Energy Policy 28 (2000) 457}469

Prices, technology development and the rebound e!ect

Fatih Birol, Jan Horst Keppler*
International Energy Agency, 9 rue de la Fe& de& ration, 75739 Paris Cedex 15, France
Abstract
Energy e$ciency is the critical parameter for policies that aim at reducing energy consumption while maintaining or even boosting
economic growth. The two main options to in#uence energy e$ciency are changes in relative prices, i.e., raising the price of energy
through economic instruments, or to introduce new technologies which increase the productivity of each unit of energy. This paper is
based on the notion that in an equilibrium economy the marginal economic productivity is identical for all factors, i.e., energy, labour,
knowledge and capital. From this premise two main conclusions can be drawn. First, any change in price or technology will have an
impact on the whole economy by creating feedbacks through the substitution of factors of production and goods, as well as increased
wealth. Second, the two policy approaches, changing relative prices and technology development, are not opposite to each other. They
are the two faces of the same reality and should be developed and promoted simultaneously and consistently. 2000 Elsevier
Science Ltd. All rights reserved.
Keywords: Technological e$ciency improvements; Energy prices; Rebound e!ect; Policy mix
1. Energy e7ciency and energy intensity at di4erent levels
of aggregation
Energy e$ciency determines the amount of energy
needed to deliver valuable goods and services at the
process level. Energy e$ciency is thus primarily a para-
meter that depends on the state of technology and pro-
duction methods. It in#uences crucially also the amount
of energy that is used per unit of GDP, which indicates
the energy intensity of an economy. However, other than
technical e$ciency, energy intensity also depends on
consumer preferences and on structural parameters such
as climate, geography and culture. Finally, both energy
e$ciency and energy intensity depend through various
channels on the price of energy relative to other economi-
cally relevant inputs.
Improvements in energy e$ciency are frequently, and
wrongly, confused with decreases in energy intensities at
the sectoral or national level. An improvement in energy
e$ciency, typically the introduction of a new technology,
certainly can reduce aggregate energy intensity, and usu-
ally does, albeit not in a linear fashion. The link between
* Corresponding author. Fax: #33-1-4057-6659.
E-mail addresses: fatih.birol@iea.org (F. Birol), jan.keppler@iea.org
(J.H. Keppler)
technological e$ciency and energy intensity, grows in-
creasingly tenuous, the higher the level of aggregation,
i.e., it matters whether one considers the energy intensity
of a plant, a sector, or a whole economy. If considered at
the level of a single machine and a single unit of output,
energy e$ciency and energy intensity are identical, as
long as the proportions of di!erent factors remain un-
changed (see also below the remarks on the rebound
e!ect). A clear indication of the level of aggregation is
thus necessary in order to avoid confusion and misunder-
standings.
Frequently, there exists a special interest in accelerat-
ing the rate of energy e$ciency improvements or in
reducing energy intensities. To the extent that increases
in technical e$ciency do lead to reduced energy use per
unit of output, higher energy e$ciency means lower
imports, slower resource depletion, less environmental
damages and lower costs per unit of output. Energy
e$ciency is of particular importance in the context of the
commitment of most OECD Member countries under
the Kyoto Protocol to reduce until 2012 their absolute
annual greenhouse gas emissions by, on average, six per
cent below their emissions in 1990. A large part of these
emissions, around 70 per cent, are energy related.
Since this commitment is coupled with the desire to
maintain vigorous economic growth, it will be only
achievable if policies are implemented that decrease the
0301-4215/00/$- see front matter 2000 Elsevier Science Ltd. All rights reserved.
PII: S 0 3 0 1 - 4 2 1 5 ( 0 0 ) 0 0 0 2 0 - 3
In order to ful"l the Kyoto commitments, greenhouse gas emissions
per unit of output (for which carbon intensity is frequently used as
a proxy) would have to decrease at a rate higher than that of economic
growth. Assuming, for illustrative purposes, a "xed link between green-
house gas emissions and energy use and that non-energy sectors con-
tribute their own share to emission reductions, then at 3 per cent of
annual economic growth, each unit of energy would need to yield
roughly double (times 1.97) the amount of output by 2010 than in 1990.
In other words energy intensity would need to be halved.
` Technically speaking energy intensity refers to the share of energy
in total production Q/E, an average value. Energy e$ciency refers to
the marginal productivity with which energy is used RQ/RE.
ratio of energy consumption and output. This in return
requires that improvements in technical energy e$ciency
translate to the largest possible extent into corresponding
reductions in energy intensities. The crucial question in
this context is whether and to what extent changes in the
relative price of energy (e.g., taxes or permit trading) are
required in addition to technical energy e$ciency im-
provements in order to achieve the necessary decreases in
energy intensity to ful"l the Kyoto commitments.
This paper attempts to answer this question relying on
basic economic theory and some empirical evidence. It
has two parts. In the "rst part, the simple, but not
ubiquitously known, story of the economic approach to
energy e$ciency improvements is told. The basic analyti-
cal tool-set employed pertains to a comparative static,
partial equilibrium approach. A general equilibrium per-
spective is, however, maintained in an informal way, as
feedbacks and interactions between product markets,
input markets, in particular the market for energy and
energy services, as well as with economic growth, are
repeatedly included in the discussion. The second part of
the paper expands the simple story by considering struc-
tural shifts and imperfect markets, such as those for
private energy end-use. The paper concludes by underlin-
ing the complementarities between price-based policy
approaches and policies aiming at accelerated techno-
logy development in achieving reduced energy consump-
tion in growing economies.
A special focus of the paper is on the so-called `re-
bound e!ecta. The rebound e!ect concerns changes in-
duced by technological e$ciency improvements
themselves, which reduce the impact of these technical
improvements on energy intensity. The rebound e!ect is
thus distinct, or additional, to the autonomous in#uences
of preferences, geography, climate, etc. that can drive
a wedge between technical energy e$ciency and energy
intensity at an aggregate level. An energy e$ciency im-
provement in this context is understood as an improve-
ment in the productivity of the factor energy. Strictly
speaking, it refers to the improved productivity of capital,
i.e., a machine, which is speci"cally dedicated to the use
or transformation of energy.`
Last but not least, the paper also highlights in passing
the di!erent implicit and explicit assumptions of di!erent
research communities (`economistsa, `engineersa) that
have in the past led to vastly di!ering points of view.
