Role of Behavioural Economics in Energy and Climate Policy

8/3/2019 Role of Behavioural Economics in Energy and Climate Policy

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The Role of Behavioural Economics in Energy and

Climate Policy

Michael G. Pollitt and Irina Shaorshadze

December 2011

CWPE 1165 & EPRG 1130


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www.eprg.group.cam.ac.uk

EP

RG

WORKING

PAPER

Abstract

The Role of Behavioural Economics in Energyand Climate Policy

EPRG Working Paper 1130

Cambridge Working Paper in Economics 1165

Michael G. Pollitt and Irina Shaorshadze

This article explores how behavioural economics can be applied to

energy and climate policy. We present an overview of main concepts of

behavioural economics and discuss how they differ from the

assumptions of neoclassical economics. Next, we discuss how

behavioural economics applies to three areas of energy policy: (1)

consumption and habits, (2) investment in energy efficiency, and (3)provision of public goods and support for pro-environmental behaviour.

We conclude that behavioural economics seems unlikely to provide the

magic bullet to reduce energy consumption by the magnitude required

by the International Energy Agency's 450 climate policy scenario.

However it offers new suggestions as to where to start looking for

potentially sustainable changes in energy consumption. We believe that

the most useful role within climate policy is in addressing issues of

public perception of the affordability of climate policy and in facilitating

the creation of a more responsive energy demand, better capable ofresponding to weather-induced changes in renewable electricity supply.

Keywords behavioural economics, energy economics, energy demand,

energy efficiency, private provision of public goods

JEL Classification D03, D10, Q40, Q58

Contact [email protected] December 2011Financial Support EPSRC, Flexnet


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TheRoleofBehaviouralEconomicsinEnergyandClimatePolicy

MichaelG.Pollitt1

IrinaShaorshadze

ESRCElectricityPolicyResearchGroup

UniversityofCambridge

December2011

1. Introduction

While energy efficiency and conservation have been important tenets of energy policy for decades,

concernsaboutclimatechangehaveputthese issuesatthe forefrontofpolicydialogue. International

Energy Association (IEA 2010) estimates that by 2020, about 34% of the global decrease in carbon

emissions in a 450 scenario (limiting the longterm concentration of greenhouse gases in the

atmosphereto450ppmCO2eq)comparedtothereferencescenarioshouldstemfromdirectenduse

energyefficiency

measures.

This

goal

calls

for

astep

change

in

how

individuals

consume

energy

and

make energyefficiency purchases. Energy consumption, energyefficient investment, and pro

environmentalactionsinvolveconsumerdecisionmakingandbehaviour.Theseaspectshavegenerated

increasedinterestindesigningpolicyinterventionsthattargetenergydemand,andinterestinassessing

theresponsivenessofconsumerbehaviourtothese interventions.Behaviouraleconomicscanprovide

new perspectives that can inform policy design on how individuals evaluate options, make decisions,

andchangebehaviour.

Itisimportanttopointoutthatenergypolicyisnotjustaboutclimatechange,butalsoaboutsecurityof

energysupplyandabouttheaffordabilityofenergy.Climatepolicysignificantly interactswithbothof

theseelements

of

energy

policy

via

the

introduction

of

expensive

and

intermittent

renewable

electricity

andheat.Ifconsumerbehaviourcanbechangedtoreduceenergydemandortomakeenergydemand

more responsive in time and space to weatherinduced shortages of energy, it could be a significant

contribution to facilitating the introduction of climate policyinduced renewable energy. By contrast,

1ThispaperwillbeachapterintheforthcomingHandbookonEnergyandClimateChangeeditedbyRoger

Fouquet,tobepublishedbyEdwardElgar.TheauthorswishtothanktheEPSRCFlexnetprojectforfinancial

supportandRogerFouquetforhisencouragementtowritethepaper.Weacknowledgethehelpfulcommentsof

RogerFouquetandananonymousreferee.Theusualdisclaimerapplies.


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failure toaddresspublicconcernsabout the securityof supplyoraffordability implicationsofclimate

policymayjeopardizetheachievementofambitiouscarbonemissionsreductiontargets.

Behaviouraleconomicsusesinsightsfrompsychologyto increasetheexplanatorypowerofeconomics.

According to neoclassical economics, agents maximize expected utility using exponential discounting,

and they have access to information that they can assess freely and completely. While this is a

parsimoniousrepresentationofhoweconomicdecisionsaremade,experimentalsettingsandempirical

observations indicate that behaviour deviates systematically from what traditional models would

predict.Someofthepuzzlesthattraditionaleconomicsstrugglestoexplainarethefollowing:whyare

returnsonequitymuchhigherthanreturnsonbonds(equitypremiumpuzzle);whyarethereuntapped

opportunitiestoreduce(energy)expenditurethroughincreased(energy)efficiency(efficiencygap);and

whydoindividualsindulgeinimmediategratification,knowinglycompromisingtheirlongrunwellbeing

(substance

abuse)?

Behavioural

economics

challenges

one

or

more

of

the

assumptions

of

the

neoclassical economics, and offers an alternative way to model decision making. These alternative

modelsoftenbettermatchempiricalobservationsandhavehigherpredictivepowerthanmodelsbased

purelyonneoclassicalassumptions.

Whiletraditionaleconomicsassumesindividualsalwaysbehaverationally,behaviouraleconomistsoften

stress the irrational aspect of decision making, often referred to as behavioural failures. These

behaviouralfailuresmaymakeindividualsactagainsttheirownlongterminterest.ThalerandSunstein

(2008)arguethatifindividualsdonotalwayschoosewhatisbestfortheminthelongrun,itiswelfare

enhancingforpolicymakerstoensurethatthesetofchoicesthat individualsface issuchthata long

term,welfare

maximizing

outcome

becomes

more

likely.

This

may

be

done

through

proper

framing

choices, setting appropriate (limited if necessary) choice sets and providing appropriate default

options. In essence, individuals are nudged towards a welfaremaximizing outcome, even if their

freedom to choose is still respected. Thaler and Sunstein (2003) called this approach libertarian

paternalism. Libertarian paternalism would argue for policy interventions in the face of behavioural

failures,evenifmarketfailuresareabsent.

Traditionally,economicshasfocusedonhowchangesinpricesaffectbehaviour.Researchinbehavioural

economicsandpsychologyhasdemonstratedthatnonpecuniary interventionscompare favourablyto

monetary interventions in changing consumer behaviour. It was also shown thatjudiciously applied

pecuniaryinterventions

increase

the

impact

of

monetary

interventions

ifused

in

combination.

This

has

increasedinterestinresearchinbehaviouraleconomicsasaguideforpolicymakinginareasasdiverse

as public health, finance, and law. Thatbehaviouraleconomics can inform decision making inenergy

policy has increasingly been recognized by policy makers and researchers (Allcott and Mullainathan

2010;DEFRA2010;OFGEM2011).

In order to realize energy savings and emissions reductions necessary to address climate change,

decision makers have to consider tapping into behavioural transformation strategies. Behavioural

Economics provides insights that can inform this effort. Behaviours that are relevant to household

energyconsumptionencompassthreebroadareas(1)energyconsumption,curtailment,andhabits;(2)


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energy efficiency investments; and (3) contribution to public goods (i.e. green energy) and pro

environmental behaviour. These three aspects of energy consumption are interrelated; for example,

proenvironmentalattitudesmaymakeefficiency investmentsmore likely,andthese investmentsmay

reduceenergyconsumptioninthelongrun.However,thesetopicsdifferintermsofthedecisionmaking

andbehavioursinvolved,andwarrantseparatereviews.

The restof this paper is organized as follows. Section 2presents themajorconcepts that distinguish

behaviouraleconomics fromneoclassicaleconomics.Sections3,4,and5 form theheartof thepaper

anddiscusshowbehaviouraleconomics relates toenergyconsumptionandpolicy.Threebroadareas

related to energy are discussed: energy consumption, curtailment, and habits (section 3); energy

efficiency investments and purchases (section 4); proenvironmental behaviour and public goods

(section5).Section6providesconcludingremarks.

