As I said in my last post, taking energy efficiency in buildings seriously means expanding our policy horizons beyond the blunt tool of raising energy prices. We have to think in creative ways about how to remove market and behavioral failures that inhibit cost-effective responses to today’s energy prices. How can we make efficiency markets more rational and robust?

What follows is not intended to be comprehensive, just to call out some of the bigger challenges and a few interesting attempts to overcome them. There are folks out there who know much more about this than me — I hope they’ll comment or email me with things to add.

Immature, fragmented markets

The market for efficiency retrofits, particularly the residential market, is immature and fragmented. Business models haven’t fully gelled; economies of scale haven’t been achieved. Right now the market involves thousands and thousands of tiny, sporadic transactions, usually involving small-scale buyers and small-scale providers.

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One way to address fragmentation is what Bill Clinton’s been trying to do through his foundation: create large purchasing pools (in this case multiple American cities) so efficiency products and services can be ordered in bulk, at discount prices. There are other private and public efforts (some I mention below) to try to aggregate purchases, even at the neighborhood level.

Collective purchasing can be a boon to people who find navigating the various products and services involved bewildering. And large, reliable purchase orders allow consolidation and efficiencies of scale on the supply end, which further lowers prices. We won’t know the full potential for building efficiency until there’s a Wal-Mart for energy services. (It’s worth noting there are some big names getting into the biz, including Fortune 500 companies like Masco Corporation.)

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Another sign of immature markets is the paucity of financing. Efficiency investments are extraordinarily secure, predictable, and, over time, profitable. The problem is “over time.” Upfront costs tend to be high, and lending institutions don’t have much experience with efficiency financing, so they’re gun shy. It can be difficult for individuals or businesses to come up with that initial chunk of money; even when they can, it’s not like long-term, moderately profitable investments are the apple of American capitalism’s eye, especially in a recession. The key to overcoming high upfront costs is finding financing mechanisms that can spread them out.

One of the coolest new ways to do this — referenced in passing in Leonhardt’s column — is a model born in Berkeley, Calif.: Property Assessed Clean Energy (PACE) loans for small-scale renewables or efficiency. Under a PACE program, loans to building owners are paid back out of property taxes. That means when the property is sold, the loan goes with it, which solves two problems at once: it virtually eliminates upfront costs, and it addresses the fear of building owners that they’ll pay for efficiency improvements but won’t stay long enough to reap the benefits. The idea is so manifestly sensible that it’s gone viral: the New York state legislature passed a PACE bill this week and there are indications it may go national through the recently unveiled Recovery Through Retrofits program. (If it goes national, loans could be backed by Treasury bonds, chopping interest rates by half and boosting returns.) PACE is one of the big overlooked stories of 2009 and will emerge as a key clean-energy driver in the next few years.

Other financing options — both in Merkley’s proposal — include on-bill-financing by utilities and performance savings contracts from energy service companies. PSCs are mostly used in the commercial building market, which is a bit out ahead of residential on this score.

Financing is already one of the key areas of innovation in building efficiency markets, and as those markets mature, that trend will accelerate.

Information and transparency

It’s difficult for individuals and businesses to determine how efficient their buildings are, or the most cost-effective way to increase efficiency. Information is hard to get and prices are opaque. There are tons of ways to tackle this problem.

One is to try to make carbon intensity a more salient part of purchasing decisions. As Matt Yglesias mentions here, you could require energy audits as part of the home inspection process. Along with more common testing, you’ll need more transparent ratings, perhaps something like California’s Home Energy Rating System, so efficiency performance can be compared easily across buildings. You could encourage the use of energy efficient and location-efficient mortgages. You could try to make walkability scores a more standard part of real estate listings. All those changes would, just by better informing consumers, shift purchasing decisions toward density and infill.

A variety of businesses, utilities, and community groups are trying to simplify the informational demands on individuals by packaging energy efficiency services together into a one-stop shopping experience. There are more and more companies springing up to do this, but one non-business model I find really intriguing is Sustainable Works, a new community-owned nonprofit in Washington state. They package efficiency services for homeowners or small businesses, insuring that everything can be paid for out of energy savings. They manage the entire process from audit to financing to final inspection. They only use contractors who pay well and focus hiring efforts on local and disadvantaged constituencies. And they use local partnerships and public events to organize whole neighborhoods to retrofit at once, to save money and foster community cohesion and education.

Most efficiency programs right now, though, are run by utilities. Utilities range widely, so their efficiency programs are a mixed bag, but overall they seem to be robustly cost-effective.

Most of the problems above are reasonably well-understood market failures. Work just has to be done properly aligning information and incentives. But what about when people don’t respond rationally to incentives? What about failures that are based in human foibles? I’ll get to that next post.