I was recently asked to talk at an investor conference about new markets for energy efficiency, below are my remarks about the fundamentals of our changing grid.
I want to start my story in Mongolia, where this summer I completed a 500 mile bike-packing trip through the Arkhangai province. Mongolia is roughly the size of western Europe with just 1.5 million inhabitants in the rural steppe.
I met Huygaa and his brother in one of just two towns we saw. They were buying a second solar panel with the winnings from the spring culling of their herd. Huygaa’s family has energy services, mobile phones, and a satellite TV, all delivered on a PV panel with a battery that he bought at the same store from which I refreshed my noodle supply. His heating and cooking fuel is the same dung that has heated the steppe for 10,000 years.
How would you explain the energy system in the U.S. to Huygaa? And would he really believe the system and trends that we have today? His only exposure to fuel costs at all is the gasoline he rides 40km to buy. How does commercial energy pricing today compare?
Gasoline around the world is sold on a flat rate, but almost all electricity markets today charge differently by time of day. In gasoline terms let’s assume that gas is $4 per gallon. If gas was charged like electricity, the price would vary: it would be $6 in the summer. Pull up to the station at night or on the weekends, and it would be $3. Fill up on a hot summer day and it could be $8. In some areas of California next year, gas will be $2, but only during spring when the grid produces too much solar.
That’s just the energy side. As many of you know, commercial energy users also pay demand charges based on the maximum power they draw. Imagine being Huygaa pulling up to a gas station and being asked the maximum speed he drove before getting his price for gas. Today, in most high renewable markets, the demand charge is nearing 50% of most buildings’ power bill.
Huygaa’s seen price spikes in gas before, but the price he pays has roughly been the same since 2008. His second solar panel, however, was less than half of the one he bought just four years ago.
The same is true for America’s grid—Lazard shows that over the last 10 years, solar has gone from the most to the least expensive energy source, clearly competitive with the coal power that fuels Mongolia’s few cities. Han’s effective rates are going down—he’s getting more power for less capital.
Anyone with a commercial building can tell you that’s not the case in the U.S. High renewable markets (where the valuable commercial buildings are) are experiencing runaway cost increases. CAGRs of 5-7% are not uncommon, at that’s before the major wildfire and nuclear decommissioning costs hit. For example, PG&E could increase 20% next year.
Huygaa is very careful with his energy use–he has to be. He’d be amazed to learn what we do with our renewable power. Not only do we waste it in our homes and businesses, but we also throw quite a bit of it away. So far this year, California has curtailed (literally put into the ground) 900GWh of solar and wind. That’s more than 100,000 homes of electricity. Or 1.8 million of Huygaa’s panels. It gets better…the wholesale markets which, in part, set your rates clear at negative prices for many hundreds of hours in California, meaning the state actually pays Arizona and Nevada to take our excess power.
Clearly there is something weird going on here.
The grid is changing. It’s moving from centralized to distributed. It’s moving from fuel-driven to capital-driven. It’s moving from constant and steady prices to dynamic and rapidly fluctuating prices. This isn’t just a California story. Today, 26 states have some version of RPS mandates on the books. Even for those, the combination of low renewable prices and federal rules for energy development mean that renewables are on a steady march all around the nation and the world.
What does this mean for buildings?
Energy and buildings go hand in hand. Energy is the largest non-mortgage expense in buildings. Taking a financial market perspective, everyone who owns a building is net short energy and exposed.
Yes, net leases transfer the cost responsibility over to the tenant. But as much as we pretend otherwise, commercial space is commodified and liquid–landlords are price takers in this market. The lease is net…until its up and then the cost over-runs come back. Higher operating costs means lower rent. When it comes to building valuation, every analyst puts energy back into the asset value equation.
Perhaps the most intriguing aspect of energy management and the grid is that this is a zero-sum game. Those rates that building’s feel rising under their foundations are not set in a high castle by some evil Mr Burns type. They are calculated based on costs and then divided by usage and demand. Put simply, if Building A can figure out to lower its spend, then it’s the other buildings that literally pay for Building A’s reduced energy spend. More sustainability managers should tap into the fundamental competitive muscle of their organizations.
Calculated rates also escalate the fundamental rate rises that we are experiencing. Those cost over runs due to renewables are exacerbated by another massive trend in the grid–sales are dropping. In California, our GDP is consistently growing over 4% per year. Yet last year electricity sales shrunk 5%. This great decoupling of energy and economic growth is happening all over the country. Residential solar, LEDs, and the decline of industrial load all lower system sales, but the expenses keep on climbing.
