LBL-353 7 6 ORNL / CON-383 UC-350

ENERGY EFFICIENCY, MARKET FAILURES, AND GOVERNMENT POLICY

M a rk 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 94 7 20 #Energy Division, Oak Ridge National Laboratory, Oak Ri dge, TN 3 7 831

This work was supported by the Office of Energy Efficiency and Renewable Energy, U.S. Department of Energy under Contract Number DE-AC03- 7 6 S F00098. 

# M A , T ER
DISTRtBtJTION Ot" THIS DOGUMEN _|" IS UNLIMITE DABS T RA C T

This paper presents a framew o rk for e v aluating engineeri n g-ec ono mi c evi dence on the diffus i on of energy efficiency improvements. Four examples are evaluated within this framework. The analysis provides evidence of market failures related to ener gy efficiency. Specific m arket 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 stand ards, are described.

I. INTROD UC T ION Can improvements in energy efficiency substantially reduce fuel use and energy b i lls in the United States with n o reductions in services or ameni ties? If so, are government and utility programs necessary to promote efficiency measures yielding cost-effective savings? Or should we rely on the normal worki n gs of the marketplace to select levels of energy efficiency? W e use th e term " en ergy effici en cy gap " to describe th e difference b etween the actual ener gy efficiency of many purchased produ cts and the level of ener gy efficiency that c an be provided cost effectively for th e s ame products. There are at least two schools of th ought about this " ener gy efficien cy 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 promo ti ng ener gy efficiency can yield substanti al economic ben efits. There i s a spectrum of vi ews withi n b o th gro ups. S o me ec o n o mi sts be li e v e there is virtually no cost-effecti ve ener gy efficiency to be acquired. They m ai nt ai n that if individuals w anted that ener gy efficiency- instead of energy

- they would have purchased it . Other eco n omists 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 amongtechnologists on how much energy efficiency can be obtained, and with what

degree o f di ff

iculty. The Energy Modeling Forum ( organized by Stanford Univer s ity) 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). Sutherl an d ( 1994) suggests that energy eff i ciency and economic efficiency are often competing goals, based in part on his belief that m arkets make good choices on ener gy efficien cy . Nichols ( 1993) uses economic theory to suggest that utility pro grams ( especi al ly customer rebates) are misguided because the m arket would have adopted the efficiency measures if their costs were truly lower th an their benefits. Joskow an d Marron ( 1993a an d 19 93b) use :lata f rom ten uti lities to suggest that utility dem an d-side management ( DSM) pro grams may not be cost-effective. Their conclus ions have been challenged by a number of others. ( See , for example, Lovins 19 93, Blumstein and Harris 19 93, Miller 1 9 9 3, and Hirst and Brown,

. 19 90). It i s ou r j u d gment th at reso lu tio n of this debate depends upon the caref ul quantitative analysis of the engineering and economic characteris tics of specific te chnologies as well as an assessment of data o n adop tion of the te chnologies in the market and of policies directed toward energy efficiency. Accordingly, our primary objective in this paper is to focus attention on the emp i rical basis f

or skepticism about the effectiveness of the market mechanism in yielding cost-effective energy efficiency improvements. We present a f

ramework for evaluating engin ee ring-economic evidence on the diffusion of energy e ffi ciency improvements. We then present a series of examples within this framework that, in our view, provide evidence for market failures related to energy efficiency. W e go on to discuss several specific market failures that may impede th e adop ti on of cost-effective energy efficiency. Next, we discuss two progr ams that have a major impact i n reducing the gap, utility DSM p rograms and appliance standards. We conclude with a summary and suggestions for further research . S p ecifi call y, we make the fo llo wing points:

• There is a gap between the ener gy efficien cy of 

### many products that are purchased and the cost-effective levels o f energy efficiency for these products. We present specific examples to show that this " efficiency gap " exists. We especially focus on cases where there is l i ttle or no evidence for the economi s t's assumed " hidden costs. "

• This gap is a significant one, in the sense that closing it woul d have a major impact on U.S. ener gy u se an d the U.S. ener gy bill.

.... ii r _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.

• Gi v en the discrepancy between the observe d an d th e achie v able le v els of energy efficiency -- and the ben eficial impacts of cost-effective energy efficiency m government policy to promote energy efficiency is desirable. We discuss two of the major energy efficiency programs, appli an ce standards an d utility DSM programs, to clarify the features of the programs that have led to th eir success.

o We identi fy research needed to refine our understanding of these important issues as well as to be able to better design an d implement pro grams to increase cost-effective ener gy efficiency in the economy.
T h e information p ro vided to support the po ints above yi e lds a bas i s for commenting on the following eco n omist's questions about the en ergy efficien cy gap:

* Aren't tech n ologists i gnoring certain " hidden costs " in their calculations that, if included, would show th at many energy efficiency investm ents are in fact not cost-effective?

• Aren't these hidden c o s ts " irreducib l e, " that is, n ot subject to reducti on 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? Th at 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 ele ctri ci ty an d gas i n dustries

.]I. EXA MPLES O F T HE G AP BE T WEEN C OST-M IN IM IZING A N D O B S ERVED LEVELS O F ENERGY EFFICIENCY A . Backgr o und Consumers and firms dem an d fuels an d 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 service s , distinguished by energyefficiency and thus by th e cost of th e serv ices delivered. Typically, the more efficient devices have higher initial purchase prices but lower operating costs. When two types of device pro vi de equivalent energy services, an internal rate-of-return for the incremental investment in the more efficient device can be c al culated provided that data on both purch ase prices and operating costs are available. T hi s rate-of-return can then be compared with social discount rates an d with the borrowing or savings rates of the purchaser. When the rate-of-return exceeds th e social discount rate but the less efficient devi ce is purch ased, we infer that energy services are not being obtained at minimum cost from a societ al perspective. When the rateof-retu rn al so exceeds market interest rates but th e less efficient device is p urchased, we infer th at energy serv ices are n ot being obtained at minimum cost from a private perspective. A v ariation on this approach is to comp are the annu al ized increment al cost of inves tment in th e 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 e ff icient allocations of resources ( Varian 1984). An al yses of many commercial ener gy using products, however, have found failure to obt ai n energy services at minimum cost, implying the existence of market failures for energy efficien cy . B. Conditions for Identifying Market Imperfections What are the conditions under whi ch untapped ener gy efficiency implies the existence of market f

ai lures? If a cost-effective efficiency investment is readily av ai lable, yet is n ot being used in m any or most suitable applications, there are either ( 1) hidden cost s that have not been included in the calculations, or ( 2) incorrect parameter specification in the calculations, or ( 3) time lags betw een the introduction an d th e acceptance of this technology, or ( 4) market failures i nhibiting th e adoption of thi s option ( Koomey 1990). In this section we provide an an al ysis of four examples of purch ase or use decisions made betw een tw o products th at are identical in customer util i ty,but that have different levels of energy efficiency. While examples in this

case are electricity-using equipment, we believe that th e conclusions outlined below hold for gas and oil end uses as well. We emph as ize th at the approach we have outli ned here i s firmly rooted in economic th eory. W hen correctly applied, the type of analysis we describe above provides solid economic information on the performance of th e market for energy efficiency and energy services. Hidden cost

s : There are several categori es of potentially " hidden " costs that may affect the analysis. First, there is th e potenti al for a reduced level of ener gy service ( e.g., quality of lighting or temperature and comfort levels with heating systems). Second, there may be irreducible private costs ( such as th e inconvenience associated with installation of the efficient equipment). Finally, other costs may not be included in the c al culations including sales, income, an d property taxes and additi onal 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. Th e examples that follow are ba se d on engineering calculations using t

