Price cannot steer emission reductions properly
In my last two posts I argued two points: emissions pricing is less popular with the public than funding of trains, renewable requirements and other types of public investment and rule based regulation . And the public is right. Clean energy, clean industry and clean agriculture are fundamentally infrastructure. Infrastructure depends much more on rules of the game and public investment than price fluctuations. Price fluctuations themselves depend as much (or more) on power relations as on supply and demand. Historically everything from U.S. agriculture, canals, telegraph, railroads, auto roads, air and water ports, utilities, wired and wireless communication spectrum have depended upon public investment in the form of right-of-ways, land and water grants, and outright cash subsidies. Even in Adam Smith’s time, the price of tobacco reflected the ability to grab land at gunpoint and work it with slave labor as much the willingness of tobacco addicts to pay high prices for it. This post will document that price still is not the primary driver in economic decision making.
Much of the infrastructure described in the preceding paragraph still exists today, still is maintained with public subsidies today, and still favors fossil fuels over alternatives. But price is a weak driver in private infrastructure too. Both individuals and businesses fail to make one-time capital investments to replace day to day expenditures that trickle out a little at a time, even when those expenditures provide savings. That profitable savings get overlooked is shocking enough to economists that they have coined a phrase for it: “the energy efficiency” gap. The existence of a large energy efficiency gap is overwhelmingly accepted within the specialty of energy economics as being supported by the empirical evidence, and by much theoretical analysis as well. I posted a bibliography and informal literature review(DOC) on Grist back in 2008 on this subject. I suspect it takes an economist to be shocked at the idea that people overlook profitable opportunities to save energy. Most people with business experience will be completely unsurprised that many managers and consumers will step over a dollar to pick up a dime.
Of course there are real, practical reasons to overlook opportunities as well.
One example is split incentives such as insulation in rented buildings. Insulation saves the tenant money, but only if she stays long enough. And since most of the value of insulation goes to the tenant, the landlord has little reason to invest in insulation:
A second example is unequal access to capital. even people who own their own homes can’t afford to invest as much to save a kWh of energy as a utility can to produce that same kWh. Investing in insulation, even if that investment provides long term savings, uses up a limited ability to borrow. That limited access to credit may be needed in a medical or other emergency.
One key indicator shows that there is an energy efficiency gap in business that applies not only to energy, but to water, consumable materials, and general flow costs. Overwhelmingly, businesses refuse to invest in reducing energy, water, or other flow costs unless the rate of return on such investment is at least 65% to 80%. In contrast, investments to save labor or increase market share generally need return only 8% to 35%.
Even in conventional neoclassical economics there are dozens of categories that make up the energy efficiency gap. A first rate popular summary on this was published by the International Energy Agency in 2005 – The Experience with Energy Efficiency Policies and Programmes in IEA Countries: Learning From the Critics (pdf).
Energy efficiency gap studies are important, because they help focus on mechanisms by which people ignore price mechanisms. But it is worth remembering that they reflect something more critical. Price cannot and does not drive behavior under capitalism as strongly as many economists believe.
My next post will move on from criticizing price as a driver of change, and generalities about public investment and regulation to specific proposals.
 The Ryan & Ryan survey does not actually list discount rates. But it surveys the basis of discount rates. “The vast majority of respondents agree that WACC is the best starting point to determine the appropriate discount rate. Popular supplemental methods include sensitivity analysis, scenario analysis, inflation adjusted cash flows, economic value added, and incremental IRR.” Depending on method, and the economic environment, this can translate to anywhere from 8% all the way up to 35%.
Patricia A. Ryan and Glenn P. Ryan,” Capital budgeting practices of the Fortune 1000: How have things changed?,” Journal of Business and Management 8, no 4 (Oct 2002), 355-364.