Economists like to work with aggregate "gures such as
national energy intensities. A typical relationship be-
tween economic growth, energy use and energy intensity
might take the form 3 : 2 : 1, i.e., an economy which
grows 3 per cent per year and in which energy use grows
2 per cent will experience an energy intensity improve-
ment of 1 per cent. As mentioned above, energy intensity
is a very imperfect measure of energy e$ciency, due to
structural di!erences amongst countries. But even as
a measure for comparisons over time for a single country,
the value of the intuitively appealing ratio of energy use
to GDP as an informative parameter for policy making
has been questioned (see IEA, 1997).
In fact, yearly "gures of national energy intensity ag-
gregate a multitude of di!erent relationships between
energy use and value creation, and hide success stories as
well as failures. An economy will typically contain some
sectors in which energy use per unit of output has been
decreasing rapidly and others in which progress has been
slow or scant. Also GDP growth varies over the business
cycle, lowering and raising energy intensity, as energy
consumption is less variable than overall output. Espe-
cially, the latter part of the paper will discuss how di!er-
ent results might be obtained from di!erent starting
assumptions and how the two research communities are
gradually growing together.
2. Drivers of energy e7ciency improvements
Consumer preferences, the structure of the economy,
the state of technology and, "nally, the price of energy
relative to other factors of production all determine the
degree of technological energy e$ciency, as well as vari-
ous energy intensities. Concerning the role of technology
in determining energy intensity, one has to distinguish
di!erent existing technologies that can be used to pro-
duce a given output, all of which might not be used at
a given point in time, from genuinely new, presumably
more energy e$cient technologies to produce the same
output.
In competitive markets, the relative prices between
energy, capital and labour will determine which available
technology is selected. Higher energy prices will imply
energy-saving technologies with high shares of capital
and labour and, conversely, lower energy prices will
imply technologies with a larger share of energy inputs
and relatively lower shares of capital and labour. The
actual changes will also depend on the substitutability of
energy with other factors of production, as well as its
absolute share in production. In this static framework,
technological changes in response to price changes are
reversible, i.e., if after a period of high prices energy
becomes cheaper, less e$cient technologies would be
458 F. Birol, J.H. Keppler / Energy Policy 28 (2000) 457}469
` It is an empirical question whether reversibility or the ratchet e!ect
prevails. Neither is a certainty. Historical developments for energy
intensity per unit of output (e.g., passenger kilometres) for aeroplanes
and personal vehicles, for instance, tell very di!erent stories. In general,
the ratchet e!ect is stronger, the larger the learning e!ect induced by the
price change (see also Section 4 on `reversibilitya).
" See also Figs. 14 and 15 in IEA (1997), which show similar relation-
ships for two disaggregated energy uses, namely household electric
appliances and automobile fuel use. See also Graph 1.
employed. In practice this is frequently not the case, as
a sort of `ratchet e!ecta can lock in e$ciency improve-
ments even if prices fall.`
In turn, this choice of technologies will determine the
overall energy intensity of production of a plant, a sector
or an economy. A good example of this working of the
price mechanism with existing technologies is constituted
by the choice of technology for power generation from
coal. The question whether a critical plant with 38 per
cent e$ciency or a supercritical plant with 45 per cent
e$ciency will be constructed depends primarily on the
price of coal. In the absence of regulatory constraints, the
supercritical plant will only be built if the price of coal is
high. From the point of view of a private decision-maker
it is of secondary importance whether the price of coal is
high due to the scarcity of the resource, or due to an
environmentally related price instrument, say, a CO
`
tax.
In practice, again dynamic e!ects such as induced
technological change (see below) and learning can be
important. For residential end-use, e.g., home insulation,
marketing and the resulting economies of scale can also
be important.
Prices of both energy and energy-using or -saving
technology are thus one of the crucial variables to deter-
mine energy e$ciency. And politicians have several in-
struments at their disposal to in#uence the relative price
of energy. The most important amongst them are taxes
on energy or energy-intensive products, subsidies for
alternative processes or products which consume less
energy, and trading schemes in which large energy con-
sumers can trade a limited amount of permits for the
emission of energy-related pollutants. Absence of any
dynamic bene"ts (see below), changes in relative prices
through taxes or subsidies lead to economic e$ciency
losses in private good terms (i.e., those goods which are
part of GDP accounts) and to lower growth, even if they
create bene"ts in public good terms (e.g., energy security,
environmental impacts).
With a given set of technologies, a one-time change in
relative prices results only in a one-o! increase in energy
e$ciency. The described mechanism thus concerns
a static, or `lastinga framework in terms of main struc-
tural components and infrastructure. It will be discussed
below how major technological changes and shocks to
the economy and the energy sector can re-de"ne the
energy}output relationship and how equilibrium is only
reached after a long and protracted adjustment process
through historical time.
While imperfect, such an approach based on the idea
of a `lastinga framework nevertheless can provide in-
sights, for instance by comparing price}energy intensity
relationships over di!erent countries at one point in time.
Of course, such simple comparisons do not tell the whole
story, as climatic di!erences, average distances travelled
(depending on the size of the country) and other struc-
tural parameters also in#uence the overall ratio of energy
use to GDP. However, the cross-country comparisons in
the World Energy Outlook between energy intensity and
retail gasoline prices show a highly inverse relationship
between prices and various energy intensities, which
would be di$cult to explain by structural factors alone
(IEA, 1998)."
Another possibility to induce the choice of the more
energy e$cient among the existing technologies is to
mandate their utilisation by law or to impose regulatory
constraints on less energy-e$cient technologies. This
would allow apparent prices to stay the same, while
raising energy e$ciency. Of course, such a shift would
also impose economic e$ciency losses, because the true
price of providing energy services is now increased by the
shadow cost re#ecting the intensity of the regulatory
constraint. Economic theory maintains that these losses
would be even higher than with price-based mechanisms
(see, for instance, Barde, 1995). Such regulatory solutions
are also limited in their impacts on technological change,
as the mandated technological changes in the absence of
an explicit price signal are con"ned to the foresight and
the knowledge of the regulator. Sections 4 and 5 discuss
instances, however, in which administrative government
intervention plays a positive role by addressing market
imperfections, including through regulation, which in
itself can have an information-increasing role.
