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Decision Making in Energy Efficiency Investments - A Review of Discount Rates and Their Implications for Policy Making

Panel: 1. Policies and programmes

This is a peer-reviewed paper.

Author:
Ruben Kubiak, European Commission, Belgium

Abstract

I look at the inter-temporal decision making of economic actors with a special focus on energy efficiency investments using a discounted-utility model. I review literature to derive empirical discount rates for individuals as well as companies, and look at underlying factors influencing their investment behaviour such as socio-economic factors. The reported discount rates for individuals vary considerably within the population with an average discount rate of 43% and median of 21%, which is considerably above the weighted average cost of capital or the interest rate on government bonds. This discrepancy can best be explained by the 'bounded rationality' of individuals. There appears to be no significant difference in an individual's assessment of energy efficiency investments compared to other types of investments. For legal entities, the available data is more limited but points to a similarly high average discount rate of 46%, which is seen as a result of the interplay of boundedly rational actors with simplistic financial evaluation methods. These are insufficient to evaluate appropriately the financial viability of energy efficiency investments.

The discount rates observed in the population are then compared to the required discount rates for investments in energy efficient products. Only around half of all profitable investments are undertaken, being an indicator for the size of the economic 'energy efficiency gap'. In a next step, the impact of public policy on investment decisions is assessed. I review literature on the effect of energy efficiency policies, counteracting the 'bounded rationality' and often reducing average discount rates by around 30% through improved information or successful risk mitigation. I conclude with a summary of main factors influencing an economic actor's decision making, followed by recommendations on how to design public policies to maximise their effect.

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