Valuing Renewable and Conventional GeneratingAssets in an

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Moreover, when added to fossil-dominated generating mixes, fixed-cost renewable technologies reduce cost at any level of risk by virtue of the

    Draft Sep 13, 2005 Valuing Renewable and Conventional Generating Assets in an

    Environment of Uncertainty and Technological Change

    Submitted to:

    Environmental Audit Committee, House of Commons

    New Enquiry: Keeping the Lights on: Nuclear,

    Renewables and Climate Change


    Shimon Awerbuch, Ph.D.

    Senior Fellow

    SPRU Energy Group ? University of Sussex

    Brighton, UK

Electricity capacity expansion questions currently focus on two principal issues:

    i) The kilowatt-hour cost of renewables such as wind, relative to the cost 1of gas turbines and, potentially, nuclear power; and

    ii) How our century-old electricity grid might be contorted into dealing

    with the so-called intermittency of wind and other renewable


In this submission I argue two principal points. First, that while electricity

    planning has long relied on the stand-alone generating costs of various technologies, this measure is no longer relevant. In its place, I suggest that

    electricity policy be based on modern portfolio theory concepts, which reflect the cost as well as the risk contribution a given generating technology makes to

    the generating mix. Financial investors routinely use portfolio optimization

    techniques to value stocks and other additions to their holdings. These

    techniques consistently show that when added to a conventional generating mix,

    wind and other fixed-cost renewables serve to lower overall generating costs.

    This outcome, which is predicted by finance theory, holds even if it is assumed

    that the stand-alone costs of wind exceed those of gas.

Second, I argue that the current debate about the system integration costs of

    wind and other variable output renewables is largely misplaced. This debate

    conceives of wind as a direct substitute for dispatchable fossil technologies,

    which it is not. As a consequence, the debate needlessly dwells on such issues

    as the cost of additional backup generating capacity. In my opinion, efficiently

    integrating wind and other new, passive, variable-output renewables will

    ultimately require changes our current electricity production-delivery paradigms

    and protocols. This is a tall order. At the very least, integration will require

    new parallel in formation networks for the electricity grid and most likely new

     1 This is not to say that other issues, such nuclear waste are not also prominent.

    ? Shimon Awerbuch, 2005 1

     Sep 13, 2005 Draft ways of charging for grid services. These must allow wind-based electricity

    products such as space and water heating, which naturally match this

    ‗intermittent‘ technology with so-called ‗dispatchable‘ load applications. The

    century-old concept of the grid as a system for transporting commodity electrons

    becomes obsolete in an environment characterized by many distributed

    generating sources and a diversity of load applications.

I. The cost of renewable and conventional technologies

Intelligent electricity policy and planning decisions cannot be made on the basis

    of traditional engineering kilowatt-hour (kWh) cost models. Such models,

    developed around the time of the Model-T Ford, have been widely discarded in

    most industries in favour of modern asset valuation concepts.

My own stand-alone kWh cost estimate, which have remained quite constant

    over the last decade, use a standard finance-oriented (CAPM) approach that

    reflects the cost of risk. Through periods of both low and high fossil prices and 2money-market rates, these estimates have consistently suggested that gas generation costs more than wind and many other renewables (e.g. Awerbuch

    June 2004, June 2003, May 2003, February 2003, November 2000, April 1995,

    1993). This is in stark contrast to estimates prepared by the DTI (2003), the

    Royal Academy of Engineering, the IEA (2005) and other national and

    international agencies, which generally find that gas costs less than wind. These

    agencies however, use calculative procedures that produce cost results with no

    economic interpretation; they should not be given any weight in policy-making.

Fossil fuel prices have risen significantly over the last two years and some

    predict oil-price spikes in excess of $100/bbl (Reuters, 2005). Finance theory

    tells us that future cost streams can be meaningfully expressed only in terms of

    their market risk. When fuel price volatility is considered, gas-based generation

    is noticeably more costly than standard engineering-based estimates indicate.

