Energy economics and project finance: LCOE and PPAs

In short

Energy economics asks whether a power project is worth building: it converts a lump-sum capital cost, a stream of running costs and a stream of electricity units into one comparable number, the levelised cost of energy (LCOE) in ₹/kWh. The power purchase agreement (PPA) is the contract that turns that cost into bankable revenue — in India usually a 25-year, fixed-tariff offtake won in a reverse auction run by SECI, NTPC or a state DISCOM. Together they decide which projects reach financial close, because lenders fund against contracted cash flow and a minimum debt service coverage ratio, not against engineering elegance. Examined in AICTE/CBCS energy-engineering and energy-management courses, in GATE-level "energy economics" questions on discounting, annualised cost and payback, and asked in interviews at developers (Adani Green, Tata Power Renewables, ReNew, NTPC Green, JSW Energy), EPC firms, consultancies (Mercados, Deloitte, KPMG energy practices) and lender/IPP finance teams.

Explained

The time value of money - the base of everything

• A rupee next year is worth less than a rupee today; comparison needs discounting to a common date. Discount factor for year *t* at rate *r* is 1/(1+r)^t.
• NPV (net present value) = present value of inflows − outflows. NPV > 0 at the project's cost of capital means the project creates value; NPV is the primary accept/reject test.
• IRR (internal rate of return) = discount rate at which NPV = 0. Compare project IRR with WACC and equity IRR with the equity holder's hurdle rate (Indian RE developers typically target 12-16% post-tax equity IRR; varies with risk).
• Discount rate used in LCOE is normally the WACC. A real (inflation-free) discount rate must be used with real costs; a nominal rate with nominal, escalating costs - mixing the two is the most common error.
• Capital recovery factor (CRF) converts a present capital sum into an equal annual payment over *n* years - the annuity that repays principal plus interest.
• Payback period (simple and discounted) is a liquidity screen, not a profitability measure: it ignores everything after payback.

Cost structure of an energy project

• Capex / EPC cost: modules or turbines, BOS, inverters/transformers, land, evacuation line, bay at the substation, pre-operative costs, IDC (interest during construction) and contingency. Quoted in ₹ crore/MW or ₹/W.
• Opex: fixed O&M (module cleaning, security, insurance, spares, land lease, transmission charges, SECI/trading margin) plus variable costs; for thermal, fuel dominates.
• Fuel cost is zero for solar/wind/hydro - hence their LCOE is almost entirely a *financing* question, and highly sensitive to interest rates.
• Energy yield: depends on CUF (capacity utilisation factor, used in India for RE: energy generated ÷ (rated capacity × 8,760)) or PLF (plant load factor, for thermal). Indicative annual CUF (AC): utility solar 19-25%, rooftop solar 14-17%, onshore wind 25-35%, coal 55-70%.
• Degradation: solar output falls about 0.5-0.7%/yr (warranty typically ≤0.55%/yr after year 1), so later years yield fewer units and must be discounted *and* de-rated.
• Residual value, decommissioning and repowering enter the final-year cash flow; for solar they are usually small and often ignored in exam problems.
• Capital structure: typical Indian RE project 70-75% debt : 25-30% equity, rupee term loan 15-18 years, floating rate linked to a benchmark; lenders demand minimum DSCR of about 1.20-1.30 and a DSRA (debt service reserve account).

