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Discussion Paper Series on Asset Pricing: Renewable Energy in Growing Economies

This is the second in a series of three discussion papers. The first paper addressed two aspects of

project discount rates for renewable energy investments: zero beta and downside risk. Both

concepts push at the edges of mainstream investment evaluation, but are nonetheless firmly rooted

in the logic of portfolio theory and the Capital Asset Pricing Model (CAPM). As CAPM is a well

installed program in the minds of current and aspiring CFOs, we argued that the model would

become increasingly relevant to investors and policymakers in this emerging sector.

In this paper, we take the opposite approach by looking for a better way to describe how investors

arrive at their financial return expectations. We explore self-reported perceptions about risk from a

range of investors in India’s renewable energy market and consider the influence of strategic options

on investment hurdle rates.

1. Analysis on required return on equity

The slew of recent investments in India’s fledgling solar PV market challenge traditional notions of

market efficiency and investor rationality. Over the past year, the Government of India has secured

commitments from private sector investors to plow roughly $1 billion into new solar power

generation facilities. What’s surprising is how little financial incentive was ultimately needed to

induce this investment.

The first round of bidding in India’s National Solar Mission (NSM) yielded bids well below

expectations. Prices for delivering solar PV power to the electric grid went below 11 Rs/kWh

($0.24/kWh)1, leading many commentators to raise “an open question how and when these projects

will be realized” (European Commission, 2011). Yet in the second round, concluded in December

2011, bid prices were even lower. Accepted bids ranged from a low Rs 7.5 to a high of 9.5/kWh

($0.16 - $0.21/kWh). In just 12 months, developers shaved 20-30% off bid prices, despite more

stringent pre-bid qualification criteria and rising debt rates.

The auctions tell a fascinating story about not just falling PV panel prices, but also investment hurdle

rates. Taking into account ongoing reductions in solar PV equipment costs, it appears that firms

sanctioned investments at IRRs of between 10% and 12%2. Given the high cost of debt in India,

levered return on equity (ROE) for those same projects would be in the range of 11-15%. Both

levered and unlevered rates are well below what would be expected from “rational” investors.

The risk-free rate in India (10 year GOI bond) has been at least 8% during all of 2011. The equity risk

premium for solar PV investment would therefore be in the range of 2-4%, less than the premium

observed in well developed markets such as the US and far below the premium typically ascribed to

emerging markets. The comparisons are even more striking when considering the illiquidity of solar

PV project investments relative to other classes of risky assets.

1 Rs45/USD 2 I am grateful to Madhavan Nampoothiri, Managing Director of RESolve (India), for valuation expertise

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Our past research on a proxy portfolio of 19 renewable energy companies indicated that a downside

risk-adjusted CAPM would predict that investors demand an unlevered ROE in the range of 15-

19%%. Various snapshots of ROE for Indian firms as a whole, such as analysis by The Economist in

Figure 1, show that average ROE has not been below 15% for the last decade. As the average firm in

the BSE 100 is less indebted than the typical solar PV project, it makes the industry-to-industry

comparison even more striking. The Government of India set auction reserve prices with the

intention of providing investors with a levered project ROE of approximately 22%3, a rate

presumably high enough to entice investors in to a seemingly risky, unproven sector.

Figure 1. Return on Equity as reported by The Economist (Nov 2011)

Compared to numerous metrics, India’s solar auctions appear to have landed investors at rates much

lower than would be expected from “rational” investors. The results are particularly confounding

given the conventional wisdom that firms typically set project hurdle rates above their cost of capital

to correct for over-optimism. Especially in the area of clean technology investing, there is a widely

held presumption that investors require a premium to invest in sectors without proven track

records. Without a reliable means of measuring objective risk, it is often presumed that the “gut

instincts” of investors lead them to set higher thresholds for project IRRs. In the words of one

prominent bank, “just because an area is unknown, there is a human tendency to assume that risks

in that area are higher than they really are.”4

2. Revisiting Risk and Return

We carried out our interviews in November 2011, just before winning bids were announced in from

the second NSM auction. The interviews were semi-structured conversations based around a series

of questions exploring organizational procedures for risk assessment, strategic logic, and individuals’

3 Shrimali, G. (2011). The Solar Auctions in India: What Can We Learn from the Telecom Auctions? Unpublished Manuscript. Indian School of Business, Hyderabad. 4 International Finance Corporation (IFC), 2011. Public Private Partnerships: Accelerating the Growth of Climate Related Private Equity Investment. World Bank Group: Washington, DC.

