Resources Radio: Energy Inefficiency and the Principal-Agent Problem

Launched in December 2018, Resources Radio is this magazine’s weekly podcast, hosted by Daniel Raimi and Kristin Hayes. Each episode features a special guest talking about a new or interesting idea in environmental and energy policy. We’ve transcribed one such episode, in which host Daniel Raimi spoke with Joshua Blonz, a postdoctoral fellow at Resources for the Future, about his recent research into an energy efficiency program in California. They discussed the goals of the program and its outcomes, which can sometimes be undermined by something economists call the “principal-agent problem.”

Resources Radio: The paper we’re going talk about is “The Welfare Costs of Misaligned Incentives: Energy Inefficiency and the Principal-Agent Problem.” The paper focuses on an energy efficiency program in California. Can you tell us a little bit about energy efficiency programs, broadly, perhaps at the federal level, and what some of the economics literature has told us about those programs over the last several years?

Blonz: Energy efficiency policy is this incredibly popular policy tool. It even has a little bit of bipartisan support because it’s seen as this win-win policy scenario where maybe your local utility, or your state government, or the federal government will provide some subsidies to people to increase the efficiency with which they consume energy. So, think of weatherizing your home, or making sure you have really new energy-efficient appliances. Maybe you’ve seen the Energy Star program out there. This is one of those energy-efficiency programs. We’re spending $8.2 billion a year on these types of programs because it seems so attractive that it will help people save on their monthly utility bills, which is a little bit of a government financial push. Everyone’s going to be better off because they will save money on their local utility bill, and we’re going to reduce energy consumption, which is going to help with CO2 emissions and local air pollution.

It sounds great, but what the recent economics literature has really found is that these programs are underperforming. They promise to save you a hundred dollars a month on your electricity bill, and they’re saving you maybe thirty or forty dollars. They’re not delivering on their promises, and when they don’t do that, they become kind of ineffective. They become not a good use of our tax dollars, and it’s been a bit of an open question as to why these programs are underperforming. There’ve been some papers which have put forward a couple of hypotheses. Things like the models that are used to predict the savings are a little bit optimistic, or maybe people are consuming more energy once it’s cheaper to consume more energy, but there isn’t really a concrete answer. It’s potentially a mix of many different factors. One of the things I’m doing in this paper is addressing this question head-on, and thinking about some of the reasons why this might be happening.

Resources Radio: Right. Let’s start talking about this paper. As I mentioned, the phrase “Principal-Agent Problem” is in the title. Can you tell us briefly what the principal-agent problem is, in general terms, and what sorts of issues it tends to create in an energy and environmental context?

Blonz: Of course. So, the principal-agent problem is definitely a bit of economics jargon, but it really captures this idea that I think most people deal with on a day-to-day basis in their everyday lives. A principal-agent problem is when you, as the principal, hires someone as an agent to do something for you. Maybe it’s your car mechanic. You need someone to service your car, or something’s not working, and so you take your car into the mechanic and you’re asking this person to diagnose what’s wrong with your car, and then tell you what that is, and then you’re going to pay them to fix it.

Now, the idea of the principal-agent is that you, as the car owner, are going to have maybe some different incentives from the mechanic. The mechanic might want to make some money on this job, or make more money by making a bigger repair than you might need. The idea of the principal-agent problem is you never really know exactly what this person’s incentives are, and in some cases, it can lead to some bad outcomes.

I take this everyday principal-agent concept, and I apply it to these energy efficiency programs. The way I’d like to think about it is, who is actually providing these energy efficiency retrofits? So here, let’s think about contractors that come into someone’s home to put new insulation in, or provide them with some new appliances. These contractors, themselves, have their own sets of incentives. They’re responsible for implementing these programs, and so it’s important to consider what are these contractors interested in, and how that might affect the overall performance of one of these energy efficiency programs.

Resources Radio: Right. So let’s look at one of these particular subsidy programs that you focus on in the paper, which is a program in California that has to do with refrigerators and other energy efficiency measures, but specifically refrigerators is what I think you focus on. Can you tell us a little bit about this particular program, and how much it costs for the state, in terms of either government outlays or tax expenditures, and what its goals are?

