by David L. Levy
A managerial and behavioral lens on low-cost carbon reductions
I’m writing this response to Jürgen Weiss and Mark Sarro’s excellent guest contribution while looking out of my antiquated and rusting steel casement windows in Brookline, Mass. These single pane windows, which date to the1951 construction of the house, are wintertime energy hogs – they are drafty, provide no insulation, and get covered in icy condensation. Why haven’t we replaced them? I teach in a business school and am outspoken on climate change, so the decision to replace the windows ought to be easy - with my business school suit on, I should see the financial benefits, and with my environmentalist hat, I would feel good about reducing emissions.
But the math does not look so good when I run some numbers. Oil heat costs us around $2000 a year, and new windows might save up to $400 a year (though we have huge south-facing windows, which help keep the house comfortable in winter, at least when the sun shines, and insulated blinds for night-time). Yet it would cost around $20,000 to replace the windows with energy efficient ones. The 2% return on investment is a little better than money market funds are paying right now, but wouldn’t be attractive to an average investor (let alone a hedge fund!) It represents a 50 year payback, while most businesses look for 3-5 year payback. Even if we had the $20,000 lying around, who knows how long we’ll be in the house, or whether new windows would add much to the sale price. And this is a big expense, so my wife would have to be onboard. Ironically, my low-tech energy management system (the blinds!) helps lower the bills and reduces the incentive to invest in new windows.
The point of this embarrassing personal saga is to reinforce Jurgen and Mark’s argument that we need to be cautious of negative-cost carbon abatement. The good news is that about one-third of needed emissions reductions appear to have positive ROI, according to the McKinsey Marginal Abatement Cost (MAC). The bad news is that about one-third of needed emissions reductions appear to have positive ROI – yet the necessary investments are not happening. The costs may be higher than engineering estimates suggest and there are a host of market, institutional, and psychological barriers (and McKinsey themselves now puts more stress on these hurdles). The same logic applies to emission reductions that the curve suggests will occur with a carbon price of, say, $50 a ton – in reality, it might take a much higher carbon price to overcome these hurdles and secure the reductions.
Jurgen and Mark frame the problem in classic economic terms of scarcity: There Is No Such Thing As A Free Lunch. If there were free MAC lunches lying around, it is axiomatic for economists that someone would already have eaten them. My own Harvard Business School training in organization and management leads to a different perspective, however. There may well be free lunches available, but they are locked up or hidden away behind misaligned incentives, inertia, and market barriers. This business school perspective leads to a more optimistic conclusion than the economists’ dismal view.
Most companies, for example, have traditionally paid little attention to potential energy savings because nobody was paid to do so. Once companies assign managerial responsibility for the task, measure the savings, and evaluate performance accordingly, they start finding a lot of low-hanging fruit (see, for example, work by the Pew Center and The Climate Group (download large pdf file). Many of the barriers are more complex, and require restructuring markets and institutions – California is famous for paying utilities to save energy, not sell it. Utilities are also finding that they can nudge consumers in the right direction with non-price signals, such as comparisons with their neighbor’s bills. The booming field of behavioral economics points to all sorts of low-cost ways of shifting behavior. There are also a host of start up companies trying to exploit the potential savings and overcome market barriers by providing customers with turnkey efficiency projects packaged with financing, and then generating a revenue stream out of the lower energy bills.
Of course, these solutions are not cost free – they involve managerial time, some capital, and transaction costs. Some of the barriers are complex and would require large scale institutional restructuring, requiring government-business collaboration. But one person’s transaction costs are another’s business opportunity (the transaction costs of carbon markets will keep financial firms smiling). The key point here is that there are creative organizational and managerial approaches to unlock the doors to low-cost or even negative-cost carbon reductions. The carbon price is, by itself, an inefficient and ineffective tool – the price would have to be at a politically infeasible level to achieve the desired goal. But we don’t have to rely just on the carbon price or on command and control; a multi-pronged attack is needed.