Economic Scenario Analysis Memo to David

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Economic Scenario Analysis Memo to David Powered By Docstoc
 To:          David Young, Acting Associate Superintendent
 From:        Patty Richards
 Date:        November 30, 2006
 Re:          Economic Scenario Analysis – Wood Chip Boiler South
              Burlington High School and Middle School


 Attached please find an economic scenario analysis of the Life Cycle Cost for the
 South Burlington School District’s Central Wood Chip Boiler project (proposed to
 heat the High School and Middle School). In an effort to consider a number of future
 cost factors, including varying fuel cost, the attached analysis starts from the work
 done by the Vermont Superintendent’s Association, School Energy Management
 Program and Salem Engineering Inc. The initial life cycle screening indicates the
 project is eligible for the State’s funding consideration. Attached is supporting
 analysis from the School Energy Management Program and Salem Engineering.
 Supplementing this work are 18 economic scenarios to provide case sensitivity to the
 analysis. The results are summarized below


 Due to rising costs and the South Burlington School District’s desire to control and
 contain heating costs, a wood chip heating system is being explored. As you can
 see from the chart below, South Burlington’s natural gas heating costs have risen
 substantially over the past 6 years. During this same time frame natural gas
 volumes used by the SBSD have remained relatively flat.

 In just 5 years natural gas has increased by 139% or almost 30% each year. While
 FY2007 costs are projected to be equivalent to FY2006 expenses, considerable
 price volatility and uncertainty of future expenses remain. The root cause of higher
 natural gas expenses is due to increased wholesale market cost, price volatility and
 the higher cost for all forms of fossil fuel.

                                             Annual Natural Gas Cost
                                       High School and Middle School Buildings


                         The cost of natural gas has increased by 139%                $141,664   $140,361
          $140,000      between FY2002 and Fy2006 while the volume of
                           natural gas used has remained relatively flat

          $100,000                                               $91,943



                     FY2001        FY2002          FY2003         FY2004    FY2005     FY2006     FY2007

It should be noted the above chart does not consider the extra expense South
Burlington incurs from burning oil during times of natural gas interruption. South
Burlington High School and Middle School are on an interruptible natural gas
contract which means the local gas utility can stop delivering gas during cold spells
or company defined curtailments. In these periods, South Burlington must burn oil,
which has higher costs and emissions than natural gas.

South Burlington is also concerned about price volatility and its inability to hedge
future gas costs due to the nature of the interruptible gas contract. Each year the
District has a one-time election to lock in at the prevailing market price for the
upcoming 12-month period. If the market happens to be high during its time of
election it can be stuck with that price for the entire year. The other alternative is not
to lock the price and then float on the market. Again this level of price volatility and
uncertainty is very risky for a school district, which has a limited annual budget.

Financial uncertainty in the volatile natural gas market, the ability to be turned off
during cold snaps, and rising natural gas prices have led to an exploration of a wood
chip heating system.

Economic Scenario Analysis

Predicting future heating costs with certainty is impossible just as predicting the
future value of the stock market is impossible. With this in mind running a number of
“what if” scenarios was completed to test the cost effectiveness of a wood chip
heating system under a number of price point conditions.

Three natural gas price cases ($11.46/mcf, $9.168/mcf, and $8.022/mcf) were
assumed for both a 90% and 75% state aid reimbursement. The price of $11.46/mcf
is the current blended cost for natural gas for the High School and Middle School.
This price was decreased by 20% ($9.168) and 30% ($8.022) to see how the
economics would play out if the price of natural gas actually declined in the future.

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For each natural gas price case, the future price inflation of fossil fuel and wood chips
was stressed between 5% and 0%. A 5%, 3% and 0% fossil fuel price inflation factor
was used to adjust the future price of natural gas and oil. This allows us to see what
happens in the financial analysis if fossil fuel increases at a rate of 5% each year.
This same effect was then applied at 3% and 0%. Wood chip costs have historically
not risen as much as fossil fuel so future costs of wood chips were inflated by 3%
and 0%.

