THE ECONOMIC AND FINANCIAL ANALYSES

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The economic and financial analysis of the some projects serves to answer two key questions: Is the project profitable for the investor? And is the project beneficial for the economy?

Sound economic evaluation of the proposed project during pre-feasibility and feasibility analysis is a fundamental requirement, particularly when the project requires a bank’s assistance and financial commitment. With respect to the financing of renewable energy technologies, there are four key characteristics that help to define the project’s scope and objectives:

  • Scale: Scale or capacity of the renewable energy project will determine the level of financing that is needed;
  • Consumers: Consumers will determine the risks and difficulties associated with guaranteeing the project revenue. For instance, it is more difficult to determine the credit worthiness of a large number of small consumers as opposed to a single buyer.
  • Technology Status: Renewable energy projects based on mature and commercially proven technologies are much easier to finance than those utilizing experimental technologies.
  • Weather: Renewable energy projects rely on weather conditions for their output (e.g., sunlight, wind and rain). There is no recourse when projects fail due to drought or other weather conditions. With no weather guarantee there can be no guarantee of power sales and similarly, no guarantee of predictable revenue. During project appraisal it is critical to take into account the respective risks and resulting variation in the average expected revenue stream due to historic weather conditions.

Using the Time Value of Money

The purpose of investments is to set aside a sum of money now in expectation of receiving a large sum in the future. By using the discounted cash flow approach, and assigning a value to the cost of capital, it becomes apparent that the cash flow in the early years of a project has greater value at the present time than the same amount in the later years of a project. The discount rate is very important for a renewable energy project analysis. The selection of a discount rate can depend on many factors. Usually the rate depends on the opportunity cost of capital, which is defined as the foregone production or potential return when capital is invested in one project rather than another.

Since renewable energy investments are measured by the consumers’ implicit discount rates, they require a high rate of return on investment, indicating high risk. These investments may appear risky to the consumer due to lack of information and resulting uncertainty. However, for society, renewable energy is a low-risk investment that deserves a low discount rate.

COST-BENEFIT ANALYSIS

The first step in any economic evaluation is to project the cash flow. The cash flow of a project is the difference between the money generated (revenue) and ongoing costs (expenses) of the project. The definition of cash flow is different from accounting profit. The cash flow, for instance, ignores depreciation and the interest charges, since they are accounted for in other ways.

Cost-benefit analysis (CBA) comprises, not one, but a set of analytical tools used to assess the financial and economic viability of a proposed investment. Some of the analytical tools that can be used include:

  • Benefit-Cost Ratio

    The benefit-cost ratio (BCR) is the ratio between discounted total benefits and costs. Thus if discounted total benefits are 120 and discounted total costs are 100 the benefit-cost ratio is 1.2: 1. For a project to be acceptable, the ratio must have a value of 1 or greater. Among mutually exclusive projects, the rule is to choose the project with the highest benefit-cost ratio. The disadvantages of the BCR is that it is especially sensitive to the choice of the discount rate, and can provide incorrect analysis if the size or scale of the various projects being compared is great.

  • Net Present Value (or Discounted Cash Flow)

    The net present value (NPV) approach (also referred to as discounted cash flow approach) uses the time value of money to convert a stream of annual cash flow generated by a project to a single value at a chosen discount rate. This approach also allows one to incorporate income tax implications and other cash flows that may vary from year to year. The discounted cash flow or net present value method takes a spread of cash flow over a period of time and “discounts” the cash flow to yield the cumulative present value. When comparing alternative investment opportunities, the NPV is a useful tool. As might be expected, when comparing alternative investments, the project with the highest cumulative NPV is the most attractive one. The only serious limitation with this approach is that it should not be used to compare projects with unequal time spans.

  • Internal Rate of Return

    The Internal Rate of Return (IRR) and the net present value approach are very similar. As outlined, the NPV determines today’s values of future cash flow at a given discount rate. On the contrary, in the IRR approach one seeks to determine that discount rate (or interest rate) at which the cumulative net present value of the project is equal to zero. This means that the cumulative NPV of all project costs would exactly equal the cumulative NPV of all project benefits if both are discounted at the internal rate of return.

  • Payback Period

    Payback Period is the easiest and most basic measure of financial attractiveness of a project is the simple payback period. The payback period reflects the length of time required for a project’s cumulative revenues to return its investment through the annual (non-discounted) cash flow. A more attractive investment is one with a shorter payback period. In development settings, however, there is little reason to assume that projects with short pay back periods are superior investments.

  • Sensitivity Analysis

    Sensitivity Analysis refers to the testing of key variables in the cash flow pro-forma to determine the sensitivity of the project’s NPV to changes in these variables. For example, in a renewable energy project proposal, one may increase fuel costs or fuel transport costs, remove import restrictions on solar panels, lower labor costs, increase land acquisition by different rates to determine the corresponding impact on the NPV. It is useful to test a variable in the cash flow pro-forma that appears to offer significant risk or probability of occurring. The analysis becomes another useful tool when combined with others to improve the decision making process.

BUSINESS PLAN

An business or investment plan is an essential part of the loan application; without it, no bank will advance a loan. This plan should convince the lender or investor of the viability of the project. The objective of the business plan is to maximize the probability of project success and minimize risk by closely examining all the financial aspects of the project. The plan should detail all financial needs as well as all revenues. It should include all projected costs and all projected cash flows. It should lay out, in clear detail, the assumptions of the project.

The business plan should be easy to follow, and clearly state why the proposed investment should be supported. For a bank, there is only one valid answer: the investment makes financial sense. Too often renewable energy projects have a tendency to emphasize the technology over the financial viability of the investment. Focus is given to the environmental or social benefits that might accrue from the project with less attention given to its commercial potential. While such factors are commendable, the banker’s responsibility to shareholders requires that all investments be financially sound. Therefore, an investment plan should address the key financial issues of the project, clearly identifying and predicting important assumptions such as project rate of return, the prospects for self-financing, projected cash flow, and capital structure (of the firm and the project).

Some of the topics which have to be presented to a lender are shown below:

Project Synopsis - Concise description of the most important aspects of the project (e.g., partners, sponsors, investment cost, requested role of the bank, etc.)

The Sponsors - The parties involved: major stakeholders in financial success, and other main parties: contractors, investors and advisors.

Market Analysis and Strategy - This analysis has to answer the question: Is there a demand for the project’s product? Long term power purchase agreements or steam off-take agreements can provide the evidence necessary.

Project Scope - Description of the technical and physical aspects of the project, e.g. who is the vendor, O&M aspects, is skilled staff available

Project Implementation - Time schedule with responsibilities for the different tasks

Project Management - Qualifications of the management (industry/project work experience)

Regulation and Environmental Information - Key regulations and permissions required. Environmental issues associated with the project

Project Costs and Timetable - Estimated cost of implementation and time schedule for disbursements

Financing Plan - Preliminary idea about the structure of financing: who will provide how much funds.

Financial Projections -  Key points from the financial analysis including: Cash flow analysis, Balance Sheet, Profit/Loss account

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