Developing a blueprint
for an energy efficiency
asset class
Lessons from institutional
entrepreneurship
WHITE PAPER
Miriam Fischlein, Cindy McComas, Timothy M.
Smith
Informing an Emerging Energy Efficiency Asset Class
Institutional entrepreneurship for developing an energy efficiency asset class
Abstract
With energy efficiency investments, initial investments are recouped over time by means of
accumulated savings from reduced energy use. Financial actors require verification and assurance
to make loans based on such future energy savings, and no firm rules exist to provide this.
Although the finance sector is showing increasing interest in energy efficiency, it remains on the
fence, because energy efficiency investments are perceived as an unknown and risky entity.
Energy efficiency projects often provide excellent returns on investment and many projects use
proven technology, but there is little experience among financial actors with this type of project
financing. Lack of access to financing poses a substantial hurdle for energy efficiency projects in
industry.
The persistent gap between economically justifiable and actual implemented energy efficiency
investments has puzzled researchers and practitioners for over four decades. Economists have
characterized this gap as market failure, while behaviorists believe it is caused by individual,
interpersonal, organizational, or cultural factors. Accordingly, they have focused on the degree to
which market and behavioral factors lead to less than optimal outcomes and where policy
intervention might correct for them. This study takes a different approach, aiming to understand
the interaction between organizational structures and their environments in perpetuating the
energy efficiency gap. Developing new rules for a widely accepted asset class for energy efficiency
may contribute to closing the energy efficiency gap. The study employs the institutional
entrepreneurship framework to identify potentially influential change agents for creating an
energy efficiency asset class. It also draws on prior examples of successful asset class
development to map out a blueprint for establishing an energy efficiency asset class.
The authors would like to acknowledge the following persons who have made contributions to this project:
Suvrat Dhanorkar, CSOM Graduate Student; Rolf Nordstrom and Lola Schoenrich, Great Plains Institute;
Danny Zouber, NorthSky Capital; Alfie Marcus, CSOM; Skip Laitner, ACEEE; and representatives from Trane
Company, Ingersoll Rand, and Egan Company.
© 2011 Green Patents and Platforms for Collaboration. All rights reserved. No portion of this paper may be
reproduced without permission of the authors. White papers are research materials circulated by their
authors for purposes of information and discussion. They have not necessarily undergone formal peer
review and may be submitted for publication.
1
Introduction
Concerns about the environmental impact of energy use and the security of future energy
supplies continue to mount, putting energy efficiency once again back in the spotlight. Energy
efficiency investments are a no or low cost solution to these issues; particularly in the industrial
sector, many energy efficiency projects carry the promise of substantial financial returns (UNEP,
2009). Even now, financial programs to increase adoption of industrial energy efficiency practices
are numerous. Most of these efforts are government funded or run by utilities in the context of
demand side management. Yet these tools have not provided sufficient incentive for companies
to take action on energy efficiency investments at a seemingly justifiable scale. It is estimated that
energy use can vary by a factor of 2 to 3 between the most and least energy efficient firms in a
sector (De Beer, 2000) and that the average firm implements less than two thirds of
recommended and economic projects (Anderson and Newell, 2004; DeWahl, 2010). Although $43
billion was spent on energy efficiency improvements in the United States alone in 2004,
amounting to 1.7 quads of energy savings (Ehrhardt-Martinez and Laitner, 2008), the market
potential is much larger according to analysts. Energy cost savings could amount to $900 billion by
the year 2020, with investment opportunities on the order of $170 billion annually (Farrell and
Remes, 2008).
To achieve this investment potential, utility and government-driven programs alone will not
suffice. As part of the increased focus on energy efficiency, policymakers are evaluating the role
of private sector companies in delivering cost effective energy savings to end users (Satchwell et
al., 2010). Energy service companies (ESCO) are devising innovative methods to deliver complete
packages for technology delivery and financing to industrial companies. Financial institutions in
search of new markets and new technologies to invest in are exploring financial tools that meet
the needs of businesses of all types. New instruments are beginning to emerge that might address
the shortcomings of existing programs by targeting more directly the motivations of industry to
implement energy efficiency. Finally, technology vendors are seeking markets and customers to
sell new, more energy efficient technologies to in the residential, commercial, and industrial
sectors. Many equipment vendors are financing projects through their own organizations or by
partnering with third parties.
The present study aims to illuminate the activities of these private actors and their potential role
in developing a new asset class for energy efficiency. In doing so, it offers a novel approach to
bridging the energy efficiency gap. For over four decades, researchers and practitioners have
been puzzled by the gap between economically justifiable and actual implemented energy
efficiency investments. Economists have characterized this gap as market failure, while
behaviorists believe it is caused by individual, interpersonal, organizational, or cultural factors.
Accordingly, they have focused on the degree to which market and behavioral factors lead to less
than optimal outcomes and where policy intervention might correct for them. This study takes a
2
different approach, aiming to understand the interaction between organizational structures and
their environments in perpetuating the energy efficiency gap.
Establishing a separate asset class for energy efficiency may contribute to narrowing the energy
efficiency gap, because it would develop new inter-organizational routines. We draw upon the
institutional entrepreneurship literature which indicates that change agents may be able to
influence a company to take steps toward energy efficiency by creating new rules and routines. In
this sense, we can describe the energy efficiency gap as the result of a structured organizational
environment creating barriers to the adoption of industrial energy efficient technologies and
practices. Structures and norms within organizations are fairly stable and difficult to change via
financial incentives, demonstrated by the relatively slow utilization of government or utility
incentive programs for energy efficiency. It may take active (re)engineering of organizational
environments, norms, and institutions to attain a new equilibrium where energy efficiency
investments become a standard business activity. We draw on lessons from the development of
other asset classes to lay out a pathway for energy efficiency investments.
Industrial energy efficiency: current state and potential
In this study, we focus on industry, the most energy-consumptive of all sectors. It produces a large
amount of climate-forcing gases and other environmental pollution. In 2009, energy use in the
United States was 94.79 quadrillion Btu and fell into four broad sectors (EIA, 2011d): industrial
(30%), transportation (29%), residential (22%), and commercial (19. Just as in the United States,
industry consumption dominates energy use in the world’s largest economies (Table 1).
Electricity consumption
(1,000 GWh)
All sectors
2,842
Industry
1,926
Germany
526
India
Japan
China
USA
Total energy consumption
(1,000 tons oil equ.)
68%
All sectors
1,371
Industry
655
48%
242
46%
236
55
23%
602
279
46%
408
115
28%
964
304
32%
319
87
27%
3,814
915
24%
1,542
295
19%
Table 1. Industrial energy and electricity consumption 2008, selected countries. Note: tTe discrepancy in
the size of the industrial sector results from difference between the IEA and the US classification system.
