1.7 Financial Management

7.
Financial Management
7. FINANCIAL MANAGEMENT
Investment - Need, Appraisal and Criteria, Financial analysis techniques - Simple payback
period, Return on investment, Net present value, Internal rate of return, Cash flows, Risk
and sensitivity analysis, Financing options, Energy performance contracts and role of
ESCOs
7.1 Introduction
Energy Projects are very important to the economy and environment. In case of energy
conservation projects—the more the number, the better it is for the environment. It is
important to justify any capital investment project by carrying out a financial appraisal.
However, the biggest constraint in increasing the number of energy projects is the lack of
finance. Alternative finance arrangements can overcome the “initial cost” obstacle, allowing
firms to implement more energy management proposals. However, many energy managers
are either unaware or have difficulty in understanding the variety of financial arrangements
available to them. Most of the energy managers and auditors use simple payback analysis to
evaluate projects, which do not reveal the added value of after-tax benefits. Sometimes
energy managers do not implement Energy Management Proposals because financial
terminology and contractual details intimidate them. The financial issues associated with the
capital investment in energy saving projects are investigated in this chapter.
7.2 Investment Need, Appraisal and Criteria

When planning an energy efficiency or energy management project, the investment involved
should be considered. The need for investments in energy conservation can arise for installing
new equipment, improving process, providing staff training, and implementing or upgrading
energy information system.
Therefore, as with any type of investment, energy management proposals should show the
likely return on any capital that is invested. Consider a case of an energy auditor or consultant
who advises the senior management of an organization that capital should be invested in new
boiler plant. Inevitably, the management of the organization would enquire:
 How much will the proposal cost?

 How much money will be saved by the proposal?
These are relevant questions as the energy project is only one of many potential projects from
which top management may choose only a few to implement. It is the job of senior
management to invest capital where it is going to obtain the greatest return. Management
normally demand higher rate of return from energy projects than core or direct profit-making
investments.
The information on costs involved in a project and potential returns is not easily obtained.
The capital value of equipment usually decreases with time and it often requires more
maintenance as it gets older. If money is borrowed from a bank to finance a project, then
interest will have to be paid on the loan. Inflation too will influence the value of any future
energy savings that might be achieved. It is important that cost appraisal process allows for
Bureau of Energy Efficiency

7. Financial Management
all these factors with the aim of determining which investment should be undertaken in order
to optimize the benefits achieved. To this end a number of accounting and financial appraisal
techniques have been developed which help managers make correct and objective decisions.
To gain acceptance of top management, top management should be appraised on the size of
energy problem technical and good housekeeping measures available to reduce waste. Before
making any investment, it should be ensured that best performance is realized from existing
plant and equipment, energy charges are set at the lowest possible tariffs, best energy forms
(fuels or electricity) are used as efficiently as possible and that good housekeeping practices
are being regularly practiced.
The benefits of energy management projects should be projected to senior management not
only as energy savings, but also in terms of lower operational costs, low risk/reward ratio,
reduced environmental cost, improved productivity, better product quality or enhanced
quality of service and potential to improve the company’s share value. Most importantly,
systematic financial management approach has to be followed to rate various investment
options against anticipated savings.
7.3 Financial Analysis Techniques

In most respects, investment in energy efficiency is not different from any other area of
financial management. So when the organization first decides to invest in increasing its
energy efficiency, it should apply exactly the same criteria to reduce its energy consumption
as it applies to all its other investments. A faster or more attractive rate of return on
investment in energy efficiency should not be demanded.
The basic criteria for financial investment appraisal include:
 Payback period – is a measure of how long it will be before the investment recovers
itself. This can determine how long the financing term needs to be there.
 Net Present Value (NPV) and Cash Flow – are measures that allow financial
planning of the project taking into account streams of money inflow and outflow over
a period of time. These measures provide the company with all the information
needed to incorporate energy efficiency projects into the corporate financial system
 Return on Investment (ROI) and Internal Rate of Return (IRR) – are measures
that allow comparison with other investment options
Payback Period
The simplest technique which can be used to appraise a proposal is payback analysis. The
payback period can be defined as the time (number of years) required to recover the initial
investment (capital cost), considering only the Annual Net Savings (Yearly benefits-Yearly
costs). 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.

The simple payback period can be calculated using the equation
Capital cost
Simple Paybackperiod 
Annual net savings
Annual Net savings is the cost savings achieved after all the operational costs have been met.
The word ‘simple’ is used as a prefix to the term ‘payback period’ to denote that time value
of money is not considered in its calculation.
Example 7.1: Simple Payback period
A cogeneration system installation is expected to reduce a company’s annual energy bill by

Rs. 23 Lakhs. If the capital cost of the new cogeneration installation is Rs. 90 Lakhs, and the
annual maintenance and operating costs are Rs. 5 Lakhs, what will be the expected payback
period for the project?
Simple payback period = 90

23-5
= 5 years
Advantages
A widely used investment criterion, the payback period seems to offer the following
advantages:
 It is simple, both in concept and application. Obviously a shorter payback generally
indicates a more attractive investment. It does not use tedious calculations.
 It favours projects, which generate substantial cash inflows in earlier years, and
discriminates against projects, which bring substantial cash inflows in later years but
not in earlier years.
Limitations of payback period
 The payback period does not consider savings that are accrued after the payback
period has finished (it favours projects which brings substantial cash inflows in earlier
years and discriminates against projects which bring substantial cash inflows in later
years).
Example 7.2: Drawback of payback period
For example consider the cash flows of two projects, A and B:
Investment Rs. (100,000) Rs. (100,000)

Savings in Year Cash Flow of A Cash flow of B
1 50,000 20,000
2 30,000 20,000

3 20,000 20,000
4 10,000 40,000
5 10,000 50,000
6 - 60,000
The payback criteria prefer Project A which has a payback period of 3 years, in
comparison to Project B which has a payback period of 4 years, even though Project
B has very substantial cash inflows in years 5 and 6.
 Simple payback period does not consider the time value of money i.e. money which is
invested would accrue interest as time passes.
 Cash inflows, in the simple payback calculation, are simply added without suitable
discounting. This violates the most basic principle of financial analysis, which
stipulates that cash flows occurring at different points of time can be added or
subtracted only after suitable compounding/discounting.
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.
Annual net cashflow

ROI   100
Capital cost
In comparing projects, ROI does not require similar project life or capital cost for
comparison. 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 7.3: ROI
An outlay of Rs.100,000 for equipment is expected to provide an after-tax cash flow of Rs.
25,000 over a period of six years, without significant annual fluctuations. What is the return
on investment?
ROI = Average annual operating cash flow = 25,000 x 100

Net investment 100,000
= 25%
Advantages
 Simple method and easy to calculate

 Returns expressed as percentage makes it easier to evaluate against the borrowing
interest
Limitations of ROI
 It does not take into account the time value of money.

