Changing Emission Standards and Shale Boom Drivers of Combined Heat and Power Industry

New regulations proposed in September by the Environmental Protection Agency under President Obama's Climate Action Plan are meant to substantially crack down on carbon emissions at power plants. Under the new rules, coal-fired plants will be permitted to release 1,100 pounds of carbon dioxide per megawatt hour, or 40 percent less than average emissions today. Natural gas-fired plants will be capped at 1,000 pounds of CO2 per megawatt hour. This proposed legislation has set the coal industry on its side and, not surprisingly, weighed on coal plays like James River Coal Company (NASDAQ:JRCC - News) and Arch Coal (NYSE:ACI - News) as investors ponder future demand. While the case is certainly not closed on the coal industry, it is time for investors to be looking at greener alternatives that will play a key role in shaping future generations of energy production.

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The President's initiatives and those of some state leaders, such as New Jersey Governor Chris Christie's Energy Master Plan, are bringing back to light more earth-friendly ways to power industry, namely combined heat and power, or CHP. In its essence, CHP (also called "cogeneration") produces heat and electricity simultaneously from one source fuel, capturing thermal energy for repurpose in the process of generating electricity. The electric power is used for some or all of the electric needs of a facility, while the heat can be used in an array of applications, such as hot water supply or process heat. This vast improvement in efficiency lowers energy costs for the user, reduces harmful emissions and lessens the risk of electric grid disruptions, amongst other benefits.

To understand how efficient CHP is, consider that the existing power grid operates at a paltry 33-percent energy efficiency; discharging about twice as much heat as electrical energy it delivers to end users. The total of energy lost in wasted heat from generating power in the U.S. each year is greater than the total energy consumption of Japan. Conversely, CHP has been shown to operate at up to 90 percent efficiency.

CHP has been in use globally for decades and it seems that the newfound government support is going to accelerate further installations. The U.S. currently has an installed capacity of 82 GW, with the largest portion (about 87%) being utilized at manufacturing facilities. The Obama Administration is in favor of the nation adding 40 GW of new CHP in the States by the end of 2020. Governor Christie's plan has a goal of 1,500 megawatts of new CHP facilities to be built in New Jersey. The importance of CHP facilities, many of which operate independent of the power grid, have hit home with Christie in the wake of devastating storms like Hurricane Sandy that left millions of people on the Eastern seaboard without power for extended periods of time.

Another point in the case for CHP is the booming shale industry in the U.S. as natural gas is the leading source fuel for CHP. Modern horizontal drilling and fracturing techniques have catalyzed domestic oil and gas production. Energy companies are tapping into some of the largest reserves in the world across seven major U.S. shale formations, including the Barnett, Bakken, Eagle Ford and massive Marcellus shale, which is the second largest natural gas find in the world and sprawls across about 95,000 square miles of New York, Pennsylvania, Ohio, West Virginia and Maryland. The sheer scale of the reserves plays a role in UBS analyst Nicole Decker forecasting that the North America will be energy independent by 2020, which has provided a boon in value to companies such as Pioneer Natural Resources (NYSE:PXD - News) and Diamondback Energy (NASDAQ:FANG - News). This energy revolution has driven down natural gas prices and displaced imports, creating a favorable situation for CHP advancement in combination with economic motivations and regulatory initiatives.

The CHP industry is still fragmented, but as majors in several industries embrace the technology and consumers look to capitalize on incentives, investors should be keen to an amalgamation of the pieces into a formidable whole that brings CHP more mainstream. Siemens SA (NYSE:SI - News) recently exemplified the growing interest in CHP, announcing that it will be commissioning a turnkey natural gas-fired CHP plant in Poland for energy utility PGE GiEK SA to replace a coal-fired plant. The new plant will operate at an efficiency rating of 84 percent, with an electric capacity of 138 MW and thermal capacity of 90 MW. Further, Siemens says, "Compared to the old coal-fired power plant, the new plant will produce 95 percent less sulfur dioxide emissions, more than 30 percent less nitrogen dioxide emissions and more than 95 percent less particulate emissions." Including a long-term service agreement, the deal is valued at roughly $216 million for Siemens.

Waltham, Massachusetts-based American DG Energy, Inc. (NYSE MKT: ADGE) is quickly emerging as a leader in the CHP industry with its design and installation services and portfolio of on-site products, including chillers, heat pumps and other mechanical energy systems. Domestic and international customers span a broad array of institutions, commercial and small industrial facilities, including DoubleTree by Hilton (which is controlled by Blackstone Group (NYSE:BX - News) and preparing for a $2.4-billion IPO this month), Roku Health in the UK and Dunstable Leisure Centre in the UK, to name just a few.

ADGE is an annuity-based company, meaning that its focus is not on selling equipment; it is on selling the energy that comes from the on-site equipment. This business model is underscored by long-term contracts, typically 15 years in duration. The value of contracts currently on the books at American DG is nearly $300 million, a key metric positioning the company for stable growth going forward.

The company epitomizes the benefits of CHP, offering their customers a guaranteed discount rate on the price of the energy produced from their equipment, while covering all the costs involved with installation, operating expense and support. Even with shouldering these expenses, gross profit from energy sales, ex-depreciation, was 44 percent in the third quarter.

During the third quarter, energy revenue increased 24 percent to $1.65 million, versus $1.34 million in the year prior quarter. Add in an energy feasibility study that added $109,749 to sales, and revenue was up 26 percent for the quarter. The company also returned value to shareholders with a special dividend of an aggregate of 4.9 million shares of its subsidiary EuroSite Power Inc. during Q3. On a GAAP basis, net loss for the quarter contracted to $1.13 million, or 2 cents per share, from $1.26 million, or 3 cents per share, in the third quarter last year. As of September 30, the company had $10.6 million in cash and cash equivalents.

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ADGE currently operates 109 energy systems, not counting the six that were recently approved by New York City, and has a backlog of 34 energy systems. It's this backlog of work, recently completed feasibility studies with an unnamed major university and large hospital group and bevy of new contracts and installs announced in the third quarter that is especially appealing about the future of CHP and ADGE.

After a lull in development a decade ago, bogged down by restructuring of the wholesale markets for electricity, burgeoning industry activity suggests that CHP is right for hearty investment activity again. It's estimated that the U.S. achieving its 2020 goal of adding 40 GW of new CHP will result in $40 - $80 billion in new capital investment in manufacturing and other U.S. facilities. European lawmakers are also chalking out their own mandates to reduce emissions and push for alternative energy production. Frost & Sullivan expects CHP to be driven by these goals, estimating the EU market earned revenues to rise at an 11.4-percent CGR from 482.5 million euros ($655 million) in 2012 to 1.03 billion euros ($1.4. billion) in 2019.

The headwinds of CHP haven't exactly turned into tailwinds yet, but many of the barriers limiting investment in the past are coming down. Motivated by growing concerns over climate change, lawmakers are not going to back down policy changes to emissions standards. Cumulatively, these factors are creating a rare, almost "grass roots" investment opportunity in the few public companies that have already established a footprint in the CHP space.

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