EROI Promotes Sharper Project Analysis

Jan-Pieter Oosterom, Charles A. S. Hall

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Companies’ impact on the world is generally the result of the investment choices they make. Whether these involve building a new factory, hiring more people, or R&D – most decisions flow from financial analysis of various investment opportunities.

Traditionally, investment decisions were based on discounted cash flow (DCF) analysis.  DCF standardizes the value of money spent or earned now (which is usually considered more desirable) vs. in the future.  Such “discounting” assigns future dollars a lower value than those generated today, facilitating comparisons of projects with varying life- cycles.

However, DCF analysis does not directly take into account the negative “externalities” of corporate activities on the environment and society. These include environmental degradation, exposure to climate risks, depletion of scarce resources, adverse impacts on local communities and other harms. DCF analysis also depends on a long-term forecasting of margins, regulations, and taxes that are inherently uncertain as the world is going through an energy transition.

Investors have begun “voting with their portfolios” by incorporating criteria other than companies’ financial prospects into their investment choices.  ESG considerations now guide close to a third of total investment flows (about $12 trillion) and are expected to become the primary investment criterion for as much as 50% of assets under management in the US by 2025 (per Deloitte). The outgoing CFO of BP, Brian Gilvary, said that he spent more than half of his time with investors talking about these issues (S&P Global Platts, 2020).

In no area of the economy are these issues playing out in a more contentious way than in the energy sector. Oil and gas still provide about two-thirds of the world’s energy, and are almost irreplaceable in agriculture, much of global transport, and chemicals.

At the same time, we are witnessing a global drive to move away from fossil fuels in order to combat climate change – which will require large energy-intensive investments (Heun and Brockway, 2019; Capellan Perez et al. 2019).  How should these tradeoffs be evaluated? DCF analysis is inadequate given the enormity of the challenges we now confront as well as the anticipated major changes.

Enter BioPhysical Economics, the study of ways and means with which societies produce and use energy. The foundational concept is Energy Return on Energy Invested (EROI) which compares the energy produced by an extraction process vs. the energy required for that process.

In a recent study (Energy Policy, Volume 168, September 2022), the authors compare two different investment projects in oil & gas.  Surprisingly, the project with superior conventional economics yielded a far worse EROI. This paradox is driven by differences in natural gas prices, taxes, and CO2 charges between the two projects.  The case illustrates that DCF analysis alone may not provide the best answer for an energy producer that seeks to balance financial goals with environmental stewardship.

Cash-flow modeling based on current subsidies and environmental standards may produce misleading results for long-term planning, given the likelihood of a changing regulatory environment. By disregarding biophysical realities, DCF analysis is prone to underestimating risks that may arise in an uncertain economic and political future.

A project that scores poorly in EROI terms indicates the activity is not in sync with society’s long-term needs. There’s a greater risk of stranded assets created by higher taxes, rising natural gas prices, and/or adverse regulatory changes.

In order to be useful, EROI analysis must be both comprehensive and practical.  Reliance on proxies inevitably means some aspects of the situation are obscured or ignored.  Even so, we believe it best to adopt a simplified framework that allows consideration of as many different cases as possible, in order to gain fundamental insights. That will be more useful than a precise estimation of EROI, which companies may find too onerous to implement.

However imperfectly it is measured, EROI is a useful complement to conventional economic analysis.  This metric differentiates investment opportunities by their physical attributes and is thus robust to changing economic and political circumstances.  By applying this method consistently over time, a company can make its portfolio more resilient to future risks while contributing to better stewardship of our scarce natural resources.

The same approach can be used to evaluate alternative energy projects, differentiating between those that are fundamentally sustainable vs. those that represent mere greenwashing. Subsidies for the production of corn-based ethanol, and certain electric vehicles are unlikely to meet this test.  Such projects may appear attractive in DCF terms, but are not sustainable, and hence not desirable for society.

As we come to terms with biophysical realities, sharper thinking about the energy intensity and long-term viability of operations will promote better decision-making by corporate leaders and investors.