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Article Excerpt
High fossil fuel prices have rekindled interest in nuclear power. This paper identifies specific characteristics making nuclear power unattractive to merchant generators in liberalized electricity markets, and argues that non- fossil fuel technologies have an overlooked 'option value' given fuel and carbon price uncertainty. Stochastic optimization estimates the company option value of keeping open the choice between nuclear and gas technologies. The merchant option value decreases sharply as the correlation between electricity, gas, and carbon prices rises, casting doubt on whether merchant investors have adequate incentives to choose socially efficient diversification in liberalized electricity markets.
1. INTRODUCTION
In the last decade, Europe and North American electricity supply industries have seen a transition from vertically integrated franchise monopoly structures (typically state-owned in Europe and regulated in the US) to unbundled companies trading in liberalized wholesale markets. There has been no new nuclear build in the last decade in liberalized electricity markets, with the exception of the recent Finnish (2004) and French (2005) European Pressurized Water (EPR) reactor orders.
The winter of 2005/6 has seen threats of gas supply disruptions in Europe and very high gas prices, particularly in the UK (with the most liberalized gas market), which have revived concerns about energy security. The backdrop of such events is a general increase of fossil fuel prices since 2004, which has rekindled interest in nuclear power generation as one of the potential solutions to diversify the primary energy supply mix of oil and gas importing nations, to reduce greenhouse gas emissions from power generation, and to provide a source of electricity with stable production costs.
Besides problems of public acceptance and nuclear waste disposal, important economic, regulatory, and financial barriers confront private investment in new nuclear power stations in liberalized markets. In the U.S., the 'Nuclear 2010 project' supports actions intended to remove the regulatory barriers to new nuclear build, e.g. through streamlining the licensing procedure, while the 2005 Energy Act introduced a cost-overrun support of up to $2 billion total for up to six new nuclear power plants and a nuclear production tax credit of 1.8 cents per kWh for the first 8 years of production from new nuclear facilities (U.S. Congress, 2005). In Europe, both Finland and France are taking the first steps towards new nuclear build aided by the high carbon price now visible on the European Emissions Trading System. A number of other countries (including the U.K., Spain, Italy, Poland, the Netherlands, and the Baltic States) have reopened the debate about nuclear power.
Much of the conventional debate around the economics of nuclear power has focused on the expected levelized cost of nuclear power compared to other forms of base-load generation. This paper tackles the question as to whether a merchant generating company (that is, one with no ownership stakes in retailing) might choose to add a nuclear power plant to their existing generation capacity to hedge the risk of volatile prices for fossil fuels (natural gas) or for carbon dioxide emissions. We conclude that for likely commercial costs of capital such option values are severely eroded by the high correlation between gas, carbon and electricity prices. As there is likely to be a social and consumer benefit in fuel mix diversity, this paper will show that merchant generators appear to lack incentives to diversify by constructing new nuclear power plants in current liberalized electricity markets.
2. NUCLEAR ECONOMICS IN LIBERALIZED ELECTRICITY MARKETS
In 2005 there were 440 nuclear power reactors in 31 countries, with a combined capacity of 367 GWe, generating some 16% of the world's electricity (WNA, 2005). (1) Until recently, however, no new nuclear power station had been commissioned in a liberalized electricity industry. One key issue for the commercial future of nuclear power is to understand how the commercial unattractiveness of nuclear power is related to electricity market structures. To what extent has the risk redistribution brought about by liberalizing the electricity supply industry and the resulting higher cost of capital contributed to the success of gas-fired plants to the detriment of nuclear power and other capital-intensive technologies?
2.1 Levelized Cost Comparisons
The traditional approach for comparing the competitiveness of different generation technologies is the 'levelized cost' methodology, based on a discounted cash flow analysis over the life of the plant. This valuation technique is appealing as it gives simple results in the form of comparable levelized production costs. The levelized cost approach was well suited to the stable environment of the electricity industry before liberalization. It continues to be widely used by utilities post liberalization, despite its inappropriateness for evaluating investment choices under uncertainty (Deutch et al. 2003, IEA/NEA, 2005).
Table 1 shows the model parameters and levelized costs for the most recent studies conducted in Canada (CERI, 2004), Finland (Tarjanne and Rissanen, 2000), France (DGEMP/Dideme, 2003), the U.K. (RAE, 2004), the U.S. (Deutch et al., 2003, and Tolley et al., 2004), and the OECD (IEA/NEA, 2005).
The table shows wide differences in the results arising mainly from the different assumptions made for construction and operating costs of nuclear and the differing financing structures of the models. (3) Construction cost for new capacities exceeding 1000 MWe ranges from about $US1,100/kWe to $US2,500/kWe. The financing assumptions differ also greatly, with real discount rates varying from 5% to 12.5%, equity shares varying from 30% to 50%, and debt repayments concentrated in the first 10 years or spread over the life of the plant (Deutch et al., 2003, Tolley et al., 2004). These different assumptions reveal not only different degrees of confidence in the nuclear industry cost figures, but also a different understanding of the impact of the electricity industry liberalization on new nuclear plants economics and financing.
2.2 Biases Against Nuclear Power in Liberalized Markets
When examining the alleged discrimination in technology choice caused by market liberalization, one should remember that the old regulated vertically integrated monopoly model also introduced biases. It was normally able to finance any required capacity in generation, but provided poor incentives for delivering investment in a timely and cost-effective way. A verch and Johnson (1962) demonstrated that regulated utilities might rationally prefer to invest in excessively capital-intensive technologies. Moreover, the subordination of utilities to regulation bodies gave rise to other distortions of investment choices. For instance, many countries directly controlled or influenced the fuel mix through subsidies to 'national' fuels (such as coal or lignite), or the financing of 'national' technologies (such as nuclear) (Newbery and Green, 1996).
In liberalized markets investments are profit motivated, with the choice of technology left to the market. The redistribution of risk among the different stakeholders is likely to make nuclear generation unattractive for an investor, even when its levelized costs are similar to the levelized costs of the dominant technology, for several reasons.
First, investors have a strong preference for a shorter payback period, which makes investments with short lead time more attractive. Nuclear lead times (5 years in the most optimistic scenario given the historical record in Table 2) are, for engineering and licensing reasons, much longer than CCGT lead times (2 years). Second, construction costs for nuclear plant are two to four times greater than for a CCGT (about $400 to $800 per kWe installed). Of the three major components of nuclear generation cost--capital, fuel, and operation and maintenance--the capital cost component makes up approximately 70% of the total, while it only represents about 20% of total costs for a CCGT (see Table 3). In addition, the size of a typical nuclear unit is much larger than the size of a typical gas turbine: recent nuclear technologies range from 1000MWe (AP1000 from BNFL) to 1600MWe (EPR from Areva), while CCGTs units are only of about 100 to 650 MWe (although it is common to build several on one site). This implies that the required minimum upfront capital investment for a nuclear plant can be ten to fifteen times greater than the smallest investment required for a CCGT. (4)
Third, the lack of recent experience with new build makes it difficult to get reliable cost estimates. The traditional optimism of nuclear vendors reinforces investors' distrust of vendors' assessments. The history of nuclear electricity includes a list of seriously delayed construction and cost overruns (Nuttall, 2004). Besides, investors must confront the regulatory and political challenges associated with obtaining a license to build and operate a plant on a specific site.
Fourth, the greater size of nuclear technology exposes investors to greater downside risks, as for the next decade only large-scale Generation III...
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