Energy Economics: Concepts, Issues, Markets And Governance 1447174674, 9781447174677, 9781447174684
This book provides an updated and expanded overview of basic concepts of energy economics and explains how simple econom
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Table of contents :
Preface......Page 5
Contents......Page 7
Abbreviations......Page 19
1 Introduction to Energy Economics......Page 22
1.1 Introduction......Page 23
Reference......Page 25
I Economic Concepts Applied to the Energy Sector......Page 26
2 Energy Data and Energy Balance......Page 27
2.2.1 Energy Defined......Page 29
2.2.2 Alternative Classifications of Energy......Page 30
2.3 Introduction to the Energy System......Page 32
2.4 Energy Accounting Framework......Page 34
2.4.1 Components of the Energy Account......Page 35
2.4.2 Commodity Accounts and Overall Energy Balance......Page 37
2.4.3 Units, Conversion Factors and Aggregation of Energy Flows......Page 40
2.5 Accounting of Traditional Energies......Page 45
2.6.1 Treatment of Primary Electricity Production......Page 47
2.6.2 Treatment of Electricity in Final Consumption......Page 48
2.7 Analysis of Energy Balance Information......Page 49
2.8.1 Energy Flow Diagrams......Page 51
2.8.2 Reference Energy Systems (RES)......Page 52
2.9 Common Energy Data Issues......Page 54
Annex 2.1: Worked Out Examples......Page 56
References......Page 59
3 Energy Demand Analysis......Page 61
3.1 Introduction......Page 63
3.2.1 Consumer Demand for Energy: Utility Maximization Problem......Page 64
3.2.2 Cost Minimization Problem of the Producer......Page 68
3.3 Energy Demand Decisions from a Behavioural Economics Perspective......Page 70
3.4 Overview of Energy Demand Decisions......Page 71
3.5.1 Visualisation of Demand Trend......Page 73
3.5.2 Growth Rates......Page 75
3.5.3 Demand Elasticities......Page 76
3.5.4 Energy Intensities......Page 77
3.6 Decomposition Analysis......Page 81
3.6.1 Analysis of Changes in Total Energy Demand......Page 82
3.6.2 Analysis of Changes in Energy Intensity......Page 85
3.6.3 Analysis Using Physical Indicators......Page 89
3.7.1 Single Equation Regression Models......Page 90
3.7.2 Other Econometric Approaches......Page 93
3.8 Big Data and Energy Demand Analysis......Page 97
3.9 Conclusion......Page 98
Annex 3.1: Consumer Demand for Energy—The Constrained Optimization Problem......Page 99
References......Page 100
4 Sectoral Energy Demand Analysis......Page 103
4.2 Energy Demand at the Sector Level......Page 104
4.3 Sectoral Energy Accounting......Page 107
4.4 Analysis at the Sectoral Level......Page 108
4.4.1 Industrial Energy Demand Analysis......Page 109
4.4.1.1 Decomposition of Energy Demand......Page 110
4.4.1.2 Econometric Approach......Page 116
4.4.1.3 End-Use Approach......Page 118
4.4.2.1 A Simple Transport Fuel Demand Model......Page 122
4.4.2.2 Transport Energy Demand Using Vehicle Ownership Modeling......Page 123
4.4.2.3 End-Use Analysis of Transport Energy Demand......Page 124
4.4.2.4 Decomposition of Energy Consumption Variation in the Transport Sector......Page 127
4.4.3.1 Purpose of Energy Use......Page 128
4.4.3.2 Econometric Analysis of Residential/Commercial Energy Demand......Page 130
4.4.3.3 End-Use Method of Residential Energy Demand Analysis......Page 131
4.4.3.4 Analysis of Residential Energy Demand Using Smart Meter Data......Page 132
Annex 4.1: Hierarchical Decomposition......Page 133
Annex 4.2: Translog Cost Function......Page 135
References......Page 138
5 Energy Demand Forecasting......Page 141
5.1.1.1 Forecasting Using Simple Indicators......Page 142
5.1.1.2 Trend Analysis......Page 144
5.1.1.3 Direct Surveys......Page 145
5.1.2.1 Scenario Approach......Page 147
5.1.2.2 Econometric Approach to Energy Demand Forecasting......Page 149
5.1.2.3 End-Use Method of Forecasting......Page 151
5.1.2.4 Input–Output Model......Page 153
5.1.2.5 Artificial Neural Networks......Page 155
5.2 Review of Some Common Energy Demand Analysis Models......Page 157
5.2.2 LEAP Model......Page 158
5.3 Conclusion......Page 160
Annex 5.1: Mathematical Representation of Demand Forecasting Using the Input–Output Model......Page 162
References......Page 164
6 Economic Analysis of Energy Investments......Page 166
6.1.1 Main Characteristics of Energy Projects......Page 167
6.2 Essentials of the Economic Analysis of Projects......Page 169
6.2.1 Identification of Costs......Page 170
6.2.2 Identification of Benefits......Page 171
6.2.3.1 Valuation of Project Inputs and Outputs......Page 172
6.2.3.2 Border Prices for Traded Goods......Page 174
6.2.3.3 Economic Prices of Non-traded Goods......Page 175
6.2.3.4 Economic Price of Labour......Page 176
6.2.3.6 Economic Price of Foreign Exchange......Page 177
6.3 Economic Versus Financial Investment Analysis......Page 178
6.4.1 Methods Without Time Value......Page 179
6.4.2.1 Net Present Value Based Indicators......Page 180
6.4.2.2 Role of Discount Rates......Page 181
6.4.2.3 Internal Rate of Return......Page 182
6.4.2.4 NPV Versus IRR......Page 183
6.5 Uncertainty and Risk in Projects......Page 184
6.6 Conclusion......Page 186
Annex 6.1: Example of a Project Evaluation Exercise......Page 187
Annex 6.2: Some Commonly Used Interest Formulae......Page 190
