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Energy Efficiency Opportunities
Why Aren't They Realized in the Marketplace?

This NRDC presentation was given before NAS: Energy Efficiency Opportunities on October 10, 2001, by David B. Goldstein, Ph.D., NRDC energy program director.
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1. How to Frame Questions on Energy Efficiency and Markets

I was asked to speak on the subject of why energy efficiency opportunities are not realized in the market. On reflecting about how best to respond in a limited presentation, I was struck by some subtle oddities about why a scientific organization would ask a question such as this.

Questions such as "Why does such and such not happen?" are rarely asked in science, in part because it is seldom possible to frame testable hypotheses that can answer such a question. A question like, "Why does a single electron, when aimed at a plate with two slits, produce a diffraction pattern on the other side?" is capable of being addressed through experiment and theory. But a question like "Why can't the electron pass through one slit or the other?" is much more problematic.

In general, questions such as "Why doesn't X do Y?" can be troublesome. So, while I will make a few observations that attempt to respond directly to the question, I will spend most of the talk trying to re-frame the question in a way that is more usable to policymakers, and then answering it.

  • The very fact that consumers do bypass great opportunities for investment in energy efficiency is not widely recognized or even universally believed, yet it is the fundamental observation underlying America's energy problems;

  • It is a very one-dimensional view of human nature, and one not supported by ordinary experience, to assume that people do react in an economically rational fashion all the time, and therefore we should not be surprised when they fail to do so; and therefore,

  • A more useful set of questions to policy makers is: "What would it take to get a given market involving energy consumption to respond in a way that maximizes societal value?"

I will show that this question does not have a simple answer but involves a comprehensive set of strategies and tactics that address the diversity of markets in which energy efficiency technologies participate; and also address the range of technology potentials from simple, well-known technologies that are available widely today to state-of-the-art improvements.

These issues are taken up next.

2. Consumers Actually Do Bypass Great Opportunities for Investment in Energy Efficiency Due to a Variety of Market Failures and Market Barriers, Some of Which Are Well Understood.

Implicit in the framing of the question, "Why are energy efficiency opportunities not realized in the market?" is an implicit assumption that people should be expected to make such investments without policy intervention . This is the unspoken but strongly accepted economic paradigm of human decision making. People will make rational self-interested decisions.

Unfortunately, this is only one model of human behavior. One can search three of the great literature of the world for examples and discussions of human motivation, and find that economic optimization is not first, or even second, among major human motivating factors. Someone, whose background is a study of Shakespearean literature, or of the Bible, or the Koran, or of Greek mythology, would not ordinarily expect people to put much effort into economic optimization. They would regard other factors as dominating the explanation of human motivations.

A widely unrecognized subsidiary question in the primary question of "Why aren't energy efficiency opportunities realized in the market?" is the question, " Are energy efficiency opportunities realized in the market?" There is not universal agreement among analysts that the market fails to capture energy efficiency opportunities. However, the hypothesis that the market does, in fact, capture all economically rational improvements in efficiency has been tested rigorously in a number of circumstances and has been thoroughly disproven. The most interesting of such cases is the provision of utility incentives for energy efficiency. In a number of states, utilities have provided rebates or other incentives to their customers in order to promote the acceptance of energy efficiency technologies that would not otherwise have been realized. Many stakeholders oppose such utility involvement, believing that it raises rates unnecessarily. Thus, to justify their expenditures, utilities have had to demonstrate rigorously that their programs meet a number of conditions:

  • That the measures that are installed provide the same or higher levels of energy service at a lower societal cost, which the utilities must quantify; and

  • That these investments would not have been made without the utility involvement.

Numerous studies of high scientific quality have been performed to test whether these conditions were met for a variety of programs, and have had to withstand policy scrutiny by public utility commissions as well. The evidence that vast opportunities for energy efficiency exist is very strong based on numerous showings throughout the country of economically beneficial efficiency investments that only occur through utility involvement.

In addition, a large literature describing market failures and market barriers has grown up, based largely around the (generally unstated) hypothesis that markets react rationally when certain conditions are met, but fail when these conditions are absent. These studies have found dozens of market barriers that have had significant impacts in retarding the adoption of energy efficiency. Yet, understanding the nature of these market failures and market barriers is not necessarily sufficient for policymakers to craft ways of overcoming them; and, indeed, many of the most successful programs that have encouraged widespread investment in more energy efficiency in a particular market have proceeded successfully without any knowledge of what the market barriers or market failures were.

