Behavioural Science and 'Pay What You Want' Pricing

Here is an interview I gave on the 23rd of July (2014) on how the rise of Pay What You Want systems of pricing for products or services can be explained by insights from behavioural science. The interview was for the BBC World Business Report program.

Nudging and the Rebound Effect

Introduction

Policy makers have become excited at the prospect of using evidence from behavioural economics and psychology to 'nudge' consumers towards reducing their energy costs. For example, evidence has suggested that providing people with feedback through smart meters, and using social comparisons in neighbourhoods, can create significant reductions in household energy consumption [1].

However, such consumer-level interventions ignore the concept of the "Rebound Effect", which has enjoyed increasing attention from energy policy makers in this debate in recent years [2, 3]. The Rebound Effect refers to the behavioural or other systemic responses to the introduction of efficiencies in energy use, which offset the beneficial effects. If we accept some of the core arguments behind the Rebound Effect, then nudges and other behavioural interventions will only work to 'move around' energy use, and will not reduce overall energy consumption at all.

  

Defining the Rebound Effect

The existence of the rebound effect is uncontroversial [2], but the arguments become more subtle and complex when considering the different kinds of rebound effects thought to exist.

	Consumer	Producer
Direct	(Efficiency -> price reduction) = more energy used by consumer	(Efficiency -> price reduction) = producers increase output
Indirect	$ saved from efficiency spent on other energy intensive goods.	Energy efficiency lowers price products, shifting consumers to buy these.
+ Macroeconomic Effect. Where more efficiency drives economic productivity overall resulting in more economic growth and consumption at a macroeconomic level.

The direct rebound effect on the consumer side arises because an energy efficiency gain reduces the effective price of energy, causing consumers to use more of it. The direct rebound effect on the producer side means that by reducing the effective price of energy, producers are potentially able to increase their output. More importantly, energy efficiency gains, by again reducing the effective price of energy, allow firms to reconfigure the inputs of new capacity to use more energy profitably.

The indirect effect on the consumer side arises from consumers taking the money saved from, say, driving a more efficient car, and spending it to purchase other goods and services that require energy to provide. On the producer side, the indirect effect means that energy efficiency gains reduce the output price of products, some more than others, causing consumers to shift toward them, carrying with this shift the "embedded" energy required to meet these demands.

The macroeconomic effects are the result of the aggregate impacts of widespread energy efficiency improvements, which combine to drive several macroeconomic mechanisms that also contribute to rebound. For example, decreases in the effective energy price due to efficiency gains can reduce the price of intermediate goods and services leading to complex economy-wide adjustments in energy use.

These different direct and indirect effects are complex and interactive, particularly in a globalised world. Price changes in one country e.g. in the US or EU, resulting in lower energy prices internationally, will mean that demand increases in other countries such as China, where lower prices mean more people are able to purchase goods and energy.

More detailed descriptions for the different kinds of rebound effects are found various sources [1, 4].

Arguments Surrounding the Rebound Effect

Many economists and engineers have studied the rebound effect both empirically and theoretically and the vast majority has concluded that it does exist but is not strong enough to outweigh the energy and financial savings resulting from energy efficiency [5]. However, many of these arguments fail to engage adequately with the full range of different rebound effects, according to Harry Saunders [6], who lays the foundations for much of the explanation of the debate which follows.

Argument 1: It is not possible to re-spend all energy efficiency savings on pure energy

One position against the rebound effect is that it must be small because we can't re-spend all energy efficiency savings on energy [7]. This means the money saved from introducing energy efficiency cannot possibly create significant rebound, because the money re-spent will not be re-spent entirely on energy. However, this position only deals with one small part of the rebound effect, re-spending, and ignores the effects of both direct rebound and further macroeconomic impacts of widespread efficiency improvements.

Argument 2: End Use Consumption is Most Important

Many nudge-based or other intervention documents implicitly assume that end-use energy consumption is all that matters [8]. But this "end use" energy consumption represents only a relatively small fraction of the energy actually consumed across the economy. Globally, some two-thirds of all energy is consumed in the energy used to produce the goods and services we consume. So interventions which only target consumer decisions, often fail to deal with this much larger share of energy consumption.

Argument 3: Energy is being "decoupled" from the economy

The impact of rebound has been argued to be small, because energy is a small share of the overall economy [9]. This position states that because energy is such a small share of the economy, energy efficiency gains cannot save enough money to be released on significant magnitudes of other energy-consuming economic activity. As energy efficiency improves still further, the link between energy and economic activity diminishes. This is an on-going debate. Others argue that the link between energy and economic activity is actually very tight [10], as virtually any economic activity imaginable requires some level of physical energy as an irreplaceable input.

Argument 4: Efficiency gains happen only in energy

Efficiency gains are not limited to energy alone. Other factors of production (capital, labour and materials) also experience efficiency gains. The problem is not so much that efficiency gains targeted at energy often also improve the efficiency of other factors; the real problem is that technology gains, considered together, increase energy consumption. Without these gains, energy consumption would be lower [6].

Argument 5: Establishing baselines

In estimating the benefits of energy efficiency, an important consideration is what the energy consumption and socioeconomic situation would have been without improved energy efficiency, or in other words the counterfactual or baseline. In many cases it may be that there would have been even higher energy consumption leading to higher costs in the long run.

Argument 5: Nudging toward less Innovation

If Nudging works, and significantly reduces the amount of energy consumer's use, then the consequence of this fall in demand will be lower prices for energy. Although this may be immediately beneficial to consumers, it may produce less innovation in the energy sector and to higher energy use in the long term. For example, Popp in 2002 used patent data to demonstrate the strong relationship between the price of energy and the number of innovations designed to reduce energy use [11].