2. BehaviouralEconomicsvs.NeoclassicalEconomicsThemaindeparturesfromneoclassicaleconomicsproposedbybehaviouraleconomicscanbegrouped

underfourmainareas:(1)timevaryingdiscountrates,(2)prospecttheoryandimportanceofreference

points,(3)boundedrationality,and(4)prosocialbehaviourandfairness.Belowwebrieflydiscusseach

oftheseareas.

2.1. Time-VaryingDiscountRates

Experimentsshow

that

individuals

use

ahigher

discount

rate

over

alonger

time

horizon

than

over

a

shorter timehorizon (Thaler 1981;Benzionetal.1989;HolcombandNelson1992).Todealwith this

apparent anomaly, behavioural economics proposes hyperbolic discounting. Under hyperbolic

discounting, individualshavehigherdiscount rates for shorthorizons,but lowdiscount rates for long

horizons (Laibson 1997). This implies that people will be farsighted when planning if both costs and

benefits occur in the future. However, they will make shortsighted decisions if costs or benefits are

immediate (Camerer and Loewenstein 2004). Some of the manifestations of the timeinconsistent

preferencesareinabilitytoloseweight,stopsmoking,andsaveenoughforretirement(Wilkinson2007).

If individuals have timevarying discount rates, at somepoint in the future theirpreferences change.

Preferencesbetween

two

future

rewards

can

reverse

in

favour

of

amore

proximate

reward,

ifthe

time

tobothrewardsdiminishes.Anindividualmayprefer$110 in31daysover$100 in30days,butprefer

$100nowover$110tomorrow.(Fredericketal.2004).Thisisinconsistentwithexponentialdiscounting

used by neoclassical economics in expected utility models. If agents were to discount future utilities

exponentially,timepreferenceswouldnotreverse,becausethedelayof30daysissharedbetweenthe

two options. Timevarying discount rates could explain the tendency to procrastinate. When given a

choicebetweenperforming5hoursofanunpleasant task todayand5hoursofanunpleasanttask

tomorrow,mostpeoplechoosethesecondoptionanddelaythetask.Ontheotherhand,whengivena

choiceof5hoursofunpleasantworkinamonth,versus5hoursofunpleasantworkinamonthanda


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day, most people take the first option. However, ifan individualdecides todo thework inamonth,

whenthedaycomes,heorshewouldagainprefertodelayituntilthenextday(ODonoghueandRabin

2000).

Some individualsmaybeawareof theirtendency toprocrastinate,andmayvalue theopportunity to

make a commitment. The fact that people value commitment devices has been demonstrated

empirically. Ashraf et al. (2006) show that when given the choice of depositing money in a savings

account from which they can draw freely and a bank account that pays the same interest rate but

restricts when funds can be withdrawn, some individuals choose the latter option. Individuals who

chosecommitmentsavingaccountsincreasedsavingratesby82%.Traditionaleconomicsfindsithardto

explainwhysomepeoplewouldchoosean illiquidassetovera liquidasset,even iftheypaythesame

interestrate.

2.2. ProspectTheoryandImportanceofReferencePointsInstandardeconomictheory,an individualspreferencesamongdifferentcommoditybundlesdepend

onwealthandprices,butareindependentfromthecompositionoftheircurrentendowment(assets)or

theircurrentconsumption.Prospecttheory,developedbyKahnemannandTversky,statesthatwelfare

changesshouldbeevaluatedaccordingtocertainreferencepoints(KahnemannandTversky1979).The

followingaresomeofthemanifestationsoftheimportantreferencepointsforwelfareevaluation.

Lossaversion.Traditionaleconomicsassumes that individualsare riskaverseor riskneutralbutplace

thesame

value

on

losses

and

gains

of

equal

amount.

Kahnemann

and

Tversky

(1979)

argue

that

valuation of losses is the mirror image of valuation of gains and refer to this phenomenon as the

reflectioneffect.Decisionmakingwillexhibit the reflectioneffectwhenthe individual isriskaverse in

the face of potential gains, but riskseeking in the face of potential loss. It has been demonstrated

empiricallythat individualstendtovalue lossesmorethangains.This isfound incontingentvaluation

studies that show that willingness to accept (WTA) is typically higher than willingness to pay (WTP)

(ShogrenandTaylor2008).ShefrinandStatman(1985)demonstratedthatinvestorsholdontoolongto

thestocksthatlostvalue,butareeagertosellthestocksthatgainedinvalue,andarguethatthisisdue

toreluctancetosellataloss.Endowment

effect.

This

refers

to

the

extra

value

that

individuals

attach

to

goods

they

already

own

or

servicestheyalreadyreceive.Inessence,theendowmentpointisthereferencepoint,andagentshavea

kink in thevaluationaroundthispoint (Thaler1980).HeberleinandBishop(1986) foundthathunters

werewillingtopay$31foraparticularhuntingpermitbutwerenotwillingtoletgoofthesamepermit

forlessthan$143.

Statusquo bias. Individuals tend to stick to the default option chosen for them. For example, in

countrieswhereorgandonation isconductedunderpresumedconsent(i.e.consentbydefault,unless

explicitoppositionwasregisteredbydonor),participationratesare25%30%higherthan incountries

wheredonation isconductedunder informedconsent(i.e.noconsent ispresumedunless itwasmade


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explicit)(AbadieandGay2006).SamuelsonandZeckhauser(1988)showedthatwhennewhealthcare

optionswereoffered toHarvardUniversity faculty,new facultymembersweremore likely tochoose

them,butolderfacultymemberswereunlikelytomodifytheircurrentplans.

2.3. BoundedRationalityBoundedrationalityreferstothephenomenonthatagentsarerationalbuthavecognitiveconstraintsin

processing information(Simon1986).Thereforetheydeviatefromrationality incertaincircumstances.

Someofthemanifestationsofboundedrationalityarethe following: (1)choiceoverload,(2)heuristic

decisionmaking,and(3)failuretoassessstatisticalprobabilities.

Choiceoverload refers to the difficulty individuals have in making a choice when presented with too

manyoptions.

Studies

show

that

more

shoppers

make

apurchase

of

ajam

when

they

are

presented

with 6 choices than when they are presented with 24 choices (Iyngar and Lepper 2000). Traditional

economicsstruggles toexplainthis tendency,andassumesthatmorechoicesarealwayspreferred to

fewerchoices.

Heuristicsareshortcutstodecisionmaking,suchasviaaruleofthumb.Traditionaleconomicsassumes

that individualsuseconceptsofstatisticalsamplingandstatisticalrules(e.g.Bayesrule)forupdating

probabilitiesoffutureeventsinthefaceofnewevidence(CamererandLoewenstein2004).Experiments

demonstratethat individualsoftenmakechoices inawaythatdeparts from theBayesianassessment

thattheyaresupposedtomakeundertraditionaleconomics.Thisdeparturemaybesystematic(biased)

ratherthan

idiosyncratic.

Individuals

may

categorize

purchases

under

different

categories

and

have

different discount rates for these categories. For instance, higher oneoff expenditures may be

categorizedundera separatementalaccountandhavedifferentdiscount rates thanmultiple smaller

expenditures. Thaler (1999) showed thatan individuals willingness to spendearned income,windfall

income,orsavedincome isnotthesame,even ifmoneycanbeused interchangeably.Thiscontradicts

the assumption of traditional economics that money is fungible. Heath and Soll (1996) suggest thatmentalaccountingcanexplainwhyindividualsmakeapparentlysuboptimalconsumptionchoices.

There is some indication that consumers do not correctly process statistical information and

probabilities. They are swayed by vivid and salient information more than by simply convincing,

statistically

correct

information.

Research

shows

that

individuals

overstate

small

probabilities

of

catastrophiclossesorlargegains.JulienandSalanie(2000)findthatonhorseraces,thereisbiastowards

bettingonlongshots, implying thatgamblers like togamble,buttheyaredisproportionallyafraidof

small chances of losing when they bet on heavy favourites. Cook and Clotfelter (1993) find that

Lotteries are popular because players are more sensitive to largejackpots than to the probability of

winning.


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2.4. Pro-SocialBehaviourandFairnessNeoclassical

economics

assumes

that

an

agent

makes

choices

that

depend

only

on

his

or

her

own

monetarypayoffandconsumption(Pesendorfer2006).However, inexperimentalgamesandempirical

studies, it has been demonstrated that individuals seem to value fairness and often act prosocially.

