The Dark Side of Cap-and-Trade

On the evening of June 26, the US House of Representatives passed HR 2454, “The American Clean Energy and Security Act.” The legislation, more commonly known as the climate bill, was ratified by a narrow 219-to-212 margin.

A lengthy delay would have inconvenienced the Obama administration; climate talks were again at the top of the agenda at the Group of Eight Summit in L’Aquila, Italy earlier this month.

In addition, the existing Kyoto Protocol is due to sunset in 2012, and the Copenhagen Climate Summit scheduled for December is expected to yield a framework for post-Kyoto Protocol carbon emissions reductions targets.

With the Copenhagen Summit looming, President Obama undoubtedly does not want to arrive empty-handed with no discernible movement on a US climate bill.

Next year is a mid-term election year and, despite a majority in both houses of Congress, it will be far harder to push through controversial legislation, especially if Obama’s approval ratings begin to slip. That means trying to squeeze in a vote on both climate change and health care as quickly as possible this summer.

Although the speedy House vote was a victory for Obama, the climate bill is by no means a done deal. Obama and the Democratic leadership in the House lobbied hard for the HR 2454 over the last few weeks; given the political capital expended, the bill’s failure would have been a major setback for the administration.

Despite intense efforts, the bill passed by an extremely narrow 219-to-212 margin, with 44 Democrats voting against the bill and eight Republicans voting in favor.

The bill’s passage indicates the president still has significant power to push his agenda in Congress if he lobbies hard enough, but it hardly shows overwhelming Congressional support for cap-and-trade legislation.

The Senate will be an even more hostile venue for the proposed climate bill than the House. Although the president likely will lobby the Senate hard for passage, the bill has little or no chance of passing in its current form; there are simply too many moderate Democrats who will side with Republicans to water down certain provisions.

I suspect that the earliest a climate bill would pass into law is September or October of this year, but it’s quite possible that no such law will pass this year.

Any bill that does gain approval probably will look substantially different than HR 2454 and involve substantial concessions to the opposition.

HR 2454 is a mammoth, 1,200-page bill filled with many complex clauses and definitions. What follows is a rundown of some of the main issues, provisions and controversies.


The bill amends the US Clean Air Act, establishing a cap-and-trade system designed to reduce US greenhouse gas (GHG) emissions 17 percent by 2020 and 83 percent by 2050. The baseline year for calculating US GHG emissions reductions under the Act would be 2005, when the nation emitted the equivalent of about 7,250 million metric tons of carbon dioxide (CO2).

Under a cap-and-trade system, the government sets absolute caps on the total amount of emissions and then allows emitters to trade allowances amongst themselves; in this case, each emissions credit would be worth 1 metric ton of CO2 equivalent.

For example, if one utility emits too much carbon in a given year, it could buy emissions credits from a firm that emits less than allowed. This effectively puts a price on carbon emissions, encouraging firms that emit too much carbon to cut back and directly rewarding those companies that emit less than allowed.

The basic mechanism is similar to the existing cap-and-trade system for sulfur dioxide emissions that cause acid rain.

The government isn’t setting direct caps on individual consumers; rather the caps would only pertain to companies emitting more than 25,000 tons of carbon or more per year. Such firms, accounting for about 85 percent of US emissions, are known as covered entities.

The headline reduction figures of 17 percent by 2020 and 83 percent by 2050 pertain to emissions from covered entities, not to the economy as a whole.

These firms would include upstream producers like energy companies, refiners and gas producers as well as downstream emitters like power companies (utilities), industrial plants and local gas distribution firms.

But the bill doesn’t restrict carbon emissions trading to covered entities: Banks and other financial institutions can buy and sell credits to and from covered entities or other banks. Some object to allowing banks and other non-industry players into the carbon trading game, but this is a facet of most cap-and-trade systems globally and tends to increase liquidity.

It’s a lot easier to control emissions from 7,000 covered entities, but individual households also will be affected indirectly; caps on carbon emissions will raise the price of energy for consumers. The amount of this increase is open to debate, but most groups–liberal and conservative–agree that energy prices will go up.

Allocate vs. Auction

Another key area of debate has been how the government would distribute carbon emission credits to covered entities. At the risk of overgeneralization, it’s fair to say that more liberal elements and environmental groups typically favor the auction of credits.

