Opportunity Cost of Investment Tax Credit

Electricity plays a major role in our everyday life in America.  The rate of electrical consumption continues to grow each year and power plants are aging so we are in need of new facilities to generate the power.  Some chooses to replace or expand upon these facilities are nuclear, coal, natural gas, wind and solar.  The largest producer of electricity at this moment is coal power.  Coal power is cheap to generate but also releases harmful emissions into the atmosphere.  The most desired form of generation would be renewable energies such as solar and wind because they use no fuel to generate electricity and produce zero emissions.  However, both wind and solar are extremely expensive to construct when compared to the aforementioned types.  That is why renewable energies are still be constructed at a much lower rate than traditional power plants.

                The US Government has stepped in to encourage the development of renewable energies with the hope that if production increases, the costs will decrease thus making them comparable to traditional power plants.  The biggest step that the government took was the Business Energy Investment Tax Credit, commonly called the ITC, which was passed in early 2009.  The ITC would grant 30 percent of all construction expenditures for any wind or solar projects that were put into operations from 2009 to the end of 2012.  There was no maximum to the credit and it would be paid in full to the company as soon as the plant was operational.  Opportunity cost of capital is defined as forgone opportunity of using cash for another purpose or the rate of return for investors.  This is a prime example of opportunity cost of capital because it made the less viable options attractive to companies for several reasons.

                The first reason the ITC was desirable is the payback.  Payback method is the number of years it takes to return on the initial investment.  For simplicity, let's say a wind energy project costs $1,000,000 to build, can produce up to $100,000 worth of electricity per year and will last for twenty years.  That would make the payback ten years under regular circumstances.  However, with the ITC the company would receive $300,000 back as soon as the project is operational.  This makes the starting debt only $700,000 which lowers the payback to only seven years.  The quicker rate of payback is more attractive to investors because it means they will start generating profits sooner.

                Another reason that the ITC is desirable is the difference it makes in the internal rate of return or IRR.  The internal rate of return can be calculated by dividing the future value of a project by its present value.  Using the example above, the future values would be the same for both scenarios but the present values would be $1,000,000 for no ITC and only $700,000 with ITC.  Since the IRR is directly proportional to the present value, having a 30 percent lower present value would create a much higher IRR.  This would be attractive to investors because it means they are getting a much higher return for investing the same amount of money.

                One reason that investors are skeptical about renewable energies is the risky cashflow.  Solar and wind are not guaranteed power sources because the sun might not be out and the wind might not be blowing.  That makes the cashflows used in evaluating the opportunity cost of the project vary and causes companies to use a risk premium when calculating the return on investment.  The main driver of the risk analysis is the present value of the project.  Since the ITC will lower the present value by 30 percent, it allows for more flexibility in the risk premium in order to achieve the desired rate of return on the project.