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Which Utilities Benefit From New Emissions Regulation?

Matthew Coffina, CFA
Charles Fishman, CFA

Matt Coffina: For Morningstar StockInvestor, I'm Matt Coffina. I'm joined today by Charles Fishman, who is an equity analyst on our utilities team. We're going to talk about how utilities are affected by carbon dioxide emissions regulations. Charles, thanks for joining me.

Charles Fishman: You're welcome.

Coffina: So, the EPA has this Clean Power Plan that's in the works right now. Can you explain a little bit about how this came about?

Fishman: Well, you've got to go back to 1970. The Clean Air Act was started back when people started getting concerned about air pollution a long time ago. It was amended in the 1990s to address other pollutants. And a few years ago--actually, it was 2007--the Supreme Court ruled that the EPA needs to be concerned about greenhouse gases. With that, the EPA had its marching orders, and they developed a draft of the Clean Power Plan, which they released last year.

Coffina: So, the Clean Power Plan has certain building blocks that are supposed to reduce carbon dioxide emissions. Could you walk us through those building blocks?

Fishman: Sure. There are four building blocks that the EPA decided on. [The first is] making plants run more efficiently; [the second is to] make the end user be more efficient with the power. For both of those, the cleanest kilowatt hour is the one that you need less fuel to make, so that's [the strategy for reducing emissions there]. Those are sort of the easiest ones, and they also were the smallest as far as the percentage of reductions that the EPA estimated.

The biggest block, about 40%, is using sources that don't produce carbon dioxide or produce very little. Those would be nuclear and, of course, things like wind turbines and solar. And then, finally, switch to lower-carbon-intensity fuels--for example, natural gas. So, those were the four building blocks. The two biggest [reducers of emissions] are [not using sources that produce carbon dioxide or using] natural gas. That's about two thirds of it.

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Coffina: So, the Clean Power Plan isn't a done deal at this point. It's still going through a multiyear review process. How do you expect the final regulation to change versus the version that's out there today?

Fishman: First of all, at Morningstar, we think it's going to happen. People say, "Well, we're going to have a new president, what if he doesn't like it--Republican or Democrat?" I'd say that the Clean Air Act started under a Republican. So, I don't think it's going to matter as far as having the legislation. It certainly could impact the details of it--and the devil is always in the details.

So, how will it change? I think the first thing [to note] is that it's a very short timeline that the EPA is on. You have to start making these reductions by 2020. In the world of utilities, that's too fast. It just can't happen that fast. I think the timeline is going to be extended. I think that'll be the main thing. I think the total reductions are achievable, and I think most utilities people believe they are, so it's just a question of how long it takes.

Coffina: So, let's take a look at which utilities are best positioned for the Clean Power Plan. Maybe we'll go industry by industry. How about just regular integrated regulated utilities?

Fishman: Sure. People [might be surprised] because the two utilities we've identified are ones that have a lot of coal--Duke Energy (DUK) and Southern Company (SO). You might say, "Well, they produce a lot of carbon dioxide. Why would Morningstar recommend them?" It's because they will have to modify their fleet, retire coal plants, build natural gas plants, and put in more renewables--probably wind, some solar.

Those two operate in what we refer to as constructive regulatory environments. Southern in Georgia and Alabama. Duke in North Carolina, South Carolina, Florida, and Indiana. These are states that have acted reasonably in the past, and we think they will in the future.

Coffina: So, how about unregulated generation?

Fishman: Unregulated, we have two names there. Exelon (EXC), obviously, is the biggest operator of nuclear energy in the country-- private company in the world as far as private utilities. It's going to benefit. We need nuclear generation. It's carbon-free. Calpine (CPN) is the other unregulated generator. It's the largest and probably most experienced as far as the number of units of natural gas combined cycle plants in the world. So, that's the technology that the EPA has recommended, and Calpine will benefit from the increase in that.

Coffina: How about on the transmission side? Do you see transmission utilities benefiting?

Fishman: Yes. Now, there are a lot of utilities that have transmission, but there's only one publicly traded company that is totally focused on transmission--that's ITC (ITC). In addition, it's located in the central part of the country. That's where there is going to be more wind. Obviously, if you've ever driven through the Midwest, the wind turbines are in the middle of nowhere. You've got to get them to where the electricity is being used; that's done by transmission.

Coffina: And lastly, we also see some opportunities for natural gas infrastructure. Which companies would you call out here?

Fishman: Dominion Resources (D) is the company we recommend for that. It's a company that has a wide moat. We like it for a lot of reasons, but one of the principal reasons is that, under the Clean Power Plan, you will build more natural gas plants. If you are going to build more natural gas plants, you've got to get natural gas to those plants. Dominion builds gas transmission lines, and they will benefit from the Clean Power Plan as well.

Coffina: So, I think a lot of investors see carbon dioxide regulations as a negative for the utility sector. It sounds like from what you just said that there are also a lot of companies that have opportunities from this. Is that fair to say?

Fishman: Absolutely. And we named some of the ones that would benefit. The companies that could potentially get hurt by this are companies that are in states that have had unfavorable regulation as well as unregulated utilities that have a lot of coal generation--those are the two that investors should be careful about.

Coffina: Thanks for joining me, Charles.

Fishman: You are welcome, Matt.

Coffina: For Morningstar StockInvestor, I'm Matt Coffina.

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