This post originally appeared on the Great Energy Challenge blog, in partnership with National Geographic and Planet Forward. 

John Maynard Keynes, a giant in modern economic theory, famously wrote, “Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits.”

This notion, laid out in his seminal book, The General Theory of Employment Interest and Money, was meant to push back on the notion that people behave in an purely economically rational manner, that many of our decisions are based not solely on a cool weighting of probable costs and benefits, but also on “spontaneous optimism” to act.

So professionally, we’ve known at least since Keynes wrote this in 1936 that sentiment and gut instincts drive a lot of our decisions. Score one for common sense.

Practically, what this means is that if people feel bad about their economic prospects, that “spontaneous optimism” is likely to be absent. This is why, for example, many of us think the Recovery Act was so critical. Cutting taxes can be a good way to get people to stimulate the economy: lower the cost of creating jobs, and businesses are more likely to create them.

But the decision to invest in a new factory doesn’t just depend on the cost of the investment, which lowering taxes can help reduce, but also on how much it’s expected to return. And when our animal spirits drive our expectations into the ground, cutting taxes is almost useless. If someone thinks there’s not going to be any market for widgets and that economic disaster might be right around the corner, then even completely eliminating the taxes on labor to make widgets or on the profits from selling them won’t be enough to get someone to build a widget factory.

A few weeks ago, I wrote about a report from Deutsche Bank that, among other things, outlined what they thought markets would need to see for clean energy investments to take off. Basically, they boiled it down to TLC: Transparancy, Longevity, and Certainty.

Last week, the Pew Charitible Trusts showed what happens when markets don’t see those things. Their report, “Who’s Winning the Clean Energy Race,” had some great news. In 2010, over $240 billion was invested in cleantech worldwide. That’s an increase of about 30 percent from 2009 levels. About $198 billion of that was in G20 nations (the 20 largest economies), an increase of 33 percent over 2009.

This is great news, of course, because it says something about the state of our global animal spirits. Coming off a terrible economic year in 2009, this shows that business sentiment is improving in clean energy industries and probably overall as well. No one is going to invest in new energy capacity if they think economies are going to continue their free fall. And significant amounts of those energy investments are going to clean alternatives.

The bad news, of course, is what’s happening in the U.S. After slipping from first place to second place in 2009, we fell again from second to third last year. 2010 was a decent year for clean energy investments in the U.S.: our $34 billion of investment was a 50 percent increase. And while it seems unlikely that we’ll fall to fourth behind Italy next year, there’s also very little chance that we’ll overtake either Germany or China to regain second.

The problem goes back to the absence of TLC in our clean energy policy. The Pew report highlights policies like renewable energy standards and feed-in tariffs as important drivers of clean energy investment. It shouldn’t be surprising that China is setting aggressive long-term targets for itself and that Germany pioneered the idea of feed-in tariffs which help guarantee economic returns to clean energy investments over the long haul.

How about the U.S.? We’re actually going backwards. Last year was a pretty good one, but a lot of that was driven by recovery spending, which is running out. Congress is looking for way to cut support for renewable energy and efficiency programs. The only predictable policy signal Congress seems willing to send clean energy markets at the moment is that they can’t count on predictable policy signals from Congress. Faced with these policy prospects, other markets just look a lot more promising for clean energy investments.

Put all of this together, and 2011 is looking a lot more like 2009 than 2010 of the U.S. clean energy industry. While the rest of the world is getting dressed up for the clean energy party, it looks like the U.S. is going to stay home and wash its hair. In the clean energy world, countries like Germany and China are the real party animals, while the U.S. runs the risk of becoming increasingly confused and dispirited.

It may be true, but domestic oil drilling won’t help.

It’s an unfortunate fact that stress has a way of making people crazy. At the moment, rising oil prices are creating a lot of stress.

One of the problems with our deep dependence on oil is that oil prices can (and do) swing wildly in relatively short periods of time. Between January 2007 and July 2008, the average price of crude oil paid by U.S. refineries went from about $51 to $129 per barrel, an increase of over 150 percent.

People, on the other hand, aren’t nearly so flexible. We don’t change where we live, work, go to school, or how we get to any of these places at anything like that pace. We can’t respond to a doubling of prices by cutting our use in half.

