Energy efficiency investment in Australia - data.daff.gov.audata.daff.gov.au/data/warehouse/pe_abarebrs99000570/PR11751.pdf · The authors would like to acknowledge Tony Marker and

Energy efficiency investment in Australia

Energy efficiency investment in AustraliaAuthors

Jane HarrisJane AndersonWalter Shafron

ABARE RESEARCHREPORT98.2

© Commonwealth of Australia 1998

This work is copyright. The Copyright Act 1968 permits fair dealing forstudy, research, news reporting, criticism or review. Selected passages,tables or diagrams may be reproduced for such purposes providedacknowledgment of the source is included. Major extracts or the entiredocument may not be reproduced by any process without the writtenpermission of the Executive Director, ABARE.

ISSN 1037-8286ISBN 0 642 26624 7

Harris, J., Anderson, J. and Shafron, W. 1998, Energy Efficiency Investmentin Australia, ABARE Research Report 98.2, Canberra.

Australian Bureau of Agricultural and Resource EconomicsGPO Box 1563 Canberra 2601

Telephone +61 2 6272 2000 Facsimile +61 2 6272 2001Internet www.abare.gov.au

ABARE is a professionally independent government economic researchagency.

ABARE project 1480

Foreword

With the recent focus on the environmental costs associated with energy use,the efficiency with which firms use energy has come under the spotlight. Acommon observation is that not all economic opportunities to improveenergy efficiency are taken up by firms — behavior which would appearirrational. The Commonwealth government’s Enterprise Energy AuditProgram (EEAP), which operated between 1991 and 1997, was designed toprovide information to firms about opportunities to improve energyefficiency, and address this issue of incomplete takeup.

Understanding the behavior of firms when they make energy related in-vestments is an important element in formulating policies to improve theefficiency of energy use. ABARE conducted a major survey of firms whichparticipated in the Enterprise Energy Audit Program, to establish whatfactors influence the energy investment decisions of firms, and also toinvestigate the extent of incomplete uptake.

This report was commissioned by the Commonwealth Department ofPrimary Industries and Energy, and follows on from a series of consultancyreports in which ABARE evaluated aspects of the Enterprise Energy Auditprogram.

BRIAN S. FISHER

Executive Director

May 1998

iiiEnergy efficiency investment in Australia

Acknowledgments

The authors would like to acknowledge Tony Marker and Jill McCarthy fromthe Department of Primary Industries and Energy for support throughout theproject. Many thanks go to ABARE colleagues Tom Waring, Roger Roseand Lindsay Hogan for help with thinking it through; to Ray Lindsay andShona Lambert for analytical support; and to Jane Melanie, Mike Hinchyand Vernon Topp for valuable referee comments and suggestions.

Information gained from the EEAP follow-up survey was very important tothis report, and the cooperation of firms who participated in the survey isalso gratefully acknowledged.

iv ABARE research report 98.2

Contents

Summary 1

1. Introduction 9

2. Background 16History of EEAP and evolution of current study 16Literature review 18Strand 1: market failure and market barriers 18Strand 2: ‘new’ theories 24

3. Research method 32Sample selection 32Conducting the survey 33Survey contents 34

4. Results 38Answers to survey questions 38Evaluation of EEAP 50

5. Discussion and policy implications 54Implementation of EEP recommendations 54Why are audits successful? 56Future policy directions 57

6. Concluding comments 60

AppendixesA Overview of EEAP data 61B Reliability of estimates 64C Rules for evaluating investments 66

References 68

vEnergy efficiency investment in Australia

BoxesKey findings of the survey 41. No regrets? 102. Case studies 123. Payback period: why are they short? 274. General information questions 355. Decision rule questions 366. Sources of risk questions 37

FiguresA Tenancy arrangements 39B Rules used in evaluating possible investments 39C Environmental considerations important in decision making 41D Firms’ general attitude to risk when investing in energy

efficiency 41E Percentage of firms receiving specific recommendations 42F Recommendations and implementations 44

Tables1 Average population values derived from the sample 382 Rules used in evaluating possible investments 403 Environmental considerations important in decision making 414 Firms’ general attitude to risk when investing in energy

efficiency 415 Percentage of firms receiving specific recommendations 426 Attributes of recommendations and implementations 437 Rating of risk in decision not to implement a specific

recommendation 458 Rating of risk by firms implementing all recommendations 469 Firms not implementing a specific recommendation 47

10 Division of firms among attribute classes and scale ofimplementation 48

11 Average total net present value of the program for audited firms 51

12 Total net present value for audited firms, by different interest rates and time periods 51

vi ABARE research report 98.2

13 Median per firm results 6114 Average per firm results 6115 Total potential annual savings 62

viiEnergy efficiency investment in Australia

Summary

Energy efficiencyEconomic efficiency is the optimal goal for an economy. Energy efficiencyis an often stated goal of governments, because the costs associated with theconsumption of energy are not always confined to the users. At present, amajor focus is on the costs, or externalities, associated with energy use.

The goal of increasing energy efficiency is often pursued by governmentsby making information publicly available. There is evidence that this is themost efficient general method but little is known about the cost effectivenessof specific alternative policies. Making information publicly available isoften tied to the commonly held view that there are economic opportunitiesto improve energy efficiency which have not yet been taken up by firms.Such opportunities are often termed ‘no regrets’.

Efficiency gapIn the academic literature, the slow diffusion of apparently cost effectivetechnologies to improve energy efficiency has been termed the ‘efficiencygap’ or the ‘energy paradox’. Many researchers have investigated this issueand put forward hypotheses to explain it. A review of the literature highlightsa complex and varied set of arguments, and a distinct lack of consensus todate, even on some basic theoretical principles. Previous work by ABAREon the issue of domestic energy market failure highlighted the need for morework directed to researching the cost effectiveness of existing and alternativepolicies.

Enterprise Energy Audit ProgramOne policy designed to provide information to firms was the Commonwealthgovernment’s Enterprise Energy Audit Program (EEAP) which operatedbetween 1991 and 1997 and was run by the Department of Primary Industriesand Energy. Under EEAP, firms were provided with a subsidy to undertakean audit of their operations, and recommendations were made to firms aboutways in which energy efficiency could be improved. The subsidy was 50 percent of the cost of the audit, up to a maximum of $5000. Approximately 1200

1Energy efficiency investment in Australia

firms participated in EEAP over the six years that it ran. The audit reportswere typically large documents containing many detailed recommendationson all aspects of a firm’s energy use.

ABARE’s analysis of the programABARE analysed the data generated by EEAP, on a consultancy basis,during the time the program ran. During the course of the ABARE analysisit became clear that little was known about the extent to which EEAPrecommendations had been implemented, and the ways in which firms hadmade their investment decisions. This reflected the ambiguous wording inthe follow-up questionnaire — 60 per cent of the limited number of firmswho actually responded to this questionnaire reported that they had notimplemented ‘some or all’ of their recommendations. ‘Some or all’ couldhave meant two out of ten or nine out of ten of the recommendations hadnot been implemented, for example.

Despite the lack of information on the extent of the nonimplementationproblem it was generally believed that significant numbers of EEAPrecommendations were not implemented. For example, in a 1996 report theProductivity Commission commented that ‘when firms say they reject“some” recommendations it could still mean that most recommendations areimplemented. But the conventional wisdom is to the contrary — “auditreports gather dust’’’.

It was decided that ABARE could contribute to the debate on the ‘efficiencygap’, and make suggestions for future policy directions, by undertaking amajor survey of EEAP participants. More specifically, ABARE investigatedthe hypothesis that among Australian firms there are low levels of uptake ofapparently sound economic recommendations to improve energy efficiency.The first question is whether recommendations are in fact ignored. Then,for recommendations which are not taken up, the second question is why.As noted above, there are many hypotheses about why the ‘efficiency gap’exists, if it does, but there is no general consensus on which hypotheses areimportant and how they fit together.

It should be noted that ABARE’s research is confined to investigatingalternative policies for the public provision of information. In a 1991 reportby ABARE it was concluded that, subject to the condition of cost effective-ness, it is desirable to proceed as far as possible with the public provision ofinformation. This is because governments have insufficient information to

2 ABARE research report 98.2

ensure that other policy instruments, such as mandatory efficiency standards,or taxes and subsidies, would be set correctly.

Policy environmentIt is recognised, however, that governments might wish to adopt other policyinstruments aimed at increasing energy efficiency in the current environmentwhere attention is focused on reducing greenhouse gas emissions. Suchpolicies might be part of an overall package but it is not within the scope ofthis study to discuss the optimal nature of such a package.

One important area of policy change at present is electricity supply industryreform, which is designed to promote competition among generators andretailers. State owned transmission grids are subject to regulation to ensurethat pricing arrangements are transparent and cost reflective, and to providenondiscriminatory access to the network. The levels of energy pricesobviously alter incentives to invest in energy efficiency and this issue hasbeen addressed by several authors.

ABARE’s energy audit surveyA representative sample of firms which had taken part in EEAP wassurveyed by telephone in mid-1997 by trained ABARE staff. Eachparticipant was asked detailed questions about the nature of the firm,attitudes to risk and the environment, rules used in decision making, thetypes of audit recommendations made to the firm and whether or not theserecommendations were implemented and why. The questions in the surveywere formulated after reviewing the extensive literature on the issue of theenergy efficiency gap. On completion of the survey, the results wereanalysed and presented along with estimates of their reliability. The keyfindings of the survey are presented in the following boxed section.

Implications of the analysisThe results of the survey and the review of the literature on the ‘efficiencygap’ led to the following main points.

The rate of implementation of EEAP recommendations was much higherthan was perhaps expected. A simplistic interpretation of this result is thatit shows that there are many undiscovered ‘no regrets’ opportunities. But analternative interpretation, which takes into account the entire range of results


Key findings of the survey

■ On average each firm employed just under 300 people, spent $7000 onan EEAP audit, and spent about $400 000 a year on energy, which rep-resented about 4 per cent of its operating costs.

■ 76 per cent of firms owned and occupied the entire building on whichthe energy audit was performed.

■ 74 per cent of firms believe that environmental considerations areimportant in decision making. This result agrees with findings from asurvey of environmental management in New South Wales industry bythe New South Wales Environment Protection Authority.

■ 58 per cent of firms are conservative when investing in energyefficiency, 26 per cent are risk neutral and only 17 per cent regardthemselves as risk takers.

■ 73 per cent of firms received at least one recommendation related tolighting, by far the most common category.

■ On average each firm received 5.8 recommendations and implemented4.7 of them, giving an implementation rate of 81 per cent.

■ There is some evidence that implementation rates fall as the costs ofinvestments rise. There is also some evidence that larger firms havelower rates of implementation of EEAP recommendations.

■ Various sources of risk are important to firms when they make energyefficiency investment decisions. Four sources of risk were identified andeach was seen as important or very important by 70 per cent or more ofrespondents. These sources included changing information, adjustmentcosts before and after installation and costs associated with breakdown,maintenance and repair.

■ The importance of risk suggests that ‘no regrets’ claims might be exag-gerated if risk is not properly taken into account when investment oppor-tunities are evaluated. It also suggests that investment rules which takebetter account of risk should be used.

■ Point estimates of expected net present value indicate choices that wouldbe socially optimal in the presence of complete markets for risk. Inpractice, markets for risk are far from complete. When the ability ofindividual firms to pool risk is limited, measures that account for risk may


give a better picture of what is achievable than will expected net presentvalue. Assessing what are ‘no regrets’ options on the basis of expectednet present values is likely to exaggerate the investment that will occur.

■ Economic factors such as insufficient rate of return and too long apayback period are the most important reasons cited for not imple-menting recommendations, as distinct from other reasons which are saidto be important.

■ Other relatively important reasons for nonimplementation of recom-mendations include energy efficiency being overlooked within firms,the irreversible nature of energy efficiency investments and the fact thatit can be unclear how to implement an investment.

■ There is some evidence that ‘hurdle rates’ (the rates of return thatrespondents said would have been necessary for recommendations thatwere not implemented to have gone ahead) averaged more than 20 percent. However, further research would be necessary to confirm thisfinding because of the limited number and wide range of responses.

■ 93 per cent of firms thought the EEAP audit had been worthwhile.

■ The opinion of firms about EEAP being worthwhile is supported byanalysis of the cost effectiveness of EEAP for a range of discount ratesand investment lives (which had to be assumed because the actual levelswere not known by ABARE). For an 8 per cent discount rate and fiveyear investment life, firms were estimated to save, on average, 8 percent of their original energy bill each year from implementing energysaving recommendations. The magnitude of this result is consistent withresults from larger overseas studies.

■ The total net present value of EEAP to the population of firms whichtook part in it was $189 million, assuming an 8 per cent discount rateand five year investment life. The costs to the government of admin-istering EEAP averaged $165 000 a year, giving a total cost of about$1 million for the six years that the program ran. This, combined withthe audit costs of $8.7 million, of which the government funded half,indicates that EEAP was a cost effective policy.

■ According to positive comments about the program, participation inEEAP led to increased awareness of energy efficiency within the firmand acted as a ‘springboard’ for further actions. The most commonnegative comment was that auditors failed to understand the way thefirm operated.


which the study has provided, is that investment in energy efficiency iscomplex. There are many factors which determine a firm’s decision to investor not, and it is unlikely that the solution is as simple as saying, effectively,that firms are naive or irrational.

Audits appear to be an efficient and effective means of addressing thecomplexity of energy efficiency investment. This is because the process thata firm goes through to have an audit done encompasses and addresses all ormany of the factors which influence an energy efficiency investmentdecision, especially the information problems. Far from implying that firmsare unaware of energy efficiency opportunities, and are ignoring a goldmineof no regrets options, this result implies that firms are aware of thecomplexity of these opportunities and the need for them to be consideredcarefully.

An audit is a collation of a large amount of information. It represents athorough investigation of the entire enterprise as a unit, including its uniqueaspects, peculiarities and preferences. Collecting information about energyefficiency involves collecting information from various sources, sifting it,analysing it, and distributing it within the firm. There are many differentcosts associated with the information problem faced by a firm. The‘processing’ aspects of information, which also include the opportunity costsof a person’s time, are alternatively referred to as transaction costs. Thesecan be substantial and tend to create an inertia in favor of the status quo.

One investment in isolation may not fit into the overall operations of thefirm. It might be necessary to investigate how one energy efficiencyinvestment relates to others in the firm. It might be necessary to closeoperations down, or disrupt production of the entire firm to install oneimprovement. For any of these reasons the firm might decide to look at thewhole picture of energy efficiency within the enterprise.

