Untangling the web of energy regulations in the U.S., let alone internationally, is a full time job. In fact, it's the reason why consultancies such as Cambridge Energy Research Associates exist. However, the broad contours of regulation offer insights for investors in energy, especially given the rapid pace of change over the past ten years. Think of everything U.S. energy markets have seen in the past ten years: blackouts in California, a tripling of the crude oil price, massive supply disruptions caused by Hurricanes Ivan and Katrina, the advent of entirely new fuel sources such as ethanol, massive potential liabilities associated with the fuel additive MBTE, the repeal of the Publicly Utility Holding Company Act, the Iraq War, the rise of energy security concerns, and the bankruptcy of Enron. And energy policy touches on an equally wide array of issues, including everything from access to public land for energy exploration, regulation of public utilities, fuel economy standards, subsidies for investment and production of alternative fuels, energy conservation, and coordination of inter-state commerce and transportation of energy, just to name a few. Where to begin?
As the issues above suggest, there are a few fundamental tensions that always need balancing in energy regulation. First is the tension between conservation and encouraging increases in supply, which surfaces in discussions of land use, conservation of public lands, permitting, etc. In times of short supply and rising prices, policies tend to move away from conservation and towards measures to increase supply. The second tension is between long-term investments and short-term measures, which typically manifests itself in discussions of how best to encourage renewable energy (subsidies versus purchasing agreements) or how best to reduce reliance on oil (e.g., tap into the Strategic Petroleum Reserve versus increase fuel standards.
For investors, the critical elements of U.S. energy regulations involve identifying the costs and benefits to individual companies -- unfortunately, the devil is in the details for a lot of these. However, a broad overview of regulation policy, as well as some detail regarding the most recent energy regulation changes, as part of the Energy Policy Act of 2005, can guide investors as to how to play broad trends in energy regulation. As the history below suggests, policy-making typically happens in response to crises, and as a result, often targets crisis response measures.
Modern energy regulation is characterized by a cautious but optimistic approach to deregulated markets and an interest in long-term development of low-cost energy sources, especially from a diversified resource base. The history of modern energy policy begins with the Energy Policy and Conservation Act of 1975, which, not coincidentally, was a response to an oil price spike after an OPEC embargo in 1973-4. The Act not only created the Strategic Petroleum Reserve to counter severe disruptions in the nation's oil supply, but also introduced for the first time Corporate Average Fuel Economy (CAFE) standards for automobile manufacturers, requiring that average fuel economy of vehicles sold by auto manufacturers in the U.S. achieve double in fuel efficiency (to 27.5 mpg) from 1974 to 1985.
Why you should care: The CAFE standards have set the baseline for all future discussions of automobile emissions standards, and continue to be hotly debated by the auto industry. Increasing fuel economy remains one of the low-hanging fruit for mitigating CO2 emissions as well. The Strategic Petroleum Reserve has become the "hot potato" issue, reawakened by every President when oil prices spike as a method to offer reassurance to consumers suffering from high gasoline prices.
In a 1990 revision to the Clean Air Act, the government instituted a cap on sulfur emissions, and a cap-and-trade system to effect this cap, in order to reduce acid rain and other environmental hazards. This system has actually worked well, and in fact helped pioneer the emissions trading systems that are developing today for CO2.
The Clean Air Act (and its revisions) also laid out detailed standards for oxygen content, benzene, and sulfur content of gasoline products. Largely left to states and municipalities to implement, these standards have created a patchwork of legislative hoops for refiners and gasoline marketers to jump through in order to make sure they are refining and delivering locally appropriate finished gasoline products. While environment standards for gasoline have increased, the end result, in addition to depressing refining margins, has been to decrease the flexibility of the American refinery network and its ability to respond to sudden demand shocks, as finished product is often not transferable from one area of the country to the other.
Why you should care: If you're considering investing in oil refineries, understanding the local market for their products is critical, as well as the future path of legislation on air quality.
The Energy Policy Act of 1992 introduced one of the key drivers of the renewable energy industry to-date, the Production Tax Credit (PTC), which offers to power independent power producers a subsidy of roughly 1.5 cents per kwh generated from renewable sources for a period of 10 years from the beginning of power generation. Considering that the cost to generate electricity from coal can be as low as 1.5-2 cents per kwh, this represents a hefty subsidy, and at the time, it spurred significant investment in renewables, especially in wind energy, the most commercially viable form of renewable energy at the time. Ironically, the PTC has a built-in sunset clause which requires it be renewed every few years by Congress. The result has been a boom and bust of investment in wind projects in particular, depending on whether the PTC is due to expire.
Why you should care: The PTC determines the financial feasibility of many renewable energy projects, but especially on-grid renewable projects such as wind and solar. PTC was also beefed up in the most recent Energy Policy Act of 2005. Moreover, the investment cycle in PTC-eligible projects has a large impact on suppliers and project owners.
An independent regulatory agency within the Department of Energy, the Federal Energy Regulatory Commission (FERC) is perhaps the leading regulatory body in determining the impact of energy on the average consumer of energy. FERC has jurisdiction over electricity pricing, licensing for hydroelectric plants and liquid natural gas (LNG) terminals, and oil pipeline transport rates. Part rate administrator, part licensing body, FERC is perhaps most infamous for its lack of oversight of market manipulation of energy prices by Enron. Going forward, however, FERC will continue to play a large role in determining the extent of utility deregulation, as well as oversight of major natural gas, hydropower, and LNG projects.