ypical buildings or appliances. Engineering c al culatio n s may overstate the benefits of ener gy efficiency by calculating ener gy savings with respect to a base case building or device that is less efficient than currentl y designed new buildings or new devices. Build in g prototypes ba s ed o n average characteristics may submerge important details and may not cont ai n al l av ai lable efficien cy technologies. Incorrect es ti mation of operating hours may also affect these c al culations. Time Lags: New technologies take time to reach the market and to be understood and accepted by the design community. ( The time an d effort needed to learn about new technologies is another hidden cost, which is likely to be greatest when these new technologi es are i ntroduced rapidly.) In some cases, m anufacturers may need ye ars to produce a new technology on sufficient scale to satu rate the m arket. This aspe ct of te chnology diffusion r ai ses an al ytical and empirical problems th at are diffi cu lt to address in the st an d ard engineering-economic fr amework. Thus, in th e examples described below, we concentrate on technologies that are readily available an d whose characteristics mini mize th e barriers to diffusion. Market Failures: If there are no hidden c o sts or time lags, and parameters have been corre ctly specified, then we conclude that m arket failures such as information problems, decision-making problems, transactions costs, an d capital market imperfections must be inhibiting the adoption of the more efficient technology. We discuss ea ch of th es e m arket failures in the next section.C. Examp l es Indicating the Existence o f Market Imperfections

In this section we p rovide 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 summariz in g the policy implications of these examples. 1 . St andard core - coil versus efficient core - coil commercial fluorescent ballast s T able 1 shows the market share and energy- related characteristics of standard core-coil and efficient core-coil fluorescent ballasts. After correcting for efficien cy standards in five states that prohibited the sale of in efficient ballasts, standard core-coil ballasts wou ld have accounted for about 90% of all fluorescent ballast sales in 198 7 ( GeU er 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 198 7 1989 $ W kWh / yr 89c

/ kWh real IRR Standard core-coil 90O / o 1 1.0 0 0 - - Efficient core-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% re al , capi

_ .al recovery factor (CRF) = 0.091 7 , and 1988 U.S. average commerci al sector electricity price of 7 .4c / kWh. Capital costs are from Geller and Mill er (1988), an d have been adjusted from 198 7-$ to 1989-$ using the cons umer price i n dex. Market shares were adjusted by Gell er and Miller to represent market shares if state stand ards di d not exist in 198 7 . By th e end of 198 7, standards prohibiting sale o f ineffi ci ent core<oil ballas ts existed in five s tates representing about one quarter of th e U.S. population ( California, New York, Massachusetts, Connecticut, an d Florida). Ins tallati on and maintenance costs are equivalent for all types of ballasts. Even more effident electronic ballas ts would have made up the remaining 1% of sal es in 198 7 (th ey have a capital co st of 33.4, po wer savin gs of 33 W, en ergy savings of 86 kWh / yr, a marginal C C

E of 2.8, and an impli ed m arginal re al IRR of 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 1 5% real discount rate, the C CE would be 74% higher, or $0.025 / kWh, which is still significantly cheaper th an th e price of electricity.models excep t that the core winding is m o re efficient, we conclude th at the

market is acting as if purchasers of stand ard ballasts are using high discount rates. 2 Hidden cost

s: 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 simil arity between this device and the one it replaces ensures that hidden costs as sociated with difference in ener gy 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 / ye ar , 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 p arameters are irrelevant because efficient core-coil ballasts are perfect substitutes f o r inefficient b al lasts ( except wi th respect to energy savings an d lifetime, where they are superior substitu tes ).
Time Lags: Efficient core-coil b al lasts were on the market for many years before 198 7 , so time lags are not relevant in this example. Conclusions: This example describes a case in which there are no hidden cos ts or time lags affecting the purch as e decision for ballasts. P arameters have been spe dfied correctly in the anal ysis. Even th ough thi s b al last saves energy at a cost below the price of electricity, we found th at most consumers still purchased the less efficient standard core-coil ballast. We conclude that market failures must have inhibited th e adoption of the more efficient corecoil ballasts. 4 S in ce fluorescent b al lasts are found in al most every commercial building, thi s f

in d in g suggests th at market failures af fecting th e adoption of efficient core-coil ball as ts are wid es pread and may af fect th e adop ti on of other cost-effecti ve devices as well.

2. The fact that consumers purchased the less efficient model doe s not mean that they actually performed a life-cycle cost calculation using a high discount rate. It strongly suggests th at cost-effective efficiency measures are ignored by many purchasers. 3. Th e lowest plausible number of annu al operati ng hours for commercial buildings is around 1300, which w ould yield a cost of conserv ed energy of 2.8c / kWh, still 1

/ 2 of the electricity price. Th ese calculations assume a real discount rate of 6% and o th er parameters as specified in Table 1. 4. A s of January 1990, only efficient core-coil and el ec tronic b al lasts may be sold in th e U.S. Th e inefficient core-coil b al lasts were outlawed by an 1988 amendment to the National Appli an ce Ener gy Conserv ation Act of 198 7.2 . 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 effi dent model in each of several regions. Their study is revealing in that it used very specific data and a simple technique: th e in crement al price of the more efficient model was compared with its reduced operating cost to compute a rate-of-return on the investment in th e efficient model. Purch ase of th e less efficient model then implies an implicit di scount rate exceeding this rate-of-return. Th e tw o refrigerators were di splayed next to ea ch o th er and sold by the same n ational retailer b etw een 19 77 and 19 7 9 . Both models were top-mount, autodefrost, roughly 1 7 cubic feet in volume, an d had the same f e atu res. 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 refrig erators was constant over th e analysis period, even th ough purch ase price for both models was reduced by rebates at various times. The high effi dency model was advertised widely, an d a prominent consumer magazine recommended it and even calculated th e monthly savin gs in electric bills. ( There were no feder al ly m an dated appliance efficiency labels in place at that time.) Th e efficient an d ineffici ent models together accounted for significant fractions of tot al unit s al es of all models of th at p arti cular br an d ( roughly 20% to 80%, depending on th e 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 ( 19 7 95), cheaper than the electricity prices prevailing in every state at th at time. Prices in 19 7 9 were lowest in Washington ( 1.5c / kWh), while the national average was about 5.4c / kWh. Us in g a 15% real discount rate, th e CCE is 2.4c / kWh, still less than half the U.S. average price of electricity in 19 7 9. During 19 77 through 19 7 9, the inefficient model was purch ased by around 45% of purchasers of eith er refrigerator in th e Midwest ( i.e., 55% p urchased the effici ent model), 35-40% in the East, 54-69% in the South, an d 5 7 -6 7 % in the Pacific Region. These purchasing patterns reflect the influence of el ectricity price, at leas t qualitati vel y: in 19 7 9, the Pacific an d S o uthern regi on had prices of 3.4c

/ kWh and 4.0c

/ k W h, respe ctiv el y, an d th e Midwest an d East had prices of 5.5c

/ kWh. Even noting this qualit ative d i fference, however, it is impossible to i gn ore th e fact that 35% to 7 0% of the p urcha se rs of th ese tw o models chose the inefficient model, i n spite of the low cost of con s erved energy. Th e results of Meier and Whittier's c al culation of the real implicit discount rate are:• In the Pac if ic regi o n, o ver 60% o f buyer s revealed disc o unt rates exceeding 34%;

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

• In th e Midwest, 45% of buyers reve al ed di scount rates ex ceeding 56%;

• In th e East, 40% of buyers reve al ed di scount rates exceeding 58%. These i mplicit rates o f return are s i gnificantly high er th an tho se prevailing in the capit al m arkets ( typically 4-12% re al ). Hidden Cost

s: The only hidden cost that might affect this comparison would be a result of having n o stand ard i zed rati ng system for energy use, which might have made it more difficult for consum ers to v erify th e energy savings that th e salesperson claimed. This factor was probably miti gated by the recommendation of the consum er magazine and the accompanying estimate of mo nthly dollar savings for the more efficient model

