Energy Planning and the Portfolio Theory

We have discussed how the risk of an individual stock may be theoretically measured using the Capital Asset Pricing Model (CAPM), which  theorizes that investors will buy a stock for as long as its return is proportionately priced to that of the entire market, and why the model doesn’t work for a country like ours.

But there is another finance theory that requires putting different stocks together to maximize the returns: the portfolio theory. As I will discuss here, this concept can be used for energy planning.  Although the literature is still scant in this field, some studies have already shown that a portfolio approach to energy planning will result to better and more robust outcomes for the economy.

What is the portfolio theory in simple terms?

An investor who puts two different stocks together in a portfolio, with each stock having its own risk-adjusted return will yield a total return that change in accordance to the behavior of the individual stocks.

For example if the portfolio has two assets–Asset A, which is considered  risk free, but only yields one percent per annum, and Asset B, which is considered high-risk, but yields 36 percent returns per annum. Asset A is priced at P50,000 apiece while asset B is priced at P1,000 per piece.  We assume that the investor has enough money to buy any of the two assets. What would an investor choose?

  • Asset A— yield= 1% p.a.; P50,000/piece; Risk-free
  • Asset B—yield= 36% p.a.; P1,000/piece; High-risk

There is no straightforward answer. It depends on the risk appetite of the investor is. If the investor is conservative, then Asset A may be the wiser choice.  If the investor is a risk-taker, then Asset B would be a perfect investment.

The world, in fact, does not have only two assets, which allows an investor to choose from a whole spectrum. And the choices do not have to be just one asset in that spectrum.  The investor can put the money in different assets or in slices of each of these assets, allowing the investor to diversify both risk and investments. .

This is the portfolio theory developed by Nobel Prize winner, Harry Markowitz, which says that risks can be minimized at any level of expected return if the investor mixes assets in a portfolio, combining high and low or zero- risk assets.

An investor should look at the best combination of stocks in a portfolio rather than invest all of the money in one. In the example earlier, an investor who combined Assets A and B in one portfolio would have maximized the return since the less risky asset enhances the returns of the portfolio. The investor puts together the assets in proportions that will make him comfortable with the associated risk for each asset.

If there is a combination that will either give a higher return with the same risk, then investors will go after that asset or group of assets. Conversely, if there is an asset or portfolio of assets that will give the same return but for a lower risk, then investors will all flock to buy that asset or portfolio. Thus in an ideal world, there will eventually be an equilibrium, where all these assets are properly priced in what is known as an efficient portfolio frontier. It has some calculus in determining this frontier, but for us laymen, it is sufficient to imagine that such a set can exist.

How do we relate this to energy planning?

I have argued that the application of “least cost” planning method is insufficient and inadequate in today’s environment.  For some reason, the probabilities for “Black Swan” events seem higher, and, therefore, any good planner must always consider risks in the planning framework.  Unfortunately, the current method of planning takes into consideration the probabilities and excludes measuring risk.

This is why a hydropower plant that costs; let us say US$4M per megawatt to build is considered more expensive than a US$2M per megawatt coal-fired plant. Yet, especially for the Philippines, the price of coal cannot be predicted.  The price of water is easy: zero.

So, which one is cheaper for the Philippines — the coal-fired power plant or the hydropower plant?

Now the answer is not straightforward anymore. If we can live with unpredictable prices, we can live with the coal-fired power plant.  On the other hand, if price stability is important to us, then the hydropower plant is the better choice.  I am, of course, assuming away technical differences like plant factors and issues like carbon emission and hydrology.

At the risk of oversimplifying the analysis, I am saying that the choice between a coal-fired power plant and a hydropower one boils down to how much we want to be at risk to global prices.  It is a choice between a risk-free asset (the hydropower one) and the riskier coal-fired power plant.

Just like the financial asset, the answer might be to combine the coal-fired power plant and the hydropower one, depending on how much risk we want to take.  And this decision is one that is difficult to process in a democracy or in a deregulated sector.

This is why the current “least cost” approach of electricity system planners is deficient and no longer applicable to today’s reality. Most planners would choose coal-fired power plants over the renewable energy power plants like hydro or wind since the coal ones would be considered as “least cost.”This “cost”, however, does not consider the risks involved.

