Measuring Equity Risk Characteristics in Real-Time

February 9, 2020

Using Stock Options to Measure Rapid Change 

It is difficult to measure how investors’ expectations change during catastrophic events like the announcement of criminal investigations, bankruptcies and natural disasters.  In November 2018 Pacific Gas and Electric (PG&E)’s equity holders were exposed to the risks from all three of these issues.

The Camp Fire ignited on November 8, 2018 by a faulty PG&E transmission line. It was not contained until November 25th.  Over these 17 days it burned over 230 square miles in Norther California, killing 85 people and doing billions of dollars of damage.  PG&E’s  stock price was down over 30% by November 12th as equity investors realized that PG&E would likely be liable for the death and destruction.  By November 25th PG&E’s stock was down about 50%, equating to $15 billion in stock value.

We can see stock price changes in real time. PG&E’s declining stock price indicated that investors thought the company was worth less because of its potential wildfire liabilities.  Common measurements of the risk take longer to adjust, however.  In particular, the beta (how much a stock moves in relation to the overall market) of a stock can take weeks to adjust to changing levels of risk exposure because they are based on historical data.

As shown in the chart below,  the beta of PG&E’s stock took significant time to adjust.  The beta calculated based on returns over a 5-year period had barely changed over the course of the Camp Fire.  Betas calculated over shorter time periods (2-years and 6 months) started to show small increases during the early stages of Camp Fire.  The chart shown that it took over a week for the 6-month beta to reflect the changing risk characteristics of PG&E’s stock. Before the start of the Camp Fire PG&E’s 6-month beta was under 1.  It did not increase significantly until about November 20th.

On the other hand, the beta calculated based on stock option prices measure changes in risk characteristics immediately.  The yellow line shows that as soon as it was suspected that PG&E was responsible for the start of the Camp Fire, its option-implied beta reacted.  During the initial chaos PG&E’s option-implied beta plunged into negative territory for one trading day.  The next time the market opened PG&E’s option-implied beta jumped into a range mostly between 4 and 5 for the remainder of the wildfire fire and in the initial stages of the aftermath.  Before the Camp Fire PG&E’s option-implied beta was about 1.

 

Setting a utility company’s authorized Return on Equity (ROE) based on investors’ expectations is the best interests of investors and consumers.  An ROE below investors equity return expectations will make it difficult, or impossible, for it to raise the funds needed for it to provide safe and reliable service.  On the other hand, setting an ROE that is above investors’ equity return expectations overcharges consumers.  Using market data, including option-implied betas shown in the chart above, is one way Utility Commissions can determine an ROE that is based on investors’ current market return expectations and thus balance the interests of investors and consumers.

At Rothschild Financial Consulting we use established methodologies to calculate a cost of equity of equity that is a direct reflection of capital markets so utilities can rise the funds they need without overcharging consumers.