How to Present Energy Projects to Investors: Why Payback Period Doesn’t Cut It
Over the course of my career evaluating energy efficiency and renewable energy projects, I have continuously come across projects that do not present cost effectiveness as an investment. This often results in great projects being ignored as decision makers are not presented with the right information. Learning how to present energy projects to decision makers and investors is key to project success.
To develop a project, an energy engineer carries out detailed energy assessments, builds out complex calculations to determine energy baselines of buildings or facilities, evaluates a variety of alternative operations and equipment, establishes costs of identified alternatives, and calculates the energy impact of each measure. Depending on the project scale, this process can take months and requires engineering expertise of energy systems and a site-specific understanding of customer operations. After spending considerable resources evaluating these projects however, reports often limit their financial analysis to the most common metric: the simple payback period.
The simple payback is the net measure cost divided by the annual savings and will tell a customer how long it will take to recuperate their investment. It is easy to understand, but it measures time, not profitability. It does not take into consideration the effective useful life of the equipment, the time value of money, the benefits accrued beyond the payback period, nor does it enable an investor to consider the project compared to alternative investments.
For this reason, an executive order in California requires that all state agencies employ full Life Cycle Cost Accounting in all infrastructure projects. Life cycle cost analysis (LCCA) accounts for all costs related to construction, operation, maintenance, and disposal at the end of the useful life of a structure. Its purpose is to provide a basis for selection of the most cost-effective design alternative over a particular time frame, considering anticipated future costs as well as initial costs of construction.
This is a great metric to compare the total cost of ownership of two or more similar projects. For anyone operating infrastructure, this is a crucial analysis necessary to plan over the long term. For energy investments in infrastructure however, it continues to fall short on evaluating profitability or the discount rate on the invested funds.
For this reason, Lincus has developed a cash-flow tool which incorporates LCCA, Net Present Value (NPV), and Internal Rate of Return (IRR). The NPV evaluates how much value a project will add to the organization. It captures the full returns over a project’s lifetime and reflects risk taken by incorporating the time-value of money. The IRR establishes the discount rate at which an investment’s future returns break even with the initial outlay. This enables the decision maker to compare the investment to the rate of return of alternative investments. Together, this analysis provides decision makers with all the tools they need to make an investment decision.