LCOE - meaning, method and limits

• Definition: the constant price per kWh that makes the NPV of all discounted lifetime costs equal to the NPV of discounted revenue - i.e. the break-even tariff at the chosen discount rate.
• Procedure: (1) list year-wise capex, O&M, fuel, tax; (2) list year-wise net generation after degradation and auxiliary consumption; (3) discount both streams at *r*; (4) divide total discounted cost by total discounted energy.
• Short-cut form (level annual costs, flat generation): LCOE = (CRF × Capex + annual O&M) ÷ annual energy. This is what most exam questions want.
• Why energy is discounted too: the denominator is a cost-weighted average; discounting only the costs overstates the value of distant units and understates LCOE.
• Advantages: one number, technology-neutral, good for screening and for comparing like-for-like generators.
• Limitations: ignores *when* the power is produced (no time-of-day value), ignores grid integration, balancing and storage costs, excludes externalities, and is extremely sensitive to the assumed discount rate and CUF. Hence the shift in Indian tenders to FDRE / RTC / peak-supply products, where the correct comparator is LCOS / system cost, not bare LCOE.
• Related measures: LACE (levelised avoided cost of energy), LCOS (levelised cost of storage, ₹/kWh discharged), value-adjusted LCOE.

PPAs - structure and Indian practice

• A PPA is a long-term bilateral contract to sell a defined quantum of electricity at a defined tariff for a defined term, with allocation of every major risk. Standard Indian RE PPA: 25 years, flat (non-escalating) tariff in ₹/kWh, single-part.
• Routes to a PPA in India:
  • *Competitive bidding under section 63 of the Electricity Act, 2003* - an e-reverse auction against Standard Bidding Guidelines; the regulator adopts the discovered tariff rather than determining it.
  • *Tariff determined by the Commission under section 62*, using CERC/SERC norms (capital cost, CUF, O&M, debt-equity 70:30, return on equity) - now used mainly for small, hydro, biomass and where no bid is possible.
  • *Intermediary procurer:* SECI or NTPC signs a PPA with the generator and a back-to-back PSA with DISCOMs, charging a trading margin of about 7 paise/kWh; this converts weak DISCOM credit into a stronger counterparty.
  • *Commercial & industrial open access* (Electricity (Promoting Renewable Energy through Green Energy Open Access) Rules, 2022 - threshold 100 kW), *captive* and group captive (consumer holds ≥26% equity and consumes ≥51% of generation, under the Electricity Rules, 2005) - which avoids cross-subsidy surcharge.
  • *Virtual / synthetic PPA* - a financial contract-for-difference against the exchange price, with no physical delivery.
  • *Merchant sale* on IEX/PXIL (DAM, RTM, GDAM/GTAM, term-ahead) - highest price risk, hardest to finance.
• Key clauses to know: tariff and term; declared CUF with a tolerance band (shortfall below the floor attracts compensation to the buyer, excess generation is bought at a discount or refused); must-run status for RE and compensation for curtailment; deemed generation; change in law (recovers GST/duty changes); force majeure; payment security - letter of credit, payment security fund, tripartite agreement, late-payment surcharge under the Electricity (LPS and Related Matters) Rules, 2022; connectivity and commissioning milestones with liquidated damages; termination payment; lenders' step-in / substitution rights; assignment and change-of-control restrictions.
• Bid-side features: tariff ceiling, bid bond and performance bank guarantee, single-stage two-envelope bids, bucket-filling allocation, greenshoe option.

Financing, taxes and policy levers in India

• Project finance = non-recourse lending against the project's own cash flows, held in an SPV, with a cash-flow waterfall: O&M → statutory dues → interest → principal → DSRA → distribution to equity.
• Credit enhancement: sponsor undertakings, DSRA, hedging of foreign-currency debt, partial guarantees; InvITs and bond refinancing (including green bonds and sovereign green bonds) lower the cost of operating assets.
• WACC falls as a project moves from construction to operation - refinancing an operating asset is itself an LCOE reduction lever.
• Tax and duty levers: accelerated depreciation on renewable energy devices (40% WDV rate, with the 50% first-year restriction for assets used under 180 days); the former section 115BAB concessional 15% rate for new manufacturing companies, which is closed to companies that did not begin manufacturing by 31 March 2024; MAT is 14% and a final tax under the Finance Act 2026; the Income-tax Act, 2025 replaced the 1961 Act from 1 April 2026 and renumbered every provision, so quote the provision by name. Basic customs duty applies on imported solar cells and modules, and ALMM restricts which models may be used in government-linked and net-metered projects. GST has 5%/18%/40% slabs since 22 September 2025, with renewable-energy devices and parts in the 5% slab - confirm the rate for the specific HSN before using it in a bid.
• Other levers: viability gap funding for BESS and for some solar/PM-KUSUM segments, production-linked incentives for module manufacturing, concessional ISTS transmission-charge treatment for solar/wind (now tapered in graded steps by commissioning date - use the current MoP notification), RPO/RCO obligations that create demand, and PM Surya Ghar subsidy for residential rooftop.

