The Voodoo Economics of Energy Efficiency

Recent reports continue to draw attention to the notion that energy efficiency predicts lower mortgage default rates. Indeed, it seems obvious that energy-efficient homes are worth more, and that mortgage default risk on such properties should be lower. This is the same kind of analysis that was previously used to promote PACE bonds. It may be superficially right, in the sense that the relationship is observable and provable, but it misses the point, simply because a more categorical understanding is possible. Or, while these relationships may exist and seem statistically significant, correlation does not imply causation. There is no consistent approach to underwriting risk for energy efficiency, nor is there an analytically sound approach to explaining why or to what extent the risk of defaulting on home loans is reduced under energy efficiency. The following attempts to fill that gap by means of a simple example.

Energy Efficiency is Secondary

First, energy efficiency is not a primary objective, but a secondary one. The first order of business is a make-or-buy decision about on site generation with renewables (Site Derived Renewable Energy) versus a carbon energy subscription. The easiest way to see this, is to realize that you cannot save yourself rich, something everybody knows and understands. Let's look at four people, property owners all, and their different approaches, Mr. Tinkerer, Ms. Efficiency, and Mr. Analyst, and Ms. Intuition.

Mr. Tinkerer - Energy Efficiency Flying by the Seat of your Pants

• Mr. Tinkerer begins by "saving" energy without thinking, and thereby accepts the status quo. In his single family home he has an $300 electrical bill and an $700 oil bill, for $1,000/month combined.
• He then buys some gadgetry that reduces energy consumption and some insulation, and his bills goes down to $900.
• A year or two later, after some energy price increases, and more wear and tear, he is back to paying $1,000 a month.
• He keeps tinkering and spending money on Energy Star appliances and other energy-efficient products, but never realizes why he's not achieving serious energy efficiency.

This is a case of casually pursuing energy efficiency, and it is probably the most common. Mr. Tinkerer operates from the unexamined belief that he can save himself rich, but all he does is overpay for "energy saving" devices, without ever realizing that energy savings are not additive. Most of us dabble in energy efficiency in similar ways, it's a way to shop without guilt. It probably is a wash in the beginning, we spend as much as we save, but in the long-run we spend way more than we "save." Sometimes it's a lot more, for the savings do not add up, EVER.

Ms. Efficiency - Energy Efficiency by the Book

• Ms. Efficiency really goes hog-wild, and does everything she can to reduce energy consumption, year after year. The first year she spends $3,000 and creates a 20% reduction, i.e. she enjoys a 15 month payback on her investment.
• The second year (she still have 3 months to go to earn back that first investment), she spends $6,000 for a further 10% reduction. Simplistically, 10% of the remaining $800/month energy bill is $80, and therefore she now enjoys a 75 month payback, or 6.25 years.
• The third year she can't find anything else to do, she wants to do something major, and now she talks to SolarCity (or any other similar provider of solar pv on a PPA- or lease-basis), and they can provide her with a solar panel (nothing down!!!) and reduce her electrical bill by 10% (she's already very efficient), for a further 3% of her overall energy bills. It's a 20 year Solar PPA. So now her monthly energy bills are down to $698.40 in constant dollars, but there were a few price increases, so she's at $750/month for the year. However, now her roof is covered with a beautiful shiny solar panel! She sends a Christmas card to her mother, to show off the solar panel, and mom is duly impressed with how green her daughter has become.
• However, once she analyzes the figures correctly, that solar panel is a 20 year investment of $40,000 for a 3% reduction in her energy bills (10% on electricity alone), which means a payback of 154 years.
• She's still paying $750/month in energy bills (including the $200/month solar lease), and the prospects remain that prices will go up for the remaining $550 "energy" portion of her monthly payments. What has she won? To a financier it seemed things have improved, for $750 now is less than $1000 a few years ago, but that PPA commits $40,000 of her borrowing capacity, and the panel locks out most of her roof, for any alternative uses that might prove to offer better results.
• The residual energy portion of her monthly obligations continues to be above 50% of her starting figure.

