LBL-35376

ORNL/CON-383

UC-350

ENERGY EFFICIENCY, MARKET FAILURES, AND GOVERNMENT POLICY

Mark D. Levine,* Eric Hirst, # Jonathan G. Koomey,*

James E. McMahon,*Alan H. Sanstad*

March 1994

*Energy Analysis Program, Energy and Environment Division, Lawrence

Berkeley Laboratory, Berkeley, CA 94720

#Energy Division, Oak Ridge National Laboratory, Oak Ridge, TN 37831

This work was supported by the Office of Energy Efficiency and Renewable

Energy, U.S. Department of Energy under Contract Number DE-AC03-

76SF00098.

MA,TER

DISTRtBtJTION Ot" THIS DOGUMEN _|"IS UNLIMITED
ABSTRACT

This paper presents a framework for evaluating engineering-economic

evidence on the diffusion of energy efficiency improvements. Four examples

are evaluated within this framework. The analysis provides evidence of

market failures related to energy efficiency. Specific market failures that may

impede the adoption of cost-effective energy efficiency are discussed. Two

programs that have had a major impact in overcoming these market failures,

utility DSM programs and appliance standards, are described.

I. INTRODUCTION

Can improvements in energy efficiency substantially reduce fuel use and

energy bills in the United States with no reductions in services or amenities?

If so, are government and utility programs necessary to promote efficiency

measures yielding cost-effective savings? Or should we rely on the normal

workings of the marketplace to select levels of energy efficiency?

We use the term "energy efficiency gap" to describe the difference between the

actual energy efficiency of many purchased products and the level of energy

efficiency that can be provided cost effectively for the same products. There

are at least two schools of thought about this "energy efficiency gap". Many

economists believe that the gap is either small or non-existent, and question

policies that promote energy efficiency. Many technologists, on the other

hand, believe that policies aimed at promoting energy efficiency can yield

substantial economic benefits.

There is a spectrum of views within both groups. Some economists believe

there is virtually no cost-effective energy efficiency to be acquired. They

maintain that if individuals wanted that energy efficiency- instead of energy

- they would have purchased it. Other economists acknowledge significant

imperfections in markets for energy efficiency. Even here, there is room for

disagreement about whether these market failures are sufficient to justify

government intervention. There is also a range of views among
technologists on how much energy efficiency can be obtained, and with what

degree of difficulty.

The Energy Modeling Forum (organized by Stanford University) is currently

addressing the "energy efficiency gap". Several recent papers address one or

more aspects of this issue (Sutherland 1991; Sutherland 1994; Nichols 1993;

Joskow and Marron 1993a and 1993b). Sutherland (1994) suggests that energy

efficiency and economic efficiency are often competing goals, based in part on

his belief that markets make good choices on energy efficiency. Nichols (1993)

uses economic theory to suggest that utility programs (especially customer

rebates) are misguided because the market would have adopted the efficiency

measures if their costs were truly lower than their benefits. Joskow and

Marron (1993a and 1993b) use :lata from ten utilities to suggest that utility

demand-side management (DSM) programs may not be cost-effective. Their

conclusions have been challenged by a number of others. (See, for example,

Lovins 1993, Blumstein and Harris 1993, Miller 1993, and Hirst and Brown,

. 1990).

It is our judgment that resolution of this debate depends upon the careful

quantitative analysis of the engineering and economic characteristics of

specific technologies as well as an assessment of data on adoption of the

technologies in the market and of policies directed toward energy efficiency.

Accordingly, our primary objective in this paper is to focus attention on the

empirical basis for skepticism about the effectiveness of the market

mechanism in yielding cost-effective energy efficiency improvements. We

present a framework for evaluating engineering-economic evidence on the

diffusion of energy efficiency improvements. We then present a series of

examples within this framework that, in our view, provide evidence for

market failures related to energy efficiency. We go on to discuss several

specific market failures that may impede the adoption of cost-effective energy

efficiency. Next, we discuss two programs that have a major impact in

reducing the gap, utility DSM programs and appliance standards. We

conclude with a summary and suggestions for further research.

Specifically, we make the following points:

• There is a gap between the energy efficiency of many products that are

purchased and the cost-effective levels of energy efficiency for these

products. We present specific examples to show that this "efficiency

gap" exists. We especially focus on cases where there is little or no

evidence for the economist's assumed "hidden costs."

• This gap is a significant one, in the sense that closing it would have a

major impact on U.S. energy use and the U.S. energy bill.

.... iir _r ......... , , ' ' ' ' II ' II II _ II
•There are undoubtedly many reasons that such a gap exists. We

identify some of these market imperfections, while acknowledging the

paucity of data detailed enough to indicate which of them yield what

impacts.

• Given the discrepancy between the observed and the achievable levels

of energy efficiency -- and the beneficial impacts of cost-effective

energy efficiency m government policy to promote energy efficiency is

desirable. We discuss two of the major energy efficiency programs,

appliance standards and utility DSM programs, to clarify the features of

the programs that have led to their success.

oWe identify research needed to refine our understanding of these

important issues as well as to be able to better design and implement

programs to increase cost-effective energy efficiency in the economy.

The information provided to support the points above yields a basis for

commenting on the following economist's questions about the energy

efficiency gap:

*Aren't technologists ignoring certain "hidden costs" in their

calculations that, if included, would show that many energy efficiency

investments are in fact not cost-effective?

• Aren't these hidden costs "irreducible," that is, not subject to

reduction or elimination by policies?

•In any case, aren't these hidden costs "normal" to many markets, not

just markets for energy efficiency? If not, what distinguishes energy

markets?

•Even if these costs can be reduced, why can't these opportunities be

exploited by private firms? That is, why do government and utilities

need to intervene?

These questions are especially relevant in the 1990s. The extent to which

efficiency improvements are less expensive than new energy sources will

influence decisions concerning the best ways to reduce greenhouse gas

emissions, cut energy-related air pollution, and promote competition in the

electricity and gas industries.
]I. EXAMPLES OF THE GAP BETWEEN COST-MINIMIZING AND

OBSERVED LEVELSOF ENERGYEFFICIENCY

A. Background

Consumers and firms demand fuels and electricity not for their own sake but

rather for the services they can provide, such as lighting, heating and cooling,

and refrigeration. At any given time a range of technological options is

commercially available to deliver these services, distinguished by energyefficiency and thus by the cost of the services delivered.

Typically, the more efficient devices have higher initial purchase prices but

lower operating costs. When two types of device provide equivalent energy

services, an internal rate-of-return for the incremental investment in the

more efficient device can be calculated provided that data on both purchase

prices and operating costs are available. This rate-of-return can then be

compared with social discount rates and with the borrowing or savings rates

of the purchaser. When the rate-of-return exceeds the social discount rate but

the less efficient device is purchased, we infer that energy services are not

being obtained at minimum cost from a societal perspective. When the rateof-return also exceeds market interest rates but the less efficient device is

purchased, we infer that energy services are not being obtained at minimum

cost from a private perspective.

A variation on this approach is to compare the annualized incremental cost

of investment in the more efficient device with the price of energy. This

requires the exogenous specification of a discount rate.

Cost minimization is a necessary condition for economically efficient

allocations of resources (Varian 1984). Analyses of many commercial energyusing products, however, have found failure to obtain energy services at

minimum cost, implying the existence of market failures for energy

efficiency.

B. Conditions for Identifying Market Imperfections

What are the conditions under which untapped energy efficiency implies the

existence of market failures? If a cost-effective efficiency investment is readily

available, yet is not being used in many or most suitable applications, there

are either (1) hidden costs that have not been included in the calculations, or

(2) incorrect parameter specification in the calculations, or (3) time lags

between the introduction and the acceptance of this technology, or (4) market

failures inhibiting the adoption of this option (Koomey 1990).

In this section we provide an analysis of four examples of purchase or use

decisions made between two products that are identical in customer utility,
but that have different levels of energy efficiency. While examples in this

case are electricity-using equipment, we believe that the conclusions outlined

below hold for gas and oil end uses as well. We emphasize that the approach

we have outlined here is firmly rooted in economic theory. When correctly

applied, the type of analysis we describe above provides solid economic

information on the performance of the market for energy efficiency and

energy services.

Hidden costs: There are several categories of potentially "hidden" costs that

may affect the analysis. First, there is the potential for a reduced level of

energy service (e.g., quality of lighting or temperature and comfort levels with

heating systems). Second, there may be irreducible private costs (such as the

inconvenience associated with installation of the efficient equipment).

Finally, other costs may not be included in the calculations including sales,

income, and property taxes and additional maintenance costs for the efficient

measure.

Parameter Specification: The input parameters in each analysis must capture

the range of possible physical situations and usage characteristics existing

throughout the economy. The examples that follow are based on engineering

calculations using typical buildings or appliances. Engineering calculations

may overstate the benefits of energy efficiency by calculating energy savings

with respect to a base case building or device that is less efficient than

currently designed new buildings or new devices. Building prototypes based

on average characteristics may submerge important details and may not

contain all available efficiency technologies. Incorrect estimation of operating

hours may also affect these calculations.

Time Lags: New technologies take time to reach the market and to be

understood and accepted by the design community. (The time and effort

needed to learn about new technologies is another hidden cost, which is

likely to be greatest when these new technologies are introduced rapidly.) In

some cases, manufacturers may need years to produce a new technology on

sufficient scale to saturate the market. This aspect of technology diffusion

raises analytical and empirical problems that are difficult to address in the

standard engineering-economic framework. Thus, in the examples described

below, we concentrate on technologies that are readily available and whose

characteristics minimize the barriers to diffusion.

Market Failures: If there are no hidden costs or time lags, and parameters

have been correctly specified, then we conclude that market failures such as

information problems, decision-making problems, transactions costs, and

capital market imperfections must be inhibiting the adoption of the more

efficient technology. We discuss each of these market failures in the next

section.
C. Examples Indicating the Existence of Market Imperfections

In this section we provide examples of purchase or use decisions made

between two models that are identical in customer utility, but that have

different levels of energy efficiency for four technologies: commercial

fluorescent ballasts, residential refrigerator/freezers, personal computers and

office equipment, and color TV standby power. We conclude by summarizing

the policy implications of these examples.

1. Standard core-coil versus efficient core-coil commercial fluorescent ballasts

Table 1 shows the market share and energy-related characteristics of standard

core-coil and efficient core-coil fluorescent ballasts. After correcting for

efficiency standards in five states that prohibited the sale of inefficient ballasts,

standard core-coil ballasts would have accounted for about 90% of all

fluorescent ballast sales in 1987 (GeUer and Miller 1988). The table shows that

the efficient core-coil ballast offered energy savings at a cost of conserved

energy (CCE) of 1.4c/kWh.1

Table 1. Characteristics of Standard Core-Coil and Efficient Core-Coil

Fluorescent Ballasts

Approximate

Adjusted Capital Power Energy Marginal Implied

Ballast Market Cost Savings Savings CCE Marginal

type Share Ca 1987 1989 $ W kWh/yr 89c/kWh real IRR

Standard core-coil 90O/o 11.0 0 0 - -

Efficientcore-coil 9% 15.4 11 29 1.4 60.3%

Assumptions: Operation lime for offices = 2600 hrs/yr, ballast lifetime=45,000 hrs=17.3 yrs, discount rate=6%real, capi_.al

recovery factor (CRF)=0.0917, and 1988 U.S. average commercial sector electricity price of 7.4c/kWh. Capital costs are

from Geller and Miller (1988), and have been adjusted from 1987-$ to 1989-$ using the consumer price index.

Market shares were adjusted by Geller and Miller to represent market shares if state standards did not exist in 1987. By

the end of 1987, standards prohibiting sale of inefficient core<oil ballasts existed in five states representing about one

quarter of the U.S. population (California, New York, Massachusetts, Connecticut, and Florida). Installation and

maintenance costs are equivalent for all types of ballasts. Even more effident electronic ballasts would have made up the

remaining 1%of sales in 1987 (they have a capital cost of 33.4, power savings of 33 W, energy savings of 86 kWh/yr, a

marginal CCE of 2.8, and an implied marginal real IRRof 26.3%).

This example assumes operating hours that are lower than those in almost all

commercial buildings (Piette et al. 1988). The resultant CCE implies a real

market discount rate of about 60% for those who purchase the standard corecoil ballasts. Since the efficient core-coil ballasts are identical to the standard

1. At a 15% real discount rate, the CCE would be 74% higher, or $0.025/kWh, which is still

significantly cheaper than the price of electricity.
models except that the core winding is more efficient, we conclude that the

market is acting as if purchasers of standard ballasts are using high discount

rates. 2

Hidden costs: The efficient core-coil ballast provides equivalent amenity and

longer lifetime than its inefficient counterpart. It is widely available and is

based on well-known, proven technology. The similarity between this device

and the one it replaces ensures that hidden costs associated with difference in

energy service are not important.

Parameter Specification: The only parameter that could be improperly

specified in this comparison is operating hours. However, we know that

efficient core-coil ballasts are cost effective when operated more than 600

hours/year, and we know that the lights in all types of commercial buildings

operate for thousands of hours every year. Thus, we can conclude that

incorrect specification of operating hours (within reasonable bounds) will not

affect the results from this calculation. 3 The other parameters are irrelevant

because efficient core-coil ballasts are perfect substitutes for inefficient ballasts

(except with respect to energy savings and lifetime, where they are superior

substitutes).

Time Lags: Efficient core-coil ballasts were on the market for many years

before 1987, so time lags are not relevant in this example.

Conclusions: This example describes a case in which there are no hidden

costs or time lags affecting the purchase decision for ballasts. Parameters have

been spedfied correctly in the analysis. Even though this ballast saves energy

at a cost below the price of electricity, we found that most consumers still

purchased the less efficient standard core-coil ballast. We conclude that

market failures must have inhibited the adoption of the more efficient corecoil ballasts. 4 Since fluorescent ballasts are found in almost every commercial

building, this finding suggests that market failures affecting the adoption of

efficient core-coil ballasts are widespread and may affect the adoption of other

cost-effective devices as well.

2. The fact that consumers purchased the less efficient model does not mean that they

actually performed a life-cycle cost calculation using a high discount rate. It strongly

suggests that cost-effectiveefficiencymeasures are ignoredby many purchasers.

3. The lowest plausible number of annual operatinghoursfor commercialbuildings is around

1300,which would yield a cost of conserved energy of 2.8c/kWh, still 1/2 of the electricity

price. These calculations assume a real discount rate of 6%and other parameters as

specified in Table 1.

4. As of January1990,only efficient core-coil and electronicballasts may be sold in the U.S.

The inefficient core-coil ballasts were outlawed by an 1988 amendment to the National

ApplianceEnergyConservationAct of 1987.
2. High efficiency versus low efficiency residential refrigeratorffreezers

Meier and Whittier (1983) present data on sales of a pair of refrigerator

models differing only in energy efficiency. They were able to estimate the

discount rate implicit in the purchases of the less effident model in each of

several regions. Their study is revealing in that it used very specific data and

a simple technique: the incremental price of the more efficient model was

compared with its reduced operating cost to compute a rate-of-return on the

investment in the efficient model. Purchase of the less efficient model then

implies an implicit discount rate exceeding this rate-of-return.

The two refrigerators were displayed next to each other and sold by the same

national retailer between 1977 and 1979. Both models were top-mount, autodefrost, roughly 17 cubic feet in volume, and had the same features. The

price of the higher efficiency model was $60 more than the less efficient one,

and it used 410 kWh/year less electricity. The absolute difference in prices for

the refrigerators was constant over the analysis period, even though purchase

price for both models was reduced by rebates at various times. The high

effidency model was advertised widely, and a prominent consumer magazine

recommended it and even calculated the monthly savings in electric bills.

