Quantifying the Effects of Market Failures in the End-Use of Energy

Quantifying the Effects of Market Failures in the End-Use of EnergyWASHINGTON, DC
Quantifying the Effects of Market Failures in the End-Use of Energy
February 2007
International Energy Agency
This draft Report was contracted by the International Energy Agency (IEA) for its own use and is copyrighted, together with all the deliverables generated in the preparation of the Report, by the OECD/IEA. The IEA granted ACEEE a non-exclusive license to use the
materials for ACEEE’s internal work. No reproduction, copy, transmission or translation of this publication may be made by any third party without the IEA’s prior written
permission. All applications should be sent to: International Energy Agency, Head of Publications Service, 9 rue de la Fédération, 75739 Paris, Cedex 15, France, or to
Quantifying the Effects of Market Failures in the End-Use of Energy, ©OECD/IEA 2006
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Methods............................................................................................................................................8 Findings..........................................................................................................................................10
U.S. Refrigerator, Water Heater, Space Heating and Residential Lighting Energy Use Affected by the Principal-Agent Market Failure ..............................................................20 Market Barriers Affecting Water Heating in Norway .............................................................46 Space Heating in Rented Houses in the Netherlands...............................................................54 Standby Power Use in the Dutch Residential Sector ...............................................................66 Market Barriers and Residential Standby Power in Norway ...................................................70 The Case of Energy Use in Commercial Offices in the Netherlands ......................................78 Market Barriers Related to Commercial Office Space Leasing in Norway.............................90 Energy Use Affected by Principal-Agent Problem in Japanese Commercial Office Space Leasing ..........................................................................................................................98 Japanese Vending Machine and Display Cooler Energy Use Affected by Principal- Agent Problem .......................................................................................................................108 Vending Machine Energy Use in Australia Affected by the Principal-Agent Problem ........120 Leased Cars in the Netherlands..............................................................................................130 Organizational Decision-Making in Australia .......................................................................146 Market Barriers Related to Organizational Decision-Making in Norway .............................168
American Council for an Energy Efficient Economy, 1001 Connecticut Ave. NW, Suite 801, Washington DC 20036 Phone: 202-429-8873. Fax: 202-429-2248. http: //www.aceee.org. For additional information, email [email protected]
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Authors Lead Project Consultant Bill Prindle American Council for an Energy-Efficient Economy (ACEEE) Australia David Crossley and Greg Watt Energy Futures Australia Pty Ltd Janet Hughes Energy Efficiency Policy, Department of Industry Tourism and Resources Japan Masahito Takahashi, Research Scientist, Central Research Institute for the Electric Power Industry Professor Hiroshi Asano Central Research Institute for the Electric Power Industry Netherlands Ernst Worrell, Suzanne Joosen, Erika de Visser, and Mirjam Harmelink Ecofys Norway Jørgen Bjørndalen, SKM Energy Consulting AS Jørn Bugge, EC Group AS Baard Baardson, Rembra AS USA Jayant A. Sathaye and Scott Murtishaw Lawrence Berkeley National Laboratory (LBNL)
National Agency Contributors Australia Clare Walsh, Janet Hughes, and Jenny Barnes Department of Industry, Tourism and Resources Netherlands Okko van Aardenne Ministry of Economic Affairs Norway Anita Eide and Ingunn Ettestoel Enova SF USA Eric Smith Office of Atmospheric Programs U.S. Environmental Protection Agency (EPA) Jeffery Dowd U.S. Department of Energy (DOE) Project Contractor International Energy Agency (IEA)
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Executive Summary Background and Objectives The International Energy Agency contracted ACEEE to prepare for the IEA a report quantifying the effects of market failures in the end-use of energy. While economists agree that markets in general respond efficiently to price signals, there is evidence that market failures can limit the effect of price signals. Where market failures exist, energy usage in these markets persists at levels higher than economic theory would otherwise suggest. The broad global trend toward liberalization of energy markets is based on the assumption that market prices, in and of themselves, are sufficient to serve the goals of energy and environmental policymakers. However, if market failures isolate significant segments of energy use from price signals, policymakers may need to supplement market price signals with other policy measures. In this project, we analyze case studies in order to define and quantify such market barriers and failures, and from this to provide policymakers guidance on whether additional policy measures are warranted. Discussion of Market Failures Market barriers in the end-use of energy are defined as factors that inhibit behaviors or investments that would increase the efficiency of energy use. In neoclassical economics, market failures occur when barriers inhibit actions that would increase both energy efficiency and economic efficiency. Some barriers may inhibit investments in energy efficiency, but unless these investments would be economically efficient, they are not market failures. Because neoclassical economic theory has recently exerted broad influence in energy policy, the project team framed its analysis in terms that are accepted in this theoretical framework. Neoclassical theory admits to relatively few types of market barriers that can lead to market failures; our literature review and discussions with economists narrowed the field to three main types of barriers:
1. Principal-agent barriers 2. Information/transaction cost barriers 3. Externality cost barriers
1. Principal-agent (PA) barriers. Based on classical concepts of agency theory and asymmetric information, the principal-agent problem occurs when one party (the agent) makes decisions affecting end-use energy efficiency in a given market, and a different party (the principal) bears the consequences of those decisions. Common examples include: new home construction markets, where home builders make decisions that affect the energy use of homebuyers; commercial building leasing markets, where builders and owners make efficiency technology decisions that affect tenant energy bills; and rental-housing markets, where rental housing owners make investments that affect energy costs to tenants.
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2. Information cost barriers. Energy efficiency at the end-use level is an aggregate function of many small decisions. Thousands or millions of decisions may be made in a given market and time period for such end-uses as home appliances, vehicles, or commercial equipment. In many cases, the decision-maker in these small investments lacks the information or expertise to make a decision that would maximize both energy efficiency and economic efficiency. By contrast, energy supply investments, which are typically larger projects, can typically bear the costs of obtaining the expertise and information needed to make well-informed decisions. In this sense, the information costs attached to end-use efficiency decisions can lead to market failures. 3. Externality cost barriers. Economists acknowledge that when the nominal market price for energy does not reflect its full cost to society as a whole, market failures can result. Environmental impacts, health impacts, and other “externality costs” are widely recognized as imposing indirect costs on society for the direct use of energy. This project focuses primarily on principal-agent barriers, because such barriers lend themselves more easily to quantification than information costs. While externality costs are important, their quantification entails different analytical and policy issues that are beyond the time and budget limitations of this project. Other barriers and economic forces. While this project focuses primarily on principal-agent barriers, we also researched other kinds of barriers and economic issues that have been observed to inhibit economically attractive efficiency investments. These “other” issues are discussed in three broad categories: individual and organizational cognitive and behavioral factors; policy and institutional issues; and larger economic issues related to price theory. These barriers and economic issues, while not the focus of the project’s quantitative analysis, offer valuable insights for understanding end-use markets in the context of making energy policy. Methodology We devised a methodology to focus primarily on principal-agent barriers. We established a general quantitative framework in which to quantify the end-use energy affected by market barriers. We selected a set of case studies in the participating countries, in which the country experts felt confident of obtaining enough data to quantify the effects of the barrier under study. For a given market barrier, the analytical framework quantified market effects by estimating four key variables:
• Stock—number of devices or units of floorspace in the sector • Average energy use per device or unit of floorspace • Fraction of devices or buildings affected by the barrier • Energy usage affected by the barrier
The approach then applied a generic four-cell matrix framework for classifying the market effects of the barriers under observation. It is represented by Table ES-1.