References......Page 193
7 Economics of Non-renewable Energy Supply......Page 194
7.1 Introduction......Page 196
7.1.1 Exploration......Page 198
7.1.2 The Economics of Exploration Activities......Page 200
7.1.3 Investment Decision......Page 201
7.1.4 Risks in Exploration Projects......Page 202
7.2 Field Development......Page 206
7.2.1 Investment Decision......Page 207
7.2.2 Resource Classification......Page 209
7.3 Production......Page 211
7.3.1 Conventional Oil Production......Page 212
7.3.2 Production Decline and Initial Production Rate......Page 214
7.3.3 Conventional Gas Production......Page 215
7.3.5 Unconventional Oil and Gas Production......Page 216
7.4.1 Field Level Economics......Page 217
7.4.2 Industry Level Economics......Page 218
7.5 Resource Rent......Page 220
7.6 Depletion of Resources......Page 223
7.6.1 Depletion Dimension: Now or Later......Page 224
7.7.1 Relation Between Discoveries and Production......Page 225
7.7.2 Supply Forecasting Methods......Page 226
7.8 Conclusion......Page 227
Annex 7.1: Mathematical Treatment of Depletion......Page 228
References......Page 233
8 The Economics of Renewable Energy Supply......Page 235
8.1.1 Status of Renewable Energies at Present......Page 236
8.2 Renewable Electricity Generation......Page 240
8.3 Bio-Fuels......Page 241
8.4 Renewable Energy for Heating and Cooling......Page 245
8.5 Drivers of Renewable Energy......Page 247
8.6.1 The Economics of Renewable Electricity Supply......Page 249
8.6.1.1 Cost Features......Page 250
8.6.1.2 Support Mechanisms......Page 253
8.6.1.3 Performance of Price and Quantity-Based Mechanisms Under Uncertainty and Risk......Page 257
8.6.1.4 Financial Incentives......Page 258
8.6.1.5 Taxing Fossil Fuels......Page 259
8.7.1 Bio-Ethanol Cost Features......Page 260
8.7.2 Bio-Diesel Costs......Page 261
8.7.3 Support Mechanisms for Biofuels......Page 262
References......Page 264
9 Energy Pricing and Taxation......Page 267
9.1 Perfectly Competitive Market Model......Page 269
9.2.1 Indivisibility of Capital......Page 272
9.2.3 Asset Specificity and Capital Intensiveness......Page 275
9.3.1 Monopoly Problems......Page 277
9.3.2 Natural Monopoly......Page 279
9.3.2.1 Two-Part Tariffs......Page 283
9.3.2.2 Ramsey Pricing......Page 284
9.3.4 Externality and Public Goods......Page 285
9.4 Tradability of Energy Products and Opportunity Cost......Page 286
9.5 Peak and Off-peak Pricing......Page 289
9.6 Short-Run Versus Long-Run Debate......Page 291
9.7 Government Intervention and Role of Government in the Sector......Page 292
9.8 Energy Taxes and Subsidies......Page 295
9.8.1 Principles of Optimal Indirect Taxation......Page 298
9.8.2 Equity Considerations......Page 300
9.8.3 Issues Related to Numerical Determination of an Optimal Tax......Page 301
9.8.5 Subsidies......Page 302
9.8.6 Subsidy Dilemma in Developing Countries with High Dependence on Traditional Energies and Informal Sectors......Page 305
9.9 Conclusion......Page 306
Annex 9.1: Peak Load Pricing Principle......Page 307
References......Page 309
10 The Economics of Environment Protection......Page 311
10.2 Energy–Environment Interactions......Page 313
10.2.1 Energy–Environment Interaction at the Household Level......Page 314
10.2.2 Community Level Impacts......Page 318
10.2.3 Impacts at the Regional Level......Page 319
10.2.4 Global Level Problems: Climate Change......Page 320
10.3 Environmental Kuznets Curve......Page 321
10.4 Economics of the Environment Protection......Page 322
10.4.1 Externalities......Page 323
10.4.2 Spectrum of Goods......Page 324
10.4.3 Private Versus Social Costs......Page 325
10.5 Options to Address Energy-Related Environmental Problems......Page 327
10.5.1 Regulatory Approach to Environment Management......Page 328
10.5.2.1 Taxes and Charges......Page 330
10.5.2.2 Who Bears the Tax Burden?......Page 332
10.5.2.3 Property Rights Approach to the Externality Problem......Page 333
10.5.2.4 Tradable Permits......Page 336
10.5.3 Assessment and Selection of Instruments......Page 338
10.6 Effects of Market Imperfection......Page 340
10.7 Valuation of Externalities......Page 342
10.8 Government Failure......Page 345
References......Page 346
11 The Economics of Climate Change......Page 348
11.1.1 The Solar Energy Balance......Page 349
11.1.2 GHGs and Their Global Warming Potential......Page 350
11.1.3 Observed Changes in the Climate System......Page 351
11.2.1 Problem Dimension......Page 356
11.2.2 Overview of GHG Emissions......Page 357
11.3 Economic Approach to Control the Greenhouse Effect......Page 360
11.3.1 Integrated Assessment......Page 362
11.4.1 Generic Options......Page 363
11.4.2 National Policy Options......Page 365
11.4.3 Emissions Trading System (ETS) of the EU......Page 370
11.4.4 International Policy Options......Page 372
11.5.1 UNFCCC......Page 376
11.5.2 The Kyoto Protocol......Page 377
11.6 Conclusion......Page 379
References......Page 380
II Issues......Page 383
12 Overview of Challenges Facing the Energy Sector......Page 384
12.2 Grand Energy Transitions......Page 385
12.3 Issues Facing Fossil Fuel-Rich Countries......Page 391
12.4 Issues Facing Resource-Poor Countries......Page 395
12.5 Energy Equity and Justice......Page 397
