California Megafires: Approaches for Risk Compensation and Financial Resiliency Against Extreme Events
Prepared for Pacific Gas and Electric Company
The increasing frequency and severity of wildfires in California is focusing attention on how to prepare for and allocate unexpected and extreme financial burdens on utility customers and shareholders. In 2017, massive wildfires throughout the state resulted in record levels of property destruction and economic damage. The 2018 wildfire season, still underway as of the issuance of this report, has already resulted in the largest fire in the state’s recorded history.
This paper evaluates the magnitude of risks from potential liability for the damages these megafires can cause. This is a one-sided, asymmetric risk, involving only downside potential for uncompensated losses—a possibility which significantly erodes investors’ expected returns and could impede a California investor-owned utility from pursuing its normal operations effectively. We explain why such risks are not fully measured or quantified in ordinary estimates of the cost of capital but need compensation, and how the cost of equity could be adjusted in order to restore the opportunity to earn a fair return on its utility investments. Specifically, we show that a premium of 500 basis points added to Pacific Gas and Electric Company’s (“PG&E”) allowed return on equity (“ROE”), equivalent to about $1 billion per year of net income, would be commensurate with the apparent size of the fire problem as it has been manifest over the past few years.