Why you should care: Investors trying to identify attractive electric utilities need to parse through the cobweb of local regulations to understand who has pricing authority and which aspects of the business are subject to a regulated Return on Investment (ROI) and which are unregulated. As energy demand grows, those with more pricing power, and reduced regulation, will be more likely to benefit. FERC has also recently finalized rules to enable interstate natural gas storage facilities, a first step towards deregulating natural gas storage markets, which have caused problems in times of short supply in the past and may present investment opportunities in the natural gas storage sector.
What to make of a law that does everything from extending Daylight Savings Time to authorizing $50 million in grants for biomass energy projects to changing the depreciation allowances for natural gas distribution lines? First, it signals that Congress has woken up to the possibility that higher oil prices are here to stay and therefore, something needs to be done about the long-run cost of energy in the U.S. Second, it speaks to Congress' preference for subsidies over belt-tightening (which is more palatable to voters, a subsidy for fuel cell development or stricter CAFE standards). Third, Congress' catch-all approach to energy policy suggests that we don't really know where future energy supplies are going to come from, so we need to hedge our bets, sprinkling subsidies as a venture capitalist sprinkles investments, and hoping that several hit it big and help solve the energy crisis.
Domestic production and refining - Producing more oil domestically (and refining heavier, less expensive oil) would represent the easiest transition to a energy independence. The Energy Policy Act includes changes to depreciation and expensing policy for investments in pipelines and refining to assist U.S. firms in upgrading our creaky oil and gas infrastructure.
Renewable energy - The PTC for wind, geothermal, landfill gas, biomass, and some hydroelectric energy was extended for projects commissioned by the end of 2007.
Ethanol - The Act includes requirements for the use of renewable fuels to increase from 4 billion gallons in 2004 to a minimum of 7.5 billion gallons in 2012, providing a substantial boost for ethanol. In addition, the Act specifies that 250 million gallons of cellulosic ethanol must be produced and used per year after 2013. The Act also stipulates that the entire Federal Flexfuel fleet of vehicles must run entirely on renewable fuels by the end of 2005. This ironically prompted a short-term shortage and price increase in E85 (85% blended ethanol). The 51 cents per gallon blender's credit, which offer refiners who blend ethanol into regular gasoline a tax credit of 51 cents per gallon of ethanol blended, was maintained by the act, meaning that blenders who produce the most common blend of ethanol (E10, or 10% ethanol) will receive a tax credit of 5.1 cents per gallon of gasoline produced (a significant chunk of the 18.4 cents per gallon federal excise tax on gasoline).
Clean coal- There are at least four loan-guarantee and cost-sharing programs for clean coal projects in the Act. In general, an investment tax credit of up to 20% of clean coal projects, including integrated gasification combined cycle (IGCC) projects.
Nuclear energy- The PTC is extended to nuclear plants for 1.8 cents per kwh for the first 8 years of generation. The government can also guarantee loans used to construct new energy technologies to reduce or avoid greenhouse gases, including new technology nuclear plants.
Notably, the Act omitted any specific commitment to procure a certain percentage of energy from renewable sources by a certain date. Such Renewable Portfolio Standards (RPS) have been fairly successful in states where they have been implemented, such as New Jersey and California, where they have created guaranteed markets for renewable energy without providing direct subsidies for investment.
Of course, also missing from the legislation is any firm commitment to reduce greenhouse gas emissions. It is widely anticipated that momentum behind such legislation is building, especially given recent legislation in California and the Regional Greenhouse Gas Initiative (RGGI) in the Northeastern States, both of which have committed to specific levels of emissions reductions.
The Congressional Research Service has created a useful schematic to put all these various changes (and proposed changes in context). See schematic at right.
The Energy Policy Act of 2005 is clear in at least one thing -- it acknowledges that U.S. dependence on coal should continue for the foreseeable future and that significant investment will be required to make coal clean enough for the U.S. to meet whatever climate change targets it sets for itself. As a result, large coal players such as Peabody Energy (BTU) should benefit from continued subsidies to roll out new technologies. Ironically, Peabody, and its carbon-belching utilities such as American Electric Power Company (AEP) could also stand to benefit from grandfathering provisions in any future CO2 regulations.
TransCanada Pipelines - The investment in infrastructure heralded by the Energy Policy Act of 2005 should benefit Canada's largest oil and gas pipeline player.
Nuclear energy continues to play second fiddle to coal and natural gas. Despite copious subsidies, nuclear companies such as Exelon (EXC) and Entergy (ETR) will continue to struggle to be cost-competitive with coal until coal companies, like nuclear companies, are required to clean up their own waste. Nuclear companies pay for waste disposal and storage directly. What if coal companies had to pay for all the waste they generated?
General Motors (GM) - Car companies find themselves attacked on all sides, with increasing CAFE standards, mandates for renewable fuels, and consumers fretting over prices at the pump. Those least well-positioned in renewable fuel technology (i.e., without smaller, fuel-efficient cars or hybrid vehicles), such as GM, will face continued challenges.