Breaking up with Pacific Gas & Electric (PG&E) is hard to do.

But the San Francisco Public Utilities Commission (SFPUC) and other municipalities across California are evaluating the possibility of doing just that, seeking to take advantage of a groundswell of public discontent in the wake of PG&E’s wildfire-driven collapse into bankruptcy, which has left the utility giant in an unfamiliar position of political vulnerability.

A move toward utility “municipalization” in the state could introduce yet another set of complications for PG&E, which has historically resisted efforts by cities to gain energy independence and is already battling with contentious bankruptcy proceedings, an uncertain legislative reform process, and the threat, just around the corner, of another vicious wildfire season.

And the municipalities themselves face a host of challenges when taking over utility assets – such as access to capital markets and sometimes fraught onboarding processes that take many years and require expensive investments in infrastructure and personnel, experts say.

On the whole, municipalization is a worthy but “complicated” prospect, says Marilyn Brown, a professor at Georgia Tech University and former board member of the Tennessee Valley Authority (TVA). (TVA also happens to be the utility from which PG&E sourced its new CEO, Bill Johnson.)

“The acquisition process can take several years, and not all cities are capable of taking on the task,” Brown said.

In the case of the TVA, for example, which is the largest public power provider in the US, some of its many distributors are so small they cannot manage on their own without coordinating with the authority, she said. TVA provides service to customers in seven states, producing power for approximately nine million people across 154 local power utilities.

Meanwhile, in addition to operational and financing challenges, a look at the historical record shows that attempts to separate from PG&E usually involve long-running litigation – a costly prospect on its own – as PG&E seeks to hold on to its revenue base. The Sacramento Municipal Utility District (SMUD), for one, used eminent domain to obtain its system from PG&E in Sacramento County, and the issue was litigated for nearly a decade until 1946, when the California Supreme Court ruled in SMUD’s favor.

“What usually happens is that the investor-owned utility will fight pretty hard to stop municipalization, because they’ll lose customers,” said Dan Aschenbach, president at AGVP Advisory, a clean energy advocate.

He added, however, that the fight usually comes down to the valuation of assets. And valuation questions could form the core of San Francisco’s decision to go it alone.

City by the Bay

The SFPUC recently released a study discussing its options for public power within San Francisco – the first step toward the potential acquisition of PG&E assets for public use.

As it stands, SFPUC provides power to 360,000 ratepayers, or about 80% of the city and county’s service area. But it does so using PG&E equipment, acting as a community choice aggregator (CCA) to distribute renewable energy from solar and wind farms using PG&E’s transmission wires. SFPUC wants to acquire that distribution system from PG&E, and it believes the company’s bankruptcy provides an opportunity to do so, since it opens up a formal setting for the city to make an offer for asset acquisition.

In its analysis, San Francisco says ratepayers give PG&E USD 300m a year for electrical services distributed through PG&E wires. It says that USD 75m of that, or 25%, goes to PG&E shareholder profits. It also says additional savings are possible through higher operating efficiencies and lower compensation for executive management.

San Francisco, as a municipal issuer, could also benefit from lower interest rates on any debt it takes on for the prospective acquisition, proponents of municipalization say. PG&E, for example, has both corporate and municipal bond debt outstanding. At the time of issuance, the municipal bond debt carried interest rates between 1.05% and 2.15%, while its fixed rate corporate debt carries interest rates between 2.95% to 8.25%, according to SEC filings.

SFPUC also notes that the city would lose out on the USD 40m in annual payments that it currently receives from PG&E for property taxes, franchise fees, business taxes and charitable contributions. And the city’s estimations do not explicitly discuss actual rate reductions for customers – saying that any rate reductions will depend on several factors related to the cost of the transaction and any necessary capital improvements.

As it stands, SFPUC had USD 6.48bn in debt outstanding at the end of FY18. Its power revenue bonds are rated AA/stable by S&P and AA-/stable by Fitch. For reference, a USD 1.26m tranche of 3% Series 2016 SFPUC water revenue bonds due 2022 last traded at 104.364 to yield 1.678% on 30 May, according to Electronic Municipal Market Access.

The majority of publicly-owned utilities are successfully operated, according to John Ceffalio, vice president of municipal credit research at Alliance Bernstein. But there have been some cases where rate-setting at publicly-owned utilities gets political, he added.

“With public power, there are no stockholders to satisfy, so there are no concerns about returns on equity and dividends and stock prices, and that tends to benefit ratepayers,” Ceffalio said. “Generally, public power benefits the ratepayers because of a lower cost of capital.”

San Francisco’s creditworthiness and service area size would in theory allow it to operate independently from PG&E, potentially distinguishing the city from the rest of Northern California municipalities. But lopping off San Francisco from the service area could also generate an adverse financial impact on the broader base of PG&E ratepayers, experts say.

“The cost of serving customers is higher in rural areas,” Brown said. “And so there is a possibility that without San Francisco, rates for everyone else served by PG&E would go up” – a politically undesirable prospect for California’s Democrat-dominated political scene.

Critics of municipalization argue, on the other hand, that the benefits of local takeovers are often inflated while the costs usually come in higher.

“It’s a very costly exercise to acquire the system,” according to David Sosa, principal at Analysis Group. “Any benefit from the lower cost of borrowing is eliminated by acquisition and litigation costs, and the government will have to pay lawyers, bankers, financial advisors and engineers … typically if assuming a fair price is paid for the system, and (being) realistic about transition costs – those costs exceed any savings from the lower cost of borrowing.”

Sosa has worked with many telecommunications and utility providers on a broad range of litigation and regulatory issues.

