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Carbon Wargames

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

Fortnightly Magazine - December 2007

correction arrived with a vengeance. The dominant strategic impulse was plant construction to replace the capacity lost as a consequence of stage-one coal-plant retirements. The principal strategic actions were:

• Continued nuclear investment;
• Major investment in IGCC plants;
• Significant ramp-up of renewables investment; and
• Significant ramp-up of DSM efforts.

This strong wave of investment in low-emissions assets, along with continued retirement of non-reformed coal plants, pushed overall emissions levels well below the target for that period, and also lowered financial returns.

For purposes of this game, technology risk was assumed to be minimal, and companies therefore invested in IGCC and renewables without significant fear of cost overruns, construction delays, or technology inadequacy. Even without this risk, average TSR fell substantially.

The collective surge to investment contributed to that result, as the market moved to a condition of overcapacity. Price increases moderated, so that wholesale prices grew less than 10 percent in real terms during this second stage of play. The over-shooting of emissions mandates left the industry holding significant quantities of banked carbon allowances.

The impulse behind this stage-two overbuild is familiar to anyone who has been part of the real-world power industry over the past decade. High price signals at the end of Move 1 yielded high spreads between marginal cost and revenue. Those short-term spreads invited utilities to make long-term investments in Move 2 that were far less profitable than hoped when the aggregate capacity caught up with demand—a demand that the same companies were simultaneously spending lavishly through DSM to reduce.

Moreover, the market rules in the game provided capacity payments that varied inversely with reserve-margin levels. At the beginning of move one, those capacity payments offered insufficient incentive to invest. At the beginning of move two, they augmented a message already conveyed loudly by market signals, and simply reinforced the already over-eager urge to invest.

Move 3: Diminishing Returns

In the third move (2023 to 2029), the industry returned to basics. The principal strategic actions were:

• Moderate shift back to coal investment;
• Attempted monetization of banked allowances;
• Diminished investment in renewables and nuclear power; and
• Discontinued DSM efforts.

Emissions during this period continued declining as earlier investment in renewable and nuclear power yielded significant production. However, financial returns for the industry also continued declining. Capacity proved more than adequate to the demand, thanks in part to large stage-two capacity investment and in part to substantial demand reduction.

Each company followed a different path, based on its starting portfolio and its particular strategic decisions (see sidebar “Two Hypothetical Utilities: Different Approaches, Different Results”) . Overall, however, the players charted a trajectory of steadily decreasing emissions and steadily decreasing financial returns. Beginning with stage two, an unfavorable gap opened between shareholder return and shareholder cost of capital—a gap that steadily widened.

Paradoxically, two artifacts of the game that appeared advantageous to companies at the time probably contributed to these declines. First, today’s new technologies were assumed to work. A few early mishaps and disappointments might have tempered the companies’ enthusiasm for investment, although