Energy Budgets at Risk (EBaR): A Risk Management Approach to Energy Purchase and Efficiency Choices (Wiley Finance) - Hardcover

Jackson, J.

Hardcover

ISBN 10: 0470197676 ISBN 13: 9780470197677

Publisher: Wiley, 2008

Synopsis

Energy Budgets at Risk (EBar)® provides everyone from facility energy managers and financial managers to government policy-makers and electric utilities program planners with the background information required to understand energy cost, price, efficiency, and related issues important in developing a balanced approach to facility energy risk management. Throughout the book, respected energy economist Dr. Jerry Jackson clearly shows how to reduce energy costs and increase cash flows by using risk management concepts developed in the financial industry.

About this title

About the Author

Jerry Jackson is an energy economist and Texas A&M professor with thirty years' experience in developing and applying practical solutions to difficult energy industry problems. As owner and President of the consulting firm, Jackson Associates, he has worked with more than one hundred clients, including more than twenty Fortune 500 companies, start-up companies, electric and gas utilities, state agencies, research labs, and the U.S. Department of Energy. Jackson has served as an expert witness at government hearings. He recently presented a keynote address at an international sustainability conference in New Zealand, and he has also served as a U.S. representative to a United Nations conference on energy modeling. Jackson has a PhD in economics from the University of Florida with a specialty in econometrics.

From the Back Cover

Energy Budgets At Risk (EBaR)®

An innovative approach to energy-efficiency investment and energy purchase decisions

Energy Budgets at Risk (EBaR)® introduces a new energy management framework that reduces energy costs and energy-efficiency investment risk by applying risk management tools developed in the financial industry.

EBaR quantitatively determines energy-efficiency investment risk and provides energy risk management investment strategies that reduce costs while meeting budget flexibility and risk tolerance requirements of individual organizations. By providing energy budget savings greater than investment costs, EBaR investments result in increased cash flows creating the same financial bottom line impact as an increase in revenues. In fact, EBaR strategies can save 30% or more of current energy bills even after paying for energy-efficiency investments.

Written for a nontechnical audience, Energy Budgets at Risk (EBar)® shows all those on the frontline who are responsible for electric, natural gas, and fuel oil budgets in commercial, industrial, government, and institutional buildings and other facilities how to develop and apply a comprehensive, consistent financial risk management framework to evaluate energy budget risk; how to make the most of alternative energy-efficiency investments; and how to integrate efficiency investment decisions with purchase decisions. An opportunity to meet environmental goals through energy-efficiency investments that reduce energy use, EBaR analysis should be a cornerstone of every organization's carbon-reducing efforts.

From the Inside Flap

Uncertainty over energy prices, equipment performance, weather, and other factors make it exceedingly difficult for many commercial, institutional, industrial, and government organizations to assess the costs and benefits of energy-efficiency investments creating severe energy budgeting and planning problems, which become even more difficult in areas with competitive energy markets. In Energy Budgets at Risk (EBaR)®, respected energy economist Dr. Jerry Jackson explains why high energy prices and market volatility can be expected to continue, and shows how to reduce energy costs and increase cash flows using risk management concepts developed in the financial industry.

The Energy Budgets at Risk (EBaR)® system developed by the author and described in this book is a new quantitative approach to evaluating energy-efficiency investments using modern risk management tools. Commercial, institutional, industrial, and government organizations can now apply investment analysis to energy-related decisions in a manner that is consistent with their financial investment analysis. EBaR can also incorporate energy purchase decisions for organizations in competitive energy markets, providing an integrated investment-purchase analysis. In short, EBaR applies quantitative risk management analysis vetted in the financial community in a process customized to meet the risk tolerance of individual organizations. It offers a road map that energy managers, corporate executives, and government officials can use to understand and implement "best practice" facility energy risk management strategies.

Because EBaR is a scalable application, it can be used in both large and small organizations of any type whether commercial, institutional, industrial, or government and its strategies can save thirty percent or more of current energy bills, even after paying for energy-efficiency investments.

Written for a nontechnical audience, this book requires no special background in mathematics or statistics. All concepts and applications are illustrated with a case study application to an Austin, Texas office building, and readers can apply similar risk management analysis by substituting data for their facilities. Appendix tables provide readers with an easy way to assess potential energy and financial benefits of an EBaR analysis.

