ISSN 1940-204X

THE TENNESSEE VALLEY AUTHORITY:

THE COST OF POWER

Bob G. Wood Steven B. Isbell Cass Larson

Salisbury University Tennessee Tech University Tennessee Valley Authority

INTRODUCTION While TVA’s core mission has remained constant, the

landscape of the industry has changed considerably, and
Driving back to Knoxville on Friday afternoon, Morgan the future remains very uncertain. The recent economic
finally had some time to think. She’d spent most of the week turmoil has caused unprecedented volatility in the prices
in Nashville meeting with many of the Tennessee Valley for commodities that are used as fuel to produce electricity
Authority’s (TVA) largest industrial customers. As the new and the cost of materials to build plants. There is also a high
VP of energy supply management, Morgan was responsible level of uncertainty in the industry with respect to potential
for formulating a plan to meet expected energy needs. legislation requiring significantly more renewable and clean
The plan must address how TVA can satisfy its multiple energy generation sources in the coming years. Legal issues,
stakeholders and mission in a long-term strategy, while at the including a recent lawsuit in North Carolina, challenged
same time maintaining the flexibility to address near-term TVA to seek costly alternatives for power generation. On top
financial and operational challenges. of these challenges, the lethargic economy has created an
uninterrupted stream of calls from customers asking TVA to
I. THE TENNESSEE VALLEY AUTHORITY keep electricity rates where they are.
The major focus of today’s meeting was TVA’s obligation of
TVA is the nation’s largest public power provider and is meeting all energy needs while at the same time keeping rates
wholly owned by the U.S. government. Although owned as low as possible. Last year, TVA generated the majority of
by the federal government, TVA is not financed with tax needed electricity using fossil fuel plants (55%), nuclear plants
dollars; rather, the utility’s funding comes from the sale (28%), hydropower plants (4%), natural gas plants (1%), and
of power to its customers. Additional funding comes from renewable sources (1%). In addition, TVA purchased 11% of
borrowings using debt issues in the financial market. TVA the needed power from other providers, since TVA generation
has a three-fold mission: (1) provide reliable, competitively- assets were unable to meet the needs of the valley. Of the costs
priced power, (2) manage the Tennessee River system and associated with generating electricity last year, 92% came from
associated lands to meet multiple uses, and (3) partner with two sources: fossil fuel costs and purchased power. Nuclear
local and state governments for economic development. power production is TVA’s most efficient production process
TVA’s unique mission has served as the foundation of (providing 28% of the electricity generated last year, but only
its business endeavors, providing the context for TVA to accounting for 7% of total costs). Electricity generated using
establish its business objectives and internal processes. hydropower and renewable sources is the least expensive

