Assessing the Energy-Efficiency Gap

Global energy consumption is on a path to grow 30-50 percent over the next 25 years, bringing with it, in many countries, increased local air pollution, greenhouse gas (GHG) emissions, and oil consumption, as well as higher energy prices.  Energy-efficient technologies offer considerable promise for reducing the costs and environmental damages associated with energy use, but these technologies appear not to be used by consumers and businesses to the degree that would apparently be justified, even on the basis of their own (private) financial net benefits.

For some thirty years, there have been discussions and debates about this phenomenon among researchers and others in academia, government, non-profits, and private industry, typically couched in terms of potential explanations of the so-called “energy efficiency gap” or “energy paradox.”

Thinking About the Energy-Efficiency Gap

I wrote about this some two years ago at this blog ().  I  noted then that Professor Richard Newell of Duke University and I had just launched an initiative – sponsored by the Alfred P. Sloan Foundation — to synthesize past work on potential explanations of the energy paradox and identify key gaps in knowledge. We subsequently conducted a comprehensive review and assessment of social-science research on the adoption of energy-efficient technologies.

We worked with leading social scientists — including scholars from economics, psychology, and other disciplines, at a workshop held at Harvard — to examine the various possible explanations of the energy paradox and thereby to help identify the frontiers of knowledge on the diffusion of energy-efficient technologies.  As materials became available, we posted them at the project’s Harvard website and the project’s Duke website.

Releasing a New Monograph

I’m pleased to inform readers of this blog that we have now released a major monograph, Assessing the Energy Efficiency Gap, co-authored with Todd Gerarden, a Harvard Ph.D. student in Public Policy and a Pre-Doctoral Fellow of the Harvard Environmental Economics Program (HEEP).  The monograph draws in part from the research workshop held at Harvard (in October 2013), in which most of the U.S.-based scholars (primarily, but not exclusively, economists) then conducting research on the energy-efficiency gap participated. HEEP co-sponsored a second such research workshop with the Centre for European Economic Research (ZEW) in Mannheim, Germany in March 2014, where European economists explored the same topic. Closely-related research was presented by panelists at the annual conference of the Allied Social Science Association in January 2015.

In the new monograph, Gerarden, Newell, and I examine both the “energy paradox,” the apparent reality that some energy-efficiency technologies that would pay off for adopters are nevertheless not adopted, and the broader phenomenon we characterize as the “energy-efficiency gap,” the apparent reality that some energy-efficiency technologies that would be socially efficient are not adopted. The contrast is between private and social optimality, which ultimately has important implications for the role of various policies, as well as their expected net benefits.

Four Key Questions

We begin by decomposing cost-minimizing energy-efficiency decisions into their fundamental elements, which allows us to identify four major questions, the answers to which are germane to sorting out the causes (and reality or lack thereof) of the paradox and gap.

First, we ask whether the energy efficiency and associated pricing of products on the market are economically efficient. To answer this question, we examine the variety of energy-efficient products on the market, their energy-efficiency levels, and their pricing. Although the theory is clear, empirical evidence is—in general—quite limited. More data that could facilitate potential future empirical research are becoming available, although firm-level data are much less plentiful than data on consumers. We do not see this area as meriting high priority for future research, however, with the exception of research that evaluates the effectiveness and efficiency of existing energy-efficiency information policies and examines options for improving these policies.

Second, we ask whether energy operating costs are inefficiently priced and/or understood. Even if consumers make privately optimal decisions, energy-saving technology may diffuse more slowly than the socially optimal rate, because of negative externalities. So, even if the energy paradox is not present, the energy-efficiency gap may be. As in the first realm, the theoretical arguments are strong. Empirical evidence is considerable, and in many cases data are likely to be available for additional research. Existing policies appear not to be sufficient from an economic perspective, suggesting that further research is warranted. Indeed, we ascribe high priority to the pursuit of research in this realm.

