The opportunities for improvement are huge, but market forces alone won't realize them.

Opportunities and barriers (This Week)

• Residential buildings
• Commercial buildings
• Road transport
• Industry

Capturing opportunities (Next Week)

• Developed versus developing economies
• Overcoming market failures
• Environmental benefits

The options available to mitigate the world's energy problems disconcert policy makers and executives alike. Securing new supplies of fossil fuels is difficult and often presents geopolitical risks; new technologies associated with alternative sources of energy, although attractive, involve significant levels of uncertainty and could have unintended consequences. Meanwhile, the prospect of reducing energy demand evokes fears that the consumer's convenience and comfort would be compromised-an unattractive proposition anywhere and an unacceptable one in the developing world, where globalization and rapid economic growth, fueled by increased energy consumption, are improving the prospects of hundreds of millions of people.

Yet McKinsey research shows that the growth of worldwide energy demand can be cut in half or more over the next 15 years, without reducing the benefits that energy's end users enjoy-and while supporting economic growth. The key is a concerted global effort to boost energy productivity (the amount of output achieved from each unit of energy consumed).

The exhibits that follow examine these opportunities by focusing on four sectors that represent 98 percent of end-use demand for energy around the world. Capturing the full range of these opportunities would improve global energy productivity by 135 quadrillion British thermal units (QBTUs), saving the equivalent of 64 million barrels of oil a day-almost 150 percent of the energy the United States consumes now. What's more, an intensive focus on improving energy productivity would spur new markets for demand-side innovation and thus generate important business opportunities for manufacturers, utilities, and other companies.

Yet market forces alone will not produce such outcomes. The obstacles that thwart improvements in energy productivity include information gaps, market- distorting subsidies, an inadequate financing infrastructure, and misaligned incentives. To overcome such barriers, policy makers must terminate distorted policies, make the price and use of energy more transparent, create new market- clearing and financing mechanisms, and selectively implement demand-side energy policies (such as new building codes and appliance standards) while also encouraging demand-side innovation by companies. Although these actions will be difficult politically, the rewards would be profound. Capturing the opportunities we have identified would not only cut the growth of energy demand dramatically but also be among the most economically attractive ways to reduce greenhouse gas emissions.

Residential buildings

The residential sector, accounting for 25 percent of total end-use demand for energy, represents the largest opportunity to raise energy productivity, by the equivalent of 21 percent of the sector's demand in 2020. The adoption of available technologies (including high-efficiency building shells, compact fluorescent lighting, and high-efficiency water heating) would cut the growth of the sector's energy demand to only 1.0 percent a year, from 2.4 percent-reducing end-use demand for energy by 32 QBTUs in 2020, equivalent to 5 percent of global end-user demand in that year.

What would prevent this reduction from happening? For one thing, consumers at all income levels tend to base their decisions about energy use on the convenience and comfort associated with the fuel and appliances they use, not just on financial considerations. What's more, even if consumers wanted to make the cost of energy a higher priority, they often lack the capital to invest in more efficient technologies, the information needed to make the right choices, or both. The monthly energy bills most households get, for example, don't itemize the electricity consumption of different appliances. If consumers won't pay for high-efficiency appliances with lower operating costs, home builders and appliance suppliers are less likely to make positive- return energy-saving choices when they buy materials or invest in technology. In any case, it's difficult for intermediaries to capture positive-return opportunities, because the market for individual homes is so fragmented.

Furthermore, the subsidization of residential energy prices, common in some countries, reduces the incentive for consumers to save energy. Removing subsidies and implementing metered usage where it isn't currently in place would offer significant opportunities to improve energy productivity. We estimate that the removal of the current subsidy on natural gas in Russia, for instance, would save more than 2 QBTUs by 2020.

Commercial buildings

Office and retail buildings, hotels and restaurants, and schools and hospitals together represent 10 percent of global end-use demand. Sixty percent of the current energy demand in the commercial sector comes from developed countries, reflecting the fact that energy demand in the commercial sector tends to take off at a later stage of economic development and as the share of services increases in an economy. Seventy-five percent of the growth we expect in commercial-sector energy demand by 2020 will come from the developing world, however-and fully 48 percent of it from China.

We identified opportunities to raise energy productivity in this sector by the equivalent of 20 percent of its demand in 2020. The nature of the opportunities varies by level of economic development. In developed countries basic energy services (such as space and water heating) account for approximately one-third of all energy use; in poorer countries such services can account for more than three-quarters of it. The biggest opportunities for developing countries thus tend to be in improving the insulation of buildings and the energy efficiency of large appliances. Reducing demand from the use of smaller appliances (for instance, by reducing standby power consumption) is more relevant to developed economies.

