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Winners And Losers Of EPA’s Carbon Plan

Introduction

The United States is hoping to take drastic measures to cut its greenhouse gas emissions. However, with the U.S. Congress gridlocked and unable to take any meaningful steps on pretty much anything, the Obama administration has decided to act unilaterally using existing executive authority.

President Obama, through the Environmental Protection Agency, has proposed limits on greenhouse gas emissions from both new – and crucially – existing power plants. The target is coal, the dirtiest form of electricity generation. Coal currently accounts for nearly 40 percent of the total electricity generation mix across the country.

The EPA’s “Clean Power Plan” will cut carbon pollution by 30 percent below 2005 levels by 2030. While that overarching national goal is the headline number, each U.S. state has individual targets for reducing carbon pollution that it must reach. The rule will allow each state to come up with their own plan on how to achieve those emissions reductions. It could mean a renewable portfolio standard, energy efficiency, cap-and-trade programs, or a number of other policies.

The Wires

No matter what pathway states choose, it can be generally assumed that a lot more renewable energy is on its way. New solar, wind, and geothermal plants will take the place of dozens of coal-fired power plants that are set to retire. As a result, a truly transformational shift in America’s electricity grid will take place over the next few decades.

And that transition will require the construction of a lot of new high-voltage electric transmission lines – the wires to connect all the new wind towers and solar farms. Since the wind blows in certain places (the windiest areas are in a thick band that runs down the heart of the country, from Montana and the Dakotas down to Texas), and the sun shines the brightest in certain regions (mainly the southwest), new transmission will be needed to carry the electrons to businesses, factories, and homes. After all, the coal plants of today are not located in the electricity generating areas of tomorrow.

As the geographic makeup of electricity generation shifts, there is a huge opportunity in transmission. The U.S. will need somewhere in the neighborhood of $240 to $320 billion in transmission investment through 2030 in order to connect new sources of power, and also ensure reliability and security of the grid. For example, ICF, a consultancy, just published a report that concluded that the Clean Power Plan will result in at least $1.5 to $2.5 billion in additional transmission investment solely for extra security.

In particular, the Southeast and the Midwest will see the most coal plant retirements. An estimated 38 gigawatts of coal capacity will be taken offline in the Southeast, and 17 gigawatts will be shuttered in the Midwest. At the same time, huge volumes of wind power will be connected to the grid in Texas, the Midwest, and the Northeast.

The Midwest Independent System Operator (MISO) – or, the grid operator in the Midwest – will face challenges maintaining its wires as coal plants shut down and variable wind towers spring up. ICF projects that the MISO area will need at least $500 to $750 million in new spending just to keep the system safe. Importantly, much of that will need to be invested over the next five years.

The changing nature of U.S. electricity generation provides opportunities for a company like ITC Holdings Corp. (NYSE: ITC), the largest independent electricity transmission company, based in the Midwest. It is also one of the few pure plays in transmission. It manages the wires that can handle a peak load of over 26,000 megawatts. Its stock has slowly but steadily increased over the past ten years, with minor blips after the financial crisis in 2008. It has posted an annual average return of over 11 percent since it went public in 2005. ITC is growing its asset base, and is expected to approve dividend increases on the order of 10 to 15 percent each year. Below is a map of its operating assets, mostly located in the Midwest.

TransmissionChart

ITC is a regulated utility of sorts, and as a result, is ensured steady returns for its services. And its outlook is expected to improve: the Federal Energy Regulatory Commission (FERC) issued a new regulation in 2011 that laid out a policy of cost sharing for large transmission projects across multiple states. This is expected to pave the way for more and bigger transmission projects, which should work to ITC’s advantage.

Out With The Old, In With The New

Other than ITC, the problem with investing in transmission is that they are normally constructed by regulated utilities that also have power plants. You should probably steer clear of any financial adviser telling you that utilities are the investment of the future. The “death spiral” for utilities is looking more serious by the day and distributed energy poses a grave threat to the large monopolies of the 20th century. With that said, the one utility that truly gets it is NRG Energy (NYSE: NRG). NRG is holding onto a lot of coal and natural gas generation, which will weigh it down going forward, but it is trying to get ahead of the curve by building solar and wind. Those new assets will benefit from the Clean Power Plan and the new transmission under construction. It has over 2 gigawatts of solar and wind, and has launched a rooftop solar program, hedging itself in case distributed energy takes off.

And that brings us to the big winners of the EPA’s plan: solar and wind manufacturers and developers. On the upstream side, there is First Solar (NYSE: FSLR), a major builder of cheap photovoltaic solar panels. First Solar reported earnings per share of $1.89 for the fourth quarter of 2014, beating expectations. It is fine tuning the conversion efficiency of its panels, and upped the rate to 14.4 percent at the end of 2014, a 1 percent increase from the year before. But it has new factories in Malaysia that have shown test results hitting 20.5 percent efficiency. First Solar has always been the low-cost low-efficiency provider of solar panels, but now it is achieving more efficient panels while still offering low prices. In February, First Solar announced that it would form a Yieldco with SunPower, another manufacturer, which should lower their cost of capital.

First Solar specializes in large-scale utility-level solar farms, but if you prefer the rooftop approach, go with SolarCity (NASDAQ: SCTY). The California company is pioneering the no-cost down solar model, and it is exploding. As more coal plants shut down, the grid will rely more heavily on rooftop solar, and SolarCity has no serious rival in this space. The company is investing a ton of money in getting panels on people’s houses, which weighs down its balance sheet in the short-term. But over time, those outlays will turn into reliable, long-term revenue streams.

Conclusion

A lot has yet to be determined. The EPA is set to release its final proposal this summer and the states need to begin submitting their carbon reduction plans in 2016. Republicans and the coal industry are fighting tooth and nail to resist the EPA’s plan. But even if they can head off the EPA, coal’s days are numbered. And if the administration can finalize limits on carbon emissions, it will successfully force coal to yield a huge slice of America’s electric power market. That should provide an enormous opening for wind, solar, and for companies building all the wires needed to tie the grid together.




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