This document provides a summary of a professional development course on energy efficiency profitability by Andres Mercado-Salomon. The course is presented over 2 hours and covers how to measure the profitability of energy efficiency projects using financial analysis tools like net present value, internal rate of return, and payback period. It also discusses how investing in cost-effective energy efficiency measures could generate internal rates of return of 17% according to a McKinsey Global Institute report and help reduce global carbon emissions. The course aims to explain why energy efficiency projects can provide good returns and address any problems with energy efficiency that are currently not being addressed.
3. About the author
Andrés Mercado‐Salomon is an engineer with over 15 years of experience in many energy related
sectors, namely sustainable energy innovation, energy efficiency program design and
implementation, financial analysis of sustainable energy projects, energy modelling of buildings and
processes and measurement and verification of performance.
Andrés has worked in 11 countries from the Americas and the MENA Region in the commercial,
industrial and institutional sectors. In Canada, Andres Mercado has worked with government
agencies and private companies to help them design and implement sustainable projects and assess
their technical and financial performance.
Andrés is an experienced trainer. He has trained engineers and technicians from the institutional
and commercial sectors in Canada, Mexico, Colombia, Chile, Peru, Algeria, Egypt, Palestine and
Saudi Arabia. In 2011, he founded Abrafo Negajoule, a company specialized in helping clients make
use of their resources efficiently and profitably.
3
Andrés Mercado Salomon, CMVP, RCx
Energy Efficiency Specialist
President and Founder
Abrafo Negajoule
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5. Global energy demand is growing rapidly
5
0.00%
0.20%
0.40%
0.60%
0.80%
1.00%
1.20%
1.40%
1.60%
1.80%
2.00%
2011 2012 2013 2014 2015 2016 2017
Change in Global Primary Energy
Demand
In 2017, energy demand increased
by 2%, the fastest annual increase
since 2011.
• Without the progress that has been
made in energy efficiency, this increase
would have been much higher.
• Energy efficiency improvements are
critical to reducing greenhouse gases
(GHG) to the levels needed to control
climate change.
SOURCE: Based on IEA 2018
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6. 6
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11. Investment in Energy Efficiency
Investments must grow to reduce the effects of climate change.
In 2017, 236 billion USD were invested
in energy efficiency.
11
But to limit climate change,
• 584 billion USD per year must be invested
between now and 2025.
• Then nearly 1.3 trillion USD annually between
2026 and 2040.
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14. In this course, Andrés refers to the following financial terms:
• Net Cash Flow
• Net Present Value
• Payback Period
• Internal Rate of Return
The purpose of this lesson is to give a quick overview of the
definitions and calculations of these terms. We will also see
how they are used to make capital budgeting decisions.
14
A quick review of the financial
terms mentioned in this course
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15. The slides that follow contain links to external videos which
explain each concept in greater detail. If you choose to see
these videos, it is best to open them in a separate tab in
your browser. To do so,
Right click on link → Choose “Open link in new tab”
otherwise,
use the back button of your browser to return to this
course.
15
Helpful hint:
Open videos in separate tab
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16. Net cash flow refers to the difference between a company's
cash inflows and outflows in a given period, usually 1 year.
In the context of energy efficiency, examples would be
Cash inflows : Energy cost savings, maintenance cost savings,
labour cost savings etc.
Cash outflows: Cost of equipment, installation cost, taxes
Want to see an example? This YouTube video shows how to
calculate Net Cash Flow using a short example problem.
(2 min 18 sec)
16
Net Cash Flow = Cash Inflows – Cash Outflows
Formula
• Net Cash Flows are used to calculate the Net
Present Value of the project.
• Decisions are not based on the net cash flow of a
given period.
Decision Criteria
Net Cash Flow
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17. The payback period is the length of time required to recover
the cost of an investment.
Want to see an example with uneven annual net cash flows?
This YouTube video shows how to calculate Payback when
the project has uneven annual net cash flows. (5 min 01 sec)
17
𝑷𝒂𝒚𝒃𝒂𝒄𝒌 𝑷𝒆𝒓𝒊𝒐𝒅
𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
𝑨𝒏𝒏𝒖𝒂𝒍 𝑵𝒆𝒕 𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘
Formula
• If Payback Period > 2*, Reject Project
• If Payback Period < 2*, Accept Project
• If comparing several projects,
choose the one with the lowest Payback Period
Decision Criteria
Payback Period
* The acceptable payback period is defined by management.
