Open Electricity Economics

Release 0.1

OEE authors

Aug 29, 2017

 Contents

1 Overview of electric power systems 3

1.1 1. Electricity: basic terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2 2. Physical setup of electric power systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.3 3. Market structure of electricity industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

2 The cost of electricity 11

2.1 Learning objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.2 1. Cost structure of power plants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.3 2. Cost metric I: Levelized Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2.4 3. Cost metric II: Screening Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
2.5 4. Short term vs. long-term profitability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

3 Indices and tables 21

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Contents:

Contents 1
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2 Contents
 CHAPTER 1

Overview of electric power systems

1. Electricity: basic terminology

Electricity is the movement of electrons along electrical conductors (wires) that form a closed circuit. In itself, elec-
tricity is not that useful, but it is valuable as a source of energy. It is also easier and more convenient to transport
electricity over long distances and it is readily convertible into other forms of energy like heat, light and mechanical
energy.
Measuring electricity. Since electricity is a form of energy like heat, it can be measured and ex-pressed in similar
terms. The conventional unit of measuring any type of energy is joule (J). Related to this, is the concept of power,
which is the rate at which energy is delivered. Mathematically power is equal to the quantum of energy delivered
divided by the time in which it was delivered. Power is measured in watts (W), where one watt is equal to one joule of
energy delivered in one second.

𝑒𝑛𝑒𝑟𝑔𝑦 = 𝑝𝑜𝑤𝑒𝑟 × 𝑡𝑖𝑚𝑒

In practice, electrical energy or electricity is often not expressed in joules but rather by referring to power. Conven-
tionally electricity is measured in Watt-hours (Wh) with one watt-hour being equal to the amount of energy delivered
in one second. But one Wh is an extremely small quantum of energy in practical applications. More useful units are
kilowatt-hours (1 kWh = 1000 Wh) or megawatt-hours (1 MWh = 1000 kWh). Very high quantum of electricity is
measured in gigawatt-hours (1 GWh = 1000 MWh) and terawatt-hours (1 TWh = 1000 GWh).
Appliance Wattage
Laptop computer 25 W
LCD Television 150 W
Dishwasher 330 W
Clothes Dryer 2780 W
Large solar power plant 750 MW
Large coal power plant 4 GW
Peak load in Germany 100 GW
Power, voltage and current. Electricity flows through electrical circuits, usually conductors (wires) made of copper
or aluminum. A simple electrical circuit would like one shown in A simple electrical circuit in which a light bulb is
connected to a source of electricity through wires. The symbols used in that figure are standardized electric symbols.

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Calculating energy consumption.

The rate at which the bulb consumes
electrical energy in such a circuit can
be calculated if the know the voltage
drop across the bulb and the electrical
current flow-ing through the wires. In
general, the rate at which an element
in a circuit is consuming energy (mea-
sured in J) is equal to voltage drop
across the element (measured in volts,
V) times the electric current (I) flowing
through it (measured in amperes, A).
More precisely: if the voltage drop
across the bulb is a hundred volts (100
V) and the current flowing through the
light bulb is one ampere (1 Amp), then
the rate at which the bulb consumes
electrical energy is equal to 100 W.
Fig. 1.1: A simple electrical circuit
Q: What is the amount of electrical
Key point: Key ideas used when describing electrical circuits are voltage, current
energy consumed by a 100 W bulb
and power. Source: Physics Stack exchange
described in the circuit above in one
hour?
A: The amount of energy consumed in
one hour is equal to the rate at which energy delivered times the amount of time for which it is delivered. Energy
consumed by the light bulb in one hour is equal 100 W (J/s) X 1 h (3600 s) or 3600 J.
Energy loss in electrical circuits. When electricity flows through a substance, including electric wires and cables,
some of it is lost (in the form of heat) due to the “resistance” offered by the sub-stance. Think about electric current as
water flowing through a pipe and resistance as the friction offered by the pipe to the flowing water. Resistance offered
by a conductor is measured in Ohms (Ω). Mathematically, the energy loss is proportional to square of the current flow.
In other words, my cut-ting the current flow in half the loss can be reduced by 75%. We saw earlier that, for a given
power, voltage is inversely proportional to current (power is equal to voltage times current, so for the same value of
power current is equal to power divided by voltage). This implies that electrical energy lost in a circuit is inversely
proportional to the square of voltage and the resistance offered by the conductor.