Third, we ask whether product choices are cost-minimizing in present-value terms, or whether various market failures and/or behavioral phenomena inhibit such cost-minimization. We find that the empirical evidence ranges from strong (split incentives/agency issues and inattention/salience phenomena) to moderate (heuristic decision-making/bounded rationality, systematic risk, and option value) to weak (learning-by-using, loss aversion, myopia, and capital market failures). Importantly, here, as elsewhere in our review, the bulk of previous work has focused on the residential sector and much less attention has been given to the commercial and industrial sectors. Some areas merit priority for future research, such as empirical analysis of split incentives/agency issues in areas where efficiency standards are not present, and much more work can be done in the behavioral realm.

Fourth, we ask whether other unobserved costs may inhibit energy-efficient decisions. We find that the empirical evidence is generally sound, and that data needed for more research are available. We assign a relatively high priority to future research, particularly to aid understanding of consumer demand for product attributes that are correlated with energy efficiency, thereby informing policy and product development decisions.

Three Categories of Potential Explanations of the Gap

Finally, we ask what these findings have to say about the three categories of explanations (reviewed in detail in my 2013 essay at this blog) for the apparent underinvestment in energy-efficient technologies relative to the predictions of some engineering and economic models: (1) market failures, (2) behavioral effects, and (3) modeling flaws.  In brief, potential market-failure explanations include information problems, energy market failures, capital market failures, and innovation market failures. Potential behavioral explanations include inattentiveness and salience, myopia and short sightedness, bounded rationality and heuristic decision-making, prospect theory and reference-point phenomena, and systematically biased beliefs. Finally, potential modeling flaws include unobserved or understated costs of adoption; ignored product attributes; heterogeneity in benefits and costs of adoption across potential adopters; use of incorrect discount rates; and uncertainty, irreversibility, and option value.

It turns out that all three categories of explanations are theoretically sound and that limited empirical evidence exists for every category as well, although the empirical research is by no means consistently strong across all of the specific explanations.  The validity of each of these explanations—and the degree to which each contributes to the energy-efficiency gap—are relevant for crafting sensible policies, so Gerarden, Newell, and I hope that our new monograph can help inform both future research and policy.  Given the many energy-efficiency policies and programs that are already in place, high priority should be given to research that evaluates the effectiveness, cost-effectiveness, and overall economic efficiency of existing energy-efficiency policies, as well as options for their improvement.

What to Expect at COP-20 in Lima

On Monday, December 1st, the Twentieth Conference of the Parties (COP-20) of the United Nations Framework Convention on Climate Change (UNFCCC) commences in Lima, Peru. Over the next two weeks, delegations from 195 countries will discuss and debate the next major international climate agreement, which – under the auspices of the Durban Platform for Enhanced Action – is to be finalized and signed one year from now at COP-21 in Paris, France.

What to Expect in Lima

Because of the promise made in the Durban Platform to include all parties (countries) under a common legal framework, this is a significant departure from the past two decades of international climate policy, which – since the 1995 Berlin Mandate and the 1997 Kyoto Protocol – have featured coverage of only a small subset of countries, namely the so-called Annex I countries (more or less the industrialized nations, as of twenty years ago).

The expanded geographic scope of the incipient Paris agreement – combined with its emerging architecture in the form of a pragmatic hybrid of bottom-up nationally determined contributions (NDCs) plus top-down elements for monitoring, reporting, verification, and comparison of contributions – represents the greatest promise in many years of a future international climate agreement that is truly meaningful.

A Diplomatic Breakthrough:  The Key Role of the China-USA Announcement

If that confluence of policy developments offers the promise, then it is fair to say that the recent joint announcement of national targets by China and the United States (under the future Paris agreement) represents the beginning of the realization of that promise. From the 14% of global CO2 emissions covered by nations participating (a subset of the Annex I countries) in the Kyoto Protocol’s current commitment period, the future Paris agreement with the announced China and USA NDCs covers more than 40% of global CO2 emissions. With Europe, already on board, the total amounts to more than 50% of emissions.

It will not be long before the other industrialized countries announce their own contributions – some quite possibly in Lima over the next two weeks. More importantly, the pressure is now on the other large, emerging economies – India, Brazil, Korea, South Africa, Mexico, and Indonesia – to step up. Some (Brazil, Korea, Mexico?) may well announce their contributions in Lima, but all countries are due to announce their NDCs by the end of the first quarter of 2015.