Usually the value used is 2 years, but it may vary from one
company to another.
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18. NPV allows you to calculate the project’s value today based
on the stream of cash it will generate in the future taking into
account the Time Value of Money (TVM). To calculate NPV,
you must first determine the project’s net cash flow for each
year as shown earlier.
Then use the formula to the left to calculate NPV, where:
t = The time period, usually in years (year 1, 2, 3, …)
r = The target rate of return per time period
Co = The initial cash outlay (i.e. the initial investment)
Ct = The net cash flow in year t
Want to see an example? This YouTube video by
Investopedia shows how to calculate NPV. (3 min 20 sec)
18
Formula
• If NPV > 0, Accept Project
• If NPV < 0, Reject Project
• If comparing several projects,
choose the one with the highest NPV
Decision Criteria
Net Present Value (NPV)
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19. The internal rate of return is the discount rate that makes the
net present value (NPV) of all cash flows from a particular
project equal to zero. It is used to estimate the potential
profitability of the project.
To calculate IRR set the NPV equation to zero and solve for r.
t = The time period, usually in years (year 1, 2, 3, …)
r = The target rate of return per time period
Co = The initial cash outlay (i.e. the initial investment)
Ct = The net cash flow in year t
Want to see an example? This YouTube video by
Investopedia shows how to solve this equation using Excel.
(4 min 17 sec)
19
Formula
• If IRR > Cost of Capital, Accept Project
• If IRR < Cost of Capital, Reject Project
• If comparing several projects,
choose the one with the highest IRR
Decision Criteria
Internal Rate of Return (IRR)
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22. I'm happy that I can try to communicate some points that I
feel very strongly about and I think are important through a
webinar without the need to have to go to every one of you
because if we had to travel all the way to deliver these
points there would be a lot of carbon emissions, right?
I always like to start with a conclusion. The conclusion is this
image I created myself. The text I got from a McKinsey
Global Institute report. I tweeted this one or two weeks ago
and I got a lot of reactions from people because, as you see,
McKinsey Global Institute calculated that we could invest
billions (170 billion is just one big number) but let's just
think of it as a lot of money…
22
Let’s start with the conclusion…
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24. This is my question. And I know I believe it. I mean is this is
the work I do. My objective became to try to make this clear
to everyone, why this is so. Why is it possible to get good
returns on energy efficiency?
And to also answer the question: What are the problems
with energy efficiency that can be addressed but are not
being addressed at this time?
24
This means that McKinsey Global
Institute, which is a very well
recognized institution, is just
putting out these numbers and
we're supposed to believe it?
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25. In the first one, we will just cover very quickly how to measure profitability because
not everyone is a financial expert, so we'll just cover that very quickly.
Then we'll do the main point of the presentation which is how to really turn energy
savings into cash flow. How do we go about doing the calculations and giving
everyone enough information and enough assurance that the cash flows are going
to be good and that they're going to be very low risk.
And in the third segment, we'll just talk about risk and how to measure it. How is it
being measured in financial projects? And how those techniques can be applied to
energy efficiency very easily. Those techniques are not being applied now but
they're very easy to apply. So we'll just cover that in that last part.
25
We have three parts for this presentation.
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26. For commercial and institutional sectors, business or social
profitability can be measured in many ways and there's a lot
of debate on the social side and not enough debate on the
business side. But, anyhow, this is something that can be
measured and there are techniques order to do this.
The private sector always wants to have economic
profitability as the primary goal. We want to increase
revenue. If we're in business this is the main objective. And
on the other side if we’re in the public sector we want to
ensure that we're giving out enough value for the money
that is being invested in the public service delivery.
26
The concept of profitability
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27. Everyone would agree that even both the private and public
sectors we need to use the resources efficiently. This is not a
debate.
27
In any case, it is very important
to use the resources efficiently.
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28. Measuring profitability is very easy. Profit is revenue less total costs.
If we see this in a graphical representation we have revenue on the
left side and that revenue needs to be equal to all of the costs and
then we get the profit at the bottom.
What happens if we reduce expenses? We will increase the net
profit. But I just want to point out that in the case of resource
consumption, may it be water or energy, we’re actually reducing
only the operational expenses.
28
Measuring profitability
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29. If we reduce operational expenses, of course, the net profit will
increase. It’s not a 100 percent relation because there are taxes and
interest which are relative to the operational margin. However, we
can agree that reducing expenses yields an increase in profit.
