Environmental Economics – A Personal Perspective

Today, I wish to take a brief hiatus from reflecting on the current status of climate change policy, whether in the often traumatic context of policy pronouncements – or rather, Twitter messages – from U.S. President Trump and his administration, or in the broader, longer-term context of global actions.  Rather, I want to seize on this mid-summer opportunity to think about the past rather than the present.  In particular, I would like to reflect on the four decades in which I have been engaged in the world of environmental policy, most recently – for the past 30 years – as a scholar, from my professorial perch at Harvard.

This reflection is facilitated by the fact that two years ago, I was asked by the editor of the Singapore Economic Review, Professor Euston Quah, to write about the evolution of the field of environmental economics.  I was pleased to do so, and I decided to take a quite personal approach to summarizing what otherwise would have required a rather Herculean effort.  The result was published earlier this year:  “The Evolution of Environmental Economics:  A View from the Inside,” Singapore Economic Review, volume 62, number 2, 2017, pages 251-274.

[By coincidence, in just a few days, I am travelling to Singapore to make two presentations – on August 4th at the 2017 Singapore Economic Review Conference, and on August 6th at the 7th Congress of the East Asian Association of Environmental and Resource Economics.]

Evolution of the Field of Environmental Economics

Over the past three to four decades, environmental and resource economics has evolved from what was once a relatively obscure application of welfare economics to a prominent field of economics in its own right.  The number of articles on the natural environment appearing in mainstream economics periodicals has continued to increase, as has the number of economics journals dedicated exclusively to environmental and resource topics.  Likewise, the influence of environmental economics on public policy has increased significantly, particularly as greater use has been made of market-based instruments for environmental protection.

My article this year in the Singapore Economic Review provides one economist’s perspective on this twenty-year evolution, first by tracing it through personal reflections on the professional path that has led to my research and writing, and then by summarizing some highlights of my research.  That article was itself rendered feasible because of two previous book projects.

In 1998, my tenth year on the Harvard faculty, I was asked by the British publisher, Edward Elgar Publishing Limited, if I would be willing to assemble my selected papers for a book.  I responded with enthusiasm, and selected 23 articles from the 80 (published and unpublished) papers I had produced as of then – frequently with co-authors – from the time I received my Ph.D. in 1988 through 1999.  Making the selection was not any easy task, but it was a rewarding one.  I categorized my research into seven topic areas:  generic issues in environmental economics; benefits and costs of environmental regulation, and the potential use of efficiency and other criteria for evaluating environmental goals; normative analysis of policy instruments; positive analysis of policy instruments; environmental technology innovation and diffusion; land-use change; and global climate change policy. The resulting volume, Environmental Economics and Public Policy:  Selected Papers of Robert N. Stavins, 1988-1999, was published in 2000.

In 2011, ten years after the publication of my first set of selected papers (1988-1999), Edward Elgar Publishing Limited suggested a second volume.  I selected 26 articles from the many more (published and unpublished) papers I wrote over the decade.  The papers again fell into seven (somewhat different) categories:  generic issues in environmental economics; methods of environmental policy analysis; economic analysis of alternative environmental policy instruments; the economics of technological change; natural resource economics; domestic (national and sub-national) climate change policy; and international dimensions of climate change policy. This led to the publication in 2013 of Economics of Climate Change and Environmental Policy:  Selected Papers of Robert N. Stavins, 2000-2011.

In those two volumes and in the recent article in the Singapore Economic Review, I not only summarized highlights of my research, but I also provided a description of the professional path I have taken.  In this blog essay, I am pleased to offer an abridged version below (with the addition of some relevant hyperlinks).

A Professional Path

In retrospect, my professional path may appear somewhat direct, if not altogether linear, but it hardly seemed so as I travelled along it.  The path I describe took me back and forth across the United States and to several continents, and it took me from physics to philosophy, to agricultural extension, to international development studies, to agricultural economics, and eventually to environmental economics.  During this time, much has changed in the profession.