Source: IEA (2011)
3
The potential for energy in this sector is especially large, not only due to its size. Energy efficiency
projects in industry are often big and offer more bang for the buck, due to scale effects and the
point-source nature of industrial pollution. Energy efficiency improvements also seem to be
associated with productivity increases (Worrell et al., 2003). The industrial sector is theworld’s
largest energy consumer, using about 37% of delivered energy worldwide (Abdelaziz et al.,
2011).The proportion of industrial energy use in OECD countries is roughly half that of non-OECD
countries, explained by both structural differences in the relative importance of industry and
service sectors, and differences in technology (EIA, 2010). Industrial energy-use in non-OECD
countries is growing much faster, too (Abdelaziz et al., 2011). Among the world’s largest
economies, the industrial sector is particularly dominant in China, where industry demand
accounts for more than two thirds of electric energy consumption and close to half of all energy
consumption.
As the leading user of energy across the world, the industrial sector appears to be a prime target
for increasing energy efficiency. In the United States, older estimates for achievable energy
savings potential in the industrial sector average slightly more than 14% (Nadel et al., 2004). More
recently, several regional studies have cited an energy savings potential of up to 25% in the
industrial sector by 2025 (reviewed in Chittum et al., 2009). Certain areas of activity and certain
end uses show particularly high savings potential. A handful of sectors dominate both electricity
and total energy use, notably petroleum and coal extraction and refining, chemicals, paper, and
metals (Table 2). While energy efficiency investments may offer the greatest returns in these
areas, opportunities exist even in the less energy intensive sectors. For many industrial products,
energy use per ton output can vary by a factor of 2 to 3 across different facilities (De Beer, 2000),
indicating potential areas of improvement.
With regard to energy consumption by end use, the largest potential for savings exists in core
production processes. On average, these processes take up close to 60% of an industrial facilities’
energy consumption, compared to lighting and HVAC at 10%, and boiler fuel at 30% (Table 2).
Companies can realize 25-30% energy and cost savings by making improvements to core industrial
processes such as compressed air, steam, process heat, motors, pumps, and fan systems, as well
as recovery of waste heat (DeWahl, 2010).
Since the mid-1990s, industrial energy consumption has been on a downwards trend both in
absolute and relative terms, whereas energy use has continued to rise in the commercial,
residential and transportation sectors (EIA, 2011c). Relative declines in industrial energy use can
be attributed to a structural shift in economic output from industry to services. However,
industrial energy use has also decreased in absolute terms, while industrial output has continued
to grow. The on-going reductions in energy intensity for the U.S. industrial sector point to an
increasing interest in energy efficiency over the past two decades.
4
END USE
INDUSTRY SECTOR
Electricity Use
All Energy Use
Petroleum and Coal
137
6,864
Chemicals
517
5,149
Paper
247
2,354
Primary Metals
458
1,736
Food
251
1,186
Nonmetallic Minerals
147
1,114
Transportation
195
477
Wood Products
91
451
Fabricated Metal
143
396
Plastics and Rubber
182
337
Machinery
111
204
Textile Mills
66
178
Computer/Electronics
94
142
Beverage/Tobacco
30
107
Electrical
44
103
Printing
45
85
Textiles
20
72
Miscellaneous
33
66
Furniture
32
61
Apparel
7
14
Leather
1
3
84
2,830
Process Heating
379
2,942
Process Cooling and
Refrigeration
Machine Drive
226
33
1,731
213
255
-
48
163
Facility HVAC (g)
285
393
Facility Lighting
215
-
Other Non-Process Use
82
130
End Use Not Reported
29
278
Boiler Fuel
Electro-Chemical Processes
Other Process Use
Table 2. Energy and electricity use in MMBtu by US industrial sectors and end uses, 2006. Source: EIA
(2011a)
5
Nevertheless, a gap persists between theoretically economic investments in energy efficiency and
those actually undertaken. Despite high rates of return to be gained, firms seem to underinvest in
energy efficiency (DeCanio, 1993). Experience has shown that companies participating in energy
efficiency incentive programs realize only a third to half of all recommended projects (Anderson
and Newell, 2004; DeWahl, 2010). Discount rates for energy efficiency are orders of magnitude
higher than typical interest rates on business loans (Sanstad et al., 1995).
Investments in the energy efficiency sector remain moderate at this point in time, although the
pace of growth is crisp. Worldwide venture capital and private equity investments in the energy
efficient technology sector reached $2.1 billion in 2009, a 4% growth rate over the previous year
(UNEP, 2010). The same year, R&D spending on energy-efficient technologies reached $ 16.8
billion (UNEP, 2010). Following the 2008 financial crisis, a proportion of stimulus funds across the
world aimed at jumpstarting the green economy. 30% of these green stimulus funds went
towards energy efficiency, for a total of $56 billion (UNEP, 2010). Overall, McKinsey and Company
estimate the global investment potential for energy efficiency at $170 billion annually through
2020 with average annual returns of 17 percent (Farrell et al., 2008). Overall, energy efficiency
investments appear to be on the upswing, but have not unfolded their full potential.
Understanding the energy efficiency gap: theoretical underpinnings
For over four decades, researchers and practitioners have been puzzled by the gap between
economically justifiable and actual implemented energy efficiency investments. Economists have
characterized this gap as market failure, while behaviorists believe it is caused by individual,
interpersonal, organizational, or cultural factors. Accordingly, they have focused on the degree to
which market and behavioral factors lead to less than optimal outcomes and where policy
intervention might correct for them. Energy efficiency programs have targeted market failures
and behavioral factors within companies. This study takes a different approach: it suggests that
the energy efficiency gap is rooted in deep institutional structures that can only be overcome by
creating new rules of the game. In this section we review explanations for the energy efficiency
gap and propose to employ lessons from institutional entrepreneurship to overcome it.
Explaining the energy efficiency gap
Market failure is the most prominent diagnosis of the energy efficiency gap. Market imperfections
include public good attributes of information, high transaction costs, and information
asymmetries, as well as uncertainty about future energy prices, technical and political
developments (Jaffe and Stavins, 1994; Golove and Eto, 1996; DeCanio and Watkins, 1998;
6
Gillingham et al., 2009). Uncertainty is a major factor in explaining the energy efficiency gap.
Compared to the residential and commercial sectors, industry is more heterogeneous,
complicating the implementation of energy efficiency programs (Chittum et al., 2009). Realizing
energy efficiency in an industrial setting brings a degree of uncertainty and change to the
organization. These uncertainties can be related to new equipment, needed training, impacts on
product quality, lack of technical expertise, lack of long-term strategic thinking, and meeting
customer needs.
Asymmetric information can also hamper energy efficiency where there is an inability to quantify
the certainty of operating cost savings. In this case, the likelihood to repay a loan from energy
savings cannot be calculated, making it unlikely to be granted (Golove and Eto, 1996). In a similar
fashion, the buyers of new equipment cannot verify the actual energy savings, but must trust the
manufacturer’s assurances. Where the energy efficiency gap is diagnosed in orthodox fashion as
market failure, external information provision and policy intervention are often proposed as the
best strategies for prompting firms to bridge the gap (Sexton and Sexton; Seligman and Darley,
1977; Anderson and Newell, 2004; Matsukawa, 2004).
