{"id":379,"date":"2012-06-05T04:47:26","date_gmt":"2012-06-05T09:47:26","guid":{"rendered":"https:\/\/allenergyconsulting.com\/blog\/?p=379"},"modified":"2012-09-07T12:10:45","modified_gmt":"2012-09-07T17:10:45","slug":"levelized-cost-of-electricity-lcoe-analysis-potentially-misguides-you-in-the-power-markets","status":"publish","type":"post","link":"https:\/\/allenergyconsulting.com\/blog\/2012\/06\/05\/levelized-cost-of-electricity-lcoe-analysis-potentially-misguides-you-in-the-power-markets\/","title":{"rendered":"Levelized Cost of Electricity (LCOE) Analysis Potentially Misguides You in the Power Markets"},"content":{"rendered":"

Levelized cost of electricity (LCOE) approach is very popular in the financial circles.\u00a0 When I was at American Electic Power (<\/span><\/span>AEP), many of the large financial companies would come and speak with our executives and present\u00a0LCOE on various technologies.\u00a0\u00a0 However, the levelized cost method has too much simplicity, \u00a0giving the presenter and the viewer internal biases.\u00a0\u00a0 Levelized costing is way too simple and will typically produce results not valid in reality.<\/span><\/span> I will present the case to you in this blog. \u00a0 <\/span><\/span><\/span><\/p>\n

One must understand the reality of power; it is a market of instantaneous nature.\u00a0\u00a0 There is minimal ability to have inventory unlike other products and commodities.\u00a0 This difference requires a market that trades intra-day and in many places intra-hour as load is not consistent through the day \u2013 as seen below for a typical load shape.<\/span><\/span>\u00a0<\/span><\/p>\n

\"Hourly<\/a>

Hourly Demand \/ Load Shape<\/p><\/div>\n

Not only is the load changing, but perhaps the supply to fill in the load could also change within the hour, depending on mechanical issues at each plant, transmission line, or distribution system.\u00a0 In addition with the implementation of wind and solar resources, we are now more dependent on the weather.\u00a0 As we see in our local news, the weatherman struggles; weather can be very unpredictable even just a day out.\u00a0\u00a0 <\/span><\/span>As result of load and supply availability changes, price swings within a day can be significant.\u00a0\u00a0 Below is hourly price ERCOT West on August 25th<\/sup> 2011.\u00a0\u00a0 The prices are so volatile that I had to plot it on a logarithmic scale, so you could see the variations.\u00a0 We had prices go from $24\/MWh to $2600\/MWh back to $34\/MWh within a day.\u00a0\u00a0 The second important realization is that only a few generation technologies can \u00a0turn on and off within minutes to an hour.\u00a0\u00a0 These units will likely have less efficiency than units who take their time to turn on. \u00a0 A fine economic balance is needed.\u00a0 \u00a0Given the variations and the volatility I would always suggest a portfolio of technologies.<\/span><\/span> \u00a0<\/span><\/p>\n

\"Ercot<\/a>

Ercot West Power Prices<\/p><\/div>\n

To show the misguided nature of levelized cost analysis, I have developed an excel file capable of dispatching various unit technologies to an hourly price curve for a year.\u00a0\u00a0 In this example, I am using the actual 2011 ERCOT West hourly price curve.\u00a0\u00a0 With the price curve and my model, I dispatched the unit.\u00a0 To prove the fallacy of the levelized cost mechanism, the easiest technology to model is the reciprocating engine. \u00a0 Given its ability to turn on and off in minutes and obtain full load heat rate, the reciprocating engine is an ideal candidate for hourly dispatching.\u00a0 With information that I obtained from Wartsila, I used the following design parameters 8 Heat Rate (mmbtu\/MWh) for the initial and final hour and $4\/MWh variable O&M.\u00a0\u00a0 This unit either produced 0 MWh or 250 MWh based on whether the unit was economical to run.\u00a0\u00a0 For the fuel price I used daily henry hub prices minus $0.20\/mmbtu to account for the basis issue (Average fuel cost $3.79\/mmbtu).\u00a0\u00a0 Using my model, the unit produced a capacity factor of 30%. \u00a0<\/span><\/span><\/p>\n

For those interested, I have spent much time and analysis evaluating the Wartsila technology. If you are interested in an independent evaluation of their technology in your portfolio please do contact me.\u00a0 In most cases, I see a large value add in their technology for a resource portfolio, particularly when combined with various wind and solar resources.<\/span><\/span><\/p>\n

Using the publicly available <\/span>levelized calculator from the NREL<\/a>,<\/span> I supplied the same parameters from above plus the following financial condition: 30 year analysis, discount rate of 8%, capital cost $950\/kW, fixed O&M $12\/kW-yr.\u00a0\u00a0 Levelized cost analysis concludes a cost of power of $71\/MWh.\u00a0\u00a0 With the average power price in ERCOT West in 2011 of $41\/MWh, one\u00a0may<\/strong> conclude the unit would be unlikely to produce much value in that environment.<\/span><\/span> However, when we look at my model, including the corresponding financials of a reciprocating unit placed in that environment, the plant produces close to $34 million in net revenue in 2011 in power sales alone.\u00a0 Subtracting FOM and firm gas transport, we are still in the $30 million neighborhood.\u00a0\u00a0 If we place this condition into a cash flow model, with the same economic parameters used in the levelized cost model, the internal rate of return (IRR) of the project over the 30 year period will be around 12%.\u00a0 This is in the environment of the average price of power for the year is $41\/MWh versus the levelized cost calculation of $71\/MWh. (Of course I am not endorsing that 2011 would be representative of the future, my purpose here is to point out the potential<\/strong> to be misguided by levelized costing.\u00a0 However, if you are interested in seeing various scenarios and forecasts, I would be more than happy to assist<\/em>). <\/span><\/span><\/p>\n

