RWE Faces High 'Green' Costs

German Utility's Experience Provides Lessons for U.S. as It Weighs Climate Rules
By LEILA ABBOUD

One of the latest business ventures at electricity supplier RWE AG is giving away light bulbs in the developing world. The German company has teamed up with an Indian utility to hand out 700,000 energy-efficient bulbs in India's eastern port city of Vishnakhapatnam.

RWE's motive for such ecocharity: It helps reduce the cost of complying with Europe's increasingly stringent limits on greenhouse-gas emissions. But even with such projects, RWE faces higher pollution-compliance costs in the coming years as emissions rules get more strict. That will likely eat into profit and lead to higher power prices for consumers and businesses.
RWE's predicament provides important lessons for the U.S. as it contemplates setting up its own system to fight climate change. Europe's greenhouse-gas "cap and trade" system has been up and running since 2005. After a rocky start, the true impact -- and costs -- are starting to be felt by regulated companies. Policy makers in the U.S. may soon have to make their own tough decisions about what sectors should shoulder the burden of reducing pollution.
President-elect Barack Obama said in a speech last week that he would move quickly to create a federal system to cap greenhouse-gas emissions by 80% by 2050. Senate Democrats say they plan to introduce legislation in January directing the Environmental Protection Agency to set up a cap-and-trade system.
RWE spent more than €1 billion, or roughly $1.25 billion, on greenhouse-gas compliance in the first nine months of this year -- equivalent to nearly half its €2.2 billion in net income for the period. The cost was just €175 million for the first nine months of last year. Since most of RWE's power stations burn brown coal, which is plentiful in Germany but releases high levels of greenhouse gas, its burden under Europe's regulations is particularly heavy.
"Climate change is a global challenge, and we support Europe's efforts to cap emissions," says Henning Rentz, RWE's head of policy affairs. He worries, however, that future regulations will weigh disproportionately on his industry. "The new rules should not discriminate against utilities that burn coal, and they need to ensure that we can stay competitive."
The European Union first set caps on greenhouse-gas emissions in 2005 for big polluting industries, such as utilities and steel and cement makers. Under the system, EU governments give companies permits to emit a certain amount of carbon dioxide, the main gas believed to cause global warming.
If a company emits more than its cap, it must cover the excess by obtaining more permits. One way is by trading on the "carbon market," that is, buying permits from companies with permits to spare. Permits also can be earned through carbon-reduction projects in developing countries, such as RWE's light-bulb giveaway in India.
In the early years of this cap-and-trade system, most European industries were given more permits than they needed, and emissions crept up about 1% a year. European regulators responded by sharply lowering the emissions caps this year. Regulators sought to soften the blow for companies facing competition from outside the EU, as in the steel and cement industries. That was offset by placing stricter limits on utilities, which often are quasimonopolies not subject to price competition and who can pass on added costs to consumers.
German utilities, including RWE and E.ON AG, will be short a total of roughly 79 million permits this year, according to Point Carbon, a market-research firm based on Oslo, Norway. At the current permit price, which is well off this year's peak, that comes to $1.42 billion to purchase permits. Italy's utilities, including Enel SpA, will be short 51 million permits, while U.K. utilities, such as British Energy Group PLC, will be short 70.5 million in total.
It's difficult to forecast the cost for purchasing permits since their price changes constantly on Europe's carbon market. The price for a 2008 permit peaked in June at €28 but has since fallen to around €18 amid Europe's economic downturn. Point Carbon projects an average price of €29 for a carbon permit for the next three years.
The rules have already hit the bottom line at some utilities. Britain's Drax Group PLC, which operates Western Europe's largest coal-fired power plant, says its profit was cut by nearly 50% in the first half from a year earlier. The company says it spent £107 million ($162 million) on carbon permits in the half, up from £11 million a year earlier.
Italy's Enel, meanwhile, is "quite confident that we can cover the whole shortfall through imported credits," says Eliano Russo, Enel's head of carbon strategy. Enel has about 70 projects under way in China, including for wind and hydro power and by helping to make steel smelters more energy efficient. Enel expects that it will be short a total of 40 million-50 million carbon permits in total this year through 2012.
RWE, though, "has the biggest [carbon-permit] shortfall to make up of any European utility," Mr. Rentz says.
The company is responding on several fronts. It has a team of about 40 people who scout for projects to earn carbon credits, such as the light-bulb giveaway in India and reducing methane at coal mines in Russia. RWE can earn these permits at an average cost of about €10, much less than the cost to buy a carbon permit. This month, RWE announced that it had purchased a 50% stake in a Singapore-based firm, Agrinergy Pte. Ltd., which specializes in putting together such projects. Terms of the deal weren't disclosed.
But Germany's rules only allow RWE to import about 90 million permits, which will leave it more than 200 million permits short through 2012. That's forcing RWE to do what the rules intend: Modernize or replace power plants so they emit less greenhouse gas.
"We have to renew our power plants as fast as possible," says Mr. Rentz. RWE is investing heavily in new technology to bury carbon dioxide underground. In September it pledged to spend €1 billion to build a coal-fired plant with such technology in western Germany.
Whether RWE or any utility buys permits or imports them from projects in emerging nations, the cost threatens to weigh on profit. As a result, utilities are likely to pass the costs of complying with Europe's cap-and-trade rules onto their customers. Electricity prices for German households and businesses increased 5% and 13% respectively in the first nine months of this year from a year earlier, according to RWE.
The burden on European utilities is set to rise in 2013, when regulators plan to scrap the annual allocation of free permits. Instead governments would put permits up for auction. Utilities would then buy permits at auction, even as they continue to import credits from overseas projects and purchase permits on the carbon market. The utilities are lobbying for a softer approach that would gradually phase in such auctions.
Write to Leila Abboud at leila.abboud@wsj.com