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Solar: Payback analysis and Internal Rate of Return

Awhile back, I wrote a column which was highly critical of using payback analysis to figure out whether installing a solar hot water system on one’s house makes economic sense. In almost every example you can imagine, the payback period for today’s solar installations ranges between long and forever.

For my system, which started operating in January 2006, payback will be achieved in a mere 19 years using today’s energy prices, though by the time 2025 rolls around, half of Florida might be under water and the rest of the country out of natural gas.

What message does payback analysis convey to the average household contemplating a solar installation? It can be boiled down to this harsh assessment: the chances that you will be living in the same house when the system is fully paid off are remote, so you’re better off leaving solar off the table.

Indeed, payback analysis reinforces the popular perception that solar energy is unaffordable, and that homeowners should wait for technological improvements or cost reductions before pursuing this energy option.

But from the standpoint of energy security and climate protection, every day of inaction leaves us in a deeper hole. We no longer have the luxury of waiting for external triggers -- be they painful market signals or nasty resource wars -- to spur us into doing the right thing.

But there’s no reason to let payback length rule one’s ability to invest in sustainable energy for the home or business, especially if there are other approaches to valuing important economic decisions. One way to sidestep the gloomy verdicts of payback analysis is to do what most companies do when contemplating a long-term investment like solar energy -- calculate the internal rate of return (IRR) on the invested capital. The definition of IRR is the annualized effective compounded return rate which can be earned on the invested capital, i.e. the yield on the investment.

By using this familiar capital budgeting method, I’m able to calculate an IRR of 6.1% for my solar water heater if natural gas prices rise a measly 3% per annum. That yield exceeds anything that a bank will offer you today. It will likely outperform the stock market this year, which is due for a substantial downward adjustment to reflect the slow-motion implosion of the housing market now underway. And, unless you live in a gold-rush community like Fort McMurray, Alberta, your house will do well just to hold onto its current valuation, let alone appreciate by six percent.

While all investments pose some degree of risk, the return on a solar energy system is about as safe and predictable as, well, the rising sun. Fortunately for the Earth and its varied inhabitants, the center of our solar system is situated well beyond the reach of humanity’s capacity to tamper with a good thing.

The collector system is simplicity itself; the panels just sit there gathering all that exogenous, renewable energy during daylight hours, unencumbered with moving parts that can wear out. The panels degrade slightly from one year to the next, but they shouldn’t lose more than 20% of their efficiency over a 30-year period. And, in the event of a violent weather event like a hailstorm, one’s homeowner insurance policy should cover the damage. All told, solar energy, whether used for electricity or heat, is about as close as it comes to a risk-free investment.

But what about solar’s contribution to the market value of the house it serves, which can be easily measured? A 10-year-old solar energy system should deliver 20 more years of electricity or heat, reducing that house’s energy overhead during that period. In the case of my installation, the 20 years of avoided energy purchases starting in Year 11 should exceed my entire out-of-pocket expense. One can infer from that calculation that houses that capture solar energy on-site will appreciate faster--or depreciate more slowly -- than houses that don’t.

Granted, calculating the IRR of a solar installation doesn’t capture the full range of benefits that flow to the system owner. It doesn’t, for example, factor in the possibility that, before too long, natural gas will become a rationed energy source, but that’s a political outcome whose probability and impacts are, at this point, unquantifiable. True, environmental externalities can be modeled but it’s just an academic exercise until emission offset markets like the Chicago Climate Exchange become accessible to homeowners and small business owners as well as to utilities and multinational corporations.

But calculating the installation’s IRR allows system owners to see something about solar energy that is not revealed in payback analysis, which is that obtaining electricity and/or heat from the sun is a sustainable and risk-free way of creating household wealth. And if the numbers support this conclusion, then why aren’t we reinvesting every last penny of profit from our fossil fuel-based economy into creating a renewable energy platform for the future?

Wikipedia - Internal Rate of Return.

First published in Petroleum and Natural Gas Watch, RENEW Wisconsin, March 20, 2007, Vol. 6, Number 5.
Petroleum and Natural Gas Watch is a RENEW Wisconsin initiative tracking the supply demand equation for these fossil fuels, and analyzing its effects on prices, consumption levels, and the development of energy conservation strategies and renewable energy alternatives. For more information on the global and national petroleum and natural gas supply picture, visit "The End of Cheap Oil" section in RENEW Wisconsin's Web site. These commentaries also posted on RENEW’s blog and Madison Peak Oil Group’s blog.

Editorial Notes: Contributor Ed Blume writes:

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