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Market Conservation vs. Government Conservationism: Understanding the Limits to Energy Efficiency and 'New-Economy' ESCOs

“Today the conservation movement is led by sober business men and is based on the cold calculations of the engineers. Conservation, no longer viewed as a political issue, has become a business proposition…. The old school looked on conservation as a governmental function; the new school believes in entrusting it to the hands of business men and engineers.”

- Erich Zimmermann, World Resources and Industries (New York: Harper & Brothers, 1933), pp. 784–85.

Profit-seeking conservation is nothing new, as economists have noted. So why must we assume that self-interested conservation is a ‘market failure’ requiring government subsidies and mandates? Why is market decision-making with energy necessarily sub-optimal?

And if “market failure” is posited, what must be said about “government failure”? Political processes are human too, and worse, bureaucrats do not have their own hard-earned cash on the line. The case for government (non-market) conservation is not self-evident.

Technological improvements and greater capital investment have often reduced resource requirements. History is replete with statistics showing how resource efficiencies have been a natural byproduct of profit-driven activity in a free and prosperous commonwealth as shown, for example, by economist Pierre Desrochers (here and here).

Coal Pounds/kWh Efficiencies: 1900 and Today

Consider the use of energy inputs to generate electricity. At Samuel Insull’s Commonwealth Edison Company in Chicago, for example, between 1900 and 1913 the amount of coal per kWh fell from approximately seven pounds to three pounds. (1) Insull spoke to such invisible-hand conservation–versus political shouts–in a 1916 speech:

I think that while a great many of our well intentioned friends have been shouting about the conservation of natural resources, the steam-turbine inventors and the designing engineers of the great power companies using steam as a prime source of power have probably done more to conserve the natural resources of this country, in so far as fuel is concerned, than has been done by all the agitation that has taken place upon the general subject of conservation (2).

And such resource conservation has continued. Less than one pound of coal is required per kWh in electric generation, and this amount continues to fall (see Appendix).

Market conservation can go too far, as indicated where profitability is low or even negative. A business can overinvest in conservation of any input just as it can underinvest in the same. Not only engineering but net-present-value economics is important in such determinations ex ante and ex post.

Energy Outsourcing in the 1990s: Hype, Exits & Even  Fraud

Enter the energy outsourcing model of energy service companies (ESCOs) in the 1990s, widely heralded as a “new economy” breakthrough and a new feature of “natural capitalism”.

Enron Energy Services (EES), in particular, the energy outsourcing division of the late Enron, was the next great thing, thought Amory Lovins and Joseph Romm, the gurus of less is more. Energy savings were easy pickings, and Enron would help lead large commercial and industrials to the Kyoto promised land via cost-effective energy-usage reductions.

“ESCOs are DEFINITELY the future,” exclaimed Romm. “I intend to work with the big ones to transform the market, which I think will take about two or three years.” ( Email communication from Romm to Enron, July 23, 1999)

Such thinking was part of Romm’s worldview of energy conservation as presented in his 1999 book Cool Companies (pp. 2, 12):

The entire notion that low-hanging fruit is easily exhausted turns out to be a myth….  A “cool” company will cut its emissions by 50 percent or more while reducing its energy bill and increasing productivity, with a return on investment that can exceed 50 percent and in many cases 100 percent.

But it hardly turned out this way. The big-player ESCO sector collapsed, and EES (1997–2001) was exposed as the fraud of frauds, a major exhibit of federal prosecutors against Ken Lay and Jeff Skilling.

Other leading ESCOs, such as PG&E Energy Services and DukeSolutions, exited the market ahead of Enron, taking their lumps rather than engage in accounting games to fool investors.

In short, energy outsourcing via a bundled service was not the money/energy saver that it was thought to be–despite  Romm’s confident talk (ibid., p. 4) about how “Cool buildings that cut energy use–and hence greenhouse gas emissions–in half are increasingly commonplace, as many of the examples in this chapter demonstrate.”

Demise of PG&E Energy Services: A Reality Moment

EES’s flawed business model was exposed by an executive of a rival company–PG&E Energy Services. In fact, Enron (EES) had purchased his company and was singing the praises of its ESCO model and efforts–while entering into uneconomic (and fraudulently “profitable”) contracts!

