Structural Effects of Climate Change on the Utility Business

COMMENTARY

Developers and other sellers of electricity have traditionally viewed utilities as creditworthy counterparties. Utilities are longstanding institutions that provide a public service and receive a regulated rate of return.

Climate change, and the resulting legal and regulatory responses, however, are beginning to change the core business model of utilities. These changes have the potential to affect the structure of the wholesale electricity market and drastically impact sellers, particularly renewable generation developers.

Increased Risk, Increased Costs

A prominent effect of climate change over the past two years has been the increased frequency and severity of wildfires in California. Fires caused by utility equipment represent a massive liability for utilities, and this is amplified by California’s inverse condemnation law, which holds a utility strictly liable for property damage and legal fees if its facilities are the substantial cause of a fire, regardless of fault.

Citing the risk of wildfire liability, Southern California Edison (SCE) filed with the Federal Energy Regulatory Commission (FERC) in April to increase its transmission rates. In particular, SCE proposed to increase its return on equity (ROE) dramatically from 11.12% to 17.62%. To support the proposed 650-point adder, SCE argued that, due to wildfire liability, credit rating agencies downgraded SCE, warned of further downgrades, and dampened investor confidence. SCE entered into an interim settlement for a 12.47% ROE, still a sizable increase.

Pacific Gas & Electric (PG&E), another California utility, also has sought an increase in ROE related to wildfires. Ultimately, PG&E’s and SCE’s increased ROEs will be reflected in higher transmission charges.

Risk of Cancellation

Climate change-related wildfires were a significant factor in PG&E’s decision to file for bankruptcy in early 2019. The bankruptcy triggered a still-unsettled legal battle over the ease with which a utility may reject wholesale power purchase agreements (PPAs) in its bankruptcy proceedings.

Normally, a company in bankruptcy is permitted to reject contracts under the deferential “business judgment” standard of the Bankruptcy Code, but FERC has asserted concurrent jurisdiction with the bankruptcy courts to prevent the rejection of wholesale PPAs, unless it finds that such rejection meets the higher “public interest” standard of the Federal Power Act.

PG&E has not yet rejected any PPAs, but the ongoing litigation poses real risks for electricity suppliers, who support FERC’s efforts to limit PPA rejections. If FERC ultimately loses this legal battle, it increases the risk that PG&E or other utilities in future bankruptcies will cancel PPAs, thereby exposing sellers.

Regulatory Uncertainty

The threat of climate change is also causing state regulatory authorities to change their market structures. For example, New York is implementing its “Reforming the Energy Vision” (REV) initiative, aimed at meeting the state’s clean energy goals. As part of the REV, New York is reforming the fundamental business structure of utilities.

Utilities will be encouraged to emphasize creation of opportunities for distributed energy resources (DERs), and move away from the traditional model of relying on load growth and capital improvements to earn a return on investment. New York also will require utilities to use new rate structures, such as the “value of distributed energy resources.” Because these structures are in development, the prevailing rates sellers can expect for power going forward are uncertain.

Both the environmental effects of climate change and the regulatory responses pose challenges for generation developers and other electricity sellers. Utilities like SCE and PG&E are attempting to pass on their risks to sellers in the form of increased transmission charges. Increased costs combined with falling wholesale electricity prices, particularly for renewables, squeeze the economics for generation developers.

Additionally, as prices fall for renewable energy, utilities are less willing to enter into long-term PPAs with renewable generators because the agreements are likely to be uneconomic in the later years of the contracts. The current debate over whether utilities may reject PPAs in bankruptcy further exacerbates concerns over the stability of long-term deals.

Utilities like PG&E may seek to reject above-market long-term contracts in bankruptcy proceedings. Rejection of, or refusal to enter into, long-term PPAs threatens a stable revenue stream that developers and investors rely on to finance new projects.

The challenges of finding revenue stability and a creditworthy buyer are multiplied when the regulatory paradigm is in flux, as in New York. The state’s changing utility model creates uncertainty as to how existing contracts will be treated and whether the sales will be at market prices. Additionally, while regulators work on calculating rates like the value of DERs, developers must ponder how their resources will be priced.

As these concerns illustrate, climate change is affecting the business and regulatory structures familiar to wholesale sellers. Many unforeseeable consequences remain, such as what happens should Congress pass a carbon tax or implements some form of Green New Deal. Developers would be prudent to stay abreast of the changing legal and regulatory landscape, and structure their businesses to minimize the risks posed by the increasingly insecure utility model. ■

—William Friedman is an associate in Davis Wright Tremaine’s Washington, D.C., office, focusing on regulatory, compliance, and transactional issues in the energy sector.