GBA Logo horizontal Facebook LinkedIn Email Pinterest Twitter Instagram YouTube Icon Navigation Search Icon Main Search Icon Video Play Icon Audio Play Icon Headphones Icon Plus Icon Minus Icon Check Icon Print Icon Picture icon Single Arrow Icon Double Arrow Icon Hamburger Icon TV Icon Close Icon Sorted Hamburger/Search Icon
Musings of an Energy Nerd

Payback Calculations for Energy-Efficiency Improvements

How to perform a simple payback analysis and calculate net present value


Image Credit: Alexkerhead

If you are considering investing in an energy-efficiency improvement for your home — for example, additional attic insulation or a photovoltaic system — you probably expect the investment will lower your energy bills. So it’s only natural to ask, “Is this a good investment?”

For example, let’s say that you are considering spending $5,000 on an improvement that will save you $350 a year on your energy bills. Does the investment make economic sense? The answer, of course, is “it depends.” Among the factors affecting such a decision:

Some of the items on this list — for example, the interest rate on a loan — are quantifiable. Others — for example, the rate of energy cost inflation — can only be estimated. And some — for example, how much one values having a reduced carbon footprint — can’t be quantified at all.

There are so many variables in this list, in fact, that some home performance contractors and solar equipment installers are sick and tired of hearing payback questions. The usual reaction from the sick-and-tired crowd is, “Nobody ever asks what the payback period is for a granite countertop or an SUV!”

(Where would we be without granite countertops? They’re such handy devices for making almost any argument…)

However, I’ve noticed that the people who make this speech are usually people who sell home improvements with a very long payback. You never hear CFL manufacturers make the same speech.

Let’s face it: payback matters. It isn’t the only factor in making home improvement decisions — other factors are important, including improved comfort and a smaller carbon footprint — but it’s an important one.

So now we come to the question: How should we calculate payback?

If you start diving into the world of payback calculations, you quickly learn that there are many ways to…

GBA Prime

This article is only available to GBA Prime Members

Sign up for a free trial and get instant access to this article as well as GBA’s complete library of premium articles and construction details.

Start Free Trial

22 Comments

  1. User avater
    John Semmelhack | | #1

    Christmas
    Martin,

    Thanks for the Christmas-themed post. It's all about the $$$!

    Seriously, though...this is a great reference for those who want to do financial analysis of energy improvements. My personal preference is to do a cash flow analysis using only the "known" variables - interest rate, term, and a conservative estimate of current energy savings and maintenance costs. I try to leave discussions of energy cost inflation and discount rate to those that possess a crystal ball.

  2. Jill Eikenhorst | | #2

    Risk assesment
    Thanks for both the detailed how-to and the notes about non-monetized factors.

    Another factor to consider is risk exposure. People usually think of that in terms of stocks vs. bonds, but the risk of high energy prices is more vital to our survival. What if energy prices go up and up and up, and you have to severely limit your energy use and/or cut back on other essentials? What if utilities are out for a few days or a few weeks? The risk of these things happening is low, but increasing from both environmental and economic factors. Because many of us haven't experienced these events in our lifetimes, we don't consider them. But the Great Depression, the energy crisis of the 70's, and even events like the earthquake in Japan should make us think twice about assuming energy security. How valuable is energy security and energy independence?

    I also think that your note about granite countertops and SUV's reveals that it's socially acceptable to "splurge" on these things, but sometimes it's not acceptable to spend extra money on green features that may not pay back, or even to consider factors like risk of energy insecurity, which I mentioned above. I find myself having to justify taking the bus to work to myself and others, I'm sure folks have gone through similar experiences with green buildings.

  3. Aaron Vander Meulen | | #3

    Thanks
    Thanks for another great article Martin. I've had a lot of people look at me with googly eyes when i tell them i'm putting 4" of foam on my house, and I'd have a hard time recommending it to someone else. But for me, It makes sense. The foam is free, minus cost of renting a lumber truck/driver, and labor is free. I don't anticipate having more than $700 into this, and I'll be here for a long time. So it makes sense to me. But at the end of the day, I really don't think there's a one size fits all answer.

