Using The Right Numbers To Estimate Renewable System Payback
October 8, 2008
By Charles Cresson Wood and Bruce Erickson
When they receive a written proposal for a renewable energy system, many managers balk, saying it’s too expensive. This article explores why many of these managers may be using outdated and irrelevant numbers to come to such a conclusion. The article proposes some alternative numbers that make the shift to renewable energy technologies look a whole lot more attractive.
Many people go about making a decision for or against an alternative energy system with a payback calculation. If a solar system, for example, reduces a monthly electric utility bill, then that reduced expense will be extrapolated over the useful life of the system, in order to come up with the number of years it takes before the system pays for itself.
For example, let’s assume the owner of small business based in California is now paying a flat commercial rate of $0.1147 per Kwh for electricity, and that the owner pays a total of approximately $450/month for electricity for his business’ headquarters building (consuming 3930 Kwh per month). Let’s also assume that this business owner is considering investing in a solar system that would cost $60,000 to install (after the Federal renewable energy tax credit and California renewable energy rebate). The annual operating expense for this solar system would be for distilled water only (for the batteries), and to simplify our calculations, we will say that the water is essentially free.
The building owner wants to use solar technology to reduce his usage of grid electricity by about 50%. In the event of a grid failure, the owner has determined that he could run the business with only the essential machines and office appliances, and this would work out to about half of the current monthly usage. Thus the hypothetical solar system could be a 16 Kw system, which could produce roughly 1920 Kwh of electricity per month on average over a yearly cycle. We also assume that the owner has already installed the most efficient lighting, and made other conservation related changes in the electrical system.
Assuming a flat rate schedule applicable to commercial customers, and assuming the cost of electricity remains the same over the years ahead, the solar system is estimated to pay for itself in approximately 23 years. If that’s as far as the analysis goes, the customer would probably not purchase the solar system. But when we go deeper with this analysis, the payback gets markedly better.
Note that if this were a residential customer, a tiered rate schedule would probably be employed, making the calculations more difficult, but also significantly improving the payback because the grid energy consumed would be purchased at a lower rate per Kwh. In a similar way, this example does not take into consideration the possibility of a time-of-day meter, which involves different buy/sell rates at which the solar system is buying/selling energy from a local utility’s grid. Depending on the usage patterns, time-of-day meters can make a solar system still more attractive from a payback perspective. This is because a solar system is generating during peak electricity usage hours, when electricity is most needed on the grid, when a local utility pays the best rates to electricity generators. Likewise, with a time-of-day meter, electricity can be bought by a small business customer at night, to charge up batteries, when rates are lower. In a similar way, for simplicity’s sake, this example does not incorporate the reduction of electricity demand rates that a commercial user pays. Demand rates are based on the maximum base load energy demand, and a solar system will bring that maximum demand down considerably, especially if a battery bank is a part of the system. Reduced demand rates would therefore markedly improve the proposed system’s payback.
The complicating factors in the prior paragraph aside, let’s consider some alternative numbers to get a better idea of the true economics of the proposed solar system. We will challenge a number of the assumptions contained in the analysis above. Let’s start with the most unrealistic of these, the assumption that the cost of electricity will continue to be $0.1147 per Kwh in California some 23 years in the future. Examining the statistics from the US Energy Information Administration, we see that the national average commercial cost of electric power has gone from $0.0764 per Kwh in 1996 to $0.0957 cents per Kwh in 2008, an increase of slightly more than 25% over the last 12 years.
If we were to assume that this same increase in the price of electricity (1.023% per year) were to be experienced again over the next 23 year period, the payback for the proposed solar system would be improved. This means that the expected annual foregone electricity payment some 23 years in the future would be $4,358, much better than the $2,643 ($450/month) mentioned above. For the sake of easy calculations, assuming a steady year over year increase compounding at 1.023% per year, the solar project would now have a payback of about 18 years.
But this assumption about the cost of electricity is probably still way too optimistic. In 2008, Pacific Gas & Electric, one of the larger local California utilities, asked the California Public Utilities Commission for a 4.5% rate increase. PG&E cited the increasing cost of natural gas, which is the primary source of energy used to generate electricity in California, as well as declining supplies of hydroelectric power provided by the states of Oregon and Washington. The utility pointed out that natural gas prices have increased 30% in 2008 alone, and that it must now pass some of those increased costs along to its customers.
So if a 4.5% annual compounded increase in the price of electricity were used in these solar system calculations, the payback period for this installation moves down to 16 years. Things get really interesting if the rate of increase in the price of electricity follows what has been happening to the price of natural gas. If a 30% annual increase in the price of electricity were used in these calculations, then the payback becomes about 8 years. This should not be surprising to those of us who remember that Pacific Gas & Electric rates went up 46% in 2001. Perhaps those of us with some gray hair remember that in 1974, right after the oil embargo, PG&E increased its rates almost monthly.