In short, a categorical make or buy decision has to be made first before anyone starts on efficiency: do we continue to buy energy, or can we economically make our own. On site renewable energy generation is the alternative to buying energy in perpetuity. Energy efficiency only comes into consideration AFTER we make that make or buy decision, or else we falsify that decision, which is now commonly the case.

Energy Efficiency and Diminishing Returns

The example above shows the effects of diminishing returns, the successive investments show less and less savings, because the base is growing smaller. Ms Efficiency started out investing $3,000 with a return of $200/mo then $6,000 with a return of $80/mo, and finally $40,000 with a return of $21.60/mo (clearly she is paying more for every successive improvement, while here additional savings decrease). This is a losing battle, and it is the battle home owners are losing all around the country, as long as they believe in the "savings" paradigm.

Short-term, yes cash flows are improving, but a few energy price hikes can wipe that out, and the result is that eventually the improvements prove minimal or non-existent within a few years.

PACE Bonds and Mortgage Default Risk

The rationale for the creation of PACE bonds was to provide building owners with a means of financing major capital investments up front to do material retrofits in the energy infrastructure of properties. Unfortunately, the PACE bond camp has been hi-jacked by the energy savers also, and thus they have become yet another customer retention program for the energy companies, and the vendors of energy saving widgets, which was not the original idea. PACE bonds were designed to overcome the capital intensity of the switch to renewable energy, not to squander money on energy efficiency enhancements. Investment in renewable energy moves energy from liabilities to assets, and therefore would structurally reduce underwriting risk, if the economics are solid.

Enter Mr. Analyst - Investing in Site Derived Renewable Energy first

Here is how it should work: Mr. Analyst, with the same $1,000/month energy bill, invests significant money (maybe $140,000), and gets 20-year PACE financing that costs him $900/month, but he wipes out 85% of his energy bills. He gets a geothermal heat pump that provides his HVAC, and a solar panel that offsets most of the electrical load. The first year he gets a 30% tax credit on some of that investment, etc., which helps, but he ends up in a similar situation to his neighbor Ms. Efficiency. She went the energy savings route for the first 3-5 years, but then gradually Ms. Efficiency observes her bills nudging above $1,000 again. Mr. Analyst stays steady at $900/mo in payments, and his residual energy bill of $150 grows a little bit, but not a lot. And Mr. Analyst looks better with every passing year. Let's assume that equipment lasts 30 years. By that time the energy profiles of the two homes will be vastly different.

Ms. Intuition - Thinking Long-Term

Ms. Intuition in the meantime may be even smarter, she gets the same geothermal heat pump, and puts it on a time of use meter, running it mostly at night. She reads the papers, and she sees that solar panels today are 15-20% efficient, but there's some new invention every few months that promises a great breakthrough. She waits a few years, until solar panels have gone from 15-20% efficiency to 35% efficiency, and she now installs a solar panel that completely offsets her electrical use, and she ends up with zero energy bills. In short, she "ate" the electricity cost for a few years, but she gained a technology advantage compared to Mr. Analyst. Geothermal heat pumps are already 400% efficient -- returning 4 joules for every 1 joule you supply -- and are not likely to get any better. With solar PV there is another patent announced every week to increase the conversion efficiency, so it was a reasonable guess to expect that the efficiency of that technology would increase in coming years, and that waiting could be prudent. Notice also that the solar panel here enhances the investment in the geothermal heat pump and improves the value of that energy price hedge even further.

These are just examples. The numbers are rough, to show orders of magnitude, but the principles are clear. They show that the passive stance of "energy efficiency" and "energy savings" is often bested by a focus on generating your own energy wherever it is economical.