Under such a system the government would establish the total amount of allowances available and then auction them off to the highest bidder, decreasing the supply of credits each year in line with emissions reduction goals. This method likely would result in higher prices for emissions immediately and would directly raise revenues (a sort of tax) for the federal government.

A second method for distributing allowances is through allocations. Under such a system some or all of the credits are given away to certain companies, which can then sell those credits to other covered entities or to non-covered entities (like banks) for trading.

This approach would still put an effective price on carbon, as the credits would be worth something on the secondary market; however, the ramp up in carbon prices would likely be smaller and more gradual. Industry groups and conservative policymakers typically favor this system.

During the presidential campaign and early in his term, Obama repeatedly favored a 100 percent auction system; the White House backpedaled a bit on this issue once it became clear that such a solution would be a tough sell in the legislature.

In the end, HR 2454 settles the debate with a sort of compromise. At first, most emissions credits will be distributed for free to certain covered and non-covered entities.

Although it might seem odd to give away credits to companies that aren’t subject to emissions caps, the credits still have value; by allocating credits to companies, the system essentially subsidizes their activity.

For example, credits could be assigned to energy research and development projects as a means of funding those deals or to auto manufacturer to encourage the production of fuel-efficient vehicles.

Gradually, the system shifts towards a 100-percent auction system. In 2016, for example, only 17.5 percent of total allowances will be auctioned, but that percentage jumps to 71.7 percent in 2030 and to 100 percent by 2033.

The decision to include a front-end loaded allocation system reflects efforts to dampen the higher energy prices that would surely result if a 100-percent auction system were implemented immediately.

Here’s a chart showing how credits will be allocated in 2016.

Source: Congressional Research Service

As you can see, most of the allocations go to local distribution companies (LDC), utilities that sell electricity and natural gas to consumers at regulated rates. In turn, these companies must apply much of the value associated with these credits to programs designed to lessen the impact of higher energy prices on consumers.

This could be accomplished through direct rebates, funding energy efficiency programs or providing support to low-income users. Much of the value the Federal government receives will also accrue to consumers, at least in the early years of the plan; of the credits slated for auction in 2016, 15 percent (86 percent of the value of auctioned credits) would be re-directed back to low-income consumers.


HR 2454 also includes a mechanism for carbon offsets, a feature of most existing carbon trading schemes around the world. This program enables companies to offset some of their emissions by funding projects designed to reduce global GHG emissions.

For example, if a company were to plant trees in Brazil to counteract deforestation–trees take in CO2 as part of photosynthesis–such a project might be used to offset emissions from a coal-fired power plant in Ohio or New York.

There are provisions in the bill that outline exactly how many offsets a covered entity can use to meet its targets. After 2017, domestic emissions credits and international offsets will no longer be equivalent on a 1-for-1 basis; it will take 5 metric tons of offsets to equal 4 metric tons worth of emissions credits.

Depending on how widely the offset system is used, some groups estimate that it could reduce the cost of emissions credits by as much as 50 percent compared to a system that doesn’t allow international offsets.

Trade and Leakage

This particular element of the bill is highly controversial, though it has been significantly watered down.

Carbon leakage refers to the risk that if the US establishes a carbon cap-and-trade system, companies will shift production abroad to regions where there is no such system or the terms are more favorable. Goods imported into the US from regions without cap and trade systems have a competitive advantage over US-produced goods, which would suffer from higher production costs.

The proposal included in HR 2454 is to create a de facto tariff on imported goods from countries deemed to have “insufficient” cap-and-trade policies. Those importing energy-intensive goods from such countries would also have to purchase “international reserve allowances” based on the amount of carbon produced before those goods would be allowed into the US.

There are numerous problems with such a clause. The two biggest are that it would be likely to spark a trade war with countries such as China and is probably illegal under international trade rules. HR 2454, however, states that this provision can’t go into effect until after 2025 and is then contingent on executive branch approval.

Renewable Energy and Efficiency Standards

Many investors believe HR 2454 is a bill solely designed to reduce carbon emissions gradually via a cap-and-trade system. But there’s another significant aspect of the bill that gets little or no press attention: A renewable energy standard (RES).

I find the lack of attention on RES surprising; in some respects, it poses even bigger challenges for energy firms than carbon cap-and-trade.

