EBaR Energy efficiency and cash flow analysis breaks new ground by:
- Focusing on cash flow to avoid operating and CapEx budget constraints
- Applying risk management analysis to ensure that actual savings meet expectations
- Simplifying the decision to move forward with energy system upgrades, savings thousand of dollars in auditing and engineering costs and bypassing sales presentations, etc.
The EBaR process focuses on identifying efficiency and other measures that reduce energy cost by more than their amortized cost, thereby increasing operating surpluses and cash flow. What makes this efficiency investment analysis different from all others is the integration of risk management in the assessment process ensuring that expected cost savings are actually achieved. This risk management element addresses savings uncertainty concerns that often lead to bypassing profitable, low risk projects.
This page provides backgound on energy efficiency risk management basics and illustrates the importance of applying risk management when considering investment in energy efficiency.
Building Energy Risk Management Basics
A huge “efficiency gap” exists in the US and Canada. Billions of dollars in easily-achievable, high return energy efficiency and demand response (EE and DR) savings are left unrealized, in large part because investment decisions rely heavily on payback and other limited investment analysis. Surveys show these simple rule-of-thumb approaches are applied to avoid risk when decision-makers face investment uncertainties.
While well-accepted financial tools, such as Value-at-Risk (VaR) are used on Wall Street to maximize uncertain portfolio returns and limit risk, no similar tool was available in the building industry until Dr. Jerry Jackson, then a Signature Professor at Texas A&M University, extended the VaR process to provide the first comprehensive risk management approach to building EE and DR investments. This process, documented in the Wiley Finance book, Energy Budgets at Risk (EBaR): A Risk Management Approach to Energy Purchase and Efficiency Choices, is now available in the EBaR software system (December, 2014).
Traditional Energy Efficiency Investment Practices
Reviews of actual capital budgeting practices consistently identify payback analysis as a predominant investment criterion for, depending on the study, 56 to 94 percent of firms1. Energy efficiency (EE) and demand response (DR) investment evaluations appear to be even more dependent on payback than other capital investments. While many of these firms also use additional criteria, meeting a payback requirement is often the necessary management condition that must be met to move ahead with EE and DR investments.
Decision-maker surveys clearly show that payback is typically used to limit investment risk. Requiring a 2 year EE or DR payback, which is not unusual, is consistent with a 50% internal rate of return (IRR) on the investment. Requiring a 50% IRR means that potential variations in performance, O&M costs, energy prices and other factors are not likely to reduce savings enough to make this a bad investment.
However, payback is a poor choice for evaluating EE and DR investment returns. With a 10 year lifetime, a $30,000 investment that provides savings of $10,000/year (a 3 year payback) would not meet the 2 years required in the example above; however, $100,000 in total savings could have been realized with this $30,000 investment over its lifetime. Even if savings end up being only $7,000/year because of a performance overestimate, the $30,000 investment would return $70,000. These issues are illustrated in the figure below.
This example shows the primary deficiency of payback analysis: its exclusion of many profitable investments. These “lost savings” can represent as much as 30% of current building energy bills.
Since payback is primarily used to limit investment risk, overcoming payback shortcomings requires addressing EE and DR investment risk with an alternative investment tool that addresses investment risk concerns. Value at Risk (VaR) is a well-accepted Wall Street quantitative approach used to maximize portfolio returns while limiting risk. The Energy Budgets at Risk (EBaR) extends VaR to identify EE and DR investments that minimize energy costs while limiting investments risk.
EBaR provides decision-makers the ability to significantly reduce current energy costs and budget risk with low-risk investments; it also provides benchmarking, monthly budget risk analysis, capital valuation and greenhouse gas reduction estimates, all in an easy-to-use, intuitive software package.
1Background on capital budgeting and details on these studies is available in Chapter 4. Capital budgeting: Theory and Practice, in Energy Budgets at Risk (EBaR): A Risk Management Approach to Energy Purchase and Efficiency Choices (John Wiley and Sons)
The EBaR Process
EBaR applies an extended version of Value-at-Risk (VaR), a widely-used quantitative approach used on Wall Street to translate energy engineering details and uncertainty over weather performance, energy prices, etc. into executive-level financial risk management results.
VaR and EBaR development provides interesting parallels.
The Bottom Line: Considering Input Uncertainty and Output Risks
Traditional energy efficiency and demand response investment analysis applies "best-estimate" input values and then hedges against risk by applying conservative threshold requirements. This approach bypasses many low risk/high return investments and results in greater energy costs and less cash-flow. Quantifying risk associated with inputs in the investment process provides risk management results that allow decision-makers to trade off savings and risk and in the process uncovers bypassed energy investments that can reduce energy costs at virtually no risk.