A Valuation Primer for Renewables (Part II)

Under Complex Considerations

In Part I of this series, the article presented the fundamental standards used to gain a basis of understanding renewables and valuation drivers. These were presented in the context of an appraisal of wind rights and what would be included, as an example, in a valuation engagement. This second article focuses on the diminution of land values resulting from collateral damage from wind turbines and solar siting and placement impacting highest and best use of the subject property.

In Part I of this series, the article presented the fundamental standards used to gain a basis of understanding renewables and valuation drivers. These were presented in the context of an appraisal of wind rights and what would be included, as an example, in a valuation engagement.

This second article focuses on the diminution of land values resulting from collateral damage from wind turbine and solar siting and placement impacting highest and best use of the subject property. Furthermore, through the development of the life cycle, stakeholders must be aware of and avoid biases inherent in net present value (NPV). Often incorporating discount rates at the initial development stage to include project risk, financial model bias can result in inflated discount rates that can lead to over or under invest. Other significant risk factors affecting valuation include the impact of terminal calculations, decommission issues, site conditions, weather, power purchase agreement stipulations impacting future revenue, and end-of-life analysis incorporating re-powering or retrofitting the generation plant

Diminution of Estate Value from the Collateral Impact of Turbines and Solar Farms

As the development of wind farms has become more widespread nearer populated growth areas, more rural land appraisals have been on property with turbines sited on, adjacent to, or within eyesight. For those landowners not participating in royalty income, there can be perceived uncertainties affecting their lands’ environmental attributes resulting in a diminution of value. When appraising collateral damage that may result in diminution of value, the appraisal must take into consideration cost, use, and risk effects to satisfy. (See USPAP Standards Rule 1-4.)

The usual guidelines of real property appraisal, broadly defined, includes land, everything attached to it, at, above and below the earth’s surface, and all the interests, benefits, and rights inherent in the ownership, commonly referred to as the “bundle of sticks”. Outside of these usual appraisals, engagements have become more specific to include sub-surface real property appraisal to include oil and gas interests based on production rates and commodity prices. These variables and decline rates of production are parameters utilized in reservoir economic software programs that provide NPV analysis of the asset owner’s mineral interest. Typically, the appraiser has a general understanding of the industry economic drivers as variables that feed into the appraisal algorithms such as commodity pricing, price escalators and production forecasts that are used to model and analyze the economic feasibility of renewable development. These specialty practice areas have expanded to include environmental hazards, spills, and surface destruction caused by mineral production development. This is analogous to mineral owners’ surface damage concerns; renewable interest owners are becoming more cognizant of collateral damages created by turbine noise pollution and blade flicker creating visual pollution on and adjacent to their properties. These operating characteristics can impact the proliferation of high demand specific game animals populating some of the properties, their habitat behavior, and population control. Where the highest and best use is trophy deer hunting property or an environmentally protected habitat, the appraiser determines a diminution of value to be assessed, where the appraiser must take into consideration cost, use, and risk effects to satisfy USPAP Standards Rule 1-4.

Use effects are those impacting the economics of the property usually near populated proposed developments. While most wind farms are sited in rural settings, more are approaching more populated housing areas especially in the Northern part of the country. In those areas, class action lawsuits have necessitated developers to provide price guarantees to protect proximate owners from diminution of value. And, in scenic areas of the Texas Hill Country, there has been significant resistance to wind development where, in addition to scenic obstruction, trophy white tail deer habitats are perceived by trophy hunters to be stigmatized or impacted by condensed turbine placement. Stigma has become more widespread as visual and audio environmental attributes have become detrimental to the potential sale of subject properties as the highest and best use is compromised.