The bill states that retail electricity suppliers must meet at least 20 percent of electricity demand via renewable energy sources such as wind, solar, waste-to-energy and geothermal power.

The exact schedule of targets laid out under HR 2454 is summarized in the following chart.

Source: Congressional Research Service

The requirement for RES ramps up quickly starting in 2012. The bill not only effectively requires companies to reduce their GHG emissions but also mandates how they’re to accomplish that task.

Just as important as the RES is the debate over what constitutes “renewable” energy. According to standard definitions used by the Energy Information Administration (EIA) and other governmental and non-governmental groups, renewable energy would include wind, solar and other alternatives as well as hydropower.

But if the purpose of RES is to reduce carbon-emissions, some have suggested that any RES should be expanded to include nuclear power.
HR 2454, however, adopts a fairly specific definition of renewable energy. The list includes solar, wind, geothermal and other lesser-known alternatives such as wave and tidal generation.

In addition, HR 2454 classifies some hydropower sources as renewable energy, but the qualifications are stringent: There can be no water elevation changes at existing dams. There’s speculation that this requirement will ultimately be relaxed in the final version of the bill, allowing far more hydropower plants to qualify under the RES system.

Under the terms of the bill, generators must submit enough renewable energy credits (REC) each year to meet their RES targets. Companies receive RECs based on the amount of renewable energy they generate–there’s no auction or allocation.

RECs function in a way that resembles carbon emissions credits; each REC represents one megawatt-hour of renewable generation in much the same way as one emissions target equals the emission of one metric ton of CO2.

Also, like emissions credits, RECs can be traded and banked; companies that generate higher percentages of RECs than required can sell excess RECs to other firms. Companies can also save RECs as needed to meet future requirements.

It’s also worth noting that the bill would allow companies to meet up to 20 percent of the RES by promoting energy efficiency rather than generating alterative energy. Examples of efficiency initiatives include the use of combined heat and power plants, dual-purpose facilities that generate heat for industrial uses and electricity.

Efficiency credits are also available for the use of solar water heaters or the installation of smart meters and other so-called Smart Grid technologies. Rather than overhauling the traditional electric grid, Smart Grid technologies make it easier to monitor and manage the flow and use of power through the existing system.

In addition, the governors of individual states would be able to request that the allowance for efficiency credits increase from 20 to 40 percent.

In summary, the RES in HR 2454 offers companies a number of different ways to meet these requirements, including more renewable generation, the purchase of REC credits, or energy efficiency investments.

As written, the RES would not define nuclear power as a renewable energy and would exclude most hydropower stations; I would not be surprised to see a Senate version add more incentives for nuclear power or widen the definition of qualified hydropower.

HR 2454 Winners and Losers

HR 2454 has received a decidedly mixed reception from the industry. Several of the major utility companies, including Duke Energy (NYSE: DUK) and Exelon (NYSE: EXC), have broadly endorsed the legislation.

Although the bill certainly isn’t a positive for their business and will raise costs, I suspect the utilities that have supported HR 2454 recognize that a climate bill of some sort was inevitable. These firms chose to get involved in crafting the legislation rather than opposing it outright; the auctioning of credits, rolling compliance window, international offsets and the large efficiency component of the RES are all elements of the bill that are relatively friendly to electric utilities.

Two of the more obscure provisions reveal the electric power industry’s handwriting in the bill. First, the bill essentially leaves loan guarantees for the nuclear power industry in place. Although power companies undoubtedly would have preferred to see nuclear included in the RES, HR 2454 isn’t as clearly anti-nuclear as might have been expected.

Second, the bill also contains language mandating that the government take steps to clear regulatory hurdles for carbon capture and sequestration (CCS) technologies.

By capturing CO2 emitted from power plants and storing that gas permanently underground, CCS represents a way to make coal plants more economic in a world where carbon dioxide emissions are regulated.

Other groups, including the American Petroleum Institute (API), oppose the bill, arguing that the allocations of allowances is inequitable and that it will raise gasoline and electricity prices for consumers.

As you can see from the pie chart above, refiners receive a small allocation of free credits but it’s tiny relative to the amount earmarked for electricity LDCs. Also bear in mind that there are no free credits for oil or natural gas producers (the companies represented by API).

