This blog builds the case for a revolving investment fund (including a financial analysis of a revolving fund vs. a traditional project based approach).

Energy waste as a strategic risk?

Within many organisations, year-on-year, OPEX is allocated to paying part of an energy bill that could otherwise be avoided if the organisation had best practice technologies and a well managed approach.

Across many industries, it can be possible that up to 30% to 50% of annual energy costs are wasted providing electricity to inefficient equipment, processes and systems.

The chart below highlights this, with the blue segment representing what percentage of energy purchased would be required if using efficient systems, processes and technologies. While this large percentage may not be possible in all cases, many energy auditors we discuss this with share similar stories of the potential reductions possible i.e. if you were to target best practice, what is technically possible?

This measure of the current state relative to what is technically possible, is what we think of as the efficiency frontier. Essentially it is where we deem energy costs to be providing “efficient energy services” or put simply, what you could be paying for instead of the additional 30% – 50% waste.

In certain select cases, this 30 – 50% is available from energy management, positive NPV investments and procuring for least cost.  If you are one of these businesses, this could be seen as a strategic risk where over time there could be significant over expenditure on waste (spending that could otherwise be avoided).

In article, we present a concept whereby “the waste can be used to fund the improvements” via a revolving investment fund focused on energy efficiency, energy management, demand response and renewables.

Why address inefficient spending?

Paying for this wastage above could be analogous to having an employee or team member (or whole department) that is employed full-time, but consistently only comes to work 2.5 to 3.5 days a week and then leaves to go fishing.

While this great for the employee (or in this case the energy retailer) it is time to adjust the culture of performance. No more fishing, come to work and do your job or you might get fired (equipment replaced in this example perhaps)!

Why not treat assets with the same productivity focus as HR. If a workplace culture was that inefficient, should we tolerate the same in our energy systems?

 

Opportunity cost of wastage

If an organisation would otherwise spend funds on inefficient energy in the eight years until 2030, a decision has not only been made to spend inefficiently, but the opportunity cost of reinvesting these funded is wasted.

Who makes this decision? Who is accountable for the opportunity cost of the continual business improvement otherwise missed and the risks this creates by continuing business as usual?

These decisions get lost and could generally be directed at the organisation as a whole given there is not a culture of continual improvement. From the director or executive manager’s perspective, the tone from the top is important and this cultural misalignment can also have other unintended consequences.

In finance terms, soft capital rationing can occur where a positive net present value (NPV) project exists although is not implemented (possibly due to trust in savings delivered from previous projects, energy literacy generally or general risk aversion).

In these scenarios, there is a possibly a human bias that business as usual is safe right?! We would pose an alternate question to test this and ask “Could there be a material risk to miss the opportunity cost here”?. Think the current Ukraine related energy crisis and reduced exposure to increased price volatility, inflation and supply chain disruptions and the benefits from a leaner, efficient cost structure.

While the best time to act was five years ago, the second best time to start is now.

 

Finance foundations

Engineering teams are often presenting projects to management based on simple payback period on a case-by-case basis. These are assessed on a once off basis based on return on investment, with the engineer preparing projects for the executive decision maker and hoping “the project has legs”.

This project focus can be inefficient as it could waste engineering and management time when projects are not funded, or worse still, the wrong projects get funded due to not having a clear investment strategy around energy costs.

Moving from a project focus to a structured investment approach, while requiring some initial groundwork, is the best way to address this problem.

By establishing the investment hurdle rates and annual investment budgets upfront, projects can compete for funds with the most efficient opportunities prioritised.

Structurally, more mature aspects such as independent measurement and verification (M&V) of avoided energy use (waste eliminated) can then be budgeted in every project to improve transparency and trust in project performance.

The cumulative savings can then be accounted for based on projects over time with adjustments to the governance, performance requirements and requirements of the investment fund generally.

 

Building a Flywheel

A more advanced way of moving from a project focus to a structured investment approach, is by using a revolving investment fund.

Put simply, this is where a certain amount of funding is borrowed internally and repaid a number of years later. The savings in this early period are reinvested into new projects so that a compounding effect adds dynamic and unstoppable momentum.

 

It is in a way like a flywheel

• The flywheel at the start is hard to turn as you set up and fund initial projects
• Imagine turning the flywheel above, it takes time as you complete each turn in the initial phase
• As it gets momentum, the flywheel turns faster and faster and it become easier to complete a revolution
• Eventually it takes off and in a way becomes impossible to stop

The focus is on execution, building a culture of ownership of projects and being accountable for the savings performance – since this is what powers future projects (and possibly the energy management teams salary).

 

A financial worked example

For simplicity we compare two options here:

• Option 1 – Invest $500,000 as a simple upfront capital investment, with a reduction in annual energy expense observed (project basis)
• Option 2 – Invest $500,000 with a simple four-year payback and allow for continual reinvestment of delivered savings over seven years, with savings flowing through to the income statement (profit and loss statement) at year eight return (reinvestment of savings / revolving fund)

 

Option 1

This is a fairly simple discounted cashflow calculation based on an upfront investment and series of cashflows attributed to avoided energy use or otherwise called energy cost savings (these figures are all thousands i.e. $500 = $500,000)

Year	–	1	2	3	4	5	6	7	8	9	10	11	12	13	14	15
Project Cashflows	-$      500	$  125	$  125	$  125	$  125	$  125	$  125	$  125	$  125	$  125	$  125	$  125	$  125	$  125	$  125	$  125
Overall reduction in expenditure	$   1,375
NPV	$      597
IRR (initial $500k)	24%

• Project NPV = $597,000 (based on 7% discount rate)
• Total reduction in energy spending, net after investments – $1.375 million
• IRR = 24%

Please note (IRR = Internal Rate of Return; NPV = Net Present Value; Discount Rate based on internal cost of secured capital and energy savings risk premium) 

Option 2

The revolving energy fund concept is a bit more complex.

• $500,000 is invested upfront
• Savings from year 1, fund projects in year 2
• Savings from year 2 fund projects in year 3
• Savings from year 3 fund project in year 4
• One final reinvestment in year 7
• At year 8 you return funds to the P&L and stop funding projects

Please note: this is a simple model and does not account for the time to deliver projects (assumed end of year investment of savings leads to a project being able to be implemented, with savings online immediately). 

Year	–	1	2	3	4	5	6	7	8	9	10	11	12	13	14	15
Initial Investment	-$      500
Savings tranche – Year 1		$  125	$  125	$  125	$  125	$  125	$  125	$  125	$  125	$  125	$  125	$  125	$  125	$  125	$  125	$  125
Savings tranche – Year 2			$    31	$    31	$    31	$    31	$    31	$    31	$    31	$    31	$    31	$    31	$    31	$    31	$    31	$    31
Savings tranche – Year 3				$    39	$    39	$    39	$    39	$    39	$    39	$    39	$    39	$    39	$    39	$    39	$    39	$    39
Savings tranche – Year 4					$    49	$    49	$    49	$    49	$    49	$    49	$    49	$    49	$    49	$    49	$    49	$    49
Savings tranche – Year 5						$    61	$    61	$    61	$    61	$    61	$    61	$    61	$    61	$    61	$    61	$    61
Savings tranche – Year 6							$    76	$    76	$    76	$    76	$    76	$    76	$    76	$    76	$    76	$    76
Savings tranche – Year 7								$    95	$    95	$    95	$    95	$    95	$    95	$    95	$    95	$    95
Savings Returned to the Business									$  477	$  477	$  477	$  477	$  477	$  477	$  477	$  477
Cash Flows	-$      500	$     –	$     –	$     –	$     –	$     –	$     –	$     –	$  477	$  477	$  477	$  477	$  477	$  477	$  477	$  477
Net reduction in expenditure	$   3,315
NPV	$   1,190
IRR (initial $500k)	20%

• Project NPV = $1,190,000
• Total reduction in energy spending, net of initial investment – $3,315,000 million
• IRR = 20%

Quick explainer:

The initial $500,000 with a four year payback gives the $125,000 (year one tranche).

In year two, this $125,000 is reinvested (as a four year payback), giving $31,000 in savings

In year three, you take the $125,000 + $31,000 = $156,000. Divide this by four (four year payback) and you get an extra $39,000 in savings in year four

In year four, take the $125,000 + $31,000 + $39,000 = $195,000. Divide this by four (four year payback) and you get an extra $49,000 (rounded) in savings in year four, and so on…

This modeling is a basic introduction and assumes availability of continual high value investments and for simplicity used no annual adjustment in energy pricing.

In Summary

Option 2 has the following benefits:

• An additional $1.94 million in reduced energy expenditure
• Incorporating time value of money and comparing the NPV of both projects, this higher net benefit is worth $593,000 in todays dollars (given Option 2 has a deferred repayment concept)
• The IRR of Option 1 is slightly higher at 24% relative to 20% although this should simply be considered as the investment hurdle rate (in my personal opinion), and given Option 2 has a higher NPV this should be the main metric used for decision making

The non-financial benefits of a revolving sustainability fund can also include:

• Improved financial discipline and a culture of execution on project deliverables
• The opportunity cost of delivering projects and not wasting time is financially valued in the model
• Transparency of savings is what this drives the flywheel and what gets monitored, gets managed
• The ability to improve governance and manage sustainability budgets more efficiency by building the infrastructure to drive performance and not relying on a project approach with “what makes a good project” changing over time

While this article is presented more so from a financial and business perspective, one final point is that this concept could also address reputational risks and stakeholder expectations associated with addressing climate change. Using Option 2, could energy savings fund the net zero pathway via reinvestment? Would this help create the financial momentum needed for such a task?

My take on it is this – with a disciplined and strategic approach,  the concept and financials in Option 2 speak for themselves.

If you enjoyed this article get in touch! I have a more detailed model, able to work with real world scenarios and would enjoy exploring the concept and if it could work for your organisation.