𝐸𝑛𝑒𝑟𝑔𝑦 𝑙𝑜𝑠𝑡 = 𝑐𝑢𝑟𝑟𝑒𝑛𝑡2 × 𝑟𝑒𝑠𝑖𝑠𝑡𝑎𝑛𝑐𝑒

𝑣𝑜𝑙𝑡𝑎𝑔𝑒2
=
𝑟𝑒𝑠𝑖𝑠𝑡𝑎𝑛𝑐𝑒
For a given amount of power, raising the voltage by a factor of 10 reduces the current by a corresponding factor of 10
and therefore the losses by a factor of 100, provided the same sized conductors are used in both cases.
We said earlier that electrical energy is more useful than other forms of energy because it can be transported over
long distances quite easily. But this is true only when electricity is transmitted across wires at high voltage; at lower
voltages energy loss would be substantial and it would not be economical to transfer energy over long distances.
High vs. low voltage. The benefit of reduced thermal losses at high voltages comes at a cost: safety. High voltages
are dangerous to operate – you should keep a distance of 4m to a conductor loaded with 400 kV. Such safety measures
are both impractical and costly for handling electricity at home. An optimal solution is to have an electricity system
that transmits electricity over long-distances at high voltages while providing connecting end-consumers to the system
at low voltages. This is accomplished using “power transformers”.
AC vs. DC power. The first power systems developed in the late 19th century provided electricity at a constant
voltage: these are known as direct current or DC systems. Later these systems gave way to alternating current or AC

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systems that were based on a voltage that varies in a constant, regular way. The rate at which AC voltage varies is
known as frequency and is expressed in hertz (Hz). Most power systems in the world operate at either 50 Hz or 60 Hz.
The frequency of current has to be maintained at a constant level throughout the electrical system as large deviations
from the frequency, at which electrical appliances and systems are designed to operate, can damage them. AC systems
are widely used because through a device called transformer the voltage within an AC system can be easily in-creased
or decreased. By contrast, it is more complicated to “step up” (increase) or “step down” (decrease) the voltage of DC
current. This is the reason that AC systems outcompeted DC ones in the 20th century, using transformers electricity
voltage can be stepped up to allow transmission at high voltages to reduce energy loss, and voltage can be reduced at
the consumption point for safe use.

2. Physical setup of electric power systems

Electric power systems. A complex network of interconnected electrical equipment and circuits is deployed
to enable supply and use electricity and makes up the electric power system. The overall working of the
system can be simplified as follows: electricity is produced at large power plants, transmitted over long dis-
tances over the transmission system and brought to the consumers through the distribution system. Schematic
view of a classical electric power system provides a schematic view of such an electrical system. Historically,
such a system emerged, as it was economical to build big power plants near the source of energy (coalmines,
rivers etc.) and use transmission and distribution system to transfer the electricity produced to consumers.

Fig. 1.2: Schematic view of a classical electric power system

Source: Wikipedia Key point: An electrical system is divided into generation, transmission and distribution fun

smaller generating units, each of which consists of two basic components: a turbine that produces rotary motion
and a generator that converts this mechanical energy of rotation into electrical energy. Different technologies and
energy sources can produce this rotation motion. In a thermal power plant pressurized steam fuels this motion that is
produced by heating water through combustion of coal or biomass, or nuclear fission, or solar heat. In certain natural
gas based thermal plants the pressure of hot gasses produced during combustion drives the rotor (these “gas turbines”

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work just like jet engines of aircrafts). In wind or hydro power plants, the pressure of wind or water against the rotor
moves it. The one exception is the solar photovoltaic (PV) generation technology, which is distinctly different from
the traditional generators as it directly converts light energy to electricity, without using a turbine or a generator.
Each generating unit in a power plant has an installed or nameplate capacity, which is its maximum mega-watt (MW)
electrical power capacity that the unit can generate. Corresponding to this generation capacity is the actual electrical
generation, which is measured in megawatt hour (MWh). One MWh is equal to the amount of electricity generated by
a generating unit with a capacity of one mega-watt running continuously for one hour.

