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Washington Watch

Winners and Losers from the EPA’s Clean Power Plan

By Roger S. Conrad, on Aug. 22, 2015

Earlier this month, the US Environmental Protection Agency (EPA) issued final rules designed to limit carbon dioxide (CO2) emissions from power plants.

As with the proposed rules released a year ago for public comment, the new regime establishes specific reduction targets for CO2 emissions in each state. Utilities and state regulators have considerable latitude in developing a course of action for achieving these goals. The final rules require states to submit and start to implement a plan by 2022; the draft that circulated last year contemplated a 2020 deadline.

Utilities and states that rely heavily on coal-fired power plants have the most work to do.

Other changes to the proposed rules include a safety-valve provision whereby states can take action to prevent disruptions to the power supply; the elimination of energy-efficiency requirements; the inclusion of nuclear power as a qualifying source of clean energy; and new incentives to promote renewable energy.

Whether these regulations survive to 2022 depends on which party occupies the White House after the 2016 election. Democratic front-runner Hillary Clinton and the party’s other candidates have either endorsed the EPA rules or suggested beefing them up even more. Republicans appear to be universally against the new rules, with some going so far as to urge states to refuse to comply.

Even if these rules don’t survive, they’ve already started to shape capital expenditures in the utility sector. Renewable-energy developers received a boost, which helps to offset the expiration of solar-power tax credits at the end of 2016 and the potential overbuilding of intermittent renewable-energy in some states. These rules are also bad news for coal producers.

Electric utilities and the pipeline owners that transport natural gas to power plants are the big winners.

House of the Rising Sun

The recent boom in solar-power deployment has suckered all too many investors into SolarCity Corp’s (NSDQ: SCTY) vision of a future where customers cut the cord and opt for rooftop solar-power installations, sending electric utilities into a death spiral.

In this self-serving view of the future, rising adoption of solar power reduces demand for traditional sources of electricity, saddling utilities’ remaining customers with higher costs and spurring more defections.

But SolarCity appears to be the only company locked in a potential death spiral. For several quarters, the solar-power evangelist has lost more money with each incremental dollar of revenue.

The company’s most recent 10-Q filing shows operational losses of 128.8 percent of revenue, compared to 121.1 percent in the second quarter of 2014. And these figures don’t include interest expense, which increased 59 percent year over year. Meanwhile, SolarCity’s operational cash losses have ballooned by more than five times.

In contrast, solar power has emerged as a major source of earnings growth for traditional utilities, primarily through investments in large-scale installations. But Southern Company (NYSE: SO) and other utilities have also launched their own businesses focused on developing and leasing rooftop solar panels.

And weather-adjusted demand for electricity has started to tick up in areas around the country, driven by customer additions and rising consumption. Bottom Line: US electric utilities don’t appear to be trapped in a death spiral.

However, the situation differs in Germany. RWE (Frankfurt: RWE, OTC: RWEOY), E.On (Frankfurt: EOAN, OTC: EONGY) and other traditional utilities find themselves saddled with huge losses because of state support for renewable energy and depressed wholesale-electricity prices. (See Electric Utilities: The American Way Versus Germany and Australia.)

Unlike in Germany, the US generation and transmission network is far more decentralized; individual states play a major role in planning, resulting in regional differences that make coordinated national efforts hard to implement.

US utilities and policymakers have also learned valuable lessons from Germany’s ill-starred plan to promote renewable energy and shut down baseload power plants.

This painful transition has made the Continent’s largest economy more dependent than ever on Russian natural gas and resulted in the country falling short of targeted reductions in CO2 emissions. And the situation will worsen early next decade, when Germany will shut down all its nuclear power plants.

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Cheap Natural Gas: The Great Enabler

An abundance of inexpensive natural gas has also enabled many US utilities to scale back their use of coal as a feedstock while reducing customers’ costs.

This shift eliminates the environmental hazards of coal-fired power plants, including coal ash, mercury, sulfur dioxide and nitrogen dioxide. Gas-burning facilities also emit about half as much CO2 to generate the same amount of electricity as a plant that uses coal for feedstock.

Technological advances also make it easier than ever to convert coal-fired facilities to burn natural gas.

Moreover, wind turbines and solar panels generate electricity intermittently; the sun doesn’t always shine, and the wind doesn’t always blow. Gas-fired power plants provide the baseload power needed to balance the grid when renewable generation powers down.

Dominion Resources (NYSE: D) has taken advantage of these trends, growing its earnings by investing in new solar-power capacity and critical infrastructure to deliver inexpensive natural gas to underserved markets.

Dominion Midstream Partners LP’s (NYSE: DM) initial public offering (IPO) gives the parent an ideal vehicle to recycle capital and finance its investments in natural-gas infrastructure, including a much-needed pipeline to transport output from the prolific Utica Shale and the Marcellus Shale to the Mid-Atlantic and Southeast.

Going Nuclear

The EPA’s decision to classify nuclear power as a source of clean energy didn’t get much play in the press, probably because of cost overruns on high-profile projects and a lack of regulatory support.

Ameren Corp (NYSE: AEE), for example, wrote off the development cost for a planned nuclear reactor at the Callaway site in Missouri, attributing the decision not to move forward with the project to unsupportive regulators. Duke Energy Corp (NYSE: DUK) likewise has put plans to develop a nuclear power plant on hold, pending a federal decision on a permanent storage facility for nuclear waste.

Utilities contemplating new nuclear power plants continue to monitor the progress of Southern Company and SCANA Corp’s (NYSE: SCG) reactors. Although both projects have encountered delays and cost overruns, regulators have granted rate hikes to ensure that the utilities recover their costs. SCANA, however, recently agreed to a slightly reduced return on equity.

Ongoing regulatory support will be critical to these projects earning an economic rate of return and avoiding the crippling financial burdens incurred during the last round of nuclear power plant construction.

The construction consortia overseeing these massive projects likely will do their best to learn from their mistakes on the first reactors so that the second units come onstream with fewer cost overruns and delays.

It’s too early to call Southern Company’s Vogtle expansion or SCANA’s Summer project a success, let alone a model for other electric utilities. Thus far, however, capital expenditures associated with these reactors should continue to drive earnings growth for both companies.

We sold SCANA Corp from our Conservative Income Portfolio for a 32 percent gain in December 2014, but Southern Company continues to rate a buy up to $47 per share. Subscribers can read my take on the latter’s second-quarter earnings in the Aug. 6 Utility Roundup. If you haven’t joined Conrad’s Utility Investor yet, learn more about how you can save $100 on an annual subscription.

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