Discussion Paper

Energy Efficiency Economics and Policy

Apr 4, 2009 | Kenneth T. Gillingham, Richard G. Newell, Karen L. Palmer


Energy efficiency and conservation are considered key means for reducing greenhouse gas emissions and achieving other energy policy goals, but associated market behavior and policy responses have engendered debates in the economic literature. We review economic concepts underlying consumer decisionmaking in energy efficiency and conservation and examine related empirical literature. In particular, we provide an economic perspective on the range of market barriers, market failures, and behavioral failures that have been cited in the energy efficiency context. We assess the extent to which these conditions provide a motivation for policy intervention in energy-using product markets, including an examination of the evidence on policy effectiveness and cost. While theory and empirical evidence suggest there is potential for welfare-enhancing energy efficiency policies, many open questions remain, particularly relating to the extent of some of the key market and behavioral failures.

Energy efficiency and conservation have long been critical elements in the energy policy dialogue—and have taken on renewed importance with intensified concerns about global climate change and energy security. Many analyses find that demand reductions from improved efficiency can be extremely cost-effective ways to address these issues.

There is lack of agreement, however, on the appropriate role for policy to spur investment in efficiency. A new RFF Discussion Paper by RFF Senior Fellow Karen Palmer with Kenneth Gillingham and Richard Newell* summarizes what is known about the role for energy efficiency policy and identifies priorities for additional research on the topic.

  • Market failures provide one justification for policy intervention and the authors review commonly cited ones including:
  • Energy market failures such as environmental externalities and average-cost electricity pricing.
  • Capital market failures due to liquidity constraints.

Innovation market failures resulting from firms' inability to capture the full benefits from efficiency investments because of information spillovers.
Information problems such as principal-agent issues and learning by using.
Many of the commonly cited market failures are not unique to energy efficiency, and addressing them tends to call for a much broader policy response, such as an economywide price on greenhouse gases or electricity market reforms moving toward marginal cost pricing.

The available evidence also suggests that systematic biases or "behavioral failures" may exist in consumer decisionmaking that could lead to overconsumption of energy and underinvestment in energy efficiency. There is a growing body of research on consumer decisionmaking, but the empirical literature testing behavioral failures specifically in the context of energy decisionmaking is very limited.

The authors review the literature evaluating actual efficiency programs and find that evidence for their past effectiveness is mixed. They conclude further research is essential to clarify the potential for energy efficiency polices to increase economic efficiency. Areas that would greatly benefit from further research include:

  • Studies of historical effectiveness and cost of energy efficiency policies.
  • Improving ways to account for consumers who would have invested in energy efficiency or conserved energy absent the policy.
  • Analysis of how behavioral failures affect energy decisionmaking.