Global Warming Opportunities - Jumping onto the Bandwagon

By: Roger_Conrad

Not everyone is on board yet—or drinking the Kool-Aid, as some call it. The world's major scientific organizations, however, have now endorsed the concept that human-related carbon emissions are warming
the Earth's overall temperature.

They're joined by the estimated 80 percent-plus of the American public who call global warming a “serious problem.” And US politicians are scrambling to get on the bandwagon--and in plenty of time for November 2008 elections.

This week, Sen. John Kerry (D-Mass.) and former Republican House Speaker Newt Gingrich got together in Washington DC for what was supposed to be a serious debate on the issue. Instead, the event quickly turned into a contest about who was the toughest on global warming. In fact, observers noted—only partly tongue-in-cheek—that the two men appeared at one point to be on the brink of hugging each other.

The lovefest's also been spreading in the corporate world. This week, ConocoPhillips became the latest big energy company to cast its lot with those who want to control carbon emissions.

The company officially joined the US Climate Action Partnership, a rapidly growing lobbying group of corporations and environmental groups. The Partnership is asking Congress to enact legislation to cut US greenhouse gas levels by 10 percent to 30 percent within 15 years and reduce the emissions by as much as 80 percent by 2050.

One of the chief counter arguments to potential carbon regulation has been that developed nations are being asked to make all the sacrifice, while developing nations like China are allowed to spew at higher and higher rates. The charge is cutting carbon will make the US economy still less competitive, resulting in greater job
losses.

For its part, China is expected to become the world's biggest carbon emitter by 2010. The country is now second with 18 percent, behind the US' 21 percent, and has fiercely resisted agreeing to caps as
spelled out in the Kyoto Accords.

Now there are even indications that China is ready to play ball. This week, on a high-profile visit to Tokyo, Chinese Premier Wen Jiabao announced an agreement with Japan that would reduce carbon emissions in the two countries.

The deal didn't include mandatory caps. Instead, it featured incentives for China to invest in energy efficiency that would create emission credits that Japanese and European companies could then purchase. Moreover, the premier committed to future talks to create a more-effective system to combat greenhouse gases.

At this juncture, the Bush administration is still resisting taking action on carbon emissions, preferring instead to rely on proposals to increase use of alternative energy. This week, the White House hosted FORD MOTOR executives, who presented a potential prototype for an automobile of the future.

The event turned into something of a fiasco, as Ford's CEO was forced to apologize for a “joke” that he had saved the president's life by preventing him from plugging an electrical cord into the hydrogen tank of the experimental vehicle. But the very fact it occurred underscores the growing pressure the White House is coming
under to take action. That's definitely being felt throughout official Washington as well as in state capitals across the country.

WHAT ACTION?

Growing political pressure makes action on global warming no longer a matter of whether or, really, even when. Instead, the key question is what shape it will take.

There are many potential paths the US and the world can take to control and eventually reduce carbon emissions. Only one, however, has been successfully used previously: the so-called “cap-and-trade”
model.

Cap and trade essentially means capping overall emissions at some level, which is then reduced over time. Polluters have the option of either making the investment to reduce their emissions or to buy “credits” from another market participant that is.

Cap and trade was the basis for the Clean Air Act of 1990, which has dramatically reduced acid rain-causing sulphur and nitrogen oxides in North America since 1990. There are still plants operating that emit these pollutants. Their owners, however, have had to buy increasingly expensive credits from companies that have upgraded or replaced facilities. As a result, investment has been incentivized and the market has responded.

The other key benefit of a cap-and-trade model is flexibility. Rather than impose some arbitrary cap and deadline for meeting it, companies are given the option of either using currently available technology to solve the problem immediately or developing more-efficient solutions.

In 1990, the primary way to reduce acid rain emissions from coal plants was with so-called “wet scrubbers,” a hugely expensive, antiquated technology that created huge amounts of toxic sludge as a by-product. A strict deadline would have forced companies to adopt this technology.

In stark contrast, the cap-and-trade system of the act gave them the flexibility to develop and implement new technologies. Today, there are commercially ready coal power plants that emit virtually no acid rain emissions, mercury or other noxious pollutants.

Developing technology, of course, is the ultimate solution to environmental problems. That was the case with replacing aerosol sprays, which were just a couple of decades ago in danger of destroying the Earth's protective ozone layer. Similarly, the invention and growing efficiency of the catalytic converter has dramatically improved air quality in America's cities, despite record traffic congestion in many areas.

Cap and trade as a system for controlling carbon emissions was codified in the Kyoto Accords, which is still accepted in virtually all the developed world. Australia, Canada and the US are notable exceptions. But even in these countries, the model is increasingly popular. California Gov. Arnold Schwarzenegger, for example, successfully pushed enactment of cap-and-trade controls in the Golden State last year, and a dozen other states have enacted similar measures.