  4. Gene Batema | | #4

    energy calculations
    GREAT ARTICLE!!! Loved it. 10 star hit.

    G. Batema; licensed Michigan GC.

  5. Ed Dunn | | #5

    Comfort is an aesthetic value
    I have designed and built over 45 custom sustainable homes over the past near 20 years. Most all were very energy efficient. Most all of my clients were impressed most with the comfort factor. After the first few years, I used comfort as a selling point. I think it counts as much or more than the granite countertops. People like to live in a comfortable home, free of cold drafts, cool in the summertime, and clean air to breathe. Worth every penny!

  6. Tina Gleisner | | #6

    Energy Calculations Too Difficult for Average Homeowner
    You've done a fantastic job of laying out from simple to more complex, how anyone can calculate the true savings from making energy improvements. There are 2 key items to make this process viable - a table of realistic energy use for existing & proposed new home features ... plus a simple to use, calculator program that lets you include (or omit) the figures you suggest.

    My biggest problem is when you add up all the theoretical energy savings promoted, it's like 3 to 5 times the actual utility bills.

  7. User avater
    Kent Mitchell | | #7

    Dollars, comfort, health, safety!
    Simple payback is a start but we are always ready to highlight other factors besides the financial factors. Comfort, health, safety, longevity, enviroment, sustainability, local products, etc... Each plays a part & should be at least quickly mentioned, or even be the "driver" when it is appropriate!.

    Another good article Martin!

  8. User avater
    Ted Clifton | | #8

    Errors in your energy inflation analysis
    Martin, you stated above that energy inflation was less than the over-all inflation between 1981 and 2009. Absolutely not true! The attached graph starts in 1980, and goes through 2011. The dip in the energy inflation graph near the end represents the drop in energy prices in 2008. This data was taken directly from the US Dept. of Commerce website, I created the graph. The average energy inflation for the period you named was about 6.33% per year, while the over-all inflation rate was only 3.34%. What is worse, for most of that time, up until the world economy collapsed in 2008, energy inflation was averaging well over 7.5%. If you drew a line roughly through the middle of the colored section between the curve representing the compounded 6.33% rate of inflation and the actual inflation year-over-year figures at the top of the graph, you would get to what a financial advisor would describe as the mean inflation rate on energy, around 7.5%.

    The slow curve at the bottom represents the 3.34% total CPI curve, compounded evenly, the dashed line just above that represents the actual year-over-year rate of inflation. Any way you look at it, if you are counting on being able to purchase your future energy needs with the same percentage of your income that you are spending today, you'd better plan on getting some nice pay-raises over the next few years! What are you going to do once you are an a fixed income, at the mercy of Congress?

    Jill Eikenhrst hit the nail on the head, it is all about risk exposure. None of us can afford the risk involved with ignoring our energy future!

  9. Troy Farwell | | #9

    A few points
    We use NPV all the time in our industry (high tech) to justify projects and investments. A couple of observations:

    I have never seen any payback calculations on green investments that include maintenance or replacement. You should take an annual maintenance reserve into the equation to be honest with a home owner. If payback is 20 years and replacement life is 20 - there is only break-even.

    You also don't take into account the declining cost of green technologies. In many cases, you will have a much better NPV if you wait to invest - depending in the retrofit costs. CFL's used to be $5 - now they are $1 - it's good to consider this when investing. Solar is dropping in cost annually.

    As far as determining an interest rate - or "cost of money": I would just use the average inflation of energy over the economy in general. The difference will provide an IRR / NPV that makes the most sense. I checked the average US cost of electricity over the past 20 years. It is running at a 2% inflation rate. The US economy is running around 3% for that period (and on the general decline) - so your cost of energy money is -1% - power is getting a bit cheaper. I'm sure this figure will make me a ton of friends in the green energy industry (vested interest is tough to deal with).

    Finally, I would not think about getting a specific figure, but create an "upside / downside" analysis that provides the anticipated NPV and break-even points. In simple terms, you could say "upside is payback in 8 years, downside is 20 years." I think helps people frame the risk in their minds.

