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XYLENE POWER LTD.

EQUIPMENT FINANCING

By Charles Rhodes, P.Eng., Ph.D.

INTRODUCTION:
This web page addresses the financing criteria that must be met in order to achieve broad implementation of private sector owned electricity generation and energy storage within the Province of Ontario. It is shown that private sector financing increases electricity rates and requires reduced project construction periods.
 

CAPITAL FINANCING:
Generators and energy storage systems are usually owned by corporate entities. Private sector entities generally attempt to earn about 30% per annum return on common share (equity) capital. Private sector corporations evaluate distributed generation and energy storage measures based on that benchmark, although they will generally leverage equity capital with 50% debt financing provided that there is reasonable certainty of a net positive cash flow.

Any distributed generation or energy storage facility has an initial capital cost C. In order to finance that facility the owner generally requires a minimum ongoing revenue net of fuel and other consumeables of about .04C per month. Of this amount, typically .01C per month is applied to operating, maintenance, and repair costs and .03C per month is applied to meeting blended principal, interest and dividend payments. In practise, construction of a practical energy facility involves payments to engineers, suppliers and trades several months in advance of when the revenue stream starts to be realized by the facility owner, so the apparent owner's simple payback period given by:
(Simple Payback Period) = C / (.03 C / month) = 33.3 months
increases to about 36 months or about three years. If the simple payback period exceeds three years the private facility owner will usually choose not to proceed with the project because the facility owner has alternative uses for his capital that earn a higher rate of return. With 50% debt financing the owner's actual blended cost of funds is about 20% per annum and the equipment must operate as projected for at least five years for the owner to break even.

Private sector owned electricity generation results in electricity that is about twice as expensive as it would be if 100% of the financing was government guaranteed debt. However, private sector financing has the advantage that financial risk associated with the project is removed from both the electricity ratepayers and the taxpayers.
 

FINANCING CONSTRAINTS:
The existing large generators in Ontario were mostly financed by long term debt instruments that were guaranteed by the government of Ontario. The interest rate on such government guaranteed financing (about 7% per annum) is about 1/3 of the cost of private sector mixed equity and debt financing with no outside guarantees. The cost of private sector financing includes legal, accounting, administration, brokerage fees, bridge construction financing, long term debt service, insurance and dividend payments.

Let C be the full capital cost of new base load generation. Assume that the generator runs 67.4% of the time per year (Capacity Factor = 0.674) to match the Ontario provincial load profile. This generation constraint is required to ensure that Ontario has enough generation to meet its annual peak requirements. For each such kW of generation capacity the generator produces:
1 kW X .674 X 8766 h / year = 5904.24 kWh / year.

Private sector entities have a revenue requirement of .04C per month or .48 C per year. Of this amount .01 C per month is set aside for administration, operation, maintenance and repair expenses leaving .03 C per month for payment of financing costs. The average value Vp per kWh required to attract private sector investment in electricity generation is then given by:
(Required Income) = (Actual Income)
or
[(.04 C / month) X (12 months / year) = 5904.24 h / year X P X (Vp - F)
where:
P = plate rated continuous power output capacity of generator;
F = the cost of fuel and other consumeables per electrical kWh generated.
Note that for reciprocating engines the engine can be viewed as a consumeable item, because the operating life of such engines (20,000 hours) under base load conditions is small compared to the typical energy supply contract term (20 years).

Then rearranging the previous equation gives:
(Vp - F) = .48 C / (P X 5904.24 h)

By comparison governments are often satisfied with a revenue net of fuel costs of .02C per month or .24C per year. Of this amount .01C per month is set aside for administration, operation, maintenance and repair expenses leaving .01C per month for long term debt service. The corresponding value Vg of a kWh required to attract government investment is given by:
(Vg - F) = .24 X C / (P X 5904.24 h)

The following table summarizes the private sector value (Vp - F) and the government financed value (Vg - F) in $/kWh as a function of capital cost per kWe [C/P] in $/kWe for generation operating at 67.4% capacity factor:
[C/P]
SECTOR
   $1000/kWe   $2000/kWe   $4000/kWe   $6000/kWe   $8000/kWe
Private
(Vp - F)
   $.0813/kWh   $.1626/kWh   $.3252/kWh   $.4878/kWh   $.6504/kWh
Government
(Vg - F)
   $.04065/kWh   $.0813/kWh   $.1626/kWh   $.2439/kWh   $.3252/kWh

Note that the amount of revenue available for financing service in the private sector case is .03C per month whereas the corresponding amount of revenue available for financing service with government guaranteed debt is .01C per month. The distinction between private sector capital and government capital is that private sector investors must bear the project risk and have other competing investment opportunities whereas government capital is designated for a specific application and shifts the project risk to the electricity rate payers and taxpayers. In Canada, for certain technologies, there is presently some tax mitigation of (Vp - F) via Capital Cost Allowance (CCA) Class 43.2. However, this mitigation would likely be cancelled by the federal government if numerous investors took advantage of it.

The issue of the cost premium for private sector financing of electricity sector fixed assets has not yet been adequately appreciated by either the Ontario Power Authority (OPA) or the present government of Ontario.