Oil prices are on the rise again, and generous people that we are, Americans are making sure we share our pain with our elected leaders. Rising oil prices lead to rising stress levels and an increasing reports of insanity on Capitol Hill.

The latest, of course, is the insistence that the administration and congressional Democrats are responsible for rising oil prices and that they should do something to stop it. Like increasing oil exploration and drilling in the Gulf of Mexico, the Arctic National Wildlife Refuge, and any other place that might have dead dinosaurs hiding beneath it.

I hate to admit it, but I have now been around long enough to have seen this cycle play out several times, and frankly, it drives me a little batty.

Despite the apparent simplicity of the “solution” that congressional Republicans are demanding (increasing supply seems like a reasonable way to reduce prices), it’s wrong in just about every way that matters.

Let’s review a few key oil facts:

Oil is sold in global markets: Oil tankers move across the oceans delivering oil to consumers not based on wind or currents, but on who is willing to pay the most. If you want to move oil prices in any one place, you must move them in all places simultaneously. The only way to reduce prices for U.S. consumers is either to get the rest of the world to lower the price they’re offering, or add enough supply to make a dent in global oil demand.

The U.S. can’t make a dent in global oil demand: Although we consume roughly 25 percent of global oil, the U.S. only sits on roughly 2 percent of global oil reserves. We simply don’t own enough oil to change market fundamentals.

Increasing supply in the short run hurts us in the long run: Our meager 2 percent of global oil reserves is unlikely to grow significantly over the long run, so every barrel we take out now is one less that we can take out in the future. In a House Energy and Commerce Committee hearing last week, Rep. Ed Markey (D-Mass.) put up the following chart showing that the U.S. is drawing down its reserves faster than any other major oil producing country:

I follow these things pretty closely, and I have to admit, I was a little stunned by these numbers.

In the exchange that followed, Markey asked Ed Caruso, head of the Energy Information Agency under George W. Bush, which countries benefit the most from rapid drawing down of our reserves. Caruso seemed as stunned by his own answer as I was by the numbers: “OPEC.”

Imagine two people sitting across from each other in a desert. One has a several barrels of water, the other has a canteen and lot of money. Now imagine the first watching as the second gulps down the contents of his canteen. What do we think is going to happen next? Someone’s going to get robbed, figuratively or literally.

Framing the problem as an “us vs. them” issue like this is a little misleading. While it’s true that government-owned oil companies in the Middle East or elsewhere could refuse to sell to countries they don’t like politically (they’ve done it before), the real enemy here is increasing global demand, stagnant global supply, and a fair bit of regional instability thrown into the mix. None of these things can be dealt with by pumping what little oil we have at a faster rate.

Every time this cycle of high oil prices comes along, we hear a lot about drilling more at home to reduce our dependence on foreign oil. But keep in mind that the price that American oil companies sell American oil to other Americans is determined by what’s going on not just in America but in every other country that either buys or sells oil.

So as soon as you hear these same people also call for a complete ban on both exports and imports, you’ll know they’re serious. Until then it’s just a political ploy (albeit a pretty successful one).

Or perhaps they might suggest that we spend a little bit of effort or even money on figuring out how to break our addiction to oil, no matter where it comes from.

Now that really would be crazy.

This post originally appeared on the Great Energy Challenge blog, in partnership with National Geographic and Planet Forward. 

Despite my seriously mixed feelings about the State of the Union speeches, I tuned in to this year’s speech for the first time in several years. Like many, I was disappointed if not surprised that President Obama didn’t mention climate change even once. Climate policy is hard sell in a down economy. I hope Mother Nature understands.

Less disappointing, and less surprising, is that he called for the economy to reduce our oil consumption. I’m sorry to be unimpressed, but when a Texas oil man turned Republican president can bemoan our “addiction” to oil, having anyone else do it seems a little passé.

Though he loses some style points, there is actually some merit in the substance of Obama’s proposal. As if having some actual substance weren’t innovative enough, he went one step further and displayed a remarkable degree of common sense in calling for an end to subsidies to oil companies.

It has long seemed to me, and others, that if we can’t bring ourselves to make oil companies pay for the environmental risks and costs their products impose on us, the least we could do is to stop paying them for the privilege.

