Why energy efficiency is key to sustainable development

2015 – an important year for climate action

2015 represents a crucial juncture for global climate governance. This year, signatories to the UN Framework Convention on Climate Change will meet at the climate summit in Paris to negotiate a legally binding and universal agreement to keep global warming below two degrees. In addition, the Millennium Development Goals (MDGs) – agreed by 189 United Nations member states in 2000 to address global poverty, hunger, disease, education, gender inequality and environmental sustainability – expire in 2015. Following and expanding on the MDGs, a new set of universal goals, the Sustainable Development Goals (SDGs), will be adopted by the UN members in September. From January 2016 until end of 2030 the member states of the United Nations are expected to frame their agendas around those goals. Up to now, the improvement of global living standards has been targeted by the MDGs mainly through the transfer of relevant technologies (e.g. electrification, telecommunications, medicine) from high-income to low-income economies. Meeting the SDGs will require a more universal approach. These goals aim at improving the lives of people worldwide while respecting ecological limits. New technologies, business models and social concepts – in both developing and developed countries alike – will play a key role to ensure a sustainable development. The SDGs are focused around six elements: (1) Dignity, (2) Basic needs of people, (3) Prosperity, (4) Planet, (5) Partnerships and (6) Justice. Around these six elements there are currently 17 suggested goals with 169 targets. Energy supply is inevitably linked to this challenge. Energy and its appropriate availability to all people can boost economic development and human well-being (e.g. cooking, heating, cooling, lighting, transportation). But it could also worsen the adverse impacts such as climate change, air pollution, and regional disparities.

Global energy supply under stress

The world’s energy demand is forecast to increase by 37% by 2040 (International Energy Agency (2014): World Energy Outlook 2014). Most of this rise will come from Asian countries, where energy consumption is driven by strong economic and demographic growth. With the worldwide energy consumption based primarily on oil, “the global energy system is in danger of falling short of the hopes and expectations placed upon it”, as states the International Energy Agency (IEA) in its World Energy Outlook 2014 report. The majority of the world’s energy sources is concentrated in few geographical locations. Hence, political and economic events in these regions play a predominant role in the global energy system. Since the 1930s the Middle East has become the world’s dominant source of low-cost oil and Russia holds among the world’s largest oil and gas resources. Recent events in these politically volatile areas have reignited worldwide concerns about energy security. Additionally, the future of nuclear energy – that was expected in the 1970s to rise rapidly as the primary source of electricity – is unclear. High capital costs and rising safety requirements, particularly after several nuclear accidents (e.g. Three Mile Island, Chernobyl, Fukushima), stopped the quick growth of this source of energy. Without improvements in energy efficiency and cost development of new energy technologies such as Photovoltaics, the global energy system would be even more under stress. Hence, changes in global trends to a decentralized low-carbon energy system are inevitable to ensure access to affordable, reliable and sustainable energy for all.

Promoting energy efficiency

The IEA sees energy efficiency as “a critical tool to relieve pressure on energy supply”. New pathways will be required to master the challenge of promoting energy efficiency: a complex combination of research and development, public and private investments in energy infrastructure, new regulations and urban planning. To promote more efficient use of energy, international and national policies remain crucial. Yet, market-based approaches can be an effective element to channel private decisions in the right direction. All activities of economic agents – individuals, businesses, governments – require energy. Therefore, market mechanisms and new business models play a significant role in helping to achieve energy efficiency improvements.

“Energy efficiency represents around 40 percent of the greenhouse gas reduction potential that can be realized at a cost of less than EUR 60 per metric ton of carbon dioxide equivalent” (“Pathways to a Low-Carbon Economy: Version 2 of the Global Greenhouse Gas Abatement Cost Curve”, at globalghgcostcurve.bymckinsey.com) . In 2012, investments in energy efficiency are estimated between USD 310 and 360 billion representing a very significant and growing market opportunity for investors and businesses. Energy savings from energy efficiency exceeded the total final consumption from any single fuel source in 2011. Energy efficiency offers an immense low-cost energy resource – but only if innovative business models can be developed to unlock its entire potential. Energy efficiency is often still underestimated by public institutions and private businesses and a number of persistent barriers need to be addressed to enable the large-scale implementation of energy efficiency initiatives.

Barriers to implementing energy efficiency measures

Different factors prevent widespread investment in energy efficiency measures. Below is a brief overview of the key barriers.

Lack of expertise and information: The implementation of energy efficiency improvements is often prevented due to the lack of expertise and information. Insufficient information and a highly technical nature make it difficult for non-experts to understand the significant potential of such measures. Information obstacles exist particularly because of poorly synthesized information regarding financial solutions. These information barriers lead to a lack of awareness amongst industrial companies for the significant financial benefits that energy efficiency projects offer.

