ECONOMICS OF ELECTRICITY

GENERATION

dr. Péter Kaderják

Director, REKK

NARUC Training on Tariff Development and Utility

Regulation
May 7-11, 2007, Baku, Azerbaijan
OUTLINE

• Costs of generation
• Demand for and supply of electricity in
the short run
• Technology choice in the long run
• Price setting at the plant level
• Price setting at the wholesale level

2
UNDERSTANDING GENERATION

• Converting one form of energy into

electric energy
• Electricity generation:
• Fossil: combustion – heat – steam cycle
• Nuclear, geothermal: heat – steam cycle
• Direct: wind, hydro
• Investment creates power or capacity
(MW)
• Both capacity and energy are flows and
the price of them can be measured in
$/MWh
3
COSTS OF GENERATION

• Total cost (TC) = Fixed cost (FC) + Variable

cost (VC)
• FC: related mostly to investment and
economic profits to be earned; in the short
run O&M, wages, depreciation social fund
and other obligations are also fixed;
independent of the level of production
• VC: fuel cost; depends on the level of
production
• Marginal cost (MC): the change of TC when
output is increased by 1 unit
• MC = constant, when VC is linear (we
assume) 4
EXAMPLE: MARGINAL COST BY
TECHNOLOGY AND MERIT ORDER

Technology Installed Marginal Life-time

capacity production years
(MW) cost
($/MWh)
Nuclear 1000 4 40

Coal 800 20 40

OCGT 400 60 40

CCGT 700 26 30
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MARGINAL COST ESTIMATION

• Costing fuel conversion into electricity:

short run marginal cost of generation
• Cost of fuel ($/m3)
• Heat content of the fuel (GJ/ m3)
• Conversion of GJ into kWh
• Heat rate (efficiency) of conversion
• Comparing costs to electricity prices
• Spark spread: gas-to-electricity market
prices
• Dark spread: coal-to-electricity prices
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COST OF FUEL

• Transparent market benchmarks

• Coal
• Gas: Henry Hub (US)
• Oil (Brent)
• Oil – gas link (log-term gas contracts)
• Long term contract prices
• Self-reports
• Extraction cost estimates (in case of own fuel
base; e.g. integrated generation and lignite
mine)

7
EXAMPLE: GAS PRICING FORMULA IN
A TYPICAL EARLY TOP

si=96,8*(0,5*A/Ao+0,5*B/Bo)

A: average of last 9 months diesel price

B: average of last 9 months heavy fuel oil price
Ao: diesel price on January 1, 1996 (147,95 $/t)
Bo: heavy fuel oil price on January 1, 1996 (135 $/t)
96,8 $/1000 m3: agreed starting price by January 1, 1996

Estimated gas import price / oil price link:

Si=4,9+4,4*brent

8
CONVERSION TABLES

• Costing fuel conversion into electricity:

9
HEAT RATE ESTIMATES

G a s /O il S T C o a l S T N u c l e a r S T C C G T G a s G a s / O il G T
1960 3 7 ,0 % 3 5 ,0 % 2 5 ,0 %
1970 3 9 ,0 % 3 7 ,0 % 2 7 ,0 %
1980 4 1 ,0 % 3 9 ,0 % 2 9 ,0 % 3 0 ,0 %
1990 4 3 ,0 % 4 1 ,0 % 3 1 ,0 % 5 0 ,0 % 3 4 ,0 %
2000 4 5 ,0 % 4 3 ,0 % 3 3 ,0 % 5 5 ,0 % 3 6 ,0 %
2010 4 6 ,0 % 3 6 ,0 % 5 8 ,0 % 3 8 ,0 %
2020 4 9 ,0 % 3 9 ,0 % 6 0 ,0 % 4 0 ,0 %
2030 5 2 ,0 % 4 2 ,0 % 6 2 ,0 % 4 1 ,0 %
2040 5 5 ,0 % 4 5 ,0 % 6 4 ,0 % 4 2 ,0 %

G r o s s f u e l e f f ic i e n c y p a r a m e t e r s a s s u m e d i n t h e K E M A
s t u d y f o r p o w e r p l a n t s c o m m i s s io n e d i n t h e i n d i c a t e d
y e a r s . F o r y e a r s i n b e t w e e n , f u e l e f f ic ie n c y c a n b e
l i n e a r l y e x t r a p o la t e d .

