Final Paper Topic: Do Environmentally Friendly Water Heaters Have a Place in Our Future?

Transcription

1 Final Paper Topic: Do Environmentally Friendly Water Heaters Have a Place in Our Future? A. Introduction The current water heater industry relies on technologies that came about in the early 20 th century using oil, natural gas, or electricity to heat water for homes and businesses. The industry is mature and owned by a few large players. The technological improvements occur incrementally as the industry is at the top of its S- curve. As environmental concerns and a push for less dependence on oil increase, alternative water heating techniques are gaining momentum. While many of these technologies have existed for some time, including heat pump, solar, and geothermal water heating, they are now garnering more interest. Our final paper seeks to understand and compare these environmentally friendly solutions to the traditional water heating solutions. We will look at the key drivers behind the water heating choices of consumers, contractors, and business owners to begin to understand if environmentally friendly water heaters are a disruptive technology at the beginning of the next S-curve in the water heating industry. 1

2 B. The Water Heater Industry Domestic residential demand for high-availability hot water has existed in some form since pre-historic times. The mechanism through which this demand has been met has varied significantly during this history, of course. Solutions have ranged from the delivery of hand-carried vessels of hot water taken from natural hot springs to the 19 th century introduction of gas- and electric-fired tank less heaters which produced hot water through a process of flowing municipally provided cold-water through a series of heating coils. Finally, the era of modern hot water heating was introduced in the early part of the twentieth century through thermostatically-monitored and controlled tanks with capacities as large as gallons. The basic designs of these tanks have remained largely unchanged over the last 70 years, resulting in only incremental design improvements, though recent advances in more-environmentally friendly technologies and the potential for changing consumer preferences in the current energy pricing environment around the world are now creating opportunities for unprecedented disruptive change in this industry. To understand the potential for these changes, it is first necessary to have a complete understanding of the consumer preferences that drive this market. As we see them, consumer preferences in the hot water heater equipment market are driven by the following: - Heater Performance Though the technical ability to meet these demands has improved tremendously over time, performance measures in this market are fundamentally unchanged since the 2

3 pre-historic times referenced in the opening paragraph of this paper. Consumers in this market primarily desire access to large quantities of hot water, made instantly available, and with extremely granular control over the temperature of the water produced. Though firms compete in this arena in terms of tank capacity, effectiveness of tank insulation and heating mechanism efficiency, at this point in time there is little room for technical improvement here, and research in these areas have yielded diminishing returns for decades. While little room for improvement likely exists in this dimension, any potentially disruptive technology will have to approach, if not match the current conventional standard on this performance dimension. - Price of Equipment, Installation and Cost of Operation Water is, of course, an undifferentiated commodity as such, it is difficult for hot water heating equipment producers to highly differentiate their products in this space. As such, cost is a particularly important dimension in the consumer decision calculus in this space. Of course, it is important to note that cost in this context has three components: 1) the cost of the equipment itself, generally purchased through massmarket retailers in the replacement market or through home-builders as part of a new home construction; 2) the cost of installing and servicing the equipment, generally performed in a fragmented, locally competitive market of plumbers, contractors and other service providers whom equipment manufacturers have little control over or interaction with; 3) the ongoing cost of usage of the equipment, which is primarily a function of the efficiency of the heating mechanism built into the hot water heater as well as the cost of the energy source used in this heating mechanism (electricity, natural gas, 3

4 oil). As these energy prices have risen significantly across the board and attracted increasingly levels of consumer attention over the last 18 months, this arena potential offers a more attractive area of competition than has historically been the case. - Reliability As a moderately expensive durable good, water heaters come with an expectation among consumers that they will last for anywhere from 7-10 years prior to needing to be replaced. Again, while the stage of the underlying technology s development leaves little basis for competition in this dimension, any potentially disruptive technology will need to approach, if not match, this established standard. - Environmental and Other Considerations Associated with Fuel Source As environmental awareness has risen in the United States and geo-political events have given rise to increasing concerns over issues associated with energy security, there are numerous examples in both related and unrelated industries of consumer concern over environmental issues driving purchasing decisions. Whole Foods Markets, for instance, has grown to nearly $4 bn in revenue and a market capitalization of over $7 bn based on the premise that consumers are willing to pay a premium for green or organic foods over conventional prices for conventionally produced foods. A similar corollary, it can be argued, is starting to be seen in the electric power industry, where gigawatts of wind and solar capacity have been installed in the United States recently despite the fact that the cost of electricity (another commodity, like water) can cost anywhere from two to ten times as much to produce from these sources than from conventional, environmentally damaging sources such as coal, natural gas or oil. At the 4

