Common Tragedies

Thoughts on Environmental Economics

Free money or high discount rates?

Posted by Rich Sweeney on January 18, 2008

A few months ago McKinsey released a study which calculated the costs of cutting GHG emissions in the US. One of the more interesting results of the consulting firm’s analysis was the large amount of savings from energy efficiency compared to modelers at PNL, MIT, and EPRI. That’s because McKinsey used a bottom up approach to develop its efficiency supply curves, as opposed to the top down approach of teasing out information from consumer purchase decisions. Put another way, McKinsey calculated efficiency supply curves in which the price is equal to the present discounted costs of energy efficient technologies above and beyond their inefficient counterparts. The result, is a graph that implies there’s a lot of free money lying around out there.

Everything below the x-axis represents a good with negative marginal costs. Now we’ve talked a lot about energy efficiency on CT lately, and I don’t want to repeat what I’ve said before. However, it is useful to think about why this estimate, and the dozens others like it, may be incomplete. As I see it there are three possible explanations for why negative marginal costs can persist:

1. People hate money.

2. There are additional/ hidden costs that aren’t being accounted for. And I’m not even talking about oversight or accounting errors on McKinsey’s part. Assuming that they considered all the actual “costs”, it’s possible that the price disparities between the efficient and inefficient goods reflect qualitative differences. One of the best examples of this is the perceived difference in light quality between incandescent light bulbs and cfls (for the record, i can’t tell/ don’t mind the difference).

3. Consumers have higher discount rates than studies like McKinsey accounted for. Most energy efficient goods have higher up front costs but lower future costs. If studies like McKinsey’s are identifying obvious positive npv opportunities but consumers aren’t taking advantage of them, it’s possible that McKinsey has overvalued the present value of future cash flows.

The more you buy into these two possible explanations, the higher up the low hanging energy efficiency fruit appears be (To continue with the whole “no free lunch” theme).

*Thanks to Anthony Paul for discussing this stuff with me. And Erica, you know you want to add something to this conversation…….

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3 Responses to “Free money or high discount rates?”

  1. Daniel Hall said

    My impression was that the study doesn’t account for transaction costs. Surely these would be as important as the reasons you cite for some types of persistent negative marginal cost goods.

  2. Tmoney said

    I think the answer is definitely not 1, and probably an even mix of 2 & 3.

    My favorite example of a technology like this is the ground source heat pump for heating, cooling, and hot water generation (see here). This is a product that, if financed at competitive rates, reduces your heating and cooling costs by more than your loan payment. For the non-engineers out there (including me), a geothermal heat pump is a system which heats your home/water by extracting heat from the earth 20-200 feet underground, and which cools by bringing up cooled fluids from that same earth. Ground source heat pump systems work because there is almost always a temperature differential between the earth (where the temperature is relatively constant) and the surface air.

    For some reason, heat pumps haven’t really caught on. They are installed in very few new construction homes (where it would make sense for a builder to include them – since your customers can buy them because pay for themselves, you have no incentive not to make them standard because they tend to cost more than traditional HVAC systems, thus increasing the price of the home you get to sell), and I don’t believe owners of existing housing have a big appetite for them in the remodeling process, despite the fact that they are a “free” upgrade.

    While I doubt anyone has looked into this empirically, reasons 2 and 3 above make the most sense in explaining this phenomenon. As far as information costs go, almost everyone knows that heat comes from burning stuff (oil/natgas/wood) and resistant stuff (heating coils on a stove and toasters), but very few people I know (aside from engineers and hippies) have even heard of a heat pump. This is a marketing problem, though not necessarily an easy one.

    As far as quality goes, the DOE reports no qualitative differences in the heating and cooling experience of ground source heat pump users. There might be a hidden quality issue though – none of my neighbors have a heat pump, therefore there must be something wrong with heat pumps.

    Discount rates could play a big factor here, even in the face of self-financing systems. The stigma of taking on a loan to upgrade your house in an “invisible” way might be too great. Even if your financing is free, the uncertainty from information costs might be too high for uneducated individuals to demand a heat pump.

    Related to the discount rate issue is the question of risk. One thing the DOE and others have failed to account for is the (unlikely) possibility that heating fuel costs will actually go down – if a homeowner bought a ground source heat pump system and natural gas prices subsequently dropped for the next 10 years, installing the heat pump would have proved to be a more expensive decision than following the status quo.

    That said, I think all of these issues have market solutions. Marketing issues are marketing issues – if someone really wanted to sell a heat pump, there are probably ways to move product, even temporarily. A big enough temporary marketing effort might have lasting consequences due to information costs mentioned above. As far as financial risk, that’s what futures markets are for. Its easy to envision a heat pump seller buying a bunch of long-term natural gas futures or options and agreeing to share the profits from those derivative positions with his or her heat pump customers if natural gas prices increased.

    Anyone with venture capital money looking for details on the above idea is should feel free to contact me – Rich knows how :)

  3. Zoneaire said

    I dont think people hate money, people are obsessed with money, thats the problem

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