So rather than talk vaguely about the need to reduce our oil dependence (as if we were all just going to stop driving to work and school) or disingenuously about the need to get off foreign oil (as if we could ever produce anywhere near enough oil to make a dent in our dependence on stable global oil markets), the president offered an approach that would at least get us started in the right direction, and if nothing else, would help cut the deficit, something politicians of all stripes could support, right?

One word of warning to the president: Finding these subsidies is a lot harder than you might think.

Not long ago, I helped the nice people at the Environmental Law Institute work on a project to identify and quantify federal subsidies to various energy industries. The end result was a very good report and this nifty graphic to go with it:

Environmental Law Institute

It turns out that the hardest part of the project was defining what a subsidy is. We wanted to be objective and clear, and to err on the side of being overly conservative. And while the “You know it when you see it” standard would have been much easier to apply, we came up with a working definition that defined a subsidy as a deliberate decision, action, or failure to act taken by the federal government that conferred some economic benefit on industry participants that directly and negatively impacted the federal budget. We measured the subsidy as the size of the budget impact (as opposed to the value conferred on the industry).

Equipped with a solid working definition, we still spent more time than I can remember debating what fit and what didn’t. What we found, which seems obvious in retrospect, is that the vast majority of subsidies don’t come in the form of government payments to industry, but rather the less obvious tweaks and exemptions to various tax laws.

Oddly enough, the largest, and most interesting subsidy to the oil industry that fit our definition was actually a slight change of a few definitions in Saudi Arabian tax law.

If you are an American company that has to pay income taxes to a foreign government, the IRS gives you a tax credit that essentially pretends as though you paid those taxes to the U.S. The idea is actually sound, because it avoids taxing the same corporate income twice. If you make money selling widgets in Canada, and the Canadian government treats those profits as taxable income, even though your company is American, then the IRS won’t make you pay taxes on those profits again.

However, if you have to pay some expenses in a foreign country, even to a foreign government, for operating licenses, for example, the IRS treats those as business expenses, just as it does with other costs of doing business, like labor or materials. In this case, companies can deduct those expenses from their income, reducing the amount of money they have to pay taxes on. With a corporate tax rate of 35 percent, every dollar a company can deduct from their income saves them 35 cents. As useful as this is, the tax credit is much more valuable, since every dollar of tax credit saves the company a whole dollar in payments.

All of this matters, because in the 1950′s, the Saudi Arabian and other Persian Gulf governments wanted to increase their share of oil revenues from U.S. based oil companies, and were considering raising their royalty payments. Royalty payments are like licensing fees that oil companies pay to the countries they drill in for the right extract the oil. The IRS treats them as a deductible business expense.

The U.S. State Department, eager to keep the Saudi government happy and the oil in the hands of U.S. companies, negotiated a deal whereby the governments would raise their royalty payments the companies had to pay them, but to reclassify them as income taxes. In the end, these governments collected more money from the oil companies, but the oil companies got a dollar-for-dollar reduction in their U.S. tax liabilities, so that the net effect was a reduction in U.S. tax revenues — to the tune of $15 billion total in just the years between 2002 and 2008 — while the oil companies themselves came out no worse, or perhaps slightly better off.

I highly recommend reading the whole paper, if only to emphasize the point that, much like the politics of the issue, defining and identifying energy subsidies is a far more convoluted undertaking than the common sense nature of the issue indicates.

This post originally appeared on the Great Energy Challenge blog, in partnership with National Geographic and Planet Forward. 

My last post on David Owen’s piece in the New Yorker and on the Jevons effect stirred up some interesting questions and discussion that I want to follow up on here. My last one purposely avoided some of the more technical parts of the issue to keep it readable and under my word limit. I think I’m about to undo that.

But first we should pay thanks to the great 20th century philosopher, Yogi Berra, from whom I shamelessly stole the title of this post. Though he discovered it nearly 100 years after Stanley Jevons, I believe his exploration of the Jevons effect is more complete and accurate than Jevons’ own, as well as being vastly shorter. The notion that we could get so efficient at using energy that we’d end up using more is about as valid as the idea that a restaurant could get so crowded that it was empty.

Dictating terms

Though I hate having arguments about how we should argue, there are a few things we need to get straight:

First, as originally observed and defined by Jevons, the Jevons effect is a decidedly micro issue. He observed that increased energy efficiency in coal-fired steam engines resulted in increased use of coal to fire steam engines as they were used in more applications and more intensively in existing ones.

