Investigating possible bias issues arising from improper use of the internal rate of return when used for decision-making on renewable energy technology investments

Ms Tanja Groth, Aarhus University/Stirling.DK ApS

The internal rate of return (IRR) is, together with net present value (NPV), the most commonly used investment decision tool for management (Ryan and Ryan, 2002). Presented as a simple percentage, it is an easily grasped concept which readily lends itself to instant investment comparisons.

The IRR is often used in conjunction with net present value (NPV) calculations to estimate the benefit of a given investment decision. Simply put, the IRR is the rate at which the benefits from an investment are equal to the investment itself.  However, using the IRR calculation indiscriminately can result in errors, particularly when disregarding the implicit reinvestment assumption, ranking of mutually exclusive projects and the potential for multiple IRRs.

These errors can lead to bias in the investment decision, particularly when applied to energy investment decisions where mutually exclusive projects with different investment costs and different lifetimes are compared. Almost all renewable energy technologies (RETs) share the characteristics of initial high capital costs followed by a stream of relatively low variable costs over the lifetime of the investment, contrary to fossil fuel technologies (FFTs), which are generally characterized by initial low capital costs with relatively higher lifetime variable costs (partially due to the use of high-cost fuels).

This paper will explore the potential for bias in the investment decision for a high-capital cost RET against a low-capital cost FFT. Particularly, the overstatement of benefits suggested by high IRRs in the FFT scenarios is illustrated using the modified internal rate of return (MIRR). The return to investment for a RET case study and an FFT case study are compared using NPV, IRR, MIRR and incremental IRR (IIRR).

This paper contributes to the existing literature by arguing the existence of an implicit barrier to investments in RETs caused by the misuse of IRR in investment decisions. This is illustrated using  a case study of a high-cost RET relative to a low-cost FFT. Investors in particular should be made aware of the dangers in using IRR when facing RET investment decisions.