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Over the last several months, I have indicated that utilities will be facing significant new challenges as they adjust to the new green initiatives from the new administration and Congress. About 56% of the electricity generated in the United States is from coal, a significant contributor to carbon emissions. Natural gas generates about 27% of the electricity, wind generates about 1% and solar generates about 0.1% of the electricity used in the United States. The efforts to reduce carbon emissions will have a significant impact on the economics of the utilities industry and their support industries.

The shift from a market-based economy to one that is more politically controlled will have long-term ramifications for the U.S. economy and certain industries. The 110th Congress produced six carbon cap-and-trade bills that could not get through all the politics in the capital. The shift in the political make up of Washington is likely to change the operations of carbon producing industries and will have significant consequences for investors in the utility industry.

Political Shift

President-elect Obama has continued to back his campaign pledge to take action to reduce carbon emissions. In a re-alignment of the house committee leadership, Representative John Dingell (D. Michigan) was replaced by Representative Henry Waxman (D. California) as chairman of the House Energy and Commerce Committee. Representing Michigan, Dingall has been a long-time ally of the automakers and favored a slower approach to reducing carbon emissions. His most recent bill required total carbon emissions to be 6% below 2005 levels by 2020.

Representative Waxman favors a more aggressive approach seeking 14% reduction from 2005 levels by 2020. Now that he is the chairman of the committee that will produce the bill for the House, it is very likely that the bill that will be put before the House will be much closer to what he favors. Representatives from coal producing states are not likely to support measures that are more aggressive. However, Representative Waxman has the support of other powerful House members, including Speaker of the House Nancy Pelosi (D. California). Speaker Pelosi is known for keeping her ranks in line and seeks to take advantage of her newfound power.

The Senate presents a slightly different situation where Democrats increased their majority. However, the Republicans still hold at least 41 seats, enough to block the Democratic majority’s initiatives. Of course, some Republicans may vote with the Democrats, so party lines do not always work as expected. A Senate bill is likely to have lower carbon emission goals than the House version, setting up a fight over which one will become the final version. Again, here the senators from states that have a major stake in the impact on the economies of their states will influence the outcome.

The changing of the guard in Washington is setting up a new political environment that will have long-term consequences for the Utility industry. Special interests and the intense lobbying will try to influence the outcome. In the mean time, investors must try to understand how to proceed in this new environment.

Impact of Carbon Caps on the Utilities Sector

Assuming more restrictive carbon emission standards become the law, the winners in this battle will be those that are able to produce most of their power from low-carbon or carbon-free sources. Think renewable and nuclear power plants. The losers will be the utilities that use carbon-intensive fuels to generate their power, i.e. coal.

The wind and solar companies will continue to benefit. Xcel Energy (NYSE:XEL) is committed to achieving 20% of its power from wind. Their Windsource and Renewable Energy Trust was ranked first in the number of customers and fifth in energy sales out of 5,000 U.S. utilities by the National Renewable Energy Lab. Florida Power and Light (FPL-OLD) is the U.S.’s largest merchant of wind power. PG&E (NYSE:PCG) is noted for their efforts to develop energy efficiency capabilities and use of renewable energy sources. Powershares WilderHill Clean Energy ETF (NYSEARCA:PBW) has broad exposure to clean energy technologies.

In the U.S., the producers of wind turbines that trade on the stock exchanges are GE and Siemens (SI). These are large diversified companies, so the impact of wind energy will be minimal on the returns for investors. ABB Ltd. (NYSE:ABB), a Swiss company could be an interesting play. ABB is involved in electricity distribution and grid upgrades where they have a dominant position. Upgrading the electrical grid in the U.S. as well as other countries will be a major focus as countries seek to invest in their infrastructure.

Other U.S companies that will benefit from the growth in wind energy include American Superconductor Corp (NASDAQ:AMSC), which provides electrical components for the electrical grid and wind generation of electricity. Upgrades to the grid will require the services for firms such as Pike Electric Corporation (PEC) and Quanta Services (NYSE:PWR).

