Perennial wildfires burn utilities solvency

Transcription

1 Perennial wildfires burn utilities solvency November 2018

2 Authors Extreme weather in the US is feeding a perennial wildfire issue that will likely continue to worsen in coming years. Peter McGoldrick Senior Vice President pmcgoldrick@lockton.com Key factors such as rising annual temperatures, reduced snowpack, deforestation, changing human land use and increased drought periods have led to a noticeable increase in the frequency and severity of wildfires in the Western US. Since 1980, there has been more than a fourfold increase in large and long-duration wildfires, with the length of the fire season expanding by 2.5 months and the size of wildfires increasing sevenfold. Nate Hudson Senior Vice President nhudson@lockton.com Nowhere is this more evident than in California, where 15 of the state s 20 largest fires have taken place since This year, the Mendocino Complex blaze, which burned 459,123 acres, became the largest wildfire in California history and surpassed the Thomas wildfire from 2017, which held the previous record for acreage burned. While the total cost associated with the past two years is not known yet, the California Department of Insurance reports that insurance claims from the October-December fires in 2017 add up to more than $12 billion. As California wildfires grow larger and more intense, an increasing number of insurance companies are not renewing policies in areas they deem too risky to cover. For those admitted carriers continuing to write coverage in these areas, they will likely face increased reinsurance premiums which, in turn, drives up costs to policyholders. However, not all companies faced with liabilities related to these wildfires see insurance as an adequate solution. 2

3 Perennial wildfires burn utilities solvency November 2018 Utility industry impact For California s utility industry, wildfires represent the most significant long-term financial challenge. They are subject to civil lawsuits alleging negligence from plaintiffs seeking to recoup money for fire-related damage and deaths. Such liability compels the utility workforce to follow laws, regulations and safe practices. This, of course, is in the public s best interest. However, the biggest challenge comes from the public needing to pay for damages without a finding of negligence or full causation. Under the doctrine of inverse condemnation, courts have ruled that utilities are responsible for any damages associated with their equipment even if there was no finding of negligence. An example might be a downed power line resulting from high wind. This approach, while appealing in its simplicity, is shifting substantial unanticipated liabilities onto the utilities, which ultimately impacts their solvency. Inverse condemnation itself is not necessarily a threat to their financial stability; rather, it is the inability of the utilities to recover such wildfirerelated liabilities via the rate recovery process. Recently, regulators decided that San Diego Gas & Electric could not pass such costs on to its customers after the utility asked if it could raise rates to cover liability from wildfires back in Some estimates from analysts suggest that Pacific Gas & Electric (PG&E) may face liabilities from the 2017 wildfires equal to that of its annual revenue. Liability insurance might be the next obvious mechanism to insulate from these third-party liabilities, but only if coverage and limits are adequate given the exposure. However, commercial capacity is quickly tightening, and becoming unreasonably priced. In some cases, 30 percent rate on line or higher for large portions of excess liability capacity are being seen. Sufficient commercial insurance capacity is scarce and in many cases is not adequate to cover a utility s wildfire liability. Rate on line is a term used to describe a percentage that is derived by dividing insurance premium by insurance limit. For example: A $10 million limit with a premium of $3 million would have an ROL of 30%. So therein lies the problem: Responsibility for third-party damage amounts is threatening utility companies balance sheets regardless of negligence. This problem is complicated by the inability to seek reimbursement or offset those costs via rate recovery and the absence of enough insurance capacity to cover that risk. Financial markets have forecast this potential risk. Stock prices dropped for Southern California Edison after the wildfires in Santa Barbara and Ventura counties, as they did for PG&E following the blazes in Napa and Sonoma counties. 3 Lockton Companies

4 Credit agencies have taken notice and are lowering bond ratings. S&P Global Ratings has said continued liability concerns related to the wildfires could push PG&E and its peers in California below investment grade. Without the ability for rate recovery for wildfire liabilities or the risk transfer products associated with them, utilities may have to divert authorized revenues away from planned work modernizing and managing the electric grid. They also may need to deploy preventative measures, which would impact large numbers of residential and commercial ratepayers. One measure is largescale public safety power outages, which occurred for the first time in Northern California this October for multiple days as a means of reducing wildfire risk during high wind speed days. Legislative climate State legislatures recognize the competing issues involved with properly managing, mitigating and apportioning the growing risk of wildfire. However, there is no consensus on what the best path forward should be. In California, 2018 saw multiple legislative proposals put forth that would address the tremendous losses mounted from the 2017 and 2018 fires as well as any future wildfires across the region. The most controversial proposal, aimed at eliminating the application of inverse condemnation against utilities following wildfires, failed to get through the legislative session; however, Senate Bill 901 was recently passed and signed into law by the governor. 4

