The Levelized Cost of Energy (LCOE) has become one of the most widely used metrics in the renewable energy industry. Whether you are developing a solar project, negotiating a Power Purchase Agreement (PPA), or assessing an investment opportunity, the LCOE provides a simple way to estimate the minimum electricity price required for a project to be economically viable.
Its popularity stems from its simplicity. The metric condenses all of the costs associated with building and operating a power plant into a single cost per megawatt-hour (£/MWh), making it easy to compare different projects and technologies.
However, despite its widespread use, the standard LCOE calculation contains two important assumptions that are often overlooked. Unless these assumptions are understood and corrected, the metric can overstate the electricity price required for a project and underestimate the return ultimately received by investors.
This article explains how the LCOE is calculated, why it is such an important tool in renewable energy finance, and how a few simple adjustments can make it far more useful for evaluating solar investments and negotiating long-term PPAs.
What is the Levelized Cost of Energy?
The Levelized Cost of Energy (LCOE) represents the average cost of producing one megawatt-hour (MWh) of electricity over the entire life of a power plant.
In simple terms, it answers a fundamental investment question:
“What electricity price must this project earn, on average, to recover all of its costs while achieving the required investment return?”
The calculation compares two discounted values:
the present value of all development and operating costs throughout the project’s life; and
the present value of all electricity generated over the same period.
The result is expressed as a unit cost (£/MWh or $/MWh). Although the calculation itself is straightforward, it incorporates the time value of money by discounting both costs and energy production using the project’s cost of capital.
Why is the LCOE Important?
The LCOE is much more than an engineering metric. It plays an important role throughout the lifecycle of a renewable energy investment.
1. Assessing Investment Opportunities
Developers and investors routinely compare the project’s LCOE against expected electricity prices. If the forecast merchant electricity price exceeds the LCOE, the project is expected to generate returns above the required cost of capital.
Conversely, if the LCOE exceeds expected market prices, the investment is unlikely to meet the investor’s return requirements without additional revenue support or lower project costs. For this reason, the LCOE is often one of the first metrics calculated when evaluating a new solar development.
2. Negotiating Power Purchase Agreements (PPAs)
The LCOE also provides a useful benchmark when negotiating long-term PPAs. Since the metric represents the minimum electricity price required to recover investment costs and achieve the target return, it becomes a natural starting point during commercial negotiations.
Developers can compare the offered PPA price against the project’s LCOE to determine whether the contract creates sufficient value. Likewise, off-takers can use the metric to understand whether proposed electricity prices are commercially reasonable.
The Two Hidden Assumptions Behind the Standard LCOE
Although the standard LCOE is widely used, it implicitly makes two important assumptions:
future inflation is fully embedded in the result; and
the calculation targets a pre-tax investment return.
Both assumptions can materially affect investment decisions.
Hidden Assumption 1: Inflation
Most LCOE calculations are performed using nominal cash flows. This means that future operating costs are projected including expected inflation and discounted using a nominal cost of capital. As a consequence, the resulting LCOE already includes every future price increase expected over the life of the project.
The published LCOE is often interpreted as the electricity price required today to make the investment attractive. In reality, that value already assumes future inflation increases. For projects selling electricity under an indexed PPA, this effectively assumes the initial electricity price is fixed at a level that already incorporates decades of future inflation.
As a result, the standard LCOE tends to overstate the starting electricity price required today. In practice, an investor may reject a perfectly viable project simply because the minimum price appears higher than it really is.
Hidden Assumption 2: Taxes
The second assumption is less obvious but equally important. The conventional LCOE is designed to recover the project’s pre-tax cost of capital. Investors, however, ultimately earn returns after corporation tax has been paid.
Consequently, using the standard LCOE directly to negotiate a PPA may produce an electricity price that appears sufficient but ultimately delivers a lower return than originally targeted. This difference arises because the standard Weighted Average Cost of Capital (WACC) includes an after-tax cost of debt through the interest tax shield while the required equity return is typically introduced before investor taxes are considered.
Although this approach is appropriate for many corporate finance applications, it is less suitable when the objective is to determine the electricity price required to deliver a specific post-tax return to investors.
How to Correct the LCOE
Fortunately, both limitations can be addressed with relatively simple adjustments.
Correcting for Inflation
To remove future inflation from the calculation:
operating costs should be projected in real terms, excluding future price increases; and
the discount rate should also be converted into real terms by removing expected inflation from the cost of capital.
The resulting real LCOE represents the electricity price required in today’s money. This provides a much more meaningful benchmark when comparing projects against current merchant prices or negotiating PPAs that include inflation indexation.
Correcting for Taxes
When the cost of capital is estimated using the WACC methodology, the discount rate should also be adjusted. Instead of using the conventional post-tax WACC:
the tax shield should be removed from the cost of debt; and
the required equity return should be grossed up using a tax wedge to reflect corporation tax.
The resulting pre-tax real WACC can then be used within the LCOE calculation to determine the electricity price required to deliver the investor’s desired post-tax return. Although this adjustment slightly increases the complexity of the calculation, it produces a far more representative estimate of the minimum electricity price required by the project.
Final Thoughts
The Levelized Cost of Energy remains one of the most powerful metrics available for assessing the economics of renewable energy projects. Its simplicity makes it an excellent tool for comparing technologies, screening investment opportunities and supporting commercial negotiations.
However, the standard calculation should not always be interpreted at face value. Because it embeds future inflation and targets a pre-tax cost of capital, the conventional LCOE can overstate the electricity price required today while understating the return ultimately earned by investors.
By calculating the LCOE using real operating costs, a real cost of capital, and an appropriately adjusted pre-tax WACC, investors obtain a metric that better reflects the underlying economics of the project and provides a stronger foundation for investment decisions and PPA negotiations.
When used correctly, the LCOE becomes much more than a simple cost metric — it becomes a practical decision-making tool that bridges engineering, finance and commercial strategy.
Interested in renewable energy project finance
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