The other main factor driving energy e$ciency is new
technological developments, i.e., improvements of exist-
ing processes, inventions or completely new forms of
satisfying energy-related needs and wants. Such develop-
ments depend on a great number of factors to function
properly such as the existing infrastructure, the degree of
knowledge and education in the labour force and the
degree of experience with similar or ancillary technolo-
gies. The number of such new inventions, as well as the
acceleration in turnover and the adoption of new tech-
nologies, are related to the size of the resources which
governments and private companies dedicate to such
e!orts. In addition, the e!ectiveness of such support
depends on the development of the appropriate national
and international institutional structures to deliver it
(see, for instance, IEA, 1999).
F. Birol, J.H. Keppler / Energy Policy 28 (2000) 457}469 459
` Both expressions have led to misunderstandings in the past. As
a matter of fact, they are only creative names for the unexplained
residual when accounting for the di!erent in#uences that shape the
ratio of energy to output over time. Strictly speaking, they have no
explanatory value.
' Of course, energy intensity can decrease for reasons independent of
energy concerns. The enormous increases in the productivity in (non-
energy related) capital, in particular in information technology, and
labour have led to large declines in energy intensity. The general shift
from manufacturing to services in mature economies has a similar
e!ect. The question posed in this article is, however, how energy
e$ciency improvements can accelerate the decrease in energy intensity
over and above these autonomous changes.
Economists agree with technology experts that public
resources should be dedicated to RD&D, in particular
concerning demonstration and deployment as long as the
corresponding objectives have a strong `public gooda
characteristic. They have not, however, developed very
sophisticated approaches to study such new technolo-
gies. New technological developments are often con-
sidered as increases in an economy's production
possibilities, essentially unrelated to other ongoing activ-
ities. Expressions such as `autonomous technical pro-
gressa or `autonomous increase in energy e$ciencya bear
witness to this hands-o! attitude.`
The third approach to analyse energy e$ciency im-
provements combines the two previous approaches. It
argues that changes in relative prices not only in#uence
the static combination of factors, but that these changes
will also lead to a re-direction of research e!orts for new
technologies. An increase in the price of energy would in
this framework not only lead to the use of the more
energy e$cient amongst the available technologies, but
also to increased research e!orts for new energy-e$cient
technologies. The relative price change would thus lead
to a dynamic of `induced technological changea, as re-
search e!orts will concentrate on the most expensive
economic input. In other words, if energy would become
a cheaper factor than capital or labour, the incentive
would be to economise on the latter, with obvious conse-
quences for energy intensity.
The underlying logic is straightforward: if technolo-
gical progress is related in some stochastic fashion to the
amount of resources dedicated to research, then it is
pro"table to allocate those resources to the area in which
progress would bring the relatively greatest bene"t. The
idea of induced technological change is a modern version
of John R. Hicks' `induced innovationa hypothesis. In
this context he wrote: `... a change in the relative prices of
the factors of production is itself a spur to invention, and
to invention of a particular kind } directed to econom-
ising the use of a factor which has become relatively
[more] expensivea (Hicks, 1932).
It is an empirical question whether energy e$ciency is
best increased through changes in relative prices or
through public investment in energy RD&D or a combi-
nation of both. In practice, however, the question
whether energy e$ciency improvements over time are
more closely related to relative prices or to energy re-
search funding is almost impossible to decide due to two
major obstacles, both related to the near-impossibility of
clearly specifying the relevant data. First, much energy
research is not indicated as such and is classi"ed as
housing, transport, agricultural, or industrial process re-
search designed to raise total factor productivity. Second,
government spending on energy research itself is often
related to the price of energy. Some governments, indeed,
react in a manner consistent with the outlined dynamic of
induced technological change.
3. Fighting the rebound * how wide can the gap between
energy and GDP be pried open?
In order to understand under which circumstance the
ratio of energy to GDP can decrease faster than GDP
grows, one has to understand under which circumstance
improvements in technological energy e$ciency can
translate into energy intensity decreases.' Improvements
in energy e$ciency mean that a given unit of energy is
used more productively. Before beginning the discussion,
how energy e$ciency, the productivity of the other pro-
duction factors and the growth of the economy are inter-
woven, the following three issues have to be clari"ed
which determine the relationships between di!erent
factors:
1. If more of one factor of production, say, energy, is
added to a "xed quantity of another factor, say
labour, then with each added unit the marginal
productivity of energy will fall and the marginal
productivity of labour will rise, as long as the two
factors are substitutable. Thus factor shares and mar-
ginal productivities are inversely related. This rela-
tionship is also known as the `law of decreasing
returnsa.
2. As long as relative prices remain the same, the relative
productivities of factors (and hence their shares) will in
a competitive market always remain in the same rela-
tionship. If one factor becomes more productive but
its price stays the same, then it is pro"table to buy
more of it. This will lower its productivity until it
eventually corresponds again to its price. Thus the
ratio of the marginal productivities will always corres-
pond to the ratio of relative prices. In other words, in
economic equilibrium (be it static or dynamic) eco-
nomic inputs will be used in a manner such that the
marginal value of output that a given amount of
460 F. Birol, J.H. Keppler / Energy Policy 28 (2000) 457}469
` If there are two factors energy (E) and capital (K) and MP denotes
the marginal productivity, then it holds that MP
#
/MP
)
"P
#
/P
)
. This
implies that MP
#
/P
#
"MP
I
/P
)
"constant.
` Of course, this does not imply that for practical policy purposes
energy research e!orts should be undertaken in isolation. In fact, it is
frequently the `puresta energy research, which loses sight of the use
context, and which develops technical solutions that are subsequently
repudiated by the market such as inappropriate lighting or under-
powered cars.
" This decline in the price of energy, measured in terms of units of
energy services or of e$ciency units is the driver of the rebound e!ect.
Consider the following example: A factory that has so far paid USD 100
for a tonne of diesel oil per month to run a generator, has costs of only
USD50 (the cost of half a tonne) per month, once the e$ciency of diesel
oil has doubled (our example). In order to increase its (now cheaper)
output, as well as to substitute for other, now relatively more expensive
factors of production, it will now ask for more of the now e!ectively
cheaper power generation services of diesel oil. All the while, the tonne
of diesel oil still costs USD 100.
