Carey King – Macroeconomic Modelling of Energy Efficiency: Implications For Reducing Greenhouse Gas Emissions

This is something very basic we need to understand if we wish to stop climate change. Simple solutions are often simple because they are wrong. Energy efficiency will lead to a reduction of energy consumption is one of these.

Carey W. King is a Research Scientist and the Assistant Director of the Energy Institute at The University of Texas at Austin. He is the author of the book The Economic Superorganism: Beyond the Competing Narratives on Energy, Growth, and Policy.

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Energy efficiency is a concept summarized by some as the cheapest source of energy and a major component of most climate policies. Invest in energy efficiency, we’re told, and we’ll reduce energy consumption making it easier to reduce greenhouse gas emissions because fewer low-carbon energy systems are needed to replace the current fossil fuel system.

There are a few major problems with this line of thinking: it’s wrong, it’s obvious from the data. We’ve effectively known this since the 1860s, and policymakers believe it because they’re advised by economists, policy analysts, and engineers who use models outside of their capability. These problems lead to policies that counter action to lessen the impact of climate change because historical investments in energy efficiency have clearly led to more consumption, not less.

To understand the linkage between energy efficiency and growth in energy consumption, one must distinguish between efficiency and investment. At its core energy efficiency is an engineering metric, not an economic one. It measures the amount of work that can be done by a machine per unit of fuel input. The choice of how to invest money, and thus energy, is an economic one, not one of physical sciences or engineering. The rest of this article explains the feedback between energy efficiency, investment, and growth.

Why do companies choose to design and invest in making more, rather than less, energy efficient devices? Two main reasons. First, in our current capitalist economic system the most successful companies make the most profits relative to costs. Second, one tactic to achieve profits is to use more energy efficient devices than the competition because this reduces the unit cost of production. This concept was first explained by William Stanley Jevons in his 1866 book The Coal Question.

To be clear, energy efficiency is not the only tactic to increase profits. We’ve created new inventions, such as mobile phones and computers, that seem to have no direct linage to energy efficiency. However, every economic activity is necessarily associated with energy consumption and conversion. Thus, even mobile phones and computers benefit from more efficient use of electricity to perform each computation.

As far back as 1866, Jevons noted that technological improvements that decreased energy use at the small scale of individual devices often caused increased energy use at the large scale of industries or entire economies. Because of this so-called backfire effect, also called the Jevons Paradox, efficiency promotes growth in consumption that would otherwise not occur. To understand why consider an excerpt from Jevons’ writing:

“It is wholly a confusion of ideas to suppose that the economical use of fuel is equivalent to a diminished consumption. The very contrary is the truth.”

To understand why he came to this conclusion, Jevons made the following argument:

“Now, if the quantity of coal used in a blast-furnace, for instance, be diminished in comparison with the yield, the profits of the trade will increase, new capital will be attracted, the price of pig-iron will fall, but the demand for it increase; and eventually the greater number of furnaces will more than make up for the diminished consumption of each.” — William Stanley Jevons (1866)

Here Jevons describes the linkage between energy efficiency and investment. An increase in energy efficiency enables more profits, and the general trend during the industrialized era of the last two hundred years has been to choose to invest a large share of profits into making more things that in turn collectively consume more energy. This backfire effect of investing in energy efficiency “now” and consuming more energy (years) “later” is known as the Jevons Paradox.

Not only is the reasoning sound for the Jevons Paradox, but the data support it.

Think about this. When is the last time you debated buying a vehicle that consumed more liters of fuel per kilometre? Maybe you’re lucky enough to be collecting vintage cars, but the vast majority of us only have the option to buy a car more fuel efficient than the one we might already own. The same goes for air conditioners, refrigerators, airplanes, etc. Manufacturers generally only make products that become more energy efficient over time, not less so. All major energy conversion devices, from power plants to internal combustion engines and electric motors, have increased in energy efficiency since the time of their invention.

At the same time as devices have become more energy efficient, we’ve accumulated more of them and consumed more energy within the entire global economy. The data are clear: devices have become more efficient, we have consumed more energy each year (on average) to date.

Now we can turn to the implications for climate policy. In order to incorporate the reality of the backfire effect into economic modelling, one must explicitly consider how the economy extracts and consumes energy resources. The most commonly-used economic growth framework, the neoclassical growth model (or Solow-Swan growth model), fails on this consideration since growth is only a factor of capital and labour that can change inside the model. There is also technological change, termed “total factor productivity”, but it is assumed before running the model, and thus is not affected by any changes within the model. (In the economic jargon, the technological change is “exogenous,” or outside the model.) To make it clear, in the neoclassical model any changes from energy efficiency cannot be influenced by variables inside the model, but are lumped into the term for technological change that is decided before you run the model.

Consider the ramifications of using the neoclassical growth theory to discuss a transition to a low-carbon energy system with near-zero greenhouse gas emissions. There are many reasonable questions for an energy transition. For example, how does the magnitude and speed of transition affect the economy in terms of debt, employment, growth, and the social cost of carbon?

Researchers use integrated assessment models (IAMs) to help discuss these questions. These IAMs link models of the Earth’s climate to models of the economy. Arguably the most widely-used IAM is the famed Dynamic Integrated Climate-Economy (or DICE) model of Nobel Laureate William Nordhaus, and it uses the neoclassical growth theory I’ve summarized. Because we want to specify the shift to low-carbon energy, the economic part of IAMs must represent different types of energy resources and technologies from biomass power plants to oil drilling rigs. And now we see the crux of the problem: IAMs based on neoclassical growth theory assume that economic growth is not affected by the quantity, conversion efficiency, or cost of energy inputs.

Policymakers want to understand the effect of energy efficiency on greenhouse gas emissions, so national and international energy agencies, such as the International Energy Agency, create low-carbon scenarios that assume a series of energy efficiency investments. Unfortunately, they usually use neoclassical growth theory posing a fatal contradiction in modelling the effects from energy efficiency. Energy consumption and efficiency are included in “technological change”, but at the same time modellers include more efficient machines (or capital) and other processes. But you can’t have your cake and eat it. You can’t simultaneously ignore energy efficiency as a characteristic of economic growth within the theory of the model and then decide to consider changes to energy efficiency when using the model. The use of the model is completely inconsistent with its theoretical assumptions, and policymakers think you can invest in energy efficiency to both promote growth, reduce energy consumption, and make it easier to reduce greenhouse gas emissions.

To many academics, this is nothing new. Practically every economist I speak to recognizes the macroeconomic modelling problem I’ve outlined in this article: that most agencies use the neoclassical growth model to run scenarios of an energy transition even though the theory of the model makes it inapplicable for the question! Nobel Laureate Paul Romer summarized this problem in his 2016 essay The Trouble With Macroeconomics:

The trouble is not so much that macroeconomists say things that are inconsistent with the facts. The real trouble is that other economists do not care that the macroeconomists do not care about the facts. An indifferent tolerance of obvious error is even more corrosive to science than committed advocacy of error.

So my call to all policymakers is this: stop blindly stating that energy efficiency reduces total future energy consumption. It is possible to reduce future energy consumption by investing in energy efficiency today, but this result requires that the efficiency-related profits are not invested such that they lead to an accumulation of so many more machines, now efficient, that their collective energy consumption is higher than in the past. This is what Jevons told us in 1866, and it is what I’m telling you in 2022.

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