The early ascendency of the field of environmental economics, during the period from 1970 to 1990, was centered within departments of agricultural and resource economics, mainly at U.S. universities, and at Resources for the Future (RFF), the Washington research institution.  Within most economics departments, environmental studies remained a relatively minor area of applied welfare economics.  So, when I enrolled in the Ph.D. program in Harvard’s Department of Economics in 1983, and when I received my degree five years later, no field of study was offered in the field of environmental or resource economics.

Fortunately, Harvard permitted its graduate students to develop an optional, self-designed field as one of two fields on which they were to be examined orally before proceeding to dissertation research.  Without a resident environmental economist in the Department of Economics (Martin Weitzman had yet to move to Harvard from the Massachusetts Institute of Technology), I developed an outline and reading list of the field through correspondence with leading scholars from other institutions, most prominently Kerry Smith, then at North Carolina State University.  My proposal to prepare for and be examined in the field of environmental and resource economics (along with my other field, econometrics) was approved by the Department’s director of graduate study, Dale Jorgenson.  So began my entry into the scholarly literature of the field.

But my interest in environmental economics pre-dated by a considerable number of years my matriculation at Harvard.  Like many others before and since, I came to the field because of a personal interest in the natural environment (the origin of which I describe below).  This personal interest evolved into a professional one while I was studying for an M.S. degree in agricultural economics at Cornell University in Ithaca, New York, in the late 1970’s, where my thesis advisor and mentor was Kenneth Robinson.  I had originally gone to Cornell to study for a professional degree in international development, but found agricultural economics more appealing, largely because of the opportunity to examine social questions with quantitative methods within a disciplinary framework.

The faculty at Cornell and the care given to graduate students (including masters students like myself) were outstanding.  Kenneth Robinson, my first mentor within the economics profession, became my ongoing role model for intellectual integrity.  It was a sad day many years later, in 2010, when Professor Robinson passed away.

A course in linear algebra, brilliantly taught by S. R. Searle, inspired me to pursue quantitative methods of analysis, and I was fortunate to have the opportunity to study econometrics with Timothy Mount.  One summer I had the privilege of learning about comparative economic systems in a small workshop setting from George Staller of the Cornell Department of Economics.   Working with Bud Stanton, I had my first experience teaching at the university level, and with Olan Forker, I had my first try at serious writing.  All of this led to my research and writing of an M.S. thesis, “Forecasting the Size Distribution of Farms:  A Methodological Analysis of the Dairy Industry in New York State.”  The methodology in question was a variable Markov transition probability matrix, the cells of which were estimated econometrically in a multinomial logit framework.  Much to my surprise, this work subsequently received the Outstanding Master’s Thesis Award in the national competition of the American Agricultural Economics Association.

Armed with my M.S. degree, I moved from Ithaca to Berkeley, California, where I eventually met up with Phillip LeVeen, who had until shortly before that time been a faculty member in the Department of Agricultural and Resource Economics at the University of California, Berkeley.  Phil was another superb mentor, and from him I learned the power of using simple models — by which I mean a set of supply and demand curves hastily drawn on a piece of scrap paper — to develop insights into real-world policy problems.  He introduced me to a topic that was to occupy me for the next few years — California’s perpetual concerns with water allocation.  I remember many afternoons spent working with Phil at his dining room table on questions of water supply and demand.

This work with Phil LeVeen led to a consultancy and then a staff position with the Environmental Defense Fund (EDF), the national advocacy group consisting of lawyers, natural scientists, and — then almost unique among environmental advocacy organizations — economists. This marked the beginning of what became an ongoing professional relationship with this rather remarkable organization.  At EDF, I was able to experience for the first time the use of economic analysis in pursuit of better environmental policy.  With W. R. Zach Willey, EDF’s senior economist in California, as a role model, and Thomas Graff, EDF’s senior attorney, as my mentor, I thrived in EDF’s collegial atmosphere, while thoroughly enjoying life in Berkeley’s “gourmet ghetto,” as my neighborhood was called.  Sadly, Tom Graff — without whose passionate and wise mentorship I would not be where I am today — passed away in 2009 after a heroic battle with cancer.

Although I found the work at EDF rewarding, I worried that I would eventually be constrained — either within the organization or outside it — by my limited education.  So, like many others in similar situations, I considered a law degree as the next logical step.  In fact, I came very close to enrolling at Stanford Law School, but instead, in 1983, I accepted an offer of admission to the Department of Economics at Harvard, moved back east to Cambridge, Massachusetts, and began what has turned out to be a long-term relationship with the University.

