### November 2012



# I ntal co BA RT SO 2 

# A ffordability

Assessment

Final Report

Prepared for

Debbie Kline U.S. Environmental Protection Agency Office of Air Waste and Toxics

A WT

- 107 1200 Sixth Ave., Suite 900 Seattle, W A 98101

Prepared by

RTI International 3040 Cornwallis Road Research Triangle Park, NC 27709

RTI Project Number 0212979.001.022_________________________________ RTI International is a trade name of Research Triangle Institute

. RTI Project Number 0212979.001.022



# Intalco BART SO 2 

# Affordability

Assessment

Final Report

November 2012

Prepared for

Debbie Kline U.S. Environmental Protection Agency Office of Air Waste and Toxics

A WT

- 107 1200 Sixth Ave., Suite 900 Seattle, W A 98101

Prepared by

RTI International 3040 Cornwallis Road Research Triangle Park, NC 27709iii CONTENTS

Section Page

1 Introduction

................................ ................................ ................................ ................... 1

- 1

2 Intalco Fac ility Economic Characteristics

................................ ................................ .... 2

- 1

3 Economic Methodology

................................ ................................ ................................ 3

- 1

4 Sales Tests

................................ ................................ ................................ ..................... 4

- 1

5 External Factors Influencing Benefits of Operating Intalco

................................ ......... 5

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6 External Factors Influenc ing Costs of Operating Intalco

................................ ............. 6

- 1

6 .1 Electricity Availa bility

................................ ................................ ......................... 6

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6 .2 Electricity Price Forecasts

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6 .3 Can Intalco Pass on Additional Costs to Consumers in the Form of Higher Prices?

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6 .4 Ability to Finance

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7 Conclusions

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- 1

8 References

................................ ................................ ................................ ..................... 8

- 1iv LIST OF TABLES

Number Page

4

- 1. Cost/Sales Ratios under Different Price and Utiliz ation Scenarios

................................ . 4

- 1

6

- 1. Alcoa Credit Rating by Agency

................................ ................................ ....................... 6

- 41

- 1 SECTION 1 INTRODUCTION

Alcoa ’ s Intalco primary aluminum smelter, located in Ferndale, Washington, is subject to controls of sulfur dioxide (SO 2 ) emissions under the Clean Air Act ’s Best Available Retrofit Technology (BART) provisions

. The U.S. Environmental Protection Agency ( EPA ) has identified limestone slurry forced oxidation (LFSO) as a control technology for SO 2 for this facility. In this report, we assess Alcoa ’ s claim that the cost of this t echnology is not affordable and that the Intalco facility would be subject to closure if th is control technology is required. To date, the evidence we have collected and present in this report is consistent with this claim. Note that this report only cons iders the LFSO control technology. The affordability of other control options could be evaluated depending on availability of annualized cost estimates.
We evaluate the affordability of the LFSO technology using sales tests, by computing the ratio of annua lized costs of the technology to sales revenue generated by the facility. The higher the cost/sales ratio, the larger the portion of total revenue represented by control costs. More details of this calculation are found in Section 3. Sales tests suggest th at the cost/sales ratio range is between 6% and 20% for the Intalco plant with installation and operation of LSFO , depending on market conditions and facility utilization. Although ratios are lower when all three potlines are operating, the ratios remain h igh. Current market conditions and uncertainty surrounding the availability of affordable electricity suggests only one to two potlines will operate in the next few
years. Alcoa is unlikely to be able to pass the control costs through to consumers

. We bas e this conclusion on historical evidence that the firm has not been able to pass through similar cost increases (e.g. higher electricity costs ) . Alcoa’s current BBB

- credit rating would make it difficult to finance the project , and the installation cost re presents 8% of Alcoa’s current cash on hand. Without increases in the price of aluminum or a favorable electricity contract, the short run
year

- to

- year utilization rates of the Intalco plant will remain uncertain over the next few years and this will place pressure on the company to make more permanent capacity reduction decisions.2

