Two sides to every equation
July 04th 2007

In 2005 and 2006, soaring energy and carbon prices saw the return of a phenomenon not seen by large consumers since the 1990s; the rebirth of significant capital investment projects to save energy. Those old CHP studies left to gather dust on the top shelf were replaced with creative reviews of the manufacturing process and scrutiny of numerous renewable energy opportunities

The catalyst for activity in 2005 / 2006 was record high energy commodity costs yet today we see a new catalyst arising, the need to control your ‘Carbon Footprint’. Moreover the need to not only control your footprint, but the need to show that you are an investor and solver of the problem and a good corporate citizen, rather than someone that just buys credits and throws the problem over the fence. Both of these catalysts for investment activity are positive motivators for economic activity, however less positive is the way companies actually take the decisions.

To invest or not to invest?

The projects that were sanctioned and developed in 2005 / 2006 and the new carbon stimulated products that are likely to happen in the next two years were the ones which happened to have their economic models run back in the days when prices were high. The ones that did not get sanctioned largely didn’t because when it came to the final day for Cap-ex approval and the numbers were re-run the market prices had fallen and the pay backs didn’t look quite so good.

It is to the casual bystander, perhaps bordering on the less than sane, that the corporate citizens of UK plc invest their money, or not, in a way which is largely driven by the coincidental market price at the time the investment decision is made. Even more concerning is that once the capex is approved,many large consumers do not routinely re-run the economics to see how the return on investment is changing over time.

However it does not need to be like this, the majority of the energy investment decisions taken in 2005 / 2006 were correct, many of the ones that were rejected, probably should have gone ahead, the problem is corporate energy consumers do not manage both sides of the investment equation.

What is the other side of the equation?

The secret to controlling your return on investment in commodity markets where the price varies between 20% and 50% year on year is to place the same level of control and effort into controlling the economics of the investment as your company does to planning the delivery of the project itself.

The one truism of capital investment is that the prices in the economics that justified the capex are likely not to be the reality of the prices over the life of the project. Therefore as the market price changes, the return on investment of your project changes. Many corporate leaders accept this as a ‘you win some, you lose some’ issue.However it does not need to be this way.The other side of the energy investment equation is price and it can be managed and it can be controlled to protect your return on investment and ensure that your project at least delivers your worst case scenario.

How do I manage the other side of the equation?

At the time you do the project economics, that look great because gas and carbon prices are at record highs, the first thing you need to do is sell some energy or carbon to de-risk some of the cash-flow. Of course this is not done for the whole cost line of the equation, it is done for the amount of energy or carbon that locks in your minimum return on investment required for the project, maybe that’s just the projects break even point but at least it means the investment will not lose money! If you do this in small steps with proper measurement and control then the process is simple, not heavily labour intensive and suddenly the economics of your project are controlled. More importantly your project now has a guaranteed minimum return on investment and a series of embedded options that give you upside opportunity.

Risk management of your energy / carbon efficiency project is easy to implement and removes the element of luck from the capital appraisal process. Despite being straight forward very few large consumers actually manage capital risk in energy projects. If they did more projects would be approved and UK plc would become cleaner and more efficient and more importantly it would make some more money as well!