Carrying Charge Analysis for Levelised Cost

A central question in evaluating the economics of solar, wind or mini-hydro power is whether the LCOE of solar power is less than then marginal energy cost. One way to use the LCOE is to compare the LCOE to the cost of energy. This page works through how to compute the carrying charge components of the LCOE. With the carrying charge rate, you can put your own capital cost per kW, operating cost, capacity factor and derive the total LCOE.  For example, if the renewable LCOE is less the cost marginal cost of energy, then consumer bills will be reduced from using more solar power.  The LCOE in turn is driven by the carrying charge rate as these technologies are very capital intensive (much more capital intensive than a refinery).

This page addresses LCOE — the levelised cost of energy and the associated carrying charge rates. LCOE and carrying charge rates are evaluated with through demonstrating how to find data, how to measure and put together all of the factors that drive the carrying charge, and how to use carrying charge rates in economic analysis. For the electricity industry and other capital intensive industries different investment alternatives that have alternative operating lives, capital costs, variable costs, fixed costs and risks the LCOE can be an effective way effectively summarise different alternatives.

More importantly, establishing carrying charge rates can make the analysis of different alternatives much more effective. The first lesson below walks through different components of the carrying charge that include evaluating project life, inflation, income taxes, deferred taxes, replacement capital costs, debt financing and maintaining a constant capital structure. The carrying charge converts a one-time cost (sometimes referred to as overnight cost) into an annual cost. In addition to carrying charges, comparing investments must evaluate the fixed and variable costs that for electricity include fuel cost. The second lesson set on this page describes how make various calculations that establish the fixed costs and the variable costs that are combined with the capital cost to establish the overall levelised cost.

Using the Levelised Cost Calculator

I have made two files that evaluate the carrying charge that is the real basis for the carrying charge evaluation. As with many different things I do, after you try it for a few times, you can finally get an analysis that is more transparent and more structured. Often, you just need to get an analysis finished and then after you are finished you can re-do the analysis to make it better. This is what happened to me with the carrying charge analysis. To illustrate how carrying charges work, I use a simple example and gradually work through the more and more complexities including inflation, taxes, tax depreciation, debt financing, degradation, different lives and learning rates.

Using the Carrying Charge Calculator

Carrying Charges.xlsx

This lesson set works through calculation of the carrying charges that are used for computing levelised cost of investment. You may think the carrying charge rate is some kind of esoteric concept that is not useful in your day to day work. If you go through this lesson set you will see that the finance, modelling and economic concepts in carrying charge rate analysis are closely related to both project finance and corporate finance.

The carrying charge is a percentage that converts a one time cost that is sometimes called the overnight cost into a level annual cost. (The level cost should be expressed in real terms (i.e. without inflation in constant currency). The lesson set involves using a single capital investment cost and evaluating each of the factors that drive the the conversion of the capital cost into an amount that must be recovered on an annual basis. You can think of this as the amount of revenues necessary to provide a given return to investors. After completing this lesson set I hope you will understand the following things about carrying charge rates:

  • 1. Overview of why understanding carrying charges is important
  • 2. Definition of Carrying Charge Rates — Annual recovery cost to total cost; EBITDA to gross investment; Amount of annual recovery to carry investment
  • 3. Normal Complications in Computing Carrying Charge Rates — Construction Period, Inflation, Required Return on Equity, Tax Policies, Capital Structure
  • 4. Addition Complications of Carrying Carrying Charge Rate — Replacement Cost, Decommissioning and Deferred Taxes
  • 5. Project Finance versus Traditional Approach to Computing Carrying Charge Rates
  • 6. Necessity to Convert to Real (i.e. constant) Currency – Would Need to Compute Present value of the Inflated Fuel Cost using Nominal Currency
  • 7. Tax Issues with Carrying Charges and the Concept that Recovery of Equity Returns can be Evaluated with the Formula: Recovery = Recovery + Recovery x t/(1-t)
  • 8. Deferred Tax Complications whereby Recovery can be Computed through First Calculating the PV of the Tax Shield and then using this to Compute the Payment
  • 9 Adjusting the Overnight Cost for Construction Periods with Both Inflation and Financing Cost. Note the Financing Cost must Include Equity and Debt
  • 10. Evaluating the Effects of Future Replacement Cost that can Occur at Different Periods
  • 11. Computing the Effects of Debt on the Analysis using a Constant Capital Structure.

There are a series of videos that describe each of the adjustments that you can make to derive the carrying charge. The video begins by describing the simple PMT

Carrying Charges and Economic Depreciation

A big difficulty in computing carrying charges with debt and and equity is keeping the capital structure constant. Debt sculpting, mortgage payments or other forms of project finance debt do not keep the capital structure constant. Instead, for computing the debt repayments and keeping the capital structure the same, you can compute the total capital and then after you compute the total capital associated with the project. The total capital can then be allocated. To compute the total capital, the capital must be based on the cash flows. To do this, I insist that you compute the economic depreciation. This is illustrated in the screenshot below.

The depreciation is backed out. Start by considering a normal simple income statement:

The income is the ROE x the opening balance. Before taxes, this income can be divided by one minus the tax rate.

  • Revenues Less Operating Expense
  • Less Interest
  • Less Taxes
  • Less Depreciation
  • Equals Income

Or, Depreciation = EBITDA – Interest – After-tax Income/(1-Tax Rate)

Or, Depreciation = EBITDA – Interest – ROE * Opening Balance/(1-Tax Rate)

Videos associated with Computing Carrying Charges

There are a series of videos that describe each of the adjustments that you can make to derive the carrying charge. The video begins by describing the simple PMT function that accounts for rate of return on investment and the asset life. Separate videos then move to inflation, tax, depreciation, construction periods, replacement cost and debt. The final video that includes all of the adjustments is explained below. Other videos that walk through each of the financial issues are listed at the bottom of the page. I hope you see how the videos describe many economic and technical aspects of project finance models and to some extent even corporate models. The videos also explain added features of the generic macros that modify colours, links, and sheet structure.

Carrying Charge Introduction
Carrying Charges and Inflation
Taxes in Carrying Charge Rates
Periodic Analysis in Carrying Charges
Completed Carrying Charge Analysis

Files associated Computing Carrying Charges

There are three files associated with this lesson set. The first file is the completed carrying charge analysis that you can use for economic analyses such as the analysis of batteries, solar and diesel. The second file includes all of the components of the carrying charge beginning with the PMT function and ultimately including effects of inflation, taxes, construction timing, replacement and debt. The third file includes exercises that you can work through in order There are a series of videos that describe each of the adjustments that you can make to derive the carrying charge. The video begins by describing the simple PMT function and moves to inflation, tax, depreciation, construction periods, replacement cost and debt.