Do Credit Constraints Explain the Energy Efficiency Gap?

One explanation for consumer under-investment in energy efficiency is a lack of access to credit or high borrowing costs. Do high auto loan interest rates deter drivers from buying fuel-efficient cars?

We’ve all heard a salesperson say something along the lines of “This product pays for itself!” This sales pitch is often used for products that are more expensive than potential alternatives, and the argument can be convincing: if I spend more money today on a higher quality product, I can come out ahead in the long run if that product outlasts cheaper alternatives or is less expensive to operate.

The “it pays for itself” sales pitch is particularly relevant in the context of embracing energy efficiency, a key strategy for combating climate change through reduced energy use. Energy-efficient products— such as Energy Star lightbulbs or appliances and hybrid vehicles—cost more upfront than less efficient alternatives.

However, their reduced energy use brings down operating costs (e.g., lower electricity bills, filling up the gas tank less often), which can more than make up for higher purchase prices. That makes energy efficient products a “win-win”—they save consumers money and use less energy. Sounds like a great deal, doesn’t it?

Unfortunately, many believe that not enough consumers are actually paying the higher prices to upgrade to an LED light bulb or to replace their Toyota Camry with a Prius. This apparent under-investment in energy efficient products by consumers has been characterized as part of an “energy efficiency gap,” which slows the uptake of these seemingly profitable technologies and undermines our efforts to reduce energy use and thus greenhouse gas (GHG) emissions.

Moreover, the existence of an energy efficiency gap has been used as justification for significant regulations such as the Corporate Average Fuel Economy standards, the thinking being that by forcing vehicles to be more fuel-efficient, we are correcting the “mistakes” that consumers make by passing on these technologies, and in doing so are helping both the environment and consumers’ bank accounts.

So why don’t more consumers purchase energy efficient products in the absence of regulation? Economists have proposed many possible factors contributing to the energy efficiency gap, which you can read more about in this article and this article.

One commonly mentioned explanation is that credit constraints—meaning a lack of access to credit or high loan interest rates—hinder consumers’ ability to purchase energy-efficient products. For example, if a car buyer is being charged a high interest rate on their auto loan, they may be hesitant to spend the additional few thousand dollars necessary to upgrade to a more fuel-efficient vehicle. Sizable financing costs increase the already high upfront costs associated with purchasing an energy-efficient product.

Despite being a common explanation for the energy efficiency gap, limited evidence exists suggesting that credit constraints inhibit consumer investment in energy efficiency. In a recent working paper, I test this explanation in the important setting of the U.S. new passenger vehicle market, which accounts for a substantial portion of GHG emissions and in which most purchases are financed.

Using a national survey of new vehicle buyers from 2010-2018, I find that consumers with higher auto loan interest rates purchase less fuel-efficient vehicles on average, even after controlling statistically for consumer creditworthiness and other relevant demographic and vehicle characteristics. However, the magnitude of the estimated effect is extremely small, suggesting that credit constraints don’t explain why people fail to purchase fuel-efficient cars.

Policymakers need to know what causes the energy efficiency gap in order to implement effective measures to increase energy efficiency adoption. For new vehicle buyers, it appears that auto loan interest rates may not be the problem, so researchers should continue exploring other potential barriers to getting more people behind the wheel of hybrids and electric vehicles.

This post highlights research presented at the Northeast Workshop on Energy Policy and Environmental Economics, hosted this year at the University of Pennsylvania.

Kevin Ankney

Doctoral Student, Georgetown University
Kevin Ankney is a Ph.D. candidate in economics at Georgetown University. His research investigates factors that influence consumer demand for fuel economy and electric vehicles in the U.S. automotive market.