(There were no federally mandated appliance efficiency labels in place at that

time.) The efficient and inefficient models together accounted for significant

fractions of total unit sales of all models of that particular brand (roughly 20%

to 80%, depending on the region).

Using a 6% real discount rate and a lifetime of 20 years, the more efficient

refrigerator saved energy at a cost of 1.3c/kWh (19795), cheaper than the

electricity prices prevailing in every state at that time. Prices in 1979 were

lowest in Washington (1.5c/kWh), while the national average was about

5.4c/kWh. Using a 15%real discount rate, the CCE is 2.4c/kWh, still less than

half the U.S. average price of electricity in 1979.

During 1977 through 1979, the inefficient model was purchased by around

45% of purchasers of either refrigerator in the Midwest (i.e., 55% purchased

the efficient model), 35-40% in the East, 54-69% in the South, and 57-67% in

the Pacific Region. These purchasing patterns reflect the influence of

electricity price, at least qualitatively: in 1979, the Pacific and Southern region

had prices of 3.4c/kWh and 4.0c/kWh, respectively, and the Midwest and East

had prices of 5.5c/kWh. Even noting this qualitative difference, however, it

is impossible to ignore the fact that 35%to 70%of the purchasers of these two

models chose the inefficient model, in spite of the low cost of conserved

energy.

The results of Meier and Whittier's calculation of the real implicit discount

rate are:
• In the Pacific region, over 60% of buyers revealed discount rates

exceeding 34%;

• In the South, 59%of buyers revealed discount rates exceeding 41%;

• In the Midwest, 45%of buyers revealed discount rates exceeding 56%;

• In the East, 40%of buyers revealed discount rates exceeding 58%.

These implicit rates of return are significantly higher than those prevailing in

the capital markets (typically 4-12% real).

Hidden Costs: The only hidden cost that might affect this comparison would

be a result of having no standardized rating system for energy use, which

might have made it more difficult for consumers to verify the energy savings

that the salesperson claimed. This factor was probably mitigated by the

recommendation of the consumer magazine and the accompanying estimate

of monthly dollar savings for the more efficient model.

Parameter Specification: Refrigerator usage does not vary by more than 10-

20%over the year or between users, so errors in characterizing usage are not a

factor in this calculation. Geographical variation in electricity prices does not

affect the results, because we compared the estimated cost of conserved energy

(using a 6% real discount rate) to the electricity prices prevailing in the state

that had the lowest electricity price in 1979 and found the efficient model to be

cost effective even in this extreme case.

Time Lags: Time lags are not relevant here, because both models were widely

available (and displayed next to one another) at the same time.

Conclusions: This example describes a case in which there were no hidden

costs or time lags affecting the purchase decision for a refrigerator. Parameters

have been specified correctly in the analysis. The energy efficient refrigerator

saves energy at a cost below the price of electricity, yet many consumers

purchased the inefficient model in spite of the efficient model's economic

advantage. We conclude that this indicates that market failures affected the

market for efficiency in refrigerators. Many consumers rejected investments

that yield returns much greater than their cost of capital. The appliance

efficiency standards that went into effect in 1990 and 1993 have significantly

changed the market for refrigerators, but many of the same factors affecting

consumers' efficiency choices in 1977-79 probably still exist for other products.

3. Energy Star computers

The Environmental Protection Agency's (EPA's) Energy Star Computer

program is a voluntary program that includes all the major U.S. computer

manufacturers (Johnson and Zoi 1992). The manufacturers agreed to produce

computers, monitors, and printers th._t switch to low-power states after a

specified period of inactivity (the low power state of 30W for the CPU

r '
represents a reduction of about 70%, with comparable reductions for monitors

and printers). When the user starts working again, the computer springs back

to life instantly. Because even heavily used personal computers sit idle for

significant parts of the day, energy use can be substantially reduced (Fig. 1).

Extensive discussions with manufacturers showed that these features could

be added at negligible cost to the purchaser, and that consumer utility would

hardly be affected. Manufacturers who meet the Energy Star criteria are

eligible to display the Energy Star Logo, which brands their product as energy

efficient, on their product literature.

We cite this example not to advocate regulating the computer industry,

which we emphatically do not favor, but to describe how electricity use was

essentially ignored by this highly competitive and technologically advanced

industry prior to the EPA's program. For example, during one meeting with

representative divisions of a major computer manufacturer, a product

development specialist remarked that they once considered incorporating

lower-power states into their mainstream product line, but that the

marketing department advised them that it would not be worth the effort.

The fact that energy is only a small part of the total costs of owning and

operating a computer may contribute to the previous lack of interest on the

part of customers in efficiency improvements. However, in businesses where

computers are widely used, wiring constraints in older buildings can force

costly renovations if the capacity of the wiring is not able to meet the demand

for power. These constraints may have increased the awareness of such

customers to the amount of energy their computers used.

Saving energy in the use of personal computers may seem like it would have

relatively minor impacts nationally. This is not the case. The rapid

proliferation of personal computers and associated printers has resulted in

significant increases in electricity use in commercial buildings. Harris et al.

(1988) projected office equipment electricity use of 65 TWh to 115 TWh by

1995, which would imply that office equipment would account for between

6% and 12% of total commercial sector electricity use as forecast by US DOE

(1994).

Hidden Costs: There are no hidden costs in this example. The level of service

remains virtually unchanged.

Parameter Specification: The manufacturers, the ones most equipped to

know, say these measures will have negligible costs. Incorrect parameter

specification is therefore not an issue.

10
ON TIME (minutes/hour)

6O

ACTUAL

ON TIME - _

50-

._ OFF AFTER

60 MINUTES

40 % kWh an

OFF AFTER % kW sav

302 15 NUTES / . s - -- - --.... ""_" "i """.

,.., / . s % s % "

_-' .l S % .

.'l %S % .

10 - .# _ ".

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O --:---- --- _--:_-- -- __1 .... _ - J, J. l i pm =:, '5,,,P ,eL,--- =--,, __1__ _

1 3 5 7 9 11 13 15 17 19 21 23

TIME OF DAY (hour)

Fig. 1. Mean on-times for 94 personal computers in a Canadian office building (Ross 1992). The lower two

curves indicate the energy and demand savings that could be achieved if the computers were automatically

turned off after 60 minutes or 15 minutes of non-use.
Time Lags: The technology involved in Energy Star Computers has existed

for years. Time lags are therefore not an issue in this case.

Conclusions: This example describes features that can be added to computers,

monitors, and printers to make them more energy efficient. The resulting

technologies have no hidden costs and no time lags. Parameters have been

specified correctly in the analysis. Adding the features saves energy at a cost

below the price of electricity, but we found that even in the competitive

computer industry, this highly cost-effective energy savings option would not

have been captured without the cooperation between EPA and the

manufacturers. Therefore, we conclude that market failures must have

inhibited its adoption.

4. Standby power in color televisions

The U.S. Department of Energy describes options for improving the efficiency

of color television sets, including the option of reducing standby power (US

DOE 1988). A small amount of power is needed at all times to allow the

remote control to turn the TV on and off. Even when the TV is operating,

this power is used to allow the remote control to adjust volume and change

channels. In a survey of 25 19" and 20" color TV models, DOE found that

more than 70% had standby power of greater than or equal to 2 W. The

average standby power for the entire sample of TV models was 4.4 W.

Televisions with standby losses greater than 2 W typically feed power to the

tuner using a resistor. By replacing this resistor with a transformer, the

standby power can be reduced to 2 W. The additional manufacturing cost

associated with the transformer is $2.15 (in 19875). The cost of the resistor is

subtracted from that of the transformer, and markups are applied to calculate

the consumer price. The consumer price of reducing this standby power was

estimated to be $4.30. This investment would save 21 kWh/year.

Using a real discount rate of 6% and a lifetime of 11.5 years, these costs and

energy savings translate into a cost of conserved energy of 2.5c/kWh. This

CCE is about a factor of three lower than the average price of electricity, yet

more than 70% of televisions had not adopted this simple technology as of

1987. At a 15% real discount rate, the CCE becomes 3.8c/kWh, which is about

half the U.S. average price of electricity.

