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«Author: Kimon Marketos, MSc Mechanical Engineering ETH Supervisors: Prof. Didier Sornette, ETH Zurich - Chair of Entrepreneurial Risks Supervisor X, ...»

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Assessment of future hydropower plants investments in

Switzerland – a Real Options Approach

Master Thesis

for the Degree of

Master of Advanced Studies in Management,

Technology and Economics (MTEC) at ETH Zurich


Kimon Marketos, MSc Mechanical Engineering ETH


Prof. Didier Sornette, ETH Zurich - Chair of Entrepreneurial Risks

Supervisor X, PowerProduction Company

Note: This is a modified version of the original Thesis. The names of the company and the power plant as well as the numbers in this version have been changed due to confidentiality obligations.

Abstract Hydropower accounts for 60% of total Swiss electricity production. Hydropower plant operators are entitled by the local authorities to use of the water. The corresponding contracts, called concessions, have been signed 50-60 years ago. In the following 10years most of the concessions will expire and a call for tenders will be issued.

Nevertheless, current operators have legally the solely right to negotiate early concession renewal with the municipalities and cantons before expiration of the respective current concessions. Furthermore, the liberalization of the electricity sector in the near future will increase competition within the existing players and enable new companies to enter the Swiss electricity market. Several hydropower operators are therefore considering early concession renewal with the goal to ensure their production portfolio and secure their positioning in the market.

In this study an assessment of investments in hydropower plants associated to the concession renewal problem is conducted. For this purpose the traditional NPV method is used as well as a more sophisticated model based on real options analysis is developed. The real options model considers the action flexibility of the firm’s management, the ambiguity related to the acceptance probability of concession renewal offers by the authorities as well as the uncertainty of future electricity prices. The results of the model comprise the financial valuation of the concessioning options along with the identification of the optimal time for the concession renewal and, thus, highlight the optimal strategy for the company. Moreover, the study identifies the advantages and drawbacks of the real option analysis method compared to the classic NPV methodology that is currently used within the company.

Note: This is a modified Version of the original Thesis. The names of the company and the power plant as well as the numbers in this version have been changed due to confidentiality obligations.

K. Marketos |


i Table of contents Abstract

Abbreviations and Notations

1 Introduction

1.1 Hydropower plants in Switzerland

1.2 Legal and political framework

1.2.1 Water-usage concessions

1.2.2 The „water tax“

1.3 „Alpine“ hydropower plants

1.4 Swiss electricity market

1.5 Goal of the study

2 Capital budgeting methods

2.1 Traditional capital budgeting methods

2.2 Real Options Analysis Method

2.3 The Choice of the Discount rate

3 Concession renewal assessment

3.1 Assumptions base-case scenario

3.2 NPV Analysis

3.3 Real Options Analysis

3.3.1 The RO-model

3.3.2 Static RO analysis

3.3.3 Dynamic RO analysis

3.4 Sensitivity Analysis

3.4.1 Interest rate sensitivity

3.4.2 Public authorities total NPV share sensitivity

4 Conclusions and Outlook



A. Sensitivity analyses - Probability distributions


–  –  –

1.1 Hydropower plants in Switzerland The electricity production in Switzerland is dominated by two main energy conversion technologies: hydro- and nuclear-power plants. Around 60% (in 2011: 30’269 GWh or 51.8%1) of the total electricity production in the country is accounted to hydro-power plants. Hydropower plants are divided into run-of-the-rivers and conventional dam plants. Figure 1-1 shows the yearly production of electricity in Switzerland sorted by technology and compared to the total yearly electricity consumption.

Figure 1-1: Yearly electricity consumption and production in Switzerland [Source: BFE, Swiss Federal Office of Energy] The conventional hydropower plants are using the water of natural or artificial water storages (lakes or dams). The water is delivered to the turbines in the turbine house that is located at a lower level. In this way the potential energy of the water in the dam is converted into electricity. In such power plants electricity output is completely controlled by the operators and can used as peak or base load energy. A more specific case of dam hydropower plants are the pump-storage plants. There water is pumped with electrical pumps to the storage reservoir in times of low electricity price and is then released back through the turbines at times of high demand.

As their name suggest run-of-the-river (ROR) hydropower plants are situated on rivers and are using the running power of water to produce electricity. Upstream of such plants a relative small storage reservoir may be placed (referred to as pondage) in order to ensure a minimum flow to the turbines in times of low natural flow. ROR plants have a very limited ability of output control and are therefore mainly used for baseload electricity production.

This number accounts for the total electricity produced in running and storage hydropower plants in Switzerland. The electrical energy of the pumps has been deducted.

K. Marketos | Introduction 1

In Switzerland there are 447 hydropower plants with a total installed capacity of more than 13’000 MW. Most of the plants are located in the mountainous southwestern and south eastern Swiss cantons of Valais, Ticino and Graubünden. On the map of Figure 1-2 the locations of all hydropower plants with an installed capacity of 20 MW or more is depicted.

Figure 1-2: Map of Switzerland with all hydropower plants with a capacity of 10MW [Source: BFE, Federal Office of Energy] 1.2 Legal and political framework All hydropower plants in Switzerland are obliged to obey to the technical, economical and legal rules defined in the Swiss federal legislation. The Federal law 721.80 called “Water-rights law” is the main relevant legal document. In this section the main obligations and rights for the owners and operators as defined in the mentioned document are highlighted and explained.

1.2.1 Water-usage concessions

The use of the water resources in Switzerland demands for a concession by the local authorities. The municipality has the right to grant the usage-right of the waters in its area and its decision has to be approved by the government of the corresponding canton. The decision of the municipality regarding the assignment of the water-usage rights should be taken “in favor of the applicant that ensures the public interest the most and presents the most appropriate usage of the waters” (WRG, 2012).