- 1 SECTION 2 INTALCO FACILITY ECO NOMIC CHARACTERISTIC S
This facility contains three potlines, two of which are currently active. Each potline has a capacity of 95,000 tonnes/year of aluminum, for a total capacity of 285,000 tonnes/year. The Intalco aluminum smelter uses electricity, labor, and other inputs to refine alumina, a raw input, into a final aluminum product. The cost of t he electricity, labor, and other inputs needed to convert the alumina raw material into the final aluminum product is known as the conversion margin. In 2012, CRU Strategies Ltd. 2006 projects this margin to be $1
, 455/tonne. Aluminum production is electric ity intensive, and electricity prices and availability will influence the profitability of individu al pot lines. Currently, Intalco purchases most of its power from Bonneville Power Administration (BPA), an operator of several hydroelectric facilities in th e Pacific Northwest. Alcoa and BPA are currently negotiating a long

- term contract that will allow Intalco to operate two potlines profitably over the next 5 years (Alcoa, 2011 ).

Alcoa is the world ’ s leading producer in primary and fabri cated aluminum (Alcoa, 2011 ). Currently , Intalco represents 6% of Alcoa ’ s global production and 18% in the United States. Should the plant operate at full capacity, Intalco ’ s share of total Alcoa production would increase by roughly 1% . If Intalco were to shut down production entirely, Alcoa would lose a significant portion of its aluminum production capacity within the United States

. Alcoa generates 55% of its revenue in the Americas, 28% in Europe, 14% from Australia, and the remainin g revenue from the Middle East.3

- 1 SECTION 3 ECONOMIC METHODOLOGY
The primary measure we use to assess affordability is the sales test

— the ratio of the stream of compliance costs to the stream of revenues over the control technol ogy ’ s lifetime (30 years). A comparison of costs to profits would be the best measure of affordability ; however, facility profits are not often available. Sales data are more commonly used as a more readily available proxy for data on firm profits in estim ating the economic burden of regulation (EPA, 2006)

. The annualized cost per sales for a company or plant represents the price increase for the affected product needed for the company /plant to completely recover the annualized costs of the regulation

. EPA has identified LFSO as a control option for SO 2 emissions from this plant , and the estimated costs of this technology are $151 million for installation and annual costs of $15 million. CRU estimates a conversion margin of $1
, 455/tonne in 2012 (CRU, 2006 ), resulting in revenues of approximately $276 million. We compare d the present value of the costs and revenues using a 30

- year time horizon under different aluminum price projections for aluminum and use d a 7% discount rate for the present value calculation.
The sales ratios are computed as follows: ∑ ( ) ∑ ( )

where T is the technology lifetime, r is the interest rate, CC t are capital costs in period t , OC t are operating costs in period t , Q is the quantity of output (in tonnes), and margin is the conversion margin in $/tonne.
We also supplement ed the quant it at ive analysis of affordability with a qualitative discussion of other issues that independently affect the net benefits of operating the Intalco plant. Overall market conditions for aluminum producers, electricity prices and availability, and Alcoa ’ s financing options for the Intalco project will interact and play an important role in closure decisions

.3

- 24

- 1 SECTION 4 SALES TESTS

T o assess affordability, we have computed sales tests under several scenarios. These sales tests are the ratio of the pr esent value of compliance costs to the present value of expected facility revenues and serve as a proxy estimate of the impact of profitability from applying the LFSO control technology . As discussed in Section 2, we consider a 30

- year time horizon for thi s analysis and a 7% discount rate that is consistent with the annualized cost estimate for the control technology

. To account for uncertainty, the scenarios consider different combinations of plant utilization as well as different aluminum price forecasts. The results of these tests are provided in Table 4

- 1.

Table 4

- 1. Cost/Sales Ratios under Different Price and Utilization Scenarios

Aluminum Price Forecast

LME CRU

Active Potl ines 1 17% 20%
2 8% 10%
3 6% 7%

We use d multiple aluminum price forecasts to scale the margin up or down to reflect possible market conditions. The table reports results for forecasts taken from CRU 2006 and a forecast constructed from current London Metals Exchange (LME) futures contracts. We have also examined a World Bank commodity forecast, but the prices were similar enough to the LME forecast that the sales test results do not differ significantly.

We find cost/sales ratios of 6

- 20%, depending on the assumptions about utilization and alumi num prices used. These ratios are smallest when all three potlines are active. At current utilization, cost/sales ratios are 8

- 10%, depending on the price forecast used. The cost/sales ratio will change linearly with the costs assuming the sales estimate r emains constant. For example, a reduction in the annualized compliance costs (including capital and operating costs) by half will yield a cost/sales ratio that is lower by half. In this analysis, we only consider full scrubbing, but the reduction in the c ost/sales ratio when considering partial scrubbing would depend on the relative reductions in capital and operating cost of that technology.5

- 1 SECTION 5 EXTERNAL FACTORS INF LUENCING THE BENEFITS OF OPERATIN G INTALCO

Worldwide demand for aluminum has been projected to increase from 44 million tonnes/year in 2011 (USGS, 2012) to 65 million tonnes/year by 2020 (CRU, 2006 ), resulting in investments in and development of new capacity as well as increasing the viability of re

- opening and/or maintaining higher cost existing production lines. The increase in demand is largely driven by urban investment in China. Plants with higher than average operating costs ( like Intalco ) may be better positioned to compete with a combination of higher electricity costs in other countries and demand increase s , which will likely result in higher utilization of existing plants as well as investments in new smelting capacity , and possibly high er aluminum prices

. However, the recent slowdown in the global economy has tempered demand projections. Additionally, Chinese producers have continued to add to inventories, causing prices to remain lower and Alcoa to reduce production at several marginal facilities (Elmquist, 2012 ). Despite these trends, Alcoa still projects demand to double by 2020 in their latest annual report (Alcoa, 2011 ). All other things equal, an increase in demand would increase product pr ices and the benefits of operating Intalco

.6

- 1 SECTION 6 EXTERNAL FACTORS INF LUENCING COSTS OF OP ERATING INTALCO

6 .1 Electricity Availability The ability of Intalco to operate multiple potlines profitably also depends on its abi lity to negotiate an electric power contract with BPA. Alcoa provides employment to the local area; however, their electricity demand competes with demand from consumer utilities. Alcoa operates a second plant in the area, in Wenatchee, that is older and h igher cost. CRU 2006 suggests that if BPA cannot reliably supply enough power for continuous operation of two potlines at Intalco, operations may be expanded at Wenatchee rather than allowing only one line to operate at Intalco (CRU, 2006 ).

Intalco ’ s ability to run at full capacity depends on the availability of affordable electricity. Aluminum refining is an electricity

- intensive process , with electricity typically representing around one

- third of total production costs . Intalco uses 15.2 MWh of electricity per tonne of aluminum produced, about average energy efficiency for an aluminum smelting plant. The plant’s cost structure is determined by its energy use and the electricity price it faces. Electricity prices can determine th e profitability of a production line, and it is expensive to bring lines in and out of production when prices change. Futures contracts are available for aluminum output on a 3

- to 5

- year basis, so ensuring similar length electricity contracts can help red uce uncertainty about future returns and profitability. If these contracts are available for electricity at fixed rates in sufficient quantities , all three of Intalco ’ s pot lines can be run more efficiently than a single potline.
Intalco requires 483 MW of continuous power to operate at its full 285,000 tpy capacity. Each of the three pot lines requires about 161 MW of electricity to produce 95,000 tpy. As of today, only two potlines are currently operating. According to the CRU rep ort, average production costs per tonne would fall from $666 to $552 if all three lines were open. This amount of electricity may not be available, however, from BPA. The availability of affordable electricity can determine whether Intalco is able to run t hree lines profitably or only one line at higher cost per tonne.
The price of electricity plays an important role in determining whether a potline remains idle

. For instance, i n 2004 to 2005, market prices averaged $50/ MWh (5 cents/ kWh ). At this price, th e Intalco facility would not be profitable at current utilization . For the facility to profitably run two potlines, electricity would need to be available at $41/MWh (4.1 cents/kWh) in sufficient quantities (CRU , 2006). Discussed below are forecasts for po wer costs.6

- 2

6 .2 Electricity Price Forecasts The Energy Information Agency ’ s (EIA) Annual Energy Outlook (AEO) for 2012 forecasts electricity prices in the Pacific region for i ndustrial users to range between $20/ MMBtu (6.8 cents/ kWh ) and $22/ MMBtu (7.5 cen ts/ kWh ) between 2009 and 2035. Prices in the Northwest Power Pool will range from 5.3 to 7.4 cents per kWh for end users. Conventional hydropower capacity and generation in the region are expected to remain nearly constant. As discussed above, at 5 cents /k Wh , Intalco would be only marginally profitable when taking advantage of economies of scale and running all three lines, assuming that enough electricity is available at this price. Intalco ’ s profitability will , therefore , be greatly affected by Alcoa ’ s ability to negotiate long

- term contracts at affordable prices with existing local hydropower facilities.
According to Alcoa ’ s 2011 Annual Report, it has signed a contract with BPA ― providing for the sale of physical power at the Northwest Power Act mand ated industrial firm power (IP)
rate. ‖ This agreement was set to expire in May 2012 but has been extended through September as negotiations to potentially extend the agreement for 5 years continue. The 2012 rates published by BPA range from 2.5 cents / kWh t o 4.5 cents/ kWh depending on month and time of day (BPA, 2012 ). These rate s are more favorable for Intalco than the market rates projected for the region , which is an intended outcome of the IP rate program

. 6 .3 Can Intalco Pass on Additi onal Costs to Consumers in the Form of Higher Prices? Aluminum is a standard commodity traded on global markets, such as the London Metal Exchange (LME). This leaves little ability for producers to pass higher costs along to consumers of the final product. Futures contracts are available for up to 5 years, allowing producers to mitigate risk. The main inputs to aluminum refining are the raw input, alumina, and electricity. Alumina is also a widely traded, nondifferentiated commodity (CRU, 2006) . Aluminum
pr oducers can negotiate long

- term contracts with alumina suppliers but have little control over price. Electricity costs will then largely determine the relative profitability of aluminum producers.
In general, firms will be able to pass on costs when the d emand for their product is inelastic with respect to price compared to the price elasticity of supply. Without observing elasticities in the aluminum market, we note that the Intalco plant is not operating at full capacity at this time. If Alcoa could pass costs to consumers, their utilization rate for this plant would be higher. For instance, Alcoa runs only two potlines at Intalco with the electricity they have negotiated with BPA, rather than purchase additional electricity at higher market rates in orde r to6

- 3

operate at full capacity. This suggests that Alcoa cannot pass the higher electricity costs through to consumers in the form of higher prices.

6

. 4 Ability to Finance As of 2011, the credit ratings provided by agencies Standard & Poor, Moody ’ s, and F itch reported Alcoa ’ s financial outlook to be stable. Although the outlook is an improvement over previous years, Alcoa ’ s ratings have remained the same since 2009. All three agencies rate Alcoa ’ s long

- term debt at BBB

- (equivalent to Baa3 on Moody ’ s scale ) (Alcoa, 2007

– 2011 ). Standard & Poor defines the BBB

- rating as ― considered the lowest investment grade by market participants. ‖ (Standard & Poor ’ s , 2012 ) . Alcoa ’ s short

- term debt ratings for S&P, Moody ’ s, and Fitch were A

- 3, P

- 3, and F3, respectively, which is equivalent to the long

- term BBB/BBB

- (Alcoa, 2007

– 2011 ).

Alcoa ’ s overall financial outlook was greatly affected by the global recession in 2008. Alum inum and alumina account for 75% of Alcoa ’ s revenue, and demand for Alcoa ’ s primary commodities dropped as LME

- based aluminum prices plummeted 56% (Alcoa, 10

- K Report, 2009 ). Table 6

- 1 represents the 5

- year change in Alcoa ’ s credit ratings and financial outlook. This outlook may improve in the future if aluminum demand and prices increase as projected. However, to our knowledge, no credit rating forecasts are available to the public.
Alternatively, Alcoa may consider financi ng the investment in control technology out of cash on hand or equity. According to the 2011 Annual Report, Alcoa had $1.9 billion in cash assets, up from $1.5 billion in 2010. The $151 million installation cost would represent a economically significant i nvestment (7.8% of total cash on hand). To do this, the decision makers within Alcoa would compare the expected benefits of using the cash on hand to purchase pollution controls with the value of using that cash for their next best alternative (i.e. closi ng the plant and using the cash for other production investments that provide value to the firm).6

