Energy Shocks Can Have Perverse Consequences

The now dismantled dth-nul-energihus on the outskirts of Copenhagen offers a vision of a future that never materialized. Built during the 1973 oil shock by the Technical University of Denmark, this chunky white building, consisting of two living spaces separated by a glass atrium and topped with a spine of solar panels, was one of the first attempts to create a zero- energy house.

The null-energihus didn’t quite reach “zero energy” but his vital stats were impressive nonetheless. It only needed 2,300 kilowatt hours of energy per year, roughly the same as six modern refrigerators. Its copious insulation and solar heating system kept it warm even in the freezing Danish winters. When a family moved in, things went downhill a bit, notes Marc Ó Riain, professor of architecture at the Technological University of Munster. Hair clogged the filtration system, which recycled heat from the sewage, and the occupants had the annoying habit of leaving the windows open.

Yet these are problems that could have been overcome. The house was almost ready for prime time. In the years since, scientists have shown that well-targeted research and development expenditures can quickly improve quality and reduce costs (see, for example, recent improvements in electric cars and solar panels). So why couldn’t a solarpunk future of clean energy abundance happen in the 1970s? And as the world faces a new energy shock, what lessons can we learn from its failure?

Economists believe that technological progress is the ultimate engine of growth. The key question is what determines the direction of this progress. In 1932, John Hicks, an economist, launched the debate on “directed technical change” when he hypothesized in his book “The Theory of Wages” that an increase in the price of a certain factor of production – work, in his example – would stimulate innovation to lower its cost. In the century before his book was published, wages had risen steadily, which meant that employers had an incentive to invest in labor-saving technologies rather than capital-saving ones. In this logic, a surge in the price of fossil fuels should contribute to accelerating decarbonization.

Such green growth, however, is not inevitable. Daron Acemoglu of the Massachusetts Institute of Technology pointed out that research spending can be directed either towards clean substitutes (like solar power) or towards complements to dirty technologies (like more efficient motors). For a company, the choice of where the money goes depends on the sometimes competing forces of price and market size. An oil shock, which increases the price of fuel, makes green technologies such as solar more attractive. But the extremely widespread use of hydrocarbons can make investments in fossil fuel efficiency, known as gray technologies, more profitable.

That’s pretty much what happened in the 1970s. Although some of the money was spent on projects like Denmark’s Zero Energy House and in the embryonic renewable energy market, much more was devoted to gray technologies. Research by Valerie Ramey of the University of California, San Diego and Daniel Vine of the Federal Reserve shows that the main way historical oil shocks have affected the US economy is by encouraging consumers to buy more fuel-efficient vehicles in fuel. The economy of a typical American car went from 13 mpg in 1975 to 20 mpg in 1980.

Rather than pocketing the savings offered by more fuel-efficient cars, Americans instead bought even bigger ones and in greater numbers. So the long-term impact of the oil shock was not to kill the country’s car culture, but to embed the combustion engine even deeper into American life. By the mid-1980s, oil consumption was higher than a decade earlier, even though many of the nation’s power plants had switched to natural gas.

Environmental economists call this phenomenon, where fuel-saving measures perversely increase demand, the “rebound effect”. Something similar happened in Danish housing. Better insulation improved its energy efficiency; as a result, homes became larger and their owners more accustomed to higher temperatures. It has become common, for example, to wear t-shirts indoors during the winter. According to official statistics, the total energy consumption of dwellings has remained unchanged over the past three decades.

Acemoglu argues that there is a “path dependency” in technological progress. Energy efficiency can make it more difficult for other technologies to compete. A well-insulated home with a state-of-the-art gas boiler uses less fuel. But that makes the initial investment of an electric heat pump less attractive. If European industry manages to maintain its production this winter while using less gas, it could, in the future, have less incentive to switch to green methods.

Differences from previous energy shocks give cause for optimism. Economic modelers refer to the “elasticity of substitution” as the critical measure of whether expensive fossil fuels accelerate the adoption of green or gray technologies. Encouragingly, this elasticity has increased since the 1970s. Today, rising prices are expected to incentivize more shifts away from fossil fuels than in the past, thanks to the greater availability and lower cost of green alternatives.

green thumbs

In addition, carbon prices put the government’s thumbs on the scales. The cost of a permit in the EU’s cap-and-trade system is only expected to increase in the future as the cap on the amount of emissions drops, meaning companies have an incentive to get ahead. With any luck, this will limit the rebound effect in the years to come. But America is heading down a different path. Subsidizing clean tech rather than taxing dirty tech — the strategy adopted by President Joe Biden’s recent Cut Inflation Act — doesn’t do as much to replace fossil fuels. A family can, for example, buy a subsidized battery-powered vehicle, but only in addition to a fossil fuel vehicle, which they can continue to drive without penalty. Policy design matters if a carbon-free world is to become more than just a future that never happened.

Learn more about Free Exchange, our column on the economy:Why Chinese policymakers are relaxed about the yuan’s fall (October 6)Economists now accept that exchange rate intervention can work (September 29)Chinese leaders seem resigned to slowing economy (September 22)

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