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USE OF CAPITAL AND COST OF GENERATION IN ELECTRICITY SUPPLY

H U G H B A R R

APPLIED MATHEMATICS DIVISION, DSIR P.O. BOX 1335, WELLINGTON, .

SUMMARY

This paper shows Electricity Division (ED) of the Ministry of Energy has had a real rate of return averaging 3% over the last 35 years. It is presently at that level, although it was as high as 5% in the I960’s. Treasury guidelines of 10% return, would require major increases in the price. The paper also considers historic cost of generation, which is heavily dependent on real rate of return (Figure 3), and discusses the difficulty of assessing the~performance of a monopoly supplier. Having ED justify investment projects and price increases to an independent review board appears a good approach.

1. INTRODUCTION

Proposals have been made to turn Electricity Division (ED) of the Ministry of Energy into a corporation, with financial objectives that would considerably raise the price of electricity [1]. Electricity supply is a state monopoly with prices set politically, and with subsidised loans. Present price is about half the cost of new generation assuming the Treasury guideline of a 10% real rate of return is required [2, P24].

The massive effect of inflation requires that costs and prices be expressed in real terms, that is deflated by the Consumer Price Index. For instance, prices increased five times between 1970 and 1984. Real prices are equivalent to assuming zero inflation. Prices are therefore expressed in 1983-4 financial year dollars. The construction cost index was not used, as it is the price of electricity to consumers, relative to other prices this is of interest.

Views expressed are those of the author. $OOOM 1084 Dollar* was life year 50 a to corresponding 2%, of rate depreciation A years. eun o h sse vr h ls 3 er [] E s lftms of lifetimes use ED [4]. years the 35 of last value the over salvage) (or system the residual for a return Given 1950. since expenditure, and chosen. The 1984 residual value, calculated from real costs depreciated depreciated costs real from calculated value, billion. $8.5 residual was 1984 2% at The chosen. system in 1984, it is possible to calculate an average real rate of of rate real average an calculate to possible is it 1984, in system transmission. This implies an average weighted plant life of 50-50 50-50 of life plant weighted average an implies This transmission. t itrc ot i tms fhg inflation. high estimated the of of times 42% in only is cost, This historic at billion. $3.6 only was 1984 in value and real total capital depreciated by 2 by depreciated capital total real and system residual value in 1984 and shows the undevaluing of assets recorded recorded assets of undevaluing the shows and 1984 book in years, 16 value next residual the in system billion $6.7 of investment capital further 1967. the and since curve, capital especially inflation, depreciated by real the caused value, between book divergence significant 100 years for hydro, 40 for thermal, 30 for geothermal and 25 for for 25 and geothermal for 30 thermal, for 40 hydro, for years 100 (at 4 times the scale), the actual book value converted to 1984 dollars, dollars, 1984 to converted value book actual the scale), the times 4 (at . AIA VLEAD EL AEO RETURN OF RATE REAL AND VALUE CAPITAL 2. Annual figures [3] are available on ED1 s capital investment, income income investment, ED1 on capital s available are [3] figures Annual ok au a $ blin n 98 i ra trs I sie of spite In terms. real in 1968, in billion $4 was value Book Figure 1 graphs real total capital , annual real capital formation formation capital real , annual capital total real graphs 1 capital. book Figure and real in Changes 1: Figure Year

i 72

anal. hr hs en a been has There annually. ed aia Frain $OOOM Formation Capital Reed Real Rate of Return (%) 8% and 10% real rate of return in 1984, would have required price price required have would 1984, in return of rate real 10% and 8% hr (, 0 i te mriain atr o a el ae frtr r, return of rate real a for factor amortisation the is 50) A(r, where of rate depreciation A closely mirrors annual real rate of return, underlining the close close the underlining return, of rate real annual mirrors closely xedtr xldn dpeito ad neet Ti i son n iue 2 Figure in shown is This interest. and depreciation excluding expenditure connection between real price and a real rate of return, over this this over return, of rate real a and price real between connection was It years. these of 4 in 5% along with the real electricity price at generation (INC/total generation generation (INC/total generation at price operating total electricity the real is the the EXP in with and along invested income, total capital the of is INC value real years, the 50 is previous TOTCAP life, year 50 a and au $ blin ihr ad ra rt o rtr i ihr t 3.3%. at higher i% return of rate real a and higher, billion $1 value increases of 24%, 59% and 100% respectively. Real price at generation generation at interval. price Real respectively. 100% and 59% 24%, of increases for the 35 years was 2.3%. A depreciation rate of li% gives a residual residual a gives li% of rate depreciation A 2.3%. was years 35 the for i Kwh). n 90 198: 0 8 9 1 5 7 9 1 0 7 9 1 5 6 9 1 0 6 9 I 5 5 9 1 1950 i ______n prxmt ana ra rt o rtr cn e on from found be can return of rate real annual approximate An Real rate of return was above 4% between 1960, and 1970 and above above and 1970 and 1960, between 4% above generation. was at return price of and rate Real return of rate real Annual : 2 Figure With a residual value of $8.5 billion, the real rate of return return of rate real the billion, $8.5 of value residual a With (, 0 = ICya) EPya)/0CPya) , EXP(year)]/T0TCAP(year) - [INC(year) = 50) A(r, 1 - - i 1 - 2i% dcess h ra rt o rtr t 2.3%. to return of rate real the decreases ______3.2% l— ____ Year n 94 T rie hs o 5%, a to this raise To 1984. in ■ ______73 i ------1 ------1 ------

1 | el rc (c/Kwh) Price Real 74

The low real rate of return in 1984 contrasts with the apparently healthy book profit of $304 million, on book assets of $3.6 billion.

