The Problem with Payback

As a commercial solar development firm exclusively focused on corporate clients, one of the most frequent questions we at PowerFlex hear from prospective clients is “what’s my payback?”. For many of our clients who opt for third-party owned arrangements such as Solar Leases or Solar Power Purchase Agreements (PPA’s), the answer to the payback question is “immediate” since there is no required capital investment (despite the immediate monthly cash savings). For businesses considering the benefits of directly owning a solar system (and fully capturing the project’s available economic benefits), the answer can be more nuanced.Payback, at its most simple level, is short-hand for “when do I get all of my money back”. While payback is easy to explain, and easy to calculate, it suffers from several critical flaws that, in our opinion, greatly reduce the relevance of payback when businesses are analyzing the financial merits of “going solar”.

Key Flaws of Using Payback for Commercial Solar Project Analysis:

1. Payback ignores the useful life of the investment. For example, a 2-year payback from a lighting retrofit project with an expected asset life of 5-years is a totally different proposition than a 3-year payback from a solar photovoltaic system with a 30+ year useful life. For many projects, expected asset life periods are similar, and therefore this flaw with “payback” is less impactful, however, solar photovoltaic systems are almost uniquely long-lived, with a design life well in excess of 30 years (as demonstrated by existing commercial installations that are older than this and still producing electricity in the field today).

2. Payback ignores the risk level associated with an investment. All investments have specific risks associated with them - essentially what is the likelihood that the investment will generate the anticipated returns. For solar projects, we believe the associated risk is quite low, something akin to the risk assumed by an investor when purchasing high-grade corporate bonds. Solar project economic returns are highly predictable and stable; the technology is proven & durable, our ability to accurately forecast a system’s electricity generation is excellent, and the operational complexity of the system is minimal (i.e. no fuel required, no moving parts at all, simple to operate and monitor). As a consequence, a 5-year payback on a solar project may be a significantly better investment than a similar payback on a new piece of equipment if that return associated with the equipment’s use is predicated on future revenue growth or requires ongoing maintenance, etc.

3. Payback typically ignores tax consequences. Payback is almost always discussed on a pre-tax basis, as in “we will have a 5-year payback by investing $100K in a new energy efficient HVAC system that will save us $20K in electricity each year”. In reality, for corporate tax-paying entities, the bottom-line cash savings from reduced electricity expenses will be less than the aforementioned $20K, since the avoided electricity costs will also result in reduced tax-deductible expenses (i.e. the loss of a tax-benefit associated with the now eliminated electricity cost). In our view, businesses should assess and compare investment alternatives – including solar projects - on a fully-loaded, after-tax basis.

4. Payback engenders a false sense of comparability across investment alternatives. Many businesses establish firm rules for capital budgeting that dictate specific “acceptable” payback periods. For the reasons mentioned above, we believe this is an overly simplistic practice, and can result in sub-optimal capital investment/allocation decision-making.This is not to say that we at PowerFlex completely ignore “payback”, but rather that we view payback as one of several financial metrics that businesses must analyze and understand when assessing a potential solar project.

For most commercial projects, we rely more heavily on the project’s Internal Rate of Return (IRR), on both a pre-tax and after-tax basis, and most importantly, on the Net Present Value (NPV) of the project’s after-tax cash flow.

To learn more about how the financial benefits of solar can help your business, please contact PowerFlex.