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Levelised Cost of Energy (LCOE) – An overview

LCOE is a key consideration in the grid parity era of renewable energy. In essence, LCOE was built as a countdown metric to when renewables would be able to compete on their own strengths in the merchant markets. And this time has come! Let’s do some housekeeping on what the metric means for the PPA market.

What is LCOE?

LCOE stands for Levelised Cost of Energy, or Electricity. It seems like the industry hasn’t made up its mind on what exactly the ‘E’ stands for, but in any case it refers to electrons, so maybe that’s a nice idea to redefine what the abbreviation means! The metric  estimates the costs of every MWh produced over an assumed lifetime of a generation asset. The aim is to differentiate from merely upfront costs needed for an asset, and paint a clearer picture including the operating costs as well.

LCOE is all about the Net Present Value (NPV) – the value of cashflows and outflows over the period of time in question at the time of calculations – of building and operating a generation plant. The period in question is typically the estimated lifetime of an asset. For renewable energy projects this can be from 20 years through to 35 depending on the technology.

What is LCOE used for?

LCOE calculations are used for both micro and macro level strategic decisions. First of all, an investor or developer needs to confirm that a project is viable during the preliminary assessment of an investment. Secondly, it gives an early indication of what are the minimum revenues a project needs to achieve to be profitable. Therefore, it gives a high-level idea of the sales strategy that needs to be pursued.

On a macro level, it gives policy makers a strategic view of the costs of different generation technologies. Such analysis is needed when it comes to deciding on subsidies allocation. For example, governments did subsidise heavily renewable energy technologies when LCOE costs were high, with the ultimate aim to help the niche technologies mature.

How is LCOE calculated?

Each single generation asset will have its own unique LCOE. When it comes to the methodology, there is no single way to compute this useful metric. Granularity of data points and sophistication of assumptions will ultimately define the accuracy of the LCOE value. Methodology considerations will also come down to technology. For example, LCOE calculations for a solar farm will be different to LCOE for a thermal plant, e.g. natural gas-fired plants merely because fuel costs would need to be included.

When it comes to aggregated average LCOE values, which are popular off-the shelf products by key providers in the market, each one has its own secret recipe for their methodology.

Some high-level standard ingredients for LCOE calculations are:

  • Upfront investment expenditures including technology costs (i.e. the price of wind turbines or solar panels), financing costs (cost of debt or equity) and development costs (i.e. costs of buying sites, gaining permits etc)
  • Operation & Maintenance (O&M) costs
  • Fuel costs, where applicable
  • Electricity generation output over the lifetime of the asset
  • Discount rate, as in the value of future cashflows over time based on a discounted cash flow analysis

Overall, LCOE calculation methodologies and formulas have received a lot of attention in academic literature and among economics and quant aficionados. Depending on the use case, interested parties will either come up with their own methodology, or acquire off-the-shelf data from third-party providers.

According to the U.S Department of Energy, a generalised standard formula could be the following:

FCR= fixed charge rate (%)

ICC= installed capital cost ($)

AOE= annual operating expenses ($/year)

AEPnet= net annual energy production (MWh/year)

Why is LCOE important for renewables?

As already mentioned, one of the main aims of the LCOE metric is to compare the costs per MWh of different generation technologies. Natural gas, oil, coal, lignite, nuclear, renewables and the list can go on! As you know, our electricity mix is comprised of various technologies, and some could be more expensive than others.

What is interesting, though, is that although LCOE tracks costs of all generation technologies, it is a concept intertwined with renewable energy. Why? Because the idea behind LCOE was to enthusiastically track how much the ‘new kid on the block’ can compete with conventional, mature and cheaper technologies. It’s not random that some of the largest providers of LCOE data only started providing such analysis approximately 15 years ago, which is when deployment of renewables started accelerating across the globe.

