Net Present Value Rate & FrontLoaded PricingFrontloaded pricing enhances the viability of community energy projects by improving cash flow and thus reducing the need for difficulttoraise community capital. Frontloaded pricing is achieved through the use of net present value calculations based on a CBED invention called “NPV rate.”
NPV Rate. NPV rate is a CBED invention that leverages NPV to reduce the cash flow constraints associated with communityowned energy projects. Since power purchase agreements (PPAs) between electric utilities and energy producers are for a fixed time period (typically 20 years for wind projects), and since the amount of electricity produced by a specific CBED project can be predicted based on modeling and wind measurements, it is possible to establish the NPV—a lump sum amount in today's dollars—that represents the dollar value of all of the electricity that's going to be produced over the 20year life of the project. Dividing that NPV by the total kWh of electricity produced over the same time period gives us the NPV rate. In formula terms, the NPV rate is the present value of electricity in dollars divided by the total expected energy production (expressed as $/kWh). How Discount Rate Affects the Value of Electricity. Because NPV rate incorporates the time value of money in the price of the electricity, it is possible to determine up front (at the time the PPA is negotiated) the value for each kWh of electricity produced over the entire 20year life of a project. Figure 1 shows how prevailing interest rates (discount rates) affect the value (price) of electricity. By fixing the NPV rate (in this case, at $0.027/kWh), we see how discount rates between 6% and 10% drive the 20year fixed price. So, for example, it can be mathematically shown that if a discount rate of 6% is used, the value of the electricity generated is equivalent to a fixed price of $0.047/kWh over the 20 years (assuming $0.027/kWh NPV rate). If a discount rate of 10% is used, the value of that same electricity over the same 20 years goes to $0.063/kWh. The NPV rate, then, incorporates the time value of the electricity being sold by taking into account the discount rate used for the large upfront capital purchase. If project owners invest a large amount of capital today for income that will be received over the next 20 years, the discount rate used will affect the fixed price the owners must receive in order for the project to be viable. FrontLoaded Pricing. Once the NPV rate has been established, community energy projects are made significantly more efficient financially through the use of a frontloaded price, that is, by establishing a higher price for electricity in the early years balanced by a lower price in the later years. By using the NPV rate as the anchor point to determine a variable price over time, it's possible to tailor the price to completely smooth the project's net cash. The utility will pay the same present value amount for the electricity over the life of the PPA, no matter how the price varies, as long as a common NPV rate is used. As a result, the utility has relatively little vested interest in whether or not the price is variable and frontloaded. The CBED owners, on the other hand, have a strong interest in the variable, frontloaded price, since such a pricing scheme supplies a way to even net cash variations over the the lifetime of the project. The net cash variations include the substantial debt repayment associated with the purchase and installation of the capital equipment, usually paid for over the first 10 years. Figure 2 shows a sample project’s fixed price compared to its frontloaded price equivalent. The frontloaded price is higher in the first ten years when debt service payments on the equipment are high, then falls in year eleven when the loan is paid off. Figure 3 shows the resulting net cash of the project described in figure 2 using the (problematic) fixed price scenario compared to the (desirable) frontloaded price scenario. In the fixed price scenario, the net cash curve gets dangerously close to zero in the early years (just before the 10year debt is paid off). Multiple years of net cash "famine" awaiting the net cash "feast" in the out years poses a competitive challenge for community projects, which are unable to easily manipulate the necessary cash flow. In the frontloaded price scenario, however, the variable price based on NPV rate allows the net cash to be completely levelized. The upward slope in the net cash curve reflects the increase in dollar value over time required to ensure a constant present value dollar amount. Conclusion. The combination of NPV rate and frontloading ensures financial efficiency in order to allow CBED projects to succeed for both the CBED owners and the utilities with which the CBED owners negotiate. Please refer to the CBED Calculator for the mathematical details behind the CBED frontloaded pricing model.