The primary opportunity to meet environmental goals is through energy-efficiency investments that reduce energy use, making EBaR analysis essential to every organization's carbon-reducing efforts. Energy Budgets at Risk (EBar)® provides everyone from facility energy managers and financial managers to government policy-makers and electric utilities program planners with the background information required to understand energy cost, price, efficiency, and related issues important in developing a balanced approach to facility energy risk management.

Excerpt. © Reprinted by permission. All rights reserved.

Energy Budgets at Risk (EBaR)

A Risk Management Approach to Energy Purchase and Efficiency Choices By J. Jackson

John Wiley & Sons

Copyright © 2008 J. Jackson
All right reserved.
ISBN: 978-0-470-19767-7

Chapter One

Energy Markets and Budgets at Risk

High, erratic energy prices have created financial crises for many businesses, institutions, and government agencies over the last several years.

This chapter provides background information on energy markets and price trends, and introduces basic Energy Budgets at Risk (EBaR) concepts. The potential role of EBaR in meeting green objectives and supporting energy policy options is also discussed.

RECENT PRICE INCREASES

As of mid-2007, average U.S. natural gas and oil prices for commercial sector (nonresidential and nonindustrial) establishments were 100 and 250 percent higher than 1999 levels (Figure 1.1). Electricity price increases in this period vary considerably by state; Figure 1.1 shows commercial sector electric prices relative to 1999 for the four most populous U.S. states of California, New York, Texas and Florida. Electric price increases over the 1999 to 2007 period range from 36 percent in California to 54 percent in Florida.

Prices in Figure 1.1 are actual prices that do not take inflation into account. Figure 1.2 shows prices adjusted for inflation. 2007 average real (inflation-adjusted) U.S. commercial sector natural gas and oil prices are 61 and 184 percent higher than 1999 levels. Real electricity price increases range from 11 (California) to 26 (Florida) percent of 1999 values. These inflation-adjusted series provide a general indication of energy price increases relative to all prices.

Energy price increases and the volatility of recent years have transformed a small component of operating costs into a threat to operating reserves and profits for many organizations. Energy-intensive organizations have been critically affected, and recent financial reports frequently identify energy costs as a primary cause of disappointing earnings. The U.S. Business Roundtable's fourth-quarter, 2006, CEO Economic Outlook Survey identified energy costs as one of the top two cost pressures faced by their businesses.

APPLYING RISK MANAGEMENT TO ENERGY BUDGETS

Evaluating risk associated with energy costs and taking steps to reduce cost and risk exposure in today's energy markets require a process different from traditional energy management approaches. Current high energy prices and volatility mean that using last year's energy costs as an estimate of next year's budget and evaluating energy-reducing investments with simple payback or internal rate of return hurdle rates (minimum acceptable rates) will expose organizations to an unnecessary level of risk and bypass profitable efficiency investments.

This book introduces a new framework to evaluate and quantify energy cost risks, energy efficiency investments, and energy purchase decisions based on risk management tools refined over the last decade in the financial industry. Energy Budgets at Risk (EBaR) analysis explicitly recognizes risk tolerance of individual organizations and risks associated with specific investment decisions.

EBaR is more than a tool to address recent energy price increases; it provides an entirely new framework to bring energy efficiency investment and purchase decisions up to date using best practice risk management tools. Even in relatively low-cost energy areas, organizations can expect to achieve annual net energy costs savings ranging from 20 to 30 percent of current energy bills (net savings are annual savings minus the annual cost of the investment amortized over its lifetime). EBaR can be viewed as an addition to the increasingly quantitative portfolio of management tools required in today's fast-paced competitive markets.

Energy Budgets at Risk shows organizations how to evaluate and manage energy risk in a way that best meets the organization's budget flexibility and risk tolerance.

ENERGY BUDGETS AT RISK WORKSHOPS

This book and the EBaR process have grown out of my consulting practice and a series of energy risk management workshops I developed at Texas A&M University. Comments and questions from my consulting clients and from the broad spectrum of workshop attendees from commercial, institutional, and government agencies make it clear that the tenor of energy concerns has changed dramatically over the last several years. Organizations are eager to reduce energy costs, but lack the ability to make sound financial decisions with respect to energy-efficiency investments. Energy managers are generally aware of many of the options available to improve energy efficiency; however, they readily admit they do not know how to evaluate and prioritize the alternatives or, most importantly, how to make the financial case to their management. CFOs and public administrators almost universally view energy efficiency as a different kind of capital budgeting problem-one that is most conveniently handled with very short payback thresholds, which, unfortunately, exclude many attractive options.

