False Dilemmas, Energy Projects and Value Creation

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1 False Dilemmas, Energy Projects and Value Creation Jonathan A. Coburn President, Building Asset Insight LLC Abstract A false dilemma is created when options are presented in an either/or" context when in fact there is at least one additional alternative. Unfortunately, most building energy management programs are built upon a false dilemma that limits the value they can deliver. I refer to the distinction between Energy Projects capital investments made for the express purpose of reducing energy cost and carbon footprint, and what I will call Infrastructure Projects capital investments undertaken to reduce business risk (i.e. maintain business continuity) by replacing the old and dilapidated building assets most likely to fail. This paper will explore why this false dilemma exists and how it limits the energy savings achievable through capital investment. The paper will then present an alternative approach that, properly implemented, can increase the savings energy capital investment programs can deliver and produce other organizational benefits. Introduction Most large companies have implemented capital investment programs to improve building energy efficiency. The typical program makes a distinction between two types of projects: Energy Projects are implemented for the express purpose of reducing energy cost and carbon footprint. Typically, a separate bucket of capital funds is set aside to finance them, managed by an Energy Team. Energy Projects must yield sufficient savings to achieve a specified investment threshold (e.g. five-year simple payback). Energy Projects are assumed to be discretionary investments; that is, the choice is always between investing in an Energy Project or making no investment at all. Infrastructure Projects are implemented to manage business risk (i.e., to maintain business continuity) by replacing old and dilapidated building assets most likely to fail. The investment threshold for Infrastructure Projects is defined by a risk-informed investment prioritization scheme. A Project Management organization owns the Infrastructure Project budget and is responsible for project delivery. This arrangement constitutes a false dilemma because it unnecessarily associates only one kind of benefit with a project, even though most projects deliver a mix of energy and infrastructure benefits. New (replacement) assets installed as part of an Energy Project are likely to be more reliable than the replaced assets, reducing maintenance cost and business risk. Conversely, new (replacement) assets installed under an Infrastructure Project are likely to be more energy efficient than the assets they replace. Projects provide dual, cross-functional benefits. When we classify a project according to just one type of benefit we lose the ability to provide the other. To better understand why, let s look at why the dilemma exists and how it encourages organizational behaviors that act as obstacles to effective energy efficiency investment.

2 How the False Dilemma Limits the Savings an Energy Investment Program Can Deliver The false dilemma exists because organizations design energy investment programs to minimize organizational change rather than to maximize value. Put yourself in the shoes of senior management for a moment and ask yourself how you would design an energy capital investment program. Surely the simplest approach is to add a small Energy Team to the organization to provide energy management expertise, leverage an existing Project Management organization to execute the projects, and tweak existing budgeting mechanisms to allow for targeted investments in energy. Voila! You have created what I call the standard energy capital investment program. The standard program underperforms because it tries to manage an inherently cross-functional activity using a functionally-aligned organization. Avoiding changes to the existing functional organization requires layering the standard program on top of the organization rather than embedding it. The result is organizational dysfunction - the program is viewed as extra work, it separates accountability from authority, it neglects to align incentives, and it institutionalizes the view that energy savings is someone else s job. Consider incentives. Measuring the performance of project managers strictly on budget and schedule compliance - as most organizations do - incentivizes them to remove energy efficiency measures included in project scopes and budgets. Doing so reduces project complexity, provides a budget cushion, eases schedule pressure and conserves the total Infrastructure Project budget. Project Managers win by buying the cheapest chiller, not the most efficient one, and by avoiding any system upgrades associated with the chiller replacement that would drive additional savings. Similarly, Procurement organizations are incentivized to buy what is cheapest rather than what is most efficient. Typical internal metrics and incentives used by functional organizations almost always act as barriers to investments in energy efficiency. The false dilemma institutionalizes the idea that it is the job of Energy Projects to save energy and the job of Infrastructure Projects to reduce risk. This reinforces the organizational bias against energy efficiency reflected in normal internal incentives and makes it harder to engage employees to support a broader energy efficiency agenda. Another barrier imposed by the standard model is the requirement that energy payback must be calculated based on total project cost. This assumes that all energy investment is discretionary; i.e. the choice is always between making the energy investment or no investment at all. This assumption is invalid when the choice is between two, non-zero investment alternatives a situation that occurs when assets are included in the scope of an Energy Project and are also targeted for replacement to manage risk. A related problem in many organizations is a requirement that all funding for a project come from a single budgetary source - Energy Projects must be funded entirely from a single bucket, Infrastructure Projects from another, Workplace Projects from yet another. Organizations set up multiple false dilemmas through their financial policies. An organization can recover the value lost to the false dilemma without wholesale changes to the organization. Let s see how.

