Moving capital from energy supply to energy efficiency
On the 14th September I was very pleased to be able to present to the Association of Environment Conscious Building (AECB) Convention. It was a great event, based in a Passive House standard community centre and it was excellent to meet some old friends, as well as make new interesting contacts. It was also an excellent opportunity to visit two amazing passive houses. The following is based on my slides and presentation:
Thank you for the opportunity to speak today. I have a long standing interest in low energy housing and in fact helped build some low energy self-build houses in the 1980s including a house at Energy World in Milton Keynes. I am here to talk today about how to shift capital away from energy supply to energy efficiency, and this is the topic I spend much of my time working on. I am going to try to paint the big picture, tell you about some things that are going on in this area, and hopefully leave you with some grounds for optimism.
I always start with this picture of the £50 and say “there is big money in energy efficiency”. I really hope they don’t withdraw the £50 note because I think it is the only bank note in the world that celebrates energy efficiency. If you travel around the world you see bank notes that celebrate oil and gas and even electricity but this one of course shows Matthew Boulton and James Watt. Contrary to what you may have learnt in school James Watt did not invent the steam engine but he did invent a more efficient steam engine, and Matthew Boulton was the entrepreneur who teamed up with him and turned that invention into a successful business. They did that by offering shared savings energy contracts, taking a share of the savings in coal that the new engine produced when pumping water out of mines. This is perhaps another example of a UK innovation that we have never really exploited properly, and even 250 years after this we still don’t really know how to exploit the massive potential for economic, cost-effective energy efficiency which is all around us.
So just how big is this potential? Over the decades there have been many, many studies of potential across many, many geographies and sectors. All of them show that there is massive potential that is not being exploited. Just to give one example, in 2012 the IEA published several scenarios including its Efficient Worlds Scenario. This estimated the potential for energy efficiency as 40% in buildings, 23% in industry and 21% in transport. Implementing this scenario would halve the rate of growth of energy demand and result in emissions peaking in 2020. Significantly the economic impact would be $18 trillion, which is more than the combined GDP of the US, Canada, Mexico and Chile in 2011. That is a lot of money.
If we are going to shift investment from energy supply to energy efficiency we need to consider the starting point so that we can measure progress. It is not easy to measure the global investment into energy efficiency but the IEA now does this on an annual basis. The IEA estimate that total global investment into energy efficiency in 2016 was $231 billion and the good news is that this is increasing. That is the good news. The bad news is that the IEA and IRENA estimate that to achieve their “66% 2°C” scenario would need to ramp up to almost $3 trillion a year in the 2040s, more than a factor of ten higher than the current level.
It is worth putting these big numbers into context. Total investment into the energy system was estimated at $1.8 trillion in 2017. A few highlights:
investment in coal was $79 billion which was 13% down – and nothing Donald Trump does will stop that going down
investment in electrical networks was $303 billion and this is expected to grow in the next few years as it includes storage
investment in fossil fuel generation was $132 billion, down 9%
investment in renewable generation was $298 billion which was down 7%. It is important to note, however, that the capacity installed in the year actually went up due to the falling costs of wind and solar generation.
Oil and gas investment went up – probably in line with the oil price and because of the growth of investment in fracking. I will say, however, that the other day I was talking to a very experienced oil and gas investment banker and he said that it was now really difficult to raise money for new oil exploration and production companies in London, which traditionally has been one of the global centres for oil and gas funding.
Next it is important to be very clear that there is not a shortage of capital. Traditional energy efficiency people have tended to say “there is no money for our projects” but there is no absolute shortage of capital. Fitch Ratings reported that there is approximately $9 trillion of global government debt that trades at negative interest rates, i.e. the investors are paying to hold that debt. There is a wall of capital looking for good investments and an increasing share of that capital wants to invest in green projects. As there is an over-supply of funds the yield a project needs to generate to attract investment has come down.
So how to tip the balance of investment more in favour of energy efficiency? I am going to talk about two areas; changing the way we think about energy efficiency and making it more investable.
