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CHAPTER 8: MANUFACTURING IMPACT ANALYSIS

In accordance with the Energy Policy and Conservation Act, the U.S. Department of Energy

(DOE) is currently in the process of revising the minimum energy-efficiency levels for the residential

central air conditioner and heat pump product category. This report assesses the financial and

employment impacts on manufacturers of these products due to a potential new efficiency standard.

8.1 MANUFACTURER IMPACT ANALYSIS METHODOLOGY

In determining whether a standard is economically justified, the Secretary of Energy is

required to consider "the economic impact of the standard on the manufacturers and on the

consumers of the products subject to such a standard." The legislation also calls for an assessment

of the impact of any lessening of competition as determined in writing by the Attorney General. The

purpose of the Manufacturer Impact Analysis (MIA) is to provide information that can be used to

evaluate these impacts. The MIA estimates the financial impact of standards on manufacturers and

reports impacts on employment and manufacturing capacity.

As proposed in the Department’s rulemaking framework, we conducted the MIA in three

phases. In Phase 1, the “Industry Profile”, we gathered relevant industry data on market share, sales

volumes and trends, pricing, employment, and financial structure. In Phase 2, we developed a

“Industry Cash Flow” analysis for the industry subject to the various efficiency standards the

Department is considering. In this phase, we adapted the Government Regulatory Impact Model

(GRIM) to the residential unitary air conditioner industry to serve as the primary tool for the

financial analysis. In Phase 3, the “Sub-Group Impact Analysis”, we assessed impacts on a generic

manufacturer of niche products and compressor manufacturers. Phase 3 also entailed documenting

additional impacts on employment and manufacturing capacity.

8.1.1 Phase 1: Industry Profile 

In Phase 1 of the MIA, we prepared a profile of the residential central air conditioner

industry. Part of this work occurred during the Engineering Analysis as part of our estimation of

markups and production costs. At that time, we collected market share, product shipment, and cost

structure information for various manufacturers. Lawrence Berkeley National Laboratory (LBNL)

also contributed information as part of their Life Cycle Cost and National Energy Savings analysis.

The Preliminary Technical Support Document (TSD) accompanying the Supplementary Advance

Notice of Proposed Rulmaking (SANOPR) presents much of the information we collected. In this

report, we provide some additional information on the industry that was not presented in the

preliminary TSD.

We relied on public sources for the industry profile. They included corporate financial reports

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submitted to the Securities and Exchange Commission (SEC 10-Ks), U.S. Census Bureau statistics,

and trade publications. 

8.1.2 Phase 2: Industry Cash Flow Analysis

The analytical tool used for calculating the financial impacts of standards on manufacturers

is the Government Regulatory Impact Model (GRIM). In Phase 2, we adapted the GRIM to perform

a cash flow analysis on the portion of the residential unitary industry devoted to the manufacture of

the residential products.

For the Industry Cash Flow Analysis, we prepared a list of financial values for use in the

GRIM. Publicly available financial statements of air conditioner manufacturers were the principle

source of information. Prices were derived from the most recent reverse engineering production cost

estimates and our estimates of typical manufacturer markups derived from financial reports and

interviews with manufacturers. Shipments are consistent with those estimated for use in the National

Energy Savings (NES) analysis.

8.1.3 Phase 3: Sub-Group Impact Analysis

During the course of the MIA, we visited and interviewed manufacturers representing over

90 percent of domestic residential unitary sales. We had previously visited many of the same

companies as part of the Engineering Analysis. The MIA interviews shifted the discussion from

technology-related topics to business-related topics. Our objective was to become familiar with each

company’s particular market approach and financial structure, and its concerns and issues related to

new efficiency standards. The assumptions derived for use in Phase 2 helped us communicate and

isolate those issues. The similarities and differences we noted between companies allowed us to

characterize subgroups that we could then aggregate to represent the situation of the industry overall

and refine the Phase 2 analysis.

8.1.3.1 Major Manufacturer Sub-Groups

In the course of our interviews, we realized that major manufacturers, who provide

conventional unitary equipment to the mass market, take two distinct approaches to market. The first

group attempts to keep operating expenses as low as possible and provides a lesser degree of service,

support, marketing, and research. This group offers products that compete primarily on low price,

targeted toward the new construction market and price-sensitive customers. They do not emphasize

sales of higher efficiency equipment. The second group prefers to offer more substantial customer

and dealer support and more advanced products. To cover these higher operating expenses, this

group attempts to “sell-up” to more efficient products or products with features that consumers and

dealers value. Both groups can exist within the same company as separate divisions, or even separate

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brands. New standards can impact manufacturers in these two groups differently because of the

commoditizing effect that standards have on products, such as central air conditioners, whose

predominant selling point is energy efficiency.

The GRIM we developed for Phase 2 is capable of assessing the financial impacts on each

of these two sub-groups of major manufacturers.

8.1.3.2 Small Manufacturer Sub-Group

During the Engineering Analysis interviews, it became clear that manufacturers of niche air

conditioning products faced special technological and financial considerations compared to those

faced by the major air conditioner producers. Comments submitted to the Department after the

release of the SANOPR reinforced our suspicion that new efficiency standards could be more

detrimental to the financial situation of niche product manufacturers than the major manufacturers.

In order to assess these impacts, we interviewed three niche manufacturers, focusing on the

differences and similarities between their situation and that of the majors.

8.1.3.3 Compressor Supplier Sub-Group

The Department received comments urging them to consider impacts on compressor

suppliers. Of all components in a residential unitary air conditioner, the compressor is the most

specialized and the most responsible for the equipment’s energy efficiency rating. It is also the

largest contributor to the production cost. We asked compressor suppliers to ascertain whether they

felt the new standards would place them at a particular competitive advantage or disadvantage. If so,

the result could impact compressor prices and availability, which could have an indirect effect on

equipment manufacturers and consumers.

8.2 INDUSTRY PROFILE

We developed a brief industry profile using information from relevant industry and market

publications, industry trade organizations, company financial reports, and product literature. This

industry characterization helped us estimate baseline retail and manufacturer prices and the industry

cost structure, and to document financial information such as the industry average discount rate, tax

rate, working capital, depreciation and capital expenditures. These values were used to develop a

preliminary industry cash flow analysis. The industry characterization also aided in the development

of a detailed and focused interview guide to perform the MIA.

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8.2.1 Product Classes

Unitary products include air conditioners (cooling-only), heat pumps (cooling and heating),

and furnaces (heating only). The rulemaking addresses only air conditioners and heat pumps. Air

conditioners and heat pumps may consist of split systems and packaged products. A split system

consists of an outdoor unit containing a compressor and condenser coil and a connected indoor unit

containing an evaporator coil. The indoor unit may also include an electric, gas or oil heating section,

an indoor blower system and associated controls. A packaged product is a single, self-contained unit

with compressor, condenser, evaporator, blower and associated controls. Packaged equipment may

also contain an electric, gas or oil heating section. They are typically installed on rooftops or beside

a structure. Ducted air conditioners and heat pumps distribute conditioned air throughout building

structures with ductwork connected to the system's blower, whereas ductless installations provide

conditioned air directly from indoor blowers without the use of ductwork.

8.2.2 Market Shares and Distribution

Roughly 60 equipment manufacturers, several hundred distributors, and more than 30,000

dealers operate in the United States. Due to a wave of consolidation over the last 15 years, the top

seven manufacturers now control 97 percent of the market share (Amana was acquired by Goodman

in 1997 and International Comfort Products was acquired by Carrier in 1999). Most remaining small

manufacturers produce only indoor coils or niche product lines. Table 8.1 shows the estimated

market shares for each manufacturers from 1994 to 1998. Each manufacturer offers multiple brand

names. Many of the brand names derive from once independent manufacturers that have been

acquired by those who remain.

Most residential central air conditioning equipment passes through a two-step distribution

chain: 1) manufacturer to distributor, and 2) distributor to dealer. Lennox uses one-step distribution

(manufacturer to dealer) for its Lennox brand products and is the only notable exception. Trane also

sells products through Sears and Home Depot. However, most industry members do not expect the

trend toward one-step distribution to have a large effect on the market.

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1987 1990 1994 1996 1998

Carrier 25 21 20 21 22

Goodman * 7 15 16 17

Rheem 15 14 13 13 12

Trane 12 10 13 13 13

ICP 1 ** ** 11 10 9

York 8 8 7 9 7

Lennox 10 14 10 8 10

Nordyne ** ** 5 4 5

Amana 2 33333

Others 27 22 8 3 5

* not an independent entity

** included in “Others”

1

 Acquired by Carrier

2

 Acquired by Goodman

Sources: Appliance Magazine in SBI Market Profile: Air Conditioning Equipment, November 1997;

Appliance Magazine September 1999

Table 8.1 Market Shares (%) in the Residential Unitary Industry (1987 - 1999)

Equipment manufacturers sell most of their products directly to distributors (also called

wholesalers.) Distributors sell to dealers at the distributor (wholesale) price. Distributors absorb

short-term imbalances in supply and demand, allowing manufacturers to operate more efficiently and

satisfying needs for fast deliveries. Distributors may specialize in HVAC equipment or may deal in

other products. They are also important sources for lucrative after-market parts that boost margins.

Distributors compete on price and service, although geographic boundaries and relationships prevent

margins from being squeezed to commodity levels.

Most dealers compete at the local level. Many carry more than one brand, and most install

the products they sell. Some are engaged in other contracting business, and most do commercial

work. Dealers are consolidating rapidly in the wake of similar trends at the wholesale and

manufacturer levels. There are now several large, national, publicly traded air conditioning dealers.

8.2.3 Sales

Sales and shipments of unitary AC products have increased considerably over the last decade.

Unitary AC market sales in the U.S. have increased at an average rate of 5.6 percent between 1989

and 1996. This increase is related to periods of growth in replacement as well as growth in the

prevalence of air conditioning installed in new residences. More and more, air conditioning is

considered a basic feature, even in cooler regions, rather than a luxury item. Figure 8.1 provides

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Figure 8.1 Value of All Unitary Shipments ($ million), 1991-1998

industry value of shipments, industry dollar sales of unitary ACs, and exports and imports for the

period 1992-1998. Notice that imports and exports declined in absolute and relative terms beginning

in 1993 and have not recovered.

8.2.4 Price Trends

Price competition has a strong influence in the residential unitary air conditioner market since

most end users perceive little difference among brands. A direct and consistent measure of air

conditioner producer price changes is the Bureau of Labor Statistic’s Producer Price Index (PPI) for

unitary air conditioners (series ID PCU3585#2). The PPI measures quality-adjusted pricing in

nominal dollars. The trend in PPI since 1989 is shown in Table 8.2. (The GNP deflator has been

shifted to equal the PPI in 1993.)

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Unitary Air

Conditioner

PPI (1)

Adjusted GNP

Deflator (2)

1989 111.3 100.0

1990 114.8 103.9

1991 115.2 107.7

1992 113.6 110.3

1993 113.0 113.0

1994 113.3 115.4

1995 116.5 117.9

1996 119.6 120.1

1997 120.7 122.4

1998 123.8 123.8

1999 126.7 125.6

(1) Series PCU3585#2

(2) Scaled to equal the PPI in 1993.

Source: U.S. Department of Commerce

Table 8.2 Historical Comparison of Unitary Air

Conditioner Producer Price Index (PPI) and the U.S.

Gross National Product Deflator

Prices are influenced by many factors. In the case of central air conditioners, weather seems

to play a strong role in the short term. For example, the rapid increase in annual average PPI from

1997 to 1998 corresponds to a sudden price increase that occurred during the summer of 1998 when

the monthly PPI increased from 120.4 to 128.2 from May to September. That year there was the most

intense El Nino weather phenomenon ever recorded and periods of unusually hot weather occurred

throughout the country. In September 1999, the PPI dropped from 128.1 to 123.4, while the GNP

deflator continued its steady rise. From 1993 to 1999, the real increase in unitary air conditioner PPI

is less than 0.2 percent per year as measured by average annual PPI and GNP deflator. In detail the

picture is more complicated, but the price fluctuations are as big as any real price trends during this

period. This means that there is significant uncertainty in forecasting recent price trends into the

future. 

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8.3 GRIM INPUTS AND ASSUMPTIONS

The Government Regulatory Impact Model (GRIM) served as the main tool for assessing the

impact on industry due to the imposition of new efficiency standards. We relied on several sources

to provide inputs to the GRIM in the form of data and assumptions. The GRIM’s accounting

methods then produce the results used to describe impacts on manufacturers.

8.3.1 Sources of GRIM Inputs

SEC 10-Ks

Corporate annual reports to the Securities and Exchange Commission (SEC 10-Ks) provided

the bulk of the financial inputs to the GRIM. These reports exist for publicly held companies, and

are freely available to the general public. The 10-Ks provide consistent and reliable financial data

for the consolidated corporation but do not provide detailed financial information for the company’s

residential unitary business line. Some 10-K’s are therefore more relevant than others to the analysis

of the residential unitary industry depending on the prominence that business has in the company’s

overall operations. In determining financial parameters for the industry, we weighted corporate

financial information contained in the 10-Ks by each company’s market share in residential unitary

products.

10-Ks provided the following GRIM inputs:

` tax rate

` working capital

` sales, general, and administration expenses (SG&A)

` research and development expenses (R&D)

` depreciation

` capital expenditures

` net property, plant, and equipment.