“Enron Picks Up PG&E Energy Services Contracts for a Song,” reported the April 14, 2000, edition of California Energy Markets . The article explained:

What many had suspected was finally affirmed this week, as PG&E Corporation revealed it will sell its PG&E Energy Services unit to Enron Energy Services. More surprising than the sale … was  the price. Enron will pay a mere $85 million for a portfolio of energy sales contracts that PG&E executives had previously reported was worth up to $3 billion in future business.

Although the retail services unit was increasing revenues, it failed to show profitability after three years. According to PG&E’s annual report, total losses for Energy Services during 1999 were $98 million, including a $58 million write-down taken in the fourth quarter.

For Enron, the deal was just another announcement in a busy week….”

But Enron was throwing good money after bad. PG&E Energy Services’s Kevin Fraser explained the flaw of the ESCO model in a widely distributed memo of May 2000 (it spread fast within EES with a lot of people swallowing hard):

Well, at least now I can say that I have worked for a failed start-up company.

All commentary aside, there is a message in the collapse of [PG&E Energy Services] for all property professionals. The message is clear – fully bundled energy services do not work. If you have had a chance to read through the volumes of material on my website you will see that I do not advocate fully bundled energy services. However, I also do not advocate unbundling without a thorough understanding of all implications and ramifications.

To explain the concept, bundling combines the provision of electric commodity with other energy related provisions that would normally have an out-of-pocket cost associated with them. As an example,

A replacement chiller may be provided without initial capital outlay by virtue of its acquisition cost being recovered through savings partially attributable to a discount in the cost of electric commodity. So, perhaps you have acquired a commodity discount of 5%, but you will not actually see this discount on your monthly bill because this discount is being collected to in part pay for the new chiller. A key element being that the contract for commodity must last at least as long as the debt recovery for the capital project. Some companies, such as Enron, want this to extend even to providing all central plant services such as running the stationary engineers, and beyond to the janitorial services, etc.

During the infancy of deregulation, several hundred companies were created to exploit this brave new world, and naturally enough as it is touted to be a $432,000,000,000 industry. You read that right. These companies break down into two categories (alright three, consultants like FRASER LIMITED being the third), and these are EXCOs and ESPs: Energy Service Companies and Electricity Supply Providers. The distinction being that the ESP company provides only a discount on commodity without associated ‘value added services’. Essentially all of the major existing utility companies created an ESCO to serve as their retail marketing entity, a transparent ploy to pretend there was a distinction from the utility itself. PG&E Corp (the parent holding company for Pacific Gas & Electric and four other subsidiaries) created Vantus which evolved into PG&E Energy Services with the hiring of Scott Gebhart as President and CEO.

PGEES had as its core concept bundled energy services. It did not want to provide commodity deals without the associated value added services (although it did as witness the BOMA San Francisco Power Pool), and ultimately prohibited commodity-only deals. PGEES felt, just as does Enron and most of the other major ESCOs, that true profit comes only from the mark-up of these value added services. Unfortunately, this is a very flawed concept.

What these companies did was try to answer a question that was not asked. There is no need for this form of performance contracting, and no need for the forty-plus percent mark-up on the package deal. The commercial real estate industry is mature and in the hands of well seasoned career professionals who have been contracting for mechanical/electrical/plumbing for decades. You professionals know how to engage a firm to install a new chiller, and you know what it cost and what their profit should be. You know how to present it to the owners, how to recover it through lease language provisions, and you want control of the project. You also know better than to entangle pure energy discounts with the convoluted provisions associated with shifting the savings to debt recovery. In short, the concept of the bundled offer is flawed.

And so the failure of PGEES. This is not unique in the industry, simply it is the largest example to-date. Enron, NEW (now NewEnergy), Duke, Edison and others have all backed away from this market after failing to achieve true profit after the smoke and mirrors of enormous revenues. Nobody gave it a better go than PGEES, at least in terms of funding and structure, I can argue the actual intent of the parent PG&E Corp.

The message here is for you, the property professional, to beware the bundled offer. It is still out there and still aggressively marketed. You will read of new deals such as Chase Manhattan Bank where it appears such deals are valid, but that is why there are consultants like me to advise on the realities. DO NOT avoid taking advantage of energy savings offers! At FRASER LIMITED we have now saved tens of millions for our clients through appropriate deal structures. The advice is simply to be cautious of the fully bundled offer.

Joe Romm’s Center for Energy and Climate Solutions: A Failure Too?

