EDF’s Investor Confidence Program (ICP) works with a wide range of stakeholders to develop our Energy Performance Protocols. In our discussions, the topic of cost effectiveness for building retrofits arises often as it is a hot topic in the industry. ICP has deliberately avoided taking a position on what the requirements should be for energy efficiency projects’ return on investment, as we believe that organizations and programs should align requirements with their own unique underwriting criteria and should include the host of non-energy benefits that are delivered by many energy efficiency projects.
Energy Efficiency projects have multiple benefits to building owners that often extend well beyond energy savings. ICP believes that when a building owners or investors decides to undertake a project, it is important that there is confidence that whatever savings are expected will be delivered, but that each investor can weigh the many benefits of each project and make an overall informed decision, without being required to only consider direct cost effectiveness based only on energy savings.
However, when cost effectiveness is required, for example in utility programs or other publicly funded efforts, then savings calculations should be consistent, reliable and transparent. In fact, cost effectiveness requirements are irrelevant unless unless the underlying savings benefits are real and there is a consistent and agreed to approach to calculating those results.
In any case, whether a program is requiring a specific level of cost effectiveness, or an investor or building owner is making an underwriting decision based on multiple factors, understanding and having confidence in payback is essential. The following methods represent some of the most common approaches to expressing the returns associated with energy efficiency investments.
Simple Payback
Perhaps the most commonly used metric when evaluating energy efficiency projects is the simple payback (SPB). It compares the cost of a measure relative to the annual energy savings produced by dividing the cost of the measures by the savings resulting from implementing those measures. The resulting calculation is the number of years that will be required for the measure to pay back the initial investment. Its popularity is probably due to it simplicity and how easy it is to evaluate a project’s benefits and risks. However, the other financial metrics covered below provide a more comprehensive view of financial performance as SPB does not consider the time value of money or financial benefits beyond the initial payback period.
Internal Rate of Return (IRR)
The internal rate of return (IRR) quantifies the rate of return and determines the “profitability” of a potential investment by calculating the rate at which a project’s present value of all future cash flows is equal to the initial investment – in other words the rate at which an investment breaks even. In general, the higher a project's IRR, the more desirable it is to undertake the project thus, assuming all projects require the same amount of up-front investment, the project with the highest IRR would be considered the best and undertaken first. Theoretically all projects whose IRR is higher than an organization’s cost of available capital should be undertaken. IRR provides a very easy means to compare different projects associated benefits and risks. The main drawback to using IRR is that the method does not accommodate changes to returns or to the cost of capital including those associated with inflation.
Net Present Value (NPV)
Another commonly used financial metric is net present value (NPV) which calculates future cash flows and discounts them in order to account for the time value of money. The result is the profit (or loss) over the lifetime of the project based on an organization’s blended cost of capital. This analysis incorporates inflation and other changes to cost of capital and cash flows. Since a profit/loss of zero is the “cost” of doing nothing, projects with positive NPV’s should theoretically be implemented if capital is available. In reality, capital is often less than abundant which means projects must be prioritized, and NPV does not provide as easy as a method for project comparison as IRR.
Savings to Investment Ratio (SIR)
A last method, that is used more specifically in the energy efficiency industry, is the savings to investment ratio (SIR). It is calculated by dividing the total savings over the project's expected useful life by the cost of the project. The key to this metric is that it incorporates the expected life of the measure and accounts for the benefits throughout, but not past, the expected useful life of the measure. SIR provides an easy to understand ROI metric that allows easy comparison of projects and is more useful than simple payback since it is based off the useful life of equipment. The challenge, which is not limited to this metric, is that accurately predicting the maintenance, efficiency, and obsolescence of equipment over its entire lifetime is more of art than science (See: DOE SIR Definition).
Expressing Cash Flow for Energy Efficiency
A growing number of software providers, including a number of members in ICP’s Ally Network, market applications that incorporate a comprehensive financial analysis of projects. ICP’s Project Performance Appraisal also provides a complete financial overview that automatically incorporates standardized savings calculations based on ICP the protocols which solves the “garbage in / garbage out” issue if metrics are based off of erroneous savings predictions.
While these methods focus on expressing return on investment in terms of energy savings, it is important not to limit analysis only to those financial outcomes that are directly associated with projects. Often there are non-energy benefits that affect tenant comfort, attraction, and retention that may be even more impactful. For instance, comfort issues are one of the most important factors for tenant satisfaction and there is a growing focus on utility bills as well as “green” aspects of buildings which directly impacts net operating incomes in the form of vacancies and rent rates.
Considerations should also be made according to the overall goals of the owner and the needs of the building. Before undertaking energy efficiency retrofits, the timing and incorporation of non-energy related projects should be evaluated. Would it make sense to coordinate replacement of the sprinkler system with a lighting retrofit? Are there projects that may in fact increase energy usage? Are you optimally combining comfort oriented and energy oriented measures? Have you fully considered how associated health and safety measures, such as air quality concerns or code compliance, might be related to energy efficiency upgrades? And what interaction do the proposed projects have on each other and on the building’s energy loads? Taking a comprehensive look at the project in combination with overall short and long term goals can help with the development of a robust package of measures that provides the most return on investment.
Financial metrics are a necessary tool to analyze any investments in energy efficiency regardless of whether the whether the projects make use of public programs and incentives. But hard and fast rules such as a “simple payback less than seven years” or “an SIR greater than one” can create a short-sighted view of a project’s potential. Failing to evaluate the full potential of projects in a comprehensive manner can result in missing opportunities that can increase tenant satisfaction, building value, net operating income, and energy efficiency itself.