The announced China-USA quantitative contributions are themselves significant. For China, capping its emissions by 2030 (at the latest) plus increasing its non-fossil energy generation to 20% by the same year will require very aggressive measures, according to a recent MIT analysis. For the USA, cutting its emissions by 26-28% below the 2005 level by 2025 means doubling the pace of cuts under the country’s previous international commitment.

Thus, the China-USA announcement begins the fulfillment of the promise of the Durban Platform. A sufficient foundation is being established for meaningful future steps, and thereby the likelihood of a successful outcome in Paris has been greatly increased.  The talks in Lima over the next two weeks will produce at least a rough draft of the the Paris agreement, which can then be elaborated and finalized over the coming year, and signed (with abundant photo opportunities for heads of state) in Paris in December, 2015.

Keeping Our Eyes on the Prize

There will be — indeed, already have been — pronouncements of failure of the Lima/Paris talks from some green groups, primarily because the talks will not lead to an immediate decrease in emissions and will not prevent atmospheric temperatures from rising by more than 2 degrees Celsius (3.6 degrees Fahrenheit), which has become an accepted, but essentially unachievable political goal. These well-intentioned advocates mistakenly focus on the short-term change in emissions among participating countries (for example, the much-heralded 5.2% cut by the Annex I countries in the Kyoto Protocol’s first commitment period), when it is the long-term change in global emissions that matters.

In other words, they ignore the geographic scope of participation, and do not recognize that — given the stock nature of the problem — what is most important is long-term action.  Each agreement is no more than one step to be followed by others.  And most important now for ultimate success later is a sound foundation, which is precisely what may finally be provided by the China-USA announced contributions under the Durban Platform structure of a hybrid international policy architecture.

All in all, this may turn out to be among the most important moments in two decades of international climate negotiations. And this means – at a minimum – that the next two weeks in Lima should be very interesting indeed.

Upcoming Events at COP-20 in Lima

As with previous Conferences of the Parties, we – the Harvard Environmental Economics Program and the Harvard Project on Climate Agreements (HPCA) – will be at the Lima talks for their second week, December 7-12. We will be participating in a number of events, and will be holding bilateral meetings with key national delegations.

In all cases, our contributions to the discussions will draw on our compendium of knowledge from our 70 research initiatives in Argentina, Australia, China, Europe, India, Japan, and the United States. Our purpose continues to be to help identify and advance scientifically sound, economically sensible, and politically pragmatic policy options for addressing global climate change.

For those of you who will be in Lima (as well as the rest of you), here is the schedule of COP-20 events that are co-sponsored by HPCA or in which I am participating as HPCA Director. It is going to be a very busy week, but I will try to blog – or at least tweet – about these events and other developments. After I return from Lima, I will follow up with an assessment.

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Monday, December 8, 4:45 – 6:15 pm, Room: Machu Picchu

Sponsors: Harvard Project on Climate Agreements, Centre for European Economic Research (ZEW), and Enel Foundation

“Implications of the energy-efficiency gap for reducing greenhouse-gas emissions”

The discussion will be based on our Duke-Harvard research project (sponsored by the Alfred P. Sloan Foundation) on the “energy-efficiency gap”—the apparent difference between predicted and measured rates of adoption of energy-efficiency technology. Panelists will explore the implications of this gap for climate-change mitigation.