12.6 Governance Issues......Page 398
12.7 Conclusion......Page 399
References......Page 400
13 Energy and Sustainable Development......Page 402
13.1 Unsustainable Development Process......Page 403
13.2 Sustainable Development......Page 410
13.3 A Brief Review of International Initiatives on Sustainable Development......Page 413
13.4 Energy and Sustainable Development......Page 417
Annex 13.1: A Brief Summary of Three Sustainability Dimensions......Page 419
References......Page 428
14 Energy Security Issues......Page 430
14.2 Energy Security: The Concept......Page 431
14.2.1 Indicators of Energy Security......Page 434
14.3 Economics of Energy Security......Page 442
14.3.1 External costs of oil imports......Page 443
14.4 Optimal Level of Energy Independence......Page 445
14.5 Policy Options Relating to Import Dependence......Page 446
14.5.1.1 Effect of Import Tax and Import Restriction......Page 447
14.5.2 Import Diversification......Page 448
14.5.4 Energy Efficiency Improvements......Page 450
14.6 Costs of Energy Supply Disruption......Page 451
14.6.1 Strategic Oil Reserves for Mitigating Supply Disruption......Page 452
14.6.2 International Policy Co-ordination......Page 454
14.7 Conclusions......Page 455
References......Page 456
15 Impact of Price Volatility......Page 458
15.2 Recent Developments in Energy Prices......Page 459
15.3 Reasons for Energy Price Volatility......Page 461
15.4.1 Consumer Reaction to Oil Price Changes......Page 464
15.4.2 Transmission of Reactions to the Economy......Page 466
15.4.3 Linkage with the External Sector......Page 468
15.5 Energy Price Shocks and Vulnerability of Importers......Page 470
15.6.1 Export Revenue Volatility......Page 472
15.6.2 Resource Curse......Page 475
15.6.3 Petroleum Funds......Page 478
References......Page 481
16 Energy Investment Issues......Page 483
16.1 Recent Investment Trend in the Energy Sector......Page 484
16.2 Future Investment Needs of the Energy Sector......Page 486
16.2.1 IRENA Transformation Roadmap 2019......Page 487
16.2.2 World Energy Outlook (2018) Scenarios......Page 488
16.2.3 Energy Transition Outlook by DNV GL (2018)......Page 489
16.3 Factors Influencing Future Energy Sector Investments......Page 490
16.4.1 High Cost of Financing Energy Investments in Developing Countries......Page 494
16.4.2 Risks in Energy Investments and de-Risking Measures......Page 496
16.4.3 Resource Availability and Mobilisation......Page 500
16.5 Conclusions......Page 503
References......Page 504
17 Energy Access......Page 506
17.1 Energy Access......Page 507
17.1.1 Current Situation......Page 508
17.2 Indicators of Energy Poverty......Page 512
17.3 Energy Ladder and Energy Use......Page 515
17.4 Energy Access Development Link......Page 516
17.5 Review of Experience on Energy Access Provision......Page 517
17.5.1 Review of Electrification Experience......Page 518
17.5.2 Review of Clean Cooking Energy Access Experience in Developing Countries......Page 525
17.6 Evaluation of Existing Mechanisms for Enhancing Access......Page 528
17.7.1 Methodology......Page 531
17.7.2 Analysis of the Results......Page 532
References......Page 534
18 Pollution Control from Stationary Sources......Page 537
18.1 Introduction......Page 538
18.2.1 Pollution Standards......Page 540
18.2.3 Emissions Trading......Page 544
18.3.1 Pollution Control Technologies......Page 549
18.3.2 Options Related to Fuels and Conversion Processes......Page 550
18.4 Indoor Air Pollution......Page 553
References......Page 555
19 Pollution Control from Mobile Sources......Page 557
19.1 Introduction......Page 558
19.2 Special Characteristics of Mobile Pollution......Page 560
19.3 Social Costs of Transport Use......Page 561
19.3.1 Infrastructure Usage Related Costs......Page 562
19.3.2 Environmental Pollution Costs......Page 565
19.3.4 Internalisation of Externalities......Page 570
19.4.1 Vehicle Emission Standards and Technologies......Page 571
19.4.2 Zero Emission Vehicles......Page 575
19.4.3 Cleaner Fuels......Page 576
19.4.4 Traffic Management and Planning......Page 578
References......Page 580
20 Energy Demand Management and Demand Response......Page 582
20.1 Introduction......Page 584
20.2.1 Definition......Page 586
20.2.2 Evolution of DSM and Demand Response......Page 588
20.2.3 Justification for DSM......Page 589
20.3 Load Management......Page 590
20.4.1 What Is Energy Efficiency?......Page 594
20.4.2 Opportunities for Energy Saving......Page 596
20.4.3 Economics of Energy Efficiency Improvements......Page 600
20.5 Analysing Cost Effectiveness of DSM Options......Page 601
20.5.2 Ratepayer Impact Measure (RIM)......Page 602
20.5.4 Programme Administrator Cost or Utility Cost Test......Page 604
20.6.1 Market Barriers and Intervention Debate......Page 605
20.6.2 What Are the Market Barriers to Energy Efficiency?......Page 606
20.6.3 Government Intervention and Its Nature......Page 608
20.6.4 Energy Efficiency Versus Economic Efficiency Debate......Page 609
20.6.5 Rebound Effect......Page 611
20.6.6 Use of Market-Based Incentives for Energy Efficiency......Page 612
References......Page 613
III Markets......Page 615
21 International Oil Market......Page 616
