Case 3 - Tennessee Valley Authority File BU-5120-OL Financial Analysis

INTRODUCTION

Driving back to Knoxville on Friday afternoon, Morgan

finally had some time to think. She’d spent most of the week

in Nashville meeting with many of the Tennessee Valley

Authority’s (TVA) largest industrial customers. As the new

VP of energy supply management, Morgan was responsible

for formulating a plan to meet expected energy needs.

The plan must address how TVA can satisfy its multiple

stakeholders and mission in a long-term strategy, while at the

same time maintaining the flexibility to address near-term

financial and operational challenges.

I. THE TENNESSEE VALLEY AUTHORITY

TVA is the nation’s largest public power provider and is

wholly owned by the U.S. government. Although owned

by the federal government, TVA is not financed with tax

dollars; rather, the utility’s funding comes from the sale

of power to its customers. Additional funding comes from

borrowings using debt issues in the financial market. TVA

has a three-fold mission: (1) provide reliable, competitively-

priced power, (2) manage the Tennessee River system and

associated lands to meet multiple uses, and (3) partner with

local and state governments for economic development.

TVA’s unique mission has served as the foundation of

its business endeavors, providing the context for TVA to

establish its business objectives and internal processes.

While TVA’s core mission has remained constant, the

landscape of the industry has changed considerably, and

the future remains very uncertain. The recent economic

turmoil has caused unprecedented volatility in the prices

for commodities that are used as fuel to produce electricity

and the cost of materials to build plants. There is also a high

level of uncertainty in the industry with respect to potential

legislation requiring significantly more renewable and clean

energy generation sources in the coming years. Legal issues,

including a recent lawsuit in North Carolina, challenged

TVA to seek costly alternatives for power generation. On top

of these challenges, the lethargic economy has created an

uninterrupted stream of calls from customers asking TVA to

keep electricity rates where they are.

The major focus of today’s meeting was TVA’s obligation of

meeting all energy needs while at the same time keeping rates

as low as possible. Last year, TVA generated the majority of

needed electricity using fossil fuel plants (55%), nuclear plants

(28%), hydropower plants (4%), natural gas plants (1%), and

renewable sources (1%). In addition, TVA purchased 11% of

the needed power from other providers, since TVA generation

assets were unable to meet the needs of the valley. Of the costs

associated with generating electricity last year, 92% came from

two sources: fossil fuel costs and purchased power. Nuclear

power production is TVA’s most efficient production process

(providing 28% of the electricity generated last year, but only

accounting for 7% of total costs). Electricity generated using

hydropower and renewable sources is the least expensive

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ISSN 1940-204X

THE TENNESSEE VALLEY AUTHORITY: THE COST OF POWER

Bob G. Wood

Salisbury University

Steven B. Isbell

Tennessee Tech University

Cass Larson

Tennessee Valley Authority

(having zero input cost), but it is also the least efficient and has

reliability issues.

The energy needs in the Tennessee Valley have grown

at more than 2.5% per year for the last 20 years. Demand is

expected to continue to grow at about 1% per year over the next

20 years, even with the recent economic downturn slowing things

considerably in the short term. Even with the downturn, TVA’s

current generation plants are unable to meet current needs. TVA

is well known for providing a very reliable source of power to its

customers, and the agency wants to maintain that reputation.

Two options exist to supply the increasing power needs:

TVA can build new generating capacity or it can buy energy

from others. Management wants to limit electricity purchases

to emergency situations—periods where demand exceeds

generation capacity. In addition to their cost, prices in this

market are extremely volatile. Even with the slower economy,

TVA needs to build new generating units at the rate of one

large coal or nuclear unit every four years to be able to meet

forecasted demand. Smaller units will also be constructed to

meet individual customers’ needs.

II. THE GREEN REVOLUTION

Driving by Carthage, Al Gore’s hometown, Morgan smiled

as she thought about how drastically attitudes have changed

towards being “green” in the Tennessee Valley. As interest at

all levels of government leads to new environmental policies,

Morgan knows that TVA will need to provide leadership in

the area of providing cleaner, more renewable energy. The

unusual operating characteristics and reliability issues of

green resources makes their adoption a challenge, however.