Kahnemanetal.(1986)showthatconsumershavestrongfeelingsaboutthefairnessofafirmsshort

run price decisions, and suggest that this prevents firms from exploiting their full monopoly power.

Individualsoftenactprosocially,contribute tocharities,andengage inproenvironmentalbehaviour,

even if this imposescostsonthem.Behaviouraleconomicschallenges theview thateconomicagents

arepurelyselfish.

If individualsarenotasselfishastraditionaleconomicshasassumed,thisunselfishnesshas important

implications

for

understanding

the

private

provision

of

public

goods.

According

to

neoclassical

economics, individuals care only about their own consumption of public goods but do not directly

benefit from theirowncontribution,norare theydirectlyaffectedbyother peoplesconsumptionor

contribution(BernheimandRangel2007).Traditionaleconomicsclaimsthatpeoplewillhaveatendency

to free ride, and that public goods will be underprovided unless provisions are mandated through

taxation. Furthermore, only very wealthy are predicted to make voluntary contributions, and as

population increases contributions should converge to zero. These assumptions provide testable

hypotheses thatarecontradictedbyempiricalevidence (Andreoni2006;BernheimandRangel 2007).

Behavioural economics provides an alternative view to help explain why and when individuals make

privateprovisionofpublicgoods.

Two behavioural explanations relate to peoples attitudes towards providing for public goods. First,

individualsarenotpurelyselfish,butplacevalueonsocialgoods.Inessence,theyvaluenotonlytheir

ownconsumption,butalsotheconsumptionofothers(theyareotherregarding).Publicgoodsmaystill

beunderprovided,butthis isbecause individualsthink it isnotfairthattheybeartheburdenfortheir

provisionat the expenseofothers.Ostrom (1998) finds that inpublic goodsgames (i.e.experiments

where individuals are given the opportunity to contribute to the provision of a public good) most

individualsareconditionalcooperators theywillcontribute, iftheyare sure thatotherswilldothe

same.Second,individualscontributetothesocialgoodbecauseofthewarmgloweffect.Warmglow

effect refers to the idea that individualsmightparticipate inpublic goods (suchasa greenelectricity

program)because

it

makes

them

feel

good

(either

because

they

feel

better

about

themselves,

or

becausetheycareaboutwhatothersthinkofthem),butnotnecessarilybecausetheycareaboutthe

publicbenefitperse(Andreoni1990;BernheimandRangel2007).Inessence,besidesvaluingtheirown

consumptionofpublicgoods,individualsvaluehavingcontributedtopublicgoodprovision.

Themotivationsforprovidingforpublicgoodsarehardtotestempirically.Asaresult,warmglow is

often treated as a reduced form of deeper underlying processes (social norms, social signalling,

reciprocity, altruism, etc.). Disentangling these processes is challenging and their representation may

vary among different policies and contexts (Bernheim and Rangel 2007). Nevertheless, different


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underlyingmotivationsmayhavedifferentpolicyimplications.Ifanindividualwouldprovideforpublic

goodsonlywith theassurance thatothersdonot free ride (i.e.showingaconcern for fairness), then

increasedcontributionbyotherswill increasethe likelihoodofhisorhercontribution. If,ontheother

hand,anindividualcontributesasastatussymbol(e.g.becauseofadesireforawarmgloworprestige),

thenprovisionbyothersmaydecreasethelikelihoodofhisorhercontribution.Inthiscase,amonetary

incentiveforcontributingmaycrowdoutthealtruisticincentivetocontribute.

Researchers indeedfindthatmonetaryrewardssometimescrowdoutintrinsicmotivation,especiallyif

themonetaryrewardsaresmall.Forexample,whenasmallmonetarypaymentwasofferedforblood

donation,blooddonationsactuallydecreased (Titmuss1987[1971]). Itwasalso found thatvolunteers

performbetterwhentheyarenotcompensatedthanwhentheyreceivesmallmonetarycompensations

(GneezyandRustichini2000).These findingsarehardtoreconcilewithtraditionaleconomics,butcan

be

explained

by

behavioural

economics,

as

they

take

away

from

the

warm

glow

satisfaction

of

giving.

3. EnergyConsumption,Curtailment,andHabits

In this section we discuss topics that involve repetitive or continuous efforts to reduce energy

consumption or to change energyuse habits. The policy interventions discussed in this section focus

primarilyonpromotingenergycurtailmentinthehouseholdenergysector.Inaddition,wediscusshow

changingthetarifforbillingstructureaffectsenergyconsumptionpatterns.

3.1. RateStructure:Flatvs.DynamicTariffs

Themarginalcostofproducingelectricityvariesthroughtheday,andthewholesaleelectricityprice is

highduringthetimeofpeakelectricityusage.Traditionally,residentialelectricitycustomersfaced flat

electricity tariffs, and were insulated from fluctuating wholesale electricity prices through the day. If

electricitydemandbecomesflatter,utilitieswillsaveonenergycostsbyminimizingusageofpeaking

plants, which are usually less efficient and produce more carbon emissions. Further down the line,

havingasmootherdemandwillresult inreduced investmentsforbuildingpeakingplants.Costsavings

caneventuallyberecycledbacktotheconsumers.

Recently,policymakersandutilitieshavebeenlookingatthepotentialofintroducingtariffsthatvaryby

thetime

of

usage.

Some

possible

variable

tariffs

are

the

following:

(1)

time

of

use

tariffs

(TOU),

when

customers face different tariffs according to the time of day; (2) critical peak pricing (CPP), when

customers facehighertariffsduringcertaincriticalpeaktimesthroughtheyear;(3)peaktimerebate,

when customers pay flat electricity tariffs but receive rebates if the electricity usage is reduced

compared to a certain benchmark at critical times through the year; (4) realtime pricing, when

customerselectricitytariffsfluctuateinrealtimeaccordingtothewholesaleelectricityprices.

Timevarying tariffs requireadvanced (smart)meters thatcanmeasureconsumption inreal time.The

UnitedKingdom, Italy,andthestateofCalifornia intheUSAhave legislated largescaledeploymentof


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smartmeters,withotherjurisdictionsplanningtofollowtheirlead(FaruquiandSergici2009).Extensive

researchisunderwaybypolicymakers,utilities,andacademicstogaugethepotentialfordemandside

response(DSR)totimevaryingtariffs.ThevalueofDSRhingesonthepotentialofcustomerbehavioural

responseandisanareathatcandrawimportantinsightsfrombehaviouraleconomics.Belowaresome

of the concepts from behavioural economics that are relevant to the decision to implement variable

rates.

Endowmenteffect.Billpayerscurrentlyenjoythebenefitofbeinginsulatedfromvariableratesduring the day. Proper design and marketing of the dynamic tariffs will be critical for

overcoming consumers resistance to changing the costbenefit structure of the way they

consume electricity. Individuals are attached to their routines and daily habits and may be

inflexibletomodifythem,ordemandhighcompensationtodoso.

Statusquobias.Researchshows thatwhenpresentedwithautilitybillwithadefaultchoice,most consumers will not change it (Brennan 2006). Those who object to having the dynamic

tariffeitherasadefaultormandatoryoption,mentiondistributionalconsiderations.Theyargue

that most households will remain on the default plan even if it is not optimal for their

consumptionpatterns.Vulnerablehouseholds,suchastheelderlyanddisabled,willnotbeable

tovarytheirloadandwillbe losersunderthedynamictariffs, ifthatissetasadefault(Felder

2010).

Timevaryingdiscountrates. Introducingdynamictariffsraisesconcernsaboutshorttermcostversus

the

lag

in

long

term

gain

(Simhauser

and

Downer

2011).

Dynamic

pricing

will

result

in

a

rate shock, as bills of some consumers will skyrocket in the near term, before behavioural

adjustments,orbeforehouseholdsacquireenablingtechnologiesorreplaceoldapplianceswith

ones that better accommodate varying tariffs. Even if the long term costs of smart meter

infrastructure proves to be beneficial, the long term may be really long (Hanser 2010). Since

individualstendtohavehigherdiscountratesforthefuture,theymaynotthinkthatthecosts

areworththebenefits,especiallyifthesavingsareinitiallysmallornil.

