What Cost of Capital Should You Use?
The cost of capital, or equivalently the discount rate, quantifies the discount for future dollars compared to today’s. Decarbonization capital investments earn returns over a long time, making the cost of capital selection decision critically important. Here, we cover some of the considerations we account for in estimating a cost of capital.
We use standardized costs of capital in our modeling. Solar projects with PPAs are 5%, for example. CCUS is 12%. Our clients sometimes ask why we use that cost of capital, and sometimes they ask us to use a different one.
Using a different one is easy: we are transparent about our modeling and the user can enter a different number if they want, as in Figure 1.
Figure 1: Transparent Model Assumptions
Let’s start from the beginning.
What is Opportunity Cost of Capital?
A dollar tomorrow is worth less than a dollar today. The premium for a dollar today is the discount rate or, equivalently, the cost of capital. Everyone agrees that the market interest rate for a riskless security impacts the cost of capital — higher US treasury yields increase cost of capital, all else equal. Beyond risk-free rates, cost of capital is impacted by business risks.
But not just any risks. Standard theory holds that cost of capital is the compensation investors demand for risks that they can’t diversify. Many risks can be diversified in a large portfolio. For example, risk of forest fire smoke or snow accumulation on solar capacity factors can be diversified geographically. This would be an uncompensated risk.
Some compensated risks are related to leverage: operating and financial. Leverage increases the equity cost of capital.
Here’s how. When an economy is in recession, revenue dries up while fixed costs remain, well, fixed. Margins collapse or might even go negative. At the same time, prices of everything drop, and every business faces worsening conditions, making capital funding scarce.
The greater the proportion of fixed costs, the greater the operating leverage, and the greater the exposure to macroeconomic conditions. Therefore, the greater the operating leverage, the greater the cost of capital, all else equal.
Financial leverage, in this model, is analogous to fixed costs. Debt service, principal repayment, and refinancing costs must be paid when due. This means higher debt loads increase the compensation that equity investors require. Because capital structure is a management choice, many investors apply an unlevered cost of capital, determined only by the asset characteristics when assessing a specific project’s return.
Finally, the word opportunity comes up in cost of capital discussions. This refers to the diversified shareholder’s investment universe. A diversified shareholder will demand a return commensurate with their opportunity cost. An opportunity-rich investor should logically demand a higher return.
Moving Beyond the Theory
To recap, opportunity cost of capital for equity investors is:
- Higher for more volatile revenue streams.
- Higher with increasing risk-free rates.
- Higher for more fixed costs.
- Higher as leverage increases, but usually ignored for asset evaluations and stated on an unlevered basis for project valuation.
- Related to a diversified investor’s opportunity cost.
Factors 1-4 might be modelled mathematically, but the fifth factor can change and be subjective. Investor preferences can and do change over time.
Other factors that can’t really be modeled are company specific. Sometimes a business has constrained management attention, instead of constrained capital resources. In such a business, managers may well rationally demand that projects recover a higher discount rate simply because they are overwhelmed with opportunity.
In other cases, companies might assert a lower cost of capital because of size, expertise or management capability. We find it harder to credit lower costs of capital due to these factors, because it means that a better company will fund worse projects. But many market participants are willing to accept lower returns from some companies and not others.
Impact of Development Stage
Early-stage, pre-construction projects require a higher rate of return, for a number of reasons. The asset under development is progressing through an interconnection queue, an intangible if there ever were one. Because the asset is intangible, recovery on partial completion or failure is small (or even zero). This increases financing risk, because a failure to fund the next step results in a total loss on the original investment.
In addition, development teams specializing in early-stage developments have a massive opportunity set. On the upside, it means a large portfolio of projects has lower risk than a single project individually. But on the downside, and increasing the cost of capital, it means that the scarcest resource is management attention. As we state above, when the bottleneck is management attention, developers will want a higher cost of capital to screen in only the best opportunities.
Finally, a portfolio of early-stage opportunities is expected to suffer attrition through time. As projects fall off and their investment values fall to zero, the remaining projects have to pick up the slack. Perhaps there’s a timing or milestone component to the cost of capital as a result. As projects level up, they achieve a value lift as they pass through a milestone, which in analogous to a falling cost of capital as they approach the notice to proceed.
We think of early-stage development as subject to a risk matrix, in which the developer’s track record, the complexity of the IQ process, competing supply, market demand and other factors impact the chance of reaching commercialization, which we outline in Figure 2.
Figure 2: Early-Stage Project Risk Weighting
The upshot: pre-interconnection-agreement projects have a cost of capital in the mid-teens or even higher. There’s no model we can point to for this assertion; rather, it’s a reflection of what investors are telling us they need. It’s subjective, but it’s real.
Isn’t There an Answer?
Renewable energy resources — wind and solar — have high fixed costs. Both initial capital and ongoing operation/maintenance are unrelated to capacity factor, energy generated and power prices. Costs are a function of installed capacity, not system energy generation. This argues for a high cost of capital.
Two factors reduce the cost of capital. First, government incentives reduce the volatility of revenues and the correlation of revenues to the business cycle. Second, many renewable investments have prices completely fixed under power purchase agreements (PPAs).
When it comes to hydrogen or CCUS projects, the capital bite is so large that we believe size alone increases cost of capital. The required return on any $1 billion project is higher than on a $10 million project. It’s a version of the operating leverage discussion above: very high capital costs demand a higher return, we believe. In addition, hydrogen and CCUS revenues are often backstopped by chemical or refining companies, which are typically higher credit risks than a regulated utility or Google.
Counteracting the base high cost of capital is the Inflation Reduction Act (IRA). The hydrogen and CCUS provisions in the IRA reduce revenue volatility and counterparty credit risk, and as such should reduce cost of capital over-and-above the impact of increased cash flow.
Finally, development stage and recovery on failure are major factors that investors definitely consider. The lower the probable recovery of the investment — or the higher the probability of total loss — the higher the return investors will demand.
When management attention is the organization’s bottleneck, figuring out how to scale that attention and focus on the best opportunities can help increase portfolio returns. On a macro, economy-wide level, improving managers’ ability to scale their attention can reduce cost of capital by reducing the risk of early-stage projects. Given our business, it’s no surprise that we believe analytics can help scale up a strong management team’s focus, both increasing an organization’s returns and increasing renewables investment.