How the bankruptcy of PG&E could lay the foundation for a new California

25 April 2019
Northern California’s rolling hills flash a vivid green this time of year, soaked with spring rains. But come June, the arid summer browns vast swaths of vegetation, leaving literal mountains of kindling for fire.
 
California is in a race against time. Another potentially explosive wildfire season is just around the corner, even as the state still cleans up from the last two years of deadly fires. It’s also in a race to meet credit rating agency demands and its own bold renewable energy targets, while hedge funds eager for a resolution pour billions into the bonds and equities of the state’s investor-owned utilities.
 
For now, those investors might have to wait. That’s because some of the brightest minds in California have been tasked with solving a sprawling web of vexing issues, from utility management and insurance markets to risk sharing and wildfire-resistant housing. It’s a process that could lay the foundation for new policies impacting many areas of California society and its 40 million people, all set in motion by the collapse into bankruptcy of Pacific Gas & Electric, the state’s – and the nation’s – largest utility.
 
Sacramento, the nexus of California’s environmental and energy policy tradition, maintains a steady hum of lawmaking activity, keeping the state at the forefront on many of the issues that are expected to dominate policy considerations in the 21st century. Lawmakers here have mandated that the state source 100% of its power from renewable sources by 2045, for example – putting it alongside Hawaii as the only states in the nation with such a directive.
 
But even though its Mediterranean climate has long been afflicted by wildfires, the state appears to have been caught flat-footed by the severity of the latest spate of firestorms, which have been amplified by the effects of climate change. And now PG&E’s bankruptcy has become intertwined with the legislative sausage-making machine, with all of its ambitions and entanglements.
 
That machinery is now grinding in high gear.
 
Earlier this month, Governor Gavin Newsom’s “strike team” of policy and financial experts released the first draft of a policy framework in response to the wildfires and their costs that, on the whole, lays out a roadmap for reducing utilities’ liabilities and distributing them more broadly among utility investors, ratepayers, insurers, and attorneys. The ambitious agenda includes two new state-sanctioned, multi-billion-dollar wildfire funds along with the reform of the doctrine of inverse condemnation, a legal precept embedded in the state’s constitution that holds utilities accountable for damages, even if they did not act negligently in causing fires.
 
If that’s not enough, Governor Newsom wants to implement sweeping new fire mitigation and resilience measures as well as reform the California Public Utilities Commission.
 
And he wants to have a comprehensive legislative package in place by 12 July, when California’s legislature takes its summer recess.
 
“It’s a big thing to take on,” said Ethan Elkind, the director of the Climate Program at Berkeley Law School. “The fundamental issues are not going away – there’s going to be increasing wildfire and climate change risk, more condemnation for the utilities, which is an ongoing problem and why we need a state policy solution.”
 
He added: “The bankruptcy proceeding may resolve some issues, but PG&E could be back [in bankruptcy] in the years to come.”
 
It wouldn’t be the first time a PG&E bankruptcy has played a role in spurring wide-reaching effects on California life. In 2001, PG&E filed for bankruptcy amid Enron-induced energy shortages that led to rolling power blackouts. Gray Davis, the state’s Democratic governor elected in 1998 and again in 2002, was ousted in a 2003 recall election after he lost favor in part due to the energy crisis. He was replaced by Republican actor-turned-politician Arnold Schwarzenegger, who served two terms as governor until 2011.
 
The wildfires
 
Arguably, the biggest threat still facing California institutions and the resolution of PG&E’s bankruptcy proceedings is the occurrence of further catastrophic wildfires.
 
The combination of climate change, widespread dead and dying trees, vulnerable utility infrastructure, and an increased number of homes in fire-prone wildlands make more destructive fires a foregone conclusion, experts laid out in reports by CalFire and the governor’s strike team. Similarly, California’s wildfire season already runs year-round in some areas of the state.
 
The climbing cost of housing in California’s cities, for example, has caused more and more people – over 11m currently, or 25% of the state’s population – to move into higher-risk areas in the wildland-urban interface, potentially putting them in the path of destructive fires. And by the year 2050, because of climate change, the average area burned in California each year will increase by 77% compared to the 1961-1990 period, according to the state’s Fourth Climate Change Assessment, issued in 2018.
 
Already, a combined 2.8m acres burned in California in 2017 and 2018 – over twice the size of Delaware.
 
The unprecedented wildfire conditions put California nearly in a category of its own. There are no off-the-shelf solutions the state can implement. Isolated and extreme wind events at the root of the severity of the 2017 North Bay Fires and the 2018 Camp Fire, for instance, led CalFire to re-map of the state’s microclimates for fire risk, which will impact land use – potentially even making some areas closed to new construction.
 
“For the kinds of fires that we’re seeing, there are no best practices elsewhere – the only people we can talk to who have the same kind of experience as we do are the Australians,” CPUC president Michael Picker said in testimony on 12 March before a state senate committee. “So what do you do when you’re out there on the cutting edge, and the only way you can learn is by experience?”
 
