Levelised cost of energy (“LCOE”) provides greater accuracy when appraising energy projects than current methods. LCOE is expressed in cents per kilowatt hour (kWh), and takes into account not only the capital cost of building a project, but also the operating and maintenance expenses incurred (such as the length of a power purchase agreement).  As it doesn’t include the profit a plant owner desires, LCOE is often not adapted by buy or sell side stakeholders now that analysis often reflects projects with bearish returns. 

The banks and project financiers who apply LCOE to their models typically hire consulting firms to generate LCOE analyses in order to help them make investment decisions.  Some large developers such as Siemens and General Electric, they have internal teams performing the service internally.  LCOE analysis is not only valuable for developers and bankers; it is also useful for policy makers, with particular regards to industries reliant on government incentives, like solar energy.

LCOE models provide greater insight and analysis when evaluating energy projects with different operating characteristics.  Typically, LCOE’s are calculated using a 20 - 40 year life, and are issued in units of kWh or MWh.

There are several ways of calculating LCOE.  The most common ways are the Simplified LCOE (“sLCOE”) Approach and the Financial Model Approach (“FMA”).  The sLCOE is the minimum price at which energy must be sold for an energy project to break even; i.e. NPV is equal to $0.

The formula for sLCOE is:

sLCOE = [(capital cost * CRF)+ fixed O&M cost]/ (8.76 * capacity factor) + (variable O&M cost * output )

Where using a discount rate i,, the capital recovery factor (“CRF”) is:

CRF = [ i*(1+i)^n] / [(1+i)^n -1] and the discount rate, i, is typically based on WACC or market interest rates which will vary depending on the entity.

On the other hand, the Financial Model Approach (“FMA”) captures more complex financial assumptions, such as revenue requirements and the impacts of tax and depreciation.   The FMA calculates the required revenue to achieve a certain internal rate of return.

LCOE can be defined in multiple ways; Real LCOE, Real LCOE (inflation adjusted), and Nominal LCOE.

Real LCOE is defined as a constant stream of values denoted in today’s currency, Real LCOE (inflation adjusted) is defined as a nominal path that maintains a constant Real value, and Nominal LCOE is defined as constant stream of values in nominal currency.  Different industries and businesses tend to use differing LCOEs for their analysis.

For example, Real LCOE is preferred by Governments and Policy makers  such as Germany, Japan, US Department of Energy and US Department of Commerce, since Real LCOE uses real discount rates to remove the inflation effects associated with fuel and O&M costs.  However, developers and project owners would prefer to use Nominal LCOE as it incorporates assumptions regarding inflation and the use of Nominal Discount Rate may be analogous to a PPA/FIT price that is constant each year or flat across the economic life of the project.  Therefore, it is very important to hire an independent valuation firm to use proper methodology for calculating, analyzing, and valuing LCOE.