3. HISTORIC GENERATING COSTS

From capital expenditure by station per year [3] one can compute real capital costs for a plant. Dividing this by expected annual energy generation gives a capital cost to produce one Kwh/year. Actual capital and operating costs are shown in Table 1.

Table 1: Historic Real Capital and Operating Costs (1984 Prices) Source [4, Table 4]

Present Capital Operati ng Construction Station Cost* Cost** Time Li fe c/Kwh c/Kwh (years) (years)

Aratiatia Hydro 55 0.7 3 100 Benmore Hydro 30 0.6 8 100 (42+) Roxburgh 39 0.6 8 100 Clyde Hydro 50 0.6 7 100 (Est imated) (64+) Wairakei (Geothermal) 33 1.1 3 30 New Plymouth (Gas) 19 2.5 7 40 Huntly (Coal) 29 4.5 10 40 Marsden B (Oil) 25 10.9 5 40

* includes 25" overheads for capacity margin and transmission ** includes 0.5c/Kwh for overheads + includes 10% transmission losses and9c/Kwh transmission capital cost to

Thermal stations have the cheapest capital costs, but have high operating costs. Hydro stations have high captial costs, but low operating costs. Geothermal is intermediate. The way of relating capital and operating costs is through the real rate of return required and the expected life. Time to build the station also has an appreciable impact. Figure 3 shows total cost/Kwh against real rate of return required, for the typical stations, Roxburgh, Wairakei, New Plymouth and Huntly (on coal).

Roxburgh, Wairakei and New Plymouth are all competitive between a 5% and 10% real rate of return. Huntly on coal is uncompetitive at all rates of return. Table 1 shows new South Island hydro, eg, Clyde will be more expensive than Roxburgh. Lack of gas rules out new gas stations. The new Mokai geothermal field is most attractive with a cost of generation of 5c/Kwh, [5, p46l. Further large stations based on underground coal will be expensive. 75

Figure 3: Variation in generating cost with real rate of return.

4. FUTURE ELECTRICITY PRICES

The Treasury argument for higher electricity prices is that industry routinely earns 10% real before tax. More important, present subsidised electricity prices discourage conservation, and consequent over-investment in supply. It would be more appropriate to charge ED market interest rates, and revalue their assets to $8.5 billion. This would put them on a par with the private sector, whose real rate of return varies and is not a constant 10%, and whose equity assets revalue on the stock market. A doubling of the price of electricity in real terms is politically unacceptable to industry and domestic consumers alike. A target 6-3% real rate of return is more realistic. This would involve a 25-70% lift in real prices. Overseas competitors may not earn such high rates. Systems in New South Wales, Victoria and Tasmania were recently earning negative real rates [6]. The target in Victoria, and Sweden is 4%.

5. CONCLUSION

The present monopoly system with direct political price setting, and subsidised loans, leads to low prices and over-supply. However, making ED a Corporation would loosen public accountability without any guarantee of better performance. 76

ED1s past performance has been both good and bad. hydro stations, built in the 1950's were the cheapestand best option available, as was Wairakei in 1960. (1960) and Marsden A (1965) are effective dry year firming stations. The Cook Strait Cable was an inspired idea, allowing much cheaper Benmore hydro to be developed (Table 1). Gas fired Stratford and New Plymouth have attractively lov costs. More questionable decisions include cheap power to the Bluff smelter, errors in forecasting and consequent over supply in the 1970s, building of oil fired Marsden B, and Whirinaki after the 1973 oil shock, the very expensive Tongariro scheme, the unneeded Clyde dam, and the too large Huntly scheme using too expensive underground coal.

Some observers picked the ED white elephants at the time, and they are readily apparent with hindsight. I believe an independent Review Board, of knowledgeable independent assessors, from which ED would need to gain approval for price increases, would be the best way to curb its monopolistic position. This system is used in the USA, with considerable success in persuading utilities to be efficient, and to try sensible alternative supply modes, including conservation.

6. REFERENCES

[1] "Financial Objectives and Pricing Review of the Ministry of Energy (Trading)" Ministry of Energy, July 1984.

[2] "Report of Electricity Sector Planning Committee: 1984", Electricity Division, Ministry of Energy, 1984.

[3] Annual Reports; State Hydro Electric Department, NZED, Ministry of Energy 1950-84.

[4] "Electricity Division Use of Capital and Cost of Generation", H 3arr, Report 124, Applied Mathematics Division, DSIR, Wellington, 1985.

[5] "Proving and Development of Geothermal Fields", HBarr, M Grant, R McLachlan, Report 116, Applied Mathematics Division, DSIR, Wellington, 1984.

[6] "Real Rates of Return in Electricity Supply: NSW, Tasmania, and Victoria", P L Swann, Australian Graduate School of Management University of NSW, May 1984.