Organizations operating in competitive electricity and natural gas markets face even greater challenges. Energy pricing options can vary in a dozen dimensions, such as contract time period and use of hourly spot market pricing. Because pricing contract terms impact efficiency investment returns and efficiency investments impact competitive price quotes, efficiency investment and purchasing decisions should be made simultaneously. However, efficiency and purchasing decisions are almost always considered separately, usually by different departments within a single organization.

The end result is that individual organizations are losing tens of thousands, hundreds of thousands and in some cases millions of dollars per year in unnecessary energy costs. Remarkably, these neglected opportunities more than pay for themselves, increasing cash flows to provide the equivalent of new revenue opportunities.

Problems presented by two of my workshop attendees are representative of the difficulties many organizations are experiencing. The first attendee is the hands-on owner of a Texas restaurant chain. His electricity bills had more than doubled over the last several years and were cutting deeply into his profits. He was concerned that prices would continue to rise and had recently invested in a dozen different energy-efficiency technologies to cover all the bases. Unfortunately, the return on his investment was small because several of his investments had little impact on his energy bills relative to their cost.

The second attendee is an energy manager at a retail grocery chain who manages more than $5 million per year in energy costs. He knew that he could save substantially with energy efficiency investments-his local equipment suppliers were marketing their efficiency products to him. He did not know how to compare the various investments, however, nor did he know how to evaluate which investments he should undertake with his limited capital budget. To make matters more difficult, his current competitive electricity market contract was about to expire, and competing suppliers were offering many different pricing options. Faced with a seemingly overwhelming number of choices, he had procrastinated for six months at the time of the workshop-the cost of indecision to his company, by my calculations, was running at about $100,000 per month. Of course these opportunity costs are not typically evaluated, so neither he nor his management were aware of the lost revenue opportunity.

Energy Budgets at Risk shows readers how to avoid these and other energy-related investment and purchase problems. The book is written for a nontechnical audience. Concepts and applications such as probability distributions and Monte Carlo analysis are introduced and described in sufficient detail to enable readers to understand and apply EBaR analysis at their organizations.

AN ENERGY BUDGETS AT RISK (EBaR) OVERVIEW

In spite of financial challenges created by recent energy price increases, few organizations apply more than a rudimentary approach to evaluate energy price risk and energy efficiency investment options (Chapter 4 discusses this issue in more detail). Payback analysis is the predominant financial analysis tool used to qualify energy efficiency investments, though conservative internal rate of return hurdle rates or equivalent evaluations are sometimes applied. In competitive energy markets, energy purchase decisions and efficiency investments are almost universally considered separately rather than as part of a coordinated energy risk management process. Energy-related decision making is virtually the same for most organizations as it was in 1972 before energy prices began their modern volatile trajectory. Using short payback periods is a reasonably effective strategy to limit risk since it limits analysis to the near term, where there is the least uncertainty; however, it also ignores some of the most profitable energy efficiency investments.

CFOs and financial administrators in most of these organizations deal with other kinds of financial risk in a much different manner. Most organizations apply sophisticated financial risk management techniques, or hire firms to apply this analysis, in order to maximize returns on financial portfolios and pension funds. Advances in quantitative financial analysis, especially over the last decade, provide an impressive ability to quantify risks and rewards associated with various investment strategies and portfolios. Value at risk, earnings at risk and other at risk measures are now a standard part of the financial risk management vocabulary.

The following sections illustrate how modern risk management techniques are used in EBaR analysis to address energy budget and efficiency investment risks.

Energy Budgeting Under Uncertainty

Although managing facility energy costs and managing financial investments appear to have little in common, they reflect remarkably similar challenges: how best to evaluate and make investment decisions in the face of uncertainty. Analyzing energy budget risk can even be cast as a portfolio problem. Each energy-using system in a facility can be considered an investment characterized in part by its operating costs. Past years' experiences can be used to characterize variability in energy prices and energy use resulting from weather variations, facility utilization and so on-thereby providing a distribution of likely facility energy budgets for the coming year. Figure 1.3 shows an expected budget of $100,000 along with a distribution of other budget outcomes that might occur based on past experience. The area under portions of the distribution, relative to the total area under the curve, shows the probability that an outcome will occur between the two points on the energy budget axis as shown for energy budgets of less than $60,000 and more than $120,000 in Figure 1.3.

