This five-part series dives deep into the economics of electricity markets and the role that markets can and must play in the decarbonisation journey. But in reality, do they? And what can be done about it?
In this second part, The incompleteness of LCOE, let’s dissect the elements comprising the cost-side of the economics of a renewable energy project. I will highlight the misconceptions behind with the statement that “renewables are much cheaper than fossil fuels!”
Read previous parts: Part I
Let’s dive into the economics of renewable energy projects by first looking at the expenses side of the analysis in this Part, followed by the revenue side of the picture in Part III.
To kick things off, let me introduce a popular metric called Levelized Cost of Electricity (LCOE), which is often touted as a key indicator of the success story of clean energy transition. LCOE has been the metric of choice when it comes to comparing various electricity generation technologies for decades now.
Stated simply, it is the cost (including the cost of capital) in $/MWh of producing one unit of energy (MWh) from a generator, averaged over its operational lifetime. Figure 1 below shows the evolution of LCOE for various technologies in the US over the last years. This cost evolution follow a similar trajectory in other countries around the world.
As can be seen, the LCOE for renewables, onshore wind and solar PV in particular, has fallen drastically over the years and has been below the fossil-fuel alternatives such as coal and gas around the world for nearly a decade now.
And this is no small feat! Behind the lines on this chart, lies the incredible success story of how relatively new technologies have transitioned quickly from laboratories to large scale installations around the world, supported by a mature global supply chain of skills and components.
It is therefore established that, from a cost perspective, renewables are already the preferred choice (and will increasingly become so as we start internalising the cost of carbon emissions. More on that in a future article!) for new electricity production projects.
“All else being equal”, this cost dynamic should bring a massive impetus for investors and banks to fund new renewable energy projects, right?
Why then, one wonders, is that renewable energy projects face challenges?
The answer lies in what LCOE is and what it isn’t.
And that all else is NOT equal — far from it, actually!
While LCOE is a great metric to compare technologies and to track their technological maturity over the years, it is also incomplete and to put it bluntly, misleading, when it comes to investment decision-making.
First, LCOE does not include geographical aspects of the costs, i.e., the cost of transporting electricity from the site of generation to consumption.
This is not an issue for fossil fuel-based generators as they (i) typically have a smaller geographical footprint and (ii) are located optimally w.r.t. transportation networks, e.g., road-, rail-, and water-ways to transport the fuel. This layout often coincides with human settlements and demand centres, meaning that fossil fuel-based generators enjoy sweet synergies with the consumption from a geographical standpoint. This is besides the fact that the energy produced is largely controllable and dispatch-able (i.e., can be scheduled ahead of time and adapted to meet demand fluctuations) by adjusting the fuel input.
Renewables, on the other hand, have a much larger geographical footprint and do not enjoy such synergies with existing infrastructure. To make matters worse, sites with high renewable production potential and large swathes of land (cheaply) available are often remote and located far away from the demand centres.
In fact, one of the biggest roadblocks (and source of delays) for renewable projects is the development process. This refers to one of the steps before the power plant gets built, primarily concerned with identifying and securing the rights to the land (or seabed for offshore wind) and the necessary permits.
Once that is in place, projects often require a massive build-up of expensive (and unpopular) power transmission lines and upgrades to the existing infrastructure to accommodate the changes in electricity flows across entire countries (or even continents, in extreme cases) to integrate large renewable energy projects to the electricity grid.
In some cases (e.g., isolated small grids with weak connections to other grids), the additional infrastructure necessary to integrate renewables may be prohibitively expensive and stall the project after an initial feasibility study.
Generally speaking, even for large-scale, interconnected, strong grids, e.g., continental Europe and North America, such costs are not insignificant by any means.
Critically, they increase as the grid becomes cleaner.
While a smaller share of weather-dependent renewables in the total generation mix may incur little to no grid integration costs (since other dispatch-able fossil-fuel based generators can provide the flexibility needed), an electricity grid dominated by such renewables faces high costs to maintain the supply-demand balance necessary for secure grid operation.
Figure 2, based on results from the article (Open Access available) from 2022, clearly illustrates such hidden costs.
