So you want to save money? Invest in some energy efficiency retrofits? Be careful how you run the numbers or you might not get the best return on your investment. All too often we see retrofit decisions put back on the shelf when they fail the in-house payback hurdle. Herein lies financial opportunity.
Why payback can be underwhelming
Analyzing an investment in energy efficiency involves quantifying the amount of incremental capital required, and the value of the assumed energy savings. The payback analysis simply establishes the time period for recovering the capital investment—it doesn’t take into account the time value of money or the actual life of the equipment.
More importantly, it precludes comparison with other corporate investment choices that need to be made on an ongoing basis, such as production process improvements, which typically use more sophisticated metrics.
The one thing that can be said in favour of the payback metric is it’s easy to understand. On the downside, it typically leads to the decision not to proceed (it doesn’t appear to grasp the concept that energy savings can more than pay for the underlying equipment). So much for your savings.
ROI is misleading too
While return on investment (ROI) may look like an improvement as a financial metric—it takes into account the life of the equipment—it still doesn’t deal with the time value of money (nor for the purist, the benefits of compound interest). Without a steady cash flow stream, it will produce misleading results and again, it doesn’t allow for effective comparative investment decisions.
IRR is getting there
Internal rate of return (IRR) on the other hand, allows for the evaluation of overall profitability of the investment decision and is the only metric that allows for direct comparison with other internal investment decisions. IRR is the measurement tool most widely used by financial professionals.
Basically, it means the interest rate at which the net present value of cash flow (both positive and negative) equals zero. In more practical terms it’s used to evaluate the attractiveness of an investment. If the IRR of a new project exceeds a company’s ‘hurdle rate’ or rate of return, the project will be viewed favorably.
But it’s not the best metric where there are multiple investment choices, all of which achieve the necessary IRR. Why? Because IRR can’t reflect the relative size of investments and the related energy savings.
Add in NPV
The winning formula is a combination that starts with IRR. After running IRR computations to assess retrofit project compliance with your company’s hurdle rate, the last set of financial metrics is the net present value (NPV). This is actually the best method for evaluating or prioritizing a number of projects, with one caveat: it requires commitment to an appropriate discount rate. This is the rate financial staff will use to compute the present values in NPV.
While this should reflect the known cost of capital to your company, this is often a “plug” number, the choice of which can lead to inappropriate conclusions. Assuming an effective discount rate choice, running the NPV computations on those retrofit projects that achieve sufficient IRR should deliver the road map to optimizing your savings.
Don’t use these metrics to simply identify and fund only the lowest-hanging fruit. You’ll only be throttling the full range of savings, short and long term, that a more holistic retrofit program can deliver.
To learn more about calculating return on investment, check out this financial dictionary.
Tom Routley is a sustainability financing strategist with Leapfrog Sustainability Inc. in Toronto. He has more than 30 years of experience in the financial services sector, having raised over $5 billion in structured financing. He can be reached at firstname.lastname@example.org