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2.0 Economic Valuation 2.1 Levelized Cost of Electricity Typically, in order for a geothermal power project to become financially viable, project developers must secure an electricity sales contract with an electricity purchaser called a Power Purchase Agreement (PPA).3 In addition to spelling out the specific terms and conditions of the power sales agreement, the PPA typically specifies the first-year electricity sales price and the annual rate of price escalation that the purchaser will pay throughout the life of the contract. Generally, projects that can offer the lowest first-year electricity price are considered the most economically competitive. Therefore, project developers often use the first-year electricity price as an indicator of a project's attractiveness. However, because the terms and structure of PPAs vary greatly from project to project, the first-year electricity price is not a reliable indicator to use when comparing different projects. The metric most commonly used to compare projects is levelized cost-of-electricity (LCOE). LCOE is the average price of electricity throughout the life of a power plant. To calculate a LCOE, a power project's expected revenue stream is discounted using a standard discount rate to yield the Present Value (PV) of the revenue stream.4 The PV is then converted to an annual stream of equal payments using a Uniform Capital Recovery Factor (UCRF). The annualized payment is then divided by the project's annual energy output to obtain the LCOE. LCOE can be a constant dollar value (which excludes inflation) or a current dollar value (which includes inflation) depending on whether the discount rate used to calculate the UCRF is real or nominal. Project developers prefer nominal LCOE because it more clearly reflects "real world" prices. However, government agencies performing long-term planning prefer real LCOE. Therefore, to accommodate both communities, both nominal and real LCOE values will be presented in this report. For all of the analyses in this report, PPAs are assumed to have a 15-year length, equity investors are assumed to require an acceptable internal rate of return (IRR) within the first 15 years of the project life, and all project debt is assumed to be provided with a 10-year term unless otherwise noted. Further, starting in project year 16, we assume that projects are still owned and operated by the original owner; however, since both debt obligations and required returns to equity investors are fully met by this time, power sales need to generate only enough revenue to cover operating expenses and pay income taxes in year 16-30. In project year 16, owners are free to engage in another PPA, or to sell power at market prices. The LCOE values presented here are calculated on a 15-year basis in accordance with the PPA term and the IRR analysis period. In this context, the LCOE values reflect the annualized cost of electricity through the 15-year PPA period. Further, for all of the analyses in this report, the expected inflation rate is assumed to be 2.8% and the nominal PPA escalation rate is assumed to be 2%. The expected inflation rate is consistent with the U.S. Energy Information Administration's (EIA) forecast of the Consumer Price Index (EIA 2001b). The PPA escalation rate is consistent with actual escalation rates for geothermal power project PPAs (Owens 2001a). 2.2 Financial Arrangements Project Finance Financial arrangements can significantly impact the value of tax credits such as the PTC. In general, when configuring a project, the financial arrangement selected depends on the financial capability of the project developer. Project developers that prefer to minimize risk to corporate assets, or those who do not have the capability to finance a project using debt that is secured against corporate assets, often look to commercial banks and other financial institutions to acquire a loan or to structure and sell bonds in order to pay for a large percentage of the project. Debt funds from lending institutions can be relatively expensive, and may 3 The power purchaser is usually a utility but may be a large industrial user, green power marketer, or other entity involved in the sale or use of electric power. 4 A utility's nominal weighted average cost of capital (WACC) of 8.6% instead of the developer's is used in this report as the discount rate in both the PV and UCRF calculations so that projects proposed by different developers can be compared on an even basis. 2PDF Image | An Economic Valuation of a Geothermal Production Tax Credit
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