Evaluating Expected Electric Generation Technology Cost and Risk: Applying Modern Portfolio Theory to North Carolina Electric Power Generation

Abstract

Efforts to diversify electric generation technology and fuel sources have received increased attention from state and federal policy makers. To what end and at what cost electric generation diversity should be pursued has been a point of contention in North Carolina. The North Carolina Utilities Commission has declined to adopt the diversity standards expressed in the 2005 Energy Policy Act, but the North Carolina General Assembly and Governor explicitly stated their intent to diversify electric generation technologies and fuels with the passage and enactment of Session Law 2007-397. Session Law 2007-397 requires renewable energy to account for 7.5 percent of electric utilities’ retail sales by January 1, 2018. This study aims to assess diversification’s role in building least-cost electric generation portfolios. To gain further insight into potential least-cost electric generation portfolios, decision-makers can employ modern portfolio theory. Since the 1950s, investors have used modern portfolio theory to reduce a stock portfolio’s risk through the selection of stocks whose returns do not move exactly together. Modern portfolio theory has also been applied to real asset portfolios, and this study uses mean-variance analysis to locate minimum cost electric generation portfolios given historical cost risk and proxy measures. The results reveal Session Law 2007-397 may create electric generation portfolios with lower expected risk than projected electricity portfolios absent a renewable portfolio standard. Wind and to a lesser degree, new biomass resources, play a pivotal role in expected cost and risk reduction; they exhibit lower investment cost risk and no or weak positive correlations with coal and nuclear fuel costs. Natural gas electric generation reduces expected portfolio risk in particular portfolios, because its fuel cost risk is negatively correlated with coal and nuclear fuel costs. Existing coal and nuclear electric generation is difficult to replace, because both electricity sources exhibit low expected cost and risk.