𝐸𝑙𝑒𝑐𝑡𝑟𝑖𝑐𝑎𝑙 𝑔𝑒𝑛𝑒𝑟𝑎𝑡𝑖𝑜𝑛 (𝐺) = 𝑐𝑎𝑝𝑎𝑐𝑖𝑡𝑦 (𝐶) × 𝑡𝑖𝑚𝑒

Where G is generation in mega-watt hours (MWh), C is capacity in mega-watt (MW) and time is hours for which the
generating unit is run. Note that, because the year has 8760 hours, a one mega-watt generating unit can generate a
maximum of 8760 MWh of electricity during a year. Practically, actual electrical generation from a unit is lower than
its installed capacity and is measured by electrical meters. Power stations are in more detailed described in Power
plants.
Transmission. Transmission and distribution systems are the means of transferring electricity from power stations to
load (consumption) centers. They differ however in the voltage levels of operation, with transmission typically being
above 220 kV (the exact voltage of demarcation differs by country and systems); the voltages are very high to reduce
the energy loss in long distance transmission of electricity. The transmission system consists of transmission lines,
sub-stations and system services. The system is like a mesh spread over hundreds of kilometers and is commonly
referred to as the transmission grid or network. Flow of electricity through the transmission grid can be stylized as
follows: electricity is fed into the grid at power plants; electricity flows towards consumption (load) centers; sub-
stations near the load centers “step down” the voltage and feed power into the distribution system to be delivered to
consumers. But the stylized picture is overly simplistic because:
• there are many power plants in the system
• there are usually many “paths” from a given power plant to the load centers (because of the meshed structure of
the grid)
• laws of physics govern flow of electricity and not contracts between power plants and consumers
These complications will be discussed in detail in Chapter Power grids. One important system service is balancing
energy, which will be discussed in Chapter Balancing.
This makes managing flow of electricity across the transmission grid a complex task. The transmission grid is like a
highway network crisscrossing a country. There is more than one route between two points and traffic is flowing on
all routes. If for some reason one road is blocked, there is a jam till the order is restored. Traffic flows on alternative
routes that get more crowded (overloading of transmission lines) and these alternative routes may develop jams as
well. Thus a problem in the network can spread and cause breakdown of the entire system. Because electrons flowing
through the transmission lines travel at much higher speeds than cars, breakdowns can occur in a matter of seconds.
Transmission systems need to be built and managed to handle such eventualities to ensure continuous flow of electricity
to consumers.
Distribution. The distribution system consists of electric lines, substations and cables reaching all the way to the
consumers. Distribution has two distinct functional components – distribution and supply. “Distribution” refers to the
physical network through which electricity is transferred from the transmission system to end consumers. “Supply”
refers to the commercial activities related to selling power to consumers. The institutional relationship between gen-
eration, transmission and distribution systems is deter-mined by the market structure of the electricity industry. The
legal system also puts restrictions on ownership of the different functions – supply and distribution are jointly operated
as a single function in many areas, while that might not be the case in other locations.

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3. Market structure of electricity industry

The way the electricity industry is organized varies across the world and has changed significantly over the last century.
To see the differences, it makes helpful to think about the industry in terms of different components of the electricity
value chain: generation, transmission, distribution, and retail supply. Depending upon the industry structure, these
functions can be either performed by one firm or by separate firms, working under competition or as regulated monop-
olies.
Vertically integrated electricity utilities. Until the 1990s electricity utilities everywhere were essentially structured
as vertically integrated, regulated monopolies. This meant that the same entity owned production, transmission, dis-
tribution and retail supply of electricity in a given area, and there were no competitors. Such a structure allowed the
utility to design and operate a system that benefits from the “economies of scale” and systemic interactions present
in large-scale electrical systems; it also allowed for integrated generation and grid planning. To ensure that the mo-
nopolist electricity utility would not charge a price that was unreasonably higher than the costs of production, retail
prices were set by regulatory bodies on the basis of “cost-of-service” regulation. The regulators also set conditions
for service of supply. Rather than regulating a large private monopoly, several countries nationalized and brought the
entire industry under direct state control. Vertically integrated utilities are still found in several OECD countries (such
as parts of the United States) and are the norm in most developing countries. This traditional regulated utility structure,
governed as a natural and technical monopoly, worked reasonably well at least in the beginning: it drove down the
cost of electricity, fostered universal access and provided for reliable electric service delivered by a single utility in a
given region. But there were inefficiencies in the model: it was difficult to set a “fair” price through regulations, lack
of competitive pressure on costs and, more importantly, lack of incentives for innovation. This, along with a general
movement towards deregulation, prompted a re-think in 1980s
Restructuring electricity utilities. Through the 1980s and 1990s many industries were liberalized round the world,
from post services to telecommunications to utilities. Steps were taken in several countries to “restructure” electricity
utilities, i.e. to split integrated utilities in parts and allow competition in segments of the industry. The path followed
varies – the eventual structures that emerged in the different regions of the United States were different, which were
again at variance from the model adopted by the European Union. The underlying logic of the new structures was
how-ever similar.
Competitive generation and wholesale markets. In most countries, generation function was the first to be liberalized.
Generation activity was de-licensed and thrown open to free entry to en-courage greater competition and incentivize
investments in the sector. While earlier most power plants were owned by one or several big utilities, the new structure
encouraged investors to setup “merchant power plants” or “independent power producers” (IPPs) that were not tied
to a particular utility. Such power plants compete with each other to sell power in the (newly created) “wholesale
markets” for electricity. It was envisaged that greater competition in generation would encourage investment and
practices to make power plants more efficient. In many cases, competition in generation was accompanied or followed
by separating (“unbundling”) the generation business of existing vertically integrated utilities from the rest of the
company. Sometimes, the generation business was split into several smaller companies to foster competition.
Grids: natural monopolies. In the new structure generation companies compete in the market. But transmission and
distribution systems are still treated like a natural monopoly: it is more economical for one company to set up one
electricity grid rather than building parallel grids. Transmission and distribution companies are allowed to charge a
fix, regulated fee for operating the grid and are required to provide non-discriminatory services to all generators and
consumers, i.e. not block entrants by refusing grid connection. To ensure non-discrimination regulations often prohibit
joint ownership of generation and transmission businesses.
Retail competition. Along with generation, supply of electricity is no longer a monopoly in many countries. In
such countries a distinction is made between the “distribution” and “retail supply” components of the distribution
system. A retail supplier of electricity typically procures power from the wholesale market and manages metering,
contracting, billing and collection of payment from end consumers. Suppliers are sometimes called “load serving
entities”. Consumers are free to choose from a set of suppliers in the market who compete amongst each other to
provide the best service to end consumers. The segregation between distribution and supply is however not universal.
Even several markets that restructured generation (allow competition) and transmission (require non-discriminatory
services) of electricity retain the regulated monopoly structure of distribution and supply of electricity.

