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What does the stock market tell us about the California wildfires?

Lucas Davis, Professor, Haas School of Business | January 16, 2018

California utilities have lost $20 billion in market value since the wildfires began.

The horrific wildfires in Northern California’s Wine Country in October and then in Southern California in December killed more than 40 people, burned 1.2 million acres, destroyed thousands of buildings, forced hundreds of thousands to evacuate their homes, and led to deadly mudslides.

From the beginning investigators have focused on power lines as a likely cause.  And, as more evidence becomes available, it continues to point to power lines. For example, the San Francisco Chronicle now reports that damaged electrical equipment was found at or near the suspected ignition points of four of the biggest wildfires in Northern California.

It will be some time before these investigations have concluded, but it is not too early to begin to assess the stock market fallout. How has the stock market reacted to this news?  What does this mean for California electric utilities? For shareholders? For utility customers?

lilacThe Lilac Fire burning across a freeway near Bonsall, California on December 9, 2017.  (Photo taken by Jeff Hall from Cal Fire)

PG&E tumbles

Pacific Gas and Electric (PG&E) has been the hardest hit. Before the wildfires began, PG&E stock was trading near $70 and the company was worth $36 billion. The selloff started shortly after the wildfires began on October 8, and by mid-October PG&E’s stock had tumbled to near $55.

pgeSource: Constructed by Lucas Davis at UC Berkeley.

Then on December 20, PG&E announced it would suspend its dividend program due to looming potential fire liability, leading to another selloff and stock prices falling to $45. Companies are generally loath to cut dividends because it is perceived by the market to be a very bad signal.

Since October, PG&E’s market value has fallen by $13 billion. This 37 percent drop reflects potential liability from the more than 50 lawsuits that have been filed against PG&E, representing hundreds of families and businesses who have suffered damages from the wildfires. With the number of lawsuits continuing to grow, PG&E’s total liability could easily exceed the $800 million in liability insurance held by the company.

Edison plummets

Southern California Edison followed a similar pattern. Before the Southern California wildfires, Edison’s stock was at $80 and the company was worth $26 billion.  When the wildfires began, Edison’s stock price immediately plunged 16 percent with shareholders concerned that, like PG&E, the utility would be forced to pay damages. Since then, the stock has continued to slide with several lawsuits alleging that Edison equipment played a role in starting the fires. Overall, Edison’s market capitalization has fallen by $6 billion, almost one-quarter of its total value.

edisonSource: Constructed by Lucas Davis at UC Berkeley.

Broader signal?

Interestingly, one of the worst days for Edison was December 21, after PG&E announced it was suspending dividends. That day, PG&E stock went down 13 percent, while Edison stock fell 7 percent, so a smaller, but still very significant decrease.

I think I understand why PG&E’s stock went down. Companies like PG&E usually try to avoid cutting dividends, so it would make sense for the market to take this announcement as bad news, implying that PG&E’s liability was greater than previous believed.

But why did Edison’s stock go down? They are separate companies, separate wildfires, and separate investigations. Yet the market took PG&E’s announcement as a broader signal. Even San Diego Gas and Electric (Sempra Energy) went down the same day by almost 5 percent, a single-day loss equal to more than $1 billion. Did shareholders conclude that Edison and Sempra were also likely to cut dividends? Or did the PG&E announcement reveal something deeper about the prospects for all California electric utilities?

A related event got a lot of attention, but had little immediate effect on stock prices. On November 30, the California Public Utility Commission rejected a request from San Diego Gas & Electric’s to charge customers $379 million to cover costs from a 2007 fire. The decision was interpreted by the media as bad news for utility shareholders, but it had little immediate impact on stock prices. Neither SDG&E (Sempra), nor Edison, nor PG&E experienced any significant decline. Either the decision was already priced into stock prices, or it was deemed unimportant by the market.

What about utility customers?

In part, the size of the stock market reaction reflects a concern that even if the utilities did nothing wrong, they could be liable for significant damages. This could occur through “inverse condemnation” court cases, a concept that flows from the U.S. and state constitutions and is closely related to eminent domain. Government and public utilities can obtain private property through eminent domain processes in which they compensate owners for the lost use of their property. If a government (or a public utility) damages private property and doesn’t compensate the owner, then the owner can bring an inverse condemnation case.

Utilities could try to argue that the damages they pays through inverse condemnation should be passed along to customers as part of the broader costs of providing electric service. But will utilities actually be able to pass along these costs? The market does not expect 100 percent of these costs to be passed on to ratepayers; otherwise you wouldn’t see these large stock market impacts. But there may well be rate increases. California legislators are introducing legislation that would prohibit the CPUC from pushing fire liabilities onto rates, but it is too soon to know what will happen with this legislation. The damages from the wildfires are very large. The Tubbs Fire and Thomas fires were the most destructive and largest fires in California history, respectively. So there is more than enough pain to go around.

santarosa.png The devastation in Santa Rosa California on October 11, 2017.  Image licensed under creative commons.

Who should pay?

Many questions remain. Who should pay for wildfire damages? How do we incentive utilities to reduce wildfire risk? How much risk should be borne by shareholders? By utility customers? What is fair?

A central tenet of law and economics is that agents should bear the costs of their actions. Utilities are constantly making investments in fire prevention and you want utilities to make these decisions efficiently, “internalizing” the potential damages from action and inaction. So you want shareholders to be liable, to have a significant “skin in the game” so that their companies will take the right actions to reduce wildfire risk.

But at the same time, you also don’t want to make utilities responsible for all wildfire damages, regardless of whether the companies acted negligently. This would raise the cost of capital for utilities, making it hard for them to finance basic operations. Put simply, you make it unattractive enough to be in the utility business, and nobody will want to do it.

Because this is not just about power lines. With climate change, average temperatures keep climbing, and the summer of 2017 was much warmer and dryer than usual.  And California’s population keeps growing, with more and more people living in fire-prone parts of the state. The devastating California wildfires of 2017 raise many very difficult questions that we are going to be asking for a long time.

Comments to “What does the stock market tell us about the California wildfires?

  1. Prof. Davis, there is a much bigger problem for California that we must not overlook, collusion between the CPUC, California utilities and California Powers That Be that has been going on for decades, and is indeed one of the greatest threats to our quality of life in California history.

    A recent episode documented by the San Francisco Chronicle is “California regulators to decide fate of state’s last nuclear plant Thursday” By David R. Baker January 10, 2018 Updated: January 10, 2018
    http://www.sfchronicle.com/business/article/California-regulators-to-decide-fate-of-state-s-12488709.php?cmpid=gsa-sfgate-result

    You might want to take this into consideration to make certain the entire picture is exposed, because wildfires is just one of the out of control global warming consequences that California must solve with the greatest urgency.

  2. These comments are excellent! You could have written my Reply Brief in the SDG&E case! Investor owned utilities are guaranteed a profit by the CPUC, are ‘regulated’ by the CPUC, enjoy a monopoly – but their shareholders come first, meaning cost savings come first. Safety costs far more than these utilities have been spending. To truly socialize costs, California would need to create an electric cooperative. I truly believe rates would be lower and California’ outdated, rotting utility infrastructure would be safer to boot! Shareholder profits, of course, would disappear. I believe it is critically important to see how much CalPERS is invested in CA utilities and the conflicts that may create with the CPUC, CalFire and the Governor’s Office. There is an important story there, as well. As a Sempra shareholder, Intervenor in the SDG&E case (writing the most detailed briefs which helped win this case, so far) and ratepayer, I am actually considering running for the Board of Sempra to shed light on this issue and educate the Board on where their employees got it so wrong. The CPUC Decision could have been far worse for SDG&E, begging even more questions.

  3. Cam, it ain’t rocket science! Fires can start for a number of reasons.
    – Act of nature examples: lighting strike and hot electrical wires blown down in high winds
    – Carelessness example: creating a campfire
    – Intentional misbehavior examples: illegal burns and arson
    Fires need fuel to spread and of course wind to carry the hot embers.

    Kurt, I agree. The solution is simple. Going forward clearing the land of dead and dying vegetation needs to be priority number one. All stakeholders must participate.

  4. PG&E had a failure analysis team at the San Ramon R&D Center (I was an Analyst for 13 years there, also analyzing fire damage) which should be investigating the sources of the fires. Perhaps arson was involved. Contact the Center!

  5. I would reply to Kurt that utilities themselves are expected to manage vegetation under existing law and failure to do so (by acting negligently) has been a cause of wildfires all the way back to the SDG&E case mentioned in this article. These costs – considered operating & maintenance expenses – are able to be passed into customer rates. So not only are customers already paying for utilities to manage their wildfire risk – they’re also currently paying for the liabilities that result from utilities not doing their job to the extent expected.

    Obviously this is a very complex issue and – if utilities are expected to absorb full liability for these wildfires – it creates a number of perverse incentives. First, utilities would rationally seek to significantly ramp up their vegetation management programs to avoid future wildfire risks, resulting in increased costs and increased electricity rates to customers as a result. Second, it would incentivize them to preemptively shut off all electricity flowing through power lines in areas when there are high wind events. This would potentially make it more difficult for individuals to gain information regarding fires in the area that may have already started, and also more difficult for firefighters to respond to these fires. Lastly, as we have seen in the market, this risk of wildfire-related liability will disincentive public market investment in the utilities. Given that utilities are highly capital intensive businesses that need to borrow debt and issue equity frequently to finance their investments, this would be costly and deleterious.

    At the end of the day however, if these utilities mismanaged their operations and this resulted in the wildfires, they should be held accountable. If they are not, then focus will remain upon returning value to shareholders by keeping operating costs down and maintaining massive ($800m-$1.2bn) cash dividends that reduce the companies’ ability to pay down the resulting wildfire liabilities in a manner that doesn’t allow them to externalize costs.

  6. Blaming Climate Change and Electrical Utility Companies does not solve the problem!

    The State, Counties, and Land Owners need to clear the land of dead and dying vegetation.

  7. Associate professor Lucas Davis fails to mention the obvious:
    the culpability of corporate executives.

    “A central tenet of law and economics is that agents should bear the costs of their actions.”

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