Special Report: Wall Street cleans up on 'clean' coal subsidies

Arq

04/12/2018 12:00

(This is the second story in a three-part series on U.S. 'clean
coal' subsidies. For more Reuters Special Reports, double-click
on  SPECIAL/ )
    By Tim McLaughlin
    Dec 4 (Reuters) - Earlier this year, the chief financial
officer of global insurance giant Arthur J. Gallagher & Co.
 AJG.N  explained to analysts how the company had turned a
little-known U.S. energy subsidy into a profit machine, worth
hundreds of millions of dollars to its bottom line.
    The money came from the U.S. “clean coal” tax credit, a
provision of the American Jobs Act of 2004 meant to encourage
the use of chemically treated coal to cut pollution in the
nation’s power plants. 
    To capitalize on the subsidy, A.J. Gallagher arranged
investor partnerships to produce vast quantities of refined
coal, as the fuel is known in the industry, for utilities across
the nation, splitting the benefit of the lucrative government
incentive – now worth more than $7 per ton.
    “Our return on investment is staggering,” CFO Douglas Howell
told analysts in the March 14 call. “Oh, 200 percent, 300
percent, 400 percent, 500 percent. I mean, just because it costs
so little to develop” clean coal facilities.
    A.J. Gallagher’s experience reflects a truth about the U.S.
refined coal tax credit, a subsidy that now costs taxpayers
about $1 billion a year: While coal mining firms, utility
companies and power consumers can benefit indirectly from the
subsidy, the big winners are a diverse group of investors –
ranging from Wall Street’s most powerful banks to insurers, meat
packers and drug makers – who identified the incentive as an
easy way to make money.
    Over the past decade, these companies have financed the
construction of facilities to produce refined coal, which are
situated next to coal-fired power plants and typically cost
about $4 million to $6 million each to develop. They then sell
the resulting coal to utilities below cost, but make eye-popping
returns from the subsidy rather than the underlying business,
according to regulatory documents and interviews.
    A.J. Gallagher’s Howell took credit for designing a business
model to maximize profits from the subsidy in his March call
with analysts.
    “It is our machine,” he said. “We developed it. We pioneered
it.”
    The company has accumulated about $850 million worth of tax
credits, mostly from its side business in taxpayer-supported
refined coal, Howell said on an Oct. 25th conference call with
investors and analysts.
    “And at current production levels” of refined coal, he said,
“that may total another $700 million through 2021.”
    Howell declined to comment for this story. A.J. Gallagher
spokeswoman Linda Collins minimized the importance of clean coal
to the company.
    “Refined coal is not a part of our core brokerage and risk
management business,” Collins said in an email.
    Refined coal activities, however, accounted for 25 percent
of the company’s $5.28 billion in total revenue during the first
nine months of this year, according to AJ Gallagher financial
statements. They also made up about a fifth of the company’s
$516 million in net earnings attributable to controlling
interests during that period.
    While the subsidy has proven a boon for investors, it has
often failed to achieve the intended reductions of nitrogen
oxides, or NOx, the primary contributor to smog and acid rain.
Utilities that burn refined coal have trailed competitors
burning raw coal in lowering NOx emissions, and 22 of 56 plants
burning refined coal have seen NOx emission rates rise instead
of fall, according to a Reuters analysis of EPA emissions data
vetted by industry experts.
    The refined coal tax subsidy is scheduled to expire in 2021.
But lawmakers, including Republican Senator John Hoeven of
coal-producing North Dakota, have introduced legislation to
extend it another 10 years. They argue it helps the environment,
extends the life of the ailing coal industry – a centerpiece of
the Trump administration’s energy policy – and reduces power
prices by giving utilities a cheap, subsidized source of coal.
    “This is really an incentive to operate in a way that’s more
environmentally friendly while keeping power costs low,” said
Hoeven, whose state sits atop an 800-year supply of lignite
coal.
    If the extension goes through, those best placed to gain
from the subsidy are an eclectic list of refined coal investors,
including Wall Street banks Goldman Sachs Group Inc  GS.N ,
JPMorgan Chase & Co Inc  JPM.N  and Capital One Financial Corp
 COF.N ; wealth management giant Fidelity Investments; drugmaker
Mylan NV  MYL.N ; U.S. affiliates of global commodities trader
Noble Group Ltd  NOBG.SI ; industrial supplier W.W. Grainger Inc
 GWW.N ; Kansas-based pork producer Seaboard Corp  SEB.N ; and
ethanol plant investor Rex American Resources Corp  REX.N ,
according to disclosures with the U.S. Securities and Exchange
Commission, state environmental regulators and the U.S. Tax
Court.
    CapitalOne, Goldman Sachs, JPMorgan, Mylan, Noble, Rex
American, Seaboard and W.W. Grainger declined to comment on
refined coal’s impact on NOx pollution.
    These and other refined coal investors stand to gain at
least $10 billion in tax incentives over the next decade if the
law is extended, based on the current annual consumption of
refined coal and the existing level of the inflation-adjusted
tax credit.
    
