Some thoughts from ACEEE Finance Forum in Washington DC, 12th-13th May 2014

For the third year running I attended the American Council for an Energy Efficient Economy’s Finance Forum (ACEEE FF) which is the leading conference on financing energy efficiency. It is a great place to get up to speed on the latest developments in the rapidly changing US market for efficiency finance and this year I chaired an international panel to bring a wider global perspective. The following are some thoughts inspired by the event.

Firstly it is clear that 2014 is an inflection point in energy efficiency finance and as Marshall Salant of Citi said in the opening session the ratio of deals to conferences is finally getting better. This year we have seen several landmark transactions including the securitisation of WHEEL (Warehouse for Energy Efficiency Loans) residential energy efficiency loans and $100 m funds for Joule assets and Kilowatt Financial. It now seems that until recently the challenge was bringing finance to the market but now it seems that the real problem may be creating sufficient demand to utilise the available finance. I have been saying for a long while that to massively expand the energy efficiency market and start to take up the massive potential we know exists, we need to scale up demand for energy efficiency goods and services, expand the supply of energy efficient goods and services, and expand the supply of finance flowing into energy efficiency from all sources, both internal money (I.e. Internal to the host organisation with the efficiency opportunity) and third party money. The provision of finance alone is insufficient to solve the problem. The analogy is that the fact that car manufacturers offer easy to arrange and often very cheap finance does not make people want to buy a car, we want to buy a car because we need a car to go work or whatever, or we lust after a particular car because we like the brand or in some hard to define way it meets some basic desire we have. The fact that finance does not mean people want to buy energy efficiency is reflected by the fact that several specialised funds that have been established in the UK and elsewhere are having trouble deploying money.

So an important issue is how to increase demand for energy efficiency. This requires a real understanding of markets and market segments. As one speaker at ACEEE FF said, the energy efficiency industry has always been woefully bad at marketing i.e. really understanding market segments and how purchase decisions are made. To build energy efficiency demand we need to really understand market segments, and that means segments way below the normal, residential, commercial, public sector split that most energy efficiency presentations talk about. Within each segment we need to really understand decision points and when interventions can be made. For instance there is little or no point trying to sell a major commercial building retrofit at any other point in the building life cycle than the point of major refurbishment. Property owners are extremely unlikely to undertake energy efficiency retrofits at any other point and so we need to focus on making sure these opportunities are maximised which requires capacity building in clients as well as property managers and architects and engineers. These critical decision points can also be influenced of course by regulation, if major refurbishments have to meet certain energy performance standards it will help drive demand but alongside regulation capacity building is needed. Likewise in the domestic/residential sector we need to understand and influence moments of intervention such as re-roofing or boiler/HVAC replacements in order to maximise the uptake of opportunities for improving energy efficiency.

Anyone contemplating design of energy efficiency finance programmes has to address demand and not just the supply of finance.

For several years people have talked about the bond market and securitisation for energy efficiency loans. With the first WHEEL deal we have now moved from theory to initial practice. There is, however, an awful long way to go before securitisation of energy efficiency loans is normal. Jack Bernard of Renewable Finance, who has had a long career in securitisation, forcefully made the point that the industry has to recognise the requirements of the securitisation industry and make products that look like products that serve other markets like auto loans or credit cards. An interesting emerging securitisation market, worth some $5 billion in 2014, is the single family home rental market. This is now growing but faces some of the same data issues as energy efficiency, the market just does not have the years of loan performance data that other markets have. In the US market there is some 150 years of loan performance data and auto loans have been offered for nearly 100 years and so there is a lot of data covering the full range of economic cycles.

Securitisation clearly needs standardisation and that is where initiatives such as the Investor Confidence Project (www.eeperformance.org) come in. The Investor Confidence Project is a US initiative of the Environmental Defense Fund and we are now close to launching a European version. It has developed a number of protocols which cover the development and documentation of energy efficiency projects in different types of buildings. Standardising processes and documentation will improve investor confidence in the performance of projects and reduce transaction costs. The ICP is increasingly being specified by large energy efficiency programmes such as the Texas PACE programme and a growing number of investors and insurers.