Note that this analysis does not explicitly incorporate the rate of inflation. Although the August 2008 numbers indicate that inflation has been around 5% per year, let’s use the average rate over the last 10 years, which has been more like 3% (using the Consumer Price Index, which notably does not incorporate the price of energy or food). Whatever numbers for inflation you use, when buying a renewable energy system, it’s like getting a fixed rate mortgage because you lock in your future costs. Adding a 3% inflation rate to the 30% annual increase in electric rates brings the payoff down to 7 years.
Perhaps still more realistic is the assumption that the cost of electricity will, in the near term, in rough terms follow the cost of petroleum, which is the most widely used fuel in the world, and which has recently been driving up the prices for all other fuels. According to statistics from The Wall Street Journal, as of May 2008, the cost of oil, on a per barrel basis, went up 95% over the prior year. With a 95% compounded increase in the cost of electricity, and a 3% compounded annual inflation rate, the solar project now has a payback of just under 5 years.
Even the 95% compounded annual increase in the cost of electricity may be conservative, if one believes that peak oil will have a serious and adverse impact on electricity rates. Evidence of the “peak oil theory” can now be found all around us, if we care to look at it. According to the US government’s Energy Information Administration, worldwide statistics for oil production show that total production has been effectively flat at about 74 million barrels per day since 2005. This is surprising given that world demand has, in the recent past, been increasing at about 2% per year. This is doubly surprising given OPEC’s stated objective is to keep oil prices relatively low in order to have production be profitable to its member states, but at the same time not put a damper on the economic growth of consuming states. Meanwhile, the Saudis have not been able to substantially increase their crude oil production, in spite of the fact that the world has been looking to them to ramp up production in order to keep the price of oil relatively low. For more on the inability of the Saudis to step in and provide much more oil, see the book entitled Twilight In The Desert by Matthew Simmons.
The continued disparity between supply and demand in the oil market may cause the price for oil to shoot up even more than 95% per year in the next few years. This is because the demand for oil is what the economists call inelastic (consumption doesn’t go down much when the price increases). Until the infrastructure changes associated with using other sources of energy can be completed, many users of petroleum will be forced to pay escalating prices. For example, changing the energy-generating infrastructure in a natural gas electricity generating plant is a giant job, certainly something that takes a considerable amount of time. Reflecting this, in some cases, utilities abandon or mothball uneconomical generating plants, and then build entirely new ones.
Wars over oil (such as the Iraqi war), political problems (such as the 1973 oil embargo), terrorist attacks (such as 9/11), disruptions in the very complex and long distribution chain for oil, and many other unstable risk factors mean that the demand for oil is going to be increasingly unreliable in the years ahead. Perhaps the unavailability of power is the greatest reason to move ahead with an on-site renewable energy proposal, such as the one mentioned above. This way of looking at the decision makes the renewable system look more like an insurance policy rather than a cost reduction proposal, although no doubt both benefits can be obtained. If one were to go out and buy insurance against electrical grid failures, if such a type of insurance were to be available, what would a small business owner pay? Probably a great deal of money, maybe $10,000/year. Maintaining the 95% annual increase in the cost of electricity, plus 3% annual inflation, and adding in the cost of this annual insurance premium forgone, the payback for the solar project mentioned above is now just over 3 years.
So the numbers reflecting the cost of energy that many people are using for their calculations are seriously out of date. Entirely different decisions can be reached if people instead use numbers reflecting the current costs of energy. This rudimentary example illustrated that point, but did not incorporate two additional factors that may be important. The first factor is accelerated depreciation that is often available on systems such as these, and that can markedly bring the purchaser’s taxes down. The second factor is the increasing price of commodities such as steel and lead, commodities that are used in the production of renewable energy systems. As energy costs go up, so too will the costs to mine, smelt, fabricate, and transport these commodities. This means that certain types of renewable energy systems, such as the solar system mentioned above, will be considerably more expensive to purchase in the future than they are today. The demand for renewable energy systems will probably also escalate in the years ahead, and this increased demand may additionally drive up solar system prices. All these factors underscore how it is wise to invest now in a renewable energy system, rather than wait to see what the future will bring.
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Charles Cresson Wood is an alternative energy consultant with Post-Petroleum Transportation, in Sausalito, California. His most recent book is Kicking The Gasoline & Petro-Diesel Habit: A Business Manager’s Blueprint For Action. Information about the book, information about his alternative fuel blog, and a way to contact him can be found at www.kickingthegasoline.com.
Bruce Erickson is the president of Mendocino Solar Service, a local provider of solar electricity and solar water pumping systems in northern California. He can be reached at 707-937-1701.
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