Financial Literacy and Energy Efficiency

Abstract

Due to its implications for energy conservation and the avoided economic costs, households’ underinvestment in energy-efficient technologies continue to be a major concern for policymakers. The reception of energy-efficient machines, durables and technologies by an economic agent offers both energy preservation and financial benefits. Refrigerators, air conditioners, and induction cooktops are just a few examples of the kinds of appliances that fall under this category. All of them use less energy while maintaining the same level of performance. Energy-efficient household goods typically have higher upfront costs but lower operating costs, resulting in long-term financial savings. The adoption of energy-efficient technologies has been sluggish, despite the potential advantages in terms of cost and energy savings. The energy efficiency gap is caused by market failures like insufficient information dissemination, principal-agent conflicts, unaccounted externalities, and difficulties obtaining credit or liquidity. Besides, conduct abnormalities including limited levelheadedness, limited resolution, and limited personal responsibility add to sub-par dynamic in this specific situation.

There is a dearth of research that examines behavioral factors, such as consumers’ limited financial knowledge (bounded rationality), to explain their underinvestment in energy-efficient technologies. Existing literature extensively examines market failures and policy measures to address them. Traditional economic models assume rational decision-making and suggest that changing the price structure should incentivize consumers to adopt energy-efficient technologies. However, behavioral economics acknowledges that individuals often face constraints in processing information and making optimal choices. Prospect theory highlights how people assess gains and losses relative to a reference point, exhibiting risk aversion towards gains and risk-seeking behavior towards losses. Bounded rationality suggests that consumers, although rational, face cognitive limitations in fully considering all available information. Heuristic decision-making strategies simplify the decision-making process but may introduce biases. These behavioral constraints result in a knowledge-action gap, value-action gap, attitude-action gap, and intention-action gap, leading to underinvestment in energy efficiency by households.

Financial literacy plays a crucial role in consumers’ ability to make informed decisions regarding investment in energy-efficient appliances. It encompasses understanding financial concepts such as budgeting, saving, investing, and analyzing financial products. In the context of energy efficiency, financial literacy extends to knowledge about energy prices, consumption, and the ability to perform financial calculations. Promoting energy-related financial literacy can empower households to comprehend the impact of energy prices on their bills, make informed decisions about energy-saving technology, and analyze investment options wisely. Initiatives to promote financial literacy are cost-effective and can have a broad reach, offering benefits such as energy conservation, environmental protection, and peak load management. Financial institutions can play a crucial role by raising awareness, providing resources, and offering financing options for energy efficiency.

Background

Investment in the energy-efficient appliances or durables by the households has been a concern since long as it not only helps to conserve energy consumption but also offers a range of the economic benefits. Energy efficiency appliances could be such as refrigerator, air conditioning, bulbs, fuel efficient bikes or induction cooktops that consumes less energy to provide same level of output. If households (or individuals) fail to make investment on such technology, there exist an energy efficiency gap. In technical sense, the energy efficiency gap measures the differences in the actual energy uses -measuring what the economic agents are currently using; and an optimal energy uses under given technology (Golove & Eto, 1996). Alternatively, the energy efficiency gap refers to the difference between the potential for energy savings through the implementation of energy-efficient technologies or practices, and the actual level of energy savings that is achieved (Jaffe & Stavins, 1994). Therefore, the answers to questions like ‘why use of the energy saving refrigerator is low?’ or ‘use of the induction cooktops is relatively low despite its thermal efficiency?’ are explained by the notion of the energy efficiency gap in economics.

One of the typical economic features of the energy efficient household durables is that they have generally high upfront cost but have lower operating cost. For example, the initial cost of purchasing and installing energy-efficient solutions, such as LED lighting, solar panels, and high-efficiency HVAC systems, is often more than that of conventional, less-efficient options. The LED light bulbs are more expensive to buy than conventional incandescent lights, but they use considerably less energy and have a much longer lifespan, resulting in cheaper long-term energy expenditures and replacement prices. Similar to solar panels, which demand a large initial investment but provide electricity with little to no recurring expenditures once installed, electricity bills are significantly reduced over time. However, due to its energy-efficient design, technology often has a substantially lower operational cost after it is implemented. Therefore, energy efficient appliances are economically beneficial as the total economic savings over the life time use of energy-efficient technologies are much larger than the energy-inefficient durables or appliances.

The question comes, then, why household usually don’t invest on the energy efficient technologies when the energy bills could be saved and economic benefits can be realized? Historically, this academic debate has been in place since the energy crisis during 1970s following the oil-price shocks. The oil-price shocks (the sudden increase in the price of fossil fuels) compelled many nations to look for energy efficiency by looking alternative technology to reduce their reliance on fossil fuels without sacrificing their ability to produce economic growth (Lovins, 1976; Patternson, 1996). The same period also saw a massive investment and development of the energy-efficient technology so that the consumption of the fossil fuel in particular can be reduced. Despite such technological advancement, the adoption of the energy-efficient technology (such as household appliances and durables) has been rather slow- even until now.

