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Arvid Kruze, B Eng, MBA
International Power Sector Consultant

Financial and Economic Analyses
Electricity Tariffs
Team Leader / Project Manager

Montreal, Quebec, Canada
+1 (514) 484-8050

Why the Equivalent Thermal Plant Method is Fundamentally Wrong

I have come across a few feasibility studies where the economic analysis of a hydro plant has been undertaken using the Equivalent Thermal Plant (ETP) method. In each case, it appears to be have been accepted by the development agency that financed the study, so I guess it might be viewed by some as a standard economic evaluation methodology for hydro plants.

The ETP method was probably developed as a way to evaluate hydro projects in instances where the consultant either did not have the resources to conduct a proper analysis using appropriate planning software, or did not have sufficient data. On both counts, I have empathy for the economist charged with undertaking the analysis, as I have been in many such situations myself. However, the premise of an equivalent thermal plant is flawed, as there is no such thing. Hydropower is a totally different resource, not only in terms of cost (as the ETP method correctly assumes), but also operationally (which the ETP method does not consider).

I would speculate that the ETP method was probably concocted by an economist who really did not know much about hydropower, and about how a specific hydropower plant can fit within a given power system. However, this method seems to have been used on a sufficient number of occasions, by numerous economic analysts who also did not know any better, that it has even been given a name. It just goes to show that the economic analyses of hydro plants is best undertaken by a technical type such as an engineer who has had some economics training (or, perhaps an economist who really knows about electric power).

Just to clarify, I am addressing only grid-connected projects. Also, the correct way to conduct the analysis is to run generation planning software (the most well-known of which is WASP) to meet given system loads over a future time period, both with and without the subject hydro plant included in the inventory of generating plant available. The difference in the present worth of total costs between the two scenarios then defines the total benefit of the project. However, in the absence of sufficient resources or data to undertake such an exercise (which happens most of the time in a developing country setting), we are looking at second-best solutions. Even given these circumstances, the ETP method just does not measure up.

So, what is the ETP method? Well, as the name suggests, it basically involves defining the hydropower benefit as the avoided cost of an equivalent thermal plant. This includes the capital cost, fixed operation and maintenance (O&M) costs, variable O&M costs, fuel costs and interim replacement costs of a typical thermal plant that would have been operating within the system in the absence of the hydro plant. These benefits then offset the corresponding costs of the subject hydro plant in ultimately arriving at the net cash flow of the project. The selected ETP would have the same capacity and energy output of the hydro plant.

Wrong, wrong, wrong, wrong, wrong.

First of all, let us look at the avoided capacity benefit. The thermal capacity actually avoided is not equal to the installed capacity of the hydro plant, but its firm capacity; i.e., the capacity that can produced by the plant most of the time (say, 95%). While the firm capacity of a thermal plant can be expressed in terms of its installed capacity (well, almost; it should be recognized that the net capacity available to the system will be slightly less, taking into account station use and perhaps a de-rating of the installed capacity due to factors such as age), hydro plants are different. Hydro plants generally do not run at their installed capacities most of the time. Output will depend on the availability of water, which can vary tremendously over the course of a year. In forecasting generating capacity required to meet new loads, utility planners will use the firm capacity of a hydro plant as a resource to meet capacity needs. This capacity is much lower than the installed capacity. Therefore, by selecting an ETP of equal capacity to the hydro plant, the avoided capacity is much overstated.

Thus, the avoided capacity is the firm or dependable capacity of the hydro plant, defined as the capacity available to meet load requirements, say, 95% of the time, and not its installed capacity. Now, the cost of this capacity should be based on the cost of thermal base load capacity, as this is the actual type of capacity displaced by the hydro plant. The corresponding cost can be estimated based on an examination of the power system and its current base load generation, as well as information from the utility on what types of thermal base load it intends to add in the future. This could be a coal plant, a gas-fired combined cycle plant, or even outside capacity purchases; i.e., whatever is the least expensive thermal base load plant available. The ETP method will probably price capacity as the cost of an intermediate-level plant, such as a steam turbine, or maybe even diesels in the case of smaller systems. Such capacity is significantly less expensive than base load capacity on a per kW basis.

Thus, we have seen that the ETP method tends to over-estimate the amount of avoided capacity, but it will also tend to under-estimate the value of that capacity. But this is really aside from the fact that the basis for making these estimates is wrong.

Now for energy benefits. Energy generated from the hydro plant will displace energy otherwise generated from thermal sources. First, there is the energy associated with the firm capacity of the hydro plant, which can be costed at the incremental (per kWh) generating cost of the avoided thermal base load plant discussed above. Second, there is the remaining energy generated above the level of the firm capacity. The benefit of this energy is more difficult to estimate, as it will likely displace thermal energy generated from a number of plants and, probably, a little bit from each, be they intermediate-level or peaking plants. My first approach to making a corresponding avoided cost estimate is to take a weighted average (by energy produced) of the incremental unit generating (or purchase) cost of each non base load plant operating on the system, as well as future intermediate/ peaking plant additions. This may be a little tricky, as the mix could change significantly over time (something that WASP would capture). If the data do not exist, then this unit cost may be approximated, say, by using an estimated generating cost of the largest intermediate-type plants on the system, as any weighted average calculation will probably be skewed in this direction. In any case, with a little bit of ingenuity, this estimate can be made, and will depend on information available, as well as knowledge of how the power system works. Although this part of the exercise might require some thought, I have always managed to make some rational estimate. In any case, this is much more preferable to taking the blind and intellectually lazy approach of the ETP method.

The result under a proper methodology can be much different from that under the ETP method, where all of the energy benefit will be valued at the incremental generating cost of the ETP. If the hydro plant has a low capacity factor, then the ETP method will probably under-estimate energy benefits, as the selected ETP will probably be a more efficient plant than those already operating on the system and will have lower incremental costs. If the hydro plant has a high capacity factor (resulting in higher firm capacity), then the ETP method might over-estimate the benefit, as its energy cost will be higher than that of the avoided base load generation. Or, it is quite conceivable that the ETP method will yield a similar result despite the wrong methodological approach, but only through luck.

In my single experience where I was able to compare the results of my analysis with a previous one using the ETP method, I recall that my resulting economic internal rate of return (EIRR) was at least 3 percentage points higher than the previous ETP based EIRR. Of course, there were other inputs that influenced the difference in results, but my gut feel was that most of it had to do with the methodology (this was a run-of-river plant with a relatively low capacity factor).

Most of all, however, it is important to get the basics right before undertaking any analysis. In this respect, the ETP premise that one can simply use the cost of a similarly sized thermal plant as the basis for estimating the benefits of a hydro plant is completely wrong.