3 Delivering More Energy Savings from Infrastructure Projects Figure 1 Unrealized Energy Savings from Infrastructure Investments Figure 1 illustrates the untapped energy savings opportunity associated with Infrastructure Projects. The Infrastructure Project on the left delivers sufficient risk reduction benefit (lower rectangle) to merit investment; it may also deliver some ancillary energy efficiency benefit (upper rectangle). Because of the incentive mismatches noted above, the standard program does not consider ancillary energy benefits, so they cannot be counted as savings delivered by the energy management program. The alternative is a Type I Dual Benefit Project. It includes the same planned infrastructure investment as the Infrastructure Project, plus an optional, complementary, additional investment in energy efficiency. For example, if the infrastructure investment is a new chiller, an additional and complementary investment could be made to (a) fund the cost differential between the cheapest and the most efficient chiller, and (b) implement complementary measures to improve the efficiency of the chill water system. This additional investment, if considered in isolation, would generate sufficient savings to meet the energy investment payback threshold. The upper rectangle represents the energy savings achieved by the additional investment. Maximizing energy savings from ongoing reinvestment in assets requires making cost effective incremental energy investments whenever possible; that is, turning as many Infrastructure Projects into Dual Impact Projects as we can. The simplest way to make a Dual Impact Project work is to separately fund the Energy and Infrastructure components and execute it as a single project. Figure 2 shows how this can work. A building owner already plans to invest an amount equal to A on an Infrastructure Project to replace building assets. The funding source for this is the normal infrastructure investment bucket. The company can make an additional investment of B from energy funds to deliver savings equal to C. The energy savings shown in Figure 2 are insufficient to provide an acceptable Figure 2 Energy Savings from Incremental Energy Investment (Dual Benefit Project Type I) payback on the total investment (A+ B), but will provide an acceptable payback on the additional investment (B). The optimum outcome for the building owner is to make the entire investment (A + B) to reap the maximum benefit in terms of both energy savings and risk reduction. Without the ability to incrementally invest in energy efficiency the organization will perform only the Infrastructure Project, forgoing the energy savings available from the Dual Benefit Project.

4 Delivering More Energy Projects Figure 3 Unrealized Energy Savings Due to the Discretionary Investment Assumption Splitting project budgets can also allow an organization to increase the number of Energy Projects it performs. Figure 3 shows an Energy Project on the left. The lower rectangle shows the energy savings benefit delivered; the upper rectangle represents the ancillary risk reduction benefit the project might provide. This is a totally discretionary investment because it does not include any assets already targeted for replacement to manage risk. Typically, this is the only type of energy savings achieved by, and credited to, the entire energy investment program. A Type II Dual Benefit Project is also shown. It includes assets already scheduled for replacement to manage risk. It does not meet the investment criteria for an Energy Project considering the entire project cost, but it would if the cost of planned asset investments to reduce risk was not included in the payback calculation. In this case, the assumption that all energy investment is discretionary is invalid. Some non-energy investment will occur anyway, so why require it to be offset by energy savings? The result of the discretionary investment assumption is that the organization cannot deliver the energy savings associated with the Dual Benefit project, limiting the value the energy investment program can deliver. The funding diagram is shown in Figure 4. The concept is the same as in Figure 2. Payback is calculated considering the energy savings (C) and only the energy funding (B) so that energy savings are not required to offset the cost of infrastructure investments that will be made anyway (A). We recover value by turning as many would-be Energy Projects into Dual Impact Projects as we can. A more formal definition of a Type II Dual Benefit Project is that it (a) includes assets scheduled for replacement in the capital plan in future years, and (b) does not meet the energy payback criteria considering total project cost, but does meet the criteria if the cost of planned asset investments to reduce risk are removed from the payback calculation. Figure 4 Energy Project Savings When the Cost of Planned Infrastructure Investments Is Excluded (Dual Benefit Project Type II)