Comparing and presenting options

• Compare projects of unequal life by equivalent annual cost (EAC) = NPV of costs × CRF, not by raw NPV.
• Always disclose the assumption set: capex, CUF, life, degradation, O&M, discount rate, tax treatment. Two LCOEs are comparable only if these match.
• Run sensitivity (tornado) and scenario analysis on discount rate, CUF, capex and curtailment; lenders also run a break-even tariff and a minimum-DSCR case.

Key points

• LCOE - constant ₹/kWh at which discounted lifetime costs equal discounted revenue; the break-even tariff.
• Discounting - both costs and generated units are discounted; discounting costs only is wrong.
• CRF - annuity factor i(1+i)ⁿ/[(1+i)ⁿ − 1]; turns capex into an equal annual charge.
• WACC - debt-equity weighted cost of capital, with the tax shield applied to debt only.
• CUF/PLF - energy ÷ (rated capacity × 8,760); the single biggest driver of LCOE after capex.
• Zero fuel cost means RE LCOE is dominated by financing - a 2-point rise in the discount rate can add 10-15% to solar LCOE.
• NPV > 0 at WACC is the accept test; IRR is the rate at which NPV = 0; IRR can mislead with non-conventional cash flows.
• DSCR = cash available for debt service ÷ debt service; Indian lenders want roughly 1.20-1.30 minimum.
• PPA - 25-year flat-tariff offtake; converts merchant price risk into contracted cash flow and makes the project bankable.
• Section 63 bidding gets the tariff *adopted*; section 62 gets it *determined* by the Commission on cost-plus norms.
• Intermediary procurer (SECI/NTPC) improves counterparty credit for about a 7 paise/kWh trading margin.
• Must-run status plus curtailment compensation protect the generator's volume risk.
• Declared CUF band - generating far below the declared floor is a breach with financial consequence.
• Group captive - ≥26% equity and ≥51% consumption exempts the consumer from cross-subsidy surcharge.
• Degradation of 0.5-0.7%/yr reduces lifetime discounted units by about 4% and so raises a ₹2.67/kWh LCOE by roughly 10 paise at a 10% discount rate.
• LCOE ignores time-of-delivery; RTC/FDRE/peak tenders and LCOS are the right tools when storage is involved.
• EAC compares unequal-life alternatives; raw NPV does not.
• Grid parity - LCOE at or below the delivered retail/open-access tariff of the consumer it displaces.

Formulas and examples

Example 1 - LCOE of a 50 MW solar plant (short-cut method). Capex ₹4.0 crore/MW → ₹200 crore; O&M ₹5 lakh/MW/yr → ₹2.50 crore/yr; CUF 21%; life 25 yr; discount rate 10%.

• (1.10)²⁵ = 10.8347 → CRF = 0.10 × 10.8347 / 9.8347 = 0.11017 /yr
• Annualised capex = 200 × 0.11017 = ₹22.03 crore/yr; total annual cost = 22.03 + 2.50 = ₹24.53 crore/yr
• Annual energy = 50 × 8,760 × 0.21 = 91,980 MWh = 91.98 million kWh
• LCOE = ₹24.53 crore / 91.98 million kWh = 245.3 × 10⁶ / 91.98 × 10⁶ = ₹2.67/kWh

Example 2 - sensitivity of the same plant.

