In March 2005, the Environmental Protection Agency (EPA) issued the final Clean Air Interstate Rule (CAIR) and Clean Air Mercury Rule (CAMR). Assessing the impact that these and other environmental policies have on the whole organization reveals implications for the corporate process at all levels.
As legislation to limit greenhouse-gas emissions is batted about at federal, state, and local levels, those of us involved with electric utilities increasingly are concerned about the effect that future greenhouse-gas regulation could have on inudstry plans to comply with existing CAIR and CAMR requirments. The central issues and questions are:
The importance of a company's emissions profile as it affects asset value, company liabilities, and cash flow, will continue to grow in significance regardless of legislative twists and turns. This article speaks to the importance of taking an integrated corporate-wide approach to environmental management, and it outlines a framework for integrating emissions into the overall utility portfolio management process.
The industry is now working to develop and implement compliance plans optimized for a three-pollutant world, but these plans may not be optimum in a future four-pollutant regulatory regime (nitrogen oxides [NOx], sulfur dioxide [SO2], mercury [Hg], and carbon dioxide [CO2]). If regulations governing the fourth pollutant are mandated, some investments may be stranded or diminished in value. Thus, companies' investment decisions in long-lived assets directly are afffected by the policies that will be in effect during the 40 years or more of an asset's life. Of course, a company's own voluntary commitments also must be factored into the analysis.
For instance, an investment that may look brilliant and obvious given today's market conditions may turn sour very quickly if environmental policies change or if there are revolutionary improvements in power generation technology. Integrated gasification combined-cycle (IGCC) power plants represent a prime example of this type of trade-off. Although this technology appears very promising today, it has yet to be tested in a full-scale commercial environment. There are only two production-grade, coal-based IGCC plants in the United States and in Europe. Also, higher capital costs compared with conventional coal or gas technologies may not be justifiable if gas prices decline dramatically or if the federal government backs down from current emission-reduction targets.
A corporate-emission strategy must be developed from a holistic viewpoint taking account of abatement costs, price and dispatch uncertainty, and different technology alternatives such as renewables, nuclear, IGCCs, carbon sequestration, and unit-retirements. Other important factors include the impact of changing legislation, emission-control technology improvements, and security of supply and emissions trading alternatives. An ongoing evaluation of changing regulation and solution approaches is essential where both the cost and environmental implications are potentially enormous.
But where does one begin the strategic process? Corporate officers and strategic-planning departments must first evaluate the impact of environmental regulation on the broader region before assessing the impact of compliance to their specific energy portfolio. Questions include:
Some basic steps can be taken to turn these wide-ranging questions on market and environmental drivers into an actionable strategy:
1) Build Environmental Scenarios.
A thorough knowledge of existing and potential legislation as well as the political landscape obviously is critical to building appropriate environmental scenarios. It is important at this stage to focus on the market and the market feedback. For instance, one utility may find one piece of legislation reasonable, while such regulation irreparably and dramatically could affect another. Credible scenario analysis cannot be performed without incorporating an impact analysis of different market players.
This strategic assessment gets more complex for energy portfolios that have assets operating in different regulatory environments, ISOs, and RTOs across North America and the rest of the world. The analytical support in these high-level exercises often is provided through deterministic structured scenario planning where identified risks and effects can be quantified using any fundamentally based, market-analytics model.
2) Incorporate Emissions Into Forecasts of Fuel Prices and Electricity.
A key process to incorporating a broad enterprise-wide portfolio management (EPM) framework for managing emissions includes a fundamental forecast of fuel prices as well as electricity. This process also should include robust scenario and uncertainty analysis of fuel markets (coal, natural gas), scenario analysis of fuel prices, and it should have that information automatically cascade into the process that simulates wholesale power prices.
This process, typically undertaken by the market analysis or strategic planning departments within organizations, also should allow for the incorporation of unit-level emission costs for pollutants such as NOx, SO2, Hg, and PM. This affects the commitment and dispatch of units to ensure they do not exceed their allocated annual emission limits. A complementary equilibrium model that is employed as part of a downstream process can be used to compare overall excess emissions from power generating units above and beyond the national limits, with the supply and demand of regional emissions, to estimate future allowance costs. If these models assume that investments in environmental controls will be reflected in the allowance prices, the equilibrium price of NOx allowances then can be defined as the price that equals the long-term marginal cost of emission controls for the last ton of NOX reduced under the cap.
3) Link Regional-Emissions Analysis to Portfolio-Specific Analysis.
An optimal emissions management process calls for a price-coupled approach to assessing the wider strategic impact of alternative legislation on portfolio mixes by simulating the operation of the portfolio under different scenarios.
A portfolio simulation should monetize the value of generation assets and associated contracts against market prices and provide for alternative technologies, plant improvement options, and contracting or new build alternatives covering both medium and long-term horizons. With the portfolio planning solution, planners can evaluate all the aspects affecting the generation fleet, including:
4) Model Generation Alternatives: How Do You Create an Expansion Plan Taking Emissions Into Account?
Another component of the portfolio-planning piece includes a methodology that assesses appropriate capacity expansion and retirement alternatives for the portfolio, and allows the automated evaluation and screening of alternative contracting strategies under various emission scenarios. Mixed-integer linear programming-based techniques that are integrated into the broader EPM framework have an advantage in that they quantify the "shadow cost" of portfolio alternatives, thereby allowing for a direct comparison of renewable alternatives versus retrofitting existing assets and participating in cap-and-trade programs.
Having established the strategic framework of market outcomes and portfolio options, each individual investment decision needs to be reviewed for both risk and return from a portfolio perspective. This can be achieved by adding the underlying market uncertainty on top of the scenario analysis. Neither a scenario with a high-gas case nor another with a low-gas case may reflect the underlying volatility of the commodity. We thus need to add another dimension-uncertainty-to the evaluation.
For a robust portfolio assessment, these regional uncertainty variables at a minimum should include:
Uncertainty and the relationship among key drivers (often referred to as volatility and correlation) need to be incorporated to ensure the flexibility of the portfolio is fully considered. For instance, a long-term contract may provide the lowest-cost solution on average under the scenario analysis, but it could impose significant risk if prices are volatile.
Having distilled the options available and assessed plausibility of different scenarios as well as underlying fundamental uncertainties through a systematic process, the road ahead becomes clearer and allows the organization to align its goals and actions accordingly. But is this enough? How do the insights from modeling and strategy development diffuse to other parts of the EPM framework?
Integrating emissions into the core of corporate strategy requires overcoming two information challenges within the organization. The first is to establish effective communication with respect to emissions among trading, planning, auditing, and risk-management functions in the organization. The second is to employ a corporate-wide process that will allow sharing of data and analytical insight at every level of the organization. This means that data and forecasts can be seamlessly shared at all levels, from the development of strategy to the trading floor and short-term generation fleet commitment and dispatch.
In this market, only those companies able to align their business units around a consistent strategy, common analytics, and a fully integrated data framework will be positioned to succeed. By improving the consistency of results, decisive action can be taken, where well-structured information and analysis can turn strategy into results. Those companies implementing a corporate-wide framework for portfolio decisions will have the advantage because they will be able to use real-time information to make more informed decisions. This will allow them to adapt to market changes, predict future trends, and forecast what is needed from an internal operational standpoint.
Progressive utilities have achieved this by proactively involving all levels of the company in a dialogue that serves to define key drivers at every level that are subsequently worked into both strategy and practice that allows them to "walk the talk."