Levellised cost of energy (LCOE) is a good way to compare the cost of a unit of energy (usually a kilowatt hour or a megawatt hour of electricity) produced by different energy systems. It is effectively the lifetime average cost for the energy produced quoted in today’s prices. Lower LCOE benefits taxpayers, the electricity producers and the electricity consumer.
For example, this figure (compiled from BVGA reports on renewable energy costs for KICInnoEnergy) compares projects with FID in 2014 / 2015 with expected LCOE for projects with FID in 2025 across three types of renewable energy technology.
Future blogs will look into this in more detail, but for now, I suggest that the simplest way to think about LCOE is to consider an average year in the life of a power generating asset. In this case:
“Average annual operating costs” and “average annual energy production” are are easy to understand, but what about ‘levellised annual capital cost’?
This is simply the share of total capital cost that gets assigned to each year in the life of the power generating asset. It depends on the total capital, when in time it is spent, the planned lifetime of the asset and on the finance cost. It is analogous to a repayment mortgage at a fixed interest rate.
We can see that there are six main factors that determine the LCOE:
- Average annual energy production – increasing this always drives down LCOE by the same percentage
- Average annual operating cost – reducing this drives down LCOE. If this cost is much larger than the levellised capital cost (for example in the case of base load power from diesel generators running on expensive fuel), then LCOE reduces by nearly the same percentage; If this cost is much lower than the levellised capital cost (for example in the case of a solar PV plant), then LCOE may hardly change at all
- Total capital cost – reducing this also drives down LCOE, in the opposite way to the average annual operating cost. So reducing total capital will have a major effect on a solar PV plant, but much less impact on a base-load diesel generator plant.
- Lifetime – increasing the lifetime can make a large reduction in LCOE, but only in cases:
- Where levellised capital cost dominates over average annual operating cost, and
- Where the combination of finance cost and current lifetime is low enough (a good rule of thumb is that if finance cost in percent multiplied by current lifetime is greater than 200, then increasing the lifetime will have little impact).
So for an onshore wind farm, with a lifetime of 20 years and finance cost of 6%, increasing lifetime would have a significant effect on LCOE.
- Finance cost (or weighted average cost of capital – WACC) – reducing the finance cost can make a large reduction in LCOE where annual levellised capital cost dominates over average annual operating cost, and where the combination of finance cost and current lifetime is high enough (a good rule of thumb is that if finance cost in percent multiplied by current lifetime is less than about 50, then reducing the WACC will have little impact). So for an offshore wind farm with a lifetime of 25 years and a finance cost of 8%, reducing finance cost would have a significant effect.
- Timing of capital expenditure – because of the time value of money, reducing the length of time between capital expenditure and the start of energy production has an impact on LCOE, especially where the finance cost is high and where significant capital spend happens more than one year before the start of energy production. So this could be significant for an offshore wind farm, but hardly at all for a containerised diesel generator plant.
As we can see, the relative importance of six factors varies depending on the type of system, its current maturity and the market view. This can make thinking about the best way to improve LCOE rather complex, even using this much-simplified model!
Further complexity usually comes from the fact that many interventions aimed at reducing costs can have multiple impacts – for example, a reliability innovation can increase total capital cost, reduce average annual operating cost and increase average annual energy (through less time being lost due to breakdowns).
Future blogs will look at more complex approaches for LCOE modelling, compare onshore and offshore wind LCOE, and at how we expect offshore wind LCOE to evolve globally over the next 15 years.