Stallard — The Cost of Capital; Not Just Money

I approached this assignment as if I were submitting a proposal to my board of directors for a project that would be funded by the member/owners of my electric cooperative — funding that is in part debt, retail electricity rates and member equity. The key concepts are the same for any proposal that involves a financial investment — to present the financial facts along with an industry and political forecast and perspective that will demonstrate the project is viable from the beginning and profitable in the end. The project needs to make sense for the people who will be funding it. In the case of a renewable energy project, I would need to be able to explain the short-term and long-term need for the power output of the project; the capital outlay or investment; what incentives, grant money or funding is available; any political, regulatory or market-based disruptions and support or opposition for the project.

With regard to the financial justification, several processes are involved. First, I would need to demonstrate the return on investment which in its very simplest terms is the ratio between the gain from investment and the cost of that investment. This represents the benefit the investors — in this case, the paying membership — gain from the utility doing the project. Second, I would calculate the return on equity, which is the net income after tax divided by shareholder equity. This is a little more complex for an electric cooperative, but given that business model, it would be the net income (income after expenses) compared to member equity and would represent the membership’s investment in the effort. The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. While it might mean the minimum the company must make to satisfy its creditors or investors, in the case of an electric cooperative, it would mean that the cooperative has money or member equity left over after all expenses are paid. Most cooperatives have an established equity level that must be maintained to satisfy internal controls and financial institution requirements. I would also need to calculate and communicate the net present value, which explains the potential for the success of the project. The NPV projects the change in the project’s value from the time the investment is made for a period of years. A positive NPV means the project is viable in the long-term.

Overall, the financial calculations need to be presented as the payback on investment, given the individual circumstances and geographical differences. Information and data used in the analysis needs to represent the true, most up-to-date cost of a project as those costs are constantly evolving with technological advances. Ultimately, it goes beyond just cost to considerations that include projections with regard to government incentives as well as legislative and regulatory initiatives. All ultimately affect cost.

Renewable Power Generation Costs in 2012. International Renewable Energy Agency. 2013. Retrieved from http://www.irena.org/DocumentDownloads/Publications/

4 thoughts on “Stallard — The Cost of Capital; Not Just Money

  1. Hi Christine,
    Great post as usual! I am always interested to learn from people who actually work in the industry, like yourself. I found it interesting to learn how the cooperative has equity levels that must be maintained. What happens when the equity falls below the required level? Is it based on quarterly or annually results?

    • Hi Mark! Always good to hear from you. An electric cooperative is a very interesting and unique business model. Equity in this business model is like a profit margin for a private utility. Operating revenue is acquired through retail rates. Any money left over at the end of the year (a profit for a private utility) is allocated back to each member in the form of capital credits. So, that part is done annually. But, it is not returned to the member (like dividends on shares in private companies would be). Instead, it is held on the books and used, along with short-term and long-term debt, to run the business. Every year, our board of directors determines if financial conditions will allow some of those capital credits/equity to be returned to the membership. My cooperative has returned capital credits that were paid (again through electric rates) up through 1986 and the goal is to be on a 25-year rotation. There is a certain range of equity levels that must be maintained according to auditing standards as well as by our financial institutions. If proper equity levels aren’t maintained, it affects your ability to borrow from regular lending institutions as well as through the federal government (RUS borrowing). To learn more about cooperatives, go to http://www.nreca.org (National Rural Electric Cooperative Association) or http://www.nrucfc.coop (National Rural Electric Cooperative Finance Corporation). Enjoy! Thanks for asking!
      Christine
      P.S. Love the Lion in the picture!

  2. Hi Katie. Sorry for the slight delay in responding. I was focusing on getting this week’s assignments completed and posted as I’m sure many students are! First, thank you for your kind words regarding my posts. I have been in this business for a long time and I like to find ways to apply what I’m learning in the classroom to what I do every day. I’m glad someone finds it interesting — and useful information!

    With regard to your questions, I could write a book about it; but I’ll try to keep it brief. I’m not sure where you live, but I live in the Pacific Northwest, a region that probably has the lowest carbon footprint in the country. My electric cooperative is a full-requirements customer of the Bonneville Power Administration, which markets energy generated through the federal hydroelectric projects and one nuclear plant. Thus, nearly all our energy is already “green,” reliable and affordable. If demand outweighs supply, the BPA also has access to the huge amount of wind generation that has been developed in the region over the past few years. Because of this, our financial analysis (and environmental analysis) for other “green” projects is quite different from what they would be for, say, a utility that relies on fossil-fuel generation. It doesn’t mean we shouldn’t promote alternative sources of energy. It just means our analysis is different. I had these same issues when completing the renewable energy project as the carbon offsets imbedded on the EPA site were for replacing fossil-fuel generation and that just isn’t the case everywhere.

    So, I promised to be brief. While renewable energy projects may not always pencil out for a full-requirements BPA customer, they may (and have) for businesses who are served by investor-owned utilities (Portland, OR, for example) because the power marketed by BPA is allocated primarily to public power utilities. If you visit Portland or Seattle you will find more businesses that have “gone green.” Enough said or I’ll put everyone to sleep. I wrote a history book for my electric cooperative’s 75th anniversary this year. If you would like to know more about the history of the electric utility industry in the Northwest, I’d be happy to send you a complimentary copy. Just email me your address.Thanks for reading and commenting on my post!

  3. Hi Christine,
    You always write such great posts and I really enjoy reading them to learn more about the renewable energy field. First, I want to say that you set this post up very nicely and enjoyed learning about finance from a different perspective! I think its also important that the investor understands exactly why renewable energy is a good investment. I think a lot of people view renewable energy systems as being high ticket items to get free electricity. Indeed, it’s partially true but, renewable energy is so much more in a business aspect. It starts paving a pathway towards sustainability and creates a new morale in work ethic. As people start familiarize their selves to the benefits of renewable energy, they can really start grasping how they can make a difference as well. For example, I live right beside a small coffee shop that has renewable photovoltaic panels roof-mounted. I love going in to sit down and have a cup of coffee there because the company takes sustainability a step further every time I go in. First, they began preparing food only using organic foods based on a vegan diet. Next, they installed a power monitor to display all the collected energy and how this reduced the impact on the environment. (The customer can interact with the monitor to find out more about solar energy as well and their operations) They also develop community activities that consist of educating the public about renewable energy and conservation. It is very uplifting to know that someone cares and is trying to do their part.
    Aside from the activities, I feel that the “green” transformation really put an edge on their business. They are always really busy and seem to be very successful! I know that they have my business before I go to let’s say- Dunkin’ Donuts (Starbucks is pushing it haha) simply for the reason that they offer a different business setting. So, although we can’t quite measure how a company can expand in popularity and grow in profits after going green, I believe it’s definitely apparent! Do you live around any “green or going green businesses” and notice how their success level is compared to comparable companies? Something to think about, huh?
    Katie Loyd

Leave a Reply