The value of electricity
Electricity is versatile, clean to use, easy to distribute and supreme to control. Just as important, it is now established that electricity has better productivity in many applications than other energy forms. All this led to the wider utilisation of electricity and its replacement with other forms of energy in many uses. Demand for electricity, although slowed down in Organisation for Economic Co-operation and Development (OECD) economies, is still growing globally at a rate near that of economic growth and, in many countries, at almost 1.5 times that of the demand for primary energy sources. Electricity generation, in 2013, accounts for 40–41 per cent of primary energy use. With the type of technologies and applications that already exist, there is nothing to stop electricity’s advancement and it attaining a higher share of the energy market. Saturation of electricity use is not yet in sight, even in advanced economies where electricity production claims a major share of the primary energy use. Other than the transport sector, electricity can satisfy most human energy requirements. Electric vehicles (EV) although still limited in sale, however, may come strongly into the market in the foreseeable future. It is expected that, by the second half of the 21st century, most of the energy needs in industrialised countries will be satisfied by electricity.
Electricity has become an important ingredient for human life; it is essential for modern style of living and for business. Its interruption can incur major losses and create havoc in major cities and urban centres. Its disruption, even if transient, may cause tremendous inconvenience.
Therefore, continuity of electricity supply is essential. Also, with the widespread use of cyber technology and other voltage- and frequency-sensitive electronic equipment, the importance of the quality of supply has become evident. A significant proportion of investment in the electricity supply industry (ESI) goes into the reserve generating plant, standby equipment and other redundant facilities needed to ensure the continuity and high quality of the supply. With the spread of smart grids and distributed electricity generation, the ESI is changing and consumers will have more say in the supply management. Optimisation of investment in the ESI requires understanding of markets, prediction of future demand and an approach based on integrated resource planning.
In this quick review of the economic evaluation of projects we have to consider two aspects: the discount rate for present valuing of investment and returns; and the levelised cost of electricity (LCOE) for calculating the cost of base-load electricity generation.
Note: This article is based on the book “Economic Evaluation of projects in the Electricity Supply Industry” – 3rd edition, published by the Institution of Engineering and Technology (IET) UK, March 2013
The Discount Rate – Overview
The life-cycle costs of a project and its feasibility, for a given output, depend on three factors: (i) the investment cost, (ii) the operational costs and (iii) the discount rate utilised. Many planners think that the discount rate is the most important of these three factors. It greatly affects the whole economics of the project and the decision making, particularly in capital-intensive projects like those of the electricity supply industry. The discount rate almost governs the choice of the least-cost solution. It also greatly affects estimation of the net returns from the project (net present value) during the evaluation stage, the project’s feasibility and the decision to proceed with the investment or not. A high discount rate will favour low capital cost with higher operational cost project alternatives. A low discount rate will tend to weigh the decision in favour of the high capital cost and low operational cost alternatives.
In spite of its crucial importance in project evaluation, it is surprising how little effort project evaluators exert to research the proper discount rate needed for their project evaluation. Simultaneously, all the efforts in estimating investment and operational costs are rendered worthless by a wrong deviation in the choice of the discount rates. Many project evaluators usually take a specific discount rate, of their own choice, as appropriate and then try to cover up for its possible inaccuracies by sensitivity analysis. Sometimes, owing to lack of clarity about discount rates, two (or more) discount rates are chosen for evaluation. Often, for government-sponsored projects, the work of the planner is made easier by the authorities fixing the discount rate (sometimes inaccurately).
In many cases, the internal rate of return (IRR) of the project is calculated and if this is considered to be appropriate by the investors (utilising their experience, hindsight and possible available returns and risks of other projects), then a decision is taken to proceed with the investment without having to resort to the detailed calculation of an adequate discount rate. However, such a procedure does not allow the calculation of the net present value of a project, or adequate comparison of different alternatives.
It needs to be explained that there are two discount rates. The first is discount rate for investment (or goods). This is a concept that measures the relative price of goods at different points of time. This is also called the real return on capital, the real return and the opportunity cost of capital. This is what we shall be dealing with below. The second is the discount rate that involves long-term environmental considerations. This measures the relative weight of the economic welfare of different generations over time. This is usually called the ‘pure rate of social time preference’.
Application of the discount rate
The discount rate is the opportunity cost of capital (as a percentage of the value of the capital). The opportunity cost of capital is the return on investments forgone elsewhere by committing capital to the project under consideration. It is also referred to as the marginal productivity of capital, i.e. the rate of return that would have been obtained by the last acceptable project. In investment decisions, the opportunity cost of capital is the cut-off rate, below which it is not worthwhile to invest in the project.
The discount rate connotes the entrepreneur’s indifference to the timing of the return. If it is equal to 10 per cent, then the entrepreneur is indifferent to whether he or she receives $1 today or $1.10 a year from today. This indifference is the basis for engineering economics. To serve this purpose, the nominal discount rate should at least be equal to a value which, after tax, would compensate the entrepreneur for the following three objectives: (i) reduction in the purchasing power of money which is brought about by inflation, (ii) provision of a real return and (iii) compensation to the extent of risk undertaken by committing capital to this investment. The value of the nominal discount rate is correspondingly a function of the above three factors: inflation, risk-free real return and the extent of risk in the project. A real discount rate, which ignores inflation, is utilised if the cash flows are presented in the base-year money. When reference is made just to the ‘discount rate’, it is the real discount rate that is meant.
