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 midyear 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 midyear 2006, with a capacity of 240280,000
ton/year. No decision has been made regarding an addition, bringing the total capacity to 360420,000 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 1,52 isk/kwh. Aluminium price has fallen by 1,5% annually over the last 12 years. It is expected to continue
falling by 11,5% annually, due to expected increase in supply. Energy amounts to around 2530% 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 + (ßE (rMrF))where ßE 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 1014%. For utilities the same
figure is between 7 and 8,5%. This comes to a real return of 6,439,53% 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.
