Risk Management and Optimal Contract Structures for the CCS-EOR* Value Chain Anna Agarwal, John E. Parsons Center for Energy and Environmental Policy Research.

Risk Management and Optimal Contract Structures

for the CCS-EOR* Value Chain

Anna Agarwal, John E. ParsonsCenter for Energy and Environmental Policy Research

Massachusetts Institute of TechnologyOctober 10, 2011

*CCS-EOR stands for Carbon Capture and Storage-Enhanced Oil Recovery

CCS (carbon capture and storage) value chain consists of three key components

Capturing CO2 (at large stationary CO2 source such as coal-fired power plant)

Transporting CO2

(by pipeline)Storing CO2

(in geological formations – in oil fields for enhanced oil recovery (EOR))

Source: Bellona FoundationSource: IPCC Report on CCSSource: IEAGHG Weyburn-Midale Project Update

2

CCS is pure cost, enabling financial value captured elsewhere in the value chain.

Commercial deployment would require enabling commercial structuring of the value chain.

Our Focus: Contract structures to distribute profits and allocate risks among the involved entities.

Optimal contract structures maximize the overall project value.

-$791m -$74m

$1,057m

Power Plant

PipelineOil Field

Motivation

3

4

We develop a cash-flow model for a prototype CCS-EOR project.

Project involves collaboration between two entities: power plant company and oil field company (pipeline jointly owned)

Analyze impact of market risks on the CCS-EOR project and evaluate optimal contingent decisions.

Evaluate risk-sharing offered by standard contract structures and resulting incentives for optimal decision-making.

Approach

0 1,000 2,000 3,000 4,000 5,000 6,000Ex-post NPV ($million)

Upper BoundsLower Bounds

Price of Oil

Wholesale Price of Electricity

Price of Coal

CO2 Emission Penalty (no pass-through on electricity price)

68% 95% 99%95% 68%99%

CO2 Emission Penalty (with pass-through on electricity price)

Project Risk Exposure(if market risk factors changed 3 years after start of operations)

Volatility in oil price is the dominant risk factor.

5

Optimal Contingent Decision-Makingexample of re-optimizing CO2 capture rate contingent on oil price

Re-optimizing CO2 capture rate leads to financial gains of

$130 million at $30/bbl, and $247 million at $20/bbl.

6

800

1,000

1,200

1,400

1,600

1,800

2,000

2,200

0%10%20%30%40%50%60%70%80%90%

Ex-

post

NP

V ($

mill

ion)

CO2 Capture Rate

$70

$50

$30

$20

Oil Price ($/bbl)90%

70%

60%0%

90% at $70/bbl

70% at $50/bbl

60% at $30/bblNo capture below $20/bbl

Key Questions Who bears the different risks along the value chain?

Are the ex ante negotiated contract terms still profitable ex post?

Are the profit maximizing contingent decisions for the individual entity aligned with the overall project?

7

Lets look at two standard contract structures

Fixed price CO2 contractsEx ante range of profitable contract prices (per ton CO2):

$62 - $ 76

Indexed price CO2 contracts – indexed to oil priceEx ante range of profitable contract prices (per ton CO2) :

82% - 101% of oil price

-50

0

50

100

150

200

250

62 64 66 68 70 72 74 76Fin

anci

al G

ain

($m

illio

n)

Fixed Contract Price ($/ton)

0

50

100

150

82% 85% 88% 91% 94% 97% 100%

Fin

anci

al G

ain

($m

illio

n)

Indexed Contract Price (%oil price/ton)-200

200

600

1,000

82% 85% 88% 91% 94% 97% 100%

Ex-

pos

t N

PV

($m

illi

on)

Indexed Contract Price (%oil price/ton)

Overall Project

Power Plant Co.

Oil Field Co.

NPV in the 'High Risk' Scenario under Indexed Price Contracts Fixed Price Contracts Indexed Price Contracts

Risk-Sharing and Incentives- Evaluating Financial Gain by Optimizing CO2 Capture Rate

Fixed price contracts result in conflict of interests, as the power plant company has no incentive to adjust the CO2 capture rate.

Risk-sharing offered by indexed price contracts incentivizes optimal decision-making and creates alignment of interests.

