The Multi $Billion Question: To Invest or Not Invest in Pollution Control

Issue 7 and Volume 106.

By Steve Blankinship,
Associate Editor

With the tremendous growth in demand for selective catalytic reduction systems and other NOx control systems to comply with regulations such as the SIP Call, many asset owners are shelling out vast amounts of capital dollars. SCR projects can run in the $50-$100 million range depending on unit size and level of control needed. But determining whether or not to invest in new pollution control equipment, how much to invest and when, can be a tough call these days.

According to a new study released by ICF Consulting, power companies may be prematurely sinking billions into NOx pollution control equipment in the face of tremendous financial, regulatory, and market uncertainty. ICF Consulting’s NOx Emissions Outlook 2002 reviews recent regulatory developments, assesses market trends, and forecasts future NOx market movements. The results of the analysis indicate that power companies should consider employing a strategy that emphasizes flexibility and postpones capital investment.

Nate Collamer, principal in ICF Consulting’s energy practice, which authored the study, explained power companies are squeezed between the need to control emissions and demands from rating agencies and shareholders to reduce debt loads and increase earnings. “The balance sheet implications of EPA’s new eastern NOx trading program (the NOx SIP Call) and upcoming multipollutant legislation are substantial, but following traditional capital-intensive control strategies could push more companies into junk bond territory,” he said.

“Power companies can deliver shareholder value by deferring NOx pollution control investments, thereby reducing debt, maintaining near-term earnings, and preserving flexibility to respond to the uncertain air regulatory future,” Collamer said. “However, pursuing a capital investment deferral approach requires good NOx market intelligence and a strong risk management strategy.”

The report says that the combination of high near-term NOx compliance costs and downward medium-term price pressures on such costs is resulting in a boom-bust cycle for the NOx market. Investments of more than $5 billion for selective catalytic reductions (SCRs) have been committed already, with an additional $5 billion in investments likely by 2006. These investment dollars come at a significant premium because the Enron debacle has increased rating agency scrutiny of power company investments (resulting in higher debt costs) and because the scramble to comply has inflated the cost of NOx control technology.

ICF believes the likely bust in NOx allowance prices will be driven by the return to a more stable financial climate for power companies, resolution of future air regulations, and falling NOx control costs. Given the considerable regulatory and technological uncertainty, the results of the ICF Consulting analysis indicate that roughly $1 billion of NOx control investments could be delayed in anticipation of lower-cost removal options and greater regulatory/market certainty.

Collamer says that power companies need to have a comprehensive understanding of NOx market dynamics in order to make the right investment decisions. “The risks of over-investment can be far greater than those of under-investment. Financially stressed power companies must understand future NOx markets to deploy successful capital deferral strategies and strengthen balance sheets.”

Yet the downside of not investing is obvious. Power facilities caught without adequate pollution controls risk loss of millions of dollars in revenue in today’s potentially lucrative power markets, while facing the need to buy expensive replacement power and being subjected to millions of dollars in potential fines. If the decision to go forward appears prudent, clearly any potential savings in project costs are important.

One area that might be overlooked is tax savings, and pollution control projects offer multiple tax saving opportunities. Using strategies from both old and new pieces of legislation, asset owners can potentially realize up to 10 percent net present value savings for qualified pollution control projects.

“For example, according to Section 169 of the Internal Revenue Code, emission control projects can qualify for accelerated depreciations schedules,” said Kathryn Tronsberg with Deloitte & Touche at the Department of Energy’s Conference on Selective Catalytic Reduction and Selective Non-Catalytic Reduction for NOx Control in Pittsburgh in May. “By taking advantage of the permitted 60-month depreciation schedule, vs. the typical 15-year or 20-year depreciation schedules associated with most power generating equipment, an approximate 6.6 percent net present value savings is possible for a power plant installing SCR.”

Deloitte & Touche has consulted with several plant owners to estimate potential tax savings. At a 1,000 MW coal-fired facility in the southeast, for example, which is installing $170 million worth of SCR and other NOx control technologies for commercial operation this year, potential net present value savings exceed $11 million.

There are some conditions associated with the Section 169 rapid amortization program. The pollution control projects must be additions to plants placed in service before Jan. 1, 1976; the owner must make an election for amortization on the plant’s tax return; and the project must be certified both by state authorities and then by federal authorities to gain approval. Gaining approval may also take persistence. Tronsberg indicated that, although these tax saving opportunities have been available since the early 1970s, there has been little activity to date. Interested parties, therefore, may need to “educate” state and regional EPA officials about the Section 169 program.

Additional tax savings are also possible via the Job Creation and Worker Assistance Act of 2002, passed earlier this year. Tronsberg stated that an additional 30 percent reduction in first-year depreciation can be taken for projects whose construction begins after 9/10/2001 and which are placed in service by 9/1/2005. Combining this bonus depreciation with the Section 169 depreciation described above, a net present value savings of approximately 9.4 percent is possible.