Firm-level energy-efficiency investment decision-making has received a great deal of attention since the late 1970s when it became apparent that observed discount rates are significantly higher than the cost of borrowed funds. The implication is that firms forego savings represented by the difference between the internal rate of return on efficiency investments and the lower cost of capital rate. This “energy paradox” or “efficiency gap” has been attributed to a variety of factors including energy price uncertainty, equipment performance uncertainty, information and transactions costs, capital market imperfections, capital rationing, bounded rationality, the irreversible nature of energy efficiency investments, and principal-agent issues.   Contributions to this literature tend to detail the litany of possible reasons for this behavior and apply empirical analysis that more often than not, establishes a limited role played by individual factors in explaining the energy paradox.  

A review of this literature suggests that the nature of efficiency-related investment decisions is too complicated to identify more satisfactory theoretical and empirical representations. This failure to understand and model efficiency investment decisions leaves policy-makers with limited insight on options to promote increased energy efficiency to achieve both energy and environmental goals.  

Several recent study results indicate that current energy efficiency programs are less effective than commonly assumed and call into question the wisdom of expanding existing programs to meet more aggressive energy efficiency goals. 

This paper reviews past literature on the energy paradox, efficiency program analysis and capital budgeting investment and develops a more general model of energy-efficiency investment behavior based on decision-making under uncertainty, bounded rationality and loss aversion.  The new model is shown to be consistent with results of previous empirical studies and suggests that current policy approaches to improving energy efficiency are likely to be even less effective than past policies in today’s volatile energy markets.   

The new model is used to identify policy prescriptions that address decision-maker barriers to energy efficiency investments.  The model also demonstrates the cost advantage of policies designed to mitigate individual decision-maker investment risk compared to traditional policies that provide financial incentives to purchase energy-efficiency equipment.