Lossaversion.Ifindividualsvalue(negatively) lossesmorethantheyvaluegains,rate increasesduring peak periods may have tobe compensated with larger ratedecreases during offpeak

periods.

Concern for Fairness. Opponents of mandatory dynamic tariffs cite fairness considerationstowardsthevulnerable.Itisarguedthatvulnerablehouseholds(elderly,disabled,andpoor)will

notbeabletoshiftconsumptiontooffpeak,sincetheyhaveminimalelectricityconsumptionto

beginwithandareoftenhomebound.On theotherhand,proponents forthedynamic tariffs

statethatitisnotfairthatpeakyhouseholdsarebeingsubsidizedbylesspeakyhouseholds

throughflattariffs(Faruqui2010).


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Highelectricitybillsaresalientandraisevociferousopposition that results inamediaoutcry.Moving

customers en mass to dynamic prices may bring adverse consequences and may result in a strong

politicalbacklash.Alexander(2010)givesexamplesoflargescaleTOUtariffrolloutsintheUSAthatdid

notmeetexpectations:

Central Maine Power Company had implemented a mandatory TOU structure in the 1980s.However, in the1990s, theTOU rate structure was changed to reflecthigherpeakelectricity

costs,buttheincreasedbillscausedconsumeropposition,andTOUratesweremadevoluntary.

PugetSoundEnergyofWashington state implementedmandatoryTOUpricing for residentialcustomers in2001.However, theprogramactually resulted inhigherbillsunder thenewrate

structure.Theprogramwashaltedin2002.

Alexander(2010)suggeststhathavingapeaktimerebate(PTR)isamoreattractiveoptioncomparedto

mandatory CPP or TOU. A PTR scheme would leave the underlying rate structure unchanged, but

provide rebates or credit to those customers who reduce usage during critical peak hours. A rebate

option should be viewed as carrot only rather than stick only (Maine Public Utilities Commission

2007;Alexander2010).WithCPP,peakycustomerswillseetheirratesincreaseiftheydonotchange

behaviour.Ifconsumersfocusmoreonthedownsideriskofhigherbillsthantheupsidepotential,they

willdislikeCPP.MoreconsumerswouldchoosetotakeadvantageofPTRthanvolunteerforCPP.Letzler

(2007)arguesthatanincentivecompatiblerebateaddressestheheuristicsofconsumerdecisionmaking

betterthanCPP.

In2008,BaltimoreGas&Electric(BGE)conductedadynamicpricingpilotwhichshowedthatconsumers

respondedtoPTRaswellastoCPP.Asaresult,BGEabandonedCPPandconductedatrialofonlyPTRin

2009.FaruquiandSergici(2009)review15pilotexperimentswithdynamicpricingofelectricity.Across

therangeofexperimentsstudied,TOUrates inducedadrop inpeakdemandthatrangedbetween3%

and6%,andCPP inducedadrop inpeakdemandthatrangedbetween13%to20%.Whencombined,

thedropinpeakdemandwasinthe27%to44%range.

3.2. BillingandPaymentMethods

Howcustomers

pay

their

utility

bills

may

have

implications

for

how

they

consume

energy.

This

was

demonstratedbyastudyofconsumptionandmeter topupbehaviourof thehouseholds inNorthern

Irelandthatuseprepaymentmeters(Brutscher2011a,b).Brutscher(2011a)showsthatconsumerswith

prepayment meters tend to consume more electricity. Households tend to purchase relatively small

amountsoftopups,andadjusttoincreasesintariffsbyincreasingtheirnumberoftopups,ratherthan

by increasing the amount. However, exogenous increases in minimum topup amount result in

decreasedenergyuse.This suggeststhatconsumersperceivecostsdifferentlyaccordingtohow large

they are. They have different mental accounts for larger purchases, and are more aware of the


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consumptionaftertheyhavemadealargetopup.Increasingminimumtopupamountwouldtherefore

likelyresultindecreasedenergyconsumption.

Brutscher(2011b)findsthatlowincomehouseholdsuseelectricheatratherthanoilbecausetheyhave

liquidityconstraintsheatingoil requiresbulkpurchase,whereaselectricitymeterscanbeprepaid in

smallamounts.Asoilheating ismoreefficientandcheaper inthe longrun,thiscouldbeexplainedby

timevaryingdiscountrates,whichprevent individualsfromsavingforbulkheatingoilpurchase. Ifthe

bulkpurchasenecessary forheatingoil involvessavingmoney fora future largepurchase,themoney

being saved will be subject to temptation to make alternative purchases with more immediate

gratification.Ifindividualshavehigherdiscountratesforthefarfuturethanforthenearfuture,theywill

repeatedly succumb to temptation, even if they are aware that saving money will buy them a more

efficientsourceoffuelinthelongrun.Aheatstampprogram(whereconsumersbuynonfungiblecredits

towards

future

purchases

of

oil)

is

a

potential

solution

for

this

behavioural

failure.

Heat

stamp

programs,

currentlyoperatinginvariouscommunitiesinNorthernIreland,letsconsumersgraduallycollectstamps

thattheycanredeemforthebulkoilpurchase.

3.3. Non-pecuniaryIncentivestoConserveEnergyNonpecuniary interventionshavebeenattemptedtoelicitreductions inenergyconsumption,often in

combinationwithmonetary incentivesandinformationprovision.Whereinterventionswerecombined

withmonetaryincentives,consumptionfeedback,orenergysavinginformation,itishardtodisentangle

theeffectsoftheseinterventions.

Competitionhasbeeneffective in incentivizing individuals to reduceenergyconsumption.McClelland

andCook(1980)studiedtheeffectofcompetitionbetweenmastermeteredresidentialbuildingsatthe

University of Colorado, USA. The buildings, where occupants were not individually metered, were

competingonwhichbuildingwouldsavemoreelectricity.Contestantsreceived informationonhowto

saveelectricityand feedbackonsavingsof theirusage,aswellas theusageof theothergroups.The

winningbuilding receiveda rewardof$80.Thecontestgroupsused6.6% lesselectricity thancontrol

groups.However,thesavingsdecreasedwithtime,suggestingthattheeffectoftherewardwasshort

lived.Fourbuildingsand228familiesparticipatedinthestudy.

Pallakand

Cummings

(1976)

studied

whether

they

could

induce

reduction

in

energy

consumption

throughsolicitingpubliccommitment.ThestudywascarriedoutinIowaCity,USA.Peoplewhosigneda

publiccommitmentshowed lowerratesof increase ingasandelectricityusethanthosewhosigneda

privatecommitmentorthoseinthecontrolgroup.

Energy savings can also be motivated by assisting consumers with goal setting. Becker (1978) gave

households a relativelydifficult goal (20%) or a relativelyeasy goal (2%) to reduce electricity use. All

householdsreceived informationonwhichappliancesusedmoreelectricity,butonlysomehouseholds

receivedconsumptionfeedback.Onlythehouseholdsthathadthedifficultgoalandreceivedfeedback


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hadasignificantchange inelectricityconsumption(15%savings).Thisstudy involved100familiesthat

livedinidenticaltownhousesincentralNewJersey,USA.

Mostoftheresearchconductedonnonpecuniary incentiveshas involvedsmallsamples,and it isnot

clear if these interventions are scalable. Most of the studies do not monitor interventions for a

prolongedperiodoftime,anditisnotcertainifhabitswerechangedorbehaviourseventuallyreturned

to preintervention norms. Where followup studies were conducted, it was typically found that the

behaviouralchangeswerenotsustained. It isworthnotingthat intheFormerSovietUnioncountries,

wherepricesignalswere ideologically frownedupon,prizeswereusedextensivelytopromoteenergy

saving via goal setting, competition, and public appeals. However, anecdotal evidence suggests that

theseincentives,evenifinitiallyheeded,becameeventuallyineffectivewherepricesignalswereabsent.

3.4. InfluenceofSocialNormsonHouseholdEnergyConsumptionSocialnormsaffectindividualactionsthroughprovidingguidelinesastowhatisacceptableornormal

behaviour. Some behavioural interventions aim to influence consumer energy consumption through

increasing awareness of social norms. A number of studies have attempted to change energy

consumptionofhouseholdsthroughprovidingthemwiththeconsumptioninformationoftheirpeers,as

anindicatorofsocialnorms.