Energy, of course, is tightly linked to sustainability and that is the other front to manage. On the top line for buildings, consumer preferences for green spaces drive leasing. The lease used to be a CFO decision, but now the VP of HR is in there too, and the LEED plaque on the wall is a checklist on the broker’s tour. Heck, you can’t even rent to the federal government if the building isn’t Energy Star certified.
Buildings are also a target, a politically vulnerable pocket of concentrated energy use. Together, buildings are 40% of U.S. carbon emissions. 550 U.S. Cities have filed climate action plans, and 52 have filed a Climate Emergency Declaration. Emissions are hard to change in other sectors, but the politics of big buildings are irresistible. Building owners in NYC are feeling this the hard way on Local Law 97, where the buildings that can’t reach the carbon targets are facing fines of $2-$3M per year. Will your building be a punching bag on this issue?
What are the opportunities? What is new in Energy Efficiency?
Ok, hopefully I’ve depressed the asset owners in the room enough. Let me talk now about some pockets of opportunity.
First, the best advice is–you are short with runaway pricing and, to address, start by trimming your position. The very meters that were installed to implement new time of use rates are also very useful for energy management feedback. Across Gridium’s base of 2,000 commercial buildings, we regularly find opportunities to trim consumption from equipment that is currently in place. There’s even more leverage with peak demand charges, where a couple of times a month an engineer can reconfigure the start time of the building to lower that demand charge. Typical savings are 4-6% a year, and for the competitive asset manager, remember the laggard next door is paying for the savings.
Of course to really use less you have to get efficient equipment and that is where this story gets very interesting.
Most buildings are very aware that there are potential savings hiding in their mechanical rooms. Researchers on this energy waste agree. McKinsey & Company estimates there is a massive $252B of energy efficiency trapped in the U.S. commercial building stock. The question has always been how to unlock that value, especially in commercial real estate where ESCO models have failed. These savings are surely not getting unlocked by traditional energy efficiency programs, where program rules are byzantine and anemic incentives are hardly worth a building owner’s time.
The secret lies in the Grid.
In a world of distributed resources, that energy waste is a resource. And it’s a resource that you currently think of as a liability. Working together, we can turn it into an asset.
Let me give an example, a peaking power plant in Oakland. It is end of life, massively inefficient, and PG&E would like to shut it down. PG&E’s aim here is to harvest energy efficiency resources in the buildings on the distribution lines served by this plant. And to do so, they are going to pay for energy efficiency about as much as they pay for natural gas. For 10 years. The resulting funds are 10-20 times traditional energy program incentive measures, and will drop energy use in the buildings-turned-mini-clean-power-plants by almost half.
Because the stream of payments is from PG&E–and not the building–these deep retrofits can also be financed just like a wind or solar farm, meaning that external capital chasing good returns can finance the retrofit upgrade projects that deliver both the efficiency resources to the grid and savings all around.
How can the absence of consumption transition into a resource?
One secret is that energy efficiency can now be metered. Its a hard problem but something we’ve been quietly working on since 2011. Because a project can now produce reliable savings over time, the waste is transformed into a highly prized resource on the grid. In fact, under many state laws, it’s the first resource the grid must buy, ahead of even solar and wind.
Metering obviously helps quantify the resource, but it also helps value it more accurately. Does your energy efficiency reduce load at noon, when we already have too much solar, or does it reduce in the evening when massive gas plants fill the supply gap between the sun and wind?
Why pour millions of dollars into your property if the lease structure means most of the savings go to the tenants? A new transaction structure, called MEETS, coming soon to a grid near you, aims to simply place the metered energy efficiency back on the same utility bill. Instead of 100% grid power, a building might chose to buy 75% grid power and 25% of its own efficiency resources. The payments for the efficiency resources are on the tenants’ bills, and once collected, can be paid back to the financial entity responsible for the capital investment. In this way, the split incentive is unified, and outside capital can contract with the Grid to invest in energy efficiency.
Notice there was no classic utility incentive here in play, but the structure unlocks 25% savings merely by changing the cost recovery (on tenant bills) and credit counter-party (the utility) for energy efficiency. The building gets sustainability benefits financed for free, and even the utility makes a small amount of money from the transaction.
It’s early days, but efficiency resources promise to transform energy market dynamics for commercial buildings. The numbers are massive. At system averages, to capture these efficiency resources, $3.5 trillion dollars could be deployed with an un-levered return in mid-double digits. Similar to smart utilities and real estate leaders entering the solar and renewable markets, we expect the same major players to mobilize their own capital to chase these efficiency resource returns.
We don’t have the same simple energy that Huygaa does out on the steppe–we have a very complex system. Building owners that understand and embrace this complexity by taking a leadership position in the climate crisis are well positioned to reduce risk, make outsized returns, and have a major and positive impact.