Full-system LCOE refers to the LCOE value supplemented by the cost of balancing the grid (via the use of storage technologies, for instance) to meet the supply obligation mandated by the demand in the area and therefore, is an attempt to complete the picture painted by LCOE. The number 95% comes from the fact that 95% of the total system demand is assumed to be fulfilled by the technology in question whereas the remaining 5% is fulfilled by the cheapest producer in the system.
It shows that considering the overall costs of enabling the consumption of a MWh of energy, given the current paradigm that a consumer may demand that MWh at any time in that geographical region, wind and solar PV no longer emerge as clear winners.
Lastly, the study underscores that even with a 90% drop in the cost of storage, from a full-system LCOE perspective, wind and solar PV remain expensive compared to alternatives.
The second issue with LCOE, which is perhaps even more relevant from an investment decision point of view, is that it does not capture the temporal aspects of the costs.
While the share of capital expenditure (aka CAPEX) in renewable energy projects is roughly 90–95% of the total project cost, it is only 60–70% in the case of fossil-fuel generators.
In the case of renewables, most of the large sum of money must be spent on fixed costs, e.g., land, equipment, and labour before even a single MWh of sellable electricity can be produced by the generator.
This is not the case for fossil fuel-based generators where operational expenditure (OPEX) forms a larger share of the total project cost, thereby spreading the cost component out over the lifetime of the project.
Now this may not sound like a big deal, but recall that cost of capital is a key component of LCOE. In simple terms, cost of capital is defined as the expected rate of return that project developers require to attract funds to a particular project.
It is, therefore, natural that a higher cost of capital would make a project more expensive.
Moreover, the cost of capital is quite specific to the context of a project. Besides the prevailing macroeconomic factors such as interest rates, other factors such as the technology underlying the project, geopolitical and regulatory environment, energy off-take agreements, etc. play a key role in determining it. Therefore, it varies dramatically across projects and is highly non-standardised. A recent report by International Renewable Energy Agency (IRENA), focusing on renewable energy financing, highlights that even for given a specific geography and a specific technology, cost of capital may vary significantly across projects. This stems partly from the fact that financial institutions often battle an expertise gap when assessing the risks associated with such non-standardised investments, and therefore, associate varied levels of risk premiums with them.
Revisiting our sombre theme of “all else NOT being equal”, renewables face serious roadblocks when it comes to an increase in cost of capital specifically because of the timing of the costs incurred.
Given that the high upfront costs are compensated over a long uncertain duration by the lower (almost zero) operating expenses and the expertise gap faced by financial institutions, renewable projects are qualified as much riskier investments compared to alternatives, as noted in the 2023 commentary published by the International Energy Agency (IEA). Therefore, investors look for additional risk premiums while injecting funds into projects with renewables. The fact that the time for previously-discussed steps of permitting and grid connection often takes years, adds more uncertainty to such renewable energy projects, thereby further increasing the cost of capital.
This makes the LCOE numbers, such as those shown in Figure 1, particularly misleading since they assume a common discount rate (as a proxy for cost of capital) across all technologies.
With such inadequacies inherent to the LCOE numbers, it is quite unfortunate that policy makers and their economic advisors alike, have regularly used (and still use) the downwards trending and seemingly favourable LCOE of renewables to justify the withdrawal of state support for renewables.
While it is a sign of confidence on the technological progress we have made and economies of scale we have reached for renewables, it overlooks the crucial aspects of grid integration costs and the risk perception associated with the costs of such projects.
It is, therefore, a welcome first step that recent academic works, such as this, are calling for a critical rethinking of this misunderstood metric to focus on the full-system costs.
Similarly, leveraging an extensive survey study and analysis of the cost of capital across various geographies, this article highlights the importance of understanding the disparities across geographies and involving financing costs as a key policy intervention measure for decarbonisation.
Unfortunately for the planet, while policy makers tend to measure the success of their clean energy policies by LCOE, banks and financial institutions do not care much about LCOE (nor for a rapidly warming planet, for that matter).
They care about profitability: the expected returns and risk underlying it.
To understand what this implies for clean energy transition, let’s shift our attention to the revenues and profitability side of the economics of renewable energy projects in the next part of this series “Part III: An elephant named Risk”.
Are electricity markets fit for purpose? Part III: An elephant called Risk
<hr><p>Are electricity markets fit for purpose? Part II: The Incompleteness of LCoE was originally published in Clean Energy for Billions on Medium, where people are continuing the conversation by highlighting and responding to this story.</p>