We also used 10-Ks to calibrate the GRIM’s operating profit margin against the weighted

industry average.

When possible, we used independent reports from such sources as

www.globalbb.onesource.com to simplify our collection of 10-K information.

Moody’s Investor Services

Moody’s provides independent credit ratings, research and financial information. Moody’s

reports are available for a nominal fee. We relied on Moody’s reports to determine the industry’s

average cost of debt for our cost of capital calculation. 

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Shipments Model

The shipment projections for the analysis came from the Department’s shipments model

described in Chapter 6.

Air-conditioning and Refrigeration Institute (ARI)

ARI is the trade organization that represents the unitary air conditioning industry. ARI

provided two pieces of information: the distribution of products by efficiency level as of 1994, and

the relative production cost of products under new efficiency standards.

ARI no longer makes sales-by-efficiency information available to non-members. Since

shipment weighted efficiencies have not changed much since 1994, and after reviewing the current

distribution provided to us by one of ARI’s members, we assumed that this distribution continues

to apply today.

The cost multipliers ARI provided relate the cost of producing baseline equipment under new

standards to the cost of producing baseline equipment under today’s standards. According to ARI,

the multipliers account for changes in indirect costs and investments as well as in direct costs. We

used the Mean cost multipliers in the GRIM analysis.

Reverse Engineering

During the Engineering Analysis, we performed a technology-based cost estimation on 3-ton

air conditioners and heat pumps. The analysis provided labor, materials, and overhead production

costs for each product class.

Interviews

During the course of the Engineering Analysis and MIA, we visited 11 manufacturers of

complete air conditioning systems, one manufacturer of indoor units and coils, and four compressor

and motor suppliers. During those visits, we discussed financial and strategic topics specific to each

company. Most of the information received from these meetings is protected by non-disclosure

agreements and reside with our contractor.

Before each visit, we provided company representatives with a formal interview guide that

included the topics we hoped to cover. For the MIA, two versions were produced. The first applied

to major manufacturers and was sent to six firms. The second applied to low volume manufacturers

and was sent to two firms. The topics included:

` Cost structure – fraction of labor, materials, operating expenses, working capital, etc.

` Shipment projections – degree of agreement with Department projections

` Product mix – sale volumes by efficiency level and projections under new standards

` Overall profitability – profitability versus corporate average

` Profitability by efficiency level

` Replacement parts – contribution to revenues and profits

` HCFC phaseout and other regulations – impacts on designs and cumulative burden

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` Exports – impacts of new standards on export sales and revenues

` Conversion costs – estimates of costs required to meet new standards

` Consolidation – reasons for, and projections of, continued mergers

` Niche products – whether any niche products would be impacted

` Effective date of standards – whether the 5 year lead time contributes to additional burden

` Fractional standard levels – whether standard levels other than whole integers would add

to the impacts

` HSPF-SEER – impacts associated with proposed HSPF-SEER pairings and possible

differences between SEER requirements

We often introduced, entertained, and discussed other topics during the course of the

interviews.

Niche product manufacturers received a different version of the interview guide. It covered

the same topics, but focused on the differences between their situation and that of the larger

manufacturers. We did not use a formal interview guide during our conversations with compressor

manufacturers regarding the MIA. We focused exclusively on whether they expected new efficiency

standards to place them at a particular competitive advantage or disadvantage.

The information we gathered from the interviews helped us adapt the GRIM to reflect the

realities of the residential unitary industry as well as to provide qualitative assessment of topics that

we cannot represent adequately in the GRIM.

8.3.2 Overview of the GRIM

The basic structure of the GRIM, illustrated in Figure 8.2, is a standard annual cash flow

analysis that uses manufacturer price, manufacturing costs, shipments and industry financial

information as an input, and accepts a set of regulatory conditions as changes in costs, investments

and associated margins. 

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Price

Quantity

Manufacturing

Financial

Cash

GRIM

Figure 8.2 Using the GRIM to Conduct the Cash Flow Analysis

The GRIM spreadsheet uses a number of inputs to arrive at a series of annual cash flows,

beginning from the base year of the analysis and continuing explicitly for ten years after the

implementation of the standard. The measure of industry net present value (INPV) is calculated by

summing the stream of annual discounted cash flows and adding the discounted value of the industry

at the end of the ten-year period (see Section 8.4.4.).

The GRIM calculates cash flows by year using standard accounting principles, and then

determines the present value of net cash flows, both without regulations (Base Case) and with

regulations (Standard Case), using a discount rate based on the industry’s weighted average cost of

capital. For the purpose of this analysis, the Base Case scenario represents the business scenario in

the absence of a new standard. In case a new standard comes into effect, it will change the product

mix and the associated prices, costs, and shipments. Such a scenario is called the Standard Case

scenario. The difference in INPV between the two scenarios becomes the financial impact of the new

standard under consideration.

8.3.3 Financial Parameters

Table 8.3 provides financial parameters for five public companies engaged in the

manufacturer and sale of unitary air conditioners averaged over a five year period (1994-1998). The

values used in the GRIM are generally the average of those results as weighted by the product of

each manufacturer’s corporate revenues and unitary market share. Companies generally confirmed

that these values are applicable for the analysis of their residential unitary business lines.

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Parameter

Industry

Weighted

Average

Manufacturer

ABCDE

Tax Rate

(% of taxable income)

45.4% 84.8% -- 39.4% 33.6% 33.3%

Working Capital

(% of revenues)

9.4% -4.0% 18.0% 22.0% 8.0% 15.0%

SG&A

(% of revenues)

16.1% 16.4% 15.1% 19.8% 16.5% 14.1%

R&D 

(% of revenues)

2.6% 2.7% 0.5% 0.9% 4.6% 0.9%

Depreciation

(% of revenues)

2.6% 2.1% 2.4% 2.1% 3.6% 1.5%

Capital Expenditures (%

of revenues)

2.9% 3.5% 2.5% 2.0% 3.4% 1.8%

Net Property, Plant, and

Equipment

(% of revenues)

15.0% 18.0% 5.0% 16.0% 18.0% 11.0%

Source: SEC 10-K Reports, Fiscal Years 1994-1998 

Table 8.3 GRIM Financial Parameters Based on 1994-1998 Weighted Company

Financial Data

8.3.4 Corporate Discount Rate

We assumed that the discount rate for use in calculating the INPV is equal to the weighted

average cost of capital (WACC) for the industry. A company’s assets are financed by a combination

of debt and equity. The WACC is the total cost of debt and equity weighted by their respective

proportions.

For the cost of debt, Moody’s Investor Services provided us with the average spread of

corporate bonds for each of the five public manufacturers over the 30 year T-Bill from 1990-1998.

We then added the industry weighted average spread to the average T-Bill yield over the same

period. Since we assume that proceeds from debt issuance are tax deductible, we reduced that gross

cost of debt by the industry average tax rate to determine a net cost of debt for the industry of 5.7

percent. Table 8.4 presents the derivation of the cost of debt.

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Parameter

Industry

Weighted

Average

Manufacturer

ABCDE

(1) Spread over 30

year T-Bill (%)

3.2% 5.5% 9.8% 3.7% 1.5% 2.1%

(2) Yield on 30 year TBill (1990-1998)

7.2% 7.2% 7.2% 7.2% 7.2% 7.2%

(3) Gross cost of debt

(1+2)

10.4% 12.7% 17.0% 10.9% 8.7% 9.3%

(4) Tax Rate 45.4% 85.0% -- 39.0% 34.0% 33.0%

Net Cost of Debt

(3*(1-4))

5.7% 1.9% -- 6.7% 5.8% 6.3%

Source: SEC 10-K Reports, Fiscal Years 1994-1998 

Table 8.4 Cost of Debt Calculation

The cost of equity is the rate of return that equity investors (including, potentially, the company)

expect to earn on a company’s stock. These expectations are reflected in the market price of the

company’s stock. The capital asset pricing model (CAPM) provides one widely used means to

estimate the cost of equity.

According to the CAPM, the cost of equity (expected return) is:

Cost of equity = riskless rate of return + beta * risk premium

where:

Riskless rate is the rate of return on a “safe” benchmark investment, typically considered the short

term T-Bill yield.

Risk premium is the difference between the expected return on stocks and the riskless rate

Beta is the correlation between the movement in the price of the stock and that of the broader

market. In this case, the Beta equals 1 if the stock is perfectly correlated with the S&P 500 market

index. A Beta lower than 1 means the stock is less volatile than the market index.

We determined that the industry average cost of equity is 14.7 percent as calculated in Table 8.5.

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Parameter

Industry

Weighted

Average

Manufacturer

ABCDE

(1) Average Beta

(1994 - 1998)

1.07 0.87 0.88 0.67 1.37 0.83

(2) Yield on 10 year TBill (1990-1998)

6.8% 6.8% 6.8% 6.8% 6.8% 6.8%

(3) Risk premium of

10 year T-Bills over

short term government

bonds

1.1% 1.1% 1.1% 1.1% 1.1% 1.1%

(4) Risk-free rate of

return (2 - 3)

5.7% 5.7% 5.7% 5.7% 5.7% 5.7%

(5) Stock market risk

premium (1935 -

1998)

8.4% 8.4% 8.4% 8.4% 8.4% 8.4%

Cost of Equity

(4 + 1 * 5)

14.7% 13.0% 13.1% 11.3% 17.2% 12.7%

Source: SEC 10-K Reports, Fiscal Years 1994-1998 

Table 8.5 Cost of Equity Calculation

The WACC is then, 0.057 (cost of debt) * 0.59 (debt ratio) + 0.14 (cost of equity) * 0.41

(equity ratio), or 9.3 percent. Subtracting an inflation rate of 3.1 percent between 1990 and 1998, the

inflation adjusted WACC, and the corporate discount rate used in the GRIM, is 6.2 percent.

8.3.5 Shipments

We took the shipment projections directly from the National Energy Savings (NES) model’s

outputs (Chapter 6). They provided the shipments (in units sold annually) of each product class at

efficiency levels 10 SEER through 18 SEER through 2030 under three different scenarios. The

scenarios were:

NAECA — a reproduction of the effects that the NAECA standard had on the industry

efficiency mix in 1992. This is the default scenario.

Shift — a translation of all products to the next highest efficiency level for each level

of increase in the standard. This is an optimistic scenario that assumes that

demand for a high efficiency product is a function of the differential between

its efficiency and the standard level.

Rollup — a translation of only those products below the new efficiency standard to the

new standard level. This is a pessimistic scenario that assumes that demand for

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a high efficiency product is a function of its price without regard for the

standard level.

Manufacturers uniformly agreed that the projected growth rates and the projected drop in

shipments in the year following the imposition of the new standard were reasonable. However, they

were divided on which product mix scenario would most likely occur. The consensus seemed to be

that customers do not, and will not, purchase products that fall within 20 percent (about 2 SEER

points) above the standard level because the energy savings are not enticing enough to cause them

to upgrade. Furthermore, manufacturers argue that there is a technological limit between 14 SEER

and 15 SEER, preventing the Shift scenario from occurring fully. Also, since prices escalate faster

than do energy savings as efficiency rises, consumers will look for an even larger SEER differential

in order to justify an upgrade. This reasoning implies that overall, manufacturers may believe that

the Shift scenario is likely to occur under an 11 SEER standard, but that the NAECA or Rollup

scenarios (or even a collapse of all sales to the new standard level) are the more probable scenarios

under a 12 SEER standard or above.

Since the efficiency scenario is an important determinant of manufacturer impact, Section

8.4.8 provides a more complete assessment of conditions that affect the likelihood of a particular

scenario actually occurring.

8.3.6 Production Costs

Changes in revenue and gross profit are driven by changes in production cost. As shown in

the Engineering Analysis, more efficient products cost more to produce. For the MIA, we adopted

the 10 SEER production costs resulting from the reverse engineering analysis. As we raised the

standard level, we calculated the production costs of the new baseline units as the product of the

10 SEER reverse engineering-based cost and the appropriate relative cost multiplier from either the

ARI Mean or reverse engineering sets of multipliers, depending on the scenario. To avoid doublecounting amortized investment cost, we lowered the ARI multipliers by an amount equal to our

estimated amortized investment, which is then reapplied elsewhere in the GRIM.

We also estimated the production cost of non-baseline (higher efficiency) equipment using

the same multipliers. For example, we estimated the cost of a 12 SEER unit today as the product of

the 10 SEER reverse-engineering cost and either the 12 SEER ARI or reverse engineering multiplier

for 12 SEER.

Besides the total unit production cost, the GRIM requires the proportion of costs devoted to

labor, materials, and overhead. Again, we used reverse engineering results to derive those fractions.

To avoid double-counting, the costs do not include outbound freight charges or depreciation. (We

assume that any changes in outbound freight are captured in ARI’s relative cost multipliers, and the

GRIM models changes in depreciation.) The GRIM assigns outbound freight to SG&A and

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Efficiency Level

(SEER)

Split Air

Conditioner

Packaged Air

Conditioner

Split Heat Pump Packaged Heat

Pump

10 SEER Cost $369 $445 $520 $526

Materials 85% 79% 81% 81%

Labor 7% 7% 7% 7%

Overhead 8% 14% 12% 12%

Note: Unlike the table presented in the NOPR, GRIM costs do not include outbound freight or depreciation, which

are included in the GRIM’s manufacturer markup.

