Utilities weigh conversions to natural gas

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by Andy Patterson and Eric Chung, Ernst & Young

Given looming Environmental Protection Agency mandates, which coal-fired generating units should be shut down early? Does it make financial sense to install environmental and other retrofits on the facilities and keep them running? Should coal plants be converted to natural gas? When are supercritical coal plants no longer sustainable in competitive generation markets?

A few years ago, such questions were nearly unthinkable. Coal--cheap, abundant and homegrown--has been the U.S. power industry's go-to fuel. Nuclear, natural gas, solar and wind generally were too expensive or too impractical to compete with coal. As utilities consider adjusting their generation mix, they should understand and evaluate their options and analyze multiple scenarios.

Rising Coal Costs

Coal supplies nearly half of U.S. electric power generation needs, but factors--most notably the rise of shale gas and abundant natural gas supply--are testing coal's supremacy as the most cost-effective energy source and driving interest in coal-to-gas conversions. First, the cost of mining coal is increasing. The richest, most accessible deposits are nearing depletion, forcing mining companies to dig deeper to access thinner seams. Add in transportation, and the all-in price per ton of bituminous coal has more than doubled during the past decade. These trends are exacerbated by a growing global market for coal and periodic incursions--especially into the Appalachian coals--by European interests. The regulatory landscape suggests further increases in the cost of operating coal plants. New federal regulations designed to limit power plant emissions will continue to require expensive upgrades to keep the oldest, least-efficient subcritical coal plants running. Meanwhile, a primary objective of many state and regional regulatory activities remains to reflect the price of carbon emissions in the cost of coal-fired generation. Most important, new shale gas drilling techniques have unlocked vast reserves in shale rock formations. The price of cleaner-burning natural gas is consistently competitive with coal and often cheaper as a generation fuel source.

Some 175 coal-fired units are expected to retire by 2016, pulling 27 GW of capacity offline, according to the U.S. Energy Information Administration. That compares to 6.5 GW retired during the previous five years. Only 10 of the plants to close are being considered for natural gas conversions. But interest in coal-to-gas conversions is rising. Regulated utilities are obligated to provide cost-effective, reliable electricity while limiting environmental impact. Because converting a coal-fired plant to burn natural gas costs far less than building a new gas-fired plant, coal-to-gas conversions can be the smartest solution. For some utilities, building a new gas plant is the right path. For others, the opportunity to leverage extant water rights, transmission access, staff and other resources makes the conversion highly compelling from a cost standpoint.

Factors to Consider

As utilities consider adding more natural gas to their generation mix, they must:

  • Understand the options. Factors include technical viability of conversion, market uncertainty, changes in regulations, ready availability of natural gas pipeline capacity and the ability to convert existing equipment.
  • Evaluate each option. This ideally would include the development of a driver-based decision model to calculate a plant's gross margin from which it can calculate the net present value of free cash flow and estimate the generation asset value under each option. Utilities also should analyze these critical assets at a portfolio level with the objective of optimizing capital spend across the fleet and not simply asset by asset.
  • Introduce innovative partnering concepts. Component manufacturers, joint development partners, local communities interested in jobs and tax incentives, natural gas pipeline owners and other parties have a vested interest in a natural gas build out. Innovative partnering concepts are a key option for making average projects look extremely lucrative.
  • Conduct scenario-based planning. Sensitivity testing, plus Monte Carlo simulation, scenario analysis or both might help utilities understand how factors such as market or regulatory forces might affect each option. Utilities would be able to leverage a risk-informed perspective in comparing the value associated with coal-to-gas conversion with that associated with early retirement or retrofit for emission controls. This effort would need to pay close attention to natural gas and coal forward price curves.

There is no better time to consider converting aging coal-fired plants to gas. Utilities that seek to maximize value for ratepayers, shareholders and their organizations should adopt a robust, well-structured, risk-informed decision-making process to determine whether coal-to-gas conversion is a viable alternative.

Authors

Andy Patterson is a principal in the power and utilities advisory practice of Ernst & Young.

Eric Chung is a senior manager in the power and utilities advisory practice of Ernst & Young.

The views expressed by the authors do not necessarily reflect the views of Ernst & Young LLP, a client-serving member firm of Ernst & Young Global Limited operating in the U.S.

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