How The Future Of California’s Power Grid Hangs On The Constitutionality Of ‘Inverse Condemnation’

Two million Californians without power; 200,000 evacuated from the path of the Kincade fire in Sonoma County, believed to have been sparked by a broken jumper cable on a PG&E power line. California Governor Gavin Newsom is sure of who’s to blame. This week he condemned the utility’s decision to shut off power to residents in fire-prone areas. “As it relates to PG&E, it’s about dog-eat-dog capitalism meeting climate change,” he said. “It’s about corporate greed meeting climate change. It’s about decades of mismanagement. It’s about focusing on shareholders and dividends over you and members of the public. It’s a story about greed.” Newsom said Californians could not accept these blackouts, and he would fine the utility $100,000 per day for rule violations.

Threats and name-calling are unlikely to be effective. PG&E, in court documents filed last week in its ongoing bankruptcy case, made clear its position that until courts and lawmakers change what the utility sees as unconstitutional state laws, northern Californians will have little choice but to suffer more forced power outages when the wind gusts.

At issue here is something called inverse condemnation—it’s a legal doctrine that holds utility companies like PG&E to a strict liability standard. It doesn’t matter if a fire starts by accident or negligence, if it happens on the company’s equipment, then the utility is responsible for damages. The application of inverse condemnation to California utilities goes back to court decisions in the 1960s and ’70s. And for decades investor-owned utilities, like PG&E, Southern California Edison and San Diego Gas & Electric, were okay with the law, because the courts held that they could “socialize the burden” by hiking electricity rates enough to cover any unexpected costs, thus spreading the pain around evenly. When PG&E, for instance, had faith that regulators would let it socialize fire damage across its 16 million customers, it didn’t feel such a need to shut off power across a broad territory to lower the already remote likelihood of a fire breaking out.

But a few years ago, the status quo changed. A legal brief—written by attorney Kevin Orsini from Weil, Gotshal & Manges and submitted October 23, jointly by both PG&E and its creditors to U.S. Bankruptcy Court in the Northern District of California—explained that a watershed moment for California’s investor-owned utilities came in the wake of a 2015 decision by the California Public Utilities Commission, in which regulators turned down requests by SDG&E for $379 million in cost reimbursements for 2007 wild fires sparked by their lines. A higher court upheld the rejection. And with that, no longer could the power companies be confident in passing along fire costs.

The seriousness of this change was realized over the next few years. The Tubbs fire hit Santa Rosa, California, in October 2017; it burned 36,000 acres, destroyed 5,600 structures and killed at least 22. It was considered the worst fire in state history until 2018 when the Camp fire broke out in Butte County. It burned 150,000 acres, incinerated 19,000 buildings and took 86 lives. The infernos left PG&E with more than $30 billion in fire liabilities that it had little hope of spreading across its rate base.

According to court filings, PG&E shareholders hope to be rescued from oblivion by the Fifth and Fourteenth Amendments to the U.S. Constitution. The Takings Clause of the Fifth Amendment provides that no private property may be taken for public use without just compensation. The U.S. Supreme Court has ruled that the purpose of this is to “prevent the government from forcing some people alone to bear the public burdens which, in all fairness and justice, should be borne by the public as a whole.” The Fourteenth Amendment furthermore protects against arbitrary or irrational deprivations of life, liberty or property by government entities.  

If PG&E were allowed to recoup fire costs from ratepayers, then all would be constitutional. But that’s not how it works today, according to PG&E’s brief:

“Because PG&E has “no guaranty” that it can spread any losses it is forced to pay as a result of inverse condemnation claims, the application of inverse condemnation to PG&E is nothing more than the transfer of private property from one private entity (PG&E) to another (the inverse plaintiff) without any compensation, let alone just compensation. This uncompensated taking of PG&E’s property violates the Fifth Amendment of the United States Constitution (as incorporated against the states by the Fourteenth Amendment) and the California Constitution. . . . Without a guarantee that PG&E can recover inverse condemnation costs, the imposition of such strict liability through a doctrine premised on socialization of losses constitutes an unlawful taking without just compensation, and an arbitrary and irrational process that violates the Debtors’ substantive due process rights.”