Purveying additional external information is a powerful approach, but it is also problematic,
because it is aimed at rational decision makers. A number of scholars have argued that the energy
efficiency gap is not (solely) due to market failure, but is also caused by institutional and
behavioral barriers. Accordingly, they propose to change behavioral biases and organizational
barriers through tools like risk management or decision support (Busenitz and Barney, 1997; Mills
and Knoepfel, 1997; Mills, 2003b). With regard to financial aspects of energy efficiency
investments, several such organizational barriers exist.
In most firms, there is an institutional separation between capital and operating budgets
(Gillingham et al., 2009). Therefore, incentives for investing in energy efficiency are split. There is
also an opportunity cost of investing in energy efficiency over other capital improvements (Jaffe
and Stavins, 1994). Energy management generally has a low status and does not figure high on
the priority list of managers concerned more with product specific improvements (DeCanio, 1993;
Rohdin and Thollander, 2006; Thollander et al., 2007). Another decision bias disadvantaging
energy efficiency investments is that managers tend to show higher sensitivity to up-front
investment costs than on-going operating costs (Hassett and Metcalf, 1993; Jaffe and Stavins,
1994; Anderson and Newell, 2004).
Managers also use a variety of shortcuts and decision rules when making investment decision;
these do not always favor energy efficiency investments. Busenitz and Barney (1997) have
demonstrated that under conditions of uncertainty and limited information, managers do not
follow a rational decision making model, but instead rely on biases and heuristics. Energy cost as a
share of operating costs is one such heuristic that seems to influence managers’ decisions on
investing in energy efficiency (Elliott and Pye, 1998). Energy costs account for roughly 2% of
7
operating costs for the entire manufacturing sector, but they can reach up to 20% for aluminum,
hydraulic cement, and industrial gases, or be as low as 1.2% for electronics and 0.6% for the
computer industry (Elliott and Pye, 1998). As a rule of thumb, the proportion of energy costs to
overall operating costs seems to be roughly equal to the share of capital investment going
towards energy efficiency (de Groot et al., 2001). This does not reflect the real importance of
energy costs, which, although a “minor component of a facility owner’s operating costs [are] a
major source of budget risk” (Jackson, 2010). They are difficult to predict and can fluctuate
widely, meaning that controlling energy costs should attract greater attention. Nevertheless,
managers seem to be more prone to use proportion of cost as an investment rule than relative
risk.
One more decision bias working against energy efficiency investments is firms’ focus on payback
period. Most firms prioritize payback time over discount rate in investment decisions. In order to
be implemented, energy efficiency projects have been shown to require at least a 12% return rate
or a payback period of less than 2 years (DeCanio, 1993). The problem with this decision bias is
that the payback rule of thumb “cannot distinguish between shorter or longer lived investments
nor […] between investments that are intrinsically more risky because of weather impacts or
other factors that vary across investment options” (Jackson, 2010), meaning that the payback
period applied has to be conservative to eliminate risky options. The short payback times
required for energy efficiency are at least partially caused by management compensation rules,
which are often tied to short-term performance and discourage longer term investments
(DeCanio, 1993; Bunse et al., 2010). In addition, it is thought that energy efficiency investments
encounter these higher ‘hurdle rates,’ because their uncertain and irreversible nature results in a
high option value (Hassett and Metcalf, 1993). However, Sanstad, Blumstein and Stoft (1995) note
that for energy efficiency investments, the “consumer must decide whether to include energy
saving attributes as part of a purchase that is being made primarily for other purposes.”
Consequently, they point out that option value alone does not adequately explain the high
discount rates for these types of projects. The term ‘energy efficiency gap’ indeed implies that
managers employ higher than economically rational discount rates (Jaffe and Stavins, 1994), as
they should invest in all projects with a positive net present value (DeCanio and Watkins, 1998).
Overall, it seems that commonly implemented energy efficiency programs aimed at providing
additional information may not adequately address the organizational barriers towards energy
efficiency investments. Energy efficiency investment decisions are inherently complex, because
they often involve multifaceted process changes and estimated returns are uncertain. If energy
efficiency investment is to grow successfully, its perception needs to be reshaped. Managers will
need to move away from seeing it as a low-priority, uncertain investment, to perceiving it as a
high value added, front of the line investment. Policy intervention may not be the only pathway
toward achieving this goal, but the private sector also has an important role to play. Not only are
firms increasingly putting into place methods to track energy use and assess efficiency
8
investments, but there is also nascent pressure from the insurance and banking industry to take
into account environmental and energy risk in investment decisions. Leveraging influential actors
outside of institutions and their power to reshape existing routines for energy efficiency
investment may represent a novel way to address the energy efficiency gap.
Overcoming the energy efficiency gap through institutional entrepreneurship
The present study proposes to look to institutional entrepreneurship theory to identify both key
actors and key actions to build new institutions favoring energy efficiency investments.
Institutional entrepreneurship refers to the “activities of actors who have an interest in particular
institutional arrangements and who leverage resources to create new institutions or to transform
existing ones” (Maguire et al., 2004). While institutionalist theory has traditionally emphasized
structure over agency, institutional entrepreneurship reestablishes agency as an important
element. In this theory, agency accounts for intentional action by individuals aimed at creating
and shaping institutions (Garud et al., 2007).
The development of this institutionalist sub-theory goes back to DiMaggio (1991) who attributes
the rise of new institutions to the actions of resourceful and organized agents who “see in them
an opportunity to realize interests that they value highly.” Institutional entrepreneurship
therefore highlights the tension between the forces of conformity and path dependency
emanating from existing institutional structures and the “entrepreneurial forces that bring about
change” (Garud et al., 2007) in these same institutions. Path dependency is understood here as
the institutional and technical lock-in caused by prior decisions and institutional design.
Institutional entrepreneurship is anchored in neo-institutionalism, which emphasizes that
institutions and formal organizations are shaped more strongly by environmental pressures and
cultural belief systems, and less by internal, rational processes. Neo-instutionalists argue that
institutions first and foremost strive for survival and legitimacy, not for efficiency. In accordance
with Barnett (2006) and others (Suchman, 1995; Fombrun, 1996; Ruef and Scott, 1998) legitimacy
can be described as an important signal of social acceptability that is subjectively bestowed upon
an organization by societal constituents (Deephouse and Carter, 2005; Thomas, 2007). In the neoinstitutionalist view, institutions are the “rules of the game” (North, 1990). They can be
understood as “humanly devised schemes, norms, and regulations that enable and constrain the
behavior of social actors and make social life predictable and meaningful” (Hargrave and Van de
Ven, 2006). Formal or informal, their primary purpose is to reduce uncertainty, by defining rules
and structuring environments. They are stable social structures created through repeated
interaction; constantly recreated and sustained over time through socialization (Scott, 2001).
