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DEPRECIATION TIME MAY ALSO DIFFER The depreciation period (or pay-back period) used in different business models may also differ – that again makes the comparison of IRR difficult as projects should be similar in order to make a correct comparison of IRR. For a classic end user owner / municipal owned DH company, the depreciation time in theory would be the technical life time minus a few years. For a pipe network, this may be 30 years or up to 50 years, for a biomass plant maybe 20 years, etc. For a commercial operator it may be shorter. How much shorter is not known! Many commercial companies do simply not allow investment that has a very long payback time, as it is considered higher risk. In this article this perspective is not discussed further but it is, however, worth considering when looking into an investment. A simple (but not entirely correct) analogy would be to consider how one would prefer to pay back a property investment – e.g. you own home. All things equal, one would prefer the longest possible payback time (up to the technical lifetime) as that would keep annual costs down. EFFECT OF DIFFERENT EXPECTATIONS TO IRR Imagine a project that is commercially viable for a commercial ESCO, i.e. the IRR is calculated to 14%. This project would be an easy sell and would be rolled out soon. The below will discuss the effects if a municipal ESCO with a threshold at 4% was asked to do the same project. In other words, what could the difference in IRR be “used” for. Remember that the price offered to the end user on the 14% project must be acceptable – otherwise it would not have been built. Some of the effects are relevant in different stages of the roll out of DH in a city. Price reductions are always welcome, expansion also. But the complex process of establishing a DH company with all the lawyers, accountants etc. is a one-off situation. Climbing the learning curve is an ongoing process, but the need to climb it will decrease over time. The first projects undertaken will be projects with the very highest IRR – they are the most obvious projects and should of course be looked at in the beginning. Projects that will provide a lower IRR should be looked at later. At that point, some of the learning and starting costs have been covered by the projects that could afford it and will therefore not influence later projects.
Figure 1 illustrates how this difference in IRR could be used for different purposes. The percentage mentioned to the left in the figure will differ from project to project, from city to city and be different depending on for example, the number of projects already completed/started.
IRR for a commercial ESCO (assumed)
14%
Climbing the learning curve step by step
?%
Create council lead ESCO
?%
Build equity to support future developments
?%
Build a surplus to balance income from year to year Build in extra network capacity to support future expansions Improve quality to minimise operation and maintenance
?%
?%
?%
Expand the network - adding areas with lower IRR
?%
Lower prices / Alleviate fuel poverty (assumed fair prices)
?%
IRR for council lead company (common threshold in Denmark)
4%
Approximate interest rate for borrowing capital
<2%
Figure 1. Illustration of how the difference in levels of IRR can be used by a council led DH company for different purposes. The obvious could be simply to lower the price for the end user, but it is assumed that the price in both cases is fair and correct.
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