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Effect of Risks and Government Policies on Investment in Electricity Markets Dhvanit K Pathak

May 02, 2012 IE590: Power Systems and Smart Grid

Effect of Risks and Government Policies on Investment in Electricity Markets


A report from a study made on the existing literature on the above topic for IE 590: Power Systems and Smart Grid

Dhvanit K Pathak

May 02, 2012

SCHOOL OF INDUSTRIAL ENGINEERING

Effect of Risks and Government Policies on Investment in Electricity Markets Dhvanit K Pathak

May 02, 2012 IE590: Power Systems and Smart Grid

Abstract:
How are investment decisions really made? In competitive markets, investment decisions are made based on the risks and prospective returns on the investment. This report was generated to describe some of the factors that inherently affect the returns on an investment made in electricity markets, power generation facilities in particular. The two factors addressed in this report are risks and government policies. Levelized costs have also been known to affect investment decision making in electricity markets but they tend to be one of the simplest factors considered in any analysis. This report however tried to deal with more complex factors. It was concluded that given the variety of effects risks and government policies can bring on investment decisions, a variety of mathematical as well as tactical tools can be used to generate these decisions.

SCHOOL OF INDUSTRIAL ENGINEERING

Effect of Risks and Government Policies on Investment in Electricity Markets Dhvanit K Pathak

May 02, 2012 IE590: Power Systems and Smart Grid

Table of Contents:
Abstract: ........................................................................................................................................................ 2 Project Scope: ............................................................................................................................................... 4 Background: .................................................................................................................................................. 5 Factors (Method): ......................................................................................................................................... 5 Risk ............................................................................................................................................................ 5 Government Policy.................................................................................................................................... 7 Effects (Results): ........................................................................................................................................... 8 Risk Effects ................................................................................................................................................ 8 Effects of risk on decision-making ........................................................................................................ 8 Effects of risk on investment finance .................................................................................................. 11 Government Policy Effects ...................................................................................................................... 12 Analysis: ...................................................................................................................................................... 13 Risk .......................................................................................................................................................... 13 Government Policy.................................................................................................................................. 14 Decision Making ...................................................................................................................................... 16 Limitations: ................................................................................................................................................. 17 Conclusion: .................................................................................................................................................. 17 Valuable references: ................................................................................................................................... 18

SCHOOL OF INDUSTRIAL ENGINEERING

Effect of Risks and Government Policies on Investment in Electricity Markets Dhvanit K Pathak

May 02, 2012 IE590: Power Systems and Smart Grid

Project Scope:
The scope of this paper is to determine the effects of different types of risks and government policies on the investment decisions made in electricity markets, especially towards generation technologies. The need of such a study arises from a very trivial question: how to position an investment in a power generation technology such that it is the right investment move at the right time. This paper does not focus, as much, on the reason behind why the factors discussed affect the way they do. The aim of this report is to provide an investor a birds eye view on how the factors discussed can affect his investment opportunity in the electricity market.

The way this task was addressed was through integrating a number of reports written on similar topics and making an analysis based on the cumulative conclusions of the reports. The report was started using a very broad scope wherein a range of factors were evaluated to determine their effect on the investment process and then the two most important ones were picked. For example, factors such as levelized costs, emissions trading, low carbon technology growth were also taken into consideration. Indirect factors such as geographical location as well as type of electricity market were also considered before leaving them out to make the report more concise.

The rest of the paper is organized in specific sections. The next section is background which discusses the work that has already been done in this area. It also reflects upon the main source that was used to generate this report. The section after background is the method section which discusses the manner in which the problem statement was approached by describing the two factors considered. It explains how different factors originated and what its types are. The next section displays the results, or precisely the effects that the factors described previously have on investment decisions. The section after, analyses the results that were obtained and makes statements regarding how companies and/or investors perceive the effects of the factors on electricity markets. The next section discusses any limitations and assumptions made during the
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Effect of Risks and Government Policies on Investment in Electricity Markets Dhvanit K Pathak

May 02, 2012 IE590: Power Systems and Smart Grid

course of generating this report. The next section makes conclusions based on the analysis done in the previous section. This will be the most important section as it will consolidate what was found in the previous sections. The sections after conclusion shall describe the references used in this study as well as the appendix.

