Oil Disasters and Sub-Prime Mortgages: When Risk is Taken Out of the Price

The BP Deepwater Horizon catastrophe has much in common with the implosion of the sub-prime mortgage market. In both instances, very intelligent people failed to take basic precautions with risky investments. Why? Because the risks were not fully included in the investment analysis.

In the sub-prime mortgage market, the rating agencies gave what turned out to be deceptively favorable ratings to Collateralized Mortgage Obligations (CMOs), in part because the risks were chopped up and spread around in pools. Investors did not demand a high risk premium because they could not see the full extent of the risks.

Something very similar happened with BP's investment in the Deepwater Horizon. BP's spill response plan estimated the worst case scenario at 177,400 barrels of oil, a number that we now know was absurdly low. And the bulk of the risk was assumed by the US government when it limited BP's liability for damages claims to $75 million.

If BP had to assume the full risk (potentially billions of dollars) in a gulf that has seen some of the worst hurricanes (including Katrina), the insurance premiums or reserves required to cover that risk presumably would have been much larger. Larger insurance premiums or reserves would have reduced the potential return on investment for the project.

What would BP have done if the financial projections for the Deepwater Horizon project had been lower because they included the full cost of insuring against a multi-billion dollar risk? Maybe BP would have invested in a less-risky natural gas project that would have produced fuel with 30% to 40% lower carbon emissions. Or maybe BP would have invested in some of the new Green and sustainable technologies that it was touting in its advertisements. Or maybe it would have invested in a different oil project that did not carry the risk of destroying the fishing industry in the Gulf of Mexico.

Here's the bottom line: Our best hope for a future of clean and sustainable energy is to encourage rational investments by the private sector. That is only possible if the price of oil includes the full cost of pollution and the full cost of insuring against environmental disasters. Once that happens, alternative energy sources that do not carry those costs will become very attractive investments and the smart money will flock to them. So if you want to start a shift to cleaner and more sustainable energy sources, the first step is to stop subsidizing oil with free liability insurance courtesy of the US Government.

John Howley
www.HowleyGreenEnergy.com
Orlando, Florida

$550 Billion In Welfare Payments for Dirty Energy

Governments around the world spent $550 billion on energy subsidies last year, mostly to keep down the price of dirty energy from oil and coal. The Financial Times broke the story today based on an advance copy of an International Energy Agency study.

In fact, that number represents only half the story. The $550 billion in direct government welfare payments for the oil and coal industries does not include all of the indirect government subsidies that these industries receive. It does not include the cost of soldiers protecting oil fields in Iraq; or the cost of treating respiratory illnesses caused by particulate emissions; or the cost of free liability insurance for oil and coal companies (in the form of limitations on their liability for harm to third parties); or the cost to individuals who lose their livelihoods when oil gushes uncontrollably into the Gulf of Mexico or the Niger Delta.

But let's stick with the very tangible number of $550 billion in cold, hard cash for now. What would happen if we took that $550 billion away from oil and coal, and invested that cash in clean, sustainable energy technologies instead?

Just taking the welfare payments away from the oil and coal industries would have a tremendous impact on the level of investments in clean, sustainable energy technologies. Think about it for a moment. You are considering an investment in a new technology. But the existing technology that you want to compete against receives $550 billion in direct government welfare payments every year to keep its price artificially low. So your new technology will not only have to be better than the existing technology, it will also have to be a half trillion dollars less expensive. That is a high hurdle for anyone considering an investment in new technologies.

Take away that half trillion dollars in government welfare payments, and now you have a level playing field. That alone removes a hurdle and provides an incentive to investors in new technologies.

And if you actually shift that half trillion dollars from the oil and coal companies to investments in clean, sustainable energy technologies, you can start a green revolution.

As an added benefit, the clean, sustainable energy technologies will not require these subsidies forever. Give a man a welfare payment to buy oil today and he'll be back for another welfare payment tomorrow. But give him the same payment to buy solar panels, and he'll have energy for a lifetime.

