Acid Rain Essay
Situation: The acid rain provisions of the 1990 amendments to the Clean Air Act were to being in 1995. Currently, it is 1992 and The Southern Company (a electric utilities holding company operating in Georgia, Alabama, Mississippi, and Florida) had to decide what actions they were going to take in order to comply with the new regulations. Before the Clean Air Act, firms did not have incentives to reduce emissions below the government specification. If a firm exceeded the amount, it would just simply pay a fine. Maximum limits were put into place and allowances could be bought and sold on the open market.
This means that companies that were able to reduce their emissions, could make money off the allowances they sold. That provided firms incentive to reduce emissions to more appropriate levels. In contrast, a company that could not reduce would have to spend more money to buy additional allowances. The allowances would start at $250 per contract but increase by 10% each year. One of the Southern Company’s Georgia plant, Georgia Power’s Bowen a coal fired plant, had a couple options to choose from to abide by the new laws.
The options included either adding scrubbers in order to drastically reduce their emissions and sell the extra allowances or spend more money to buy additional allowances. Either way, Bowen was looking to spend more money in the near future with the Clean Air Act. Question/ Decision: What is the lowest cost option for the plant? Knowing the plant will be extinct in 2016, what estimations can we assume from 1995 to 2016? What are the unknown factors? How long will it take to implement the scrubbers? Do we have the man power to handle the maintenance for the scrubbers?
What is the best option for the company that still makes us look good to the public? Will allowance prices increase by more than 10%? Will there be enough allowance contracts on the open market for Bowen to purchase in order to maintain it’s current level of emissions? Hypothesis: Bowen had two main possibilities to comply with the new law: purchase allowances or sell allowances. Purchasing contracts appears to be the easy option but has the potential to get very costly especially in phase two (2000) since emissions will be reduced by almost 50%.
Also, we have no idea if it will be possible to purchase all the contracts we need. If there are not enough contracts on the market, it could turn into a bidding war for the available contracts. In order to sell allowances, Bowen would have to drastically reduce their emissions. The most logical way to do this would be to install scrubbers that would remove sulfur dioxide from the exhaust gases of the generators. Installing the scrubbers was expensive but would reduce the emission by so much making it possible for Bowen to sell the extra allowances to on the open market for a profit.
If the company plans to stay in business for longer than 2016, they should purchase the scrubbers to begin working in the second phase. This would help the company look better in the public’s eyes and will pay off more in the future. Since the company does not plan to stay in business, they should continue operating the way they do now and purchase the additional contracts. Even though it is the riskier option, this is the lowest cost option for the company. Proof of Action: The least cost alternative is to purchase additional allowances and continue operating as usual. The cost to the firm, if all estimations hold true, would be 267.
Installing scrubbers could run up the costs to either 408 or 294 depending on when they are installed. Graph 1, PV of Cash Flows illustrates the cash flows for all high high-sulfer coal options. Option 1 offers almost no cost to the firm at the beginning stages, but increases in 2000. By 2005, the no scrubber option will be costing the firm more than the other two options. However, installing the scrubbers is much more costly at the beginning stages of the Clean Air Act. As time goes on though, the money made from selling the contracts and the costs of maintaining the scrubbers will offset each other.
Installing the scrubbers to be ready for the second phase would reduce the costs to the firm much more throughout the 2000’s. Graph 1: PV of Cash Flows Option 1, no scrubbers, does not come without a lot of risk. The two main risk factors the company faces are government policies and the purchasing/selling of the allowances on the open market.
a. The change in government policy. As the government becomes more and more concerned about pollution, there are possibilities that more policies or stimulus such as ecological taxation would be carried out. Although the current effective tax rate is 37. %, the company will save a portion of tax expense by installing scrubbers to control once a tax refund policy is implemented to low level pollutants emission companies.
b. The change in allowance price. The company planners assume the price of allowances would be $250 per ton of sulfur dioxide in 1995 and would rise at 10% per year through 2010 and stay at that price since after. However, since the allowances could be traded in open market, their value is volatile. If the starting price of allowance rises to a certain level or the price increases at a higher rate, the PV cost of option 1 will be higher. graph 2 and 3). Graph 2: PV cost of option V. S. starting price of allowance Graph 3: The PV of option cost v. s. Allowance inflators Conclusion: In conclusion, according to the NPV of costs we should not install the scrubbers at this time. We should continue operating at our current levels and purchase contracts on the open market. This option is the riskier option but it is the lowest cost. If we are more concerned about risk, we should install the scrubbers to be ready for the second phase. The question becomes, how accurate do we think our estimations are?
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