A Power Efficiency White Paper ENERGY EATING INTO EBIT A report on the board-level need for energy representation THE SOLUTION This paper provides an insight into the issues which senior directors will need to address in the process of developing an effective energy management strategy and outlines the role of an energy director in business today.
ENERGY EATING INTO EBIT Introduction Contents Introduction 2 The key considerations of energy management 3 Energy Eating into EBIT Cash, kilowatts and carbon The business case for investing in energy-saving programmes 5 The role of an energy director 7 Why and how does a business finance an energy efficiency project? 8 Power Efficiency White Papers 10 This is the second white paper in a series of three Power Efficiency is producing outlining the need for an energy management strategy. Our first paper The Energy Price Challenge looked at the key imperative, the need to deal with rising energy costs. We worked with the respected independent market analysts, Waters Wye Associates (WWA), to project energy costs in 2021 based on known and expected measures. We concluded that energy costs for gas and electricity combined will increase by 81% in the coming decade. Clearly, energy is going to be an escalating business cost which, in the current economic environment, will be hard to pass on. In order to protect profitability, senior management is going to have to take energy as an issue out of the plant room and into the boardroom. We are arguing the case that listed UK companies should consider having an energy director on the board. Our research indicates that only three per cent of FTSE 100 companies have a named energy representative at board level. This paper looks at the key considerations a business should address in developing an energy management strategy and the role an energy director can play in addressing them. Julius Brinkworth Energy & Technical Director Power Efficiency Power Efficiency, a Balfour Beatty company, is an integrated energy solutions company and an energy-focused management consultancy which advises many leading corporate and public sector clients on how to reduce their energy costs and comply with regulations. 2
The key considerations of energy management The key considerations board directors should address in developing an energy management strategy are: Preventing rising energy costs from eating into EBIT and eroding profits: We are predicting that energy prices are likely to rise by at least 81% by 2021. This will have a significant impact on any business, eating into EBIT and profits at an alarming rate. We calculate that this level of energy inflation, if unaddressed, would represent a 13 billion hit on margins across the FTSE 100 as a whole. In the current economic cycle, the traditional solution of passing rising costs onto the customer may not be a realistic option for most businesses. Ensuring that energy is represented at board level: Most boards have representation for various functions where costs need to be controlled and reported on, i.e. there are directors responsible for finance, HR, logistics, marketing, IT, property and a whole list of other functions, but an energy director is a rare breed indeed. A quick desk research study we undertook, reviewing the websites and annual reports of 100 FTSE-listed companies, could only find three companies with a named energy representative at board level. Financing an energy solution: The energy dilemma facing UK businesses today can be expressed like this: It is going to cost the business time and money to reduce both energy consumption and its carbon footprint against a backdrop of rising energy prices. How then, can the business set an effective energy-management strategy and decide on the investment levels it will require both in management time and money? Boards need to decide what level of investment they should commit to, on the targets which should be set and on how the business will measure performance and its return on investment. Turning compliance into a business opportunity: For many companies, reporting for the CRC Energy Efficiency Scheme has proved to be a bureaucratic nightmare. For the first time, businesses have a clear picture of their carbon impact having been forced to implement processes to collate and report on energy data. Now the Government is changing the scheme, only in its second year, into a straight environment tax. On the basis that there is nothing as inevitable as death and taxes, businesses need to understand both how they can mitigate their tax liabilities whilst at the same time turning compliance from an administrative problem into a real commercial opportunity. Outsourcing and risk transferring the energy problem: There are new radical and creative options in the way businesses can manage their energy issues. There are various financing deals available which make energy efficiency projects relatively easy to finance. Globally, this market is led by what is termed as the ESCO model outlined later in this paper. This option effectively outsources the responsibility and risk of energy management for the client company. The ESCO delivers integrated outsourced energy solutions including procurement, finance, supply, technical solutions, compliance and project management services and measurement and verification, transferring the risk by guaranteeing savings to reduce the risk of investment. 3
25 Energy Eating into EBIT 20 20.8% % of turnover 15 18.6% 10 10.2% 5 3% 12.5% 5% 0 2011 2012 2013 201 2015 2016 2017 2018 2019 2020 2021 EBIT as a percentage of turnover Profit as a percentage of turnover Energy as a percentage of turnover This graph illustrates how energy inflation is likely to erode margins over the next decade. We have taken an average FTSE company reporting a turnover in 2011 of 10.8 billion, an EBIT of 20.8% and an operating profit 12.5%. In that year, it spent just 3% of its turnover on energy costs. We believe, based on our energy price forecasts, that its energy spend is likely to rise to well over 5% of turnover by 2021, which might sound like a marginal difference, but this could equate to a 130 million hit on margins over this period and would see EBIT dip to 18.6% and profit fall to 10.2% of turnover.
