Financial evaluation

Financial evaluation is usually the most important part of a business case, used to calculate the return on investment for an energy efficiency measure (EEM). Estimates of costs and savings need to be prepared to a level of detail and accuracy that enable decision makers to make an informed investment decision.

Developing a robust financial case is critical. If the financial benefits do not meet the criteria set by executive management, the non-financial benefits are unlikely to be considered significant.

There are two main aspects to the financial case – the projected energy savings and the cost to implement. Both of these must be calculated, validated and verified before being used to support business case.

Projected energy savings Costs of implementing the EEM

This is the reduction in operational expenses due to lower energy use. Monitoring and energy auditing may yield this information, however it should be validated by:

  • Asking all users of the planned EEM for feedback on their experiences
  • Getting an independent view from professional consultants
  • Using modeling and simulation

If there are concerns about whether the EEM will deliver the predicted results, one option is to request funds for a pilot program with a view to full-scale implementation if it demonstrates the expected outcomes.

Projected energy savings calculations also need to take into account the lifetime of an EEM – i.e. the period of time that it remains effective.

Projected costs for purchasing EEMs need to be validated based on multiple quotes for the equipment or technologies, including installation, commissioning and maintenance.

  • Source the information from multiple vendors and system installers
  • Try to ensure a turnkey basis, with one party responsible for overall successful technical implementation
  • Obtain fixed quotes to ensure exact cost is known

There are many financial tools for developing a business case, however only a few have a building energy efficiency focus. The US Environmental Protection Agency (EPA), as part of its Energy Star program, has developed the following free-to-use tools, which can be downloaded from their website:

The tools can be used as a first pass to determine the financial viability of a given EEM or opportunity. To ensure a correct financial picture, it is important to use the actual, local energy costs in the analysis rather than the default energy costs. In most cases, these tools will be sufficient for gaining the support of the management team, with more detailed analysis performed as needed.

Note: The US EPA tools listed above are for reference example purposes and are available for users of this Toolkit to trial. However, we do not necessarily endorse them and there are alternatives available.

It can be difficult to decide which financial methodology to use to evaluate a prospective investment in energy efficiency projects and what to present to senior management. Generally, Net Present Value (NPV) is the preferred method, especially for capital budgeting and investments, although some organizations use alternative methods including Simple Payback Periods (SPP), Return on Investment (ROI), and Internal Rate of Return (IRR).

Simple Payback Period (SPP)

The simplest and most familiar way to evaluate and express the financial value of such a project is the Simple Payback Period (SPP) calculation. It is defined as the expected time period required to recover an original investment. It divides the cost of a project into the cash inflows (savings) as a result of implementing the energy efficiency project over a given time period. For example, a US$5 million project generating US$1 million in cost savings revenues per year has a 5-year payback period. Studies show that the acceptable payback period for EEMs often varies from 1 to 3 years, with large firms willing to wait for longer for payback on initial investment.

Engineers, in particular, tend to prefer the use of SPP as the preferred method for evaluating the economic viability of projects, primarily due to its simplicity. However, the method is not popular from a financial management perspective because it does not account for any savings or benefits beyond the payback period, nor does it take into account the time value of money (the idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity), inflation or questions about “what if” the money was invested elsewhere.

Another shortcoming of the SPP approach is that it has no indication of the overall impact of the proposal. For example, replacing incandescent lamps with compact fluorescent (CFL) lamps would give an excellent SPP but may only have a negligible impact on the overall carbon footprint.

Thus, while SPP gives a quick and rough calculation to compare alternative EEM, it is not the preferred method used for robustly evaluating investment decisions.

Return On Investment (ROI)

Return on Investment (ROI) is defined as the ratio of benefits to the costs of a project in terms of their present value. As such, ROI is a measure of the savings a project delivers for the time period that the project and its measures are in place. It is an improvement over SPP as it accounts for savings resulting from a project, even after the initial investment has been recovered.

An ROI above one indicates that the project benefits outweigh the costs, but an ROI of less than one indicates that the project‘s costs exceed the benefits. Similar to SPP, the main disadvantage of using ROI is that it does not consider the time value of money.

Net Present Value (NPV)

The Net Present Value (NPV) of a project is defined as the sum of discounted cash flows (DCF) resulting from a project over its anticipated lifetime. Since the value of future savings are discounted, calculations of NPV acknowledge that savings in the long-term are likely to be worth less than those in the short-term. This overcomes some of the shortcomings of the SPP and ROI methods, which do not capture the time value of money or illustrate how the proposed project compares with other possible investments.

NPV can be illustrated by considering money deposited in a savings account in a bank. Given that the bank will pay interest on the amount saved, any amount of money is worth more the sooner it is invested. For example, assuming a 5% interest rate, $100 invested today will be worth $105 in one year. Conversely – and importantly for NPV – $100 received one year from now is in effect only worth $95.24 today.

The DCF in one future period is calculated by dividing cash flow by (1+k)t, where k is the interest or discount rate (i.e. the rate at which money changes in value) and t is the year. The sum of DCF at the end of the project lifetime provides the NPV.

NPV is advocated as a more appropriate value mechanism for EEMs1 because it takes into account the length of time a company can expect to benefit from savings, and discounts it back at market rates of return to arrive at an appropriate value, or cost, of the investment. If the cost is more than the NPV, then the decision is clear – it will not be providing a positive financial outcome, so the project should not be undertaken. The key inputs are the same as for calculating ROI and SPP, however the method uses Discounted Cash Flow (DCF) to establish the ‘true’ level of return from investment.

