Many major energy projects last a long time. Even those that aren't quite so long-lived are built with the intention that they will operate for many years. Moreover, different energy technology options have different construction and operating costs. The finances of energy projects can be difficult to evaluate for just this reason - they often involve large immediate capital outlays, followed by a stream of revenues (or costs, if the project is uneconomical) over a long period of time. The process of "discounting" is the way that we think about future costs and revenues in terms of decisions that we are forced to make today.
This lesson will be the most mathematically-intensive of the semester. We will learn about the "net present value" as a way of measuring the benefits versus the costs of a long-lived energy project. We will also discuss several other metrics that can be used to evaluate energy projects, and how these metrics are complementary — and can sometimes cause confusion. These metrics represent the “language” of the energy finance community who is responsible to make decisions about financing projects. The market participants use these metrics to compare energy capital investments against each other as well as against other ways to invest capital. For this reason it is very important for the energy professional to master them.
By the end of this lesson, you should be able to:
- Discuss topics related to cost-benefit analysis and decision making
- determine discounted cash flows for an energy project and calculate the net present value based on the pro forma statements
- calculate the internal rate of return for an energy project
- compare the internal rate of return with the project's discount rate, and explain why the internal rate of return will not necessarily lead you to choose the most profitable project
- calculate the levelized cost of energy for an energy project
- develop a solid estimate of the capital costs for your final project
There are lots of good online resources for understanding net present value. Our primary external resource will be the article Have We Caught Your Interest? This article goes deeper into the math than we will need to, but is nice and concise, and has all of the relevant information on discounting. You should skim this piece before you start in on the lesson material online. You can then return to the reading as a reference.
What is due for Lesson 5?
This lesson will take us one week to complete. Please refer to the Course Calendar in Canvas for specific due dates. Specific directions and grading rubrics for assignment submissions can be found in the Lesson 5 module in Canvas.
- Final Project: Capital Costs
If you have any questions, please post them to our Questions? discussion forum (not email). I will not be reviewing these. I encourage you to work as a cohort in that space. If you do require assistance, please reach out to me directly after you have worked with your cohort --- I am always happy to get on a one-on-one call, or even better, with a group of you.