  10. User avater GBA Editor
    Martin Holladay | | #10

    Response to Ted Clifton
    Ted,
    I respectfully disagree. Anyone who wants to verify the information on the Consumer Price Index from 1980 to 2010 can view the data here:
    http://www.census.gov/compendia/statab/2012/tables/12s0725.xls

    Just like you, I took my data from the U.S. Department of Commerce Web site.

    The Web site uses the period from 1982 to 1984 as its benchmark. The CPI for that period is given the arbitrary value of 100. In 1980, the CPI for all items (indicating overall inflation) was 82.4. That indicator rose to 218.1 in 2010, indicating an inflation rate of 264% for the time period in question.

    The same Web site includes a column showing the CPI for energy during the same period. The index for energy rose from 86.0 in 1980 to 211.4 in 2010, indicating an inflation rate of 246% for energy for the time period under discussion -- a rate lower than the overall rate of inflation.

    I have attached my own Excel spreadsheet with these numbers.

    Concerning predictions of energy price inflation: my own position is that of the cynic. As I wrote in my article, "All you have to do is tweak your assumptions, and you can prove any conclusion you want." It's certainly possible to choose a historical time frame that shows that energy prices increase at a faster rate than the general rate of inflation. Conversely, it's equally possible to choose a historical time frame that shows that energy prices increase at a slower rate than the general rate of inflation.

    Right now, natural gas prices are dropping. Good luck predicting the future!

  11. User avater GBA Editor
    Martin Holladay | | #11

    Response to Thomas Farwell
    Thomas,
    You wrote, "I have never seen any payback calculations on green investments that include maintenance or replacement." It's surprising that you are posting that comment on this blog page, since my article specifically addresses both points.

    In one of my examples, I wrote this concerning maintenance costs: "For example, if you are considering the purchase of a solar hot water system, it would be wise to budget for system maintenance. Maintenance costs are a negative cash flow, just like a mortgage payment.... Let’s assume that a homeowner borrows $5,000 to install a solar hot water system that saves $350 on the energy bills during the first year of operation. The homeowner wants to budget $50 per year for system maintenance, and assumes that maintenance costs will rise at the rate of 3% per year."

    This is what I had to say on replacement costs: "If you invest $5,000 in a solar hot water system, the equipment will wear out in 20 years and be carted off to the dump. On the other hand, if your money is invested in a government bond, you might earn 2% interest per year — and you’ll still have the $5,000 of capital at the end of 20 years."

    For three years I had my own business providing capital needs assessments for multifamily housing projects, so I am well acquainted with replacement reserve accounts.

    Concerning another one of your points -- "You also don't take into account the declining cost of green technologies" -- the point applies to some but not all technologies. Moreover, future prices are hard to predict. Cellulose insulation hasn't gotten cheaper over the last 30 years; nor have replacement windows. The cost of these items has tracked overall inflation rates, or perhaps increased at a faster rate.

    On the other hand, you're right about the cost of PV systems and CFLs. However, the cost of these items won't continue to drop indefinitely, and it's hard to predict future costs. In 1980, widely publicized predictions of dropping PV prices were uniformly overoptimistic.

    Finally, I agree with your "upside/downside" approach -- that makes sense.

  12. User avater GBA Editor
    Martin Holladay | | #12

    Response to Tina Gleisner
    Tina,
    You wrote, "There are 2 key items to make this process viable - a table of realistic energy use for existing & proposed new home features ... plus a simple to use, calculator program that lets you include (or omit) the figures you suggest."

    Concerning your first suggestion: it is impossible to create "a table of realistic energy use for existing & proposed new home features."

    While such a table is impossible, it is possible to identify the current cost of energy use for a specific house, as well as projected savings for various energy retrofit improvements to that house. To do this, one needs to have a complete energy audit of the home, and to input the information into an energy modeling program like REM/Rate.

    The reason that this information can't be presented in a table is that it is specific to each home. Variables include the local climate, local energy costs, the home's air infiltration rate, glazing specs, window orientation, insulation levels, etc.