John Howley
www.HowleyGreenEnergy.com
Orlando, Florida

When Big Oil Buys the Gas Company

Earlier this week ExxonMobil, the world’s largest publicly traded oil and gas producer, announced that it had agreed to buy XTO Energy, the second-largest producer of natural gas in the US. ExxonMobil will acquire XTO for stock valued at $31 billion, making this the biggest oil and gas deal in four years.

This acquisition (and more like it) will have very significant impacts in at least three areas: energy prices; advances in natural gas innovation; and climate change legislation.

1. The Impact on Energy Prices

By acquiring the second-largest natural gas producer in the US, ExxonMobil will increase its ability to influence natural gas prices.

Prices for natural gas under long-term contracts are currently fairly close to prices for oil when measured on a cost per BTU basis. But prices for natural gas on the spot market are much lower -- often as much as 400% lower -- than prices for oil. The more natural gas that remains available on the spot market, the more likely it is that prices for natural gas under long-term contracts will come down.

When independent natural gas companies like XTO selling gas on the spot market, there is pressure on prices for natural gas to go down. Which makes gas a nice alternative to oil and coal. Which ultimately puts pressure on oil and coal prices.

ExxonMobil and other major oil companies that buy natural gas companies could influence prices by simply selling less natural gas on the spot market. The major oil companies have plenty of cash, so they could hold onto their natural gas inventories until the gap between gas and oil narrows. That is not good for consumers . . . or for the country.

2. The Impact on Natural Gas Innovation

Over the last decade, a handful of the nation’s small energy companies discovered huge amounts of natural gas in new fields stretching from Texas to Pennsylvania. XTO was one of these companies. It grew almost unnoticed into the nation’s second-largest gas producer by amassing a substantial portfolio of gas fields and developing expertise in the complex technology needed to extract the gas from shale beds.

If the major oil companies buy up these smaller, innovative companies that are making all the new natural gas discoveries, then who will pursue new natural gas technologies in the future?

Good question.

3. The Impact on Climate Change Legislation

Oil is one of the major contributors to carbon emissions worldwide. Gas is a much cleaner fuel.

The oil industry and its trade organization, the American Petroleum Institute, have vehemently opposed any aspect of climate change legislation that would raise the price of petroleum-based products. In contrast, the natural gas industry has supported many aspects of climate change legislation. Because natural gas has relatively low carbon emissions, any restriction on carbon emissions will give it a competitive advantage over oil and coal.

If the major oil companies buy up all the significant natural gas companies, then who will advocate for climate change legislation?

Another good question.

John Howley

Orlando, Florida

More Important Than Copenhagen

I told you so.

Four months ago, I predicted that, "Those looking for simple solutions to climate change will be very disappointed by the absence of firm emission reduction targets in Copenhagen later this year. . . . But at the same time, [the US and China] will pursue a second path of cooperation towards achievable solutions with or without an agreement on targets." See US and China Forge a New Path on Climate Change.

That is exactly what the US and China did in Copenhagen yesterday.

Why? Because nothing this important and this complicated ever gets resolved by a committee.

Consider for a moment the race to put a man on the moon. Thomas Friedman and others have said that this should be our model for the Green energy revolution.

I agree. But we did not get to the moon by holding international conventions and listening to dictators and despots like Iran's Ahmadinejad, Zimbabwe's Mugabe, and Venezuela's Chavez lecture us on the evil nature of our plans to be the first to put a man on the moon. Nor did we wait until we could reach the lowest common denominator consensus with Russia, China and 180 other nations on how and when to put a man on the moon.

If we had followed the path of seeking international consensus before we went to the moon, then we probably never would have achieved the goal.

So, now that we have gotten Copenhagen out of our system, let's get down to the serious work of pursuing the Green energy revolution the old fashioned way. With vigorous competition among nations to be the most energy efficient and energy independent economies in the world.