Table 8.6 Production Costs Used in the GRIM Analysis

depreciation to its own line item. This means that the costs appear lower than those resulting from

reverse engineering, which included outbound freight charges and depreciation. However, since the

markups are also different, the prices to the distributor are comparable.

For split air conditioners, we combined units with fancoils and units with cased coils by

taking the arithmetic average of the two costs.

Tables 4.7 and 8.6 provide the production cost assumptions we used in the GRIM.

8.3.7 Markups

To derive the price of the equipment sold, we developed markups that the GRIM applies to

the production costs resulting from Tables 8.6 and 4.7. We assumed the markups were the same

across product classes, but not necessarily the same across efficiency levels. We then adjusted the

markups until the GRIM produced a base case operating profit of 6 percent, equal to the industry

average.

We confirmed during our interviews that a company’s markups reflect its pricing strategy.

Some companies said their markups were the same across all residential products, some said they

were the same within a product line, and some said they increased with efficiency. Since the markup

issue is among the most important determinants of the impacts of a new standard on a company’s

finances, we modeled two types of companies (Section 8.1.3.1). The first type prices equipment

similarly across efficiency levels and brands. Manufacturers in this group typically have below

average operating costs. Markups for this group stay “flat” as efficiency increases. The second type

prices baseline equipment aggressively, but applies larger markups to premium and higher efficiency

products. Manufacturers in this group typically have higher operating costs than the first group.

Markups for this group are “linearly increasing” as efficiency increases. We will discuss this concept

more in Section 8.4.3.

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Efficiency

Level

Lower

Operating Cost

Manufacturers

Higher

Operating Cost

Manufacturers

Base 1.31 1.36

Base + 1 1.31 1.43

Base + 2 1.31 1.50

Base + 3 1.31 1.57

Base + 4 1.31 1.65

Base + 5 1.31 1.74

Table 8.7 Manufacturer Markups Used in

the GRIM

Table 8.7 presents the markups for the two groups. The markups for the higher operating cost

group are relative to the baseline at the time. For example, under the current 10 SEER standard, the

markup on a 12 SEER would be “Base + 2", or 1.50. If the standard were to increase to 11 SEER,

the markup at 11 SEER would become the new “Base”, or 1.36, and the markup at 12 SEER would

become “Base +1", or 1.43.

Differences between the GRIM and Engineering Analysis explain the apparent differences

in markups on baseline equipment (the manufacturer markup in the Engineering Analysis is 1.23–see

Section 4.3.2). The GRIM markups include the 6 percent freight and 2.6 percent depreciation that

were included in reverse engineering production costs rather than in the Engineering Analysis

markups, and 4 percent higher operating profit margins. Also, the GRIM does not provide for

interest expenses, so Earnings Before Taxes (EBT) and Earnings Before Interest and Taxes (EBIT)

are indistinguishable. Thus, it is not possible to calibrate the GRIM exactly using corporate financial

statements which do include interest expense. Since the Engineering and MIA analyses address

separate issues, slight discrepancies between the two markups are not of concern.

We experimented with lowering the markups as the standard level increased to represent a

situation where pricing pressure prevents manufacturers from reestablishing their markups under

new standards. However, we found that doing so in a way that maintained their operating profit

margins made little difference to the overall conclusions.

8.3.8 Conversion Costs

Table 8.8 provides the capital and non-capital expenses used in the GRIM at each efficiency

level. One of our major objectives during the manufacturer interviews was to determine the level

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Standard

Level (SEER)

Split Air

Conditioner

Packaged Air

Conditioner

Split Heat

Pump

Packaged

Heat Pump

Total

Capital

11 $11 $8 $8 $7 $34

12 $54 $14 $23 $10 $101

13 $99 $21 $38 $12 $171

Non-Capital

11 $15 $15 $15 $15 $61

12 $31 $30 $31 $30 $121

13 $46 $45 $46 $45 $182

Total

11 $26 $23 $23 $22 $95

12 $85 $44 $54 $40 $222

13 $145 $66 $84 $57 $353

Table 8.8 Summary of Industry-wide Conversion Cost Assumptions used in the

GRIM ($ million)

and types of investment the companies expected to incur to comply with a new efficiency standard.

The major costs they identified were those associated with capacity and warehouse expansion and

development and testing.

Although the shipment projections call for sales volumes to decrease after a new standard

is promulgated, manufacturers contend that as efficiency increases, the size of the products and the

time required to fabricate and assemble them also increase. The Engineering Analysis concurs with

their assessment. Since manufacturing capacity in the industry is currently strained, a standardinduced drop in throughput will result in a shortage unless manufacturers add capacity.

From a development and testing standpoint, most manufacturers employ engineers and

testing personnel on staff and maintain their own testing facilities. However, inadequate testing

facilities represent a bottleneck in the product development cycle for many firms. In order to develop

products to comply with a new standard, manufacturers will have to dedicate their design staffs and

testing facilities almost exclusively to the new products, leaving few remaining resources to conduct

their ordinary product development and testing efforts. Furthermore, since all new products must be

tested rigorously before certification, the costs of testing mount up quickly. This burden increases

as the standard level rises, since more products are affected and more substantial design alterations

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are required.

The GRIM treats capital investments differently from non-capital investments. Capital

investments include modifications or additions to plant, property, and equipment that increase its

useful life. Capacity increases and new tooling are capital expenditures, which the GRIM amortizes

over a five year period. Non-capital expenses, such as marketing and R&D, are expensed in the year

in which they are incurred. The following two sections explain in more detail the derivation of the

assumptions presented in Table 8.8.

8.3.8.1 Capital Expenditures

Manufacturers provided us with information during the manufacturer interviews that allowed

us to estimate the capital expenditures associated with new efficiency standards. They include

additions to plant capacity and warehouse space. We derived estimates for a typical company holding

a 14 percent market share. 

Since higher efficiency products are larger and heavier than today’s 10 SEER equipment,

each unit takes slightly longer to produce. Coils and cabinets are larger, requiring longer fabrication,

assembly, and charging times. The density of units on the assembly line is lower, reducing the

throughput in the processes that require a minimum residence time per unit such as painting and leak

testing. Handling the more cumbersome equipment takes additional care. Due to the recent surge in

air conditioner sales, most manufacturers face some sort of capacity constraint which more stringent

efficiency standards will exacerbate. In order to continue to satisfy demand, we assumed that new

standards would trigger manufacturers to improve productivity or add capacity to recuperate their

lost production capacity.

The model used to estimate production costs in the reverse engineering analysis also

estimates product cycle times. According to the model, cycle times will increase 0 percent under an

11 SEER standard, 2 percent under a 12 SEER standard, and 7 percent under a 13 SEER standard.

Below 12 SEER, we would not expect standards to prompt manufacturers to invest in capacity. At

12 SEER and 13 SEER, however, we estimate each manufacturer will spend $6 million and $14.5

million to upgrade capacity, respectively. These expenditures are equivalent to 50 percent and 125

percent of the annual ordinary capital expenditures incurred by a typical firm, according to the

GRIM. These sums would include costs associated with the purchase and installation of new

equipment, including modifications or additions to the existing plant. 

Larger equipment not only implies reduced production capacity, it implies reduced warehouse

capacity. Since manufacturers must store the incoming and outgoing materials and equipment, any

increase in the volume of components or the size of the assembled equipment will require more

storage space. We assumed that manufacturers face warehouse storage constraints that they cannot

mitigate by reducing the number of units in inventory. Therefore, new standards that increase the size

of the product will result directly in a need for new warehouse floorspace.

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Standard Level

(SEER)

Capacity

Additions

Warehouse

Additions

New Tooling Total

Capital Expenditures per Company

11 $0.0 $0.9 $4.0 $4.9

12 $6.0 $4.4 $4.0 $14.4

13 $14.5 $6.0 $4.0 $24.5

Resulting Capital Expenditures for the Industry (seven companies)0

11 $0 $6 $28 $34

12 $42 $31 $28 $101

13 $102 $42 $28 $172

Table 8.9 Capital Expenditures used in the GRIM (million 1999$)

The reverse engineering analysis provides information on equipment cabinet sizes for each

efficiency level. The increase in size for 11 SEER, 12 SEER, and 13 SEER condensing units and

cased coils is 0.8 cu. ft., 7.7 cu. ft. and 12.1 cu. ft., respectively. We then assumed that the extra

floorspace required to store each unit equals the extra volume of the unit raised to the two-thirds

power. That yields additional floorspace requirements of 0.9 sq. ft., 3.9 sq. ft., and 5.3 sq. ft.,

respectively. This method should accurately estimate new floorspace requirements if the height of

a stack of units in the warehouse remains fixed. Finally, we assumed that warehouses are sized to

accommodate an inventory of 12,000 units (one-tenth the annual production of 120,000 units used

in the GRIM) and that new warehouse floorspace costs $100 per square foot to construct and

integrate with existing facilities.

New tooling is also a capital expenditure. We assumed that new tooling would cost $500,000

per product family, regardless of the standard level. The implicit assumption is that any new standard

will result in the need for new tooling. We assume that a typical firm possesses two product families

in each product class.

Table 8.9 summarizes the capital expenditure assumptions.

Finally, in order to fit capital expenditures into the GRIM framework, we allocated the totals

to each product class based on the fraction of sales volume attributable to that class. Table 8.10

illustrates those breakdowns by product class.

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Standard

Level (SEER)

Split Air

Conditioner

Packaged Air

Conditioner

Split Heat

Pump

Packaged

Heat Pump

Total

Fraction of

Sales Volume

65% 10% 22% 4% 100%

11 $11 $8 $8 $7 $34

12 $54 $14 $23 $10 $101

13 $99 $21 $38 $12 $171

Note: Differences in Totals from those in Table 8.9 are due to rounding.

Table 8.10 Industry-wide Capital Expenditures by Product Class used in the GRIM

(million 1999$)

8.3.8.2 Non-capital Expenditures

Non-capital expenditures such as product development, testing, and marketing depend on the

number of a company’s products that are affected by the new standard. We assumed that a typical

company’s product offering consists of two product families in each product class, that each split

system family consists of three product lines, and that each packaged family consists of two product

lines. That results in a total of eight product families and 20 product lines that could be affected by

a new standard for a typical major manufacturer.

Based on input we received during the interviews, we considered the testing, development,

and marketing expenditures related to a new standard. We assumed that testing and development

expenses scale with the number of product families affected and marketing expenses scale with the

number of product lines affected, and that they also increase linearly with an increase in standard

level. Table 8.11 provides our assumptions regarding non-capital expenditures.

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Category Split Air

Conditioner

Packaged

Air

Conditioner

Split Heat

Pump

Packaged

Heat Pump

Total

Product Family Expenses

(1) Number of Product

Families

22228

(2) Testing Expense per

Family ($ thousand)

$333

(3) Development

Expense per Family

($ thousand)

$667

(4) Total Testing and

Development Expenses

(1) x (2+3)

($ million)

$2.0 $2.0 $2.0 $2.0 $8.0

Product Line Expenses

(5) Number of Product

Lines per Family

3 2 3 2 n/a

(6) Number of Product

Lines

6 4 6 4 20

(7) Marketing Expenses

per Product Line

($ thousand)

$33

(8) Total Marketing

Expenses

(5 x 6 x 7)

($ million)

$0.2 $0.1 $0.2 $0.1 $0.7

(9) Total Non-Capital

Expenses per Firm

(4 + 8), ($ million)

$2.2 $2.1 $2.2 $2.1 $8.7

Total Industry NonCapital Expenses

(9 x 7 firms),

($ million)

$15.4 $14.9 $15.4 $14.9 $60.6

Table 8.11 Non-capital Expenses used in the GRIM

8.4 INDUSTRY FINANCIAL IMPACTS

Using the GRIM inputs and assumptions described in the previous chapter, the GRIM

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produced indicators of financial impacts on the residential unitary equipment manufacturing

industry. We are reporting three of these:

` Net Present Value

` Return on Invested Capital

` Annual Cash Flow

8.4.1 Scenarios

The GRIM results depend strongly the mix of product efficiencies assumed under new

standard levels. There are three efficiency scenarios as described in 8.3.5:

1) NAECA

2) Shift

3) Rollup

In addition to the scenarios that describe efficiency mix, there are two scenarios that describe

production costs:

1) ARI manufacturing cost — a set of production cost estimates based on the product of the

mean relative production cost multipliers provided to the DOE by ARI and the costs

for 10 SEER equipment estimated by reverse engineering. This is the default

scenario.

2) Reverse engineering cost — a set of production cost estimates based on reverse

engineering analysis. This scenario was evaluated only in conjunction with the

NAECA shipment scenario to isolate the effects of the cost assumptions on the

results.

Finally, there are two scenarios that describe the life of the product. Product lifetime has a

direct impact on the shipment projections provided to the GRIM:

1) 18 year lifetime — assumes an 18.4 year product life with a compressor replacement at

14 years. This is the default assumption.

2) 14 year lifetime — assumes a 14 year lifetime based on anecdotal evidence and comments

of various industry members and groups. This scenario was evaluated only in

conjunction with the NAECA shipment and ARI manufacturing cost scenarios to

isolate the effects of the product lifetime assumption on the results.

