IRR is a theme discussed everywhere when looking at establishing DH systems – the IRR concept is still to be understood in detail in the industry. Still, it is an essential part of understanding the effect of the rollout of city-wide networks. All cities planning to enjoy the benefits of DH must understand what the IRR means and how a low or a high level of IRR will affect the rollout of DH. Not least how high IRR requirements will limit, if not jeopardize, city-wide expansions of DH.
By Morten Jordt Duedahl, Business Development Director, DBDH, and Lars Gullev, Managing Director, VEKS
The critical part is how the DH company is structured – the technical design is assumed to be the same. A well-chosen business model will lead to success. The conclusion is to pick the low-hanging fruits first, but be sure to do it in the right way.
Otherwise, a city may never be able to reap all the fruits available (the ultimate goal). The entire city – not only small, selected areas This article assumes that it is insufficient to make green heat transitions in smaller city areas. The ambition must be to ensure that the entire city can enjoy the benefits of green, affordable heating solutions in the future. And here, district heating is obvious (if not the only solution) in small, large, and megacities.
Internal Rate of Return – IRR
Internal rate of return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. IRR calculations rely on the same formula as NPV does.
In the DH industry IRR is used as a simple (maybe not always 100% correct) tool to compare the economic viability of a project. We recognise that it is not absolutely theoretically correct, but also recognise that IRR creates the best common understanding of a project’s economic viability.
The two basic models for ownership
There exist two basic models of ownership in the DH world. A strictly commercial and a strictly municipal/cooperative, one difference being the expectation to IRR. Many scholars have identified several other models between the two, but for clarity, this article claims that there are only these two.
Level of IRR in the two models for ownership
For both models, we assume they are active market players accessing the competitive and commercial market to optimize their business, e.g., find the best offers for pipes, welding, digging, planning, finance, operation, maintenance, etc. In this sense, they are both equally cost and quality-conscientious and similarly well-managed. We have found no general evidence of the opposite. The assumption also is to compare similar systems – pears to pears, apples to apples, pipes to pipes! The projects are similar.
This is a re-write of an article published in 2019 in Hot Cool. The articles have created a lot of attention and a lot of discussion. The authors have decided to divide the original article into two separate ones – both are published in this magazine.
The articles both circle around IRR and the understanding of the effects on DH.
One article discusses the effect of different expectations on IRR (this one), and another discusses how a municipal lead DH company can benefit from picking the low-hanging fruits in the right way and how making the decision on the choice of business model must be made from early on. This article is called IRR – Internal Rate of Return and how it affects the development of DH projects. You will find it on page 12 of this magazine HERE
Figure 1: Example of an entire city laid out for DH at a 0% IRR level. The black figure to the right is a significant, no-carbon-free surplus heat source. Readers familiar with the east of Scotland will recognize the map of Dundee. The examples given are not based on the actual situation. Dundee has merely been used, as discussion with knowledgeable people from Dundee led to the initial idea for this article.
In many places with municipal or cooperative ownership, the calculated IRR threshold for a DH project can be around 4%, based on a security element, leaving room for small changes in the system’s economy when established. This is not a set standard, as the DH company may accept a lower IRR if the project is straightforward and something that has been done many times before. Or it may be a bit higher if the DH company finds that extra uncertainties or risk factors should be included.
The 4% threshold is used in Denmark to evaluate project proposals. The IRR for established projects should be 0% in total for a classic not-for-profit company and can be lower for specific projects. Municipal companies operating like this are often tasked with rolling out DH to the entire city.
For a strictly commercial operation, the level of IRR will vary from project to project. Numbers as high as 18% have been mentioned – but a more realistic level may be around 14%. It must be stressed that these numbers are speculations only, as the actual level is a strict commercial secret and, therefore, unknown. On the other hand, numbers around 14% are not unrealistic. It seems to be accepted in some DH communities that 14% is correct, and sometimes 14% is even discussed as a fact.
Looking at it from a different perspective, 14% does not seem wrong. Commercial companies can invest in other projects (in any industry or country) that could provide owners with an IRR at the same level. Commercial companies exist to give their owners the highest possible return on investments with the lowest potential risk. If that leads to developing DH or something else, it is entirely up to the company’s owners.
Figure 2: A simplified example of several projects to be developed over time with different levels of calculated IRR that, in total, will become a city-wide system. Please note that the IRR numbers are fictional and for illustration only. The IRR for the city-wide system is 0%.