Low priority of energy efficiency projects: Energy efficiency almost always, sits outside the core competencies of most businesses. As a result, the company’s core business activities are prioritized when determining annual budgets. Having comparably long paypack periods (> 3 years) many companies prefer other internal investments generating shorter-term profits – even though cost reductions from lower energy intensity are significant and predictable.

Size of energy saving projects: The size of energy saving projects is relatively small in comparison to other investments. Therefore, energy efficiency enhancements in industrial facilities or private and public buildings are associated with high transaction costs and corporate entities generally prefer to finance other projects with better replicability.

Access to capital: Access to capital is cited as the most important barrier to the deployment of energy efficient technologies (Prognos (2009): Rolle und Bedeutung von Energieeffizienz und Energiedienstleistungen in KMU). Energetic retrofits often require high upfront investment. As mentioned, a company’s budget tends to prioritize core business activities and short-term projects with rapid returns (despite lower long-term savings potential) than energy efficiency improvements. Accessing external capital for energy savings can be very difficult. Building/facility owners often cannot take any additional debt for these kind or projects as they do not contribute to securing the company’s debt ratio. Besides, only a limited number of financial products are available to finance the improvement of energy efficiency performance. Today, primarily Energy Service Companies (ESCOs) have financed energy efficiency measures via contracting solutions. Since the financial crisis though, ESCOs are frequently not able – and willing – to meet the financial needs of their clients. Leasing companies provide an alternative financing solution but are only financing measures that have asset-based character.

Solution to finance energy efficiency initiatives

In many countries policy is focusing increasingly on energy efficiency – by developing energy efficiency targets and policy measures from subsidies to mandates. For instance, the European Union has set a binding target of 20% energy savings by 2020 in the EU’s member states. But reaching these goals on energy efficiency still remains a great challenge with many countries lagging significantly behind. Around EUR 100 billion of investment per year is needed to meet the EU-wide target. Given the state of public finances and the current economic growth, private investors are encouraged to bridge the financial gap. Traditional institutional Investors in OECD countries such as pension funds and insurance companies manage over EUR 65 trillion of assets and need to ensure a 3-4% annual return (OECD Global Pensions Statistics and Institutional Investors databases and OECD estimates).

With government bond returns in Europe below 2% investors are increasingly under pressure to find alternatives to their fixed-income allocations. Due to the generation of stable and predictable cost savings, energy efficiency projects can be an attractive investment opportunity for these investors. Energy efficiency projects which are not financed from internal resources of the energy saver and are interesting for external financing usually have payback periods of between 3 and 7 years. However, in many cases, the projects are small and too complex for direct investments. To generate attractive returns for institutional investors, the investments and returns need to be aggregated and packaged into investment vehicles. By bundling energy efficiency projects into a fund structure an appealing investment opportunity for institutional investors can be created. An energy efficiency fund provides investors with sufficient investment size whilst reducing the risks and improving the stability of cash flows through diversification. Additionally, energy efficiency projects have a low correlation to financial markets and a positive impact on the environment by reducing CO₂ emissions.

A specialized energy efficiency fund is interesting not only for investors but also for industrial customers and technology providers. Implementing energy efficiency projects in cooperation with a fund allows companies to pre-define financing and contractual conditions. This enables projects to be scaled up to large portfolios of manufacturing plants, reducing complexity and transaction costs for all parties involved. Additionally, such a cooperation allows performance contracts to be tailored to customer needs (e.g. off balance sheet treatment). A cooperative approach provides the platform for harnessing energy efficiency’s full potential, significantly reducing the energy bill of industrial or public customers in the immediate term without taking performance risk nor requiring the customers own capital to be deployed, ultimately making energy efficiency an economic as well as environmental success.

Energy efficiency investments do not only bring financial returns to investors, private and public owners as well as asset operators – they create public benefits in terms of lower greenhouse gas emissions, increased employment, reduced foreign energy import dependence and improvement of a country’s or communities’ fiscal balance. Therefore, energy efficiency investments address six of the SDGs (Goals 8, 9, 11, 13, 16 and 17) due to theirs strong links with sustainable development in all its dimensions – economic, environmental and social.

This article is published in collaboration with Huffington Post. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Otto von Troschke is Co-Founder and Chief Investment Officer of SUSI Partners AG, an investment house focusing on sustainable energy infrastructure investments in the area of renewable energy, energy efficiency and energy storage.

Image: Eskom’s electric pylons are pictured in Soweto, southwest of Johannesburg, March 31, 2015. REUTERS/Siphiwe Sibeko.