Any industry segment implementing energy efficiency measures needs to evaluate multiple project possibilities, prioritizing where to spend dollars. A large portion of an organization’s budget goes to pay for energy costs, and the decisions about which projects to implement can benefit ratepayers with affordability.
A General Manager or Operations Manager may lead the initial evaluation of projects. Once they have decided on project recommendations, they will need to use various financial metrics to create cost justifications to upper management, including the accounting or finance department, as well as the Board of the organization. All of these layers of approvers need to understand that a project meets certain financial requirements.
Learning how to present energy projects to decision makers and investors is key to project success. If a project doesn’t present cost effectiveness as an investment, decision makers don’t have the right information and projects that are great for a company’s bottom line may be ignored.
Moving Past Simple Payback Period
To develop a project, an energy engineer carries out detailed energy assessments, builds out complex calculations to determine energy baselines of buildings or facilities, evaluates a variety of alternative operations and equipment, establishes costs of identified alternatives, and calculates the energy impact of each measure. Depending on the project scale, this process can take months and requires engineering expertise of energy systems and a site-specific understanding of customer operations. After spending considerable resources evaluating these projects however, final project reports often limit their financial analysis to the most common metric: the simple payback period.
Simple payback period measures the length of time required to recover the cost of an investment (net measure cost divided by the annual savings). While it was once a common standard for evaluating energy efficiency projects, simple payback can skew the decision-making process because it doesn’t view equipment lifetime and long-term savings impacts.
The simple payback metric ends up measuring time, not profitability; it does not take into consideration the effective useful life of the equipment, the time value of money, or the benefits accrued beyond the payback period. It does not enable an investor to compare and contrast the project against alternative investments.
In practice, simple payback treats a piece of equipment with a useful life of 2 years the same as one that has a useful life of 20 years. For example, a City Manager may be considering a measure like a lighting project for a library, which may only have an effective useful life of 5 years before a unit has to be replaced. But when comparing that project to a more complex project that generates savings for 15 years, simple payback only looks at the first year savings and treats the two different streams of savings (5 versus 15 years) as the same.
Relying solely on simple payback analysis can leave a lot of money on the table. It’s a quick, easy-to-understand metric, but for the large financial decisions surrounding these projects, with millions of dollars on the line, industries are moving toward more sophisticated financial metrics. Analysis that considers long-term financial implications is necessary to effectively evaluate projects that may be more complex to implement, but provide deeper energy savings over time.
Encouraging Life Cycle Cost Analysis (LCCA)
To support this shift toward sophisticated metrics beyond simple payback, some state and federal agencies are setting new standards. For example, Executive Order 13123 required that federal agencies employ full lifecycle cost accounting in all infrastructure investments, including energy efficiency projects.
Life cycle cost analysis (LCCA) involves accounting for all costs related to construction, operation, maintenance, and disposal at the end of the useful life of a project. It includes the total cost of ownership, such as capital, operating, and energy costs. The purpose is to provide the basis for selection of the most cost-effective design alternative over a particular time frame, taking into account initial construction costs and anticipated future costs.
LCCA is a useful metric for comparing the total cost of ownership between projects, a helpful analysis for long-term planning. However, LCCA on its own falls short on evaluating profitability or the discount rate on invested funds.
Leveraging a Cash Flow Tool for Energy Efficiency Projects
Since 2003, Lincus has provided a broad range of successful energy-efficiency engineering consulting services to clients in the utility, commercial, industrial, and institutional segments. To support customers in comparing different projects, our team saw the need to develop a more robust financial analysis tool specifically for energy efficiency projects.
Our cash-flow tool incorporates LCCA, Net Present Value (NPV), and Internal Rate of Return (IRR).
- NPV shows the value added to a customer in dollars. It captures the full returns over a project’s lifetime and reflects risk taken by incorporating the time-value of money. NPV is a measure of how much value the proposed project will add to the customer over time.
- IRR reflects the discount rate at which an investment’s future returns break even with the initial outlay (NPV = 0). It is a percentage for which customers often have a minimum threshold, and this enables decision makers to compare the investment to the rate of return of alternative investments. Simply put, an IRR greater than the internal threshold rate indicates that the project is a good investment.
Both of these additional sophisticated metrics are necessary for decision makers to make a wise investment decision. Compared to simple payback, which only looks at first-year savings, NPV and IRR look at equipment life savings.
This Excel-based cash flow tool is surprisingly simple, but it incorporates all of the most important considerations for an energy efficiency project. Presenting the results of the tool can help a customer understand a measure, as well as provide an opportunity to demonstrate incentives available through integrated demand side management programs.
This tool can also be used to evaluate innovative project financing approaches such as zero or low interest loans. In certain cases, through a combination of incentives and innovative financing, projects have been shown to be net cash flow positive on day 1. A simple payback analysis will not provide this level of sophistication or shine light on innovative pathways to get projects financed and installed.
This is a financial analysis tool that can be used to develop required financial metrics to properly qualify project approaches. This analysis provides decision makers with all the information they need to make a sound investment decision.
For support in developing sophisticated analysis of energy efficiency projects for your agency, contact Lincus today.