Valuing Energy Security Quantifying the Benefits of Operational and Strategic Flexibility Tom Parkinson 4 October 2013
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1 Quantifying the Benefits of Operational and Strategic Flexibility Tom Parkinson 4 October 2013
2 We at The Lantau Group are experts in the economics of energy systems Seoul (TLG Korea) Asia Pacific Energy Experts Competition, Markets, Regulation Economic Consulting Testimony Hong Kong The founding partners of TLG first worked in the Asia Pacific region as part of Putnam, Hayes & Bartlett (PHB) and later with Charles River Associates Market Analysis Asset Valuation Business & Regulatory Strategy Office Presence 1
3 Overview What exactly is energy security? Is fuel diversity valuable? Is strategic flexibility important? 2
4 Energy security is one leg of the trilemma that appears in energy policy discussions for many countries 3
5 The concept of energy security is seemingly simple An electricity system that embodies a high degree of energy security will be resilient to exogenous physical and financial disruptions But what can we do to increase energy security and what is the value of doing so? 4
6 So much has been written on the topic of energy security but so little of it is useful policy guidance 10 percent Useful 10 percent Attempts to provide useful policy guidance 90 percent Drivel 90 percent Attempts to quantify energy security so as to rank countries 5
7 The useful literature recognizes that energy security risks take different forms and must be analyzed and addressed separately Energy Security Risk Matrix Physical (supply shortfall) Financial (high prices) Short-Term Technical failure Extreme weather events Political disruption Supply disruption Cartel production quota Long-Term Resource depletion Resource nationalization Policy/regulatory failure Fuel price shifts New technologies 6
8 Each class of risk can best be managed via different strategies Energy Security Risk Matrix Physical (supply shortfall) Financial (high prices) Short-Term Physical redundancy Supplier diversity Bilateral contracts Hedging instruments Long-Term Prudent planning Clear policy guidance Clear policy guidance Strategic flexibility 7
9 Clear policy guidance requires a value-based framework From Ambiguous Triangle To Clarifying Prism Cost Competitiveness Cost- Competitiveness? Apparent Ranking A, B, C, D TRILEMMA VALUE FRAMEWORK Trilemma Ranking C, B, D, A Environmental Sustainability Energy security Environmental Sustainability Energy Security But this requires an approach to valuing energy security 8
10 Overview What exactly is energy security? Is fuel diversity valuable? Is strategic flexibility important? 9
11 Much of the energy security literature is intertwined with discussions of "diversity" but diversity itself is not a source of value Fuel diversity lowers risk via the portfolio effect a basket of fuels will have lower overall price risk than a single fuel But contracts and hedging instruments already exist to mitigate short-term volatility Long-term correlation between fuel prices in international markets is very high What long-term risks are we worried about anyway since it is virtually impossible (and probably not desirable) to decouple from international energy prices in the long run? An electricity system incorporating fuel diversity can reap the benefits of operational (dispatch) flexibility that is, the ability to burn the least expensive fuel at any time Reaping operational flexibility benefits requires that fuel prices be free to float and quantities variable (that is, no binding take-or-pay constraint) so that such dispatch opportunities arise The primary fuel competition today in Asia is between gas and coal whose prices are so far apart as to create relatively few opportunities to realize the benefits of dispatch flexibility Strategic flexibility can reap the benefits of long-term relative shifts in fuel prices Separately, physical redundancy or supplier diversity can offer value through lower probabilities of physical failure 10
12 Diversity advocates point to fuel-diverse systems as examples of good public policy but fail to recognize that diversity often results from strategic flexibility Relatively low coal prices in the early 1980s and late 2000s induced waves of coal development 11
13 For example, CLP (Hong Kong) has a diverse fuel mix that resulted from a series of purely economic decisions made at various points in time Fuel diversity could well be an outcome, it should not be a goal 12
14 The relative coal versus crude prices illustrate the impacts of commodity price uncertainty and stock returns are another good example Post Korean War 1957 money policy 1962 crash OPEC Iran 1987 crash Russia & Asia Global Financial Crisis Positive Returns 15 Z-Score 10 Daily returns of an investment in the S&P 500 expressed for each day as the number of standard deviations from the average daily return since Twenty Years Negative Returns -15 Any major capital investment in the last 60 years has experienced at least two, maybe three, Uncertainty is a reality in the major market! financial Good market decisions disruptions must account for uncertainty 13
15 This uncertainty gives rise to the value of operational and strategic flexibility Fuel price changes driven by uncertainty Other cost changes driven by uncertainty Changing dispatch decisions (such as merit order) s.t. system constraints Changing optimal capacity expansion plan s.t. system constraints Operational flexibility Strategic flexibility 14
16 Spread factor between HSFO and LNG benchmark crude prices Strategic flexibility implies that entry decisions accommodate the dynamic fuel markets 15
17 Overview What exactly is energy security? Is fuel diversity valuable? Is strategic flexibility important? 16
18 We analyze the benefits of diversity using a value-based framework, driven by the consideration of system cost uncertainty Expected Capital Expected O&M Traditional System Costs Total Cost Expected System Cost Expected Fuel Expected Customer Customer Cost of Unserved Energy Expected Externality Shadow Prices of Environmental Externalities Risk Premium Risk is defined as the extent to which investment in a given technology increases (or decreases) the variance in cost relative to the least-cost system 17
19 We actually use two different approaches to analyze the impacts of uncertainty Probabilistic analysis Screening curve analysis Considers uncertainty at a point in time Easier to analyze and understand Does not account for existing system And fails to capture the impact of risk premium and investment mistakes Stochastic optimization Models evolution of uncertainty over time Harder to analyze and understand Incorporates existing system effects Also captures the impact of risk premium and investment asymmetry 18
