Schengen visa to Luxembourg
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As Henning Makholm stated in comment, Schengen Visa Code requires "proof of accommodation or means to provide one". It certainly does not require prepaid accommodations. If you are dealing with a Consulate, you can argue with them, but usually this is waste of your time.
One possibility is to book and prepay the accommodation, which allows free cancellation. Many booking websites allow this. Agoda, for example, provides travel vouchers which clearly state the accommodation has been paid for. This way you are following the rules, since your accommodation is prepaid.
Another option is to book with a local travel agency, which offers reasonable cancellation policy and can provide a written confirmation in English.
After you get visa, you can then cancel the prebooked accommodation - Schengen Visa Code does not require you to stick to your original accommodation.
Please also note that if you do this, the border guards might ask you about your accommodation once you arrive to Luxembourg. You'll attract much more scrutiny if you come without a booked reservation.
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