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Table ES-1. Principal-Agent Classification of End-Users Can Choose Technology Cannot Choose Technology Direct Energy Payment Case 1: No Problem Case 2: Efficiency Problem
Indirect Energy Paymenta Case 3: Usage and Efficiency Problem Case 4: Usage Problemb a Occupants pay the energy costs, but not directly commensurate with energy use. This may take the form of utilities included in rent or a separate, but flat, energy fee. Often, this is due to the presence of a master meter serving multiple housing units although a significant number of individually metered units also have utilities included in rent. b There may also be an efficiency problem if three parties are involved: one who chooses the technology, one who pays the energy cost, and the end-user. Table ES-1 defines the four basic classes of end-users as they are or are not affected by the principal-agent problem. In case 1, for example, would be end-users who pay their energy bills directly and make the technology-choice decision for the energy-using device. Homeowners buying replacement refrigerators would fall in this category. In case 4 would be users who do not pay their energy bills directly, and who do not choose the technology for the energy-using device. This classification highlights two kinds of effects of the principal-agent problem. The first is an “efficiency problem,” meaning that the end-users would otherwise be motivated to reduce energy costs, but cannot choose the technology needed to do so. These users would fall in case 3. The second effect is a “usage problem,” where customers neither choose the technology nor pay their energy bills. Principal Findings Table ES-2 summarizes the findings of the case studies in the report. The overriding finding from these case studies is that large fractions—up to 90%—of the energy use in many major markets is affected by the principal-agent market barrier. This does not mean that 90% of the energy in such end-use markets can be saved cost-effectively; that would require additional analysis, based on technology and cost-effectiveness estimates. However, there is a wealth of analytical experience quantifying the size of cost-effective energy efficiency potential in many markets. The objective of this study is to quantify the magnitude of market barrier effects; the additional analysis needed to estimate the magnitude of market failures in these markets would be straightforward. In a few case studies, data was available to estimate such cost-effective savings potentials. To cite a few leading examples, almost half of residential space-heating energy use, up to 77% of residential hot water usage, and up to 90% of commercial leased-space energy use are found to be subject to barriers. These are each major end-use markets, using substantial amounts of energy. While the case study results are not uniformly comparable due to data limitations and market differences in the participating countries, the country experts examined similar markets in different countries, and in many cases found similar ranges of market barrier effects. Another key finding is that market barrier effects can cumulate across end-uses to exert significant impacts in entire sectors. The U.S. case studies, for example, addressed space heating, water heating, refrigeration, and lighting, which collectively account for 73% of U.S. residential energy consumption, and found that the PA barrier affected some 50% of the combined energy use in these four end-uses. It is reasonable to infer that PA barriers also affect other major
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residential end-uses, such as air conditioning—that would suggest that some 50% of total U.S. residential energy usage is subject to the PA barrier.
Table ES-2. Summary of Case Study Results Case Study Type—End-Use
Market Barrier Type Country Percent of Energy Usage
Affected by Barrier Residential refrigerators PA USA 25.2% Residential water heating PA USA 77.0% Residential water heating PA NO 38.3% Residential water heating Information NO 85.0% Residential space heating PA USA 47.5% Residential space heating PA NL 46.1% Residential lighting PA USA 2.3% Residential standby power Information NL 12.0% Residential standby power Information NO 3.0% Leased vehicles PA NL 32.2% Commercial leased space PA NL 40% Commercial leased space PA NO 80-90% Commercial leased space PA JP 60% Vending machines PA JP 44% Vending machines PA AU 80% Organization decision-making Organizational behavior NO 68.0% Organization decision-making Organizational behavior AU NA Information cost barriers are significant. Three of the case studies attempted to estimate the impact of information cost barriers, and other research reviewed for this project supports the thesis that information costs can be significant barriers in many end-use markets. In the U.S. residential lighting market, for example, the principal-agent barrier was found to have little effect; however, the U.S. country experts have published other research that quantifies the information costs in that market. Information costs also appear to play a large role in standby power markets. Organization decision-making. While the main focus of this study was the principal-agent barrier, two cases studies examined the more complex issues involved in organization decision- making on energy efficiency. For example, purchasing departments typically specify equipment purchases on a minimum first-cost basis, and facility operators are typically responsible for energy bill payments even though they cannot specify equipment efficiencies. The two case studies in this project, for Australia and Norway, take a detailed look at survey results of commercial/industrial energy users in their respective countries. They suggest that a version of the principal-agent problem exists in many large organizations, where one department makes energy-technology decisions while another pays energy bills. While these case studies do not “fit” the analytical model for the overall project, they offer a rich discussion of issues relevant to programs and policies to encourage energy efficiency investment in these sectors.
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Policy Implications The report’s overriding findings—that a wide range of energy end-use markets is subject to persistent market barriers, and that these barriers affect a large share of energy use—have significant policy implications. These include:
• Price signals alone may not be sufficient to attain policy goals for energy consumption, and for air pollutant and greenhouse gas emissions. While prices are a major influence on markets, barriers like those described in this report isolate large fractions of energy use from the intended effects of price signals.
• The effect of market barriers on isolating energy consumption from price signals is compounded by fundamental market forces in industrialized economies like those of OECD countries. The price elasticity effects of energy prices are muted in affluent economies by countervailing income elasticity and cross-elasticity effects.
• The demonstrated effects of market barriers and other economic forces in limiting the effect of price signals suggest that policymakers should consider additional policies and measures, beyond energy pricing policies, to overcome these effects. Such policies can include rating and labeling, efficiency standards for appliances and other equipment, building energy codes, incentive programs, and technical assistance and consumer information.