It’s unclear exactly how high energy prices will rise, but there’s no such thing as a free lunch; consumers will ultimately pay more for energy in a carbon-regulated world.

Broadly speaking, it’s fair to say that the bill is not as negative for the energy industry as a whole. And I expect that the bill will undergo further industry-friendly revisions if it’s to pass the Senate.

Perhaps even more important, in typical Washington fashion, the politicians have more or less kicked the proverbial can down the road; as written, the bill wouldn’t go into effect until 2012, and the reductions mandated are relatively small in the first few years after the cap-and-trade system goes into effect.

Back in April I attended the EIA’s conference in Washington, DC. One of the speakers was Mike Rowe, CEO of Exelon. One of the key points he made is that reducing emissions is relatively inexpensive up to a point–there’s a good deal of low-hanging fruit to be picked.

Exelon put together a chart that estimated the costs of various carbon abatement methods. According to that presentation, Exelon believes that some energy efficiency initiatives and upgrades to existing plants actually have a negative cost, meaning that such measures save more money than they cost to put in place. According to the company’s internal estimates, carbon savings up to around 5 million or 6 million metric tons would essentially be free.

But there is a point where companies have to spend money to cut emissions. For example, additional nuclear generation capacity would cost about USD45 per metric ton of CO2 saved.

Alternative energy solutions incur even higher costs; for example, solar photovoltaics (PV) cost more than USD700 per ton of carbon without subsidies and more than USD250 under the current subsidy regime.

To put these numbers into context, every USD10 spent on saving 1 ton of carbon emissions raises electricity prices by about 1 cent per kilowatt-hour. As of March, the average price of electricity delivered to residential customers was just under 11.4 cents per kilowatt hour; it’s easy to see how quickly carbon abatement can have a meaningful impact on actual electricity prices.

Rowe went on to explain how renewable energy standards can be even more expensive depending upon how they’re enacted. The reason is simple: Alternatives like solar PV and wind are among the more expensive carbon abatement methods–any law that requires a certain percentage of renewable power will be expensive.

According to one estimate referenced in Rowe’s presentation, California’s strict renewable portfolios standard would raise the average retail price of electricity in the state from an already high 15 cents per kilowatt hour to about 30 cents per kilowatt hour.

Bottom line: The short-term impact of HR 2454 will be fairly mild as companies pick the low-hanging fruit to cut emissions, but it will become increasingly expensive as time goes on. The RES included in the bill is relatively benign compared to some of the state-imposed standards currently in place, so its impact will also be minimal in the short term.

How to Play It

Alternative energy companies are probably getting the most attention as potential beneficiaries of HR 2454; after all, the use of these technologies would be mandated by the RES, and putting a price on carbon tends to make energy sources that don’t emit carbon more attractive.

But don’t go overboard; the bill isn’t a legitimate reason to aggressively buy alternative energy stocks.

First, passage of some sort of climate bill is already factored into the group–the passage of HR2454 was already largely factored into the sector. And second, the near-term benefit for alternative energy firms is relatively small as the bill would have only minimal impact on firm behavior in the short run.

Among alternative energy plays one of the more obvious winners is Red, White and Blue Portfolio holding Itron (NSDQ: ITRI).

Itron is a leading play on energy efficiency and Smart Grid technologies, a key, near-term component of cutting carbon emissions and meeting RES. In addition, both HR 2454 and the stimulus bill passed earlier this year include direct subsidies aimed at promoting efficiency and building a more intelligent electric grid.

Beyond alternatives both natural gas and nuclear power are big winners from HR2454. Natural gas emits about half the CO2 of coal to produce the same amount of electricity, and natural gas plants are relatively easy to site and can be constructed far more quickly than coal or nuclear facilities.

In addition, the US is energy independent when it comes to natural gas. In North America, the outlook for natural gas production has changed rapidly over the past five years thanks to the rapid development of unconventional natural gas reserves such as the Barnett Shale of Texas, the Haynesville Shale of Louisiana and the Montney Shale in Canada.

Finally, natural gas and alternative energy go hand-in-hand. Alternative energy sources like wind and solar are by definition intermittent. Power isn’t stored on the electric grid, but supply and demand must be balanced at any given point in time. Therefore, the spikes and lulls in output from alternative energy sources must be balanced by shadow capacity.