29
Measuring profitability
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30. Let's just now think for a minute: What choices has any
organization in order to increase value, may it be business
value or social value?
We can increase the revenue which means increasing value
also for social ventures or we can reduce the costs that we
pay in order to work, in order to operate as a business or as
a government institution.
30
Investment decision making
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31. When the financial departments of any organization are
looking into investing for the next year or for the next few
years to grow the business or to improve the social value
that is being delivered, they use some financial criteria in
order to select which projects will be retained. My point
here is that when the work of choosing which investments
are going to be realized, there are techniques that are being
used by every financial officer that allow the person to really
understand the value that is being created from many
different points of view. I'm not going to go into the detail of
this criteria but just bear in mind that this is work that
people are doing on a daily basis. They are applying
techniques that exist and that have been proven over the
years.
31
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32. 32
Let's just contrast this amount of
rigour and amount of scientific
work to what is being applied to
energy efficiency in most of the
cases.
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33. 33
What about Energy Efficiency
projects?
In energy efficiency, the criteria that is being applied is the
Payback Period. I've seen this in every country. I was born
in Mexico and worked there on many occasions. People in
Mexico tend to say, "Oh, this is because in Mexico we do it
this way. In North America they do it properly. We don't
do it well here.“ But this same argument I've heard in
many countries. I've heard it in Colombia, I've heard it in
Peru. I've heard it in Algeria. I've heard this in Egypt. Every
country thinks that they’re not doing things right.
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34. 34
Payback Period is just a bad way
of evaluating the value of an
investment.
But there are reasons why the payback period is being used.
Of course, it's not like everyone is wrong. I mean there are
very fair reasons why it's being used. Let’s get into the detail
of this.
Let me give you an example of an investment in a building
retrofit. This comes from a study done by Mr. Jerry Jackson. I
will get back to him because he’s a very influential person in
this field. He said:
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35. 35
Let's take an example of an
investment retrofit of $300,000.
If we calculate the value of the savings in monetary terms it
amounts to $153,000, in this example. If we deduct financial
costs we end up with a net cash flow of $95,000. Which
yields a rate of return of 46 percent. But the Payback is more
than three years.
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36. 36
In most of the of the technical
committees set‐up to approve
the project, this project would be
rejected because its payback is
over two years.
Let's just keep this in mind this example will come back in the
presentation.
I want to invest some time in explaining why Payback is being
used and why this is a problem. I will also discuss the
benefits of using payback. But let's just say that the benefits
are fewer than the problems that it incurs.
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37. 37
Why is the Payback Period being
used as a decision tool in EE
projects?
Payback is used because the financial department does not
understand energy efficiency. Energy efficiency is a technical
thing. The technical department must deal with it.
In the minds of some people, energy efficiency is for saving
the Earth. They say, “I like the Earth and I want to save the
Earth if I am a financial officer but I'm too busy at this time.”
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38. 38
Energy efficiency is seen as a
technical project. It's not an
investment because it is not
being presented as an
investment, so, the financial
decision makers do not see it as
such.
Instead the financial department thinks, “We have some
budget for all these technical projects. If we have extra
budget next year we will do the energy efficiency project, so
just call us next year."
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39. 39
And then the third most important reason, I think, is that
technical projects are thought to be the responsibility of
the technical department not the financial. It's like, "It's
not this department. The Financial and Investment
Analysis department does not deal with these kinds of
projects. It's just technical stuff."
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40. 40
There is a communication problem between the technical
department in any organization and the financial department
of the organization. In my experience, what happens is that
the financial department will think that,
"There’s a lot of need for investment in the technical
department, so we just need to give them enough power for
them to decide where to invest the money. But as a financial
officer and as the person responsible for the financial well‐
being, of the institution I cannot give them (the technical
department) all the decision power."
But more importantly, I think, is
that the Payback metric is being
used as a tool to assess risk.
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41. 41
So, if some company in energy efficiency comes and presents
a very nice project about savings to the technical
department, then the technical department can and should
approve these kinds of projects if the Payback is low. That
means that the risk of something going bad is very low.
Because if the payback is very low, then we don't need to
wait a long time to see if there's any benefit. We know that
there will be results in two years and therefore we can just
avoid dealing with all the complex analysis required to really
assess the value of the investment.
A maximum Payback of two years
means that that investment is a
safe choice.