Cash, kilowatts and carbon The business case for investing in energy-saving programmes There are compelling reasons as to why any board of directors should look at investing in energy efficiency. These are: Energy inflation will drive up the cost base as already mentioned, passing on rising costs to the customer may not be practical in the present economic environment. Competiveness reducing energy costs will help the business remain on a reasonably level playing field, especially with its competitors located in markets with lower energy costs such as the USA. Security of supply the UK s spare electricity generating capacity could fall from 1% to only % in the next three years, creating a higher risk of power shortages and blackouts. Security of electricity supply is of critical importance, so the business needs to look at ways to address this through onsite generation and Demand Management services. Carbon reduction and tax liabilities Carbon reduction commitments imply carbon taxation. The business will need to calculate a base of 16 per tonne of carbon emissions from this year, rising to 30 per tonne by the end of the decade and 70 per tonne by 2030. Return on capital - British businesses are reportedly sitting on 750 billion of cash reserves. Bank deposits will offer only modest interest for the foreseeable future, so will an investment in energy savings offer a more attractive yield and make this capital work harder for the business? The tipping point in the argument will be the ability to show how the business can realistically expect to achieve a return on its investment in a reasonably short timeframe. A model needs to be presented to the board along the lines illustrated below. This is a much simplified version a working business evaluation model Power Efficiency uses with its clients who are seeking advice on how to plan and finance an energy-savings programme. For this white paper, we have taken an imaginary FTSE-listed company with a turnover of 800 million with an annual energy spend in 2012 of 10 million. The model helps the business look at two options. The first involves the business financing the programme from its own cash reserves at its own risk with a 10 million investment. The second option looks at a risk transferred solution provided by an Energy Performance Contract and financed through an ESCO. Based on these assumptions, we predict that the business from its 10 million investment, financed by the business itself, could potentially: Realise an IRR before tax of 13% and an NPV of 7.6 million Realise a ROI within four years of implementing the energy-saving programme Make average annual cost savings on energy of over 3 million over a seven year period Realise savings of over 21.3 million cumulated over seven years Cut its carbon emissions by 11,226 tonnes per annum reducing its Energy Tariff Exposure. Find that energy indexation is likely to be higher than the cost of borrowing for the foreseeable future. 5
25,000,000 20,000,000 The business case for investing in energy-saving programmes 15,000,000 10,000,000 ROI 5,000,000 2013 201 2015 2016 2017 2018 2019 2020 2021 2022 Projected energy spend without savings Projected energy spend with 20% savings Cumulative energy savings Energy Solution Investment Projected energy spend without savings 2013 10,000,000 201 11,90,000 2015 12,00,000 2016 12,850,000 2017 13,33,000 2018 1,520,000 2019 1,810,000 2020 15,780,000 2021 17,200,000 2022 18,100,000 Projected energy spend with 20% savings 10,000,000 11,90,000 12,00,000 10,280,000 10,67,00 11,616,000 11,88,000 12,62,000 13,760,000 1,80,000 Annual energy savings 2,570,000 2,668,600 2,90,000 2,962,000 3,156,000 3,0,000 3,620,000 Cumulative energy savings 2,570,000 5,238,600 8,12,600 11,10,600 1,260,600 17,700,600 21,320,600 Energy Solution Investment 5,000,000 5,85,550 Ammortised loan repayment (ESCo) If carried out through an ESCO, access to finance to make an investment in an energy-saving drive might be simpler to obtain and could realise: The avoidance of risk, saving the 10 million investment and associated financing costs Guaranteed energy savings with the benefits to be shared by the company and the ESCO on a pre-agreed basis A cut in carbon emissions and carbon tax liability identified above. We have assumed annual energy demand for the business remains constant between 2013 and 2022, but that it achieves very realistic and achievable energy reductions of 20% in electricity and gas consumption. We have based energy price inflation for this period on the forecast made in our own white paper, The Energy Price Challenge, which is that energy costs for electricity and gas will be 81% higher in 2021 than they were in 2011. The model can obviously be adapted to include variations in energy inflation forecasts, GDP growth, borrowing costs, energy consumption patterns, tax regimes, carbon emission taxation and different levels of energy savings achieved. What the model provides is the clarity and the financial motives the board will need to make a decision to invest and commit to an energy-saving programme, not based on the loose and unspecified needs for good corporate social responsibility, but on the hard facts of cash, kilowatts and carbon. Developing the business case should be the remit of the energy director, who can be tasked with a number of roles identified opposite. 6
The role of an energy director Providing the big picture on energy: An energy director can be tasked with: setting the energy management strategy for the business; mitigating energy costs during a period of rising energy inflation; putting in place the appropriate monitoring and measurement systems to give the business a fully informed reporting system of its energy consumption in a way senior management will understand; providing the creative vision; and looking to secure security of supply through its own power generation through renewables, CHP and biomass. Reviewing the ESCO option: An energy director with board-level status will have direct access to the MD and FD and can make clear to them the pros and cons of outsourcing and risk transferring the energy problem through ESCOs and Energy Performance Contracts. Procurement: An energy director can make informed judgements about how the company s energy is procured, whether on a fixed price or flexible basis. If the latter, they can set the parameters for the risk management strategy. Managing compliance: A key task will be to ensure the business is fully compliant, mitigate any environment tax liabilities, and turn tick box environmentalism into real commercial and competitive advantage for the business. Setting investment levels and commissioning the company s energy assets: An energy director can recommend investment levels for the company s energy efficiency projects, which can generate significant gains that include lower carbon emissions and taxes alongside lower energy costs. Achieving energy efficiency delivers a competitive edge to any business. But building this principle into any operation means the company needs expert management of its energy consumption, ensuring that assets like heating, air conditioning and ventilation (HVAC) plant all fulfil best potential to deliver maximum control and value for the business. Good project implementation in energy management is based on three key principles: monitor everything; manage your assets carefully; and understand that when you use your electricity is as important as how you use your electricity. Running Operations and Maintenance (O&M): This is a key role and understanding the pros and cons of the various O&M programmes available to a business is critical to success. For example, reactive maintenance can be expensive, typically requiring approximately 10% of the asset replacement cost each year to maintain performance and availability. The fixed schedules for Planned Preventative Maintenance (PPM) might not be cost-effective either as they can treat all plant maintained under the plan the same, with no allowance for the environment in which the plant operates, the length of time it operates per day or the criticality of the equipment under consideration. A more flexible approach provided by a Conditioned Based Maintenance (CBM) programme or our tailored Intelligent Asset Management (i-am) programme might be better suited for the business. This will ensure that all statutory maintenance obligations are met and that business-critical assets are maintained to a higher standard ensuring business continuity. There are pros and cons to each approach. Selecting the optimum O&M model for the business builds in profitability going forward. Managing external relationships: An energy director should be responsible for managing the relationship with suppliers and any external energy procurement and carbon compliance consultancies the business may be using. 7
Why and how does a business finance an energy efficiency project? Energy efficiency projects can offer very attractive pay-offs, with the average internal rate of return (IRR) of 8% and a payback within three years. (Carbon Connect Report) It is estimated that British businesses are collectively sitting on cash reserves of 750 billion, so for many companies funding an energy project should not be a problem, it is just a question of making the business case for it to happen. If just 10% of these reserves were committed to energy efficiency, not only would this represent an enormous stimulus to the economy, it would also be a relatively safe bet with the energy inflation forecasts outlined earlier in this document. After all, through the carbon price floor, British business will now be paying 16 per tone of carbon emissions rising to 30 by the end of the decade. As a result, a business is faced with this choice today: Accept the carbon price floor and live with this cost going forward forever or avoid the carbon price floor by investing in energy saving solutions now by, say, 300 per tonne. The latter choice will impact on our P&L reporting, so we will need a business case to justify the investment made now by the savings achieved in coming years. But how long will it take to say we have achieved a return on this investment and will the board and shareholders buy into this? Finally, we could choose to offset our carbon liability; this is cheaper than any energy solutions, say 100 per tonne, so we will save money, but our shareholders and other stakeholders may not find this acceptable because of the risk of negative PR linked with offsetting. Like the carbon price floor, we will also have to live with the cost going forward forever. To help decide which option to select, they may create a very crude calculation table that looks like this, excluding indexing but based on a nominal figure of 30 per tonne for the next ten years: Option Cost per tonne Cost per year 5 Cost per year 10 Cost per year 20 Carbon floor 30 150 300 600 Offsetting 100 500 1000 2000 Energy solutions 300 300 300 300 Obviously, investment in energy solutions delivers as a long-term investment in respect of any ROI. But, in today s economic environment, we recognise this will still be difficult to push through, especially for businesses with little or no cash reserve and for public sector bodies facing spending cut backs. Organisations like these should look at energy solutions like Energy Performance Contracts (EPCs) provided through an ESCO which can help with funding now and take on the future energy risk for the client. 8 An energy service company (acronym: ESCO or ESCo) is a commercial business providing a broad range of comprehensive energy solutions including designs and implementation of energy savings projects, energy conservation, energy infrastructure outsourcing, power generation and energy supply, and risk management. A newer breed of ESCO evolving in the UK now focuses more on innovative financing methods. Wikipedia
