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Beuth University of Applied Sciences Berlin

MBA Renewables

WRITTEN ASSIGNMENT

INVESTMENT AND FINANCING

Case study: Geothermal energy project inHungary

Lecturer: Prof. Dr. Andreas Taschner

Student: Mario Maras, Dipl. Ing.

Berlin, 21st July 2013

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Table of contents

Task 1. Characteristics of the project and general characteristics of similar projectsand risks......................................................................................................................3

Task 2. Verification of the statement that 2MWn power plant will be repaid in 13

years............................................................................................................................5

Task 3. Sensitivity Analysis.........................................................................................6

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Task 1. Characteristics of the project and general characteristics of similarprojects and risks

Geothermal energy project take around seven years until the actual operation of theinstallation. This number can be decreased or increased by one to two years depending onpermitting and licensing issues. Generally, geothermal projects can be divided in fivephases. Each phase requires different equity and financing solutions with very different riskprofiles at each stage in the development process.

In the Exploration Phase, geophysical surveys and collected geochemical and geologicaldata are being analyzed and temperature gradient drilling provides and overview of wherethe geothermal potential lies for further development. The risk is high and only developmentequity can provide necessary financing, mostly though own financing provided by thedeveloper or outside seed capital. In Pre-Feasibility Phase, a focused exploration on mostfavourable resource areas is being conducted with sufficient exploration data being collectedand analyzed. At this stage, the risk is still relatively high and financing can only be providedthrough development equity. but venture capital and early stage private equity can also helpdriving the project further. Still it is difficult to raise necessary financing and only equity canbe of help at this point in time of a project.Each of mentioned phases take about one year.In the Feasibility Phase, which normally takes around 2 years, the first full-sized productionwell and additional confirmation wells are being drilled. The successful drilling here proofsthe resource and significantly reduces the risk for project. It also allows the preliminarydesign of the planned plant.Detailed Design & Construction Phase takes round 2-3 years when the remaining productionand re-injection wells are being drilled and tested, necessary civil works are being finishedand the final design and testing of the plant can processed. At this stage strategic partners,e.g. suppliers and/or utilities can come into the picture providing further equity into theproject.After these seven years, plant can be operated and maintained.

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Task 1. Characteristics of the project and general characteristics of similarprojects and risks

Geothermal energy project take around seven years until the actual operation of theinstallation. This number can be decreased or increased by one to two years depending onpermitting and licensing issues. Generally, geothermal projects can be divided in fivephases. Each phase requires different equity and financing solutions with very different riskprofiles at each stage in the development process.

In the Exploration Phase, geophysical surveys and collected geochemical and geologicaldata are being analyzed and temperature gradient drilling provides and overview of wherethe geothermal potential lies for further development. The risk is high and only developmentequity can provide necessary financing, mostly though own financing provided by thedeveloper or outside seed capital. In Pre-Feasibility Phase, a focused exploration on mostfavourable resource areas is being conducted with sufficient exploration data being collectedand analyzed. At this stage, the risk is still relatively high and financing can only be providedthrough development equity. but venture capital and early stage private equity can also helpdriving the project further. Still it is difficult to raise necessary financing and only equity canbe of help at this point in time of a project.Each of mentioned phases take about one year.In the Feasibility Phase, which normally takes around 2 years, the first full-sized productionwell and additional confirmation wells are being drilled. The successful drilling here proofsthe resource and significantly reduces the risk for project. It also allows the preliminarydesign of the planned plant.Detailed Design & Construction Phase takes round 2-3 years when the remaining productionand re-injection wells are being drilled and tested, necessary civil works are being finishedand the final design and testing of the plant can processed. At this stage strategic partners,e.g. suppliers and/or utilities can come into the picture providing further equity into theproject.After these seven years, plant can be operated and maintained.

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Task 1. Characteristics of the project and general characteristics of similarprojects and risks

Geothermal energy project take around seven years until the actual operation of theinstallation. This number can be decreased or increased by one to two years depending onpermitting and licensing issues. Generally, geothermal projects can be divided in fivephases. Each phase requires different equity and financing solutions with very different riskprofiles at each stage in the development process.

