Energy Projects Are Different
A typical energy productivity initiative will ask plant leaders to develop a portfolio of recommended energy efficiency investments. All too often, the request is greeted with skepticism due to past refusals of this kind of investment. Based on experience, the plant teams have given up even asking.
I call this the “We have more important places to invest” syndrome, and it becomes self-fulfilling. During the recent rollout of a new corporate energy productivity strategy at a plant in Europe, the local team explained to me that the major barrier to improvement was headquarters’ refusal to approve efficiency investments. In probing further, the plant team admitted that no such requests had been made for a long, long time. The assumption of refusal was so strong that they felt there was no point in even asking.
Breaking this capital impasse is one prerequisite for a successful energy productivity strategy, since typically at least half of the overall productivity gains come from well-managed capital projects.
Most companies have a corporate hurdle rate, or minimum investment return, that capital projects must achieve to gain approval, typically in the 15% to 25% range. Energy efficiency projects must compete with other investment requests to expand capacity, make acquisitions, develop new products and open up new markets. All too often, these competing projects have estimated returns that far exceed the hurdle rate and by their nature attract more management interest and excitement.
But the risks of investing in growth and new products are often underestimated. Typically only one in five to 10 R&D investments result in a successful commercial product, two out of three acquisitions fail to deliver their full promise, capacity expansions often run into unexpected cost or market changes that diminish the return, and new market expansion always meets unforeseen surprises.
In contrast, well-designed and implemented energy efficiency investments have returns that can be predicted to a high degree of certainty, assuming only that the plant remains in operation. Thus, on a risk-adjusted basis, an energy efficiency investment with an estimated return of 20% to 25% would be equivalent to an acquisition portfolio made up of projects with individual returns of 50% to 75%. So the first requirement for a successful energy efficiency capital program is to ensure decisions are made with relative risk in mind.
A second barrier to capital approval is the wisdom of the past. At historic U.S. energy prices, typical capital investments in efficiency would have payback periods of five to 10 years, and would fail to make it over the corporate hurdle rate. This perception still lingers despite the fact that an efficiency investment with a 10-year payback at 2000 energy prices could well have a three-year payback at today’s prices. Thus, the second requirement is to readjust mental benchmarks to today’s energy cost reality.
A third barrier is scale. A successful plant energy efficiency investment program will consist of a relatively large number of small, interlocking projects, some with very short payback time, some with longer paybacks, but with a portfolio average well above the corporate hurdle rate on a risk-adjusted basis. These smaller projects are frequently subjected to the same capital approval process as multimillion-dollar strategic investments in growth or new products. Another point to bear in mind is that energy efficiency projects deliver predictable cash flows the day they are commissioned, so delays are inherently counterproductive. Thus, a third requirement is to create a capital approval process appropriate to the scale and immediacy of the investments. At a total company level, the scale barrier can be reduced by proliferating similar projects at many sites.
The fourth barrier is the sense that these kinds of investments fail to deliver the estimated efficiency gains. This comes from failure to put into place suitable measurement procedures, so the achieved efficiency or lack of it becomes little more than a personal opinion. Investing in energy-efficient equipment without commensurate changes in local management energy awareness and training usually fails to deliver or maintain the expected efficiencies. Like safety, energy productivity has much to do with consistent management habits. This barrier is overcome by effective energy performance measurement and ongoing management approaches.
In summary, a breakthrough energy productivity strategy must be supported by a capital approval process that recognizes the inherent low risk of energy efficiency investments; can make multiple, speedy investments and proliferate them rapidly across the company; and that requires rigorous long-term follow up on delivered performance. If we believe, as I do, that energy prices can only rise in the coming years, the relative value of efficiency will increase proportionally.
Last but not least, the investments will only deliver their full potential when energy productivity is incorporated into the day-to-day process leadership. Next month I’ll explore the management barriers and challenges of creating a leadership culture of continuous improvement around energy productivity.