The Welfare Costs of Misaligned Incentives: Energy Inefficiency and the Principal-Agent Problem

In many settings, misaligned incentives and inadequate monitoring lead employees to take self-interested actions contrary to their employer's wishes, giving rise to the classic principal-agent problem. In this paper, I identify and quantify the costs of misaligned incentives in the context of an energy efficiency appliance replacement program. I show that contractors (agents) hired by the electric utility (the principal) increase their compensation by intentionally misreporting program data to deliberately authorize replacement of non-qualifi ed refrigerators. I provide empirical estimates of the impacts of misaligned incentives on (1) the effectiveness of energy efficiency retro fits and (2) social welfare. I estimate that unqualifi ed replacements reduce welfare by an average of $106 and save only half as much electricity as replacements that follow program guidelines. The same program without a principal-agent distortion would increase welfare by $60 per replacement. The results provide novel evidence of how principal-agent distortions in the implementation of a potentially bene ficial program can undermine its value.

• The study uses variation in program rules to identify contractors intentionally misreporting program data to increase their compensation.
• About half of the refrigerator replacements conducted in the program did not qualify based on program rules. Each unqualified replacement reduced welfare by $106. In contrast, qualified replacements increase welfare by $60.
• The study provides the first empirical evidence for a cause of the non-performance of energy efficiency programs: the principal-agent problem.
• These results apply to other energy efficiency programs because the incentives of contractors can undermine potential savings.