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Convened by Senator Robert Hill, Minister for the Environment and Heritage, Canberra, 5 July 2000
Environmental Economics Research Paper No. 7
© Commonwealth of Australia, 2000
ISBN 0 642 19485 8
Professor FREEBAIRN–I want to take up the economists' bait. I think you have rightly shown us a picture of how important profit is in driving people’s decisions and, as you rightly say, that can be driven on the demand side. There are some people who will pay premiums for so-called green products because that gives them extra utility; again, on the cost side, saving energy inputs but saving the amount of wastage and so on. In all of that, prices are really the big signals that make things work. It seems to me that in terms of the technology story, price is also driving technology. When oil was really cheap there was not much incentive in developing more fuel-efficient engines. When oil became expensive, then the pay-off of having engines which were fuel-efficient went up a lot more. So suddenly you got a switch in technology to say, ‘How can we cut down on oil use?’ and a little less put on, ‘How can we make this go bigger, faster and louder?’ I do not think we are seeing that going on all the time. Of course, this takes a long time to happen so you do not see the price response; not next year, maybe not in five years–you are seeing it some decades down the track, so it is very hard to measure.
The thing I think is important about price is that it is explicit, it is up-front and it fronts everybody–every producer has to confront this story–and you stop getting free-riders. So I think prices have to be a key part of the story. In many cases, I would argue there are demonstrated market failures where we do need some sort of intervention, whether it is by taxes or subsidies or tradeable permits and so on–that is another set of debates. But I would not like you to feel that you have got away with ‘price does not matter.’
Mr LOVINS–Just to be clear, I did not say price did not matter. I think price mechanisms are extraordinarily important. I have actually developed most of the mechanisms now in use for trading resource efficiency to take advantage of precisely those mechanisms. I love carbon trading with no entitlements, everything open, and I do not have any objection to getting prices right. I am just saying that enabling people to respond to the price signals, whatever they are, by busting barriers to efficient market behaviour is even more important than getting the prices right, and yet it has not been on the agenda much at all.
I want also to emphasise, because I think I heard a little assumption creeping in, if you were to think of resource efficiency as having a supply curve rather than being a shift in a demand curve or a longer demand curve. We are used to thinking that the more of a resource you save, the more and more steeply the marginal cost of the savings rises until you hit the wall and you stop. But in practice there is often another bit, much better known to engineers than to economists, in which you keep going and the price comes down again to less than you started with.
That sort of non-monotonic supply curve is terribly important. Efficiency need not cost more in most cases. It can cost less just in private internal cost. The classic example is the way one can often cut three per cent to five per cent off the construction cost. An office building that uses one-tenth of the energy of the normal design works better in all respects. I agree with you historically that in the oil past, price was very important to both short-term and long-term responses. I think in the oil future, however, when you combine the stunning advances in exploration and production and substitution on both the supply and demand side, you have to conclude that oil is probably going to become uncompetitive, even at low prices, before it becomes unavailable even at high prices. Or, in the immortal words of Don Huberts, the head of Shell hydrogen, the Stone Age did not end because the world ran out of stones; the oil age will not end because the world runs out of oil. That is not, I think, the future that most economists or environmentalists expect. But I think he is absolutely correct–and it is because of technology.
Mr D’ARCY–We do see a future for oil for some time yet, I should say! Just following on the comment about ‘prices do matter,’ I think you made the message very powerfully that, even at existing prices, there are profitable opportunities for good environmental outcomes, and you mentioned buildings and the carbon example and so on. What I think puzzling is that there are profitable opportunities going begging, and perhaps that is the point that Robert was referring to in his introduction. What are the informational impediments to companies taking up these profitable opportunities that are lying around ready to be grabbed?
Mr LOVINS–They are enormous. I have been working with Shell for 27 years and I think we all know that there are many curious behaviours in large organisations that make it difficult to capture obviously profitable opportunities. Organisational economists actually study some of these, and they have fancy names for them, but we all know if we work in a large outfit it is much more a Dilbert world than a perfectly functioning market abstraction. But there are some salient examples. I have already mentioned some of the perverse incentives, let me mention two other examples. One is in capital allocation. It turns out that most firms allocate capital to efficiency investments as if they were terribly capital-constrained and had implicit real discount rates up around 60 per cent or 80 per cent a year or even more. They will typically require efficiency to meet a hurdle rate at least six times their marginal cost of capital. This is absolutely daft. It often traces back to a curious kind of cultural anthropology phenomenon that the operating engineers think they are constrained to an 18-month simple payback and they do not have the Rosetta stone to translate into the discounted financial measures used by the finance department, which might want a 17 per cent after-tax return. As soon as you show them the formula for translating, they see that there is an enormous gap–almost an order of magnitude gap–between what the financiers actually want and what the engineers think they have to deliver. They just did not speak the same language.