Where it gets more interesting is when the phrase ‘grid parity’ became mainstream in the renewables sphere. Grid parity means when the LCOE of renewables is competitive with the LCOE of conventional power generation technologies. In essence, the cost of producing a MWh from mature renewable technologies such as solar and onshore wind, is equal or less than the respective cost of production from coal or natural gas. According to BNEF analysis, this milestone was reached approximately in 2018, when onshore wind and solar became the cheapest electricity generation technologies worldwide.

BNEF’s global levelised cost of electricity benchmarks, 2009-2022

Source: Bloomberg New Energy Finance H1 2022 LCOE update

Decreasing LCOE for renewable energy technologies meant that governments started reducing support in the form of subsidies. As we discussed, LCOE helps policy makers with strategic decisions such as subsidies allocation. The fact that mature technologies became competitive meant that it was time for solar and onshore wind to compete in the market on their own feet. Therefore, project owners need to make sure that the profits from their energy sales are higher than the minimum cost of generating, which brings us to the billion-dollar section: the role of LCOE in the Power Purchase Agreements (PPA) market.

LCOE and PPA prices  

In the grid parity era, energy sales decisions are extremely critical. As PPAs are a core part of sales management strategies, the PPA price needs to take certain elements into consideration – the current and projected baseload prices, as well as volume, profile and cannibalization risks. Very importantly, the PPA price needs to be above the current or projected LCOE of the project in question. LCOE acts as the bare minimum of what the PPA price needs to be to ensure the financial viability of the project.

Benchmark PPA prices do not take into consideration LCOE values. For example, Pexapark’s benchmark PPA price methodology is:

PPA Price= Sum of (monthly forward prices * monthly capture factors * monthly volumes)/ Overall Volume- Risk Adjustment

For this reason, benchmark PPA prices need to be compared with LCOE data. Knowing how each interacts with the other will give critical information on the leeway buyers and sellers have in negotiating a PPA price. In short, market-level factors such as baseload power prices need to be compared to the minimum cost of generation, illustrated by the LCOE.

The two do not always go hand-in-hand. For example, it was only after the advent of the grid parity era when the idea of private green PPAs became mainstream. Buyers were interested in the fact that they could buy cheaper energy through renewable energy plants, and they started pursuing PPAs with renewables. The grid parity era coincided with the arrival of PPAs in Europe.

Another example is the not-so-far-ago period of the Covid-19 pandemic, where baseload prices plummeted to an extent that it was no longer viable for some projects to sign at such low prices, leading to a decrease in PPA activity across Europe. At the time, LCOE of certain technologies in some markets was below market prices.

The different perspectives of sellers and buyers

Depending on each project’s LCOE, the seller and buyers can have different price negotiating power  in different markets.

LCOE has traditionally been a primary concern for project owners (i.e. energy sellers), who will need to manage the commercial business model of the project. For example, when sellers who own generation capacity are bidding in corporate tenders, they will put a benchmark price that ensures the viability of a project. Of course, they would want to achieve the best price possible based on additional market factors, but their floor would be equal to their LCOE.

On the other hand, LCOE becomes more and more relevant to energy buyers as well. Corporate buyers in particular are increasingly focusing on additionality, as in enabling new capacity to come online through their PPA commitment. Therefore, knowing the LCOE of the projects helps them understand what’s their negotiation capacity in the room.

For example, in May [2022] German multinational chemicals company BASF agreed on a term sheet for a 25-year PPA with Brookfield Renewable to power its Zhanjiang Verbund site in China. What was interesting in the deal’s announcement is that both parties will use the concept of LCOE to reflect the pricing of the PPAs. Such an approach could become more frequent amid increasing power prices.

Pexapark and Bloomberg New Energy Finance have teamed up to look at how PPA prices and the levelised cost of energy (LCOE) interact in Europe’s main markets for solar and wind. Access our LCOE: What Should You Consider When Pricing a PPA?  to find our more. 

By Maritina Kanellakopoulou, Insights Analyst, Pexapark

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