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Market models. Different Market Structures in electricity illustrates typical ways of organizing electricity markets. In
Model 1 (Vertically integrated utility) a single utility operates generation, transmission and distribution (including re-
tailing) business; the utility may be either a regulated private corporation or state-owned entity. In Model 2 (Integrated
utility with single buyer), independent power producers are allowed to operate, which sell electricity to the utility.
These typically long-term contracts are often called power purchase agreements (PPAs). The terms and conditions of
PPAs in a single buyer market are often subject to regulation. In Model 3 (Wholesale competition) large consumers
are allowed to buy electricity directly from generators, i.e. there is no single buyer anymore. The regulated utility
continues to supply all smaller customers. In Model 4 (Wholesale and retail competition) all consumers can pick a
supplier: large consumers will buy directly at the wholesale market while small consumers choose a retail sup-plier.
Transmission and distribution remains regulated. There exist at least two flavors of Model 4, the American “central
dispatch” model of an Independent System Operator that conducts security-constraint economic dispatch and the Eu-
ropean “self-dispatch” model where wholesale market participants interact on power exchanges and through brokers.

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Fig. 1.3: Different Market Structures in electricity
Key point: Electricity markets have evolved from the vertically integrated model. Many, somewhat varying structures are currently in operation a
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of the electricity industry at the turn of this century the regulatory/legal status of electricity – in generation, trans-
mission, distribution and supply – changed little in the last decade. But concern regarding the environmental impact
of fossil fuel based generation technologies and improvement in renewable energy technology has prompted a policy
shift towards wind and solar generation. The growth of wind and solar generation sources raises two issues that
are now coming to dominate policy discussions among utilities and policy makers: (1) economic and technical
management of intermittent-production resources for which costs are largely sunk before production begins and (2)
policy towards distributed generation resources that are on the property of the end user. The latter is primarily an issue
with rooftop solar PV today, but could expand to batteries and other generation or storage devices in the future. Both
these concerns reflect shifts that could shape the electricity industry in the future (Borenstein & Bushnell, 2015). In
addition, provision of feed-in-tariffs to renewables in come countries has distorted the wholesale power markets with
consequences for effectiveness of these markets.

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 CHAPTER 2

The cost of electricity

Learning objectives

This chapter provides an overview of the cost structure of electricity generation. After reading this chapter the reader
should be able to answer:
• What kind of costs are associated with electricity generation?
• What is the difference between fixed and variable costs?
• Which metrics can be used to compare cost of generation of different power plant?
• How is the least-cost technology-mix required to fulfill electricity demand in an electrical system?

1. Cost structure of power plants

Like other economic goods, generation of electricity requires land, labor, raw material and capital, which imply an
intrinsic cost of production. For example, electricity generated using a coal-based power plant first requires the coal
power plant to be built which for which an investor much bear the cost of land, equipment, construction, grid connec-
tion, financing and project management. In addition to this there are additional costs involved in running the power
plant: the cost of coal that is burnt daily and expenses, including labor cost, to maintain the power plant in running
condition. While the actual costs involved in electricity generation vary with the technology used, we can nevertheless
build a general understanding of costs associated with electricity generation.