21.2.1.1 Phase 1: Oil Rush and Intense Competition (1859–1870)......Page 617
21.2.1.2 Phase 2: Rockefeller Monopoly (Between 1870 and 1911)......Page 618
21.2.1.3 Phase 3: Internationalization of Oil Industry (1911–1928)......Page 620
21.2.1.4 Phase 4: Between 1928 and 1960: Rise of the Seven Sisters......Page 621
21.2.2 OPEC Era......Page 624
21.2.2.1 First Phase: 1960–1973......Page 625
21.2.2.3 Phase 3: 1975–1981......Page 626
21.2.2.4 Phase 4: 1981–86......Page 627
21.2.2.5 Phase 5: OPEC in the 1990s......Page 629
21.2.2.6 Phase 6: Return of High Prices in the New Millennium......Page 630
21.2.3 New World Petroleum Order......Page 632
21.2.4 Commoditisation of Oil......Page 635
21.2.4.1 Physical Trading......Page 636
21.2.4.2 Derivatives Trading......Page 637
21.3.1 National Oil Companies......Page 639
21.3.2 International Oil Companies......Page 640
21.4.1 Evolution of Oil Reserves, Oil Production and Oil Consumption......Page 641
21.4.2 Analysis of the OPEC Behaviour......Page 644
21.4.2.1 Cartel Model......Page 645
21.4.2.2 Cartel with a Leader (Dominant Firm Model)......Page 647
21.4.2.3 Limit Pricing Model......Page 648
21.4.2.4 Target Revenue Model......Page 650
21.4.3 A Simple Analytical Framework of Oil Pricing......Page 651
21.5 Low Carbon Energy Transition and the Future of Oil......Page 652
21.6 Conclusion......Page 653
References......Page 654
22 Natural Gas Market......Page 656
22.2.1 Advantage Natural Gas......Page 657
22.2.2 Gas Supply Chain......Page 658
22.2.3 Specific Features......Page 660
22.3.1 Reserves......Page 661
22.3.2 Production......Page 663
22.3.3 Consumption......Page 664
22.3.4 Gas Trade......Page 667
22.3.4.1 North American Market......Page 668
22.3.4.2 European Market......Page 669
22.3.4.3 Asia-Pacific Market......Page 671
22.4.1 Economics of Pipeline Transport of Gas......Page 673
22.4.2 Economics of LNG Supply......Page 677
22.4.3 LNG Versus Pipeline Gas Transport......Page 680
22.5.1 Rules of Thumb......Page 683
22.5.2 Parity and Net-Back Pricing......Page 685
22.5.3 Spot Prices of Natural Gas......Page 686
22.6 Natural Gas in the Context of Developing Countries......Page 688
22.7 Conclusion......Page 689
References......Page 690
23 Coal Market......Page 692
23.2 Coal Facts......Page 693
23.3 Changes in the Coal Industry......Page 702
23.4 Technological Advances and the Future of Coal......Page 704
23.5 Conclusion......Page 705
References......Page 706
24 Markets for Electricity Supply......Page 707
24.2 Basic Concepts Related to Electricity Systems......Page 709
24.3 Alternative Electricity Generation Options......Page 712
24.4 Economic Dispatch......Page 715
24.4.2 Incremental Cost Method......Page 716
24.5 Unit Commitment......Page 717
24.6.1 Levelised Cost......Page 719
24.6.2 Screening Curve Method......Page 722
24.7 Sophisticated Approaches to Electricity Resource Planning......Page 724
24.8 Electricity Markets Around the World......Page 725
24.8.1 Wholesale Electricity Markets......Page 726
24.8.1.1 US Wholesale Power Market......Page 727
24.8.1.2 European Electricity Wholesale Market......Page 728
24.8.1.3 Wholesale Electricity Markets in Developing Countries......Page 730
24.8.2 Retail Electricity Markets......Page 731
24.9 Ancillary Services and Their Pricing......Page 732
24.10 Electricity Markets and Emerging Technologies......Page 735
Annex 24.1: Levelisation Factor for a Uniform Annual Escalating Series......Page 736
Annex 24.2: A Brief Description of the WASP-IV Model......Page 737
References......Page 739
25 Carbon Market......Page 742
25.1 Introduction to Carbon Markets......Page 743
25.2 State of the Carbon Markets......Page 744
25.2.1 European Carbon Market......Page 746
25.2.2 North American Carbon Market......Page 750
25.2.3 Other Emissions Trading Markets......Page 752
25.3 Carbon Market Issues......Page 753
References......Page 756
IV Governance......Page 758
26 Institutions and the Energy Sector Governance......Page 759
26.1 Introduction......Page 760
26.2 Governance from the Institutional Economics Perspective......Page 761
26.3 Global Energy Governance......Page 764
26.4.1 Governance of the European Energy Sector......Page 767
26.4.2 Other Regional Cooperation in Energy......Page 768
26.6 Reforms from an Institutional Economics Perspective......Page 770
26.6.1 Changing the Rules of the Game......Page 771
26.6.1.1 Rule Makers’ Stability......Page 772
26.6.1.2 Hurdles Along the Process......Page 774
26.6.1.3 Acceptance of Changed Rules......Page 775
26.6.1.4 Limitations of Rule Changes......Page 776
26.6.3 Modifying the Governance Mechanism......Page 777
26.6.3.2 Transactional Changes......Page 778
26.6.3.3 Adaptation to the New Environment......Page 779
26.7 Concluding Remarks......Page 780
References......Page 781
27 Reform of the Energy Sector......Page 783
27.2 Government Intervention in Energy Industries......Page 784
27.3 Rationale for Deregulation in the 1990s......Page 787
27.4.1 Competition for the Market......Page 790
27.4.2.1 Open Access......Page 791
27.4.2.3 Competition for New Capacity Expansion......Page 792
27.5 Restructuring Options......Page 793
27.5.1 Vertically Integrated Monopoly Model (VIM)......Page 794
27.5.2 Entry of Independent Power Producers (IPP)......Page 796
