Investing In Financially Feasible Renewable Energy Projects
By: Thomas Pastore
A June 2010 article in the Financial Times.com discusses the debate over global warming. Ms. Jane Lubchenco, the administrator of NOAA (US National Oceans and Atmospheric Administration) states that, “the average temperature in the world has increased by 0.56 degrees Celsius (or 1 degree Fahrenheit) over the past 50 years. The rise may seem small but it has already altered our planet…glaciers and sea ice are melting, heavy rainfall is intensifying, and heat waves are more common.”
One of the sure most concerns of citizens in the United States and worldwide is reducing carbon emissions. Environmental and climate concerns have resulted in government agencies and businesses making significant capital expenditures in the implementation of renewable energy projects. Some economists have coined this the next industrial revolution. Renewable energy projects represent a paradigm shift in energy consumption planning for any organization. This article focuses on the implementation of a solar photovoltaic (“PV”) system in Southern California by a non-profit organization. However, in general these analyses can be applied to businesses as well as other renewable energy or hybrid systems.
Federal and State incentives along with a number of different financing structures can help make the implementation of renewable energy systems feasible.
SUCCESSFUL ENERGY PLAN IMPLEMENTATION
The following major steps need to be taken when putting together a successful energy consumption strategy:
1. Assessing the energy consumption under the existing overall infrastructure, such as building insulation, equipment age, and types of light bulbs, just to name a few. This is called a demand side audit.
2. Implementing the necessary changes, as a result of the demand side audit, to minimize energy consumption and make the overall infrastructure most efficient.
3. Installing efficient and cost effective renewable energy central plants, including PV systems.
4. Continuously monitoring energy consumption levels and patterns.
5. Developing a curriculum program and ongoing training around the implementation and operation of a renewable energy central plant.
Conducting proper due diligence is essential to evaluate installation, maintenance and contractual obligations. Due diligence procedures entail various analyses of proposed PV systems as follows:
1. Engineering analyses of design proposals, installation sites, and ongoing maintenance.
2. Financial analyses of a PV system’s implementation costs, financing costs, operating costs, and maintenance costs.
3. Legal analyses of proposed contracts between a non-profit organization, the PV system installer, and the investor who becomes the owner once the PV system is energized.
4. Project management and analyses from the perspective of the non-profit organization.
LIFE-CYCLE FINANCIAL ANALYSIS OF A PV SYSTEM
The life-cycle analysis must encompass all cash flows during the life of a PV system, from the preliminary design stage through the removal of the PV system once it ceases operations.
Several different designs may be presented from the original preliminary design to the ultimate one that meets an organization’s current and anticipated near future energy needs.
A. Considerations important to this analysis include:
A PV system may be fully financed or upfront capital investment may be required.
Applications for all available incentives, both federal and state.
Structuring a power purchase agreement (“PPA”) or an equipment lease agreement with a third party that commences once the PV system is energized.
Maintenance of the PV system, along with production guarantees from the maintenance provider, for a negotiated time period, usually of 20 years or less.
Current energy costs escalated periodically to reflect expected energy costs could be used as the baseline for calculating savings during the life of the PV system.
Once the PV system stops operating, it has to be replaced or removed, also known as decommissioning costs.
It is important to note that maintenance costs are relatively minimal since the PV panels are usually guaranteed for 20 years, and the inverters are guaranteed for 10 years. A PV system could operate for as many as 25 to 40 years.
Monetary incentives are available from both federal and state programs to assist with the cost of installing PV systems. Federal incentives are provided by the National Energy Policy Act of 2005, while state incentives are usually provided through the local utility company servicing the area and the California Public Utility Commission (“CPUC”).
Federal incentives include an Investment Tax Credit (“ITC”) or a Treasury Cash Grant (“TCG”) equal to 30% of eligible costs. Another incentive comes from the IRS’s Modified Accelerated Cost Recovery System, under which businesses can recover investments in solar, wind, and geothermal property placed in service after 1986 over a five-year schedule of depreciation deductions. Since the economic life of such property is 25 to 40 years, this incentive allows for relatively rapid recovery of deductable depreciation of an investment compared to the expected economic life of the property installed.
The California Solar Initiative (“CSI”), which is regulated by the CPUC, offers an incentive to further reduce the cost of installing PV systems. The CSI is a performance based incentive (“PBI”) that is calculated based on projected kilowatt hours produced by a PV system. Different PV system size limits exist under each utility company. In addition, the CSI is composed of a number of declining steps, where the PBI rebate rate decreases as the number of MW installed increases by certain increments.
Incentives may change considerably over time. It is important to keep abreast of changes in incentives and formation of new incentives. Information on all federal and state incentive programs around the country is available at the Database of State Incentives for Renewables and Efficiency, www.dsireuse.org/.
Non-profit organizations are not able to benefit from any tax credit or depreciation incentives since they do not generate taxable income. For-profit third party ownership allows non-profit organizations to indirectly benefit from all available incentives that would otherwise not be available. This benefit is passed through to the non-profit organization in the form of a lower payment under the chosen financing structure, as discussed next.
