2nd March 2023
Chris Bowden, MD, Squeaky
6 minute read
Understanding power markets: The levelised cost of energy
The levelised cost of energy provides a very useful way of valuing new renewable energy assets and determining the energy price a project needs to be viable.
What does it cost to generate a megawatt/hour of electricity? This simple question throws up a lot of complicated answers. For a solar farm, powered by sunlight, the answer could – arguably – be close to ‘zero’.
A natural gas plant, conversely, would have to factor in the price of the fuel, the cost of carbon emissions permits and its other operating costs. On top of this, the cost of the capital needed to build the plant needs to be taken into account. That cost might be zero for a 25-year-old asset, which has had its original capex amortised down to zero. Or it could represent the lion’s share of a new wind farm’s cost.
As we have seen, the price of electricity in most wholesale markets is based solely on the operating costs of the various generators that bid to supply power. This is expressed as the marginal price – the price required to incentivise sufficient capacity to meet demand at a given point.
However, because these operating costs do not include the costs of repaying debt and generating a return for equity investors, they only tell part of the story. To compare the costs of different types of generating capacity, analysts use the levelised cost of energy (LCOE).
The cost of energy on the level
Put simply, a power plant’s LCOE is a measure of its lifetime costs divided by the volume of energy it produces over that lifetime.
The calculation incorporates the costs of building, financing and operating the plant (including fuel costs, staffing, maintenance and emissions allowances, if applicable). It also includes a discount rate to depreciate the cash flows to account for the returns expected by the investor, and to factor in risks, etc.
It should be noted that there is no universally agreed methodology to calculate an LCOE, and different analysts could generate different LCOEs for the same asset, depending on the assumptions they make and the granularity of the data used. However, the US National Renewable Energy Laboratory provides a useful calculator.
Once derived, the LCOE can be compared with the expected revenues a project can earn from selling electricity (and, in some markets, from selling other attributes, such as frequency control, reactive power and avoided emissions). If the expected revenues are greater than the LCOE, then the project should be profitable and, all things being equal, a developer will develop the project. Conversely, where the LCOE is higher than expected revenues, the project won’t be developed. This disconnect from the wholesale market means that it is the LOCE, not the wholesale power price, that is the driver of the price of power from new-to-earth generation.
The LCOE is not without its drawbacks. It can oversimplify the complexities around project risks and the cost of capital. But it is a useful tool for comparing different technologies and project types. It’s also very useful in establishing the price at which a project needs to sell its output under a long-term contract, and was used by the UK’s Department of Business, Energy and Industrial Strategy in developing pricing for its Contracts for Difference.
Plummeting green energy LCOEs
Over the last decade or so, the LCOE of renewable energy has fallen spectacularly. Bloomberg New Energy Finance (BNEF) produces benchmarks that track the global LCOE of various power generating technologies. Between 2009 and mid-2022, the average LCOE for a fixed-axis solar photovoltaic plants fell from $304/MWh to $45/MWh. Onshore wind fell from $93/MWh to $46/MWh, while offshore wind has fallen from a peak of around $220/MWh in 2012 to $81/MWh.