# Efficiency of Energy Use, Economic Concerns and

# EFFICIENCY OF ENERGY USE, ECONOMIC CONCERNS AND

The large increases in energy prices during the 1970s encouraged extensive interest in reducing energy use and in using energy resources efficiently. The common belief resulting from the energy crisis was that private markets would not provide an adequate supply of energy and would not conserve the use of energy resources. A particular concern was that households and businesses have insufficient incentives to invest in energy-saving technologies. A simplified investment model illustrates this point. The characteristic of any investment is that an initial commitment of funds is made with the expectation of a future payoff. Funds received in the future are of less value than identical funds today; hence investors must discount future cash flows.

Textbooks on investment present a simple model where the net present value (NPV) of an investment equals annual future revenues (R) summed and discounted at the rate r, minus the initial investment cost, I. Using t as a time subscript to denote different years, the equation is Revenues are summed from an initial period throughout the economic lifetime of the investment. The business decision rule is that an investment is profitable when its net present value is positive. If revenues accrue at a constant rate, continuously and forever, the equation becomes simpler. In the inequality I < R/r, an investment is profitable if annual revenue, R, divided by the discount rate, r, exceeds the initial investment cost. For instance, assume an initial investment of $100 yields annual net revenues of $11 and the discount rate is set equal to the interest rate for obtaining credit of 10 percent. The net present value of the investment (R/r) is $11/.10, or, $110, which exceeds the initial investment. The investment is profitable, and businesses and households who find 10 percent an acceptable annual rate of return are inclined to make such an investment in an efficient market.

In the above equation, r can indicate the internal rate of return on an investment. Suppose that an investment in an energy-saving technology cost $100 and reduces energy costs by $20 per year indefinitely. The reduction in costs is comparable to net revenues received. The above equation can be modified as follows: I equals R/r, where the values of I and R are specified and the value of ris computed. Hence $100 equals $20/r, and r equals 0.20, or 20 percent. The internal rate of return on the $100 investment is 20 percent per year. An investment is generally profitable when its internal rate of return exceeds the (interest rate) cost of obtaining credit. The investment is attractive when its internal rate of return exceeds the investor's hurdle rate, which may vary depending on the riskiness of the investment, and on the rate that can be earned from alternative uses of the investment funds.

Another investment performance measure is the payback period, which, in its simplest form, is the number of years until the net revenue from an investment equals the initial cost. In the above example of a $100 investment cost and a $20 annual payoff, the investment pays off in five years. The payback investment criterion, a crude rule of thumb, is to accept the investment if it continues to return revenue well after the payback time is reached, without any offsetting costs. This criterion has less appeal than investment decision rules based on net present value and rates of return. Investments with a short payout period may yield a high net value or internal rate of returns, but this result is not inevitable. Investments with a low return for the first few years but a very high return in later years can have a long payout period but still offer a high net return. The payoff period has some merit in considering highly risky investments where risk is a function of time. Where the entire initial investment is at risk—such as in a country with a politically unstable government—recovering an initial investment as soon as possible is important. Note, however, that payback is essentially a break-even measure, not a measure of profitability.

Households and businesses use energy jointly with technologies to produce energy services. In almost every application, consumers have a choice between highly efficient technologies that cost more initially but have lower energy costs, and less efficient technologies that have lower initial costs but higher operating costs. For instance, electric heat pumps use differing amounts of electricity to produce space heating and cooling, depending on their efficiency. The standard investment model indicates that rational consumers will invest in the more efficient heat pump if the present value of energy saving exceeds the higher initial investment cost of the more efficient unit, other factors being equal.

Data obtained from the U.S. Energy Information Administration illustrate the trade-off between efficient heat pumps and currently purchased models. In Table 1, the current popular model heat pump uses 6,973 kilowatt-hours (kWh) per year on average to produce heating and cooling, whereas the new and efficient model uses 5,279 kWh per year. Energy efficiency is sometimes interpreted as a simple technical coefficient, such as the amount of energy required to perform a unit of work. Using this technical definition, the efficient heat pump is necessarily more energy-efficient than the current model. Whether this energy efficiency investment makes good economic sense is another matter.

The efficient heat pump reduces energy use by 1,676 kWh per year on average. Is the efficient model heat pump a good investment? Suppose the incremental cost of the efficient unit, as compared with the less efficient unit, is $1,000, and electricity cost 10 cents per kWh. With this price of electricity, the efficient heat pump reduces electricity costs by $167.60 per year. Taking a simplified approach for purposes of illustration and assuming that each unit lasts indefinitely and has no repair, maintenance, or replacement costs, and ignoring possible tax effects, the internal rate of return may be calculated as $1,000= $167.60/r, which is 16.76 percent per year. If the household can borrow money at, say, 10 percent per year and earn 16.76 percent, the investment makes economic sense. If we assume a 10 percent discount rate, the present value of the investment is $1,676, which exceeds the initial investment cost. The net present value is $676, which indicates that the investment is feasible.

