Bridging the Energy Efficiency Gap: Policy Insights from Economic Theory and Empirical Evidence

Despite several decades of government policies to promote energy efficiency, estimates of the costs and benefits of such policies remain controversial. At the heart of the controversy is whether there is an "energy efficiency gap," whereby consumers and firms fail to make seemingly positive net present value energy saving investments. High implicit discount rates, undervaluation of future fuel savings, and negative cost energy efficiency measures have all been discussed as evidence of the existence of a gap. We review explanations for an energy efficiency gap, including reasons why the size of the gap may be overstated, neoclassical explanations for a gap, and recent evidence from behavioral economics that has potential to help us understand why a gap could exist. Our review raises fundamental questions about traditional welfare analysis, yet we find the alternatives offered in the literature to be far from ready for use in policy analysis. Nevertheless, we offer several suggestions for policymakers and for future economic research.

Despite the lack of federal legislation placing a price on carbon dioxide emissions, recent energy policies in the United States have nonetheless revolved around the goal of reducing greenhouse gas emissions while simultaneously enhancing national energy independence and security. A wide variety of standards and incentives are currently being employed to increase the energy efficiency of everyday services, ranging from space heating and cooling to transportation.

RFF Research Director and Senior Fellow Karen Palmer and coauthor Kenneth Gillingham of Yale examine the theory used to motivate such policies in a new RFF discussion paper, “Bridging the Energy Efficiency Gap: Insights for Policy from Economic Theory and Empirical Analysis.” The energy efficiency gap is the failure of consumers to make seemingly economically beneficial investments in energy efficiency. Gillingham and Palmer discuss the many explanations for the gap, from ones rooted in traditional economics to those that relate to recent work in behavioral economics. They identify both the explanations and the empirical evidence to support them.

They note that an important step in understanding the gap is assessing the role of factors such as hidden costs and uncertain future energy prices that could cause the size of the gap to be mismeasured. They also find evidence that asymmetric information—when one individual has more information than another—can contribute to the energy efficiency gap. Other reasons for the gap that have some empirical support include:

• Agency Problems: when energy users and purchasers of energy or energy-using equipment are not one in the same and thus have non-aligned incentives to invest in energy efficiency.
• Externalities: the price of energy does not reflect the costs associated with environmental damages such as carbon dioxide emissions or the cost of protecting access to foreign sources of energy.
• Behavioral anomalies: consumers appear to undervalue future fuel savings from investments in energy efficiency, perhaps due to factors such as inattention and systematically incorrect beliefs about the future.

Overall, the great diversity of energy users and uses inhibits a complete explanation of the energy efficiency gap. The authors also note that policy interventions are likely to be most cost-effective when they target specific market failures. Future research should focus more on behavioral economics and information processing, as well as identifying the full costs of energy-efficient investments by individual consumers and businesses.