Further, the central point of Jevons’ theory was that advances in energy efficiency forced increases in energy consumption. Not merely that consumption increased despite efficiency, but that efficiency caused the increase.

So, if you believe that energy consumption would have been higher without advances in energy efficiency then, by definition, you do not also believe in the Jevons effect.

Much of the debate around this, including the comments to my last post, seem to center around a weaker form of the Jevons effect, i.e. that energy efficiency can’t keep up with demand growth. This is a very different argument than the strict form of the Jevons effect.

The distinction is important, because more than once I have found myself arguing that the Jevons effect doesn’t widely exist, and demonstrating that with examples, only to have people say that Jevons doesn’t mean we shouldn’t invest in efficiency and that I’m missing the macro question, neither of which are consistent with the definition of the Jevons effect, at least in the strict form.

I believe it is this second argument, over the weaker form of Jevons that most people are really arguing about, which is really about the size of the rebound effect.

With this in mind, let’s take a look at the different potential sources of rebound.

Home economics 101

Looking first at household energy use (which is very different from using energy as a factor of production), I believe there is very little evidence for any Jevons effect.

Increased energy efficiency can often be treated as a decrease in energy prices, which can be broken down into two separate effects. The substitution effect and the income effect. When the price of any good falls, it frees up some amount of money we would have spent on it, essentially increasing disposable income (thus the name “income effect”). If consumption patterns don’t change, we would expect people to buy more of everything more or less proportionately.

Of course, falling energy prices do impact peoples’ consumption patterns. When energy prices fall, we tend to buy more of it because it is more affordable. This is the substitution effect. Because energy has become cheaper relative to other goods, we buy more energy and less of some other things, substituting one for the other.

For households, both these effects tend to be small. The substitution effect is small because energy is already so cheap that it tends not to influence our decisions to watch TV, use our computers, or put lights on. Most people have no idea how much it costs to run a TV (about five cents an hour), so owning a more energy efficient TV will have little impact on how much TV they watch.

The income effect also tends to be fairly small because (as you can see in this nifty graphic) the average household spends less than 12 percent of its income on gasoline and utilities (which here includes water, garbage, etc., as well as electricity). For the average household, if everything suddenly became 10 percent more efficient, energy would fall to 10.8 percent of their income, and their disposable income would go up by 1.2 percent. Energy consumption would rebound to about 10.93 percent (10.8 percent x 101.2 percent), producing an 11 percent rebound, far below the 100 percent needed for Jevons.

The places where you should expect the combined substitution and income effects to be large are where energy consumption is more of a luxury than a necessity. Using an air conditioner or heating our homes above a certain minimum level are good examples because when energy is expensive or the budget is tight, this is where people will economize. But, as I showed about air conditioning in my previous post, and Matt Kahn showed about driving in his, even for non-necessities, the Jevons effect is hard to find.

And admit it, while high gasoline prices might make you cancel the family road trip to the Grand Canyon this summer, nothing, not even free gasoline, could make you do it twice.

Industrious efficiency

For industry, the income effect is the fact that with the price of energy (more appropriately “energy services”) falling, they become more profitable on a per unit basis. This increase in profitability should lead to an increase in production levels, though how large is hard to know. If we make the conservatively high assumption that businesses plow all of the increased profits back into making product, we can do the same type of calculation as we did for households. In 2006 (the most recent data available), energy consumption made up just over 3 percent of total input costs in the manufacturing sector (labor was about 21 percent). So, by the same calculation as above, the income effect would create a very small rebound effect: a 10 percent increase in operating efficiency in the manufacturing sector would result in a 9.7 percent reduction in energy use, a 3 percent rebound.

The substitution effect is even smaller in industry. Though we can often think of increases in efficiency as reductions in energy prices, that’s really just a form of intellectual shorthand. Increases in industrial end-use efficiency typically result from things like investments in more efficient equipment or higher expenditures on labor for operations and maintenance. These represent substitutions of physical capital and labor for energy in the industry’s production process. Because increasing expenditures on labor and machinery are what cause the cost savings in energy, firms can’t take advantage of this efficiency by shifting expenses b
ack to energy. That would undo the savings they created in the first place.

