Sometimes a failure can arrive disguised as a success. For example, DDT. The A-bomb. “Don’t Ask, Don’t Tell.” The Industrial Revolution (if it ends up destroying civilization with runaway climate change). Highly profitable energy efficiency.
Wait—energy efficiency? Isn’t that what’s going to help save humanity?
Well, yes. Efficiency is one of the key climate solutions, according to virtually anyone thinking about the problem. Joe Romm, of the blog “Climate Progress,” points out that it’s cheap, easily and rapidly deployable, abundant, and therefore arguably the biggest carbon-free resource we have. Studies confirming this abound, whether from Mckinsey or PricewaterhouseCoopers.
So how can energy efficiency, especially the really profitable kind, be a failure dressed as success?
Here’s how: Successful energy efficiency programs almost always mean “picking the low-hanging fruit” or “cream skimming.” This means implementing the most cost-effective retrofits—upgrades that offer the largest and quickest return on investment (ROI). This sort of action is praised as “win-win” by consultants. You save tons of energy and money, and do good for the environment. What’s not to like?
The problem is that even though “picking the low-hanging fruit” implies there’s more work to be done (now get the higher stuff!), nobody ever gets the ladder. Progress typically stops with the out-of-the-park home run project that was almost too good to be true, like a lighting retrofit. The result is that only the highest ROI projects comprise the entirety of an organization’s or household’s energy efficiency program, achieving, say, 5 or 10 percent of the total available carbon footprint reductions (if you’re lucky) and leaving the rest on the table.
While climate scientists tell us we need to cut CO2 emissions 80 percent globally by 2050 if we hope to stabilize warming, our energy efficiency efforts typically stop at a fraction of their full potential. The result: While property owners save money, help reduce emissions and get great PR helping to “save the planet,” collectively we fail in the ultimate goal of stopping or abating climate change. This state of affairs remains true even though many leaders know that runaway warming will hurt their business or community, or could eventually render them unviable.
This cream skimming problem has been documented by The American Council for an Energy Efficient Economy’s 2009 Survey of Corporate Energy Efficiency Strategies, which showed an average corporate energy savings target of 20 percent: “Simple payback criteria were mostly three years or less, though two were as high as five years.” Even at five years, that’s the definition of cream skimming.
Cream skimming isn’t all bad. I’ve argued that purely cream-skimming projects can sometimes help grease the skids for future, bigger energy efficiency work by educating how incredibly profitable efficiency can be. After a few successes, managers might as well happily move forward with deeper (and typically lower return and longer tenor) investments.
But my experience suggests that while that may happen sometimes, the mainstream reality is less rosy. In fact, picking the low-hanging fruit, while cutting emissions and creating great PR, actually hurts deeper sustainability and prevents firms, governments and households from undertaking more comprehensive efficiency.
Why it Can Be Harmful
Pretend you’re a corporation that has undertaken company-wide lighting retrofits. You saved hundreds of thousands of dollars on your investment with 100 percent payback, meaning energy savings from the retrofit paid back your capital investment in one year. You received great PR for it in business journals—your CEO even appeared on the local news—and your company became perceived as a sustainability leader. And so you moved on to do more.
And the next project was, let’s say, a boiler retrofit. It’s very expensive and very large, requiring huge upfront capital. It doesn’t meet the ROI thresholds established by the company for energy efficiency retrofits—it would receive a 6 percent ROI after taxes, or a 16-year payback—even though it saves huge amounts of money over the expected lifetime of the boiler and more than pays for itself in that timeframe. Still, other projects—a new production line, for example—have more competitive ROI and trump the retrofit. With some repair work and duct tape, you can coax the old boilers along for a few more years, maybe a decade. My friend, you just ran into the one-two punch that knocks out many efficiency projects: competing opportunities that are often more lucrative combined with a fixed amount of available capital. In this case, that means the boiler retrofit gets cut year after year.
Here’s the essential problem: By doing the lucrative lighting retrofit on its own, you missed the opportunity to bundle it with other, lower return efficiency projects that are less attractive, and therefore, have prevented those projects from ever happening. The only way to make those lesser projects appealing is to blend them with big winners to achieve an acceptable combined ROI—say 18 percent. Doing this enables you to capture much more untapped savings over time; it lets you hedge against future energy price volatility, run more efficiently and achieve the crucial scale that, if replicated widely, could solve climate change.
But because of your success picking the low-hanging fruit, you can’t make additional progress—your success induced failure. How do we get beyond that?
There are two directly related problems:
1) The Definition of ROI. What are we actually counting when we measure returns? Current analysis typically counts cost savings from reduced energy use. But that’s only the tip of the iceberg. There are myriad other benefits, some that are harder to measure and monetize, but real nonetheless.
2) ROI requirements. Return on investment “hurdle rates” or “thresholds” required for efficiency projects are often too high to allow for even mid-range efficiency improvements, let alone deep efficiency.
Both need to be fixed to enable deeper efficiency solutions. And the following are ways to help fix ROI problems.
