Incentives and subsidies, if structured correctly, should act to make the technologies that qualify for those subsidies more competitive (compared to technologies that do not qualify). One mechanism that we can use to measure how this works, and whether the subsidy or incentive is likely to be effective, is by looking at how the incentive measure affects the levelized cost of energy (LCOE) for different projects.
Incentives and subsidies can affect the LCOE in one of two basic ways: they can reduce the LCOE directly through tax credits or feed-in tariff type structures, or they can reduce the WACC faced by the project developer (i.e., through loan guarantees or low/zero-interest loans).
The production tax credit (PTC) is one of the most well-known incentive programs for renewable energy in the United States. The structure of the PTC has changed over time, but it currently provides a tax credit equal to $22 per MWh for each MWh of electricity generated by a qualifying wind facility. The PTC does not actually extend over the entire life of the wind facility but, for the purposes of this example, we'll ignore that detail.
Suppose that we had a single 1 MW wind turbine that cost $1,200 per kW (or $1.2 million total) to construct. The wind turbine produces 3,000 MWh of electricity each year and the developer faces a WACC of 15% per year. The operations cost for the wind turbine is $5 per MWh. The lifetime of the project is assumed to be ten years. Remember our formula for the LCOE:
Here the LVC is $5/MWh. Looking back to the formula from Lesson 9, verify for yourself that the LFC for our hypothetical wind turbine is $79.70 per MWh, so the LCOE is $79.70 + $5 = $84.70 per MWh.
Recall that the way the production tax credit works is that it acts like a rebate to the owner of the project receiving the credit, for each MWh of electricity generated (note that not all tax credits work like this - some tax credits are based on capacity or on the amount invested). That rebate is functionally like a discount on the LCOE. So, to incorporate the impact of the PTC, we just subtract it from the LCOE. Thus, the impact of the PTC on our hypothetical wind turbine is:
Recall from the introduction to the lesson that there is some equivalence, in terms of encouraging low-carbon energy resources, between providing subsidies or incentives for those resources and imposing a tax or a price on emissions from polluting resources. You can see how this might work using the LCOE equation. If we were to take a hypothetical 1 MW coal plant with a capital cost of $2,000 and a marginal operations cost of $20 per MWh, assuming that the coal plant produced 7,000 MWh each year under the same financial terms (WACC and time horizon) as the wind plant, you would get the LCOE for that power plant to be $76.93 per MWh (try it yourself). Without any taxes, subsidies or incentives the coal plant would look cheaper than the wind plant. But with the PTC, the LCOE for the wind plant would fall below that of the coal plant.
Now, let's see what happens if we were to impose a carbon tax of $10 per MWh on the coal plant (one MWh of coal-fired electricity has about one tonne of embedded CO2, so a tax of $10 per MWh is roughly equivalent to a carbon tax of $10 per tonne of CO2). The carbon tax is just a variable cost of operation, so it increases the LVC for the coal plant from $20 per MWh to $30 per MWh. The LCOE rises by $10 per MWH to $86.93 per MWh. With the carbon tax, the coal plant now looks to be more expensive than the wind plant without the PTC. (The wind plant looks a lot better if it happened to get the PTC at the same time that the coal plant was being taxed for its carbon emissions.)
Next, we'll take a look at the impact that a loan guarantee or low-interest loan might have on the LCOE for our hypothetical wind project. Suppose that we got to our 15% WACC for the wind plant through the following calculation: the wind plant is financed 50% by debt and equity, with costs of 15% and 20%, respectively. If the tax rate is 35%, then we would get a WACC of approximately 15% (try it yourself).
Now, suppose that the wind project is able to obtain a loan guarantee that lowers its cost of debt to 3% (assume for the purposes of this example that the share of debt and equity financing stays constant). This would lower the WACC to 11.2% and would lower the LCOE to $73.49 (again, you should try these calculations yourself). In this case, comparing the impact of the loan guarantee to the impact of the PTC, we can see that the PTC is more advantageous (i.e., it yields a greater reduction in LCOE).