LCOE’s to compare energy investments?

Levelized cost of energy (LCOE) is one of the essential measures when it comes to energy-related projects, no matter the energy source, timespan, size, or location of the project. Not only provide LCOE’s a possible point of comparison across the various sources, but also a reasonable estimate and guideline of how power plants can break even, generate profit and eventually how expenditures need to be handled. 

The minimum necessary generated revenue per unit of electricity that eventually covers the lifetime costs of the energy project itself can be one of the definitions of LCOE^[1]. In other words, this represents the net present costs per output unit of installing and operating a power plant, which will ultimately help investors, of any kind, to make an investment decision. Calculating these costs does not only give you the possibility of calculating the likelihood of breaking even (if costs & asking price are known, they are easily comparable), however, it also lets you include variable as well as fixed costs into the calculation. 

Next to assessing whether a specific project is a worthwhile venture, calculating the LCOE is a vital method when it comes to comparing energy sources, regardless of parameters. Even the individual projects risks are included in the calculations, as this is directly reflected in the applied discount rate. By dividing the net present value of the lifetime costs of the asset by the total generated electricity over the lifetime of this asset, the usual unit of currency per kilowatt-hour, $/kWh (or MWh), is obtained.^[2]

The input variables of the above-described calculation vary between the energy sources, as different costs accompany different power plants. Wind and Solar PV plants are not faced with fuel costs, for example. Furthermore, the importance, relative size and therefore, the emphasis of different values differ significantly throughout the various power sources. Another aspect that needs looking at is potential growth factors of operational costs (OPEX)  along the way. Additionally, apart from solely looking at expenses, the LCOE calculation must also include subsidies and tax incentives, which are provided for low-carbon-emissions projects.^[3] On a side note, such grants deflect the comparability of considered projects in opposition to unsubsidised investments and therefore give a biased outcome.  

One possible (simplified) formula for calculating the LCOE’s of a given project is as follows: 

LCOE = [S^t_n=1 (I_t + M_t + F_t) / (1+r)^t] / [S^t_n=1 E_t / (1+r)^t] ; where (i) I_t is the invested capital in period t, (ii) M_t are the costs of maintenance in period t, (iii) F_t symbolizes the cost of fuel in period t, and (iv) E_t is the energy output in period t.

This is a generalized approach for calculating the levelized costs, however, there are differences for every individual input source, which will be discussed within the next weeks. 

Besides LCOE’s relatively uncomplex nature, other benefits are their broad applicability and easy understanding. What is an advantage to some, however, is often seen as a disadvantage to others. This concern is especially shared regarding the simplifications the calculation follows, particularly when it comes to pricing the risks associated with the uncertainty of future input prices like O&M costs, fuel costs, and unforeseeable repairs.^[4] Consequently, there are limitations to everything, yet, overcoming these may be possible by including as many aspects as practicable. Another facet, believed as essential to keep in mind, is that these problems are the same for all; therefore, comparisons and estimations are feasible again. 

As already mentioned, LCOE’s are limited, mainly due to their inability to adequately capture the costs that renewable technologies increasingly require to ensure a stable, reliable, and constant energy supply.^[5]Hence, possible alternatives to LCOE, like (i) Levelized Avoided Costs, (ii) Value Adjusted LCOE, and (iii) Realised Power Prizes might be beneficial to look at in addition to LCOE’s.^[6]

Over the next weeks, a series of posts on levelized costs of energy, covering the different renewable energy sources, will follow, so stay tuned and share some useful input with us. 

Do you believe that LCOE is a good indicator that can and should be used to determine the feasibility of a project, or is there a better way to do so? 

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^[1] https://energyeducation.ca/encyclopedia/Levelized_cost_of_energy#cite_note-2

^[2] https://www.nrel.gov/analysis/tech-lcoe-documentation.html

^[3] https://www.eia.gov/outlooks/aeo/pdf/electricity_generation.pdf

^[4] https://www.sciencedirect.com/science/article/pii/S0301421518306645?via%3Dihub

^[5] https://publications.csiro.au/rpr/download?pid=csiro:EP187001&dsid=DS3

^[6] https://www.nrel.gov/docs/fy20osti/75657.pdf