Wednesday, January, 22, 2014
By Joseph Sarkis
For a number of years I've been investigating topics related to making the business case and justifying investments in environmentally conscious business practices, sustainability investments, etc. These investigations focus on aiding organizations in evaluating various programs and investments to make themselves greener and more sustainable. There have been many decision support tools.
Personally, my focus has been on the elegance, flexibility, and generalizability of the models and tools. The mathematical niceties are important for reviewers to accept these works. In fact, a current research project in which I am involved seeks to improve models for energy efficiency investments advancing standard investment appraisal approaches.
The focus of this current work is developing a Bayesian simulation approach to help generate cash flows in a carbon trading market environment. We are applying these new tools using the standard net present value (NPV) approach. Most managers and students who have completed any business courses will know NPV.
In this current work we are currently running various simulations, testing the model and assumptions.
This research effort represents the first time in my studies to have strictly focused on the use of NPV as an investment appraisal approach. Much of my previous work focuses more on strategic investments (e.g. here and here). NPV may or may not be part of that evaluation. So, delving further into the use of NPV, given its short-termism and discounted value limitations, uncovered for me an interesting issue.
The arguments for the limitations of NPV and other traditional appraisal techniques resides in their inherent problems when considering long-term and broader impacts. Discounting caused many long-term investments to result in negative returns and thus investment would be hard to justify. This limitation of traditional investment tools has been relatively pervasive in the investment justification literature. I have used it to justify developing more strategic approaches.
Recently, in my further investigation of NPV limitations, I came across a phenomenon where even with positive economic and financial returns, i.e. positive NPV, organizations and managers would still not invest in energy efficiency projects. The term used to define this phenomenon was the energy efficiency gap.
The economic issue here is that a rational person would not leave $50 bills (inflation raises this amount from $10 and $20 dollar bills used by economists) on the floor to be picked up.
A few questions do arise. Is this economically irrational behavior true? And if so, what is causing it?
Researchers have provided a number of reasons for this occurrence:
Hidden Costs including administrative costs, search costs, or opportunity costs which may include the quality of the new investment.
Consumer Heterogeneity where different consumers will use the product differently and may not get full efficiency advantage from the product. As an example an air conditioning unit used only intermittently in a vacation home versus one that might be used all the time.
Uncertainty, in everything from cash flows to energy prices or even market prices for carbon. In our own continuing research we have described how various uncertainty assumptions through variations in data distributions for Bayesian analysis can greatly influence NPV values. Larger uncertainties with similar cash flow magnitudes, result in lowered NPV. There may also be some information asymmetries and imperfect information theory at work here that increase organizational and managerial uncertainty.
Overestimating Energy Savings from assumed perfect situations and poor information is considered a cause.
The Rebound Effect has also been used as reasoning for the energy efficiency gap. Essentially that even with more energy efficiency, people and organizations would tend to use more energy that supersedes advantages from the savings.
These issues are intertwined with various market and behavioral failures such as imperfect information, lack of knowledge and attention, principal-agent issues, and plain bad decision making processes.
There have been many explanations and possibilities. There is substantially more research needed to understand the economic, organizational, behavioral, and even technological issues around this phenomenon.
It certainly is an intriguing topic, not only for energy efficiency investments, but environmental and sustainability investments overall. Management and organizational practitioners and researchers can provide significant insights to this issue, potentially one of the largest barriers to energy and environmental conservation by organizations and consumers.