Approaching Efficiency as an Investment
Approaching Efficiency as an Investment
Cost is the perennial barrier to green corporate investments in energy efficiency, whether it is upgrading equipment or replacing the inefficient lighting in a facility.
Although these types of capital expenditures can actually save a company money in the long run, the factor that often determines whether the project will get the green light is its payback period.
The recently released book, "Energy Budgets at Risk," offers a different approach. Author and Energy Economist Jerry Jackson has developed a framework that he says will reduce energy costs and risk using tools created by the financial industry.
Today we'll talk to Jerry about how using this analysis can help companies meet their environmental goals through energy efficiency investments.
Tilde Herrera: Hey, Jerry. Welcome to the program.
Jerry Jackson: Thank you.
TH: Now, this book is billed as a Wall Street approach to energy efficiency investments. Before we get into the mechanics of Energy Budgets at Risk, could you talk a little bit about the philosophy?
JJ: Sure. Energy Budgets at Risk, or EBaR, is a new quantitative process that provides financial analysis of energy efficiency projects by explicitly representing all the sources of risk that include energy prices, operating characteristics, weather and those sorts of things. EBaR represents an extension of technique called Value at Risk, which is a financial management tool that's been around for more than a decade. Traditionally, businesses and government organizations evaluate energy efficiency investments by calculating payback requirements, and payback is simply the cost of the investment divided by the annual savings.
So, an investment that pays for itself in two years has a two-year payback. And in fact, most organizations require a two-year payback before they will make an investment in energy efficiency. That's a real shame because a payback of two years translates to about a 50 percent rate of return, so these organizations are bypassing lots of profitable investments, and what we've done with EBaR is to develop, like I said, this financial risk management approach to making these evaluations. So, most organizations who apply, say, about 30 percent of their energy cost, and that's after deducting the financing cost of the investment. In other words, the day after these organizations implement these efficiency options their cash flows increase by about 30 percent of their last year's energy cost.
TH: So, basically this approach factors in the amount of savings after the investment is returned?
Jerry: That's right. But the real problem in terms of the way people have approached energy efficiency in the past is that they haven't attempted to evaluate risk, so what happens is if I'm an energy manager and I have a great project I'll take it to my CFO and say, "I've got this great project that has a payback of three years," and the CFO will listen to me, but he knows or she knows that there's some risk associated with that because I may have used the current prices and prices may go down, or I'm not factoring in weather variations and things like that. So, the CFO listens to my three-year payback and says, "It's a 3-year payback but there's a lot of risk associated with that.” So, they reject my three-year payback project because I haven't been able to quantify the risk associated with the investment.
So what EBaR does is it analyzes efficiency options, but it provides the results in ways that CFOs and financial administrators can evaluate it in the framework they're used to evaluating financial investments. So, it really kind of bridges that gap between the engineering characteristics of an efficiency project and what financial administrators do, and that is decide how to invest the company's money in a way to maximize returns.
TH: Let's look at this case study that's given in the book. It's a 120,000-square-foot office building in Austin, Texas, and the way it is currently set up the energy bill costs about $210,000 a year, and natural gas costs about $50,000. The company was considering two energy options. Can you tell us about those?
JJ: Sure. In this case we looked at the two options that are most frequently considered in terms of efficiency investments. One relates to lighting, and the other related to HVAC or heating, ventilation and air conditioning. And when we tool a look at those investment options what we found was that the total investment cost was about $225,000, and the energy-cost savings -- the estimated energy-cost savings was about $98,000. So, that provided a payback of 2.3 years. As I indicated before, most organizations would not go for investment options that provide a payback of anything of over about two years.
Well, again, the investment, if it turned out to be exactly what's calculated, would represent a very profitable investment, a rate of return of about 42 percent and would increase cash flows almost $60,000 for this particular building. But of course, there is risk involved with the project, so, again, based only on payback the project would have been rejected.
Well, we went ahead and did the EBaR analysis for this particular project, and what we found was that, in fact, there was very little risk, specifically there was only about a 2.5 percent chance that the rate of return on this investment would be less than 32 percent and the same probability of 2.5 percent that the cash flow increase would be less than $37,800.
So, what this example shows, then, is that while traditional payback analysis gives you a yes-or-no decision, this EBaR analysis allows us to look at the risks and rewards of individual projects. In this case there was very little risk, so this was a project that any financial administrator looking at it would say, "Go ahead." But without the financial risk analysis that 2.3-year payback probably wouldn't have been enough to move the project forward.
TH: Now, let's talk about how you do it.
JJ: Sure. There are two ways to perform the EBaR analysis. The first and the easiest way is to utilize the software that we provide at energybudgetsatrisk.com. And what users do with the software is they input the last 12 months of energy bills and provide a little bit of additional information on the facility, and the software then takes historical information, and it evaluates risks associated with energy prices and with equipment performance and lots of other factors and provides a full financial risk analysis as the output. So, in this case, the software pretty much does everything except providing the input data. Again, like I said, it's available on energybudgetsatrisk.com. The cost of that software is $2,900.
Now, I've written the book in such a way that anybody who's interested can follow the specific steps and the middle chapters of the book and, beginning with energy bills, they'll do the same kind of process the software does. Again, I've laid that out very specifically, step by step. All the processes are performed with Excel, so it's just a matter of doing through the process to develop the mathematical relationships that characterize the risk and uncertainty associated with energy prices with operating performance and with weather and the other variables. Then all those relationships are put back together, and the result then of that process is the same kind of result that you get with the software we provide, which is a distribution of rates of return and a distribution of increases and cash flow that would result from these investments.