Walmart has given us a good first step. The company has sent out a Sustainability Index survey to 100,000 of its suppliers. The survey asks each supplier to provide information about their carbon footprint, energy and water usage, plans and goals to reduce their carbon footprint, energy consumption and water usage, and other factors that affect the sustainability of their operations. For now, Walmart will review this data internally. But it plans in later stages to release the data to consumers and possibly even disclose a ranking of individual products based on a Sustainability Index for the product and the company that manufactured it.

If you were a factory owner in China, what would provide a better incentive for you to reduce your carbon footprint and use of energy and water? (a) An international treaty that committed China to nation-wide carbon reduction targets over a 20 or 30 year period? Or (b) a Walmart Sustainability Index that made your products unsellable to the world's largest retailer unless you reduced your own company's carbon footprint and use of energy and water?

Forget Copenhagen. We need barriers to entry that will make it difficult for producers around the world to sell their products unless they are made using non-polluting energy sources and sustainable manufacturing practices.

We also need to alter the economics of energy at home. Yes, solar and wind are more expensive than most carbon-emitting alternatives right now. But only because those carbon-emitting alternatives do not pay the full cost of their pollution. If we make coal and oil companies include in their pricing the cost of eliminating their products' emissions (either with cap and trade or a carbon tax), then solar, wind and other non-emitting alternatives would seem very inexpensive by comparison.

Lastly, we need to use government funding and regulations to promote sustainable energy based on the long-term benefits -- just as we did when we used government funds to finance space exploration.

Imagine, for example, if all new construction and renovations in the US had to be "net zero" in terms of direct and indirect carbon emissions. By "net zero" I mean that the amount of energy used by a facility from non-carbon-emitting sources like solar and wind is equal to or exceeds the amount of energy from carbon-emitting sources. This could be accomplished by a combination of building codes requiring higher levels of efficiency in buildings (which many local governments are already imposing) and subsidies for investments in solar, wind and other non-carbon-emitting energy sources.

Yes, this would cost us in the short term. But think for a moment about the competitive advantage this would give us in the longer term. What if five or ten years from now our factories used highly efficient buildings that required less energy, and that energy was supplied by solar and wind plants that had ZERO fuel costs. Our factories would have a tremendous competitive advantage over factories in China and elsewhere that continued to use power generated by coal and petroleum fuels.

I hear all those out there who say that climate issues are different because they transcend borders. But space travel transcended borders too. And we did not succeed with space travel by waiting for everyone to agree. We went out and did it.

John Howley
Woodbridge, New Jersey

Lessons From the History and Economics of Oil

My first assignment as a young lawyer -- and my introduction to the history and economics of the oil industry -- was on a behemoth antitrust case against the major oil companies.  In re Petroleum Products Antitrust Litigation involved allegations that the major oil companies conspired to fix prices by "signaling" price changes to one another and by manipulating supplies and refinery operations during the 1970's.

In between days of reviewing thousands of documents, my fellow young lawyers and I had the pleasure of working with Daniel Yergin, who was retained as one of our expert witnesses and who had just written The Prize: The Epic Quest for Oil, Money and Power, for which he would win the Pulitzer Prize.  His book is a comprehensive and fascinating account of the history and economics of the oil industry.  It is still about the best book you can find on the subject, and anyone interested in any aspect of the green energy movement must read it.

Recently, I came across a short video of Daniel Yergin reflecting on lessons that can be learned from previous shifts in energy usage as we try to move towards a more sustainable energy future.  He describes the environmental concerns of the 1950's that forced a shift from coal to oil, followed by a shift back to coal as the principal fuel for electricity generation due to coal's cost advantages and emerging technologies that ameliorated some of the environmental harms.  He also talks about the sunk costs in our existing energy infrastructure and how that creates inertia and limits our willingness and ability to change.

Click here to view the video.  Short and to the point . . . . . and definitely worth watching.

Of Energy Dreamers, Past and Present

Rich Karlgaard, the publisher of Forbes magazine, writes a column in every issue called “Digital Rules.” He is a very smart guy and, usually at least, very innovative and forward thinking.

I say “usually” because he just missed the boat in his latest blog entry on the future of renewables.

