A National Meltdown


Discordant global-warming solutions may end up burning utilities.

Fortnightly Magazine - October 2006

California Gov. Arnold Schwarzenegger’s surprise move in September to regulate his state’s carbon emissions has the entire industry buzzing over what might come next, such as a national carbon plan. California’s legislation to reduce carbon-dioxide (CO2) emissions by 25 percent by 2020 is forcing a renewed debate over global warming that some believe may force Congress to move forward with a national plan. Such thoughts are fueled by grave concerns over the alternative—that states, left to their own devices in regulating carbon, will pass a patchwork of inconsistent rules that harm the economy.

How will utilities in the next 10 years manage a multi-billion-dollar infrastructure buildout, higher interest rates/cost of capital, diminishing free cash flows, state renewable mandates, and political pressures to keep rates or power prices low, all while complying with carbon emissions programs that emphasize higher-cost fuels?

This question will define the utility industry. Meeting the challenges may depend on whether a national carbon program that regulates carbon emissions is established.

The Ups and Downs of the RGGI

The Regional Greenhouse Gas Initiative (RGGI), a coalition of Northeastern and Mid-Atlantic states working toward a mandatory greenhouse-gas program, has come under fire from a number of quarters. Massachusetts Gov. Mitt Romney last year pulled his state out of the RGGI in favor of another plan, believing the RGGI would be overly burdensome to businesses. Furthermore, a report by law firm Latham & Watkins described concerns over the leakages that have plagued the RGGI process:

“RGGI state utilities may face increased competition if their costs rise and their customers can purchase cheaper energy from states which are not part of RGGI. Importation of power from unregulated sources has the potential to counterbalance some or all of the in-region emissions reduction, as well as to increase the economic impact of the RGGI program on RGGI state resources.”

The RGGI has promised to monitor for these leakages, but how enforceable can a carbon program be when one state in the region has left the program and several have not wholly committed to joining? States such as coal-rich Pennsylvania are listed as mere “observers.” And with Northeast markets extremely integrated, the difficulties in policing such behavior are all the more apparent.

To RGGI’s credit, the organization has been actively engaging the industry on solving this leakage issue and is to issue a report in July 2007. Beginning in 2009, RGGI will cap CO2 emissions from power plants in the region at current levels—121 million tons annually— with the cap remaining in place until 2015.

Latham & Watkins notes that the absence of readily available CO2 control technologies means that the RGGI-regulated entities must switch fuels, buy allowances on the market, or invest in projects to “offset” or generate allowance credits or compliance. “If the offset provisions are overly complex or restrictive, higher allowances and energy prices may result, and it may be more difficult for generators to expand to meet growth in power demand,” the company’s report says.

The true test of the Northeastern carbon program will come in the next few months, as regulators and legislators review the final model set of regulations. RGGI claims that the program will increase household bills by approximately $3 to $21 annually, but one analyst, who has asked not to be identified, says that there are too many details yet to be resolved before figures can be determined.

Meanwhile, in the West

The same problems and unknowns plaguing the RGGI are vexing Schwarzenegger in California. There is much speculation as to what will happen to coal-fired power in the West. California accounts for 40 percent of the Western coal load. The California PUC has prohibited the state utilities from signing long-term contracts for electricity if the emissions exceed those of the cleanest gas-driven plants.

One might conclude that the result will be less coal-fired power plants built in the region, and more reliance on high-priced natural gas region-wide.

Environmentalist V. John White told the Herald Tribune recently that he believes the proposed sale of a stake in the coal-fired Granite Fox power station in Nevada by San Diego Gas & Electric and Sempra Generation was a result of California’s new policy, which is clearly reaching beyond borders.

Furthermore, in September, Arizona unveiled a climate-change strategy without knowing how well it might integrate with California’s.

All of these new developments raise a much bigger question: Will investors’ valuations reward or penalize utilities for having coal resources? Until now, the financial community has taken a wait-and-see attitude. But that may be changing now that these carbon programs are to have the force of law.

The Carbon Discount

It long has been known that utilities with predominantly coal-fired power would be the obvious losers in a carbon- constrained world. But with new gasification technologies and sequestration technology, and with vague carbon program details, some utility executives optimistically believe they can remain competitive under such conditions.

However, a significant divide has opened in the industry over the establishment of a national carbon program, which some say is driven by resource competition among utilities. Last April, Exelon Corp, Duke Energy Corp., PNM Resources, and Sempra Energy urged Congress to impose mandatory restrictions on carbon, while Southern Co., AEP, and the Edison Electric Institute urged a voluntary program. Whether Congress will be spurred to action due to recent developments in California is anybody’s guess, but some financial experts are starting to make grim predictions.

An executive with a top New York investment bank, who asked to remain anonymous, says that valuations may change significantly for utilities with extensive coal holdings. “Valuations are going to be a function of who pays for climate change. If ratepayers cover the higher costs to utilities from meeting tough global warming programs, utilities’ valuations will be unchanged,” he says.

But if there is no regulatory guarantee and utilities must pay more for carbon reductions, and if a program like Schwarzenegger’s goes national, he says the analysis changes dramatically.

“A back-of-the-envelope calculation, looking at the dark spread, indicates that [Earnings before Interest, Taxes, Depreciation, and Amortization] would be significantly lower because of the higher costs,” he surmises.

As a result, he says, “utility valuations could be cut by one-third.”

The Perfect Storm

A drawback to the Northeast carbon program, according to Americans for Balanced Energy Choices (ABEC), is that the program “covers only CO2 emissions from electric generators, which account for about one-third of regional emissions. It ignores other source sectors such as transportation, as well as other greenhouse gases.” ABEC believes ignoring other emissions may lead to increased CO2 emissions, not less. AEP CEO Michael Morris, chairman of EEI earlier this year, said, “EEI strongly favors an economy-wide approach, including all sources and sectors of the U.S. economy.”

Let’s not be timid. It is the U.S. economy that hangs in the carbon balance. Congress must develop a thoughtful, comprehensive national plan on climate change now rather than later.