" A way to think about this e!ect is the competition between
beverages delivered in aluminium cans and those delivered in bottles.
An improvement in the e$ciency of energy would disproportionately
bene"t aluminium production. Consequently, it would be more advant-
ageous for retailers to buy and promote beverages delivered in alumi-
nium cans, which would hence expand their market share.
money (say, one dollar) can buy is the same for all
inputs.`
3. What exactly constitutes an increase in the marginal
productivity of energy? When talking about an in-
crease in energy e$ciency through technological pro-
gress, one usually refers to new more energy-e$cient
machinery, i.e., capital. For conceptual purposes it
would facilitate matters if technological progress in
the energy "eld were as exclusively dedicated to en-
ergy as possible. Otherwise, it is very di$cult, if not
impossible, to separate increases in the e$ciency of
energy from increases in the e$ciency of capital and
labour and from the overall growth rate of the econ-
omy.` In order to avoid these di$culties as much as
possible, the example used for illustrative purposes in
the rest of the paper is the following: a new re"nery
process doubles the calori"c value of a tonne of fuel.
With these considerations in mind one can proceed to the
question of what happens to the share of energy in
production, the energy intensity, when the marginal pro-
ductivity (e$ciency) of energy is increased. An increase in
the e$ciency of energy means that a greater number of
energy services #ow from each physical unit of energy.
Since the price per tonne of fuel is assumed to remain the
same, the price per energy service (or e$ciency unit) will
fall in proportion to the e$ciency increase. Thus it is now
pro"table to buy more energy services (e$ciency units)
until the marginal productivity per e$ciency unit will
correspond to the new, e!ectively lower price." Other
than by the size of the e$ciency increase, this process is
determined by the ease with which additional energy
services (e$ciency units) can be integrated into the pro-
duction process, i.e., by the elasticity of substitution. In the
process of adding energy services (e$ciency units), the
marginal productivity of the other factors, capital and
labour will be increased since each unit of capital and
labour is now working with more e$ciency units of
energy than before. In terms of energy services, not neces-
sarily in terms of tonnes of fuel, more energy services are
now used per unit of output than before.
The process will continue up to the point where mar-
ginal productivities correspond again to factor prices.
This is due to the fact that the relative price of energy in
terms of energy services (e$ciency units) has been dra-
matically reduced, even if the price on a per unit of
volume basis has remained unchanged. This implies that
the other factors of production will be reduced. Overall,
less of each factor is now needed to produce one unit of
output, which is equivalent to an increase in GDP
growth. Fig. 1 provides some illustration for this relation-
ship; note that E

, the new amount of energy in physical

quantity terms, can be smaller, equal or even larger than
the original amount of energy used, E
"
(Layard and
Walters, 1978).
The `rebound e!ecta is now the increase in demand for
energy services and eventually in energy due to the de
facto lower price of energy measured in terms of energy
services or e$ciency units. The rebound e!ect depends
on the elasticity of substitution between factors, as well as
on the elasticity of demand for the (now cheaper) "nal
good. The higher the elasticity of substitution and the
higher the elasticity of demand, the more the share of
energy will increase after the improvement in energy
e$ciency. Its share will increase in the production of
a speci"c good, as well as in the total economy, to the
extent that goods using large amounts of energy in their
production are now comparatively cheaper.
An energy e$ciency improvement will thus lead to an
expansion of sectors with energy-intensive goods due to
the fact that their relative costs are now lower. Due to
competition for consumers' expenditure even small cha-
nges in "nal prices can make substantial di!erences."
Whether a technological improvement ultimately leads
to increased or decreased energy use in terms of physical
quantities depends on the elasticity of substitution. Nor-
mally, due to limited substitutability of factors, as well as
of "nal goods, we would still expect some decrease in
overall energy intensity; i.e., the rebound e!ect is a frac-
tion between zero and one.
The rebound e!ect is due to the fact that a new techno-
logy, which increases, say, doubles, the e$ciency of using
energy automatically halves the price of energy services
(or the price of energy e$ciency units), as long as eco-
nomic instruments do not o!-set this de facto decline in
F. Birol, J.H. Keppler / Energy Policy 28 (2000) 457}469 461
Fig. 1. Relative factor shares resulting from increased energy e$ciency.
prices. This will increase the use of the now e!ectively
cheaper factor (substitution e!ect) and will also increase
demand for the now also cheaper "nal product (output
e!ect). The size of the rebound e!ect cannot be deter-
mined on conceptual grounds alone. If there is any sub-
stitutability between factors (at the level of the "rm) or
products (at the level of the consumer) at all, it can only
be said that the decrease in energy intensities will be less
than the original increase in technical e$ciency (see, for
instance, the overview by Greening et al. (2000) which
locates the rebound e!ect for households somewhere
between 0 and 0.5).
The rebound e!ect is a truly `perversea e!ect to the
extent that it is the result of forces, which have aimed in
the opposite direction. This is because a technical im-
provement makes energy services cheaper, even if the
price of energy (measured in physical quantities) stays the
same. To lower absolute energy consumption at un-
changed prices per unit of energy is therefore exceedingly
di$cult in a growing economy. The achievement of such
a feat, necessary for instance to achieve the Kyoto tar-
gets, would require annual technical e$ciency increases
of the magnitude g/(1-rb), where g is annual GDP growth
and rb is the size of the rebound e!ect. At 3 per cent
economic growth, a rebound e!ect of 0.5 would require
technical e$ciency improvements of 6 per cent per year.
At the same time, it would be wrong to see the rebound
e!ect as negative. The very fact that factor and product
substitution takes place indicates that the technical im-
provement has created new and better options to in-
crease e$ciency in production and consumer satisfaction
and that consumers and producers move to take advant-
age of them. It is the rebound e!ect that translates tech-
nological e$ciency improvements into economic growth.
There is thus a trade-o! between the contribution of
a technological energy e$ciency improvement to de-
creasing energy intensity and its contribution to eco-
nomic growth. The higher the elasticity of substitution
between energy and other factors and goods, the lower
will be the impact on energy intensity and the higher the
contribution to economic growth and vice versa.