Another reason for the high rate of implementation of audit recom-mendations is probably that firms commit to the audit process for energyefficiency. They make a decision to thoroughly investigate an activity whichis likely to be beyond ‘core business’.

The results of the survey indicate that EEAP was, in all likelihood, a costeffective policy and that EEAP audits were worthwhile to the great majorityof firms which took part. The results also provide strong evidence that auditswould have been worthwhile for the firms which took part even without the


government subsidy. It should be noted, however, that ‘hidden costs’,especially those associated with risk, are not incorporated into the evaluationtool used to analyse the program and, to the extent that these costs areimportant, the value of the program would be overstated.

The survey results might be construed as evidence of ‘market failure’ in thesense that privately profitable opportunities had not been taken up. Or itmight be that the market for energy services within Australia has not yetfully evolved. Whatever the case, there is probably a role for the governmentto foster energy efficiency in private sector activity. While it may be difficultto justify such ‘promotion’ solely in terms of the impact on energy efficiency(given that auditing seems to be privately profitable), in a broader climatechange context, energy audits might be a cost effective means of reducingemissions relative to other policy instruments. The New South WalesEnvironment Protection Authority in a recent survey of environmentalmanagement in 500 New South Wales firms found that only 17 per cent hadundertaken an ‘environmental audit or review’.

Now that the public sector has run a ‘demonstration program’ in the formof EEAP, the results could be promoted to the private sector. Promotioncould take the form of limited tax concessions or subsidies as was the casebefore. There may be a need for some system of certification for approvedauditors. Alternatively, or in addition, the government could concentrate ondistributing information on the benefits of undertaking an audit.

The essential goal is that firms pursue a systemwide view of the inter-relationships between their energy activities. This might be achieved by oneaudit alone, or a number of audits. Another way to view the audit process isas stocktaking, consolidating, sorting out, setting future plans, or appointingan expert adviser as is done for other matters.

Firms might find it profitable to have a process in place to monitor theirenergy efficiency. And, on the basis of the experience with EEAP, it is clearthat a well developed monitoring process is also needed for whatever futurepolicies are adopted. This is necessary both to ensure cost effectiveness andto avoid policy decisions being made on the basis of erroneous information.The type of survey technique used in this study provides a thoroughmonitoring device.


Additional research

The fact that 80 per cent of firms use the payback period, by far the mostpopular investment rule, illustrates the need for additional promotion ofinvestment rules which give a better idea of profitability, taking into accountrisks and uncertainties. Payback period might be a useful ‘rule of thumb’ butit does not take into account the full life of the investment, as benefits whichaccrue after the payback period are ignored, and it takes no account of thesize of an investment. Further investigation into the combination of ruleswhich firms use to make investment decisions is needed.

It would also be useful to further pursue the preliminary finding that therewere lower rates of adoption of audit recommendations by larger firms thansmaller ones. Firm size seems to be an important variable and perhapsdifferent programs and different incentives are required for firms of differentsize.

The result that audits may be privately profitable yet underprovided couldbe further examined from the viewpoint of whether or not this represents‘market failure’. That is, whether or not the market for energy efficiencyservices within Australia is constrained in any way from developing oroperating. It would be useful to examine whether certification schemes forproviders of energy services are warranted and whether these should beprivate or public schemes.

In conclusion, EEAP worked because it addressed the complexity ofinvesting in energy efficiency. However, this does not necessarily mean thatEEAP should be reinstated. Although the government subsidy served toinitiate a firm’s involvement in EEAP, the end result was usually worthwhilefor the firm. Results of analysis indicate that this would have been the caseeven without the subsidy. The main policy implication is that private activityshould be fostered and that promotion of the type of process which occurredunder EEAP might be a useful direction to pursue.


Introduction

Strictly speaking, energy efficiency should not be regarded as a goal in itselffor an economy. The optimal goal should be economic efficiency, the sortingof society’s resources (not just energy) into their most beneficial outputs andactivities. This of course assumes that this sorting will occur through a pricemechanism which itself is operating efficiently by capturing all of thebenefits and costs associated with the use of a particular resource. In the caseof energy, costs associated with one firm’s use of this input may not beconfined to that firm alone — for example, there may be costs associatedwith emissions of greenhouse gases. Such externalities associated withenergy use may adversely affect society, which means that it may be optimalto raise energy efficiency to levels higher than those that occur withoutgovernment intervention.

The benefits of addressing an externality should be greater than the costs iffixing the problem is to be a sensible option. But measuring the benefits andcosts of increased energy efficiency is very difficult, especially when thepossibility of climate change is involved. So it does tend to be taken forgranted that higher energy efficiency is necessarily a good thing. ‘Drivingenergy efficiency’ is a fundamental element in realising goals in the Com-monwealth government’s Sustainable Energy Policy for Australia GreenPaper (Commonwealth of Australia 1996).

Providing information as a means of improving energy efficiency has oftenbeen chosen as a policy instrument by governments at the federal and statelevels, both here and overseas. The rationale might reflect the common beliefthat there are cost effective opportunities to improve energy efficiency thatfirms have not yet identified or chosen to adopt (sometimes referred to as‘no regrets’ opportunities, a term which is discussed in more detail in box 1).

As a method of providing information the Energy Efficiency Branch of theCommonwealth Department of Primary Industries and Energy (DPIE) beganan ‘Enterprise Energy Audit Program’ (EEAP) in 1991, which ran until May1997. The original information brochure explained the rationale for thepolicy as follows. ‘All Australian businesses and organisations have theopportunity to improve their productivity, achieve energy and cost savingsand at the same time help prevent damage to our environment. How? An

9

1


The view that there are abundant ‘free’ opportunities to improve energy efficiency isa common one. The diagram below is a deliberately simple attempt to make the pointthat firms might be operating at an optimal level of energy efficiency (that is, operatingquite rationally) even if they have not yet adopted every investment option that appearsto be economic. Because information is not free, the price of information (includingcollecting it from various sources, sifting it, digesting it, assembling it, spreading itaround the firm) will determine the amount of information which firms choose tosearch out. The ‘processing’ aspects of information, which also include theopportunity costs of a person’s time, are alternatively referred to as transactions costs(Hinchy et al. 1991).

Before applying for a subsidy a firm might be operating at point A, with the amountof information Q1. If the EEAP subsidy brings the price of information down from P1to P2 then the ‘best’ amount of information will rise to Q2. That is, the subsidy changesthe firm’s optimal point of operation from A to B, and assuming that a firm does haveopportunities to increase energy efficiency, the optimal level of investment willincrease (EEAP audits show that many firms do have such opportunities).

This graph is an oversimplification because there are other factors besides informationcosts which might stop firms from taking up options to invest in energy efficiencywhich appear to be economic on the surface. These are examined in this report. Toolsused to evaluate investments, such as net present value, should be capable of reflectingall of the costs associated with an investment.

Rather than being a strategy to soak up ‘no regrets’ options, EEAP might be morecorrectly regarded as a subsidy designed to address any externalities associated withenergy use. Improving energy efficiency within a firm will not necessarily reduceenergy use, as structural changes may alter energy intensity and increase energy use,but this is not likely in most firms. So EEAP leads to firms taking up ‘options that maynot have otherwise been economic’ (because of the information costs) as distinct from‘no regrets options’.

1 No regrets?


Price of information

Quantity of information

EEAP subsidy

S

D

A

B

S1

P1

Q1

P2

Q2

{

energy audit can identify where energy and cost savings can be achievedwithout a reduction in the output or quality of your product or service’ (Com-monwealth of Australia 1991, p. 1).

Firms electing to enrol in EEAP were given a subsidy to have an energyaudit done, with the purpose of identifying economic options to improveenergy efficiency. This subsidy was 50 per cent of the cost of the audit, upto a maximum of $5000. Approximately 1200 firms participated in EEAPover the six years that it ran. The audit reports were typically large documentscontaining many detailed recommendations on all aspects of a firm’s energyuse. To give an idea of their size and scope, the average cost of an audit wasabout $7000, and took several months to complete, depending on manythings including the size of the firm. Two case studies are provided in box2 to provide readers with additional insights into how the EEAP may haveoperated within a firm.

ABARE produced four consultancy reports for DPIE during the course ofthe EEAP program (Mander and Wilson 1993; Warr, Wilson and Holmes1994; Melanie, Chang and Shan 1995; Harris, Weston, Warr and Peat 1996).The objective was to analyse the information contained in the audit reportsand compact the large amount of data into useful average measures ofpotential energy savings, potential reductions in carbon dioxide emissionsand the attractiveness of investments in energy efficiency. ABARE was alsorequired to comment on any issues it saw as being relevant to the operationof the EEAP and the objectives of this policy.

As EEAP progressed it became clear that issues were arising that needed tobe addressed. Most importantly it appeared on the surface, from theinformation available, that firms were electing not to take up audit recom-mendations to improve energy efficiency. These were recommendationswhich had been assessed as being economic by auditors and which metaccepted economic evaluation techniques, such as net present value. This‘nonimplementation’ issue was arising with EEAP at the same time as the‘energy efficiency gap’ or ‘energy paradox’ was emerging as an importantsubject of research, especially overseas.

The ‘energy efficiency gap’ can be formally defined as the divergencebetween socially (and perhaps privately) optimal levels of investment inenergy efficiency and those actually seen in practice. Jaffe and Stavins(1993, p. 36) describe the efficiency gap as ‘the paradox of the gradualdiffusion of apparently cost-effective energy efficient technologies’. In


During 1997 ABARE staff, accompanied by a DPIE journalist, visited two enterpriseswhich had taken part in EEAP. The objective was to bring EEAP to life by relatinghow firms came to be involved in EEAP, how it worked in practice, and what theoutcomes were.

Australian Automobile AssociationThe Australian Automobile Association (AAA) had their multistorey office buildingaudited under EEAP in 1996. At the time of the energy audit the AAA building, whichin total accommodated 140 people, was occupied by a single Commonwealthgovernment department and eleven AAA employees. Little work on energyefficiency investments had been done on the building for a long time.

The audit process took two and a half months from start to finish, during which timean interim and a final report were produced. Most of that time was spent monitoringcurrent energy consumption patterns and checking energy equipment. A detailedpresentation of the results was given on completion, making clear the recom-mendations and ways to implement them.

Energy investment decisions are not determined solely by standard investment rulesat the AAA. Nonmonetary benefits such as more friendly workers and better relationswith other companies were cited as important factors in investment decisions. Theorganisation also views environmental impacts seriously, and gives these prioritywhere possible when evaluating energy investments.

Recommendations that were implemented included converting the water heating togas and reducing the power of the circulating pump, and repairing the economy cycleoperation of the air conditioner which was broken. High efficiency lighting wassuggested throughout the entire building, and this is still under consideration. Thebuilding needs refurbishment in the near future, and the level of refurbishment, andtherefore the installation of new lighting depends on the leasing intentions of a tenant.If a longer term lease is chosen, the AAA will go ahead with the relatively expensivebut large energy saving investment, otherwise they will select a cheaper option.

Some recommendations were unsuitable. Turning off the water heating and coolingoutside core hours was suggested, but deemed inconvenient, especially as thebuilding has tenants who may want access to these facilities at other times.

AAA was very happy with the audit. The auditor had the knowledge and experiencenecessary to undertake a successful audit. Most of the recommendations were takenon board, and one was still under consideration at the time of the interview.

Goulburn Wool ScourGoulburn Wool Scour was built in 1982 and has been significantly upgraded since.There are about 50 employees, and the plant operates around the clock for five toseven days a week. Around 14 million kilograms of clean weight wool a year areprocessed at Goulburn and a further 20 million kilograms at a ‘sister facility’ atJandakot in Western Australia.


2 Case studies

The owner of Goulburn and Jandakot, based in France, is the largest commissionedscourer in the world and one of the largest wool trading companies in the world.

The price of scouring is set as a fixed proportion of the price of wool. Traditionalmethods of wool scouring, which were energy intensive and wasteful, came underscrutiny when the wool price fell in the late 1980s. This coincided with the appoint-ment of a managing director with engineering experience who instituted a programof energy efficiency measures. These measures included a total heat recovery systemusing heat exchangers to preheat all water coming into the plant. The hot water systemwas completely replaced with a refitted second hand boiler. The lighting bill wasreduced by $3500 a year by having all lights on photocells and installing skylights.

The business is now ‘cost conscious to the point of knowing the cost of processingevery kilogram of wool that comes through the plant to the second decimal point ofevery cent’. This is necessary for survival. Energy costs (electricity and gas com-bined) are around $72 a tonne of wool, about half what they were in 1990.

Involvement in EEAP came about through the request of the owners in 1994 becausean audit at Jandakot, an older plant, had been of great benefit. The audit at GoulburnWool Scour took one week, of which the auditors spent three days on site ‘crawlingall over the plant checking everything from the circuit boards on’.

The audit cost $6000 and although it was very thorough, the auditors ‘did not reallyunderstand the industry’. A standard computer package was used in the audit, whichlisted various alternatives to any situation; however, the standard options did notalways fit with the needs of the firm. For instance, one suggestion was load sheddingin the lanolin plant, which wasn’t possible because while the lanolin plant requires afairly high electrical load it has to run in parallel with the wool scour. ‘That sort ofrecommendation is based on a misconception of what actually happens in theprocess’, said Howard Kneebone, the managing director of Goulburn Wool Scour.

Although the audit did not provide major new cost saving options for Goulburn WoolScour, it is still regarded as having been worthwhile for two reasons. First, it servedto totally confirm the current production plans. Second, the auditors suggested enteringthe National Energy Awards which Goulburn Wool Scour subsequently won in 1995.

When selecting investments, Goulburn Wool Scour’s planning horizon is generallyanything up to two years but a new scour plant and a new press are each on a fouryear payback. Mr Kneebone stated that, ‘investments with a payback period longerthan two years are selected on a case by case basis. Anything under two years is noproblem, anything under twelve months and I would get kicked around the boardroom for not doing it’.

Goulburn Wool Scour has periodically considered investing in cogeneration. Atpresent, cogeneration is a border line proposition in the wool scouring industry. Tomake it pay for itself would require nonstop operation but at the moment it is notefficient to run a cogeneration plant overnight because of the very low offpeak powerprices.


