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…….