Factors correlated with market failures, behavioural anomalies cause underinvestment in energy efficiency, leading to the energy efficiency gap
The popular belief that private benefits would automatically induce the adoption of energy efficiency and the market would provide necessary support has some flaws.
It is often admitted that there is a wedge between the identified energy efficiency opportunities and the ones being realised – well-known as the energy efficiency gap.
When hundreds and thousands of industries – operational in a jurisdiction – are taken into account along with all other sectors, the total energy efficiency gap would be quite stupendous.
Over the years, the average energy efficiency level in the world has improved, imputed to the availability of products, appliance and machinery with higher efficiency.
Yet, the so-called energy efficiency gap persists in different jurisdictions and to a varying degree.
Empirical evidence shows that several market failures – asymmetric information, energy price distortion, credit constraints – often lead to inappropriate decision making about energy efficiency.
Imperfect or asymmetric information hinders the capitalisation of energy efficiency in different sectors.
In a market where manufacturers and suppliers of different appliance or machinery or products compete, people do not always have reliable information on their efficiency potential.
While the manufacturers and suppliers have better information than others, they may be unable to make the information credible to the market.
As a market encompasses a wide range of energy efficiency products, the flow of accurate information for all such products to the end-users, be it industry of household, may not be so simple.
Markets also, at times, create barriers to the free flow of information. So, consumers fail to comprehend the improvement potential in energy efficiency level in the appliance or equipment available in the market compared to the ones they have.
So, with uncertainty over the performance of energy-efficient products and given the considerable resources required to own them, people do not go for such products or probable energy efficiency projects.
Information asymmetry also hurts the credit assessment process of banks and financial institutions on which clients depend for a loan to advance energy efficiency at their establishments or industries.
Lenders often cannot decide on the actual credit requirement of the clients because of imperfect information on energy-efficient technologies.
It is highly likely that the lenders may reject energy efficiency project proposals – with high returns and low risks of defaults – when they cannot separate them from investments in inefficient products with low returns.
The presence of energy price distortion – pricing anomaly and the failure to reflect the true cost of energy – disincentivises potential energy efficiency investments.
The lower the energy price, the higher the payback from an energy-efficient product is. And as long as energy price includes subsidy, energy efficiency would remain less attractive.
The other side of the coin is an anomaly in pricing different forms of energy.
In an energy system with the provision of low gas price – where electricity generation from natural gas is economical compared to grid electricity – people, especially in industries, would perhaps try to switch to electricity generation from gas as frequently as possible to save cost instead of undertaking a capital intensive energy efficiency project.
And since energy saving is, more often than not, the parameter to decide on energy efficiency investment, the likelihood to opt for energy efficiency project is higher under the regime of no energy price distortion.
However, the behavioural failures or anomalies or irrationality – we are confronted with in real life and as the academic literature shows – inhibit the acceptance of energy efficiency measures, contradicting the assumption that people would make the rational decision to act on their best interest.
There are different dimensions of such anomalies.
One of the primary behavioural biases can be linked to one's unwillingness to move from business-as-usual – the persistence to hold on to the old and inefficient equipment or appliance when the best decision is to replace it.
This can be better explained with the example of the deeply rooted behaviour of individuals that are difficult to change. This inertia is a kind of endowment effect.
Inertia also appears when the consumers have several options to choose from, and then they waste time while deciding on efficient products.
Another route of inertia arises from the tendency to overvalue the product that one currently owns compared to the new one.
Also, people are risk-averse while taking an investment decision on energy efficiency. The consequence of all these is the status quo on the energy efficiency front.
Salience factor is another behavioural bias where people prefer to enjoy the present benefits – which are perceptible – instead of reflecting on future gains.
Despite the notion that one would consider the fuel economy while purchasing a car, the appearance and features may suddenly sway the consumer to make a sub-optimal decision to buy an inefficient but luxurious car.
In this given case, according to literature, the consumer puts less weightage on the future energy price hike, giving up significant cost saving over the lifetime of the car.
So, some factors correlated with market failures and behavioural anomalies cause underinvestment in energy efficiency, leading to the energy efficiency gap.
However, despite investments in energy-efficient products, the energy efficiency gap may still emerge.
The rebound effect explains this paradox. This occurs when overuse offsets a certain percentage of energy savings from using a newly acquired efficient appliance, undermining energy efficiency benefits.
Simply put, having an energy-efficient car and driving it more than usual is the illustration of a rebound effect.
Needless to say, the International Energy Agency has labelled energy efficiency as the "first fuel," and different countries have embarked on it, supported by policy instruments, not only to tackle some of the energy challenges but also to cushion ensuing dangers of climate change.
But realising the full benefits of energy efficiency would entail efforts to eliminate market and behavioural failures. Both empirical and anecdotal evidence shed light on these failures and the suitable interventions that have the potentials to fix these barriers.
For instance, energy labelling of appliance or equipment can lower information asymmetry and enable consumers to compare the energy performance of existing equipment with a new one.
Also, subsidies and pricing anomalies influence energy consumption to expand beyond the natural level and limit the tendency to strive for energy efficiency. And this calls for regulatory adjustment on both subsidy removal and minimising pricing anomalies.
In dealing with inertias of different energy consumers – industries, households – stemming from behavioural traits – many countries have taken the route to shore up consumers' energy efficiency awareness.
If we want to bridge the energy efficiency gap, these awareness-raising programmes will have to be carried out consistently for years because of the existence of rebound effects.
The author is a Humboldt Scholar and also an engineer and environmental economist