8

Risk-Sharing and Ex post Insolvencies- Evaluating Resulting Ex-post NPV

9

-800

-400

0

400

800

1,200

1,600

2,000

2,400

62 64 66 68 70 72 74 76Ex-

pos

t N

PV

($m

illi

on)

Fixed Contract Price ($/ton)-200

200

600

1,000

82% 85% 88% 91% 94% 97% 100%

Ex-

pos

t N

PV

($m

illi

on)

Indexed Contract Price (%oil price/ton)

Overall Project

Power Plant Co.

Oil Field Co.

NPV in the 'High Risk' Scenario under Indexed Price Contracts

Fixed Price Contracts90% CO2 Capture

Indexed Price Contracts Optimal CO2 Capture

High risk of ex post insolvency in fixed price contracts can lead to inefficient investment decisions.

Risk-sharing through indexed price contracts not only maximizes the project value, it also minimizes the insolvency risks.

-800

-400

0

400

800

1,200

1,600

2,000

2,400

82% 85% 88% 91% 94% 97% 100%Ex-

pos

t N

PV

($m

illi

on)

Indexed Contract Price (%oil price/ton)

Summary

10

Market risks are significant in a CCS-EOR project.

Choice of contract determines :

•Who bears the risks?

•What incentives does the risk allocation produce?

Standard contracts have weaknesses in terms of ex post insolvencies and

poor incentive structures that result in sub-optimal project value.

Future WorkExtend analysis to technical risks such as uncertainty in CO2 storage operations.

Analyze how contracts would evolve as the CCS industry matures.

Thank you

11

Extra Slides

12

Power Plant    

Overnight Cost $/kW

6,900

Fixed O&M Cost $/kW/year

50

Variable O&M Cost mills/kWh

9

Price of Coal $/MMBtu

2

Penalty for CO2 Emissions $/ton

5

Wholesale Electricity Price cents/kWh 10Oil Field    

Capital Investment $/bbl

5

O&M Cost $/bbl

10

CO2 Recycle Cost $/ton

30

Price of Oil Recovered $/bbl 75Royalty Payment (% of oil production value) 12.5%Pipeline    

Capital Investment $million/mile

1.7

O&M Costs $/ton

2.5

13

Project Timeline 2010 2011 …. 2017 2018 2019 2020 2021 …. 2044

Construction Starts Operation Starts

25 years

14

68% conf. int. 95% conf. int. 99% conf. int.

  Volatility Base case High Low High Low High Low

Oil Price ($/bbl) 21% 75 108 52 155 36 223 25

Wholesale Price of Electricity (¢/kWh) 10% 10 12 8 14 7 17 6

Coal Price ($/MMBtu) 9% 2.0 2.3 1.7 2.7 1.5 3.2 1.3

CO2 Emission Penalty ($/ton CO2) 47% 5 11 2 25 1 57 0.4

Ex-post Risk Factor Values

0

10

20

30

40

50

60

70

80

4,000 5,000 6,000 7,000 8,000

CO

2C

ontr

act P

rice

($/t

on)

Overnight Cost ($/kW)

Minimum

Maximum

Negotiable contract price

Base Case

6,900

Sensitivity of ex-ante negotiable contract prices

Depending on the overnight cost – minimum negotiable price can vary from $11-$73 per ton CO2.

15

-1200

-1000

-800

-600

-400

-200

0

200

400

2017 2020 2023 2026 2029 2032 2035 2038 2041 2044

Ann

ualiz

ed C

ash-

flow

s ($

mill

ion)

Year

Annualized Cash-flows of the Power Plant and the Oil Field

Power Plant

Pipeline

Oil Field

start of operationsstart of construction end of operations

16

500

550

600

650

0%30%60%90%

Net

Pow

er O

utpu

t (M

W)

CO2 Capture Rate

10%

15%

20%

25%

Recoverable Energy Penalty

(from 90% to 0% capture)

Net Power Output as a Function of the CO2 Capture Rate for Different Levels of Recoverable Energy Penalty

17

18

Contractual Profit-SharingNegotiable Contract Terms

$62-$76 per ton CO2 delivered(for indexed price contracts: 82%-101% of oil price)