option the state’s utilities will adopt. Credit raters clearly favor the insurance option, which is more expensive up front but also reduces risk more effectively.
S&P has kept
There are, however, some obvious winners already. Front and center is Governor Newsom, who it appears will not preside over a utility collapse as former Governor Gray Davis did almost 20 years ago. In fact, the wildfire crisis should be well in the rear view mirror the next time California voters go to the polls. Stabilizing utilities’ financial health is also a big plus for the state’s aggressive decarbonization plans.
The principal cost of the deal is new utility equity issuance to fund a projected $7.5 billion up front payment and $3 billion over 10 years. As the biggest company, PG&E will take on the lion’s share at 64.2 percent, with Edison at 31.5 percent and Sempra 4.3 percent. Closing California utilities stocks’ valuation gap with the sector, however, should eventually offset prospective dilution.
Our favorite bet on a California utilities comeback this year has been Edison. The company targets 9.5 percent annual rate base growth for the next decade, by investing in electric vehicle infrastructure and grid modernization to improve efficiency and solar power adoption. That pace may slow in light of a rate case decision this past spring but would still be fast enough to fund at least high single digit yearly dividend growth.
Edison shares have gained ground following passage of AB 1054. That’s justified by the good news and shares are still cheap at less than 14 times expected 2019 earnings. Nonetheless, we’ll wait until management formally decides between the liquidity and insurance options before raising our buy target above 65.
The new utility law also benefits Sempra though less so: Its California electric utility is less than a quarter of overall earnings versus 100 percent for Edison and PG&E. The company would also only have to contribute $450 million to the prospective insurance fund. And with a BBB+ credit rating from S&P, it would hold an investment grade rating even if management chooses the liquidity option instead.
Sempra also already trades at a premium valuation of 23.2 times expected 2019 earnings. It’s a hold in our Conservative Income Portfolio holdings.
We highlighted the unfolding battle between PG&E management and the creditors’ committee led by Elliott Management in our June 26 Utility Roundup “PG&E Vs Power Suppliers: A New Wrinkle.” The wildfire legislation is a huge plus for the utility coming out of Chapter 11, as it effectively sets a cap on future wildfire liability.
The bankruptcy battle itself, however, has emerged as far more important to the stock, as details of the creditors’ plan have emerged. Proposals include a demand for 85 percent of PG&E equity in exchange for the promised $19 billion equity investment. Bloomberg Intelligence estimates PG&E common shares would be worth $6.33 if the plan is adopted, a nearly two-thirds haircut from the current price.
The creditors’ plan also limits pre-petition wildfire claims to just $16 billion, well below the estimates that range as high as $54 billion. That’s led a coalition of insurance companies holding $20 billion in fire related claims to declare it a “non starter,” and to submit their own plan.
We continue to believe PG&E shares will ultimately be worth more than their current mid-teens price. But in light of the uncertainty, contract power producer Clearway Energy (NYSE: CWEN) is a far better high stakes bet.
Management has promised a 50 percent plus dividend increase when PG&E eventually emerges from Chapter 11. At the point, the company will regain access to cash now being held at facilities selling power to the bankrupt utility. We’re buyers up to 18 for a ride to the low 20s in the next 12 months.