27.5.3 Single Buyer Model......Page 797
27.5.4 Transitional Models......Page 799
27.5.5 Wholesale Competition: Price-Based Power Pool Model......Page 802
27.5.6 Wholesale Competition: Net Pool......Page 804
27.5.7 Wholesale Competition: Cost-Based Pool......Page 805
27.5.8 Wholesale Competition Through Open Access......Page 806
27.5.9 Full Customer Choice: Retail Competition Model......Page 807
27.6 Reform Sustainability: A Framework for Analysis......Page 809
27.7 Experience with the Energy Sector Reform......Page 812
27.8 Conclusions......Page 814
References......Page 815
28 Regulation of Energy Industries......Page 817
28.1 Introduction......Page 819
28.2.1 Rate Level Regulation......Page 820
28.2.1.1 Expenses......Page 822
28.2.1.3 Rate of Return......Page 823
28.2.2 Rate Structure Regulation......Page 827
28.3 Problems with Traditional Regulatory Approach......Page 829
28.4.1 Incentive Regulation......Page 831
28.4.2 Regulation by Contract......Page 833
28.4.3 Conduct Regulation......Page 834
28.5 Price-Cap Regulation......Page 835
28.5.1 Choice of Inflation Factor......Page 837
28.5.2 X Factor......Page 838
28.5.4 Choice of Form......Page 839
28.5.5 Advantages and Disadvantages of a Price Cap Regulation......Page 840
28.5.7 Experience with Price Cap Regulation......Page 841
28.6 Revenue Caps......Page 842
28.7 Yardstick Competition......Page 843
28.8 Performance Based Regulation......Page 846
28.8.1 Base Revenue Requirement......Page 847
28.8.3 Quality Control......Page 848
References......Page 849
Concluding Remarks......Page 853
Citation preview
Subhes C. Bhattacharyya
Energy Economics Concepts, Issues, Markets and Governance Second Edition
Energy Economics
Subhes C. Bhattacharyya
Energy Economics Concepts, Issues, Markets and Governance 2nd ed. 2019
Subhes C. Bhattacharyya
Institute of Energy and Sustainable Development De Montfort University Leicester, Leicestershire, UK
ISBN 978-1-4471-7467-7 ISBN 978-1-4471-7468-4 (eBook) https://doi.org/10.1007/978-1-4471-7468-4 1st edition: © Springer-Verlag London Limited 2011 2nd edition: © Springer-Verlag London Ltd., part of Springer Nature 2019 The author(s) has/have asserted their right(s) to be identified as the author(s) of this work in accordance with the Copyright, Designs and Patents Act 1988. This work is subject to copyright. All rights are reserved by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Springer imprint is published by the registered company Springer-Verlag London Ltd. part of Springer Nature. The registered company address is: The Campus, 4 Crinan Street, London, N1 9XW, United Kingdom
V
Preface The first edition of Energy Economics: Concepts, Issues, Markets and Governance was well received by the academic community. Readers have provided positive feedback on the book and it has trained a generation of young energy economists, who have appreciated the wide range of topics covered by the book. Since the book was published in 2011, a lot of changes have taken place in the energy sector. The emergence of the US as an energy exporter has wiped out the peak oil debate and hardly anyone is talking about the concerns of energy security these days. Instead, the launch of the Sustainable Development Goals has galvanised the attention on global energy access, sustainable energy and green growth. In addition, the Paris Agreement has revived the global climate change agenda and made a breakthrough by adopting a common agenda for all countries. All these developments made a revision to the book essential and at the suggestion of the publisher, Springer, I agreed to revise and update the book more than 2 years ago. However, the revision task appeared to be a never-ending process and I continued to miss deadline after deadline. Increased workload at the University meant that the book project had to be moved to personal working time—in the evenings, weekends and holidays. However, the work pressure started to encroach on these personal times, making the project completion a major challenge. I have managed to complete this during the summer when I was supposed to go on a family vacation but this had to be sacrificed to complete the manuscript. The revised version retains the same features of the first edition. Most of the content of the book is accessible to persons of non-mathematical background. The economic concepts have also been explained in simple terms, often using graphical presentations. However, for those who cannot imagine an energy economics book without mathematics, I have added some materials and have provided references for further reading. Essentially, mathematics has been used as an aid and not for the sake of it. The organisation of the book has been updated. This now reflects closely the title of the book. Accordingly, the book is divided into four parts instead of six parts found in the first edition. The content has also been thoroughly revised to reflect the changes in the industry and the business environment. I am grateful to the readers who provided valuable feedback and encouraging comments on most of the materials of this book. Their suggestions and criticisms have always have helped me in improving my work.
