Carrying Charge Analysis Part 1 — No Debt, No Taxes, No Inflation

A central question in evaluating the economics of solar, wind or mini-hydro power is whether the LCOE of solar power is less than then marginal energy cost.  If the renewable LCOE is less the cost marginal cost of energy, then consumer bills will be reduced from using more solar power.  The LCOE in turn is driven by the carrying charge rate as these technologies are very capital intensive (much more capital intensive than a refinery).

This page addresses LCOE — the levelised cost of energy and the associated carrying charge rates. LCOE and carrying charge rates are evaluated with through demonstrating how to find data, how to measure and put together all of the factors that drive the carrying charge, and how to use carrying charge rates in economic analysis. For the electricity industry and other capital intensive industries different investment alternatives that have alternative operating lives, capital costs, variable costs, fixed costs and risks the LCOE can be an effective way effectively summarise different alternatives. More importantly, establishing carrying charge rates can make the analysis of different alternatives much more effective. The first lesson below walks through different components of the carrying charge that include evaluating project life, inflation, income taxes, deferred taxes, replacement capital costs, debt financing and maintaining a constant capital structure. The carrying charge converts a one-time cost (sometimes referred to as overnight cost) into an annual cost. In addition to carrying charges, comparing investments must evaluate the fixed and variable costs that for electricity include fuel cost. The second lesson set on this page describes how make various calculations that establish the fixed costs and the variable costs that are combined with the capital cost to establish the overall levelised cost.

This page will eventually include a variety of issues involving electricity analysis that includes among other things, coming up with appropriate incentives in different contracts (PPA, EPC, O&M etc) as well as selected issues surrounding distribution, transmission and generation. A subject that I have also include on the page is measuring the LCOE for power projects. As I have made a few videos on LCOE this is the first subject on the page.

Carrying Charge Components.xlsm

Carrying Charges.xlsx

 

Carrying Charge Rates for Levelised Cost

This lesson set works through calculation of the carrying charges that are used for computing levelised cost of investment. You may think the carrying charge rate is some kind of esoteric concept that is not useful in your day to day work. If you go through this lesson set you will see that the finance, modelling and economic concepts in carrying charge rate analysis are closely related to both project finance and corporate finance.

The carrying charge is a percentage that converts a one time cost that is sometimes called the overnight cost into a level annual cost. (The level cost should be expressed in real terms (i.e. without inflation in constant currency). The lesson set involves using a single capital investment cost and evaluating each of the factors that drive the the conversion of the capital cost into an amount that must be recovered on an annual basis. You can think of this as the amount of revenues necessary to provide a given return to investors. After completing this lesson set I hope you will understand the following things about carrying charge rates:

1. Overview of why understanding carrying charges is important
2. Definition of Carrying Charge Rates — Annual recovery cost to total cost; EBITDA to gross investment; Amount of annual recovery to carry investment
3. Normal Complications in Computing Carrying Charge Rates — Construction Period, Inflation, Required Return on Equity, Tax Policies, Capital Structure
4. Addition Complications of Carrying Carrying Charge Rate — Replacement Cost, Decommissioning and Deferred Taxes
5. Project Finance versus Traditional Approach to Computing Carrying Charge Rates
6. Necessity to Convert to Real (i.e. constant) Currency – Would Need to Compute Present value of the Inflated Fuel Cost using Nominal Currency
7. Tax Issues with Carrying Charges and the Concept that Recovery of Equity Returns can be Evalutated with the Formula: Recovery = Recovery + Recovery x t/(1-t)
8. Deferred Tax Complications whereby Recovery can be Computed through First Calculating the PV of the Tax Shield and then using this to Compute the Payment
9 Adjusting the Overnight Cost for Construction Periods with Both Inflation and Financing Cost. Note the Financing Cost must Include Equity and Debt
10. Evaluating the Effects of Future Replacement Cost that can Occur at Different Periods
11. Computing the Effects of Debt on the Analysis using a Constant Capital Structure.

There are a series of videos that describe each of the adjustments that you can make to derive the carrying charge. The video begins by describing the simple PMT

Videos associated with Computing Carrying Charges

There are a series of videos that describe each of the adjustments that you can make to derive the carrying charge. The video begins by describing the simple PMT function that accounts for rate of return on investment and the asset life. Separate videos then move to inflation, tax, depreciation, construction periods, replacement cost and debt. The final video that includes all of the adjustments is explained below. Other videos that walk through each of the financial issues are listed at the bottom of the page. I hope you see how the videos describe many economic and technical aspects of project finance models and to some extent even corporate models. The videos also explain added features of the generic macros that modify colours, links, and sheet structure.

Carrying Charge Introduction https://www.youtube.com/edit?o=U&video_id=z9s06nXh7U4
Carrying Charges and Inflation https://www.youtube.com/edit?o=U&video_id=9uh8ZN_SHN4
Taxes in Carrying Charge Rates https://www.youtube.com/edit?o=U&video_id=n3MWZvnleWg
Periodic Analysis in Carrying Charges https://www.youtube.com/edit?o=U&video_id=zp06ubSxiGQ
Completed Carrying Charge Analysis https://www.youtube.com/edit?o=U&video_id=ho2RnSHOWfk

 

Files associated Computing Carrying Charges

There are three files associated with this lesson set. The first file is the completed carrying charge analysis that you can use for economic analyses such as the analysis of batteries, solar and diesel. The second file includes all of the components of the carrying charge beginning with the PMT function and ultimately including effects of inflation, taxes, construction timing, replacement and debt. The third file includes exercises that you can work through in order There are a series of videos that describe each of the adjustments that you can make to derive the carrying charge. The video begins by describing the simple PMT function and moves to inflation, tax, depreciation, construction periods, replacement cost and debt.