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<td width="75%" valign="top"><b><font face="Arial" size="6"><strong>ELECTRIC POWER
OUTLOOK: <br>
The Cost of New Capacity and the Price of Electric Power</strong></font></b><font SIZE="2"><p></font><font size="4"><font face="Arial"><strong>BY KEMM FARNEY and RALPH RUSSO</strong></font><br>
<small>(<em>originally published by PMA OnLine Magazine: 07/98</em>)</small></p>
</font><i><b><p></b></i> </p>
<font FACE="Arial" SIZE="4"><b><p>Introduction</b></font><font FACE="Arial" SIZE="3"></p>
<p></font><font face="Arial">The most important uses of an electric power price forecast
are to appraise the value of existing assets and to assess the earnings potential of
proposed assets. For an existing plant, the market price less operating costs yields the
plant’s earnings potential; when capitalized, it becomes one measure of the
plant’s fair market value. For a proposed plant, the capitalized earnings potential
indicates whether it is economic to build.</font></p>
<p><font face="Arial">This important role of the price forecast stands in contrast to the
classic problem of microeconomics: in equilibrium, price is equal to the short run
marginal cost of the marginal plant. The marginal plant’s marginal unit of output
makes no contribution to earnings, or what we used to think of as the fixed charges
component of rates. Of course, the nature of power generating equipment is that beyond the
design capacity of the plant marginal costs can increase suddenly and rapidly. Even the
marginal plant, therefore, may be earning something on its intramarginal output to
contribute to its fixed costs – in fact, these intramarginal earnings may be
substantial. The intramarginal plants all earn a contribution to their fixed costs also,
and the most efficient producers cover their fixed costs and may even earn something
extra.</font></p>
<p><font face="Arial">Under competition there is no guarantee that a firm or a plant will
cover its fixed costs. <i>Ex ante</i>, of course, we would expect that no plant will be
built unless it is expected to produce and cover its total economic (all-in) costs. <i>Ex
post</i>, however, the hard realities of the market set in – plants must compete for
the opportunity to produce. Plants can do so only by producing more cheaply than their
competitors. And since all plants are competing to lower their costs, it is not sufficient
to be the low cost producer today – the consistently profitable plants will be the
ones that reduce their costs faster than their competitors.</font></p>
<p><font face="Arial">It is the nature of competitive markets to cycle between three
fundamental states (figure 1):</font><b><ul>
<li></b><font face="Arial">a condition of surplus where too much capacity chases too little
demand and results in a cutthroat auction among producers;<br>
</font></li>
<li><font face="Arial">a situation of deficit where insufficient capacity leads to a
bidder’s auction, complete with panic bids and speculative bubbles;<br>
</font></li>
<li><font face="Arial">and third, a more or less balanced market where prices cover a
producer’s short run marginal costs (SRMC) and may also contain a premium which may
be small and which may or may not be sufficient to provide an incentive for the
construction of new facilities</font></li>
</ul>
<p align="center"><img src="../images/electric.gif" alt="electric.gif (4499 bytes)" WIDTH="359" HEIGHT="297"></p>
<p><font face="Arial">As power producers begin to cycle from one of these market states to
an-other, sometimes building new plants and sometimes trying to get their money out of the
plants they have already built, we will begin to see investment cycles in the power
industry that are very similar to the investment cycles that are experienced in other
competitive industries such as copper, aluminum or commercial real estate. Of course,
throughout the cycle, the job of the power producer will be to make sure that his cost of
production continues to fall rapidly, maintaining his competitive edge in the market
place.</font></p>
<p><font face="Arial">If the market is in a state of excess capacity, price will be at a
discount to short run marginal cost as the owners of excess capacity attempt to monetize
their asset. With insufficient capacity, however, price will contain a premium to short
run marginal cost that may provide the incentive for construction of new plant. This
premium may be large enough to stimulate new construction, or it may be small enough that
it provides little more than a windfall to the owners of existing capital goods. It will,
however, become larger and smaller over the course of the business cycle, alternately
stimulating investment and construction to the point of excess supply, followed by a
period of intensely competitive pricing and distressed asset values.</font><b></p>
<p><font face="Arial">What Does New Capacity Really Cost?</font></b></p>
<p><font face="Arial">To understand the economics of power plant construction, we need to
know both the market clearing price of power and the cost of new construction for the
relevant choices of plant types. The problem is somewhat simultaneous, however, since the
amount of new construction contributes to price setting and the market clearing price
helps to determine the amount of new construction. The first step, however, is to
calculate <i>pro forma </i>estimates of the cost of new construction for the various plant
types available.</font></p>
<p><font face="Arial">For purposes of this discussion we examine the costs of building
three types of plant in a green field:</font><b><ul>
<li></b><font face="Arial">a traditional coal fired steam generating station;<br>
</font></li>
<li><font face="Arial">a gas fired combined cycle installation; and,<br>
</font></li>
<li><font face="Arial">a gas fired combustion turbine.</font></li>
</ul>
<p><font face="Arial">Our conceptual cost estimates are based upon a Delphi survey of
power plant builders and purchasers that are currently involved in projects of these
particular types.</font></p>
<p><font face="Arial">First we consider our conceptual capital cost estimate for a <b>new
coal fired steam station</b>. The plant consists of three 650 mW units that are expected
to be base loaded, operating at a 70% capacity utilization rate. It can be built for
$886/kW, measured in 1997 dollars, with a construction period of 7 years.</font></p>
<p><font face="Arial">We calculate the running costs associated with this coal plant by
assuming: all costs are stated in current year dollars; a 3% rate of general inflation and
a 12.5% cost of capital. Based upon an economic test, this plant will only be built if a
price of more than $36.45/mWh is expected to be realized in 1997, or $64.66/mWh in 2010.