    Concerning your second suggestion -- to create "a simple to use calculator program that lets you include (or omit) the figures you suggest" -- that's theoretically possible. But for the reasons outlined in the article -- namely, because many of the variables are unknown and have to be guessed at, and because many of the benefits of energy retrofit work (like improved comfort or energy security) can't be quantified -- I think such a calculator would give the misleading impression that precision is possible in an area where precision is in fact impossible.

  13. Rick Barnett | | #13

    Payback
    Martin
    you ask "Does the investment make economic sense?". I ask: why are thermal improvements the only element of a building project where this question is asked? Does a granite countertop make economic sense? Or a media room? Or the stuff that goes into the media room? And why aren't thermal upgrades evaluated for what they actually do: generate savings over the life of the structure? Perhaps the potential of efficiency to create jobs and reduce carbon is not being realized because too many people ask the wrong question.

  14. User avater GBA Editor
    Martin Holladay | | #14

    Response to Rick Barnett
    Rick,
    I agree with you, which is why I quoted the same (oft-delivered) speech in my blog: “Nobody ever asks what the payback period is for a granite countertop or an SUV!”

  15. User avater
    Ted Clifton | | #15

    Interesting Data (or lies, damned lies, and statistics)
    Martin,

    A closer examination of our data from the Dept. of Commerce website shows that it not only makes a difference which years you look at, but which months as well. Because i wrote my article on this topic last February, I used monthly data from January 30th of each year, which was the most up-to-date at the time. Energy costs rose about 10% in 1981, between January and the end of the year, which is when your annual data seems to have been taken for the table supplied in your link. While energy was also rising quickly this year, it did not rise nearly as quickly on a percentage basis as it did in 1981. Either way, however, if you discount the economic collapse of 2008-2009, in which energy costs dropped about 20%, energy still out-paced all other inflation by a considerable margin. If you go back to the Arab Oil Embargo days of 1973, and start your calculations just before then, you get even scarier numbers than you would beginning in 1981.

  16. User avater GBA Editor
    Martin Holladay | | #16

    Response to Ted
    Ted,
    As I said, all you have to do is tweak your assumptions (or the years of historical data you choose to look at) and you can prove any conclusion you want.

  17. User avater
    Ted Clifton | | #17

    Basis for my graph
    BTW, the increases in energy costs shown on my graph were taken directly from the Dept. of Commerce year-over-year percentage increases for the years from January of 1981, through January of 2011, and applied to the starting average cost of household energy of $214. I do not remember where I got the $214 number, but I think it was from local Puget Sound area utility company data. You can clearly see the dip in 2008-2009, but it barely takes the cost of energy below the 6.33% inflation line.

    One other comment on an opinion stated above by others, regarding the possible advantages of waiting until prices come down to start saving energy. Call me a fanatic, but when it comes to fossil fuels, energy used is energy gone, forever. Once it is all gone, there is no turning back. Does anyone know how to quantify that? The best example I could think of I used during a talk at the National Green Building Conference a couple of years ago: We all flew in here from somewhere, what if we suddenly had used the last drop of jet fuel, and all had to walk home. Many of us would have found ourselves thousands of miles from home. It would have been at least four months of walking for me, and I am certain I would have missed my wife and children during that time, if I survived the trip!

  18. John Porterfield | | #18

    Contrarian Thoughts
    We're not so rational as this . . . We are driven to action by our values, such as doing our part for our planet. We invent the economics we need to realize larger values (at least in the long run). Economics available today is helpful for handling risk, keeping essential resource flows in place as we reach for our values (a stone at every step across the river keeps us above the surface through the journey). Economics informs current constraints to realizing our values. Economic analysis is helpful to determine if our seat will remain available once our adrenalin drives us up and away to realize our values. We are not economic animals. I doubt economics drives adrenalin (though I'm willing to learn), so I doubt economics drives much anything -- constrain yes, drive no -- doctrine that humans are economic animals to the contrary.
    Reducing energy use impacts the income statement AND the balance sheet. Play with a full deck! Carefully selected efficiency and renewable energy upgrades may "pay for themselves" with a balance sheet entry, especially if one's income statement improves. Using ROI: (annual savings - annual maintenance) / (cost - asset value). One may adjust for time value of money, differential energy price inflation, depreciation charges, etc. in pursuit of accuracy (and don't forget reduced utility cost is tax free income).
    Chicago-area natural gas prices vary as much as +/- 35% year-to-year and seasonally. Cost to install efficiency measures easily varies as much, as do issues of quality installation, durability, loan terms, etc. Let's not over-rationalize our calculation procedure in a context of real-life uncertainty.
    Perhaps most certain: not addressing climate change will be BAD. Without a planet, you can't have an economy.

