In the words of the inestimable Jim Anchower, it's been a while since I rapped at ya, #energytwitter. Today's thread: capital budgeting in the industrial sector and what that means for the (in)efficiency of energy investments in that space.
https://twitter.com/SeanCasten/status/1293905402686574592
1/ First, as many of you know, I spent 16 years before coming to Congress running companies that built, owned and/or operated energy assets in the industrial sector. I built 80 projects. I failed to close an order of magnitude more.
2/ One of the disconnects you find in that industry is that at every trade show you meet people selling boiler economizers, more efficient heat exchangers, better insulation or any number of other efficiency technologies with the same sad story:
3/ Namely: "I can't sell anything unless I can show a simple payback of 2 years or less." Since those assets typically have 15 - 20 year operating lives, that implies industrials won't make those investments unless they provide compound annual returns on capital of 40%+
4/ But then if you go talk to economists (or politicians who vaguely remember their freshman econ class) you will be assured that markets are hyper-efficient and coldly rational at allocating capital, so the mfrs must be lying (or else these are just really risky investments)
5/ Both of these things cannot be true. Insulation is not a risky investment, but there is no industrial that is consistently earning a 40% return on shareholder capital. What gives?
6/ The answer is that industrials are coldly rational, but not in the way that simple economics tells us.
7/ First, in any given year, corporate Treasurers & CFOs set their annual capital budget. In some years, that number is zero. If you need more $ than is in their budget, it doesn't matter what the return is. The project doesn't get built.
8/ Then typically, that capital is allocated into 3 buckets. The first is mandatory compliance capital and often has zero or negative return. Upgrades to meet new OSHA/EPA regs, fixing leaky roofs, etc - the sort of capital you always have to spend, but never love to spend.
9/ Then, IF there is money left over, capital is invested in discretionary projects. But since every CEO had to read Michael Porter in B-school, they prioritize discretionary projects in their core business, and efficiency upgrades rarely sit in that bucket.
10/ This makes sense: if you're a paper manufacturer, you want your team focusing on how to make higher quality paper at lower cost first, before they start thinking about whether to put an organic rankine cycle on their boiler stack.
11/ Then finally IF there is any money left, it goes to non-core capital. And now you get into an interesting managerial problem:
12/ If you're a plant manager in a paper company, there is a path where you might someday be the CEO. On the other hand, if you're the utility manager in that same plant, your internal career trajectory is probably capped at the head of Global utility operations.
13/ That matters because an investment pitch from the plant manager to the CEO is always going to be internally perceived as less risky than a pitch from the utility manager to the same CEO. Which means it demands a higher return.
14/ Funny story: a friend & ex utility operations jock at one of the oil majors told me that their the accounting office dealt with this perceived risk by converting all capital costs from the utility department from "Celsius to Farenheit"
15/ When I asked to explain he said "I estimated the capital cost, made the investment pitch and after I left the room they multiplied my capital estimate by 9/5 and added 32"... and that was why none of his efficiency projects ever got approved!
16/ From an entrepreneurial perspective, this is why I went from being a manufacturer to an owner/operator. I figured that if businesses with access to 6% capital wouldn't make 40% return projects, maybe I could raise 15% capital and split the upside.
17/ That is - in essence - the business model of the entire energy outsourcing industry. But note that if the simple economist argument is right, that industry shouldn't exist. The 3 buckets explain why it does.
18/ But entrepreneurship alone can't close that gap. State electric regulations severely constrain the tools that a 3rd party can bring to bear on someone else's premises. And the perceived risk issue never really goes away.
19/ ...because that paper mill manager is always going to be nervous to let an outsider control the energy plant that she depends on to make paper.
20/ But all that leaves really interesting policy opportunities: the fact that capital is NOT efficiently allocated in the industrial energy efficiency space means there are lots of economically accretive, CO2-reduction projects that won't get made without a policy nudge.
21/ Which is what I'm now trying to do in this new gig. In the meantime, if you've got any good ideas for policy nudges to close that gap, shoot 'em our way! /fin
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