Mixing business with biofuels

Scott Mongeau
Lead Consultant and Founder at Sark7
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Post date: Thursday, 9th February 2012

While it is accepted wisdom that the world needs to increase its focus on sustainable energy, there is still much dispute about whether initiatives of this kind are financially viable. However, much of this can be resolved by bridging the gap between populist enthusiasm surrounding ‘green’ initiatives and the intensive financial risk analysis demanded by capital investors and participants.

The key to achieving this is intensive, integrated computer-based modeling and simulation to provide in-depth decision-making insight. Using risk analysis software such as Palisade’s DecisionTools Suite enables the development of profitable business cases for sustainable energy projects.  In effect, these act as due-diligence tools for prospective sustainability entrepreneurs, investors, project managers, providers and organisations.

A biofuel plant provides a good example to show the viability of this thinking, although the principles are equally applicable to sustainable energy initiatives such as wind or solar energy.

Determining Net Present Value

First of all the overall feasibility of the project needs to be determined.  A model using Palisade’s Monte Carlo simulation solution @RISK, an element of Palisade DecisionTools Suite, allows for in-depth Net Present Value (NPV) sensitivity analysis of the plant, with factors accounted for including: the capital costs of building the biofuel plant; the most efficient configuration for annual yield; the (variable) price of feedstock (the raw material used to make biofuel) based on historical commodity price analysis, and the energy, yeast, enzyme and processing costs used to generate the biofuel; research and development costs; different oil and ethanol price scenarios to determine potential turnover; and competition simulation to determine the range of prices that can be charged for the end-product. 

In addition, the costs of financing the overall project (such as the interest payable on debt and optimal capital mix, depreciation and tax scenarios) are incorporated into the model.

Finance fundamentals

This complex modelling shows which factors will have the most influence over whether a project will be profitable. This holistic approach addresses a fundamental principle of finance. Rather than looking at potential profit in an isolated static case, it is important to balance the highest profit that can be gained for the lowest aggregate risk exposure across integrated implementation, technical, economic and financial aspects.

It also ensures that key stakeholders factor in ‘real world’ issues such as the cost of commodities, which can be volatile because they are linked to global systems and events and therefore, where possible, should be hedged via financial instruments such as futures and options to reduce risk.

Balancing risk and reward

Throughout the whole project, analysing different scenarios guides the decision-making process. For example, using the PrecisionTree component of the DecisionTools Suite, the option of whether to build a large scale biofuel plant can be weighed up against developing a smaller ‘proof-of-concept’ plant by comparing central risk / reward factors such as the investment required and the chance of technical success. At major stages, project abandonment via sale of the plant can be considered as flexibility of this nature adds potential value as a formal risk management contingency.

At the crux of this type of integrated analysis is an understanding that implementation, technical, economic and financial decisions all overlap. Changing the plant configuration adds to capital and financing costs, but creates the potential for high yields, though balanced by technical risk. The DecisionTools Suite’s Evolver identifies the most cost effective, efficient, advanced plant possible while controlling financing costs and economic risk exposures.

The business case for sustainability projects

Using the DecisionTools Suite therefore enables the business case for a biofuel plant to be presented to potential investors, who can see immediately whether it meets their funding criteria. This includes having a clear understanding of the risks involved in the programme, and the knock-on effect this could have on their finances.

The overall premise is simple: environmental experts and enthusiasts need to be realistic about whether their proposal is financially viable if they are going to attract the funds that will make it a reality. Palisade’s risk analysis tools provide the language that is familiar to the financial world, as a result of which the project is more likely to receive funding.  Sustainability criteria can therefore be met at the same time as providing investors with a risk-balanced return - so everyone wins.

Energy and Environment