Is There an Energy Efficiency Gap? Hunt Allcott and Michael Greenstone July 2012 Abstract Many analysts argue that energy efficiency investments offer a "win-win" opportunity to reduce negative externalities and save money. This paper presents a simple model of investment in energy-using capital stock with two types of market failures: uninternalized externalities from energy consumption and imperfect information causing consumers and firms not to exploit profitable energy efficiency investments. The model clarifies that only if the second type of market failure cannot be addressed directly through mechanisms like information provision, energy efficiency subsidies, and standards may energy efficiency investments be merited. We review empirical work on the magnitude of profitable unexploited energy efficiency investments, which often do not meet modern standards for credibly estimating net present value of energy cost savings and often leave other benefits and costs unmeasured. Despite these problems, recent empirical work in various contexts implies that the magnitude of profitable unexploited investment opportunities is much smaller than engineering-accounting studies suggest. There is tremendous opportunity and need for policy-relevant research using randomized controlled trials and quasi-experimental techniques to estimate the returns to energy efficiency investments and the welfare effects of energy efficiency programs. JEL Codes: D11, D18, D61, D62, H23, L91, L94, Q41 The paper discusses the "Energy Efficiency Gap," a wedge between the cost-minimizing level of energy efficiency and the level actually realized. It distinguishes between two types of market failures: energy use externalities and investment inefficiencies. If energy use externalities are the only market failure, the social optimum is obtained with Pigouvian taxes or equivalent cap-and-trade programs. If investment inefficiencies also exist, the first-best policy is to address the inefficiency directly. However, when these interventions are not fully effective, policies that subsidize or mandate energy efficiency might increase welfare. The central economic question is whether there are investment inefficiencies that a policy could correct. The paper examines two classes of evidence on the existence and magnitude of investment inefficiencies that could cause the Energy Efficiency Gap. First, it examines choices made by consumers and firms, testing whether they fail to make investments that would increase utility or profits. Second, it focuses on specific investment inefficiencies, testing for evidence consistent with each. After presenting the evidence, it discusses policy implications. Three key conclusions arise. First, although there is a long literature assessing investment inefficiencies related to energy efficiency, this body of evidence frequently does not meet modern standards for credibility. Second, when one tallies up the available empirical evidence from different contexts, it is difficult to substantiate claims of a pervasive Energy Efficiency Gap. Third, because consumers are quite heterogeneous in the degree of their investment inefficiencies, it is crucial to design targeted policies. The paper also discusses the background facts on energy demand, an overview of energy demand and energy efficiency, energy efficiency policyIs There an Energy Efficiency Gap? Hunt Allcott and Michael Greenstone July 2012 Abstract Many analysts argue that energy efficiency investments offer a "win-win" opportunity to reduce negative externalities and save money. This paper presents a simple model of investment in energy-using capital stock with two types of market failures: uninternalized externalities from energy consumption and imperfect information causing consumers and firms not to exploit profitable energy efficiency investments. The model clarifies that only if the second type of market failure cannot be addressed directly through mechanisms like information provision, energy efficiency subsidies, and standards may energy efficiency investments be merited. We review empirical work on the magnitude of profitable unexploited energy efficiency investments, which often do not meet modern standards for credibly estimating net present value of energy cost savings and often leave other benefits and costs unmeasured. Despite these problems, recent empirical work in various contexts implies that the magnitude of profitable unexploited investment opportunities is much smaller than engineering-accounting studies suggest. There is tremendous opportunity and need for policy-relevant research using randomized controlled trials and quasi-experimental techniques to estimate the returns to energy efficiency investments and the welfare effects of energy efficiency programs. JEL Codes: D11, D18, D61, D62, H23, L91, L94, Q41 The paper discusses the "Energy Efficiency Gap," a wedge between the cost-minimizing level of energy efficiency and the level actually realized. It distinguishes between two types of market failures: energy use externalities and investment inefficiencies. If energy use externalities are the only market failure, the social optimum is obtained with Pigouvian taxes or equivalent cap-and-trade programs. If investment inefficiencies also exist, the first-best policy is to address the inefficiency directly. However, when these interventions are not fully effective, policies that subsidize or mandate energy efficiency might increase welfare. The central economic question is whether there are investment inefficiencies that a policy could correct. The paper examines two classes of evidence on the existence and magnitude of investment inefficiencies that could cause the Energy Efficiency Gap. First, it examines choices made by consumers and firms, testing whether they fail to make investments that would increase utility or profits. Second, it focuses on specific investment inefficiencies, testing for evidence consistent with each. After presenting the evidence, it discusses policy implications. Three key conclusions arise. First, although there is a long literature assessing investment inefficiencies related to energy efficiency, this body of evidence frequently does not meet modern standards for credibility. Second, when one tallies up the available empirical evidence from different contexts, it is difficult to substantiate claims of a pervasive Energy Efficiency Gap. Third, because consumers are quite heterogeneous in the degree of their investment inefficiencies, it is crucial to design targeted policies. The paper also discusses the background facts on energy demand, an overview of energy demand and energy efficiency, energy efficiency policy