SOUTHERN

COMPANY –ACID
RAIN PROJECT
CORPORATE FINANCE

EMBA GA GROUP 4

ALAN KIM, ANNA LITSIOU,

JERRY CAO, SID RAMANI

AGENDA

CASE SUMMARY

PROBLEM STATEMENT

METHODOLOGY & ASSUMPTIONS

ANALYSIS

RECOMMENDATIONS & CONCERNS

 CASE SUMMARY

Problem Solution

• Sulfur Dioxide pollution • A cap-and-trade approach, introduced

• How to balance the need to protect by the 1990 Clean Air Act
the environment, while still keeping • Birth of a new “commodities” market
the power plant business viable – sulfur emission allowance
PROBLEM STATEMENT (1)

• For Bowen Plant, identify the option with minimum cost involvement and meet emission
compliance obligations with the amendments in Clean Air Act coming in effect as of 1995

• Main issue: SO2 Emission/hr = 30 Tons in 1990 & annual emissions very high & amount
to comply with the quota/allowances below

• As per Act, Phase I Allowances (1995-1999): 254, 580 tons /year Phase II
Allowances (2000 onwards): 122, 198 tons/year
PROBLEM STATEMENT (II)

Proposed Options:

Extra Implementation
Option Coal Type Scrubbers
Allowances Phase

High Sulphur Coal Buy allowances No 1&2

1 –”Do Nothing”

High Sulphur Coal Sell allowances Yes 1

2 – “Over-comply”

High Sulphur Coal Buy allowances in Phase I Yes 2

3 – “Postpone investment”

Low Sulphur Coal Buy Allowances No 1&2

4 – “Switch to low Sulphur”
METHODOLOGY

• Discounted cash flow (DCF) approach

1. Determine an appropriate discount rate
2. Determine the timing and amount of cash flows
3. Calculate the Net Present Value (NPV) as per the equation below

𝑁𝑒𝑡 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑡

• 𝑁𝑃𝑉 = σ𝑇𝑡=1
(1+𝑟)𝑡

• Cashflows considered are incremental costs under each option which are discounted
• Costs are denoted as positive values
 Revenue of 0.056 per
kilowatt-hour is
Discount rate of 10% Valuation date as of
constant with an output
per annum 1992
of 21,551M kilowatt-
hours

ASSUMPTIONS
Buy and Sell as many Operating cost of
Interest is paid at the
pollution allowances as $0.00281 per kilowatt-
end of the year
required hour

Sulfur Dioxide
allowances
Tax rate of 37.7% • 1995 -1999 [254,580]
• 2000-2016 [122,198]
ANALYSIS – OPTION 1 [“DO NOTHING”]

Option 1 1992-1994 1995-1999 2000-2010 2011-2016

Lost Revenue (a) 0.0 0.0 0.0 0.0
CapEx(b) 0.0 0.0 0.0 0.0
Cost of Coal (c) 0.0 0.0 0.0 0.0
Emissions Cost (d) 0.0 -18.3 -1077.0 -904.5
Operating Cost (e) 0.0 0.0 0.0 0.0
Depreciation(f) 0.0 0.0 0.0 0.0
Tax Shield(g) 0.0 6.9 406.0 341.0
Incremental Costs(h) 0.0 -11.4 -671.0 -563.5
NPV/NPC 0.0 -7.0 -185.8 -73.6 TOTAL NPC = -266.4 M

• “Lost Revenue” is defined as a cost component (applicable to all options)

• Only Incremental costs are considered in this analysis (applicable to all analysis)
ANALYSIS – OPTION 4 [“SWITCH TO LOW SULPHUR”]

Option 4 1992-1994 1995-1999 2000-2010 2011-2016

Lost Revenue (a) 0.0 0.0 0.0 0.0
CapEx(b) -22.1 0.0 0.0 0.0
Cost of Coal (c) 0.0 -18.5 -339.1 -256.8
Emissions Cost (d) 0.0 108.0 -470.7 -284.8
Operating Cost (e) 0.0 0.0 0.0 0.0
Depreciation(f) 0.0 -15.5 -4.9 -1.8
Tax Shield(g) 0.0 -27.9 307.2 204.8
Incremental Costs(h) -22.1 61.6 -502.7 -336.7
NPV/NPC -18.3 36.1 -146.8 -44.0 TOTAL NPC = -172.9 M
ANALYSIS – SUMMARY OF OPTIONS

