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Of special interest to Power and utilities executives
Is converting coal to gas the right move?How to make a critical asset decision in the face of uncertainty
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Historic and planned retirements of coal-fired generators
1 “Coal-to-gas conversion not an easy decision for Midwest utilities,” http://www.statejournal.com/story/18363508/coal-to-gas-conversion-not-an-easy-decision-for-midwest-utilities, 12 May 2012 (updated 11 June 2012).
2 “27 gigawatts of coal-fired power to retire in the next five years,” U.S. Energy Information Administration, 27 July 2012, http://www.eia.gov/todayinenergy/detail.cfm?id=7290.
3 http://www.eia.gov/todayinenergy/detail.cfm?id=6990
In Becker, Minnesota, Xcel Energy’s coal-fired plant has been operating for more than 30 years. But over the next 12 months, Xcel will likely decide the future of the Sherburne County Generating Station as it reviews its long-term power needs.1
Xcel Energy is not alone. Reports by plant owners and operators to the US Energy Information Administration (EIA) suggest that utilities plan to retire 175 coal-fired generators between 2012 and 2016. The 27 gigawatts (GW) of coal-fired capacity expected to be retired in that time frame is more than four times greater than the 6.5GW of capacity utilities retired in the preceding five years.2
Fueling 50% of America’s power needs, coal is still the US’ primary source of energy.3 However, as the Environmental Protection Agency (EPA) and other regulators and agencies continue to introduce rules that impose limits on carbon dioxide and other emissions from
new and existing power plants, utilities with aging coal-fired plants are thinking about accelerating the retirement of these assets in lieu of making costly capital investments to mitigate their environmental impact.
Furthermore, as natural gas prices continue to hover around an all-time low and as technology makes abundant shale gas deposits more accessible, natural gas is becoming even more attractive as a replacement energy source for an increasing number of utilities.
Although the number of large-scale conversion projects announced is small relative to the number of expected retirements, major utilities appear to be increasingly interested in evaluating the conversion of their coal assets to burn natural gas. The question is, how should leading utilities approach this complex decision?
Source: U.S. Energy Information Administration, Form EIA-860, “Annual Electric Generator Report.”
Note: Data for 2005 through 2011 represent actual retirements. Data for 2012 through 2016 represent planned retirements, as reported to EIA, as of 3 October 2012. Data for 2011 through 2016 are early release data and not fully vetted. Capacity values represent net summer capacity.
These planned retirement values reflect the early release version of the 2011 reports by plant owners and operators on the Form EIA-860, “Annual Electric Generator Report.” The data are subject to change and may not reflect all the retirements that companies are considering. Respondents to this survey include industrial and commercial generators, as well as those in the electric power sector.
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What’s the issue?The cost of operating a coal-fired plant is rising. A multitude of EPA regulations requiring utilities to meet new emission standards under the Clean Air Act is a contributing cost factor, but it is not the sole source of rising costs. The all-in cost of mining and transporting coal is also rising. At the same time, natural gas prices have been falling. New drilling techniques have opened up previously untouchable shale gas, thereby increasing the domestic supply of natural gas and making the fuel economics of running a gas plant highly attractive versus running a coal plant.
This confluence of factors has utilities thinking hard about accelerating a replacement of some of their coal fleet with gas-fired generation. For some utilities, building a brand-new gas plant is the right path forward. For others, the opportunity to leverage water rights, transmission access, existing staff and other resources makes the conversion of existing coal units to burn natural gas a highly compelling investment. Deciding on which path to take is the issue many utilities face today.
Why now?At the federal level, the EPA has spent the last several years working on new rules to limit carbon emissions on power plants. With the re-election of President Obama, the implementation of those rules is expected to accelerate. At the same time, state- and regional-level energy regulators (e.g., the Regional Greenhouse Gas Initiative and state environmental quality agencies such as the California Air Resources Board) are implementing their own environmental regulations to limit carbon dioxide and other emissions from coal plants. The result is a significant number of regulations for coal plants that will be coming into force within the next several years.
In the past, the power and utilities industry has shown that as an environmental mandate nears, competition among utilities for scarce resources tends to drive up the all-in costs of compliance. Hence, while there exists significant uncertainty as to the exact timing and stringency of regulations, adopting a wait-and-see approach may not be the prudent path forward.
In the past, the power and utilities industry has shown that as an environmental mandate nears, competition among utilities for scarce resources tends to drive up the all-in costs of compliance.
