Return on Investment

It’s funny, but certain approaches and phrases seem to suddenly gather unexpected currency, and return on investment (ROI) is one that I have been hearing all over the place recently.  For example, a senior manager recently asked me for the ROI on an energy conservation project, and one of my excellent consultants recently provided a payback and ROI summary for an upcoming project.

It was not clear to me, however, how people were talking about ROI in the context of energy conservation projects.  To see why, let’s start with the fundamental question: What is Return on Investment?

Investopedia provides the following definition, and it is sufficient for our needs:

What is ‘Return On Investment – ROI’

A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. ROI measures the amount of return on an investment relative to the investment’s cost. To calculate ROI, the benefit (or return) of an investment is divided by the cost of the investment, and the result is expressed as a percentage or a ratio.

The return on investment formula:

Return On Investment (ROI)

In the above formula, “Gain from Investment” refers to the proceeds obtained from the sale of the investment of interest. Because ROI is measured as a percentage, it can be easily compared with returns from other investments, allowing one to measure a variety of types of investments against one another. 

First, let’s contemplate a simple example of this.  Say you buy a house for $100,000 and

eventually sell it for $120,000.  The ROI is then:
($120,000 – $100,000) / $100,000 = 20%
Notice two things here:
  1. The ROI applies to a unitary transaction
  2. The ROI is unconcerned with time.  Whether this profit is captured after one year, or after ten years, the ROI is unchanged.

An energy conservation project is not like this.  While there is an initial capital cost that we can identify, the energy project has the following unique characteristics that we really need to capture:

  1. The project delivers energy savings (gains) on an annual basis, not just once
  2. The project has a finite useful life

Let’s take a look at a proposed energy project to see where the ROI approach might take us under differing scenarios.

A recent project delivered the following economics:

Net Capital Cost                                                                $215,047

Net Annual Energy and Operational Savings            $  63,439

Project Simple Payback (years)                                           3.4          [ $215,047 / $63,439 ]

Anticipated Useful Life (years)                                            10

The consultant then calculated the ROI by dividing the annual saving by the capital cost:

ROI [ $63,439 / $215,047 ]                                                      29%

However, we see that this is in actuality nothing but the inverse of the simple payback.  The “Gain from the Investment” is actually the net present value of that discounted annual saving over the ten years of the measure life.   This account for both the recurrence of savings on an annual basis, and the fact that the energy project (probably) has a finite useful life that is more or less known.

Here’s a refresher on NPV and discounted cash flows for those who want it:

https://lifeentropic.wordpress.com/2013/03/27/payback-2/

If we assume a discount rate of 5%, our 10 year NPV factor is 7.27 and the net value of the accrued savings is:

7.27 x $63,439 = $461,202

Not bad.  And our ROI is subsequent found to be:

($461,202 – 215,047) / $ 215,047 = 114%

Now, 114% return is going to cause some eyeballs to pop, but if we think this through, it’s clear why an ROI should be very high for any energy project with an acceptable simple payback.  Unlike almost any other investment, an energy project doesn’t just deliver a return, it is expected to actually pay for the original capital outlay in a relatively short period of time relative to it’s useful life.  This is significantly different than the kind of ROI one expects with a transaction involving solid assets that possess intrinsic value like a house or a factory.

Consider our house example.  To compare with our energy project, we would need to buy a house for $100,000 and expect it to sell after ten years for $214,000 to deliver an equivalent ROI.  At least, this is the case if we subscribe to the notion of net present value of savings.  And while energy projects may be stipulated with a “three year simple payback” constraint, who makes an investment on a house by limiting the selection to houses that can deliver a three year simple payback on investment?  No one.

This brings up a perverse aspect of energy project funding.  Few organizations or individuals expect traditional investments to completely recover the initial capital cost and provide additional returns on top of it, but the standard “simple payback” limitation that is put on energy projects puts them in exactly this disadvantaged position when in competition for investment capital.  When one looks at life cycle costs, energy projects are actually extremely competitive.

We’ve gone a bit sideways, but the point is, when someone carelessly says they’d like to see the ROI on an energy project, ask them to clarify:  Do you want the ROI based on the life cycle NPV cost savings of the project?  Because that will paint a totally different and more attractive financial picture than simple payback.

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