We started this series discussing how payback is a poor choice as way to convey the value of solar. In our last article we introduced two better approaches: NPV and IRR. We went into depth with NPV, today we will cover Internal Rate of Return (IRR).
In evaluating the attractiveness of an investment in the solar energy project, one of the things that we like to point out to people is that solar energy projects can have very attractive Internal Rates Of Of Return. The problem is that IRR is not a very intuitive metric.
According to Investopedia, IRR is:
The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. (Source: Definition of 'Internal Rate of Return - IRR, Investopedia, Link)
What does this really mean?
You should consider the Internal Rate of Return to be the rate of return that an investment would have to beat in order to be better than the proposed solar array. So, for example, if you are presented with a solar project with an IRR of 5% over 20 years, the operative question is whether you have an alternative to invest that same amount of money in a savings account, CD or other investment that would beat that return.
Let's take a real live example of a project we recently proposed for a large commercial business in Ohio. We calculated the IRR at 5% over 10 years for an investment of $100,000. That is the same as if the business owner had put $100,000 in a CD. As of the writing of this article, the 10 year CD rate at Chase bank is 0.9%. That means that the solar project is paying 4.1% more in interest than the CD.
What is the downside: you have to consider the risk of the investment. A bank CD is guaranteed by the FDIC, so it is more or less a risk free investment. On the other hand the risk factors in the solar investment are:
- Electricity prices
- Incentive payments - There are many different types of incentive payments with differing degrees of business risk.
- Fixed benefits, such as the 30% federal investment tax credit, are valued based on the installed cost of the system and the risk of that benefit being reduced are very low.
- Variable and production based incentives, such as solar renewable energy credits, can be extremely volatile and their risk should be evaluated as such. This topic will be covered in a future post.
- Array output - While the amount of sun varies considerably day by day, over the course of a year, and especially over the course of several years, the output of a given array in a given location can be predicted with remarkable accuracy. Over the long run, the U.S. Department of Energy estimates that the long-term estimates are plus/minus 10%.
- Operational / equipment risk - This is very low for standard, fixed solar PV arrays. They have no moving parts and all critical equipment should be warranted for at least the period of the financial analysis.
Calculating the IRR of a project provides a useful metric to helping understand the economic value of a project. However, it does have a number of limitations which should be taken into consideration (a good summary is here).