Returns not Payback Periods, please!

Does a payback period of 5 years sound like a long time? How often have you heard of clean technology companies being cagey about their payback periods for things like micro-wind, heat pumps and energy efficiency measures like loft insulation? Having been an avid fan of ‘Dragon’s Den’ it might just be that some of these start-ups just ‘aren’t good with figures’.

Its more likely that they don’t like talking in terms of years to payback or ‘break even’. Talking about money in years spells risk and hardship. The term also forgets that the ‘payback’ will continue after the ‘payback period’, turning into a good old-fashioned profit; instead people think ‘I have to wait x years just to get my money back’. It really annoys me, its such a negative way of selling something.

It also assumes that the technology has zero value once installed, patently untrue. Even cavity wall insulation, which has little intrinsic value, will add to the value of a property, particularly after July with the introduction of home energy ratings. Solar panels lose little value once installed, only the installation costs are lost on day one. In a new build, these costs are minimal and these can add more than their cost to the value of a home – nearly 9% (Guardian).

To me, its much better to think of it in investment terms, the financial sector agrees. Ever heard of Nationwide talking of payback periods? No? that’s because savings and bonds are advertised in annual interest rates. Mutual funds are sold on the return over the last 5 years. Are banks and fund managers better at selling than clean tech firms? Yes. Let’s compare: a long term savings bond at 6% compounded annual interest would have an equivalent payback period of 12 years. Not exactly inspiring.

Also, and I haven’t seen much made of this at all, remember that money saved isn’t taxable income. So, to a higher-rate taxpayer, this bond has a 28-year payback, a lower-rate payer would wait 25 years to ‘break even’. Ouch.

So, what if common clean technologies were sold in terms of annual rates of return on investment instead? Well we have…

energy efficient lighting at 240% (Energy Savings Wales)
cavity wall insulation: 50% *
loft insulation: 100%*
draughtproofing: 25% *
hot water cylinder jacket: 200% *
ground floor insulation: 30% *
Solar thermal: 6.6% (Guardian)
Solar PV: 4.7% (Guardian)
Microwind (Swift): 12.5% (BWEA)

* Plymouth City Council

Remember, these are all ‘tax free’, the best high street savings accounts pays 4.2% net of basic rate tax.

So, please, clean energy companies of whatever ilk, start talking about annual return on investment and ditch the payback period, or Mel'll have ya.

Comments

[Miles Perry]

I'd like to agree with you Will but I'm not sure I can. It's a kind of liquidity thing if you're an economist - or fixed vs. current assets issue if you're an accountant. But thinking about it as a miserly human being...

- If you buy a mutual fund, you wouldn't view the purchase as a sunk cost. i.e. You'd be expecting to sell the fund in the future, hopefully at a profit (and you'd be able to check its current at all times). So you wouldn't necessarily be thinking of holding it until the payback point*. The time when the sum of the income equals the amount you paid for it becomes arbitrary.

- If you buy one of the environmental improvements listed the chances are it has little second-hand value (light-bulbs) or its capital value is tied to something else you might not be selling for the foreseeable (house, factory)**. When the resale value is uncertain, the point at which you pay back the initial investment and start generating profit is much more relevant.

So basically, if you want to think of it in terms of return on investment, you have to be confident that the person buying your house will be happy to pay extra to repay your investment in environmental improvements. If only!!

Miles

* - you could have a fixed term bond of some kind, but you'd still know it's ultimately redeemable and be able to judge its present value accordingly

** - firms can capitalise the assets (i.e. add the value of the improvement to the value of the company) as long as they can demonstrate that it's expected to provide a tangible income stream over its useful life

[Will Dawson]

Hi Miles,

Thanks for your comments. I certainly understand the economic principles you put forward and did consider them.

I don't think that all of these techs have little intrinsic second hand value. For instance, solar PV panels often come with 25 year guarantees and are simple to uninstall.

This aside, the second hand value is actually rather irrelevant because these technologies provide 'necessary' services (insulation, warmth, light, electricity) and so have an intrinsic 'use value'. In short: why would you sell your light bulbs?

As another example: the glass in a house's windows has very little value on the open market, but you try and sell a house without windows (or live in one) and see how it affects the value of the house. So, these techs can't really be removed from a house without being replaced, so you wouldn't want to sell them anyway.

So if you agree that you will need to spend money to provide these services in a building, there is a choice between an efficient but (sometimes) more expensive (to buy) tech (e.g. fluorescent bulbs) and a cheaper less efficient one (e.g. incandescent bulbs). If you buy the expensive one, you forego an opportunity cost on day 1, which can reasonably be assumed to be putting the difference in costs into a savings account deposit at prevailing interest rates. With most people paying tax, the benefit from this is the interest net of tax. This is why I used the high interest bond for comparison with the savings over time the more expensive techs bring.

So the crux is that you can either invest the difference in costs in a 'liquid investment' or in the more efficient tech. So, the two investments are comparable.

(The only other factor to consider in favour of the liquid asset is that the money can be retrieved easier by selling the asset, so poorer people will favour the cheaper inefficient tech., but this is becoming less important as lenders are prepared to lend more for such technologies if the later savings are higher than the interest on the loan).

So whilst, I agree, it seems absurd to talk about payback periods for liquid assets, it is only because it is equally absurd to talk about these technologies in the same terms.