2 Case studies Continued

simple terms, as explained by Eyre (1997, p. 26), ‘investment in energyefficiency is consistently observed to fall short of levels which informedanalysts assure policy makers is both possible and economic’. Thisobservation, in a time of attention to the environmental impacts of energyuse, is leading to much analysis on why it might be the case.

Although the ‘efficiency gap’ issue was becoming associated with EEAP(see, for example, Productivity Commission 1996), the extent of theproblem, if it existed at all, was by no means clear. This was because thefollow-up procedures, to monitor what actions firms had taken on their auditreport recommendations, were inadequate. It was impossible to gauge theimplementation rate owing to ambiguous wording in the follow-up question-naire and the poor response rate to this questionnaire (explained in moredetail in the next chapter). The Productivity Commission (1996, p. 12) inter-preted the situation as follows, ‘Of course, when firms say they reject “some”recommendations, it could still mean that most recommendations areimplemented. But the conventional wisdom is to the contrary — “auditreports gather dust”’.

In a bid to better understand these issues, ABARE undertook the presentstudy. Its broad objective is improving the understanding of policy makersand the community of the factors which encourage and constrain investmentin energy efficiency among firms in Australia. That is, if the aim is to ‘drive’energy efficiency, the process should start in the right direction. The aim inthis report is to draw on ABARE’s involvement in EEAP to enhance under-standing of how firms make decisions about investing in energy efficiency.More specifically, the hypothesis that among Australian firms there are lowlevels of uptake of apparently sound economic recommendations to improveenergy efficiency is investigated. Having done this it should be possible tocomment on the cost effectiveness of EEAP and whether any implicationscan be drawn for future policy directions.

There are two main questions to be addressed. The first is whether recom-mendations are in fact ignored. What are the actual levels of uptake of EEAPrecommendations? It is important to remember that despite all the debateabout the ‘efficiency gap’, it remains unclear whether underinvestmentactually occurs, and if so to what extent (Johnson 1994). Second, ifrecommendations were not taken up, why weren’t they. As noted above,there are many hypotheses about why the ‘energy efficiency gap’ exists.Many of these are plausible, but it is not clear which are the most importantand how they fit together.


One of the most popular topics is whether market failure exists in energymarkets or not. ABARE reviewed and researched this issue in the early1990s (Hinchy et al. 1991, discussed in chapter 2) and the subject has beentackled by many others since. Most of the debate over the energy efficiencygap continues to revolve around differing views about first principles,particularly the degree to which the gap is consistent with economic theory(Koomey and Sanstad 1994). The aim here is not to contribute directly tothis debate (although the literature is reviewed in chapter 2). Rather, the mainrecommendation from the previous ABARE work (Hinchy et al. 1991), thatefforts in this area could usefully be directed to researching the costeffectiveness of existing and alternative policies, is followed.

It should be noted that the research reported here is confined to investigatingalternative policies for the public provision of information. Hinchy et al.concluded that, subject to the condition of cost effectiveness, it is desirableto proceed as far as possible with the public provision of information. Thisis because governments have insufficient information to ensure that otherpolicy instruments, such as mandatory efficiency standards, or taxes andsubsidies, would be set correctly.

It is recognised, however, that governments might wish to adopt other policyinstruments in the current environment where attention is focused on re-ducing greenhouse gas emissions. Such policies might be part of an overallpackage but it is not within the scope of this study to discuss the optimalnature of such a package. One important area of change at present is reformof the electricity supply industry, designed to promote competition amonggenerators and at the retail level. State owned transmission grids are subjectto regulation to ensure that pricing arrangements are transparent and costreflective, and to provide nondiscriminatory access to the network(Naughten, Melanie and Dlugosz 1996). The levels of energy pricesobviously alter incentives to invest in energy efficiency and this issue hasbeen addressed by authors such as Diesendorf (1995) and Crawford-Smith,Ellis and Outhred (1996).

The principal method used in this report is a representative survey of firmswhich have participated in EEAP. Details of the method are provided inchapter 3. Readers can proceed to this chapter, or read chapter 2 first formore details about EEAP, the development of the current study and theliterature on the ‘efficiency gap’.


Background

History of EEAP and evolution of current studyThe EEAP audits were required to be conducted by an energy auditingorganisation which had been accredited by the Institution of Engineers,Australia. As previously stated, funding for the energy audits was 50 percent of the cost of the audit up to a maximum of $5000 and firms wererequired to seek and receive funding themselves (that is, audits were neverimposed on firms). As a condition of receiving the funding, participants inthe program were required to complete a follow-up questionnaire withintwelve months of the audit which asked whether recommendations had beenimplemented and if not, the reasons why.

Each of the 1200 firms that participated in EEAP received an audit reportcontaining a profile of current energy use together with specific recom-mendations about where and how energy could be saved, at what cost andwith details of the attractiveness of each investment using variousinvestment criteria such as net present value and payback period.

ABARE’s role in EEAP was to analyse the information contained in the auditreports on a consultancy basis (each year for four years between 1993 and1996). To do this ABARE used summary sheets of information from eachaudit report and then packaged the large amount of data into aggregatemeasures for evaluating the progress of EEAP in meeting its objectives. Eachyear ABARE’s analysis of EEAP was on the cumulative total of firms sincethe program’s inception. The aggregate measures published were ofpotential energy savings, potential reductions in carbon dioxide emissionsand measures of the attractiveness of investments (such as net present valueand payback period). This information was supplied at state and industrylevel, for various savings areas (such as lighting or air conditioning) andsavings measures (such as upgrading or maintenance and repair). To give anidea of the nature of the ABARE analysis an overview of the results fromthe last consultancy report is given in appendix A.

Each year in its commissioned report ABARE was also asked to commenton any issues relevant to the future of EEAP and as the program progressedit became clear that issues were arising that did need to be addressed. Most

16

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ABARE research report 98.2

importantly, the issue of ‘nonimplementation’ of supposedly economicopportunities to improve energy efficiency had become firmly associatedwith EEAP and other programs like it which operated overseas. For example,the Industrial Assessment Centre program, which has been operated by theUS Department of Energy since 1976, reported energy audit implementationrates of about half in their recent evaluation (US Department of Energy1996). That program provides about 900 free audits a year to ‘small andmedium’ manufacturing plants (those with fewer than 500 employees).These are performed by teams of staff and students from selectedengineering schools. The database contains very detailed data on individualaudit recommendations including plans for implementation and reasons forrejection of individual recommendations (Productivity Commission 1996).

Despite the depth of interest in whether firms were implementing their EEAPrecommendations, the EEAP follow-up questionnaire was completed by lessthan half of the participating firms, and the questions asked were inadequateto determine the actual level of implementation. Of the firms which didcomplete the questionnaire, 60 per cent reported that they had not imple-mented ‘some or all’ of the recommendations (Harris et al. 1996) — anunfortunate choice of words. In addition, firms were only given the choiceof three reasons for not implementing recommendations: too costly/noteconomic; lack of funding; and other.

The most common reason cited for not implementing a recommendation wasthat it was perceived to be uneconomic. This posed a dilemma because therecommendations had been assessed as being economic according tocommon evaluation techniques (such as deterministic NPV, which assumesa single value for costs and benefits each time period, and calculates a netvalue from these; stochastic NPV on the other hand takes account ofuncertainty in the values of key variables such as costs and energy savings,recognising that there is a range of possible values. This approach is used inStephens et al. 1995.)

So what was being missed? Were there hidden costs associated with therecommendations that had not been picked up by auditors? Is deterministicNPV an appropriate tool to evaluate energy efficiency investments or dosuch investments have special attributes which invalidate this tool? A lot ofquestions were raised. And a further problem still was that the questionnairehad not been designed to capture long term decision making. It was requiredto be returned in the year after the audit was done, yet there were no questionson whether plans for implementation were still in progress.


When it became clear that the issue of ‘nonimplementation’ should beinvestigated in more detail, it was decided that a survey, or more detailedquestionnaire, of firms which had participated in EEAP would be the mostuseful way to proceed. ABARE was in a position to undertake the analysisgiven its economics skills base, its expertise in survey techniques, and itsknowledge of the EEAP data and issues.

Literature reviewThe following literature review covers a selection of the large body ofliterature on the efficiency gap, and identifies the main hypotheses whichare represented in the EEAP questionnaire.

Most authors start by defining the concept of the energy efficiency gap(sometimes using other terms but meaning the same thing) and then progressto asking why it exists. As previously stated the energy efficiency gap is adivergence between the level of investment in energy efficiency consideredoptimal from society’s perspective, and the level which is estimated to occurin practice.

For the purposes of this study the literature is divided into two strands:

• strand 1 represents those who (implicitly or explicitly) accept traditionaltheory and discuss whether or not there is ‘market failure’ in energymarkets; and

• strand 2 those who investigate whether traditional theory on investmentbehavior of the firm should be modified.

There are various threads to the theoretical problem which can be treatedslightly differently by different authors. This turns out to be importantbecause, as the example shows, even small differences in theoretical inter-pretations can lead to different policy implications.

Strand 1: market failure and market barriers

Energy market failure: previous ABARE researchIn 1991 ABARE published a comprehensive technical paper on the subjectof domestic energy market failure. In this paper Hinchy et al. (1991) arguethat the starting point for analysis is the definition of market failure. This isbased on an idealised model of a competitive economy using many strong


simplifying assumptions and in which maximising efficiency requires thatvarious optimality conditions hold. Any observed deviation from theseconditions can be defined as evidence of market failure.

As far as measuring market failure, a practical test (according to theseauthors) is a comparison between an individual’s discount rate for energyefficiency and the rate of interest at which they can borrow. Any differencebetween the two rates can be regarded as evidence of market failure. This isbecause if the discount rate exceeds the interest rate, individuals areforsaking the opportunity to make profits (they would be able to repay a loanfrom the returns from the investment and still retain a surplus).

In reality the taxation system and transaction costs can account for some ofthe differences between discount rates and interest rates. So although it isnot expected that these would be exactly equal, Hinchy et al. argue that theremight be a basis for policy concern if investments in energy efficiency arebeing discounted at rates well in excess of the interest rates at whichindividuals can borrow.

Hinchy et al. then review the many studies of implied discount rates andstate that ‘the overwhelming impression from the large volume of statisticalevidence is that there does appear to be prima facie evidence of marketfailure in the implied discounting of energy efficiency’ (p. 4) The three ‘mostlikely’ sources of market failure are imperfect information, transactionscosts and imperfections in capital markets and policies to address theseshould be shown to be welfare improving although measurement is difficult.

Market failure or an ‘engineering’ problem?Since the ABARE research described above there has been a large amountof continuing theoretical and empirical attention to the topic of how energymarkets work and whether or not they are characterised by market failure.There are widely varying views on the subject.

A special issue of Energy Policy titled ‘Markets for energy efficiency’containing eleven articles on the subject was published in 1994. In theirintroductory review the editors (Huntington, Schipper and Sanstad) say that‘the basic battle lines are well known’. On the one hand, there are those whobelieve that market barriers or market failures are responsible for the rangeof unexploited opportunities for cost effective investments in energyefficiency and that policies to overcome these barriers and thus promote


investments in energy efficiency are warranted. On the other hand, someview this picture ‘with scepticism at best’, believing that markets for energyand energy using technology basically ‘work’. Probably the most commonargument with the latter, or what has been called the ‘engineering’ approachto the problem, is that there are ‘hidden costs’ associated with adopting newtechnologies that are not captured in traditional forms of analysis. Avariation on the latter view is the argument that the problem is not marketfailure but a failure to understand markets.

Jaffe and Stavins (1993, 1994) combine both views in their analysis,suggesting that there could be economic and engineering explanations forthe energy efficiency gap. They start with the assumption that there areproven technologies that engineering calculations show to be cost effectiveat current prices but that are not widely used (for example, compact fluores-cent light bulbs). The two fundamental explanations for this ‘seeminglyanomalous behavior’ are as follows.

First, market failures cause what appears to be nonoptimising behavior. Jaffeand Stavins describe sources of potential market failure as being informationproblems, principal–agent problems (when energy efficiency decisions aremade by parties other than those who pay the bills), and ‘artificially low’energy prices to consumers (which explain their lack of interest in conser-vation). The first of these, information problems, encompasses factors whichare sometimes described as transaction costs by other authors such as Hinchyet al. For example, it can be costly for people to learn of an innovation’sexistence and to learn enough to know if it is profitable and how to use it.An additional information problem arises because information has publicgood attributes so that it might be underprovided by the market. Further, ifothers’ use of a technology is an important source of information, adoptioncreates positive externalities because it generates information that isvaluable to others.

The second explanation of the efficiency gap, according to Jaffe and Stavins,is that observed behavior is privately optimal, despite engineers’ calcula-tions. Engineers are ignoring or underestimating certain costs of adoption(these are commonly termed ‘hidden costs’ by other authors). If these couldbe measured and included in analyses of what is optimal, the notion of whatis optimal would shift. For example, there may be ‘purely private’ aspectsof information acquisition and absorption that are not included incalculations, such as those related to fitting a new technology into one’s firmand learning about reliable suppliers. These could also be termed ‘qualitative


attributes’ of new technologies which make them less desirable thanexisting, less efficient technology.

Different policy outcomesAlternative approaches can lead to different policy suggestions. For example,Hinchy et al.’s attribution of high discount rates to market failure leads to thesuggestion that policies to correct market failure might be warranted. Jaffeand Stavins, on the other hand, argue that high discount rates may be a truereflection of consumer preferences and market conditions. If so, this does notconstitute market failure, and correction policies are not required.

Other researchEmpirical analysis of ‘hidden costs’Various authors have attempted to measure ‘hidden costs’, as defined above,by comparing potential energy efficiency savings to those actually obtained.For example, Koomey and Sanstad (1994) present a framework forevaluating ‘engineering–economic evidence on the diffusion of energy-efficiency improvements’. They apply this to examples of ‘cost-effectiveenergy-efficient technologies whose adoption in the market has beenimpeded’ (p. 831), including energy star computers and higher efficiencyresidential refrigerators and freezers. They find that low rates of adoptiondo indeed exist but, according to their framework, hidden costs are not thecause, because there do not appear to be any. The authors therefore concludethat they have demonstrated the existence of market failure and call forfurther empirical research to determine the specific causes.

In a later paper, Howarth and Sanstad (1995) state that (anecdotes andinformal arguments notwithstanding) there is no compelling evidence thatmeasurement imperfections are a major factor behind the perceivedefficiency gap. They point out that measuring costs and benefits is animprecise art but that this is a general problem of benefit–cost analysis andnot a special problem in evaluating energy efficient technologies. Theyassert that it is perhaps just as likely that there are hidden benefits attachedto energy efficiency investments.

‘Market barriers’Metcalf (1994) devotes a paper to discussing the idea that the differencebetween market barriers and market failures should be distinguished. Amarket barrier is defined as ‘some force that is working against investment


in energy-efficient technologies’ and requires no particular policy response,as distinct from market failures which lead to insufficient competition andeconomically inefficient outcomes, and may call for some policy response.His aim in making this distinction is to highlight that the appropriate amountof energy conservation (or policy induced investment in energy efficiency)must take place within a benefit–cost framework. Referring to marketbarriers instead of market failures is not uncommon (see also, for example,Nichols 1994; Lutzenhiser 1994).

Adverse selectionThe general problem of adverse selection is well established in economictheory (Akerlof 1970) and means that asymmetric information can impedethe adoption of desirable goods. In the context of energy efficiency, Howarthand Sanstad (1995) use the example of a seller who holds energy efficienttechnologies and knows that these would provide clear ex post benefits tobuyers. However, the effective conveyance of this information to consumersturns out to be difficult or impossible because product characteristics are notreadily observed in the course of market transactions.

‘Bounded rationality’Bounded rationality is another concept that has been fairly widely discussedin the literature on the efficiency gap. Basically it is ‘the possibility thatconsumer decisions differ systematically from the conventions of formaloptimisation theory’ (Sanstad and Howarth 1994).

The Productivity Commission (1996) embraces this concept in their studyof energy efficiency for small and medium sized enterprises, stating that they‘prefer the weaker assumption of bounded rationality to the assumption ofrationality in the strong sense’ (p. 33). The commission believes thatmanagers aspire to rationality by learning from mistakes and approachingdifficult problems in an orderly fashion. This might involve, for example,the search for satisfactory rather than optimal solutions, the substitution oftangible subgoals for an intangible global goal, and the allocation of differentparts of the decision making task to different specialists. In this environment,‘management scientists have found that conventions, norms, rules of thumband limited aspirations play important roles in business decisions.’ Althoughcompetitive pressures ‘help weed out the most inefficient practices … weshould not expect rational outcomes in the strong sense that economists usethe word’ and ‘inefficiencies can go unchallenged for long periods’ (p. 33).In other words, it takes considerable resources to gather and analyseinformation and implement the resulting decisions. As the degree of


competitive pressure on a firm will influence its speed and thoroughness ofaction, this observation may well be of competition with allowance for trans-action costs.

In the summary of their report, the Productivity Commission concludes thatproposals to invest in energy efficiency will not necessarily be treated strictlyon their merits. This is because they ‘fall foul of management structures anddecision-making processes that, understandably, focus managers’ attentionon core issues like markets, innovation or industrial relations’ (p. xi). TheProductivity Commission lists the following examples of ways in whichenergy efficiency suffers from its noncore status:

• noncore investments are required to pay back quickly, usually within twoyears, sometimes in one;

• the middle managers who are typically responsible for energy have neitherthe budgets nor the authority on the energy efficiency opportunities that arise;

• purchases of energy efficient equipment may require special approvalbecause they breach traditional arrangements with equipment suppliersor maintenance contractors;

• noncore proposals are easily lost in bureaucratic processes within firms; and

• operational rules give precedence to core concerns, to the extent that goodenergy efficiency opportunities are lost because they interrupt productionfor longer than normal maintenance downtime.

While many of these observations might be intuitively appealing there is onemajor problem with the concept of ‘bounded rationality’: it does not seemto have any bounds in itself despite its alleged ‘systematic’ method ofworking. The bounds would appear to be the extent to which the particularindustry or firm is forced to cut costs to remain competitive in order tosurvive. Still, there is a considerable amount of literature, again with someintuitive appeal, which asserts that corporate bureaucracy and problems ofindustrial organisation cause inefficiencies within firms and may preventinvestments in energy efficiency (some of this literature explicitly incor-porates the concept of bounded rationality and some does not).

Firm organisationDeCanio (1993) puts emphasis on the short term reward systems withinfirms and other such issues including the extent to which moral hazard ispresent. Moral hazard is present if the principal (the owner) cannot observeeither the manager’s effort or the random state of nature ex post and the


manager has disutility for effort (see also Levin, Levin and Meisel 1987).DeCanio recognises that competitive pressure in the immediate productmarket in the form of potential market entry by other firms, or the possibilityof changes in management through the market for corporate control, exertsome pressure for efficiency. At the same time, however, he asserts that thefirm is shaped by internal information and incentive factors having little todo with the neoclassical optimisation paradigm — the profitabilityperformance of the firm is influenced as much by its structure, governanceand organisation as by its adherence to any set of mechanically applicableprocedures for maximisation of profit with a given technology.

Firm sizeThe ‘organisational’ types of theories related to the energy efficiency gapare sometimes lumped together in the notion that energy efficiency proposalsget ‘buried’ (see, for example, Productivity Commission 1996). Hence, thereis sometimes a tendency to relate firm size to lack of adoption of recom-mendations. However, there is also evidence that the opposite is true. Forexample, Rose and Joskow (1990) provide evidence that large firms andinvestor owned electricity utilities are likely to adopt new technologiesearlier than are their smaller and publicly owned counterparts and attributethis to competitive pressures to cut costs.

The importance of informationAn observation from reviewing the literature is the importance of infor-mation to nearly every argument. Although the ‘strand 1’ literature is diffi-cult to pull together and reconcile, problems with information tend to standout as being covered by most authors, albeit in different ways and eitherimplicitly or explicitly. ‘Problems with information’ can cover terms suchas imperfect information, landlord–tenant problems, transaction costs,bounded rationality, moral hazard and asymmetric information. It seemslikely that problems with information are at least part of the explanation forthe energy efficiency gap, whether the latter is caused by market failure (orbarriers) or not.

Strand 2: ‘new theories’

OverviewThe basic assumption of ‘strand 1’ (implicit or otherwise) is that traditionaleconomic theories, or models, of competitive markets are sound. Authors


then go on to discuss whether or not energy markets are ‘working’ accordingto the idealised models. In contrast, ‘strand 2’ literature involves efforts tobuild alternative models which explicitly recognise certain characteristicsof markets (which would be regarded as deviations from the ideal in strand1) as being so common or entrenched that they must be included ascomponents of basic theory. Obviously this distinction between the twostrands becomes blurry at times, but it serves as a convenient method ofpresentation.

Dixit and Pindyck (1994) clearly state that their ‘new theory of investment’‘contradicts the orthodox textbook view of production and supply goingback to Marshall’ (p. xi). The following is a brief overview of the work ofthese authors (see also McDonald and Siegal 1986; Pindyck 1991; Dixit1992; Hassett and Metcalf 1993). Pindyck (1991) argues that when invest-ments are irreversible the net present value rule changes to ‘invest when thevalue of a unit of capital exceeds the purchase and installation cost by anamount equal to the value of keeping the investment option alive’. Dixit(1992) asserts that ‘a great deal of inertia is optimal when dynamic decisionsare being made in an uncertain environment’.

Hurdle ratesInstead of the conclusion that high discount rates imply market failure, theemphasis in the work of the above authors is on the notion of ‘hurdle rates’.It is argued that key aspects of investment decisions are not captured intraditional theory and this means that traditional investment ‘rules’ such asnet present value (NPV) are inappropriate. These aspects include, first, theirreversible nature of many investments. Because their initial cost is at leastpartially sunk it cannot be recovered following a change of mind. Second,there is uncertainty about how future changes in information (where infor-mation encompasses ‘technology’) will affect the future rewards from achosen investment relative to existing alternatives or those that might arise.Third, there is some flexibility about the timing of investments — most canbe postponed to await additional information.

These three characteristics interact to determine the optimal decisions ofinvestors (Dixit and Pindyck 1994). According to these authors theopportunity cost of investing can be large and investment rules that ignoreit can be largely in error. In other words a firm can attach a high value towaiting rather than immediately taking up an investment that a deterministic


NPV rule would suggest was economic. A high rate of return is needed tocompensate for giving up this option to wait — the hurdle rate.

Uncertainty is a feature of the investment climate, especially because of thepace with which information changes. This is related to the pace oftechnological change and the pressure for such change to occur givenconcern over climate change (see, for example, Brown 1997). There arenumerous energy technologies which seem to be ‘just around the corner’.

In addition, many of the investments would be irreversible as defined above.Johnson (1994) uses the examples of more energy efficient industrialprocesses and solar water heaters in homes. He argues that for each there isuncertainty over the installed technology’s future effectiveness and overfuture energy prices which will determine the value of the energy savingsprovided. Each requires a sunk cost since it is unlikely that a significantfraction of the necessary investment could be recovered if the investmentwas later reversed (Johnson 1994, p. 880). Generally speaking, investmentexpenditures are more likely to be sunk costs when they are firm or industryspecific or have the problem of being judged as ‘lemons’ (Akerlof 1970).

On the timing of investments it is probably true that in many or mostindustries or sectors there is considerable flexibility or discretion amongfirms on exactly when an investment in energy efficiency is made.

One criticism of the model is that it rests on a market imperfection which isthe lack of a complete resale market for used units. Because of this, Sanstadand Howarth (1994) argue that it does not provide an alternative to modelsbased on market imperfections.

Modifying the NPV ruleAs previously stated, the above theories lead to the conclusion that modifiedNPV rules are more suited to evaluate energy investments. There has beencontinuing work on estimating discount rates. For example, Pugsley andOlejniczak (1994), looking at refrigerator purchases in Australia and usingstar ratings as a proxy for energy efficiency, found some evidence that con-sumers apply high implicit discount rates to energy efficiency investments(box 3). But there is also a view that this method of investigating energyefficiency investment does not provide sufficient information on the causeof any divergence between rates and therefore is not useful from a policyperspective (see, for example, Jaffe and Stavins 1994).


A payback period is a specified period of time during which the initial capital outlayof an investment is recouped. Many firms select a specific payback period as a methodof investment appraisal. The length of a payback period implies a particular rate ofreturn for an investment (given a certain investment life). For instance, assuming aten year investment life, a two year simple payback period implies a 40 per cent rateof return (as shown in the graph below). Similarly, a six year payback period impliesa rate of return of less than 7 per cent for the same investment. Thus the shorter apayback period the higher is the rate of return required, and the more stringent theinvestment rule.

Eighty per cent of firms surveyed used the payback period, a much higher rate of usethan for any other investment rule (see figure B, chapter 4). The average paybackperiod was 42 months. Overall, this translates into an average rate of return of justunder 19 per cent (this is the simple noncompounding rate of return, averaged overten years, assuming constant energy savings and a ten year investment life.) Firmswould normally be expected to use payback periods along with complementarydecision making processes (an investment will not go ahead just because it has a shortpayback period but shorter payback periods do work in favor of investments).Although payback periods are popular with firms, they are not used alone. Some firmscited both payback period and NPV as investment rules they used.

These results agree with other empirical evidence which suggests that short paybackperiods are important to firms. That is, firms tend to select investments that returntheir initial capital outlay in a short time, meaning that the rates of return commandedare much higher than market rates of interest. For example, results from the US energyaudit program known as IAC (discussed in chapter 2) indicate that manufacturingplants typically pay for energy efficiency investments within two years. ABAREresearch on Australian purchases of refrigerators, using star ratings as a proxy for


3 Payback periods: why are they short?

90Rate of return

80

70

60

50

40

30

20

10

%1 2 3 4 5

Payback period6 7 8 9 10

energy efficiency (Pugsley and Olejniczak 1994) revealed that levels of potentialenergy savings were sufficient to pay back the additional investment within two tothree years at current market rates of interest yet the lifetime of a refrigerator is aroundten to fifteen years.

In principle the payback criterion may be seen as irrational as it does not take accountof the investment life. That is, benefits achieved after the payback period are ignored.Another problem is that the rule does not capture the size of the investment whichdetermines the absolute return. Only choosing investments with a short paybackperiod may mean forgoing (larger) longer term gains. Despite these factors, however,it is possible that firms are acting rationally in using the payback rule, given theconstraints they face.

It is worth looking more closely at why the rule is so commonly used. It is commonto hear of reasons which are related to incentives within firms. For example, DeCanio(1993) asserts that managerial information is often tied to recent performance,especially when companies have job rotation policies.

Another line of reasoning is not related as much to how labor markets function as itis to how the markets for energy efficiency investments operate. Of particular interestis the notion of risk, which is discussed in detail by Hinchy et al. (1991). They arguethat in an ideal competitive economy with complete risk markets the considerableuncertainty about future movements in relative energy prices and changes intechnology would not affect decision making since all risks could be insured. Forexample, insurance could be taken out against the risk that a change in technologycould make what appeared to be the best investment in energy saving technologynow, an inferior investment at some future date. However, in an actual economy withincomplete risk markets, uncertainty can have a considerable impact on investmentdecisions by raising the discount rate (shortening the payback period). A shortpayback period allows earlier scrapping of a past investment to take advantage ofchanged relative prices and new technology. The nature of a firm’s business may alsochange substantially during the potential lifetime of an asset. There may be few assetsthat remain useful with a change of structure. The longer the payback period thehigher the risk that actual energy savings will be less than originally anticipated.

There is a further, simple explanation which might also be relevant to the popularityof payback period as an investment rule. Information on investments is costly toobtain, and this cost increases with the rigor and method of selection evaluation.Payback period calculations are relatively simple and use minimal information: theinitial capital costs and estimated benefit per year from the investment after that(discounted or not). The costs that could be incurred in more complex evaluation mayoutweigh the expected benefits, and simple rules such as payback period might beefficient.

Sanstad and Howarth (1994) believe that while consumers often lack completeinformation about the energy decisions they must make, they more importantly lackexpertise in processing and applying the information that is available to them.


3 Payback periods Continued

Alternatively, if the costs of an ex post optimal decision exceed the expected benefits,it might be rational to base decisions on simple rules of thumb that are imprecise yetcognitively efficient. The broad term which is sometimes applied to this type ofthinking is ‘bounded rationality’ (see, for example, Productivity Commission 1996).

