Nov. 4: What's Not at Stake

To hear some people tell it, national elections are always some version of good versus evil. One party is the great hope of the nation, while the other is leading us down the road to ruin. One party is full of upstanding “reasonable” people, and the other a bunch of lying philanderers.

Of course, there’s a lot at stake in elections, particularly on the national level. No matter who’s been in the White House, the size of the federal government has continued to grow; the rate under the current president is one of the highest in history. As a result, the winner has a massive money pot to divvy out to the favored.

More important for investors, elections also can trigger changes in the rules for businesses as well as how Americans are taxed. And both are particularly important considerations this year.

With the Democratic convention slated for next week in Denver and the Republican convention set for the following week in Minneapolis, this election season will soon be in full swing. And like every other campaign in memory, this one is likely to focus as much--or more--on the negative than the positive.

Basically, both parties will try to play up the least appealing aspects of the other, and it will be increasingly difficult to discern just what the real positions are and where the differences lie. Fortunately, there are three issues of particular importance for utility investors, as well as income seekers in general, where positions have been staked out. Here’s a rundown of what we know and what we don’t.

Front and center is taxation, particularly the fate of the current preferential rate for dividend income. Under the current law, the 15 percent taxation cap is scheduled to expire in 2011. At that point, all dividends as well as capital gains will again be considered “ordinary income.” Investors will be taxed at their overall rate.

My view for the past several years has been that the preferential rate was never really priced in for income investments. That’s in part because it was always viewed as temporary and partly because of the continuing confusion about just what is and what isn’t a “qualified dividend” eligible for the lower rate.

Congress basically punted the question when the legislation was passed in 2003. So did the Internal Revenue Service (IRS), which has simply stated that investors shouldn’t assume their 1099s are correct and that all filings should have backup to justify the classification used.

For their part, many investors have continued to receive 1099s at tax time that are often riddled with errors. In fact, many have actually received several “corrected” versions of 1099s from their brokers, throwing a major monkey wrench into the timing of their filings.

Now for the good news: Since the lower rate was never really priced in, moving to a higher rate won’t have that much impact. And the really good news is both major presidential candidates are on record favoring the extension of preferential tax rates for dividends as well as capital gains. In fact, both actually favor going one step further than President Bush did by making them permanent.

The fact that Republican John McCain would stake out such a position isn’t surprising. Although he had opposed tax cuts at various times over the past eight years, the candidate must hold his party’s base of voters to have any chance to win this election.

Of course, if he wins, he’ll almost certainly be facing a Democratic-controlled US Congress--very likely one with substantially improved majorities in both houses. That means compromise will be necessary to get anything through. And if one isn’t forthcoming, the preferential rate will die in 2011.

That leads me to the following likely controversial conclusion: The odds of extending or making permanent a preferential rate on dividends and capital gains may actually be better if Democrat Barack Obama proves victorious.

That’s not something you’ll read in The Wall Street Journal editorial pages. But consider this: Any president is going to face considerable opposition from Democrats to extending preferential rates on dividends and capital gains. It would be far easier for Democrats to buck a Republican president’s attempts than those of a Democrat, especially since they’ve only controlled the White House for just 12 of the last 40 years. Some will vote “no” in any case. But enough are likely to vote “yes” to join with the likely unanimous Republicans to pass the legislation.

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The tradeoff, of course, is Obama’s proposed top rate on dividends and capital gains is 20 percent rather than the current 15 percent. That, however, will impact even the highest income taxpayers a good deal less than paying at the top rate, which is also likely to rise under a Democratic administration.

Either way, the good news is the odds of permanently extending the preferential tax rates on dividends and capital gains look a lot better than they did just a few months ago. If 20 percent does become the new permanent top rate, I fully expect to see it priced into income investments of all stripes, resulting in a nice gain for most.

Perhaps most important of all is that candidate Obama has adopted the idea that preferential tax rates to promote savings are a very good thing for the economy, not a tax dodge that benefits only the rich as some in his party maintain. That bodes well for other policy matters affecting businesses and individuals as Washington tries to get a grip on runaway budget deficits. And again, if McCain wins, the top rate he’ll push for permanency is the current 15 percent.