Mr. Karlgaard argues that we are stuck with coal, oil and nuclear as our major sources of electricity in the United States for the foreseeable future. He asserts that “[t]here is no way the U.S. economy can enjoy future prosperity without the big three electrical energy sources of clean coal, natural gas and nuclear.”

Why? Because only 10% of current electricity generation comes from renewable sources, and most of that comes from hydro. Solar and wind provide less than 3% of current electricity generation.

According to Mr. Karlgaard, solar, wind and other renewables cannot possibly meet a significant part of our electricity needs 10 years from now when they are starting from such a small base. His Forbes colleague Ken Fisher agrees, urging investors to “buy into fossil fuels” because they account for “89% of electricity” and “that fraction won’t change dramatically in the next decade.”

As for Thomas Friedman, John Doerr, and others who point to Moore’s Law and argue that renewables will experience the same rapid technological advances as semiconductors if given the right incentives, Karlgaard calls them “dreamers.”

Funny. That’s exactly what they said about Thomas Edison, Nicolas Telsa, and others who set out to build centralized electric power plants in the late 1800’s.

At that time, centralized electric power plants had an even smaller share of the market than renewables have today. In fact, there were only a couple of electric demonstration projects involving only a few hundred streetlights. Gas companies had a virtual monopoly on powering lights in homes and businesses, and the new electric power plants being built had to charge far higher prices than gas. The gas companies also had an existing and very efficient distribution system for their gas, while the electricity dreamers needed to build very expensive copper mains to carry the electricity to customers.

Edison, Telsa, Westinghouse, and the other dreamers who built our current centralized electric generation system also faced a number of very significant barriers beyond price. There was, for example, the fact that the electric motor had not yet been invented. So they were trying to sell electricity before it could be used in factories.

How did the dreamers prevail? Transportation and municipal contracts. The electricity dreamers got their break by building dedicated power plants for new electric streetcars and streetlights.

Once they built a base of electric generating capacity for streetcars and streetlights, the pace of innovation and growth quickened. Innovators began inventing other things to use electricity, including electric motors which revolutionized the economics of running a factory. By 1892 – less than 15 years after Edison’s first streetlight project – General Electric’s capitalization was $50 million. The incredible speed at which centralized electric power plants developed is described in The Power Makers, by Maury Klein:

“By 1900 electricity had become an integral part of American life, especially in cities. Between 1890 and 1905 the output of electric power in the United States increased a hundredfold. By revolutionizing production and manufacturing, electricity made possible the rise of the consumer economy that was to dominate the twentieth century and transform every corner of American life. Already factories consumed more than half of the electricity generated…. Arc lights illuminated the streets of even small towns and flooded with light the avenues of large cities. In 1902, some 51,000 electric streetcars whisked urban passengers along 22,000 miles of track."

Now Messrs. Karlgaard and Fisher may be correct that coal, oil and nuclear will still be significant contributors to our energy mix ten years from now. After all, centralized electric power plants did not force the gas industry into bankruptcy.

But the history of centralized electric power plants suggests that renewables can and will grow at a much faster pace than traditional fossil fuels as sources of electricity. Once started, that pace will accelerate as the competitive advantage of renewables starts having a significant impact on the bottom line.

Think about it. Five years from now, those who invested in solar and wind today will have ZERO fuel costs for that portion of their electricity needs, while those who did not invest in renewables today will still have to pay the cost of fuel for every kWh – and at higher prices than it is paying today. Add in the fact that renewable technologies five years from now will be even more efficient than today, and everyone will be clamoring for renewables. It is easy to see how the tipping point will be reached.

Or has it already been reached? China has just announced that it is constructing a 2 gigawatt solar power plant in Inner Mongolia, the largest solar plant in the world. That is on top of nearly 80 gigawatts of renewable energy that China has already built in recent years. When China has hundreds of gigawatts of fuel-free energy, what country will be able to compete when it must continually pay for fossil fuels to generate 90% of its electricity? More to the point, what country can afford to wait?