POWER PURCHASE AGREEMENTS
A PPA can be a contract between a non-profit organization and a third party, typically an investor, where the non-profit organization purchases power produced by a PV system based on a pre-determined price per unit, i.e., $/kWh produced. A PPA specifically for the purpose of providing a solar energy system is also known as a solar service agreement. A typical PPA term is 20 years. Such an agreement allows a non-profit organization, which cannot fully utilize all available incentives, to indirectly benefit from them through a lower PPA energy rate.
EQUIPMENT LEASE AGREEMENTS
Under an equipment lease agreement, the installer sells the PV system to a third party, typically an investor, which then leases the PV system to a non-profit organization. As the PV system owner, the lessor can apply for and receive the TCG. The lease payment is a fixed amount and, unlike a PPA, does not vary with production. A typical lease term is 15 years. Tax counsel should be consulted to assure that the terms of the lease meet the criteria of an operating lease. All available incentives are reflected in the form of a lower lease payment.
MEASURING SAVINGS FROM A PV SYSTEM
Determining if a PV system is financially feasible requires a comparison of annual costs to the purchasing party, i.e., non-profit organization, over the life of the PV system to the purchasing party’s offset utility costs during the life of the PV system.
The first step in calculating the utility cost that is being offset by the PV system production is establishing the appropriate utility rate per kilowatt hour, and then applying it to the PV system’s kilowatt hours produced. For example, Southern California Edison utility rates include charges for energy use, by customer, and by demand. Energy use charges involve delivery service and generation charges based on time of use (“TOU”), customer charges and related facilities, and a power factor adjustment. Demand charges are not TOU charges. Time related demand depends on TOU during summer (12 a.m. on the first Sunday in June through 12 a.m. of the first Sunday in October) and winter (the remainder of the year). TOU rates are based on three time periods, on-peak, mid-peak, and off-peak, with maximum demand rates established for each time period based on the maximum average kilowatt input recorded during any 15-minute interval during each month. On-peak hours are noon through 6 p.m. on summer weekdays, except holidays. Mid-peak hours are 8 a.m. to noon and 6 p.m. to 11 p.m. on summer weekdays, except holidays, and off-peak hours account for all remaining hours.
FINANCIAL FEASIBILITY ANALYSES
There are three primary methods of financial analyses.
The first is the net present value (“NPV”) method, which is the sum of the present values of the annual cash flows during the life of the PV system minus the present value of the investments. An appropriate discount rate accounts for the time value of money and uncertainties associated with the cash flows. This method is important, as it shows the net value of the PV system from year to year.
Another method is based on the internal rate of return (“IRR”), which is the discount rate that makes the project’s cash flows and investments have a zero NPV. It is important to define a threshold IRR prior to evaluating the PV system. An IRR of 0% does not make a project financial feasible as it fails to compensate an investor for the time value of money and the uncertainties associated with future cash flows.
The last method is the payback period, which is the length of time required to recover an initial investment through cash flows generated by the investment. The payback period is important when considering an organization’s financial ability to implement a PV system.
All financial feasibility analyses are highly dependent on a PV system’s cost, which in turn is subject to market price fluctuations of commodity type raw materials, such as PV panels and steel. If these price fluctuations cannot be controlled in the procurement process, there is the potential for a significant adverse impact. This could make a PV system financially unfeasible.
OTHER QUANTITATIVE BENEFITS
Additional quantitative benefits to the PV system owner include carbon credits, renewable energy credits (“RECs”), and possible employee health care savings as a result of a cleaner environment. Qualitative externalities include reduction of pollution and greenhouse gas emissions, reduced dependency on utility providers, and greater control over energy price volatility. In addition, PV systems can provide power during traditional power outages, whether due to natural disasters or any other reason.
Installing PV systems in parking lots and on rooftops or other existing structures provides shade while not infringing on an organization’s operations and not requiring the acquisition of additional space. Finally, minimal maintenance cost is associated with PV systems, with long-term reliability of 25 to 40 years.
Financial analysis is critical to assessing the feasibility of an energy consumption plan. A complete financial analysis includes all factors present during the life-cycle of a PV system. These factors include, but are not limited to, the financing structure terms, investment costs, available incentives, utility energy costs, and externalities. Proper application of financial analyses to determine the financial feasibility of a PV system provides a critical portion of the overall due diligence procedures in implementing a PV system.
ABOUT THE AUTHOR
Thomas Pastore, ASA, CFA, CMA, MBA
Mr. Thomas E. Pastore is Chief Executive Officer and co-founder of Sanli Pastore & Hill, Inc. Mr. Pastore is an Accredited Senior Appraiser (ASA), Business Valuation Discipline, of the American Society of Appraisers, a Chartered Financial Analyst (CFA) Charterholder, a Certified Management Accountant (CMA), and received his Masters in Business Administration (MBA). He has valued over 2,000 businesses during his career, including numerous energy and clean technology companies. He regularly testifies in court as an expert witness. Mr. Pastore frequently speaks on business valuation to professional organizations.