Complex Valuation Assumptions at Renewables’ End-of-Life

Having a general understanding of the drivers that make up the valuation build-up of renewables is straightforward with most wind and solar farms in the design stage where the variables are assumed to be verifiable from due diligence of historical projects in the production stage with similar design patterns following common design, construction, and integration (DCI). All is well with straight forward assumptions that can be plugged in and extended into the end-of-life, providing developers and financial off-takers with sellable project metrics. It is in this stage of development that management bias can creep in as the NPV model typically includes optimistic project variables prior to commercial operation date. The bias to include optimistic factors is likely because renewable generators have long operational lives built upon complex assumptions through the power purchase agreement (PPA), post PPA, and end-of-life where rebuilding and decommissioning of the plant is years in the future. Add to that the impact of existing and proposed transmission. Will proposed transmission providing access to modeled load occur per the Public Utility Commission integration plan in terms of capacity and timing? Will propose transmission build out to provide additional access to load for competitive projects being developed competing for the same access to load to avoid power curtailment and subsequent reduced revenue?

Initially, modeling wind farms feasibility was based on an NPV analysis where revenue with escalators provided in the off-taker agreement was plugged in, transmission was assumed to be available based on generalized and hypothetical discussions with the Electric Reliability Council of Texas (ERCOT) regarding long term plans publicly available and provided in regional planning groups open to members. Revenue was also dependent on the viability and credit worthiness of the off-taker provided in their agreement that included escalator provisions and cut-off dates for termination with the generators. These provisions also included penalties for deficiencies and some included default agreements. As the future revenue streams are forecasted towards the project’s end-of-life, other complex assumptions must be made regarding proposed termination issues. Is the project terminating at the mechanical end-of-life? If so, when, and what decommissioning costs are projected? Does the power purchase agreement end at the project’s end-of-life or instead does the feasibility of repowering provide economic sense for investing in a rebuild or retrofit per the IRS tax rules?

And, most importantly, constructing the base model includes the mystique of developing the forecasted terminal value with a perpetuity growth rate (PGR). This is a common standard of valuation with long-term projects or companies with long lives. The further you must model the revenue streams, the broader the assumptions must be made that reflect the perpetual growth rate that can be impacted by multiple factors, many of which are years out and some are unknown. As the valuation model is constructed, the impact of small changes in the perpetual growth rate can create major financial destruction.

An example will provide context:

Subject has a NOPAT of $1200, net investment of $200, PGR of 2%, and WACC of 12%, providing a terminal value of $10,000. Comparing PGRs:

                            PGR                             PGR                             PGR

                            0%                               2%                               4%

WACC                  12%                             12%                             12%

Terminal value      $8,333              $10,000            $12,500

Projecting just a 4% increase in the PGR from 0% results in a terminal value 50% higher, indicating the magnitude of escalation or potential de-escalation from even minor changes to the terminal value.

Decommissioning

The long lives of renewable assets require detailed analysis to determine the point of decommissioning the generator. Is the generator at end-of-life? Is residual operational control and cost of operation and maintenance able to provide sufficient net operating profit to continue energy generation? Although the cost of decommissioning varies depending on several factors and the salvage value of project components, on average, the Center for Rural Affairs estimates, on average, the cost to decommission per megawatt for a wind farm is $51,000. Brian R. Zelenak, Manager, Regulatory Administration, Xcel Energy, estimated, conservatively, that for the Nobles Wind Energy Project, decommissioning expenses are approximately $445,000 per 1.5MW. Restoration includes the removal of all physical materials and equipment related to the project to a depth of 48 inches

Rebuilding and Retrofitting

Does a feasibility analysis provide an economic opportunity to rebuild or retrofit the generators to provide a sufficient return on the build investment in compliance with the IRS investment tax rulings as well? Rebuilding is basically replacing the turbines and/or major components effecting a broad based technology enhancement. Under Revenue Ruling 94-31, the IRS explains that each facility eligible for the premium tax credit (PTC) is defined as the wind turbine, together with its tower and supporting pad. The 80/20 test requires that the market value of the used property is not more than 20 percent of the facility’s total value (the cost of the new property plus the value of the reused property).