On the other hand, it is difficult to put any bounds on what bounded rationality actuallymeans. A recent article in the Australian Institute of Energy News Journal (Haines1997) can be used to illustrate this point. Haines proposes ‘that the energy industryadopt the concept of “doubling time” to evaluate the financial benefits of energyinvestments. The doubling time is the time required for the original investment capitalto double, ignoring that it may first go to zero. It should be clear that this is just twicethe payback; the payback period returns the capital, and the second period returns itagain …’ Haines goes on to argue that this concept has the advantage of being ‘sosimple that the calculations can be done in our head’.


3 Payback periods Continued

There has also been some research into developing the deterministic NPVrule to incorporate stochastic factors. A particularly useful paper by Johnson(1994) compares the relevance of three investment theories for explainingthe ‘energy technology investment paradox’. He concludes that the ‘theoryof irreversible investment and enhanced net present value’ is more usefulthan the ‘capital asset pricing model’ and the ‘arbitrage pricing theory’. Innoting the weakness of deterministic NPV in dealing with uncertainty andirreversibility, Johnson suggests that engineering estimates of the costeffectiveness of new technology, using these NPV methods, neglect im-portant aspects of the actual problems of individual consumers. Simpleengineering approaches ignore the fact that the typical purchaser of energytechnologies is not an energy technology expert and therefore faces infor-mation limitations not reflected in engineering analyses. In addition, theyalso face site specific questions about the integration of particular energytechnologies as components of a larger energy use system. Such issues arelargely outside the scope of traditional technology specific analyses. Thenonexpert can only mitigate or resolve these concerns at a cost, a cost whichmust be balanced against the benefits of the resolution obtained andultimately against the benefits of the adopted technology. Another importantfactor is the role of uncertainties which even experts cannot resolve, such asthose related to future equipment performance levels, maintenance costs andobsolescence and, more fundamentally, uncertainty over future energyprices.

In summary, Johnson is asserting that ‘engineering’ estimates of cost effect-iveness are deficient in their treatment of a decision maker’s informationlevel and information costs, and of the impact of uncertainties inherent inenergy technology decisions. He then goes on to discuss how recent workin investment theory addresses these issues and how NPV analysis can beenhanced to better account for them.

According to Johnson, deterministic NPV is still the most commonly usedtool for analysing investments because it is easy to understand, easy to applyand is convincing and practical. This is despite weaknesses in its treatmentof information and uncertainty, both of which are incorporated into thediscount rate. That is, deterministic cash flows are assumed for simplicityand the discount rate is left to incorporate both the time value of money anduncertainty about future cash flows. Johnson states that ‘while these sim-plifying assumptions are now taken almost as part of the definition of NPVanalysis owing to their prevalence, they are not necessary, and can beweakened to improve the accuracy and expand the content of the results’.In particular, Johnson suggests the following extensions to the NPVapproach.

(i) Uncertainty about the amount of future cashflows can be representedexplicitlyIn deterministic NPV analysis, the decision maker’s beliefs about the dis-tribution of future cashflows is summarised in one number, a best guess orexpected value, so information is lost about the extent of the decisionmaker’s uncertainty, such as the range of potential outcomes believedpossible. In addition it is implicitly assumed that the decision maker is riskneutral and that sources of uncertainty are independent (if there is more thanone source). Stochastic NPV, on the other hand, allows for the inclusion ofa range of possible values for key variables.

Johnson suggests that a distribution of possible NPVs be computed for aninvestment, instead of just one best guess number. The decision maker thenhas a full range of possible levels of profitability of an investment togetherwith their relative likelihood. Best and worst possible outcomes can benoted.

(ii) With cashflow uncertainty represented explicitly, the discount rate canbe used to isolate the time value of moneyWhen uncertainty about future cashflows is addressed directly as suggestedabove, the discount rate no longer needs to attempt to account for the effects


of the riskiness of an investment. Instead, the prevailing risk free rates forthe term of the cashflows being analysed can be used to adjust for timingeffects, and cashflow uncertainty can then be considered directly afterhaving been collapsed to one point in time.

(iii) The ‘state of information’ of the decision maker can be representedexplicitly, and the value of changing this state of information by gatheringinformation or hiring experts can be calculated in monetary termsThe framework used in (i) above can also be used to replace the decisionmaker’s original information. The initial probability distribution for theuncertain variable is replaced by a more accurate distribution gained throughsome costly process of information gathering or learning. The key is toincorporate the fact that better information is available at a cost and thedecision maker has to judge whether a marginal change in the level of un-certainty is worth the cost of gathering the information to achieve this gain.

(iv) Project stages, including immediate decision points, can be represented(for example, research phase, pilot program, full scale implementation)It can then be decided at each stage whether the next is worth progressingto or not.

The importance of information problemsAs suggested in the concluding paragraph on strand 1 literature, ‘informationproblems’ tend to stand out as something that most authors who investigatethe energy efficiency gap will cover. This is true even though it might behard to decide whether the problem is due to one or more of the following:the public good nature of information; externalities attached to it; its asym-metric nature; the costs of searching for it and managing it in other ways(sometimes called transaction costs); the risks associated with possiblefuture changes in available information. Similarly, information problemswould appear to be a common link between strand 1 and strand 2 literature(uncertainty over future information is a central theme in the latter).

The literature review illustrates the complexity of the ‘efficiency gap’debate, in terms of the number of reasons that are offered for the gap, andthe ‘economic’ and ‘engineering’ reasoning behind these explanations. Itappears likely that there are lots of reasons, many of them interrelated.Theory is useful to highlight this complexity. However, on this occasion,ABARE has the opportunity to contribute in a different way. The approach


to the problem was to ask firms questions about their behavior. The methodis provided in the next chapter.

32

3


Research method

Sample selectionDuring the period that EEAP operated, over 1200 firms had an energy auditand received a government subsidy. To ensure there had been adequate timefor firms to consider their recommendations, those audited after June 1996were deleted from the survey population. This reduced the population to1120 firms. The final population was 1103 firms because of nonresponsewithin industries with small populations, or other reasons including auditreports being incomprehensible or of unmanageable size. All resultspublished in this report, unless otherwise stated, represent this targetpopulation.

A sample of 100 firms was selected from the survey population. A stratifiedrandom sampling technique was applied, with the population being stratifiedby industry (ten industries). The purpose was to obtain a coverage of firmsin each industry to provide a more robust sample than if it were selectedrandomly across the population. The sample weight allocated to each firmwas a proportional weight, calculated at industry level. That is, for a par-ticular industry the weight was the population in that industry divided by thesample size in that industry. Appendix B contains information on thereliability of survey estimates.

The industry definitions follow the Australian and New Zealand StandardIndustrial Classification (ANZSIC). A list of the industry classifications isas follows:

MiningManufacturingElectricity, gas and waterConstructionWholesale and retail tradeTransport and storageFinance, property and business servicesPublic administration and defenceCommunity servicesRecreation, personal and other services


The first step after the sample had been selected was to contact the firms andexplain the focus of the survey and overall aim of the research. This wasdone by mail and firms were requested to respond, providing the name ofthe person most suitable to answer survey questions, such as the engineer,plant manager or company director (this person was usually the one who hadhad the most involvement in the EEAP process within the firm). Firms inthe sample of 100 who did not respond to the letter were telephoned to assesstheir willingness to proceed with the survey before the step was taken toreplace them with a reserve. A large sample of reserves received theexplanatory letter at the same time as the selected sample.

Of the 100 firms selected in the sample, ten had moved premises, shut downor had been taken over since the audit. Poorly maintained and presented auditrecords prevented detailed questioning of a further twelve firms, and thenature of the business had changed in four cases, causing part or all of theaudit to be invalid. Seven firms declined the survey owing to insufficientinformation about audit recommendations, usually as the person involvedwith the audit and implementation had ceased employment with the firm. Afurther ten firms were deemed unsuitable for various reasons. As a result,43 of the selected sample were replaced by other similar firms in the sameindustries.

Conducting the surveyThe survey was conducted by telephone during May and June 1997 byexperienced and highly trained staff within ABARE. The average length oftime taken to conduct an interview was 30 minutes. Telephone interviewingwas chosen over face to face interviewing and postal surveys for a numberof reasons. Budgetary constraints meant that large scale ‘in person’ inter-views were not an option. Postal surveys were considered as it would havebeen possible to include every firm involved in EEAP. However, theresponse rate to postal surveys is generally quite low, and the sample thatresponds is likely to be a biased representation of the population.

Two case studies were also carried out to give an insight into how EEAPmight have operated in practice. For the selected firms the key decisionmakers were interviewed and information gathered about how the firmbecame involved in the program, what the program entailed, its usefulnessand various other aspects of the process. The case studies are contained inbox 2 in chapter 1.



How many people work in the building covered by the audit?

Approximately what percentage of your firm’s total operating costs were spent onenergy bills?

The purpose of these questions was to investigate arguments that firm size and/or thebudgetary importance of energy might influence the way decision making isorganised and its status — for example, whether energy use is part of core businessor not.

What is the situation with respect to tenancy (own or lease) and the length of leaseif applicable?

The purpose of this question was to investigate hypotheses under the ‘landlord–tenant’ banner.

How would you rate your firm’s general attitude to risk when it comes to energyefficiency?

This was done on a scale of 1–5, where 1 is ‘very conservative’, 3 is ‘risk neutral’and 5 is a ‘high risk taker’.

More specific information about sources of risk involved with investments in energyefficiency was gained by asking firms to rate the following sources of risk (on a scaleof 1–5, where 1 is ‘not at all important’ and 5 is ‘very important’):

• the fact that information is continually changing (for example, prices, technology,costs);

• adjustment costs during installation (for example, disruption to production);

• adjustment costs after installation (for example, staff learning to live with newequipment);

• potential costs associated with breakdown, maintenance and repair.

Note that this question was asked for specific recommendations which were notimplemented, as explained later. For firms that had implemented all recommenda-tions it was asked as a general question.

Environmental considerations play an important role in our decision makingprocess’.

An indication of the firm’s general attitude toward the environment was indicated bytheir response (on a scale of 1–5, where 1 is strongly disagree and 5 is strongly agree)to the statement.

Was the audit worthwhile?

A simple yes or no answer was sought. The opportunity to comment further on theEEAP program generally was also given to respondents.

4 General information questions


Respondents were asked whether the following rules were used (yes, no or don’tknow):

Positive net present value: If so, what discount rate or minimum rate of return wasused to calculate net present value? Net present value was defined as the discountedstream of benefits from an investment after investment costs have been subtracted,assuming a particular discount rate.

Rate of return on capital: If so, what percentage? With this rule the firm selects aspecific rate of return that capital investments must return, and selects projectsaccording to this criterion.

Payback period: If yes, what was this period? Payback period was defined as aspecified period of time during which the initial capital outlay of an investment isrecouped.

Upper limit on debt–equity ratio: If so, please specify the limit. With this rule thefirm takes into consideration their debt–equity ratio before deciding whether toinvest. There may be a maximum level of debt–equity above which they will notadopt new investments.

Other: Please specify.

5 Decision rule questions

Survey contents

Hypotheses about the behavior of firms in relation to energy efficiencyinvestments are reviewed in chapter 2. The questionnaire was designed tocover as many of these hypotheses as possible. The questionnaire had to bestructured and worded to avoid economic jargon that may be misunderstoodby either interviewer or interviewee. It was important, however, thateconomic issues be covered. It was therefore necessary to engage in ex-tensive consultation with survey design experts before the final question-naire was agreed.

Three groups of questionsThe questions included in the final questionnaire broadly form three groups.In some cases, the reasons for asking specific questions are given brieflybelow, but generally are not needed, being self-explanatory after readingchapter 2.

General information


First, respondents were asked the same question about specific sources of investmentrisk as in the general information questions, but were asked to apply it to therecommendation in question (instead of in general terms as happened if the firm hadimplemented all recommendations).

Second, respondents were asked to rate on a scale of 1–5 (where 1 was ‘stronglydisagree’ and 5 was ‘strongly agree’), how the following 10 reasons rated in theirdecision not to implement recommendation x. The reasons were grouped under threesubheadings:

Costs/profitability1. The investment was too risky.

2. The auditors assessment of costs and /or savings was inaccurate.

3. The rate of return on the investment was too low.

4. Finance was unavailable.

5. The payback period was too long.

Expertise6. There was a lack of staff with expertise in this.

7. From the audit report, it was not clear how to actually implement the changes.

Other reasons8. The decision to invest in the recommendation is beyond our control (for example,

the premises are rented and some decisions are up to the landlord).

9. ‘Investments in energy efficiency are largely irreversible’ (meaning that once themoney has been invested it cannot be fully recovered).

10. Energy efficiency issues are often overlooked by managers.

6 Sources of risk questions

The first group of questions was designed to obtain some generalinformation about each firm (box 4).

Decision ‘rules’The second group of questions was designed to elicit more information aboutwhich ‘rules’ firms use when they make their investment decisions — theseare outlined in box 5. ABARE was interested in whether firms use thetraditional economic decision rules — such as net present value — forevaluating investments.

Note that it is possible and perhaps even likely that firms could use the samerules without calling them the same names. For example, firms may use adiscounted cash flow analysis but may not call it net present value.

Recommendations not implementedThe third group of questions involved a detailed analysis of the implementa-tion of recommendations (as detailed in box 6). The focus of the analysiswas on recommendations that were not implemented and the associatedreasons.

For each firm in the sample a list was constructed of the recommendationsmade by the auditor and the cost of each. This list was included in thequestionnaire (10 biggest cost items only if more than 10 were made). Foreach recommendation the firm was asked to indicate whether they had

38

4


1 Average population values derived from the sample

Unit Result RSE a

Audit cost $ 7 248 5

Energy bill as percent of total costs % 4.0 15Own and occupy entire building % 76 5Own and occupy part of the building % 12 27Lease and occupy entire building % 4 52Lease and occupy part of the building % 8 36Average length of lease mth 60 12

Number of employees no. 297 17

Total energy use $’000 434 14

Total operating costs $’000 10 797 14

a Relative standard errors, expressed as percentages of the estimates — see appendix B for anexplanation.

decided not to implement, or were not planning to implement within the nextone to two years. For up to two recommendations that were not implemented,detailed questions as to the particular reasons were then asked. These weredesigned to provide information on why recommendations that wouldpurportedly improve energy efficiency, and which had been assessed asbeing economic by auditors, had not been taken up. This was an attempt toinvestigate the reasons for the so-called ‘efficiency gap’, with the suggestedreasons drawn from the substantial body of literature reviewed in chapter 2.

