Appendix 2 Investing in Energy Efficiency

Investing in Energy Efficiency Introduction

Section 2.6 of this manual has some introductory material on investment in energy efficiency including the purpose of financial appraisal and key steps in appraisal. This Appendix provides information on key appraisal methods and a tool to evaluate an organisations current practice in investment - the Financial Energy Management Matrix. For further information on this subject see SEIs manual Investing in Energy: A Practical Guide to Preparing and Presenting Energy Investment Proposals. It was published in 2004 by SEI and is available free of charge and can be downloaded from SEIs website www.sei.ie.

Undiscounted Appraisal Methods

Before any method of appraisal can be applied, it is necessary to identify the energy saving opportunities and gather all the appropriate information. All the costs and benefits must be established and the time period over which this will occur. This will yield the cash flow for the project and help to build the case. Simple Payback is the simplest method of evaluation but also the crudest and it can be misleading. If we take the following project (Project X) where a 10,000 investment is made today (Year 0) with savings of 5,000 per year achieved over 3 years. Year 0 1 2 3 Capital Cost () (10,000) Savings () 5,000 5,000 5,000

Payback is defined as the capital cost divided by the annual savings. Payback (Years) Payback = = Capital Cost Annual Savings 10,000 = 2.0 years 5,000

Advantages of Payback: Payback is simple to calculate, easy to understand, is expressed in tangible terms (years). Also, it does not require any assumptions about the project lifetime or interest rates. Disadvantages of Payback: Payback has the disadvantage of not taking into account savings achieved after the payback period. Also the time value of money is ignored (e.g. 5,000 saved in 3 years time is worth less than 5,000 saved today). Finally, at the end of the project life no account is taken of any residual capital asset value. Payback simply indicates the time when the cashflow becomes positive.

However, in many organisations payback is used as a method of filtering out good from poor projects. This can lead to serious errors. For example if faced with following choice between Project X and Project Y. Project X Capital Annual savings Payback Project Life 10,000 5,000 2 years 3 years Project Y 10,000 4,500 2.2 years 10 years

If the investment sum available is limited to 10,000, a choice must be made. On a simple payback basis the choice is Project X. However, if the life of both projects is taken into account: then Project Y will clearly be more attractive than Project X over a 10 year period, because a considerable amount of savings are made after the payback period.

Discounted Appraisal Methods

Discounted evaluation methods take into account the time value of money, life of the project, interest rates and other factors. A key purpose of discounting is to take into account that the value of a sum to be received next year is less than the value of the same sum received today. For example, if 935 were deposited in a bank at an interest rate of 7%, one year from now the value would be 1000. This is calculated from a compound interest formula: S A S r So = = = = A (1+r) initial sum sum accumulated after n years interest rate

S = 935 (1+0.07)1 = 1000

If we have an energy saving project which delivers savings of 1000 one year from now it is helpful to know what they would be worth in todays money. This can be done by rearranging the above formula to: A A r S = = = = S (1+r) todays (present) value of received in n years time discount rate forecast savings in year n

So if a project delivers 1000 saving a year from now, then at a discount rate of 7% then it is worth in todays money:

1000 (1+0.07)1

935

Compounding 7%

Present 935 Discounting 7%

Future 1000

The purpose of discounting future savings in each year in the project life is to get all the savings assembled in a common time currency of todays value or present value. When added together they represent the gross present value. If the capital cost is deducted we have the net present value or NPV. If we return to Projects X and Y and using a nominal discount rate of 13% we can calculate the NPV of each project: Project X Year Capital Expenditure (10,000) Savings Discount Factor at 13% Discount Rate 1.0 0.885 0.783 0.693 Net Present Value Present Value

0 1 2 3

5000 5000 5000

(10,000) 4425 3915 3465 1805

Project Y Year Capital Expenditure (10,000) Savings Discount Factor at 13% Discount Rate 1.0 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295 Net Present Value Present Value

0 1 2 3 4 5 6 7 8 9 10

4500 4500 4500 4500 4500 4500 4500 4500 4500 4500

(10,000) 3982 3523 3118 2758 2443 2160 1912 1692 1498 1327 14,413

The Net Present Value is a financial measure of particular interest to financial managers. It tells them what the project will earn over its costs in todays money over its expected lifetime. The NPV of a project should be positive to be a viable option. In comparing Project X with Project Y, then Project Y gives a much greater NPV and therefore is more attractive. A key issue to consider is the risk that the life of Project Y is significantly longer (i.e. 10 years) and the building may be refurbished, sold or demolished during this 10 year period. Selecting Discount Rates: The appropriate discount rate can be shown, from the application of more advanced financial theory, to be the cost of capital, i.e. interest which has to be paid on acquiring the capital to invest in the project. This idea is comparatively new and over some years use of the phrase cost of capital has been displacing the term discount rate. Public sector bodies often use a fixed discount rate. In the private sector it is worth asking the finance/accounting department what discount rates they use for NPV calculations. Internal Rate of Return: If we take Project X and keep repeating the calculation using higher discount rates the Net Present Value decreases and passes zero to become a negative number. This occurs between 23% and 24% discount rate. The discount rate which yields an NPV = 0 is significant. It defines the Internal Rate of Return.

+ 25 + 20

Net Present Value

+ 15 + 10 + 5 21% Discount Rate - 5 - 10 - 15 - 20 - 25 22% 23% IRR = 23.3% 24% 25%

DR 22% 23% 24% 25%

NPV + 21.50 + 5.50 - 10.00 - 24.00

Internal Rate of Return (IRR) is defined as the discount rate at which the Net Present Value reduces to zero. It is often used as a financial yardstick in organisations with no particular policy on discount rates, in which case it is not possible to calculate NPVs. The Internal Rate of Return is significant in that it roughly represents the rate of return money would have to earn in the organisation or externally to be a better investment. The higher the IRR the better. IRRs allow projects or investments to be compared. The IRR can be compared with the current interest rate for borrowing the capital required. If the IRR is lower than this interest rate, the project would loose money if it was financed by borrowing. If the IRR is greater than the cost of borrowing the capital, the project will generate enough income to repay the loan and still provide profit.

Sensitivity Analysis In evaluating a project, some of the quantitative aspects of the project may not be known initially and therefore are assumed or estimated. Sensitivity analysis is the process by which these estimates are tested to determine what impact they may have on the value of a project. For example for Project Y if the project life and discount rate remain fixed but the capital costs and the annual savings varied it is possible to see the impact of the changes in the NPV. Project Y Capital 10000 15000 10000 15000 Annual Savings 4500 4500 4000 4000 Project Life (years) 10 10 10 10 13% 13% 13% 13% 14413 9410 11700 6700 Discount Rate NPV

By varying key parameters it is possible to test the sensitivity of the project. It is likely that decision makers will ask questions about sensitivity, e.g. What happens to the NPV if the price of gas increases by 15%? It is well worth anticipating questions and possibly pre-empting them during a written or verbal presentation to show to the decision-makers that you are aware of the impact on the project by variations in key parameters.

Selecting Discount Rates In the private sector it is important to ask the finance department or accounts what discount rate should be used for NPV calculations. The rate will vary from company to company depending on their financial situation, how cash rich the company is, the cost of borrowing and assets and liabilities. Typically discount rates are between 6 and 12%. In the public sector a test discount is usually used and this tends to be fixed for long periods typically at 6%