So, we now seem to be at the initial stages of solving the finance problems. The shortage now seems to be the ability to develop large scale, multi-premise, energy efficiency programmes that are standardised and designed to take advantage of the available finance.

For a while I have been thinking and talking about the need to change the language around energy efficiency because the old language that we grew up with isn’t working well. If it was working we wouldn’t have “low hanging fruit” and huge untapped potential for cost effective investment in energy efficiency. We wouldn’t be hearing the same old objections to energy efficiency we have been hearing for more than 30 years like, “energy efficiency doesn’t work”, “you can’t measure the results” and “it is not strategic” etc etc.

At the recent workshop I attended at KAPSARC (King Abdullah’s Petroleum Studies and Research Center ) one of the participants made an excellent point about changing the language of energy security. As he pointed out we don’t actually want energy we want services like comfort, light etc and therefore we should not talk about ensuring energy security but rather ensuring the security of the services that energy provides. This comment was “a light bulb moment” for me, not about energy services of course – this has long been a given – but about the potential effects of changing the language around energy security.

Think about it – if you say “energy security” you immediately think about how do we physically secure the physical flow of energy commodities – usually oil, gas, LNG or coal. That takes you into trade deals, (there is nothing wrong with trade of course but let’s face it – some energy deals have had a heavy moral price), strategic investments in pipelines and other infrastructure to gain preferential treatment, potentially having to outbid the competition for energy supplies, and of course ultimately military force projection starting with the question all US Presidents supposedly ask whenever there is a crisis, “where are the aircraft carriers?”, to all out invasions and occupations. Historically and to this day much overt military force and of course lots of covert military and espionage work is dedicated to causes related to securing energy supplies.

So how does this change with changing the language to one around securing energy services? First of all it makes you focus closer to home (literally) – the services are needed/consumed here – not in some remote place where we get physical energy supplies from. Next it pushes you towards a strategy in which you look at how to reduce the energy you need to use to deliver the services – energy efficiency gets elevated as a way of securing supply of comfort in people’s homes. Ensuring security of energy services – for example comfort in people’s homes – becomes less about doing deals to buy gas from Russia or elsewhere, or making sure the Straits of Hormuz stay open to ensure the flow of oil, and more about making sure we have as many near zero energy consuming households through super insulating new homes and retrofitting old ones.

So here is an idea – next time someone talks about “energy security” just say “we should not be interested in energy security – only in the security of the services that energy is used to supply”. Then start a conversation about the true cost of “securing energy” as opposed to “securing energy services”. Putting aside the non-financial costs and as a starter on the financial equation the US spent $6.8 trillion between 1976 and 2007 on military force projection in the Persian Gulf[1], an average of $323 billion per annum. Given c.17 million barrels of oil a day go through the Straits of Hormuz[2] this represents a cost of c.$50 per barrel of oil – and only about 10%[3] of this goes to the US so for the US the cost of oil is c.$500 per barrel – on top of the actual price of just over $100 per barrel. Of course that only counts the US contribution and does not count the considerable expenditure in the Persian Gulf by the UK and many other countries.

Of course we could not reduce expenditure on keeping the Straits of Hormuz open to zero even if we didn’t need the oil – which I think we always will if only for petrochemicals – free trade and the idea of free passage on the high seas should be defended as a general principle otherwise the pirates and the terrorists will take over and that is not good for anyone.

[1] Stern, R.J. United States cost of military force projection in the Persian Gulf, 1976–2007.

[2] Energy Information Administration. World oil transit choke points.

[3] Energy Information Administration. U.S. Imports from Persian Gulf Countries of Crude Oil and Petroleum Products.

