October 15, 2020

Devil is in the Details: The Financial Analysis Challenge with Energy Cost Savings

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The journey from energy savings to financial impact analysis for an energy efficiency improvement project is not as straightforward as it may seem. In fact, the path often contains a minefield of potential problems that can lead the energy professional astray in ways that may ultimately result in a dissatisfied client. Simply estimating the cost savings from an improvement project is rarely sufficient for today’s demanding cash flow-focused building owners who prefer to see savings presented in the financial metrics they are accustomed to in their business.

The list of potential issues that needs to be addressed begins with a careful understanding of the utility rate schedule for the building. It is essential that the proper rate schedule be identified and interpreted correctly. As previously discussed in my July blog, Devil is in the Details: Understanding Utility Bills for Energy Cost Savings Analysis, understanding electricity generation charges, demand-delivery charges, potential ratchet provisions and monthly fixed charges will help to estimate the energy cost savings of an energy efficiency improvement project more accurately.

Estimating the savings of these improvements over equipment lifetime requires several key assumptions to be made including, for example, predicting the useful life of the equipment, identifying equipment potential performance degradation over time, estimating potential maintenance savings, and forecasting how utility energy costs might increase over the lifetime of the equipment. Making such estimates and assumptions about the future will always be challenging, particularly considering that most energy-consuming equipment has expected useful lifetimes of 15 to 20 years or more.

Experience has shown that the most common energy improvement financial metrics needed to make the business case to today’s building owners and managers include:

• Simple Payback (SPB)
• Net Present Value (NPV) of Lifetime Savings
• Savings-to-Investment Ratio (SIR)
• Property Value Appreciation (PVA)

Simple Payback (SPB)

The SPB period refers to the amount of time it takes to recover the cost of an investment, or more simply, the length of time it takes for an investment to reach break-even. For energy efficiency investments, SPB equals the total upfront capital investment divided by the first-year energy cost savings.

Unfortunately, the SPB period ignores the time value of money—the idea that money today is worth more than the same amount in the future. Moreover, it does not account for the costs associated with financing a project over time (interest costs) or other factors affecting future energy cost savings, such as equipment performance degradation, utility cost escalation rates, etc. Although easy to calculate, there are many other questions and limitations associated with the SPB method that make building owners and managers rarely want to make investment decisions based on this metric alone. Some of these other questions and limitations include:

1. The simple payback period does not account for savings that exist after the payback period. Since the method ignores all savings beyond the payback years, it will favor projects that offer high savings for a relatively short period.

2. The specific values used in the payback calculation are often subject to misunderstanding. For example, questions may arise in an energy efficiency project as to what is included in the upfront capital investment, for example:

• Does the investment include soft costs, such as an energy efficiency audit, project development fees, permit fees, legal fees and financing costs?

• Have utility or other incentives, including tax credits and grants, that can reduce the investment been taken into consideration?

• Does the installed cost estimate include a contingency? If so, is it included in the investment?

3. Questions may also arise regarding the definition of energy savings, including:

• How exactly are the savings defined?

• Are they just the first-year savings?

• Are they pre-tax or after-tax savings?

• Are maintenance savings included?

• How were the energy consumption savings leading to the energy cost savings calculated? Were they based upon weather-normalized end-use energy consumption, or were they [incorrectly] estimated based on the actual weather experienced in the baseline period?

Many energy professionals rarely go beyond the SPB period calculation which, though relatively easy to use, can be quite misleading. Building owners and managers today recognize its limitations and often require additional information before making an investment decision.

Net Present Value (NPV)

NPV analysis considers the time value of money. The analysis identifies the present value of expected future cash flows using a discount rate. Building owners and managers use the NPV concept to determine whether future cash flows (energy savings) of an energy improvement investment are equal to or greater than the value of the initial investment. If the NPV is positive, the opportunity is viewed as attractive, with the greater the NPV the better.

To conduct NPV analysis, an investor must make estimates about future cash flows. The investor must also determine an appropriate discount rate for the project under consideration. The discount rate is viewed as the company’s cost of capital or expected rate of return for an investment. In other words, it effectively represents the minimum rate of return that a company or investor requires over the life of the investment. Discount rates used in energy efficiency project financial analysis typically range between 3 to 7 percent.

Savings-to-Investment Ratio (SIR)

A more substantial and representative financial metric for building owners and managers today is the SIR. The SIR equals the ratio of the project’s estimated lifetime energy cost savings to the total installed cost (including any financing costs) of the energy efficiency improvement project.

