FOCUS FINANCE & ECONOMY
By Lars Gullev, Managing Director, VEKS & Morten Jordt Duedahl, Business Development Director, DBDH
INTERNAL RATE OF RETURN - IRR Internal rate of return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments. Internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project, equal to zero. IRR calculations rely on the same formula as NPV does.
IRR is the theme discussed everywhere when looking at how to establish district heating (DH) systems – these words are still to be understood in detail and are at the same time a very important part of understanding how to roll out city-wide networks. All organisations hoping to enjoy the benefits of DH must understand what the IRR means and how a low or a high level of IRR affects the roll-out of DH. Not least, how high IRR will limit city-wide expansions of DH.
uncertainties, normal but good management etc. – nothing fancy or extraordinary, just a good ordinary system.
Cities discuss how to buy back their DH companies from private companies, how they can get private funding involved and how to become more competitive and efficient all over the world. This discussion often leads back to one of private ownership or council led ownership and then again to the IRR. In this article the authors do not discuss local framework conditions that allow or do not allow specific business models nor how local traditions influence the choice of ownership of public goods. The authors have simply noted that ownership of DH companies is (one of) the most important discussions these days – at least in Europe. The discussion of how control, cost, expansions etc. differs depending on the ownership, is becoming more and more important and often ends up being the crucial factor for a project to go forward. THE TWO BASIC MODELS FOR OWNERSHIP In this article we discuss two basic models of ownership: A strictly commercial and a strictly municipal/cooperative with the only difference being the expectation to IRR. Many scholars have identified several models in between the two, but for simplicity, this article claims that in essence, there are only the two. In the end, the actual ownership of pipes and production facilities is the key. For both models, we assume that they are active market players accessing the competitive and commercial market for the best offers for pipes, welding, digging, planning, finance, operation, maintenance etc. In this sense they are both equally cost and quality conscientious. We have found no general evidence of the opposite. LEVEL OF IRR IN THE TWO MODELS FOR OWNERSHIP The assumption of this article is to compare similar systems – pears to pears, apples to apples! The projects are in both cases well managed, well planned, well built, well financed – in short, a “well-made” project. DH systems with their small flaws, some
In many places with a municipal or co-operative ownership, the IRR threshold for a DH project can be around 4%, based on the cost of capital plus a security element, leaving room for small changes in the economy of the system. This is not a set standard, as the DH company may accept a lower IRR, if the project is straightforward and something that has been done many times before. Or, it may be a bit higher, if the DH company finds that there are extra uncertainties or risk factors that should be included. The 4% threshold is used often in Denmark to evaluate projects and could be used in many other countries where the main interest is to provide comfort and city development. For a strictly commercial operation, the level of IRR will vary from project to project. Numbers as high as 18% have been mentioned – but a more realistic level may be around 14%. It must be stressed that these numbers are speculations only, as the actual level is a commercial secret, and therefore most often unknown. On the other hand, numbers around 14% are not unrealistic. It seems to be accepted in some DH communities, that 14% is acceptable and sometimes even discussed as a fact. When looking at it from a different perspective, 14% does not seem way off. The commercial companies can invest in other projects (in any industry or country – chicken farming in Uganda, wind turbines in Vietnam or solar projects in Australia – just to mention a few) that will provide an IRR at the same level to their owners. And they should! The commercial companies are here to give their owners the highest possible return on investments with the lowest possible risk, including the perceived risk of long pay back times. If that leads to developing DH or something else, it is entirely up to the owners of the company.
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