Discussion Paper

Energy Efficiency Policy: Surveying the Puzzles

Jul 6, 2011 | Timothy J. Brennan


Promoting energy efficiency (EE) has become a leading policy response to greenhouse gas emissions, energy dependence, and the cost of new generators and transmission lines. Such policies present numerous puzzles. Electricity prices below marginal production costs could warrant EE policies if EE and energy are substitutes, but they will not be substitutes if the energy price is sufficiently high. Using EE savings to meet renewable energy requirements can dramatically increase the marginal cost of electricity. Rejecting "rationality" of consumer energy choices raises doubts regarding cost–benefit analysis when demand curves may not reveal willingness to pay. Decoupling to guarantee constant profit regardless of use contradicts findings that incentive-based mechanisms outperform cost-of-service regulation. Regulators may implement EE policies to exercise buyer-side market power against generators, increasing consumer welfare but reducing overall economic performance. Encouraging utilities to take over potentially competitive EE contradicts policies to separate competitive from monopoly enterprises.

Energy efficiency—using less energy to get the same level and quality of service from an appliance or machine—has long been a favored policy option of those concerned with energy-related emissions (including greenhouse gases), energy security, and helping consumers save money by reducing spending on electricity, gasoline, or other fuels. In arguing for the merits of energy efficiency, particularly regarding electricity use, its proponents often make a number of presumptions, such as the following:

  • More energy efficiency means less energy use.
  • Energy efficiency can be combined with renewable fuel policies to reduce fossil fuel use.
  • Policy rationales support energy efficiency when consumers fail to appreciate that the savings from reduced energy use more than make up for the initial costs of energy-efficient technology.
  • Economic arguments favoring energy efficiency support “decoupling” utility revenues from use.
  • Using energy efficiency to reduce the need for new power plants benefits the economy as a whole.
  • Electric utiities should be the leaders in implementing energy efficiency.

In a new RFF Discussion Paper, Senior Fellow Tim Brennan shows that, in fact, each of these presumptions either fails to hold in general or creates a puzzle regarding how to evaluate the merits of energy efficiency policies. Not only might energy efficiency lead to more energy use by reducing operating costs, but if energy prices are sufficiently high, this energy-increasing effect will be observed. Using energy efficiency savings to meet renewable use requirements may have unintended and perverse consequences. Standard methods for evaluating policies, based on inferring value from consumer choices, become inapplicable if consumers make mistakes in their energy efficiency decisions. 

Brennan notes that politics, rather than economics, may drive interests in the last three presumptions listed. Economic arguments for decoupling are weak and overwhelmed by the fact that preserving utilities’ profits keeps them from opposing energy efficiency legislation and regulations. Energy efficiency policies could be a tool by which regulators drive down the price of fossil-fuel generated electricity below competitive levels, benefiting consumers but with greater costs to the economy as a whole. Finally, although many see electric utilities as the engines behind economic benefits resulting from energy efficiency, allowing them to lead contradicts long-standing principles limiting the role of regulated monopoly utilities in sectors (such as energy efficiency) that seem promising for entrepreneurs in open competition. The rationale for handing energy efficiency to utilities, says Brennan, may be that legislators can avoid having to raise rates to pay for subsidies and other initiatives, leaving the burden of cost recovery to regulator-approved electricity rate increases.