But although numerous studies have reinforced the value of energy efficiency investments — they are cash-flow-positive at competitive rates of return — these investments lag in the marketplace. As a result, the energy efficiency of a region’s building stock typically improves very slowly, as old buildings are demolished and new ones are constructed. One reason for this is the high transaction costs for energy efficiency improvements. The projects themselves may not be expensive, but they require complex engineering skills to implement. Also, because of the historical variability in building practices, the returns from efficiency improvements in specific buildings are difficult to predict; larger financial institutions are therefore reluctant to support the necessary capital investments. Finally, although the companies that occupy buildings often benefit from efficiency upgrades, they understandably prefer to allocate capital and management time to their core business, not to the buildings they inhabit.
The result is a market failure: The incentives for building owners, operators, and managers to implement the kinds of improvements needed are insufficient to overcome the hurdles they face, even when the outcomes would be better for everyone.
To be sure, efforts have been made to align and strengthen incentives, but they have not been sufficiently successful. Tax credits, for example, provide building owners with motivation to undertake efficiency improvements, but they do little or nothing to connect owners with the capital or expertise needed to identify and execute improvements. Publicly funded efficiency programs provide a capital infusion that helps in meeting rate-of-return hurdles, but support is typically provided for particular technologies, not for the net gain in overall savings per building. A building owner might install better windows or insulation, but never realize the efficiency gains possible from rethinking the entire energy system. Energy service companies (ESCOs) have been created that offer comprehensive energy efficiency improvements and operate by collecting most or all of their payment from the stream of savings. But ESCOs typically finance quick-return projects on a building-by-building basis, and their efficiency “investments” are illiquid and not transferable to other locations.
But what if more governments at all levels sought creative ways to align incentives that would unlock greater improvements in energy efficiency? They would find many opportunities. For example, they might establish finance agencies to serve as a secondary market catalyst for energy savings, akin to the role the bond market plays in the home mortgage industry. A finance agency could define technical criteria that ESCOs (or other service providers) would have to meet if they wanted to qualify for inexpensive financing. It could also help ensure low-cost financing by serving as a secondary market for the rights to savings generated by energy efficiency improvements, thereby reducing payment risk. This arrangement could be further enhanced by tradable carbon credits, which would be awarded to owners of buildings with verifiable reductions in energy use. Building owners and operators could then finance improvements with either their future savings or their revenues from selling carbon credits.
Finally, if more energy regulators agreed to decouple utility revenue from earnings — allowing power companies to earn money more easily on their efficiency-related investments — it would remove a major disincentive for promoting conservation and the development of distributed generation of electric power. In the U.S., six states have attempted decoupling, with mixed results; the design of particular programs matters a great deal. The key with incentives in general is to structure all innovations so that they reinforce, rather than undermine, one another. If regulators put such a structure in place, it would, for the first time, powerfully align utilities, building owners, energy service providers, and financial institutions in support of broader and deeper energy efficiency improvements.