“Does energy efficiency pay?” is no longer the question on everyone’s mind. When the Great Recession made cost control a paramount concern, one of the positive outcomes was that organizations took a chance on energy efficiency projects and proved that they do, in fact, pay. Paradoxically, the hard times have also led to scarce resources to pursue energy efficiency. With both working capital and staff capacity still limited, the new question is this: “What’s the best way to identify and execute energy efficiency projects?”
As two eager MBA/MS students at the University of Michigan’s Erb Institute for Global Sustainable Enterprise, we’re betting on the concept of revolving energy funds (REFs). This kind of sustainable fund is a proven but not yet widely adopted method for leveraging initial capital to make an ongoing series of energy efficiency improvements. Rather than performing energy efficiency improvements and simply decreasing annual operating expenditures, an REF captures a portion of this energy savings and enables it to be dedicated to future retrofits.
The REF concept has seen a recent increase in popularity. The American Recovery and Reinvestment Act allocated $3.2 billion to energy efficiency nationwide, and approximately 140 recipients – cities and states across the country – used at least a portion of their funding to start REFs. Our financial modeling suggests that as communities establish REFs, they pay attention to key project parameters. First, and not surprisingly, REF performance is highly sensitive to variations in project paybacks. Funding projects with quick payback allows for faster reinvestment and greater leveraging of the initial capital, but this must be balanced against the desire for achieving maximum energy savings through deep retrofits. Second, larger projects help amortize the cost of energy audits and other overhead, so it is important to maximize the quality of audit & design, and aggregate projects wherever possible.
Making the case for REFs
A 2009 report by McKinsey and Co. concluded that the commercial sector in the United States could reduce its energy consumption by 29% by making only net present value (NPV) positive investments in energy efficiency. Yet with a few notable exceptions, the promise of energy efficiency has failed to gain momentum at a smaller scale. There are three primary reasons for this gap: the lack of capital, the uncertainty of factors that affect energy use, and high transaction costs.
Capital is often the largest of these concerns, and unfortunately, there is no easy way to secure it. But when it comes to energy efficiency, most organizations can start small. Often, allocating even a small amount of capital to energy efficiency can have benefits. By soliciting energy saving projects from employees or informing them about energy efficiency measures, it is possible to engage them in a broader conversation about energy use. Because human behavior is one of the most important variables in saving energy, employee engagement will help an organization meet its energy saving targets. Start by changing a few lighting fixtures, then move onto more substantial projects over time.
These initial projects are just the beginning. Where they can prove most beneficial—and have a larger, long term impact—is when companies capture the energy savings that results and use it to fund subsequent projects.
Putting Theory into Practice
If the concept of REFs and their benefits still doen’t seem clear, consider the project we are currently implementing as part of a team of Master’s students at the University of Michigan’s School of Natural Resources and Environment and the Erb Institute. We’re working with the Clean Energy Coalition, a Michigan non-profit, to implement REFs in Michigan’s “Cities of Promise,” the state’s poorest cities.
The Michigan Public Service Commission provided $4.4 million for building retrofits in Detroit, Saginaw, Flint, Benton Harbor, Highland Park, Pontiac, Muskegon Heights and Hamtramck. A grant from the Ford Motor Company enabled us to provide the detailed financial modeling and analysis necessary to make the case for creating REFs in each municipality. Reinvesting the energy savings will result in a 3.8x leverage on the initial capital over the first 10 years of the REF. For each of the cities, an initial investment of $463,000 will result in $1.8 million in benefits. Furthermore, there will also be beyond-bottom-line advantages that include increased comfort for occupants as well as improved maintenance and operational savings.
Creating a Replicable Model
Our analysis identified two pre-conditions for success. First, money should be allocated to the REF based on a project’s expected (rather than actual) savings. This minimizes the transaction costs associated with adjusting energy use for weather, occupant behavior and other factors when trying to compute actual savings. Second, only a portion of the expected savings should be allocated to the REF. We have found that 80% is a good number, because it provides an immediate reduction in the customer or department’s operating expenses while still replenishing the REF rapidly enough that it can make subsequent investments.
With the public sector facing a decline in grant funding and the private sector lacking sufficient access to capital, REFs offer a compelling way for managers to invest in energy efficiency at a scale that outpaces the up-front capital requirements. For those who have an interest in starting an REF within their organization, our experience has yielded the following advice:
Ryan Flynn and Graham Brown are MBA/MS students at the University of Michigan’s Erb Institute for Global Sustainable Enterprise.
