Association for Public Policy Analysis & Management

The energy efficiency gap, defined as underinvestment in energy efficiency relative to a purely rational economic agent, has received significant academic and policy attention.  For example the benefit cost analysis for the U.S. Government’s Corporate Average Fuel Economy Standards attributes large benefits from correcting consumers’ inattention to vehicle fuel costs.  There are several behavioral biases that may drive down investments from the optimal level.  One of the primary interventions to assist consumers make energy efficiency investments is providing information either through labels or behavioral nudges.  We take a different approach and explore what types of people are making choices that are inconsistent with neoclassical economic behavior.

To investigate heterogeneity in the energy efficiency gap we augment a standard choice experiment for the purchase of a new hot water system with incentivized tasks from the experimental economics literature.  We elicit individual discount rates and risk aversion parameters since these are important components of consumers’ investments in energy durables.  Additionally, we collect financial literacy data by asking three financial literacy questions standard in the literature as well as three questions specific to hot water system purchases.  This allows us to estimate the impact of financial literacy on the willingness to pay (WTP) for reduced future energy costs while controlling for relevant idiosyncratic preferences.  We also randomize which respondents see a payback period button that calculates the number of years that a system will take to recoup the higher fixed cost relative through lower energy costs.  This is a way to exogenously make the decision easier for some respondents, potentially moderating the impact of financial literacy.

 Our primary result is that financial literacy is an economically important and statistically significant determinant of investment in energy efficiency.  A one standard deviation increase in our metric of financial literacy increases the WTP for energy savings by 16%.  This result is robust to including additional controls such as income and education, indicating that financial literacy is not merely a proxy for standard demographic characteristics.  We find that the presence of the payback period information does not change the WTP for energy savings, nor does it mitigate the effect of financial literacy. 

 Analyzing optimal investment decisions using both individual discount rates, and a range discount rates found in the economic literature (5%, 10%, 15%), shows that financially literate respondent make better choices. This helps to explain the energy efficiency gap since the financially literate respondent both make better choices and invest more in energy efficiency.  The payback period button does increase the probability of optimal choices, indicating that neutral information does help people make better investments even if it does not increase investments in energy efficiency. The policy recommendation from our research is that education campaigns to improve decision-making should extend beyond financial investments to include other large consumer decisions.  This can help consumers make better decisions with respect to durable appliances and also reduce externalities from energy consumption.