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.
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.
Franklin Pierce University
(*Man in the Mirror: One of my favorite Michael Jackson tunes. From the album Bad released in 1987. Enjoy Man in the Mirror)