Economics of Installing Combined Heating and Power Systems

With states adopting programs to encourage energy users to install combined heating and power (CHP) systems, building owners and asset managers are asking themselves the bottom line question - how can CHP increase my operating income and asset value?

Every building varies in energy use, energy efficiency and fuel supply arrangement. Large users such as hospitals, universities, hotels, offices and residential buildings each have unique considerations. CHP presents an integrated alternative to (a) using on-site oil or gas boilers for heating while (b) purchasing electricity from the local utility. CHP generally provides a cost effective way for a building to generate its own electricity, heating and cooling by sequentially running a single fuel input through a combined power and heating system. CHP can increase a building’s operating income, and in turn increase its asset valuation. CHP will make the most economic sense when (1) a building’s thermal requirements are high, (2) its boilers are aging, (3) electricity prices are greater than $0.10/kWh, or (4) major boil retrofits are needed to satisfy new environmental regulations. Typically natural gas fueled CHP systems can achieve system efficiencies of around 80%, depending on steam load.

Example

To understand the economics of CHP, assume a commercial building with 500,000 square feet charging rent to its tenants at $50/sq. ft., inclusive of energy. We assume delivered natural gas at $11.00 mmBtu ($5.50 commodity), and electricity purchases from the local utility at $0.20/kwh.

Using the assumptions set forth in Table 1, the building will spend approximately $3 million annually in energy expenses, and have an annual net operating income of approximately $16 million. If the building’s revenue increases by 6% per year, the asset would be valued at approximately $271 million:

Table 1: Assumptions

Actual savings will be determined based on the actual consumption and load patterns of the building, what it actually pays for its electricity and gas or steam, how energy efficient the building is, the availability of natural gas to the building and other site-specific factors.

By installing a CHP system, the building will begin to generate its own electricity while using the waste heat from electricity production to meet its thermal demands (heating, domestic hot water and potential absorptive cooling). The higher the building’s thermal requirements, the more cost effective CHP will be as the cost of electricity per mmBtu of fuel declines. The corollary is that the cost difference between buying electricity and generating it on-site increases, thereby reducing utility expenses and increasing operating income.

The key economic relationships determining the profitability of CHP are: 1) the grid price of electricity; 2) the efficiency of the CHP unit (expressed as a “heat rate” in mmBtu/kwh), and 3) the price of fuel. This relationship is shown in Table 2. Based on our usage assumptions, by installing CHP the building would increase its net cash flow by approximately $830,000 annually. This in turn will increase the asset value by approximately $14 million. The CHP system payback would be approximately 7 years, based solely on energy savings without considering incentives or tax credits, compared to the cost of installing new boilers, which would be approximately 10 years.

Avoiding Upfront Capital Costs

Given the financial attractiveness of using CHP in our building, there remains the question of whether it makes business sense to incur the higher costs to install CHP rather than replacing or retrofitting the system boilers. Most building owners want to avoid making major capital improvements as they represent a lost opportunity cost for alternative investments. Building owners also get deterred by the uncertain risks and costs associated with power production and performance. These risks, along with the necessity of deploying the incremental capital costs of CHP, can be avoided by entering into an Energy Services Agreement (ESA) with a third party developer who will agree to design, build, finance, own or lease, and operate the system for a specified term. The building owner will then acquire the asset at the end of the term at an agreed-upon price.

A third party project finance arrangement typically encompasses the following:

• Developer agrees to design, engineer, permit, finance, build, own (or lease) and operate the CHP system for a specified term. The developer takes on the risk of construction cost overruns, delays, forced outages and system performance.
• Developer and owner agree on a price at which electricity and heating/cooling will be sold to the building. Operating and maintenance services are often included in the price. The price will be negotiated at a discount or provide a guaranteed savings to the annual energy costs (heating/cooling, fuel and electricity) the building otherwise would expend. The contract would include penalties for non- or under-performance by the system.
• The developer takes on the financing obligations, which is done on an “off-balance sheet” basis to the building. The developer also provides insurance to cover construction and performance risks. Energy payments made to the developer begin only once the CHP system is in commercial operation.

In addition to increasing net operating income using the above off-balance sheet arrangement, the building owner or asset manager obtains a predictable long-term operating budget and increases its energy security. The incremental value associated with mitigating or avoiding power supply disruption in areas subject to frequent utility outages (e.g., Hurricanes Katrina and Sandy), cannot be over-estimated.

A third party ownership and operation arrangement also can provide the building owner with the following additional benefits:

• Decreased Property, Casualty, and Disaster Recovery Insurance costs
• Increased Balance Sheet and Debt Capacity
• LEED points for up to 50% energy cost reduction over Baseline
• More Competitive rental space due to reduced tenant costs
• Increased Building Sustainability and Reduced Carbon Footprint
• Potential additional operating revenues by selling demand response and other energy products into the regional power pool

Mitigating the Impacts of Electric Supply Disruption

It is difficult in our model to precisely estimate the economic impact of power-related outages. Various studies estimate the costs from power-related outages to the U.S. economy to be between $104 billion and $164 billion annually. During Hurricane Sandy Manhattan alone suffered $20 billion in damage that left millions of New Yorkers without power, heat and hot water. In the aftermath of the storm, the City could not even meet the energy demands of essential facilities such as hospitals, nursing homes, public housing – and even evacuation shelters. Hotels, casinos, schools and businesses shut down.

CHP systems are designed to operate independently of the grid and automatically “island” themselves from the utility grid during grid emergencies. This is important as external events, such as storms or failed substation transformers, can shut down the electric grid for extended periods of time and disrupt operations of customers. In addition, Emergency Backup Generators are insufficient as extended outages fully utilize the fuel stored ‘on-site’ in a matter of hours. Facilities dependent on a stable electric supply may incur costs due to loss of production, compensation to customers, and equipment damage. Biotechnology research facilities risk the destruction of irreplaceable research materials when refrigeration or climate control systems fail. Medical centers and nursing homes may be unable to continue to provide essential patient care. Many CHP systems at hospitals, universities, and other facilities operated continuously during major storms like Hurricanes Katrina and Sandy, as nearby buildings lost power for days and even weeks. This is possible as CHP systems are primarily run on Natural Gas. The Natural Gas pipeline supply is not dependent on local electricity to maintain gas pressures to continue delivery in the pipeline.

Special thanks to our guest co-author, Craig Gontkovic. Mr. Gontkovic is the CEO of Grid Energy Services, LLC., which advises companies on integrating distributed energy systems into buildings on a turn-key, off-balance sheet basis. He can be reached at crg@gridenergyservices.com, 917-273-2360.