5 consumer level, green power is being marketed with increasing success, and consumers across numerous segments have expressed a willingness to pay premiums of up to 30% for electricity produced from environmentally friendly, renewable, and/or domestically produced energy sources. In the specific case of grid-connected solar power produced in a distributed fashion on commercial and residential rooftops, sustained annual growth rates approaching 33% a year have been seen over the last ten years, even with installed costs that produce payback periods extending beyond 7 to 10 years. Clearly, there is an analogue here to residential and commercial hot water heating industry, and if companies in this industry can piggyback on the environmental and energy security concerns that these other industries are leveraging, they could potentially overcome current cost and functionality obstacles where they lag behind conventional equipment manufacturers. 5

6 C. Who should become the future protagonists? Currently, technological improvements occur incrementally as the industry is at the top of its S-curves for caloric efficiency, cost effectiveness, and environmental impact. Alternative water heating techniques are gaining momentum as environmental concerns increase as well as the need for lower energy costs. While many of these technologies have existed for some time, they are now garnering more interest. So far, new technologies, compared to the established technologies, are at lower levels in their S-curves, having more space to compete and improve. Consumers, as potential users of these products, have also started to develop significant interest in environmental issues and energy costs, challenging the current water heater market dynamics. It s foreseeable that those companies able to satisfy these needs and develop complementary assets around them will be better positioned to capture most of the value in the water heater industry. Environmentally friendly water heater manufacturers will play a critical role, and so far, the existing firms can take advantage of the expertise already achieved and their understanding of these issues. Building a competitive advantage: Lessons learned The hot water heater industry has traditionally obtained revenues from three sources new construction, remodeling/renovations, and most importantly, the replacement market. 6

7 Until now, trends in home design, safety regulations and improving standards of living, have largely driven demands for the first two water heater markets. Now, the replacement market has become the most relevant one. Where competition does occur, it tends to be oriented around technology, branding, building customer perceptions of quality, and competing for channel relationships and access to major retailers. Shorter replacement cycles of water heaters, and much more understanding by the consumer about water heaters, have driven the rapid growth of the replacement market. Relationships with home builders, but especially access to retailers such as Home Depot and large appliance retailers have also become essential to success in this industry. As part of this trend, brand name awareness and association with quality have also become critical. As a result, large companies like Maytag and Ruud have invested heavily in advertising campaigns promoting quality, reliability, and efficiency. Despite the fact that the industry s technological improvements have been relegated to the realm of the incremental, leading companies still devote significant energy and money to research and development, as innovations and manufacturing improvement continue to be a differentiator. All this suggests that complementary assets play a key role in the competition for the water heater market. Price does not appear to a major source of competition in the industry, as most competitors prices are roughly in line with each other s. Some recent pricing pressure 7

8 has been seen from lower-cost entrants, however, attempting to enter the market from low cost-manufacturing geographies such as China, with some success. Environmentally Friendly Water Heater Industry Among environmentally friendly water heaters, heat pumps or heat exchangers have become the most popular ones. The value proposition of manufacturers of these devices has been key and highlights the energy savings achieved; enough to offset the cost of the system while at the same time minimizing the environmental impact. As an example, Water Source Heat Pump (WSHP) systems are one of the most efficient, environmentally friendly ways to heat and cool buildings. They move energy from where it is not needed to where it is needed. In this category, geothermal heat pumps (GHP) offer the highest efficiency, using the energy contained in the ground. During the last decade, residential and commercial use of GHP has increased more than 6% per annum, growing its share as a source of heat against wood, oil and electricity alternatives. Among the main players in this segment we can find ClimateMaster, FHP Manufacturing, WaterFurnace International, McQuay International, and The Trane Company. Because the GHP market is still developing, is hard to identify a clear leader, but all off them share some characteristics that may explain their success. Despite that, these firms have started to follow the lessons from their more conventional colleagues, building complementary assets that are unique and sustainable to let them capture the value created. 8

