SLOAN SCHOOL OF BUSINESS

MASSACHUSETTS INSTITUTE OF TECHNOLOGY

MEMORANDUM

TO: The Southern Company Board of Directors
FROM: Group 8: Mrinmay Kulkarni, Matthew Ten Pas, Xin Liu, Ruqing Zhou
DATE: August 19, 2014
SUBJECT: Impact of Acid Rain Provisions of 1990 Clean Air Act

Introduction
The effects of the 1990 Clean Air Act threaten the future profitability of the Southern
Company. This memo will analyze the available options for a single plant (the Bowen Plant)
and provide a recommendation to management that will preserve shareholder value. This
recommendation could be extrapolated to similar coal-fired plants that The Southern
Company operates.
Comparison of Options
There are three main options available to respond to the acid rain provisions of the
clean air act. The first is to continue operating the plant normally. As of 1995, the plant will
need to start buying pollution credits. The cost of these credits will continue to grow at a
steady rate and as of 2000 the number of credits The Southern Company needs to buy will
significantly increase. By 2010, the company will need to buy $151 million (in nominal
terms) in pollution credits annually. This strategy has a net present value of $5,107 million.
The second option is to implement the scrubbing technology as soon as possible.
Compared to the first option, option two will decrease sales and increase operating costs
(that do not include fuel or pollution) starting in 1995. The company will also receive positive
cash flows from selling pollution credits from 1995 through 2016. The Southern Company
will incur significant costs in implementing the scrubbers in 1992, 1993, and 1994 and these
costs will provide some benefit as a tax shield through depreciation the next twenty years.
This option has a net present value of $4,922 million.
The third option is to switch to low-sulfur coal starting in 1996. Compared to the first
option, this will increase fuel costs (due to the projected increase in demand for low-sulfur
coal) and create gains from selling tax credits in 96, 97, 98, and 99, and reduce the losses
from buying tax credits in 2000 and in future years. It will also require an initial outlay in
1995 which can then be depreciated and used as a tax shield in the next twenty years. This
option has a net present value of $5,195.
Assuming that there is not a significant consequence in future sales due to any
publicity received from choosing one of these options, it would save The Souther Company
the most money to choose the option with the highest net present value, which is option 3.
Delaying Implementation of Scrubbers
Delaying the implementation of the scrubbers by five years increasing the NPV of
option two by $160 million to $5081 million. (In this calculation, we assume that the
difference between book value and salvage value of the scrubbers in 2016 has a positive tax
benefit.) The difference in net present value between option 1 and option 2 is $185 million.
This means that choosing to implement the scrubbers is essentially a project with an
individual NPV of -$185 million. By delaying the project five years we are essentially
discounting the net cost of the project by five years, reducing the number of years that
operating costs are increased, and reducing the number of years over which the scrubbers net
tax benefits are fully realized. This reduces the net cost of the second option from $185
million to $25 million.
Sensitivity Analysis
Future Price of Scrubbers
The second option is relatively insensitive changes in the salvage value of the
scrubbers. To determine this, we assumed there will be a salvage value of 10% of the
scrubbers in 2016 and continued to use the same method of depreciation from 1995 to 2015.
The new NPV decreases 0.22% from $4,922 million to $4,911million. Therefore, we believe
the NPV is not strong sensitive to the future price of scrubbers.
Future Prices of Allowances/Growth
To test the sensitivity of the options NPV to changes in the value of pollution
credits, we discussed two situations in scenario, which are growth rates of 5% and 15%. For
option one, when we assume a 15% discount rate, the NPV decreases 5.2% from $5,106.67
million to $4,841.37 million, while NPV increase 1.9% from $5106.67 million to $5,205.70
million with 5% growth rate. For option two, when we assume a 15% growth rate, the NPV
increases 3.8% from $4,921.517 million to $5,109.357 million, while NPV decreases 2.6%
from $4,921.517 million to $4,844.789 million with a 5% growth rate. For option three, when
we assume 15% discount rate, the NPV decreases 2.5% from $5,194.98 million to $5,116.50
million, while NPV increases 0.5% from $5,194.98 million to $5,221.56 million with a 5%
growth rate. Therefore, option three is the least sensitive to changes in the growth rate of the
value of pollution credits and option three and option 2A relatively sensitive.
Conclusion & Recommendation
It is in the best interest of The Southern Companys shareholder to implement option
three at the Bowen Plant and continue normal operations until changing to low-sulfur fuel in
1996. This option has the highest net present value and maximizes shareholder wealth, while
also significantly reducing the environmental impact of the company. Additionally, this
option is less sensitive to some inputs, such as the salvage value of scrubbers and the future
value of pollution credits than the other options. The board should strongly consider
switching to low-sulfur coal for coal-fired power plants that have similar cost-structures to
the Bowen Plant near the year 1995.