carbon limited

Over on Zero Champion, Phil brought up the subject of payback periods, citing some examples from clients: 12 months, or 18 months, or 39 months.

Those periods equate to ridiculously high rates of return! 100%, 67%, and 31%! Are there so many fabulous investments out there that clients can justify hurdle rates like this?

Could it be that clients are being deliberately obstructive? Or maybe they just want to carry on doing things the way they’ve always done them? By demanding short payback periods they ensure they won’t be lured out of their narrow comfort zone. But this approach is completely unjustifiable.

Ignoring the inherent benefits and taking a purely financial view, a client ought to evaluate low carbon technology in the same way they would look at any other potential investment. Let’s assume our client is a developer with a weighted average cost of capital of 12.5%*. That means they should seriously consider investments that will achieve better than this rate of return. Being conservative, let’s bump it up to 15% – a very attractive investment. We’re still talking nearly 7 years before you’ve recouped your money.

There’s an issue of risk, but only with immature technology. CHP, solar thermal, PV, wind, hydro, biomass heating: these are all tried and tested and, given good site data, their performance can be predicted with a high degree of accuracy. Even with something trickier like biomass gasification, you can factor things like increased downtime into your figures and take a pessimistic view when predicting performance. But that doesn’t mean your hurdle rates suddenly leap into the stratosphere.

So it’s disappointing to hear that client’s are requiring payback periods like 12 months or even 39. They’re taking a distorted view of technology and, in the mean time, promoting the impression that low carbon is somehow so shoddy, so flawed, such a special case, that it should only used if it promises a financial miracle.

* For this example, assume of our developer’s capital, 40% is equity and 60% is debt. Assume cost of debt is 7.5% (LIBOR of 5.5% plus another 2%) and cost of equity is 20%. I’ve ignored tax.