Synopsis

Global climate change has become a major concern for our communities. This has led the
government and regulatory agencies to introduce various regulatory schemes to address the
current climate change situation. This paper "Stochastic internal rate of return on
investments in sustainable assets generating carbon credits" consider an investment
decision involving a sustainable, energy efficient, greenhouse gases (GHG) reducing asset
through calculating IRR for the unpredictable future scenario. It incorporates the value of
carbon emission allowances for investing company. It is unavoidable for the managers to
consider the volatility that carbon emission credits and energy conversation bring in the
cash flows with the increasing significance and global solidarity towards environment
conservation. Energy efficient investments such as use of renewable energy production,
alternative of fuels helps in addressing the greenhouse effect.

One of the most popular capital budgeting decision tool used by managers is Internal Rate of
Return (IRR) analysis. The paper aims to address uncertainties in the trading markets for
carbon emission permits and to portray various cash flows for a discounted cash flow
approach using a Bayesian approach. The paper addresses the IRR for the energy efficient
investment using the Bayesian framework. The advantage of the Bayesian model is that it
uses the historical data to predict the future outcomes of an event. The paper talks about
the impact on IRR due to the volatility of carbon credit cash flows. So, all cash flows, except
the carbon credit cash flows, are kept deterministic. However, the model is versatile enough
to take any cash flow variables as a stochastic variable. The throughput of Bayes formula in
expressed in the posterior distribution, where hyperparameter defines the prior parameters
of the model. But, there are limitations to the posterior distribution i.e. the distribution
cannot be expressed as a closed form such as function. So, the posterior distribution cannot
be used to make inferential and predictive statements about the IRR of the project. But, by
applying Gibbs sampler technique it is possible to develop information about marginal
posterior distribution without obtaining the joint posterior probability density functions. The
Gibbs sampler is designed to obtain the additional information about IRR when the carbon
credit cash flows fluctuate due to uncertainty and volatility and can generate observations
that have a steady-state, where successive values of a random variable depends upon its
immediate prior value.

The article presents the example of hypothetical manufacturing company that is willing to
invest in sustainable and energy efficient manufacturing systems. The company wants to
derive the economic benefits from investment in energy efficiency measures such as
benefits from reduction of electrical power and generation of carbon credit allowances from
the reduced emission of greenhouse gases which can be sold in market or use internally to
cover deficiencies in other division.

The example is based on first assumption of initial investment of $40 million. $5 million is
the incremental cost associated with the project which constitutes of 12% of initial
investment is considered based on the assumption that more efficient equipment holds
additional cost between 10% and 20%. The authors estimated that the manufacturing unit
will consume 20 million Kilowatt hours(kWh) of energy. The use of energy efficient
equipment will help in annual savings of 30% of the total energy consumption per year
equivalent to $600,000. In addition, the article has put a saving escalator of 2% per year and
maintenance cost escalator of 1% per year. It is estimated that 1 kWh of electrical energy
production and transmission results in 0.4939 kg of CO2 equivalent GHG emitted. So, the
annual energy savings of 6million Kilowatt x 0.4939kg gives 2,963,400 kg of CO 2 (carbon
credits). These credits can be sold at $10 per kg with annual increment of 10% which yields
cash flow of $29,634 in the first year, $32,597 in second year and so on over 10-year
investment period.
The randomness in cash flow is measured using four different analytical distributions namely
normal, logistic, double and students t to study the impact of uncertainty and volatility of
carbon prices. Kurtosis, a measure of how much probability is outside the distributions
shoulders, is used to measure the dispersal of uncertainty within a probability distribution
function and its value lies between zero to infinity. Excess kurtosis which has a value range
for all distribution between -2 to infinity is used for all four distribution models. The volatility
of the model is checked with the help of standard deviation. The standard deviation
measures the fluctuations in the price of the carbon credit price over the assigned
distribution. According to the traditional capital budgeting process, the IRR (Base Case) of
the example used in the article is 11.04%. The model first considered the impact of Kurtosis
of a distribution on IRR and found out that the higher the value of kurtosis the higher the
IRR. This interesting result shows that the higher the risk associated with a project the higher
the rewards or IRR. Secondly, the model increased the standard deviation (20% - 100%) for
each of the analytical distribution. And, the results show that the increase in standard
deviation adversely impacts the value of IRR i.e. the higher standard deviation value the
lower will be the IRR value. This clearly states that the high volatility in future cash flows will
result in lower IRR.

This leads us to the conclusion that carbon credit cash flow uncertainties have a positive
impact on IRR when compared to volatility. The analysis of IRR model for the energy efficient
manufacturing systems indicates that IRR generated from conventional deterministic
method might consistently overestimate investments value of the company. Company
management can utilize the information to reduce the uncertainties in investments as IRR
method can provide additional ideas in decision making. The model concept developed in
this paper can be utilized to study renewable energy investments, behavioral programs such
as telecommuting and carpooling. Also, this model can be applied on capital budgeting
framework where Bayesian framework is used. Thus, the paper presents a very relevant and
practical solution to the problem of effectively integrating the variations in cash flows from
energy efficient equipment that occurs from the energy saving and carbon credit
allowances.