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SHARED VALUE CREATIONLITERATURE HC2: Blok et al.: The effectiveness of policy instruments for energy-efficiency
improvements in firms
Blok et al. - Chapter 2: A framework for analyzing the adoption of energy-efficient technologies
2.1 - Introduction
Associated with economic development are increases in energy use and harmful emissions. Changes
in total emissions can basically decompose into three components:
- macroeconomic growth that results in increased emissions
- structural change
- technological change
Over the last decades, worldwide emissions have increased tremendously. These developments have
resulted in concrete policy goals set out in the Kyoto protocol. These goals have prompted countries
to develop policies oriented towards sustainable development, sustainable energy use and a
reduction of emissions. A key question in the development of policies is therefore how firms respond
to policy measures aimed at stimulating adoption of energy-efficient technologies.
The aim of this chapter is to present a simple, unifying economic framework that incorporates most
of the available insights on the complex process of technology adoption. In doing so, we deliberately
restrict the attention to a positive analysis aiming at explaining the energy-efficient paradox. At the
heart of this framework is the concept of the Net-Present-Value (NPV), which reflects the
‘profitability’ of technologies.
2.2 – The net-present-value framework
2.2.1: The basic framework
Firms will adopt a technology as long as it adds to their profits. The standard approach for empirically
assessing the profitability of technology I is to determine its NPV, which equals the formula below:
Ii = the initial investment cost of technology I
N = the lifetime of the installed capital
Sit = the (energy) savings to be achieved by adopting technology I during period t
C it = operating and maintenance costs during period t.
Any technology with a positive NPV should be adopted. From the NPV-formula, we can derive a
closely related figure that characterizes the profitability of an investment, namely, the internal
discount rate (r I ). This discount rate is equal to the discount rate for which the NPV would be equal
to zero. Rational firms will invest in technology as long as the internal discount rate exceeds the
critical discount rate imposed by the firm.
The incorporation of market-based policy measures into this basic framework is straightforward.
Market-based instruments are those instruments that foster the adoption through market signals
(pollution chargers, subsidies, tax deductions, et cetera). Command and control regulations such as
standards are less straightforward to incorporate. Technology-based standards are characterized by a
limited flexibility for firms in choosing the means of achieving goals and they have a tendency to
force firms to adopt a particular behavior. Performance standards are very difficult to incorporate as
they yield firms some freedom in how to meet the target that is imposed. One way would be to
include the required standards as a constraint in the firm’s profit maximization problem.
,The model discussed so far is static in nature. It cannot explain one of the most prevalent stylized
facts in literature on technology adoption, namely the S-shaped diffusion of technologies over time.
Two broad approaches can be discerned in the literature that tries to explain the gradual diffusion of
technologies.
1. When the technology under consideration is still in an early phase of development, only
those firms that gain relatively much from adoption will invest. As technology gradually
improves, more and more firms will find the adoption profitable. The technology will thus
diffuse gradually throughout the economy.
2. It rests on the assumption that at low rates of penetration, the knowledge about the
existence of a technology is also limited. Therefore, the technology is only considered by a
limited number of firms. As penetration increases, more firms will realize the potential of
the technology and subsequently adopt the technology.
A well-known problem with this framework is that many energy-efficient technologies have been
estimated to be cost-effective according to standard NPV computations using ‘reasonable’ discount
rates but are nevertheless not adopted.
2.2.2: Hidden initial investment costs
Apart from the ‘direct’ costs of technology, costs of information gathering, research, negotiations on
contract terms and of decision-making should also be considered as initial investment costs. When
considering the adaptation of a technology in isolation, the underestimation of costs tends to result
in the overestimation of the degree of adaptation. Not that when comparing the adoption of
different technologies, it is the difference in hidden costs that matters for explaining adoption
behavior, and not the presence of hidden costs per se.
2.2.3: Hidden annual costs
Also, in assessing annual costs, problems can arise. Capital costs, including costs of raising funds, tend
to differ between firms. For example, the level of the discount rate is larger for SME’s than for
large(r) companies, corrected for the different risk-return ratios of these two categories.
Costs that may be underestimated are annual costs of maintenance and operation associated with
the technology. The limited possibilities of exploiting economies of scale should appropriately be
accounted for when determining the profitability of adopting a particular technology.
A final cost-related problem could be that currently used technologies have to be depreciated before
new technologies are purchased. In essence, the annual depreciation costs of the old and not yet
fully depreciated technology should be considered as annual costs of the new technology.
2.2.4: Hidden annual savings
There is evidence that in many firms the total use of energy and energy costs are too low to be of
interest. This essentially means that the energy base over which savings can be made is too low for
the technology to ever be profitable. Even though for firms with a low energy bill certain investments
may be profitable, energy costs are often seen as part of ‘other costs’ such as furniture, telephones,
et cetera, and receive little attention in investment decisions.
Furthermore, large energy users pay relatively low prices in most countries for energy based on
special contracts with energy suppliers, which should approximately be accounted for in the
application of the NPV framework.
2.2 – Extensions of the standard framework
In this section, we turn to a discussion of contributions to literature on technology adoption that
have provided alternative or additional factors that have to be considered when describing adoption
behavior.
,2.3.1 Information as a precondition
The gathering of information regarding the existence of technologies is the first essential step in any
adoption process. A significant part of the total available energy-efficient technologies is unknown,
and this information gap is especially large in small firms facing limited competition and spending
relatively little on investment.
Apart from the knowledge on the existence of energy-efficient technologies, many firms also turn out
to be uniformed about policy instruments and institutions for innovation support. There is an evident
role for the government or government agencies to provide the information that has important
elements of a public good. This can be done directly by, for example, information campaigns,
labeling, etc., or more indirectly via stimulating co-operation among firms by using, for example,
negotiated agreements.