For PG&E, liabilities from another fire would come in as senior administrative claims, with the potential to swamp recoveries for holders of pre-petition debt and equity. In contrast, the existing wildfire-related claims, which the company estimates at around USD 30bn, are unsecured.
 
 
The utilities
 
Utility infrastructure is at the center of the firestorm. PG&E – along with Southern California Edison and San Diego Gas & Electric – have started a combined 2,000 fires in California in the last four years, according to research from the University of Pennsylvania’s Wharton Risk Center. And from a high level, the most consequential policy shift among the strike team’s proposed initiatives involves new ideas for cost sharing and recovery in the aftermath of catastrophic wildfires.
 
As it stands, legislation passed last year requires certain investor-owned utilities to submit yearly wildfire mitigation plans for approval with the CPUC. PG&E, which serves over 16m people in Central and Northern California, is viewed as a basket case with respect to its wildfire mitigation efforts, including delaying crucial maintenance work, according to the findings of a Wall Street Journal investigation. San Diego Gas & Electric, in comparison, began a fire mitigation and safety program after it was found to be at fault for a series of fires in 2007.
 
As a result, PG&E is racing to complete an inspection of its utility infrastructure in high fire-risk areas before the onset of the 2019 fire season, including the review of roughly 50,000 of its structures: ground inspections of electric poles and transmission towers, and further aerial inspections using helicopters and drones, court documents show.
 
The liquidity-only fund proposed by the Governor’s strike team would allow utilities to tap into a pool of money to pay for wildfire costs as it waits for a determination from the CPUC over whether the utility can recover those costs from ratepayers. This “bridge” fund would cover the near-term period under which utilities are implementing their wildfire mitigation plans, in hopes of, eventually, reducing the incidence of utility-caused fires.
 
A second, larger catastrophic wildfire insurance fund would also promote risk sharing and remove utilities as the ultimate backstop for wildfire utilities. Both funds would be financed by pooled capital from investor-owned utilities in combination with a potential extension of a Department of Water Resources charge, and utilities could tap the funds in the event of catastrophic wildfires. The report proposes setting up a trust for the administration of claims for the wildfire fund.
 
Finally, the strike team’s roadmap calls for the reform of inverse condemnation (IC), the legal provision that holds California utilities responsible for wildfire damages even if they didn’t act negligently. IC, which is written into the state’s constitution, can be reformed through a constitutional amendment – a controversial prospect – or through a modified interpretation of the law from the California Supreme Court.
 
Following PG&E’s bankruptcy filing, ratings agencies put California on notice, saying that without significant changes to the state’s regulatory construct, all its investor-owned utilities – amounting to USD 91.2bn of debt and USD 95.8bn of equity value as of today, including PG&E – could be downgraded to junk status. As in the case of PG&E, a downgrade to sub-investment grade can break utility funding models by triggering higher borrowing costs that flow through to ratepayers.
 
In addition, PG&E alone has 387 power purchase agreements with 350 counterparties – many of which support the state’s renewable energy targets – adding up to USD 42bn in future committed payments. Rejecting these contracts in bankruptcy, on top of being messy and legally fraught, could put the state’s renewable energy goals at risk, as it could disincentivize new investments in renewable generation capacity.
 
The municipalities
 
 
Local control of utility infrastructure has been a pet project of non-profit groups and municipalities across California, including PG&E’s home city of San Francisco, for many years. But now PG&E, long an assertive opponent of reform, has been weakened politically. And California Democrats hold the governor’s office as well as a supermajority in both the state assembly and senate. Utility takeover advocates are sensing a political window of opportunity.
 
“PG&E has always been more aggressive politically, and has built up a lot more resentment among the California population,” said Wesley Hussey, a political science professor at Sacramento State University. “So when PG&E gets in trouble, there are a lot of people in Sacramento who gleefully look to the future.”
 
California, overall, has about 54 public power utilities, and Los Angeles’s system is the fourth largest public power utility in the United States, according to a 2018 report by the American Public Power Association.
 
California municipalities have used eminent domain to purchase private electrical distribution systems many times, and could again. Redding in 1921, Palo Alto in 1931, Burbank in 1937 all pursued this method. Notably, Sacramento County used eminent domain to acquire PG&E’s system to create the Sacramento Municipal Utility District (SMUD), a move that was subject to a decade of litigation against PG&E but ultimately given the green light in 1946 by the California Supreme Court.
 
San Francisco, today, already has a fractured relationship with PG&E, and the bankruptcy case provides an opportunity for the city to explore taking over the city’s assets within city limits, because the proceeding “creates a disciplined venue for PG&E to consider serious offers for acquisitions of assets,” said Barbara Hale, assistant general manager for power at the San Francisco Public Utilities Commission (SFPUC).
 