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How does it affect you?Regulated utilities have an obligation to provide cost-effective, reliable electricity with limited impact on the environment. As coal costs continue to rise and emissions regulations at federal, state and regional levels come into force, utilities with a large number of coal-fired plants in their portfolios may
not provide the best value to ratepayers or the company’s shareholders. And merchant coal plant owners are stretched to create shareholder value in the context of rising operating costs.
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What’s the fix?As utilities consider shifting their generation mix away from coal and toward more efficient fuels such as natural gas, they need to consider a number of complex factors. For decisions of this scale and complexity, EY recommends a structured investment decision-making approach that enables utilities to understand their options, effectively assess the feasibility of the options and make risk-informed decisions regarding their aging coal-fired assets.
• Understand the options. Utilities need to consider a range of options based on a number of factors, such as the technical viability of conversion, market uncertainty, changes in regulations and the cost to convert existing equipment. The potential conversion options for each coal unit should be evaluated carefully for technical feasibility, which in turn impacts project costs.
• Evaluate each option. Once the utility understands its options, it should evaluate each option for economic viability. This would ideally include developing a driver-based model to calculate a plant’s gross margin, from which it can calculate the net present value of free cash flows and estimate the generation asset value under each option. It is also important that
utilities analyze these critical asset decisions at a portfolio level to optimize capital spend across the fleet rather than on an asset-by-asset basis. Lastly, benchmarks for production costs (compared against actuals) and forecasts for future market prices need to be factored into the assessment.
• Conduct scenario-based planning. In addition to determining the economic viability of available options, utilities may want to consider conducting sensitivity testing, simulation and/or scenario analysis to understand how other factors, such as market or regulatory forces, may impact each option. Utilities would then be able to use a risk-informed perspective to compare the value associated with coal-to-gas conversion to that associated with early retirement or retrofit for emission controls.
• Consider creative alternatives. Finally, utilities should leverage the analytics above to introduce alternatives not previous considered, including any real options embedded within their control. In addition, partnerships with component manufacturers, joint development partners, local communities interested in jobs and tax incentives, and/or natural gas pipeline owners can make average projects look extremely lucrative.
3. Conduct scenario-based planning
• What does sensitivity testing tell us about the robustness of each option?
• How does the probabilistic treatment of key risk drivers via simulation and/or scenario analysis inform our preferred path forward?
Sensitivity analysis Probability distributions
2. Evaluate each option
• Based on a driver-based model, what is the most economically valuable option for each coal unit?
• At the asset portfolio level, what set of strategic investment decisions optimizes total generation asset value across the fleet?
Driver model
12345
A B C
Funding curve
4. Consider creative alternatives
• Are there any embedded options or learning events that could strengthen the analysis?
• What innovative approaches (e.g., partnerships with joint developers, manufacturers, and/or pipeline owners) could increase the value of a given option?
Real options Value creation
1. Understand the options
• Which coal units are in scope? • Based on key technical considerations, what are the
viable conversion options for each unit in scope? • What are the key decision drivers (i.e., controllable
versus uncontrollable)?
Decision tree Driver diagram
Key questions Analytical tools Work steps
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What’s the bottom line?According to the EIA, utilities are expecting to retire 175 coal-fired plants between 2012 and 2016. To date, fewer than 10 of those plants are being considered for coal-to-gas conversion. As coal costs continue to rise and federal, state and regional regulations seek to limit carbon emissions from coal-fired plants, there is no better time to consider converting aging coal-fired plants to gas.
As fuel price dynamics play out, it will be vital to have a long-term view on the mix of fuels (e.g., coal, gas, nuclear, renewables) present in the generation asset portfolio.
If utilities set to retire coal-fired plants are seeking to maximize value for ratepayers, shareholders and their own organization, they should leverage a robust, well-structured, risk-informed decision process to determine whether coal-to-gas conversion is a viable alternative.
6 | 5 Insights for executives [Sector/Industry]
Want to learn more?
For related thought leadership, visit www.ey.com
The answers in this issue are supplied by:
Dana HansonPower & Utilities LeadAmericasErnst & Young LLP +1 704 491 [email protected]
Andy PattersonPrincipalErnst & Young LLP +1 404 433 4040 [email protected]
Eric ChungSenior Manager Ernst & Young LLP +1 503 414 7957 [email protected]
As coal costs continue to rise and federal, state and regional regulations seek to limit carbon emissions from coal-fired plants, there is no better time to consider converting aging coal-fired plants to gas.
75 Insights for executives [Sector/Industry] |
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