In summary, we estimated the impacts on the industry under five combinations of scenarios

as shown in Table 8.12:

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Table 8.12 Scenarios Evaluated in the MIA

Efficiency Scenario Production Cost Scenario Product Life

Scenario

1. NAECA ARI 18 years

2. SHIFT ARI 18 years

3. ROLLUP ARI 18 years

4. NAECA Reverse Engineering 18 years

5. NAECA ARI 14 years

The first three scenarios express the range of possible outcomes using the ARI Mean cost

multipliers and 18 year lifetime assumptions. The likelihood of each scenario developing depends

on market conditions, access to new technologies, and the standard level set. We explore this further

in Section 8.4.8.

The last two scenarios evaluate the implications of using the reverse engineering relative

costs or a 14 year product life instead of the ARI Mean relative costs and 18 year product life.

8.4.2 Trial Standard Levels

We evaluated industry impacts at each of four Trial Standard Levels (TSLs). The four we

evaluated are shown in Table 8.13:

Table 8.13 SEER Requirements for Product Classes in the Trial Standard Levels

Evaluated in the MIA

Trial Standard

Level

Split Air

Conditioners

Packaged Air

Conditioners

Split Heat

Pumps

Packaged Heat

Pumps

1 11 11 11 11

2 12 12 12 12

3 12 12 13 13

4 13 13 13 13

The Department also considered a TSL 5 to include the Max Tech level of 18 SEER for all

classes. We did not evaluate TSL 5 in the MIA since consumer impacts rendered it economically

unjustified prior to the start of the MIA.

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8.4.3 Manufacturer Subgroups

As we introduced in Section 8.1.3.1, the interviews revealed that manufacturers use different

pricing strategies and place different levels of emphasis on the sale of higher efficiency products.

Manufacturers fall into two basic groups in this regard. The first group targets price-sensitive

consumers such as builders and price-sensitive consumers and attempts to keep operating costs, such

as sales and marketing, research and development, and dealer support as low as they can sustain.

They also reduce the number of product variations and features. This approach to market limits the

ability and desire of this group to sell premium equipment and equipment above the minimum

efficiency level. Because they have a cost advantage over their competitors, these manufacturers can

establish a higher operating profit margin on their baseline equipment and still maintain a price

advantage. They then apply a fairly consistent gross margin across efficiency levels. We use the

phrase “lower operating cost” manufacturers to describe this group.

The other group, the “higher operating cost”, manufacturers typically place more of an

emphasis on product differentiation than cost leadership. Achieving successful differentiation often

requires a combination of marketing, service, research, and product development that exceeds that

of the lower operating cost manufacturers. Faced with stiff price competition from the lower

operating cost manufacturers in price-sensitive markets, the higher operating cost manufacturers are

forced to reduce their price (and gross margin) on their baseline equipment to the minimum level

sustainable. They then target less price sensitive customers by offering products with premium

features and higher efficiency. These products carry higher gross margins.

Since higher efficiency standards will affect each group of manufacturers differently, we set

up two versions of the GRIM to model each group independently. In the first group, to represent the

lower operating cost manufacturers, we slightly reduced the operating expense ratio and research and

development expense ratio below the industry averages. We also assumed that a single gross margin

applies to products across all efficiency levels. In the second group, to model higher operating cost

manufacturers, we raised operating and R&D expense ratios above the industry average. We then

assume that gross margins increase roughly linearly as the efficiency level increases. This represents

two effects: selling a greater fraction of higher margin premium product as efficiency level rises, and

being able to secure a higher margin on product simply by virtue of its higher efficiency.

To represent the industry in aggregate, we combined the results of the two GRIM versions,

giving 25 percent weight to the results of the lower-operating-cost group and 75 percent weight to

the results of the higher-operating-cost group. This ratio reflects the prevalence of each strategy in

the marketplace. Many companies pursue both strategies simultaneously through different brands

and divisions.

Section 8.5.1 discusses the differences in the two GRIMs in more detail.

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8.4.4 Impacts on Industry Net Present Value (INPV)

INPV is an important indicator of the value of the entire industry. It is not to be confused

with the Department’s NPV applied to the whole U.S. economy. By comparing the base case (no

new efficiency standard) to each standard case, we can isolate the effects that a new standard is likely

to have on the industry’s value. INPV is calculated as the sum of all discounted net cash flows

between 2000 and 2016 (ten years after the new standard would become effective) plus the

discounted terminal value of the industry in 2016. The value of the industry in 2016 is simply the

net cash flow in that year divided by the discount rate. If net cash flow drops either due to a drop in

net income or an increase in depreciation or capital investment, INPV will also drop.

Tables 8.14 through 8.16 provide the net present value estimates for the industry. These

results supercede any others previously published.

Table 8.14 Changes in Industry Net Present Value — Industry Relative Cost, 18 Year Life,

NAECA Efficiency

Trial

Standard

Level

Net Present

Value

($ million)

Change in NPV from Base

Case

$ million %

Base $ 1,603 -- --

1 $ 1,566 $ (37) -2%

2 $ 1,417 $ (186) -12%

3 $ 1,406 $ (197) -12%

4 $ 1,420 $ (183) -11%

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Table 8.15 Changes in Industry Net Present Value — Industry Relative Cost, 18 Year Life,

Roll-up Efficiency

Trial

Standard

Level

Net Present

Value

($ million)

Change in NPV from Base

Case

$ million %

Base $ 1,603 -- --

1 $ 1,422 $ (181) -11%

2 $ 1,241 $ (362) -23%

3 $ 1,236 $ (367) -23%

4 $ 1,268 $ (335) -21%

Table 8.16 Changes in Industry Net Present Value — Industry Relative Cost, 18 Year Life,

Shift Efficiency Mix

Trial

Standard

Level

Net Present

Value

($ million)

Change in NPV from Base

Case

$ million %

Base $ 1,603 -- --

1 $ 1,740 $ 137 9%

2 $ 1,825 $ 222 14%

3 $ 1,854 $ 251 16%

4 $ 1,914 $ 311 19%

The NAECA and Roll-up scenarios reduce industry NPV compared to the Shift scenario.

This result occurs because we assume the higher-operating cost manufacturers accrue much of their

profits from the sale of higher efficiency equipment. As the standard level increases, they earn lower

profit margins on that equipment. The loss in profits can be offset by the combination of more sales

and more expensive equipment.

The Shift scenario provides a much more favorable projection of high-efficiency equipment

sales than do the NAECA and Roll-up scenarios. The Roll-up scenario, whereby a new standard does

not increase the shipments of equipment that exceed the minimum efficiency level, is the worst case

of the three. The slight differences in shipments between the Roll-up and the NAECA scenarios are

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enough to double the loss of industry value. Later, we will discuss which scenarios we believe will

dominate at each Trial Standard Level. 

Notice that there is little difference between INPV effects between TSLs 2, 3, and 4 under

the NAECA and Roll-up scenarios. Since most shipments occur at 10 SEER and 12 SEER, there is

little negative effect on higher-operating-cost firms in moving to an 11 SEER standard (TSL 1). The

large impact occurs at 12 SEER (TSL 2), when the profit margin on 12 SEER is squeezed. Once that

impact is felt, there is little incremental impact in moving to the higher standard levels for a given

efficiency scenario. However, we believe that the Roll-up efficiency scenario becomes increasingly

likely under TSL3 and TSL4 as explained further in Section 8.4.8.

Tables 8.17 through 8.18 present the results for the 14 year life assumption and the Reverse

Engineering Relative Cost scenario, both applied to the NAECA Efficiency Mix scenario. 

Table 8.17 Changes in Industry Net Present Value — Industry Relative Cost, 14 Year Life,

NAECA Efficiency Mix

Trial

Standard

Level

Net Present

Value

($ million)

Change in NPV from Base

Case

$ million %

Base $ 1,726 -- --

1 $ 1,701 $ (25) -1%

2 $ 1,558 $ (168) -10%

3 $ 1,555 $ (171) -10%

4 $ 1,598 $ (128) -7%

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Table 8.18 Changes in Industry Net Present Value — Reverse Engineering Relative Cost,

18 Year Life, NAECA Efficiency Mix

Trial

Standard

Level

Net Present

Value

($ million)

Change in NPV from Base

Case

$ million %

Base $ 1,539 -- --

1 $ 1,509 $ (30) -2%

2 $ 1,380 $ (159) -10%

3 $ 1,368 $ (171) -11%

4 $ 1,370 $ (169) -11%

The Reverse Engineering and 14-year Life scenarios have little impact on the percent change

in INPV compared to the Industry Mean and 18-year Life assumptions, the results of which are

presented in Table 8.14. This means that cost and lifetime considerations are relatively unimportant

compared to the assumptions regarding efficiency mix. These two sets of scenarios are not

considered further in the MIA.

8.4.5 Impacts on Return on Invested Capital (ROIC)

ROIC is a measure of the effectiveness of capital employed. ROIC is calculated as net income

divided by net operating capital. Therefore, a rise in employed capital without a corresponding rise

in net income will cause ROIC to drop. A low ROIC can prompt a company to deploy those assets

in a more profitable business, or to liquidate them altogether. Unless a significant change in finances

occurs, ROIC changes little from year to year. Therefore, we report only the ROIC in 2011, five

years after a new standard would become effective.

Table 8.19 presents the 2011 ROIC results for the industry for each of the three efficiency

scenarios using the 18 year lifetime and ARI Mean cost assumptions.

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Table 8.19 Impacts on Industry’s Return on Invested Capital in 2011

Trial

Standard

Level

NAECA Roll-up Shift

Return on

Invested

Capital

(ROIC)

Change in

ROIC

from Base

Return on

Invested

Capital

(ROIC)

Change in

ROIC

from Base

Return on

Invested

Capital

(ROIC)

Change in

ROIC

from Base

Base 13.3% -- 13.3% -- 13.3% --

1 12.6% -5% 11.3% -15% 14.1% 6%

2 10.9% -18% 9.5% -29% 14.0% 5%

3 10.8% -19% 9.5% -29% 14.1% 6%

4 10.5% -21% 9.5% -29% 13.9% 5%

As is the case with INPV results, there is little change in the ROIC results above TSL 2

within each scenario. 

8.4.6 Impacts on Annual Cash Flow

While NPV and ROIC are most useful for evaluating the long-term effects of new standards,

short-term changes in cash flow are also important indicators of the industry’s financial situation.

For example, a large investment over a period of one or two years could strain the industry’s access

to capital, or a sharp drop in performance could cause investors to flee, even though recovery may

be near. Thus, a short-term disturbance can have long-term effects that the GRIM cannot capture.

To get an idea of the volatility of annual net cash flows, we report the annual undiscounted cash flow

series from 2000 through 2016.

Figures 8.3 through 8.5 present the annual net cash flows for the base case and each of the

three efficiency scenarios using the 18 year lifetime and ARI Mean cost assumptions.

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Figure 8.3 Industry Net Cash Flow -- Shift Efficiency Scenario

Figure 8.4 Industry Net Cash Flow -- NAECA Efficiency Scenario

 

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Figure 8.5 Industry Net Cash Flow -- Roll-up Efficiency Scenario

Prior to the effective date, the cash flows are nearly identical for all three scenarios. They are

driven by the level of capital and product conversion investment assumed and factors which describe

our assumptions of the proportion of those investments spent each year. In the year the standard

becomes effective (2006) some residual product conversion expense occurs and there is a one-time

dip due to the requirement for more working capital in that year.

The scenarios differ substantially in the years following the effective date. Compared to the

base case, the Shift scenario net cash flow results are higher, the Roll-up scenario results are lower,

and the NAECA scenario results are similar. Thus, under the NAECA scenario, the level of

investment required explains most of the projected loss in INPV. Under the Roll-up scenario, INPV

is negatively impacted by the unrecovered investment as well as the lower net cash flows that result

from stagnant shipments of higher efficiency, premium equipment. Under the Shift scenario,

manufacturers are more than able to recover their investments.

8.4.7 Impacts by Efficiency Level

The previous sections have illustrated the important role that the efficiency mix assumptions

play in the financial projections. This section examines the other main factor, which is the

contribution of products in each efficiency level to industry profits.

We have already described the dynamics by which the profits of manufacturers with higher

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Figure 8.6 Contribution of Products at Each Efficiency Level to Industry Profits

(EBIT) under Trial Standards – NAECA Efficiency Scenario

operating costs depend on the sale of premium products, and how those products are differentiable

only at efficiency levels higher than the baseline. In the GRIM, we model this effect as gross margins

that increase linearly with efficiency level. Linearly increasing gross margins produce exponentially

increasing profit margins (EBIT) that drive net cash flow. The relationship between efficiency level

and profits is tempered somewhat by the presence of the lower-operating cost manufacturers. We

assume that their gross margins and profit margins do not change as the efficiency level increases.

Figures 8.6 through 8.8 illustrate for each efficiency scenario how the industry’s collective

EBIT, as projected in 2011, depends on the sale of products at each efficiency level.

