I'm Lena Kitzing, and I'm Head of

Section for Society, Market and Policy and Associate Professor in

Energy Economics and Policy at DTU. Today's lecture is about
wind energy economics and, in particular,
I will focus on value metrics. After this lecture, you should be able to explain
why value
metrics are important for wind energy. Name three different
economic return metrics, explain the relationship between risk and
return, and describe how value scope is enlarged
in the socioeconomic perspective. Let me start by giving you an example
of why value metrics are important. You have these two beautiful wind
turbines here, the red and the blue. They both have the same capacity,
however, the blue one has a much larger rotor diameter and
this comes with a lower specific power. Because of that,
they also have different power curves with different power
outputs per wind speed. And in my example, you can see that
the larger blades, they have higher costs, and here the levelized cost of energy
is higher for the blue wind turbine. But when we look into the power
output of the two turbines, you can see that the larger
swept area gives us larger energy yield in
the lower wind speed areas. And if you are operating in a wind
market with varying power prices and with high variable renewable
energy generation, it is often the case that in
these high wind speed areas, the market prices are actually quite low, whereas in
these lower wind speed areas,
the market prices are high. So on average,
it can be assumed that the blue turbine has an average higher achieved
price than the red wind turbine. So here in this example, you can see
one wind turbine with lower cost and another wind turbine with higher prices. That
should give you an indication that
it is not sufficient to only look into the cost side if you want to determine
if a wind farm investment is attractive. There are different types of value
that are relevant for wind energy. The example before was about
project economic value. There are other ones that
are relevant as well. You can broadly categorize them into
business, private economic values, this side, and
socioeconomic values down here. In this lecture, we will briefly
touch upon just a few of those, and we will start with
project economic value. The first thing that we are looking
at is project profitability, and you have already heard about free
cash flows and net present value in the economy lecture of our first
version of the MOOC given by Tom Cronin. I will supplement that with the internal
rate of return here, and this should give you a full picture of this project
profitability cost benefit analysis. What we are then also looking into
more the financial value of a wind energy project, where we are looking
into risk return relations and required rate of return. This would give you a
better idea
of looking into the project as a portfolio for the firm. Let's start with the
return metrics for
project profitability. Return is the rate at which your money
grows that you have invested in, and this is also called yield. It's not to be
mixed up with the energy
yield that is used in wind engineering oftentimes, so here we are talking
about the growth of the invested money. The simplest return metrics is
the return on investment, ROI. And here we are simply looking into the
value in the beginning of a project versus the value in the end of a project, and
then we can see how much that has changed. This is the total growth
rate of an initial investment over a given period of time. It does not take into
account
the period in between, the compound annual growth rate,
CAGR, does exactly that. It looks at the value in the beginning of
a project and in the end of a project, and also takes into account that
in between your money grows. So it's the compound annual growth
rate over a given period of time, however, it only looks into
these two points in time. So there is no variation in annual cash in
and cash outflows possible in this metric. If you have a project that has varying
production values, for example, or prices, you would turn to
the internal rate of return metrics, which is the compound annual
growth rate over a given period of time at varying annual cash in and
cash outflows. The internal rate of return gives
you the project return rate, the expected return rate. Let's have a quick look at
this. If you estimate this return rate,
you would have, for example, you can put it on this axis, the cost benefit analysis
would return
you a number, for example, 10%. And then you can take this number and
compare it to other projects, and in this way you can determine
which one you want to invest in. So here in this very simple example, you would
compare three different
projects, and Project A would be deemed most attractive because this is
the one that has the highest return. In financial analysis, however,
we would never look into return as the only indicator because we
are talking about investments. Investments are always about the future. We are
today using money that in
the future should give us some returns. These returns, however, are uncertain. We
are not quite sure what the electricity
prices are going to be, what our costs are going to be, so we have a certain
investment and an uncertain return. And how uncertain this is can be
shown with this enlarged graph, where we have two axes,
the return and the risk. And here you can already see that
Project A, which gives the highest return, actually also gives the highest risk or