Why do so many untapped opportunities remain? First, the people who make the decisions that determine energy productivity often don't benefit from the savings gained by consuming less energy: neither landlords nor tenants have much motivation to invest in ways that would benefit the other party. Second, commercial buildings have a high turnover rate, which reduces the payback time that many businesses require when they make energy-saving investments. In the United States, for instance, nearly three- quarters of commercial energy users require a payback of less than two years, which limits the range of feasible energy-saving options. Finally, more than 20 percent of the commercial sector's energy demand comes from municipalities, universities, schools, and hospitals. The stringent capital constraints facing them often limit their ability to invest in energy-saving technologies.

Road transport

Road transport currently represents 16 percent of global energy demand and 46 percent of global demand for petroleum products. In this sector, unlike the residential- and commercial-building sectors, information on the price and efficiency of fuels is readily available to end users. In addition, fuel costs account for a significant part of the overall expense of transportation, so fuel efficiency is important for transportation companies and individual consumers. Most available opportunities to boost energy productivity have therefore already been identified and implemented, except in countries (largely oil- producing ones) where fuel subsidies reduce the incentive to improve energy productivity.

The removal of fuel subsidies is thus a very large opportunity to improve the sector's energy productivity (Exhibit 3). Cutting them by 80 percent would reduce global demand for road transport fuel by 5 percent- the equivalent of shaving 2.5 million barrels a day off global fuel demand-and would also improve social welfare if more efficient transfer-payment mechanisms replaced subsidies.

Outside the subsidized regions, we found opportunities to improve energy productivity by the equivalent of 9 percent of global road transport demand in 2020, comparable to increasing the average fuel economy of the world's automobile fleet by about five miles a gallon. These opportunities exist because consumers sometimes choose not to pay up front for future fuel savings, perhaps because they respond to nonfinancial considerations, such as style or comfort, or don't have access to credit. Consequently, automakers don't always make every possible positive-return investment in raising fuel economy, because they can't be certain that they'll recoup the cost from consumers.

Of course, fuel prices matter too. Higher fuel taxes in Europe, for instance, create incentives for automakers-and consumers-to adopt fuel-efficient technologies at lower oil prices than would be true in regions such as the United States, where fuel taxes are lower; the average vehicle's fuel economy is 37 percent higher in Europe than in the United States.Indeed, we estimate that in Europe more than half of the efficiency-improvement technologies available to automakers today would have positive economic returns at an oil price lower than $60 a barrel, as against none in the United States. In an environment of sustained high oil prices, such findings could have significant competitive implications for automakers everywhere.

Industry

he industrial sector currently uses more energy than any of the other sectors we studied (47 percent of global end-use demand), though its demand is growing more slowly than that of the others. Industry is also the most heterogeneous end user, with highly energy-intensive sectors (such as steel, chemicals, and aluminum) and a broad array of less energy- intensive ones (such as food processing and textiles).

Opportunities to improve energy productivity in this sector represent 16 to 22 percent of its total demand in 2020. In the United States, for example, we noted significant opportunities in every part of the sector we studied (Exhibit 4). Two of the largest are the recovery of heat generated in the production of mechanical or electrical power and the optimization of motor-driven systems, such as pumps and compressors. These technologies offer substantial benefits to the developing world as well. In China, for instance, rapid growth and favorable economics make new capital development attractive. We reckon that implementing best-practice energy-efficient technologies in all new Chinese industrial-production capacity would cut global energy demand in 2020 by 13 QBTUs-fully 10 percent of the global energy productivity opportunities we identified.

One reason for the large scale of the opportunities in the industrial sector is that many companies in it are government-owned or protected from competitors by regulation. Without market pressure, such companies have scant motive to boost their energy productivity. Even private-sector companies face barriers, however. In industries where energy costs are a small portion of overall costs, for example, managers who aren't responsible for ongoing operating expenses often make decisions that affect energy productivity (for example, when a company's IT department chooses its computer hardware). What's more, industrial companies sometimes apply internal- rate-of-return hurdle rates of 20 percent or more to plant-level investment projects because of the cumulative risks associated with costs, future prices, and operations. These high hurdle rates also apply to energy-saving projects, which may be less risky.

Continued Next Week

Source: McKinsey & Company, 2007