9 There is still little information about environmentally friendly water heater market. Despite that, there is some evidence that these firms learned from their more conventional competitors, taking advantage of this disruption to build their own complementary assets looking forward to deliver and capture a huge part of the value they created and will create. So far, we could identify four main areas where they are focusing their energies to build complementary assets: Distribution network: These companies rely heavily on construction networks and associations in the renewables area. Each company plays in a different way to influence home design, contractors, regulators, and associations. GHP are not off-the-shelf solutions, and they require a significant degree of customization that has to be properly conveyed to the end consumer. Research and Development: The market demands a high efficiency for GHP as an additional heating appliance. They sell mostly on the basis of the energy savings they generate. GHP represent a savings to homeowners of 30 to 70% in the heating mode, and 20 to 50% in the cooling mode compared to conventional systems. In this dimension, companies rely in a range of strategies, from being 100% focused in the GHP like ClimateMaster, FHP Manufacturing, and Waterfurnace, to commercializing a broad portfolio of heating/cooling systems like McQuay International and The Trane Company. Expertise/people: They require a lot of flexibility and know-how to adapt the systems to geographic conditions and existing construction limitations. 9

10 Patents: Patents are important, both in the design and in the use of the equipment and systems. Specifically, companies like McQuay International believe that certain patents are important to distinguish a company's equipment and systems from those of its competitors. Despite that, they recognize that any particular patent, or any groups of related patents, are essential to their operations. Perhaps by chance, because of historic reasons, or because of a well thought out strategy, the environmentally friendly water heater market has accounted for free sources of energy as their main resource. This gives them the benefit and the advantage to leverage their cost effectiveness of their systems and be at the same time an environmental solution. In the future, the increasing energy demand, the increasing cost of energy, and the growing concern for environmental technologies, should propel the introduction and the further development of technologies like GHP that increase efficiency, reduce cost and minimize environmental damage. 10

11 D. What the future holds There are three main factors that will shape the future of environmentally friendly water heating solutions within the water heater industry. These factors are future legislation, energy prices, and the ability to meet customer needs. These three factors will determine whether solutions like heat pumps and solar water heating will remain a niche player or take over as the next generation in water heating. Legislation Current legislation provides few incentives for environmentally friendly water heating solutions and the most compelling incentive to date has more to do with the actual cost savings of consuming less electricity, gas, or oil. The incentives that do exist are tightly coupled to incentives for green buildings which are being promoted by organizations like the U.S. Department of Energy (DOE), the Partnership for Advancing Technology in Housing (PATH), the Environmental Protection Agency (EPA), and Energy Star. They help publicize and market the benefits of green buildings, fund development of clean building technologies like water heating solutions, and offer tax breaks and small subsidies to consumers who purchase energy efficient equipment. However, these modest incentives have not been enough to drive mass adoption of environmentally friendly water heating solutions. Despite a study by the Green Building Initiative indicating that 62% of people want a green-built home and 17% of people are willing to pay more for a green-built home, the actual numbers of green homes built are substantially smaller. In 2002, out of 1.25 million new homes built, only 13,224 or 1% were green homes. While the number of green homes being built is 11

12 increasing (only a total of 18,887 were built from 1990 through 2001) and the number of local green building initiatives in the U.S. is also increasing (from 1 in 1991 to 29 today), it still remains very much a niche market. If future legislation provides stronger incentives or mandates for green building, this may push environmentally friendly water heating solutions into the mainstream market. The Kyoto Protocol, aimed at reducing greenhouse gases (particularly CO2), is perhaps the most promising legislation on the horizon for green building proponents. One major component of the Kyoto Protocol is the creation of an international market for carbon emissions credits. This would provide additional financial incentives to switch to environmentally friendly water heating solutions and would greatly bolster the demand for green buildings. In the U.S. there are more than 76 million residential buildings and nearly 5 million commercial buildings which use one-third of all energy consumed in the U.S. and two-thirds of all electricity. More applicable to the Kyoto Protocol, these buildings account for 35% of the U.S. CO2 emissions, in addition to 49% of SO2 emissions, 25% of NO emissions, and 10% of particulate emissions. According to one estimate, if only 10% of homes used solar water heating, the U.S. would avoid 8.4 million tons of carbon emissions each year. It the U.S. were to adopt the Kyoto Protocol, those carbon emissions savings would have an economic value providing financial incentives for adoption of environmentally friendly water heating solutions. Currently, the Kyoto Protocol has been adopted by many European nations and some Asian nations, but the U.S. has indicated that it does not intend to adopt the protocol in the near future. Nevertheless, more local legislation is providing some incentives for green 12

