Contrary to public opinion, some dreams don’t die with one stroke of the pen but are the result of many small decisions that seem to make sense in the moment.
With the September California legislative session wrapped up, it looks like utilities will be able to access the capital markets to cover extensive fire damages and remain financially workable. In other words: The California utility industry, though threatened by wildfires, remains standing. But dense smoke fogs the investment horizon, and that’s the real problem. Details about how much of the damages will ultimately be absorbed by shareholders is yet unknown. Little doubt remains that the number will be substantial. Wildfires, in 2017 alone, left an estimated $9.5 billion in insurance claims in Northern California, and another $2.1 billion in Southern California (Source: Sacramento Bee, March 29, 2018). How long it takes for the California legislature to substantively address the long-term problem and, ultimately, how it chooses to address the damages for 2017, this year and in future years, will have a very real effect on the shape of that state’s utility industry for decades to come.
One thing is for sure; the uncertainty in contending with these very real charges makes it ever more difficult to plan for long-term spending; so much so that the delay may well threaten the dream of shifting to renewable energy sources by 2045. The political drama over who pays may make great television, but it directly undermines the stability needed for long range planning no matter what the outcome.
The whole dilemma over who bears the costs can be explained easily enough. California law sports a tough interpretation of something called inverse condemnation, which, in practice, makes it easy to force corporations to pay for damages from events like forest fires, even if the company is not at fault. But there’s a limit to how much losses even the biggest corporations can bear. PG&E, deemed to have started 14 of the 16 Northern California fires in 2017 (Source: PG&E second quarter earnings call, July 26, 2018 [transcript]), suspended its dividend and reserved $2.5 billion by the second quarter of 2018 for estimated charges. A stock that once traded at $70 now hovers around $45.
It’s the job of active money managers to assess these real risks and account for them in their trading strategies. “Yesterday’s loss won’t help our state deal with the impact of tomorrow’s wildfires,” said Geisha Williams, chief executive officer and president of PG&E, at a July 26 earnings call (Source: PG&E second quarter earnings call, July 26, 2018 [transcript]). The CEO complained, remarking on what she declared was the basic unfairness of inverse condemnation, “The strict liability contract that is applied to investor-owned utilities in California today, is unsustainable and is already having very real consequences.” (Source: PG&E second quarter earnings call, July 26, 2018 [transcript])
The immediate result: Higher insurance premiums and higher capital costs from expected downgrades from the ratings agencies. PG&E declares that every 100 basis point increase in the cost of capital equals about $400 million in increased costs borne by customers (Source: PG&E second quarter earnings call, July 26, 2018 [transcript]). The utility will have the right to argue to pass on these higher costs to the consumer in upcoming hearings.
Inverse condemnation works like this: In the extreme, if a drunk driver swerves off road and hits a utility pole, which falls and starts a fire, or if a piece of utility equipment even starts or worsens a California blaze, the utility shoulders the damages, regardless of fault. If a utility is truly at fault, because of poor maintenance or negligence, the company should indeed be held liable for the damages, but to operate with strict liability regardless of fault means that higher costs loom in the background for every major California utility. These costs will ultimately be borne by Californians—hitting the poor the hardest of all because they spend a higher proportion of their income on basics like energy. “We find ourselves in this climate…facing wildfire after wildfire,” said Williams. “The numbers that we’re seeing already in California and in the Western United States (are) staggering…This is going to be a perennial issue.” (Source: PG&E second quarter earnings call, July 26, 2018 [transcript])
As active managers, our job is to assess the unique risks in each investment. Much of our historic success has come from avoiding the worst performers as opposed to owning all the best stocks, so we see this risk assessment as a vital part of our investment process. For example, in the past decade we have, for the most part, avoided utilities index heavyweights (Utilities contained in the S&P 500 Utilities Index) First Energy, Exelon and Entergy because of concerns about the direction of power prices. That decision, plus a focused effort on identifying companies that could grow earnings over time, led to strong performance.