How Risky is Elecriciy Generaion? Tom Parkinson The NorhBridge Group Inernaional Associaion for Energy Economics New England Chaper 19 January 2005 19 January 2005 The NorhBridge Group
Agenda Generaion economics Analyical framework Saic equilibrium Dynamic equilibrium Resuls and conclusions. 19 January 2005 1 The NorhBridge Group
For a merchan generaion plan, he uncerainy in ne revenues is he key unknown o deermining boh deb coverage and equiy reurn: Deb Coverage = Equiy Reurn = ( R f ) (1 τ ) + C dτ + I τ I + P ( R f ) (1 τ ) + C dτ I (1 τ ) E P R = Ne revenues d = Tax depreciaion rae f = Fixed O&M cos I = Ineres on deb τ = Marginal ax rae P = Principal repaymen C = Capial cos E = Equiy invesmen 19 January 2005 2 The NorhBridge Group
Ne revenues represen he margin beween he elecriciy price and he variable cos when he uni is dispached! 70 60 Spo Price ($/MWh) 50 40 30 20 10 Elecriciy Gas Dispach 0 Jan-02 Feb-02 Mar-02 Apr-02 May-02 Jun-02 Jul-02 Aug-02 Sep-02 Oc-02 Nov-02 Dec-02 19 January 2005 3 The NorhBridge Group
The resuling ne revenues sream is quie volaile: Monhly Ne Revenues ($/kw) 120 100 80 60 40 20 0 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Over his eigh-year period, almos half of he ne revenues occurred in jus hree monhs. 19 January 2005 4 The NorhBridge Group
The price duraion curve is a useful way o concepualize he annual ne revenues sream probabilisically: 100 Spo Price ($/MWh) 80 60 40 20 Ne Ne Revenues Dispach Cos Dispach Cos 0 0.0 0.2 0.4 0.6 0.8 1.0 Fracion Fracion of of Annual Hours Figure 1: Ne Revenues and Price Duraion Curve 19 January 2005 5 The NorhBridge Group
Agenda Generaion economics Analyical framework Saic equilibrium Dynamic equilibrium Resuls and conclusions. 19 January 2005 6 The NorhBridge Group
The ne revenues sream is subjec o differen forces a differen ime scales: Time Scale Capial Sock Key Uncerainies Characerizaion Shor Fixed in boh quaniy and ype Weaher, fuel sorage Shor-erm uncerainy Medium Fixed in ype, bu no quaniy Economic growh, new capaciy Invesmen dynamics Long Fixed neiher in quaniy nor ype Fuel finding coss, echnology characerisics Technology compeiion 19 January 2005 7 The NorhBridge Group
The fundamenal decomposiion expresses ne revenues for a merchan plan in any given year as he produc of four erms: R = S * S S * R S R R Saic Enry Obsolescence Invesmen Dynamics Shor-Term Uncerainy * S = Saic equilibrium enry hreshold for new uni in year S = Ne revenues in year based on saic equilibrium R = Acual ne revenues in year of operaion R = Expecaion of ne revenues as of beginning of year 19 January 2005 8 The NorhBridge Group
The assumpion of independence also allows us o approximae he variance of ne revenues as he sum of hree erms: var R [ ] [ ( )] R ln( R ) var ln S + var ln + var ln S * * R Saic Enry/ Obsolescence Uncerainy Invesmen Dynamics Uncerainy Shor-Term Uncerainy 19 January 2005 9 The NorhBridge Group
We used a scenario-based framework o evaluae each source of uncerainy: Invesmen Dynamics Annual load Saic Enry Thresholds Iniial Saic Equilibrium Forward ne revenues (new unis) Scenario Generaor Saic Equilibrium Tech. adv. Inflaion Risk-free rae Annual fuel prices Iniial Saic Equilibrium Uni ouages Load Fuel prices Saic enry hresholds Saic ne revenues Shor-Term Marke Model Acual ne revenues Forward ne revenues (exising unis) 19 January 2005 10 The NorhBridge Group
Agenda Generaion economics Analyical framework Saic equilibrium Dynamic equilibrium Resuls and conclusions. 19 January 2005 11 The NorhBridge Group
