Markets for energy-using equipment are marked by a seeming anomaly: households and firms routinely pass up investments in energy-efficient technologies yielding rates-of-return well above those available on standard financial instruments. Market participants reveal high "implicit discount rates" in their evaluations of the costs and benefits of energy efficiency (Ruderman et al., 1987). Technology analysts point to the observed efficiency gap - the difference between the level of energy efficiency actually achieved and the level judged cost-effective by standard financial criteria - as clear evidence that real-world markets deviate from the ideals of Pareto efficient resource allocation. Since "market barriers" prevent the adoption of cost-effective energy-saving technologies, government presumably should intervene with equipment performance standards, demand-side management programs, and related policy measures (Carlsmith et al., 1990).
Economists as a group are broadly skeptical of such claims. Empirical studies purporting to demonstrate the existence of the efficiency gap have been challenged on methodological grounds, and the notion of "market barriers" has been questioned in light of economic theory (Sutherland, 1991). The claim that consumers reveal high discount rates in evaluating the costs and benefits of energy-using technologies, for example, is seemingly at odds with the hypothesis of utility maximization. Principles of rational behavior suggest that investors should evaluate alternative investments at a common discount rate, equated with the market rate of interest on standard financial instruments such as government bonds. However, potential investors might rationally demand high rates of return on risky assets. Accordingly, high implicit discount rates might reflect the perceived risk of efficiency investments - an explanation consistent with the hypothesis of efficiently structured markets.
With this in mind, the argument that high discount rates imply a need for policy intervention requires further justification. Although technology analysts generally frame their arguments in informal terms, they in fact already have taken a first step toward that justification. The market barriers typically discussed in the literature point to a range of factors that one might interpret as well-defined market imperfections (Carlsmith et al., 1990; Schipper et al., 1992; Krause, 1993). Consumers appear to be poorly informed concerning the net benefits of energy efficiency, and institutional factors forestall presumably desirable transactions. Behavioral studies suggest that people use rules of thumb that deviate from the norms of substantive rationality and thus bias their decisions against energy-efficient technologies (Kemp ton and Montgomery, 1982; Kempton and Layne, 1994; Sanstad and Howarth, 1994a).
II. ENERGY EFFICIENCY: MEASURING THE GAP
Economists sometimes argue that evidence on the costs and benefits of energy efficiency is derived using "engineering" techniques, implying that the results are necessarily suspect. However, the economic reasoning on which the results are based is conceptually straightforward: the main criteria are net present value and life-cycle cost. If consumers and firms render decisions in a fully rational manner and if markets are free from imperfections, then only cost-effective energy-efficient devices - those that minimize life-cycle costs at prevailing prices and interest rates - will be implemented under laissez faire conditions. Otherwise, it would be possible to find an alternative resource allocation providing higher levels of energy services - the flow of tangible and intangible benefits derived from energy-using devices - without offsetting reductions in the provision of other goods. Alternatively, society could maintain the level of energy services while increasing expenditures on other items.
Implicit discount rates are a test criterion used to evaluate the effectiveness of individual decisions or observed market outcomes. …