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Energy Investing in a Carbon-Conscious America

The political landscape has shifted toward cleaner energy.

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Given that the 110th Congress produced six carbon cap-and-trade bills and that President-elect Barack Obama has so far stood by his campaign rhetoric backing quick action on carbon, utilities executives and Beltway insiders have acknowledged that carbon regulation is coming in one form or another. We think this could have significant consequences for investors in the utility, energy, and transportation sectors.

On Thursday, the balance of power in the carbon debate again shifted sharply to the left when Rep. Henry Waxman (D-Ca.) unseated Rep. John Dingell (D-Mich.) as chairman of the House Energy and Commerce Committee. Although both are Democrats, the two men take very different views on carbon regulation. Dingell, a longtime ally of the automakers, has favored a slow, measured approach. His bill requires total carbon emissions to be 6% below 2005 levels by 2020. Waxman, along with Sens. Bernard Sanders (I-Vt.) and Barbara Boxer (D-Ca.), favors a 14% reduction from 2005 levels.

These days, committee chairs are not quite the feudal lords of your father's Congress. Ordinary members will have more to say in the carbon debate. The GOP staunchly opposes aggressive targets. Democratic Representatives who hail from coal states also are unlikely to support extreme action. Still, Rep. Waxman is a close ally of House Speaker Nancy Pelosi (D-Ca.), who has shown very little tolerance for dissent within the ranks and is keen to produce landmark legislation with her newly strengthened majority. Because Waxman will control the version of the bill that makes it to the House floor, we consider it a relatively safe bet that it will have to win his seal of approval.

In the Senate, the Lieberman-Warner bill briefly saw the light of day this summer before being voted down. There is a fierce debate about the bill's relatively lax targets, its cost "safety valve," and whether or not to include a Federal renewable portfolio standard. The bill garnered 54 votes in favor, and it would require 60 to be filibuster-proof. The Democrats could wind up with 59 next year; it is not outside of the realm of possibility that it will pass the next time, setting up a showdown with the House version. Sen. Boxer could also revive her more aggressive bill with a strengthened negotiating position.

As with everything in Washington, the balance of power in Congress and politicians' special interests likely will determine the victor. However, with the President-elect calling climate change one of his top priorities, the Democratic gains in the House and Senate, and the changing of the guard in the House Energy and Commerce Committee, the situation is getting very interesting.

Investing in a Carbon-Constrained World
So, what does this mean for investors? In the utilities industry we see two distinct camps taking shape, roughly approximating the potential winners and losers under carbon caps. Among the leading carbon-cap proponents--and potential winners--are utilities that produce a substantial amount of electricity from low-carbon or carbon-free sources, most notably nuclear power plants and renewables. In the other camp are utilities that produce most of their power from carbon-intensive fuel sources, most notably coal.

The extent to which individual utilities win or lose under carbon caps depends on politicians and regulators. If politicians take an aggressive stance, we think  Exelon (EXC), the nation's largest nuclear power producer, and  FPL Group (FPL), the nation's largest merchant wind power producer, should be winners for investors. About 10% of our fair value estimate for Exelon comes from our assumption that carbon caps take effect in 2012.

Natural gas should be another big winner. This low-carbon fossil fuel likely would replace the production lost from marginal coal plants and become the second-largest fuel source for U.S. electricity production. This is especially true over the intermediate term as there is currently an abundance of underutilized natural gas capacity already built. Most companies involved with natural gas production, transportation, and power generation should benefit from carbon caps. In the fund space, we like  iShares Dow Jones US Oil and Gas E&P ETF (IEO) for its large exposure to domestic natural gas producers and  PowerShares WilderHill Clean Energy ETF (PBW) for its broad exposure to clean energy technologies. Losers could include utilities  Edison International (EIX),  FirstEnergy (FE), and  PPL (PPL) because of the large share of earnings these companies derive from carbon-intensive power plants. High-cost coal and oil producers also could suffer.

If politicians pass less-aggressive carbon caps, we see fewer winners or losers. The proxy we have for this scenario is the Regional Greenhouse Gas Initiative (RGGI) that takes effect Jan. 1, 2009, for 10 states in the Northeast. Politicians made RGGI carbon caps so loose that utilities in the region likely will not have to make any changes to comply until 2014. By then, we expect new investments in low-carbon power generation sources and transmission should negate any significant effects.

For regulated utilities, the key question will be how each state treats carbon costs. If regulators in carbon-intensive states such as Wyoming, Kentucky, Indiana, West Virginia, and Ohio raise customer rates to pay for the higher costs, utilities should be mostly unaffected. However, if regulators balk at higher rates,  Allegheny Power (AYE),  American Electric Power (AEP), and  Dayton Power & Light (DPL) could face lower earnings and dividends. For regulated utilities such as  Pacific Gas & Electric (PCG) that already have low-carbon profiles, customers--not investors--are most likely to benefit if the company can sell its excess allocated carbon credits.

Mark Barnett also contributed to this article.

Travis Miller does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.