Speakers:

Daniele Agostini, Head of Low Carbon Policies and Carbon Regulation, Enel Group

Andreas Löschel, Chair of Microeconomics, and Energy and Resource Economics, University of Münster, and Research Associate, ZEW

Richard Newell, Gendell Professor of Energy and Environmental Economics, Nicholas School of the Environment, Duke University, and Director, Duke University Energy Initiative

Robert Stavins, Director, Harvard Project on Climate Agreements and Albert Pratt Professor of Business and Government, Harvard Kennedy School

Jesus Tamayo Pacheco, President of the Supervisory Body for investment in energy and mines of Peru

See also background paperhttp://belfercenter.ksg.harvard.edu/publication/24749

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Tuesday, December 9, 12:00 – 2:00 pm, China Pavilion

Sponsors: National Center for Climate Change Strategy and International Cooperation (NCSC), National Development and Reform Commission (NDRC), People’s Republic of China

“International Cooperation: Towards the 2015 Agreement –A perspective from international think tanks”

This event aims at exchanging ideas from various international think tanks on the design of the 2015 Agreement with consideration of interaction and cooperation of parties on bilateral and multilateral basis, with a view to provide for inputs to the debates of the negotiation of the 2015 Agreement.

Speakers:

H.E. Minister Xie Zhenhua, Head of Chinese Delegation to COP-20 and Vice Chairman, NDRC

Li Junfeng, Director General, NCSC

Zou Ji, Deputy Director, NCSC

Robert Stavins, Director, Harvard Project on Climate Agreements

Du Xiangwan, Former Vice President, Chinese Academy of Engineering

Martin Kohl, President, South Center

Jennifer Morgan, Global Director of Climate Program, World Resources Institute

Teresa Ribera, President, Institute for Sustainable Development and International Relations

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Tuesday, December 9, 4:30 – 6:10 pm, International Emissions Trading Association (IETA) Pavilion

“What Role will Markets Play in the 2015 Climate Agreement? How can the Agreement Facilitate Linkage of Carbon Pricing Policies?”

Speakers:

Dirk Forrister, President & CEO, IETA

Robert Stavins, Director, Harvard Project on Climate Agreements

David Hone, Chief Climate Change Adviser, Shell Research

Anna Lindstedt, Ambassador for Climate Change, Government of Sweden

Mary Nichols, Chair, California Air Resources Board

Amber Rudd, Parliamentary Under Secretary of State, Department of Energy and Climate Change, Government of the United Kingdom

See also background paperhttp://belfercenter.ksg.harvard.edu/publication/24568

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Thursday, December 11, 11:30 am – 1:00 pm, Room: Caral

Sponsors: International Emissions Trading Association, Arizona State University, Harvard Project on Climate Agreements

“Linkage among climate policies in the 2015 Paris agreement”

Panelists will discuss how the Paris agreement might facilitate or impede linkage among cap-and-trade, carbon tax, and non-market regulatory systems. Panelists will also address related issues involving market mechanisms in the new agreement.

Speakers:

Daniel Bodansky, Foundation Professor of Law, Sandra Day O’Connor College of Law, Arizona State University

Dirk Forrister, President & CEO, IETA

Robert Stavins, Director, Harvard Project on Climate Agreements

Alexia Kelley, Senior Climate Change Advisor, U.S. Department of State

Nathaniel Keohane, Vice President for International Climate, Environmental Defense Fund

Ulrika Raab, Senior Advisor Climate Change, Swedish Energy Agency

See also background paperhttp://belfercenter.ksg.harvard.edu/publication/24568

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EPA’s Proposed Greenhouse Gas Regulation: Why are Conservatives Attacking its Market-Based Options?

This week, the Obama Administration’s Environmental Protection Agency (EPA) released its long-awaited proposed regulation to reduce carbon dioxide (CO2) emissions from existing sources in the electricity-generating sector.  The regulatory (rule) proposal calls for cutting CO2 emissions from the power sector by 30 percent below 2005 levels by 2030.

The Fundamentals in Brief

Through a carefully designed formula, EPA’s proposal lists specific targets for each state, under Section 111(d) of the Clean Air Act. States are given broad flexibility for how to meet their targets, including:  increasing the efficiency of fossil-fuel power plants; switching electricity dispatch from coal-fired generating plants to natural gas-fired generating plants; developing new low-emissions generation, such as new natural gas combined cycle plants, more renewable sources (wind and solar), nuclear, or coal with carbon capture and storage; and more efficient end-use of electricity.

States are also given flexibility to employ (in their implementation plans to be submitted to EPA) any of a wide variety of policy instruments, including but by no means limited to market-based trading systems.  Furthermore, states can work together to submit multi-state plans.

