Many readers will know that we are fans of renewable energy and that we have recently engaged with Abundance Generation to help educate advisers about the opportunity to invested directly into UK based renewable energy projects.

We’re also producing a a supplement to AiR (download your copy for free here) that will take an in-depth look at investing in energy.

Here’s an extract to whet your appetite:

Energy Production: costs, subsidies and investment

It’s actually much more difficult to put a figure on how much it costs to produce energy from a particular source than you might imagine.  The reason for this is that it is difficult to get agreement on what should be included in the calculation.

The cost of input fuels, such as coal or gas, obviously should be included. Likewise, the cost of running the facility. These factors would appear to favour renewables as the cheaper source.  But it is also important to include the cost of developing the facility, connecting it to the grid and financing the development. These factors tend to favour conventional sources of electricity.

It is basically these broad areas mentioned above that are included in most cost-of-production calculations today.

However, we should also be considering including other costs: such as the cost of carbon emissions from conventional fossil fuels, which harm our environment and therefore have a cost to us all.  This line of argument can also be extended to put a figure on the environmental cost of for mining coal or uranium.

We should also include the cost of decommissioning facilities. The cost of decommissioning is relatively cheap for renewable energy facilities, more expensive but at least pretty well understood for conventional power stations, extremely expensive and not well understood at all for nuclear power.

These costs that are not included in the cost of production are known in economists’ language as ‘externalities’.

Finally, we could also factor in the cost of ‘grid balancing’: at any given time electricity production must be balanced to meet (and not exceed) demand. This means that there is an additional cost associated with intermittent sources of energy such as wind and solar as this grid balancing task is carried out. Grid balancing is nothing new and it still required with conventional fuels, but it is yet another consideration when calculating the cost of production.

As if deciding what to include in the cost calculation was not difficult enough, there are some other issues to consider. Do you assume that the price of fossil fuels will increase? That the price of renewable technology will come down? That the price of carbon will go up or down? Furthermore, these assumptions have to be applied and costs estimated over multi-decade time frames. It’s easy to see how this can be a controversial area with widely varying opinions.

Levelised cost of energy (LCOE)

The most common way for trying to resolve this dilemma is to use the ‘Levelised cost of energy’. This is still difficult, uncertain and controversial, but it is a starting point for making comparisons between different sources of energy production. Essentially, the LCOE is the costs of generating electricity over the lifetime of the project, divided by the amount of energy generated, in net present value terms. It is expressed in pence per kWh (p/kWh) or pounds per MWh (£/MWh).

This includes the cost of building the power plant (capital costs), the cost of the funding of that investment (i.e. the rate of return) and the cost of continuous operation (including fuel and maintenance costs). It does not include, unless explicitly stated, the cost of long distance connections to the grid (which can be significant), grid-balancing costs, or (unless explicitly stated) the environmental cost of emissions or decommissioning of nuclear.

Results of a 2011 DECC commissioned report into the cost of energy production in the UK

 (The reports assume a rising price of carbon starting from £14.10 a tonne per CO2e in 2010, to £16.3 a tonne in 2020. It also assumes a 10% discount rate).

Note that the analysis for solar is already considerably out of date. Since the report, costs have fallen dramatically, by 50% from summer 2011 to March 2012. A recent McKinsey report suggests that costs could fall 40% by 2015 and a further 30% by 2020. If nothing else, this is a good example of how forecasting the cost of production is so difficult.

Subsidy

The complexity around establishing the true cost of production is also instructive when it comes to thinking about the level of government subsidy various energy sources receive. For example, if the costs of carbon pollution or nuclear decommissioning are not taken into account, than this is an implicit government subsidy as nobody else will be picking up the tab. There are also more explicit government subsidies for conventional fuels and nuclear. The state is the only institution that will insure nuclear energy providers, which is a huge subsidy. And incentives to the value of well-over £280m go towards the production of oil and gas in the North Sea.

It is also worth remembering that all energy industries received state subsidies in the early years of their development.

Renewable sources of energy are often criticised for relying upon government subsidies, often ultimately paid for by the consumer. Whilst it is true that Feed in Tariffs provide support to the renewable energy industry in the UK, there are some wider considerations that must be examined before any conclusions can be drawn.

Investment

The calculation of the levelised cost of energy also has implications for investment into renewables. As the LCOE is sensitive to the timing of costs incurred during the life of an energy project and renewable energy facilities upfront capital costs are a high proportion of overall costs – this means that a return has to be paid on that initial capital invested for a much longer period and renewable energy projects are much more sensitive to the discount rate used in the model.  The opposite is true for gas fired power stations, which can make them look like much more attractive investments. This is another good reason for the government to use Feed in Tariffs to offer long term price stability to investors.

Summary

When it comes to understanding the cost of energy production and the level of subsidy that different energy sources receive in the UK, there is much more to it than meets the eye initially. As a defensive asset class that promises long term revenue streams, advisers are likely to come across clients who are interested in investing in the sector, either directly or through a collective and therefore it is worth keeping broadly abreast of these subtleties within the energy industry.

If you want more information on Abundance Generation, or to pre-register for a copy of the energy report, please contact us at: enquiry@intelligent-partnership.com

Thanks

Dan