Fortunes in Cap-and-Trade

Respond to the editor
[email protected]
Richard Schlesinger

Although the electric industry has endorsed the concept of cap-and-trade as
the least onerous approach to carbon regulation, at least one major company
endorses it with unalloyed enthusiasm. Exelon not only supports the idea, it
stated in a second-quarter conference call to analysts, which it posted to
its Web site, that it expects to see a "$1.1 billion and growing annual
upside to Exelon revenues from implementation of Waxman-Markey." Is that
number real or simply wishful thinking? Does Exelon know something that's
escaped the rest of us?

Actually, if one makes a couple of assumptions, the potential earnings boost
is very real. Here's how it works. Exelon's 17 nuclear plants, the largest
nuclear fleet in the country, generated just over a record 132 million
megawatts-hours of power in 2007. That's fact. Assumption number one: The
Senate follows the House and passes an unchanged version of the
Waxman-Markey bill.

At the start of the program, about 85 percent of the permits would be given
away. Over time, the percentage of free permits would decline. About 15
percent of the permits would be auctioned off to begin with, and that
percentage would increase over time. What concerns us is the value of these
permits, because that value translates into increased costs for generation.
Which brings us to assumption number two: The EPA estimates that during the
early years of the program, a permit to emit one ton of CO2 would cost
approximately $15.

In the unregulated markets where Exelon operates, the price of power is set
by the last power plant dispatched to meet demand. In the Philadelphia area,
for instance, one of Exelon's markets, the last power plants to be
dispatched tend to be gas-fired plants, according to Hugh Wynne, senior
research analyst at Sanford C. Bernstein & Co. On average, Wynne said,
gas-fired plants emit one-half ton of CO2 per megawatt-hour generated.
Assuming the EPA's estimate of $15 per ton, that means an incremental cost
for gas-fired plants of $7.50 per megawatt-hour.

Coal plants emit twice the carbon as gas-fired plants, or one ton per
megawatt-hour generated. In order to level the playing field, Waxman-Markey
grants coal-fired plants a half-ton of CO2 for free for every megawatt-hour
produced. In other words, coal- and gas-fired plants would each incur an
additional cost of $7.50 per megawatt-hour. All things being equal, that
means the price of power sold into unregulated markets would rise by $7.50
per megawatt-hour.

Multiply Exelon's nuclear generation of 132 million megawatt-hours by the
price increase of $7.50 per megawatt-hour and -- voila! -- you get a revenue
increase of $990 million. Call it a billion dollars. As time goes on and the
carbon cap gets smaller, the price per ton should rise accordingly.

Tim Winter, utility analyst at Gabelli Funds, noted another possible boon to
companies with nuclear fleets. Certain coal-fired plants, particularly those
older plants that operate inefficiently, could find that once the price of
carbon allowances goes beyond a certain point, the price of power might fall
below their cost of producing it. In that case, the plant would shut down,
tilting the supply/demand equilibrium, creating a shortage of power, and
pushing the price of power even higher. Again, Exelon, as the lowest-cost
producer in the Northeast, would benefit.

Many Variables

So Exelon, as the low-cost producer, would benefit from the increased price
of power under a cap-and-trade scheme, which helps to explain the company's
enthusiasm for cap-and-trade. One would expect that companies such as
Florida Power and Light and Entergy, with nuclear capacity and markets that
are, at least in part, unregulated, would share Exelon's enthusiasm.

And so they do. Brent Dorsey, director of corporate environmental programs
for Entergy, endorses cap-and-trade as a "good first step" in regulating
greenhouse gas emissions, although from a strictly environmental
perspective, he would rather see a shorter timeline than Waxman-Markey
proposes. FPL Group's chairman and CEO, Lewis Hay, endorses cap-and-trade,
adding, "The sooner we can establish a price on carbon dioxide, the sooner
we can tackle climate change and begin the transition to the clean-energy
economy of the 21st century." And the sooner FPL can enjoy the benefits of
an increase in the cost of power cap-and-trade would deliver.

But even non-nuclear facilities could benefit under this scenario. Assuming
the relative prices of gas and coal remain as they are, the extra cost
incurred by coal should encourage companies that can to shift more of their
production toward gas, thus increasing margins.

While utilities may be motivated to switch to cleaner burning fuels, some
doubt they will be inspired to actually trade the credits. Edward Tirello,
managing director and senior power strategist for Berenson & Co., is one
such person. "The big money will be made by those that put up the capital,
trading folks like Goldman Sachs and Morgan Stanley."

But any kind of trading assumes a price that makes any risk involved
worthwhile. And although the EPA assumes a price of $15 per ton during the
early years of the program, the market doesn't support that price, at least
not today. The limited experience gleaned from the small volume of trading
that's taken place so far, such as what the Regional Greenhouse Gas
Initiative has sponsored, certainly doesn't come even close -- $3 a ton last
spring.

The political odds are also at play here, meaning no bill has yet to pass.
So the forecast by Exelon remains, at this point, wishful thinking. Whatever
profit actually materializes will depend on the price the market sets for
carbon, and on whether cap-and-trade ever becomes more than a theoretical
scheme to address the issue of global warming.