As the start of the 2019 wildfire season in California approaches, S&P Global Ratings is providing an updated perspective on its views regarding the credit risks and potential ratings ramifications that California's regulated electric utilities continue to face. Please note that throughout this report "utilities" refers only to investor-owned utilities.
Our issuer credit ratings on Edison International (Edison) and Southern California Edison Co. (SCE) are on CreditWatch with negative implications and our outlooks on Sempra Energy, San Diego Gas & Electric Co. (SDG&E), and Southern California Gas Co. are negative. In our Feb. 19 report, "Will California Still Have An Investment-Grade Investor-Owned Electric Utility?" we indicated we could possibly downgrade the electric utilities to below investment grade as soon as this summer. This comes as California attempts to advance a framework to mitigate wildfire risks and related credit exposure to the state's utilities. In April 2019, California Governor Gavin Newsom's Strike Force published a report that contained proposals to reduce wildfires attributable to electric system infrastructure and to better manage related financial liability. More recently, the Commission On Catastrophic Wildfire Cost And Recovery published a report detailing the commission's work to date, which included key findings and recommendations to reduce the credit risks for California's electric utilities. Although, in our view, the implementation of all of these recommendations is remote, we continue to actively monitor policy developments in the state to determine which, if any, of the recommendations become law and their possible effect on credit quality. Here we address investors' most frequently asked questions.
Frequently Asked Questions
S&P Global Ratings has previously indicated that absent concrete actions to reduce credit risk, downgrades could commence at the start of California's wildfire season, which could be as early as June 2019. Is this still the case?
Yes, this remains the case, but we are closely watching whether the state legislature will pass legislation that reduces the credit risks for the state's electric utilities by July 12 or prior to the start of the summer recess. In April 2019, following Governor Gavin Newsom's Strike Force report, at his press conference, the Governor expressed hope that the representatives would pass legislation prior to the start of the summer recess. Although the wildfire season can begin as early as June, we expect fire risks will grow as the summer unfolds. Unless legislation passes that reduces the credit risks to California's electric utilities, our current expectation would be to downgrade the utilities at or around July 12. That said, credit downgrades could occur sooner if SCE or SDG&E are found to be the cause of a catastrophic wildfire.
What if comprehensive legislation to reduce the credit risks for California's electric utilities is not passed by the legislative summer recess but is passed at the end of the legislative session, on or before Sept. 13?
We would likely downgrade California's electric utilities to possibly below investment grade on or about July 12 if solutions are not implemented that address utility credit exposure. The downgrades would reflect the higher wildfire risks that California's electric utilities are facing without adequate regulatory protections to effectively reduce those risks. We would possibly upgrade the utilities sometime after the end of the legislative session if we believe the new legislation signed into law significantly reduces credit risk.
What if by July 12 behind-the-scenes steps appear to have been taken that increase the likelihood that future concrete legislation would pass, reducing the credit risks for California's electric utilities?
Entering the 2019 wildfire season, S&P Global Ratings will incorporate within its base case only the concrete steps taken to reduce the credit risks for California's electric utilities. Any behind-the-scenes developments or steps that could lead to potential legislation would be considered outside of our base-case scenario.
One of the Strike Force's recommendations was for a legislative reform to inverse condemnation. Does S&P Global Ratings expect this will happen?
Under California courts' interpretation of the legal doctrine of inverse condemnation, a California utility could be held liable for the entirety of a wildfire's property damage and other associated costs without the utility being found negligent. In our view, California's interpretation of the legal doctrine of inverse condemnation raises the risk for electric utilities by potentially exposing them to significant contingent liabilities.
Based on our conversations with political officials over the past year, we assess the likelihood of a legislative solution to inverse condemnation as low, and it is not currently part of our base case. We believe there may be significant legal hurdles to reform inverse condemnation and many key groups, including the insurance industry, trial lawyers, and wildfire victims, are opposed to reforming inverse condemnation. Given the substantial opposition, we believe changing this law could be a highly contentious ordeal and unlikely to pass. Furthermore, last year's attempt to reform inverse condemnation was not successful.
Due to our expectation that inverse condemnation will not be reformed, and the continued threat of frequent and catastrophic wildfire exposure associated with climate change, we believe California's electric utilities will continue to face elevated credit risks.
What are the other key credit risks facing California's electric utilities?
