LCOE: what it is and how the levelised cost of energy is calculated
The LCOE, which stands for Levelized Cost of Energy is one of the main indicators used to analyse and compare the generation costs of different energy technologies. The LCOE expresses how much it costs to produce a unit of electricity over the entire lifetime of a facility, taking into account both the initial costs and the costs associated with its operation.
In the energy sector, and particularly in the development of renewable energy projects, the LCOE enables the investment required to build a plant to be linked to the amount of electricity it is expected to generate over its operational lifetime. The result is usually expressed in monetary units per megawatt-hour, such as €/MWh or $/MWh.
The concept of LCOE is particularly relevant in technologies such as solar photovoltaic and wind power, where capital costs account for a significant proportion of the total costs, whilst variable operating costs are relatively low.
What does LCOE mean?
The LCOE represents the average cost of generating electricity at a facility over a given period. It is calculated by comparing, in present value terms, the costs associated with the project with the amount of electricity expected to be generated over the same period. In simple terms, the LCOE can be calculated using the following formula:
LCOE = discounted total costs / discounted energy generated
The calculation takes into account the time value of money. This means that costs and energy production occurring in different years are not considered directly equivalent, but are discounted using a discount rate. The LCOE can be understood as the cost which, when applied to each unit of electricity produced over a given period, brings the total costs associated with the project into line in present value terms. Therefore, an LCOE of €40/MWh means that, under the assumptions used in the model, the levelised cost of producing electricity over the economic lifetime under consideration is equivalent to €40 for every megawatt-hour generated.
How is the LCOE calculated?
The calculation of the LCOE takes into account various technical, economic and financial variables. The specific methodology may vary depending on the type of project and the assumptions used, but it typically considers capital costs, operation and maintenance costs, energy output, the plant’s useful life and the cost of finance.
- Capital expenditure (CAPEX): this includes the costs associated with the development, construction and commissioning of the facility. In a photovoltaic project, this may include modules, inverters, mounting structures, civil engineering works, grid connection, engineering and construction.
- Operating and maintenance costs (OPEX): these are the costs required to keep the facility operational throughout its useful life, including preventive and corrective maintenance, plant management, insurance and other operating expenses.
- Energy production: this refers to the amount of electricity expected to be generated during the period under review. In renewable energy projects, the estimate depends on factors such as solar or wind resources, availability, system losses, degradation and operating conditions.
- Project lifetime: determines the period over which the costs and electricity generation used in the calculation are spread.
- Discount rate: this allows the time value of money to be factored into the calculation and has a significant impact on the final LCOE result.
- Degradation and availability: with certain technologies, output may decline over time. Taking this trend into account provides a more realistic estimate of the energy generated over the project’s lifetime.
The U.S. Energy Information Administration (EIA) It includes in its LCOE methodology capital costs, fixed and variable operation and maintenance costs and, where applicable, fuel costs, whilst also taking into account the financial assumptions used to annualise the investment. In the case of a solar photovoltaic plant, for example, the absence of fuel costs means that the LCOE is particularly influenced by CAPEX, financial costs, annual output and operation and maintenance costs.
What factors influence the LCOE of a renewable energy plant?
The LCOE of a renewable energy project does not depend solely on the price of the equipment. The final figure is determined by the relationship between the investment required and the amount of electricity the plant generates over its entire lifespan. In a photovoltaic plant, for example, a reduction in the cost of the modules can lower CAPEX and improve the LCOE. However, lower energy output can also increase the levelised cost by spreading the investment over a smaller amount of electricity generated.
Factors that can significantly affect the LCOE include:
- Energy resource: higher solar irradiance or better wind resources can increase annual output and reduce the LCOE.
- Equipment costs: modules, inverters, wind turbines, structures, transformers and other components have a direct impact on the initial investment.
- Financing costs: the cost of capital and the project’s financial structure can significantly affect the LCOE.
- Plant availability: higher availability means that generation capacity can be utilised for longer.
- Degradation: the gradual reduction in the generation capacity of certain pieces of equipment affects cumulative output over the life of the project.
- Operating and maintenance costs: an increase in OPEX raises the levelised cost of the electricity generated.
- Service life: extending the operational period may make it possible to spread certain investment costs over a greater amount of energy generated, although the effect depends on the assumptions used.
- Grid connection: the costs associated with the infrastructure required to connect the project to the electricity grid can have a significant impact on the total cost.
What is the LCOE used for?
The main purpose of the LCOE is to facilitate the comparison of generation costs between different technologies or projects under specific assumptions. It can be used to analyse solar photovoltaic installations, wind farms, hydroelectric power stations, thermal technologies and other electricity generation systems. In the renewable energy sector, the LCOE is commonly used during the planning, economic analysis and comparison of technological alternatives phases. It can also help to assess how variables such as CAPEX, energy output, financing and operating costs affect the cost of generation.
However, the LCOE alone does not represent the full economic value of the electricity generated. A technology may have a low LCOE whilst, at the same time, generating electricity at times or in locations where its value to the electricity system is different. For this reason, the LCOE must be interpreted in conjunction with other variables such as the market price, the hourly generation profile, connection costs, the plant’s capacity to provide system services, and the specific conditions of the project.
The U.S. Energy Information Administration points out specifically that the LCOE is a useful metric for comparing costs, but that, on its own, it does not take into account aspects such as the temporal and locational value of electricity or certain services that a technology can provide to the grid. For this reason, the LCOE should be understood as a metric for generation costs and not as a comprehensive measure of the profitability of an energy project.