In summary, an e$ciency-enhancing technological im-
provement contributes generally, at unchanged prices per
unit of volume of energy, less to the reduction of energy
intensity than the technical e$ciency improvement sug-
gests. The total rebound e!ect is thus composed of three
distinct e!ects:
1. The price decrease in energy services due to an in-
crease in productivity at unchanged energy prices
measured in physical units will lead to an increased
use of energy (in terms of energy services or e$ciency
units, not usually in terms of physical units) at the level
of the single "rm. This impact depends on the elastic-
ity of factor substitution, as well as on the share of
energy in production. The elasticity of substitution
(and hence the rebound e!ect is lower for households
than for industries).
2. Due to the fall in the real price of energy services (or
energy e$ciency units) products that use energy will
now become cheaper. The more energy intensive
a good, the more its relative price will fall. This leads
to re-adjustments between economic sectors with en-
ergy-intensive goods and sectors gaining at the ex-
pense of less energy-intensive ones. This e!ect depends
on the elasticity of substitution between products at
the level of consumers, private and corporate ones,
which co-determines the elasticity of demand. The
"nal e!ect depends, of course, also on the magnitude
of the price change.
462 F. Birol, J.H. Keppler / Energy Policy 28 (2000) 457}469
If the policy issue is de-coupling greenhouse gas emissions rather
than energy use per se from economic growth, this consideration might
provide an argument to increase research e!orts for technologies that
increase carbon e$ciency.
` This issue has been comprehensively analysed by the Economic
Analysis Divisions before designing the new World Energy Model
(WEM). On the basis of several econometric tests, including standard
regression analysis and Granger causality tests, it was decided to model
electricity demand separately. This di!ers from the previous WEM,
where fossil fuel and electricity demand was modelled jointly, implying
an expectation of price-induced interfuel substitution. For an in-depth
technical discussion of this issue see EAD Working Paper (1997).
3. An additional e!ect is due to the fact that the eco-
nomic growth brought about by an energy e$ciency
improvement due to the "rst two components of the
rebound e!ect will in itself increase energy consump-
tion by some second-order fraction. That this e!ect is
relatively small can be inferred from the fact that
energy costs are generally less than 10 per cent of
a country's GDP. In other words, if the rebound e!ect
contributed 1 per cent to economic growth only 0.1
per cent of additional energy would be used. The
contribution of energy e$ciency improvements to
economic growth due to the rebound e!ect (an impor-
tant fact) should be distinguished clearly from the
additional energy use due to this incremental growth
(a minor component of the overall rebound e!ect).
The rebound e!ect thus increases with the level of ag-
gregation. We would expect the rebound e!ect at the
level of the single "rm or the single consumer to be
smaller than at the level of the sector, and the re-
bound e!ect at the sectoral level to be smaller than
the rebound e!ect at the national level. In other
words, decreases in energy intensity at the national level
are harder to achieve than decreases at the level of the
"rm.
Last but not least, one additional point should be
mentioned in connection with the rebound e!ect,
which is of potential policy relevance regarding the
above-mentioned commitments of most industrialised
countries to limit the emissions of greenhouse gases and,
in particular, carbon dioxide. While there is rightly
a considerable discussion about the size of the rebound
e!ect for increases in technological energy e$ciency,
most analysts agree that it exists. There exists, how-
ever, no rebound e!ect for decreases in the carbon
intensity of energy services, as carbon consumption has
no intrinsic value. The rebound e!ect results from the
desire of producers and consumers to use more of now de
facto cheaper energy. There exists no such incentive
to increase demand, when the implicit price of carbon
has fallen.
4. Complicating the basic story * structural shifts and
imperfect markets
The preceding section has told the basic economic
story of what happens if energy experiences an increase in
e$ciency through the development of new technologies
or processes. It has shown the existence of a rebound
e!ect, which limits the ability of such technological e$-
ciency increases to reduce energy intensity, as long as
the relative price of energy per physical unit stays the
same. In the absence of changes in the price of energy,
one would therefore expect a limited impact of energy
e$ciency increases on energy intensities.
How well are these considerations borne out in prac-
tice? In the absence of detailed empirical studies, which is
not the purpose of this paper to provide, the authors
nevertheless would like to provide a piece of indicative
evidence for the overarching role of prices in the
determination of energy intensities. At least for national
level electricity consumption, Fig. 2 shows a strongly
inverse relationship between relative prices and elec-
tricity consumption per unit of GDP. There is clear
evidence throughout 49 countries that electricity prices
have a strong in#uence on the intensity of electricity
demand.
Another historical example is provided by oil con-
sumption. The price impact on oil consumption during
the two oil shocks when the relative prices of oil nearly
doubled each time was considerable. While the oil inten-
sity of IEA countries was steadily rising throughout the
1960s, it experienced a sharp turnaround in 1973 and has
practically been halved in the 20 years since the second
oil shock. While the initial price hike led to severe eco-
nomic disruptions, overall economic growth over the
past 30 years has been sustained even while substantially
reducing oil intensity (for a more detailed discussion, see
EAD Working Paper, 1999).
The role of prices increases to the extent that the goods
in question are a basic input into the production of goods
and services due to the possibilities of substitution. That
means oil demand is more elastic than electricity de-
mand, which in return is more elastic than the demand
for home lighting. Thus the price of electricity has been
less a!ected by the two oil shocks than the price of oil or
its substitutes in power generation, coal and gas.` Sim-
ilarly, the relationship between mobility, measured as
time spent in movement, and economic output is more
stable than the relationship between output and fuel use,
partly due to increased possibilities of substitution be-
tween the latter. This observation bears an important
policy lesson: relative price changes to decrease energy
consumption per unit of output are most e!ective where
possibilities for substitution are highest.
F. Birol, J.H. Keppler / Energy Policy 28 (2000) 457}469 463
Fig. 2. Electricity prices and electricity use per GDP, 1996 (27 OECD and 22 non-OECD countries) Sources: IEA (1998), Energy Balances; IEA (1998),
Energy Prices and Taxes, Fourth Quarter.
` It was not deemed necessary to repeat the assumptions one by one,
since all considerations were clearly identi"ed as being based on eco-
nomic theory, where these assumptions form a constituent part of the
conceptual framework.
4.1. Interpreting the basic story
While Fig. 1 and the experience of the oil price shock
present important evidence for the price}energy intensity
link at the national level, they clearly provide informa-
tion only at a very high level of aggregation. It is now
time to complicate the basic story told in the preceding
section, which was based on implicit assumptions of
smoothly working competitive markets, rational pro"t-
maximising agents and the absence of structural shifts.`
Clearly, in practice these assumptions are not always
ful"lled. One could even say they are never ful"lled and
only provide a coherent conceptual backdrop against
which more realistic phenomena can be assessed.
