Alternative Energy Vexes Autos and Utilities

High prices for oil and natural gas are leading automakers and utilities to seek alternative energy solutions, but it's going to take years

The recent high prices for oil and natural gas have been particularly hard on hydrocarbon-reliant industries with no easily available substitute. Airlines, for instance, still need aviation fuel made from petroleum, chemical companies need fossil fuels for plastics, and truckers can't make their runs without diesel fuel. Many companies in these industries have been hard-hit and face endangered ratings, squeezed profits, or the task of trying to pass along the higher costs to their customers—sometimes successfully, sometimes not.

Still, other industries are trying to switch to alternative technologies or energy sources. In theory, based on past estimates of the point at which the higher-cost alternative fuels become competitive with traditional ones, the recent rapid increase in oil and natural gas prices should boost the pace of this conversion—especially considering that many experts view recent energy price increases as permanent, rather than as the temporary spikes of the past.

Two of the most voracious energy-consuming industries—autos and utilities—illustrate the obstacles to rapid conversion. Car companies are suddenly (and at last) deadly serious about lessening the dependence of their products on oil, now that it's north of $130 per barrel. And utilities are just as eager to burn less natural gas, now that it's at around $12 per million Btu (mmBtu), or roughly two and one-half times the pre-Katrina price.

Toyota and Honda's Head Start

Natural gas prices can and do vary enormously because of the weather. Still, the total cost of electricity from wind compared to natural gas was already fairly close in 2007, when gas was at only $7 per mmBtu. That means wind should be a decidedly more affordable option now. But while a wider use of alternative energy sources seems almost certain to occur, it's also clear that it will take time—years, in fact—before alternative energy generates more than its current tiny 2% share (not including hydroelectric or nuclear power) of U.S. electricity.

The problem both automakers and utilities face is time. Though Toyota (TM) and Honda (HMC) have a head start, most automakers have a long way to go to perfect energy-efficient technologies, not to mention convert existing production capacity. And with more hybrid models coming out, each auto company is also facing an increasingly competitive field.

Utilities, once they have the technologies, must also negotiate the minefield of government and regulatory policy and approvals. The bottom line is that while conversion efforts will bear fruit over the long term—perhaps five or 10 years from now—we don't believe that they'll lead to meaningful improvement in the credit quality of carmakers or utilities any time soon.

Automakers Look Beyond Gasoline

Probably no industry would like to convert more quickly than U.S. automakers, which until recently pinned their business strategies on gas-guzzling pickup trucks and SUVs. Buyers are now shunning these vehicles and buying smaller cars and crossover utility vehicles. Hybrid cars, while still a niche segment—they have a single-digit U.S. market share—continue to grow in popularity despite their price, which might be several thousand dollars above that of a comparable conventionally powered vehicle.

Automakers are responding the best way they can on short notice. "It's causing them to sharply cut production of trucks and SUVs and increase the production of cars," says Standard & Poor's Ratings Services credit analyst Robert Schulz. General Motors (GM), Ford (F), and Chrysler (each carries an S&P credit rating of B) are all going through the painful process of idling truck plants while trying to boost production of conventional cars and hybrids.

This difficult transition and its effect on the companies' cash flows and prospective liquidity was the major factor in Standard & Poor's recent placement of GM, Ford, and Chrysler's ratings on CreditWatch with negative implications. "Even higher-rated automakers are cutting SUV and light-truck production in light of prospective market conditions," said credit analyst Gregg Lemos Stein.

Hybrids Present a Challenge

Suddenly, in fact, every car company is trying to catch up with Toyota, whose popular Prius compact car has given it a head start in the hybrid market. The market is becoming crowded, as even pickups and SUVs now use hybrid technology. Yet the combination of tough competition and the high cost of product development makes the hybrid market a difficult one to earn profits.

That timetable depends on continuing innovations in technology. For instance, several automakers are also developing or considering plug-in electric vehicles. GM hopes to lead the pack with its Volt, a plug-in electric car that can also run on gasoline to provide drivers greater range. GM says the vehicle will be ready by late 2010, although the company hasn't worked out all of the details necessary to produce a commercially viable lithium-ion battery. Toyota and Ford are also currently working on plug-in electric vehicles.

