Notes on Internal Rate of Return (IRR) Calculations

Introduction

A solar + energy storage system (ESS) project can be thought of as an asset which produces a cash flow each month, typically offsetting the owner’s electricity bill.

In order to determine the viability of such a long-term project, a discounted cash flow analysis is often performed. It accounts for the time-value of money by applying a discount rate1 to future cash flows in order to evaluate their present value. With a solar energy project, the amount of these future cash flows is directly related to the solar energy bill credits and/or solar energy export value. Because of this, an energy policy can make or break a solar + ESS project, just as well as the initial equipment and installation costs can.

The sum of the initial project costs (negative) and discounted future cash flows (positive) is known as the net present value (NPV), and the discount rate that makes the net present value (NPV) equal to $0.00 is known as the internal rate of return (IRR).

If the IRR of a proposed project is greater than the IRR of an alternative investment with a similar risk level, then the proposed project is a viable course of action according to the analysis.

Details

The IRR calculation for a project should account for the likelihood that a property owner’s energy policy will change in the future2. To do this, one might calculate two different cash flow models — each with its own revenue calculations based a unique energy policy scenario — then combine the two into a single cash flow stream with a weighted average, assigning to each cash flow model a probability that the energy policy will be enacted. The IRR is then derived from this overall expected cash flow.

The expected inflation rate of energy prices also enters the equation. It’s possible for energy prices to decrease over time in some regions, while simultaneously increasing in others, so it’s important to consider the situation in your local area.

While solar and energy storage are becoming more affordable for residential customers, energy companies have economies of scale on their side, so they will likely continue offering prices that compete with the levelized cost of energy (LCOE) of residential solar & energy storage. That said, if you take a loan to finance solar and energy storage, your loan payments will remain constant regardless of what happens to energy prices in the future. While batteries may degrade anywhere from 75% to 80% of their original capacity over the course of ten years, a solar array loses only 0.5% to 1.0% efficiency per year after the first year, which is far lower than the typical rate of inflation.

Aside from the effects of inflation and energy efficiency, It’s also important to account for miscellaneous expenses such as the increased cost of roof replacement (if applicable), and system maintenance/repair costs. Such costs might reduce your IRR by a percentage point or more. (The inverter is often cited as the component most likely to require maintenance or replacement. While the most reputable inverter manufacturers often honor warranties that replace parts and cover re-installation costs, this is not always the case.)

Depending on the energy market in your region, it might be reasonable to expect the overall cost of solar + energy storage to be price-competitive with a typical energy bill plus the cost of a total-home backup generator (as indicated in our previous case study).

Leveraging Freely Available Resources

If you’re interested in calculating your own project’s NPV and IRR based on your own energy consumption profile, ReOpt3 is an excellent tool which can provide you with such metrics (NPV and IRR). While there is currently no option for “building type” resembling “single family home”, selecting another building type and uploading your own energy usage profile in the proper format should produce the desired results.

Keep in mind the above information, as financial models are only as accurate as the information that goes into them. Tools such as ReOpt are no exception.

  1. The discount rate can be thought of as the amount of return that one would expect on an investment that has a similar risk profile. It should be at least as high as the risk-free rate of return, which is often estimated as the return on short-term U.S. treasury bills. ↩︎
  2. Energy companies occasionally offer a policy with a guarantee that it will remain active for several years. However, in the long term, one might end up relying on competition within the energy market to provide customers with compensation for their solar energy exports. One might also count on energy storage becoming cheaper in the future, to a point that installing batteries actually lowers their overall energy-related expenses in the long run. ↩︎
  3. Scenarian is not associated with ReOpt, or the Department of Energy (DOE). ↩︎