Are Energy Efficiency Standards Justified?

This paper develops and parameterizes an overarching analytical framework to estimate thewelfare effects of energy efficiency standards applied to automobiles and electricity-using durables. Wealso compare standards with sectoral and economywide pricing policies. The model captures a wide rangeof externalities and preexisting energy policies, and it allows for possible “misperceptions”—marketfailures that cause underinvestment in energy efficiency.Automobile fuel economy standards are not part of the first-best policy to reduce gasoline: fueltaxes are always superior because they reduce the externalities related to vehicle miles traveled. For thepower sector, potential welfare gains from supplementing pricing instruments with efficiency standardsare small at best. If pricing instruments are not feasible, a large misperceptions failure is required tojustify efficiency standards, and even in this case the optimal reductions in fuel and electricity use arerelatively modest. Reducing economywide carbon dioxide emissions through regulatory packages(combining efficiency and emissions standards) involves much higher costs than pricing instruments.

From ramped-up efforts to improve the efficiency of home appliances to mandates requiring a net fleet-wide fuel economy increase in the coming years, efficiency standards are shaping up to be a golden child of U.S. energy policy. But with a slew of other options on the table to reduce energy consumption and carbon dioxide emissions—such as carbon taxes, emissions trading schemes, and emissions intensity standards—are efficiency standards the most efficient policy option?

In “Are Energy Efficiency Standards Justified?” authors Ian W.H. Parry, David Evans, and Wallace E. Oates take a closer look at the economic arguments for efficiency standards. According to the authors, there are two main economic rationales for energy efficiency standards applied to automobiles or electricity-using durable goods: creating environmental benefits and addressing the possibility that consumers might not fully grasp future energy savings from improved efficiency.

The problem with using efficiency standards to mitigate pollution, especially that from carbon dioxide emissions, according to the authors, is that efficiency standards are an inferior policy instrument compared to energy or emissions taxes, because they exploit fewer options for reducing emissions. Unlike fuel taxes, for example, fuel economy standards do not encourage people to save on gasoline by driving less, and appliance standards do not encourage electricity providers to alter their fuel mix to reduce carbon intensity.

Efficiency policies may work to address the so-called energy paradox—the observed reluctance of energy users to adopt apparently cost-effective, efficient technologies. However, whether this reluctance reflects a market failure due to consumers undervaluing efficiency or whether it instead reflects hidden costs—for example, consumers preferring the quality if incandescent lighting to compact fluorescents—remains contentious.

The authors surmise that efficiency policies only make sense on economic grounds if there are large market failures due to consumer undervaluation. However, even in this case, they result in only modest reductions in energy use and emissions. Overall, pricing policies are much more effective, and much more cost-effective, at reducing energy use and emissions.