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Figure 8.7 Contribution of Products at Each Efficiency Level to Industry Profits

(EBIT) under Trial Standards – Roll-up Efficiency Scenario

Figure 8.8 Contribution of Products at Each Efficiency Level to Industry Profits

(EBIT) under Trial Standards – Shift Efficiency Scenario

The base case for all three scenarios is identical. Ten SEER products contribute only about

50 percent of the industry’s EBIT, even though they comprise 76 percent of the units sold. Eleven

and 12 SEER products contribute another 38 percent of EBIT. Since those levels comprise only 21

percent of units sold, this reveals the importance of the 12 SEER level to industry finances. Overall,

the lowest three efficiency levels contribute 88 percent to EBIT, and the rest contribute12 percent.

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As the efficiency scenarios project different shipments, they alter the relative contribution

of each level of product to EBIT. For example, in the Roll-up scenario, the EBIT contribution of

products at 14 SEER and above drops from 5 percent in the base case to 2 percent at TSL4.

Meanwhile, the contribution of the minimum efficiency product grows from 50 percent in the base

case (10 SEER) to 97 percent at TSL4 (13 SEER). This means that under the Roll-up scenario

manufacturers are increasingly dependent on their baseline product to generate profits. Since the

baseline air conditioner is a low margin, price sensitive product, the Roll-up scenario describes a

transition to a commodity-driven industry.

The Shift scenario describes the opposite phenomenon. Here, manufacturers are able to sell

seemingly as much high efficiency equipment as they desire. The EBIT contribution of baseline

equipment stays fairly constant, and actually drops to around 45 percent under TSL4. At the same

time, the EBIT contribution of equipment 14 SEER and above grows from 5 percent to 55 percent.

The Shift scenario describes a transition to an efficiency-driven industry.

The NAECA scenario displays characteristics of both the Roll-up and Shift scenarios, but

bears a closer resemblance to Roll-up. Still, the EBIT analysis magnifies the slight differences

between the NAECA and Roll-up scenarios in units sold. Under the NAECA scenario, the EBIT

contribution of the baseline products grow only to 81 percent under TSL4 (versus 97 percent under

the Roll-up scenario) and the contribution of products 14 SEER and above grows to 19 percent under

TSL4 (versus 3 percent under the Roll-up scenario).

8.4.8 Efficiency Scenario Assessment

Since the GRIM results are so strongly tied to the selection of efficiency scenario, it is

important to consider the likelihood of any of the scenarios actually occurring, and what conditions

would tend to promote one over another.

The closer the baseline unit is to the technological limit the fewer consumers will “buy up”

to a higher efficiency. For more and more consumers, the baseline will be the cost-effective option,

and those consumers who wish to “buy up” will have fewer options and less financial incentive to

do so. We can examine this situation by examining the payback periods resulting from a consumer’s

decision to “buy up” in efficiency. Today, for instance, a large fraction of consumers are willing to

purchase 12 SEER equipment. According to the definition of SEER, this 2 SEER boost over the

baseline 10 SEER results in a 16.7 percent decrease in energy consumption for the average user (1-

10/12), who would assume that would translate into a 16.7 percent savings in annual operating costs.

Thus, the theory is that, for whatever reason, some consumers are willing to pay the 12 SEER

product’s premium in order to obtain the 16.7 percent savings in operating cost. Assuming a 10

SEER production cost of $893 and a 47.4 percent price premium of a 12 SEER over a 10 SEER

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1 Relative production cost multipliers are intended to represent the costs of baseline equipment under new

standards only. Using them as a proxy for estimating the cost of producing more efficient equipment under a lower

standard level yields only approximate results. On one hand, the method underestimates those costs by including

production efficiencies gained under high volume baseline production. On the other hand, it tends to overestimate those

costs by including amortized conversion costs. The subtlety has little effect on the results of the GRIM analysis.

8-36

(based on the Industry Mean relative production cost multipliers1, a 25 percent/75 percent blend of

lower/higher operating cost manufacturer markups presented in Table 8.7, and the distribution

markups presented in Table D.1), and an annual operating cost of $250, that translates into a 10.1

year simple payback. (0.474*893/0.167*250 = 10.1). Table 8.20 provides the same calculations for

the other SEER levels available.

Table 8.20 Consumer Payback for Efficiency Upgrades of Split Air Conditioners Under a

10 SEER Standard using Industry Mean Relative Costs and a “Flat” Markup

Efficiency

(SEER)

Energy

Savings

versus

10 SEER

Price

Premium

versus

10 SEER

Simple

Payback

(years)

10 -- -- --

11 9% 21% 8.1

12 17% 47% 10.1

13 23% 82% 12.7

14 29% 136% 17.0

15 33% 185% 19.9

Table 8.21 provides the simple payback calculations for products under new standard levels

assuming the same Industry Mean production cost multipliers.

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Table 8.21 Consumer Payback (years) for Efficiency Upgrades of Split Air Conditioners

Under a New Standard Levels using Industry Mean Relative Costs

Equipment

Efficiency

(SEER)

Standard Level (SEER)

10 11 12 13 14

10 -- -- -- -- --

11 8.1 -- -- -- --

12 10.1 11.6 -- -- --

13 12.7 15.0 17.7 -- --

14 17.0 19.7 23.9 28.7 --

15 19.9 23.3 26.9 31.1 31.0

Payback periods for each additional SEER are longer at higher standard levels. This suggests

that under new standard levels, consumers will have less of a financial incentive to “buy up”

compared to consumers today.

Table 8.22 shows that the picture is similar using Reverse-Engineering-based relative

production costs. In that case, the payback to buy up 2 SEER points from 10 SEER is 8.1 years,

which again is not possible to find under standard levels higher than 10 SEER.

Table 8.22 Consumer Payback (years) for Efficiency Upgrades of Split Air Conditioners

Under a New Standard Levels using Reverse Engineering Costs

Equipment

Efficiency

(SEER)

Standard Level (SEER)

10 11 12 13 14

10 -- -- -- -- --

11 6.4 -- -- -- --

12 8.1 9.1 -- -- --

13 9.4 10.9 12.0 -- --

14 13.8 16.1 19.7 26.4 --

15 17.2 20.4 24.0 29.9 31.2

If we assume that consumers under new standards will “buy up” in the same proportion as

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they do today (the Shift scenario) only if they are able to achieve the same paybacks, it is clear that

new standards, by resulting in longer payback periods, reduce the possibility of the Shift scenario

occurring.

Of course, it would be possible to achieve those shorter payback periods if the price

differential between baseline products and higher efficiency products were to decrease under new

standards. For example, if under a 12 SEER standard the price of a 14 SEER product dropped 20

percent and the price of a 12 SEER product dropped 10 percent, more consumers would be willing

to purchase the 14 SEER product because of the shorter payback period. If the differential price

dropped low enough, the payback period between a 12 SEER and 14 SEER would equal today’s

payback period between a 10 SEER and 12 SEER product, and we could imagine that the same

number of consumers would buy-up to 14 SEER as do today to 12 SEER, bringing about the Shift

scenario. Table 8.23 shows the reduction in differential prices that would have to occur in order to

reproduce the simple paybacks offered under the current 10 SEER standard.

Table 8.23 Required Decrease in Split Air Conditioner Price Differentials Under New

Standard Levels to Reproduce the Consumer Paybacks Realized under the 10 SEER

Standard Level – Industry Mean Relative Production Costs

Equipment

Efficiency

(SEER)

Standard Level (SEER)

10 11 12 13 14

10 -- -- -- -- --

11 -- -- -- -- --

12 -- -30% -- -- --

13 -- -32% -54% -- --

14 -- -36% -58% -72% --

15 -- -27% -53% -67% -74%

Table 8.23 shows, for example, that under a 12 SEER standard, the price differential between

a 12 SEER unit and a 14 SEER unit would have to drop by 58 percent from our estimates in order

to offer the 10.1 year payback that consumers currently realize in a product that exceeds the current

baseline by 2 SEER. The required reductions are lower under an 11 SEER standard (27 to 36

percent) and higher under a 13 SEER standard (67 to 72 percent). 

Table 8.24 provides results of the same calculations using Reverse-Engineering relative

costs, which require comparable decreases in price differentials.

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Table 8.24 Required Decrease in Split Air Conditioner Price Differentials Under New

Standard Levels to Reproduce the Consumer Paybacks Realized under the 10 SEER

Standard Level – Reverse Engineering Mean Relative Production Costs

Equipment

Efficiency

(SEER)

Standard Level (SEER)

10 11 12 13 14

10 -- -- -- -- --

11 -- -- -- -- --

12 -- -30% -- -- --

13 -- -26% -46% -- --

14 -- -41% -59% -76% --

15 -- -32% -61% -73% -79%

It is highly unlikely that these reductions in differential prices could be realized in the

foreseeable future utilizing conventional technologies. Pricing pressure on baseline equipment would

be downward under new standards, tending to increase, not decrease, the differential. Furthermore,

any technological improvement that could reduce the price of higher efficiency equipment would

also be adopted in baseline equipment, tending to keep the differential constant. Manufacturers could

lower their markups on higher efficiency equipment to stimulate shipments, but that action could

reduce rather than increase total profits.

Emerging technologies do have the potential to reduce the price differentials (see

Section 4.5). Table 8.25 shows the maximum reduction in production cost differentials we would

expect if the emerging technology with the greatest potential impact, advanced modulating

compressors, were applied in split air conditioners with fancoils, using Reverse Engineering relative

cost multipliers. To the extent that cost reductions are passed on to consumers, the reduction in price

differentials would be similar.

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Table 8.25 Maximum Decrease in Split Air Conditioner (fancoil) Production Cost

Differentials Under New Standard Levels using Emerging Technologies

Equipment

Efficiency

(SEER)

Standard Level (SEER)

10 11 12 13 14

10 -- -- -- -- --

11 0% -- -- -- --

12 0% 0% -- -- --

13 -49% -58% -82% -- --

14 -45% -50% -65% -27% --

15 -47% -52% -65% -42% -65%

Note that the reductions in Table 8.25 exceed those shown in Table 8.24, indicating that it

may be possible to duplicate today’s consumer “buy up” payback periods for some products using

emerging technologies, thereby bringing about the Shift scenario for those products. The viability

of emerging technologies is far from certain, but more stringent efficiency regulations clearly provide

incentive for manufacturers to develop and deploy them in an attempt to induce the Shift scenario.

If, on the other hand, price differentials change according to an analysis based strictly on

conventional technologies, we would expect an outcome even more severe than the Roll-up scenario.

For example, in Table 8.22, the payback to move from a 10 SEER unit to a 13 SEER unit today is

9.4 years. Under a 12 SEER standard, however, the payback to move to a 13 SEER is 12 years. That

suggests that fewer consumers would purchase a 13 SEER unit under a 12 SEER standard than do

today under a 10 SEER standard. This “collapse” scenario is more pessimistic than the Roll-up

scenario which predicts that purchases of 13 SEER equipment would stay the same. Of course,

manufacturers, dealers, utilities, and government programs would attempt to maintain demand for

higher efficiency equipment, but a collapse scenario is certainly possible, particularly at the highest

standard levels where the payback periods become significantly longer.

Since the NAECA scenario is the only scenario based on historical observation, it is certainly

reasonable to consider it the one most likely to occur under increases in the standard level of a

similar magnitude as NAECA imposed (TSL1/TSL2). There are differences, however, between the

market today and that of 1987 when the NAECA standards were announced. At that time, 8 and 9

SEER products were being sold in fairly similar proportion (40 percent each), although 9 SEER

products were taking share rapidly from 8 SEER. Products over 10 SEER, which itself made up

15 percent of sales, were also gaining share. Thus, the unregulated market was in the midst of a

transition toward higher efficiency that had been underway for at least a decade. This transition was

influenced by a burst of activity in technological development that allowed air conditioner efficiency

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to increase with little change in production cost. Specifically, advances in compressor efficiency and

fin and coil design were underway. Sales volumes were increasing, companies were consolidating,

and new design and production technologies allowed manufacturers to reduce operating expenses,

product development cycle times, and production costs.

Since 1992, these technological advances have proceeded at a much slower pace. Compressor

efficiency has seen little improvement, and no new heat exchanger technologies have been

introduced in several years. Since the baseline 10 SEER product and the popular 12 SEER product

are approaching the practical limit on coil-only residential equipment efficiency of 14.5 SEER, the

cost of realizing further compressor and heat exchanger efficiency improvements is much higher,

and the potential financial return is much lower. In other words, today’s market faces a “cap” that

was in the process of being raised rapidly when NAECA went into effect.

Thus, the “buy up” payback analysis would suggest that the NAECA scenario represents a

likely outcome only under an 11 SEER standard level. Under a 12 SEER standard, the Roll-up

scenario would be more likely to occur than the NAECA scenario. Under a 13 SEER standard, the

Roll-up scenario would actually be optimistic. Should emerging technologies reach their full

potential, however, the paybacks seen today in moving to higher efficiency products could be

attained, suggesting that the Shift scenario may be possible for some products under any standard

level.

The preceding analysis based on paybacks does not consider that consumers who “buy up”

may be attracted to absolute annual savings rather than payback periods. As standard levels increase,

even if price differential decrease to maintain payback periods, annual savings decrease in absolute

terms. Under this framework, it is difficult to imagine conditions under which the Shift scenario

could occur, even with emerging technologies reaching their full potential.