John Howley
Woodbridge, New Jersey

Pollution Economics 101

The oil industry is attacking the proposed climate change legislation that has passed the House and is on its way to the Senate. Here is a summary of the arguments from the American Petroleum Institute:

“The House climate change bill will increase costs of gasoline, diesel and aviation fuel, and drive jobs and production overseas, increasing greenhouse gas emissions (GHGs) in foreign countries that will have a new competitive advantage. Under the so-called ‘American Clean Energy and Security Act’, U.S. refiners will have to buy allowances, increasing their costs and giving a competitive advantage to non-US refiners. U.S. jobs will be lost and contrary to the bill’s intention, America will be less energy secure and more reliant on imports of gasoline and other refined products."

Wow. That’s a lot to swallow. Let’s take it step-by-step.

First, the proposed climate bill “will increase costs of gasoline, diesel and aviation fuel.”

Yes! Absolutely! Totally true! That is the entire point of the legislation! And it is a good thing!

Now before you think I am some kind of tree-hugging, left-leaning radical, let me tell you what the most famous conservative and libertarian economists say about the subject.

Alan Greenspan – the former Federal Reserve Chairman, acolyte of Ayn Rand, and self-described Libertarian – favors a hefty gasoline tax of at least $3 or more per gallon because, he says, we “need significantly higher gasoline prices to wean us off gasoline-powered motor vehicles.”

Milton Friedman agrees. Remember him? He was the Nobel-prize-winning economist from the University of Chicago who provided much of the intellectual firepower behind Reaganomics.

Why do these intellectual giants of conservative and libertarian economics favor taxes on gasoline? Simple. It has to do with something economists call “externalities.”

To understand externalities, consider a chemical company that offered to create more jobs and lower prices. There is just one catch. They will save the money to make this possible by dumping their toxic wastes into the pond in your backyard instead of disposing of the waste properly. In other words, they will make the cost of avoiding or cleaning up pollution “external” to the price of their product.

Obviously, that is not acceptable. Proper disposal of toxic waste is a cost of doing business and it should be factored into the price of the product – even if that means higher prices and/or fewer jobs.

The costs of avoiding or cleaning up pollution, however, are not always incurred by the producer or passed on to its customers. For example, coal-fired power plants have delivered relatively low-priced electricity for more than 100 years, but have also been dumping carbon dioxide and other greenhouse gases into the atmosphere. The same with petroleum products like gasoline and diesel fuel.

That is why Greenspan, Friedman, and many other conservative and libertarian economists have favored taxes on gasoline and other substances that cause pollution. Because the failure to account for the cost of pollution tends to distort many basic economic decisions such as pricing and competition. People think they are getting a good deal because their gasoline and electricity are relatively cheap. But they are really only imposing the cost of pollution on the environment.

By imposing a tax equal to the cost of avoiding or cleaning up the pollution, the market will make rational choices based on the real cost of the polluting product. And – this is very important – inventors and investors will have an incentive to develop cleaner alternatives that can be sold at a competitive price without the pollution tax.

So, the oil industry does not get any points for arguing that the climate change legislation will increase the price of gasoline, diesel fuel, and aviation fuel. That is what it is supposed to do.

BUT! The oil industry has a very legitimate point when it argues that the proposed legislation will “drive jobs and production overseas, increasing greenhouse gas emissions (GHGs) in foreign countries that will have a new competitive advantage.”

Anyone who has seen horrific pollution in developing countries knows what will happen to our environment if we simply drive up costs in the more developed economies. Without a comprehensive, global approach to pollution and climate change, we will just shift the externalities (costs of pollution) from our own backyards to backyards of very poor and politically less influential people in developing countries. And we will not be able to fence in the adverse effects.

Which leads to questions that have more to do with politics than economics. How do we get to a global solution on climate change? To what extent must we, in the more economically developed world, take the first step and make the first sacrifices? And to what extent should we refuse to budge until the rest of the world agrees to follow?

And you thought economics was the dismal science. More on the politics and diplomacy of a global climate change agreement in later posts.

