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Working Paper

The Welfare Costs of Misaligned Incentives: Energy Inefficiency and the Principal-Agent Problem


Abstract: In many settings, misaligned incentives and inadequate monitoring lead employees to take self-interested actions contrary to their employer's wishes, giving rise to the classic principal-agent problem. In this paper, I identify and quantify the costs of misaligned incentives in the context of an energy efficiency appliance replacement program. I show that contractors (agents) hired by the electric utility (the principal) increase their compensation by intentionally misreporting program data to deliberately authorize replacement of non-qualified refrigerators. I provide empirical estimates of the impacts of misaligned incentives on (1) the effectiveness of energy efficiency retrofits and (2) welfare. I estimate that unqualified replacements reduce welfare by an average of $106 and save only half as much electricity as replacements that follow program guidelines. The same program without a principal-agent distortion would increase welfare by $60 per replacement. The resul ts provide novel evidence of how principal-agent distortions in the implementation of a potentially beneficial program can undermine its value.

Keywords: Energy efficiency; Firm behavior; Principal-agent problem;

JEL Classification: D22; H32; Q48; Q5;

https://doi.org/10.17016/FEDS.2019.071

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Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2019-09-20

Number: 2019-071

Pages: 39 pages