Conclusions This study found that significant percentages of energy use are affected by the principal-agent market barrier in major end-use markets in five IEA Member countries in four continents. These findings suggest that market barriers are widespread across markets in many kinds of economies. Based on research on the substantial economic potential for energy efficiency technologies in these markets, we conclude that market failures are significant and widespread. This conclusion suggests that to make substantial energy efficiency gains in such markets, energy policies must go beyond pricing structures to address market barriers in specific markets. This report represents an importance advance in the energy policy analysis field, for several reasons. It is the first study of market barriers that rigorously applies the theoretical framework of neoclassical economics to focus on market barriers that are accepted in that field. Most studies of barriers have been “bottom-up” analyses of particular markets and technologies that have gone beyond the theoretical constructs that neoclassical economics will accept as valid. This is also the first attempt to quantify the amount of energy use affected by market barriers, across multiple markets and technologies. Lastly, it represents the first attempt to apply a common framework and analytical approach in multiple nations. Other IEA energy policy assessments indicate that world energy markets are entering a new era of higher energy prices and unprecedented supply challenges. Rising energy demand is increasingly problematic as it strains energy market delivery capabilities. As a result, many governments are showing an increased interest in moderating energy demand through energy efficiency. However, the policy case as well as the specific policy tools for government
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intervention in energy markets are not as well defined as they need to be to support major new public commitments to energy efficiency. In this larger context, this report provides a service by providing a quantitative basis for policy intervention where market failures exist. It gives neoclassical policy analysts a framework for understanding the real and measurable effects of valid market barriers. It also provides some initial directions for markets that merit policy focus because of the amount of energy use affected by market barriers. In a few cases, the report documents the success of policies aimed at overcoming market barriers, thus providing further guidance for policymakers. Further research would be valuable in several areas, including:
• Follow-up analysis that seeks to identify the largest market barrier impacts, in terms of both total energy consumption and percentage of total usage, across all major energy-use markets. This would help direct policy attention to the markets where policy action would have the greatest effect.
• Follow-up analysis that applies research on the economic potential for energy efficiency to the findings of this and future market barrier assessments. Such analysis would focus on quantifying the size of the market failures in these markets.
• Developing comparable levels of accuracy and detail in end-use energy consumption data in IEA nations, so that market barrier impacts can be compared more consistently across markets and nations. This would also entail developing market information on specific markets and technologies, so that analysts can better discern technology choices, market structures, market sales volumes, and other data needed to assess market barriers and their impacts.
Acknowledgements ACEEE, in preparing the draft Report for the IEA, would like to acknowledge the cooperation of, and the technical contributions made by, the Australian Department of Industry, Tourism and Resources, the Ministry of Economic Affairs of The Netherlands, ENOVA SF (Norway), the U.S. Environmental Protection Agency and the U.S. Department of Energy. We are also indebted to Marvin Horowitz for his economics expertise in helping the project team frame its research in terms consistent with neoclassical economic theory. For the completion of the report, we are grateful to Sarah Black and Renee Nida for their editorial skills and patience.
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Introduction Project Background and Objectives The International Energy Agency contracted ACEEE to prepare for the IEA a report investigating the effects of market failures in the end-use of energy that may isolate some markets or portions thereof from energy price signals. While there is a general presumption among economists that markets respond efficiently to price signals, there is also substantial evidence that, at least for some markets and some end-uses, market failures exist that limit the effect of price signals. The result is that energy usage in these markets persists at levels higher than economic theory would otherwise suggest. The broad global trend toward liberalization of energy markets has raised the question of whether market prices, in and of themselves, are sufficient to serve the goals of energy and environmental policymakers. If barriers to the efficient end-use of energy are causing market failures of significant magnitude, policymakers may need to supplement market price signals with other policy measures. This project thus serves an important purpose by defining market barriers and failures, determining whether and where they exist, and quantifying their effects in a select set of end-use markets. ACEEE pursued this question by enlisting participants from multiple nations: Australia, Japan, the Netherlands, Norway, and the United States. Working collaboratively with the ACEEE as lead consultant, government representatives and country experts from the participating countries analyzed case studies to identify a set of market failures and a set of end-use markets in which to calculate the amount of energy usage in these markets that is isolated from price signals by these market failures. Discussion and Categorization of Barriers, Failures, and Related Issues This section discusses the market barriers that are the main focus of this project, as well as other economic forces and issues that affect market behavior. These topics are summarized in Table 1. Market barriers in the end-use of energy are defined as forces or mechanisms that can be observed to operate in specific markets in such a way as to inhibit behaviors or investments that would increase the efficiency of energy use. Classical economics considers that market failures occur when barriers are found to inhibit actions that would increase both energy efficiency and economic efficiency. In this context, if a barrier is found to inhibit investments that would be cost-effective in a generally accepted economic framework, it would be termed a market failure. Some barriers may be observed to inhibit investments in energy efficiency, but unless these investments would be economically efficient, they cannot be termed market failures. Another way to view this issue is that an energy efficiency policy invention is economically efficient if its benefits to the economy or society as a whole outweigh the costs of intervention.
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Table 1. Summary of Barriers and Other Market Forces Affecting Energy Use Principal-agent barriers Information/transaction cost barriers
Market barriers based on classical economic theory
Externality cost barriers Bounded rationality Market barriers based on transaction cost economics and
behavioral economics Organizational issues Income elasticity Cross-elasticity Other market forces Price volatility
Classical economic theory admits to relatively few types of market barriers that can lead to market failures (Sorrell et al. 2004). For the purposes of this project, we review three principal types of classical economic barriers:
1. Principal-agent barriers 2. Information/transaction cost barriers 3. Externality cost barriers
1. Principal-agent barriers. Stemming from classical concepts of agency theory and asymmetric information, the principal-agent problem occurs when one party makes decisions affecting end- use energy efficiency in a given market, and a different party bears the consequences of those decisions. Common examples include:
• The new homes market. In industrialized economies, where most housing is built in volume on a speculative basis, and the home builder does not know the buyer until after the home has been designed, home builders make energy efficiency decisions in the home’s design and construction. Their motivation is to minimize construction costs, since they do not pay the energy bills for occupancy of the home. As the agent for the buyer, they frequently under-invest in energy-efficient designs and construction methods that would be cost-effective. This constitutes a market failure.
• The commercial leasing market. Commercial building developers and designers, building for a speculative market where the ultimate tenants are unknown, operate under a principal-agent problem similar to that observed in home building. Their economic interests are served by minimizing construction costs and base rents. In addition, since commercial lease terms typically pass through energy costs to tenants, owner-operators of commercial properties also have no economic interest in minimizing energy costs to tenants.
• The rental-housing market. Similar to the situation observed in commercial rental property, rental housing owners typically do not benefit directly from investments that reduce energy costs to tenants. Yet the tenants must rely on the property owners to be their agents, as the tenants typically do not have a legal basis or a financial incentive for making energy efficiency investments in their housing units.
