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Utility Winners and Losers in the Carbon Bill

Legislation with emissions caps and renewable energy standards could impact utilities.

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As the U.S. House of Representatives Committee on Energy and Commerce debates the American Clean Energy and Security Act of 2009, we think investors should begin positioning their energy portfolios for what could be the most sweeping energy legislation in decades. While this bill includes numerous energy-related initiatives, our early analysis produces some intriguing areas of opportunity for investors in the electricity sector. The most impactful programs are the proposed national renewable portfolio standard, which requires a set amount of total generation to come from renewable sources, and the carbon cap and trade system, which seeks to limit carbon dioxide emissions. These programs will, in our opinion, create some clear winners and losers.

Regulated Utility Winners
Any nationwide renewable energy standard should create investment opportunities for regulated utilities in renewable generation, energy efficiency, and transmission lines to move "green" power to demand centers. Regulated utilities whose portfolios are light on renewable energy are poised to benefit the most, in our view. State regulation that supports timely cost recovery and a healthy return on new investments also is key. We think  Southern Company (SO), which operates mostly coal-fired facilities in investor-friendly states, is one potential beneficiary. A renewable portfolio standard could also offer growth opportunities at utilities that lack owned generation. Boston-based  NSTAR (NST), New York-based  Consolidated Edison (ED), and Connecticut-based  Northeast Utilities (NU), all of which could need new transmission lines to import renewable power into their densely populated service territories, are three examples. Regulators tend to grant strong returns on equity for transmission investments, making them an attractive area for growth.

The carbon cap-and-trade scheme proposed in the legislation, in our opinion, could have less of a direct impact on regulated utilities, as the costs of compliance largely will hit ratepayers in carbon-heavy regions. However, higher power costs could have a significant impact on regional economies and hence customer usage. The system proposed in the bill does allocate a portion of emissions credits to the sector based upon an equal combination of historical emissions and electricity use. Our analysis suggests this allocation scheme would most disadvantage the Midwest and Southeast, where coal-fired power plants supply most of the electricity. If regulators are reluctant to let utilities pass these costs to customers, utilities could suffer lower margins and increased regulatory lag (the time it takes a utility to recover costs through higher regulated rates). Those that can pass these costs on could still see reduced customer usage due to higher rates. On the flip side, states like California with high usage and relatively little coal generation appear to be big winners. Utilities in these states such as San Francisco-based  Pacific Gas and Electric (PCG) and  Sempra's (SRE) San Diego Gas and Electric could be able to lower customer rates and incentivize more electricity demand by selling their excess emission allowances.

Merchant Winners and Losers
On the merchant side, the winners and losers are clearer. Nuclear and renewable power appear to be clear winners. The low-cost, low-carbon advantage of nuclear-based generators like  Exelon (EXC),  Entergy (ETR), and  Public Service Enterprise Group (PEG) could strengthen as their fossil fuel-based peers shoulder carbon costs.  FPL Group (FPL) also should benefit as the largest renewable energy developer in the U.S. As generation costs rise for fossil fuel-based generators, so too will market power prices. This should widen margins for owners of low-carbon power sources. Natural gas generation, which is half as carbon-intensive as coal, might not be as much of a winner within the current legislation as in other proposed greenhouse gas legislation. Coal plants could receive free allocations that allow them to offset about 15% of their emissions, but natural gas plants will not be eligible for those allocations. Still, coal-heavy merchant operators like  Dynegy (DYN) and  RRI Energy (RRI) could suffer as their higher costs might not be fully reflected in markets such as the Mid-Atlantic and Texas where natural gas typically sets power prices.

While this bill certainly represents some sweeping changes for the electricity sector in the U.S., we caution investors that it is still in its early stages and critical details could change as it moves to the full House and Senate. We think the key variable to watch is the method for allocating carbon allowances. Our analysis suggests the current allocation scheme would transfer a significant amount of wealth from certain states to other states. Senators from key Democratic-led states in the disadvantaged Midwest, Central Plains, and Southeast could insist on more free allocations to limit customer price increases. Another key element will be the structure of the renewable portfolio standard and the levels of renewable generation required, as this will determine the quantity and type of investment options for each utility.

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