• We can't save ourselves rich, and energy efficiency might reduce underwriting risk somewhat, but there are better alternatives, such as investing in Site Derived Renewable Energy (SDRE) instead of energy efficiency.
• Energy efficiency is an operational expense, not an investment, it is short term in nature and mostly not part of permanent plant, but subject to wear and tear.
• Energy generation with renewable sources is an investment that adds to property values, by moving energy from liabilities to assets.
• Logically, in the short-term "energy efficiency" might be a self-liquidating proposition, which by definition would reduce the underwriting risk and the chance of mortgage default by the amount cash outflows are reduced, however these effects don't last, for easily provable reasons.
• Site Derived Renewable Energy (SDRE) is a clear and lasting energy price hedge, certainly if more than 50% of the energy requirement can be economically generated on site. In this case the performance of the property improves with every energy price hike, and thus there is a long-term reduction in underwriting risk, and we can expect a commensurate, but lasting reduction in mortgage defaults.
• SDRE also offers protection against a carbon tax, if it ever were to come. Again, energy efficiency cannot do that, even if it may temporarily reduce mortgage default risk. 

Current research into the issues of mortgage default rates fail to distinguish these structurally and financially very different alternative scenarios, while it is analytically clear that the one has a short-term effect, and the other adds lasting value to a property.

Conclusion - Investment in SDRE wins out over Energy Efficiency

Energy efficiency can be shown to produce improved cash flows in the short-run, and therefore should reduce underwriting risk and mortgage defaults. However, for good analytical reasons the longer term value of energy efficiency alone is uncertain, and a better option is renewable energy generated on site (SDRE), that is justified not only by the marginal savings of the equipment, but also by the lasting improvement of property values.

NYC Clean Heat Destroys Property Values

PlaNYC Heating Oil Regulations are pushing buildings from #6 and #4 oil to #2 oil, natural gas, or biodiesel. Conversions are in full swing. Sadly, many of the buildings are suitable for renewable energy conversions which would produce far better results for the environment and for occupants, as well as better long-term financial results for owners. It says on the website that owners can apply for compliance waivers through NYC DEP. Owners should do this if their buildings are suitable and if they have the financial wherewithal to make that transition to a renewable solution. As long as a credible renewable solution can be found, owners are in fact placing a long-term hedge on their energy costs, and will do far better than they would going along with the conversions which the City is pushing. The typical 30% gains in efficiency are too easily wiped out by the next energy price hike.

Compound investment returns from energy independence through renewables

Not only are these conversions counterproductive as long as there is a renewable energy alternative, owners are being offered subsidized financing to make it easier to make the wrong decision, and destroy the asset value of their buildings. Having said that, there may be some buildings that realistically could not make a transition to renewable energy economically, but in many cases it is well within reach to do in buildings that are 40 units and up. (Size matters because of economies of scale). In the long run, this will produce a steady path to asset appreciation.

Presently we are in PlaNYC 2013, but it started in 2007 as Plan NYC 2030, and since then evolved to PlaNYC 2.0. Clearly this is an extraordinarily important plan, and it puts NYC in a very proactive stance with respect to climate change issues, but in this area of renewable energy, not nearly enough is being done. Most of that shortfall rests on the general confusion in our society that energy efficiency somehow is an additive phenomenon and would result in energy independence. In that context renewable energy is then relegated to a marginal role. If you were to actually do a long-term energy plan for a building, you would see this is not so, unless the building is not capable of a renewable conversion. Most of the buildings that burn #6 could do it.

The first issue is a choice of what energy system do I want? Do I make my energy (renewables) or buy my energy (subscription-based, gas, electric, oil). The two paths are to a large degree mutually exclusive, because of engineering interdependencies. One clear example, if I can go the renewable route and perhaps eventually eliminate gas for cooking, and most heating/cooling, I may be able to eventually do centralized HVAC, and choose very different replacement windows, etc.