To complete the picture, there is evidence that for every £1 a efficient technology reduces the annual utility bills by, it increases the value of the property by £20 see this US study Shares are often assessed in the same way, by their P/E (price to earnings ratio). (Interestingly, the FTSE 100 tends to have a lower P/E of 10-12).

Also, as I said there is evidence that 'sexy' techs like solar PV have a status value over and above this, with a 9% increase in property values being quoted, which is more than they cost to install.

Also, in June every house for sale in England and Wales will have to have an energy audit, giving an A-G rating. This will make all buyers aware of the energy performance of properties and so should increase the value of efficient ones further.

So that even if a house is sold immediately after the installation of many of these techs, its value should have increased by at least the cost of installation, so they certainly aren't worthless after installation by any means.

[Miles Perry]

Thanks Will, now I get it.

You mean if you decided not to spend money up-front on ultimately cost-saving and/or value-adding improvements, you'd have to put the savings into some highly profitable venture to outweigh the long-term savings you would have made?

Maybe some day you can help me with the spreadsheet I tried to write once on this very subject - calculating the implied discount rate that consumers display when choosing to buy incandescents over energy-saving bulbs. I reckon by buying incandescents you display a discount rate of 47.5% - but that's just on the cost of the bulbs - I got stuck trying to factor-in the electricity savings as well.

[Will Dawson]

Miles,

Exactly, they are comparable because the investment in one technology is necessary to provide the service. I'm glad you understood my ramblings and were able to summarise it more succinctly than me!

Discount rates are pretty hard to establish from lightbulbs* because they require the purchaser to have good knowledge about the running costs. These just aren't presented on the labels so decisions are made on the sticker price with some vague idea that they might be cheaper to use. To be accurate, consumers would need to know the price of electricity, have a calculator in the shop and be mathematically literature. Not very likely.

The solution is for the labelling to state the annual savings of a bulb in, say, 3 different usage conditions or rooms of the house. The trouble is that electricity prices vary between suppliers and over time a lot.

*I think I'm write in saying that discount rates are particular to a person/organisation, rather than particular person and product. So you could use such buying decisions to calculate discount rates for a particular person, but these should be applicable to other decisions. If they aren't, then there is an information difference.

[Miles Perry]

Cheers Will,

As I understand it, if you calculate the discount rate necessary to equalise the cost of a stream of light provided by both types of bulb then you get an idea of how much consumers who still choose the incandescent prefer the up-front saving.

You're right about each consumer being different but any consumer who chooses to buy an incandescent is displaying a combination of discounting the future cost, displaying a genuine preference for incandescent on the grounds of quality, being unaware of the savings offered by compact fluorescents, being too lazy to do the calculation etc...
All that would be encapsulated in the discount rate (so calling it discount is probably a bit misleading).

[Will Dawson]

The discount rate is the discount on a certain sum of money in the a year's time necessary to induce the individual to accept the money now instead.

The trouble is that the consumer currently has no way of knowng how much money they will be receiving in the future, mainly due to the information gaps you and I list above, so I think using lightbulbs to calculate personal discount rates doesn't work so well.

I think the rates you show are high because people are underestimating the future savings, I'd be intersting in seeing how you calculated them. Also, to tease out the discount rate, you would have to control the other factors you mention, such as perceived* quality and difficulty in dimming them. Quite difficult.

I think all this shows the authorities, manurfactures and resellers that they need to show the financial savings clearly to buyers and publicise the quality of CFLs; as I said in Simon's subsequent post, there's something wrong when people aren't all buying CFLs even with such high rates of savings and longevity.

* I use CFLs all over my flat and can't tell the difference, except some of the ikea ones take about 30 seconds to reach full brightness. The Philips are instantly up to full brightness.

[Simon Bennett]

Calculating the discount rate for an equivalent stream of light from two different sources seems a fascinating ex-post theoretical exercise. I am inclined to believe, however, that it flatters the average cosumer. It may be able to encapsulate ideas like the opportunity costs of sitting down with a calculator, or the transaction costs of taking advice and doing some research on product quality, but can it cope with bounded rationality?

Folk who continue buying incandescents because saving a few quid in the future isn't important to them have a high discount rate, true. However, many folks don't buy CFLs because they just carry on doing what they have always done ("if it ain't broke don't fix it") and only absorb the information that fits with their own worldview, i.e. the sporadic comments about yellow light, long start-up, no dimmers. This is equivalent to those who search for any and every scrap of anti-anthropogenic-climate-change reasoning so they don't have to change any of their routines and decision rules (I suppose you could also include rampant anti-capitalists who use climate change to justify their asceticism). And then there are those that don't buy them because they don't want to incur the social cost of being labelled as a 'greenie'.

Discount rates at a consumer level can surely never be very useful because consumer decisions are so very rarely economic. Any numbers generated are likely to suffer from not being very inclusive and from being inherently product-specific. For the moment I think I'll go with Will's rates of return as they are such persuasive comparisons when placed next to traditional returns on savings. I agree that direct comparisons of the two are dodgy due to the difficulties of estimating the extent to which installed technologies retain their value, but in the case of CFLs there is a need for persuasion and erosion of inaccurate (and silly) opposition.

Having said that, where trends exist for consumer discount rates across an aggregated basket of goods, it is probably worth taking notice.

[Miles Perry]

I was just thinking the discount rate offers a kind of counterintuitive demonstration - a bit like Will's point with the rate of return. i.e. you wouldn't willingly throw money away and yet...

A discount rate of 400-odd% is ridiculously high as a pure time preference, but that's the whole point of using it for this purpose.