The US government is moving to reduce pollution from power plants. New rules announced by the US Environmental Protection Agency in the past year will require power companies to spend billions of dollars on new pollution control equipment within the next five to 10 years. Power companies are being urged by pension funds and other shareholders holding large blocks of stock to take into account the possible costs to comply in their financial reports.

A panel at the Chadbourne project finance conference in late June discussed what participants in the domestic power sector should know about the looming costs and what bets they are making by investing. The speakers are Dr. Terry Surles, who holds a Ph.D. in chemistry and is vice president for the environmental sector at the Electric Power Research Institute, Leonard Hochschild, a commodity trader who is director of the San Francisco office of Evolution Markets LLC, a brokerage house that trades in renewable energy credits and in the national and regional air emissions markets, Michael King, an economist who is senior vice president of NERA Economic Consulting, and Roy Belden, an environmental lawyer in the New York office of Chadbourne. The moderator is Keith Martin.

MR. MARTIN: There are four main pollutants that come out of power plants: sulfur dioxide, nitrogen oxide, mercury and carbon dioxide. The Bush administration has been clamping down on three of the four and, Roy Belden, perhaps you can explain briefly what has happened in the last year to crack down on three of the four, and on which three?

MR. BELDEN: The US Environmental Protection Agency issued a “clean air mercury rule” in May that sets a two-phase target for the reduction of mercury from coal-fired power plants. The first phase starts in 2010, and the second phase begins in 2015. By 2015, you will have had about a 70% reduction in mercury from current levels. Current levels of mercury emissions are around 48 tons a year from US power plants, and the reductions will get down to a 15-ton level.

The second recent action is the “clean air interstate rule” that places limits on nitrogen oxide and sulfur dioxide from power plants and other industrial plants in the 28 eastern states. The rule builds on an existing nitrogen oxide reduction program that affects about 21 states. The first phase of NOx reductions under the clean air interstate rule will start in 2009, and the second phase will start in 2015. The first phase of sulfur dioxide reductions starts in 2010, and the second phase begins in 2015. Ultimately, you will end up with about a 60% reduction in NOx emissions and about a 75% reduction in SO2 emissions from 2003 baseline levels in the 28 states.

Significant Reductions?

MR. MARTIN: George Bush is viewed by many people as not being terribly interested in dealing with pollution, yet these seem like significant reductions. I wrote down a 70% reduction in mercury, 60% in NOx, and 75% for sulfur dioxide. Terry Surles, will these new rules will require significant reductions in power plant emissions?

DR. SURLES: A lot of what has been proposed has been in motion, in one form or another, for a number of years and, while these are significant reductions — make no mistake of that — there will not be a real push by the Bush administration to do much more. So, I would not really characterize this as a crack-down.

MR. MARTIN: So you don’t view Bush as really cracking down significantly on pollution?

DR. SURLES: There will be continued pressure to reduce the amounts of some of these emissions further. I think we have seen everything taken care of for the time being, but over the coming years one should expect a further racheting down.

MR. MARTIN: Mike King, will what has been done so far cause significant pain for US power companies?

MR. KING: I think there is an opportunity to make money, now that we at least know what the ground rules are with the release of the clean air interstate rule and the mercury rule. I think the Bush administration has been both business friendly and environmentally astute. By that, I mean the administration realizes that the biggest impediment to installing pollution controls is uncertainty. Now that it has established the rules of the game, it is getting out of the way and letting industry decide how best to comply. I think it is really a fantastic move by the Bush administration. Now if the administration can get rid of the litigation hammer that it has been holding over utilities in “new source review” cases, which only introduces additional uncertainty, I think you would see environmental improvements start to be made by US companies.

MR. MARTIN: Back up one step. You said that this is a good move by the Bush administration because it introduces more certainty. Do power companies have the certainty they need now to know what pollution controls to install?

MR. KING: Perhaps. The big uncertainty that remains is what will happen with carbon dioxide in the United States. Resolution of some of the rules of the game is causing people to start thinking about investing substantial sums in pollution control, but I go back to the settlements in the new source review cases.

MR. MARTIN: Could you explain what that is?

