A power plant that produces emissions of sulfur dioxide (SO2). Annual emissions are 1,000 tons per year in perpetuity and it currently faces an emissions tax of $20 per ton of SO2. The power plant can install a scrubber with a capital cost of $50,000. If it uses the scrubber, it incurs a one-time cost of $250,000 and the plant will not emit any SO2 for the remainder of its operational life. The plant faces a discount rate of 10%. There is no marginal cost to using the scrubber. We can thus view the scrubber as an option to control SO2 emissions in the future.
1. Should the power plant install the scrubber and commit to using it?
2. There is a 50% probability that the emissions price will increase to $35 per ton next year. Calculate the value of the option to control SO2 pollution. Should the power plant install the scrubber?