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(having zero input cost), but it is also the least efficient and has On the other hand, some individuals are extremely
reliability issues. skeptical of energy efficiency initiatives. Many of these people
The energy needs in the Tennessee Valley have grown believe that, given the current shape of the economy, money
at more than 2.5% per year for the last 20 years. Demand is should not be spent on energy-efficiency programs in the
expected to continue to grow at about 1% per year over the next near term. Morgan definitely has her work cut out for her in
20 years, even with the recent economic downturn slowing things this area. She wonders: “Is it in TVA’s best interest to invest
considerably in the short term. Even with the downturn, TVA’s in these energy-efficiency programs? If so, how can her team
current generation plants are unable to meet current needs. TVA analyze which energy-efficiency programs are best for TVA?”
is well known for providing a very reliable source of power to its
customers, and the agency wants to maintain that reputation. III. POWER GENERATION ALTERNATIVES
Two options exist to supply the increasing power needs:
TVA can build new generating capacity or it can buy energy Returning to the more critical issue, Morgan remembered
from others. Management wants to limit electricity purchases a recent discussion at TVA about a report that summarized
to emergency situations—periods where demand exceeds the benefits and costs of each type of power generation.
generation capacity. In addition to their cost, prices in this She knows that any plan she develops must consider these
market are extremely volatile. Even with the slower economy, factors. Highlights of the report include:
TVA needs to build new generating units at the rate of one
• Coal: Pulverized
large coal or nuclear unit every four years to be able to meet
• Coal accounted for over 40% of power generation in
forecasted demand. Smaller units will also be constructed to
the U. S. in 2011.
meet individual customers’ needs.
• Coal plants are classified as “high-emitting” with
respect to pollutants.
II. THE GREEN REVOLUTION
• Carbon-related legislation could add 50-100% to the
cost of future coal power generation due to stricter
Driving by Carthage, Al Gore’s hometown, Morgan smiled
requirements for carbon and expensive carbon
as she thought about how drastically attitudes have changed
controls, possibly even making it necessary to close
towards being “green” in the Tennessee Valley. As interest at
some existing units.
all levels of government leads to new environmental policies,
• While coal has been a cheap and domestically available
Morgan knows that TVA will need to provide leadership in
fuel source, the world’s increased use of coal generation,
the area of providing cleaner, more renewable energy. The
particularly in China (China builds a coal plant every
unusual operating characteristics and reliability issues of
week), is causing increased volatility in coal prices.
green resources makes their adoption a challenge, however.
• Coal prices cannot be managed using derivatives
In addition to thinking about cleaner and more cost-effective
and they rely on longer-term bilateral contracts with
energy sources, Morgan could not help but think of another hot
suppliers who, in general, have poor financial stability.
topic of interest for TVA. In addition to renewable supply side
alternatives, TVA has recently committed to increasing efforts to • Natural Gas: Combined Cycle
gain more savings from energy efficiency and demand response • Using essentially the same technology used in jet
programs. These initiatives are targeted to achieve maximum engines, combined cycle plants are built around one or
benefits during the highest periods of power demand on the TVA more combustion turbines.
system. TVA’s overall goal is to reduce energy use during times • Modern combined cycle plants, which have a relatively
when the demand for power is highest—often referred to as the low construction cost and modest environmental
“peak”—by about 5% by the end of 2014. impacts, can be used to meet base-load, intermediate,
By helping consumers use energy more efficiently, TVA and peaking demand, since they are easy to start and
is hoping to save money for the entire valley. In fact, TVA is stop as power is needed.
targeting total energy efficiency savings to be about 3.5% of • These plants can be built fairly quickly and are
sales by 2017, which would roughly translate to 0.1% annual very efficient.
load growth to that period. Although the concept seems simple • Natural gas, which fuels combined cycles, has had
on the surface, Morgan knows that there’s a lot of work to be significantly greater price volatility when compared to
done with limited resources, introduction of new technologies, coal in recent years, and carbon legislation could add
and capital expenses for some of these programs. about 25% to the cost. Still, natural gas volatility can

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 be managed using financial contracts to lock in prices given to the Southern Company for the construction
well in advance of needing the fuel. Table 1 compares of a two-reactor facility. The industry views this as
coal and natural gas prices from 1990 to 2010. a commitment to expanding nuclear energy in the
United States.
TABLE 1 • Nuclear generation is “zero-emitting” while producing,

Cost of Selected Fossil-Fuel at Electric Generating Plants but has waste disposal (spent nuclear fuel rod) issues.
1990-2010* • One advantage of nuclear power is that it provides
large amounts of base-load electricity without releasing
COAL NATURAL GAS carbon dioxide. This furnishes a steady supply of
Year ($/MMBTU) ($/MMBTU)
reliable electricity for industries looking to expand or
1990 1.46 2.32
relocate operations to the valley.
1991 1.45 2.15
1992 1.41 2.33 • Wind
1993 1.39 2.56 • Wind power plants (sometimes referred to as wind
1994 1.36 2.23 farms) use wind-driven turbines to generate electricity.
1995 1.32 1.98 • Wind is a variable renewable resource because its
1996 1.29 2.64 availability depends on the whims of the weather. The
1997 1.27 2.76 Southeast U.S. is fairly wind-poor, and transmission
1998 1.25 2.38 from the middle of the country may be required if
1999 1.22 2.57 wind energy is used in large amounts.
2000 1.20 4.30 • Wind supplied 3% of total U.S. power in 2011.
2001 1.23 4.49 Assuming no changes to current law and regulation,
2002 1.25 3.53 the Energy Information Administration estimates an
2003 1.28 5.39 increase to 20% by 2030.
2004 1.36 5.96 • The high capital costs and unpredictable generation
2005 1.54 8.21 make wind power costly when used for large
2006 1.69 6.94 generation purposes.
2007 1.77 7.11 • Solar
2008 2.07 9.01 • Solar photovoltaic (solar PV) power uses solar cells to
2009 2.21 4.74 directly convert sunlight to electricity. To date, most
2010 2.27 5.09 of the solar PV installations in the United States have
*U.S. Energy Information Administration Monthly, Energy Review, 201 been small (about 1 MW or less). Solar cells produce
energy only about one-third of the time.
• Nuclear • It would take a great deal of land area to produce large