But where did my interest in the natural environment begin?  Not at Cornell; it was present long before those days.  But it had not yet arisen when I was studying earlier at Northwestern University, from which I received a B.A. degree in philosophy, having departed from my first scholarly interest, astronomy and astrophysics.

Rather, the origins of my affinity for the natural environment and my interest in resource issues are to be found in the four years I spent in a small, remote village in Sierra Leone, West Africa, as a Peace Corps Volunteer, working in agricultural extension (in particular, paddy rice development).  It was there that I was first exposed both to the qualities of a pristine natural environment and the trade-offs associated with economic development.

So, I had begun in astrophysics, moved to philosophy (both at Northwestern), then to agricultural extension in a developing country (Sierra Leone), then to international development studies and subsequently to agricultural economics (both at Cornell), then to environmental economics and policy (EDF), and eventually to graduate study in economics at Harvard.

My dissertation research at Harvard was directed by a committee of three faculty members:  Joseph Kalt, Zvi Griliches, and Adam Jaffe.  Joseph Kalt was the first faculty member at the Department of Economics to validate my interest in environmental and resource issues, and he was unfailingly generous to me and many other graduate students in making his office (and personal computer, then a rather scarce resource) available at all hours.  Later a colleague at the Kennedy School, Joe provided examples never to be forgotten — that economics could be a meaningful and enjoyable pursuit, and that excellence in teaching was a laudable goal.

Zvi Griliches was not only my advisor and mentor, but my spiritual father as well.  Generations of Harvard graduate students would offer similar testimony.  My own father had died only a year before I entered Harvard, and Zvi soon filled for me many paternal needs.  It is now approaching two decades since Zvi himself passed away.  I felt as if I had lost my father a second time.

If Zvi Griliches provided caring and inspiration, Adam Jaffe provided invaluable day-to-day guidance.  It was Adam who convinced me not to go on the job market in my fourth year with what would have been a mediocre dissertation, but to put in another year and do it right.  That turned out to be some of the best professional advice I have ever received.  Our intensive faculty-student relationship from dissertation days subsequently evolved into a very productive professional (and personal) one that continues to this day.  The name of Adam Jaffe appears frequently in my curriculum vitae as a co-author; he has been and continues to be much more than that.

Although they were not members of my thesis committee, I should acknowledge two other faculty members at the Harvard Department of Economics who played important roles in my education.  I was fortunate to take two courses in economic history (a department requirement) from Jeffrey Williamson, who had recently arrived from the University of Wisconsin.  Williamson’s class sessions were as close as anything I have seen to being economic research laboratories.  In class after class, we would carefully dissect one or more articles — examining hypothesis, theoretical model, data, estimation method, results, and conclusions.  If there was any place where I actually learned how to carry out economic research, it was in those classes.

The other name that is important to highlight is that of Lawrence Goulder, then a faculty member at Harvard, and now a professor at Stanford.  I say this not simply because he was willing to be my examiner in my chosen field of environmental and resource economics, nor because he subsequently became such a close friend.  Rather, what is striking about my professional relationship with Larry is the degree to which he has been an unnamed collaborator on so many projects of mine.  Although he and I have co-authored no more than a few articles, his name probably appears more frequently than anyone else’s in the acknowledgments of papers I have written.  There is no one whose overall judgement in matters of economics I trust more, and no one who has been more helpful.

When I began graduate school at Harvard in 1983, it was my intention to return to EDF as soon as I received my degree.  But by my third year in the program, I had decided to pursue an academic career, although one that was heavily flavored with involvement in the real world of public policy.  Within the context of this professional objective, it was not a difficult decision to accept the offer I received in February, 1988, to become an Assistant Professor at the Kennedy School.  Although some of the other offers I received at that time were also very attractive, the choice for me was obvious, and I have never regretted it — not for a moment.

I remain at the Kennedy School today, where I was promoted to Associate Professor in 1992 (an untenured rank at Harvard), and to a tenured position as Professor of Public Policy in 1997.   In 1998, I accepted an appointment as the Albert Pratt Professor of Business and Government, and in 2017, I was appointed the A. J. Meyer Professor of Energy and Economic Development.

