By Alison Ernst
In the energy efficiency class discussion, an apt analogy was made: energy efficiency projects may be $100 on the ground, but it’s in the form of 10,000 pennies, not a one-hundred dollar bill. This seems to be a common theme. Sure, there is enormous potential in energy efficiency, and as that infamous McKinsey greenhouse gas abatement cost curve shows (seen below), the vast majority of abatement activities that actually create value are energy efficiency measures such as LED lighting, appliance replacement, and insulation retrofits.
For many reasons, it can be difficult to capture this value. I’d like to explore some of these reasons, but would also like to push back on a few and argue that the problem also has something to do with managerial shortcomings.
One common argument is the misaligned incentives of the landlord and tenant. Landlords capture none of the value of a capital expenditure on energy efficiency if the tenant pays the utility bills. Furthermore, if the landlord tries to capture this value by paying the utility bill himself, the tenant no longer has any incentive to conserve consumption. Neither of these problems seems terribly difficult to overcome; by paying the utility himself and simply bumping up the rent to account for the ‘average’ utility bill, the building owner can capture the savings. To avoid the moral hazard problem, the landlord can implement fines or penalties which the tenant will incur if he exceeds an allotted energy usage. To implement this fairly, smart meters would be required so that consumers can track their electricity usage, but the nominal cost of these useful devices (roughly $250 upfront and $10-20/year in operational expenses in the U.S.) can be passed on to the resident.
Another commonly cited issue is the data problem; because this market is small and nascent, there is little proof for how well these projects actually work. This lack of clarity makes investment decisions more difficult. While true, I feel this argument is a bit of a cop-out; managers make investment decisions with uncertain returns all the time. In the Phu My Hung case, for instance, we saw investments being made where demand was completely unknown. I am certainly not arguing for reckless investment; rather, I just don’t think managers should use ‘lack of near-perfect information’ as a reason not to invest.
Quick payback requirements are also blamed for lack of investment in energy efficiency; the case referenced 18 months as one example. As a quick exercise, I modeled a series of cash flows with an initial outflow of $10,000 and inflows which would allow for this 18 month payback ($555/month). The annual IRR for these cash flows over 5 years was a whopping 86%, which seems like a massive required return for a project that is technically both proven and simple. Is it possible managers’ required returns are out of line due to their lack of experience in the space?
On the supplier side, perhaps a push needs to be made for more cost-effective customer acquisition. For instance, Kevin Surace, CEO of Serious Materials (an energy efficiency building materials supplier), states: “The average resident nationwide pays $1,200 a year in utility costs. My cost of acquiring that consumer may be $2,000, and that would be cheap. ” Lower costs of acquisition would mean more customers and allows suppliers to spread their fixed costs over a larger base.
There are still some very valid reasons for the relatively small size of the market; perhaps managers simply do not have the resources (time, money, or talent) to make these upfront investments. Financiers may be wary at the difficult-to-measure risk. Additionally, because utility bills generally make up a small percent of revenues, this type of project won’t be at the top of the priority list. Still, we must really assess which reasons are defensible and which are simply excuses if this is to become a more legitimate market.