Acid Rain: The Southern Company

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out to be option 1 (i.e., burn high-sulfur coal without a scrubber). In this option, the revenue & expense breakdown is relatively simpler than that of option 2. Specifically, we assume that the annual output of electricity, operating revenue per KWH, and thus the annual consumption of coal and operating cost per KWH, stay constant over the 25-year-period. In calculating each year’s operating cash flow, we paid special attention to the cost of buying emission allowance. The price of allowance rises 10% annually in the period of 1995-2010 and then stays at 2010 price. Also, given the data of permitted sulfur emission in both phase 1 & 2, we were able to calculate the annual cost of purchasing allowance. Finally, after subtracting the tax expense, we discount all the future cash flows back to the year of 1992 at the rate of 10% and got a present value of about $4,642 million.

In option 2, things become more complicated in the following aspects. First of all, the installation of scrubber can start in 1992 to meet both phase 1&2 requirements or it can wait until 1997 to begin the installation process and meet only the phase 2 requirement. Secondly, since the scrubber is installed, the plant is able to generate electricity with very low emission so it can sell the extra allowance and contribute to the operating revenue.

If the installation starts in 1992, it takes 3 years for the process to complete and the company would be able to generate revenue by selling allowance each year after 1995. In addition to the operating cost mentioned in option 1, the company has to afford a 2% reduction of revenue to support the scrubber and pay extra $0.0013 per KWH to operate the scrubber. On top of that, the scrubber depreciates at 14% in the first 5 years and at 2% in the remaining 15 years. After subtracting the tax expense and discounting all the cash flows, we got a present value of $4,339 million. If the installation starts 1997, the company has to buy allowance in the period of 1995-1999 and then it can sell allowance from 2000-2016. Taking the installation cost, operating cost, allowance cost/revenue and all other expenses into consideration, we discounted all the cash flows and got a present value of $4,537million.

In conclusion, in terms of the highest present value and the lowest cost, option 1 seems to be the better alternative for the company.

4. What uncertainties does the company face that might cause it not to pursue the “least cost” solution?

· Since the prices of allowances were predicted values in the case, they may change in the future and lead the Southern Company to choose a different option. When the most of coal-fired companies burn high-sulfur coal, it is possible that their allowances are not enough and they all need to buy allowance from the market, thus, the prices of allowance may rise a lot according to the Law of Demand and Supply. The main cost of option one is purchasing allowance, therefore, the higher the price of allowance, the higher the cost. To a certain extent, the total cost of option one may exceed that of option two, in that case, the company would choose option two as “the least cost” solution.

· To take an extreme situation into consideration, there could be absolutely no available allowance in the market. In this case, if the company chose the option one, they would have to reduce the production of electricity, or have to pay a fine. In contrast, they don’t have to worry about this situation if they conduct option two and install the scrubbers in 1992, because they don’t need to buy any allowance in this plan. Hence, if the company wants to be really comprehensive, they better choose the option two and start construction in 1992 instead.

· It is still unknown whether the Public Service Commission would approve rate increase of the prices that the Southern Company charge for its electricity from users. If the commission thought the company has complied with the Cleaner Air Act in the least-cost manner, which may be option two, it may allow the company to pass to cost of construction scrubbers to the ratepayers. In this circumstance, the capital cost of company would dramatically reduce, and the option two would definitely be the” least cost” solution.

· The delivered price of high-sulfur coal was expected to fall to $29.82 per ton in 1996. However, if this reduction did not happen, then the cost of option one would be higher than we assume now, or even higher than option two.