Geothermal handbook: PlanninG and Financing power Generation t e c h n I c a L r e p o r t 2 / 2

reaching for high returns on Equity
While an operating geothermal power facility promises a steady and long-lasting revenue stream 
making it an attractive investment opportunity in the long run, the risks discussed above make 
financing more complicated and certainly put upward pressure on the cost of capital, particularly at 
the early stages. This is true for both debt and equity, and the role of the latter needs to be especially 
emphasized. While debt financing typically covers the greater part of the capital requirements 
(commonly 60 to 70 percent of the total project cost), lenders usually require that a significant amount 
of equity be invested in the project as well. In fact, equity may be the only source of capital in the initial 
phases of the project apart from possible grant support from government or international aid.
When financing geothermal projects, private equity investors are likely to require relatively high rates 
of return on their invested capital. For an equity investor entering at an early stage, required return 
on equity of 20 to 30 percent per year is not unusual (BNEF 2011). The resource risk makes the 
greatest contribution to the high risk premium. The long and uncertain completion time is often next 
in significance while other factors discussed above (including regulatory risk) contribute as well. In 
addition, from an equity investor’s perspective, risk factors should include not only those affecting the 
return on the project as a whole, but also the risks associated with the financing structure (leverage). 
For example, return on equity is sensitive to changes in the terms of the debt financing, such as the 
interest rate, maturity period, grace period (if applicable), and debt-to-equity ratio. 
It is also important to note that the long lead time for geothermal projects (with the first revenues 
coming only in Year 6 or even later) can greatly increase the difference in results based on the 
levelized cost that assumes relatively low cost of capital coming largely from public sources (with 
LCOE looking rather attractive at about $US 0.04 to 0.10/kWh), versus the tariff level required to reach 
the targets for financial return on equity. Based on a hurdle rate of, for example, 25 percent for return 
on equity, a geothermal project will tend to require, at least initially, tariff levels well in excess of the 
levelized cost, even if debt financing is available on relatively favorable terms.
One of the options to bring return on equity above the threshold rate required by the private investor 
is for the government (or international donors) to pay for, or at least subsidize, the costs of the initial 
project development—including exploratory drilling, if possible. The following illustrative example 
shows the impact of a government commitment to absorb 50 percent of the costs during the first three 
years of the project including test drillings. The methodology of the underlying financial model is given 
in Annex 3, along with the summary spreadsheets and sensitivity analysis for key variables.

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