The private sector's perception of risk in electricity investments in Ontario is in large part a result of thirty years of Ontario government interventions in the electricity market by way of loan guarantees, artificial rate fixing, concealment of stranded debt, preferential treatment of government owned generators and distributors, sector subsidies, etc. all of which have combined to make private sector investment in electricity generation in Ontario a very risky undertaking. There is no short term solution to this problem. Many private sector parties who made good faith investments in the electricity sector lost money as a result of vacillations in government policy. If the government of Ontario now wishes to use private sector capital for financing electricity projects, contracts where the financing is not government guaranteed will bear a high cost premium.

The Ontario Energy Board (OEB) may wish to express its view to the government and to the electricity ratepayers regarding the stated plans of the Ontario Power Authority (OPA) to use private sector financing in place of government guaranteed financing, because the effect of the private sector financing premium is to approximately double the long term cost of electricity in Ontario. It may be more prudent for the OEB to insist that the stranded electricity debt be rapidly paid off so that Ontario can return to use of government guaranteed debt for financing major electricity projects.

Common sense suggests that, to minimize the cost of electricity, major electricity sector fixed asset investments should be financed via government guaranteed debt. However, that policy only works if the electricity rates are set at a level which repays that debt principal within the operating life of the fixed asset. That principle was abandoned by Ontario in 1992 and for 20 subsequent years governments of all political stripes failed to face the the issue that electricity rates in Ontario were not sufficient to recover electricity system costs. Only very recently have electricity rate increases been sufficient to narrow the gap between electricity system revenue and electricity system costs.

Note that as a generator's load factor or capacity factor goes down its required compensation rate (in $ / kWh) for financial viability increases. Thus, even with government guaranteed financing, a natural gas fuelled peaking generator with a load factor of 10% and a capital cost of $1000 / kW requires a (Vg - F) value per kWh of:
(Vg - F) = [(.02 / month) X (12 months/year) X ($1000/ kW)] /[.1 X 8766 h/year)]
= $.274 / kWh
which, at present natural gas prices, implies an average Vg value in the neighbourhood of:
Vg = $.40 / kWh
This rate reality is presently concealed by the OPA via a system of standby charges.

Hence, the availability of energy storage and sheddable loads to displace low load factor peaking generation is a crucial issue in minimizing on-peak electricity costs. The present electricity rate structure and the present OPA incentive programs do not adequately value energy storage.

The required generator compensation (Vp - F) is proportional to the capital cost per kWe of power output capacity and is inversely proportional to the load factor. This author's personal experience was that in 1998 - 1999 the full capital cost of natural gas fueled behind the meter base load electricity generation with heat recovery was about:
[C/P] = $2000 / kWe.
All forms of non-fossil fuel electricity generation are more expensive.

The source of the aforementioned required revenue requirements and the required provision for ongoing operating, maintenance and repair costs is this author's 30 years of experience designing, selling, financing, manufacturing, installing, operating and maintaining complex energy systems for both government and private sector customers.
 

CONSTRUCTION PERIOD:
A major issue with private sector financed electricity projects is the length of the construction period. This issue is most evident with nuclear projects. Most past nuclear projects have relied on government financing. A culture has arisen within the nuclear industry that tolerates construction periods in the 6 to 10 year range. However, with private sector financing the same work must be done in 3 to 5 years in order to prevent the capital cost being dominated by the cost of financing. It is crucial that nuclear construction agencies such as CANDU Energy recognize this issue and act accordingly. Minimizing the "overnight cost" (the cost of construction without any interest or inflation) does not minimize the resulting cost per kWh of electricity supplied. For example, it is much less expensive for the electricity ratepayer to build two 500 MWe reactors in successive 5 year periods than it is to build one 1000 MWe reactor over a 10 year period. Use of smaller reactors also reduces the cost of Spinning Reserve, which is a significant fraction of the cost of electricity supplied to the end user.

To demonstrate the capital cost impact of the construction period, it is helpful to consider a numerical example. Consider two electricity utilities that are nearly identical. Utility A builds a 500 MWe reactor in a 5 year period and then builds another 500 MWe reactor in the following 5 year period. Utility B builds a 1000 MWe reactor in the same 10 year period. Both utilities have an overnight cost of $5000/kWe or $5,000,000/MWe. Both utilities spend money directly on nuclear construction at the rate of $500,000,000/year. After 10 years both utilites have spent $5 billion on overnight costs. After 10 years both utilities are generating electricity at the same rate. Both utilities have a cost of private financing which is 20% per annum. However, for the two utilites the effect of the cost of financing on the capital cost C and hence the cost per kWh of electricity generated is very different.

Utility A:
The increase in capital cost C for a 500 MWe reactor due to the cost of construction financing is given by:
[(1.2) + (1.2)^2 + (1.2)^3 + (1.2)^4 - 4] X $500,000,000
= [1.2 + 1.44 + 1.728 + 2.0736 - 4] X $500,000,000
= 2.4416 X $500,000,000
Thus the reactor capital cost increases from the overnight cost of $5 X 500,000,000 to $7.4416 X $500,000,000 which is an increase of:
(2.4416 / 5) = 0.48832 = 48.832%.