An SIR of 1 or greater indicates that the improvement(s) will pay for itself over the project lifecycle. For example, an SIR of 1.4 indicates that for every $1 invested in the project, the investor will receive $1.40 in return.

Notwithstanding, just as with the SPB metric, there are items that need to be explained to a client if an SIR calculation is being used. These include:

1. How exactly are the savings defined? Are they based on the savings over the equipment’s estimated useful life (EUL), or simply the first-year savings multiplied by the equipment’s EUL? Also, the questions raised previously for the SPB period calculation will apply to the SIR metric as well.

2. Equipment EUL has a significant impact on the SIR. Unfortunately, it can vary considerably depending on the source. As such, it is important to have a reliable source for such information, e.g., ASHRAE, Department of Energy, Fannie Mae, state utility energy efficiency program technical resource manuals, etc. Has the source used for the EUL been specified?

3. Equipment performance degradation can have an impact on the energy cost savings and therefore the SIR. As with equipment EUL, it is important to have a reliable source for such information. Has the source for the performance degradation factor(s) of the equipment being installed been specified?

4. What is the source for the utility escalation rate that is being applied to the future energy cost savings associated with the improvements?

5. Many of the questions raised previously regarding the SPB calculation that relate to the total cost of the investment also apply here.

Property Value Appreciation (PVA)

If the net operating income of a building is increased due to energy saving improvements (and any maintenance cost savings that might be associated with these improvements), it will have a positive impact on building valuation. This has been the subject of my August blog, Devil is in the Details: The Impact of Energy Efficiency Improvements on Building Valuation.

Example Evaluating the Financial Impact of an Energy Efficiency Investment

Assume an energy efficiency project includes the following:

• A high efficiency air conditioning roof-top unit (RTU) is selected to replace an existing unit beyond its useful life.
• The total installed cost of $600,000 is paid upfront out of the capital budget.
• The first-year energy (utility) savings is projected to be $68,000.
• The RTU is expected to have a 15-year estimated useful life (EUL).
• A 3 percent average annual utility cost escalation factor is considered representative over the equipment’s EUL.
• A 0.5 percent average annual performance degradation is anticipated over the equipment’s EUL based on manufacturer’s test data.
• A 3 percent discount rate is assumed.
• The capitalization (“cap”) rate for the owner-occupied building is 6.5 percent.

The SPB period will be $600,000 / $68,000 = 8.8 years. For many building owners, this might not represent a compelling investment opportunity. A payback of 3 years or less is often cited by building owners as the criteria for investment in energy improvements. However, as previously indicated, the SPB period does not consider the estimated lifetime savings which may make for a stronger business case.

Expanding the financial analysis to include lifetime savings and incorporate the time value of money would be the next step. If the time value of money is not considered, the savings over the 15-year equipment EUL would be $1,218,041 (refer to the table below), less the upfront investment of $600,000.

However, with the time value of money taken into consideration (using discounted cash flow and a 3 percent discount rate), the lifetime savings over the EUL would be $956,371, less the upfront investment of $600,000. (If the $600,000 investment is not paid upfront out of the capital budget, but rather is 100 percent financed, the cost of the loan each year would need to be subtracted from the savings in those same years, and there would be no initial investment. In many cases, particularly where long-term, low interest, fixed rate government-supported loans for energy efficiency projects exist, the annual savings each year can exceed the annual cost.)

The investment becomes even more appealing when one looks at the SIR. The SIR in this case would be $956,371 / $600,000 = 1.6, which suggests an attractive energy efficiency investment, despite the less attractive simple payback period.

Finally, the $68,000 expected first-year savings would likely increase the building’s value by $68,000 / 6.5 percent (cap rate) or $1.05 million.

Conclusion

Building owners or managers evaluate the financial impact of an energy efficiency investment in the language of commercial real estate, i.e., cash flow. Commercial real estate effectively runs on cash flow. As such, owners and managers typically will want to see the business case for an energy efficiency improvement investment. Merely providing the installed cost of the project is no longer sufficient. This is especially true in our current “pandemic” economic environment where building owners are closely scrutinizing their estimated return on capital expenditures. The business case should include NPV analysis of the energy savings with the project’s SIR and its potential impact on property valuation. This would be the most realistic (and potentially the most attractive) way of presenting a project’s true financial impact. Clients will appreciate the thoughtful presentation, and if the business case is compelling, they will more quickly make the investment decision and do so with greater confidence.

To learn more about how energy efficiency professionals are presenting the financial analysis of a project’s cost savings to building owners and managers to improve proposal acceptance, checkout SRS’s latest innovation: The Energy Performance Improvement Calculator (EPIC^TM) at SRSworx.com.