Levelized costs of electricity have inherent limitations
Assessing the costs and benefits for different renewable energy technologies as accurately as possible is essential for investors to initiate profitable projects, for politicians to channel available public and private funds to the most promising technical solutions and for system planners to design the most cost-efficient configuration of the future power system.
Levelized cost of energy (LCOE) is the standard measure to compare the cost of different production technologies. It describes the costs of the total energy produced during the economic lifetime of a project in terms of EUR per energy unit. The concept has some obvious advantages: It is simple, measurable and uses input parameters that are relatively easy to assess in different technical and economic environments. LCOE is well suited to compare technologies with similar operational characteristics and to make investment decisions when compared to the expected capture price in the relevant markets.
However, LCOE and capture prices fall short as a singular benchmark for governments, regulators and system planners who need to retain a more holistic perspective: The metric ignores how a production technology impacts the system, e.g. energy adequacy, capacity, flexibility (e.g. in balancing markets) and grid consequences. These additional aspects are not captured by the LCOE, which also makes it poorly suited to compare technologies with different operational flexibility (e.g. dispatchable and non-dispatchable) or projects that capture more than one revenue stream.
Alternative metrics exist. Two prominent examples are the Value adjusted LCOE (IEA), that captures energy adequacy and value of capacity and flexibility and Enhanced LCOE (BEIS) that additionally captures the costs and benefits of grid integration. When applying these metrics for different technologies, e.g. solar PV and gas turbines, the assessment of the economic competitiveness of the technologies can be drastically different than when relying on LCOE alone.
Differences in costs of capital change the technology value significantly
Still, all metrics use LCOE as a baseline, which makes it important to quantify it as accurately as possible. The LCOE depends on parameters like capital investments, operational expenditures, lifetime and resource abundance. Additionally, costs of capital are important especially for technologies with high upfront investments. While the importance of these costs was moderate in times where cheap money was available, it gained importance in the last years due to increasing interest rates. Recently, high costs of capital have jeopardized particularly capital-intensive offshore wind projects.
Renewable projects are financed with equity and debt that have different costs, depending on the return requirements of an investor and the interest rate of a bank, respectively. The projects’ total costs of capital are described by the average of the two, weighted by the respective equity and debt share. This is called the weighted average cost of capital (WACC).
The higher the investment risk, the higher the costs of capital. The risk factors depend on individual investor risk preference, project type and market and technological maturity. Additionally, policy and regulatory risks are strong determinators of the cost of capital. As a result, the financing costs differ from country to country just like other cost factors. In fact, differences in costs of capital can even outweigh differences in resource abundancy and change competitiveness of capital-intensive technologies.
In the special issue of the most recent edition of our Technology Trends & Insights report, we evaluate the country-specific investment risks across Europe and show how they impact technology costs differently. Furthermore, we discuss the differences between LCOE and other more advanced metrics to support better investment decisions.
** THEMA publishes the Technology Trends & Insight twice a year. The report provides investors, system developers and power utilities alike a deeper understanding of the latest developments in key decarbonization technologies and the potential roles they will play in the energy system of the future.**