. Parameter Specification: Refrigerator usage does not vary by more th an 10- 20% over the year or between us ers, so errors in ch aracterizing usage are not a factor in thi s c al culation. Geographic al variation i n electricity p ri ces does not affe ct th e results, becaus e we co mp ared the estimated cost of conserved ener gy ( using a 6% real discount rate) to the electricity prices prevailing in the state that had the lowest electricity price in 19 7 9 and found the e ffi cient model to be cost effective even in this extreme case. Time Lags: Time lags are not rele vant here, be cause both models were widely available ( and displayed next to one an other) at the same time. Conclusions: This example describ es a case in whi ch there were no hidden costs or time lags af

fecting the purchas e decision for a refrigerator . Parameters have been specified correctly in the an alysis. The ener gy effi ci ent refrigerator saves energy at a cost below th e price of electri ci ty, yet many consumers purch ased the ineffi ci ent model in spite of the effi ci ent model's economic advantage. We conclude that thi s indicates th at market failures affected the market for efficiency in refrigerators. M any consumers rejected investments th at yi eld retu rns much greater th an th eir cost of capital. The applian ce efficiency standards that went into effect i n 1990 an d 1993 have signific antly ch an ged the market for refrigerators, but m any of the s ame factors affecting consumers' effi ci en cy ch oices in 19 77 - 7 9 probably still exist for other products. 3 . Energy St

ar computers The Environmental Protection Agency's ( EPA's) Energy Star Computer program is a voluntary program th at includes al l the major U.S. computer m anufactu rers (Johnson an d Zoi 1 992). The manufacturers a gree d to produce computers, mo nitors, and pri nters th.

_t switch to low-power states after a specified period of inactivity ( the low power state of 30W for the C PU

r 'represents a reduction of about 70%, with comparable reducti o ns for monitors

and printers). When the user st arts working again, th e computer sp ri ngs back to life instantly. Because even heavily used personal computers sit idle for significant parts of the day, energy use c an be substanti al ly reduced ( Fig. 1). Exten s i ve discus sio ns with manufacturers sh o wed that these featu res cou ld be added at negligible cost to th e purchaser, and th at consumer utility would hardly be affected. Manufactu rers who meet the Energy Star criteria are eligible to display th e Ener gy St ar Logo, whi ch br an ds th eir product as ener gy efficient, on their product literature. We cite this example not to advocate regulating the computer industry, which we emphatic al ly do not favor, but to describ e how electricity use was essenti al ly ignored by this highly competitive an d te chnologically advanced indus try prior to the EPA's program. For example, during one meeting with representative divisions of a major computer manufacturer, a product development specialist rem arked that they once considered incorporating lower-power states into their mainstream product line, but that the m arketin g department advised th em th at 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 th e previous lack of interest on the p art of cu stomers in efficiency improvem ents. However, in busines se s where computers are widely used, wiring constraints in older buildings can force costly renovatio ns if the capacity of th e wirin g is not able to meet the dem an d for power. These constraints may have in creased the awareness of such customers to th e amount of ener gy th eir computers used. Saving ener gy in the use of person al computers may seem like it would have relatively minor impacts nation al ly. This is not the case. The rapid proliferation of personal computers and associated printers has resulted in significant increases in electricity use in commerci al buildings. H arris et al . ( 1 988) 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 tot al commerci al sector electricity use as forecast by US DOE ( 1994). Hidden Cost

s: There are no hidden costs in this example. The level of service remains virtu ally unchanged. Parameter Specification: The manufacturers, the ones most equipped to know, say these measures will have negligible costs. Incorrect parameter specification is therefore n ot an issue.

10

### ON TIME (minutes/ hour) 6 O ACTUA L ON TIME
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### 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 1 992). 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 technol o gy inv ol ved in Energy Star Computers has existed

for years. Time lags are therefore n ot an issue in this case. Conclusions: This example describes features that can be added to computers, monitors, an d printers to make them more ener gy efficient. The resulting technologies have no hidden costs and no time lags. Parameters have been specified correctly in th e analysis. Adding the features saves ener gy at a cost below the price of electricity, but we found th at even in the competitive computer industry, thi s highly cost-effective ener gy savin gs option would not have been captured without the cooperation between EPA and the manufacturers. Therefore, we conclude that market failures must have inhi bite d i ts ado p tion. 4 . St andby power in color televisions The U

. S. Department of Energy describes o ptions for i mprovin g the e ffi ci ency 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 operati ng, this power is used to al low the remote control to adjust volume and change channels. In a survey of 25 19 " and 20 " color T V models, DOE found that more than 7 0% had standby power of greater than or equal to 2 W. The average st an dby power for the entire sample of TV models was 4

. 4 W. Te l evis ion s wi th s tandb y los ses greater than 2 W typ i c ally fee d power to th e tuner using a resistor. By replacing this resistor with a transformer, the standby power can be reduced to 2 W. The addition al manufacturing c o st associated with the tran sformer is $2.15 ( in 198 7 5). The cost of the resistor is sub tracted from that of the transformer, and m arkups are applied to c al culate the consumer price. The consumer price of reducing this stan dby power was estimated to be $4.30. This investment would save 21 kWh / year. Using a re al discount rate of 6% and a lifetime of 11.5 years, these costs and en ergy savi n gs tran slate into a cost of conserved energy of 2.5c / kWh. This CCE is about a factor of three lower than th e average price of electricity, yet more than 7 0% of televisions had not adopted this simple tech n ology as of 198 7 . At a 15% real discount rate, the CCE becomes 3.8c / kWh, which is about half the U.S. average pri ce of electricity. Appr o ximate l y 18 mill ion c olo r te l e v is ion s were s o ld i n th e U.S. i n 1986. Changes of a few watts in stan dby power may sound small for ind i vidual televisions, but wi th hundreds of millions of televisions in existence and the st an dby power being consumed every hour of the day, 2.4 W savings per TV would ( after 20 years) add u p to appro xi mately 450 megawatts and 3.2 TWh of annu al savings. Su ch savings would be worth about $240 million per year if ev al uated at nation al av erage electricity prices.

12Hidden Cost s: 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 st andby losses is based on w ellknown, 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. Reducin g 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 effecti ve, energy-saving option. 5 . Implications The four examples described above are not isolated ones. Th ey 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. O r , in the cases of television sets an d computers, they illustrate the fact that consumers did not have the choice of saving energy because the manufactu rers 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 equi pment and buildings compared with what is otherw ise chosen. For an extensive discussion of the measures that can be applied to new and existing residential buildings, includ in g costs an d energy savings, see Koomey et al. ( 1991). 5 Th ese examples show that the technology choices made by manufacturers and consumers are often far from the economic optimum. H owever, 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 th at could be obtained through cost effective investments in energy efficiency, see Fickett, Gellings, and Lovin s ( 1990) an d Rosenfeld, et . al. ( 1993).