Figure: Sensitivity of nuclear and coal power stations costs to discount rate
To demonstrate the importance of discount rates, the cases for nuclear and coal power station were compared. The results of the evaluation are demonstrated in the Figure above. The figure gives the price per kWh of output and shows how the economics of each alternative changes with the discount rate. At low discount rates less than 7 per cent, the nuclear alternative is cheaper. However, at a discount rate of 9–10 per cent or higher, it is definitely the coal alternative that is in favour, even at high coal prices. Obviously, the discount rate is crucial in such decision making between alternatives.
Investment cost ($million)
Operating costs kWh−1
Fuel cost kWh−1
Note: figures are only indicative and do not represent today’s figures
From the Figure it is clear how, for evaluation purposes, the cost per kWh generated is greatly affected by the discount rate for high capital-intensive investments, like those of a nuclear power station. The cost of 2c kWh−1 more than doubled when the discount rate was increased from 4 per cent to less than 11 per cent. Between these two discount rates, the cost of each kWh from a coal power station, which is less capital intensive but has a much higher operational cost, increased by less than one third.
The Figure demonstrates the important fact of the sensitivity of different types of investment to the choice of the discount rate. It is clear that, because future net benefits are greatly reduced by the higher discount rate, the cost per kWh rapidly rises for capital-intensive nuclear power stations more than it does for the less capital but higher operating cost coal power stations. For low operating cost alternatives, like nuclear, the high net benefits are severely eroded by the high discount rate, while the high front capital investment is compounded by the high discount rate to the base year of commissioning. For the higher operating cost alternative, the net benefits as well as the front investment are smaller, and correspondingly the result is less affected by discounting. The choice of the proper interest rate is crucial in such highly different investment cost alternatives.
In most countries, projects financed by the government use a different discount rate than those used by the private sector investors. Normally, government investments are less risky, because they are mostly in regulated utilities and industries. The discount rate of the private sector investments is influenced not only by risk, but also by returns in the bond market which can change significantly from one period to another. Both discount rates are, however, significantly influenced by availability of capital for investment and the cost of borrowing.
Levelised cost of electricity (LCOE)
This is the method mainly used to compare the cost of base-load electricity production from different generation technologies (nuclear, fossil, renewables).
The DEEC (UK) – Electricity Generation Costs of 2013 defines the levelised cost of electricity (LOCE) is as “the discounted lifetime cost of ownership and use of a generation asset, converted into an equivalent unit of cost of generation in £/MWh. The levelised cost of a particular generation technology is the ratio of the total costs of a generic plant (including both capital and operating costs), to the total amount of electricity expected to be generated over the plant’s lifetime. Both are expressed in net present value terms. This means that future costs and outputs are discounted, when compared to costs and outputs today.
This is sometimes called a life cycle cost (LCC), which emphasises the “cradle to grave” aspect of the definition. The levelised cost estimates do not consider revenue streams available to generators (e.g. from sale of electricity or revenues from other sources), with the exception of heat revenues for CHP plant which are included so that the estimates reflect the cost of electricity generation only.
As the definition of levelised costs relates only to “those costs accruing to the owner/operator of the generation asset, it does not cover wider costs that may in part fall to others, such as the full cost of system balancing and network investment, or air quality impacts”. Levelised cost estimates are highly sensitive to the underlying data and assumptions including those on capital costs, fuel and carbon costs, operating costs, operating profile, load factor and discount rates. This measure makes no assumptions about how particular generating stations would be financed, or the allocation of risk between parties. A Contract for Difference (CfD) stabilises revenues for a particular generating station at a fixed price level known as the ‘strike price’ over a specified term, at a rate of return which reflects contract duration and design, financing costs, and risk allocation between parties.
The levelised cost measure does not explicitly include the financing costs attached to new generating stations. Therefore levelised costs estimates are highly sensitive to the underlying data and assumptions used including those on capital costs, fuel and carbon costs, operating costs, load factor and particularly discount rates. As such it is often more appropriate to consider a range of cost estimates rather than point estimates.
The LCOE for a generating facility is the real time price that would equate the net present value of revenue from the plant’s output with the net present value of the cost of production.
Therefore the LCOE can be calculated through the following equation
(1+r)-t being the discount factor for year “t”, where “r” is the discount rate which is the opportunity cost of capital. The opportunity cost is the return on investments forgone elsewhere by committing capital to the project. If there is carbon pricing or decommissioning costs these should be added to the cost section of the above equation.
The IEA Projected Costs of Generating Electricity (2010 Edition), explains that the notion of levelised costs of electricity (LCOE) is a handy tool for comparing the unit costs of different technologies over their economic life. It would correspond to the cost of an investor assuming the certainty of production costs and the stability of electricity prices. In other words, the discount rate in LCOE calculation reflects the return on capital for an investor in the absence of specific market or technology risks. Given that such specific market and technology risks frequently exist, a gap between the LCOE and true financial costs of an investor operation in real electricity markets with their specific uncertainties is usually verified. For the same reason, LCOE is also closer to the real cost of investment in electricity production in regulated monopoly electricity markets with loan guarantees and regulated process rather than to the real costs of investments in competitive markets with variable prices.
The following figure details the levelised electricity costs for new power plants, excluding subsidies, for year 2020 and 2035 (2010 cent per kWh) as calculated by the U.S. EIA in their Annual Energy Outlook 2012.
Figure: Levelised costs of electricity in the USA for years 2020 and 2035
We have to explain that the generation investment cost is the overnight construction cost plus interest during construction. Overnight costs include owner’s cost, EPC (engineering, procurement and construction) and contingency. In the above analysis we did not include the environmental and social cost of electricity generation (emissions, pollution, etc).