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Levelized Cost Of Electricity: Renewable Energy’s Ticking Time Bomb?

Solar panels and wind turbines are rapidly becoming competitive with conventional electric generating technologies like natural gas and coal.

At least that is what many of Wall Street’s most esteemed investment firms seem to be telling anyone willing to listen to them.

Last week, Diane Cardwell, a reporter at the New York Times, did just that. In Solar and Wind Energy Start to Win on Price vs. Conventional Fuels, Cardwell reported that renewable generating technologies are not only competitive with fossil fuels but in some markets are now “cheaper than coal or natural gas.”

The story relies primarily on the most recent version of an economic analysis that compares the costs of competing power generating technologies by the investment banking firm Lazard.

Lazard evaluates the economics of renewable energy technologies based on the “levelized cost of electricity,” a metric commonly used to gauge the overall competitiveness of power generating technologies.

The LCOE represents the per-kilowatt hour cost (in real dollars) of building and operating a power plant over an assumed financial life and duty cycle.

Lazard was hardly the first to bake the books on the economics of renewable generating technologies using the LCOE.

In May, Barclays downgraded the credit ratings for the entire electric utility industry based on an analysis very similar to Lazard’s.

“In the 100+ year history of the electric utility industry, there has never before been a truly cost-competitive substitute available for grid power,” Barclays wrote.

What does that mean?

It means that the LCOE for renewable generation is or is likely to be lower in the near-term future than the “average” price of electricity provided by the electric power grid.

However, in 2010, Paul Joskow, the President of the Alfred P. Sloan Foundation and an economics professor at the Massachusetts Institute of Technology (MIT), published a paper showing how use of the LCOE to compare renewables and conventional power generating technologies “tends implicitly to overvalue intermittent generating technologies compared to dispatchable alternatives.”

Per Joskow:

This paper makes a very simple point regarding the proper methods for comparing the economic value of intermittent generating technologies (e.g. wind and solar) with the economic value of traditional dispatchable generating technologies (e.g. CCGT, coal, nuclear). I show that the prevailing approach that relies on comparisons of the ‘levelized cost’ per MWh supplied by different generating technologies, or any other measure of total life-cycle production costs per MWh supplied, is seriously flawed. It is flawed because it effectively treats all MWhs supplied as a homogeneous product governed by the law of one price. Specifically, traditional levelized cost comparisons fail to take account of the fact that the value (wholesale market price) of electricity supplied varies widely over the course of a typical year.

There is no homogenous price of electricity. On the contrary, the difference between the high and the low hourly prices over the course of a typical year can be up to four orders of magnitude, according to Joskow.

“Electricity is among the most heterogeneous services you can imagine as the prices varies every few minutes,” said Joskow.

Wall Street calculates levelized costs and declares the technology with the lowest number to be the winner. Nevertheless, it is not representative of what actually happens in the market.

Wholesale electricity prices reach extremely high levels for a relatively small number of hours every year. Only power plants that can supply power during those hours can monetize those high prices. The revenue earned by selling power during these high-priced hours may make or break the profitability of investing in new generating plants. Failing to properly account “for output and prices during these critical hours will lead to incorrect economic evaluations of different generating technologies,” said Joskow.

The problems with the LCOE are not limited to academic researchers. Indeed, the U.S. Energy Information Administration has concluded that the LCOE “can be misleading as a method to assess the economic competitiveness of various generation alternatives.”

In the most recent Annual Energy Outlook, the EIA began using the “levelized avoided cost of energy” (LACE) as an alternative to the LCOE for assessing the economic competitiveness of different generating technologies. The LACE metric estimates what it would have cost the grid to generate the electricity otherwise displaced by a new generation project.

The LCOE is like a bad line of code in a software program used to develop other software programs. It has dangerously skewed investors’ understanding of the economics of generating electricity from renewable energy resources. It has also had perverse and difficult to undo impacts on local, state and federal energy policies.