One steam of literature diagnoses the existence of the energy efficiency gap with the market failure arguments. Imperfect information, principal-agent issues, unpriced externalities, and credit or liquidity restrictions are just a few of the market failures that have been found to make it difficult to decide whether to invest in energy-efficient technologies (Backlund et al., 2012; Jaffe & Stavins, 1994). Imperfect information refers to situations where consumers, producers, or policymakers do not have access to complete or accurate information about the costs, benefits, and risks associated with investing in energy-efficient technologies. Principal-agent issues arise when one party (the principal) hires another party (the agent) to act on its behalf, but the agent has incentives that differ from those of the principal. Unpriced externalities refer to the costs or benefits of an action that are not reflected in the market price. Credit or liquidity restrictions can also create barriers to the adoption of energy-efficient technologies.

On the other hand, behavioral anomalies take into account the consistent veering away from economic reason that decision-makers make. These may manifest as “bounded rationality,” “bounded willpower,” and “bounded self-interest” (Mullainathan & Thaler, 2000). Bounded rationality, or the idea that people have constrained cognitive abilities, faulty memories, as well as relying on heuristics to make decisions, may limit people’s capacity for making sound decisions (Mullainathan & Thaler, 2000; Simon, 1990). Individuals with bounded willpower may make choices that aren’t always in their best interests over the long term (i. e.they might show myopia, inconsistency with time, bias toward the present, etc.) (Mullainathan & Thaler, 2000; Thorgeirsson & Kawachi, 2013) . Bounded selfishness and the notion of altruism are closely related; in the latter, people may choose to forgo their own interests (and thereby depart from the behavior of Homo-Economicus) in order to assist others (Mullainathan & Thaler, 2000).

One of the primary reasons for low investment in the energy efficient technology is because the costs and benefits are distributed unevenly over the lifetime of the durables. As discussed, the cost of purchasing such durables are instant (and high) but the benefits are realized over the longer period. The owners often enjoy the advantages of owning energy-consuming durables in the longer term, such as lower energy expenses, more comfort, and convenience. But the expenses related to owning and using these durables including purchase, maintenance, repair, and replacement prices has to be borne in the nearer term. This in economics term refers that household may not be able to properly the discount the costs and benefits spread over a life span of the household durables, and therefore, household may be reluctant to invest in such technology. That is consumer’s financial literacy is much crucial here as they need to know costs, benefits and proper discounting of these costs and benefits spread unevenly over the period of time.

Behavioral Economics and Energy Efficiency Gap

Whereas the literature is abundant in understanding the market failures, and subsequent policy measures to correct those market failures; the literature is thin in exploring the behavioral factors such as consumers limited financial knowledge (Bounded rationality) to explain the underinvestment by consumers in the energy efficient technologies. The assumption of the new classical framework economic agents are rationale, therefore they will be able to perform the cost-benefits of their decision making the decision optimal (Simon, 1990). Even the axiomatic assumptions on choices rest on the rationality of the consumers (Varian, 2010). It assumes that economic decision makers have the rational preferences, and aims at maximizing utility. While do so, they are able to possess and process the all relevant information, and therefore act in the best of its interest. The prediction from such model is that changing the incentive (price) structure should induce consumer to adopt the energy efficient technologies.

The behavioral economics recognizes that people often have constraints when it comes to understanding or processing the information needed to come to the best choices (Mullainathan & Thaler, 2000). Prospect theory, bounded rationality, and heuristic decision-making are the three main ideas that emerge from behavioral economics and have been utilized in the context of energy efficiency. According to the prospect theory of making decisions in the face of uncertainty, the welfare change resulting from gains and losses is assessed in relation to a reference point, often the current situation. The welfare shift from a loss is substantially bigger than from an expected gain of the same magnitude because consumers are risk averse when it comes to gains and risk seeking when it comes to losses (Edwards, 1996, Kahneman & Tversky 1979). This can lead to loss aversion, anchoring, status quo bias, and other anomalous behavior (Shogren & Taylor, 2008). Tversky (1972) developed the theory of elimination by aspects, wherein consumers use a sequential decision-making process where first they narrow their full choice set to a smaller set by eliminating products that do not have some desired feature or aspect (e.g., cost above a certain level), and then they optimize among the smaller choice set, possibly after eliminating further products. Not much economic literature empirically tests these behavioral hypotheses to uncover whether there is a systematic bias, either negative or positive, in decision making related to energy consumption (Häckel et al., 2017; Levy, 1996).

Likewise, bounded rationality suggests that consumers are rational but face cognitive constraints in processing information that lead to deviations from rationality in certain circumstances (Simon, 1990). Household may value the upfront costs over the long term energy savings as decision making agents may not be fully considering all available information along with their ability to process those information (Blasch et al., 2018; Filippini et al., 2019).

Heuristic decision making is related closely to bounded rationality and encompasses a variety of decision-making strategies that differ in some critical way from conventional utility maximization in order to reduce the cognitive burden of decision making. The decision-making process is streamlined and the amount of information required is decreased by applying ways to evaluate a small number of signals or possibilities. Heuristics can expedite decision-making, but they can also taint conclusions with bias and inaccuracies (Levy, 1996). It is believed that people and organizations frequently rely on simple heuristics in an adaptive way, and that ignoring part of the information can lead to more accurate judgments for low predictability and small samples. It also contends that formal models are required to answer both descriptive and prescriptive questions about heuristics (Gigerenzer & Gaissmaier, 2011).

Such behavioral constraints have implications in terms of ‘knowledge-action gap’, ‘value action gap’, ‘attitude-action gap’ and ‘intention-action gap’ (Frederiks et al., 2015). The first relates to phenomena where people fail to act in their own best interests while having the knowledge to do so is known as the knowledge-action gap in behavioral economics. The cognitive biases, procrastination, a lack of self-control, and social influence, can contribute to the knowledge-action gap (Courtenay-Hall & Rogers, 2002). The value action gap is difference between a person’s values or beliefs and their actual conduct. Some household may belief that energy efficient appliances are good for the environment but they may end purchasing the less efficient appliances (Flynn et al., 2009). Attitude-action gap, that closely relates to value action gap, is scenario when a person’s attitudes or intentions do not convert into comparable acts or behavior. These all lead to the different behavioral constraints that impede the household to underinvestment in the energy efficiency technology. Such cases are presented in Table 1.

Form of Behavioral Biases	Examples
Myopia and Present Bias	Those that prioritize immediate savings over the long-term advantages of investing in energy-efficient technologies or renewable energy sources are said to have myopia. When making decisions concerning energy consumption and investment, people have a propensity to put instant satisfaction or short-term rewards ahead of long-term benefits.
Satisfice	This notion exists when people are happy with what they have in view of complexity of information search and processing. That means, instead of putting efforts to understand what is the best for them, they are happy or satisfy with the ‘good enough’ choices.
Status Quo Biases	Even though the situation is not ideal, people frequently prefer the way things are right now, which might make them resistant to change. It may be challenging to persuade people to adopt more energy-efficient behaviors or convert to renewable energy sources due to this prejudice. The decision makers are usually stick to default settings or defer decision-making entirely (inertia), especially as the amount or complexity of information increases.
Social Norms	The expectations and actions of others around them, or what is known as social norms which has the potential to influence energy-related behavior in both positive and negative ways. People may adopt energy-efficient activities, for instance, if they observe others doing so, but they may also oppose change if it deviates from societal norms. It is believed that people are influenced by the attitudes and actions of others, and they frequently imitate what they perceive to be righteous or normal.
Framing Biases	This may manifest in loss aversion, risk aversion or suck cost approach. The loss aversion exists when the advantages of preserving energy is discussed and presented, it is preferable to discuss the expenses and losses they might incur if they waste it. The risk aversion, on the other hand, focuses on safe, secure, and low-risk energy-saving techniques and investments, particularly for new, pricey, or unconventional technology. For many consumers, investment in energy-saving goods and services seems unappealing due to the unpredictability of the electricity supply, market prices, governmental regulations, and long-term financial returns.
Confirmation Biases	A tendency for people to disregard information that contradicts their ideas and seek out information that supports those beliefs. Because of this bias, it may be challenging to persuade people to alter their energy-related behavior if they already have strong opinions about the most effective way to use energy.

Role of Financial Literacy and Energy Efficiency

As discussed earlier, consumers need to have the ability to posses and process the information about the costs and benefits when it comes to making decision regarding the investment in the energy efficient appliances. The financial literary in its core form refers to the ability to manage investment effectively and with understanding are referred to as having financial literacy. Understanding financial terms and goods like budgeting, saving, investing, borrowing, and debt management are part of this. Making informed judgments based on one’s financial requirements and goals as well as the capacity to analyze and compare financial products and services are all part of financial literacy. An individual with strong financial decision-making skills can successfully traverse the complex world of money and reach their long-term financial objectives.

