The Effects of Coal Contract Constraints on SO2 Trading Program Compliance Decisions

Several studies on Phase I of the Title IV SO2 Trading Program have found that actual compliance costs realized by the electric power industry have far exceeded the least-cost outcome in spite of allowance prices being much lower than expected. Prior work has either conjectured or shown that some of these excess costs could be a result of inefficiencies related to state regulatory constraints, but this does not explain all the additional costs above the least cost outcome. A possible explanation for these additional costs that has been offered, but neither modeled, simulated, nor estimated, is the presence of fuel contracting constraints or rigidities. This paper models utility sulfur dioxide compliance incorporating the possibility for long-term coal contract constraints. During Phase I of the Title IV SO2 Trading Program, long-term high sulfur coal contracts could restrict a utility’s ability to cost-effectively switch to low sulfur coal, and force generating units into more expensive compliance options such as scrubbing or allowance purchases. The existence of contract constraints in the model may force scrubber installation, which increases unit-level compliance costs, increases supply of allowances in the market, and may explain the lower than expected allowance prices observed during Phase I of the Title IV SO2 Trading Program. Under the recently promulgated Clean Air Interstate Rule (CAIR), the use of low sulfur coal alone will likely no longer be sufficient to achieve the desired emissions reductions. Consequently, long-term low sulfur coal contracts may prevent utilities from cost-effectively switching back to high sulfur coal and scrubbing, forcing utilities to higher cost compliance options such as purchasing allowances or scrubber installation with low sulfur coal. The model shows under policies such as CAIR low-sulfur contract constraints raise both unit-level compliance costs and increase the demand for allowances in the market, which may lead to higher allowance prices than would exist in the absence of low sulfur contract constraints.