The retrofit of the Empire State Building (ESB) a few years back deservedly got a lot of publicity and helped put energy efficiency on the agenda for commercial property owners – at least in the US.  Once completed in all tenant spaces savings are projected to be 38%.  The measured savings have exceeded the targets in the first two years.  The savings were 5% higher than the target level in year 1 and 4% higher in year 2.  The ESB is a brilliant case study of what is possible using state-of-the-art retrofit practice and is now widely referred to.  Some commentators, however, seem to miss the real lessons of the ESB project.  Based on my readings of the project and talking directly to some of the participants these are my take-aways.

Timing

The ESB project was part of a much larger $500m refurbishment designed to bring the ESB into the 21^st century, reduce voids and increase rentals.  This is an important point, the best time to do deep energy retrofits is during a major refurbishment.  Expecting building owners to do them at any other time is simply unrealistic.  Therefore we need to ensure that these opportunities to improve energy (and water) performance are not missed and at that point integrated design techniques are applied.  Policies need to be put in place to ensure that the highest energy performance standards apply to major refurbishments as well as new buildings.  Right now buildings are being refurbished and major opportunities to do deep retrofits are being missed – locking in excessively high energy consumption and costs for at least the next twenty years until the next major refurbishment.

Energy efficiency can improve yields but it is only one factor

The effect of the energy efficiency projects in the ESB means that tenants have electricity bills about half of those in unimproved buildings.  This has a definite effect on the attractiveness of the office space but at the end of the day other features such as location, design, the overall fit with the organisation’s needs and ultimately price are likely to be bigger drivers on a  relocation decision.  The real driver of improved yields at the ESB was that the office space, which had been dated, was brought into line with the needs of 21^st century clients.

The need for holistic or integrated design. 

The ESB retrofit is a great case study of how to implement integrated design and the great benefits that come from applying it.  Integrated design gets us away from the argument “efficiency costs more” – in many cases it can cost the same or less when integrated design is applied properly.  Integrated design has been promoted by Eng Lock Lee in Singapore, the Rocky Mountain Institute (RMI) and others for many years now but the uptake remains low – at least in the UK – despite the proven benefits of reduced energy usage and often reduced capex.   We need to promote the use of integrated design and step-up training amongst engineers and architects as well as clients.  Supply of integrated design solutions would be improved if more building owners demanded it.  In the case of the ESB it was lucky that Tony Malkin, the owner, was an informed and determined client.  Original proposals for the refurbishment did not include integrated design and Tony made it very clear that if vendors and contractors wanted to be on the job they had to do it this way or they would be shown the door.  We need more clients who know enough to do this.

The power of leadership and open source information

Tony Malkin is a committed environmentalist but he also insists on a three year payback period on any investment.  The use of integrated design and techniques such as remanufacturing the windows on-site meant that the additional capital required for energy efficiency, (net after all additions and subtractions of $13m on top of an original $93m for energy related work), had a three year payback.  One of the great things about the ESB project is that all the other New York City property owners know that Tony Malkin insists on a three year payback – this gave the project great credibility and helped lead to other owners starting similar projects on their buildings.  Tony also insisted on the project being “open source” and all the contracts and M&V reports are available on-line.   He has also spoken widely about the project.  As a result of this leadership and the work of RMI and the other companies involved there are now many other similar integrated design retrofit projects now being worked on.

The importance of Measurement and Verification (M&V). 

M&V was built into the process right at the beginning and independent M&V professional report on the savings – calculated using techniques under the International Performance Measurement & Verification Protocol (IPMVP).

Look at all the costs.

When looking at energy costs it is important to look at all the costs associated with energy usage.  This includes electricity and fuel costs, capex of energy using equipment, operations & maintenance costs and any other associated costs e.g. energy taxes etc.  Only a full consideration of all the costs can give the building owner (or an external investor) an accurate investment analysis.

