Restructuring PG&E's Management to Encourage Ethical Business Practices

What is the crucial aspect of the Pacific Gas and Electric Company story that few are talking about? It isn’t about the crisis resulting from California’s massive wildfires or widespread power shutoffs. Instead, it’s a more fundamental issue: the impact that the ownership of a public utility exerts on the ethical conduct and responsibility of its managers.

Ethics courses in business schools generally teach students to analyze the decisions and behavior of the top management of investor-owned firms. After all, firms owned by investors will employ an overwhelming proportion of MBA graduates. But these courses devote insufficient analysis to whether a different ownership structure might better serve the long-term interest of key stakeholders—like the safety of customers and the public—through encouraging executives’ ethical decisions and managerial responsibility.

PG&E’s remarkable history and formidable current challenges elevate the need for such analysis and bring the implications of failing to do so to center stage.

Who is PG&E?

The Pacific Gas and Electric Company is the largest investor-owned utility in the United States, serving 5.48 million electricity customers. Along with Southern California Edison and San Diego Gas and Electric, PG&E is one of California’s three main regulated, investor-owned utilities. Except for several California municipalities that provide utility service, PG&E’s massive service area stretches across the northern two-thirds of the state. The region extends north from Santa Barbara and Bakersfield to the Oregon border, and from the Pacific Coast east to the Nevada and Arizona borders. About 16 million—one in every 20 people in the United States—are served by PG&E.

PG&E is also a six-time convicted felon. Those unfamiliar with this corporation might be shocked to learn a few highlights from its recent history:

• In 2016, a federal court convicted PG&E of five felonies for the knowing and willful violation of federal gas pipeline safety laws. Those crimes resulted in a violent explosion and fire in 2010 that killed eight people and leveled neighborhoods occupied by 100 houses in San Bruno, not far from San Francisco International Airport.

  The court also convicted the utility of obstruction of justice for intentionally misleading federal investigators. Federal attorneys told the court they had evidence that PG&E had tossed safety records in a dumpster that included pipeline survey documentation for the San Bruno explosion’s source, Line 132.

  Regulators fined the utility $1.6 billion. In 2019 a federal judge ruled that PG&E also violated the terms of its probation agreement in that case.

• The San Bruno explosion wasn’t PG&E’s first criminal conviction. In 1997, a jury convicted the firm of 739 counts of criminal negligence resulting from insufficient maintenance, mainly because trees in contact with electrical wires sparked the Trauner Fire that burned down much of a small town in Nevada County in 1994. The court fined PG&E the maximum penalty of $2 million.

• PG&E is now under a criminal investigation that may lead prosecutors in Butte County to file as many as 85 counts of manslaughter related to the November 2018 Camp Fire. The deadliest wildfire in California history, the Camp Fire destroyed the town of Paradise as a part of 153,336 acres worth about $16.5 billion, including $4 billion that was uninsured. The state’s attorney general has issued an opinion that the utility could be tried for murder as fire investigators concluded that the utility started the Camp Fire that killed those 85 people and led to such devastating loss of land, property, and life.

• Moreover, state fire investigators also determined that only 13 months before the Camp Fire, PG&E’s equipment started 17 of 2017’s 21 major fires in Northern California. Centered in the wine country of Sonoma and Napa Counties, those fires killed 44 people and burned more than 245,000 acres at a cost of $14.5 billion.

• In October 2019, the California Public Utilities Commission charged PG&E with violating state law more than 170,000 times during the six years ending in 2017. The firm paid a $5 million penalty and funded a $60 million program to resolve the accusations that employees falsified records depicting how they managed requests to mark locations of underground equipment before excavations. According to the Wall Street Journal:

The utility’s response? It removed the midlevel managers, promoted the program director and reported as fact figures it had been given reason to doubt, according to the testimony and a state investigative report.

Confronted by state regulators. . .PG&E said it had provided the best information it had. It said employee conduct “fell short of the high standards of integrity and the ethical action to which the company is committed.”

It was no anomaly. The Wall Street Journal identified repeated instances over 25 years in which PG&E misled regulatory authorities, withheld required information, didn’t follow through on promised improvements, engaged in improper back-channel communications with regulators or obstructed an investigation.

“Things Really Got Squeezed on the Maintenance Side”

Typically, market competition brings out the best in executives. However, in the case of a regulated utility like PG&E with enormous infrastructure that would be uneconomical or infeasible to replicate, there cannot be competition.

Like the electric and gas utilities that serve most of America’s customers, PG&E is a government-sanctioned monopoly. Instead of competitors, governments rely on administrative law boards like the California Public Utilities Commission to “regulate” these monopolies. These boards also approve the monopolies’ rate schedules, which guarantee that each utility earns income at a rate of return that typically remains constant from month to month.