To our north, the Conservative Party minority government has officially declared it won't hold to the Kyoto Accords signed into law by the previous Liberal Party government. But it, too, has been forced by political reality to ramp up environmental measures concerning the warming issue. Meanwhile, the Canadian province of British Columbia has broken off to join the three Pacific Coast US states in an alliance to cap and reduce carbon emissions.

In the US, cap and trade has been endorsed as the official Democratic Party position on the national level, including the issue's chief advocate, former Vice President Al Gore. And although some Republicans are resisting in preference to incentives—Gingrich's position in his “debate” with Kerry—many others are joining the Democrats.

At this point, opponents of cap and trade for carbon emissions appear to be holding out hope they can delay until the November 2008 elections. Increasingly, however, the corporations who finance campaigns are pushing for more-immediate action in order to establish certainty on the issue before it can turn into an election
issue.

BEST AVAILABLE

“Democracy is the worst possible form of government, except for all the others.” That famous quote from one of the West's greatest leaders can certainly be paraphrased to apply to cap and trade.

Problems are myriad. For one thing, while utilities, transportation and heavy industry get most of the blame, many human actions release carbon into the atmosphere, including agriculture. In my view, some of the permutations are already bordering on the ridiculous, such as travel agencies offering clients the opportunity to offset carbon emitted when they go on vacation. And we're just getting started.

Despite its problems and potential problems, however, cap and trade is the only way proposed to reduce carbon emissions that's actually worked before on other substances. It's also the only system that's accomplished its goals without serious economic consequences and dislocations.

That's one reason the industry has come out in favor of it. Another is that settling on a system that sets rules and promotes flexibility on compliance will enable companies to think strategically about the capital spending. That way, they can prosper and perhaps even turn the rules to their advantage.

Until the rules are written for cap and trade, we won't know precisely who the major winners will be. In my opinion, however, we already have a pretty good idea in the utility sector.

First are the owners and operators of nuclear and wind power plants. Because these plants emit no carbon, they won't have to make expenditures to meet the new caps. As a result, the power they produce will become ever-more competitive against coal, which is still 50 percent of electricity produced in the US.

As I pointed out last week, three nuclear plants have received initial permits for construction and more than a dozen other sites should get the OK from the Nuclear Regulatory Commission later this year. Locked in a battle to win approval for its buyout by a private capital consortium, TXU announced this week that it would build a
fleet of nuclear plants to meet new demand as well as replace much of its fossil fuel fleet.

Once derided as dinosaurs, US nuclear plants are running at record capacity rates and outage times are shorter than ever. The key is that ownership has dramatically consolidated in the sector. Rather than being dispersed over dozens of companies, the majority of nuke ownership is in the hands of a half-dozen giant utilities. These
companies are now able to apply lessons learned at one plant across their fleets, improving efficiency and cutting costs. That's the same formula the French nuclear fleet has used to provide most of that nation's power reliably for decades.

Record capacity levels and price competitiveness versus fossil fuels will continue to make running existing nuclear plants a very profitable business. That's good news, particularly for the likes of DOMINION RESOURCES, ENTERGY, EXELON and FPL GROUP.

On the other hand, despite technological advances, the time table for building a new nuclear power plant is still nearly a decade, including the cumbersome permitting process. On the plus side, once the permits are granted, the law now prohibits them from being revoked by localities. Even that, however, could change if an anti-nuclear majority emerges in Congress. The bottom line: Getting new nuclear plants up and running is going to be a slow process. The good news is those who make it to the end will own major profit centers, probably the most-valuable assets in the power business.

As for wind, the business is surging and enriching the coffers of major producers AES CORP and FPL Group. And with many more projects on the table, the cash will continue to flow.

Spanish utility IBERDROLA is another major player, particularly in Europe. AES is also a major leader in transmission technology.

In addition to being more competitive, nuclear and wind power companies should also stand to gain from the sale of pollution credits, particularly to coal-burning utilities. And they'll gain credits as they add capacity.

The biggest losers of a cap-and-trade system are logically those who have to make the most expenditures, either to pay for credits to emit or to adjust their processes. This would logically include the biggest coal burners. Real exposure, however, will depend on how much regulators will allow them to recover in rates. That's why it will be increasingly critical to monitor utes' regulatory relations going forward.

CLOUDY THINKING

Industry has another reason to support cap and trade--namely, the plethora of other “solutions” to global warming.

Chief among these is the growing hysteria concerning coal-fired power plants. The Wednesday “Wall Street Journal,” for example, includes a full page ad paid for by the Union of Concerned Scientists with the headline “Face It, Coal is Filthy.” The text—which is accompanied by a heart-wrenching picture of a little girl with a sooty face—exhorts readers to “stop the filthy coal plants” by “letting government officials…know you want clean air.”

Even the new generation of clean coal plants will produce some carbon emissions. But carbon has little to do with sooty air. New coal plants can replace older ones that produce mountains of soot and sludge. And by running more efficiently than the prior generation of plants, they'll produce less carbon as well.

Sound like a good solution? Not if you see this issue in purely black-and-white terms, which unfortunately many people are coming to do. To today's true believer, it's not enough just to reduce emissions from coal plants; we have to eliminate coal from the power mix altogether.

That's obviously the fastest way to cut carbon emissions. Advocating such a course, however, can lead to only one of two things. One is a total shutdown of the US economy because coal accounts for half our current power mix and the vast bulk of our fossil fuel reserves. The other and far more likely is that Americans suddenly realize the idiocy of such a course and carbon reductions never happen.

Popular science forums from magazines to blogs are chock-full of articles and items touting so-called revolutions in how the world gets its energy. One such pop science theme making the rounds is the so-called “hydrogen society,” in which nonpolluting fuel cells and the sun's rays will power everything from automobiles to electricity
in homes.

Proponents argue that the age of the central power station is over, that no more need to be built and that the existing ones should be phased out. We'll have no need for utilities in this brave new world, so they say. Instead, everyone will have the ability to generate their own electricity, cleanly and safely.

A less-exotic theory touts the advantages of ethanol over conventional gasoline. Heavily promoted by farm state politicians, the idea is that we can grow our own fuel and eliminate dependence on imported fossil fuels.

These theories all make for good reading. The problem is they're completely impractical. Second, they distract policymakers from areas they should be focusing on. Third, they may prevent companies from taking the real actions they must to protect their interests and help reduce carbon emissions.

The first reason boils down to zeros—the inability of much of the public to distinguish between megawatts and gigawatts (1,000 megawatts). Basically, even if you add up all the available conservation measures, exploit wind and solar power to their fullest and imagine the best possible scenario for commercial fuel cell development, you're not going to replace more than a fraction of the electricity produced by today's coal and nuclear plants.

Today's central station power grid wasn't imposed by Soviet-style regulation or corporations intent on dominating the world. Rather, it was the result of decades of fierce industry battles in the early days of electricity.

Thomas Edison's original idea is much like today's hydrogen society proponents are advocating. That was to have small scale power generation based on direct current, or DC. His vision, however, was ultimately eclipsed by that of his business manager Samuel Insull, who proved beyond the shadow of a doubt that electricity generation is a scale-based industry in which increased output generally means lower overall costs.

Insull was able to expand electricity usage with alternating current (AC) from a luxury product enjoyed only by the elite into something everyone could afford. And the more available power became, the cheaper and more widely it was used.

The lesson of scale in the power industry has been relearned time and again, most recently with the attempted deregulation and restructuring of utilities in the 1990s. In the early '90s, the consensus was that small, supposedly more-nimble companies were going to eat the big lumbering utilities' lunch. Today, the only survivors from the ranks of those fry are frantically trying to consolidate. MIRANT, for example, has put itself up for sale, and CALPINE CORP is expected to do so shortly after it emerges from Chapter 11 later this year.

Later in the decade, the popular “powercosm” and “telecosm” theories emerged, predicting that power and communications service would soon no longer be provided by giants exercising economies of scale. Instead, they'd be built by a new generation of smaller companies involved in fuel cells and other technologies. Today, the companies projected as the winners are in even shorter supply than small power producers.

In short, electricity has always been a scale business. Converting off our current grid would cost trillions of dollars that, ironically, only the big utilities could afford. And even if the government stepped in and tried to force change, the lesson of '90s deregulation is clearly that scale would eventually triumph again.

Of course, the sheer impracticality of extreme measures to reduce carbon emissions means they're unlikely to be adopted. That's in large part because of the severe economic hit they would cause. It's far more likely nothing will get done.

The real danger is that pie-in-the-sky thinking will distract government and industry from doing the job they should be doing. Many of the same people who are so stridently anti-coal, for example, are also anti-nuclear and are working hard now to prevent new plants of either type being built.

TXU has already cancelled its plans to build coal plants. North Carolina regulators rejected one of DUKE ENERGY'S proposed clean coal power plants, in large part because of political pressure. Dominion Resources' plants in Virginia are also being opposed.

Ironically, global demand for coal continues to rise, even in the US. The black mineral is still our largest energy resource and—except for nuclear plants—the only one capable of providing the quantities of power we'll need as our economy becomes increasingly electrified.

Coal is also likely to be increasingly used as a replacement for oil in gasoline. This week, President Bush took up the torch for promoting this technology, which has been highly developed by South African giant SASOL. His efforts will be supported strongly by western state leaders like Gov. Schweitzer of Montana and their
colleagues in Congress.

As for the other aspects of the global warming issue, these will continue to unfold in the coming months. The good news is as long as cap and trade is the model, there will be far more opportunity than risk.

By Roger Conrad
KCI Communications

Copyright © 2007 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.

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