Levelised Cost of Energy

What is the Levelised Cost of Energy, and how does it compare the expense of different electricity generating technologies?

When policies are drawn up for energy markets, the system market operators want to attract investment from a variety of entities, in order to provide sufficient upfront capital to build the assets required for a functioning grid. Many tools can be used to determine what mix of technologies should be utilised, as policies are designed around the financial viability of different asset types. But grids are complex, and decisions are not purely made from an economic perspective - as consumers are central to any strategy.

The Levelised Cost of Energy (LCOE) is a widely-used metric in the energy sector, helping both investors & policy makers to gauge what technologies to invest in. It represents the per-unit cost (typically per megawatt-hour or MWh) of building and operating a generation asset over its life cycle. The LCOE is calculated by taking the total costs of a project (initial investment, operations, maintenance, fuel costs etc) and dividing it by the total amount of energy the project is expected to produce until decommissioning.

When making investment decisions, LCOE is a crucial metric for several reasons:

1️⃣ Comparative Analysis: The formula provides a standardised method of comparing costs of technologies across the spectrum (eg. wind, solar, coal, nuclear) on an equal footing, allowing investors to determine which option provides the best value for money long-term.

2️⃣ Economic Feasibility: It gives a snapshot of the commodity price required for a project to break even. If the LCOE exceeds the going market rate, the project may not be viable without subsidies or other support.

3️⃣ Accounting for Total Costs: The equation encompasses all associated costs, from initial capital expenditures through to eventual decommissioning expenses - with operational overheads considered along the way. This comprehensive approach ensures investors aren't solely focusing on upfront costs, but are considering the entire life cycle.

4️⃣ Informing Policy and Subsidies: Governments and regulatory bodies often use LCOE to shape energy policy, determine subsidies, or set feed-in tariffs. For example, by understanding the comparison of renewable tech costs vs fossil fuels, policymakers can create incentives to promote the adoption of cleaner energy sources.

5️⃣ Risk Assessment: By assessing different scenarios (ie. rising fuel prices, changes in interest rates, technological advancements), investors can gauge the sensitivity and risks associated with a particular asset.

6️⃣ Long-term Planning: Since the calculation spans the expected life of the facility, it encourages a long-term perspective, which is vital for assets that are operational for decades.

It's important to note that while LCOE is a valuable tool, it doesn't capture all aspects of system value, or the broader grid implications of deploying certain technologies. For example, a solar farm might be good value for money, but doesn't produce energy at night - necessitating storage or backup solutions. Conversely, a gas-peaker might have a higher overall cost, but provides valuable grid stability during periods of increased demand. Thus, LCOE is just one of many tools used when evaluating potential developments.

Investors also look into long-term supply chains and skill requirements, which is especially relevant for nuclear energy. BEIS compared the LCOE of four technologies in their latest report, calculating estimates for sites set to commission in 2025, but with prices given in £/MWh in real 2021 terms:

📌 CCGT – Combined-Cycle Gas Turbine £114/MWh Pre-development, construction, operations & maintenance (O&M), fuel, and carbon costs are included No costs for CO2 transportation/storage & decommissioning/waste

📌 Onshore & Offshore Wind £44/MWh Pre-development, construction, fixed & variable O&M costs are incorporated The only difference is a minor cost is applicable for the decommissioning/waste of offshore turbines Fuel, carbon, and CO2 transportation/storage hold no relevance

📌 Grid-Scale Solar £41/MWh Pre-development, construction, and fixed O&M costs are accounted for Variable O&M, fuel, carbon, CO2 transportation/storage, and decommissioning/waste aren’t taken into consideration

As the above figures show, renewable technologies are considerably cheaper on a £/MWh basis than even the most efficient fossil fuel technologies. This is primarily due to both the high fuel and carbon costs required. Offshore wind has hugely reduced its LCOE in recent years. As wind turbines at sea get bigger, the load factor also rises - dividing the costs by a much greater sum of MWh generated. On a strictly LCOE basis, renewables would always deliver a better ROI. But the BEIS report discusses uncertainties that this calculation doesn’t consider, such as:

▷ Planning constraints
▷ Network constraints
▷ Payments made to locals
▷ Additional cost on balancing networks

Some of these issues are non-economic and must be resolved during the planning process. Although they don’t necessarily represent an additional cost per se, they are a significant blocker when it comes to getting a project off the ground. A key resolution to this has been payments made to locals, but as it’s such a new area - it’s difficult to quantify a true baseline yet. Other elements include costs which are socialised may require external investment to resolve, such as network constraints preventing the deployment of projects in certain areas. LCOE also doesn’t account for secondary costs like balancing, which occur as a result of not being able to schedule intermittent renewable generation on demand.

A key problem with levelised cost estimates though is that they do not consider the revenue streams available. We know the market volatility of the past 2 years has introduced significant risk premiums, discounting the power prices offered for more intermittent technologies (such as wind) vs the more consistent assets (such as AD). As prices rise, the risk premium percentage increases - thus widening the gap in potential earnings.

Renewable, intermittent, low energy density generation has typically borne the brunt of these non-LCOE costs. Increasingly, investors and planners are moving away from strictly technology comparative analysis models and towards project specific models which aim to mitigate some of these issues. A technology like hydropower is typically ranked as one of the cheapest using the LCOE methodology, and will continue to be a key part of our power mix for decades to come. However the extremely high CapEx, environmental impact, limited suitable locations and changing climate are diverting attentions elsewhere - despite the 80-year average lifespan. Grid constraints in the UK have been such an enormous issue that decisions around technology can often seem a luxury though - principle analysis must be on the most time and cost effective way of securing a connection.

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