Energy Efficiency, Pollution Prevention, and the Bottom Line
For many years, efforts to promote energy efficiency and pollution prevention (P2) traveled on parallel paths. Most energy efficiency advocates considered only the energy savings aspects of their projects and most proponents of P2 did not include energy on their list of sources of pollution. More recently, the two groups promoting energy efficiency and P2 have begun to realize the synergies of working together. Energy efficiency projects often have non-energy P2 benefits and P2 projects often save energy. By joining forces, energy efficiency and P2 advocates can strengthen the case they present to industry because they have more potential cost savings to offer. By showing business management how they can minimize costs by using resources more efficiently, energy efficiency and P2 advocates can capture management's attention more readily since the primary responsibility of management is to maximize shareholder value. This paper discusses the role of energy efficiency in preventing pollution, energy savings potential, and bottom-line impacts and financial analysis of energy efficiency and pollution prevention.
Energy and Pollution
Energy-related carbon emissions in the U.S. rose for the fifth straight year in 1996 based on data from the U.S. Department of Energy (DOE). Emissions from the use of fossil fuels climbed to 1,454 million metric tons (MMT) of carbon equivalent in 1996, an increase of 3.3 percent relative to emissions in 1995, and 8.7 percent compared to 1990. Carbon emissions in the form of carbon dioxide are the main contributor to global warming. Limited improvement in energy efficiency (as compared to substantial efficiency improvements achieved in the late 1970s and early 1980s) was a key factor causing the growth in carbon emissions since 1990 (Geller and Thorne 1997).
Carbon emissions in 1996 were well above the level targeted in the Clinton Administration's Climate Change Action Plan. The U.S. is not on track for returning its greenhouse gas emissions to 1990 levels by 2000, which is a commitment made as part of the Framework Convention on Climate Change (Geller and Thorne 1997).
Energy Savings Potential
Recent estimates of the electricity conservation potential in the industrial sector range from 9–45 percent of total industrial electricity consumption (3-15 percent of total electricity consumption and 17-26 percent of total energy use). Well-designed, cost-effective, energy efficiency programs can play an important role in capturing some of the energy-savings potential in industries as well as branching out to encompass other, direct pollution prevention measures.
For most industries, however, energy expenditures are a very small part of their operating costs, averaging less than two percent of value of shipments for the manufacturing sector. Industries such as primary aluminum, hydraulic cement and industrial gases are notable exceptions, with energy accounting for more than 20 percent of value of shipments. However, for some of the fastest growing industries, such as electronics and computers, energy expenditures represent only 1.2 and 0.6 percent of shipments, respectively. In most industries, larger costs, such as labor and raw materials, receive attention before energy (Census 1992).
Energy is not perceived as a discrete issue by most industries, but as a component of other broad issues such as cost of manufacturing, environmental compliance, safety and productivity. A 1996 survey of 40 corporate energy managers from large companies indicated that only 12 percent of these managers focus solely on energy, with the majority also responsible for issues such as water, waste disposal, environmental compliance, facility design and management, fire and safety (Shepard 1996). Since most projects that yield energy efficiency improvements impact some of these other issues, the decision-making process will involve an evaluation of all these issues together (Elliott, Pye and Nadel 1996).
The Bottom Line
Energy efficiency must compete with other issues for finite resources within a company. While capital is the most often cited resource, staff time may be of equal or greater importance. With the restructuring of industrial companies, we have seen decreasing expenditures for issues that do not relate directly to the continued operation and near term profitability of the company. Downsizing of companies has resulted in less staff available to address all issues. When a choice must be made between addressing a potential emissions-compliance, production-reliability, or product-quality problem, and identifying and implementing energy efficiency projects, the former receives the attention since failure to do so may result in the plant being shut down. Presenting projects based on total benefits is more effective than presenting on energy benefits alone (Geller and Elliott 1994).
