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US Energy Policy Changes and Potential Profits

Companies / US Utilities Jul 14, 2007 - 09:52 AM GMT

By: Roger_Conrad

Companies

Talking policy is cheap. Creating and implementing something that works is an entirely different matter. Just ask the army of politicians, bureaucrats, industry executives, academics, consumer advocates and analysts now working on major potential regulatory changes in the energy and communications industries.

The newly installed Democratic Congress has stated two goals for energy policy: promoting US energy independence from the increasingly volatile Middle East and curtailing emissions of greenhouse gases that produce global warming.


Clearly, there's not a universal mandate for these goals. Super Oils like EXXONMOBIL, for example, have asserted that total energy independence is simply not possible or even desirable in an increasingly interconnected world. Rather, they argue consumers should always look for the cheapest energy source and let the market sort out winners and losers. Global warming has been even more hotly debated, though the scientific community seems roughly decided that carbon emissions are having an impact on climate.

Both goals are, of course, very popular politically, at least in theory. The problem the majority party in Washington has is how to weave legislation that can move both of them forward and garner enough votes to pass a divided US Senate with enough force to discourage an otherwise almost certain presidential veto.

That looks difficult even at first glance. And once you start examining the details, it's even more problematic.

For starters, the easiest and fastest way for America to achieve energy independence is to burn more coal, both for generating electricity and powering vehicles. The continental US is commonly referred to as the Saudi Arabia of coal. We already get more than half our electricity from coal-fired plants and there's plenty to displace the gasoline we use as well.

As for technology, South Africa's SASOL and others have taken early 20th century coal-to-liquids processes to 21st century efficiency. A mass scale program to build these plants would quickly reduce demand for Middle East oil for use as gasoline. And a new generation of integrated gasification-combined cycle power plants--fueled by coal that's converted into clean gas--would all but eliminate sulfur oxides, nitrogen oxides and mercury pollution without the need for scrubbers and other old plant technology, which still creates rivers of waste water and mountains of sludge.

On the other hand, the fastest way to reduce carbon emissions would be to convert the nation's coal-fired power plants to other fuels.

And many environmental advocates have made fighting the use of coal--either for transportation fuel or generating power--a primary objective.

Some of these people champion a switch to nuclear power as a long-term solution for getting the nation off coal. But many, including some utility regulators and policymakers who ought to know better, seem to believe we can have a painless transition to wind, solar and conservation that will avoid using both coal and nuclear power--now 70 percent-plus of our power supply.

Obviously, if one could reduce or eliminate carbon emissions from burning coal, policymakers could have their cake and eat it, too. But simultaneously ramping up coal use and cutting carbon emissions is only possible if there's commercially available technology to do the job. And while there are many ongoing projects to accomplish that, we're still some years away from a commercially viable solution.

The technique of carbon sequestration, for example, proposes to take carbon from burning coal and “sequester” or store it in underground tanks. There it could presumably be processed into something saleable, much as waste from oil and gas drilling sites is processed by companies like NEWALTA INCOME FUND in Canada. But while there are motivated companies working on it, even the most optimistic project will be 15 to 20 years before anything economic is commercially available. And even then, the cost will mandate much higher prices for electricity.

Washington politics is fundamentally interest group politics. And with literally hundreds of billions of dollars at stake on this issue, the knives are out on all sides. When that happens, not everyone is going to be happy with the final policy.

Like the Republicans who ruled for the previous 12 years, the Democrats in the House of Representatives have demonstrated a great deal of unity in 2007. The US Senate, however, is a far more fractious place. Among the Democrats alone, interests range from a Midwest-based pro-coal crowd--including presidential candidate Barrack Obama--to the champions of renewables that dominate the western states.

Basically, anything that doesn't at least somewhat mollify all of these interests doesn't stand a chance of passing the Senate. That will be true even if a Democrat is living at the other end of Pennsylvania Avenue in 2009. Therefore, any resolution to the inherent conflict between promoting energy independence and curtailing carbon emissions will come first and foremost from the US Senate.

This week, two senators--Jeff Bingaman (D-NM) and Arlen Specter (R-PA)--stepped into this minefield with their version of climate legislation. In a very real sense, the pair represent opposite ends of the energy interest group spectrum. Bingaman was Senator Pete Domenici's (R-NM) Democratic foil when the Republicans controlled the Senate, and the two have long been champions of nuclear power, renewables and technology-based solutions to energy challenges.

Specter, meanwhile, represents a state in the heart of coal country.