Firms were also asked what rate of return they would have considerednecessary to have undertaken this investment (to overcome the statedreasons for nonimplementation). The aim was to obtain an indication of whathas been termed a hurdle rate for different types of investments.


0Percentage of firms within each category

10 20 30 40 50 60 70 80

Lease and occupy part of building

Lease and occupy entire building

Own and occupy part of building

Own and occupy entire building

A Tenancy arrangements

76

12

4

8

0Percentage of firms that use each of the rules10 20 30 40 50 60 70 80

B Rules used in evaluating possible investments

4

8Upper limit on

debt/equity ratio

Payback period

Rate of return on capital

Positive net present value

53

30

80

15

The results obtained from the questionnaire are presented in chapter 4 ingraphical and tabular form.


2 Rules used in evaluating possible investments

Unit Result RSE a

Payback period % of firms 80 5– average length mth 42 9

Positive net present value % of firms 30 14– average discount rate % pa 13 14

Rate of return on capital % of firms 53 9– average specified % pa 26 8

Upper limit on debt to equity ratio % of firms 15 24



Percentage of firms within each category

C Environmental considerations important in decision making

Strongly disagree

Disagree

Niether agree nor disagree

Agree

Strongly agree

0 5 10 15 20 25 30 35 40 45 50

27

47

17

5

4

D Firms’ general attitude to risk when investing in energy efficiency

Percentage of firms within each category

High risk takers

Risk takers

Risk neutral

Conservative

Very conservative

0 5 10 15 20 25 30 35 40

20

38

26

13

4

3 Environmental considerationsimportant in decision making

Result RSE a

%Percentage of firms

in category whichStrongly disagree 4 48Disagree 5 44Neither agree or disagree 17 24Agree 47 11Strongly agree 27 15

4 Firms’ general attitude to riskwhen investing in energyefficiency

Result RSE a

%Percentage of firms in category which are

Very conservative 20 17Conservative 38 14Risk neutral 26 18Risk takers 13 29High risk takers 4 51a Relative standard errors, expressed as percentages of the estimates — see appendix B for an

explanation.


0

%

10 20 30 40 50 60 70 80

E Percentage of firms receiving specific recommendations

General

Industrial equipment

Mechanical services

Conveyors

Process heating

Refrigeration

Boilers

Chiller plant

Space heating

Steam production

Water heating

Compressors

Air conditioning

Lighting 73

45

21

35

3

19

13

14

10

7

3

26

34

74

5 Percentage of firms receiving specific recommendations

Result RSE a

%

Lighting 73 6Air conditioning 45 11Generators 0 .Compressors 21 16Water heating 35 14Steam production 3 56Space heating 19 23Chiller plant 13 27Boilers 14 22Refrigeration 10 26Process heating 7 31Conveyors 3 50Mechanical services 26 18Industrial equipment 34 13General 74 6


Results

The results of the survey of EEAP participants are presented in this chapter.They are grouped under various subheadings each of which refers to aquestion or group of questions contained in the survey. Results are presentedin graphical and tabular form. Each numerical result has a measure ofreliability attached to it called the relative standard error (RSE), which isdiscussed further in appendix B.

Answers to survey questions

Background informationEighty-eight per cent of firms owned their premises, and most of theseoccupied the entire building (figure A, table 1). Only 12 per cent of firmsowned and occupied only a section of a building. For firms that leasedpremises, the average length of lease was about five years. The averagenumber of employees of firms which took part in EEAP was 297, and theaverage energy bill was $434 000, representing 4.3 per cent of a firm’s total


6 Attributes of recommendations and implementations Average per firm

Unit Result RSE aNumber of recommendations– all no. 5.8 4– implemented no. 4.7 5Implementation rate % 81 3

Recommendation costs– all $ 120 970 19– implemented $ 87 750 22

Recommendation net present value– all $ 428 940 14– implemented $ 364 360 15

Recommendation benefit– all $ 81 950 14– implemented $ 67 380 15


operating costs. The average amount spent on an EEAP audit was around$7200.

Decision making rules used by firmsBy far the most widely used decision making rule is the payback period.Eighty per cent of firms reported that they use this rule for evaluatinginvestments (figure B, table 2). The average length of time during whichinvestments must recoup their costs (the average payback period) is 42months. Just under a third (30 per cent) of firms use positive NPV as adecision rule when evaluating investments. The average discount rate usedto calculate NPV is 13 per cent. Over half (53 per cent) require a particularrate of return on capital, and the average rate required is 26 per cent. Only15 per cent of firms stated that they take debt to equity ratios into con-sideration before deciding whether to go ahead with an investment.

Attitudes to the environment and riskMost firms were supportive of the statement ‘Environmental considerationsplay an important role in our decision making process’. In fact 47 per cent


F Recommendations and implementations

Number for each savings area0 200 400 600 800 1000 1200 1400 1600

General

Industrial equipment

Mechanical services

Conveyors

Process heating

Refrigeration

Boilers

Chiller plant

Space heating

Steam production

Water heating

Compressors

Air conditioning

Lighting

ImplementationsRecommendations

of firms agreed with this, and a further 27 per cent strongly agreed (figureC, table 3). Overall, only 9 per cent of firms disagreed with the statementand 17 per cent neither agreed nor disagreed. These results agree with thosefrom a survey on ‘environmental management in New South Wales industry’of 500 randomly selected firms in New South Wales by that state’s Environ-ment Protection Authority (1997). For example, almost 60 per cent of thesefirms said that ‘management of this company gives high priority toimproving its environmental performance’, and 86 per cent agreed that ‘ourstaff are generally supportive of practices that will improve our environ-mental performance’ (p. 44).

Firms were then asked ‘How would you rate your firm’s general attitude torisk when it comes to investing in energy efficiency?’ The majority of firms(58 per cent) stated they were either conservative or very conservative(figure D, table 4). About a quarter were risk neutral, and only 17 per centregarded themselves as risk takers (4 per cent were ‘high risk takers’).

Types of recommendationsFigure E shows the types of recommendations most commonly received byfirms (see also table 5). Seventy-three per cent of firms received at least onerecommendation related to their lighting, by far the most common category(ignoring ‘general’). The next most important category was air conditioning,with 45 per cent of firms receiving recommendations, followed by waterheating, industrial equipment and mechanical services. More detaileddescriptions of the types of recommendations which are generally givenunder the various broad categories are available in Harris et al. (1996).


7 Rating of risk in decision not to implement a specific recommendation

Proportion rating source as important or very important RSE a

%Source of riskInformation is constantly changing 38 15Adjustment costs during installation 43 16Adjustment costs after installation 28 21Potential costs associated with breakdown 28 21


Implementation of recommendationsEach firm participating in EEAP received an average of just under sixrecommendations and implemented just under five of them, giving animplementation rate of 81 per cent (table 6). This implementation rate isperhaps higher than might have been expected given the discussion inchapters 1 and 2. This may be an indication of the commitment to energyefficiency by firms who chose to be in EEAP.

Figure F shows the implementation rates for the different types of recom-mendations. For example, of the estimated 1484 lighting recommendations,1224, or about 82 per cent were implemented. The ratio of the number ofrecommendations made to the number implemented appears to be quiteconsistent across different types of recommendations. However, there doesappear to be a relationship between the average cost of a particular type ofrecommendation and the implementation rate.

Generally speaking it appears that the higher the average cost the less likelyit is that a recommendation will be implemented. There are two reasons forthis claim. The first is that the average cost to implement all recommenda-tions was about $121 000 per firm, compared with only $88 000 for thoseactually implemented, giving a ratio of about 73 per cent (table 6). Second,the result is intuitively appealing because higher cost recommendationsmight be expected to be given more rigorous scrutiny and to be the first tobe culled if things were tight. However, the hypothesis would have to betested on the basis of ‘all other things being equal’ (such as firm size forexample) in order for strong conclusions to be drawn.


8 Rating of risk by firms implementing all recommendations

Proportion rating source as important or very important RSE a

%Source of riskInformation is constantly changing 75 10Adjustment costs during installation 70 11Adjustment costs after installation 71 11Potential costs associated with breakdown 74 10


Table 6 contains further information about the implementation of recom-mendations. The average benefit, or potential savings per year, from imple-menting all recommendations (according to the auditors) was about $82 000and was about $67 000 for those which were actually implemented by firms.Using both the (one-off total) cost and savings (per year) reported by theauditor, the net present value (NPV) of each investment was calculatedassuming a ten year investment life, and a discount rate of 8 per cent.Information about the specific life of each recommendation was not givenin audit reports, so a best estimate of ten years was assumed. For example,if an investment costs $10 000, and the estimated savings are $2500 a year,the return on the investment over ten years, discounted at 8 per cent, wouldbe $16 775. This is consistent with the evaluation procedures used inprevious EEAP reports (see, for example, Harris et al. 1996). In these reportsand in the current study the assumptions about investment life have beennecessary because this information was not included in the summaries of theaudits which ABARE used for its analyses.

The average NPV per firm from implementing all recommendations wascalculated to be $429 000, and the NPV of the recommendations actuallyimplemented was $364 000 per firm. On a benefit–cost basis, the measuresthat firms chose to implement were considerably better than those notadopted.


9 Firms not implementing a specific recommendation

Proportion agreeing orstrongly agreeing with reason RSE a

%Reason for not implementingRate of return too low 53 12Payback period too long 45 14Auditor’s assessment inaccurate 38 18Energy efficiency often overlooked 35 20Unclear how to implement 28 20Investments irreversible 28 22Finance unavailable 20 28Investment too risky 20 26Lack of staff with expertise 17 31Not our decision 13 35



10 Division of firms among attribute classes and scale of implementation

Implementation categories

Under 70% 70–90% Over 90%All firms implemented implemented implemented

% RSE % RSE % RSE % RSEAttribute classOwn all or part of building 88 4 90 7 83 9 89 6Lease all or part of building 12 28 10 64 17 43 11 46

Staff numbers– under 50 34 15 28 33 37 27 37 20– 50–200 32 14 27 34 34 25 34 20– over 200 34 14 45 26 30 21 30 21

Energy costs– under $100 000 30 15 25 27 25 28 36 22– $100 000–400 000 40 14 23 40 44 22 48 18– over $400 000 31 13 52 18 31 24 16 33

Operating costs– under $1.7 million 41 12 48 19 39 25 37 17– $1.7–6.0 million 29 15 14 27 22 41 43 17– over $6.0 million 31 15 38 25 39 23 20 33

Audit costs– under $5000 37 11 31 25 36 14 41 16– $5000–8000 29 15 25 30 30 29 31 22– over $8000 34 14 44 19 33 25 28 26

Rule used by firm– net present value 30 15 38 28 32 23 24 29– rate of return on capital 53 10 51 19 50 18 57 15– payback period 80 5 78 9 82 9 80 7

Environment important– agree 74 7 59 19 79 11 80 8– disagree 9 32 13 54 7 69 8 49

Firm is risk taker– agree 16 25 27 39 18 42 9 51– disagree 58 9 60 19 55 19 58 13

Thought audit worthwhile 93 2 84 6 95 5 98 2


Risk: importance in investment decisionsThe importance of four sources of risk that could influence energy efficiencyinvestment decisions was investigated. Questions were asked about recom-mendations that were not implemented (table 7). For firms that had imple-mented all of their recommendations, questions were asked in general terms(table 8).

For individual recommendations (table 7), the most significant source of riskis ‘adjustment costs during installation’ which was quoted as important orvery important by 43 per cent of respondents. This probably indicates thatthere are costs associated with disruption to the running of the firm thatinvolve risks great enough to prevent particular investments from goingahead. These are a source of ‘hidden costs’ not included in traditional NPVcalculations. Such calculations would also ignore risks associated withconstantly changing information which is regarded as important by 38 percent of firms. A further 28 per cent regard adjustment costs after installationand breakdown costs as important or very important in their decision not toimplement a specific recommendation.

For firms that had implemented all recommendations (table 8), a highpercentage believe that all of the nominated sources of risk are importantwhen it comes to investing in energy efficiency. These respondents wereexpressing their opinions about the importance of the various risk categoriesfor investments in energy efficiency generally. The risk category with thehighest response rate was ‘information is constantly changing’, with three-quarters of those surveyed regarding it as important. This supports the viewthat more effort should be made to incorporate this category of risk intoinvestment evaluation procedures. The same can also be said for the otherthree risk categories, which were also regarded as important or veryimportant by at least 70 per cent of respondents.

This result could also imply that so-called ‘no regrets’ opportunities toimprove energy efficiency are exaggerated. They would be exaggerated ifan opportunity was labeled ‘no regrets’ without adequate account taken ofthe riskiness of the investment when the investment was evaluated. In otherwords, where a measure such as NPV that takes inadequate account of riskis taken as the sole indicator of economic viability then the extent of ‘noregrets’ options will be inflated. Even if standard NPV measures are sociallyoptimal (there is a view that risk averse individuals should not deprivesociety of the full expected value of investments) despite being individually


risky, there will be a practical difference between what is achievablehypothetically and what will be achieved in practice. In this context, talkingin terms of ‘no regrets’ from the firm’s perspective is not very helpful.

Reasons for not implementing specific recommendationsThe incidence of other possible reasons that firms had for not implementingrecommendations is given in table 9.

The three most important reasons for not implementing recommendationscome under the heading of ‘costs/profitability’. Fifty-three per cent of firmscited low rates of return, 45 per cent cited long payback periods and 38 percent did not agree with the auditor’s economic assessment of a particularinvestment. The relative importance of these economic criteria as distinctfrom other criteria which are commonly cited as reasons for nonimple-mentation is interesting. One interpretation is that firms may be actingrationally in rejecting energy efficiency investments purely on economicgrounds, and the extent of no regrets opportunities in the Australian economyis exaggerated. This is consistent with the observation that the recommenda-tions adopted had a higher benefit–cost ratio than those not adopted. Inaddition, it supports the view that current techniques for evaluatinginvestments are not capturing all of the factors which are important to firms.

The common view that energy efficiency is often overlooked by manage-ment, perhaps because it is not ‘core business’ (see, for example, Produc-tivity Commission 1996), received support by 35 per cent of respondents,making it the fourth most important reason for nonimplementation ofrecommendations. Other reasons receiving support by more than 20 per centof those surveyed were the irreversible nature of investments and the factthat it was unclear how to implement investments.

Relationship between scale of implementation and firmcharacteristicsIn table 10 the scale of implementation of EEAP recommendations is brokendown into the categories of less than 70 per cent, 70–90 per cent and morethan 90 per cent of recommendations implemented. These are then tabulatedagainst various attribute classes. In this way a relationship may be discoveredbetween behavior as it relates to implementation, firm and other traits.