1.1. Fixed and variable costs of generation

Broadly speaking all generation costs can be categorized into two groups depending on the point in time at which the
costs are incurred: at time of the investment decision (should the power plant be built?) or at the time of the production
decision (should electricity be generated using the power plant?). The costs associated with the investment decision
are usually called fixed or investment costs and the costs incurred only at the time of generation are called variable or
generation costs.

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Fixed costs. These costs comprise of the cost of equipment, land, financing, project management, grid connection,
and construction of the power plant and are usually expressed per unit of installed capacity (in per kW or per MW
terms). Fixed costs are often regarded as “sunk costs” because once the investment decision is taken fixed costs cannot
be recuperated. The plant may be sold or scrapped at some point but such a transaction usually carries a large cost.
Therefore once a plant is erected and the fixed costs incurred they are called “sunk costs”.
Variable costs. That decision depends on the variable costs, which consist of fuel cost, operation and maintenance
expenses and carbon dioxide emission charges (where applicable). They are typically calculated per unit of electricity
generated (in per MWh terms). In general, fixed costs are irrelevant to production decision i.e. the decision whether
to actually generate electricity using the plant at any given point in time (refer The value and price of electricity).
There is a third category between fixed and variable cost, sometimes called quasi-fixed costs, which includes cost
of labor; staff can be hired or fired after the investment decision at discrete points in time but not for every single
production decision. In electricity generation, such quasi-fixed costs are small enough not to merit separate treatment
and are subsumed in variable cost.
Cost structure of generation technologies. Electricity generation technologies vary dramatically in their cost struc-
ture. Some plants, such as nuclear, wind and solar power, have virtually zero variable costs. This is in stark contrast to
fossil fuel based power plants. For example, variable costs (fuel costs and emission charges) comprise approximately
40% of the levelized costs of a coal-fired power station and as much as 60% of a gas-fired combined cycle plant.

In
gen
era
tech
nol
gie
wit
low
car
bon
dio
ide
em
sion
are
also
the
one
wh
fixe
cos
ma
up
a
hig
per
cen
age
of
Fig. 2.1: Cost structure of different types of electricity generation technologies (illustrative, but realistic assumptions) to-
Key point: Generation cost certain technologies (wind, solar, nuclear) is almost equal to the fixed costs, while in case of other technologies (coal, tal
gas, etc.) fixed costs make up about half of the total costs. Source: Hirth & Steckel (2016) cos
The
fac

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that modern renewables (like wind and solar) have much lower variable costs than conventional fossil fuel power
plants has problematic implications for the existing power systems and markets, which is explained in subsequent
chapters on Economics of Renewable Energy.

1.2 Annualized Fixed Costs

Most power stations are designed to run for 20 to 60 years (‘technical lifetime’). Thus even though fixed costs
are incurred at the time of investment, for analytical purposes it make sense to translate the fixed costs incurred in
annualized terms i.e. calculate the cost of constructing the station per each year of its technical life. This metric is
known as Annualized Fixed Costs (AFC). AFC is calculated by converting fixed costs at the time of investment into
an annuity using the following formula:

(1 + 𝑟)𝑌
𝐴𝑛𝑛𝑢𝑎𝑙𝑖𝑧𝑒𝑑 𝐹 𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 (𝐴𝐹 𝐶) = 𝐼 × 𝑟 ×
(1 + 𝑟)𝑌 − 1)

where I is the investment or fixed cost in EUR per kW, r is the discount rate and Y is the technical lifetime of the power
plant in years. Thus AFC depends on the actual cost of setting up a plant and its expected technical lifetime, both of
which are determined to a large extent by the engineering and manufacturing processes. The discount rate on the other
hand is a financial concept.
The discount rate: weighted average cost of capital (WACC). The most commonly used discount rate for the
purpose of calculating annualized fixed costs is weighted average cost of capital or simply WACC (we use the terms
WACC and cost of capital interchangeably). For investment in a power plant (or any other investment), WACC is
calculated as share of equity times the cost of equity plus share of debt times the cost of debt. Cost of capital is used
for discounting as it represents the “opportunity cost” of the money that is invested building the power plant: cost of
equity reflects the foregone return that an investor could have earned on an alternative investment and cost of debt
reflects the foregone return from leaving the money in a bank.
Q: What is the AFC of the wind turbine in the following example?
Q: What is the impact of a reduction of WACC by half?
Items Wind turbine
Investment cost 1000 C/kW
Discount rate 8%
Life-time 20 years
A: EUR 101.9 per kW per year (101.9 C/kW/a)
A: 73.6 C/kWa, or 28% less than at a WACC of 8%.