In addition to thinking about cleaner and more cost-effective

energy sources, Morgan could not help but think of another hot

topic of interest for TVA. In addition to renewable supply side

alternatives, TVA has recently committed to increasing efforts to

gain more savings from energy efficiency and demand response

programs. These initiatives are targeted to achieve maximum

benefits during the highest periods of power demand on the TVA

system. TVA’s overall goal is to reduce energy use during times

when the demand for power is highest—often referred to as the

“peak”—by about 5% by the end of 2014.

By helping consumers use energy more efficiently, TVA

is hoping to save money for the entire valley. In fact, TVA is

targeting total energy efficiency savings to be about 3.5% of

sales by 2017, which would roughly translate to 0.1% annual

load growth to that period. Although the concept seems simple

on the surface, Morgan knows that there’s a lot of work to be

done with limited resources, introduction of new technologies,

and capital expenses for some of these programs.

On the other hand, some individuals are extremely

skeptical of energy efficiency initiatives. Many of these people

believe that, given the current shape of the economy, money

should not be spent on energy-efficiency programs in the

near term. Morgan definitely has her work cut out for her in

this area. She wonders: “Is it in TVA’s best interest to invest

in these energy-efficiency programs? If so, how can her team

analyze which energy-efficiency programs are best for TVA?”

III. POWER GENERATION ALTERNATIVES

Returning to the more critical issue, Morgan remembered

a recent discussion at TVA about a report that summarized

the benefits and costs of each type of power generation.

She knows that any plan she develops must consider these

factors. Highlights of the report include:

• Coal: Pulverized

• Coal accounted for over 40% of power generation in

the U. S. in 2011.

• Coal plants are classified as “high-emitting” with

respect to pollutants.

• Carbon-related legislation could add 50-100% to the

cost of future coal power generation due to stricter

requirements for carbon and expensive carbon

controls, possibly even making it necessary to close

some existing units.

• While coal has been a cheap and domestically available

fuel source, the world’s increased use of coal generation,

particularly in China (China builds a coal plant every

week), is causing increased volatility in coal prices.

• Coal prices cannot be managed using derivatives

and they rely on longer-term bilateral contracts with

suppliers who, in general, have poor financial stability.

• Natural Gas: Combined Cycle

• Using essentially the same technology used in jet

engines, combined cycle plants are built around one or

more combustion turbines.

• Modern combined cycle plants, which have a relatively

low construction cost and modest environmental

impacts, can be used to meet base-load, intermediate,

and peaking demand, since they are easy to start and

stop as power is needed.

• These plants can be built fairly quickly and are

very efficient.

• Natural gas, which fuels combined cycles, has had

significantly greater price volatility when compared to

coal in recent years, and carbon legislation could add

about 25% to the cost. Still, natural gas volatility can

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be managed using financial contracts to lock in prices

well in advance of needing the fuel. Table 1 compares

coal and natural gas prices from 1990 to 2010.

TABLE 1 Cost of Selected Fossil-Fuel at Electric Generating Plants 1990-2010*

COAL NATURAL GAS Year ($/MMBTU) ($/MMBTU)

1990 1.46 2.32

1991 1.45 2.15

1992 1.41 2.33

1993 1.39 2.56

1994 1.36 2.23

1995 1.32 1.98

1996 1.29 2.64

1997 1.27 2.76

1998 1.25 2.38

1999 1.22 2.57

2000 1.20 4.30

2001 1.23 4.49

2002 1.25 3.53

2003 1.28 5.39

2004 1.36 5.96

2005 1.54 8.21

2006 1.69 6.94

2007 1.77 7.11

2008 2.07 9.01

2009 2.21 4.74

2010 2.27 5.09 *U.S. Energy Information Administration Monthly, Energy Review, 201

• Nuclear

• Nuclear power plants use the heat produced by

nuclear fission to produce steam that drives a turbine

to generate electricity.

• Nuclear plants are characterized by high investment

costs but low variable operating costs, including low

fuel expense. Because of the low variable costs and

design factors, nuclear plants in the United States

operate exclusively as base-load plants (operating and

providing energy continuously).

