Acid Rain Project: EMBA GA21 Group 4 Report

SOUTHERN COMPANY: ACID RAIN PROJECT

ANALYSIS & RECOMMENDATIONS

EMBA GA21 Group 4: Alan Kim, Anna Litsiou, Jerry Cao, Sid Ramani
1.0 Executive Summary

Southern Company (SC) is the 2nd largest American Electricity Utility Company based in Southern US.
SC owns different plants, and the biggest one is Georgia power Bowen (Bowen), a coal-fired plant
producing enough power to serve the residential commercial and industrial demand of one million
people.

Utility Companies like SC will utilise sulphur containing coal as the key fuel for electricity generation
and one of the by-products is the high emissions of Sulphur Dioxide (SO2). In the 1990s, due to the
high emissions of SO2, the impact was the Acid Rain with devastating impact on the environment.

Hence, the Clean Air Act 1990 introduction by the Government was aiming at the reduction of SO2
emissions and was coming into effect in 1995 through 2-phases, 1995-1999 (Phase I), and 2000
onwards (Phase II). The implementation was called Acid Rain Program. In this legislation companies
were permitted to pollute the air by certain amount of SO2. If the companies remained in the limit
spelled out in the act, special allowances were given in the form of incentive. Allowances could be
consumed by the producing company or sold to other companies.

The problem presented here is how Georgia Bowen plant can comply with Acid Rain Project over a
period of 25 years by identifying a cost-minimising method while complying with the Act and
meeting the expectations of Government Commission, who was setting the electricity price. Note
worthy that the key leadership were risk averse.

A discounted cash methodology has been employed on an incremental basis to assess out of the 4
mentioned options the Southern Company possess how the net present value of the costs incurred
varies. This case study falls under the class of real options where managers must make decisions on
projects involving tangible assets.

The recommendation is option 4 which entails the switch to a lower Sulphur coal in phase 1, and
purchase of allowances in phase 2. Worth noted is that the final decision is dependent on the
management and how they view the evolution of allowance prices.

In real time, SC adopted option 4 until 2008 and then they installed the scrubbers from 2008
onwards (decision to install scrubbers were made in 2005). The allowance prices were stable at
around 150 up to 2006 and then it had levelled at 400 after a spike in 2006.
2.0 Problem Statement

Bowen Plant’s challenge was to identify the optimum option allowing minimum cost involvement
and meeting emission compliance obligations with the amendments in the Clean Air Act coming in
effect in 1995.

The main issue was that in 1990, Bowen Plant’s SO2 emissions per hr were 30 Tons, and hence
annual emissions were very high. According to Act amendments, the Plant’s management had to
comply with the following regulated quota/allowances below over two phases:

a) Phase I Allowances (1995-1999): 254, 580 tons /year

b) Phase II Allowances (2000 onwards): 122, 198 tons /year

The company could either buy extra allowances from other firms or reduce the emission amount by
either employing scrubbers to clean SO2 from exhausted gases or use lower sulphur coal. Another
challenge was the setting of allowance permit prices as in 1990s, the market did not have exposure
to historical prices of setting allowance permits.
 Acid Rain Project: EMBA GA21 Group 4 Report

2.1. Relevant Options

Four options are described below, other alternatives exist however are deemed out of scope.

 Option 1 “do nothing”: No investment and continuing operating with burning high Sulphur
coal without scrubbers
And buy allowances from other firms across both phases.
 Option 2 “over-comply”: Investment on installing scrubbers to clean exhaust gases from SO2
by installing them from 1992- 1994 to be ready for Phase I. The Bowen Plant would then be
generating lower SO2 emissions that could be sold to other firms in the open market. This
would be a revenue stream.
 Option 3 “postpone investment”: Delaying the investment on installing scrubbers to clean
exhaust gases from SO2 by installing them from 1997- 1999 to be ready for Phase II.
However, during phase I, allowances will have to be purchased to comply with the Act. From
Phase II onwards, the Bowen Plant would then be generating lower SO2 emissions that could
be sold to other firms in the open market. This would also be a revenue stream.
 Option 4 “low Sulphur coal”: Switching to low Sulphur coal and no scrubbers installed. The
emissions would be lower than the amount permitted in Phase I but in Phase II, they would
need to buy allowances.

Table 1 summarizes the options.

 Acid Rain Project: EMBA GA21 Group 4 Report

Extra Implementation
Option Coal Type Scrubbers
Allowances Phase

1 – ”Do Nothing” High Sulphur Coal Buy allowances No 1&2

2 – “Over comply” High Sulphur Coal Sell allowances Yes 1

3 – “Postpone investment” High Sulphur Coal Buy allowances in Phase I Yes 2

4 – “Switch to low Sulphur” Low Sulphur Coal Buy Allowances No 1&2

Table 1: Option description

 Acid Rain Project: EMBA GA21 Group 4 Report

3.0 Methodology

A discounted cash flow approach is adopted using the data presented in the study. The period is 24
years when it is anticipated that the plant will be decommissioned. The incremental costs are
assessed and discounted back till 1992 to understand which option from a financial point of view has
the lowest net present value. The lowest NPV is assessed as additional costs are only considered.
Revenue is constant across all options and hence is not deemed as an incremental cash flow. The
following assumptions are common across all options:

 Tax rate of 37.7%

 Constant allowance price at US $250
 Discount Rate of 10% compounded annually
 Constant revenue of 0.056 per Kilowatt-hour with an output of 21, 551 Kilowatt-hours
 Operating cost of 0.00281 per kilowatt hour
 Energy required 202.5 Million MMBtu
 Allocated Sulphur Dioxide allowances for the two phases: Phase I equates to 254,580 tons
/year and Phase II equates to 122,198.

