Regulation is the ever-present risk for utility companies, and this came to the fore again this week with new potential EPA pollution regulations. In particular, these rules will target emissions of sulfur dioxide, nitrogen oxides and fine particles. If the EPA gets its way and the rules go into effect, it will mean tougher air pollution standards that affect 31 states in the eastern half of the United States. (Check out Save The Earth: Become A Capitalist.)
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Regulations always come with costs, though, and this one is no different. As the primary producers in the affected areas, American Electric Power (NYSE:AEP), Southern Company (NYSE:SO) and Duke Energy (NYSE:DUK) would face the brunt of the new rules.

Although the EPA says the regulations will add $2.8 billion a year in new costs, you can assume that the industry will disagree and point to higher costs. After all, these companies are going to face tough decisions about buying new technology, switching fuels, and shutting down small plants. Couple that with expected new rules on mercury emissions, and the industry is going to be facing some serious budgeting decisions in the coming years.

Some Will Win
These new rules could be bad news for the utility companies, but others certainly stand to benefit. I do not think that the utilities can meet the new mandates by simply shutting down plants, so that means opportunities for companies in the emissions control space.

Whether utilities go with low-NOx burners, flue gas desulfurization or selective catalytic reduction systems, major companies like Honeywell (NYSE:HON), BASF and Foster Wheeler stand ready, as well as smaller companies like Fuel-Tech (Nasdaq:FTEK). Before buying up these stocks, though, remember that plant retrofits are expensive and time-consuming. It would not surprise me to see the companies wait or only take incremental steps in the hopes that a change in the political landscape in 2012 could lead a change or cancellation of the rules. In other words, the utility companies might upgrade their most essential plants (those that are not already upgraded), but may hold off on more marginal projects.

Along similar lines, utility companies may look to meet the sulfur dioxide requirements by incorporating more low-sulfur coal into their fuel mix. Powder River Basin (PRB) coal is especially notable for its lower sulfur content, and Arch Coal (NYSE:ACI) and Peabody Energy (NYSE:BTU) are the two dominant names there. Using lower-sulfur coal is certainly an easier and cheaper step for most utility companies, but here too it is no free ride - a sudden jump in demand for PRB coal is going to lead to supply shortages and higher prices, and it is no certainty that new permitting or mining projects would get underway quickly enough.

The Bottom Line
Unfortunately for utility company investors, there are no sure-fire places to hide. Wind and solar just are not ready for prime-time (that is, replacing coal and gas-fired generation), hydroelectric is only available in certain areas, nuclear is thought of as a non-starter, and environmental concerns are getting more and more airtime.

One way or another, then, utility companies are going to have to pay more. Some will choose to invest more in solar and wind generation, others will go through the expensive retrofits necessary to reduce emissions. Still others may brave the regulatory process and try to build new nuclear facilities. Some of these expenses will no doubt be passed on as higher power prices, but the companies may just have to swallow some of the costs and accept lower returns in the future.

On the flip side, as I mentioned above, this will be good news for others. People will enjoy breathing easier (whether they support the regulations or not) and a host of companies stand ready to sell technologies to the utilities to reduce their environmental exposure. Then, perhaps, utility stock investors should look at ideas like Foster Wheeler or some of the wind and solar companies as a way of offsetting some of the risks to their core holdings. (For information on this topic, take a look at Carbon Trading: Action Or Distraction?)

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Tickers in this Article: AEP, SO, DUK, HON, FTEK, ACI, BTU

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