The levelized cost of energy – a misleading value

Disclaimer; This post will briefly explain the LCOE to the general public, its strengths, shortfalls and an alternative. It is for now a living document, as I have little writing time, but therefor, please provide me with feedback which I can implement.

During the last years, I have been more and more intrigued with the use of the Levelized Cost of Electricity, or LCOE. When the LCOE came to my table during my studies, it looked like the ideal parameter to compare electricity generators. The lower the LCOE, the better the source of electricity from an economic perspective, right? Well, these days, I tend to think differently. I discussed the LCOE, discounting and an alternative in my thesis (Thesis here!). After reading again about the LCOE and discounting in an article by Rauli Partanen (Click here!), I now finally want to write out my ideas for a more general public, as I believe some knowledge should be in place in the world of today.

So, about that LCOE

The LCOE is a number that describes the average cost of electricity (lets say a kWh) from a generator during its lifetime. A true LCOE would take into account all costs (development, operations and decommissioning) and divide this number over the total energy production within the same lifetime. Discounting, as explained by Rauli (Click here!), can be applied to account for future risks. Sounds simple right? Chose the one with low cost per kWh and you have cheap electricity…

The misleading value of cost

Cost is not always the driving force behind decisions we make. We might laugh over people buying stuff they do no need just because it was so cheap. However, this is exactly what the LCOE makes us do, as it only describes the cost of energy, not its usefulness. Try a quick search, for any given electricity generating technique. Quotes such as “Cost of renewables drop sharply” and “Cost of nuclear on the rise” can be found in abundance. However, the quotes and the numbers they are based on should be taken with some scrutiny.

Let me elaborate on this one with an example:

You are the proud owner of an off the grid house. It is neatly located in the woods, and your power comes from a generator run on diesel. The diesel is expensive, lets say 10 ct/kWh, and smelly. Now you got the generator for cheap and getting rid of it wont really cost you much either, so we can say that the cost, or LCOE of your electricity from diesel power is 10 ct/kWh. Now lets say you use 10 kW of power, so that will cost you 1 Euro per hour (10 kW * 1 hour = 10 kWh, 10 kWh * 10 ct = 1 Euro). This equals to 24 euro a day for 240 kWh.

Now you don’t really like the smell anymore, nor expensive gas, so you buy a small wind turbine that can deliver 5 kW. This turbine is a little expensive when you bought it, but it doesn’t use gas. So you expect that if you divide the cost of owning it (buying it and getting it to the dump) by the expected amount of energy it will produce during its lifetime, it will cost you 5 ct/kWh. Now, if you are living in a windy stretch of the woods and this turbine will run all day at its rated power output, you will have half your power from wind! That is 120 kWh for 6 euros, instead of the 12 euros it would have costed you if your generator would have to run at full power. This means that your turbine saved you 6 euro’s per day.

Now, the price of diesel fluctuates. So, sometimes, you get your power from your generator for only 3 ct/kWh. So your government provides you with a subsidy that guarantees that you will get 5 ct/kWh, for all the electricity your wind turbine produces, no matter what, so you will always have enough profit to recover your costs.

Now of course, the wind does not blow all the time. For simplicity, we say that the wind blows 50% of the time. Now, your wind turbine only gives you 60 kWh per day. For the remaining 180 kWh, you will have to use your expensive generator or buy more wind turbines! According to the LCOE, one might think that we can buy 4 wind turbines, bring the generator to the dump and have all our power for 5 ct/kWh, as provided by the subsidies, instead of 10 ct/kWh by smelly diesel. We safe up to half our money per day and the clean air around our cabin is saved. This is how you currently are informed by most parties, like our government and how you get tweets like these:

However, things do not work this way. Your turbines will all run at the same time. This means that they will provide on average your daily demand, but at twice the power you need at the moment the wind is blowing. So now we have a problem and some options:

  • You can store that energy in batteries
  • You use your generator as a backup
  • You can use all your power during those 12 hours of wind
  • You can shut two turbines down (curtailment)

It is clear that the first two options will cost you more money, while the third can be hard to accomplish. The fourth makes you wonder if they were useful the build. Furthermore, you are inclined to just keep your turbines running no matter what, as the government provides you with the subsidy, so you consider giving you neighbor power for free, to keep your turbines running, placing costs on your community for your own benefit. Sounds bad right?

This is where the LCOE fails and where system costs come in. While the wind turbines still provide cheap electricity, the LCOE of those turbines do not describe the total (social) cost of the energy system. And this is what slowly is happening on the scale of our countries.

The importance of system costs and the levelized avoided cost of electricity (LACE)

Now, take another look at the tweet. On average indeed, the German system provided enough electricity to be completely green. However, conventional coal was still used and had to ramp again during the night. If we check the Fraunhofer, (Here!), we can see on the first of May that wind and solar provided most of the energy. Coal and nuclear were run on minimum output, and the surplus was exported. There was so much power, that prices dropped and became negative. Hence, one got payed to use electricity, while at the same time renewable generators get subsidy for their production, creating a perpetual cycle of production and consumption while inducing high social cost.

To take these system costs into account, the EIA introduced the concept of the Levelized Avoided Cost of Electricty, or LACE (Link!). In a very short explanation, the LACE provides the amount of money a new generator would save the total grid, and therefor its users, in costs. If LACE (avoided cost) > LCOE (cost), a generator is economically attractive to build.

To visualize this in the same way with wind turbines; We can safely assume that the first turbine can replace a bit of expensive generation, and the total costs go down. However, with every added turbine, the value of produced power at the interval of production declines (that moment, or interval, the wind picks up, all turbines provide power at the same time, creating a lot of supply and therefor drop in value). At the same time, every wind turbine creates increasing system costs due to the need for additional infrastructure such as backup power (batteries, peaking plants). This creates an optimal amount of wind turbines for the system as a whole, the optimum penetration depth.

System costs should be the driving force

The bottom line is that there is much more to system cost and your final energy bill than just the cost of a generator. Counter intuitively, cheap generators can create expensive grids if applied the wrong way. In the same way, more expensive generators can lower the total system costs. The implementation of subsidies, portfolio mandates and other market regulating incentives create for a non-transparent market in which simple numbers such as the LCOE become the leading tool for executive decisions. This in turn has the potential to drive up social costs.

In the end, you get what you paid for…

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