II. COSTS AND BENEFITS OF DIABLO IN 1985
Calculating the Costs of Diablo Canyon
Table 7.1 reports various estimates of the costs of units 1 and 2 of the Diablo Canyon plant as of January 1, 1985.[4] The first two rows report the construction costs of both units in absolute terms and in dollars per kilowatt of capacity. These are expenses reported by PG&E to the California Public Utility Commission (CPUC) excluding taxes and with no adjustment to account for inflation during the construction period. Taxes are excluded because they represent a transfer of revenue from one party to another and our focus is on the economic resource costs of the project.
The economic cost of Diablo Canyon includes the foregone interest on capital that is invested in the construction of the plant. Because this money could have been invested elsewhere, the foregone income is a cost of construction. A regulatory approach to estimating the cost of foregone income is allowance for funds used during construction. AFUDC credits the utility with an estimate of the interest cost of debt and the return on equity used in construction. This credit accumulates in an AFUDC account, which, under traditional rate of return regulation, is added to the capital expenditures to determine the plant's contribution to the rate base when the plant is operational.
The plant's contribution to the rate base, Rt , accumulates according to:
Rt +1 = (I + xt ) (Rt + It ) | (7.1) |
[4] Not all the capital expenditures had been made by the first day of 1985. Remaining expenditures that were being forecasted at that time were discounted back to 1/1/85 using a discount rate of 10%.
where xt is the AFUDC rate and It is the plant investment in year t.[5] Under traditional rate-of-return regulation with AFUDC accounting, the utility receives no actual earnings on Rt until the plant is operational.[6] If the plant is completed in year T and no costs are disallowed, the contribution to the rate base is Rr .
The AFUDC account in year t, A t , is the difference between Rt and cumulative construction expenditures up to date t, Kt For Diablo Canyon, projected totals corresponding to a 1986 completion date are
R1986 = $5.67 billion
K1986 =
and
A1986 = R1986 - K 1986 = $1.96 billion
AFUDC alone accounts for about 35% of the total book cost of the plant.
These figures are in nominal dollars and do not accurately reflect the true replacement cost of the plant. To estimate the replacement cost of Diablo Canyon, we first converted the construction cost to 1985 dollars by dividing annual construction costs by the GNP price index (normalized to 1985). This gives a construction cost in 1985 dollars of $5.03 billion.
The conversion of AFUDC earnings to constant 1985 dollars is more complicated. AFUDC is a payment for foregone interest and, as such, includes compensation both for the real cost of capital and for anticipated inflation over the construction period. Thus any calculation of the "replacement AFUDC" would depend on the time path of replacement investment and the cost of capital over the construction period.
A "replacement AFUDC" can be calculated in 1985 dollars by converting actual investment expenditures to 1985 dollars and applying a real (no inflation) cost of capital to expenditures over the actual construction period. This is very similar to what is actually done in AFUDC accounting, except that actual AFUDC expenditures are in nominal (rather than constant) dollars, and the AFUDC rate corresponds to the nominal (rather than real) cost of capital.
[5] Equation 7.1 assumes that investments are made at the start of each year and earn interest for the first year. Actual accounting practices may vary. For example, investment may be averaged over the year and may or may not earn interest in the first year.
[6] Prudence and other considerations can reduce the amount of reported costs that are allowed in the rate base. Also, some utilities are experimenting with regulatory procedures other than traditional rate-of-return regulation.
Suppose that the operation date T is the base year for measuring the replacement value of the plant. An investment of Ir t in year- T dollars makes a contribution to the rate base in year T equal to (the superscript r denotes real quantities)
 | (7.2) |
where xrv is the AFUDC rate in year t used for the replacement value calculation.
The constant-dollar investment Irt is related to the nominal investment I t by
Irt =  | (7.3) |
where it is the rate of change of the cost index in year t . Combining equations (7.2) and (7.3) gives
d RrT =  | (7.4) |
In nominal dollars, the contribution of It to the (nominal) rate base in year T is
It | (7.5) |
The contributions in equations (7.4) and (7.5) are equal, to a first-order approximation, if xt = x rt + it in every year. In other words, if the nominal AFUDC rate equals the real rate plus the inflation rate for capital investment, the two methods for calculating the rate base differ only by terms of the order i t xrt The replacement cost calculation yields the higher value, but the difference shrinks if the rate base is compounded over shorter time periods and disappears for continuous compounding.[7]
In evaluating whether the AFUDC account correctly compensated investors for the opportunity cost of capital, the answer hinges only on the relation between x t and xrt + i t If they are equal, then to a first-order approximation
[7] Note that inflating reported AFUDC expenditures by the price index would be a drastic case of double counting if the AFUDC rate correctly accounts for the opportunity cost of capital.
