Replacing a HVAC system

There are key barriers often found to the implementation of energy management measures, particularly in persuading senior management to make investments and commit to projects. Here David Thorpe looks at one way of presenting and comparing the financial case.

Suppose you are a visionary in an organisation, be it a project or energy manager or a policy head, and you have an idea for a project that you know will save the organisation money over its lifetime, but which has a relatively high initial capital cost.

This is something that is common to big projects such as external insulation, upgrade of the old airconditioning system to include heat recovery and reuse, or other piece of energy-saving equipment.

Your challenge is to persuade those who hold the purse strings or other people in your organisation of the value of the project. A simple ROI (rate of return) on the investment may not be sufficient. The interest or profit on the investment depends on how the calculation of the benefits is made.

The most useful way to go about it is to begin by working out the total costs and benefits over the lifetime of the building, or over a reasonable investment period, using Discounted Cash Flow (DCF).

There are four stages:

  1. Estimate the resulting cash flow
  2. Apply the discount rate
  3. Calculate the end value (net present value)
  4. Compare it to a standard investment Internal Rate of Return

1. Cash flow

The cash flow is taken from the estimated savings in energy cost resulting from the measure taken. This will depend on projections of future energy cost. For example, energy prices over the last three years can be projected on a median basis into the future. You might also factor in external savings on factors such as workers’ days off due to ill health saved by a measure that will improve their health, or credits for reducing greenhouse gas emissions.

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 on 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)]

2. Apply the discount rate

The chosen discount rate is subjective. The UK industrial model ENUSIM uses private fuel prices and a 10 per cent discount rate to reflect the incentives faced by firms. Some organisations adopt the rate used in their government’s modelling. Others 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.

If a discount rate of 3.5 per cent a year is chosen, this implies that it values $1 today equally with the certainty of $1.035 in a year’s time; or that $1 in a year’s time is worth only 96.62c now, because 1/1.035 equals 0.9662. The 96.62c figure is called the Present Value (PV) of the $1, and the 0.9662 figure is the relevant “discount factor”. You conduct discounting at annual intervals.

It is useful to run the calculation several times with different discount rates. Here is a useful table of discount factors at one per cent to 10 per cent over 30 years.

3. Calculate the Net Present Value (NPV)

From the figure for the total cost savings, (S), is deducted the discounted cost (C) of taking the measure, which gives us the net present value (NPV) of the project, representing the value in today’s money of all of the net profit that will be generated in the future from taking this measure.

NPV = S – C

This is the most useful way of comparing the value of different measures because it accounts for the full value of the project and presents it in easily comparable form.

4. Compare the internal rate of return (IRR)

The NPV lets 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, by calculating the internal rate of return (IRR). Using Microsoft Excel (and the figure below):

  1. Type the initial expenditure into a cell as a negative number
  2. Enter the subsequent discounted cash return figures for each year into the cells beneath this
  3. Reveal the IRR by typing into the next cell beneath all the values the function command “= IRR (A1:A4)” and pressing the enter key. In this example, the IRR value, 18 per cent, 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.

Do this for alternative investment strategies and compare.

Asset finance such as leasing and renting are other ways of offsetting risk. This might including leasing land or roof space to a local utility or energy firm to generate electricity from photovoltaic panels.

David Thorpe is an author, journalist, consultant, leader and speaker on carbon-free energy and sustainable development based in the UK. He is a patron of the One Planet Council and special consultant on Sustainable Cities Collective.

This is an edited extract from the chapter on finance from David Thorpe’s The Earthscan Expert Guide to Energy Management for Buildings.