Independent Project: The Rise of Electric Heat Pumps

How do you assess the viability of a heat pump? Through an Independent Project with Professor George Serafeim, Meghavi Talati (MBA 2023) set out to develop a tool to help the average consumer navigate this decision.

The Rise of Electric Heat Pumps by Meghavi Talati

Disclaimer: the cost of items included varies by source and will change over time

In the U.S., 17% of homes have an electric heat pump installed. In the South – in states such as North Carolina and Alabama – this number is above 40% [1]. It is clear that electric heat pumps are already quite prevalent throughout the U.S., so why are homeowners making the switch? Electric heat pumps provide homeowners the opportunity to reduce their energy bills and work towards greater energy independence. A heat pump could cost as little as ~$7,100 over the lifetime of use, while a comparable natural gas furnace might run as high as ~$26,000 [2]. However, this lower total cost of ownership (TCO) for electric heat pumps is not standard across the U.S.– we will cover an overview of electric heat pumps and main drivers that will likely impact U.S. adoption patterns.

The “Electrify Everything” movement has gained momentum in the last few years as a call to action for consumers to take charge and switch to a 100% electric platform as a pathway to decarbonization. Electric heat pumps are appliances that use an electrical input to move heat between the air inside and outside the home. They are multifaceted—they have the ability to both heat and cool homes (serving as an alternative to furnaces and air conditioners). So, why exactly do heat pumps matter? Electric heat pumps have many benefits for both the homeowner and the climate. As mentioned above, most homeowners will see a lower TCO over the 15-year lifetime of the pump versus a traditional gas-fired system due to lower utility bills and greater energy efficiency. Heat pumps can also insulate from the effects of energy price spikes. Next, making the switch will enable homeowners to take control of their climate impact and reduce emissions at a large scale. In fact, installing an electric heat pump in every household in the U.S. would reduce annual emissions by 160 million metric tonnes [3]. Lastly, heat pump adoption will lead to less pollution and cleaner, safer air.

There are currently many regional and infrastructural considerations leading to high adoption in the Southern U.S. and limiting broader adoption across the country. One major consideration is that heat pumps have traditionally been less effective in freezing-cold temperatures. Thus, the ongoing monthly energy bill is typically higher for heat pumps compared to fossil fuel alternatives in colder regions. However, while heat pumps have historically been known to be more economical in warmer regions, recent studies have cited improvements in newer heat pumps, such as inverter technology, making them effective and efficient at keeping homes warm in frigid states in the Northeast [4]. Next, certain U.S. regions are more likely to have the electrical infrastructure required for installation. According to the Energy Information Administration (EIA), 25% of U.S. homes were all-electric as of 2015. This is largely composed of homes in the South. 45% of homes in the South are all-electric versus only 18%, 15% and 8% in the West, Midwest, and Northeast respectively [5]. Thus, homes in the South are more primed for heat pump installation and will likely benefit from lower upfront expenditures. Lastly, the cost of electricity vs. other fuel alternatives is extremely relevant. According to analysis from EIA data, it is clear that the Northeast has the highest electricity rates (16 cents per kilowatt-hour) on average and thus the largest operating costs associated with heat pumps. Conversely, the South has the cheapest electricity rates (9.8 cents per kilowatt-hour) on average [6]. These factors have led to most heat pumps today to be installed in Southern states, such as Florida and Texas (Figure 1) [7], and will likely continue to drive adoption there before permeating to the rest of the U.S.

