It’s strange: we view ourselves as rational creatures, but
then we don’t do what we should, even when we know what the right thing to do
is. That’s a mouthful, I know, but I have been thinking a lot about energy
efficiency (EE) of late. We all know that EE is good for us and the planet, but
the problem is that we often don’t make the investments. This divide between
knowing that EE is the right thing but failing to take action is known as the energy efficiency gap.
It is important to understand the reasons for the separation
between knowledge and action. We often read that we don’t need to make investments
in energy infrastructure, such as power plants, natural gas pipelines, wind
farms, or transmission lines; instead, we read that all we need to do is to
make investments in energy efficiency. We are told that such investments would
curtail our growing energy demand and we could make do with the existing
supply. In principle, I agree wholeheartedly and endorse this idea, but the sad
truth is that we don’t make the necessary EE investments. Instead, our energy
consumption grows and we end up having to make the investments in energy
infrastructure anyway. The fact of the matter is that we often fail at making
decisions in our own best interest. This failure to act in favor of our
long-term interest is at the heart of our problems with energy.
Consideration of, support for, and implementation of EE plans are
very important parts of any state or national energy plan. The importance and
benefits of EE, such as reduced energy
demand, lower costs, and lower greenhouse gas emissions, have been
long recognized: As I noted in a previous blog, EE can be considered as an energy source in its own right. The International Energy Agency (IEA) now refers to energy efficiency as the first fuel because the savings from avoided
energy use are now greater than the supply of any single energy source (oil,
electricity, or natural gas) in Australia, USA, and certain EU countries. EE is, in fact, considered an energy
source in its own right. In other words, more can now be achieved by EE
measures than by increasing the supply of a particular energy resource. Moreover, much of the potential from EE
remains untapped.
We face two
choices as our demand for energy increases: we either build new power plants or
we become more efficient in our consumption to curtail our demand. It is not
widely appreciated that EE is the lowest cost option when compared with installing new
power production capacity. The consulting
company, Lazard, carries out an interesting analysis every
year,
in
which they examine renewable and fossil-fuel electricity generation options and
calculate the levelized cost of energy or LCOE. This parameter takes into account the initial
cost of an operation, its electrical output, the annual cost of fuel, annual
maintenance, and an interest cost (normally set by the minimum rate of return
one would like to earn on a project, often equivalent to the bank loan interest
rate to purchase the equipment). These costs are then evenly distributed over
the life of the project to yield a single “levelized” cost for energy. The
attraction of this approach is that it allows a side-by-side comparison of
different projects and energy sources that have very different financial
requirements and expense flows. For example, it allows comparison of a solar
system with high capital but low operating costs with a diesel generator
project that has low capital but high operating costs. LCOE provides a means
for determining which project is better from a lifecycle energy cost point of
view. In the figure below, I have rearranged the Lazard data, showing
renewable technologies in green and fossil fuel options in blue. On an LCOE
basis, it is clear that that EE (shown in red) is the lowest cost option, with
an average value of 2.5 cents/kWh. By way of comparison, I noted in my last post that the
EE numbers for NH through the NH EE Core program were of the order of 3.7
cents/kWh for EE investments.
Source: Lazard
So, if EE is so clearly the lowest cost option, why don’t we
do more of it? Why is there this energy efficiency gap?
The biggest issue is that it requires long-term thinking and
making big investments now to reap benefits far into the future. This is not something
that we are good at. EE costs money and is not always popular, especially with
politicians wrestling with the fallout of high energy prices. Here in NE,
energy prices are already high and EE adds to these costs. The approach adopted
by some is to kick the can down the road by saying No to EE investment and make
high energy consumption a problem for future generations.
I have been wrestling with this this EE paradox: if we know
EE is good for us, why don’t we do it? It is like exercise! We are bombarded
with messages about the benefits of exercise and healthy lifestyles, but often
we come home, crack open a beer, open a bag of Doritos, sit in front of the TV
for the evening— and tell ourselves that we will start exercising tomorrow.
In my thinking about energy efficiency, I have taken a hard
look at the man in the mirror* and my own actions in this regard. I write about
and research energy matters, I teach energy efficiency classes to MBA students,
and I write papers on energy efficiency, but I have not implemented all the EE
measures in my life that I could have. Compared with most folks, my knowledge
of these measures is much deeper, but I still don’t take all the action that I
should. Clearly, I am still on the beer, Doritos, and TV train. Why is this so and why I am standing on the
other side of the energy efficiency gap? What accounts for this paradoxical behavior?
It turns out that this issue has been studied in a fair
amount of depth by economists, but the challenge is that these studies are
often shrouded in arcane language, economic theories, and complicated equations,
which makes them difficult to understand. I wanted to share some of the thinking
behind the reasons for the energy efficiency paradox, so I turned to one of my recently
graduated students, Alexander Ziko, and asked him to explain, in non-economic
language, the reasons for the EE gap.
