The big news of the week was the U.S. Environmental Protection Agency’s proposed rule to limit greenhouse gases from existing power plants, a move that is intended to reduce carbon pollution by 30% by 2030. The regulation is a colossal move for the electric power sector, one that will overhaul the makeup of America’s power plants and strikes at the heart of the coal industry.
EPA chief Gina McCarthy went to great lengths to emphasize the fact that states will have flexibility to meet the targets, using both efficiency on site, but also investments in “beyond the fence” measures such as offsetting pollution by investing in renewable energy.
The mixed reaction by the electric power industry to the June 2 announcement was telling. Utility executives liked the fact that the EPA rule was not rigid; it gives broad leeway for them to find the cheapest way to achieve emissions reductions.
But more importantly, the mixed reaction was the result of how the EPA rule will create an interesting division of winners and losers. Utilities that have invested in renewable energy will be positioned well to meet the targets. Ditto for holders of nuclear power. Interestingly enough, the EPA’s plan depends heavily on a huge increase in consumption of natural gas – so natural gas generators were not exactly outraged at the limits.
The clear and unambiguous loser is coal. Coal producers, owners of coal-fired power plants, and their investors have a grim future.
According to EPA’s assessment, coal-fired generation is expected to decline by 20% to 22% by 2020 – that’s a significant drop off over the next five to six years. That equates to about 30 to 49 gigawatts of coal-fired capacity that becomes uneconomical due to the regulation. And just to be clear, that is the additional loss of coal capacity from the new rules – there were already around 60 gigawatts of coal plants expected to be retired by the end of the decade before EPA’s rule came out due to poor economics, according to U.S. government data.
Make no mistake – this is bad news for the coal industry.
It also comes at a time when the international coal market is already experiencing supply gluts on slowing demand in China and India. According to SNL, a financial analysis firm, weaknesses in the coal market are being felt across the world. Several Australian companies, including New Hope Corp. Ltd. and Wollongong Coal Ltd. are closing mines and laying off workers. In the UK, several hundred employees at UK Coal Mine Holdings Ltd. are also losing their jobs as mines are shuttered. In Europe, coal prices are down by nearly 20% since January on weak demand.
But it will be American coal companies that will be slapped with a double whammy – weak international conditions coupled with a tightening regulatory vise from the EPA. Shuttering coal plants means less coal burned – EPA predicts this will cause coal production to decline by 34% in the western U.S., and by 37% in Appalachia.
Peabody Energy Corp (NYSE: BTU) – the largest coal producer in the United States – will be a major loser. Its stock price has declined by over 75% in only the last three years as utilities are increasingly switching to natural gas and coal prices decline. Even though the company’s downfall has been underway for three years now, more pain is in the offing. Investors are increasingly shorting the stock after its first quarter earnings disappointed (an EPS loss of $0.19), and second quarter numbers looking no better (between an EPS loss of $0.14 and $0.39). With coal demand in the U.S. expected to be slashed significantly over the long-term, there is little upside for this company.
The trajectory for Peabody is either similar or worse for America’s other coal producers. While the exact financial figures may vary from company to company, structural decline for the industry is pretty likely at this point. UBS recently said that bankruptcy is not impossible for some of the weaker coal companies.
That means expect a negative outlook for Arch Coal Inc. (NYSE: ACI), Alpha Natural Resources (NYSE: ANR), and CONSOL Energy (NYSE: CNX) – the second, third, and fifth top coal producers. Consol is more insulated as it has some natural gas assets. Cloud Peak Energy (NYSE: CLD) – the fourth largest – is in a bit of a better position as well since it operates surface mines exclusively in the Powder River Basin, a lower cost region for coal production. Still, while its costs are lower than Appalachian producers, Cloud Peak still faces the same shrinking market as the others.
On the generation side, utilities that have bet big on coal assets are in trouble as well. That means companies like American Electric Power (NYSE: AEP) – the utility that emits the most greenhouse gases emissions in the country – could be in for a world of hurt. The only saving grace for AEP is that it has already begun the process of retiring some of its coal plants, facing up to the reality of other EPA regulations. It has already planned to retire 6,600 megawatts of coal over the next few years. Still, AEP generated 73% of its electricity from coal as recently as 2012, so maintaining profitability – let alone achieving growth – will be difficult in a carbon constrained world. The outlook for Duke Energy (NYSE: DUK) and Southern Company (NYSE: SO) – two other huge coal-dependent utilities – is similarly fraught with financial pitfalls.
The historic EPA regulations will be highly damaging to anyone with a hand in coal, but it will not lead to the widespread economic malaise that coal boosters say. For one, the Obama administration chose an industry-friendly baseline year of 2005, a time when U.S. greenhouse gas emissions were at a peak.
Due to cheap natural gas, U.S. emissions have already declined by around 12% since 2005. That means, because of how EPA decided to calculate its baseline, we are nearly half way to the 2030 goal already. So, achieving the rest of the 30% reduction goal over the next 15 years can be done relatively painlessly.
Natural gas will fill a big part of the void left by coal – natural gas demand could rise by 45%, according to one estimate.
Utilities switching from coal to gas provides opportunities for natural gas companies. Chesapeake Energy (NYSE: CHK), the second largest natural gas producer in the U.S. (behind ExxonMobil), stands to gain from the dozens of east coast and Midwest coal plant retirements in the coming years. With its massive acreage in the Marcellus Shale, it is positioned to serve the rise of natural gas demand. Bloomberg reported last week on high levels of debt among many shale gas producers, auguring a coming shakeout in the industry. The big producers, like Chesapeake, should survive a shakeout and will be stronger as competition falls away. And with natural gas prices finally above $4.50 per million Btu after a winter of high demand, drillers are seeing the light at the end of the tunnel.
And Of course, the obvious winners of the EPA’s new carbon rules are generators of low carbon electricity. That means that companies like Exelon (NYSE: EXC) – the owner of the nation’s largest nuclear power fleet – will see an uptick in the viability of its reactors. There are also dozens of manufacturers, parts suppliers, and project developers for solar and wind installations that will be on the receiving end of a flood of new demand as coal plants shut down. Take a look at First Solar (NYSE: FSLR), a huge solar manufacturer, and SolarCity (NYSE: SCTY), a huge residential solar developer.
There is also GE (NYSE: GE), which may not be the first company that jumps to your mind, but ultimately stands to profit in multiple ways. It produces highly-efficient natural gas turbine systems, electricity management software, energy-efficient appliances for both consumers and industrial users, and also renewable energy (wind turbines and utility-scale solar projects). So it almost doesn’t matter what type of generation is constructed to replace coal, GE will surely make money either way.
The EPA regulations may not kill off coal, but they will inflict a mortal wound that will cause slow bleeding. On the other hand, there are plenty of eager companies waiting in the wings to pick up the pieces.