Thursday, April 24, 2008

We Are The Solution

Last week I gave a presentation on “Energy Efficiency Best Practices” to more than 100 CEOs of multinational corporations. The presentation began with a disclaimer. I did not intend to talk about alternative energy. I would focus, instead, on energy efficiency. On how companies can dramatically reduce their energy costs -- without changing what they do -- simply by using existing technologies to make their facilities run more efficiently.

Just to be clear, the first slide in my presentation said: “Focus on Efficiency.” Then I ended with the same slide: “Focus on Efficiency.”

What happened during the Q&A session? No one asked about energy efficiency. Instead, every one asked about alternative energy. What about electric cars? What about fuel cells? What about biofuels? What about cellulose? What about solar? What about wind?

Why were they asking about alternative energy? Because we all want to find the magic new technology that will make energy both environmentally friendly and inexpensive. Then we won’t have to do anything ourselves.

Don’t get me wrong. I’m no Luddite. In fact, I firmly believe that over time very smart scientists and engineers will make major breakthroughs that will eliminate our dependence on carbon-based fuels. Just in my lifetime, the microprocessor has revolutionized communications, media, data processing, medical diagnostics, and virtually every aspect of our lives. Once discovered, similar types of breakthroughs in energy and power generation will relegate carbon to the same dustbin of history as the rotary telephone.

But continuing to waste energy while waiting for alternative energy breakthroughs is a bit like continuing to spend recklessly while waiting to hit the lottery. It might happen someday. Maybe not. Even if it does, who knows when.

In the meantime, we have such a simple solution…….and it is us. Simply by taking very basic steps, we can reduce our energy consumption by 20% or more without altering our lifestyles or business practices. And we can do that today with existing technologies that have very short paybacks.

So, please, a little focus on efficiency.

John Howley
Hong Kong

Tuesday, April 22, 2008

The Laws of Physics

The first law of thermodynamics (conservation) holds that energy cannot be created or destroyed. The total amount of energy and matter in the Universe remains constant, merely changing from one form to another. Simply put, we cannot get energy from nothing.

Think about what that means for our hopes (and dreams) of a carbonless future for energy. Unless the first law of thermodynamics is disproved, we will always have to transform some form of matter or energy to get energy. If not carbon, then something else. Neutrons for nuclear plants. Food for biofuels. Land for windfarms. Silicon or some other material for solar panels.

Which leads to that other basic law. There is no free lunch.

John Howley
Manila, Philippines

Saturday, April 12, 2008

The Economics of Energy Conservation

I remember watching President Jimmy Carter on television during the OPEC Oil Embargo. He was wearing his Mr. Rogers sweater, sitting in front of a fireplace, and telling the country that we all must conserve energy. His message was plain. Energy conservation means making sacrifices, like turning down the thermostat and putting on sweaters to keep warm in front of a fire.

Being fond of comfortable wool sweaters, wood fires and the notion that a little personal sacrifice could help eliminate our dependence on foreign oil, I was taken with President Carter's message. Unfortunately, President Carter's approach to energy conservation was not sustainable. You cannot heat the clean rooms in semiconductor manufacturing plants with fireplaces in the winter, nor can you cool hospital operating rooms by opening windows in the summer. Most big energy consumers -- factories, hospitals, office buildings and other commercial and industrial enterprises -- were not going to solve the energy crisis or our dependence on foreign oil by going back to a simpler time or by doing less.

We soon found out that even personal sacrifice would last only so long. Once the immediate crisis of the embargo ended, our society lost its sense of urgency about conservation. Within a few years we had discovered the joys of driving gas guzzling SUVs.

Fast forward 30 years to where we are today, the early 21st Century. Al Gore and others have focused our attention on global warming and the need to reduce carbon emissions. At the same time, we are facing another energy crisis caused by rising energy costs. Oil above $100 a barrel. Electricity rates going through the roof.

This time we are talking about energy conservation in terms of becoming more efficient. Major corporations and venture capitalists have jumped on the bandwagon, asserting that conservation is not just good for our environment, but it is also good for business. For example, the President and CEO of Wal-Mart noted in a recent interview that his company is pursuing energy efficiency because it is good business -- consistent with the company's founding principles -- to cut costs by becoming more efficient:

“We looked at what Sam Walton started and how he developed the company. It was by eliminating waste, bringing in efficiencies. And by thinking about sustainability from our standpoint, it really is about how do you take cost out, which is waste, whether it's through recycling, through less energy use in the store, through the construction techniques we're using, through the supply chain. All of those things are simply the creation of waste. We found it's consistent with the entire model we've had since Sam opened the first store.” H. Lee Scott Jr., President and CEO, Wal-Mart Stores Inc., quoted in “Waste Not”, The Wall Street Journal, March 24, 2008.

Even altruistic environmentalists have made their arguments for conservation based on what is most cost effective. For example, the Canadian Chapter of the World Wildlife Federation has focused on the cost-saving benefits of energy efficiency: “Energy efficiency investments such as building retrofits are one of the lowest-cost and most effective options for reducing greenhouse emissions.” WWF-Canada Backgrounder, March 24, 2008.

How do businesspeople determine whether energy conservation measures are "cost effective"? They simply compare the financial returns available from investments in energy conservation projects with returns available from other types of investments. This requires nothing more than an analysis of (a) how long it will take for the financial savings generated by an investment in the energy conservation project to equal the cost of that investment, known as the PayBack Period; (b) how long those financial savings will continue in the future; (c) what those savings equate to in terms of a percentage return, known as the Internal Rate of Return; and (d) an adjustment for the company's cost of capital, depreciation on any equipment that is installed as part of the conservation project, and other factors.

