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Profit/Loss Analysis
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Estimate of Profitability for The Karahnjukar Hydroelectric Power Plant

Thorsteinn Siglaugsson, MBA

English Summary of the Report Commissioned by the
Iceland Nature Conservation Association
Reykjavik, June 2001



Introduction

The proposed hydropower project at Karahnjukar in the east of Iceland is the largest project of the Landsvirkjun power monopoly to date, involving 16 dams and reservoirs, including the highest dam in Europe, and 80 km. of tunnels. The plant would be the main power source for a planned 390.000 ton aluminium smelter in Reydarfjordur in the east of Iceland and would be built specifically for this purpose.

The purpose of this report is to estimate the profitability of the project using a net present value analysis. The analysis is based on information already available from Landsvirkjun and common estimates regarding probable energy prices, return on equity and return on debt. The scenario uses real, as opposed to nominal values, based on expected long term inflation in the USA.

Methodology

This report uses the net present value, NPV, method, which the most common way of analyzing the value of firms and specific projects. Using estimated expected return on debt and equity the present value of future cost and investment is subtracted from the present value of future revenues to find the net present value of the project. If this figure is positive, the project is financially viable, if it is not, the project should not go ahead.

Investment and energy sales

The estimated cost of the project is 107 billion ISK, approximately 1,07 billion USD, split 70/30 between the first and second phase of the project. The first phase is expected to start in the beginning of 2002 and finish mid-year 2006. The start of the second phase is planned in 2009, lasting for 4 years. For each phase, the investment is split evenly throughout the investment phase. The lifetime of the investment is expected to be 60 years, which is well above the lifetime indicated by Landsvirkjun┤s depreciation rules. Anyway, cost and revenues beyond 60 years make almost no difference to their present values.

The Reydaral smelter is expected to be built in two phases, the first being ready mid-year 2006, with a capacity of 240-280,000 ton/year. No decision has been made regarding an addition, bringing the total capacity to 360-420,000 ton/year, but the second phase of the power plant is dependent on this addition, which is expected to be in operation in the year 2009.

The expected power usage of the planned Reydaral project is 5,500 gwh/year. The capacity of the power plant is 4,890 gwh/year, 3,760 for the first phase and 1,220 for the second phase. Thus, the capacity of the first phase will leave 130 gwh/year from being fully utilized by the first phase of the refinery, but the total power usage will require 610 gwh/year in addition to the full capacity of the Karahnjukar project.

Expected energy price

The average price Landsvirkjun received from its heavy industry clients in the year 2000 was 1 isk/kwh. According to specialists in the field, and based on the general cost structure in aluminium production, new aluminium smelters are viable only if the price falls below 20 mills, approximately 2 isk/kwh. In Iceland, the expected price would most probably fall within the range of 1,5-2 isk/kwh.

Aluminium price has fallen by 1,5% annually over the last 12 years. It is expected to continue falling by 1-1,5% annually, due to expected increase in supply. Energy amounts to around 25-30% of total cost in aluminium production, including capital recovery. As a result of this, energy prices, like other inputs, move with the expected long term change in aluminium price. This is, according to common practice, reflected in contracts between energy suppliers and aluminium smelters. In this report, energy price is expected to fall by 1% annually on average, which is at the lower limit of the expected long term change in aluminium price.


Expected return on debt and equity

Risk

To find a realistic discount factor, or expected return, one must look at comparable projects that are financed with securities traded on an open market. In the case of Landsvirkjun comparison with utilities may seem the relevant one. However, the Karahnukar project is different in that it is specifically built to supply the Reydaral smelter with energy, so its success depends on the solvency and continuing operations of one buyer, as opposed to many buyers in different industries, as is generally the case with utilities.

The total annual energy sales of Landsvirkjun amounts to around 7000 gwh/years at present. The Karahnjukar project would in total add around 5000 gwh/year to this figure, coming to around 40% of the total energy sales. Thus, whether the project is regarded by itself, or in the context of Landsvirkjun as a company, it is clear that the dependence on the Reydaral aluminium smelter will strongly affect its success. This means that the Karahnjukar project will bear a very similar risk to the Reydaral aluminium project. Should the smelter be discontinued at any point in time, there would be no market for the energy from the Karahnjukar project. Still, it would not be impossible to find a new buyer, but it is highly probable that this would take considerable time and there is no guarantee regarding the price paid by a new buyer. Based on this high dependence, expected return on debt and equity should be based on expected return in aluminium production to a large extent. Here, the risk is based on utilities to a third and on aluminium producers to 2/3.

Expected return

Return on equity in aluminium production is found by comparing average risk in the industry with market risk and the risk free rate of interest, using the formula rE=rF + (▀E (rM-rF))where ▀E is the beta of equity, or risk factor, Rf is the risk free rate, rE is return on equity and rM is market risk based on a 5 year average return of the S&P 500 index. Based on this calculation for traded aluminium producers we come to an expected return on equity of 10-14%. For utilities the same figure is between 7 and 8,5%. This comes to a real return of 6,43-9,53% based on 2,4% average inflation in the USA for the last 5 years.

