Should a coal-fired power plant be replaced or retrofitted?

In a cap-and-trade system, a power plant operator can choose to operate while paying for the necessary emissions allowances, retrofit emissions controls to the plant, or replace the unit with a new plant. Allowance prices are uncertain, as are the timing and stringency of requirements for control of mercury and carbon emissions. We model the evolution of allowance prices for SO2, NOx, Hg, and CO2 using geometric Brownian motion with drift, volatility, and jumps, and use an options-based analysis to find the value of the alternatives. In the absence of a carbon price, only if the owners have a planning horizon longer than 30 years would they replace a conventional coal-fired plant with a high-performance unit such as a supercritical plant; otherwise, they would install SO2 and NOx, controls on the existing unit. An expectation that the CO2 price will reach $50/t in 2020 makes the installation of an IGCC with carbon capture and sequestration attractive today, even for planning horizons as short as 20 years. A carbon price below $40/t is unlikely to produce investments in carbon capture for electric power.