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Carbon Wargames

U.S. utilities gain strategic insights by playing out a carbon-constraint scenario.

Fortnightly Magazine - December 2007

The U.S. power industry stands frozen in the headlights of the onrushing worldwide CO 2 crisis. While power demand continues growing, and reserve margins continue shrinking, uncertainties in long-term natural-gas prices, carbon regulation, and clean-technology alternatives create a prohibitive level of investment risk for most power companies.

Moderate changes in the costs of gas or carbon credits can have a dramatic impact on the economic viability of coal-fired power plants (see Figure 1) . If coal plants shift positions with gas plants on the dispatch curve, the economics of all generation sources will be affected profoundly.

In the present state of policy uncertainty, companies are prudent to try muddling through. A sharp drop in planned generation investments between 2005 and today suggests many companies in America’s power industry have adopted this approach (see Figure 2) .

But the industry can’t postpone investments to meet growing power demand and replace aging capacity indefinitely. Although the current RPS-driven investment in renewable-power capacity is useful and important, it is at best a very partial response. Society’s long-term power needs dwarf the current scope of “no-regrets” moves.

It’s not too soon to begin assessing the long-term strategic options that may arise if and when the expected public-policy carbon intervention occurs. That intervention likely will redefine the generation playing field for the next several decades. What a particular company’s options might be in such an event will depend not only on the particular policy that is imposed, but also on the responses that other power companies might make. The collective responses of these companies in the short term will affect power prices and emission-allowance prices, and in the long term the further evolution of public policy.

For companies that must make multi-billion-dollar investment decisions in generation over the next several years, it’s important to explore how these dynamics might play out. For this reason Booz, Allen & Hamilton recently hosted an emissions “wargame,” drawing on a technique the firm has long used with the Pentagon, to explore how competitive (or even partially cooperative) actors might respond to each others’ moves when stressed by large, multidimensional, and uncertain changes.

A wargame provides an efficient and intuitive way to begin the process of thinking through the strategic dynamics those actors will encounter. It challenges players to think systemically, and yields insights into the issues that can operate, often in unexpected ways, to validate or to undermine a given strategy.

The Set-up

The carbon wargame began with a view of reality that was radically simplified for “playability,” yet faithful to the principal drivers of future strategies (see sidebar, “Designing the Game”). For example, players’ actions occurred in two mega regions—Coal Land, where coal-fired generation sets the normal marginal cost, and Gas Land, where gas generation sets the normal marginal cost. Of course, such a simplified model is not

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