Take it away, Alex.
This is Alex Ziko, a 2016 graduate from the Franklin Pierce University
MBA in Energy and Sustainability Studies program. I have been studying
energy matters with Prof. Mooiman for the past two years. Having graduated, I
thought I was all done with energy assignments from Prof. Mooiman, but he posed
an interesting question to me and, as I am interested in energy efficiency and
behavioral economics, I decided to tackle the question as to why there is an
energy efficiency gap.
As a brief introduction, I would describe
myself as a native New Englander, recreationalist, and environmentalist living
in the White Mountains of New Hampshire. I work as a data analyst for a small
analytics software company; and spend my spare time reading and studying the
intersection of economics, energy, and sustainability. This fall, when Prof.
Mooiman posed to me an interesting question about the EE gap, he assumed I
would balk at the opportunity of completing yet another assignment regarding
energy economics – especially as this one would be on my own time. However,
accepting Prof. Mooiman’s challenges always proves to be a personally
enlightening experience. So let’s get comfortable as I attempt to turn the
economically arcane into the intellectually engaging.
Why We
Don’t Invest in Energy Efficiency When We Should
Increasing energy efficiency is a
trend that Americans have been seeing for years. The idea of saving energy (and
thus money) is a frequent topic on news broadcasts and daytime television; EE
goods and services are given approving nods from consumers (think EnergyStar
products and LED lighting); and when you crunch the numbers, EE investments
almost always make long-term financial sense. However, consumers still act
imprudently and opt not to make the investments – once again proving that “rational economic
actors” (an economist’s term for everyday people) aren’t always rational with
their choices. Why? Why is there a gap between what is available to the
consumer and what the consumer chooses to do – the so-called energy efficiency
gap? The reasons why consumers choose not to adopt energy efficient options are
complex and different for everyone. One cannot point to one specific area because
there three main reasons for this energy
efficiency paradox that can explain why, for an energy consumer, knowledge does
not lead to action.
Modeling
Flaws - The best decisions are made with good data –
the world of EE is no different. Just as a bank would require accurate and
convincing data before offering you a small business loan, a consumer looking
to invest in EE hardware needs to be convinced of its short- and long-term
value. Let’s use insulation as an example. Upgrading insulation has become a
ubiquitous investment by homeowners as a way to save on energy (electricity,
oil, natural gas, etc.). However, the savings available to a consumer depend
greatly on: the state in which they live, the energy rates in that area, customer
behavior, and the capacity to which the upgraded insulation would reduce heat
losses. This puts a lot of pressure on the forecasting model used by firms that
consult on and commission EE projects to provide an accurate forecast when
proposing an energy project. Factors like the current income and cash flow (how
much you make and spend each month) and budget allocations of the homeowner also
need to be taken into account, along with an analysis of the opportunity cost
associated with the project (opportunity cost can be thought of as the cost of
the “next-best” option for a client). The homeowner’s opportunity cost for
investing upfront cash for better insulation may present itself in the form of
not being able to afford to take a family vacation this year or passing on
orthodontic work for little Billy. In addition, one of the reasons for
investment hesitation with energy investments is the concern that energy prices
will not remain high enough to allow a return on a sizeable upfront investment.
For example, in New England, the primary source of home heat is heating oil. In
the past two years, heating oil prices have fallen. With opportunity costs in
mind, and a relatively low market price for oil, consumers may not see
sufficient benefits to warrant paying to upgrade the insulation in their home,
especially in an economic climate of stagnant wages. Instead, they choose to
keep the money in savings or perhaps spend it on that orthodontic work.
One overlooked and unaccounted for
economic result that doesn’t always show up in an initial energy model is what
is known as the rebound effect. This is the additional consumption of a
product, or the additional emission of negative effects (like pollution),
because you change your consumption habit due to your investment. Sound
complicated? It makes sense if you think about our very human behavior. Let’s
use the example of a hybrid vehicle. Perhaps you traded in your inefficient SUV
for a new or used hybrid; heck, maybe you even acquired the car through a
private sale and got a really good deal. However, with that new car, it is
likely that some of your driving habits are going to change. Because you now
buy less fuel, you might drive more than you did when you were more
conscientious of every mile per gallon. Even though you are driving a more
energy efficient vehicle, you undo some of the EE gains by driving more. Or, in
the case of upgrading your insulation, you perhaps increase your thermostat
setpoint by a few degrees because you don’t burn as much oil as before. These
negative effects are seldom included in the calculation of EE gains, which
could lead to their overstatement. When determining EE benefits, it is important
to monitor energy consumption behavior afterwards to make sure that you really
are achieving your forecasted savings.
