Gene Freeman

1. Financial / Managerial Considerations in the Electric Power IndustryWhat’s Behind the SwitchLecture 7 Gene Freeman ECEN 2060 Fall 2013

2. Agenda • Decision Environment for Utility Companies • The Profit Equation & the Nature of Costs • Comparison of Generation Technologies & Decision Making Dilemmas • Predicting Future Costs for Facilities That Have Not Been Built Yet • Fixed Costs • Variable Costs • LCOE • Tactical Planning - Load vs. Capacity • Politics • Appendix Methods ECEN 2060 Fall 2013

3. Quiz • A business sells a device for $1.00 that costs $0.50 in variable cost to make. It sells 1,000,000 of them per year. The company’s fixed expenses are $250,000. What is the break-even point • What is the annual Operating Income at 1,000,000 units ECEN 2060 Fall 2013

4. Quiz Answers • QBE = FE / (ASP – uVC) = 250,000 / (1.00 - 0.50) = 500,000 units • OI = Q x (ASP x - uVC) – FE = 1,000,000 x (1.00 – 0.50) – 250,000 = $250,000 ECEN 2060 Fall 2013

5. Annual Fixed Cost Prediction for a New Facility • Adding a new utility plant involves • 20+ year estimates of future cost • $B of borrowing high interest loads • Uncertainties in future fixed costs • Interest rate fluctuations • Fixed operations cost variations (e.g. salaries, materials) • Insurance, Tax Rates, etc. • What is known before a new plant it is built • PR = Rated capacity (net output) in kW, MW or GW • Estimated capital cost of the project • Weighted Average Cost of Capital (WACC) ECEN 2060 Fall 2013

6. Estimating Cost of Capital - WACC • WACC = Weighted Average Cost of Capital • 2 kinds of borrowing for new plants • Construction loans during the build phase • Permanent financing once the plant is finished • “Over Night” vs. “All-In” construction costs • “Over Night” ignores construction loan charges • Allows comparison of big projects to small ones (e.g. CCNG to Solar) • Each company calculates its own WACC based on its particular capital structure and costs ECEN 2060 Fall 2013

7. Annualized Fixed Costs & FCR% • Fixed costs on a new plant are estimated as follows • (PR x Capital cost / kW) x FCR% • FCR% = Fixed Charge Rate • FCR% = CRF% + Ops Fixed Cost% + Tax % • FCR% may also include target profit objective • CRF = Capital Recovery Factor = [ i * (1 + i )n ] / [(1 + i )n -1] • i = WACC • n = # years • Appendix A elaborates on the “finance” concepts • It is the largest part of the FCR% • For a $1B loan @ 10% over 20 years • CRF = 11.75% • Annual Payment = $117.5M ECEN 2060 Fall 2013

8. Other Annualized Fixed Cost % • It is impossible to predict accurately the future fixed costs for a facility that has not been built yet • Ops Fixed Cost% factors are based on history from other plants of similar technology • Tax Rates are normally stable so % factor can be derived from prior history for the area where the facility is being built • Other fixed charge factors can be similarly estimated based on history or other data • These are added to CRF% to determine the multiplier that will be applied to the projected cost of construction of a new asset ECEN 2060 Fall 2013

9. Example 1.2 in book • Investor Owned Utility has 52% equity @ 11.85% and 48% debt @ 5.4% • 20 year payback period • WACC = (0.52 x 0.1185) + (0.48 x 0.054) = 8.754% • CRF = [0.08754 x (1 + 0.08754)20 ] / [(1+0.08754)20 – 1] = 10.763% • To build a new facility with estimated values • Construction cost = $1300/kW rated power • 2% adder for Ops Cost • 4% for Taxes • FCR = 16.763% (10.673% + 2% + 4%) • For every kW of rated power, • Fixed Costs = ($1300 / kW * 0.16763) = $218 / year ECEN 2060 Fall 2013

10. Agenda • Decision Environment for Utility Companies • The Profit Equation & the Nature of Costs • Comparison of Generation Technologies & Decision Making Dilemmas • Predicting Future Costs for Facilities That Have Not Been Built Yet • Fixed Costs • Variable Costs • LCOE • Tactical Planning - Load vs. Capacity • Politics • Appendix Methods ECEN 2060 Fall 2013