For example, if replacing an incandescent light bulb with a compact fluorescent bulb (CFL) costs an average of $2.00 (including labor) and will result in a reduction of $2.00 per year in the cost of electricity, then the CFL pays for itself in one year and the PayBack Period is one year. If the CFL will last 10 years, then each investment of $2.00 in CFLs today will generate financial savings of $20 over the life of each new bulb. A very rough Internal Rate of Return is close to 100% because your $2.00 investment is generating 100% return ($2.00 per year). Put another way, to match the return on your investment in CFLs, you would have to invest in something else that generated almost 100% per year.

The actual Internal Rate of Return is less than 100% because you have to factor in your cost of capital -- that is, how much did it cost you to earn or borrow the original $2.00 investment -- and other factors such as depreciation of any equipment installed as part of the conservation projects. But for our purposes, it is sufficient to understand that energy efficiency investments with one-year PayBack Periods are extraordinary investments that cannot be matched by almost any other investment, at least not without taking on much more significant risks.

The Internal Rates of Return for investments with two-year and three-year PayBack Periods are also extraordinary. If an investment pays for itself within 2 years, then it is generating financial savings equal to 50% of its cost each year. And if an investment pays for itself within 3 years, then it is generating financial savings equal to 33% of its cost each year. Depending on how long the savings will last (10, 20 years or more), the cost of the company's capital, etc., investments with two-year and three-year PayBack Periods usually will generate Internal Rates of Return in the range of 30% to 45%.

Since energy efficiency investments carry very little risk (and a lot of side benefits), any energy efficiency investment that generates an Internal Rate of Return of 30% to 45% makes good business sense. It is almost impossible to get that type of return on your investment anywhere else without taking on significant risks.

The bottom line: A CFO will almost always invest in energy efficiency projects that have PayBack Periods less than three years, because Internal Rates of Return over 30% are hard to find without taking on significant risks. And a CFO is almost compelled to invest in energy efficiency projects that have PayBack Periods in the two-year range, because low-risk Internal Rates of Return over 40% are almost impossible to find.

The Internal Rate of Return for energy efficiency investments with four-year PayBack Periods are also good. A four-year PayBack Period means the investment is generating savings equal to 25% of the investment every year. Even after discounting for cost of capital, the Internal Rate of Return should be in the 15% to 20% range. This is still very good considering the relatively low risk of energy efficiency investments compared to the types of risk that must be taken to obtain returns of 15% to 20% in other investments.

In addition, energy efficiency investments generate other types of returns that make them much more valuable than pure financial investments. These side benefits include reducing carbon emissions, generating good will as a "green" company, reducing maintenance costs on equipment that now runs more efficiently, etc.

PayBack Periods longer than four years are more difficult to justify on financial considerations alone. Depending on cost of capital, a five year PayBack Period will generate an Internal Rate of Return that often is in the same range as what the company can earn by reinvesting in its own business. The energy conservation project then starts to compete with other internal capital needs. Do we conserve energy? Or do we expand our plant so we can grow into an important new market? The energy conservation project can still win out, but not on financial considerations alone.

What are the implications when companies make their energy efficiency decisions based on Internal Rates of Return? I've already gone on too long for today, so I'll save that for another blog entry. In the meantime, I look forward to your comments and questions on this primer on the economics of energy conservation.

John Howley
Hong Kong

Wednesday, April 2, 2008

Oil (and golf) Lessons

Yesterday's plan for an afternoon of golf with Sue and Charlie ended suddenly when the lightening siren went off before we finished the second hole. Not wanting to leave Florida without playing golf, I showed up at my local course this morning hoping for an opening.

The starter got me out with a couple from Switzerland. Liz is a hospital administrator and Bruno just retired after trading oil for more than 40 years from offices in Singapore, Japan and Switzerland. Much as I dislike talking business on the golf course, this was an opportunity I could not pass up.

Here's what Bruno had to say:

JH: Do you miss trading?

BB: I never thought we would see oil over $100.

JH: How much of that is due to the weak dollar?

BB: A majority. That plus speculation. You have increased demand from places like China and India. But speculators have pushed prices past what demand can support.

JH: What about supply?

BB: There are some refinery bottlenecks, but we don't have an immediate crude shortage.

JH: What do you think about the new interest in global warming and conservation?

BB: Actually, I feel a little guilty. I spent my career helping to put all that carbon in the air.

JH: Do you think we can sustain the current interest in clean energy?

BB: I hope so. We'll see what happens when energy prices drop again.

JH: You sound pretty certain that will happen.

BB: Prices will drop suddenly when speculators realize that they have gone beyond what the fundamentals will support. Over time the dollar will get stronger too. It doesn't deserve to get stronger, but it will.

JH: How much will prices drop?

BB: That is difficult to calculate. There are too many variables. You have subjective variables like the panic of speculators caught on the wrong side of the trades, and a lot of other variables like inflation.

JH: The government statistics still show relatively low inflation numbers.

BB: The government must not buy milk or bread.

JH: When will oil prices drop?

BB: Do you think this putt will break to the right?

I took the hint. My interview was starting to distract Bruno from his game. He had been straight off the tee all morning, and now he was pushing everything to the right. Liz noticed too, and she stepped in to get Bruno focused back on golf.

She began by saying something in German that sounded a little harsh. Bruno straightened his spine. Then she switched to English to give him the most basic golf advice, but in the sweetest way. "I'll watch where the ball goes, darling," she said. "You can keep your head down."

John Howley
Orlando, Florida