The profit paradox

It is common to hear people say that we will address climate change when it is profitable to do so. That is a limited viewpoint. There is overwhelming evidence that we don’t act in so-called rational manners. We will commonly ignore cheap and low-risk profitable changes.

It is well known that we don’t make rational decisions. However, it is a pervasive belief that we will act when it is profitable to do so.

The following post is an extract from Chapter 3 of my Ph.D.

Introduction

There can no longer be any doubt that the micro assumptions of the theory — the assumptions of perfect rationality — are contrary to fact. It is not a question of approximation; they do not even remotely describe the processes that human beings use for making decisions in complex situations.

Herbert Simon, Rational decision making in business organizations (1979)

The section below highlights the extent to which profitable, low-risk, changes are not implemented. There is a substantial body of evidence demonstrating that currently available technologies and practices could cut energy demand and deliver cost savings. Moreover, such changes offer substantial returns on investment and could result in meaningfully large greenhouse gas emission reductions. Viewed in this light this is something of a paradox. It is quite common for us to believe we will act on climate change when it is in our financial self-interest to do so. Conversely, the fact that it may be less profitable to act is often raised as a barrier and as a reason why these issues are not addressed sufficiently. Hence the paradox — we say we will act to maximize profits but fail to act on very low-risk energy opportunities that would deliver such profits. 

Paradoxes such as these are useful as they highlight conditions and inconsistencies that may lead to a deeper or more integrated understanding. This is especially important when dealing with complex and ambiguous issues such as sustainability.18

Energy Efficiency Theory

Practical analysis of energy efficiency and other GHG mitigation options often makes the narrower assumption that people are cost-minimizers. Such assumptions are undermined by experience with energy efficiency programs. It has long been recognized that consumers do not necessarily act on their stated values, and fail to take up measures that appear on paper to be economically worthwhile. 

IPCC: Jayant Sathaye, Daniel Bouille et al. Barriers, Opportunities, and market potential of technologies and practices (2001 p367). Note: quote omits citations.

Over a decade ago, Cameron and Quinn (1988) claimed that by exploring paradox,researchers might move beyond oversimplified and polarised notions to recognize the complexity, diversity, and ambiguity of organizational life.

Marianne Lewis, Exploring paradox: Toward a more comprehensive guide (2000)

Energy efficiency refers to improvements that can be undertaken that reduce the amount of power used for a given activity. A clear example is lighting. The same amount of light can be delivered from a variety of sources including incandescent, compact fluorescent and LED bulbs. An LED bulb is approximately an order of magnitude more efficient, delivering the same quantity/intensity of light while using 10 times less electricity. Changing a light bulb, or lighting sources, is relatively simple, low risk, with savings and profits quickly realized (IEA, 2006 pp25-28). Consequently, from a purely objective or financial perspective, high rates of uptake and implementation should be expected (Gillingham, Newell, & Palmer, 2006; Gillingham et al., 2009). 

Energy efficiency opportunities extend well beyond artificial lighting and are ubiquitous across human power uses. The term is used specifically for technology as well as more broadly across a physical system. For example, using waste heat from electricity generation (combined heat and power) can be regarded as energy efficiency (Garnaut, 2008 p445; Sorrell, 2007 p11; von Weizsäcker et al., 2009). There are multiple examples including designing buildings, suburbs, transport systems, industrial production, and across primary and secondary industry (Farrell, Nyquist, & Rogers, 2007; von Weizsäcker et al., 2009). Importantly, cutting carbon-intensive power use through efficiency can address greenhouse gas emissions and these technologies are commonly discussed in relation to climate change (IPCC, 2007b; Pacala & Socolow, 2004).19

Despite this evidence, cost-effective changes generating profitable returns through reduced energy bills are not being implemented. Studies (e.g. Energy Efficiency and Greenhouse Working Group, 2003; Enkvist et al., 2007; Farrell et al., 2007; Gillingham et al., 2009; A. Lewis et al., 2008; Sanstad, Hanemann, & Auffhammer, 2006) demonstrate that substantial unrealized efficiency opportunities exist. Internationally, these assessments typically calculate large savings (negative cost greenhouse gas abatement) that can be achieved through efficiency measures. There are numerous examples such as Farrell, Nyquist and Rogers (2007) who find that efficiency could be implemented at more than twice the current rates. For lighting alone, the International Energy Agency finds that US $2.6 trillion of costs could be avoided by shifting to more energy efficient lights globally (IEA, 2006 p28; Waide, 2007 p26). 

In Australia, six giga-tonnes of greenhouse gas cuts are available at a net profitable return or at zero cost (A. Lewis et al., 2008). Nearly 25% of the total target for Australian greenhouse gas emissions reduction that could be met with profitable or zero net cost actions.20 Similarly, a major Australian Government report (all state, territory and federal governments) calculates the potential for emissions reduction from efficiency opportunities. It finds 20 to 30% of Australian emission reduction requirements can be achieved from efficiencies with a payback period of less than four years (Energy Efficiency and Greenhouse Working Group, 2003).

The Energy Efficiency and Greenhouse Working Group (2003) using a conservative scenario (50% adoption in 12 years of its low improvements scenario) finds the following benefits:

• Real GDP would be $1.8 billion higher (+0.2%)
• Employment would increase by around 9000 (+0.1%)
• A 9% reduction in stationary final energy consumption
• A 9% reduction in greenhouse emissions from the stationary energy sector.