Joe Romm got into the ESCO boom, trying to do on the nonprofit side with the Center for Energy and Climate Solutions (CECS) what Enron, PG&E, and Duke were trying to do on the profit side. His hopes were high. As Romm said in the introduction of Cool Companies (p. 14):

In 1998, I left the Department of Energy to work with companies to identify best practices and develop customized strategies. I am constantly amazed at how many major companies are unaware of how much money and energy they are wasting and how many are misinformed about cogeneration and other opportunities for lowering emissions while increasing profits. That is why I have written this book and established the nonprofit Center for Energy and Climate Solutions [CECS]. The center is a one-stop shop for businesses seeking to reduce greenhouse gas emissions and is helping companies to adopt the cool strategies discussed in this book.

But the nonprofit CECS bit the dust too, which raises further questions about the ESCO model of the time. For if profits were just lying on the ground, why did Romm need to form a nonprofit to get companies to pick them up? Why didn’t he form an outsourcing company himself, or work for PG&E or Enron or Duke–and make BIG MONEY.

And why was CECS dissolved–not unlike PG&E Energy Services, EES, and Duke Energy Services? Why did the Ph.D. physicist have to find a new line of work as a climate/energy pundit at the Center for American Progress?

I ask these questions in hopes that they will be answered by Dr. Romm himself–or an economist or historian documenting the limits to self-interested energy conservation or just the failure of conservationism versus the real thing in self-interested markets.

Caveat & Question

I am not challenging the concept of outsourcing in general or energy outsourcing specifically. I am sure there are niche applications, and I imagine that government entities need this sort of “privatization” service from the private sector. But for large commercial and industrial company, is there a proven advantage for energy outsourcing? And if so, what might the monetary and energy savings be versus business-as-usual (non-outsourcing)? It is certainly not in the range that Romm, Lovins, or EES were touting, but what might it be?

Comments from those in the field would be very appreciated!

(1) Samuel Insull. “Centralization of Energy Supply” (1914). In Insull, Central-Station Electric Service. Chicago: Privately Printed, 1915, 445–75, at 469. Also see Harold Platt, The Electric City (Chicago: University of Chicago Press, 1991), pp. 114, 178–79, 208–12, 229–30, 252.

(2) Samuel Insull. “Progress of Economic Power Generation and Distribution” (1916). Reprinted in S. Insull, Public Utilities in Modern Life, 40–53. Chicago: Privately Printed, 1924, p. 51.

 

Appendix: Increasing Thermal Efficiencies in Modern Coal Plants (Robert Peltier)

Assuming the ComEd plant was burning a typical Illinois bituminous coal, the 7 lb/kWh equates to a thermal efficiency of only 4%–and 3 lb/kWh a thermal efficiency of about 9%.

The average coal-fired plant in the U.S. operating under standard sub-critical steam conditions is about 33%.  One source states the average coal plant efficiency world-wide is 31%  but that seems a bit low to me.  The only reference on the EIA website uses a heat rate of 10,300 Btu/kWh for pre-1965 plants which is a thermal efficiency of 33%.  The better number for a current subcritical steam plant is 9,500 Btu/kWh or 36% thermal efficiency.  Those two numbers bracket our U.S. fleet of coal plants reasonably well.

State-of-the-art coal plants is another issue.  The Wisconsin Public Service Co’s Weston Unit 4 was the POWER magazine 2008 Plant of the Year—it was the first supercritical coal-fired plant built in the U.S. in over 20 years.  This Weston 4 plant’s heat rate is 8,910 Btu/kWh or a thermal efficiency of 38%.  AEP’s John W. Turk Jr. 600-MW plant under construction in Arkansas will be the first ultrasupercritical plant in the U.S.  It’s efficiency will exceed 40% and will enter commercial service in early 2012.

To directly answer your question, assuming each of these plants were burning the same Illinois Bituminous coal given the stated efficiencies

  •  
    •  
      • Pre-1965 coal plant with 33% efficiency = 0.86 lb/kWh
      • Post-1965 coal plant with 36% efficiency = 0.79 lb/kWh
      • Current supercritical designs with 38% efficiency = 0.75 lb/kWh
      • First USC in U.S. with 40% efficiency = 0.71 lb/kWh

On the horizon are new coal plant designs (double reheat, USC, etc) that are expected to reach 46% efficiency by 2015–2020 or so.  Those plants would burn 0.62 lb/kWh.