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perceptions about market risk. Twenty-one individuals, each representing a unique company

participated. A summary of the participant profiles is shown below.

Figure 3. Participants by Job Title

Figure 4. Participants by Type of Firm

Figure 5. Participants by Company Headquarters

43%

19%

19%

19%

n=21

CEO/COO/CFO

Managing Director

Director

Manager

33%

19%14%

14%

19%

n=21

IPP

Private Equity Firm

Consulting Firm

Conglomorate

Investment Bank

38%

38%

24%

n=21

US / EU

India

Other Asia

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The interviews explored various aspects of the firms’ investment decision-making processes and

investigated individuals’ beliefs about renewable energy technologies, markets and governmental

policies.

Several themes emerged from our conversations:

a. Market Evolution. Nearly all interviewees touched upon an idea that the renewable energy

market in India was “evolving” with respect to investment risk. Their collective emphasis on

this idea raises new questions: Towards what is the market evolving? What evolutionary

mechanism would best describe the current state of the market? Our sense from listening to

investors was that an equilibrium state was still many years away. When we asked investors

to describe the risk/return tradeoff in solar PV power project investing relative to other

types of investment, we heard a wide range of opinions. Even from this small sample, we

did not gain from participants a stable set of descriptions about the level of risk or return

available from the market. Risk/return expectations appeared widely dispersed.

Additionally, we noted diversity in the way firms were approaching the task of asset pricing.

Overall there seemed to us a lack of quantitative precision in setting risk-adjusted hurdle

rates. Investment decision rules were commonly linked to achieving a levered IRR target

set in isolation from project risk assessment.

b. Expectations about High Growth. Despite recent setbacks in the headline growth rate,

general confidence about India’s economy remains relatively high. When we asked

investors about growth prospects for solar power, investors returned time and again to the

linkage between economic growth and electric power demand. Many participants remarked

that an “uncoupling” was occurring in market structure that would allow solar power to

escape the ongoing turmoil of insolvency amongst state distribution companies. Looking

towards prospects for further falls in PV module prices and escalating prices/availability of

imported fossil fuels, many investors saw a scenario whereby solar power could enter a new

phase of growth in off-grid, commercial/light industrial, and utility-scale markets. Many

investors expect India to have an endless need for new sources of electric power. Amongst

our sample there was a growing belief that imported coal and natural gas will not be

available to meet that demand. Higher power prices and a bright future for solar seemed, to

them, inevitable.

c. Declining Policy Uncertainty. As in many markets, the single greatest risk issue was related

to government policy. There was a generalized concern that the government could leave

early investors stranded if/when new solar PV power installations become more affordable.

Yet overall, we noted a feeling amongst most investors that policy uncertainty was resolving,

rather than increasing. For project developers working in certain states such as Gujarat,

there was a notable level of confidence about regulatory actors and their assurances to

investors. In discussions of state/national policy risks, only rarely did they make references

to past historical occurrences, expected probabilities, or quantitative ratings. We suspect

that there is a collective belief in the market that policy uncertainty has crossed some peak,

triggering anticipation that with additional time it will decline further. In the words of one

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investor, renewable energy policy-making had “turned a corner.” When pressed for details

about the reduction in uncertainty, most participants did not mention specific events but

rather a change in the general sentiment and pointed again to the “learning process.”

