The portfolio diversification value of nuclear power in liberalized electricity markets

Abstract

The key difference between a regulated and a liberalized electricity market is the establishment of a competitive generation marketplace via spot markets, day-ahead auctions, and over-the-counter trading activity. In a liberalized market, power plants are no longer guaranteed a fixed return on capital investments or the ability to pass on increases in fuel prices to customers directly. Therefore, power generators have had to modify their capital allocation and marketing strategies to resemble that of a typical competitive market participant more closely, balancing expected returns with portfolio risk. Advanced Combined Cycle Gas Turbine (CCGT) power plants are currently viewed as the most attractive generation investment option, offering low capital costs, short construction lead-times and financial optionlike qualities. In contrast, a nuclear power plant's levelized cost is dominated by large fixed costs and capital expenditures. Even the perception of nuclear power as being a hedge against volatile natural gas markets has been called into question by power market Monte Carlo simulations. These simulations indicate that CCGT power plants are actually the generation option with the least exposure to natural gas and electricity price uncertainty because of the intrinsic hedge created by the historically high correlation of natural gas and electricity prices[1, 2]. Nevertheless our simulations, heavily focused on modeling the non-linearity of the power supply curve, indicate that the portfolio diversification value of nuclear power is dependent on the generation composition of the power market. In markets primarily composed of natural gas fired capacity, an investment in nuclear power offers no portfolio diversification value, with all three baseload generation types are effectively long positions in natural gas. Conversely, in markets with a large amount of coal capacity there is a competition for market share between major marginal fuel types, coal and natural gas, which creates less favorable market dynamics for the CCGT. While we still observe a high natural gas-electricity correlation, the intrinsic hedge no longer stabilizes the CCGT profits. Our simulations indicate that in a bi-marginal fuel market a CCGT power plant is short natural gas, with cheaper natural gas helping to boost capacity factors, reduce operational heat rates, and displace coal power plants. Similarly, as currently observed in Northeastern power markets, cheap natural gas has not only shrunk coal power profit margins but also negatively impacted plant capacity factors. Therefore, the portfolio diversification value of nuclear comes from it being insulated from fossil fuel price uncertainty, but not because this attribute equates to a more stable levelized cost. Rather, nuclear power's low cost and low volatility fuel insures that an unfavorable shift in fossil fuel prices will not result in a large decrease in capacity factor and subsequent increase in profit volatility.