MR. KING: The new source review program was instituted in 1974 and then amended in 1977 through an act of Congress, but the Clinton administration in 1997 brought a series of lawsuits against power companies, primarily in the Midwest. Some of the defendants are independent power producers who bought generating assets from utilities, and the government alleges that, back as far as 30 years ago, the maintenance activities that they had undertaken at their power plants were really not maintenance but rather were major modifications of the plants as defined in the Clean Air Act.

MR. MARTIN: So people were rebuilding their power plants, and they should have gone into the federal government for a permit before undertaking such improvements?

MR. KING: That is what is at the core of many of these cases. They are huge cases in which power companies are facing billions of dollars of exposure if the government prevails, because they will have to expend huge amounts of capital and possibly pay civil fines that are on the order of millions of dollars, depending on how you think the statute of limitations applies.

American Electric Power is facing the largest suit; it goes to trial in about two-and-a-half weeks, and who knows what the full liability is that AEP is facing, but it is something on the order of $7 to $10 billion.

My point is the clean air interstate rule has provided some needed certainty. Thus, for example, Illinois Power, which was awaiting a ruling from a federal district court in its own new source review case, saw that the economics are now well enough established in the market place, and that the regulatory framework, at least as it relates to NOx, SO2, and mercury is now well enough established, that Illinois Power could choose to settle with the government. It settled for about a billion dollars, but the billion dollars will be spent on installing scrubbers that the utility can see it will have to install anyway as a result of the new regulations.

Giving more regulatory certainty allows the government to get out of the way and let utilities figure out what to do. No one wants to strand an investment that he or she might make in pollution control because there is still a regulatory process underway that could alter the equation.

Enough Certainty?

MR. MARTIN: Terry Surles, let me come back to you. Is there enough certainty now for utilities to know what to do?

DR. SURLES: There is more certainty in the current regulations, but one of the issues to consider is a potentially carbon-constrained world because more power plants will have to be built in the next decade to replace an existing fleet that, in many cases, is 40 or 50 years old. The industry would also like to see some level of certainty related to carbon constraints.

For NOx, SO2 and mercury, the industry is comfortable with these standards.

The one fly in the ointment is the ongoing litigation about the mercury rule.

MR. MARTIN: There is litigation over whether the government can do what it proposed?

DR. SURLES: Right. There are a number of states, primarily northeastern states and California, that would like to see more stringent mercury rules, and they are suing the US government over that. I might point out, in the case of mercury, because we have done the analysis, about 80% of the mercury deposition in this country comes from foreign sources. Most of it comes across the Pacific from eastern Asia.

MR. MARTIN: Any idea how much the programs proposed by the Bush administration so far will cost the industry in terms of new investment in pollution control? Roy Belden, we will start with you.

MR. BELDEN: The number I have heard is around $23 billion dollars.

MR. MARTIN: I believe that is just spending through 2010. I read somewhere that 13% of total capital spending by utilities between now and 2010 will be on pollution control.

On a call to prepare for this panel, we talked about whether utilities like being ordered to install pollution control because it gives them an excuse to add to rate base. I suggested that, but our panelists disagreed. Terry Surles, what is your view?

MR. SURLES: My view is mixed. I think most of the industry would just as soon keep costs down, but I come back to the issue of certainty. One of the problems with lack of certainty is that you get into battles with public utility commissions over what rates you can charge. There was a recent case before the Public Service Commission in Wisconsin where We Energies wanted to build an integrated gasification combined-cycle facility using coal. Its request was denied because the rates would have had to be substantially increased to do that compared to the cost of a pulverized coal unit.

The reason We Energies wanted to go with integrated gasification combined-cycle is that if there are even more stringent limits on NOx, SO2, and particulates in the future, integrated gasification combined-cycle will let it reduce emissions a lot more effectively, and there are also opportunities for removing CO2 from the atmosphere as well.

However, the PSC rejected the request because it is only speculation that there might be more stringent regulations in the future, it is not prepared to accept the additional burden on ratepayers in the meantime. Clarity allows a utility to have a much more powerful set of arguments in front of the public utility commissions.

MR. MARTIN: We have been talking about this as if there are potentially tougher regulations in the offing on those three pollutants — nitrogen oxide, sulfur dioxide and mercury. Does anyone really see that potential?

DR. SURLES: Certainly in the case of mercury, at least one of our clients is already looking to cut a deal with its coal-fired power plants to meet maximum achievable control technology, because it believes that the US government is going to lose the mercury litigation. There is also the driver, particularly more in the particulate matter standards, that as the analytical instrumentation gets more and more refined and you start looking at the speciation of particulate matter and also the further issues with NOx as an ozone precursor, it is conceivable the government might adopt tougher limits. That said, I think you will not see any changes for maybe up to a decade.

Cost to Comply?

MR. MARTIN: Lenny Hochschild, you wanted to add to that?

MR. HOCHSCHILD: Just getting back to the question of the overall costs, I think it is public knowledge that American Electric Power announced that it will spend just over $4 billion over the next five years.

MR. MARTIN: Just one utility? Does that call into question the $23 billion estimate for all power companies?

MR. HOCHSCHILD: AEP consumes about 75 million tons of coal per year, which is roughly 8% of the market. So if you multiply 3.7 by 12, that should get you a rough back-of-the-envelope number. The number is around $40 billion.

MR. MARTIN: Let me ask, what power plants are affected most directly by the clean air interstate rule and the mercury rule? Is it just older power plants, or is it also some newer independent power plants? Is it mainly coal, or is it also gas and other types of fuels? Roy Belden?

MR. BELDEN: For mercury, it really depends on the type of coal that the plant is burning. The mercury rule could affect new plants as well as older plants. Newer plants may already have scrubbers and selective catalytic reduction systems and would likely be able to meet the first phase reductions for mercury. For the second phase, it is a question of the type of coal being burned and whether plants may need to install additional controls.

For NOx and SO2, the newer plants have typically been built with state-of-the-art technology. So your NOx and SO2 emissions will already be at fairly low levels. It is mainly older plants that are facing big costs for NOx and SO2 reductions.

Just one other comment, Keith. You asked whether there are more stringent regulations on the horizon. In the northeastern and mid-Atlantic states, they are talking about implementing a new rule that would go beyond what the federal government is requiring under the clean air interstate rule.

MR. MARTIN: Mike King, if you were a banker lending money to a project and trying to get into the pro forma all the foreseeable costs, what would you look for as a guide to whether billions of investment might be required in pollution control?

MR. KING: The first question is, what fuel is it? If it is a gas-fired power plant, then you have a lot fewer environmental risks. But certainly you want to be thinking about what the future carbon schemes are going to be that may apply in the United States. I think most people have the sense that it is not a question of whether there will be carbon regulation, but a question of when and how long it is going to take us to get there. So, if I was a banker, I would think long and hard about the implications of the various types of possible carbon schemes.

Another Shoe Left to Drop?

MR. MARTIN: We have an odd dynamic in this country. We have a national administration that is dragging its feet on controlling greenhouse gas emissions, and yet there is a lot of pressure to take action coming from shareholders and from utilities that want certainty. I saw a report that Prime Minister Blair met with President Bush last week about greenhouse gas emissions, among other things. The Financial Times had a headline the next day that President Bush conceded that he needs to “learn more about” global warming. So maybe we are heading in that direction. Lenny Hochschild, do you see a crackdown on carbon looming?

MR. HOCHSCHILD: Yes. There is no question. My job on a daily basis is to broker renewable energy credits and renewable energy. And in the United States you now have 20 states that have renewable portfolio standards. That’s up from roughly 12 just last year. Taking it to a lower level, the trade association for mayors recently met in Chicago and it unanimously passed a resolution that calls for meeting or exceeding the Kyoto protocol target reductions for greenhouse gas emissions.

Then if you take it to an even lower level and just look at the American population, here in California, 89% of the public supports actions to promote renewable energy and combat global warming. It is probably not 89% in the United States as a whole, but it is also probably above 50%.

You have regional carbon initiatives. For example, Governor Schwarzenegger just announced a new California initiative last week at the conference of mayors in San Francisco.

And you have the regional greenhouse gas initiative in the northeast. RGGI is a consortium of I believe nine states in the northeast that are working together to come up with a cap-and-trade system for greenhouse gases. It is not really a question of whether carbon constraints are coming; it is a question of what constraints and when.

You asked what assumptions a banker should build into the pro forma for a project? I think the thing that everyone here needs to realize is that, even today, you are taking a position regarding carbon risk, whether you like it or not.

MR. MARTIN: Terry Surles, when do you see a crackdown on carbon emissions coming?

