I"~UTT ERWO RTH I"~EIN E M A N N 0301-4215(95)00068-2 EnerI<vPolio,. Vol 23. No. 10, pp. ~85 892 1995 Copyright L. 1995 Elsevier Science l.td Printed in Great Britain. All rights reserved 0301-4215/95 $ I 0 00 + 0 00 Becoming proactive about environmental risks Regulatory reform and risk management in the US electricity sector Clinton J Andrews Woodrow Wilson School o/Public and International AlfiTirs, Princeton University. Princeton. NJ 08544, USA Shivani Govil Environ Corporation, 1980 Post Oak Boulevard, Suite 2120. Houston. TX 77077, USA Future environmental requirements are an important component of investment risk for long- lived facilities such as electric power plants. Yet the industry's current regulatory compact dis- courages proactive environmental investments, and thus encourages suboptimal long-term compliance strategies. This paper develops an indicative estimate of the resulting inefficiency by analysing a typical US power system, it argues that market-oriented regulatory reform can en- courage environmental risk management by utilities. Keyw,rds: Regulation; Electricity; Environment Environmental regulations evolve over time because sci- entists develop new information, environmental prob- lems become severe, and society's preferences change. For example, the US Clean Air Act Amendments of 1970 set limits on SO 2 emissions rates for new power plants, while the 1990 Amendments set a tight national cap for SO 2 emissions from both old and new plants. Acceptable ambient levels of pollutants have also changed over time, so that now utilities in many jurisdictions have to reduce NO x emissions. To reduce the potential for global climate change, utility reductions in CO 2 emissions are now being encouraged on a voluntary basis; they may one day become mandatory. Compliance targets have never been static, nor will they be so in the future. The cost of complying with environmental regulations is a significant part of total economic activity, represent- ing 2% of GNP in the US in 1990 (EPA, 1991). in the electric power sector, current regulations can add 10% or more to the cost of constructing a power plant, and also increase operating costs (based on Keeth et al, 1990). Sub- optimal compliance represents a threat with measurable consequences for individual firms and the economy as a whole. Yet in the electric power sector the deck seems stacked against efficient compliance: environmental standards are moving targets, utility regulators apply backward-looking prudency tests, and utilities adopt a reactive environmental posture. Utilities are responsible for a major portion of the air emissions of sulphur dioxide, nitrogen oxides, particu- lates and carbon dioxide (CECARF, 1993). We suggest that the current utility practice of targeting only regu- lated emissions can lead to suboptimization of invest- ment strategies relative to future regulations. This is because the least-cost compliance strategies for current regulations may contribute nothing in terms of reducing other emissions. This paper argues that since environmental compli- ance costs are large, and compliance targets are inher- Energ3, Polio~ 1995 Volume23 Number 10 885