Journal of Economic Perspectives—Volume 26, Number 1—Winter 2012—Pages 3–28 Is There an Energy Effi ciency Gap? Hunt Allcott and Michael Greenstone any analysts of the energy industry have long believed that energy effi ciencyciency offersoffers anan enormousenormous “win-win”“win-win” opportunity:opportunity: throughthrough aggres-aggres- M sive energy conservation policies, we can both save money and reduce negative externalities associated with energy use. In 1979, Pulitzer Prize-winning author Daniel Yergin and the Harvard Business School Energy Project made an early version of this argument in the book Energy Future: If the United States were to make a serious commitment to conservation, it might well consume 30 to 40 percent less energy than it now does, and still enjoy the same or an even higher standard of living . Although some of the barriers are economic, they are in most cases institutional, political, and social. Overcoming them requires a government policy that champions con- servation, that gives it a chance equal in the marketplace to that enjoyed by conventional sources of energy. Thirty years later, consultancy McKinsey & Co. made a similar argument in its 2009 report, Unlocking Energy Effi ciency in the U.S. Economy : Energy effi ciency offers a vast, low-cost energy resource for the U.S. economy— but only if the nation can craft a comprehensive and innovative approach to ■ Hunt Allcott is Assistant Professor of Economics, New York University, New York City, New York. Michael Greenstone is 3M Professor of Environmental Economics, Massachusetts Institute of Technology, Cambridge, Massachusetts. Allcott is a Faculty Research Fellow and Greenstone is a Research Associate, both at the National Bureau of Economic Research, Cambridge, Massachusetts. Their e-mail addresses are 〈[email protected]〉 and 〈[email protected]〉. doi=10.1257/jep.26.1.3 4 Journal of Economic Perspectives unlock it. Signifi cant and persistent barriers will need to be addressed at mul- tiple levels to stimulate demand for energy effi ciency and manage its delivery . If executed at scale, a holistic approach would yield gross energy savings worth more than $1.2 trillion, well above the $520 billion needed through 2020 for upfront investment in effi ciency measures (not including program costs). Such a program is estimated to reduce end-use energy consumption in 2020 by 9.1 quadrillion BTUs, roughly 23 percent of projected demand, potentially abating up to 1.1 gigatons of greenhouse gases annually. In economic language, the “win-win” argument is that government interven- tion to encourage energy effi ciency can improve welfare for two reasons. First, the consumption of fossil fuels, which comprise the bulk of our current energy sources, causes externalities such as harm to human health, climate change, and constraints on the foreign policy objectives of energy-importing countries. Second, other forces such as imperfect information may cause consumers and fi rms not to undertake privately profi tabletable investmentsinvestments inin energyenergy effi effi ciency. ciency. These These forces, forces, which which we we refer refer to as “investment ineffi ciencies,”ciencies,” wouldwould createcreate whatwhat is is popularly popularly called called an an Energy Energy Effi ciencyciency Gap: Gap: a awedge wedge between between the the cost-minimizing cost-minimizing level level of of energy energy effi effi ciency ciency and and the level actually realized. Yergin, McKinsey & Co., and other analysts have argued that this gap represents a signifi cant cant share share of of total total energy energy use: use: in in their their view, view, the the ground is littered with $20 bills that energy consumers have failed to pick up. The energy effi ciency policy debate often comingles these two types of market failures—energy use externalities and investment ineffi ciencies—causingciencies—causing impreci-impreci- sion in research questions and policy goals. In this paper, we distinguish between the two market failures and clarify their separate policy implications. If energy use externalities are the only market failure, it is well known that the social optimum is obtained with Pigouvian taxes or equivalent cap-and-trade programs that inter- nalize these externalities into energy prices, and that substitute policies are often much less economically effi cient.cient. IfIf investmentinvestment ineffiineffi cienciesciencies alsoalso exist,exist, thethe first-best rst-best policy is to address the ineffi ciencyciency directly:directly: forfor example,example, byby providingproviding informa-informa- tion to imperfectly informed consumers. However, when these interventions are not fully effective and investment ineffi cienciesciencies