PERFILES PROFESIONALES DEL TÍTULO DE GRADO EN HUMANIDADES

Barriers and impediments other than market failures and the influence of organisational, cultural and behavioural factors may also be at work. Failure to consider all of the costs associated with adopting energy efficiency investments or the impact of those investments on output, can make energy efficiency investments

FINDING 4.2

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less attractive to households and firms than they might appear to an outsider. Some of these include:

• Implementation costs — some energy efficiency technologies and processes entail additional costs when implementing an investment.

• Risk and uncertainty — some energy-efficient investments are inherently risky, financially and/or technically. The presence of such risks may reduce the level of investment, or even restrict access to finance.

• Asset replacement costs — upgrading plant and equipment to the latest energy-efficient technologies may require the premature scrapping of existing assets.

A further factor to consider is the heterogenous nature of consumers and producers.

Although not a barrier as such, heterogeneity can account for differences in the uptake of energy efficiency. Estimates of the cost effectiveness of a particular energy-efficient technology or service are often based on characteristics of an average user within a particular class, or based on assumptions of the performance of the technology or process under specific or average conditions. If cost-effectiveness studies do not reflect these variations, they will overstate the potential for the uptake of energy efficiency improvements (Jaffe and Stavins 1994;

Sorrell et al. 2000).

Implementation costs

Households and organisations may not invest in apparently worthwhile energy-efficient technologies because of additional costs that can be involved in the implementation phase (that is, additional to the direct capital and operating costs of the energy efficiency improvement). Estimates of the size of the energy efficiency gap may be overstated if the models do not take all such costs in to account, given that those costs would be considered by individual firms and households.

Implementation costs can arise for a variety of reasons. Costs can be incurred when the workplace or household must change its behaviour to accommodate the new investment before the new technology can reach its peak performance. Such costs include retraining the workforce or hiring new staff, and adopting new workplace or household practices.

Alternatively, benefits may be forgone when the new replacement technology is not perfectly substitutable for the old technology. In these instances, the firm or household may either incur additional costs to maintain productivity or functionality, or forgo benefits from the new technology (Jaffe and Stavins 1994).

The new technology might also pose problems with safety, noise, working conditions or require extra maintenance and service quality. As a result, either the

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cost effectiveness of the technology might be diminished because of decreased returns, or additional costs might be incurred to ensure that it performs at the same level as the old technology (Sorrell et al. 2000).

Risk and uncertainty

Investment in a new appliance or plant and equipment involves some degree of risk or uncertainty.² If the degree of risk and uncertainty facing producers and consumers is not adequately recognised, estimates of the potential for taking up energy efficiency related investments will be overstated.

Three sources of risk and uncertainty associated with energy efficiency investments are:

• technical — those associated with the management of the energy efficiency investment, such as the irreversibility of many energy efficiency investments or its effects on production processes;

• external — those over which the household or firm has little direct control, such as sovereign risk; and

• financial — those associated with the household’s or firm’s capacity to respond to changes in costs and prices, including the costs and availability of capital and energy prices (Sorrell et al. 2000; Hassett and Metcalf 1993).

Origin Energy identified technical risks as being important for new investments:

Risks include operational difficulties associated with changing to new processes and opportunity loss of management time and effort as it is diverted away from higher priority areas of the business and toward[s] energy efficiency. (sub. 25, p. 5)

Technical risks can be very high when investments are irreversible. Even where the prima facie evidence suggests that an investment is capable of generating high returns, it may be rational for firms and households to delay making such investments until more information is obtained that would help resolve its uncertainties (Dixit and Pindyck 1994).

The Australian Aluminium Council pointed to sovereign risk as an important issue for long-term investments:

Equally rational is the decision not to proceed with energy efficiency investments where policy certainty is not adequate to support the investment required; this is

2 Risk refers to those possible future outcomes of an investment for which the probabilities of possible outcomes are known, and uncertainty refers to those possible outcomes for which the probabilities are not known.

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exacerbated by the large capital requirements and by the length of time required to recover the new capital investment; the involvement of state governments often causes further uncertainty within the market, with policy activity directly and indirectly (eg greenhouse policy actions). (sub. 29, p. 10)

Financial risk also includes the uncertainty about the cost and availability of capital.

Faced with uncertainty, constraints can be externally imposed by the capital market or internally imposed within a household or firm. In the presence of such constraints, households and managers may ascribe a hurdle rate of return that is higher than the prevailing market rate, reflecting the need to allocate limited financial resources between competing investments.

Sorrell et al. (2004) observed that firms apply high discount rates to energy efficiency projects when internal finance is constrained. For example, senior managers in larger firms will impose high hurdle rates on non-core projects being administered by more junior staff.

Sanstad and Howarth (1994, p. 815) noted that financial institutions similarly place borrowing limits on low-income households for energy-efficient investments because such investments are perceived to be risky:

… [Households] frequently must pay substantial premia to obtain loans from lending institutions; indeed, they may be unable to obtain credit at any price. Under these conditions, the poor might rationally use high discount rates in evaluating the merits of energy efficiency improvements.

In effect, capital constraints encourage households and firms to purchase cheaper and less energy efficient appliances and investments:

In many cases consumers do not have ready access to capital to purchase more efficient equipment (more expensive). This is particularly so in the residential end use sector.