John Howley
Tokyo, Japan

Solar Panel Glut??

Yesterday's electronic version of the Wall Street Journal had an interesting headline:

"Solar Prices Headed Down on Massive Glut"

The story reports that the "supply of solar panel modules ramped up at the beginning of this year and came into collision with slack demand, sending inventories up 64.3%." (emphasis in original).

Wow! Massive Glut! Inventories increased by 64.3%! That is terrifying! The solar energy industry must be headed for disastrous over-supply and ruin!

Wait a second. What does a 64.3% increase in inventories actually mean?

It means, according to an expert quoted in the WSJ story, "the equivalent of one-and-a-half months of excess inventory."

So, let me get this straight. The Stimulus Bill contains tens of billions of dollars for investments in renewable energy including solar, plus it looks like we will have some sort of "cap and trade" or other carbon reduction legislation in the US that will provide a further incentive to invest in solar, plus the Obama Administration is taking a leadership role in global efforts to reduce carbon emissions which will require more investments in renewables like solar, plus the price of oil is still over $60 per barrel despite the worst global recession in most of our lifetimes -- and who knows where the price of oil will go once we start emerging from recession -- which makes renewables like solar attractive alternatives.

But the solar panel industry is experiencing a "massive glut" because it has one and a half months of excess supply?

Fortunately, solar energy investors have a slightly longer perspective than journalists and financial analysts. That one and a half month excess supply of solar modules will soon be history.

John Howley
Orlando, Florida

The Economics of Energy Conservation

I remember watching President Jimmy Carter on television during the OPEC Oil Embargo. He was wearing his Mr. Rogers sweater, sitting in front of a fireplace, and telling the country that we all must conserve energy. His message was plain. Energy conservation means making sacrifices, like turning down the thermostat and putting on sweaters to keep warm in front of a fire.

Being fond of comfortable wool sweaters, wood fires and the notion that a little personal sacrifice could help eliminate our dependence on foreign oil, I was taken with President Carter's message. Unfortunately, President Carter's approach to energy conservation was not sustainable. You cannot heat the clean rooms in semiconductor manufacturing plants with fireplaces in the winter, nor can you cool hospital operating rooms by opening windows in the summer. Most big energy consumers -- factories, hospitals, office buildings and other commercial and industrial enterprises -- were not going to solve the energy crisis or our dependence on foreign oil by going back to a simpler time or by doing less.

We soon found out that even personal sacrifice would last only so long. Once the immediate crisis of the embargo ended, our society lost its sense of urgency about conservation. Within a few years we had discovered the joys of driving gas guzzling SUVs.

Fast forward 30 years to where we are today, the early 21st Century. Al Gore and others have focused our attention on global warming and the need to reduce carbon emissions. At the same time, we are facing another energy crisis caused by rising energy costs. Oil above $100 a barrel. Electricity rates going through the roof.

This time we are talking about energy conservation in terms of becoming more efficient. Major corporations and venture capitalists have jumped on the bandwagon, asserting that conservation is not just good for our environment, but it is also good for business. For example, the President and CEO of Wal-Mart noted in a recent interview that his company is pursuing energy efficiency because it is good business -- consistent with the company's founding principles -- to cut costs by becoming more efficient:

“We looked at what Sam Walton started and how he developed the company. It was by eliminating waste, bringing in efficiencies. And by thinking about sustainability from our standpoint, it really is about how do you take cost out, which is waste, whether it's through recycling, through less energy use in the store, through the construction techniques we're using, through the supply chain. All of those things are simply the creation of waste. We found it's consistent with the entire model we've had since Sam opened the first store.” H. Lee Scott Jr., President and CEO, Wal-Mart Stores Inc., quoted in “Waste Not”, The Wall Street Journal, March 24, 2008.

Even altruistic environmentalists have made their arguments for conservation based on what is most cost effective. For example, the Canadian Chapter of the World Wildlife Federation has focused on the cost-saving benefits of energy efficiency: “Energy efficiency investments such as building retrofits are one of the lowest-cost and most effective options for reducing greenhouse emissions.” WWF-Canada Backgrounder, March 24, 2008.