Taking action to curb global warming is another hot topic of debate in which the November election may have profound implications. Basically, funding for renewable energy and conservation, or “negawatts,” is popular with the public and, therefore, the politicians. And we can count on a lot more tax credits and subsidies to go there no matter who wins.

More controversial is how to regulate carbon dioxide (CO₂) emissions, the gas blamed for global warming. Clearly, it’s impossible to quickly transition the US power grid away from coal-fired power, which still accounts for roughly half of total electricity produced. And the job is only going to get harder, with under very conservative estimates for power demand growth, which calls for a 30 percent rise by 2030.

Companies that burn coal to generate electricity, however, may get socked with huge cost increases, depending on how legislation to regulate carbon is shaped. In turn, the bulk of that will be passed onto ratepayers in the affected states, many of which are much less affluent than states in which utilities use far less coal such as California.

Both McCain and Obama are on record advocating a “cap and trade” system for CO₂ emissions. This is the same system employed in the Clean Air Act of 1990, signed by the first President Bush, which was designed to curb emissions from coal plants that cause acid rain.

Overall emissions nationwide were subjected to a cap, which was steadily lowered over time. Coal plants, however, were allowed to continue running as long as their owners purchased “pollution credits.” As caps were lowered, credits became progressively scarcer, and the price rose. That, in turn, increased the incentive to reduce emissions by purchasing lower sulphur coal and/or by installing scrubbers or some other emission-reducing technology.

The upshot: Over time emissions of acid rain causing sulphur and nitrous oxides were dramatically reduced. Polluters, meanwhile, had time and flexibility to make needed changes without bankrupting themselves. The result was a relatively painless elimination of what had been the very serious problem of acid rain.

Cap and trade with CO₂ faces some additional hurdles. For one thing, carbon sequestration technology still isn’t commercially available. Consequently, if the conditions are set too harshly, coal-burning utilities will have no choice but to buy increasingly expensive pollution credits until it is, or else switch off coal entirely.

Either way, their ratepayers will wind up paying a lot more for power at a time when the overall economy may be weak. That’s a strong argument for more flexible regulation, which senators in the Southeast and Midwest will be pushing for, against the advocates of more radical anti-CO₂ moves on the coasts. And they’re likely to get their way, particularly with energy independence becoming a major issue as well.

One of the more interesting developments in this debate is what’s been happening recently at Southern Company, itself one of the largest emitters of CO₂ in the US. Southern’s plants emit 173 million tons of CO₂ annually, according to at least one watchdog group. The 3,300 megawatt Scherer plant in Georgia alone produces 25.3 million tons, the most in the US and more than all of Brazil’s plants combined.

As a result, Southern certainly has a lot to lose in this debate. And as is always the case for this well-run company, it’s been an aggressive advocate of its interests.

Last week, Southern’s CEO David Ratcliffe stated he didn’t “believe there’s an impending catastrophe in front of us” regarding CO₂ emissions and global warming. Rather, he maintained “there are impacts and certainly there are changes that occur,” but “the environment has an ability to adapt to that.” Ratcliffe went on to say of advocates of CO₂ regulation, “Their intentions are good, but I think their enthusiasm outstrips the logic of this situation. We have time to do this without upsetting the economy.” He also called a Senate bill to cut CO₂ 66 percent by 2050 “too aggressive.”

Ratcliffe’s comments, predictably, drew heavy fire from climate change activists. But even as he was stirring the pot by staking out this position, Southern’s biggest unit, Georgia Power, had already been moving in a far different direction.

Basically, the company filed an updated integrated resource plan with the state Public Service Commission calling for the following: The addition of 1,102 megawatts of new nuclear capacity at the Plant Vogtle facility, a plan to convert a coal plant to renewable biomass, a solar research project, renewable energy and energy efficiency programs to meet 11 to 18 percent of future resource needs over the next 10 years and expansion of the company’s Green Energy program with additional renewable energy credits and large volume renewable options.

All of these moves are basically designed to do one thing: Reduce the utility’s current and future CO₂ emissions in a major way. And the company is requesting regulators approve a phasing in of the costs into rates to allow long-term planning and, ultimately, better control of expenses.

