1.2 Levelised Cost of Electricity Generation

The LCOE of renewable energy technologies varies by technology, country and project based on the renewable energy resource, capital and operating costs, and the efficiency/performance of the technology. The approach used in the analysis presented here is based on a discounted cash flow (DCF) analysis. This method of calculating the cost of renewable energy technologies is based on discounting financial flows (annual, quarterly or monthly) over the project lifetime to a common basis, taking into consideration the time value of money. Given the capital-intensive nature of most renewable power generation technologies and the fact that fuel costs are low, or often zero, the weighted average cost of capital (WACC), often also referred to as the discount rate4, used to evaluate the project has a critical impact on the LCOE.

There are many potential trade-offs to be considered when developing an LCOE modelling approach. The approach taken here is relatively simplistic, given the fact that the model needs to be applied to a wide range of technologies in different countries and regions. However, this has the additional advantage that the analysis is transparent and easy to understand. In addition, a more detailed LCOE analysis results in a significantly higher overhead in terms of the granularity of assumptions required. This often gives the impression of greater accuracy, but when it is not possible to robustly populate the model with assumptions, or to differentiate assumptions based on real world data, then the "accuracy" of the approach can be misleading.

The formula used for calculating the LCOE of renewable energy technologies is:

Where:

LCOE = the average lifetime levelised cost of electricity generation;

It = investment expenditures in the year t;

Mt = operations and maintenance expenditures in the year t;

Ft = fuel expenditures in the year t;

Et = electricity generation in the year t;

r = discount rate; and

n = economic life of the system.

All costs presented in this paper are real 2010 USD, that is to say after inflation has been taken into account.5 The LCOE is the price of electricity required for a project where revenues would equal costs, including making a return on the capital invested equal to the discount rate. An electricity price above this would yield a greater return on capital, while a price below it would yielder a lower return on capital, or even a loss.

As already mentioned, although different cost measures are useful in different situations, the LCOE of renewable energy technologies is a widely used measure by which renewable energy technologies can be evaluated for modelling or policy development. Similarly, more detailed discounted cash flow approaches that take into account taxation, subsidies and other incentives will be used by renewable energy project developers to assess the profitability of real world projects.

4 These are not necessarily the same but in the analysis in this paper are assumed to be equivalent values.

5 An analysis based on nominal values with specific inflation assumptions for each of the cost components is beyond the scope of this analysis. Project developers will develop their own specific cash flow models to identify the profitability of a project from their perspective.