One caveat: the range of fuel energy content is wide.  Powder River Basin coals or sub-bituminous coal has a much lower heat content but are also lower in sulfur making it the favorite coal for plant use today, especially for fuel switching. Because the energy content of this coal type is lower, that means a plant has to burn more coal to obtain the same energy content as a higher quality coal. These comparisons were all made using a 12,000 Btu/lb Illinois Bituminous coal.

Email communication from Peltier to Bradley, June 16, 2009.

16 comments

1 Kevin Fraser { 06.25.09 at 4:02 pm }

Little has changed since I wrote that piece ten years ago. True performance contracting is still viable and one of the best means for a property owner to direct capital funds in other directions than energy conservation. But attepmting to ‘secretly’ fund the project by skimming the margin off commodity still doesn’t work, and I don’t know anyone trying that fully bundled approach anymore… well, except for some solar (PV) providers that is…

2 Andrew { 06.25.09 at 4:36 pm }

Ultimately the question comes down to whether you believe individuals had have a right to decide on conserving for themselves. Disturbingly, many do not seem to think so.

3 rbradley { 06.25.09 at 9:39 pm }

Kevin:

If I understand you correctly, it was a mistake for ESCOs to assume that they could mark up the commodity portion in their total outsourcing contracts. But what about the hardware part–are there ESCO companies today that are that much better than the energy/engineering staff of the outsourcing company to win the business in outsourcing contracts? Or are “high transaction costs” in arm’s-length contracts a problem now as it seemed to be in the 1990s?

4 Kevin Fraser { 06.28.09 at 2:06 pm }

It wasn’t the marking-up of commodity – it was trying to play the margin that was flawed. An ESCO would provide wholesale power at retail price, and apply the margin against the cost of the physical project. Since the cashflow was unchanged from the viewpoint of the consumer this allowed a very high profit on the physical improvement project. Problem was the delta for commodity didn’t really exist for a regulated utility or its supposed unregulated retail arm. Too much cost involved in hedging the credit risk. So there was no margin to cover the project cost.

I don’t know of any ESCO companies today that are playing the game with success. I do know of plenty of performance contractors large and small doing well with simple performance margin convering the cost of improvements while showing no cash outflow increase to the consumer. This is standard business and makes a lot of sense. Some PV providers are offerring the old commodity margin play but they are finding it very difficult to find financing as these projects go out a good many years.

5 Joseph Romm and Enron: More for the Record — MasterResource { 06.30.09 at 10:08 pm }

[...] future post [now published] will explore the failure of EES, PG&E Energy Services, and Duke Energy Solutions–the [...]

6 Robert Michaels { 07.01.09 at 8:36 pm }

The ESCO model swims against one of the most important economic currents of the late 20th – early 21st centuries. The Enron/ PG&E ESCO was an attempt to bundle several goods and services into a single package with the hope that they could [1] assemble exactly what the customer wanted more cheaply than the customer could, unlikely if users are market-savvy and can easily inform themselves about the values of the individual pieces, and [2] because they could do it more cheaply than the customer they could mark up the package accordingly despite having little or no market power in its components.
I’ll post more on this later.

7 Enron and Waxman-Markey: Response to Joe Romm — MasterResource { 07.02.09 at 7:07 am }

[...] But more than that, Enron is the perfect foil for the Romm-beloved HR 2454, the Waxman-Markey cap-and-trade bill, or what I call the  Enron Revitalization Act of 2009. Last year I did a reason.tv video about Enron, Obama’s Enron Problem, and I have posted repeatedly about how Enron’s failure and fraud were closely related to its “sustainable energy” strategy with solar, wind, and energy efficiency. [...]

8 Kevin Fraser { 07.02.09 at 10:27 am }

Robert I agree that what you state is the appearant goal, however the real goal is to conceal the economics. The whole bundling thing was to create a blanket of concealment on the cash flow so either tenants or execs would not know the facts. As long as the outgoing cashflow was unchanged things must be OK – right? The fact that the construction project was earning the contractor a margin of fifty percent would not be brought into question because it would never be known. And those on the buying end, even though they had a feeling they might be overpaying, went along because it was the only way to accomplish capital projects that otherwsie wouldn’t get approved.

