Introduction
Every solar investment ultimately depends on one question:
Will future prices be high enough to justify building the project today?
Developers can usually estimate a project’s construction cost with reasonable confidence. Energy production can be forecast using decades of irradiation data, while operating costs are generally well understood through long-term land leases, equipment warranties and operation and maintenance (O&M) contracts.
Investors also know the return they require to compensate for the risks associated with developing and operating a solar plant.
The remaining uncertainty is electricity prices.
Without a view of future electricity prices, it is impossible to forecast project revenues and determine whether an investment is economically viable
This is where the Levelized Cost of Energy (LCOE) becomes one of the most powerful tools available to renewable energy investors.
Rather than predicting future electricity prices, the LCOE answers a different—and often more useful—question:
What electricity price does this project need to earn in order to achieve the target investment return?
By comparing this required price with merchant market forecasts, Power Purchase Agreements (PPAs) or Contract for Difference (CfD) strike prices, investors can quickly determine whether a project is likely to create value.
In this article I explain:
- what the LCOE really measures;
- how investors use it to assess project viability;
- why it is essential when negotiating PPAs and bidding for CfDs;
- why it provides a useful benchmark for long-term electricity price forecasts; and
- how different electricity prices translate into different investment returns
What is the Levelized Cost of Energy?
The Levelized Cost of Energy (LCOE) represents the constant electricity price required for a project to recover all of its development and operating costs while delivering a specified investment return.
Mathematically, it is calculated as:
Present Value of all project costs (CAPEX + OPEX)
divided by
Present Value of all electricity generated
Both costs and energy production are discounted using the project’s required cost of capital to reflect the time value of money.
Although the calculation itself is straightforward, the insight it provides is extremely valuable.
Instead of asking whether projected electricity prices are attractive, the LCOE tells investors the minimum long-term electricity price required to justify the investment.
If you want to learn more about the LCOE calculations, I have full article on this topic
Worked Example – A 30 MW Solar Plant
Consider a utility-scale solar project with the following assumptions.
| Assumption | Value |
|---|---|
| Capacity | 30 MWp |
| Asset life | 30 years |
| Annual energy yield | 1,650 MWh/MWp |
| Annual degradation | 0.4% |
| CAPEX | USD 850 k /MWp |
| Fixed OPEX | USD 15k/MWp/year |
| Inflation | 2.5% |
| Required return (discount rate) | 7% |
Under these assumptions:
- Total lifetime electricity generation exceeds 2,300 GWh.
- The present value of electricity generated is approximately 981 GWh.
- Total project costs amount to approximately USD 76 million over the asset’s life.
- The present value of those costs is approximately USD 54 million.
The resulting LCOE is USD 56/MWh.
| Variable | Unit | Value |
| Produced Energy (NPV) | GHh | 981,226 |
| Total Costs (NPV) | USD million | 54,876 |
| LCOE | USD per MWh | 56 |
Interpreting the Result
The result is surprisingly intuitive.
An LCOE of USD 56/MWh means the project requires an average electricity price of USD 56 per MWh throughout its life to generate the target 7% pre-tax return.
This benchmark immediately allows investors to assess project viability.
- If long-term electricity prices are expected to average above USD 56/MWh, the project should exceed its required return.
- If prices are expected to average below USD 56/MWh, the project is unlikely to satisfy investor expectations.
Rather than building a detailed financial model for every opportunity, developers can use the LCOE as a powerful first screening tool.
A Common Misunderstanding: Real versus Nominal LCOE
One of the most common mistakes when interpreting LCOE is confusing real and nominal electricity prices.
The calculation above assumes a constant electricity price throughout the project’s life.
In reality, many PPAs and long-term electricity forecasts include annual inflation indexation.
Consequently, the flat electricity price produced by a conventional LCOE calculation often overstates the price required today.
In our example:
- A constant electricity price of USD 56/MWh produces the required return.
- The economically equivalent alternative is an initial electricity price of approximately USD 42/MWh, increasing annually with 2.5% inflation.
Understanding this distinction is essential when comparing LCOE results with market forecasts or indexed PPA prices.
Does the Standard LCOE Include Taxes?
Not usually.
Most LCOE calculations are performed on a pre-tax basis, meaning the resulting electricity price is sufficient to achieve a target pre-tax investment return.
For project valuations or investment decisions where taxes materially affect cash flows, investors should either:
- explicitly model taxes within a full discounted cash flow model; or
- adjust the required cost of capital using a pre-tax equivalent discount rate.
Ignoring taxes when comparing projects operating under different tax regimes can lead to misleading conclusions.
Why LCOE Matters When Negotiating PPAs
A Power Purchase Agreement transfers merchant price risk from the generator to the electricity buyer.
In exchange for this revenue certainty, the producer usually accepts a lower electricity price than would be expected in the merchant market.
Across Europe, long-term PPA prices have often been observed at discounts of 10%–30% relative to expected merchant prices, although the exact discount depends on market conditions and price volatility.
Knowing a project’s LCOE allows developers to negotiate from an informed position.
If the agreed PPA price falls below the project’s LCOE, shareholder value is destroyed because the investment fails to achieve its required return.
Conversely, a PPA price comfortably above the LCOE creates additional value for investors.
Exactly the same principle applies when bidding into Contracts for Difference (CfDs).
Without understanding the project’s LCOE, it is impossible to know whether a successful bid is actually profitable.
Why Long-Term Electricity Prices Tend to Follow LCOE
LCOE is not only useful for assessing individual projects—it also provides a valuable benchmark for evaluating long-term electricity price forecasts.
Competitive electricity markets naturally encourage prices to gravitate towards the cost of new generation.
When long-term electricity prices remain well above renewable LCOEs, new investment becomes highly attractive. Additional generating capacity enters the market, increasing supply and placing downward pressure on prices.
The opposite occurs when electricity prices remain below the cost of developing new renewable projects. Investment slows, future supply tightens and electricity prices eventually recover.
Although short-term electricity prices can fluctuate dramatically due to weather conditions, fuel prices or supply disruptions, over the long term they tend to move towards the marginal cost of new generation.
For renewable technologies, the LCOE provides one of the best available estimates of that long-run equilibrium.
Final Thoughts
Every renewable energy investment ultimately depends on one question:
Are future electricity prices high enough to justify today’s investment?
The Levelized Cost of Energy provides a simple yet remarkably powerful framework for answering that question.
Whether assessing development opportunities, negotiating PPAs, bidding into CfD auctions or reviewing long-term electricity price forecasts, understanding a project’s LCOE allows investors to make faster, more informed investment decisions.
While no single metric can replace a comprehensive financial model, few provide such an effective first test of project viability.
Interested in renewable energy project finance
Explore our free LCOE calculator or download the Solar Project Finance Model.