The Inflation Reduction Act

The Inflation Reduction Act of 2022 is the most significant climate legislation in U.S. history, offering funding, programs, and incentives to accelerate the transition to a clean energy economy. Most provisions become effective 01/01/2023. Through at least 2025, the Inflation Reduction Act extends the investment tax credit (ITC) to 30% and the PTC of $.0275 of Kwh as long as projects meet prevailing wage and apprenticeship requirements for projects over 1 MW AC. Starting January 01, 2025, the Inflation Reduction Act replaces the traditional PTC with the clean energy production tax credit which are functionally similar to the ITC/PTC but is not technologically specific. Eligible for ITC includes energy storage technologies, microgrid controllers, fuel cells, geothermal, and interconnection costs. Eligible for ITC or PTC are multiple solar and wind technologies, municipal solid waste, geothermal, and tidal.

AI’s impact on Complex Renewable Valuations and Collateral Damages

Critical assumptions that factor into traditional valuation standards throughout the development life cycle require sophisticated data analytics and evolving AI applications and approaches.

As a basis for renewable valuations, comparative analysis can be constructed based on mineral valuations where both renewable and mineral valuations have revenue profiles based on variable production, pricing, royalty schemes with applicable discount rates including risk factors. For renewable developers, pre-development models provide an NPV analysis of the income streams from the production of the turbines or solar panels based on contracted prices from off-taker agreements referred to as power purchase agreements. Most agreements establish contracted prices and escalators extending through the first 15 years of the project life. Complicating the pre-development analysis is identifying the complex of relevant variables following the life of the PPA. In addition to the impact of commodity prices, inflation, project end-of-life assumptions include partial or complete re-building, cost of decommissioning, future policy implications, and biases all of which comprise feasibility analysis

AI’s Growing Impact

In accordance with Executive Order 14110 on the Safe, Secure, and Trustworthy Development and Use of Artificial Intelligence (AI), DOE developed a report that identifies near-term opportunities for AI to aid in four key areas of grid management: planning, permitting, operations and reliability, and resilience. Coincident with these AI areas of interest, on-going development centers on all aspects of risk assessment that factor into valuation criteria may also include political bias and regulatory bias that influence grid infrastructure and planning that impacts off-taker interest and access. Compiling available data requires reviewing and analyzing a variety of site conditions often against a scarcity of market comparables. The KWH Solar Risk Assessment reports have assessed the last five years’ challenges of compiling the universe of available data analytics for analyzing the multitude of probable site conditions for performing reliable due diligence. Their reports are based on data input from a significant number of stakeholders. The collaboration has resulted in significantly relevant variations in economic outcomes. Lawrence Berkely Laboratory and the National Renewable Lab have recently done extensive holistic scans relevant to land estate valuations that provide more probable impacts for diminution of value analysis. The contribution of AI scans of similar properties will now be able to replicate subject characteristics and attributes to provide more comparable “comps” for comparing valuations. As algorithms become more refined and models become more holistic through stakeholders’ utilization of AI, risk adjustments and assumptions will help proliferate economically feasible renewables.

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Frank Horak, CVA, MAFF, MBA, has over 30 years’ experience in energy, economics, and valuation. His experience began as an engineering intern at Texas Instruments Inc. and Boeing Aerospace. He had a broad range of financial consulting engagements with Arthur Andersen & Co., Price Waterhouse, and several other management consulting firms.

Subsequently he played a lead role in the concept development, management, and oversight of venture-based technology projects including energy economics, portfolio valuation modeling, and renewable energy development.

Mr. Horak was an Acting Director of Real Estate and a lecturer in finance and accounting at the Graduate School of Business at the University of Texas at Austin. He also has been a guest lecturer at the Schools of Law at The University of Texas and University of Houston. He is a frequent speaker on the valuation of minerals and alternative energy assets and interests.

Mr. Horak can be contacted at (512) 470-1771 or by e-mail to Frank@AstekEnergy.com.