Who Wins in a Competitive Power Market: Gas? Coal? or Rail & Mining Interests?...

Who Wins in a Competitive Power Market: Gas? Coal? or Rail & Mining Interests?

 Those who ignore coal to focus on natural gas for electric generation should proceed carefully. Granted, gas may attract the lion's share of new construction. It may even define a cap on prices during periods of peak demand. Gas-fired generation typically enjoys substantial capital, environmental and operating advantages to coal and is expected to dominate installation of new capacity. Nevertheless, coal should continue to supply much of the base load generation in many markets throughout the country. 

 Coal enjoys a cost advantage over other fossil fuels in power plant operations, as measured in dollars per delivered MMbtu. That margin--the gap between gas-based clearing prices for electricity and the lower cost of producing coal-fired power--represents potential economic value. And it is that economic value that lies vulnerable to appropriation by other interests that occupy commanding positions in the coal fuel cycle. 

 Some coal-fired generation capacity remains underutilized. Its use can be expanded, however, through open-access competition. This access to markets will make it easier for cheaper, coal-fired generation at one utility to displace the more expensive gas-fired generation of its competitor. These savings should flow through to retail power customers. Often overlooked, however, is whether up- stream suppliers will appropriate these savings. In fact, the chance for appropriation appears quite substantial, particularly due to the increasing concentration of market shares in coal transportation (meaning railroads) and, to a lesser extent, in coal supply industries. 

 Those who would ask whether consumers will gain from electric competition would do well to start with the economics of coal use in power generation. 

 The Growing Concentration in Transport and Supply...  

Whatever the virtues of natural gas as a fuel for electric generation, a substantial investment still exists in coal-fired capacity. Coal accounts for more than half of domestic electric generation, despite a lower share of available capacity. ¹ 

 Nevertheless, some of the underlying conditions that contributed to current favorable coal economics are starting to erode. Not only does coal-fired generation depend on the coal mining industry, it also depends on the railroads for transportation. Specifically, there has been a substantial consolidation among the railroads that haul coal, and increasing concentration in the coal mining industry. 

 Consolidation is especially apparent among the railroads. In 1990, there were five major Western coal-hauling railroads: the CNW, the Burlington Northern, the Union Pacific, the Southern Pacific, and the Santa Fe. Those five carriers have now been consolidated into only two Western railroads, The Burlington Northern Santa Fe and the Union Pacific/Southern Pacific, which together control 96 percent of the Western railroad coal traffic. This situation is hardly conducive to long-term competition. 

 The success of the CNW (since acquired by and merged into the UP) in capturing business from the incumbent Burlington Northern has led to some abatement in competitive conditions. CNW paid more than $300 million to acquire, construct and rehabilitate trackage to serve the Southern Wyoming portion of the Powder River Basin of Wyoming and Montana (SPRB), which the Union Pacific largely financed. CNW and the Union Pacific acted aggressively when they first entered the SPRB to attract sufficient traffic volumes to justify their investment. Over time, their share grew, and in 1994 they originated more coal from the SPRB mines than Burlington Northern. Since the market has achieved "maturity," competition is apt to be less aggressive. 

 Railroad mergers are not confined to the West. CSX and Norfolk Southern (both products of large, 1980s mergers) are now in the process of carving up Conrail. Soon, two major carriers in the East will control 92 percent of the Eastern railroad coal traffic-- as there are in the West. 

 Abundant speculation exists that two transcontinental mergers will shortly follow the Conrail merger--leaving only two transcontinental railroads and a number of much smaller carriers. While the two large railroads are poised to compete with trucks for traffic that can move in different transportation modes, commodities that move primarily by rail--of which coal is the most prominent--are unlikely to benefit from such an industry structure. 

 Less conspicuous, but still very significant, is a growing consolidation among coal producers. For example, assuming consummation of recently announced transactions, the number of major producers in the PRB will be reduced to four. Peabody, the largest coal producer in the United States, will have 30 percent of PRB production, and Kennecott will have 20 percent, with Cyprus Amax (the second largest domestic producer) and Arco constituting the rest of the major PRB producers. 

 Substantial consolidation has also taken place in recent years within the coal industry as a whole. From 1976 to 1991, the number of mines was cut in half, but total production increased by 45 percent, and the average mine size tripled. By 1991, only 7 percent of the nation's mines were producing two-thirds of U.S. coal. The trend has continued. For example, the second largest producer (Cyprus Amax) was formed through the 1993 merger of the third and 14th largest producers. 

 Pricing Implications of Consolidation... 

 Consolidations within the railroad and coal industries potentially enhance the leverage of those firms with their common customers-- electric utilities. Leverage can take a range of forms including outright acquisition of generating plants, commercial arrangements that tie the price of the coal or transportation directly to the price received for power generated, or rates that reflect the expected level of the utility's demand load. These arrangements all exist today. 