Blonz: Sure. It’s called the California Energy Savings Assistance program. It’s a bit of a mouthful, but its goal is to help people in California who are low-income deal with the high energy bills that we have in California. It’s a pretty expensive state to purchase electricity, and the idea here is it’s a free program, so eligible low-income households can sign up, and the utility will come into their home, determine what sort of upgrades they might be eligible for, and then provide them at no cost to the homeowner. It can be a really great program if you’re low-income. Around a third of the state qualifies. They spend around $285 million a year on it in California, so it’s actually a pretty substantial program that’s supposed to help low-income people.

So I focus on, like you mentioned, this refrigerator replacement component of the program. One of the reasons I was drawn to this part of it is it’s one of the most important parts of the program, based on the people involved with running it. They say that this is where they’re getting most of their energy savings from in this policy. The way they’ve structured it is if your refrigerator, when you sign up for the program, was manufactured in the year 1992 or earlier, you as the homeowner or the renter, the person who lives there, is going to get a brand new, free, energy-efficient refrigerator. They’re going to take out your old one. They’re going to dispose of it. They’re going to give you this brand new refrigerator.

Resources Radio: That sounds good.

Blonz: Yeah. If you’re low-income in California, this is a really great program. It’s designed to help people who are renters, as well. So a pretty common problem is you’re renting, you’re paying for your energy bill, but your landlord may not want to give you the newest appliances because they’re not paying the high energy bills responsible for the old appliances, so this program can come in and just give you that brand new appliance and help you save on your utility bill.

Resources Radio: So people in California, who are taking advantage of this program, are presumably saving some money on their energy bills, but you identify a principal-agent problem that manifests itself in the form of these refrigerator replacements, particularly looking at elements of the contract structure for the contractors who come in and do the refrigerator replacements. Can you talk a little bit more about how the principal-agent problem manifests itself in this context, and how the contract side of things plays into this story?

Blonz: Of course. Contractors in this program are being paid for the amount of work they do. They get paid for replacing the refrigerator, enrolling people in the program, and all of it. This is a pretty typical contract structure. If you’ve ever had someone work on your house, you pay them for the job they do, but it also gives these contractors this incentive to maybe break the program rules a little bit, and actually misreport data. So if they walk into someone’s home, they can look at the refrigerator. There’s usually a little plaque on the inside of your refrigerator that tells you the serial number, with which you can very easily determine the age it’s manufactured. A contractor can come into someone’s home. They can see that a refrigerator was manufactured in 1995, which would make it ineligible under this program, but they can just write down 1992 in the program documents, and that refrigerator is going to be replaced under the program.

Since the contractors are going to be paid to actually do that replacement, there’s a very large incentive for them to do this misreporting, and this is paired with the fact that the utility isn’t verifying the data that they’re submitting, so it actually makes it an easy situation for these contractors to tweak the data a little bit to increase their own compensation.

Resources Radio: Right. So it would be hard for the utility to track down every refrigerator at the dump and track it to each document, right? With this program?

Blonz: Yeah. There’s monitoring systems that you can imagine implementing. You can have the contractor take a picture of the little plaque on the inside with their cell phone, and submit that as a part of the packet. For me, as the researcher, it’s actually quite nice that they don’t have that part of the program there because I can see the incentives of these contractors, and how it affects their reporting behavior.

Resources Radio: Tell us about what you found when you looked at the principal-agent problem in this program.

Blonz: So first, what I end up finding is that around half of the refrigerators that were replaced in this program were done as a result of this misreporting. It’s actually a pretty large deal. It has some pretty significant effects on the overall program. So to quantify, actually, how this matters, I use household level electricity consumption data so I can observe before and after these households’ consumption. So using some econometric techniques, I can estimate what is the effect of a refrigerator replacement, and I can do this differently for those that qualified for the program, the ones that they were intending to be done, and the ones that didn’t qualify. What I find is that the qualified replacements, those manufactured before that cutoff year, they’re saving households 16 percent of their monthly electricity consumption, which is quite a lot. Old refrigerators use a lot of electricity, and so having a brand new refrigerator is actually going to do a pretty good job at saving electricity.