Market
Failures - Market failures sound complex,
but they are actually very simple. When the supply of a resource is not matched
by its demand, market failures are present. These can be found in many areas of
the EE universe. Whenever a subsidy for an investment is given, or whenever
pollution is emitted without accounting for its clean up, an imbalance in the
true cost of production and the price of the product is created: this imbalance
is a market failure. For example, subsidizing a homeowner’s EE investments is a
market failure (albeit arguably a positive one) because the homeowner does not
bear the full cost of the investment – they are subsidized by other ratepayers,
thereby creating a market distortion. Then there are the indirect benefits that
the neighbors benefit accrue from the EE investment, such as: improved resiliency of the energy-delivery systems because less energy
has to be sourced, lower costs because fewer power plants have to be built, our
resources last longer, less pollution and greenhouse gas emissions are reduced,
local job creation, etc., as alluded
to by Prof. Mooiman in his blog.
Sometimes, market failures can take the shape of incomplete information.
Energy consumers don’t have the same information that is available to suppliers
of EE products or service: there is a fear that the projected savings might not
materialize and that perceived risk can be an obstacle in moving forward with
an investment.
Another market failure occurs when
multiple people are responsible for the same energy system: those individuals
may not view the system in the same way. This can be found in apartment
buildings where a landlord may not have an incentive to properly insulate and
upgrade the building if the tenant is responsible for the heating bill.
Whenever multiple people have the ability to change the consumption of energy,
there is a possibility that the usage will not happen in an efficient manner.
In economic speak, this is known as the principal/agent or split incentive
problem. Anyone who has grown up in New England can attest to the paternal
fallout that may happen if you touch the thermostat in the living room lest you
decline to put on a sweater.
Other forms of market failures also
fall within the realm of credit constraints.
EE investments normally require high upfront costs: lenders generally
have a poor view of the potential return on these investments and can be
reluctant to lend money for these projects.
Behavioral
Failures - A very common explanation for the EE gap can
be found in the way that people behave. I cannot stress enough that Economics
is much, much more than the examination of dollars and cents; it’s an
examination into how communities and individuals use their finite resources. Improved
understanding of economic behavior has been aided by the field of behavioral
economics, which looks at the differences in the ways that people, as rational
beings making efficient economic choices, are predicted to act and how they
actually behave in real life when they are presented with options. This is what
makes behavioral economics a fascinating and worthy study, because it is just
as much about psychology and philosophy as it is statistics and quantitative
analysis. Behavioral reasons for an EE gap may be centered around personal
beliefs, personal decision making, and personal preferences. For example,
consider a homeowner who uses oil as a heating source. They may have a personal
belief that the future price of heating oil will only go down in the future as
less expensive forms of energy, such as those released by hydraulic fracking,
become available; and therefore it is not financially worthwhile to invest in a
solar hot water system. An example of a personal preference may be found in the
decision to keep driving an inefficient vehicle rather than a hybrid vehicle,
because the owner identifies more with the model of car they own – a personal
identification that is worth more to them than potential fuel savings.
Consumers may also be wary of the reality of energy savings, and are perturbed
by the motives of a sales person looking to make a commission rather than the
true effectiveness of potential energy savings that would result.
Other behavioral failures include:
inattentiveness and salience, myopia, prospect theory, and bounded rationality.
Inattentiveness addresses the fact that we are bombarded by information and
have limited capacity to deal with it all and that we have to make choices
regarding what we do pay attention to. As a result, doing the research
(remember our definition of Economics as resource management, not just dollars
and cents), contacting the vendor, and finding the money for an EE investment
tends to be far down the list of what catches our attention. This is difficult
because it requires more critical thinking and economic creativity than we
usually ask of ourselves in our daily life. We also don’t pay attention to the
long-term energy savings. Instead, we focus on the upfront cost of the
investment – the feature that is most relevant (salient) to us at the time of
the decision. When buying a car, the
upfront premium on a hybrid vehicle and the increased taxes can be more
important to us than the long-term savings. We also tend to discount the
importance of something like much higher fuel prices that might happen in the
future.
Prospect
theory suggests that we, as consumers, are more concerned about the possibility
of loss than the prospect of long-term gains. We tend to weigh losses more
heavily than gains. The spending of $1000 on EE has a greater emotional impact
on us than $2000 of future gains. In
other words, we are concerned about our EE investment being a bad one and are
risk-adverse to the possible gains. Future money is more abstract than the
current balance on the bank account.
Bounded
rationality is another behavioral economics explanation and explains that it is
impossible to analyze and understand all information associated with a
decision, especially a complex technical one. As a result, we resort to short
cuts. For example, in buying a car, we simply might not have time to analyze
all the data, so we might resort to a short cut, such as using Consumer Report
ratings. Or perhaps we simply follow the lead of our neighbors and buy a
similar car.