• Nuclear power supplied almost 20% of the nation’s

electricity in 2011.

• Construction of a nuclear plant requires approval from

the Nuclear Regulatory Commission, which until this

year had not approved the construction of a new plant

for 16 years. But in February of 2012, approval was

given to the Southern Company for the construction

of a two-reactor facility. The industry views this as

a commitment to expanding nuclear energy in the

United States.

• Nuclear generation is “zero-emitting” while producing,

but has waste disposal (spent nuclear fuel rod) issues.

• One advantage of nuclear power is that it provides

large amounts of base-load electricity without releasing

carbon dioxide. This furnishes a steady supply of

reliable electricity for industries looking to expand or

relocate operations to the valley.

• Wind

• Wind power plants (sometimes referred to as wind

farms) use wind-driven turbines to generate electricity.

• Wind is a variable renewable resource because its

availability depends on the whims of the weather. The

Southeast U.S. is fairly wind-poor, and transmission

from the middle of the country may be required if

wind energy is used in large amounts.

• Wind supplied 3% of total U.S. power in 2011.

Assuming no changes to current law and regulation,

the Energy Information Administration estimates an

increase to 20% by 2030.

• The high capital costs and unpredictable generation

make wind power costly when used for large

generation purposes.

• Solar

• Solar photovoltaic (solar PV) power uses solar cells to

directly convert sunlight to electricity. To date, most

of the solar PV installations in the United States have

been small (about 1 MW or less). Solar cells produce

energy only about one-third of the time.

• It would take a great deal of land area to produce large

quantities of energy—about 2 acres to provide 1 MW

of generation. To match the energy of a nuclear unit, it

would take around 4,000 acres of solar panels.

• Smaller photovoltaic solar units could be “distributed”

generation in many customers’ locations, which could

avoid transmission costs. These units are currently

being built by a small number of environmentally

sensitive customers. TVA has a program to pay

customers a premium for the solar energy they produce.

• The main issue is the cost. Though high, the

costs continue to fall because of technological

improvements. This is in contrast to the increasing

cost of most other generation alternatives.

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IV. THE UNIQUE NATURE OF ELECTRICITY

The biggest part of the rewrite of the strategic plan is

developing a strategy for capital investments to increase

capacity for future energy needs while at the same time

minimizing electricity rates. Morgan keeps the following

table of cost estimates from the Energy Information

Administration on her laptop (shown in Table 2).

Capital costs, the costs that are incurred bringing a

generating plant on-line, are amortized over the operating

life of the plant. Costs of generation are realized as the

generating plant operates. It is important to keep in mind

that, like most government-regulated monopolies, TVA must

set rates equal to long-run average cost.

Morgan remembered something else that the group

failed to talk about. Electricity cannot be stored in the grid.

Instead, it is consumed as it is produced. The problem with

this is that electricity consumption varies not only by season

of the year, but also by the time of day. On late afternoons

and early evening on weekdays, demand rises. This increase

is more pronounced during warm weather months. These

high demand periods are known in the industry as “peak

loads.” At other times, especially in the very early morning

hours, demand is quite low. Of course, electricity demand

never falls to zero, so TVA must always be generating power

to meet the minimum level of power demanded of the grid.

This minimum level is called the “base load.”

Electric utilities use different power generation

technologies to serve base and peak loads. It can take many

hours or even days to get nuclear or coal generation plants

up to their functioning power levels. This trait makes them

very inefficient as peak load power producers. Instead, they

run continuously to serve base load demands. As power

demand increases during the day, technologies that can be

cycled up and down (natural gas plants) are used to produce

the additional energy for the peak load. Base load plants

have high fixed costs but very low marginal costs; peak

load generators have lower fixed costs but much higher

marginal costs of operation. Any strategic plan must take into

consideration not only how much to increase total generation

capacity, but also how the different loads will be met. This

will require that forecasts be made of both peak and base

load demands.

