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Coal has probably already seen the worst [ClearOnMoney]
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Coal has probably already seen the worst

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Commentary

Coal has probably already seen the worst

10 Sep 2012 by Jim Fickett.

Pressure on coal from environmental regulation has been growing, and studies in 2010 and 2011 predicted significant reductions in demand as the least economic coal plants would be closed rather than upgraded. In fact, the fall in demand that has already occurred is greater than that predicted. What has happened is that cheap natural gas has already forced the closure of plants that probably would have been closed later due to environmental regulation.

The history of environmental regulation in the coal power industry is complex for several reasons

  • Regulation covers local air quality standards, air quality standards for what gets blown by the wind elsewhere, cooling water uptake and effluent standards, ash disposal standards, and more
  • There is a permanent battle in the courts between the EPA, environmental groups, and the coal industry, so that no regulation ever seems to be final
  • Standards are set by the EPA, but enforced by the states, often with some variation, and with delays

It is challenging for an investor to understand what regulations are and are likely to be and, even more, what effect the regulations are likely to have. Much of what is written is emotional, exaggerated and obfuscatory, on all sides. Fortunately, there have been at least a couple calm, objective, and very useful studies.

One is an Oct 2010, 109-page report from Bernstein Research, entitled U.S. Utilities: Coal-Fired Generation Is Squeezed in the Vice of EPA Regulation; Who Wins and Who Loses?. Bernstein attempted a full quantitative analysis by looking at the effect, from all proposed and existing environmental rules, on the profitability of every existing and planned coal power plant in the country. They projected current financial results forward using futures prices for commodities. Obviously there are many assumptions here that will turn out to be wrong. However there is probably no better way to get a sense of what the overall effect of environmental regulation is likely to be. Bernstein's main conclusion is,

we expect U.S. utilities by 2015 to: (1) install the requisite emissions controls at power plants that today supply 23% of U.S. coal-fired generation, and (2) cease operation at coal-fired power plants that today produce 15% of U.S. of coal-fired generation, or 275 million MWh [megawatt-hours]. This reduction in coal-fired generation will be offset to a significant degree by the output of new coal-fired power plants scheduled to come on line by 2015, which are expected to generate 110 million MWh annually. We thus estimate the net decline in U.S. coal-fired generation by 2015 to be 165 million MWh, equivalent to 9% of U.S. coal-fired generation in 2009. Such a drop in coal-fired generation would nonetheless reduce utility demand for coal by 108 million tons, equivalent to 11% of U.S. coal production in 2009

So, bottom line, in 2010 Bernstein expected coal demand in 2015 to drop by 11%. If we look at a 12-month moving average of coal use for electric generation, we find that usage in the latest 12-month period available, June 2011 - May 2012, was 8% down from Jan 2009 - Dec 2009. Usage in 2009 was extremely depressed due to the recession. Since Bernstein is talking about loss of demand due to regulation, and not loss due to the business cycle, it probably makes more sense to look at the drop from the average of usage at the peak of the boom and usage at the bottom of the recession. This drop is 14%. Within the limits of this kind of analysis, it looks likely that cheap gas has accelerated the closures of antiquated plants, and most of the damage that was likely to come from environmental regulation has already been done by gas.

The second objective study available is an August 2011 report from the Congressional Research Service. This study is less detailed than that from Bernstein. It is a meta-study, looking at various projections of the effect of environmental regulation, done by various groups, and noting where the assumptions or methods used are too optimistic or pessimistic. One of the most pessimistic studies was from the Edison Electric Institute, a trade organization for the electric power industry. The EEI study projected that coal might provide as little as 36% of the energy mix for electric generation by 2020.

EEI projected that coal will be responsible for 36% to 46% of electricity generation in 2020, depending on the scenario. …

The most extreme scenario in EEI’s analysis showed 76 GW of coal-fired capacity retirements by 2020 (a little less than 25% of current capacity) as a result of the regulations it analyzed. As noted in the discussion of the individual regulations, in many cases EEI’s analysis assumed regulations far more stringent than EPA actually proposed.

In fact, as of June 2012, coal's share of the energy mix was down to 34%. So again, from a different perspective, we find that cheap gas has already done the damage that was feared from environmental regulation.

There is no guarantee that regulation and cheap gas are completely equivalent forces, closing the same plants. But in general it is the smaller, older, and less efficient plants threatened by both, so I do think gas has already done most of the damage feared from regulation.

Some of the drop in demand may be from delayed construction of new plants. If so, when construction plans are taken up again, it will cushion any further closures due to environmental regulation.

The main point of this post, then, is that while most analysts see two big threats to coal – regulation and cheap gas – I suspect there is only one major one. At the moment, many further closures are still planned. However this is based on the widely held belief that gas will be cheap forever. I think not, and so probably the coal market, also, is somewhere in the neighborhood of a bottom.

Previous commentary on coal