Common Tragedies

Thoughts on Environmental Economics

A Price Signal May Not Be Enough to Promote Energy Efficiency

Posted by Erica Myers on March 7, 2008

As energy prices increase, consumers will reduce their demand through energy efficiency measures and behavioral changes, which in turn will lead to fewer GHG emissions, right? Not according to the latest Carbon Market News Release form Reuters. Despite a recent spike in domestic gas and electricity prices, demand for energy has barely moved. In fact, the more that 100% increase in oil prices in recent years may actually be leading to an increase in carbon emissions.

” ‘The paradox here is that what looks like an increase in energy prices is in fact feeding through to an increase in carbon emissions rather than a reduction,’ said Oxford University economist and government adviser Dieter Helm.

‘That is because the oil price is not a genuine carbon tax. Far from cutting demand for carbon, the high energy prices have prompted a rush for coal — the dirtiest fuel,’ he told Reuters.

While known reserves of oil are expected to last only to around mid-century, and gas is in relatively plentiful but still finite supply, coal reserves are estimated to last for several centuries more.

There are big increases in coal burn in China, India and the United States where even tar sands have started to look attractive to investors again.”

Why isn’t a price signal enough to kick start investment in energy efficiency, “the low hanging fruit”? Rich did call me out on CT almost two months ago to put in my two cents on this; better late than never. Here are a few thoughts-most of these issues work in tandem:

1. The incentives for energy savings are not always there

– The person making the capital investment decisions is not always the person benefiting from energy savings (principle-agent problem). For example, the owner/manager of a building may not be the one paying the utility bills.

– The benefits from energy efficiency often come from relatively small diffuse pieces, and private businesses are more likely to invest in one large deal.

– People can’t respond to prices because they don’t have real time pricing information

2. The costs of achieving energy efficiency are likely higher than some estimates suggest (they are sometimes reported as negative costs)

– Lack of substitutability/Hidden Costs- Rich’s example of the difference in the quality of light emitted from incandescent vs. CFL light bulbs (though they do come in soft white now)

– Transaction costs of raising awareness or implementing programs such as putting smart grid technology in everyone’s house.

3. How people actually behave does not always match theory

– With advances in behavioral economics, we are recognizing things such as the “status quo bias” where there seems to be some added cost to switching behavior. The investment that it takes to review the options to make a different decision may seem confusing and not worth it for uncertain benefits.

– Rich suggested (in the same post as above) that people may be using higher discount rates than those in many energy models. For example, if people deal with expenses on a monthly basis, a large upfront cost may seem more expensive than the meager per month savings felt over time. This could be the case even if the cost savings exceed the initial capital investment at market discount rate.

“Evidence shows that there are few visible behavioural changes as a result of high prices. Governments need to do more than just rely on the price mechanism,” said Jim Watson of the Sussex Energy Group. “You need demand side measures too.”

Getting these demand side measures right means getting the incentives right, and matching them to actual human behavior.


4 Responses to “A Price Signal May Not Be Enough to Promote Energy Efficiency”

  1. […] for the externalities, maybe the price runup will have a similar effect. Sadly,  not so much, as Erica Myers pointed out last week: Despite a recent spike in domestic gas and electricity prices, demand for energy has barely moved. […]

  2. Sarah Darley said

    Regarding your point:

    -The benefits from energy efficiency often come from relatively small diffuse pieces, and private businesses are more likely to invest in one large deal.

    It is a puzzling thing to think about how decision-makers evidently prefer to bypass optimizing on the margin in exchange for fewer, lump-sum investment decisions and/or defaulting to the status quo of bigger is better, etc. I think that this directly ties to the principal-agent problem you mention as well. For anyone who’s interested in the merits of smaller-scale energy solutions, I recommend “Small Is Profitable”, a Rocky Mountain Institute publication.

  3. Evan Herrnstadt said

    I think that there are probably some reduced transaction costs associated with making a few big investments instead of numerous smaller ones. Perhaps that explains some of it?

  4. If the benefits are small/diffuse, but transaction costs or other explanations dictate one large deal, the entrepreneurial response is one large contract with a energy efficiency consultant to do a top-to-bottom review of a company.

    Of course the next problem is in writing a contract with the consultant that provides the right incentives for improvements.

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