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August 12, 2007

Jitters About Regulatory Outlook Rile Confidence in Coal Mining Stocks
    by Francesca Rheannon

Growing political momentum for enacting state and national laws to reduce CO2 emissions is raising worries among investors of the long term viability of the coal industry. -- It's not just its color that's looking black for coal these days, according to a recent report by Citigroup that downgraded the financial outlook for coal stocks in 2008. Issued on July 18, the report voiced pessimism about future earnings of coal mining company shares due in part to worries over the uncertain regulatory climate facing coal due to global warming.

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our sponsorsCiting elevated coal inventories and a "hostile" political environment going into the 2008 election, Citigroup shifted from the positive view it has held on coal so far this year, forecasting "grim" second quarter earnings. Overall, coal production is down by 2.3% since the beginning of the year with inventories brimming and pricing flat. As a result, the report lowered its financial forecast for the top two industry leaders, Peabody Energy (ticker: BTU) and Arch (ticker: ACI), with the latter coming in for an estimated 18% decline in second quarter earnings per share. Other companies fared poorly in the report, as well.

Several factors caused concern, such as lower coal demand due to cooler summer temperatures this year, weather disruptions to rail shipments, and rising input costs. But the lion's share of worries centered on the prospect of increased regulation and carbon "constraints" that Citigroup said were "certain to pinch" future earnings. Coal-fired power plants are major emitters of climate-warming greenhouse gases, especially since most employ pulverized coal, the most polluting production method.

The coal industry has been facing a swelling tide of opposition over the past year, beginning with a successful campaign against Texas utility TXU's (ticker: TXU) plans to build eleven new (mostly pulverized) coal power plants in its home state (see links below). A coalition of environmental and shareholder activists coordinated by the organization Ceres was able to force the utility to drastically pare its plans down to three new plants.

"We think investors should be asking hard questions about building pulverized coal plants," Ceres spokesman Peyton Fleming told SocialFunds. "We are seeing much more hesitancy by builders. And future costs [of regulation] will be borne by rate payers and investors," he added.

The Citigroup report bears that out: "It is naive to believe that CO2 legislation will fail to pinch margins. We believe this necessary industry will be allowed to operate, but windfall margin expansion is unlikely, as fee will follow regulation will follow mandate."

Opposition to coal is mounting across the nation. In June, Florida Power and Light was denied permits to build a new coal-powered plant, following on the heels of similar permits denied in Delaware, Minnesota, North Carolina, Oregon and Illinois.

Further, on August 1, the U.S. House of Representative passed an energy bill favoring renewable fuels over coal, gas and oil. Several new bills are pending, such as Rep. Jim Stark's "Save Our Climate Act." It would tax carbon-based fuels beginning at $10 per ton of carbon and rise each year until total CO2 emissions fall to 80% below 1990 levels.

Bruce Nilles, director of the Sierra Club's Coal Campaign, sees this as just the beginning. The campaign is going after the one hundred and forty new coal plants proposed by Peabody Energy and he's optimistic about getting them off the drawing board through further legislation. "Right now, we are poised to make some changes in the electric generating structure. If Congress can enact a renewable energy standard it will be an enormous boost," he told SocialFunds.

Citigroup faulted the unfriendly political environment for the dearth of new coal contracts for 2008. But its report expressed optimism that the horizon for coal may still be bright if the industry can transition to new, cleaner technologies, especially after a tough period near term leads to a shake-out among coal companies: "Our sense is that within three years the industry will be significantly consolidated, around the time that clean coal technologies begin to harden and national energy shortages materialize. This should open a new chapter for Coal." The report specifically cited Peabody Coal as poised to take advantage of opportunities in the long term, with investment in carbon capture and coal-to-liquids technologies.

But some question whether investment in building "clean coal" plants is worthwhile, given high construction costs and technological doubts about the viability of long-term carbon storage. Coal-to-liquids may also be vulnerable to regulatory constraints due to concerns that the technology carries too steep an environmental price tag. To these critics, investment in renewable energy sources like wind and solar is a better bet both for the investor and the environment.

Coal, however, is unlikely to go away, at least in the near term. What's unsettling investors most of all is uncertainty about just how severe the financial impact of regulation on carbon emissions will be. Once the way forward is clearer, investors may yet favor coal stocks again.

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