2. Cost metric I: Levelized Cost

While the distinction between fixed and variable cost of electricity is important, for various analytical and practical
purposes it is often useful to compare the “average cost” of generating electricity from different power plants. Can
fixed and variable costs be meaningfully combined in one metric to answer this question?
One cost metric that is frequently used for this purpose is the levelized cost of electricity (LCOE) or the levelized
energy costs (LEC). This is defined as the aggregated discounted lifetime cost (fixed plus variable costs) of generating
electricity per unit of output and is usually expressed in EUR per MWh. It is calculated using the following formula:
∑︀𝑌
𝑦=1 (1 + 𝑟)−𝑦 × 𝐶𝑦
𝐿𝐶𝑂𝐸 = ∑︀𝑌
𝑦=1 (1 + 𝑟)−𝑦 × 𝐺𝑦

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where G y is electricity generation in MWh, C y are aggregated fixed and variable costs for an year (in EUR per year),
r is the discount rate and Y is the technical lifetime in years. The costs are called levelized because they are “leveled”
over all the generation.
Q: Calculate the levelized cost of electricity produced using a wind turbine with the following specifications. You may
need to use a spreadsheet program such as MS Excel.

Investment cost 1000 C/kW

Discount rate 8%
Life-time 20 years
Generation 2000 MWh/MW
A: 47 C/MWh.

2.1. LCOE of different technologies

It is common practice in policy and industry documents (and also in academic ar-
ticles) to compare the LCOE of different technologies. A comparison of LCOE
across various technologies is given in LCOE of different power generating technologies.

LC
is
of-
ten
use
as
a
me
sur
of
cos
ef-
fi-
cien
or
com
pet
i-
tive
nes
of
dif-
fer-
ent
tech
nol
gie
Suc
ana
Fig. 2.2: LCOE of different power generating technologies y-
Source: Bloomberg New Energy Finance (2015) sis
is

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in-
deed reasonable in case of traditional thermal power plants. Things are more complicated in case of renewable energy
and such comparisons should be treated with caution. An underlying assumption of LCOE is that the output of all
power plants being compared i.e. the electricity produced is identical. But this assumption may not hold when some
power plants can produce electricity only at certain times of the day or year. In this case the output produced by the
plants in no longer homogenous. This point is often overlooked in publications and academic literature and discussed
further in chapter on “The value and price of electricity”.
LCOE may also vary for the same technology. For example, in regions with strong winds and low costs of capital
wind energy is much cheaper than in regions with low wind speed and high WACC. In China and India, constructing
coal-fired power plants is much cheaper than elsewhere because of low labor costs and economies of scale owning to
the expected increase in installed capacity. In jurisdictions that price carbon and other emissions, the cost of fossil fuel
based power plants is higher. As coal has to be transported over long distances, generating electricity from coal plants
located near coalmines is cheaper than plants located inland.

2.2. What impacts LCOE?

LCOE can obviously be calculated ex post, looking back at a power plant’s lifetime and knowing the costs that were
incurred. More frequently however LCOE is calculated ex ante, before an investment decision is taken. At this time
the fixed and variable costs, the generation and the discount rates (or the actual financing costs) are uncertain. Thus
most LCOE calculations are necessarily based on projections and estimates.
LCOE depends on electricity generated. The levelized cost of electricity depends on how much electricity is gen-
erated per unit of installed capacity (MWh/MW). Generation per capacity is usually termed as full load hours (FLH),
where zero FLH means no electricity is generated whereas 8760 FLH means that the power plant is producing at full
capacity without interruption throughout the year. For example, a power plant of 1 MW capacity would have run 8760
FLH if it generated 8760 MWh of elec-tricity during the year. Similarly, a 10 MW power plant would have run 8760
FLH if it generated 87600 MWh in a year (note that a non-leap year consists of 24 X 365 = 8760 hours). Dividing
FLH achieved by a plant by 8760 yields the “capacity factor”: another term that is frequently used to indicate the
amount of electricity generated per unit of installed capacity. A power plant that runs for 8760 FLH in a year would
have a capacity factor of 100%.
Power stations are sometimes categorized as “base load plants”, “mid load plants” and “peaking plants” (or “peak-
ers”) depending on the number of number of hours they run in a year or their FLH. Base load refers to power stations
that operate almost around the clock almost every day of the year. Peaking plants produce electricity only during little
time of the year. Mid load plants operate most days, but are turned off during nights or weekends. While, there is no
uniform definition, generally base load plants have 7000 FLHs or more, mid load plants have 2000 to 7000 FLHs, and
peaking plants have 2000 or less FLHs.
The FLH that a power plant runs during a year or the amount of electricity it generates is a determinant of the average
cost of generating electricity from that power plant. We can restate the LCOE formula given in equation (3) as follows
to see the relationship between the levelized cost of electricity and running hours:
𝐶𝑓 𝑖𝑥 + 𝐹 𝐿𝐻 × 𝐶𝑣 𝑎𝑟
𝐿𝐶𝑂𝐸 =
𝐹 𝐿𝐻
𝐶𝑓 𝑖𝑥
= + 𝐶𝑣 𝑎𝑟
𝐹 𝐿𝐻
where C fix is the annualized fixed cost in EUR per MW, C var is the variable cost in EUR per MWh and
FLH is full load hours in MWh per MW. It is also evident from equation (4) that higher full load hours re-
sult in a lower LCOE because the same fixed or investment costs are distributed over more units of gener-
ation. The reduction in LCOE with FLH is also higher when variables costs are relatively low. The fig-
ure below shows the relationship between FLH and LCOE for power plants based on various technologies.