 In general, the coal industry is still much less consolidated than the railroad industry. And although aggressive competition is prevalent, coal's financial health is significantly less robust. Perhaps because of its more competitive nature, the coal industry has acted faster to adopt innovative approaches to pricing. 

 Some coal companies have formed power marketer affiliates, and are considering buying coal-fired power plants, including those in bankruptcy or being divested in utility restructuring. Cyprus Amax, over the past year and a half, has entered into alliances with approximately 12 "leadership utilities" under arrangements. These arrangements include "coal tolling," whereby the coal price is tied to the price that the utility receives for power generated from the coal. Other coal companies and coal brokers have reportedly entered into such arrangements. 

 Implications for Deregulation... 

 As noted, open access and the accompanying increase in competition in generation may permit railroads and coal suppliers to extend into the generation industry. To the extent that coal-fired generation is cheaper than gas-based market clearing prices, the gap is potentially available to consumers through lower power rates, utilities through higher power rates, and railroads and coal suppliers through higher transportation and coal prices. 

 Those entities with the highest concentration--the railroads--are best positioned to exploit the opportunity. Railroads can increase their rates (particularly compared with their declining costs of providing service) without losing market share, while rail- delivered coal remains the cheapest fuel option for generation according to marginal-cost-dispatch principles. 

Of course, there will be some exceptions. Some railroads will continue to compete vigorously. However, such situations are likely to moderate when the competition is confined to two carriers in either the West or the East (or nationally, should there be transcontinental mergers). Undoubtedly, rates will decline for some from levels established in the 1970s or the early 1980s before the entry of the CNW into the SPRB. Deregulation will give utilities added incentive to control fuel costs. Nonetheless, where a power plant remains captive to a single railroad, that railroad will have little incentive to bring the plant's delivered fuel costs significantly below that of gas-fired dispatch or alternative power sources. This means that railroad contribution margins should remain substantial. ² 

A January 1997 report by Salomon Brothers, prepared with assistance from RDI, Utility Deregulation's Impact on the Railroads, claims that deregulation will result in a loss to the railroad industry of 0.9 percent to 1.3 percent of its coal revenue (or 4 percent to 6 percent of operating income forecast). However, the report fails to quantify Western coal growth, coal-fired electricity growth, continuing improvements in railroad productivity, and the consequences of duopoly pricing. Any of these considerations could more than offset the claimed reductions in revenue and income. 

 The Salomon Brothers report attributes much of the projected decline in rail revenues to the expiration of older, above-market contracts of Burlington Northern Santa Fe and Norfolk Southern. Even absent utility deregulation, the railroads would feel considerable pressure to reduce such rates as older contracts expire. The fact those rate reductions are accompanied by deregulation hardly means the changes are caused by deregulation. Significantly, both Burlington Northern, Santa Fe, and Norfolk Southern have taken vigorous exception to the report's analysis. 

 The report also discusses such possibilities as "coal-by-wire," by which a utility receives coal-fired generation from another utility's power plant, thus providing an alternative to high coal transportation costs. The coal-by-wire scenario presumes a surplus of economic coal-fired generation and transmission capacity. Even before open access, coal-fired plants with low delivered costs had ample incentive to achieve high capacity use. One must question the real potential for coal displacement to occur in the magnitude claimed by the report. Displacement is more likely to involve coal replacing more expensive gas, meaning increased volumes and revenues for the railroads. In short, railroads are posed to be net winners from utility deregulation. 

 Coal Generators Should Proceed with Caution... 

 Those who posit improved consumer welfare inevitably follows increased competition would do well to consider that other sectors may compromise competition in one sector. This is especially likely to happen when one sector is dependent upon another, highly concentrated sector, as is the case of the coal and railroad industries. Likewise, utilities with coal generation facilities should approach their transportation and supply arrangements in the open access era with care. The favorable trends of the past 10 or 15 years will not necessarily continue. 

The time may also be ripe to reassess the regulation of rates for railroad transportation of coal. For the past 20 years, there has been a strong drift toward reliance on competition, accompanied by ever-increasing railroad consolidation, which could culminate in two transcontinental carriers. 

 Given the consolidation that has occurred within the rail and coal industries, and robust financial condition of the railroads, one must question whether trends will continue to be mutually advantageous. In approving the various rail mergers within the past few years, the Interstate Commerce Commission and its successor, the Surface Transportation Board, have generally refused to grant relief to utility shippers, primarily on the grounds that merger conditions should not be used to create new competition. 

The board also recently rebuffed efforts by several utility shippers to confine rate challenges to the captive or "bottleneck" portion of a longer movement that contained competitive and captive segments. Permitting bottleneck rate challenges would have allowed utilities to benefit from rail-to-rail competition where it exists. The board's decision enables bottleneck carriers to appropriate the benefits of the available competition. These developments limit the potential of electric utilities to be successful, and to confer the benefits of production efficiencies on their customers, in the emerging competitive environment. 