Scenarios at 90% State Funding (SBSD's Net Capital Cost = $192,000)

                       Based on current cost for gas                   20% discount on current cost for gas       30% discount on current cost for gas
Price of Gas ($/mcf)    $      11.460 $           11.460 $   11.460             9.168         9.168         9.168       8.022        8.022           8.022
Price of Wood                       47                 47         47                47            47           47          47           47               47
Inflation for Gas                5.0%               3.0%       0.0%              5.0%          3.0%         0.0%        5.0%         3.0%             0.0%
Inflation for wood               3.0%               3.0%       0.0%              3.0%          3.0%         0.0%        3.0%         3.0%             0.0%
NPV of Project         $    1,865,049 $      1,047,841 $     672,193 $      1,176,447 $ 519,562 $ 301,700 $ 832,146 $ 255,423 $                   116,454
Years Payback                    3.46             3.67          3.85             5.76      6.74      7.56      8.27     11.60                       15.65
IRR                               34%              29%           26%              22%       17%       13%       17%       11%                          8%

Assuming 90% State Aid all three natural gas price cases resulted in positive Net
Present Value Savings (NPV)1 and cost effective Internal Rate of Returns (IRR)2.
The best savings case assumed today’s gas costs of $11.46/mcf, $47/ton wood
costs, 5% fossil fuel inflation and 3% wood inflation (dollar savings $1,865,049,
payback 3.46 years, and IRR 34%). Even at the middle case of $9.168/mcf natural
gas and 3% inflation applied to both wood and fossil fuel resulted in a positive dollar
savings of $519,562 a 6.74 year payback and 17% IRR.

Assuming 75% State Aid and natural gas price cases of $11.46/mcf and
$9.168/mcf the Project NPV remained positive ranging from $1,577,049 to
$13,700 savings. As you can see as gas prices are assumed to decline the
dollar savings decreases substantially. The last case of $8.022/mcf natural
gas and assuming 3% and 0% fuel inflation resulted in negative dollar
savings (this means it would be cheaper to stay with natural gas in these
scenarios and not invest in the woodchip project).

It is important to note that regardless of your projection of future natural gas
prices it will take the school district 4 years of gas at $11.46/mcf or above to
recover its capital and other costs for the project. If natural gas supplies are
stressed by an active hurricane year or other supply disruption, the price of

 NPV measures a future stream of cash flows in today’s dollars and discounted for the time
value of money. The “NPV of Project” equals future natural gas costs minus total wood chip
project costs (SBSD’s capital cost + wood chip fuel + residual natural gas and oil + O&M +
contingency). A positive “NPV of Project” indicates amount of money saved from wood chip
project. A negative “NPV of Project” indicates amount of money lost as a result of wood chip
 IRR is a method of ranking project proposals using the rate of return for a project. Any
project with an IRR less than the rate of borrowing should be rejected because it means it
costs more to finance the project than the project brings in dollar value.

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gas is projected to be higher than $11.46. This analysis does not factor in
the prospect of natural gas being higher than current prices. If natural gas
prices are higher than $11.46 (before inflation) the savings are more
substantial and the payback is of course shorter.

The other issue to note is that no interest expenses has been factored into
the above tables. The above numbers assume no cost of borrowing money
to fund the project. By assuming SBSD borrows short term by way of a
“State Aid Anticipation Note” and long term from a 20-year bond (see
discussion below for more information on borrowing options) for its capital
portion of the project, the result is a decrease in the NPV savings values. At
90% state aid funding level the NPV is decreased in all cases by $192,997.
Therefore savings drop in the first case from $1,865,049 to $1,672,053.
Each case thereafter the NPV decreases by $192,997. When factoring in
interest expense the cut off based on project NPV is $8.022 gas and 0%

At 75% state aid the NPV dropped by $138,228 in each case by adding in
the cost of borrowing. Therefore the best case dropped from $1,577,049
savings to $1,438,821 savings. When factoring in interest expense the cut
off based on project NPV is at $9.168/mcf gas and 0% inflation.