5 A Real-Life Example Does the standard program really drive the behaviors described? Do Dual Impact Projects really add value? To answer these questions, let s look an actual example. A building in which critical research is conducted has a dedicated central utility plant with one HVAC chiller, two process chillers, and one boiler used for both HVAC and process loads. If the HVAC chiller or boiler fails the required building environments can no longer be maintained, resulting in failure of very expensive laboratory equipment and disruption of core business operations. Two investment alternatives have been developed: An Infrastructure Project to cross-connect the chillers and install another boiler to provide redundancy, thereby reducing business risk. Project cost is $1.5 million with all funds coming from the Infrastructure bucket. Energy savings are assumed to be zero. A Dual Benefit Project (Type I) to provide both chiller and boiler redundancy and reduce annual energy cost by $280,000. Project cost is $2.2 million, $1.5 million to come from infrastructure funds and $700,000 from energy funds. The choice is between investing $1.5 million and saving nothing or investing $2.2 million and saving $280,000 annually. Note that investing nothing is not an option at least $1.5 million will be spent regardless of the option chosen. The only discretionary investment is the incremental capital outlay of $700,000 that saves $280,000 per year. This equates to an ROI of 38% and a simple payback of 2.5 years, well within the energy investment threshold of a five-year simple payback. At a discount rate of 10% it provides a net present value (NPV) of $1.09 million. The shareholder value created by the project over ten years calculated using Economic Value Added (EVA) techniques is $1.6 million. Absent a decision to sell the building, the better option for the company and its shareholders is the Dual Benefit Project. Yet internal policy prevented this; it required the entire project cost to be assigned to an infrastructure investment bucket - with no consideration of energy savings - or to an energy investment bucket which required that the project savings offset the entire project cost with a five-year payback. So, the company implemented the $1.5 million Infrastructure Project, thereby destroying more than $1.0 million in value. In a large organization with several hundred projects identified in its five-year capital plan, the value destroyed across the building portfolio by not pursuing Dual Impact Projects is likely to be enormous. Making It Work - Organization and Process Changes Making Dual Impact Projects work requires some people and process changes. It is crucial that the Energy Team own the energy capital budget and the Project Management (PM) organization own the infrastructure capital budget. A screening process is needed to allow the Energy Team to review planned infrastructure investments to identify which have sufficient energy savings potential to pursue as Dual Impact Projects, and to provide design input to ensure the project scope captures the energy savings opportunity. The same measurement and verification (M&V) protocols used for Energy Projects must be extended to Dual Benefit Projects to ensure that all energy investments meet the program payback criteria. Rules need to be set up for assigning costs from multiple budgets to a project. Some metrics need to be put in place. Some change is needed, but the scope of the change is manageable.

6 Because the Energy Team brings money to the table for any incremental energy investment, the incentive for the PM organization to remove the energy efficiency scope is weakened. Project execution becomes a matter of budget and schedule delivery - no different than for any other project - provided that the Energy Team remains involved as the project is executed to ensure the integrity of the design is maintained. These changes more closely align accountability and authority within an organization. Energy Teams are often accountable for savings without being able to control the activities required to achieve those savings a classic case of organizational dysfunction inherent to the standard approach. In contrast, Dual Impact Projects promote a more collaborative organization. Silo conflict is reduced by bringing together the Energy Team and PM organization to implement a value-maximizing, cross-functional approach to both energy reduction and asset renewal within a trust, but verify relationship with checks and balances built in. The program becomes embedded in the organization rather than layered on top of it, enabling it to deliver more value. Conclusions The Energy Project vs Infrastructure Project false dilemma is a crude attempt to push a square peg capital investments which inherently provide cross-functional benefits - into a round hole a functionally-aligned organization that can only work within its functional boundaries. Aligning projects to a single functional organization destroys value. Dual Benefit Projects embrace the inherent crossfunctional nature of capital investments; the corresponding organization, process and policy changes enable the Energy and Project Management organizations to deliver them. Dual Benefit Projects come in two varieties. A Type I Dual Impact Project is an Infrastructure Project with incremental energy investment, and a Type II Dual Impact Project is an Energy Project with incremental infrastructure investment. They change the game because they don t limit the benefit a project provides to a certain type, don t assume that all energy investments are discretionary, and don t restrict project funding to a single source. Instead of looking at building energy investments as a light switch either off or on we can view them as a dimmer switch either off or with various degrees of on. The latter perspective is much more flexible. It provides new opportunities to create value without compromising the financial integrity of the program, and it promotes a more collaborative organization. As the example suggests, the opportunity for realizing additional savings through Dual Impact Projects is substantial. After the low-hanging fruit of short-payback Energy Projects is harvested, incremental investment in Dual Benefit Projects is likely to provide the highest ROI for energy efficiency initiatives funded with capital. It just makes sense to extract the most energy savings possible from ongoing investments in building assets. We can t do this when we constrain our energy investment programs by creating a false dilemma between Energy Projects and Infrastructure Projects. Mr. Coburn has more than twenty years of experience in the buildings sector in consulting, asset management program design & delivery, risk management, energy management, technology, organizational change, facility management outsourcing and operations. He is President and founder of Building Asset Insight LLC, a company dedicated to maximizing the value generated by building assets through cross-functional optimization of maintenance, capital, energy and risk. He can be reached at jacoburn2@gmail.com.