The Investor Confidence Project's goal is to increase confidence in savings regardless of underwriting criteria or program requirements. We believe that confidence is critical to scaling up energy efficiency in all cases.
Energy Efficiency projects have multiple benefits to building owners that often extend well beyond energy savings. ICP believes that when a building owners or investors decides to undertake a project, it is important that there is confidence that whatever savings are expected will be delivered, but that each investor can weigh the many benefits of each project and make an overall informed decision, without being required to only consider direct cost effectiveness based only on energy savings.
However, when cost effectiveness is required, for example in utility programs or other publicly funded efforts, then savings calculations should be consistent, reliable and transparent. In fact, cost effectiveness requirements are irrelevant unless unless the underlying savings benefits are real and there is a consistent and agreed to approach to calculating those results.
In any case, whether a program is requiring a specific level of cost effectiveness, or an investor or building owner is making an underwriting decision based on multiple factors, understanding and having confidence in payback is essential. The following methods represent some of the most common approaches to expressing the returns associated with energy efficiency investments.
Simple Payback
Perhaps the most commonly used metric when evaluating energy efficiency projects is the simple payback (SPB). It compares the cost of a measure relative to the annual energy savings produced by dividing the cost of the measures by the savings resulting from implementing those measures. The resulting calculation is the number of years that will be required for the measure to pay back the initial investment. Its popularity is probably due to it simplicity and how easy it is to evaluate a project’s benefits and risks. However, the other financial metrics covered below provide a more comprehensive view of financial performance as SPB does not consider the time value of money or financial benefits beyond the initial payback period.
Internal Rate of Return (IRR)
The internal rate of return (IRR) quantifies the rate of return and determines the “profitability” of a potential investment by calculating the rate at which a project’s present value of all future cash flows is equal to the initial investment – in other words the rate at which an investment breaks even. In general, the higher a project's IRR, the more desirable it is to undertake the project thus, assuming all projects require the same amount of up-front investment, the project with the highest IRR would be considered the best and undertaken first. Theoretically all projects whose IRR is higher than an organization’s cost of available capital should be undertaken. IRR provides a very easy means to compare different projects associated benefits and risks. The main drawback to using IRR is that the method does not accommodate changes to returns or to the cost of capital including those associated with inflation.
Net Present Value (NPV)
Another commonly used financial metric is net present value (NPV) which calculates future cash flows and discounts them in order to account for the time value of money. The result is the profit (or loss) over the lifetime of the project based on an organization’s blended cost of capital. This analysis incorporates inflation and other changes to cost of capital and cash flows. Since a profit/loss of zero is the “cost” of doing nothing, projects with positive NPV’s should theoretically be implemented if capital is available. In reality, capital is often less than abundant which means projects must be prioritized, and NPV does not provide as easy as a method for project comparison as IRR.
Savings to Investment Ratio (SIR)
A last method, that is used more specifically in the energy efficiency industry, is the savings to investment ratio (SIR). It is calculated by dividing the total savings over the project's expected useful life by the cost of the project. The key to this metric is that it incorporates the expected life of the measure and accounts for the benefits throughout, but not past, the expected useful life of the measure. SIR provides an easy to understand ROI metric that allows easy comparison of projects and is more useful than simple payback since it is based off the useful life of equipment. The challenge, which is not limited to this metric, is that accurately predicting the maintenance, efficiency, and obsolescence of equipment over its entire lifetime is more of art than science (See: DOE SIR Definition).
Expressing Cash Flow for Energy Efficiency
A growing number of software providers, including a number of members in ICP’s Ally Network, market applications that incorporate a comprehensive financial analysis of projects. ICP’s Project Performance Appraisal also provides a complete financial overview that automatically incorporates standardized savings calculations based on ICP the protocols which solves the “garbage in / garbage out” issue if metrics are based off of erroneous savings predictions.
While these methods focus on expressing return on investment in terms of energy savings, it is important not to limit analysis only to those financial outcomes that are directly associated with projects. Often there are non-energy benefits that affect tenant comfort, attraction, and retention that may be even more impactful. For instance, comfort issues are one of the most important factors for tenant satisfaction and there is a growing focus on utility bills as well as “green” aspects of buildings which directly impacts net operating incomes in the form of vacancies and rent rates.
Considerations should also be made according to the overall goals of the owner and the needs of the building. Before undertaking energy efficiency retrofits, the timing and incorporation of non-energy related projects should be evaluated. Would it make sense to coordinate replacement of the sprinkler system with a lighting retrofit? Are there projects that may in fact increase energy usage? Are you optimally combining comfort oriented and energy oriented measures? Have you fully considered how associated health and safety measures, such as air quality concerns or code compliance, might be related to energy efficiency upgrades? And what interaction do the proposed projects have on each other and on the building’s energy loads? Taking a comprehensive look at the project in combination with overall short and long term goals can help with the development of a robust package of measures that provides the most return on investment.
Financial metrics are a necessary tool to analyze any investments in energy efficiency regardless of whether the whether the projects make use of public programs and incentives. But hard and fast rules such as a “simple payback less than seven years” or “an SIR greater than one” can create a short-sighted view of a project’s potential. Failing to evaluate the full potential of projects in a comprehensive manner can result in missing opportunities that can increase tenant satisfaction, building value, net operating income, and energy efficiency itself.
The Investor Confidence Project's goal is to increase confidence in savings regardless of underwriting criteria or program requirements. We believe that confidence is critical to scaling up energy efficiency in all cases.
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