Q:
Which

2.3. 2. Cost metric I: Levelized Cost 15

Open Electricity Economics, Release 0.1

power
sta-
tion
is
more
cost-
efficient?
Item
Coal-
Gas-
fired
fired
power
power
sta-sta-
tiontion
Fixed
16301160
C/kW
costs C/kW
Vari-
30 50
ableC/MWh
C/MWh
costs
A:
It
de-
pends
on
the
amount
of en-
ergy
pro-
duced
or the
num-
ber of
FLH
for
which
the
plant
is run.
Total
cost for
gener-
ation
of each
unit of electricity would be equal to fixed cost plus variable cost divided by generation in MWh. In this case, the
break-even point is 23,500 MWh per MW. If the power plant is expected to run less that 23,500 full load hours during
its lifetime, then a gas-fired station is cheaper, otherwise the coal-fired station is cheaper. Note that this calculation
ignores discounting.*
The fact that average cost of electricity decreases with running hours has important implications for the way power
systems have been planned historically. Technical experts often point out FLH is determined by the technology and
running conditions, including the age of the plant. They argue that nuclear or some coal-fired power plants operate
as base load plants because it is technically difficult to increase or decrease generation at short notice (to ramp up or
down the “cycle”), while gas plants are more flexible. This view misses the point that coal and nuclear power plants are
designed to be inflexible because it is economic to do so. It is the economics that historically determined the flexibility

16 Chapter 2. The cost of electricity

 Open Electricity Economics, Release 0.1

of power plants rather than the other way around. Traditionally thermal power plants based on coal or nuclear energy
were built to operate round the clock and regularly achieve a capacity factor of about 90-95 percent. These plants
have relatively high fixed costs as compared to variable costs so, once they are constructed, it makes sense to run them
as much as possible under almost any condition to achieve the highest FLH, and in turn, the lowest LCOE possible.
On the other hand open cycle gas turbines were designed for lower FLH because high variable costs put a lower limit
on the levelized costs that can be achieved. Flexibility limitations should be thought of as a consequence rather than
precondition: if it is economic to almost never turn off a plant, then it does not make sense to spend much thinking in
how to make it flexible!
LCOE depends on cost of capital. As in case of Annualized Fixed Costs, the weighted average cost of capital
(WACC) of a power project is frequently used as a discount rate while calculating levelized cost. LCOE is therefore
depends on WACC. If for any given power plant (or in general a type of power plant) the proportion of fixed costs in
total cost is high, the LCOE for the power plant is more sensitive to changes in WACC. This implies that wind and
solar power plants, which have small variable costs and high fixed costs, benefit much more from decrease in interest
rates than coal or gas fired power plants. Conversely, the cost of solar and wind power plants increases more with any
increase in the cost of capital (Figure 3).
What impacts the WACC? In general WACC is closely related to the general level of interest rates in an economy.
But WACC also depends on market risks: if investors perceive an investment to be risky, for example because they fear
that the investment may be expropriated or because income streams are very uncertain, they charge a higher WACC.
Investors in emerging economies often face higher cost of capital, a factor that hinders the decarbonization of electrical
systems. Further reading: Hirth & Steckel (2016).