Approximately 18 million color televisions were sold in the U.S. in 1986.

Changes of a few watts in standby power may sound small for individual

televisions, but with hundreds of millions of televisions in existence and the

standby power being consumed every hour of the day, 2.4 W savings per TV

would (after 20 years) add up to approximately 450 megawatts and 3.2 TWh of

annual savings. Such savings would be worth about $240 million per year if

evaluated at national average electricity prices.

12
Hidden Costs: There are no hidden costs in this example. The consumer

would see no difference in performance, and reliability would not be affected.

Parameter Specification: Standby power use is constant, so there are no usagerelated variations. The cost of reducing standby losses is based on wellknown, simple teclmology, so this parameter has been specified accurately.

Time Lags: The technology to reduce standby losses to 2W or less is well

within the capabilities of all television manufacturers.

Conclusions: This example describes a cost effective improvement in

television efficiency that has no hidden costs and no time lags. Parameters

have been specified correctly in the analysis. Reducing standby power saves

energy at a cost below the price of electricity, yet most manufacturers choose

not to add this option. We conclude that market failures have inhibited the

adoption of this cost effective, energy-saving option.

5. Implications

The four examples described above are not isolated ones. They were chosen

to illustrate specific cases where equipment purchasers chose less energy

efficient products over more efficient ones, even though the more efficient

ones were cost effective. Or, in the cases of television sets and computers,

they illustrate the fact that consumers did not have the choice of saving

energy because the manufacturers did not make the measure available, even

though its application was straightforward and highly cost-effective.

Dozens of studies have indicated the potential for achieving substantial costeffective energy savings in buildings and equipment, generally in the range of

20 to 40% for new equipment and buildings compared with what is otherwise

chosen. For an extensive discussion of the measures that can be applied to

new and existing residential buildings, including costs and energy savings, see

Koomey et al. (1991).5

These examples show that the technology choices made by manufacturers and

consumers are often far from the economic optimum. However, such

calculations are only the first step in assessing the existence of market failures.

They do not indicate precisely what those failures are, only that some failure

exists. We now turn to examples of markets failures that may be present in

energy markets.

5. For a summary of the results of a number of estimates of national energy savings that could

be obtained through cost effective investments in energy efficiency, see Fickett, Gellings,

and Lovins (1990) and Rosenfeld, et. al. (1993).

13
Ill: FACTORS ACCOUNTING FOR THE ENERGY-EFFICIENCYGAP

A. Background

We presented evidence above that consumers and firms often fail to

minimize their costs of obtaining specific energy services. Since, as we

discussed above, cost minimization is a necessary condition for economically

efficient allocations of resources, these examples provide prima facie evidence

of economic inefficiency in energy markets. What market imperfections

might impede economic efficiency in markets for energy services and be

correctable through well-designed policies?

In a "first-best" world, consumers and firms would make decisions regarding

energy services that were both privately and socially optimal. The theory of

welfare economics, however, provides a list of stringent conditions for

decentralized markets to achieve efficient allocations, including:

• prices that fuUyreflect both private and social costs;

• complete and identical information on the part of consumers and

firms;

• perfect capital markets;

• no transaction costs.

Each of these conditions fails to one degree or another to be satisfied in

markets for energy services. That is, the "energy efficiency gap" reflects an

"economic efficiency gap" that is amenable to correction by appropriate

policies. These market imperfections can be used to interpret the evidence we

presented above and can guide the design of policies (Sanstad and Howarth

1994).

B. Market Imperfections Related to Energy Efficiency

1. Existing price distortions

It is universally recognized that electricity prices do not reflect environmental

costs. It is important to recognize, however, that price reform is by no means

a panacea for correcting market imperfections related to energy. First, simply

determining correct prices (i.e., prices that internalize all social costs) is itself a

difficult and possibly insurmountable policy hurdle. The magnitudes of

environmental externalities are site-specific and typically quite controversial

(ECO Northwest 1993). Estimates of the costs associated with carbon dioxide

(CO2) emissions range from $1 to more than $20 per ton, reflecting different

and not easily reconciled assumptions about the damages related to global

climate change and the most efficient ways of reducing CO2 emissions

(Ottinger et al. 1990). Beyond this, there are substantial political and

institutional barriers to energy price reform as illustrated by the recent failed

effort to impose a Btu tax.

14
Second, the examples we presented above show that existing markets at

current prices are not performing efficiently since cost-effective measures are

not being adopted, so that market imperfections arising independently of

price distortions must be addressed.

2. Information problems

Consumers often lack information regarding both their current energy

consumption patterns and ways to reduce this consumption. In the

residential sector, this problem occurs because consumers get a monthly bill

that provides no breakdown on the contributions of individual end-uses to

that bill. This is analogous to shopping in a supermarket that has no

individual prices; because one receives only a total bill at the checkout

counter, one has no idea what individual items cost. Kempton and Layne

(1989) suggest that utilities need to provide considerably more information on

the monthly bills if consumers are to have the necessary information to make

"rational" decisions on energy use.

Komor et al. (1989) show that small commercial customers are often just as

ignorant about their monthly electricity bills as residential customers. They

interviewed owners and managers of 40 small commercial establishments

and found that they knew little about energy use in their facilities. For

example, not one of the interviewees was aware of the electricity demand

charge ($/kW-month), even though this component accounted for almost

half of the typical electric bill!

Asymmetric information is a market imperfection in landlord/tenant or

building/occupant situations.6 A significant difference in energy efficiency

investment between owners and renters was empirically documented by

Brechling and Smith (1992) in a rigorous econometric study of the British

housing market. This problem arises from different levels of information

between owners and renters. If tenants pay utility bills, they could gain (in

the form of lower utility bills) from the installation of efficiency measures by

building owners. Owners would wish to earn a return on such investments

in the form of higher rents. Owners cannot easily overcome, however, the

problem of informing current and prospective tenants (who are unknown) of

the benefits available from increased efficiency. Hence, in a competitive

rental market, the opportunity for mutual gains from improved energy

efficiency can go unexploited.

If the landlord pays utility bills, he or she could again benefit from the

installation of efficiency measures to lower tenants' energy consumption. In

6. That different levels of information among market participants can have significant

consequences for economic efficiency is one of the central insights of the field of information

economics. This problem was first examined by Akerlof (1970).

15
this case, however, the tenant pays nothing for energy and thus has no

incentive to use it efficiently (Kempton et al. 1992). Thus, the circumstance

that favors efficient use of energy (tenant pays utility bills) leads to a

disincentive for the purchase of energy-efficient equipment. The case that

favors the purchase of efficient equipment (landlord pays bill) leads to a

disincentive for the tenant to use energy effidently.

Similar problems may occur in the markets for new homes and for energyefficiency improvements in single-family homes (Dubin 1992; Stoft 1993).

Because of information gaps, customers often must use energy technologies

selected by others. Builders frequently buy furnaces, water heaters, and

appliances for new homes. Not surprisingly, builders focus more on initial

cost and less on operating cost than homeowners would. The same situation

occurs in construction of commercial buildings. Owner-occupied buildings

are much more likely to have energy-efficient technologies than are tenantoccupied buildings, as shown in a survey of new construction practices in

Washington, D.C. (Hines 1990). This difference, which is rather dramatic in

the case examined, was true for almost all the lighting, building shell, HVAC,

motor, and control measures examined (Fig. 2).

3. Decision-making problems

Behavioral research studies the decision rules consumers use in making q

energy-related choices. Humans have limited or "bounded" rationality, since

they can only process limited amounts of information (March and Simon

1959). The time it takes to process information is an information cost, while

humans' inability to analyze and understand every issue is an indication of

bounded rationality. For example, technical information related to energy is

not "transparent" to consumers but is subject to psychological processes that

may distort its content (Stem and Aronson 1984, Yates and Aronson 1983). In

addition, consumers appear to use heuristics in making energy decisions that

deviate systematically from those that would be employed in expert

calculations (Kempton and Montgomery 1982). The result of such factors is

often sub-optimal decisions relative to the specific set of choices available to

the individual consumer (Howarth and Andersson 1993).

