New report from eceee assesses how setting interest rates affects the Commission’s energy modelling

Increasingly, the European Commission is being challenged that its energy modelling is undervaluing the full set of benefits of energy efficiency. The modelling, many are saying, has faulty assumptions, particularly on discount rates. There have been concerns for years but as the review of current energy efficiency policies is set to take place to see what further is needed to meet current targets. The European Council for an Energy Efficient Economy (eceee) has published a report that analyses the Commission’s energy modelling. Voices are rising. As Brook Riley wrote in a recent article on the energypost website, “It’s hard to adequately convey the consequences of this mess. The EU is currently aiming to reduce energy use by 27% by 2030. Its true potential is at least 40%.”

So, where are we and how is the Commission reacting?

The topic is so important that there was a hearing on October 20th21st at the European Parliament. EiD is sure there will be more such gatherings.

It would be good to get your views.

 

Commission’s energy modelling underestimates societal benefits of energy efficiency

European energy and climate policies are partly based on questionable assumptions, resulting in short-sighted assessments that under-value the economic benefits of energy efficiency, a new study shows. The findings by the European Council for an Energy Efficient Economy suggest that higher targets for energy efficiency in the European energy and climate policies could be more than justified. Most EU Member States use more realistic assumptions in their efficiency assessments.

The European Council for an Energy Efficient Economy (eceee) reveals that there is a clear economic justification for higher energy efficiency investments in Europe than originally anticipated by the European Commission. In the study Evaluating Our Future, authored by Ecofys, eceee demonstrates that EU Member States often apply lower interest rates to evaluate energy efficiency investments than the Commission’s own calculations suggest.

Energy efficiency technologies (e.g. in buildings) typically have relatively high upfront costs, which need to be recovered by savings over longer periods. To attribute a value to the future cash flows of an investment, the European Commission uses so-called discount rates. The higher the discount rate, the lower the value we assign to future savings in today’s decisions. Consequently, high discount rates make energy efficiency measures and supporting policies look less attractive.

According to the report, neither economic theory nor actual Member State practice provide good reasons for the major differences between discount rates observed to be used in EU Impact Assessments and individual Members State impact assessments. In fact, some Member States explicitly follow the clear advice from EU Impact Assessment Guidelines to use a discount rate of 4%.

The Commission thus recommends Member States to use a discount rate of 4%, but uses a rate of 17.5% for its own energy efficiency scenarios.

“The report reveals that the Commission in its impact assessments applies many times higher discount rates than individual Member States are doing in their own policy evaluation work” says lead author Dr Andreas Hermelink of Ecofys. “For households this figure is 17.5%, whereas most Member States use figures in the range of 3 to 6%.”

The high discount rates used in the studies for the Commission’s impact assessments had previously been identified as a major reason for this under-valuation of efficiency.

“The EU could have proposed a much more ambitious efficiency target if it had used lower discount rates. This reality-check suggests that Member States are ahead of the Commission when it comes to assessing the benefits of energy efficiency investments. In light of this, the EU should consider increasing its efficiency target”, said Nils Borg, Executive Director at eceee.

One main concern with Commission modelling practice is the apparent mix-up of private and societal discount rates. Private discount rates should reflect the perspective and cost of capital for individual investors and determine their investment decision making. The (lower) societal discount rate reflects the perspective of society as a whole and thus needs to be applied for evaluating the societal impact of individual investment decisions.

The authors point to a lack of transparency as to why the same high discount rate for modelling private investment behaviour of individuals and companies are applied to the evaluation of societal costs and benefits of policies.

“Impact assessments should support policy makers. The Commission needs to be more transparent with its calculations to enable policy makers to evaluate the underlying inputs and assumptions. This is a democracy problem as much as it is a problem for the environment,” Nils Borg added.

Summary of the conclusions:

  • The use of discount rates for modelling of individual investment decisions and for the evaluation of energy system costs from a societal perspective must be kept apart. This is currently not the case.
  • Member States use much lower discount rates than recent EC Impact Assessments. Neither economic theory nor actual Member States’ practice provide good reasons for the major differences between discount rates observed to be used in EU Impact Assessments and Member States individual impact assessments.
  • Discount rates used in EC Impact Assessments for determining the annual total energy system costs should be revised. Preferably an EU-wide social discount rate should be calculated based on existing theory. If no consensus can be found about going that way, an average EU Weighted Average Capital Cost (WACC) could be calculated. Either way, the assumed result will be in the range of 3% to 6%, as compared to the 17.5% used for households in the Impact Assessment for the 2030 energy and climate policy framework.
  • The translation of barriers and policy measures into “subjective” discount rates needs to be transparent. In the modelling underlying EC policy making, the “subjective discount rate” is the major parameter mimicking individual decision making about technology choices. However, there is no common understanding on how to translate individual behaviour and time/risk preferences into subjective discount rates. This should be the reason for giving a fully transparent explanation for how the discount rates used in modelling are set and how they adapt as a consequence of targeted energy policies.
  • The role of Impact Assessments is to support and not to replace policy making. Their inputs, logic and outputs should be fully transparent. Outputs should always be tested against other modelling tools.

The eceee report can be download from its website.

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