3. Cost metric II: Screening Curves

While LCOE has the advantage of summarizing all kinds of fixed and variable costs that occur associated with elec-
tricity generation, this brevity comes at the cost of blurring the differences between variable and fixed costs. A way
of representing costs in a way that explicitly accounts for the differences between fixed and variable costs are the
so-called screening curves.
Interpreting screening curves. Screening curves (actually, lines) depict the total cost of thermal power plants
during the course of one year per unit of capacity. The x-axis shows full load hours (or capacity factors)
and the y-axis shows annualized fixed costs. In Figure 5 each line represents the total cost per kW for
a different thermal generation technology. The slope of the curve corresponds to the variable costs, while
the intercept of a particular line corresponds to the annualized fixed cost for that technology (power plant).

Determining
the least-
cost
tech-
nology.
Screening
curves are
a simple
but power-
ful tool to
“screen”
all thermal
tech-
nologies
available
to find
out the

2.4. 3. Cost metric II: Screening Curves 17

Open Electricity Economics, Release 0.1

least-cost
option to
generation
electricity
(a limi-
tation of
screening
curves
is that
other tech-
nologies,
notably
hydro-
electricity,
wind
power and
solar power, cannot be sensibly depicted through them). For a given level of generation (full load hours), the lowest
curve indicates the least-cost option. Take the example of Figure 5: if a power plant is meant to be used 500 hours per
year or less, the least-cost option is an open cycle gas-fired power plant. If it is used more than 500 hours but less than
6000 hours, the least cost option is a combined-cycle has plant. If the station is meant to run around the clock during
the entire year, the least cost option is a nuclear power plant.
We started this chapter by asking, “How is the least-cost technology-mix required to fulfill electricity demand de-
termined in an electrical system?” It is evident that the answer depends on the cost parameters of the technologies
available. But screening curves show us, that though less obvious, it is equally important to consider the use to which
power plants are put. The least-cost technological choice for a power plant that is expected to operate only rarely is
almost certainly different from the least-cost choice for a plant that will run around the clock.
Q: Draw the screening curves of the following two plants.
Item Coal-fired power station Gas-fired power station
Annualized fixed costs 140 C/kW/a 100 C/kW/a
Generation costs 30 C/MWh 50 C/MWh
Q: Draw the screening curves of the following five plants.

4. Short term vs. long-term profitability

One of the consequences of a differentiated cost structure of power plants is that there is much con-fusion, particularly
in political debates, about profitability of the electricity sector. The confusion often results from not differentiating be-
tween short-term and long-term profits accruing to power plants. Short-term profit (sometimes called the “contribution
margin”) of a power plant is calculated as the total revenue earned by a power plant minus variable costs of generation.
As opposed to this long-term profit is the total discounted revenue earned by a power plant over its lifetime minus the
total cost (fixed plus variable costs) incurred over the lifetime of the plant. Mathematically, long-term profit is equal
to discounted sum of short-term profits minus fixed or investment cost.
Net Present Value. Another way of assessing long-term profitability of a power plant is by calculating the Net Present
Value (NPV) of the investment. The NPV of an investment (in a power plant) is calculated using the following formula:
𝑌
∑︁ 𝑅𝑦 − 𝐶𝑦
𝑁 𝑒𝑡𝑃 𝑟𝑒𝑠𝑒𝑛𝑡𝑉 𝑎𝑙𝑢𝑒 (𝑁 𝑃 𝑉 ) = −𝐼
𝑦=1
(1 + 𝑟)𝑦

where R y is total revenue in a certain year y (in EUR), C y is the variable cost (in EUR), I is the total investment or
fixed cost (in EUR), r is the discount rate and Y is the number of years for which the power plant is expected run.

18 Chapter 2. The cost of electricity

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Q: Discuss this statement: “A nuclear power plant earns profits of 1 million Euros per day”. This statement is often
heard in the political debate, sometimes to suggest that nuclear power plants earn an excessive amount of money.
A: The statement refers to short-term profits i.e. the revenue minus average cost of a nuclear plant is around Euro
1 million per day or about EUR 365 million per year. Taken in isolation, the statement can however be misleading,
as it does not tell us anything about long-term profitability of nuclear power plants. One way to assess long-term
profitability of the power plant would be to calculate net present value of the investment. Considering an initial
investment of about EUR 5 billion (the rough cost of a new nuclear power plant), technical lifetime of 60 years and
a discount rate of about 8%, the net present value of such an investment is equal to (-) 482 million. This implies that
short-term profits of EUR 1 million per day are not sufficient to make this a profitable investment in the long-term!

2.5. 4. Short term vs. long-term profitability 19

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20 Chapter 2. The cost of electricity

 CHAPTER 3

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