Argument 6: Using Taxes as an alternative to Nudges

A traditional approach to reducing energy consumption would be to tax energy use more and reinvest this into research on sustainable energy, such as artificial photosynthesis and solar fuel cells [12], which have the potential to create energy long term with lower levels of energy use.

However, taxes can be distortive and it is difficult to design an optimal tax to address something as specific as the change in energy prices as a result of efficiency improvements. Where fiscal measures are uniformly applied across sectors, they can be too indirect to be effective and lead to unnecessary costs. For example, with a uniformly applied energy tax , as sectors have different price elasticities with respect to the price of energy, this tax would have different impacts across the economy creating a burden for some sectors which exceeds any benefit gained. Further, evidence shows rebound effects vary depending on the energy intensity of the sector, so uniform approaches are less likely to be equitable.

Argument 7: Problem of measurement

One of the reasons there is debate on the rebound effect is because it is hard to measure and varies depending on the intervention (policy, technology, practice), the type of products/services/resources investigated (energy, food, transport, etc.), as well as other related factors e.g. income level, productivity, price elasticity, saturation, location and time [13]. This is one explanation proposed for why it is not currently factored into key energy studies informing policy or traditional energy economic models used for energy policy modelling.

Conclusion

If the rebound effects arguments are taken seriously, then behavioural interventions designed to nudges consumer decision making will not work. This is a very difficult argument for many within and outside government to accept, because of the wide benefits of energy efficiency. These include benefits for the individual (health and wellbeing, and poverty alleviation through increased disposable incomes), business (increases in industrial productivity and competitiveness) and governments themselves (job creation, reduced public expenditure, energy security and development goals). These benefits are substantial and should not be ignored, but if the goal of the nudging policy is to reduce energy consumption, then if the central arguments of the Rebound Effects are accepted, nudges will not work to achieve this goal.

the Rebound Effect has significant implications as to whether it is possible to decouple resource consumption from economic growth (i.e. maintaining economic productivity without depleting limited resources e.g. energy, water and land). Consumer focused measures to tackle rebound effects should clarify that raising energy or resource efficiency alone is not enough but absolute reduction of energy and resources is required. To reduce energy consumption, we must consider moving beyond traditional economic models where GDP growth is the main success factor. Recent recognition of this in France and the UK with the consideration of introducing social and environmental well-being indicators, and making GDP a measure of market activity only, are relevant developments in this agenda for the rebound effect.

When considering the role of energy efficiency at the policy level we need to ask - what is the goal of our society? At present the economic priority is for maximum growth in consumption and production which is in conflict with a planet with limited resources.

References

[1] S. Darby. The effectiveness of feedback on energy consumption: A review for DEFRA of the literature on metering, billing and direct displays. Tech. report, Environmental Change Institute, University of Oxford, 2006. [http://www.eci.ox.ac.uk/research/energy/downloads/smart-metering-report.pdf]

[2] The Rebound Effect: Implications of Consumer Behaviour for Robust Energy Policies

 A review of the literature on the rebound effect in energy efficiency and report from expert workshops. Report. International Risk Governance Council. 2013. [http://www.irgc.org/wp-content/uploads/2013/04/IRGC_ReboundEffect-FINAL.pdf]

[3] Frondel, M.; Vance, C. Energy efficiency: Don’t belittle the rebound effect. Nature 2013, 494, 430, doi:10.1038/494430c.

[4] Gavankar, Sheetal, and Roland Geyer, “The Rebound Effect: State of the Debate and

Implications for Energy Efficiency Research,” June 2010, Bren School of Environmental

Science and Management.

[5] Nadal, S. The Rebound Effect: Large or Small? August 2012. ACEE White Paper. [http://aceee.org/files/pdf/white-paper/rebound-large-and-small.pdf]

[6] Saunders, H. Six Misconceptions about Rebound and Backfire. [http://thebreakthrough.org/archive/six_misconceptions_about_rebou]

[7] Mangling Energy Efficiency Economics [http://blogs.cfr.org/levi/2010/12/14/mangling-energy-efficiency-economics/]

[8] Behavioural Insights Team, 2011. Behaviour change and energy use. Cabinet

Office, London (available at)/http://www.cabinetoffice.gov.uk/resourcelibrary/

behaviour-change-and-energy-useS

[9] Owen, James. The Efficiency Dilemma: If our machines use less energy, will we just use them more? New Yorker, 20/12/2010 http://www.newyorker.com/reporting/2010/12/20/101220fa_fact_owen

[10] Stern, D.I., Cleveland, C. J., 2004. Energy and Economic Growth. Rensselaer

Polytechnic Institute, Troy, NY.

[11] Popp, D. 2002. Induced innovation and energy prices. American Economic Review, 92(1): 160-180.

[12] Thapper, A. et al. 2013. Artificial Photosynthesis for Solar Fuels – an Evolving Research Field within AMPEA, a Joint Programme of the European Energy Research Alliance. Green 2013; 3(1): 43 –57. [http://www.eera-set.eu/lw_resource/datapool/_items/item_734/artificial_photos__ampea_pub.pdf]

[13] Madlener, R. and B. Alcott. 2009. Energy rebound and economic growth: A review of the main issues and research needs. Energy 34: 370–376 [http://www.cepe.ethz.ch/publications/Madlener-Alcott_Porto_Venere_2006_final_header.pdf]