Financial literacy in the energy efficiency context, therefore, is the capacity to make thoughtful decisions in the area of household energy consumption. According to DeWaters and Powers (2011), this idea has three dimensions: cognitive, emotive, and behavioral. An individual must be knowledgeable about energy usage and production, as well as how these factors affect society and the environment. They ought to act in a manner that is consistent with their views and ideals regarding energy saving. Energy literacy is defined more strictly to primarily represent the individual’s awareness of energy prices and the energy consumption of various household equipment. The financial literacy on other hand refers to consumer’s ability to perform some basic financial calculations. This may include the understanding the cost and benefits over the life time, and ability to perform some calculations such as use of compound interest rate (discounting). That is, it warrants an investment analysis and weigh various investment options, such as selecting appliances or making decisions regarding energy-efficient improvements, is referred to as investment literacy. Financial literacy literature offers explanations of this skill. According to studies, those with higher levels of education are more likely to choose their investments wisely.

The recent literature suggests that consumers have to have the knowledge about both energy as well as the financial literacy to be able to make decision to invest in the energy efficient technologies (Blasch et al., 2018; Filippini et al., 2019). This notion has been excelled with what is called the ‘energy related financial literacy’. The first component relates to consumers knowledge about the energy prices and uses. For example, in order to know the cost of owning an appliance, one must know the energy uses by that appliances and the energy bills the consumers have to pay. Knowing unit price of the electricity, for an instance, is important aspect of the energy knowledge. Second component relates to their ability to perform a financial calculation such as calculating costs, use of the simple and compound interest rate among others.

Therefore, it is important that promoting the (energy related) financial literary may be helpful in encouraging the household to invest in energy efficient technology. Consumers can comprehend how energy prices effect their monthly bills and the long-term cost savings from purchasing energy-efficient appliances if they have financial literacy in the area of energy. They may be inspired to make more informed judgments about purchasing energy-saving technology as a result of this information. The amount of energy that consumers’ appliances use and how this usage translates into energy expenditures can be understood by consumers who are financially literate in energy-related matters. This knowledge may encourage them to spend money on energy-saving equipment that lowers energy expenditures and usage. And finally, consumers can analyze various investment options with the aid of financial literacy in the energy sector when selecting energy-efficient equipment. Consumers can choose which technology to invest in more wisely if they are aware of the financial repercussions of their selections.

This calls for promotion of the financial literacy among the consumers and households. It can offer several benefits such as energy conservation, environmental protection, and peak load management among others. It is important to underscore that promoting the financial literacy campaign are often have lower costs and broader reach. Compared to other forms of governmental action, such tax breaks or subsidies, financial literacy initiatives may be reasonably affordable. When compared to, say, adopting a subsidy program, the cost of creating and conducting a financial literacy campaign is typically lower. Campaigns to promote financial literacy can connect with a broad range of people. These campaigns can be created to reach a narrow cross-section of the public or to target particular demographics or income levels. Campaigns to promote financial literacy are therefore effective in encouraging consumer energy efficiency. Further, campaigns for financial awareness can leave a lasting impression. People can use financial literacy in a variety of scenarios, including making decisions about energy efficiency, once they have gained the appropriate skills. This indicates that the advantages of financial literacy initiatives can go beyond simply boosting energy efficiency.

The role of the banking and financial institutions is crucial in this aspect. Financial institutions can make aware about consumers about energy-efficient goods and technology as well as point them in the direction of resources that can explain the financial advantages of purchasing such goods. Financial institutions can create cutting-edge financial products with a focus on promoting energy efficiency. For instance, they might provide loans for energy efficiency that are contingent upon the borrower’s reduction in utility costs. Consumers who purchase energy-efficient goods and technologies may be eligible for incentives and financing options from financial institutions. For instance, they might provide loans used to finance energy efficiency improvements at reduced interest rates or with longer repayment terms.

Conclusion

This article sheds light on the fact that behavioral factors are crucial in making investment in the energy efficient appliances and durables (technology) by the household. The behavioral economics acknowledges cognitive limitations and heuristics that can result in biased judgment. These limitations lead to discrepancies in knowledge, values, attitudes, and behaviors, which prevent households from making energy-efficient technological investments. Behavioral concepts that might explain these biases include prospect theory, elimination by aspects, and heuristic decision-making.

The financial literacy may help to overcome such limitations. The capacity to handle investments efficiently and make wise decisions based on one’s financial needs and goals is crucial in such decisions. This can offer a range of benefits to both consumer and economy such as energy conservation and environmental preservation. The energy efficiency can be effectively encouraged by promoting financial literacy campaigns. Compared to other forms of governmental intervention, such tax breaks or subsidies, such campaigns can be developed to reach a wide spectrum of individuals at a cheaper cost. By educating consumers about energy-efficient products and technologies, offering loans and incentives for energy efficiency improvements, and developing cutting-edge financial products that support energy efficiency, financial institutions play a critical role in this area. Initiatives to promote financial literacy can often provide advantages that go beyond simply increasing energy efficiency. And, the role of the banking and financial institutions is crucial to this account.

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