Projected Costs of Generating Electricity - OECD Nuclear Energy ...

power reduces the value of the power produced. On
the other hand, the fact that solar electricity from
photovoltaics is produced at the point of consumption
and during daylight hours, when prices are generally
higher, increases the value of its electricity.
Reciprocating engines and fuel cells are two distributed
generation technologies that use fossil fuels.
Like photovoltaics, these distributed generation
technologies have very short lead times and can be
installed directly at the site of an electricity consumer.
Their flexibility of use means that they can
be operated during hours when power prices are
favourable.
The competitiveness of reciprocating engines is
thus dependent on the cost of delivered electricity
that the distributed technology replaces. When fuel
prices are low and electricity prices high, owners
of these distributed generation technologies can
produce their own electricity and reduce purchases
from the electricity market. Electricity consumers
that own generation facilities thus have a kind of
“physical hedge” on the marketplace that allows
them to cap the prices they pay. Reciprocating
engines are also portable, i.e. they can be sold and
moved to another location.
Finally, but also quite significantly, investors will
need to account for the effects of corporate tax on
the profitability of investments (see box). Taxes on
the profits earned by the project increase the profits
required. Relatively capital-intensive technologies
are thus more strongly affected.
The impact of corporate income taxes
on financing investment
In the United States, firms are allowed to deduct
interest costs (payments to debt-holders) as an
expense when computing Federal income tax liabilities.
However, for tax purposes, firms cannot deduct
payments to shareholders from income as an expense.
It can be shown that in a “perfect world” where payments
to debt-holders and shareholder are treated
the same for tax purposes, the discount rate, or the
weighted average of the cost of debt and cost of
equity, will not be affected by increasing the amount
of debt. That is, the decrease caused by the increased
use of low cost debt will just offset the increase
caused by the increase in the cost of equity. 7
However, as just noted, in the United States there are
differential tax benefits from using debt and equity
capital, and because of this, up to a point, the risk
(and tax) adjusted discount rate will fall as the
amount of debt financing increases.
In short, the effects of debt financing on risk adjusted
discount rates depends upon the nature of a country’s
tax laws. At least in the United States, up to
some point, the overall discount rate will fall as the
relative amount of debt financing increases.
Increases in the debt component will cause risk to
increase, and this will increase the cost of the equity
component. However, this increase will be more than
offset by reductions caused by the use of more tax
beneficial debt capital.
Quantifying investment risks in power generation
While identifying investment risks in power generation may be straightforward, investors in power
generation attempt to understand the relative importance of different risks by quantifying them where
possible. For the more important risks, it will be prudent to adopt risk management strategies that can
cost-effectively reduce exposure to such risks.
The levelised cost methodology, used in this study, has been a useful tool for investors and for overall
economic analysis because it evaluated costs and energy production and discounted them to take account
of the time value of money. It provided an objective basis on which to provide a comparison of different
technologies, e.g. for base-load power generation. This approach reflected the reality of long-term
financing, passing on costs to the (captive) customers, known technology paradigms, a predictable place
in the merit order, a strong increase in consumption and a short build-up time for selling the output of a
new plant.
7. This is essentially Modigliani and Miller’s Propositions I and II.
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