Background:
A range of work has already been carried out on the topic of factors affecting investments in electricity generation in the recent past. There are specific organizations dedicated to research this domain in some universities like the Imperial College London (UKERC United Kingdom Energy Research Centre), Stanford University (GCEP Global Climate & Energy Project), MIT (CEEPR Center for Energy and Environmental Policy Research) as well as Purdue University (Discovery Park Energy Center). The backbone of this paper is however the report generated by a team of experts in UKERC, called Investment in electricity generation: the role of costs, incentives and risks published in May 2007.

Factors (Method):
This section describes which particular factors we found to be important for investment decision making in liberalized electricity markets. The respective sub sections will also try to entail detail regarding why the particular factor so largely affects the investment decision. A specific methodical approach was used to organize information within this section. It is organized in the order of following points: Description Types Origin

Risk
SCHOOL OF INDUSTRIAL ENGINEERING

Effect of Risks and Government Policies on Investment in Electricity Markets Dhvanit K Pathak

May 02, 2012 IE590: Power Systems and Smart Grid

Description: Risk forms the most fundamental type of uncertainty that affects investment in any kind of project or market, including electricity generation project/market. Risks can arise from many sources. They can range from general risks such macroeconomic and political situations to the more project-specific ones. However, while dealing with electricity generation technologies some specific types of risks can be pointed out which affect the projects on a larger scale.

Types: Revenue risks Price risks Cost risks Technical risks Financial risks

Origin: The most important type of risk from the list above is the price risk. All generation technologies within a given market are largely subject to the same time of day price of electricity but the level of exposure to this price risk varies considerably between generating technologies. As a result, electricity price risk turns out to be an important risk factor affecting technology choice in investment appraisal1. Price risks arise because of uncertainties about future prices for electricity. These in turn arise for a range of reasons such as large scale economic events or political changes, volatility in fuel prices, technical problems with power generation stations, etc1.

Some of the other reasons that generate risks of above types are listed as follows. Market structures in liberalized markets differ between countries and are subject to change over time. This change can occur as a direct result of regulation changes as well as market governance changes (e.g. mergers, consolidations or new market entrants). Markets may also be highly
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Effect of Risks and Government Policies on Investment in Electricity Markets Dhvanit K Pathak

May 02, 2012 IE590: Power Systems and Smart Grid

competitive, with many companies competing for and within separate functions (e.g. generation, supply, distribution) or dominated by an oligopoly (or even monopoly) of vertically integrated generation and supply companies1.

Government Policy

Description: The changes that occur in the government governing a particular geography in which an electricity market is located can have deep rooted effects on the structure, functioning as well as investment returns of the electricity market. The political changes that occur in the government as well as the stance that a particular government takes on energy sector will highly influence the way electricity markets react and therefore affect investment decisions. Types: Political changes Regulation approach Government pricing Incentives Technology specific schemes Revenue support schemes o o o Renewables Portfolio Standards with renewable electricity certificate trading Fixed price schemes (feed in tariffs) Premium prices (on top of electricity sales)

Capital grants Governments taking equity stake through PFI (public private partnership) Public procurement rules 7

SCHOOL OF INDUSTRIAL ENGINEERING

Effect of Risks and Government Policies on Investment in Electricity Markets Dhvanit K Pathak

May 02, 2012 IE590: Power Systems and Smart Grid

Tax incentives Direct (command and control) regulation.

Origin: Changes in government policies can result from a number of sources. Government policies can originate out of political changes that occur within a government, specific policy changes granted under a particular stance taken by the government, specific laws passed by the government in order to evangelize a particular technology, etc. For example, the UK passed the RO (the Renewables Obligation) law in order to places an obligation on UK electricity suppliers to source an increasing proportion of electricity they supply to customers from renewable sources4.

Effects (Results):
This section describes the results that each factor creates on interacting with the investment process. Each of the factors described in the previous section has a dedicated sub-section that describes its effects on investment making in electricity generation technologies. A particular sub-section may have further sub-sections detailing effects on particular investment related processes.

