When analyzing alternative energy options, seemingly counterintuitive financial relationships sometimes emerge. We have had some clients question our findings that combining cleaner heating technologies with energy efficiency (EE) investments typically increases both the levelized cost of energy (LCOE) and payback periods. Their skepticism reflects a common assumption that energy efficiency should make investments more financially attractive, not less. Let’s explore why this result occurs and, importantly, when it doesn’t.
Understanding the Metrics
Before diving into the dynamics of how technology switching and EE investments interact, let’s clarify our key metrics:
- Levelized Cost of Energy (LCOE) measures the average cost per unit of energy delivered over a system’s lifetime, including all capital and operating costs. This metric comes in two important variants:
- Financial LCOE reflects actual market prices and costs faced by consumers
- Economic LCOE incorporates broader societal costs and benefits, including environmental externalities, health impacts, and true resource costs
- Payback Period measures how long it takes for cumulative cost savings to equal the initial investment. While intuitive for consumers, payback periods have important limitations—they ignore both the opportunity cost of capital (financing costs) and differences in the lifetime of investments. They should be viewed as just one of many indicators for assessing investment opportunities.
The General Rule: Higher Investment, Longer Payback
Evidence from the European Union’s extensive database of energy efficiency projects (https://deep.ec.europa.eu/), covering more than 10,000 implementations, shows a clear pattern: payback periods tend to increase with investment size. This makes intuitive sense—adding substantial capital expenditure (CAPEX) to an investment package should increase payback periods unless the fuel savings are exceptionally large.
The Key Exception: High Operating Costs
There is an important exception to this general rule: when clean technologies have high operating costs, combining them with energy efficiency investments can actually improve financial metrics. This dynamic manifests in several ways: When the new clean fuel is expensive, the savings from reduced consumption can be substantial enough to overcome the high upfront costs of efficiency investments. In one city we studied, combining EE measures with a switch from coal stoves to ecodesign wood stoves dramatically reduced the payback period substantially—from 100+ years to roughly 25. In other cases, switching to clean technologies increases recurring costs so much that the switch alone would never pay for itself, but adding efficiency measures reduces consumption enough to create net savings and a finite payback period.
The underlying principle is the same: energy efficiency becomes more financially attractive when it’s reducing consumption of an expensive service. This helps explain why efficiency investments often make more financial sense in regions with high energy costs.
The Financial-Economic Disconnect
Technologies that are economically optimal often aren’t the most financially attractive to consumers. Consider these examples from places we have worked:
- In the Kyrgyz Republic, electric heaters appear least costly on a financial basis because of heavily subsidized electricity prices. However, when accounting for carbon emissions and true resource costs, air-air heat pumps emerge as the economically optimal choice.
- In rural Serbia, existing wood stoves show the lowest financial cost because of underpriced wood in informal markets. However, they become the highest-cost option when environmental and health impacts are considered.
In several other locations, coal-based heating systems appear financially attractive but become the highest-cost option when carbon emissions and health impacts are included in the analysis.
Policy Implications
These findings suggest several critical policy considerations:
- Energy Pricing Reform: The gap between financial and economic costs points to the urgent need for cost-reflective pricing of electricity, wood, and coal. This should include mechanisms to price-in externalities, particularly carbon emissions.
- Technology Selection: The choice of clean energy technology matters. Some efficient technologies, like heat pumps, may appear cost-effective on a levelized basis but might not deliver expected carbon reductions if the electricity grid is predominantly coal-based.
- Public Funding Need: The long payback periods for building EE investments—often approaching or exceeding 20 years—suggest a clear need for public funding support. Without it, many worthwhile projects may never overcome their initial investment hurdles.
Looking Ahead
Understanding these financial dynamics helps explain why market forces alone often fail to drive adoption of optimal clean energy solutions. While energy efficiency plus clean heating might increase certain financial metrics in many cases, there are important exceptions that depend on local energy prices and technology characteristics.
The key is recognizing when and how to combine these investments effectively, understanding both their financial and economic implications, and developing policy frameworks that can bridge the gap between private costs and social benefits.