3. A rational explanation for irrationally low hurdle rates

Our focus on non-quantitative elements of the decision-making process was motivated by a

behavioral view of asset pricing that recognizes subjectivity in the risk assessment process. While it

seems self-evident to most corporate finance practitioners that individuals’ beliefs play a role in

investment decision-making, mainstream financial theory does not recognize a psychological

foundation of asset pricing. Where pricing anomalies as shown to exist, these are often dismissed as

short-run phenomenon attributable to irrational agents, or “noise traders”.

In the traditionalist view, the discount rate is derived from observed levels of objective risk. The

measured amount of risk determines the compensation required by investors in excess of a

“certainty-equivalent”, or risk-free, rate. In instances where risk is unquantifiable, firms invest under

conditions of uncertainty. Over time, uncertainty may be reduced as investors learn from new

information that allows them to make clearer forecasts of future states of the world. Learning

within the system promotes a gradual reduction in perceived uncertainty.

The standard view is well represented by the chart below, taken from a US Department of Energy

report, whereby the discount rate is a function of time and a measure of product commercialization

(e.g. cumulative sales).

Figure 6. Evolution of the Project Discount Rate

In conditions of economic equilibrium, where by supply and demand relationships are stable

cost of capital within an industry

And while the ideas of dislocation

Joseph Schumpeter recognized these in the early 1930’s

economic thinking. Perhaps for this reason, these concepts have

corporate finance practices.

There is no shortage of academic

markets. Every hour of every day, investors

date, nearly all of this work has been focused on behaviors within financial markets

stocks, bonds, commodities and derivates. The

understanding the seemingly c

“internal capital markets” of firm

exchanges to be of much use in explaining the apparent paradoxes of investment patterns

No matter whether one’s focus is internal or externa

arises as to what extent economic actors behave rationally.

are people that do things which

economic interpretation of rationality as the

the situation presented to them

“best interests” cannot always be represented in monetary terms

5 National Renewable Energy Laboratory (NREL). 2003. Bridging the Valley of Death: Transitioning from Public to Private Sector Financing. NREL/MP

Project Discount Rate5

equilibrium, where by supply and demand relationships are stable

cost of capital within an industry is seen to reduce gradually towards the certainty

islocations, discontinuities, and non-linearity are hardly new to economics

recognized these in the early 1930’s – it adds considerable complexity

. Perhaps for this reason, these concepts have hardly touched

There is no shortage of academic and practitioner research advancing a more sophisticated view of

. Every hour of every day, investors make money from inefficient market

f this work has been focused on behaviors within financial markets

stocks, bonds, commodities and derivates. These new models have not been m

seemingly chaotic patterns of capital allocation within firm

“internal capital markets” of firms (i.e. capital budgeting) are too different from

in explaining the apparent paradoxes of investment patterns

focus is internal or external capital markets, a common question

arises as to what extent economic actors behave rationally. In the behavioral school, rational agents

do things which are, for them, sensible. This differs from the traditionalists’ s

of rationality as the maximization of personal utility. Sensible people

the situation presented to them, make decisions in their best interest. The key difference is that

cannot always be represented in monetary terms. Not assigning a monetary value

National Renewable Energy Laboratory (NREL). 2003. Bridging the Valley of Death: Transitioning from Public

REL/MP-720-34036. May 2003.

Charles Donovan IE Business School

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equilibrium, where by supply and demand relationships are stable, the

certainty-equivalent rate.

hardly new to economics –

considerable complexity to

touched mainstream

research advancing a more sophisticated view of

market pricing. Yet to

f this work has been focused on behaviors within financial markets – the trading of

new models have not been much help in

firms. It seems the

from tradable securities

in explaining the apparent paradoxes of investment patterns.

l capital markets, a common question in both

school, rational agents

the traditionalists’ strict

ensible people, given

The key difference is that

. Not assigning a monetary value

National Renewable Energy Laboratory (NREL). 2003. Bridging the Valley of Death: Transitioning from Public

Charles Donovan IE Business School

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to one’s preferences poses a tremendous challenge to economics based on individuals’ marginal

utilities.

