FINANCIAL AND ECONOMIC ANALYSIS

OF ENERGY EFFICIENCY PROJECTS

FINANCIAL AND ECONOMIC ANALYSIS

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 Table of Content

▪ Introduction to Financial and Economic Concepts

▪ Financial Analysis Techniques (Payback, Net Present
Value, Internal Rate of Return)
▪ Life Cycle Cost and Levelized Cost of Energy
▪ Financing Options
▪ Energy Service Contracts

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 Introduction

❑ Energy Projects are very important to the economy and environment.

However, the biggest constraint in increasing the number of energy
projects is the lack of finance.

❑ As with any type of investment, energy management proposals

should show the likely return on any capital that is invested.

❑ Management will enquire the

• How much will the proposal cost?
• How much money will be saved by the proposal?

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 Economic and Financial Analysis Techniques
❑ Economic Analysis compares the benefits and cost to the whole
economy while financial analysis is focused on the B/Cs to the firm.

❑ Tool kits for financial and economic analysis of energy savings

measures.

❑ Energy Manager and Energy Auditor must have knowledge of financial

appraisal for EMOs, with or without incentives, putting into
consideration return on investment based on cost of EMO
implementation.

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 SIMPLE PAYBACK PERIOD

❑The payback period can be defined as the time (number of years)

required to recover the initial investment (capital cost). Once the
payback period has ended, all the project capital costs will have been
recovered and any additional cost savings achieved can be seen as
clear ‘profit’.

❑The shorter the payback period, the more attractive the project
becomes. The length of the maximum permissible payback period is a
matter of company choice or established policy.

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 SPP Calculations

The cost of a new heat exchanger is N 150,000. What is the simple payback period
(SPP) in years considering annual savings of N 60,000 and annual maintenance cost
of N10,000?

Simple Payback = Capital Cost /Annual Energy Cost Savings

= 150,000 / (60,000 - 10,000) = 3years

Limitations:
• The payback period does not consider savings that are accrued after the
payback period has finished.
• Simple payback period does not consider the time value of money i.e.
money which is invested would accrue interest as time passes.

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 Return on Investment (ROI)

❑ ROI expresses the "annual return" expected from a project as a percentage of capital
cost or initial investment. ROI is an inverse of payback period.

❑ ROI must always be higher than cost of money (interest rate) so as to make the
project attractive; the greater the return on investment better is the investment.

Example
An outlay of N100,000 for equipment is expected to provide an after-tax cash flow of
N25,000 over a period of six years, without significant annual fluctuations. What is
the return on investment?
ROI = N25,000/N100,000 X 100 = 25%

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 Time Value of Money

❑ A dollar in hand today is more valuable than one to be received at some time in
the future. Money today is very valuable and future money is less valuable.
❑ Time value must be placed on all cash flows into and out of the company.
Present Value (PV)—the current value or principal amount.
Future Value (FV)—the future value of a current investment.
Annuity (A) - fixed payments at the end of a specified period
Interest/Discount Rate (i)—It is the expected rate of return from an alternative
investment. Interest rate (rate applied to PV to determine its FV) & Discount rate
(rate applied to determine PV of a future cash flow)
Term of Investment (N)—the number of years the investment is held.
Formula: FV = NPV (1 + i)n or NPV = FV / (1+i) n

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 Net Present Value (NPV)

❑ The net present value method considers the time value of money. This is done by
equating future cash flow to its current value today. The present value uses discount
rate.

❑ NPV may be defined as the difference between the total present value of the cash
inflows and the total present value of the cash outflows.

❑ NPV compares the value of the investment today versus the value of that same
investment in the future, after taking inflation and returns into account.

• If the NPV of a prospective project is positive then it should be accepted (i.e. NPV > 0)
• if the NPV of a prospective project is negative, then the project should be rejected
because cash flows are negative (i.e. NPV < 0)
• If the NPV of a prospective project is zero then it should probably be rejected as it
generates exactly the return that is expected (i.e. NPV = 0)

❑ Useful to compare Two EMO projects.

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 NPV CALCULATIONS

EXAMPLE
A lighting retrofit project cost N200,000 and the estimated Energy Cost Savings are N40,000
per year. The estimated life of lighting equipment 10 years and the discount factor is 10%.
Calculate the NPV?

SOLUTION

NPV = - 200,000 +40,000/(1+0.1)1 + 40,000/(1+0.1)2 + 40,000/(1+0.1)3 + 40,000/(1+0.1)4 +

40,000/(1+0.1)5 + 40,000/(1+0.1)6 + ……………………. + 40,000/(1+0.1)10 =N45,780

• Calculated using EXCEL or Compound Interest tables

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 INTERNAL RATE OF RETURN (IRR)
❑ The internal rate of return (IRR) of a project is the discount rate, which makes its net
present value (NPV) equal to zero

❑ The IRR will assist in determining and comparing with the rates you could earn by
investing your money in other projects or options.

❑ If the IRR is less than the cost of borrowing used to fund the project, investment is
not sound.

❑ To be within acceptable limits , a project must be expected to earn an IRR that is at

least several percentage points higher than the cost of borrowing or other
alternatives.

❑ IRR method is designed to assess whether or not a single project will achieve a
target rate of return.