 It also does not account for the variable nature of annual net cash inflows. The 25
percent return indicated in the Example would be economically valid only if the
investment yields Rs. 25,000 per year in perpetuity -not a very realistic condition!
Time Value of Money
A project usually entails an investment for the initial cost of installation, called the capital
cost, and a series of annual costs and/or cost savings (i.e. operating, energy, maintenance,
etc.) throughout the life of the project. To assess project feasibility, all these present and
future cash flows must be equated to a common basis. The problem with equating cash flows
which occur at different times is that the value of money changes with time. The method by
which these various cash flows are related is called discounting, or the present value
concept.
For example, if money can be deposited in the bank at 10% interest, then a Rs.100 deposit
will be worth Rs.110 in one year's time. Thus the Rs.110 in one year is a future value
equivalent to the Rs.100 present value.
In the same manner, Rs.100 received one year from now is only worth Rs.90.91 in today's
money (i.e. Rs.90.91 plus 10% interest equals Rs.100). Thus Rs.90.91 represents the present
value of Rs.100 cash flow occurring one year in the future. If the interest rate were something
different than 10%, then the equivalent present value would also change. The relationship
between present and future value is determined as follows:
FV = NPV (1 + i)n or NPV = FV / (1+i)n
Where, FV = Future value of the cash flow

NPV= Net Present Value of the cash flow
i = Interest or discount rate
n = Number of years in the future
Net Present Value Method
The net present value method considers the time value of money. This is done by equating
future cash flow to its current value today, or in other words by determining the present value
of any future cash flow. The present value is determined by using an assumed interest rate,
usually referred to as a discount rate. Discounting is the opposite process to compounding.
Compounding determines the future value of present cash flows, whereas discounting
determines the present value of future cash flows.
The net present value method calculates the present value of all the yearly cash flows (i.e.
capital costs and net savings) incurred or accrued throughout the life of a project and
summates them. As a matter of convention, costs are represented as negative values and
savings as positive values. The sum of all the present values is known as the net present value
(NPV). The higher the net present value, the more attractive is the proposed project.
The net present value (NPV) of a project is equal to the sum of the present values of all the
cash flows associated with it. Symbolically,

CF0 CF1 CFn n CFt

NPV = _ ------------- + -------------- + - - - + ------------- =  -----------
(1 +  )0 ( 1 +  )1 ( 1 +  )n t = 0 ( 1 +  )t
Where NPV = Net Present Value

CFt = Cash flow occurring at the end of year ‘t’ (t=0,1,….n). (As per our
convention, net savings or inflows are represented by + sign and net costs or outflows are
represented by – sign. Since capital investment is an outflow, it will be treated as negative (-)
as per our convention.)
n = life of the project
 = Discount rate
The discount rate () employed for evaluating the present value of the expected future cash
flows should reflect the risk of the project.
Hence the decision rule associated with the net present value criterion is: “Accept the project
if the net present values is positive and reject the project if the net present value is negative”.
A negative net present value indicates that the project is not achieving the return standard and
thus will cause an economic loss if implemented. A zero NPV is value neutral.
The net present value takes into account the time value of money and it considers the cash
flow stream in entire project life.
Example 7.4: NPV
Using the net present value analysis technique, evaluate the financial merits of the two
proposed projects shown in the table. The annual discount rate is 8% for each project.
Project 1 Project 2
Capital cost (Rs.) 30000 30000
Net annual Net annual
Year
saving (Rs.) saving (Rs.)
1 +6000 +6600
2 +6000 +6600
3 +6000 +6300
4 +6000 +6300
5 +6000 +6000
6 +6000 +6000
7 +6000 +5700
8 +6000 +5700
9 +6000 +5400
10 +6000 +5400
Total net savings
+60000 +60000
at end of 10th year

For Project 1
30000 6000 6000 6000 6000

NPV      
1  0.08 0
1  0.081
1  0.08 2
1  0.08
3
1  0.084
6000 6000 6000 6000 6000 6000
     
1  0.085
1  0.08 6
1  0.08 7
1  0.08 8
1  0.089
1  0.0810
= - 30000 x 1 + 6000 x 0.926 + 6000 x 0.857 + 6000 x 0.794 + 6000 x 0.735 + 6000 x
0.681 +
6000 x 0.630 + 6000 x 0.583 + 6000 x 0.540 + 6000 x 0.500 + 6000 x 0.463
= + 10254
For Project 2
30000 6600 6600 6300 6300

NPV      
1  0.08 0
1  0.081
1  0.08 2
1  0.08
3
1  0.084
6000 6000 5700 5700 5400 5400
     
1  0.085
1  0.08 6
1  0.08 7
1  0.08 8
1  0.089
1  0.0810
= - 30000 x 1 + 6600 x 0.926 + 6600 x 0.857 + 6300 x 0.794 + 6300 x 0.735 + 6000 x
0.681 +
6000 x 0.630 + 5700 x 0.583 + 5700 x 0.540 + 5400 x 0.500 + 5400 x 0.463
= + 10867
For a 10-year life-span, the net present value for project 1 is Rs. 10,254, while for project 2 it
is Rs. 10867 Therefore project 2 is preferential proposal.
The whole credibility of the net present value depends on a realistic prediction of discount
rate which could often be unpredictable. It is prudent to set the discount rate slightly above
the interest rate at which the capital for the project is borrowed.
Advantages
The net present value criterion has considerable merits.

