It isn’t easy to be optimistic about energy resources these days. The supply of fossil fuels on the Earth, the number of rivers amenable to damming, the amount of arable land available to generate biomass, the willingness of citizens to accept the perceived risks of nuclear power—all of these have limits. And it isn’t clear how quickly scientists can develop innovative alternatives.

Furthermore, a recent McKinsey Global Institute (MGI) analysis of the economic sectors most responsible for the end use of energy indicates that overall demand, which has increased by 1.6 percent a year for the past decade, is on track to grow by 2.2 percent annually over the next 15 years (see sidebar “Modeling energy demand”).¹ Developing countries such as China account for the largest part of this growth. Curbing demand for energy in the emerging world would mean asking its consumers to reduce their newfound expectations of comfort, convenience, and economic growth—an unacceptable proposition for them.

Is there an escape from the vice grip of finite supplies and surging demand? We believe there is. Both developed and developing economies could use energy more productively by reducing the raw-materials inputs required to produce a given level of energy use, increasing the quantity or quality of the economic output from a given set of energy inputs, or both. These approaches wouldn’t call for reducing the benefits that energy’s end users enjoy.

As part of a broader report on global energy markets, MGI has uncovered many opportunities to boost energy productivity beyond base-case levels. All are substantial, economically viable, and technologically proven.² MGI identified large opportunities across all the sectors we studied, including residential use, industrial use, and power generation. In these and many other sectors, capturing the wide variety of opportunities for greater productivity—each boasting an internal rate of return (IRR) of at least 10 percent—could cut the growth in annual global energy demand, through 2020, to 0.6 percent, from the base case of 2.2 percent.

Market-distorting subsidies, information gaps, misaligned incentives, and other market inefficiencies now undermine energy productivity. Consumers often lack the information and capital they need to use energy more productively and tend to make comfort and convenience higher priorities. Manufacturers of consumer products such as the automobile often don’t invest in energy efficiency because they cannot recoup the savings that consumers would enjoy. Businesses refrain from boosting energy productivity because energy costs are fragmented. And a range of policies—particularly subsidies—dampen price signals and give end users less incentive to become more efficient.

It would be far from easy to implement the remedies: removing policy distortions, making the price and usage of energy more transparent, and selectively deploying demand-side energy policies, such as building codes and efficiency standards for appliances. But if policy makers muster the political will to put incentives in place, and if businesses and consumers respond, the results will be dramatic. A 25 percent drop in overall consumption by 2020, relative to business-as-usual growth, is achievable. Because many of the opportunities lurk in emission-intensive areas (such as electricity use and power generation, as well as industrial use in developing countries) such a decline would bring about a corresponding 27 percent reduction in carbon dioxide emissions. (For a detailed analysis of the relative economics of available approaches to decreasing greenhouse gas emissions, see “A cost curve for greenhouse gas reduction.”)

Why energy productivity matters

When wildcatters struck oil in the United States, the Caucasus, and the Middle East, cheap and seemingly limitless supplies encouraged its use in countless ways. The resulting new products and services and automation of processes stimulated economic growth, labor and capital productivity, and, of course, demand for energy. The oil crises of the 1970s awakened the world to the need for and possibility of constraints, and the policy changes, technological innovations, and consumer and business choices that followed shifted the global economy to a more energy-productive path. Today’s surging demand calls for a renewed focus on energy productivity.

What does energy productivity mean?

MGI defines energy productivity as the ratio of value added to energy inputs. Like labor or capital productivity, energy productivity thus measures the output and quality of the goods and services generated with a given set of inputs. Today, it stands at $79 billion of GDP per quadrillion British thermal units (QBTUs).³

Energy prices, business practices, market forces, and government policies all influence energy productivity. Japan leads the world here thanks to consistently high energy prices and strict government energy efficiency standards based on the best practices of leading companies. Japanese gas- and coal-fired power plants are 70 percent more energy productive than Russian ones, and Japan’s 2007 standards for room air conditioners are nearly 50 percent stricter than their Chinese counterparts. The Arab Gulf, by contrast, is among the least energy-productive parts of the world as a result of large, sustained energy subsidies and an energy-intensive growth model. Similarly, US cars are 15 percent less energy efficient than European ones in the same class, partly because European gasoline taxes are roughly seven times higher and partly because US regulatory exemptions have long helped automakers market SUVs as light trucks, which are subject to less stringent fuel-efficiency rules than passenger vehicles.

Economies can improve energy productivity in two ways:

• They can generate a given level of energy-related benefits with fewer inputs by using energy less intensively (with smaller appliances, for example), using energy in a more technically efficient way (car engines that use less fuel, say), or changing the mix of fuel they use (for instance, by switching from wood-burning stoves to electric ranges powered by coal-generated electricity).
• They can increase output more rapidly than demand for energy by changing the composition of economic activity. Energy productivity rises, for example, when growth shifts from more to less energy-intensive sectors—from steel, say, to services, or to higher value-added activities within services.

