Required Reading for Steve Chu and Barack Obama

House of Lords,
Committee on Science and Technology - Second Report
July 5, 2005.

Chapter 3: Energy efficiency and energy demand

3.1. One of Government's fundamental goals is to promote economic growth and prosperity. For this to be combined with the reduction of greenhouse gas emissions there will have to be a "decoupling" of economic growth from its environmental impacts. Such decoupling was advanced as an objective by both British and Swedish Governments, in the joint letter sent by the Prime Minister and his Swedish counterpart, Mr Persson, to the European Commission in February 2003.[25] The object of this chapter is to analyse some of the arguments underpinning this objective.

3.2. Underpinning the discussion of "decoupling" is the progressive fall in the energy intensity (that is, energy use per unit of GDP) of developed countries. Data provided by the International Energy Agency (IEA), itself established in 1974 in the wake of the oil crisis, show that the ratio of total primary energy supply to GDP (or "energy intensity") in IEA members has fallen by more than a third since 1973.[26] This is presented by some as evidence that "partial decoupling" of energy use from environmental degradation has already occurred.[27] As Lord Whitty said, "we have decoupled in the relative sense quite dramatically on energy and I see no reason why we should not decouple in an absolute sense on energy as well" (Q 710). Figure 6, which derives from the DTI, illustrates the extent of such "partial decoupling" in the United Kingdom since 1970.

3.3. However, while Figure 6 illustrates the changing relationship between GDP and energy use, it does not in itself demonstrate any reduction in environmental degradation. When emissions are added to the equation, the picture becomes more complicated. Figure 7 illustrates the relationship between per capita GDP, energy use and emissions in four countries—the United Kingdom, United States, Australia and Sweden. It reveals significant differences in the relationship between GDP and energy use—indeed, the United Kingdom has the lowest energy intensity of the four. However, there are much more dramatic differences in emissions. Australia and Sweden, for instance, have almost identical per capita energy consumption, but Australia's per capita emissions are almost three times Sweden's. Thus while energy intensity may play a part in "decoupling", the most dramatic gains are likely to be made in addressing the carbon intensity of the fuel mix.

3.4. Moreover, the nature of the link between energy consumption and GDP is in fact the subject of considerable debate among economists.[28] In particular, there is a school of thought, deriving from the work of the nineteenth century economist Stanley Jevons, which argues that while increased energy efficiency at the microeconomic level may lead to a reduction in energy use, at the macroeconomic level it in fact leads to an increase in overall energy use. This proposition is known as the "Khazzoom-Brookes postulate", after the economists Daniel Khazzoom and Leonard Brookes, who independently published papers putting forward this argument in 1979-80. We received evidence on this debate from a number of sources, including the Institution of Electrical Engineers and A Power for Good Ltd, as well as from Dr Brookes himself.

3.5. Dr Brookes' argument is that for any resource, including energy, "to offer greater utility per unit is for it to enjoy a reduction in its implicit price". Cheaper energy has two effects: the substitution of energy for other factors of production, which are now relatively more expensive, and the release of income which can then be reinvested in new production capacity, and so on. As a result, Dr Brookes argues, developed countries have, since the Industrial Revolution, seen "rising energy productivity outstripped by rising total factor productivity, hence rising energy consumption alongside rising energy productivity".

3.6. A further consequence of this argument is that while rises in the price of energy may stimulate improvements in energy efficiency, such improvements, rather than leading to a lasting fall in energy use, may serve to accommodate the price rise, with the result that energy consumption stabilises at a higher level than it otherwise would.

3.7. The "Khazzoom-Brookes postulate", though it has not been proven empirically, is consistent with classical economic theory, and offers a plausible explanation of patterns of energy use in developed economies. As Professor Paul Ekins, head of the Environment Group at the Policies Studies Institute and co-Director of the new United Kingdom Energy Research Centre (UKERC), told us, "In the economics literature it is … well known that increased efficiency in the use of a resource leads over time to greater use of that resource and not less use of it" (Q 261).[29] This might explain, for instance, why there appears to be no example of a developed society that has succeeded in combining sustained reductions in energy consumption with economic growth. Mr Alan Meier, of the IEA, referred to "several countries that, for brief periods, reduced their electricity consumption or their energy consumption"—often in response to short-term supply crises—but such reductions in demand have never been sustained. This does not mean that sustained reductions in energy consumption are impossible—simply that it is yet to be demonstrated that they are possible. (Q 424)

3.8. We pressed a number of witnesses on the macroeconomic effects of energy efficiency, but did not receive convincing answers. Mr Meier openly admitted that "I always have to retreat to a micro analysis here" (Q 416). Lord Whitty also argued at the microeconomic level, as did his officials, though without Mr Meier's acknowledgement that there might be difficulties in so doing (QQ 717, 9-15). At this microeconomic level, for instance in the case of an individual household, savings that are made through, for instance, improved insulation, release money that will be spent on other goods. These will entail some energy consumption, creating a "rebound effect", but in practice the money that has been released, which was previously being spent essentially on either primary fuel (e.g. gas or oil) or on electricity, is unlikely to be spent on anything equally energy intensive.[30] Absolute reductions in energy consumption are thus possible at the microeconomic level.

3.9. However, this does not mean that an analogy can be made with macroeconomic effects. Apart from anything else, the substitution effects observable at the macroeconomic level cannot be replicated by households, where demand for a range of goods is relatively inelastic. If energy becomes, in effect, cheaper, there is very limited scope for the individual simply to divert money, say from food to energy. A business, on the other hand, could respond to cheaper energy by deliberately increasing consumption—using a more energy intensive process, which would allow savings to be made elsewhere, for instance in manpower.

