A disconnect has been widening in the energy markets in the six weeks since GOP candidate Donald Trump was declared the winner of America's 2016 presidential election. The energy markets have been rallying strongly, even after accounting for some profit-taking that occurred last week (see figure). While higher energy prices have played a role in the move, with natural gas and WTI crude prices rising by 54% and 17%, respectively, since November 8 on news of cold temperatures and OPEC's output reduction, they don't completely explain the reaction. Refiner margins usually undergo compression as petroleum prices increase, for example, yet the VanEck Vectors Oil Refiners ETF (NYSEARCA:CRAK) has steadily outperformed the S&P 500 over the same period.
The rally has been particularly pronounced among coal mining shares, although not all of the names have maintained their initial post-election gains. Walter Energy (OTC:WLTGQ) continues to lead the pack, although Westmoreland Coal (NASDAQ:WLB), Foresight Energy LP (NYSE:FELP), Rhino Resource Partners LP (OTCQB:RHNO), and CONSOL Energy (NYSE:CNX) have all maintained double-digit returns since November 8 (see figure). Only Peabody Energy (BTUUQ) and Cloud Peak Energy (NYSE:CLD) have lagged behind the broader S&P 500 over the same period.
A broader explanation for improved energy sector sentiment since the beginning of November is that investors expect Mr. Trump to carry through with his campaign promises to, among other things, create a coal renaissance by eliminating federal restrictions on coal-fired power plants, maximize domestic petroleum and natural gas production, and reduce refiners' regulatory expenses under the federal biofuels blending mandate. Many in the media have been quick to point out, however, that the incoming administration will struggle to implement many of these pledges despite installing critics of renewable energy mandates and other Obama-era climate policies at the top of important federal agencies and departments.
The U.S. Environmental Protection Agency's [EPA] Clean Power Plan, for example, will be very difficult to quickly and completely rescind via executive order due to the fact that it has already been finalized at the federal level. Likewise, for federal regulations requiring higher future fuel economy from U.S. auto fleets and the EPA's recent restriction on mercury emissions from power plants. This is not to say that the Trump administration will have no impact on the energy sector compared to the impact that a Hillary Clinton administration would have had, of course, not least because the above restrictions and regulations were intended to be the opening salvoes rather than final steps. But Trump's campaign pledges are widely expected to become bogged down in years of legal challenges and bureaucratic battles. And this ignores larger international considerations, such as the risks that would come of pulling out of America's bilateral agreement with China on future greenhouse gas emission reductions, let alone the now-ratified international Paris Climate Agreement (aka "COP21").
Making discount rates controversial again
A thought-provoking piece from Bloomberg that was published last week broadly agrees with the assessment that the finalized Obama-era regulations on the energy sector are unlikely to be quickly repealed. Despite this, however, the article identifies the chink in the regulatory armor that could cause their overall scope and impact to be greatly weakened: the discount rate that is used to calculate environmental benefits.
Most U.S. regulations must pay lip service to modern economics by demonstrating that the costs that they would incur are smaller than the benefits that they would produce if implemented. I say "lip service" because, as with any financial analysis, the results can be manipulated in any manner of ways. The EPA's aforementioned mercury emissions rule, for example, was rejected by the U.S. Supreme Court earlier this year on the grounds that it was only able to demonstrate higher benefits by accounting for emission reductions that fell outside of the scope of the regulation (e.g., particulate matter emissions). In regulatory cost-benefit modeling as in financial analysis, assumptions matter.
Ironically, the benefits of certain forms of emission reduction requirements are relatively easy to ascertain. Particulate matter, for example, which is released in especially high volumes by coal-fired power plants and certain types of diesel engines, quickly causes respiratory damage in localized areas, allowing for rapid quantification of damages after the fact. Particulate matter emissions in China's industrial city of Shenyang, for example, mean that breathing the "fresh" air of the outdoors on certain days is equivalent to smoking three packs of cigarettes daily.
The monetary damages caused by greenhouse gas emissions, on the other hand, are more difficult to accurately establish at this time, not least because most of the damages won't occur until after the 450 ppm atmospheric carbon concentration threshold has been passed later this century. Calculating those damages, therefore, requires the prediction of a future effect rather than the measurement of a past effect, and this necessarily introduces an additional element of uncertainty into the equation. Beyond that, the fact that the bulk of the damages (and, by extension, the benefits of today's regulations preventing those damages) are in the future means that the monetary value of those damages must be discounted accordingly.
