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

Fortnightly Magazine - February 15 2000

now. It provides an efficiency gain in the form of more desirable risk-return combinations.[Fn.21] In addition, such a move creates strategic benefits; long term, in order to improve from M, we will have to reduce the cost of renewables.

What happens if the cost of renewable energy comes down, thus boosting the return (cost per kilowatt-hour) earned on such resources?

Recall that the optimal coal-gas mix is located at M, the tangency point between the line and the curve. As the cost of renewables drops (i.e., as their returns increase), the tangency point moves to the right so that the optimal mix contains more gas. That implies that our current gas expansion policy cannot be implemented in an economically efficient manner without a simultaneous national focus on reducing the cost of PV, wind and other riskless renewables. Such cost reductions could be accomplished through various policies including a national portfolio standard to accelerate PV production.[Fn.22]

A national policy that helps reduce the costs of renewables provides a portfolio benefit by significantly increasing the attainable risk-reward gains. If the cost of riskless renewables were to drop to say $.08 per kilowatt-hour, (a 12.5 percent return), the optimal coal-gas mix would shift up to N (Figure 4). Now deploying additional renewables would produce sizeable risk reductions accompanied by only small cost increases. For example, Portfolio H is half as risky as fossil portfolio N, yet costs less than a penny more.[Fn.23]

Spikes and Contracts:

The Physical Limits of

Financial Hedging

These findings suggest that any portfolio should contain some proportion of riskless (fixed-price) power. Even so, while private firms can attain optimal results by including riskless contracts for the purchase and sale of power,[Fn.24] these contracts need not be supported by renewable generation.

Indeed, individual firms may not be much impressed by the fixed-cost nature of PV or wind since they can readily obtain long-term power contracts at fixed prices. In addition, they can hedge positions with a variety of futures and options.

Unfortunately, we can't all continue to offer each other futures and fixed-price energy contracts based on underlying technologies whose costs fluctuate unpredictably without inviting financial disaster at some point.[Fn.25]

Building optimal physical generation portfolios that include riskless renewables is one alternative to dealing with price risk. Financial hedging strategies provide a second alternative for individual firms, but it is incorrect to presume that this is a superior or less-costly alternative. Hedging strategies are not free. Neither are they free of risk. Indeed, the firm will pay what it "should," for its hedging, which ultimately must include a premium for those agents undertaking risk. To the extent that these agents can diversify the risk, they may be able to undertake it at lower cost. Still, no perfect hedge can exist in reality - as evidenced by the multi-billion dollar collapse of Long Term Capital Management, a firm whose principals included prominent Nobel laureates who contributed to the valuation theories underlying the options and derivatives the firm employed.[Fn.26]

When many firms undertake strategies to hedge against the same risk, it seems reasonable to