|A Competitive Environment: Key to Future Nuclear Success|
|Bruce A Lacy|
Competition is the essential element for future nuclear success. This was the basic theme of a paper that I presented to the Uranium Institute’s Annual Symposium in 1997. It was a startling thought to some and a cause for alarm or objection by others. This paper re-examines that theme in light of the developments in restructuring in the United States. Future nuclear success, what does it mean? Why is competition essential? Can we even compete? What is taking place in the USA where competition is being introduced, state by state? And what do these developments in the USA mean for our future nuclear success?
Future Nuclear Success: What Does it Mean?
Future nuclear success is an environment in which:
This list is intended to be more representative than exhaustive. However, the items selected are important. The key is getting the right investor interest in the public policy, regulation, operation and design of the technology.
Why is Competition Essential?
Competition is essential because it is the foundation for solving the other frequently cited obstacles to future nuclear success. The list of obstacles typically includes poor public opinion, legal and political constraints, lack of government policy support, tough treatment by safety regulators, investor indifference to operational performance, dispersed and fragmented ownership, and general lack of investor interest. Let’s look at these obstacles and see how traditional rate regulation in the USA fosters or tolerates them, and how competition would change them.
Poor public opinion, legal and political constraints and lack of government support are all tolerated by rate regulation. What the public thinks or government does do not affect the rate regulated company as long as any impacted costs are found to be prudent and can be included in rates. In some rate-regulated jurisdictions, there are even limitations on the ability to educate or influence the public. The key to success in a rate-regulated environment is to stay prudent.
In a competitive environment, if public attitudes or governmental action affect your business, you go to the source and seek to change it by marketing, education, advocacy and lobbying. Your success depends on your ability to influence change in the poor attitude or lack of support that is impacting your business.
Tough treatment by safety regulators and investor indifference to operational performance are also fostered by rate regulation. Rate cases provide relief against increasing requirements, and who can argue against the prudence of issues driven by nuclear safety, particularly if it comes directly from the safety regulator? The job of the safety regulator is complicated by a general lack of public policy direction, and the direction that is received from the public policy establishment is sporadic and not very balanced. Investors provide limited input to the public policy environment because their interests are largely met by management performance in rate cases.
Further, if a plant is shut down, there is no immediate impact on investors because the base costs are collected in rates and the cost of replacement power in most cases is covered by an energy adjustment clause that passes the replacement power costs directly to customers. If the shutdown involves costs over and above what is in rates or circumstances become significant, then rate action may have an impact on the company.
Overall, rate regulation disconnects the investor from the performance of the plant and the external affairs that impact its performance. In a competitive environment, the profitability of the company is immediately affected by cost increases or operational difficulties and investors are highly interested in the circumstances. Investors will either directly, or through management, seek to change the external influences that are driving up costs and reducing production.
Dispersed and fragmented ownership of US nuclear plants is a fundamental outcome of rate regulation. The individual state regulatory jurisdictions make asset transfers between states virtually impossible. And the different rate structures for utilities even within a single state can make asset transfers within the state just as difficult. In a competitive environment, plants would be bought or sold at market rates allowing the consolidation of ownership and operation that is long overdue. This consolidation of ownership and operation, made possible by a competitive environment, provides the greatest opportunity for nuclear generating businesses to capture the economies of scale and shift downward their long run average costs.
Lack of investor interest is driven by another fundamental characteristic of rate regulation. The basic rate making formula separates investor return on investment from the treatment of costs incurred by the business. Cost reductions contribute to improved investor return only until the next rate case. Long term return on investment is determined and set at a specific number by the rate authorities in an administrative process that calculates a weighted average cost of capital for the utility. Being a weighted average, it is inevitable that investors will see it as less than what they perceive as the specific risk associated with the company’s nuclear interest, and with it being fixed at a specific value there is essentially no opportunity to do better.
Consequently, investors will be opposed to any further expansion of their nuclear risk. In a competitive environment there are two very important differences. First, cost reduction and operational improvement go right to the benefit of investors. This is a very powerful and positive mechanism to get the investors interested in the internal and external details of the business. And second, there is no artificial or fixed cap on what the investors can earn from the business, the only limit is how well the plants can be operated compared to the market-clearing price.