 1. Energy Information Administration, Annual Energy Review 1995 (July 1996). 
2. The Surface Transportation Board has the authority to provide rate relief where a railroad has market dominance over a captive shipper. The governing statute prevents the agency from setting a rate that is less than 180 percent of the railroad's variable cost of providing the service. Variable cost represents average variable, and not incremental, cost of service, including a return on investment. The result is a generous return to the carrier, particularly compared to a utility that can sell power at only a small mark-up to incremental cost. 

Coal's History of Dependence on Transportation 

Health of Industry Linked to Railroads...

 In the early and mid-1970s, many utilities turned to coal-fired generation to meet increasing customer loads. This increased demand resulted from the OPEC oil embargo, natural gas curtailments and, particularly, federal energy and environmental mandates such as the Fuel Use Act, which restricted use of fossil fuels other than coal in new power plants. ² The energy industry responded by opening new surface mines for low-sulfur coal, particularly in the Power River Basin of Wyoming and Montana (PRB). 

 The initial availability of PRB coal was nonetheless very constricted. Utilities had to enter binding contracts, despite the restricted supplies, to obtain approval and financing for their new power plants. The result was a substantial run-up in coal prices. 

 Developments within the railroad industry also contributed to the high, initial delivered costs for coal. Until 1984, only a single carrier, the Burlington Northern Railroad, served the PRB. Utilities sought to protect themselves by entering into letter rate agreements with the Burlington Northern. However, the railroad industry experienced substantial financial difficulties of its own during the 1970s, and deregulation emerged as the solution to those perceived difficulties. Burlington Northern, along with various destination carriers, took advantage of the new price flexibility by increasing coal transportation rates. 

 Fortunately, these adverse trends reversed themselves in the 1980s. New PRB mines came on line and eventually achieved substantial output and associated productivity gains. ³ Increased productivity and competition among the mines have translated into nominal PRB mine prices that approximate those before the OPEC oil embargo in 1973. 

 Rail developments also have helped utilities. In 1984, the Chicago and North Western Railroad began serving mines in the Southern Wyoming portion of the PRB and, over time, created meaningful competition with the incumbent Burlington Northern Railroad. Notable increases in volumes ⁴ helped the railroads achieve substantial productivity gains in their coal movements. Those utilities with viable competitive options benefitted form improved rail productivity. Nonetheless, trends in rail rates have generally not tracked declines in the railroads' costs of providing service. Rail rates of PRB coal often exceed the cost of purchasing the coal from the mine. 

Alliances Between Coal and Rail Are Infrequent...

But, railroads are fluent in special pricing options....

Mixing Coal, Gas and Marketing...

How U.K.'s Energy Group PLC would deal with captive transport...

 That seems to be the strategy of The Energy Group PLC, a newly formed public limited company incorporated in England and Wales after its "demerger" (spinoff) from Hanson PLC. With Derek Bonham as its executive chairman, The Energy Group will own Peabody Coals, the largest coal producer in the U.S., and Eastern Electricity, a British regional electricity company that serves 9 percent of the U.K. market, according to Bonham (2 million meters; 7 million people). 

 When Hanson announced the demerger, the U.K. press reported the energy Group was ready to acquire power plants in the U.S.* Later, on March 10, the Energy Group announced plans to acquire Citizens Lehman Power LLC, one of the top five U.S. power marketers, giving it a diversified portfolio of assets and expertise. 

 U.K.--Playing Both Sides. In the U.K., Eastern has added coal to its gas-fired portfolio. 

 "At Eastern," says Bonham, "we decided [we] needed to be on both sides of the pool. We started in generation by building some combined-cycle turbines, but we acquired 5 coal-fired projects from National Power. So we have something like 6500 megawatts of capacity-about 10 percent of the market. We can decide 48 times a day whether to run gas plants or coal plants, depending on price. 

"We actually trade about 17 percent of the market in the U.K., So if you look at our experience in the U.K., we are moving toward vertical integration." 

 U.S.A--Giving Price Relief. How will the Energy Group integrate its coal assets in the U.S. with its overall strategy? "Just because we are buying generation plants in the U.S., it doesn't mean that we will be buying [coal] plants served by Peabody," says Chris Farrand, vice president, corporate affairs for Peabody Holding Company Inc., parent company of Peabody Coal Co. "We might do some novel deals where we might lease some plants and then sell the power output. We signed an interesting deal with Enron. We will supply gas for the turbine and then take the output." 

 Farrand continued: "At Peabody, we've done some experimenting with customers who have excess [generating] capacity. We hope to acquire a power marketing company. With the marketer, and with electric transmission agreements, we may be able to give price relief to the customer by taking some of the excess capacity and marketing the power. 

 "We may be able to ship power to the customer instead of shipping coal long distance." --BWR