While firms typically have greater technical expertise available to them, intrafirm complexities of decision-making may result in deviations from the

classical hypothesis of profit maximization in the case of energy investment

decisions (DeCanio 1993, Ross 1986). These factors can result in firms'

internal hurdle rates exceeding their cost of capital, so that even profitable

energy efficiency investments are passed up. For example, principal agency

problems between managers and technical personnel, or between

shareholders and management, may result in biases against energy-efficiency

investments (DeCanio 1993). This would explain the seeming "paradox" of

firms failing to optimally invest in energy efficiency.

16

_, ! 11
.......... 71 IllIll "-I:--I-i'-| ..........==i-Illllll ............ -.....= ............. -"

PERCENT OF NEW COMMERCIAL BUILDINGS

100 i OWNER-OCCUPIED P-/iTENANT-OCCUPIED

80

60

4O;

/I/11

Ilil

2O _

/I/11

I!111

0

HIGH TASK HIGH ENERGY LOW-E HIGH

EFFICIENCY LIGHTING EFFICIENCY MANAGEMENT GLAZING EFFICIENCY

LAMPS MOTORS CHILLERS

Fig. 2. Percentages of new commercial buildings in Washington, D.C. with various energy-efficiency

measures, by building occupancy (Hines 1990).
4. Transaction costs

These problems related to information and decision-making can also be

viewed in terms of transaction costs, including the costs of gathering and

processing information, making decisions, and designing and enforcing

contracts relating to the purchase and installation of energy-using technology.

These are sometimes referred to as "hidden costs" associated with energy

efficiency, with the implication that their inclusion in engineering

calculations would dose the "efficiency gap."

From a theoretical perspective, the suggestion that transaction costs have no

implications for economic efficiency is incorrect (Sanstad and Howarth 1993).

These costs associated with making energy choices are "real" costs that must

be taken into account in policy and program analysis.

For policy purposes, however, the question is whether there are

interventions that can overcome specific types of costs in a manner not

available to consumers acting individually. From this perspective, different

"hidden" costs have different implications. For example, the amount of time

and effort required to find a refrigerator that has a cost-effective level of

energy eff_dency can be very high. The typical consumer will seek a

refrigerator that has important features such as size, color, design, a respected

brand, correct type of ice maker, etc. One of these features may be costeffective levels of energy efficiency (or more likely "high" energy efficiency, as

the consumer is not likely to have enough information or knowledge to

perform even a simple payback calculation on energy efficiency). The time

and inconvenience needed to obtain the energy efficient refrigerator -

transaction costs- may be prohibitive.

In this case, appliance standards may remove all inefficient refrigerators from

the market or even induce more efficient ones to appear. (We discuss

appliance standards in section IV). Such standards are a policy intervention

that (among other things) eliminates the transaction costs that prevent the

purchase of energy-efficient appliances. In the case of appliance efficiency, we

suspect that these transaction costs are the largest reason that high efficiency

products were not purchased prior to appliance standards; to the extent that

this is the case, the appliance standards reduce imperfections in the market.

5. Capital market imperfections

Electric and gas utilities are able to borrow money at a real cost of capital of

about 6%. The market for energy efficiency, determined by the decisions of

millions of individual investors, operates at much higher discount rates.

Indeed, in most cases the decision on efficiency choice is made with a

discount rate several times greater than the utility cost of capital. To the

extent that energy efficiency substitutes well for new energy supplies, this

18
disparitiny the decisioncriterifoa rinvestmentin efficiencyand in new

supplymeans thatcapitawill l be preferentiaallyllocatetdosupply.The large

differencebestweenthecostofcapitalforutilities and theeffectivdise count

ratethatistypicallyusedinthepurchaseofenergyefficienrceysultins avery

largemisallocatiofoncapital.

One ofthebestexamplesofthisproblemisresidential appliances.Priorto

appliancestandardsRud , erman,etal.determinedthatthemarketbehavedas

iftherealdiscountrateforenergyefficiencywas 15 to more than 100%

(Ruderman,etal.1987).Exceptforairconditionersth,emarketdiscountrates

were in the upper end of thisrange. This analysisimplicitlyconsidered

factorsbeyond thecontrolofthepurchaser(e.g.un,availability oftheefficient

appliancebundling , of efficiencywith otherhigh-costitems,differential

markups forhigh effidencyitems,etc.)Th. e calculationwas performedfor

thetypicalefficiencyofa new applianceinthelate1970'sthroughthemid1980's(priortoappliancestandards).

Knowledge of the costand benefitsof efficiencymeasuresnot purchased

provideda basisforestimatinthg ediscountrate(applietod themarketas a

whole)oftheaverageefficiencychoiceforeachofthemillionofs products

sold. Thus,new power plantsarebuiltinsteadof investining appliance

efficienbecycausethecentralizeddecisionmaker borrowsat6% realwhilethe

complex end-use market for appliancestypicallydeclinesinvestments

yieldingreturnsthatarefivetotentimesgreater.

C. A PracticaIllustr l ation: The Designand Constructionof Commercial

Buildings

In a recentattemptto understandwhy buildingsare not designedas

efficiently astheycouldbe,Lovins(1992)interviewedmore thanfiftdyesign

professionalands analystsofthedesignprocessand founda marketrifewith

inefficiencyand "perverse"incentives.These inefficienciaesre driven

mainlyby thedifficuloftycreatingoptimizedc,ustom-builtbuildingsys stems

inthefaceofpersistentinstitutional failures.

As an exampleofsuchan institutional failurLovins e, citestheprevailinfgee

structureofs buildingdesignengineerswhich , areexplicitlyor implicitly

basedon a percentageofthecapitaclostoftheproject.The reasonthatfee

structureslikethisone areperniciouissbecausegood designforheating,

ventilationand, air-conditionin(HVAC g ) systemscanoftenallowsubstantial

reductionsin capitalcostsand operatingcosts. Such designrequires

additionalexpenditurebseyond thetypical"rule-of-thumeb"quipmentsizing

thatmost engineersdo, which resultsin a net penaltyfordesignersof

efficiesyst nt ems.

19
HVAC systemsaretypicallovers y izebdy factorsoftwo orthree,which isa

major sourceof unnecessarycapitaelxpenditureass wellas lessefficient

delivery of energy services. Such oversizing is typically justified because of

uncertainty about the plug loads of individual tenants who may not even be

signed up to lease the space when the mechanical equipment is specified. The

systemic benefits from optimizing mechanical systems cannot be captured by

such a linear, piecemeal approach.

Cross-subsidiesand incorrectpricesignalsarecommonplacein commercial

buildings.Managersofmaster-meteredbuildingsoftenchargetheirtenants

basedon floorspace,failintgorewardmore efficientetnants.

Lovins explores a variety of other institutional failings, including nonexistent

or faulty operation, monitoring, post-occupancy evaluation, maintenance,

and building commissioning. He explores every step in the design process,

documents how this process fails, and suggests ways to fix it. This study is an

important example of the kinds of empirical work _hat are crucial to

understanding the extent of market failures affecting efficiency in buildings.

D. Observations

Our discussion shows that factors preventing the adoption of cost-effective

energy efficiency measures can be framed in terms of the standard economic

theory of market imperfections. Further research is needed to clarify the

theoretical analysis of energy-related market imperfections, to guide empirical

research on this set of issues, and to apply theory and empirics to the design of

effective energy policies.

2o
IV. POLICIES TO PROMOTE COST-EFFE_ ENERGY EFFICqENCY

Two major energy-saving policies have been pursued aggressively during the

past decade. The first involves utility promotion of energy efficiency among

their customers through demand-side management (DSM) programs. U.S.

utilities are presently spending more than $2 billion annually on such

programs. This represents more than 14% of total investment in new

generation (including non-utility generators) (Energy Information

Administration 1994). The second energy-saving policy is appliance efficiency

standards. These standards result in a projected savings equivalent to the

output of more than 20 1,000-MW power plants after 20 to 25 years.

