# **Transaction costs of low-carbon technologies and policies:  The diverging literature**

Luis Mundaca<sup>,</sup> Mathilde Mansoz, Lena Neij and Govinda R Timilsina<sup>1</sup>

## **1. Introduction**

Transaction costs (TCs) can be broadly defined as costs not directly involved in the production of goods or services but that arise from transactions that are essential for realising the trading of those goods and services as such (Coase, 1960). Low-carbon technologies are, in general, more expensive than conventional ones. Even if they are economically attractive, as with for example net saving of electricity bills through the use of more energy efficient appliances, the economic benefits may be outweighed by, for instance, the costs of searching and assessing information about low-carbon technologies, the costs of making decisions on optimal selection of technologies, and the costs of validation, monitoring and verification of emission reductions. As technology costs for low-carbon technologies are higher, policy instruments are needed to deploy the technologies; but the results of policy will be limited by transactions costs. Reduction of transaction costs is a critical condition for increased deployment of low-carbon technologies.

Conventional top-down and bottom-up modelling of low-carbon technologies and policies have tended to assume that transactions required to implement low-carbon technologies are costless (see e.g. Hourcade et al., 1995; 2006; Worrell et al., 2004). The outcome is that modelling results might underestimate the costs of reducing GHG emissions. For instance, many bottom-up modelling studies, such as World Bank (2009), World Bank (2010), McKinsey, (2009) estimate that most energy efficiency measures could result negative net costs to investors (i.e., energy savings outweigh implementation costs). McKinsey (2009), particularly, estimates that energy efficiency improvements can reduce up to 14 GtCO2 per year approximately – or nearly 40% of the global GHG abatement potential by 2030 – at negative net costs for investors. However, these studies overlook long-standing critiques of conventional bottom-up models, in particular the treatment of market and behavioural failures<sup>2</sup> that impede the realization of such potentials .<sup>3</sup> These studies consider only the market costs of technologies (i.e., investment for purchasing and installation of technologies, expenditure on operation and maintenance of these technologies for their economic life).

> 1 Mundaca, Mansoz, and Neij are with the International Institute for Industrial Environmental Economics at Lund University, PO. Box 196, 221 00 Lund, Sweden.  Timilsina (corresponding author) is with the Development Economics Group of the World Bank (email:  gtimilsina@worldbank.org).  The authors thank Sunil Malla, Ashok Sarkar and Mike Toman for insightful comments and acknowledge the Knowledge for Change (KCP) Trust Fund for financial support. The views and findings are those of the authors and do not necessarily reflect those of the World Bank or its member countries.

> 2 Market failures are hereby defined as flaws in the market that do not allow efficient or optimal allocation of goods and services (e.g. negative externalities not reflected in energy prices, asymmetric and imperfect information about the performance and risks of mitigation technologies). Behavioural failures are defined as decision-making actions by firms and consumers that lead to apparent divergences from utility/profit maximization goals.

> 3 This is also termed an ‘ _energy efficiency gap’_ which is generally used to describe the slow diffusion of profitable efficient technologies that fail to achieve market success (Jaffe and Stavins, 1994).

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