Scenarios at 75% State Funding (SBSD's Net Capital Cost = $480,000)

                       Based on current cost for gas                   20% discount on current cost for gas       30% discount on current cost for gas
Price of Gas ($/mcf)    $      11.460 $           11.460 $   11.460             9.168         9.168         9.168       8.022        8.022           8.022
Price of Wood                       47                 47         47                47            47           47          47           47               47
Inflation for Gas                5.0%               3.0%       0.0%              5.0%          3.0%         0.0%        5.0%         3.0%             0.0%
Inflation for wood               3.0%               3.0%       0.0%              3.0%          3.0%         0.0%        3.0%         3.0%             0.0%

NPV of Project         $    1,577,049 $       759,841 $      384,193 $        888,447 $ 231,562 $         13,700 $ 544,146 $ (32,577) $          (171,546)
Years Payback                    7.43            8.52           9.75            11.11     14.85            20.32     14.35     23.83                29.31
IRR                               17%             13%            10%              12%        8%               5%        9%        5%                   3%

Borrowing Options

SBSD has two options to fund the capital related needs of the woodchip

Option 1: Ask Voters to Redirect Use of 2005 Bond Proceeds (Admin Bldg
and HS Renovations)

         This option entails incurring no new debt. Rather this would allow
         SBSD to use already existing money that is not currently in use. To do
         so would involve asking voters to reauthorize use of the 2005 bond
         proceeds for the wood chip heating project.

         In 2005 voters approved $2.795 million to build an Administration
         building and to provide renovations at the High School for class and
         cafeteria space. Due to rejection of state aid for the Administration

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     Building and uncertainty of the project moving forward, it has been
     suggested that this fund could be used for the wood chip boiler.

     Per discussions with legal counsel (Paul Giuliani) the SBSD can ask
     voters to reauthorize use of the 2005 bond. This option would make
     use of existing funds and therefore result in no impact on the tax rate.
     Once state aid is received those funds can be set up to create a debt
     retirement fund and pay for the P&I portion of the funds reimbursed by
     the state.

Option 2: Incur New Debt

     In this case voters would need to authorize SBSD to incur two forms of
     debt. The debt can be characterized as short term and long term. The
     short-term debt portion would cover the amount of funds projected to
     be paid back from State Aid and would be called a “State Aid
     Anticipation Note.” This note would be obtained from a local bank at
     prevailing interest rates. The second form of borrowing, or long-term
     debt, would be obtained from the Vermont Municipal bond bank and
     would cover the SBSD’s portion that is not covered by state aid. This
     form of borrowing is assumed to be for 20 years and is not allowed to
     be prepaid in advance. Therefore, the District is on the hook for the
     interest portion of the debt for the full 20 years.

     The project if voted by 12/31/2006 is projected to qualify for 90% state
     aid. Therefore if the project cost is $1,920,000, SBSD’s projected state
     aid is $1,728,000 (assuming a 90% funding scenario). However there
     is a lag period between SBSD spending the money on building the
     project and SBSD getting a check from the State. Due to the number
     of wood chip projects being planned in Vermont, state aid
     reimbursement is projected to be delayed due to fiscal constraints on
     the state’s capital fund. In the analysis it was assumed at the end of
     year 3 the state aid contribution would be received from the State. In
     this example, SBSD would borrow $1,728,000 short term from a local
     lending institution or bank as a “State Aid Anticipation Note.” If State
     Aid is received sooner than the end of year three, SBSD can pay off
     the short-term debt in advance and avoid further interest expenses.

     The remaining project cost of $192,000 (10% of $1,920,000) would be
     borrowed from the Vermont Municipal Bond Bank for 20 years. The
     reason to go with the bond bank is to take advantage of lower interest
     rates, but then SBSD is obligated to pay for the debt over the full 20
     years of the bond (there is no option to pay off the debt in advance and
     avoid future interest expenses).

     Therefore option 2 involves two sources of debt (one short term and
     one long term) and the interest expense is an added cost stream to

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    assume for the project. Both a 90% state aid and 75% state aid
    scenario were considered for the analysis. The cost of interest
    decreases the project NPV savings in both cases. At 90% state aid
    each NPV savings value decreased by $192,997. At 75% state aid the
    interest expense decreased the NPV values by $138,228.

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