The second example–and let me give you US numbers on this because I do not know the Australian ones–is: let us suppose we are in a fluorescent-lit office. What do you suppose is the after-tax return of making the wire that powers the lamps one size fatter so it has less resistance? Any guess? It is about 193 per cent a year after tax. Why is that opportunity not captured? Where did it come from? It arose because of two different market failures: first, that the wire size is specified by the low-bid electrician who is told to meet the national electrical code. People might assume that is an economic optimum, but actually it is just meant to prevent fires from overheated wiring. If you want to save money you make the wire twice as fat at least with a quarter the resistance from four times the copper. But that is not in code and very few people know to do it. Anyway, who would get to do it? The electrician that is altruistic enough to buy four times as much copper to save your electric bills later–notice the split incentive–would never get the job in the first place because the general contractor hires the low bidder and that will not be the person that buys four times as much copper. So this is a double-barrelled problem, and you have to understand it is there before you can do any of the half-dozen obvious things to fix it.
That is why we wrote up this little prospector’s guide. We found that most people are not aware that those market failures exist. I think between the private and public sectors there is a huge job to be done here. That is why I would put it at the very top of the policy agenda for greenhouse.
Dr BUTCHER–Firstly, a comment on the price. I suppose prices are relative. In general terms, many of the products of natural resources are now cheaper than they were many years ago. So it is a little bit like your paper mill model with the outlet and the inlet: if you do not internalise your externalities then your price will remain artificially low. My question is more about the opportunities for a house to produce its own electricity. This is to eliminate where a lot of waste is–as you said, copper and wire size and so forth. Actually taking electricity to a house is very expensive, so what about the opportunity for actually having a power station in each house? Demand?
Mr LOVINS–It is there. There are tens of thousands of houses doing it in the US and, I dare say, quite a few in Australia. The key to it is to use the electricity very efficiently. My household uses an average of about 110 watts, one globe’s worth, for all the household purposes. That means a few square metres of photovoltaics will cover the whole usage. That is cheaper than hooking up to the grid, even if it is a few metres away.
Dr BUTCHER–A supplementary, then, using a fossil fuel to actually fire a generator in the house; so natural gas as a demand supply of electricity?
Mr LOVINS–Yes. Right now you could do this with an engine or microturbine. However, I think with the cheap fuel cells entering the mass market (they will not be cheap but still very worthwhile even at next year’s prices) we will see a rapid shift to a black box that sits next to your gas meter, makes the natural gas, the methane, into hydrogen and runs a fuel cell that produces with extreme reliability all your power, heating, cooling and dehumidification, and gives you hot drinking water to boot. That is part of the distributed utility revolution, and it is part of the reason it is absolutely daft to be building more coal plants.
You are absolutely right, by the way: the commodity prices keep going down. Part of the reason they look cheap is that we are not booking a lot of their costs. If you did fully book their environmental and social costs, it would be interesting to know what the shadow prices would actually look like–whether they are still going down or not. I think there is a lot more scope to make commodities even cheaper. But my point is that we have enormously more scope for dealing on the elasticity side than the price side, and we ought to pay attention to both opportunities.
Dr NORGAARD–As an economist I am very comfortable to say that technology and institutional organisations are the major drivers, and prices are just little fine tuners. If you look at the last 300 years and explain economic change, you certainly would not look to what has happened to all these prices. You would say: what has happened to this technology? What has happened institutionally? You would see tremendous technological change and the rise of the corporation and the financial sector. So you are sort of looking 50 years ahead and saying, ‘It’s the technology and the institutions that are going to make the difference. Here are the directions they are likely going to go.’ What I am not comfortable with is: why hasn’t it gone this way earlier? What are the conditions now that make it so obvious to you that this is the way we are going to go?
Mr LOVINS–Partly hyper-competition in business, partly much more open flows of information, greater transparency, partly that a lot of people in many walks of life and in the public, private and NGO sectors are starting to have what my old mentor Edward Land called a ‘sudden cessation of stupidity.’ That was his term for invention. By the way, he said mistakes are simply events that have not yet been fully turned to your advantage. He also said–importantly, I think–that people who seem to have had a new idea have often just stopped having an old idea. We are getting better at stopping having old ideas and at asking, ‘Now, wait a minute. Why are we doing this?’ It is more a change in mentality even than in technology. But they both come together and we know they are all going into fast forward. This is in a competitive world with less and less protectionism at all levels: the recipe for business success, not doing it as the recipe for business extinction, I think. When you look at the confluence of all these forces it is very hard to forecast business as usual.