In the Exploration Phase, geophysical surveys and collected geochemical and geologicaldata are being analyzed and temperature gradient drilling provides and overview of wherethe geothermal potential lies for further development. The risk is high and only developmentequity can provide necessary financing, mostly though own financing provided by thedeveloper or outside seed capital. In Pre-Feasibility Phase, a focused exploration on mostfavourable resource areas is being conducted with sufficient exploration data being collectedand analyzed. At this stage, the risk is still relatively high and financing can only be providedthrough development equity. but venture capital and early stage private equity can also helpdriving the project further. Still it is difficult to raise necessary financing and only equity canbe of help at this point in time of a project.Each of mentioned phases take about one year.In the Feasibility Phase, which normally takes around 2 years, the first full-sized productionwell and additional confirmation wells are being drilled. The successful drilling here proofsthe resource and significantly reduces the risk for project. It also allows the preliminarydesign of the planned plant.Detailed Design & Construction Phase takes round 2-3 years when the remaining productionand re-injection wells are being drilled and tested, necessary civil works are being finishedand the final design and testing of the plant can processed. At this stage strategic partners,e.g. suppliers and/or utilities can come into the picture providing further equity into theproject.After these seven years, plant can be operated and maintained.

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Geothermal project power plant as described in UNEP article states the background of thecompany MOL, potentials for building geothermal projects in Hungary, historical andgeological aspects, MOL´s geothermal exploration activities, technical background of thefuture project and capital costs and electricity prices. When working on details in of theproposed project, it easy to see that pilot project is still in the second or pre-feasibility phasewhich is in the best scenario in the second of seven years of development of the project. Thearea is being analysed, technical aspects were proposed by their own research and by theresearch of United States Trade and Development Agency. UNEP´s article was published inDecember 2006. According to the article Geothermal Power Generation in the World 2005-2010 Update Report, written by Ruggero Bertani, in Hungary in 2010 there were 0 MWinstalled electrical capacity and 0 MWh electricity produced in Hungary. It is also stated thatMOL has drilled several wells in Ortahaza in West Hungary and that some of them can beused for geothermal energy production. According to this article, till 2010 MOL has reachedthe forth, or drilling phase. At the end of this phase, in the best case scenario it would hadtaken four years, but at the end of 2010 it would had been the sixth year of development ofthe project meaning that development was slower for two years in 2010. As this is the firstproject in Hungary which should produce electrical energy, further risks can emerge -weather MOL has necessary know-how for building first geothermal energy power plant inHungary?Risks can generally be classified in two categories: a) endogenous - risks that can becontrolled or influenced by project parties, and b) exogenous - risks that are beyond thecontrol of individual project parties. Generally, this project can be infected by all endogenousrisks like credit risk, market risk, construction and installation risk, performance (oroperational) risk and structural or contract risk when looking at all phases of projectdevelopment. At this current state, when the project is still in drilling phase the main risksthat can influence project would be credit risk, construction and installation risk and structuralor contract risk. Up to this level, project only consumes large amounts of money, therefore itis a question if MOL can service its investments in this phase of a project. Second risk -construction and installation risk referring mainly to construction of building, i.e. will wholeinfrastructure development follow deadlines, will be used only state-of-the art materials,components etc.. Third risk - contract risk tells if all contracts are that are signed, are suitedand/or proper to this project - will there be enough money to finish constructions, willeveryone be paid on time, will the plant be operational on time, will there be grid connectionand utility company that will buy produced electricity etc.Risk management is a term used when parties wish to properly address all possible risk.Therefore, instruments to deal with market, construction, performance, resource andtechnological risk are introduced. Many possibilities are introduced and some can be betterthan the other. Concerning market risks, the best possibility to satisfy all parties would be"Take-and-pay" contract meaning that the purchaser of electrical energy is obliged to pay theenergy that was consumed, or in our case, utility company will buy all electricity that wasproduced, no more, no less. Concerning construction risks, instrument "Selection of acompetent and a reputable party" is essential as geothermal power plants need state of theart technology which is expensive, therefore the care who will construct the plant is veryimportant. For the project owner, instrument "delay-in-start-up insurances" could be veryuseful as there are insurance companies which take care if completion date is met and if not,they compensate losses to the project owner. Turnkey construction contracts is very usefulinstrument for project owner and project sponsor as these contracts oblige the constructor toconstruct proper plant which will operate on agreed deadline, and potential losses aremoved to hands of constructor. If there are problems with performance of the power plant,like insufficient input of raw materials (in our case geothermal hot water), or technical

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problems with the plant, hiring qualified and experience team for management and operationof the plant would be useful. As MOL is just starting with this business, this option could berather beneficial. Resource risk concerns with constant supply of raw materials, i.e. hotwater. If analysis of the amount of hot water were conducted well prior to building powerplant, there shouldn´t be issues here. Concerning technological risks, it is best to use proventechnology only to be sure that plant will be operational as planned. Again, as this is the firstMOL´s project, it would be useful to hire third party to help with managing all phases of theproject cycle in order to gather all necessary know-how.

