Weighing the Economic Risk of New Nuclear Build Using Real Options

The question of whether and when to resume building nuclear power stations is fundamental to the UK's energy strategy. Government now approves in principle of new nuclear build, but wants any new nuclear-power programme to be managed and financed wholly by the private sector, meaning that the decision on whether to proceed or not needs to be based primarily on economics. This paper analyses the case using a risk-based, realoptions approach. It is shown that it is economically advisable to invest in new nuclear power generation either now or in the very near future. One of the biggest technological decisions facing the UK at the present time is whether and when it should build new nuclear power stations. While the 2003 Energy White Paper1 recommended only that the nuclear option should be kept open, by this year Government2 was stating its belief that "nuclear has a role to play in the future UK generating mix alongside other low carbon generation options". The background to this strengthening of the Government's position is the need to install replacement generation capacity at a time when the world's energy supply has been tightening and prices have been rising dramatically. During the last decade of the 20th century the UK enjoyed a stable and well-balanced source-mix for power generation, and this situation continued into the first few years of the new millennium, so that in 2002 the percentage of electricity from gas-fired generation amounted to 34%, with 32% from coal, 23% from nuclear, 3% from renewables and 4% from oil and other sources3. But this benign situation is unlikely to continue. DTI projections for 2020 are 60% from gas, 15% from coal, 7% from nuclear, 14% from renewables, and 4% from other4. Gas will be the predominant fuel, and Laughton5 suggests it is set to assume even greater dominance, accounting for 70% of all electrical power generated by then. By 2020 rising electricity demand will have combined with the retirement and closure of aging and inefficient power stations to give rise to a need for 50 GW of new and replacement power generation, equivalent to 50 major power stations. The UK’s indigenous gas supply is diminishing with the UK now a net importer. Furthermore 80% of gas used in the UK is expected to be imported by 20206. Of this, the Minister of State for Energy identified that 27% could come from various world-wide suppliers of liquid natural gas, 22% from Norway, and 51% through pipelines from Russia, North Africa and Central Asia7. With 80% of gas being imported and with up to 70% of power generation relying on gas, the UK economy will face uncertain availability of electricity as a result of potential, political instability in some gas supplying countries8. At the same time there will be a rising demand for gas worldwide as emerging economies power their growth, and the two factors will work together to increase the UK's vulnerabitity to gas-price volatility. Establishing a degree of independence from world-wide economic and political events will become an important policy objective, and this implies a need for diversification of sources and fuels for electricity production. Government intends streamlining both the safety authorisations and the planning procedures for new nuclear power stations but it has emphasised that such stations should be financed privately for the whole of their lifecycle, including decommissioning and long-term waste management2. This puts the economic case for new nuclear construction at the heart of the decision of whether and when to build. Traditional investment appraisal methods such as net present value fail to acknowledge the degree of uncertainty surrounding the investment, the volatility of the future value of an asset, and the length of time before an investment decision needs to be made. Real-options modelling extends the risk-based, probabilistic methods used to value stock-market options to cover tangible assets such as engineering plant that are subject to similar investment uncertainty. Nuclear-generated electricity has the environmental advantage of zero operational carbon emissions and carbontrading regulations would increase the attractiveness of nuclear energy. However, this paper ignores the potential benefits to the nuclear case of such regulatory mechanisms.