TODAY’S STUDY: The Way To Handle Wildfire Costs
Financing Third Party Wildfire Damages: Options for California’s Electric Utilities
Carolyn Kousky, Katherine Greig, and Brett Lingle February 2019 (Wharton Risk Management and Decision Processes Center, University of Pennsylvania)
• Wildfire risk is escalating in the western United States, devastating and disrupting communities and creating billions of dollars in property damage.
• Under a unique legal regime in the state of California (inverse condemnation), electric utilities are held strictly liable for property damage associated with any wildfire where utility infrastructure is found to have been a significant cause of ignition, even if the utility was not negligent in their risk management actions.
• Wildfires in 2017 and 2018 have shown that these liabilities can reach into the billions, threatening the financial health and solvency of utilities, with consequences for ratepayers, shareholders, and the state’s ability to meet its climate and energy goals.
• This liability poses challenges for traditional approaches to risk financing as it is concentrated and potentially catastrophic.
• When utilities act negligently, they should bear costs proportional to their negligence. Absent reform to eliminate or modify the application of the doctrine of inverse condemnation to utilities, however, utilities need financing mechanisms that enable them to cover this growing liability.
• There are a range of mechanisms that could facilitate a utility’s ability to access capital to cover this risk, including funded self-insurance, commercial insurance, catastrophe bonds, industry captives, an industry risk pool, and recovery bonds. These financing options are not mutually exclusive, and several should be layered together to ensure funding for third-party liability from wildfires of various magnitudes.
• Each of these strategies would require an annual contribution and/or initial capitalization. How those costs are distributed has implications for who ultimately bears the costs of wildfires. To align with the regulatory compact, ratepayers would shoulder cost-effective pre-wildfire financing and shareholders would pay post-loss costs in proportion to utility imprudence.
• With the significant increase in wildfire risk due to climate change and continued development in the wildland urban interface, risk mitigation by all stakeholders will be needed to complement financing efforts. This includes land use planning modifications, adoption and enforcement of strong building codes, broad education campaigns for those living in high-risk areas, and costeffective mitigations by land owners and business owners.
In California and across the west, the frequency and severity of catastrophic wildfires are increasing, as are the damages. Eight of the twenty most destructive wildfires in California history occurred in 2017 and 2018, destroying more than 31,000 structures—double the number consumed by the other twelve.2 In the 1980s, the California Department of Forestry and Fire Protection (Cal Fire) spent an average of $61 million (2018 USD) per year on fire suppression. Since then, costs have escalated steadily and significantly, reaching an average of $121 million in the 1990s, an average of $304 million from 2000- 2009, and averaging roughly $450 million annually since 2010 (all in 2018 dollars). 3 Beyond the direct property damage and suppression costs, these fires have substantial indirect damages, as well, such as lost tax revenue to local governments, health impacts from the smoke, increased carbon emissions, and lost environmental values.
In most places outside California, the direct property damages from wildfires—the focus of this paper— are borne by property owners, insurers, and taxpayers (via state or federal disaster assistance programs). In California, however, electric utilities can be required to pay all property damages for wildfires where utility infrastructure was a significant cause of wildfire ignition. The California state constitution says that private property may be “taken” or damaged for public use only when just compensation is provided.4 Several courts in California have held this doctrine applies to electric utilities, since they have a state-granted monopoly and provide a public service. As such, in California, electric utilities are strictly liable for property damages arising from wildfires traced to their equipment; that is, they must pay for the damages even if they are without fault.5
Note, the reasoning for inverse condemnation, as explained by the courts, is that costs associated with activities that generate broad public benefits should be “distribute[d] throughout the community...to socialize the burden...that should be assumed by society.”6 The courts have held that utilities are able to socialize costs through rates and thus spread wildfire related costs on all those who benefit from electricity. In contrast to a classic “taking” where a government entity can raise taxes to cover the costs, whether or not these costs can be passed to ratepayers is under the control of the California Public Utilities Commission (CPUC) and is not guaranteed. In making decisions, the CPUC adheres to a standard of evaluating whether the utility acted “reasonably and prudently” in operating and managing its system.7 This is a distinct standard from legal negligence. A party can be found negligent for a single act, whereas a reasonable and prudent operator is one who operates its system consistent with the standards in place at the time even if an adverse event nonetheless occurs.
The potential costs arising from this strict liability regime in California have recently been substantial. For fires in 2007, San Diego Gas and Electric had to pay $2.4 billion in wildfire costs.8 PG&E estimated it could face up to $15 billion in liability and hundreds of lawsuits if their infrastructure was involved in the ignition of 2018’s Camp Fire.9 The company’s financial viability in the face of these liabilities has been so tested that it filed for bankruptcy at the end of January 2019. All three major rating agencies have downgraded the investor owned utilities in response to California’s application of strict liability for wildfire damages. 10 Lower ratings may discourage investors from purchasing utility-issued bonds and from buying equity in the company. This makes it more difficult and expensive for utilities to refinance debt maturities and raise debt and equity capital for critical projects.
