Replacing Discount Rate Driven NPV with IRR Analysis
David Magnus Boonin is president and founder of TBG Consulting. He served as a member of the Philadelphia Gas Commission, chief economist of the Pennsylvania PUC and a principal at the NRRI. Recently he has focused on issues such as rate design, resource planning, cost management, and climate change.
Warning! Standard net present value (NPV) analysis that relies on selected discount rates used to guide typical public utility integrated resource planning (IRP) analysis or policy assessment is likely flawed and biased and has been for decades. This standard NPV provides decisionmakers with inferior information; a deficiency that can be abated with honed analytics.
Utilities and their regulators have different goals and constraints than other businesses. Utilities have an obligation to serve and have profits constrained by revenue requirements and return on equity established by their regulators. Regulators typically look to minimize the revenue requirement stream in the short and/or long-term, possibly including the internalization of certain externalities, rather than profit maximization metrics used in most other industries.
NPV analysis relies on the selected discount rate. The selected discount rate can affect the outcome of the analysis. Thus, the introduction of a new metric; the differential internal rate of return (DIRR), and its expected value are discussed below.