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Tip of the Carbon Cap

If robust, a cap-and-trade system could remake a broad swath of the economy.

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A signature facet of President Obama's domestic agenda is to slow or reverse the march of global warming. In fact, one of the President's campaign promises was to implement a "cap-and-trade" system on carbon emissions. This is especially relevant to the coal industry, as coal, which generates about 50% of our electricity, is the "dirtiest" of the fossil fuels. Over the past several years, there had been much apprehension in the industry over the coming of cap-and-trade. We think this system, if implemented robustly, would remake not only the coal industry, but also a broad swath of the economy.

Carbon Cap-and-Trade Basics
First: a quick introduction to cap-and-trade. Essentially, for the right to emit carbon dioxide, an entity must buy a "credit" from the government. Each credit represents the right to emit one ton of CO2. Over time, the government ratchets down the supply of credits, thereby lowering our economy's total emissions. In theory, putting a clear price on emissions will incentivize companies and consumers to either consume less carbon-intensive goods and services or find more carbon-efficient methods of production. The Obama administration recently released the first draft of its plan in the fiscal 2009 budget proposal. The plan is ambitious--starting in 2012, we reduce emissions to 14% below 2005 levels by 2020 and 83% below 2005 levels by 2050. The administration thinks it will raise about $80 billion per year through selling credits. The money will be used to support green energy and to protect vulnerable families from sudden rises in electricity, fuel, and other prices. Provisionally, the budget estimates that credits will cost $20 per ton, a price that will rise slowly as standards tighten.

We Need More Details
It will be a long while before the final legislation is developed, and we are missing many critical details. What facilities and sectors will be subject to caps? What will be the penalty for noncompliance? Will the legislation include a "carbon tariff" to prevent carbon-intensive industries from moving to foreign countries? Will investments in carbon reduction be rewarded with tradable credits? What are the auditing and verification requirements? These are just a few of our questions. The point is that there are many potential "loopholes" and weaknesses in designing such a complex framework. For example, in Europe, the pioneer of carbon cap-and-trade, initial overallocations of credits and ample opportunities to receive credits for "green" investments helped keep carbon credit prices relatively low and the program fairly ineffective. In fact, both coal usage and carbon emissions have actually increased since Europe initiated their cap-and-trade system in 2005.

There are a lot of reasons for designing a relatively "weak" system. Such a system won't do a good job of reducing emissions, but it will raise a lot of cash for the government. Also, it's a way to generate political capital without putting an unpalatable burden on the economy. Finally, and perhaps most importantly, a truly robust program to reduce emissions would probably be painful for consumers, companies, and politicians. It won't be easy for voters to stomach some of these potential changes.

At What Price?
The administration itself has acknowledged that their estimate of $20 per ton for carbon is conservative. We agree--$20 per ton is simply not enough to induce consumers and businesses to change their behavior. For example, transportation accounts for a bit less than 30% of total United States carbon emissions. Burning one gallon of gasoline releases about 20 pounds of carbon dioxide. Therefore, a $20 carbon tax only adds 20 cents, all else equal, to the price of gas. Very few motorists would materially change their behavior over such a minute expense. It took $4 gasoline in mid-2008 for people to curtail their car usage. Similarly, electric utilities, which account for a third of our emissions, would not abandon coal in favor of natural gas or other generation sources. The $20 carbon price simply does not economically justify this switch-off. The whole point of putting a clear price on carbon is to induce consumers and businesses to change their behavior. So, the price must be high enough for people to care. This means that if we are serious about reducing emissions, it's necessary for people to pay much higher prices for heating, power, transportation, and carbon-intensive goods like steel, cement, and glass. The problem is that very few people actually want to pay more for these necessities.

We Think High Carbon Prices Are Unlikely
For these reasons, we think a truly robust cap-and-trade system is unlikely at the present. Nevertheless, there is growing support for curbing emissions and protecting our environment. What would happen to the coal industry if such a system were crafted and implemented? The short answer is that we think there would be a massive shakeup, many companies would disappear, and the industry landscape would be irrevocably altered. The reason is simple. Under high carbon credit prices, the "penalty" for burning coal can be huge. For example, a ton of Powder River Basin coal costs about $10. But burning this coal releases 1.9 tons of carbon. So, if carbon credits cost $50, a power plant has to pay $95 to the government. We think coal companies will struggle to "pass on" this added cost to their customers. Furthermore, coal companies have very high fixed costs and are very margin-sensitive. Even a small erosion of a company's gross margins has grave consequences for its health. This is especially true given that many coal companies have substantial amounts of debt and legacy liabilities tied to mine reclamation obligations or retiree benefits. In this scenario, the U.S. would still produce a lot of coal, albeit less than before. But we expect many coal companies would require Chapter 11 protection in this scenario.

An often cited savior for the coal industry is "clean coal" technology, possibly involving "carbon sequestration." Basically, this technology strips out carbon dioxide from burning coal and injects the gas underground or into the deep ocean, hopefully trapping the pollutants forever. Indeed, the Obama administration promised about $3.4 billion in support. We think clean coal will not save the coal industry. For one, it's too immature and too expensive, and the resultant plants are too inefficient. Capturing, transporting, and injecting carbon dioxide consumes massive amounts of energy, making "clean coal" plants up to 30% less efficient than regular coal power plants. The plant itself is also much more complex to operate and more expensive to construct. Finally, we do not expect the technology to be ready for mass adoption for 15 years--well after the start of cap-and-trade.

Relative Positioning in a High-Carbon-Price Scenario
Of course, not all coal companies are created equal. In general, we think companies that are smaller, more indebted, or concentrated in the Powder River Basin are in worse shape than their peers. The Powder River Basin contains some of the thickest, easiest to mine coal in the world. However, this coal also emits about 10% more carbon dioxide per British thermal unit than their Appalachian counterparts. Therefore, despite its massive geological advantage, the PRB becomes much less competitive given high carbon credit prices. Within our coverage universe of eight U.S. coal companies, we think  CONSOL Energy (CNX) is the best-positioned, owing to its attractive Northern Appalachian mines and its natural gas operations. We think natural gas will benefit from coal's pain. Following closely are  Alpha Natural Resources (ANR) and  Massey Energy (MEE), both relatively large and efficient Central Appalachian miners.  Peabody Energy (BTU) would also do okay, despite its exposure to the PRB, thanks to its international asset portfolio. On the other hand, we expect  James River Coal (JRCC),  International Coal Group (ICO), and  Foundation Coal (FCL) to be in the worst shape. These companies are either small marginal miners with unattractive geological profiles, heavily indebted, or too exposed to the PRB.  Arch Coal (ACI) fits in this category as well. We think Arch is an attractive miner, but its exposure to the PRB shackles its fate to carbon prices.

Michael Tian does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.