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19 November 2020

Is modular nuclear the solution to Rolls Royce’s terminal decline?

Last week one of Britain’s oldest companies sowed the seeds of a mammoth transformation in its operations. Having built an empire through petrol cars and gas turbines, Rolls Royce now faces the same bleak reality as many of its legacy counterparts – change or die. For the engineering icon, a lifeline has been extended by the UK government and its obsession with nuclear power.

The plan at hand, which Boris Johnson is poised to back with £200 million as part of his £525 million pledge to the nuclear industry, details 16 Small Modular Nuclear Reactors (SMRs), essentially scaled down versions of the technology drawing criticism at the UK’s Hinkley Point C and Sizewell C developments.

Both of these white elephant projects will have a capacity of around 3.2 GW, operating for around 60 years, and are expected to be run behind time and hugely overbudget. Hinkley Point C is predicted to have a strike price of around £92.50 per MWh, far above the UK’s average expected strike price of £53 per MWh between 2023 and 2035 and significantly more expensive than prices for solar and onshore wind power. Austria is even in the process of suing the European Commission as a result of the Hinkley project, UK, calling it a “technology of the past” which “should not be kept artificially kept alive with government subsidies.”

The argument for nuclear remains in its lack of emissions, flexibility, and ability to operate when the wind isn’t blowing, and the sun isn’t shining – an argument that is starting to crumble as energy storage technology continues to explode onto the scene.

SMRs, such as those being developed by a Rolls-Royce consortium in the UK, aim to adapt nuclear to modern day markets. Through a standardized, modular approach, each of the 16 plants that Rolls Royce hopes to build in the UK will have a capacity of just 440 MW at a capital cost of around £2 billion – 11 times cheaper than Sizewell C. The construction phase has been estimated to take just 500 days, with man hour requirements cut by over 40% due to dedicated offsite module manufacture.

The 440 MW size isn’t to be sniffed at – it will still be able to power a city roughly the size of Sheffield, and the 7 GW that the aggregated 16 plants could bring to the UK’s electricity mix would equate to nearly 20% of current demand, along with substantial heat production. These sites are also expected to be on the ground of retired nuclear sites, where security infrastructure and planning permissions are already in place.

At a reduced size, the first of these projects is likely to have a levelized cost of electricity (LCOE) generated at under £75 per MWh, falling below £65 per MWh due to economies of scale after the installation of the fifth unit. In the medium term, the consortium, which consists of partners including National Nuclear Laboratory and building company Laing O’Rourke, is aiming for a sub-£60 per MWh LCOE.

Last year, Rethink reported on the project after it received a paltry £18 million from the UK government.

But make no mistake, the UK is hell bent on a future that includes nuclear: the Financial Times last month reported that the government was backing the plans to commit between £1.5 billion and £2 billion of nuclear investment as part Boris Johnson’s 10-point plan for the environment. Many senior officials have stated that the technology is essential if the country is to reach net zero emissions by 2050.

Maybe it is – along with rising demand and phasing out its gas and coal plants, the UK also faces the retirement of seven of its eight nuclear reactors by 2030, with the last one, Sizewell B, set to come offline in 2035. Interestingly, once the capacity factors of these plants are accounted for, they also account for around 20% of the UK’s current electricity supply – so in theory they could be directly replaced by Rolls Royce’s SMRs. Advocates behind the technology claim SMR’s not only to be the future of nuclear, but a key complementary partner to renewables, without issues around intermittency.

Rolls Royce’s SMRs will use similar processes to those at Sizewell B – using a triple-loop pressurized water reactor (PWR). It is slightly different to other SMRs being developed in the global market in that rather than focusing on new nuclear technology, it will “productize” a nuclear power station – with emphasis on the “station.” This entails producing a single design which can be produced repeatedly with only minor modification – imagine a high-tech Lego set for nuclear power. This would effectively design out costs and risks associated with traditional project-based approaches. With each component small enough to be standardized, modules can be mass-produced at a factory before being transported to site.

The only project-specific elements of each SMR are related to site geology and geography, which are largely accounted for by the use of a foundation slab with a seismic bearing pad to prevent damage from seismic or thermal loading. Support from the UK government in alleviating speedbumps in UK regulations and supply chain has led manufacturers to expect operational power stations to be built as early as 2029.

Another key facet of the UK’s nuclear aspiration is job creation in the wake of Covid-19. EDF has stated that Sizewell C will create 25,000 job opportunities, while Rolls Royce claims that it will put 6,000 to work within five years, if the government supports its SMR proposition, with as many as 40,000 more to follow in subsequent years.

And then there’s the post-Brexit export opportunity, both for technology and electricity. Rolls Royce has anticipated that the global SMR market will reach £250 billion in coming decades, and with the UK hoping to lead the energy transition, there will be a vast export market for any low carbon technology as other countries play catch up. The consortium this week signed agreements with the US company Exelon Generation and the Czech power company CEZ to consider the reactors. This will tick all the boxes for Boris Johnson, whose advocacy of nuclear is likely to see Sizewell C reach approval in the coming weeks, despite widespread objections from environmental campaigners.