13Ill: FA C TO RS A CC O UNTING FO R THE ENERGY-EFFICIENCY GAP

A. Back g r ou nd We presented evidence above that consumers and firms often fail to minimize their costs of obtainin g specific ener gy services. Since, as we di s cussed above, cost minimization is a necessary co ndition for econo mi c al l y efficient al locations of res ourc es , thes e examples provide p r ima facie evidence of economic ine ff

iciency in energy markets. What market i mperfection s mi g ht impede economic ef f iciency in m arkets f

or ener gy service s and be correctable throu g h well-d es igned polici es ? In a " first-best " w o rld , c on sumers and firms wou l d make decis ion s regard in g energy servic es th at were bo th privately an d socially optimal. The theory of welfare economics, however, provides a list of stringent conditions for decentralized m arkets to achieve efficient al locati o ns , including:

• p ri ces that 

## f

u Uy refle ct bo th p riv ate an d soci al costs;
• complete and identical information on the part of consumers and firms;

• perfect capit al markets ; • no trans action co sts . Each of these conditions fails to one degree or another to be satisfied in markets for ener gy services. That is, the " energy efficien cy g ap " reflects an " economic efficiency gap " that is amenable to correction by appropriate policies. Th ese market imperfections c an be us ed to interpret the evidence we presented abo ve an d c an guide th e desi gn of po licies ( Sanstad and H owarth 1994). B. Market Imperfectio ns Related to Energy Efficien cy 1 . Existing price distortions It i s uni versally recognized that electri city p ri ces do not reflect environmental costs. It is important to recognize, however, th at price reform is by n o means a panacea for correcting m arket imperfections related to ener gy . First, simply determi ni ng corre ct p ri c es ( i

. e., prices that internal i ze all soci al cos ts ) is itself a difficult and possibly insurmountable policy hurdle. The magnitudes of environmental extern al ities are site-specific and typically quite controversi al ( ECO Northwest 1993). Estimates of th e costs associated with c arbon dio x ide ( CO2) emissions range from $1 to more than $20 per ton, reflecting different and not easily reconciled assumptions about the damages related to glob al climate change an d the most efficient ways of reducing CO2 emissions ( Ottinger et al. 1990). Beyond this, there are substantial political an d in stitutio n al barriers to energy p ri ce reform as i llus trated by the recent faile d effort to impose a Btu tax.

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

current prices are not performing efficiently since cost- ef fecti ve measures are not bein g adopted, so th at m arket imperfections ari sing independently of p ri ce 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 provid es no breakdown on the contributions of in dividual 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 in di vidu al items cost. Kempton and Layne ( 198 9) sugg es t th at utilities need to provide consid erably more information on the monthly bills if consum ers are to have the necessary information to make
" rational " decisions on energy use. Komor et al. ( 1989) show th at small commercial customers are often just as ignorant about th eir monthly electricity bills as residential customers. They i nterviewed owners and managers of 40 small commerci al establishments and found that th ey knew little about energy use in th eir facilities. For example, not one of the interviewees was aware of the electricity demand charge ( $

/ kW-month), even though this component accounted for al most half of th e typic al electric bill ! Asymmetric information is a market imperfecti on in landlord / tenant or building / occupant situations.6 A significant difference in energy efficien cy investment between owners and renters was empirically documented by Brechling and Smith ( 1992) in a ri gorous eco n ometric study of the British housing market. This problem arises from different levels of information between owners and renters. If tenants pay utility bills, th ey could gain ( in the form of low er utility bills) from the installation of efficiency meas ures 

### by buildin g owners. Owners would wish to earn a return on such inves tments in th e form of higher rents. Owners cannot easily overcome, however, the problem of informing current an d prospective ten ants ( who are unknown) of the benefits available from increased efficiency. H ence, in a competitive rental market, the opportunity for mutual gains from improved energy efficiency can go unexploited. If the land lo rd pays utility bills, he or she could again benefit from the installation of efficiency measures to lower tenants' ener gy 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 th e field of information ec ono mi cs. This problem was first examined by Akerlof ( 19 7 0). 15this 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. Th e case that favors th e purchase of efficient equipment ( l an dlord pays bill) leads to a dis in centive for th e tenant to use ener gy effi dently. S imilar problems may occur in th e 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, an d appliances for new homes. Not surpris in gly, builders focus more on initial cost and less on operating cost than homeowners would. The same situation occurs in construction of commerci al build in gs. Owner-occupied buildings are much more likely to have en ergy -e ffi cient technologies th an are tenantoccupied buildings, as shown in a survey of new construction practices in Was hi ngton, D.C. ( Hines 1990). This di fference, whi ch is rather dramatic in the case examined, was true for almost all th e lighting, building shell, HVAC, motor, an d control meas ures examined ( Fig. 2). 3 . Decision - making problems Behavioral rese arch studies the decision rules consumers use in making q energy-related choices. Humans have limited or " bounded " ration al ity, since they can only process li mited amounts of information ( March and Simon 1959). Th e time it takes to process informati on is an information cost, while humans ' inability to anal yze and understand every issue is an indication of bounded rationali ty. For ex ample, technical i nf ormati on related to energy is not "transparent " to consumers but is subject to psychologic al processes that may distort its content ( Stem and Aronson 1984, Yates and Aro ns on 1983). In addition, consumers appear to us e heuristics in making ener gy 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 relati ve to th e specific set of ch oices available to the individual consumer (H ow arth an d Andersson 1993). While firms typically have greater technic al expe rti se 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 th eir cost of capital, so that even profitable ener gy efficiency investments are passed up. For ex ample, p rincip al agency problems betw een managers and technical personnel, or between shareholders an d management, may result in biases against energy-efficiency investments ( DeCanio 19 93). This would explain the seeming " paradox " of firms failing to optimally invest in ener gy efficiency.

16

_ , ! 11.......... 71 Ill Ill "- I :- - I-i ' -|

.......... ==i-Illllll

............ -..... = ............. - "



### PERCENT OF NEW COMMERCIAL BUILDINGS 100 i OWNER
-OCCUPIED P -/i TENANT
-OCCUPIED
80
60
4O; /I/1 1 Ili l 

### 2O

_ /I/1 1 I!11 1 

### 0 HIGH TASK HIGH ENERGY LOW
- E HIGH EFFICIEN C

Y LIGHTING EFFI CIEN C Y MANAGEMENT GLAZING EFFICIEN C Y LAMPS MOTOR S CHILLERS
Fig. 2. Percentages of new commercial buildings in Washington, D.C. with various energy-efficiency measures, by building occupancy (Hines 1990).4 . Transaction cost s The s e problems related to inf o rmati o n and decisi o n-makin g can als o b e viewed in terms of transaction costs, in cl uding the costs of gathering and processing information, making decisions, an d designing and enf orcing contracts relating to th e purchase and installation of energy-using te chnolo gy . The s e are someti me s referred to as " hidden costs " a ss ociated with en ergy efficiency, with the implication that their inclusion in engineering calculati ons would dose th e " effici en cy gap. " From a theoreti c al perspective, th e suggestion that tr an saction costs have no implicatio ns for economic effici en cy is incorrect ( Sanstad an d Howarth 1993). These costs associated with making energy choices are " re al" costs that must be t aken into account in poli cy and program an alysis. For policy purposes, however, the question is whether there are interventi ons 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, th e amount of time and effort required to find a refrigerator th at has a cost-effective level of energy ef

f _dency can be very hi gh. Th e typical consumer will seek a refrigerator th at h as important features su ch as size, color, design, a res pected brand, correct type of ice m aker, etc. One of th ese features may be costeffective levels of ener gy effici ency ( or more likely "hi gh " ener gy effi ci ency, as the consumer is not likely to have enough information or knowledge to perform even a s imple payback c al culation on ener gy effi ci en cy ). The time and inconvenience needed to obtain the ener gy efficient refrigerator - tr an saction costs- may be prohibitive. In this case, appliance st an dards may remove all ine ffici ent refrigerators from the market or even induce more effi ci ent ones to appear. ( We discuss appliance st an dards in se ction IV). Su ch st an dards are a po licy intervention that ( among other things) eliminates the tran saction costs that prevent the purchase of ener gy -efficient app lian c es . In the ca se of appli an ce effi ci ency, we suspect that these transaction costs are th e l argest reason that high eff i cien cy products were not p urchased prior to appliance standards ; to the extent that this is the case, the appli an ce st an d ards reduce imperfectio ns in th e market. 5 . Capit

al market imperfections Electric an d gas utilities are able to borrow money at a real cost of capit al of about 6%. Th e market for ener gy effi ci ency, determined by the decisions of millions of individu al investors, operates at much higher discount rates. Indeed, i n most cases the de ci sion on efficiency choice is made with a discount rate several times greater th an the utility cost of capital. To the extent that energy efficien cy substitutes well for new energy supplies, this
18d i sp a rit y in the d ec is i on

c r iteri a fo r inve s t m ent

in e ffi c i e n cy

a n d in n ew s upply mea n s t h a t

ca pi ta l will b e pr e f e r e nti a lly

a llo cate d

t o s upply. Th e l a r ge diff e r e n ce s

b e t wee n th e c os t

of ca pi t al

forutili ties

a nd th e e ff ec tiv e

dis c ount r a t e th at istypi ca lly

us e d in th e

pur c h a se

of e n e r gy

e ff i c i e n c y

r e sul t s in a v e ry l a rg e m i sa llo cati on

of capit a l. On e of t h e b e s t

e x am pl e s of this

probl e m i s r e siden tial a ppli a n ce s.

