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December 22, 2006
Costs of Carbon and Coal: Examining Emissions Trading Scheme Impact on Shareowner Value
    by Bill Baue

WWF and SAM Group collaborate on a study modeling impacts of rising costs of carbon dioxide emissions on the valuation of German utility RWE, the biggest private carbon emitter in Europe.

As the largest German electric utility, RWE (ticker: RWEG) is a poster child for illustrating how climate change impacts companies when the emission of carbon dioxide (CO2--the primary greenhouse gas (GHG) causing global warming) becomes increasingly regulated. The 2005 European Union Emissions Trading Scheme (ETS) created a market-based carbon cap-and-trade system that constrains big carbon emitters such as RWE, forcing them to factor carbon into their business decisions. On the other side of the coin, the company announced this week it is under investigation by the German Federal Cartel Office on charges of illegally factoring the costs of CO2 into electricity prices, exemplifying the risks of walking a tightrope between carbon and regulatory constraints.

RWE thus represents an excellent case study for assessing the risk to shareowner value from rising constraints on corporate carbon emissions, which regulators are doing in order to internalize the cost of carbon pollution that companies have until now externalized onto society. WWF, which criticizes the embedding of full carbon costs in electricity prices since ETS provides free carbon allowances, and Sustainable Asset Management (SAM) Group, which manages the Dow Jones Sustainability Indexes (DJSI), joined forces to produce just such a study. The study, entitled Carbonizing Valuation: Assessing Corporate Value at Risk from Carbon, finds that RWE could lose up to 17 percent of its shareowner value if it continues on a "business-as-usual" strategy that fails to take increasingly stringent carbon limits into account.

"In a world where carbon emissions will become expensive, utilities need to keep an eye on the long-term value of their company," said study co-author Bjørn Tore Urdal of SAM Group. "[T]he European Commission [recently] rejected nine out of ten National Allocation Plans (NAP) for the next phase of the EU Emission Trading System; this illustrates that in the long term the carbon price is going to climb high and those companies and investors need to take note."

The European Commission (EC) has slashed seven percent from proposed NAPs that European countries submitted, with Germany bearing the biggest brunt of cuts--by 32 million tons. The EC justified the cuts as requisite to meet the projected 80 percent reduction in carbon emissions by 2050 necessary to stabilize the level of carbon in the atmosphere at 450 parts per million (ppm) and avoid catastrophic climate change, according to scientific consensus.

"The CEO of RWE has written to the German Chancellor to complain about the European Commission's decision to lower CO2 allowances to 453 million tons in the second phase of the EU-ETS system (NAP 2 period)," Mr. Urdal told "This is lower than what we have modeled for in this study, and reflects a game change that is difficult to accept for utilities."

The study models three scenarios for replacing the aging infrastructure of RWE's power plant portfolio: fuel-by-fuel (with replacement plants run by the same fuel as retiring plants), coal only, and natural gas only. Coal-fired plants represent more than half (56 percent) of RWE's current generating capacity, with six hard-coal and eight lignite (a softer form of coal) plants. The company has seven natural gas plants (accounting for 17 percent of generating capacity) and five nuclear plants (27 percent.) The report points out that 70 percent of the new electricity generating capacity being built or planned in Germany from 2006 to 2020 is coal based.

"A likely scenario for RWE will be to carry on its capacity on a status quo level, replacing retiring capacity by the same technology," the report states, noting the practicality of continuing with existing infrastructure for coal and lignite in particular.

However, natural gas emissions are typically one third of those for combusting lignite coal, according to the report, calling into question the wisdom of fuel-by-fuel or coal-only replacement strategies once the rising cost of carbon is taken into consideration.

"In the context of these imminent replacement strategies, the main aim of introducing the CO2 trading scheme is to reduce, if not completely eliminate, coal-based electricity generation and to substitute lignite generation [with less carbon intensive alternatives]," the report states.

To understand the study methodology comprehensively, readers must have an in-depth understanding of both financial calculations of shareowner value and scientific calculations of carbon emissions. The study also factors in political calculations that anticipate increasing costs for carbon as emissions limits become stricter and stricter--an assumption proven correct by the recent EC decision to lower NAPs.

After crunching all the numbers by various scenarios, the researchers find it most financially rewarding to replace retiring plants with coal plants--so long as the price of carbon remains under €33 per ton.

"A replacement strategy based purely on coal carries nearly twice the value of a pure gas replacement," according to the study. "Needless to say, the resulting carbon emissions based on the most valuable replacement strategies cases raise serious concerns . . ."

"The comparison of carbon emission trajectories with the concept of a sustainable emission path for the modeled portfolio shows that emissions will be massively over the norm," it continues. "For coal-only and plant-by-plant, we calculate aggregated carbon emissions for the period 2006 to 2050 to be a staggering 50 percent beyond the sustainable level required."

Once carbon becomes more expensive than €33 per ton, as it inevitably will, gas becomes the hands-down choice, both from an environmental and a financial perspective. At €45 per ton of CO2 (compared to the base rate of €20 per ton), the study calculate 17 percent decrease in value for fuel-by-fuel replacement, versus only one percent loss of value for natural gas only.

"In the case of RWE, we have demonstrated that, all else being equal, value at risk from carbon is significantly reduced by increasing gas exposure as an active replacement strategy," the report states.


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