Running Out of Places to Hide

Global warming appears in the news with increasing frequency.  Few have not heard of the irreversible environmental effects of emitting harmful gases such as carbon dioxide into the atmosphere. For decades scientists have been warning about the consequences of melting polar ice and shifting ocean currents that follow.  True enough there remain those who still get called by the derisive appellation ‘climate denier.’   However, most now acknowledge rising temperatures and the connection to human use of fossil fuels.  Most understand the need to use resources more wisely and reduce use of oil and gas.  Even investors are jumping on the band wagon, divesting of oil and gas holdings in favor of renewable fuel stocks or providing venture capital to an alternative energy start-up.

Yet such investment decisions have impacted only a small portion of the global energy sector.  Most investors have avoided the entire issue of global warming and the economic consequences: land loss from rising ocean levels, more volatile weather conditions, altered food supplies, and water shortages, to name just a few consequences already in evidence.  They remain ‘investment deniers’ at a time when markets are making it clear there is a new truth.

Reality in Old Blighty

A case in point is recent electricity auction in the United Kingdom.  Last week British power authorities were sorely disappointed by the results of a capacity auction intended to bring new power generating capacity to the country’s electricity grid. The United Kingdom government set up a mechanism called the Capacity Market to help ensure adequate back-up power generating capacity is available as the country transitions to more intermittent renewable energy sources. Beginning in 2014, this Capacity Market operates alongside the regular Electricity Market to help smooth availability of low-carbon electricity sources while protecting consumers from spikes in electricity costs.

The back-up power auction process is intended to encourage new power plants, but only 14% of the power capacity that was up for bid in the recent auction was snapped up by bidders contemplating new power plants. The rest went to existing power plants that have their eyes on the back-up power capacity market. The tepid response can be found in the price. The auction ‘cleared’ at 8.40 British pounds per kilowatt (US$11.70) for power delivery in 2021 to 2022. Government analysts had been expecting bids at at least twice the final results.

Final results of the auction are provided by National Grid Plc (NGG: NYSE), which has suggested cuts to Capacity Market auction targets.  In the most recent auction several of the coal power plants withdrew from the auction process.  With no power supply agreements in place beyond 2019, some may now be headed for closure. For example, SSE Plc (SSE: London) did not secure a successful bid for its coal-fired power plant at Fiddler’s Ferry. SSE executives were quoted by news organizations as stating investors will be consulted on the next move for Fiddler’s Ferry given the short runway left in its existing power supply agreement.

The U.K. experience is instructive for the power industry, investors and consumers alike. The Capacity Market was set up to ‘smooth’ the transition and help develop the necessary back-up power sources needed to make up for the ebb and flow of power from renewable sources. From this side of the pond the process seems everything but ‘smooth.’ Earlier than expected power plant closures appear imminent and that typically is followed with a write-down of asset values. Profit margins will be lower than expected because power supply agreements were awarded at lower than anticipated selling prices.

Government authorities indicated some of the unsuccessful bids will be revisited with the possibility of providing subsidies to bridge the gap between the auction clearing prices and costs experienced by the plant owners. Unfortunately, government subsidies often mean increases in taxes or in the least pressure to increase utility rates to help cover the costs.

Consequences

There is simply no easy, painless transition to a safe, sustainable power supply, in the United Kingdom or anywhere else for that matter. We have must confront the consequences of a decadent life of instant on, uninterrupted power at our finger tips. There will be discomfort in the form of higher electricity prices.  There will be disappointment from investment losses.  Long standing companies may be reduced in size or even ultimately fall.

If someone were to ask who is responsible for the pain we must now all endure, it would be this analyst’s response to point a finger of blame at the oil and gas industry. They obviously had a great deal of incentive to minimize and dispute the connection between environmental decay and use of fossil fuel. In the end though, it is the investor, the consumer, the voter who must take ultimate responsibility for any disappointment and we have run out of places to hide from reality.

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.