The lower the IRR, the more DH
It is as simple as that. The lower the expectations for IRR, the more or larger DH projects a DH company can invest in.
The first drawing illustrates how large DH can cover an area of a city with a 0% IRR threshold. A well-qualified consulting engineer has made heat maps to establish demand, calculated the pipe network, and continued to expand the area covered by DH until the magic 0% was reached. Here DH can provide affordable green heat to the entire city!
A city-wide system will always consist of several individual projects built over time – the blue “circles” in figure 2. The IRR can be calculated for each of them, ranging from very high to very low. The sum of these developments is an IRR of 0%, as shown above. Over time each of these systems will be built one by one, connected, and be able to benefit from shared heat sources, reach out to “free” heat sources, etc. In a planned and controlled way – all the apples will end up in the basket.
With a company structure around the DH company that is happy with 0% IRR, the entire city can have district heating! Usually, the small 18% project will be built first, but other goals may lead to other projects being built earlier (e.g., fuel poverty or the presence of heat sources).
Figure 3: An example of projects that can be developed with high IRR expectations (14% or more) – the complete lines. More may be developed but would then rely on subsidies or grants from, e.g., the local authority – the dotted lines. The large low-carbon heat sources to the left will not be included in the project and will be lost.
Higher IRR approach
If a project can only muster less than the required 14% IRR, a commercial company would not accept it unless financial support is given, that would bring the calculated IRR up to the threshold. A municipal DH company – with a threshold of 0% IRR would see 14% (and less) as a very relevant and investable project. It would go ahead, adding positively to the rollout in the entire city.
In the case of a strictly commercial ESCO approach, only one project would be built in this city (see figure 3) – the one with an IRR of 18%. It may be possible to identify smaller areas in some of the projects described where an IRR of 14% can be calculated. The smaller areas in picture 4 with IRR of 14% and 15%. Please note that these are smaller projects than in the drawing in figure 2.
Please also consider what happens to the potential IRR for the remaining part of the city after an 18% project has been built. It will become lower, making the rollout to the rest of the city more complicated. If you have picked the best apple (without planning), the average value of the rest will become lower.
If the local authority can financially support the development of more projects, these could be added as the support will lift the IRR to the required 14%. Sooner or later, the ongoing support from any benefactor will run out, and then no more projects will be developed. The complexity of having up to three individual and competing companies operating in the same city and the effects on possibilities for expansions and alterations to the systems is also a relevant discussion – but another time.
In this case, the solution may look like this – 3 areas developed directly by commercial ESCOs and three developed by commercial ESCOs financially supported by the local authority. Please also note that the free heat provider is not included in this case; maybe, more importantly, the rest of the city now has to find a different solution (The red circle has been removed).
DH led by a municipal-led DH company
A municipal-led DH company with a 0% threshold will, over the years, develop DH throughout the entire city. Of course, they start with the most economically viable projects and then work through the different expansions and new projects. Please note that a municipal-led company planning to build out into the entire area will consider building a project with a very low IRR before other projects. In this example, it could create the 3% project (to the right in the picture) with the primary purpose of gaining access to low-cost surplus heat (as illustrated with the small black production site) and connecting several individual projects to that heat source through the 1%
Other factors than strictly economic could similarly influence the order in which projects are rolled out. For example, areas with severe fuel poverty, areas in need of renovation, and for local and political reasons may lead to decision-makers prioritising specific projects before projects with a higher IRR – again illustrated as the very low IRR areas.
This article demonstrates the effect of DH rollout in a city depending on the accepted level of IRR. It also shows that if the low-hanging fruits are not picked in the right way, the ultimate goal may be jeopardized.
It is clear that high levels of IRR jeopardize a city-wide development of DH and could also make access to large low-carbon heat sources impossible.
This way, the low-hanging fruits will be picked in a structured and planned way, and the low-hanging fruits will be picked first, but in a way that ensures that all fruits on the tree will be picked. We will have a full basket.
The case of Denmark
This article is not directly related to how DH is rolled out in Denmark – besides that fact that Denmark has chosen to use this approach for the cities DH developments. This approach has also been used in many other places all over the world, in a recognition that critical infrastructure can be a municipal task and responsibility to be able to deliver to all citizens.
It also does not mean that jobs are not created – Denmark has a lot of jobs both directly in the DH companies and in the supporting industry. Each Danish DH company will always operate in the commercial market for all services and in that way operate like a classic commercial company. In a way the Danish DH companies are commercial companies operating in a natural monopoly.