DR. SURLES: I don’t think you are going to see any significant rulemaking for a while.

MR. MARTIN: What if the Democrats regain the White House in 2008?

DR. SURLES: I have rattled back and forth between Washington for a long time. The US government is like a huge oil tanker; it takes it a long time to turn. The earliest you might see any real regulations on this is in the 2011 time frame, which would then imply that somewhere between 2015 and 2020 you would have implementation of some type of national standards — perhaps a carbon tax of some type.

When you think about it in terms of the construction that is going on now — it gets back to the certainty issue — you will have some kind of standards with which the project will have to comply. For example, if you have a plant that will go on line around 2010 that you would like to run for 50 years, that means that early in its lifetime, you will face carbon restrictions.

MR. MARTIN: Let me ask the other panelists quickly — does each of you agree that 2015 to 2020 is the first period when we would see some significant action required on greenhouse gas emissions? Lenny Hochschild?

MR. HOCHSCHILD: I think that’s a pretty political question, so I don’t really have a view on it, but I would not be surprised if it happened earlier.

MR. MARTIN: Mike King, is that the right time period, if the Democrats regain control?

MR. KING: I don’t think it matters whether the Democrats are in control or not. It is really a matter of economics. It is a question of whether, with the huge base of installed coal-fired power plants in the United States, we can really afford a carbon tax. It will take time to work through that. It is out there somewhere; 2015 to 2020 is as good as any guess.

MR. MARTIN: Let me throw out one statistic. US utilities account for 39% of greenhouse gas emissions in the US and 10% of global emissions. Paul Anderson of Duke Energy has said that government policies will inevitably lead to a carbon constrained world, so Duke is already taking action in anticipation. It is not waiting for the government. What do carbon and other pollution controls mean for the power industry? Lenny Hochschild?

MR. HOCHSCHILD: A good starting place is the forward curve for NOx and SO2. SO2 was recently at an all-time high, and SO2 allowances are trading today at around $800 per ton. If you look at the forward curve for SO2 allowances, 2010 to 2015, they are trading at about $400 per ton, but the figure is deceptive because under the new clean air interstate rule, there is a two-to-one ratio that is required, which basically means that when you look at $400 per ton on the forward curve, that is really the equivalent to $800 dollars per ton today.

MR. MARTIN: Let’s back up and dissect that for people who don’t follow the air emission markets as closely as you do. Power plants require a certain number of allowances to cover their emissions of sulfur dioxide and nitrogen oxide?

MR. HOCHSCHILD: Right, but we are talking just about the acid rain program. Under the acid rain program, SO2 allowances are traded. There is a separate NOx component, but that is based on emission limits.

MR. MARTIN: So the prices you were citing were for acid rain program SO2 allowances.

MR. HOCHSCHILD: Right. If you convert that $800 per ton number into dollars per megawatt hour, then the cost translates into $7 a megawatt hour.

The cost of existing NOx controls right now is roughly the same, or $7 per megawatt hour. The total of $14 per megawatt hour is obviously not insignificant, but if you look at a coal-fired plant — the type of plant that has the most exposure to these NOx and SO2 prices — and then you compare it to a 6,500 heat-rate natural-gas unit, the volatility of natural gas prices will make a significantly larger difference than the price of SO2 allowances, or the price of NOx allowances, even at these high levels for those allowances.

MR. MARTIN: That’s very interesting. Back up one step. A coal-fired plant, based on current allowance prices, is paying roughly $14 dollars per megawatt hour just for pollution allowances. What does the forward price curve suggest about the cost in the future?

MR. HOCHSCHILD: For SO2, the forward curve is fairly flat-lined. Companies will evaluate the incremental cost of adding scrubbers and other pollution control equipment to reduce sulfur dioxide as opposed to buying allowances. At some price level, companies choose to clean up rather than buy allowances.

MR. MARTIN: Suppose you then layer on top of the $14 a megawatt hour the need to buy allowances for greenhouse gas emissions or carbon emissions. How much more do you have to pay per megawatt hour?

MR. HOCHSCHILD: I think that’s the unknown, and that’s the certainty that the industry needs. If you look at what is going on in Europe today, CO2 allowances there are trading about €18 per ton. My understanding from my colleagues in Europe is that adds around $10 per megawatt hour.

MR. MARTIN: That is $24 a megawatt hour just to deal with pollution costs.

