Economics

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The Motor Challenge Programme encourages its Partners to tap a large reservoir of profitable investments without the need for specific financial incentives from the European Commission. Some financial incentives may be present at national level, please check with your Motor Challenge National Contact Point. The Motor Challenge investments use proven technology, products and services which can reduce motor systems energy use by 30% to 50%, earning rates of return between 20% and 50%.

 

How to calculate profitability?

Improvements in energy efficiency generally have an initial cost which then leads to reduced future energy costs. For example an existing ventilation installation may be providing suitable ventilation during the day when the shop is in full production, but remain switched on overnight on when there is no one in the shop. The installation of an automatic control system to turn off the ventilation will entail the expenditure of an initial sum of money, but future running costs will be reduced. Is this future saving sufficient to justify the initial expenditure? In order to decide this question, first of all the costs involved must be added together, and then the benefits, in the form of energy savings, evaluated. An assessment of the cost effectiveness of the proposed system can be made in a number of ways.

Costs: They fall into two categories: initial costs and running costs. Initial costs are those incurred in getting the plant/equipment/control systems installed and running. They include equipment costs: motor, drives, etc., controls and cables; installation costs: wiring and builders' work; and commissioning: checking and adjusting controls, testing circuits and measuring the output (torque, speed, pressure, flow, etc.). Running costs often exceed the initial purchase cost of the installation within a short time. They include the energy costs, the maintenance cost and replacement of any other failed components, e.g. oil, filters, etc.

Benefits: These are usually in the form of reductions in energy costs and in some cases reductions in maintenance and component replacement costs. Improvements in energy consumption in motor system can also yield other benefits, such as improved productivity (less down time), and higher production quality. 

Simple payback 
This is the simplest method of appraisal. It is usually used where a new proposal is being compared with an existing scheme. If the initial expenditure for the new scheme is x and the annual cost saving is y, then the payback period is x/y years. 
Example: consider the installation of a new motor ( 4-pole 15kW) motor driving a water cooling pump, operating at full load for 6,000 hours per year. The two option for the installation are a EFF1 and standard motors with efficiencies of 91,8% and for e.g. 88,2% respectively. Electricity costs 0.05€:/kWh

  • The annual saving are = hrs x kW x %FL x €:/kWh x (1/hstd - 1/h HEM)
  • Where hrs = annual running time (hours)
  • kW = motor rating in kW
  • %FL = Fraction of full load power at which motor runs
  • €:/kWh = electricity cost in €:/kWh
  • hstd = Efficiency of standard motor
  • h HEM = Efficiency of HEM
  • Saving = 6,000 x 15 x 100% x 0.05 x (1/91,8 - 1/88,2)
  • Annual energy saving = 200 €:
  • At a typical cost of €:1650 for an EFF1 motor, compared to €:1300 for the standard motor motor.
  • then the simple payback of the investment is (350/200) or just below two years.

However, simple payback is not a good indicator of profitability because it does not consider returns beyond the payback period and ignores the time value of money. Therefore, the Motor Challenge Partners are advised to choose between two other more powerful indicators: the Net Present Value and the Internal Rate of Return. 

Net Present Value
An improvement to the simple payback assessment is to consider the discounted value of the annual savings. Money today is worth more than the same amount of money in the future because it can be invested today to earn interest and produce a greater sum in the future. For example 100 Euro invested today at a real rate of return of 10% per annum will be worth 110 Euro in a year's time; alternatively 110 Euro in a year's time is worth 100 Euro today if discounted at 10%. It is possible to calculate what future savings are worth today by discounting them by the rate of return anticipated on an investment. This is a common financial appraisal technique. The discount factor for a single year is calculated from:

Discount factor

  • Where f = discount factor 
  • R = discount rate (<1) 
  • m = year considered 

For example the factor for the third year at a rate of 10% would be: 

Discount third year

The cumulative discount factor (c) over n years is given by: 

Dicount cumulative

The present value (PV) of annual savings is given by: 

  • PV = annual savings x c

For example a saving of 50 Euro per year for 10 years discounted at 5% is worth today: 

PV

The net present value (NPV) of an investment is the present value of the income or savings less the initial cost of the investment (calculated over its lifetime, i.e. 15 years for a motor). A cost effective investment is one where the NPV is positive, ie the savings are worth more than the initial investment. 

Internal Rate of Return 
The Internal Rate of Return (IRR) is the interest rate that equates the present value of expected future cash flows to the initial cost of the project. Expressed as a percentage, IRR can be easily compared with loan rates to determine an investment's profitability. The higher the IRR, the more cost-effective the investment. 

For the Motor Challenge a profitable investment is one that provides an annualised IRR equivalent of at least 20% over a 15-year period. 

 

Financing options you can choose from 

(with extracts from the EC Guide to Energy Efficiency Bankable Proposals) 

The basic financing methods for the energy-efficiency lighting upgrades fall into three categories: 

  • Self-financing 
  • Debt-financing 
  • Third party-financing by Energy Service Companies (ESCOs) 

Self-financing 
The simplest and most important source of finance is shareholders' equity, raised either by stock issues or retained earnings. Advantages: all cost savings realised from the upgrade are immediately available and the equipment depreciation becomes a tax deduction. 

Debt-financing 
The next most important source of finance is debt. Debtholders are entitled a fixed regular payment of interest and the final repayment of the principal. It is important to note that tax authorities treat interest payments as a cost. This means the company can deduct interest when calculating its taxable income. Interest is paid from pretax income. Dividends and retained earnings come from after-tax income. 

Third party-financing by Energy Service Companies 
The basic role of the Energy Service Company (ESCO) is to provide comprehensive energy efficiency services to consumers including project finance, engineering, project management, equipment maintenance monitoring and evaluation, usually through Energy Performance Contracts (EPC). ESCOs can package their services using a variety of finance schemes whereby they finance up-front capital improvements in the client's premises in exchange for a portion (or the total, depending on the EPC) of the savings generated. 

The ESCOs are in effect able to turn the cost savings from efficiency measures into a revenue stream which can be used to repay debt and provide a profit. That's why performance contracts are sometimes referred as "paid from savings" contracts. 

They may constitute the preferred financing option if your organisation wants to keep the upgrade project off its balance sheet. This type of contracting can be complex, but it is emerging in Europe. 

 

List of European Service Companies (ESCO)

Visit the European Database of ESCOs

 

Additional references 

Building Research Establishment:
"Financial aspects of energy management in buildings - Good practice guide 165", 1995 

Shows those responsible for managing energy how to identify the most promising projects, how to locate investment funds and develop a sound financial case effectively with decision takers and finance specialists.

European Commission Directorate General for Energy & Transport:
"Guide to Energy Efficiency Bankable Proposals".

Jointly prepared by The European Commission THERMIE and SYNERGY Programmes and The European Bank for Reconstruction and Development. 
To understand how to write a business plan with a focus on energy efficiency projects.

European Commission Directorate General for Energy & Transport:
"Shared energy saving and supply agreement for UK buildings", Luxembourg: Office for Official Publications of the European Communities, ISBN 92-827-5874-5, 25 pp. 1996
 
Template for contract with Energy Service Companies (made for UK buildings but can serve as example in other countries).

International Council for Local Environmental Initiatives:
"Profitting from energy efficiency! A financing handbook for municipalities", ed.: Dan J. Goldberger and Philip Jessup, Sept. 1993
 
Describes a number of approaches to financing energy efficiency, with an emphasis on municipal building retrofit programmes 

International Council for Local Environmental Initiatives:
"Energy Smart Cities, Energy Efficiency Financing Directory", Nov. 1995 

World Energy Efficiency Association: "Manual on financing energy efficiency projects", ed.: James B. Sullivan and Rolf R. Anderson, 1997 
Deals almost exclusively with capital intensive energy efficiency investments.