has the highest risk. So it is not so clear anymore if that's
the one that we find most attractive. In fact, we can start analyzing the risk
return relation of those projects. And you can see here that B has
the steepest line, which is then obviously also the project with the best
risk return relationship here. And this would be the one that
in portfolio analysis would be deemed the most attractive project. The takeaway is
if there is higher risk, an investor requires
a higher rate of return. We look always at both
indicators at the same time. But what does that mean to have
risk in investment projects? Here we always mean the uncertainty
of the project value. Let me give you two examples. The first project has
a fixed price contract. You can see that here on
the axis the price is the same over the whole project period. However, what is
uncertain still is how
much the wind farm is going to produce. We don't know,
it could be taking different pathways, and because of that,
the project value is uncertain. What we can do now is we can calculate
the project profitability distribution. So this is the probability
distribution which we expect the project to be yielding. What we can do is we have
a mean, which
is the expected value of the project, and then we can determine
the standard deviation, which is a measure for the variation. In this example with
merchant sales,
again, we assume we operate in a market where we are selling
at a variable price at the market. You will see that both the price and
the production volume are changing, which can lead to the situation
that our overall probability distribution is broader,
the project is more uncertain. So let's keep these two projects in mind. I would
deem the first one a low risk
project because there is a narrow probability distribution, and the second project
a high risk project
with a broad probability distribution. So it can be the case now that
both of these projects have the same internal rate of
return in the mean, however, one project has a higher required
return because it is riskier, and the other has a lower required
return because it is less risky. So projects with the same internal
rate of return can, on the one hand, be deemed not profitable, or
on the other hand be deemed profitable. What we can say here is
that the required returns, we look at the project and
see what does it need to yield for me can also be seen as the financing cost.
Because that is what the investors, the shareholders would want to have
in return to giving you the money, or even the banks would have in interest
in return to giving you the money. So the required returns
are also the financing costs, which are the costs of capital, which you use as a
discounting in
your net present value calculation. Let's turn to portfolios, because you would
very rarely invest
into a project that is a standalone. You would bring the project into the
portfolio of an already operating firm, and here there can be
very different projects. And what is really interesting for
us is what this one new project addition change in
the company financials. So we are always interested in looking
into the incremental impacts on the business, and that might be
related to synergies, for example. So the project might be helping on
bringing down risk exposure, or it might add to your risk
exposure of the whole firm. So these changes in risk
exposure is what we are interested in looking
at in portfolio value. So we are not looking into one project
as a project value alone anymore, it's the effect of the project
onto the firm's portfolio. Let's look into a little
broader perspective, because until now we've only looked
into the firm and the value for the firm, first the project,
then the portfolio. However, the wind farm itself
has much more effect on the overall environment,
for example, climate, local pollution,
the social society around. And if we want to include
these other elements of value into this perspective,
then we need to try and estimate what these effects are. I'm just giving you
a couple of examples here. Avoided emissions are a value that are
often counted for wind energy projects. How much is this wind energy project
contributing to mitigation of climate change? That is related to the policy
objectives
that might be related to this area, but there are other policy objectives
that the project could help with. For example, increased security of supply,
project could also be used to
increase local community benefits. There might be some additional
local economic activity. The project might help with job creation. And these are
all values that,
especially, policymakers would put onto a project to determine if this
technology should be supported and how much value is generated for
the whole of society. We should not forget that there
are also negative environmental and social impacts related to wind energy
which have to be taken into account. In general, the socioeconomic
analysis is a cost benefit analysis very similar to
the firm business case analysis, where you would generate cash flows or
monetized flows of costs and benefits, and
weigh them against each other and determine the attractiveness of
the project for society as a whole. In summary, in this lecture you
should have learned now why value metrics are important for wind energy. I have
given you three different
economic return metrics. I've looked into the relationship
between risk and return and how the value scope is enlarged
by a socioeconomic perspective.