Utility B:
The increase in capital cost C for a 1000 MWe reactor due to the cost of construction financing is given by:
[(1.2) + (1.2)^2 + (1.2)^3 + (1.2)^4 + (1.2)^5 + (1.2)^6 + (1.2)^7 + (1.2)^8 + (1.2)^9 - 9] X $500,000,000
= [1.2 + 1.44 + 1.728 + 2.0736 + 2.48832 + 2.985984 + 3.5831808 + 4.2998169 + 5.1597802 - 9] X $500,000,000
= [2.4416 + 13.51708] X $500,000,000
= 15.95868 X $500,000,000
Thus the reactor capital cost increases from the overnight cost of $10 X 500,000,000 to $25.95868 X $500,000,000 which is an increase of:
(15.95868 / 10) = 1.595868 = 159.5868%.

Clearly, with private sector financing a construction period longer than 5 years is completely unacceptable. If the reactor size has to be reduced to meet the required construction time frame, the nuclear industry will simply have to accept that reality. If the construction period exceeds five years there is no way that economies of scale can keep pace with increases in the cost of construction financing.
 

WIND TURBINE:
Consider a private sector investment opportunity where the OPA offers $.14/kWh for all the electricity that can be generated by an on-shore wind turbine that operates at a capacity factor of 30%. Another government program offers a green generation incentive of $.01 / kWh. The wind generation facility can be built in less than one year. Then:
(Vp - F) = .48 C / (P X 8766h X 0.30)
where:
F = 0
and
Vp = $.14/ kWh + $.01/kWh
= $.15 / kWh

Substituting the values of Vp and F into the above formula and rearranging gives:
[C / P] = ($.15 / kWh)(0.30 X 8766 h) / .48
= $821.8 / kW
Thus on-shore wind projects only make economic sense for a private sector investor if the projected costs for building the wind generation facility can be kept under $821.8 / kW. The facility value mentioned for public consumption is typically three times that figure, or:
3 X $821.8 / kW = $2465.4 / kW
That facility value is the price that the developer might reasonably seek if he was selling the fully functional wind generation facility to an arms length party.
 

PRIVATE SECTOR FUNDED NUCLEAR POWER STATION:
Consider a private sector investment opportunity where the OPA offers $.30/kWh for all the electricity that can be generated by a nuclear power station that operates at a capacity factor of 90%. The nuclear power station can be built in less than five years. Then:
(Vp - F) = .48 C / (P X 8766 h X 0.90)
where:
F ~ 0
and
Vp = $.30 / kWh

Substituting the values of Vp and F into the above formula and rearranging gives:
[C / P] = ($.30 / kWh)(0.90 X 8766 h) / .48
= $4930.87 / kW
Due to the five year construction period the maximum amount available for meeting "overnight costs" is given by:
(5 / 7.4416) X $4930.87 / kW = $3313.04 / kW
Thus under these terms nuclear power projects only make economic sense for a private sector investment if the projected overnight costs for building the nuclear power station facility can be kept under $3313.04 / kW and the construction period can be kept under five years. The facility value mentioned for public consumption is typically:
3 X 4930.87 / kW = $14,792.61 / kW
That facility value is the price that the developer might reasonably seek if he was selling the fully functional nuclear power facility to an arms length party. Nuclear construction has not proceeded on these terms because private sector investors do not believe that they can achieve overnight costs as low as $3313.04 / kw and governments have been reluctant to contract for base load electricity at a price of over $.30 / kWh.
 

GOVERNMENT FUNDED NUCLEAR POWER STATION:
Consider a government investment opportunity where the OPA offers $.30/kWh for all the electricity that can be generated by a nuclear power station that operates at a capacity factor of 90%. The nuclear power station can be built in less than five years. However, to minimize risk related to completion delay the government requires private sector construction bridge financing, which costs 20% per annum. Then:
(Vg - F) = .24 C / (P X 8766 h X 0.90)
where:
F ~ 0
and
Vg = $.30 / kWh

Substituting the values of Vg and F into the above formula and rearranging gives:
[C / P] = ($.30 / kWh)(0.90 X 8766 h) / .24
= $9861.75 / kW
Due to the five year construction period and the 20% per annum construction bridge financing the maximum amount available for meeting "overnight costs" is given by:
(5 / 7.4416) X $9861.75 / kW = $6626.09 / kW
Thus under these terms government funded nuclear power projects only make economic sense if the projected overnight costs for building the nuclear power facility can be kept under $6626.09 / kW and the construction period can be kept under five years. The facility value mentioned for public consumption is $9861.75 / kW which matches the amount of public funds actually committed during the construction period.

Note that even with government funding of nuclear power Ontario can reasonably anticipate that the cost of base load electricity supplied to the grid by new nuclear reactors will be about $.30 / kWh.

However, provided that the nuclear reactors can be located close to load centers, the delivered cost of new nuclear electricity will be small compared to the delivered cost of equivalent electricity from remote wind generation.
 

This web page last updated May 25, 2013.

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