In the year 2000, I launched the Harvard Environmental Economics Program, which today brings together — from across the University — thirty-two Faculty Fellows and twenty-seven Pre-Doctoral Fellows, who are graduate students studying for the Ph.D. degree in economics, political economy and government, public policy, or health policy.  The Program, which I continue to direct, forms links among faculty and graduate students engaged in research, teaching, and outreach in environmental, natural resource, and energy economics and related public policy, by sponsoring research projects, convening workshops, and supporting graduate (and undergraduate) education.

A key reason why the Program — and its various projects, including the Harvard Project on Climate Agreements — have been so successful is the marvelous administrative leadership and staff support it enjoys.  Everyone who has been involved in virtually any way has come away impressed by our Executive Director, Robert Stowe, Program Manager, Jason Chapman, and Bryan Galcik, Communications Coordinator.

At the Kennedy School, I have had an excellent mentor, William Hogan, and a superb advisor and friend, Richard Zeckhauser.  Over the years, six successive deans have provided leadership, guidance, and support (including abundant time for my research and writing) — Graham Allison, Robert Putnam, Albert Carnesale, Joseph Nye, David Ellwood, and Douglas Elmendorf.  At Harvard more broadly, I have benefitted from regular interactions with Daniel Schrag, director of the Harvard University Center for the Environment, and Martin Weitzman of the Department of Economics.  For two decades, Marty and I have co-directed a bi-weekly Seminar in Environmental Economics and Policy, which has provided me with frequent opportunities to learn both from seminar speakers and from Marty’s questions and comments.

I will also note that Harvard President Drew Faust has provided superb leadership of Harvard’s increasing research, teaching, and outreach activity on global climate change, and has been exceptionally supportive of my work on climate change policy.  I will refrain from naming the many others at Harvard and elsewhere from whom I continue to learn — including my many co-authors — only because the list of such valued colleagues and friends is so long.  Included have been a most remarkable set of Ph.D. students, many of whom have gone on to productive — indeed illustrious — careers.

Along the way, I have had my share of administrative responsibilities at Harvard, including serving as Director of Graduate Studies for the Doctoral Program in Public Policy and the Doctoral Program in Political Economy and Government, and Co-Chair of the Harvard Business School-Harvard Kennedy School Joint Degree Programs.  Outside of Harvard, I have had the privilege of being a University Fellow of Resources for the Future, a Research Associate of the National Bureau of Economic Research, and the founding Editor of the Review of Environmental Economics and Policy, as well as a member of the Board of Directors of Resources for the Future, the Scientific Advisory Board of the Fondazione Eni Enrico Mattei, and numerous editorial boards. I must also note that I serve as an editor of the Journal of Wine Economics.  In 2009, I was elected a Fellow of the Association of Environmental and Resource Economists.

What originally attracted me to the Kennedy School was the possibility of combining an academic career with extensive involvement in the development of public policy.  I have not been disappointed.  Indeed, a theme that emerges from my professional engagements over the past twenty-five years is the interplay between scholarly economic research and implementation in real-world political contexts.  This is a two-way street.   In some cases, my policy involvement has come from expertise I developed through research, following a path well worn by academics.  But, in many other cases, my participation in policy matters has stimulated for me entirely new lines of research activity.

Finally, what I have characterized as involvement in policy matters is described at the Kennedy School as faculty outreach, recognized to be of great institutional and social value, along with the two other components of our three-legged professional stool — research and teaching.  I should note that my outreach efforts have fallen into five broad categories:  advisory work with members of Congress and the White House (for example, Project 88, a bipartisan effort co-chaired by former Senator Timothy Wirth and the late Senator John Heinz, to develop innovative approaches to environmental and resource problems); service on federal government panels (for example, my role as Chairman of the Environmental Economics Advisory Committee of the U.S. Environmental Protection Agency Science Advisory Board); on-going consulting — often on an informal basis — with environmental NGOs (most frequently, the Environmental Defense Fund) and private firms; advisory work with state governments; and professional interventions in the international sphere, such as service as a Lead Author for the Second and the Third Assessment Reports and a Coordinating Lead Author for the Fifth Assessment Report of the Intergovernmental Panel on Climate Change, professional roles with the World Bank and other international organizations, and advisory work with foreign governments.

