Life Cycle Costing - Energy Exchange

Rhode Island Convention Center • Providence, Rhode Island

Life Cycle Costing

Session: Life Cycle Costing

T. Kenneth Spain, PE, CEM, CLEP The University of Alabama in Huntsville

August 10, 2016

Energy Exchange: Federal Sustainability for the Next Decade

• Increase understanding of the principles of Life Cycle Costing of energy-using systems

• Be conversant on key terminology related to Life Cycle Costing

• Recognize resources available to support Federal Life Cycle Cost Analysis

• Know where to find additional training support to help apply these principles

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Objectives


• Why do Life Cycle Costing?

• Understanding time value of money

• Life Cycle Costing terminology

• Interest tables

• Cash flow diagram

• Discounting future values to present values

• Calculating economic decision statistics

• Tax-related issues and investment credits

• For additional study…..

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Agenda


What is the meaning of Life Cycle Cycle Costing?

• For thousands of years, philosophers have pondered the meaning of life

• For the next 80 minutes, we will ponder the meaning of Life Cycle Costing

– Why is that important?

• Legal reasons (for Federal agencies)

• Practical reasons (for everyone)

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• Legal reasons

– Energy Policy and Conservation Act 1975

– National Energy Conservation Policy Act 1978

– Energy Policy Act 1992

– Energy Policy Act 2005

– 10 CFR 436 Subpart A “Methodology and Procedures for Life Cycle Cost Analyses in Federal Buildings”

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Why do Life Cycle Costing?


• Practical reasons

– Engineering economic analysis and Life Cycle Cost Analysis (LCCA) provide a systematic, structured process to make good decisions about economic options

– Types of decisions:

• Accept/reject

• Mutually exclusive choices, optimization

• Funding prioritization

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Why do Life Cycle Costing?


• The sum of time-equivalent costs of acquiring, owning, operating and maintaining a system over a designated study period

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Life Cycle Cost (LCC)

Energy Exchange: Federal Sustainability for the Next Decade 8

Life Cycle Cost Analysis (LCCA)

• A method of economic analysis that sums all relevant project costs over a given study period in present value terms.

• Most relevant when selecting among mutually exclusive project alternatives that provide the same functional performance, but have different initial costs, OM&R costs, and/or expected lives.


• For capital investments that reduce future operating costs….

• ….savings must exceed costs (in Present Value terms)

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Basic Economic Criterion


Resources to support LCCA

• NIST Handbook 135

• Annual Supplement

• BLCC


Resources to support LCCA


• Primary considerations affecting time value of money

– Inflation

– Risk

– Cost of money

• “Opportunity cost”

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Time Value of Money


• How much is $100 today worth:

– in one year? • At 10% interest, $100 x 1.1 = $110

– in five years? • At 10%, $100 x 1.15 = $100 x 1.61 = $161

• What is the value today of $1000 which is not to be received until:

– one year from today? • At 10% discount rate, $1000 x 1/1.1 = $1000 x 0.909 = $909

– ten years from today? • At 10%, $1000 x 1/1.110 = $1000 x 0.386 = $386

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Time Value of Money


• What is the Federal discount rate for energy (and water) projects?

– 10 CFR 436 Subpart A

“Subject to a ceiling of 10 percent and a floor of three percent the real discount rate shall be a 12 month average of the composite yields of all outstanding U.S. Treasury bonds neither due nor callable in less than ten years….”

– Annual Supplement to Handbook 135

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Time Value of Money


• “Real” vs “nominal” discount rates

• “Constant dollar” vs “current dollar” cash flows

• Since, done properly, the LCC calculated with either approach will be identical, we typically express cash flows in terms of constant dollars based on current costs, and use real discount rates, simply because it is easier.

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LCC Terminology


• Describing cash flows – Investment costs

– Recurring costs

– Non-recurring costs

– Salvage value

– Study period • Base date

• Planning and construction period

• Service date

• System lifetime

– What about “sunk costs”?

