Levelized Cost of Energy (LCOE) and its application to storage projects

Making an investment decision, especially in very long-lasting assets like storage is a very difficult decision and it comes with great consequences. Stranded assets tell stories about wrong investment decisions all over the world. The biggest difficulty is to foresee the future which is of course not possible. What’s possible, however, is to investigate into possible scenarios and assess the flexibility of the asset under consideration in various circumstances. That may sound very technical but in practice, subsidies may end abruptly, single events can trigger a change in politics (Fukushima event triggered the end of nuclear energy in Germany, for example).

One method could be the levelized cost of energy. Let’s have a closer look what it is and what it can tell us and what it can’t tell us.

What are LCOE and LCOS?

LCOE stands for Levelized Cost of Energy and it is defined as the discounted total lifetime cost divided by the discounted total lifetime energy output of an asset (This is a customer-oriented definition). For generation assets this calculation often is easy and straightforward. In fact, for wind or solar parks, the lifetime generation can be easily predicted, based on decades of project experience. The whole model becomes meaningful by using the discounting method, that is calculating the value of future income and expenses back to the begin of the lifetime, to the time, the investment decision is made, that is.

It is important to know that LCOE represents a special case of Net Present Value (NPV) calculation. NPV is calculated as follows:

NPV = PV(Revenue) – PV(Cost) = PV(Revenue) – Initial Cost – PV(Operations Cost)*,

(*for the sake of readability, the notation of present value calculation is simplified in the whole text.)

subtracting the Present Value (PV) of all cost streams from the present value of all revenue streams. On the revenue side it is usually an energy output per time slot weighed by the price for this energy that results in the revenue per time slot. The cost may be split into initial cost and cost of operations:

NPV = PV(Energy Output * Variable Price) – Initial Cost – PV(Operations Cost).

The LCOE is the average price, the energy must be sold in order to yield a zero NPV, neglecting the time-variable price and assuming a constant price for the whole lifetime:

LCOE * PV(Energy output) – Initial Cost - PV(Operations Cost) = 0,

LCOE = Initial Cost + PV(Operations Cost) / PV(Energy Output).

The important implication is the assumption of a constant price of the sold energy for the whole lifetime. The discount rate is similar for energy output and operational cost.

As far as storage is considered, we have to consider the fact that a storage device cannot generate energy. It must be charged at some point in time, resulting in charging cost and may be discharged at a certain rate later, creating some revenue. The efficiency of the storage system must be considered, including all losses from charging to discharging again. However, the efficiency of a storage system is not as trivial as a single number but usually depends on several parameters like power, State of Charge, temperature, device aging, among others.

In the literature, the term Levelized Cost of Storage (LCOS) has been established. We will use this term to distinguish from LCOE for generation. LCOS also derives from the net present value:

NPV = PV(Energy Output * discharge Price) – Initial Cost – PV(Operations Cost) –

PV(Energy Input * charge price)

Again, assuming a constant discharge price for the whole period under consideration and some rearranging yields:

LCOS = Initial Cost + PV(Operations Cost) + PV(charging cost) / PV(Energy Output).

The newly introduced term for the present value of the charging cost over time represent the nature of the storage system.

What does the LCOS tell us?

The outcome of every model is dependent on the data input to the model. The LCOS condenses very complicated system behavior and project framework conditions into one single number. This can be very useful when comparing different technologies. It also helps to get a feeling of sensitivities towards discount rate, system cost split (high initial cost vs. low operations cost), project lifetime.

LCOS, by definition, level the revenue of the equation (that is neglect the structure and time variance of the revenue stream) and emphasize on the cost side. However, the application profile (that is how often the device is charged, discharged and at what power levels and duration, idle states depth of discharge and son on) governs the performance, degradation and lifetime, replacement cycles for all system components, including but not limited to the storage device.

Calculating revenue streams for storage projects has proven to be a very complex task with many unknowns in the equation. The task doesn’t get easier with the need to calculate the charging cost of the storage asset, as several possible schedules may be possible. The performance and lifetime depend on the duration, power and frequency of the charging events making it a complex system to model.

Be careful, when using the LCOE to compare the economic viability of the investment. In fact, one should consider performing complete net present value calculation of the investment. The LCOS/LCOE can easily be derived from such calculations.

In practice, well-organized calculation spreadsheets prove to be a powerful tool to model all relevant details of a certain application/use case. The author has completed many net present value analyses for complex projects. Please contact me for further information.

Recently, the concept of the Return Justified Investment Cost (RJIC) has been developed. It is based on the net present value concept but rearranges the terms for better understanding. The RJIC is calculated as follows:

RJIC = PV(Revenue Streams) – PV(Operations Cost)

In the next step the RJIC is compared to the initial cost. If, the RJIC is higher than the Initial Cost, the investment is economically justified. A quick comparison with the basic definition of the net present value reveals that this criterion is identical to a positive NPV.

Final remarks

For all above calculations, the choice of the discount rate is crucial. However, the derivation of a meaningful discount rate is a complex topic itself. A common approach is the usage of the Weighted Average Cost of Capital (WACC), balancing the interest rates for debt and equity capital.

Quite often, people refer to the internal rate of return (IRR) to assess the viability of investments. The IRR is simply the discount rate at which the NPV becomes zero. The IRR is then compared to the required hurdle rate. If it is above the hurdle rate, the investment is beneficial. A higher IRR implies a quicker pay-off which can be related to less risk. I am personally not in favor of the IRR methodology as it is again a special case of the net present value method and it may contain some (hidden) pitfalls which all can be avoided by using the net present value methodology.

In summary, the LCOE/LCOS should be used as part of the assessment process and for technology comparison and the derivation of explicit formula proves to be useful in advanced modeling of storage systems in combination with other generation assets.

However, it cannot replace a thorough investment analysis as input for real-world decision making. Involvement of specialists to perform or check the analysis can avoid costly mistakes and stranded investments.