11. Variable Cost Uncertainty • Fuel is the biggest operating cost for a fossil fuel plant • Future fuel costs are difficult to predict and compare • Variability in pricing • Differences in conversion rates of fuel into electric power • Transportation costs • Economic modeling is used to smooth out variability ECEN 2060 Fall 2013

12. Computing Annualized Variable Costs • Annual Energy Output kWhr/yr = PR x 8760 hrs/yr x CF PR = Rated Output Power in kW CF = % of a year that the plant operates • Preventative maintenance • Break-downs • Fuel shortages • Lack of demand • Planned Utilization • Margins • Annualized Var. Cost $/yr = (fuel cost + OM var) $/kWhr x Output kWhr/yr • Fuel Cost $/kW = Fuel Cost $/MBTU x Heat Rate BTU/kW x LF • LF (leveling Factor) is the accounting method for normalizing future fuel cost fluctuations (see graph on next slide) • Variable Operations and Maintenance cost are usually specified in $/kWhr ECEN 2060 Fall 2013

13. LF – Levelizing Curves for Cost of Energy • See Appendix A in Text for derivation ECEN 2060 Fall 2013

14. Annualized Variable Cost Estimate from Ex 1.3 • NGCC plant has the following statistics • NG costs - $6/MBtu with 5% / yr inflation rate • Interest (Discount) Rate = WACC = 10% • Thus LF =1.5 based Fig 1.28 @ 5% inflation & 10% discount rate • O&M variable Cost = 0.4¢ / kWhr • Heat Rate = 6900Btu / kWhr • CF = 0.7 (i.e. plant runs 70% of the time during a year) • Annual Energy Delivered per kW of rated power = 8760 hrs x 0.7 = 6123 kWhr / yr • Annual Fuel Cost / kWhr rated 6132 kWhr / yr x 6900 Btu / kWhr x $6 / MBtu x 1.5 = $381 / yr • O&M cost /kW rated per year = $0.004 x 6132 kWhr / yr = $25 / yr • Total annual variable cost per kWhr = $381 + $25 = $406 / kWhr ECEN 2060 Fall 2013

15. Agenda • Decision Environment for Utility Companies • The Profit Equation & the Nature of Costs • Comparison of Generation Technologies & Decision Making Dilemmas • Predicting Future Costs for Facilities That Have Not Been Built Yet • Fixed Costs • Variable Costs • LCOE • Tactical Planning - Load vs. Capacity • Politics • Appendix Methods ECEN 2060 Fall 2013

16. LCOE – Levelized Cost of Energy • = (Annual Variable Cost + Annual Fixed Cost) / Annual Output = $/kWhr • This is an important figure when comparing various types of power generation systems, especially conventional fossil fuel systems to alternative energy sources • It is an estimate of what future electric power output would cost from any given technology based on • Rated Capacity of the facility • Planned Construction Costs • A bunch of assumptions • Prior experience • Accounting methodologies • For Example 1.3 LOCE = ($218 + $406) /( 8760 x 0.7) = 10.17¢ per kWhr ECEN 2060 Fall 2013

17. Agenda • Decision Environment for Utility Companies • The Profit Equation & the Nature of Costs • Comparison of Generation Technologies & Decision Making Dilemmas • Predicting Future Costs for Facilities That Have Not Been Built Yet • Fixed Costs • Variable Costs • LCOE • Tactical Planning - Load vs. Capacity • Politics • Appendix Methods ECEN 2060 Fall 2013

18. Tactical Decisions - Cost Optimization Issues • Load vs. Capacity – hour by hour business problem • Peak Load Buying • Base Load Selling • Customer Demand Profiles • Proximity of Loads to Sources • Fuel costs / kWhr are a different • Different Conversion Efficiencies • Different $ / MMBTU $ / kWhr • Different Emissions • Location of plants affects both revenue and cost • Rate Governance is Local • Tax Rates are Local, State & Federal • Grid losses to the loads • Transportation Costs for Fuels • Fixed costs are different from plant to plant • Operations & Maintenance (age of systems) • Depreciation & Amortization (initial cost of systems) • Interest Rates on the Debt ECEN 2060 Fall 2013

19. Demand Profile for a Mid-Western Utility • Mix of customers in 8 states in Mid-West • Load peaking occurs during Summer Afternoons (cooling) and Winter nights (heating) • Buy power from suppliers to cover the peaks • Sell excess power to the grid at wholesale rates • Proximity of generation to large demand customers is important to reduce line losses • Proximity of plants to fuel sources reduces transportation costs • Generation sources are spread out over the region ECEN 2060 Fall 2013