After it is built, however, this coal plant will cover its operating costs and contribute
to its capital costs – and run – at any price above $17.64/mWh in 1997 or
$33.16/mWh in 2010. In other words, it will take expectations of a sustained high market
price for power to bring forth the investment needed to build a new coal plant, but the
plants that are currently in place will produce and compete successfully even during an
extended period of relatively low prices.</font></p>
<p><font face="Arial">As would be expected, the cost of constructing <b>a combined cycle
facility </b>is much lower. We now assume one unit of 470 mW, and now the plant operates
at a 95% capacity utilization rate and is equipped for cycling. This combined cycle
facility can be constructed for $470/kW in 1997 dollars. The construction period is about
two years.</font></p>
<p><font face="Arial">This combined cycle plant has higher running costs than coal,
however. Based upon an economic test, this plant will only be built if a price of more
than $24.78/mWh is expected to be realized in 1997, or $44.08/mWh in 2010. After it is
built, this combined cycle plant will cover its operating costs and contribute to its
capital costs at any price above $17.13/mWh in 1997 or $30,48/mWh in 2010. In other words,
this plant is more attractive than coal as a construction choice in a market with lower
prevailing power prices, but after it is put in place and must compete with existing coal
plants it may or may not be at a slight disadvantage to coal, depending upon the relative
cost of coal and gas per million BTUs.</font></p>
<p><font face="Arial">The third construction choice that we look at is a <b>gas fired
combustion turbine</b>. Our benchmark is a stand alone 75 mW facility operated at a 5%
capacity utilization rate. This is the lowest cost capacity to build of the three choices,
at $323/kW in 1997 dollars, with a construction period of about 18 months.</font></p>
<p><font face="Arial">Running costs for the combustion turbine are the highest of the
three choices, however. Based upon an economic test, this plant will only be built if a
price of more than $117.42/mWh is expected to be realized in 1997, or $200.80/mWh in 2010,
because of its typically low capacity utilization rate. It is no wonder that these
facilities are not being built, even though they are the most frequently listed piece of
equipment in Integrated Resource Plans. After construction, however, this combined cycle
plant will cover its operating costs and contribute to its capital costs at any price
above $34.87/mWh in 1997 or $61.78/mWh in 2010.</font><b></p>
<p><font face="Arial">The Cost of a Combustion Turbine Is the Value of What?</font></b></p>
<p><font face="Arial">The cost of a combustion turbine is often viewed as the cost of pure
capacity, and it is often incorporated into an <i>ad hoc </i>calculation referred to as
long run marginal cost. This practice has resulted in terrible confusion, not the least of
which is the idea that in the long run the price of power should tend towards this
improperly calculated measure of long run marginal cost. Actually, nothing could be
further from the truth.</font></p>
<p><font face="Arial">Combustion turbines were developed beginning in the 1950s, and the
early ones were hardly different from jet engines. The characteristic features of a
combustion turbine are:</font><b><ul>
<li></b><font face="Arial">very short delivery/construction times, as short as 18 months;<br>
</font></li>
<li><font face="Arial">very low capital costs, in the neighborhood of $325/kW of installed
capacity;<br>
</font></li>
<li><font face="Arial">very high fuel cost; and,<br>
</font></li>
<li><font face="Arial">very fast ramp rates, as high as 200 mW/minute.</font></li>
</ul>
<p><font face="Arial">These characteristics describe a machine that is not well suited to
serving most capacity needs. In fact, because of its high fuel cost, the only load it is
really suitable for is an occasional load of short duration, such as occurs at the time of
a peak demand. But even most of this demand can be served at a lower cost if the power
producer has the ability to use the quick ramp rate of the combustion turbine to quickly
increase output as load increases, and then gradually back off the combustion turbine as
output is increased at a more efficient unit with a slower ramp rate. Then when the load
on the system is about to reduce, the more efficient unit can be ramped down gradually
while the combustion turbine again uses its higher ramp rate to follow the load down.</font></p>
<p><font face="Arial">This service being provided by the combustion turbine is called
"load following," for obvious reasons, and it is one of the much discussed
"ancillary services." Analysts have confused the capacity cost of a combustion
turbine with long run marginal cost as a result of our muddied thinking about the power
industry’s products. Until recently we didn’t think about ancillary services,
and it has only been very recently that we have had concrete ideas about what they are.