The agency problem would not exist, in classical theoretical terms, if the “principals” had perfect information, and if capital markets were perfect. Agency theory, a deeper exploration of which is
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beyond the scope of this project, probes these issues. The prevalence of the principal-agent problem emerges from analysis of actual rather than theoretical markets, because real markets are frequently found to show “asymmetric” information and capital flows. Asymmetry in this context means that one set of market participants possesses better access to information or capital than others. 2. Information cost barriers. Energy efficiency at the end-use level in a given market is an aggregate function of many small decisions. Thousands or millions of decisions may be made in a given market and time period for such end-uses as home appliances, vehicles, or commercial equipment. In many cases, the decision-maker in these small investments lacks the information or expertise to make a decision that would maximize both energy efficiency and economic efficiency. By contrast, energy supply investments, which typically occur in fewer and larger projects, are usually large enough to bear the cost of obtaining the expertise and information needed to make well-informed decisions. In this sense, the information costs attached to end-use efficiency decisions can lead to market failures. The theory behind information or search costs is that buyers do research only to the point that the marginal costs of research equal the marginal benefits of the search (e.g., reduced energy costs). For most small energy users, the perceived search costs can be high, given that most energy- using devices in a home or small business setting afford savings that are relatively small. Standby energy in electronic devices is a good example; the absolute amounts of energy per device are too small to warrant much research time. The program theory behind labeling policies and other public initiatives is that by reducing search costs, consumers are more likely to choose energy-saving options. 3. Externality cost barriers. Economists acknowledge that when the nominal market price for energy does not reflect its full cost to society as a whole, market failures can result. Environmental impacts, health impacts, and other “externality costs” are widely recognized as imposing indirect costs on society for the direct use of energy. This project will consider the principal-agent and information cost barriers as its principal areas of focus. While externality costs present important issues, their quantification and mitigation entail wholly different analytical and policy challenges, and given the time and budget limitations of this project, we do not focus on this topic. Other Issues Affecting Market Response to Price Signals While this project focuses primarily on the principal types of barriers recognized by classical economics (principal-agent barriers and information cost barriers), there is also a substantial literature devoted to other kinds of barriers that have been observed to inhibit economically attractive efficiency investments. These “other” issues can be grouped in three broad categories: individual and organizational cognitive and behavioral factors; policy and institutional issues; and broader economic issues. These issues are not explored in the case studies, which focus solely on the two main barrier types, but the project team’s discussions addressed them, and therefore they are included to provide a broader context for the report and to suggest further investigation for interested readers.
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Transaction cost and behavioral economics. Cognitive and behavioral factors depart from the classical economics framework in that they posit variations and limitations in the perceptions, motivations, and behaviors of individuals and organizations. Classical economics is firmly rooted in the assumption that all actors in a market think and behave rationally to maximize their own economic interests; in this framework, there is a strong aversion to “looking inside the heads” of consumers or organizations. Yet the emergence of new movements in the economics field—most notably transaction cost economics (TCE) and behavioral economics—have generated a rich new literature that addresses these issues. Transaction cost economics builds upon classical theory, in that it bases explanations on individual behavior rather than social structure, and assumes that these individuals intend to be rational. Like agency theory (the basis of the principal-agent concept), TCE emphasizes asymmetric information and opportunism. But TCE extends the classical framework by:
• Introducing the concept of bounded rationality • Focusing on the nature of different transactions and their associated costs • Showing how different types of transaction are associated with particular types of
governance structure. The concept of bounded rationality (Simon 1957) argues that classical economics fails to be descriptively accurate, since it assumes that individuals make decisions in a completely rational, optimizing way. Bounded rationality assumes that people and organizations make decisions bounded by constraints on their time, attention, resources, and ability to process information. It argues that their choices will thus not be fully rational and optimizing, and that individuals adopt rules of thumb to make “good enough” decisions rather than spending the time and effort needed to reach optimum decisions. This is sometimes called satisficing. Behavioral economics extends the concept of bounded rationality still further. Led by researchers such as Daniel Kahneman, this field explores the ways that human decision-making systematically deviates from the expected utility model assumed in orthodox economics, seeking to show how these deviations are both regular and predictable. A leading precept in this body of thought is that the mental shortcuts that individuals use in bounded rationality do not just result in “limitedly rational” decisions, but lead to systematically biased and erroneous decisions (Piattelli-Palmarini 1994). Behavioral economics argues that human decision-making biases need to be taken seriously to better explain the data on economic organization and behavior, and to improve the predictive capability of economic models. Kahneman and others have used experimental tests of decision- making under a variety of conditions to demonstrate that such biases are universal, predictable, and largely unaffected by either monetary incentives or learning (Kahneman and Tversky 2000). Their study of individuals’ decisions preferences in situations of risk, such as the well-known finding that people systematically choose an option whose monetary value is X with 100% certainty over an option whose value is 2X with 50% certainty, directly controverts classical theory, in which such choices would have equal value. Such research documents systematic biases that belie the simpler assumptions of perfect rationality in classical economic theory.
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Organizational barriers and related issues. For the purposes of this project, we pay added attention to the issues revolving around “firm failure,” or barriers and related issues that have been observed to significantly limit energy efficiency investment by organizations, even when such investments are found to be otherwise economically efficient. One of the implications of transaction cost economics and behavioral economics is that the bright line between market failures and other outcomes becomes blurred. The picture becomes more of a continuum from outcomes that are fully rational from an energy and economic viewpoint, to those that clearly evidence failure. Further, there exists a large body of situations in between, in which classical failures may be hard to prove, but in which efficiency investment can be improved while increasing economic efficiency. To compare energy efficiency investment decision-making among countries or regions, for this project we have established a categorization based on mechanistic structures such as the functional, product, and geographical structures, and organic structures can be applied to organizations (see Table 2). Each structure displays a different decision-making hierarchy and other features, each with implications for energy efficiency investment decision. For each of the structures we posit a number of generic management and cultural issues that affect the decision- making process. In some cases these mimic behavioral barriers such as bounded rationality. In other cases, they act to reinforce the effect of behavioral barriers, for example, sectional goals at the expense of firm-wide goals. Gruber and Brand (1991) point out that in some sectors there are quite general reasons why profitable energy efficiency measures are not pursued. For example, bakeries give priority to the quality and appearance of the “salesroom” and hence the retail shop claims priority for investment capital. Smaller meat production firms are mainly interested in short-run cost reduction to compete with larger competitors, and this is achieved most easily by cutting labor costs. Other industries, such as those involved with perishable foods (for example, dairies) will not take any risks with product quality, or the continuity or security of production. At the individual firm level there also exist informal or semi-formal structures, such as trade associations, and sporting and social clubs, that can enhance or constrain the group from making otherwise rational decisions. For example, issues related to trust, attitude to risk, stress, fears and anxieties, social interactions, and factions and politics can influence employees’ attitudes toward operation and investment policies.
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Structure Comments Possible Common Generic
Management and Cultural Issues Decision-Making Hierarchy
Functional
• Jobs and activities are grouped together into departments or sections
• Clear discrete functions
• Sectional goals at the expense of firm-wide goals
• Sections resistant to any change, because of the separation from the customer
• Coordination among sections onerous and not well defined
• Perception of a wide gap between “top and bottom” levels of the firm
• Duplication of functions among sections and consequent negative effects of competition
• Lack of strong central control over each separate section
• Department manager (technical services, finance, etc.)
• CFO / General Manager
• Reflects the different types of materials handled or processes undertaken
• Used by complex organizations to encourage specialist expertise
• Sectional goals at the expense of firm-wide goals
• Duplication of functions among sections and consequent negative effects of competition
• Manager (retail sales, networks, etc.)
