Old-Fashioned Energy Play

By MATTHEW CURTIN
Forget windmills. Investing in Drax, owner of a 35-year-old British coal-fired power plant, could be a savvier way to profit from Europe's efforts to cut carbon-dioxide emissions.
Sound far-fetched? Not when considering the skewed incentives and lack of certainty in the EU's policy of reducing CO2 emissions 20% by 2020 partly through ensuring renewable energy meets 20% of demand.
The chief uncertainty surrounds the EU's emissions-trading system, which has led to volatile and unexpectedly low prices, below €15 ($22) a ton, less than half last year's peak. There is no visibility on what carbon will cost after 2020. That is a serious issue given the life of a new power plant is measured in decades, and new technology -- such as carbon capture and sequestration (CSS) -- is years from commercialization.
Unless governments address the uncertainty pushing up the cost of capital for new low-CO2 generation, too little capacity may be built to meet future demand and environmental targets. The recession has simply delayed the crunch, because it has also deterred new investment. In the U.K., plans for two new coal-fired power stations were suspended last week and with them opportunities to test CCS technology.
The U.K. may need 22 gigawatts of new capacity by 2020, and not just to replace aging facilities. Extra capacity will have to be built if wind is to provide a fifth of energy supply, because it is an intermittent power source. Should enthusiasm for wind wane, the double-digit earnings multiples windmill-makers like Gamesa, Vestas Wind Systems and Nordex are trading on may prove too high.
Extending the life of existing plants looks the likely way to ensure the lights don't go out in the U.K. and other countries, requiring politicians to rethink policy. Take Germany's tentative re-evaluation of nuclear power and Belgium's recent decision to delay nuclear decommissioning by a decade.
Should this happen in the U.K., it would benefit Drax because, as a low-cost, pure-play supplier meeting 7% of domestic demand, it is highly geared to any life-extension. The slump in U.K. energy prices this year has left Drax with an enterprise value of just five times 2010 earnings before interest, tax, depreciation and amortization. That is barely half the level enjoyed by its bigger utility and renewable-energy rivals. Barring an environmental-policy shakeup, "yesterday's" technology is starting to look unjustly undervalued.
Write to Matthew Curtin at matthew.curtin@dowjones.com