And all of this is supported, if not proved, by actual data. Again, I can’t let Owen (remember him? He started all this) off the hook for laziness. All of this is easily accessible from the DOE’s Manufacturing Energy Consumption Survey and BEA’s Input Output tables. I took a look at some of the heavier and more intensive industries, ones that would be most sensitive to energy prices and most likely to show large rebounds or even a Jevons effect. Between 1998 and 2006 (the periodicity of some of the data is a little odd), here is what I found:

This shouldn’t be surprising to anyone: Energy efficiency leads to reduced energy use, with some rebound. The pattern is consistent across the manufacturing sector. Despite a 26 percent increase in GDP and a 7 percent increase in manufacturing output over that time period, both energy intensity and energy use fell for the sector as a whole and for almost all of the sub-sectors that I looked at. Try it for yourself.

So you’ll have to pardon my incredulity when I hear people like Owen claim that Jevons effects are everywhere, because everywhere I look, I can’t find them.

Some of the whole and all of its parts

A final word about the macro question. There is nothing particularly magical about the macroeconomy, it is merely the sum of all the micro parts. If we can’t find a Jevons effect in all the individual places we look, it will continue to be absent if we sum them all up.

The one exception to this is the question of productivity. If energy efficiency increases overall productivity (it does), which in turn accelerates economic growth (it should), then there is a third source of rebound effect that won’t show up in the income or substitution effects I describe. A self-fulfilling income effect, perhaps.

This is tough to address in a few words (or even in many), because it links back to very technical questions of multi-factor productivity and the like. But looking at past increases in gasoline prices, history shows that for every 1 percent increase in gasoline prices, GDP tends to decline about 0.05 percent, so that a doubling of gas prices might knock a half a point off of GDP. If we’re willing to assume that this is at least the right neighborhood for all energy types and that the response to a reduction in prices would be about as large as it is for an increase in prices (and there are good reasons to doubt this), then this productivity effect would still be pretty small. A 1 percent across the board increase in energy efficiency might produce an increase in GDP of 0.2 percent (not insignificant given historic annual growth rates in the 3 percent neighborhood). This, in turn, would lead to an increase in energy consumption of slightly less than the same relative magnitude, a rebound effect of less than 20 percent.

Putting all of these things together, you the most you can reasonably expect is a total rebound effect of 30 percent under some pretty generous assumptions. Combine this with income growth caused by other things, population growth, and other factors, and the gains from efficiency can get buried in the weeds. All that’s really clear is that for significant periods, energy efficiency has not increased fast enough to cause energy use to go down.

But, and this is the key point, this is not the same as saying, and it does nothing to justify saying that efficiency can’t grow fast enough to reduce overall energy use. That is exactly as valid as saying that nuclear power can never reduce our use of fossil fuels, because even when we made large investments in nukes, fossil use still increased. I’ll have plenty more to say about nukes later, but nuclear advocates would rightly respond that this is proof only of the fact that our investments in nuclear were not large enough to offset increases in electricity demand. The same is true for efficiency. If efficiency investments have never forced energy use to decline, that’s proof only that we, as a nation, have never really given it a try.

So while there may be many good reasons to go to a crowded restaurant, being alone isn’t one of them.

Let’s talk rebound.Photo: Ryan Fung

Energy efficiency has become very popular in recent years. So much so that it’s becoming cool for the truly hip to hold it in disdain.

Case in point: David Owen’s piece in this week’s New Yorker: “The Efficiency Dilemma” [$ubreq].

It reads like he’s being contrary just for the sake of being contrary. I don’t want to make a habit of highlighting this type of work, and to do a thorough job of dismantling the piece would take more time and space than I have. But it generated some genuinely interesting conversations in my email this week and I have a hard time letting such poor and frankly lazy reasoning pass without comment.

As a compromise, I’ll try to focus more on the serious issues in the article, and less on the serious issues I have with the article itself. Wish me luck.

The focus of the article is something called the Jevons paradox (named after economist William Jevons), or the more common and more broadly defined “rebound effect.” In essence the rebound effect is the fact that as energy efficiency goes up, using energy consuming products becomes less expensive, which in turn leads us to consume more energy.

Jevons’ claim was that this rebound effect would be so large that increasing energy efficiency would not decrease energy use. The rebound effect would eat up all (or more than all) of the energy savings.