Since 1980 changes in input intensity, technology, the fuel mix, and economic activity have generated annual worldwide energy productivity improvements of roughly 1 percent a year—a pace that should continue over the next decade and a half in the absence of significant changes in the way energy regulations and markets operate. The pace will continue to be most rapid in emerging markets, particularly China, simply because they start from very low energy productivity levels that provide huge opportunities for improvement (Exhibit 1). The rapid construction of new urban housing, for example, should help the country boost its residential energy productivity by 2 percent a year.

How energy productivity is related to global demand

Unfortunately, the gain of 1 percent a year in energy productivity over the past decade has been outstripped by global energy demand, which has risen by 1.6 percent a year. In the near future, that demand is likely to grow even faster—by 2.2 percent a year in MGI’s base-case scenario. Growth of this magnitude would increase global energy demand to 610 QBTUs in 2020, from 422 QBTUs in 2003 (see sidebar “Sources and uses of energy today”).

That growth comes mainly from rapidly developing emerging markets, which together are projected to generate nearly 80 percent of the growth in world energy demand in our base case through 2020 (Exhibit 2). China, with six of the ten sectors likely to grow most quickly, represents 32 percent of world growth. In contrast, India’s growth in energy demand represents just 4 percent of the world total through 2020. One explanation for the lower Indian figure is that rapid urbanization should lead to a significant change in the mix of fuels residential consumers use—from relatively inefficient biomass (wood and dung, which today meet roughly 80 percent of India’s residential energy needs) to electricity.

Although these projections rest on bottom-up forecasts of demand in dozens of microeconomic sectors, they are subject to considerable uncertainty. In particular, the rate of global GDP growth (3.2 percent in MGI’s base-case scenario) will have a major impact on the rate of growth in energy demand.⁴ Our analysis indicates that GDP growth, particularly in developing economies, will drive the biggest swings in global energy demand. Higher than expected GDP growth would boost growth in energy demand to 2.7 percent a year (an increase in global energy demand of roughly 50 QBTUs by 2020 over the base case), while slower GDP growth would reduce demand (from the base level) by around 50 QBTUs.⁵

Sustained oil prices of $70 a barrel would cut global energy demand much less—by roughly seven QBTUs. A key explanation for this modest reduction is a complex brew of market failures, market-distorting public policies, and information and capital constraints. In addition, changes in relative prices induce energy users to switch to other fuels—from gasoline to biofuels for transportation, from natural gas to coal for generating electricity—but don’t reduce overall energy demand as significantly. And high oil prices boost GDP and energy demand in the Arab Gulf region, where energy productivity is low, thereby partially offsetting lower GDP and energy-demand growth in more efficient, oil-importing regions.

Boosting energy productivity

All this should make clear the inextricable relationship between energy demand and energy productivity: the higher the productivity, the lower the demand at any level of GDP. But to make energy productivity grow more quickly, a variety of targeted interventions will be needed.

Seeking out the opportunities

Conventional technologies with an IRR of 10 percent or more offer tremendous opportunities for improving productivity in a broad range of end-use areas. Capturing these opportunities would reduce growth in global energy demand to below 1 percent annually (from 2.2 percent in the base-case scenario) while shrinking projected 2020 end-use demand—perhaps 610 QBTUs—by somewhere between 116 and 173 QBTUs, some 19 to 28 percent of total energy demand (Exhibit 3). To put these figures in context, consider the fact that if nonhydroelectric renewable power sources increased their share of global power generation from 2 percent today to 5 percent in 2020, and if biofuels boosted their share of the transportation fuel market to 10 percent, from 1 percent, all of these sources would contribute only about 30 QBTUs to the world’s energy supply in 2020. What’s more, rather than requiring subsidies, energy-productivity opportunities provide a positive rate of return, freeing up resources that could be consumed elsewhere or invested for faster growth. We consider some of the most promising opportunities below.

Residential heating and lighting. With 25 percent of global energy demand, residential property represents the largest energy-use segment. Key opportunities include fitting out new homes with tight building shells, including chemically treated windows to reduce the amount of cold that comes in during the winter and the amount of heat that comes in during the summer; high-grade insulation; compact fluorescent lighting; and solar water heaters. In addition, higher efficiency standards for appliances and reductions in standby power requirements yield positive returns and simultaneously cut demand for energy. We estimate that these and other technologies in lighting, heating, and cooling could slow growth in residential energy demand to 0.5 percent a year, from 1.4 percent, and reduce 2020 energy demand by 15 QBTUs (or 3 percent of the total).

Electricity generation and distribution. Another large opportunity would come from reducing the losses that arise in generating and distributing electricity. In 2003, 129 QBTUs (30 percent of global energy use) were needed to generate 57 QBTUs of delivered electricity—meaning that generation and distribution consumed nearly 60 percent of all energy inputs. This implies a conversion rate (energy delivered divided by energy used) of around 40 percent. Some of the losses are unavoidable, but even today conversion rates range from under 30 percent in older coal plants to more than 50 percent in newer gas ones. We estimate that new technologies, such as advanced combined-cycle gas turbines, with an IRR of 10 percent or more, could reduce demand by 18 QBTUs as of 2020.

