Evaluating energy efficiency policies.

• Author: Allcott, Hunt
• Position: Research Summaries

One of the great mysteries in environmental and energy economics is what's called the "energy efficiency gap." Since the 1980s, a series of influential analyses has constructed energy efficiency cost curves--engineering estimates of the costs of conserving energy. These engineering analyses consistently find that individuals and firms fail to adopt significant privately profitable energy efficiency investments. For example, a widely publicized study by McKinsey & Company found that the U.S. economy could reduce energy demand by 23 percent through privately profitable investments that have a net present value of $700 billion. (1) These findings are closely related to "takeup problems" in other areas, such as "Why don't more farmers use fertilizer and high-yielding variety seeds?" and "Why don't firms adopt privately profitable management technologies?"

If these results are correct, improving energy efficiency presents a remarkable "win-win opportunity" to both lower energy costs and reduce emissions of carbon dioxide and other pollutants. Policymakers have seized on this argument, and there was a remarkable expansion of energy efficiency policy over the past decade: the Bush and Obama administrations both tightened fuel economy standards and appliance energy efficiency standards, and more than half of states have now passed Energy Efficiency Resource Standards that require utilities to run energy conservation programs.

This argument raises two questions. First, for privately profitable energy efficiency investments to remain unadopted, there must be some market failure(s). What are these market failures, and how large are they? An alternative explanation for low adoption of seemingly profitable investments is that the investments are in fact not profitable, and that the engineering analyses by McKinsey and others overstate private net benefits. A further question is: Are the energy efficiency policies now in place well-designed to address the market failures? In this summary, I describe my research on these and other questions, much of it done with a great group of collaborators and colleagues. (2)

The 'Consumer Protection' Rationale for Energy Efficiency Policy

In addition to concern about environmental externalities, policymakers often use a "consumer protection" or "paternalistic," rationale for energy efficiency policy, suggesting that imperfect information and "behavioral" mistakes could explain why consumers don't take up privately profitable energy efficiency investments. One example of the argument is from the U.S. government's 2010 Regulatory Impact Analysis for Corporate Average Fuel Economy (CAFE) standards:

"Although the economy-wide or 'social' benefits from requiring higher fuel economy represent an important share of the total economic benefits from raising CAFE standards, NHTSA estimates that benefits to vehicle buyers themselves will significantly exceed the costs of complying with the stricter fuel economy standards this rule establishes. [...] This raises the question of why current purchasing patterns do not result in higher average fuel economy, and why stricter fuel efficiency standards should be necessary to achieve that goal. To address this issue, the analysis examines possible explanations for this apparent paradox, including discrepancies between the consumers' perceptions of the value offuel savings and those calculated by the agency" (3) In 2007, Ian Parry, Margaret Walls, and Winston Harrington described the state of knowledge on these potential behavioral biases: "Unfortunately, there is little in the way of solid empirical (as opposed to anecdotal) evidence on this hotly contested issue." (4)

Since then, three empirical strategies have been used to measure systematic consumer "mistakes" in purchases of energy-using durables such as cars, air conditioners, and lightbulbs. These strategies have close connections to behavioral economics work in other domains, such as tax salience, health, and retirement savings. (5)

The first strategy builds on the insight that, absent credit constraints, consumers should care only about a good's total user cost, not the share of that cost that comes from purchase price versus energy costs versus other costs. For example, consumers should be indifferent between a $1 increase in purchase price and...