5 Perennial wildfires burn utilities solvency November 2018 Senate Bill 901 is a compromise, stop-gap measure aimed primarily at reducing wildfire risk and improving utilities risk mitigation efforts. It establishes new protocols for risk mitigation which include vegetation management, mechanical and electrical system improvements and upgrades, and improved communications between regulatory, firefighting and utility stakeholders. It also doubles the fines (from $50,000 to $100,000) that are assessable against utilities by the California Public Utilities Commission (CPUC) for violations of law or regulation regarding wildfire causation or exacerbation. In addition to incentivizing improved wildfire mitigation efforts going forward, Senate Bill 901 also addresses some of the financial burdens that utilities have been forced to bear due to inverse condemnation. The Bill establishes mechanisms by which CPUC can assess the existing financial impacts on utilities from the 2017 and 2018 fires and establishes a new, multipart review process for fires in 2019 and beyond. In all cases, CPUC must ultimately determine if utility wildfire costs and expenditures were just and reasonable and whether the utility acted as a prudent manager of infrastructure and operations before any financial recovery from the rate base would be allowable. For the utility costs associated with 2017 (and presumably 2018) wildfires, CPUC is now authorized to use a financial stress test to determine the maximum amount of liabilities and costs that a utility can absorb without negatively impacting its overall financial health and credit rating status. The CPUC can then seek to allow rate base recovery beyond that maximum threshold through the use of rate recovery bond issuance, slowly increasing rates while providing strong financial security to bondholders. For 2019 and beyond, CPUC will create and apply a 12-factor review process to determine whether utilities can recover wildfire costs. Included in the review is the appropriateness of the actions of the utility and its management, the design of system assets, the adequacy of risk assessment, preparation, mitigation efforts, monitoring and compliance, and the presence and impact of factors outside of the utilities control such as extreme weather events. Approved rate base recoveries following this assessment would likely take the form of rate recovery bonds rather than immediate reimbursements. Potential legislative solutions Growing wildfire risk continues to create an undue financial burden on utilities and value chain participants, which jeopardizes the safety and reliability of the electric grid. This ultimately costs ratepayers through utility lost opportunity costs such as the inability to invest in cleaner and smarter technologies. Legislatures are in the best position to create more equitable risk apportionment schemes which incentivize all stakeholders to assess and mitigate these increasingly frequent and severe risks. 5 Lockton Companies

6 In California, if inverse condemnation remains an applied doctrine, a potential solution to the problem would include the assured rate recovery of costs incurred in wildfire events where utilities are found not to be negligent. Utilities could then be permitted to self-insure and prefund portions of reserve accounts up to specified levels with liability caps enacted as a financial backstop. This approach is already used to address various other perils such as nuclear power plant decommissioning and oil spill legislation. An alternative approach in California could abandon the inverse condemnation doctrine and assign a fault-based liability structure which incentivizes utility capital investment in safety, risk mitigation, and new technologies while holding them accountable for fault. Current and potential commercial solutions Given the political climate and perceived competing interests of the stakeholders involved, it is not likely that a legislative solution will come soon. As such, commercial market solutions need to be refined or created to address the wildfire challenges particularly evident in the Western region. While traditional liability insurance remains available at least at lower levels of capacity, the overall market capacity is rapidly shrinking, and the cost is rising exponentially. After each new fire event, reinstatement coverage or program renewals have become extremely difficult and costly. However, as wildfire loss modeling improves, there are opportunities for insurers, capital markets and stakeholders to creatively address exposures using various combinations of risk management approaches. 6

7 CAT bonds/insurance-linked securities For some utilities, catastrophe bonds, or insurance-linked securities (ILS), might provide an option. It is possible to structure these instruments to provide a corporate cedent with risk transfer. Ultimately, they shift extreme insurance risks into the hands of bondholders, who get paid a high coupon for taking the risk. A few recent transactions featured this arrangement whereby an issuer/special purpose vehicle issues notes to be sold to ILS funds and ILS investors. The proceeds collateralize a multiyear aggregate and indemnity reinsurance arrangement with a reinsurer, which in turn reinsures a captive insurance cell owned by a utility, which then ultimately insures the utility. These instruments feature an indemnity trigger to protect the utilities solely from third-party exposures caused by wildfires for which they are liable. These transactions featured tranches of notes issued between $125 million and $200 million with initial attachment points in excess of $1.25 billion. Initial investor feedback appears to suggest that notes are being offered with a coupon priced at 5.0 to 7.5 percent. Parametric insurance Another flexible approach to addressing this risk is the use of parametric insurance, which uses specific event parameters or catastrophe models to calculate insurance policy payouts. These products can be designed to closely mirror actual losses but allow for much more rapid claim settlement so that funds can be deployed. Advanced modeling is now available for wildfire risks to estimate acreage burned, wind speed factors, number of drought days and a host of other potential triggers. 7 Lockton Companies

8 Lockton Power Lockton Power is an aligned, international team advising power generation and utility clients on all phases of transactional, project and operational risk. The group was formed for clients seeking bespoke risk advisory services to address an evolving risk landscape. We continue to monitor the market dynamics at play and are actively working on risk solutions for our clients. The benefit of parametric insurance solutions is the ability to decouple financial recovery from an actual wildfire event, allowing utilities or other stakeholders the ability to prefund escrow-type accounts to use when actual wildfire liability losses are realized. In conjunction with changing legislation, this approach could benefit ratepayers by allowing a smooth rate increase during a longer time period. Other potential solutions for stakeholders With this threat increasing annually, all of the major stakeholders need to consider solutions that will more cost-effectively address mitigation and recovery from these events. While traditional risk transfer will continue to be available in the short term, it is uncertain what the future holds for overall capacity and pricing. Stakeholders should consider risk-pooling and sharing mechanisms as a way to align interests, drive safety and accountability, and seek economies of scale and geographic spread of risk. 8

9 Perennial wildfires burn utilities solvency November 2018 NOTES 9 Lockton Companies

10 RISK MANAGEMENT EMPLOYEE BENEFITS RETIREMENT SERVICES LOCKTON.COM 2018 Lockton, Inc. All rights reserved. KC: 50175