Your Hedge Against Utility Inflation. An investment in a solar renewable energy system project will protect you from utility rate inflation. Levelized Cost of Energy (LCOE) analysis provides us with a “hurdle rate” (the levelized cost of energy), which can be compared to the expected change in utility rates (by way of utility rate inflation). LCOE is the average lifetime cost of energy produced by a particular system. We can compare the LCOE to the current utility rate and its expected change in price as time goes on. In this manner one can judge the investment as a “better bet” than utility rates to contain energy costs.
In electrical power generation, the distinct ways of generating electricity incur significantly different costs. Calculations of these costs can be made at the point of connection to a load or to the electricity grid. The cost is typically given per kilowatt-hour or megawatt-hour. It includes the initial capital, discount rate, as well as the costs of continuous operation, fuel, and maintenance. This type of calculation assists policymakers, researchers and others to guide discussions and decision making.
LCOE is a measure of a power source that allows comparison of different methods of electricity generation on a consistent basis. It is an economic assessment of the average total cost to build and operate a power-generating asset over its lifetime divided by the total energy output of the asset over that lifetime. The LCOE can also be regarded as the average minimum price at which electricity must be sold in order to break-even over the lifetime of the project.
The third dimension of concern about a proposed solar renewable energy system investment is the predictability of its anticipated costs and returns, which requires measures of the uncertainty associated with them. Uncertainty about the amount of investment required, the project’s useful life all fall into this category.
An industry-standard formula takes into account the time-value of money (via the “discount rate”). Future-year cash events are accommodate by discounting their value to their present value. Likewise, energy production is also discounted to its present value. Using a present-value approach allows multi-year cash events to be included in the LCOE model; such as RECs or performance-based incentives, O&M costs, inverter replacements, etc.
Discounting the generation of power seems, at first glance, incomprehensible from a physical point of view but is a consequence of accounting transformations. The idea behind it is, that the energy generated implicitly corresponds to the earnings from the sale of this energy (via utility savings, FIT revenue, production credits, etc.). The farther these earnings are displaced in the future, the lower their cash value. The annual total expenditures over the entire operational lifetime are comprised of the investment expenditures and the operating costs accumulating over the operational lifetime. As with NPV calculations, the Discount Rate is used to calculate present values in the LCOE formula.
In the following calculation a cash purchase is assumed. Meaning, the cash effects of loans to purchase the system(s) are not included in the calculation. Specifically, the gross price (“price to quote”) is used. If a Loan is applied, the loan amount and interest payments are not included. If a Lease is being modeled, present value of the lease payments (and buy-out price) are used in lieu of a gross price (“price to quote”).
LEC = (System Price + Present value of any Income Tax on incentives + present value of O&M costs – present value of Incentives) divided by (present value of energy produced or displaced over the system life).
LCOE Calculation Example: Assume $1,000 invested (Year 0), $10 a year O&M expenses and 1,000 kWh in year is produced (ignoring degradation). Also assume a 5% discount rate and a system life of 2 years (to keep it simple).
LCOE = [$1,000 + $10 x (1 – 5%) + $10 x (1 – 5%)^2] / [ $1,000 x (1 – 5%) + ($1,000 x (1 – 5%)^2 ]
LCOE = [$1,000 + $9.50 + $9.025] / [ 950 + 902.5] = $1,018.525/1,852.50 = $0.55 per kWh
Interpretation of LCOE: For example, if the LCOE of a solar electric project is $0.18 per kWh, we can compare this to the current utility rate and its expected rise (or fall) in price as time goes on. Let’s say the customer’s current utility rate averages $0.14 per kWh and the customer agrees that utility rates will inflate at a rate of 3% a year over the next 25 years.
Using the following graph we see that the “hurdle rate” (LCOE is met with some room for error; it occurs at about year 9 on a 25-year horizon (this would be the point of “grid parity”, or where the cost of energy produced by renewable energy equals that of utility energy). In this manner the customer can judge for themselves how likely they think it is that their investment will be a “better bet” than utility rates to contain the customer`s energy costs.
In most cases, the LCOE is well below the utility rate and the customer may incur immediate savings on their next month’s utility bill enabling Day 1 positive cash flow.