To meet muster, then, the costs of today's regulations on carbon emissions must be exceeded by the discounted value of future benefits. And, since the greater part of the value of those benefits will not be recognized for at least a couple of decades, even a low discount rate can cause that value to dwindle rapidly from a modeling perspective. On the other hand, even the discounted future value of the regulatory benefits can be quite large given the global scope of anthropogenic climate change.
Regulators have been calculating the so-called "social cost of carbon" [SCC], or the value of the future benefit of reduced greenhouse gas emissions, since Barack Obama assumed the presidency in 2009. The administration's researchers initially calculated a central SCC of $21/metric ton, and this value was subsequently raised to $36/metric ton. This figure has been the basis for the Obama administration's regulatory cost-benefit analyses, which have assumed that every metric ton of carbon emissions that are avoided bring a benefit of $36. The widespread availability of inexpensive natural gas that has resulted from U.S. fracking has, when combined with this benefit, made it very easy for regulators to argue that the benefits exceed the costs. Combusting an MMBTU worth of natural gas incurs roughly half of the carbon emissions of combusting an MMBTU worth of coal, for example, so cheap natural gas has allowed many power plants to actually save money by reducing their emissions even before accounting for the future benefit. Such "negative carbon abatement costs" are very much the Holy Grail of climate policy.
The catch is that much, if not most, of the low-hanging fruit has already been picked now that natural gas has overwhelmingly taken coal's spot as America's leading power plant fuel (see figure). The SCC will become increasingly important under existing regulations as a result, making its assumed discount rate equally important. A value of only 3%, as it turns out, has been employed to calculate the aforementioned SCC value of $36/metric ton. While many environmental groups have argued that this should be still lower (and possibly even negative) to reflect the inherent uncertainty of climate change cost predictions, the opposite argument can also be made. Future developments resulting in cost-effective emission reductions, much as fracking has already done, could justify a higher discount rate. Likewise, a higher discount rate could be appropriate if the calculation incorporates one of the many parts of the world that still suffers from energy poverty since people there place an even higher value on consumption today than do their developed-world peers compared to impacts in future decades.
The choice of discount rate has a major impact on the SCC calculation. Increasing it to 5% results in an SCC of only $12/metric ton. An assumed rate of 7% or higher, as is common in many financial analyses, actually generates a negative SCC, which is another way of saying that the future benefits are never justified by today's costs. Notably, such a result can be calculated without suggesting that anthropogenic climate change is "a hoax", or otherwise discounting the scientific consensus on the climate. Rather, it just requires a showing that inexpensive energy today has a greater value to society than was assumed under the Obama administration. Show this, then, and the Trump administration has a plausible legal argument that these regulations fail to pass established regulatory muster. To be fair, the calculation can also be moved in the opposite direction: researchers at Stanford recently argued that $220/metric ton is a more appropriate SCC.
This is not to say that a higher SCC discount rate will automatically invalidate all of the current regulations, of course. The EPA's Clean Power Plan is unique in that it imposes different requirements on each state in reflection of its current energy mix. States such as West Virginia that currently have high electric sector carbon intensities, for example, can meet their obligations simply by switching from coal to natural gas before 2030. If natural gas prices remain low, as is possible if Mr. Trump succeeds in expanding its domestic production, then even a sub-$36 SCC could outweigh today's regulatory costs. Likewise, the states such as New York that the EPA imposes the lowest carbon intensities on are currently characterized by especially high energy prices, resulting in low carbon abatement costs even if its future energy needs are assumed to be met by higher-priced sources such as solar PV. What the higher discount rate would do, however, is weight the cost-benefit analysis more in favor of coal in the presence of higher natural gas prices.
I argued in the aftermath of the election that investors in the coal mining sector were overreacting to Mr. Trump's victory on the grounds that its problems to date have had more to do with cheap natural gas, which the president-elect has pledged to prioritize, than the so-called "war on coal." The high valuations reflected by many coal mining firms' share prices today will require the recent rally in natural gas prices to be maintained if they are to be justified. That said, anti-coal regulations could have a negative impact on the industry in the event that natural gas prices do indeed remain high for the foreseeable future, in which case the ability of the Trump administration to weaken its predecessor's regulations could have a meaningful impact on coal mining earnings. It appears that the administration does have a path forward here, although whether natural gas prices will continue to play along is a very different matter.
Disclosure: I am/we are long XLE.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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