Winners of the Coal-to-Gas Switcheroo
03/08/2012 8:00 am EST
With natural gas prices at incredibly low levels and a new effort to tap more domestic natural gas already moving briskly forward, many utilities are considering the short-term costs and long-term value of converting to natural gas-fired plants, says Roger Conrad of Investing Daily.
In January 2010, the Sierra Club targeted 105,000 megawatts’ worth of then-running coal-fired power plants for closure. To this end, the environmental advocacy group pledged a massive lobbying and public relations effort, rallying support from like-minded individuals and organizations.
At the time, conventional wisdom held that “cap-and-trade” legislation to regulate carbon dioxide (CO2) emissions would be the easiest road to reduced coal use in the US. Faced with higher costs, the reasoning was, owners of coal-fired power plants would choose: Absorb new taxes of unknown magnitude, switch to less CO2-intensive fuel, or try to retrofit existing facilities with equipment that would reduce CO2 emissions.
All were considered too expensive for utilities and other power producers to be trusted with doing on their own. So the Sierra Club and other environmental advocates focused on pushing the president and what were then overwhelming Democratic Party majorities on Capitol Hill to act.
They failed. And with the crushing Republican Party victories in the 2010 midterm elections, cap-and-trade’s chances of seeing the light of day went from slim to non-existent.
That’s where things stand in the political arena today. The Environmental Protection Agency (EPA) is more aggressively enforcing other emissions regulations for coal-fired plants passed under prior legislation, such as for mercury and emissions that cross state lines. And EPA Administrator Lisa Jackson now says the agency will have a rule for carbon dioxide “early this year” for power plants.
Even if this proves to be the case, however, there’s already a challenge to EPA’s authority on the issue in the US Court of Appeals for the District of Columbia. And if there’s a change in control at the White House in November, any rules Jackson promulgates will almost surely be quickly discarded by her successor.
Ironically, the power industry is already halfway to meeting Sierra Club targets on its own. To date, companies have announced shutdowns of 106 coal-fired plants by 2015, or a total of 43,000 megawatts. And more are certain to follow.
Producers have roundly blamed environmental rules for the closures. The cost of new power plants, however, has always been passed along to customers, either as higher regulated electricity rates or higher wholesale power prices. This was the case with the cap-and-trade systems that limited ozone emissions and, later, acid rain.
There are two key differences this time around, both of which are directly related to market forces.
- First, these plants are aging. Companies have been able to keep them running by replacing parts when needed. But doing so has become progressively more expensive, even as run rates have declined.
- Second, natural gas prices have crashed to the neighborhood of $2.50 per million British thermal units, at the same time utilities’ cost of borrowing has slid to near all-time lows. Low gas prices are due to massive new discoveries found in shale, and the ability to get it out with hydraulic fracturing.
This trend is likely to be with us for a while, or at least until there’s meaningful liquefied natural gas (LNG) export capacity. And with pipelines and energy midstream assets getting it out as never before utilities and other generators are locking in cheap supplies, even as they’re able to construct new plants to run on gas with inexpensive capital.
Those economics won’t change, even if President Obama is defeated and a Republican-controlled EPA rolls back all clean-air regulations. This means we’re almost surely going to see more coal-fired plants shut down around the country, as owners come to the decision they’re better off running on something cheaper.|pagebreak|
Last week, Edison International (EIX) became the latest producer to make that calculation. The company stated its unregulated Edison Mission Energy unit—which sells power into the unregulated Illinois and New York State wholesale markets—announced it would shut three major coal-fired plants whose output it sells into the Land of Lincoln’s wholesale power market, taking a $386 million charge on fourth-quarter earnings to write the value of the plants down to zero. It also took a $623 million after-tax impairment charge at its Homer City plant, which it intends to divest to the city.
The cost of pending environmental regulations isn’t helping their economics. But even without them, these plants are no longer competitive, with natural gas-fired power so cheap to produce.
The good news is Mission Energy is effectively ring-fenced from the rest of Edison. So the negative impact of exiting them will have only a minimal impact on the bottom line or on Edison International’s ability to grow dividends, which is backed by solid utility operations in California.
That’s also the case for regulated utilities like Southern Company (SO), which are actually adding to rate base and earnings with spending on new generation sources. The company expects to be able to grow its earnings 5% to 7% annually as it spends $6 billion over the next three years, the bulk on diversifying away from coal.
CMS Energy (CMS) will grow its earnings the same way by spending $6.6 billion through 2015 on its own efforts, all with the blessing of Michigan regulators. And utes across the country are following suit, switching not just to reduce exposure to rules that may never see the light of day but to cut costs and boost profits.
Unfortunately, independent power producers like GenOn (GEN) don’t have that luxury. The company announced this week that it will shut seven coal-fired facilities with 3,140 megawatts of capacity by 2015, representing 13% of its generating capacity.
Management blamed new EPA rules governing mercury and emissions crossing state lines for the shutdown. That’s partly true. But deteriorating fourth-quarter numbers and reduced guidance for 2012 and 2013 cash flows also tell the story of old coal plants not being able to compete in an era of cheap and plentiful natural gas. In fact, GenOn is planning to build gas-fired facilities to replace the shuttered coal plants.
Of course, this transition could well get a lot more difficult for companies going forward. Draconian rules from the EPA or a resurrection of legislation to regulated or limit CO2 from power plants, for example, will make it much more difficult to cut coal without severely slashing profit.
GenOn and Dynegy Inc (DYN) are already good candidates for bankruptcy. And even much larger and more stable NRG Energy (NRG) showed some signs of fraying in the face or rising coal costs and falling wholesale power prices. Any tightening of the rules would only worsen their situation.
So would surging interest rates and/or a sharp rebound in natural gas prices. Neither looks likely any time soon.
But sooner or later, market history is clear that they will occur, upending the economics of power once again. That’s why utility managements aren’t going to shut down all or even most of their coal plants, particularly not the giant state-of-the-art facilities that are the bulk of their output.
At this point, however, the move to cut coal is proceeding in a benign (if not beneficial) way for the US power industry. As investors, this is our only concern, whether you’re a climate skeptic or change advocate.