TH: Now, for those readers who choose to perform these calculations themselves, there are pages of tables and data at the end of the book. Will that information need to be updated, and if it does, readers can get that at the website?
JJ: No. Actually, that information is benchmark information that I've developed from a database -actually, that's developed from over a million individual facilities across the country. What that database provides is information on how buildings of various types and various operating hours' categories use energy. So, the appendix allows a reader to take their monthly bills, to go to the appendix and to calculate what their likely savings are with respect to applying an Energy Budgets at Risk kind of analysis. Again, the steps are detailed there, and I've even included an example so readers can work through that.
But the appendix is really a nice aspect of the book in that it allows readers to very quickly, even standing at a bookstore, for instance, to take a look at the back of the book and compare their energy use to the energy use of these thousands of other buildings across the country and compare what they can do with respect to reducing their energy use to be in one of the more efficient percentiles that's shown in those tables.
TH: So that information is sort of timeless.
TH: Now, Jerry, tell us a little bit about yourself. Tell us a little bit about your background and why you wrote this book.
JJ: Sure. I'm an energy economist, and I'm also a professor at Texas A&M University, and I've worked in the energy area for 30 years. I've consulted with business and government agencies on a whole variety of issues that range from developing conservation programs to forecasting future energy use, and I've been aware of the problem that traditional payback approaches have created in terms of energy efficiency investments for years, but it's really only the rampant increase in prices over the past three or four years, along with the fact that energy prices will, undoubtedly, continue to rise in the future that really creates a financial crisis for lots of businesses and organizations.
In talking to energy managers over the last couple of years, I realized that their inability to translate the engineering calculations into financial risk analysis that's meaningful to the CFO was a real key stumbling block to taking advantage of efficiency opportunities. So, what this book does then is to translate energy efficiency project characteristics into the kind of investment analysis that is familiar to CFOs and financial administrators.
TH: O.K. Tell us about the target audience. Is this book geared toward any particular sector?
JJ: Sure. It's - well, this really cuts across all business institutional, that is, hospitals and government agencies. So, it's really -- and even manufacturing firms can use it. It really is applicable to every sector out there in the economy except residential applications because they're a little bit different in a variety of ways.
But the target audience includes two main groups. The first group is composed of CFOs and financial administrators and managers who are concerned about the cost of energy and the volatility and, again, the financial threat that it poses and want to learn more about what can be done within their organizations. So, I've written the first part of the book to provide background on energy markets and the kinds of efficiency investments that are out there and just why risk management is the appropriate approach to looking at energy efficiency.
Then towards the end of the book I've included a chapter that provides the financial analysis report so they can go directly to that and see how that relates to the kinds of financial investments they make in other areas. Again, I mentioned the appendix, which also allows managers and executives to take a quick look at their facilities and get some idea of the potential savings that exist.
Then the second audience is composed of all the energy managers and energy engineers who are out there working with great projects and going to their financial people and trying to get the projects approved. They're not approved because the financial administrators are - don't have the kind of financial risk analysis they need to make these decisions. So, the middle part of the book then provides all the detailed processes and calculations that these engineers need to do to put their analysis in a framework that the CFOs can understand.
I was actually presenting this at a meeting - lunchtime meeting in Houston, and one of the engineers - energy engineers there came up to me and said, "This is really the missing link. This is what I've been missing to convince my financial guys that what I've got really is worthwhile for the company." So, it's - those two audiences sort of come together to benefit the entire organization.
Then, of course, there are policymakers, certainly. This is an important issue in terms of information, but this also goes to university students and energy service companies who are out there installing lots of this equipment and trying to interact with businesses and government.
TH: What advice would you give to businesses or companies in relation to energy and energy efficiency? If listeners could take away one helpful hint from this segment, what would you want that to be?
JJ: The first thing I'd say is that any company that has not undertaken an efficiency analysis or efficiency actions within the last several years can easily save 20 percent of their energy bills, and the beauty of this approach is that they can save more than it would cost them to institute the investment. So, they'd be increasing their cash flows.
Any company that has not undertaken the detailed evaluation and audit of what they can take away from investments in energy efficiency is missing a great opportunity to increase their bottom line. Right now we're in a really unprecedented time with respect to energy markets. Companies like Russia that used to be the largest oil producer in the world has just had their first decline in quarterly output. Oil prices are at $115 a barrel and looking at $120. Natural gas prices in this country follow oil prices, and electricity prices follow natural gas prices because natural gas is used to generate electricity.
So, we're really all in for a rather shocking kind of new energy crisis here over the next three or four years, and I think that every business can look at what's happened in financial markets and see what kinds of issues can arise when companies are unprepared and haven't accurately quantified risks, and there certainly are a lot of risks associated with energy costs. So, I would really recommend that every organization, government, company, hospital take a look at where it is and seriously consider taking advantage of the opportunities, both to improve their bottom lines with respect to energy efficiency, but also to protect themselves from future risks that undoubtedly will come as prices continue to increase.
TH: Great. Jerry, thank you so much for joining us today.
Tilde Herrera is the associate editor of GreenBiz.com.