While stability can be positive, these social structures also discourage beneficial changes.
9
In fact, institutionalists argue that institutional pressure does not necessarily result in efficiency,
because information is incomplete, actors have cognitive limits and institutions are often not
concerned with outcomes, but with processes. This cognitive turn in neo-institutionalism accounts
for intrinsic restraints in action (Scott, 2001). For instance, sometimes actors may not be able to
conceive of any different way to act. This view portends that taken for granted scripts play an
important role in structuring action. Generally, when uncertainty is high, the number of players is
low or information is scarce, players look to institutions to orient their behavior (North, 1990).
Therefore, the notion of institutions suggests inherent stability. By shaping the rules of the game,
institutions create path dependencies; they are slow to change. Based on the institutionalist
approach, it is conceivable that there exist stable patterns and routines applied to energy
efficiency investment decisions. The institutional practices of energy efficiency investment exist
both inside and outside the firm. The persistent energy efficiency gap indicates that they are
highly stable.
Nevertheless, organizations do change, and institutional entrepreneurship provides a window into
how this happens despite and because of institutional forces. Among theories of institutional
change, institutional entrepreneurship stands out as an approach that emphasizes agency and
interests over structure. Other approaches to explaining institutional change focus on common
stages and dynamics in the development of institutions (life-cycle models) or external changes
and their interaction with internal organizational factors to create change (evolutionary models).
While insightful, neither of these approaches leave much room for intentional shaping of
institutions. The study of institutional entrepreneurship fills these gaps by emphasizing elements
such as the importance of actors engaging in framing, the creation of shared understanding and
beliefs, and resource mobilization. It may give some guidance on how to shape new financial
instruments that can overcome existing energy efficiency investment practice that are locked in at
a modest level.
As Aldrich & Ruef (2006) have pointed out, in new populations, “mimetic isomorphism – copying
the most common or highly valued structure in the population […] is not an option”, because
what is legitimate is still undefined. Entrepreneurship research has shown that legitimacy is an
important factor in new venture success, since it facilitates the acquisition of other resources
(Delmar and Shane, 2004). Against this backdrop, institutional entrepreneurship attempts to
create new rules of the game, while attempting to legitimize them. Framing processes play an
important role in legitimizing new institutional rules. McAdam et al. (1996) understand them as
“conscious strategic efforts by groups of people to fashion shared understandings of the world
and of themselves that legitimate and motivate collective action.” Therefore, framing constitutes
an active shaping of commonly shared meanings. Framing puts the spotlight on the importance of
shared beliefs, ideas, and values, but also new ideas. Framing often means that actors refer to
existing ideas or institutions. In the sustainability arena, supporters of novel environmental
practices have often taken that route. Brown et al (2009) study the emergence of the Global
10
Reporting Initiative (GRI) as the preeminent corporate sustainability reporting tool and as an
“established norm of behaviour of socially responsible businesses.” They find that despite the
comparative powerlessness and limited resources of GRI’s backers, they were able to balance
diverse interests and create a new institution without putting in question existing ones. Arguably,
modeling environmental reporting on financial reporting helped to advance environmental
reporting in the case of the Global Reporting Initiative (Etzion and Ferraro, 2010).
Besides framing, resource mobilization seems to be central to successful institutional
entrepreneurship. Dorado (2005) theorizes that interested actors mobilize resources through
both planned activities of resource mobilization and collective action and the fortuitous
convergence of events. Actors mobilizing resources to establish new institutional practices are
often called change agents. Institutional entrepreneurship approaches have been used in
different contexts to describe and illuminate institutional change processes and the role of
change agents. A number of studies in the healthcare industry examine how institutions emerge
around technological innovations or how encrusted systems react when challenged by new
conditions. Maguire (2004) analyzed how advocate networks for AIDS patients have successfully
changed not only FDA permitting systems for new medications, but also challenged preconceived
notions about which research and patient care strategies are ‘right’ and ‘wrong’. Van de Ven and
Garud (1993) have looked at the development of the cochlear implant industry. They show that
institutionalization is a process that occurs over long time frames and involves multiple actors,
who both cooperate and compete. They also point to the fact that ‘institutional arrangements
and resource endowments’ that may be functional at the outset can hinder innovation in later
stages.
These and other studies offer insights into the important role of resourceful actors in proposing
and establishing legitimate new routines. Based on the insights gained from institutional
entrepreneurship into the importance of change agents and framing processes, the following
sections present an overview of actors influencing energy efficiency investments and review the
development of other asset classes to propose some pathways towards an energy efficiency asset
class.
11
Actors influencing energy efficiency investments
Prior research frames the energy efficiency gap either as market failure to be addressed by policy
intervention, or as behavioral bias at the firm level. Little attention has been paid to institutional
and stakeholder pressure’s role in shaping the decision context for energy efficiency investments
at the firm level. Accordingly, initial activity in this area was driven by governmental actors,
followed by utility programs. More recently, other private actors, such as insurance companies,
private investors, banks, and energy service companies have gained importance. Energy efficiency
programs offered by governments and utilities are important, but the efficiency gap continues to
persist. New instruments are now beginning to emerge that might address the shortcomings of
the existing programs by targeting more directly the motivations of industry to implement energy
efficiency. The private, non-utility sector plays an increasingly important role in driving energy
efficiency investments. The present section gives a brief overview of the role of each of these
actors in driving industrial energy efficiency.
Governments
Governmental actors have long taken an
active role in supporting increasing energy
efficiency through financial instruments.
Governments are ramping up energy
efficiency activities at all levels: federal,
state, and local.
The National Energy Policy Act of 2007
aims to reduce energy intensity by 2.5%
per year each year between 2007 and
2017. In the wake of the recession, there
has been a significant increase in federal
funding for energy efficiency programs
through the American Recovery and
Reinvestment Act (ARRA). The federal
government grants a variety of corporate
tax credits for commercial buildings,
industrial energy investments, and energy
efficiency compliance manufacturing. It
also runs market transformation programs
like Green Lights and Energy Star. Federal
Box 1. Property Assessed Clean Energy
Based on the historic model of issuing
municipal bonds to fund public projects, the
PACE financing structure enables local
governments to raise money through the
issuance of bonds or other sources of capital
to fund energy efficiency and renewable
energy projects. Property owners benefiting
from the improvement repay the bond
through property assessments. PACE allows
a property owner to install improvements
without a large up-front cash payment. The
debt is repaid over a set number of years for
those property owners who choose to
attach the cost of the energy improvement
to their property tax bill. The financing is
secured with a lien on the property and in
the event of foreclosure; the energy
financier is paid before other claims against
the property. PACE allows for the
repayment obligation to transfer
automatically to the next property owner if
the property is sold. While innovative, PACE
has recently been classified as a higher risk
program by Fannie Mae and FHFA due to
the decline in the housing markets.
