A real option analysis on retiring existing coal-fired electricity plants in the United States

Sang Baum Kang, Pascal Letourneau and Steve Sala

Abstract

To reduce carbon dioxide emissions from the electricity generation sector, the United States introduced the Clean Power Plan (CPP) in 2015. Specifically, building block #2 aimed to replace coal-fired electricity generation with natural-gas-fired generation. In 2017, the US federal government decided not to honor the United Nations’ Paris Agreement and repealed the CPP. In this paper, we study the conditions under which a reasonable green policy by a US state encourages the early replacement of existing coal plants with new natural  gas plants, as CPP building block #2 suggested. Using a real option model, we calculate the probability  that a firm makes an investment decision to retire an existing coal plant and build a new natural gas plant within the next few years. We find that the results critically depend on the remaining useful life of the existing coal plant. When the remaining life is short, government policies do not play a significant role in this asset replacement decision. However, if the remaining useful life is approximately twenty-plus years,a state government’s green policy does play a significant  role in the plant’s replacement. Because such plants were built during the “coal plant boom” period from 1965 to 1987, our findings are particularly relevant.