Explanation of observed high implicit discount rates of conservation investments using the theory of ‘investment under uncertainty’

A well documented observation is that consumers (and also firms) use high implicit discount rates when deciding about energy conservation investments. This fact is almost universally labelled a ‘market failure’, which in turn has led many analysts (most famous Amory Lovins) to argue for either public or utility sponsored conservation programmes. This paper applies the theory of real options to a familiar example: the choice between conventional and energy saving bulbs assuming risk neutral decision makers. The results are that the implicit discount rates accounting for the option value of waiting and delaying the investment are close to reported implicit discount rates. Hence the conclusion of market failure from observed high implicit discount rates requires a more careful and subtle analysis. This applies a fortiori to the recommendation of conservation programmes.