Thursday, January 16, 2014

How to make the financial case for sustainability

Barriers are often found to the implementation of sustainability measures in persuading senior management to make investments and commit to projects. These can include a lack of understanding, conflicting priorities, misaligned financial incentives, hassle cost and lack of financial backing. Managers fighting for sustainability have to master successful tactics to overcome them. Here are a couple of ways of presenting and comparing the financial case for different measures.

Marginal abatement cost curves

A marginal abatement cost curve (MACC) is a helpful, visual aid to providing an idea of the annual potential to reduce emissions and the average costs of doing so for a wide variety of technologies. We first met them in the Introduction. MACCs are a useful tool for cost-effectiveness analysis. But how are they compiled?

In Britain, the Committee on Climate Change (CCC) has produced several MACCs for energy efficiency that incorporate research generated by three other important models:

BREDEM (the Building Research Establishment’s Domestic Energy Model);

N-DEEM (the Non-Domestic buildings Energy and Emissions Model), which is based on detailed assessments of energy use in around 700 buildings, since they are extremely diverse in nature; and

ENUSIM (the Industrial Energy End Use Simulation Model), originally designed to model industrial energy use by considering the take up of energy saving technologies in industry.

Source: CCC A marginal abatement cost curve (MACC) illustrating the technical potential for improvements in the non—domestic sector. Each column represents a particular measure. The vertical axis represents the cost per megaton of carbon dioxide saved. The horizontal axis represents megatons of carbon dioxide saved throughout the lifetime of the measure. Measures to be taken on the left of the graph with columns descending beneath the horizontal axis have a negative cost; i.e., they save money. The ones on the right with columns are sending above the horizontal axis have a net cost; i.e., they cost more than they save. The further right that a measure is positioned, the greater its lifetime cost. All energy management measures have a negative cost and save money, as do many efficient heating and cooling methods.

The MACC for the non-domestic sector is illustrated above. The CCC concludes that, for the UK as a whole, there is “a very significant contribution from improved energy management. These measures include turning monitors off at night, adjusting heating times or adding improved controls to lighting. These measures are almost entirely low cost measures with the potential to save over £800m countrywide per year for firms with very little (if any) up front expenditure. They could save over 8 MtCO₂ per year. “

Source: CCC A marginal abatement cost curve (MACC) illustrating the potential for CHP (combined heat and power) in different sectors. It shows that even within a sector, whether is a particular project is cost-effective depends on individual conditions. This is why, for each sector, there are different instances (illustrated by columns of the same colour), some of which are above the line (net cost) and some below the line (net benefit).

Estimating payback

MACCs are arrived at by calculating the payback for various measures. Projects are usually sold to management on the basis of return on investment. This can be expressed in two ways: as an effective interest rate, based on the net present value; and as a payback period, i.e. the length of time it takes for the initial investment to be recouped by the savings earned or income generated.

Simple payback

The most basic of these is simple payback. However, it does not always illustrate the true benefits of an investment. Suppose an organisation demands a two-year payback period from any investment. Then, as the following example shows, it would miss out on the benefits of a project with a six-year payback period that actually had a better return on investment.

A project costing £60,000 which receives £30,000 in benefit per year following completion but which only lasts for three years would yield a total of £90,000. A project which costs the same amount, but only yields £22,000 per year, yet lasts for six years would give a total of £132,000. However if it were only evaluated on a two-year basis, it would lose out to the three-year project.

A project which repays its cost every three years is demonstrably better than one which promises to return the investment in three years. To help establish this, the concept of Discounted Cash Flow is introduced.

Discounted Cash Flow (DCF)

Discounted Cash Flow provides a more realistic way of establishing payback. There are three stages for estimating DCF:

Estimate the resulting cash flow;

Apply the discount rate;

Calculate the end value (net present value).

