Evaluate three scenarios of coping with new Clean Energy Act pollution control requirements in one of Southern Company's power plants

• The company will be allowed to use SO2 allowances
  • 254,580 tons during 1995-1999
  • 122,198 tons during 2000-2016
• Three possibilities
  • Do nothing and buy additional allowances
  • Build Scrubbers in 1995 worth $800 mil; sell unused allowances
  • Convert to low sulfur coal; sell allowances before 1999, then buy them
• Revenues, Operating Costs constant and the same under all three scenarios
  • Relevant or irrelevant cash flows?
  • We need to focus on INCREMENTAL cash flows - i.e. additional costs associated with each scenario
• Tax rate = 37.7%
• Discount rate = 10%
• Prices of allowances unknown
  • Expected to start at $250 per ton of SO2, increase by 10% until 2010

Scenario 1: Do Nothing

• Company would burn 8.338 mil tons of coal, containing 1.6% of SO2. Ultimately, the company would emit 266,550 tons of SO2 per year
• Extra allowances needed:

DIF = 266,550 - allowances assigned

• Additional costs = [DIF*Price per allowance]*(1-Tax)
• The present value of all these costs is the ultimate cost of the scenario

Scenario 2: Build Scrubbers

• Company would burn 8.338 mil tons of coal, containing 1.6% of SO2. Scrubbers remove 90% of SO2. Ultimately, the company would emit 26,655 tons of SO2 per year
• Extra allowances needed:

DIF = 26,655 - allowances assigned

(note this number is negative)

• Additional costs = [DIF*Price per allowance]*(1-Tax)

(note this number is negative, we make PROFITS)

• The scrubbers are costly
  • Necessary investment: $143.85 mil in 1992, $503.61 mil in 1993, $71.97 mil in 1994
  • Additional operating costs: $0.0013/kwh (plant produces 21,551 mil kwh)
  • Scrubbers consume energy: 2% of revenues (21,551*$0.056)
• The scrubbers provide additional depreciation tax shield
  • Book value = $800 mil
  • Depreciated starting 1995: 14% per year for first 5 years; 2% per year for next 15 years
  • Depreciation tax shield (positive CF!) = Tax*Depreciation
• The present value of all these costs AND benefits is the ultimate cost of the scenario

Scenario 3: Use Low Sulfur Coal

• Company would burn 8.391 mil tons of coal starting 1996. Ultimately, the company would emit 167,650 tons of SO2 per year
• Extra allowances needed:

DIF = 167,650 - allowances assigned

(note this number is negative until 1999, then positive)

• Additional costs = [DIF*Price per allowance]*(1-Tax)

(note this number is negative until 1999, we make PROFITS until 1999)

• Low sulfur coalis costly
  • Additional fuel costs: 8,391*Price of low sulfur coal - 8,338*Price of high sulfur coal
  • Additional necessary investment: $22.1 mil in 1996
• The extra investment provides additional depreciation tax shield
  • Book value = $22.1 mil
  • Depreciated starting 1997: 14% per year for first 5 years; 2% per year for next 15 years
  • Depreciation tax shield (positive CF!) = Tax*Depreciation
• The present value of all these costs AND benefits is the ultimate cost of the scenario

1. Which scenario should we choose?

2. What is the NPV and the IRR for each?