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Earnings and dividend growth drive utility stocks' returns over the long run. But you should also keep a watchful eye on regulatory developments and their implications for your portfolio holdings.

Oversight of power, natural-gas distribution and water service historically has occurred at the state and local level. In the best situations, companies work closely with regulators to develop a plan for regular system upgrades that will ensure reliable service at a low cost and give the utility a reasonable return on investment.

When relations between utilities and regulators become adversarial, short-term thinking predominates and chronic underinvestment in system improvement ultimately leads to deteriorating service quality and higher costs. For investors, selecting names that enjoy a salutary relationship with their local regulators has been critical to long-term outperformance.

This focus on local regulation remains just as critical today, though developments at the federal level have stolen the show as of late. The federal government entered the regulatory scene in the 1970s, with the creation of the Environmental Protection Agency (EPA) by President Richard Nixon and Congress' reorganization of the Federal Power Commission as the Federal Energy Regulatory Commission (FERC).

FERC's initial mission was to integrate the nation's natural-gas markets. However, the commission in the 1990s expanded its reach into the electricity market, overseeing the creation of regional transmission operators (RTO) to manage interstate power flows and create competitive wholesale markets. But power deregulation stalled when Enron imploded in late 2001, and the regulator has struggled to introduce RTOs in the South.

In this installment of Income Insights, we take a closer look at two newsworthy regulatory developments at the federal level.

Coal in the Crosshairs

Not long ago, coal-fired power plants accounted for more than 70 percent of US electricity generation. This percentage was expected to rise sharply with the construction of a new generation of coal-burning facilities.

Today, the vast majority of these projects have been canceled. Concerns about carbon dioxide (CO2) emissions, subsidies for wind and solar power and a growing domestic supply of inexpensive natural gas have prompted utilities to replace retired coal plants with other sources of electricity.

The only coal-fired power plants under construction use integrated gasification combined-cycle (IGCC) technology, which operates more efficiently and dramatically reduces air pollution. Duke Energy Corp (DUK) in June 2013 completed one of these facilities in Edwardsport, Ind., while Southern Company (SO) has an IGCC plant under construction in Kemper, Miss. Both projects encountered significant cost overruns-a major deterrent for utilities and regulators seeking to update the power grid.

The EPA this week made headlines by unveiling a proposal to limit CO2 emissions from new coal-fired power plants to between 1,000 and 1,100 pounds per megawatt-hour-the industry had lobbied for a cap of 1,900 pounds per megawatt-hour. Despite the media coverage and predictable outpouring of partisan commentary, this "news" isn't really newsworthy; the only new coal-fired plants under construction use IGCC technology and would comply with this proposed rule.

Southern Company's IGCC power plant in Kemper, for example, uses a low-heat oxidation process to convert lignite coal into synthetic gas, a process that reduces CO2 emissions by 65 percent. Plant economics are further enhanced by collecting and selling carbon dioxide to the oil and gas industry, which pumps the gas into mature oil fields to enhance production. The facility will also produce meaningful volumes of ammonia and sulfuric acid that can be sold to industrial users. And the further coal falls from favor, the cheaper the plant's feedstock will become.

The big question is whether the EPA will apply similarly stringent limits on CO2 emissions to the nation's existing fleet of coal-burning power plants. There's speculation that the agency will require these facilities to cut their CO2 emissions by 25 percent to 30 percent. Such a newsworthy announcement that would have important implications in the real world; installing the requisite carbon-capture equipment wouldn't come cheap, suggesting that utilities and customers would have to shoulder the cost of these upgrades. We'll have to wait until June 2014 for the EPA to make an announcement regarding CO2 emissions from existing coal-burning plants.

In the interim, investors should keep in mind that the more draconian the limits on CO2 emissions, the greater the likelihood that years of litigation will postpone their implementation. And if the Republicans recapture the Senate in 2014 or the White House in 2016, any regulation of CO2 emissions would likely be rolled back.

Bashing Binz

President Obama's nomination of Ron Binz, a former chairman of the Colorado Public Utilities Commission, faces an uphill battle for Senate approval. In his former post, Binz pushed through then Governor Bill Ritter's plans to reduce air pollution in the state by converting some of Xcel Energy's (XEL) power plants from coal to natural gas.

Given Binz's background, the coal industry is pulling out all the stops to oppose his nomination. Meanwhile, environmental advocates have arrayed themselves in support of Binz. At last count, however, the Senate Energy and Natural Resources Commission appeared to be breaking against Binz, with Senator Joe Manchin of West Virginia likely to join Republicans and vote against the appointment. A no vote from either Senator Tim Scott (R-S.C.) or Senator Mary Landrieu (D-L.A.) would doom Binz's nomination.

Investors shouldn't expect Binz-or any other Obama nominee, for that matter-to take FERC in a different direction than the one charted by outgoing Chairman Jon Wellinghoff, who focused primarily on encouraging greater integration of U.S. transmission infrastructure.

After the political theater of appointing a new FERC chairman plays out, we'll monitor the prospective rates of return that the regulator approves for new and existing transmission infrastructure. In recent years, FERC has encouraged the construction of these assets by returns on investment that are well above those granted in many states.

A steady hand in the chairman's seat will be critical in coming years if the recent opinion issued by FERC Administrative Law Judge Michael Cianci Jr. is any indication. In this initial decision, Cianci found that the current base return on equity of 11.14 percent granted to New England transmission owners was no longer "just and reasonable."

Local Concerns

In this age of expanding federal power, investors shouldn't forget to monitor utilities' relationships with their respective state and local regulators. Duke Energy, Southern Company, FirstEnergy Corp (FE), American Electric Power Company (AEP) and other utilities with significant coal-fired capacity should hold up reasonably well as long as local regulators support their efforts to contend with adverse actions at the federal level. If relations between these utilities and local regulators start to deteriorate, investors should look to reallocate their capital to other names.

Source: Utility Investors Keep An Eye On Washington