Prior t o a pplian ce

s ta ndards ,

Rud e rma n , et a l.

d ete rmined

th at th e mark et

b e h a v e d as if t h e r ea l dis c oun t

r a t e for e n e r gy e f fic i e ncy w a s 1 5 t o mor e th a n 100% ( R ud e rma n ,

e t a l. 1 98 7 )
. Ex ce p t for a ir c ondi ti on e rs ,

th e mark et dis c oun t

r ate s w e r e in th e upp e r e nd of t his rang e . This an a ly s is impli c itly

c on s id e r e d f ac tors b e yond th e c ontrol

of th e purch a ser

( e .g. , un a vail a bility

of th ee f fic i e nt a ppli a n ce ,

bundling of e ffi c i e ncy wi t h o t h e r high- c os t i te ms , diff e r e nti a l ma rkups forhi g h e ffid e ncy i tem s , etc . )
. Th e ca l c ul ati on

w a s p e rform e d for th e t ypi c al

e f fic i e ncy

of a n ew a ppli a n ce

in th e l ate

1 9 7 0's t hrou g h

th e mid1 98 0' s (prior to a pplian ce

s t and a rd s)
. Knowl e dg e of th e c o s t and b e n efit s of e ffi c i e ncy

mea sur e s not pur c h a s e d provid e d

a b a sis for e s ti mati n g

th e di sc ount

r ate( a ppli e d

to th e mark e t a s a whol e) of t h e a v e r age e ff ici e ncy

choi ce for eac h of th e m illion s of produ ct s sold. Thus , n ew po we r plan t s ar e buil t

ins tea d of inv e s t in g

in a ppli a n ce e f fi ci e n c y

be ca use th ec entralized

d ec ision

ma k e r borro w s

at 6% r ea l

whil e t h e c o m pl e x e nd-us e ma rk e t for a ppli a n ce s t ypi ca ll y

d ec lin e s

inv e stm e nts y i e lding

r et urns th a t ar e fiv e t o te n tim e s gr eate r. C. A Pr actica l

Illustr at ion:

Th e D e sign a nd Con s tru c tion of Co mme r c i a l Buildin g s In a r ece ntat t e mpt to und e rstand why buildin g s a r e no t d es i g n e d a s e ffi c i e ntly

as th e y c ould

be , Lovins (1 992)

in te rvi e wed

mor e than fi ft y

d e si g n professional s

and analy s ts

of th ed e sign

pro c ess a nd found a mark e t rif e with in e ffi c i e n cy

a nd "p e rv e rs e "

in ce n t iv e s. Th e s e in e ffi c i e n c i es a r e driv e n ma inly by th e d i ff ic ul t y

of cr ea ting

op t imiz e d ,

c ustom-built

building s

sy stem s in th e f ace

of p e rsis te nt

ins ti tu ti onal

f a ilur e s. As a n e x am

pl e of su c h a n institu ti onal f a ilur e , Lovins cit e s

t h e pr e vailin g

f ee stru c tur e s

of buildin g

d e si g n e ngin ee rs ,

which a r e e xpli c itly or i m pli c itly b a s e d on a p e r ce n tage of th e ca pi ta l

c ost of t h e pro jec t.

Th e r ea son

t h a t f ee stru c tur es

lik e t his on e a r e p e rniciou s

i s b eca u se

good d e si g nfor h ea tin g , v e ntil ati on ,

a nd air- c onditionin g (HVAC ) sy s te ms

c an o fte n

a llow s ubstanti a l r e du ct ions

in ca pi ta l

c os ts an d op e r at in g c ost s . Su c h d e si g n r e quir e s a ddi ti onal

e xp e nditur e s

b e yond th e t ypi c al

"rul e -of-thum

b" e quipm e n t sizin g t h at most e ngin ee rs

do , whi c h r e sul t s

in a n et p e n a l ty

for d e sign e rs

of e ffi c i e nt

syst e ms.

19HV

AC sy st ems

a r e typ ica ll y

overs iz e d

by f act o rs

of t wo o r t hr ee,

whi c h is a maj or sour ce of unn ecess ary ca p ita l e xp e ndi t ur e s

as w e ll a s l ess

e ffi c i e n t delivery o f energy service s . Su ch o versizing is typically justified becau se o f uncertainty about the plug load s of individu al tenant s who may not even be s ign ed up to lease the space when the mechanic al equipment i s specified. The systemic benefits from optimizing mechanic al systems cannot be captured by such a line ar , pieceme al approa ch . Cr os s-subsi dies

a n d i n c o rrect

price s ig nals a r e c o mmonp lace i n c omm erc i al buildin gs .

M a n age r s o f ma st e r-m ete red buildings

o fte n ch a r ge th e ir te n a n ts bas e d on fl oorsp ace,

fa ilin g t o r ewa rdmor e effic ien t te n a nts. L ov ins expl ores a variety o f oth er ins titutio n al failings, i n clu din g n on exis tent or faulty operation, monitorin g, post-occupancy ev al uation, maintenance, and b ui lding commissioning. He exp lores every step in the desi gn process, documents how this proce s s fai ls, and suggests ways to fix it. This study is an important example of the kinds of empirical work

_hat are crucial to underst andi ng the extent of market failures affecting efficiency in buildings. D. O b servatio ns O ur discussio n sho w s th at factors p re v enting th e a do pti on o f c o st-effecti v e energy e ffi cien cy meas ures can be framed in terms of th e stand ard economic theory of market imperfections. F urth er rese arch is needed to clarify the theoretic al anal ysis of energy-related m arket imperfecti ons, to guide empirical rese arch on this set of issues, an d to apply th eory an d empirics to the design of effective energy policies.

2oIV. POLICIES TO PROMOTE COST-EFFE_ E N ERGY EFFICqENCY

T wo major energy-saving policies have been pursued aggres sively during the p ast dec ade. The first involves utility promotion of en er gy efficiency among their customers through demand-side management (DS M ) progr ams. U.S. utilities are presently spending more th an $2 billion annu ally on such pro grams. This represents more th an 14% of tot al investment in new generation (including non-utility gener ators) (Energy Inform ation Administr ation 1 99 4). Th e second ener gy -s aving poli cy is app lian ce efficien cy st and ards. Th ese st and ards result in a projected s avings e quiv al ent to the output of more th an 2 0 1,000-MW po wer pl ants after 20 to 25 ye ars. A. Th e Role of Utiliti es in Pro moting Ener gy Efficien cy During the p ast sever al ye ars, U.S. electric utilities h ave played an incre asingly import ant role in encour aging their customers to improve energy efficiency.8 As shown in Fig. 3, util i ty expenditures on dem and-side man agement (DSM) progr ams and their effects (energy s avings and reductions in demand at the ti me of system pe ak) incre ased sh arply between 1 9 8 9 an d 1 99 1 ; utility pl ans show continued incre ases during the coming dec ade (Energy Inform ation Admi ni s tration 1 99 3). Wh at f actors led utiliti es to get involved on the " custo mer side of th e meter, " given th eir long tradition of focusing on l y on th e provision of electricity (i.e., gener ation, tr ansmission, dis tribution, an d custo mer bil l ing)? Th ese f actors included: .Growing interest in inte grated resource pl anning (IRP), which involves explicit consider ation of DSM progr ams as cost-effective altern atives to some new power pl ants ; .Pr o vision of fin anci al incentives to utility sh areholders for implementing cost-effective DSM progr ams; *Incre asing concern about the environment al effects of electricity produ ction and tr an smission, es peci al ly global w arming an d acid r ain; and *Growing recognition of the powerful role th at utilities c art pl ay in overcoming m arket imperfections th at impede adoption of cost-effective ener gy -efficien cy opportu niti es (Hirst 1 99 1).