• Nuclear power plants use the heat produced by quantities of energy—about 2 acres to provide 1 MW
nuclear fission to produce steam that drives a turbine of generation. To match the energy of a nuclear unit, it
to generate electricity. would take around 4,000 acres of solar panels.
• Nuclear plants are characterized by high investment • Smaller photovoltaic solar units could be “distributed”

costs but low variable operating costs, including low generation in many customers’ locations, which could
fuel expense. Because of the low variable costs and avoid transmission costs. These units are currently
design factors, nuclear plants in the United States being built by a small number of environmentally
operate exclusively as base-load plants (operating and sensitive customers. TVA has a program to pay
providing energy continuously). customers a premium for the solar energy they produce.
• Nuclear power supplied almost 20% of the nation’s • The main issue is the cost. Though high, the

electricity in 2011. costs continue to fall because of technological

• Construction of a nuclear plant requires approval from improvements. This is in contrast to the increasing
the Nuclear Regulatory Commission, which until this cost of most other generation alternatives.
year had not approved the construction of a new plant
for 16 years. But in February of 2012, approval was

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IV. THE UNIQUE NATURE OF ELECTRICITY to meet the minimum level of power demanded of the grid.
This minimum level is called the “base load.”
The biggest part of the rewrite of the strategic plan is Electric utilities use different power generation
developing a strategy for capital investments to increase technologies to serve base and peak loads. It can take many
capacity for future energy needs while at the same time hours or even days to get nuclear or coal generation plants
minimizing electricity rates. Morgan keeps the following up to their functioning power levels. This trait makes them
table of cost estimates from the Energy Information very inefficient as peak load power producers. Instead, they
Administration on her laptop (shown in Table 2). run continuously to serve base load demands. As power
Capital costs, the costs that are incurred bringing a demand increases during the day, technologies that can be
generating plant on-line, are amortized over the operating cycled up and down (natural gas plants) are used to produce
life of the plant. Costs of generation are realized as the the additional energy for the peak load. Base load plants
generating plant operates. It is important to keep in mind have high fixed costs but very low marginal costs; peak
that, like most government-regulated monopolies, TVA must load generators have lower fixed costs but much higher
set rates equal to long-run average cost. marginal costs of operation. Any strategic plan must take into
Morgan remembered something else that the group consideration not only how much to increase total generation
failed to talk about. Electricity cannot be stored in the grid. capacity, but also how the different loads will be met. This
Instead, it is consumed as it is produced. The problem with will require that forecasts be made of both peak and base
this is that electricity consumption varies not only by season load demands.
of the year, but also by the time of day. On late afternoons There is another strategy that should be considered,
and early evening on weekdays, demand rises. This increase however. “Demand side management” programs could
is more pronounced during warm weather months. These be implemented to reduce the costs of adding additional
high demand periods are known in the industry as “peak capacity to meet peak load demands. If there were some way
loads.” At other times, especially in the very early morning to reduce power usage during the peak load times and move
hours, demand is quite low. Of course, electricity demand that power to the base load periods (a strategy known as
never falls to zero, so TVA must always be generating power “load shifting”), then building additional power generation