 It takes into account the time value of money.
 It considers the cash flow stream in its project life.
Internal Rate of Return Method
By setting the net present value of an investment to zero (the minimum value that would
make the investment worthwhile), the discount rate can be computed. The internal rate of
return (IRR) of a project is the discount rate, which makes its net present value (NPV) equal
to zero. It is the discount rate in the equation:

CF0 CF1 CFn n CFt

0 = __
------------- + -------------- + - - - + ------------- =  -----------
(1 +  )0 ( 1 +  )1 ( 1 +  )n t = 0 ( 1 +  )t
Where, CFt = cash flow at the end of year “t”

 = discount rate
n = life of the project.
CFt value will be negative if it is expenditure and positive if it is savings.
If this discount rate is greater than current interest rate, the investment is sound.
This procedure, like net present value, can also be used to compare alternatives. The criterion
for selection among alternatives is to choose the investment with the highest rate of return.
The calculation procedure for determining IRR is tedious and usually requires a computer
spreadsheet. The IRR function formula is available in Excel and can be used in practice.
However, it is important to get acquainted with the fundamental procedure of determining the
IRR. Determining IRR is an iterative process requiring guesses and approximations until a
satisfactory answer is derived.
Example 7.5: IRR (Example of iterative procedure to estimate the 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:
Investment Rs. 20,000

Saving in Year Cash flow
1 6000
2 5500
3 5000
4 4500
5 4000
6 4000
The cost of capital (discount rate), κ, for the firm is 8 per cent.
The net present value of the proposal is:
20000 6000 5500 5000 4500 4000 4000

NPV        
1 0.08 0
1 0.081
1 0.082
1 0.083
1 0.084
1 0.08 5
1 0.086
= - 20000 x 1 + 6000 x 0.926 +5500 x 0.857 + 5000 x 0.794 + 4500 x 0.735 + 4000 x
0.681 + 4000 x 0.630

= 2791
The discount rate has to be increased to bring NPV to zero.
Increasing the discount rate to 12%,
20000 6000 5500 5000 4500 4000 4000

NPV        
1 0.12 0
1 0.121
1  0.12 2
1 0.12 3
1 0.12 4
1 0.12 5
1 0.126
= - 20000 x 1 + 6000 x 0.893 +5500 x 0.797 + 5000 x 0.712 + 4500 x 0.636 + 4000 x
0.567 + 4000 x 0.507
= 495
Further increasing the discount rate to 16%
20000 6000 5500 5000 4500 4000 4000

NPV        
1 0.16 0
1 0.161
1  0.16 2
1 0.16 3
1 0.16 4
1 0.16 5
1 0.166
= - 20000 x 1 + 6000 x 0.862 +5500 x 0.743 + 5000 x 0.641 + 4500 x 0.552 + 4000 x
0.476 + 4000 x 0.410
= -1508.5
For a discount rate of 13%
20000 6000 5500 5000 4500 4000 4000

NPV        
1 0.130
1 0.131
1 0.132
1 0.133
1 0.134
1 0.13 5
1 0.136
= - 20000 x 1 + 6000 x 0.885 +5500 x 0.783 + 5000 x 0.693 + 4500 x 0.613 + 4000 x
0.543 + 4000 x 0.480
= -65
It can be clearly seen that the discount rate which results in the net present value being zero
lies somewhere between 12% and 13%. It is closer to 13%.
The exact internal rate of return can be found by interpolation or plotting the net present
value on a graph as shown in Figure 7.1.
By interpolation Method
NPV at 13% = -65
NPV at 12% = +495

IRR = Lower rate + NPV at lower rate x (Higher rate-lower rate)

(NPV at lower rate – NPV at higher rate)
IRR = 12 + 495 x (13-12)

495- (-65)
= 12.88 %
By Graphical Method
Figure 7.1 NPV versus Discount Rate
The Figure 7.1 shows the IRR for the project from graph is around 12 %.
Advantages
A popular discounted cash flow method, the internal rate of return criterion has several
advantages:
 It takes into account the time value of money.
 It considers the cash flow stream in its entirety.
 It makes sense to businessmen who prefer to think in terms of rate of return and find
an absolute quantity, like net present value, somewhat difficult to work with.
Limitations
 The internal rate of return figure cannot distinguish between lending and borrowing
and hence a high internal rate of return need not necessarily be a desirable feature.
Comparison between Net Present Value and Internal Rate of Return
Although, they look similar, there is an important difference between the two methods.
In the net present value calculation, NPV of the project is determined by assuming that the
discount rate (cost of capital) is known. In the internal rate of return calculation, we set the
net present value equal to zero and determine the discount rate (internal rate of return), which
satisfies this condition.

The net present value method is essentially a comparison tool which enables number of
different projects to be compared while the internal rate of return method is designed to
assess whether or not a single project will achieve a target rate of return.
7.4 Cash Flow

Capital Investment Considerations
To judge the attractiveness of any investment, we must consider the following four elements
involved in the decision:
 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)
Initial capital cost or net investment
When companies spend money, the outlay of cash can be broadly categorized into one of two
classifications; expenses or capital investments. Expenses are generally those cash
expenditures that are routine, ongoing, and necessary for the ordinary operation of the
business. Capital investments, on the other hand, are generally more strategic and have long
term effects. Decisions made regarding capital investments are usually made by senior
management and carry with them additional tax consequences as compared to expenses.
The capital investments usually require a relatively large initial cost. The initial cost may
occur as a single expenditure or occur over a period of several years. Generally, the funds
available for capital investments projects are limited.
Initial capital costs include all costs associated with preparing the investment for service. This
includes purchase cost as well as installation and preparation costs. Initial costs are usually
non-recurring during the life of an investment.
Net operating cash inflows
The benefits (revenues or savings) resulting from the initial cost for a capital investment
occur in the future, normally over a period of years. As a rule, the cash flows which occur
during a year are generally summed and regarded as a single end-of-year cash flow. Annual
expenses and revenues are the recurring costs and benefits generated throughout the life of
the investment after adjusting for applicable taxes and effects of depreciation. Periodic
replacement and maintenance costs are similar to annual expenses except that they do not
occur annually.
Economic life
The period between the initial cost and the last future cash flow is the life cycle or life of the
investment.