    For example, conventional estimates such as those produced by DTI and IEA

    suggest that gas-based electricity costs in the range of ?0.03–?0.05/kWh. The true, risk-adjusted cost is quite likely in excess of ?0.06–?0.07/kWh, making 3many renewables generally competitive.

II. Externality Benefits of Wind: Enhancing Cost and Energy Security

    Risk-adjusted CAPM procedures more reliably estimate the cost of gas and wind.

    But even CAPM results are only as good as the underlying gas price forecasts,

    which could dramatically change even before this inquiry is concluded.

    Meaningful kWh cost estimates require unbiased gas price forecasts. But

     2 Inflation expectations and money-market rates underlie CAPM-based discount rates.

    3 The cost advantage of wind survives when system integration charges are added, e.g.

    per Dale, et. al. (2004) or the DENA Grid Study (2005).

    ? Shimon Awerbuch, 2005 2

     Sep 13, 2005 Draft

    history provides little comfort that today‘s fossil price forecasts will be any

    more reliable than those of the past. Nonetheless, suppose we assume for the

    moment that the conventional analyses which predict that gas generation costs less are correct. Does this imply that we should abandon wind and other

    options and invest only in gas? This is the traditional ―least-cost‖ approach to

    energy investment decision-making. It makes little sense in today‘s highly

    uncertain energy environment.

    Energy planners need follow financial investors, who are used to dealing with

    risk. No one can predict the performance of a corporate share of stock over 20

    years just as no one can predict the price of gas. Financial investors deal with

    market risk by holding efficient, diversified portfolios. These offer the best

    hedge against an uncertain future. Prudent investors do not try to chase today‘s

    best performing securities; these may be the laggards of tomorrow. Rather, they

    balance their portfolios with a mixture of potentially high yielding securities

    along with low-yielding government obligations and similar ―safe‖ investments.

    Policy makers must take note of this important idea. It matters little that gas

    might appear to be the lowest cost alternative (on the basis of conventional

    costing models). Even if correct today, that picture could change dramatically,

    suggesting that electricity planning and energy policy making in general must

    abandon its fixation with identifying alternatives with the lowest stand-alone

    cost and focus instead on developing optimal generating portfolios and


    When added to a risky, fossil-dominated generating mix, wind and other fixed-

    cost renewables reduce generating cost and risk, as long as the mix can be

    altered over time [Awerbuch 2005, February 2000, 1995, Awerbuch and Berger

    2003]. This so-called portfolio effect, (e.g. see Brealey and Myers, 2003) holds

    even if wind costs more on a stand-alone basis. Wind‘s generating costs are

    uncorrelated to fossil costs which means that it diversifies the mix and reduces

    expected overall cost and risk the same way diversification improves the

    expected performance of financial portfolios.

For example, DTI‘s Year-2010 target generating mix (DTI, 2004, 2003) has an

    overall cost of 2.96 p/kWh (Table 1). It consists of 71% fossil generation and

    11% wind. By contrast, applying the same generating costs, it is possible to 4 which cost no more, but have identify a number of optimized UK portfolios

    wind shares of 31% to as much as 54% three to five times as much wind as the DTI target mix. The ‗Equal Cost‘ portfolio, (Table 1) has the same cost but

    lower risk than the DTI target mix, yet contains 31% offshore wind, in spite of 5the fact that this technology is assumed to cost 75% more than gas.

