Coming to terms with the projected future value of energy
MARKETS are powerful economic tools to encourage economic efficiency. However, financial markets do not necessarily price capital for investments in energy markets at a rate that encourages long-term energy security.
The graph shows that, as the cost of capital increases, today’s value of energy in the future (energy used by our children) decreases. (This is known as the discounted value of energy.)
International lenders are more concerned with getting their money back (with a profit) than in providing for our children and grandchildren.
Debt refers to borrowing from banks, usually in the form of selling a contract to repay the debt at specific rates and at specific times, known as a “bond”.
The rate of return is generally known as the “interest rate”.
Equity (stocks) refers (1) to the funds raised from the retained earnings of a company, and (2) to funds raised in financial markets through the sale of “stocks”, traded on stock exchanges.
The rate of return on equity is known as the “rate of return on capital”.
Together the rates paid to debt and equity combine to form the “cost of capital”, and are used to determine the rate at which to discount into the present the future expenditures and returns on investments.
As the graph shows: As the cost of capital rises, the value of energy, for example, electricity, is lower and lower in today’s average cost calculations.
If the cost of capital were 3 percent, known to economists as the “social rate of discount”, after 23 years (about the time that a baby born today may start to have their own children), the value of electricity is worth half as much as its worth today (because we would prefer to consume electricity today, than wait for 23 years).
At a cost of capital of 5 percent, the value of electricity is worth about a third of its value today after 23 years.
At 7.5 percent, the value of electricity is worth less than a fifth of what it is today.
At 10 percent, the value of electricity is only worth a tenth of what it is today.
Riskiness
Required rates of return rise as their “grade” or “rating” in the international financial markets fall.
Agencies in the international financial markets evaluate the riskiness of debts and equities, and assume that the riskiness of the stocks and bonds issued by an electric utility today is at least equal to the riskiness of the country in which the utility generates and sells electricity.
And the riskiness of an electricity-generating project is at least as great as the riskiness of the electric utility.
There are many firms rating bonds and stocks; however, 95 percent of the financial instrument rating market is dominated by the “Big Three” credit rating agencies: Standard & Poor’s (S&P) and Moody’s in New York, and the Fitch Group in London.
Their primary rating is between “investment grade” securities (Moody’s rated AAA to BBB) and “speculative grade” securities (Moody’s rated BB to C).
Although they dominate the international market, they are fallible: they rated mortgage-backed securities before the financial crisis of 2007-2008 as investment grade, when, in reality, they were speculative.
S&P’s is currently rating most electric utilities in Europe, the Middle East, and Africa at A-, BBB+, and BBB, where the minus sign implies that the rating could decline in the future and the plus implies that the rating could increase in the future.
Currently, S&P’s rates bonds paid in foreign currencies by South Africans at BBB- and bonds paid in rand at BBB; that is, the same ratings as most of the electric utilities in Europe, the Middle East and Africa.
On April 3, S&P’s downgraded South African government debt to be repaid in dollars to BB+ (below “investment” grade) and on April 6, they downgraded debt issued by South African banks to be repaid in dollars to BB+.
Next, they will quite possibly downgrade other South African companies and their potential investments. Debt to be repaid in rand remained “investment grade”, but the rand against other currencies has fallen in currency markets.
Competitive
When building electricity generation capacity, the cost of capital rises as the bond rating falls. In other words, banks buy bonds only if the rate is competitive with comparable bonds for all countries and firms, and investors only buy stock if the rate of return is competitive with investments of comparable risk.
This is a problem in the electricity-generating market, where all carbon-free generation technologies are capital-intensive. This includes nuclear power, hydro, wind and solar. Banks and investors are considering short-term returns, but investments in carbon-free electricity-generating technologies pay off in the long term.
High costs of capital mean that the needs of future generations are not considered by the financial markets.
This implies that governments must intervene to ensure that investments “meet the needs of the present generations without compromising the ability of future generations to meet their needs” (World Commission on Environment and Development, 1987).
This problem becomes acute when considering investments in hydro and nuclear power capacity that could provide electricity for three generations.
Investors in these generating technologies are throwing away the value of electricity to future generations, hence they appear to be more expensive.
In contrast, wind turbines are designed to last for only 20 years, after which they have to be replaced.
The problem with investments in nuclear power is that they are expensive only in artificial, and intrinsically flawed, electricity power and financial markets.
Therefore, governments must step in to provide capital to invest in the future beyond the time horizon of the international financial community.
Future energy-sector investments should be made with debt and equity that can be paid back in rand, decreasing the necessity of exporting goods for dollars and increasing future investment in South Africa.
Dr Geoffrey Rothwell, Principal Economist, Organisation for Economic Co-operation and Development, Paris, France, was a guest speaker at the recent Nuclear Africa 2017 Conference on nuclear power, held in Centurion.