A Market Based Model for Determining the Investment Benchmark of Renewable Energy

Projects in South Africa

Wednesday 20 June 2012 16.25 – 16.50 Parallel Session 2: ‘Promoting Renewables’

John Fay & Umesh Kumar (SUNY Canton)University of Cape Town – Graduate School of Business

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Need for Alternative Energy Sources

• At present, renewable energy is relatively expensive in comparison to traditional fossil fuel based energy sources

• Financial incentives are required to pilot and implement renewable energy technologies, such as solar and wind

• Effective incentives must fully recognize the underlying local financial drivers

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Cost Effectiveness of Alternative Sources

• Innovative Financing Mechanisms, are being deployed to entice Independent Power Producers (IPPs) at the national level (Price vs. Demand options)

• Internationally, Kyoto Protocol’s Clean Development Mechanism (CDM)and voluntary carbon markets provide incentives to use alternative source of energy in “Developing Countries”

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A Case of South Africa - Discount Rate for Project Evaluations

• SA has tremendous potential for alternative energy and increasing electricity demand

• Residential pricing per Kwh in SA is 0.52 ZAR ($0.074) in 2011 – increasing 16% in 2012 to 0.61 ZAR

• 2009 SA REFIT wind pricing at 1.25 ZAR ($0.18), changed to competitive bidding- first window 1.14 ZAR (December 2011); second window 0.89 ZAR (March 2012)

• Key assumption is Real Return on Equity for renewable energy projects deemed to be 17%

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A New Framework to Determine Benchmark IRR

• Arbitrary choice of discount rate for project evaluations may hinder the development of a robust market

• So, the question we are asking is how to determine optimal level of financial returns for new projects

• Approach: A index model to make a fair estimate of the required discount rate using financial markets observation

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International Scenario – Project Evaluations

• Internationally, projects have primarily used capital asset pricing model (CAPM) model or extensions of the CAPM to estimate the IRR

– The CAPM provides investors with useful and influential concepts for thinking about return on investments.

– The risk premium is determined by the country risk, liquidity risk, technology risk, equity risk, size risk, firm-specific risk and combination of these risks

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Proposed Model for New Project Evaluation

• The proposed model is an index based model

• Derives the rate of return on a broad index of securities which is a valid proxy for the common macroeconomic factors of the country

• Provides the cumulative assessment of investors about their expected return

• Practitioners routinely estimate the index model using total returns to estimate expected return

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Index Based Market Model

• Financing for a renewable energy project can be fully equity based or a mix of debt and equity capital

• The nature of returns for a project differs from debt holders versus equity holders

• Investors look for a risk premium on equity investment

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Index Based Market Model

• E(Re) = YTM on a Long Term Bond Index + Equity Risk Premium + New Industry Risk Premium

– The above equation is the bond yield plus risk premium method of estimating the expected return on equity

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Index Based Market Model

• The interest rate indices traded on the JSE are reported on July 01, 2011, includes all bond index, government bond index, and other bond index

Interest Rate Index Year on Year Return

ALBI Index 10.78%GOVI Index 10.64%OTHI Index 11.63%

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Indexed Based Market ModelEquity Premium Over Different Investment Horizons

Year Mean Equity Premium (%) over Bond

Yearly Geometric Mean 5.37%

Arithmetic Mean 7.08%

3-year Geometric Mean 6.36%

Arithmetic Mean 6.89%

5-year Geometric Mean 6.68%

Arithmetic Mean 6.97%

10-year Geometric Mean 7.29%

Arithmetic Mean 7.43%

20-year Geometric Mean 8.14%

Arithmetic Mean 8.19%

JSE Interest Rate Market Data on 6/14/2011

Non-Sovereign Bond Index 11.94%

All Bond Index 11.16%

“The Equity Premium and Risk-free Rate Puzzles in a Turbulent Economy: Evidence from 105 Years of Data from South Africa by Shakil Hassan and Andrew Van Biljon, South African Journal of Economics Vol. 78:1 March 2010 ”.

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Indexed Based Market Model

• Ibbotson Associates full-information beta estimation process* computes industry risk premium as presented in equation: IRPi = (RIi x ERP) – ERP

• As of June 30, 2011 fund report, the beta of the Powershares WilderHill Clean Energy fund relative to the S&P 500 is 1.59

• New Industry Risk Premium = (RI x ERP) – ERP= (1.59 x 7.29%) - 7.29%= 4.30%

*Barad, M. and McDowell, T. (2002) Capturing industry risk beta in a buildup model. Ibbotson Associates, Chicago.

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Benchmark IRR Based on Market Model

• E(Re) = YTM on Non-Sovereign Bond Index + 10 Year Equity Risk Premium + New Industry

Risk Premium 22.23% = 10.64% + 7.29% + 4.30%

• An equity investor will expect at least 22.23% return from a renewable project in South Africa

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Summary

• The proposed index model is parsimonious and it captures the common macroeconomic factors

• As the equity premium and bond yield are the index data, they increase the reliability of the estimation

• Market data shows the enduring economic relationships between elements of the real economy

• Using the index model, global or local investors can easily extrapolate the benchmark IRR.

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DISCUSSIONJohn Fay (john.fay@gsb.uct.ac.za)

&Umesh Kumar (kumaru@canton.edu)

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