Wind energy has had much greater success in Europe where Denmark, Germany and Spain are leading. Electricity from wind is a little more than 1 percent of global power supplies. The leading country is Denmark, with 20 percent. Wind provides 9 percent of energy in Spain, and 7 percent in Germany, though this is increasing rapidly. Located in Denmark, Vestas (OTCPK:VWSYF) is the world's largest wind turbine manufacturer along with NEG Micon (NEGMF.PK) and Bonus (BONU.CO). These companies trade on the Copenhagen stock exchange. The German wind market includes Enercon (ENDC.PK) and Nordes (OTCPK:NRDXF). None of these companies’ shares is listed on U.S. stock exchanges.

T. Boone Pickens' Mesa Power recently ordered 667 turbines from General Electric to begin a $10 billion wind far project in Texas. When completed by 2014, the wind farm will be capable of producing 4,000 megawatts, or enough energy to power 1.2 million U.S. homes. Gamesa (GAM.MC) is expanding beyond its home market in Spain and entering the U.S. market. The First Trust ISE Global Wind Energy ETF (NYSEARCA:FAN) is an ETF that specializes in wind energy. Sixteen percent of the fund is allocated to the U.S. with additional companies in Denmark, Germany, Spain and the United Kingdom. For example, REpowersystems AG makes up 10.5% of the funds holdings while Vestas is 10.2% and Gamesa is 8.8%. This fund is a way for U.S. investors to participate in pure wind energy plays globally. Be careful, as the average volume for this ETF is only 72,000 shares a day.

A study by the U.S. Energy Department found that wind energy could generate 20% of the total generating capacity by 2030. The problem is that the demand for electricity is expected to continue to grow. This means there will still be a need for new sources of electrical power. Therefore, nuclear may also see renewed interest, despite the decades long absence of any new construction of nuclear power plants in the U.S. Nuclear has zero direct carbon emissions. In this case, Excelon (NYSE:EXC), the largest nuclear power producer my see some new interest. Excelon’s goal is to reduce, offset or displace more than 15 million metric tons of greenhouse gas emissions per year by 2020. They are exploring construction of new nuclear plants with up to 3,040 MW in capacity.

Firms that have experience in nuclear plant design and construction should also benefit. McDermott (NYSE:MDR) has built large power plant boilers and generation components, and they are one of the primary contractors to the US Government for nuclear services. Fluor Corporation (NYSE:FLR) has extensive design and construction expertise that would benefit from new interest in nuclear power generation.

Utilities that use natural gas should also do well. Natural gas has lower carbon emissions than coal and oil, though higher than wind and nuclear. Moreover, it is currently abundant with excess supply available and additional sources still to be drilled. The iShares Dow Jones US Oil and Gas E&P ETF (NYSEARCA:IEO) has significant exposure to the natural gas producers.

Should Washington pass less stringent carbon emission restrictions, then there will be fewer winners and losers. While this is not likely in the current political environment, it is something to be considered.

The losers in a carbon-capped setting will be the firms that depend on how each state regulator treats carbon costs. If the regulators allow the firms to raise customer rates to pay for the higher costs, the utilities should be unaffected. On the other hand, if regulators shy away from allowing the companies to pass on the higher costs, then the utilities will suffer accordingly. Utilities such as Allegheny Power (AYE), American Electric Power (NYSE:AEP) and Dayton Power & Light (NYSE:DPL) could experience lower earnings. Duke Energy (NYSE:DUK) is also a major user of coal fired power plants, though they are investing heavily in alternative energy sources including wind.

The Bottom Line

The political economy and especially the move to carbon-caps will have a significant impact on the utilities sector and their suppliers. If, as expected, the government passes more restrictive carbon emission and trading legislation, some utilities will benefit and other will suffer. Moreover, this political influence will encourage investing in various alternative energy companies especially wind generation of electricity. The more conservative approach is to buy utilities that will benefit from the new emission standards and avoid those that are heavily dependent on coal fired generation capacity.

Investors that are more aggressive should look to invest in wind generation companies where they are proven. So far, most of the companies that are achieving success are based in Europe. U.S. based investors can participate in these firms through ETFs that invest in these companies. In the U.S., there are a number of start-up companies that have yet to demonstrate a proven record of accomplishment. This makes them a more risky alternative.

The utility sector is about to undergo significant transformation that will have winners and losers. Investors should be aware of the characteristics of each company so they can invest accordingly. It is a time of greater opportunity and greater risk.

Source: How Carbon Caps Will Affect Utilities Sector