- 4

Table 6

- 1

. Alcoa Credit Rating by Agency

Year S&P Moody ’ s Fitch

Long Term 2011 BBB

- Baa3 BBB

2010 BBB

- Baa3 BBB

2009 BBB

- Baa3 BBB

2008 BBB+ Baa1 BBB
2007 BBB+ Baa1 A

Short Term 2011 A

- 3 P

- 3 F3
2010 A

- 3 P

- 3 F3
2009 A

- 3 P

- 3 F3
2008 A

- 2 P

- 2 F2
2007 A

- 2 P

- 2 F2

Outlook 2011 Stable Stable Stable
2010 Negative Negative Negative
2009 Negative Stable Negative
2008 Negative Stable Negative
2007 Stable Stable Negative7

- 1 SECTION 7 CONCLUSIONS
Even in the absence of regulation, the Intalco plant is currently operating at less than full capacity; operating the third potline is not economical given existing market prices for aluminum and electricity , limited availability of IP rate electricity , and potline production costs. BPA is only likely to provide enough power at IP rates to operate two potlines. Alcoa would then
compar e the benefits of operating the third, highest cost (CRU, 2006) potline with the costs of operating it at higher market electricity prices. This third line is not profitable at currently projected market electricity and aluminum prices

. If Alcoa cannot neg otiate for additional quantities of electricity from BPA a t compet it ive prices, it will continue to operate at less than full capacity.

If Intalco were to install the LS F O control technology, the cost of installing and operating the equipment will repres ent approximately 8

- 10% of the facility’s sales revenue over the 30 year lifetime of the equipment at current utilization. The cost/sales ratios may be higher or lower depending on plant utilization and future aluminum prices , but are high in even the most optimistic cases

. Alcoa is unlikely to be able to pass these costs along to consumers, as shown by its historical inability to pass through higher electricity prices and operate its third potline. Alcoa’s BBB

- credit rating may limit its ability to borro w resources to purchase pollution control equipment

. Although cash reserves are available, the control technology expenditure would use 8% of Alcoa’s cash reserves; Alcoa may decide those cash reserves could be better used in other ways that provide valu e to the firm.
While we cannot definitively determine what business decisions Alcoa will make, should installation and operation of LSFO be required by EPA, it is our belief based on sound business practices that Alcoa would seriously consider other opti ons rather than continue aluminum production at Intalco with LSFO (full or partial) installed and operated.8

- 1 SECTION 8 REFERENCES Alcoa, 2009. ―Turning Crisis Into Opportunity: 2009 Annual Report and Form 10

- K.‖

Alcoa

. 2010. ―Seizing Opportunity, Accelerating Value: 2010 Annual Report and Form 10

- K.‖

Alcoa. 2011 . ―Alcoa Won ’ t Wait: Taking Decisive Action in a Turbulent World: 2011 Annual Report.‖

Bonneville Power Administration. 2012. ― 2012 Power Rates Schedules and General Rate Schedule Provisions (FY 2012

- 2013). ‖ Available at http://www.bpa.gov/corporate/ratecase/2012/docs/FinalPowerRateSchedulesGRSPs_Upl oad_01

- 17

- 2 012.pdf

. Accessed September 18, 20 12. CRU Strategies Ltd. 2006. ―Northwest Smelter Operating Outlook: A Report Pr epared for Alcoa.‖ Available at http://www.bpa.gov/power /pl/regionaldialogue/alcoa_smelter_outlook.pdf

. A ccessed September 18, 20 12. Elmquist, S. 2012. ― Alcoa Sees Aluminum Cuts as Production Gains: Commodities

. ‖ Available at http://www.bloomberg.com/news/2012

- 04

- 09/alcoa

- sees

- aluminum

- cuts

- as

production

- gains

- commodities.html. Accessed September 18, 2012

. Standard & Poor ’ s . 2012. ― Credit Ratings Definitions & FAQs

. ‖ Available at http://www.standardandpoors.com/ratings/definitions

- and

- faqs/en/us

. Accessed September 20 , 2012. U.S. Environmental Protection Agency. 2006. EPA’s Action Development Process. Available at http://www.epa.gov/rfa/documents/Guidance

- RegFlexAct.pdf , Accessed October 16, 2012.