Such benefits are a two part paradox. The first element of this is that there is an enduring gap between the rate at which such efficiency opportunities should be implemented — as gauged by economic theory — and actual practice (DeCanio, 1994, 1998; Gillingham et al., 2009; van Soest & Bulte, 2001). The gap is well documented with a wide range of publications addressing the topic (Shove, 1998; Thollander, Palm, & Rohdin, 2010; Weber, 1997). However, the existence of such a paradox is not necessarily widely accepted (Gillingham & Palmer, 2014).

Economic theory struggles to explain the gap. For example, Diederen, Van Tongeren and Van Der Veen (2003) analyze a specific case using a hurdle rate — that is, assuming that people are unwilling to invest as they may believe that in doing so they miss out on other potential profitable opportunities. However, the hurdle rate only correctly models 6% of businesses that did not invest in such efficiency. Consequently, hurdle rates do not account for this gap (Diederen et al., 2003; Sanstad, Blumstein, & Stoft, 1995).

How people think they act, versus what can be measured in practice, is a second element of the paradox. Economically rational human behavior should result in the adoption of energy efficiency actions at optimal rates and such rational behaviour does not occur (Gillingham et al., 2009; van Soest & Bulte, 2001). This paradox manifests as the difference between polarised perspectives — that we will act on climate change mitigation if it is in our economic interest to do so — and actual behavior observed from energy efficiency studies. Such an economically driven action perspective – we do not act on climate change as it is not in our economic interest to do so – is an established reason for the lack of action on sustainability or climate change issues. Stern (2007b) and Garnaut (2009), for example, highlight market failure, as the world’s ability to absorb carbon emissions is overused and using this resource is free. However, the slow implementation of economically beneficial energy efficiency actions contradicts the theory that humans behave in such a rational manner. Yet the assumption that we do act in this way dominates climate change discussions — a paradox (as defined by Caprar et al., 2010 pp. 146-147). 

For efficiency, Gillingham, Newell and Palmer (2009) analyze this paradox — defining it as a significant difference between the level of energy efficiency implementation we observe and what could be regarded as ‘socially optimal’. In seeking to understand this they argue from two perspectives: market and non-market failures. Market failures include the perception of cost and price, as well as more objective pricing and investment barriers. Non-market failures are those particularly related to individual and group actions — that is, behavioral failures.

Within such broad categories, there is a range of theories and frameworks such as discount rates — a ‘discount’ on future cost savings and profits that is typically applied to investment decisions (Weitzman, 1998). The higher the rate, the less value placed on profitable future savings. For typical investments, this rate is approximately 5 to 10%. However, the implied discount rates for energy efficiency projects are estimated at 20% or more and continue upwards above 100% (Gillingham et al., 2009; Jaffe & Stavins, 1994b; Sanstad et al., 2006). 

These high discount rates are well beyond levels expected for such investments. This raises significant questions about the presence of other factors, such as substantial non-market behavioral influences. Soest and Bulte (2001) highlight this, saying that “the economic literature has difficulty explaining why firms don’t undertake profitable investments in energy saving”. Gillingham et al. (2009) are more direct – discussing behavioral economics and non-market barriers and arguing that “consumers are irrationally reluctant to move from the status quo” and “systematic biases may exist in consumer decisionmaking (sic)”. Stern (2007b p378) similarly notes that “consumers and firms frequently do not make energy efficiency investments that appear cost-effective”.

Consequently, the literature and analysis support considering objective factors (such as discount rates and market forces), as well as subjective influences (such as individual perspectives and organizational cultures) to explain and understand individual and society responses to energy efficiency. This paradox reflects the main lines of inquiry for this thesis — why do some organizations or groups act while others may not? For example, within the case example of energy efficiency, employees of the companies in this study describe success and failure that is not necessarily based on economics (see Chapters 4 and 5).

Further reading

The full references (bracketed names and/or dates in the text above) are at the end of A Climate for Change (pdf).

For an overview of my whole thesis, including an outline of the chapters, see the post on it here>>>.

Image: How many legs does the elephant have? It’s often worthwhile going past the first things we see and assume.

Footnotes

18 A paradox occurs when related concepts contradict each other and any element on its own makes logical sense but when put together the contrasts appear irrational or absurd. For clarity, it’s useful to think of the term ‘paradox’ in general and specific categories. Firstly, it’s an umbrella definition of contradictory statements. It gets used to point out inconsistent perspectives, for example questioning how an individual can hold one view about themselves but, paradoxically, not behave in this way to others. Secondly, there are logical paradoxes (e.g. “I always lie”), which are difficult to understand as either true or false. Paradoxes in social research and the one being examined here, energy efficiency, are generally the first type (M. W. Lewis & Smith, 2014; Poole & Van de Ven, 1989).

19 There is considerable discussion on whether the ‘Jevons’ paradox means that energy efficiency, within a household or organization with net positive economic and emissions benefits, leads to an overall reduction in greenhouse emissions on a larger scale. The issue arises as an overall increase in greenhouse emissions could result if energy becomes cheaper — if this occurs as a result of resource efficiency. Broader policy, cultural, pricing and behavior measures are likely to be necessary to address this. Consequently, a policy that relies solely on promoting energy efficiency is unlikely to address greenhouse gas emissions effectively (Hanley, McGregor, Swales, & Turner, 2009; Herring, 1999; Sorrell, 2007). Conversely, economy-wide savings from efficiency can beneficially offset climate mitigation costs (Enkvist et al., 2007; Farrell et al., 2007). As a result, efficiency is generally regarded as a major mechanism to mitigate emissions.

20 Target to meet Enkvist, Nauclér and Rosander’s (2007) total based on global requirements.