The lack of regulatory predictability or certainty regarding the timing and the amount of allowable wildfire cost that a utility could ultimately recover from ratepayers, in our view, is a significant risk for California's electric utilities. As such, we believe this risk could cause a board of directors for a utility facing potential liabilities from a catastrophic wildfire, as seen with PG&E, to determine that its best course of action is to file for a voluntary bankruptcy.
We believe this risk has many credit implications including the weakening of liquidity, an increase in leverage, heightening general business risk, and the hindrance of consistent access to the capital markets. The uncertainty on cost recovery from ratepayers could create a significant timing mismatch between when a utility makes payment to third parties claimants and when it ultimately recovers costs from ratepayers, weakening a utility's liquidity. Also, we expect that a utility's financial measures would weaken if the payments made to third parties are financed with debt. In addition, under our rating methodology for utilities, we view a utility's regulatory framework as critically important to its credit risk because it defines the environment in which a utility operates and has a significant bearing on a utility's financial performance. We view investment-grade utilities as requiring a regulatory framework that is stable, transparent, predictable, and allows for timely recovery of all operating and capital costs--the lack of these basic elements signifies higher business risk. Lastly, utilities make ongoing capital investments within their electric operations to improve and maintain service levels. As a result, they typically have negative discretionary cash flow and depend on reliable access to the capital markets to operate their businesses. In our view, if a utility's creditworthiness weakens, investor confidence could wane and a utility's access to the capital markets may be limited, potentially increasing its cost of capital, and adding considerable strain to the utility's business model.
A secondary credit risk would be the effect on the customer bill. While in our view this risk is not as immediate as the aforementioned credit risk, it is still a longer-term risk that relates to the ability of ratepayers to consistently absorb wildfire costs over time.
Because California's electric utilities continue to face the risk of exposure to wildfires associated with climate change in addition to the risks associated with California courts' interpretation of the legal doctrine of inverse condemnation, we expect that wildfire payments to third parties could be substantial. Even if electric utilities had certainty around the timing and the amount of allowable wildfire costs that a utility could ultimately recover from ratepayers and the California Public Utility Commission (CPUC) allowed for the immediate securitization (i.e., funded by ratepayers) of all wildfire payments made to third parties, California's electric utilities would still face this long-term risk regarding customers' ability to absorb these costs over time. In this scenario, an increasing portion of the customer bill would be for the collection of wildfire costs, i.e., non-infrastructure investments, which could frustrate customers and make it increasingly difficult for a utility to effectively manage regulatory risk going forward. In our view, this would increase business risk.
The Strike Force's report identified liquidity and wildfire funds as potential credit risk solutions. What is S&P Global Ratings' view regarding these recommendations?
We think these solutions could potentially reduce the credit risks for California's electric utilities. However, the details of any solution are unclear and thus, it is difficult to assess the potential effect on ratings. An unanswered question of interest: Who would make the initial payment to third parties--the utility or the fund? At this point, without these and other specific details, S&P Global Ratings lacks the necessary information to assess these solutions.
Could a wildfire fund alone significantly reduce utilities' credit risks?
While we believe that such a scenario is possible it would have to incorporate many credit-supportive aspects. For example, such a hypothetical scenario could include California setting up a large wildfire fund that has an automatic replenishing mechanism funded through diversified sources, outside of the utilities. Under this hypothetical scenario, third-party subrogation claims are made directly to the wildfire fund and the fund administrator would directly negotiate settlements with the third parties. As the wildfire fund makes payments to third parties, the fund is then replenished. Under this hypothetical scenario, the utility is effectively removed from all aspects of wildfire payments, materially reducing the credit risks to California's electric utilities.
What if the wildfire fund is not financed through diversified sources, outside of the utilities, but is only funded by utility ratepayers and shareholders?
If the wildfire fund is funded by utility ratepayers, depending on the specific details, we would need to understand how much incremental pressure this places on the customer bill, which we expect could be significant and therefore, may not fully mitigate our credit concerns. As a result, over time we would expect that an increasing portion of the customer bill would be for the collection of wildfire cost recovery. In our view, the rising customer bill for non-infrastructure investments could frustrate customers and make it increasingly difficult for a utility to effectively manage regulatory risk, increasing business risk.
We believe if a wildfire fund is financed by utility shareholders it could be partially sourced with debt, potentially weakening a company's financial measures and thereby increasing its credit risk.
What if the wildfire fund does not have a replenishing mechanism?