Long-erm forecass regardless of iniial condiions converge o a paricular rajecory, which we can find by: Posiing compeiion among a number of alernaive fuure echnologies Accouning for echnological advancemen and obsolescence Opimizing dispach, reiremen, and invesmen o deermine he leas-cos soluion o meeing load Solving for he opimal capaciy mix and associaed saic ne revenues hresholds. 19 January 2005 12 The NorhBridge Group
Given cerain assumpions, he resuling saic equilibrium soluion is saionary ha is, a single soluion describes he oucome for all ime: The capaciy sock increases in size wih load growh, bu he capaciy mix says consan Elecriciy prices increase wih inflaion less he rae of echnological advancemen, bu real prices say consan. This allows us o ranslae he economics of unis of differen vinages a a single poin in ime ino he economics of a new uni over is enire life. 19 January 2005 13 The NorhBridge Group
Alhough individual unis come and go, he composiion of he capaciy sock iself is consan: 2010 Analysis across uni life Year of Operaion 2009 2008 2007 2006 2005 Analysis across flee 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Year of Insallaion 19 January 2005 14 The NorhBridge Group
Given a se capaciy sock, we can develop he associaed supply curve: Dispach Cos ($/MWh) 200 180 Coal CC CT 160 140 120 100 80 60 40 20 0 0.0 0.5 1.0 1.5 2.0 Insalled Capaciy (deraed MW/MW of average load) 19 January 2005 15 The NorhBridge Group
The supply curve maps ino a price duraion curve, ne revenues, and operaing cash flows: 160 Operaing Cash Flow ($/kw-yr) 140 120 100 80 60 40 20 Coal CC CT 0 0 20 40 60 80 100 Delivery Year 19 January 2005 16 The NorhBridge Group
Given he opimal mix, he ne revenues rajecories define expeced obsolescence: 240 200 Ne Revenues es ($/kw-yr) 160 120 80 40 Saic Enry Threshold Exising Uni Expeced OObsolescence 0 2004 2014 2024 2034 2044 2054 Delivery Year 19 January 2005 17 The NorhBridge Group
Acual obsolescence will depend on he naure of he scenario rajecories: 240 200 Ne Revenues ($/kw-yr) Ne Revenu es ($/ kw -yr) 160 120 80 40 Acual Saic Enry Threshold Acual Saic Enry Threshold Acual Exising Uni Exising Uni Acual Obsolescence Acual Obsolescence 0 2004 2014 2024 2034 2044 2054 Delivery Year 19 January 2005 18 The NorhBridge Group
Agenda Generaion economics Analyical framework Saic equilibrium Dynamic equilibrium Resuls and conclusions. 19 January 2005 19 The NorhBridge Group
Invesmen dynamics are complicaed by he fac ha he annual ne revenues and saic enry hresholds are uncerain. Consider hree cases: Insananeous invesmen, known saic enry hreshold Finie lead ime, known saic enry hreshold Finie lead ime, uncerain saic enry hreshold. The underlying heory is an exension of he Dixi and Pindyck Invesmen Under Uncerainy framework. 19 January 2005 20 The NorhBridge Group
Load uncerainy causes he capaciy price o evolve randomly bu insananeous enry caps he price: 100 90 Iniial Enry Capaciy P rice ($/kw-year) 80 70 60 50 40 30 20 10 Enry Price (reflecing barrier) Equilibrium Price 0 2002 2007 2012 2017 2022 2027 Delivery Year Noe ha he enry price exceeds he equilibrium price. 19 January 2005 21 The NorhBridge Group
Wih finie lead ime, he expeced capaciy price is capped, bu he acual price may exceed he cap: 200 180 Capaciy P rice ($/kw-year) 160 140 120 100 80 60 40 20 On-Line Dae Expeced Price Enry Barrier Acual Price Condiional Expecaion 0 2002 2007 2012 2017 2022 2027 Delivery Year Hence we mus rack boh he acual and expeced price. 19 January 2005 22 The NorhBridge Group
