The challenges of building gas and wind have left many in the industry turning to a combination of solar and batteries as the answer to the transition. But what is the relative cost of building enough solar and storage capacity to meet power requirements 24 hours a day, 365 days a year, for a reasonable set of conceivable weather years? And how much more does it cost than including wind and gas in the generation mix? Against this backdrop, in this article, we ask: what is the long-run marginal cost of supplying a flat load for various allowable sets of technologies?
The concept of Long Run Marginal Cost
Marginal cost refers to the additional expense incurred to produce one extra unit of output. Marginal cost is a critical concept in microeconomics and economic regulation. Importantly:
Marginal costs look to the future, not to the past: it is only future costs for which additional production can be causally responsible; it is only future costs that can be saved if that production is not undertaken.
-Alfred Kahn
There are both short run and long run notions of marginal cost. The distinction is whether all factors of production are fixed or can be varied, ie:
- the short run marginal cost is the cost incurred to produce one extra unit of output, holding at least one factor of production constant; and
- the long run marginal cost is the cost to produce one extra unit of output assuming all factors of production can be varied.
We will focus on long run marginal cost (hereafter ‘LRMC’). There are many ways to estimate LRMC, but for the purposes of this discussion we will use a standalone or greenfields method. This roughly assumes the cost to rebuild the whole system from scratch. LRMC is therefore equal to the average system cost were we to rebuild the whole system from nothing.
The key word to consider here is average. The art of estimating LRMC lies in what we average over. Do we consider a single day, a single month, a single weather reference year? Or do we average over all possible outcomes? The challenge is that there can be significant differences between the costs of supplying a megawatt-hour of energy depending on when that megawatt-hour is consumed.
For the purposes of this discussion, we consider a broad possible set of megawatt-hours, ie, how much it costs to supply one megawatt hour, when that megawatt-hour could have been consumed in any of the last 13 years. This is effectively saying that the cost of building a resilient system is the cost to supply energy under any weather conditions that have prevailed in recent memory.
LRMC versus levelised cost of electricity
It is critical to understand the difference between LRMC and the levelised cost of electricity (LCOE). Before the advent of renewables, LCOE was a helpful way of comparing technologies like coal and gas, whose output closely matched the profile of demand. But when the profile of generation from technologies varies greatly over time – as is the case with renewables – this simplistic measure ceases to be relevant. Indeed, LCOE provides highly misleading estimates of cost because it does not capture the time-dependent nature of generation costs, ie, that there are some times of the day or year that are significantly harder to supply.
Consider the profile of a solar plant. This profile is drastically different to the profile of system demand, wind output, or simply a flat load. LCOE is the average cost of generation, not the average cost of supplying load. It tells us the cost of generating some profile of output, not the cost of meeting demand. This is a critical difference, because it means that LCOE is now of virtually no benefit in understanding the costs that consumers face.
So what is the LRMC of a unit of energy?
We start by considering the LRMC when all technologies are available. For explanatory purposes, we have calculated the LRMC on the basis of supplying 1 GW of flat load. Figure 1 below shows the generation mix that our optimisation model yields: 1.5 GW of wind, 1.3 GW of solar, 0.3 GW of 8-hour batteries, and 0.8 GW of gas. The total cost – and so the LRMC – of the generation is $122/MWh (the sum of the system costs shown on the graph, dividing by the load served over the year).
Figure 1 – 4 GW of capacity are required to meet 1 GW of load at least cost
Optimal generation mix to supply 1 GW of flat load, NSW, median weather year
But what if we limit the set of allowable technologies. Figure 2 shows the generation mix and the change in cost (on a dollars per megawatt-hour basis) from removing wind, gas, and both wind and gas from the system.
Figure 2 – As we remove technologies from the mix, LRMC rises massively
Optimal generation mix to supply 1 GW of flat load and related sensitivities, NSW, median weather year; attendant LRMC shown in bottom panel
We note the following:
- In the absence of wind, the LRMC rises from $122 per MWh to $146 per MWh.
- If we remove gas from the equation, the LRMC rises from $122 per MWh to $230 per MWh.
- A system that relies solely on solar and batteries will have a cost of $371 per MWh, ie, $3.2 billion for a single year.
What happens when we change the weather reference year?
An important input assumption is the weather reference year, ie, the assumed temperature, wind and solar irradiance profiles that underpin the modelling. Figure 3 shows the same analysis as Figure 2, but for 13 weather reference years. The difference between the median and the extreme outcomes can be substantial and speaks to the resilience of the system.
Figure 3 – The cost of a new system depends on the assumed weather
Optimal generation mix to supply 1 GW of flat load for 13 reference years versus attendant LRMC, NSW.
What does this mean?
I draw four conclusions from this analysis:
- First, running a reliable, high penetration renewable system without gas is virtually impossible. If we really believe in the need for renewables, we must work out a solution for the supply of gas and gas-powered generation as well.
- Second, in the absence of wind, the cost of the system is substantially higher, particularly when we consider the outcomes across different weather years. If we want to reduce costs for consumers, we need to work out a way of getting wind into the system, and that will require not just investment in wind but also transmission.
- Third, building a system that is resilient to all weather conditions will be markedly more expensive than one that is reliable ‘on average’, unless we have access to all available technologies.
- Finally, even in the world where we consider all possible technologies, the LRMC is markedly higher than many of projections that we see across the market. We need to level with consumers that wholesale prices will have to be higher than historical levels to make investments whole.
The narrative that we can complete the transition with solar and batteries, ensure a reliable system, and keep prices low is fundamentally at odds with the facts. Instead, we need to focus on unlocking constraints on technologies that can limit price increases and building a resilient system that can ensure reliable supply not just on average but at the extremes. If we continue to perpetuate the myth that solar and batteries can do everything, we will be left with a brittle, unreliable, and expensive system that does not meet consumers’ needs. Ultimately, this will hinder rather than help the transition.