We define an ESCO as a new integrated energy service which provides a guarantee on the energy savings which can be achieved for corporate and public sector clients. After an initial review and preliminary audit of a client s energy consumption and profile, the ESCO supplier will offer to provide a fully outsourced and risk-transferred integrated energy solution to its client. This can include a full and comprehensive range of energy management services such as energy procurement, carbon reduction, energy solution development, project implementation, operations & maintenance (O&M) and measurement and verification (M&V), freeing up the client s own management time by transferring responsibility for detailed and complex energy management issues to the ESCO. The ESCO supplier will then develop a tailored energy management strategy and plan specific to the client s needs and which will work towards achieving set targets in energy savings and carbon reduction over an agreed timeframe. It will make its return by using its experience and knowledge to develop the best integrated energy solution, investing in new and upgraded technologies and by sharing further financial benefits accruing from savings achieved with the client. The guarantee is based upon achieving a minimum pre-agreed percentage reduction in energy costs, but typically ESCOs will be looking to exceed energy-saving targets of more than 20 per cent. 9
Power Efficiency White Papers Energy eating into EBIT is the second in a series of White Papers Power Efficiency is publishing aimed at helping key decision makers understand the need for developing an energy management strategy. The papers look at: THE PROBLEM - Why do we need an energy management strategy? It is clear that rising energy prices will rapidly move the issue of energy management from the plant room to the boardroom as businesses try to protect profitability and public sector bodies seek to defend budgets through a period of rising energy inflation. THE SOLUTION - What is an energy management strategy? Addressed in this paper, how does a business go about finding the solution to the problem? This paper sets out to explain how a business or a public sector body should develop an energy management strategy and will look at the issues they will need to address in order for it to be successful. THE DELIVERY - How do I implement an energy management strategy? Our third paper will look at how an energy strategy can be implemented. It will provide an insight into the practical steps any organisation can take to mitigate energy price rises through a four-tier action plan which includes avoidance, reduction, substitution and compensation. In practical terms, this will involve businesses radically changing the way they use energy. Other actions Power Efficiency suggests businesses should take will involve monitoring and targeting energy use, undertaking regular energy reviews, initiating creative and imaginative energy reduction projects, looking at carbon offsetting, developing an energy efficiency policy and looking at corporate governance. If you would like to receive any of these White Papers, email info@powerefficiency.co.uk About the author Julius Brinkworth has 20 years experience of UK energy management. Previously, the Head of Energy & Environment at Sainsbury's, Julius designed and implemented over 100M of energy improvement projects, ensuring savings were sustained to maximize returns. He is a buildings services engineer with an extensive knowledge of mechanical, electrical and building controls equipment. He is responsible for energy and carbon strategies, legislation and local planning support and energy reduction projects. 10
ABOUT POWER EFFICIENCY Power Efficiency, a Balfour Beatty company, is an integrated energy solutions company and an energyfocused management consultancy which advises many leading corporate and public sector clients on how to reduce their energy costs and comply with regulations. Part of multinational infrastructure group, Balfour Beatty, both companies have considerable collective experience in this field, delivering unique insights and bespoke, end-to-end solutions to corporate clients, SMEs, government agencies and the voluntary sector. Using a suite of integrated services spanning procurement, compliance, strategy, implementation, operations and maintenance, the firm s mission is to deliver added value to its clients by helping them use energy more effectively, sustainably and profitably. THE NEXT STEP For a boardroom presentation on how to develop an effective energy management strategy for your business, contact our team of experts at Power Efficiency by emailing info@powerefficiency.co.uk or telephone 020 8269 6100 The content of this White Paper is based on information available from a range of sources at the time of publication. The interpretation of it is not, however, an exact science and the factors which impact on the wholesale price of oil, natural gas and electricity change in relative importance at short notice. The content should, therefore, be regarded as informed opinion, provided for general purposes and not as professional advice. Readers should be wary of using it for commercial decision making or other purposes. Copyright Power Efficiency June 2013. 11
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