2.3.2 Capital as a precondition
There are some strong indicators that firms, and especially SME’s, are restrained in their financial
resources. A lack of capital is the most important barrier regarding general innovation investments
and energy-efficient technologies. Apart from the importance of financial constraints in general, the
lack of internal capital appears to be a larger constraint than the lack of external capital. It is unclear,
however, if and to what extent a lack of internal financial resources is a constraint in itself or whether
it reflects the fact that a lack of equity induces credit rationing by banks, thus resulting in an external
financial constraint in the end.
2.3.3 Uncertainty and the option value of waiting
The simplest and stylized NPV-framework presented in section 2.2 assumes the absence of
uncertainty. This subsection emphasizes the importance of approximately accounting for uncertainty.
In the presence of uncertainty, it pays for a firm to wait for new information to arrive. The NPV that
firms require when taking into account uncertainty is larger than the NPV that results in the absence
of uncertainty.
The relevance of uncertainties associated with energy-saving technologies is easy to illustrate. First,
there is uncertainty regarding the future prices and qualities of currently used and future
technologies. Second, there is uncertainty regarding the future level and the volatility of interest
rates, and the interest costs associated with them. Third, the potential savings of energy-efficient
technologies are uncertain. Finally, there is uncertainty regarding future policies. Firms can, however,
reduce the risk associated with energy-price uncertainty.
Other investments, either real or monetary, whose profitability’s are negatively correlated with the
profitability of energy-related investments, could provide a hedge against the risk of energy-related
investments. The risk associated with energy-related investments is then highly overestimated.
2.3.4 Non-rational behavior
Our analysis so far presumed rational behavior of firms deciding on whether or not to invest in
technologies. The best-known critique on this framework goes back on the seminal work of Simon
(1955). He proposed that firms often behave according to a ‘satisficing principle’, where they look for
‘satisfactory profits’ instead of maximum profits and apply rules of thumb and routines.
Adoption decisions are more sensitive to upfront cost-benefit considerations than to longer-term
benefits. Non-rational behavior is clearly the most logical candidate to explain this result.
2.3.5 Complementarities among technologies and network externalities
The basic framework of section 2.2 considered technologies in isolation. This assumption can be
challenged on the basis of at least two considerations. First, different technologies within a firm often
do not function in isolation. In general, good arguments can be made for the existence of returns to
diversity. In the presence of complementarities and gradually improving technologies, firms continue
to invest in relatively old technologies, which – when considered in isolation – are inferior to newer
technologies. This results in only a gradual ‘phasing out’ of old technologies, instead of the
, immediate replacement that would be predicted by this type of model when not considered the
complementarities. Second, the performance of a technology in one firm can be reinforced by the
presence of that same technology in another firm. In this case, there are network-externalities. At
the other extreme, technologies subject to network externalities are sensitive to ‘lock-ins’ in inferior
technologies once the diffusion process has sufficiently progressed.
2.3.6 Learning and the dynamic evolution of technological performance
In its simplest setting, the framework presented in section 2.2.1 assumes the costs and benefits of
technology adoption as constant over time. This assumption is at odds with a wealth of empirical
evidence revealing the gradual decline of costs of technologies. This empirical evidence has been
gathered in studies determining so- called learning curves or experience curves. From an analytical
point of view, it is relevant to make the distinction between learning that is internal to the firm
(returns only accrue to the firm adopting the technology), and learning that is external (adoption
results in an overall decline of the costs that accrues to all subsequent investors in the technology). In
the former case, the learning effect can be incorporated in the assessment of the profitability of the
technology and the standard framework is still valid. In the latter case, however, firms can have an
incentive to wait for other firms to adopt and to only buy the technology after it has sufficiently
improved.
2.3.7 Vested interests, resistance to technology adoption and the distribution of benefits
A final (implicit) assumption in the framework of section 2.2 is that the ‘total’ NPV of a technology is
relevant for determining whether or not a technology is adopted. This assumption neglects the
potential relevance of the distribution of the benefits of adoption of various actors that are affected
by the adoption. There are a wide variety of arguments that can be put forward as to why these
distributional issues are relevant for understanding actual adoption behavior and technology
diffusion. These arguments are generally classified under the heading of agency problems. A simple
example is the situation of a firm with different departments, each with their own budget, in which
one department is responsible for the acquisition of equipment and another department is
responsible for the payment of utilities. Situations can arise in which the department that buys the
equipment resists the acquisition of energy-efficient but relatively expensive technologies since these
do not pay-off in terms of the performance of the department. Agency problems can also have
important temporal aspects. A second class of agency problems arises in the light of the age
distribution of the actors involved. The adoption of a technology tends to affect different age groups
differently. Younger workers are generally more flexible and have more time to recoup the costs
associated with the adoption of a superior technology. Older workers on the other hand, have
already gained experience in working with old, inferior technology and have relatively little time to
experience the gains associated with the new technology.
2.4 – Evaluation and conclusion
The economist’ framework for analyzing adoption behavior regarding energy-efficient technologies is
often criticized. Arguments against its relevance that have been put forward are that owners and
managers of firms lack the time, the personnel and the resources to make decisions on adopting
energy-efficient technologies in the manner an economist would expect a rational agent to do.
Furthermore, the notion of ‘satisficing’ instead of maximizing behavior in complex environments may
sometimes be more suited to describe the reality of decision-making in especially SME’s. Also, the
relevance of uncertainties, distributional issues, informational, learning effects and capital
constraints are often not incorporated in analyses based on the conventional NPV framework.
In the end, we think that the simple framework laid down in this chapter with the modifications and
extensions that were proposed, is well suited for describing crucial elements of actual adoption
behavior, which are consistent with insights from empirical evidence.
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