8 . Na tu ra l - g as

u til i ties , af ter c o n s i dera b le

a c tivi t y during th e 19 7 0 s ,

reduce d t hei r ene r gy eff i c i e n c y

progr ams

sh a rply in th e 19 8 0s. During th e p a s t fe w y ear s ,

how e v e r ,

g as u ti li ties a r e on ce ag a in b e ginning

t o pro mo te c u st o me r e n er g y effic i e ncy.

A c on tr ov e rsi a l

issu e , no t a ddr e ss e d

h e r e , c on ce rns

th e rol e o f g a s or e l ect ri c

util ities in e n c our a ging

c ustom e rs

t o s w i tc h f ro m on e f u e l t o a no t h er ( e .g. , f rom e l ect ri c ity

t o g a s f or re sid e n tia l

w ate r h eat ing , orfro m g as t o e l ec t r i c ity

f o r indu s trial

d r ying )
.
21

### % OF PEAK DEMAND , SALES, AND RETAIL REVENUES

10

_ 1989 NN 1991

_ 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, 1 9 89 through 1991 an d plans to the year 2001I n essence, electric uti liti es and their re g ulators now recognize that utilities

can be providers of energy s ervices not just of kWh and kW product s . For purposes of this paper, the key factor is the last one, the role of utilities in overcoming market imperfections. As d i scu ss ed earl i er , cu s to mer s face market failure s whi ch i mpede the adoption of what would o th erwise be cost-effective energy efficiency actions. Utilities have important chara cteristics that position them to help customers overcome these failures. Utilities have monthly contact with all t :mir customers through meter reading an d billing. Utilities have long-standing and generally good relationships with th eir customers and with the communities th ey serve. Utilities are widely recognized for their technical competence. Utilities have l arge field organizations that can deliver DSM programs to customers. Utilities have ready access to capital, leading to a low cost of capital an d steady cash flows, enabling th em to offer loans an d rebates for customer purch ase of ener gy -efficient systems. And many utilities are increasingly knowledgeable about th e ener gy serv ice needs an d w ants of their customers, primarily because of their DSM programs. All these factors make it easier an d more efficient for utilities than for other organizations to design an d implement DSM pro grams. U til i ties can al so he l p o v erc o me i nfra s tructure limi tations . F o r example, v arious ener gy -efficient technologies ( e.g., low-emi ssivity windows and other advanced glazings, an d compact florescent l amps an d other new lighting systems ) are not available in m any p arts of the country. Utility progr ams that promote th ese devices can transform the market so that wholesalers and retailers wi ll routinely stock, advertise, an d sell th ese products. According to Energy User News , " [m]uch of the recent demand for compact fluorescent p roducts has been fostered by atilities. Since April [1990], utilities in California, Washington, Oregon, Massachusetts and Connecticut have expanded investments in conservation pro grams, all of which help foster compact fluorescent te chnolo gy" ( Bryant 1990). Uti lities c an provide c redible, s i te-specific informati on to customers on th e app l i cab i li ty , costs, and benefits of different DS M technologies. Residenti al and commerc i al ener gy audits, offered by m any uti liti es, are an effective w ay to provide s u ch i nform ation. Bec ause rese arch h as demonstr ated th e i mport ance of credib i l ity and follow-up in successfu l l y conveyi n g en ergy i nformation (K atzev an d Joh n son 1 9 8 7; Winett an d Ne ale 19 7 9), u tilities are especi al l y we ll -pl aced to u ndert ake the se ty p es of interv enti ons. Utilities c an also provide appropri ate design and fin anci al incentives for i n st al l atio n of DSM me asures in new b u ildings. In many c ases, no other institu tion appe ars to b e as effective in providing such site-specific inform ation, especi all y wh en it is co mb in ed with in centive pro grams that boost co n s u mer adoption of th e DSM techno l o gy .

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

toward greater attention to customer service and satisfaction. DSM pro grams allow utilities to expand the range of services they p rovide to customers beyond selling a single-dimension p roduct, electricity. As electricity markets become more competitive, utilities will increasingly use their DSM programs to enhance their cu stomer 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 p rograms are optimistic ( Nadel and Keatin g 1991 ; Joskow and Marron 1993a and 1993b). The more important issue is whether, given actual savings less than p redicted, the programs are still cost-effective. H ere the evidence is mixed. Some programs are clearly cos t -effective, based on rigorous accountin g of all p rogram costs and measurement of electricity savin gs ( Nadel 1992). Others are not. New England Electric System ( 1993), which has a hi story 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 We atherization Program was highly cost-effective in its early years, but by 1989 decreased levels of electricity savings caused the p rogram's costs to exceed i ts 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 p rograms. These efforts are reflected in various conference proceedings, protocols for evaluating DSM programs, and the increased availability of data on the costs and savin gs of DSM measures and programs. 9
9

. See th e conferenc e p roce e ding s f rom th e Evaluationpanel of the biennial Summer Study on Energy Efficiency in Buildings, sponsored by th e American Council for an Energy-Efficient Economy and the proceedings from th e biennial conferences on Energy Program Evaluation, sponsored by the National Energy Program Evaluation Conference. 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, IRT Environment, Electric Power Research Institute, an d Lawrence Berkeley Laboratoryall col

_lect,

analyze, and publish informationon the performance of utility DSM pr o grams .

24-_ I I I "

_ II=-' II
-

_ : -:- :_"- IBI I -- -- I IIII
- -



## BENEFIT

/ COST RATIO (without externalities) 3 

# D 1991 !1 1992

.. 

## 2.5
- ' "" 1991 AVERAGE ///// .w j j " I IIIi



## 2 - /////



## __ // / 1992 AVERAGE 1.5 ,, / //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 comp rehensive; the reduced focus on lighting, which is very c o st effective, lowered the p rogram's overall cost effectiveness in 1992.2 . Market transforma t. m

U ti li ties can increase the benefits and reduce th e c o sts of th e ir DS M programs by working closely with trade allies an d by movin g upstream from retail customers. Th es e efforts are call ed market-tr an sformati on programs, because their intent i s to change the operati on of markets, not just to s ti mulate o n etime changes in customer behavior. Utilities are increasingly designing their DSM programs to work with government pro grams and stand ards, as well as m anufacturer and other trade- al ly efforts. For ex ample, rather than encouraging i n dividual customers to purch ase high-efficiency appli an ces, utiliti es can work with manufacturers, wholesalers, an d deal e rs to be sure that only efficient appli an ces are sold. The Super Effici ent Refrigerator Pro gram ( often called th e Golden Carrot) is a example of m arket transformation. Roughly 25 utilities pooled a $30 million incentive, whi ch was offered to refrigerator manufacturers to design an d build units that do not use CFCs an d that exceed the 19 93 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 st art marketing these high-e ffi ciency units in the service areas of the sponsoring utilities in 1994. The utiliti es will pay Whirlpool as the units are delivered in their areas (Demand-Side Report 1 993). The Model Conservation St an d ards provide another example of market transformati on. The Bonneville Power Adminis tration has run pro grams 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 an d motivate different stakeholders, c oordinated with those of the North w es t Power Planning Council, several utilities, and other org anizations, led to passage of tougher building codes in the Pacific Northwest states. Th es e new codes require construction that meets the Model Conservation Standards an d reduces th e need for Bonneville participation in new-home construction markets.
Market transformation requires the utility to move upstream from its customers to retailers, wholes al ers, distributors, manuf acturers, as well as the organizations that install, service, and finance equi pment and structures (H ammarlun d 1993). Working with these "trade alli es " with in 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, su ch as ener gy -efficien cy standards and government p rograms.

