Use and Abuse of the LCOE: A Market-Based Valuation Framework

The levelized cost of electricity LCOE is a popular cost metric used to assess the financial viability of variable renewable generation technologies. The paper provides a formal market-based valuation framework and derives a consistent value-based LCOE metric from the NPV criterion. It shows that the cost-based LCOE is a flawed valuation metric unless it is adjusted for a time-varying technology specific covariance factor that captures flexibility. Failure to adjust for covariance effects underestimates the cost-based LCOE of intermittent technologies, over-estimates the LCOE of dispatchable technologies, and yields biased inferences about grid parity, even after accounting for firming costs. Value maximization rather than the traditional (flawed) cost minimization criterion must be used to gauge the competitiveness of variable intermittent technologies. The results question the validity and usefulness of the cost-based LCOE for policy assessment.