Nolan et al. (2008) left door hangers at 271 homes in San Marcos, California, USA, with different,

randomly assigned energy conservation messages. Door hangers that compared a given households

energydemand

to

that

of

their

neighbours

led

to

10%

more

energy

demand

reduction

than

door

hangersthatgaveonlyenergyconservationtips.Schultzetal.(2007)leftdoorhangersin286homesin

thesamecity.Residentswhohadlowerenergyconsumptionthanaverageincreasedconsumption(the

boomerangeffect).However,thiseffectwaseliminatedwhenasmileyfacewasdrawnnexttotheir

energyconsumption.Theauthorpostulatesthatthesmileyfacewas interpretedasanormativesignal

andresultedinbehaviouralchange.

While the above studies were based on small sample sizes, their findings were consistent with the

results of a program run by OPOWER, one of the largest randomized field experiments in history.

OPOWERmailedhomeenergyreportletterstocustomers,comparingtheirenergyusagetothatoftheir

neighbors.These

letters

also

gave

customers

energy

conservation

tips.

OPOWER

ran

aprogram

for

23

utilities,including6ofthelargest10utilitiesintheUSAand600,000households.Thestudyfoundthat

the interventionreducedaverageenergydemandby1.11%to2.78% fromthebaselineusage (Allcott

andMullainathan2010).

Itisnotclearifthebehaviouralchangesresultingfromtheseinterventionscanbesustainedinthelong

run, or if the novelty of the social comparison would eventually wear off. Costa and Kahn (2010)

analyzedtheOPOWERdataandfound,infact,thattheprogrameffectswereheterogeneous:whilethe

electricity conservation nudge of providing feedback to households on their own and peers home


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electricity usage works with political liberals, it backfires with political conservatives. The largescale

OPOWERexperimentgainedconsiderablemediapublicityandwashailedbyleadingpolicymakersasa

testament that behavioural economics should motivate viable policy alternatives. However,

Loewenstein and Ubel (2010) cautioned against being overly reliant on these types of interventions,

pointing out that the energy savings they generated were very small. They stated that traditional

mechanisms, such as a carbon tax would be far more effective even if politically more difficult to

implement,astheywouldincreasethepriceofcarboninlinetoitstruecost.

3.5. InfluenceofInformationProvisionProviding energysaving information and energyconsumption feedback is successful in eliciting

behavioural changes. The residential electricity market has traditionally suffered from asymmetric

information.Traditional

electricity

meters

provide

cumulative

consumption

information

and

individuals

donotalwaysknowwhichappliancesconsumemostelectricityandwhen.Newtechnologies,suchas

smartappliancesandsmartmetersprovideinnovativewaystoaccessconsumptioninformation.Having

accesstodisaggregatedconsumption informationthroughavarietyofmedia (i.e.the Internet)makes

electricity consumption more tractable and easier to manage. Information asymmetry is typically

assumedtobeamarketfailure,and isstudiedundertheparadigmoftraditionaleconomics.However,

behaviouraleconomicsfindsthatnotonlyistheinformationimportant,butalsothewayitispresented

orframed.

Ifthecommunicationof informationtakes intoaccountthebehavioural failuresandheuristicdecision

making

of

consumers,

messages

can

be

crafted

to

solicit

a

sharper

behavioural

response.

Since

individualsareaffectedmorebysalientinformationratherthansimplyaccurateinformation,thenvisual

cuesandvividdescriptionsareimportant.Forexample,ThalerandSunstein(2008)foundthatwhenthe

energycompany inSouthernCaliforniagave itscustomersanAmbientOrbthatglowed inredwhen

energy consumption was high (salient signal), orb users reduced peak energy demand by 40%. With

largescale deployment of new technologies that provide innovative ways of communicating

information, providing appropriate vivid cues will become increasingly important. If consumers are

affectedby lossesmorethangains,theeffectivemessageshouldstressmoneywastedbymissingthe

opportunity to save energy rather than emphasizing energysaving behavioural change. The former

formulationprovidesthesameinformationbutismoreeffective,althoughlesswelcomed,especiallyby

elderlyand

vulnerable

customers.

Thecredibilityandtrustworthinessofinformationsourcesmakesadifference.CraigandMcCann(1978)

showed that when consumers received identical letters giving energy conservation advice but on

different letterheads, the letter from the local energy commission had higher impact than the letter

from the local utility. In communication, simple, salient, and personally relevant information is more

effectivethandetailed,technical,andfactualinformation(WilsonandDowlatabadi2007).


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3.6. ChoiceofElectricitySuppliersorTariffsThe

unregulated

monopolist

does

not

have

the

incentive

to

keep

prices

down.

Competition

between

suppliersresults in lowerprices if thebuyersareabletoshop forthebestdealandchangesuppliers.

However,thereare indicationsthatwhenpresentedwithmanysuppliers,consumersdonotswitch. If

consumersdonotshoparoundforthebestsuppliers,openingmarketsthatwereformerlyregulatedcan

reduce welfare, if the incumbent supplier increases prices above those that were set by regulators

(Brennan 2006). Behavioural economics explains this phenomenon by status quo bias, and/or

informationoverload.

Traditionaleconomicsoftenassumesthatinformationiscostlessandfreelyavailable.Butwhenallowing

for cost of searching and obtaining information, traditional economics would explain consumers

unwillingnessto

choose

suppliers

by

the

fact

that

search

is

costly

(electricity

bills

are

notoriously

hard

to

read)andthattheproduct(electricity) ishomogenous.WilsonandWaddamsPrice(2005)providethe

behaviouralexplanation thatconsumersare irrationaland fail to switch.Thishas implications for the

offeringofmorechoicestoenergyconsumers,whichmightbefacilitatedbythedeploymentofsmart

meters. Having more choices implies more opportunities for mistakes to be made by customers by

selecting inappropriatesuppliersfortheirneeds.Itmayalsoreduceswitchingfrom incumbentsdueto

informationoverload.

4. Energy-EfficientInvestmentsandPurchasesIncreasing

energy

efficiency

can

play

asignificant

role

in

reducing

overall

energy

consumption

and

associatedemissions.Efficiency investments involveonetime, large monetarycostsbut result incost

savings over the long run through lower energy consumption. It has been shown that efficiency

improvements could result in substantial longrun cost savings. However the energy efficiency gap

puzzle remains. The gap normally refers to the difference between the observed level of energy

efficiencyandwhatisconsideredoptimalenergyuse(Jaffeetal.2004).Sometimestheenergyefficiency

gapis illustratedbycomparingthemarketdiscountrateandtheimplicitdiscountrateimputedfrom

appliance purchase decisions, taking into account cost of appliances and their energy efficiency

(Hausman 1979). Studies have shown that the implicit discount rate is between 25 and 100 percent

(Sanstadetal.2006;Train 1985).Belowwediscussbehaviouralexplanationsof theenergyefficiency

gapand

effectiveness

of

policy

interventions

that

aim

to

tackle

it.

4.1. BehaviouralExplanationsfortheEnergyEfficiencyGapItisnotcostlesstoassesshowanewtechnologyfitsintooneshome,ortofindareliablesupplierand

installer.Furthermore, futureenergypricesand futuresavingsareuncertain.The transactioncostsof

newtechnologyadoptioncanstillbesignificant,sothatthepurchasepriceisonlythelowerboundof

adoptioncost (JaffeandStavins1994).Belowwediscusssomeofthebehaviouralexplanationsofthe

efficiencypuzzle.


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Time inconsistency. Individuals have a high discount rate for future cost savings, but a smalldiscountrateforlargeinitialinvestmentoutlay.Alternatively,individualsmaywanttoinvestin

energyefficiencybutareprocrastinating,ordonothavethedisciplinetosavemoneytopayfor

theinitialinvestment.

Endowmenteffect.Householdsareattachedtotheappliancestheycurrentlyown,andarenotwilling to replace them, even if it is efficient to do so. This can partly be rationalized by the

certainty that the new equipment works, against the risk of problems in installation or

operation.

Salience. Yates and Aronson (1983) suggest that individuals place disproportional weight onvivid

and

observable

factors.

