Clean Air Act To Favor Coal Over Natural Gas

Administrative regulatory changes in how the Environmental Protection Agency enforces the Clean Air Act are tilting the scales in favor of coal, which is cheaper than natural gas, plentiful, and requires no new construction in an industry swamped by excess generating capacity.

There is a moment of suspended animation in each swing of the pendulum where everything pauses in perfect balance before the weight starts back the other way.

Such an event is at hand in the electric utility sector, and it will have long-term repercussions for the natural gas industry which is straining to keep production flat in the face of forecasts that call for expanded demand for electrical power generation.

Those forecasts, like the promise of $100 oil in 1981, are based on false assumptions. Nonetheless, the utility industry went on a building spree over the last four years, adding a quarter of a million megawatt hours of new power generating capacity to meet expectations of growing electrical consumption under deregulation.

More than 90 percent of that capacity is fired by natural gas. The building spree was a major factor stimulating natural gas exploration and production in North America. But it also created excess power generation capacity just as demand for electricity dropped due to the economic slowdown.

Now the rush to expand gas-fired generating capacity is on hold, swamped by billions of dollars in debt service costs. New capacity additions will fall from a peak of 60,000 megawatt hours in 2003 to 10,000--or less--next year.

At the same time, the Bush administration is pushing for changes in how the Environmental Protection Agency (EPA) enforces pollution control under the Clean Air Act, particularly with regard to emissions from coal-fired generation, a move that will further favor coal over natural gas.

Former Utah governor Michael Leavitt assumed the lead administrator's post at the EPA last month and promised a 500-day program to revamp environmental actions on the Clean Air Act. These include pushing the Bush administration's interest in reforming the legislation, originally passed during his father's presidency, through a program called the Clear Skies Initiative (CSI).

CSI creates a cap and trade system for power companies operating coal-fired power generation plants. CSI involves setting regional limits for 30 states on sulfur dioxide and nitrogen oxide emissions from coal-fired power plants. Utilities can buy and sell rights to emit the pollutants as long as the total within the region remains under the limit. Those limits would be lowered in two steps through 2015 with the intent of achieving a 70 percent reduction in the targeted pollutants by 2018.

The program mimics a cap and trade approach credited with reducing acid rain in the eastern U.S. during the late 1990s.

The cap and trade system is a popular approach for the power industry because it provides flexibility, simplifies overlapping or duplicative regulatory requirements, and uses market-based principles to reach air quality goals. The regulatory changes have the net effect of decreasing the amount of capital investment the coal-burning portion of the electric power industry needs to meet environmental compliance, which will ultimately add to coal's competitive cost advantage over natural gas.

The cost to generate power from natural gas rose 66 percent over the last five years, while coal-fired generating costs remained flat. Today, gas-fired power generation costs three times as much per unit of electricity as coal-fired power. Furthermore, the spark price, or the margin between the cost of fuel and the value of power sales, narrowed over the last two years for natural gas because of higher fuel prices, impacting the industry's ability to generate power profitably at new gas-fired facilities.

Meanwhile, new gas-fired generating capacity sits stranded because of transmission bottlenecks that prevent electricity from getting into the national grid. The electricity that does make it to market sells at prices that are too low to cover fuel costs and service the debt involved in building the new gas-fired generating plants.

For the enduser, electricity is electricity. But creating electricity involves a diverse mix of stock fuels ranging from nuclear power to natural gas. Although attention has centered on gas during the last half-decade, coal by far is the most prominent of these fuels, accounting for more than half of electrical power generation in the United States. Natural gas garners approximately 18 percent of the power generation market, while nuclear energy accounted for 20 percent in 2002.

The electric power industry is lobbying aggressively through trade organizations like the Edison Electric Institute to promote fuel diversity, a term that essentially means using less natural gas and increasing the use of coal and, to a lesser extent, nuclear power.

The campaign is working. In August, the Bush administration redefined New Source Review provisions in the Clean Air Act, which required utilities to upgrade equipment to meet current emissions standards whenever major repairs or expansions were made to older power plants.

Under the Clinton administration, the EPA had litigated and won a series of test cases on New Source Review involving more than 50 power plants. The change in the New Source Review provision, which typically involves coal-fired power plants but which was potentially applicable to 17,000 power plants, refineries, paper mills, and chemical plants, specified that if new equipment cost less than 20 percent of the expense for essential production equipment, it was exempt.

Last month the EPA decided to drop the remaining enforcement cases against coal-burning power plants under New Source Review in the wake of the rule change. From the perspective of the natural gas industry, it means old coal-fired power plants, freed from expensive upgrades, can now press their economic advantage over newer, cleaner plants, which must amortize high capital costs associated with new construction.

The changes are not a given. Attorneys general in 15 eastern states are looking at filing suit to enforce New Source Review provisions of the Clean Air Act.

Additionally, the Bush administration is studying a rule change on mercury that would add it to the cap and trade system by reclassifying how it is regulated. The EPA is facing a court order to produce a plan regulating mercury emissions by December 15.

Natural gas is losing popularity in the power generation business. The power sector took on $120 billion in debt to finance power plant construction over the last half-decade, with nearly $90 billion invested in new gas-fired power plant construction after 1999. Much of that debt is due by 2010. However, there are estimates that nearly 30 percent of the value in new plant construction has evaporated in less than three years through a combination of falling wholesale electricity prices from excess generating capacity coupled with increased natural gas costs. As a result, the power sector is struggling under the debt load. The industry is on track to refinance as much as $40 billion in debt during 2003 alone.

The fact of the matter is that the financial sector is carrying the gas and power sector, which continues to post earnings losses on a quarterly basis. Were those power sector loans not being rolled over, usually at highly disadvantaged terms for the power sector, the weight of the write offs would devastate an already fragile financial industry.