EPC does not need to be externally funded

The ESB often comes up in discussions of energy performance contracts (EPC) in the commercial building sector.  The work was undertaken under an EPC but entirely financed by the owner.  It does raise the prospect of an externally financed energy retrofit using the same kind of techniques.  Integrating external financing into the financing needed for the building itself or a major refurbishment can be challenging but is certainly possible.  By adopting more integrated design techniques EPC contractors can differentiate themselves and make externally financed solutions more attractive than they often are now.

So to sum up, the lessons of the ESB for building owners are:

•  use the opportunity of major refurbishments to implement deep energy retrofits and don’t just accept “business as usual” solutions

• use integrated design – it can reduce capex as well as energy costs
• count all the costs including energy, maintenance and capex in evaluating alternatives
• use independent M&V to prove results and manage contractors.

For policy makers:

• work with the design professions and building owners to improve capacity in integrated design – both on the supply and demand sides

• enact policies (building regulations) to ensure that the opportunities for deep retrofits presented by major refurbishments are not missed.

I saw an interesting guest blog on Steve Blank’s blog by Henry Chesbrough who developed the idea of Open Innovation which is relevant to the discussion of innovation in the energy sector.  It was comparing start-ups to established companies and defined the difference like this:

• A startup is a temporary organization in search of a repeatable, scalable business model.
• A corporation is a permanent organization designed to execute a repeatable, scalable business model.

This is simple but profound realisation, and understanding it is critical to success in corporate venturing and creating new products and services within existing companies.  “The processes that companies have optimized for execution inevitably interfere with the search processes needed to discover a new business model”.   Although existing corporations have far more resources than startups this conflict can severely hamper them those very resources can become liabilities in searching for new ventures.  A corporate venture effectively has to fight two wars; one in the external market, and internally against the parent company.  This is something that those of us who have been in that situation definitely recognize.  It is a major issue for energy companies trying to innovate new products, services and business models.  It drives you to the conclusion that any corporation that really wants disruptive innovation has to either explicitly encourage and reward it in the culture, as 3M has successfully done for decades, or if that is not appropriate (and for many companies it won’t be) you have to separate people and resources entirely in the manner of a Lockheed Skunk Works^®.

Given the massive economic and political disruption going on in the energy markets that threatens the very existence of the incumbent suppliers, if I was an energy company CEO I would be setting up a skunk works with the objective of coming up with a repeatable, scalable business model that will disrupt the traditional energy supply model.   If the big suppliers don’t do it someone else will (or is already).

A few days after I published my blog on innovation warning about the dangers of technology hype and a lack of understanding of the realities of the innovation process, particularly in the energy sector, the Independent on Sunday provided a perfect example.  Across the bottom of the front page the headline said (screamed?) “Exclusive: Renewable energy from rivers and lakes could replace gas in homes“ and the article started by saying “millions of homes across the UK could be heated using a carbon-free technology that draws energy from rivers and lakes in a revolutionary system that could reduce household bills by 20 per cent”.  The whole of page 4 was devoted to reporting on this “magic” “new” technology that takes heat out of rivers and lakes and turns it into heat for use in heating buildings.  The Secretary of State Ed Davey was quoted as saying it was “game changing” and it reported that he has asked officials at DECC “to draw up a nationwide map showing where renewable heat can be drawn from water to explore the potential of heat pumps”. If you read the piece with no prior knowledge you would have thought that this technology would soon be everywhere providing cheap, low carbon heat.