Changing the way we think about efficiency starts with thinking about it as an energy resource in exactly the same we think about other energy resources. Wallace Everett Pratt, a famous petroleum geologist said that “where oil fields are really found is in the minds of men”. When you think about it is true. When Edwin Drake first drilled for oil in Pennsylvania in 1859 people thought he was mad. The physical material was there all the time, in fact oil seeped to the surface and was collected, but sub-surface oil became realisable when someone thought it was there and assembled the technology and the resources to prove it. It is the same in energy efficiency. If you think about it there is an energy efficiency resource in every building, industrial plant and transport facility (except of course this passive building) but the resource is only there when you think about it, if you look at a building in a certain way you can see energy (and money) flying out through the roof, the walls, the doors and the windows.
In the oil and gas industry there is something called the Petroleum Resources Management System which sets out the different types of oil and gas resources and reserves. This has been standardised by the industry and is the basis of fund raising. If you have a prospective resource you can raise money on the back of it, it will be high risk money because you still have to drill holes and test it and even if oil is there you still need to work out a viable, financeable way of getting the oil out to market. We need to think about efficiency in these terms. A potential study is like a prospective resource. The output of an energy audit moves that resource into a contingent resource. Then some of the projects identified will be developed and ultimately move into production, that is production of savings of negawatt hours. Imagine if we could get the market to think about efficiency in this way. Building owners could lease their buildings open to efficiency exploration and production companies in exactly the same way that the owner of a field in Pennsylvania or Texas may choose to lease it to an oil and gas company. Owners of buildings could even hold auctions based on selling the right to explore the building for efficiency resources.
Energy efficiency has many barriers. There is a whole genre of research on barriers to energy efficiency. All of that is important work but there is one fundamental problem that energy efficiency has that the books don’t mention…….it is really, really boring. For most people, nearly everyone, it is tedious beyond belief. People just don’t care about it. Unless we recognise this we are kidding ourselves. So how do we overcome this?
The answer I believe is non-energy benefits. We only really started thinking about the multiple non-energy benefits of energy efficiency a few years back. Non-energy benefits include, amongst many others:
better health outcomes
better employee productivity / reduced absenteeism
better plant productivity
increased asset value
reduced need for capex in energy supply
improved local air quality
and many more.
We need to consider the impact of non-energy benefits and how people make decisions. Even in the corporate and investment world, where economics are critical, it has been found that profitability is not the main driver of investment decisions and that financial evaluation tools only play a secondary role in decision making. The strategic nature of a project or investment carries a heavier weight than just the economics. If an action is considered strategic there is much less consideration of the investment return. Therefore we need to make energy efficiency more strategic. Non-energy benefits such as comfort, productivity, increased resilience etc. are the way to do this as they are much more strategic and therefore much more interesting than simple energy cost savings. Nowadays I always say to people developing efficiency projects, work out what is strategic to the decision maker and stress those strategic benefits, only as an addition say “by the way you will also save some energy costs”.
There is an increasing amount of work going on around the world to value these non-energy benefits including several projects funded by the European Commission. Some are difficult to value but many have real and measurable value. Studies by the World Green Building Council and Rocky Mountain Institute have shown the value of benefits such as a reduction in sick days, higher asset values and reduced capex and build times.
To build better business cases we need to assess the value of energy savings, as we have always done, assess the financial value of non-energy benefits, and assess the strategic effect of the proposed investment. Putting these three elements together will make better business cases and better business cases help more capital will flow.
Of course I have been talking about capital investment in organisations. Individuals choosing houses exhibit some of the same characteristics. Evidence shows that people, and here we are talking about “ordinary” customers, not energy geeks or specialists, are sold on passive houses because they increase the overall quality of life by providing a quieter environment, better air quality, greater comfort and longevity.
Now I am going to turn to making efficiency more investable. Energy efficiency is hard to invest in for lots of reasons including:
there is a lack of standardisation
the outcomes rarely measured
there is uncertainty i.e. the risks are unknown
projects are small compared to needs of institutional investors
there is a lack of capacity in financial institutions and CFOs – but also in the supply chain and amongst decision makers
traditional contracting models like Energy Performance Contracts don’t actually work well – especially in the real estate, industry and residential sectors
Several groups and analysts including the Energy Efficiency Financial Institutions Group identified that lack of standardisation in the way that energy efficiency retrofit projects are developed and documented is a barrier to investment. Michael Eckhart of Citi, one of the world’s top “green bankers” said:
“Energy efficiency projects do not yet meet the requirements of capital markets. No two projects or contracts are alike.”