KT + AT = K rT + ArT | (7.6) |
Using equation (7.6), the reported values for KT and A T ,and the calculated value for KrT gives (in billions of 1985 dollars)
ArT = 3.71 + 1.96 - 5.03 = 0.64
The real compensation for funds used to finance the construction of Diablo Canyon totals about $640 million when a replacement value is calculated in 1985 dollars.
Figure 7.1 shows values of A rT and RrT that would be calculated with reported investment expenditures converted to 1985 dollars using the GNP deflator and using the indicated real cost of capital for xrt in every year. An AFUDC compensation of $640 million in 1985 dollars corresponds to a real AFUDC rate of about 1.75%/year.
Table 7.2 shows AFUDC rates for Diablo Canyon imputed from PG&E reports in nominal and real terms (using the GNP deflator). The AFUDC rate that justly compensates investors for the use of their funds is equal to their real after-tax cost of capital. This may be approximated by the weighted average of the before-tax cost of debt (because debt is deductible against earnings) and the after-tax cost of equity capital, with the weights corresponding to the firm's debt-equity ratio. The real weighted average cost of capital (WACC) after taxes is shown in column 3 of Table 7.2. This exceeded the real AFUDC rate in every year. Investors were not compensated for foregone interest until after 1968.[8] Since that time, the real AFUDC rate varied from a low of-2.84% in 1974 to a high of + 4.89% in 1984. Over the same period, PG&E's WACC varied from a low of 0.62% in 1975 to a high of 8.84% in 1985, with a geometric mean of 3.8% over the period 1966-1984. The average annual rate, weighted by the total investment in each year, was 5.75%.
The lower AFUDC rates can be rationalized by appealing to traditional regulatory practice with its lower risk for utility investors relative to the manufacturing sector. Recent events have upset this historical relationship. Nonetheless, it is our view that the implicit real AFUDC rate of 1.75% was not adequate compensation for foregone interest, and a figure of 3.0-6.0% would have been more appropriate. A value of 4.75% gives real AFUDC earnings of about $1.5 billion, in 1985 dollars.[9] Adding this to the replacement value of capital investment ($5.4 billion, 1985 dollars) gives a total replacement value of the plant equal to about
[8] Total construction expenditures through 1968 were relatively small, so this had only a small impact on total compensation.
[9] 4.75% is about at the center of the range bounded by the simple geometric mean of the annual values of PG&E's WACC (3.8%) and the geometric mean of the WACC weighted by the proportion of total investment made up to that year, including cumulated AFUDC (5.75%).
$6.9 billion in 1985 dollars. The nominal dollar cost of constructing the plant is $2.3 billion.
Comparisons of the costs of the Diablo Canyon plant with other nuclear power plants can be misleading because the available cost data are in nominal dollars and therefore include the toll of inflation over the construction periods. With this important caveat in mind, a simple comparison of the numbers in Table 7.1 with data available for other nuclear generating stations indicates that the costs of Diablo Canyon are about average for reactors coming on line in the mid-1980s. Komanoff (1984) reports, for instance, that the average construction and AFUI)C costs for 34 nuclear projects he sampled is $3,123/kW in nominal dollars, over $500/kW (nominal dollars) greater than Diablo. The sample included 14 multireactor projects that are generally less expensive (per kilowatt) to build. For multiunit plants, the average nominal cost including AFUDC drops to approximately $2,240/kW, about $350/kW (nominal dollars) less than PG&E's costs for Diablo Canyon.