Options NPV/NPC Ranking NPV OF INCREMENTAL COSTS

300
Option 1 NPV/NPC -266.4 2
200
Option 2 NPV/NPC -435.8 4
100
Option 3 NPV/NPC -345.7 3
0
Option 4 NPV/NPC -172.9 1 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

 Sensitivity Analysis

SENSITIVITY
0
65 150 200 300 400 450
-100

ANALYSIS ON -200

NPV/NPC
ALLOWANCE -300
-400
PRICE -500
-600
-700
Allowance Price

Option 1 NPV/NPC Option 2 NPV/NPC

Option 3 NPV/NPC Option 4 NPV/NPC
PROS AND CONS OF EACH OPTION
PROS CONS
 No technological risk  Reputational risk, as company can be seen as
Option 1  No additional capital expenditure ‘environmentally careless’
Do Nothing  No change in business process  Dependent on other companies to sell allowances
 Possible reduction in coal price  No notable tax benefits
 Notable reduction in SO2  Technological risk
Option 2
 Viewed as an environmentally friendly power  Large upfront investment in Phase 1 (719.4 million)
Over-comply
plant  Reduction in revenue/sales
 Notable reduction in SO2
Option 3  Viewed as an environmentally friendly power  Technological risk
Postpone plant  Large upfront investment in Phase 2 (719.4 million)
Investment  Take advantage of high allowances during Phase 1  Reduction in revenue/sales
(before introducing mitigants)
 Dependant on low-sulphur coal providers
 Notable reduction in SO2
Option 4  Dependent on other companies to sell allowances
 Viewed as an environmentally friendly power
Switch to low  Possible disconnection from existing contracts
plant
sulphur  Risk of volatile market price of low sulphur coal given the
 Negligible technological risk ($22 mil)
uncertainty of the demand
LIMITATIONS

Static NPC/NPV analysis Given no readily available Constant price of

of this sort does not market for pollution electricity would most
consider managerial allowances , the actual likely not reflect market
flexibility , the option to evolution of the prices for dynamics as firms try to
wait and see carries pollution allowances is pass on the cost of
intrinsic value difficult to assess compliance
CONCLUSION & RECOMMENDATIONS

• Without the value of hindsight , Option 4[Sourcing low sulphur coal] is the most cost
minimizing option
• However decision is heavily dependent on how “comfortable” management is with the
evolution of pollution allowance prices
• The NPV analysis does not account for managerial options that is inherent in this project
THE EVOLUTION OF SO2 PERMIT PRICES

Phase I Phase II

MA Boutaba et al. 2008

SC REAL TIME STRATEGY

Phase I Phase II

SC adopts lower sulphur coal scenario

SO2 Scrubbers adopted

as 2008

MA Boutaba et al. 2008

THANK YOU

Q& A
BACK UP SLIDES
APPENDIX - ANALYSIS – OPTION 2 [“OVERCOMPLY”]

Option 2 1992-1994 1995-1999 2000-2010 2011-2016

Lost Revenue (a) 0.0 -120.7 -265.5 -144.8
CapEx(b) -719.4 0.0 0.0 0.0
Cost of Coal (c) 0.0 0.0 0.0 0.0
Emissions Cost (d) 0.0 347.9 712.9 598.7
Operating Cost (e) 0.0 -140.1 -308.2 -168.1
Depreciation(f) 0.0 -560.0 -176.0 -64.0
Tax Shield(g) 0.0 178.3 13.9 -83.6
Incremental Costs(h) -719.4 265.4 153.1 202.1
NPV/NPC -661.2 163.8 34.8 26.7 TOTAL NPC = -435.8 M
APPENDIX - ANALYSIS – OPTION 3 [“POSTPONE
INVESTMENT”]
Option 3 1992-1994 1995-1999 2000-2010 2011-2016
Lost Revenue (a) 0.0 0.0 -265.5 -144.8
CapEx(b) 0.0 -719.4 0.0 0.0
Cost of Coal (c) 0.0 0.0 0.0 0.0
Emissions Cost (d) 0.0 -18.3 712.9 598.7
Operating Cost (e) 0.0 -140.1 -308.2 -168.1
Depreciation(f) 0.0 0.0 -611.5 -107.9
Tax Shield(g) 0.0 59.7 178.1 -67.0
Incremental Costs(h) 0.0 -818.1 317.2 218.7
NPV/NPC 0.0 -472.2 98.0 28.6 TOTAL NPC = -345.7 M