A shift from least-cost basis to efficient power generation model

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A crucial factor for the development of geothermal resources has been the price the state electricity utility PLN is willing to pay for electricity from geothermal power plants.

Price delivers information and defines a complete Power Purchase Agreement (PPA) transaction. Unless a subsidy is provided, a price higher than the willingness of PLN to pay does not assure a transaction. Similarly, a price lower than a cost of production cannot guarantee a transaction be completed.

PLN determines the price it is willing to pay on “the least cost basis”. This seems quite normal as for the last half century a least-cost notion in many countries has provided the basis for capacity expansion. Utilities are confident that by adding so-called “least-cost” alternatives, they could — at the lowest cost — expand their electricity structure. Least-cost worked sufficiently well in a technological regime marked by relative cost certainty, technologically homogeneous generating alternatives, and stable energy prices.

Before deregulation, we invested in oil-fired power plants, both because we had enough oil and were an oil exporting country. The price of oil was relatively stable. The reality today is that we have to import oil, and the price of oil has become not only high, but also very volatile, and unpredictable. While PLN is striving for, and achieving, diversification of its generating source, the fact is that close to 80 percent of PLN’s annual expenditures goes on oil purchases, as the generation mix cannot be changed over time.

Today, by contrast, a broadly diverse range of technological and institutional options for generating electricity is available. Under the first fast-track program we have focused on coal and under the second on a mixture of geothermal, hydro and gas.

What has not been determined is the price that PLN should pay, which appears to be inhibiting the rapid growth of a more diversified electricity mix.

With deregulation, and the increase in the cost of fossil fuel-based electricity, we have changed our focus from supply-driven energy generation and implemented a string of regulations focused on demand side management. The supply side is regulated by increasing the efficiency of energy utilization in all sectors, while maximizing supply of renewable energy by applying an “avoided fossil fuel cost” model.

The fundamental regulation resulting from the changed paradigm requires PLN to purchase geothermal electricity at a price below than the cap of avoided fossil fuel costs — 9.70 US cents/kWh. This has considerable potential benefits in the reduction of energy subsidies.

It also created problems and shows a potential conflict between the interests of local and national governments. Although proper statistical evidence is not available, observation of the price per kWh in 2011/2012, after the announcement of this cap price, are all very close to the 9.7 US cents per kWh, as compared with prices between 2008 and 2011, of 7.2 US cents and below.

Without prejudice, this would be a very logical position from the point of view of the local government, as royalty over a higher price will provide more benefits for the local community and can pay for additional infrastructure or other public spending.

Such a higher price might not be in the interest of the national government, which is providing a very high subsidy to allow PLN to charge a minimum retail tariff.

Is the avoided cost principle a sufficient basis to define the national future energy (electricity) mix? To answer that question, we can borrow a modern portfolio theory developed by Harry Markowitz, Nobel Laureate in economics in 1990. Markowitz’s theory looks at the performance of a portfolio of assets based on the combination of its components’ risk and return.

Efficient portfolio principles require that we evaluate conventional fossil fuel and renewable alternatives not on the basis of their stand-alone cost, but on the basis of their portfolio cost — i.e., their contribution to overall generating cost relative to their contribution to overall risk.

It sounds complicated, but here is a simple explanation. At any given time, some items in the portfolio have higher costs while others have lower, yet over time, an astute combination of resources serves to minimize overall expected generating costs relative to the anticipated risk. The idea that adding a more costly technology, such as geothermal, has to increase average generating cost seems obvious and compelling. Nonetheless, it is incorrect.

And here is the implication. Estimating overall generating costs for a given mix, involves assessing long-term future cost expectations for highly uncertain fossil fuel and other outlays that have fluctuated significantly and unpredictably in the past.

In other words, generating cost estimates reflect an assessment of how costs will behave in the distant future, not in one or two years, but 20 to 25 years from now. Highly uncertain long-term costs cannot be directly observed or calculated the way we calculated cost for oil-based power generation 25 years ago.

We know that rising fossil price levels and volatility depress macroeconomic activity as measured by GDP growth, employment and inflation. Energy mixes that are needlessly exposed to fossil risk reduce energy security. A portfolio approach helps us evaluate the cost and risk of alternative generation mixes and create efficient portfolios that best meet energy diversity and security objectives.

Efficient portfolios minimize the energy price risk and thus reduce or eliminate subsidies for electricity generation. This is a crucial aspect of our energy security. We must focus not only on energy security considerations due to the threat of abrupt supply disruptions such as what happened in Europe in 2001. We should consider another more profound aspect of energy security — the risk of unexpected increase of fossil fuel cost.

Energy security downgrades, as occurred in 2008 and 2011, when our portfolio was needlessly exposed to fossil price risk, result in unexpected needs for additional huge energy subsidies. In this regard, geothermal energy is a very important generation asset. Unlike the cost of oil, coal or gas, the cost of geothermal, after the resources have been proven, is constant, only affected by cost of living increases.

In summary, geothermal is one of the best assets to have in our would-be efficient energy generation portfolio. Even relatively small percentage increases in fossil prices can yield sizeable economic losses through higher energy subsidies. The avoided-fossil fuel cost principle indeed reduces the energy subsidy but efficient generating portfolios structurally minimize national exposure to such long-term price fluctuations.

The writer is director for energy, mineral resources and mining at the National Development Planning Agency (BAPPENAS). The opinions expressed are personal.