    BIRTH OF THE BUSINESS
    As originally drawn in 2004, the refined coal tax credit
required producers to increase raw coal’s market value by 50
percent to qualify for the subsidy. The market-value clause made
cost-conscious utilities unwilling to buy the specialized
product. Prospects for the clean coal business were dim.
    But in the wake of the 2008 financial crisis, two U.S.
senators changed the landscape by deleting the market-value
clause – a subtle tweak tucked away in the massive $700 billion
U.S. financial rescue package.
    A.J. Gallagher, along with utility firms Ameren Corp and DTE
Energy, also had been lobbying on the issue of refined coal,
according to lobbying disclosure filings, though it is unclear
if they lobbied specifically on the market-value clause.
Officials at Ameren and DTE declined to comment on the lobbying.
    The policy edit – by Democrat Max Baucus of coal mining
state Montana and Republican Chuck Grassley of Iowa – made it
possible for refined coal producers to receive the subsidy even
if they sold their product to utilities below cost. That paved
the way for investors to set up operations and to ultimately
make billions of dollars building refined coal to its current
share of about a fifth of the U.S. coal market.
    Baucus said he does not remember the change to the refined
coal tax credit. “It was a tax-credit blizzard; a deluge of
credits was being discussed,” Baucus said. “It’s very easy to
change the code to give credit to companies to spur investment.
The code gets crusted with barnacles of credits, and then
they’re removed. It’s the natural ebb and flow of things.”
    Grassley declined to comment for this story.
    The subsidy is now worth more than $7 a ton, an amount that
covers losses on the discounted pricing and the operations that
produce refined coal, while often leaving a profit that can
amount to tens or hundreds of millions of dollars per year per
investor, according to disclosures by tax credit investors.
Because some of the operating expenses of running a refined coal
facility are deductible, the tax credit’s effective value can
top $9 a ton.
    Goldman Sachs, one of the world’s most powerful banks, is
currently generating estimated annual gross tax credits of about
$50 million from two Missouri power plants alone, according data
from the U.S. Energy Information Administration showing refined
coal consumption patterns at the plants. Goldman declined to
comment.
    “It was virtually impossible to make money producing clean
coal for utilities,” said Roger Jones, senior counsel at
McDermott Will & Emery LLP in Chicago, who has represented
refined coal tax investors. “But as soon as the credit was
there, people thought about capital-raising to engage in this
activity.”
    After the tax credit was revised, A.J. Gallagher led the
race to build refined coal facilities, constructing them next to
power plants that burned the most coal in the country so as to
maximize credit volumes.
    It now has investments in 34 refined coal facilities in the
United States, along with a 46.5 percent controlling stake in
Chem-Mod LLC, a leading supplier of chemicals used to refine raw
coal, according to A.J. Gallagher SEC filings.
    Gallagher’s main rival, Colorado-based Advanced Emissions
Solutions Inc  ADES.O , holds interests in 19 refined coal
facilities with tax credit investors, through a joint venture
with Goldman Sachs and NexGen Resources Corp. Affiliates of
Goldman Sachs account for most of those investors, SEC filings
show.
    Goldman Sachs, in 2011, purchased a 15 percent stake in the
joint venture, a refined coal operator called Tinuum Group LLC,
formerly known as Clean Coal Solutions, for $60 million.
Advanced Emissions owns a 42.5 percent stake in Tinuum, whose
operations produced and sold about 60 million tons of refined
coal during the 12-month period that ended Sept. 30, SEC
disclosures show.
    
