Who of us likes to leave money on a table when it comes to a deal? Unfortunately, that’s too often the case when it comes to energy efficiency retrofits. The cause: faulty assessments that use only simple payback as the core metric. In contrast, a properly analyzed investment in your building will easily beat the return on a blue-chip stock.
What is simple payback?
Simple payback is often used to determine the attractiveness of an investment – including in the building retrofit market. The indicator refers to the period of time, in years, required for a return on an investment to repay the sum of the original investment. Simple payback has been used for decades as a way of understanding the return of the funds invested in an energy efficiency project. The financial calculation is popular and entrenched in the industry because it’s simple to do.
The upside: Many energy retrofit projects have been completed because the buyer was persuaded by a favourable simple payback. The downside: A stringent payback requirement of three years or less is unreasonable when compared to other investments. The result: Money is left on the table. Many excellent financially rewarding energy efficiency projects are put aside because of an adherence to a flawed logic. For comparison, no investor would expect a publicly traded equity to have a guaranteed return of 33 per cent.
Drawbacks of simple payback
Simple payback is a wolf in sheep’s clothing. A non-financial practitioner might not see the danger in using simple payback, but a look at the drawbacks shows why the calculation does not do the building owner any favours:
- The simple payback calculation does not include the amount of return that is available post the initial three year period: It’s as if the assets stopped delivering any cash flows after the payback period. This is simply not the case as well maintained equipment will deliver energy savings i.e. positive cash flows for many years past the payback period.
- There is no reduction of the calculated return for the time value of money: A critical component of any financial capital budgeting analysis is that a dollar is worth more today than tomorrow. Without that fundamental concept in the calculation, the answer provided is insufficient to make the decision.
- The net present value of a longer-running project may be higher than one with a shorter simple payback period: If the analysis stops at simple payback, better projects don’t receive approval. Money is left on the table, reducing the potential improvement to the value of a property.
In short, simple payback is a comparator between projects with similar returns and profiles. A shorter project payback for one out of two projects that promise the same financial returns would be an indication of lower risk.
Better decisions through alternative calculation methods
So what should an owner or building manager do instead of using simple payback? There are several financial analytical tools that decision-makers should use, including Net Present Value (often shortened to NPV), Life Cycle Cost Analysis (LCCA), and Internal Rate of Return (IRR).
NPV, the most common of these methods, is critical to creating value from your investment decision. This approach focuses on the concept that “cash is king.” The NPV can demonstrate that more cash is generated when several retrofit measures are bundled. The calculation is simply the net of the cash outflow against the sum of the cash inflow over a defined period, discounted at an acceptable rate to reflect risk and inflation.
Consider the following simple, but realistic example:
Project 1: This project consists of four energy retrofit measures, each with simple paybacks of less than three years and an average payback of 3.0 years.
Project 2: This project combines the four measures from Project 1 with nine additional measures. The combined payback of all 13 measures is 4.3 years, with each measure’s payback period exceeding three years. Two measures even have paybacks of over 11 years and yet Project 2 has the better financial return as expressed by its net present value.
Project 2 generates $470,740 versus Project 1, which generates $250,839. A knowledgeable financial investor would choose Project 2, as it generates almost double the cash.
Instead of relying on simple payback as a faulty metric, building owners and managers should use additional analysis to make better decisions and ultimately generate more cash. If simple payback is used, it should never be seen as a standalone and an absolute – only as a part of a broader analysis and used as a comparative tool when projects are competing for capital. Otherwise, you risk shortchanging yourself on your energy retrofit project and your building’s value.
Photo credit: Copyright Queen’s Printer for Ontario; photo source: Ontario Growth Secretariat, Ministry of Municipal Affairs