Reflections on Common Themes

Preparing the brief professional autobiography for the 2000 and 2013 books and for the 2017 SER article caused me to review many of the several hundred articles, book chapters, and essays I have written over the years.  This allowed me to identify some common themes that emerge from these more than two decades of research and writing.

First, there is the value — or at least, the potential value — of economic analysis of environmental policy.  The cause of virtually all environmental problems in a market economy is economic behavior (that is, imperfect markets affected by externalities), and so economics offers a powerful lens through which to view environmental problems, and therefore a potentially effective set of analytical tools for designing and evaluating environmental policies.

A second message, connected with the first, is the specific value of benefit-cost analysis for helping to promote efficient policies.  Economic efficiency ought to be one of the key criteria for evaluating proposed and existing environmental policies.  Despite its limitations, benefit-cost analysis can be useful for consistently assimilating the disparate information that is pertinent to sound decision making.  If properly done, it can be of considerable help to public officials when they seek to establish or assess environmental policies.

Third, the means governments use to achieve environmental objectives matter greatly, because different policy instruments have very different implications along a number of dimensions, including abatement costs in both the short and the long term.  Market-based instruments are particularly attractive in this regard.

Fourth, an economic perspective is also of value when reflecting on the use of natural resources, whether land, water, fisheries, or forests.  Excessive rates of depletion are frequently due to the nature of the respective property-rights regimes, in particular, common property and open-access.  Economic instruments — such as ITQ systems in the case of fisheries — can and have been employed to bring harvesting rates down to socially efficient levels.

Fifth and finally, policies for addressing global climate change — linked with emissions of carbon dioxide and other greenhouse gases — can benefit greatly from the application of economic thinking.  On the one hand, the long time-horizon of climate change, the profound uncertainty in links between emissions and actual damages, and the possibility of catastrophic climate change present significant challenges to conventional economic analysis.  But, at the same time, the ubiquity of energy generation and use in modern economies means that only market-based policies — essentially carbon pricing regimes — are feasible instruments for achieving truly meaningful emissions reductions.  Hence, despite the challenges, an economic perspective on this greatest of environmental threats is essential.

 A Personal Message

On a personal level, the professional path I have taken offers confirmation that research can influence public policy, and that involvement in public policy can stimulate new research.  The quest — both professional and personal — that took me from Evanston, Illinois, to Sierra Leone, West Africa, to Ithaca, New York, to Berkeley, California, and finally to Cambridge, Massachusetts suggests some consistency of purpose and even function.  I find myself doing similar things, but in different contexts.  It is fair to say that my professional life has taken me along a path that has brought me home.  The words of T. S. Eliot (1943) ring true:

                        We shall not cease from exploration

                        And the end of all our exploring

                        Will be to arrive where we started

                        And know the place for the first time.

Writing these essays, this year’s article, and today’s blog post have forced me to reflect on the past, and think about the future.  The twenty-two articles that comprised the first book of my selected papers and the twenty-six essays that comprised the second volume were the product of twenty-three years on the Harvard faculty (now almost 30 years).  I continue to learn about environmental economics and related public policy from colleagues, collaborators, students, friends, and inhabitants of the ”real world” of public policy – individuals from government, private industry, advocacy groups, and the press.  I hope my learning will continue.


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.


Thinking About the Energy-Efficiency Gap

Adoption of energy-efficient technologies could reap both private and social rewards, in the form of economic, environmental, and other social benefits from reduced energy consumption. Social benefits include improvements in air quality, reduced greenhouse-gas emissions, and increased energy security. In response, governments around the world have adopted policies to increase energy efficiency.  Still, there is a broadly held view that various barriers to the adoption of energy-efficient technologies have prevented the realization of a substantial portion of these benefits.

For some thirty years, there have been discussions and debates among researchers and others in academia, government, non-profits, and private industry regarding the so-called “energy efficiency gap” (or “energy paradox”) — the apparent reality that many energy-efficiency technologies are not adopted even when it makes sense for consumers and businesses to do so, based on their private costs and benefits. That is, decision makers appear to “under-invest” in energy-efficient technologies, relative to the predictions of some engineering and economic models.