What are the risks involved of being highly dependent on fossil-based power generation?

According to the Energy Information Agency (EIA), there has been an increasing demand in fossil fuels for the last 30 years and estimates show that oil can possibly last up to the next 20 years given the rise in consumption. Fossil fuels, after all, are natural resources, which are non-renewable.  And as the law of supply and demand says, fossil fuel prices are likely to shoot up in the next decades when supply slows down while demand increases. Although the prices are down today, no one can really predict when the next up-tick will be.

Similar data found in the BP Statistical Review of World Energy published in June 2014 echoed the claims of EIA.  For 2013, both consumption and production increased for all fuel types except for nuclear power. However, consumption outpaced production for the top three fuel types—natural gas, coal and oil.


Fuel Type World Consumption Increase World Production Increase
Oil 1.4% 0.6%
Natural Gas 1.4% 1.1%
Coal 3% 0.8%

Source: BP Statistical Review of World Energy 2014

World consumption for oil increased by 1.4% in 2013, but oil production only grew by 0.6%. Similarly, the global consumption of natural gas accelerated by 1.4%, but production only increased by 1.1%.  Coal, which was the most consumed fossil fuel type in 2013, posted a growth of 3%, but world production only grew by 0.8%, the slowest production growth since 2002.

Clearly, using the favored fossil fuels is risky since prices are highly volatile. And if price stability is what we want, then reliance on fossil fuels is the wrong way to go.

The Energy Regulatory Commission (ERC) of the Philippines currently uses the CAPM as the basis of determining the appropriate tariff of EACH power plant. Right away, one can sense the problems with this approach: a) the CAPM does not work in non-efficient economies; b) even if it does, how does one calculate the betas; there are not enough companies to represent the “market” and c) the regulatory body should be looking at an efficient PORTFOLIO rather than individual assets if the country is to gain from the application of the CAPM as a regulatory basis for tariff setting.

These regulatory issues will be discussed some other time.

The point I would like to make here is: power planning in this country should be looking at the risks associated with costs rather than on costs alone. Otherwise, our country might lose its chance for real economic growth. Faulty energy planning, after all, also means throwing away our single most important resource: our natural resources.


The CAPM is nothing more than a theory about how investors will behave when given an opportunity to do so. It theorizes that investors will invest in a stock or asset for as long its return is commensurate to the risk it has. This return and risk is benchmarked against the over-all return and risk of the entire market. If the return is too high against the risk, then an arbitrage situation occurs causing other investors to demand for that stock. This raises the price and consequently brings down the return.

This risk-return relationship is vital in any transaction. The allocation of the risks inherent in a transaction determines whether a contract is fair or appropriately priced. If a particular risk is given to a party that has no experience in dealing with the particular risk, then this party can price this risk so high that the entire transaction can become economically unattractive. It is therefore important to identify the risks properly and allocate to the proper party, and price the risk accordingly.

Let us take the case of a person buying a car. The price that one has to pay for the car includes an explicit guarantee from the car company saying that the car company will be responsible should the buyer find anything defective with the automobile within a defined time frame. This is only logical because otherwise, the buyer will have to conduct a technical due diligence on the car and determine for himself its technical soundness. The car in this case may be cheaper, but the buyer runs the risk of making a mistake in the technical analysis of the car.  There is no way for the buyer to know the condition of the car unless the buyer is an automotive engineer.

On the other hand, the car company cannot be responsible for the buyer’s driving habits. If a part breaks down because of bad driving, then the buyer is responsible, not the car company.  This is logical because there is no way for the car company to vet the driving habits of its buyers unless it does its own tests on its buyers.  This is a very expensive process, not to mention, an impractical one.

Thus, the car gets priced according to this risk allocation model of car buying – the car company is responsible for major breakdowns in case of normal wear and tear within a time frame, and the buyer is responsible for normal wear and tear.  Some brands price their products because of implicit and explicit guarantees of superior engine performance and track record. Others are priced lower with the appropriate lower guarantees of engine performance.