In contrast, the unqualified replacements save half as much. They save only 8 percent of a household’s monthly electricity consumption, so there’s this very large difference between the ones that followed the program rules and the ones that didn’t. The forces that are driving that is they designed the program very intentionally to remove the oldest, least efficient refrigerators, and starting in 1993, refrigerators became quite a bit more efficient because they have to satisfy some federal guidelines, some minimum efficiency standards, and so what these contractors are doing by breaking program rules is they’re replacing these much newer, and more efficient refrigerators, and hence getting a lot less energy savings out of the program for the exact same cost.

Resources Radio: Right.

Blonz: So then, I can take these electricity savings numbers and think about what us economists like to call “the welfare effects,” which is a jargony way to say “the social scorecard.” I’m the social planner who wants to make everyone better off. I’m weighing all these different factors to go into this welfare effect, and I make this calculation using all these parameters I’ve thought about in this paper, and what I find is that qualified replacements, those that follow the program rules, they’re increasing welfare by $60 per replacement. This is going to include a whole lot of things. This includes externality reductions— so we have lower amounts of CO2 emissions and local air pollution—which are all great benefits associated with making these replacements. We’re making the households better off. They’re paying less money for their utility bills. That’s another really good benefit to have. There are costs associated with all of this. You have to purchase these refrigerators. You have to pay people to install them. So that all goes into the calculation.

Now when I do that same calculation for these unqualified refrigerator replacements, I find that they actually reduce welfare, on the order of $106 per installation, so there’s a really big difference between those that followed the program rules and those that didn’t. The way I like to think about all these results together is from the policy perspective. You can take a program, which on paper appears to be welfare improving. It’s making everybody better off, when you take into account the costs and the benefits, but when you introduce the incentives of these agents to the situation, these contractors, you can actually turn the program into a welfare-reducing program. This might be one of the explanations for why these energy-efficiency programs are underperforming. That the people tasked with doing these installations, with these retrofits, are actually making it less effective.

Resources Radio: You mentioned that there are papers in the literature finding that these energy-efficiency programs are less effective than we might hope that they are. It sounds like your paper is explaining, at least potentially explaining, part of the reason for that ineffectiveness. So do you see this as a potential avenue to maybe improve these efficiency programs going forward, or are there other solutions out there that you’re thinking about?

Blonz: Exactly. So most energy-efficiency programs use this third-party contractor structure, and so it’s likely that other energy-efficiency programs are susceptible to these exact same kind of principal-agent problems that could be reducing the effectiveness of this program. Now it’s going to be context specific, but I think, what one of the findings in my paper suggests, is that we really need to be cognizant of these incentives. It hasn’t really been talked about and addressed directly, and so I think policymakers, as they continue to implement these energy efficiency programs, should put monitoring into place, or think about how the contract structures might be incentivizing agents to maximize their own payouts, which could potentially hurt the overall program outcomes.

Resources Radio: Right, and that could apply at the federal level, state level, as well as private utilities that are undertaking these efforts on their own? Are there implications of this work for other non-energy industries?

Blonz: There are many kinds of papers that have looked at these types of principal-agent problems. Bonuses are a big area. People trying to reach their year-end bonus by hitting specific sales targets, and there’s been some papers out there, which have shown how people are strategically reporting their sales in certain ways, using accounting tricks to hit their bonus. It’s unclear as to what the actual consequences are of these types of behaviors, so what my paper is doing is picking one of these principal-agent cases and showing that there are some really significant welfare costs associated with it.

The principal-agent problem isn’t this kind of new idea. It’s pretty well understood in the economics profession, but understanding what the consequences are is really important, and I think there’s a lot of research to be done using this framework to examine various federal programs, state programs, or just contracts in general between employers and employees.