26To the extent th at utility market transformation programs are successful, the

role of utilities in promo ti ng customer energy efficiency is temporary. That is, if utili ti es can work with trade allies to change " stand ard operating procedures, " to adopt and implement stricter build in g an d app lian ce energyefficien cy st an dards, an d to make ener gy efficien cy 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 th e Bonneville Power Administration ( as well as other utilities in th e Pacific Northwest) c an reduce the rebates it offers builders to cons truct ener gy -e ffi cient homes and devote its res ources to training code officials an d builders on how best to administer an d comply wi th th e new codes.
3 . Fw : ure prospect

s Market research can help utilities to identify market failures and to understand better the ener gy -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 an d do so at lower cost. For instance, National An al ysts ( 1990) developed computer models that help utilities identify appropriate market segments among th eir residential customers and assess the likely res ponse of these segments to different types of DSM programs. Much of this rese arch c an be done inexpensively. Pacific Power & Light ( now PacifiCorp) spent about $50,000 on a residential lighti ng pilot effort to identify likely participation rates and potential ener gy savings. Because the utility industry is becoming more competitive, th e focus of DSM programs will likely shift away from resource acquisition to improved customer service. Energy effi ci en cy will continue to be a key driver for such programs as uti lities seek to help their customers become more competitive. In such an atmosphere, utiliti es c an continue to use th eir unique position to ! help customers overcome market failures and adopt cost-effective energysaving technologi es . B. Appli an ce Effi ci ency St an d ards 1 . Background The State of California was the first to promulgate energy efficiency regulations for residential appliances, whi ch li mited th e sale of refrigerators to those with ener gy consumption less than a specified maximum. The range of other applianc es legally permitted to be sold w as similarly res tricted, based upon their energy effi ci ency or annual energy consumption. In 1986, after several states had adopted different energy efficiency regulations, manufacturers and environmental groups negotiated a set of national efficien cy standards ( California Energy Commi ssion, 1983). These national

2 7appliance standards were encoded in the National Appliance Energy

Conservation Act of 1987. Since then, the U.S. Department of Energy has updated th ose stand ards 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 19 7 9 to 1993 (Adams 1993). These expenses included development of test procedures for measuring efficiencies, technic al an alyses to provide an engineering an d economic basis for th e st an dard levels selected, administrative costs associated with public hearings, publication of laws and supporting technic al documents, and management of th e pro gram. 2

. Benefit

s of appliance st

andards The benefits of the program have been determined by using end-use forecasting models, which account for the primary effe ct ( increased efficiency of new appliances) and important secondary effects ( more expensive applianc es , fu el switching, and chan ges in operating practices). The results suggest a cumulati ve net benefit to th e nation for app li anc es sold from 1990- 2015 of $46 billion. This consists of a net present cost of $32 billion for higher priced app li ances an d a n et present savin gs of $ 7 8 bil li on. These be nefits as well as the cumulative ener gy savin gs of the stand ards to date ( those al ready promul gated) are shown in Fig. 5. Figure 6, which shows th e effects of standards that have been promulgated, shows substantial reductions in re sidential energy demand growth due to the st an dards. Proposed st an dards for eight products will cause signific ant additional declines in residential ener gy dem an d if adopted. The two lower curves in Fig. 6 show th e impa ct of the st an d ards propo se d by the U.S. DOE in M arch 1994 for eight products. The lower curve is for implementati on of th e stand ards in 1996 ; the curv e above it is for implementation in 1998. In cl u de d in th i s acco u nting are th e proje cted i n crease d c o sts passe d on to consumers, an d the value of energy savings ( c al culated at average energy prices). Th e costs to manufacturers are accounted for and ( mostly) passed o n to consumers. However, the be nefits accounted for do not i n clude th e v al ue of decreased emissions of air pollut ants and c arbon dioxide. (Th e qu antities saved represent 1.5 to 2% of total nati on al emi ssions of SOx, NOx, an d CO2). The benefits al so fail to assign a v al ue to th e deferral of new electricity generating plants beyond the average p rice of ener gy paid by the consumer ( McMahon et al . 1990).

28

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### recently proposed eight product rulemaking, as suming implementation in 19 96, and (5) recently proposed rulemaking with implementation in 1998.3 . P ossible criticis ms

It h a s been s u gg e s ted that the consumer' s choice in a p pliance m odels may be restricted as a re s ult o f the s tandards, thereby creatin g a hidden cost. Con s iderin g re f

ri g erator s a s an example, how e ver, there were more mod els available after th e regulations became effective in 1990 th an were available in 1 986 (M c / vIahon 199 1 ). Moreover, real price s o f refri g erator s have declined fro m 1986 to 1991 (AHAM 1993a). The avera g e re fri gerator purch ased after efficiency s t an dards is l arg er than before an d more lik el y to be a " side-b y -side" than another type (AHAM 1993b). The engineering cost data, when manufacturer an d deal er markups are added, suggest th at the more efficient appliance s required b y the feder al st an d ards pay back their incremental inve s tment in three y e ars or l es s (US DOE 1989); u sing actual price data on re f ri g erator s be f

ore and after the stand ards, it i s difficult to detect any significant post-stand ard p rice increases. Another potential criticism of the s t an d ard s i s th at th ey may cause a s a crifice in s ome amenity th at th e consumer v al ue s . In fact, as noted above, s uch a criticis m is l arg el y ruled out by defining different stand ards for various classes of appli an ces whi ch differ in th e features offered. Thus for refrigerators, some of the different class es in clude freez in g co mpartments th at are top- mounted , side- mounted , and bo ttom-mounted . For purposes of rulemaking, ea ch class of refrigerator, as well as ea ch size, must meet a different standard. ( In p ractice, an equation specifies the size-dependence of the stand ard level within each refrigerator cl as s.) We believe that the large cost-effective energy savings resulting from appliance st an dards-- amounting to 0.1 quadri llion Btu (almost $1 billion) per ye ar at present an d growing to eight times this amount in 15 to 20 years itself provides evidence of market failure related to en ergy effi ci ency. First, there is no evidence th at th ese substantial ener gy -effici ency gains would have come about in th e absence of stand ards. Second, while th ere has been no definitive rese arch on what constitutes th e imperfections in the m arket, we specul ate that there are variety of factors, few of whi ch a ctu al ly 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 e arlier, th e transaction costs of seeking out ener gy efficient models that have all th e o th er d es ired features are likely to be high. The manufacturers know that consumers value attributes other than ener gy efficien cy , and undoubtedly also believe that consumers may not be able to ev al uate th e true ener gy cost savin gs of greater efficiency. In a competitive market, manufacturers are motivated to minimize costs. Thus, given a ch oice be tw ee n proliferati ng mod el s (an expensive proposition) and choosing one effi ci ency level for each set of features , manufacturers ch ose the latter. This does not mean that the consumer does not value or be nefit from costeffective levels of effi ci en cy . It means that, until standards, most consumers
31w e re poorly i n formed about th e se benefi t s and could only avoid purchasin g

