Each potential energy efficiency project will require a forecast that includes the initial incremental investment, annual savings and costs. Energy cost savings will likely be the main financial driver, but changes in labor and replacement costs of equipment may also be significant.

The Climate Corps financial analysis tool is designed to help expedite this investment analysis. This chapter discusses the overall framework of the tool and the many financial variables it uses.

The financial analysis tool calculates net present value (NPV), the sum of forecasted discounted cash flows minus the initial investment, as the primary measure of a project’s attractiveness. Using NPV properly positions energy savings opportunities as an investment, not as an expense.

There are several variables included in the financial analysis tool that affect the calculation (discount rate, tax rate, and depreciation).

Discount rate: As a default, the discount rate in the financial analysis tool should be set as the host company’s internal hurdle rate. Discount rates reflect both the time value of money and the risk involved in a specific project. Typically, energy efficiency investments have much lower risk than other investments that companies choose to pursue. From a strictly financial perspective, efficiency investments should therefore be evaluated using correspondingly lower discount rates. However, most CFOs will not want to adjust discount rates for relatively small investments because of the time and discussion entailed in settling on the “right” number. If a large energy-efficient investment, such as a new HVAC system, is on the threshold of profitability, then it may be worth presenting a sensitivity analysis using multiple discount rates.

Note that the EPA uses a 4% real discount rate in its Energy Star® efficiency investment calculators.1 In one report, the California Public Utilities Commission uses an 8.15% nominal rate for energy efficiency investments; assuming 2.5% inflation, this implies a real discount rate of 5.5%.^{1} [(1+inflation rate)*(1+rreal)=(1+rnominal)].

Tax rate: Some companies will want to look at investments on a pretax and some on a posttax basis. Whereas posttax is more accurate, it also creates opportunities for errors if the company’s tax policies are not followed precisely. The financial analysis tool is structured so tax and depreciation effects can be included at one’s discretion. The default marginal tax rate is 35%.

If the financial manager at the host company wants to look at the analysis posttax, it is important to speak with the finance department to understand how purchases for lighting and other improvements are depreciated. In particular, some purchases may qualify for a Section 179 deduction, which allows firms to deduct the full expense in the year of purchase.^{2}

Depreciation: Companies will vary in which assets they depreciate. Based on IRS guidelines, the financial analysis tool assumes five years for computers, copiers and printers, seven years for office fixtures and equipment and 39 years for HVAC systems.^{3},^{4}

If taxes are not included in the financial analysis, including or excluding depreciation will have no effect on the analysis as there will be no tax shield.

Payback is the time required for accumulated savings to equal the initial investment. This metric is frequently used in energy efficiency investments. It is simple to understand and can be powerful when the payback period is one to three years. In most variants, however, paybacks ignore cash flows after the payback period and time value of money, thus underestimating the value of a longer-term investment.

Again, if this metric is used, it should be accompanied by an NPV calculation.

The internal rate of return (IRR) is closely related to NPV and is used by corporations with similar frequency. If IRR is used as the principle criterion, however, it could sway the corporation towards efficiency improvements that require little to no upfront investment, even if these generate less financial value (and energy savings) to the firm. On a more positive note, the relatively simple cash flow structure of most energy efficiency projects prevents some of the common calculation errors that plague this metric.

## Prioritizing efficiency investments

From a financial perspective, the most attractive investments will be those that generate the greatest cash flow in excess of the cost of capital—those with the largest NPV. Recognizing that size of the upfront investment does have an impact on the decision, one way to present

this information may be a matrix with NPV and initial investment on each axis. Investments with relatively low initial investments and high NPV or energy savings potential should obviously be pursued first.

## Financing investments

Once investments are prioritized, the next challenge is to determine how they will be paid for. There are four broad categories of payment structures, including cash, loan, leasing or performance contracts.

Cash: Paying with cash is ideal if the investment is relatively small and the firm has a strong balance sheet. It also allows the firm to depreciate the investment. If the firm does decide to pay in cash, no adjustments need to be made to the base NPV analysis.

Loan: Depending on the cash position of the host company and the size of the required investments, a loan may be required. It may be useful to identify whether there are any below market rates available for specific investments. The value created by a subsidized loan (to be used only if the loan is sizable and the analysis includes taxes) can be calculated using the adjusted present value (APV) method, which estimates the value created by the operations and the financing separately. With this methodology, one can calculate the NPV using the project-specific discount rate and add the value of the subsidized loan.

Table 13.1 sets out an example of how to calculate the value of a $100 subsidized loan offered at a below market interest rate of 9% when the market interest rate is 12% and tax rate is 35%.

Lease: This financing vehicle is not very common in energy efficiency investments. Certain office equipment such as copiers are often leased, but this decision is independent of whether the equipment is Energy Star® certified.

Performance contracts: This method of financing shifts some or all of the risk to an outside vendor and can be applied to purchases and leases. In this structure, a service provider pays the up-front costs of an efficiency upgrade and receives the resulting savings from reduced energy costs. Alternatively, the service provider pays a percentage of the up-front costs in exchange for a percentage of the resulting

savings. Any performance contract should be valued against the cash flows from the purchase option and should consider staff time required to negotiate the contract and manage the project implementation and maintenance.