Moving the discount rate from 8% to 12% raises LCOE by about 32% with no change in hardware - this is why cheap, long-tenor rupee debt is the main policy lever on solar tariffs.

Example 3 - rooftop solar and grid parity (100 kWp commercial roof). Capex ₹45,000/kWp → ₹45,00,000; O&M ₹30,000/yr; specific yield 1,500 kWh/kWp/yr → 1,50,000 kWh/yr; life 25 yr; r = 9%.

• (1.09)²⁵ = 8.6231 → CRF = 0.09 × 8.6231 / 7.6231 = 0.10181 /yr
• Annualised capex = 45,00,000 × 0.10181 = ₹4,58,127; total = 4,58,127 + 30,000 = ₹4,88,127/yr
• LCOE = 4,88,127 / 1,50,000 = ₹3.25/kWh, against a commercial grid tariff of about ₹8/kWh → clear grid parity.
• Simple payback = 45,00,000 / (1,50,000 × 8 − 30,000) = 45,00,000 / 11,70,000 = 3.85 years.

Example 4 - is a ₹2.70/kWh PPA bankable? (100 MW solar). Capex ₹400 crore (75% debt = ₹300 crore at 9.5% for 15 years, equity ₹100 crore); CUF 24%; O&M ₹5 crore/yr.

• Energy = 100 × 8,760 × 0.24 = 2,10,240 MWh = 210.24 million kWh
• Revenue = 210.24 × 10⁶ × ₹2.70 = ₹56.77 crore/yr; EBITDA = 56.77 − 5.00 = ₹51.77 crore/yr
• Debt annuity: (1.095)¹⁵ = 3.9011 → CRF = 0.095 × 3.9011 / 2.9011 = 0.12775 → debt service = 300 × 0.12775 = ₹38.32 crore/yr
• DSCR = 51.77 / 38.32 = 1.35 → above a 1.20 covenant, so bankable.
• Break-even tariff at DSCR 1.20: required EBITDA = 1.20 × 38.32 = ₹45.99 cr → revenue = ₹50.99 cr → tariff = 509.9 × 10⁶ / 210.24 × 10⁶ = ₹2.43/kWh. Below this the bid fails the lender's test.

Example 5 - NPV, IRR and WACC of the same project (pre-tax, level cash flow).

• WACC with kₑ = 14%, k_d = 9.5%, T = 25.17%: WACC = 0.25 × 14 + 0.75 × 9.5 × 0.7483 = 3.50 + 5.33 = 8.83%; at 30:70 it is 0.30 × 14 + 0.70 × 9.5 × 0.7483 = 9.18%.
• NPV at 10% over 25 years: PVIFA = (1 − 1/10.8347)/0.10 = 9.0770 → NPV = 51.77 × 9.0770 − 400 = 469.9 − 400 = +₹69.9 crore.
• Project IRR: PVIFA required = 400 / 51.77 = 7.727. PVIFA(12%) = 7.843, PVIFA(13%) = 7.330 → interpolating, IRR ≈ 12.2% - comfortably above the 8.8-9.2% WACC.

Ranges are indicative and move with module prices, interest rates and duties; quote the latest discovered tariff from a named SECI/NTPC/state auction when precision matters.

Where it is used

• IPPs and developers (Adani Green, ReNew, Tata Power Renewables, NTPC Green, JSW, Juniper) - bid models that convert capex, CUF and debt terms into the lowest DSCR-compliant tariff for a reverse auction.
• Lenders and investors - PFC, REC, IREDA, SBI, NIIF and infrastructure funds size debt from DSCR and run sensitivity cases; InvITs and green bonds refinance operating assets.
• Regulators and utilities - CERC and SERCs determine section 62 tariffs and adopt section 63 tariffs; DISCOMs compare bid tariffs against their average power purchase cost.
• C&I energy managers - choosing between open access, group captive, rooftop and grid supply on landed ₹/kWh, and signing 10-25 year PPAs; relevant to BEE-certified Energy Manager/Auditor work.
• Consulting and EPC roles - techno-commercial feasibility reports (DPRs), bid support, lender's independent engineer, and PPA/contract negotiation.
• Storage and green hydrogen business cases - LCOS and levelised cost of hydrogen use exactly this machinery, with electricity price as the main input.

