Are Your Sustainability Initiatives Missing a Critical Component? A Perspective on Risk
Since re-launching our Sustainability practice in late 2011, HVS has contended that sustainability initiatives should focus on utility efficiency and be driven by the bottom line. We believe that a valid business case exists for numerous types of investments in building equipment and enhanced operating practices, and across the hospitality sector there are literally thousands of good projects with strong return on investment that are waiting to be undertaken.
What Types of Risk Should Be Considered?
Relating to investment in building equipment, we believe there are six basic types of risk including: 1) Investment Risk; 2) Operational Risk; 3) Technology Risk; 4) Construction Risk; 5) Utility Price Risk; and 6) Project Financing Risk. A brief commentary on each of these areas is provided below.
For the vast majority of building equipment upgrades, an owner’s investment decision is based on both upfront cost and annualized savings. While the investment numbers may appear straightforward on paper, HVS suggests that owners and operators should ask the following prior to moving forward: Have I done everything possible to optimize the ROI from this project?
There are a number of steps that can be undertaken to manage risk during each phase of the investment process. First and foremost, a strategy should be in place to secure the lowest possible installed cost. Although there are multiple ways to lock in a competitive price, the most straightforward manner is to negotiate with vendors or contractors in an open bid scenario that is based on a common definition of the proposed improvements. Owners and operators should also remember to differentiate between the gross cost and net cost of a project. It is easy to overlook opportunities for significant rebates and incentives from utility providers or municipalities – all of which can significantly reduce the final out-of-pocket cost.
Relating to the investment returns, the financial projections of cost savings are only as valid as the competency of the individual or firm that has completed the calculations. For example, if complex mechanical improvements are under consideration, does the entity that has calculated the savings have extensive HVAC/MEP experience in an applied hospitality context, and was a professional engineer (P.E.) engaged in the process? On a coinciding note, were the savings projections prepared by a person or company with an agenda that may not entirely align with the owner’s best interests? To minimize the risk of savings not materializing as promised, owners and operators can consider commissioning an independent, vendor-agnostic evaluation of the cost/benefit of the contemplated improvements.
Because sustainability initiatives are oftentimes implemented in clusters of projects that are bundled together, we have observed that individual projects that may not meet ownership’s investment objectives occasionally slip through the cracks and are installed anyway – which in turn diminishes the returns from other more viable projects. Projects should therefore initially be evaluated on a stand-alone basis to determine conformity with the owner’s investment parameters. However, since there is oftentimes interactivity between various efficiency initiatives (especially relating to energy conservation), it is also advisable to consider the combined impact of projects, since the aggregate savings can oftentimes be less than the sum of the parts.
Stated simply, operational risk is the probability that an equipment retrofit project may not perform according to its specifications, or may have unanticipated externalities associated with ongoing hotel operations. Operational risk is of paramount concern to hoteliers, who in most cases will not proceed with projects if there is even the slightest potential for the project to negatively impact guest experience or satisfaction.
As an example of operational risk, consider a project involving the upgrading of the guest room HVAC controls. Although the technology may appear use-friendly based on the vendor’s demonstration and product cut-sheets, such an installation could unintentionally result in large thermal swings or cause confusion on the part of guests who cannot operate the units correctly. There may be significant differences or operational anomalies amongst competing vendor’s products – with some systems functioning ideally while other systems miss the mark.
This type of risk can usually be minimized by conducting proper due diligence on the manufacturer and equipment, as well as visiting properties (or speaking with personnel at other properties) where the technology has already been installed. Hotel operators should also meet with the local manufacturer’s representative for installations which may require ongoing support, as the quality of service will typically only be as good as the local representative’s expertise.
There are multiple layers of technology risk inherent in sustainability initiatives – especially those relating to energy, where significant advances in equipment and controls seem to be occurring every year. However, an owner or operator will most likely have two simple questions relating to a new or emerging technology: 1) Does it work?; and 2) Does it make sense to wait as the technology evolves?
HVS stated in a previous article that the greatest indication of the viability of a new or emerging technology is its performance in a real-world operational context. As such, we believe the first step in the due diligence should be to speak with owners or operators with the technology already in place at their properties – or better yet, schedule an in-person tour to discuss the system’s performance and cost-effectiveness.
Owners should be aware that a relatively new technology or product (within 1 – 2 years) may not provide an adequate indication of longer term performance and maintenance costs, both of which factor into the final return on investment. Therefore, if the hotelier is being asked to take on some level of technology risk, the vendor should be accommodating this risk in the form of a discount on the equipment and/or service.
Regarding whether it is advantageous to apply the “wait and see” approach, we believe it is really a factor of the scale of investment required and the payback period for the project. If a project has a relatively rapid ROI, the opportunity cost of postponing installation can be significant. However, for large-scale capital improvements with extended payback periods, it may make sense for an owner to wait as technology is further developed (especially if significant research & development is occurring in a particular area of technology).
At some point, building equipment retrofits will advance from a concept into reality – which is where construction risk enters the picture. The more obvious impacts to ongoing hotel operations can be controlled via careful construction scheduling and sequencing, as well as selecting contractors who are familiar with the challenges of working in a hospitality environment.
