Fitch Downgrades PG&E Corp (PCG) and Utility Sub to 'BBB-' on Negative Watch

Fitch Ratings has downgraded PG&E Corporation's (NYSE: PCG) and Pacific Gas and Electric Company's (PG&E) Long-Term Issuer Default Ratings (IDR) to 'BBB-' from 'BBB' and placed them on Rating Watch Negative. A full list of rating actions follows at the end of this release.

The rating action reflects the enormous increase in the size, intensity and destructive power of wildfires in California during 2017-2018, the implications of potential, vastly increased third-party liabilities under inverse condemnation and uncertainties regarding full and timely recovery of such costs. The placement on Rating Watch Negative primarily reflects concerns regarding the enormity of potential liabilities given the magnitude and frequency wildfire activity in 2017 and 2018 and the utility's ability to fund such outsized liabilities. The Rating Watch Negative status also considers uncertainty in creating and implementing the regulatory mechanisms that are required under recently enacted legislation to achieve actual recovery of 2017 fire related liabilities and the fact that recently enacted wildfire legislation does not address 2018 wildfire-related liabilities.

Future events that could resolve the Rating Watch Negative are clear legislative and/or regulatory measures to ensure timely recovery of catastrophic wildfire related liabilities and determinations that utility equipment was not involved in ignition of the Tubbs and Camp wildfires. Conversely, Fitch believes exposure to liabilities if utility equipment is deemed to have sparked both wildfires could lead to multi-notch downgrades without regulatory/legislative support.

Key milestones in assessing the ultimate impact of catastrophic wildfires on PG&E and PCG include release of the California Department of Forestry and Fire Protection's (Cal Fire) reports on the cause of the Tubbs and Camp wildfires; prospective regulatory/legislative action to provide recovery of liabilities associated with 2018 firestorms; implementation of regulatory mechanisms to facilitate wildfire cost recovery under S.B. 901 including securitization; the magnitude of disallowed wildfire-related liabilities; quantification of the stress test and cap; the frequency, magnitude and destructive force of future wildfires; and, efforts by PG&E and other California-based IOUs to reverse application of inverse condemnation.

KEY RATING DRIVERS

Access to Capital: PG&E's stock price has declined significantly reflecting concerns regarding wildfire activity and potential exposure to liabilities without a clear path to timely and full recovery of such costs. Earlier this week, PCG fully drew its revolvers as a precautionary measure and currently has cash and cash equivalents of approximately $350 million at the corporate parent and $3.1 billion at the utility.

S.B. 901: Senate Bill (S.B.) 901 was signed into law by Governor Brown earlier this year and is a constructive development for investor-owned utilities (IOUs) in California compared to the status quo. Nonetheless, Fitch believes the business risk profiles of PG&E is significantly weakened by the enormous increase in the size, intensity and destructive power of wildfires evident during 2017-2018, the implications of potential, vastly increased third-party liabilities under inverse condemnation and uncertainties regarding full and timely recovery of such costs.

Cost Recovery Remains Uncertain: Under S.B.901, uncertain prospects for full recovery of large third-party liabilities associated with the firestorms and upward pressure on customer bills, should they be recovered, are secular headwinds for PG&E. While S.B. 901 did not address equitable distribution of catastrophic wildfire-related costs or inverse condemnation, it does provide a potential path to recovery of wildfire liabilities and establishes a commission -- the Commission on Catastrophic Wildfire Cost Recovery -- to consider and make recommendations regarding such costs to the Legislature by July 1, 2019. However, the methods, timing and implementation of mechanisms to facilitate recovery of prudently incurred costs by the IOUs are yet to be established by the commission.

CA Regulatory Compact: California is prone to natural disasters and a relatively high degree of political risk, dating back to the energy crisis of 2001-2002. S.B. 901 is a constructive development in that regard, providing a path to recover prudently incurred wildfire-related liabilities. However, catastrophic wildfire costs not deemed to be just and reasonable by the CPUC are not recoverable under S.B. 901 subject to a stress test and cap that limits potential disallowances.

This prudency aspect associated with the utility's role in wildfire causation differs from natural disasters, such as hurricanes, and brings with it risk of meaningful but undefined financial pressure. Given the unprecedented size of recent wildfires future multi-notch downgrades cannot be ruled out.

CA Wildfire Exposure: Fitch believes the potential financial exposure of PCG subsidiary PG&E in a worst-case scenario could approximate $15 billion or more for the 2017 wildfires. If liability under inverse condemnation is applied to these claims as expected by Fitch, PG&E would be compelled to absorb wildfire-related costs within a relatively short timeframe. Incurred costs under S.B. 901 would be eligible for recovery and securitization subject to CPUC review of IOU performance prior to and during catastrophic wildfires for compliance with state rules and regulations and determination by the agency that such costs were just and reasonable.

S.B. 901 includes a stress test and cap to be applied to potential disallowance of 2017 catastrophic wildfires to avoid harm to ratepayers from disallowed fire-related costs and resulting, sharp deterioration to utility financials and creditworthiness. Fitch believes this feature is likely to mitigate potential worst-case exposure, in which PG&E equipment is deemed to have ignited the lion's share of the 2017 NorCal fires, including the Tubbs fire.

Parent-Subsidiary Rating Linkage: Operating utility PG&E accounts for virtually all of PCG's consolidated earnings and cash flows. As such, Fitch applies a weaker parent-stronger subsidiary approach in applying the agency's parent-subsidiary rating criteria. PCG is dependent on cash flows from PG&E to meet its ongoing obligations. PCG's IDR is the same as PG&E's, reflecting the parent's dependence on the utility to meet its ongoing obligations, relatively low parent-only debt and structural subordination of PCG debt relative to PG&E.

Inverse Condemnation Looms Large: California, unlike most states, applies inverse condemnation to wildfires caused by utility equipment. Under the doctrine of inverse condemnation, a utility may be held strictly liable for property damage and legal expenses if its equipment is deemed to have played a role in igniting the fires, even if the utility followed all rules and regulations. Inverse condemnation is typically applied to public utilities which, unlike private utilities, have the ability to raise rates to recover costs associated with third-party liabilities on a timely basis as a way to socialize costs associated with floods and other disasters.

Cal Fire Findings: Cal Fire has completed investigations into 17 of the 21 major NorCal fires of October 2017, alleging that all 17 fire ignitions involved PG&E equipment. In addition, Cal Fire determined that PG&E allegedly violated state rules and regulations in 11 of 17 fires. The full magnitude of PG&E exposure to third-party liabilities is yet to be determined with regard to the 2017 fires, including Tubbs. At this juncture it remains unclear if PG&E equipment was involved in causing the Tubbs and Camp fires.

Tubbs Report: Cal Fire has yet to announce the results of its investigation into the Tubbs Fire, which was the most destructive wildfire in California history prior to the Camp fire. The agency's report with regard to both fires will be crucial milestone in assessing the ultimate impact to PG&E creditworthiness. The fires collectively destroyed more than 12,000 structures. Tubbs is expected to account for approximately two-thirds of 2017 wildfire-related damages. The October 2017 NorCal wildfires consisted of 21 major wildfires at their peak, burned more than 245,000 acres and resulted in 44 fatalities.

If PG&E equipment is determined by Cal Fire to have not been involved in ignition of Tubbs, PG&E's potential wildfire exposure could prove to be significantly smaller than Fitch's potential worst-case scenario, meaningfully reducing credit concerns. In this scenario, Fitch believes PCG's and PG&E's ratings would likely remain investment grade with or without legislative changes.

Dividend Cut Preserves Cash: Suspension of PG&E's and PCG's common and preferred dividends, announced late last year, allows the companies to retain more than $1 billion of cash on an annual basis, which has strengthened PG&E's balance sheet ahead of the recently announced second-quarter 2018 charge to earnings. Notwithstanding realization of a $2.5 billion pretax charge for wildfire liabilities, PG&E's second-quarter 2018 average utility equity as a proportion of total capital remains modestly above its 52% statutory equity capital threshold.

