[ Spotlight: Energy efficiency ] Take this simple (and hypothetical) example:
A capital investment of £45,000 produces a healthy energy saving of £10,000 per year, but there is a maintenance cost of £500 per year.
Payback = 45,000 (10,000 – 500)
Most clients have their own criteria for deciding whether to proceed with various investments. A payback period of three to five years is common. The example above would clearly satisfy a ‘five-year payback’ criterion. Obviously, any increase in energy price would further increase savings (compared to the cost of energy if the measures were not installed) and thus reduce the payback time. While clients cannot be expected to welcome rising energy prices, they can be a powerful and credible selling point for those who provide energy solutions. Of course, we don’t know what the future price of energy will be. ECA Today readers can insert their own educated guess here, but many might agree that an annual rise of 10 per cent is a fair working assumption. A compelling calculation is then to assess what a
10 per cent annual rise would mean to the forward cost of energy without the measures (the energy bill with no extra energy solutions), and what the bill will be if the proposed measures are installed (the new, lower figure). This gives the projected cost savings – and the more the unit price of energy rises, the bigger the savings, with all that means for payback times. (Note, too, that if an annual £10,000 energy bill rose 10 per cent every year for five years, the total bill would be more than £61,000. This can be a surprise, and is a result of compound price inflation.) Basic payback is seldom accurate, but it is
easy to calculate and it can be indicative, help with comparisons and be easily communicated. Since energy saving activity requires persuasion before installation, the power of easy financial communication should not be underestimated.
Other basic accounting methods Accountants also look for more sophisticated ways of assessing an investment, so they can be better compared against the other options for capital expenditure. Measures such as net present value (NPV) and gross present value (GPV), return on investment (ROI) and investment rate of return (IRR) are commonly used. It pays for anyone who wants to install energy efficiency measures to understand conversations with clients where these terms are used. Notable among these basic accounting methods are:
i) Gross return on capital
This is the total saving produced by a project over its lifetime. It is divided by the capital cost and then expressed as a percentage.
30 ECA Today March 2013 = 4.74 years
It is a simple tool that allows contractors and clients to communicate the cost- effectiveness of various energy solutions
ii) Net return on capital As above, but this represents the total savings, less the initial capital cost. iii)Gross average rate of return This is the return on capital, divided by the lifetime of the project iv) Net average rate of return This is the net return on capital, divided by the project lifetime.
If we take the simple ‘payback’ example (similar
to the one shown previously), and apply each of the above calculations, we get:
Year Year Year Year Year Year
0 1 2 3 4 5
Investment Savings Savings Savings Savings Savings
Total energy savings: £50,000 Less investment: Net savings:
i) Gross return on capital: £50,000 /£45,000 x 100 = 111 per cent ii) Net return on capital: £5,000 /£45,000 x 100 = 11 per cent
iii) Gross average rate of return: 111/5 = 22.2 per cent
iv) Net annual average rate of return: 11/5 = 2.2 per cent
However, notably due to price inflation, money tends to lose value over time. Accountants like to build this effect into their calculations. The decrease in the value of money over time is the ‘discount’, and you may hear of accountants, banks and the government talking about the ‘discount’ rate. The discount rate for calculations is specified by the Treasury in the case of public works, and by accountancy staff in private organisations (so there can be numerous commercial rates). The discount rate is used to calculate the following:
About the authors
Paul Reeve CEnv is the ECA’s head of Business Policy and Practice. Bill Wright is the ECA’s head of Energy Solutions.
i) Gross present value The gross present value (GPV) or present value (PV) includes all cash flows excluding initial cash flows (such as the cost of the asset). ii) Net present value The net present value (NPV) includes all cash flows, including initial cash flows such as the cost of purchasing an asset. iii) Internal rate of return The Internal rate of return (IRR) is a rate of return on an investment. The IRR of an energy efficiency or microgeneration project is obtained from the discount rate that gives it a net present value of zero.
The ECA’s energy FAS deals with all these values. It
£45,000 £5,000
(£45,000) £10,000 £10,000 £10,000 £10,000 £10,000
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