QUESTIONING THE VIEW THAT PRIVATE INVESTORS ONLY HUNT DOWN LARGE IRRS

The Internal Rate of Return (IRR) is undoubtedly a key metric used within the financial appraisal for investing in a project. It is probably the most quoted financial metric because it is so easy to understand – “I will get a 10% return on my investment”. What could be simpler? As the IRR is a percentage value, it gives the impression of being comparable to other projects: “This project is forecast to achieve a 10% IRR, and the other is forecast to achieve a 4% IRR.” All things being equal, the rational investor would select the 10% IRR. Of course, no two projects are entirely alike, and therein lies the rub. This article questions the presumption that private investors invariably want double-digit returns in UK DH.

By George Robinson
George leads on investment and finance in the Heat Network Delivery Unit (HNDU) in the UK Department for Business, Energy and Industrial Strategy (BEIS). All opinions expressed in this article are his alone.

Options Appraisal

Let’s imagine two UK DH projects that are looking for investment.

1. Project 1 has a forecast 12% actual pre-tax project IRR (30 years) and an investment requirement of £3m.
2. Project 2 offers a forecast 6% real pre-tax project IRR (40 years) and an investment requirement of £18m.

The IRR has caught our attention, but now there are some key questions we should be asking ourselves:

1. How probable is the project to realise the forecast profits?
2. What is the risk that we will need to invest more? E.g., what if there are construction delays, unforeseen issues, etc.? How would these contingent scenarios impact our forecast returns, and therefore, what contingent capital do we need to have in place?
3. How much capital do we have available to invest
4. What are our responsibilities regarding the capital available to invest?

Quality of cash flows

If we were to appraise this on IRR alone then Project 1 would win hands down as not only does it offer a higher return, but it is also forecast to realise the return ten years earlier than Project 2. However, it could be that the likelihood of Project 2’s revenue streams being achieved is far more probable than those of Project 1. Let’s imagine:

• Project 1 is heavily reliant on gas CHP combined with private wire to commercial customers;
• Project 2 is designed to sell low-temperature hot water to publicly owned buildings, which will undergo a degree of retrofit activities to accommodate a lower than current supply temperature.

With this information, as a potential investor, you might need to rethink Project 1 and want to appraise it over 15 years to align with the expected useful economic life of the gas CHP as the carbon case for fossil gas CHP after the first life cycle might be anticipated to be prohibitive if the UK 2050 carbon targets are to be met.

In this made-up example (but still using actual numbers), the returns drop to 8.6%, all things being equal, assessing the cash flows up to year 15 only.

We would also want to compare the credit quality of the public sector energy off-takers in Project 2 against the credit quality of the commercial energy off-takers in Project 1. It could be that a 2.6% IRR premium for Project 1 (15-Year Project 1: 8.6% less Project 2: 6%) is deemed insufficient compensation to manage the risk of default or non-renewal of energy supply from one or more commercial customers. This would need to be carefully weighed up as a greater certainty over sales warrants a discount.

“Perhaps…
we should all press the reset on any presumptions we may have on what private sector investment hurdle rates will be and rethink whether IRR alone is as significant a motivator for investment decisions in UK DH as is sometimes thought.”

George Robinson

Contingent Capital

Plenty of papers have been written on risk management strategies in DH. For example, guidance on this can be found on our website: https://www.gov.uk/government/collections/heat-networks-guidance-for-developers-and-the-supply-chain For this exercise, I will assume that Project 1 and Project 2 do not have fundamentally differentiated technical and commercial risk profiles (needless to say that they would – certainly on the technical).

Capital Available

Project 1 only represents a £3m opportunity, whereas Project 2 is six times larger. Assuming that the investor can only invest in one project, then she must have less than £21m of capital available (or else she might consider investing in both) – let’s assume she has exactly £18m.

If she opts to invest in Project 1, the investor will have £15m of capital that remains unemployed. The investor will not want that capital sitting in a bank account earning next to 0% interest! Let’s assume that she successfully found other projects, but it all took a bit longer than hoped.

Let’s also assume that the investor was able to see a comparable investment every two years until the £15m was fully invested (referred to as a staggered investment in the chart below):

Figure 1: Chart showing that undeployed capital (grey bar chart – i.e., sitting in a bank) has an opportunity cost as it could have been invested elsewhere to generate a return. The yellow bar chart shows the staggered investment of that undeployed capital.

The investor’s blended pre-tax project return on this staggered investment approach would be estimated at 7.1%, assuming that every new investment achieved a 12% return (no easy feat in UK DH!) and unemployed capital earning nothing.

The investor must have been confident that a sufficient pipeline of such projects would be forthcoming to rationalise the additional 1.1% IRR benefit. Were Project 1 only appraised over 15 years then the estimated blended pre-tax project IRR falls to 6.6% – only a 0.6% IRR benefit over Project 2 (although forecast to be realised ten years earlier).

The portfolio benefit of the projects developed (spreading risk across several projects and gaining learning) might still push the investor in this direction, but this could easily be outweighed by the transaction costs associated with appraising each opportunity (not included in the analysis above).

As such, opting for a higher IRR in this case may have been cherry-picking – the rational investor needs to ensure that all capital available is employed as efficiently as possible.

