ECONOMICS

Economics of investment

On the next two pages, we look at the economics of an investment in wind energy from the point of view of society as a whole, as economists typically do. We do not account for environmental benefits, we shall do that later. We do not look at financing or taxation. These items vary enormously from one country to the other, but they do not make any nation richer or poorer: they only serve to redistribute income. What society gets in return for investment in wind energy is pollution-free electricity; let us find out how much that costs.

If you are a private investor in wind energy you can still use our calculations - pre tax, that is: Generally speaking, investments which have a high rate of return before tax will have an even higher rate of return after taxes. This is a surprise to most people. The reason is, however, that depreciation regulations for all sorts of business tend to be very favourable in most countries. With rapid tax depreciation you get a higher return on your investment, because you are allowed to deduct the loss of value of your asset faster than it actually loses it value. This is nothing special for wind turbines. It is true for all sorts of business investment.

Once again, do note, that our calculations in real terms omit financing and taxes. As a prudent investor, you would probably want to plan your cash flow to make sure you can pay your debts. This you obviously have to calculate in money terms, i.e. in nominal terms.

With any investment, you pay something now to get something else later. We assume that a dollar in your pocket today is more valuable to you than a dollar tomorrow. The reason is that you could invest that dollar somewhere or put it into a bank account and earn interest on it.

To tell the difference between today's and tomorrow's dollars, the interest rate is used. If we do that, 1 euro a year from now is worth 1/(1+r) to you today. r is the interest rate, for example 5% per year. Thus 1 euro a year from now is worth 1/1.05 = 0.9523 euros today. 1 euro 2 years from now is worth 1/(1.05*1.05) = 0.9070 and so forth.

But what about inflation? To deal with that we shall simply only work with euros which have the same purchasing power as a euro does today. Economists call that working with real values, instead of nominal ones.

An investment in a wind turbine gives you a real return, i.e. electricity, and not just a financial (cash) return. This is important, because if you expect some general inflation of prices during the next 20 years, you may expect electricity prices to follow the same trend.

Likewise, we would expect operation and maintenance costs to follow roughly the same price trend as electricity. If we expect all prices to move in parallel (with the same growth rates) over the next 20 years, then we can do our calculations quite simply: We do not need to adjust or calculations for inflation, we simply do all of our calculations in the price level of our base year, i.e. the year of our investment.

In other words, when we work with real values, we work with money which represent a fixed amount of purchasing power.

Since we are studying the real rate of return (profitability) of wind energy, we have to use the real rate of interest, i.e. the interest rate minus the expected rate of inflation. If both rates are high, say, above 10%, you cannot really subtract the percentages, you should divide like this (1+r)/(1+i) but let's not make this into a course in economics.

Typical real rates of interest for calculation purposes these days are in the vicinity of 5% per annum or so. You may say that in countries like Western Europe you could even go down to 3%. Some people have a very high demand for profitability, so they might wish to use a higher real rate of interest, say, 7%. Using the bank rate of interest is nonsense, unless you then do nominal calculations, i.e. add price changes everywhere, including to the price of electricity.