Salvage value
The salvage (or terminal) value of an investment is the revenue (or expense) attributed to
disposing of the investment at the end of its useful life. If substantial recovery of capital from
eventual disposal of assets at the end of the economic life, these estimated amounts have to
be made part of the analysis. Such recoveries can be proceeds from the sale of facilities and
equipment (beyond the minor scrap value), as well as the release of any working capital
associated with the investment
Cash Flow Diagrams
A convenient way to display the revenues (savings) and costs associated with an investment
is a cash flow diagram. By using a cash flow diagram, the timing of the cash flows is clear
and the chances of properly applying time value of money concepts are increased.
The economic life establishes the time frame over which the cash flows occur first. This
establishes the horizontal scale of the cash flow diagram. This scale is divided into time
periods which are frequently, but not always, years. Individual outlays or receipts are
indicated by drawing vertical lines appropriately placed along the time scale.
Upward directed lines indicate cash inflow (revenues or savings) while downward directed
lines indicate cash outflow (costs) as a matter of convention. Figure 7.2 illustrates a cash flow
diagram.
Figure 7.2 Typical Cash Flow Diagram for an Investment
Although cash flow diagrams are simply graphical representations of income and outlay, they
should exhibit as much information as possible. The requirements for a good cash flow
diagram are completeness, accuracy, and legibility.
7.5 Sensitivity and Risk Analysis

Many of the cash flows in the project are based on assumptions that have an element of
uncertainty. The cash flows such as capital cost, energy cost savings, maintenance costs can

usually be estimated fairly accurately. Even though these costs can be predicted with some
certainty, it should always be remembered that they are only estimates. Cash flows in future
years normally contain inflation components and project life itself can vary significantly.
Sensitivity analysis is an assessment of risk. Because of the uncertainty in assigning values to

the analysis, it is recommended that a sensitivity analysis be carried out - particularly on
projects where the feasibility is marginal. How sensitive is the project's feasibility to changes
in the input parameters? What if one or more of the factors in the analysis is not as favourable
as predicted? How much would it have to vary before the project becomes unviable? What is
the probability of this happening?
Suppose, a feasible project is based on energy cost saving that escalates at 10% per year, but
a sensitivity analysis shows the break-even is at 9% (i.e. the project becomes unviable if the
inflation of energy cost falls below 9%). There is a high degree of risk associated with this
project.
Many of the computer spreadsheet programs have built-in "what if" functions that make
sensitivity analysis easy. If carried out manually, the sensitivity analysis can become
laborious - reworking the analysis many times with various changes in the parameters.
Sensitivity analysis is undertaken to identify those parameters that are both uncertain and for
which the project decision, taken through the NPV or IRR, is sensitive. Switching values
showing the change in a variable required for the project decision to change from acceptance
to rejection are presented for key variables and can be compared with post evaluation results
for similar projects. For large projects and those close to the cut-off rate, a quantitative risk
analysis incorporating different ranges for key variables and the likelihood of their occurring
simultaneously is recommended. Sensitivity and risk analysis should lead to improved project
design, with mitigation actions against major sources of uncertainty involved.
The various micro and macro factors that are considered for the sensitivity analysis are listed
below.
Micro factors
 Operating expenses (various expenses items)

 Capital structure
 Costs of debt, equity
 Changing of the forms of finance e.g. leasing
 Changing the project life
Macro factors
Macro economic variables are the variable that affects the operation of the industry of which
the company operates. They cannot be changed by the firm’s management. Macro economic
variables, which affect projects, include among others:
 Changes in interest rates

 Changes in the tax rates
 Changes in the accounting standards e.g. methods of calculating depreciation
 Changes in depreciation rates

 Extension of various government subsidized projects e.g. rural electrification

 General employment trends e.g. if the government changes the salary scales
 Imposition of regulations on environmental and safety issues in the industry
 Energy Price change
 Technology changes
7.6 Financing Options

Capital investing requires a source of funds. For large companies multiple sources may be
employed. The process of obtaining funds for capital investment is called financing. The
various conventional financing options are:
 Debt financing
 Equity financing
 Retained earnings
 Capital lease
 True lease
 Performance contracting
Debt financing
Debt financing involves borrowing and utilizing money which is to be repaid at a later point
in time. Interest is paid to the lending party for the privilege of using the money. The
company owns the equipment and this arrangement is good for long-term use of equipment.
The borrower is simply obligated to repay the borrowed funds plus accrued interest according
to a repayment schedule. Car loans and mortgage loans are two examples of this type of
financing.
The two primary sources of debt capital are loans and bonds. The cost of capital associated
with debt financing is relatively easy to calculate since interest rates and repayment schedules
are usually clearly documented in the legal instruments controlling the financing
arrangements. An added benefit to debt financing under current tax laws is that the interest
payments on debt capital are tax deductible. However, in case of debt financing it is the
company that takes all the risk and must install and manage the project.
Equity financing
Under equity financing the lender acquires an ownership (or equity) position within the
borrower’s organization. As a result of this ownership position, the lender has the right to
participate in the financial success of the organization as a whole. The two primary sources of
equity financing are stocks and retained earnings.
The cost of capital for stocks is higher than the cost of capital for debt financing. Apart from
higher profit sharing, this is also partially attributable to the fact that interest payments are tax
deductible while stock dividend payments are not.
Retained earnings
Retained earnings are the accumulation of annual earnings surpluses that a company retains
within the company’s coffers rather than paying out to the stockholders as dividends.

Although these earnings are held by the company, they truly belong to the stockholders and
hence the same cost of capital for stock is applied.
Capital lease
Capital lease allows for lower cost of capital with third-party participation. It is a mid-way
between pure debt and pure equity financing.
True lease
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. Lease payments are tax deductible. No depreciation tax benefits are
available and ownership does not occur even at the end of lease period.
If the project is to be financed externally, one of the attractive options for many organizations
is the use of energy performance contracts delivered by energy service companies, or ESCOs.
7.7 Energy Performance Contracting and Role of ESCOs

Energy Performance contracting is a
unique arrangement that allows the What are ESCOs?
industry to make necessary improvements
in energy efficiency while investing very ESCOs are usually companies that provide a
little money up-front. The contractor complete energy project service, from
usually assumes responsibility for assessment to design to construction or
purchasing and installing the equipment, installation, along with engineering and project
as well as maintenance throughout the management services, and financing.
contract. But the unique aspect of
performance contracting is that the contractor is paid based on the performance of the
installed equipment. Only after the installed equipment actually reduces expenses does the
contractor get paid. Energy service companies (ESCOs) typically serve as contractors within
this line of business.
This aspect of ‘payment-on-performance’ removes the incentive to “cut corners” on

construction or other phases of the project, as with conventional contracting. In fact, often
there is an incentive to exceed savings estimates. For this reason, performance contracting
usually entails a more “facility wide” scope of work (to find extra energy savings), than loans
or leases on particular equipment.
With an industry-wide scope, many improvements can occur at the same time. For example,
lighting and air conditioning systems can be upgraded at the same time. In addition, the
indoor air quality can be improved. With a comprehensive industry management approach, a
“multiplier effect” on cost reduction is possible. For example, if industry improvements
create a safer and higher quality environment for workers, productivity could increase.
Depending on the company’s capability to manage the risks (equipment performance,

financing, etc.) the company will delegate some of these responsibilities to the ESCO. In
general, the amount of risk assigned to the ESCO is directly related to the percent savings
that must be shared with the ESCO.

For example, a lighting retrofit has a high probability of producing the expected cash flows,
whereas a completely new process does not have the same “time tested” reliability. If the in-
house energy management team cannot manage this risk, performance contracting may be an
attractive alternative.
Types of Performance Contracting
There are a few common types of contracts. The ESCO will usually offer the following
options:
 Fixed fee
 Shared savings
 Guaranteed savings
In fixed fee, ESCO conducts an audit, designs the project and either assists the customer to
implement the project or simply advises the customer for a fixed lump-sum fee. In the fixed
fee contract, the ESCO bears less risk compared to a savings based fee payment because their
fee does not depend directly on the amount of the achieved savings.
In shared savings, ESCO designs, finances and implements the project, verifies energy
savings and shares an agreed percentage of the actual energy savings over a fixed period with
the customer. Percent energy savings contracts are agreements that basically share energy
savings between the host and the ESCO. The more energy saved, the higher the revenues to
both the parties.
A combination of part- fixed fee and part- shared savings is practiced as well.
In guaranteed savings, ESCO designs and implements the project but does not finance it,
although it may arrange for or facilitate financing. The ESCO guarantees that the energy
savings bill be sufficient to cover debt service payments.
Obviously, energy managers would prefer the options with “guaranteed savings.” However
this extra security (and risk to the ESCO) usually costs more. Percent energy savings
contracts are agreements that basically share energy savings between the host and the ESCO.
The more energy saved, the higher the revenues to both the parties.
Drawbacks of ESCOs
Performance Contract: Pros & Cons “Pros”
Performance contracting does have  allows use of equipment with reduced
some drawbacks. In addition to installation /operational risks and reduced risk
sharing the savings with an ESCO, the of poor performance, service, equipment
tax benefits of depreciation and other obsolescence, etc., and
economic benefits must be negotiated.
 allows host to focus on its core business
Whenever large contracts are
objectives
involved, there is reason for concern.
“Cons”
Many industries feel that dealing with
 potentially binding contracts, legal expenses
an ESCO would be too confusing or
and increased administrative costs and
complicated. Some feel that with
complex contracts, there may be more  host must share project savings

margins for error. Therefore, it is critical to choose an ESCO with a good reputation and
experience within the types of facilities that are involved.
In some contracts, the ESCOs provide a guarantee for the savings that will be realized, and
absorb the cost if real savings fall short of this level. Typically, there will be a risk
management cost involved in the contract in these situations. Insurance is sometimes
attached, at a cost, to protect the ESCO in the event of a savings shortfall.
What is Depreciation?
Most assets used in the course of a business decrease in value over time. Tax law permits
reasonable deductions from taxable income to allow for this. These deductions are called
depreciation allowances. To be depreciable, an asset must meet three primary conditions: (1) it
must be held by the business for the purpose of producing income, (2) it must wear out or be
consumed in the course of its use, and (3) it must have a life longer than a year.
Role of ESCOs
Through the years, ESCO services have become more varied. It has become a customer-
driven industry and the customer typically has a selection of ESCO services from which to
choose (Figure 7.3). Services offered by an ESCO usually include:
 An investment grade energy audit to identify energy and operational savings

opportunities, assess risks, determine risk management/mitigating strategies, and
calculate cost-effectiveness of proposed measures over time;
 Financing from its own resources or through arrangements with banks or other
financing sources;
 The purchase, installation and maintenance of the installed energy efficient
equipment; possibly maintenance on all
energy-consuming equipment;
 New equipment training of operations
and maintenance (O&M) personnel;
 Training of O&M personnel in energy-
efficient practices;
 Monitoring of the operations and energy
savings, so reduced energy consumption
and operation costs persist;
 Measurement and savings verification;
and
 A guarantee of the energy savings to be
achieved.
Figure 7.3 Role of ESCO
Benefits to Industry
 An immediate upgrade of facilities and reduced operating costs— without any initial
capital investment;
 Access to the ESCO’s energy efficiency expertise.
 Positive cash flow—most projects generate savings that exceed the guarantee;
 The opportunity to use the money, which would have been used for required upgrades

or replacements to meet core business needs;

 Improved and more energy-efficient operations and maintenance;
 Several normal business risks are assumed by the ESCO, including the guaranteed
performance of the new equipment for the life of the contract (not just through a
warranty period);
 A more comfortable, productive environment; and
 Services paid for with the money which the customer would otherwise have paid to
the utilities for wasted energy.
7.8 Developing a Typical ESCO Contract

a) Self-assessment by organization to assess motivation for energy efficiency projects
b) Establish goals for the EE project
c) Conduct Feasibility study for EE project
d) Determine suitable EE project contract and financing
e) Enter into Energy Performance Contract (EPC) to initiate investment grade energy
audit. (IGA)
 The contract will have rewards and penalties built into it in the form of various
guarantees. Contract duration will affect the project risk. The longer the duration,
the higher is the risk and uncertainty of the contract.
 Organization can contract with ESCO in one of three payment mechanism: a)
fixed fee; b) shared savings; c) guaranteed savings.
f) Conduct of IGA and Implementation of commercially feasible energy efficiency

measures
 An investment grade energy audit is the process of conducting an energy audit to

identify efficiency opportunities, and translating the technical findings into
financial terms to present it as a bankable project capable of securing a loan.
 Services of ESCO may be engaged in single step or two steps. In single step
process, ESCO conducts the IGA and effects energy savings by implementing
recommended measures. In two step process, organization contracts the ESCO to
only conduct IGA and submit audit report. The organization prioritizes the
measures for implementation based on time, capital investment and payback
period.
A detailed audit includes data collection, measurements of the systems, analysis of the
historical and measured data, and detailed energy savings calculations for suggested
projects. The ESCO not only analyzes the performance of individual equipment, but
evaluates the complete system in order to obtain a comprehensive efficiency solution
that captures all energy efficiency opportunities, not just the more obvious ones.
An investment grade evaluation includes the following:
 Description of the baseline situation

 Project design, including basic engineering
 Technical analysis
 Project financials

 Baseline calculation
 Options for monitoring and verification
 Assessment of potential technical and financial risk and a risk mitigation plan
Based on IGA and discussions with organization, list of potential projects are
prepared for implementation. The approved projects are taken up for detailed financial
analysis taking into account savings, costs for engineering, design and implementation
If the project is financed by commercial bank, detailed cash flow, internal rate of
return, debt service coverage ratio and sensitivity analysis are prepared.
g) Risk assessment and mitigation plan is prepared covering design and construction
risk, performance risk, financial, economic and regulatory risk.
h) Monitoring and verification of the project progress as per agreed protocols by

organization and ESCO to undertake any midcourse correction for successful
implementation.
Calculating savings
In addition to agreeing upon the baseline and allowable adjustments, both organisation and
the ESCOs must agree on how to calculate the energy and cost savings resulting from the
project. Once the work has been done to determine the baseline and adjustments, the energy
savings is calculated as:
Energy Saved = Baseline – Current +/- Adjustment
Where,
Energy saved is the energy saved over a period of time from project start to a set point in time
Baseline is the baseline energy consumption (say in kWh)
Current is the current energy consumption (determined by metering or the utility energy bill)
Adjustments are any adjustments, positive or negative, that need to be made to the baseline to
bring energy use at the current point in time to the same set of conditions as the baseline set.
In order to calculate cost savings from the energy savings, the parties must agree on how to
handle energy price fluctuations because the resulting amount should be a function only of
the efficiency measures, not fluctuating energy costs. One method is to agree on a set price,
either one defined upfront in the performance contract, or a formula or definition for
calculating one (e.g. the average monthly energy cost over the time period being examined).
These are details that need to be negotiated in the performance contract.
7.9 A Case Study - Energy Efficiency in Buildings through ESCO

Project
ABC is one of buildings taken up for implementation of Energy Efficiency Measures (EEMs)
under performance contracting. The investment grade energy audit for both buildings was
conducted and energy savings potential was estimated. During the energy audit, special
consideration was given to the application of performance measurement and verification

system. The energy audit included collection of past energy consumption data and field-
testing of various energy consuming equipment and systems.
Summary of EEMs
The energy efficiency measures are developed based on individual energy systems. The
major energy consumption in the ABC Tower is in Lighting and Air Conditioning systems. A
brief overview of EEMs is presented in table 7.1 below:
Table 7.1 Overview of Energy Efficiency Measures
S.No. Area Brief Description

Retrofit based on Design and Technology for task
1. Lighting
lighting
Replacement of Window and Split ACs with Centrifugal
2. Air Conditioning
Chiller based Central AC System
With the infrastructure available for central cooling
3. Winter Heating distribution system, it is possible to use the same for
Central Heating System in winter at marginal cost
Replacement of existing pumps with the more efficient
4. Pumping System pumps and piping modification for more efficient
pumping
5. Canteen Heating Replacing Electrical heating with LPG heating
In addition to the capital cost for EEMs mentioned above, additional costs will be incurred
for baseline establishment, detailed engineering of EEMs and preparation of Detailed Project
Report (DPR) in project preparation.
The total energy reduction potential is estimated to be 39% in energy consumption and 33%
in energy bill.
Summary of Project Financials
The project financials indicate viability if all the EEMs are implemented together. The
project assumes the ownership of all EEM assets with contractor and at the end of the
contract it is transferred to the facility owner at nominal costs. The project viability is further
improved as the contractor is given the responsibility of disposing the existing assets, which
are being replaced by the more efficient one, and contractor is given the benefit.
Performance Measurement and Verification (PMV)
Contractor and facility owner shall do the performance measurement and verification jointly.
The PMV would ensure that the guaranteed savings have been achieved. The whole facility
PMV has been selected for establishing baseline and post implementation verification. This
baseline is established based on the historical energy bills, inventory, weather data and
adjustments. After the implementation of project, the actual savings is calculated based on
the facility utility bills after making adjustments.

Operation and Maintenance
The Contractor’s payments are linked to the actual energy bill reduction during the contract
period. To ensure the savings, Contractor shall also do the operation and maintenance of the
building energy system during the contract period.
Baseline Power Consumption
The present power consumption based on the analysis of three years energy bill and adjusting
the errors in the metering is as follows.
Baseline Energy Consumption
Baseline Energy
Sl.No. Month
Consumption, kWh
1 January 165390
2 February 127480
3 March 120570
4 April 214800
5 May 216090
6 June 245320
7 July 253742
8 August 231330
9 September 176477
10 October 152870
11 November 104506
12 December 119970
13 Complete One Year 2128545
Savings Guarantees
The contractor guarantees that in each year of the term following substantial completion, the
facility owner will realize the savings of at least 7,93,250 kWh (95% of the proposed 39%
savings of approximately 8,35,000 kWh)
Term of Contract
The term of the Performance Contract and Maintenance services is 5 years from the day of
Project.
Energy Saving Payments
The energy savings would be shared between contractor and facility owner in the ratio of
95% for contractor and 5% for owner for the first three years and in the ratio of 90% for
contractor and 10% for owner in the fourth and fifth year. From the sixth year, the asset
would be transferred to the host at the end of the contract period at nominal cost.
Maintenance Expenses Payment
In addition to above facility owner will pay contractor a fixed sum for maintaining the