The proposed regulation will be finalized after receipt of comments one year from now (June 30, 2015).  Then states will have until July 2016 to submit their plans, and can request one-year extensions (or two-year extensions for multi-state plans). Compliance commences in 2020.

A Big-Picture Assessment of the Proposed Rule

Let’s start by acknowledging that the proposed policy will be less effective environmentally and less cost-effective economically than the economy-wide approach the Administration previously tried with the Waxman-Markey bill, which passed the U.S. House of Representatives in 2009, but failed to receive a vote in the U.S. Senate.  Electricity generation is responsible for about 38 percent of U.S. CO2 emissions, and about 32 percent of U.S. greenhouse gas (GHG) emissions.

Given ongoing political polarization in Washington and the inability of Congress to approve that more comprehensive and more cost-effective approach, this is probably the best the administration could do.  Together with the motor-vehicle fuel efficiency and appliance energy efficiency standards previously put in place, this is certainly a step in the right direction.

More broadly, the importance of these U.S. moves in the international context should not be underestimated.  Although the United States accounts for only about 17% of global CO2 emissions (second to China’s 26% in 2010), these steps by the U.S. government can help international efforts to bring the large emerging economies (China, India, Brazil, Korea, South Africa, and Mexico) on board for a future (Paris, 2015) agreement under the Durban Platform for Enhanced Action.

Domestically, EPA’s proposed state-by-state approach does not guarantee cost-effectiveness, because under the formula employed, marginal abatement costs will initially vary across states.  However, freedom is given to the states to employ market-based instruments, in particular, cap-and-trade systems (with carbon taxes presumably also an option).  And EPA has emphasized its willingness to consider multi-state implementation plans (think, for example, of the existing Regional Greenhouse Gas Initiative – RGGI – the cap-and-trade system operating in nine northeast states; and the likelihood of a future linked policy bringing together California’s AB-32 cap-and-trade system with policies in Oregon and Washington).

The ability of states to develop under EPA’s rule such linked systems of market-based instruments, as well as the freedom for states and regions to subsequently establish linkages means that although EPA may not be guaranteeing cost-effectiveness, it is certainly allowing for it, indeed it is facilitating it.

Response from Environmental Advocacy Groups and Industry

Much of the response this week has not been surprising.  The major environmental advocacy groups have been supportive of the proposed rule, despite the fact that they would prefer even greater ambition.  Many in industry have also offered praise for the approach, particularly because of the flexibility that EPA has given for the means of achieving emissions reductions.  In fact, some electricity-sector executives have been supportive, precisely for this reason, and appear to be encouraging the adoption of cap-and-trade systems.  At a minimum, leading electric utilities, including some that are fossil-heavy, such as FirstEnergy Corporation and American Electric Power, Inc., have taken a “wait-and-see” attitude, rather than attacking the proposal.

Also not surprising has been strong opposition from the coal industry, as well as some prominent industry trade associations, including the U.S. Chamber of Commerce.  Once the rule has become final (about a year from now), lawsuits will surely be filed by some of these private industry opponents and by a number of resistant states.

I will leave it to the lawyers to comment on the likely grounds of those anticipated lawsuits, as well as their probabilities of success.  But, clearly, for the plan to succeed it will need to survive those legal challenges, which will work their way through the courts over several years.

Also, a significant change in the senate majority and in the party holding power after the next presidential election could result in progress being slowed to a crawl, if not the abandonment of the approach proposed by the current administration.

None of that is particularly surprising, but what should be surprising is the fact that conservative attacks on EPA’s proposed rule have focused, indeed fixated, on one of the options that is given to the states for implementation, namely the use of market-based instruments, that is, cap-and-trade systems.  Given the demonization of cap-and-trade as “cap-and-tax” over the past few years by conservatives, why do I say that this fixation should be surprising?

