Four Stocks Set to Thrive in a Greener Economy

The polar bears are dying, deserts are expanding, and freak hurricanes are ravaging coastlines worldwide. Before long, you won't be able to ski in the Swiss Alps! No, it isn't just Al Gore saying these things--global warming and carbon dioxide are on a lot of lips these days. It seems more likely than ever that the U.S. government will eventually curb carbon emissions. In fact, there are almost a dozen bills shuffling through Congress as you read this.

The introduction of carbon regulation would be a watershed event, not only for our environment, but for many sectors of the economy, as well. We believe investors would be wise to both anticipate the related challenges and take advantage of the many great opportunities that may emerge. Unfortunately, we can't predict the exact form of any future legislation, but by studying the general themes of current proposals, we can point out some broad effects a greener economy will have on your wallet, and your portfolio.

How Would a "Carbon Tax" Work?
Most of the current proposals espouse a "cap and trade" system, similar to what we use now for sulfur dioxide (which causes acid rain). The European Union adopted such a system for carbon a few years ago in order to comply with the Kyoto Protocol. We think following in their footsteps makes sense, as we can learn from their experience and perhaps eventually form an efficient global carbon market.

The cap-and-trade system is simple in principle. In order to emit carbon dioxide, companies must buy credits, either from each other or from the government. The price of the credits will be set by the market. Of course, companies can also invest in technologies that reduce the amount of pollution they produce, or generate "offset" credits by investing in green projects, such as wind farms. In theory, by forcing companies to pay for their emissions, we will ultimately reduce the amount of pollution in the atmosphere and create a cleaner planet.

Unfortunately, implementation can be tricky. For example, how do we prevent companies from simply exporting their dirtiest operations to China? How do we make sure increasing electricity prices don't hurt low-income families? Should we give free credits to fund emerging technologies? Everyone has solutions for these issues, but instead of getting bogged down with details, let's focus on some general themes we see for the future, no matter how a carbon tax may be implemented.

Key Trends Following a Carbon Tax
For consumers, the most conspicuous change may be higher utility bills. About 50% of our electricity comes from coal, one of the most carbon-intensive ways to generate electricity. If carbon prices are high enough, utilities may choose to burn more natural gas, a much more "carbon friendly" fuel, and less coal. Natural gas is currently more expensive than coal, and greater demand for gas would drive its price even higher. Plus, utilities will have to pay for the carbon they emit. Ultimately, all of these costs will be passed on to consumers, leading to higher monthly bills.

The impact won't be limited to the utility sector. Carbon-intensive manufactured products, such as cement and steel, may become more expensive, as well, leading to more expensive cars and houses. Moreover, our economy might also react in completely unpredictable ways. For example, entrepreneurs may reforest pasturelands in order to generate offset credits, driving up the cost to raise cattle, and therefore beef prices. We can't predict all of these changes, but we will do our best to point you in the right direction.

The Winners
Carbon controls may be a game changer for many segments of the economy, especially the energy and industrial sectors. However, the laws may never pass. Or if they do, they may end up mere slaps on the wrist for our biggest emitters. Therefore, even with the prospect of astronomical returns, we think investors should not forget their margin of safety. We think the best way to profit from carbon is to identify attractive companies that will benefit from regulation and buy them at appropriate discounts to their fair value estimates. If Congress decides to act, great! You win! However, if nothing happens, you would still own some solid companies, and potentially earn a very good rate of return.

 Sempra Energy (SRE)
Moat: Narrow | Risk: Average | Price/Fair Value Ratio*: 0.88 | 4 Stars
Sempra is anything but a humdrum utility. In addition to providing gas and power to millions of customers in California, it has two businesses that will benefit tremendously from carbon legislation. First, the firm is constructing three liquefied natural gas (LNG) terminals in the United States and Mexico. As we burn more natural gas and less coal, we will strain our domestic supplies. We need to get gas from somewhere, and the most obvious place is the gas-rich Middle East. To receive these shipments, we need LNG terminals. With tight gas supplies and high barriers to entry for building new terminals, Sempra's assets could become enormously valuable. Second, Sempra has built up a formidable commodities and energy trading operation over the years. If an active carbon market develops in the U.S., Sempra can use its trading expertise to reap generous rewards.

 Waste Management 
Moat: Narrow | Risk: Average | Price/Fair Value Ratio*: 0.70 | 5 Stars
A trash hauler might seem like an odd choice for this article, but Waste Management happens to be the largest gatherer of landfill methane gas in the country. Methane is an insidious greenhouse gas--in terms of warming potential, one unit of methane is 23 times more powerful than a unit of carbon dioxide. Landfills happen to account for a third of methane emissions in the U.S. Waste Management basically puts tubes into its landfills, gathers up the methane, and uses the gas to generate electricity, which is sold into the grid. If we regulate carbon, not only would the company benefit from higher electricity prices, it may also receive carbon credits for not allowing methane to escape into the atmosphere. Granted, landfill gas is a relatively small segment of Waste Management's business, but we think it may provide an additional jolt of upside for this already-undervalued company.

 EOG Resources (EOG)
Moat: Narrow | Risk: Average | Price/Fair Value Ratio*: 0.73 | 5 Stars
This is perhaps an obvious choice, as EOG is a major independent North American natural-gas producer. This company owns some of the most attractive assets in the country and has one of the lowest cost structures in the industry. Even without the impetus of carbon legislation, we expect this company to generate solid returns for years to come because of its great reserves and shrewd management.

 Genesee & Wyoming 
Moat: Narrow | Risk: Average | Price/Fair Value Ratio*: 0.72 | 5 Stars
G&W owns a portfolio of 47 short-line railroads, primarily in the U.S. As fuel prices rise and efficiency improves, railroads are becoming ever more competitive with trucking, a trend we expect to continue. With an attractive and diversified asset base, and a disciplined acquisition strategy, we think G&W has built a narrow moat around itself, and the stock looks attractive at today's prices. Additionally, if the government decides to restrict carbon emissions, the picture looks even better. Moving goods by truck emits 300%-400% more carbon dioxide than moving them by train. Moreover, we think G&W is especially attractive, as its exposure to coal shipping is less than half the industry average, at 17% of freight revenues. Thus, the company should weather a decrease in coal demand much better than the typical rail operator.

* Price/fair value ratios calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, Jan. 11, 2008.

Brian Nelson, Paul Justice, Keith Schoonmaker, and Justin Perucki contributed to this article.