Energy Efficiency Measures.
7.10 Municipal Energy Efficiency Project through Performance

Contracting
Project selection basis:
Municipalities spend large amounts of its money on purchasing energy for public services
such as street lighting and water supply. Energy saving potential in water pumping alone is
estimated at least 25 percent.
The budgets for these services lack funds to invest in energy efficiency improvements, and
municipalities are looking for alternative ways to finance energy efficiency projects.
Performance contracting is one such alternative to finance efficiency improvement projects
without upfront investment. The project cost is paid out of the savings accrued thus allowing
municipalities to finance the improvements out of savings accrued from the project.
In municipalities, performance contracts may often involve engineering firms such as water
engineering companies in case of efficiency project involving water supply, other than an
ESCO. However, ESCO participation in the project is beneficial because they bring
managerial, technical and turn-key project implementation skills that often are lacking at the
municipalities combined with the ability to structure project financing. Based on the
municipalities’ needs, the ESCOs can finance EE implementation and collect their dues from
shared or guaranteed savings accruing from the EE project.
Steps for developing Energy Efficiency Project in Municipality
1. Identify reasons for undertaking EE project. If need for EE project is established as a

priority. Municipality should select most suited contract and financing option
2. Collect energy usage data by carrying out a preliminary (walk-through) audit.

Municipalities should collect basic data on energy usage in an information sheet and
internally assess the low cost and no cost options that can be implemented using its
own operation and maintenance (O&M) funds (Self-assessment).
3. Develop and issue a request for Expressions of Interest (EOI) for conducting an
investment grade energy audit and implementing an efficiency project in the target
sector(s), such as water, wastewater, street lighting and municipal buildings. The EOI
contains a brief description of the scope of work and basic information on the
municipal installations to be audited, and requests information on the technical and
financial capabilities of service firms including their personnel, audit instrumentation,
and relevant experience.
4. Issue a Request for Proposal (RFP) to all viable firms who submitted EOIs. The RFP
describes the facility's energy use, equipment, operating schedule, maintenance
problems, and equipment replacement or renovation plans, as well as the utility bill
history for the past three years. It is desirable that a site visit be organized for
interested ESCOs to tour the facility and interview facility staff before submitting
their responses to the RFP.

5. Evaluate the proposals according to the terms of the RFP.
6. Finalize ESCO selection based on its expertise and relevant experience, making sure
to match the skills of the ESCO with the needs of the Municipality.
7. Award the Investment Grade Audit (IGA) contract, which is an agreement with the
ESCO to develop a project concept, and perform the IGA. The IGA report forms the
basis for the energy performance contract between the Municipality and ESCO,
identifying all feasible short- medium- and long-term energy saving measures and
their payback periods, and providing the baseline data to be used during monitoring
and verification.
8. Package the documentation for third party financing, if necessary. The party taking on
the financing (be it the Municipality or ESCO) puts together a package of information
on the project, including the IGA report, for review by financial institutions. The
financially relevant information contained in the IGA report is critical at this stage for
convincing a financial institution to provide a loan.
9. Enter into the performance contract. The contract sets the terms and conditions, by
which the ESCO implements the energy efficiency measures, including the
responsibilities of the ESCO and Municipality, the compensation schedule for the
ESCO, financing conditions, maintenance, personnel training, monitoring and
verification procedures, risks and a risk mitigation plan, and the definition of the
baseline and possible adjustments to it.
10. Monitoring and Verification (M&V) of results is performed according to the

procedures in the performance contract. M&V determines the actual savings over the
period of the contract and ensures that all parties are getting full value from the
energy performance contract, including compensation for the ESCO. It includes
approval of equipment installation based on the contract specifications, and involves
regular communication between the ESCO and Municipality to monitor successful
implementation of the energy saving measures. Often, M&V can be performed by an
independent third party expert(s).
Solved Example:
An oil fired reheating furnace heats steel billets from 40oC to 1220oC at a furnace efficiency
of 28%. The furnace operates for 4700 hours per annum. The GCV of furnace oil is10,000
kcal /kg and density is 0.94kg/litre. The cost of furnace oil is Rs.45 /liter. The specific heat of
billets is 0.12 kcal/kgoC.
a. Calculate the amount of energy necessary to heat 12 tons of steel billets per
hour
b. Calculate liters of furnace oil fired per tons of steel billets.
c. If the efficiency of the furnace is improved from 28% to 30% by adopting
ceramic fibre insulation, calculate the hourly furnace oil cost saving
d. What is the simple payback period if the investment is Rs. 20 lakhs ?
e. How large could be the investment to improve the efficiency at an internal rate
of 16% and per year over 6 years.

Ans:
a) Amount of energy necessary to heat 12 tons of steel billets

= m x cp x t
= 12000 Kgs x 0.12 x (1220- 40) kCals/hr
= 16,99,200 Kcals/hr
b) Litres of furnace oil fired per ton of steel billet

= [( 1699200/12)]
= 141600 Kcal/ tonne of billet
Input energy per ton of billet = 141160/0.28
= 505714 kcal/ tonne of billet
Furnace oil required in kg = 505714
10,000
= 50.57 Kg/ tonne of billet
Furnace oil required in litres = 50.57
0.94
= 53.79 litres/ tonne of billet
c) Hourly furnace oil cost savings/ton

= 53.79 x [ 1 – (0.28/0.30)] * Rs 45
= Rs 161.37/tonne
Hourly furnace oil cost savings for 12 tons

= Rs 161.37 *12
=Rs 1936/hr
d) Simple payback period @ 4700 hrs of operation

=20,00,000/1936*4700
= 0.352 yrs or 4.2 months
e) Net cash inflow per annum = 1936*4700

= Rs 91.0 lakhs
Investment = 91.0 [ 1 + 1 + 1 + 1 + 1 + 1 ]
1.16 (1.16)2 (1.16)3 (1.16)4 (1.16)5 (1.16)6
= 91.0 [0.862+ 0.743+0.641+0.552+0.476+0.410]
= Rs. 3.35 Crores

