Energy Report: Two Ways to Profit from the Coming Carbon Cap

 

Carbon Emission Reductions Already Have Begun

By 2020, Washington is committed to reducing carbon emissions to 17% of 2005 levels. That means whatever limits are placed on those emissions by Congress in the current legislative round will be the first step in a process - not the last. Whether one refers to the target as a greenhouse gas initiative or as a carbon emissions cap... the results are the same. 

In fact, the emission reductions already have begun. Last year, energy-related carbon emissions dropped by a full 7%, the largest annual decline in 60 years. The Energy Information Administration (EIA) pointed out that it was greater than the decline in the gross domestic product (GDP), meaning the emissions cuts were caused by more than just the economic recession. 

All of this has significant consequences for investors. As Congress moves toward regulating the release of carbon dioxide into the atmosphere from the use of coal and oil, one of the immediate effects will be to make electricity produced from coal and inefficient refining of oil products more expensive. 

That means investors looking to stay ahead of the game need to start thinking now about who will win... and who will lose. 

The real loser here is the coal-fired power plant. The sudden abundance of domestic natural gas, coupled with the unlikelihood of any rapid rise in gas prices - both results of the acceleration in shale gas and other unconventional production in the U.S. - have increased reliance on gas for power production. Any regulatory increase in the cost of employing coal to generate electricity (by taxing carbon emissions or requiring upgrades of plants to keep the carbon dioxide below a certain limit) will have the effect of delivering a greater market share to gas. 

The impact of carbon taxation on coal-first plants is a measurable thing. If that impact translates into the equivalent of a levy of $30 per ton - a level very much in line with current Congressional sentiment - gas becomes a cheaper fuel alternative than coal in most of the country. If the level reaches $60 a ton - a level probably unrealistic (at least initially) in states other than California - renewable sources, such as wind, biomass, and even in some locations solar, become competitive with coal. 

While we don't know the amount coal will have to bear, the power market for some time has widely anticipated that such a burden is coming. 

Last October, General Electric Co. (NYSE:GE) invited me down to their gas turbine research campus in Greenville, South Carolina. I provided a briefing on the future of natural gas to an audience of several hundred representatives from most of the major power producers in the country. And I learned something interesting: Not one of them was intending to build a new coal-fired generator or even a facility capable of co-generation (coal and gas). 

With coal prospects certainly not improving since then, gas has already become the fuel of choice. Of the three main fuels for electricity - coal, oil, and gas - gas produces far less of a greenhouse gas problem than the other two. 

Of course, any cap and trade system emerging would still provide a place for coal, with the ability to trade emission permits providing a number of existing power plants the ability to continue operations off of their expected grandfathered status. 

How to Profit

1. As the future of carbon emissions regulation takes shape, you could take positions in the most liquid exchange-traded funds emphasizing green or clean power generation.
   
   Four of these currently fit the purpose: PowerShares WilderHill Clean Energy (AMEX:PBW);PowerShares Cleantech Portfolio (AMEX:PZD); First Trust Nasdaq Clean Edge Green Energy(NasdaqGM:QCLN); and, for the more internationally adventurous, the Market Vectors Global Alternative Energy ETF (NYSE:GEX).
   
   All four have been hit rather hard this year but are now poised for an extended rebound, in light of the carbon initiatives coming from Washington and the rising concerns over crude oil usage.
   
   Of these four, my initial choice is PZD. It has the widest number of energy providers likely to benefit short-term from the renewed emphasis on non-fossil fuels. And it has retained by far the best price stability of any ETF in the category thus far this year.
   
2. The other move here is to identify publicly traded power companies or providers to the sector having the greatest diversification in fuel sourcing, combined with a strong positioning to trade off of current coal assets.
   
   Of the two I find best suited to our purposes - CONSOL Energy Inc. (NYSE:CNX) and Duke Energy Corp. (NYSE:DUK) - DUK is the better short-term play (next one to two quarters) and should become part of an ongoing energy portfolio.
   
   However, CNX is positioning itself to be the stronger choice longer-term. It has rapidly acquired significant natural gas holdings - absorbing CNX Gas Corp. and the natural gas business of Dominion Resources Inc. (NYSE:D) to add access to shale gas production in offsetting what had been a heavy coal-based in its fuel provisions. CNX will be the best-positioned company in the coal-gas exchange when the caps start taking hold.

In the meantime, I'm traveling in Uganda, where an old-style "crude rush" is underway. More on that next time...