Figure 1: Heat pump adoption strongest in Southern states

Compared to fossil fuel alternatives, electric heat pumps are actually much cheaper on a total cost of ownership basis, especially in areas where electricity rates are lowest. Figure 2 highlights my analysis of a TCO comparison of electric heat pumps versus traditional alternatives. The average TCO for an electric heat pump ranges from $7K to $33K (influenced by size of home, subsidies available, etc.). In comparison, the average TCO for natural gas, propane and oil-based furnaces are significantly higher at $26K, $47K and $55K respectively. While the upfront capital expenditures and ongoing maintenance costs for these fossil-fuel based appliances tend to be lower, ongoing fuel costs make up the bulk of the ownership costs (55-75% of costs depending on fuel type). Among these traditional furnaces, natural gas tends to be the most widespread (48% of U.S. homes) and the cheapest option. However, the cost of natural gas varies widely by state—the price can range from ~$10/thousand ft^3 (Idaho) to ~$50-60/thousand ft^3 (Hawaii) [8]. Thus, depending on the state a homeowner lives in, the TCO can vary dramatically, making it much less attractive to own a natural gas furnace in states with higher prices, such as Hawaii, New Hampshire, and Massachusetts (Figure 3) [9].

Figure 2: TCO of electric heat pumps mostly lower or on par with natural gas furnaces, while much lower than propane / oil furnaces Source: my analysis

Figure 3: Residential natural gas price ranges by state.

The next major relevant fuel type is propane, which is present in only ~5% of U.S. homes. Propane is attractive because it is the greenest carbon fuel and is available for widespread distribution in areas that do not have easy access to natural gas (North Dakota, Montana, New Hampshire, South Dakota). However, while costs of upfront equipment and maintenance are comparable to natural gas furnaces, the ongoing cost of propane can be 2-3x that of natural gas, making it much more costly on a TCO basis. Lastly, heating oil furnaces are present in only about 8% of U.S. homes and are highly concentrated in the Northeast in homes built before 1990. Heating oil furnaces are increasingly being seen as cost prohibitive as the ongoing cost of heating oil has doubled over last two years due to supply constraints from the Russia-Ukraine conflict and the pandemic. Heating oil also undergoes the same price volatility that motor oil faces, making it more expensive and unpredictable over time. Thus, given that propane and heating oil furnaces seem to be prohibitively more expensive on average (7-8x electric heat pump costs), natural gas furnaces are the most comparable alternative. Natural gas furnaces are 3x the best-in-class TCO of a heat pump, but are likely more cost-competitive in regions with cheaper natural gas and colder temperatures (where heat pumps are less efficient).

As mentioned earlier, the total cost of owning a heat pump can vary significantly based on a range of factors. The TCO can vary from ~$7K to ~$33K as highlighted in Figure 4 due to various factors including incentives, location, size of home, and infrastructure. There are three major types of heat pumps: air-source heat pumps (central ducted and ductless minipumps) and ground source. We will analyze central ducted air source pumps as they are the most viable to meet a home’s holistic heating and cooling needs. Here are the most important components of TCO and how they may drive meaningful cost differences:

Government incentives: the Inflation Reduction Act makes owning a heat pump much more tenable with incentives and tax credits; some homeowners can claim >$10K in incentives [10]. The following incentives are offered:

Installation credit: the Inflation Reduction Act (IRA) offers $600 for upgrading electrical infrastructure if it is required prior to heat pump installation
Total cost credit: certain homeowners can claim >$10K in total state and federal incentives.

Any taxpayer can claim a federal tax credit for 30% of total project costs (including installation, equipment, and labor), up to $2K.
Beyond this, there is an attractive state-administered rebate of $8K that is tiered by income level (100% of project costs up to $8K for households earning <80% of area’s median income). As shown in in Figure 4, higher-income households will not have access to these state-specific incentives, which drives a sizable difference in TCO.

