In fact, many efficiency gains come at a negative marginal cost, meaning that they are actually profitable (a recent McKinsey study estimated the market at $170 billion per year at a 17 percent annual rate of return). However, there are a variety of market barriers that prevent these opportunities from being realized. Prominent among these market barriers is the lack of well-developed energy efficiency business models.
The current landscape of energy efficiency business models can be divided into three groups. The first is composed of various product manufacturers and marketers selling energy efficient products (GE, Sylvania, etc.). This is the most traditional business model for energy efficiency. However, companies that sell products only care that the products are sold; they are not necessarily selling efficiency, but rather one specific means of becoming more energy efficient.
The second business model, more innovative than product manufacture/marketing, is generally referred to as the Energy Service Company (ESCO) industry. It describes companies that offer energy services, either on the supply or demand side, but are not directly connected to a utility (although utilities can create ESCOs). On the supply side, ESCOs in deregulated markets (markets that allow energy competition) can supply energy to customers that they create or buy from others. On the demand side (i.e. energy efficiency), ESCOs will install or redesign building and industrial systems to reduce energy use and finance their fees out of the energy cost savings. As will be clear later, some of these ESCOs have parent companies that focus on products manufacture/marketing.
The third business model, much more rare, involves utilities offering for-profit energy efficiency services. Unlike ESCOs, most utilities are regulated to some extent by commissions appointed by state or local governments. While this regulation can limit investment returns, it also allows for lower investment risk, as regulators virtually guarantee returns based on energy demand projections. In this context, there is a long history of utilities offering energy efficiency services for regulatory reasons, usually with prescribed spending limits. However, utilities are increasingly looking to energy efficiency services as a profit-center separate from their main business of supplying energy to customers, leveraging existing relationships and brand identification.
The future of the energy efficiency business will largely be determined by the role these business models play in the market. It is not an easy market; besides the diet industry, there are not too many companies that make money off of a lack of something. And there are also many "agency" issues, with one party paying the bills and another party receiving the benefits. But as the size of the opportunity becomes more apparent and the need to realize these opportunities becomes more urgent, the market dynamics of these business models will determine the nature of the energy efficiency industry in the years ahead.
History of Cooperation and Competition
ESCOs and utilities have a long history of both cooperation and competition. In a long cooperative tradition, ESCOs have provided energy efficiency services to utility customers in order to fulfill various regulatory requirements. Utilities in turn can provide the transmission services (wires, billing, etc.) to ESCOs looking to supply energy in deregulated markets.
But while cooperation may be the norm, there is also a history of competition between ESCOs and utilities. Back in the go-go mid-1990s, the energy services business experienced a rapid rise due to the growth of deregulation in US energy markets. Utilities, which for decades received guaranteed returns on its power plant investments, soon found themselves in a strange new world where energy customers (especially large industrial users) could choose their own energy providers. Energy services companies (ESCOs), which had started in the 1970s as efficiency providers in response to that decade's energy crisis, started to expand into the supply business, providing energy to large commercial, industrial, and residential users. Companies such as Enron began to see themselves as energy service providers, no longer concerned with whether those services were supply (providing energy) or demand (providing energy efficiency).
In this period for ESCOs, the biggest opportunity was on the supply side; energy prices were historically low (thus discouraging energy efficiency investments) and utility regulations were allowing for competition in energy delivery for the first time in recent history. In theory, ESCOs could buy or build power anywhere and sell it to anyone.
The utilities, realizing this competitive threat, started to respond in kind. While traditionally demand-side ESCOs added supply services, the utilities began to supplement their traditional supply services with for-profit demand-side energy efficiency services, although they severely cut down on not-for-profit demand-side management spending since their profits were no longer linked to the benevolence of state utility regulators. For a period, it looked as if these two groups would continue to converge: both ESCOs and utilities would offer energy services, competing against each other for customers.
This free-market utopia ended abruptly, however, in the wake of the California energy crisis. The deregulation dream quickly turned into a nightmare, as energy companies learned how to game the system and regulators failed to anticipate severe market failures implicit in the new energy market (in many cases the utilities were forced to buy energy at a higher price than they were allowed to sell at). The crisis also helped to expose the Enron accounting scandal, which sent shivers up the spine of every energy company. All of a sudden, it was not so cool to be an innovative "energy services" provider, and bread-and-butter supply or demand services did not seem so bad.