Bundling starts with a target and works backwards. Some businesses embark on efficiency by undertaking energy-saving projects. That sounds blindingly obvious, but that approach ensures cream skimming and shallow retrofits. Instead, managers should first understand their energy universe and then establish goals. They can determine what mix of projects they need to get there at the very end of the process.
Even companies that have carbon reduction goals and know their energy universe—where they use the most energy, what it costs, how they get it—often start with the easy projects just because they’re easier. A better approach is to say, “We want to achieve energy reductions of 30 percent. Now let’s work backwards to see how to get there, compiling all the projects we need.” It will quickly become apparent that goals can’t be achieved by pursuing the low-hanging fruit. The projects will then be understood as a portfolio, even if they don’t happen at the same time. This bundling of low and high ROI projects is how Energy Service Companies, or ESCOs, approach efficiency. ESCOs implement energy efficiency programs as a third party, covering capital cost (or steering the client to a bank) and taking payment out of savings. This is a neat way to get efficiency by not having to do anything or put up capital, and to keep the work off your balance sheets.
Revisit ROI Thresholds or Use Alternatives that Address Threshold Concerns
In reality, most corporate ROI “hurdle rates” for energy efficiency projects are set way too high. In some businesses, these thresholds for acceptable projects are as high as 50 percent or more—meaning two-year payback. But in the post-recession economy, even returns of 6 percent (16-year payback) should be acceptable. Actually, they should be rip-your-wallet-off-your-pants-attractive these days because they are guaranteed after tax returns. Even though those returns are low, most buildings last decades and the investments will pay for themselves many times during the life of the structure.
Lowering ROI thresholds bundles efficiency project ROI over time to create a long-term acceptable return—even if component retrofits don’t meet the highest standards. So, for example, you implement the really lucrative 70 percent ROI lighting retrofit, but as policy you also green-light anything with a 6 percent or better ROI. You’ve tacitly acknowledged that your whole system ROI on retrofits will come out somewhere in between. It doesn’t matter if the projects happen together because those lesser projects will still happen since you’ve dropped your thresholds.
Accurately Assess ROI
Many analysts don’t accurately calculate ROI in the real world. They include ideas like “net present value,” “internal rate of return” and “opportunity cost of money,” but ignore many (equally obscure but just as real) factors that ought to be in ROI calculations such as worker retention and attraction, health benefits, asset improvements, morale and PR. To illustrate: If the New York Times covers your hotel boiler retrofit, does the ROI go up? It should. Some of these benefits can be harder to capture and monetize, and work needs to be done to do make that happen, such as creating standard methodologies for calculating inclusive ROI.
There are also more tangible aspects of retrofit ROI that often don’t get included in financial analysis. For example:
- Old equipment has a maintenance cost, including spare parts, staff labor and service visits. In addition to the energy cost savings from retrofits, there are maintenance cost savings.
- Lots of equipment is changed at end of life, regardless of energy efficiency. What often happens is that an engineer will say: “Inefficient boiler X will pay for itself in 10 years in savings over the existing model. More efficient boiler Y will pay for itself in 15 years. We’ll take the less efficient cheaper model.” But ROI calculations on these projects should only consider the delta between the cost to replace equipment (which would be spent anyway) and cost to replace with more efficient equipment.
- More efficient equipment is often smaller, less noisy and takes up less space. There may be instances where a conversion can result in captured space that can be used for a different purpose. For example, at the Snowmass Club in Colorado, by using a ground source heat pump system in a new building instead of a conventional boiler, Aspen Skiing Company was able to add one more employee unit over what had been designed. This served business goals of housing employees onsite and also provided cash flow from the rental unit.
- Fuel types present risk and opportunity. Some interventions are energy-type specific and, as a result, offer hidden benefits or risks. Lighting, for example, is about electricity; boilers typically use oil or gas. An equipment retrofit might also require or offer the opportunity for fuel switching, which could deliver another type of cost savings. For example, if the technology takes you from coal to gas, and gas is cheaper in your region, then you have savings beyond the efficiency improvements of the equipment. If the equipment lasts twenty years, you’re also avoiding likely regulation that will increase the cost of coal-fired energy. Certain energy types (like natural gas) are more volatile than others, resulting in different hedging risks and opportunities. These all play into sensible ROI calculations. Many CFOs will willingly accept a higher price today for reduced volatility and/or a long-term fixed rate.
- Systems benefits increase ROI. Some interventions are mutually reinforcing (e.g. if I replace boilers, I save 30 percent of my energy, but these boilers are meant to work with certain controls. I can increase my efficiency if I do them together). This is almost a universal tenet, and it’s called a “systems” approach. So, for example, better insulation lets you reduce the size and capital cost of your heating system. More efficient lighting and better windows cut the quantity and cost of air conditioning required. This point further reinforces the idea that cream skimming leaves a lot on the table.
- Ancillary benefits abound. Lighting retrofits usually pay out on their own. But they offer a host of other real benefits that don’t always make the ROI calculation either: reduced labor, as bulbs last longer. Reduced cost of new bulb purchases. Reduced disposal costs. Reduced air conditioning costs. And, in one hotel garage we know of, reduced accidents because the area was too dimly lit for valets who occasionally scraped against support beams.
Change Incentive Programs
How do we create the conditions to go beyond cream skimming in society as a whole? How do we increase project ROI itself? One way is to change how utilities create incentives for savings.
The funny thing about many utility rebate programs is that they incentivize retrofits, such as lighting, that are so lucrative that any business or homeowner in their right mind would do them anyway. Perhaps the incentives do help by making customers aware of opportunities, but that can be done with education, not rebates. Rebates, instead, should be used as incentives for energy efficiency measures that would not occur without the rebates—for example, anything with an ROI below 15 percent. These measures are the “deep efficiency” we’ve been talking about, which get us to the scale needed to solve climate change. They include retrofits of pumps, motors, drives, boilers, furnaces, insulation and windows.
Put in Your Eight Cents: Influence Policy
Changing rebate programs to change the return on investment of energy efficiency projects requires something unexpected from corporations and individuals: policy advocacy. You’ll have to lobby your utility or government to help you out. At a national level, we’ll never solve the cream skimming problem until energy costs more in America. If we want deep efficiency, we need a carbon tax, which acts like a rebate program but on a national scale.
Here’s how and why. I live in Colorado with two small children. I come home every day to a sink full of dishes. To hire someone to do those dishes, perhaps an hour of work, would cost me $15 on the free market. Instead, though, I will load the dishwasher, and in an hour, I’ll have clean dishes for a total cost of eight cents. But that’s insane: It doesn’t remotely scale with the market value of the work done, and the eight cents doesn’t account for the fact that the electricity used to do the dishes comes in large part from coal, which increases my children’s risk of asthma and other diseases, loads their blood with toxic mercury and crushes their chance of future prosperity by warming the planet. Eight cents.
The extreme fix to this problem is to tax carbon to the point that energy price reflects its true cost (and value) to society. But while that would be nice some day, even if the price of energy goes up just a little, it will strengthen the market signal and drive more change. Another story further illustrates the problem of cheap energy. Touring an industrial plant in Minnesota, I asked the facilities manager why he hadn’t retrofitted the lights. “Do you know what I pay per kilowatt-hour for electricity?” the manager asked. “Four cents.” So all the projects I can barely get through in Colorado at eight cents are twice as hard in the land of ten thousand lakes.
Who would have thought that a corporate energy manager’s job (or a mom’s or dad’s) is also to change energy policy, and perhaps even lobby for a carbon tax? But it is.
Creative Financial Solutions
Some good news is that problems like cream skimming and ROI thresholds aren’t simply being admired. There has been a lot of effort to overcome barriers to deep climate solutions such these and others. While there is no silver bullet, and all solutions come with their own baggage, two are worth mentioning: MESA and PACE.
Managed Energy Services Agreements (MESAs) or just Energy Services Agreements (ESAs) are one way to approach energy efficiency that provide upfront capital and off-balance sheet accounting. Use your house as an example—today, you pay your energy bills, do efficiency projects and get your payback. A MESA program turns all that over to a third party, which manages energy procurement and efficiency. The third party charges for energy like a utility. It then installs more efficiency equipment in your house, which is maintained and operated by the third party. Last, the third party uses some or all of the costs savings from its retrofits to finance those improvements and earn a profit. Businesses can move the cost of efficiency retrofits off their balance sheets because what was once a capital expense (a new furnace) becomes an operational expense (your energy contract).
Property Assessed Clean Energy (PACE) programs allow local governments to offer sustainable energy project loans to property owners. One of the big problems with home energy retrofits—particularly high-cost projects like window replacements or solar panel installation—is that they cost a lot up front. Many people don’t have thousands of dollars sitting around, and they’re reluctant to take on the debt. Another problem is that many homeowners don’t plan to own their houses long enough for investments like solar panels or new windows to pay for themselves, so they don’t pull the trigger. What’s unique about PACE is that the loan is tied to the property, not the homeowners mortgage, and repayment happens through property taxes. In short, project debt stays with the house, even after a homeowner moves. Often, a PACE annual payment will be exactly offset by the energy saving or energy generating project it funds.
A New Reality
Kevin Anderson, from the Tyndall Center for Climate Change Research at the University of Manchester, and many others have argued that society is at risk of missing the opportunity to keep warming below 2 degrees Celsius (2 C), the threshold widely seen to be the difference between adaptation and disaster. A 4 C rise in global temperature would threaten civilization. He writes: “There is a widespread view that a 4 C future is incompatible with an organized global community, is likely to go beyond ‘adaptation,’ is devastating to the majority of ecosystems and has a high probability of not being stable. (Meaning 4 C would be an interim temperature on the way to a much higher equilibrium.)”In short, we live in a new world, one in which the best efficiency efforts of the past are not good enough by, roughly, an order of magnitude. Clearly, the challenge is enormous. But from a purely financial standpoint, the benefits are substantial. And if you add ethics to the mix, the rewards of rapid and aggressive action become infinite.
by Auden Schendler