The question whether this conceptual backdrop is
a helpful simpli"cation of reality or whether it is an
undue distortion depends largely on the discipline to
which the researcher formulating the judgement belongs.
Much discussion centres on the importance of the re-
bound e!ect, which in return depends on the elasticity of
substitution between factors and products. If the sub-
stitutability between factors and "nal products is high,
then technological improvements are subject to large
rebound e!ects. If it is low, technological improvements
lower the ratio of energy to output much more easily.
If one is convinced that elasticities are high one is
prone to emphasise the role of the rebound e!ect, if one
assumes that factors are essentially used in "xed propor-
tions, then the rebound e!ect reduces to an ephemeral
phenomenon due to marginal GDP growth. Much of the
di!erences in perceptions concern the time frame under
consideration. The elasticity of substitution is lower in
the short-run, when the transition from one technology
or one set of consumption good to another is costly. The
di!erence between those who underline the importance
of the rebound e!ect (let us call them `economistsa) and
those who tend to dismiss it (let us call them `engineersa),
relates to how much importance is given to the long run,
when the possibilities of substitution are much higher.
The biggest di!erence between engineers and econom-
ists in their approach to the possibilities of substitution
lies in the distinction between ex ante and ex post substi-
tution. For the economist the world is an open "eld in
which di!erent factors of production and di!erent con-
sumption goods have to be constantly re-combined in the
most pro"table fashion in response to their prices and
marginal productivities. An e$ciency increase in one
factor immediately leads to a complete re-arrangement
due to implicit price changes and hence to a large re-
bound e!ect. His view of the range of available choices
concerning the technological structure as well as the
structure of demand is ex ante. For the engineer, instead,
the world consists of a set of given technologies or activ-
ities, which determine demand in which relative shares
are "xed. Any increase in the productivity of one factor
a!ects only that factor and hence there is no rebound
e!ect.
The di!erent approaches are also brought into focus
by the modelling approaches favoured by the two disci-
plines. In general, engineers favour so-called bottom-up
models, in which the costs and the penetration potential
of each technology are estimated without regard to sub-
stitution between factors or products and hence without
regard for potential rebound e!ects. Step-shaped supply
464 F. Birol, J.H. Keppler / Energy Policy 28 (2000) 457}469
" Top-down econometric models, which are calibrated on historical
data, might also provide little guidance for a future, in which not only
technologies change quickly, but in which even preferences and general
policy orientations might be radically di!erent. The authors would like
to thank one of the anonymous referees for highlighting this issue.
curves are built up by moving from the cheapest techno-
logy, given externally imposed constraints, to higher
ones. The absence of feedbacks from an endogenously
modelled demand side and the absence of any constraint
to assure market clearing lead to the absence of rebound
e!ects and large possible decreases in energy intensity.
Economists favour so-called top-down models which de-
termine supply and demand on the basis of the same
endowments and structural parameters and in which
prices are gearing the optimal combination of factors and
where historical relationships indicate much lower de-
creases of energy intensities."
Fortunately, there are fewer and fewer pure &&econom-
ists'' or pure &&engineers''. Newer generations of models
and increased co-operation between modellers from both
schools are, however, in the process of combining the
strengths of both approaches and eliminating some of the
inherent conceptual limitations. New hybrid approaches
such as MARKAL-MACRO in the European Union,
NEMS in the United States or CIMS/ISTUMin Canada
bridge the gap between the two basic approaches. In
particular, they take account of recent progress in the
economics of information and behavioural organisation.
The economists' story that was told in the preceding
section is thus always part of the picture and never the
whole picture. It is a useful starting point to discuss
policies to enhance energy e$ciency, a starting point,
which has to be subsequently developed, enriched and
extended. Four such extensions are indicated in the sec-
tions below.
4.1.1. Imperfect markets
Real-world energy markets are far from perfect and in
practice there exists a large gap between the theoretical
energy e$ciency potential and the actually achieved
level. While industries can grosso modo be expected to
conform to the basic economic model, private consumers
cannot. Due to lack of information, asymmetries in in-
centives or sheer inertia many cost-e!ective opportuni-
ties to save energy remain unrealised, particularly in the
areas of home heating and electric appliances. Small
consumers also have possible high cost of decision-
making. The potential barrier here is transactions cost,
which a consumer cannot spread out over large pur-
chases as can a producer. There are situations in which
there can be a net gain to society if government facilitates
ways of achieving scale economies in carrying out
transactions.
In contrast, it is not always true that consumers always
choose too low a level of energy e$ciency. In some
cases, end-users may choose too e$cient a technology,
i.e., one that lowers energy consumption beyond what
would be the optimal level given its price and the charac-
teristics of the other economic inputs, while others
choose technologies not e$cient enough. It is doubtful
whether end-users attempt at all to make rational deci-
sions at the margin with respect to energy. One explana-
tion for such sub-optimal behaviour is provided by the
`budget theorya, i.e., that the overall budget for electric-
ity, heat or mobility consumption is allocated until ex-
hausted independent of optimal adjustments at the
margin. An additional possibility is that the price mecha-
nism breaks down, because the amount of money spent
on energy is too small to be considered in an optimising
fashion.
Another interesting issue is whether markets are or-
ganised so as to facilitate e$cient decisions. For example,
in the building sector, the savings from energy e$ciency
often do not accrue to those who make the initial
design and investment decisions (architects, real estate
developers, landlords, etc.). Similarly, tenants of apart-
ment buildings with centrally regulated heating have
little choice but to adjust room temperature by opening
the window. There can be net bene"ts from bringing
about structural changes in such markets. While a full
discussion of this matter is beyond the scope of this
paper, the important point is that in some cases govern-
ment action to mitigate these barriers to improving en-
ergy e$ciency is warranted by the bene"ts of correcting
market failures.