Practice has far surpassed theory in energy efficiency policy development: many policies are known to work even if no one really understands why.

This observation sets up a more productive question to frame: "What would it take to get the markets to do what is rational with respect to energy efficiency?" This issue is addressed next.

3. What Would It Take to Get Markets to Invest in All Economically Justified Energy Efficiency Opportunities?

After the energy crisis of 1973, more than a decade before most of the serious research attempts to describe and characterize market barriers to efficiency, energy decisionmakers began developing and implementing policies to realize the energy efficiency opportunities presented by current technologies. Energy officials, particularly at the state level in the United States, developed experience and expertise in what worked and what didn't, and have refined programs into a relatively-limited number of categories that fall into just a few categories and have had dramatic success. These opportunities are:

  • Energy efficiency standards for major uses of energy, such as buildings, appliances, equipment, and automobiles.

    Economic incentives:

      a. Short-term incentives to encourage the best practices currently widely available.

      b. Market transformation incentives to encourage the development of new technologies or the commercialization of tiny niche products or services.

    The most successful incentives are based on performance.

    In the transportation sector, major gains are possible both through improving the efficiency of cars, and through improving the efficiency of urban structures.

  • Education and outreach programs on energy efficiency.

  • Research on energy efficiency technologies and systems. .

These policies work best when designed together within a strategic framework. When this is done, standards can provide a foundation on which incentives can be based, and incentives can complement standards by allowing high-value products to be sold in part based on premium energy efficiency. With the need to comply with standards and the ability to qualify for incentives, outreach programs will attract a larger and more motivated audience.

There have, in addition, been a few programs aimed specifically at overcoming markets barriers within particular markets. But these programs have not been where the major successes have occurred. The largest energy savings to date have been accomplished by energy efficiency standards and by targeted incentives for products currently available in the marketplace. For example, appliance efficiency standards adopted to date will cut U.S. electric peak demand in 2020 by 120,000 MW, or over 12%, while saving some $200 billion.

Perhaps the best illustration of the success of appliance efficiency standards - supplemented by incentive programs and R&D - is the refrigerator industry. The progress of efficiency decline until after 1992 followed by dramatic improvement is illustrated in Figure 1.

All of these energy efficiency programs generally have been designed without much understanding as to why energy efficiency opportunities aren't realized in the market or on what market barriers need to be overcome.

One particular problem became apparent by the late-1980's, even without rigorous research on market failures. If consumers were known to ignore energy efficiency opportunities with paybacks of two or three years, what incentives would manufacturers have for introducing new energy efficiency technologies? It became clear that there would be no incentive whatever to develop new technologies: because even if the product development efforts were successful technically, and a new product could produce energy efficiency savings with a two or three-year payback, it would not necessarily succeed in the marketplace.

Subsequent conversations with appliance manufacturers confirmed that this dynamic was indeed working. Good ideas were sitting on the shelf gathering dust because of the (warranted) concern that they wouldn't sell even if they were developed.

Evaluations of incentive programs show a particularly interesting and odd result when analyzed in the light of an attempt to understand market failures and market barriers. Studies funded by the utilities running the programs have shown that appliance rebate programs have been remarkably successful at realizing energy efficiency potentials. Many of the California refrigerator incentive programs have had the following dramatically successful results: when the rebates were offered, products that previously were unavailable to the consumer, and contemporaneously were unavailable to consumers elsewhere in the country, captured 20%-30% of the market in the areas were rebates were applicable. When programs were offered for two or three years running on a statewide basis, the level of efficiency brought forth by the programs increased from year to year, and the fraction of products qualifying for the higher tier incentives also grew. See Figure 2 for an illustration of the progressive improvements in efficiency over time.

Yet, the evaluation studies found that:

  • Manufacturers were prepared to introduce these incentives in any event;

  • Retailers felt that utility rebates didn't make that much difference in the marketplace because they were comparable or smaller in size to manufacturer rebates that were frequently offered for reasons entirely unrelated to energy efficiency; and

  • Consumers who took advantage of the rebate say they would have bought the product anyway.

All of the major market players say that the rebate changed their behavior only slightly if at all, yet both on a time-series basis and a cross-sectional basis, it is evident that the existence of rebates changed the market dynamic completely.

