From Simple Payback to Shared Savings: Turning Project Risk Assessment on Its Head
Early on at business schools, future Chief Financial Officers are trained to evaluate projects by calculating the simple payback period of investments. The payback period of an investment is the timeframe within which the cash flow (additional revenue, savings) from the investment pays for the investment. Smaller payback periods are better than longer ones. The theory goes as follows: Over a longer timeframe, there are more things that can go wrong, including the producing power of the investment. This uncertainty is responsible for the increased risk, and CFOs by nature are responsible for evaluating and mitigating financial risks in the business. It is with this lens that CFOs have been evaluating the capital projects that promise and deliver energy cost savings.
We’ve talked to decision makers (especially in the private sector) who have discussed their investment criteria with us. Projects with a payback of less than one year are typically approved and funded from operational budgets. Projects with a payback of less than 4 years are typically approved and are funded through capital budgets. However, anything longer than 3-4 years is considered too risky. These projects are mostly approved when the equipment has failed or is about to fail, i.e. asset renewal drives these investments.
The proof is in the pudding. Just take a look at the fact that the largest percentage of approved projects fall within the lighting and controls projects category. Relatively low investments (less than $200,000) and savings that are easy to estimate, measure and verify characterize these projects. More importantly, these projects have a relatively short payback period and therefore a perception of low overall risk.
Over the last 10 years, a new model of evaluating risk is taking shape in this industry, originating from the solar industry, and that is Shared Savings. The Power Purchase Agreement (PPA) typifies this model. In the PPA model, the buyer does not take ownership of the solar equipment and only pays for the benefit of the investment as the benefit is delivered. As a result, the buyer participates in the upside (buys electricity generated from solar at a reduced rate), can offload the downside risk to parties who are better able to address these (the solar service provider maintains the equipment), does not have to put up any upfront cash (the buyer is buying ongoing electricity instead of the solar equipment), does not have to put anything on their balance sheet (the purchase of electricity is an operational expense while the equipment is financed and owned by a 3rd party financier) and is shielded from the increase in the price of electricity (the purchasing agreements are long term contracts with a minimal escalation rate for electricity). This is a new model for evaluating and mitigating performance risk. Under this model, the payback period is largely immaterial and as a result, investments, which were previously being rejected, are now getting broad acceptance.
A very similar transformation is taking place in the energy efficiency world, led through an innovative financing structure called a Shared Savings Agreement. Under this agreement buyers, instead of buying energy efficiency equipment, purchase savings of energy efficiency. For example, on one end, if there is an opportunity to avoid $100 in energy cost through an investment, the buyer is paying $80 for it, thereby saving themselves effectively $20, without putting any upfront money. On the other end, if no savings are realized, the worst the buyer does is that it continues to pay $100 in energy costs. Under this arrangement, the buyer participates in the upside (the buyer takes a share of the avoided costs), can offload the downside risk to parties who are better able to address these (the vendor has an ongoing O&M obligation for the equipment and a financial interest in the savings), does not have to put up any upfront cash (the buyer is buying ongoing savings instead of the retrofit equipment), does not have to put anything on their balance sheet (the purchase of electricity is a operational expense while the equipment is financed and owned by a 3rd party financier) and is not only shielded but benefits from any future increase in utility prices (higher utility rates lead to higher avoided costs).
Like the solar PPA, this Shared Savings Agreement is a quantum step forward in the way CFOs evaluate and mitigate risks associated with investments. Under this model, the payback periods are irrelevant. What matters is the vendor’s historical track record in their ability to deliver savings to their clients. This model allows the Chief Financial Officer/Chief Sustainability Officer to consider deeper retrofits that promise larger savings. With this, CFOs can deliver bottom line savings without allocating funds from their capital budgets or be restricted by them, resulting in higher asset values, higher EBITA margins and increases in earnings per share.
Aditya Rustgi is director of product management for Noesis Energy, which introduced the Shared Savings Agreement financing structure.
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