Regulation of carbon dioxide (CO2) in the US is only a matter of time, as I’ve written for some time in Utility & Income and Utility Forecaster.

I’ve also said that many utility companies would benefit and that the financial impact on the sector on the whole would be relatively benign. Now it’s looking more and more like both of those forecasts are panning out.

One of the few benefits of being laid up with flu is time to read.

Last week, I picked up a copy of one of the more controversial books in recent years, at least concerning utilities: The Weather Makers, a treatise on the global warming issue by Tim Flannery.

I’m no global climate specialist. But I do have an abiding interest in how what’s accepted as fact on global warming will impact the power sector in the US and abroad. And it looks to me like regulating CO2 and controlling its emissions from power plants will be the single most important environmental issue for power companies over the next decade.

The first thing that struck me on picking up the book was a preface by Paul Anderson, former CEO of DUKE ENERGY (NYSE: DUK). Mr. Anderson is no tree-hugger. He’s a multi-decade veteran of the energy industry who deserves most of the credit for Duke Energy’s remarkable recovery from near disaster earlier this decade.

That recovery required making some tough decisions. Through it all, Anderson maintained a squarely pro-shareholder focus. Executive salaries were strictly linked to the company meeting certain targets in its recovery, from shedding risky assets and reducing debt to improving operating efficiencies. The strength of today’s Duke is a testament to that practical vision and ability to carry it out.

In past years, the typical energy executive’s primary concern on the warming issue would be to keep his or her company in good stead with regulators and try to do as little else as possible. Anderson’s preface, however, suggested a wholly different kind of involvement.

Though Anderson admitted it’s unrealistic to expect energy industry CEOs to agree on every point with environmentalists, he also wrote “it is time to move from denial to action.”

Duke is part of a coalition of utilities trying to shape legislation to control or regulate CO2. But with a large number of coal power plants to its credit, the company is far from a pure beneficiary of such a move, no matter how such a bill would be shaped. In addition, Anderson is now retired and has no need to toe any kind of party line. For him to endorse a book calling for control of CO2 emissions is a pretty clear sign this issue has come a long way.

There are still plenty of skeptics out there. One of our competitors in the investment publishing business just released a book calling the entire issue a giant hoax--backing it up, presumably, with “expert” testimony. The Wall Street Journal’s editorial page continues to charge “the pro-warming crowd” with jumping to conclusions based on poor science.

To some Americans, the entire issue is still part and parcel of a thinly veiled attempt by Al Gore to run for president again. To them, any admission that there might be something to the relationship between CO2 and temperature is practically tantamount to a betrayal of President Bush and throwing in one’s lot with a bunch of empty-headed greenies. Some still cling to the idea that the Kyoto Accords are simply an attempt by foreign countries to hook the US into a worse, uncompetitive position.

With Anderson and others who aren’t liberal Democrats joining the call for action, however, it’s clear the skeptics have lost the issue. In fact, during the past month or so, we’ve seen news item after news item adding to the momentum. A recent Wall Street Journal news article, for example, detailed China’s efforts to study ways to control CO2.

EXXONMOBIL (NYSE: XOM) and other Super Oils have spent millions of dollars over the past few years funding advertising campaigns to cast doubt on the science of global warming. Now even they are adding their voice to the call for action to control CO2, publicly trumpeting ways they’re joining the effort.

President Bush campaigned in 2000 on the promise that he would honor the Kyoto Accords, then did a 180-degree turn and abandoned the idea soon after taking office. Since then, the White House has been one of the most vocal global warming skeptics.

Contrary to rumors floating before this year’s state of the union address, the president did not propose aggressive steps to combat global warming in his speech. But he has since advocated aggressive new funding for alternative energies that emit no CO2. His counterpart in Canada, Conservative Party Prime Minister Stephen Harper, announced this week a major investment in funds to combat global warming. Even TXU CORP (NYSE: TXU), which has proposed building 10 major new coal power plants in Texas, is talking about boosting its stores of renewable energy to curtail CO2.

