April 19th, 2010

The Worst Metric in Renewables: ‘Payback Period’

Chris Williams

16 Comments
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TOPICS: BOSTON, Business Insights, Renewable Energy

BOSTON -

For as long as I can remember, since I was 16 and first stated going to NESEA, the renewable industry has talked about renewable investments in terms of this silly little term call ‘the payback period’. you might have heard this before, and from now, when you hear this term YOU HAVE the responsibility and obligation to correct the individual that uses this term.

At first, I went with it and used that term which we will no longer name. Then I went to school and learned something. I learned about finance, accounting and marketing and realized that ‘it’ is the least useful and most stupid metric to discuss investments, its paralyzing the renewable energy industry.

When you are thinking about investing you money, lets say in the stock market, a CD, or on a house, how often do people talk about ‘that’ term (the payback period that is)? They don’t! There’s a reason that Wall Street does not talk in terms of payback period.

Basic finance tell us that if free cash is available, if the discount rate (or internal rate of return, IRR) is greater than the weighted average cost of capital (WACC or just CC for short) the investment should be made. Thus, if an investment (in the worst case scenario) will have an IRR of 7% and the WACC is 4%, you just made 3% profit, or savings for the life of the investment.

The usefulness of speaking in terms of IRR really hit me when I was talking with my cousin, who is very interested in installing geothermal, solar thermal and solar PV on his house to reduce his substantial utility bills. The conversation went something like this:

Me: Bob, you could substantially reduce you utility bills by installing renewable energy systems on your house.

Bob: Really? Like what?

Me: Geothermal for your heating and cooling, solar thermal for hot water, and solar PV for your electricity

Bob: Hmmmm, what’s the payback on something like that?

Me: Actually, payback period is not really a useful way to compare this investment to another. For example, whats the payback of your IRA? What’s most useful is IRR and in Massachusetts most investments are usually at least 10% over the life of the system, so its a better investment then the stock market and has no risk, because you’re going to use energy even during a recession.

Bob: really?! Better than the stock market? That’s amazing! So, I might as well put my money into this.

Me: Yes, yes you should. blah blah blah

Lets be honest, most customers that can afford solar and geothermal can afford the large upfront payment and thus tend to have a lot of money. These type of customers also tend to have a lot of investments and understnad IRR much better then payback period.

Here’s my point. Stop saying/using/marketing payback periods, you’re shooting yourself in the foot! Start educating your customers about why the IRR is a much better metric and this will allow them to effectively compare this investment to other investments.

We need to remember that we’re the expert, and that we need to educate our customers about how to talk about these investments. To use a sale term, we need to frame the discussion so no objection can even be made and a renewable energy investment is the best choice.

Here’s the real pickle, why the heck was payback ever used in the first place?

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Chris Williams

About Chris Williams

Chris Williams is the editor of Green Light Distrikt and Chief Marketing Officer at HeatSpring . He has experience in business development, prototyping and new venture research with a focus on geothermal heat pumps, solar thermal and solar photovoltaic technologies. Chris is an IGSHPA accredited geothermal installer and NABCEP certified solar installer. Chris is focused on solving customer facing issues in the creation and adoption of clean energy technologies and products. Chris has installed over 300kW of solar and tens of geothermal systems. He's invented the PV Pal , developed many trainings at HeatSpring, publishes the NABCEP Study Guide , the Hitchhikers Guide to Cleantech and has done due diligence research for Urgent VC . Feel free to connect with him @topherwiliams , on Linkedin , or through email about new ventures, collaborating, writing, research or whatever is on your mind.

  • http://SimpleEnergyWorks.com Randy

    Thanks for the excellent insight. It has already changed the way I talk to potential “customers”. It seems that comparing apples with apples is best.

    When you have a low 1-5 years payback period I think it still makes sense to talk of payback. Anything over that and it needs to be compared with other financial options.

    Thanks for the post.

    Randy
    SimpleEnergyWorks.com

  • http://www.wattzy.com/ Alex Patriquin

    Chris,

    Great point! The renewable and efficiency industries should sell themselves as great investments whenever possible. Many times the ROI is genuinely not there for the individual homeowner, but when it is, this is the most reliable marketing angle a firm can take.

    Not only can the IRR of an investment in geothermal and energy efficiency exceed stocks or bonds, but the risk of that investment is much less. A homeowner is basically investing in physics, as demonstrated in the principles of building science.

    Yes, there is some variability with occupant behavior and the weather. BUT behavior is controllable and the weather is a lot more predictable than the stock market, even a long-term index fund.

    Check out this analysis provided by the LBL. If you had $4,000 in 1990 and lived in an energy gusher of a house (not so uncommon — even today), you would do better by investing in energy efficiency (16%) than the Dow Jones Industrial Average during a historic bull run (14%).

    http://hes.lbl.gov/hes/profitable_dat.html

    The only time I would say that the payback period IS useful in the sales process is when we’re talking about the really basic efficiency measures, like behavior changes, lighting retrofits and air sealing. These typically payback in under 1 or 2 years, so homeowners can easily incorporate those calculations into their short-term budgeting.

    best,

    Alex

  • http://www.FuturaSolar.com Patrick O’Leary

    Why not go to the next level? Daylighting and solar thermal are already economic. Wind, PV and other fancy green methods are just subsidy mining. Most buildings can harvest the energy they need from the environment.

