Monday, June 7, 2010

Economics of Green Alternatives

"Civilization and profits go hand in hand." ~Calvin Coolidge

Lately, I have seen more and more businesses adopting new technologies to save energy and garner applicable tax incentives. While saving energy and other natural resources is critical to our earth, these decisions must be made within an economic framework.

Before my inbox is flooded with emails from environmentalists, let me just tell you that I have been driving a Prius for the last four years, and I am a staunch believer in the responsible stewardship of our natural resources. However, in business, green technologies must always be evaluated within the economics of reality. The question entrepreneurs must ask is not how many natural resources will be saved, but whether or not saving these resources is economically viable.

From geo-thermal to solar, new green technologies are very expensive right now, and the amount a business can end up spending on them is unlimited. The technology is also changing rapidly, which normally means falling prices. Additionally, over time, existing technology will need repairs, and those repairs could become very expensive as new technologies emerge.

As with any investment, you must look at the rate of return. I frequently hear people talking about a 10-year or longer payback, which refers to the number of years required to recover the initial project cost out of the annual savings. For example, if a new technology costs $100,000, and the additional annual savings are $10,000, the payback is 10 years.

The problem with payback is that it ignores the time value or opportunity cost of money. A better way to evaluate these green investments is by the project’s real rate of return.

Going back to the example of the $100,000 investment, we see that they recover enough through savings to pay back the cost of the project in 10 years. While this sounds okay, it does not consider rate of return, which most businesses should be using. In this case, when we take the time value of money into account, we see that the annual return on this investment is only eight percent.

After establishing the ROI, every entrepreneur should determine their opportunity cost. That is, if a firm could earn a higher rate of return by investing elsewhere, from an economic point of view, this would not be a sound decision. However, if a higher rate of return was not available, the firm should feel confident in this investment.

While investing in new environmental technologies feels great, this is not an adequate basis for making prudent business decisions.

Now go out and make sure you have processes and procedures in place to help you make rational decisions when evaluating green – or any other – technologies.

You can do this!