VI
Preface
A book of this size always takes special personal efforts. I am grateful to Mr. Anthony Doyle of Springer Nature for his understanding and agreeing to my requests for extension. Above all, I could not have realised this work without the support and sacrifice of my family members—my spouse Debjani and my daughter Saloni. I have no words to express my gratitude for their altruistic gesture of letting me work during the entire summer holidays of 2019, without any complaint. This summer will never return and the loss of opportunity to recharge the battery for the next year will be dearly felt. Perhaps it is high time to assess the external costs academics impose on their near and dear ones, but that is outside the scope of this book. Subhes C. Bhattacharyya Leicester, UK August 2019
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Contents 1 Introduction to Energy Economics. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 1.2 Organisation and Content of the Book. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
I Economic Concepts Applied to the Energy Sector 2 Energy Data and Energy Balance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 2.2 Energy Basics. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 2.2.1 Energy Defined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 2.2.2 Alternative Classifications of Energy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 2.3 Introduction to the Energy System. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 2.4 Energy Accounting Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 2.4.1 Components of the Energy Account. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 2.4.2 Commodity Accounts and Overall Energy Balance. . . . . . . . . . . . . . . . . . . . . . . 17 2.4.3 Units, Conversion Factors and Aggregation of Energy Flows. . . . . . . . . . . . . . 20 2.5 Accounting of Traditional Energies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 2.6 Special Treatments of Some Entries in the Energy Balance. . . . . . . . . . . . . . 27 2.6.1 Treatment of Primary Electricity Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 2.6.2 Treatment of Electricity in Final Consumption . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 2.6.3 Self Generation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 2.7 Analysis of Energy Balance Information. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 2.8 Alternative Presentation of Energy Accounting Information. . . . . . . . . . . . 31 2.8.1 Energy Flow Diagrams . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 2.8.2 Reference Energy Systems (RES) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 2.9 Common Energy Data Issues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 2.10 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 Annex 2.1: Worked Out Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Energy Demand Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 3 3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 3.2 Basic Rational Choice Model of Energy Demand. . . . . . . . . . . . . . . . . . . . . . . . 44 3.2.1 Consumer Demand for Energy: Utility Maximization Problem. . . . . . . . . . . . . 44 3.2.2 Cost Minimization Problem of the Producer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 3.3 Energy Demand Decisions from a Behavioural Economics Perspective. . . . . 50 3.4 Overview of Energy Demand Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 3.5 Simple Indicators for Energy Demand Analysis. . . . . . . . . . . . . . . . . . . . . . . . . 53 3.5.1 Visualisation of Demand Trend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 3.5.2 Growth Rates. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
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3.5.3 Demand Elasticities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 3.5.4 Energy Intensities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 3.6 Decomposition Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 3.6.1 Analysis of Changes in Total Energy Demand. . . . . . . . . . . . . . . . . . . . . . . . . . . . 62 3.6.2 Analysis of Changes in Energy Intensity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 3.6.3 Analysis Using Physical Indicators. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 3.7 Energy Demand Analysis Using the Econometric Approach. . . . . . . . . . . . . 70 3.7.1 Single Equation Regression Models. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70 3.7.2 Other Econometric Approaches. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 3.8 Big Data and Energy Demand Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 3.9 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 Annex 3.1: Consumer Demand for Energy—The Constrained Optimization Problem. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79 Annex 3.2: Cost Minimization Problem of Producers. . . . . . . . . . . . . . . . . . . . 80 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
Sectoral Energy Demand Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83 4 4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84 4.2 Energy Demand at the Sector Level. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84 4.3 Sectoral Energy Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87 4.4 Analysis at the Sectoral Level. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88 4.4.1 Industrial Energy Demand Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89 4.4.2 Energy Demand Analysis in the Transport Sector. . . . . . . . . . . . . . . . . . . . . . . . . 102 4.4.3 Energy of Energy Demand in the Residential and Commercial Sectors. . . . . 108 4.5 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113 Annex 4.1: Hierarchical Decomposition. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113 Annex 4.2: Translog Cost Function. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118 Energy Demand Forecasting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121 5 5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122 5.1.1 Simple Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122 5.1.2 Advanced or Sophisticated Techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127 5.2 Review of Some Common Energy Demand Analysis Models . . . . . . . . . . . . 137 5.2.1 MAED Model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138 5.2.2 LEAP Model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138 5.3 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140 Annex 5.1: Mathematical Representation of Demand Forecasting Using the Input–Output Model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144 Economic Analysis of Energy Investments . . . . . . . . . . . . . . . . . . . . . . . 147 6 6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148 6.1.1 Main Characteristics of Energy Projects. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148 6.2 Essentials of the Economic Analysis of Projects. . . . . . . . . . . . . . . . . . . . . . . . . 150 6.2.1 Identification of Costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
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6.2.2 Identification of Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152 6.2.3 Valuation of Costs and Benefits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153 6.3 Economic Versus Financial Investment Analysis . . . . . . . . . . . . . . . . . . . . . . . . 159 6.4 Indicators of Cost-Benefit Comparison. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160 6.4.1 Methods Without Time Value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160 6.4.2 Methods Employing Time Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161 6.5 Uncertainty and Risk in Projects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 6.6 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167 Annex 6.1: Example of a Project Evaluation Exercise. . . . . . . . . . . . . . . . . . . . 168 Annex 6.2: Some Commonly Used Interest Formulae. . . . . . . . . . . . . . . . . . . . 171 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
Economics of Non-renewable Energy Supply . . . . . . . . . . . . . . . . . . . . 175 7 7.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177 7.1.1 Exploration. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179 7.1.2 The Economics of Exploration Activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181 7.1.3 Investment Decision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182 7.1.4 Risks in Exploration Projects. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183 7.2 Field Development. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187 7.2.1 Investment Decision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188 7.2.2 Resource Classification. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190 7.2.3 Classification of Crude Oil, Natural Gas and Coal. . . . . . . . . . . . . . . . . . . . . . . . . 192 7.3 Production. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192 7.3.1 Conventional Oil Production. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193 7.3.2 Production Decline and Initial Production Rate . . . . . . . . . . . . . . . . . . . . . . . . . . 195 7.3.3 Conventional Gas Production. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196 7.3.4 Coal Production. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197 7.3.5 Unconventional Oil and Gas Production. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197 7.4 Economics of Fossil Fuel Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198 7.4.1 Field Level Economics. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198 7.4.2 Industry Level Economics. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199 7.5 Resource Rent. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201 7.6 Depletion of Resources. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204 7.6.1 Depletion Dimension: Now or Later. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205 7.7 Supply Forecasting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206 7.7.1 Relation Between Discoveries and Production. . . . . . . . . . . . . . . . . . . . . . . . . . . 206 7.7.2 Supply Forecasting Methods. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207 7.8 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208 Annex 7.1: Mathematical Treatment of Depletion. . . . . . . . . . . . . . . . . . . . . . . 209 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214 The Economics of Renewable Energy Supply. . . . . . . . . . . . . . . . . . . . . 217 8 8.1 Introduction: Renewable and Alternative Energy Background. . . . . . . . . . 218 8.1.1 Status of Renewable Energies at Present . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218 8.2 Renewable Electricity Generation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222 8.3 Bio-Fuels. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223
