Moodys and S&P Need to Get Serious About Carbon Risk

Following two important announcements in the past month, it seems clear that industry and government now both converging on the view that carbon risk will have a significant impact on the economics of building new coal fired power plants. 

In December, the EIA released its Annual Energy Outlook for 2009 (AEO2009) and for the first time incorporated an investor carbon risk factor in its reference case. To quote from the report "the AEO2009 reference case assumes no changes in current laws and regulations. However, it reflects the behavior of investors and regulators who, in their investment evaluation process, are implicitly (or explicitly) adding a cost to many proposed power plants that employ GHG-intensive technologies", as a result "additions of new coal-fired power plants are significantly reduced from earlier projections."

The impact of applying carbon risk to the economics of building new coal in the EIA's analysis is fairly dramatic. Using demand growth assumptions just 4% below the AEO08 estimates, the number of new coal-fired power plants built through 2030 drops from 100GW to 42GW. In addition, the EIA in their AEO09 report is now expecting almost no new coal capacity will be built between 2013 and 2024 (1.2GW additions) apparently due to investor concerns about uncertainty of carbon emissions  regulation.

This new government projection preceeded the release of the USCAP Blueprint for Legislative Action that not only calls for coal fired power plants to pay for their carbon emissions from 2012, but would also establish performance standards on new coal builds. The document also includes performance-based subsidies to develop and deploy carbon capture and storage (CCS) technology to scale as a way to mitigate the impacts of new regulation on power providers. 

Government and Industry Get It on Carbon Risk. What about the ratings agencies?

Indeed, with President Obama signaling his intention to put climate legislation near the top of his policy agenda, investment in new long-lived coal power generation needs to incorporate carbon risk as a prominent factor in assessing a projects economic viability. This link between assessing carbon risk and applying it on a consistent basis across the power generation spectrum is where the ratings agencies should fit in. Unfortunately this is not happening. In fact, S&P and Moodys have been taking a fairly reactive role in assessing the potential carbon risk from new coal projects.

This lack of focus on carbon risk from the ratings agencies not only affects new investments, but also impacts the asset values the agencies have assigned to the existing power generation capital stock. With trillions of dollars of capital stock subject to carbon regulation under a climate bill, investors will need to know how the ratings agencies intend to model the impacts of carbon risk and as of today this isn't happening to any large degree.

Given that both the USCAP companies and the US government's Energy Information Administration recognize that the rules of the game are changing, Moodys and S&P need to become more involved in an area that should be a growth area for their businesses. Indeed, with USCAP now advocating a performance standard that would apply at some point to all new coal builds not permitted by January 1st 2009, the agencies should also be focused on the credit risks inherent in plant design selection, since performance standards supported by many of the countries largest emitters is likely to have enough buy in to be included in other legislation addressing climate change. 

AMP-Ohio's desire to build a 960MW coal-fired power plant in Meigs County, Ohio offers a telling example how little impact carbon mitigation plans have had on the ratings agencies assessment of the economic viability of coal plants in recent years. In October 2008, AMP-Ohio released a revised RW Beck study of the economic risks of its planned facility. In this report, RW Beck revised up its assessment for construction and fuel costs for the plant in line with market estimates but decided to leave out carbon costs estimates altogether in its base case scenario. It had previously included very conservative estimates of these costs but eliminated them entirely based on their assessment that the political climate is too uncertain to determine whether or not AMP-Ohio would be required to pay for their carbon emissions. This base case scenario of zero carbon costs appears to have been acceptable to the ratings agencies, as the banks have already begun marketing the debt for this $4bln deal to their clients.

As the AMP-Ohio deal is being structured with 50 year take or pay contracts which leave the 70 municipalities in Ohio plus other communities in Michigan, Virginia, and West Virginia with nearly $23bln in potential hidden costs down the road, the risk assessment from the ratings agencies appears to view the carbon risks as being extraneous to the investors. However, as detailed in my blog AMP-Ohio's New Coal Plant is a Bad Bond Bet, if the total risk exposure including carbon is not properly assessed, the lack of disclosure of these risks today will not make the bond holders immune from default down the road. If they are to truly serve the investor's interests, the ratings agencies need to measure the carbon risk of this facility independently of AMP-Ohio's analysis, especially with carbon legislation becoming more and more likely in the near term.

In sum, the ratings agencies need to become more involved in assessing carbon risk as climate legislation will directly impact new coal investments as well as the asset value of trillions of dollars of long-lived capital stock. Relying on company produced reports to determine whether management is thinking about carbon risk is not enough. Metrics must be created and used across the power sector to determine how well these new facilities are able to adapt to higher performance standards and carbon regulation. S&P can be applauded to some degree for the metrics it has created to encourage energy efficiency efforts at the utility level to reduce emissions but more needs to be done to directly measure the carbon risk of new coal in a systematic and transparent way.