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Nov 05 2020

Net Present Value – Business Energy Savings over Time

In commercial buildings, there are always repairs and maintenance to be done, from the biggest manufacturer to the smallest retail shop.  Municipal buildings can be very similar in usage, although quite different in how they make decisions on capital improvements.   

Investment in a building is no different than a home, but the scale is much larger and complex, especially in terms of energy efficiency.  This is due to the heavy usage and hours of commercial buildings vs residential.  To put this in perspective, a typical high bay fixture uses more energy than the lighting of an entire home – and the hours are much greater.

For the past 10 years, I have run a business focused on helping businesses reduce their energy usage.  We have several key client segments that are really interesting, since they are typically longer term in thinking and are able to think about longer term investments. These building types include fire stations, libraries, and McDonalds – about as safe as you can have in terms of a future need for that building in the future.  

Our commercial customers typically want to see a “payback” or ROI of 2 years or less.  These terms are used interchangeably, although they have a wildly different meaning in finance.  As of late, I have been exploring the net present value of energy efficiency investment to help our clients look longer term. 

Payback for Energy Savings

Payback can be the easiest to understand, and is simply the energy savings per year divided by the investment.  If the investment is $2,000 and the savings is $1000, the payback on an energy efficiency investment is 2 years.  

Our business is located in Illinois, and we are fortunate to have an incredible utility incentive system.  For that reason, we can often find greater impact projects that normally would have a 8-10 year payback, and bring it back within a clients expectations of within 2 years.  Each client is different – so we always ask what they consider a good investment payback range.

Return on Investment for Energy Savings

This is a different term, but often gets used interchangeably.  Another way to look at energy efficiency investment is to think, “What else would the business or community do with this money?”

In the same $2,000 investment above with $1000 of annual savings, that would be a 50% Return on Investment. I often ask business owners – what else could you do with your money that would return 50% a year as long as you operate this building?  

Even a $5,000 investment that returned $1000 of annual savings would bring a 20% return on investment.  An, in fact, the original $5,000 likely improves the value of the building.  And again, I ask owners if you were to invest $5,000 into the stock market and it returned 20% a year for the next 10 years, how would you feel about that?  Why do you evaluate this investment differently than others?

Net Present Value for Energy Savings

When you look at projects that are more complex, like Solar PV, Heating and Ventilation improvements, or advanced sensor and control systems, you likely need to go past 2 years to evaluate a return on investment or ROI.  For example, when moving into a new building for a warehouse, a business often will have a 10 lease.  Investments in HVAC equipment or lighting systems can make sense with a short term return, but they often lead to longer term savings with advanced considerations.  Net present value is a tool that helps people consider this.

Net present value is not just adding up 10 years of savings, as would be the logical way to do it.  And doing that is not necessarily the wrong way to to do it, but it is a stagnant way of looking at savings in the future.  NPV is a way to account for what else you would do with that money, or better said, discounting the future savings to account for inflation.  

The exact formula is as follows, and basically any investment smaller than the net present value of a project checks the box of cost effectiveness.  It is confusing, and there will  not be a test at the end of this.  However, it basically means that if a business is saving $500 per year in an investment, you would discount each additional year a slightly greater amount to reflect the lower value of today.

net  present value savings formula

Fortunately, the formula in excel is much easier.  NPV =(3.75%,savings first year:savings last year) with 3.75 as the discount rate and then the summary of the years of savings. In excel, it calculates the t or time period for you based on the number of years of savings in your list of years.  

Below is an example, where the savings are $1,000 per year on an efficiency project, and the time is a 10 year lease. You can image the investment in a high efficiency water heater, HVAC system, or even advanced lighting control system that monitors and reports your energy usage.

10 year savings accouting

The net present value on System A is $8,212 and the NPV on System B is $10,676.  Let’s imagine a scenario where System A investment cost is $10,000 and System B is $10,500.  Project A is not worth doing if the building will only be occupied for 10 years, as the long term savings are less than the cost today.  However, System B has additional savings – maybe the light have a control system and claim an additional 30% saving each year, and the investment is less than the net present value of the savings.

Discount Rate for Energy Efficiency

Now the devil is in the details of this formula, especially in terms of the interest rate chosen.  I have 3.75% for mine, as that is the current rate loaned by the US government to businesses in the EIDL loan.  It is also the interest rate of our current line of credit with our bank.  The higher the interest rate, the more conservative you will find your net present value – it is counterintuitive but a lower interest rate will make the savings bigger.  

This tool can of course be used to manipulate data to make a project more appealing, like any finance tool.  But it is still worth understanding and using with projects.

Future Energy Cost Inflation

Another thing not considered in this formula is the rising costs of future energy rates.  Often, those increases in energy costs will offset the discounted future savings – so if you assume 4% increase in energy rates each year and a discount rate of 3.75% – you would actually see a higher NPV than the summary of the savings.  However, I tend to leave that off as it can get go down a rabbit hole of making a project fit into your world view.  I have seen many projects fall apart because people cannot agree on an inflation cost of energy.  In my scenario, it is conservative and hard to argue against, as long as you agree on the time period being evaluated and the savings calculated.  

 

 

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