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April 19th, 2010
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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