First, I wondered why, on a facility that was projected to cost $2.5 million dollars a year for utilities, the savings from a high-performance envelope would only result in savings of 2% of the expected utility cost. More importantly, however, I wondered why an owner that would perform a fifty-year financial analysis (as the speaker stated the university had), would have a negative present value for this analysis.
Turns out it has to do with rates.
The university uses a discount rate of 4.5% when performing financial analysis. This generally reflects that a dollar spent today is worth more than a dollar spent at some time in the future, and can provide some measure of how much value the capital spent by the university today means for the future growth of the institution. However, since our economy uses currency as a measure of many different aspects of civilization, it could also suggest that a service today is worth more than a service in the future, that a comfort today is of greater value than a comfort in the future, or that a life today is worth more than a life in the future. A 4.5% discount rate suggest that the present has ten times as much value as the future (for a handy chart, see page 8 of Caring about the Distant Future in the University of Chicago Law Review). On the surface, it means that savings of a one dollar in the future has equal value to saving a dime today, so expenses with significant future value will have to have benefits that far exceed the current established market cost. Looking deeper though, and realizing that the issue really under scrutiny deals with the quality of human life through the impact of environmental degradation due to energy use, through a discount rate of 4.5% we are saying that improving the quality of life of one person today counteracts the negative value of decreasing the quality of life of ten people fifty years into the future. The moral underpinning of the superficial financial analysis can create a challenge for those justifying positive discount rates on the grounds of economic growth, especially when life-damaging consequences and not just economic consequences await the future.
The discount rate has a significant impact on the understanding of whether or not improving the envelope adds value. Decreasing the rate to 3% from 4.5% suggests that only five lives in the future equal one life in the present (as opposed to ten), and in that circumstance, the result shifts from (232,000) to positive 75,000. If we were to assume that a life in the future has equal value to a life in the present, or a discount rate of 0%, then the net present value of the high-performance envelope would carry a positive NPV of over $1.3 million...almost a no-brainer investment.
Even allowing that any institution has the right to set its own discount rate based upon the values of the school (e.g. that the work done with the investment will improve the lives of ten times as many people in the future than are harmed), the other curious rate-setting choice relates to the value of the savings. The analysis assumes that the cost of energy - the basis for the value of the savings - remains constant over a fifty year horizon. That same assumption in 1960 would have been off by a factor of 5 for electricity and a factor of 10 for natural gas (the primary energy sources for buildings in our area). Using the standard balance of natural gas and electricity in buildings in this climate zone, the actual value of the savings in the fiftieth year would be over $363,000. Based on current trends in usage, and current depletion patterns of assumed and known reserves, the assumption that scarcity over the next fifty years will remain the same over the next fifty represents, at best, a conservative estimate. Instead of assuming no escalation in energy costs as the original assessment did, if we conservatively assume escalation at the same rate as the past fifty years, the NPV of pursuing a high-performance envelope changes from (232,000) to positive 980,000. Accounting for escalation and lowering the discount rate to 3% would result in an NPV of just over 2,000,000. Either of these should justify the investment.
The process of assessing future risk based upon present action inherently carries uncertainty. We deal with this uncertainty by making as accurate assumptions as possible, and by building a model that minimizes uncertainty with accepted science. I have ignored the fact that the energy model suggesting that a high-performance envelope upgrade would result in only 2% energy savings underestimates the value of such work. (Energy models, much like financial models, depend on the assumptions and inputs into the model...an inexact science influenced heavily by the desired output of the modeler.) Even without this improvement*, the selection of discount rate and decision to ignore escalation in costs prove to be flawed choices that reinforce the owner's desire to ignore energy efficiency in the name of economic practicality. The discount rate because the environmental impact of the decision means that human life and not human wealth ultimately hangs in the balance, and the escalation rate because nothing about energy scarcity suggests that fossil fuels will become more ubiquitous. If even reasonable assumptions on discount and escalation rates were made, the decision to include a high-performance envelope would have moved forward.
Unfortunately for us, the continued reliance on a man-made system, rife with imperfections, as opposed to the natural and moral systems associated with our existence, which exist regardless of our desire for them not to, places us in peril. We can change our economy to suit our needs and desires; we cannot change the laws of nature to accomplish the same.
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