To be clear, the rebound effect is real. The theory behind it is sound: Lower the cost of anything and people will use more of it, including the cost of running energy consuming equipment. But as with many economic ideas that are sound theory (like the idea that you can raise government revenues by cutting tax rates), the trick is in knowing how far to take them in reality. (Cutting tax rates from 100 percent to 50 percent would certainly raise revenues. Cutting them from 50 percent to 0 percent would just as surely lower them.)

The problem with knowing how far to take things like this is that unlike real scientists who can run experiments in a controlled laboratory environment, economists usually have to rely on what we can observe in the real world. Unfortunately, the real world is complicated and trying to disentangle everything that’s going on is very difficult.

Owen cleverly avoids this problem by not trying to disentangle anything.

One supposed example of the Jevons paradox that he points to in the article is air conditioning. Citing a conversation with Stan Cox, author of Losing Our Cool, Owen notes that between 1993 and 2005, air conditioners in the U.S. increased in efficiency by 28 percent, but by 2005, homes with air conditioning increased their consumption of energy for their air conditioners by 37 percent.

Owen presents this as clear and obvious proof of a Jevons effect. Case closed.

Here is where Owen gets lazy: A few key facts disprove the point. Facts that are not hard to track down. I write for this blog in my spare time (for free), and I managed to find it without breaking a sweat. I’m not sure why a paid writer for a magazine like The New Yorker couldn’t do the same.

Consider the following:

Real (inflation adjusted) per capita income increased by just over 30 percent over that time period. All else being equal, when people have more money, they buy more stuff, including cool air.

The average size of new homes increased from 2,095 to 2,438 square feet, over 16 percent. More square feet means more area to cool and more energy needed to cool it.

In 1993, of homes that had A.C., 38 percent only had room units while 62 percent had central air. By 2005, 75 percent of air conditioned homes had central units. Bigger units covering more rooms means more cool air and, you guessed it, more energy.

(Real electricity prices were mostly flat over this time period, falling by just over one percent, contributing little, if anything, to the increase.)

Finally, even though air conditioners were 28 percent more efficient in 2005 than in 1993, air conditioners last between 15 and 25 years. Using the mid-range lifespan of 20 years, and assuming that efficiency increased gradually from 1993 to 2005, and accounting for the introduction of new AC units associated with new home construction (about 1.5 percent of the housing stock in any given year), I calculated the efficiency of the average central air unit in service in 2005 to be about 11.5 percent more efficient than the average unit in 2009.

Accounting only for the increased income over the timeframe and fixing Owen’s mistake of assuming that every air conditioner in service is new, a few rough calculations point to an increase in energy use for air conditioning of about 30 percent from 1993 to 2005, despite the gains in efficiency. Taking into account the larger size of new homes and the shift from room to central air units could easily account for the rest.

All of the increase in energy consumption for air conditioning is easily explained by factors completely unrelated to increases in energy efficiency. All of these things would have happened anyway. Without the increases in efficiency, energy consumption would have been much higher.

Worse, and even more transparently wrong, Owen points to the increasing use of air conditioning in the developing world, especially India and China, as evidence of a globally expanding Jevons effect. Never mind the fact that income in China is growing something like three times as fast as in the U.S. and that the cost of air conditioning as a share of average incomes are falling at an even greater rate.

It’s one of the well-established frustrations of the energy efficiency world that people pay too much attention to the up-front cost of goods and not enough to the cost of energy needed to use them. More expensive, highly-efficient products have a hard time competing. Suddenly, however, Owen wants us to believe that falling up-front prices and rising incomes couldn’t possibly explain the accelerated market penetration of air conditioners in China and that rising efficiency is the reason.

It’s easy to be sucked in by stories like the ones Owen tells. The rebound effect is real and it makes sense. Owen’s anecdotes reinforce that common sense. But it’s not enough to observe that energy use has gone up despite efficiency gains and conclude that the rebound effect makes efficiency efforts a waste of time, as Owen implies. As our per capita income increases, we’ll end up buying more of lots of things, maybe even energy. The question is how much higher would it have been otherwise.

The even more interesting question is whether efficiency growth can ever overpower the effect of income grow
th and start reducing energy consumption in absolute terms.

