– Internal Rate of Return and how it affects the development of DH projects
A well-planned approach from day one to how a city would like its district heating systems to develop is essential. Taking the benefits from the first most beneficial systems and making sure these benefits will support the entire city over time is key. A city needs to establish the DH company, climb the learning curve, etc., to reach the goal of delivering sustainable heat to the entire city. An understanding of IRR is a part of the road leading to success. Effect of different expectations on IRR Please imagine a project with a calculated IRR of 14%. This project would be an easy sell and would be rolled out soon no matter the chosen business model – a commercial ESCO or co-operative/municipal-led DH company. Such a 14% project would be one of the first projects to be done in a city. And if done right, it will benefit all the future developments. The assumption is that this project will be owned by an ESCO aiming at a 0% overall IRR threshold. The DH company will benefit from the difference in IRR – they will, in a way, “earn” the 14%. What could the difference in IRR be “used” for? Operating a project that can provide a 14% IRR but a lower cost will create a surplus (not a profit!). This surplus should be used wisely, creating positive effects for the entire city! And not just be used to lower the price for a few selected end-users. Here a threshold of 0% IRR is used. This is the correct number for not-for-profit company when looking at the entire city. The many projects should have an av- erage of 0%. Some may know that in Denmark a calculated IRR of 4% is used as the threshold (required by law). The 4% is based on project proposals (calculations) and is used as a security so that new projects will not influence ex- isting customers. If a project when established have a positive IRR, the “surplus” generated will be used to lower prices or create further expansions. For a not-for-profit company the price (= the revenue stream) can be decreased until the IRR is 0%. In this article we assume the price is fixed, fair and acceptable.
Some of the positive effects are only relevant in different stag- es of the rollout of DH in a city. The complex process of estab- lishing a DH company with all the lawyers, accountants, etc., is a one-off situation that must be done together with the first systems. Climbing the learning curve is an ongoing process, but (hopefully) the need to climb steep learning mountains will decrease over time. Making sure that main pipes are di- mensioned for future expansion is also important – and is a benefit (and investment) that could be included throughout the entire city development, even as a part of the lower IRR projects. The first projects undertaken will be projects with the very highest IRR – they are the most apparent projects and should, of course, be looked at in the beginning. Projects that will provide a lower IRR should be looked at later – unless other reasons push them forward. After the high IRR projects have been built, the learning and starting costs have been covered by the projects that could afford it and will therefore not in- fluence later projects. Very low IRR projects will always need support from the higher IRR projects. The price offered to the end-user must be acceptable and at a reasonable level. In fact, the municipal ESCO will provide the same price to all citizens in the entire city. This is very similar to roads and other natural monopolies – we all pay the same. This is a re-write of an article published in 2019 in Hot Cool. The article has created a lot of attention and a lot of discussion. The authors have decided to divide the original article into two separate ones – both are pub- lished in this magazine. The articles both circle around IRR and the understanding of the effects on DH. This article is about how a municipal lead DH company can benefit from picking the low hanging fruits in the right way and how making the decision on business model must be made from early on. The other article discusses the effect of different expec- tations to IRR (please read IRR – Internal Rate of Return and how it affects the development of city-wide DH projects on page 8) on how IRR influences the roll out of DH to the entire city.
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