The Irony of Conservatives Targeting Cap-and-Trade

Not so long ago, cap-and-trade mechanisms for environmental protection were popular in Congress. Now, such mechanisms are denigrated. What happened?  Professor Richard Schmalensee (MIT) and I recently told the sordid tale of how conservatives in Congress who once supported cap and trade had come to lambast climate change legislation as “cap-and-tax.” Ironically, in doing this, conservatives have chosen to demonize their own market-based creation.

In the late 1980s, there was growing concern that acid precipitation – the result of SO2 and, to a lesser extent, nitrogen oxides (NOx) reacting in the atmosphere to form sulphuric and nitric acids – was damaging forests and aquatic ecosystems, particularly in the northeast U.S. and southern Canada. In response, the U.S. Congress passed (and President George H.W. Bush signed into law) the Clean Air Act Amendments of 1990. Title IV of this law established the SO2 allowance-trading system.

By the close of the 20th century, the SO2 allowance-trading system had come to be seen as both innovative and successful.  However, the successful enactment and implementation of the SO2 cap-and-trade system in 1990 combined with the subsequent Congressional defeat of CO2 cap-and-trade legislation 20 years later has produced a striking irony. Market-based, cost-effective policy innovation in environmental regulation – in particular, cap-and-trade – was originally championed and implemented by Republican administrations from that of President Ronald Reagan to that of President George W. Bush.  But in recent years, Republicans have led the way in demonizing cap-and-trade, particularly as an approach to limiting carbon emissions.

For a long time, market-based approaches to environmental protection, such as cap-and-trade, bore a Republican label.  In the 1980s, President Ronald Reagan’s EPA put in place a trading program to phase out leaded gasoline. It produced a more rapid elimination of leaded gasoline from the marketplace than had been anticipated, and at a saving of some $250 million per year, compared with a conventional no-trade, command-and-control approach. Not only did President George H.W. Bush successfully propose the use of cap-and-trade to cut SO2 emissions, his administration advocated in international forums the use of emissions trading to cut global CO2 emissions (a proposal initially resisted but ultimately adopted by the European Union). In 2005, President George W. Bush’s EPA issued the Clean Air Interstate Rule, aimed at reducing SO2 emissions by a further 70% from their 2003 level. Cap-and-trade was again the policy instrument of choice.

From Bi-Partisan Support to Ideological Polarization

When the Clean Air Act Amendments were being considered in the Congress in 1989-1990, political support was not divided on partisan lines. Indeed, environmental and energy debates from the 1970s through much of the 1990s typically broke along geographic lines, rather than partisan lines, with key parameters being degree of urbanization and reliance on specific fuel types. Thus, the Clean Air Act Amendments of 1990 passed the Senate by a vote of 89-11 with 87% of Republican members and 91% of Democrats voting yea, and passed the House of Representatives by a vote of 401-21 with 87% of Republicans and 96% of Democrats voting in support.

But twenty years later, when climate change legislation was receiving serious consideration in Washington, environmental politics had changed dramatically, with Congressional support for environmental legislation coming mainly to reflect partisan divisions. In 2009, the House of Representatives passed the American Clean Energy and Security Act of 2009 (H.R. 2454) – the Waxman-Markey bill – that included an economy-wide cap-and-trade system to cut CO2 emissions. The Waxman-Markey bill passed the House by a narrow margin of 219-212, with support from 83% of Democrats, but only 4% of Republicans. In July 2010, the Senate abandoned its attempt to pass companion legislation. In the process of debating this legislation, conservatives (largely Republicans and some coal-state Democrats) attacked the cap-and-trade system as “cap-and-tax,” much as an earlier generation of liberals had denigrated cap-and-trade as “selling licenses to pollute.”

It may be that some conservatives in Congress opposed climate policies because of disagreement about the threat of climate change or the costs of the policies, but instead of debating those risks and costs, they chose to launch an ultimately successful campaign to demonize and thereby tarnish cap-and-trade as an instrument of public policy, rendering it “collateral damage” in the wider climate policy battle.

Today that “scorched-earth” approach may have come back to haunt conservatives.  Have they now boxed themselves into a corner, unable to support the power of the marketplace to reduce their own states’ compliance costs under the new EPA CO2 regulation?  I hope not, but only time will tell.