ST: s t e a m t u r b in e
CCGT: c o m b in e d -c y c le g a s tu r b in e

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ESTIMATION: INDIVIDUAL
GENERATION UNIT

1. Generating plant
2. Number and type of units
3. Unit capacity – Total plant capacity –
Available capacity
4. Year of commissioning
Gross efficiency (e)
5. Fuel type
6. Fuel cost (cent/GJ) (C)
7. Marginal cost: C*0,036/e
8. Correction for self consumption
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LOAD DURATION (SUPPLY) CURVE:
EXAMPLE

$/MWh

60

26

20

1000 1800 2500 2900 MW

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SHORT RUN MERIT ORDER AND
MARKET PRICES

Prices are set by the marginal plant

Price formation on competitive short-term electricity markets
Marginal Cost

Supply

Demand

Market price

GT

CCGT

coal

nuclear lignite
hydro

Capacity

Source: EU Energy Sector Inquiry Report

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PRICE FORMATION BY CHANGES
IN DEMAND AND SUPPLY

Price Price
Preis
Preis

P2 P2

S2 S1

D1 D2
P1
P1
D
S

Q1 Q2 Volume
Menge Q Volume
Menge

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APPLICATION BASED ON PUBLIC DATA –
estimated merit order for SEE markets

60.00
UNMIK
MK RS

50.00
HR

ME BG RO
40.00

BA
€/MWh

AL
30.00

20.00

10.00

-
0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 18,000
MW

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APPLICATION BASED ON PUBLIC DATA –
estimated aggregate merit order for SEE

60.00

50.00

40.00
€/MWh

30.00

20.00

10.00

-
0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000
MW

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APPLICATION BASED ON PUBLIC DATA –
peak demand, January 2006; source: UCTE

9,000

8,000

7,000

6,000

5,000
MW

4,000

3,000

2,000

1,000

0
AL BA BG HR ME MK RO RS UNMIK

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APPLICATION BASED ON PUBLIC DATA –
estimated equilibrium in peak and off-peak
periods

60.00

50.00

40.00
€/MWh

Off-peak
30.00
demand
Supply
20.00 Peak
demand

10.00

-
0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000
MW

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EFFICIENT INVESTMENTS:
ACCOUNTING FOR FIXED COSTS

• Coal vs. gas based generation unit: which is

the better investment option?
• Additional information is needed:
• Price of capacity ($/kW)
• Capacity factor (usage % of 8760 hours)
• Price of capacity: conversion of the overnight
cost of capacity into the annual fixed cost of a
kW
• Overnight cost of capacity: lump sum up front
payment to construct the capacity

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LONG RUN: ACCOUNTING FOR
FIXED COSTS

Converting overnight r ∗ OC r ∗ OC
FC = − rT
≈
cost into fixed cost: 1− e 1 − 1 /(1 + r ) T

Technology VC VC OC FC FC
(/MWh) (/kWy) (/kW) (/kWy) (/MWh)
Gas turbine $35 $306.6 $350 $40.48 $4,62

Coal plant $10 $87.6 $1050 $106,96 $12,21

r: discount rate (in % per year); here r = 10% (or 0,1)

T: life of the plant; T = 20 years for gas turbines and 40 for coal plants

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SCREENING CURVES (OR TOTAL
COST CURVES)

ARR
$/MWh $/kwy
b i ne
ur
ast
g
coal

$12.21 $106.96

$40.48

0.3 Capacity factor 1

Annual Revenue Requirement: ARR = FC + cf x VC

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LOAD DURATION CURVE

MW
i ne
8500 t u rb
s
ga

6000

coal

0.3 Capacity factor 1

Efficient generation park (only coal and gas): 6000 MW

coal, 2500 MW gas
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GENERATION PRICE REGULATION

• Objective:

Total Revenue (TR) = ARR

Price*electricity sold = FC + VC
Price = (FC + VC) / electricity sold

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COSTS: FIXED OR VARIABLE?

• Cost of capital
• Weighted average cost of equity and debt
• Cost of equity (e.g.12%)
• Cost of debt (e.g.10%)
• Financing structure (e.g. 70% equity and
30% debt)
• WACC = 0,7*12 + 0,3*10 = 11,4%
• Capital employed for electricity production
• Combined generation?
• Overnight cost?
• Book value?
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COSTS: FIXED OR VARIABLE?

• Depreciation
• Operating & Maintanence
• Wages
• Social obligations (if any)
• Taxes
• Fines
• Fuel cost
• Is pass-through efficient?
+ Production projection
• Uncertainties?
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GENERATION PRICE REGULATION

Follow the example of

Azeri wholesale revenue
requirement worksheets

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SUMMARY

• Fixed cost, variable cost, marginal cost

• Short run operations
• Demand curve
• Merit order (marginal cost) curve
• Investment planning
• Load duration curve
• Overnight cost of capacity
• Screening (total cost) curve
• Price regulation
• Annual revenue requirement
• Weighted average cost of capital
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