As you can see, explaining why there
is a slowness to adopt EE measures is not simple. There are many layered and
nuanced economic reasons for why customers don’t install LED light bulbs,
continue to use inefficient home appliances, drive inefficient vehicles, and
delay upgrading home energy systems. Some of this reasoning lies in the information
gap between EE suppliers and energy consumers, but a lot is wrapped up in the
way that consumers view their budgets, the future benefits of changing their
actions, and their preference to the way that they do things now, information
overload, and other choices that draw them away from making EE investments. Getting
people to make EE efficiency investments is not straightforward. Consultants
and EE experts face significant barriers in helping residents and businesses
see through these situations and getting them to make the right decision; while
at the same time learning from their own forecasting errors and mastering a
more accurate prediction of energy savings.
Thanks Alex. So, there we have an explanation as to why I can
sometimes be such an EE slacker. It is a combination of too little information,
and, at times, too much information, inattention, short-term thinking, other
opportunities to spend my money, and more concern about spending money now
rather than long-term energy savings. Overall, the point is that we are not
always rational in our approach and it takes work to get humans to think in the
long term, to do the right thing, and to make those EE investments. As a result, depending on voluntary EE action
is limited in its effectiveness. This is why Federal programs, such as
appliance and fuel economy standards, or State programs, such as building codes
or the Energy Efficiency Resource Standard (EERS) programs, are so important.
They get us to make the right EE decisions by making EE the default option or
by providing incentives such as subsidies for EE investments.
It has been noted by the International Energy Agency in
their 2016 Energy Efficiency Market Report that policy
is the key driver for EE improvements. These policies take one of five forms:
- Mandatory standards, e.g., building energy codes;
- Mandatory energy savings targets, such as those in the NH EERS program;
- Information and labelling, e.g., Energy Star Appliances;
- Financial incentives, such as the subsidies provided by the NH EERS program; and
- Financial disincentives, e.g., consumption taxes, like fuel taxes.
With this powerful range of tools, our legislators have the
ability to make a profound impact on our energy consumption, should they take a
long view. Quite frankly, if EE policy is not used as a tool, our demand will continue
to grow until the point that diminished energy resources and excessive energy
prices will provide the incentive to curtail our energy usage. Escalating demand
will also, by necessity, lead to increased supply: bringing in that increased
supply—renewable or not—will have an impact and, one way or another, we will
end up paying for it. It must be appreciated that every energy project, whether
renewable, nuclear, or fossil-fuel based, has an impact on somebody somewhere.
There is no free lunch when it comes to energy. The choice is a stark one: we
can work to moderate our energy consumption through policy and voluntary
action, or wait for increased demand, higher energy prices, and impacts on our
society and environment to drive our actions. With EE, we have the ability to
moderate, over the long term, our demand in a controllable and less drastic fashion.
I understand the dilemma faced by our elected
representatives. They are concerned about high energy prices in New England and
the negative impact that they have on local companies that need to remain
competitive. It takes foresight and courage, especially when you are up for
election, to support programs that may marginally increase energy costs,
despite their enormous long-term positive energy usage impact. We and our
elected representatives should take courage and lessons from the many local
companies that do take action and make investments to improve their energy
efficiency by utilizing EE programs like CORE and EERS, discussed in my last post. I
suspect that a company can do more to control their energy use through EE
actions than by waiting and lobbying for lower energy prices.
We are often reminded that NH has amongst the highest energy
prices: there are states with rates 50% lower.
This is an outcome of the fact that we
are in New England and have little in the way of cheap hydropower, wind, or
fossil-fuel resources. We are a densely populated area with a lot of energy
infrastructure and, in many respects, we are at the end of the energy pipeline.
On top of this, we are closing down aging coal and nuclear power plants and are
notoriously reluctant to deal with and commit to new generation or supply infrastructure.
Our higher prices should not be a surprise and we will never be able to match
those low electricity prices in other states. However, we can and should deal
with the situation then by curtailing our energy use. We can put our Yankee
ingenuity to work. We can take action, drop the thermostat temperature by a
degree, put on a sweater, make those EE investments, and encourage our
politicians to make a commitment to EE programs. Energy efficiency is indeed the
first fuel and let’s encourage our politicians to support it.
In the meantime, think about your own actions with regard to
energy efficiency. Like me, take a look at the man in the mirror* and ask
yourself if there is more you can do to reduce your energy consumption—and then
take action. And, as usual, start with remembering
to turn off the lights when you leave the room.
Mike Mooiman
Franklin Pierce
University
mooimanm@franklinpierce.edu
(*Man in the Mirror: One of my favorite Michael Jackson
tunes. From the album Bad released in
1987. Enjoy Man in the Mirror)
