Energy Efficiency Economics
and Policy
Kenneth Gillingham,
1
Richard G. Newell,
2,3,4,*
and Karen Palmer
3
1
Precourt Energy Efficiency Center, Stanford University, Stanford, California 94309;
email: kgilling@stanford.edu
2
Nicholas School of the Environment, Duke University, Durham, North Carolina
27708; email: richard.newell@duke.edu
3
Resources for the Future, Washington, D.C. 20036; email: palmer@rff.org
4
National Bureau of Economic Research, Cambridge, Massachusetts 02138
Annu. Rev. Resour. Econ. 2009. 1:597–619
First published online as a Review in Advance on
June 26, 2009
The Annual Review of Resource Economics is
online at resource.annualreviews.org
This article’s doi:
10.1146/annurev .resource.102308.124234
Copyright
© 2009 by Annual Reviews.
All rights reserved
1941-1340/09/1010-0597$20.00
*Corresponding author
Key Words
appliance standards, market failures, behavioral failures
Abstract
Energy efficiency and conservation are considered key means for
reducing greenhouse gas emissions and achieving other energy policy
goals, but associated market behavior and policy responses have
engendered debates in the economic literature. We review economic
concepts underlying consumer decision making in energy efficiency
and conservation and examine related empirical literature. In partic-
ular, we provide an economic perspective on the range of market
barriers, market failures, and behavioral failures that have been cited
in the energy efficiency context. We assess the extent to which these
conditions provide a motivation for policy intervention in energy-
using product markets, including an examination of the evidence on
policy effectiveness and cost. Although theory and empirical evidence
suggests there is potential for welfare-enhancing energy efficiency
policies, many open questions remain, particularly relating to the
extent of some key market and behavioral failures.
597
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ANNUAL
REVIEWS
1. INTRODUCTION
Energy efficiency and conservation have long been critical elements in the energy policy
dialogue, and they have taken on a renewed importance as concerns about global climate
change and energy security have intensified. Many advocates and policy makers hold that
reducing the demand for energy is essential to meeting these challenges, and analyses tend
to find that demand reductions can be a cost-effective means of addressing these concerns.
With such great policy interest, a significant literature has developed over the past
30 years, providing an economic framework for addressing energy efficiency and conser-
vation, as well as empirical estimates of how consumers respond to policies to reduce the
demand for energy.
We begin by defining a few terms to put the literature in context. First, it is important
to conceptualize energy as an input into the production of desired energy services (e.g.,
heating, lighting, motion), rather than as an end in itself. In this framework, energy
efficiency is typically defined as the energy services provided per unit of energy input. For
example, the energy efficiency of an air conditioner is the amount of heat removed from
air per kilowatt-hour (kWh) of electricity input. At the individual product level, energy
efficiency can be thought of as one of a bundle of product characteristics, alongside
product cost and other attributes (Newell et al. 1999). At a more aggregate level, the
energy efficiency of a sector or of the economy as a whole can be measured as the level of
gross domestic product per unit of energy consumed in its production (for analyses of the
determinants of energy intensity at the state and national levels, see, for example, Metcalf
2008, Sue Wing 2008).
In contrast, energy conservation is typically defined as a reduction in the total amount
of energy consumed. Thus, energy conservation may or may not be associated with an
increase in energy efficiency, depending on how energy services change. That is, energy
consumption may be reduced with or without an increase in energy efficiency, and energy
consumption may increase alongside an increase in energy efficiency. These distinctions
are important when considering issues such as the “rebound effect,” whereby the demand
for energy services may increase in response to energy efficiency–induced declines in the
marginal cost of energy services. The distinction is also important in understanding the
short- versus long-run price elasticity of energy demand, whereby short-run changes may
depend principally on changes in consumption of energy services, whereas longer-run
changes include greater alterations of the energy efficiency of the equipment stock.
One must also distinguish between energy efficiency and economic efficiency. Max-
imizing economic efficiency—typically operationalized as maximizing net benefits to
society—is generally not going to imply maximizing energy efficiency, which is a physical
concept and comes at a cost. An important issue arises, however, regarding whether
private economic decisions about the level of energy efficiency chosen for products are
economically efficient. This will depend on the economic efficiency of the market condi-
tions the consumer faces (e.g., energy prices, information availability) as well as the
economic behavior of the individual decision maker (e.g., cost-minimizing behavior).
