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Hybrid Finance

A solution to high electricity prices in restructured states.

Fortnightly Magazine - September 2010

There has been increased consideration of nuclear power because of global warming and the need for clean baseload generation. If taxes or other constraints on carbon are imposed, the economics of nuclear power would be increased. The low marginal cost of new generation assures that it will displace other fossil generation, which is frequently coal fired, leading to less pollution and fewer greenhouse gases.

Additional efficient baseload generation with its low marginal cost of operation will reduce the market price of electricity because it will displace the equivalent amount of generation with higher marginal costs, which sets the market clearing price at any given level of demand. The actual price impact depends on the marginal cost of the generation resource being displaced, but the clearing price is always lower—except when demand is so low that only baseload units are being dispatched—than it would have been without the addition of the low cost baseload generation (see Figure 1) .

Adding new baseload capacity to the generation mix would lead to lower electricity prices because less expensive generation would be on the margin. The new baseload capacity would displace more expensive coal and natural gas-fired capacity and electricity prices would fall.

Market Hybrid Financing

Financing new baseload generation in restructured markets presents significant challenges to regulators, plant owners and the financial markets. Baseload generation projects are capital intensive, subject to lengthy construction horizons, and entail material operating, regulatory and financial risks. Because of the magnitude of baseload generation projects, the cost of capital is an extremely important consideration in determining construction feasibility.

Under the market hybrid approach, new baseload plants would be partially owned and financed by both the regulated distribution company and the unregulated or merchant generation company.

The portion owned by the regulated distribution company would be subject to cost-of-service regulation. Commission involvement on a continuous basis would minimize risks and promote regulatory support on issues important to the project. Regulated assets are attractive to pension and infrastructure funds because of their stable cash flows. Large electricity users such as steel mills, oil refiners and real-estate proprietors might be interested in partial ownership of regulated assets in order to assure a long-term source of cost-based, emissions-free baseload power. Such investment might be in response to state or federal mandates to reduce carbon emissions. In areas where substantial baseload generation is being built, there would be less need for the market hybrid approach.

The unregulated generation company would have the lead in constructing and operating the plant and market forces would determine its profits or losses. Other entities such as equipment suppliers and investors seeking more than a regulated return could be partial owners. Deregulation has shown that generation efficiency improved under competition as evidenced by lower heat rates at fossil plants and higher capacity factors at nuclear plants. These efficiency gains help achieve environmental goals especially with respect to carbon emissions (see “Best of Both Worlds”).

The output of a baseload plant financed under the market hybrid approach would be sold into the market and receive market prices. The revenue allocable to