SFPUC distributes electric power to customers through community choice aggregation, a distribution mode that has sprouted up around California in recent years as a popular way for energy-conscious consumers to choose how their power is generated. Instead of paying PG&E to use their infrastructure to distribute power, San Francisco would acquire that distribution system and control it itself.
 
SFPUC is still working on a feasibility study to determine by the end of April whether the acquisition is possible, Hale said.
 
 
Meanwhile, the strike team report, though it refers to so-called “municipalization” as a policy option, does not offer a detailed framework for doing so. But that didn’t keep Governor Newsom from using the idea of municipalization as an explicit threat against PG&E, saying in a 12 April press conference that if the utility “gets in the way of doing the right thing, all options are on the table.”
 
The cost to analyze and effectuate a municipal takeover of a utility as large as PG&E introduces manifold complications, experts said, and though it might make more sense for well-capitalized cities like San Francisco, it becomes much more complicated for rural zones with fewer resources and less creditworthiness. And in the end, it could be politically unpopular.
 
“California does have the capitalization, but there are mixed feelings about the state running the utility,” said Severin Borenstein, an energy economist at UC Berkeley. “Some say ‘Anything’s better than PG&E,’ or they’ll say, ‘My last trip to the DMV was unpleasant – if that’s who’s running the utility, I don’t think that’s a good idea.’”
 
Still, the fact remains that “the current path doesn’t seem to be working very well,” Borenstein said, calling attention to the added liability and risk associated with running a utility compared to 20 years ago. “We are going to be faced with selecting from bad alternatives.”
 
The insurance
 
Insurance companies suffered staggering losses on California homeowners insurance in the last two years. Insurers paid out USD 12.28bn across all lines in 2017, and USD 13.1bn in 2018, correlating to homeowners insurance loss ratios of 201.17% and 170.1% in those years, respectively, according to the California Department of Insurance.
 
Because insurance coverage and premiums are tied to risk, the growing California fire hazards have resulted in more at-risk homes with inadequate or no insurance. The state’s insurance regulators, as such, have taken to promoting wildfire mitigation measures, such as aligning building codes and community preparedness with the new wildfire reality.
 
In last year’s deadly Camp Fire, which obliterated the town of Paradise, 51% of the homes that were built after 2008 survived the fire, but just 18% of the homes built before 2008 survived, according to a report from McClatchy. That’s because, in 2008, California began implementing beefed up building codes for new construction in fire hazard zones.
 
Still, roughly 95% of California’s housing stock was built before 2008, meaning wide-ranging retrofits are likely necessary – and a new bill, along with the availability of PACE funding, could accelerate that process.
 
PACE funding – a state program which allows property owners to borrow money from private lenders for certain types of property improvements up front, and then repay the money over time via an assessment on their tax bills – is one way homeowners in fire hazard zones could finance such mandated retrofits, said Stephani Mae, vice president of asset-backed securities at research firm Morningstar, during a panel earlier this month in New York City. The residential program is currently available in 3 states, including California.
 
“In the past few years, we’ve seen our fair share of natural disasters,” Mae said. “There’s legislation being passed that’s helping spur those [resiliency] initiatives.”
 
Last year’s California Wildfire Safety Finance Act, SB 465, expanded the use of PACE for retrofits to prevent or reduce wildfire damage. A new bill, AB 38, would require CalFire Marshall to create a list of low-cost retrofits “that provide for comprehensive site and structure fire risk reduction to protect structures from fires spreading from adjacent structures or vegetation and to protect vegetation from fires spreading from adjacent structures,” according to the bill’s current text.
 
Beginning on 1 July 2025, the bill would require sellers of buildings in very high fire severity zones to provide buyers with documents certifying that the retrofits had been made.
 
Insurance companies, meanwhile, are being asked to play a part in reform efforts by capping so-called “subrogation claims” as part of the creation of the wildfire catastrophe fund.
 
Typically, in the event of a fire, the insurance company pays an insured property owner’s claim and absorbs the loss. Through inverse condemnation, if the utility caused the fire, the insurance company can then seek reimbursement for the damage claim paid to homeowners—known as a “subrogation claim.” Similarly, the wildfire fund would cap attorney’s fees and expenses that are owed to plaintiffs as part of the claim under inverse condemnation.
 
The cap on insurance claims and attorney’s fees, however, risks saddling homeowners and victims with added costs, according to a wildfire victims’ attorney.
 
At a press conference following the release of the strike team report, Governor Newsom riffed on the importance of addressing these issues simultaneously, with broad stakeholder buy-in, or risk setting off a chain of events that would worsen the quality of life for Californians, starting with downgrades of the state’s investor-owned utilities.
 
“[The utilities’] borrowing costs go up, insurance rates go up, property values as a consequence go down – you can’t get insurance in these wildland-urban interfaces, that means the value of your property diminishes. Your property tax diminishes. Your ability to invest in pre-school and after-school programs diminishes,” he said.
 
“These things are all connected,” the Governor added.