Source: DOE (2011)
loan programs for energy efficiency
12
include Qualified Energy Conservation Bonds and a loan guarantee program by the Department of
Energy. The federal government also facilitates financing with initiatives like the Better Buildings
Challenge, which brings together six financial firms and numerous customers. It aims to increase
the energy efficiency of commercial buildings by 20%. Additionally, the federal government aims
to transform markets as a first mover and early adopter of energy saving technologies.
Consequently, many federal programs require retrofitting of federal buildings or set certain
efficiency standards for new building and equipment. Energy Savings Performance Contracting is a
tool widely used in federal and MUSH (municipalities, universities, schools and hospitals) settings.
Here, the value of the energy efficiency investments is “not the equipment cost, but the creation
of ongoing savings over time” (Christmas, 2011). This model used in the public sector could
potentially be replicated in the commercial and industrial markets, if loan guarantees by the
government and performance guarantees by the contractor were to be combined.
State level activities include the establishment in 24 states of statewide energy savings goals to be
obtained from adoption of an Energy Efficiency Resource Standard (EERS), legislative or state
regulatory directives to obtain all cost effective demand side resources (Barbose et al., 2009). For
example, in Minnesota, the Next Generation Energy Act of 2007 sets a goal for all utilities to
achieve an energy savings goal of 1.5% of gross annual retail energy sales Other state
government-run programs mostly provide passive incentives for energy efficiency, offering tax
rebates and loans to businesses and individuals. Direct loans and loan guarantees are the most
popular types of programs used by US states, followed by rebates on personal, corporate, sales
and property tax (DSIRE, 2009). Local and state governments are also turning to financial markets
to finance energy efficiency loan programs by issuing bonds (see Box 1).
While important and widely used, these financial tools require that an organization is already
interested in investing in energy efficiency and knows about the availability of the program.
Government-driven programs are also hampered by the fall-out of the recession. As states and
the federal government struggle to address budget deficit, funding is becoming less secure.
Government programs have been quite successful in the residential sector, but have struggled to
gain penetration in the industrial sector. Successful industrial energy efficiency programs require
expertise in the targeted industry, explaining perhaps why most government-run programs shy
away from process improvements, targeting instead low hanging fruits such as lighting.
Electric Utilities
Energy efficiency activities spearheaded by electric and gas utilities have come into widespread
use in the past three decades. These activities are often called demand-side management (DSM)
and “involve actions on the demand- or customer-side of the electric meter, either directly caused
or indirectly stimulated by the utility” (Gellings and Chamberlin, 1988). By the mid-1980s, utility13
based DSM had spread throughout the United States primarily as a load management tool for
delaying the need for new power plants (Loughran and Kulick, 2004). Originally, the term
therefore referred to programs aimed at producing desired changes in a utility’s load shape, but it
has since become closely associated with energy efficiency and conservation (Gillingham et al.,
2006) and expanded to include natural gas as well as electric energy. Currently, demand side
management is being utilized by close to 50% of all electric utilities (EIA, 2011b), and is employed
in almost every US state . In 2009, utilities reported cumulative energy savings from industrial
energy efficiency of 14.9 million Megawatt-hours (MWh), achieving a savings equivalent to 0.6%
percent of total retail sales (EIA, 2011b).
Funding for utility-run energy efficiency programs is generally collected through a mandatory
surcharge on customer bills, often referred to as a systems-benefits charge (Chittum et al., 2009).
Depending on state policy, energy efficiency finance programs are either run directly by utilities,
or funds are channeled through energy finance companies. Typical utility programs include rebate
programs, low interest loans, training and marketing, technical assistance, direct installation of
efficient technologies, or some combination of these measures. Another tool increasingly used by
utilities is on-bill financing, where loans – either provided directly by the utility or provided by
third party financiers and guaranteed by the utility – are repaid through the electricity bill over
time (Freeling, 2011). Industrial energy efficiency projects are highly attractive to utilities, because
they can achieve substantial energy savings in a single project and transaction costs are lower
than for residential projects. However, with utility-driven DSM, the pressure for adopting energy
efficient technologies is relatively weak, given that utilities have little direct influence over firms
and no direct knowledge of their operational process.
Insurance Industry
Insurance companies are relatively new players in the energy efficiency world. They have an
interest in energy efficiency investments due to their loss prevention benefits with regard to
climate change (Mills and Knoepfel, 1997; Schmidheiny and Zorraquín, 1998). Energy efficiency
can serve as a risk management tool (Mills, 2003a), because energy saving technology has
ancillary benefits, i.e., it also uses raw materials more efficiently, reduces health risks, business
interruption risk (greater reliability), and the risk of catastrophic events (e.g., fire, water leaks
etc.). Consequently, insurance companies are now starting to build these risk management
aspects into their insurance products. Increasingly, environmental indicators are becoming an
added basis for rate decisions (Schmidheiny and Zorraquín, 1998). Insurance companies provide
discounts to companies for energy efficient technology or offer to bundle business interruption
insurance with energy efficiency technology, which is often more reliable (Mills and Knoepfel,
1997). As the investment in energy efficient technology often hinges on the potential to recoup
14
the cost in energy savings, insurers are also starting to offer “energy-savings insurance” (Mills,
2003b), which covers the risk of new technology not achieving the promised energy savings.
Insurance involvement in energy efficiency is however hampered by several factors. In the United
States, the insurance industry is highly regulated, and insurers have to defend their rates in rate
cases. Therefore, there is insufficient flexibility to adjust for energy efficiency benefits in rates
(Mills, 2003a). In addition, insuring energy efficient technologies is a relatively new phenomenon
and so insurance companies are currently lacking high quality actuarial data to base their rates
and decisions on (Mills, 2003a). Finally, insurance companies, though among the biggest
institutional investors, tend to invest primarily in ultra-safe government bonds, minimizing their
potential role as investors in energy efficiency (Schmidheiny and Zorraquín, 1998). Nevertheless,
there seems to be some interest in energy efficiency investments due to their long-term fixed rate
characteristics, which makes them attractive instrument for the insurance industry with regard to
meeting their annuity commitments (Freeling, 2011).
Financial industry
Financial institutions participate in energy efficiency investments in their function as lenders and
investors. Similar to other operations and process loans, banks supply loans for investments in
energy efficiency, including as third party financers in ESCO contracts. Most loans provided by
commercial banks are therefore simply a form of project financing. Overall, commercial banks
have little direct participation in energy efficiency finance to date. According to Freeling (2011),
even where banks work with energy service companies to supply energy efficiency loans,
“performance guarantees, largely, are offered to the borrower to ensure the improvement prove
cost effective, but are not collateralizing the loans, nor necessarily, of particular concern to the
commercial banks involved.” This indicates that banks do not currently understand, nor take
advantage of the special characteristics of energy efficiency investments to reduce the
uncertainty associated with such project finance. Energy efficiency loans are often small and
considered risky.
