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Regulation and Compliance > Federal Regulation

Fossil Fuels: More International Investment Risk Than Opportunity?

By Marlene Y. Satter

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With the energy sector in flux, the growth of renewables, and a rising public outcry in many regions against the potential hazards of fossil fuels and their production, investors need to tread carefully as opportunities shift and risks surface. This article, the second in a series, looks at some of the pitfalls and possible opportunities in the fossil fuel sector.

The increase of ever more violent weather phenomena such as Superstorm Sandy has spurred greater concern over climate change, and that has narrowed the focus on coal in particular. Coal has been the primary source, globally, for electricity, providing 40%, according to the Energy Information Administration (EIA); its use has also increased by more than 50% over the past 10 years.

The EIA projected in July that coal’s use would grow by a third by 2040, with developing countries increasing their use of it. But other parts of the world are turning away from coal and actively discouraging its use, thanks to its status as the largest generator among major fuel sources of carbon dioxide per energy unit entering the atmosphere. Coal is looking more and more in many quarters like a problem rather than a solution, and wealthy countries are withdrawing government funding for coal elsewhere in the world, leaving its use in developing countries threatened in many places.

Global lenders have also begun withdrawing support from coal projects, with first the U.S. Export-Import Bank , then the World Bank and finally the European Investment Bank halting support of coal-fired plants and turning instead to renewables. There are some exceptions; for instance, the World Bank is still considering a Kosovo coal project.

Over the past five years those three institutions have provided over $10 billion for coal projects; the absence of that much money will certainly be felt. Oil Change International data indicate that the U.S. Export-Import Bank provided $1.4 billion in financing to two coal projects in India and in South Africa, while the World Bank accounted for some $6.26 billion in coal project funding during the period.

Coal companies are feeling the squeeze, and so, now, are investors as well. Analyst Christian Lelong at Goldman Sachs Australia said in research that the “window for thermal coal investment is closing,” and that “[e]arning a return on incremental investment in thermal coal mining and infrastructure capacity is becoming increasingly difficult.”

In a late July report, Lelong stated that despite the fact that coal presently is the top fuel used for power generation, it will be losing that market share because of three main trends: environmental regulations that will discourage its use, competition from gas and renewable energy sources, and improvements in energy efficiency. Weaker demand growth and seaborne prices near marginal production costs will mean that “most thermal coal growth projects will struggle to earn a positive return for their owners.”

LeLong stressed that “even when carbon prices are low or nonexistent, the downside risks of future regulation can offset the cost advantage of thermal coal relative to alternative energy sources.” And despite the fact that demand continued strong in India and southeast Asia, “the number of new plants is expected to decline by the end of the decade and the energy sources with the most upside potential include gas and solar power,” he stated.

Of course, such change won’t happen overnight. According to the World Resources Institute, 1,200 coal-fired plants are in the planning stage across the world, with more than 75% of those scheduled to be built in India and China. But WRI says it is unlikely that all 1,200 will be built.

Still, China, which produces the lion’s share of the world’s coal and is also its largest importer, doesn’t need to rely on outside funding to build coal-based projects. India, too, uses foreign money only rarely for power infrastructure projects. So demand will continue in some quarters. And Japan has been relying more heavily on coal since the Fukushima disaster destroyed much of its nuclear generation capability.

While China hopes to export its coal plant technology, along with its myriad other exports, it’s fighting a pollution battle at home that could change its dependence on coal in the long run. The heavy concentration of pollutants in the air has not only endangered the health of its people, it has also contributed to a drastic drop in tourism as visitors opt to go elsewhere rather than face the smog-filled skies of many Chinese cities.

Other forms of fossil fuels are encountering their own difficulties. In Germany, Europe’s largest energy market, fossil fuel-powered utilities suffer as solar and wind power dominate, causing EON of Dusseldorf and RWE of Essen to consider shutting down coal and gas plants. Demand for power has fallen, and preferential treatment of clean energy production has crippled profits at conventional energy plants. Since neither RWE nor EON were heavily invested in renewables, the damage to their bottom lines has pummeled their stock prices.

In addition, the phase out of nuclear generation in Germany—a response to the Fukushima disaster in 2011—has added a further blow to profitability at a time when reports coming out of Japan indicate that the Fukushima site is still releasing nuclear contamination more than two years after the disaster.

Elsewhere in the world, protests over fracking have threatened Prime Minister David Cameron’s drive to increase production of shale gas, as demonstrators in Britain have delayed projects from the north of the island nation to the south out of concern for long-lasting environmental damage. In Canada, environmentalist concerns intensified after the wreck of a runaway train in Lac-Mégantic, Quebec that carried crude from South Dakota; not only is the rail company under fire, but the oil itself is being analyzed in Ottawa after experts confirmed that it reacted “in a way that was abnormal” after the wreck. Complaints have already been lodged over the fracked oil’s chemical makeup, not just by environmentalists, but also by Canadian pipeline operator Enbridge Inc.

In an interview, Morningstar energy analyst David McColl, commenting on Alberta oil sands production, said that one issue facing companies, and also investors, was how to get the final product to market in the teeth of protests against pipelines, on which construction has been slowed or even halted. Although more expensive, rail transport has emerged as an alternative means of market access. Since the Quebec disaster, however, rail could find itself in for additional regulation, given the circumstances of the wreck.

McColl pointed out that there’s also the possibility of additional cost being added to the production of oil produced via fracking because of the chemicals contained in it—as became clear after Lac-Mégantic.

All is not doom and gloom for oil sands, however. McColl said, “We view oil sands producers as very undervalued right now … There are no groundwater issues or contamination that I’m aware of, and I’ve been following it for over a decade.” The oil sands industry issue, he said, “boils down to reclamation … that … has to happen after a project is concluded, and these are multidecade projects that can last 30-60 years or so.”

Arboreal forest reclamation is a problem, although McColl said that “producers are working on land reclamation and trying to reclaim the land to a comparable habitat, and that seems to be happening.” Another is the existence of tailing ponds. “The Alberta government imposed new regulations that  took on a liability for tailing ponds that used to be attached to the end of life of a project.” The new Directive 74 took future liability that there was risk and uncertainty, and accelerated it to today. Its purpose, said McColl, is to address tailing ponds, and it’s “added up to a million dollars to most projects.”

Diversification plays a role, too, driving other companies away from fossil fuels. German development bank KfW Group is financing a French energy company’s wind farm in Uruguay. In a truly international spirit, 80% of the loan for the project is being guaranteed by Danish export credit insurer Eksport Kredit Fonden. Even Ikea is getting into the act, with the planned purchase of a wind farm in Ireland adding to its program to invest 1.5 billion pounds ($2.3 billion) in wind and solar by 2015. The company, which already owns 137 wind turbines, intends to become energy independent by 2020.