All stakeholders agree that when utilities have acted negligently, they should bear costs proportional to their negligence. However, when they have not acted negligently, this strict liability legal regime will subject California’s utilities to financial hardship with risks now recognized as potentially so large, it could threaten their viability, impacting ratepayers, shareholders (who tend to be older and middle income11), and undermining the state’s ability to meet climate and energy goals that require investments by the utility. While PG&E’s bankruptcy has raised myriad questions, this paper does not address PG&E’s past or future management, decision-making, or actions. The paper looks at the broader issue for all utilities of how to finance a catastrophic risk, for which traditional risk financing approaches are stressed, absent reform of the application of inverse condemnation.
Recognizing concerns about the unsustainability of the status quo, the California Legislature created a Commission on Catastrophic Wildfire Cost and Recovery to “examine issues related to catastrophic wildfires associated with utility infrastructure.”12 The Commission, seated in January 2019, is tasked with recommending policy options for action by the governor and legislature that would “socialize the costs associated with catastrophic wildfires in an equitable manner,” as well as options for establishing “a fund to assist in the payment of costs associated with catastrophic wildfires.” 13 Legislation has also recently been introduced to create a risk pooling mechanism for California’s utilities.
To inform the ongoing policy dialogue, this paper discusses potential financing options for third-party wildfire damages for California’s electric utilities, assuming that the current liability regime remains in place. We focus on the state’s investor-owned utilities (IOUs) since they have had the largest liabilities to date, they cover a significantly larger service area, and have commensurately greater exposure to wildfire risk. The three largest IOUs in the state—Pacific Gas and Electric (PG&E), San Diego Gas and Electric (SDG&E) and Southern California Edison (SCE)—are responsible for providing roughly threequarters of all electricity used in California (see Figure 1 for service areas). That said, publicly-owned utilities (POUs), of which there are over 40 in the state, could also face these concerns and we discuss POUs explicitly where relevant. Indeed, the CEO of the Sacramento Municipal Utility District (SMUD) noted in a hearing to the California state legislature on August 9, 2018 that if a POU were ever found to have had equipment igniting a wildfire, that could lead to massive rate increases for customers or bankruptcy for a smaller POU.
Section 2 begins with an overview of the current arrangements for utilities to cover wildfire damage. Section 3 presents a range of risk financing strategies that could help facilitate access to capital to cover property damage from wildfires for which utility equipment is deemed to be a cause of ignition. This includes discussion of funded self-insurance, commercial insurance, catastrophe bonds, industry captives, an industry risk pool, and recovery bonds. The financing options are not mutually exclusive, and several could be utilized simultaneously to ensure funding for various magnitude wildfires. We discuss this in Section 4. Each of these financing strategies would require an annual contribution and/or initial capitalization to be viable. In Section 5, we present potential funding sources and mechanisms, and their distributional implications. Section 6 concludes with high-level policy recommendations…
The effects of climate change, along with development in the wildland urban interface are continuing to drive up the risk of wildfire damages in California. The state needs to adopt a sound financing strategy for its electric utilities to protect all parties and to ensure continued progress on broader climate and energy goals. The most straightforward way to achieve this may be to eliminate strict liability for thirdparty wildfire damages coupled with a cost recovery standard at the CPUC that is tied to universally agreed upon risk reduction activities (such as could be articulated in the utilities’ SB 901 wildfire management plans). The current regime has created a risk that is difficult to finance due to its concentrated and catastrophic potential. Eliminating strict liability for third-party damages for wildfire, while simultaneously adopting new regulations on wildfire mitigation activities for electric utilities, could preserve incentives for proper risk reduction yet not threaten the ability of utilities to provide electrical service in high-risk areas by forcing them to cover escalating costs even when they are not negligent.
Absent reform, addressing third-party wildfire liability for California’s electric utilities will require layering together multiple risk financing options. Utilities likely need a dedicated rate component for some level of funded self-insurance as the initial financing layer. Commercial insurance and catastrophe bonds may be able to play a small role, but currently, the private market has seen rising prices and decreasing interest in assuming this risk. As such, utilities likely need to pursue, in consultation with the CPUC, some type of risk pool or industry captive. If utilities could be guaranteed pre-disaster state backing or CPUC approval of rate recovery, recovery bonds are another viable financing option. Without more certainty, *however, they may not provide needed financial assurances. Ex-ante financing and guidelines are necessary to have in place, because without them, post-wildfire there are protracted negotiations between the utility, CPUC, the state legislature, and other stakeholders on how to divide costs between ratepayers and shareholders. Reducing this post-disaster confusion is in the interest of all stakeholders.
Only about 5% of wildfire ignitions are from power lines (this is just over 10% of acres burned).56 For the state as a whole, then, property damage from wildfire is a much broader issue than electric utilities. As concerns mount about the affordability and availability of property insurance in highly wildfire-prone regions,57 the state must have a larger policy discussion with utilities, insurers, and all other stakeholders, about how to equitably fund this growing risk and provide greater incentives for risk reduction to all parties, including local governments and households.