Risk-Adjusted Discount Rate and Its Components for Onshore Wind Farms at the Feasibility Stage

Abstract

The concept of risk is well known in the energy sector. It is normally recognized when it comes to price and cost forecasting, annual production calculation, or evaluating project lifetime. Nevertheless, it should be pointed out that the quantitative evaluation of risk is usually difficult. The discount rate is the only parameter reflecting risk in the discounted cash flow analysis. Therefore, knowledge of the discount rate along with the major components affecting its level is of fundamental significance for making investment decisions, capital budgeting, and project management. By referring to the standard coal-fired power generation projects the authors of the paper tackle the analysis of the composition of discount rate for onshore wind farm technologies in the Polish conditions. The study was carried out on the basis of a typical (hypothetical) onshore wind farm project assessed at the feasibility stage. To enable comparisons and discussions, it was assumed that the best reference point for such purposes is the real risk-adjusted discount rate, RADR, after-tax, in all equity evaluations (the ‘bare bones’ assumption); that is because such a rate reflects the inherent characteristics of the project risk. The study methodology involves the a priori application of the discount rate level and subsequently—in an analytical way—calculation of its individual components. The starting point for the analysis of the RADR’s composition was the definition of risk, understood as the product of uncertainty and consequences. Then, the risk factors were adopted and level of uncertainty assessed. Subsequently, using the classical sensitivity analysis of IRR, the consequences (as slopes of sensitivity lines) were calculated. Consequently, risk portions in percentage forms were received. Eventually, relative risks and risk components within cost of equity were assessed. Apart from the characteristics of the discount rate at the feasibility stage, in the discussion section the study was supplemented with an analogous analysis of the project’s cost of equity at the operating stage.

Keywords

• onshore wind
• risk assessment
• cash-flows
• discount rate
• cost of capital
• cost of equity