This

tendency

may

result

in

placing

too

much

emphasis

on

initial

investment costs, and underinvestment in energy efficiency. They recommend giving salient

examples of energy savings and state that energysaving advice should demonstrate the

experienceofahighlyefficienthouseholdforthemessagetobebetterretained.

Heuristics.KemptonandMontgomery(1982)useasurveyandfindthatconsumersusesimpleheuristics to assess their energy consumption, which leads to systematic underinvestment in

energyefficiency.Theyconcludethatthis istheexampleofboundedrationality,whenpeople

adaptknownmethodstosolvingnewproblems,eveniftheknownmethodsarenotoptimalfor

thenewsituation.Thismaybetheoptimalstrategy,asitavoidstheeffortofanalyzingthenew

situation(Simon

1955).

For

example,

families

used

current

energy

prices

to

calculate

expected

savings fromefficiency investment, thusnot taking intoaccount futureprice increases.When

comparing consumption over the years, households compared their highest utility bills to

estimatetheirconsumptiontotals.Kemptonetal.(1992)showsthatconsumerssystematically

miscalculatepaybackperiodsforairconditioners,andthisleadstooverconsumptionofenergy.

4.2. IncentivesforEnergy-EfficientInvestmentsSinceenergyefficiency investmentsaresubject tomarketandbehavioural failures,policymakersand

utilities have devised various incentives to overcome them. Behavioural economics can shed light on

whichefficiency

promoting

incentives

are

more

effective.

Since

high

upfront

costs

appear

to

discourage

efficiencyinvestments,policymakersoftenattempttoincentivizetheseinvestmentsthroughtaxcredits

orefficiencyprogramsadministeredbyutilities.

Income tax credits or deductions have been used in the USA as an instrument to encourage energy

efficientinvestments.Howeverevidenceoftheireffectivenessismixed.TheU.S.EnergyTaxActof1978

(ETA78) provided a federal tax credit for residential energyefficiency investments and encouraged

investment in solar, wind, and geothermal energy technologies. Carpenter and Chester (1988)conductedasurveywithover5,000respondents fromtheUSA.Around89%oftherespondentswere


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awareofETA78sfederaltaxcredit,butonlyaroundonethirdofthemfiledthisclaim.Outofthosewho

did file the claim, 94% were going to make the investment even without tax incentives (free riding).

However, Hassett and Metcalf (1995) found that tax credits do encourage efficiency investmentsa

changeof10percentagepointsinthetaxpriceoftheinvestmentincreasesprobabilityofinvestmentby

24%. Williams and Poyer (1996) found that tax credits have a significant effect in improving energy

conservation,evenwithfreeriders.Theysuggestthatthismaybeduetospillovers,assomehouseholds

maketheinvestmentbecauseofthetaxcredit,butthenfailtofileforthecreditwhenitcomestimeto

file their taxes. This explanation is consistent with timevarying discount rates and tendency to

procrastinate.

In summer 2011, the UK government ran a pilot trial of the Green Deala scheme to encourage

homeowners to upgrade their buildings by installing energysaving improvements at no upfront cost.

Repayments

for

these

investments

would

be

made

via

a

charge

paid

from

savings

made

on

a

customers

energybills.The trial tookplace in theLondonboroughofSutton,and involved400households that

respondedtotheadvertisement.Ofthe126householdsthateventuallyreceivedhomeenergyaudits,

only60signedupforthescheme,evenifthesubsidyrepresented40%.Thehouseholdsthatdidsignup

fortheschemeindicatedthatfinancialincentiveswerenottheprimarymotivation(BioRegional2011).

Studiesshowthatevenwhenautilityofferedtosubsidize93%ofthecostofhomeinsulation,consumer

takeupvariedfrom1%to20%,dependinghowthesubsidywascommunicatedtotheconsumer(Stern

et al. 1985). Stern (2000) suggests that incentives and interventions interact, and thejoint effect of

combiningthemisoftenbiggerthanthesumofeachinterventiononitsown.

4.3. AppliancestandardsandbuildingcodesIf consumers indeed make biased decisions in their efficiency investment, and they do not take

operating cost into consideration, then appliance standards may be welfare enhancing. Mandatory

appliancestandardscandefinetheminimumenergyefficiencystandardthatwillberequiredbylawfor

agivenappliance.Buildingcodeswoulddefinecertainminimumefficiencycharacteristicsthatbuildings

shouldhave.Inessence,consumerswillnotbeabletochoose inefficientappliancesorhomes,asthey

will not be on the market. Mandatory standards and codes will encourage manufacturers to provide

better

energy

efficiency

in

the

context

where

it

is

not

the

most

salient

feature

for

consumers

(DEFRA

2010).

Koomeyetal.(1999)foundthateachdollarofU.S.federalexpenditureonimplementingtheappliance

energyefficiencystandardscontributed$165ofnetpresentvaluedsavings to theU.S.economyover

the1990to2010period.Theyestimatedtheaveragebenefit/costratiosfortheseefficiencystandards

tobeabout3.5 fortheUSAasawhole.Howeverhouseholdsthatare lowapplianceusersmayprefer

lessefficientappliances,andsufferwelfarelosseswhenstandardsareimposed(Morss1989).


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5. PublicGoodsandPro-EnvironmentalBehaviourSupporting

green

energy

and

combating

global

warming

is

apublic

good.

Behavioural

economics

can

helpunderstandwhyandunderwhichcircumstancesindividualsarewillingtocontributetothesepublic

goodsvoluntarily.Thesecontributionsmaybemonetary(i.e.whenindividualspayapremiumforgreen

energy)ornonmonetary(i.e.whenindividualsactproenvironmentallybutsacrificetheircomfort).

5.1. ProvisionPointMechanismsandGreenEnergyBehaviouraleconomicsclaimsthatmany individualsareconditionalcooperatorsandvalue fairness.

Individualswouldbewillingtocontributetopublicgoodsiftheyknowthatothersdonotfreerideand

also

contribute

(this

is

what

a

tax

system

can

achieve

formally).

In

essence,

the

difference

between

a

behaviouralexplanationandatraditionalexplanation is thatunder the former, individualsdonot

wanttofreeride,theyarejustconcernedthatothersdoandthinkthatthisisnotfair;underthelatter,

individualshaveaninnatetendencytofreeride,andthatwillbethecaseevenifotherscontribute.

Moskovitz (1992, 1993a, 1993b) argued that customers would voluntarily sign up and pay higher

electricityratesiftheadditionalmoneycollectedwereearmarkedtosupportrenewableenergyprojects

andenvironmentalactivities.Sincethen,utilitiesinmanyjurisdictionshaveofferedgreenenergytariffs.

These green tariffs represent a contribution to public good. If individuals are indeed willing to make

voluntary contributions, public policy may harness this tendency through devising mechanisms that

makethese

contributions

more

likely.

Public economics has dealt with the problem of underprovision of public goods through such

mechanismsastaxes,andprovisionpointmechanisms(PPMs).UnderPPMs,individualsmakevoluntary

contributionstoaproject,withdisclaimerthatifthenecessarybenchmarkamountisnotcollected,the

contributionswillberefunded.Rondeauetal.(2005)comparedthevoluntarycontributionmechanism

(VCM)withthePPMinthelaboratoryandinasmallfieldexperiment,andfoundthatthePPMwasable

to achieve higher contributions. Traverse City Light and Power in Michigan, USA, successfully built a

windmillusingthismechanism(Holt1996a);thecityofFortCollins inColoradoraisedmoneyforthree

separatewindturbinesusingit(Holt1996b).

Roseetal.(2002)usedlaboratoryandfieldexperimentstotesttheuseofaPPMtofinancearenewable

energyprogramrunbyNiagaraMohawkPowerCorporation intheUSA.Inthe laboratoryexperiment,

the PPM increased the rate of participation in a green energy program substantially above that of a

treatmentgroup.WhenthePPMwastestedinthefield,signupratesobservedweremuchhigherthan

thosefromothergreenpricingprogramsthatsolicitvoluntarycontributions.