Risk Effects
As discussed in the previous section, risk forms the most fundamental uncertainty to affect the investment making process. Organized in sub-sections, detailed effects on particular investment related processes have been brought together. Effects of risk on decision-making Investment decision making is a very complex process. While making investment decision on projects with magnitudes as such taken into consideration in this report, a mere breakeven

SCHOOL OF INDUSTRIAL ENGINEERING

Effect of Risks and Government Policies on Investment in Electricity Markets Dhvanit K Pathak

May 02, 2012 IE590: Power Systems and Smart Grid

analysis is not enough. A more detailed and informed decision making comprises of financial appraisal (but is not limited to it).

This financial appraisal can be done through several ideas. One is for the investors to consider the net present value (NPV) and the internal rate of return (IRR) of an investment. NPV is the difference between the present value of cash inflows and the present value of cash outflows. NPV can be used in capital budgeting to analyze the profitability of an investment. In colloquial terms, NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account (Investopedia.com2). IRR is the discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. An example of a NPV analysis based on a discrete data set from the Department of Trade and Industry in UK is shown in the figure below:

Figure 11

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Effect of Risks and Government Policies on Investment in Electricity Markets Dhvanit K Pathak

May 02, 2012 IE590: Power Systems and Smart Grid

The range of NPVs illustrated in the above figure of the box-plot provides a simplified indication of a spread of possible returns, hence risks. The vertical length of line represents the range of returns in a particular generation technology in terms of todays value. The longer the vertical line, the higher is the uncertainty of returns. The horizontal line in the center of respective vertical spreads represents the average.

However, in reality any investment proposition is be further complicated by a range of other factors that affect the cost of capital and hurdle rate. These may reflect, for example, the size of investment, timescales and qualitative factors. This metrics defined above are used by comparing a projects expected IRR with a given hurdle rate that the company uses. Projects considered to have different classes of risk may be ascribed different hurdle rates. This hurdle rate may be linked to the cost at which a company can raise capital. It also represents the amount of risk a company can be exposed to without reducing its credit rating. Such models may be used to assess possible financial outcomes, hence risks, by either generating a set of NPVs from a set of discrete scenarios and/or a by generating a spread of NPVs using a stochastic approach. Strategic investment considerations may also factor into the hurdle rate expected of projects. Hurdle rates may be lower for strategic projects and/or more relaxed assumptions may be permitted in the estimation of returns.

Another idea would be to use a scenario approach. This approach would build scenarios which give a forward curve for each of above parameters, such that each scenario leads to a given NPV outcome. The analysis would then give a range of NPVs for the project depending on how the project performs under the different scenarios. A stochastic approach would run the model hundreds or thousands of times, each time picking a different value from within the range for the different uncertain parameters. The model would pick values with a frequency determined by an assumed probability distribution for the uncertain variable. Correlation between different variables would also be taken into account (i.e. so that if a high value of one variable was picked, there would be a greater probability of a high value being picked for another correlated
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Effect of Risks and Government Policies on Investment in Electricity Markets Dhvanit K Pathak

May 02, 2012 IE590: Power Systems and Smart Grid

variable). This analysis would give a probability distribution for the NPV, the mean of which would be the expected NPV for the project1.

Another technique that would be to explicitly quantify the effects of different sources of risk is the real options theory.

Effects of risk on investment finance Financing can be broadly divided into two types, debt and equity. Debt providers lend money to companies in exchange for an agreement to pay back an amount at a predetermined rate for a given length of time. Debt can either be raised through lenders such as banks and issuance of bonds. In both cases, the key concern of lenders or bond traders is the ability of the borrower to be able to service the loan repayments. Hence credit risk forms a key driver of the cost of debt. It is obvious to conclude that the companies that are deemed to be highly credit-worthy will have lower repayments because of lower interest rates as compared to companies that have significant risk of financial distress1.

In case of equity, investors focus on estimating the risk dependent returns as well as evaluating if the returns are worth the risk they are exposing their capital to. Because there is no guaranteed level of return in equity, the risks for equity investors are higher. But as result the returns they expect are higher as well. Therefore equity forms a more expensive form of financing than debt.

