Economic Indexes

In order to assess the attractiveness of an investment in a pre-commercial floating wind farm to investors, we need to evaluate the economic profitability of this investment in the project under different support scheme scenarios. The economic indexes chosen to evaluate the economic attractiveness are net present value (NPV), internal rate of return (IRR), return on investment (ROI), levelised cost of electricity (LCOE) and discounted payback period (DPBP). All of these, except ROI, are considered the most important economic indexes when determining the economic feasibility of a floating offshore wind farm (Castro-Santos and Diaz-Casas, 2014;

Castro-Santos and Diaz-Casas, 2015. ROI was chosen in addition to the indexes above because it captures the return an investor can expect under each funding regime and is therefore of great interest to our study. The indexes together deliver a comprehensive picture of the profitability of our model wind farm under each funding mechanism scenario. In this section of the chapter we will explain each economic index in turn and outline how they complement each other.

Net Present Value (NPV)

The net present value method is particularly well suited to determine the economic desirability of a project (Gosens, 2015) and constitutes the standard method for the financial evaluation of long-term investments in renewable energy projects (Cucchiella, D'Adamo and Gastaldi, 2015).

The NPV calculation includes the initial investment in a project as well as the running costs and revenues over time. The various cash inflows and outflows are adjusted for the time value of money and risk, which is reflected by the real interest rate. The basic assumption behind the time value of money concept is that money is worth more today than tomorrow because of the devaluation of money and the opportunity to earn bank interest. The NPV model uses the interest rate to calculate the present value of future cash flows.

The formula for the NPV is (Berk and DeMarzo, 2014):

𝑁𝑃𝑉 = ‒ 𝐼 + ∑

(5)

We assume that cash flows occur at the end of each time period considered. This is an assumption intended to simplify the model and limit excessive computations. Because our model is not attempting to maximise the NPV of each model per se, but rather to evaluate the relative differences between the different funding schemes, we believe that this assumption is reasonable.

The most challenging part of this index is the calculation of the real interest rate. The immaturity of floating wind technology and the lack of experience with offshore wind power projects in general across the 25-year life cycle are the main sources of uncertainty. Interestingly, a study by Narbel, et al. (2014) showed that capital-intensive technologies such as offshore wind are less affected by a presumptive future interest rate increase when compared to fuel powered plants because fuel powered

plants incur more costs in the future than wind farms due to expenses for fuel while wind farms incur the vast majority of their costs at the outset of the project. Thus, an offshore wind power project is likely to be the more attractive investment when interest rates are low but expected to increase in the future, as it is currently the case with global interest rates. Fuel power plants on the other hand tend to be a more attractive investment when interest rates are high but expected to decrease because then it makes more sense to make use of currently prevailing high interest rates putting money in the bank and earning interest on it and spending it later, rather than spending it now.

Real Interest Rate

In order to calculate the net present value of each of our four funding regime models, we need to discount future cash flows with the real interest rate. This rate reflects the level of risk inherent in the project. The real interest may be defined as an ex ante rate, which subtracts the expected rate of inflation from the actual nominal rate (King and Low, 2014).

The formula for the real interest rate is (Berk and DeMarzo, 2014):

(6) 𝑟 = 𝑑 ‒ 𝑖

Where,

real interest rate 𝑟:

nominal interest rate / discount rate 𝑑:

inflation rate 𝑖:

The nominal interest rate is equal to the discount rate, which we calculate for each funding regime respectively. From this, the assumed inflation rate of 2% (see section 3.1.3) is subtracted and the resulting real interest is then used to discount future cash flows in every model to calculate the NPV.

Internal Rate of Return (IRR)

While the NPV method is straight-forward, it does not allow for determining the economic differences between two projects that have the same NPV but different cost

providing some insight into the economic aspects of a project. This profitability index has been cited as one of the most meaningful to investors of renewable energy projects (Talavera, Nofuentes and Aguilera, 2010). IRR is defined as the interest rate that leads to a project NPV of zero. In other words, IRR is equal to the actual interest rate at which the upfront investment into a project is ought to be lent during the project’s lifetime. Due to the nature of the NPV formula, there is no analytical way to calculate IRR so that NPV = 0 and an approximation of IRR has to be found through either trial and error or by means of a computer programme (Nofuentes, Aguilera and Muñoz, 2002). In our calculation we will use Microsoft Excel’s IRR function. In general, higher project IRRs are preferred over lower IRRs.