DERIVATION SUMMARY

PG&E's historic credit metrics generally compare favorably with similarly positioned utility operating companies Southern California Edison Co. (SCE) and Arizona Public Service Co. (APS; A-/Stable). PG&E's FFO-adjusted leverage of 2.9x for the trailing 12 months ended March 31, 2018 is 30bps better than SCE's 3.2x and 70bps better than APS's at 3.6x. PCG's credit metrics are also well positioned relative to similarly positioned peers, Edison International and Pinnacle West Capital. PCG is PG&E's corporate parent. EIX and PNW are similarly positioned with cash flows provided by utilities operating in a single state.

PG&E is one of the nation's largest utilities with total assets as of March 31, 2018 of $68 billion, considerably larger than SCE's $52 billion and APS's $17 billion. The regulatory environment in Arizona, similar to California prior to the wildfires, has generally been supportive from a credit point of view with both jurisdictions providing utilities operating in the state with a reasonable opportunity to earn their authorized returns on equity. However, unlike APS, meaningful uncertainty regarding exposure to future firestorms and potentially large, related third party liabilities with uncertain prospects for timely and full recovery increases business risk for PG&E and SCE.

KEY ASSUMPTIONS

Fitch's Key Assumptions Within Our Rating Case for the Issuer Include:
--PG&E assets are deemed by Cal Fire to have ignited the 2017 NorCal wildfires;
--Exposure to third-party liabilities of $15 billion averaged over 10 years;
--PCG funds the liability with new equity and debt consistent with the utility's statutory capital structure;
--Dividend suspension provides annual cash retention of more than $1 billion per year;
--Capex approximates $6 billion per year.

RATING SENSITIVITIES

Developments That May, Individually or Collectively, Lead to Positive Rating Action
--Credit rating upgrades are unlikely in the foreseeable future at PG&E given the overhang of anticipated wildfire related liabilities and the Negative Rating Outlook.

Developments That May, Individually or Collectively, Lead to Negative Rating Action
--Determination that PG&E equipment is responsible for the Camp and Tubbs wildfires.
--Absent clear legislative/regulatory support for timely recovery of wildfire liabilities should PG&E equipment be deemed responsible for igniting the Tubbs and Camp wildfires.

LIQUIDITY

Bolstering Liquidity: PG&E relies on internal cash generation, access to debt capital markets and equity infusions from PCG to meet its liquidity needs. PG&E has fully drawn its credit facilities. As a result, cash and cash equivalents approximate $3.1 billion at PG&E and $356 million at PCG. In addition, PCG has suspended dividends retaining more than $1 billion per annum. Earlier this year, PG&E issued five- and 10-year debt in August 2018 at 145bps and 170bps over treasuries, respectively. PCG announced the suspension of common and preferred dividends in the face of large potential wildfire liabilities in December 2017.

FULL LIST OF RATING ACTIONS

Fitch has downgraded the following ratings and placed them on Rating Watch Negative:

PG&E Corporation
- Long-term IDR to 'BBB-' from 'BBB';
- Senior unsecured revolver to 'BBB-' from 'BBB'.

Pacific Gas and Electric Company
- Long-term IDR to 'BBB-' from 'BBB';
- Senior unsecured notes to 'BBB' from 'BBB+';
- Senior unsecured revolver to 'BBB' from 'BBB+';
- Preferred Stock to 'BBB-' from 'BBB'.

In addition, Fitch has placed PG&E Corporation's and Pacific Gas and Electric Company's short-term ratings on Rating Watch Negative as follows:

PG&E Corporation
- Short-term IDR 'F3';
- Commercial paper 'F3'.

Pacific Gas and Electric Company
- Short-term IDR 'F3';
- Commercial paper and short-term debt 'F3'.

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