An Update on the California Wildfires

1. Summary. The fires in California to begin the year will likely mark the costliest natural disaster in history once damages are fully assessed. There are insurance programs and funds set aside to help utility companies pay for damages if they are found liable for equipment contributing to the fires, but those backstops are likely going to be depleted going forward. Corporate utilities are under higher scrutiny, but there are still potential liability concerns surrounding lawsuits against municipal entities as well.

From an investment perspective, we have a negative view on the taxable utility credits operating in California. There are opportunities in secured credits, but the amount of uncertainties and high likelihood of future liabilities correlated to future fires leads us to believe the risks are not worth an investment at this time. However, in the municipal space, we think that many affected issuers are beginning to offer attractive opportunities not only for California residents, but also for national accounts, as forced selling has created pockets of relative value.

2. Fires. The Los Angeles region sadly experienced the most devastating natural disaster in terms of property damage in history to begin 2025, and our thoughts continue to be with those that have been affected. Three separate fires, Palisades, Eaton, and Hughes, spread quickly due to high winds, and the ultimate source of these fires is still under investigation. While there are many unknowns that will come out in the coming months and year, there are a variety of potential impacts for issuers of both taxable and tax-exempt bonds.

We will continue to provide updates should circumstances change. Please let us know if there are any questions.

3. Inverse Condemnation & AB1054 Fund. Key risks from a credit perspective will be in determining which, if any, issuers will be found at fault for equipment starting the fires or any other negligence. California operates under an Inverse Condemnation legal construct that results in strict liabilities for utility companies. A utility company can be found liable for all property damages, legal fees, and other related costs if their equipment even contributes to a wildfire without the need to prove the utility acted negligently. The most recent example of inverse condemnation being tested were the 2017-18 fires that resulted in Pacific Gas & Electric (PCG) filing for bankruptcy and ultimately led to the establishment of a $21 billion wildfire fund to pay fire damages (AB1054).

The AB1054 fund was initially funded with $18 billion in 2019 and $10.5 billion from extending surcharges on taxpayers, along with $7.5 billion from the three largest investor-owned utilities in the state (PCG, Edison International (EIX), Sempra (SRE)). After the initial funding, the three utility companies have contributed $300 million annually to reach the $21 billion total fund size today. The fund can be tapped by the utilities to pay for wildfire damage caused by their equipment and is ineligible from being tapped by municipal or co-op utilities.^[1]

Chart 1: Assembly Bill 1054 Wildlife Fund Mechanics^[2]

4. Taxable Credit Implications. Of the three fires, only the Eaton fire was started in one of the three corporate utilities service areas, and videos have surfaced showing a flash of light under EIX’s equipment at the time the fire is suspected to have begun. EIX has filed two reports with regulators saying they did not detect any anomalies on their lines ahead of the fires. However, a third party detected two large faults on their lines that corroborate the videos showing their equipment starting the fire. The company has also admitted a fault with its equipment several miles away which sent a surge of power over their entire SoCal system.[3]

The three utility companies have seen spreads widen and stocks selloff, EIX wider than the others, on not only potential liability but also concerns surrounding the depletion of AB1054. The base case assumption is that EIX’s equipment will be faulted for the Eaton fire and the damage will be covered by AB1054, but that charges will be large enough so that they effectively wipe out the entire AB1054 fund. The three corporate utilities would then operate without the backstop of the fund and will likely be subject to downgrades from rating agencies; bonds that are secured will likely provide a strong investment opportunity as they are high enough on the capital structure to receive payments before any damage-related payments, but unsecured bonds are now a higher risk with no AB1054 backstop for future damages.

Going forward, there is significant uncertainty, among the biggest issues: utilities will be pressured to take further prevention measures (burying transmission lines underground, undergrowth clearance, technology to stop transmission lines as quickly as possible), politicians will be pressured to replenish AB1054 or find some other backstop measures, and ratepayers will likely face higher rates. Overall, the short-term credit concern is EIX, with medium-to-longer term implications for PCG and SRE.

5. Tax-Exempt Implications. Municipal credits have seen spreads widening similar to the aforementioned corporate credits, as both revenue bonds for electric and water entities and General Obligation bonds secured by property taxes may be affected. Electric revenue bonds, specifically LA Department of Water & Power (LADWP) have come under scrutiny for potential liabilities in the Palisades fire. With the loss of property, there is less to be taxed on which will decrease correlated revenue derived to pay GO bonds.

LADWP’s exposure differs from EIX as there has been no evidence that their power lines started a specific fire, but rather the focus on lack of available water to combat the Palisades fire has come up. A report by the LA Times explained that a large reservoir in Pacific Palisades which is part of the Los Angeles water supply system was out of commission and had been since February 2024. This has sparked a variety of lawsuits to be filed against the municipal entity. This report surfaced as questions were growing about why firefighters ran out of water while battling the fire after reports showed that several fire hydrants in higher elevations of Palisades went dry. Officials for LADWP have stated that demand for water during the fire made it impossible to maintain any pressure to hydrants at high elevations, but had the reservoir been operable, water pressure in Palisades would have lasted longer, but only for a time. The CEO of LADWP knew of the lack of water supply and working hydrants for months which has stemmed the lawsuits, and there is legal precedent with respect to the claim: in 2008, Yorba Linda Water District has problems with its water system during the Freeway Complex fire and the case was settled through judgement. While it will be some time before ultimate financial penalties occur, litigation and headline risks will continue to pressure the credits. There is a high likelihood LADWP will borrow heavily to finance future fire-prevention projects.

The municipal utility is the largest in the nation, has strong financials, rate-setting abilities, and reserves, but will be the most scrutinized of municipal issuers depending on the liability assessed to it. S&P downgraded LADWP’s electric and water system two notches each (to A from AA- for electric revenue bonds, to AA- from AA+ for water revenue bonds) and kept both on negative outlooks. So far, Moody’s has affirmed its Aa2 ratings but revised the outlook to negative.

General Obligation bonds (Los Angeles GO’s, Los Angeles Unified School District GO’s) will not be subject to any fault for the fires but have experienced property losses in its service areas. Specific to LAUSD, the bonds are backed by a protected lien of property taxes which has the backing of state legislature. With this backing, bondholders are deemed secured credits and all revenues received from ad valorem property tax levies are put in a “lockbox” dedicated to repayment of the bonds, a strong credit positive. LAUSD’s service area was only affected by the Palisades fire, in which the district operates nine schools that were damaged by the fire; in the event of $0 recovery of impacted real estate, this impact would only represent a 3.2% decline in LA USD’s tax base.

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Sources

^[1] Source: Credit Sights. As of February 4, 2025.

^[2] Source: Edison International. As of July 2021.

^[3] Source: Credit Sights. As of February 3, 2025.

Disclosure

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