Do We Have a Business Case

In this blog, I present a novel method for analyzing the finances of power plant operations, geared towards investors and entrepreneurs focusing on the viability of a business case.

A Different Approach

My approach to financial modeling is different to traditional model as follows.

Complex and Obscure. Traditional financial models in the energy sector tend to be overly complex, sprawling across numerous spreadsheets, which obscures understanding and adaptability. My model overcomes this by condensing the essentials onto a single sheet, distilling the cost of electricity production into four key areas: fuel costs, financing costs, operations and maintenance (O&M) costs, and miscellaneous expenses. This streamlined approach solves the common ‘circular problem’ of determining both the required investment for capital expenditures and the interest rates during the construction phase, making it more transparent and user-friendly.

Predicting the Future. Traditional models often try to forecast inflation, exchange rates, and other variables decades ahead. This is speculative at best. My approach doesn’t rely on crystal ball predictions; instead, it uses a constant money model that can be adjusted over time, reflecting real-world changes and maintaining the model’s relevance as conditions evolve.

Practical Adjustments. The reality is, most pricing models already include mechanisms to update costs based on inflation and currency exchange rates. My model follows this practical approach, using baseline figures that can be updated periodically, ensuring that future projections are grounded in the present.

Entrepreneur-Friendly. While many financial models are developed by accountants or bankers and speak their language, mine is different. It’s built to be accessible to entrepreneurs, addressing their specific needs while also satisfying the detailed requirements of financial professionals.

I designed a model for entrepreneurs and officials to determine the investment potential of power plant projects. The model evaluates key aspects: profitability, electricity costs, overall expenses, risk factors, investment and returns, funding structure, investor attractiveness, optimization areas, the robustness of the business case, and comparison to other options. Here are some questions that my model aim to address:

Is it attractive, profitable? And viable ?
What cost of electricity are we looking at ?
What will it cost to make it happen?
What are the major risks I need to address to ensure success?
How much do I need to invest and what will be my returns ?
How does the overall funding structure look like?
Will it be attractive to other partners / investors that I may invite to participate?
Where can I optimise, most effectively ?
Is the business case robust ?
How does it compare to other options ?

The Assumed Tariff Formula

I use a financial based on a constant value of money because I assume that the tariff formula will have adjustment factors to account for inflations and changes in the currency exchanges (if applicable), thus maintain the value of the tariff constant in respect of a base year whereby the tariff could be formulated as follows:

In my financial model, I employ a constant value of money and assume that the tariff formula will account for adjustments due to parameters such as inflation and currency exchange to maintain its consistent value from a reference year. The tariff formula would account for future variations, ensuring its stability over time. The formula of the tariff could be as follows:

$T_n = T_b \times (1 + i_n - i_b) \times (1 + c_n - c_b)$

Where:

$T_n$ is the tariff in year n
$T_n$ is the base tariff in the base year
$i_n$ is the inflation rate in year n
$i_b$ is the inflation rate in the base year
$c_n$ is the currency exchange rate in year n
$c_b$ is the currency exchange rate in the base year

Evaluating A Power Plant

Let’s evaluate my model using a test case. Let do the financial model of a 100MW gas power plant. I use excel for the financial model. The following figure presents the sections of the model each starting with a sequence number.

Let’s now go through each section or part of the spreadsheet.

1. Energy production. Given the power output 100MW and an availability of 95%, we get an annual energy output of 819 GWh.

2. Conversion constant. In this step we define some conversion parameters such as currency exchange rate, the tax rage, etc … that will be used in the model.

3. Fuel consumption. Given the plant’s annual energy output and its efficiency and the price of the gas we can derive the price of fuel in USD/kWh, i.e. 0.07 USD/kWh.

4. Additional cost. This section specifies additional costs to be accounted for such as wheeling and stay in business (SIB).

5. O&M cost. We give an estimated value of the operation & maintenance cost. I use a slightly higher figure than the EIA overnight cost table of 2023, at 0.01 USD/kWh.

6. Cost of Money (COM). Using the EIA overnight cost table of 2023, we use a CapEx rate of 1.2 million USD/MW and an allowance of 10% for the interest rate during construction that will be capitalized to give an overall investment amount of 145 million USD. Assuming a 25% to 75% equity to debt ratio on the investment we estimate the respective amount at 36 million USD and 109 million USD. Assuming a return on equity of 15% to be achieved over 9 years requires an annual return of 7.6 million USD. Assuming an interest rate of 10% over 20 years for the loan, requires an annual repayment of 12.8 million USD. Thus the business must pay a total 20.40 million USD to cover at least the equity and the loan.

7. Depreciation. We assume that 80% of the value of the investment could converted into depreciable amount, over 10 years that we could use in the profit & loss calculations.

8. Cost of Electricity. This step adds up the costs of fuel, O&M, COM, SIB and others to give the overall cost of electricity (COE) in USD/kWh and in absolute amount per annum.

9. Tariff. This step reproduces a Profit & Loss statement to account for other important parameters such as corporate tax and depreciation and adjusts the CoE into a Tariff amount that will generate enough revenues to result in a net profit.

10 and 11. Profit & Loss and Balance sheet statements. Steps 10 and 11 are the Profit and Loss and the Balance Sheet statements over 20 years. Figure 2 and 2 below show extracts of these statement over the first 7 years. Not that the degradation in the power output and the efficiency of the power plant are accounted. Otherwise we assume a constant value of money approach and thus no adjustment are made to estimate the impact of inflation, currency exchange variations, etc …

12. Investment Summary. This section summarises the overall investment and returns. In this case we have an overall return of ±18.4% on Equity. However, if we assume a scenario whereby the first developer took the project to prefeasibility level and gave 90% of the equity to a major investor who cover the rest of the costs, this majority partner will effectively have a ROE of ±14.9%.

13. Sensitivity analysis. This section presents how the constant value of the tariff needs to change to maintain the ROE for changes in the cost of fuel and the CapEx. In this a 50% swing in the fuel costs results in a 50% in the tariff, while 20% increase in the CapEx rate only results in 5.4% swing in the tariff.

Figure 2. Profit & Loss for first 7 years.

Figure 3. Balance Sheet statement for first 7 years

Conclusions

In this blog, I’ve detailed my approach to a simple financial modeling of power plants, using a gas power plant as a case study. My method avoids speculative long-term forecasts by employing a constant money model. I’ve crafted a model that lays out the tariff components in a straightforward way, directly addressing an entrepreneur’s core questions regarding the viability of a business case, the investment required, potential returns, and the influence of key risks on the project’s success. My model addresses the fundamental question of an entrepreneur: do I have a business case and is it attractive. Once addressed, one can pursue mored detailed modeling that addresses the need and the specific information sought by accountants and bankers.