Being fond of comfortable wool sweaters, wood fires and the notion that a little personal sacrifice could help eliminate our dependence on foreign oil, I was taken with President Carter's message. Unfortunately, President Carter's approach to energy conservation was not sustainable. You cannot heat the clean rooms in semiconductor manufacturing plants with fireplaces in the winter, nor can you cool hospital operating rooms by opening windows in the summer. Most big energy consumers -- factories, hospitals, office buildings and other commercial and industrial enterprises -- were not going to solve the energy crisis or our dependence on foreign oil by going back to a simpler time or by doing less.
We soon found out that even personal sacrifice would last only so long. Once the immediate crisis of the embargo ended, our society lost its sense of urgency about conservation. Within a few years we had discovered the joys of driving gas guzzling SUVs.
Fast forward 30 years to where we are today, the early 21st Century. Al Gore and others have focused our attention on global warming and the need to reduce carbon emissions. At the same time, we are facing another energy crisis caused by rising energy costs. Oil above $100 a barrel. Electricity rates going through the roof.
This time we are talking about energy conservation in terms of becoming more efficient. Major corporations and venture capitalists have jumped on the bandwagon, asserting that conservation is not just good for our environment, but it is also good for business. For example, the President and CEO of Wal-Mart noted in a recent interview that his company is pursuing energy efficiency because it is good business -- consistent with the company's founding principles -- to cut costs by becoming more efficient:
“We looked at what Sam Walton started and how he developed the company. It was by eliminating waste, bringing in efficiencies. And by thinking about sustainability from our standpoint, it really is about how do you take cost out, which is waste, whether it's through recycling, through less energy use in the store, through the construction techniques we're using, through the supply chain. All of those things are simply the creation of waste. We found it's consistent with the entire model we've had since Sam opened the first store.” H. Lee Scott Jr., President and CEO, Wal-Mart Stores Inc., quoted in “Waste Not”, The Wall Street Journal, March 24, 2008.
Even altruistic environmentalists have made their arguments for conservation based on what is most cost effective. For example, the Canadian Chapter of the World Wildlife Federation has focused on the cost-saving benefits of energy efficiency: “Energy efficiency investments such as building retrofits are one of the lowest-cost and most effective options for reducing greenhouse emissions.” WWF-Canada Backgrounder, March 24, 2008.
How do businesspeople determine whether energy conservation measures are "cost effective"? They simply compare the financial returns available from investments in energy conservation projects with returns available from other types of investments. This requires nothing more than an analysis of (a) how long it will take for the financial savings generated by an investment in the energy conservation project to equal the cost of that investment, known as the PayBack Period; (b) how long those financial savings will continue in the future; (c) what those savings equate to in terms of a percentage return, known as the Internal Rate of Return; and (d) an adjustment for the company's cost of capital, depreciation on any equipment that is installed as part of the conservation project, and other factors.
For example, if replacing an incandescent light bulb with a compact fluorescent bulb (CFL) costs an average of $2.00 (including labor) and will result in a reduction of $2.00 per year in the cost of electricity, then the CFL pays for itself in one year and the PayBack Period is one year. If the CFL will last 10 years, then each investment of $2.00 in CFLs today will generate financial savings of $20 over the life of each new bulb. A very rough Internal Rate of Return is close to 100% because your $2.00 investment is generating 100% return ($2.00 per year). Put another way, to match the return on your investment in CFLs, you would have to invest in something else that generated almost 100% per year.
The actual Internal Rate of Return is less than 100% because you have to factor in your cost of capital -- that is, how much did it cost you to earn or borrow the original $2.00 investment -- and other factors such as depreciation of any equipment installed as part of the conservation projects. But for our purposes, it is sufficient to understand that energy efficiency investments with one-year PayBack Periods are extraordinary investments that cannot be matched by almost any other investment, at least not without taking on much more significant risks.
The Internal Rates of Return for investments with two-year and three-year PayBack Periods are also extraordinary. If an investment pays for itself within 2 years, then it is generating financial savings equal to 50% of its cost each year. And if an investment pays for itself within 3 years, then it is generating financial savings equal to 33% of its cost each year. Depending on how long the savings will last (10, 20 years or more), the cost of the company's capital, etc., investments with two-year and three-year PayBack Periods usually will generate Internal Rates of Return in the range of 30% to 45%.
Since energy efficiency investments carry very little risk (and a lot of side benefits), any energy efficiency investment that generates an Internal Rate of Return of 30% to 45% makes good business sense. It is almost impossible to get that type of return on your investment anywhere else without taking on significant risks.
The bottom line: A CFO will almost always invest in energy efficiency projects that have PayBack Periods less than three years, because Internal Rates of Return over 30% are hard to find without taking on significant risks. And a CFO is almost compelled to invest in energy efficiency projects that have PayBack Periods in the two-year range, because low-risk Internal Rates of Return over 40% are almost impossible to find.
The Internal Rate of Return for energy efficiency investments with four-year PayBack Periods are also good. A four-year PayBack Period means the investment is generating savings equal to 25% of the investment every year. Even after discounting for cost of capital, the Internal Rate of Return should be in the 15% to 20% range. This is still very good considering the relatively low risk of energy efficiency investments compared to the types of risk that must be taken to obtain returns of 15% to 20% in other investments.
In addition, energy efficiency investments generate other types of returns that make them much more valuable than pure financial investments. These side benefits include reducing carbon emissions, generating good will as a "green" company, reducing maintenance costs on equipment that now runs more efficiently, etc.
PayBack Periods longer than four years are more difficult to justify on financial considerations alone. Depending on cost of capital, a five year PayBack Period will generate an Internal Rate of Return that often is in the same range as what the company can earn by reinvesting in its own business. The energy conservation project then starts to compete with other internal capital needs. Do we conserve energy? Or do we expand our plant so we can grow into an important new market? The energy conservation project can still win out, but not on financial considerations alone.
What are the implications when companies make their energy efficiency decisions based on Internal Rates of Return? I've already gone on too long for today, so I'll save that for another blog entry. In the meantime, I look forward to your comments and questions on this primer on the economics of energy conservation.