     4 An infinite number of such portfolios exist, all with different cost-risk and different

    technology shares. 5 This study focuses on wind. Nuclear output is constrained so it does not exceed 2004


    ? Shimon Awerbuch, 2005 3

     Sep 13, 2005 Draft

    Table 1:

    DTI Targets Versus Optimized Generating Portfolios

    (UK 2010)

    DTI 2000 / 2010 Technology Generating Costs (p/kWh):

    Coal: 4.0 / 3.6 - Gas: 2.0 / 1.9 - Wind: 2.7 / 2.0 - Offshore: / 3.6

    Typical Optimized Portfolios DTI 2010

    Target Portfolio ‘Equal Cost’ ‘Equal Risk’

    2.96 p/kWh 2.96 p/kWh 2.49 p/kWh Portfolio Cost

    Portfolio Risk .08 .04 .08

    Fossil Share 71% 32% 52%

    Nuclear Share 16% 12% 14%

    On-shore: 11% On-shore: 25% On-shore: 31% Wind Share

     Offshore: 0% Offshore: 31% Offshore: 0% Source: Awerbuch Airtricity (2005)

These results are not meant to suggest that 50% wind shares are feasible given

    today‘s network architecture, or even that such a target cold be attained in five years. The results are presented to illustrate that stand-alone costs, even if

    adjusted for risk, are not necessarily a meaningful metric for evaluating energy

    options. Because various technology costs move in unison, (e.g. are correlated),

    intelligent energy strategy, by necessity, requires that cost interrelationships be

    considered. Electricity capacity planning must reflect the cost and risk of the

    overall portfolio.

The UK results shown above are representative of similar, and in some ways

    even stronger results I have obtained for the US, the EU, as well as Mexico,

    Morocco, and other nations (Awerbuch, 2005, Awerbuch, Jansen and Beurskens,

    2003). The portfolio approach illustrates the idea that increasing the

    deployment of wind, even if it is assumed to cost more, does not necessarily raise overall generating cost, as long as the generating mix can be re-optimized

    over time. Wind production costs are relatively fixed. This creates important

    cost-risk benefits for generating portfolios.

Energy Security The Oil-GDP Effect

Oil price increases and volatility dampen macroeconomic growth by raising

    inflation and unemployment and by depressing the value of financial and other

    assets. This so-called Oil-GDP effect has been reported in the academic

    literature for a quarter of a century, although it received little attention from the

    media and energy policy makers prior to the recent oil price spikes. The Oil-

    ? Shimon Awerbuch, 2005 4

    Draft Sep 13, 2005

    GDP effect is sizeable. In a recent paper Raphael Sauter and I (2005) estimate

    that a 10 percentage-point increase in the global share of wind (or other

    renewables) can help avoid GDP losses of $95$176 billion (Table 2).

    Table 2:

    Avoided GDP Losses for 10-Percentage-point Increase

    in the Wind Generation Share (USD $Billions)

     US EU-15 OECD World

    2003 GDP $10,882 $10,970 $18,659 $36,356

     Avoided GDP Losses

    High Estimate $53 $53 $90 $176

    Low Estimate $29 $29 $49 $95

     Source: Awerbuch and Sauter, 2005 Table 2: Wind Deployment Offsets Sizeable Macroeconomic Oil-GDP Losses

These avoided losses offset 20% of the renewables investment needed to meet

    2020 EU RES-E targets and 40% the OECD requirements. Our analysis

    suggests that each additional kW of wind helps society avoid $250 in GDP

    losses. Stated differently, avoided GDP losses offset 20%-25% of today‘s investments in wind and other renewables.

Energy security is enhanced when nations hold optimal generating mixes that

    minimize exposure to fossil volatility. As the last two sections have described,

    wind and other renewables provide a joint set of benefits: they enhance energy

    diversity/security while they reduce overall generating costs (Awerbuch, Stirling,

    Jansen and Beurskens 2006).

     stIII. Modernizing Power Networks to Accommodate 21 Century


     6Widespread debate prevails about how to manage wind‘s variable-output and how to make it fit into today‘s electricity production-delivery system, designed

    over a century ago for dispatchable, fossil-fired central station generation. Had

    a different generating technology emerged in the 1890‘s, it would have no doubt

    given rise to a different set of network system architecture and protocols. But

    we are stuck with our system at least for time being. System engineers have

    been weaned on dispatchable technologies with central control. It is difficult for

    them to imagine anything else: they see the challenge as making wind fit into

     6 The concept of wind intermittency is misleading. Wind blows a high percentage of

    the year, at least at better sites, although its force varies so that output is variable.