Lack of standardisation creates several problems for investors. It:
increases performance risk
increases transaction costs
makes it hard to aggregate projects – aggregation is essential because energy efficiency projects are so small compared to the “cheque size” of financial institutions
makes it difficult for a financial institution to build capacity – if a bank wants to deploy capital into energy efficiency it is hard to build human capacity and scale without standardisation.
An important response to the lack of standardisation is the Investor Confidence Project (ICP) which has a project certification system, Investor Ready Energy Efficiency™ (IREE™), which is based on best practice, is transparent and has independent certification by quality assurance professionals. We introduced ICP and IREE™ to Europe from the US a few years back with the assistance of the European Commission’s Horizon 2020 programme. The system is now up and running across Europe for energy efficiency projects in buildings, industry, street lighting and district energy. Its impact has been confirmed by Munich Re HSB who offer energy efficiency performance insurance. If you take them an IREE™ certified project they will offer a lower insurance premium and not require an independent engineering analysis (which the customer pays for), thus proving the thesis that IREE™ reduces risk and transaction costs.
I want to turning now to the role of banks and investors. There are four reasons why financial institutions should consider deploying capital into energy efficiency:
it is a large potential market
it can reducing risks in two ways:
improving the cash flow of clients
avoiding financing stranded assets
it helps Corporate Social Responsibility
banking regulations are increasingly looking at climate risks through bodies such as the Financial Stability Board Task Force on Climate-related Financial Disclosures (FSB TCFD)
The impact of risk reduction and the banking regulations will become more significant. If as seems likely banks will need to measure and declare their climate related risks it will drive banking behaviour. Having a mortgage portfolio dominated by high energy consuming houses will be higher risk than having a portfolio dominated by low energy houses and that could affect regulatory capital and the stress testing that you hear about nowadays.
Banks and investors are paying attention to this. The International Investors Group on Climate Change, which represents investors with more than €21 trillion of assets under management supports energy efficiency. In Europe, as well as the work of the Energy Efficiency Financial Institutions Group we have a number of financial institutions that are leading the way. ING Real Estate, which has c.€50 billion lending to commercial real estate, has developed an app to help its borrowers assess the potential for improvement and offers higher Loan to Values for high efficiency portfolios as well as cheaper money for efficiency improvements. They see this as a) good business and b) reducing the risk of stranded assets as the Minimum Energy Efficiency Standards in the Netherlands progressively tighten.
Another important European initiative is the European Energy Efficient Mortgages Plan which is backed by the European Mortgage Federation, the European Covered Bonds Council and Horizon 2020. It is developing a standard energy efficiency mortgage for Europe. This is a challenge but will enable scaling which ultimately will allow refinancing through issuing green bonds, an asset class that is much in demand by institutional investors.
Finally I want to talk about creating a level playing field and a real market for energy efficiency. The market for energy is clear and functional, like all markets it is based on standard units, known risks, standardised contracts and liquidity. We often talk about the market for energy efficiency but I can tell you categorically there isn’t one – there are only markets for stuff like boilers or insulation. I can call an energy broker or sit at a Bloomberg terminal and buy some energy in the energy market but I can’t buy energy efficiency. That is a major barrier.
Now, with the advent of smart meters, cloud computing and big data we are starting to see the emergence of tools and regulatory systems that can create a real market for energy efficiency. In California now, and increasingly in other states, utility regulators are introducing metered efficiency and ‘pay for performance’ models where payments are based on actual metered results and not just on the basis of installing a piece of kit. We are now working with OpenEE, the pioneer of this approach, to bring it to the UK and Europe. We believe that it has the potential to transform the energy efficiency world by making efficiency a reliable, contractable, distributed energy resource that utilities can rely upon and easily invest in.
So, finally, looking to the future, I see that we are moving:
from justifying energy efficiency on cost savings alone to justifying energy efficiency on the basis of its strategic non-energy benefits
from a world where energy efficiency was considered to be “no risk” to a world where we understand the real risks of efficiency projects
from a situation where basically efficiency is a pain to utilities to one in which it is a reliable, contractable distributed energy resource
from a world where it is hard to invest in energy efficiency to one where it is easy to invest in
from a global annual investment in energy efficiency of c.$250 billion to more than $1 billion a year.