I49 o At a Glance The World Bank FPD Note No. 16 July 1994 Power Sector Investment How Market Forces Are Challenging the Least-Cost Plans of Power Utilities Dennis Anderson Most of the power industry's engineers dustryperformance because they can and planners have gained their work help show whether investments, plant experience in vertically integrated operating (dispatching) schedules, and public utilities, where investments are prices are indeed being competitively identified through least-costplanning determined. models and bids are invited forprecise- ly specified types of plant. Now, howev- Massive change in the power sector er, private producers are "contesting" Institutionally and technologically, the the least-cost investment plans ofpublic electric power industry is undergoing utilities on the grounds that they can the most far-reaching changes in near- build and operatepower stations more ly six decades. From 1900 until around cheaply and more quickly than public 1940, independent producers were the utilities can. Private producers-togeth- main drivers of industry expansion. er with the new energy technologies- But rapidly declining marginal costs are driving a new approach to least- arising from scale economies and tech- cost investments in electricity supply. nical progress, together with econo- They are willing to absorb technical mies of interconnection, led to the andfinancial risks-something that consolidation of the independent pro- least-costplanning has never dealt ducers into "natural" public monopo- with satisfactorily-and to find more lies. Least-cost planning models were innovative ways to reduce risk-for example, by turning to more modular technologies with shorter lead times. Table 1 Private sector power development opportunities Traditional approaches to least-cost in the next five to ten years planning need to be overhauled. As (gigawatts) private investment increases, least-cost Private planning models will become less use- Current Future sector fulfor identifying the best investment Region capacity need potential cboices. Under the newparadigm, Asia 280 170 55 competition should lead to lower-cost Latin America 135 70 30 supplies. However, the least-cost models Source, Unpublished indicative data compiled by still will be usefulfor monitoring in- Mangesh Hoskote, World Bank. Industry and Energy Department Hka Vice Presidency for Finance and Private Sector Development * base-load plant with higher thermal efficiencies Forces shaping the power industry are still needed. * peak-load plant will usually be the older thermal * growth of privatization and independent generation. plant on the system, supplemented by low-capital- * increased range of power plant types now available. In cost plant, such as gas turbines. addition to conventional pulverized coal and stoker * thermal plant will still be operated in merit order, boilers, there are combined-cycle gas-fired, fluidized bed combustion, aeroderivatives, and integrated coal gasifi- except that the dispatchig schedules will be de- cation combined-cycle plants. There are also renewable cided by competitive bids rather than by a central energy technologies: thermal solar; wind power; cogen- dispatcher relying on the fuel and operating cost eration; photovoltaics for off-grid and (now being test- coefficients provided by the utilities' engineers. ed) decentralized grid connected supplies; and biomass- * where hydro plants provide a large share of the fired power plants using conventional boilers or gasification processes and combined-cycle technology. * modularity in power plant technologies. This modularity needed in dry years. has changed the locus of scale economies from the * the cost and operating characteristics of small- power plant to the factory. A consequence of this scale plant, of the decentralized forms of genera- change is that investments in small, modular power tion noted above, and of intermittent supplies plants are becoming feasible for independent producers. with or without storage, will be the same in prin- In the past, by contrast, economies of scale favored the large power plants built and operated by public utilities. ciple whether the supplies are public or private. So the cost simulation models developed by public enterprises could be used to predict how a com- developed in response to this situation, and have petitive system of private generation is likely to since been in widespread use. evolve or, alternatively, to assess whether private investment is taking place under genuinely com- Now, however, changes in technologies and costs are petitive arrangements. The models also can be working in the opposite direction, and the industry is adapted to analyze the prospects for new technol- becoming more "unbundled." Budgetary and other ogies, to estimate the marginal costs of supply (for stresses arising from poor operational and financial example, for regulation and oversight), and to ex- performance are also encouraging governments to amine questions of the cost and price efficiency of open up the industry to independent producers. private or public arrangements for the provision of supply. The numbers of private bids, unsolicited or otherwise, and the challenges to existing plans of public utilities, Private producers drive radical new approach will increase as private generation grows. There are Private generation entails few, if any, changes in many cases already-for example, in India (gas versus methodology, but it does involve a radical change coal), the Czech Republic (alternative types of coal in the approach to deciding on least-cost arrange- plant), and Honduras (wind versus diesel). Table I ments. Rather than identifying capacity and energy illustrates the scope for change by providing a recent requirements first and then using simulation studies assessment of private investment opportunities in the to identify the least-cost program, as the public util- power sector over the next five to ten years. ities do, in the private model both capacity require- ments and the choice of plant are determined by Narrower role for least-cost models competitive bidding and licensing. In other words, The economic characteristics of the least-cost solu- the algorithms in the computer software of the pub- tion are the same in theory whether the investments lic utilities are replaced by the market, and simula- are public or private. In privately as in publicly tion studies are no longer required to determine the owned systems: least-cost investment plan. There is an intermediate 2 Table 2 Methods for determining investments Capacity requirements Choice ofpower plant Traditional model Estimated by utility Cost simulation - Invite bids Intermediate case Estimated by utility Open bidding - Cost simulation studies Private model Market-determined Market-determined Cost simulation for monitoring only case in which private generation is allowed to com- there are questions of antitrust and integrity in pri- pete with public generation on an essentially public vate investment, and so on. The three cases are system; in such cases, bids are solicited from pri- summarized in table 2. vate producers before the simulation studies are performed, to help determine the least-cost invest- Investment choice and risks ment. This approach, similar to that used in the The technical and institutional changes in the pow- United States,' is relevant for countries that prefer a er sector suggest that the industry is likely to phased approach to privatization or for those that change rapidly and unpredictably. Already private see value in using the models for indicative plan- investment is producing a wider range of technical ning. In a fully privatized industry, planning and options. There is more emphasis on modular units simulation models may be used for looking back- with shorter lead times. Another possibility is the ward rather than forward, to assess market behav- emergence of decentralized generation, the "distrib- ior-whether prices are reflecting costs, whether uted utility." How investment decisions are made through least-cost planning The traditional approach to least-cost planning starts with a forecast of demand. Forecasts take into account a range of fac- tors-the growth of per capita incomes and populations; urbanization; the growth of industry and whether new electricity- intensive industries are emerging; the number of people who lack electric service and would like to have it (more than 2 billion in developing countries); and improved efficiency of consumer equipment and appliances. The next step is to define an investment program that would enable the power system to meet forecast energy and peak power demands with a reasonable probability of avoiding brownouts and blackouts. The investment program is not confined to new power plants, but could also include, for example, the reinforcement of transmission links with other regions that have lower-cost supplies or spare peaking capacity (for example, if their peak demands occur at different times). Simulation studies are then made of how the system would be operated to minimize costs; from these studies, total system operating costs are then estimated. The capital costs of the investment program are calculated separately and added to system operating costs to give the overall costs of the program being considered. Several alternatives and their technical feasibility are usually examined under this approach. Once the least-cost investments have been identified and agreed upon, bids are invited for each type of plant-for example, for a coal-fired station of a given capacity, for a hydro plant, for so many megawatts of gas turbines for meeting peak loads, or for a gas, diesel, or coal plant to provide the thermal complement to a hydro scheme. Consistency with efficiency in end- use is sought through commercial pricing policies in which prices reflect the marginal costs of supply by time of day, voltage level, and (depending on the system) season. 3 How risks are allowed for and who bears them will lead to different investment decisions-for example, Figure 1 Coal-fired power plants in the United a move to investments with shorter lead times, such States: Cost versus size as a gas-fired combined-cycle power plant. A more dramatic example is the reaction of private produc- Calculated cost ers to nuclear power. Private producers have been distinctly more circumspect than public producers. 2,500 Privatization has made the real costs of the environ- 2,000 - ; mental risks associated with nuclear power more transparent. 1,500 -- 1,000 - : ,._ Technical, economic, or other risks have never been - - . - _ "modeled" in a fully satisfactory way in the least- 500 - 9- ,- - ' - cost investment planning of public utilities. They 0 - have often been ignored. Investments normally 0 200 400 600 800 1,000 1,200 1,400 have been compared on the basis of expected costs, Nameplate capacity (megawatts) with risks addressed through sensitivity analysis. Allowances for contingencies (typically 10 to 25 Note: Costs were calculated using nameplate capacity and including allowance for funds used during construction. Sample percent, and slippages of up to one year) usually size is 401 plants. are included in the cost estimates. But in reality the dispersion of costs ex post is much greater than the ranges commonly assumed in sensitivity studies. vate costs. But as company records and reported Cost overruns of 20 to 50 percent are not uncom- returns in the financial markets show, real returns of mon.2 Even for a mature technology such as coal- this magnitude are not widely realized in practice. fired plant in an industrial country, ex post costs Where high returns are achieved initially, they are can vary enormously (figure 1). better seen as a benefit to the early risk-takers- unless there is evidence of disorderliness and a loss Private producers have to allow for risks in their of integrity in the bidding process. As risks decline, bids. (Exceptions arise only when contracts need- investment will increase, and the returns should de- lessly transfer technical and financial risks to the cline to more normal rates. So too should the real public purse, something that good contractual ar- costs of electricity production. rangements should avoid.) That helps to explain wh-iy high discount rates (20 percent or more) are See Hirst and Coldman in Annual Review of Energy and the often quoted for private investment. The high dis- Environmzent, Vol. 17, 1992. count rates allow for cost escalation and slippages. 2 Refer to forthcoming survey by John Besant-Jones (Energy and Indus- They will also include an allowance for country and try Department Paper, World Bank). political risks-an area where public insurance or risk guarantees may legitimately help to reduce pri- Dennis Anderson, Senior Advisor, Industry and Energy Department This series is published to share ideas and invite discussion. It covers financial and private sector development as well as industry and energy. The views expressed are those of the authors and are not intended to represent an official statement of Bank policy or strategy. i9 Printed on recycled paper. Comments are welcome. 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