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42. 42
Therefore, Payback is not being used for its analytical value.
It's just being used because it reduces the risk of a mistake
being made in an investment.
Other investments in the company, like asset acquisition or
mergers and acquisitions of other companies or investing in
new infrastructure, are dealt with by the financial
department because those are deemed important. As a
result, those have all the information needed to really do a
proper appraisal.
But technical projects, they fall under the responsibility of
technical people so we just give them one tool: Payback. This
is my experience and this is why I believe Payback is being
used so widely.
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44. 44
Energy measurement is an activity that can be performed
when energy is created.
In the image you see an array of solar panels and wind
turbines. These devices produce energy. So, it's very easy to
just measure the energy produced by the installation with
the help of an instrument, an energy meter.
That is not so in energy efficiency. A measurement of energy
savings is really a difficult endeavor.
Energy Measurement
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45. 45
This image shows an invoice in Chinese. But it could be in
English or in Spanish because energy invoices and water
invoices are just as complex. They're just difficult to read and
it hard to see their relation with the real world.
We know that if we consume more energy, if we produce
more, if the weather is more, stringent we will be using more
energy. But the exact relationship between the real world
and the energy invoice is difficult to comprehend. And
there's another problem with energy invoices. They always
arrive late. You pay for whatever you consumed in the past.
Savings “measurement”
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46. 46
So if you want to do something different, then you have to
do it without knowing if your actions will have the impact
that you were going after. It's a time perspective that is
difficult to assess.
And energy savings cannot be measured. The only thing that
can be measured is energy. Energy usage or energy
production.
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47. 47
Energy savings cannot be
measured because savings are the
absence of consumption.
The absence of something cannot
be measured. It can only be
estimated.
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48. 48
How do we go about estimating these savings?
When I started working in this field, we didn't have
measurement and verification protocols. They just came into
existence around 10 years ago. There are some older efforts
to create protocols but the most widely used protocols today
are only 10 years old. You can say that these protocols are
very new. But the progress that we have made in using and
improving this protocols over the last 10 years has been
really magnificent.
Today, we can really say that these protocols are ready to be
used as measurement devices.
M&V Protocols
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49. 49
For example, one of the protocols, which is the most used in
the world, which is called the International Protocol of
Measurement and Verification, IPMVP, presents a framework
and defines terms used in determining savings.
Basically, what that means is that it says how we need to
agree about the terms and agree about how to do things. It's
like bringing a third party to the contracting agreement so
that this third party can dictate what is fair and what is not.
How can we use these protocols
as a measurement device?
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50. 50
The IPMVP specifies the topics to be addressed in a
measurement and verification plan for a specific project. It
points out what needs to be covered, things that cannot be
left out. We will go into the detail a little bit later.
But, for me, the most important part of the International
Performance Measurement and Verification Protocol is that
it allows flexibility in creating M&V
plans. It's not like a recipe.
It just gives you what you need to think about when
contracting a service to reduce consumption, consumption
of energy and water also.
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51. 51
There are six principles that need to be followed with any
protocol, in any M&V plan.
1. Accuracy
Accuracy" means that one party needs to arrive at the same
result as the other party. And this needs to be established in
a document. So, if I'm the energy efficiency company and I
say to the client that the savings will be estimated by this
formula, the client can take that formula and use the same
numbers and can arrive at the same result, exactly.
The 6 principles of M&V
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52. 52
2. Completeness
The principle of "Completeness" is that everything that is
important needs to be taken into account.
3. Conservativeness
We should always err on the low side. We should always
estimate less savings than the best possible scenario so that
those savings are guaranteed.
4. Consistency
That is pretty self explanatory.
The 6 principles of M&V (cont’d)
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53. 53
5. Relevance
We don't need to measure anything else than what's
important. This sounds very logical, but let’s just think about
it. Measuring energy really is expensive. So, we don't need to
measure more than whatever is necessary so that we can
have confidence in the result. One rule of any M&V plan is
that
measurement costs should not be
more than 2% of the total cost of
the project.
The 6 principles of M&V (cont’d)
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54. 54
We can see this as an assurance that we are going to have
enough measurement so that everyone is happy with the
results and not too much measurement as it can become a
very high cost.
6. Transparency
All of the documents and all of the calculations and all of the
assumptions should be known to both parties in the
contract.