Nevertheless, in an effort to provide capital to help reduce carbon emissions and energy
consumption, banks are beginning to support programs tailored to support energy efficiency
improvements. This is seen as the first step toward coordinated industrial energy efficiency
finance. For example, the Bank of America recently announced a new $55 million competitive
program to encourage energy efficiency improvements in older buildings through low cost loans
and grants (Bank of America, 2011). The energy cost savings realized over time will create cash
flow to repay the loan.
15
Another important impetus for energy efficiency finance comes from the investment industry.
Institutional investors have devised new rules for sustainable investment. An increasing number
of social and environmental funds target their investments specifically towards sustainable
companies. A number of such private equity and mutual funds have been created in the past two
decades. Ethical mutual funds have reported performance on par with conventional funds (Bauer
et al., 2005). A potential new trend in the investment sector is the securitization of energy
efficiency loans, where the risk of individual loans would be spread out by bundling and
repartitioning a large number of loans.
Overall, energy efficiency can be described as an up and coming investment sector, with very
good returns for the amount of risk involved. According to estimates by the McKinsey Global
Institute, global investments on the order of $170 billion annually through 2020 ($38 billion in the
US) in energy efficiency could deliver annual returns at a rate of 17 percent (Farrell et al., 2008).
The WilderHill New Energy Global Innovation Index, tracking 88 advanced clean energy
companies, lists energy efficiency as its best performing sector in 2010, with average share prices
up 19.5% from the previous year (Bloomberg New Energy Finance, 2011).
Energy Service Companies
Energy Service Companies (ESCOs) have been important in financing and implementing energy
efficiency projects, focusing on “improving the energy efficiency of facilities owned by others”
(Rivest, 1995). These organizations provide a service that encompasses energy audits, proposals
for improvements, installation and maintenance, performance contracts--all with the purpose of
offsetting the upfront costs with energy savings (Painuly et al., 2003). Their business model is
based on the principle of letting the customer outsource the risk of the energy efficiency
investment. In contrast to conservation consultants or energy service provider companies, ESCOs
assume at least some of the risk of performance for the projects they implement (Rivest, 1995).
They either provide financing themselves or can arrange for financing by third party providers
(Bertoldi et al., 2006). In some cases, ESCO even operate and own the facility (Goldman et al.,
2005).
ESCOs operate around the world, but their relevance and role can differ from country to country.
They are very active in Europe, where they have long been sustained by favorable regulation and
have mostly targeted the public sector (Bertoldi et al., 2006). In the United States, the ESCO
segment is somewhat smaller than in Europe, while also favoring the public and institutional
sector. In developing countries, ESCOs are gaining importance, but more sustained government
action will be required to achieve similar levels of activity as in industrialized countries (Painuly et
al., 2003). Developing ESCO industries is a declared objective of the World Bank, which has
16
implemented several dozen programs to that end (Sarkar and Singh, 2010). In some industrializing
countries, ESCO have made rapid gains, in particular in China (Sarkar and Singh, 2010).
ESCOs also have a long history in the United States (Goldman et al., 2005). In 2008, ESCOs
represented a market of US$ 4.1 billion in the United States, growing at a rate of 7% (Satchwell et
al., 2010) and up from roughly $2 billion in 2000 (Goldman et al., 2005). To a large extent, and
similar to the European case, demand by government and educational institutions drives this
business, with only 16% of ESCO revenue coming from the private sector (Satchwell et al., 2010).
Of these, energy efficiency investments in the industrial sector accounted for only 7% of ESCO’s
business in the US, although this share is slightly larger outside the US. In the industrial sector, US
industry has been hit hard by the recession, resulting in plant closures, job losses and reduced
capital investment in facilities. Many industrial customers are reluctant to enter into long-term
contracts, because they are not sure how long the manufacturing plants will remain open or at
what operation level. Also, measurement and verification (M&V) of savings tends to be more
challenging for industrial process retrofits, which may involve technologies that are proprietary or
commercially sensitive, as a result of which outside parties on site are not typically welcome
(Satchwell et al., 2010).
ESCOs use two basic strategies for recouping the energy efficiency investment cost: guaranteed
project savings and shared savings (Rivest, 1995). Within these contract forms, the degree of risk
sharing and the involvement of the ESCO vary. In guaranteed project savings, the ESCO only
facilitates the loan and the company bears the risk and pays back the credit based on a payment
schedule or from actual energy savings, which can vary from month to month. In this type of
contract, the savings guarantee becomes a kind of collateral for the third party financer, who is
guaranteed to recoup the loan via the energy savings(Bertoldi et al., 2006). In shared savings, the
ESCO either provides the financing or signs the loan and therefore assumes both the credit and
the performance risk. Shared savings without third party financing is the predominant model used
in the European ESCO market, where most ESCOs are subsidiaries of large companies(Energy
Charter Secretariat, 2003). In the US, there is some evidence that the use of performance
guarantees is declining, as customers become increasingly confident about and familiar with
energy efficiency investments (Goldman et al., 2005).
Guaranteed project savings are preferred by ESCOs over shared savings for several reasons. First
and foremost, guaranteed project savings keeps the ESCOs balance sheets clean. A few years ago,
the ESCO world was shaken by a Financial Accounting Standards Board (FASB) ruling that required
them to disclose the value of their energy guarantees on balance sheets, because they could
potentially result in payments to customers (Mayer, 2002). Additionally, external financing
agencies may be better equipped than ESCOs to evaluate credit risks (Gilligan, 2011). In
guaranteed project savings, ESCOs also do not incur the debt directly; which might be preferable
to smaller ESCO with fewer funds, but also because third party financing is cheaper than equity
17
financing (Bertoldi et al., 2006). Finally, because the customer is also the borrower, there are no
split incentives, meaning there is greater motivation for the customer to resolve problems with
the project (Gilligan, 2011).
These new types of project financing with shared or outsourced risks can be helpful to industrial
operators in an investment climate where business is under intense competition and tends to
focus narrowly on investments in core competencies (Möllersten and Sandberg, 2004). ESCOs can
counteract some of the energy efficiency market failures, for example by providing information,
reducing uncertainty and risk, and lowering transaction cost through standardized services
(Goldman et al., 2005). Nevertheless, the continued growth of ESCO services faces some
challenges. In small projects, transaction costs may exceed energy savings, and in large process
based projects, asset specificity may preclude outsourcing (Sorrell, 2006). An international survey
of ESCOs (Vine, 2005) cites the lack of preparedness of the regulatory system, banks’ inexperience
with energy efficiency investments, and the perceived riskiness of non-asset based projects
among the prime reasons that ESCO are not more widely used.
Business to business relationships
In the business world, energy efficiency can be a side-product of new equipment ordering, or can
feature as an element of supply chain optimization. Additionally, companies are influenced by the
actions of their peers.