  19. Bryan Mekechuk | | #19

    Remember Taxes ...
    Good article on the financial and non-financial considerations of investing in energy improvements.

    One element that you may wish to add to your calculations is the tax effect of the cash flows. For many people, the interest cost is tax deductible, which lowers the effective cost. On the other hand, the cost of energy is not tax deductible.

    Each of the elements in the investment analysis has a tax impact, and they may be at different rates. For example, the capital appreciation may be at a lower rate.

    Most people considering investing in home improvement pay income tax, albeit at various rates. And,
    those rates may change (e.g., go up?). A robust analysis of investments, even home improvements, should consider the tax effects.

    If you are putting a spreadsheet together, it is easy to put in a calculation for the tax effect of each element, and then link that to a tax rate. Do the calculations at 0% tax (I wish!) and then try 10%, 20%, etc. and see how the numbers change.

    If you are looking at the various elements in a comprehensive investment analysis, you should include the tax iimpacts of each of those cash flows and see what that does to the numbers.

  20. User avater GBA Editor
    Martin Holladay | | #20

    Response to Bryan Mekechuk
    Bryan,
    At the end of my article, I explained why it is usually unnecessary to get overly fussy and precise with payback calculations. That said, you make a good point, and any accountants among our readers should take your advice to heart.

    Although your comment focused on income taxes, property taxes can also affect payback calculations. In some (but not all) communities, tax assessors may assign a higher value to a house with a large PV array on the roof. After all, the PV array makes the house more valuable. If the homeowner ends up paying higher property taxes because of such a higher assessment, the property taxes can take a big bite out of any energy savings.

  21. Ted Kidd | | #21

    Nice article -
    I like the implication that too simple an analysis on a complex decision might be stupid. "Payback" is a term I often hear unsophisticated people using in an attempt to appear sophisticated because they are afraid of being taken advantage of.

    When people who hardly have 2 sheckles to rub together tell me they want a 3-4 year payback I have to work hard to stifle laughter. I look for Alan Fundt and wonder who did the makeup on Warren Buffet to make him look like the person in front of me. Anyone with the magic ability to generate 20-30% annual after tax returns doesn't ask for crazy paybacks on home improvements. Their time is too valuable. They simply fix their houses. They want the experiential results of efficiency - quiet, comfort, and control - the portion of these improvements paid for by energy savings is totally anecdotal for these heavy hitters.

    I like the cash flow analysis. That's how most people pay for improvements - just happens these improvements help pay for themselves - so we are attempting to do net cost analysis.

    As one commentor suggested, when comparing rate of return one DEFINITELY needs to consider the income tax factor of alternative investments.

  22. Roger Williams | | #22

    I liked both the article and the comments
    I have been working on cutting my energy costs over several years and recently had my second energy audit completed. Total cost $6,500 - $2000 gov rebate = $4500. Estimated energy savings are $480. Currently our electricity has a sales tax of 13% which takes that saving up to $542. The payment on the 10 year loan is $580 a year + $50 maintenance. $88 a year for the more secure feeling is worth the difference. Using a 3% increase in electricity costs those savings will rise to $707 in ten years. Put in the equation that we will also cut our annual "carbon footprint" by 3.8 tonnes, it becomes a no-brainer. Have a great day, everyone!

Log in or become a member to post a comment.

Related

Community

Recent Questions and Replies

  • |
  • |
  • |
  • |