NPV is typically preferable to discounted payback period (DPP) because it evaluates the overall value of a project. By contrast, DPP gives the number of years it takes to break even from undertaking the initial expenditure.

The key advantage of NPV is that it allows for an easy decision-rule for accepting projects:

  • A positive NPV means that the project has returns exceeding the initial investment and promotes financial profitability for the organization. The higher the NPV, better the financial return on that project.
  • A negative NPV indicates the project is expected to lose money.
  • A NPV of zero means that the project is expected to be cost neutral.

Example scenario 1

The following hypothetical and simple scenario illustrates the differences between financial methods.

Project A will save US$ 50,000 a year for three years, while Project B saves US$ 45,000 per year but the savings will last five years. Both projects cost US$ 100,000 to implement.

Project A Y0 Y1 Y2 Y3 Y4 Y5
Cost of project $100,000          
Savings   $50,000 $50,000 $50,000    
Cash flow -$100,000 $50,000 $50,000 $50,000    
Project B Y0 Y1 Y2 Y3 Y4 Y5
Cost of project -$100,000          
Savings   $45,000 $45,000 $45,000 $45,000 $45,000
Cash flow -$100,000 $45,000 $45,000 $45,000 $45,000 $45,000

SPP is calculated by dividing the initial project cost by the annual savings, giving in effect the time period after which the original investment of $100,000 will be recovered:

  • Project A has an SPP of 100,000/50,000 = 2.0 years
  • Project B has an SPP of 100,000/45,000 = 2.2 years.

Based on SPP alone, Project A appears to be a better investment than Project B. However, Project B has a total return of $125,000 over its five year lifetime, compared to the total return of $50,000 from Project A over three years – this is not reflected by the SPP calculation.

ROI does take into account total return. It is calculated by dividing the total savings by the initial investment:

  • Project A has a ROI of 150,000/100,000 = 1.5
  • Project B has a ROI of 225,000/100,000 = 2.25

Unlike both these methods, NPV also takes into account the time value of money for each future year, as shown below and assuming a constant interest/discount rate of 5%.

Project A Y0 Y1 Y2 Y3 Y4 Y5
Cash flow -$100,000 %50,000 $50,000 $50,000    
Interest/discount rate   0.95 0.91 0.86    
DCF -$100,000 $47,619 $45,351 $43,192    
Cumulative DCF -$100,000 -$52,381 -$7,029 $36,162    
Project B Y0 Y1 Y2 Y3 Y4 Y5
Cash flow -$100,000 $45,000 $45,000 $45,000 $45,000 $45,000
Interest/discount rate   0.95 0.91 0.86 0.82 0.78
DCF -$100,000 $42,857 $40,816 $38,873 $37,022 $35,259
Cumulative DCF -$100,000 -$57,143 -$16,327 $22,546 $59,568 $94,826

The NPV of Project A and B can be calculated by summing the DCF for each future period:

  • Project A has an NPV of $36,162
  • Project B has an NPV of $94,826

Example scenario 2

In practice, the financial costs and savings associated with any potential EEM are likely to be complex, with multiple factors influencing the profitability such as:

  • Ongoing running costs (for example the use of a heat recovery system may need additional pumps and therefore more electrical energy)
  • Maintenance costs
  • Potential additional savings in the first year (Year 0)
  • Fluctuating energy prices (due to supply constraints, inflation, market dynamics, etc.)
  • Varying tax regimes or subsidies associated with energy efficiency or GHG emissions

The following scenario provides a more realistic view of how the financial evaluation of an EEM might proceed:

Project Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Initial Cost $10,000          
Maintenance   -$500 -$750 -$1,500 -$750 -$750
Additional Electrical Power -$100 -$250 -$300 -$360 -$432 -$518
Savings $2,000 $5,000 $6,000 $7,200 $8,640 $10,368
Cash flow -$8,100 $4,250 $4,950 $5,340 $7,458 $9,100
Interest/discount rate 1.00 0.81 0.66 0.53 0.43 0.35
DCF -$8,100 $3,445 $3,253 $2,845 $3,221 $3,185
Cumulative DCF -$8,100 -$4,655 -$1,402 $1,443 $4,664 $7,849 (NPV)

In this scenario, the following aspects are covered:

  • Some savings in the year of implementation;
  • Variable maintenance costs vary, peaking in the third year;
  • Some additional electrical energy costs due to the EEM measure;
  • Energy costs that increase at a rate of 20% per year (accounting for inflation);
  • Estimation of the cash flow and discounted cash flow (DCF) for each year; and
  • Inclusion of cumulative DCF to give a Net Present Value (NPV) of the EEM of $7,849 after five years.

Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is the interest or discount rate that will give a NPV of zero for any given EEM. This means that it is the interest or discount rate that balances the present value of a cash investment to the present value of its expected future costs and savings. The benefit of calculating the IRR is that it can be compared to an organization’s cost of capital or other internal metrics established by the finance department. If the IRR of a project is greater than the organization’s cost of capital, it would indicate that the project would have positive financial impact.

References

1 Matthew Armstrong, 2012. ‘A Thorny Problem: How Exactly Do You Measure the Benefits of an ECM?’. Available online