Their bill proposes a cut in US greenhouse gas emissions back to 1990 levels by 2030, with a 60 percent cut in current levels by 2050. It would be reached via a cap-and-trade system, similar to that which has dramatically reduced acid rain emissions over the past decade and a half, which would apply solely to utilities.

Utilities would receive some allowances to emit carbon dioxide and would be allowed to buy and sell them in the market place. Companies that reduced emissions over that time would be net sellers of credits, which would be increasingly valuable as caps were tightened.

That would benefit utilities that increase use of renewables and nuclear power, as well as those implementing carbon-reducing technologies at coal plants.

Utilities would also have the option of burning natural gas instead.

As I've pointed out in Utility & Income, that's the course many company managements have indicated they'll follow at least initially.

Gas emits less than half the carbon coal does when burned. Long term, however, this would have to be balanced against higher natural gas prices that increased demand would undoubtedly trigger.

For investors, there are two encouraging things about the Bingaman/Specter bill. First, it relies on market-based responses to carbon regulation, rather than government mandates about what companies should or shouldn't do. That formula proved itself with the massive reductions in acid rain emissions under the 1990 Clean Air Act, just as pure government mandates have consistently shown their ineffectiveness.

Relying on market-based solutions doesn't guarantee some companies won't make classically stupid moves. It certainly doesn't ensure state and federal regulators will allow companies to recover even prudently incurred costs. Regulatory support will be critical to success, particularly in the states.

It does, however, allow companies flexibility and the ability to chart their own course through this challenge without melting down financially, and possibly even adding to earnings as asset bases expand. And for those out front on the solutions, there's a lot of money to be made.

The other encouraging thing is the broad range of support already shown by the utility industry. AMERICAN ELECTRIC POWER CEO Michael Morris, for example, was on hand at the unveiling this week expressing his strong support, though his company is the largest US producer of electricity from coal and the biggest producer of carbon dioxide as well according to an April 2006 report by the Natural Resources Defense Council.

On the other side of the spectrum, EDISON INTERNATIONAL CEO John Bryson--a player in drawing up California Governor Arnold Schwarzeneggar's carbon regulation plan in that state--was also on hand. So were PNM RESOURCES' Jeff Sterba and PPL'S James Miller, both early advocates of carbon caps. Ditto EXELON CEO John Rowe, whose company's nuclear fleet makes it a major winner from carbon regulation.

We've yet to see much reaction outside the industry to the bill, which is still in its infant stages. At least one crucial Democratic constituency is already on board. AFL-CIO Secretary-Treasurer Richard Trumka pronounced the proposal “balanced and fair.”

Some environmental groups, however, are already attacking portions of the proposal, particularly a provision to cap the price of credits to ensure against a spike. Sierra Club global warming director Dan Becker, for example, called the “safety valve” provision a “giant loophole” in the bill,” which could create “a formula for inaction.”

At this point, there are literally dozens of potential bills circulating both houses on the subject of carbon regulation. Senator Barbara Boxer (D-CA), for example, is allegedly considering a tougher bill without a cap on the price of carbon credits. And her committee is likely to produce a bill. Also, this one's still more broad strokes than specifics and will almost surely require weeks of negotiations before it reaches passable form. But it does set a very encouraging tone for the utility industry, and by extension investors.

My favorite plays remain wind and nuclear producers like DUKE ENERGY, Exelon and FPL GROUP. But if this approach prevails, even the companies that have to invest the most now on the problem like AEP are in good shape for growth.

THE SPECTRUM SPAT

If universal connectivity and product diversity are the benchmarks, the communications industry has been a remarkable global success story over the past decade. There are still plenty of holes, as I found out on KCI's recent cruise of the Baltic Sea region.

But the ability to communicate and do business--as well as access a host of entertainment options literally anywhere--has never been better. And far from bankrupting the consumer, the price of service continues to trend downward, even as service providers are making more money than ever.

The shape of the industry, however, is far from what deregulators envisioned even a decade ago. The architects of the 1996 Telecom Deregulation Act in the US, for example, thought they were busting up the old monopolies to create a system with myriad providers. Instead, as industry sales have grown, market share has sharply consolidated to a handful of giants.

Competition is more robust than ever and will become even more so in coming years, as technological advances continue to bridge the gap between industry sectors that were formerly wholly separate. Cable television companies, for example, are now making money hand-over-fist by providing Internet-based telephone service over wires that once brought only entertainment. And telephone companies are providing formerly cable-constrained entertainment to the home, as well as over wireless phones.