Interview questions

• Q: Define LCOE in one sentence. A: The constant price per kWh that makes the present value of a project's lifetime costs equal to the present value of its revenue at a chosen discount rate.
• Q: Why is generation discounted in the LCOE denominator? A: Because LCOE is a ratio of present values; units produced 20 years out support less of today's investment, so they must be weighted the same way as costs.
• Q: Which single assumption moves solar LCOE the most? A: The discount rate, since solar has no fuel cost and is almost entirely capital-recovery - followed by CUF and capex.
• Q: Difference between section 62 and section 63 of the Electricity Act, 2003? A: Under section 62 the Commission determines the tariff on cost-plus norms; under section 63 it adopts a tariff discovered through competitive bidding under the standard guidelines.
• Q: What DSCR do lenders look for and why? A: Roughly 1.20-1.30 minimum, so that cash flow can absorb generation shortfalls, delayed DISCOM payments and tariff or cost shocks without default.
• Q: What does an intermediary procurer like SECI add? A: It takes the PPA and signs back-to-back PSAs with DISCOMs, substituting its own stronger credit for about a 7 paise/kWh trading margin, which lowers the developer's cost of capital.
• Q: What happens if a plant generates below its declared CUF? A: The PPA's CUF band is breached and the generator pays compensation to the procurer on the shortfall; persistent shortfall can trigger default remedies.
• Q: Why can a project with the lowest LCOE still be the wrong choice? A: LCOE ignores when power is delivered and the balancing, storage and transmission costs it imposes - a peak or round-the-clock product may be cheaper at system level.
• Q: NPV or IRR - which do you trust? A: NPV at the correct WACC, because IRR assumes reinvestment at itself, can be multiple or undefined for non-conventional cash flows, and is blind to project scale.
• Q: How do you compare a 25-year solar plant with a 10-year diesel option? A: Convert each NPV of cost into an equivalent annual cost using the CRF for its own life, then compare the annual figures.
• Q: What is a virtual PPA? A: A financial contract-for-difference settling the gap between a fixed strike price and the exchange price, with no physical delivery - used for RE attribution without open-access logistics.
• Q: Name three risks a PPA allocates and to whom. A: Volume/curtailment risk to the procurer via must-run status and curtailment compensation; tax and duty changes to the procurer via change in law; construction delay to the developer via liquidated damages and bank guarantees.

Common mistakes

• Mixing a real discount rate with nominal escalating costs, or applying inflation twice.
• Using CRF for the wrong life or the wrong rate - and forgetting that the debt tenor (say 15 years) is shorter than the asset life (25 years), which is why DSCR, not LCOE, decides the floor bid.
• Dividing total undiscounted cost by total undiscounted units and calling it LCOE.
• Taking DC capacity for AC capacity in CUF, or using 8,000 instead of 8,760 hours.
• Ignoring degradation, auxiliary consumption and transmission losses, so the energy denominator is overstated.
• Applying the tax shield to the cost of equity in WACC, or using the headline corporate rate instead of the effective rate.
• Comparing a bare solar LCOE with a dispatchable thermal tariff without adding storage or balancing cost.
• Quoting an obsolete duty, GST rate or ISTS-waiver level in a bid model instead of checking the current notification.

Related topics

Renewable energy policy in India: MNRE, net metering and RPO · Energy audit and conservation · Energy efficiency in buildings and industry: ECSBC and the PAT scheme · Solar PV system design and yield estimation · Energy storage systems and BESS economics · Power system economics, load dispatch and electricity markets