Risk Management and Optimal Contract Structures for the CCS-EOR* Value Chain Anna Agarwal, John E. Parsons Center for Energy and Environmental Policy Research Massachusetts Institute of Technology October 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 CO 2 (at large stationary CO 2 source such as coal-fired power plant) Transporting CO 2 (by pipeline) Storing CO 2 (in geological formations – in oil fields for enhanced oil recovery (EOR)) Source: Bellona Foundation Source: 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. 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 Coal-fired Power Plant 500MW IGCC with 90% CO 2 Capture Pipeline (dedicated) 50 mile Oil Field 190 million bbl of recoverable oil

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-Making example of re-optimizing CO 2 capture rate contingent on oil price Re-optimizing CO 2 capture rate leads to financial gains of $130 million at $30/bbl, and $247 million at $20/bbl. 6 90% at $70/bbl 70% at $50/bbl 60% at $30/bbl No 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 CO 2 contracts Ex ante range of profitable contract prices (per ton CO 2 ): $62 - $ 76 Indexed price CO 2 contracts – indexed to oil price Ex ante range of profitable contract prices (per ton CO 2 ) : 82% - 101% of oil price

Fixed Price ContractsIndexed Price Contracts Risk-Sharing and Incentives - Evaluating Financial Gain by Optimizing CO 2 Capture Rate Fixed price contracts result in conflict of interests, as the power plant company has no incentive to adjust the CO 2 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 Fixed Price Contracts 90% CO 2 Capture Indexed Price Contracts Optimal CO 2 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.

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 Work Extend analysis to technical risks such as uncertainty in CO 2 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 Costmills/kWh 9 Price of Coal$/MMBtu 2 Penalty for CO 2 Emissions$/ton 5 Wholesale Electricity Pricecents/kWh 10 Oil Field Capital Investment$/bbl 5 O&M Cost$/bbl 10 CO 2 Recycle Cost$/ton 30 Price of Oil Recovered$/bbl 75 Royalty Payment (% of oil production value) 12.5% Pipeline Capital Investment$million/mile 1.7 O&M Costs$/ton Project Timeline

14 68% conf. int.95% conf. int.99% conf. int. VolatilityBase caseHighLowHighLowHighLow Oil Price ($/bbl)21% Wholesale Price of Electricity ( ¢ /kWh) 10% Coal Price ($/MMBtu)9% CO 2 Emission Penalty ($/ton CO 2 )47% Ex-post Risk Factor Values

Sensitivity of ex-ante negotiable contract prices Depending on the overnight cost – minimum negotiable price can vary from $11-$73 per ton CO 2. 15

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18 Contractual Profit-Sharing Negotiable Contract Terms $62-$76 per ton CO 2 delivered (for indexed price contracts: 82%-101% of oil price)