Columnists: Brook Riley, Rockwool International

Published on: 7 Jul 2015

First victory in the battle of the discount rates

Good news! A few days ago, the European Commissioner for climate and energy, Miguel Arias Cañete, told me the discount rate for energy efficiency will go down. (For more information on discount rates and why they’re so important, see here ).

Commissioner  Cañete didn't give a concrete number. He just said the rate for efficiency in the upcoming PRIMES reference scenario will be put on an equal footing with the rates for power generation and industry. But he was quoting word for word from an internal Commission document which recommends reducing the rate from 17.5% to 10-12%.

This is still too high, of course. A series of reports by Cambridge Econometrics , the Regulatory Assistance Project and Fraunhofer ISI recommend lowering the discount rate for energy efficiency to about 4%. Many Commission officials agree. Still, it’s a victory worth celebrating. The lower the rate, the lower the estimated costs – and the more attractive the policy. Put simply, a low discount rate justifies action on energy efficiency instead of inaction.

Cañete seems well aware of the consequences of lowering the discount rate. He says it will bring big changes, knows a more ambitious efficiency target for 2030 will be justified on purely costs grounds. He promised to recommend a 30% target in next year's revision of the energy efficiency directive. The target should be binding, he says – this is what President Juncker wants.

So now we’ve a foot in the door, how do we push it open further?

There’s a lot more to win in the discount rate debate. The rationale for lowering the rate in the PRIMES reference scenario is that better policies – the energy efficiency directive, energy labelling – remove barriers, boost investor certainty and drive down capital costs.

It’s a safe bet that the positive impact of these policies will increase with higher targets. For example, building standards will get tougher, inefficient fridges will be banned. This should be reflected by using progressively lower discount rates for 30%, 35% and 40% efficiency scenarios. In other words, decreasing the discount rate means anticipating some success for EU energy efficiency legislation and translating it into energy modelling. The result: estimated costs would remain more or less flat with increasing energy efficiency, but benefits would increase significantly.

This would be a game changer.  On cost grounds, as well as on the benefits, the Commission would be able to recommend going well beyond 30% efficiency by 2030.

Here is what I think is another promising lead. In the impact assessment accompanying its energy efficiency communication last year, the Commission published GDP analysis from the National Technical University of Athens (which runs the PRIMES model) and from Cambridge Econometrics. The differences were huge. For example, according to the University of Athens, a 40% by 2030 efficiency scenario would reduce the EU’s GDP by 1.20%. By contrast, Cambridge Econometrics predicted an increase of 4.45% with the same scenario.

Why are the results so different – and who’s right? I’m still digging, but the main reason seems to be that the University of Athens uses a general equilibrium model which assumes that change – new energy efficiency polices, in this case – creates a negative shock effect. Because the model assumes a limited pool of capital, efficiency and renewables, with their hefty upfront investment requirements, quickly become very expensive.

Cambridge Econometrics, on the other hand, doesn’t assume the same capital restrictions. GDP increases with higher  efficiency targets because, for example, efficiency investments in the EU replace capital outflows for gas imports from Russia. Cambridge Econometrics' real-world approach gets my vote.

I know – the GDP issue is just as geeky and technical as the discount rate debate. But there’s just as much at stake. Imagine if the Athens modellers ‘relax’ the limits and assume, like Cambridge Econometrics, that capital can shift from region to region. If there is a consensus that efficiency policies increase GDP, policymakers will push for higher targets.

This is where it gets exciting. The Athens modelling team have already updated their assumptions for employment impacts. Rather incredibly, they had previously assumed full employment in Europe. In their model, job gains from more ambitious efficiency policies resulted in job losses in other sectors. This mistake was corrected for last year’s energy efficiency communication, and the 40% scenario showed a 2.96% increase in employment.

So there’s a precedent for doing the same for GDP. Meanwhile, more and more Commission officials are in favour of these dull-sounding, but critically important, reforms. I don’t think I’m being too optimistic when I say it’s perfectly possible over the next years to increase the 2030 efficiency target into the 35%-40% range. And as Naomi Klein would say, this changes everything – for climate action, fossil fuel phase-out and so much more.

Other columns by Brook Riley