There is another strategy that should be considered,

however. “Demand side management” programs could

be implemented to reduce the costs of adding additional

capacity to meet peak load demands. If there were some way

to reduce power usage during the peak load times and move

that power to the base load periods (a strategy known as

“load shifting”), then building additional power generation

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TABLE 2 Estimated Levelized Cost of New Generation Resources (USA)*

Levelized Estimated Capacity Capital Cost Service Levelized Cost of Factor (%) $/MW-year Life (yrs) Generation $/MWh

Conventional Coal 85% $515,263 30 $31.20

Pulverized Coal 85% $604,615 30 $29.30

Pulverized Coal with CCS 85% $689,500 30 $36.70

Conventional Combined Cycle 87% $174,525 20 $60.20

Advanced Combined Cycle 87% $170,715 20 $56.90

Conventional Combustion Turbine 30% $108,011 20 $98.40

Advanced Combustion Turbine 30% $101,178 20 $85.00

Advanced Nuclear 90% $748,192 40 $24.10

Wind 34% $388,681 20 $18.80

Wind - Offshore 39% $546,282 20 $31.20

Solar PV 22% $726,169 20 $19.30

Solar Thermal 31% $609,381 20 $32.20

Geothermal 90% $693,792 45 $27.70

Biomass 83% $532,950 20 $37.70

Hydro 51% $463,290 50 $16.20

* Source: Energy Information Administration

capacity might be postponed for several years. TVA cannot

dictate when power is used during the day, but it might

be able to influence power usage by changing its pricing

model. Instead of pricing power at long-run average costs,

TVA could employ a “time-of-use” pricing model and price

electricity close to the marginal cost of producing it. During

base load periods, price per kilowatt would be lower; during

peak load periods, price per kilowatt would increase with the

increased costs of supplying the power. This strategy should

reduce energy consumption during peak load periods and

increase it during base load periods. In effect, total power

usage doesn’t change; it just moves from peak load to base

load periods. This allows TVA to provide more power from

less expensive base load generation plants. It could also save

the cost of building additional generation capacity to meet

future peak load needs.

Load shifting is not a new idea, but power utilities across

the nation have not been able to implement it because of

the difficulties of determining exactly what time of day

a consumer actually uses a unit of electricity. But recent

development of “smart meters” not only allows TVA to

monitor power usage instantaneously, but also allows

consumers to track their energy use and make adjustments

that can reduce their utility bills. Appliance manufacturers

are even developing “smart” appliances that communicate

with the power grid to use real-time information on

pricing and determine the optimum time to run, allowing

the consumer to use a “set-it-and-forget-it” approach to

managing energy needs.

Though this sounds like the ideal solution, consumers

have been reluctant to embrace the technology. They also

have trouble believing that the strategy benefits all parties

involved—the consumer, the utility, and the environment.

Morgan chuckled as she remembered the problems Pacific

Gas & Electric had introducing smart meters to the San

Francisco Bay area. In a unanimous vote, the County Board

of Supervisors imposed a moratorium on “smart meter”

installation, citing health (the devices allegedly caused brain

tumors) and privacy (the collection of information on private

household habits) concerns. If the devices can’t be sold to

environmentally-conscious Californians, what chance does

TVA have with Tennessee Valley residents?

Morgan’s smile slowly dissolved as she realized

something else about the potential use of the newer

technologies. Higher-income and highly-educated

households are most likely to purchase the smart meters and

to take advantage of the smart appliances. A part of TVA’s

service area is Appalachia—a region with pockets of extreme

poverty where families live on the edge of destitution. If

TVA follows this pricing model and passes on the costs

of installing the new meters to all of its customers, these

families would share those costs and almost certainly not be

purchasing the smart appliances. In addition, many of these

consumers are employed in manufacturing, doing shift work

with schedules that would not allow them the flexibility of

managing the timing of their energy use. The result of time-

sensitive pricing would actually be increased energy bills for

households that could least afford it.

Even worse, TVA could be accused of subsidizing higher-

income households. Given the national conversation about

increasing income inequality, this would not look good

for TVA. But that’s not the way to look at things, thought

Morgan. The question is, What is the right thing to do?

V. FUNDING CONSIDERATIONS

TVA’s current rate schedule is designed to cover operating

expenses, interest and debt issue retirement, production

plant fuels, and all other miscellaneous costs. The TVA

board is allowed to raise rates as needed to cover costs, and

a fuel-cost adjustment can be made on a quarterly basis to

offset volatile fuel prices.

