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Leonard Hyman & William Tilles

Leonard Hyman & William Tilles

Leonard S. Hyman is an economist and financial analyst specializing in the energy sector. He headed utility equity research at a major brokerage house and…

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This Trend Will Reshape Power Generation In The Coming Decades

The decarbonization of electricity production around the world today may be seen as part of a technological shift. Everyone wants electricity or its immediate benefits like cell phone charging. And until relatively recently, most consumers didn’t care how it was produced as long as it was affordable and accessible. But environmental or political movements aside, we are also witnessing a technological shift. The production of electricity on a commercial or wholesale scale is moving away from big-and-complicated machines and systems to small-and-less complicated forms of production. This implies no more gigantic projects that take 10 years to complete with costs that tally into the tens of billions. What’s interesting is that we seem to be witnessing a reversal of the idea of economies of scale with respect to both production of electricity as well as the optimal size of the distribution grid itself. This seems like a fairly radical departure that may shape the industry for decades.

Years ago, we had a discussion with one of the last centuries most fabled engineers. We asked, “If economies of scale really prevail was that a good reason to upsize electric power plants?” He replied that economies of scale did in fact prevail and utilities should go forward with big projects as long as they were certain about four key aspects relating to the project: 1) the ultimate completion costs; 2) duration of construction; 3) total capital costs (equity plus debt); and 4) expected market or demand for electricity at time of completion. What this asks, to borrow a phrase is, if you build it will they come—at the prices you ultimately have to charge?

Our readers know that recent nuclear new build has pretty much failed thoroughly on points one through three. And bringing it up in this context feels like piling on at this point. But this past week also saw the cancellation of a proposed gas fired base load project by a wholly reputable builder. Somehow this feels different in that perhaps we can no longer assume base load natural gas will be the bridge fuel as we transition away from fossil fuel based electricity production. With these facts in mind, we believe the concept of economies of scale for utilities might be ripe for revision. A recent study by a sextet of European and Canadian academics supported this view (Science, 3 April 2020) by examining the trade-offs of costs versus complexity concluding that in their terms granularity has advantages over lumpiness. 

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Our take on the key, statistically significant findings, from a business standpoint:

- Risk of cost overrun is smaller for small projects and that should reduce their cost of capital.

- Smaller projects generally have shorter lifetimes and that leads to more rapid modernization of asset base and lower cost per unit of capacity.

- Small projects are less complex technologically and that leads to lower costs.

- Small projects create more jobs.

- Unit cost per kw rises with size for both energy supply and energy end use projects.

In a detailed analysis made for presentation at a regulatory conference this spring now cancelled (to be found on blog page, lenhyman.com), we argued total decarbonization of electricity production would spur a rather large increase in industry capital expenditures but at a cost that would have little adverse impact on consumers. In our evaluation we did not consider that reduction in technological size or scale would lead to lower overall costs or— and this is vital— lower cost of capital. As we go forward capital cost becomes even more important given the size of contemplated industry expenditures as well as the eventual disappearance of fossil fuel as an operating expense entirely. Even if the findings only applied to cost of capital, savings would be significant. We calculate that a one percentage point reduction in pretax cost of capital reduces prospective electricity prices five percent in twenty years assuming the transition to decarbonization were completed by then.

How would we translate these findings into more concrete business policy? Decarbonization technology creates business benefits for two obvious reasons—it’s cleaner and cheaper (with zero fuel costs). And there is the possibility of reaping these benefits at far smaller, less capital intensive scale. The bigger is better/economy of scale thinking still pervades much US utility industry thinking and capital planning. This seems to be changing slowly. What we believe accelerates this change is a growing recogition that the traditional concept of a spoke and hub grid system is simply no longer necessarily an optimal business model.

By Leonard Hyman and William Tilles

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  • James Hilden-Minton on April 13 2020 said:
    It's very important to be aware of shifting economies of scale. Many technologies do tend to shrink economies of scale. Specifically battery based microgrids can pack a lot of grid capability very close to the end consumer, minimize the need for larger grid asset to standby for occasional need. Rather that infrastructure gets used more efficiently so that ultimately less of it is needed per kWh consumed. So we see a trend of more capital flowing into microgrid assets near the consumer than into macrogrid asset remote from end consumers. T&D cost as fraction of retail power prices decline. The danger for grid operators is that if they fight this trend, they will be stuck with diseconomies of scale, while their customers will defect to owning their own distributed assets. So utilities really do need to stay at the front of the innovation curve to localize investments and gain the economies of smaller scale.
  • Stephen Harris on April 13 2020 said:
    This post is interesting but seriously lacking in facts and examples. Is the intent to discuss distributed solar or group windmills or what? Obviously small scale is cheaper. The best example of such is the modern nuclear plants that are significantly smaller than the older plants and significantly safer today. Decarbonization as a concept is pretty silly as it is a homage to enviro-activists thinking that carbon is a bad word among the public. Carbon is the difference between all life forms and rocks and to politicize carbon by "scientists" is its own contagion. Carbon, locked in oil or gas or coal is ultimately the world's primary paleo-solar plant with energy originally derived from the sun and locked up until combustion, maybe hundreds of millions years later.
  • Peter Farley on April 13 2020 said:
    I think you have highlighted a point that most analysts don't appreciate, the big is better mantra in many things from transport (A380) to power stations has passed its use by date. People will use less energy and generate more of it locally because these days the cost of transmission and generation is often more than the cost of the actual energy.
    Even plants like steel mills, car plants and aluminium smelters can be efficient at much smaller scales than in the past and with wind, solar and flexible operation can place very small demands on the grid, while being located close to a source of demand rather than near a coalfield or hydro plant. This in turn reduces transport distances and costs both for raw materials and finished goods

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