After removing the AFUDC component for each plant and converting all expenditures to constant dollars, Komanoff reports the average construction cost for all 34 plants to be $2,428/kW in constant 1985 dollars.[10] Our estimate of the equivalent figure for Diablo Canyon is $2,295/kW. The Komanoff paper does not give enough information to estimate the average constant-dollar cost for multiunit plants excluding AFUDC, but his data show that the average would be in the range of $1,400/kW-$1,650/kW. The constant-dollar construction cost of Diablo is appreciably larger than the multireactor national average: 39 to 63% larger, depending on where the national average actually lies. Yet the nominal cost of Diablo, including AFUDC, is only 15% larger than the multireactor national average. Thus compared with national averages, Diablo Canyon is relatively expensive in terms of construction expenditures but relatively cheap in terms of AFUDC. It seems that the extremely low real rates used to compute AFUDC earnings make Diablo appear, on a book-value basis, to have been bought at a fairly reasonable cost. The cost saving is only illusory, because the low AFUDC rates mean that much of the interest costs of Diablo Canyon were paid by utility investors without adequate compensation.
Comparison of Costs and Benefits
To make comparisons of costs of electricity from Diablo and other sources available or potentially available to PG&E, consistent estimates
[10] . Komanoff's cost estimates are not directly comparable with ours because he uses the Handy-Whitman Index of electric power plant construction costs. His index is therefore appropriate for comparing costs of alternative central station electricity plants, whereas the index used in this chapter allows the value of the Diablo Canyon investment to be compared with some average of all other uses to which that the money could be put.
of the levelized cost of electricity must be made and compared with the value of displaced electricity that would have been produced by an alternative generating technology. Realistic alternatives to nuclear power include fossil fuels (coal, oil, gas), and the more exotic technologies of solar, wind, and renewable resources. Hydropower and geothermal are sufficiently limited in supply to make them unavailable as replacement sources of energy. Conservation also has been proposed as an energy source: the cost of investments required to reduce demand, or the cost of foregone consumption, are measures of the cost of making energy available through the conservation option.
In this time period, oil and/or natural gas (henceforth gas) is the energy source used in the PG&E system with the highest operating cost (which includes the cost of fuel, labor, and wear and tear on equipment). Given the current configuration of the PG&E electric power system, most of the power produced by Diablo Canyon will displace gas, and hence the value of this production is the cost of gas fuel and the operating costs of the gas-fired capacity. One can argue whether different supply planning decisions and/or different approaches to load management might have created a situation in which the marginal energy source for the system would be something other than gas. In addition, with the benefit of hindsight, the power from Diablo Canyon might have been produced with different technologies; perhaps coal or wind.
This chapter takes the existing PG&E system as a given and measures the value of energy displaced by Diablo Canyon based on the cost of existing power from displaced facilities. Specifically, we estimate the energy benefits of the Diablo system on the basis of payments made by PG&E to small power producers for electric energy. Diablo Canyon also will displace generating capacity that would have been necessary in the absence of the Diablo capacity. We use the cost of a new gas-fired steam turbine plant as a measure of the cost of future displaced electric power capacity.
Oil and gas are proven technologies with relatively short lead times. Whether these energy sources are cheaper than alternatives such as coal, solar, or conservation is a subject of heated debate. Nonetheless, taking oil or gas as the alternative energy source provides an upper bound on the value of electricity produced by Diablo Canyon.
The assumptions contained in the base case are presented in Table 7.3. The most important of these are that the real discount rate is 10%; the expected real rate of increase in the price of oil and gas is zero until 1988 and 3%/year thereafter; the average heat rate of plants that are displaced by Diablo is 11,300 Btu/kWh; and Diablo Canyon achieves a capacity utilization rate of 65%.
Our basecase heat rate (the rate at which the heat content of fuel is converted to electric energy) is based on estimates provided by the
CPUC. These estimates are made to establish the price that PG&E must pay small power producers for electric energy. Before Diablo came on line the annual average heat rate for marginal plants was 12,427 Btu/ kWh. After both reactors came on line the annual average is estimated to be 10,356 Btu/kWh. The figure that we use for the heat rate in our base case is an average of the pre- and post-Diablo heat rates, used in computing payments to small power producers. These heat rates are actually lower than the heat rates of the plants displaced by Diablo Canyon (Pacific Gas and Electric, 1984a).[11]
The fuel cost assumed for a gas plant is $19/barrel of oil equivalent (BOE). This is the CPUC's estimate (California Public Utilities Commission, 1985, p. 22) of the incremental cost of natural gas plus delivery cost in 1985. The actual cost of gas delivered to PG&E's plants in early 1985 was $31.32/barrel of oil equivalent (in January according to Federal Energy Regulatory Commission [FERC] filings), falling to $27.27/barrel of oil equivalent in August. Establishing an appropriate price for the alternative fossil fuel is complicated by the fact that the CPUC has mandated (through its G-55 rate) that PG&E must charge itself a premium rate for natural gas used to produce electricity. The base case of $19/barrel of oil equivalent attempts to correct for this premium, which is effectively a transfer between electricity and gas ratepayers.