The essential nature of competition for future nuclear success now becomes clear. A competitive environment, the opposite of rate regulation, directly correlates investor returns with total operational performance. Consequently, investors have an abiding interest in both the operational performance of the plant staff and in the regulatory and public policy environment in which the plants operate. The operators, the regulators and the public policy leaders will be under the scrutiny of the investor for their good performance. This investor interest is the basis for changing the overall public policy and regulatory environment. It is the same process by which any business activity seeks to favourably improve its business performance by insuring an appropriate public policy and regulatory environment. The jurisdictional distinctions between states and utility service territories that are so important in rate regulation would be eliminated.
A competitive environment is not a threat to public health and safety. A competitive environment strengthens the link between economics of plant operation and safety. Investors expect the designers, operators and regulators to produce plants that run well.
Can Nuclear Even Compete?
The short answer is yes. Economics teaches us that the competitiveness of an activity is determined by looking at its costs, not including sunk costs. On this basis, nuclear has a bright future for three basic reasons: the ability and opportunity to reduce costs; the growing recognition of environmental costs of other generating technologies; and the need for new generation as capacity becomes short. Together these three reasons are a powerful argument for the future competitiveness of nuclear energy.
First, nuclear has excellent ability and opportunity to reduce its costs. This is illustrated in Figure 1. The US industry as a whole has shown continuous improvement over the five year period 1994–98. Average top quartile costs measured in US$/MWh has gone down from US$15.40 to US$14.40/MWh, a US$1/MWh reduction. Second quartile costs have gone from US$19.60 to US$17.10/MWh, a reduction of US$2.50/MWh, and third quartile performance has gone from US$23.80 to US$20.80/MWh, a US$3/MWh reduction. The 1998 average cost of the top three performance quartiles is less than US$18/MWh. Only in the volatile and troubled fourth quartile, dominated by historically poor performers or plants that have experienced long shutdowns and performance related regulatory difficulties, do we see an increase in costs. Further, the gap between the lowest and highest cost performers shows there is significant room for improvement. If nothing else, this gap shows the inefficiencies that have been tolerated by rate regulation.
The labour costs that dominate nuclear costs, seen by some as a major obstacle to competitiveness, are actually a strategic advantage. The costs of nuclear’s major competitors, coal and gas, are dominated by fuel costs. Because of this dominance by fuel costs, fossil operators have limited opportunity to further reduce their costs. They are at the mercy of their fuel supplies. In the case of nuclear, fuel costs are smaller than those for a fossil plant and are only a small portion of the total, with people being the significant cost. By marshalling the talent of people who are innovative and take initiatives in an environment that rewards investors for supporting such activities, we can improve plant performance, reduce costs, and create new opportunities for our industry.
Second, there is increasing recognition of the environmental costs of other generating technologies. The waste products of nuclear fission have been repeatedly thrust into the public eye as reasons to fear or oppose nuclear generation. We are now at the front edge of a growing wave of concern over the emissions of the fossil generation technologies of coal, gas and oil. The average citizen is now hearing more about CO2, NOX, SOX and a list of toxic materials that are released from fossil fuelled stations.
What the final form of regulation will look like for all of this is still unclear, and it will probably be subject to change. However, whatever form it takes will imply restrictions and increased costs. Tradable allowances are becoming a model in the USA for controlling fossil station SOX emissions. Another example is ozone levels in the northeastern USA. Meeting new ozone standards is already credited with driving up prices of electricity in that region. The exact amount and nature of the impact is still being worked out as traders in the electricity markets and electricity generators position themselves for NOX emission allowances. Estimates of compliance costs range from US$2/MWh to US$20/MWh.
An important benefit of the allowance system is that it puts the economic burden on the emitting technology. This is a superior public policy position for nuclear in that it improves the relative competitiveness of nuclear without any public policy struggle that would be involved in trying to get some kind of "clean air" subsidy for nuclear.
Third, there is an increasing need for new capacity across the USA as reserve margins dwindle. Economics tells us that in an expanding competitive market, the market price will be set by the lowest cost new entrant. Nuclear will be competing with its ongoing costs against installation of new capacity. The current competition for new baseload generation is gas-fired combined cycle combustion turbines. Estimated costs of electricity from a new CCCT range from US$30–35/MWh. New single cycle combustion turbines are estimated by some to produce electricity at US$60–70/MWh. The average nuclear costs for the top three performance quartiles ranges from US$14 to US$20. In such an expanding competitive market, nuclear should fare well and provide an increasingly attractive reward to its investors.
So, nuclear can be competitive and is already competitive in some cases. Its future competitiveness will be enhanced by further operational improvements, increasing assignment of environmental costs to competing technologies, and the addition of new generation for rising demand. Whether investors are rewarded for the benefits of nuclear competitiveness will depend to what degree the nuclear plants are indeed selling into a competitive generating market.