Dr BYRON–I want to pick up on that last point, one of the possible institutional drivers being increasing competitiveness. A year or so ago we did a study on improving the environmental performance of commercial buildings. The good news was, as you say, there are 1,001 technologies out there that would make enormous gains, many of them extremely cost effective with high rates of return already. The bad news was that it was very difficult to even get improving environmental performance–energy efficiency, water efficiency–onto the agenda for the boards of big corporations. If you are running a national chain of department stores or a national banking network or whatever, even though you have thousands of buildings using very large amounts of energy, the board does not think in terms of: how can we improve the environmental efficiency of all our infrastructure? But I think, with increasing competition, any of those energy savings basically go straight to the bottom line. So a board that does not look at ways of saving a few hundred thousand dollars in their electricity bills is derelict in its duty and is likely to get what happens to incompetent boards.
The other thing that seems to be happening now is the arbitrage: the engineers, the innovators, the people who have that sort of technology, who will come along and say to the board of one of these big national companies, ‘We’re pretty sure that we know how to cut your energy bills by 50 per cent, 80 per cent’ or whatever. ‘If you hire us to do it we’ll split the savings with you.’ That is one of the things that starts to get it on the agenda. It was not that the ideas were being explicitly rejected; we just could not get boards to consider them. Is that consistent with your observations?
Mr LOVINS–Yes. Let me give you a practical example. I was dealing with a 19,000 square metre, all glass and no window-curtains office near Chicago which is both very hot and very cold. It was 20 years old, had a failing glazing system and needed renovation. We figured out a way to save three-quarters of the energy and make it a much healthier, happier and more productive place for people at the same cost as the normal 20-year renovation that had to be done anyhow. By the way, they did not do it–not because the owner was dumb. The owner was actually the biggest fiduciary owner of commercial property in the United States and I think they believed the numbers. The problem was that, unknown to them and to us, this property was controlled by a letting agent incentivised on deal flow. She did not want to delay her commissions from letting up the building for a few months in order to do the retrofit, so she did not do the retrofit. But then it was so costly and disagreeable nobody wanted to be in the building and they had to flog it off to a bottom-feeder at a distressed price.
Our approach is then to say, ‘Oh well, that’s fine. We’ll work with their competitors over the road until they catch on,’ because our model at Rocky Mountain Institute is to work with one or a few early adopters in a given segment or sector to help them achieve such conspicuous success as natural capitalists that their rivals are forced by competition to choose whether to follow suit or lose share. This seems to work very well and we have done it now in quite a few sectors. But when you analyse, say, the commercial property market and the life cycle of a building, you find there are about 25 parties each speaking different languages–they hardly have any occasion or ability to communicate–with each having perfectly perverse incentives. Each systematically is rewarded for inefficiency and penalised for efficiency. So, if you were trying to set up an institutional framework to ensure that buildings use 10 times the energy they should do and are less good places to be in than they should be and cost more to build than they should do, you would be hard-pressed to improve on the system we have got.
On the one hand that is a formidable institutional problem to which governments have paid essentially no attention in any country I know of. However, it is also a huge business community for entrepreneurs who can figure out how to turn each of those perversities into an arbitrage chance. We have actually published a book of 100 case studies across all property product categories showing that the same integrative design that gives better human, environmental and resource performance also typically gives superior market and financial performance. What is happening now that is very exciting is that through our green development practice we see many developers picking up on this as the way forward if they want to get an edge in a very competitive business. The head of the Urban Land Institute, who wrote the foreword, said, ‘Just knowing this practice is out there, seeing the projects, seeing how they perform financially, is changing developers’ mind-set about what business they are in. They’re now realising that, if they do it right, property development is a way to heal natural inhuman communities at a huge competitive advantage.’ I think that is the sort of thing we need to do more of in more sectors.
CHAIR–Thank you very much indeed, Amory. It is always inspiring, it is really thought-provoking, to take that somewhat longer term perspective and get away from our normal presumptions in models in the way in which we treat technology and see the opportunities for fundamental shifts and changes. I guess we will come back to these issues later in the day. In the next session we will be talking about environment management systems, and then in the afternoon we will be talking about government interventions. I suppose you are saying to us to focus on taxes at an appropriate level in terms of adjusting prices, but to think almost as much or more about property description, market design and information freedom so that our markets and competition actually drive us in a more overall, efficient direction.