Selling energy efficiency projects typically involves preparing a financial analysis that compares the costs and benefits associated with a new solution compared to the current systems costs and in some cases the costs of replacing the current system with a similar system. Both the current system and the proposed solution(s) have common costs associated with operating and maintaining them over time. We’ll review those common costs first, followed by a review of typical financial metrics to gauge the financial performance of a new system, and finish with an overview of which metrics are appropriate for different decision maker types.
Energy System Typical Costs
Energy Costs: This is the hourly, monthly, and annual energy costs associated with running the energy system. For the existing system, we can determine this cost from a) utility billing data, b) site audits, c) benchmarking via data loggers, and/or d) sub-metering the systems in question. A new system requires an energy model to determine expected energy consumption followed by a conversion to expected costs based on utility rates.
Maintenance Costs: This is the total cost of maintaining the system and can include replacement parts, installation costs to replace the parts, staff time to manage sub-contractors, and other related costs. This can be determined for existing systems through historical actual costs incurred or an estimate based on expected equipment lifetime and typical part and install costs.
Replacement Costs: This cost accounts for major equipment replacement at the end of its useful costs. This can be determined for existing equipment that is at, or very near, the end of its useful life as the cost to replace, including part and install costs.
Downtime Costs: This is a rarely used cost, but including the costs to business operations from equipment downtime can be appropriate in certain circumstances. For example, if a boiler goes down for a day and a pool can’t get hot water, there may be lost revenue to the pool business.
Financial Metric Terms
Annual Savings: This is the total annual savings, including energy, maintenance, and other annual savings.
Total Savings: This is the sum of annual savings over the analysis term
Investment: This is the total upfront investment of the new solution. Depending on the financial metric and presentation goals, this term should be the total gross investment or the net investment after incentives and replacement costs.
Term: This is the length of time for the financial analysis. This typically is the length of financing, expected solution lifetime, warranty period, and/or industry standards.
Discount Rate: This refers to the interest rate used in discounted cash flow analysis, including net present value. It accounts for the time value of money which generally means a dollar next year is worth less than a dollar today.
Return on Investment (ROI): The traditional definition of ROI is (Current Value of Investment — Cost of Investment)/Cost of Investment*100. In the energy efficiency industry, we typically use Simple ROI which translates to Annual Savings/Project Cost. If a lighting project has an Annual Savings of $10,000 and the Project Cost is $40,000, the ROI is $10,000/$40,000 = 0.25 = 25%. If incentives, including utility rebates are near instantaneous, then it’s typical to use the Net Project Cost instead of the Gross Project Cost. Using our example above, if incentives were $20,000, then the Net Project Cost = Gross Project Cost-Incentives = $40,000-$20,000=$20,000 and the ROI is $10,000/$20,000=$50,000. It is not typical to include any tax incentives when calculating Net Project Cost. The key drawback of using ROI is it doesn’t taken into account the total project savings, time value of money, or term. As a result, ROI is useful for comparing similar investments, but isn’t a good metric for comparing a 20 year HVAC project to a 10 year lighting project.
Payback Period: Payback Period refers to the length of time it takes to recover the cost of an investment, which requires a thorough cash flow analysis, including any financing costs. In the energy efficiency industry, we typically use Simple Payback Period which is the inverse of the ROI and equal to Project Cost/Annual Savings. Using our example above, the Payback Period would be $40,000/$10,000 = 4.0 years if using the Gross Project Cost and the Payback Period would be $20,000/$10,000 = 2.0 years if using the Net Project Cost. The same drawbacks of using the ROI apply to the Payback Period. A good example of how a Payback Period may not be a good metric would be for a solution where the Payback Period is longer than the Solution Lifetime.
Net Present Value (NPV): The Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. In the energy efficiency industry, we typically simplify by using the net annual cash flows over the term of the project and then discounting them to today’s value using the Discount Rate. The NPV equation assumes the investment is made today and then looks at the expected savings over the term to determine if the net value of that investment is positive or negative. If the NPV Is positive, then the investment has a positive return over the term and if it is negative, then the investment has a negative return. Since the NPV accounts for the time value of money and looks at the investment over its expected lifetime, it’s useful for determining whether the investment results in a positive or negative return on investment over time. The major drawbacks are NPV doesn’t indicate how fast the investment is returned and it doesn’t allow for easy comparison’s against other possible investments unless the investments are similar. Since this metric evaluates the investment over the Project Term, it’s important to note the Project Term when reporting this metric.
Internal Rate of Return (IRR): IRR is a metric used to estimate the profitability of potential investments. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. Basically this means it back calculates the discount rate for an investment so that the investment is worth $0 at the end of the Project Term. If the IRR is positive, then the investment has a positive return and if the IRR is negative, then the investment has a negative return over the Project Term. Another way of thinking about IRR is it’s the ROI, but adjusted for annual cash flows over time or you could think of it as being similar to the APR on a credit card. Since IRR accounts for the time value of money and looks at the investment over its expected lifetime, it’s useful for gauging the relative strength of the investment compared to other possible investments. Many organizations compare possible investments, including capital expenditures, and select those that with the highest IRR while others set a minimum IRR threshold for approving a project. Since this metric evaluates the investment over the Project Term, it’s important to note the Project Term when reporting this metric.
Modified Internal Rate of Return (MIRR):
Savings to Investment Ratio (SIR):
Cash Flow Analysis:
Cost of Waiting:
I’ll cover these metrics in a subsequent update to this blog post.