The Levelized Cost of Energy (LCOE) in Project Finance: How to Become Famous with the Help of Lazard

Levelized Cost of Energy (LCOE) Definition: The Levelized Cost of Energy (LCOE) in Project Finance and Infrastructure Modeling equals the Present Value of a power asset’s Lifecycle Costs (OpEx + CapEx + Fuel) divided by the Present Value of its Lifetime Energy Production; it gives you an idea of the long-term marginal cost of electricity generated by the asset.

The Levelized Cost of Energy metric went from obscurity to ubiquity thanks to the famed investment bank Lazard, which publishes its LCOE analysis comparing different electricity-producing assets each year:

The idea is simple but tricky to execute correctly in real life.

You normally take the Present Value of the Operating Expenses, Capital Expenditures (initial construction + maintenance + decommissioning), and Fuel Costs (if applicable) and divide it by the Present Value of the total electricity generated over the asset’s life in Megawatt-Hours (MWh):

But the devil is in the details.

For example, with the Present Value calculation, which Discount Rate do you use? Do you apply the same Discount Rate to both the numerator and the denominator?

How do you determine the asset’s “useful life” or economic life? And which types of expenses and cash outflows are counted in the calculation?

Finally, once you have the LCOE number, how do you use it in real life?

Does it show that renewable energy sources are now cost-competitive with conventional assets, such as gas, coal, and nuclear power?

We’ll address these points below, but the short answer is that LCOE “proves” less than many think because different power assets are not directly comparable.

They each have strengths and weaknesses, and the LCOE metric cannot account for issues such as the intermittency of generation, pollution, or transmission costs.

Files & Resources:

• Levelized Cost of Energy – Slides (PDF)
• Levelized Cost of Energy – Excel Example for a Solar Development (XL)
• Lazard – Annual LCOE Analysis (PDF)
• Australia – Solar Plant LCOE Comparison (PDF)
• Why Comparing LCOE Across Energy Sources is Absurd (Medium)
• LCOE and Value-Adjusted LCOE (IEA.org)

Video Table of Contents:

• 0:00: Introduction
• 0:52: The Short Version
• 5:16: Part 1: Solar Development Calculation
• 9:09: Part 2: What Does LCOE Mean in This Context?
• 11:15: Part 3: Nuclear Power Plant LCOE Example
• 12:25: Part 4: Controversies, Uses, and Misuses of LCOE
• 15:02: Recap and Summary

How to Calculate the Levelized Cost of Energy (LCOE) for a Solar Asset

This section is based on a small excerpt taken from a larger quarterly model for a new solar development in Australia.

For the Discount Rate in this calculation, we use a 12% targeted equity IRR for the Cost of Equity and the interest rate on the Debt for the Cost of Debt:

It’s a 60% / 40% split of Debt and Equity for this new solar development, so we use this information and the Development & Construction CapEx, Operating Expenses, and Maintenance CapEx to set up the model:

Revenue in this model is based on the “feed-in tariff” (FIT) rate applied to the asset’s electricity generation in kilowatt-hours (kWh), plus production incentive payments in the first 5 years.

Most of the Operating Expenses are linked to the project’s Capacity (130 MW or 130,000 kW) or are fixed annual expenses that escalate based on expected long-term inflation (examples are the audit fee and lease expense).

Items such as the Change in Working Capital, Reserve Contributions and Withdrawals, and Maintenance CapEx are too complex to explain here, but they trend with the asset’s cash flows and upcoming maintenance needs, such as inverter replacements on the solar panels.

The Development and Construction Costs are based on estimates from the developers and the time required to build this plant.

Note that these numbers do not include ANY financing costs, such as the Interest Expense, Loan Fees, or Debt Principal Repayments.

That’s because the electricity generated by the asset is “available” to all the investors, and the OpEx and CapEx affect the potential repayments to all the investors – so this analysis corresponds to Enterprise Value and WACC.

Therefore, we look at everything on a capital structure-neutral basis.

In the LCOE calculation, we can discount the OpEx + CapEx and Electricity Generated to Present Value based on the nominal Discount Rate of ~9% or use the “real” Discount Rate of 6% for the Electricity Generated under the argument that it has less risk attached:

What Do These Levelized Cost of Energy Figures Mean?

To say much here, we must compare the LCOE figures to those of similar solar plants in Australia.

Our LCOE numbers are above those cited in the Lazard report, even when converted to USD, but they seem to be in line with numbers from Australia from a few years before construction began (but costs change rapidly in this industry, so…):

Based on all this, we’d say that this utility-scale solar project has a high but not unreasonable expense profile.

Is the initial feed-in tariff (FIT) of $0.13441 per kWh too low for the overall IRR to be 9%?

Initially, it might seem like the answer is “yes” because this FIT rate corresponds to $134.41 per MWh, which is below the nominal LCOE.

However, what matters is the weighted average rate over the project’s lifespan.

The simple average FIT rate over the 20-year useful life is ~$190, so this initial rate with 3% annual escalations might be enough for the unlevered IRR to meet or exceed 9%.

However, we’d have to calculate the IRR to verify this (which would require more setup and model assumptions).

How to Calculate the Levelized Cost of Energy (LCOE) for a Nuclear Power Plant

The main difference for conventional power assets, such as nuclear, gas, and coal, is that the fuel costs must also be counted as Operating Expenses in the LCOE calculation.

Here’s an example taken from a nuclear plant development in South Korea in our Project Finance course:

The Discount Rate calculation and other aspects are more complex because this deal uses Preferred Stock in addition to the traditional Construction Loan and Investor Equity, but the basic idea is the same.

The difference is that there are both Fuel Costs and “Spent Fuel Costs” (for disposing of the used uranium) included in the Operating Expenses, while these do not exist for renewables:

Problems with the LCOE Calculation and Why It Is Often Misused

First, people often disagree about the specific expenses to include. For example:

• Do you include Taxes? Some textbooks say “yes,” while many online examples do not do this. If you include them, do you adjust for the effects of interest and loan fees?
• What about maintenance CapEx (e.g., replacing inverters in the solar panels), decommissioning costs, reserves, and the change in Working Capital? Different sources say different things.

Second, historically, some industries have not discounted the future electricity generation at all (!), which makes the numbers too good to be true.

Third, LCOE does not account for factors such as the intermittency of generation, pollution/carbon emissions, transmission costs, or the risks around fuel prices and supplies.

Matching costs are also an issue: Yes, it’s great if a solar plant produces a huge amount of power during the day, but what if the grid doesn’t need the extra power then?

Sure, the asset owners could attach a storage device to the solar plant, but that costs extra to construct and operate, and these costs must also be factored into the LCOE.

Finally, there’s some controversy around the proper Discount Rate, with banks like Lazard tending to use higher rates (e.g., 10%+) than many government and public sources.

Using LCOE to compare different types of energy assets is like using the same valuation multiples to compare different types of companies, such as SaaS growth stocks vs. mature industrial firms.

It doesn’t make sense because the key metrics, valuation levels, and advantages and disadvantages are completely different. These company sets are not truly comparable!

LCOE is best used to compare similar assets, such as two solar plants of similar sizes with similar grid/transmission requirements in the same country.