Minimum Sustainable Price
Understanding Sustainable Business Practices in Clean Energy Technology
May 12, 2016
Kelsey Horowitz, National Renewable Energy Laboratory
Tonio Buonassisi, Massachusetts Institute of Technology
Mike Woodhouse, National Renewable Energy Laboratory
Ran Fu, National Renewable Energy Laboratory
Market prices fluctuate. The ebbs and flows of supply and demand can be understood just by looking at how gas prices change at the pump. For some clean energy technologies, such as solar photovoltaics (PV), price fluctuations have at times spelled the end of companies and spawned the skepticism of investors. The recent plunge in PV module prices has also, however, helped make this renewable form of energy competitive in many scenarios—something that many were skeptical was possible a decade ago. But just as the story of gasoline prices defies simple supply-and-demand explanations because of subsidies, technology, business strategy, and a host of other factors, so does the story of clean energy manufacturing.
Predicting the future is a messy business; projections are almost always wrong. Instead of using projections as a precise crystal ball, researchers understand that modeling a range of scenarios of what could happen in the future if different actions are taken today can help make better, more informed decisions.
A key question about the future for any industry is: how sustainable is a given endeavor? When the industry both produces electricity and aids in the mitigation of climate change, this question is of keen interest not only to the industry, but also to policymakers and citizens around the globe.
There are many ways to look at the sustainability of a given industry or a business practice. One rather simple question to ask is, are most companies (or at least a handful of large, viable companies) making enough money to cover their costs? We can formalize this question using a construct called a minimum sustainable price (MSP). This term has been used in publications by the National Renewable Energy Laboratory (NREL) and the Massachusetts Institute of Technology (MIT), but the concept is basic and commonly calculated in business finance. The MSP is equal to the minimum price a company would have to charge for a good or service in order to cover all variable and fixed costs and make enough extra money to pay back investors at their minimum required rates of return, but no more. A company may be able to get away with selling at lower prices and providing lower returns (or negative returns) in the short term, but this cannot continue indefinitely. Eventually, investors will need to be repaid, or financing will dry up and business units will be shut down for being unprofitable. Practically, the MSP is computed by setting the net present value of an investment (for example, a manufacturing plant) equal to zero with the internal rate of return equal to the weighted average cost of capital (WACC). We use a discounted cash flow methodology consistent with standard finance and accounting practices for these calculations.
The concept of MSP has been subject to significant debate since its introduction. Part of this is confusion over the term “minimum sustainable price,” which is often misinterpreted as the minimum price a company could charge in the market. Of course, this is something very different, and market prices below the MSP can and are often observed because market prices are set by a multitude of factors and fluctuate over time. For example, a company can sell at a price below the MSP in the short term to undercut competitors and gain market share. If a manufacturer’s selling price is below MSP but above variable cost, the business unit can be marginally “cash flow positive.” But selling below MSP risks not having the revenue necessary to finance R&D, cover depreciation expenses, repair and upgrade equipment, and finance further growth. This would be the automotive equivalent of covering the cost of gasoline, but having to choose between preventative maintenance, repairs, oil changes, insurance payments, loan interest payments, etc. Eventually, if the selling price is too low, and all costs are not covered or investors are not repaid, the company will either need to raise its prices or reduce its costs so that the margin is recovered. Note that the MSP is lower if consistent subsidies are available from different government entities. Our publications to date typically do not include subsidies in the MSP, partly because of the often uncertain nature of government support for clean energy technologies. However, the MSP can be calculated with and without subsidies, or indeed with or without a range of other incentives, and these calculations can be used to understand the role of governments and policies in different industries.
Many other questions about the MSP focus on the legitimate question of the cost of capital. There are several issues surrounding the cost of capital—people are willing to give money to different companies and different business endeavors at different rates, and a wide variety of financing schemes, many of them sustainable, can be employed. This uncertainty is dealt with in our models by computing an average WACC for an industry based on data from financial statements of publically traded companies, computing a different cost of capital for different countries using standard financial practices, updating these estimates regularly, and providing error bars around our MSP estimates. However, private companies may have different financing schemes, and in some cases—CIGS solar technology for example—a private firm produces the vast majority of modules. Today, we don’t have a good way to deal with this issue outside of sensitivity analysis, but this can still be useful. We can see, for example, if the story of the competitiveness of a product in the market or the long-term sustainability of a business changes if the cost of capital varied within a wide range of expected values. We can then look at different possible ways of securing sustainable financing for new clean energy projects or understand if certain financing schemes that may fuel growth could be unsustainable in the long-term (e.g., a heavy debt burden).
This bring us to the last major point of confusion we’ve heard about MSP—before we reach this “long-term” state, can’t and won’t companies reduce their costs (either cost of goods sold or financial costs) so that the MSP will be lowered, and thus the MSP is an ever elusive concept? After all, the march of technology and human ingenuity has gotten us this far. While indeed we expect learning and innovation to continue and drive down costs, this is not something that simply occurs on its own; instead, it is the result of a massive amount of investment in R&D, manufacturing, and management efforts. The MSP is a very useful tool for understanding just how much costs need to come down to be competitive in different markets and provide for a margin sufficient to cover the investments in R&D and plant expansions required to drive these reductions. Instead of predicting future prices, we can use this concept to make the right investments today that will enable a flourishing clean energy economy in the future.
Check out the video below showing how MSP works and why it matters.
We’ve also starting studying some cases where MSP might be critical to industry sustainability, and computing this value for a range of different technologies. Check out these publications that talk more about the MSP:
Chung, Donald, Emma Elgqvist, and Shriram Santhanagopalan. 2015. Automotive Lithium-ion Battery Supply Chain and U.S. Competitiveness Considerations. PR-6A50-63354. Golden, CO: National Renewable Energy Laboratory.
Clean Energy Manufacturing Analysis Center. 2016. CEMAC Research Highlights. NREL/BR-6A50-65312. ORNL/SR-2016/98.
Goodrich, Alan C., Douglas M. Powell, Ted L. James, Michael Woodhouse, and Tonio Buonassisi. 2013. "Assessing the drivers of regional trends in solar photovoltaic manufacturing." Energy and Environmental Science 6:2811–2821.
Needleman, David Berney, Jeremy R. Poindexter, Rachel C. Kurchin, Ian Marius Peters, Gregory Wilson, and Tonio Buonassisi. 2016. "Economically Sustainable Scaling of Photovoltaics to Meet Climate Targets." Energy and Environmental Science, accepted.
Powell, Douglas M., Mark T. Winkler, Alan Goodrich, and Tonio Buonassisi. 2013. "Modeling the Cost and Minimum Sustainable Price of Crystalline Silicon Photovoltaic Manufacturing in the United States." IEEE Journal of Photovoltaics 3(2):662–668.
Powell, Douglass, M., Ran Fu, Kelsey Horowitz, Paul A. Basore, Michael Woodhouse, and Tonio Buonassisi. 2015. "The capital intensity of photovoltaics manufacturing: barrier to scale and opportunity for innovation." Energy and Environmental Science 8:3395–3408.