Most importantly, the path to energy efficiency of my existing fossil fuel system is an investment in becoming a long-term consumer of gas or oil, or even biodiesel, so it is a customer retention program for the energy industry. In this case it is driven by the well intended reduction of CO2 and particulates emissions of gas versus oil, but as long as a renewable alternative exists, the latter would produce greater benefits in the long run. Successive investments in energy efficiency produce strongly diminishing returns, so a property owner paints himself into a corner financially. Once the transition to a renewable infrastructure can be made, the financial future of that building is assured, because subsequent investments will produce compounding results. The transition to renewable energy practically ensures building preservation, because of superior economic performance over time.

Underwriters risk collateral values by underwriting energy efficiency

If you check the website for NYC's Clean Heat program you will see energy efficiency as the sole qualification for subsidized financing. All the usual culprits are there, CPC, NYSERDA et al, many of whom have energy credentials, for this conversion effort is a subsidy to the energy industry to the detriment of building values. Underwriters should learn to test for the difference between energy independence (renewables) vs. energy efficiency of carbon-based energy systems, simply because of the issue of diminishing returns with the former, and compounding returns with the latter. Energy Efficiency loans are riskier than Energy Independence loans, by far. To lump them all into one category is bad for owners and bad for underwriters. Building values for buildings that are 50% or better energy independent would rise strongly over the life of the mortgage, compared to buildings that invested in energy efficiency alone.

DaBx PlaNYC 2020: the Energy independence plan

Windspeeds over NYC are higher than Chicago

With my consulting company DaBx Demand Side Solutions, we offered an alternative model to Mayor Bloomberg on July 4th 2011, which would achieve better results, and faster than the mere conversion from #6 to natural gas, and, as noted above, better financial outcomes for building owners. The plan is within reach for probably at least 50% of the building stock that is now converting to natural gas. It is more capital-intensive at first, but not much so once you evaluate it against the alternative of the forced gas conversion. The outcomes for air quality and building preservation would be far superior, not to mention public safety and national security. The conversion to gas only seems easier and cheaper in the short run, it is not if you do a 30 year energy plan for a building.

The basic model is based on understanding that in C and D class apartment buildings that are usually only 6 stories high, the old steam boilers usually provide Domestic Hot Water (DHW) through a coil in the boiler, and 30-50% of BTU output of those boilers goes to DHW. In those cases, economically feasible solutions can start from providing DHW with renewable energy, either geothermal or solar thermal. This eliminates 25-50% of CO2 and particulates emissions right away, it also gives the boilers the summer off, so it extends their useful life, and then at the time when the boiler dies from natural causes, the conversion to renewable HVAC can be completed. And yes, the famous split incentive between landlords and tenants needs to be cured.

Energy independence, wind and geothermal energy

Energy independence of buildings means the building stays lit during an outage, even if only partially. The two technologies that have been underappreciated so far are geothermal and wind power. In 2008 the press practically ridiculed Mayor Bloomberg about his advocacy for wind power on buildings, but they did not understand that specific wind turbines for buildings where just starting to come to market, and the Mayor was right on target, perhaps without knowing it. Average wind speeds around NYC are higher than in Chicago, supposedly the windy city. Moreover, around buildings, wind speeds pick up dramatically, offering excellent opportunities for wind power especially in the city.

Geothermal is the most strategic technology of them all, and City Hall is only just now starting to research it. Basically a geothermal system gives you a 400% gain in BTUs, and most importantly it can act as energy storage, besides providing domestic hot water. Here is one place where compounding returns come in, for energy storage is the single biggest problem in renewable energy, but DHW ends up acting as energy storage for your building. Unfortunately most existing geothermal systems in apartment buildings were wrongly designed, as DHW only, and not for energy harvesting. Buildings need 30 year energy plans, not point solutions.

Conclusion:

PlaNYC can be much more successful if the confusion between energy efficiency and energy independence through renewables is eliminated. Better outcomes for building preservation, air quality, and economic competitiveness of the city would result. Energy efficiency of a building with a carbon-based energy system is financially inferior and prolongs the period of CO2 emissions, energy independence through renewables reduces CO2 faster.