Sellers or suppliers of energy efficiency technologies can influence a company’s evaluation or
assessment of their technology options (Fine, 1993). Technology developers and suppliers can
organize technology demonstrations or pilots to show the energy efficient technology in
operation in a manufacturing plant. They are usually willing to install new equipment for a trial
run to allow companies to fine tune or tweak it for their production needs. These trials allow
companies to gain more confidence in the technology and more likely to invest. Suppliers may
also serve on industry association boards and develop relationships with companies. This may
make it easier to recruit companies for installation working with investors to move the technology
investment forward. Especially for small manufacturers, technology vendors take on the role of
energy efficiency (finance) providers, through capital lease to own, operating leases and
equipment rentals (Personal communication, Becker, 2011).
Under the guise of environmental management systems, life-cycle assessment, and supply-chain
optimization, energy efficiency has also made inroads into client-supplier relationships (Mosovsky
et al., 2000; Srivastava, 2007). A growing number of firms now realize that much of their
environmental impact is due to production activities at their suppliers and are encouraging and
supporting those suppliers in the adoption of, among other changes, energy efficiency.
18
Additionally, companies are increasingly realizing the cost-savings potential inherent in
implementing supply chain energy efficiency projects.
Outside parties, including ESCOs, consider this an encouraging and useful development for several
reasons. First, pressure on factories by customers can provide uniquely powerful motivation to
adopt energy efficiency. This is especially true as more customers make similar requests. Even
though compliance is only voluntary at this time, most suppliers believe that mandatory programs
are being prepared. In addition, this motivation simplifies the very first step of project
development: sales. Second, customer involvement is also believed by ESCOs and financial
partners to reduce project risk, since factories that have been accepted into the supply chains of
major customers are assumed to be more stable and sophisticated, financially and otherwise.
Some parties also believe that customer involvement in energy efficiency promotion
simultaneously reduces credit risk associated with project finance for smaller firms, but this is
speculative at this point. Third, customer pressure to adopt energy efficiency also performs a
useful aggregation function, bringing together groups of firms with similar opportunities. For
ESCOs, this aggregation simplifies the task of serving especially smaller firms, narrowing the
addressable markets from hundreds of thousands of firms to those that produce for major
customers.
Industry peers can also have a significant impact on a firm’s decision to invest in new energy
efficient technologies. When technologies show increasing returns in the number of firms
adopting, then a single firm will typically make its technology choices after considering which
technology others are likely to invest in. For example, if a new energy efficient technology
innovation is viewed as particularly risky when it is first developed, a company will view it as less
risky if many other companies being to adopt it. There may also be economies of scale associated
with the manufacture, service and distribution of a technology such that significant benefits
accrue from investing in the energy efficiency technology with the largest possible market share.
19
Energy efficiency investments as an emerging asset class
The wide variety of players in the energy efficiency finance world demonstrates that actors
external to firms might play an important role in inducing them to invest in energy efficiency.
Above, we have highlighted the financial tools currently used by these external actors, and
pointed to both opportunities and challenges towards their growing importance in the future. We
now build on this review to develop recommendations for establishing energy efficiency as a
distinct asset class.
Institutional entrepreneurship could form a new pathway towards energy efficiency. There are
multiple examples of institutional entrepreneurs creating new inter-organizational routines and
norms to establish a new market sector (Munir and Phillips, 2005), create legitimacy for a new
field of activity (Maguire et al., 2004; Child et al., 2007), push for sustainability (Brown et al., 2009;
Montiel and Husted, 2009; Etzion and Ferraro, 2010), or develop standards for interoperability
(Sanjay et al., 2002). Conceivably, some of these same tactics could be used to develop a new
asset class for energy efficiency.
An asset class can be defined as “a set of assets that bear some fundamental economic similarities
to each other, and that have characteristics that make them distinct from other assets” (Greer,
1997). Establishing energy efficiency investments as a separate asset class has multiple benefits,
such as driving growth of this sector by creating a commonly accepted set of risk assessment rules
and investment benchmarks. As a separate asset class, energy efficiency would benefit from
strategic asset class allocation, which is undertaken to spread risk across several types of
investments. Ideally, fund managers seek to spread investments over distinct asset classes whose
value development over time is independent of each other.
At the broadest level, asset classes fall into three groups (Greer, 1997): capital assets (equities,
bonds, income-producing real estate; valued based on net present value), consumable or
transformable assets (commodities, valued based on demand and supply) and store of value
assets (e.g., fine art, currency). While describing asset classes in terms of their value base is
useful, in practice, the term asset class more often refers to a specific investment tool. Investors
describe equities, bonds, and money market instruments as the three core asset classes. To these
are added real estate and commodities. Other types of investments are generally termed
alternative asset classes. We will follow this latter distinction here in exploring the potential for
energy efficiency investments to be recognized as a new alternative asset class.
Based on the above definition, energy efficiency investments harbor some important
characteristics of a new asset class: They are independent of other asset classes, as their value
does not depend directly on that of most other asset classes. Energy efficiency investments have
the desirable characteristic of long-term fixed rate investments, with dependable payments over
a period of time (Freeling, 2011). Energy efficiency investments could also be described as
counter-cyclical, as their value is not tied to those of stocks or equity in a recession.
20
Energy efficiency investments do however have some correlation with commodity prices. As
energy prices go up, so does the value of energy efficiency investments; which can act as a hedge
against rising commodity prices. Similarly, as energy prices fall, so does financial gain to be
garnered from energy savings. For industrial facilities investing in electrical energy efficiency, this
is buffered by the relative stability of electrical rates over time. In contrast, investments in
thermal energy efficiency may be more strongly exposed to fluctuations in fuel prices. Overall,
despite the correlation with commodities, energy efficiency investments are sufficiently
independent of other major investment classes – such as stock, bonds and money market
accounts – to provide a reasonable foundation for a new alternative asset class.
Energy efficiency investments have potential to gain the status of an independent asset class; as
of yet, they have not reached critical mass. While energy efficiency investments possess the
characteristics necessary for the creation of a separate asset class, multiple hurdles will have to
be overcome to achieve this goal. Rules governing energy efficiency investments and loans need
to be reinvented, and tools need to be developed to bundle these assets into securities. In the
remainder of this section, we look to examples from the financial sector to describe the process of
asset class formation and draw lessons for an energy efficiency asset class.
New asset classes are not created out of thin air; and backers of an energy efficiency asset class
can learn from the historical development of new classes. Alternative asset classes such as
derivatives (Canter et al., 1997; Van Lennep et al., 2004) and new types of securitized assets
(Forrester, 2008) have grown tremendously over the past decades. Within 20 years of its creation,
the asset-backed securities market had reached $584 billion (Edwards, 2001), cresting at $888
billion in 2008 (Agarwal, 2010). Historically, securitization has happened in sectors that are both
relatively large and have predictable cash-flows, but are characterized by insufficient funding,
(Gorvett, 1999). As described in more detail in section II, energy efficiency investment
opportunities cut across all sectors and could reach several hundred billion dollars in the coming
decades (Farrell et al., 2008). Like credit card loans before the 1990s, energy efficiency loans have
predictable cash flows, but insufficient funding. These characteristics suggest that securitization is
a promising pathway for this class of investments.