    There are very few days when wind ceases entirely implying that variable-output is a better concept.

    ? Shimon Awerbuch, 2005 5

     Sep 13, 2005 Draft

    the system. I see the challenge as rearranging the electricity production-delivery stparadigm to accommodate a variety of 21 Century needs, including the

    integration of wind and other variable-output sources.

Many new process technologies have faced significant impediments to their

    integration and were fully exploited only after underlying systems and

    infrastructures were extensively modified. We tend to conceptualize new

    technologies in terms of the capabilities and functionalities of the previous

    vintages that we better understand. This was true for word processing, which

    was initially conceived merely as a replacement for the typewriter, and is true

    for wind. How do engineers want to integrate wind? By making it act like a gas

    turbine (as much as possible) so it can be centrally dispatched by the control

    room operator, just the way it has been done for a nearly a century. Fully

    integrating wind will likely require new approaches, including different system

    architecture and protocols and powerful parallel information networks to

    manage electricity grids in a decentralized, market-responsive manner.

We need to alter the electricity production-delivery system to better staccommodate 21 century needs and capabilities. This involves adopting mass-

    customization concepts from manufacturing and moving decision making to loads, which have better information about their hour-to-hour requirements than

    a central dispatcher. At any moment, the system‘s total load consists of

    thousands of transactions, each with a different value. Electricity to power

    water pumping or heating likely does not have the same value as electricity

    required for microchip processing (Awerbuch, March 2004, July-August 2004).

    Adapting to these realities will yield a more efficient, more market-oriented

    production-delivery paradigm under which the network operator becomes the

    electricity market enabler. The traditional transportation function of the network

    becomes obsolete in an environment characterized by a large number of

    distributed resources.

Today‘s network is based on outmoded mass-production concepts. Electricity

    mass customization will allow users to take power in the forms that best match their various applications. Implementing these ideas requires new strategies for

    regulating network system operators, who hold a key position in an electricity

    system that has been partially deregulated in the belief that markets, not

    regulation, produce the greatest efficiency (Awerbuch, Hyman, Vesey, 1999,

    Chap 3). Yet the system operator continues as a monopoly entity with no

    incentives to create new market-driven products or to diversify the mix to

    broaden consumer access to competitively priced supply markets that include

    traditional generation along with wind and other renewables.

Policy-makers correctly focused on deregulating generation first. Much of the

    potential benefit of those policies however is lost because the essential market

    facilitator, the transmission operator, is naively conceived as a caretaker of the

    wires with no incentive to enhance overall system performance. Efficient

    integration and exploitation of wind may have to wait until policy-makers focus

    ? Shimon Awerbuch, 2005 6

    Draft Sep 13, 2005

    on the governance, organization, regulation and pricing structures of electricity


IV. Conclusions

CAPM-based risk-adjusted procedures suggest that at currently projected gas

    prices, wind and other fixed cost renewables are likely to provide electricity at

    lower cost. Moreover, when added to fossil-dominated generating mixes, fixed-

    cost renewable technologies reduce cost at any level of risk by virtue of the

    portfolio-effect. This holds even if they are assumed to cost more on a stand-alone basis.

Wind and similar fixed-cost technologies enhance energy security and their

    deployment will help the UK avoid costly macroeconomic (GDP) consequences

    induced by oil price volatility. Every kW investment in wind offsets $250 USD

    in oil-induced GDP losses. The benefits of wind and other renewables are

    strong, verifiable and highly certain. Our challenge is to re-engineer the

    electricity production-delivery paradigm so it efficiently integrates variable-stoutput renewables and meets other 21 century requirements.


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     Sep 13, 2005 Draft

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