During periods in which TVA revenues fail to cover

expenses, the agency reduces costs across functional areas,

including slowing capital improvements, limiting new hires,

and freezing wages. Alternatively, TVA can borrow funds.

This solution may be optimal from a cost standpoint in that,

as an AAA-rated agency, TVA can borrow money significantly

below market rates. TVA’s long-term debt ceiling, set by the

U. S. Congress, is $30 billion, however. The ceiling has not

been raised in the last four decades. Currently, long-term debt

(traditionally reserved for capital projects) remains almost $9

billion, despite several years of debt-reduction efforts. TVA’s

outstanding long-term debt portfolio averages 5.5%. Although

TVA has issued debt with maturities of up to 50 years in the

past, the current economic climate will limit new issues to

maturities of 15 to 30 years. Given the longer-termed asset

life of most of the generation alternatives, Morgan believes

that a new 30-year debt issue would be used to fund capital

construction. Since TVA’s current outstanding bond issues

are of shorter maturity, Morgan knows that she must use U.S.

Government bonds as a benchmark. She remembers a recent

meeting with senior treasury officials at TVA; a premium of 80

to 100 basis points over current government rates is expected.

Since there is so much uncertainty in today’s economic and

political environment, Morgan believes that 100 BPS is most

likely. Table 3 shows current interest rates for outstanding

TVA and U.S Government debt instruments.

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Still another alternative to increase funding is to raise

utility rates. Increasing the cost to customers is never a

popular option, and it is TVA’s mandate to keep rates as low

as possible. Low rates are especially important given TVA’s

mission of economic development in the Tennessee Valley,

and inexpensive energy costs keeps industry growing in the

region. Besides, the outcry following a rate increase large

enough to fund capital construction would be heard across

the Southeast and in Washington.

VI. OTHER CONSIDERATIONS

While TVA has an extraordinarily low cost of capital, new

generation means that bumping up against the debt ceiling is

a real possibility. Morgan pursed her lips, thinking, “Because

of the debt ceiling, I don’t know the best way to think about

rationing capital spending. Given the current economic and

political environment, would it be possible to get our debt

ceiling raised? Or am I better off to not even think about that?”

As Morgan approached Knoxville, she looked to her left

and saw the Kingston-TVA coal facilities and considered

that disastrous event. Coal units produce leftover fly ash that

requires disposal. At the Kingston plant, the ash was stored in

a collection pond near the facilities. Just before Christmas of

that year, the walls of the pond ruptured, and the ash sludge

flooded about 300 acres of land, including some people’s

homes. TVA management reacted quickly and did everything

they could to right the situation, but at a cost of about $1

billion, the clean-up cost was enormous. There continue to be

calls for increased regulation of coal combustion by-products.

TVA faces other financial difficulties on top of the

costs associated with the Kingston situation. There’s the

decreased demand and lack of pricing-increase flexibility due

to the weak economy. It is also faced with another $1 billion

expense from complying with the air quality standards

imposed by a lawsuit with North Carolina. Even though TVA

had already developed a plan and had started construction on

plant upgrades required for improving air quality, the lawsuit

forced TVA to expedite its schedule, and in some cases

required more money than originally budgeted. Finally, TVA

has experienced a long period of drought, which has reduced

hydro generation from dams, forcing the agency to replace

that lost energy with expensive purchased power, since other

generation assets are producing at or near capacity. Morgan

thought how all of these unexpected events, taken together,

equal almost 20% of one year’s revenue.

VII. DECISION TIME

Finally, Morgan arrived at the TVA corporate tower in

downtown Knoxville and sighed. How should she fit the

complicated pieces together to form a strategy for TVA to

satisfy its many stakeholders? What are the keys to TVA’s

strategy going forward? Before tackling these two questions,

Morgan must look at what she knows.

