Policy instruments

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One instructive way of categorizing policy options is to make the distinction between a set of market instruments (such as taxes and permits) designed to boost the motivation for higher efficiency, and a second set of instruments designed to set production on a path of reducing costs and improving energy efficiency of products. The debate between the two centers around which policy options would be most effective and which are politically feasible.

An underlying reason for energy efficiency improvements not having greater penetration is the historic low price of energy. Proponents of boosting energy efficiency via market instruments see the price internalization of all the costs of using energy as the most effective route to spurring reductions in energy use. This strategy recognizes that the bottom line that motivates most users to adopt commercially available energy efficient technologies is economic savings. The motivation to adopt would increase following an internalization of all costs and the consequential rise in the price of energy. Other observers point out the overwhelming political difficulties in achieving this desirable goal of raising energy prices in the near term.

Therefore, rather than pursue the hope of political action to increase the costs of fuels and electricity, other policy options to increase the numbers and performance of energy efficiency technologies are proposed. These include performance standards to eliminate the least efficient models and promote the trend towards higher efficiencies, and increased research and development on energy efficient technologies. Most analysts recognize the desirability of both policy options and suggest a combination of the two. A collection of views from the debate on the best policy instruments is given in the next section on policy prescriptions.

Tietenberg (1992) provides a good summary of market based instruments. If the costs to the economy of these instruments are deemed too great, a far smaller levy could be used to stimulate R&D into energy efficient technologies. This would be the starting off point on a path of increasing energy efficiency and reducing costs. Such R&D would cover the spectrum from basic research to commercialization, and is already being pursued in major programs under the auspices of the US Department of Energy and the European Union's DG 12 and 17. But as an instrument, R&D only provides half the impetus, as new technologies must be adopted and continue to be refined and improved. Instruments to achieve these goals include information campaigns such as the numerous US Federal programs, the UK EEBPP,2 or the international CADDET3 organization. Insights from diffusion theory tell us that these information sources must offer both mass media and individual sources of information for successful implementation of energy efficiency.

Another mechanism to promote an energy efficiency path is minimum standards to which suppliers must adhere. Examples of these include building codes, CAFE4 standards for vehicles, and energy standards for appliances. An advantage of standards is that they remove the least efficient options from adopters' possible list of purchases, and successive applications of standards can steer an industry down a more efficient path. However, these standards are usually based on the best available technology (BAT) and thus can be technology limiting as suppliers might see no incentive in carrying out research into more efficient models if they believe that this level of efficiency will then become mandatory.5 An additional option is for government to stimulate economies of scale and resultant lower costs by itself adopting many units of a new technology.

Other mechanisms for promoting less energy intensive technologies include tax breaks or credits. The Californian experience of tax breaks to support wind energy production was deemed by some to be technology limiting and a subsidy of expensive power under guaranteed favorable economic circumstances. One solution to these objections has been used in the UK where quotas for renewable energy have been allocated on an auction basis with the lowest bids gaining a subsidized rate. This program (NFFO6) has seen the prices of renewable technologies fall by a factor of three to the point that they are now competitive with peak time electricity prices (Mitchell, 1997). Lastly, energy efficiency savings have been claimed through utility demand side management programs, although the potential for abundant future savings from such programs has been called into question (Sonnenblick, 1995).

Governments' investment in energy efficiency has been extremely successful, at least by their own estimates. In the US, $8 billion (1997$) in federal outlays for research, development and deployment of energy efficiency technologies between 1978 and 1996 helped spur private sector investment, achieving $150 billion in annual savings. This is a tremendous return on investment, not counting environmental and health improvements (PCAST, 1997). Although these figures are extremely impressive, they may be overestimated due to the free rider problem of government paying for research that private firms might have

2 Energy Efficiency Best Practice Program.

3 Center for the Analysis and Dissemination of Demonstrated Energy Technologies.

4 Corporate Average Fuel Economy.

5 The CAFE performance standards were designed to ensure this did not happen.

6 Non Fossil Fuel Obligation.

done anyway. In addition, there are cases of energy savings and cost reductions being serendipitous results of government programs designed to support at-risk industries or technologies for political motivations. (An example of this was the successful NFFO program in the UK that included renewable energy to make public support of the UK nuclear program allowable under EU rules).

4.8.2 Policy prescriptions

The "Energy Innovations" (EIA, 1997) study argues that "sector-specific market mechanisms would guide consumer and business decisions toward greater efficiency. Examples include an electricity generation emissions allowance and tradable permit system; a revenue-neutral industrial investment tax credit, which can offset increase in energy costs by reductions in the cost of capital; and transportation pricing reforms such as pay-as-you-drive insurance, which would shift a portion of auto insurance premiums to a cost that varies with miles driven. Each such policy reallocates costs in order to motivate higher energy efficiency and lower emissions while avoiding a net increase of taxes or fees within the sector." The study also includes policy initiatives for advanced vehicle development and deployment, market introduction incentives to help move prototype energy efficient technologies into mass production, and minimum efficiency standards.