Roof retrofitting is going to require the private financial system.Photo: David Trebosc

The sad truth is that if you want to learn about or work on energy efficiency, you need to understand the world of finance. Many of us in the energy/environment field (especially those working on policy) are more comfortable talking about efficiency ratings than credit ratings. But implementing energy efficiency projects at the scale we need will require large sums of money moving through our financial system.

Government programs are all well and good, but they are necessarily limited by the amount of money we can convince politicians to spend, and even the most generous programs can only scratch the surface. For example, the Department of Energy’s Better Buildings program is aimed at retrofitting homes for energy efficiency and has been granted about $500 million for local and regional efficiency programs. But with over 100 million households in the nation, if we want to retrofit even a tiny fraction of those, say one percent, it will take 10 to 20 times more money than the DOE can put into it.

If we want to make a dent in household energy efficiency, we will need to move large amounts of private capital. That money will not move unless the financials look good, because unlike the DOE, private investors are not in the habit of giving their money away without good prospects of getting it back with interest.

Unfortunately, this makes everything a little messier and a little more complicated than we might like. Sticking with residential retrofits as an example, one of the obstacles to getting home retrofits done is that, in relative terms, the up front costs of a project are pretty high. Doing a thorough energy audit and whole home retrofit can cost anywhere between five and ten thousand dollars. This is an expense in the neighborhood of buying a car, except that for many people, owning a car is essential for daily life, and a home retrofit isn’t.

Most people won’t have that amount of cash on hand to spend on a project like this, and just like buying a car, they will need to finance some of all of the project costs. In the best case scenario, a homeowner would have access to some type of home equity loan or line of credit. Right now, these carry interest rates of somewhere around four percent. Combined with the fact that the interest on these loans is usually tax deductible, this is a pretty affordable option.

Unfortunately, many homeowners don’t have ready access to home equity financing, and in the current environment of falling home values, many will be unwilling or unable to go through the process of getting it.

At the other end of the interest rate spectrum is credit card debt. Most home owners have access to credit cards and might be able to put a project of this size on their cards, but average interest rates for credit cards and other so-called “unsecured consumer debt” is around 15 percent. Rates like this will make virtually any retrofit project uneconomical.

Turning to a bank is not much better. From a bank’s perspective, these loans look a lot more like unsecured consumer debt than anything else. Unlike a car loan, which you can get for about six percent if you have good credit, retrofit loans don’t have anything the bank can repossess if you don’t pay. Home equity loans have low interest rates because banks can put a lien on your house if you don’t pay, so they can get paid back when you sell your house. Here, it’s virtually impossible for a bank to come in and repossess your insulation or new windows, which makes the loan inherently more risky and the interest rate much higher.

This leaves the retrofit market in something of a bind. Fortunately, the situation is not impossible, and there have been a handful of proposals and finance vehicles designed to offer a way out of this bind. Starting with my next post, I’ll run through some of these, starting with the ill-fated Property Assessed Clean Energy program.

Cross-posted from the Wonk Room.

Economics is critical to getting decent climate legislation passed, as Nobel Prize-winning economist Paul Krugman discusses in a extended piece for the New York Times. Economists like me have always suspected that this was true, but then we also suspect that economics is critical to pretty much everything. The problem is that economics hates the environment, or at least environmental policy.

In the real world, environmental policy has been very good for the economy. But economic analyses of climate legislation find that pollution limits slow economic growth and increase costs. The Waxman-Markey climate bill — the American Clean Energy Security Act (ACES) — is a perfect example. As any good wonk will tell you, the economic analyses of ACES actually looked pretty good, especially when compared to some of the econolyptic predictions of past climate policy. The problem is that while the analyses were pretty good for ACES, they were horrible for climate policy. The analysis done by the EPA was the source of some the lowest cost estimates that anyone put out. This analysis was actually bad news.

The reason why this is such bad news for climate policy is because it resonates strongly with people’s fears, it reinforces the conventional wisdom that climate policy will hurt the economy, and because it’s wrong.