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

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capacity might be postponed for several years. TVA cannot TVA follows this pricing model and passes on the costs
dictate when power is used during the day, but it might of installing the new meters to all of its customers, these
be able to influence power usage by changing its pricing families would share those costs and almost certainly not be
model. Instead of pricing power at long-run average costs, purchasing the smart appliances. In addition, many of these
TVA could employ a “time-of-use” pricing model and price consumers are employed in manufacturing, doing shift work
electricity close to the marginal cost of producing it. During with schedules that would not allow them the flexibility of
base load periods, price per kilowatt would be lower; during managing the timing of their energy use. The result of time-
peak load periods, price per kilowatt would increase with the sensitive pricing would actually be increased energy bills for
increased costs of supplying the power. This strategy should households that could least afford it.
reduce energy consumption during peak load periods and Even worse, TVA could be accused of subsidizing higher-
increase it during base load periods. In effect, total power income households. Given the national conversation about
usage doesn’t change; it just moves from peak load to base increasing income inequality, this would not look good
load periods. This allows TVA to provide more power from for TVA. But that’s not the way to look at things, thought
less expensive base load generation plants. It could also save Morgan. The question is, What is the right thing to do?
the cost of building additional generation capacity to meet
future peak load needs. V. FUNDING CONSIDERATIONS
Load shifting is not a new idea, but power utilities across
the nation have not been able to implement it because of TVA’s current rate schedule is designed to cover operating
the difficulties of determining exactly what time of day expenses, interest and debt issue retirement, production
a consumer actually uses a unit of electricity. But recent plant fuels, and all other miscellaneous costs. The TVA
development of “smart meters” not only allows TVA to board is allowed to raise rates as needed to cover costs, and
monitor power usage instantaneously, but also allows a fuel-cost adjustment can be made on a quarterly basis to
consumers to track their energy use and make adjustments offset volatile fuel prices.
that can reduce their utility bills. Appliance manufacturers During periods in which TVA revenues fail to cover
are even developing “smart” appliances that communicate expenses, the agency reduces costs across functional areas,
with the power grid to use real-time information on including slowing capital improvements, limiting new hires,
pricing and determine the optimum time to run, allowing and freezing wages. Alternatively, TVA can borrow funds.
the consumer to use a “set-it-and-forget-it” approach to This solution may be optimal from a cost standpoint in that,
managing energy needs. as an AAA-rated agency, TVA can borrow money significantly
Though this sounds like the ideal solution, consumers below market rates. TVA’s long-term debt ceiling, set by the
have been reluctant to embrace the technology. They also U. S. Congress, is $30 billion, however. The ceiling has not
have trouble believing that the strategy benefits all parties been raised in the last four decades. Currently, long-term debt
involved—the consumer, the utility, and the environment. (traditionally reserved for capital projects) remains almost $9
Morgan chuckled as she remembered the problems Pacific billion, despite several years of debt-reduction efforts. TVA’s
Gas & Electric had introducing smart meters to the San outstanding long-term debt portfolio averages 5.5%. Although
Francisco Bay area. In a unanimous vote, the County Board TVA has issued debt with maturities of up to 50 years in the
of Supervisors imposed a moratorium on “smart meter” past, the current economic climate will limit new issues to
installation, citing health (the devices allegedly caused brain maturities of 15 to 30 years. Given the longer-termed asset
tumors) and privacy (the collection of information on private life of most of the generation alternatives, Morgan believes
household habits) concerns. If the devices can’t be sold to that a new 30-year debt issue would be used to fund capital
environmentally-conscious Californians, what chance does construction. Since TVA’s current outstanding bond issues
TVA have with Tennessee Valley residents? are of shorter maturity, Morgan knows that she must use U.S.
Morgan’s smile slowly dissolved as she realized Government bonds as a benchmark. She remembers a recent
something else about the potential use of the newer meeting with senior treasury officials at TVA; a premium of 80
technologies. Higher-income and highly-educated to 100 basis points over current government rates is expected.
households are most likely to purchase the smart meters and Since there is so much uncertainty in today’s economic and
to take advantage of the smart appliances. A part of TVA’s political environment, Morgan believes that 100 BPS is most
service area is Appalachia—a region with pockets of extreme likely. Table 3 shows current interest rates for outstanding
poverty where families live on the edge of destitution. If TVA and U.S Government debt instruments.

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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