20. Generation mix for Mid-Western Utility Note the range of output capacity vs. the type of generation ECEN 2060 Fall 2013

21. Transmission & Distribution ECEN 2060 Fall 2013

22. Capacity Utilization Logic – All Utilities • The Mid-Western example company has 50% more capacity than it was able to sell • (17GW ~ 150GkWhrs) • The company sold 105GkWhrs in 2012 • It also had to buy 34.9GkWhrs at wholesale rates on top of what it could generate on its own • Why is there so much excess capacity in their system? • No plant can operate at a CF = 1 • Some plants are too expensive to operate at all (i.e. uVC > ASP) but they are required to cover peak load periods • Plant failures occur that cause unscheduled down time • Preventative maintenance is required for all equipment, especially plants that are at the end of their useable life • Weather and accidents sometimes hit the grid causing localized outages that must be “boot-strapped” by other sources • Transmission & distribution losses reduce effective capacity (10% to 20% ECEN 2060 Fall 2013

23. Capacity Utilization Logic – All Utilities • Maximize utilization (CF) of existing high fixed cost / low variable cost generation facilities first • Coal Fired Steam • Nuclear • Hydro in some regions • Use higher variable cost facilities next to supplement base capacity • Gas fired steam or Combined Cycle plants • Cover peaks with purchased power or Gas Fired Central Turbines (highest variable cost) only when needed • How Solar and Wind fits depends upon the company • Safety margins are set to protect grid during peak loading and buffer down time • Avoid rolling blackouts to compensate for capacity shortages, but protect the grid ECEN 2060 Fall 2013

24. Yearly Load Profile – Load Duration Curve Hour to hour load variability over a whole year – 8760 hours Load Variability reordered from highest to lowest ECEN 2060 Fall 2013

25. Load Duration Curve ECEN 2060 Fall 2013

26. Screening Curves • These curves plot the LCOE vs. capacity utilization for various types of generation technology • The logic for developing these curves is explained in the text on pgs 42 & 43 for a NGCC plant . A similar logic is used for the other technologies • These curves are used to rank order which types of power will be used to meet what parts of the load duration curve i.e which plants will be turned on at what time of day ECEN 2060 Fall 2013

27. Break Even – The Utility Industry Model • The x axis is the number of hours in a year and any point along it represents the CF for a given asset (the number of hours in a year it is actually utilized) • The dark line is the total cost line. • This kind of graph is used to derive the screening curves that dictate which asset is to be used for which load level. This is different for each type of generation asset in the company The text needs to be corrected for ex1.3. Total cost of energy @ 0.7 CF is $624 not $579 ECEN 2060 Fall 2013

28. Adding in Crossover Points from Screening Curves This curve is unique for each operating company. ECEN 2060 Fall 2013

29. Agenda • Decision Environment for Utility Companies • The Profit Equation & the Nature of Costs • Comparison of Generation Technologies & Decision Making Dilemmas • Predicting Future Costs for Facilities That Have Not Been Built Yet • Fixed Costs • Variable Costs • LCOE • Tactical Planning - Load vs. Capacity • Politics • Appendix Methods ECEN 2060 Fall 2013

30. $$$$$$ $$$$ $$ $ $$ $$$ $$$$$ 3 Sides of the Alternative Energy Argument • Nothing needs to change • Large sums are being spent by critics debunking the data / science • Fostered by those with a big stake in the present economics • “Global warming is a farce driven by political agendas in Wash. D.C.” • “Use only PC or NG, we have plenty of it, it is the cheapest solution” • “Stop using tax $ to develop new technologies” • We are running out of time • Intolerable climate change due to green house gases • “Eliminate fossil fuel consumption” • “Energy conservation a strategic imperative” • “Use alternative energy regardless of the cost” • The system will continue to be governed by basic economics • Core issues with alternative sources must be resolved before they can be deployed. More engineering work is needed • Investment in alternative sources will be paced by market forces • New additions must demonstrate technical and economic competence • Decisions will be based on costs & ROI • Investment in Grid management reduces excess capacity • Convert PC to CCNG to reduce costs and emissions ECEN 2060 Fall 2013

