A Closer Look at Energy Efficiency

President Obama recently announced plans to use his executive authority to encourage energy efficiency as it pertains to federal buildings. This comes at a time when the Senate recently failed to pass legislation designed to promote energy efficiency. Given all this attention, now is a good time to ask what people really mean when they talk about “energy efficiency.”

The term itself is actually very confusing, because it has nothing to do with efficiency in the economic sense. Energy efficiency is about reducing energy consumption, while economic efficiency is concerned with tradeoffs.

Hypothetically, we could create a vastly more energy-efficient world right now. All we have to do is turn out the lights, stop using electricity and running water, and start using horses and buggies again. It’s a ridiculous proposal, but it demonstrates why we should ultimately care more about economic efficiency than energy efficiency. Economic efficiency takes into account what we sacrifice in order to reduce our energy consumption. Energy efficiency does not.

When economists talk about efficiency, they usually mean one of two things: One type of efficiency is known as “Pareto efficiency,” after economist Vilfredo Pareto. This is a state of the world in which no one is made better off without making someone else worse off. A “Pareto improvement,” though, is a change that makes everyone better off while making no one worse off.

The other type of efficiency economists talk about is called “Kaldor-Hicks efficiency” (after Nicholas Kaldor and John Hicks), sometimes referred to as “benefit-cost efficiency.” Kaldor-Hicks efficiency is concerned with maximizing the value of social resources to people. A Kaldor-Hicks improvement is a situation where some people are made worse off, but others are made better off by a greater extent, such that those who benefit from the change could compensate (at least theoretically) those who are made worse off, and everyone would still be at least as well off or better than they were before.

For public policy purposes, Kaldor-Hicks efficiency is what matters because every government policy always makes at least one person worse off (and thus policies will never result in Pareto improvements). The problem with energy efficiency is that it only concerns itself with reducing energy consumption. This may lead to some benefits, such as lower pollution, but at what cost?

The energy-efficiency standards that the government issues take several forms. Sometimes, the government mandates that products use less energy when they operate. States also pass legislation related to energy efficiency, often by setting goals for energy consumption at the public-utility level. The goal of these bills is always to reduce energy consumption. But energy consumption is not a bad thing and should not be viewed as a bogeyman. In fact, energy consumption gave rise to the tremendous increase in living standards seen over the last few centuries. It lifts billions of people out of poverty and creates countless positive spillover effects in areas from information technology to health care to art.

It’s important to consider that products are never quite the same after they’re revamped to run on less energy. Light bulbs don’t emit the same warm glow, washing machines don’t work as well and microwave ovens have clocks that break more easily.

Because energy efficiency concerns itself only with the benefits of reducing energy consumption (i.e., reducing pollution), it ignores the tradeoffs that come about because we use less energy. Some tradeoffs are even counterproductive in terms of environmental protection. For example, increasing the fuel efficiency of vehicles means new cars are more expensive. As consumers avoid the costly upgrade, old cars stay on the road longer and cause more pollution, not less. They may also be smaller and less safe in a crash.

Unfortunately, the myopic gaze of regulators will often focus on the issue in front of them and ignore important tradeoffs. The peril here is that we will likely see policies with costs that are out of proportion to the benefits they produce. If policymakers really want to improve general welfare, they should care less about energy efficiency and start worrying about economic efficiency.