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The Cost of Reducing SO2 (It?s Higher Than You Think)

Fortnightly Magazine - May 15 1998

what gives these allowances financial value.

A second consideration is the ability to bank allowances for future years, which strongly influences today's allowance trading prices. In fact, if Phase II control costs turn out to be high enough, Phase I excess controls may yet generate a return despite the low current price for allowances. How high must prices rise to make banking a profitable strategy? If we take an average price in 1996 of about $100 per ton, and assume that the average real rate of return of utilities is 8 percent, then the 1996 price appears consistent with expected allowance prices in 2008 to 2010 of $233 to $272 per ton (in constant dollars). With equally plausible, higher discount rates, today's low prices appear consistent with even higher future marginal costs. This sort of comparison should not be overdone, however; it compounds uncertainties (coal generation levels, choices of discount rates, many cost assumptions and other regulatory and business risks not explicitly accounted for).

Thus, today's allowance prices do tell us something, but it isn't what total control costs have been so far. First, they indicate the present value of today's expectation of future compliance costs, using a rate that embodies a probably substantial risk premium for future regulatory changes. Second, the current allowance price offers a picture of today's short-run marginal costs.

In the short-run, the considerable FGD capacity now installed creates an effective floor to allowance prices at FGD's operating cost of about $50 to $65 per ton. %n9%n This cost appears consistent with the very lowest allowance price experienced of about $70 per ton. Today's higher allowance prices are thus consistent with the short-run cost of switching to low-sulfur coal, which is based on the price premium for coals with lower-sulfur contents, and is $100 to $120 per ton of SO2 reduced. Thus, the current short-run marginal cost of switching is the current cost most related to today's allowance price.

Future Price Trends:

Dependent on Ozone, Particulates and CO2?

What might happen to future allowance prices if additional control costs were imposed through new regulations for ozone, particulate matter or carbon dioxide? Answer: It all depends on how the new regulations might be implemented.

PARTICULATES. The new NAAQS for fine particles (particulates less than 2.5 microns, or PM2.5) is one regulatory change that substantially affects expectations of the SO2 allowance market. (A standard for particulates would target SO2 emissions, which contribute to fine particle formation.)

EPRI has estimated this new target would increase projected control costs by $3 billion to $5 billion per year greater than those of Phase II. It finds marginal costs could be as high as $1,350 per ton, %n10%n and the benefits of emissions trading relative to a straight technological requirement are reduced.

In the SO2 market, if the Title IV cap-and-trade program was retained and allowance allocations were cut in half through new legislation, then allowance prices would increase substantially. The stricter cap would greatly reduce the range of options, since the sulfur content of coal simply does not go low enough. If, however,