The credit impact of climate change

The energy industry is bracing for a carbon-constrained world, but the ways governments choose to control carbon around the globe may have vastly different impacts on company bottom lines.

Industry today generally accepts the inevitability of mandatory carbon controls and is now seeking to influence the final form of these controls and negotiate the future participation of developing nations in a global carbon regime.

Credit consequences may result as restrictions on greenhouse gas (GHG) emissions cause significant increases in capital costs and/or reductions in profitability. Standard & Poor's sees carbon controls impacting power sector credit quality globally in four broad ways.

Sectoral Distribution

The distribution of emission reductions, and hence costs, among various sectors of the economy will vary substantially depending upon the mechanisms chosen to implement carbon legislation.

A cap-and-trade approach, taken in isolation, may result in a disproportionate allocation of emission reductions to certain sectors while not meaningfully affecting others at all.

The power and automobile sectors provide a prime example of this. Some US Senate bills propose that oil refiners be responsible not only for their own emissions, but also for auto tailpipe emissions.

However, refiners control neither the fuel efficiency of cars nor the driving habits and model preferences of drivers. At best, refiners can indirectly affect such decisions by passing through to customers the cost of carbon allowances in the form of higher gasoline prices.

But this is potentially a weak price signal. To take an extreme example, at a price of $100 per ton for CO2 credits, the price increase to consumers would only be about $1 per gallon of gasoline (burning 100 gallons of gasoline produces one ton of CO2), a sum drivers have absorbed in the recent past without switching en-masse to less-polluting vehicles.

If an economy-wide emission cap is adopted in the US, legislation that mandates higher fuel economy for autos, or greater use of ethanol, biofuels, etc. would be a key determinant of how much reduction is achieved from autos and how much is demanded from other sectors.

Power generation may end up with a disproportionate share of emission reduction responsibility (and the attendant credit risks) because, even at $100 per ton for carbon credits, auto emission reductions will depend on the extent to which consumers and automakers view higher gas prices as permanent and change their behavior.

By contrast, with carbon at $100/ton, the power sector could become almost entirely emissions-free, as most-if not all-estimates of the cost of capturing and sequestering carbon are less than $100 per ton.

Impact on existing power plants

The choice between auctioning and allocating carbon credits in a cap-and-trade regime has the greater impact on the value of existing generating assets.

The free allocation of CO2 emission allowances in Phase I of the European Union's Emission Trading Scheme (ETS) allowed gas and coal-fired generators to be more profitable than in the absence of the ETS.

This profitability will decline in Phase II and beyond as more credits are auctioned rather than assigned and the absolute level of freely granted allowances to the power sector is likely to decline.

Regional initiatives in the US, such as the Regional Greenhouse Gas Initiative (RGGI) in the Northeast, are looking at auctioning a majority of their credits.

We used a dispatch model licensed from EPIS by Platts to identify aspects of the power markets that drive compliance costs. We've estimated the economic cost of compliance as the change in EBITDA that a power plant (or portfolio of plants) earns under a base case with no carbon controls and under two GHG scenarios, each modelled after one piece of pending Senate legislation-the Carper/Feinstein bill (GHG1), and the more stringent Boxer/Sanders bill (GHG2).

We ignore factors such as regulation and contractual arrangements since these will only influence how costs are allocated and not the economic cost itself.

Created: Dec 4, 2007