Applying at Risk Analysis to the Energy Budget Process

Readers familiar with the widely used Value at Risk (VaR) financial analysis will recognize the similarity between this energy budget analysis and VaR analysis. VaR analysis, with a history that traces back to 1922, was popularized by JP Morgan in the early 1990s and is now widely used in financial analysis to assess risks associated with investments and financial portfolios. As indicated in Figure 1.4, VaR statistics show the maximum daily, weekly or monthly portfolio loss that can be expected to occur based on a specified confidence level. A variety of other "at risk" measures such as Earnings at Risk, Profits at Risk and Cash Flow at Risk have been developed. Technical analysis related to estimation of these VaR-related risk measures is now an active area of academic and applied research. U.S. and international financial regulatory agencies have adopted VaR analysis to evaluate financial institutions' risk exposure. As indicated in the lower panel of Figure 1.4, EBaR reflects an energy budget-counterpart to VaR analysis.

Including New Energy-Efficiency Investments

EBaR analysis can be applied to evaluate new energy-efficient investments-such as replacing existing fluorescent ballasts and lamps with new high efficiency products. Future variations in electric price and uncertainty over the number of hours each fixture will operate result in a distribution of likely returns on this investment. Returns can be measured as annual energy cost savings and an internal rate of return, IRR. The internal rate of return reflects the effective yield on the efficiency investment (investment basics are covered in Chapter 4).

Figure 1.5 shows a hypothetical distribution of annual savings reflecting potential variations in electricity price and operating hours. In this example, the investment cost is $80,000; annual savings are $40,000; and the annual financing cost to pay for the investment over ten years at a 12 percent interest rate is approximately $14,000. Deducting annual financing costs from annual energy cost savings provides an annual cash flow increase of $26,000 per year. However, the payback for this investment is two years, which is more than many organizations accept in traditional efficiency screening analysis.

At the expected value, the internal rate of return is 49 percent. Traditional budgeting practices would recommend this investment if the $40,000 were a guaranteed return-that is, if there was no uncertainty. Of course, there is uncertainty regarding electricity price and operating hours so this investment is rejected based on its failure to meet the organization's payback threshold. The EBaR investment distribution shows, however, only a 2 percent probability that the savings will be less than $30,000 per year. Savings of $30,000 per year provide an internal rate of return of 35.7 percent and an increased cash flow of $16,000 per year. Information on the distribution of investment returns provides insights on investments like this that fail traditional payback or internal rate of return hurdle rates but provide attractive returns and can generate significant cash flows with little risk.

What happens to total energy budget risk with this investment? Subtracting the annual amortized cost of the investment from the annual energy savings and applying the same calculations as above provide a new distribution of expected energy budgets (Figure 1.6). Expected savings were $40,000; however, the amortized cost of financing the investment offsets some of the savings in the new budget to give a new net savings of $26,000 per year. The new distribution reflects a smaller expected energy budget and less variation in potential outcomes, that is, less energy budget risk. The figure shows that while the expected or average energy budget will drop by $26,000, the "worst case" outcome defined by the EBaR probability of 10 percent declines by $34,960. Thus, the investment reduced the expected budget but it reduced even more the exposure to extreme budgets that can occur with high energy prices, weather, and other events.

Management and Decision-Making Advantages

The EBaR representations above are only part of the process; however, the intuitive appeal of this approach is obvious-rather than trying to make investment decisions based on a traditional single estimate of expected energy savings, the entire range of investment outcomes and their probability of occurrence should be considered. This inclusive representation allows individual organizations to better understand the risks and rewards of alternative energy strategies, and this understanding accommodates their ability and desire to bear risks. As shown in Chapter 9, assessing uncertainty using this distribution-based analysis is accomplished with Monte Carlo analysis, an accepted and easy-to-apply-approach to treating uncertainty that has been applied in financial and many other application areas for decades.

(Continues...)

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Edition details

• Publisher: Wiley
• Publication date: 2008
• Language: English
• ISBN 10: 0470197676
• ISBN 13: 9780470197677
• Binding: Hardcover
• Edition number: 1
• Number of pages: 318