JNNSM reverse auction : A rational explanation for irrationally low hurdle rates

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In this discussion paper on Asset pricing - Renewable Energy in Growing Economices , Charles Donovan,(Visiting Professor, Department of Finance, EADA Business School, Spain), analyses the reverse auction for allotment of solar projects under Indian's National Solar Mission and offers a "rational explanation for irrationally low IRRs"

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JNNSM reverse auction : A rational explanation for irrationally low hurdle rates

  1. 1. Charles Donovan 1 IE Business SchoolDiscussion Paper Series on Asset Pricing:Renewable Energy in Growing EconomiesThis is the second in a series of three discussion papers. The first paper addressed two aspects ofproject discount rates for renewable energy investments: zero beta and downside risk. Bothconcepts push at the edges of mainstream investment evaluation, but are nonetheless firmly rootedin the logic of portfolio theory and the Capital Asset Pricing Model (CAPM). As CAPM is a wellinstalled program in the minds of current and aspiring CFOs, we argued that the model wouldbecome 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 investorsarrive at their financial return expectations. We explore self-reported perceptions about risk from arange of investors in India’s renewable energy market and consider the influence of strategic optionson investment hurdle rates.1. Analysis on required return on equityThe slew of recent investments in India’s fledgling solar PV market challenge traditional notions ofmarket efficiency and investor rationality. Over the past year, the Government of India has securedcommitments from private sector investors to plow roughly $1 billion into new solar powergeneration facilities. What’s surprising is how little financial incentive was ultimately needed toinduce this investment.The first round of bidding in India’s National Solar Mission (NSM) yielded bids well belowexpectations. 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 projectswill be realized” (European Commission, 2011). Yet in the second round, concluded in December2011, 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 morestringent pre-bid qualification criteria and rising debt rates.The auctions tell a fascinating story about not just falling PV panel prices, but also investment hurdlerates. Taking into account ongoing reductions in solar PV equipment costs, it appears that firmssanctioned 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%. Bothlevered 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 riskpremium for solar PV investment would therefore be in the range of 2-4%, less than the premiumobserved in well developed markets such as the US and far below the premium typically ascribed toemerging markets. The comparisons are even more striking when considering the illiquidity of solarPV project investments relative to other classes of risky assets.1 Rs45/USD2 I am grateful to Madhavan Nampoothiri, Managing Director of RESolve (India), for valuation expertise
  2. 2. Charles Donovan 2 IE Business SchoolOur past research on a proxy portfolio of 19 renewable energy companies indicated that a downsiderisk-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 inFigure 1, show that average ROE has not been below 15% for the last decade. As the average firm inthe BSE 100 is less indebted than the typical solar PV project, it makes the industry-to-industrycomparison even more striking. The Government of India set auction reserve prices with theintention of providing investors with a levered project ROE of approximately 22%3, a ratepresumably 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 muchlower than would be expected from “rational” investors. The results are particularly confoundinggiven the conventional wisdom that firms typically set project hurdle rates above their cost of capitalto correct for over-optimism. Especially in the area of clean technology investing, there is a widelyheld presumption that investors require a premium to invest in sectors without proven trackrecords. Without a reliable means of measuring objective risk, it is often presumed that the “gutinstincts” of investors lead them to set higher thresholds for project IRRs. In the words of oneprominent bank, “just because an area is unknown, there is a human tendency to assume that risksin that area are higher than they really are.”42. Revisiting Risk and ReturnWe carried out our interviews in November 2011, just before winning bids were announced in fromthe second NSM auction. The interviews were semi-structured conversations based around a seriesof 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 ofClimate Related Private Equity Investment. World Bank Group: Washington, DC.
  3. 3. Charles Donovan 3 IE Business Schoolperceptions about market risk. Twenty-one individuals, each representing a unique companyparticipated. A summary of the participant profiles is shown below.Figure 3. Participants by Job Title 19% 43% CEO/COO/CFO 19% Managing Director 19% Director Manager n=21Figure 4. Participants by Type of Firm IPP 19% 33% Private Equity Firm 14% Consulting Firm 14% 19% Conglomorate Investment Bank n=21Figure 5. Participants by Company Headquarters 24% 38% US / EU India 38% Other Asia n=21
  4. 4. Charles Donovan 4 IE Business SchoolThe interviews explored various aspects of the firms’ investment decision-making processes andinvestigated individuals’ beliefs about renewable energy technologies, markets and governmentalpolicies.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
  5. 5. Charles Donovan 5 IE Business School 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 ratesOur focus on non-quantitative elements of the decision-making process was motivated by abehavioral view of asset pricing that recognizes subjectivity in the risk assessment process. While itseems self-evident to most corporate finance practitioners that individuals’ beliefs play a role ininvestment decision-making, mainstream financial theory does not recognize a psychologicalfoundation of asset pricing. Where pricing anomalies as shown to exist, these are often dismissed asshort-run phenomenon attributable to irrational agents, or “noise traders”.In the traditionalist view, the discount rate is derived from observed levels of objective risk. Themeasured 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 underconditions of uncertainty. Over time, uncertainty may be reduced as investors learn from newinformation that allows them to make clearer forecasts of future states of the world. Learningwithin 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 Energyreport, whereby the discount rate is a function of time and a measure of product commercialization(e.g. cumulative sales).
  6. 6. Charles Donovan 6 IE Business SchoolFigure 6. Evolution of the Project Discount Rate5In conditions of economic equilibrium, where by supply and demand relationships are stable the stable,cost of capital within an industry is seen to reduce gradually towards the certainty certainty-equivalent rate.And while the ideas of dislocation discontinuities, and non-linearity are hardly new to economics – islocations,Joseph Schumpeter recognized these in the early 1930’s – it adds considerable complexity toeconomic thinking. Perhaps for this reason, these concepts have hardly touched mainstream .corporate finance practices.There is no shortage of academic and practitioner research advancing a more sophisticated view ofmarkets. Every hour of every day, investors make money from inefficient market pricing. Yet to .date, nearly all of this work has been focused on behaviors within financial markets – the trading of fstocks, bonds, commodities and derivates. The new models have not been m These much help inunderstanding the seemingly c chaotic patterns of capital allocation within firm firms. It seems the“internal capital markets” of firm (i.e. capital budgeting) are too different from tradable securities firmsexchanges to be of much use in explaining the apparent paradoxes of investment patterns patterns.No matter whether one’s focus is internal or external capital markets, a common question in both externalarises as to what extent economic actors behave rationally. In the behavioral school, rational agentsare people that do things which are, for them, sensible. This differs from the traditionalists’ sstricteconomic interpretation of rationality as the maximization of personal utility. Sensible people given ensible people,the situation presented to them make decisions in their best interest. The key difference is that them,“best interests” cannot always be represented in monetary terms. Not assigning a monetary value terms.5 National Renewable Energy Laboratory (NREL). 2003. Bridging the Valley of Death: Transitioning from Publicto Private Sector Financing. NREL/MP REL/MP-720-34036. May 2003.
  7. 7. Charles Donovan 7 IE Business Schoolto one’s preferences poses a tremendous challenge to economics based on individuals’ marginalutilities.Accepting that investment decision-makers are not always be rational does not mean that they can’tbe understood. As an alternative to rationality, we can pursue insights about in which ways thereare sensible. Adopting sensibility as our mental frame, our goal becomes understanding howindividual decision-makers approach the issue of investment risk. We want to know how they makesense 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 oflow ROEs in solar PV project investments. Many observations of mispricing are more accuratelycharacterized as “near rational” than irrational, owning to the fact there is frequently wide latitudefor deviating from full optimization without incurring significant losses.6 We suggest that a key tounderstanding differences in observed hurdle rates among investors is recognition that risk is notperceived uniformly by investors.Conventional wisdom is that regulatory risk typically leads firms to exploit their option to delay.7 Bywaiting an extra time period, a firm can narrow the range of probabilities and reduce the chances ofmaking a negative NPV investment. But in many situations, such as those involving highly regulatedindustries or involving rapidly advancing technology, uncertainty is endemic to the investmentdecision. 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 toinvest uncertainty is still high. For example, a recent study of the German power-generationindustry 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 Indiansolar PV sector.4. Real Options in Technology Investing and Their Impact on InvestmentLearning within individual firms occurs with a set of collective thought about how to compete andsurvive. Building the capability to compete and extract rents from new business areas is asimportant as observing specific decision rules. We propose that firms respond in different ways tothe uncertainty presented to them. For some, uncertainty is reason to delay and or others a reasonto move faster. What matters most in determining waves of investment is not the absolute level ofuncertainty, but rather the amount of uncertainly relative previous levels9. Declining uncertainty canbe 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 PostponeInvestments? 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
  8. 8. Charles Donovan 8 IE Business SchoolNot all actors perceive such an opportunity in the same way. Some firms will be willing to pay a realoption premium to establish a new position, while others, given their resources at hand, prefer towait. This diversity in how firms respond to uncertainty becomes a source of heterogeneity in thediscount rate used to evaluate new investments.In an emerging industry, the opportunity for accumulation of new skills and know-how will promptsome investors to invest in prospects promising returns below the industry-average ROE. Inneoclassical economics there is one equilibrium discount rate. But viewed from the perspective ofthe firm, it may be very sensible to adjust investment hurdle rates below expected return thresholdsin 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, wecontend that the curve is not gradually sloping downward. Rather, the availability of real optionslead some firms to break from the pack. In instances where a sub-group of firms sensibly invest forlower returns, the observed discount rate will be substantially lower than the equilibrium discountrate. Adopting a strategic view of firm behavior, we could anticipate that in mature industries, thedispersion of hurdle rates used by firms would be relatively low. Conversely, we should expect awide range of hurdle rates for industries, such as renewable power generation, characterized bytechnological change and fluctuation perceptions of uncertainty.Figure 7. Firm Hurdle Rates Relative to an Industry Average High Dispertion Low DispertionIn a fast moving industry where opinions are still forming and new actors are entering, we maintainthat 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 hurdlerates 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-termphenomenon, 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 continueto deviate from purely rational expectations.
  9. 9. Charles Donovan 9 IE Business School5. Implications for policymakingA strategic view of firm behavior will lead to very different conclusions approach about optimalrenewable 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 regulatoryapproaches to promoting investment. It seems that renewable energy policy has been clouded byviewing environmental investments through the lens of pollution abatement. In an investmentlandscape 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 hasgotten its policy mix of feed-in tariffs and auctions just right? Has is uncovered a magical recipe forcapturing 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 therisk judgments of firms are not homogenous, nor are they static. Instead of relying upon theexpertise of government planners and outside experts, auctions allow prices to be set through acompetitive process amongst investors.We are at the very beginning of a shift in how policymakers react to environmental investmentproblems. Most policymaking still takes the view of technology choice from the point of view ofgeneric levelized costs. A better approach would be to acknowledging the risk factors associatedwith 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 ofall investors. For that reason, two policy instruments providing the same amount of averagesubsidy are expected to deliver similar outcomes. But with a proper consideration of investment riskand the motives of the firm, we see strong preferences emerge for one instrument as compared toanother11. For example, if the volatility of expected cash flows from renewable energy certificates ishigh, 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 lowerproject 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 qualitativeprocess. Only in very rare cases, can real option be valued precisely. Nonetheless, they appear toweigh heavily in the minds of investment decision-makers.Behavioral aspects of corporate finance practices have been poorly explored in the debate aroundpolicy 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: Conceptualframework and opportunities for further research. Energy Policy 40, January 2012, 1-10.
  10. 10. Charles Donovan 10 IE Business Schoolperceptions about the amount of long-term government support, the potential for retroactive policychanges, and unforecastable supply and demand factors. And just as each type of subsidy carrieswith it a different level of objective risk, so do certain policy and market conditions lead to differingperceptions of risk. Hunches based on perceptions of risk usually can’t be quantified, but thatdoesn’t stop them from being followed.5. Looking ForwardTo this point, we have been concerned with judgments that have are solely related to the potentialconsequences of the investment decision. In the third and final discussion paper in this series, wewill dedicate more time to the topic of subjective assessments and explore the intrinsic motivationsof investors.We welcome your feedback. Please send comments and questions tosolarinvestmentrisk@gmail.comDiscussion Paper No. 3 will be sent by the end of February 2012.

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