Current Model | Efficient Model | |||

Annual kWh | Efficiency | Annual kWh | Efficiency | |

Heating | 4742 | 7.5 | 3984 | 9.4 |

Cooling | 2297 | 12 | 1802 | 15.3 |

Annual kWh | 6973 | — | 5297 | |

Efficiency data are seasonal energy efficiency ratings (SEER) for cooling and heating; seasonal performance factors (HSPF) for heating. |

The technical literature on the economic return to energy-efficient investments is vast and yields two main conclusions: First, energy-efficient investments frequently offer a positive net present value, or alternatively, a high internal rate of return; second, energy-efficient technologies often fail to achieve a significant market share, at least for the first few years after introduction. For instance, J.G. Koomey, A. H. Sanstad, and L. J. Shown (1996) conclude that consumers fail to purchase energy efficient light bulbs, even though such purchases offer very high internal rates of return. Paul Ballonoff (1999) challenges their estimates and argues that their estimated internal rates of return are the result of erroneous calculations.

There is an enormous controversy about whether consumers and businesses undertake an efficient level of investment in energy-saving technologies. The view of energy conservationists is that energy-efficient investments offer consumers abnormally high rates of return, but consumers still refuse to make such investments. Furthermore, government efforts are required to encourage energy-efficient purchases in these inefficient markets. The alternative view, often associated with mainstream economists, is that consumers make reasonably efficient choices. Taking this view, additional government regulations are more likely to impose market inefficiencies than reduce them.

In the illustration of the electric heat pump, the simple internal rate of return is 16.76 percent. We observe that some households purchase the efficient model, but others purchase the current model. Are these households irrational, or are there simple explanations? Many economists are concerned whether energy-efficient investments make good economic sense. There are numerous explanations for the refusal of households to buy the more efficient heat pump. The cost of borrowing money is not 10 percent, as assumed above, but for some households the cost of borrowing could be a credit card rate, such as 18 percent per year. At this rate, the NPV of the investment is negative. In the above illustration, the price of electricity is 10 cents per kilowatt-hour, but this is an average cost, not the marginal cost of incremental electricity use, which may be much lower. If the incremental cost of electricity is only 5 cents per kilowatt-hour, the annual energy cost saving is $83.80. The internal rate of return is 8.38 percent. Some households find this rate attractive and purchase the efficient heat pump; others do not. Furthermore, this example ignores other system costs, or assumes them to be the same as for the current system, which may not be realistic if the efficiency gains are achieved through newer, less proven, technology.

The alternative estimate of net present value assumes that households are identical; but households have important differences. The energy saved by the efficient heat pump depends on climate and household conditions. Heat pumps have a lower payoff in very cold regions than in regions with moderate climates. Efficient heat pumps are an attractive investment in some regions; but in other regions, the current model is a better choice. Residential structures that are "tight" offer lower benefits to the efficient heat pump. The net present value of the efficient heat pump may be positive for some households but negative for others.

Technologies that offer increased efficiency tend to be the newest technologies that are entering the market. The adoption rate for many new technologies and products may increase very slowly over time, even when such purchases appear to offer high internal rates of return. The adoption rate of new technologies and products tends to be low at first, but as information becomes more widespread over time, the adoption rate of superior technologies increases. Information about a technology or product is a broad concept. Consumers must first become aware of the new technology. Consumers must also become aware of the performance and cost features of thenew technology. Acquiring this information is time-consuming and expensive, but is required if a new technology is to capture a large share of the market. New energy-efficient technologies do not immediately achieve a large market share even when their estimated NPV is positive. Moreover, most new technologies and products that are not energy-related also do not immediately achieve a large market share when their NPV is positive.

The energy-efficient heat pump is likely to achieve a small market share for at least its first few years after introduction. Similarly, other energy-efficient technologies, as well as nonenergy related technologies, are likely to achieve a small market share after they enter the market.

The initial rejection of the efficient heat pump by many consumers may be well founded or not. In addition to the sound economic rationales for rejection, there may be market-impediment explanations. Consumers may have imperfect information and be unaware of the energy savings of new, efficient technologies. The transaction cost of acquiring information and making an efficient choice may be just too high. Because of these impediments, households often fail to make investments that would actually save them money over time.

In summary, the main points in this controversy are first, the contention by energy conservation proponents that numerous investment opportunities currently exist to reduce energy costs. Further, these investment opportunities would meet the investment criteria noted above. Although there are few challenges to this contention, it is not the center of controversy. Conservationists contend that the failure of private markets to make these investments is indicative of serious inefficiencies. Some economists dispute this contention and provide explanations of why normal, well-functioning markets may defer on energy-efficient investments.

*Ronald J. Sutherland*

See also: Auditing of Energy Use; Capital Investment Decisions; Conservation Supply Curves; Economically Efficient Energy Choices; Economic Growth and Energy Consumption; Efficiency of Energy Use; Efficiency of Energy Use, Labeling of; Energy Economics; Environmental Economics; Government and the Energy Marketplace; Industry and Business, Energy as a Factor of Production in; Industry and Business, Productivity and Energy Efficiency in; Supply and Demand and Energy Prices.

## BIBLIOGRAPHY

Arthur D. Little, Inc. (1998). EIA-Technology Forecast Updates-Residential and Commercial Building Technologies-Advanced Adoption Case. Washington, DC: Energy Information Administration.

Ballonoff, P. (1999). "On the Failure of Market Failures." Regulation: The Cato Review of Business and Government 22(2):17–19.

Koomey, J. G.; Sanstad, A. H.; and Shown, L. J. (1996). "Energy-Efficient Lighting: Market Data, Market Imperfections, and Policy Success." Contemporary Economic Policy 14(3):98–111.

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