At the same time, public power advocates have admitted that full takeovers of investor-owned utility assets are not essential for municipalities to get what they want – cities can win concessions just by beginning the process of municipalization, according to a report from the American Public Power Association.

The long timelines for the municipalization process, in turn, could mean that the SFPUC will miss the window to take advantage of PG&E’s bankruptcy, since California Governor Gavin Newsom is urging parties to resolve the bankruptcy quickly.

Electron flow

PG&E has acknowledged in securities filings that its financial results could be affected by the loss of utility customers through municipalization of its facilities.

San Francisco, specifically, encompasses a low fire-risk service area made up of affluent customers, representing a lucrative pocket of Northern California where wildfire risks otherwise run rampant. PG&E serves 5.42 million electricity customers, while the SFPUC operating at full independence would serve 400,000 customers, or more than 7% of PG&E’s customer base.

“If San Francisco is no longer part of the customer base, how are they going to manage that? From a revenue perspective, it’s an important point.” Aschenbach said. “San Francisco is a fairly large part of the PG&E service territory. Investors would get compensated for the [lost] revenue of the assets, but the revenue stream would no longer be PG&E’s, it would be San Francisco’s.”

From there, the parameters of a valuation fight start to take shape, experts said, with both sides digging in over preferred valuation methodologies. Sources surveyed by Debtwire agreed the value of the assets was in the multiple billions of dollars, but could not posit specific valuation metrics.

Barbara Hale, assistant general manager for power enterprise at SFPUC, said it was still unclear how much it will cost San Francisco to acquire PG&E’s distribution assets, but it is certain that, if it happens, it will likely be a multi-billion dollar transaction, financed by debt, with additional investment necessary to modernize the grid.

According to Ursula Schyver, vice president of education and customer programs at the American Public Power Association, the assets could be valued based on four distinct methodologies: original cost plus depreciated book value, replacement cost and depreciation (the cost of the building system now, minus the depreciation cost), replacement cost of a new facility less depreciation, and “going concern,” or how much the utility brings in plus cost and expenses.

Often, fair valuations for utility assets can be cost-prohibitive for municipalities, Sosa said.

“A government would have to pay the utility for the economic value of the assets – and that’s one of the big reasons at a conceptual level, these types of efforts typically don’t make financial sense for municipalities,” Sosa said.

He added: “There will certainly be scenarios that will be advanced by local governments – they claim it makes economic sense, but if a fair price is paid for the assets, it’s going to end up being very costly to acquire the assets and those costs will have to be recovered from ratepayers. And those are expenses ratepayers wouldn’t have to bear if they remained in the hands of an investor-owned utility.”

And even if a deal with the SFPUC is somehow wrung out, PG&E’s distribution system is not ring-fenced. Losing the San Francisco area would create an “island” in PG&E’s service territory – and a lot of questions about how to link up PG&E’s disparate parts, said Brown.

“There will have to be arrangements made for that system to link to the rest of PG&E … it’s complicated and there has to be a lot of modeling – where do the electrons go? How much responsibility does PG&E have for the upkeep of wires even if it doesn’t own them? The city would still have to use PG&E assets – that’s just the way electricity flows,” Brown added.

Bold and Boulder

Some recent examples beyond California further illuminate the challenges of municipalization.

Like SFPUC, Boulder, Colorado has been attempting to separate from Xcel Energy since 2010, with the dual goals of local control and the expansion of clean energy. But the city’s former mayor, Will Toor, once an advocate of municipalization, no longer supports the concept after nearly a decade of costly negotiations and stagnant progress. Toor told the publication Grist that de-regulating the utilities and teaming up with other large regions in the state could be more effective in the quest toward clean energy. The municipalization remains in progress, and is likely to take several more years before it’s complete.

In another example, The Long Island Power Authority (LIPA) was developed in 1986 after the Long Island Lighting Company, an investor-owned utility, experienced financial distress after a failed investment in a nuclear power plant. Though the utility continued to operate, in 1998, LIPA acquired the electrical transmission and distribution assets for USD 7bn in a debt-financed transaction, the largest-ever municipal bond transaction at the time. Overall, the process took twelve years.

Back in California, a more recent example of the complications that arise when municipalities vie for independence comes in the form of the South San Joaquin Irrigation District (SSJID), which has been engaged in an ongoing 15-year battle with PG&E to acquire the system in their service area.

PG&E pays taxes to four municipalities that would be served by SSJID under the proposed takeover – taxes that SSJID, as a government entity, wouldn’t have to pay. To compensate for that lost revenue, SSJID proposed making payments in lieu of taxes (PILOT) to those entities. PG&E is arguing against this arrangement, saying that state law suggests that SSJID, as a government unit, cannot make payments to keep the other municipalities whole after the transaction.

The City of Davis has been exploring municipalization since 2014 – a process, of course, opposed by PG&E. And following California’s energy crisis in 2000-2001, several small municipal utilities were established as greenfield service territories, each with fewer than 10,000 customers – the Rancho Cucamonga Municipal Utility, Corona Department of Water & Power, Moreno Valley Electric Utility, Victorville Municipal Utility Services, and City of Industry Public Utilities District.

In an emailed statement to Debtwire, a PG&E spokesperson wrote: “We look forward to reviewing [San Francisco’s] analysis, and appreciate the city’s open and transparent dialogue on the subject. We all agree on the importance of continuing to serve the citizens of San Francisco, clean, affordable, and reliable energy. PG&E has been a part of San Francisco since the company’s founding more than a century ago, and we are committed to working with the city and will remain open to communication on this issue.”