The heart of the problem is that the economic models economists use were written, for the most part, by economists. They are based on logical economic theories that make sense to economists because, in part, they assume that everyone understands that economics is critical to pretty much everything, and act rationally as a result. Not “rational” in the sense that people understand the difference between up and down, but rational in the sense that if your boss cut your hourly wage, you would voluntarily choose to work fewer hours, even if you have a family to feed. If you take the assumptions that underlie economic rationality to their logical conclusions, they can result in a pretty strange view of the world and how it works:

SOME FALLACIES OF CONVENTIONAL CLIMATE ECONOMICS:

1. We already live in an economically optimal world. In an economically rational world, there is no inefficiency and everyone is investing the optimal amount of money on research and development of new technologies. If a business could save money by switching to a more efficient heating and cooling system, it would have done it already. Likewise, firms are investing in energy efficiency research up to the point where an additional dollar of investment yields an expected return of one dollar in energy savings. To do less would leave money on the table, and to do more would be a waste. Anything else would be irrational. The implication of this is that, with everyone constantly and correctly optimizing their behavior, there is nothing the government can do to make us any better off. If everyone is investing exactly the right amount in energy efficiency, government incentives for to do more would induce people to do too much, diverting resources from other areas with a higher rate of return. This assumption is most prevalent in what are called “general equilibrium” (GE) models. As you might guess, GE models are preferred by the economic profession, yielding logically consistent if demonstrably wrong results.

2. There can be no win-win solutions. Since everyone is constantly optimizing their energy decisions, anything that could cut carbon emissions while simultaneously saving money or increasing profits has already been done. Emissions cuts that save money have, in economics terms, a negative price. Since no one would ever give you something you wanted and pay you for the privilege of taking it (that would be irrational even to most non-economists, I think), negative cost emissions reductions can’t exist. While it might sound trivial, there is also a technical problem with this. Economic models have a hard time assimilating prices with a negative sign in front of them. So, we declare win-win solutions non-existent by fiat. The EPA analysis comes out looking so good for ACES in large part because the costs of carbon abatement are lower than in other models. But what if someone, say a big consulting firm (McKinsey & Company), went out into the real world and found that carbon abatement costs look more like this:

   All those negative cost (win-win) emission reduction opportunities on the left of the McKinsey cost curve are essentially excluded from the EPA analysis — and CBO, EIA, NAM/ACCF … So even the most optimistic analysis of the bunch badly overstates the costs of cutting carbon. No doubt that some of these negative cost reductions require some effort to capture, which is what policy is for.

3. No one ever learns. One thing that has bedeviled economists for a while is how to approximate what we call “induced technical change,” the technical advances that occur because of policy changes or in response to price changes. If energy prices go up, you would expect that people would look for new ways to use less energy, resulting in innovations of various kinds. This makes common sense, but figuring out how it all works in the context of an economic model turns out to be pretty tricky. One attempt at this was to use the idea of “learning by doing” — the idea that the more you use of something the more efficient you get at using it. That’s great, except when you plug it into a model along with a climate policy, the climate policy causes you to use less energy, and the less you use of something the less efficient you get at using it. The end result was that carbon pricing slowed innovation in carbon efficient technologies. Back to the drawing board.

Put all these together with the difficulty of parameterizing the global economy, along with a few more that get even wonkier (like how to value ecosystem loss a hundred years down the road), and the odds of getting things right starts to fall pretty rapidly. What’s worse is that almost all of these problems bias the models’ results in the same direction: toward higher economic costs of meeting any given reduction target.

The good news is that there are a few people working to set the record straight. I’ve done some work of my own on this, basically forcing a model to understand the returns to investing in efficiency. The good people at ACEEE are always on the leading edge of research on energy efficiency and have done some very good work recently on laying out the case for why and how economic models should be improved. The E3 network of economists has some excellent work related to this as well.

The bad news is that the really good work is badly outnumbered. So when Congress and other people look at the literature and see it dominated by the bad or merely unhelpful, they naturally tend to discount the other stuff as outliers, as exemplified by how the Congressional Budget Office reinforced incorrect conventional wisdom with its analysis of climate policy. The CBO basically took an average of some of the existing (flawed) work in the field and used it as their basis for figuring out the macroeconomic costs, giving the conventional wisdom an implicit stamp of approval that it doesn’t deserve. As a friend of mine once said: If you’re a physicist and you come up with a new theory that turns the orthodox on its head, they give you a Nobel Prize. If you’re an economist, they deny you tenure.

Economist James Barrett is the executive director of Redefining Progress.