What went wrong with the levelized cost approach is the inability to actually be in the real world.\u00a0\u00a0 Power is much too complex to simplify into a year model.\u00a0\u00a0 In the example above, which represents real world economics, because of the significant price volatility, 10 days represented over 50% of the plants revenue. <\/span><\/span><\/p>\n

I do believe in simplification versus paralysis analysis, but it has to be in context of the problem.\u00a0 By creating an hourly dispatched model in Excel, I did simplify real life, but not to the point it didn\u2019t mean anything.<\/span><\/span><\/p>\n

Some people feel comfortable using the levelized cost analysis to simply compare alternative technologies.\u00a0Once again, I believe it will misguide you, probably towards traditional past generating technologies, largely because of the influence of the capacity factor assumed.\u00a0\u00a0 Many people go back in time to quantify the capacity factor for various technologies, often not considering the environment nor the actual engineered capacity factor.\u00a0 Case in point, at AEP some wanted to use capacity factors of gas units in the teens because many of the units had experienced that or even less.\u00a0 When one put in a low capacity factor for the gas unit while putting in the high capacity factors (65+%) for the coal and nuclear plants the bias is tremendous.\u00a0 The lower historical heat rates were a function of the past market conditions.\u00a0 Obviously the market is changing with increasing load and increasing coal retirements.\u00a0 How will units respond given this changing environment?\u00a0\u00a0 One will not know using the levelized costing approach.\u00a0\u00a0Levelized costing puts the\u00a0threshold of gas very high relative to the reality of the world in the future.\u00a0\u00a0 In addition, the capacity factors do not need to be high for units that are flexible because they will mitigate the hours where the units are losing money.\u00a0 However, units such as coal and even combined cycles will have to swallow many hours when the unit is out of the money in order to capture the times the unit is in the money.\u00a0\u00a0 Another simple example is that solar technology will be generating only in the on-peak hours (unless you are in Alaska during summer times).\u00a0 Looking at\u00a0the levelized cost of solar will mislead you\u00a0in how bad the economics of solar is compared to\u00a0wind,\u00a0which in most places occur in off-peak periods.\u00a0\u00a0 Levelized costing generalizes too much\u00a0of the operations and interactions with the market.<\/span><\/span>\u00a0 In conclusion, the\u00a0levelized cost analysis is not appropiate to use for the power markets.\u00a0\u00a0 My suggestion is to model\u00a0units\u00a0on an hourly basis incorporating some of the operations reality.\u00a0 I\u00a0have many years of experience in evaluating various technologies, planning, and developing an integrated resource plan.\u00a0<\/span><\/span><\/p>\n

If you are looking for some insights and or additional points of view into the future technologies and\/or power markets please contact All Energy Consulting.<\/span><\/span><\/p>\n

Your Energy Consultant,<\/span><\/span><\/p>\n

David K. Bellman<\/span><\/a>
\n614-356-0484<\/span><\/span><\/p>\n","protected":false},"excerpt":{"rendered":"

Levelized cost of electricity (LCOE) approach is very popular in the financial circles.\u00a0 When I was at American Electic Power (AEP), many of the large financial companies would come and speak with our executives and present\u00a0LCOE on various technologies.\u00a0\u00a0 However, the levelized cost method has too much simplicity, \u00a0giving the presenter and the viewer internal […]<\/p>\n","protected":false},"author":1,"featured_media":32,"comment_status":"open","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[1,6],"tags":[143,147,22,146,369,145,144],"class_list":["post-379","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-market-insights","category-power","tag-gas-units","tag-lcoe","tag-levelized-cost","tag-levelized-cost-of-electricity","tag-power","tag-resource-planning","tag-valuation"],"_links":{"self":[{"href":"https:\/\/allenergyconsulting.com\/blog\/wp-json\/wp\/v2\/posts\/379","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/allenergyconsulting.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/allenergyconsulting.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/allenergyconsulting.com\/blog\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/allenergyconsulting.com\/blog\/wp-json\/wp\/v2\/comments?post=379"}],"version-history":[{"count":11,"href":"https:\/\/allenergyconsulting.com\/blog\/wp-json\/wp\/v2\/posts\/379\/revisions"}],"predecessor-version":[{"id":390,"href":"https:\/\/allenergyconsulting.com\/blog\/wp-json\/wp\/v2\/posts\/379\/revisions\/390"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/allenergyconsulting.com\/blog\/wp-json\/wp\/v2\/media\/32"}],"wp:attachment":[{"href":"https:\/\/allenergyconsulting.com\/blog\/wp-json\/wp\/v2\/media?parent=379"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/allenergyconsulting.com\/blog\/wp-json\/wp\/v2\/categories?post=379"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/allenergyconsulting.com\/blog\/wp-json\/wp\/v2\/tags?post=379"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}