Beyond hybrids and electric cars, automakers are looking at hydrogen fuel-cell technology—another long-term answer to reducing gasoline use and greenhouse gas emissions. However, this technology is many years if not decades from widespread use. Automakers (the early experimenters include BMW , GM, and Honda) must first perfect the technology and dramatically reduce its now-astronomical cost. Even after that, someone will have to pay the massive cost of building enough hydrogen fueling stations to make widespread use practical.

Moving Beyond Fossil Fuels

Electric utilities, meanwhile, are caught in a bind of a different kind: Power demands are growing, environmental mandates are becoming tougher, consumers want lower rates, and absolutely no one wants a new power plant built near them. Sometimes they don't even want the wires that carry the power from somewhere else to run through their properties. Add to those concerns the fact that the price of natural gas, which is essentially the only fuel utilities use to generate electricity at most new power plants, has taken off, and it becomes clear that alternative fuels are gaining greater importance to this industry.

The greening of the power business, or the move away from fossil fuels (coal at older plants and natural gas at newer ones), shows up in the increasing use of renewable portfolio standards (RPS). These state regulatory standards call for a certain share of energy in each state to come from nonfossil fuels. The number of states with RPS has grown steadily, and now about 40% of the U.S. electric load falls under states with them. The implementation of these standards is gradual, but, ultimately, California is requiring 20% of its electricity to come from renewable energy by 2010 and is considering 33% by 2020, New York has a 24% goal by 2013, and Illinois wants 25% by 2025.

However, the costs of these mandates aren't immediately clear. "That uncertainty could result in the chief credit risk for utilities—that consumers could rebel at higher rates needed to bring power from renewable resources online," says S&&P credit analyst Anne Selting. That risk increases in states that already have high energy rates and have also imposed aggressive RPS.

The high price of natural gas, however, is making investments in renewable resources look better and better to utilities, even without RPS. "The higher the price of gas, the higher the price of electricity will be and the better the alternatives look," said credit analyst Terry Pratt.

Wind Power's Pluses and Minuses

Wind power, for example, is a strong contender in many areas, for investor-owned utilities such as MidAmerican Energy (A-) and Xcel Energy (XEL) (BBB+), and for independent power producers such as FPL Energy (FPL), PPM Energy, and Invenergy. There are problems with wind, however. Many people don't like the look of big propeller turbines, and some environmentalists have raised concerns about their effect on birds and other wildlife. Moreover, wind resources suitable for generating large amounts of electricity are often located far from population centers, so transmission can be a costly issue.

Wind is also still relatively expensive and much of its recent development has depended on federal production tax credits (PTC), whose future is uncertain. The most obvious drawback: Wind power depends on the vicissitudes of weather. In its favor, however, wind power plants can be quite large and take just a few months to build.

Solar power, also still relatively expensive to produce, makes true economic sense mainly in areas where sunlight is not just abundant but also intense, such as parts of New Mexico and Arizona. A mix of both large and small utilities already use solar power, though as a share of total national power production it's still small. Industry growth also relies on the PTC, and some states mandate minimum solar power generation through the RPS.

Although hydropower can be an exceptional source of cheap, renewable energy, most of the opportunities for harnessing it have been tapped out in the U.S. Very few places are left where the water source for new, sizable hydropower is abundant and dams can be built to harness it.

That leaves nuclear energy, by far the most controversial nonfossil-fuel source of power. No nuclear power plants have been built for decades, but the rising demand for power is causing some utilities, such as Southern Co. (SO) (A), SCANA (SCG) (A-), and Duke Energy (DUK) (A-), to consider this option. It's far from certain that these efforts will come to fruition, and if they do, 2016 or so looks to be the earliest any nuclear plant would come on line.

Change Isn't Just Around the Corner

To meet U.S. electricity needs, alternative fuels will likely play a greater role in the years to come, either through mandates or increasingly competitive pricing. Nevertheless, more often than not, it is substantial federal financial support that makes these changes happen. At the very least, it will be many years before alternative fuels provide a significant share of power generation.

Until then, the car companies will keep pushing to bring out more energy-efficient vehicles, while utilities will continue to pass on higher fuel costs through the rate process and hope consumers learn that though some fuels are clean, green, and renewable, there will be a price to pay.

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