As an illustration, in the population as a whole (the ‘all firms’ column),88 per cent of firms own all or part of their building. Looking only at thegroup of firms which implemented less than 70 per cent of their recom-mendations, 90 per cent of these own all or part of their building. Generally,rates of implementation do not differ noticeably between firms that leasedand firms that owned their own premises: the distribution across the ‘scale


11 Average total net present value of the program for audited firms

Discount rate

6% 8% 10% 12% 15% 20%

$’000 $’000 $’000 $’000 $’000 $’000

1 year –31.4 –32.6 –33.7 –34.8 –36.4 –38.82 years 28.6 25.2 22.0 18.9 14.6 8.03 years 85.1 78.7 72.6 66.9 58.9 47.04 years 138.5 128.2 118.6 109.7 97.4 79.45 years 188.8 174.0 160.4 147.9 130.9 106.56 years 236.3 216.5 198.5 182.0 160.0 129.17 years 281.2 255.8 233.0 212.5 185.3 147.98 years 323.4 292.2 264.5 239.7 207.4 163.69 years 363.3 325.9 293.1 264.0 226.5 176.6

10 years 400.9 357.1 319.0 285.7 243.2 187.5

12 Total net present value for audited firms, by different interest ratesand time periods

Discount rate

6% 8% 10% 12% 15% 20%

$’000 $’000 $’000 $’000 $’000 $’000

1 year –34.1 –35.4 –36.6 –37.8 –39.5 –42.22 years 31.0 27.3 23.8 20.5 15.8 8.63 years 92.4 85.4 78.8 72.6 63.9 51.04 years 150.4 139.2 128.8 119.1 105.8 86.35 years 205.1 189.0 174.2 160.6 142.1 115.76 years 256.7 235.1 215.5 197.7 173.8 140.27 years 305.3 277.8 253.1 230.8 201.3 160.68 years 351.2 317.3 287.2 260.3 225.2 177.69 years 394.5 354.0 318.3 286.7 246.0 191.8

10 years 435.4 387.8 346.5 310.3 264.1 203.6

of implementation’ classes is roughly the same as in the population as awhole. Indeed, this appears to be the situation across all attributes except forthe size indicators.

Four size indicators are presented: staff numbers, energy costs, operatingcosts and audit costs. From table 10 there is evidence that larger firms havelower rates of implementation. To see this, the distribution of the populationwithin attribute groups, is compared with the ‘all firms’ column for each sizeindicator group. Generally, for all indicators, the larger units are over-represented in the less than 70 per cent group and underrepresented in thegreater than 90 per cent group.

Taking energy costs as an example and looking at the population as a whole,31 per cent of firms have energy costs greater than $400 000. But lookingonly at the group of firms that implemented less than 70 per cent of theirrecommendations, 52 per cent of these have energy costs greater than$400 000. Of the group that implemented more than 90 per cent, only 16 percent have energy costs greater than $400 000.

Implementation and ‘hurdle rates’For specific recommendations that were not implemented, the question wasasked ‘What rate of return would your firm consider necessary to haveundertaken this investment (given the uncertainties mentioned)?’ This wasthe way firms were asked for the ‘hurdle rate’ for a specific investmentwithout using the term itself which might have been unfamiliar.

There were 27 responses to this question, and these ranged from 4 to 75 percent a year. On average, the rate of return that firms reported as the minimumnecessary for investment was 26 per cent, and the median rate was 20 percent. These results suggest that firms require high rates of return for energyefficiency investments, as discussed in chapter 2. The key ‘hurdles’ to beovercome, according to the theory in chapter 2, are constantly changinginformation and irreversibility. These were found to be relatively importantreasons for nonimplementation.

The hurdle rate concept is supported by the results as far as they go butfurther analysis of this type would be useful before strong conclusions couldbe drawn.


Evaluation of EEAP

Cost effectivenessThe cost effectiveness of EEAP is evaluated in table 11 (the average valueof EEAP to an individual firm) and table 12 (the total value of EEAP for thepopulation of firms which took part in it). Each number in the body of thetables is a net present value for a particular assumed interest (or discount)rate and a particular assumed investment life (number of years for whichbenefits accrue). As previously explained, the summaries of the audit reportson which ABARE based its analyses did not include information oninvestment lives and this is the reason for making assumptions about thisaspect of an investment. Each NPV is calculated using the costs and benefitsprovided by the auditors of the investments which firms actually imple-mented. The cost of the audit is subtracted from the calculation with therebeing no distinction between the government and firm funded componentsof the audit cost.

Looking first at table 11, EEAP was unambiguously beneficial to anindividual firm in every case except where investment life is assumed to beone year, probably an unrealistic situation. Taking one figure as an example,say an investment life of five years and an interest rate of 8 per cent, theNPV of implementing all recommendations is $174 000 over the five years.The average amount spent on energy a year by a firm is $434 000 (table 1).So on average, a firm saves 8 per cent of their total annual energy bill overthe five years. The levels of savings from the energy bill are similar inmagnitude to those observed from the operation of a large audit program inthe United States which found that on average a manufacturing firm reducedits energy costs by about 10 per cent a year as a result of implementing energyaudit recommendations (US Department of Energy 1996).

Taking the same assumed interest rate (8 per cent) and investment life (fiveyears) the total NPV of EEAP to the population of audited firms wascalculated to be $189 million (table 12). The costs to the government ofadministering EEAP are estimated to have averaged $165 000 a year, givinga total administration cost of about $1 million for the six years that theprogram ran (Tony Marker, DPIE, personal communication 1997). Giventhat the total audit cost was about $8.7 million (of which the governmentfunded half), it therefore appears that EEAP was a cost effective program.


The net present values given in tables 11 and 12 do not include ‘hidden costs’which are excluded from standard evaluation techniques. Risk can representa substantial ‘hidden cost’ which is not accounted for in deterministic NPVanalysis. Risk is seen as an important factor in energy efficiency investmentdecisions by a significant proportion of the population. For example, 75 percent believe that the rate at which information is changing, or the pace oftechnological change, is important or very important. If this were to besomehow included in NPV as a cost and subtracted from the potentialsavings, the values contained in tables 11 and 12 would be lower. Undoubt-edly the firms made some sort of assessment or judgment about the pace oftechnological change and other risk factors before making their investmentdecisions. To the extent that this is true the NPV figures in tables 11 and 12would tend to overstate the cost effectiveness to firms of the audit process.

Despite the above provisos it can probably be concluded that the EEAP auditprocess was cost effective for the majority of firms which took part. This isbacked up by the 93 per cent of EEAP participants who said that it wasworthwhile (table 10). In addition it is probably safe to say that, given themagnitudes of the results, audits are worthwhile for many firms even withoutgovernment subsidies.

CommentsRespondents were given the opportunity to make comments about any aspectof the EEAP audit process. Most of the comments were in areas that havebeen discussed already in this chapter, such as whether or not the audit wasworthwhile.

One comment made in various forms is that EEAP had led to increasedenergy efficiency awareness. Several firms mentioned that their audit was aspringboard for other energy investigations. A number of firms noted thatthey had had more audits done since the EEAP audit. Such commentssupport the conclusion that audits are cost effective, because they indicatethat there may be additional benefits which are not included in this analysis.

Not all comments were positive, and most of these were critical of the auditprocess or outcome. For example, several firms said that some auditrecommendations were unsuitable or impractical. This was mainly attributedto a lack of understanding on the part of auditors of the specific productionprocess of the firm. Some firms noted specifically that the auditor’sknowledge was insufficient to make judgments accurately.

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Discussion and policy implications

Implementation of EEAP recommendationsAs previously noted, the existence or otherwise of supposedly economicopportunities to improve energy efficiency is a popular topic of debate.

The rate of implementation of EEAP recommendations has turned out to bemuch higher than was perhaps expected, at around 80 per cent for the morethan 1000 firms that took part in EEAP. A simplistic interpretation of thisresult, which could be appealing at first glance, is that it shows that there aremany undiscovered ‘no regrets’ opportunities: each auditor found an averageof six recommendations per firm of which five were implemented. But thereis an alternative interpretation that takes into account the entire range ofresults which the survey has provided. The main point is that investment inenergy efficiency is a complex issue. There are many factors which de-termine a firm’s decision to invest or not, and it is unlikely that the solutionis as simple as saying, effectively, that firms are naive or irrational.

The complexity of investment in energy efficiency can be largely attributedto the complexity of the information problems faced by potential investors.Reviewing the literature (chapter 2) reveals that although different authorsoffer various suggestions about why the efficiency gap exists, informationis a common theme. Problems with information are, among other terms,described as imperfect information, asymmetric information, landlord–tenant problems, bounded rationality, transactions costs, and moral hazard.In other words, there are costs associated with collecting information, sortingit, pulling it together and presenting it to decision makers. Decision makersmust constantly re-evaluate whether the marginal benefits of collectingfurther information exceed the marginal costs.

An alternative explanation to ‘no regrets’, which was put forward in box 1of this report, appears to be supported by ABARE’s results. This explanationis that audits are an efficient and effective means of addressing thecomplexity of energy efficiency investment. This is because the process afirm goes through to have an audit done encompasses and addresses all ormany of the factors which influence an energy efficiency investmentdecision, especially the information problems described earlier. And this,


therefore, is the reason for the high rate of implementation of EEAPrecommendations. The extent to which firms would have initiated their ownaudit in the absence of a subsidy is not shown in the results of the survey,which leaves inconclusive the question of why some firms do not in-dependently commission audits.

The mere fact that firms decided to take part in EEAP may have indicatedthat they were serious about thoroughly assessing their energy efficiencyand implementing cost effective recommendations. EEAP participants oftencommented that the audit had led to increased awareness of energy efficiencywithin the firm, some referring to other audits and investigations performedafter the initial audit.

Negative comments about EEAP most frequently referred to dissatisfactionwith the auditors themselves. Metcalf (1994) asks the question ‘how are weto know if the energy auditor we hire is any good?’ He suggests that acertification program — either by the government or by some nationallyreputable organisation — could screen out shoddy inspectors. He points outthat this practice occurs in other areas — for example, home inspection.Additional research could determine whether such a scheme is necessary inAustralia and who should provide it — for example, should it be thegovernment or the private sector.

Two further results from the survey suggest that no regrets is an exaggeratedconcept, in that conventional methods used to calculate benefits of energyefficiency investments tend to overstate these benefits. The first is theimportance of risk to investors in energy efficiency. To the extent thatopportunities are labeled ‘no regrets’ without adequate account taken for therisk, the opportunities will be exaggerated. Talking in terms of ‘no regrets’from the firm’s perspective is not very helpful as without a market for riskinsurance to allow risk pooling over a large number if individuals, there willbe a practical difference between what is achievable hypothetically and whatwill be achieved in practice.

The second result is the importance of ‘economic reasons’ given by firmsfor investments that they had decided not to implement. This is as distinctfrom other reasons which are often said to be important, such as firms lackingtechnological expertise. The point is that there may be genuinely rationalreasons that firms have for not implementing recommendations made byothers. To the extent that these are underestimated when labeling oppor-tunities as ‘no regrets’, the opportunities will be exaggerated.


Why are audits successful?

In this section, the points made above are expanded to look at the questionof why audits appear to be successful in getting firms to undertake energyefficiency improvements.

The point is stressed again that investing in energy efficiency is not a simpletask. It is becoming ever more complex with deregulation and reform ofenergy markets. An audit enables this complexity to be addressed. It is acollation of a large amount of information. It represents a thoroughinvestigation of the entire enterprise as a unit, including its unique aspects,peculiarities and preferences. Collecting information about energyefficiency involves collecting it from various sources, sifting it, digesting it,and spreading it around the firm. There are many different costs associatedwith the information problem faced by a firm. The ‘processing’ aspects ofinformation, which also include the opportunity costs of a person’s time, arealternatively referred to as transaction costs. These can be substantial and,as previously mentioned, they tend to create an inertia in favor of the statusquo.

One investment in isolation may not fit into the overall operations of thefirm. It might be necessary to investigate how one energy efficiencyinvestment fits in with, or relates to, others in the firm. It might be necessaryto close operations down, or disrupt production of the entire firm to installone improvement (for example, if power has to be turned off). For any ofthese reasons the firm might decide to look at the whole picture of energyefficiency within the enterprise, or ‘do it all in the one go’.

It is important in itself that the firm makes a decision to look at the energyefficiency of the enterprise, something which is probably outside normal or‘core’ business, and pay to have this fully investigated. This is not somethingthat just occurs by itself. The fact that a decision has been made and an auditundertaken is probably another reason for high rates of implementation ofrecommendations. This is much different from the relatively random natureof events that might occur without an audit-type process. For example, onemight envisage an employee in a large, busy organisation with many con-flicting priorities. This person might see a pamphlet produced by a govern-ment agency, highlighting a new type of energy efficiency investment suchas a lighting product. It might be one of numerous papers which pass overthe desk during the day and might catch attention for a moment before beingsubmerged by other priorities and placed in the in/out tray or rubbish bin.


Future policy directions

Previous ABARE research concluded that, subject to the condition of costeffectiveness, it seems desirable to proceed as far as possible with the publicprovision of information (Hinchy et al. 1991). The results of ABARE’ssurvey indicate that EEAP was, in all likelihood, a cost effective policy andthat the EEAP audits were worthwhile to the great majority of firms whichtook part.

Promoting or fostering the audit-type processThe results of this analysis provide strong evidence that audits would havebeen worthwhile for the firms which took part even without the governmentsubsidy, since the subsidy was subtracted in the cost effectiveness cal-culations. This might be construed as evidence of ‘market failure’ in thesense of forgone privately profitable opportunities. A debate about theexistence or otherwise of market failure is not entered into here. However,it does seem that energy auditing is a privately profitable activity and thatprivate sector activity could be fostered. The New South Wales EnvironmentProtection Authority (1997) in their survey of environmental managementin 500 New South Wales firms found that only 17 per cent had undertakenan ‘environmental audit or review’.

Now that the public sector has run a ‘demonstration program’ in the formof EEAP, the results of this program could be promoted to the private sector.Promotion could take the form of tax concessions, or perhaps subsidies aswas the case before. There could also be some system of certification forapproved auditors as suggested above. Note that while it may be difficult tojustify such ‘promotion’ solely in terms of the impact on energy efficiency(given that auditing seems to be privately profitable), in the broader contextof climate change policy energy audits might be a cost effective means ofreducing emissions relative to other instruments. Alternatively, or inaddition, the government could concentrate on distributing information onthe benefits of undertaking an audit.