A. The Role of Utilities in Promoting Energy Efficiency

During the past several years, U.S. electric utilities have played an

increasingly important role in encouraging their customers to improve

energy efficiency.8 As shown in Fig. 3, utility expenditures on demand-side

management (DSM) programs and their effects (energy savings and

reductions in demand at the time of system peak) increased sharply between

1989 and 1991; utility plans show continued increases during the coming

decade (Energy Information Administration 1993).

What factors led utilities to get involved on the "customer side of the meter,"

given their long tradition of focusing only on the provision of electricity (i.e.,

generation, transmission, distribution, and customer billing)? These factors

included:

.Growing interest in integrated resource planning (IRP), which involves

explicit consideration of DSM programs as cost-effective alternatives to

some new power plants;

.Provision of financial incentives to utility shareholders for

implementing cost-effective DSM programs;

*Increasing concern about the environmental effects of electricity

production and transmission, especially global warming and acid rain; and

*Growing recognition of the powerful role that utilities cart play in

overcoming market imperfections that impede adoption of cost-effective

energy-efficiency opportunities (Hirst 1991).

8. Natural-gasutilities after ,considerabalectividuring ty the1970sreduce , dtheiene r rgyefficienprogr cy amssharplyinthe1980s.Duringthepastfewyearshow , everg,asutilities

areonceagainbeginningtopromotecustomeernergyefficiency. A controversiissu al eno,t

addressehdere,concernstheroleofgasorelectriutil c ities inencouragingcustomersto

switchfromonefueltoanother(e.g.from , electrictity ogasforresidentia watel rheating,

orfromgastoelectricfity orindustrial drying).

21
% OF PEAK DEMAND, SALES, AND RETAIL REVENUES

10 _ 1989 NN1991 _ 1995 J_ 2001

4 iii!i_

° - ,,,.,.. m

2 !:!:!:1 __

0 --

DEMAND ENERGY PROGRAM

REDUCTION SAVINGS COST

Fig. 3. The costs and effects of electric-utility DSM programs, 1989 through 1991 and plans to the year 2001
In essence, electric utilities and their regulators now recognize that utilities

can be providers of energy services not just of kWh and kW products. For

purposes of this paper, the key factor is the last one, the role of utilities in

overcoming market imperfections.

As discussed earlier, customers face market failures which impede the

adoption of what would otherwise be cost-effective energy efficiency actions.

Utilities have important characteristics that position them to help customers

overcome these failures. Utilities have monthly contact with all t:mir

customers through meter reading and billing. Utilities have long-standing

and generally good relationships with their customers and with the

communities they serve. Utilities are widely recognized for their technical

competence. Utilities have large field organizations that can deliver DSM

programs to customers. Utilities have ready access to capital, leading to a low

cost of capital and steady cash flows, enabling them to offer loans and rebates

for customer purchase of energy-efficient systems. And many utilities are

increasingly knowledgeable about the energy service needs and wants of their

customers, primarily because of their DSM programs. All these factors make

it easier and more efficient for utilities than for other organizations to design

and implement DSM programs.

Utilities can also help overcome infrastructure limitations. For example,

various energy-efficient technologies (e.g., low-emissivity windows and other

advanced glazings, and compact florescent lamps and other new lighting

systems) are not available in many parts of the country. Utility programs that

promote these devices can transform the market so that wholesalers and

retailers will routinely stock, advertise, and sell these products. According to

Energy User News, "[m]uch of the recent demand for compact fluorescent

products has been fostered by atilities. Since April [1990], utilities in

California, Washington, Oregon, Massachusetts and Connecticut have

expanded investments in conservation programs, all of which help foster

compact fluorescent technology" (Bryant 1990).

Utilities can provide credible, site-specific information to customers on the

applicability, costs, and benefits of different DSM technologies. Residential

and commercial energy audits, offered by many utilities, are an effective way

to provide such information. Because research has demonstrated the

importance of credibility and follow-up in successfully conveying energy

information (Katzev and Johnson 1987; Winett and Neale 1979), utilities are

especially well-placed to undertake these types of interventions. Utilities can

also provide appropriate design and financial incentives for installation of

DSM measures in new buildings. In many cases, no other institution appears

to be as effective in providing such site-specific information, especially when

it is combined with incentive programs that boost consumer adoption of the

DSM technology.

23
Finally, expanding utility DSM programs is consistent with industry trends

toward greater attention to customer service and satisfaction. DSM programs

allow utilities to expand the range of services they provide to customers

beyond selling a single-dimension product, electricity. As electricity markets

become more competitive, utilities will increasingly use their DSM programs

to enhance their customer services. For example, an industrial audit might

uncover various measures that, upon installation, cut the customer's electric

bill, boost productivity, and make that customer more competitive in its

markets.

1. Performance of DSM programs

A key issue for DSM is its actual performance, i.e., the measured energy and

demand reductions relative to program costs. Considerable evidence shows

that, in general, the a priori engineering estimates of the amounts of energy

to be saved by particular measures and programs are optimistic (Nadel and

Keating 1991; Joskow and Marron 1993a and 1993b).

The more important issue is whether, given actual savings less than

predicted, the programs are still cost-effective. Here the evidence is mixed.

Some programs are clearly cost-effective, based on rigorous accounting of all

program costs and measurement of electricity savings (Nadel 1992). Others

are not. New England Electric System (1993), which has a history of successful

program design, implementation, and evaluation, found that most of its

programs were cost-effective for both 1991 and 1992 (Fig. 4). On the other

hand, the Bonneville Power Administration Residential Weatherization

Program was highly cost-effective in its early years, but by 1989 decreased

levels of electricity savings caused the program's costs to exceed its benefits

(Brown and White 1992)

In general, electric utilities (and their regulators) are becoming more

conscientious about carefully measuring the energy savings and load

reductions caused by DSM programs. These efforts are reflected in various

conference proceedings, protocols for evaluating DSM programs, and the

increased availability of data on the costs and savings of DSM measures and

programs. 9

9. See the conferenceproceedingsfrom the Evaluationpanel of the biennialSummerStudy on

EnergyEfficiencyin Buildings,sponsored by the AmericanCouncil for an Energy-Efficient

Economyandthe proceedingsfrom the biennialconferenceson EnergyProgram Evaluation,

sponsored by the National Energy ProgramEvaluationConference. Evaluation protocols

have been developed by the U.S. Environmental Protection Agency and the states of

California and New Jersey. The Northeast Region Demand-Side Management Data

Exchange, IRTEnvironment, Electric Power Research Institute, and Lawrence Berkeley

Laboratoryall col_lect,analyze, and publish informationon the performance of utility DSM

programs.

24
-_ I I I "_II=-'II - _ :-:-:_"- IBII-- -- I IIII --

BENEFIT/COST RATIO (without externalities)

3

D 1991!11992 ..

2.5 - '

/////"" 1991 AVERAGE

.w j j

" IIIIi

2- /////

1.5 __,,

/ / / 1992 AVERAGE

///I/

/////

7//.-/7"/.-/".

/////

/ /

0.5 ///i J

/////

• i

II//I

Fig. 4. NEES estimates of DSM-program benefit/cost ratios, based primarily on measured electricity

consumption. Design 2000 is aimed at new commercial/industrial construction, while Energy Initiative

focuses on retrofit. In 1992, NEES made Energy Initiative much more comprehensive; the reduced focus on

lighting, which is very cost effective, lowered the program's overall cost effectiveness in 1992.
2. Market transformat.m

Utilities can increase the benefits and reduce the costs of their DSM programs

by working closely with trade allies and by moving upstream from retail

customers. These efforts are called market-transformation programs, because

their intent is to change the operation of markets, not just to stimulate onetime changes in customer behavior.

Utilities are increasingly designing their DSM programs to work with

government programs and standards, as well as manufacturer and other

trade-ally efforts. For example, rather than encouraging individual customers

to purchase high-efficiency appliances, utilities can work with manufacturers,

wholesalers, and dealers to be sure that only efficient appliances are sold.