Note on efficiency: Heat pumps are incredibly efficient, transferring 300-450% of energy they consume versus the most efficient furnaces at 95% efficiency. While furnaces generate energy by burning fuel, heat pumps simply move air between outside and inside your home with an electrical input. Thus, electric heat pumps tend to have lower operating costs in the long run [11,12].
Electricity costs: Due to higher efficiency, homeowners can save 20-40% on their ongoing utility bill versus traditional HVAC systems [13]. Thus, the average ongoing expense for a homeowner is ~$15K over a 15-year lifetime (vs. up to $40K for an oil furnace) [14,15]. This value will vary based on U.S. region (varying electricity rates) and efficiency of the home (e.g., energy power user vs. saver as seen in Figure 4).
Set-up of the home:~$4-5K added cost on average based on whether home has:

Duct system: Most heat pumps require a central duct system. For a single-family home, the average cost for duct installation/repair is $3K/home [16,17].
Electrical paneling: Electrification of the home requires 100-200A of electrical service, meaning most homes will need some type of electrical infrastructure upgrade. According to a study conducted by Pecan Street, as many of 48 million U.S. homes (~40% total homes) would require an electrical infrastructure upgrade. The baseline cost ranges from $750-$4K, with an average of ~$2K/home [16,18].

Upfront capex: Looking at a variety of sources, the upfront cost of a heat pump typically ranges from $5.2K-9.9K for the average home (including labor). Main drivers of cost variance include size of home (and thus pump tonnage required), level of efficiency of pump, and cost of regional labor. [12,13,19].
Maintenance: Because heat pumps are multifaceted and are used year-round (vs. a furnace that is used only a few months during the year), heat pumps have higher annual maintenance costs on average compared to traditional HVAC systems. An average annual cost of $150 is assumed with a one-time event of $1K [19,20,21].

Figure 4: Waterfall analysis ranging from lowest-cost heat pump to highest-cost heat pump with incremental expenses. Expenses include (1) operating expenses—factors that influence level of and pricing of electricity used and (2) upfront expenditures—factors such as infrastructure upgrades and type of pump used. Source: my analysis

As homeowners across the U.S. look to replace their legacy heating/cooling systems, there are several segments that are most equipped to make the switch first:

Smaller-sized homes requiring smaller, cheaper pumps
Lower-income households that can qualify for up to $10K in rebates. The IRA has been a major tipping point in electric heat pump adoption as this reduces a significant economic barrier
Houses in the South with cheaper electricity rates and warmer climates that promote higher efficiency in pumps
All-electric homes with electrical paneling (and duct systems) already installed

Homes with these characteristics are likely to find options in the ~$7-10K range and may be more inclined to make the switch first. Homes with opposite parameters may see more gradual adoption as they find pumps in the ~$20-30K range. However, all hope is not lost — the TCO of pumps will likely decline over time across the U.S. as technology/efficiency improves, electricity rates drop (while natural gas/propane/oil prices rise) and further incentives release.

Regardless of the “ideal characteristics”, there are several steps a homeowner can take to make the switch to an electric heat pump right now. First, even if a homeowner goes electric progressively, he/she can take the first step by upgrading the pre-requisite infrastructure (e.g., electrical paneling and servicing). Second, homeowners can explore which incentives are available at the federal and state level. Homeowners can take advantage of $10K+ incentives depending on infrastructure upgrades, level of pump efficiency, income levels and more. Next, homeowners can engage in more energy conservation and efficiency measures. Actions such as improving insulation can lower ongoing utility bills. In addition, homeowners can claim tax credits for such efficiency upgrades, such as for air-sealing and insulation materials, helping to further reduce total costs. Lastly, states need to consider adopting additional incentives in regions where the TCO of heat pumps far exceeds that of alternatives. Specifically, states in the Northeast can consider additional incentives on an ongoing basis to help subsidize the higher cost of electricity compared to natural gas and the higher cost of energy due to lower efficiency of pumps in cold climates. Overall, there are many actions individuals and governments can take to promote widespread adoption of electric heat pumps. While there are still some barriers to electrification, it is clear that heat pumps are on the path to widespread adoption.

If you want to try the Excel calculator or learn more about the calculations, please email bei@hbs.edu.

Sources:

Cover image source: Getty Images

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Independent Project: The Rise of Electric Heat Pumps