    DRUG, TRASH FIRMS GET INTO COAL
    Some partnerships include players even farther afield from
the energy business. In one of refined coal’s earliest and
biggest financial commitments, trash collector Waste Management
Inc  WM.N  teamed up with JPMorgan Chase to invest in the
refined coal facility at Coal Creek Station in North Dakota.
    The bank and the trash company invested in a facility that
treats coal by preheating it in a process that dries out several
million tons of soggy lignite coal each year, increasing its
energy output. Electric cooperative Great River Energy, the
owner of the plant, agreed to lease its refined coal facility to
JPMorgan and Waste Management for $530 million over 16 years,
according to a January 2011 deal disclosed by the co-op.
JPMorgan and Waste Management declined to comment for this
story.
    Another big beneficiary is drug maker Mylan. Refined coal
tax credits were the second biggest component in producing a tax
benefit of $358.3 million in 2016, according to Mylan’s annual
report. That tax benefit lifted its consolidated earnings for
the year to $480 million, from $121.7 million.
    Power plant owners typically sell their coal at cost to
refined coal operations controlled by tax credit investors. Once
the coal is treated with chemicals or dried out at an on-site
refined coal facility, the tax credit investors sell the coal
back to the power plants at a discount that can be anywhere from
75 cents to $2 per ton – a way to ensure utilities get some
benefit from the subsidy, according to agreements filed with
state regulators. Central-Appalachian coal, which has high
energy content for power generation, costs about $75 a ton.
    Coal plant owners also may structure deals with refined coal
producers to collect coal-handling and licensing fees or to
charge rent through leases of their land used for the
facilities, the disclosures show.
    Last year, Louisville Gas & Electric and Kentucky Utilities,
a unit of PPL Corp  PPL.N , struck a deal with an affiliate of
Goldman Sachs to burn refined coal at the utility’s Ghent power
station. The utility stands to receive $10 million a year in
incentives and would bear no expense for running the refined
coal operations, according to disclosures with Kentucky
regulators.
    For Goldman and any other tax credit investors in the deal,
the gross annual tax credit, before refined coal operating
expenses and incentives for the utility, is $39 million, Reuters
estimates. That estimate is based on Ghent’s average annual coal
consumption of 5.5 million tons multiplied by the $7.03 per ton
tax credit.
    Goldman declined to comment on the revenue or profit it
derives from clean-coal tax credits.
    Utility companies themselves haven’t been in the vanguard of
capitalizing on the refined coal subsidy. That’s because the
original wording of the refined coal tax credit, passed in 2004,
stipulated that the producer of refined coal had to sell it to
an “unrelated person.” So, utilities couldn’t invest in clean
coal and sell it to themselves.
    The IRS issued new guidance in 2009, however, that opened
the door for affiliates of utilities like Detroit-based DTE
Energy to control or take stakes in refined coal production
facilities in recent years. DTE has received some $639 million
in refined coal tax credits since 2012, SEC disclosures show.
DTE declined to comment for this story.
    
    PAYING NO TAXES
    In today’s thriving clean coal industry, A.J. Gallagher’s
early moves to monetize the tax credit seem prescient.
Months before the subsidy first entered the tax code in 2004,
the company paid $300,000 for a 5 percent ownership stake in
Chem-Mod, which at the time was developing chemical treatments
designed to reduce coal pollution. A core group of five people
at A.J. Gallagher was overseeing the move into the business,
according to the company’s disclosures to investors.
    A.J. Gallagher was among several investors who paid
Washington firms to lobby on refined coal, according to lobbying
disclosure filings. In 2008, before Congress modified the
refined coal tax credit to erase the market-value clause, the
company paid two law firms – Winston & Strawn, and Steptoe &
Johnson – to lobby on “refined coal” and “energy and tax”
issues, respectively. The lobbying disclosure documents do not
detail what specific objective the companies had in their
lobbying activities.
    Officials from those law firms involved in the lobbying
declined to comment.
    David Lowman, a partner at Hunton Andrews Kurth LLP, was
lobbying on refined coal on behalf of a different company at the
time. He said the refined coal industry successfully pushed to
have the market value clause eliminated. In return, the industry
agreed to double the pollution reduction requirement on mercury
and sulfur dioxide to 40 percent from 20 percent.
    By the end of 2008, Gallagher had built up a 42 percent
stake in Chem-Mod for a total investment of $13.3 million,
according to company disclosures. Now it was ready to launch
into developing facilities.
    The dive into a newly subsidized business was part of the
company’s strategy to find profits in taxpayer-financed
incentives. Dating to the 1980s, Arthur J. Gallagher has sought
out opportunities, for example, in subsidized low-income housing
and the so-called synfuel tax credit, designed to promote
domestically-produced synthetic fuels that can reduce U.S.
import dependence.
    Gallagher’s approach to refined coal, however, has made it a
heavyweight, and it has been pivotal in recruiting tax investors
to help finance refined coal operations throughout the country.
In 2009, it negotiated partnerships with Fidelity and the U.S.
subsidiary of France’s Schneider Electric SE  SCHN.PA  to
produce refined coal for a utility at three South Carolina power
plants, U.S. Tax Court disclosures show. Gallagher also has
struck deals to put refined coal operations inside the fence of
power plants owned by DTE and St. Louis-based utility Ameren
Corp  AEE.N .
    Net earnings from its “clean energy” investments are
estimated to be $115 million in 2018, or 17 times more than what
the company reported in 2010. Looking ahead, the company can
carry forward its stockpile of $850 million in credits to reduce
its taxes in future years. 
    “We will not be paying much, if any, U.S. federal income tax
for many years to come,” CFO Howell said this spring during a
conference call with investors.
    

    <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^
SPECIAL REPORT-The truth about 'clean' coal    https://www.reuters.com/investigates/special-report/usa-coal-pollution/
SPECIAL REPORT-Wall Street cleans up on 'clean coal' subsidies  
 https://www.reuters.com/investigates/special-report/usa-coal-wallstreet/
  
SPECIAL REPORT-Little lab clears big profits for 'clean coal'
investors     https://www.reuters.com/investigates/special-report/usa-coal-labs/
    ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>
 (Reporting by Tim McLaughlin
Editing by Richard Valdmanis, Janet Roberts and Brian Thevenot)
 ((tim.mclaughlin@thomsonreuters.com; +1 617-856-4409; Reuters
Messaging: Tim.McLaughlin.thomsonreuters.com@reuters.net))