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In this inquiry, the Commission has applied its economywide charter to the assessment of privately cost-effective energy efficiency improvements.

Underpinning this approach is a wide public perspective and an underlying goal of improving the wellbeing of the community. The framework for assessing the overall impacts of policy interventions on society — and where it is appropriate to intervene — are described in this section.

Economic efficiency and cost effectiveness

‘Economic efficiency’ and ‘cost effectiveness’ are concepts used extensively to evaluate the overall effect of policies and programs on the economy. However, these concepts are not interchangeable.

Essentially, the concept of overall economic efficiency is about ensuring individuals in society maximise their utility, given all resources (including, but not limited to, energy) available in the economy. Increasing economic efficiency is necessary to achieve the ultimate goal of policy or regulatory endeavours — which is to improve the wellbeing and living standards of the community.

Overall economic efficiency requires satisfaction of productive, allocative and dynamic efficiency (box 2.1):

• Maximum productive efficiency requires that goods and services be produced at the lowest possible cost. This is a question of the input mix used to produce the output of any good or service.

• Maximum allocative efficiency requires the production of the set of goods and services that consumers value most, from a given set of resources. This is a question of the output mix of the economy.

• Greater dynamic efficiency means that consumers are offered, over time, new and better products, and existing products at lower cost.

An activity is economically efficient if there is no other use of the resources that would yield a higher value or net benefit. More commonly, an activity is said to be economically inefficient if its costs (including all costs associated with social and

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environmental externalities) exceed its benefits; or if it can be shown that the resources could be used to produce something with a higher net benefit.

Box 2.1 Components of economic efficiency

Economic efficiency is about maximising the wellbeing of the members of the community. Economic efficiency requires satisfaction of three components.

Productive efficiency is achieved when output is produced at minimum cost. It incorporates technical efficiency, which refers to the extent to which, in the production of any good or service, it is technically feasible to reduce any input without decreasing the output, and without increasing any other input. If waste is avoided in this way, improvements in productive efficiency can generate more income and improve living standards.

Allocative efficiency is about ensuring that the community gets the greatest return (very broadly defined) from its scarce resources. A nation’s resources can be used in many different ways. The best or ‘most efficient’ allocation of resources is the one that contributes most to community wellbeing. Improvements in allocative efficiency bring improvements in living standards because resources are used to generate more income and satisfy more needs and desires.

Dynamic efficiency refers to the allocation of resources over time, including allocations designed to improve economic efficiency and to generate more resources. This can mean finding better products and better ways of producing goods and services.

Investments in education, research, development and innovation are involved.

Dynamic efficiency can also refer to the ability to adapt efficiently to changed economic conditions, a capacity for optimally modifying output and productivity performance in the face of economic ‘shocks’. Improvements in dynamic efficiency bring growth in living standards over time.

Source: Adapted from PC (1999a).

The term cost effectiveness is sometimes defined as achieving a stated objective or outcome using the lowest-cost mix of inputs. Cost effectiveness can also be used to describe the achievement of the best outcome for a stated level of inputs or cost.

Cost-effectiveness analysis can be used to assess options where it is easier to identify benefits than to value them. However, if it is not possible to value all outcomes, it may be difficult to compare options which differ in both outcomes and costs.

Cost effectiveness is sometimes used as shorthand for asserting that there is a net benefit — that is, the total benefits of an activity exceed its total costs. A policy option that generates net benefits will not necessarily be the preferred option, because other options could generate greater net benefits, and be more cost effective. Moreover, even if a policy option is the most cost effective one available

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to achieve a particular policy objective, employing it will not necessarily improve overall economic efficiency. Consideration must be given to whether greater net benefits could be generated by abolishing the program and using the resources to produce something else entirely. Achieving the best input mixes to achieve stated outcomes does not guarantee that the mix of outcomes will be preferred over other feasible options.

The role of government intervention

If all individuals act to maximise their utility, in ideal circumstances perfectly competitive markets will, of themselves, allocate resources in an economically efficient way, maximising net benefits to society. However, in reality there are various sources of market failure that prevent markets from allocating resources in this way.

Government intervention could be warranted to address market failures such as imperfect competition, imperfect information, public goods, and externalities. In this inquiry, the Commission has examined market failures in energy markets (such as imperfect competition in electricity generation) as well as market failures in the market for energy efficiency technologies, such as:

• information asymmetries in the markets for energy-efficient appliances, buildings and industrial equipment;

• public good characteristics of information about energy efficiency;

• split incentives arising from a divergence in incentives (typically those faced by landlords and tenants); and

• positive externalities resulting from research, development and the demonstration of energy efficiency technologies.

Several participants suggested that government intervention might also be warranted to address the negative externalities associated with energy use — particularly greenhouse gas emissions. However, it is beyond the terms of reference to assess policy options to address this type of market failure.

Regardless of the nature or extent of market failures, government intervention is not appropriate if the costs of intervention outweigh the benefits. The costs of intervention often take several forms, including administration costs to government;

distortions associated with revenue raising to cover these administration costs; and compliance costs incurred by regulated firms, other organisations and households.

An unintended consequence of a policy intervention might be that it imposes costs on participants in markets other than that originally targeted by the intervention.

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Governments also intervene on social grounds — such as to redistribute the gains from improvements in economic efficiency. Furthermore, as there are many ways to improve economic efficiency (each with different distributional consequences), decision makers also use other criteria — especially equity — to help determine which approaches are appropriate.