TODAY’S STUDY: WHY NOT TO BET ON COAL

In the case of coal, Wordsworth was wrong.

“The world is too much with us,” 19th-century British Poet Laureate William Wordsworth wrote. “Getting and spending, we lay waste our powers; Little we see in Nature that is ours…”

But in the case of today’s coal, taking note of “getting and spending” will bring “Nature” closer.

The evils of coal are thoroughly chronicled. The spew that comes with burning it has a Billboard-sized list of toxic “hits” (with bullets) that begins with lung disease-inducing sulfur dioxide, nitrogen oxide and particulate matter in the air, goes through birth defect-inducing mercury in the water and the food chain and culminates with climate change-inducing carbon dioxide greenhouse gas emissions.

But all of that has been a “world” not nearly “too much with” the people who generate electricity and the people who consume it. Their reliance on coal marches on, like Hitler’s storm troopers into Europe.

“Getting and spending” has been the foundation on which coal’s strength rests. Coal-burning may have health and pollution costs that make it essentially unaffordable but those externalities do not matter to coal’s storm troopers because they are not included in the electricity market price. They are not part of what burners pay to generate power and they are not part of what ratepayers see on their bills.

But the cost issue, according to the report highlighted below, has caught up with coal. Low natural gas prices and increasing price competitiveness from the New Energies, the cost of building or retrofitting plants with pollutant-trapping technologies and other rising construction costs, market volatility and the ever-more costly illusion of “clean” coal are combining to make investors more and more leery of new coal plant investments.

Ground has not been broken on a new coal plant in the U.S. since October 2008. With dramatic increases in electricity demand anticipated, the getting-and-spending marketplace would not let that happen if new coal plants made economic sense.

In the case of coal, therefore, Wordsworth was wrong. The more “Getting and spending” is considered, the better off “Nature” will be.

The world is too much with us; late and soon,
Getting and spending, we lay waste our powers;
Little we see in Nature that is ours;
We have given our hearts away, a sordid boon!
This Sea that bares her bosom to the moon,
The winds that will be howling at all hours,
And are up-gathered now like sleeping flowers,
For this, for everything, we are out of tune;
It moves us not.--Great God! I'd rather be
A Pagan suckled in a creed outworn;
So might I, standing on this pleasant lea,
Have glimpses that would make me less forlorn;
Have sight of Proteus rising from the sea;
Or hear old Triton blow his wreathed horn.
…William Wordsworth, 1806

White Paper—Financial Risks of Investrment in Coal
Amy Galland, Leslie Lowe, Tom Sanzillo, June 2011 (As You Sow)

Executive Summary

Coal in the United States is at a crisis point that the investment community is just beginning to perceive. In the past year, a spate of industry reports from analysts have detailed the unprecedented risks facing electric utilities that depend on coal-fired generation and the attendant risk to domestic demand for coal…In 2009, coal accounted for 44.5% of this country’s electricity generation and 93% of domestic coal was consumed by U.S. power plants. But the nation’s aging coal fleet, 60% of which is over 40 years old, needs to be modernized. In the past five years, plans for 153 new coal plants have been cancelled and there is consensus among analysts that a significant portion, possibly 20% or more, of U.S. coal-burning generation could be retired in the very near future. Replacement resources are likely to come from natural gas, solar, wind, and energy efficiency, not new coal.

This historic shift in coal’s fortunes stems from a combination of factors, among them:

• Competition from low natural gas prices, which is exerting downward pressure on power prices;

• Capital expenditures for environmental compliance and uncertainty about the cost implications of pending and anticipated environmental mandates;

• Persistently high construction costs;

• Coal price volatility, rising costs for mining, and shifting markets all placing upward pressure on coal prices;

• Improved profitability and policy preferences for solar, wind, and energy efficiency investments; and

• The slow pace of development of viable commercial scale carbon capture and storage for coal plants.

click to enlarge

The fundamental change that is undermining coal is the price reversal of coal relative to natural gas, which is in abundant supply for the foreseeable future. With the development of technology to access the large natural gas reserves in the U.S., the price of natural gas has dropped and is expected to stay low for several years…The impact was felt in 2009 with a drop in coal use in the U.S. electric grid and a concomitant increase in the use of natural gas for generation. As the economy rebounds, if natural gas prices remain competitive there will be a permanent loss of coal’s market share in many parts of the country.

