By: Rocky Mountain Power
Key Points
· Payback is a simple and widely used method to measure the financial value of energy upgrades. · More sophisticated tools may provide a clearer picture of the potential benefits of a project.
· Selecting an analysis tool may depend on the specific nature of the project or the typical practices of your organization.
Energy-efficiency upgrades are one of many investment options that organizations can choose from to cut costs and increase revenue streams. A variety of analysis tools are used to weigh the cost and benefits of an investment and judge whether it is financially sound. Three analysis methods are commonly used to estimate the financial risk and value associated with energy efficiency upgrades—payback period, net present value, and internal rate of return. While payback is the simplest and most widely used method, it may provide only a limited view of the potential benefits of an energy-efficiency project.
Payback Period
Payback is simply the amount of time—typically in years—for the total cash flow from a project to reach zero. Cash flows include any initial and subsequent costs associated with an energy project, as well as any savings directly relating to it. For example, if a building upgrade costs $10,000 and the annual savings are expected to be $2,000, it would be easy to divide the two figures and come up with a payback period of five years. However, annual savings projections may fluctuate, depending on factors such as energy prices or maintenance costs. A more accurate assessment can be made by accumulating the annual cash flow associated with the upgrade rather than by just dividing the first year's savings by the initial cost.
Even with varying cash flows, payback is easy to understand and calculate. It can be used as a rough estimate of the risk involved in an energy project. The shorter the payback period, the less chance that some problem or unforeseen circumstance might interfere with recovering the initial investment. As a financial analysis tool, however, payback has some serious shortcomings. It does not account for cash flows after the payback period and thus may under value any positive long-term value associated with the energy project. Also, it treats money in its present day value—ignoring the principle that money received in the future tends to be less valuable than money received today.
Net Present Value
Net present value (NPV) is a financial analysis tool that accounts for the time value of money. NPV is similar to payback period in that it is calculated from the annual cash flows that result from the building upgrade. Unlike payback period, cash values in NPV are adjusted or discounted so that near-term cash flows have a greater value than those in the more distant future. The discount rate is an interest rate used to adjust future cash flow to its current value.
The net present value is the sum of all the present values of every cash flow associated with the energy upgrade, including costs, which are expressed in negative numbers. NPV helps to measure the financial worth of an energy project over time. If the NPV is above zero, then the present value of future cash flow is greater than the initial cost. The choice of the discount rate can have a significant impact on an NPV calculation. A higher or lower discount rate can impact the present value amounts. In selecting a discount rate, many organizations start with the interest rate associated with the investment. For example if a $10,000 upgrade requires financing at 8%, then that figure can be used as the discount rate to calculate present value.
Internal Rate of Return
Internal rate of return (IRR) is closely related to net present value. IRR is a percentage figure that estimates the return on an energy-efficiency investment over time. The IRR is the discount rate that results in an NPV of zero. Determining the IRR of an upgrade involves a tedious process of testing different discount rates until finding one where NPV equals zero. Fortunately, the task can be automated using a spreadsheet program or a financial calculator. So, once you know the IRR, how do you know if it is high enough to justify the investment in the energy project? The answer depends on the discount rate. If the IRR is higher than the discount rate, then the energy project is a financially sound investment. As discussed above, the discount rate can be either a general one used throughout the organization or a financing rate specific to the project.
Selecting a Method
Which financial analysis tool should you use to evaluate an energy-efficiency upgrade? The analysis method that your organization typically uses to make investment decisions would be a good place to start. For instance, if your organization typically requires an estimated payback period as part of any investment proposal, then a payback analysis should be included in your evaluation. Relying solely on payback, however, can result in a limited view of the potential advantages of an energy-efficiency upgrade. The analysis stops at the point when the initial costs have been covered and fails to measure long-term benefits such as a positive return-on-investment. When there is freedom to choose an analysis tool, or you want to present more than one result, both NPV and IRR are probably better choices than payback. Both account for the time value of money and measure the potential benefits over the entire useful life of an energy-efficiency upgrade.
A useful tool is the Building Upgrade Value Calculator developed by the U.S. Environmental Protection Agency. It is designed specifically for analyzing the financial impact of an energy-efficiency upgrade. It projects cash flows and calculates IRR, NPV, and other investment measures. The tool is in spreadsheet format and can be downloaded for free from the ENERGY STAR Web site.
Please note: This and other useful energy management information is found in the free, online Rocky Mountain Power “Business Solutions Toolkit.” You can access the Toolkit at RockyMountainPower.net/toolkit
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