Oneoftheproblemswithsellinggreenenergy insomejurisdictions(suchastheUK) isthatofproving

additionality.Fixedtargetsforgivenquantitiesofrenewablessetbythegovernmentmeanthatbuying

greenelectricitysimplyassignsrenewableoutputthatwouldhavebeenforthcominganywaytoagiven


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groupofcustomers.Thisisbecauseallcustomerswillbemadetopayfortherenewableenergyanyway,

regardlessofwhetheranymakevoluntaryorconditionalcontributions.

5.2. CrowdingOutIntrinsicMotivationBehaviouraleconomicssuggeststhatifindividualsaremotivatedbythewarmgloweffect,thengiving

monetary incentives would decrease their motivation for contributing to public goods. On the other

hand, if individualspayafineforbehaviourthatdiminishespublicgoods,their intrinsicmotivationfor

avoidingthisbehaviourmaybereduced.Thiscrowdingouthypothesisisintellectuallyappealing,but

sofarfewstudieshavedemonstratedthiseffectempiricallyinthecontextofenergy.

Jacobsenetal.(2010)usebillingdataofparticipantsandnonparticipantsinagreenelectricityprogram

in Memphis, Tennessee. They find that households participating at the minimum threshold level

increaseelectricityconsumptionby2.5%afterenrolling intheplan.Theyexplainthiswiththebuyin

mentalityofthesehouseholds.Householdsguiltofgeneratinghighemissionsisreducedbybuyinginto

green electricity at the minimum threshold, and payment for green electricity crowds out their

motivation to reduce energy consumption. However, the effect was not large enough to offset the

environmental benefit of paying for green electricity. Therefore the net effect was a reduction in

emissions.

5.3. VoluntaryContributionsandPublicImageIndividuals

may

be

more

likely

to

provide

public

goods

if

their

contributions

are

publicly

acknowledged.Thustokengifts(i.e.pins,mugs,andstickers)giveninexchangeforthecontributionare

onewaytoencourageprovisions.

Yoeli(2010)conductedalargescaleexperimentincollaborationwithPG&E,aregulatedinvestorowned

utilityinNorthernCalifornia.Consumersweresent lettersinvitingthemtovolunteertoinstalladevice

intheirhomesthatwouldallowtheutilitytocontroltheirairconditionerswhenelectricitysupplywas

tight.Volunteershadtosignupfortheprogramonasheetthatwasdisplayedpubliclynearmailboxes.

Thetreatmentgroupofhouseholdswasrequestedtowritetheirnamesonthesignupsheet,whilethe

controlgroupofhouseholdsprovidedaunique,anonymousnumerical identifier.Householdsthathad

to

provide

full

identity

information

had

a

higher

signup

rate

(however,

the

difference

was

not

statisticallysignificant).

5.4. PublicAppealstoConserveEnergyWhenincreasingpricesisconsideredsociallyorpoliticallyunacceptable,governmentshaveoccasionally

resorted topublic appeals through themassmedia to induceenergyconservation. In theabsence of

price signals, traditional economics would not expect public appeals to change behaviour, because

individualswouldhavealreadyoptimizedtheirconsumptionchoicesforthegivenprice(andwouldfree


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rideonotherscontributionstothepublicgoodofavoidingblackouts).However,behaviouraleconomics

suggeststhatpublicappealsmayresultinincreasedawareness,andmayinducealtruisticallymotivated

individuals to conserve more energy. In addition, some behavioural economists postulate that public

appealsaffectsocialnorms.

Reiss and White (2008) used householdlevel data on energy conservation in California during theenergycrisisof20002001.Dataconsistedofa fiveyearpanelofSan Diego Gas & ElectricCompany

households utility bills. The sample consisted of 70,000 accounts. The prices increased sharply as a

responsetothecrisiselectricitypricesmorethandoubled inaspanofthreemonths.Asaresult,the

averagehouseholdelectricityuse fellmore than13% in60days.Following the initialprice increases,

prices were rolled back and capped, and consumption rebounded to former levels. Subsequently, to

avoid blackouts, the government used televised public appeals to urge households to reduce energy

consumption.

Public

appeals

were

accompanied

by

energy

saving

advice.

Public

appeals

resulted

in

a

7%

decline in energy use over six months. It should be noted that the households in California had

heightenedawarenessoftheconsequencesofenergyshortages.Electricitypriceshaddoubled intheir

recent memory. Therefore increasing prices was a credible threat for the consumers, and may have

madethemmorereceptivetosocialappeals.

IEA (2005)providessome internationalcasestudieswherepublicappealsweresuccessful in reducing

energyconsumptionquickly.Someofthesuccessfulsolicitationstoreduceenergyoccurred in2001 in

NewZealand,Australia,andBrazil,asaresultofshortfallscausedbydrought.AtthebeginningofNew

Zealands 2001 shortfall, the government calculated that blackouts could be avoided if everybody

reducedtheir

consumption

10%

for

10

weeks.

Thus

10

for

10

became

the

goal.

The

government

distributed advice on how to obtain those savings but gave no incentives towards more efficient

equipment or reduced bills. New Zealand employed public appeals through many extremely short

remindersontelevision.Theconservationgoalwasreachedwithin6weeks.

IEA(2005)statesthatwhileapriceincreaseisthefirstbestscenariotodealwithshortfalls,itmaynotbe

politicallyfeasibleintheshortrun.Indesigningsuccessfulpublicappealstoreduceelectricityquickly,it

is importanttoeducateconsumers,raisingtheirawareness,andmakingconservationamatterofcivil

duty or prestige. This is particularly important inelectricity markets where richer, less pricesensitive

consumers, by not reducing their consumption in a time of crisis, impose a negative consumption

externalityon

the

poor.

This

is

in

contrast

to

most

markets

where

consumption

of

the

rich

creates

a

positive consumption externality for the poor by allowing economies of scale to be exploited in

productionandfacilitatingincreasedcompetition.

5.5. PublicPolicyInstrumentsandEnvironmentalMoralsWhen economic activity has a negative externality, traditional economics suggests that following

instrumentscanbeusedtocurbtheextentofharmfulbehaviour:taxes,restrictions(i.e.quotasorbans)

and tradable permits. Taxes will discourage the harmful behavior through increasing its price, while


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quotasdiscouragethebehaviorthroughrestrictingthequantityofthebadallowedoravailable.Taxes

levied on the activity that generates negative externalities are called Pigovian taxes, and have

traditionallybeenappliedtogoodssuchascigarettesandalcohol,ortoactivitiessuchaspollution.With

tradablepermits, theoverallallowable levelofactivity isestablished,andthepermits forthisactivity

areallocated toentities (usually firms).Theseallowancescanbe traded, sothat theentitieswith the

lowestmarginalcostsofreducingtheactivitytowardstheallowable levelwillbetheonesthatdoso.

Tradable allowances have been used to regulate fisheries and air pollution (Frey 2005; Tietenberg,

2003). Traditional economics assumes that the difference among these three policy instruments is

purelyintermsofeconomicandadministrativeefficiency.

Psychologistsarguethatanother importantdistinctionbetweenthese instruments isthattheyvaryto

the extent that they send the signals that crowd out intrinsic motivation. Frey (1999) calls intrinsic

motivation forproenvironmentalactivityenvironmentalmoral.Heargues thatboth tradablepermits

andtaxes

will

have

two

opposing

effects

on

consumers

an

increase

in

price

of

activity

will

discourage

behavior,butintrinsicenvironmentalmoralwillalsogodownasaresult(crowdingout).Hearguesthat

environmentalmoralwillbereducedbytradablepermitsmorethanbytaxes:tradablepermitsmaybe

viewedasbeingsimilarto indulgencessold forsins intheMiddleAges (Goodin,1994).Thesepermits

mayconveyimpressionthatitisacceptabletosinaslongasonepaysthepriceforit.Freyalsoproposes

thatbothlowandhighenvironmentaltaxesaremoreeffectivethanmediumleveltaxes.Hearguesthat

withlowtaxes,consumersmayfeelthatprotectingenvironmentissomethingthathastobedonefrom

moral obligation. On the other hand, high environmental taxes make harmful behavior prohibitively

costly and dominate the crowdingout effect. Meanwhile medium environmental taxes result in

crowdingout intrinsic motivation,butare insufficient to cause reduction inbehavior due toextrinsic

motivation.

