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Getting It Right: The Real Cost Impacts of a Renewables Portfolio Standard

Fortnightly Magazine - February 15 2000

purposes. Their addition to a fossil fuel portfolio can serve to lower the risk and/or cost of electricity produced.

For policymakers, the message should be clear. These portfolio-enhancing properties of renewables - risk and cost reduction - provide a sound basis for pursuing the RPS idea in electric restructuring.[Fn.7]

Portfolio Theory: The Basic Ideas

Figure 1 shows the risk-reward tradeoff for a financial portfolio of two risky assets, A and B, which can be two common stocks (or groups of common stocks), or two groups of generating assets. Risk is defined as the standard deviation of the periodic (i.e., year-to-year or month-to-month) returns to the portfolio.[Fn.8] [Note: Figures/graphics not included. See print copy.] Stock A (top right) is riskier; it has an expected return of 17 percent, coupled with a standard deviation of 0.41. Stock B offers lower return coupled with less risk; its expected return is just over 7 percent and its standard deviation is 0.27.

From a risk-reward perspective, it makes little sense to own only Stock B (or analogously, generating technology B), since there exist combinations of A and B that will produce superior results. In general, it makes no sense to own any portfolio combination that lies below portfolio V. For example, Portfolio R (consisting of 48 percent A plus 52 percent B) has the same standard deviation as Portfolio P (18 percent A plus 82 percent B) but produces a higher expected return. Investors seeking returns greater than those provided by V and R must accept greater risk by incorporating more Stock A into their mix. This choice moves them along the risk-reward curve to portfolios like S.

Given the two risky assets A and B, it is not possible to prescribe a single optimal portfolio combination, only the range of efficient choices, i.e., those that lie on the risk-return curve above V. Investors will choose a risk-return combination based on their own preferences and risk aversion. More risk-averse investors would be inclined to own relatively conservative portfolios such as V, while less risk-averse individuals will operate at S or A.

The Riskless Asset:

Diversification and Leverage

Adding a riskless asset to the A-B mix produces interesting and counterintuitive results. In financial portfolios, riskless assets generally consist of U.S. Treasury bills. The term "riskless" actually is misleading since even short-term T-bills bear some risk; e.g., their market value will fluctuate in response to changing interest rates. For this reason, T-bills are more properly called zero-beta assets, to distinguish that they are not truly free of risk, but are riskless when the returns are expressed in a particular manner.[Fn.9] This section describes the remarkable effect that so-called "riskless" Treasuries have on the financial portfolio.

Figure 2 illustrates the effects of adding riskless T-bills (that yield 5 percent) to the previous mix of risky stocks A and B. The risk-reward curve for various combinations of A and B remains unchanged from Figure 1. The new element in Figure 2 is the straight line, which represents the risk-return combinations for portfolios consisting of risky and riskless assets.[Fn.10] Point M, the