We have seen how power plant technologies generally exhibit a tradeoff between capital cost and operating cost. Some types of power plants, like wind and solar, cost a bit more to build but cost very little to operate. Other types, like natural gas-fired power plants, cost little to build but can be very expensive to operate. The question faced by electric utilities is which type of plant they should build — which has the lowest lifetime cost? A similar question is faced by power generation companies that build power plants and sell the output at whatever price the market will bear — given a choice between two power plant fuels or technologies, which will be more profitable?
In economics classes, this question is often answered by looking at the long run average cost, which is simply the total cost of the plant (capital plus lifetime operating cost) divided by total lifetime output. For a given market price, the plant with the lowest long run average cost would be the optimal one to build.
In the electricity industry, there are two related ways to define this long run average cost:
- We could calculate the average cost of each unit of energy (MWh) that the plant is expected to produce over its lifetime. This long run average cost of energy is called the Levelized Cost of Energy or LCOE.
- We could calculate the average lifetime cost of each unit of capacity (MW) that might be built. This long run average cost of capacity is called the Annual Revenue Requirement or ARR.
In the following sections, we'll describe how to calculate LCOE and ARR, and illustrate how each of these metrics is used to make decisions on power plant investment.
Before we get into the LCOE and ARR, we'll need to define one more variable that describes how much electric energy a power plant produces each year, versus its capacity to produce electric energy. This variable is called the capacity factor.
The capacity factor is defined as the ratio of how much a power plant actually produces in a year to how much it could produce in a year running at full capacity:
The capacity factor is a unitless quantity that ranges between 0 and 1. So it can be viewed as a percentage measure of how frequently a plant operates.
A power plant has a capacity of 500 MW. It produces 100,000 MWh each year. Its capacity factor would be:
A power plant has a capacity of 500 MW and has a capacity factor of 50% (cf = 0.5). How much electric energy does it produce each year?
To answer this question, we start with the capacity factor:
We solve this equation for Q to get: