Ample Green Foundation

Using Levelized Cost of Energy as a tool
(Abhishek Uppal)

Levelized Cost of Energy (LCOE) is the methodology used to understand the commercial breakeven of alternative energy technologies in the electricity market. There are two ways to use the tool:

at an industry level, and
at an individual project level, varying assumptions to assess project economics. While the idea of LCOE is attractive at an industry level, adapting the framework to work as a project-level investor spreadsheet is ultimately more useful.

Calculating LCOE
LCOE considers the total electrical output generated by a technology over its lifetime, divided between the total cost of investment, the interest rate, cash flow during construction, and any additional operational and maintenance costs, all in present value terms. Typically, the LCOE result is given in a currency per kilowatt (or megawatt)-hour unit, such as $/kWh or €/MWh.

Depending on which of the breakeven points is under consideration, carbon pricing and incentives and subsidies can be switched on or off in an LCOE model.

Economic Inputs
Not all variables are taken into account when developing an LCOE model; often, varying boundaries, assumptions or scenarios are established to compare the LCOEs of different technologies under different scenarios. Different fuel prices, tax incentives and carbon prices may be key shifting factors. The standard, industry-level LCOE uses a common discount rate, but for this methodology to be used in project evaluation, the discount rate would need to be varied.

LCOE at an industry level
Each energy-generating technology has different underlying economic characteristics. It can be difficult to make a direct comparison between different technologies by only considering one or a few of those characteristics. This is a critical issue when performing a cross-industry comparison of conventional and alternative sources of energy, as their economic drivers are quite different.

For example, capital costs for renewable installations tend to be higher than those for fossil fuel power plants, while renewables do not have any fuel expenditures, meaning that their operating costs are often lower than those of their fossil fuel counterparts.

The only fair way to compare power generation methods at an industry-level, then, is through a methodology that takes both capital and operating costs into account, and translates the two into a common currency. The Levelized Cost of Energy (LCOE) model is an effective way to determine a consistent comparison that accounts for fixed and variable drivers behind each technology.

LCOE? The discount rate question and project-level analysis
Normally, the LCOE model uses a common discount rate when comparing different technologies and energy sources. This has some merit, as it permits analysts to understand the breakeven point at an industry level. However, this does not fully satisfy the needs of the investor.

The discount rate chosen, and other project-level inputs, such as specific regional factors in the electricity markets, will have an important influence on project economics. Before discussing each of the factors that need to be varied in developing a project-level analysis, we introduce the most important characteristics of electricity markets.

Developing an “investor’s spreadsheet” for individual projects from the LCOE model requires a number of modifications.

While all of the inputs into the investor’s spreadsheet will need to be project-specific, some of the inputs will be more important than others:

The most important factors for project evaluation will be tailoring the discount rate to the individual project under consideration, as well as modeling how the project fits into the local energy market. This is because these factors will have the greatest impact on the economic viability of projects across the board;
Other factors that will be important to investors include performing scenario analysis on fuel price, carbon price and incentives and subsidies in order to determine the exposure of the investment target to these factors, and develop a view of the risk/return profile of the target.

By adapting the LCOE model to take these factors into account, investment decisions and project evaluation become considerably more sophisticated. In the next section of this chapter, we look at how the investor’s spreadsheet can be used to develop a more comprehensive view of risk/return.

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