The elusive negawatt
From The Economist print edition
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IN WONKISH circles, energy efficiency used to be known as “the fifth fuel”: it can help to satisfy growing demand for energy just as surely as coal, gas, oil or uranium can. But in these environmentally conscious times it has been climbing the rankings. Whereas the burning of fossil fuels releases greenhouse gases, which contribute to global warming, and nuclear plants generate life-threatening waste, the only by-product of energy efficiency is wealth, in the form of lower fuel bills and less spending on power stations, pipelines and so forth. No wonder that wonks now tend to prefer “negawatts” to megawatts as the best method of slaking the world's growing thirst for energy.
Almost all blueprints for tackling global warming assume that energy efficiency will have a huge role to play. Nicholas Stern devoted a whole chapter to it in the report he wrote on climate change for the British government. In the greenest of futures mapped out by the International Energy Agency, a think-tank financed by rich countries, greater efficiency accounts for two-thirds of emissions averted. The McKinsey Global Institute (MGI), the research arm of the consultancy, thinks that energy efficiency could get the world halfway towards the goal, espoused by many scientists, of keeping the concentration of greenhouse gases in the atmosphere below 550 parts per million.
MGI is particularly enthusiastic because it believes that unlike most other schemes to reduce emissions, a global energy-efficiency drive would be profitable. The measures it has in mind, all of which rely on existing technology, would earn an average return of 17% and a minimum of 10%. The Intergovernmental Panel on Climate Change, a group of scientists advising the United Nations on global warming, makes a similar point. It believes that profitable energy-efficiency investments would allow Pakistan to cut its emissions by almost a third, Greece by a quarter and Britain by more than a fifth.
In other words, big investments in energy efficiency would more than pay for themselves, and fairly fast. Although a lot of money would have to be spent—$170 billion a year until 2020—by MGI's reckoning that is only 1.6% of today's global annual investment in fixed capital. Moreover, with ample profits to be made, financing should be easy to attract.
Yet if there are so many lucrative opportunities to improve efficiency, why are investors not already taking advantage of them? To a degree, they are: in America, for example, “energy intensity”—the amount of energy required to generate each dollar of output—is falling by about 2% a year (see chart 1). This is only partly because America's factories, houses, cars and appliances are becoming more efficient: it is also because energy-guzzling factories have moved to cheaper spots such as China. But globally, too, energy intensity is falling by around 1½% a year.
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That decline is not predestined. Before the first oil shock, in 1973, America's energy intensity was falling by only 0.4% a year. At that languid pace, America would now be spending 12% of GDP on energy instead of 7%, according to Art Rosenfeld, an efficiency pioneer and a member of the California Energy Commission, which sets efficiency standards and other energy policies for the state. Simply by buying more efficient fridges over the years, he reckons, Americans have come to save more than 200 terawatt-hours (TWh) annually, or roughly 80 power plants' worth.
But as McKinsey points out, there are still hundreds of billions of dollars' worth of unfulfilled but potentially profitable opportunities in energy efficiency available to households and companies. What is holding investors back?
One answer is price. In the eyes of many consumers, electricity and fuel are often too cheap to be worth saving, especially in countries where their prices are subsidised. Industrialists in Russia are profligate with natural gas, because it sells there at a quarter of the international price. Drivers in Qatar have little incentive to scrimp on petrol when they pay barely a dollar a gallon for it.
By and large, energy intensity is, not surprisingly, lower in countries where electricity prices are higher. It is no coincidence that Denmark has both high power prices and an energy-efficient economy. Among American states, for every cent per kilowatt-hour by which prices exceed the national average, energy consumption drops by about 7% of the average. George David, the boss of United Technologies, a conglomerate that makes air-conditioners, lifts and aircraft engines, among other items, argues that higher fuel and power prices are the only motor needed to drive energy efficiency.
But there are still plenty of profitable investment opportunities in energy efficiency, even in the places with the most expensive power. David Goldstein, author of a recent book on energy efficiency, points out that until recently businesses in New York lit their premises more brightly than did those in Seattle, despite New York's much higher power prices. And Hawaii, the American state with the dearest power, is not the most efficient (although the one with the cheapest, Kentucky, does come bottom of the efficiency table).