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TABLE 3 Tennessee Valley Authority Bonds* Maturity Yield to Coupon % (Month-Year) Bid Ask Maturity %

6.00 3-13 103.26 103.27 0.01

4.75 8-13 104.21 104.23 0.13

6.25 12-17 128.12 128.30 0.76

6.75 11-25 148.12 148.25 0.65

7.13 5-30 158.00 158.17 2.89

U.S. Government Bonds Maturity Yield to Coupon % (Month-Year) Bid Ask Maturity %

2.50 3-13 101.59 101.60 0.17

4.25 8-13 104.30 104.33 0.17

2.75 12-17 111.02 111.06 0.68

6.875 8-25 159.41 159.45 1.76

6.25 5-30 161.91 161.99 1.22

5.00 5-37 149.59 149.66 1.59

3.00 5-42 109.45 109.51 2.54

* Source: Wall Street Journal, July 23, 2012

From the most recent 10-K, Morgan knows that TVA

currently has a 37,188 MW capacity; about 40% of capacity is

generated from coal and the remainder is generated primarily

by nuclear, hydro, and natural gas plants. Less than 1 percent

of current capacity is from renewable resources. Last year’s

long hot summer caused TVA to exceed this capacity, which

required purchasing power from other producers.

TVA has multiple options for producing power in order to

ensure its commitment to reliable and affordable electricity

to the service area in the future. Each of the options has

unique capacities, cash flows, and useful lives.

Morgan wonders whether it would be better to go with

longer-lived assets such as advanced nuclear or pulverized

coal plants with expected lives of 30 years from the day

construction is started, or shorter-lived assets such as

advanced natural gas combined cycle, wind generation,

or solar photovoltaic plants to take advantage of expected

improvements in technology and production efficiency. Each

of these alternatives has an expected life of 20 years.

Construction project costs and lengths also vary greatly.

The $5.5 billion cost of a nuclear plant dwarfs the other

alternatives and also has the longest construction time (4

years). A coal plant is less expensive to build (costing roughly

one-third as much--$1.8 billion), but takes almost as long to

build (3 years). Although much less expensive to construct

($650 million), a natural gas plant still requires 2.5 years for

construction. Both of the renewable energy alternatives have

short construction times (1 year); the costs differ significantly.

The solar plant cost of $300 million is 20 times the cost of a

wind plant ($15 million).

The alternative sources also have different production

capacities. Coal and nuclear plants have significant

production capacities (2,300 and 2,000 MW per year,

respectively). The other alternatives have lower capacities.

The gas plant’s capacity is 720 MW per year, the wind plant’s

capacity is 150 MW per year, and the solar plant’s capacity is

100 MW per year.

The cost of input materials also significantly affects the

expected yearly cash flows from each production source.

The cash inflows will begin in the year following the end of

construction and will remain constant for the life of the asset.

Given the long-lived nature of uranium, the nuclear plant’s

expected cash flow of $680 million per year is significantly

higher than the other alternatives. The relatively high cost

of production inputs used in the coal and natural gas plants

reduces the expected cash flows from each of these plants

to $97 million and $85 million, respectively. The expected

yearly cash flow from the wind plant is $2 million; the yearly

cash flow from the solar plant is $3 million.

Morgan thought, “There are so many factors that are

unique to each of the production alternatives—capacity,

reliability, input costs, etc. No one alternative dominates.

What factors should I use to compare the alternatives? Are

some factors more important than others?”

TVA recently revealed plans to retire multiple coal units

by 2018 to comply with its goal to be a leader of clean energy.

TVA will need to replace 5,670 MW of generation before

these coal units are retired. Half of this generation will be

met by converting the old coal plants with combustion

turbines. At least 70% of the remaining needed capacity will

be met with new base load generation; the remainder can be

from peaking or intermittent transmission.

At least one thing should help. Since TVA has

traditionally funded new power generation construction

with debt, the low interest rates will reduce borrowing costs.

In addition, the cost of capital used in discounted cash flow

analysis should be easier to explain to those few “financially-

challenged” board members, since TVA uses no equity costs

in its capital budgeting process.

The TVA board will be looking to her for a plan to

meet the customer needs within TVA’s resource guidelines.

Morgan wonders how she should evaluate the production

alternatives, given their different cost and output

characteristics. In addition, how do the other factors affect

TVA’s strategic direction? The meeting is scheduled for early

Monday morning. Morgan realized that she wouldn’t need

those football game tickets after all.

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