31. Economic Realities • The installed base will not be scrapped in favor of alternative power alternatives • $ write off of existing generation capacity ~ $1T - $10T • $ investment required for the alternatives ~ $20T • Operating cost differentials favor new technology - $3 - $10 /MWhr, but • $12.6B - $42B / yr saving for 4.2M GWhrs • 595 year payback (best case) • 2381 year payback (worst case) • Conversion to alternative technologies will depend on • Fixing deficiencies • ROI • Nuclear & hydroelectric have the lowest atmospheric impact • Both require a lot more political / social support • Large $$$$$$ investments required • Nuclear waste disposal methods are not yet accepted by most people ECEN 2060 Fall 2013

32. Scientific / Political Realities • Global warming evidence is not fiction • How much is caused by human activity • How much is due to natural phenomenon • The effects of both are additive! • Regulations on pollution output will be stringent • Adding to plant cost (initial investment and operating costs) • Use of coal for generating electricity will continue to decline • Converting obsolete capacity to cleaner alternatives is good politics and good business • Installing pollution free sources for new capacity is problematic • The industry has to continue to develop alternatives • Decisions on which ones fit best will be made on a regional / company by company basis • Spending more money on PR campaigns won’t change the facts ECEN 2060 Fall 2013

33. Agenda • Decision Environment for Utility Companies • The Profit Equation & the Nature of Costs • Comparison of Generation Technologies & Decision Making Dilemmas • Predicting Future Costs for Facilities That Have Not Been Built Yet • Fixed Costs • Variable Costs • LCOE • Tactical Planning - Load vs. Capacity • Politics • Appendix A Methods ECEN 2060 Fall 2013

34. Analysis Methods Text – Appendix A • Payback Period: Time when ∑profits = Initial Investment (I) • Text Example - 5 yr payback ($200 / yr savings) on an energy efficient air conditioner that cost $1000 more to buy • Most projects have non-linear payback rates • I = $1000 & profit schedule below • Payback Period ‘A’ = 2.33 Yrs • Payback Period ‘B’ = 4.0 Yrs • ‘A’ looks better but ‘B’ has better • overall return • Method ignores total life cycle returns • Suppose ‘A’ was in months ECEN 2060 Fall 2013

35. Analysis Methods Text - Appendix A • Return on Investment ROI = (Returns – I) / I • Text Example - 5 years of $200 on a $1000 investment • For non-linear returns, add up annual returns and calculate a ROI • Consider the following for the same $1000 investment • ROI ‘A’ = 300 / 1000 = 30% - 4 yrs cum • ROI ‘B’ = 1100 /1000 = 110% - 6 yrs cum • ROI ‘B’ = 0 / 1000 = 0% - 4 yrs cum • B looks better with 6 yr investment horizon • Ignores time value of money and risk ECEN 2060 Fall 2013

36. Analysis Methods Text – Appendix A • Present Value = Future Returns / (1+discount rate) n n = number of years returns are accumulated • Text Example – Constant annual returns for 2 different motors discounted over 20 yrs • In our example I = $1000 & discount rate = 10% • NPV = PVx – Initial Investment • ‘B’ looks better • NPV ‘A’ = 78.81 (7.9%) • NPV ‘B’ = 403.94 (40.4%) • Emphasis still on total return • Could fund both – NPV >0 ECEN 2060 Fall 2013

37. Analysis Methods Text – Appendix A • IRR – special case in NPV method • Determines discount rate that causes PV = I • Difficult to compute manually – requires iteration or spread sheet function • Helps normalize return for projects with different life times and return profiles • Allows comparison of projects to cost of capital (COC) • IRR ‘A’ ~ 14% • IRR ‘B’ ~ 19% • ‘B’ has better IRR • Both could be funded if COC <14% ECEN 2060 Fall 2013

38. Analysis Methods Text – Appendix A • Cash flow analysis is a way to look at the effect of variability of the independent variables or results over time • Revenue • Costs • Interest rates • Tax rates • Etc. • The engineer makes inputs to these types of analyses, they are normally handled by bean counters • This is nothing more than a “Model” for how cash flows into and out of an enterprise as a result of a decision ECEN 2060 Fall 2013

39. Which Analysis Method Is Best? • Whatever one your company / boss requires • Avoid over-analysis. Remember Pareto’s Law • Most important is getting the assumptions right • Future costs (labor rates, material costs, energy, interest rates) • Pricing (what people will be willing to pay, competitors) • Use high / low / median values to establish ranges for results ECEN 2060 Fall 2013