The share of debt and equity (known as gearing) are fundamental to the overall cost of capital and the level of return expected of an investment. At the company level, the weighted average cost of capital (WACC) measures the weighted average of the cost of debt and the cost of equity can be used internally by the company to determine the economic feasibility of new investments as the WACC represents the minimum value for the IRR of a new project1. Now, because of the lower cost of capital associated with debt, companies aim to get more debt financing. However,
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Effect of Risks and Government Policies on Investment in Electricity Markets Dhvanit K Pathak

May 02, 2012 IE590: Power Systems and Smart Grid

as the debt gearing rises, the risk of default also rises and so the lenders tend to increase interest rates and/or restrict gearing rates. The level of debt that can be raised therefore depends on the type of project and its perceived risk profile by the lender. It is therefore easy to correlate that a riskier project might have the higher risk-taking equity as the major shareholder and the project will require having returns high enough to sustain the higher cost of finance.

Overall, investors and lenders will favor the sector, project, or location where they get the best return. Therefore the ratio of return to risk offered by the electricity market will therefore determine the extent and the conditions financiers and lenders will be interested in electricity generation projects.

Government Policy Effects


Investments in the electricity market and government policy are known to influence each other from time to time. It is quite uncertain as to which influences the other more. However, a range of sub-factors under the government policy factor affect the investment making in electricity markets. Some of the prominent ones are detailed below.

Political changes at a local as well as national level can affect markets of all kinds. Particularly, if incoming political parties have a different view of energy policies than the previous one and change or remove support mechanisms or introduce new schemes, the electricity market can react strongly or mildly depending upon the change.

Governments are prone to change the laws at any given time based on its internal requirement as well as external motivating factors. For example the UK has changed its electricity trading arrangements thrice since the 1990s. Such changes can impact on electricity markets thereby increasing prices, price volatility and risks.

Like in any market, there is a specific governing body for the electricity markets too. The stance that this governing body takes towards the way it prefers to govern the market can have an impact on the investment too. For example, breaking up companies to

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Effect of Risks and Government Policies on Investment in Electricity Markets Dhvanit K Pathak

May 02, 2012 IE590: Power Systems and Smart Grid

reduce market concentration. This can affect market structure and price volatility. However, market power can decrease price volatility but fear of regulatory intervention can also discourage certain types of investment. Another factor affecting investments within governmental control is the permission related issues such as the difficulty in securing planning permissions, grid consents and transmission system pricing. These factors the ease with which they can be procured can determine the barriers to entry in this market and also the feasibility of investments. Governments also have the power to stop investments in certain segments of a market. This too can negatively affect the investors confidence. An example of such a case is the moratorium on new gas generation imposed in Britain during the late 1990s. Governments have the power to provide incentives and support schemes can form great support towards companies trying to evangelize a technology. An example if this would be the current subsidy that government offers to the buyers of residential renewable energy generation adopters. Carbon permit prices. A carbon permit price is the amount of price that a company needs to pay while releasing carbon based pollutants (above a certain limit set by the governing authority) in the environment. Such type of trading is referred to as Emissions trading. A common concern in this regard is the volatility of carbon permit prices6. This sub-factor can be very crucial while considering investing in a conventional carbon source powered generation technology. (A good place to read about the effect of carbon permit prices on the risk in electricity generation is Green, R. (2007) report5.)

Analysis:
Risk
Companies have different ways of assessing the ideas discussed in the previous sections to make their investment decisions. As the UKERC report puts it, they may simply put a value on the downside risks, and compare these between the various projects available to them to reduce risk exposure. In any case, companies will be concerned about the absolute level of down-side
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Effect of Risks and Government Policies on Investment in Electricity Markets Dhvanit K Pathak

May 02, 2012 IE590: Power Systems and Smart Grid

risk to which they can be exposed without damaging their credit ratings, as this would affect their cost of borrowing. Another method that companies can use is to classify the risk rating of a project based on the distributions obtained and then use these to determine the hurdle rate to be used to compare with the IRR. However, the UKERC report notes that, this may be most appropriate when considering projects with well understood risks.

