EU Energy Policy Blog

The physicists want many efficiency regulations and care little for price signals. Neoclassical economists want only price signals and no energy efficiency regulations.

Neoclassical economists say: the physics camp claims all its proposals are free lunches, but there’s no such thing. We need taxes. The physics camp says: call them free lunches if you like, but there are a lot of ways to save money and energy at the same time—who needs taxes?

[...] The two camps focus on two different problems. The price of fossil fuel is too low, so we need the neoclassical solution of higher price signals. Consumers are short sighted when evaluating future energy savings, so some efficiency standards can help them save money. Many if not most economists favor both approaches when each is used to solve the matching problem.

This compromise rejects the extreme neoclassical position of assuming perfectly rationale of consumers, but it also requires two changes in the tendencies of the physics camp. It requires taking fossil-fuel prices far more seriously and it requires backing away from the notion that physicists know how to fix literally hundreds of market imperfections while saving money.

I believe economists are right to be suspicious of large numbers of “market-fixing” efficiency regulations. Their skepticism is not based on an implausible assumption of consumer rationality, but on the four realistic concerns listed in the insert below, which are consistently ignored. Moreover the design of even major efficiency standards is poor and fails to use modern economic tools. This has resulted in such fiascoes as fuel economy standards that remained at their initial 1975 setting for over thirty years, and that reward designs that kill more people while using more fuel. I am referring to the requirement that cars be aggressively redesigned so they can be reclassified as trucks and qualify for a lower fuel efficiency.

Generally, claims that the programs will save more than they cost omit four considerations, each of which can be quite important:
Regulatory Inefficiencies. Neoclassicals assume perfectly efficient markets. Physicists implicitly assume perfectly efficient regulation. This bias is the result of omitting any cost for regulatory mistakes, such as setting a standard incorrectly. I have not found energy regulators to be any more rational than new car buyers.
The Take-Back Effect. When an appliance is made more efficient it often becomes cheaper and more convenient to use. Consequently people use it more or buy a bigger one. This is a benefit to society and actually makes efficiency programs more valuable than the physicists claim. But it also means efficient appliances use more energy than estimated.
Here’s how the evaluation of savings from compact fluorescent bulbs can go wrong. […]
• Replace a 40-watt incandescent bulb with a 100-watt-equivalent compact fluorescent lamp (CFL).
• The CFL uses 23 watts.
• The actual savings is 17 watts.
• CFL program evaluation assumes that when a 100-watt CFL is used, it replaces a 100-watt incandescent bulb (they can’t tell, so they make this guess).
• Replacing a 100-watt bulb with a 23-watt bulb saves 77 watts.
• Calculated savings: 77 watts. Actual savings: 17 watts.
In addition, because the light is cheaper, people may leave it on more, and the savings could actually be zero. This is an extreme case, but it happened in my kitchen. Most efficiency gains are not lost to the take-back effect—at least not right away.
Consumer Inconvenience. Some ways of gaining efficiency cost no money, but do cause inconvenience. For example, making the walls of a refrigerator thicker means it either takes more space in your kitchen or holds less food. The cost of such inconvenience is nearly always ignored.
Consumer Variability. If I run my air conditioner 1000 hours per year, any improvement in efficiency will be 100 times more valuable than if I run it 10 hours per year. It does not make sense for a low-use appliance owner to buy as much efficiency as a high-use owner. This means that even the best efficiency standard is likely to be a waste of money for the low-use owner. I have never seen this accounted for.
Although there are many imperfections in markets, that does not mean there are many free lunches. There’s only a free lunch if the problem can be fixed at a cost that is less than the savings. All four of the considerations just discussed either raise the cost of fixing the problem or reduce the benefit. Since they are generally ignored, the claims of free lunches are frequently overstated.

It would accomplish far more to design the major standards well and evaluate them carefully, rather than to charge ahead with hundreds of smaller measures that ignore economic concerns. But the real challenge for the physics camp is to accept the importance of price and to realize that their entire campaign is at risk without the proper price signals.

Having worked in the physics camp for years, I have heard many excuses for ignoring the take-back problem, but have never actually seen it taken into account. This is too bad because, if the problem were faced squarely, the natural conclusion would be that the neoclassicals’ price signals do not substitute for efficiency measures but rather are a necessary complement.

Think about the history of take-back. Ordinary bulbs are 150 times more efficient than candles. But we don’t uses 150 times less energy for light, we use more energy than in colonial times. Scientists of the past have provided us with enormous efficiency gains, but never enough to reverse our increasing use of energy and fossil fuel.

So the physicists are taking a real gamble. Compact fluorescent bulbs may save energy this year, but ten years from now, people may have discovered they can afford to light their gardens at night as brightly as the sun lights them in the daytime. And the less energy a light uses the less it pays to switch it off. If history is a guide, increasing wealth combined with the take-back effect will eventually win out over the energy savings of increased efficiency.

There is a simple way out of this dilemma. Raise the price of electricity, and refund the extra cost. […] The higher price of electricity reduces or reverses the take-back effect. The price increase should not be tied to the efficiency gain, but implementing the price signals of the economist greatly reduce the risks of take-back inherent in the physics approach.

The compromise then between the extreme neoclassical camp and the physics camp is simple and positive. The most important efficiency programs, especially fuel-economy standards, should be accepted and perfected. Neoclassical economists should stop arguing against these on the basis of untested theory.

The physics camp should recognize that there are real problems with “fixing” markets and that blind faith in regulatory fixes is no more appropriate than blind faith in markets. Physicists and economists should join forces to make the big efficiency programs work better, and on implementing better fossil-fuel prices. This will help protect the energy efficiency gains from the energy-consuming take-back effect [...]

Steve Stoft

These are excerpts from chapter 6 of my forthcoming book Carbonomics.

This entry was posted on Tuesday, December 26th, 2006 at 11:59 pm and is filed under Carbonomics. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.