Particularly in triple net properties where the tenants pay the electric bill through their rent, a landlord could acheive millions of dollars of capital improvements paid for by the tenants – without the tenants knowing this because it was concealed in the energy bill. Even today the things that get concealed in a tenants electric bill might surprise many of them.

9 More Deceit from Climate Progress, Center for American Progress (Is Joe Romm shooting himself in the foot?) — MasterResource { 08.25.09 at 1:02 am }

[...] cheerleader for the company’s climate alarmism, wind and solar investments, and (contrived) as it turned out) energy outsourcing deals. I risked my job by fighting against such shenanigans [...]

10 A War on CO2? Civil Libertarians, Beware! — MasterResource { 09.14.09 at 1:01 am }

[...] We should also remember Jimmy Carter’s thermostat regulations that set maximum winter temperatures and minimum summer temperatures in buildings. That got a little personal for the American way of life too. Price and allocation deregulation proved to be the cure for that energy crisis–just as price and allocation regulation created the supply/demand imbalance that inspired government conservationism. [...]

11 Jigar Shah { 10.13.09 at 6:52 pm }

Kevin, great thread. I am curious, since the 1970s people have documented energy efficiency projects in homes and businesses with rates of return that exceed 20% (3 year payback or so). However for reasons that probably relate to human behavior, many people seem to not be making an economically rationale decision. Alternatively, maybe the business has many other uses of the capital that exceeds 20% returns or the customer believes they will leave their building within 3 years. Even in lighting which has the highest penetration, you still see people using T12 lamps — mostly because smaller buildings have projects that are less than $5,000, not worth going after for a sales person.

At some point isn’t it far more cost effective for the government to mandate tougher building codes and retrofit requirements instead of providing subsidies to increase the 20% rate of return projects to even higher numbers? It seems that energy efficiency just is not sexy enough to convince people to be rationale with their investment decisions. The reason it matters is because requiring energy efficiency could easily put off a new electricity generation plant, saving the “system” money.

12 Robert Bradley Jr. { 11.12.09 at 10:22 am }

I bring your attention to the post “Climate McCarthyism Part 3: The Hyper-Partisan Mind” by by Michael Shellenberger and Ted Nordhaus where I have the second comment:

http://thebreakthrough.org/blog/2009/11/climate_mccarthyism_part_3_the.shtml

13 Kevin Fraser { 12.17.09 at 4:45 pm }

Jigar – I am not a fan of government requirements in general, and specifically not in the case you present. I prefer market forces to drive change.

Many buildings have a master meter, and the tenant pays their power bill by way of a charge embedded in their monthly rent – called CAMs for Common Area Maintenance. This is not a metered calculation but rather a formula for approximate cost. The landlord pays the utility, and the landlord imposes a ‘management fee’ on top of the energy cost. So you can see there is no incentive for the landlord to promote conservation because the lower the monthly energy bill – the lower will be the management fee in terms of actual dollars.

Now, if the government mandates conservation, the landlord will find a new way to collect money, perhaps higher rents. That isn’t good for business. And if the property owner is holding the property to sell in the near future, conservation measures will add to the sale cost (price) without particularly adding any value to the buyer. Again this is not good for business.

Another factor is that commercial properties typically have distinct budgets for capital improvements and for operations, with each in annual competition for more money. Why would the people in charge of capital projects spend their share of the money to help the people in operations? Which is indeed the case with energy conservation projects. And why would the people in operations spend their money on capital projects that will be built by another department in the company? These businesses simply aren’t structured to work this way.

Building codes in the US have already reached a point where builders cannot surpass required levels with any practical amount of capital (new construction). In other words the standards now in place are very stringent, and to surpass them would require such a significant increase in capital that people might very well simply elect not to build at all.

14 Coerced Energy Efficiency in Texas { 03.25.10 at 11:20 am }

[...] will argue that more government-directed conservation (or conservationism) is a good thing. After all, it is frequently claimed that the existing efficiency program is [...]

15 shanemiller { 04.11.11 at 4:29 am }

Really the time has come when people should understand their duties for energy economy.

16 Energy Conservationism: Taxpayers, Consumers BewareInstitute for Energy Research | Institute for Energy Research { 07.30.12 at 1:28 pm }

[...] efficiency as market-driven, not government-engineered. Resource economist Erich Zimmermann noted back in [...]

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