California utilities will keep almost all profits as regulators ease up. They’re still upset

California regulators trimmed allowed shareholder returns for the state's three major investor-owned utilities by 0.3% (down from a proposed 0.35% cut), setting 2026 potential returns at PG&E 9.98%, Edison 10.03% and SDG&E 9.93%. Utilities had requested returns above 10%; regulators and the Public Advocates Office argued lower returns are warranted given utilities' low-risk, rate-regulated business, while utilities warned the cuts hinder investment amid wildfire risk. The decision is unlikely to materially change customer bills but matters for investors because rising multi‑billion-dollar rate bases (Edison’s 2023 rate base was $29.7bn) continue to drive growing absolute dollar earnings for shareholders despite modest percentage cuts, and one commissioner dissented citing affordability concerns.

Analysis

Market structure: The 0.3ppt ROE cut (PG&E 9.98%, Edison 10.03%, SDG&E 9.93%) is a modest headline shock but reduces aggregate shareholder entitlement by mid‑hundreds of millions annually given rate bases (EIX ~ $29.7bn). Winners are ratepayers in the margin and capital allocators to grid contractors who still benefit from rising capex; losers are utility equity holders (especially PCG) whose forward allowed earnings growth is capped even as rate base climbs ~10%/yr. The decision does not change system supply/demand for electricity but mildly reduces utilities’ pricing power on future GRAs, preserving the utilities’ predictable cash flow profile while tightening ROE expectations.

Risks: Tail risks include an accelerated political/regulatory clampdown (annual ROE reviews, further cuts >50bps), wildfire-related liability resets, or credit downgrades if utilities increase leverage to fund capex. Immediate (days) market moves should be muted; short term (weeks–months) the story will center on appeals and investor sentiment; long term (quarters–years) rising rate bases mean absolute dollar returns to shareholders can still increase even at slightly lower ROEs. Hidden dependencies: under‑recovery mechanisms, inclusion of SoCalGas assets, and cost‑overrun pass‑throughs can materially change realized ROEs.

Trades and positioning: Favor relative shorts in PCG (higher negative sentiment, operational risk) and selective longs in EIX if valuation dislocation occurs; consider buying 6–12m puts on PCG (10% OTM or 30Δ) and collars on EIX to harvest yield. Rotate tactical exposure into non‑regulated power/gird contractors (transformers, hardening) and away from long‑duration regulated equity; if utility IG spreads widen >50bps, add 5–10yr IG utility bonds for spread capture.

Contrarian angle: The market may overestimate earnings pain — a 30bps ROE cut on a growing rate base is likely <5% EPS impact for EIX and PG&E over 12 months, so any >10% equity selloff would be a buying opportunity. Historical precedent (past ROE ratchets) shows short‑term equity underperformance but long‑term recovery as capex normalizes; unintended consequence: investors pushing for lower ROEs can force utilities to borrow more, creating credit rather than equity mispricing to exploit.

Key Decisions for Investors

• Establish a 2–3% short position in PCG (size of portfolio) over a 6–12 month horizon; set a hard stop at +15% and target 8–12% downside driven by regulatory risk and wildfire exposure; hedge with 6–12m 10% OTM puts (0.5–1% notional).
• Initiate a relative value pair: long EIX 1–2% and short PCG 1–2% (neutral beta) for 3–9 months to capture expected relative resilience in EIX; rebalance if CPUC announces annual ROE revisit or if spreads move >25bp.
• Buy 6–9 month PCG puts (30Δ) sized at 0.5–1% portfolio as asymmetric downside protection; simultaneously sell 1–3 month covered calls on EIX at ~5% OTM to generate income while holding the long name.
• If utility IG credit spreads widen by >50bp vs Treasury (or >40bp vs historical 5y average), deploy 2–4% portfolio into 5–10yr utility bonds (PG&E/EIX or peers) to capture pickup; exit when spread reverts by 25–30bp or after 12 months.