How do businesspeople determine whether energy conservation measures are "cost effective"? They simply compare the financial returns available from investments in energy conservation projects with returns available from other types of investments. This requires nothing more than an analysis of (a) how long it will take for the financial savings generated by an investment in the energy conservation project to equal the cost of that investment, known as the PayBack Period; (b) how long those financial savings will continue in the future; (c) what those savings equate to in terms of a percentage return, known as the Internal Rate of Return; and (d) an adjustment for the company's cost of capital, depreciation on any equipment that is installed as part of the conservation project, and other factors.

For example, if replacing an incandescent light bulb with a compact fluorescent bulb (CFL) costs an average of $2.00 (including labor) and will result in a reduction of $2.00 per year in the cost of electricity, then the CFL pays for itself in one year and the PayBack Period is one year. If the CFL will last 10 years, then each investment of $2.00 in CFLs today will generate financial savings of $20 over the life of each new bulb. A very rough Internal Rate of Return is close to 100% because your $2.00 investment is generating 100% return ($2.00 per year). Put another way, to match the return on your investment in CFLs, you would have to invest in something else that generated almost 100% per year.

The actual Internal Rate of Return is less than 100% because you have to factor in your cost of capital -- that is, how much did it cost you to earn or borrow the original $2.00 investment -- and other factors such as depreciation of any equipment installed as part of the conservation projects. But for our purposes, it is sufficient to understand that energy efficiency investments with one-year PayBack Periods are extraordinary investments that cannot be matched by almost any other investment, at least not without taking on much more significant risks.

The Internal Rates of Return for investments with two-year and three-year PayBack Periods are also extraordinary. If an investment pays for itself within 2 years, then it is generating financial savings equal to 50% of its cost each year. And if an investment pays for itself within 3 years, then it is generating financial savings equal to 33% of its cost each year. Depending on how long the savings will last (10, 20 years or more), the cost of the company's capital, etc., investments with two-year and three-year PayBack Periods usually will generate Internal Rates of Return in the range of 30% to 45%.

Since energy efficiency investments carry very little risk (and a lot of side benefits), any energy efficiency investment that generates an Internal Rate of Return of 30% to 45% makes good business sense. It is almost impossible to get that type of return on your investment anywhere else without taking on significant risks.

The bottom line: A CFO will almost always invest in energy efficiency projects that have PayBack Periods less than three years, because Internal Rates of Return over 30% are hard to find without taking on significant risks. And a CFO is almost compelled to invest in energy efficiency projects that have PayBack Periods in the two-year range, because low-risk Internal Rates of Return over 40% are almost impossible to find.

The Internal Rate of Return for energy efficiency investments with four-year PayBack Periods are also good. A four-year PayBack Period means the investment is generating savings equal to 25% of the investment every year. Even after discounting for cost of capital, the Internal Rate of Return should be in the 15% to 20% range. This is still very good considering the relatively low risk of energy efficiency investments compared to the types of risk that must be taken to obtain returns of 15% to 20% in other investments.

In addition, energy efficiency investments generate other types of returns that make them much more valuable than pure financial investments. These side benefits include reducing carbon emissions, generating good will as a "green" company, reducing maintenance costs on equipment that now runs more efficiently, etc.

PayBack Periods longer than four years are more difficult to justify on financial considerations alone. Depending on cost of capital, a five year PayBack Period will generate an Internal Rate of Return that often is in the same range as what the company can earn by reinvesting in its own business. The energy conservation project then starts to compete with other internal capital needs. Do we conserve energy? Or do we expand our plant so we can grow into an important new market? The energy conservation project can still win out, but not on financial considerations alone.

What are the implications when companies make their energy efficiency decisions based on Internal Rates of Return? I've already gone on too long for today, so I'll save that for another blog entry. In the meantime, I look forward to your comments and questions on this primer on the economics of energy conservation.

John Howley
Hong Kong