3.10. We have recently learnt that the UKERC is proposing to commission work on the both the "rebound effect" and the Khazzoom-Brookes postulate under its programme of technology and policy assessments. Results should be available in 2006. While this is welcome, pending the outcome of this work the possibility remains that many of the arguments about the extent of "decoupling" may, at least so far as business and industry are concerned, be fundamentally misplaced. Many improvements in energy efficiency, particularly within industry, are simply products of technical and economic development—investment in new machinery, for example, that optimises productivity across the spectrum, including energy consumption. What the Minister described as the "relative decoupling" of energy use from economic growth may thus simply reflect the fact that greater efficiency in the use of energy is one of the drivers of that growth. We have already noted, with regard to the evidence from Defra, regarding "real relative savings", that savings against a "what might have been" scenario are not real savings at all.

3.11. The Government's proposition that improvements in energy efficiency can lead to significant reductions in energy demand and hence in greenhouse gas emissions remains the subject of debate among economists. The "Khazzoom-Brookes postulate", while not proven, offers at least a plausible explanation of why in recent years improvements in "energy intensity" at the macroeconomic level have stubbornly refused to be translated into reductions in overall energy demand. The Government have so far failed to engage with this fundamental issue, appearing to rely instead on an analogy between micro- and macroeconomic effects.

3.12. We welcome the UKERC project to investigate the "rebound effect" and the empirical basis for the "Khazzoom-Brookes postulate", and recommend that the Government, in parallel with the establishment of a more robust measure for energy efficiency, take full account of the project's progress and results in developing future policies in this area.

Cost-effectiveness

3.13. A related issue is the Government's use of the term "cost-effective". The meaning of the term is of course dependent on circumstances, time horizons, and so on, but few of these subtleties are reflected in the Government's use of the term. We are all, as individuals and businesses, free to choose where to invest our resources. In the case of a business, for any action to be "cost-effective", it is not enough that it is cheap, or even that it pays for itself over an arbitrary period—one year, say, or five years. Rather, it must represent the optimal use of resources at that moment. This point was forcefully made to us by Dr Brookes:

"Fuel or any other source of energy—and indeed any other economic resource—cannot be used with greater economic efficiency than in a system in which all the resources involved are used with maximum economic efficiency" (p 181).

3.14. It follows that if a business can, by investing a sum of money in energy efficiency, achieve a return on its investment within three years, but by investing the same sum of money in new plant or processes can achieve that return within two years, investment in energy efficiency is not in itself "cost-effective". As Mr Matthew Farrow, of the Confederation of British Industry, said, "it is a competitive world out there", and any proposal for investment "has to be compared against whatever else it can be used for in the business" (Q 572). It is notable that the only period in recent time in which significant reductions in energy use were achieved was the late 1970s, when the economic imperative was enormously strengthened by the oil crises. Significant rises in energy prices today might similarly encourage investment in energy efficiency—but at serious cost to the economy as a whole, and, in the absence of effective measures to reduce the cost to low-income households, to the Government's legally binding commitment to reducing fuel poverty.

3.15. This confusion over cost-effectiveness is typified by the widely reported statement that there is an overall cost-effective potential to reduce energy use by 30 percent. This derives from the 2002 Energy Review[31] by the Performance and Innovation Unit (now the Prime Minister's Strategy Unit), and is repeated in the Action Plan and in the Government's written evidence to this inquiry (p 11). But as Professor Ian Fells pointed out, these savings are simply not being achieved—because, he argued, "they are the technical potential for saving rather than the economic". Savings that are not "economic" cannot be regarded as "cost-effective".

3.16. On the other hand, there are circumstances in which "cost-effectiveness" may not by itself be an optimal test of investment decisions. In the building sector, for instance, the assessment of cost-effectiveness is distorted by the predominance in this country of "build for sale" development, as distinct from the "build and manage" approach which dominates elsewhere in Europe. This leads the developer to minimise capital expenditure, even where this increases the cost of subsequent occupation of the building. For example, at the point of installation electrical resistive heating is the cheapest form of heating. However, it is associated with both the highest carbon emissions and the highest running-costs, which makes it a significant contributor both to climate change and fuel poverty.[32] The division between the interests of the builder, and the ongoing interests of the subsequent occupants and society at large, means that merely commercial decisions on "cost-effectiveness" are unlikely to be optimal, and Government may have to intervene by means of regulation. Similar issues arise in the rented housing sector, where the economic interest of a landlord is to minimise expenditure on capital and maintenance.

3.17. There are also circumstances in which longer time-horizons are appropriate in making investment decisions. The public sector is subject to rules set out in the Treasury's Green Book, which is based on a 25-year horizon to compare all discounted costs, incomes and benefits. This is intended to avoid perverse decisions based solely on first cost without considering lifetime costs.

3.18. We recommend that the Government exercise caution in using the potentially misleading term "cost-effective" to describe investment in energy efficiency. They should seek to demonstrate realism as to what is economically achievable by means of private sector investment in energy efficiency.

3.19. We further recommend that the Government promote the application of the Green Book guidelines, encouraging decision-makers at all levels, including local authorities, housing associations, PFI projects and other private sector providers to the public sector, to consider lifetime costs in committing expenditure to long-term capital projects.