The following is a contributed article by James Loewen, an independent consultant and founder of Everspring-Energy.
To compare the cost of energy generation from among different options — for example, a new natural gas-burning plant, a wind turbine, a solar array, buying from the wholesale energy market, or sticking with the current utility tariff price — people find it useful to have a metric that is easy-to-understand and that accurately captures the time value of money.
The popular favorite is a metric called the "levelized cost of energy (LCOE)." The LCOE metric couldn't be simpler — cents per kWh.
The annual publication by Lazard, a leading financial advisory firm, of LCOE numbers from different energy types is eagerly awaited each November, as it documents the inexorably shrinking cost of renewable electricity. Prestigious national laboratories and independent think tanks use LCOE frequently in their publications. And state regulatory bodies use LCOE in their integrated resource planning to help decide which technologies will deliver the cheapest electricity over time.
In sum, LCOE is an extremely important messaging and analytical tool that informs our understanding of how much electricity costs, and what we should invest in.
It is both surprising and unfortunate, then, that LCOE, while certainly easy-to-understand, fails to address the time value of money correctly. This ongoing error has the unfortunate consequence of slowing the deployment of renewable energy.
For those of you who missed that lecture in school, let us back up a minute and look at what I mean by "the time value of money."
Basically, it boils down to the fact that in normal times (i.e. times in which there is no coronavirus-induced deflation and no economic contraction) $100 in your pocket in 2020 is worth more than $100 in your pocket in 2021. And that is because, if we invest that money, the odds are good that by next year it will have yielded a positive return.
We then might ask, "How much money would I need to have in my pocket this time next year so that I feel indifferent to having that amount next year, or $100 right now?"
If that number, for 2021, is $105, we might say, "The present value of $105 in 2021 dollars is equal to $100 in 2020 dollars." That's why this sort of analysis is called "present value analysis." And because present value analysis requires that you "discount" the value of those amounts listed in future dollars, the annual difference in the value of a dollar from one year to the next is called the "discount rate," (which in the example above would be 5%).
So, when looking at a stream of revenue, or of costs, over a period of years, a proper analysis will "discount" the dollar numbers in each year according to how far off into the future it is. This is what the practitioners who use LCOE seem to believe that the LCOE formula incorporates, but in fact it does not.
In the July 2019 issue of Electricity Journal, I published a paper detailing exactly how the LCOE formula erred in handling the time value of money. I argued that in fact LCOE was an undiscounted metric that delivered a distorted (elevated) value, with the distortion increasing with the discount rate and with the expected life of the generation plant.
The LCOE formula treats all the energy units produced during the life of the project at the same nominal value, without discounting them for the time value of money. In that 2019 paper, I proposed a metric that properly discounts the dollars associated with that generation, and named it "present value of the cost of energy," or PVCOE.
So, what is the impact of this failure to properly discount the dollars in the LCOE? If we choose an annual discount rate of 5%, and a 25-year project life, the amount of distortion is 77%. That is, LCOE delivers a number that is 77% higher than it would be if it were properly discounted, i.e., than the PVCOE.
In response to the first paper, one of the informal reactions I received was, in effect, "OK, you're right, but so what? We don't use LCOE in our investment decisions, and it doesn't matter."
Partly to address that response, (and putting aside the fact that LCOE is in fact used by some state commissions in resource planning) I have now published in the July 2020 issue of Electricity Journal a second paper, showing how the LCOE formula — or, to be exact, a "simple LCOE (sLCOE)" formula published by the National Renewable Energy Laboratory — systematically disfavors renewable energy sources when compared to natural gas-based electricity.
The reason why the LCOE distortion affects fossil-based generation differently from how it affects renewable generation is that a significant portion of fossil-based power cost is for on-going fuel costs, whereas renewables like wind, and especially solar, have most of their costs occurring at the outset of the project. Because the sLCOE formulation applies the LCOE distortion only to the capital costs (which are front-loaded) and not the fuel costs (which are taken at today's prices) the price distortion affects renewable-based generation much more than fossil-based energy.
I found that, using reasonable assumptions, the LCOE formulation overprices solar energy by 27% as compared to natural gas-based power, and it overprices wind energy by 18% as compared to natural gas-based power.
While the conclusions noted here were demonstrated rigorously in the 2020 paper only for the sLCOE formula, I believe the argument also holds for more sophisticated versions of the LCOE, since the underlying approach with respect to discounting is the same.
Time for a change?
If you have been reading this piece carefully, and are knowledgeable about energy policy, right about now you must be telling yourself, "This guy is off his rocker, and can't possibly be right." When I published my first LCOE paper in 2019, I fully expected to receive strong opposition articulating all the ways in which my argument was faulty.
But the Electricity Journal is a peer-reviewed journal, and no one posted or published any counter-arguments.
Now, the second paper has just gone online. I invite energy analysts and environmental advocates to have a look at both papers.
Now, let's say you agree that LCOE is faulty, but you're thinking, "Why rock the boat? The published LCOE numbers continue to get better for renewable energy, so there's no need to change the framework, which is already well-established." I would simply note that an 18% or a 27% error in relative cost effectiveness really is a mistake worth fixing.
If you agree that my argument is correct, then you owe it to science to support logic, to your constituency or clientele to support cost effective decisions, and to your children to take advantage of facts that support the increased deployment of renewable energy.
It's time to retire LCOE and start using PVCOE.