News Release

Analysis: Risk aversion plays an important role in the coal-contracting behavior of US power plants

Peer-Reviewed Publication

Carnegie Mellon University

From 1983 to 1997, U.S. power plants purchased most of their coal from long-term contracts, consistently paying prices above prevailing spot market prices. Previous research has suggested that this contract price premium reflects relationship-specific investments between electric utilities and coal suppliers. But a new analysis suggests that risk aversion also plays an important role in why power plants purchase coal primarily from long-term contracts. The analysis proposes that plant-level risk aversion arises because regulators are less likely to incorporate high input cost realizations into the output price they set for utilities; price-regulated utilities respond to this practice by taking costly actions to reduce the variance of their input costs.

The analysis, by a researcher at Carnegie Mellon University (CMU), appears in the Journal of the Association of Environmental and Resource Economists.

“Plant-level risk aversion has important implications for environmental policy design,” explains Akshaya Jha, assistant professor of economics and public policy at CMU’s Heinz College, who did the analysis.

Jha estimated the degree of risk aversion exhibited by U.S. power plants using transaction-level data on the coal purchases made by nearly every power plant in the United States from 1983 to 1997. According to his analysis, a 10% increase in spot price uncertainty is associated with a 0.9% increase in contract coal prices. This estimated effect implies that plants are willing to trade off a $1.62 increase in their expected total costs for a $1 decrease in their standard deviation of total costs.

“This is far larger than the risk premiums traditionally paid in commodities markets, suggesting that price-regulated electric utilities have an especially low tolerance for risk,” explains Jha. To put his estimate in perspective, he adds: “If every power plant purchased all their coal from the spot market, the annual aggregate cost savings would be $2.9 billion on average.”

More than 40 governments have implemented some form of carbon pricing to reduce climate risk, with some, such as the United Kingdom and British Columbia, choosing to implement a carbon tax while others, such as the European Union and California, choosing cap-and-trade. Using his estimates of plant-level risk aversion, Jha finds that a carbon tax can reduce carbon emissions more cost effectively than cap and trade because of the uncertainty in permit prices inherent to cap-and-trade markets.

“The results of my analysis highlight that risk aversion should play an important role in policy decisions regarding which of these two instruments are implemented,” Jha concludes.

The analysis was supported by the John M. Olin Program in Law and Economics at Stanford University.

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