8.5 SUBGROUP IMPACTS

The results in Section 8.4 relate to the residential air conditioning manufacturing industry as

a whole. There are segments of the industry that an observer would suspect could be more negatively

or positively impacted than the typical firm. In section 8.4.3 we discussed that differences exist

between major manufacturers based on their market approach and cost structure. It is also reasonable

to assume that low volume manufacturers, most of whom rely on the sale of niche products, would

experience impacts that differ from the major manufacturers. Furthermore, producers of specialized

components may also be impacted more or less severely than the major OEMs.

The Department is interested in the impacts on each of these segments for different reasons.

First, understanding the differences between low- and high-operating cost manufacturers can help

to identify companies that are likely to consolidate or change their R&D strategy. The Department

would not want to impose a standard that removed the incentive for the private sector to continue

its innovation. Second, the law requires the Department to evaluate impacts of new standards on

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small businesses. Many small businesses in the air conditioning industry manufacture niche products,

and in some cases, the Department may be obliged to modify the standards to protect those

companies from impacts that would eliminate those products from the marketplace. Third, if the

standard favored a particular component supplier, it could alter competition in that area and result

in higher prices to the OEM and eventually the consumer. The Department of Energy and the

Department of Justice are both interested in examining possible influences of new standards on the

competitive balances in the industry.

8.5.1 Major Manufacturer Subgroups -- Lower Operating Cost and Higher Operating Cost

Section 8.4.3 introduced the concept of segmenting the industry into two major groups based

on their operating cost structure and approach to market. Those with lower operating cost target price

sensitive markets and limit their R&D efforts, service programs, and frills. They depend on their

baseline equipment to generate most of their profits, and will generally benefit from more stringent

efficiency standards. The manufacturers with higher operating costs place more emphasis on product

development and research, service programs, and other value-added attributes. Premium products

and higher efficiency products generate a substantial portion of their profits. More stringent

efficiency standards tend to reduce the profitability of those products. This section describes some

of the differences in GRIM assumptions and results for the two groups.

8.5.1.1 Differences in Assumptions between the Subgroups

We developed this characterization of the two groups over the course of two years and more

than a dozen interviews with major manufacturers. Each company described its own unique situation

and concerns, but some similarities began to emerge that suggested the classification we developed.

Although manufacturers may not think of themselves as falling into one of two groups, the

simplification was necessary to capture what we believe to be the main differences among companies

with regard to the impacts of new efficiency standards on their businesses. We found that the

framework helps us assess not only financial impacts, but partially explains why companies react

differently to the prospect of increased standards.

In the GRIM, the primary difference between the two groups is their markup structure as

presented in Table 8.7. The lower operating cost group maintains a fixed gross margin across

efficiency levels, and the higher operating cost group increases their gross margin linearly as

efficiency increases. This increasing margin represents either increasing margins within a product

line, or a growing fraction of sales of premium, high margin, products. 

We also made some minor adjustments to operating expense ratios to simulate somewhat the

differences between the two groups of manufacturers. While these differences do not have much of

an effect on the results, they are useful for distinguishing the two groups and calibrating the markups

and profit margins. Table 8.26 summarizes the different operating cost assumptions.

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Table 8.26 Operating Cost Assumptions for the Two Major Manufacturer Subgroups

Lower Operating Cost

Group

Higher Operating Cost

Group

R&D Expense (% of revenues) 1.0% 2.0%

SG&A Expense (% of revenues) 14.0% 18.0%

The operating expense differences, in addition to the differences in markups, produce

differences in price and profit margins between the two groups. Table 8.27 summarizes GRIM’s

prices under a 10 SEER standard level based on the Industry Mean relative production costs (see

footnote 1 on page 8-35). Product premiums range from $19 (4%) for 10 SEER split air conditioners

to $625 (41%) for 15 SEER packaged heat pumps.

Table 8.27 Equipment Price Assumptions for Lower Operating Cost (LOC) and Higher

Operating Cost (HOC) Subgroups Under a 10 SEER Standard

Equipment

Efficiency

(SEER)

SACLOCSACHOCPACLOCPACHOCSHPLOCSHPHOCPHPLOCPHPHOC

10 $483 $502 $583 $605 $681 $707 $689 $715

11 $555 $609 $652 $741 $732 $811 $700 $845

12 $636 $744 $677 $837 $804 $951 $686 $929

13 $750 $932 $829 $1,094 $916 $1,153 $871 $1,260

14 $944 $1,222 $969 $1,325 $1,052 $1,383 $1,023 $1,514

15 $1,123 $1,521 $1,179 $1,669 $1,359 $1,858 $1,202 $1,827

SAC- Split Air Conditioner; PAC-Packaged Air Conditioner; SHP-Split Heat Pump; PHP-Packaged Heat Pump

Table 8.28 summarizes the differences in profitability (EBIT) for each manufacturer group

at each efficiency level according to the GRIM in the year 2000.

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Table 8.28 Profit (EBIT) per Unit Sold (2000)

Equipment

Efficiency

(SEER)

Higher

Operating Cost

Group

Lower

Operating Cost

Group

10 4% 6%

11 7% 6%

12 11% 6%

13 14% 6%

14 17% 6%

15 20% 6%

To calculate EBIT by efficiency level, we assumed that corporate operating costs are

allocated to each efficiency level in proportion to the revenues generated at that level. In actuality,

firms have the flexibility to allocate overhead and operating costs however they choose to create

different metrics and incentives for management. For example, some firms may prefer to allocate

overhead based on labor cost, instead of revenue. This would produce different EBIT results.

We made sure to calibrate the assumptions regarding operating expenses and markups so that

both groups displayed similar overall profit margins that were in line with the industry as a whole.

The GRIM’s before-tax EBIT for the lower operating cost group is 6.04 percent versus 6.09 percent

for the higher operating cost group. Keeping profitability roughly equal between the two groups

helps to reduce fluctuations in the combined INPV when the results of the two groups are added

together, allowing us to focus on differences in profitability due only to the impact of new standards.

In summary, the parameters that we adjusted were:

` R&D expense ratio

` SG&A expense ratio

` Markups

We tried to maintain an EBIT of 6 percent while keeping the parameters within bounds that

we developed during the course of our interviews and our evaluation of pubic financial data.

8.5.1.2 Net Present Value Impacts

Section 8.4.4 presented the results of the GRIM analysis of INPV impacts on the entire air

conditioner manufacturing industry assuming that higher operating cost manufacturers comprise

75 percent of the market and lower operating cost manufacturers comprise 25 percent. This section

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explores the INPV results for each subgroup.

8.5.1.2.1 Lower Operating Cost Subgroup NPV Results

Tables 8.29 through 8.31 present the results of the GRIM analysis of INPV impacts on lower

operating cost manufacturers. All results assume ARI mean relative costs and 18 year equipment life.

Table 8.29 Changes in Net Present Value – Lower Operating Cost Subgroup – NAECA

Efficiency Scenario 

Trial

Standard

Level

Net Present

Value

($ million)

Change in NPV from Base

Case

$ million %

Base $ 375 -- --

1 $ 394 $ 19 5%

2 $ 401 $ 26 7%

3 $ 407 $ 32 9%

4 $ 430 $ 55 15%

Table 8.30 Changes in Net Present Value – Lower Operating Cost Subgroup – Roll-up

Efficiency Scenario

Trial

Standard

Level

Net Present

Value

($ million)

Change in NPV from Base

Case

$ million %

Base $ 375 -- --

1 $ 387 $ 12 3%

2 $ 392 $ 17 5%

3 $ 398 $ 23 6%

4 $ 422 $ 47 13%

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Table 8.31 Changes in Net Present Value – Lower Operating Cost Subgroup – Shift

Efficiency Scenario

Trial

Standard

Level

Net Present

Value

($ million)

Change in NPV from Base

Case

$ million %

Base $ 375 -- --

1 $ 403 $ 28 7%

2 $ 421 $ 46 12%

3 $ 429 $ 54 14%

4 $ 453 $ 78 21%

Lower operating cost manufacturers are expected to benefit slightly from any increase in the

efficiency standard under any efficiency scenario. Production costs are increasing at a faster rate than

sales volumes are dropping, so revenues increase. The fixed gross margins generate enough cash

flow to fully recover the required investments, with excess to contribute to an increase in NPV.

8.5.1.2.2 Higher Operating Cost Subgroup NPV Results

Tables 8.32 through 8.34 present the results of the GRIM analysis of INPV impacts on higher

operating cost manufacturers.

Table 8.32 Changes in Net Present Value – Higher Operating Cost Subgroup – NAECA

Efficiency Scenario

Trial

Standard

Level

Net Present

Value

($ million)

Change in NPV from Base

Case

$ million %

Base $ 1,228 -- --

1 $ 1,172 $ (56) -5%

2 $ 1,016 $ (212) -17%

3 $ 999 $ (229) -19%

4 $ 990 $ (238) -19%

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Table 8.33 Changes in Net Present Value – Higher Operating Cost Subgroup – Roll-up

Efficiency Scenario

Trial

Standard

Level

Net Present

Value

($ million)

Change in NPV from Base

Case

$ million %

Base $ 1,228 -- --

1 $ 1,034 $ (194) -16%

2 $ 849 $ (379) -31%

3 $ 838 $ (390) -32%

4 $ 846 $ (382) -31%

Table 8.34 Changes in Net Present Value – Higher Operating Cost Subgroup – Shift

Efficiency Scenario

Trial

Standard

Level

Net Present

Value

($ million)

Change in NPV from Base

Case

$ million %

Base $ 1,228 -- --

1 $ 1,337 $ 109 9%

2 $ 1,404 $ 176 14%

3 $ 1,425 $ 197 16%

4 $ 1,461 $ 233 19%

Higher operating cost manufacturers display a benefit only under the Shift scenario, which

we have indicated is a highly unlikely outcome of new standards. Under the NAECA and Roll-up

scenarios, which are more probable, this subgroup loses a considerable amount of value. Although

revenues rise under new standards, margins and profits decline. This effect prevents the subgroup

from recovering its investments related to the new standard, reducing the NPV. Under TSL3, for

example, the NPV loss per company would be on the order of $40 million. 

8.5.1.3 Impacts on Return on Invested Capital (ROIC)

As explained in section 8.4.5, ROIC measures the effectiveness of the industry’s capital

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investment. Since new efficiency standards would cause manufacturers to make investments that

would not result in an increase in profits, ROIC drops for the industry as a whole. However, the

lower operating cost subgroup would experience little change in ROIC. The ROIC change in the

higher operating cost subgroup drives the industry ROIC results.

Tables 8.35 through 8.36 provide the ROIC results for the two subgroups under each

efficiency scenario.

Table 8.35 Changes in ROIC in 2011 – Lower Operating Cost Subgroup

Trial

Standard

Level

NAECA Roll-up Shift

Return on

Invested

Capital

(ROIC)

Change in

ROIC

from Base

Return on

Invested

Capital

(ROIC)

Change in

ROIC

from Base

Return on

Invested

Capital

(ROIC)

Change in

ROIC

from Base

Base 13.2% -- 13.2% -- 13.2% --

1 13.6% 3% 13.4% 2% 13.9% 5%

2 13.2% 0% 13.0% -2% 13.8% 5%

3 13.3% 1% 13.0% -2% 13.9% 5%

4 13.5% 2% 13.3% 1% 14.0% 6%

Table 8.36 Changes in ROIC in 2011 – Higher Operating Cost Subgroup

Trial

Standard

Level

NAECA Roll-up Shift

Return on

Invested

Capital

(ROIC)

Change in

ROIC

from Base

Return on

Invested

Capital

(ROIC)

Change in

ROIC

from Base

Return on

Invested

Capital

(ROIC)

Change in

ROIC

from Base

Base 13.3% -- 13.3% -- 13.3% --

1 12.3% -8% 10.7% -20% 14.2% 7%

2 10.2% -23% 8.4% -37% 14.2% 7%

3 10.0% -25% 8.3% -38% 14.2% 7%

4 9.6% -28% 8.3% -38% 14.0% 5%

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The decrease in ROIC in the higher operating cost subgroup under both the NAECA and

Roll-up scenarios is of concern since we expect those to be the most likely outcomes at TSL2 and

TSL3, respectively. The results suggest that higher operating cost firms would strive to reduce their

capital expenditures below that assumed for the GRIM and to tailor their conversion in such a way

that their expenditures allow them to meet the efficiency standard but also improve productivity,

reduce costs, or otherwise improve profitability. More drastic reactions are possible. Capital

currently dedicated to the production of air conditioners could be diverted to more profitable uses.

This can be accomplished through liquidation or conversion of the assets to the production of

different types of products. However, conversion to new products has associated costs of its own,

and it is likely that companies would choose to invest in meeting the new standard rather than to

pursue such a path. More likely, some companies may decide to sell their air conditioning assets to

other companies who would continue to use them in the production of air conditioners. This sort of

divestiture would improve the selling company’s ROIC (by turning capital into cash that can then

be redeployed), and the purchasing company would secure a price for those assets that allowed it to

meet its ROIC targets. During our interviews, manufacturers commented that continued mergers

within the industry certainly were probable.

8.5.1.4 Impacts on Annual Cash Flow

Section 8.4.6 discussed GRIM’s results for industry net cash flow through 2016. Just as with

INPV and ROIC, there are large differences in net cash flow results between the higher operating

cost and lower operating cost subgroups. Again, the higher operating cost manufacturers would fare

worse under new standards than would lower operating cost manufacturers.

