Apples to Oranges

Investment Note #18 - 6th September 2024

Apples to Oranges

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Synopsis

• The importance of successfully delivering on the energy transition cannot be overstated. However, one of the main challenges is that it is incredibly complex; but the discussion is focused on simplifying complex topics into soundbites or concise rules of thumb. This approach benefits no one.

• For this reason, we expect it is a topic we will revisit, and indeed, in Investment Note #14, we highlighted the impact of the AI boom on electricity demand.

• In this Investment Note, we want to delve into the somewhat obscure but essential area of the levelised cost of electricity (LCOE).

What is LCOE?

• LCOE is a construct of the financial services firm Lazard. In their words, it creates 'an apples-to-apples' comparison of the cost of electricity generation across all methods. One of its primary uses is to evaluate power-generating projects in advance to determine whether they should proceed.

• To calculate LCOE, Lazard calculates the proposed power generation plant's expected lifetime electricity generation and compares it to the costs of building and maintaining the facility. It accounts for factors such as generation/output, upfront capital costs, fuel costs, operating and maintenance expenses, asset lifetimes, etc.

• While Lazard acknowledges its calculations have limitations, this has yet to cause them sufficient concern to stop its annual publication. Furthermore, once published, it is available for potential misuse (either knowingly or inadvertently) by market commentators.

'Wind and Solar are the Cheapest Forms of Electricity'

• The above is a reasonably non-controversial statement that most people will likely agree with. Additionally, if it were supplemented by referencing that these renewable energy sources have become increasingly cheaper in recent years, it would still be a consensus statement.

• Indeed, numerous reputable sources in the mainstream media would support this statement. For example, in August 2023, the New York Times, in an article titled 'The Clean Energy Future is Arriving Faster Than You Think,' stated that "since 2009, the cost of solar power has plunged by 83 per cent, while the cost of producing wind power has fallen by more than half." The article sourced Lazard's LCOE.

• However, as financial professionals, we are fully aware of the importance of understanding the assumptions underpinning any analysis. So, let's look at some of the limitations of LCOE because getting the energy transition right is too important to avoid getting into the details.

LCOE Ignores Intermittency

• The purpose of an electricity system is not to generate electricity but to supply a specified amount of electricity to a particular place at a specific time. One of the most important limitations of LCOE is that it does not control for time effects associated with matching electricity production to demand.

• Intermittency is embedded in wind and solar electricity generation, as the wind doesn't always blow and the sun doesn't always shine. But LCOE ignores intermittency as it assigns no time value to electricity. It assumes that electricity is needed when it is produced and takes no account of the baseload requirements.

• When intermittent energy sources such as wind and solar make up a small proportion of a country's energy supply, the impact of their availability / non-availability is less obvious. However, as national grids become more dependent on wind and solar, their fluctuating availability starts to significantly impact the grid.

• In these situations, one solution is 'natural gas peaker power plants' that only run when needed to fill the gap and accommodate such fluctuations. The cost of these peaker plants is ignored by LCOE calculations and is not incorporated into the cost of intermittent renewable energy sources. But there is a cost, and ultimately, it needs to be understood and accounted for.

• The concept of intermittency is related to correlation. In essence, this captures the fact that wind turbines in the same area will all spin/not spin in unison, creating gluts and shortages of electricity. If, for example, wind energy was intermittent but uncorrelated, it would make incorporating it into the national grid a lot easier.

Stick It in the Bank

• For some, the solution to intermittency is to create large-scale electricity storage systems that can "bank" excess energy from renewables when it is plentiful so that it can be utilised on the grid when needed. This might be when demand is high or when output from wind or solar is low—for instance, during a low-pressure period in winter.

• A recent Irish Times article states that this will provide cheaper, green electricity to the consumer (Source: ‘Electricity storage policy and 'private wires' regime to speed up renewables delivery’, 5th July 2024).

• However, it is interesting that Lazard’s LCOE does not link the cost of energy storage infrastructure to the cost of generating renewable energy. This approach appears motivated by a desire to lower the stated cost of renewable energy sources.

Connecting the Dots

• Other incremental system costs are associated with transitioning to new sources of energy generation and the step-change in the quantum of electricity generated.

• The cost of this infrastructure has been increasing exponentially. For example, as noted by The Conference Board (a non-profit research organisation) in June 2023, the cost of transformers have increased by more than 400% since 2020, and this is compounded by significant supply shortages.

• LCOE excludes these costs from its calculation.

Has Lazard Seen the Light?

• Interestingly, after 16 years of producing the LCOE analysis, Lazard has started to incorporate a supplemental graph that includes the cost of "firming the intermittency", which adds the cost of providing power when there's not enough wind or sun to meet demand. This cost is either the cost of gas peaker power plants or utility scale energy storage. In this new analysis, the revised LCOE estimates for wind and solar are significantly higher than in the LCOE 1.0 calculations and are at or above the median costs for natural gas plants.

• However, as this new analysis is not incorporated into Lazard's base case figures, many commentators will likely miss the detail.

Summary

• While most people understand the necessity of successfully delivering on the energy transition, many commentators are not willing to acknowledge the cost or complexity involved. The odds of delivering on this truly global challenge, will only be enhanced by increased transparency and honesty about the true costs involved.

• Furthermore, the energy transition will significantly increase the importance of electricity grids globally. Western economies have come to depend entirely on uninterrupted access to electricity, so losing power for just a few days would be catastrophic, especially in crowded urban areas.

• Therefore, in addition to the cost, the energy transition will be a considerable challenge to achieve without reducing grid reliability. For these reasons, the details should not be ignored.