I believe this example illustrates a fairly universal truth: that understanding why efficiency opportunities aren't realized may be an interesting sociological research question, but it isn't a particularly interesting public policy question. For the overwhelming majority of cases, understanding what the market barriers are does not lead to dramatic improvements in the policies used to capture these missed opportunities. In many cases, programs can be designed with utter disregard for what market failures are and they still can succeed.

In contrast, understanding how markets work for particular energy-using devices or systems, and how they begin to work differently when policies are in place, can be extremely important. Codes and standards that are designed to accommodate real or perceived needs in the marketplace for energy-using features get enforced better and are easier to upgrade in efficiency level than ones that were developed without an understanding of where the potential conflicts and synergies between energy use reduction and market needs might be.

In the design of incentives, understanding who the decisionmaker for energy efficiency is can help design programs that achieve higher market penetration. Understanding how markets for energy efficiency work allows the design of programs that increase competition for energy efficiency and push markets towards the design of products that are even more energy efficient for the same cost, or deliver the same level of energy efficiency for lower cost, than products available when the programs were designed. Basing incentives on energy performance rather than cost is one fairly universal market understanding that helps programs to succeed.

Detailed evaluations of programs can reveal areas where differences in program design can achieve better results. For example, many incentive programs aimed at industrial energy efficiency found a reluctance on the part of management to invest in energy efficiency, despite the existence of loan programs that overcame the apparent market barrier to investment in efficiency: capital rationing. Yet, evaluation of these loan programs determined that even if the corporation could borrow unlimited funds from the utility administering the program, they would not take advantage of such an opportunity - because the existence of the loan on the company's balance sheets would compromise its overall financial objectives. In this case, the problem was overcome by regulatory agreements that the utility could recover the cost of energy efficiency investments on the customers' utility bill, rather than through loan payments. This financial mechanism prevented a loan from showing up on the balance sheets of the customer and overcame the barrier to success.

It is doubtful to me that such a problem would be identified in a study of market barriers. It was identified by a more problem-solving approach of trying to design programs to encourage energy efficiency and then evaluating what the limitations of those programs were.

4. Conclusions and Recommendations

A Conclusions

Markets relating to energy efficiency are diverse and complex. There is a broad array of reasons why markets fail to deliver optimal investments in energy efficiency from an individual point of view, much less from a societal perspective. These reasons may be of academic interest, but in most cases, they are not of much policy interest. While a few programs designed explicitly to overcome market barriers have been successful, the overwhelming majority of energy efficiency investments induced by policy have resulted from program designs that were insensitive to any understanding of why markets were failing.

Successful programs have been designed based on specific experience with the successes and failures of previous programs in the markets to which they were directed. Better understanding of markets that has been obtained through evaluation of past programs has helped improve the cost effectiveness and market success of the programs.

B. What Could the National Academy Do to Encourage End-Use Energy Efficiency?

The National Academy could focus more attention within the scientific community on the question of how much energy could be saved and how much emissions of greenhouse gas and other significant pollutants could be reduced at zero or negative cost if we pursued a wide variety of energy efficiency policies. At present, there is a chasm of disagreement within the scientific community on whether, for example, compliance with the Kyoto Protocol in the United States is a net cost or a net benefit. The environmental community believes that the wide range of studies showing how environmental goals could be met at a negative cost to society have not been given serious attention by parts of the academic community and most of the policy community.

Fundamentally, all of our energy issues are related to the question of how America can meet a growing need for energy services at the least societal cost. Yet, this question is seldom posed, and almost never answered, in energy policy debates. In the few cases where least-cost energy planning has been tried on a regional basis (and for electricity only), the results have been that a higher degree of consensus than would have been thought possible was achieved on plans that focused heavily on energy efficiency and produced significant, purely economic benefits as well as large environmental benefits.

This leads to a second major issue where the National Academy could help. If new policies such as enhanced energy efficiency standards, more economic incentives for efficiency, broader information and educational programs and expanded research and development could lead to vast economic gains, why isn't there an effort to design energy efficiency/environmental policies explicitly to promote economic growth? A specific issue that the Academy could address is how energy efficiency policies could be crafted so that they promote economic growth and technological innovation more effectively. This question actually has two sub-questions: "how is this done from a process perspective?" And, "how is this done from a substantive perspective?"

A better understanding of what energy efficiency policies have worked, and how they can work synergistically, could help reduce the amount of arguments over abstract philosophical positions and focus the debates on technology, policy, and economics. It could lead to more consensus on energy policies as well as greater prosperity and a healthier environment.

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