However, the evidence suggests that in PG&E’s case, the CPUC for many years didn’t regulate the utility as aggressively or effectively as it should have. The commission may have been under-budgeted, with the attention of the commissioners and the staff spread too thin. That’s because the CPUC is responsible for regulating a variety of industries, including telecommunications, railroads, and now even new ride-sharing services like Uber and Lyft. At the same time, because routine stories about utilities don’t tend to attract large audiences, the press failed to focus on the interplay between PG&E and the CPUC.

In situations like these, the “regulator of last resort” becomes the legal system. Legal actions include civil litigation, mostly filed by contingency fee tort lawyers. In cases involving potential criminal violations, actions involve prosecution by local district attorneys, state attorney generals, and the federal Department of Justice.

Surprisingly, in PG&E’s case, even the threat of legal sanctions—either civil or criminal—doesn’t seem to have influenced the firm’s executives. What did influence them? The financial markets on Wall Street.

Mike Florio, a California PUC commissioner from 2011 to 2016, told the New York Times “There was very much a focus on the bottom line over everything: ‘What are the earnings we can report this quarter?’ And things really got squeezed on the maintenance side.”

This 2017 report, prepared for the CPUC by the NorthStar Consulting Group, concluded that PG&E frequently made improvements only following disasters. NorthStar also determined that the safety policies of the utility’s transmission and distribution divisions were less robust than even those implemented by the natural gas division—the division that caused the deadly San Bruno explosion.

Moreover, this CPUC investigation found that PG&E had been spending millions less on capital equipment, operations, and maintenance than it should have in the years before the San Bruno disaster. According to the Times:

PG&E’s gas and transmission revenues exceeded what it was authorized to collect by $224 million in the decade leading up to the explosion. But capital spending fell $93 million short of its authorized budget between 1997 and 2000.

As any MBA graduate who has taken a required course in corporate finance knows, investor-owned corporations absolutely hate to reduce or eliminate dividend payments. At best, the result can be intense scrutiny from Wall Street because investors fear a poor short-term outlook. At worst, the result can be a collapse in the stock price, as investors sell shares and instead buy the stock of firms that will pay dividends.

High Shareholder Dividends and Paltry Investments in Routine Maintenance

What’s alarming about PG&E is that between 2009 and 2017, the utility paid an astonishing $7 billion worth of dividends to their shareholders. Yet PG&E actually cut maintenance and safety improvements during that same period. And even more troubling is that immediately before the 2017 fires, the company paid dividends worth $1.92 billion during 2016 and 2017.

It’s one thing in the typical situation where a corporation in compliance with all applicable laws and regulations continues to pay dividends to investors. But it’s another matter entirely when a monopoly that neglected to maintain or upgrade their capital infrastructure for decades diverts billions of dollars that could be more responsibly allocated in the name of safety. It almost seems like dividend-addicted PG&E chose to continue smoking that financial crack rather than going through the tough rehab program administered by Wall Street and the financial press should they give up paying dividends cold-turkey.

In fact, the utility was so strongly addicted to paying dividends that even after $30 billion worth of wildfire-related lawsuit claims drove the firm into bankruptcy in January 2019, a federal judge nevertheless had to order PG&E to stop their dividend payments just weeks later. He admonished the firm that all those funds could have been better allocated to wildfire prevention and safety.

U.S. District Court Judge William Alsup, who supervises PG&E’s probation following the firm’s felony convictions for blowing up much of San Bruno, echoed critics who charge that $7 billion would have gone a long way towards repairing and maintaining the firm’s deteriorating transmission and distribution infrastructure. In his order, he wrote “The essence of the problem is that the offender’s unsafe conduct led to a deadly pipeline explosion and to six felony convictions. Now, the offender’s unsafe conduct has led to recurring deadly wildfires caused by its electrical system.”

Restructuring PG&E: Two Strategic Options

Like any other private, profit-driven, investor-owned U.S. utility, PG&E is only required by law to provide limited accountability and transparency to customers and the public. Because of that fact, and because of PG&E’s continuing track record of irresponsibly putting Wall Street first before all other priorities—even safety—critics contend that restructuring PG&E into a non-investor-owned organization makes sense.

Proponents of non-investor-ownership argue that it would better align the public’s interest with the company’s financial interests. They assert that this structure would also ensure that the company will have access to large-scale financing with a significantly lower cost of capital once it emerges from bankruptcy.

Moreover, proponents argue that such a plan affords the best hope for avoiding future loss of life to power outages and wildfires by building in structural safeguards to ensure management would function in more responsible ways. Consider the way that all investor-owned utilities experience poorly aligned incentives and asymmetry in their exposure to wildfire risks. Such utilities might face financial liability for sparking fires, but they face little if any liability for deaths and economic damage because of protracted blackouts.

And as long as management can take advantage of frequent “public safety preventative shutoffs,” executives have their own “safety valve” through which they can escape responsibility for dangerous neglect of their network’s maintenance and safety.

Municipalization or Mutualization?

