Net Present Value Rate & Front-Loaded Pricing
Front-loaded pricing enhances the viability of community energy projects by improving cash flow and thus reducing the need for difficult-to-raise community capital. Front-loaded pricing is achieved through the use of net present value calculations based on a C-BED invention called “NPV rate.”
There is a significant difference between capital raised from communities and capital raised conventionally. Conventional capital is formed when a group of people with financial connections leverage concentrated wealth. Thus, conventional capital can be made available very quickly, sometimes in a single meeting. Community capital, on the other hand, is inherently disparate and distributed, and therefore requires much time to gather and manage. Community energy projects require levelized cash flow in order to mitigate this inherent disparity in their ability to rapidly manipulate capital.
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NPV Rate. NPV rate is a C-BED invention that leverages NPV to reduce the cash flow constraints associated with community-owned energy projects. Since power purchase agreements (PPAs) between electric utilities and energy producers are for a fixed time period (typically 20 years for wind projects), and since the amount of electricity produced by a specific C-BED project can be predicted based on modeling and wind measurements, it is possible to establish the NPV—a lump sum amount in today's dollars—that represents the dollar value of all of the electricity that's going to be produced over the 20-year life of the project. Dividing that NPV by the total kWh of electricity produced over the same time period gives us the NPV rate. In formula terms, the NPV rate is the present value of electricity in dollars divided by the total expected energy production (expressed as $/kWh).
How Discount Rate Affects the Value of Electricity. Because NPV rate incorporates the time value of money in the price of the electricity, it is possible to determine up front (at the time the PPA is negotiated) the value for each kWh of electricity produced over the entire 20-year life of a project.
Figure 1 shows how prevailing interest rates (discount rates) affect the value (price) of electricity. By fixing the NPV rate (in this case, at $0.027/kWh), we see how discount rates between 6% and 10% drive the 20-year fixed price. So, for example, it can be mathematically shown that if a discount rate of 6% is used, the value of the electricity generated is equivalent to a fixed price of $0.047/kWh over the 20 years (assuming $0.027/kWh NPV rate). If a discount rate of 10% is used, the value of that same electricity over the same 20 years goes to $0.063/kWh.The NPV rate, then, incorporates the time value of the electricity being sold by taking into account the discount rate used for the large up-front capital purchase. If project owners invest a large amount of capital today for income that will be received over the next 20 years, the discount rate used will affect the fixed price the owners must receive in order for the project to be viable.
Front-Loaded Pricing. Once the NPV rate has been established, community energy projects are made significantly more efficient financially through the use of a front-loaded price, that is, by establishing a higher price for electricity in the early years balanced by a lower price in the later years. By using the NPV rate as the anchor point to determine a variable price over time, it's possible to tailor the price to completely smooth the project's net cash. The utility will pay the same present value amount for the electricity over the life of the PPA, no matter how the price varies, as long as a common NPV rate is used. As a result, the utility has relatively little vested interest in whether or not the price is variable and front-loaded. The C-BED owners, on the other hand, have a strong interest in the variable, front-loaded price, since such a pricing scheme supplies a way to even net cash variations over the the lifetime of the project. The net cash variations include the substantial debt repayment associated with the purchase and installation of the capital equipment, usually paid for over the first 10 years.
Figure 2 shows a sample project’s fixed price compared to its front-loaded price equivalent. The front-loaded price is higher in the first ten years when debt service payments on the equipment are high, then falls in year eleven when the loan is paid off. Figure 3 shows the resulting net cash of the project described in figure 2 using the (problematic) fixed price scenario compared to the (desirable) front-loaded price scenario. In the fixed price scenario, the net cash curve gets dangerously close to zero in the early years (just before the 10-year debt is paid off).
Multiple years of net cash "famine" awaiting the net cash "feast" in the out years poses a competitive challenge for community projects, which are unable to easily manipulate the necessary cash flow. In the front-loaded price scenario, however, the variable price based on NPV rate allows the net cash to be completely levelized. The upward slope in the net cash curve reflects the increase in dollar value over time required to ensure a constant present value dollar amount. Conclusion. The combination of NPV rate and front-loading ensures financial efficiency in order to allow C-BED projects to succeed for both the C-BED owners and the utilities with which the C-BED owners negotiate. Please refer to the C-BED Calculator for the mathematical details behind the C-BED front-loaded pricing model.
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Setting the Discount Rate. Establishment of appropriate discount rates for C-BED projects should be based on each individual utility's discount rate—the rate used by the utility in financing projects in its everyday business. For example, a utility that pays 7% interest for 20-year debt financing in the course of its ordinary business would be required to specify that same 7% rate to all C-BED developers as a basis for negotiations for projects. Another utility in the same jurisdiction that gets debt financing at 8% would be required to use that rate for all C-BED negotiations for the same electricity from the same C-BED project. Why treat different utilities differently? Because the relative discount rate each utility uses in the course of its everyday business accurately reflects the relative value of C-BED electricity compared to acquiring electricity elsewhere (for instance, if the utility were to build a new generation facility itself). Setting the NPV Rate. NPV rates will vary on a per project basis. In a market-driven environment, the primary determinant of project viability is the difference between cost and price. The higher the NPV rate, the more financially viable the C-BED projects are, and the more expensive the electricity is to the purchasing utility. The lower the NPV rate, the less financially viable the C-BED projects are, and the less expensive the electricity is to the purchasing utility. For the C-BED owners, the established NPV rate must be sufficient to pay the debt for the large capital purchase along with operations and maintenance costs, with enough left over to make the project economically profitable. For the purchasing utility, the established NPV rate must be low enough to reasonably compete with other sources of electricity in the marketplace. The establishment of a maximum NPV rate is a political decision. The original 2005 Minnesota state law specified that utilities must give consideration to C-BED projects as part of their mix of electricity sources. In return, a maximum NPV rate of $0.027/kWh was established in order to protect utilities from highly uneconomical projects being forced into the system. Now that Minnesota has had several years experience with C-BED and its NPV rate model approach, the fears of highly uneconomical projects being forced into the system have not materialized. Thus, the maximum NPV rate was removed from the C-BED statute in the 2007 legislative session. |