Buyers are then free to choose from European, American, Korean, Japanese, or recently Chinese automobile brands. Consumers choose according to their tastes and risk preferences.  Some consumers choose to buy more expensive brands while others buy lesser known brands knowingly that the car may breakdown more often than the better-known ones.

This transaction about a car is a practical application of the CAPM.  After the risks have been properly allocated between the buyer and the car company, then consumers choose the car according to their own risk preferences.  Those who want a cheap car take more performance risks than those who buy more expensive brands.  This is what the CAPM says: When the asset is priced properly, then no car in the market will be bought because of its lower price than the equivalent risk.

This means that if a four-cylinder Chinese brand car is priced at P100,000 and a similar engine displacement BMW car is priced at P100,000 also, then the demand for the BMW can go up so high and the car’s price will reach a level at which the demand will be satisfied. Let us say this price reaches P1,000,000.  So, two similar cars are priced vastly different – one is P100,000 and the other P1,000,000.

Which is more expensive?

Conventional wisdom will tell us that a P1,000,000 car is more expensive than a P100,000 one. Really? Having gone through the arguments of the CAPM and the risk allocation for the car transaction can you really say that one is “more expensive”than the other?

Setting aside the issue of affordability, the choice is really down to personal preferences. I may prefer the cheaper car even if I can afford the more expensive one because since I do not travel often, I do not expect the car to breakdown often.  On the other hand, I may prefer the more expensive one because I need to know my children are safe when I drive cross country with them.

In reality, there are no “expensive”or “cheap”assets since the asset is properly priced.  Such assets appear in the market occasionally. But if, in theory, the market is efficient, then consumers will see this as a bargain and the demand for the asset will drive this price up to its appropriate level. As we always say, we get what we pay for. In the case of hiring people, if you pay peanuts, then you get monkeys.

This leads me to a brief discussion on how this concept has an impact on government procurement. Again, conventional wisdom tells us that the government should always buy the “cheapest”product.  We hear of “overpricing”scandals almost everyday.  Having gone through the arguments of the CAPM, risk allocation and consumer preference; can we really say a product should be bought because it is “cheaper”than the other one?

Let us say, a hypothetical government agency bid out its requirement for a sedan. For example, the two car companies are Volvo and Cherry (both are Chinese-owned) and the results are as follows:

Chery              P 99,999.99

Volvo             P100,000.00

If you were buying the car for yourself, which one will you choose?

Chery Car. Photo from

Chery Car. Photo from

Volvo. Photo from

Volvo. Photo from

Why should the government decide any different?

For a small difference in price I can get a car that has a better safety record, a risk factor that is important to me as a father of a family.  Why shouldn’t the government care about its employees in the same way?

More importantly, from a finance perspective, the government will actually lose more value by choosing the “cheaper car”. The catch in this example is that most likely one or the other is wrongly priced. Assuming this is the case, the government will stand to gain more value from lower risk by buying the slightly more expensive car. Clearly, this is an arbitrage situation.

Unfortunately, the person making that decision i.e. buying the more “expensive”car can go to jail.  Government regulations will force the agency to choose the Chery over the Volvo. The government in that case lost value, but the agency head can retire with full pension and a clean record.

Clearly, the CAPM and risk allocation concepts can get lost in government, especially in a democratic government, particularly the Philippine government.  Before we get lost in this discussion, however, let me introduce one more important concept in Finance: portfolio theory. How all these concepts are intertwined and become important in the power sector will be seen soon enough.




The CAPM and Portfolio Theory are decades-old concepts in Finance that deal with the theory of how investors price assets and how they can maximize value by putting all these assets in a portfolio. In recent times, these concepts have been adapted by regulators in the case of the CAPM and by reform-minded thinkers in the power sector in the case of Portfolio Theory.

The CAPM was put forward in the 1970s as a theory on how investors determine their return.  Without getting into details, the CAPM theorizes that investors will invest in assets that will have a higher return over the risk-free rate of the economy plus a premium for risky assets.  The tricky part was how to determine or measure this “premium.”

