The specter of stranded assets in the US electric utility industry has risen again like the undead in a typical horror movie. A leading Wall Street analyst noted recently that a survey of electric utility employees showed that 45% believed that asset stranding was the number one risk the electric industry faced. However only 18% of them believed this to be an issue of serious financial or regulatory concern. This would suggest an overall industry complacency despite the worldwide concern about climate change and potentially rather expensive means of mitigation.
The utility assets most at risk presently are those devoted mainly to retrofit old coal-fired power generating plants to make them more environmentally acceptable and treatment of coal ash waste disposal facilities. If US coal fired power generating facilities are retired prematurely (meaning before they are fully depreciated) who will pay to recover costs?
The traditional regulatory response has been to charge these assets to the consumers who benefit from the electricity provided. However, regulators and electric utilities would prefer, we suspect, to not have to ask for a premature or accelerated recovery of these increasingly unpopular assets. It would be simpler to remain below the radar and permit these things to quietly amortize away.
But coal fired electric power generation in the US is responsible for two thirds of the greenhouse gas emissions (GHGs) emitted by the industry. In a policy environment seeking to rapidly reduce GHGs, we believe that assuming the continuation of existing regulatory and accounting treatment of these assets is highly questionable. Stated bluntly, in the context of environmental remediation, these are the low hanging fruit. Consequently, if we were utility managers we would at the very least prepare for less than cordial discussions about stranded costs and attempts to delay action in order not to incur those costs.
In the end we expect the financial burdens of environmental remediation will fall mainly on the consumers. The regulatory compact has been weakened at times in previous periods but its basic logic is still accepted by the US regulatory community. US utilities invested in those coal facilities and associated waste ponds and accepted a moderate return on investment in turn for assurance of payment. We see nothing to suggest that regulators will fail to uphold their end of this bargain.
But that is not likely to completely resolve the stranded assets question. The oil industry has taken up the argument adding a different twist. Those firms (and their investors) point to the spending to develop oil reserves and the distribution system that brings oil to consumers. Why permit that investment to go down the drain simply because the transportation sector is migrating to electricity from oil? A transformation that is likely to continue to damage those companies and the regional economies in which they play an outsized role. Readers of a more free enterprise bent might ask why anyone should care? The oil companies are not public utilities. Consumers do not have firm contracts with oil companies requiring a set level of purchase to insure profitability. If the companies over-invested in assets no longer deemed as highly valuable by the market that is their problem not ours.
But spokespeople for the oil industry, borrowing from their utility cousins, have suggested we try to maintain the financial strength of the oil industry. The reason? This proposed generosity will keep the oil companies financially strong and afford them the resources to help the world transition to a low carbon economy. And over this proposed transition period the oil industry has begun to publicly discuss reducing its carbon footprints to zero over a rather leisurely period of say two to four decades.
Color us skeptical about the oil companies in their new role as champions of carbon attenuation. One of the key tools in reducing greenhouse gas emissions is electrification. Electricity is the new oil. The displacement of fossil fuels, both oil and gas, is a growing trend. Interestingly, oil companies have no expertise in electrification. Furthermore, the electric industry has had no difficulty in raising funds for expansion of renewable investments or anything else for that matter. The electric companies do not need the oil companies to provide the money. In addition, electrification of the vehicle fleet, which would significantly reduce the nation’s emissions profile, is not remotely in the interest of the oil industry which sells two thirds of its output for fuel transportation. Instead we would expect the oil industry to focus on virtually any remotely viable “green” technology that postpones electrification.
Economists tell us to ignore sunk costs when making decisions. Calling sunk costs “stranded assets” does not change the advice. We believe the US’s regulated utilities will in fact collect the bulk of these potentially stranded costs for two reasons. First, primarily state utility regulators continue to believe they have an obligation to deliver rates that are fair and reasonable to all parties. Second, and to us far more interesting, the actual cost to consumers of zeroing out carbon from US utility power generation is not that expensive in relation to consumer’s income or on an annual percentage increase in price. On the other hand, oil companies could have as much as half of their assets at risk.
Looking at the price action in the equities markets, utilities are at all time highs while much of the oil space is in the doldrums. Three years ago, any hedge fund manager putting this on as a pair trade, long ‘utes’ and short oil would have been likely and quickly relieved of duties. Maybe all those politically correct, socially responsible investing types urging de-investment from the oil industry actually nailed it for once.