Energy Basics – Fixed versus Variable Costs

Fixed versus variable costs is a basic business concept. It is also a basic concept in energy engineering. Unfortunately this not stop energy professionals from getting into trouble by misunderstanding it.

In my previous role we had a project looking at the feasibility of a Combined Heat & Power (CHP) plant at a pharmaceuticals site. Previously two consultants had looked at the site and concluded that a 2 MWe gas engine would be an economic project. We expected that good CHP projects would have payback periods of five to six years. These two consultants had modeled a payback below two years!

We took a look at the technical fundamentals (annual profiles of site heat & power demands) and agreed that the site was well suited to a 2 MWe gas engine. However once we took a step further and started to evaluate the economics things started to unravel.

A crucial part of any energy project are prices – for CHP electricity prices in are crucial. To know what price we should model we took a look at twelve months of electricity invoices for the site.

What we wanted to know was the variable electricity price. This price will represent the savings for reducing import electricity to site through use of on site generation.

Table 1 – A simplified electricity invoice

Electricity consumedMWh2,500
Variable electricity price£/MWh65
Variable electricity cost£162,500
Fixed costs£100,000
Total annual cost£262,500
Delivered electricity cost£/MWh105

When we compared our analysis of the electricity invoices to the prices used by the two consultants, we were shocked to find they had used they delivered electricity cost in their model – not the variable cost.

This overstated the value of electricity saved and the value of the CHP project.

To understand why this is a problem think what would happen if we saved all 2,500 MWh of electricity. This would mean we have no variable cost – a saving of £162,500. But even with no electricity consumed we still incur fixed charges.

However if we use a value of £105/MWh, we calculate a saving of £262,500 – which is incorrect!  While this seems obvious when spelt out, two consultants from separate well renowned energy companies made this mistake.

 It was difficult going back to the pharmaceuticals site and telling them their fantastic project was perhaps not so fantastic. But it is far better to understand it now rather than after the engine was installed.

You might be wondering why people calculate a delivered electricity cost at all. It can be useful for understanding the total cost for delivering electricity to a site.

But it is not useful for understanding the savings from projects like CHP or reducing site electricity consumption.

Key lessons to take away are:

  • Always check your customer’s actual invoices. It takes time but it is worth it to build up an accurate picture of what is going on by replicating the invoice from the rates (£/MWh) and amounts (MWh). What you want to arrive at is a total marginal and a total fixed cost.
  • Be aware that not all £/MWh costs are equivalent!  When you are given an electricity price to use in a model be sure that you understand what that price represents.