An application of normative decision theory to the valuation of energy efficiency investments under uncertainty

Abstract

Abstract Previous market analyses have projected a huge potential for reduction of building energy consumption through retrofits. Large-scale application of currently available technologies could save at least 20% of the total energy consumed by buildings in the next decade. It is expected that such savings will not be realized unless involved parties, and in particular the clients and investors, trust the predicted savings and can engage in a transparent contracting process. The authors argue that this requires a comprehensive and innovative investment valuation method. Conventional investment decisions in energy efficiency rely on deterministic analysis of net present value and internal rate of return, both of which suffer from two critical drawbacks. First, the assumption that decisions are made with certain, accurate information is unrealistic. The other drawback is that traditional investment valuation does not take the risk preferences of each decision maker into account, hence it does not recognize that a certain decision maker will weigh the risk of future loss more heavily than a potential gain, or vice versa. This paper aims to address these drawbacks by applying axiomatic utility theory as a normative basis for decision-making. We analyze optimal decisions involved in drawing up a performance contract that accounts for uncertainty and uses explicit risk preferences of the decision maker. How this can work in practice is demonstrated in a real-life case study. It is discussed how the proposed methodology manages uncertainty in energy saving predictions while incorporating a decision maker's risk preferences. Results show that the methodology results in a decision that will rationally maximize the decision maker's value. As energy performance becomes an important factor in awarding construction projects, the availability of risk-transparent information will increase the willingness of all parties to follow through with a contract and agree on the budget. Moreover, the downstream automation of the decision process that maximizes all decision makers' values will lead to a higher realization rate, thus benefitting the construction market as a whole.