CONSUMER THEORY, HOME PRODUCTION, AND ENERGY EFFICIENCY

Philip B. Thompson (*) Arguments about the existence of the so-called energy efficiency gap are typically based on evaluations of efficiency measures as investments whose end result is to reduce the cost of providing a given level of energy services. This article demonstrates that the investment approach tends to undervalue energy efficiency improvements because it omits the increase in utility that results from the consumer's substitution of energy services for other goods. The substitution occurs because the efficiency measure reduces the marginal cost (implicit price) of energy services. Sample calculations based on a Cobb-Douglas utility function are used to illustrate the potential size of the undervaluation of efficiency investments. (JEL Q40, Q41, D13) I. INTRODUCTION A prominent feature of the literature regarding the economics of energy efficiency is the debate over the existence of, the extent of, and the appropriate public policies toward the so-called efficiency gap -- the failure of many energy consumers to take advantage of apparently cost-effective opportunities to reduce energy consumption. Energy efficiency activities typically involve the purchase of physical capital that allows energy services to be produced at a lower variable (fuel) cost than is possible without the capital expenditure. For example, measures that increase the thermal integrity of the building shell, such as adding insulation or storm windows, will lower the consumer's heating and cooling fuel bills, and replacing incandescent lighting with fluorescent fixtures reduces expenditures on electricity. The purchase of fuel-saving capital is therefore typically viewed as an investment whose payoff is a reduced future stream of fuel costs. The application of standard investment analysis would lead the consumer to adopt a fuel-saving measure whose present value of fuel cost reductions exceeds the initial capital expenditure. The investment should be made if (1) [C.sub.K] [less than or equal to] [V.sub.K] = [summation over (T/t=1)]([[P.sub.t]([F.sub.C] - [F.sub.N])]/[(1+r).sup.t]); where [C.sub.K] is the initial cost of the fuel saving measure; [V.sub.K] is the present value of the fuel cost savings, which can also be interpreted as the consumer's demand price for the efficiency measure; [P.sub.t] is the price of fuel in period t; [F.sub.C] is the amount of fuel used with the current capital equipment; [F.sub.N] is the amount of fuel used with the new or improved capital equipment; T is the time horizon over which the investment is to be evaluated; and r is the discount rate applied by the consumer. Alternatively, (1) could be solved for the r that yields [C.sub.K] = [V.sub.K] (i.e., the internal rate of return), and if this r exceeds the consumer's cost of capital, the investment should be undertaken. The numerator of the right-hand side of equation (1) contains each year's savings in fuel expenditures, and it is assumed here that the two technologies use the same fuel. The time horizon T is set equal to the life of the efficiency measure, the period of time over which the consumer exp ects to use the measure, or some arbitrary payback period selected by the consumer. An efficiency gap is said to exist when [C.sub.K] [less than or equal to] [V.sub.K], but the investment is not undertaken. (1) In cases involving new construction, or in which the existing equipment has exhausted its useful life, [C.sub.K] represents the difference in capital costs between the less efficient and more efficient equipment. There are many explanations for the efficiency gap or, from a more skeptical viewpoint, reasons why the gap does not actually exist. Discussions of these issues are provided by Jochem and Gruber (1990), Sutherland (1991), Jaffe and Stavins (1994), Sanstad and Howarth (1994), and Metcalf (1994). Those who believe the gap is real generally argue that the decision rule of (1) is not correctly applied by consumers. …