How to calculate the Levelized Cost of Energy (LCOE)?

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The levelized cost of energy (LCOE) is a central key figure in energy projects. To keep it simple, the total costs of a project are divided by the production volume over the entire life cycle of a system.

On the one hand, the LCOE can be used for comparison purposes, e.g. wind energy vs. coal power. On the other hand, the LCOE can be used in project financing as the most accurate estimate possible for the electricity sales price (e.g. in PPA tenders).

LCOE calculation for comparison purposes

LCOE calculations for comparison purposes often use a simplified formula for the calculation, which typically takes into account WACC (weighted average cost of capital) instead of a specific return target and cash flow level without taking into account debt or taxes. This is because the country specifics including the corresponding taxes or the project specifics (leverage ratio) are not known or are not of interest for the purpose of comparison. A corresponding formula can be found, for example, in the study “Fraunhofer ISE – Levelized cost of electricity: Renewable Energy Technologies”.

LCOE calculation for Project Finance

An approximation with WACC only works with constant leverage. This requirement is not met in the world of project financing, as projects usually have a decreasing level of debt over time. In addition, all project specifics must be taken into account in order to calculate the electricity sales price as accurately as possible. Accordingly, the calculation of the LCOE in greenmatch includes all cost items, including taxes, debt capital and other details such as current assets, payout restrictions, shareholder loans, etc., as these are also available in detail if the user records them accordingly.

The LCOE in greenmatch is calculated using the following formula:

The numerator (sales – cash flow to equity) includes all cost items of the project, consisting of operating costs, taxes, investments and transaction costs, debt capital and reserves. These costs are discounted using the discount rate (hurdle rate). The denominator includes production over the entire project period, also discounted using the discount rate.

In greenmatch, not only the entire LCOE but also each individual cost item is listed. This means the user can understand which costs are caused by which category. This makes it possible to deduct individual categories such as taxes and thus carry out LCOE calculations analogous to the formula for comparison purposes shown this above.

Summary and differences between the approaches

Application area

In summary, while generalised formulas like the one used by the Fraunhofer Institute for LCOE calculation provide a useful baseline for comparing the costs of different energy technologies, financial models of project financings require a more detailed and project-specific approach.

Discount rate

For comparison purposes in studies, WACC is used as a simplified discount rate. In project finance, a project-specific discount rate should be used because leverage is changing over the project lifetime. The discount rate should reflect the unique risks and financing conditions of the project. These rates could be derived from the project’s cost of debt, adjusted for project risk premiums, and the specific expectations of equity investors.

Included cost categories

For comparison purposes in studies, often debt costs and taxes are not considered. In project finance, all cost positions should be considered. Doing this, the LCOE is the most accurate estimate for the electricity sales price, e.g. in PPA  negotiations or FIT tenders.

Project FinanceStudies
Application areaAccurate estimation of generation costs, for example as a basis for PPA negotiations or FIT tendersComparison of costs between different technologies, for example wind vs. coal
Discount Rateproject-specific discount rateWACC
Cost CategoriesAll cost categories (including debt and taxes, operating costs, investment and transaction costs and reserves)Often without debt and taxes due to lack of availability
Comparison chart for the application of discount rates