What causes this gap?  The answer to that question could presumably help inform the development of better public policy in this realm.

Possible Explanations for the Energy-Efficiency Gap

Potential explanations for the energy efficiency gap tend to fall into three broad categories: (1) market failures, such as lack of information or misplaced incentives; (2) behavioral effects, such as inattentiveness to future energy savings when purchasing energy-consuming products; and (3) modeling flaws, such as assumptions that understate the costs or overstate the benefits of energy efficiency.  In this essay, I simply want to outline the types of hypothetical explanations of the gap that have been posited within these three broad categories.

Market-Failure Explanations

First, various Innovation Market Failures have been posited, including:  research and development (R&D) and learning-by-doing spillovers; inefficient product quality and differentiation due to market power; and inefficient introduction of new products due to consumer taste spillovers (for example, consumers becoming comfortable with a new technology).

Second, another set of potential market-failure explanations for the gap may be characterized as Information Problems.  These include:  lack of information on the part of consumers (learning-by-using or so-called experience goods; energy prices; energy consumption of products; and available substitutes); asymmetric information (the “lemons problem”); and split incentives and principal-agent issues (such as the frequently-discussed renter/owner dichotomy).

Third, there are Capital Market Failures and Liquidity Constraints, which may be a particularly significant issue in developing-country contexts.

Fourth, there are Energy Market Failures, including various externalities (environmental, energy security, congestion, and accident risk), as well as average-cost pricing of electricity.

Behavioral Explanations

The rise of behavioral economics has brought to the fore another well-defined set of potential explanations of the energy efficiency gap.  A variety of alternative taxonomies could be employed to separate these explanations, but one such taxonomy would categorize the explanations as:

Model and Measurement Explanations

The third category of possible explanations of the energy efficiency gap consists essentially of a set of reasons why observed levels of diffusion of energy-efficiency technologies may actually be privately optimal.

First, there is the possibility of unobserved or understated adoption costs, including unaccounted for product characteristics.

Second, there may be overstated benefits of adoption, due to inferior project execution relative to assumptions, and/or poor policy design.

Third, an incorrect discount rate may be employed in an analysis, when the correct consumer and firm discount rates should vary with:

  • opportunity cost of and access to capital
  • income
  • buying versus retrofitting equipment
  • systematic risk
  • option value (see below)

Fourth, there is frequently heterogeneity across end users in the benefits and costs of employing energy-efficiency technologies, so that what is privately optimal on average will not be privately optimal for all.  This can refer either to static (cross-sectional) heterogeneity or to dynamic (intertemporal) heterogeneity, that is, technology improvements over time, which raises two possibilities:  the reality of some potential adopters being short of the frontier, and the presence of option value to waiting.

Fifth and finally, there is the possibility of uncertainty (real, not informational, as above), irreversibility, and option value.  This could be due to uncertainty regarding future energy prices, or can be linked with option value that arises for delaying investments that have only minimal if any salvage value.

Public Policy and Next Steps

Determining the validity of each of these possible explanations — and the degree to which each contributes to the energy efficiency gap — are crucial steps in crafting the most appropriate public policy responses.

To inform future research and policy, Professor Richard Newell of Duke University and I have launched an initiative – sponsored by the Alfred P. Sloan Foundation — to synthesize past work on these potential explanations of the energy paradox and identify key gaps in knowledge.  We are conducting a comprehensive review and assessment of published and ongoing social-science research on the adoption of energy-efficient technologies, including scholarly literature, industry case studies, reports from national and sub-national governments, and, to the extent possible, consulting reports evaluating specific programs.

We are working with leading social scientists — including scholars from economics, psychology, and other disciplines — 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.  We hope the products of this initiative will help decision makers in industry and government better understand the energy efficiency gap, and will thereby contribute to decisions that maximize the potential economic, environmental, and other social benefits associated with optimal adoption of energy-efficient technologies.  As materials become available, we will post them at the project’s Harvard website and the project’s Duke website, and I will alert readers of this blog.  In the meantime, please stay tuned.