    America has done it before, and lost it in the meanwhile. See Dia Beacon, which was built as a Nabisco cookie tin factory in the 1920′s. Futura Solar isn’t the only company to have revived the technology. We just added additional solar benefits. Dia Beacon has single pane daylighters (northern light) and no facility for gathering thermal. Futura Solar has replaced the expanded joists that underpin flat roofing and replaced them with triangle trusses which frame up the roof as a solar array. That takes an amortized item into, yes, a payback situtation.

    The tri-truss is modified by the inclusion of daylighting and a 2 pass air heater. Who remembers the Minnesota Window Heater (1880-1890 Midwest, late 1970 to early 1980′s Whole Earth Catalogue)? The air can be ducted anywhere in the building that might use it to displace fossil fuels.

    The air heater feeds from just below the ceiling, recovering waste heat and conditioning the space. AC has displacement conditioning, just turn it around, it works as well either way. That eliminates the mechanical cross purposes at which most systems work.

    The absorber plate of the air heater doesn’t care if it’s painted black, amorphous PV or SWH. The light strikes it and gives up energy in the infrared, to the air. Until a PE contradicts me, I’m going to say that the PV can be direct wired, DC, to the fans ducting the hot air. Dedicated circuit, no net metering.

    Elegant?

  • http://www.thegreenlightdistrikt.com Chris Williams

    Randy,

    Glad it was helpful! I look forward to learning more about what you’re working on.

    Alex,

    I love the information about comparing efficiency to the Dow Jones! Really great stuff.

    Patrick,

    There is amazing technology for sure, but adoption is always the trick. People can have no impact if they live in a cave right! If it’s available why haven’t people used it?

  • http://www.brightstarsolar.net Mona Reese

    Chris, this article is right on the mark! As a fellow Babson grad, I couldn’t agree with you more. We have the same conversation with prospective customers about the payback period. It’s just not a good measure for customers to base their decision. Rather, they should compare this investment to other investments they could be making. Thank you for educating the community.

  • http://www.thegreenlightdistrikt.com Chris Williams

    Mona,

    Thanks for the support and I’m glad to see that this way of framing the discussion and educating customers around solar and renewables is taking hold.

    I just looked up and found that Bright Solar in is Ontario. Is the feed-in-tariff up there really around $.80 a kWh?!? That’s a hefty check, even for a residence with a 5kW system.

    I may be coming up to Toronto area this summer to visit my uncle and would love to see some of the developments happening!

    Chris

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  • http://www.brightstarsolar.net Mona Reese

    Chris, the company is located in Brighton, MA. The name of our company is actually Solar – http://www.brightstarsolar.net

    Our company has been getting more involved locally with the Boston green networking community and I hope to see you around.

    Mona

  • http://www.thegreenlightdistrikt.com Chris Williams

    Mona,

    Huh, someone google put me in a different company with the same name! My fault! I look forward to seeing you around!

    Chris

  • Carrington_Ward

    Here’s the real pickle, why the heck was payback ever used in the first place?

    I'm guessing it descends from the idea that solar power and off-grid living is a lifestyle choice, not an investment within a portfolio.

  • http://www.thegreenlightdistrikt.com Chris Williams

    Thats a good question! I'm trying to think…..

    Another good thing is when else do you use payback period? I can't even think of any other products that I would apply this logic to. Can you?

  • http://www.dougcoe.com Dougcoe

    Chris–This is a very interesting idea. My problem is: I never studied basic finance and haven’t gotten my head around IRR and WACC. Can you explain it in very simple terms even a twelve year old can understand? Or point me toward a website that does that? The one’s I found are hard to comprehend to me.

    Btw, I’m an architect trying to get clients more interested in green options. Thank you.

  • http://www.thegreenlightdistrikt.com Chris Williams

    Doug,

    IRR is internal rate of return. Think of it just an interest rate on a CD.
    It’s called internal because it doesn’t consider inflation rate of interest
    rates of capital. WACC is wait average cost of capital. Capital, money,
    costs money to get. What drives a WACC depends on a corporatations bond
    rating, credit line interest rate, etc and where it plans to get cash from
    (debt, offering equity, cash). All else equal, a company with a better
    credit rating will have a lower WACC because they can float a bond cheaper
    (ie less risky) then a company with a worse credit rating.

    IRR comes into play when looking at various investment opportunities on the
    cost OR revenue side of the business. A toy company might be looking to
    invest in a new toy line that has an expected IRR of 8% or they may be
    looking to get a light retrofit in their manufacturing facility that has a
    IRR of 40%.

    On a residential basis, WACC is just going to be what a homeowner can get
    money for from the bank and the IRR is going to be a discount cash flow
    statement of the money they’ll be saving without whatever upgrade they’re
    looking to do.

    Does this make sense?

    Chris

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