As told by Nalin Yogasundram VP at T. Rowe Price Associates

Nalin Yogasundram is a vice president of T. Rowe Price Associates. He is a research analyst in the U.S. Equity Division, following the alternative energy industry, and serves on the Investment Advisory Committee of the Global Technology, Science & Technology, New Era, and New Horizons Funds. He earned a B.S. in electrical engineering, magna cum laude, from the University of Arkansas; an M.S. in electrical engineering from Southern Methodist University; and an M.B.A. from The Wharton School at the University of Pennsylvania.

The idea of examining new lighting technologies—like compact fluorescent lamps (CFLs) and light-emitting diodes (LEDs)—was brought up to me by a couple of portfolio managers here. They tend to think "big picture," and they saw some developing trends and policy changes that intrigued them, such as bans on incandescent light bulbs in the U.S., European Union, and Japan, and some recent commentary from Walmart about energy efficiency. (The company has a goal of 100 percent renewable energy use, and has started converting to LED lights.) So we started investigating the drivers behind these trends in lighting, and whether they are sustainable.

There are a couple of approaches to alternative-energy technology: supply-side and demand-side. Creating energy involves tapping into a supply of raw material, so the supply-side is made up of innovations in solar, wind, and other renewable supplies.

But there's no cheaper, better way of increasing our energy security and reducing our energy use than innovating on the demand-side: lowering the demand for energy by building smarter power grids, and making both lighting and heating more efficient.

There are some questions and basic tenets we have to keep in mind as we evaluate CFLs and LEDs, or really any new innovation:

1. Does it provide a sustainable improvement?
2. What are the potential risks and rewards of displacement?
3. Timing is (almost, but not quite) everything

Before we start digging deeply to try to find the best companies or figure out how to make a return for our clients, we have to determine whether it's a good idea, whether the time is right for this idea, and whether or not it will be profitable. So let's consider these issues one by one.

Does it benefit consumers economically? Does it improve lives? We call these "market opportunities," and ultimately, if you want to have a sustainable business, you're going to have to improve things. If we find something that can make people's lives better over time—not just in the immediate term, but over the next 50 or 100 years—it's probably a good place to be.

You may or may not remember this, but back in the 1980s, the government tried to force people to buy CFLs, and force utilities to recommend or subsidize them. The effort blew up, because the Department of Energy (DOE) forgot one key thing: CFLs are good for cost and energy savings, but the quality of light that CFLs delivered back then was not very good.

The DOE is being much smarter this time around as it pushes LEDs and CFLs. They are making sure the quality of light generated by CFLs measures up to the quality that people are used to. Once the quality question is answered, the economic case begins to resonate. (For a primer on lighting technology—where we've come and where we're going—read our article The Lighting Revolution is Now.)

In the case of LEDs, the quality question is being answered incrementally. If you want aesthetically warm lights that make you feel good—a particular shade of off-white rather than an industrial white or off-blue—you may never get over incandescent bulbs. But there have been some innovations that enable LEDs to generate warmer looking light that is more in line with what people like. There are color-rendering options for LEDs that make the warmth and softness controllable to some extent, and those options will only continue to improve. (See Instead of Coffee, Try Some Light for more on some intriguing trends in LED lighting.)

Another market where LEDs can make an impact is consumer TV displays. When you see an LED display, you can see a clear difference. LED displays are high-quality, and they're constantly getting brighter and crisper; and while doing so, they're actually reducing their energy consumption compared to other display technologies.

Liquid crystal display (LCD) TVs, for instance, have proven to be energy hogs, and LED technology used for back-lighting enables newer LCD TVs to maintain current light output needs with fewer LEDs, and to dramatically reduce energy consumption. And leading manufacturers like Samsung want to cut the number of LEDs used in their TVs in half by using more powerful, higher-quality LEDs. It's ironic that lighting technology that got its start in simple traffic signals has been put to use in these sophisticated display technologies.

When we look at the consumer application of energy innovations like LEDs and CFLs, we also have to look at the industry: does the innovation we're considering represent a change to the structure of the industry? And how easy would it be to change the structure of the industry?

If LEDs are going to get adopted on a wide scale, it's important that they feel better and look better; but for big chunks of the market, the decision will be made based on cost.

Just a couple of years ago, LED light bulbs cost $50 a piece, and now they're now more like $20 to $25. Over the next couple of years, we'll probably see them get down to the $5 to $10 range per bulb, depending on the quality. And at that cost curve, the industry is able to drastically reduce the sticker shock to consumers.

That's for residential use. For commercial and municipal adoption, the payback is clearly visible within as little as two or three years. The upfront investment in new LED lighting is offset because municipalities and commercial companies use lights much longer than consumers, and therefore benefit more from using less energy and not having to roll out a maintenance truck every three months to change light bulbs. (See How Streetlights Became the Darling of City Hall, for more on municipal adoption of LEDs.)

It just makes economic sense, especially for municipalities. The biggest hurdle for mass adoption is financing, because you're trading a high variable cost (fossil fuel prices) for high fixed cost (installation). The upfront cost is high, but then you really don't pay anything for the next 10 to 20 years for what you've done. That said, this can still be a tricky trade-off for city councils, but municipalities with good outlooks are dealing with it by getting very cheap rates on their bonds, and then pushing it through.

The key question they're asking is how many years it will take for cost savings to pay back an initial upfront cost. Innovative technologies can't just be green and 10 times more expensive. They have to be green and offer the same value, or a higher value for a comparable price.

The payback on LEDs used to be about 10 years, and then it was three or four years. Now we're seeing a payback in two or three years. On that kind of timeline—which coincides with an election cycle—financing for LED installation might be tough, but you can make both an economic and a societal case for it.

You can have a good idea, but it just can occur too early, right? You can also have a good idea at the right time, but if you don't have the right business model or the right cost structure to sustainably make a profit, then it may not last. So we look at that, and then we look at the economics.

Sometimes even good ideas take time. Tablets didn't arrive on the scene at quite the right time 10 years ago, but they're perfect for right now, so adoption is happening. In many cases, we just wait it out. Look how long it took recycling to reach a meaningful scale—and everyone knew it was a great idea!

The problem with energy technology is that it can take trillions of dollars to build infrastructure, and energy technology can take decades to adopt. And so whereas in areas like communications and the Internet, a couple of guys in a room can change the world in five years, that's generally just not the case in energy.

Over the past 10 years we have moved from an energy-abundant mentality—energy is cheap and it's our right to have it—to now, when it's not so cheap. Whether you are talking about oil or carbon emissions, there are costs to this energy: direct, indirect, immediate, and long-term costs.

People are thinking about how to add energy supply more efficiently, but energy efficiency has the potential to reduce our energy consumption by 25 percent, and there's a clear economic reason for it. (For more on this, read our article
A Demand-Side Case for LEDs.)

The low-hanging fruit for improving energy efficiency right now is buildings. Buildings account for well over half of the power use in the U.S., and the best and easiest way for them to reduce energy is with upgraded lighting, because lighting accounts for about 20 to 30 percent of a building's energy use.

I mention all of this to say that the timing appears to be right for widespread LED adoption. The technological timeline of LED innovation is intersecting with the socio-economic timeline that finds us looking for energy efficiencies and cost-cutting technologies.

I try to take a balanced view of the new technology. We have some promising answers to the three questions I posed above, all of which make me optimistic about the future of LED lighting and its potential for market dominance. T. Rowe Price has taken a long-term perspective.

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