Carbon Capture Retrofits and the Cost of Regulatory Uncertainty

Power generation firms confront impending replacement of an aging coal-fired fleet in a business environment characterized by volatile natural gas prices and uncertain carbon regulation. We develop a stochastic dynamic programming model of firm investment decisions that minimizes the expected present value of future power generation costs under uncertain natural gas and carbon prices. We explore the implications of regulatory uncertainty on generation technology choice and the optimal timing of investment, and assess the implications of these choices for regulators. We find that interaction of regulatory uncertainty with irreversible investment always raises the social cost of carbon abatement. Further, the social cost of regulatory uncertainty is strongly dependent on the relative competitiveness of IGCC plants, for which the cost of later carbon capture retrofits is comparatively small, and on the firmÕs ability to use investments in natural gas generation as a transitional strategy to manage carbon regulation uncertainty. Without highly competitive IGCC or low gas prices, regulatory uncertainty can increase the expected social cost of reducing emissions by 40 to 60%.