Letter from the Editor: Economics of Electrical Energy

Before discussing nuclear energy economics, it might be useful to understand how power plant investment decisions are made by electrical utilities. It is a complex subject, but one that is worth a bit of study.

Normal Commodity?

If electrical power was a normal commodity, the question that would rule production capacity investment decisions is, “How much will it cost a new plant to produce a unit of electricity over the life of the facility compared to that of other alternatives?” Fully answering this question is enormously complicated and takes into account many factors including technological risk, regulatory risk, political risk, external costs and market risk.

Of course, electricity is not treated as a normal commodity, so the above statements do not apply. This can be demonstrated by the rather incredible variations in electricity pricing around the country. In the Northwest, in areas served by the Bonneville Power Authority, electricity can cost as little as 2.5 cents per kilowatt-hour. On Long Island, in areas served by the Long Island Lighting Company, electricity can cost as much as 16.5 cents per kilowatt hour.

In some areas of the country, people who live a few miles apart can pay electric rates that vary by more than 40 percent for an identical level of service simply because they are served by different utility companies.

Electricity Pricing

For most of this century, producers of electricity in the United States have been regulated under the assumption that they are natural monopolies producing a necessary product. There is a great fear that such an entity might use its market power to demand outrageous prices from captive customers.

Therefore, utilities have been prevented from making a key business decision, that of pricing their product. Instead, they have been required to justify their price requests to state regulators, who have the power to set final prices.

Most regulators have chosen to ensure a “fair” price for electricity using a system known as rate-of-return pricing. They look to the capital markets to determine what seems to be a reasonable rate of return for capital investments. The regulators then apply this rate to the total investment that utility companies have made in their capital assets. Expenses like personnel costs, repairs to equipment after storms and administrative costs are normally passed on to ratepayers.

Every so often, the utility must appear in front of the state regulators and present a case for either raising or lowering the price of electricity. These rate cases include evidence on the projected growth of customer needs, the action that the utility has taken or proposes to take to meet those needs and a rate of return that they feel is needed to attract sufficient capital.

When the state regulators and their staffs review the rate cases, they decide whether or not to allow each investment into the rate base and make the final decision about the allowed rate of return.

Regulation Methods Outdated

If load growth, inflation and technology behave, this kind of price regulation can work. In the United States, it worked reasonably well until the early 1970s when technology began advancing at a rapid pace, fuel price inflation went crazy and the steady growth in customer demand suddenly flattened out.

The success of nuclear power plants built in the 1960s and early 1970s played a role in the breakdown in the regulatory system. Their cost distributions are completely different from those of a fossil fuel plant.

In a fossil fuel plant, the cost of consumable raw materials, like fuel and chemicals, drives the cost of electrical power production. Fuel prices vary widely, depending on geographic location, since they are bulky and require an expensive transportation infrastructure.

In a nuclear plant, however, fuel is a minor cost item with essentially no geographic dependence, while engineering design work, regulatory compliance and personnel costs can be higher than comparable fossil plants. The calculations needed to compare these apples and grapefruit are difficult and based on estimates that are increasingly inaccurate with longer time horizons.

The comparison calculations became even more significant after the Arab Oil Embargo of 1973-74, when the price of oil jumped by a factor of four. Though the price slope was not as sharp, the cost of competitive coal and natural gas also increased. Nuclear power should have been a big beneficiary of the rapid rise in fossil fuel prices.

Nuclear Power’s Enemies

Fighting against nuclear power, however, were inflation, high interest rates, regulatory changes and a dramatic reduction in the rate of electricity load growth. The large nuclear plants that were under construction suddenly increased in price because of escalating component prices, higher costs of borrowed capital, and the need for redesign in the middle of construction. Utilities also realized that they did not need as much generating capacity as they had planned.

To protect fossil fuel dependent utilities from severe financial distress in a time of great uncertainty, most state regulatory boards established fuel adjustment surcharges allowing rapid pass-through of fuel costs to consumers. This policy did not help the ability of nuclear utilities to gain any financial reward from their capital investments, since one of the key features of a nuclear plant is that its fuel price is more predictable and lower than competing fossil fuel.

Regulatory Uncertainty

As the capital costs of nuclear plants began to climb, and the anticipated demand growth did not materialize, many utilities cancelled or delayed their nuclear plans. In some circumstances, regulators refused to allow the costs of cancelled projects into the rate base since they were not providing service to ratepayers. Although each case was different, many commentators have lumped all nuclear projects into one risk category.

In this regulatory climate, utility investors have logically decided that it is safer to invest in fossil fuel plants (based on well-proven technology) than it is to invest in an advanced nuclear plant that has never been built. There is little technological risk, low political risk, and the inflation risk of fuel price increases is mitigated by the fuel adjustment clauses.

AEI’s Viewpoint

We at AEI believe that the decision to eliminate nuclear power from consideration is short-sighted. There are no guarantees that the fuel adjustment clauses will continue or that fossil fuels will continue to sell for historically low prices. We also feel that concerns about air pollution are based on real dangers, particularly in localized areas. Technology that is clean enough to operate inside sealed submarines has a place in the power production market.