PG&E’s crown jewel generation sale faces – surprise – complex regulations

Inside Infra 17 February

PG&E’s crown jewel generation sale faces – surprise – complex regulations

Pacific Gas & Electric is pursuing a sale of a minority stake in an essential California generation portfolio that could attract interest from a raft of institutional investors. But the assets’ growth prospects as well as a complicated regulatory and management picture could hamper valuations.

Pacific Gas & Electric’s (PG&E) bid to hive off and sell a minority stake in its non-nuclear generation assets is likely to draw interest from a variety of investors and could entail a lofty price tag. But the utility operator’s troubled reputation, regulatory hurdles, and management structure all serve as barriers to a deal, experts tell Infralogic. 

For the right buyer — or buyers — the new generation company could represent an appealing investment, offering a rare entry point into essential regulated generation assets and promising predictable, steady returns. 

However, any sale of PG&E’s core assets is likely to draw scrutiny from state and federal regulators and outright suspicion from a consumer base short on love or trust for PG&E after years of wildfires, liability lawsuits, and bankruptcy proceedings — a dynamic that could ultimately weigh on deal valuations, experts say. 

PG&E in December sought Federal Energy Regulatory Commission (FERC) approval to transfer “substantially all” of its non-nuclear generation assets into a new entity called Pacific Generation, in order to sell off a minority interest in the new company to meet its substantial capital needs. 

If the California utility wins approval to form the new entity, it plans to move forward with a two-phase auction process via Barclays this summer to sell off as much as 49.9% of the newly formed subsidiary. In a process first laid out to regulators in September of last year, the utility operator said it needs the proceeds to invest in system safety, reliability upgrades and other important system improvements. 

Duke Energy in 2021 used a similar strategy to raise capital — albeit for an integrated operating company — selling off a 19.9% stake in its Indiana subsidiary to Singapore sovereign wealth fund GIC for USD 2.05bn. FirstEnergy followed last year with a USD 3.5bn sale of its transmission unit to Brookfield Super-Core Infrastructure Partners. 

The rate base for the assets in question amounts to USD 3.5bn, which at a roughly 1x multiple — not unreasonable given the assets and the investment environment, experts say — would allow PG&E to raise roughly USD 1.75bn. 

Generational change 

Consumer groups have already pushed back firmly against PG&E’s request for approval to transfer its generation assets to Pacific Generation in anticipation of a sale this summer. And California regulatory attorneys say that opposition could grow if one or more active portfolio managers emerge as potential buyer. 

By walling off the generation component, PG&E is insulating Pacific Generation from reputational risk and legal liability from its transmission and distribution system, which has been blamed for sparking multiple deadly wildfires. What remains could be a low-upside asset with predictable returns that could fit nicely in the portfolios of any number of pension funds and other institutional investors, a California regulatory attorney with experience before the CPUC and FERC said. 

But with a nearly 50% stake sale eyed for the generation company, consumers and regulators will likely want to know what’s baked into the deal for any prospective buyer. 

“There’s a lot of feedback locally of people who fear that, if you bring in external capital it’s simply going to mean — either implied or directly — higher return requirements which are going to turn into higher rates for the generation business,” a senior investment banker said. 

Absent such an increase in returns, the investment case for a large institutional investor becomes more difficult to make. And while cloistering the generation assets into a separate entity from PG&E’s transmission and distribution (T&D) portfolio offers insulation from wildfire risk and the only-in-California inverse condemnation law, the same move introduces a potential misalignment with PG&E’s management, which is prioritizing investment of scarce capital in the T&D business. 

“The unspoken part of that is that PG&E won’t be investing in the rate base in the generation business, because they don’t have the money to invest in the rate base there,” an infra fund manager said, noting additionally that PG&E would likely tap its substantial political resources to advocate for good outcomes for the distribution system. 

Meanwhile, the return on equity for the generation business is currently lumped in with that of the integrated company — at a statutory rate of around 10%. A company September presentation noted that the entity would be a standalone PG&E subsidiary with a separate management team and board, and that the revenue requirements would be set through the rate case and cost of capital proceedings, “essentially unchanged from the current process.” 

But that may not always hold. 

Following the carve-out, “PG&E may go to the regulator and say, ‘You know what, that generation business runs itself, it’s easy. We only need an 8% return over there. But the transmission business, that’s really complicated, we’re spending all this time and money there. We need a 10% ROE on that,” the fund manager said. “For every basis point they get at transmission it’s worth a whole lot more money to them than a basis point in a generation where they only own half.” 

Asset quality 

Experts who spoke with Infralogic were also split on the appeal of the underlying generation assets themselves. Pacific Generation’s portfolio will boast an outsized portion — nearly 4 GW, according to FERC filings — of its generation capacity from hydroelectric assets. Those could draw a premium, given the growing market sentiment that hydroelectric represents a scarce source of zero-carbon firm power that will play an increasingly valuable role as variable generation sources such as solar and wind increase their presence on the grid. 

But California is also confronting unprecedented drought concerns that have already impacted generation at PG&E dams. Given the increasingly visible impacts of climate change, a long-term rebound or even preservation of the status quo seems like a risky bet. 

“The assets could appreciate over time but it’s difficult to say if they’re on the right rivers,” the investment banker said. “What do the next 100 years for the climate in California look like?” 

Moreover, PG&E’s right to sell off its stake in at least one hydro facility slated for sale is subject to dispute. 

The City of Santa Clara raised similar concerns as other commenters to FERC about the lack of detail about the proposed sale provided by PG&E. But the California municipality also said that it has not consented to the sale of the Bucks Creek Project, a hydroelectric facility for which Santa Clara holds a joint operating license. 

The next largest portion of the generation assets — natural gas, at 1,400 MW — might not sit easily with ESG-focused investors. And those assets in the footprint additionally present the risk of future non-support for environmental reasons. 

Ratepayer pushback 

For California’s powerful ratepayer interest groups, fears of higher rates are just the beginning of concerns about the sale. 

Public Citizen, in comments urging FERC to reject approval of PG&E’s spinoff transaction, said the utility has not provided documentation and analysis to show that the planned transaction will not harm consumers or result in unreasonable rates. 

The progressive consumer rights advocacy group specifically raised concerns that a private equity buyer could seek to insulate the company from regulatory oversight. 

A second California regulatory attorney expressed similar concerns, raising the prospect that a takeover firm could use a sizeable minority stake in the generation company to wrest effective control away from PG&E. 

“The real question is how do you ensure that this remains under PG&E’s control?” the attorney said. 

Another California regulatory attorney suggested a buyer could try to skirt CPUC oversight by seeking to reclassify the facilities as wholesale generation assets. Such a proposal, the attorney said, would draw massive pushback from the California regulator. 

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