Almost every week we see in the media news about record prices in both wind and solar auctions. And it is inevitable to associate these levels with generation cost or LCoE. Even in news as in the recent one about the tender in Saudi Arabia won by EDF-Masdar, the offtake price and LCoE are spoken of indistinctly as if they were the same. So, I think it’s time to shed some light on the issue, is the auction price the same as LCoE? But before that, what exactly is LCoE?
Let’s start then with the LCoE, acronym for Levelized Cost of Energy. It is defined as the total cost discounted per unit of energy produced:
Seen the formula above, it seems very complicated, but in reality is to sum all the costs (upfront or CAPEX and operation or OPEX) discounted to the WACC and divide it between the production also discounted to obtain €/MWh.
This is the academic definition, but I like another one: LCoE is the price of energy that equals revenues with expenses, that is, that makes the NPV=0
This second formula also helps to model in Excel a simple calculation of LCoE, since, having the annual production, the CAPEX and OPEX you can look for an energy price (constant for the whole life of the project to simplify) that equals discounted income with discounted expenses. If anyone is encouraged to try, some advice:
– The theory says that the costs have to be discounted with the nominal WACC while the income to the real WACC. To make a simple calculation is better to use only the real WACC, but if someone wants to deepen, here are the formulas
- For the WACC calculation, the key is the cost of the equity (Ke). There are no formulas for that, it will depend on the country, the project, the risk, similar investments, etc…if the project is in a low risk country, 7-8% would be reasonable.
- It is important not to forget the financial costs. If the project is leveraged, you will have to calculate the cost of the debt each year.
- To simplify, a single debt cost can be assumed, although if a finer calculation is to be made, one rate would have to be used during construction and another during operation. Obviously, the construction debt rate will always be higher than the operation one.
Since it is clear to us that the LCoE is the minimum energy price level that offsets all costs (capex, opex, debt, etc.) but does not create any additional value, it seems clear that energy prices should always be higher than the LCoE. In fact, we could intuitively resemble that difference at the promoter’s margin. What seems so clear clashes with recent news: Auction prices in Portugal at 20€/MWh or in Saudi Arabia at 19 $/MWh or in Brazil at 17.3 $/MWh! Can we say then that the wind or solar LCoE is below 20 $/MWh? The answer is no. There are several reasons for this mismatch. Let’s look at some examples
- Auctioning is only a part of total revenues: In both Brazil and Mexico auction prices cover about 50% of energy. Promoters sign such low prices with the expectation of closing higher PPAs afterwards or of the pool offsetting such low prices. This trend is well explained in the GTM article.
- The scope of the auctions: before releasing the headline “New record…” it would be advisable to know the details of the auction in question because the reality is that no two are the same. As an example, in the recent auction in Portugal there were 2 types of auction: one for a kind of connection reserve and another for a PPA. There was news that mixed both, with the consequent confusion. In other cases, there are costs that are covered, so the price level is lower (case of some offshore auctions where the grid connection is provided by the state).
- Singular projects: in cases such as the EDF-Masdar wind project in Saudi Arabia, both the wind resource (>3300 Eq hours) and the financing, as well as the strategy of entering the country’s first project, make the price very low. Probably the LCoE of the project is also very low, but it is not representative. Large solar projects in the Middle East are also potential singular projects.
- Date of connection: this is another key aspect. If the project is planned to be connected in 4-5 years, the promoters will play with the expectation of cost reduction, so the published prices will not be a reflection of the current LCoE but, in any case, of that expected at the time of construction. A clear example is the A-4 auctions in Brazil, where the very low prices for solar already discounted the significant capex reductions expected for solar projects in the next 3 years
- Irresponsibility: all of us who work in this sector should be clear that such low prices are not good as they introduce great risk into the system. This is the case in India where such low prices mean that there are auctions that are cancelled or that projects are not finally made. It is the responsibility of the auction planner to put in place the mechanisms to get the lowest price by ensuring the viability of the project (and the supply chain). There are projects that with these prices it is impossible for them to be profitable, which will mean that they will have many options of never being done. There is an article where a simple analysis is made of one of these projects in the USA and it is concluded that it is not viable.
Ultra-low auction prices are irresistible candy for journalists, but their large media coverage should not confuse us: LCoE’s average levels are by no means in those figures and such low prices are not good news for the renewable sector as they increase risk and reduce (if not completely eliminate) profitability in the value chain.