It's also hard to argue investment has suffered from industry consolidation. Verizon's investment in fiber-to-the-home or FiOS represents one of the most aggressive network buildouts since the original AT&T wired the nation early in the last century. Wireless providers are constantly upgrading networks to handle ever more traffic and high volume data. Blackberries are everywhere and APPLE'S iPhone appears to be gathering steam. And Wi-Fi networks are popping up even in the most unlikely places.

Where there's money, however, there are aggressive interest groups in Washington trying to get their hands on more. And with constituents howling for changes, it's increasingly tough for regulators and politicians to keep their hands off.

That's the backdrop for the latest communications industry spat, this time over the US government's plan to auction off some of the last remaining and most valuable wireless spectrum. As I reported previously in U&I, a Federal Communications Commission (FCC) sharply divided on party lines recently ruled there's no need to implement so-called network neutrality regulation on the Internet.

The FCC currently has three Republicans and two Democrats, owing to the fact that President Bush is a Republican. To date, the Democrats have favored network neutrality regulation, while the Republicans--including Chairman Kevin Martin--have been opposed.

Network neutrality is a concept being pushed by a group of major Internet service providers--namely GOOGLE, AMAZON, YAHOO and SKYPE--that want to prevent network owners (namely Big Telecom and Big Cable companies) from being able to grant preferential treatment on their networks to their best customers. To date, this hasn't been done by any of the network owners. But theoretically, under current rules they could provide faster service to customers willing to pay more, much in the same way airlines upgrade high paying, frequent customers. They could also differentiate network availability to businesses using the Internet.

Were network owners to do this, it could, in theory, disadvantage anyone doing business on the Internet. And as a matter of disclosure, that could also include U&I's publisher KCI Communications.

The issue is far from resolved. Legislation to mandate network neutrality has thus far failed by bipartisan vote in the US Congress.

And with the Big Telecom and Big Cable lobbies fighting on the same side, they wield considerable clout. It's certain to remain an issue going forward, however, particularly if network providers do adopt such strategies, though they're unlikely to as long as their primary goal is to add users.

The latest iteration is the fierce debate that's erupted over the airwaves auction. Under a proposal being circulated by Chairman Martin--and favored by the Internet service providers--a third of the available spectrum would be used to build an open network that would allow the use of any mobile device or service without the restrictions current network owners place on their networks. Another portion would be set aside for an emergency network, favored by many first responders to disasters and lobbied for by former FCC Chairman Reed Hundt and former FBI Director Louis J. Freeh.

The proposal is apparently favored by the FCC's two Democrats and opposed by the other two Republicans. Ultimately, that could be the vote on the plan. But in the meantime, enormous pressure is being brought to bear on all five commissioners from a range of lobbyists, including technology developers, academics, consumer advocates and of course the industry.

Their efforts have the ability to radically reshape Martin's proposals, particularly the myriad details defining what an open network is. There are also sharp disagreements between potential bidders on the size of the blocks to be bid on. Martin, for example, favors the ability to auction large regional segments, a provision favored by dominant wireless companies like AT&T and VERIZON because it eases network expansion. Cable companies and small rural wireless companies, meanwhile, favor smaller blocks because they're smaller mouthfuls to digest.

Getting anything through the divided FCC will be difficult. And it's impossible to say what the final details will be. As investors, however, there are several things to keep in mind.

First, while the media--and even Wall Street--will be quick to play up winners and losers, this is only one battle in a very long war for influence in Washington. Today's winners will no doubt be losers on other equally important issues.

Second, no matter what Martin and other would-be industry shapers have in mind, what ultimately emerges from their policy will no doubt be quite different. Industries evolve according to market forces. The history of communications has been about consolidation for one simple reason: Bigger companies have the ability to provide more services more cheaply than smaller ones. That's because they have better scale and access to capital. No matter how regulators try to divvy up market power to ensure “fairness,” the natural tendency will be to move for scale and consolidation of market power in communications.

Third, the odds of anything draconian emerging from this battle are almost nonexistent. US communications regulation--backed by strong bipartisan majorities in Congress--is still squarely on the side of letting market forces run. Contrast that with New Zealand, where the chief regulator is forcing the breakup of the country's leading communications service provider in the name of promoting competition.

Most important, all of the players in this battle are extremely prosperous and getting more so all the time. We're going to see that demonstrated once again as second quarter earnings results are released in the next couple of weeks. No matter who wins or loses these stocks--particularly service providers--are cheap and headed a lot higher in coming years. Any selling that occurs due to some media trumpeted threat will be yet another great chance to buy great businesses.

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.

KCI has assembled a team of top investment analysts to create the finest financial news service possible. With well-developed research skills and years of expertise in their particular fields, our analysts provide quality information that few others can match.

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