Considering Reduced Risk from Energy Price Exposure When Evaluating Energy Efficiency Projects

Energy efficiency projects often face steep hurdle rates and compete for capital alongside other priorities within manufacturing plants.  As plants decide how to allocate financial capital, it is critical that benefits other than energy cost reductions are taken into account when energy efficiency projects are evaluated.  Often, benefits from upgrades in both length of time and scope of impact will extend beyond consideration in a net present value, payback, or other commonly used financial analysis.

Ancillary Benefits

Alongside productivity gains, extended equipment life, and reduced maintenance requirements1, an often overlooked benefit to efficiency improvements is reduced price exposure to variable energy costs.

The volatility of energy prices exposes industrial firms to a variety of financial risks that can quickly erode a company’s cash flow position as energy prices rise.  As the energy intensity of a plant is reduced, not only can energy costs be reduced, but so can risk.  Therefore, energy efficiency investments can play a critical role not only in a firm’s financial performance but also in a risk management strategy.

Evaluating Reduced Risk

If companies choose to consider the risk of volatile energy prices, what financial analysis model is appropriate to evaluate such risks?

One option is to use a version of the value-at-risk analysis to determine the probability that an investment will achieve a payback.  Value-at-risk is a model, most often used in the analysis of financial products such as stocks, to determine a risk of loss under normal conditions by considering historical price data and other variables.

In energy efficiency analyses, the most prominent variable would be energy prices evaluated historically, against the expected savings resulting from an energy efficiency upgrade along with a confidence level of the upgrade achieving those savings.  Therefore, not only can the analysis show an expected return but it can also offer a probability of achieving those returns considering historical variances.

A frequently referenced adaption of the value-at-risk model was developed by Jerry Jackson, Ph.D., a former Associate Professor at Texas A&M University and currently Leader and Research Director of the Smart Grid Research Consortium.  His analysis method called, Energy Budgets at Risk™2 is designed to consider a variety of variables while offering confidence intervals that an energy efficiency investment will achieve specific returns, in line with value-at-risk.  This can allow financial managers to understand that although some energy efficiency projects may fall short of reaching their company’s internal hurdle rates, the confidence in the returns is high enough that the projects can move forward.  An example analysis is available.

Achieving Energy Efficiency’s Potential

Repeatedly, energy efficiency investments have been shown to extend beyond simply the energy efficiency gains.  Yet, with tremendous potential gains for intensity improvements still possible, these benefits may not be comprehensively considered by management. 

Left as a standalone investment, energy efficiency can face the same hurdle rates and a range of competition from other capital projects and priorities.  This overlooks the additional benefits gained from pursuing energy efficiency, including reduced risk exposure for the company.   When ancillary production benefits, reduced risk, and payback rates that are qualified with confidence intervals are considered, energy efficiency becomes more compelling as a strategic organization-wide priority. 

1. Miriam Pye, and Aimee McKane. "Making a stronger case for industrial energy efficiency by quantifying non-energy benefits." Resources, Conservation & Recycling 28, (2000): 171-183. ScienceDirect, EBSCOhost (accessed May 25, 2012).

2. Energy Budgets at Risk (EBaR): A Risk Management Approach to Energy Purchase and Efficiency Choices , J. Jackson, John Wiley and Sons, March 2008