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Nuclear Standoff - Nuclear Breach

Federal failure to fulfill spent-fuel obligations creates expensive risks.

Fortnightly Magazine - December 2009

says in its Boston Edison decision that Entergy employed “an IRR [internal rate of return] that exceeded 20 percent.” Such rates weren’t unreasonable because this was a risky venture for Entergy at that time; Boston Edison’s Pilgrim unit was only the second nuclear power plant sold, and the Commonwealth of Massachusetts wasn’t considered particularly supportive of nuclear plant operations. 

Market depth, market liquidity, and the corresponding irreversibility in a nuclear transaction also factor into the risk. Unlike other generating technologies, there’s a limited market for nuclear power plants, substantially defined by the ability to transfer the operating license. Only a handful of companies are qualified to run a nuclear facility. The sales transaction is costly, time-consuming and subject to intervention and disruption by local authorities. Thus, once purchased, a buyer likely will be stuck with the deal and will incur sunk costs associated with the transaction. Since the nuclear plant market is neither deep nor very liquid, a company considering a nuclear purchase might try to capture in its IRR or discount rate the market’s view of investment irreversibilities and potential losses. Losses might include the potential for an accident, an extended regulatory shutdown or, worst of all, a scenario requiring premature shutdown and decommissioning of a nuclear unit.

In the Boston Edison decision, the court reports Entergy’s analysts were concerned about the potential for premature shutdown, decommissioning risk, and market price risk, while speculating on importance and ranking. Incredibly, CoFC doesn’t appear to recognize that most of these risks can be substantially hedged away or have nothing to do with SNF. 

For example, market price risk would apply to any generator of Pilgrim’s size at that location. Market price risk can be, and routinely is, hedged through power agreements, and offsetting financial and physical hedges. In any case, market risk doesn’t present the potential for catastrophic losses of the kind associated with a premature shutdown. 

Nuclear capacity-factor risk is dominated by operational events and regulatory risk, and there are ways to manage and offset this risk. Again, short of a premature shutdown, the effects on investment returns are far from catastrophic. Since Boston Edison provided a decommissioning fund when the plant was sold and decommissioning costs appeared to be trending downward, decommissioning risk was mostly hedged, as well.

The only remaining component that couldn’t be hedged away because of its magnitude was the risk of premature shutdown and loss of the entire investment. Standard computational methods exist for estimating the valuation sensitivity to this premium. Today those methods would include embedded options, and a formal treatment of market irreversibilities. 

For purposes of illustration, however, the more familiar net present value (NPV) calculation of the kind often used 10 years ago to value assets can be used to test the sensitivity to three potential nuclear risk premiums: 250, 500, and 750 basis points (100 basis = 1 percent). The court reports Entergy assumed that the plant would operate through 2012, subject to risk of premature shutdown encapsulated in the higher IRR used. Lacking any other information concerning Entergy’s analysis, one makes the