Tuesday, November 20, 2007

Rethinking "Payback" on Energy Projects

Today’s post takes a new look at the financial criteria that businesses use for justifying energy improvements. The take-away points are these:

1. By focusing on payback, the business explicitly perceives energy cost control as a series of isolated projects as opposed to a coordinated and continuous improvement process.

2. As you will see below, "payback" is a risk management tool that is mistakenly used as a measure of profitability. Payback is severely limited in its ability to analyze investment performance.

3. Make sure that your evaluation of energy projects asks the right questions—and that you use the right tool for answering those questions.

Whenever a business invests in itself, it implies making a change. With change comes risk. Before committing money to creating change, top managers will want to know the risk of losing their investment, or at least the risk of failing to invest in more valuable alternatives. Energy investments, like all investments, put time and money at risk. Therefore, proposed energy improvements need to withstand hard scrutiny:
• What’s the value that the investment will provide?
• How quickly will the benefits become available to the business?
• What will the proposal cost?
• What’s the most that should be paid for the improvement?
• How does this investment compare with other ways to use money?

Many business decision-makers depend on "payback" as a way to evaluate proposed energy improvements. Payback, of course, is a measure that describes the number of years that it takes for an investment to "pay for itself" through the annual savings or benefits that the investment creates. Compared to more sophisticated financial measures, payback is simple to understand and calculate—perfect for "back of the envelope" analysis. But its inherent simplicity also creates problems. Payback measures are routinely (and mistakenly) used to measure profitability when thousands or even millions of dollars are at stake.

Investors use payback simply to decide whether they will accept or reject an investment proposal. The greater the investor’s concern with investment loss, the shorter the payback time demanded. For example:
• A 12-month payback is preferred to a 24 month payback, and
• A 6-month payback is preferred to a 12-month payback.

Now take this to its logical conclusion: a zero-month payback would be most preferred—because there’s no wait to get the money back! The investor is assured of avoiding loss only by making no investment at all.

Payback only indicates whether a proposal should be accepted or rejected. It reduces investment analysis to a “yes/no” decision. As a consequence, this approach reduces energy management to a stop-and-go process. The company's beleaguered energy manager has to reset his or her agenda back to zero with each project rejection.

Energy improvements need to be held to a different standard. Why? Once a business commits to operations, it commits to using energy. Understand that some portion of energy consumption is subject to waste. That portion—the energy at-risk—is an expenditure that the business is committed to make. The real question is: How much is the business willing to pay for the portion at-risk? The choice is simple: the business will either (A) continue buying the energy at-risk at the prevailing market price, or (B) implement an energy-reducing improvement when the annualized cost to save energy on a per-unit basis is less than the price to purchase it. Seen this way, energy improvements are not a yes/no choice, but a question of degree. How much do you want to pay for energy that can be avoided?



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