• Branches working as autonomous units
• Head office provides some support services but is not involved in the daily running of the business
• Conflict between area and central management
• Duplication of resources and functions
• Area branch manager • CFO / General Manager
Matrix—task force
• Flexibility to meet unforeseen challenges
• Employees gain a wider understanding of a firm’s needs
• Pressures on management to deal with increased complexity (including of the management hierarchy) and greater co-operation
• Project leader and / or department manager
Broader economic issues related to price theory. Modern regulatory theory rests firmly on the assumption that government’s role is to make sure that prices are set fairly and that they reflect costs appropriately. This assumption rests in turn on the presumption that the price elasticity of demand—that is, the percentage change in demand for a good as a function of the percentage
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change in its price—is a force sufficient to achieve an economically optimal set of decisions in the market. Price elasticity, a central element of price theory, is a well-established and observable force in most markets. However, it is not the only elasticity effect operating to affect consumer decisions. At least two other elasticity effects—income elasticity and cross-elasticity—operate in ways that can reduce the effect of price elasticity. Income elasticity of demand is the change in demand for a good as a function of consumer income. Rising incomes, particularly in relatively affluent industrialized economies, can drive increased demand for goods, including energy. Gasoline sales in the United States, for example, have continued to rise at historical rates from 2001 through 2004, despite a 24% increase in average gasoline prices in the same period. This may be explained in part by income elasticity, in that U.S. incomes for the majority of households are high enough that moderate changes in gasoline prices may blunt the effects of price elasticity. Cross-elasticity of demand is the change in demand for a good as a function of the increase in price for another good. For example, in the United States during 2004 and 2005, marginal drops in retail sales were attributed by some economists to higher gasoline prices. The theory was that higher fuel prices were causing consumers to reduce purchases of other goods, rather than directly reducing fuel consumption. In this context, energy consumption for such ubiquitous uses as heating, lighting, and transportation are seen as relatively inelastic “essentials,” and cross- elasticity displaces consumption reduction effects into reduced demand for more discretionary purchases. Another market price effect with significant implications for energy efficiency investment is price volatility. Volatility affects consumer demand in that it reduces price certainty as a consumer perception; consumers are increasingly unable to predict whether prices will rise, fall, or remain steady. The effect of volatility in this context is to increase perceived risk associated with investments of significant size or period of return. When consumers cannot predict future prices, they are unwilling to make many investments that would be economically attractive across a range of future price points. These three price effects—income elasticity, cross-elasticity, and volatility—are not barriers per se, but simply market forces. Nonetheless, because they can significantly reduce the expected effects of price elasticity, they are important considerations for energy policymakers. Similar to market barriers, these price effects can serve to blunt or distort the intended of effects of price signals on energy markets. Policymakers therefore should consider these effects in the broader context of designing energy policies, because they serve to limit the effectiveness of price signals as a sole and sufficient basis for an economically optimal energy policy. Project Focus: The Principal-Agent Barrier After a careful literature review and discussions among the project team, we decided to focus our data analysis primarily on the principal-agent barrier. We reached this decision on two primary bases:
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• The principal-agent barrier is widely observable in markets among all the participating countries. Both residential and commercial buildings sectors showed evidence of real and persistent principal-agent problems.
• The effects of the principal-agent barrier lent themselves more readily to quantification than others. It is easier, for example, to obtain data on the percentage of refrigerators sold to owners of residential rental units, where the tenant paying the energy bill would be the principal and the building owner would be the agent, than it is to estimate the information or transaction costs associated with the purchase of a replacement refrigerator by a homeowner, where the principal-agent problem would not apply.
For these reasons, the case studies in this project focus primarily on principal-agent barriers in specific countries and markets. Three case studies—water heating in Norway, and standby power in Norway and the Netherlands—include an assessment of information costs barriers, but the majority of the quantitative results are based on the effects of the principal-agent barrier. We also note that information cost barriers can be significant and should be kept in mind as additional support for the conclusions of this report. In this respect, the analysis in this report is inherently conservative and should not be viewed as an inclusive assessment of the impact of market barriers on end-use efficiency. At the same time, however, the narrower focus of this approach lends greater methodological rigor to the report and greater confidence to the robustness of the findings. Methods This project was designed to focus primarily on principal-agent and information/transaction cost barriers, as the two most common types that are accepted within neoclassical economic theory, are observable in a wide range of sectors and end-uses, and lend themselves to quantification at least to some degree. We also investigated the impact of organizational behavior on energy use; however, the methods used in this part of the project were necessarily rather different because of difficulties in quantifying impacts of this type. With this approach in mind, the project team selected a series of case studies in which to assess the amount of energy use that may be isolated from price signals by these market barriers. The case studies are summarized in Table 3. We designed an analytical framework designed to produce data estimates on the amount of energy use that may be isolated from price signals in each of these end-use sectors. We first applied four qualitative variables:
• End-use sector definition and description • Applicable barrier type and description • Evidence of barrier’s presence • Mitigating factors
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Table 3. Case Study Summary Case Study Type Barrier Type Country Participation
Residential Refrigerators PA, split incentive US
Water heaters PA Information/transaction costs
NO US
Standby power (consumer electronics) Information/transaction costs NL
NO Commercial/Industrial
NE NO JP
PA, split incentive JP AU
Transportation Leased vehicles PA NL
Organizational Behavior Industrial/commercial large organizational decision- making
Information/transaction costs Decision-making process/
organizational barriers
AU NO
We then sought to quantify the barrier’s impact on energy use through estimates of the following numerical variables:
• Stock—number of devices or units of floorspace in the sector • Average energy use per device or unit of floorspace • Fraction of devices or buildings affected by barrier • Energy usage affected by barrier
We also developed a generic four-cell matrix framework for classifying the market effects of the barriers under observation. This is represented by Table 4.
Table 4. Principal-Agent Classification of End-Users Can Choose Technology Cannot Choose Technology
Direct Energy Payment Case 1: No Problem Case 2: Efficiency Problem
Indirect Energy Paymenta Case 3: Usage and Efficiency Problem Case 4: Usage Problemb a Occupants pay the energy costs, but not directly commensurate with energy use. This may take the form of utilities included in rent or a separate, but flat, energy fee. Often, this is due to the presence of a master meter serving multiple housing units although a significant number of individually metered units also have utilities included in rent (Levinson and Niemann 2004). b There may also be an efficiency problem if three parties are involved: one who chooses the technology, one who pays the energy cost, and the end-user.
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Table 4 defines the four basic classes of end-users as they are or are not affected by the principal- agent problem. In case 1, for example, would be end-users who pay their energy bills directly and make the technology-choice decision for the energy-using device. Homeowners buying replacement refrigerators would fall in this category. In case 4 would be users who do not pay their energy bills directly, and who do not choose the technology for the energy-using device. Residential renters whose energy bills are included in rent payments or commercial building tenants whose energy costs are allocated without direct metering as part of lease terms would be examples of case 4 end-users. This classification approach shows that there can be at least two effects of the principal-agent problem. The first we refer to as an “efficiency problem,” meaning that end-users would otherwise be motivated to reduce energy costs, but cannot choose the technology needed to do so. These users would fall into case 3. The second effect we term a “usage problem,” typified by customers who do not pay their energy bills directly (with the implication that the users’ choices have no effect on the size of their energy bills). In cases 3 and 4, users are not motivated to reduce energy costs because their energy bills are not directly metered and paid by the users. Interestingly, this usage problem effect applies regardless whether customers do or do not have the ability to choose the technology. While not all end-uses in all countries lent themselves fully to this analytical approach, generally speaking we were able to estimate the fraction of energy use in a given end-use market that is affected by the barrier under study. Because of differences in data availability, market characteristics, and analytic approach in the various country case studies, it was necessary to make judgment calls on the appropriate denominator to use in stating the fraction of affected energy use in summarizing the findings of each case study. In some cases, the percentage of affected usage was a straightforward calculation, especially when typical values for energy consumption in a given end-use were well-established. Examples of this type include residential refrigerators, water heaters, and space heating. In other cases, it was more difficult to establish the appropriate denominator; for example, residential standby power used total residential electricity usage as the denominator, as the energy use associated with the devices that use standby power is not well-documented. This produced a much lower fraction of affected energy use than would have occurred had better data been available. Findings This section summarizes the findings of the case studies. The individual case study narratives are found in Appendix A. Table 5 summarizes the case study findings and shows that up to 90% of the energy use in an end-use market can be affected by the market barriers included in this study. This does not mean that up to 90% of the energy in that end-use market can be saved; that is a separate estimate and depends on technology substitution options to provide the energy services in a given end-use category. This percentage refers to the number of devices, units of floorspace, or other metrics and their associated energy use in the market affected by the barrier. While it doesn’t indicate the level of energy savings potential, it does indicate that energy can be saved in that portion of the market.
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Table 5. Case Study Results Summary
Case Study Type—End-Use Market Barrier Type Country Percent of Energy Usage
Affected by Barrier Residential refrigerators PA USA 25.2% Residential water heating PA USA 77% Residential water heating PA NO 38.3% Residential water heating Information NO 85% Residential space heating PA USA 47.5% Residential space heating PA NL 46.1% Residential lighting PA USA 2.3% Residential standby power Information NL 12% Residential standby power Information NO 3% Leased vehicles PA NL 32.2% Commercial leased space PA NL 40% Commercial leased space PA NO 80–90% Commercial leased space PA JP 60% Vending machines PA JP 44% Vending machines PA AU 80% Organization decision-making Organizational behavior NO 68% Organization decision-making Organizational behavior AU NA An energy efficiency potential study would seek to quantify the potential energy savings that could be realized if market barriers were overcome. While some of the case studies make estimates of the energy that could be saved though elimination of barriers, this was not the primary focus of this study. Accordingly, we do not report energy efficiency potential. Several factors should be understood as caveats for the interpretation of these case study results:
• For this study, within its funding and time limitation, the project team sought to be representative but not comprehensive. We did not attempt to systematically study all major end-use markets or all major barriers. We identified a manageable set of end-use markets and barriers where it was anticipated that barriers would exist and data would be available.
• Data availability and quality limits the accuracy and predictive ability of these findings. These factors varied from country to country. However, the fact that so many of the findings show large segments of energy use is affected by barriers tends to mute the importance of the variances attributable to data issues.
• Some variances in the percentage of energy affected by a barrier are attributable to market differences among countries. For example, the variance in the percentage of energy use affected by the principal-agent barrier in the commercial leased space markets of the Netherlands, Norway, and Japan could be related to the relative percentage of leased space in those markets, or differences in leasing contract terms.
The overridingly important finding from this analysis is that significant portions of energy use were found to be affected by the principal-agent and information barriers in a diverse range of residential and commercial end-use markets. To cite a few leading examples, almost half of residential space-heating energy use, up to 77% of residential hot water usage, and up to 90% of commercial leased-space energy use are found to be subject to barriers. It might be pointed out that such single-market findings may not be indicative of widespread PA problems. However,
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the U.S. case studies for residential refrigeration, space heating, water heating, and lighting combined find that over 50% of the energy used in these end-uses is affected by the principal- agent barrier. This suggests that such barriers apply broadly across energy end-use markets. It also suggests that barriers can affect large shares of energy end-use. Discussion of Case Studies As indicated earlier, the case study results are not uniformly comparable due to data limitations and market differences in various countries. Nonetheless, because the country experts examined similar markets in different countries, there are a number of notable observations that emerge from the case studies. This section briefly discusses some of the more interesting observations in this vein. Multi-market aggregate effects. These case studies focused on single end-use markets. In some cases, the percentage of energy use and/or total amount of energy use affected was rather small, such as the case of U.S. residential lighting, where the PA problem was found to affect less than 3% of total usage. The percentage could also be large, as in the 77% of U.S. water heating energy use affected by the PA barrier. However, the U.S. case studies were conducted in such a way that the individual end-use market results could be combined. The LBNL analysis, when it aggregated refrigeration, water heating, space heating, and lighting, found that the PA barrier affected some 50% of the combined energy use in these four end-uses, and some 37% of total U.S. residential energy consumption (on a site-energy basis). The fact that half of energy usage in four of the main residential energy end-uses (they collectively account for 73% of U.S. residential energy consumption) is affected by just one type of market barrier is a significant finding. From this finding, it is reasonable to infer that PA barriers also affect other major residential end-uses, including air conditioning and clothes washing; if so, the U.S. case studies would suggest that some 50% of total residential energy usage is subject to the PA barrier. Refrigerators. The residential refrigerator market was studied only in the United States. However, the analysis of the refrigerator market provides a useful model for market classification, using an extended version of the four-cell matrix approach illustrated in Table 4 on page 9. Figure 1 illustrates the way that country expert LBNL broke out market segments between owned and rented homes, then further disaggregated end-users according to age of home (for owned homes), purchaser of the refrigerator (for rental units), and so on (a larger and more readable version of the figure is found in the U.S. case study in Appendix A).
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Multi family residence 25.3
Case 1
105.8
Using the methodology in Figure 1, LBNL was able to isolate the segments of the market affected by the principal-agent barrier. The estimated finding was 25% of U.S. residential refrigerator energy usage, or 134 TBtu (.134 EJ) of primary energy. While quantitative results might vary, due to differences in market shares (e.g., rental vs. owned), market practices (e.g., provision of refrigerators by builders and landlords), and technology (average refrigerator energy consumption), the LBNL model provides a rigorous yet flexible method that can be adapted for various markets. Based on consultations conducted in the two workshops held in Oslo and Sydney, by and large the country experts used a similar approach. The LBNL U.S. refrigerator case study findings support an observation long made by efficiency professionals, that rental housing markets contain substantial market barriers to energy efficiency. The case study showed that in the 32% of U.S. households that rent, landlords choose refrigerators in 81% of those units, and of those units, 84% of tenants pay the energy bill. These data strongly support indications of a significant principal-agent problem. Water heaters. Case study data are available for the United States and Norway for residential water heater markets. The U.S. case study shows that an estimated 77% of residential hot water energy use is affected by the PA barrier, while the Norwegian analysis shows that an estimated 38% of hot water usage is affected. One possible explanatory factor for this difference is that the U.S. analysis assumed that 60% of water heaters are replaced on an emergency basis, and that such situations effectively preclude technology choice, thus treating this phenomenon as a principal-agent problem. One could say instead that the emergency-replacement phenomenon is
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an example of an information-cost barrier; in fact, that is how it appears to be viewed in the Norwegian case study. The Norwegian study looked at both the PA problem and the information-cost barrier, quantifying them separately. The Norwegian study finds that 85% of residential hot water usage is affected by the information barrier. Since the U.S. estimate is in- between the two Norwegian estimates, it is possible that application of the same assumptions and calculation procedures might have produced more similar results. Space heating. Case studies were developed for both the U.S. and the Netherlands. While the overall estimates of space heating energy use that could be affected by the PA barrier are very close (47% in the U.S. study and 46% in the Netherlands study), these results are less comparable than they might first appear. In the Netherlands study, data was available on efficiency measures installed in owned and rented households, and so the project team took that data into account. The team used the data to surmise that the PA problem in rental housing had largely been offset by public policies that had caused the retrofit of a large fraction of the Dutch social housing stock. On that narrower basis, the amount of space heating usage affected by the PA barrier was estimated to be in the 5–11% range. However, overlooking these effects, the overall percentage of energy use affected in the two countries could be quite similar. The Netherlands case study is also noteworthy in that the team found data sufficient to estimate the energy savings impact of public policies, a goal not included in the scope of this project but made possible by careful analysis of available data. Lighting. The United States was the only country for which residential lighting was studied. The analysis showed that only 2.3% of residential lighting usage is affected by the PA barrier. However, there are indications that the information cost barrier is much more influential in the residential lighting market (Sathaye and Murtishaw 2004). Given the significant first-cost premium for high-efficiency lighting, most consumers may not do the calculations that would show such purchases to be economically rational. Standby power. The case studies from Netherlands and Norway both examine standby power not from the PA perspective, but from the information cost perspective. They both find that the information-cost problem is significant in this market, but because standby power is a relatively small portion of residential energy use, the total amount of residential energy use affected by the information cost barrier is also found to be somewhat small. It is worth noting parenthetically that the Norwegian study found a smaller percentage of residential electricity use affected by standby power in large part because of the prevalence of electric heating in that country. Moreover, it is worth noting that energy savings potential in electronic device standby power is estimated to be large in percentage terms, and that standby power use in many higher-income IEA countries is the fastest-growing end-use. Moreover, because of the global nature of the electronics industries that produce such devices, it has been shown that voluntary labeling and regulatory standards can rapidly and inexpensively achieve large reductions in standby energy use. This to say that the fact that a given market accounts for a small fraction of energy use should not be used to suggest that policy intervention is unwarranted. The possibility for large multi-national (if not global) impacts from straightforward policies should also factor into such decisions.
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Leased vehicles. The Netherlands case study found that about one-third of the energy used by company-owned vehicles and about 9% of all passenger vehicle energy use is subject to the principal-agent barrier. Since drivers of company-owned cars don’t select the vehicle and typically don’t pay the energy bill, the PA barrier creates both a technology and a usage problem. This same phenomenon applies in theory to leased-vehicle markets in other industrialized IEA countries. However, business practices and national policies can create significant differences in the ways that this barrier operates. For example, in Australia, there is a 30,000 km/year driving minimum required to qualify vehicles for tax benefits. This results in strange end-of-year driving behavior to meet the minimum distance requirement. Commercial leased space. A large fraction of commercial building space is leased rather than owner-occupied in most industrialized countries. Case studies in this market were developed for Norway, the Netherlands, and Japan. As in other markets, the availability of data, differences in data segmentation, differences in application of the methodology and interpretation of data, and differences in market practices make fully uniform comparisons among these country markets difficult. In Norway, 80–90% of commercial energy use is found to be subject to the PA barrier, in part because about 80% of office space is estimated to be leased. In the Netherlands, only 40% of commercial office energy use is found to be affected by the PA barrier, because only 40% of the office space market is tenant-occupied. In Japan, 60% of office space is tenant-occupied; however, a different interpretation of market data and methodology led to a much smaller estimate of the effect of the PA barrier. However, if one compares the Japanese market data on the gross level with that of Norway and the Netherlands, one could apply the project methodology to estimate that 60% of the office space market is affected by the PA barrier. Japanese survey data, on the other hand, yield findings that lead the analysts to question whether the PA barrier is actually affecting energy use. Vending machines. This market is widely seen as subject to the PA barrier. However, the Japanese and Australian case studies showed that market structures and practices can vary widely among countries. The Australian study found that some 80% of refrigerated beverage vending machines (RBVMs) are affected by the PA barrier, while in Japan only 44% of the market is found to be affected (using methods comparable to the Australian study: the Japanese study conclusions, because of differences in market practices and interpretations of methods and data, found a much smaller fraction of energy use affected by the PA barrier in this market). In Japan, building owners more typically purchase and pay operating costs for vending machines, whereas in Australia the vending machines are owned by the beverage distributors and the energy costs are paid by the retailers at whose establishments the machines are placed. Organization decision-making. Neoclassical economic theory does not consider factors operating inside firms or individual consumers; they are assumed to be fully rational, utility-maximizing entities. However, within many large organizations a version of the PA problem can be observed. For example, purchasing departments typically specify equipment purchases on a minimum first- cost basis, and facility operators are typically responsible for energy bill payments even though they cannot specify equipment efficiencies. There may also be other factors in firm decision- making that create barriers to efficiency investment. The two case studies in this project, for Australia and Norway, are atypical in that they don’t attempt to apply the PA barrier analysis in the way the other case studies do. Rather, they take a more encompassing look at investment
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decisions. The case studies take a detailed look at survey results of commercial/industrial energy users in their respective countries. By reviewing this data and comparable literature, they explore the barriers internal to the organizations that could explain the relatively low uptake rate for recommended energy efficiency measures. While these case studies do not “fit” the analytical model for the overall project, they offer a rich discussion of issues that appear to be relevant to policymakers in exploring programs and policies that would encourage energy efficiency investment in these sectors. Policy Implications The report’s overriding finding—that a wide range of energy end-use markets is subject to persistent market barriers, and that these barriers affect a large share of energy use—has significant policy implications. These include:
• Price signals alone may not be sufficient to attain policy goals for energy consumption, and for air pollutant and greenhouse gas emissions. While prices are a major influence on markets, barriers like those described in this report isolate large fractions of energy use from the intended effects of price signals.