2 K. Marketos | Introduction

Each hydropower plant has to ensure a minimum remaining water flow (defined by law) in order to comply with environmental requirements. This minimum flow cannot be used in power production and, thus, limits the maximum output of the power plants.

The duration of the concession is regulated by laws of the Swiss Federation as well as of the cantons. Federal law allows a maximum usage right time of 80 years, while some cantons limit the maximum concession duration (WRG, 2012). The canton of Graubünden defines the maximum concession duration to 60 years (WRG Kanton GR, 2012).

After the period defined by the concession has lapsed out the right of the concessionaire on the usage of the waters expires. The concessionaire is allowed to apply for a renewal of the concession (“early reconcessioning”) before the expiration of the valid concession. The responsible authorities are only allowed to negotiate with the current concessionaire during a valid concession. At expiration of the concession an official call for tenders may be launched by the authorities for appointing the new concessionaire.

The federal law prescribes that at expiration of a water-usage concession all parts of the hydropower plant that are necessary for the operation of the plant (dams, intake constructions, pipes, water turbines, buildings etc.) have to be rendered to the municipality. This is called reversion obligation of the “wet parts”. On the other hand, the “dry parts” (referring to the equipment and buildings that are used to electricity conversion) belong to the plant owner and a financial compensation is due by the municipality.

In case of an early concession renewal the concessionaire looses the remaining time and income of the old concession until its theoretical expiration. Furthermore, a financial compensation has to be paid by the concessionaire to the corresponding authorities (canton, municipalities) for their waiver of the reversion right. The form and the amount of the compensation is defined in negotiations between the involved parties (participation in a shareholder firm, direct payment etc.). In case of compensation in form of a direct payment by the concessionaire the term “Reversion-waivercompensation” (Heimfallverzichtsentschädigung, HFVE) is used.

1.2.2 The „water tax“

During the operation of the hydropower plants the concessionaire is obliged to pay to the municipality and/or the canton certain operation fees. These fees are either in the form of a “power plant tax” or an electricity-production-dependent “water tax”. By federal law the sum of the imposed tax and “water tax” is limited to a maximum of 100 CHF per kW of gross installed power. This limit is valid until the end of year 2014; thereafter a limit of 110 CHF per kW will apply (WRG, 2012). In the canton of Graubünden the relevant fees are raised to 50% as “power plant tax” (by the canton) and to 50% as “water tax” by the corresponding municipalities (WRG Kanton GR, 2012).

K. Marketos | Introduction 3

„Alpine“ hydropower plants2 1.3 In the canton of Graubünden „PowerProduction“ owns and operates the „Alpine“ hydropower plants. This group of power plants consists of five plants: Plant 1, Plant 2, Plant 3, Plant 4 and Plant 5. Its total installed producing capacity is 750 MW and its average yearly production is 2’450 GWh. Figure 1-3 shows the arrangement of the five plants in „Alpine“. The water accumulated in the Albigna storage is used to produce electricity (together with the water coming from the Plant 1 intake) at the Plant 3 power plant (3 turbine groups with a total of 95 MW). Plant 1 is a small-scale hydropower plant close to the Plant 1 intake with a capacity of 2.5MW. Plant 2 is a ROR-plant with 33 MW capacity. Another ROR plant is located in Plant 5 (34.5 MW). The water from the storage dam in Plant 3 is delivered to the power plant in Plant 4 (500MW). Between Plant 3 and Albigna-storage two pumps can be used for directing the water up to the Albigna-storage (mainly in the summer months).

Figure 1-3: Map of the canton Graubünden with the location of the „Alpine“ power plants Start of the constructions works in „Alpine“ power plants was in XXXX and the commissioning was successfully completed in XXXX. The concession of all four „Alpine“ hydropower plants took effect as of XXXX and allowed the use of the water in the region for 80 years. Thus, at the end of 2039 the concession will fall due.

„Alpine“ hydropower plants have the highest installed capacity of all other hydropower plants of „PowerProduction“ (taking into account the shares at partnership-plants) producing almost 30% of the total yearly production of „PowerProduction“ hydropower.

Thus, it is of high importance for „PowerProduction“, in order to be able to retain its positioning in the market as a reliable power producer and distributor. Therefore, „PowerProduction“-Management has launched working groups to study the best possible way of assuring a concession renewal of this group of hydropower plants Note: This is a modified Version of the original Thesis. The names of the company and the power plant as well as the numbers in this version have been changed due to confidentiality obligations.

4 K. Marketos | Introduction

either through an early concession renewal process or an renewal over the bidding process (under competition) at the expiration of the concession in 2040.

In the following sections the business case of the „Alpine“ hydropower plants is going to be assessed and the results are going to be discussed. The goal is to present an assessment model that incorporates the complex situation of the concession renewal process for hydropower plants in Switzerland. This model is aspired to serve as a decision tool by the management and should therefore be able to present to the decision makers the flexibility and decision options that they have, in a comprehensive and informative manner.

1.4 Swiss electricity market

The Swiss electricity market is going through major restructurings in the recent years. In 2008, the new electricity bill came into effect as a first step towards a more liberal market structure. With this bill, consumers with a yearly consumption of 100’000 kWh are allowed to choose their electricity distributor freely. This is a big leap change in Switzerland, where up to then municipal and cantonal utility companies where granted the exclusive right of electricity distribution in their geographical region. It is expected that until 2015 all consumers will be able to choose their provider by their own ("PowerProduction", 2012).

The liberalization of the Swiss electricity market calls for adaptation to the new situation by the existing players in the electricity market. New entrants of abroad as well as geographical expansion of the Swiss utility companies are almost certain in near future.

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