Cost of capital estimation for energy efficiency projects through a cash flow beta approach

This paper presents a methodological framework for project beta estimation according to the Capital Asset Pricing Model (CAPM) when relevant stock price data are not available but cash flow data are. The methodology suggests estimating a cash flow beta first, which can then be converted into the traditional stock beta of a project. Estimation of the cash flow beta requires a series of past expectations regarding the project's cash flows. We generate these expectations from time-series models describing the cash flow process. In the case of energy efficiency projects, we argue that it is sufficient to consider only the energy price uncertainty in the cash flows. Analyzing monthly residential retail price data for electricity, natural gas, and heating oil in the USA, we find that the use of price changes, as applied by related studies, is inappropriate for beta estimation and that it may lead to errors in magnitude, incorrect signs, and wider confidence intervals for beta estimates because none of these prices are martingales. After adjusting for this issue, we find very small betas. Moreover, considering their possible range, we conclude that the risk-free rate is generally a good approximation for energy efficiency projects.