Due to the electric utilities' ongoing exposure to wildfire risk and inverse condemnation, we believe that claims against a proposed wildfire fund will be consistent and large. Without a replenishing mechanism or equivalent, we think the wildfire fund would eventually be depleted, thereby failing to eliminate the risk for California's electric utilities.
Why does S&P Global Ratings view the establishment of a fund paid by the utilities as lower risk than direct payments made by utilities to third-party claimants following a wildfire?
While both scenarios would seem to require that the utilities ultimately fund the wildfire costs, we believe that funding these costs at a time when it is more likely that the utility would have access to the capital markets reduces liquidity risks and is more supportive of credit quality overall. Following a catastrophic wildfire for which the utility is determined to be the cause, access to the capital markets may be limited and its cost of capital may increase, adding considerable risk.
Are tools such as pre-prudency, revising the prudent manager standard, or a liability cap important for reducing credit risk?
We believe these tools could significantly help to reduce some of the credit risks by providing predictability as to the amount that the electric utilities will ultimately recover from ratepayers.
Pre-prudency proposals contemplate a determination of a utility's conduct in advance of the wildfire season. In our view, this could provide a utility that was determined to have acted prudently with greater certainty of wildfire cost recovery from ratepayers, thereby reducing some of the overall credit risk.
Currently, the burden of proof with respect to a utility's recovery of wildfire expenses is on the utility. The CPUC requires that a utility prove by a preponderance of evidence that these expenses were prudently incurred to ultimately allow recoverability. If revisions to the prudent manager standard includes shifting the burden of proof to the party challenging the utility's prudency, which in our view would increase the likelihood that wildfire costs could be recovered from ratepayers, then we believe that this modification could be an important tool for reducing some of California electric utilities' credit risks.
A liability cap is designed to limit a utility's wildfire financial exposure to a predetermined amount, even if the utility was determined to be negligent with regard to the wildfire. This mechanism would provide certainty as to the maximum amount that a utility could be financially exposed, thereby reducing some of the overall credit risk.
S&P Global Ratings has consistently rated SDG&E higher than peers because over the past decade the wildfires within its service territory have either been insignificant or SDG&E has not been determined to have been the cause of these wildfires. The company has also deployed state-of-the-art technology that can effectively predict the likelihood of a catastrophic wildfire. As such, could SDG&E remain investment grade?
Given our view of SDG&E's operational excellence that enhances its ability to effectively manage regulatory risk, it has a higher likelihood to remain investment grade. However, this does not preclude the possibility that if concrete steps are not taken to reduce credit risk, we could downgrade the utility to below investment grade. Additionally, ratings would be further lowered if SDG&E is found to be the cause of a catastrophic wildfire. Historically, we have rated SDG&E one to three notches above SCE and expect that this distinction will be maintained absent a catastrophic wildfire in SDG&E or SCE's service territory.
If concrete steps are not taken to reduce the credit risks for California's electric utilities, will Sempra Energy remain investment grade?
If concrete steps are not taken to reduce the credit risks for California's electric utilities by July 12, it is currently unlikely that we would downgrade parent Sempra to below investment grade unless it is determined that subsidiary SDG&E is the cause of a catastrophic wildfire. While we have previously indicated that a further downgrade of SDG&E would likely result in a downgrade to Sempra, the link between SDG&E and Sempra is not one-for-one. To date, we have lowered our ratings on SDG&E by two notches and have not downgraded Sempra. SDG&E accounts for about 35% of consolidated Sempra, and we believe that if there is a catastrophic wildfire in SDG&E's service territory and the utility is identified as the cause of the fire, Sempra's support for SDG&E would be limited to protect its other investments.
If concrete steps are not taken to reduce the credit risks for California's electric utilities, could Edison International and Southern California Edison remain investment grade?
If concrete steps are not taken to reduce the credit risks for California's electric utilities by July 12, we would probably downgrade Edison and SCE to the 'BB' category (i.e. 'BB+', 'BB', or 'BB-'). Additionally, ratings could be further lowered if SCE is found to be the cause of a catastrophic wildfire.
Related Criteria And Research
- Will California Still Have An Investment-Grade Investor-Owned Electric Utility?, Feb. 19, 2019
This report does not constitute a rating action.
|Primary Credit Analyst:||Gabe Grosberg, New York (1) 212-438-6043;|
|Secondary Contacts:||Sloan Millman, New York + 1 (212) 438 2146;|
|William Hernandez, Dallas + 1 (214) 765-5877;|
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