According to Deutsche Bank, a key driver of the coal-to-gas switch “is a $4-6/mmBtu natural gas price due to the major increase in supply coming from unconventional shale gas.”3 Energy expert Daniel Yergin writes that estimates of the U.S. natural gas resource base, including shale gas, “are now as high as 2.500 trillion cubic feet,” which amounts to “more than a 100-year supply” of natural gas for all uses, from home heating and cooking to petrochemical and electric power production…

click to enlarge

The Brattle Group’s analysis projects average prices through 2020 under $6.50 per mmbtu…and the U.S. Energy Information Administration (EIA) foresees gas prices reaching $6.00 per mmBtu by 2025…At this price, cleaner burning natural gas is competitive with coal. Given future predictions for relatively flat gas prices, low power prices, and volatility in the price of coal, underutilized gas plants will be called upon to dispatch before coal-fired plants on an increasing basis. Industry analysts M.J. Bradley & Associates and the Analysis Group found that “existing gas units have significant untapped power production potential, which can be expanded during off peak periods without constructing new generation…”

In addition to the risk posed by natural gas, a shifting array of risks related to construction prices, regulatory risks, and policy choices individually diminish coal’s usefulness as a fuel source for electric generation. This white paper demonstrates that these factors combine to make current and future investments in coal-dependent utilities and coal mining companies exceedingly risky.

click to enlarge

Pension, institutional, and endowment fund sponsors, trustees, board members, and managers need to consider the individual and cumulative impact of these risks and evaluate options to mitigate adverse impacts on portfolio value. We believe that the analysis presented in this white paper requires all investors, but particularly responsible investors concerned with environmental, social, and governance issues, to engage the management of utility companies to find alternatives to coal-based power generation in order to protect shareholder value.

The costs of continued operation for existing coal plants that must comply with recently adopted and pending environmental mandates can be seen in the chart below. Increasingly, coal’s competitive advantage is being eroded by the individual and cumulative impact of regulatory and market forces.

Abstract financial models are only one indication of coal’s market losses. Results of operations are even more telling. In 2009, many coal-fired plants did not recover their costs – even without the additional expense of new environmental regulations. The 2009 State of the Market Report for PJM, which includes 13 states in the mid-Atlantic and portions of the Midwest, concludes that “if this result is expected to continue, the retirement of these plants would be an economically rational decision.” Throughout 2010, despite some pickup in the national economy, coal generation repeatedly lost out to other fuels in the electricity marketplace in certain regions of the country. By year’s end, utilities reported that coal plants nationwide had lost 10% of their asset value…

click to enlarge

At present, the clearest signal that the utility industry acknowledges these risks is the cancellation by public utility commissions and utilities of 153 new coal plants. The plant cancellations amounted to $243 billion in investment decisions being reversed, or disinvested, from coal in the past four years. In 2010, a growing list of utility announcements carrying the message of existing coal plant closures and plans for new natural gas plants and alternative energy projects continued the trend.

Investment and pension fund fiduciaries, whose duty requires diligent inquiry and prudence in evaluating investment alternatives, must consider the financial implications of these coal exposure risks and factor them into assessments of “risk adjusted returns” for both the electric utility and coal mining sectors. Although markets may not yet fully reflect these risks, due in part to market failure in pricing environmental externality costs, this is certain to change given that “the correlation between environmental performance and financial performance is affected by the content and strength of environmental regulation.”10 As we document in this white paper, the climate for increasing regulatory compliance in the electric power sector is upon us, whether driven by initiatives of federal and state environmental agencies or by litigation. And this changing climate comes at a time when industry margins are squeezed by competitive prices for natural gas while both capital and operating costs are increasing.

This paper synthesizes the economic case that industry analysts have presented and examines the criteria that investors should use in assessing their exposure to coal risk. Although the coal industry is offering a series of arguments and programmatic actions to bolster its position, nevertheless, its bottom line competitiveness has eroded. How institutional investors react to this change in the coming months and years will help determine the shape of energy investments in the United States in the coming decades. It will also answer the question of whether a rational, stable allocation of capital can be achieved against the backdrop of profound economic, technological, political, and environmental change that is unfolding at global, national, and local levels.

click to enlarge
Introduction

Throughout the 20th century, the coal mining and electric power generation industries have been close allies as they worked together to provide the nation’s electricity. For the last five decades they have been stable economic forces, growing at a slow but steady rate and, in most cases, delivering dividends to investors. Yet due to changing economic, political, and environmental conditions the future of these industries requires companies to adapt to a different set of drivers. Failure to shift business strategies in this changing landscape exposes coal-dependent utilities and coal mining companies, as well as their investors, to increasing levels of financial risk and diminished value.

click to enlarge

For the purposes of conceptual clarity, the risks discussed in this paper are organized into three broad categories.

1. The unprecedented level of regulatory uncertainty. Existing regulations are being more strictly enforced as a result of litigation and the change of administration in Washington. New regulations in the pipeline will impart significant, unpredictable individual and cumulative costs on coal-reliant utilities.

2. Commodity risk due to low natural gas and power prices and volatile and rising coal prices. An abundant supply of natural gas in the U.S. and the rapid decline in its price have driven power prices lower nationwide. This market condition is expected to persist for the foreseeable future. The changing nature of domestic coal markets and the prospect of future increases in the price of coal make its uncertainty as an inexpensive fuel for electricity production a new piece of the energy calculus in the United States.

click to enlarge

3. Increasing construction costs. Global price increases for construction materials due to new power plant construction in China and India have established a new floor for coal price construction at a time when domestic regulatory mandates, the age of the nation’s coal fleet, and low power prices are driving decisions to replace the existing fleet of coal plants with other sources of power generation.

This paper discusses the market dynamics and investor actions that are at play globally, nationally, and regionally as our energy infrastructure is remade. Throughout, we show how geological, technological, energy planning, economic, and political factors all play into the assessment of investor risk and rewards from companies that depend on coal.

click to enlarge

Conclusion

The risks to investors with holdings in coal mining and coal-dependent utilities are significant. Depending on the size, location, and mix of an individual utility’s coal-fired utilities, the risk takes different forms but the concerns over revenue, CapEx, and growing regulatory burdens are shared. For mining companies, market changes, location, regulation, and cost of production are altering the industry’s make-up, if not its fundamental purpose.

As detailed in this report, a combination of factors underscore the financial risks of continued reliance on coal for electricity generation including:

• Low natural gas and power prices;

• Coal price volatility;

• Regulatory uncertainty related to the enforcement of federal environmental laws;

• Weak economic performance and faltering electricity demand forecasts; and

• Rising construction prices due to global demand.

click to enlarge

Investor activity identifying the financial risks related to coal-fired generation has taken several forms:

• JPMorgan Chase, Citigroup, Morgan Stanley, and other banks have adopted a set of enhanced diligence principles for power plant financing. The “Carbon Principles” are designed to raise red flags regarding the risks of investing in new carbon intensive power generation.

• Stock and credit analysts are offering more frequent and more comprehensive reporting on the topic of coal risk. Some have begun basing credit judgments on coal exposure.

• The utility markets which include investor-owned utilities, public power authorities, rural electric cooperatives, and municipal electric systems have canceled or postponed 153 new coal plant proposals. Banks, bond underwriters, and the Rural Utilities Services have all but shut down financing for new coal projects.

• Utility companies and financial underwriters are engaged in a robust discussion, based on a fairly broad consensus to replace significant portions of the nation’s coal fleet with natural gas, wind, solar, and energy efficiency.

click to enlarge

The coal industry has made recent gains in Congress, pressuring the EPA to push back some regulatory timing. However, continued uncertainty over energy policy and climate legislation does not work in the industry’s favor as investments in CCS will require a substantial price on carbon to justify the high cost of the technology. Although some new coal plants are opening and some already in the pipeline are going forward, no new ones are being proposed.

A growing industry consensus is paving the way for coal plant retirements and replacement of this capacity with natural gas, renewable energy, and energy efficiency. Although there is considerable and well-founded concern about the environmental impacts of the hydraulic fracturing process used to extract shale gas, and it is likely that increased regulatory oversight will add to the cost of gas production, most experts still believe that gas prices will remain low enough to displace coal-fired electric power generation. Some utilities are responding with significant plans, some are waiting, hoping, for market and regulatory tides to switch back to coal. All are doing both, to some extent.

click to enlarge

Depending on how investors view the material risks to the profit and loss of coal and coal-reliant industries, there are a range of actions they can take. Better understanding of coal exposure risks should prompt greater diligence by investors, their portfolio managers, and advisors. Investors should engage with management of utility companies and ask the utilities to disclose their coal exposure and address the risks with specific programs of action. Investors should also examine available options to shift their utility holdings toward companies that are reducing coal exposure risk and to avoid companies with insufficient programs to address coal’s financial liabilities.

The reaction of institutional investors to the unprecedented risks that reliance on coal presents to companies and to their portfolios will determine the shape of energy investments in the U.S. in the coming decades. It will also answer the question of whether a rational, stable allocation of capital can be achieved against the backdrop of profound economic, technological, political, and environmental change that is unfolding at global, national, and local levels.