Q&A: Valuation Issues and Renewable Energy (Part One of Two)

Published by H. Blair Kincer on Friday, October 1, 2010
Journal thumb October 2010

Question: How is fair market value determined for renewable energy assets?

Answer: Novogradac & Company LLP is often asked to determine the fair market value of renewable energy assets in connection with financing and structuring decisions. Additionally, the reports generated as a result of these requests are often used in connection with the application for the federal grant identified as Section 1603 of the American Recovery and Reinvestment Act of 2009.

Novogradac & Company LLP designed its methodology for determining fair market value of renewable energy assets in compliance with with Treasury and Internal Revenue Service (IRS) guidelines and regulations and with the requirements set forth by the Uniform Standards of Professional Appraisal Practice (USPAP) for a Summary Report.

The first step is defining market value. The firm uses the following, which we believe is consistent with Treasury and IRS guidelines.

Market value is defined as:

The most probable price that a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. Implicit in this definition is the consummation of sale as of a specified date and the passing of title from seller to buyer under conditions whereby:

  1. Buyer and seller are typically motivated;
  2. Both parties are well informed or well advised and acting in what they consider their best interest;
  3. A reasonable time is allowed for exposure in the open market;
  4. Payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto; and,
  5. The price represents normal considerations for the property sold, unaffected by special or creative financing or sales concessions granted by anyone associated with the sale (see 1 12 C.F.R. Part 34.42(g); 55 Federal Register 34696, August 24, 1990).

The asset valued is the equipment described by the client (typically solar panel installations or wind turbine installations). An important clarification is that the rights that are retained with the development are valued. These rights include sale of the electricity generated and certain state and federal grants attributed to the development of the examined system. These assignments should be conducted assuming both a value in use and a going concern basis.  

The expected useful life is based upon market parameters and warranty information. For example, solar panel installations have a cash flow term of 30 years. This is supported by the typical warranty period of 20 to 25 years.  

Forecasted data should be used and generally accepted valuation procedures based on economic and market factors should be applied relating to such data and assumptions. The financial analyses are used in the sense contemplated by the USPAP.

Contemporary appraisers usually gather and process data according to the discipline of the three approaches to value, i.e. the cost approach, income capitalization approach and the sales approach. Because the majority of the interests valued include intangible and financial assets, a sales comparison approach is not applicable.  

The cost approach consists of the cost to reproduce or replace the improvements, less appropriate deductions for depreciation. Reproduction cost is the cost to construct a replica of the subject system. Replacement cost is the cost to construct improvements having equal utility. The firm’s methodology uses replacement costs to estimate the value. We compare the utility with similar systems. We maintain a file of comparable cost information. Further, we gather additional third-party information regarding costs of similar systems. We use this data to test the reasonableness of the cost estimates for the subject system.

The income capitalization approach requires estimation of the anticipated economic benefits of ownership, gross and net incomes, and capitalization of these estimates into an indication of value using investor yield or return requirements. Yield requirements reflect the expectations of investors in terms of asset performance, risk and alternative investment possibilities. The alternative energy systems have an income producing aspect and the income approach is considered a valuable methodology. Given the economic infeasibility of developing alternative energy sources there are several state and federal programs designed to increase feasibility.  These assets have also been incorporated into our estimate of value. We have included these subsidies in the income approach for several reasons:

1) Without the subsidy the anticipated benefits would not equal the cost of production. These subsidies are necessary to entice any investor into the industry. Investors and all market participants view them as part of the benefit stream when determining deal structure, return parameters and ultimately investment. Therefore, the market recognizes their inclusion.

2) It is consistent with typical valuation methodology. As discussed, USPAP is a central resource in the appraisal industry. While intended for the real estate industry, its theories and methodologies are relevant. According to USPAP, page A-34, “Standards Rule 1-2(e) allows the inclusion of intangible assets that are not real property in the appraisal.” Further, it states that when intangible assets are present in the appraisal, “the appraiser must analyze the effect on value of such non-real property items.” Therefore, inclusion of all assets tangible and intangible are to be included.  

The issue is more specifically addressed on page A-35, which says,  “Because Standards Rule 1-2(c) also states that terms of submarket financing or financing with unusual conditions or incentives must be clearly set forth, their contributions to or negative influence on value must be developed by analysis of relevant market data.”

3) In the tax credit industry there is precedent for the inclusion of intangible assets such as subsidies, below market debt and incentives. In the appraisal of low-income housing tax credit (LIHTC) properties, it is typical for the tax credits and any below market debt to be included in the valuation. In our experience with completing appraisals for new markets tax credit (NMTC) deals, we have included below market debt calculations to reflect all values, intangible and tangible.

These sources of funding, both the anticipated value of future energy production and the financial incentives, should equal (or approximately equal) the costs determined above.

While the valuation of energy assets is a relatively unique endeavor, Novogradac & Company LLP is fully capable of testing the developer assumptions within a market framework. We do this primarily through third-party articles and conversations with those knowledgeable in the industry. As the industry grows so does the accumulated database of information. We test the developer assumptions regarding expense levels, alternative costs, and lease revenue to verify that they are within the generally accepted market parameters.  

The firm reconciles the overall subject system’s value using the two approaches just discussed. The present value of the energy system is the discounted value based on the revenue and operating expenses.  This is known as a going concern value. The intangible portion of the value (the state and federal grants and incentives) is not a going concern value. Once the grants are issued, they represent no value to the entity as they have no anticipatory value. Therefore, our value assumes that the energy system is operational and that the intangible assets will accrue to the purchaser as of the effective date of valuation.  

The intangible assets are designed to bridge the gap between cost and value of the electricity generated. The need for these subsidies is generated by the fact that alternative installations are not economically feasible (they do not generate sufficient revenue to cover costs). Therefore, the most appropriate measure of value for the solar installation is the cost methodology. We support this methodology with an income approach. Because the income generated will not support the cost without subsidy we also include the intangible assets as part of the sources of funds. These intangible assets come in the form of grants which are not discounted. The summation of the intangible assets and the present value of the energy value should approximate the cost of the system. If this is true, the cost is supported by the income approach. Obviously, the cost approach is considered most reliable because of the circular nature of the calculation of the grant amounts.

Our value conclusions are based on general economic conditions as they existed on the date of the analysis and did not include an estimate of the potential impact of any sudden or sharp rise or decline in general economic conditions from that date to the effective date of our report, nor does it contemplate sharp increases in fossil fuel prices in the near term which, all other things being equal, could likely change our conclusions significantly.  

Next Month
In part two of this article, we will discuss current costs and market trends related to the valuation of renewable energy assets. Stay tuned.