As long as important market failures such as high
information and transaction costs exist relative price
changes might have little or no e!ect. The removal of
market barriers through regulation or technological im-
provements (for instance, the administrative requirement
to install e$cient meters in single dwellings) would be
more important. In general, market failures are more
important concerning consumers and residential energy
consumption than concerning "rms and energy con-
sumption in the industrial and the power-generation
sector. The reason is simply that the latter are well
prepared to take account of price signals and to make
`rationala, pro"t-maximising decisions. Consumers in-
stead optimise their welfare also in non-monetary terms
and negligence of price signals might be the economist's
market failure but it might be the workman's essential
part of leisure.
4.1.2. Structural shocks
All the relationships discussed were considered to
be part of an economic framework developing in a
stable, continuous manner. It is, however, conceivable
that a major shock to this framework alters these
F. Birol, J.H. Keppler / Energy Policy 28 (2000) 457}469 465
` Of course, in this context active technology policies also play an
important role. However, it should be added that such breakthrough
technologies are rarely foreseeable in advance and remain subject to
great uncertainties and time lags between conception and implementa-
tion.
' The authors distinguish three major shifts in the relationship
between US output and electricity demand in the last 100 years.
` Consider the following item from the New York Times of 5 Octo-
ber 1999 under the title `With SUVs More Popular, Fuel Economy
Continues to Falla: `Detroit * The average fuel economy of new
vehicles fell to 23.8 miles per gallon in the 1999 model year, the lowest
level since 1980, as Americans continue to shift from cars to less
fuel-e$cient light trucks, particularly sport utility vehicles, the Environ-
mental Protection Agency has concluded in a new report.a
relationships in a discontinuous manner. Three di!erent
kinds of these shocks are imaginable:
1. external shocks such as a war or major political shifts,
2. major technological breakthroughs such as the inven-
tion of electricity as opposed to incremental improve-
ments,`
3. fundamental re-orientations of government policies
and infrastructure provision.
Such shocks upset the process that was outlined above,
i.e., that a technological improvement will lead to an
e!ective fall in relative prices which leads to a new mix of
factors and ultimately to increased economic growth.
In the case of such shocks the normal structural adjust-
ment of the economy to the new technical and economic
opportunities is prevented for the following two reasons.
The "rst is that the sheer speed or magnitude of the
technological development (this relates to the `break-
through technologiesa mentioned under 2) happens too
quickly to be fully translated into economic growth
through factor substitution. The second is that external
factors such as war, or internal policy shifts supersede
the market mechanism and hence prevent the usual
adjustment.
In other words, an external shock can, in fact, lead to
a signi"cant lowering of energy intensity through techno-
logical improvements alone as long as the economy
adapts slower than the technology advances. It should,
however, be kept in mind that these e$ciency improve-
ments are acquired at a price in terms of potential output
increases foregone. In the periods following such shocks,
the rebound e!ect only re-asserts itself with a certain time
lag, re-establishing the link between e$ciency improve-
ments and output growth discussed above. During these
catch-up phases, the energy intensity improvements of
the economy are necessarily less than the trend (see also,
Starr and Searl, 1985).'
4.1.3. Reversibility
The simple story was told above in a static framework,
where in principle all changes due to energy e$ciency
improvements or price changes are reversible. It is often
maintained that reality, which displays itself in irrevers-
ible historical time, does not conform to this assumption.
People will not rip out insulation just because the price of
heating fuel has fallen (although it is an open question
whether new houses will have the same degree of insula-
tion in a low price environment). In addition, as there is
a constant #ow of technological innovations even at
moderate prices (although not at very low or zero prices)
as well as learning and increases in dexterity, there is
reason to assume that some sort of `ratchet e!ecta exists.
The ratchet e!ect indicates that once an energy e$-
ciency improvement has been e!ectuated it is here to stay
and hence there is no reversibility. Technological know-
ledge once acquired becomes part of the common pool,
almost independent of the particular price environment.
This is particularly true if energy is only a small share of
the total budget.
The truth is, as almost always in these matters, in the
middle. Of course, there is a continuous process moving
upward due to increased knowledge and learning. At the
same time, at each stage of this process there exist di!er-
ent options, which are dependent on the relative price of
energy and structural changes.` Outside the margins
de"ned by adjustment costs (every change up- or down-
grading e$ciency is costly, and will only be undertaken if
the increased pro"tability exceeds these adjustment
costs), the choice of these options will again at each point
in time be determined by the relative prices of energy and
capital.
The graph in Fig. 3 might provide an illustration of the
interaction between technical energy e$ciency improve-
ments, net energy intensity improvements once the re-
bound e!ects have been taken into account and actual
energy intensity developments in response to price cha-
nges. While the improvements in energy e$ciency estab-
lish an irreversible trend towards lower energy intensity,
reversible price impacts make for signi"cant deviations
from the trend.
Notes: (1) Energy intensity has been expressed as
GDP/E in order to display the graph in the usual
NorthEast quadrant. (2) The ratio AB/AC can be inter-
preted as an indicator for the size of the rebound e!ect.
(3) A drop of actual energy intensity below the original
level of energy intensity such as at point T

is theoret-
ically possible, but highly improbable. (4) The actual
development of energy intensity displays * within the
limits of adjustment costs * reversibility with respect to
changes in relative prices and other structural para-
meters, however this reversibility displays itself around
the rising trend of technical energy e$ciency improve-
ments. (5) There exist feedbacks between changes in rela-
tive prices and structural parameters and the size of the
466 F. Birol, J.H. Keppler / Energy Policy 28 (2000) 457}469
Fig. 3.
` At the other extreme, energy prices could rise in the case of perfect
substitutability if a very large rebound e!ect would lead to an increase
in the demand for energy (on a per tonne basis).
" We are indebted to one of the two anonymous referees for pointing
this out.
rebound e!ect, as well as the development of the tech-
nical potential (induced technological change) that are
not taken account of in this graph.
4.1.4. Absence of substitution
Last but not least, it has to be discussed what happens,
if there do not exist possibilities of factor substitution. In
cases in which there exist no possibilities of substitution
between energy and other factors of production, energy
intensity is actually reduced in proportion to the increase
in technical e$ciency.
