Article25 Aug 2015

Time to Price Carbon: Obama's Clean Power Plan Alters Energy Landscape

Citi GPS Opinion Article
The powerful impacts of President Obama’s Clean Power Plan (CPP) extend well beyond US energy prices and assets to global climate policies. The CPP is set to re-shape risk and return in US energy markets – whether or not it is implemented. The detailed 1,546 page plan introduces significant risks around carbon pollution liability into energy markets. Like any finance risk, it should be factored into prices and asset values. Hence, financial markets should start factoring in “shadow carbon prices” into investment decisions starting today.

The CPP is also a major step for US climate action going into the December United Nations climate negotiations, addressing the largest emitting sector in the US and sending signals that the world’s second largest emitter is ready to lead. But the key implication of the CPP for global climate policy is likely not what it means for the UN process, but rather that it increases the possibility that other nations are willing adopt similarly strong domestic policies at home.

As the plan faces a gauntlet of legal, political, and implementation risks up to its 2022 start date, what matters less are the details and more when and how much risks from carbon should be priced. In addition to legal risk, political risk should play out almost daily on cable news in dramatic pronouncements from the menagerie of Presidential candidates.

This GPS Opinion explains (1) why we need to start pricing in carbon risk in energy and financial markets, (2) why conventional wisdom on commodity prices and energy assets may be naïve, and (3) what CPP means for global climate policies.

(1) Time to Start Pricing in Carbon Risk
Directionally, we know which way the economics are shifting, with energy firms supporting or factoring in carbon prices, governments laying out emissions plans, and the public increasingly concerned about extreme weather and climate events.

What we don’t know is when or how much these incentives will affect investment decisions and power prices. The organizing facts and principles are simple: the power sector is responsible for ~40% of US carbon emissions, and coal is responsible for three-fourths of those. The complexity of the plan and multiple possibilities for how it could be implemented will make it difficult for investors to quantify risks. The question is therefore how to dynamically price carbon risk as new details emerge on the long road to 2022.

The most straightforward way to price the risk in investment decisions is to assume what the carbon price will likely be. Effects on energy and financial markets should be felt almost immediately, as (1) power assets typically last 20 to 60 years; (2) CPP creates (nominal) incentives for early compliance; and (3) commodity futures curves should start reflecting potential costs of compliance for carbon pollution.

The CPP explicitly encourages a trading system. In a market-based system, the price of carbon should be set by the marginal abatement cost. But the rule will not necessarily result in an economically optimal carbon market, adding a wrinkle to economic forecasting. For instance, coal-to-gas switching looks like “low hanging fruit” in carbon markets, but policy makers may prefer renewable energy for other reasons, which can be more costly near-term.

Other carbon markets offer some signposts, but for now, it may be “safe” to assume a carbon price somewhere between $0 and $50/ton. Emissions pricing has ranged between €0 and €30/ton in EU’s Emissions Trading System (ETS) and between $11 and $23/ton in California’s AB32. The US government puts its “social cost of carbon” at ~$37/ton, though possibly higher depending on assumptions.

In the early days of the plan, the marginal cost of abatement will most likely be set by coal to gas switching in making gas more competitive than coal. For example, at $35/ton for Illinois Basin coal and $3.5/MMBtu Henry Hub gas, the marginal generation cost could be ~$19/MWh for coal and ~$26/MWh for gas. This could lead to a theoretical carbon price of ~$14/ton. Other commodity price dynamics are involved, but this could be the first step.

(2) Upending Conventional Wisdom on Winners and Losers of Commodity Prices and Asset Values
Conventional wisdom suggests that coal is the biggest loser in any climate plan, renewables the biggest winners and gas should benefit somewhat. However, this expected outcome is not guaranteed; in alternate scenarios, coal is much less of a loser, renewables get less support and gas becomes more of a loser. An example is the European power market, where commodity prices and renewable energy policies have at many times been more influential than carbon prices.

How these scenarios play out depends on (a) relative prices of gas and coal; (b) the value of emission credits, which may make or break generation economics of fossil fuel; (c) renewables tax credits; and (d) regional electricity demand growth as a function of energy efficiency and demand response efforts.

Prices and asset values of coal and natural gas
Despite our base case assuming that coal’s share in total generation would fall from the mid-30s% in 2015 to 25% in 2030, natural gas demand for power generation could fall in a credible alternative scenario, thereby dragging down gas prices. Coal’s share in generation may only fall to around 30%, too.

Although coal assets are supposed to be a major loser from the CPP, how the CPP affects coal assets is far from pre-determined; variables in gas and renewable energy markets may shape how badly those losses are. CPP’s risk to reserves values may be more of an issue for coal company creditors as they evaluate asset coverage for a sector facing distress or for potential bidders for distressed mining assets. Longer-term restructuring may allow a smaller sector to emerge leaner and meaner to better compete under the new rules.

Impacts on natural gas reserve assets will be function of CPP’s impacts on gas price. See the report “The New American (Gas) Century II” for details.

Electricity prices and valuation of renewable energy assets
While assets should also price in “avoided future liabilities” that disadvantage fossil investment, the effect of CPP as a positive incentive for renewable energy investment may be weaker, as the market cannot yet easily price CPP’s incentives or lend against them

Until this plan is translated into concrete economic incentives that investors can comfortably translate into cash flows, the renewal of the Production Tax Credits (PTC) and Investment Tax Credits (ITC) should remain much more important for renewables’ future. Programs within the CPP, like the Clean Energy Incentive Program (CEIP), support renewable energy, but the lack of detail and how CEIP interacts with the carbon market remain uncertain.

Several key risks remain for renewables investors looking to the CEIP for support in the near term including: (1) Risk to value of credits: the precise level of their value is unknown they are positive; (2) Process risk: How and when the credits will be delivered, and who takes title when; (3) Timing risk: If a state ends up delayed in submitting its plan, a project could lose several years’ worth of credits; and (4) Political risk: potential discord between state implementation and Federal implementation.

Nonetheless, consumers should benefit in the end, as the risk may be biased toward lower power prices over time. Greater energy efficiency, more demand response programs (especially during peak demand hours) and the increased deployment of rooftop solar should reduce the overall grid-connected electricity demand, with impact on peak power demand. Keeping electricity demand flat to lower should put downward pressure on power prices.

(3) Assuming Leadership in Climate Negotiations
The CPP is a major step for US activity on climate change, with the US assuming much of the needed policy leadership. It puts the US in a strong position going into the Paris COP21 climate negotiations this winter, sending credible signals that the US, as one of the world’s top emitters, is ready to lead. But as long-term observers of the UN process know, the objective of coordinated, enforceable emissions caps has been elusive.

For the US to assume an even stronger leadership role, the CPP requires additional reductions beyond the power sector to meet more aggressive carbon targets. Our analysis shows that the combination of CPP and existing policies outside of the power sector may only reduce US economy-wide carbon emissions by 19% in 2030 vs. 2005’s level, short of the 26-28% goal President Obama announced in November 2014 with China’s Xi Jinping at the APEC summit.

The key implication of the CPP may be that it increases the possibility that other nations are willing to take on similarly strong domestic policies at home, whether or not the UN process yields any action or headlines.

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