How regulation is making natural gas the new coal

Surrounded by coal industry workers, donned in khaki pants and polo shirts, President Trump signed an executive order in March pulling the plug on his predecessor’s plan to close hundreds of coal-fired power plants to reduce carbon emissions. “You’re going back to work,” Trump told the miners.

At a Kentucky rally and a morning talk show leading up to the signing, President Trump and Scott Pruitt, the new Environmental Protection Agency head, both said the order will add jobs to an anemic coal mining industry and promote domestic energy production.

So, what does this mean for private credit? While the executive order may slightly move the goalposts, fund managers and advisors active in the US energy sector tell PDI they’re carrying on as usual.

Executives at New Energy Capital Partners, say the general expectation in the energy sector is that Trump’s order may slow the retirement of some US coal plants, at least those that were marginally profitable in the last four or five years. At the same time, however, they don’t expect the order to change the seismic shift in US electricity production away from coal and towards natural gas, renewables, and other sources of power. The firm closed its first energy fund focusing primarily on debt in April.

“It’s fair to say there won’t be a spike in coal investments following Trump’s executive order,” says Scott Brown, chief executive and managing partner at New Energy Capital. “No one will make a 40-year investment based on a four-year administration.”

Brown points to other costly regulations on coal – such as the mercury and air toxicity restrictions – remaining on the books after the order. “Those regulations will continue to make coal less economically viable,” he says.

The Trump executive order comes as natural gas has defrocked coal from its reign as the top energy source for electricity generation in the US. Between 2000 and 2008, coal supplied about 50 percent of total US power generation, Department of Energy data show. However, since then, large amounts of natural gas produced from shale formations in North America  – particularly Marcellus, Stack, and Haynesville – changed the equation.

By 2016, the share of US power generated by coal had dropped to 30.4 percent, while natural gas accounted for the largest share of power generated in the US, with 33.8 percent, according to the federal agency. 

“Gas is now the preferred hydrocarbon for electricity production,” says Brian Williams, managing director at Carl Marks Advisors. Williams, who advises debt and other financings for US oil and gas companies, says it’s hard to see this trend changing, given the abundance and ease of tapping into unconventional gas reserves in North America and current energy prices. 

The numbers bear that out, with the price gap between coal and natural gas having narrowed. Government data show that the average cost of generating electricity for gas power plants was $33.24 mills (or 1/1000th of a US dollar) per kilowatt-hour (the amount of electrical energy required for 1,000 watts of power for one hour), which is significantly down from $70.72 mills in 2008.

By comparison, fossil fuel plants (including coal) cost $37.26 mills per kilowatt-hour in 2015, compared with $35.75 in 2008.

Williams says the effect of this order, which also opens previously protected federal land to oil and gas drilling, “will be minimal, if there is any effect at all”.

He points to the heart of gas activity today, which is in the Marcellus formation in the eastern US, where new forms of extraction, utilising horizontal drilling and fracking technology, have exploded despite government regulations.

“This order may marginally relieve some burdens to oil and gas producers, but it’s not like there’s a bunch of people sitting around waiting to be relieved from the Obama administration regulations or waiting for federal land to open before they start drilling,” adds Williams.

At least some in the administration are aware of this, he says. During a recent event Williams attended this April in his home town of Houston, Texas, Mike McKenna, president of MWR Strategies and energy advisor to Trump’s transition team, spoke. “During the Q&A, I asked him, ‘Is there anything the Trump administration was doing that would have any effect on increasing drilling or overall effect on gas and oil markets,’” says Williams. “McKenna’s short answer was ‘no’.”

Just as Trump’s order may not change the rise of natural gas or downfall of coal, the order is not likely to change the attractiveness of energy debt, especially distressed. The Carlyle Energy Mezzanine Opportunities Fund II made the list of top 10 fundraises last year, closing on $2.77 billion last October. In PDI’s annual LP survey last year, 80 percent of limited partner respondents selected energy as the best opportunity for investment, particularly distressed.

Growing niche

Though many distressed investors have their eye on commodity-dependent sectors like oil and gas, some fund managers instead play in the growing niche market of wind and solar. The Clean Power Plan’s goal is to tip the energy scales away from coal, gas and oil towards non-emitting sources like wind and solar, to meet emission reduction targets that the US and international community set in the 2015 Paris Agreement.

This sector won’t likely be impacted by the Trump’s reversal of the Clean Power Plan, says Brown. At the time of Trump’s executive order, the plan was temporarily on ice due to a US Supreme Court ruling. And regardless, the Clean Power Plan was not scheduled to go into effect for several more years. It also wasn’t clear how each state was going to implement its required plan to comply with the federal regulations.

Last year was a record one for deployment of capital to renewable energy companies, says Brown, but not necessarily because of Obama’s plan. Instead, the industry expected renewable energy investment tax credits to expire at end of 2015, so developers rushed to jump-start projects in 2015 and complete them in 2016, Brown recalls. Congress, however, through bipartisan legislation supported strongly by Republicans as well as Democrats, unexpectedly extended the tax credits for several more years at the end of 2015.

“The pipeline for 2016 was already in place so we had a record build-out,” he says. “The next few years will follow a more normal growth path after a slowdown in 2017, driven more by industry fundamentals and ongoing cost reductions.”

He expects the cost of solar and wind generation to be lower than natural gas soon and says in some locations this is already true. Because the manufacturing scale is driving the cost down, the price of solar modules has dropped by more than 70 percent since 2010, while wind costs have declined as blade lengths and turbine efficiencies have increased.

“Policies have contributed to that, by increasing deployment, but the costs are following a typical manufacturing experience curve, driven by scale and increasing efficiencies in technology, especially in the solar sector,” Brown says.

However, Williams is sceptical that renewables will be as competitive as oil and gas.

“Those energy sources exist primarily due to government incentives and mandates, and without any outside support, you wouldn’t see them develop,” he says. “Renewables are still a tiny percentage of the energy marketplace.”

Brown says he has found solid ground in the niche of renewable energy and clean infrastructure, and that Trump’s order “will not deter New Energy Capital’s current debt strategy”.

Brown oversaw the final close of the New Energy Capital Infrastructure Credit Fund on $325 million this April, well above its original fundraising target of $250 million. This is the firm’s fourth infrastructure and energy fund, but the first focused primarily on debt, targeting both senior debt and mezzanine. The investment strategy focuses on “clean infrastructure”, which includes solar, wind, hydroelectric, water treatment and reuse facilities, and even lighting retrofits in North America.

“We have demonstrated consistent returns in the clean energy infrastructure market – the market is growing and investor demand is strong,” Brown says. “We’ll just keep doing what we know how to do.”