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Optimal Abandonment of Coal-Fired Stations in the EU

Keywords: power plants, coal, natural gas, emission allowances, futures markets, stochastic processes, abandonment, real options

Author(s): Luis M. Abadie, Mikel González-Eguino and José M. Chamorro

Date: 2010-26-05

Issue: 2010-07

  Download this working paper (332 KB.)

Carbon-fired power plants could face some difficulties in a carbon-constrained world. The traditional
advantage of coal as a cheaper fuel may decrease in the future if CO2 allowance prices start to increase.
This paper seeks to answer empirically the most drastic question that an operating coal-fired power plant
may ask itself: under what conditions would it be optimal to abandon the plant and obtain its salvage
value? We try to assess this question from a financial viewpoint following a real option approach at firm
level so as to attract the interest of utilities and the broader investment community. We consider the
specific case of a coal-fired power plant that operates under restrictions on carbon dioxide emissions in
an electricity market where gas-fired plants are considered as marginal units. We also consider three
sources of uncertainty or stochastic variables: the coal price, the gas price and the emission allowance
price. These parameters are derived from future markets and are used in a three-dimensional binomial
lattice to assess the value of the option to abandon. Our results (and sensitivity analysis) show the
conditions that have to be met for the abandonment option to be exercised. This option to abandon coalfired
plants is, however, hardly likely to be exercised if plants can operate as peaking plants. However,
the decision may go differently in different circumstances, such as high CO2 allowance prices, very low
volatility of allowance price or a decrease in the price of gas. The decision is also influenced by the
remaining lifetime of the plant and its thermal efficiency. In any case the price of CO2 will work to bring
forward the decision to abandon in older and less efficient coal-fired plants, which are less likely to be
retrofitted in the future.

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