A Case for “Payback Period” as an Acceptable Metric for Financial Evaluation of Renewable Energy Projects

By 2024 Fellow Layo Sotin

One of the most used metrics for assessing financial returns in project finance is the Internal Rate of Return (“IRR”); a measure of investment profitability. Subject to risk, opportunity cost among other considerations, a project is generally considered acceptable if the IRR is greater than the investors hurdle rate. While the IRR is a robust return measure, another useful metric that deserves more weight particularly in renewable energy finance is the payback period “PBP” — the time it takes for sponsors to recover their initial investment from project cashflows. To illustrate, I will describe some weaknesses and benefits of the IRR and PBP focusing on renewables.

First, four important facts about renewable projects bear mentioning:

1. Projects typically sell power via Power Purchase Agreements (“PPA”) for a portion of their useful life. Contracts could range between 10 to 30 years and the project is usually expected to sell power in the wholesale markets for its remaining useful life after the contract which can be up to 40 years depending on the technology.

2. In calculating returns after the contract, sponsors take a view on market prices in the future to estimate the value projects can capture in the wholesale market. Financiers rely on informed third-party forecasts that take historical prices, expected demand, utility resource mix and costs, regulation, transmission constraints, etc. into consideration.

3. It is difficult to accurately forecast prices due to market volatility. Volatility is caused by factors such as introduction of lower cost technologies, events in global markets and policy changes such as the recent tax credit phase out under the One Big Beautiful Act.

4. Each revenue stream to renewable energy projects carries different levels of market risk.

Internal Rate of Return:

The major advantage of the IRR is its consideration of time value of money (“TVM”), a concept which suggests that cash is worth more today than in the future. This is critical when analyzing energy projects with cashflows expected over a long operating period. The IRR is also used with the Net Present Value (“NPV”) metric which calculates the current value of a future stream of cashflows at a determined discount rate typically reflecting the investors cost of capital.

Weakness:

Given the competitive nature of the market, it is common for sponsors to make investments focused majorly on project life return (“PLIRR”) targets. i.e., IRR target considers cashflows generated over the useful life. Thus, a significant portion of the estimated economic value of such projects, can rely on market price forecasts. Heavy reliance on post PPA revenues can lead to suboptimal PPA contracting increasing the chances that projects fail to meet expected return thresholds in the future or don’t get built, neither of which is healthy for the industry.

How does the PBP Help?

The PBP measures how long (in years), it will take for a sponsor to recover the initial investment in a project. In renewables, the PBP provides a view of exposure to the wholesale markets. For instance, on a project with a 10-year PPA where the PBP is 9 years, the sponsor can recoup at least the initial investment from contractual PPA revenues as long as the project meets operating requirements. The sponsor would only depend on the wholesale market for revenues to make a premium on the investment. However, with a PBP of 15 years, the sponsor would depend on the volatile wholesale market for at least 5 years for capital recovery.

Limitations of the PBP:

Two commonly identified weaknesses of this method are:

• Ignores cash flows after the PBP: The argument is that cashflows after the PBP are not evaluated as part of the project’s economic viability.
• The PBP ignores the TVM: The argument is that unlike the IRR, this approach does not consider the timing of cashflows since it is a simple nominal calculation. For example, project A and B could be viewed as equally attractive if they have similar payback without consideration for the fact that larger cashflow payments could occur earlier in project A compared to B, which, would be more valuable.

These are important considerations. However, the value of the PBP is in its ability to tell us how much of project returns is subject to market risk. It should be considered in combination with other metrics and not as a sole deciding factor. Moreover, cashflows after the PBP have a different risk profile if uncontracted, and, the discounted PBP, variation accounts for the TVM by discounting the annual cashflows being considered against the initial investment.

PBP and CLIRR:

It is worth mentioning that in recognition of the risks associated with long term price forecasts, some sponsors set contract life return (“CLIRR”) targets in PPA deals. This sets a minimum return expectation relying on cashflows from the PPA and can be used interchangeably with the PBP. Effectively, a project with a positive CLIRR achieves payback within the PPA meaning the sponsor recovers their investment and a margin before market risk begins to dominate.

Conclusion:

Power prices are volatile and unforeseen events will continue to challenge forecasts. Incorporating PBP into the suite of investment screening metrics will promote disciplined contracting and sustainable capital deployment allowing sponsors to innovate around key areas of competitiveness e.g., project design, commercial and execution expertise, superior customer service. This is particularly critical as the industry matures; investors who balance returns with resilience will be better positioned to navigate current policy headwinds.