Energy Economics and Policy Spring 2012 Instructors: Chu Xiaodong, Zhang Wen ： Office Tel.:

Energy Demand Energy is crucial to the improvement of social and economic welfare One contributing factor of the great economic achievements over the last century is the replacement of manpower with mechanical and/or electrical power

Energy Demand Nowadays global energy demand is met primarily by fossil fuels The composition of energy demand is not constant, which is shaped by many factors such as availability, price, technology, economic structure and environmental considerations

Energy Demand World total final consumption from 1971 to 2009 by fuel (Mtoe) 1973 and 2009 fuel shares of total final consumption

Energy Demand World electricity generation from 1971 to 2009 by fuel (TWh) 1973 and 2009 fuel shares of electricity generation

Energy Accounting Energy balance tables are used to track the total energy required for consumption by sector and fuel type – Raw energy commodities must usually be converted to some other form prior to being consumed by end-users For example, raw crude oil is generally converted into products such as gasoline Wet natural gas is typically processed into natural gas liquids The energy conversion industries convert primary energy inputs to products for final consumption

Energy Accounting Energy balance tables

Energy Accounting From energy balance tables – Total primary energy requirement (TPER) is greater than total final consumption (TFC) – The difference between TPER and TFC stems from conversion and distribution losses

Energy-Capital Relationship The demand for energy is a derived demand – Energy is an input to provide a set of energy services such as producing steam, driving certain industrial processes, and providing transportation services The relationship between energy use and capital stock can be expressed as where E denotes energy use, K denotes the capital stock, u denotes capacity utilization of capital, and ε denotes the energy efficiency of capital

Example 2.1: Motor Fuel Consumption Consider the case of motor fuel consumption – Capital stock K is expressed as the number of motor vehicles – Capital utilization u is expressed as miles per vehicle – Efficiency ε is expressed as miles per gallon

Example 2.1: Motor Fuel Consumption The service derived from vehicle ownership and the consumption of gallons of fuel is miles It is possible to rearrange the equation and obtain the amount of fuel consumption required to achieve a given level of transportation service

Example 2.1: Motor Fuel Consumption Energy use is positively related to capital utilization that denotes the service rendered by capital equipment, such as miles driven per vehicle However as efficiency increases, the energy required per unit of service declines Efficiency gains can offset increased utilization and growing vehicle stocks thereby mitigating increased fuel consumption

*Writing Skill The paragraph of “According to the US Federal Highway and Traffic Safety Administration…” (on page 92 of [Evans & Hunt, 2009]) is a good example of deducing results from facts

Energy Demand in Long Run Economic structure and technology influence energy intensity – Energy intensity is defined as the quantity of energy consumed per unit of economic output Energy intensity ultimately declines as economies develop Trends in energy intensity in the US (1880–2005)

Energy Demand in Long Run The theory of dematerialization – Energy intensity initially increases then decreases with increasing GDP – The later in time economic growth occurs, the lower the maximum intensity of use of energy will be Dematerialization and energy intensity

Energy Demand in Long Run Changing economic structure has a significant influence on energy use – The structural changes result in changes in the structure of the capital stock, which will promote changes in energy intensity At higher levels of economic development, energy intensity declines as the service sector relative to other sectors

Energy Demand in Long Run Consider a three-sector economy – Total energy consumption is the sum of energy use across all sectors – Total output is – Total energy intensity is

Energy Demand in Long Run Consider a three-sector economy (cont’) – Assume that the energy intensity of each sector can be ordered such that – If sector I grows faster than sector A, holding the output share of sector S constant, how will the total energy intensity change?

Energy Demand in Long Run Consider a three-sector economy (cont’) – The derivative of the total energy intensity w.r.t the output share of sector I – The impact on energy intensity of the shift to sector I is positive

Energy Demand in Long Run Technological progress effectively lowers the peak energy intensity of an economy The influence of technology change can be expressed by – An increase in energy efficiency in any sector (by adopting a new technology) will lead to a decline in the energy intensity of sector and overall energy intensity – The impact of the technological change will be the greatest if it occurs in the sector with the largest share of total output

Energy Demand in Long Run How is the second derivative of the total energy intensity to energy efficiency in any sector? – The negative effect on energy intensity is increasing with the innovation – Any innovation in a sector that occurs in one country can have a substantial impact on energy intensity in countries that develop later in time, provided the technology is transferable

Modeling Energy Demand The decision of energy consumption usually involves three choices as – The choice to invest in capital stocks – The choice of a particular type of capital stocks – The choice of a rate of capital utilization These choices all lead to a desired amount of energy service

Modeling Energy Demand Dynamic models that incorporate dynamic investment behavior are suited to capture both the short- and long run responses of energy demand to changes in economic variables Static models that do not incorporate dynamic behavior are also widely utilized, and they can be valuable in understanding full-adjustment variable response

Modeling Energy Demand Model taxonomy – The static model of a firm – The dynamic model of a firm – The static model of a household – The dynamic model of a household Please reference a proper model when you will work on a modeling problem – Models on Pages are two good examples

Elasticity of Energy Demand Elasticity is a measure of how much buyers and sellers respond to changes in market conditions The responsiveness (or sensitivity) of consumers to a price change is measured by a product’s price (or income) elasticity of demand – If a specific percentage change in price produces a larger percentage change in quantity demanded, demand is elastic, otherwise it is inelastic

Elasticity of Energy Demand Cross elasticity is the responsiveness of demand of one good to changes in the price of a related good either a substitute or a complement

Elasticity of Energy Demand Price Quantity Demanded The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded

Elasticity of Energy Demand Price Quantity Demanded The importance of elasticity is the information it provides on the effect on total revenue of changes in price Total revenue is price x quantity sold. In this example, TR = 5 x 100,000 = 500,000 This value is represented by the grey shaded rectangle Total Revenue

Price Quantity Demanded D If the firm decides to decrease price to (say) 3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue Total Revenue Elasticity of Energy Demand

Price Quantity Demanded 10 D % Δ Price = -50% % Δ Quantity Demanded = +20% E d = -0.4 (Inelastic) Total Revenue would fall Producer decides to lower price to attract sales Not a good move! Elasticity of Energy Demand

Price Quantity Demanded D Producer decides to reduce price to increase sales 7 % Δ in Price = - 30% % Δ in Demand = + 300% E d =-10 (Elastic) Total Revenue rises Good Move! Elasticity of Energy Demand

The price elasticity is often used as an indicator of the impact of various policies aimed at conservation, such as energy taxes or subsidies – For example, if policy targets a demand reduction through the implementation of a tax in a sector where price elasticity is very low, then the policy is unlikely to achieve its stated goal, which results in large costs being imposed on consumers without an off setting benefit

Next Lecture The main topic will be Economics of Energy Supply Pages from textbooks are good learning reference including Chapter 3 of [Evans & Hunt, 2009] and Pages of [McConnell, Brue & Flynn, 2012]