The 6 principles of M&V (cont’d)
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55. 55
The basis of M&V is to create a mathematical model to
correlate the energy use and an independent variable. What
that means is that energy is always the consequence of an
action. If a business consumes energy, it's because it uses it
and it goes about working everyday and uses devices that
consume energy. This is being done in order to produce
something under some critical conditions.
For instance, take an office building. It uses light, it uses
electricity for the computers, for the HVAC system and there
is always an energy driver for this.
Mathematical modelling
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56. 56
If the weather is hotter, of course, the air conditioner will be
consuming more energy. And if we work longer hours, of
course, the computers will be used a lot longer and then the
energy consumed will be higher. There's always an
independent variable that produces the energy use.
What we need to do is to find a mathematical model to
correlate these two variables.
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57. 57
Let’s look at this example of gas consumption and the
production of a certain product in a manufacturing facility.
You see that we have one year of data here. We have the
production of this product on the right hand side and then
we have the gas units on the left hand side. If we were to
plot, to do a graphical presentation of this data, we see that
there is a trend, of course, and this is logical. We're just
putting into numbers what is already logical.
If the production increases, the gas consumption will
increase. The problem is that just by doing this we don't have
an exact measurement of the relationship between the two.
So, we need to go a little bit further.
Mathematical modelling example
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58. 58
If we use a computer analysis, and this is very easy to do just
with Excel. If we plot this data on Excel, we’ll see that there is
a trendline. We can get the equation from the trendline.
What that means is that the monthly gas, which is on the left
hand side, can be estimated from inputting the production in
tonnes and multiplying it by a factor.
We see that this relationship is linear, or it looks like it's
linear. But, it can be that the relationship between the
consumption of a resource and an independent variable can
be also non‐linear.
Determining the baseline model
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59. 59
In this example, if we try to do a straight line it's difficult to
correlate the two. We need to go further and try to apply
some more techniques to find the logic between the energy
use and the independent variable.
As you see on this example, we have the outdoor
temperature on the x‐axis. If we try to use a straight line on
this one, it doesn't work. So, let's try something else.
Non‐linear models (example 1)
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60. 60
Let's try to use a straight line on first part and also on the
second part.
What you see on this graph is something that everyone
understands. It's just that in the graphical form, it's a little bit
difficult to comprehend. This is just a building that has a
winter mode and a summer mode. In the winter, so any time
the temperatures go below 40 degrees F, the gas
consumption increases, of course, because we need to heat
the building. And when the temperature goes above 40
degrees, we don't need to heat the building anymore so the
gas is consumed used in a very constant manner.
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We can also have other types of non‐linear relationships
between the energy consumption and the independent
variable. We could have a quadratic line, for example. This is
getting a little bit complex already, but the main point I am
trying to get across is that this analysis can be done very
easily with the help of Excel. We can use it to arrive to
conclusion with regards to the relationship between an
independent variable and the energy consumption.
Let's stop here for a moment.
Non‐linear models (example 2)
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62. 62
My point is that there is always risk around knowing why
we're consuming the amount of energy that we are. There's
always risk related to understanding that. But if we have data
on the energy consumption, and if we have data on variables
that we think might be influencing energy consumption, we
can apply this analysis to try to define this relationship in the
ofrm of a mathematical model.
And if we do this, then we can really go forward in trying to
understand: What happens if we have more production?
What happens if we have higher temperatures? We can use
this mathematical model to try to estimate the consumption
that would result from making those types of changes.
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63. 63
Once we determine the mathematical model, how do we
decide if this model is good enough and that we can trust it?
This decision making process is covered in the Measurement
and Verification Protocols. We need to use the Coefficienct
of Regression (R‐squared). Its value ranges between 1 and 0.
One means that it's a perfect correlation between the two
variables and zero means that there's no correlation
whatsoever. The M&V protocols, define R‐squared > 0.7 as
being acceptable as a level of relationship. This can be very
complicated, but just retain the idea that
Regression analysis
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if we determine a relationship and
R‐squared > 0.7 then we can be
sure that there is a correlation
between the two variables.
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65. 65
In the example that I gave you in the first part, the R‐squared
was 0.93. In other words, this means that 93% of the gas
consumption is explained by this mathematical model.
This is the method used to determine the relationship
between an independent variable and energy consumption.
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66. 66
How can we how can we apply this to energy savings? You
have a graph in the presentation here. Let me just take a
little bit of time to explain what it represents.
The line at the top of the chart is the baseline energy model.