All costs incurred or reduction in revenue incurred above and beyond the options listed above are
included as “costs” that need to be absorbed by Southern to comply with the Clean Air Act. Tax
shields are applied to all relevant costs post.

4.0 Data Analysis

For an informed decision, the quantitative analysis, Section 4.1 focuses on the NPV (Net Present
Value)/NPC (Net Present Cost) using the assumptions above.

In section 4.2 further sensitivity analysis is carried out to see if there is a correlation between
NPV/NPC and fluctuation of allowance price. This is because 1992 was the first time that the market
was establishing the allowance price without the availability of historical data for an informed
decision.

In Section 4.3, reviewing each option from investment, technological risk, and other aspects, this
qualitative analysis can address different questions of SC Executive team.

4.1 NPV/NPC Analysis

Based on the assumptions, a discount approach cash flow was applied for every option over a period
of 24 years.

Tables 2 summarizes the aggregated NPV (Net Present Value)/NPC (Net Present Cost) for all options.
Ranking represents lowest to highest NPV value. Figure 1 depicts the movement of NPV/NPC over
the years.
 Options NPV/NPC Ranking
Option 1
NPV/NPC -266.4 2
Option 2
NPV/NPC -435.8 4
Option 3
NPV/NPC -345.7 3
Option 4
NPV/NPC -172.9 1
Table 2 Four Options Aggregated NPV/NPC

NPV OF INCREMENTAL COSTS

300
200
100
0
1992-1994 1995-1999 2000-2010 2011-2016
Millions of Dollars

-100
-200
-300
-400
-500
-600
-700
-800
Time Period

Option 1 Option 2 Option 3 Option 4

Figure 1: Incremental costs

Tables 3 through 6 present the detailed NPV analysis for each option and all elements considered for
NPV/NPC calculation across the 24 years. 24 years timeline of this project have been split into 4
periods: pre-phase I (1992-1994), Phase I (1995-1999), and Phase II split into two periods, 2000-2010
and 2011-2016, respectively.
Table 3 Option 1 NPV/NPC Analysis over 24 years

Table 4 Option 2 NPV/NPC Analysis over 24 years

Table 5 Option 3 NPV/NPC Analysis over 24 years

 Table 6 Option 4 NPV/NPC Analysis over 24 years

4.2 Sensitivity Analysis Allowance Prices vs NPV/NPC

Figure 2 represents the sensitivity analysis of allowance price versus NPV/NPC in the range of US $65
to US $400 for all 4 options. Option 4 looks to be linear while NPV/NPC remains stable.

Sensitivity Analysis
0
65 150 200 300 400 450
-100
-200
NPV/NPC

-300
-400
-500
-600
-700
Allowance Price

Option 1 NPV/NPC Option 2 NPV/NPC

Option 3 NPV/NPC Option 4 NPV/NPC

Figure 2 Sensitivity analysis

 Acid Rain Project: EMBA GA21 Group 4 Report

4.3 Qualitative Analysis: Pros and Cons for each option

This analysis reviews the pros and cons for each option summarized in table 7. All the options result in negative overall NPVs given adhering to the Clean Air
Act requires cash outlays either in the form of:

 Purchasing allowances OR (Option 1)

 Investment of some form either for technology (2,3,4)

Table 7 Pros and Cons for Options 1 through 4

 Acid Rain Project: EMBA GA21 Group 4 Report

5.0 Recommendation

The problem statement for this case is that the Bowen Plant would like to follow an option with the
small investment allowing to comply with Act 1990 coming into force in 1995. Also, this option
should reflect the executive management perspective, which is risk averse, and reflect the key
stakeholder view, the Government Commission. The Government Commission view is that they want
to see that the Bowen Plant is proactive in complying with the Act but with the lowest cost.
Government run organization have challenges as they out to be profitable and no at the expense of
the end-user, the consumers.

Based on the NPV/NPC analysis, and assuming a 250 dollar per ton of Sulphur output Option 4 would
seem the most economically justifiable. Given the NPV of the incremental costs is the lowest
however Southern should only ensure this option is undertaken if contracts with existing suppliers
can be economically ceased and new contracts can be easily entered into. This option is ideal for the
following reasons:

 Relatively lower technology risk compared to Option 2 & 3

 Viewed as taking action mitigating and reputational risk
 Regulators may allow Southern to pass on some of the cost to consumers given this is the
least costly option given the initial assumptions.

The sensitivity analysis also supports that option 4 because emissions prices can change over a range
but NPV is constant over time. This will address the concerns of the Government Commission, and
SC Senior Management.

Given option 4 has relatively lower technology risk and lower reputational risk such an option would
also suit a risk averse executive management team whilst at the same team delivering a relatively
cost-effective solution.
6.0 Southern Company Real Time Strategy

As SC is a real company, and the enforcement of the Clean Air Act 1990 indeed impact their strategy.
Also, emission allowance was a main variant impacting the NPV/NPC, and we also looked the
behavior of the emission prices over the period of 20 years.

Our research has shown that

a) Emission allowance stayed stable at about $ 150 until 2004, and then it started increasing
with a spike in 2006. After 2008, it leveled at around 400.
b) SC choose to adopt option 4 until 2008 when they installed scrubbers (option 2).

The above are depicted in figure 3.

Figure 3: Allowance price (real time data)