The essential point is that it is important for firms to achieve a systemwideview of the interrelationships between their energy activities. This might beachieved by an audit alone or might require additional processes or perhapseven substitute processes which are similar. Another way to view the audit-type process is as one of stocktaking, consolidating, sorting out, settingfuture plans, or appointing an expert adviser as is done for other matters.


Firms might find it profitable to have a process in place to monitor theirenergy efficiency. The word ‘audit’ has a ‘one-off’ feel to it whereas energyefficiency might require ongoing attention. Whatever the actual method, thekey issue is the value of looking at energy efficiency from a firm or enterpriseperspective as distinct from a technology perspective. By the latter is meantpolicies which promote individual technologies or types of energy efficiencyinvestments to a firm by providing information on separate items.

An audit can be a time consuming and expensive process. This might be thereason that EEAP tended to attract ‘large’ firms (the average number ofemployees was nearly 300). In other words EEAP seems to have missedsmall firms, yet there is no evidence that such firms have less problems withenergy efficiency than larger firms. Perhaps there is a need for promotion ofthe advantages of an audit-type process to be especially targeted at smallerfirms. To reach small firms there could be the option of running a ‘pilot’public sector scheme or offering stronger incentives than to large firms to par-ticipate in any private sector scheme.

On the basis of the experience with EEAP, it is clear that a well developedmonitoring process is needed for whatever policies are adopted. This isnecessary both to ensure cost effectiveness and to avoid policy decisionsbeing made on the basis of erroneous information. The type of surveytechnique used in this study would provide a thorough monitoring device.

Investment rulesThe results indicate that there is a need to encourage auditors, firms anddecision makers in general to use more advanced evaluation techniques totake account of factors which are important yet are ‘hidden costs’ becausethey are not included in deterministic NPV or payback period rules. Thefactor which stands out, as discussed above, is risk. Stochastic NPV is oneoption, so long as it can be easily used as a rule by firms.

Workable rules which incorporate risk, such as those which attach differentprobabilities to different investment outcomes, are especially needed forlarge (or ‘lumpy’) investments and investments with long payback periods(perhaps much longer that typical remuneration periods for decisionmakers).

Encouraging the use of a more advanced NPV framework is one suggestionfor future policy. Another is developing the hurdle rate as a manageable

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investment tool. The results of this survey indicate that firms see theirreversible nature of investments and constantly changing information asimportant decision making factors. The ideal investment tool would enablefirms to discover the hurdle rate for which these factors were overcome asbarriers to investment.

Other additional researchIt would be useful to further pursue the preliminary finding that there werelower rates of adoption of recommendations by larger firms than smallerones. A number of hypotheses (probably not mutually exclusive) can besuggested. Larger firms have more complex operations where interrelation-ships are likely to be more important and this is where EEAP auditors aremost likely to have misunderstood the nature of the operation. Althoughlarger firms are more likely to have studied the efficiency of their energyuse, they are more likely to have a higher level of bureaucratic inertia.

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Appendix

13 Median per firm results

Energy CO2 Energy Net presentsavings reductions savings value

GJ/yr t/yr $/yr $Discounted payback period2 years or less 481 110 17 656 59 9674 years or less 843 179 26 200 76 218

All measures 1 001 223 30 500 66 281

14 Average per firm results

Energy CO2 Energy Net presentsavings reductions savings value

GJ/yr t/yr $/yr $Discounted payback period2 years or less 6 092 788 59 548 189 3134 years or less 9 672 1 339 83 460 220 856

All measures 12 489 1 687 96 009 190 804

The survey by the New South Wales Environment Protection Authority(1997) of 500 randomly selected New South Wales companies was stratifiedon the basis of industry sector and size of workforce. They found thatalthough larger companies are more environmentally active (for example,the percentage of companies which had staff with specific environmentalresponsibilities tended to increase with company size), smaller companiesare more likely to mention ‘interest or enthusiasm of senior management’as a cause of environmental improvements made in the previous three years.It would be useful to investigate this issue in further detail since firm sizeseems to be an important variable and perhaps different programs anddifferent incentives are required for firms of different sizes.

The result that audits may be privately profitable yet underprovided couldbe further examined from the viewpoint of whether or not this construes‘market failure’. That is, whether or not the market for energy efficiencyservices within Australia is constrained in any way from developing oroperating. It may not be ‘market failure’ but just that this complex markethas not yet fully evolved (see, for example, Kasper 1997). One suggestionis further investigation of the need for energy service providers to becertified, and if so, the form which such a certification scheme should take.


15 Total potential annual savings

Total potential Share of total Total potential Share of the totalenergy savings firm energy use energy savings cost of energy

GJ % $ %Discounted payback period2 years or less 4 995 243 5.3 48 829 481 9.34 years or less 8 327 737 8.4 71 859 279 13.3

All measures 10 753 306 10.5 82 664 027 15.2

Source: Harris et al. (1996).

Concluding comments

‘No regrets’ is a simplistic notion and energy efficiency is a complex issue.EEAP worked because it addressed the complexity of investing in energyefficiency. However, this does not necessarily mean that EEAP should bereinstated even though it was in all likelihood a cost effective policy.Although the government subsidy served to initiate a firm’s involvement inEEAP, the end result was usually worthwhile for the firm. Results of analysisindicate that this would have been the case even without the subsidy.

The main policy implication is that promotion of the type of process whichoccurred under EEAP might be a useful direction to pursue (assuming thatenergy efficiency policies will be pursued in future and that public provisionof information is a cost effective general method). Promotion shouldconcentrate on the desirability of a firm taking an enterprisewide view oftheir energy efficiency, perhaps also consulting an expert. This is distinctfrom a view which concentrates on the government providing informationon individual technologies separately.

Promotion should be targeted to firms of all sizes, but the fact that EEAPtended to attract larger firms means that a special focus for ‘small’ firms isimportant. Some sort of certification program might also be necessary toensure confidence in the ‘experts’ who conduct the audit-type process ormonitor a firm’s energy efficiency.

Another important area requiring attention is decision making rules. Atpresent there is a big gap between theory and practice. The popularity of the‘simple’ payback rule, despite there being problems with it from aneconomic perspective, illustrates the need to encourage the use of moreadvanced evaluation techniques. One option is stochastic NPV, which takesaccount of the riskiness of investments and the costs of collecting additionalinformation.


Overview of EEAP data

The following is an overview of the results from the last consultancy reportABARE provided for DPIE on the EEAP (Harris et al. 1996). It is takenfrom the ‘summary’ section of this report with the addition of a few keytables of data (tables 13–15).

• Manufacturing and community services sector firms account for close to30 per cent and 20 per cent of the total number of audit reports respec-tively.

• The largest number of audit report recommendations relate to lighting,and the most common energy savings measure is to install automatictimers or sensors. These are relatively low cost measures which yield sig-nificant energy savings and their identification is therefore important.

• New South Wales, the ACT and Victoria jointly account for almost 60 percent of participants in the energy efficiency audit program.

• The median annual potential energy saving across all the audited firms is1001 gigajoules, valued at $30 500. This is similar to last year’s findingand corresponds to a potential annual reduction in carbon dioxideemissions of 223 tonnes per firm. These results are detailed in table 13which also contains the median per firm results for investments withrestricted payback periods.

• The average per firm results reported in table 14 are higher than themedian results of table 13. The is because there are a few extreme valuesin the data set (the data set has a skewed distribution). Total potentialsavings across the whole sample, again with results for various paybackperiods, are reported in table 15.

• The highest potential energy savings, which also offer the largest potentialreduction in carbon dioxide emissions, are found in the manufacturingsector. In previous years the ‘electricity, gas and water’ sector has offeredthe largest potential for reductions in carbon dioxide emissions.

• Within the manufacturing sector, the highest potential energy savings arein the textiles industry, while the highest potential value of savings andpotential carbon dioxide reductions are found in the wood, wood productsand furniture industry.

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Appendix

• Within the community services sector, the highest potential energysavings in gigajoules and in carbon dioxide emissions are still estimatedto be in the health services sector.

• At the state level, the highest median potential savings are found inQueensland followed by New South Wales and the ACT.

• The areas which offer the highest potential energy savings are those whereenergy is used for steam production and process heating. Steam pro-duction is also the area where carbon dioxide emissions are potentiallythe highest.

• The savings measures which are estimated to generate the highestpotential savings are the use of cogeneration and the installation of highefficiency motors.

• As in other years the most attractive investments, or those with the highestpotential returns (taking account of the costs of implementation as wellas the savings generated), are in the electricity, gas and water industry,followed by the transport industry and then the manufacturing industry.The extent of the difference in the economics of energy efficiency optionsbetween the electricity, gas and water and other sectors has narrowedsignificantly since last year.

• The highest potential returns to energy saving investments on a state basisare in South Australia.

• Energy saving investments which can be undertaken at relatively low costbut still generate large potential returns relate to the use of energy inlighting, industrial equipment and air conditioning.

• About 96 of the firms which participated in the audit program reportedpotential energy savings of more than 10 000 gigajoules a year. Thesefirms represent only 11 per cent of all firms in the analysis but accountfor 71 per cent of potential energy savings. The majority of these firms(68 per cent) are in the manufacturing sector. The measures for whichpotential energy savings exceed 10 000 gigajoules a year are the use ofhigh efficiency motors and alternative energy sources.


Reliability of estimates

An indication of the reliability of the estimates contained in this report isgiven by the relative standard error (RSE) of these estimates.

Sampling errorsOnly a small number of firms from the total number of firms audited areused to produce the survey estimates. The difference between these estimatesand the estimates that would have been obtained if information had beencollected from all audited firms are called sampling errors. The estimatederrors, expressed as percentages of the survey estimates and termed ‘relativestandard errors’, are included in all tables. In general, the smaller the relativestandard error, the more reliable the estimate. Note, however, thatnumerically small estimates tend to have large relative standard errors.

Nonsampling errorsThe values obtained in a survey are affected by errors other than thoserelating directly to the sampling procedure. For example, it might not bepossible to contact certain types of firms, the respondent may provideinaccurate information or may differ from nonrespondents in certainattitudes or investment behavior. ABARE’s experience in conductingsurveys of industries has resulted in procedures designed to minimisenonsampling errors. However when drawing inferences from estimatesderived from sample surveys, users should bear in mind that both samplingand nonsampling errors do occur.

Sample weightingThe estimates presented in this report are calculated by appropriatelyweighting the data collected from each sample firm and then using theseweighted data to calculate population estimates. The sample used for thisreport has been weighted to represent the audit population, as distinct fromthe population of firms in Australia.

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Appendix

Example of the interpretation of relative standard errors

The following example of the interpretation of relative standard errors istaken from ABARE (1997). To obtain the standard error from the relativestandard error, multiply the relative standard error by the survey estimateand divide by 100. For example, if average total operating costs are estimatedto be $10 000 with a relative standard error of 6 per cent, the standard errorfor this estimate is $600. There is roughly a two in three chance that a surveyestimate is within one standard error of the value which would have beenobtained if all firms in the target population had been surveyed. There isroughly a nineteen in twenty chance that a survey estimate is within twostandard errors of this value. Thus, in the above example, there is anapproximately two in three chance that the population value is between$9400 and $10 600, and an approximately nineteen in twenty chance thatthe population value lies between $8800 and $11 200.


Rules for evaluating investments

There are a number of possible approaches to measuring the attractivenessof investments. The following is taken from Harris et al. (1997, p. 10–12).

The net present value (NPV) of an investment is the sum of all discountedcosts and benefits (or savings) from the investment. The future streams ofcosts and benefits are discounted to current dollar terms. To calculate the netpresent value it is necessary to specify the discount rate, the life of theinvestment (or for how many years the benefits will flow), the initial outlayand the size of the benefits each period. A positive net present value indicatesa net benefit to the investor while a negative result indicates a net loss.

The internal rate of return is the rate of interest that equates the presentvalue of benefits with the cost of the project. It is found by setting the netpresent value equal to zero, for a given economic life of the investment, andsolving for the discount rate. The internal rate of return can be comparedwith the market rate of return to assess the attractiveness of the investment.

The discounted payback period is the number of years before the investmentbreaks even — that is, where the net present value equals zero. It is foundby setting the net present value equal to zero, for a given discount rate, andsolving for the number of years.

Theoretically, the best criterion for ranking investments is the net presentvalue. It can be used to compare projects with different flows of costs andbenefits over time. For projects with different flows of costs and benefitsover time, the other two criteria can lead to rankings which do not necessarilyreflect the most attractive investment option. That is, the project with thehighest net present value, which is therefore the most attractive option, willnot necessarily have the highest internal rate of return and shortest paybackperiod.

However, the payback period is often used by firms as a guiding principle.For example, unless the returns will cover the initial outlay within a fewyears, many firms may not be interested, even if the net present value overthe full life of the investment is high. Firms often implicitly apply somemaximum payback period.


A number of assumptions must be made when calculating net present value,internal rate of return and payback periods. The following assumptions weremade in Harris et al. (1997) and used again in the current study:

• The economic life of an investment is ten years. This assumption isnecessary because the audit reports often do not provide informationabout the expected economic life of investments.

• The real discount rate is 8 per cent.

The full cost of investments is incurred at the start of the first year. Benefits,in the form of energy savings, flow uniformly over the life of the investment.The cost of the audit is subtracted from the discounted flow of benefits.


References

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—— and Pindyck, R.S. 1994, Investment Under Uncertainty, PrincetonUniversity Press, New Jersey.

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Eyre, N. 1997, ‘Barriers to energy efficiency: more than just market failure’,Energy and Environment, vol. 8, no. 1, pp. 25–43.

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Hinchy, M.D., Naughten, B.R., Donaldson, P.K., Belcher, S. and Ferguson,E. 1991, The Issue of Domestic Energy Market Failure, ABARE TechnicalPaper 91.5, Canberra.

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—— and —— 1994, ‘Energy efficiency investments and public policy’,Energy Journal, vol.15, no. 2, pp. 43–65.

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Documents

Energy efficiency investment in Australia - data.daff.gov.audata.daff.gov.au/data/warehouse/pe_abarebrs99000570/PR11751.pdf · The authors would like to acknowledge Tony Marker and