The newly Democratic US Congress hasn’t yet put its imprimatur on CO2 regulation. But it’s a safe bet we’ll soon see something sent to the president’s desk that would be extremely embarrassing not to sign. Even Representative John Dingell (D-MI)--the auto industry’s man in Congress for a generation--has spoken favorably of some form of legislation. Any bill is also certain to get a large number of Republican votes in both houses.

That would be tough--if not impossible--for the ever-shrinking chorus of global warming skeptics to block.

A NEW LAW

With legislation to control CO2 inevitable, the main question now is what form it will take. In a best-case, the new rules will allow industry the time and flexibility needed to apply the best technologies to cut CO2 without putting an inordinate burden on either power producers or consumers.

That was certainly the case with the last major environmental cleanup challenge affecting the industry: dramatically limiting the sulphur (SOX) and nitrogen oxides (NOX) that cause acid rain.

Like it or not, 50 percent of America’s electricity comes from coal-fired power plants. Moreover, the percentage of our energy coming from electricity continues to grow by leaps and bounds, growing to more than 40 percent last year from just 14 percent in 1970. Ironically, the next great leap forward may come from the substitution of electric vehicles for gas-fueled cars, as nanotechnology dramatically improves battery and energy storage.

As the US becomes more electrified and uses ever-more energy, it’s hard to see a future where we’re not going to use even more coal than we do now. Only nuclear energy has the capacity to replace it on a vast scale, and we wont’ see a new nuke anywhere in this country for another decade at least.

In 1990, it was clear SOX and NOX from coal plants were becoming a major problem for public health. Moreover, acid rain was corroding everything from national monuments to bridges and buildings.

Some of the loudest voices on the issue wanted to shut down all the coal plants, or place major restrictions or burdens on the polluters until expensive cleanup solutions were implemented. The best available technology then was wet scrubbers, which had the unfortunate side effect of generating tons of sludge.

Washington could have clamped down on SOX and NOX immediately at tremendous cost to the country, and almost surely the environment as well. But the first President Bush helped break a log jam in the Democratic Congress a different way, with an innovative cap-and-trade system that allowed polluters to buy credits from companies that made innovations to reduce SOX and NOX faster.

The plan was ridiculed by more radical environmentalists at the time as ineffective. To be sure, some dirty plants have stayed open as their owners worked to clean up. But the overall level of emissions of both gases has steadily fallen over the years to the point where acid rain is no longer anything close to the concern it once was.

This time around, there are still the same voices for drastic action--consequences be damned. The Weather Makers, for example, floats the idea that this is an opportunity to eliminate the world of central power stations in favor of widespread use of more modular sources of energy. In their place the author advocates solar, geothermal and wind power along with more efficient use of energy to meet future demand.

There’s an extremely bright future for renewable and energy saving technologies. But there are infinitely more products constantly coming on the market that are sucking down ever-more power. It’s simply pie-in-the-sky to expect renewables alone to make a significant dent on the need for baseload power facilities, despite recent cost innovations. Neither is it realistic to expect the human race is ready for an enmasse move to small-scale personal power, and away from the baseload plant concept which dominates every major power system on the planet.

For anything to work to control CO2, it’s going to have to be grounded in practicalities. Making sure the zeros add up properly is industry’s job. And companies are definitely motivated this time around to ensure it’s done right and that they’re not saddled with unattainable mandates. In short, they’re at the table and they’re going to be heard.

It’s still far too early to say how CO2 regulation will ultimately be shaped in this country. But the overwhelming favorite at this point is for a repeat of the successful 1990 Clean Air Act model.

That’s pretty much what California has done already with the deal between Governor Arnold Schwarzenegger and the Democratic state legislature. That model is already being pursued in several states and some foreign nations are considering it as well.