lower efflden cy by investin g considerable time and effort. 4 . A lte rnative approache s Consid e rin g the magnitud e of the b e nefits of high applianc e effici e ncy, the qu e stion is what al te rnativ e rol e the gov e rnm e nt could hav e play e d th at would hav e b ee n more e conomically effici e nt. Prior to st an dards, som e sugg e ste d th at informati on and lab elin g programs coul d achi e v e significant e n e rgy effici e ncy gains. Such pro grams w e re in plac e for many y e ars b efore th e NAE C A stand ards w e nt into eff e ct , with only limite d impact (McMahon 19 9 1 ). C ould the $50 mi l lio n spent by th e g overnment for e ffi cien cy st andards h av e been spent in some o th er w ay to achieve equ al or g re ater be n ef its ? We are unable to propo se a pro gram wi th a $2 to 4 million annu al budget (over 1 5 ye ars) th at could h ave effectively achieved the be nefits of th e appli ance effici ency st an dards pro gram. E ach ye ar th e 100 mi l l io n households in th e U.S. spend abo ut $ 6 7 billion for residenti al appli an ces (including heatin g and cool in g equip ment) to p urch ase abo ut 5 5 mi llion ma j or appli an ces and 12 million he atin g and air conditioni n$ systems. If th e $2 to 4 mi ll ion th at the g overnment spent on appli ance st andards were spent on consumer education, this woul d amount to abo ut $0.02 to 0.04 per household pe r ye ar. It is h ard to believe th at such exp enditures would af fect many purch ase decisions and it is inconceiv able th at the imp act wou l d be in any w ay comp ar ab l e to th at of the st and ards. 5 . Summa ry We b el i eve that ap pliance s t andar ds have had a large b eneficial impact on residential energy expenditu res. The stand ard s 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 con s truction by more th an 40 500-M W uni ts over the next 20 year s , have not reduced th e choice of appliance s or the s ervice they provide, and have occasioned almost no objection from consumers. While s ome may argue on theoretical grounds that s uch a po li cy ought to have major flaw s ( or hidden cost s ), th e evidence indicates o th erwise. The po s itive experi en ce with appliance s tandards itself is additional evidence for s ubstantial imperfections in the market that have made pos s ible s u ch large savi ngs.

32V. SUMMARY AND CONCLUSIONS

We hav e presented a methodology for identifyin g techni c al e v idence o f market failures related to energy efficiency, and appl / ed thi s framework to several examples of c o s t-effective ener g y-e f fi c ient technologies whose adop tion in the market has been impeded. These efficient technologies off er c on s um er services identi c al (or, indeed, supe rior) to those provided by less efficient te c hnologie s an d th eir adoption clearly yield s e c onomi c benefit s . Although we c annot s ay exactly why these te c hnologies have no t been adopted, th ese examples demonstrate the existence of market failures. We reviewed sever al market imperfections th at may account for the ener gy ef fi ci en cy

g ap. We have al so di s cussed utility demand-side mana g ement pro g rams and appliance st an dards regulations, two major initiati ves aimed at overcoming market f

ailures to improve energy efficien cy . We have argued that sizable economic benefits are accrui ng fro m th e s e program, an d th at , with out these interventions, th ese benefits would go uncaptured in th e marketplace. We can now summarize our an swers to th e questio n s raised i n th e Introduction:

• Aren ' ttechn o log

/ sts ignorin g certain "hidden costs" in their calculations

that, i l in cluded, would show that

many energy efficiency investments

are in fact not cost-effective? We have p rovided four examp les i n which th ere are either n o hidden costs or th e s e costs are mini mized and thus cannot be used a prior i to explain why consumers sti ll failed to purchase the co s t-eff e ctive, more e f ficient produ c t.

• Aren ' t these hi dden co s ts "irreducible, " that is , not subject

to reduction or el

/ m / nation by policies? When hidden costs do appear in other ca se s, they are to a l arg e extent s ubje ct to reduction or elimi nation by pol i cies. Gov ernment and uti l ity pro g rams can sub s tantially reduce th ese costs by taki ng acti on s once o n behalf of thousand s or millio n s of customers. For examp le, federal appliance effi ci ency standards involve a g reat de al of techni cal analys i s. However, thi s analysis is done only once, an d is used to eli mi nate all appliances that do not meet economi cally-based en er g y-eff icien cy cri teri a. Similarly, utility D S M pro grams that provide finan ci al incentives to p urchase and ins tal l energy-effi ci ent devices reduce th e capital market d ich oto my of th e hi g h cost of money th at consumer s face and the much lo w er cost of money th at utilitie s enjoy.

• In any case, aren ' t the se hidden costs "normal" to many markets,

not just markets for en ergy effi cien cy? If not, what dis ti nguis h es energy markets?
33Like all markets, markets related to ener g y have some unique c haracteristi c s. Ener g y consump ti on has very si g ni f i c ant societal i mpli c ations, includin g very lar g e environmental i mpacts and potential sign ific ant e ff

ects on nation al security. Addition al ly, because the nation's consumers and in dustry are both vitally dependent on its availability and affordability - an d because a sizable porti on o f GNP is sp ent on energy - the proper f

u n c tionin g of energ y markets is widely recognized as critical to economic w ell-being . However, we make no gen eral claim th at markets related to en ergy effici en cy are intrinsically " special, " nor is such a claim required for th e cas e w e are maki ng. If e vi d en ce of market impe rfection is present, as we believe it is in this case, the n in principle intervention is warran ted , in en e rgy as well as oth er m arkets.

• Evenif these costs canbe reduced, why can't these opportunities

be e xploited by private firms? That is, why do g ov

_t and utilities need to intervene? A defining ch aracteristic of market imperfections is th at th ey cann ot be overcome by co n sumers or firms actin g in depen d ently; this is equ ally true o f markets related to ener gy as w ell as o th er markets. We fully recognize the problem of "g overnment failure " and the f act that not all problems can be overcome throu g h public or utility policies. As we have shown, however, there is ample reason to conclude that po licie s to redu ce market imperfectio ns re l ated to ener gy effici en c y can be and h av e been successful. Additional behavior al research is needed. In p articular, utilities, EPtU, and DOE should sponsor proje cts to pinpo int an d quantify the various market failures rel ated to ener gy efficien cy . These projects need to examine failures at a disa ggre g ate level -- by market segment (e. g . , multifamily tenants vs. owner-oc cu pi ed medium-size office buildin g s) , by end use, by technolo gy, and by type of decision (purchase or operation). These projects will quanti fy the impo rtance of different failures in different circumst ance s. Uti lities an d g overnm ent can th en u se th e res ult s of th ese projects to analyze program and po li cy option s to address the most important failures. If, for ex ample, lack of capital is the problem, th en rebates may be the solution. If, on the other hand, uncertainty about th e likely energy savings of a new technology is the barrier, th en a perform an ce gu arantee m ay be the solution. In other word s , progr ams ne ed to be d es igned to address sp

_ ., : ific, documented failures. Such empirical research co uld provide two be nefits. The primary be nefit will be better pro grams that provide more s avin gs at lower cost. A secondary benefit will be the resoluti on of controversi es over th e role of governments and utiliti es in pro moting energy efficiency.

34VL ACKN OWL B DG

_

We w ould like to th ank the follo w in g people for th eir helpful comments: Albert Nichols ( N ational Economic Rese arch A sso dation); Danie l Kirschner (Environment al Defense Fund); Henry Lee ( H arv ard University); Ho w ard Gruenspe cht (Department of Energy); How ard Geller (American Council for an Ener g y Efficient E conomy); Ron Sutherland (Ar g onne National Laboratory); Marilyn Brown (Oak Rid g e 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 Ener gy Efficiency and Renewable Ener gy , U.S. De p artment of En er gy under Contract Number D E AC03-76SF00098.
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