Published: 15 June 2024
Contributors: Alice Gomstyn, Alexandra Jonker
The levelized cost of energy (LCOE) is a metric for gauging the average cost of electricity generation over the lifetime of an energy asset. LCOE helps determine the viability and competitiveness of an electricity generation project and can also serve as an indicator for heating and cooling projects.
LCOE calculations consider the costs associated with building and operating an energy asset over its lifecycle, including capital, fuel and maintenance costs. Different LCOE models and tools use different variables, and some LCOE formulas are more complex than others. LCOE is also known as the “levelized cost of electricity.”
Energy analysis incorporating LCOE helps companies, developers and investors evaluate the competitiveness of an energy production project. It also allows for the cost comparison of power generation between different types of technology to inform decisions by policymakers and analysts.
LCOE is an important metric for the global energy transition—the shift from high-emissions fossil fuel energy sources to renewable energy technologies and low-carbon alternatives. As economic and political conditions change, the energy transition landscape also changes. For instance, new government subsidies improve financing prospects for renewable energy projects, while escalating fuel costs make fossil fuel-based projects less attractive. Amid such developments, LCOE can help decision-makers determine the cost-effectiveness and viability of different clean electricity generation technologies and projects.
Its widespread use notwithstanding, critics suggest approaching LCOE with caution. It might not paint a holistic picture of an energy project’s value because LCOE formulas exclude important factors like site-specific costs and reliability.1
LCOE can be determined by dividing an energy asset’s total lifetime costs by the asset’s total energy generation over its life cycle. LCOE formulas can also include a discount rate to account for inflation and other factors that affect future cash flows.
The result of LCOE calculations is the price at which an energy-generating entity must sell that energy to break even or, in finance terms, achieve a net present value (NPV) of 0. It is typically expressed as price per unit of electricity, such as a kilowatt-hour (KWh) or megawatt-hour (MWh).
The included variables and overall complexity of this energy cost calculation can differ depending on the method or tool used. For example, the US National Renewable Energy Laboratory (NREL) tool for determining LCOE is a simple calculator that takes into account 8 variables, while a tool from Stanford University includes more than a dozen.
Though factors used in LCOE calculations vary, common ones include:
LCOE calculations require a set number of years to be input for the purposes of analysis. This is often the energy generation project’s expected lifetime, which is typically two decades or more, depending on the type of energy resource and technology in question.
A capacity factor is the ratio of energy actually produced by a generating unit over a set period of time to the energy that would have been produced if the unit was operating at full power for the entirety of that period. A power plant that is generating energy all the time, for instance, has a capacity factor of 100%. In reality, capacity factors range from 92% for nuclear power plants to just under 25% for solar photovoltaic (solar PV) installations.2
Capital costs are the upfront project costs including land purchases, equipment and infrastructure for its operation. For example, the capital costs of a large onshore wind power plant might involve the cost of wind resource assessments at the project site, wind turbine generators, transportation of the generators to the project site and electric interconnection of the energy system to the electric grid.
Not to be confused with capital costs, cost of capital refers to the cost of financing a project. A common cost of capital is the interest rate paid on a loan. Other costs of capital include those associated with equity financing (selling shares) and issuing bonds. Overall, the cost of capital reflects the risk financial markets perceive in providing funding for a project.
In accounting and finance, a discount rate is an interest rate used to determine the present-day value of future cash flows. In the energy sector, lower discount rates tend to increase the attractiveness of renewable energy projects, which have higher capital costs and lower operating costs. In turn, higher discount rates boost the attractiveness of fossil fuel projects, which boast lower capital costs but higher operating costs.
Fuel expenditures are only considered for power plants that require fuel—namely, thermal power plants. Fuels used by thermal power plants include fossil fuels such as coal and natural gas and biomass. Nuclear power is also a form of thermal energy, with plants using uranium that is processed into fuel.
Heat rate is the amount of energy used in electricity production to generate one kilowatt-hour (kWh) of electricity. It’s a measure of the efficiency of a power plant and, as with fuel cost, it’s generally a variable used for thermal power plants. It’s often expressed in British thermal units (Btu) per net kWh.
Also known as O&M costs, operations and maintenance costs are often divided into 2 categories: fixed and variable. Fixed costs do not fluctuate depending on energy production while variable costs do. For example, the cost of replacing equipment that wears out more quickly when a power plant is in operation (versus when the plant is offline) would constitute a variable O&M cost. On the other hand, an annual insurance premium is an example of a fixed cost.
Additional inputs that may be included in LCOE calculations are the costs of greenhouse gas emissions and the costs of decommissioning power plants, among others.
Energy storage technologies can be an important component of renewable energy projects. However, some LCOE formulas and calculators, such as the NREL calculator, do not measure the cost of energy storage.
Instead, analysts might turn to levelized cost of storage (LCOS) formulas. They use these formulas to calculate the per-unit cost of discharged energy from an energy storage system over a set period. LCOS formulas, while like LCOE formulas, have a few key differences. For instance, in its LCOS calculations, the US Energy Information Administration replaces the fuel cost used in LCOE formulas with the cost of the electricity used to charge the storage system.3
Different technologies and energy resources each have a different LCOE. For more than a decade, the LCOE of renewable energy sources like solar power, onshore wind energy and offshore wind energy dropped precipitously due to innovation, growing economies of scale and government support. For example, the LCOE of onshore wind energy dropped from an average of USD 135 per MWh in 2009 to less than half of that in 2024. Over the same period, the average price of utility-scale solar photovoltaic power plummeted from USD 359 per MWh to USD 61.4
The LCOE of geothermal energy hasn’t seen as great a decline due to relatively high capital costs compared to other renewable energy technologies. However, prices might drop more in the future due to new initiatives such as the Enhanced Geothermal Energy Shot, a US Department of Energy research program.
Such downward trends help make renewable energy sources more competitive with gas and coal-fired generation—which have LCOEs as high as USD 228 and USD 168—therefore supporting the global energy transition. Geopolitical strife has contributed to rising fossil fuel costs and electricity prices, further increasing the appeal of renewable energy projects.
The COVID-19 pandemic and resulting supply chain breakdowns leveled out the price declines in renewable energy costs. However, by 2024, supply chain challenges were reconciled according to “Levelized Cost of Energy+,” an annual LCOE report by the financial services firm Lazard. As in previous years, the firm’s analysts concluded that “the cost-competitiveness of renewables will lead to the continued displacement of conventional generation and an evolving energy mix.”
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Footnotes
1 “Insider: Not All Electricity Is Equal—Uses and Misuses of Levelized Cost of Electricity (LCOE).” (link resides outside ibm.com). World Resources Institute. 1 August 2019.
2 “What is Energy Generation Capacity?” (link resides outside ibm.com). Office of Nuclear Energy, US Department of Energy. 1 May 2020
3 “Levelized Costs of New Generation Resources in the Annual Energy Outlook.” (link resides outside ibm.com). U.S. Energy Information Administration. April 2023.
4 “Levelized Cost of Energy+” (link resides outside ibm.com). Lazard. June 2024.