Withtheclimatepolicythenegativeactivitytobecurtailediscarbonemissions.Taxes,restrictionsand

tradablepermitsareusedasclimatepolicyinstruments,oftensimultaneously.EuropeanUnionhasthe

largesttradableemissionsschemeintheworld(EUETS).Sofar,tradablepermitshavebeenassignedto

the businesses, but not to final consumers. On the other hand, consumers in manyjurisdictions are

subjecttocarbonpricesdirectly(effectivelyataxonemissions)andquotasindirectly(throughemissions

standards).Unfortunately,theevidenceofcrowdingoutenvironmentalmoralduetothesignalingeffect

of taxes and tradable permits has not been evaluated empirically, but studies have established the

existenceofthephenomenoninthelaboratoryandfieldexperiments(FreyandJegen2001;Decietal.

1999).However,

its

relevance

to

the

actual

behavior

of

consumers,

as

well

as

the

magnitude

of

the

effectremainsyettobedetermined.Meanwhile,publicperceptionoftheeffectoftheseinstrumentsis

relevant for the political economy of public policy. To the extent that the public (particularly pro

environmental activists) perceive that taxes and tradable permits are morally inferior because they

seemtosanctionpollutionandemissions,governmentmay findpoliticallyharderto implement these

mechanisms.


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6. ConcludingRemarksEconomics

studies

how

agents

interact

and

allocate

limited

resources.

In

essence,

economics

is

about

behaviourbydefinition.Thetraditionaleconomicsdiscipline isbasedonbehaviouralassumptionsand

axiomswhichallowmodelstoexplainthekeyphenomenaofinterestparsimoniouslybutwithsufficient

clarity and accuracy. What is referred to as behavioural economics is the modification of traditional

assumptions by drawing insights from psychology. Normally, behavioural economists start from

observationsofhow individualsactuallybehaveandthenshowhowthisbehaviourviolatestraditional

assumptions.Researchers thenproceedtooffermodelsbasedonalternativeassumptions thatbetter

match theobservedphenomena.Behaviouraleconomics isagrowingand thriving field,butthereare

sometheoreticalandempiricalgaps,manyofwhichwerementioned inthissurvey.Belowwediscuss

someofthefuturedirectionsforbehaviouraleconomicsingeneral,anditsapplicationtoenergypolicy

inparticular.

Technological

innovations,

such

as

smart

meters

and

smart

appliances

(and,

in

the

future,

widespreaduseofelectricvehicles)providenewways tostudyhowconsumerbehaviour responds to

monetaryandnonmonetaryinterventions.

Theoreticalandempiricalworkaimedatsortingouttheinteractionsofvariousbehaviouralphenomena.

Behaviouralstudiesuncoveranomalies inbehaviourthatare inconsistentwithneoclassicaleconomics.

However,theseanomaliesareoftenstudiedonanadhoc,casebycasebasis.Synthesizingbehavioural

anomalieswithinaconsistent frameworkwouldbewelcome.Someof thequestions thatneed tobe

addressed are the following: How do we disentangle behavioural explanations from conventional

information effects? What are the interactions between the alternative behavioural insights and

betweenbehavioural

failures

and

market

failures?

For

example,

how

do

loss

aversion

and

hyperbolic

discount rates interact? Sorting out these interactions will be important in designing the optimal

packageofbehaviourchangeinducingmeasurestoreduceorshiftenergyconsumption.

Increased reliance on empirical research and impact evaluation. A lot of behavioural work has been

basedonexperimentalstudies.However,ultimatelyeconomics isconcernedaboutactualbehaviourin

markets, and some of the behavioural failures may no longer hold in a real market setting where

behaviouralanomaliescancelout.Itis importanttoconductempiricalstudiesinordertouncoverhow

relevantbehaviouralanomaliesaretothewaythemarketsworkinnonidealconditions.Thereseemsto

be good scope for linking experimental work with empirical trials to see the extent to which strong

experimentalresults

can

be

reproduced

in

fieldwork.

Studyoflargescaleinterventions.Alotofbehaviouralresearch,bothinexperimentalandfieldsettings,

hasbeencarriedoutonsmallsamplesizes.Thisraisestwoconcerns:Howscalablearetheinterventions,

and even if behavioural anomalies do exist, do they represent fundamental departure from the way

individualsmakechoices,orisitonlyaboutthetailsofthebehaviouraldistribution?Iftheobservation

is only regarding the tails of the distribution, how thick are the tails (Shogren et. al. 2008)? What is

needed is much more attention to whole population interventions (i.e. the general rollout of smart

meters)ornaturalexperiments(suchastheNewZealandscampaignforelectricitydemandreductionin


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2001). Conducting randomized, controlled experiments involving largescale interventions would help

provide answers to these questions. Widespread useof smart meters will make this sort of research

mucheasiertoimplementinthefuture.

Increasedstudyof the relationshipbetweenshortrunand longrunbehaviouralchanges.Whileshort

runbehaviouralchangesmaybeextremelyusefuland important inenergy,thereare important issues

todowithwhethercertainbehaviouralchangescanbesustainedoveraprolongedperiod.Withenergy

consumption this may be important in designing the school curriculum with a view to increasing

awarenessofenergyconservation,orinkeepingeffectiverepeatedinterventionsaimedatdealingwith

successiveshortrunenergyshortages.Moststudiesofenergyconsumptionbehaviourdonotresample

behaviouroveraprolongedperiod,butclearlytheremaybeopportunitiestodesignstudiestomonitor

theeffectsoflongterminterventionsinthefuture.

Integratingbehavioural economicswithin theframework of traditional economics. While behavioural

economics provides insights about the way decisions are made, some of the departures from

neoclassicaleconomicsarehardtoreconcilewithinthetraditionalframework.Forinstance,howdowe

evaluate the impacts of policy if we cant make neoclassical assumptions about discounting? If

individualsarereallyselfconflictedintheirevaluationofcostsandbenefitsovertimethenwhat isthe

rationaleforthepolicymakerstocatertotheirfarsightedselvesratherthantheirnearsightedselves?

Whilehyperbolicdiscountingisintellectuallyappealing,itmakesequilibriummodelsintractable.Further

theoreticalworktoreconcilethesedifferencesisneeded.Institutionaleconomics(followingNorth1990)

includesthestudyofthe impactoflongrunbehaviouraldifferencesbetweeneconomicagents.Itmay

bethat

behavioural

economics

is

away

of

understanding

how

short

run

behaviour

can

be

changed,

whileinstitutionaleconomicsstudieshowlongbehaviouraldifferencescanbesustainedviathecreation

ofappropriateinstitutions.Thusunderstandingtheprocessofinstitutionalizingbehaviouralchangemay

allowareconciliationofmoretraditionaleconomicswithbehaviouraleconomics.Thismaybeimportant

insuggestingwaysinwhichdifferencesinenergyconsumptionpercapitacurrentlyattributedtovaguely

definedinstitutionaldifferences(suchasbetweentheUKandDenmark)canbenarrowed.

Behavioural economics can provide valuable insights on how individuals make their decisions. These

insightscanbeusedtoincreaseeffectivenessoftraditionalinterventionsinenergypolicy.However,itis

important that behavioural interventions do not crowd out more effective traditional interventions

(Loewensteinand

Ubel

2010).

Behavioural

economics

should

complement,

not

substitute

for,

more

substantiveeconomicinterventions,suchasthosebasedoninfluencingenergypricing(e.g.viataxation)

orenergyinvestment(e.g.viasubsidyschemes).

Tocomebacktowherewebegan,behaviouraleconomicsseemsunlikelytoprovidethemagicbulletto

reduceenergyconsumptionby the magnitude requiredby the IEA (2010) recommended450 climate

policy scenario. However it does offer exciting new suggestions as to where to start looking for

potentiallysustainablechanges inenergyconsumption. Italsomaybethat itsmostusefulrolewithin

climatepolicy is inaddressing issuesofpublicperceptionof theaffordabilityofclimatepolicyand in


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22

facilitatingthecreationofamoreresponsiveenergydemand,bettercapableofrespondingtoweather

inducedchangesinrenewableelectricitysupply.


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23

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Role of Behavioural Economics in Energy and Climate Policy