By then, the expansion of China’s power sector will represent 13 percent of the growth in global energy demand. If China meets it by building new, high-efficiency coal plants, the country’s overall energy demand will fall by 7 QBTUs—more than 1 percent of the global total—by 2020.

Steel, refining, and other industrial sectors. There are enormous opportunities to improve energy efficiency by replacing the least efficient tail of production with current technologies and by implementing currently economical energy-saving upgrades. These opportunities could reduce global energy demand roughly 65 QBTUs by 2020.

In the US steel industry, for instance, realizing a large number of small opportunities, such as expanding cogeneration and improving recuperative burners,⁶ would allow steel mills to cut their demand for energy by about 30 percent. The opportunity in the developing world’s steel mills, which are some 20 percent less efficient than their US counterparts and could be maintained more efficiently thanks to less expensive labor, is even larger.

Similarly, recent demonstration projects in US petroleum refineries have highlighted numerous opportunities with a payback of one year or less—opportunities that taken together would raise the sector’s energy productivity by 12 percent.⁷ As with steel, the opportunities in developing countries should be larger because their refineries are relatively inefficient.

Paper manufacturers can boost their energy productivity by introducing equipment such as extended nip presses, which extract an additional 5 to 7 percent of water from intermediate products, thereby reducing the load on relatively less energy-efficient dryers. Cement makers can save energy by fitting out their traditional ball mills (used to grind materials such as limestone) with high-pressure roller presses or by replacing those mills with more modern horizontal roller mills.

Correcting market failures

In view of today’s high oil prices, why haven’t companies and consumers already seized the opportunities? The answer is that systematic market failures involving consumers, businesses, and governments dampen the demand response to changes in price. Any effort to boost energy productivity must take these issues into account.

• Consumers, information, and capital. Most consumers lack information about the range of energy productivity improvements available to them, even though exploiting these improvements would serve their economic interests. Furthermore, to capitalize on energy productivity opportunities, consumers must often make up-front capital investments for which they have neither the funds nor the desire. Another issue, particularly in developing countries, is the fact that energy savings are often highly fragmented and their impact on household expenditures murky. As a result, the benefits of greater energy productivity are often obscured by the consumer’s focus on using energy for comfort, convenience, style, and health or safety. And since few consumers are willing to pay now for energy savings in the future, suppliers of energy-consuming products (such as cars and appliances) have less incentive to develop, produce, or market energy-efficient technologies and features.
• The relative unimportance of energy costs to business. Total US energy costs now represent less than 10 percent of the value of the output in all nonenergy sectors—indeed, less than 5 percent for most economic activities. Energy efficiency is thus typically a minor consideration, at most, when businesses invest in equipment such as automated- manufacturing tools or IT hardware. Many companies require a payback of three years or less (corresponding to an IRR of more than 30 percent) for capital expenditures to reduce energy consumption.
• Governments and subsidies. Energy productivity is systematically undermined by government policies. For starters, many developing-world industries that transform energy or use it intensively are state owned, which often reduces the financial incentives to improve energy productivity. What’s more, at least 20 percent of current global energy demand is subsidized or priced in a nonmarginal way, and both practices reduce or eliminate incentives to use energy as productively as possible. These energy-distorting policies include fuel subsidies in oil-producing countries in the Middle East and elsewhere, a lack of metering for the gas used in Russia’s homes (setting energy’s marginal cost at zero), and widespread energy subsidies for state-owned enterprises. Not surprisingly, energy efficiency in these areas lags behind global best practice dramatically.

The first step for governments hoping to solve these problems is to remove policies, such as subsidies, that discourage energy productivity. Governments should also look for sector-specific opportunities to promote it. Building codes and appliance-efficiency standards, for example, can help overcome the information barriers that inhibit many consumers from installing more efficient heating and lighting. Codes and standards are also helpful in dampening the impact of an agency problem in the construction industry: builders of offices, apartments, and homes often have little incentive to focus on energy efficiency, because the potential occupants may be reluctant to spend more now for a building that promises energy savings in the future.

Innovative companies also have a role to play in ameliorating market failures. Consider, for example, a general problem: energy users implicitly place extremely high discount rates on investments in fuel-efficient technologies, thereby limiting their adoption. Creative sales terms, perhaps developed through collaborations between utilities and the companies that sell the relevant technologies, could bridge the time gap and dampen the impact of high discount rates.

The right policies are likely to vary by region. Average fuel economy targets would have a faster impact in countries such as China, where new vehicles purchased over the next 15 years will represent most of the country’s stock of automobiles. By contrast, in the United States, where the stock of vehicles will turn over more slowly, higher gasoline taxes would create broader incentives for existing car owners to use private cars less and public transport more and to move closer to the workplace.

The world faces many problems whose scope and complexity make them virtually intractable, but energy doesn’t have to be one of them. If leaders muster the political will to eliminate market inefficiencies, companies and consumers will seize attractive energy productivity opportunities and create a brighter future.