Coal market gears up for next millennium

Peter K. Nance

Mark H. Holtz

Teknecon Energy Risk Advisors LLC

Historically, coal has been one of the main fuels of choice for electric power generation in the United States over the past 50 years. With a continuing strong growth, coal demand can be expected to increase. However, the continuation of these trends into the next millennium will also depend upon changes in electricity and coal market structures, national environmental policy, and technology trends.

Over the next few years, the restructuring of the electricity industry is likely to accelerate changes in coal markets. Financial instruments, which are widely used in the natural gas markets, are likely to become more common in coal and electricity trading. In addition, implementation of environmental strategies driven by the Kyoto accords are likely to affect the cost structure of the energy portfolio and impact new electricity generation additions. Privatization is also likely to continue to influence all aspects of the electricity sector during the next few years. Finally, generation technology changes are likely to have ripple effects in the industry as well, contributing to technology substitution and increases in overall productivity and efficiency. Coal will be challenged to remain competitive as a generation fuel by meeting and overcoming these changing conditions.

Economy and market effects

The need for power, which in the 1990s is a consequence of a strong domestic economy, has traditionally driven U.S. coal demand. The accompanying figure shows as U.S. Gross National Product (GNP) rises, so does coal consumption with a strong linear correlation (0.9757).

Over the next 20 years, the Energy and Information Administration (EIA) predicts that high- and medium-sulfur coal production will rise at a rate of 0.1 percent a year and low-sulfur coal production will rise at a rate of 2 percent a year. EIA predicts that domestic coal demand will be at 1,275 million tons in the year 2020. In the short term, as long as steady economic growth is sustained, the market for coal is likely to be healthy.

The U.S. coal market is likely to be vastly different early in the next millennium. New market sources for coal may compete with domestically produced coal. In addition, the development of financial instruments for coal and electricity may reshape coal marketing strategies and usher in various forms of environmental commodity trading.

Thus, commoditization of coal and electricity is likely to put downward pressure on coal prices into the beginning of the next millennium. In addition, coal prices may become more volatile as the extremely high natural price volatility of electricity is better reflected in the coal markets.

From 1990 to 1998, domestic coal imports from Indonesia were almost 6 times greater than at the start of the decade on a per-ton basis. Over the same period, Colombian imports rose by a factor of 1.6, and Venezuelan imports were 3 times greater. Although the volume of imports is small relative to total consumption, these countries are emerging hard coal producers and their imports will likely continue to rise, adding to competition in the U.S. market.

Privatization and the rise of electricity merchant plants may also affect the coal industry. Privatization and merchant plants add financial risk to investor balance sheets. One likely outcome is that these companies will hedge part of that risk in new ways. As a result, spot markets may continue to grow and evolve, but these organizations will utilize new tools to guarantee project cash flows. In addition, the shorter lead times for developing natural gas-fired plants may lead to a bias in new plant development, as merchant plant developers seek to maximize returns earlier to overcome uncertainties in demand growth.

Widespread availability of financial instruments can reinforce the trend to shorter duration coal purchase contracts that have more standardized features. Risk management seems likely to become an important new tool for coal producers. Coal futures markets, already being developed in some areas, will provide a mechanism for risk hedging and for price discovery. When mature, they can allow risk reduction for railroads, power producers, coal producers, multi-fuel conglomerates and marketing companies.

In the future, some type of environmental permit trading may be intermingled with coal market trading, resulting in additional portfolio management possibilities and needs. In June 1998, the Norwegian Parliament made tradable permits a key instrument in meeting Norway`s Kyoto commitments, resulting in the development of an environmental commodity market. Italy has taken another approach-a carbon tax in the electricity sector has been introduced instead of a trading permit program. In other commodities, the introduction of trading or permit programs has facilitated over-reductions in effluent, while preserving flexibility for technology choice at the local level.

From a supply perspective, coal prices may continue their downward trend into the beginning of the next millennium. More than 200 years of coal reserves exist in the U.S. at 1997 production levels. As a result, commodity supply constraints leading to price increases seem unlikely. At the 1999 Western Coal Council Spring Coal Forum, John Slater, chairman of the World Coal Institute (WCI) noted that “…writing off of capital investment and the increasing productivity improvements have allowed the (coal) business to continue to operate in a cash positive way, but investors would have been better putting their money in almost anything else.”

Coal reserves are widely distributed and the existence of several major U.S. importers ensures that the scope for expansion of exports from countries with low-cost reserves and the existence of potential new exporters tend to restrain prices in the long term.

Technology and environmental policy effects

Pressure for environmental action seems likely to escalate in the short to medium term. The coal industry is part of the international community that ratified the United Nations Framework Convention on Climate Change. Broadly speaking, the objective of the Convention is to achieve stabilization of greenhouse gas concentrations in the atmosphere at a level that would prevent anthropogenic interference with the climate system.

Future environmental pressures have the potential to increase the usage of electricity, possibly increasing demand for coal. The emergence of new strategies and technologies for the cleaning, and capture and sequestration of stack emissions from generation plants may have a more profound effect in the future.

Currently, on an international basis, the average efficiency of coal plants is slightly below 25 percent. In the U.S., production technologies have pushed this efficiency well into the 30 percent range. Numerous public and private parties are funding research into new technology solutions. In addition, emissions capture and sequestration technologies are also under consideration. For example, the Department of Energy`s Federal Energy Technology Center is funding a carbon sequestration program. The goal of the program is to offset all projected growth in baseline emissions of greenhouse gases by the U.S. after 2010. Carbon dioxide power plant emissions have been increasing since the mid-1990s, and total CO2 emissions have been on a steady rise since the start of the 1990s.

Future coal technology and competing energy sources will have a strong impact on coal`s competitiveness. Currently, continuing productivity increases in coal extraction has kept coal competitive. In the future, market changes may require the application of cleaner burning coal technologies.

Clean coal research has and will continue to make progress in increasing coal combustion efficiency and the cleaning of emissions. A large number of technologies are already commercially viable, and a large number of others will become available in the near future. Increasing coal combustion efficiency results in less fuel used per unit of electricity generated thereby reducing all emissions and cost.

WCI reports use of new advanced materials to pulverized fuel (PF) power plants should enable burning efficiencies of up to 55 percent in the future. Pressurized fluidized beds technologies that can achieve efficiencies of up to 45 percent are at advanced stages of demonstration. Gas turbine technologies are now capable of reaching above 50 percent efficiencies. Further increases may be achievable with hybrid combined cycles that are currently under development.

Near term, coal`s future is bright based on a strong economy. In the medium term, coal`s success as a generation fuel depends upon developments in electricity and coal market structures, implementation of national environmental policies, and continued advances in technology. Coal costs may be lowered by continued productivity improvements, efficient market structures, and advanced technology that will extract more energy with less pollution.

Nance and Holtz may be contacted at 512-261-3663.

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