Government Policy
The list of sub-factors mentioned in the previous section can affect the cost of capital and hence investment in electricity markets. The main point to note from the given effects is that, higher the stability of the government policies, the easier it is to procure capital for investments. However, policy is not necessarily negative in its impact. New policies also have the ability to create markets, through a variety of support or incentive mechanisms as mentioned in the last sub-factor above. One of the most prominent types of such support systems is technology specific support systems. Governments tend to provide subsidies as well as incentives to the early adopters of the technology that the support system is evangelizing. For example, the government can provide premium price or subsidy schemes for technologies involving renewable energy. The bottom-line purpose of such an intervention is to remove any financial inertia hindering the adoption of new technology. Support systems as such aim to increase revenues, improve cash-flow, and enable these energy sources to compete for capital with other investment options1. There are numerous examples of new renewable energy firms that have procured such grants from the government, such as Ener1, Solyndra, Evergreen Energy, etc. A specific example of a policy improving technology adoption is quoted below: Since the ROs introduction in 2002, it has succeeded in supporting the deployment of increasing amounts of renewables generation from 3.1GW in 2002 to 8GW in 2009 and more than tripling the level of renewable electricity in the UK from 1.8% in 2002 to 6.6% in 2010. It is currently worth around 1.3 billion a year in support to the renewable electricity industry.

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Effect of Risks and Government Policies on Investment in Electricity Markets Dhvanit K Pathak

May 02, 2012 IE590: Power Systems and Smart Grid

In April 2010, the end date of the RO was extended from 2027 to 2037 for new projects to provide long-term certainty for investors and to ensure continued deployment of renewables to meet the UKs 2020 target and beyond.

This piece of literature was retrieved from the UK Renewables Obligation website 7. We can also see that because the policy was generating positive responses from the market, the government took the necessary steps to increase the policy period by another ten years to provide stability to the investments. However, a policy-created market can also pose a risk for itself. If there is a policy or regulatory change resulting from a change in government, or any other circumstance, the markets might find these changes very difficult to digest; especially if the technology is still in the process to get its grip over the market. For example, at the moment there is a US federal subsidy of US$1.01/gallon on cellulose biofuels. However, the subsidy is set to expire in 2012 and what action Congress might take on the extension of this policy is unknown12. Such uncertainty can negatively affect the market for cellulose biofuels. Wallace E. Tyner (James and Lois Ackerman Professor of Agricultural Economics at Purdue University) who has conducted research in the area of effects of government policies on renewable fuel has the following to say on the topic, Congress has always placed a term limit on the subsidy. Usually the limit has been 58 years out. That time limit means that potential investors can be assured of having the subsidy only for a short period of time during the production life of the plant, since these plants will require 23 years for construction. Options that do a better job of guaranteeing a market would be much more likely to be successful in launching the industry. An example would be a reverse auction, in which the government issues a call for a fixed quantity of biofuel with a given specification and delivery point. For example, it could say that we want 200 million l/year for the next 15 years of bio-JP8 (jet fuel) delivered to air base X. Companies would bid for the right to supply under that contract. Such a system would eliminate market price uncertainty and government policy uncertainty.12
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Effect of Risks and Government Policies on Investment in Electricity Markets Dhvanit K Pathak

May 02, 2012 IE590: Power Systems and Smart Grid

Decision Making

Figure 25 Figure 2 summarizes a basic approach to the methodology that can used in the investment decision making process using one or more of the factors mentioned in this report. To start with, it is very important to review the existing literature on the subject (an approach that was taken while writing this report as well). This literature can point you in the right direction as to what needs to be referred to next. Historical trends form a very important part of the literature review as many cause and effect cases can be found out easily from historical charts. A lookout should also be kept for future events such as national or regional elections which might bring about a change in policies that can directly affect investments. A good thing to do in such a scenario would be to wait. Along with this written knowledge, it is also necessary to consult some of the industry participants to gain a second person perspective who deals with the electricity markets on a daily level. Governing bodies also usually have go-to people from whom you can obtain the information you are looking for. Once this is done, a data set will be ready for actual analysis to be carried out. Once the data is arranged in a manner that could be understood by analysts, the next and final step can be taken. The final step would be to carry out the actual analysis based on the different simulation, modeling, statistical approach that an
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Effect of Risks and Government Policies on Investment in Electricity Markets Dhvanit K Pathak

May 02, 2012 IE590: Power Systems and Smart Grid

investor likes or finds feasible to follow. Based on results from such analysis, one can have a good assumption to base ones decision about the investment on.

