Home Articles INTERNAL RATE OF RETURN AND HOW IT AFFECTS THE DEVELOPMENT OF DH PROJECTS

INTERNAL RATE OF RETURN AND HOW IT AFFECTS THE DEVELOPMENT OF DH PROJECTS

by Linda Bertelsen
Internal Rate of Return and how it affects the development of DH projects

A well-planned approach from day one to how a city would like its district heating systems to develop is essential. The key is to take the benefits from the first most beneficial systems and ensure these benefits will support the entire city over time.

By Morten Jordt Duedahl, Business Development Director, DBDH, and Lars Gullev, Managing Director, VEKS

Published in Hot Cool Special Collection, edition no. 1/2022 | ISSN 0904 9681 |
 

A city needs to establish a DH company, climb the learning curve, etc., to reach the goal of delivering sustainable heat to the entire city. An understanding of IRR is a part of the road leading to success.

Effect of different expectations on IRR

Please imagine a project with a calculated IRR of 14%. This project would be an easy sell and would be rolled out soon, no matter the chosen business model – a commercial ESCO or cooperative/municipal-led DH company. Such a 14% project would be one of the first projects to be done in a city. And if done right, it will benefit all the future developments.
The assumption is that this project will be owned by an ESCO aiming at a 0% overall IRR threshold. The DH company will benefit from the difference in IRR – they will, in a way, “earn” the 14%. What could the difference in IRR be “used” for?
Operating a project that can provide a 14% IRR, but a lower cost will create a surplus (not a profit!). This surplus should be used wisely, creating positive effects for the entire city! And not just be used to lower the price for a few selected end-users.

Here, a threshold of 0% IRR is used. This is the correct number for not-for-profit companies when looking at the entire city. The many projects should have an average of 0%.
Some may know that in Denmark, a calculated IRR of 4% is used as the threshold (required by law). The 4% is based on project proposals (calculations) and is used as a security so that new projects will not influence existing customers. If a project, when established, has a positive IRR, the “surplus” generated will be used to lower prices or create further expansions.
For a not-for-profit company the price (= the revenue stream) can be decreased until the IRR is 0%. In this article, we assume the price is fixed, fair, and acceptable.

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

Some of the positive effects are only relevant in different stages of the rollout of DH in a city. The complex process of establishing a DH company with all the lawyers, accountants, etc., is a one-off situation that must be done together with the first systems. 

Climbing the learning curve is an ongoing process, but (hopefully) the need to climb steep learning mountains will decrease over time. Making sure that main pipes are dimensioned for future expansion is also important – and is a benefit (and investment) that could be included throughout the entire city development, even as a part of the lower IRR projects.

The first projects undertaken will be projects with the very highest IRR – they are the most apparent projects and should, of course, be looked at in the beginning. Projects that will provide a lower IRR should be looked at later – unless other reasons push them forward. After the high IRR projects have been built, the learning and starting costs have been covered by the projects that could afford it and will, therefore, not influence later projects. 

Very low IRR projects will always need support from the higher IRR projects. The price offered to the end-user must be acceptable and at a reasonable level. In fact, the municipal ESCO will provide the same price to all citizens in the entire city. This is very similar to roads and other natural monopolies – we all pay the same.

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.

Figure 1 illustrates how this difference in IRR could be used for different purposes. The percentage indicated to the left in the figure will differ from project to project, from city to city, and be different depending on, for example, the number of projects already completed/started, hence the question marks. The top ones tend to be benefits that are most relevant at the beginning of a city’s engagement with DH. The button ones are benefits that are generally relevant.

A detailed discussion of how a lower IRR could be “used.”

Let’s start from the top – with the benefits that are important to harvest in the first phases of a DH rollout to a city. The benefits will help secure a rollout to the entire city and prepare the city for the following projects and expansions.

Climb the learning curve

If the project is among the first projects undertaken, it would be expected that small and big mistakes will be made, and that the organisation is still not top-professional – the positive spin on this is that the organisation will climb the learning curve. As more projects are completed/undertaken, the DH company will climb the learning curve quicker and make fewer mistakes. The first few projects will pay (and can afford) for the team to climb the learning curve to benefit other future projects. One way of overcoming this, or rather making the curve less steep, could be establishing a national competence centre as in Germany these days. Such a center can support all DH developments with expertise and at the same time act as a training center.

Create the local DH company – the Council ESCO

If this is the first project undertaken by a city-run DH company, the city will need to establish and develop the DH company – this may be at a substantial cost. This would be a one-time cost and only influence the IRR for the first project. Here, the first project “pays” the total cost of establishing the DH company to the benefit of future projects, who then have access to an experienced DH company that is already well established. Great care must be taken here, as this is the vehicle that will ensure future success.

Build in extra network capacity to support future expansions – Future-proofing

Another vital option is to build in future-proofing of the network. As the plan is to create citywide projects, the first projects (the ones with the highest IRR) could be dimensioned to be the backbone of the future system. Here, cash flow would remain unchanged (if we assume that operation cost is not affected by this short-term over-dimensioning). Still, the investment would increase, thereby lowering the IRR. The extra capacity will help future projects reach an acceptable IRR, as the first project has already made small additional investments to benefit the following projects. The same argument can be used for building extra production capacity or preparing sites to be ready to install more heat production capacity.

Build equity to support future developments

The whole idea of a citywide municipal-owned ESCO is to ensure that the company can expand the DH system to the entire city. As the first initial one-off cost has been covered, some of the surpluses in the following projects could be earmarked to simply building equity to support future projects with a much lower IRR. Then the DH company has the capital it can inject into projects with a very low or maybe even negative IRR as a part of the goal to deliver sustainable, affordable heat to the entire city.

Improve quality to minimise operation and maintenance cost

Project developers will always seek the right balance between investing in high quality to avoid operation and maintenance costs or vice versa. The effect on IRR could be neutral as an increase in investment would be offset by an increase in net cash flow, as costs would decrease. To the extent that the first projects will be developed as part of the backbone of future projects, it may be relevant to overdo quality over operation and maintenance. If the project is again among the first undertaken by the municipal lead ESCO, overdoing focus on quality to avoid troubles and uncertainties on maintenance and operation costs may be relevant until the organisation has climbed/completed the learning curve.

Build a surplus to balance income from year to year

Many DH companies prefer to offer stable prices over the years and avoid price fluctuations. Many DH companies have a standard price for the whole season to allow the end-users to budget correctly. It is common to create an income buffer that allows a DH company to run a small surplus one year (if the winter is colder or warmer than expected) to cover a small deficit the following year to balance the price over time.

Price reductions

Not relevant! The price is assumed to be fair for the entire city! But still lowering prices should be the aim of the DH company – of course!

Conclusion

A city must ensure the district heating business structure created can support the development of the citywide DH system. The business model chosen should be able to harvest the benefits from the highest IRR projects and make the city capable of making the lower IRR projects come through over time.

For further information please contact: Jordt Duedahl, e-mail: md@dbdh.dk

Meet the authors

Morten Jordt Duedahl
Business Development Director, DBDH
Lars Gullev
Senior Consultant, VEKS
“IRR – Internal rate of Return and how it affects the development of DH projects” was published in Hot Cool Special Collection, edition no. 1/2022. You can download the article here: