Chief financial officer sign-off is critical to advance your onsite energy plan. Fortunately, it’s not difficult to secure when you know which metrics are required to build a strong business case. You’ve already read Carbon Reduction Goals Linked To Additional Advantages Including Improved Profitability And Reputation so you’re aware of the big picture financial benefits of onsite energy. Now you need to develop actual projections to present to the CFO.
Which financial metrics of your onsite energy plan should you calculate to guarantee not only approval but enthusiasm? That may depend on approval processes specific to your organization, however, a strategic business case will make everything easier.
Companies’ parameters for project valuations will vary, but based on our experience, those listed below are almost always required. Keep reading to understand the financial metrics you need to develop and quantify to present a compelling business case for utilizing onsite energy to meet sustainability commitments.
Financial Metrics of Onsite Energy
There are at least six parameters that are important when telling your financial story:
Capital Expenditure (CAPEX) of Onsite Energy
In onsite project terminology, CAPEX is used in reference to all the investments that take an onsite energy project from inception to operation. This includes design, supply, construction, and commissioning of the system, among other expenditures.
CAPEX is crucial for companies to determine the investment scope and identify where to get the funds for a project. It is also the basis of other metrics you will need, so be sure to get this one right.
CAPEX, as the name suggests, gets capitalized (recorded on the balance sheet), which may go against a business’s financial goals. In that case, there are a plethora of funding solutions available. Two such examples are leases, in which you could still operate the assets yourself but they belong to somebody else, or a Power Purchase Agreement, in which you completely outsource your project (including maintenance and operation) and pay for the electricity generated.
CAPEX Tools and Objective
There are great free databases and tools out there for CAPEX estimation, including the National Renewable Energy Laboratory (NREL) and VECKTA’s Insights Report. They will provide you a much needed north star to get a ballpark number. However, you will eventually need a functional design to get firm proposals for your specific system, over which you will be adding a risk contingency, to get this important metric right.
Your objective is to minimize CAPEX.
Operating Expenses (OPEX) of Onsite Energy
In onsite energy project terminology, OPEX encompasses all the investments that happen after the start of operations of a project. It will roughly include operation and maintenance costs for the lifetime of the project.
If you think about the total costs throughout the lifetime of this project (also known as TOTEX), OPEX is the other part of the equation with CAPEX.
OPEX will be useful for similar reasons to CAPEX. Early on in planning your onsite energy project, it’s important to estimate it (and eventually calculate it with firm proposals).
It’s worth noting that the cost of renewable technologies are nearly all in CAPEX, with very limited OPEX given the no-cost nature of the energy resource.
Work to minimize OPEX.
Return on Investment (ROI) of Onsite Energy
Return on Investment (ROI) is a popular profitability metric used to evaluate how well an investment has performed, or to estimate how it will perform.
ROI is expressed as a percentage and is calculated by dividing an investment’s net profit (or loss) by its initial cost or outlay.
Here we need to consider two cases:
- If you are a power producer – you will be providing electricity to someone in exchange for dollars – the logic here is that after the project starts operating, you will start receiving income from selling that generated electricity. From that income, you discount the pertaining OPEX to get to net income, and you obtain the ROI by dividing the net income by the CAPEX.
- Now, if you are using this project to replace your current utility costs, including buying energy assets to own and operate them, the logic is that the ROI will be a metric of savings. As a rough example, if you previously spent $50k in electricity, but now you spend close to zero to operate a solar array, that net benefit is what you should use.
Your objective is for the ROI for your project to be higher than competing projects in the organization, and ideally higher than the company’s minimum acceptable rate of return (also known as hurdle rate). ROI can be presented annualized, or for the lifetime of the investment.
Payback Period for Onsite Energy
The payback period refers to the amount of time it takes to recover the cost of an investment or how long it takes for an investor to reach breakeven.
The payback period is calculated by dividing the amount of the investment by the annual cash flow. In the case of replacing current utility costs, instead of cash flow, we would use net savings.
Some industrial companies want paybacks as low as 18 months, but usually a 3 to 7-year payback will be acceptable to the CFO.
In the specific case of companies with a net zero target, a 10-year payback may still be doable. This is because payback is only a value of financial performance. There are other values that can be stacked and aren’t always easily quantifiable, like what will hitting or not hitting your net zero target do for your branding, how much is the added resilience worth to you, and many other factors.
Payback Period Objective
Your objective is to keep the payback as short as possible, given your overall business goals.
Net Present Value (NPV) of Onsite Energy
Net present value, or NPV, is used to calculate the current total value of a future stream of payments – or net savings. In other words, it is used to determine how much a series of cash flows is worth.
To calculate NPV, you need to estimate future cash flows for each period and determine the correct discount rate. Discount rate is the interest rate charged to the company borrowing the money. The way that I like to think about this one is that NPV will tell me if the project meets or exceeds my “hurdle” rate or expected rate of return.
The interesting thing about NPV is that it recognizes the time value of money and will include non-cash items such as depreciation.
NPV has two main weaknesses:
- It assumes you know exactly what your future cash flows (or net savings) will be.
- It assumes your discount rate is perfectly set, and will remain the same throughout the lifetime of your project. However, discount rate expectations tend to change a lot over the years.
The best way to get this one right is to find the optimal technology and economic mix using powerful optimization tools. An example tool is the VECKTA Insights Report, powered by XENDEE, that can run these scenarios, and even be bankable (meaning the results will likely be accepted by third parties, such as financiers).
So for us here, if the NPV of our project is:
- positive, it means that the discounted present value of all future cash flows related to that project will be positive, and therefore attractive.
- negative, we need to reevaluate whether our discount rate isn’t perhaps too aggressive.
As noted above, there’s more to an onsite energy project than financials, so it’s important to take a second look. What you can absolutely establish, though, for two equally calculated projects is that you should probably start with the ones that are above zero.
Internal Rate of Return (IRR) of Onsite Energy
The internal rate of return (IRR) is the annual rate of growth that an investment is expected to generate. In other words, the interpretation for IRR is this: what discount rate would cause the net present value (NPV) of my project to be 0?
The cool thing about IRR is that it is very simple to obtain and understand. One of its best uses is to compare capital projects side-by-side. The one with the highest IRR wins. The one disadvantage though is that IRR does not care about the size of the project.
The calculation of IRR can be fairly easily accomplished using a spreadsheet.
The objective is to maximize the IRR.
Gain CFO Buy-In on the Journey toward Sustainability Targets
We recommend gauging the interest level and support from your CFO before presenting, which you may do as you socialize your onsite energy plan in the organization. It may also be effective to open a dialogue with the CFO to understand their expectations as well as their knowledge base or exposure to onsite energy. This enables you to tailor the above metrics to ensure the CFO can accurately evaluate – and hopefully, approve – your onsite energy plan, so you can progress toward your sustainability target.
Written By Felipe Sarubbi