State Policy on Criteria for Project Feasibility

Historically, the primary criteria the state has used to evaluate an energy project have been the project’s technical and economic feasibility. These are generally still the explicit tests of a project.

Technical feasibility means technically feasible given Alaska’s temperature, wind, and other conditions; consequently it is inappropriate to adopt a technology that is technically feasible elsewhere without testing it here. Economic feasibility is usually based on life-cycle costs over 30 years compared to those of the next best alternative, usually diesel when analyzing rural energy projects.

Two other important feasibility criteria for rural Alaska are location feasibility and human resource feasibility. Location feasibility is the support infrastructure in place in the community to deal with the normal but unanticipated situations that arise over the life of a facility. Rural Alaska communities have limited access to an inventory of spare parts or technical expertise in the event of a breakdown. Human resource feasibility is the technical, managerial, and administrative support within the community to take care of the equipment. The importance of location feasibility and human resource feasibility has not yet been documented for rural Alaska electricity projects.

For example, because of today’s improved technology wind generation would seem to be an ideal choice for parts of rural Alaska with excellent wind resources. However, wind generation must be used in conjunction with either a diesel system and/or batteries that supply the electricity when the wind is not blowing. Thus a simple solution rapidly becomes more complicated by the need to integrate technologies and operate and maintain them together, and location and human resource feasibility must be considered.

Economic feasibility has consistently been an illusive and controversial topic for Alaska energy projects. This stems from the focus on electric power generation and transmission projects and their tendency to have project economic analyzes with benefit-cost ratios below 1.0 (the benefit-cost ratio is equal to the net present value of a project divided by the project’s capital cost). This is because of the low price of Cook Inlet natural gas, high capital costs, and limited rate payer market base. The consequence is that projects considered in the 1980s were shelved when oil prices declined, and resurrected during oil price spikes.

In rural Alaska, PCE provides rate relief but unintentionally removes some of the market incentives for local utilities and rate payers to improve the efficiencies of their utilities or invest in energy conservation. Given the small number of rate payers and the high proportion of utility fixed costs, conservation measures tend to benefit the state of Alaska through reduction in PCE payments more than they assist ratepayers and utilities.

A central challenge for both urban and rural project economic feasibility analyzes is assumptions regarding future crude oil and thus diesel and natural gas prices. Those prices are at the heart of any comparison of the status quo to alternative projects. A comprehensive review1 was recently completed on a number of theories of what produced the high price of oil in the summer of 2008, including commodity price speculation, strong world demand, time delays or geological limitations on increasing production, OPEC monopoly pricing, and an increasingly important contribution of the scarcity rent (growth in prices due to scarcity in petroleum reserves and production). The study focused on our inability to forecast crude oil prices. ISER tested the statistical behavior of oil prices, related these to the predictions of theory, and looked in detail at key features of petroleum demand and supply. The study concludes that future oil prices are at best very difficult to predict. For example, using historic oil prices and a first quarter 2008 oil price of $115 per barrel, a prediction of the second quarter 2008 oil price within a 95% confidence interval ranged from $85 to $156 per barrel. Statistically the same forecast projected out four years would give a 95% confidence interval for oil prices being as low as $34 or as high as $391 per barrel.

When investigating the causes of the 2008 price run up, the three key features identified as unquestionably important are the low price elasticity of demand for petroleum products, the strong growth in demand from China, the Middle East, and other newly industrialized economies, and the failure of global oil production to increase. These facts explain the initial strong pressure on prices that may have triggered commodity speculation in the first place. Speculation could have edged producers like Saudi Arabia into the discovery that small production declines could increase current revenues and may be in their long-run interests as well. And the strong demand from emerging economies may be initiating a regime in which scarcity rents, while negligible in 1997, became perceived as an important permanent factor in the price of petroleum.

In other words, all of these factors contributed to price fluctuations and are likely to continue to do so. This suggests that when screening projects for their potential to lower the cost of energy, an average price of oil should be used: over the course of the project’s useful life it is likely to be both more and less expensive than its natural gas or diesel alternative. However, scarcity is likely to keep fossil fuel prices trending upward without a significant destruction in world demand.

What is certain is that Alaska’s oil production is declining and thus so are future state revenues. Competition for state funding will increase and the opportunity costs of building uneconomic projects will increase. Similarly, the opportunity costs of not completing projects with benefit-cost ratios above 1.0, such as those identified in the 2004 Rural Energy Plan, also increase. Real capital costs for building any projects are also likely to continue to increase with an increase in fossil fuel prices, as commodity prices for construction materials such as steel and concrete trend upward along with oil and gas prices.

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