The baseline is that the amount of energy that results from
the application of the equation that we found out in the
statistical model. That is the baseline. Then you have the
histogram on the bottom part of the graph. These bars
represent the real energy consumption that is being
measured at the facility level. In other words, this is what the
utility will be billing us. The invoice will say that we’ve
Computing energy savings
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67. 67
consumed this amount of energy. Normally, the baseline
model should be pretty close to the real consumption. Just
remember that the baseline model is a mathematical model
and that it is not 100% accurate but it should be accurate
enough.
Now let's just look at the graph from a different perspective.
You have the first half of the time period and then the
second half. In the first half, you have the baseline period.
You see that the baseline is pretty close to the real
consumption. At the dotted line in the middle, the date
break, we carried out an energy efficiency project at that
point. From that point onwards, the baseline is very different
from the real consumption.
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68. 68
That means that the real consumption has diminished. So,
we have lower consumption as a result of an energy
efficiency project. But if we calculate the consumption that
would have happened in the absence of the project, then we
get the baseline. Really what happens here is that,
if we measure the distance
between the baseline and the
real consumption, then we can
estimate the savings.
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69. 69
In real life, what happens is that once we have finished with
the energy efficiency project and we're getting savings from
the project, what we need to do in every reporting period (or
every time we want to calculate the savings) is get the
invoice from the utility and look the real consumption that
we're paying for to the utility. Then use the mathematical
model to calculate the consumption that would have
happened if we hadn’t implemented the project. Now we
can really compare apples to apples.
We do this comparison every time that we want to know the
exact amount of savings based on the mathematical model
and the independent variables.
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70. 70
If the facility is producing more, then we can get those
transparent figures from the facility production service. If
there is hotter weather, then we can get this information
from the statistics office of the country. In short, we have
access to information about the independent variables that
no one can influence. Then we use the mathematical model
to calculate what energy we would have consumed in the
absence of the project.
This combined with the real energy consumption from the
utility we can really estimate the energy savings.
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71. 71
Now we need to go one step further in order to calculate the
monetary savings. The monetary savings is derived from the
application of a utility cost structure or the tariff structure.
We pay for the energy in a certain manner, so, we need to
use the same tariff structure to calculate the savings.
Computing $$ savings
We must use the full utility price
schedule.
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72. 72
Let’s look at an example.
We have an adjusted baseline energy use of 270,000 kWh.
Again, the baseline energy use is the use that we calculated
using the mathematical model.
We also have a real consumption of 200,000 kWh in this
example. So, the total energy savings is 70,000 kWh.
Computing $$ savings (example)
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73. 73
In the adjusted baseline, we have 270,000 kWh. We break
down that consumption and apply the different prices of the
tariff structure and we get a total "money amount" of
$20,000. That is the cost if we applied the tariff structure to
the adjusted baseline.
We do exactly the same for the reporting period. "Reporting
period" is just jargon that means the real consumption of the
month that we're analyzing. The amount of the dollars that
we need to pay for the consumption is $15,000.
If we look at the savings and we break down the savings and
apply the tariff structure, we get an amount of $4,800.
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74. 74
Why is it important to go through all of this trouble to
calculate the monetary savings? Is there any other way to do
it? Well, really, there isn’t. There is no other way.
If we use an average price,
we’ll just overestimate the savings.
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75. 75
But, don't be surprised if an energy service company tries to
use an average price for a kilowatt hour. Of course, this is
better for them if they want to charge you for the savings.
In conclusion, we really need to apply the tariff structures to
get the real value of the savings. That is the main point and
this is a recommendation of the M&V protocols that I really
like to follow because it gives full transparency on how much
money is really being saved by the energy efficiency project.
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77. 77
This is the definition of risk and this is why the financial
department doesn’t want to give much latitude to the
technical department. The financial department doesn't
want any surprises. This is what it understands as being risk:
surprises that cause us to not get the results that we wanted.
Measuring risk
Risk is the chance an investment's
actual return will differ from the
expected return.
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78. 78
In an energy efficiency investment, there are many of
sources of variation, which means that there's a lot of
sources of risk, really.
You have the energy price that can vary. You have the
performance of the technology in the sense that you have a
technology that is working now that you want to replace
with a new technology that you don't know anything about.
The financial professional sees a lot of risk in this operation.
And then you have the weather risk. We all know that
climate change is giving a lot of headaches to everyone. This
is true not only in real life but also in the life of a financial
investment
Sources of risk in EE projects
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People just don't know how to prevent the variations in
weather. Variations in weather lead to variations in cost also.