remain,remain, policiespolicies thatthat subsidizesubsidize oror mandate energy effi ciencyciency mightmight increaseincrease welfare.welfare. TheThe centralcentral economiceconomic questionquestion around energy effi ciency ciency is is thus thus whether whether there there are are investmentinvestment ineffi ineffi ciencies ciencies that that a a policy could correct—in other words, “Is there an Energy Effi ciency ciency Gap?” Gap?” We examine two classes of evidence on the existence and magnitude of invest- ment ineffi ciencies ciencies that that could could cause cause the the Energy Energy Effi Effi ciency ciency Gap. Gap. First, First, we we examine examine choices made by consumers and fi rms, rms, testing testing whether whether they they fail fail to to make make investments investments that would increase utility or profi ts. ts. Second, Second, we we focus focus on on specifispecifi c investmentc investment inef- inef- fi ciencies,ciencies, testingtesting forfor evidenceevidence consistentconsistent withwith each.each. AfterAfter presentingpresenting thethe evidence,evidence, we discuss policy implications. Throughout the paper, we highlight how the economics of energy effi ciencyciency connectsconnects toto importantimportant questionsquestions inin otherother appliedapplied micro fi elds,elds, including including behavioral behavioral economics, economics, industrial industrial organization, organization, and and develop- develop- ment microeconomics. Hunt Allcott and Michael Greenstone 5 Three key conclusions arise. First, although there is a long literature assessing investment ineffi ciencies ciencies related related to to energy energy effi effi ciency, ciency, this this body body of of evidence evidence frequently frequently does not meet modern standards for credibility. A basic problem is that much of the evidence on the energy cost savings from energy effi ciencyciency comescomes fromfrom engineeringengineering analyses or observational studies that can suffer from a set of well-known biases. Furthermore, even if the energy cost savings were known, energy effi ciency ciency invest- invest- ments often have other unobserved costs and benefi ts, making it diffi cult to assess welfare effects. This problem is general to other economic applications: in order to argue that an agent is not maximizing an objective function, the analyst must cred- ibly observe that objective function in full. We believe that there is great potential for a new body of credible empirical work in this area, both because the questions are so important and because there are signifi cant unexploited opportunities for randomized controlled trials and quasi-experimental designs that have advanced knowledge in other domains. Second, when one tallies up the available empirical evidence from different contexts, it is diffi cult to substantiate claims of a pervasive Energy Effi ciency ciency Gap. Gap. Some consumers appear to be imperfectly informed, and the evidence suggests that investment ineffi ciencies do cause an increase in energy use in various settings. However, the empirical magnitudes of the investment ineffi ciencies appear to be smaller, indeed substantially smaller, than the massive potential savings calculated in engineering analyses such as McKinsey & Co. (2009). Third, because consumers are quite heterogeneous in the degree of their investment ineffi ciencies,ciencies, itit isis crucialcrucial toto designdesign targetedtargeted policies.policies. SubsidizingSubsidizing energyenergy effi cientcient durables,durables, forfor example,example, changeschanges relativerelative pricesprices forfor allall consumers.consumers. WhileWhile thisthis policy will increase welfare for some consumers, such benefi tsts mustmust bebe tradedtraded offoff against distortions to consumers not subject to ineffi ciencies.ciencies. PolicyPolicy evaluationsevaluations mustmust therefore consider not just how much a policy increases energy effi ciency, but what types of consumers are induced to become more energy effi cient. cient. Welfare Welfare gains gains will will be larger from a policy that preferentially affects the decisions of consumers subject to investment ineffi ciencies.ciencies. Background Facts on Energy Demand Overview of Energy Demand and Energy Effi ciency Table 1 presents the breakdown of total energy demand across the sectors of the U.S. economy. Much of our discussion focuses on household energy use and personal transportation instead of commercial and industrial energy use, because these are areas where ineffi ciencies of imperfect information might be more severe. In 2007, the average U.S. household spent $2,400 on gasoline for their autos and another $1,900 on natural gas, electricity, and heating oil (U.S. Bureau of Labor