The California model is real and has teeth. The state has now forbidden utilities in the state to buy power from out-of-state coal plants, which have supplied it since the state forbade coal power within its borders. But rather than require uncertain and sudden adjustments, the new regime gives companies time to make expensive investments, while it rewards those who act speedily.

There are going to be costs, and banning coal-fired power is not realistic in most of the country. But the overall effect of a national system to control CO2 emissions on the California model should be consistent reductions from a range of actions by government, industry and the consumer, and with as little economic impact as possible.

Under cap-and-trade, sellers of the credits make money. Meanwhile, polluters are given time to make adjustments in an economic way.

Limits of overall pollutants are steadily reduced, driving up the cost of credits and the cost of not doing anything.

Armed with these economic incentives, industry has gradually eliminated the acid rain emissions NOX and SOX that cause acid rain.

And while it’s taken nearly 20 years, what was once a critical health problem is far less so today.

A California-style cap-and-trade system would face plenty of opponents, including the Bush administration. Consequently, it may be a while before a national system is developed even along those lines. But as a proven formula for accomplishing environmental goals in a way that’s benign for industry and its consumers, cap-and-trade is certainly attractive to industry and is therefore by far the most likely to prevail.

WINNERS AND LOSERS

At this point, identifying winners and losers from a cap-and-trade model for CO2 controls is imprecise at best. There are, however, a number of immediately identifiable areas of interest.

One of these is wind energy. Much of the attention has been focused on the makers of turbines such as pure play VESTAS WIND (OTC: VWSYF) or giants like GE (NYSE: GE) and SIEMENS (NYSE: SI). Vestas shares have moved into the stratosphere even as its financial performance has remained lackluster. As for the giants, wind is only a fraction of their overall business, though power could become far bigger deal eventually if building new nuclear plants becomes a priority in the US.

Rather than focus on the builders, the best wind plays are the actual producers. In the US, two players currently dominate the market: AES CORP (NYSE: AES) and FPL Energy, a unit of FPL GROUP (NYSE: FPL).

With more states mandating the use of renewable fuels, these companies are locking in utilities nationwide under lucrative long-term contracts. Each new deal adds to cash flow and provides the basis for faster growth down the road. That’s a lot of leverage and--unlike the builders--their stocks are cheap.

Nuclear power is an obvious beneficiary of regulating CO2, at least in a rational world. Plants are going up like wildfire in other nations. Unfortunately, the only ways for US investors to play are with big builders like GE, Siemens and TOSHIBA (OTC: TOSBF), since new building for US utilities remains in slow motion.

There remains a considerable opportunity in the country’s existing fleet of nuclear power plants, ownership of which has rapidly consolidated in the past decade. That consolidation has dramatically improved performance, boosting capacity to 90 percent in 2005 from just 66 percent in 1990 and cutting the average outage time from 104 to 38 days.

In addition, with natural gas prices several times their level of a decade ago, nuclear has become extremely competitive on a cost basis as well. The result: Nukes are finally minting money for their owners, just as the original builders promised back in the ’50s.

That’s money in the bank for the dominant companies that own nuclear plants in the US, including CONSTELLATION ENERGY (NYSE: CEG), ENTERGY (NYSE: ETR) and EXELON (NYSE: EXC).

As for the losers, even the most CO2-burdened utilities will be able to work their way out of trouble if they have the support of regulators. In stark contrast to the early ’90s, when regulator/utility relations were at a low, officials in most states appear quite supportive today. SOUTHERN COMPANY (NYSE: SO) is already in line to recover up to $9 billion in environmental costs over the next decade or so. Assuming it controls costs during the projects, it will actually add to earnings as it boosts rate base.

There will no doubt be some states where utilities will be less fortunate in recovering the cost of controlling their CO2. Their cases, however, will have more to do with poor management of utility/regulator relations that with any structural problem at the company in question now. As such, we’ll be able to spot the risk with traditional utility analysis, and in plenty of time.