Carbon Leads Long List of Electricity Market Risks

Kathy Carolin Larsen, Editorial Director, Platts Noth American Electric Markets

With concerns over global warming rising, federal carbon emission mandates are expected in the next five to ten years—a step Europe is encouraging. Already various states are implementing their own regulations, creating a mismatch of rules that hinder comprehensive planning for power suppliers.

WHEN TALK OF BUILDING NUCLEAR PLANTS in the U.S. gets really serious, there's no doubt it's a new day. A carbon-conscious day.

Some in the power industry are clearly ready to try investing in nuclear, at least in part to lower their risk of big, future carbon liabilities, which look suddenly more concrete going into 2007.

But carbon is hardly the only risk the industry is having to navigate, although it's a huge one and likely to be the longest-lived.

When Congress passed the Energy Policy Act in 2005 (EPAct), some of its intent was to give industry new certainty for investment. Some of the provisions, though, opened new opportunities for unpredictability, especially in the area of state-federal conflict, which is classic in the U.S. power industry structure.

A good example is transmission. EPAct established a process for getting important new transmission facilities built, to shore up an old system that needs investment and to relieve congestion on lines into growing load centers. A key element is new federal power to designate critical needs and to override state opposition to new power lines.

The process had barely begun when conflicts started. Companies and system operators proposed lines that the Department of Energy should put on its "critical" list, but some states, including California, took offense at DOE's failure to consult with them.

A group in New York state took offense at what a brand-new member of the Federal Energy Regulatory Commission said about siting new lines, before he had yet become a member, and he had to pledge to recuse himself if the line that group opposes ever reaches FERC for a decision.

This uncertainty comes even as "there's a ton of money out there searching for a home" in the transmission sector, according to Scott Taylor, a director at Standard & Poor's. (Standard and Poor's, like Platts, is a division of the McGraw-Hill Companies.)

Jon Larson, managing director for Trimaran Capital Partners LLC, noted that certainty has value: "Investors will pay a premium for predictability," he said. Whether the federal transmission siting process provides that predictability remains to be seen.

Another change EPAct made was to repeal the 1935 Public Utility Holding Company Act; repeal aimed at broadening the possibilities for utility ownership and stimulating investment in the power industry. Merger proposals have not multiplied like rabbits, however, and one reason could be that states were so sensitized after PUHCA repeal that they have taken their roles even more seriously. Companies are wary.

New Jersey and Maryland flexed their muscles big-time with respect to two major mergers. New Jersey succeeded in snuffing Exelon Corp.'s acquisition of Public Service Enterprise Group, which would have created the country's biggest electric utility. Federal regulators were satisfied that market power issues were resolved with the companies' commitment to divest themselves of 5,600 MW of generation. But New Jersey did not agree, and Exelon eventually called it off.

Maryland killed FPL Group's acquisition of Constellation Energy, which owns a major utility in the state but also owns power plants and the country's largest-volume physical power sales operation. State leaders rebelled when caps on Maryland retail rates were scheduled to come off and, because of earlier astronomical gas prices, rates were set to rise more than 70% all at once.

Not only did legislators punish state regulators, whom they charged with being far too chummy with the utilities, but they took the merger along for the ride. The companies eventually called it off.

On another front in EPAct, Congress could not muster quite enough support to include a national renewable-energy portfolio requirement, and states have continued to take matters into their own hands. Utilities are thus scrambling to comply with requirements that range from 30% renewables by 2000 in Maine for example, to 25% by 2013 in New York, and 20% by 2015 in Nevada.

Carbon Mandate Expected

The biggest and longest-term risk factor, though, appears to be climate change. Congress hasn't been able to agree on a policy yet, and the White House opposes controls, but industry and environmentalists alike believe a mandate of some kind will come in only a few years.

Federal action could come because of pressure from a growing numbers of scientists and from Europe, as officials there get ready to look ahead at negotiating extension of the Kyoto Protocol before 2012; and from some in the power industry who are frustrated by the uncertainty created as individual states take their own actions.

Even as they contemplate gearing up for the lobbying wars to come—pitting gas-heavy power companies against coal-rich concerns, for example—power company representatives have lamented the patchwork of state activity that makes comprehensive planning difficult.

A survey of utility executives by Cambridge Energy Research Associates this fall found 81% expected binding CO₂ mandates within 10 years. The American Public Power Association has said it expects a federal policy to be set by 2010.

In mid-October, the Pew Center on Global Climate Change issued a report that said more than 80% of 31 companies surveyed believe federal carbon regulation will take effect by 2015. These companies included oil-and-gas giants like Shell and electric utilities like Duke Energy, as well as companies in diverse other industries.

So far, companies are positioning themselves voluntarily by taking a variety of steps that may include efficiency measures and renewables purchases, and buying and selling CO2 credits on the voluntary Chicago Climate Exchange.

Some are taking the nuclear route to slash their carbon risk. With Congress' promise of federal financial incentives to make generation more profitable, the Nuclear Regulatory Commission expects applications for as many as 30 new unit licenses; TXU Corp. alone is looking at applying for up to six. Early builders would be eligible for production tax credits, risk insurance and federal loan guarantees.

In the Northeast and on the West Coast, however, not only are new nuclear units unlikely but voluntary measures are just not going to cut it if state carbon-control regimes survive legal challenges. In California, the law now requires greenhouse gas cuts to 1990 levels by 2020, and specifically requires that power contracts for baseload power will have to comply with a greenhouse gas performance standard.

That restriction has implications for the coal plants planned in other Western states to feed the power-hungry coastal load centers. Integrated gasification combined-cycle plants may be called for, with accompanying carbon sequestration, but the technology is not yet demonstrated on a large scale in the U.S. and carries a lot of financial risk.

The Northeastern greenhouse plan, which still needs some approvals but is far along in the process, involves seven states teaming up to create the Regional Greenhouse Gas Initiative (RGGI), a cap-and-trade program for power plants' CO2 emissions. All fossil-fueled power plants would have to freeze their emissions at current levels from 2009 through 2015; at that point they would have to start ratcheting down emissions until 2019, when their levels would have to be 10% below today's.

This fall, California Governor Arnold Schwarzenegger directed the state to develop a framework to connect California's future greenhouse gas emissions market with the East Coast's RGGI. Although there are major disconnects between the programs, some analysts saw the governor's move as a smart one to prod activity toward a real carbon marketplace.

Europe Wants U.S. Action

For U.S. climate policy, the European factor could be significant. Preparing to take over the rotating leadership of the European Union in 2007, Germany's Chancellor Angela Merkel has told groups this fall that she intends to make U.S. participation in carbon controls a priority.

European industrials are likely to bring similar pressure. John Hall of energy user group John Hall & Associates said that European manufacturers are penalized by the costs of the carbon emissions program, and that the nations needed to take a stand on the fairness of other countries, including the U.S., not having to bear similar costs.

European countries are drawing up quotas for emissions in 2008 to 2012, phase two of the EU's carbon credit trading regime.

Addressing phase two, some power industry executives have recommended major changes. The chief executive of UK regulator Ofgem advised this fall that complexity is a problem with the current emissions trading scheme (ETS). "For me, there are three key issues with the ETS: predictability, consistency and complexity," Alistair Buchanan said, referring to wild price fluctuations and countries' differing ways of implementing the program.

Revamping the emissions regime will be one of the major European ventures in the coming year. Another will be the European Commission's intention to propose a "well-researched, proportionate set of measures" to fix what some EC leaders see as remaining problems with the continent's electricity market.

Three areas especially need work, Fabrizio Barbaso, EC deputy director-general for energy, said at a fall regulatory forum: the role of national energy regulators, transmission system operator organization and unbundling, and transparency.

These three categories of issues are echoed in the U.S.: National energy regulators are constantly finessing their role vis-à-vis individual-state regulators; regional transmission system operators are formed in some areas but not in others and that mixed structure looks certain to last for some time to come; and transparency of market information and market prices is an issue that federal regulators continued to wrestle with.

The EC's Barbaso said the commission sees the need for more consistent powers across the EU, and an end to the regulatory cross-border gap, "which it is alleged, the most powerful companies can exploit to gain an advantage," he said.

In early January 2007, the commission's annual energy market opening progress report should include detailed country reviews, Barbaso said, that will reveal "considerable evidence of a lack of effectiveness of competition for smaller commercial customers and a lack of preparation for market opening for households"—something that, again, echoes much experience in U.S. states that have initiated retail competition.

According to Barbaso, the reason for the lack of effective competition is "the unsatisfactory state of unbundling of distribution system operators" and the EC "will not tolerate further delays" in unbundling, he vowed. In the U.S., unbundling has taken place in some states, but in many, the vertically integrated utility model remains king, and federal regulators have no authority to change it. The hybrid structure is expected to remain for the foreseeable future.

On the transactional front, the FERC is rewriting its open-access rules to try to eliminate vestiges of discrimination that remain in the vertically integrated sector. Its revamping of those rules, contained in what's called Order 888, is due early in 2007.

Likewise, in Europe, Barbaso said he wanted to make it clear that the EC would not only not tolerate more unbundling delays, it also would require that "any discriminatory practices, cross-subsidies or distortions coming from vertically integrated distribution and supply companies must be stopped."

The EC may find a strong industry backer for an EU-wide seamless market: E.ON AG, the German gas and power giant, which made what became a dramatically embattled bid for Spanish power company Endesa SA in 2006. "With the Endesa bid we will cover all areas of Europe," E.ON CEO Johannes Teyssen told a European Parliament hearing in September. "Why do we build an international company if we end up with isolated national pockets? The capital markets would kill us."