Accepting that investment decision-makers are not always be rational does not mean that they can’t

be understood. As an alternative to rationality, we can pursue insights about in which ways there

are sensible. Adopting sensibility as our mental frame, our goal becomes understanding how

individual decision-makers approach the issue of investment risk. We want to know how they make

sense of risk and return. These are the psychological foundations of investment decision-making.

But we need not steer too far from traditional economics to find space for a sensible explanation of

low ROEs in solar PV project investments. Many observations of mispricing are more accurately

characterized as “near rational” than irrational, owning to the fact there is frequently wide latitude

for deviating from full optimization without incurring significant losses.6 We suggest that a key to

understanding differences in observed hurdle rates among investors is recognition that risk is not

perceived uniformly by investors.

Conventional wisdom is that regulatory risk typically leads firms to exploit their option to delay.7 By

waiting an extra time period, a firm can narrow the range of probabilities and reduce the chances of

making a negative NPV investment. But in many situations, such as those involving highly regulated

industries or involving rapidly advancing technology, uncertainty is endemic to the investment

decision. While uncertainty may be reduced, complete elimination of uncertainty will never occur.

In these cases, delay becomes counterproductive. In these situations, it may be more productive to

invest uncertainty is still high. For example, a recent study of the German power-generation

industry indicated that some firms accelerate investment decisions under regulatory uncertainty.

The sensible reasons are to secure competitive resources, to leverage complementary resources,

and to alleviate institutional pressures8. We see many of the same dynamics at work in the Indian

solar PV sector.

4. Real Options in Technology Investing and Their Impact on Investment

Learning within individual firms occurs with a set of collective thought about how to compete and

survive. Building the capability to compete and extract rents from new business areas is as

important as observing specific decision rules. We propose that firms respond in different ways to

the uncertainty presented to them. For some, uncertainty is reason to delay and or others a reason

to move faster. What matters most in determining waves of investment is not the absolute level of

uncertainty, but rather the amount of uncertainly relative previous levels9. Declining uncertainty can

be a powerful trigger an ecosystem-wide response to accumulate resources.

6 Akerlof, G. and Yellen, J. 1987. Rational Models of Irrational Behaviour. The American Economic Review, Vol. 77, No. 2, May 1987. 7 Dixit A. and Pindyck, R. 1994. Investment Under Uncertainty. 8 Hoffmann, V., Trautmann, T., and Hamprecht, J. 2009. Regulatory Uncertainty: A Reason to Postpone Investments? Not Necessarily. Journal of Management Studies, 181, 2009. 9 Pastor, L. and Veronesi, P. 2005. Rational IPO Waves. Journal of Finance, Volume 60, Issue 4, pages 1713–1757, August 2005

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Not all actors perceive such an opportunity in the same way. Some firms will be willing to pay a real

option premium to establish a new position, while others, given their resources at hand, prefer to

wait. This diversity in how firms respond to uncertainty becomes a source of heterogeneity in the

discount rate used to evaluate new investments.

In an emerging industry, the opportunity for accumulation of new skills and know-how will prompt

some investors to invest in prospects promising returns below the industry-average ROE. In

neoclassical economics there is one equilibrium discount rate. But viewed from the perspective of

the firm, it may be very sensible to adjust investment hurdle rates below expected return thresholds

in order to pursue new sources of sustainable economic rent.

And while it seems evident that the discount rate reduces over time as an industry matures, we

contend that the curve is not gradually sloping downward. Rather, the availability of real options

lead some firms to break from the pack. In instances where a sub-group of firms sensibly invest for

lower returns, the observed discount rate will be substantially lower than the equilibrium discount

rate. Adopting a strategic view of firm behavior, we could anticipate that in mature industries, the

dispersion of hurdle rates used by firms would be relatively low. Conversely, we should expect a

wide range of hurdle rates for industries, such as renewable power generation, characterized by

technological change and fluctuation perceptions of uncertainty.

Figure 7. Firm Hurdle Rates Relative to an Industry Average

In a fast moving industry where opinions are still forming and new actors are entering, we maintain

that there will be a wide variety of factors to discourage (and encourage) learning investments.