With $30 billion-plus of fire liabilities hanging in the lurch, PG&E has every incentive to fight California’s application of inverse condemnation all the way to the U.S. Supreme Court, if needed. If it prevails, Californians will need to gird themselves for even higher electricity prices. Divvying up existing fire liabilities would cost the average PG&E customer about $2,000.

Among California’s investor-owned utilities, PG&E is most exposed, with half of its 70,000-square-mile territory in high-fire-risk zones, it has had three times more fires per mile of power lines than SCE or SDG&E, according to analyst Hugh Wynne with SSR. It’s unlikely the utility will survive these fires, at least in its current form.

Before the Kincade fire broke out in Sonoma County last week, the judge in PG&E’s bankruptcy case had allowed the parallel development of dueling reorganization plans offered by the company as well as its major creditors. Hearings are scheduled to continue into 2020. PG&E, for its plan, had lined up $34 billion in debt financing and would have paid $8.4 billion to fire victims and $11 billion to insurers, while maintaining a nugget of value for common shareholders—all contingent upon the avoidance of a devastating 2019 fire season. Bondholders, meanwhile, pitched a plan that would pay out $25.5 billion to victims and insurers, but would wipe out shareholders. All this is up in the air now that the Kincade fire has burned 75,000 acres and is encroaching upon the towns of Windsor and Healdsburg, with another round of ferocious winds forecast.

Will they have to scrap the plans and start over? Too soon to tell, but the Kincade fire has already burned 75,000 acres and 150 structures. Given that cropland and pastureland in California averages between $3,000 and $12,000 an acre, according to the USDA (more for Sonoma Valley vineyards), it’s likely that PG&E will be on the hook for hundreds of millions in additional damages.

Is there any hope for PG&E shareholders, like Abrams Capital Management, Knighthead Capital and Redwood Capital Management, which reportedly bought shares earlier this year above $6.50 only to ride them down to a current $4.50 (down from $70 in 2017)? Probably not. PG&E’s equity market cap of $2.4 billion is overwhelmed by $75 billion in total liabilities, including about $22 billion in long-term debt, according to Factset. The biggest debtholders include PIMCO, with about $4 billion, Elliott Management $1.6 billion, Varde Partners $990 million and Apollo Global $700 million, according to court documents. Assets on PG&E’s balance sheet total $83 billion. Damages for the Tubbs fire have yet to be fully tallied.

And if the company can’t convince the court its rights have been violated? California lawmakers could come to the rescue and write a new interpretation of inverse condemnation, heeding the recommendation of this year’s Final Report of the Commission on Catastrophic Wildfire Cost and Recovery which found that:

“The current interpretation of inverse condemnation, holding utilities strictly liable for any wildfire caused by utility equipment regardless of standard of care or negligence, imperils the viability of the state’s utilities, customers’ access to affordable energy and clean water, and the state’s climate and clean energy goals; it also does not equitably socialize the costs of utility-caused wildfires.”

Among other recommendations, the commission suggested replacing the strict liability interpretation of inverse condemnation with a “fault-based standard.” Such reform could save a sliver of value for shareholders and pay off big for owners of PG&E’s debt.

If reform doesn’t happen, it could push the company to sell assets in a reorganization that could put much of the company in the hands of new municipal power utilities, owned by the public rather than investors. But don’t think that the outright socialization of California’s power grid would keep electricity rates lower. Unlike the investor-owned utilities, municipalities already have the ability to levy new taxes on residents, and wouldn’t require the blessing of the Public Utilities Commission to use inverse condemnation to hit ratepayers with the costs of future fires. One way or another, if Californians want to keep the lights on, they’re going to have to pay for it.