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8.4 Renewable Energy for Heating and Cooling. . . . . . . . . . . . . . . . . . . . . . . . . . . . 227 8.5 Drivers of Renewable Energy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229 8.6 The Economics of Renewable Energy Supply. . . . . . . . . . . . . . . . . . . . . . . . . . . 231 8.6.1 The Economics of Renewable Electricity Supply. . . . . . . . . . . . . . . . . . . . . . . . . . 231 8.7 The Economics of Bio-Fuels. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242 8.7.1 Bio-Ethanol Cost Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242 8.7.2 Bio-Diesel Costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243 8.7.3 Support Mechanisms for Biofuels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244 8.8 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246
Energy Pricing and Taxation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249 9 9.1 Perfectly Competitive Market Model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251 9.2 Extension of the Basic Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254 9.2.1 Indivisibility of Capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254 9.2.2 Depletion of Exhaustible Resources. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257 9.2.3 Asset Specificity and Capital Intensiveness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257 9.3 Market Failures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259 9.3.1 Monopoly Problems. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259 9.3.2 Natural Monopoly. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261 9.3.3 Existence of Rent. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267 9.3.4 Externality and Public Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267 9.4 Tradability of Energy Products and Opportunity Cost. . . . . . . . . . . . . . . . . . . 268 9.5 Peak and Off-peak Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271 9.6 Short-Run Versus Long-Run Debate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273 9.7 Government Intervention and Role of Government in the Sector . . . . . . . 274 9.8 Energy Taxes and Subsidies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277 9.8.1 Principles of Optimal Indirect Taxation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280 9.8.2 Equity Considerations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282 9.8.3 Issues Related to Numerical Determination of an Optimal Tax . . . . . . . . . . . . 283 9.8.4 Who Bears the Tax Burden?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284 9.8.5 Subsidies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284 9.8.6 Subsidy Dilemma in Developing Countries with High Dependence on Traditional Energies and Informal Sectors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287 9.9 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288 Annex 9.1: Peak Load Pricing Principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291 The Economics of Environment Protection. . . . . . . . . . . . . . . . . . . . . . . 293 10 10.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295 10.2 Energy–Environment Interactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295 10.2.1 Energy–Environment Interaction at the Household Level. . . . . . . . . . . . . . . . . 296 10.2.2 Community Level Impacts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 10.2.3 Impacts at the Regional Level. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301 10.2.4 Global Level Problems: Climate Change. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302
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10.3 Environmental Kuznets Curve. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303 10.4 Economics of the Environment Protection. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304 10.4.1 Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305 10.4.2 Spectrum of Goods. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306 10.4.3 Private Versus Social Costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307 10.5 Options to Address Energy-Related Environmental Problems. . . . . . . . . . . 309 10.5.1 Regulatory Approach to Environment Management . . . . . . . . . . . . . . . . . . . . . 310 10.5.2 Economic Instruments for Pollution Control. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312 10.5.3 Assessment and Selection of Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320 10.6 Effects of Market Imperfection. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322 10.7 Valuation of Externalities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 324 10.8 Government Failure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327 10.9 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328
The Economics of Climate Change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331 11 11.1 Climate Change Background. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332 11.1.1 The Solar Energy Balance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332 11.1.2 GHGs and Their Global Warming Potential. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333 11.1.3 Observed Changes in the Climate System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334 11.2 The Economics of Climate Change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339 11.2.1 Problem Dimension. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339 11.2.2 Overview of GHG Emissions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340 11.3 Economic Approach to Control the Greenhouse Effect. . . . . . . . . . . . . . . . . . 343 11.3.1 Integrated Assessment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345 11.4 Options to Cope with Global Warming. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346 11.4.1 Generic Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346 11.4.2 National Policy Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 348 11.4.3 Emissions Trading System (ETS) of the EU . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353 11.4.4 International Policy Options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355 11.5 Climate Change Agreements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359 11.5.1 UNFCCC. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359 11.5.2 The Kyoto Protocol. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360 11.5.3 The Paris Agreement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362 11.6 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363
II Issues 12 12.1 12.2 12.3 12.4 12.5
Overview of Challenges Facing the Energy Sector . . . . . . . . . . . . . . 369 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370 Grand Energy Transitions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370 Issues Facing Fossil Fuel-Rich Countries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376 Issues Facing Resource-Poor Countries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380 Energy Equity and Justice. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 382
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12.6 Governance Issues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383 12.7 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 384 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 385
Energy and Sustainable Development. . . . . . . . . . . . . . . . . . . . . . . . . . . . 387 Unsustainable Development Process. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 388 Sustainable Development. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 395 A Brief Review of International Initiatives on Sustainable Development. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 398 13.4 Energy and Sustainable Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 402 Annex 13.1: A Brief Summary of Three Sustainability Dimensions. . . . . . . 404 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 413 13 13.1 13.2 13.3