Here are a few facts to consider:

• Using heat pumps to take low grade heat out of rivers and turn it into higher grade (higher temperature) heat is not new.  (To be fair the article did acknowledge this). The Royal Festival Hall on London’s South Bank had a heat pump installed to use the heat in the Thames in 1951 (subsequently removed I believe).
• The main advantage of the Mitsubishi technology referred to in the article seems to be the relatively high output temperature of 45^oC.  Higher temperatures are usually better but heat pump efficiency goes down as output temperature goes up.  (See below for the real innovation in the system).
• A traditional wet heating system using radiators operated with flow temperatures of c.75-80^oC but modern systems in well insulated houses can operate at 50-55^oC.  Large surface area low temperature heating systems such as under-floor heating operate at c.30-60^oC but the majority of houses don’t have this (unless the sample of houses is from Grand Designs!
• The real innovation in the Mitsubishi system referred to seems to be dynamic control of flow temperature rather than the heat pump itself.
• The combination of having to build coils in water plus use of low temperature heating systems means this kind of system is likely to be confined to new build and will make it expensive (but not impossible of course) for retrofitting existing buildings.
• Fouling of river coils can be a long-term issue that affects performance and hence costs.
• Performance of heat pumps is measured by Coefficient of performance or COP.  COP is defined as the total energy out (heat) divided by the electrical energy input.  Heat pumps always sound neat because COPs are typically three to five, meaning you get three to five times more energy out than you put in.  As output temperature goes up COP goes down.
• The total system efficiency is lower than the COP as it takes into account the delivered heat (less than total heat generated) and electricity supplied to circulation pumps and any additional electric heating required.  An Energy Savings Trust (EST) report on the Mitsubishi web site reported on measured results in 23 heat pump sites between October 2011 and March 2012.  The average system efficiency reported was 2.91 with a standard deviation of 0.37.

A few critical questions:

• How much does it cost (capital, Operations & Maintenance and running cost) and how much does it save compared to conventional systems?  There was absolutely no mention of cost in the Independent on Sunday article.  The EST report quoted above found in the 23 sites studied that the estimated annual operating cost savings were 8%.  (These installations may not have been the new system so savings on the new system could be higher).  The Mitsubishi web site claims savings of 20% savings compared to conventional radiator systems but does not mention capital costs – either total or marginal compared to a conventional system.
• Why is the Secretary of State making such a song and dance about this particular technology and this particular solution provider?  Perhaps the Secretary of State is just desperate to show green credentials in the wake of recent pro-nuclear and pro-shale gas decisions he was forced to take?  Or was it just to push the Renewable Heat Incentive (RHI) which applies to heat pumps even if they use grid electricity which is currently 67% driven by gas and coal (source: Digest of UK Energy Statistics).
• How many houses and buildings in the UK are close enough to rivers and lakes to benefit from this kind of system? (Hopefully to be answered by the DECC study).

I have always been puzzled by the DECC Chief Scientist’s (and consequently DECC’s) apparent obsession with heat pumps.  Replacing gas boilers with heat pumps theoretically makes sense if you are seeking to minimise carbon and you assume a switch to low carbon electricity.  Based on the belief that heat pumps were a good idea and that millions of households (a target of 4.5 million covering both water and air source heat pumps) would somehow switch to heat pumps from gas boilers, along with equally aggressive assumptions about the rate of adoption of electric vehicles led to an analysis that showed electricity demand growing significantly.  This whole analysis always struck me as a neat theoretical set of calculations without much real engineering, economic or market reality and yet it was a major driver for the Electricity Market Reform (EMR).  As opposed to growth in electricity demand there is increasing evidence that we may well find ourselves in a world where more efficient lights and appliances result in stable or even declining electricity use.

It seems extremely unlikely to me that water source heat pumps will be the solution to the UK energy problems of cost and security that the Independent on Sunday seems to think.  This critique is not aimed at the technology per se or the particular solution provider or project developer – more the lack of analysis and quality of reporting on innovation.  There will be some circumstances where water source and air source heat pumps may make good sense for some new buildings but they are unlikely to solve the massive problems of a grossly inefficient building stock and fuel poverty.

To sum up when looking at articles like this remember:

• the stages of the hype cycle
• there isn’t a single technology solution to our energy problems
• the viability of technologies is usually very site specific
• adoption of technology is usually driven by real cost saving and/or regulation and not by hope
• answers promoted by politicians – especially before any serious analysis has been done – should be treated with a large pinch of salt.