Levelized Cost of Energy
Executive Summary
Key Takeaways
- ✓ LCOE expresses the average discounted cost of generating one unit of electricity over an asset's life, combining capital cost, operating cost, and expected output into a single comparable figure.
- ✓ LCOE is the standard metric for comparing generation cost across technologies and projects on a like-for-like basis, independent of financing structure or contract terms.
- ✓ LCOE is a cost metric, not a revenue or return metric — a project's realized economics also depend on its actual revenue stack, which can sit above or below LCOE depending on contract and market price.
- ✓ Because LCOE discounts cost and output over the full asset life, its result is sensitive to the discount rate used, and comparisons across projects should use a consistent discount rate assumption.
- ✓ LCOE should be cross-checked against a project's actual modelled revenue stack as a sanity check on whether the underlying contract or merchant price assumptions produce a commercially viable outcome.
Definition¶
Levelized cost of energy (LCOE) is the average discounted cost of generating one unit of electricity over an asset's operating life. It combines discounted capital cost, operating cost, and fuel cost (where applicable) with discounted expected output into a single comparable per-unit figure.
Calculation¶
LCOE = Sum of Discounted Lifetime Costs ÷ Sum of Discounted Lifetime Energy Output
(Costs = capital expenditure + discounted fixed and variable operating cost + fuel cost where applicable)
Both the numerator and denominator are discounted to present value over the asset's operating life, which is why LCOE's result is sensitive to the discount rate assumption used — comparisons between projects should hold the discount rate assumption consistent.
Why It Is the Standard Cross-Technology Comparison Metric¶
LCOE reduces a project's entire cost and output profile to a single per-unit figure, independent of each project's specific financing structure or contract terms. This makes it possible to compare generation cost between, for example, a solar project and a wind project, or between projects with entirely different capital structures, on a like-for-like basis that a raw capital cost or total operating cost figure would not permit.
LCOE Is a Cost Metric, Not a Revenue or Return Metric¶
LCOE describes what it costs to generate a unit of electricity — it says nothing directly about what a project is actually paid for that electricity. See Energy Revenue Models for how a project's realized revenue stack, combining contracted, capacity, and merchant components, is built separately and should be cross-checked against LCOE as a sanity check: a revenue stack whose blended realized price sits persistently below LCOE indicates an unsustainable contract structure or overly optimistic price assumption.
Audit Considerations¶
- Confirm the discount rate used in the LCOE calculation is stated and consistent with the rate used elsewhere in the model.
- Confirm both capital and full lifetime operating cost (fixed, variable, and fuel where applicable) are included in the cost numerator, not capital cost alone.
- Confirm LCOE is not presented as, or confused with, the project's actual contracted or merchant realized price.
Common Errors¶
| Error | Description | Risk |
|---|---|---|
| Capital cost only | Operating and fuel cost omitted from the LCOE cost numerator | Understates true generation cost |
| Inconsistent discount rate | Different discount rates used across projects being compared | Misleading cross-project comparison |
| Confused with realized price | LCOE presented as if it were the project's actual contracted or merchant price | Overstates confidence in the project's actual revenue outcome |
Continue Reading¶
Prerequisites¶
- Energy Revenue Models — the parent guide
- Energy Financial Modelling
Related Glossary¶
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Frequently Asked Questions
What is levelized cost of energy (LCOE)?
The average discounted cost of generating one unit of electricity over an asset's operating life, combining discounted capital cost, operating cost, and expected output into a single comparable per-unit figure.
How is LCOE calculated?
LCOE = (Sum of discounted lifetime costs) ÷ (Sum of discounted lifetime energy output), where costs include capital expenditure, fixed and variable operating cost, and fuel cost where applicable, each discounted to present value, divided by discounted expected output over the same period.
Why is LCOE useful for comparing across technologies?
Because it reduces a project's entire cost and output profile to a single per-unit figure, independent of each project's specific financing or contract structure, allowing a like-for-like cost comparison between, for example, a solar project and a wind project, or between projects in different markets.
Is LCOE the same as a project's actual realized price or return?
No — LCOE is a cost metric describing what it costs to generate a unit of electricity, not a revenue or return metric. A project's actual economics depend on its realized revenue stack (contracted, capacity, and merchant components), which can sit above or below LCOE depending on the specific contract and market price achieved.
What discount rate assumption should be used for LCOE?
A rate consistent across the projects being compared, since LCOE's result is sensitive to the discount rate applied to lifetime cost and output — comparing LCOE figures calculated with different discount rate assumptions produces a misleading comparison.
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