Harvey (1998) suggests a strategy that would include realistic pricing of energy, but he takes issue with the widely held notion that price is the only key variable. He points out that gasoline purchases account for only 11% of the cost of running a car - considerably less than insurance. Doubling the price of gasoline would increase fuel mileage by a third at most, he says, which is far short of what is technically feasible, not to mention the fact that it is politically intractable. More broadly, most economists estimate that it would require a carbon tax of some $100 per ton to cap US carbon emissions. Changing energy consumption through price signals, when energy represents only a small fraction of the cost of doing business, is very difficult, and it may be politically impossible. Therefore, he recommends that modest taxes - $4 or $5 per ton of carbon - be assessed against environmentally damaging fuels, and the proceeds of those taxes be used to transform energy technologies. "Promoting the commercialization of energy efficiency and renewable energy technologies is a far cheaper way to achieve the same effect as raising taxes, and requires a much more modest political effort."

Advances in science and engineering (through public and private R&D efforts) have already done much to reduce the costs of many energy efficiency technologies. But in many cases, making technologies commercially competitive requires bringing their prices down further by producing and deploying them on a significant scale. Bulk purchases provide both the economies that result from large-scale production and the savings from improvements discovered when a technology is applied in the field. There are few programs to bring key technologies down the last part of the cost curve, leaving important advances in science and engineering adrift. Auctions are one option for directly supporting commercialization. An auction selects, through a bidding process, the most competitive technologies; a subsidy (paid for through a modest carbon tax as described above) makes up the difference between the winning bid and the market energy price. As mentioned earlier, such a system used in the UK cut the price of renewable energy offerings in half in just six years. The subsidy was funded through an increase in electricity rates that amounted to less than 0.5% (PCAST, 1997).

Harvey (1998) concludes that a national program of this type in the US of $3 billion to $6 billion per year, guaranteed to last at least five to ten years, should be adequate to make half a dozen key technologies (for energy efficiency and renewable energy) commercially viable. While not a trivial sum, compared to our national energy bill or the consequences of continued CO2 production and local air pollution, it is a modest investment indeed. A carbon tax of only $4 per ton would support a fund of $5.6 billion per year. The total amount needed should be contrasted, perhaps, to a carbon tax required to reduce carbon production through elasticities of demand, which most economists project to be in the range of $50 to $100 per ton. A tax only 5 or 10% as large, efficiently applied to reducing the cost of key technologies, represents an intelligent commercialization strategy which makes a broader carbon cap much easier to achieve and much less costly.

Messner (1997) endogenized technology dynamics into a bottom-up energy systems model to examine the relationship between declining specific investment in energy technologies and overall experience or capacities installed. Her results show the importance of early investment in new technology developments. "New technologies will not become cheaper irrespective of research, development, and demonstration (RD&D) decisions; they will do so only if determined RD&D policies and investment strategies enhance their development." WEC/IIASA (1995) adheres to this position, and in their modeled scenarios, technology is not assumed to "fall like 'manna from heaven' but instead is the result of deliberate search, experimentation, and implementation, directed by both social and political policies as well as economic opportunities."

Azar and Dowlatabadi (1998) recommend a policy of investment credits to help gain experience with new technologies or deploy them more widely, thus inducing cost savings. They further recommend technology performance standards to "limit the choice consumers face to those technologies that meet consumer needs and embody progress towards severing the link between energy services and carbon emissions."

A study by the Alliance to Save Energy and Dale Jorgenson, Chair of Harvard's Economics Department (ASE, 1998), recommends an energy tax that is distinct from the carbon, ad valorem (market value), or Btu (energy content) taxes commonly proposed. Instead, "the taxes are based on damage estimates associated with costs from air pollution and global climate change mitigation not currently internalized through existing regulation." Another unique feature of the ASE study is that it provides results for the combined effects of fiscal and energy tax reform rather than the more common focus solely on the latter. ASE (1998) finds that "correctly pricing energy and taxing consumption - by taxing fossil energy to reflect air pollution and climate change damages and by replacing the present income tax system (at federal, state and local levels) with a consumption tax, all on a revenue-neutral basis ... increases investment, consumption, exports, and the GDP; decreases fossil-fuel energy use, fossil fuel energy intensity, and carbon emissions; and increases aggregate social welfare."

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