Background on the Cost of Generation and the Chabot Profitability Index Method

By Paul Gipe

Renewable Tariffs in Germany, France, and Spain are derived from the cost of generation plus a “reasonable profit”.

This is quite similar to the concept of “cost recovery” that had been used in utility rate regulation in North American for many years. Regulatory commissions determine the costs of generation from a technology or a particular power plant and then determine what is the revenue required to earn a profit based on these costs.

Regulatory commissions also determine what the acceptable or “reasonable” rate of return that is permitted to a utility based on the cost of capital.

Using the cost recovery model, it is logically consistent to award different tariffs for different technologies just as it is to award different revenue streams to different power plants. This leads to “tariff differentiation by technology”.

Further, it is also logically consistent to award different tariffs for different resource intensities notably in the case of wind energy where the cost of generation is markedly determined by slight differences in wind speed. This leads to tariff differentiation by resource intensity or productivity. Thus, the concept of cost recovery enables higher prices for wind energy in areas of lower, less-energetic winds to provide equal opportunity for all, and lower prices in areas of higher, more-energetic winds to guard against excessive or unwarranted profits.

Chabot Profitability Index Method

ADEME’s Bernard Chabot uses a variation of the formula for the cost of energy. In the Chabot Method he uses an additional parameter called the Profitability Index. The Profitability Index is the Net Present Value of the Cash Flows divided by the Present Value of the total Installed Cost.

Economics textbooks discuss how and when to best use the Profitability Index and when to use it in preference to Rate of Return. This is an important subtlety that is lost on most business applications of the Internal Rate of Return (IRR). Below are two citations for the Profitability Index.

Profitability Index: Project Economics and Decision Analysis By M. A. Mian

Profitability Index: Wikipedia Note that this explanation is not equivalent to that used by everyone else.

In the Chabot system of sliding tariffs for wind energy, the Profitability Index is used to increase or decrease the margin of profit. That is, there is a fixed or desired Rate of Return derived from the Average Weighted Cost of Capitol based on a targeted medium wind site. The Profitability Index is varied to increase the margins on windy sites to a targeted upper limit while decreasing those on less windy sites. This system encourages economic efficiency by more greatly rewarding those at windy sites than those at less windy sites. That is, those at windy sites will make proportionally more money than those at less windy sites. Above the targeted upper limit, the margin or Profitability Index is capped to prevent unfair or “excessive” profits. These are profits above and beyond what is necessary for rapid development of new wind generation.

Below is an example of the application of the Chabot Profitability Index Method to the pricing of wind generation at various resource intensities. The units of merit are the annual specific yield in kWh/m²/year.