20 LRMC Traditional screening curve analysis compares the costs of alternative technologies at different capacity factors to determine preferred technologies Option A has lower fixed costs, but higher variable costs, so at low capacity factors it has the lowest LRMC Option B has higher fixed costs, but lower variable costs, so at sufficiently high capacity factors there is enough higher LRMC at low capacity factors because there is less output across which to amortize the fixed costs A B 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Optimal choice for capacity of a given capacity factor: Option A Annual Capacity Factor Option B 19
21 Load factor LRMC The cross-over in the screening curves determines the capacity factor at which one technology yields to another and thereby the optimal mix Comparing the screening curves and the loadduration curve gives the optimal capacity mix if the system were perfectly flexible A B 100% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Annual Capacity Factor 90% 80% 70% 60% 50% In this example about ninety percent of the capacity should be B (and the remainder A) Annual Hours 20
22 Asian LNG Spot Price ($/mmbtu) Representative fuel price and technology cost/performance scenarios that span the range of possibilities are then used to drive the model Fuel price uncertainty 50 (only LNG shown but also for other fuels) Carbon cost uncertainty Overnight project cost uncertainty Technological improvement (heat rate) uncertainty Load uncertainty
23 Likelihood If we look at a time slice, these scenarios imply cumulative distributions on the various fuel prices Cumulative frequency distribution of fuel prices 100% 90% 80% 70% 60% 50% 40% 30% 20% NG Diesel HSFO Coal Pet Coke Uranium Biomass 10% 0% Fuel price (2012 SGD/MMBTU) 22
24 Likelihood This structure yields a probabilistic optimal mix in which each technology has some Likelihood likelihood of of each being technology the least-cost being unit lowest at a given LRMC capacity at different factor capacity factors 100% 90% 80% 26 percent CFB Subcritical (100 percent pet coke) 70% 60% 50% 27 percent PC Subcritical (100 percent coal) 40% 30% 20% 48 percent CCGT (1x1 Siemens H) 10% OCGT (5xLMS100) 0% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Capacity factor 23
25 Number of scenarios The system average cost for the incremental capacity is lowered by strategic flexibility the opportunity to harness the least-cost mix of technologies/fuels Actual Mean = SGD 114/MWh With No Flexibility = SGD 127/MWh System Average Cost (SGD/MWh) But this analysis assumes perfect strategic flexibility which overstates the realistic value 24
26 Annual capital recovery (percent of investment) This stochastic optimization accounts for the impact of investment asymmetry and out-of-the-money technology options Coal: Capital intensive 14% 12% Technologies that have lower variable costs face a relatively smaller risk of being displaced once built Modelled Fit Constant profile 10% 8% Investment asymmetry means that the investment must aim to recover more in the first year in order to break even over its life 6% 4% 2% 0% Year of service (Note: 25 year lifetime assumed. Final six years not shown) Source: TLG analysis 25
27 Annual capital recovery (percent of investment) Investment asymmetry and out-of-the-money technology options have differential effects on alternative technologies Gas: Higher variable cost 14% 12% 10% 8% Technologies that have higher variable costs face a much larger risk of being displaced Lower capital cost results in lower investment asymmetry premium Modelled Fit Constant profile 6% 4% 2% 0% Year of service (Note: 25 year lifetime assumed. Final thirteen years not shown) Source: TLG analysis 26
28 In our example, coal investments tend to reduce system costs but increase the deviation from a perfectly flexible system thereby increasing risk 3.0 Contribution to future PV system cost (SGD mil / MW) (0.5) (1.0) (1.5) (2.0) (20,000) (15,000) (10,000) (5,000) 0 5,000 10,000 15,000 Coal CCGT Relative deviation of PV system cost from that with perfect strategic flexibility (SGD mil) Each dot represents a different investment year in each scenario 27
29 The net effect is a preferential shift towards less capital-intensive technologies Least-cost average generation fuel mix Percent 100 Incineration HSFO 80 Gas Coal Increased capital recovery requirements in earlier years means that less coal capacity tends to be built Lower capital intensive technology options tend to offer greater strategic flexibility to change the future capacity expansion plan 0 No risk premium Risk premium and profiled capital recovery 28
30 Using this framework, we can value flexibility the value of strategic flexibility is comparable to that of operational flexibility Illustrative example: Expected PV of system costs Percent of deterministic case Probabilistic Dispatch and Capacity Expansion Value of strategic flexibility Probabilistic Dispatch Value of operational flexibility Deterministic Dispatch and Capacity Expansion 29
31 Implications of trilemma value framework Expanding the opportunity to profit from strategic flexibility has great value Investments in infrastructure that expand the scope of technology/fuel options are valuable But long-term take-or-pay contracts that force utilization of such infrastructure reduces strategic flexibility Policies that create non-market constraints such as carbon caps that preclude the use of international offsets limit strategic flexibility High-capital, low-variable cost investments offer fewer opportunities for the overall system to gain from strategic flexibility By itself, diversity has relatively little value Incremental operational flexibility associated with diversity has relatively little value given existing fuel price expectations in SE Asia Strategic flexibility can capture much of the long-term potential dispatch flexibility The value of portfolio diversification appears to be small (on the order of a few percent of capital cost) relative to differences in long-run marginal costs Hedging mechanisms exist that do not require investment in diverse resources 30
32 Thank You! Power Utilities Energy Insight Rigour Value For more information please contact us: By General Capabilities Inquiries Direct Communications By phone (office) By mail Tower 1, Metroplaza 223 Hing Fong Road, Kwai Fong, Hong Kong Online 31
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