Where assets are securitized, cash flows derived from similar assets with different levels of risk
are bundled into investment packets and resold to investors, providing both a risk management
tool and an investment opportunity. In securitization the “key to success is whether the asset
class can be commoditized, i.e., whether its cash flows are stable and predictable and relate to a
service provided en masse to the public” (Welsher and Penrose, 2004). Energy efficiency
investments are inherently capable of fulfilling these conditions. Not only do investments in
energy efficiency create predictable financial savings over time, but they have tremendous
growth potential, given the extensive opportunities for energy efficiency across industrial facilities
and commercial buildings.
While the potential dangers of securitization, especially with regard to mortgage-backed
securities, have become widely known in the aftermath of the 2008 real estate crisis, they should
21
not rule out this pathway for energy efficiency. Many of the problems in mortgage backed
securities were related to insufficient vetting of the securitized assets as well as unrealistically
optimistic ratings of mortgage-backed securities. As other successful securitization efforts have
shown (e.g., insurance securitization, see Gorvett, 1999), these problems are not inherent to
securitization itself, and could be avoided with careful rule-setting and a deliberate credit rating
system.
To attain asset class status for energy efficiency investments and allow for rapid growth of the
sector, careful rules will have to be set up vet the risk of investment opportunities. The example
of REIT (real estate investment trusts) index return data shows that the existence of a commonly
accepted metric for judging the quality of an investment can be key for a new investment sector
to take off (Mull and Soenen, 1997). One potential yardstick for energy efficiency investments is
value at risk. Used for example in target date funds to reallocate assets over time (Lewis and
Okunev, 2009), value at risk describes the maximum expected loss in value for an asset over a
given time period and at a given confidence level. In other words, it is a measure of the
probability of an adverse event.
As outlined by Jackson (2010) conservative rules of thumb on payback times designed to rule out
risky investments often inadvertently eliminate long term, but less risky energy efficiency
investments. She suggests applying the value at risk tool to energy efficiency. Jackson’s (2010)
proposed measure, energy budgets at risk (Ebar) “applies historical energy use data, weather
data, engineering-based efficiency savings analysis and other factors to quantitatively determine
the risk associated with any efficiency investment.” This and similar proposals building on existing
and accepted financial metrics will prove useful in driving acceptance of energy efficiency
investments as a separate asset class. They bridge the language barrier between engineers and
financial investors and reduce transactions costs for assessing project risk.
To address the confidence issues and perceived riskiness of energy efficiency loans due to
underperformance of equipment, proponents of an energy efficiency asset class could also look to
the established practice of performance pricing. Performance pricing ties a loan rate directly to a
borrower’s credit rating, without having to refinance (Asquith et al., 2005). Performance
contracting for energy efficiency loans could borrow from performance pricing to include flexible
loan terms. Interest rates for energy efficiency loans could be linked to the performance of the
energy saving equipment. If savings are less than expected, interest would increase. Conversely, if
the savings surpass estimates, interest would decrease. Where interest can increase, the risk of
moral hazard to the bank is reduced, while borrowers still gain access to financing at initially low
rates; where interest can decrease, borrowers with decreasing credit risk do not have to
renegotiate the contract to benefit from better rates (Asquith et al., 2005).This might help
overcome initial barriers to financing availability for energy efficiency. Asquith, Beatty, and Weber
(2005) have shown that “riskier borrowers use interest-decreasing performance pricing,” making
this an attractive option for energy efficiency loans. These loans are often considered risky simply
because they are not well known to bankers or widely used, and could benefit from automatic
22
performance driven interest adjustments to reduce the cost of financing energy efficiency
investments.
Another significant barrier towards energy efficiency investment is the small size of many
projects. Large institutional investors are not interested in piecemeal investment. Aggregation has
been successfully used in public sector markets (Energy Charter Secretariat, 2003). Currently,
bond markets have entry barriers for investments smaller than $ 100 million, reflected in price
differences between bonds and loans (Angbazo et al., 1998). This represents a significant problem
for energy efficiency projects, as they are often small and therefore unlikely to gain access to
lower priced bond financing. One potential solution to this problem is to bundle or aggregate
energy efficiency projects, and then sell these investments as a security. As noted by Edwards
(Edwards, 2001) “the entity securitising its assets it not borrowing money, but selling a stream of
cash flows that was otherwise to accrue to it.” This model seems equally reasonable for energy
efficiency projects. T
Overall, aggregating energy efficiency investments for securitization appears to be the most
important step leading to the creation of an independent energy efficiency asset class. Table 3
provides a summary of the frames of reference that could be used to achieve securitization and
the potential role each external actor could play in aggregating energy efficiency investments for
securitization.
23
Governments
Electric
utilities
Frames of reference for
securitization
PACE
Bonds
Small Business Administration
Loan Guarantees
Energy efficiency performance
standards
On-bill financing
Insurance
industry
Loss prevention insurance
Risk management through
insurance securitization
Financial
industry
Securitization
Financial risk indices
Performance banking
Energy
service
companies
Performance contracting
Business to
business
Supply chain management
Lean manufacturing
Potential role in aggregation
Governments can match investors and
clients for loan programs and provide loan
guarantees. They can develop standard
contracts.
Utilities can utilize existing relationships
with industrial customers and knowledge of
their energy use profile; identify those
offering the best opportunities for loadshifting. Given the right financial incentives
(decoupled rates, time of day pricing, EE
performance standards), utilities can bring
together similar companies.
Insurance providers can offer standardized
insurance for energy performance
contracts. The insurance industry can lower
the transaction costs and risk of EE
investments by offering loss prevention
insurance. They also have a role to play as
institutional investors interested in annuity
style investments’
The financial industry can build on the
experience with securitization of credit card
and other assets to develop rules for EE
investments. It also can build on the
experience with metrics and financial risk
indices to develop a yardstick for evaluating
EE investments.
ESCO could expand their business into the
small business sector and develop
methodologies to streamline contracts for
firms with similar characteristics.
Downstream businesses can manage their
supply chain to make EE a part of lean
manufacturing and performance
contracting.
Table 3. Frames of reference and potential role in aggregation for various external actors
24
Conclusion
The persistence of the energy efficiency gap has many reasons, and no single solution. Instead of
diagnosing the market and behavioral failures at the root of the problem, it might be more useful
to treat the symptoms. This white paper points to the institutional entrepreneurship framework
to identify potentially influential change agents for creating an energy efficiency asset class. It
reviews the role of a set of external actors in creating new rules and routines for energy efficiency
investment. It also draws on prior examples of successful asset class development to map out a
blueprint for establishing an energy efficiency asset class. Aggregation of energy efficiency
projects and securitization of energy efficiency loans are identified as the key ingredients for
creating an independent energy efficiency asset class.
25
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