Since the 1970s, utility energy efficiency programs for the industrial sector have focused on energy-efficient equipment and elimination of wasted energy. Utilities have justified these projects based upon energy savings realized. Impressive savings have been achieved, and projections indicate that still more cost-effective savings exist. However, the behavior of industrial customers has appeared anomalous to utilities when they implement projects with long paybacks from energy savings, while failing to implement projects for which energy savings offer better paybacks. This occurs when programs provide other benefits to the customer (e.g., pollution prevention, cost reductions, and productivity enhancements) that the utility or government agency does not include in their economic analysis. Because these other benefits are quantified by the industrial customer, their value impacts a customer's investment decision on projects in which energy efficiency represents only part of the savings.
Programs to reduce industrial pollution have evolved from prescriptive, measure-based regulations that focus on the 'tail pipe,' to more flexible programs that focus on reducing pollution by minimizing waste and redesigning processes. The success and cost effectiveness of this approach have been proven. P2 programs have also been noted for reducing production cost and improving product quality. Beginning in the late 1980s, some in the industrial energy efficiency arena recognized that significant energy savings could be realized from P2 programs. Notable program examples are EPRI's Partnership for Industrial Competitiveness (EPIC) program, and DOE's Industrial Assessment Center (IAC) program.
EPRI's Partnership for Industrial Competitiveness (EPIC) program focuses on maximizing energy efficiency, pollution prevention and industrial competitiveness through integrated industrial process assessments, looking at the entire facility, rather than focusing on specific technology applications. The program reports that industries value safety first followed by environmental compliance and then productivity. EPRI sees EPIC as a path for moving utility programs from prescriptive, broad-based programs targeted at the entire industrial class, to targeted programs that develop and demonstrate technologies and techniques that enhance specific customer competitiveness. One program success is an audit performed for a blow-molded plastic products fabricator served by PECO Energy. The customer implemented three audit recommendations: quick die changes; extrusion barrel insulation; and infrared heating of preformed bottles prior to blow molding. The first resulted in a 20 to 30 percent decrease in required inventory, while the latter two resulted in 20 percent and 50 to 70 percent reductions in energy consumption for each process. Payback is on the order of three to six months (Smith 1995).
The IAC program conducts combined waste minimization and energy efficiency audits for small- to medium-sized industrial companies. It evolved from the Energy Analysis and Diagnostic Center program started by DOE in the 1970s by adding a waste minimization audit component to the energy audits. Recent analyses of the results from the integrated audits infer that more energy is being saved from the P2 measures than from the purely energy efficiency measures (Woodruff, et al., 1996).
Analysis of the IAC program, as well as ACEEE's own preliminary analysis, support this approach. Conventional measure-based, energy efficiency assessments focus on increasing the efficiency of existing processes, while P2 assessments focus on restructuring processes to eliminate waste and more efficiently use raw materials. In many cases, the portion of the product that is wasted has required significant energy to produce. This situation is particularly true if the waste occurs late in the production process. If this waste is reduced, the energy and other resources required to produce the product can be redirected to the production of salable product, and the energy and other costs associated with waste disposal can be avoided.
Understanding the Financial Analysis
The primary responsibility of business management is to increase shareholder value. In order for management to accomplish this goal, they must understand all of the costs and benefits associated with an investment in efficiency, and make decisions based on whether the company's total net benefits are greater than total net costs. We intentionally refer to an investment in efficiency, rather than specifically in energy efficiency, because often energy efficiency projects have non-energy benefits and efficiency projects that are not specifically targeting energy produce energy savings. It is critical that all the savings related to such projects—energy and non-energy—be included in the financial analysis so that management understands the complete financial ramifications of an efficiency project.
The financial analysis of an efficiency project is the basis for making the investment decision. The financial analysis may range in sophistication from a simple payback (investment/annual net savings) or rate of return (average annual net savings/total investment) to more accurate calculations, such as net present value (NPV) or internal rate of return (IRR), which take into account the time value of money. Regardless of which calculation is used, the most important part of a financial analysis is the estimation of project costs and benefits, as discussed below.
There are numerous phases (Elliott, Pye and Nadel 1996) in a project, each with several cost components:
technology identification and project design,
purchasing and procurement,
startup and training, and
If investment incentives are offered to the company (e.g., investment tax credits or utility or government incentives), they reduce the company's total cost and therefore should not be included in total costs to the company when performing a financial analysis.