The volailiy erm srucure reflecs wo separae sources of uncerainy in he expeced price and in he acual price during consrucion: 50 On-Line Dae Average Volailiy (percen) 40 30 20 10 Acual Price Condiional Expecaion 0 2002 2007 2012 2017 2022 2027 Delivery Dae 19 January 2005 23 The NorhBridge Group
A known saic enry hreshold ranslaes ino a known dynamic enry hreshold: Ne Revenues es ($/kw-yr) ) 300 250 200 150 100 50 Online Dae Acual Ne Revenues Expeced Ne Revenues Dynamic Threshold Saic Threshold 0 0 5 10 15 20 25 30 Year of Delivery 19 January 2005 24 The NorhBridge Group
Uncerainy in he saic hreshold has a proporional effec on he dynamic hreshold: Ne Revenues ($/kw-yr) 300 250 200 150 100 50 Online Dae Online Dae Expeced Ne Revenues Expeced Ne Revenues Expeced Dynamic Threshold Expeced Dynamic Threshold Expeced Expeced Saic Threshold Threshold 0 0 5 10 15 20 25 30 Year of Delivery Wha maers is he relaionship beween he expeced ne revenues and he expeced dynamic hreshold. 19 January 2005 25 The NorhBridge Group
Agenda Generaion economics Analyical framework Saic equilibrium Dynamic equilibrium Resuls and conclusions. 19 January 2005 26 The NorhBridge Group
Peaking unis have he greaes ne revenues uncerainy: Log-Variance of Ne Revenues 2.0 1.6 1.2 0.8 0.4 0.0 Technology Risk Technology Risk Invesmen Dynamics Invesmen Dynamics Shor-Term Uncerainy Shor-Term Uncerainy 0 10 20 30 40 Year of of Delivery This uncerainy is relaively consan across ime. 19 January 2005 27 The NorhBridge Group
By conras, he risks for combined cycle unis climb seadily as he unis age and move up he meri order: 1.6 Log-Variance of Ne Revenues 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 Technology Risk Technology Risk Invesmen Dynamics Invesmen Dynamics Shor-Term Uncerainy Shor-Term Uncerainy 0 10 20 30 40 Year of Delivery 19 January 2005 28 The NorhBridge Group
Coal unis are subjec o compeiive pressures from CCs and herefore face considerable echnology risk: 0.7 Log-Variance Log-Variance of of Ne Ne Revenues Revenues 0.6 0.5 0.4 0.3 0.2 0.1 0.0 Technology Risk Invesmen Dynamics s Shor-Term Uncerainy 0 10 20 30 40 Year of Delivery Year of Delivery 19 January 2005 29 The NorhBridge Group
While coal unis have he lowes proporional variance in value, his echnology risk is mos difficul o hedge: 00.8 00.6 Technology Risk Risk Invesmen en Dynamics Shor-Term Uncerainy am ics Sh or-te rm Unce rain y R Relaive Variance 00.4 00.2 00.0 CCoal l CC CT 19 January 2005 30 The NorhBridge Group
Conclusions The separaion ino shor-erm uncerainy, invesmen dynamics, and echnology compeiion enables analysis and sheds insighs Baseload plans like coal have less risky ne revenues sreams Bu baseload plans are subjec o considerable echnology risk, which has a disproporionae effec on value risk and is less readily hedged Iniiaives o creae forward capaciy markes such as conemplaed by PJM will advanage CCs and CTs by hedging invesmen dynamics risks. 19 January 2005 31 The NorhBridge Group
Conac Informaion Thomas W. Parkinson Direcor The NorhBridge Group Lincoln, MA 01773 781-266-2613 wp@nbgroup.com Dr. Parkinson has over 25 years experience in capial-inensive, risky, commodiy-based naural resource indusries. For he las 15 years, Dr. Parkinson has focused almos exclusively on he elecriciy indusry, where he applies he financial heory of commodiy and derivaives markes o pracical problems facing managers. He has worked wih EPRI and many elecriciy companies on applicaions ha chiefly include probabilisic price forecasing, asse and conrac valuaion, and risk assessmen. Dr. Parkinson holds a B.S. in managemen from M.I.T. and a Ph.D. in engineering-economic sysems from Sanford Universiy. 19 January 2005 32 The NorhBridge Group