Fitch: Climate regulation good for gas sector; mixed impacts for power

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With the belief that greenhouse gas emissions limits will be implemented in the United States either through federal legislation or by the U.S. Environmental Protection Agency, Fitch Ratings said in a Nov. 3 report that those pending regulations loom as a serious long-term challenge for the energy industry at a time when weak industry fundamentals are already providing challenges.

Fitch acknowledged that predicting the ultimate shape of carbon regulations at this preliminary stage is imperfect and said the final details of any regulations will shape how difficult the credit challenges are for energy companies. The initial allocation of emissions allowances by industry and by firm, the speed with which the allowance pool is tightened, any grandfathering or exemptions for individual firms, the commercial availability of CO2 sequestration, the cost of CO2 compared to that of clean technologies, the ability of firms to pass through the costs of CO2, and the relative emissions burden imposed on imports will be crucial facets of climate legislation as it pertains to impacts on energy companies' credit.

Domestic refiners and heavy oil producers will likely bear the biggest negative brunt of federal climate policy, while other energy sectors will experience mixed impacts, Fitch said in the report.

In the exploration and production sector, producers using CO2 injection for enhanced oil recovery could be major beneficiaries, as power generators seek avenues to sequester CO2 emissions. In addition, natural gas producers will benefit from climate regulations due to a naturally favorable emissions profile.

"Natural gas is likely to remain the fuel of choice for new electricity supply in the near term and continue to play a key role in grid reliability as the proportion of variable-output wind power grows," Fitch said in the report. "In addition, provisions in [HR 2454, the Waxman-Markey climate bill, and S 1733, the Boxer-Kerry climate bill] encourage the development of electric vehicle fleets, which could provide a meaningful boost to natural gas demand and create an important link between natural gas and the oil-based transportation fuel market."

The power sector will experience mixed impacts, Fitch said, as utilities with low-carbon profiles will be "relatively well-positioned" and carbon-heavy utilities will face operating and free cash flow pressures as they try to transition to a lower CO2 profile.

"In the long term, the ability of utility and power companies to recover incremental carbon costs through regulated or market-based rates will be a key detriment to future free cash flows, and ultimately, credit quality within the sector," Fitch said. "Generally, as carbon costs are phased-in, the ability of investor-owned utilities (IOUs) to fully recover costs associated with mandated emissions reductions is expected to be a crucial factor in the determination of the sector's ongoing creditworthiness."

Regulatory backlash may result if regulators begin to feel ratepayers' ability to absorb the costs to reduce emissions is exhausted, Fitch said.

Overall, utilities appear well-positioned in the near to intermediate term to deal with climate regulations, but insufficient flexibility to recover carbon costs from consumers stands as a significant threat to utility and merchant generator sector credit quality.

Specifically in the merchant space, Fitch said the historical cost advantages of coal-heavy generators will likely erode and make those companies vulnerable to competition from efficient gas-fired and renewable merchant generators. In an environment of low gas prices such as the current one, the results could be meaningful financial stress for merchant generators, Fitch said.

Carbon regulations will ultimately reduce the power sector's reliance on fossil fuel generation, and power company capital expenditure budgets are already soaring, reflecting increased investment in renewable energy and other low-carbon generation, Fitch said. While CapEx budgets in the sector are expected to drop by about 10% from 2008 peaks because of the recession, Fitch said it expects CapEx growth will resume in 2011.