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financing195 involves much higher costs and are applicable only for larger scale and well established ESOs. For SMEs, financing capital intensive ESOs is much more challenging as they do not have the financial capacity, as compared to larger enterprises, or access to finance. Furthermore, high transaction costs to evaluate the debt carrying capabilities to service a number of SME sized ESO projects can be high, thus discouraging the financing of EE investments. There are limited EE financial products available to support the needs of industrial customers in the current market. Although the ESCO model aims to the lower risk associated with EE finance, the majority of its success has been in the public sector. In the private sector, mortgage challenges196, and longer project development cycles have limited ESCO performance contracting uptake.
5.1.2.5 Risk perception and mitigation
The discussion of risk is highly subjective as it is a matter of perception. As perception differs, risk evaluation is exposed to different interpretation. Classic economic theory discusses the concept of loss aversion197, which refers to an individual’s tendency to strongly prefer avoiding losses to acquiring gains. In decision-making, this leads to risk aversion.
Risk aversion is compounded if the perception of key decision makers, such senior management or finance providers are not aligned, For example, a decision maker with a weak technical background may have a different perception of technical risk compared to a decision maker who has a stronger technical background.
Liquidity is another issue which deters ESO uptake. Investment in ESOs is generally non- transferable and the investment committed cannot be diversified, hence it is illiquid. Beyond the scope of the ESO, decision makers also need to consider if the ESO is aligned with the enterprise’s strategic plans. For instance, an enterprise downsizing or producing commodities that are exposed to price fluctuations will be less inclined to commit to long term ESOs.
Risk is usually mitigated through preventive actions. These preventive actions (e.g., stringent project controls, dedicated resources, trading only with reliable partners, application of established technologies) usually incur additional cost. Some risk (e.g., equipment failure, accidents), also known as residual risk, cannot be completely mitigated, and is often covered by some form of insurance. Insurance for industrial energy efficiency is still in its infancy; it is not a common product most established insurers provide.
Investment in ESOs has multiple positive benefits on the main business in addition to energy savings. Bottom line profitability is increased with lower energy cost (especially for energy intensive industries where energy costs represent a significant portion of value added or turnover). Energy security is also improved when enterprises start producing more with less.
In addition, implementation of ESOs may result in positive environmental benefits. In view of this, investment in ESOs should fundamentally reduce the risk profile rather than the contrary.
However, over-cautious financial providers typically fail to recognise this when it comes to financing ESOs198.
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convince decision makers.199 In fact, commercial experience with industrial enterprises suggests that average payback requirements for ESO projects are usually ≤1 year. Projects with up to 2 years payback will be given due consideration but the likelihood of it being implemented are fairly low. Such high returns lead to the question whether enterprises are making rational decisions when it comes to ESO investments.
Organisational behaviour is a known discipline of study. However, its application to ESO decision making has been under investigated. The subject is gaining interest and recognition, and recent studies suggest that it is far more random than classical economic understanding [Kahneman, 2012].
Section 5.2.1 to 5.2.4 highlights some of the key organisational behaviour issues impacting ESO uptake.
5.2.1 Low status of energy efficiency
The priority of energy performance and energy management issues is proportionate to the energy intensity of the industry or enterprise, i.e. the more energy intensive it is, the more attention and priority it gives to EE and ESOs. For non-energy intensive industries, the priority of energy issues slips down the rank as it is not considered to be a significant part of the enterprise’s business strategy.
Energy performance of an organisation is often not visible to senior managers. In larger enterprises, the hierarchal distance between energy managers and decision makers are wider resulting in poor communication of energy management issues at decision making level. The evidence suggest that enterprises with energy managers having a closer working relationship with the decision making level tend to be more active in energy management issues.
5.2.2 Inertia and bounded rationalities
Inertia (or bounded rationalities) relates to the individual tendency to rely on established or familiar assumptions therefore exhibiting reluctance to revise those assumptions, even though the existing assumptions are irrelevant or obsolete. These assumptions are often deeply rooted within decision-makers steering the enterprise’s strategic goals. This resistance to change carries on towards evaluation of ESOs whereby the more radical it is, the higher the resistance to accept the ESO or change the set of prior assumptions. This results in favouring quick and low investment opportunities with lower expected returns, through familiar ESOs which may be less intrusive on existing operations.