Return on Investment (ROI)

Evaluating the efficiency of an investment, the return on investment (ROI) index constitutes a simple method to test for profitability (Berk and DeMarzo, 2014). ROI measures the amount of return on an investment relative to the costs of the project.

The result is expressed as a percentage, which should be positive. Otherwise an investor will lose money when going through with the investment.

The formula for ROI is:

(7)

𝑅𝑂𝐼 = (𝐺𝑎𝑖𝑛 𝑓𝑟𝑜𝑚 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 ‒ 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡) 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

The gain from investment in (7) is the sum of all discounted free cash flows over the 25-year lifetime of the project, accounting for operating costs, taxation and depreciation. The cost of investment is the initial capital expenditure in year 0 when the wind power plant is build. The operating costs are already accounted for in the

‘gain from investment’ position because they are part of the free cash flows calculated for each year.

Levelised Cost of Electricity (LCOE)

The levelised cost of electricity (LCOE) is a widely used benchmarking and ranking tool to evaluate and compare the cost of energy production of different sources of electricity (Branker, Pathak and Pearce, 2011). It denotes the cost of electricity over the entire life cycle of a power plant and is constituted by the ratio of the total costs to

the total amount of electricity expected to be generated over the project lifetime (DECC, 2013). The LCOE calculation is based on discounting annual, quarterly or monthly cash flows to a common basis. The principal components of a wind farm’s LCOE include capital costs, O&M costs and the expected annual power generation (IRENA, 2012). The LCOE of wind energy can vary significantly according to the quality of the wind resource, the investment cost, O&M expenditure, the cost of capital, and technological improvements leading to higher capacity factors (IEA, 2013). Using the correct rate to discount cash flows is crucial for the LCOE calculation (IRENA, 2012). In a case of debt financing, the weighted average cost of capital (WACC) would be used to discount the project’s costs over time but because we consider a model without debt, we will use the normal discount rate calculated for each project respectively. The formula for LCOE is:

Initial installation cost i for plant p (in £/MW) c_pⁱ:

the end of the plant life (Narbel, Hansen and Lien, 2014). This factor is calculated with a third formula (10) and accounts for increases in O&M costs over time as the plant ages. The escalation rate is the rate at which O&M are assumed to grow every 𝑒 year. The first and second elements in the first formula (8) are each divided by the number of hours that the plant runs at full capacity every year to find the cost per hour of operation. The number of hours at which the plant runs at full capacity is calculated by multiplying the total number of hours in a year by the capacity factor . The 𝐻 𝑓_𝑝 capacity factor denotes the number of hours the plant runs at full capacity, and is expressed as a percentage of the total available production capacity.

The LCOE is primarily used for calculating the cost of a power plant and is a useful instrument to compare the cost of different energy sources. It allows for a clear comparison between the price of wind power and the price of other energy sources across countries and regions, as well as for a comparison between the costs of offshore fixed, offshore floating and onshore wind farms (IRENA, 2012). In our study this parameter allows for assessing the cost of one unit of electricity under different funding regimes.

Discounted Payback Period (DPBP)

The discounted payback period (DPBP) complements the previous indexes by indicating the time in which the initial investment of a project can be recovered from the cash inflows generated by the project (Zountouridou et al., 2015). One of the simplest investment appraisal techniques, DPBP constitutes the extended form of the simple payback period model, in contrast to the latter also accounting for the time value of money.

In contrast to the other indexes considered in this study, the DPBP technique focuses on capital recovery rather than project profitability (Zountouridou et al., 2015) and therefore does not account for the cash flows after the break-even point. In thus it complements the rest of the series of other economic indexes.

The formula is:

𝐷𝑃𝐵𝑃 = 𝐴 +

(11)

Where,

last period with a negative cumulative cash flow A:

absolute value of cumulative cash flow at the end of period A B:

discounted cash flow during the period after A C: