While the month was brimming with enthusiasm for graduates, the fixed income and equity markets continued to present little excitement, with performance remaining mostly even.
As the California wildfires continue to cause concern across the nation, we provide thoughts on the implications for municipal credit.
- Outside of isolated credit situations, we do not expect the recent wildfires to have a significant impact on municipal bonds in California. As we discussed in From Drought to Flood: Assessing Risks in California, lasting impacts from natural disasters are often minimal and local governments have a long history of honoring debt obligations after these events.
- However, the wildfires highlight important risks. First, the potential for California to have to support electric utilities – both public and private – buffeted by extreme weather adds several layers of risk to the state. Second, California has a unique combination of weather risks that include flood, drought, earthquake and wildfire. These extreme weather events raise questions about how communities that suffer catastrophic damage can recover. The extreme weather events also have implications for property insurance costs, suggesting that additional state intervention may be necessary.
Will the State Step In?
- Solvency of PG&E in Question. Pacific Gas and Electric Co. (PG&E) is one of the state’s major investor-owned electric utilities, providing services to roughly two-thirds of Northern California utility customers. It is a highly essential entity, and its failure would portend health and safety risks and significant economic dislocation – potentially making it “too essential to fail.” PG&E has been one of the hardest hit utilities by California wildfire liabilities, prompting the company to tap its revolving credit facility in mid-November for more than $3 billion.
Senate Bill 901 (SB901), passed in August 2018, gives regulators the power to allow PG&E and other utilities to partially recover their fire costs by increasing customer rates.1 In addition, the bill allows costs to be recovered through securitization bonds over a period of time, typically 15 years or longer. However, the law excludes any wildfires in 2018, so it will need to be amended to potentially allow PG&E to recover costs associated with this year’s wildfires. Liability totals for PG&E are yet to come, but the liabilities seem likely to exceed the company’s $14 billion market cap.
Looking Broadly to the Future, State Support Could Be Costly. While the outcome of the regulatory debates are uncertain, we think PG&E’s problems highlight the pressures on the state of California to determine how to manage wildfire damage while preserving stability to its electric grid. If the state steps in and provides financial assistance, it could negatively impact the state’s balance sheet – particularly if it occurs at some point in the future when the state is under greater fiscal stress.
The 2000-2001 California electricity supply crisis is a trenchant historical example of state credit risk materializing from failing private electric utilities. In that crisis, Enron Corp.’s manipulation of the state’s power grid sent wholesale energy prices soaring and crippled PG&E, Southern California Edison and San Diego Gas & Electric Co. The state saw electricity shortages and several days of blackouts. To rescue the ailing utilities without increasing customer rates, California borrowed against state funds and later repaid the debt with a $12 billion bond issuance in 2002 – at that time, the largest municipal bond in history.2 The state established a ratepayer revenue agreement in which charges can be imposed on the utilities' customers by the state Public Utilities Commission.
We believe that one-off events such as the 2000-2001 California electricity supply crisis can be managed. However, the fact that extreme weather events have been occurring with increasing frequency raises the question of whether ratepayers can be relied upon to fund future disaster liability costs. This could force the state to find new solutions to provide stability to the electric grid.
Muni Electric Utilities Could Need State Support. Publicly owned electric utilities also carry exposure to fire liabilities. These utilities are typically much smaller than investor-owned entities such as PG&E and lack the customer base or the resources to independently combat major wildfire damage. Should a municipal electric utility be found culpable for a significant fire event, we expect that the state would face even greater pressure to provide extra-financial support for the system and its customers.
As an example of extreme weather impacting a public utility, the Los Angeles Department of Water and Power is currently facing a lawsuit due to its contribution to the destruction from a 2016 wildfire known as the Creek Fire.3 Though the magnitude of Creek Fire damage was much smaller than the more-recent wildfires, future hazards could destabilize any public utility.
Vulnerable communities could see negative impacts on homeownership, property insurance.
