P10
Build a surplus to balance income from year to year Many DH companies prefer to offer stable prices over the years and avoid price fluctuations. Many DH companies have a standard price for the whole season to allow the end users to budget correctly. Others change their price from month to month depending on their actual cost ensuring that all costs will be covered. It is common to create an income-buffer that allows a DH company to run a small surplus one year (if the winter is colder or warmer than expected) so as to cover for a small deficit the next year; this in turn balances the price over time. Build equity to support future developments This is the same as creating a surplus to balance income from year to year. Here the surplus is earmarked to building equity to support future projects with a much lower IRR – this may be projects that will connect existing areas to low-cost surplus heat. Create the local DH company – the Council ESCO If this project is the first project undertaken by a city run DH company, the city will need to establish and develop a DH company – this may be at a substantial cost. This would be a one time cost and only influence the IRR for the first project. Here, the first project “pays” for the total cost of establishing the DH company, to the benefit of future projects, who then have access to an experienced DH company that is already well established. Climb the learning curve If the project is the first project, it would be expected that small and big mistakes will be made. As more projects are being completed/undertaken, it must be assumed that the company will climb the learning curve quicker and make fewer mistakes. Again, the first few projects pay (and can afford) to climb the learning curve to the benefit of other future projects. CONCLUSION This article does not give guidance to which business model is the best or most relevant in different countries or under different framework conditions. It simply demonstrates the effect on the roll out of DH in a city dependent on the accepted level of IRR. It is clear that a high level of IRR jeopardizes a city-wide development of DH and could also make access to large low carbon heat sources difficult or impossible. Besides the theme of this article, a local authority should also consider the benefits of having just one company in charge of developing DH city- wide, as opposed to having several companies and being responsible for supporting the cooperation and coordination between several independent entities.
A DETAILED DISCUSSION OF HOW LOWER IRR COULD BE “USED”
Price reductions The simplest way to reduce the IRR is to reduce the cashflow i.e. simply lower the price for the end-users. The definition of IRR mentions “all cash flows”. This means that if the cash flows are reduced, the IRR will go down. Here, the local DH company can simply calculate backwards and find the price (cash flow) that would result in an IRR that is acceptable. In this article, this option is less relevant as we assumed the price to be fair from the beginning. Expansions of the network Another opportunity is to expand the project further into areas that are less economically viable – i.e. provide a smaller IRR. In this example, the DH company would increase the scope of the projects into areas with a lower IRR. The larger project would therefore be more expensive, requiring a larger investment. The cash flow would increase as more end users are connected at the specified price, but the IRR would go down as the investment grows faster than the cash flow.
Improve quality to minimise operation and maintenance cost
Project developers will always seek to find the right balance between investing into high quality to avoid operation and maintenance costs or vice versa. The effect to IRR could be neutral as an increase in investment would be offset by an increase in net cash flow, as costs would decrease. To the extent that the first projects will be developed as part of the backbone in future projects, it may be relevant to “overdo” quality over operation and maintenance. If the project is again among the first undertaken by the municipal lead ESCO, overdoing focusing on quality to avoid trouble and uncertainties on maintenance and operation costs may be relevant until the organisation has climbed/completed the learning curve.
Build in extra network capacity to support future expansions - Future proofing
Another option is for the city DH company to build in future proofing of the network. If the plan is to create citywide projects, the first projects (of course the ones with the highest IRR) should be dimensioned to be the backbone of the future system. Here cash flow would remain unchanged (if we assume that operation cost is not affected), but the investment would increase and thereby lower the IRR. This will help future projects to reach an acceptable IRR, as the first project has already acquired investments that will benefit the next projects.
For further information please contact:
Lars Gullev, lg@veks.dk
Morten Duedahl, md@dbdh.dk
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