Even now, reports of transactions in ancillary services are anecdotal and infrequent.</font></p>
<p><font face="Arial">For our new power markets to work, however, and to deliver efficient
prices that can be used as investment signals, we must have more than just well developed
and liquid cash and forward markets in the underlying commodity. We must also have fully
specified property rights, with liquid trading and efficient pricing in each of those
rights, in order to avoid a "tragedy of the commons," which in the power
industry would bring the whole system down. It takes great faith sometimes to believe that
the market will devise the products necessary to address all of the important property
rights, but at least for this ancillary service it appears to be doing so.</font></p>
<p><font face="Arial">A combustion turbine that might be used for peaking no more than 100
hours/year almost never represents truly marginal capacity at the extensive margin. As in
any inefficiently operated industry, there is tremendous hidden capacity at power plants.
The true marginal capacity in the power industry, amounting to 15% to 20% of current
installed capacity, is the capacity available through de-bottlenecking or de-derating
plants. After the past decade of regulatory uncertainty, most power plants have
accumulated a backlog of deferred maintenance and have been derated as a result.</font><b></p>
<p><font face="Arial">Finding "Hidden" Capacity</font></b></p>
<p><font face="Arial">In a truly competitive industry, hidden capacity is almost unheard
of. An aluminum or copper smelter is expected to produce more units of output at a lower
unit cost each year – so called "process creep" – as its operators get
to know the equipment better. Investment decisions are critical in a heavy industry that
faces boom/bust cycles, and firms traditionally weather the cycle by timing investment to
the demand cycle, careful management of working capital, maintaining aggressive industrial
marketing, consolidating through mergers or acquisitions, and most important of all –
focusing new investment on existing plant expansions rather than green field projects. </font></p>
<p><font face="Arial">As just one example, it is frequently said that the average US
nuclear plant has accumulated and now requires about $100 million in deferred maintenance.
The result has been a notorious increase in nuclear safety problems. Several plants are
rapidly reaching the point where they must receive their share of deferred maintenance or
lose their license; a half dozen plants may already be there and are off line. The $100
million investment, however, buys you the continuing availability about 1,000 mW of
capacity, at a cost of $100/kW – far less than the cost of a combustion turbine.</font></p>
<p><font face="Arial">De-bottlenecking is also a very popular investment at conventional
thermal plants right now. Many owners of 400 mW to 500 mW thermal stations are gaining 10%
capacity increases by investing $4 million to $5 million to upgrade to a more modern and
efficient turbine. They are buying perhaps 40 mW of new capacity for a cost of only
$125/kW – again far less than the cost of a combustion turbine.</font><b></p>
<p><font face="Arial">The True Cost of Recovering Hidden Capacity</font></b></p>
<p><font face="Arial">We have argued until now that there is a tremendous reserve of
hidden capacity that could easily amount to as much as 15% to 20% of currently installed
capacity. It can be realized through heightening stacks, cofiring boilers, completing
maintenance that has been postponed, and by generally de-bottlenecking existing plants.
Most important of all, this capacity can be had at a very low cost – the examples
cited above strongly suggest that much of this capacity can be recovered for $100/kW to
$125/kW. Finally, these are appealing projects to utility executives – they appear to
have very little risk because the plants are thought to be well known, and the individual
projects become relatively small items on the capital budget. This last point matters a
great deal at those companies where the corporate culture is strongly averse to new
construction.</font></p>
<p><font face="Arial">Once the investment in recovering hidden capacity is made, the
running costs offer significant advantages over new construction. This capacity can be
recovered economically even if a very low market price of $15.63/mWh is expected to be
realized in 1997, or $27.81/mWh in 2010, because of very low capacity costs coupled with
the fuel cost advantage enjoyed by the existing coal plant. The construction period on a
project of this type would be about two years.</font></p>
<p><font face="Arial">After it is built the picture is even better; this recovered
capacity will cover its operating costs and contribute to its capital costs at any price
above $12.80/mWh in 1997 or $22.78/mWh in 2010. These prices are very low, almost
competitive with dump nuclear energy. It will be the pursuit of these opportunities that
will lead to the large amounts of process creep that we expect in our forecast.</font><b></p>
<p><font face="Arial">The Significance of Hidden Capacity For Market Pricing</font></b></p>
<p><font face="Arial">The very low cost of recovering this hidden capacity has sweeping
implications for the pricing of electric power. Even with rapidly falling power prices it
will be economic to quickly develop these "strategic reserves." The result will
be to prolong the period of excess capacity that is to be expected from the
rationalization of production processes after deregulation. This, in turn, will lead to
intense cost competition, further lowering power prices, and will serve to choke off
construction of some new large generating stations.</font></td>
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