Overview

A key assumption in a comprehensive valuation analysis is discussion around the concluded discount rate, which is a key component to the income approach to value and the discounted cash flow method. The discount rate, also known as the cost of capital or required rate of return, is applied to a series of projected cash flows and should accurately account for the riskiness in the forecasted cash flows being valued. The required rate of return at the project level differs compared to a tax equity or sponsor interest; however, similar considerations and approaches should be taken, and appropriate adjustments should be applied as applicable.

Current Macroeconomic Environment

As of February 2024, interest rates remain elevated with no clear sign from the Fed regarding timing of rate cuts. Basel III seems to be causing some uncertainty and hesitation with the proposed capital requirements potentially quadrupling for tax equity investments; developers and investors are waiting for clarification from regulators. Tax equity supply is expected to remain stagnant from the previous year. Transferability made possible by the IRA is opening doors for new dollars flowing to projects, but at a slower pace than expected with market participants still vetting best practices. These headwinds, among others, are leading to a rise in the cost of capital to all stakeholders in renewable energy projects as compared to just a few years ago. Project finance tends to lag the bond market, but it’s anybody’s guess on timing for those impacts to trickle down.

Methodologies for Estimating Discount Rates

When conducting a valuation or appraisal, we typically consider two methods to estimate the appropriate discount rate to apply when analyzing renewable energy projects.  There are, of course, other ways to estimate an appropriate discount rate, but we will focus on the following:

1. The Capital Asset Pricing Model (CAPM)
2. Weighted average cost of capital (WACC)
3. Market indications

The Capital Asset Pricing Model

The Capital Asset Pricing Model was developed in the 1970s by William Sharpe (you may also know him from the Sharpe Ratio). It estimates the cost of equity for a hypothetical market participant by adding a premium to a risk-free rate (typically a U.S. Treasury) as of the valuation date. The premium can be broken down into three categories: risk for the market, risk for size, and risk for a specific company or asset. To determine these premia, comparable “guideline” public companies are analyzed and used as a proxy for the subject company or asset being valued. These guideline companies, whose shares are actively traded in the market and thus their price at any time represents fair value (not always consistent with intrinsic value), can provide key data such as how the market views the risk of investing in the company versus the overall market (beta), or how the market is valuing the company on an EBITDA multiple. This information can be adjusted and used to value private assets and companies.

Weighted average cost of capital (WACC)

If you are valuing cash flows to multiple stakeholders such as equity and debt holders, it is common to use the weighted average cost of capital (WACC) as the discount rate. Once the cost of equity is estimated, an analysis should be performed to estimate the appropriate long-term weighting of debt that can be expected to be available to the company or project. Some ways to estimate this could be the use of guideline companies, or a hypothetical amortization analysis. Once you have the concluded long term capital structure, the cost of equity, and the cost of debt, you can estimate the WACC to apply to enterprise cash flows. Be mindful if you are looking at pre-tax or post-tax cash, and adjust the discount rate accordingly if required.

Market indications

A common renewable energy transaction will have a final financial deal model with terms that the buyer and seller agree upon. It’s typically “battle tested,” meaning reviewed and challenged by the key decision makers in the deal such as sponsors, investors, transaction attorneys, tax experts, and capital markets financial advisors. The final deal model implies a rate of return for the transaction given a set of specific assumptions. It is crucial for appraisers and market participants to remain up to date on transaction data including agreed upon rates of returns by market participants, which is constantly changing with market conditions.

Considerations in Estimating the Discount Rate

It is important to match the discount rate to the riskiness of the cash flows in the forecast. For example, in renewable energy projects, the characteristics of each project are unique. Key considerations include:

• Debt rates and terms: What terms are lenders offering to the project and the overall market for project debt or corporate debt?
• Production estimates: A forecast using P50 estimates has more risk than a forecast using P99 estimates.
• Revenue assumptions: Does the project sell power under a contract or in the merchant market? What is the offtaker’s credit worthiness? Which merchant forecast is being used?
• Expense assumptions: Is major maintenance expense built into the forecast and the ARO?
• Debt or fractional partnership interest: Are you valuing debt or a fractional partnership interest? Where do the cash flows lie in the overall waterfall structure? Is it cash flow to the equity holders or all stakeholders? Are there any discounts for lack of control or marketability that need to be accounted for? How is the overall market adjusting for it?
• NTP projects: If you are valuing an NTP project, are there any unique risks to the construction of the project?
• Pre-NTP projects: If you are valuing a pre-NTP project, are there any risks to not being able to complete permitting? Will there be any push back from the local community? What is the IX upgrade cost outlook looking like? What is the IX queue timeline for the project?
• Reviewing comps: Are you looking at pre-tax or post-tax rates? Levered or unlevered? Based on what assumptions and terms, and how does it translate into the valuation of your subject asset or appraisal?

Key Takeaways

CAPM is useful and the data is public and readily available. It is an academic approach that is commonly accepted by auditors, regulators, and industry professionals. However, CAPM is just one data point. Calculated CAPM can rapidly change with fluctuations in the stock market, inflation, Fed targets and policy rates, macroeconomic conditions, market sentiment, and other ever-changing elements. Further, these changes might not necessarily represent the market terms that companies and assets are currently trading at a particular point in time.

Market indications are useful because they provide real life return data that buyers and sellers agree upon. Indications are very project specific and tend to reflect the assumptions used in the final deal model, which need to be considered and adjusted. Sensitivity analyses for a range of candidate rates may also be helpful to compare value indications under different sets of assumptions, or to see which rate is implied by indications of value from other approaches.

Valuers, appraisers, and deal analysts should use multiple approaches and judgement when estimating a discount rate. A strong valuation analysis considers many sources of data and information. This information should be interpreted and synthesized appropriately, and then applied in the analysis.