within Barriers firms to energyefficient investments
Stephen J. DeCanio
Many investments in energy efficiency fail to be made despite their apparent profitability. Internal hurdle rates are often set at levels higher than the cost of capital to the firm. Reasons for these practices include bounded rationality, principalagent problems, and moral hazard. The policy implication is that government can simultaneously improve overall energy efficiency and increase private sector productivity by providing informational and organizational services that go beyond the traditional regulatory framework. Keywords:Energy efficiency;Principal-agentproblem; Bounded
rationality
A considerable body of evidence suggests that the US economy could become much more energy efficient than it presently is. Opportunities to improve energy efficiency can be found in residential and commercial buildings and industrial processes. 1 A study by the Office of Technology Assessment of the US Congress (OTA) recently found that the government could save at least 25% of the energy used in federal buildings, with no sacrifice of comfort or productivity. 2 Of perhaps greater significance from the economic point of view, many of these potential energy saving investments appear to have very high rates of return in comparison to the economy-wide average cost of capital. Residential consumers resist energy saving investments that have rates of return of 30% to 40% or more, while detailed, on-site surveys of selected industrial corporations have uncovered energy conservation projects with rates of return frequently in excess of 30% .3
The existence of such sizable unrealized profits poses both theoretical and policy problems. On the theoretical side, how can we account for such a deviation from the standard economic presumption of cost minimization or profit maximization? What characteristics of the markets, agents, or of the observations themselves account for the discrepancy? On the policy side, it is natural to ask how government might intervene to improve the situation. The difference between what is and what could be realized suggests that well designed policies to improve energy efficiency might achieve one of the most sought after objectives of economic policy Pareto improvement with gains for all concerned. Before ambitious policy goals can be set, however, it is necessary to examine the causes for the apparent gap between actual and theoretical performance. 4
Barriers to profitable investments
Firms do not behave like individuals
In thinking about why firms may not always behave optimally, it is important to remember that a firm is a collection of individuals, brought together under a complex set of contracts both written and unwritten, but that the firm itself is not an entity acting with a single mind. Economists often talk about 'the firm' as though it had its own consciousness, but this is either an (often very useful) theoretical simplification or an example of sloppy thinking. The behaviour of the firm is the outcome of the interplay of the motivations of the individuals comprising it, the rules and conventions governing their interaction, and the environment within which the firm operates. The firm makes choices and decisions, but these are generated through its rules of procedure, rather than being the products of an individuated volition. The top decision makers of the firm exercise a considerable degree of control, but that is not sufficient to
0301-4215/93/090906-09 1993 Butterworth-HeinemannLtd
The author is with the Department of Economics, University of California, Santa Barbara, CA 93106, USA and The Fielding Institute, Santa Barbara, USA.
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Barriers within firms to energy-efficient investments
transform it into a conscious entity with a unitary will. Other hierarchical organizations (eg government bureaucracies, armies, university administrations) can experience divergence between goals and actions. Recognizing this possibility has important consequences. The individuals making up a business firm may all be rational seekers after their own interest, but the outcome of their collective action may be suboptimal. The logic of collective action is such that, in general, 'rational, self-interested individuals will not act to achieve their c o m m o n or group interests. 's This principle applies to private sector c o r p o r a t i o n s as well as to g o v e r n m e n t bureaucracies or political collectives. The presence of public goods, externalities, and the clash between individuals' private incentives and the good of the whole all combine to produce outcomes that fall short of what could be obtained if all the resources of the group were deployed by a single guiding intelligence. Some of the specific ways in which a corporation's internal operating rules may thwart optimization of its activities will be discussed below. Before beginning that discussion, however, it is important to note that the inefficiency of a corporation will not be easy to detect. Whatever flow of profits is being ge...
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