While gas and coal are currently major competitors to nuclear, we need to keep a watchful eye on potential new competitors. These could come from surprising directions. Restructuring is highlighting the importance of the transmission and distribution (T&D) system as the means by which competitively produced electricity is delivered to customers. This system is still considered suitable for rate regulation and is becoming the base upon which a host of stranded investments, decommissioning funding and other public policy charges are being loaded. As the T&D cost of delivered electricity increases, it creates a potential competitive advantage for small distributed generation technologies such as fuel cells or micro-turbines that will not need the regional or local grid.
What is Taking Place in the USA, State by State?
What is the progress of restructuring in the USA? Figure 2 shows a map of the USA with each state grouped into one of three broad categories by their relative cost of electricity. The wide variation in cost of electricity between states has been a major driver of restructuring. Business and industry are pressing hard for better electricity rates and the current disparities are a powerful force in decisions as to where new businesses will locate.
In Figure 3 the states are coded according to a simple categorisation of restructuring. While a few states have completed their restructuring, there are many more to go. From a nuclear point of view, the important states have been California, Illinois, Pennsylvania, New York and Massachusetts. These are important because they have been high cost states and have included nuclear plants in their areas. There is a whole wave of states that are in various stages of restructuring, and the timing of when they will actually do something is speculative until the ink is dry on the finally approved laws. Let me briefly review the states with nuclear plants that have completed restructuring programmes.
Looking at Figure 4, we note that plants have been sold only in states that have completed restructuring programmes, i.e. Illinois, Pennsylvania, New York and Massachusetts. We also see numerous nuclear plants being held on to by their current owners located in states that have restructured. Why are the current owners holding on to these power plants? The answers vary by each state and utility.
In California, nuclear assets were excluded from the portion of the restructuring law that created incentives for divestiture of generation. The California plants are essentially still in a rate regulated environment. In Illinois, the restructuring legislation does not require divestiture of generation. Commonwealth Edison has indicated an interest in staying in the nuclear business. The one single unit nuclear plant, Clinton, is in the process of being sold to AmerGen. In Michigan, although the state regulatory commission has issued a final order, there is no requirement to divest generating plants and there is yet to be supporting legislation for the commission’s order.
There is no requirement to divest in Texas and utilities there have made no indication of their plans for their nuclear units. In Arkansas there is no requirement to divest. The two plants located there, ANO units 1 and 2, are owned by Entergy which is buying, not selling, nuclear plants.
In Virginia, divestiture is not required and Virginia Electric Power continues to maintain its excellent operating record with its current plants, with no indication of interest to increase or decrease its nuclear commitment. In Maryland, divestiture is not required. Baltimore Gas & Electric appears committed to its nuclear operation by its plans for licence renewal. In New Jersey, divestiture is not mandated but may be used to mitigate market power. There is currently no indication of what utilities plan to do other than General Public Utilities (GPU) has announced plans to try again to sell its Oyster Creek plant.
In Pennsylvania, the commission is not allowed to require divestiture. Each utility files with the commission for approval of its own plan for recovery of stranded investment. PECO, 50% partner in AmerGen with British Energy, is holding on to its nuclear assets. GPU is selling all of its generating assets including TMI-1 to AmerGen. Duquesne Light and Pennsylvania Power are engaged in an asset swap that puts full ownership of Beaver Valley in Pennsylvania Power, a subsidiary of First Energy. The plants will be operated by First Energy Nuclear Operating Company. Duquesne Light plans to divest all of its generating assets and become a transmission and distribution company, similar to GPU’s strategy in divesting TMI-1.
In New York, functional unbundling is required and there are incentives for divestiture of generation. Niagara Mohawk is selling its interests in Nine Mile Point-1 and -2 to AmerGen. 41% of Nine Mile-2 is still held by three other New York utilities that have the option of matching AmerGen’s offer, participating in the sale or retaining their shares. Of the remaining four plants in New York, two are publicly held, complicating any action on them, and two are held by utilities that have not yet indicated any decision. In Connecticut, Northeast Utilities is required to sell its nuclear plants, Millstone-2 and -3, by 2004 as part of a deal to recover stranded investments. The utility expects to beat that deadline. In Massachusetts, Boston Edison has completed its sale of Pilgrim to Entergy. In New Hampshire, Northeast Utilities has indicated that a sale of Seabrook is likely, but no specific announcement has been made.
The four nuclear plant sales that have taken place to date have some common characteristics, and some differences. All four plants were sold for amounts well below their book value. This is reflective of the view that there will only be a small margin between nuclear operating costs and market clearing prices for electricity. All the sellers will receive significant stranded investment recovery from their rate authorities. Transitional agreements help bridge the gap for the old owners in terms of continued access to generation and provide some near term market price assurance to the new owners. These transitional agreements are generally of short duration, the longest one being five years.
The greatest differences in the sales are in the handling of the nuclear decommissioning liability. The first purchase to be completed was by Entergy of the Pilgrim station. Entergy is assuming the financial responsibility for decommissioning and is receiving a fully funded decommissioning fund from the original owner, Boston Edison. The GPU sale of Three Mile Island to AmerGen is pending. In this sale, the decommissioning risk is transferred to AmerGen, but GPU will hold its decommissioning trust fund until the time of decommissioning at which time it will provide a specified amount to AmerGen.
The pending Illinois Power sale of the Clinton station to AmerGen transfers the decommissioning liability, but only about half of the projected decommissioning cost is being transferred by Illinois Power. The pending Niagara Mohawk sale of Nine Mile Point-1 and 59% of Nine Mile Point-2 involves transferring the decommissioning liability to AmerGen with a transfer of essentially complete funding from Niagara Mohawk. The US Nuclear Regulatory Commission (NRC) has ruled that the 50% non-US ownership interest in AmerGen is not a problem for licence transfers. Indications are that licence transfer by the NRC will be handled on a timely basis and that the financial assurance requirements posed by the NRC for both operational contingencies and decommissioning are not unreasonable.
In addition to the activity going on in states that have restructured, a group of four utilities that own and operate nuclear generating stations in the upper Midwest are working together to position for a variety of possible future outcomes. The continuing separate ownership of the plants by four utilities in three separate regulatory jurisdictions complicates this co-operative effort. Current efforts are focussed on joint efforts that do not involve asset transfers.
What Does This Mean for Future Nuclear Success?
First and most important, investors are ready to invest in nuclear power plants. They are willing to take both operational and decommissioning risks of investing in the plants given the prospect of a corresponding return on their investment. Currently two companies are buying and others are talking about joining in.
Second, investor opportunities for nuclear power plants are limited by the pace of restructuring and the details of each state’s transition plans. Original owners are insisting that they be "made whole" for their historical nuclear investments prior to selling them to new owners. And new prospective owners are insisting that future decommissioning liabilities be reasonably provided, before they will buy from the original owners. In states that have restructured, the number of plants still held by the original owners is large compared to those sold.
For many of these unsold plants in restructuring states, the original owner’s business interest in the plant is driven more by the recovery of stranded cost than it is by sale of electricity from the plant. This will change over time as book values are reconciled with market values and decommissioning funding approaches necessary levels. This will extend out over many years and it is unclear what is the "critical mass" of investor owned nuclear plants in a competitive environment for there to be a favourable impact on the public policy environment.
Third, new power plants are being built by investors. Growing customer demand and increasing environmental restrictions on current fossil plants are driving the need for new generation. Gas technology is the leader in new plants, but its higher fuel costs will be its competitive weak point. There should be opportunities for new nuclear generating plants as time passes and electricity markets adjust and develop for baseload, intermediate and peaking demand, changes in the mix of generation plants and transmission system constraints. This poses a specific challenge to designers of new nuclear plants for economically attractive designs.
We should see future nuclear success in the form of new nuclear plants built by investors. The key is getting the right investor interest in the public policy, regulation, operation and design of the technology.
Competition is essential because it is the foundation for solving the other frequently cited obstacles to future nuclear success. Competition accomplishes this by directly correlating investor returns with overall operational performance of the technology.
Nuclear will be able to compete based on its ability further to improve its costs, the rising concerns over emissions from competing fossil technologies, and the need for new generation to meet rising demands for electricity.
Restructuring is proceeding in the US electricity industry with each state trying its own variation. The trend is competition in electricity generation but continued rate regulation of transmission and distribution.
The restructuring taking place is encouraging for future nuclear success. There is clear investor interest in existing nuclear plants. However, this interest is constrained by the rate at which individual states are restructuring. As competitive markets are developing, investors are already building new power plants. This need for new power plants is our greatest opportunity for future nuclear success.
© copyright The Uranium Institute 1999 SYM979899