In a direct-fired gas water heater, the heat source is a flame burning on the bottom of the water heater. Air gets in the combustion chamber, combines with the fuel, and the blend is ignited. Heat is then moved to the water with metal surface areas at the bottom of the tank. The vent pipe, an exhaust pipe which holds the by-products of combustion to the outside, also functions as a heat exchanger. This pipe is generally surrounded by the water containment tank, and typically contains baffles to slow the escape of these gases with the vent, hence enabling even more time for heat to be moved to the water around the pipe.
Energy is lost in the transfer of heat from the flame to the water, and some heat is lost up the flue we suggest.
Here are some good ideas from About.com.
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