In the current policy environment many energy technologies can appear attractive with the right set of assumptions: discounted clean energy technologies (wind, solar and nuclear) where the discount rate is heavily influenced by risk (see graph) and, perhaps surprisingly, new load-following fossil fuel plants (especially natural gas) where continued wind/solar technology forcing actually provides substantial upside potential. CCS researcher Schalk Cloete looks at the different technologies and highlights how risk can come from any factor that could unexpectedly increase the cost and/or reduce the revenue relative to the assumptions employed in the levelized cost calculation.
Wind and solar
The primary risk facing wind and solar power is that generators will eventually be exposed to their true market value and be expected to cover their full integration costs. Currently, these generators are not liable for the increased system costs imposed by their variable and non-dispatchable nature and are protected from value declines via feed-in tariffs or other arrangements that guarantee a fixed electricity price over the plant lifetime.
Under these conditions, the risk of investing in wind and solar power is attractively low. Both technologies are thoroughly proven and operators can have a high degree of certainty that these technologies will operate over several decades according to the specifications of technology providers.
In reality, however, a continued expansion of wind and solar market share over the lifetime of an installed plant will gradually increase the cost and decrease the value of the produced electricity. Three such effects will eventually need to be internalized:
The first and most important effect is the value decline, which is caused by wind and solar generating most of their output during times of self-imposed electricity oversupply.
Correlation between combined wind and solar output and electricity price in Germany for the year to date (source).
As wind and solar market share increases, this effect magnifies, causing the average value of all wind and solar in the system to fall. If wind and solar market share continues to increase by about 1% per year, the value of electricity produced by today’s plants will drop by half by the end of their lifetimes. Direct exposure to this natural market dynamic is a major risk for wind and solar generators.
Wind and solar value factors (a value factor of 1 is for a generator with a constant output) as a function of their respective market shares (source).
In parallel, two significant costs will also continue to increase with further wind and solar deployment. The first is grid integration costs, which is related to grid congestion and imperfect forecasting. This cost is already highly significant (€10/MWh) in Germany.
Development of German grid integration costs per unit of wind and solar electricity (source).
The second is grid expansion costs. This is especially important in regions where major demand centres are located far from the best wind and solar resources. Wind power in Germany is a good example, where power generated in the North needs to be transported over hundreds of miles to demand centres in the South. This cost will become especially large as new wind developments are increasingly forced offshore in the far North of the country.
Planned transmission (a) and generation (b) system in Germany in 2020 (source).
Long distance transmission costs about $2/kW/km and can face large additional cost inflation from public resistance. As wind and solar market share expands, more of these lines will need to be installed to avoid grid congestion, which causes most of the grid integration costs mentioned above (largely in the form of redispatch and curtailment). As a rough quantification of grid expansion costs, a grid connection transporting wind power 500 km to a distant demand centre will add about $1000/kW to the wind installation cost (over $2000/kW if public resistance forces lines underground) – a very large increase.
Currently, wind and solar generators are shielded from all these value declines and cost increases, but this cannot last forever.
Nuclear does not work well in combination with wind and solar power. As an example, the figure below shows that wind market value declines much faster in France with its high share of nuclear plants than in other European countries.
Wind value decline in several European countries (source).
Technology-forcing of wind and solar power beyond a certain point will also start to reduce the capacity factor of nuclear plants. If the combined output of wind, solar and nuclear exceeds total demand, nuclear plants will have to ramp down. Due to the high capital costs of nuclear plants, such capital under-utilization will have a significant negative effect on economics. This negative effect will be partially balanced out by an increase in average value of the sold electricity (wind and solar will only displace nuclear at the lowest price point), but the overall effect will still be negative.
Public perception also remains a very important risk for nuclear power. This leads to very strict regulation that requires overly complex plant designs, often leading to substantial budget and time overruns. A black-swan event like Fukushima can also cause early shutdowns of perfectly functioning plants.
The rise of wind and solar is an important contributing factor to the decline of nuclear power. Nuclear safety issues are much easier for the public to understand than wind/solar integration challenges, making nuclear look very risky next to wind and solar for the average taxpayer.
Contributions to global primary energy according to the BP Statistical Review. Note that electricity output is divided by 0.38 to convert to primary energy, thus inflating the share almost by a factor 3. For wind and solar, this assumption is only defensible at very low market shares where value declines and cost increases are negligible.