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LCC Terminology


The Study Period


Adjusting for Different System Lives


• PV = “present” value, $

• F = “future” value, $

• A = “annually” recurring amount, $

• i = “interest” (or d = “discount”) rate, %

• n = term, “number” of years (or t = “time”)

• SPV = “Single Present Value” discount factor

• UPV = “Uniform Present Value” discount factor

• UPV* = “Modified” UPV discount factor

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LCC Terminology


LCC = total Present Value of all costs over a study period


Choose alternative with lowest total LCC

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Life Cycle Costs of two alternatives

$ $

— Operating

Costs

— Investment

Costs

Alternative

A

Alternative

B


Economic optimum of many alternatives

Total Life-Cycle Cost is Minimized

0

2

4

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Energy Efficiency

Do

lla

rs

Q*


Summary of Present Value Factors

PV

PV

PV

Ft

Ao Ao Ao

A1 A2

A3

SPV

UPV

UPV*

Single future amount (year t) PV = Ft x SPV (t,d)

Recurring annual amount (over n years) PV = Ao x UPV(n,d)

Changing annual amount (over n years) PV = Ao x UPV*(n,d,e)


Single Present Value (SPV) discount factor

SPV = 1 / (1 + i)n


Uniform Present Value (UPV) discount factor

UPV = ((1 + i)n – 1) / i (1 + i)n


SPV and UPV from Annual Supplement


Modified Uniform Present Value (UPV*) discount factor

UPV* = [(1 + e) / (i – e)] * [(1 + e) / (1 + i)]n

Escalation (e) = 5%


UPV* from Annual Supplement for non-fuel costs


UPV* from Annual Supplement for fuel costs


• Cash Flow Diagrams are useful to help identify all costs over the study period and to assist in identifying amounts subject to different discount factors

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Cash Flow Diagrams


Cash Flow Diagram Example


• Basic decisions to be made:

1. Do I accept or reject this project?

2. Which of these proposed projects do I select?

a. Mutually exclusive choices – optimal

efficiency level, system choice,

or combination of interdependent systems

b. Independent projects – prioritize for funding

What decision statistics should be used?

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Life Cycle Cost Analysis (LCCA)


• Life Cycle Cost (LCC)

• Supplementary Measures

– Simple Payback Period (SPB)

– Discounted Payback Period (DPB)

– Net Savings (NS) • Most Engineering Economy texts refer to this as the “Net Present

Value (NPV)” or “Net Present Worth (NPW)”

– Savings-to-Investment Ratio (SIR)

– Adjusted Internal Rate-of-Return (AIRR) • Internal Rate-of-Return (IRR) is more common, yet cannot be

solved directly (solved by iterative means), and assumes that savings are re-invested at the same rate

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LCCA Decision Statistics


• Considers all costs over the project “life cycle” with appropriate adjustments for “time value of money”

• Most fundamental statistic for making choices among “mutually exclusive” alternatives – for example:

– Which of three alternative lighting designs is the most economic choice?

– Which of five proposed alternative building designs, each of which meets or exceeds the ASHRAE/IES 90.1 Standard, is the most economic choice?

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Life Cycle Cost (LCC)


• Length of time required to recover investment from savings

SPB = Investment Cost

Annual Savings

What is the SPB for a lighting project that costs $100,000 and saves $20,000 per year?

• What are two fundamental weaknesses of SPB?

• What is the appropriate use of SPB for decision-making?