The cash flow is taken from the estimated savings in energy cost resulting from the measure taken. This will depend upon projections of future energy cost. For example, energy prices over the last three years can be projected on a median basis into the future. But this will then need to be discounted at a discount rate to be chosen. Discount rates are a function of the rate of inflation and represent what one unit of currency will be worth in a year's or 10 years' time. An average price [P] is calculated this way for each year of the projected lifetime [L] of the project. Each of these figures is then multiplied by the amount of energy [E] expected to be saved every year.

The lifetime period chosen for the project will depend upon the expected lifetime of the technology. If it were a boiler, for example, it could be 15 years. Should it be an insulation measure, it could be 30 years. The total cost savings [S] generated by energy not used compared to not doing the project, over the lifetime of the project will then be:

S = E x [P_{(year 1)}] + E x [P_{(year 2)}] + E x [P_{(year 3)}] ... E x [P_{(year L)}]

What discount rate should be chosen? The industrial model ENUSIM uses private fuel prices and a 10% discount rate to reflect the incentives faced by firms. Some UK organisations adopt the rate used in the UK government Treasury's Green Book, that sets out the framework for the evaluation of all policies and projects, which is 3.5%. Others simply adopt the current rate of inflation, or interest rate on a loan taken out for the purpose of the measure that would need to be repaid. It is useful to run the calculation several times with different discount rates.

Net Present Value (NPV)

The figure for the total cost savings, [S], is not the final step in our calculation. We now need to deduct the cost [C] of taking the measure, which gives us a figure called the net present value [NPV] of the project. This is the value in today's money of all of the net profit that will be generated from taking this measure. It is the most useful way of comparing the value of different measures. It takes account of the full value of the project and presents it in easily comparable form. The net present value is therefore:

NPV = S - C

This is how all of the figures were arrived at that are represented in the MACC graphs above. Applying this to the two projects above, with a 10% discount rate, lets us see the following:

Project 1 yields:

£30,000 (year 1) + £27,000 (year 2) + £24,300 (year 3) = £81,300, not £90,000

Project 2 yields:

£22,000 (year 1) + £19,800 (year 2) + £17,820 (year 3) + £16,038 (year 4) + 14,434.20 (year 5) + £12,990.78 (year 6) = £103,082.98, not £132,000

Both projects cost the same, £60,000. Subtracting this from the cost savings reveals that the NPV of the first is just £21,300, while that of the second is £43,082.98, over double.

Internal rate of return (IRR)

The NPV can also let the projects be compared to what would happen to the same amount of money were it to be invested in a bank account with the same interest rate as the discount rate chosen. This is done by calculating the internal rate of return (IRR), or the interest rate on the investment, and is easily accomplished using Microsoft Excel as follows (and the figure below):

The initial expenditure is typed into a cell on a spreadsheet. This must be a negative number. Using our original example, –60,000 would be typed into the A1 cell;

The subsequent discounted cash return figures above for each year are entered into the cells directly under the first one. Following the example in Project 1, this would mean typing 30,000 into cell A2, 27,000 into cell A3, etc.;

The IRR is then revealed by typing into the next cell beneath all the values the function command "=IRR(A1:A4)" and pressing the enter key. In this case, the IRR value, 18%, is then displayed in that cell.

Using Microsoft Excel to calculate the internal rate of return of an investment. The formula in the field at the top is entered into cell A5 and yields the percentage rate based on the figures above.

The IRR of the second project, calculated by the same method, is 20%, and so provides a better rate of return. It is relatively easy to set up a template in Microsoft Excel to enable the performance of a similar calculation for any capital investment project. Further costs that are unique in any given year can be added, such as figures for additional maintenance, additions or repairs, and, at the end of the project, a figure for resale of any equipment, for example its scrap value.

Presenting projects in such a way to senior management will allow them to compare their value with other projects they may be considering, as well as enabling the energy manager herself or himself to prioritise projects.

This article is an extract from my new book, the Earthscan Expert Guide to Energy Management in Buildings published this month by Earthscan. This comprehensive book covers how to: