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Calculating the risk premium

Financial risk adds cost to any project that depends on borrowed money. The bigger risk that margins on earnings may be smaller than planned for, the greater the added cost, or the "risk premium." Power projects with firm construction costs, reliable production estimates and guaranteed energy purchase prices carry least risk of defaulting on loans and promised returns to investors, while projects where revenues fall short of projections and where costs may overrun carry most risk of not meeting their loan repayments and the expectations of their owners for profit. Only by correctly assessing the risk premium for any long term investment can true cost comparisons be made (main story).

Investments in nuclear, coal and gas power plant are inherently riskier than investments in wind plant. Nuclear power stations have a long history of cost overruns and being bailed out of financial difficulties by taxpayers. Coal and gas plant must contend with volatile fuel prices and the chance prices will rise faster than expected.

Wind suffers from neither affliction, although correct assessment of the size of the available resource -- wind strengths over the economic life of the project for a specific location -- is paramount. Despite the industry's youth, wind speed estimates for the life of a project are increasingly robust and expected to improve further.

In the financial world, any risk can theoretically be translated into a cost. The investor in a fossil fuel power plant can either live with the risk that its generation costs will fluctuate due to the variations in fuel prices, or "hedge" that risk on the financial markets. Hedging the risk comes at a cost. To quantify the additional costs associated with hedging gas prices, analysts look at historical fluctuations in natural gas prices using standard financing procedures.

According to a 2003 analysis for the International Energy Agency by the late Shimon Awerbuch, an increment of $12/MWh (about EUR 10/MWh) should be added to estimates of the generation costs from natural gas to cover the cost of hedging investment risk. A figure of $5/MWh has been suggested by California's Lawrence Berkeley National Laboratory, which while smaller than Awerbuch's calculation is still a significant sum.

Both figures were arrived at before the recent excursions in oil and natural gas prices. Once these are used to refine the database for fuel price uncertainty, higher estimates for the "risk premium" on fossil fuel investments are likely to result. The bigger risk premium increases their generation costs and makes wind power relatively more competitive.

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