Utilities are often singled out by environmentalists for not doing enough to respond to climate change, but the perception that the industry is only reluctantly fulfilling its responsibility to society isn't quite accurate. An analysis of the 16 largest utilities and power generators in the United States -- comprising half of the nation's installed power capacity -- shows that the power sector is on pace to blow away even the most ambitious decarbonization projections.
In fact, even without market intervention, it might be possible to retire most of the country's coal-fired power plants by 2040. Considering coal power is responsible for roughly 30% of America's electricity generation and 69% of power sector carbon emissions today, that'd be a huge step to reaching the nation's climate change goals.
The bad news is that may not be quick enough to limit the most damaging effects of climate change. The good news is that it's entirely possible for the United States to send most of its coal-fired power plants to an even earlier retirement, perhaps as soon as 2030. There's just one major hang up: a quirky financial accounting mechanism called accelerated depreciation. It rarely comes up in conversations about climate change, but it actually represents one of the biggest obstacles and opportunities to rapidly decarbonize the economy. For better and for worse, investors in electric utility stocks will need to become familiar with the term.
What is accelerated depreciation?
Depreciation is a part of basic accounting. You can check out a detailed description here, but the gist of it is that the value of an asset deteriorates over time because of use or age, and companies get to deduct the future expense of replacing it through depreciation.
Utilities do the same thing for multi-million-dollar power plants, depreciating the assets over a period of decades. If a coal-fired power plant built in 1990 was expected to have a useful life of 50 years, then the owner won't account for the full depreciation expense until 2040. If the owner of the power plant wants to retire the facility 20 years early, in 2020, then it has to account for two decades' worth of depreciation expense in a much shorter time frame. That's accelerated depreciation.
Why is accelerated depreciation an obstacle to climate change goals?
When a utility wants to make changes to its power generation portfolio, it must submit a proposed power plan to its regional regulator. The regulator weighs various factors when assessing a plan, such as how it will affect grid resiliency based on projected energy consumption growth and, most importantly, how it will change rates for customers. And that's become a sticking point lately.
Let's say a utility wants to retire a coal-fired power plant 10 years early and shows it can completely replace the lost electricity with wind, solar, and energy storage. The cost to generate electricity will be the same or even lower for ratepayers. But since utilities are tightly regulated, and depreciation is an expense on the income statement, the accelerated depreciation expense is treated as an unrecovered investment that generally has to be recouped from ratepayers or offset by savings elsewhere in the proposed power plan. Regulators aren't always willing to increase rates just to pay for accelerated depreciation, so sometimes coal-fired power plants are forced to keep operating against a utility's wishes.
That's not just a hypothetical.
Xcel Energy (NASDAQ:XEL) almost had its ambitious Colorado Energy Plan rejected over these concerns last year. The utility proposed to retire 660 megawatts of coal-fired power plants 10 years ahead of schedule and replace them with 380 megawatts of natural gas, 700 megawatts of solar, 1,100 megawatts of wind, and 275 megawatts of energy storage.
The Colorado Public Utilities Commission didn't think the long-term savings from cheaper renewable energy sources would make up for the accelerated depreciation expense and almost nixed the power plan because of it. The company's shares struggled to overcome the uncertainty last summer -- a rare feature for a usually steady utility stock with a long history of thumping the returns of the S&P 500.
Investors can expect more uncertainty -- and more battles between utilities and regulators -- over the issue in the coming years. While a sizable amount of coal-fired power capacity has been retired in the last 10 years, it comprised mostly older, smaller, and less efficient facilities averaging 52 years in age and 102 megawatts in capacity. The nation's existing fleet boasts an average age of 39 years and an average capacity of 319 megawatts. Early retirement of these assets would result in a higher accelerated depreciation due to both their youth (more years of depreciation) and size (higher overall depreciation expense).
The issue certainly isn't going away for Xcel Energy, which recently became the first utility to commit to 100% zero-carbon electricity by 2050. The utility will still lean on coal for 22% of its electricity generation in 2027 after overhauling its portfolio in Colorado -- not to mention a significant amount of natural gas. That means investors will need to be prepared for the risks posed by accelerated depreciation, both in terms of wrangling with regulators and the possibility it will have to keep underperforming coal facilities on line longer than it wants.
An under-the-radar risk for electric utility stocks
Few discussions over how to best tackle ambitious climate change goals mention accelerated depreciation, but given the average age and size of America's operating coal-fired power plants, it's going to become an increasingly important detail handicapping utilities. The uncertainty that gripped Xcel Energy in summer 2018 might only be the first example to flash across investor radars.
Unless the federal government steps in to eat the cost of accelerated depreciation currently creating a stalemate between utilities, regulators, and ratepayers -- a move some experts have estimated might only cost $50 billion in total, and one that could flip the risk into a gargantuan opportunity -- investors in electric utility stocks will need to keep the accounting mechanism top of mind as companies release ambitious long-term carbon reduction strategies.