Thursday, January 14, 2016

Managerial Challenge

In the second decade of the twenty-first century, companies all across the industrial landscape are seeking to achieve sustainability. Sustainability is a powerful metaphor but an elusive goal. It means much more than aligning oneself with environmental sensitivity, though that commitment itself tests higher in opinion polling of the latent preferences of American and European customers than any other response. Sustainability also implies renewability and longevity of business plans that are adaptable to changing circumstances without uprooting the organizational strategy. But what exactly should management pursue as a set of objectives to achieve this goal?

Management response to pollution abatement illustrates one type of sustainability challenge. At the insistence of the Prime Minister of Canada during the Reagan Administration, the U.S. Congress wrote a bipartisan cap-and-trade bill to address smokestack emissions. Sulfur dioxide and nitrous oxide (SOX and NOX) emissions precipitate out as acid rain, mist, and ice, imposing damage downwind over hundreds of miles to painted and stone surfaces, trees, and asthmatics. The Clean Air Act (CAA) of 1990, amended in 1997 and 2003, granted tradable pollution allowance assets (TPAs) to known polluters. The CAA also authorized an auction market for these TP A assets. The EPA Web site ( displays on a daily basis the equilibrium, market-clearing price (e.g., $250 per ton of soot) for the use of what had previously been an unpriced common property resource—namely, acid-free air and rainwater. Thereby, large point-source polluters like power plants and steel mills earned an actual cost per ton for the SOX and NOX-laden soot by-products of burning lots of high sulfur coal. These amounts were prompdy placed in spreadsheets designed to find ways of minimizing operating costs.2 No less importantly, each polluter felt powerful incremental incentives to mitigate compliance cost by reducing pollution. And an entire industry devoted to developing pollution abatement technology sprang up.

The TPAs granted were set at approximately 80 percent of the known pollution taking place at each plant in 1990. For example, Duke Power's Belews Creek power plant in northwestern North Carolina, generating 82,076 tons of sulfur dioxide acidic soot annually from burning 400 train carloads of coal per day, was granted 62,930 tons of allowances (see Figure 1.1 displaying the 329 x 365 = 120,085 tons of nitrous oxide). Although this approach "grandfathered" a substantial amount of pollution, the gradualism of the 1990 cap-and-trade bill was pivotally important to its widespread success. Industries like steel and electric power were given five years of transition to comply with the regulated emissions requirements, and then in 1997, the initial allowances were cut in half. Duke Power initially bought 19,146 allowances for Belews Creek at prices ranging from $131 to $480 per ton and then in 2003 built two 30-story smokestack scrubbers that reduced the NOX emissions by 75 percent.

Another major electric utility, Southern Company, analyzed three compliance choices on a least-cost cash flow basis: (1) buying allowances, (2) installing smokestack scrubbers, or (3) adopting fuel switching technology to burn higher-priced low-sulfur coal or even cleaner natural gas. In a widely studied case, the Southern Company's Bowen plant in North Georgia necessitated a $657 million scrubber that after depreciation and offsetting excess allowance revenue was found to cost $476 million. Alternatively, continuing to burn high-sulfur coal from the Appalachian Mountain region and buying the requisite allowances was projected to cost $266 million. And finally, switching to low-sulfur coal and adopting fuel switching technology was found to cost $176 million. All these analyses were performed on a present value basis with cost projections over 25 years.
Southern Company's decision to switch to low-sulfur coal was hailed far and wide as environmentally sensitive. Today, such decisions are routinely described as a sustainability initiative. Many electric utilities support these sustainable outcomes of cap-and-trade policies and even seek 15 percent of their power from renewable energy (RE). In a Case Study at the end of the chapter, we analyze several wind power RE alternatives to burning cheap high-sulfur large carbon footprint coal.

The choice of fuel-switching technology to abate smokestack emissions was a shareholder value-maximizing choice for Southern Company for two reasons. First, switching to low-sulfur coal minimized projected cash flow compliance costs but, in addition, the fuel-switching technology created a strategic flexibility (a "real option") that created additional shareholder value for the Southern Company. In this chapter, we will see what maximizing capitalized value of equity (shareholder value) is and what it is not.

Discussion Questions
  1. What's the basic externality problem with acid rain? What objectives should management serve in responding to the acid rain problem?
  2. How does the Clean Air Act's cap-and-trade approach to air pollution affect the Southern Company's analysis of the previously unpriced common property air and water resources damaged by smokestack emissions?
  3. How should management comply with the Clean Air Act, or should the Southern Company just pay the EPA's fines? Why? How would you decide?
  4. Which among Southern Company's three alternatives for compliance offered the most strategic flexibility? Explain.

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