The Super Efficient Refrigerator Program (often called the Golden Carrot) is a

example of market transformation. Roughly 25 utilities pooled a $30 million

incentive, which was offered to refrigerator manufacturers to design and

build units that do not use CFCs and that exceed the 1993 federal efficiency

standard by at least 25%. Whirlpool was selected as the winner of this

competition for development of a _ cubic foot side-by-side refrigerator

freezer than consumes 30% less than the 1993 standards. The company

expects to start marketing these high-efficiency units in the service areas of

the sponsoring utilities in 1994. The utilities will pay Whirlpool as the units

are delivered in their areas (Demand-Side Report 1993).

The Model Conservation Standards provide another example of market

transformation. The Bonneville Power Administration has run programs for

several years intended to encourage builders to construct, households to

purchase, and local governments to require energy-efficient new homes.

These efforts to educate and motivate different stakeholders, coordinated

with those of the Northwest Power Planning Council, several utilities, and

other organizations, led to passage of tougher building codes in the Pacific

Northwest states. These new codes require construction that meets the Model

Conservation Standards and reduces the need for Bonneville participation in

new-home construction markets.

Market transformation requires the utility to move upstream from its

customers to retailers, wholesalers, distributors, manufacturers, as well as the

organizations that install, service, and finance equipment and structures

(Hammarlund 1993). Working with these "trade allies" within their existing

infrastructures should yield larger energy savings, lower costs, and more

permanent changes than programs aimed at individual customers. In

addition, market transformation requires integration of utility efforts with

those of government organizations, such as energy-efficiency standards and

government programs.

26
To the extent that utility market transformation programs are successful, the

role of utilities in promoting customer energy efficiency is temporary. That

is, if utilities can work with trade allies to change "standard operating

procedures," to adopt and implement stricter building and appliance energyefficiency standards, and to make energy efficiency the norm rather than the

exception, then the need for additional utility intervention is greatly

diminished. For e;;ample, passage of tough building standards in

Washington and Oregon means that the Bonneville Power Administration

(as well as other utilities in the Pacific Northwest) can reduce the rebates it

offers builders to construct energy-efficient homes and devote its resources to

training code officials and builders on how best to administer and comply

with the new codes.

3. Fw:ure prospects

Market research can help utilities to identify market failures and to

understand better the energy-related attitudes, interests, and needs of different

market segments among their customers. This information, in turn, can be

used to design DSM programs that attract more customers and do so at lower

cost. For instance, National Analysts (1990) developed computer models that

help utilities identify appropriate market segments among their residential

customers and assess the likely response of these segments to different types

of DSM programs. Much of this research can be done inexpensively. Pacific

Power & Light (now PacifiCorp) spent about $50,000 on a residential lighting

pilot effort to identify likely participation rates and potential energy savings.

Because the utility industry is becoming more competitive, the focus of DSM

programs will likely shift away from resource acquisition to improved

customer service. Energy efficiency will continue to be a key driver for such

programs as utilities seek to help their customers become more competitive.

In such an atmosphere, utilities can continue to use their unique position to

! help customers overcome market failures and adopt cost-effective energysaving technologies.

B. Appliance Efficiency Standards

1. Background

The State of California was the first to promulgate energy efficiency

regulations for residential appliances, which limited the sale of refrigerators

to those with energy consumption less than a specified maximum. The range

of other appliances legally permitted to be sold was similarly restricted, based

upon their energy efficiency or annual energy consumption. In 1986, after

several states had adopted different energy efficiency regulations,

manufacturers and environmental groups negotiated a set of national

efficiency standards (California Energy Commission, 1983). These national

27
appliance standards were encoded in the National Appliance Energy

Conservation Act of 1987. Since then, the U.S. Department of Energy has

updated those standards for refrigerators, freezers, and some other products,

and continues to study updates for possible future rulemakings (McMahon et

al. 1990)

Cumulative expenditures by the federal government for the applianceefficiency program total about $50 million from 1979 to 1993 (Adams 1993).

These expenses included development of test procedures for measuring

efficiencies, technical analyses to provide an engineering and economic basis

for the standard levels selected, administrative costs associated with public

hearings, publication of laws and supporting technical documents, and

management of the program.

2. Benefits of appliance standards

The benefits of the program have been determined by using end-use

forecasting models, which account for the primary effect (increased efficiency

of new appliances) and important secondary effects (more expensive

appliances, fuel switching, and changes in operating practices). The results

suggest a cumulative net benefit to the nation for appliances sold from 1990-

2015 of $46 billion. This consists of a net present cost of $32 billion for higher

priced appliances and a net present savings of $78 billion. These benefits as

well as the cumulative energy savings of the standards to date (those already

promulgated) are shown in Fig. 5. Figure 6, which shows the effects of

standards that have been promulgated, shows substantial reductions in

residential energy demand growth due to the standards. Proposed standards

for eight products will cause significant additional declines in residential

energy demand if adopted. The two lower curves in Fig. 6 show the impact of

the standards proposed by the U.S. DOE in March 1994 for eight products. The

lower curve is for implementation of the standards in 1996; the curve above it

is for implementation in 1998.

Included in this accounting are the projected increased costs passed on to

consumers, and the value of energy savings (calculated at average energy

prices). The costs to manufacturers are accounted for and (mostly) passed on

to consumers. However, the benefits accounted for do not include the value

of decreased emissions of air pollutants and carbon dioxide. (The quantities

saved represent 1.5 to 2% of total national emissions of SOx, NOx, and CO2).

The benefits also fail to assign a value to the deferral of new electricity

generating plants beyond the average price of energy paid by the consumer

(McMahon et al. 1990).

28
-0 -.lO

gt0661. i _ueJ _B / s !^e s6u

i" [-- 0661. I;)N u;;8 al!l 95 L

O[ - _ t 66 P, U:i eJ XO Se A UI GS - _ O

L 66 P, IeN u;)8 eJ!l 85 L

.R JeU B_ 9e A! UBs! u one sp leN ueseJd 1, Jeue8 l! $) B(

-4VN O' V SI INV C II:IV CS A'B Eld O "I£1 101

EI3N:II OA IAVS N SE) INV C N 13 N3S:II:Id 1 II..-I:IN313 40
TOTAL RESIDENTIAL ELECTRICITY (QUADS, PRIMARY)

12

11.5 -------_1

_i..i_..._.._

Q.._----I}____A _ -,_ _"_ NAECA

(_ _ "_-_....._.:_ _ , NAECAupdatesthru1994

8 Product,effective1996

_._ <>8 Product,effective1998 ._.... I II I

10.5

10

1990 1992 1994 1996 1998 2000

' YEAR

Fig. 6. Projected residential electricity demand in five cases: (1) no appliance standards, (2) standards set by the

National Appliance Energy Conservation Act (NAECA), (3) NAECA with updates through 1994, (4) recently

proposed eight product rulemaking, assuming implementation in 1996, and (5) recently proposed rulemaking

with implementation in 1998.
3. Possible criticisms

It has been suggested that the consumer's choice in appliance models may be

restricted as a result of the standards, thereby creating a hidden cost.

Considering refrigerators as an example, however, there were more models

available after the regulations became effective in 1990 than were available in

1986 (Mc/vIahon 1991). Moreover, real prices of refrigerators have declined

from 1986 to 1991 (AHAM 1993a). The average refrigerator purchased after

efficiency standards is larger than before and more likely to be a "side-by-side"

than another type (AHAM 1993b). The engineering cost data, when

manufacturer and dealer markups are added, suggest that the more efficient

appliances required by the federal standards pay back their incremental

investment in three years or less (US DOE 1989); using actual price data on

refrigerators before and after the standards, it is difficult to detect any

significant post-standard price increases.

Another potential criticism of the standards is that they may cause a sacrifice

in some amenity that the consumer values. In fact, as noted above, such a

criticism is largely ruled out by defining different standards for various classes

of appliances which differ in the features offered. Thus for refrigerators, some

of the different classes include freezing compartments that are top-mounted,

side-mounted, and bottom-mounted. For purposes of rulemaking, each class

of refrigerator, as well as each size, must meet a different standard. (In

practice, an equation specifies the size-dependence of the standard level

within each refrigerator class.)