And then you have the peak load variations that are not well
explained by the energy driver. You have differences between
one month and the other even though the production is the
same. So, you have also variations that are not explained.
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80. 80
The thing is that, this is not new. Risk analysis is a fairly
mature technique or field of study. There are techniques that
we can apply in order to quantify the risk.
This image is from a paper published by Mr. Jerry Jackson. I
really liked it because it summarizes what his approach is,
and the approach that I use myself in assessing risk in energy
efficiency projects. You can see that you have different
statistical distributions for weather, for performance, and for
energy price.
Monte Carlo Analysis
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A statistical distribution means that the actual value will vary
as a normal distribution.
If we take all these variations and we put them in one single
model, then we can actually quantify the risk of the whole
project, taking into account all of the single inputs. This is
called a Monte Carlo Analysis. It’s a very old technique, so,
we can apply it with much confidence.
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82. 82
Remember the example of the energy efficiency retrofit that
was rejected because it had a payback that was much higher
than 2.1 years? We took this same example and did a Monte
Carlo Analysis in order to quantify risk. Remember that we
want to know what would be the worst case scenario
because, in order to reduce the risk, we need to know how
much the expected results could differ from the reality.
What you see here is that the expected Internal Rate of
Return was 46.1%. But in the worst case scenario, we would
have 36.2%.
When to invest (example)
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83. 83
In this case, the worst case scenario is an Internal Rate of
Return of 36%, which is quite high! And this is not the best
project in the world. This is a typical retrofit project in an
existing building. So, how do we use this information?
If the Internal Rate of Return is
greater than the Cost of
Capital, in other words, if you
can borrow money for less
than this interest rate, then
this investment is profitable.
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84. 84
You can go ahead and borrow in order to carry out this
project and you will get enough to pay the capital and
accumulate actual savings in your budget.
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85. 85
Now, we will look at the minimum net savings. In the best
case, we had savings. A net cash flow, which means that this
is the real cash flow net of the financial needed to carry out
the project.
The expected scenario is $95,000 in savings. The worst case
scenario is $65,000 in savings. In the worst case, the worst
weather, the higher increase in energy prices with regards to
historical values, and the worst performance still tolerable
from the technology… in the worst case, you will still get
$65,000 out of this project in net cash flow.
Minimum net savings
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86. 86
The last graph that I want to discuss shows how the energy
budget changes under the different scenarios. Organizations
predict how much money they will spend for their energy
use. This is known as the energy budget. This applies also to
water and other resources.
In this case, the energy budget of this organization, that is,
the original energy budget was almost $340,000. If we
carried out the project, the energy budget would be
$185,000. In other words, they would just need to spend
$185,000.
Variance in energy budget
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87. 87
In the worst case, the difference between these two, the
budget with the project and without the project, would be
about $30,000.
If you look at the last scenario on the far right with the
original budget of $50,000 the difference is $27,000.
Notice that even if you don’t carry out the project, you are
still exposed to risk since the independent variables could
change regardless. You have weather that could change even
if you don't do the project. You have energy prices that could
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88. 88
change even if you don't do the project. And the
performance of the existing technology could also change as
it ages. As it gets older you could have more maintenance
costs as its performance diminishes. This is true for any
technology. So, even if you don’t implement the energy
efficiency project, you still have a risk of not getting the
return that you currently have on that asset.
Notice that the risk of variation will be lower if you do the
energy efficiency project (see blue bars). You will have less
surprises if there's a hotter year or if the technology fails or if
the energy prices go higher. So you see, you will have less
surprises if you go ahead with the energy efficiency project
than if you don't.
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89. 89
What is the magnitude of benefits offered by the investment?
• If you use Payback as a criteria to select projects, you
don't really know how much money the project will
generate because payback is relative. Payback is the
same for a million dollar project or a $100,000 project.
If you're refusing a million dollar project that has very
low risk that will produce a lot of results, you don't
really know if you use Payback. You need to use other
criteria like Net Present Value.
The astute business investor
would ask…
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90. 90
How quickly do the benefits of the investment accrue?
• In other words, the Internal Rate of Return. Using
Payback is not enough. With Payback, you don't know
what is the rate of return is on the project. Without
this information you cannot make any decisions based
on the interest rate of any bank loans you may need
to carry out the project or compare it to the Internal
Rate of Return of the core activities of company.
