The Renewables Obligation (RO) is a programme of the UK government that requires electricity suppliers to create more of their sales from renewable sources. Businesses who do this receive a Renewables Obligation Certificate

(ROC), which they can sell. This extract describes a way of evaluating the projects.

The figures show the evolution of IRRs through time for two expensive technologies (offshore wind and energy crops) and two cheap technologies (onshore wind and landfill gas), along with the expected cost of capital used for each technology. Two cost assumptions have been used – high and low – covering a range of assumptions about the initial level and the subsequent possible evolution of capital and operating costs. The figures suggest that there will be some tendency for the cost of capital required for the most risky technologies to decline over time. This is a reflection of an assumed reduction in risk as the market becomes more comfortable with investments of this kind.

In all cases, the estimated IRR tends to fall through time: build costs fall over time and ROC prices also decline from their highest levels during the early years of the RO. Under the high electricity price scenario, new offshore wind and energy crop plant would cease to be built from 2013/14 or so, whereas onshore wind and landfill would cease to be built from 2018/19. Under the low electricity price scenario, there would be no offshore wind or energy crop build, and onshore wind and landfill plant construction would cease a year or so earlier. It might be thought that declining build costs would lead to an increase in rates of return over time, but the merit of the RO is that, as generation costs fall, and with a static target, the ROC price falls below the buy-out price. Thus, the scheme manages to extract these gains for the consumer.

Discussion points
1 Why has IRR been used to compare the projects?
2 How does the calculation of IRR allow for sensitivity to a range of economic conditions?

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-High estimate -Low estimate Assumed cost of capital Estimated IRR, cost of capital 2003/04 2005/06 2007/08 2009/10 2011/12 2013/14 2015/16 2017/18 2019/20 2003/04 2005/06 2007/08 Estimated IRR, cost of capital 2009/10 2011/12 2013/14 2015/16 2017/18 0% + 2019/20 5% 10% 15% 20% 25% 30%- Onshore wind projects 10% 15%- 20% 25% 30% Landfill gas projects 2003/04 2005/06 2007/08 2009/10 2011/12 2013/14 2015/16 2017/18 2019/20 2003/04 2005/06 Estimated IRR, cost of capital 2007/08 2009/10 2011/12 Estimated IRR, cost of capital 2013/14 2015/16 2017/18 14%- 16%- 2019/20 Offshore wind projects 15% 20% 25% - 30%7 Energy crop projects