“People often have a tendency to make decisions based on unverified instincts and outright guesswork – because it’s quick,” says Chris Lord, instructor of HeatSpring’s Financial Modeling For Solar PV Projects class.
Too often, those instincts and guesswork land developers in less-than- ideal financial situations.
A Cautionary Tale about Failing to Model
For example, one developer told Lord that he had won a power purchase agreement (PPA), and noted that the PPA price was based on a price his client had requested. Lord said he didn’t think that number would pencil out.
When Lord asked him if he had tried to negotiate a higher price, the developer said he felt comfortable with whatever the client wanted. A few weeks later, Lord learned that the developer had given up on the project.
“I learned he had abandoned the project, in large measure, he conceded, because the PPA price was too low to make the project pencil out. Worse yet, the window to negotiate a price with the client had closed. The client (or former client) now believed any price higher than the original agreement was a rip-off.”
That’s a cautionary tale about the importance of running the numbers.
Making Decisions that Make Economic Sense
“In solar and wind power development, margins are very tight and leave little room for error, yet a surprising number of people in the solar business community are slow to take up the modeling or quantitative side of project development,” says Lord. “It’s critical to look at the quantitative side consistently in order to measure and make sure you are making decisions that economically make sense, and maximize your return. You don’t want the project to end up underwater,” he says.
Lord’s financial modeling course focuses on working with project income statements, partnership flips and sale-leasebacks. Also covered are return calculations that take into account Modified Accelerated Cost Recovery System (MACRS) depreciation and the investment tax credit (ITC).
Students learn how to project the probable financial outcomes of their projects with sensitivity analysis, examining the range of possibilities as opposed to black-and-white estimations. These possibility ranges give students a fuller understanding of the risks and rewards of projects, giving class participants a competitive edge over the average layman.
Don’t Choose Numbers that Worked Once Before
For example, when securing a site using a lease agreement, the lease rate is critical. Many people just go with a number they know worked once before or heard another developer offer, all without understanding whether the target return will be adversely impacted, says Lord. “For example, if other costs are projected to be high, such as site prep or operating and maintenance (O&M) costs because of site-specific conditions, you need to run your model to know how much downward to adjust your price and still hit the target return.”
While the obvious purpose of financial modeling is to forecast performance, one of the main benefits of learning the financial modeling process is to gain a deeper understanding of the project and all of its details.
Optimizing Project Sizing to Deliver Least Expensive Electricity
Often times the small or overlooked details are the ones that can hurt returns, especially in solar and wind power. EnSync Energy, a distributed energy resources developer, uses financial modeling to “optimize project sizing and setup for delivering the least expensive and most reliable electricity,” according to a press release.
Brad Hanson, CEO of EnSync Energy, touts the benefits of financial modeling. “Our capability to perform increasingly intricate analysis and modeling, in addition to applying expertise in policy implications enables us to construct a customized PPA that benefits all stakeholders economically,” he says in the press release.
Integral to success in the solar and wind energy fields is the concept of the risk-to-reward ratio. The risk-to-reward ratio is simply your predicted possible risk divided by your predicted possible rewards.
“Using financial modeling, you can tweak the variables of your project to maximize your risk-to-reward ratio, giving you the best possible chance of yielding the most profit while protecting your downside,” says Lord.
“Typically, a successful developer takes risk management much more seriously than the unsuccessful developer. Many developers by nature are risk takers, and this can get them into trouble down the line.,” says Lord.
Being Risk-Averse and Successful
For example, as Lord mentioned, it’s not unusual to see newer and less experienced developers agree to power purchase agreements without first checking their model to see if other options would be more cost-effective. The truly successful developers are risk-averse, and are always looking for ways to reduce risk or increase return. They constantly look at the quantitative aspects of a project, and usually know how to squeeze an extra bit of return, or where to focus efforts to reduce risk of a project failure.
“You must be able to make and check your models for any given project to have any confidence that you are making a good investment of time and effort,” says Lord.
While the terms used in financial modeling can be daunting to the uninitiated, a few definitions are integral to understanding solar financing. They include power purchase agreements, escalators, MACRS, and investment tax credits.
Know Your Financial Terms
In a power purchase agreement (PPA), a developer completes an entire solar project for a customer at little to no cost. The developer then sells the power generated back to the customer at a fixed rate that is often lower than the local utility’s retail rate, according to the Solar Energy Industries Assoc. (www.SEIA.org). If developers don’t do their due diligence in modeling and make mistakes involving the utility’s retail rate, their projects will not get built, and the development effort is a total loss, he says. .
An “escalator” is an increase in an annual cost or revenue item. Typically, there is an annual rate increase of up to about 3-percent-per year built into the PPA. For example, the first-year rate may be 10 cents, but after 20 years, a 3-percent escalator could result in a rate of about 17 cents/kWh, according to SEIA.
MACRS depreciation is used to depreciate business investments over variable lengths of time, and qualifying wind and solar energy equipment is eligible for a 5-year cost recovery period.
The ITC is a 30-percent federal tax credit claimed against the tax liability of solar investors. The business that installs, develops, and/or finances the project may claim this credit.
Being Prepared for Success
“People get intimidated by modeling,” says Lord. “They think, ‘Wow, I better set aside three days for that,’ when the fact is if they just got comfortable with the models it wouldn’t take anywhere near that amount of time.”
Too often, people in the solar industry don’t put a high priority on financial modeling, he adds.
“Everybody says ‘Oh, that sounds like a good idea,’ but not as many people follow through with it. The ones who do are absolutely better prepared for success in their industry.”