MR. HOCHSCHILD: That is correct. But, I’ll go back to a natural gas example. If you look at a 6,500 heat rate unit and you see the amount of natural gas needed dropped from 650 thermal BTUs down to 350 BTUs, that is $20 right there.

MR. KING: The big bet that people are taking in this business is a bet on future carbon controls. That is going to dictate which way these technologies go.

One of the reasons that CO2 allowances are trading so high in Europe — at €18 per ton — is that the allocation scheme for the post-2007 time frame is not yet set. Some believe that if you trade your emission allowances in the current cycle, you may affect your entitlements in the next cycle. That means the current price may be artificially inflated because people are holding back allowances in an effort to get their gains from the distribution for the next cycle.

MR. KING: Pollution control has an effect on the shape of the US fleet. If we have a carbon policy going forward, I think we will see people thinking about new gas-fired power plants, but what that will do is drive up the price of natural gas. Gas prices are already under pressure because of declining gas reserves. I don’t believe the United States has any alternative; coal will be the fuel for new power stations going forward. Whether that drives companies toward integrated gasification combined-cycle plants in the long run, who knows? It is not yet economic to build an integrated gasification combined-cycle unit in today’s market.

Making Lemonade

MR. MARTIN: The previous panel on gas talked about gas prices coming down because of the LNG entering the US market. Here is a factor that will tend to push them back up because there will be more demand for gas-fired power plants if there is a looming crackdown on carbon emissions from coal.

Let me switch to the final topic for this panel and that is, what opportunities are created by this looming crackdown on pollution? Jeffrey Immeldt from GE has announced an Ecomagination program. Immeldt says that GE will be earning $20 billion a year from sales revenue from products that deal with pollution by 2010, and that’s quite a significant addition to GE’s revenues.

What opportunities are created by pollution control?

MR. HOCHSCHILD: Renewables are clearly one big opportunity. Investors and investment banks are starting to take renewables to the next level. Goldman Sachs just acquired US wind developer Zilkha. We are starting to see companies like Shell increase their wind holdings dramatically. That’s one opportunity.

Whether nuclear is an opportunity remains to be decided. Some argue that the only way to comply with future carbon constraints is to invest more heavily in nuclear, but there are a lot of issues with nuclear.

The “clean tech” players, backed by venture capital, are coming into this market, and that’s another opportunity. “Clean tech players” are guys who come up with new clean types of technologies.

Finally, forward-thinking companies that are big buyers of electricity — Dupont is an example — have retooled their manufacturing processes to reduce emissions and, in the process, freed up allowances for sale. I believe the initial reason why they acted was concern about public perceptions. The decision to be good public citizens ended up turning into a source of additional revenue. Excess allowances are sold into both voluntary and compliance markets.

MR. MARTIN: What other opportunities do people see from pollution control? Certainly trading in pollution credits, which is what you do for a living, Lenny Hochschild. What about financing? We talked about how $23 to $40 billion will be needed for new investment between now and 2010, and God knows what after that.

MR. BELDEN: There will be the opportunity to finance pollution controls in larger plants, particularly coal-fired plants. There will be new opportunities in emissions trading. Trading volumes should increase dramatically, particularly with the renewable energy credit market. Carbon trading in some form will also pick up.

MR. MARTIN: Mike King, anything to add to the list?

MR. KING: Whatever bet you place in the power generation sector is a bet on the environmental regulations that will come into place in the future. Therefore, if you think that carbon controls are not going to happen any time soon, you might think about investing in entities like Exxon, which has disavowed any issues associated with global warming or, for that matter, coal-fired power stations. On the other hand, if you want some exposure to the upside of carbon, you might be thinking about investing in gas-fired vehicles.

I would just point out, though, that I don’t think that under any scheme of carbon in the next 20 years can we expect environmental regulation to save the gas-fired power plants that have been overbuilt in some US markets. Pollution control has some impacts around the margin, but it is probably not enough to cause some of these underwater power plants to become more economic.

MR. MARTIN: Terry Surles, you have the last word.

DR. SURLES: Let me add one thing we didn’t talk about earlier. Electricity prices are expected to go up under almost every scenario. We really have to be thinking about new technologies associated with end-use energy efficiency and demand-side management and demand response, because that will also enter into the mix in the long run.