Subsidies and Low-Value Interventions

TL;DR: Subsidizing low-value interventions can make high-value interventions more expensive. In such cases, governments should only subsidize high-value interventions. Case study: the recent Italian energy-efficiency subsidies.

Italy recently subsidized house renovations improving energy efficiency and earthquake resilience. It backfired, and insulation costs ballooned 3x.

The problem is not subsidies, many are great, nor rising prices per sé – this is expected whenever subsidies occur. [1]

The problem is that Italy fully subsidized all qualifying interventions without cost-benefit considerations. For example, my grandma’s condominium accessed subsidies in excess of the condo’s value to improve its energy efficiency by a bit and to improve its earthquake resilience even if it is located in an area with little to no earthquake risk. 

The public funds could have gone to buildings that badly needed the renovations. Instead, they went to buildings that didn’t need them much.

Even worse, the subsidized demand increased prices, making all renovations, including high-value ones, more expensive. 

In other words, the subsidies caused the following mechanic:

1. Renovating a building used to cost X.
2. Italy announced the subsidies, saying it will fully reimburse any renovation improving a building’s earthquake resilience, as long as they are located in an area with non-zero seismic risk.
3. Both the landlords living in high-risk and those living in low-risk areas applied for the subsidies.
4. Subsidies were assigned on a first-come-first-serve basis, so only a few landlords managed to access them.
5. Most landlords living in a high-risk area ended up worse off than they were before: renovation costs are now higher due to the inflated demand.

The core problem is that when subsidies are used for low-value interventions, price increases make high-value interventions harder (as Luis Pedro Coelho noted in this tweet).

Compare this scenario to a hypothetical in which the government reimbursed 90% of costs (instead of 100%) and instead of accepting all applications on a first-come-first-serve basis, it prioritized them by cost-benefit considerations. This would have prevented low-value interventions from grabbing finite subsidies and inflating prices. The final outcome would have been more high-value interventions made, with a larger impact on the country’s environmental sustainability.

Of course, this reasoning doesn’t apply to all scenarios. Sometimes, subsidizing low-value interventions increases supply and stimulates technological innovation. But it’s important to ask ourselves, are supply and technological innovation more elastic than demand? If not, we shouldn’t subsidize low-value interventions.

Notes:

[1]: In the short term, subsidies cause demand to increase faster than supply; therefore, prices rise. In the long term, prices might become cheaper, but only if demand can catch up with supply and/or technological or infrastructural advances lower production costs.