8.5.1.4.1 Lower Operating Cost Subgroup Cash Flow Results

Figures 8.9 thorough 8.11 illustrate the net cash flow results for the lower operating cost

subgroup under each Trial Standard Level for each efficiency scenario. Two characteristics stand out.

First, cash flows in the years prior to the effective date of the standard dip due to expenditures related

to product and capital conversion. For TSL3 and TSL4, cash flow can become negative, requiring

the firm to draw from its cash reserves, liquidate investments, or borrow to fund operations. GRIM

does not capture the opportunity costs associated with these financing activities. Cash flow results

prior to the standard effective date are independent of the efficiency scenario since all investments

occur prior to the effective date. Second, in the years following the effective date, cash flows recover

and exceed the base case under all shipment scenarios for low operating costs manufacturers. The

decline in shipments under new standards does not offset equipment cost increases which we assume

low operating cost manufacturers pass through as price increases. This increase in revenues

combined with fixed gross margins more than offsets expenditures related to new capital and results

in stronger cash flows.

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Figure 8.9 Net Cash Flows for the Lower Operating Cost Subgroup – NAECA

Efficiency Scenario

Figure 8.10 Net Cash Flows for the Lower Operating Cost Subgroup – Roll-up

Efficiency Scenario

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Figure 8.11 Net Cash Flows for the Lower Operating Cost Subgroup – Shift Efficiency

Scenario

8.5.1.4.2 Higher Operating Cost Manufacturer Cash Flow Results

Net cash flow projections for higher operating cost manufacturers are shown in Figures 8.12

through 8.14. The explanation of the cash flow estimates is similar to that of the lower operating cost

subgroup. Prior to the effective date, cash flow results are worse than for the base case due to

expenditures related to the new standards. They become negative for TSL3 and TSL4. In fact, cash

flows prior to the effective date are almost identical to those of the lower operating cost group, but

three times higher by virtue of the 3-to-1 market share ratio we assumed. We allocated capital and

product conversion costs according to the same 75 percent/25 percent ratio as we did sales volume.

After the effective date, the cash flows of the higher operating cost group differ substantially from

those of the lower operating cost group. Under the NAECA and Roll-up scenarios, cash flows for

the higher operating cost group never attain the level of those in the base case. Pricing pressure

requires higher operating cost manufacturers to absorb some of the cost increases related to more

efficient equipment. Therefore, their stronger revenues are coupled with lower gross margins,

resulting in lower cash flows than in the base case.

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Figure 8.12 Net Cash Flows for the Higher Operating Cost Subgroup – NAECA

Efficiency Scenario

Figure 8.13 Net Cash Flows for the Higher Operating Cost Subgroup – Roll-up

Efficiency Scenario

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Figure 8.14 Net Cash Flows for the Lower Operating Cost Subgroup – Shift Efficiency

Scenario

8.5.1.5 Summary of Impacts on Major Manufacturer Subgroups

GRIM analysis indicates that new efficiency standards will benefit manufacturers who have

a low cost, commodity-product strategy. Owing to their lower operating costs, they are better

positioned to pass their cost increases on to their customers in their baseline equipment. Conversely,

the analysis indicates new standards, by reducing opportunities for product differentiation, will

negatively impact higher operating cost, higher value-added, manufacturers who must absorb some

cost increases in order for their baseline equipment to compete successfully on price with their lower

cost competitors. Both groups could experience negative cash flows in the years leading up to the

new standard under TSL3 and TSL4, but only the higher operating cost group is expected to suffer

a long term decline in value, cash flow, and return on invested capital. The severity of these negative

impacts depends to a large extent on which efficiency scenario occurs. The NAECA scenario is more

likely to occur under TSL1, but the Roll-up scenario is more likely to occur under TSL2 and might

underestimate impacts under TSL3 and TSL4. Therefore, based on the GRIM, we conclude that trial

standard levels TSL2, TSL3, and TSL4 will impact higher operating cost manufacturers significantly

and disproportionally.

In response, some companies in the higher operating cost subgroup may seek merger

partners, and most will likely seek to reduce their production and operating expenses. Reductions

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in sales, service, and research expenditures would dampen innovation in the air conditioner industry.

However, some companies may decide to redouble their efforts to develop and sell higher efficiency

products, attempting to create the profitable Shift scenario for themselves. Their success would

depend on their ability to develop a new generation of highly efficient equipment that is profitable

at a far lower price premium than today’s equipment. The prospect for such a development depends

on the success of emerging technologies and their ability to decrease the price differential between

efficiency levels.

8.5.2 Niche Product Manufacturer Subgroup

Since low volume manufacturers have fewer units over which to recover the costs associated

with converting to new standards, we would expect the business impacts on low volume

manufacturers to be more severe than those on major manufacturers. Indeed, the number of small

manufacturers has declined over the last decade, and some manufacturers attribute that decline

directly to the effects of the NAECA standards. Cost allocation is not the only issue. Low volume

manufacturers typically possess less ample research and product development resources than their

major competitors, and are not able to react as quickly or successfully to new standards.

Low volume manufacturers fall into two groups. The first is manufacturers of equipment for

niche markets. Their products fill specific space conditioning needs that are not widespread enough

to support the high sales volumes and economies of scale sought by the major manufacturers. The

second group manufactures indoor coils and fancoil units.

Of the two groups, the indoor coil manufacturers bear the lowest burden. Indoor coil

manufacturers must rate their coils with new outdoor units from other manufacturers, and may have

to develop new coil configurations, but those expenses are minor in comparison to the expenses

required to develop new product lines of matched systems. If new standards increase the size of the

indoor coils, indoor coil manufacturers may bear some expense in increasing their production

capacity and warehouses to accommodate them. However, indoor coil manufacturers we interviewed

expressed no major concerns over the impacts of new standards on their businesses.

The niche product manufacturers, on the other hand, do raise some serious concerns. Those

manufacturers whose products face tight constraints, usually on size, must overcome technical

challenges in developing products to meet more stringent standards. Their ability to do so is limited

by their engineering resources and the availability of useable components. If components do become

available, they often do so at a much higher cost for low volume manufacturers compared to the

major manufacturers. Assuming niche product manufacturers can meet their technical challenges,

the costs of redesigning and retooling to produce those new products must be allocated over a

relatively small number of unit sales. Compounding the problem, some niche manufacturers produce

several types of niche products, all of which must be redesigned and re-certified. This higher

allocation of costs, combined with the higher cost of components, raise the cost of niche products

more than that of mainstream products from major manufacturers. Thus, we could expect a high drop

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in shipments and more downward pressure on gross margins. Both results impose a burden on niche

product manufacturers that is disproportionately higher than that imposed on major manufacturers.

These burdens would likely cause one or more companies to exit the market and could certainly

cause the sale of several niche products to be discontinued.

Because each niche manufacturer’s financial structure and product offering is unique, we did

not perform a GRIM analysis on the niche manufacturer subgroup. Our assessment is qualitative

based on interviews with five niche product manufacturers and information submitted to the

Department in the form of public comment.

8.5.3 Compressor Supplier Subgroup

Although the manufacturers of systems and equipment are the primary focus of the MIA, new

standards could also impact the price or availability of key components. The concern relates to

components from a limited set of suppliers for which there are no viable substitutes and which

represent a significant fraction of the cost of the product. In central air conditioners and heat pumps,

the compressor is the only component that fits those criteria.

In the U.S. four compressor manufacturers offer products for use in residential air

conditioners: Bristol (a division of York), Copeland (a division of Emerson Electric), Tecumseh, and

Scroll Technologies (a joint venture between Bristol and Carlysle, which itself is a division of

Carrier). Bristol and Copeland are the dominant firms. Bristol’s product line is limited to

reciprocating compressors, which use pistons to compress the refrigerant. Reciprocating compressors

have the longest history and have a reputation for reliability. Copeland offers reciprocating

compressors, but is known more for its line of scroll compressors. Instead of pistons, scroll

compressors use interlocking helixes to compress the refrigerant in a continuous action. Tecumseh

and Scroll Technologies are less prominent. Although it offers both types of compressor, Tecumseh

supplies mainly reciprocating and rotary compressors in smaller air conditioners and refrigerators.

Scroll Technologies is effectively Bristol’s scroll division and is capable of supplying only scroll

compressors.

Reverse engineering and manufacturer interviews suggested that scroll compressors are

currently more popular choices at higher efficiencies. This raises concerns that more stringent

standards could provide an advantage to Copeland, the industry leader in scroll compressor sales.

During discussions with the leading compressor suppliers regarding the impacts of new

standards and whether new standards would place them at any particular competitive disadvantage,

no company we spoke with expressed serious concerns. All companies offer competitive

compressors at each efficiency level, and companies are also capable of developing new products

to respond to the needs of the market under new standards. They expect the impacts to be

proportionate to those on the equipment manufacturers, since the product development costs and

process modifications will be of a similar nature. However, they point out that new compressors will

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2

 From reverse engineering: $17.18 fully burdened hourly wage; 240 operating days per year;2 shifts per day

plus 50 percent indirect labor of direct labor. From GRIM: $141 million in labor expenses in 2000. Direct and Indirect

Employment = $141 million/(240 days /yr x 2 shifts per day x 8 hrs/shift) / ($17.18 x 150%) = 1,424 employees.

8-56

have to be available well ahead of the effective date of a new standard to allow equipment

manufacturers to incorporate them into air conditioner designs and qualify them for commercial

production.

We expect new standards to alter the dynamics of the compressor market, but it is not

possible to predict what the changes will be. There certainly will be viable competitors under any

scenario who will possess only limited power to impact prices. Even if one company comes to

dominate domestically, overseas firms can exert pricing pressure. Therefore, we do not expect new

standards to significantly alter the pricing or availability of compressors. 

8.6 OTHER IMPACTS

8.6.1 Employment

Manufacturers generally stated that they consider direct labor costs to be related

proportionally to materials cost on a per unit basis. Therefore, assuming constant wages, they would

expect employment levels to scale with the cost of materials for the industry. We incorporated this

assumption into the GRIM, which projects labor expenditures annually. Labor expenditures are a

function of the labor intensity of the product, the sales volume, and an implicit wage assumption that

remains fixed over time. Table 8.37 provides the changes in labor that would result using that

assumption for the three efficiency scenarios as projected by the GRIM. Labor is measured as

cumulative change in labor expenditures from 2000 through 2030 versus the base case for each

scenario.

Table 8.37 Projected Change in Cumulative Labor Expenditures in the Air Conditioner

Industry 2000 - 2030

Efficiency

Scenario

Relative Cost Scenario Trial Standard Level

1234

NAECA ARI Mean 10% 21% 25% 38%

Reverse Engineering 7% 16% 19% 28%

ROLLUP ARI Mean 8% 19% 23% 36%

SHIFT ARI Mean 12% 26% 31% 44%

Based on these results, we would expect employment among air conditioner manufacturers

to increase roughly in proportion to the increase in minimum SEER. Assuming base employment

related to air conditioner and heat pump production of 1,4242

in 2000, minimum expected job

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creation is 7 percent (100 employees) under TSL1 and maximum potential is 44 percent (342

employees) under the TSL4 Shift scenario. This conclusion is independent of any conclusions

regarding employment impacts in the broader U.S. economy.

8.6.2 Production Capacity

Several trends in residential construction have converged recently to produce a surge in air

conditioner and heat pump sales. Most manufacturers told us they are nearing their capacity

constraints and would plan to add capacity in response to a new standard. The new standards will

not obsolete existing production facilities or equipment. Some tooling may become obsoleted, but

manufacturers will attempt to transition to new tooling in accordance with their normal retooling

cycle.

More stringent efficiency standards, to the extent that they cause an increase in coil size, will

somewhat reduce plant throughput, particularly for those plants that are constrained in their coilshop. In an attempt to recoup capacity, manufacturers will make investments in productivity or

equipment, or consider outsourcing some coil production. The five-year planning horizon associated

with the new efficiency standard will allow manufacturers to have these solutions ready by the time

the new standard goes into effect.

It is not clear that all new capacity will be added in the United States. Some manufacturers

stated that more stringent standards will tend to result in the addition of some new capacity outside

of the country. This would occur if companies decided that they could free-up capacity in domestic

plants by moving export production elsewhere, or if they found that new plants outside of the U.S.

could be built and operated more cost effectively.

8.6.3 Exports

Unitary air conditioner and heat pump exports comprise about 4 percent of unitary air

conditioner sales, and about one-quarter of that flows to Canada. Although split and packaged

equipment popular in North America is used far less in the rest of the world, a few major

manufacturers look to foreign markets, particularly Latin America and the Middle East, as a source

of revenue growth. Nations in those regions do not require products to meet minimum efficiency

requirements. Therefore, as the U.S. efficiency standard increases, baseline domestic air conditioners

become less and less like export air conditioners. As manufacturers find that synergies between the

domestic and export product lines diminish, manufacturers have less incentive to continue to produce

export products domestically. They may decide to reduce their emphasis on the export market, or to

build or buy production capacity outside of the U.S. to supply those markets. If the actual sale of

U.S. air conditioners to foreign markets decreases as a result of the new standard, there will be a

negative effect on company revenues that the GRIM does not capture since the GRIM only considers

domestic shipments.