Market conditions may depart from efficiency if there are market failures, such as
environmental externalities or imperfect information. Aside from such market failures,
most economic analysis of energy efficiency has taken cost-minimizing (or utility/profit-
maximizing) behavior by households and firms as a point of departure in analysis.
Some literature, however, has focused more closely on the decision-making behavior of
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Newell
Palmer
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economic actors, identifying potential “behavioral failures” that lead to deviations from
cost minimization and motivated at least partly by results from the field of behavioral
economics. Much of the economic literature on energy efficiency therefore seeks to con-
ceptualize energy efficiency decision making, to identify the degree to which market or
behavioral failures may present an opportunity for net-beneficial policy interventions, and
to evaluate the realized effectiveness and cost of actual policies.
This line of research has important implications both for assessing the cost of correcting
market failures—such as environmental externalities—and for clarifying the role of policies
that are oriented toward the correction of behavioral failures. For example, if behavioral
failures lead to underinvestment in energy efficiency, then some reductions in energy-related
emissions could be available at low or even negative cost. At the same time, policies that
provide an efficient means of correcting environmental externalities—such as an emissions
price—may not be well suited to inducing these relatively low-cost energy and emission
reductions. In principle, a set of policies addressing both market and behavioral failures
could, therefore, potentially provide a more efficient overall response. In practice, the value
of individual policy components depends on the extent of existing market problems and the
ability of specific policies to correct these problems in a net beneficial manner.
This article views the literature through this perspective and begins by introducing the
notion of energy efficiency as an investment in producing energy services. After presenting
evidence of energy market influences on energy efficiency, we then turn to identifying and
examining empirical evidence on a range of market and behavioral failures that have been
discussed in the energy efficiency literature. We then address the implications of this evidence
for policy interventions and briefly review the empirical evidence on the effectiveness and cost
of policy, including price policies and information policies. Finally, we provide overall con-
clusions. We limit the scope of this study primarily to energy efficiency and conservation in
buildings and appliances and do not address transportation in detail. Nonetheless, most of
the same conceptual and empirical issues carry over to transportation as well.
2. ENERGY EFFICIENCY AS AN INVESTMENT IN PRODUCING
ENERGY SERVICES
From an economic perspective, energy efficiency choices fundamentally involve invest-
ment decisions that trade off higher initial capital costs and uncertain lower future energy
operating costs. In the simplest case, the initial cost is the difference between the purchase
and installation cost of a relatively energy-efficient product and the cost of an otherwise
equivalent product that provides the same energy services but uses more energy. The
decision of whether to make the energy-efficient investment requires weighing this initial
capital cost against the expected future savings. Assessing the future savings requires
forming expectations of future energy prices, changes in other operating costs related to
the energy use (e.g., pollution charges), intensity of use of the product, and equipment
lifetime. Comparing these expected future cash flows against the initial cost requires
discounting the future cash flows to present values. Holding consumption of energy
services constant, a privately optimal decision would entail choosing the level of energy
efficiency to minimize the present value of private costs, whereas economic efficiency at a
societal level would entail minimizing social costs. This makes energy efficiency different
in character from many other product attributes for which there may not be a well-defined
notion of what constitutes optimal or “rational” behavior on the part of the individual.
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This conceptualization of the problem maps directly into a production function frame-
work, where capital and energy are viewed as inputs into the production of energy
services. Along an isoquant describing a given level of energy services, the cost-minimizing
level of energy use (and thus energy efficiency) is found at the point of tangency where the
marginal increase in capital cost with respect to energy reduction is equal to their relative
price (in present-value terms) (Figure 1). As described above, the relative price will depend
on the capital cost of efficiency improvements, the discount rate, expected energy prices,
equipment utilization, and decision-time horizon. This framework applies at the house-
hold level as well as at a broad sectoral or multisectoral level where energy and capital are
used to produce energy services.
1
Focusing on the household level as an example, greater energy efficiency can be driven
by market forces in two ways within this production function framework. First, households
may move along the energy-services isoquant by substituting capital for energy in response
to a change in relative prices (Figure 1a, with relative prices changing from P
0
to P
1
).
