Common Tragedies

Thoughts on Environmental Economics

Energy efficiency: if wishful thinking won’t make it so, what will?

Posted by Rich Sweeney on January 6, 2008

Commenting on the Democratic debate last night, Alex Tabarrok writes the following,

On energy and economics, Clinton was very poor. She made some crazy argument that mandating energy efficiency was the way to get us out of the looming recession – as if wishing for greater efficiency would make it so.

Ignoring Clinton’s very tenuous connection with economic growth, what can we make of her advocacy of governmental promotion of energy efficiency in general? Can the idea really be simply dismissed as wishful thinking?

UPDATE: According to N-dot, Hillary’s comments actually fall under the category of “magic wand economics”.

Keep reading to see why I’m not quite as dismissive.

We’ve written about energy efficiency (EE) several times before on CT. What’s so interesting about EE from an academic standpoint, and frustrating from a policymaking standpoint, is that there seems to be so much low hanging fruit. CFL’s invariably save you money. A gas fired water heater will save you a G, easy. Home heating and cooling bills remain unnecessarily high, while, as the saying goes, caulk is cheap.

Since economists don’t believe that people leave money lying on the ground, we have to come up with an explanation for what’s going on here. I’d say that the possibilities can be broken down into three categories:

  1. Principal agent problems – A lot of energy consumption decisions are made by actors who don’t utltimately bear the costs of these decisions. Renters are are a good example of this.
  2. Capital constraints – Many energy efficient upgrades are NPV positive in the long run, but require significant upfront capital outlays.
  3. Asymmetric or imperfect information – People simply don’t know about the cost/ energy savings opportunities available to them.

Assuming you buy any of these possible market failures, the question becomes is there anything the government can do to fix them?

The first one’s probably the toughest. My sense is that the set of losers is pretty diverse, and that the losses they incur are often small relative to their other concerns (such as housing security or flexibility). The second market failure seems the easiest to solve. The government could simply provide cheap financing for EE investments. In fact many local governments and non-profits are already doing just this. The real question for me is why more businesses aren’t stepping up to fill this financing gap. Seems like this is essentially a specialized example of what banks do all the time.

Finally we come to the information question, which for me is the most interesting. If companies had products or services that were superior to the their competitors’, they would spend money to inform consumers. I’m not going to pretend to be even remotely up to speed on the relevant literature (and if anyone else is, please comment), but it seems like there are times when, for whatever reason, the private sector doesn’t fill the informational void and there may be an opportunity for the government to step in.

At my previous job, I spent a lot of time analyzing prescription drug purchase behavior. One of the things we looked at was why some consumers chose to shell out significantly more money for branded drugs when generics are bioequivalent, and much much cheaper. For many consumers, the answer was that they simply lacked information. They irrationally questioned a generic’s efficacy or side effect profile. In order to address this problem, many state government implemented a policy analogous to mandating energy efficiency: they enacted mandatory substitution laws, which forced pharmacists to fill all prescriptions with generic substitutes unless the patient or physician explicitly asked for the brand.

Now I don’t want to get into the competitive and R&D effects of these laws (Ernie Berndt and Henry Grabowski have some good papers on this if you’re interested), but the laws have undeniably increased generic substitution. Of course generic substitution was also boosted by the advent of PBMs and formularies, which is a great example of the market solving both agency and informational problems. Until a market solution arrives though, should the government try to do for EE what it did for drugs? The extreme extension of this analogy would be a mandatory substitution of energy efficient products. A much more market friendly approach would simply be to undertake a massive public information campaign, which would explain the energy and money-saving opportunities available, while still allowing consumers to make their own choice. This, coupled with the financing program mentioned above and possibly electricity decoupling, could result in considerable energy savings. While this may just be “wishful thinking” on my part, government sponsored EE programs are gaining more and more traction in policy offices across the country, and will almost certainly play a part in Reggie, Meggie, and Weggie.