Capital savings due to fossil fuel plants not required as a result of Diablo are also included. Lost Capacity is made up by the addition of 1,900 MW of capacity that is assumed to have been constructed in 1983 and one 300-MW plant brought on-line in 2004. The addition of the first of these plants is justified by the capacity shortage experienced by the utility in 1983-1984.[12]
The levelized cost of electricity is computed by dividing the total cost of the project by the lifetime production of electricity, discounted to the present. The total cost includes the construction and AFUDC earnings of the project charged as a single lump-sum payment at the end of the construction period. In addition, operating and maintenance costs are
[11] By using the small power producer rate, we do not mean to imply that it is the appropriate rate to use. There are other developments that may be driving the heat rate down even lower, such as cogeneration and combined-cycle plants. However, all these possible alternative sources of supply are uncertain. Given these uncertainties, we feel that the heat rate assumptions are a reasonable place to start.
[12] Diablo Canyon's high forced-outage rate and its large size reduce its capacity value to the system to well below its nameplate capacity. We do not examine this question using a full-blown system reliability model but arbitrarily set the size of the alternative fossil fuel plant at a nameplate capacity that is 18% less than the nuclear plant. Because PG&E's system already has plenty of capacity, even this imputed capacity value may be too high. As the results presented below indicate, the capacity credit ranges between 20 and 27% of the value of the plant, depending on the assumption of fossil fuel prices.
calculated over the life of the project and discounted back to the first day of 1985. The same computations are made for the gas-burning alternative. For the purposes of the results reported in Table 7.4, the capital cost of Diablo is the reported value in nominal dollars.
Estimates of levelized costs are made on the basis of a variety of assumptions as indicated in Table 7.4. The results suggest that, based on reported nominal costs of Diablo Canyon and base case projections of oil and gas prices, the nuclear plant falls short of paying for itself as measured by the value of oil and gas displaced over its useful life. In the base case, the levelized value of displaced oil and gas is 6.79¢/kWh, whereas power from Diablo Canyon has a levelized cost of 7.75¢/kWh.
Of course, these results are sensitive to assumptions such as projected oil and gas prices, the choice of the discount rate, Diablo Canyon's capacity utilization rates, and the heat rate in fossil fuel plants that are displaced by Diablo Canyon.[13] If gas prices are projected to increase by 6%/ year, electricity from Diablo Canyon will be cheaper over the life of the plant. However, a 6% increase in gas prices is not sufficient to push the benefits of the project above its costs when the benefits of future price increases are discounted at 12%. In addition, a cost of gas of $24/barrel oil equivalent (escalated at the base case rate) would also result in Diablo Canyon paying for itself in terms of displaced oil and gas. This price is significant because it approximates the cost of gas to PG&E in 1985. In all cases, the assumption of no real increase in the cost of gas results in a shortfall in the net benefits of the nuclear project.
Table 7.5 shows the sensitivity of the results to changes in the assumed heat rate under the base case assumptions. The heat rates indicated in Table 7.5 are, in declining order, PG&E's average heat rate from marginal plants before Diablo Canyon came on-line, our base case rate, PG&E's average gas-fired heat rate after both units of Diablo came online, and the heat rate of PG&E's most efficient gas-fired unit operating at its most efficient level of production (Pacific Gas and Electric, 1984a). Even at the highest rate cited, the cost of electricity from the nuclear plant is 0.49¢/kWh above the cost of the gas alternative when other parameters are at their base case values. Lower assumed heat rates merely reduce the measured benefits further.[14]
The cost of Diablo Canyon in the above analysis consists of the nominal dollar reports of the construction costs and of the payments into the AFUDC account. To compare the economic costs that would have been incurred had Diablo not been built with the economic costs of Diablo, it
[13] Derived from Table III-5 of the report "Diablo Canyon Nuclear Plant Value-Based Pricing Proposal."