QUESTIONS
Objective Type Questions
1. What does the concept of time value of money imply
a) present value of money b) future value of money

c) discounting of cash flows d) all of the above
2. Return on Investment (ROI) as a fraction means
a) initial investment / annual return b) annual cost / cost of capital

c) annual net cash flow / capital cost d) none of the above.
3. The net present value (NPV) is
a) equal to the sum of the present values of all cash flows b) equal to the sum of
returns
c) equal to the sum of all cash flows d) none of the above
4. The Internal Rate of Return (IRR), of an investment is calculated by
a) selecting a discount rate so that NPV = 0

b) equating total discounted costs with total discounted benefits
c) making sure the benefit / cost ratio equals unity d) all of the above
5. Assume project A has an IRR of 85% and NPV of Rs 15,000 and project B has an IRR
of 25% and NPV of 200,000. Which project would you implement first if financing is
available and project technical life is the same?
a) B b) A c) cannot be decided d) question does not make sense

6. Which of the following equation can be used to calculate the future value from the
present value of cash?
a) NPV = FV x (1 + i)n b) FV= NPV x (1 - i)n

c) NPV =FV/ (1 + i)n d) none of the above.
7. The Net Present Value of a project at a discount rate of 16% with an investment of Rs
50,000 at the beginning of the first year, and savings of Rs 23,000 and Rs 36,000 at the
end of the first and second year, respectively is
a) 6,581 b) -246 c) 862 d) 3,419

8. A sum of Rs 10,000 is deposited in a bank at the beginning of a year. The bank pays 6%
interest annually. How much money is in the bank account at the end of the fifth year, if
no money is withdrawn?
a) 13,382 b) 12,625 c) 13,000 d) 10,937

9. The broad indicator of the annual return expected from initial capital investment is
a) NPV b) IRR c) ROI d) Discount factor

10. Which among the following is not a typical performance contract
a) a) Shared savings b) Guaranteed savings c) Fixed fee d) Hire purchase

Short Type Questions

S-1 100 numbers of fused 60 Watt incandescent light bulbs (ILB) are replaced by
same numbers of 12 Watt CFL instead of new ILB. Calculate the following for
4000 hours of operation per year.
(i) The annual reduction in electricity costs if Rs. 4 per kWh is the energy
charge and Rs. 250 per kVA per month is the demand charge.
(ii) The simple payback period if the ILB costs Rs. 10 and the CFL costs Rs.
100 (assume life of ILB and CFL as 1000 hours and 4000 hours
respectively).
S-2 Explain briefly the operation of an ESCO?
S-3 What are the limitations of payback period?
S-4 What are the limitations of ROI method?
S-5 Compare between NPV and IRR?
Long Type Questions
L- A company invests Rs.10 lakhs and completes an energy efficiency project at the
1 beginning of year 1. The firm is investing its own money and expects an internal
rate of return, IRR, of at least 26% on constant positive annual net cash flow of
Rs.2 lakhs, over a period of 10 years, starting with year 1.
1. Will the project meet the firm’s expectations?

2. What is the IRR of this measure?
L- The cost and estimated savings data for an energy saving retrofit project is given
2 in table below.
Retrofit cost Energy & demand Maintenance cost savings

savings
Rs. 1,00,000 6000 kWh/year & Annual maintenance cost savings
Rs.3800/year as will be Rs. 2000/-.
demand charges
The key data is given below:

Energy savings are based on Rs 3.00/kWh
No changes in energy rates for 10 years
The project has a 10 year life period
Calculate NPV for the upgrade option against 12% discount rate.
REFERENCES
1. Financial Management, Tata Mc-Graw Hill – Prasanna Chandra.
2. Manual for the Development of Energy Efficiency Project ----International Finance
Corporation.

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7.

7.2 Investment Need, Appraisal and Criteria

 How much will the proposal cost?

Bureau of Energy Efficiency

7.3 Financial Analysis Techniques

The basic criteria for financial investment appraisal include:

Bureau of Energy Efficiency

The simple payback period can be calculated using the equation

Example 7.1: Simple Payback period

A cogeneration system installation is expected to reduce a company’s annual energy bill by

Simple payback period = 90

Limitations of payback period

Example 7.2: Drawback of payback period

For example consider the cash flows of two projects, A and B:

Investment Rs. (100,000) Rs. (100,000)

Bureau of Energy Efficiency

Return on Investment (ROI)

Annual net cashflow

Example 7.3: ROI

ROI = Average annual operating cash flow = 25,000 x 100

 Simple method and easy to calculate

 It does not take into account the time value of money.

Bureau of Energy Efficiency

Time Value of Money

FV = NPV (1 + i)n or NPV = FV / (1+i)n

Where, FV = Future value of the cash flow

Net Present Value Method

Bureau of Energy Efficiency

CF0 CF1 CFn n CFt

Where NPV = Net Present Value

Example 7.4: NPV

Bureau of Energy Efficiency

30000 6000 6000 6000 6000

30000 6600 6600 6300 6300

The net present value criterion has considerable merits.

Internal Rate of Return Method

Bureau of Energy Efficiency

CF0 CF1 CFn n CFt

Where, CFt = cash flow at the end of year “t”

CFt value will be negative if it is expenditure and positive if it is savings.

Example 7.5: IRR (Example of iterative procedure to estimate the IRR)

Investment Rs. 20,000

The net present value of the proposal is:

20000 6000 5500 5000 4500 4000 4000

Bureau of Energy Efficiency

The discount rate has to be increased to bring NPV to zero.

Increasing the discount rate to 12%,

20000 6000 5500 5000 4500 4000 4000

Further increasing the discount rate to 16%

20000 6000 5500 5000 4500 4000 4000

For a discount rate of 13%

20000 6000 5500 5000 4500 4000 4000

NPV at 13% = -65

NPV at 12% = +495

Bureau of Energy Efficiency

IRR = Lower rate + NPV at lower rate x (Higher rate-lower rate)

IRR = 12 + 495 x (13-12)

Figure 7.1 NPV versus Discount Rate

Comparison between Net Present Value and Internal Rate of Return