Still another alternative to increase funding is to raise billion, the clean-up cost was enormous. There continue to be
utility rates. Increasing the cost to customers is never a calls for increased regulation of coal combustion by-products.
popular option, and it is TVA’s mandate to keep rates as low TVA faces other financial difficulties on top of the
as possible. Low rates are especially important given TVA’s costs associated with the Kingston situation. There’s the
mission of economic development in the Tennessee Valley, decreased demand and lack of pricing-increase flexibility due
and inexpensive energy costs keeps industry growing in the to the weak economy. It is also faced with another $1 billion
region. Besides, the outcry following a rate increase large expense from complying with the air quality standards
enough to fund capital construction would be heard across imposed by a lawsuit with North Carolina. Even though TVA
the Southeast and in Washington. had already developed a plan and had started construction on
plant upgrades required for improving air quality, the lawsuit
VI. OTHER CONSIDERATIONS forced TVA to expedite its schedule, and in some cases
required more money than originally budgeted. Finally, TVA
While TVA has an extraordinarily low cost of capital, new has experienced a long period of drought, which has reduced
generation means that bumping up against the debt ceiling is hydro generation from dams, forcing the agency to replace
a real possibility. Morgan pursed her lips, thinking, “Because that lost energy with expensive purchased power, since other
of the debt ceiling, I don’t know the best way to think about generation assets are producing at or near capacity. Morgan
rationing capital spending. Given the current economic and thought how all of these unexpected events, taken together,
political environment, would it be possible to get our debt equal almost 20% of one year’s revenue.
ceiling raised? Or am I better off to not even think about that?”
As Morgan approached Knoxville, she looked to her left VII. DECISION TIME
and saw the Kingston-TVA coal facilities and considered
that disastrous event. Coal units produce leftover fly ash that Finally, Morgan arrived at the TVA corporate tower in
requires disposal. At the Kingston plant, the ash was stored in downtown Knoxville and sighed. How should she fit the
a collection pond near the facilities. Just before Christmas of complicated pieces together to form a strategy for TVA to
that year, the walls of the pond ruptured, and the ash sludge satisfy its many stakeholders? What are the keys to TVA’s
flooded about 300 acres of land, including some people’s strategy going forward? Before tackling these two questions,
homes. TVA management reacted quickly and did everything Morgan must look at what she knows.
they could to right the situation, but at a cost of about $1

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 From the most recent 10-K, Morgan knows that TVA Morgan thought, “There are so many factors that are
currently has a 37,188 MW capacity; about 40% of capacity is unique to each of the production alternatives—capacity,
generated from coal and the remainder is generated primarily reliability, input costs, etc. No one alternative dominates.
by nuclear, hydro, and natural gas plants. Less than 1 percent What factors should I use to compare the alternatives? Are
of current capacity is from renewable resources. Last year’s some factors more important than others?”
long hot summer caused TVA to exceed this capacity, which TVA recently revealed plans to retire multiple coal units
required purchasing power from other producers. by 2018 to comply with its goal to be a leader of clean energy.
TVA has multiple options for producing power in order to TVA will need to replace 5,670 MW of generation before
ensure its commitment to reliable and affordable electricity these coal units are retired. Half of this generation will be
to the service area in the future. Each of the options has met by converting the old coal plants with combustion
unique capacities, cash flows, and useful lives. turbines. At least 70% of the remaining needed capacity will
Morgan wonders whether it would be better to go with be met with new base load generation; the remainder can be
longer-lived assets such as advanced nuclear or pulverized from peaking or intermittent transmission.
coal plants with expected lives of 30 years from the day At least one thing should help. Since TVA has
construction is started, or shorter-lived assets such as traditionally funded new power generation construction
advanced natural gas combined cycle, wind generation, with debt, the low interest rates will reduce borrowing costs.
or solar photovoltaic plants to take advantage of expected In addition, the cost of capital used in discounted cash flow
improvements in technology and production efficiency. Each analysis should be easier to explain to those few “financially-
of these alternatives has an expected life of 20 years. challenged” board members, since TVA uses no equity costs
Construction project costs and lengths also vary greatly. in its capital budgeting process.
The $5.5 billion cost of a nuclear plant dwarfs the other The TVA board will be looking to her for a plan to
alternatives and also has the longest construction time (4 meet the customer needs within TVA’s resource guidelines.
years). A coal plant is less expensive to build (costing roughly Morgan wonders how she should evaluate the production
one-third as much--$1.8 billion), but takes almost as long to alternatives, given their different cost and output
build (3 years). Although much less expensive to construct characteristics. In addition, how do the other factors affect
($650 million), a natural gas plant still requires 2.5 years for TVA’s strategic direction? The meeting is scheduled for early
construction. Both of the renewable energy alternatives have Monday morning. Morgan realized that she wouldn’t need
short construction times (1 year); the costs differ significantly. those football game tickets after all.
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 ABOUT IMA
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respectively). The other alternatives have lower capacities. IMA is the world’s leading organization dedicated to
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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.

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