A restructuring plan could transform PG&E into non-investor-owned structures through two strategies: municipalization or mutualization. In municipalization, government or a political, nongovernmental subdivision would take control of the utility. By contrast, in mutualization, the customers would assume control in what is known as a cooperative.

It’s important to note that most electric utilities in the United States aren’t owned by investors. Although they serve 72 percent of ratepayers, investor-owned electric utilities like PG&E only amount to less than six percent of utilities across the nation.

Two-thirds of such U.S. utilities are publicly owned, serving 16 percent of customers. Cooperatives, accounting for 27 percent of organizations, serve the remaining 13 percent. Many of the utilities in these groups developed in rural areas of the United States that investor-owned utilities in cities deemed too costly to serve.

Non-investor-ownership offers a powerful advantage: it may afford the most viable option for guaranteeing financial solvency in the face of sudden, massive capital requirements for rapid equipment maintenance and modernization. That’s because these organizations don’t pay some of the biggest costs of for-profit utilities, like dividends and taxes.

One difference arises in the methods for raising capital. According to the California Energy Commission, publicly owned utilities can raise capital through tax-exempt bond issues. By contrast, co-ops can finance operations through low-interest loans.

Municipalization

The frequently cited “takeover” option that would transform PG&E into a publicly owned utility (POU) is known as municipalization. Besides ownership by federal, state, county, and municipal governments, political subdivisions also operate POUs. These subdivisions—also called public utility districts—are utilities that residents vote into existence but operate independently of government.

The State of Nebraska provides electric power exclusively through community ownership, where 166 POUs supply power for two million customers. But the largest single POU in the country is the Los Angeles Department of Water and Power, with 1.43 million customers, followed by the Puerto Rico Electric Power Authority, with 1.47 million. California is also home to a number of these municipal utilities in cities like Sacramento, Palo Alto, Pasadena, and Santa Clara.

Advocates of this approach include California Governor Gavin Newsom and U.S. Senator and Presidential candidate Bernie Sanders. One outspoken proponent is U.S. Representative Ro Khanna from Silicon Valley.

The director of the Energy Institute at the University of California at Berkeley’s Haas School of Business told the Wall Street Journal that the fires and blackouts could galvanize support for restructuring the utility.

“This is going to play into making PG&E a public power agency and municipalizing pieces of PG&E, and it will have a big impact on the installation of solar and batteries,” said Severin Borenstein, a professor of business administration who has published extensive research on the electric power markets.

Mutualization

Like public ownership, mutualization—customer ownership—has a long tradition in the American economy. Several iconic brands in the insurance business, like Mutual of Omaha and Liberty Mutual, represent nonprofit cooperatives.

In the energy sector, 812 co-op utilities operate in 47 states and serve about 20 million ratepayers, mostly in the Midwest and Southeast. The biggest is the Pedernales Electric Co-op. Based east of Austin, Pedernales serves 333,000 customers throughout a Texas-sized service area of 8,100 square miles.

With its high-profile proponents, municipalization has received the lion’s share of the media attention, and mutualization has received far less. But mutualization has found an ardent advocate in Harvard Law-educated Sam Liccardo, the mayor of San Jose.

Liccardo writes that “creating a customer-owned utility will realign PG&E’s orientation because customers will be represented on the board overseeing the company’s management and its decision-making.” He seems to prefer mutualization not only for this reason, but also because municipalization is “fraught with legal challenges, multi-billion-dollar capital costs, and operational challenges.”

An Ethical Imperative

Whether owned by customers or government, non-investor ownership won’t be a silver bullet for solving all of the restructured company’s problems. But what such a structure will accomplish is providing incentives for executives to make responsible decisions that prioritize the interests of customers and the public. Liccardo expressed the notion this way:

It will ensure that the company that emerges from bankruptcy is not distracted by demands by investors for short-term financial performance, and better able to access capital to invest in its infrastructure. It will also ensure that decisions about [public safety preventative shutoffs] are made with properly aligned incentives.

The editorial board of the Los Angeles Times concurred:

Of course, merely changing control of PG&E won’t solve the problems caused by decades of neglect. Nor does public ownership automatically translate into trouble-free utilities. Angelenos who are served by [the] city-owned Los Angeles Department of Water and Power can attest to that fact. Public agencies are equally susceptible to bungling basic administrative duties and recklessly deferring maintenance in the face of public pressure to keep rates low. Just as shareholder-owners want more profits, ratepayer-owners want lower bills. The difference with publicly-owned utilities is that there is more transparency and accountability when they screw up.

Finally, an associate professor at Santa Clara University’s law school, Catherine Sandoval is a former commissioner of the California Public Utilities Commission. She wrote,

It is our legal and ethical duty to consider new approaches to manage utility infrastructure. . .Stemming utility-caused wildfires is a legal and ethical imperative to protect the safety and health of the people of California, and the future of our state and planet.