Investor responsibilities

Investors have competing responsibilities for their disposable capital. We have seen in the previous example the importance of employing capital available and the impact on returns when that is not achieved.

Making a sufficient return on capital employed is important, but it is understood that not every investment will reach the desired return. The key is that the blended return is at or ideally above market trend across a portfolio of investments.

Understanding how a given market performs is essential. This can be achieved through market analysis, acquiring/investing in companies in the sector with historical performance data, or combining the two. Getting this kind of intelligence can be challenging.

One of the many hopes of our £320m capital budget, the Heat Network Investment Project (HNIP) (https://www.gov.uk/government/publications/heat-networks-investment-project-hnip-scheme-overview), is to encourage a wider pool of investors into the sector to enable them to understand better how DH performs in the UK context. This is hoped to help stimulate a self-sustaining UK DH market that delivers low/zero carbon heat at a deployment rate necessary to achieve our 2050 aspirations in this area [1].

Looking at the Heat Network Delivery Unit’s portfolio of live projects that are at the techno-economic feasibility stage (and for which we have usable data), we can see a distribution of forecast returns [2] with an average Project IRR of 6.8%:

Figure 2: This chart shows the distribution of forecast returns of a sample of the portfolio of UK heat networks supported by the UK Government’s Heat Network Delivery Unit

The average forecast returns of UK DH are no secret: it is challenging to make double-digit returns as, typically, energy generation and energy distribution capital costs both need to be recovered in a single investment appraisal.

The HNDU portfolio of projects suggests a standard deviation to the average might be in the region of +/- 3%, which, assuming normal distribution (the blue curve), would suggest that a little less than 70% [3] of new DH projects should perform between 3.8% and 9.8% [4].

The “alpha” that an investor should bring is an ability, through good due diligence, to ensure better that forecast returns are achieved – e.g., through tighter contractual terms – and enhance returns – e.g., through stacking revenue streams such as combining a DH with agricultural processes, bidding into electricity market mechanisms, etc.

This should mean that lower-than-expected project IRRs can be acceptable to, yes, private investors. Our own market intelligence and publication of investors have confirmed that at least some are certainly willing to consider them for UK DH (https://www.gov.uk/guidance/heat-networks-overview#investing-in-heat-networks).

Local Authorities and broader public sector investors may well consider investing in projects with lower returns than most private investors would be able to go down to. However, this is not necessarily because they have access to cheap finance: many private investors also have access to affordable finance. Rather, public sector bodies should, and indeed do, consider the more comprehensive societal benefits that DH brings.

In the UK, we guide how to attribute a monetary value to emissions and air quality impacts: https://www.gov.uk/government/publications/valuation-of-energy-use-and-greenhouse-gas-emissions-for-appraisal. DH schemes supported by BEIS would always be expected to reduce emissions and have limited local air quality impact relative to an appropriate counterfactual. As such, the Social IRR should always be higher than the project IRR for UK DH. A project with an IRR of 3% could have a Social IRR double that.

By way of example, below are 6 HNDU-supported projects that intend to utilise Low or Zero Carbon technologies. They have undertaken techno-economic feasibility studies for which we have data on capex, carbon, and project IRR:

Figure 3: This chart shows the potential impact of further evaluating and monetising the forecast carbon abatement and air quality improvement potential that a heat network project should offer. Guidance on how this calculation can be done can be found in the UK’s Green Book Supplementary Guidance: valuation of energy use and greenhouse gas emissions for appraisal.

As can be seen, the impact on the reported IRR can be substantial irrespective of whether the carbon saved displaces traded carbon (i.e., carbon already accounted for under the European Emissions Trading Scheme) or non-traded carbon.

Increasingly, private investors are also considering their social role and how impactful their finance is in achieving the UK’s and, indeed, the world’s long-term objectives about climate change.

Demonstrating to a private investor that a sufficient monetary return can be achieved (our non-representative market engagement suggests currently 5-6% or more) and that the social impact is high could be a strong pull for private investment.

Footnotes: 

[1] It is important to note that the UK DH sector is essentially a primary investment sector – investors are investing in new infrastructure. Construction and connection risks are probably the two most significant risks that UK DH faces (I’m sure there are a variety of views on this, but they are key risks). With an expectation of long-term stable cash flows from DH schemes, the hope is that a secondary market might evolve in the UK DH sector whereby developed schemes are bought and sold. The cost of capital associated with such schemes should be substantially lower for investors with these upfront risks being passed and the performance of a given network understood.

[2] Much of the data is available in our published pipeline of projects: https://www.gov.uk/government/publications/hndu-pipeline. Projects with less than 0% IRR have been excluded on the basis that they would unlikely be taken forward

[3] In statistics, one standard deviation from the mean would be expected to represent 68% of the sample population.

[4] The data is quite strongly positively skewed. I think this is more a product of the UK DH sector, where there is a split between projects intending to use gas CHP with its highly valuable electricity as a means to enhance returns versus projects that focus on generating heat from lower carbon sources (e.g., ground/water source heat pumps) from the get-go. It is important to note that they are just forecasts. Still, they do indicate how engineering specialists in the UK generally expect DH schemes to perform economically, typically over a 30-40 investment period.

For further information, please contact: George.Robinson@beis.gov.uk