Supporters of coal have called the planned
new rules from the EPA on CO2 emissions from coal-fired power generation
a war on coal and have pledged to fight the rule-making process. It is
true that there will almost certainly not be a new coal-fired electric
generating station built in the U.S. for at least the next several
years, but the hiatus won’t be caused by any specific rule. The real
danger to the coal industry is uncertainty.
Investing in the electric business is about long stable returns.
Electricity assets last a long time, are expensive to install, and are
typically expected to provide long-term stable, if modest, returns.
Since returns are spread over a long period and are stable, with limited
upside (10x returns on energy infrastructure don’t exist) investors and
lenders require a quantifiable and manageable amount of risk.
Uncertainty in any form makes the quantification and valuation of risk
in an electric generation investment much more difficult (or impossible)
and severely limits investor interest.
An excellent illustration of the impact of uncertainty on electric
generation investment is a recent history of the wind industry. Despite a
pattern of consistent, and even retroactive extensions, the uncertainty
created by the political fight over extending the Production Tax Credit
for wind power has caused nearly complete cessation of new wind
facilities being brought on line each time the credit wasn’t extended
well in advance of expiration.
The impact of the PTC on the economic case for a wind project has
been substantial and was (and still is for some projects) the difference
between a profitable and an unprofitable project, so the uncertainty
regarding the availability of the credit was a threshold requirement for
an investor. An investor simply could not have certainty that it could
earn the necessary return (or in most cases any return) without
realizing value from the credit, so no investments were made. The result
of this uncertainty in 1999, 2001 and 2003 is stark, as investment
dropped precipitously from year to year, even though any project would
have qualified for the credit because of retroactivity of the
extensions.
The challenges for the wind industry
have been the result of unstable subsidies – the lack of availability of
the PTC was (and as we race towards another sunset, is) a fixed,
defined reduction in revenue of about 2 cents per kwh produced from the
project (the credit is indexed for inflation and is currently 2.2 cents
per kwh). While the subsidy is important, and a significant addition to
most wholesale power prices in the US it is also a clearly definable
amount. As the credit was again set to expire at the end of 2012
investment slowed, but given that some projects may now be break-even or
better without the PTC and because the potential impact of the PTC not
being available was limited to the amount of the credit some projects
could engage investors despite this uncertainty because the associated
risk is quantifiable and therefore manageable.
The challenge for coal generation projects to attract investors and
lenders in light of the forthcoming rules on CO2 emissions is more
severe. By directing the EPA to draft rules on regulating CO2 emissions
from power plants, the White House has sent a clear signal that there
will be an economic impact on coal-fired electric generation (and to a
lesser extent gas fired generation). What is unclear until the rules are
finalized is how significant that economic impact could be. The
consensus is that the effect will be significant, but that could mean
anything from a material yet measurable impact on potential returns to
an economic effect so severe that new investment in coal generating
assets is completeley unviable.
Against that uncertainty it is virtually impossible to have
confidence that an investment in a coal-fired power plant is an
economically good decision – the potential effect of the regulation
isn’t defined so the impact could shave a percent from returns, or could
absorb all of the potential returns and even cut into the return of
capital invested. The trade between risk and return simply can’t be
evaluated, and investors and lenders remain risk-sensitive following the
financial crisis.
The ongoing market pressure (and uncertainty) caused by relatively
low natural gas prices acts as a multiplier on the impact of uncertainty
from expanded application of the Clean Air Act. Thermal coal as a
source of electric generation has already declined significantly due to
earlier regulations and has been accelerated by competition from low-cost natural gas
and renewables over the past few years. Even as gas prices rise, the
baseline potential economic advantage for coal over gas (and for that
matter wind) will remain marginal, and with the adjustment for
regulatory uncertainty investors will have easy alternatives to pursue.
There is an important secondary effect of uncertainty on investment.
Some investors and lenders will simply not look at a market segment
where there is this kind of uncertainty overhang, which reduces the
number of potential investors, and in turn makes investments more
difficult to obtain and more costly. This “segment avoidance” effect is
much worse for less established industries where it acts as an
additional barrier for new investors from entering a market. The
biofuels industry and the uncertainty from the Renewable Fuels Standard
is an example of this – despite a growing industry with potentially good
deals to be had many investors won’t even take the time to learn enough
to quantify the risk of the program uncertainty. Instead they will wait
for the uncertainty to resolve before making a decision on whether to
commit to the industry. In the case of coal generation it has been a
historically well-served market by the financial community, and so there
are still many sophisticated investors and lenders that could be drawn
into the market. However, as time passes, that community will shrink
leaving fewer and fewer potential investment partners.
If uncertainty is damaging, what is potentially devastating to the
industry is that there is almost certainly no fast resolution with this
uncertainty overhang persisting for years. A long protracted legal fight
over how the rules will be written and enforced is assured.
I spent some time discussing the rule making process with my colleague Jeff Karp,
who spent more than a decade on environmental and enforcement inside
the federal government. “Given the magnitude of the stakes – the
economic viability of the entire coal sector” finalizing the rules is
“certainly a long way off and unlikely to actually occur while the
present Administration still is in office.” Curiously, the fight being
waged by coal supporters may actually be making the industry position
worse by extending this period of uncertainty. A better solution would
almost certainly be to find some legislative compromise, possibly built
around a broader Congressional compromise on greenhouse gas emissions,
which could be more nuanced or gentle in its implementation (though how
this would come together in light of the current atmosphere in Congress
is unclear). Instead, the rule-making process will force this long
period of regulatory uncertainty.
Irrespective of the timing and structure of the final emission rules,
the power sector in the U.S. will be permanently altered. It will not
be the actual rules, rather this period of uncertainty as the legal and
political battles play out, that will make that declining share for coal
steeper and permanent. The final version of the rules will likely be of
little relevance, as the uncertainty of the rule-making process will
immediately frighten away potential investors. This loss of outside
capital for large expensive projects will effectively cease all new
development of thermal coal generation and will also significantly
hamper upgrade investments at existing facilities forcing an
acceleration of retirements.
http://www.energytrendsinsider.com/2013/08/22/uncertainty-and-investment-in-electric-generation-dont-mix-the-real-danger-to-the-coal-industry/
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