The problem, analysts explain, is a series of distortions and market failures that discourage investment in efficiency. Often, consumers are poorly informed about the savings on offer. Even when they can do the sums, the transaction costs are high: it is a time-consuming chore for someone to identify the best energy-saving equipment, buy it and get it installed. It does not help that the potential savings, although huge when added up across the world, usually amount to only a small share of the budgets of individual firms and households. Despite recent price increases, spending on energy still accounts for a smaller share of the global economy than it did a few decades ago.
For all these reasons, homeowners, as Lord Stern pointed out in his climate-change report, tend to demand exorbitant rates of return on investments in energy efficiency—of around 30%. They generally want new boilers or extra insulation to pay for themselves within two or three years, says Mark Hopkins, of the United Nations Foundation, an NGO. Businesses are not quite so demanding, he says, but they still tend to put greater emphasis on increasing revenues than on cutting costs.
Similar stories crop up in the markets for new homes and offices, appliances and vehicles. Builders are not the ones who end up paying the utility bills, so have little reason to add to the construction costs—and hence the price of a home or office—by incorporating energy-saving features. The makers of appliances and cars also know that not all consumers and drivers will think as carefully about running costs as about the purchase price. By the same token, landlords have scant incentive to invest in energy efficiency on their tenants' behalf. And power companies are usually keen to encourage their customers to consume as much power as possible.
Financing energy-efficiency investments can also be difficult. In the developing world, capital can be scarce. In rich countries, the savings from making individual homes more efficient are too small and the overheads involved too high to be of much interest to most banks.
Despite these obstacles, as energy prices rise and more countries adopt limits on greenhouse-gas emissions, banks and consultancies are beginning to sniff an opportunity. Firms that help businesses and families to trim their energy bills have become common enough to earn an acronym: ESCos, or energy-service companies. Their industry group in America says business, which had been growing at 3% a year in the early part of this decade, is now increasing by 22% a year. The total revenues of the 46 ESCos it surveyed were about $3.6 billion in 2006, about three-quarters of which came from energy efficiency.
Typically, an ESCo designs a scheme to reduce a building's energy bill, borrows money to pay for the kit it needs, and installs and maintains it over a fixed period. Clients do not need to provide any cash up front: the ESCo's reward comes from retaining most of the savings—out of which it must repay the loan. The revenues are steady and predictable enough to allow ESCos to unburden their balance sheets and lower their borrowing costs by securitising them. Hannon Armstrong, one of the financial-service firms involved, says it has arranged more than $1.5 billion-worth of such securities.
The hitch is that 80% of ESCos' customers in America are from the various branches of the government, along with schools, hospitals and universities. Small businesses and households would provide a much bigger market, but they tend to be less creditworthy and to move more often. Moreover, the transaction costs tend to outweigh the savings.
Jeff Eckel, of Hannon Armstrong, believes it is possible to overcome these problems by aggregating many similar properties and by drawing up clever contracts. The Clinton Climate Initiative, a charity set up by the former American president, is thinking along the same lines. It has persuaded the local authorities in 40 big cities around the world to co-ordinate their investments in energy efficiency. It then used the allure of such a big market to persuade the makers of energy-efficient goods, the ESCos that will install them and the banks that will finance them to reduce their margins. The cities with which the charity has linked up include Chicago, London and New York.
Most governments, however, do not seem convinced that businessmen and do-gooders are capable of overcoming the impediments to energy efficiency on their own. So they are intervening in markets. The variety of methods they use hints at the difficulties.
The simplest tactic is to try to get the public to think. Britain set up a body called the Energy Saving Trust in 1993; America has a similar outfit, called Energy Star. Among other things, it helps consumers identify energy-efficient products and houses through a voluntary labelling scheme. The European Union goes slightly further, with compulsory labelling of goods such as fridges, washing machines and dishwashers; and Britons selling a home must now have its energy efficiency assessed.
But consumers often ignore such labels or at least do not give them as much weight as price, appearance or convenience. So governments sometimes try to make efficient appliances more appealing through financial incentives. America's federal government, for example, offers a tax credit to makers of extremely efficient appliances—and several states give rebates, income-tax credits or sales-tax exemptions to anyone who buys them. China has just said it will subsidise makers of compact fluorescent light-bulbs, which are four or five times more efficient than the cheaper incandescent sort.
Other governments blanch at bribing people to do something that is already in their interest. Australia has proposed banning incandescent light-bulbs outright. Many have adopted building codes and appliance standards that dictate minimum levels of efficiency. Several tighten the standards regularly, to foster constant improvement. Japan's Top Runner scheme, for example, identifies the most efficient appliances on the market in different categories, and then requires all competing brands to improve on them within four to six years. Those that fail face fines.
Businesses often complain that such tough measures impose undue costs, which they must then pass on to consumers as higher prices. They also argue that their customers should be free to buy bigger or more powerful devices if they want, even if that makes them relatively inefficient. Notably, America's carmakers have used such arguments to resist increases in fuel-economy standards.
When Congress raised standards last year it tried to address these complaints by setting different targets for heavy and light vehicles. Each firm's target is an average across all the cars it sells, not a model-by-model limit, so there is still scope to make the odd guzzler. Anyway, environmentalists dispute the notion that energy-efficiency standards drive up prices. The average price of fridges in America has fallen by more than half since the 1970s, even as their efficiency has increased by three-quarters, according to Mr Goldstein. Those gains have come in spite of steady increases in the size of the average unit (see chart 2).
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Governments are also obliging utilities to get involved in the business of energy efficiency. Some, including many American states, add an extra sum to electricity bills to finance investments in energy efficiency. Others specify the amount of energy to be saved, rather than the amount to be spent. France, for example, requires gas and electricity suppliers to invest enough over three years to reduce projected demand by 54TWh.
Britain and Italy have similar schemes, although the targets are expressed in tonnes of carbon and barrels of oil, respectively. External auditors verify the savings, and the “white certificates” they issue when they have done so are tradable. The intention is to keep the cost of the scheme low by allowing those that can achieve reductions most cheaply, including ESCos, to do so on behalf of less expert participants. The idea is also spreading in America: Connecticut, Nevada and Pennsylvania have all adopted it.
But a white-certificate scheme would have to be very demanding to outweigh a utility's incentive to sell more power. So other American states have gone further, and attempted to “decouple” utilities' profits from their sales. Regulators forecast demand and allow utilities to charge a price that would recoup their costs and earn a fixed return on the basis of that forecast. If demand turns out to be lower than expected, the regulator lets prices rise so that the utility can make the mandated profit; if it is higher, the regulator cuts prices to return the excess to customers.
California, predictably, has gone further still. It first decoupled sales and profits for gas in 1978 and for electricity in 1982. Last year, it adopted a scheme called “decoupling plus”, which aims to make investments in energy efficiency more profitable for utilities than new power stations would be. Fees to finance energy-saving measures are added to each bill, and utilities spend the money in pursuit of targets set by the regulator, the California Public Utilities Commission (CPUC). The commission then calculates the savings from these investments, compared with the cost of new power plants. If a utility achieves between 85% and 100% of the target, it is allowed to keep 9% of these savings. If it exceeds the regulator's target, it gets 12%, more than it would earn from building new infrastructure. Between 65% and 85% it does not earn any return at all, and below 65% it pays a fine for every kilowatt-hour by which it has fallen short.
This complicated system is designed to make sure utilities spend more on energy efficiency, but do not waste billpayers' money on investments of dubious merit. California's private utilities now spend about a $1 billion every year on energy efficiency. In July the CPUC will announce their energy-savings targets as far as 2020. The state, says Dian Grueneich, one of the commissioners, hopes to meet half of all projected demand growth through increased energy efficiency.
Less dainty governments just oblige the most energy-hungry firms to cut back. The 13,000 factories in Japan with the highest energy use are required to improve their efficiency by 1% a year. Those that fail to do so are fined. China's central government has followed suit, setting energy-efficiency targets for the country's 1,000 biggest firms. That step, in turn, has spawned similar initiatives in the provinces. Overall, the Chinese government hopes that energy intensity will be 20% lower in 2010 than it was in 2006.
However, no matter what methods governments adopt to encourage energy efficiency, the results may not be as impressive as they imagine. The culprit is something called the “rebound effect”. Falling demand for electricity or fuel brought on by an efficiency drive should lead to lower prices. But cheaper energy, in turn, is likely to prompt greater consumption, undermining at least some of the original benefits. What is more, consumers with lower electricity or fuel bills often put the money they have saved to some other use, such as going on holiday or buying an appliance, which is likely to involve the consumption of fuel and power.
Economists disagree about the size of the rebound effect, which is hard to measure. The British government commissioned two studies of the effect, from two different universities. The first found that it cancelled out roughly 26% of the gains from energy-efficiency schemes; the other put the figure at 37%. Either way, negawatts are worth pursuing. But they are unlikely to satisfy the world's thirst for energy to the extent their advocates assume.
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