Return On Investment (ROI) Analysis
Few solar customers justify the purchase of a PV system solely on the good feeling of owning a renewable energy system. Most enjoy the thought of producing and consuming clean energy, but they require a certain financial gain to approve the initial investment. Those leasing a PV system might feel they get the financial gain right away (they’re motivated by the monthly cash flow improvement) rather than waiting for a long-term investment return. So why make the initial investment and wait several years to see a positive cumulative cash flow? Do those making the financial plunge resurface with a return that favors the upfront cash investment? This article explains the various ROI metrics used in proposals that help installers and customers weigh these options. The intent here is to explain the ROI metrics and not to suggest whether leasing or owning is preferable. You should seek the advice of a tax professional or financial advisor in such matters, but they will likely want to see these metrics in order to advise you.
ROI/Cash Flow Metrics
The Summary section of the proposal has a Financial Analysis table that displays the key financial metrics for the deal. Commercial jobs don’t display Resale Value and most of these metrics are not applicable in a leasing scenario. Below is a list of the metrics followed by an explanation of each.
Financial Analysis table contents
Utility Savings Over System Life
Total Life-Cycle Payback
Levelized Cost of Solar Energy
Rate of Return on Cash Invested
Utility Savings (aka Solar Savings) Over System Life
This is the accumulated savings over 25 years of not having to pay for utility electricity. For leased systems, the Lease Term is the system life except if there is a Buyout Price; in that case, it’s 25 years.
You don’t need to calculate each year’s utility bill savings from the rate schedule(s). Instead, only the first year pre-solar and post-solar bills are based on the rates schedules. Formulas are used to extrapolate future year bills from Year 1 billings, annual usage, inflation rate, and production degradation. The details of such formulas are beyond the scope of this article, but the following paragraph explains the downsides of doing simpler estimations.
One can over-estimate this value simply extrapolating the first year savings over the 25yr system lifetime. As electric rates increase, the avoided cost of utility energy (“solar savings”) does increase but not at the same rate. Since PV production decreases over time, less utility usage is offset each year. Each successive year the utility savings grows by the electricity inflation factor set in the job (Energy tab) but decreases in relation to the PV System default degradation percentage (Quote Model). It’s also a simplification to subtract the PV degradation rate from the inflation rate and applying the net rate over the remaining 24 years, though it’s a better estimate.
Total Life-cycle Payback
Consider all the positive cash flow over the system life and divide it by the initial cash investment and you get the total life-cycle return percentage. The initial cash investment is net cost of the system in year 0 net of any loan amount. So it’s the hard investment amount. There is no time value of money factored into this formula. It’s just a straight percentage of the amount of money that will come back to you over 25 years as a percentage of what cash is put in. The cumulative positive cash flow = the cumulative cash flow + the absolute value of the year 0 cash investment.
Levelized Cost of Solar Energy (LCOE)
While a PV system may have a high up-front cost, a better valuation of cost might be the cost of what it provides. The photocopier industry uses this metric when it asks you to consider the cost per copy. You might consider the value of a car on the number of miles you can get out of it. For a PV system, LCOE considers the cost per unit of energy produced or $/kWh. In Tools, this is the upfront net cost divided by the expected 25 year energy production.
A number that’s very tangible to homeowners and business owners/CFO’s is the amount of time it takes for the positive cash flow to ‘payback’ the initial negative cash flow outlay. Put in simpler terms, “how many years till I get my money back?” This is just the year in which the cumulative cash flow becomes positive. This assumes cash flow is negative in year 0 and becomes positive some year during the system life. If there is a loan for the net cost of the system, then there is usually a positive cash flow in year 0 and this metric doesn’t apply. If the cash flow starts negative and becomes positive in some year but then goes negative briefly again (e.g. inverter replacement), the payback period is the number of years till the cash flow first goes positive, regardless of its behavior thereafter.
Rate of Return on Cash Invested
Of all the ROI type metrics, the Internal Rate of Return (IRR) provides the best indication of the system’s financial yield over 25 years. Unlike Lifecycle Payback, IRR considers not just how much positive cash flow occurs but also when it occurs in the 25 years. Two investments with the same upfront cash, same term, and same cumulative cash flow will have different IRR’s if the annual cash flows differ. A higher return is made when the positive cash flow occurs earlier in the term. This is due to the time sensitive nature of IRR.
For those wanting more detail, IRR is the rate of return equal to the discount rate that results in the Present Value of each year’s cash flow equaling zero. In other words, what is the discount rate such that the Net Present Valuation (NPV) of this 25 year cash flow stream is equal to zero? To determine this rate, different rates are tried in a formula till the NPV is at or near enough to zero. Then, tools test discount rates from .1% to 49.9% by .1% increments till NPV is zero or negative. If the NPV is positive, the discount rate is not high enough and the next number is tested. If .1% results in a negative number, the IRR is presumed to be 0% or negative and thus is not even displayed in the Financial Analysis table. If a discount rate of 49.9% results in a positive number, the presumption is that the IRR is 50% or greater. That’s why you may see an IRR of “> 50%”.
This metric appears for non-commercial properties. It’s value added to the property due to the PV system’s energy production and utility bill savings. The Resale Value is equal to 20 times the annual utility bill savings.