Build the Financial Base Case and Calculate Business-As-Usual NPV
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A financial model is a decision-making tool to help the project team identify which ECMs should be packaged together in order to optimize carbon savings and mitigate higher cost of some synergistic ECMs. A discounted cash flow calculation can be used to aggregate the incremental cash flows associated with each proposed ECM and calculate the net present value (NPV). These incremental cash flows include all positive and negative cash flows associated with the ECMs (e.g., capital costs, utility cost savings, repair and maintenance savings, incentives, and avoided LL97 fines in the NYC context, etc.) and are distributed over time according to when the cash flow will occur. The NPV of each package of ECMs can then be calculated as the sum of the NPVs of each individual ECM included in the package. NPV, along with other important metrics like cumulative carbon emissions reductions, will be used to determine the optimal retrofit solution.
Baseline Energy Consumption and Utility Costs - The adjusted baseline energy model and associated energy consumption should be utilized to determine the baseline utility costs. This information can be obtained directly from the energy model and is the reference point from which all energy savings for the proposed ECMs will be calculated.
Building Operational Expenses Budget- Defining what this budget would be under the business-as-usual scenario is necessary to understand the impact of a potential ECM on current operational expenses,. This budget should cover expenses for any regular maintenance of the existing building systems and be forecast through the duration of the financial analysis study period.
Building Capital Expenses Budget - Given the lifespan of current building equipment and components, there should be an existing budget for the replacement of equipment reaching end of life. Reviewing this budget is beneficial to the project team as it will highlight opportunities to synchronize the implementation of ECMs with the existing budget and provide access to an additional pool of funding that may otherwise not be available.
Discount Rate- The building owner should provide the discount rate to be use in the financial model. This rate will be used to determine the net present value (NPV) of future cash flows associated with the implementation of ECMs. Because NPV calculations are highly sensitive to the assumed investment rate of return on capital, this variable should not be assumed.
Utility Escalation Rate- Utility escalation rates should be applied to the baseline utility costs of the building in order to capture projected increases in utility rates throughout the study period. Typical electrical escalation rates can range from 3% to 5%, while fuel escalations can range from 1% to 2%. It may be beneficial to review historic annual energy bills to fine tune these escalators for your project.
Construction Escalation Rate - This rate typically ranges between 2.5% - 3.0% but may vary depending on the duration of the study period and the specific technologies and industries involved in the implementation. For example, a zoning change that fuels a construction boom could increase this factor as could a recovery from a recession.
Time Horizon for Financial Model - The project team and owner must establish a time horizon for the financial analysis. This will be informed by the expected payback period for ECMs, the implementation timeline anticipated for certain ECMs (i.e., those that would most economically be completed at the time of tenant lease renewal), as well as project objectives associated with meeting LL97 emissions limits or other similar goals. A ten year time frame is a reasonable starting point, however a longer view often creates substantially more carbon reduction.
Incorporate Known Inputs into the Financial Model - Prior to the inclusion of ECMs into the financial model, the financial base case can be constructed for “business as usual” operations. Given the building’s current energy consumption and associated energy cost, the operations and maintenance budget, the capital expenses budget, and the anticipated fines associated with LL97, it is possible to get a sense for what the building will spend during the study period using and maintaining the existing systems. This will be the baseline against which all ECMs and their associated incremental cash flows are compared. The business-as-usual financial model should be reviewed with the building’s financial and operations teams to ensure that all inputs have been accurately interpreted and incorporated.
Net Present Value (NPV) of the Business-as-Usual Case - Using all known information about the building (utility costs, repairs and maintenance budget, capital expenditures budget, anticipated LL97 fines) it is possible to calculate the NPV of business as usual operation. It is important for the project team to highlight to the client the cost of “doing nothing” or not implementing any ECMs as it relates to LL97 fines. This will be the financial baseline against which all proposed ECMs and ECM packages will be compared.
- Select and Verify Financial Model Inputs - The owner should be involved in the set up of the financial baseline model to ensure the correct inputs are used. The owner will need to provide the project team with the discount rate to be used for the analysis, the current maintenance and capital expenditures budget, and can provide input on the recommended study period and construction escalation rate.
- The Business-As-Usual case should also consider the cost of inaction – There is a cost to inaction. Cities are increasingly following New York City and limiting or increasing the cost of carbon emissions from large buildings. Over time, equipment will age and require replacement, while tenant expectations will evolve. Buildings that do not plan for decarbonization are taking on risk they have not quantified.
- Time horizon for financial model should be as long as possible – The longer the time horizon, the more optimal carbon reduction strategies will emerge. A minimum of 10 years is recommended for this type of analysis.
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