Energy Cost Analysis

Payback analysis is traditionally used to identify energy-efficiency investments with most investments required to pay for themselves in two years or less. However, attempting to avoid risk with conservative payback rules excludes many profitable investments costing US firms more than $66 billion annually in unnecessary energy costs.

Energy Budgets at Risk (EBaR) ® is a new energy management framework that significantly reduces energy costs and energy-efficiency investment risk by applying risk management tools similar to those developed in the financial industry.

By providing energy budget savings greater than investment costs, EBaR investments result in increased cash flows-creating the same financial bottom line impact as an increase in revenues. In fact, EBaR strategies can save 30% or more of current energy bills even after paying for energy-efficiency investments.

Commercial, institutional, industrial, and government organizations can now apply investment analysis to energy-related decisions in a manner that is consistent with their financial investment analysis. EBaR can also incorporate energy purchase decisions for organizations in competitive energy markets, providing an integrated investment-purchase analysis.

In short, EBaR applies quantitative risk management analysis vetted in the financial community in a process customized to meet the risk tolerance of individual organizations. It offers a road map that energy managers, corporate executives, and government officials can use to understand and implement "best practice" facility energy risk management strategies.

The remainder of this section describes the EBaR process in more detail.

Financial Risk Management Basis of EBaR

Risk associated with financial investments has increased significantly since the early 1970s because of volatility in international exchange rates, commodity prices, interest rates, and geopolitical events. Investment portfolio management now depends heavily on an array of quantitative tools to assess risks and returns associated with financial investments. The most widely used quantitative tool is "value at risk" or VaR which measures the probability that portfolio losses over some period will exceed a set amount at a predetermined confidence level.

Virtually all investment firms, banks and financial institutions manage their investment risk using some variant of VaR analysis. VaR is also used by US and international regulators to insure financial institutions' capital adequacy.

Energy Budgets at Risk or EBaR is a new energy-efficiency investment analysis process that extends and applies the VaR methodology to assess investment risk associated with energy-efficiency investments. Not only has the basic analytical application applied in EBaR been vetted in the financial industry, it provides the kind of easy to evaluate decision variables favored by financial decision-makers.

Energy Budgets at Risk (EBaR) Investment Analysis

EBaR efficiency-investment analysis applies quantitative characterizations of uncertainty associated with each of the variables that determine energy cost savings.

EBaR investment analysis is described in this section with an illustrative case study analysis of an energy efficiency option for a five story, 120,000 square foot Austin, Texas, office building. The least-cost baseline design results in modeled annual electricity use of 16.42 kWh/square foot and natural gas use is 35.1 kBtu/square foot. Energy bills at current prices will be approximately $210,000 per year for electricity and $50,000 for natural gas.

Additional detail on this case study example is provided in the book Energy Budgets at Risk: A Risk Management Approach to Energy Purchase and Efficiency Choices, published by John Wiley in March 2008.

Two efficiency options are considered. The first is a package of lighting technology upgrades, and the second is an HVAC redesign including an energy management and control system. A summary of the efficiency investments is shown in Table 1.

Table 1. Investment Analysis Summary

Item	Value	Item	Value
Total investment cost	$225,000	Internal rate of return	42.30%
Estimated energy cost savings	$98,000	Net cash flow	$58,300
Payback	2.3 years

The payback of 2.3 years is longer than the building owner's 2-year requirement. Consequently, even though this investment would reduce the building's annual energy costs by 38 percent, the investment would not be made because it falls short of the payback criteria. From the owner's perspective, investments with expected paybacks greater than 2 years carry too much risk of unacceptable investment returns.

EBaR efficiency investment analysis applies quantitative characterizations of uncertainty associated with each of the variables that determine energy cost savings using Monte Carlo analysis, the same analysis technique used in scheduling and budgeting risk management software.

How does this investment fare when evaluated with the EBaR risk management framework? Uncertainty surrounding electricity prices, natural gas prices, weather and operating performance are based on historical data (see Jackson, 2008). Uncertainty surrounding model-estimated efficiency savings estimates is specified as +-15 percent for lighting impacts and +-20 percent for HVAC impacts based on consultations with equipment representatives and internal analysis.

EBaR analysis results are generated as probability distribution of outcomes. Distributions for the two primary investment variables, internal rate of return (IRR, or annualized return over the life of the equipment) and net savings (energy cost savings minus annualized cost of the investment) are not a "user-friendly" presentation for most financial and other executives. Selecting several levels of risk that match potential decision-maker risk-tolerance provides more transparent decision statistics. Table 2 and Figures 1 and 2 show IRR and net savings (savings after deducting financing costs) in presentation format for the lighting and HVAC investment.

Table 2. Efficiency Program Returns

Confidence Level	Minimum IRR (%)	Minimum Net Savings
Expected	42.3	$58,300
90%	35.5	$44,000
95%	33.5	$40,000
97.5%	32.4	$37,800

Figure 1. Investment Internal Rates of Return (IRR)

Figure 2. Investment Net Savings

As indicated in the table and figures, this investment has an expected payback of 2.3 years and 42.3% IRR with virtually no chance (2.5 %) of providing an IRR less than 32.4% and an annual net savings of less than $37,800. Expected returns are great enough and the risk of unacceptable results is small enough to override the payback outcome and recommend the investment.

Figure 3 shows the expected budget with and without efficiency investments and expected budget variances at three confidence levels. Not only have the investments reduced the expected annual energy budget from $261,000 to $163,000, the size of likely budget variances (the amount by which actual costs exceeds the budgeted amount for any year) is reduced by about 45 percent. Both the annual budget and budget risk have been significantly reduced.

Figure 3. Expected Annual Energy Budgets Before and After the Investment

Summary

Payback analysis traditionally used to evaluate incremental energy-efficiency investments is designed to avoid investment risk. However, payback analysis does not consider energy cost savings beyond the required payback period, rejecting many profitable building design options - options that reduce annual energy costs by even more than the annualized investment cost.

Energy Budgets at Risk (EBaR) provides a new quantitative energy risk management process based on Value at Risk (VaR), a financial risk management process vetted in financial industry.

EBaR provides information on the least attractive returns likely to occur at various confidence levels. This information is provided in a simple decision-variable framework like payback analysis; however, EBaR avoids all of the limitations of payback analysis. Investments with varying lifetimes, savings throughout the life of the equipment and a comprehensive and explicit accounting of the uncertainty associated with every aspect of the analysis is included in EBaR analysis.