Task 2. Verification of the statement that 2MWn power plant will be repaid in 13years.

1) If power plant with electrical capacity 2MWn with capacity factor of 95% is used, then itcan produce amount of electricity per year (in kWh): Electricity = electrical capacity *capacity factor * number of hours per year = 2000 kW * 0,95 * 8760 h = 16.644 kWh. If theexpenses per kWh are USD $0,015/kWh and if electricity can be sold for USD $0,089/kWh,then total amount of money that can be earned per year (before taxes and other expenses)is Electricity produced per year * (electricity price, sold - electricity price, produced) = 16.644kWh * ( $0,089/kWh - $0,015/kWh) = USD $1.231.656. Out of this figure, total cash inflowwould be 16.644kWh * $0,089/kWh = USD $1.481.316, and total cash outflow would be16.644kWh * $0,015/kWh = USD $249.660. If power plant can generate USD $1.231.656each year, and if total investment costs were USD $16.000.000, then amount of time that isneeded to repay initial investment would be USD $16.000.000 / USD $1.231.656 = 12,99years or about 13 years meaning that statement from the MOL is true. If we assume that thisgeothermal power plant will be operational as planned and that there will be no problemswith input energy, i.e. hot water from geothermal wells throughout the whole year(s), nodebts, i.e. interest rate on debt capital then we can calculate future cash flow in the paybackperiod and see that the statement given by the MOL is true. This method that can be used isalso called Simple Payback Period and makes sense only if there are no interest ratesinvolved.

2) As stated in the article: "Geothermal power plant investment study case: Indonesia"written by Faudi Arif Nasution, typical market interest rates for geothermal power plantprojects are between 9% and 12%." I will assume that MOL negotiators are very good andnegotiated interest rate of 9%.Net Present Value in one period is present value of cash inflows in that period and thepresent value of cash outflows in that period, meaning that cash inflows and cash outflowsneed to be divided by interest. NPV for whole period is sum of NPVs for each year. Whenworking through NPV it is obvious that it is impossible to repay the initial investment in 13years as stated in the article if we assume that some of the initial capital will be debtinvestment.

3) When working through LCOE for this project, the value is around USD $0,024/kWh.According to U.S. Energy Information Administration, Total levelized system cost forgeothermal power plants in 2013 is USD $89,6/MWh = USD $0,896/kWh. This figure thatcan be calculated from excell seems very low, i.e. seems very cheap. If the figures given inthe article are true than this would be a good investment. But, when we look the statement

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that the whole project investment will be repaid in 13 years and how the real truth is veryeasy to prove, the whole investment information, i.e. numbers given should be checked oncemore. Concerning LCOE sensitivity to interest ratio, when looking at the formula it can bevery easy to see that LCOE is more sensitive to energy produced and total costs that occurduring the year than to the interest rate. For the sake of checking this formula and mystatement, in the excell sheet can be found calculation for interest rate of 6% and thecalculated LCOE is USD $0,022, so there is no such difference. Overall, I would recommendrechecking the figures given in the case study and redo all the calculations and if thenumbers show to be true, then I would recommend this investment.

Task 3. Sensitivity Analysis

Alternative 1) shows AVDSCR over 1 and DSCR in just first two years below 1, and for eachother year over 1. Alternative 2) shows AVDCR below 1 and DSCR over 1 as of year 8. Thisfinancial ratio shows whether operating cash flow can service debt in certain period of timeor not. From this perspective it is obvious that alternative 1) is better for the investor and forthe project owner as he will start generating cash surplus and more profit much earlier thanwith alternative 2). LLCR for example shows whether the project owner can generateenough cash surpluses for servicing the debt. Alternative 1) shows LLCR over 1 andalternative 2) shows below 1 meaning that also from this point of view, alternative 1) isfinancially more attractive for both, project owner and the investor. From the point of view ofproject owner, ratios that are attractive to him are Net Present Value and Internal Rate ofReturn.