The Palisades, Eaton, and Hughes wildfires in the Los Angeles area may be the costliest ever in California, with at least 28 deaths, around 130,000 displaced residents, and property damage estimates of up to $45 billion. Although the cause of the fires is still unknown, California utilities have come under scrutiny for possible mismanagement and/or their role in potentially starting the fires. As a result, several municipal borrowers in the region – including the Los Angeles Department of Water and Power (LADWP or the Utility), the largest municipal electric utility provider in the United States – have exhibited material spread widening since the fires (see Figure 1). The size of the potential liability underscores the risks facing municipal utilities and the considerations facing active managers as they navigate increasingly severe climate events. With that context, we take a closer look at LADWP’s current exposure to liability risk from the Palisades fire.
LADWP: Under Pressure
Located in the City of Los Angeles, LADWP provides water and electric services to 1.6 million retail and commercial accounts throughout Los Angeles and several cities on its borders. The Utility has approximately $20 billion of municipal debt outstanding, including approximately $13 billion of debt associated with the Power Division. The Palisades fire, the largest of the three fires with over 23,000 acres burned, is within LADWP’s service area. In California, utilities are subject to “inverse condemnation” laws which omit a negligence standard and hold a utility strictly liable for damages if the utility’s equipment is determined to have caused a fire. Given the dense population and high property values in the service area for LADWP, the cost of damages related to a fire would be steep.
Figure 1
Los Angeles Department of Water and Power* yield widening versus Bloomberg California 1-15 Year Municipal Intermediate Index (%, YTW)
Blackrock. *A custom composite of all LADWP CUSIPs in the Bloomberg California 1-15 Year Municipal Intermediate Index.
While LADWP’s service territory is not considered a “high wildfire risk” by the California Public Utilities Commission (CPUC) and the U.S. Forest Service due to its urbanized terrain and robust vegetation management programs, this has not stopped mounting speculation that LADWP’s Power Division may be to blame. For example, state and local officials have publicly criticized the Utility for not turning off the electric grid in certain affected areas, a standard practice for many utilities when a wildfire occurs. However, turning off the grid was not a protocol included in LADWP’s formal wildfire response plan, which was approved by the State of California’s Office of Energy Infrastructure Safety. Furthermore, most of the Utility’s electrical polls are steel and have already been hardened.1
In addition, LADWP’s Water Division has also come under attack for, among other things, failure to maintain a nearby reservoir that was out of service, as firefighting efforts throughout the Palisades were hampered by poor water pressure. A lawsuit has already been filed against LADWP’s Water Division directly related to the empty reservoir and the Utility’s decision to keep it closed.
Potential Outcomes for LADWP’s Power Division
The U.S. Bureau of Alcohol, Tobacco, Firearms and Explosives (ATF) is working to discover what caused the Palisades fire. Causes could range from fireworks to one of LADWP’s electrical towers in the vicinity of the fire’s origin. Below, we consider the potential outcomes from an investor’s perspective.
Outcome 1:
If LADWP’s utility wires are at fault, the size of claims would dwarf the Utility’s available insurance and liquid assets. In addition, LADWP may come under further modest negative rating agency action. Despite this concern, LADWP would likely remain financially viable, and we would not expect the Utility’s debt to suffer permanent principal impairment. Favorably, the Utility has enormous scale as it provides an essential service to nearly 4 million people throughout the City of Los Angeles. Unlike investor-owned utilities, LADWP has rate-raising authority that is not subject to the regulatory purview of the CPUC or any other state or federal agency. This allows it to raise rates without regulatory approval.
In addition, LADWP has de-levered over the past four to five years, leaving it room to issue several billion dollars of revenue bonds without risk of a ratings change (See Figure 2). We believe the Utility would also have the option to pursue a ratepayer reduction bond to fund the settlement of claims over time. In the past, utilities that have experienced costly disasters have received such state legislature-approved financing vehicles. These vehicles allow a portion of rates on customer bills supporting the ratepayer reduction bond to be securitized while providing cost of financing advantages to the issuer.
Figure 2
Los Angeles Department of Water and Power's power division has been reducing leverage (gross debt / cash flow available for debt service ratio)
LADWP, PGIM Fixed Income.
In our estimation, bonding out $20 billion of property damages with a ratepayer reduction bond would raise the average LADWP customer’s power bill by a manageable 10%. This assumes the City of Los Angeles will share some responsibility for claims. There would likely be consternation among affected residents and politicians given the already high electric rates in both the city and state, but this framework would be the least disruptive to LADWP customers. Given this resilience, current spread levels on LADWP bonds may provide an attractive entry point.
Outcome 2:
If LADWP’s Power Division is found to have not caused the Palisades fire, it would still likely need to increase leverage to support capital expenditures intended to replace damaged equipment and harden infrastructure further for future wildfire prevention. Under this scenario, we believe the impact on LADWP’s balance sheet and financial metrics would be modest. Furthermore, we would expect credit spreads on LADWP bonds to materially tighten from current levels.
The Outcome for LADWP’s Water Division Is Less Clear
The lawsuits against LADWP’s Water Division are more complicated as inverse condemnation laws may apply, even if the Water Division was not at fault for starting the fire. In 2012, a Southern California water district (Yorba Linda Water District) was found liable under inverse condemnation because the utility failed to maintain fire hydrants that could have prevented fire damage. LADWP is being sued by residents of Pacific Palisades for failure of the Water Division to properly manage water supplies that may have combatted the blaze. We estimate that water rates would need to rise far more than the 10% we estimate for the Power Division if $20 billion in property damage claims were to accrue to the Water Division. With that stated, it is our view that the damages would likely be socialized among LADWP’s Power and Water Divisions, and the City of Los Angeles may shoulder some of the costs.
A Fractured Insurance Market & Rising Rates
The long-term impact of the fires is difficult to ascertain as there are many second order effects to consider. However, it’s clear that there will be mounting pressure on residents from the aggregate impact of higher insurance costs and utility rates. Furthermore, the higher cost of living could lead to outmigration from the state.
Insurance companies have been decreasing their exposure to wildfire risk in California for many years. Increasingly, residents have turned to the state’s insurer of last resort, FAIR, which has a deductible under its own reinsurance policies that exceeds the plan’s cash on hand. This program may need comprehensive reform or access to additional capital. To help mitigate the issues, California recently allowed private insurers to raise rates to reflect modeled catastrophe risks and to pass on the cost of reinsurance in exchange for writing 85% of their coverage in high-risk areas. The quid-pro-quo may leave insurers worse off and accelerate the pull-back of coverage further.
In addition, water and utility rates – especially in Southern California where water is naturally less abundant— may need to reprice to reflect the reality of hardening infrastructure and the increasing frequency of recovering costs for liabilities incurred during wildfires.
Implications of California’s Wildfires for LADWP
LADWP’s credit trajectory will be dependent on the result of the investigation, although we believe the Utility has the resources to recover from the recent fires and current spread levels may largely reflect downside risks. However, the spread widening exhibited by the Utility is a reminder that fires are becoming more prevalent and large municipal utilities are not immune to intensifying climate risks. We hope that the recent outbreak will serve as an inflection point for state and local officials, leading to improvements in water and utility infrastructure, firefighting resources, and polices that mitigate the State of California’s risk to fires.
1 Physical improvements to plant and equipment, including power lines and supporting structures, making them more resistant to extreme heat and damage from wildfires.