- Declining Property Values. The recent California wildfires follow the Northern California firestorm of 2017. The total financial damage from last year’s wildfires is still unknown, but estimates are that insured losses exceed $15 billion.4 The recent wildfires have been even more severe, leading to estimates of more than $30 billion in combined damage from last year and this year. If recovery occurs slowly in some areas and/or residents permanently relocate, this could harm property values and limit economic growth. In this respect, the recovery of Paradise bears watching as preliminary estimates indicate that 80 percent to 90 percent of structures in the town were destroyed.5
As an extreme example of this, the New Orleans labor force fell 20 percent in the 12 months following Hurricane Katrina’s landfall, and an estimated 180,000 housing units were severely damaged or destroyed.6 Trends have improved since then,7 which is a testament to the ability of municipalities to regain strength after natural disasters. That said, now more than 13 years since Hurricane Katrina struck land, New Orleans’ population currently sits at 393,292 – over 20 percent below its population in 2005.8
- Higher Insurance Costs. As discussed in the New York Times article “How Wildfires Are Making Some California Homes Uninsurable,” California is also struggling with rising home insurance costs.9 While the state’s FAIR Plan is meant to cover homeowners with extreme exposure to wildfire risk, if enough insurers pull out of insuring residents entirely the state may have to set up its own insurance program to support residents. An example is Florida’s Hurricane Catastrophe Fund, which was set up in the 1990s to underwrite private catastrophe insurance.10 Also, as discussed in Municipal Credit and the Path of Federal Natural Disaster Support, reduced federal support for communities experiencing environmental damage could further raise risks in California. As the federal government and property insurers pull back, the state may have to allocate more resources to fill the gap.
While we think that extreme weather introduces many additional layers of risk to the state, we continue to see opportunities in California bonds across many sectors. Breckinridge fully incorporates environmental, social and governance (ESG) risks such as extreme weather into its credit evaluations. California bonds can offer tax advantages for many clients, and our goal is to always make sure that the pricing and tax advantages of investing in-state are enough to compensate for the bonds’ credit risks.
 Before SB901, California could not partially recover costs from ratepayers. It was “all or nothing.” California is one of only two states (along with Alabama) that operates under the legal precedent of “Inverse Condemnation,” whereby the utility is liable for property damages, legal fees and firefighting costs if its equipment is found to have merely contributed to the fire, even if the equipment was in working order or the utility isn’t negligent. If the utility is not linked to the fire, the utility can recover these costs from ratepayers. With SB901, the utility can recover costs from ratepayers based on determinations from the California Public Utilities Commission (CPUC).
 “Anatomy of a Jolt,” The Wall Street Journal, June 25, 2001.
 Bradley Bermont, “More than 300 Creek Fire Victims Just Filed a Lawsuit Against LADWP,” Los Angeles Daily News, November 9, 2018.
 Citi Market Commentary, as of November 16, 2018.
 Keeley Webster. “Wildfire's destruction of California town creates uncharted credit territory.” The Bond Buyer, as of November 13, 2018.
 U.S. Department of Housing and Urban Development's (HUD's) Office of Policy Development and Research (PD&R), New Orleans, LA, Comprehensive Housing Market Analysis, as of April 1, 2018.
 Merritt Financial Services. Based on total taxable assessed value, from December 31, 2005 through December 31, 2017.
 U.S. Census Bureau. Current New Orleans estimates as of July 2017. 2005 data from the U.S. Census and Breckinridge Capital Advisors.
 Mary Williams Walsh, “How Wildfires Are Making Some California Homes Uninsurable,” The New York Times, November 20, 2018.
 Leslie Scism. “Storm Clouds Gather Over Florida Issuers,” The Wall Street Journal, February 6, 2012.
DISCLAIMER: The opinions and views expressed are those of Breckinridge Capital Advisors, Inc. They are current as of the date(s) indicated but are subject to change without notice. Any estimates, targets, and projections are based on Breckinridge research, analysis and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.
Nothing contained herein should be construed or relied upon as financial, legal or tax advice. All investments involve risks, including the loss of principal. An investor should consult with their financial professional before making any investment decisions.
Some information has been taken directly from unaffiliated third party sources. Breckinridge believes such information is reliable, but does not guarantee its accuracy or completeness.
Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.
BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices.
Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.