• The effect of market barriers on isolating energy consumption from price signals is compounded by fundamental market forces in industrialized economies like those of OECD countries. The price elasticity effects of energy prices are muted in affluent economies by countervailing income elasticity and cross-elasticity effects.
• The demonstrated effects of market barriers and other economic forces in limiting the effect of price signals suggests that policymakers should consider additional policies and measures, beyond energy pricing policies, to overcome these effects. Such policies can include rating and labeling, efficiency standards for appliances and other equipment, building energy codes, incentive programs, and technical assistance and consumer information.
Conclusions This study demonstrated that significant percentages of energy use are affected by the principal- agent market barrier in major end-use markets in five IEA countries in four continents. These findings suggest that market barriers are widespread across markets in many kinds of economies. Based on research on the substantial economic potential for energy efficiency technologies in these markets, we conclude that market failures are significant and widespread. This conclusion suggests that to make substantial energy efficiency gains in such markets, energy policies must go beyond pricing structures to address market barriers in specific markets. This report represents an importance advance in the energy policy analysis field for several reasons, chief among which are:
• This is the first study of market barriers that rigorously uses the theoretical framework of neoclassical economics to isolate market barriers that mainstream economics will accept as worthy of discussion. Past studies of barriers have tended to focus on bottom-up analyses of particular markets and technologies; while these studies have often been well-
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researched, they have gone beyond the theoretical constructs that neoclassical economics will accept as valid.
• This is the first attempt to quantify the amount of energy use affected by market barriers across multiple markets and technologies.
• This study is the first to apply a common framework and analytical approach in multiple nations.
Other IEA assessments indicate that world energy markets are entering a new era of higher energy prices and unprecedented supply challenges. Rising energy demand is becoming increasingly problematic as it strains energy market delivery capabilities. As a result, many governments are showing an increased interest in moderating energy demand through energy efficiency. However, the policy case as well as the specific policy tools for government intervention in energy markets are not as well defined as they need to be to support major new public commitments to energy efficiency. In this context, this report provides a service by providing a quantitative basis for policy intervention in markets where a substantial fraction of energy use is isolated from market price signals. It thus gives neoclassical policy analysts a rationale for understanding the real and measurable effects of valid market barriers. It also provides some initial directions for markets that merit policy focus because of the size of the fraction of energy use that is affected by market barriers. In a few cases, the report documents the success of policies aimed at overcoming market barriers, thus providing further guidance for policymakers. Further research would be valuable in several areas, including:
• Follow-up analysis that seeks to identify the largest market barrier impacts, in terms of both total energy consumption and percentage of total usage, across all major energy-use markets. This would help direct policy attention to the markets where policy action would have the greatest effect.
• Follow-up analysis that applies research on the economic potential for energy efficiency to the findings of this and future market-barrier assessments. Such analysis would focus on quantifying the size of the market failures in these markets.
• Developing comparable levels of accuracy and detail in end-use energy consumption data in IEA nations, so that market barrier impacts can be compared more consistently across markets and nations. This would also entail developing market information on specific markets and technologies, so that analysts can better discern technology choices, market structures, market sales volumes, and other data needed to assess market barriers and their impacts.
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Appendix A—Detailed Case Studies
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U.S. REFRIGERATOR, WATER HEATER, SPACE HEATING AND RESIDENTIAL LIGHTING ENERGY USE AFFECTED BY THE
PRINCIPAL-AGENT MARKET FAILURE
Scott Murtishaw and Jayant Sathaye, Ernest Orlando Lawrence Berkeley National Laboratory
Introduction This study investigates the magnitude of principal-agent (PA) problems in the U.S. residential sector. A PA problem arises in many spheres of economic activity, when one person, the agent, performs tasks on behalf of another person, the principal, but the agent performs the expected tasks in a way contrary to what the principal would like. The PA problem is often referred to as one of the barriers to greater energy efficiency. This may arise when an agent buys a piece of equipment that is more expensive over its lifetime because the agent saves money on the initial cost while the principal pays the operating costs. In the residential sector, the conceptualization of principal and agent must be stretched beyond a strictly literal definition. For example, PA problems often exist between renters and landlords. The renter pays the landlord/agent for the use of the apartment and any included furniture and appliances. The renter does not specifically request the landlord to choose the appliances. Indeed, any included appliances are usually already in place. The “principal” is really the whole set of possible renters. These principals would prefer to have efficient appliances that produce lower utility costs, but their agents, the landlords, are more concerned with initial costs since they do not incur the expense of running the appliances. Note that although the PA phenomenon is described as one type of market barrier to efficiency, it is actually a function of several different conditions. First, the incentives of the principal and the agent must be misaligned. If both have the same motive, then generally the agent will make decisions in accord with the principal’s interests. A second condition concerns the status of information related to equipment performance, which is central to the PA problem. The quality and extent of information may be thought to lie along a spectrum. At one end there is no information. Even the equipment manufacturers may not know the expected annual energy consumption of their devices. Without any performance information, there is no way to determine the extent, or existence, of inefficient energy consumption. In this case, research is necessary to assess the annual energy consumption of the available models under expected operating conditions. At the next stage, manufacturers may have determined the efficiency of their products but are not required to provide the information on efficiency labels. Neither the landlord nor the tenant has enough information to know how the equipment will perform. In this case, one cannot say that there is a PA problem because the agent cannot know whether she is acting in the principal’s interests or not. In the middle of the spectrum, information is available, but its distribution is asymmetric. The landlord has the opportunity to inspect efficiency labels before purchase, but then he can remove the labels before installing them in his rental units. An unscrupulous landlord could claim that the appliances are particularly efficient even when they are not. At the other end of the spectrum, both principal and agent have adequate information to know whether the equipment is the best choice. However, a third condition may still produce a PA problem: the capacity of the principal to control the agent’s actions. Even a fully informed
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tenant cannot force a landlord to buy a more efficient piece of end-use equipment. Thus, the PA problem is a function of incentives, information asymmetry, and enforcement capacity. This study focuses on isolating the extent of the PA problem. Inefficiencies arising from barriers to energy efficiency that are primarily related to lack of information, or the inability to process it, are not included. Generally, information barriers are predominant when an occupant has the ability to choose the devices he or she will use and either no performance information is available, or it is available but the occupant fails to purchase a comparable, more energy-efficient model. Characterization of the Principal-Agent Problem in Energy End-Use The PA problem arises in two separate transactions in the end-use of energy. The first transaction is between the seller and purchaser of the end-use device, and the second one between the owner and user of the device. In the first transaction, the purchaser may not buy the most efficient device, and in the second case, the user may use the device wastefully, if he/she does not pay the fuel and/or electricity costs in a manner directly proportional to consumption. In either case, a problem arises since either the selection or use of the device is shielded from a utility price signal. The response to a price signal is then masked and delayed because it is felt through a higher cost of owning or renting a residence. In order to determine whether any particular end-use is a