Sometimes energy efficiency projects have higher
returns than the core business of the institution. This
is very important to keep in mind.
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91. 91
What is the risk of making this investment?
• Do I have any way of really assessing the risk? Because
I don't want to reject a project that is very low risk just
because it has a Payback higher than two years. If it's
low risk, it's low risk. Sometimes, the core business of
the company has a higher risk than energy efficiency.
What is the risk of not making this investment?
• If I don't do anything about energy efficiency or water
efficiency, am I vulnerable to variations in
independent variables like energy price, like the
weather or the like the performance of the existing
technology? If I make the investment, would I be
shielding myself against these variations?
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92. 92
How does this investment compare to others?
• All the investment projects should be quantified with
the right techniques such as Net Present Value,
Internal Rate of Return, and Monte Carlo Analysis. If
you want to really assess an energy efficiency project,
you need to compare it in the same terms as the
other investment projects. My experience is that
when you do apply these techniques, you will find
that energy efficiency projects are very, very, very
profitable and that they compare very well to other
projects that might be in the list for decision making.
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95. #2
Is the Payback Period a good tool for
evaluating energy efficiency projects?
Payback Period is just a bad way of evaluating the
value of an investment, but there are reasons why the
payback period is being used. In short, the payback
metric is being used as a tool to assess risk.
That means that the risk of something going bad is
very low because if the Payback is very low, then we
don't need to wait a lot to see if the project yields the
95
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96. Expected results. A maximum Payback of two years
means that the investment is a safe choice.
The astute business investor would ask, “What is the
magnitude of benefits offered by the investment?” If
you use Payback as a criteria to select projects, you
don't really know how much money the project will
generate. You need to use other criteria like Net
Present Value.
96
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97. #3
Which protocols can be used to
estimate energy savings?
Savings are the absence of consumption. The absence of
something cannot be measured. It can only be estimated.
For example, one of the protocols which is the most used
in the world, is called the International Protocol of
Measurement and Verification, IPMVP. The IPMVP
specifies the topics that need to to be addressed in a
Measurement and Verification Plan for a specific project.
It points out what needs to be covered. But, for me, the
97
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98. The most important part of the International Performance
Measurement and Verification Protocol is that it allows
flexibility in creating M&V plans. It's not like a recipe. It
just gives you what do you need to think about when
contracting a service to reduce consumption of energy
and water also.
98
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99. #4
Can the average energy price be used
when calculating the actual monetary
savings?
We pay for the energy in a certain manner, so, we need to
use the same tariff structure to calculate the savings. If we
try to use an average price we’ll just overestimate the
savings. We really need to apply the tariff structures to get
the real value of the savings.
99
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100. #5
Which method can be used to quantify
the risk in an energy efficiency project?
There are techniques that we can apply in order to
quantify the risk. A paper published by Mr. Jerry Jackson
summarizes what his approach is, and the approach that I
use myself, in assessing risk in energy efficiency projects.
You have a different statistical distributions for weather,
performance, and energy price. The statistical distribution
100
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101. means that the actual value will vary as a normal
distribution in statistical terms. If we take all these
variations and put them into one single model, then we
can actually quantify the risk of the whole project, taking
into account all of the single inputs.
This is called a Monte Carlo Analysis.
101
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102. The astute business investor would ask:
• What is the magnitude of benefits offered by the
investment? You need to use criteria like Net Present
Value.
• How quickly do the benefits of the investment accrue?
In other words, the Internal Rate of Return. Sometimes
energy efficiency projects have a higher return than the
core business of the institution. This is very important
to keep in mind.
102
#6
What are the important points to
consider before investing in an EE
project?
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103. • What is the risk of making this investment? Do I have
any way of really assessing the risk? Because I don't
want to reject a project that is very profitable because
its payback is longer than two years. If it's low risk, it's
low risk.
• What is the risk of not making this investment? If I
don't do anything about energy efficiency or water
efficiency, am I vulnerable to variations in independent
variables like energy price, weather or the performance
of the existing technology? If I make the investment,
would I be shielding myself against these variations?
103
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104. • How does this investment compare to others in terms
of Net Present Value, Internal Rate of Return, and
Monte Carlo Analysis? My experience is that when you
do apply these techniques, you will find that energy
efficiency projects are very, very, very profitable and
they compare very well to other projects that might be
on the list for decision making.
104
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