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5 Responses to “Energy efficiency: if wishful thinking won’t make it so, what will?”

  1. Evan Herrnstadt said

    That generic drug analogy is really interesting. Whenever I’m in CVS or Target or wherever, I always wonder how Advil, Aleve, and other brand-name NSAID’s can get away with charging twice as much for the exact same chemical.

  2. Jeff said

    Good summary of some key market failures associated with the adoption of energy efficient technologies. A couple of comments:

    There are businesses set up to help address the capital (and information) constraints you reference — they’re called Energy Service Companies, or ESCOs — and they primarily work with commercial and institutional customers, providing energy audits and financing, and performing the retrofits; they’ve seemed to have a harder time penetrating the residential sector, perhaps because of high transaction costs relative to the value of the energy savings. I don’t think many local government or non-profits have yet filled the financing gap — the Berkeley example you reference is the 1st of its kind in the US I’m aware of, and they’re just getting started. Some states, like CA, are encouraging/requiring utilities to help fill the financing gap with “on-bill financing” programs (as a part of their broader portfolio of EE programs), where the utility arranges the financing for the EE upgrade and recovers the costs over time on the customer’s energy bill (which will be presumably lower after the EE retrofit) (e.g., Southern California Edison). Of course, removing the throughput incentive (through decoupling, as one mechanism) is a necessary condition if you want the utilities to be the deliverers of EE programs.

    Re the information barrier, see EPA and DOE’s ENERGY STAR and CA’s Flex Your Power as examples of government trying to step in.

  3. Jeff said

    Sorry about the links, my first time trying to use the xhtml tags…

    Here’s the text without the missing words (and no tags):
    Good summary of some key market failures associated with the adoption of energy efficient technologies. A couple of comments:

    There are businesses set up to help address the capital (and information) constraints you reference — they’re called Energy Service Companies, or ESCOs — and they primarily work with commercial and institutional customers, providing energy audits and financing, and performing the retrofits; they’ve seemed to have a harder time penetrating the residential sector, perhaps because of high transaction costs relative to the value of the energy savings. I don’t think many local government or non-profits have yet filled the financing gap — the Berkeley example you reference is the 1st of its kind in the US I’m aware of, and they’re just getting started. Some states, like CA, are encouraging/requiring utilities to help fill the financing gap with “on-bill financing” programs (as a part of their broader portfolio of EE programs), where the utility arranges the financing for the EE upgrade and recovers the costs over time on the customer’s energy bill (which will be presumably lower after the EE retrofit) (e.g., SCE). Of course, removing the throughput incentive (through decoupling, as one mechanism) is a necessary condition if you want the utilities to be the deliverers of EE programs.

    Re the information barrier, see EPA and DOE’s ENERGY STAR and CA’s Flex Your Power as examples of government trying to step in.

  4. Daniel Hall said

    Jeff, thanks for the extra info and web resources. I fixed the links in your first comment. (The key is to close the tags; thus, for bold I would not only type the “open bracket” “b” “close bracket” at the beginning of the bolded section, but also “open bracket” “slash” (i.e. / ) “b” “close bracket” after what I want bolded. For hyperlinks you close with “open bracket” “slash” “a” “close bracket”.)

  5. S. Salyer said

    Although not anything nearing an economic explanation, I would add to the list:

    4. Human nature: General laziness, stupidity, and ego. People feel a certain sense of power when they drive 70 instead of 60, regardless of whether it will save them gas, a speeding ticket or higher insurance rates. Everyone knows that having indiscriminate, unprotected sex with lots of people is stupid and dangerous, but some do it anyway. Minor improvements in your home can guarantee thousands of dollars worth of savings, but hey, there’s a football game on this weekend.

    Maybe they are acting as rational players in the market, but put far too much value on their time, freedom of choice, or sense of self. Still, it seems like real economics plays very little role in some decisions that many people make.

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