This blog was written by John D. Wilson, former Deputy Director for Regulatory Policy at the Southern Alliance for Clean Energy.

Guest Blog | November 16, 2011 | Climate Change, Energy Efficiency

This blog is one of a series of posts about how the “power of free markets” may be able to help solve climate change. You can view the rest of the posts here.

Bob Inglis’ call to rely on a carbon tax as the main weapon to fight climate change is based on the idea that price signals, or the “power of free markets,” are central to the solution to climate change. Paradoxically, ensuring that price signals connect meaningfully with the energy consumer often requires government regulation, mandates, incentives, educational programs and the like.

Why is it that using “free market” solutions like price signals leads to “big government” programs like regulation and incentives? Isn’t that a contradiction?

Economists speak of “market barriers,” those real-word conditions that make it difficult for customers to respond to price signals, or to even know that those price signals exist. And to understand why we need what some might characterize as intrusive government interference in the “free market,” we must shift from the economists’ world (debates over cap-and-trade vs carbon tax) down to our world, the world of renting apartments, repairing air conditioners, and replacing hot water heaters.

We pay the price but don’t make the choice.

Energy prices matter to the person (or company) who pays for the energy, but energy use is often affected by the choices of people (or companies) who aren’t paying the price. In fact, efficiency expert Bill Prindle estimates that about 50% of total U.S. residential energy usage occurs in these circumstances. These problems occur in both residential and business markets.

• In new home construction markets, builders make decisions that affect the energy use of home buyers.
• Rental housing owners make investments that affect energy costs to tenants.
• In commercial building leasing markets, both builders and owners make efficiency technology decisions that affect tenant energy bills.
• Within large enterprises (business or institutional), one department makes energy-technology decisions while another pays the energy bills.

For example, a tenant in a rental house calls the landlord complaining about the HVAC system failing. While the landlord is there, the tenant complains about the high electric bill. The landlord smiles politely, and replaces the busted HVAC system with the cheapest system on the market. The landlord doesn’t have a financial interest or incentive to help the tenant reduce the high electric bill. Or maybe the landlord pays the electric bill, and the tenant never bothers to change the clogged dust filter, wasting energy and burning out the blower motor.

Using the “power of free markets” won’t solve these type of problems, which are known to experts as “principal-agent” or “split incentive” problems. In fact, if we get the price “right” for electricity (increase the electricity rate), we make these problem worse. In my example, the bill for electricity at the rental house would rise even further, but since energy decisions are split between the landlord and the tenant, neither person has the opportunity to make all the right choices to minimize costs.

It is hard to figure out what the right choice is.

Even when the price of energy is high, making choices about energy efficiency can be difficult. Investments in energy-using devices (vehicles, motors, buildings, etc.) commit the owner to energy costs for many years. There are a lot of variables to consider.

For example, for the purchase of a hot water heating system, buyers are advised to consider:

• Fuel type, availability and cost;
• Size;
• Energy efficiency; and
• Costs.

Not only is it complicated to decide which kind of hot water heater to buy, but fewer than 1/3 of consumers make the choices and bear all the costs associated with their use of hot water. So why would a typical consumer go to all the trouble to understand all the hot water heating alternatives?

Considering other energy technology choices, I would add several items to the list of factors a buyer reasonably considers. One important factor is the buyer’s expected length of time owning the property and ability to recover costs if the property needs to be sold. Factor in to that not just the current cost of energy, but its likely future costs and the risk that future costs will be significantly higher or lower than expected. Also one needs to consider impacts of installation on the use of the property (both positive and negative).

For example, comparing the value of a geothermal heat pump system with an electric heat pump involves all of these considerations. For a buyer who plans to live in the home for many years, and doesn’t see much chance of moving, the investment can make a lot of sense. Market value comes into the equation, however, when a long residence isn’t so certain. If standard mortgage appraisals don’t recognize the value of a geothermal heat pump, only all-cash buyers can offer to pay the economic value sellers would like to recover.

Price signals need support.

Creating a meaningful connection between energy price signals and consumer means dealing with market barriers that are expressed in very particular ways, and require equally particular solutions. Those market barriers are particularly acute when it comes to energy waste (but are also present for customer-sited renewable energy); overcoming barriers to energy efficiency requires creating better opportunities to make good choices and offering more information. Creating those solutions with a coordinated package of measures and practices involves both government and private sector leadership. These solutions are discussed in a companion blog that focuses on six ways to help price signals deliver energy savings.

• Appliance standards and building codes
• Driving customer cost down
• Product labels
• Energy audits
• Contract provisions
• Opportunity to earn profits when saving energy

Bob Inglis is right, price signals are a big component of promoting smart energy choices. But as any savvy businessman knows, pricing strategies are a component of marketing – the effort to get buyers to acknowledge the true value of a product. Sending the proper price signal is ultimately up to Congress. But receiving the energy price signal depends on using all six types of solutions to help consumers overcome barriers that limit their opportunity to react to those price signals appropriately.