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Finance costs methodology

This note sets out the approach used to include finance costs in the 2050 Calculator.

Case for including finance costs in the 2050 Calculator

Many of the assets in the 2050 Calculator involve significant upfront investment – in particular, electricity generation technologies. The cost of financing these lumpy investments can be a significant component of their costs.

It could be argued that the 2050 Calculator should not include finance costs because it only captures physical costs (fuel, technology and operating costs).

However we have opted to include finance costs in the Calculator for the following reasons:

  • Enterprise as a resource cost. The Calculator captures resource costs; classical economics defines these as: labour (e.g. wages of engineers to design and build cars), land (e.g. cost of the raw materials required to build a car) and capital (e.g. cost of machinery used to mass manufacture cars in a car plant). However neo-classical economics extends the definition of resource costs to also include enterprise (e.g. the upfront finance used to pay for the start up costs of the car manufacturer – hire of premises, purchase of equipment, hire of workers, etc). The return to enterprise is the rate of interest on a loan. The rate of interest can also be regarded as the opportunity cost of finance: if the money was not used to finance low carbon technology, it would be used for something else. On this basis, finance costs should be included in the Calculator.
  • Prudent to err on side of inclusion. It is prudent to err on the side of including finance costs rather than excluding them. In reality, finance costs can be significant so it is better to have an understanding.
  • Biased towards capital intensive projects. Excluding finance costs would make very capital intensive projects look favourable compared to projects where the composition of costs was less capital, more opex and fuel. This would not be a fair comparison.

Choice of interest rate

In reality, the interest rate a project faces is likely to depend on the risk premium associated with the technology and with the source of funding, for example through private markets, government bonds, or general taxation.

Taxes and subsidies are excluded in the 2050 Calculator analysis, so this interest rate is the “take home” return the investor receives. During the evidence gathering process, we sought stakeholder views on what interest rate has been used in the market and received the following:

Source Real “take home” interest rate
Tim Stone Nuclear, CCS, wind: 5-8%.
Offshore wind, tidal and other more experimental methods 7-10%.
Various DECC, CCC and IEA power sector studies 10%

So we are setting the high end of the interest rate range at 10% and the default at 7%. This 7% default rate represents a low/moderate interest rate for the power sector, and is probably closer to rates private individuals would pay to finance the cost of, for example, a loan for a car or a domestic heat pump . The 7% default rate is intended to be a compromise between rates faced by private individuals purchasing heat/transport infrastructure (which accounts for over half the capital costs in the Calculator) and the typically higher rates faced by power generation technologies.

Choice of loan period

The period over which the cost of financing a project is repaid can vary in response to a number of factors.

When considering loan periods, it is worth distinguishing between:

  • Asset life – the period of time an asset could be used for, determined by technical factors. For example, a CCGT gas plant could be used for a maximum of about 30-35 years.
  • Economic life - the period of time over which an asset is likely to be economically viable to use. This may be less than the asset’s technical life due to rising maintenance costs or obsolescence. For example, the CCGT plant mentioned above will typically be retired after around 25 years.
  • Typical investment horizon – lenders may wish to recoup their costs before the end of an asset’s economic life. For example, investors may not be prepared to wait until the end of a nuclear power plant’s 40 year economic life to see a full return on their outlay.

The most technically accurate approach would be to use the economic life of assets to determine when to build new capacity in the relevant technologies, and then spread the relevant finance costs across the typical investment horizon for that technology.

We have adopted a simpler approximation, namely:

  • use the economic life of each asset to determine the replacement rate of technologies in the Calculator
  • spread the finance costs of this investment across the economic life or 30 years (whichever is shorter).

We have adopted a “30 year cap” because:

  • The typical investment horizon for assets tends to be less than 30 years.
  • For those very long lived assets with longer investment horizons, the interest rate on the first 30 years is typically higher than for subsequent years. This is because the first 30 years are relatively more risky than subsequent ones (as the earlier years include the design and build phase ).

Functionality of the 2050 Calculator

Above we set out a simple approach for capturing finance costs in the Calculator. This will be the default setting when results are displayed. However we have built in functionality to the Calculator so the user can explore different ways of looking at these costs:-

Web tool: user will be able to experiment with the impact of reducing finance costs to zero. This could represent a lower or zero interest rate across all technologies (perhaps reflecting different assumptions about sources of funding).

Spreadsheet: in addition to the above, the user will be able to explore any combination of finance costs possibilities including:

  • specify different interest rates and loan period for different technologies
  • view costs in an amortised format
  • calculate the NPV of a pathway or technology (which is calculated using amortised costs)
  • view cash flow costs excluding finance costs. This will show the lumpy nature of investments.