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8.6 CUMULATIVE REGULATORY BURDEN

While any one regulation may not impose a significant burden on manufacturers, the

combined effects of several impending regulations may have serious consequences for some

manufacturers, groups of manufacturers, or an entire industry. Assessing the impact of a single

regulation may overlook this cumulative regulatory burden. 

Companies that produce a wider range of regulated products may be faced with more capital

and product development expenditures than their competitors. This can prompt those companies to

exit the market or reduce their product offerings, potentially reducing competition. Smaller

companies can be especially hard hit since they have lower sales volumes over which to amortize

the costs of meeting new regulations. If multiple regulations drain the resources of companies across

an industry, industry value can be reduced. That can make the industry more susceptible to foreign

competition and reduce the attractiveness of investing in the sector.

The Department considers that a proposed standard is not economically justified if it

contributes to an unacceptable cumulative regulatory burden.

8.6.1 Federal Regulations on Central Air Conditioners and other Products Produced by the

Same Manufacturers

In addition to the efficiency regulations on residential air conditioners, several other federal

regulations and pending regulations apply to central air conditioners and other products produced

by the same manufacturers. The most significant of these are the EPA-mandated phaseouts of

HCFCs. Table 8.38 provides the timetables for these regulations. In addition to those listed, the DOE

has lower priority plans to reassess efficiency standards for residential furnaces and boilers.

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Table 8.38 Summary of Major Regulations on Central Air Conditioner Manufacturers

Regulation Key Affected Appliances Effective Date

Residential appliance energy

efficiency requirements (DOE)

Room air conditioners

Refrigerators/freezers

Water Heaters

October 1, 2000

July 1, 2001

January 2006*

EPA ban on new equipment using

HCFC refrigerants

Room and central air

conditioners, commercial air

conditioners, refrigerators,

freezers

January 1, 2010

EPA ban on HCFC-141b foam

blowing agent

Water heaters, refrigerators,

freezers

January 1, 2003

Consumer Product Safety

Commission prompted voluntary

standards for flammable vapor

ignition

Water heaters imminent

EPA standards on emissions of

allowable hazardous air pollutants

from the coating of large appliances

(NESHAP/MACT standards, Clean

Air Act Section 112(d))

Central air conditioners,

refrigerators, freezers,

furnaces

October 2004*

DOE adoption of ASHRAE 90.1-

1999 energy efficiency standards for

new commercial buildings

Unitary and applied air

conditioners, furnaces,

boilers

2003 – 2005

* anticipated effective date

Table 8.39 lists the market shares of major air conditioner manufacturers subject to the

regulations listed in Table 8.38. High market shares imply that the companies will bear a significant

portion of the burden of the regulation.

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Table 8.39 Market Shares of Major Air Conditioner Manufacturers in Regulated Products

Carrier Goodman

(including

Amana)

Rheem Lennox

Nordyne

Trane

York

Others Total All Air

Conditioner

Manufacturers

Residential

Central Air

Conditioners

31 19 13 34 3 100

Room Air

Conditioners

3 7 10

Residential

Water Heaters

27 27

Residential

Clothes

Washers and

Dryers

5 5

Residential

Refrigerators

9 9

Source: Appliance Magazine, September 1998.

Since we have not obtained market share estimates for commercial products covered by the

ASHRAE 90.1 standard, we did not include them in Table 8.39. However, Carrier, Lennox, Trane,

and York all participate extensively in the market for applied heating and cooling equipment.

In residential products, the overlap between companies who produce central air conditioners

and other regulated products is small except in the case of water heaters. Two companies, Rheem

and Goodman, face the greatest cumulative burdens. Rheem holds a leading position in the supply

of residential water heaters which are subject to a forthcoming EPA ban on the foam blowing agent

HCFC-141b, a DOE rulemaking which would raise their energy efficiency requirements, and a

Consumer Product Safety Commission requirement to adhere to voluntary standards regarding the

ignition of flammable vapors. Goodman is in a slightly different but similarly burdensome situation.

Goodman’s Amana division produces and sells a broad line of residential appliances. Refrigerators,

room air conditioners, and clothes washers will all be impacted by forthcoming increases in energy

efficiency requirements, and Amana’s refrigerators will be subject to the ban on HCFC-141b.

Table 8.40 indicates the level of impacts that the central air conditioning industry may face

due to other federal regulations that will become effective over the next ten years. The estimated

investment for the air conditioner industry in each category is the product of the total industrial

expenditures in the category and the total market share of air conditioner manufacturing companies

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presented in Table 8.39. The projection exceeds $479 million, mostly related to the phaseout of

HCFC-22.

The uncertainty surrounding these values is high for several reasons. First, manufacturer

impacts depend largely on the company's ability to pass conversion costs through to consumers.

Second, information on capital expenditures, R&D, and other conversion costs and project plans are

usually considered confidential. Third, companies may be able to incorporate regulatory-driven

expenditures into other product development or process improvement efforts.

Table 8.40 Estimated Investments Required to Meet Impending Federal Regulations ($ million)

Total Investment

by All

Manufacturers

Estimated Investment

Incurred by Central Air

Conditioner

Manufacturers

Source of Estimate

HCFC-22 ban n/a $350 Interviews with central air

conditioner manufacturers

HCFC-141b ban–water

heaters 

$15 $4 DOE water heater

efficiency rulemaking

HCFC-141b

ban–refrigerators

? ? No estimate

Flammable Vapor

Ignition

$95 $25 Water heater consortium

estimate

Refrigerator/Freezer

Efficiency

$500 $45 Estimated investment in

DOE rulemaking analysis

Room air conditioner

efficiency

$8 $1 Estimated investment in

DOE rulemaking analysis

Water Heater Efficiency $61 $13 DOE water heater

efficiency rulemaking

Clothes Washer

Efficiency

$823 $41 DOE clothes washer

efficiency rulemaking

NESHAP/MACT ? ? No estimate

Total All Regulations $479+

The most significant regulation facing the central air conditioning industry is the ban on new

equipment utilizing HCFC-22. Manufacturers of residential air conditioners also engage in the

production and sale of commercial air conditioners, chillers, and refrigerators, all of which will

require some conversion to an alternative refrigerant by 2010. For residential air conditioners,

conversion to 410A requires new design and certification, testing, production equipment and

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processes, and tooling. Since HCFC-22 has been the dominant refrigerant for decades, companies

must develop a wealth of new knowledge and experience. The level of expenditure required to

convert all production of residential equipment to 410A is expected to be on the order of $50 million

per company. This is comparable to what we have assumed would be the expenditures related to

converting to a 13 SEER efficiency standard. To the extent that manufacturers can introduce new

products utilizing the new refrigerant and meeting the new efficiency standard, the cumulative

burden will be reduced.

The EPA’s pending NESHAP/MACT regulations impact primarily the painting, or surface

coating, of air conditioners and other large appliances. They will establish a standard for the emission

of hazardous atmospheric pollutants for a facility based on the maximum achievable control

technology as displayed by the facility’s peers. Some air conditioner facilities may have trouble

meeting the new requirements and could incur significant investments. The EPA plans to publish

estimates of industry impacts prior to establishing its final rule. Any new regulation will likely

become effective three years after the publication of the rule, which is scheduled for October 2001

according to EPA’s website.

8.6.2 Pending Regulations and Regulations at the State Level

Manufacturers also identified several regulations which are either under consideration or will

be imposed at the state level. These include:

• Compliance with the International Standards Organization (ISO) testing procedures for air

conditioners, which will likely require duplicate testing and certification for products

• Performance or prescriptive standards set at the state level, which include a proposed

requirement in Texas that all new commercial and residential air conditioning units installed

in Central and East Texas reduce the ground level ozone in air passing through the units by

at least 70 percent through the use of new technology, starting in 2002.

• State level safety regulations

Of these, the proposed Texas requirement is of the highest concern to manufacturers who

claim that the technology under consideration is unproven, reduces equipment efficiency, is

potentially toxic, and would add as much as $1,000 to the cost of a new air conditioner. Most of all,

manufacturers are concerned that if states begin to establish separate standards, they will have to

design, develop, test, certify, and produce separate products for each market, largely reversing the

economies of scale that the manufacturers currently obtain by producing a single product that can

be sold anywhere in the United States. ARI believes the total required investment by industry could

exceed $1 billion.

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8.7. CONCLUSIONS

8.7.1 Trial Standard Level 1 (TSL1)

Impacts on manufacturers due to TSL1, which would require all products to meet an

11 SEER standard, are modest. Even though over 70 percent of products will no longer meet the new

standard levels, the differences between 10 SEER and 11 SEER products are slight, and all

manufacturers and subgroups should be able to respond with viable, reliable, and competitive

product without facing a severe strain on capital or cash flow. Furthermore, manufacturers will

continue to be able to differentiate their products and induce consumers to “buy up” to products at

the 12, 13, and 14 SEER levels, allowing companies who depend on such sales to retain their

profitability. Industry value will lower only slightly, and could actually increase since the Shift

efficiency scenario has a good chance of occurring. Additionally, all niche products should be able

to satisfy TSL1 using conventional technologies.

8.7.2 Trial Standard Level 2 (TSL2)

Eighty-one (81) percent of products currently sold would not meet the requirements of TSL2,

which would require all products to meet a 12 SEER standard. We estimate that current 12 SEER

products generate 30 percent of the industry’s profits. Under TSL2, the 12 SEER product would be

required to compete primarily on price rather than premium features, resulting in the loss of those

profits, and a corresponding reduction in industry value. Manufacturers who emphasize baseline

equipment would benefit slightly under TSL2. Those manufacturers whose profits depend more

substantially on the sale of 12 SEER equipment, however, would have to look to the 14 SEER level,

or higher, to retain their profitability. Since 14 SEER is quite near the technical limit of efficiency

for products sold without a blower (comprising half of all sales), they may find it difficult to provide

enough value to consumers in those products to duplicate their current 12 SEER sale volumes. The

same is true for non-modulating, single speed systems at 14 SEER. Under these conditions, the Rollup efficiency scenario becomes possible.

In an attempt to ward-off the Roll-up scenario, higher operating cost manufacturers faced

with TSL2 would have the incentive to develop a new generation of single speed, non-modulating

products at and above 14 SEER in an attempt to retain their profitability and differentiation. These

products would likely rely on conventional technologies, but should also provide an impetus to

deploy the microchannel heat exchanger and new technologies that improve heat transfer and steadystate compressor efficiency. If that outcome occurs, impacts could resemble the NAECA or even the

Shift scenarios, with burdens less than half as severe as the Roll-up scenario. The NAECA scenario

is the most likely outcome, resulting in a loss of industry value on the order of $200 million.

Some manufacturers in the higher operating cost subgroup, because of lack of financial or

technical resources or competitive advantage, would choose not to attempt the development of new

14 SEER products. Instead, they would focus on operating and production cost reductions and seek

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to retain their profitability at the 12 SEER level.

Manufacturers of through-the-wall condensing units would find it quite difficult to meet

TSL2 without additional infusions of capital and considerable development expenditures. Other

niche product manufacturers will likely be able to sustain their sales volumes and revenues.

TSL2, because of the larger refrigerant charges required, would likely hasten the introduction

of products based on HFCs to avoid exceeding the federal cap on HCFC-22.

8.7.3 Trial Standard Level 3 (TSL3)

TSL3 retains the 12 SEER standard requirements from TSL2 for cooling-only equipment,

but requires heat pumps to meet a 13 SEER standard. Approximately 95 percent of heat pumps

currently sold would not meet TSL3. However, since heat pump products comprise only 25 percent

of all products sold, several manufacturers may choose to discontinue or drastically trim their heat

pump product lines rather than invest in the production capacity and product development required

to supply heat pumps under the new standard. Aside from that possible outcome, the impacts on

major manufacturers of TSL3 are expected to be generally similar to those of TSL2.

All niche product heat pumps evaluated, except through-the-wall packaged units built for

new construction, would find it nearly impossible to meet the new heat pump requirements with

conventional technologies and still expect to retain sales volumes necessary to sustain their

profitability.

8.7.4 Trial Standard Level 4 (TSL4)

Ninety-seven (97) percent of the products currently sold would not meet the standards

required by TSL4. That represents a serious discontinuity for an industry whose product

development and marketing revolve around product efficiency levels. Manufacturers would be

required to invest in new production capacity, develop new marketing strategies and products, and

perhaps transition to new business philosophies. It is highly unlikely that manufacturers would be

able to develop products at the 15 or 16 SEER levels that would offer the incremental value to

consumers that 12 SEER products offer to consumers under the current 10 SEER standard. The Rollup scenario, therefore, is quite likely to occur with a resulting loss in industry value of something

on the order of $360 million. Several major companies would likely consider selling their production

assets rather than making the investment required to meet the new standard or facing the loss of

profitability associated with the absence of viable premium and higher efficiency products. A large

reduction in the number of firms in the market would raise concerns about a reduction in

competition, although it is likely that enough competitive companies would remain to prevent any

of them from being able to control prices.

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It is highly unlikely that any niche product would be technically able to attain TSL4. Small

manufacturers engaged in the production of conventional equipment would find it difficult to

overcome the financial and technical burdens associated with the transition, and could decide to exit

the market.

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