These factors act upon on the project cost of capital. And while we the upward revisions of hurdle

rates by firms are well documented, there are logical reasons for downward revisions as well.

To the potential criticism that the evidence from India is nothing more than a short-term

phenomenon, we point out that the solar PV business has been in existence for more than 30 years,

the last 10 of those as a global, multi-billion dollar industry. Yet private sector hurdle rates continue

to deviate from purely rational expectations.

High Dispertion

Low Dispertion

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5. Implications for policymaking

A strategic view of firm behavior will lead to very different conclusions approach about optimal

renewable energy investment policy than one based on a static view of the industry cost of capital.

Heterogeneity in the discount rate would call into serious question many current regulatory

approaches to promoting investment. It seems that renewable energy policy has been clouded by

viewing environmental investments through the lens of pollution abatement. In an investment

landscape characterized by accelerating resource scarcity and high rates of growth in consumption,

conventional wisdom no longer holds. So what is the possibility that the Government of India has

gotten its policy mix of feed-in tariffs and auctions just right? Has is uncovered a magical recipe for

capturing the renewable power at the lowest cost for consumers?

While auctions carry with them a certain degree of additional risk, they are a powerful and under-

used tool for stimulating investment in renewable power. Auctions capitalize upon the fact that the

risk judgments of firms are not homogenous, nor are they static. Instead of relying upon the

expertise of government planners and outside experts, auctions allow prices to be set through a

competitive process amongst investors.

We are at the very beginning of a shift in how policymakers react to environmental investment

problems. Most policymaking still takes the view of technology choice from the point of view of

generic levelized costs. A better approach would be to acknowledging the risk factors associated

with each technology and the market structure created by policies. The effect will be to “re-order”

technology attractiveness10.

Traditional economic policy making assumes that the equilibrium discount rate is representative of

all investors. For that reason, two policy instruments providing the same amount of average

subsidy are expected to deliver similar outcomes. But with a proper consideration of investment risk

and the motives of the firm, we see strong preferences emerge for one instrument as compared to

another11. For example, if the volatility of expected cash flows from renewable energy certificates is

high, then investment risk will be higher relative to a project with a low expected cash flow variance.

A straightforward conclusion is that renewable energy investors facing feed-in tariffs will have lower

project hurdle rates than those gaining revenue subsidies from tradable certificate markets.

Yet the preferences of investment decision-makers are not just tied to objective risk measurements.

They are also influenced by subjective evaluations of investment risk. We believe options thinking,

despite the extensive math that has been proposed to value real options, is most often a qualitative

process. Only in very rare cases, can real option be valued precisely. Nonetheless, they appear to

weigh heavily in the minds of investment decision-makers.

Behavioral aspects of corporate finance practices have been poorly explored in the debate around

policy instrument choice. Every form of subsidy involves some form of future uncertainty:

10 Gross, R. and Blyth, W. and Heptonstall, P. 2010. Risks, revenues and investment in electricity generation: Why policy needs to look beyond costs. Energy Economics 32 (2010), 796–804. 11 Wüstenhagen, R. and Menichetti, E. 2012. Strategic choices for renewable energy investment: Conceptual framework and opportunities for further research. Energy Policy 40, January 2012, 1-10.

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perceptions about the amount of long-term government support, the potential for retroactive policy

changes, and unforecastable supply and demand factors. And just as each type of subsidy carries

with it a different level of objective risk, so do certain policy and market conditions lead to differing

perceptions of risk. Hunches based on perceptions of risk usually can’t be quantified, but that

doesn’t stop them from being followed.

5. Looking Forward

To this point, we have been concerned with judgments that have are solely related to the potential

consequences of the investment decision. In the third and final discussion paper in this series, we

will dedicate more time to the topic of subjective assessments and explore the intrinsic motivations

of investors.

We welcome your feedback. Please send comments and questions to

solarinvestmentrisk@gmail.com

Discussion Paper No. 3 will be sent by the end of February 2012.