NAHB: The "Right" Rate of Return on Energy Efficiency
 In the housing industry, it has become common practice to use a rate of return to evaluate the cost and benefits of energy efficiency. NAHB policy, for example, classifies a change in building codes as cost effective if it returns at least 10% in energy savings the first year.
A more common, approach uses a rate of return to discount future energy savings to their present value equivalent. In this context, the rate of return is supposed to capture a home buyer’s time value of money (how a buyer makes tradeoffs when evaluating costs and benefits that will be realized at different times). Often, the current rate on a fixed-rate mortgage is used for this purpose.
An important advantage of the one-year rate of return in NAHB’s policy is its simplicity. The present value calculation is more complicated, requiring many assumptions that may be difficult to understand. This makes it relatively easy to introduce unrealistic assumptions and produce unrealistic results.
Using the current mortgage rate to discount energy savings is, in fact, one these unrealistic assumptions. In particular, the assumption fails to capture borrowing constraints and doesn’t reflect the way buyers actually evaluate alternatives when deciding which features to include in a new house.
Here are three other rates of return that more realistically reflect household decision alternatives. |