On the other hand, inertia or bounded rationalities could work on the reverse whereby an investment will proceed as long as the decision originates from the decision makers, irrespective of its financial attractiveness. When an idea is generated from the top (attributable to strategic priorities, biases, appeal to shareholder/customers, or other bounded rationalities), inertia is established and more often than not, the decision is made prior to completing the decision making process.
There are four key stages (prior to implementation) in an investment decision making process:
Initial idea → Diagnosis → Build up solutions → Evaluation and Choice, bounded by internal organizational and individual factors. It has been observed from prior empirical studies that financial evaluation techniques are often not as important, often playing a secondary role and carried out at very late stages of the decision making process. In smaller organizations, decisions are often made by a single or very few individuals, which further aggravates the rationality issue as decisions are potentially influenced by bounded rationalities (or biases) of
199 Centre for Sustainable Energy (CSE) and the Environmental Change Institute, University of Oxford (ECI);
“What are the factors influencing energy behaviours and decision - making in the non-domestic sector?”; 2012
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very few individuals.200. The strategic value of implementing ESOs in some cases may be more important than the energy saving benefits itself.
ESOs are generally presented as potential gains, however enterprises naturally commit resources towards main business activities. This leads to more focus on avoiding losses on main business activity rather than committing resources for potential gains. As such, enterprises tend not to interfere with any operations if it is perceived to be in working order.
5.2.3 Imperfect evaluation criteria
The decision to implement ESOs is often based on imperfect evaluation criteria, i.e. the potential benefit and risk of the ESO is assessed through differing facts, perceptions or biases.
This is mainly attributed to asymmetric information, whereby the presenter of the ESO has more or superior information compared to the decision maker, or vice-versa. Enterprises tend not to reveal operational issues (often viewed as trade secrets) to external parties due to competitive reasons. As a result, the wider non-energy saving benefits or true potential of ESOs may potentially be unaccounted for if the supplier or service provider is unaware of an application for it, leading to poor decision making.
One of the key issues limiting evaluation is the lack of sub-metering. The lack of sub-metering may in turn lead to a split incentive as business units and staff are not responsible for the cost of energy. Furthermore, unlike energy supply, energy efficiency consists of a wide range of complex technologies and services, which are purchased infrequently and for which it is difficult to determine their quality either before or after purchase. As a consequence, the transaction costs for obtaining and processing information on energy efficiency are higher than for energy supply. Without appropriate metering and sub-metering, it is difficult to assess and verify the ESO benefits, making it much more challenging for decision makers to commit.
Evaluation of ESOs are also influenced by accounting classification and reporting standards.
International accounting standards have strict criteria on how intangible assets201 are classified. As such, investment into non-physical ESOs, which could be knowledge or service based (e.g. EnMS), are classified under expense rather than assets.
5.2.4 Competencies and awareness
Organisations often lack the internal skills and competencies to interpret technical information or evaluate the ESO. ESOs are often highly complex and involve multiple system components across multiple technical disciplinaries (electrical, thermal, mechanical, civil, etc.). ESOs with benefits that rely on multiple system and plant processes requires a strong integrated understanding of the plant’s multiple operations in order to realize the benefits. This requires a strong understanding of inter-departmental needs and priorities, which is difficult to achieve in practice due to resource and time constraints. SMEs are typically unaware of potential ESOs as they lack labour resources to identify and address ESOs, such as a dedicated energy manager.
ESOs sometimes span beyond the enterprise’s own facility. Since many heat intensive industrial facilities have historically been co-located in clusters due to a need to share infrastructure or resources, there are opportunities for the sharing of heat infrastructure.
However, it is difficult for enterprises to be aware of energy needs of neighbouring facilities.
Commercial and technical challenges are high, especially on managing different heat requirements between different organisations; and a lack of understanding of the potential process integration available have limited the sharing of heat within these clusters. This requires a strong commitment from clustered facilities on time and resource, which is difficult to achieve in practice.
200 Cooremans, C. (2012); “Investment in energy efficiency: do the characteristics of investments matter?” Energy Efficiency, 5: 497-518
201 Intangible asset is defined as an identifiable non-monetary asset without physical presence.
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