The upshot: Southern will publicly fight as hard as it can to ensure whatever legislation passes muster is flexible for coal-burning utilities. But at the same time, it recognizes action is inevitable, and it’s taking steps to ensure shareholders earn a fair return on the investment it does wind up making to control CO₂.

Of course, commercially available carbon capture technology would be the best thing for this company, as well as other coal-burning utilities. Until it’s developed, however, this is how companies will navigate their way through the issue.

Where do the Democrats stand on drilling for oil and natural gas off America’s coastline? That used to be a pretty easy question to answer, as the public’s fear of another major coastal spill trumped any economic concerns. That’s changed, however, in an election season where the price of a gallon of gasoline has regularly been hitting above $4 this year.

More than a third of the 45 candidates in House Democrats’ “Red-to-Blue” campaign—aimed at capturing seats now held by the GOP—are supporting lifting the current moratorium on drilling. That’s still at odds with a good chunk of the Democratic base. But with some polls showing two-thirds of Americans now support new drilling, even old-line pols such as House Speaker Nancy Pelosi (D-CA) may be coming around.

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It seems energy independence has become a new national priority. To date in the campaign, Republicans have been able to get some headway on the issue by painting the Democrats as more concerned about seals than ordinary Americans suffering from high gasoline prices.

Switching ground to support offshore drilling is one way to defuse this particular part of the issue. But it’s really only the tip of the iceberg.

Obama also looks increasingly vulnerable on the issue of nuclear power, which also appears to be gaining support in polls. With the Three Mile Island accident now 30 years in the rear view mirror, the public appears to be losing its fear of nuclear plants—among whose strongest supporters now are environmentalists who like the fact that nukes produce zero emissions of CO₂. And the plants are also perceived as a way the US can limit use of fossil fuels and, therefore, imports as well.

The fact that Obama has been losing ground on this issue is somewhat quizzical, given that he’s enjoyed the support of the leading nuclear utility in the country, Exelon. As with offshore drilling, however, I don’t expect him to be on the unpopular side of the issue for long.

The result: No matter who wins this election, odds are great we’re going to see more support for nuclear power in Washington. That’s certainly a very good thing for the companies that already own nuclear plants. They’ll continue to enjoy the benefits of generating stable priced power in a volatile market. And, the sites where they already own and operate nukes are by far the most likely sites for new ones.

Nuclear power’s greatest hurdle in this country is the time needed to build plants, which makes their ultimate cost far less predictable than other sources of energy. Utilities such as Scana (South Carolina) and Southern Company (Alabama, Georgia, Florida and Mississippi) operate in states that encourage long-term planning. That gives them a far easier road to build them than is the case in states where regulators have historically constantly been looking over utilities’ backs.

Once again, the only real way to change the dynamics here—and have a China-sized wave of nuclear plant construction—would be something of a Nixon-goes-to-China scenario. In other words, a future President Obama pulls along enough Democratic votes to join with Republicans and establish a massive change in national policy. That’s something President Bush and his majority failed to do in six years. However, a Democrat might have an easier time of it.

In the final analysis, what politicians say and do are entirely different things. And promises made in the heat of the campaign are all too often forgotten when the realities of governing set in.

When you come down to it, the next president and Congress are going to be constrained in several ways. The country continues to fight not one--but two--wars, neither of which seem close to resolution. And there are no easy decisions.

Also, in stark contrast to eight years ago, the country has fallen into its biggest fiscal hole in history. The next president is going to have to find some way to bring things back into balance, or at least closer to it. Again, that means making tough choices on spending and taxes, and there’s no easy way out.

Finally, there’s the economic slowdown—recession in at least some parts of the country—and the country’s weakened financial system, which have hit consumers in the pocketbook, property values and stock portfolios. There will be a recovery, but it will almost certainly take time. And inflation is a growing risk as well, with producer prices rising at a double-digit clip last month.

As far as utilities go, we’re really going to have to see how this plays out on both the federal and state level, where most utility regulation takes place. The December 2008 issue of Utility Forecaster will have the run down on what the election means for individual companies as well as the industry as a whole.

What we do know is at least on these three issues—dividend taxation, CO₂ regulation and energy independence—both McCain and Obama are staking out positions that are generally favorable to utility investors. And that’s good news indeed.