What the CAPM developers did to measure this premium was to say that if the investors were to invest in the ENTIRE market of assets, then the return of the ENTIRE market would accurately reflect the correct return for the risk for the ENTIRE market.  The measure of this risk was called “beta.”  So the ENTIRE market will have a “beta” of 1.  Individual assets that were more risky than the entire market should have a beta greater than 1, while those that were less risky will have a beta of less than 1.

Tests were conducted across different markets to see whether investors followed or behaved according to the “theory of the CAPM.”  As it will be impossible to measure all classes of assets, the country’s stock market was used to test the validity of the CAPM.  In general, scientists and economists found that the CAPM works in markets that are “efficient.” The term “efficient” here is defined as a market where the price of the stock reflects all available information related to the stock or company. In other words, these are stock markets where insider trading is strictly prohibited.

Clearly, only the markets of the more developed markets were seen to be efficient, making the CAPM generally valid. So, when these countries’ energy regulators use the CAPM as a way to measure allowable equity returns for regulated entities, the results are generally accepted by the investing public.

The problem with the CAPM as it is used in energy or any type of regulation for that matter is when it is adopted in countries where clearly the stock markets are NOT efficient. A study conducted by Prof. Rodolfo Q. Aquino of UP revealed in his work “Informational Efficiency Characteristics of the Philippine Stock Market” the following:

“Thus, for all practical purposes, it can be stated that the market is weak- form efficient in the sense that market players cannot make abnormal profits using only past price information…When macroeconomic information is added to the information set, the statistical evidence is that the market is also not semi strong-form efficient. In addition, the degree of inefficiency may be enough to enable skilled market players to trade on publicly available information and make above average profits in excess of transactions costs.”

As previous studies have shown, the CAPM will not work in non-efficient markets. Based on Prof. Aquino’s findings then, it can be safely concluded that the CAPM will not work here in the Philippines.

Furthermore, a cursory check with the PSE will reveal that it does not calculate betas for the stocks in the exchange. The fact that the PSE does not calculate the betas says many things for me.  One can calculate the betas of these stocks;however, these are only linear regressions anyway. As such, the validity of the results would be in question.  Any statistician can tell you that a regression analysis can be done between two random numbers over time.  But whether these random numbers are indeed random and not subject to any manipulation can determine the meaningfulness of the results of this analysis.

It is therefore important for the Energy Regulatory Commission to be absolutely critical in using the CAPM in regulating the power sector.  In fact, using any first world tool for financial analysis can be literally deadly for poor countries like the Philippines.  We, as a country, cannot afford to use sophisticated tools when only basic tools are required.

Let us take the following case:

Investment 1: zero cash inflow in period zero and then P10M in period 1

Investment 2: P1M cash inflow in period zero, then P2M every year until the 5th year

If the CAPM determines that the appropriate discount rate is 15%, then the Net Present Value (NPV) will always choose Investment 1 as the preferred investment. The problem arises when the investment is for a basic necessity like water or power.  One can imagine that with the first investment, the people may no longer be around when the P10M comes.  So, what use is the money if the intended beneficiaries are dead due to, for example, dysentery or tuberculosis?

Of course, my example is an extreme one, a hyperbole.  But this is an argument I have made many times whenever I had to present power projects to the National Economic and Development Authority (NEDA) during my time in government. By putting a “cut-off” of 15% Internal Rate of Return or IRR, the government has created what people in finance call “credit rationing.”  This is the situation where more meritorious projects, those with returns that are commensurate to their risks are not pursued because of an arbitrary number like the IRR of 15%.

In conclusion, we have to be very careful when using “first world” financial tools in a country like the Philippines. If we succumbed to this during my time in NPC, many projects will not get done. Foremost among such projects would be the Mindanao Coal project and San Roque Hydropower Project. “First world” financial tools seemed to show these projects were not viable. We could not accept these financial tools in a situation where our people were suffering far beyond what the capitalist markets could predict. Breakdown of markets such as what we experienced are indeed clear indications that even supposedly strong economies like the United States and the European Union can fall prey to these tools.

The CAPM is a good tool but like any good tool, we should know how to use it properly. Otherwise, this good tool can become a murder weapon literally slashing away any investment that may be needed in the power sector.

How does the CAPM connect with the Portfolio Theory and how these concepts are applicable to the Power Sector? Let’s discuss this next time.