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The financing factor

All electricity generation prices are dependent on location, not only because of different fuel prices in different parts of the world, but also because of different financing structures. Wind is more strongly influenced by differences in the cost of finance than its fossil fuel competitors. It is "capital intensive," meaning that since it has no fuel costs, nearly all the cost of a wind generated kilowatt hour lies in the initial investment and loan -- and the interest rates that have to be paid on both.

National institutional factors have a major influence on financing terms for borrowed money and on investors' expectations for a decent return on the equity they put into a project. To deal with this problem, at least in part, prices are quoted in ranges for all generation. Price ranges, however, cannot account for all the influencing institutional factors. A pragmatic approach is to use "typical" prices within a range.

The concept of levelised costs is commonly applied to calculations of all generation costs. It is used by most governmental and inter-governmental agencies, such as the International Energy Agency (IEA). The methodology means that costs are calculated net of inflation and are assumed constant over the life of the plant. As well as using levelised costs, both the IEA and the European Commission calculate electricity prices using common standards, typically using interest rates of 6% to 7.5% and project lifetimes of 15-20 years, leading to an "annual charge rate" of 10% (the amount charged to a project each year to account for depreciation and interest). The same common standards are used by Windpower Monthly.

In the real world, however, interest rates and project lifetimes vary. In Denmark, wind energy prices are calculated on the basis of a return on capital of just 5-6% and long project lifetimes (for financing) of 20 years. In the UK there are no agreed yardsticks. With most investments in the UK electricity sector regarded as risky, investors might well expect a return of 10-15% on their capital. Repayment periods in the UK rarely exceed 12 to 15 years for thermal plant -- and even less for renewables. In the United States, long term contracts can be secured, with annual financing costs lying between those of Denmark and the UK. Applying the levelised cost concept and using typical prices allows cost comparison across technologies and across borders.

Costing risk

With future fuel prices subject to uncertainty, levelised costs for fossil generation are being questioned. Financiers and economists allow for uncertainty by adjusting interest rates -- the riskier the project, the higher the rate of return that is demanded. As the traditional methods of calculating electricity generation costs assume that prices remain constant during the life of the plant, they do not deal with rising fuel prices.

Alternative approaches to estimating future electricity prices from fossil fuels are now being advocated. In the United States, where power markets are less protected from fuel price pressure than in much of Europe, Western Resource Advocates use a higher "capital recovery factor" (the annual fraction of capital charged each year) for fossil fuel plant. This is equivalent to using a higher interest rate.

Another approach, advocated by Shimon Awerbuch of the UK's Science Policy Research Unit at Sussex University, is to use a lower discount rate than traditionally used to work out the Net Present Value of fuel costs over the life of any fossil-fuel fired power station. Awerbuch suggests using discount rates between 2.1% and 6%, instead of the usual 6-10%. His "central case" uses 3.5%.

Awerbuch's approach yields similar results to those derived by assuming a steady increase in the price of gas, which is an easier way of understanding its impact. Other studies have attempted to quantify the risks associated with future fuel prices -- again producing results that tie in with the assumption of a steady rise in gas prices.

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