In other words, when power output from wind facilities hits a lull, producers need to have gas plants that can be fired up quickly to feed power to the grid and compensate. Countries that have major wind power capacity have typically relied on gas as this back-up source of power; I suspect the same will be true in the US.

In the short run, all the negative news is already well known and largely priced into the natural gas market. Inventories of natural gas are bloated and most are expecting a cool summer (negative for gas demand) and an uneventful hurricane season.

Few are talking about the fact that the latest data from the EIA suggesting that US natural gas production is already falling sharply. The number of rigs actively drilling for natural gas has fallen by more than 60 percent last summer; that drop-off in drilling activity is impacting production and that effect will continue to strengthen for the remainder of 2009.

Meanwhile, industrial demand for gas plummeted in late 2008 and early 2009 alongside the broader economy. But the main indicator of industrial gas demand is industrial production.

Source: Bloomberg

Industrial production figures have begun to run higher in recent months; US gas demand should continue to stabilize through the balance of 2009. Stabilizing demand and falling supply will spell higher prices by year’s end. I’m looking for gas to rally from current prices around USD3.50 per million British thermal units (MMBtu) to around USD6 per MMBtu.

The most direct play on natural gas is US Natural Gas Fund (NYSE: UNG), an exchange traded note that tracks the price of near-month natural gas futures. US Natural Gas Fund rates a buy under USD15.

Alternatively, exploration and production (E&P) firms with a focus on prolific unconventional natural gas reserves should benefit from higher prices. XTO Energy (NYSE: XTO) has been one of the most consistent performers among the gas-focused E&Ps and has an extremely low cost of production relative to its peer group.

XTO is highly acquisitive and has amassed an impressive acreage position in the hottest unconventional natural gas plays in the US. The company has exposure in the Rockies, the Marcellus Shale, the Barnett Shale, the Fayetteville Shale and in the Haynesville. Roughly 80 percent of XTO’s production is gas, although the firm does have an acreage position in the Bakken oil play.

XTO has a history of making many small “bolt-on” acquisitions each year. This year, XTO has made several deals, including the acquisition of acreage in the Marcellus Shale from Linn Energy (NSDQ: LINE). XTO most recently purchased a large tract of land from Hunt Petroleum.

As a result of these deals, XTO now has a huge inventory of acreage in well-understood gas-producing regions. This gives XTO plenty of drilling prospects for years even if the firm doesn’t do any more deals. XTO Energy rates a buy under USD50.

Finally, loan guarantees for new nuclear plants remain intact in the climate bill and will help to kick-start the construction of a new generation of nuclear plants in the US. Moreover, nuclear remains the largest source of carbon-free energy in the US; putting a price on carbon emissions makes nuclear less expensive relative to other forms of energy production.

Because nuclear power is a baseload source, it will ultimately play a larger role in meeting US power demand and carbon emissions guidelines than either wind or solar. Finally, I suspect a Senate version of the climate bill might even include some more direct subsidies for nuclear power.

For a low-risk play on nuclear power, consider Beyond our Borders Portfolio holding Electricite de France (France: EDF, OTC: ECIFF) the French national electricity company that is a key player in the expansion of nuclear power in the US and Great Britain as well as France. 

Alternatively, the key fuel for nuclear plants is uranium; Cameco (TSX: CCO, NYSE: CCJ) is the world’s largest pure-play uranium producer. The company taps what are the world’s richest and highest-grade uranium mines.

To put this into perspective, some of Cameco’s mines have ore grades over 20 percent uranium oxide; some mines being mined globally and commercially have ore grades less than 0.5 percent.

This contributes to the fact that Cameco’s cash costs for uranium are among the lowest in the world at under USD20 per pound. This is also why the company was among the only players to survive the long uranium bear market intact.

Cameco sells much of its production under long-term contracts. Therefore, during strong uranium markets, realized prices rise far more slowly than for producers selling mainly through spot markets. But in markets like this, Cameco is still rolling over legacy contracts signed four or five years ago and earning much higher rates.

Of course, the stock isn’t without risk. Further delays to its already troubled Cigar Lake project are inevitable in my view, but those issues are already priced into the stock and Cameco should see steady growth in production in coming years.

The 800-pound gorilla of the industry, Cameco rates a buy under USD30.

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