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.
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.
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:
- Inattentiveness and Salience Issues (although inattention can be rational and efficient under some circumstances);
- Myopia (that is, short-sightedness);
- Prospect Theory (and reference point issues);
- Bounded Rationality and Heuristic Decision-Making; and
- Systematically Biased Beliefs (regarding, for example, future energy prices and the development of new technologies).
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
- 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.
One thought on “Thinking About the Energy-Efficiency Gap”
I spent my career in the energy industry, first in technical RDD&D on residential, commercial and industrial appliances and equipment; and later in Market Development, Marketing and consulting. In the course of my career, I interfaced with industry corporate management, appliance and equipment manufacturer management, industry associations, US DOE, state regulators and consumer advocates, consumer groups, builders and developers and customers. I have seen examples of the issues you raised above, as well as others. In my personal life, I have also: purchased numerous appliances and pieces of equipment; purchased two existing homes; and, contracted for the construction of two custom homes.
I have concluded that it is almost never economically rational to replace an existing, functioning appliance or piece of equipment with a new, more efficient appliance or piece of equipment. The economic dead loss resulting from such a replacement is almost always prohibitive. The potential customer with a functioning appliance or piece of equipment must justify the entire installed cost of a new device, whereas the customer with a failed device need only be concerned with the incremental installed cost of the more efficient device, since the failed device must be replaced anyway. It is also often very difficult and expensive (and, in some cases, dangerous) to replace equipment of one generation of technology with equipment of a later generation of technology. US DOE encountered such a safety issue years ago when it effectively banned manufacture and sale of atmospherically vented gas furnaces and required “partially-condensing” furnaces. DOE was warned of the potential safety issues, but chose to ignore them. Ultimately, the manufacturers were required to conduct a complete product recall after numerous, potentially hazardous failures.
US DOE has also contributed to consumer confusion with its “alphabet soup” of efficiency ratings, including AFUE, HSPF, SEER, etc.; and, its infamous Home Energy Rating System (HERS) and Energy Star Home program. DOE has also used extremely low estimates of the costs of installing disparate technology equipment in existing homes in analyzing customer costs and savings . For example, many gas furnaces approaching the ends of their useful lives are naturally aspirated, gravity vented devices which draw their combustion air from inside the building and vent their combustion products through double-walled metal vents of typically 6-8″ diameter. The highest efficiency gas furnaces available today are condensing furnaces, which draw their combustion air from outside the structure through plastic pipe and vent their exhaust products through similar plastic pipe. They are not suitable for use with the existing venting system; and, the required venting system is frequently very expensive to install, particularly when it must be run through finished spaces to an outside wall. Also, even with the availability of the internet, it is very difficult for the consumer to compare equipment prices, since the equipment is not available for direct purchase by the customer, but rather must be purchased installed.
Realtors involved in the resale of existing homes typically know very little about the water heating, space heating and space cooling equipment installed in the homes they are selling. That information is also not easy for a typical customer to decipher, even if the “yellow label” is still attached to the equipment. Builders, even custom builders, generally focus very little attention on the aspects of the buildings and their equipment which are not highly visible (kitchen vs. utility room). It is extremely rare for a customer arranging to have a custom home built to meet with the HVAC contractor to review options for the heating and cooling system; or, with the insulation contractor , to review options for types and amounts of material to be installed.. However, the builder will assure that the customer meets with the appliance, plumbing fixture, electrical fixture, flooring, countertop material and cabinet suppliers.