Biases in the LCOE methodology

It is, perhaps, useful to discuss some of the hidden biases in the calculation of LCOE even if it is not always possible to accurately quantify them.

One fixed discount rate

The calculations presented here assume that one discount rate applies for all time and to all forms of generation. But Eq. 5.1 indicates that the discount rate depends upon p, the coefficient of relative risk aversion, which expresses the commercial risk of a venture compared to a safe investment. It seems likely that, to a potential investor, a mature, widely deployed developed technology such as CCGT will be preferred to one that is only part developed such as coal+CC. Also, a proposal that requires heavy funding might not be as favoured as one that does not — simply because of the added difficulty of accumulating a large fund. Finally, our investor may be swayed by ‘policy risk’: the possibility that, though one form of generation may now be encouraged by government, this preference may not endure. For these and other reasons it has been suggested15 that investment in nuclear power may incur a 3-5% premium in financing costs over other technologies. A recent report for the UK Committee on Climate Change goes further, arguing that discount rates may also be skewed against high-risk projects and supports this with data gathered,16 which from investment firms in the City of London (columns 2 and 3 of Table 5.4). The report focuses on low-carbon technologies and therefore provides no values for coal-fired generation without carbon capture. For this technology, therefore, we adopt the values for CCGT but raise the numbers by 2% to account for additional policy risk. We then calculate the corresponding LCOE values and compare them with the values presented previously in Table 5.3.

Table 5.4 Estimated discount rates (see text) and corresponding LCOE values for the five technologies considered here shown alongside LCOE at 7.5% discount rate. All other parameters (including carbon at $50 per tonne) are as Table 5.3

Discount rate %

LCOE $/MWh(e)

Low

High

Low

High

7.5%

CCGT

6

9

90.9

95.3

93.0

Wind

7

10

125.4

156.9

130.4

Coal

8

11

120.8

136.7

118.4

Nuclear

9

13

108.6

164.3

91.5

Coal + CC

12

17

161.2

221.4

118.3

Such an approach clearly has the potential to completely upset any rankings derived for a constant discount factor. With the exception of CCGT, all the average discount rates are higher than the 7.5% adopted in this study. This is consistent with the idea that private investors will generally apply higher discount rates to investments seen as large and commercially ‘risky’. As a result we see that, at the most disadvantageous rates, the LCOE values for nuclear and coal+CC are increased by 75% and 88% respectively.

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