Energy Efficiency Mandates: No Free Lunch

“Why should utility customers continue to pay for bad programs that increase their rates at the benefit of a few? We should be mindful of the words of Milton Friedman:  ‘One of the great mistakes is to judge policies and programs by their intentions rather than their results.’ “

In the real world, “free lunches” that benefit society are as rare as snow in Phoenix. Even when given a free meal, one often has to listen to a (often boring) sales pitch or speech.

Only in fantasy land are socially-beneficial “free lunches” ubiquitous. As one example, Amory Lovins once remarked that energy efficiency is the “lunch you are paid to eat.” Using the label “no-regrets,” policymakers frequently push actions that they endorse as unequivocally good – everyone wins, no one loses.

In truth, we see free lunches mostly going to those who benefit at the expense of society, which was the subject of my essay A Cautionary Tale About Energy Efficiency Initiatives in the current issue of Regulation magazine (Cato Institute).

How often have we heard how wonderful utility and government-mandated energy efficiency initiatives are? Many supporters of conservationism (less energy usage for its own sake) claim it is the most cost-saving way to reduce carbon emissions—that by reducing energy consumption along with emissions, these initiatives more than pay for themselves.

For instance, in 2009 the consulting firm McKinsey & Co. estimated that adoption of cost-effective energy efficiency investments in the United States could generate $700 billion in net private cost savings. This was the age-old pitch from the aforementioned Lovins, an environmental scientist and chairman of the Rocky Mountain Institute.

Yet these free lunches should seem suspicious to anyone. They do to many analysts who have studied the benefits and costs of conservationism. If these efforts are such a good deal, then why must government mandate them and utilities push for them?

Policymakers attribute the “low” adoption of investments in energy efficiency (EE) to market failure or consumer-behavioral problems:  Consumers are incapable of making the correct calculations from a societal perspective, or make decisions contrary to their self-interest. This so-called “EE gap” provides the raison d’etre for both government standards and utility initiatives.

This rationale makes two assumptions that often go overlooked by EE advocates:

• The gap truly represents a market or behavioral failure.
• The benefits from correcting this failure are greater than the costs.

But, just because market problems exist that might hinder EE investments does not mean that utility or governmental intervention is socially desirable.

One problem is that supposedly objective analysis of specific EE initiatives often reaches very different conclusions. Utility-sponsored studies of EE proposals, for example, often yield results that are much more optimistic about energy savings than subsequent academic, peer-reviewed studies of the programs once they are in place. Why is this, and whose results should policymakers and regulators believe?

Academic reviews of conservationist programs conclude that such programs are not the “low-hanging” fruit that many people believe. They show that utilities grossly overstate energy savings because they rely on ex ante engineering estimates that neglect to account for consumer behavior in using, say, their air conditioners and heating systems more intensively because of lower operating costs for the EE technologies. Studies also find “free riders.”

These are individuals who would have purchased lower energy-use appliances or heating and air conditioning systems regardless of the existence of the utility programs.  Their energy savings should, therefore, not be counted as benefits created by the policy. The subsidy they receive for purchasing their EE products is a pure transfer from other utility customers.

Studies also note that utilities often fail to consider “hidden costs” for consumers from the time and effort spent on both energy audits and investments. The combination of these factors, according to some academic studies, have led to utilities understating the true costs of EE programs by as much as 50% or more.

As an illustration, a widely-held view is that residential weatherization programs have produced large and cost-effective savings to low-income households. But a 2015 study by Fowlie, Greenstone, and Wolfram and a 2016 study by Joshua Graff Zivin and Kevin Novan provide empirical evidence to the contrary. They find ex ante energy-savings projections to be grossly high and the overall net benefits to participating households in many instances to be negative.

Most utilities fail to apply the best analytical tools to their evaluations of EE programs. These tools include randomized trials and quasi-experimental designs to measure energy savings and understand consumer behavior. The problem with other approaches is that they are unreliable —in some instances grossly unreliable—in measuring the actual energy savings from individual EE programs.

Despite the negative evaluations of EE programs by academics, these programs are politically popular. Legislatures, governors, and state utility commissions (PUCs) want utilities to promote EE with subsidies. Some utilities may initially balk at this, but PUCs then offer support to ensure the utilities’ profitability isn’t hurt by reduced sales.

For instance, about half the states have adopted “revenue decoupling” for gas utilities that permits utilities to raise their rates in order to offset lower sales. These initiatives have been instrumental in mitigating utility opposition to EE programs.

Everyone’s happy, right? Well, someone has to pay for these initiatives, and it is almost always the utility’s customers. But is it equitable and good public policy to compel utility customers to pay for EE initiatives? Many of these initiatives benefit only a relatively few customers, most of whom can afford to pay for EE without any financial assistance. Besides, these consumers are quite capable of making rational decisions, just like they do when they invest in other activities. So, why should utilities offer these customers subsidies and why should other customers bear the costs?

The rationales for EE programs of both electric and gas utilities are less valid today than when they were first implemented. Their customers have better information on EE programs, and natural gas prices are low and expect to remain so for the next several years. One can presume that the most cost-effective actions have already been exploited. It seems then that market failures for EE have diminished over time, weakening the need to have utility or government intervention to advance EE.

Regretfully, the best evidence has had little effect on these programs because the public is unaware of the transfers, energy efficiency is widely popular, and utilities can enjoy their support— for example, gaining goodwill with regulators—without suffering any financial consequences. Despite that, many of these programs would fail a cost-benefit test and should be called into question.

Why should utility customers continue to pay for bad programs that increase their rates at the benefit of a few? We should be mindful of the words of Milton Friedman:  “One of the great mistakes is to judge policies and programs by their intentions rather than their results.”  For many observers, EE programs transmit good feelings about using less energy.  But for those programs with a negative effect on society, it is time to kill them for the sake of the public good. 
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Kenneth W. Costello, formerly Principal Researcher, National Regulatory Research Institute, is a noted regulatory economist specializing in energy. His previous post at Master Resource was Rent-Seeking under Public Utility Regulation: Who Protects Ratepayers?