Financial Risk Mitigation
As the energy industry moves from the monopoly, no-risk financial environment toward more competition, financial risks must be addressed. The no-fuel, modular attributes of renewable-energy technologies can mitigate many of these financial risks. Below we study some of these financial risk-management values.
Uncertainties/Financial Risks
Fuel Prices/Fuel Costs
Environmental Regulations/Environmental Compliance Costs
Energy Demand/Lead
Time
Plant Construction Costs/Lead Time
Plant Construction
Costs/Modularity
Plant Availability/Modularity
Plant
Value/Investment
Reversibility
Fuel Costs
A frequently cited attribute of renewables is that they have no fuel costs. So, there is no uncertainty associated with future fuel prices. The value of eliminating fuel-price uncertainty can be determined by evaluating what it would have cost to enter into a long-term, fixed-price fuel contract such as a natural-gas contract. This transaction has a direct cost and an indirect cost. The direct cost is the present value cost of the fuel contract with the discount rate being the firm's debt rate. The indirect cost is the cost associated with changes in the firm's capital structure because such a contract is comparable to taking out a loan and has characteristics that are similar to debt financing.
Supporting Publications:
"Integrating Renewable Energy Technologies in the Electric Supply Industry: A Risk Management Approach" Abstract or in PDF format (PDF 431 KB).
Environmental Compliance Costs
Renewable-energy technologies tend to have minimal costs associated with environmental legislation. This results in a benefit of renewables relative to fossil-fuel-based plants. Environmental costs incurred by a fossil-fuel-based plant owner fall into two categories. First, there is the added cost of building the fossil-fuel-based plant to satisfy current environmental standards. Second, there are the potential costs that the fossil-fuel-based plant owner might incur in the future to satisfy environmental standards that have not yet been established. While the added cost to satisfy current standards is typically included in the initial capital cost of the fossil-fuel-based plant, potential future costs are not. This results in a relative benefit associated with renewables.
Supporting Publications:
"Integrating Renewable Energy Technologies in the Electric Supply Industry: A Risk Management Approach" Abstract or in PDF format (PDF 431 KB).
Plant Construction Costs/Lead Time
Utilities are still considered to be regulated natural monopolies. This requires them to serve all customers regardless of whether or not it is profitable to do so. The interaction between demand uncertainty, plant lead-time, and capacity additions is of concern to these utilities. A typical approach to incorporating demand uncertainty is to project high, average, and low demand scenarios. An accurate evaluation of the value of technologies with short lead-times, however, requires that the dynamic nature of demand uncertainty be captured because demand can grow at different rates over time. As shown below, highly modular, short lead-time plants can have a much higher per-unit cost than the non-modular, long-lead-time plants. The solid line presents the expected plant cost when the dynamic nature of demand uncertainty is considered and the dashed line presents the expected plant cost when the dynamic nature of demand uncertainty is not considered. That is, considering demand growth as a dynamically unfolding process makes longer-lead-time plants even less valuable because so much more uncertainty accumulates about whether and when they might be needed.
Supporting Publications:
"Integrating Renewable Energy Technologies in the Electric Supply Industry: A Risk Management Approach" Abstract or in PDF format (PDF 431 KB).
"Investments Under Uncertainty: State Prices in Incomplete Markets" Abstract or in PDF format (PDF 422 KB).
Plant Construction Costs/Modularity
In addition to having short lead-times, a number of renewable technologies provide plant owners with added value because they are modular and have location flexibility. The figure below shows the value of a short lead-time. When combined with modularity and location flexibility, this value can be high when the technologies are used to defer long-lead-time transmission and distribution (T&D) system investments.
Supporting Publications:
"Integrating Renewable Energy Technologies in the Electric Supply Industry: A Risk Management Approach" Abstract or in PDF format (PDF 431 KB)
"Identifying Distributed Generation and Demand Side Management Investment Opportunities" Abstract
"Distributed Generation: An Alternative to Electric Utility Investments in System Capacity" Abstract
Plant Availability
Modular plants are attractive from an availability perspective. First, modular plants can begin operation as each segment of the total plant is completed (shown as the red "stepped" path on the figure below). So, modular plants produce revenue earlier than non-modular plants.
Second, the availability of a modular plant is more certain than non-modular plants if equipment failures are independently distributed. This is because a failure in a modular plant only affects a portion of the plant while a failure in a non-modular plant affects the entire plant.
Supporting Publications:
"Integrating Renewable Energy Technologies in the Electric Supply Industry: A Risk Management Approach" Abstract or in PDF format (PDF 431 KB)
Plant Value
Modular plants are attractive from an initial capital-cost perspective. First, fewer capital resources are tied up for a shorter period of time when the plant is under construction. This reduces the possibility that the firm building the plant will get into financial difficulty and may result in a lower rate of return required by investors.
Second, modular plants have off-ramps so that stopping a project is not a total loss. The figure below shows that the modular plant with two segments is worth $125,000 more than the non- modular plant when plant cost is uncertain.
Supporting Publications
"Integrating Renewable Energy Technologies in the Electric Supply Industry: A Risk Management Approach" Abstract or in PDF format (PDF 431 KB).
Investment Reversibility
Investment reversibility is the degree to which a completed investment is reversible. A reversible plant will have a high salvage value should the plant owner need to remove the plant for some reason (e.g., if the plant s value becomes low in the particular application). Modular plants are likely to be more reversible than non-modular plants because they can be moved to areas of higher value or used in other applications.
The figure below presents the value of the option to abandon a plant as a percentage of current market value versus the plant's salvage value. The U's denote the level of future plant value uncertainty (a larger number means that there is more uncertainty). The percentages on the x-axis describe how much of the plant can be salvaged. And the percentages on the y-axis describe how much more the plant is worth when the investment can be reversed. The figure suggests, for example, that the value of the abandonment option is 20% of the plant's current market value when the value uncertainty (U) equals 50% and plant salvage value is 75% of the current market value.
Supporting Publications:
"Integrating Renewable Energy Technologies in the Electric Supply Industry: A Risk Management Approach" Abstract or in PDF format (PDF 431 KB).