Nuclear is therefore in direct competition with wind and solar power. As long as wind/solar technology-forcing policies remain strong, nuclear will be on the back foot, both due to a gradual decline in capacity factor and an increase in the perceived risk next to the renewable energy alternative.
Coal and gas plants
The biggest risk to fossil fuel power plants is the eventual introduction of significant CO2 taxes. Just like the internalization of wind/solar integration costs, the internalization of climate change damages will have to happen eventually. To hedge against this risk, it is important that new fossil fuel plants are built to enable easy CCS retrofitting in the event of a rapid CO2 price hike.
There is no longer a case for building baseload fossil fuel plants. If we are to reduce our near-complete fossil fuel dependence (below), baseload plants are exactly the wrong direction due to their mandate to maximize fuel consumption over any given year. Instead, new fossil fuel power stations are being constructed as load-following plants to complement wind/solar or nuclear power.
Data from the BP Statistical Review.
For new load-following fossil fuel plants, continued wind/solar technology-forcing is actually a good thing. As shown below, dispatchable plants produce their highest output during times of high prices (when wind/solar output is low). Larger electricity price fluctuations caused by increased wind/solar market share is therefore positive for profitability.
Correlation between dispatchable power output and electricity price in Germany for the year to date (source).
As shown below, the average unit of load-following hard coal and gas power was already 50% more valuable than the average unit of wind power in Germany over 2017. This large difference will only continue to grow in the future.
Average value of different power sources in Germany for 2017 (source).
Capacity factors of new load-following coal and gas plants should not be greatly affected by further increases in wind and solar market share. Continued wind/solar technology-forcing will gradually displace baseload nuclear and coal plants, but load-following plants will remain critical for supply security for decades to come because of the low capacity value of wind and solar.
Another risk-mitigating factor for thermal power plants is the fuel price dynamic that will play out when fossil fuel demand finally plateaus and eventually starts falling. As soon as fossil fuel demand starts declining due to high CO2 taxes, fuel prices will drop precipitously. In a declining market, the need for new investments will dwindle, leaving only the operating costs to extract fossil fuels from existing fields and mines. From the point of view of a power plant, this dynamic will cancel out a sizable portion of the added cost of the high CO2 taxes responsible for the fossil fuel peak. CCS retrofits look particularly attractive in this scenario since it will capture the benefits of lower fuel costs while avoiding most of the high CO2 costs that caused the fuel cost decline.
Natural gas plants stand to benefit most from these trends. Compared to coal plants, natural gas plants have lower CO2 intensity, more to gain from fuel price declines after the fossil fuel peak, and greater flexibility to capitalize on increasing electricity price volatility caused by wind and solar. Natural gas supply security presents an important risk in some countries, but this is something the industry has decades of experience with.
From this qualitative analysis, nuclear appears to be the riskiest investment whilst load-following fossil fuel plants (especially natural gas) appear to be the safest. This will remain the case as long as wind/solar technology-forcing policies stay strong. However, these technology-forcing policies which not only include direct subsidies but also indirect incentives such as artificially low financing costs, no accountability for value declines and cost increases caused by intermittency, cannot last forever and when they fall away, wind and solar investment risk will increase substantially, while nuclear risk will decline. Under current conditions load-following fossil fuel plants will continue to benefit being hedged as they are against the unlikely (but very necessary) scenario of rapid CO2 price hikes by the possibility of CCS retrofits. This underlying CO2 factor will stay in play until fossil fuel demand eventually peaks.
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Appendix: Other factors influencing the discount rate
Aside from risk, the most important factor is the opportunity cost. This factor represents all the other potential investments that could have been made with the time, materials and expertise devoted to constructing the chosen power plant.
In the developing world, where the majority of future energy infrastructure will be built, a wide array of other economically enabling infrastructure is also required, including housing, roads, schools, hospitals, factories and commercial districts. It is crucial that investment is directed to the infrastructure that can deliver the fastest payback time to drive further economic growth. This can only be ensured by imposing a high discount rate, well in excess of the real economic growth rate.
Projected primary energy demand in developed and developing countries (source).
Other important factors that can impact the profitability of a new power plant include gradual performance degradation, gradual technological advancement of alternative solutions, and financial/legislative costs. If these factors are not directly accounted for in the levelized cost calculation, they should be included by increasing the discount rate by 3-5%.
All-in-all, the discount rate applicable to a developing nation should be around 10% plus a sizable risk premium.