RJIC, an alternative to the LCOE
- Oct 20, 2020 12:52 pm GMT
The "Levelized Cost of Energy" or "LCOE" is a metric widely used by energy analysts to assess the commercial viability of a power plant. Like any good metric the LCOE summarizes a lot of information into one simple number -- that number is the price that the plant needs to capture to hit its target return.
But the LCOE has its flaws, and these flaws are especially apparent when viewing projects through the lens of an investor. It's time to develop other metrics. In this short post, I propose the "Return Justified Installation Cost" or "RJIC", which draws inspiration from cost-benefit analysis (specifically the Benefit-Cost Ratio) to succinctly answer the following question: "What's the maximum I can spend on this plant and still hit my returns?"
First, a brief review of LCOE's flaws:
- The LCOE doesn't really tell me if a plant is economically viable. The LCOE gives me the price the plant needs to capture in the market (or from a customer) to be economically viable. I still need to have a forecast of market prices for the particular service(s) the plant offers (which is arguably the hardest part of the analysis).
- You can only compare LCOEs of plants that do exactly the same thing, and most plants don't. The power price changes drastically throughout the day, month, and year. A plant with a $50/MWh LCOE that can only generate in the middle of the night and other "off-peak" hours is vastly less valuable than one that can run whenever you want it to, all things equal. Comparing the two doesn't make sense.
Enter the RJIC.
The RJIC answers the question: "What is the maximum I can spend to install this plant and still hit my returns?". So it's kind of like an LCOE, but focusing on installation costs instead of the power price. I did this to solve the two issues of the LCOE described above:
- I can instantly tell if the plant is economic. I can compare the RJIC to the installation costs of the plant, which I can find objectively by getting vendor quotes or reviewing third-party literature. If the RJIC is higher or equal to the install costs of the plant and I believe the assumptions used to develop the RJIC, I build the plant.
- I can compare different plant options by subtracting the installation costs of the plant from it's RJIC and normalizing for size (say, $/kW).
Practically speaking, the RJIC is calculated by taking the Net Present Value (NPV) of all of the value streams a plant produces (energy revenues, capacity revenues, ancillary services, customer revenues, etc.) and subtracting off the NPV of all the running costs (fuel costs, charging costs, O&M, etc.). You use your hurdle rate to calculate the NPV.
Calculating the RJIC can also produce some interesting graphs that give insight into the reasons why certain plants are economic despite very different characteristics.
Let's use two examples to illustrate this point. First, let's look at the RJIC calculation for a front of the meter utility-scale solar plant, as shown below.
The left most box is the build up of the components of RJIC.
- On the benefit side (above the x axis), we have an off-take agreement on energy priced at $35/MWh. The 10 MW plant generates roughly 17.5 GWh/year, running only about 20% of the time. We also have the tax benefits of the Investment Tax Credit (ITC).
- On the cost side (below the x axis), we have fixed operations & maintenance (O&M) cost of $10/kW per year, and nothing else because the plant burns no fuel and has no variable O&M, one of the key benefits of a solar plant.
Taking the NPV@5% of these benefits and costs and netting them yields an RJIC of $1,125/kW, which is the green middle box. Since the RJIC is higher than the installation cost of the plant ($1000/kW, the right-most box), the plant's costs are justified and we should build it.
This framework can be applied to any type of plant. Below we show a similar analysis for an open cycle gas turbine (OCGT) -- a dispatchable peaker. The picture is quite different, but the analysis is the same.
Again, the left most box is the build up of the components of RJIC, which are more involved for the OCGT than for the solar plant.
- On the benefit side, we make much more on energy as the OCGT is able to run only when prices are higher. The OCGT also captures capacity and ancillary service revenue because of its dispatchability.
- On the cost side, we have higher fixed O&M ($30/kW per year) and also the costs of fuel and variable O&M to net off.
Taking the NPV@9% of these benefits and costs and netting them yields an RJIC of $1,100/kW, which is the green middle box. Since the RJIC is higher than the installation cost of the plant ($1000/kW, the right-most box), the plant's costs are justified and should be built.
As an investor, the RJIC offers the answers I need over the LCOE. It also offers an interesting way to visually examine the benefits and costs of the plant. This metric can be applied outside power to any other capital project.
Please let me know if you agree, have any questions, or have any improvements on the methodology.
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