With zero substitutability, the technological improve-
ment of doubling the per tonne e$ciency of a fuel, would
indeed reduce the ratio between energy use and output
by half. In the extreme case of no substitutability between
factors, the price for energy (on a per tonne basis) would
fall in response to an e$ciency improvement, as stable
demand would face a de facto increased supply of energy
(measured in terms of energy services or e$ciency
units).`
However, in the rare case of zero substitutability ("xed
factor proportions and Leontie!-type production func-
tions), the technological improvement will have no posit-
ive impact on output growth. In cases, in which also the
other factors experience e$ciency increases, output
would grow proportionately with the factor that experi-
ences the smallest increase. Increasing energy e$ciency
beyond the ability of the economic system to fully absorb
them will decrease energy intensity, but will not make
a contribution towards growth. Typically one would
assume that such features of production prevail in the
short run, as there would be expected at least some
substitution in the long run. In the long run, investment
would also recombine the surplus energy with new fac-
tors of production thus again increasing output and
leading to a certain rebound e!ect."
5. Markets and governments * an informed mix of
measures for successful policies
According to the preceding discussion, lowering the
absolute consumption of energy in a growing economy
only through technology improvements is close to im-
possible in a stable market economy unless correspond-
ing price changes are introduced to keep the cost of
energy services #owing from one physical unit of energy
unchanged. Disconnecting the link between GDP and
energy consumption is increasingly di$cult without rela-
tive price changes, e.g., carbon or energy taxes, as more
and more technological improvements put downwards
pressure on the e!ective price of energy services.
Of course, it is always conceivable that technological
progress delivers forms of energy that have no external
side-e!ects, whether environmental or otherwise, and
which would make the achievement of energy e$ciency
no longer a target for policy interventions. In this case,
F. Birol, J.H. Keppler / Energy Policy 28 (2000) 457}469 467
`" The case of nuclear energy was considered an option in this
context, under the conditions that it would be (1) cost competitive with
other fuels, (2) acceptable to public opinion at commercially viable
levels of safety and (3) that solutions for long-termstorage of waste were
found.
` Certain instruments are, of course, better applicable to some sec-
tors than to others. Private energy users, for whom energy is often only
a limited share of their budget, react di!erently to price changes than
companies, which monitor their energy expenses carefully.
the rebound e!ect would also cease to be a reason for
concern. However, for the time being such prospects
remain speculations rather than options.`"
If the objective of lowering absolute consumption of
energy in a growing economy is taken seriously, relative
price changes have to be taken into account.` If societies
accept to employ relative prices to help achieving reduc-
tions in the energy-output ratio, this means that markets
have to be enabled to ful"l their function of equating
marginal costs and bene"ts.
There exist many obstacles, particularly in the energy
sector, for markets to function properly: subsidies which
have lost all relation to veri"able public goods, high
transaction costs and incentive failures make it di$cult
for decision-makers to re#ect the true costs and bene"ts
of energy in their actions. Markets are complex institu-
tions, which need careful nurturing, prudent care and
time to develop. The role of governments in this area is to
remove disincentives such as obsolete subsidies, ensure
that prices re#ect the full costs of production and lower
transaction costs by providing information, establishing
responsibilities and ensuring contracts.
However economic instruments are subject to their
own `rebound e!ecta. Even with functioning markets,
relative price changes alone will impose e$ciency losses
on the economy and lower economic growth measured in
terms of GDP. This is why energy technology improve-
ments are constantly required to keep the economy
growing as the real price of energy gradually rises. Com-
bining the two is therefore the only way to approach the
holy grail of energy policy making, which is to achieve
stable or declining energy consumption in growing econ-
omies. Two conditions, however, are necessary to bring
about this happy state of a!airs:
1. Competitive markets have to be enabled by appropri-
ate framework-setting policies in order to allow
transparency of prices, quick reactions to changing
structural conditions and the rapid di!usion of new
technologies. Where markets are clearly subject to
failures (housing), some interventions might increase
economic e!ectiveness, but these must be scrutinised
on a case by case basis.
2. Government policies to further energy technology im-
provements need to be strengthened. E!orts need to
be concentrated in those areas, which are least likely
to crowd out private e!orts and maximise positive
spillovers. This would suggest, at "rst sight, areas such
as basic research, co-ordination and technology
di!usion.
Overall a balance between economic and technology-
based policy approaches has to be sought. There are
market failures and there are government intervention
failures. At the same time, there clearly are instances in
which either market instruments or technology policies
have a role to play.
While technological improvements alone will most
likely not be able to reduce absolute energy consumption
in a growing economy for any lengthy period of time,
they are sources of overall productivity improvements
and economic growth. An energy e$ciency improvement
remains a contribution to total factor productivity and to
economic growth and is thus subject to potentially large
rebound e!ects. As engineers and technicians complete
admirable feats of technological progress, energy con-
sumers continue to demand at e!ectively lower prices
more and more energy-related services or energy-inten-
sive goods.
In order to come to terms with the development of
energy use in a growing economy the realities of the
relationship between factor productivity, output growth
and factor substitution have to be taken into account.
Multiple objectives such as maintaining economic
growth while decreasing energy intensities require mul-
tiple instruments. In addition to policies aimed at the
introduction of new technologies price-based instru-
ments need to be included in the policy mix in order to
o!-set the rebound e!ect, as well as to support and
maintain continued incentives for the development and
adoption of new technologies.
Like technological development, price changes alone
are most likely unable to bring about declining levels of
energy consumption in a growing economy. Energy
intensity decreases would have to be paid for with output
losses in GDP terms. New technologies and processes
o!ering new possibilities for factor and product substitu-
tion are needed to o!set these constraints. This is why an
environment enabling the #exibility and the inventive-
ness of individuals is so important. For truly signi"cant
results price signals and e!orts to increase the capacity
for technological improvements have to complement
each other. Neither can deliver economic and environ-
mental least-cost solutions on its own. Together they
might.
Acknowledgements
The statements expressed in this paper engage only the
authors and do not represent the views of the IEA or any
of its Member countries. The authors are indebted to
468 F. Birol, J.H. Keppler / Energy Policy 28 (2000) 457}469
Paul Atkinson, OECD Economics Directorate, Lee
Schipper and Mel Kliman, both IEA, as well as two
anonymous referees for reviewing the paper and for pro-
viding helpful comments. They would also like to thank
Jean-Marie Bourdaire, IEA O$ce for Long-Term Policy
Co-operation, for providing the initial idea for the paper.
Any responsibility for errors and omissions lies solely
with the authors. An earlier version of the paper has
appeared under the title `Energy e$ciency: The role of
prices and technology developmenta in the OECD SI
Review.
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