Owners and operators can consider engaging a specialized construction manager or owner’s representative to serve as a liaison between the property operations team, the contracting team, and ownership. This can reduce the likelihood of conflicts between the contractors and operator, as well as minimize delays and the extent of impacts on guest experience. Likewise, an experienced construction manager or owner’s representative can review contractors’ qualifications and experience and administer the bid process – which further defines the level of risk to be borne by the owner and contractors during the preconstruction and construction process.
Under a traditional Design-Bid-Build approach, the owner controls the design and construction process, thereby increasing the probability that the project’s technical characterization and financial inputs/outputs are in accordance with ownership objectives. The open bid approach assures maximum competitiveness in the final contract price; however, the project schedule can be lengthy, and the owner also assumes a level of financial responsibility for delays or change orders resulting from incomplete or erroneous design.
Under a Design-Build or Construction Manager at Risk approach, a level of risk is transferred from the owner to the Design Builder or Construction Manager. The maximum construction cost can be fixed earlier in the process, and the project schedule can be expedited (since construction can commence concurrent with final design); however, the owner loses a certain level of control over the final project deliverable. Both of these approaches can be modified to include an Engineer-Assist, wherein an engineering firm can remain engaged in the process to help ensure the owner’s interests are accommodated during the design and construction phase.
To identify a preferable construction delivery approach, consideration should also be given to the complexity of the project and the qualifications and experience of local contracting firms – both of which will define the level of risk associated with the project. Regardless of the contracting mechanism that is identified, the owner should assess the level of risk based on the specific contractual terms and dispute mechanisms, as well as the amount of time / commitment that is required on behalf of ownership.
Utility Price Risk
Of all of risk topics discussed in this article, utility price risk is probably the area with the most uncertainty. Commodity prices are based on a wide range of macroeconomic and local market factors that can be daunting to navigate. Utility rates are impacted by regulatory activity, aging infrastructure, energy policy, security, smart grid technology, and renewable energy targets - just to name a few of these factors. Although complex, there are nevertheless a range of sources which can be used to gauge high-level trends in commodity rates. In the U.S., these include various reports and market indices published by governmental agencies (U.S. Energy Information Administration), private consultancies (e.g. Black & Veatch), and others.
An understanding of local market conditions can also be helpful in anticipating future shifts in rates. For example, many municipalities have embarked on major investment programs in infrastructure. The costs for these improvements are oftentimes passed along to utility rate payers, which are reasonably foreseeable by following local media coverage and political proceedings. Likewise, market forces will typically prevail to drive prices higher in areas with commodity scarcity (e.g. frequent brownouts due to lack of adequate electrical grid capacity, or water shortages in areas with ongoing drought conditions).
In the context of evaluating the cost and benefit of utility efficiency initiatives, HVS recommends applying a sensitivity analysis based on varying commodity rates – to enable owners to ascertain a range of returns under best case, worst case, and middle-of-the-road scenarios. The commodity rates used in the sensitivity analysis can be adjusted based on both national-scale projections and historic local tariff patterns.
Project Financing Risk
After reviewing various proposals provided to our clients for turn-key installation of onsite power generation systems (including solar PV, cogeneration plants, and fuel cells), we have observed anywhere from a moderate to a substantial level of risk associated with alternative financing structures (including performance contracting, energy purchase agreements, and other emerging financing mechanisms). While the specific terms of the contract will dictate the proportional level of risk to be borne by the owner and investor, we provide commentary below on a typical alternative financing structure – a power purchase agreement (or PPA).
A PPA would typically involve third party ownership and installation of a more efficient energy plant system – along with a corresponding agreement to sell energy to the hotel owner. To properly evaluate a contractual relationship such as this, it is essential to understand which party is assuming the commodity price risk and performance risk associated with the installation – both of which may be negotiable as part of the contract structuring. A couple of basic questions relating to risk that an owner should consider include: 1) What happens if commodity rates change and conventional energy (e.g. electricity from the municipal grid) becomes more competitive than the rates specified in the PPA?; 2) What equipment downtime could be anticipated, and which party would be at risk under existing and/or modified tariff structures?
Relating to turn-key agreements where a third party will finance or own the building equipment, HVS recommends that hotel owners should conduct their own due diligence regarding the actual costs of construction, available incentives to offset the capital cost, and levels of savings generated through the project. In some cases, it may be more advantageous to self-finance installation of a project if the returns are strong enough, but this decision can only be made if the owner aggressively attempts to understand all of the facts regarding the project.
Putting the Pieces Together – Integrated Risk for Retrofit Projects
The level of risk associated with a particular utility efficiency initiative or equipment retrofit project is oftentimes a factor of the complexity and number of moving parts of the project itself. Any particular project can have multiple layers of risk inherent in its financial projections, technical implementation, and operations.
HVS believes that hotel owners and operators can substantially minimize their financial exposure by engaging in open conversations about risk with their consultants, vendors, and contractors. Are your sustainability initiatives missing this critical component? If so, please contact HVS Sustainability to see how we can assist you.