[14] Heat rates of less than 9,000 Btu/kWh could be justified if the marginal energy source displaced by Diablo Canyon were cogeneration.
is necessary to convert the nominal dollar costs of the nuclear project to constant dollars. We recalculated the cost of Diablo by adding to the 1985 dollar cost an AFUDC earning estimated with a real allowed rate of 4.75%. This raises the 1985 dollar cost of Diablo to $6.9 billion. The resulting levelized costs, under a limited set of assumptions, are presented in Table 7.6.
A comparison between Tables 7.4 and 7.6 reveals that, once these corrections are made, the costs of Diablo Canyon substantially exceed the estimate of the avoided costs of oil and gas under base case assumptions. The 8.83¢/kWh estimate for the cost of electricity from Diablo is 30% greater than the cost of gas-fired electricity. Even if the cost of oil and gas increases at 6%/year from 1988, the avoided costs will not justify the investment in Diablo Canyon.[15]
Avoided cost is the basis of the regulatory procedure that was implemented by the CPUC to determine the earnings that PG&E is allowed on its investment in Diablo Canyon (California Public Utilities Commission, 1985). Under this scheme the utility is allowed to collect revenues as if it were operating the generating stations that were displaced by the nuclear plant.
PG&E already purchases electricity from small power producers at a price that is based on its (short-run) avoided cost. In the first quarter of 1985, before the first unit of Diablo Canyon came on-line, the purchase price for electricity averaged 7.2¢/kWh, with a peak price of 8.6¢/kWh. At that time PG&E announced that it would pay, during the next quarter, an average of 6.3¢/kWh if Diablo Canyon did not come on line and 5.6¢/kWh if it did, with peak prices being 7.4 and 6.4¢/kWh, respectively (Pacific Gas and Electric, 1985, Table E). The computed prices are biased upward in that they include the G-55 gas price surcharge but are biased downward by their exclusion of a capacity price. Payments made in the winter months also tend to be higher. The PG&E purchase prices again indicate that the benefits of Diablo Canyon fall short of its book value when measured against payments that the utility would have to make in the absence of the project.
The results presented in Tables 7.4 and 7.5 indicate the avoided costs that would be applied to Diablo Canyon under our assumptions. In general, the results indicate that payment to PG&E on the basis of avoided cost should allow the company revenues that would fall about 15% short of the total nominal cost of the nuclear plant. The CPUC (1985) report also provides estimates of annual revenue that PG&E would be allowed
[15] Our assumptions may not cover the entire ranges of reasonable alternatives or possible outcomes. However, there is enough variation in the assumptions used and the results presented here that readers can make their own adjustments to the results to fit their own information and forecasts.
to collect under an avoided-cost scheme. We have incorporated the CPUC assumed cost of gas of about $19/barrel of oil equivalent in our base case. Under the CPUC assumptions this price declines substantially until 1990 but increases at a high rate in the 1990s. Overall, their forecasted gas prices are equivalent to ours when discounted and averaged over the life of the plant. However, the CPUC assumptions differ from ours in a few notable areas. The CPUC heat rates for gas plants[16] average about 9,500 Btu/kWh. Capacity credits, on the other hand, are based on the cost of cheap, but inefficient, gas turbine capacity, whereas ours are based on the cost of steam-driven generators. Finally, the CPUC assumes a 60% capacity factor. The total effect of these differences in assumptions results in a CPUC estimate of the avoided cost of Diablo Canyon being about two-thirds of our base case estimate. In fact, their estimated total payment (on a levelized basis) is about 3.8¢/kWh, about 56% of ours. This includes a payment for energy savings that implies a levelized cost of fuel of $14.20/barrel of oil equivalent, reflecting the considerable amounts of geothermal, other nuclear, and purchased energy that the CPUC estimates will be displaced by Diablo Canyon.
At a 10% real discount rate, the present value of payments to PG&E for the avoided cost of electricity displaced by the project is $4.13 billion under the CPUC scenario. Subtracting the nuclear plant's operating costs allows about $1.7 billion to pay for the capital invested, leaving $4.0 billion of the book value of the plant to be paid by stockholders and taxpayers (through tax deductions of losses). Of this, between $1 billion and $1.5 billion will be borne by PG&E's stockholders, depending on the tax regime during the plant's life. Under our base case assumption, the total cost will exceed total benefits by about $1 billion with about a quarter to a half billion of that paid by stockholders. In the next section we analyze whether such a shifting of the costs of Diablo Canyon from ratepayers would be justified on the basis of expected costs and benefits rather than on the basis of what actually transpired.