HOT|COOL NO. 1/2020 - "How to District Energize your City"

George Robinson George leads on investment and finance in the Heat Network Delivery Unit (HNDU) in the UK Department for Business, Energy and Industrial Strategy (BEIS). All opinions expressed in this article are his alone.

The Internal Rate of Return (IRR) is undoubtedly a key metric used within the financial appraisal for making an investment into a project. It is probably the most quoted financial metric because it is so easy to understand – “I will get a 10%

With this information, as a potential investor you might need to rethink Project 1 and actually want to appraise it over a 15 year period to align with the expected useful economic life of the gas CHP as the carbon case for fossil gas CHP after the first life-cycle might be expected to be prohibitive if the UK 2050 carbon targets are to be met. In this made up example (but still using actual numbers) the returns drop to 8.6%, all things being equal, assessing the cash flows up to year 15 only. We would also want to compare the credit quality of the public sector energy off-takers in Project 2 against the credit quality of the commercial energy off-takers in Project 1. It could be that a 2.6% IRR premium for Project 1 (15 Year Project 1: 8.6% less Project 2: 6%) is deemed to be insufficient compensation to manage the risk of default or non-renewal of energy supply from one or more commercial customers. This would need to be carefully weighed up as evidently a greater certainty over sales will warrant a discount.

return on my investment”. What could be simpler? As the IRR is a percentage value, it gives the impression of being comparable to other projects: “this project is forecast to achieve a 10% IRR and the other is forecast to achieve a 4% IRR.” All things being equal the rational investor would select the 10% IRR. Of course, no two projects are completely alike and therein lies the rub. This article aims to question the presumption that private investors invariably want double digit returns in UK DH. Options Appraisal Let’s imagine two UK DH projects that are looking for investment. 1. Project 1 has a forecast 12% real pre-tax project IRR (30 years) and an investment requirement of £3m. 2. Project 2 offers a forecast 6% real pre-tax project IRR (40 years) and an investment requirement of £18m. The IRR has caught our attention but now there are some key questions we should be asking ourselves: 1. How probable is it that the project will actually realise the forecast profits? 2. What is the risk that we will need to invest more? E.g. what if there are construction delays, unforeseen issues etc.? How would these contingent scenarios impact our forecast returns and therefore what contingent capital do we need to have in place? 3. How much capital do we have available to invest? 4. What are our responsibilities regarding the capital we have available to invest? Quality of cash flows If we were to appraise this on IRR alone then Project 1 would win hands down as not only does it offer a higher return, but it is also forecast to realise the return 10 years earlier than Project 2. However, it could be that the likelihood of Project 2’s revenue streams being achieved is far more probable than those of Project 1. Let’s imagine: • Project 1 is heavily reliant on gas CHP combined with private wire to commercial customers; • Project 2 is designed to sell low temperature hot water to publicly owned buildings which will undergo a degree of retrofit activities to accommodate a lower than current supply temperature.

“Perhaps…. we should all press the reset on any presumptions we may have on what private sector investment hurdle rates will be and rethink whether IRR alone

is as significant a motivator for investment decisions in UK DH as is sometimes thought.” George Robinson

Contingent Capital Plenty of papers have been written on the subject of risk management strategies in DH. For example, guidance on this can be found on our website collections/heat-networks-guidance-for-developers-and-the- supply-chain. For the purposes of this exercise I will assume that Project 1 and Project 2 do not have fundamentally differentiated technical and commercial risk profiles (needless to say that they would – certainly on the technical).

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