The expected debt/equity ratio of the Karahnjukar project is not known, but based on comparable companies the debt ratio is expected to be within 70% and 90% of total investment. Return on debt is found by estimating the average required return on long term debt for utilities and aluminium producers respectively. In real terms, the expected return on debt for the Karahnjukar project will be between 4,07 and 4,67%.

It should be noted that the above figures are based on large traded utilities and aluminium producers. There are, however, considerable economies of scale in aluminium production, but it is unlikely that the Reydaral project will enjoy any such advantages. It is therefore very likely that investors and lenders will require a considerably higher return Reydaral than they require from companies such as Alcan or Alcoa. Obviously this will translate directly into a higher return for the Karahnjukar project.

Note regarding government secured borrowing

Based on recent discussions the government of Iceland may be considering to secure borrowed capital for the Karahnjukar project. This would bring down expected return on debt, but due to the sheer size of the project this would undoubtedly adversely affect the ratings of Iceland as a borrower, since the investment in the project is about the same as the total book value of the country┤s foreign debt. Instead of using government secured interest rates and then estimating the effect from government secured loans this reports considers the Karahnjukar project as an independent project for the sake of simplicity.

The Net Present Value of the Karahnjukar Project

The NPV of the project has been estimated based on three different scenarios, where the variables are energy price and expected return on investment. The investment horizon is 60 years, gross investment 107 billion isk and cost of operations and maintenance 1,250 million isk/year. Energy price is expected to fall by 1% in nominal terms annually.

Pessimistic estimate

60 year investment horizon

First phase

Second phase

Total

Return on debt

4,67%

4,67%

4,67%

Return on equity

9,96%

9,96%

9,96%

WACC

6,26%

6,26%

6,26%

Investment

-74,90

-32,10

-107,00

Present value of investment

-67,45

-19,21

-86,66

Present value of net revenues

34,86

1,72

36,58

Net present value

-32,59

-17,49

-50,08

NPV as percentage of investment

-48%

-91%

-58%

The pessimistic estimate uses a weighted average cost of capital of 6.26% based on a 30% equity ratio. This gives a present value of future revenues of 36.58 billion isk. net of maintenance. The present value of investment is -86.66 billion isk. bringing the net present value to -50.08 billion isk. based on a 60 year investment horizon.

Optimistic estimate

60 year investment horizon

First phase

Second phase

Total

Return on debt

4,07%

4,07%

4,07%

Return on equity

6,87%

6,87%

6,87%

WACC

4,35%

4,35%

4,35%

Investment

-74,90

-32,10

-107,00

Present value of investment

-69,55

-22,38

-91,93

Present value of net revenues

64,72

5,42

70,14

Net present value

-4,83

-16,96

-21,79

NPV as percentage of investment

-7%

-76%

-24%

According to an optimistic estimate the net present value of net revenue is 70.14 billion isk. Present value of investment is -91.93 billion. The net present value of the project is thus -21.79 billion isk. This is based on 10% equity ratio and 4,35% real rate of return. Expected energy price at the start of the project is 2 isk/kwh and the investment horizon is 60 years.

Realistic estimate

60 year investment horizon

First phase

Second phase

Total

Return on debt

4,37%

4,37%

4,37%

Return on equity

8,42%

8,42%

8,42%

WACC

5,18%

5,18%

5,18%

Investment

-74,90

-32,10

-107,00

Present value of investment

-68,62

-20,93

-89,55

Present value of net revenues

48,78

3,32

52,10

Net present value

-19,84

-17,61

-37,45

NPV as percentage of investment

-29%

-84%

-42%

The pessimistic and optimistic estimates use on one hand the highest and on the other the lowest possible return on debt and equity. A realistic scenario uses the average expected return, 8.42% on equity and 4.37% on debt. This gives a weighted average cost of capital of 5.18% in real terms based on 20% equity ratio. Energy price is 1,75 isk/kwh. This brings the net present value of the project to -37.45 billion isk, or around -400 million USD.

Conclusion

Most likely, expected loss from the project would amount to a negative NPV of around 37 billion isk, which is about 34% of Iceland┤s government debt and 6% of the country┤s GDP last year. Looking at the Landvirkjun monopoly this amounts to 3.2 times the gross annual revenue of the company.

In particular the second phase of the project would produce a huge loss, or 84% of investment, as opposed to 29% of investment for the first phase according to a realistic estimate. In order for the project to yield an NPV of 0 the energy price would have to be 2,70 isk/kwh which is far above the expected price of 1,5-2 isk/kwh.

Solving for the WACC bringing NPV to 0 gives 2.34% if energy price is 2 isk/kwh, 1.12% if energy price is 1.75 isk/kwh and -0.33 for the price of 1.5 isk/kwh.

This analysis is based on current energy prices, range of possible return on debt and equity and expected evolution of aluminium price. Any additional risks are omitted, such as the probability of higher construction costs due to the high complexity of the power plant and the likelyhood of above average risk for the Reydaral project. Still, the most optimistic estimate indicates a negative NPV of at least 22 billion isk., or $220 million. The conclusion is that the Karahnjukar power project is a highly unfeasible investment for Landsvirkjun as the investment could not be recovered based on the expected energy price.


(Some graphics have been omitted!)