13 building construction and this is leading to a small increase in the demand for environmentally friendly water heaters. Energy Prices Another factor that will contribute to the adoption of environmentally friendly water heaters in the future is the continued increase in energy prices. As energy prices increase, so does the recurring operating costs of conventional water heaters. One cost advantage that environmentally friendly water heaters have over their traditional counterparts is a lower operating cost due to the need for less fuel. Even though initial purchase costs and installation costs may be higher for environmentally friendly water heaters, with high enough fuel costs, they can be cheaper to own and operate over the lifetime of the water heater. Figure 1, below, shows an increase in heating oil prices, even over the high prices during the energy crisis of the late 1970 s. This past year (not shown in Figure 1), the prices rose even higher to levels of 165 cents/gallon. Figure 1: Historical Heating Oil Prices 13

14 Natural gas is also on the rise as shown in Figure 2, below. This past year (not shown in Figure 2), natural gas reached as high as 8.5 $/MCF. Figure 2: Historical Natural Gas Prices The increasing energy costs and speculation of further increases provide financial incentives for consumers to switch to environmentally friendly water heating solutions. If energy costs fall, there will likely be little incentive for the mass population to switch from conventional sources, but most predictions call for continued energy increases which will provide opportunities for environmentally friendly water heaters to move out of their niche market into the mainstream. Customer Needs A final factor that will enable environmentally friendly water heaters to enter the mainstream market is their ability to meet customer needs. Earlier we identified heater performance, cost of equipment, installation, and operation, and concerns associated with the fuel source as the consumer preferences that drive the water heater market. If environmentally friendly water heaters are able to greatly exceed their traditional 14

15 counterparts in these categories, they will be able to acquire market share. However, it does not appear that this will occur anytime soon. One reason for the proliferation of fossil fuel burning water heaters is the incredible energy density contained in fossil fuels and the relatively efficient use of that energy density by conventional technologies. When compared with the efficiencies of solar water heaters, conventional technology is a clear winner. However, significant improvements are being made each year in the efficiencies of environmentally friendly solutions compared to relatively stagnant efficiencies of traditional water heaters. This indicates future potential for the environmentally friendly solutions to approach the metrics of the conventional technologies. The costs of the equipment and installation of the environmentally friendly water heating solutions typically exceed those of traditional technologies. Much of this is attributable to economies of scale. If demand increases and production ramps up, costs will drop in the environmentally friendly sectors. However, certain components like solar collectors will require a significant technological advance to bring the costs down because the limiting factors are currently raw materials costs. Again, clean water heating sources are making greater technological strides each year, but it will still be several years before they approach the low equipment costs of conventional technologies. Installation costs will remain lower for conventional technologies because the infrastructure to support them exists currently. Switching to environmentally friendly solutions requires significant initial investment, but once that is made, replacement installation charges will be small. 15

16 One advantage that environmentally friendly solutions have over traditional water heaters is operating costs. Because the green solutions use less fuel and often free fuel (solar and geothermal), they cost much less to operate. This combined with the technological advances that help reduce purchase price and a greater installed base that will reduce installation costs, may help to bring environmentally friendly water heaters to the mainstream. Another win for green water heating sources is the concerns about the fuels used to heat water. As this becomes a greater concern of consumers, environmentally friendly water heaters will have a better chance of entering the mainstream market. While the future is uncertain, it seems clear that environmentally friendly water heaters will grow in acceptance and adoption. The question of whether they will encroach on conventional water heaters as a mainstream source of hot water will depend largely on the technical advances in the area to meet customer needs, the continued trend of increasing energy prices, and the adoption of legislation to encourage green building solutions. All trends currently favor environmentally friendly water heaters, but realistically it will be at least twenty years in the future before they unseat conventional technology. 16