As part of his Ten Point Plan for a Green Industrial Revolution, one point aims to “Advance nuclear as a clean energy source, across large scale nuclear and developing the next generation of small and advanced reactors, which could support 10,000 jobs.” Of the £525 million allocated to this part of the plan, which will see a £12 billion spend in total, around £200 million is likely to end up with the consortium, with the rest pushing towards the development of Sizewell C.

In true Etonian fashion, it could also provide a revival of the ‘Best-of-British-Heritage’ for Rolls Royce, which was founded in 1904, with aero-engineer Henry Royce chumming it up with carmaker Charles Rolls. Having played an instrumental role in WWII, the company sits alongside Fish and Chips in British pedigree.

While its iconic automobile business was sold to Vickers in 1980 and subsequently to Volkswagen in 1998, Rolls Royce’s expertise in turbine technology allowed it to hold a position at the top of the tree in power systems and aviation on an international scale.

In a nutshell, that is now the problem. With climate pressure rising, the outlook of both of these technologies is uncertain at best. Having served at the pleasure of emission-intensive sectors like aviation, maritime and gas-fired power generation, a Darwinian shakedown is seeing business-as-usual approaches deterring investors. Even before Covid-19, the downward trajectory of the company’s stock price was ominous – it fell nearly 40% in the two years up to January.

At this point investors were bullish on Rolls Royce. Despite the fall in stock price, revenues in 2019 were up from the year before (£16.6 billion vs £15.7 billion), while the company was making progress back towards turning a profit, with losses of £1.3 billion far below the £2.4 billion in 2018. But as one analyst prophesized in 2019 “Rolls-Royce’s shares may be impacted negatively in the short run by possible threats to the world economy.” Covid-19 provided just that.

With 49% of its 2019 revenue coming from its ‘Civil Aerospace’ segment through the manufacturing and servicing of engines, the international shutdown of air travel has had knock on effect on Rolls-Royce. Its stock price continued to tumble – it was down nearly 85% for the year so far in October, although with economies reopening and a promising Pfizer vaccine it has recovered 19% of this. Analysts expect that the group will generate a net loss of £2.6 billion for the year, meaning that it will have turned a profit just once in the past five years.

Seen by some as this as a bargain based on historic prices, Rolls Royce has seen a surge in stock market activity – it was the second most bought stock on Hargreaves Lansdown last week. But with such weak financials – regardless of the pandemic – it’s hard to be anything other than pessimistic about the future of Rolls Royce’s current operations.

Global defense spending is likely to hold relatively firm for the foreseeable future, with Rolls Royce operating in major markets like China, the US and the UK. But for Civil Aerospace and Power Systems, which account for nearly three-quarters of the company’s revenues, pressure to reduce emissions – including through the introduction of carbon taxes – will both reduce demand and necessitate a change in operations.

The European Commission this week announced that natural gas will not be an appropriate transition fuel to net zero meaning that many developers will be wary of the risk of developing new stranded assets. Demand for passenger flights is also unlikely to bounce back from the pandemic for several years at least, and the financial state of the airlines is unlikely to warrant frivolous spending on new aircraft – especially without significant emissions reduction.

Looking at the company’s current revenues – it’s obvious that SMRs aren’t going to turn around the company overnight. But to be fair, this isn’t where it has built its business. Rolls-Royce’s primary nuclear successes have been in small reactors for submarines, having designed reactors for seven classifications since the 1950s, leading to two separate land-based prototypes and now the SMR consortium.

The SMR approach will be largely due to the support that the UK government has for both nuclear and Rolls Royce as a company – hoping to bail it out of such uncertain times. While the company is also exploring innovation in electric turbines for aircraft, it’s clearly of the opinion that SMRs are a key part of its future – it now lists nuclear among its core operations on its website.

The 7 GW scale of Rolls Royce’s UK plans could theoretically generate annual revenues from electricity sales in excess of £3.6 billion, before expanding into other markets. Obviously, this would be divided up between other stakeholders, or even sold on to developers, but with forecast internal rate of returns of between 8% and 18%, the consortium could benefit to the tune of nearly £6 billion.

While the government is likely to be fairly protectionist about Rolls Royce for SMRs in the UK, any success beyond this will depend on delivering plants that are competitive in cost and technology, on time and on budget.

Key competition is likely to come from America’s NuScale and Russia’s Rosatom, which anticipate their commercial SMRs could come online from 2025 – ahead of Rolls Royce’s timeframe. GE Hitachi Nuclear Energy has also recently entered a licensing process with the Nuclear Regulatory Commission in the US for its BWRX-300 SMR design. Starting with a safety analysis, this is currently leading the race to cross the licensing milestone.

The other key threat is that of renewables-plus-storage, which for all intents and purposes, is the preferable options for power generation: there’s less of a safety risk, and no issues around waste management. Currently, nuclear power, with the ability to deliver 24/7 power, can command a cost premium above wind and solar. However, as the cost of storage falls, renewables-plus-storage can be compared side-by-side. Environmental organizations like Greenpeace are hot on this topic, stating that if the government want to take a punt on technologies like SMRs, then they’d be better off backing hydrogen or geothermal power.

If SMRs fall behind in this race, then groups like the UK SMR consortium face the risk of becoming redundant in the electricity mix. However, the UK’s established nuclear industry, with a developed supply chain and national professionals, means that there is arguably more certainty within SMRs than in energy storage, and investors are likely to latch on to this alternative future for the nuclear sector rather than jump ship completely.