Here, initial investment in energy efficiency can be seen to be large compared with significantly lower purchase costs, but higher operating costs of less-efficient alternatives. (TransGrid, sub. 62, p. 3)

Similarly, Origin Energy observed that capital constraints effectively reduce the attractiveness of energy efficiency investments:

Even if risk-adjusted IRRs [internal rates of return] are substantial, it may be that the net present value of energy efficiency investments are small relative to alternative investment projects, and not pursued as a result (given the practical limits on the availability of capital that often apply). This is likely to be a rational explanation of the reluctance of businesses (and financial institutions) to underwrite investment in energy efficiency improvement in some cases. (sub. 25, p. 5)

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However, some financial intermediaries are actively courting business in this area.

For example, the Bendigo Bank provides home loan mortgages with reduced interest rates for borrowers prepared to invest in energy-efficient technologies.

Are risk premiums for energy efficiency investments unreasonably high?

A number of inquiry participants and commentators have argued that the high risk premiums accorded to energy efficiency investments act as barriers to their adoption. For example:

The South Australian Government believes there is a strong case for government intervention to encourage energy efficiency … Key barriers to energy efficiency include the high risk premiums businesses often apply when evaluating energy-efficiency investments… (South Australian Government, sub. 80, p. 2)

The Energy Efficiency Working Group (EEWG 2004, p. 8) reported that:

Uncertainty within organisations on the success of energy efficiency projects, has often resulted in higher investment return hurdle rates being applicable to these investments relative to others.

Similarly, the Total Environment Centre argued:

… that a very high effective discount rate is applied to energy efficiency opportunities for both households and industrial customers, when capital is available at all. … In effect, energy efficiency opportunities developed by consumers [households and industrial customers] typically must meet far more demanding requirements for financial performance than do other projects. (sub. 81, pp. 4–5)

To some extent, the use of high discount rates is a reflection by the household or firm of the additional but not readily identifiable costs that the investment might entail. It might also be explained by senior managers using high hurdle rates as a discipline on more junior staff and as a substitute for the cost of their time.

Though high risk premiums can reduce the estimated cost effectiveness of energy efficiency investments, it is not clear that they warrant government intervention.

Risk and uncertainty per se do not represent a source of market failure. As Jaffe and Stavins (1994, p. 805) noted:

It is reasonable and appropriate for individuals to take uncertainty into account in making investment decisions, and to apply relatively high discount rates to irreversible investments whose returns are uncertain. To the extent that consumers’ true discount rates were high for these reasons, this would not represent a market failure.

It is also not clear to what extent households and firms are attaching higher risk premiums to energy efficiency investments than to other comparably risky investments. The Atech Group (2003) argued that energy efficiency investments in

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commercial applications represent a relatively low risk investment and, as a result, should attract lower risk premiums than for the average commercial sector investment.

Yet other authors have argued that energy efficiency investments were risky and justified their high discount rates. Greely et al. (1989), in a study of actual energy savings obtained from commercial building retrofits, found that actual savings varied significantly from the predicted energy savings. Very few predictions of actual energy savings came within 20 per cent of the expected savings.

Nor is it clear that government intervention is justified on the basis of incorrect perceptions of risk — apart from providing information. The Commission notes that market intermediaries, such as energy service companies, can play an important role in helping their customers to manage risk and uncertainty. Such contractors operate by undertaking to develop, install, and manage projects that will improve the energy efficiency and maintenance costs of their customers, in exchange for an agreed portion of the energy savings (chapter 7).

Although risk and uncertainty are not the sources of market failure in themselves, there are important lessons for policy if the source of uncertainty stems from sovereign risk. Minimising sovereign risk is always important, but clearly governments will need to change policy settings from time to time as circumstances change, so some risk is inevitable. As this report notes, there is considerable uncertainty in the current policy framework, particularly in relation to a national response to greenhouse policy.

Asset replacement costs

Many energy-using technologies have long asset lives. Since the adoption of more energy-efficient technologies can require either the replacement or the refurbishment of existing assets, new investments will usually occur relatively infrequently and will be governed by a variety of economic considerations, energy efficiency being only one of them.

For example, the Electricity Supply Association of Australia said that large electricity customers would only change their energy use if their capital stock changed:

For large electricity customers, the level of consumption tends to be embedded in existing plant and equipment and only replacement investment can effect a substantial change in the efficiency of their energy use. (sub. 68, p. 8)

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In some cases, very large improvements in energy efficiency may be needed to bring forward asset replacement, other things being the same. This issue is taken up in more detail in chapter 7.

In the Commission’s view, these other barriers and impediments to the adoption of energy-efficient investments are rational explanations for their non-adoption by the private investor. Though some energy efficiency investments will not be privately cost effective because of them, they are not necessarily problems that need to be, or can be, addressed by government intervention. As a result, these issues are not considered to be barriers and impediments to privately cost effective increases in energy efficiency, later in the report. There is, however, always a role for governments to reduce sovereign risk, such as that which arises from the involvement of governments in energy efficiency investment markets.

Barriers and impediments, such as risk and uncertainty, asset replacement costs and implementation costs, increase the costs to energy users of adopting energy efficiency improvements. However, the role of governments in addressing these issues may be quite limited.

FINDING 4.3

ENERGY EFFICIENCY