Second, technological change that shifts the isoquant in a way favoring (i.e., biased toward)
greater energy efficiency (Figure 1b, with isoquant
0
shifting to isoquant
1
) could change the
production possibilities available to households. In contrast, energy conservation not
driven by energy efficiency improvements would be associated with a lower level of energy
services (i.e., a lesser isoquant).
Market failures can be represented within this framework as a divergence of the relative
prices used for private decisions from the economically efficient prices. For example, both
unpriced environmental externalities and missing information on the energy intensity of
product use would tend to lower the relative price of energy, leading to choices of inefficiently
low energy efficiency (e.g., P
0
compared with P
1
in Figure 1a). Note that this framework
presupposes optimizing behavior by the consumer, given available information—an assump-
tion subject to debate within the behavioral economics literature, as discussed below.
The next section further explores the role of energy markets in governing energy
efficiency decisions. Section 4 then identifies potential market and behavioral failures that
may lead to suboptimal decisions.
a
Ener
g
y
P
1
P
0
P
1
P
0
Capital
Isoquant
1
Ener
gy
Capital
Isoquant
0
P
1
P
0
P
1
P
0
Isoquant
0
b
Figure 1
(a) Energy efficiency–improving substitution versus (b) energy-saving technological change.
1
Understanding the economic forces governing the rate and direction of energy-related technological change at the
product, sectoral, and aggregate levels has been an important area of research, particularly in the context of climate
change modeling. For a review of literature devoted to this topic, which is beyond the scope of this paper, see
Gillingham et al. (2008).
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3. ENERGY MARKET INFLUENCES ON ENERGY EFFICIENCY
Energy markets and market prices influence consumer decisions regarding how much
energy to consume and whether to invest in more energy-efficient products and equip-
ment. An increase in energy prices will result in some energy conservation in the short run;
however, short-run changes in energy efficiency tend to be limited owing to the long
lifetimes and slow turnover of energy-using appliances and capital equipment. Nonethe-
less, if an energy price increase is persistent, it also is more likely to significantly affect
energy efficiency adoption, as consumers replace older capital equipment and firms have
time to develop new products and processes.
The extent of demand responsiveness to changes in price is captured in the price elastici-
ty of energy demand. Table 1 presents the ranges of energy own-price elasticity estimates in
the literature. Long-run price elasticities are larger than short-run elasticities, correspond-
ing to more energy efficiency improvements as capital turns over. On average, natural gas
price elasticities are greater than electricity or fuel oil elasticities. Note that, because they
are based on actual consumer behavior, these price elasticity estimates include any increase
in consumption of energy services that might occur in response to a lower unit cost of
energy services resulting from increased energy efficiency (i.e., the rebound effect).
Other studies have focused specifically on factors influencing technology adoption,
finding that higher energy prices are associated with significantly greater adoption of
Table 1 Ranges of estimates of energy own-price elasticities
a
Short run Long run
Range References Range References
Residential
Electricity 0.14–0.44 Dahl (1993) 0.32–1.89 Bernstein & Griffin (2005), Hsing (1994)
Natural gas 0.03–0.76 Bohi & Zimmerman (1984),
Dahl (1993)
0.26–1.47
b
Bohi & Zimmerman (1984), Dahl (1993)
Fuel oil 0.15–0.34 Wade (2003) 0.53–0.75 Dahl (1993), Wade (2003)
Commercial
Electricity 0–0.46 Dahl (1993), 0.24–1.36 Wade (2003), Dahl (1993)
Natural gas 0.14–0.29 Dahl (1993), Wade (2003) 0.40–1.38 Wade (2003), Bohi & Zimmerman (1984)
Fuel oil 0.13–0.49 Dahl (1993), Wade (2003) 0.39–3.5 Wade (2003), Newell & Pizer (2008)
Industrial
Electricity 0.11–0.28 Bohi & Zimmerman (1984),
Dahl (1993)
0.22–3.26 Bohi & Zimmerman (1984), Dahl (1993)
Natural gas
b
0.51–0.62 Bohi & Zimmerman (1984) 0.89–2.92 Dahl (1993), Bohi & Zimmerman (1984)
Fuel oil 0.11 Dahl (1993) 0.5–1.57
c
Bohi & Zimmerman (1984)
a
Absolute values shown; all values are negative.
b
Estimates drawn largely from regional studies.
c
Estimates for 19 states.
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