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 INTERNAL RATE OF RETURN (IRR)
A proposed project requires an initial capital investment of Rs. 20,000. The cash flows generated
by the project are shown in the table below:
1. With a discount rate of 8%, the NPV is 2791

2. With a discount rate of 12 %, the NPV is 495

3. With a discount rate of 13%, the NPV is -65

Use interpolation method, to calculate the IRR using formula or graphical method

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 Cash Flow Analysis

Capital Investment Considerations

The attractiveness of any investment is determined by this four elements involved:
Initial capital cost or net investment
Net operating cash inflows (the potential benefits)
Economic life (time span of benefits)
Salvage value (any final recovery of capital)

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 Life Cycle Analysis
❑ It is a rigorous method of evaluating energy conservation options over the life of a system
or project.
❑ It involves the comprehensive identification of all cost associated with an EMO project
❑ Useful when comparing alternative solutions to a particular problem.
❑ Energy intensive equipment procurement should be assessed based on LCC and not least
capital investment.

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 Where to get data as an Energy Auditor
❑ Investment:
✓ Benchmarks, experience, google
✓ Consultants,
✓ Pre-feasibility

❑ Life expectancy -benchmarks, experience, standards

❑ Cost of capital –finance department, Financial records
❑ Cost of energy –look at the bills,
❑ Maintenance cost –experience, benchmarks
❑ Labour cost –experience, finance, human resources, benchmarks
❑ Other: insurance,… lump sumps (i.e. 1 % of capex)

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 Levelized Cost of Energy (LCOE)
❑It is a measurement used to assess and compare alternative methods
of energy production. The LCOE of an energy-generating asset can
be thought of as the average total cost of building and operating the
asset per unit of total electricity generated over an assumed lifetime.
For example, Natural Gas Plant VS Solar powered solution.

❑Calculated by accounting for all of a system’s expected lifetime

costs (including construction, financing, fuel, maintenance, taxes,
insurance and incentives), which are then divided by the system’s
lifetime expected power output (kWh).

❑If this price is lower than the existing energy costs, the investment
should be made.

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 LCOE Calculations

Where:
•Initial cost of investment expenditures (I)
•Maintenance and operations expenditures (M)
•Fuel expenditures (if applicable) (F)
•The sum of all electricity generated (E)
•The discount rate of the project (r)
•The life of the system (n)

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 Financing Options

There are three basic types of financing:

1.Equity
2.Debt
3.Grants

Others include:
•Leasing / Renting
•Vendor Financing
•ESCO Financing
•Factoring / Forfeiting

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 Debt Financing
❑ Debt financing involves taking a loan (or issuing a bond) to provide capital.
Repayment of both the amount of money borrowed and the interest charged.
❑ Debt financing it is the company that takes all the risk and must install and
manage the project.
❑ Debts can be Recourse (backed by company’s assets/collateralized) or Non-
Recourse (long-term financing based upon the projected cash flows of the
project)
❑ Loans can be provided by:
•Commercial banks: apply market conditions to terms of repayment period and
interest rates. They are more accessible than the following debt providers
•Multilateral or development banks
•Investment banks/funds: loan or equity(capital investors), e.g SUNREF

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 Equity Financing

❑Lender acquires an ownership (or equity) position within the

borrower’s organization for provision of capital.
❑Equity involves ownership and the right to get involved in the
decisions to be made regarding the project and the equity
investor expects higher returns.
❑Capital can be provided in the form of pure equity or investor
loans. In the case of an investor loan, the amount lent has to be
repaid but with flexible repayment terms. This loan also bears
interest.

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 Project Financing Options
❑ GRANTS: No repayment of the amount granted. No or little interest. Less attractive
markets, counterparts funding etc
❑ LEASING/ RENTING: True lease allows use of equipment without ownership risks,
offers reduced risk of poor performance, service, equipment obsolescence etc. and is
particularly suitable for short-term use of equipment.
❑ VENDOR FINANCING: Lending of capital by a vendor to a capital for energy projects.
In the form of debt or equity. Usually higher rates of interest because of the long
repayment period. Helps build good relationships.
❑ FACTORING/FORFAITING:
• In Factoring, a business receives cash advances (from lenders or banks) against their
account receivables – short term, domestic.
• Forfaiting- exporter sell his rights of trade receivables to a forfaiter to acquire immediate
cash- mid-long term, international.

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 Energy Service Contracts
❑ An energy service contract is normally signed between the industrial facility (client) and the
energy service company (ESCO). The contract allows the client to transfer risk of generating
energy and focus on its core business and to reduce operating cost.
❑ ESCOs are usually companies that provide a complete energy project service, from
assessment to design to construction or installation, along with engineering and project
management services, and financing.
❑ Only after the installed equipment actually reduces expenses does the contractor get paid
(payment on performance approach).

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 Energy Service Contracts Models

1. Shared savings in which savings are shared between client and the ESCO at
an agreed percentage over an agreed duration. In this model, the ESCO finances
the cost of equipment (capital expenditure) through equity (own funds) or debt.

2. Guaranteed savings in which the ESCO assumes the project risk though
capital expenditure is borne by the client. Here, the ESCO guarantees the
quantum of energy and savings to be made. In the event of not meeting agreed
figures, the ESCO makes up for the difference.

3. Lease rental in which the ESCO is responsible for capital expenditure. The
client makes regular payments to cover capital expenditure and interest based on
verifiable energy and cost savings made. Usually at the end of the lease period,
ownership is transferred to the client.

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 Energy Service Contracts Models

4. Build-own-operate-transfer in which the ESCO designs, builds, finances, owns

and operates the equipment for a defined period of time before transferring
ownership to the client. In this model, the client enters into long term supply
contracts with the ESCO and is charged according to service delivered.
5. Build-own-operate is a form of public-private partnership (PPP) in which the
ESCO provides energy services to a government owned facility. The government
does not provide direct funding but grants special incentives to the ESCO as a form
of cost recovery.

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 THANK YOU FOR YOUR ATTENTION

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