Limitations:
This report being a beginners report on how certain factors affect investment decision making in electricity markets, a lot of assumptions were made to keep the report true and concise. The electricity markets assumed in this report were liberalized and deregulated. No single particular region or geography was chosen. Also, most examples were taken from the UKs electricity market and governance system. The UK follows a liberalized electricity market system. Also, no method or explanation was provided as to why the two factors were chosen above the others. This was again primarily done to keep the report concise. Not all terms mentioned in the paper were described; it was assumed that the reader of this report would already have some background knowledge about electricity markets. Care was taken to cite each and every fact that was borrowed from an outside source. If any citation was missed, it was purely due to ignorance and no credit-snatch was intended.

Conclusion:
Electricity markets, in the coming future, will be much talked topics as well as hot investment prospects. This is because we stand at the beginning of a series of changes that will likely occur as the world shifts from power generation from conventional sources of energy to renewable ones. Such shifts, as proved by history, are a great time to invest as the returns during such times are the highest. And in order to invest during such times, a deep rooted knowledge about the factors that affect investment making in electricity markets would be very beneficial to the investor. We can conclude from this report that risks and its different types affect investments significantly and the better one can evaluate such risks, the better one can make the investment
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Effect of Risks and Government Policies on Investment in Electricity Markets Dhvanit K Pathak

May 02, 2012 IE590: Power Systems and Smart Grid

decision. Statistical as well as simulation tools can come in very handy in this process. Government policies on the other hand are more of an external factor that can help or hinder a specific investment. One needs to have a very acute understanding of the politics as well as the concerned governing bodies in order to predict future policies to make better investments.

Valuable references:

1. UKERC (May 2007). Investment in electricity generation: the role of costs, incentives and risks. 2. Net Present Value: Investopedia. Retrieved from

http://www.investopedia.com/terms/n/npv.asp#ixzz1tHQZDfet on April 27, 2012. 3. Internal Rate of Return: Investopedia. Retrieved from

http://www.investopedia.com/terms/i/irr.asp#ixzz1tHR7ocUv on April 27, 2012. 4. Renewables Obligation: Ofgem Promoting choice and value for all gas and electricity customers. Retrieved from

http://www.ofgem.gov.uk/Sustainability/Environment/RenewablObl/Pages/RenewablO bl.aspx on April 27, 2012. 5. Green, R. (2007). Carbon tax or carbon permits: the impact on generators risk. Institute for Energy Research and Policy, University of Birmingham, Working paper March 2007. 6. Electricity generation investment analysis: Final Report. Deloitte. (April 2011). 7. The Renewables Obligation (RO). Retrieved from

http://www.decc.gov.uk/en/content/cms/meeting_energy/renewable_ener/renew_obs/re new_obs.aspx on April 28, 2012. 8. Blyth, William (2009). Risks and uncertainties in low carbon energy investments. European Review of Energy Markets, vol 3, issue 2, June 2009. 9. Blyth, W. Bradley, R. Bunn, D. Clarke, C. Wilson, T. Yang, M. (2007). Investment risks under uncertainty Energy Policy 35.

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May 02, 2012 IE590: Power Systems and Smart Grid

10. Fleten, S., K. Maribu, and I. Wangensteen (2007). Optimal Investment. Strategies in Decentralized Renewable Power Generation under Uncertainty. Energy Vol 32 Issue 5. 11. Masters, Gilbert. Renewable and efficient electric power systems. Wiley-Insterscience. 2004. 12. Tyner, W (2010). Cellulosic biofuels market uncertainties and government policy. Biofuels (2010) 1(3), 38939.

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