We believe that the large cost-effective energy savings resulting from

appliance standards-- amounting to 0.1 quadrillion Btu (almost $1 billion)

per year at present and growing to eight times this amount in 15 to 20 years

itself provides evidence of market failure related to energy efficiency. First,

there is no evidence that these substantial energy-efficiency gains would have

come about in the absence of standards. Second, while there has been no

definitive research on what constitutes the imperfections in the market, we

speculate that there are variety of factors, few of which actually relate to

consumer interest in energy efficiency. In particular, we believe that

consumers are interested in a variety of features, of which energy efficiency is

not primary. As we noted earlier, the transaction costs of seeking out energyefficient models that have all the other desired features are likely to be high.

The manufacturers know that consumers value attributes other than energy

efficiency, and undoubtedly also believe that consumers may not be able to

evaluate the true energy cost savings of greater efficiency. In a competitive

market, manufacturers are motivated to minimize costs. Thus, given a

choice between proliferating models (an expensive proposition) and choosing

one efficiency level for each set of features, manufacturers chose the latter.

This does not mean that the consumer does not value or benefit from costeffective levels of efficiency. It means that, until standards, most consumers

31
were poorly informed about these benefits and could only avoid purchasing

lower effldency by investing considerable time and effort.

4. Alternative approaches

Considering the magnitude of the benefits of high appliance efficiency, the

question is what alternative role the government could have played that

would have been more economically efficient. Prior to standards, some

suggested that information and labeling programs could achieve significant

energy efficiency gains. Such programs were in place for many years before

the NAECA standards went into effect, with only limited impact (McMahon

1991).

Could the $50 million spent by the government for efficiency standards have

been spent in some other way to achieve equal or greater benefits? We are

unable to propose a program with a $2 to 4 million annual budget (over 15

years) that could have effectively achieved the benefits of the appliance

efficiency standards program. Each year the 100 million households in the

U.S. spend about $67 billion for residential appliances (including heating and

cooling equipment) to purchase about 55 million major appliances and 12

million heating and air conditionin$ systems. If the $2 to 4 million that the

government spent on appliance standards were spent on consumer

education, this would amount to about $0.02 to 0.04 per household per year.

It is hard to believe that such expenditures would affect many purchase

decisions and it is inconceivable that the impact would be in any way

comparable to that of the standards.

5. Summary

We believe that appliance standards have had a large beneficial impact on

residential energy expenditures. The standards yield a benefit to cost ratio of

almost 2.5 (at a real discount rate of 7%) without counting the value of

environmental externalities, will reduce power plant construction by more

than 40 500-MW units over the next 20 years, have not reduced the choice of

appliances or the service they provide, and have occasioned almost no

objection from consumers. While some may argue on theoretical grounds

that such a policy ought to have major flaws (or hidden costs), the evidence

indicates otherwise. The positive experience with appliance standards itself is

additional evidence for substantial imperfections in the market that have

made possible such large savings.

32
V. SUMMARY AND CONCLUSIONS

We have presented a methodology for identifying technical evidence of

market failures related to energy efficiency, and appl/ed this framework to

several examples of cost-effective energy-efficient technologies whose

adoption in the market has been impeded. These efficient technologies offer

consumer services identical (or, indeed, superior) to those provided by less

efficient technologies and their adoption clearly yields economic benefits.

Although we cannot say exactly why these technologies have not been

adopted, these examples demonstrate the existence of market failures. We

reviewed several market imperfections that may account for the energy

efficiengcyap.

We have also discussed utility demand-side management programs and

appliance standards regulations, two major initiatives aimed at overcoming

market failures to improve energy efficiency. We have argued that sizable

economic benefits are accruing from these program, and that, without these

interventions, these benefits would go uncaptured in the marketplace.

We can now summarize our answers to the questions raised in the

Introduction:

•Aren'ttechnolog/stsignoringcertain"hiddencosts"in theircalculationsthat,il included,

wouldshow thatmanyenergyefficiencyinvestmentsareinfactnotcost-effective?

We have provided four examples in which there are either no hidden

costs or these costs are minimized and thus cannot be used a priori to

explain why consumers still failed to purchase the cost-effective, more

efficient product.

• Aren'tthesehiddencosts"irreduciblethat ," is, notsubjectto reductionor el/m/nationby

policies?

When hidden costs do appear in other cases, they are to a large extent

subject to reduction or elimination by policies. Government and utility

programs can substantially reduce these costs by taking actions once on

behalf of thousands or millions of customers. For example, federal

appliance efficiency standards involve a great deal of technical analysis.

However, this analysis is done only once, and is used to eliminate all

appliances that do not meet economically-based energy-efficiency criteria.

Similarly, utility DSM programs that provide financial incentives to

purchase and install energy-efficient devices reduce the capital market

dichotomy of the high cost of money that consumers face and the much

lower cost of money that utilities enjoy.

•Inany case, aren'tthese hiddencosts "normal"to many markets,not justmarketsfor

energyefficiency?Ifnot,whatdistinguishesenergymarkets?

33
Like all markets, markets related to energy have some unique

characteristics. Energy consumption has very significant societal

implications, including very large environmental impacts and potential

significant effects on national security. Additionally, because the nation's

consumers and industry are both vitally dependent on its availability and

affordability - and because a sizable portion of GNP is spent on energy -

the proper functioning of energy markets is widely recognized as critical to

economic well-being. However, we make no general claim that markets

related to energy efficiency are intrinsically "special," nor is such a claim

required for the case we are making. If evidence of market imperfection is

present, as we believe it is in this case, then in principle intervention is

warranted, in energy as well as other markets.

•Evenif thesecosts canbe reduced,why can'ttheseopportunitiesbe exploitedby private

firms?Thatis,whydo gov_t andutilitiesneedtointervene?

A defining characteristic of market imperfections is that they cannot be

overcome by consumers or firms acting independently; this is equally true

of markets related to energy as well as other markets. We fully recognize

the problem of "government failure" and the fact that not all problems

can be overcome through public or utility policies. As we have shown,

however, there is ample reason to conclude that policies to reduce market

imperfections related to energy efficiencan cy be and have been successful.

Additional behavioral research is needed. In particular, utilities, EPtU, and

DOE should sponsor projects to pinpoint and quantify the various market

failures related to energy efficiency. These projects need to examine failures

at a disaggregate level -- by market segment (e.g., multifamily tenants vs.

owner-occupied medium-size office buildings), by end use, by technology, and

by type of decision (purchase or operation). These projects will quantify the

importance of different failures in different circumstances.

Utilities and government can then use the results of these projects to analyze

program and policy options to address the most important failures. If, for

example, lack of capital is the problem, then rebates may be the solution. If,

on the other hand, uncertainty about the likely energy savings of a new

technology is the barrier, then a performance guarantee may be the solution.

In other words, programs need to be designed to address sp_.,:ific,documented

failures.

Such empirical research could provide two benefits. The primary benefit will

be better programs that provide more savings at lower cost. A secondary

benefit will be the resolution of controversies over the role of governments

and utilities in promoting energy efficiency.

34
VL ACKNOWLBDG_

We would like to thank the following people for their helpful comments:

Albert Nichols (National Economic Research Assodation); Daniel Kirschner

(Environmental Defense Fund); Henry Lee (Harvard University); Howard

Gruenspecht (Department of Energy); Howard Geller (American Council for

an Energy Efficient Economy); Ron Sutherland (Argonne National

Laboratory); Marilyn Brown (Oak Ridge National Laboratory); and Paul

Measher (Electric Power Research Institute). We would also like to thank

Lynn Price (Lawrence Berkeley Laboratory) for her comments and editing

assistance. This work was supported by the Office of Energy Efficiency and

Renewable Energy, U.S. Department of Energy under Contract Number DEAC03-76SF00098.

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