When estimating project costs, only those costs that are incremental as a result of the project should be included when determining the financial ramifications of the investment on the company. In other words, count only those costs that arise as a result of the project and would not exist if the project were not pursued. These costs are, in general, dominated by direct costs such as:
installation contractor fees,
costs of off-site training for employees,
lost production resulting from disruption of production during project installation and figuring out how to make the system work, and
ongoing maintenance of new equipment.
Those costs that do not change as the result of an investment decision are irrelevant to the decision. For example, overhead costs that may be allocated to a project, but which would exist regardless of the project should not be included in a financial analysis because they are not incremental costs. Examples of these costs are internal staff time associated with:
identifying and evaluating the project and project design,
winning management approval for the project,
financing the project either internally or externally,
identifying, selecting, contracting, and coordinating with engineers and contractors, and
identifying sources for and procurement of project equipment and supplies.
The internal staff that performs these functions will exist whether or not the investment is made. Although these non-incremental overhead costs, often referred to as transaction costs, are not included in a financial analysis, they are still barriers to efficiency. To the extent that efficiency advocates can minimize these barriers by making efficiency easier to understand and implement, more efficiency will occur.
Another type of cost that should not be included in an investment decision is a 'sunk cost.' A sunk cost is one that has already been incurred and will not go away if the investment is not made. For example, if $10,000 is spent on a feasibility study that recommends an additional $50,000 investment in efficiency, the $10,000 sunk cost is not part of the costs that are included in a financial analysis that will determine the investment decision. Thus, the investment decision is based on costs going forward, not looking back.
As with project costs, project benefits should reflect any and all net benefits that are incremental to the project. Total project benefits often substantially exceed those accruing from energy savings alone. Historically, external parties (e.g., utilities and government agencies) have focused on energy savings because their goal was to save energy. For industry, however, benefits can come in several categories:
reduced costs of environmental compliance,
improved worker safety (resulting in reduced lost work and insurance costs),
reduced production costs (including labor, raw materials, and energy),
improved product quality (reducing scrap and rework costs and improving customer satisfaction)
improved capacity utilization, and
While energy is a component in these categories, other benefits can far exceed energy savings. Since each project is unique and uniquely interacts with other aspects of the manufacturing operation, it is difficult to accurately estimate average total benefits that result from energy efficiency projects.
As an example, in 1990 a North Carolina textile firm installed a radio frequency dryer to replace a gas dryer that was used to dry cashmere. The project reduced the energy required for drying by almost half, and reduced fiber loss from over drying by more than 5 percent. The energy savings was about $0.05 per pound of cashmere, while the savings in lost raw fiber, at $30 per pound, was more than $1.50 per pound (Cato, et al. 1991).
While the so-called 'cashmere effect' may seem to be an extreme example of larger productivity benefits, it is not a case in isolation. Indeed, many other examples can be cited. For instance, the average total annual savings from efficiency projects from 1982 to 1993 from the Louisiana Division of Dow Chemicals were 3.2 times the energy savings. In the later years for which data are available, the annual ratio of total savings to energy saving varied from four to more than 13 (Nelson 1993). A review of eight industrial projects, listed among the EPA/DOE Climate Wise participants, suggests that total savings are about three times energy savings while some 30 projects in DOE/EPA's NICE-cubed program suggest a ratio of 2.5 times the energy savings (Laitner, 1997).
Both costs and benefits need to reflect tax implications when making an investment decision. For example, if a project saves $4,000 a year in lower energy costs and $16,000 from improved operations and maintenance, a company's taxable income increases by $20,000. The result is that it pays more taxes. Taxes also affect costs by way of depreciation. Although depreciation is a noncash charge, it is treated as an expense that lowers taxable income. Thus, depreciation must be subtracted from incremental profits to arrive at the taxable income, and then be added back to profits, after tax, to reflect actual cash flow. The hypothetical example below shows how savings are affected by depreciation and taxes:
Energy Savings $ 4,000
Plus: Other Savings 16,000
Total Pre-tax savings 20,000
Less: Depreciation - 5,000
Profit before tax 15,000
Less: Tax at 50% - 7,500
Profits after tax 7,500
Plus: Depreciation + 5,000
After-tax Cash Flow $12,500
Thus, net benefits in this example are $12,500, and would yield a four-year payback on a $50,000 investment. This simplistic example is given to show the non-financially oriented reader that taxes are an important consideration when making an investment decision. Because each company's tax rate will differ and depreciation calculations can be complex, it is best to leave this portion of a financial analysis to a financial analyst. The most important inputs to a financial decision, however, are still the costs and benefits, which are best estimated by technical/engineering staff.