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Simple Payback Period (SPB)


• Length of time required to recover investment from savings, given consideration of discount rate

– Compute cumulative present value of savings year by year to determine point in time at which cumulative present value of savings equals the investment cost

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Discounted Payback Period (DPB)


• Difference between the LCC of the “Base Case” (the existing situation or the status quo in a retrofit, the lowest first cost alternative in a design scenario) and the “Proposed Alternative”

• Also can be computed by calculating the difference between the present value of the savings over the study period and the present value of the investment-related costs

• Referred to as the Net Present Value (NPV) in many Engineering Economy textbooks

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Net Savings (NS)


• While lowest total LCC alternative is most intuitive and useful for making choices among “mutually exclusive” alternatives (for example, “Which of several design alternatives is best?”), ranking by highest NPV of proposed alternatives relative to the base case alternative will always give the same ranking

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Life Cycle Cost (LCC) vs Net Savings (NS)


SIR = Ratio of PV of operational savings to PV of additional investment costs

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Savings-to-Investment Ratio (SIR)


AIRR = Measure of performance of investment as a percentage yield, assuming reinvestment of cash flows at a given rate (r)

AIRR = (1+r)SIR1/N-1

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Adjusted Internal Rate of Return (AIRR)


• AIRR and SIR are most intuitive and useful for making choices among “independent” project alternatives – for example, which of a group of good projects, all of which cannot be funded (limited funding is available), should be funded first?

– Rank from higher to lower AIRR

– Ranking by higher to lower Savings-to-Investment Ratio (SIR) gives the same result

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Ranking Independent Projects for funding


• IRR is the interest rate (discount rate) that makes the present value of the savings over the life cycle exactly equal to the present value of the investment-related costs

• IRR cannot be solved directly, only by iterative (“trial and error”) solution

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Internal Rate of Return (IRR)


For long equipment lifetimes (n ≥ 20), the IRR will be very close to the savings divided by the cost (the reciprocal of the simple payback) expressed in percent.

IRR(upper limit) = A/P Note that this is the upper limit of the actual IRR and for shorter project lifetimes, the IRR will be lower. This simple statistic may be referred to by some authors as the “return on investment (ROI)”, the “investor’s rate of return” or simply “rate of return”, but it is subject to the same weaknesses as the SPB since it gives the same result for any given discount rate or lifetime.

For example, assume we have a project that saves $20,000 and costs $100,000 and is expected to last 25 years.

IRR(upper limit) = $20,000/$100,000 = 20% which is very close to the actual IRR due to the long lifetime.

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Estimating the IRR in select situations


• Although taxes are generally not pertinent to government LCCA, in special cases, tax incentives available to third-party contractors may improve economics of projects done for government clients

• It is helpful for Federal energy managers to have a general awareness and understanding of tax-related issues

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Tax-Related Issues


• A “Tax Deduction” is an amount that is subtracted from income before total tax liability is computed

• A “Tax Credit” is an amount that is subtracted directly from the total tax liability – a credit can be 3 or more times more

advantageous to the taxpayer than a deduction, depending upon tax bracket

– For example, a tax credit of $1,000 for someone in the 28% tax bracket is equivalent to a tax deduction of $3,571 (i.e, $3,571 x 0.28 = $1,000)

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Tax Deduction vs Tax Credit


• Tax credits are currently available at 30% of the cost (through 12/31/2019), with no upper limit, for – Geothermal Heat Pumps – Solar Panels – Solar Water Heaters – Small Wind Energy Systems – Fuel Cells

• Credit is currently schedule to gradually reduce to – 26% beginning 1/1/2020 – 22% beginning 1/1/2021 – 10% beginning 1/1/2022 – Expiring 12/31/2022

• See energy.gov/savings for current tax credits and rebates

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Investment Tax Credits


Building Life Cycle Cost (BLCC) Software


For additional study – NIST Handbook 135


For additional study – FEMP On Demand Training


• DD Form 1391 for ECIP Projects

• Dealing with Risk and Uncertainty

• Calculating savings under complex utility rate schedule

• Evaluating Energy Saving Performance Contracts (ESPC)

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Discussion Topics

Rhode Island Convention Center • Providence, Rhode Island

Life Cycle Costing

Session: Life Cycle Costing

T. Kenneth Spain, PE, CEM, CLEP The University of Alabama in Huntsville

[email protected], 256.337.8572 August 10, 2016

Life Cycle Costing - Energy Exchange

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