Since businesses make most decisions based on bottom-line impact, it makes sense to look at energy efficiency (E2) as a part of P2 in order to account for all the savings that a business will realize from E2/P2 projects. It is equally important to take into account any other savings (e.g., process efficiency, enhanced productivity) to be reaped by a business when evaluating the cost effectiveness of E2/P2 projects. ACEEE has found that the linkage between pollution prevention and industrial energy efficiency is not well understood by either community. ACEEE has established as a strategic goal the assessment of the energy savings potential of P2, and the building of bridges between the energy efficiency and P2 communities.
We need to do a better job thinking about the decision-making process of business management in order to make our case more attractive to those we're trying to entice. This means working hard at measuring costs and benefits so that we understand the financial ramifications of our proposals and can communicate to management in terms with which they can identify. Probably the most effective way to get management's attention is to not even mention energy efficiency or pollution prevention, but to just call it 'efficiency' since efficiency has always had a positive connotation in the business community. Combining energy efficiency and pollution prevention forces and viewing them simply as efficiency is an opportunity for alignment among stakeholders: business, environmental advocates, and regulators.
We wish to thank the Environmental Protection Agency Atmospheric Pollution Prevention Division for providing funding for this work.
Cato, Michael J., Kenneth K. Crabtree, Denise L. Flora, Perry L. Grady, George L. Hodge, and Gary N. Mock. 1991. Handbook of Radio Frequency Drying of Textiles. Raleigh, N.C.: NCSU College of Textiles.
Census, Bureau of. 1992. 1991 Annual Survey of Manufacturers: Statistics for Industrial Groups and Industries (M91AS-1). Washington, D.C.: Government Printing Office.
Elliott, R. Neal, Miriam Pye, and Steven Nadel. 1996. Partnerships: A Path for the Design of Utility/Industrial Energy Efficiency Programs. Washington, D.C.:American Council for an Energy-Efficient Economy.
Geller, Howard and R. Neal Elliott. 1994. Industrial Energy Efficiency: Trends, Savings Potential and Policy Options. Washington, D.C.: American Council for an Energy-Efficient Economy.
Geller, Howard and Jennifer Thorne. 1997. U.S. Carbon Emissions Climb 3.3% in 1995. Washington, D.C.: American Council for an Energy-Efficient Economy.
Laitner, Skip 1997. Working calculations made by the author using a series of project data from the Climate Wise Program and the National Industrial Competitiveness through Energy, Environment, and Economics. These programs are jointly sponsored by the U.S. Environmental Protection Agency and the U.S. Department of Energy.
Nelson, Kenneth E. 1993. 'Creating an Empowered Conservation Culture,' In Proceeding of the Workshop on Partnerships for Industrial Productivity through Energy Efficiency: 209-224, Washington, D.C.: American Council for an Energy-Efficient Economy.
Shepard, Michael. 1996. Corporate Energy Managers Express Their Views in E Source Survey. Boulder, Colo.: E Source, Inc.
Smith, William M. 1995. 'Industrial Competitiveness: Utility/Industry Partnership Successes.' In Proceedings of the ACEEE 1995 Summer Study on Energy Efficiency in Industry, 2:209. Washington, D.C.: American Council for an Energy-Efficient Economy.
Woodruff, M.G., J.M. Roop, H.E. Seely, M.R. Muller, T.W. Jones, and J. Dowd. 1996. Analysis of Energy-Efficiency Investment Decisions by Small and Medium-Sized Manufacturers. Richland, Wash.: Battelle Pacific Northwest Laboratory.