Energy Security Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 415 14 14.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 416 14.2 Energy Security: The Concept. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 416 14.2.1 Indicators of Energy Security . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 419 14.3 Economics of Energy Security. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 427 14.3.1 External costs of oil Imports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 428 14.4 Optimal Level of Energy Independence. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 430 14.5 Policy Options Relating to Import Dependence . . . . . . . . . . . . . . . . . . . . . . . . 431 14.5.1 Import Restrictions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432 14.5.2 Import Diversification. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 433 14.5.3 Diversification of Fuel Mix. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 435 14.5.4 Energy Efficiency Improvements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 435 14.6 Costs of Energy Supply Disruption. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 436 14.6.1 Strategic Oil Reserves for Mitigating Supply Disruption. . . . . . . . . . . . . . . . . . 437 14.6.2 International Policy Co-ordination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 439 14.7 Conclusions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 440 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 441 Impact of Price Volatility. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 443 15 15.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 444 15.2 Recent Developments in Energy Prices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 444 15.3 Reasons for Energy Price Volatility. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 446 15.4 Impacts of Energy Price Shocks: Case of Importing Countries. . . . . . . . . . . 449 15.4.1 Consumer Reaction to Oil Price Changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 449 15.4.2 Transmission of Reactions to the Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 451 15.4.3 Linkage with the External Sector. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 453 15.5 Energy Price Shocks and Vulnerability of Importers . . . . . . . . . . . . . . . . . . . . 455 15.6 Impact of Oil Price Shocks: Case of Oil Exporting Countries. . . . . . . . . . . . . 457 15.6.1 Export Revenue Volatility. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 457 15.6.2 Resource Curse . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 460 15.6.3 Petroleum Funds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 463 15.7 Conclusions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 466 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 466
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16 Energy Investment Issues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 469 16.1 Recent Investment Trend in the Energy Sector. . . . . . . . . . . . . . . . . . . . . . . . . 470 16.2 Future Investment Needs of the Energy Sector. . . . . . . . . . . . . . . . . . . . . . . . . 472 16.2.1 IRENA Transformation Roadmap 2019. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 473 16.2.2 World Energy Outlook (2018) Scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 474 16.2.3 Energy Transition Outlook by DNV GL (2018) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 475 16.3 Factors Influencing Future Energy Sector Investments. . . . . . . . . . . . . . . . . . 476 16.4 Issues Related to Investments in the Energy Sector. . . . . . . . . . . . . . . . . . . . . 480 16.4.1 High Cost of Financing Energy Investments in Developing Countries . . . . . 480 16.4.2 Risks in Energy Investments and de-Risking Measures. . . . . . . . . . . . . . . . . . . . 482 16.4.3 Resource Availability and Mobilisation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 486 16.4.4 Energy Pricing- Investment Link . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489 16.5 Conclusions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 490
Energy Access. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 493 17 17.1 Energy Access. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 494 17.1.1 Current Situation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495 17.1.2 Future Outlook . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 499 17.2 Indicators of Energy Poverty. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 499 17.3 Energy Ladder and Energy Use. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 502 17.4 Energy Access Development Link. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503 17.5 Review of Experience on Energy Access Provision. . . . . . . . . . . . . . . . . . . . . . 504 17.5.1 Review of Electrification Experience. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505 17.5.2 Review of Clean Cooking Energy Access Experience in Developing Countries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 512 17.6 Evaluation of Existing Mechanisms for Enhancing Access. . . . . . . . . . . . . . . 515 17.7 Sustainability Analysis of Energy Access Programmes. . . . . . . . . . . . . . . . . . 518 17.7.1 Methodology. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518 17.7.2 Analysis of the Results. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519 17.8 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521 Pollution Control from Stationary Sources. . . . . . . . . . . . . . . . . . . . . . . 525 18 18.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526 18.2 Direct Pollution Control Strategies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 528 18.2.1 Pollution Standards. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 528 18.2.2 Emission Taxes and Charges. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 532 18.2.3 Emissions Trading. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 532 18.3 Indirect Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 537 18.3.1 Pollution Control Technologies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 537 18.3.2 Options Related to Fuels and Conversion Processes. . . . . . . . . . . . . . . . . . . . . . 538 18.4 Indoor Air Pollution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541 18.5 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 543 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 543
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19 Pollution Control from Mobile Sources. . . . . . . . . . . . . . . . . . . . . . . . . . . 545 19.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 546 19.2 Special Characteristics of Mobile Pollution. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 548 19.3 Social Costs of Transport Use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 549 19.3.1 Infrastructure Usage Related Costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550 19.3.2 Environmental Pollution Costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 553 19.3.3 Infrastructure-Related Costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 558 19.3.4 Internalisation of Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 558 19.4 Mitigation Options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 559 19.4.1 Vehicle Emission Standards and Technologies. . . . . . . . . . . . . . . . . . . . . . . . . . . 559 19.4.2 Zero Emission Vehicles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 563 19.4.3 Cleaner Fuels. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 564 19.4.4 Traffic Management and Planning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 566 19.5 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 568 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 568
Energy Demand Management and Demand Response. . . . . . . . . . 571 20 20.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 573 20.2 Energy Demand Management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 575 20.2.1 Definition. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 575 20.2.2 Evolution of DSM and Demand Response. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 577 20.2.3 Justification for DSM. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 578 20.3 Load Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 579 20.4 Energy Efficiency Improvements and Energy Conservation. . . . . . . . . . . . . 583 20.4.1 What Is Energy Efficiency?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 583 20.4.2 Opportunities for Energy Saving. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 585 20.4.3 Economics of Energy Efficiency Improvements. . . . . . . . . . . . . . . . . . . . . . . . . . . 589 20.5 Analysing Cost Effectiveness of DSM Options . . . . . . . . . . . . . . . . . . . . . . . . . . 590 20.5.1 Participant Test. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 591 20.5.2 Ratepayer Impact Measure (RIM). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 591 20.5.3 Total Resource Cost Test. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 593 20.5.4 Programme Administrator Cost or Utility Cost Test. . . . . . . . . . . . . . . . . . . . . . . 593 20.6 Energy Efficiency Debate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 594 20.6.1 Market Barriers and Intervention Debate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 594 20.6.2 What Are the Market Barriers to Energy Efficiency?. . . . . . . . . . . . . . . . . . . . . . . 595 20.6.3 Government Intervention and Its Nature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 597 20.6.4 Energy Efficiency Versus Economic Efficiency Debate . . . . . . . . . . . . . . . . . . . . 598 20.6.5 Rebound Effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 20.6.6 Use of Market-Based Incentives for Energy Efficiency. . . . . . . . . . . . . . . . . . . . . 601 20.7 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 602 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 602
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III Markets 21 International Oil Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 607 21.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 608 21.2 Developments in the Oil Industry. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 608 21.2.1 Pre-OPEC Era . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 608 21.2.2 OPEC Era . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 615 21.2.3 New World Petroleum Order. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 623 21.2.4 Commoditisation of Oil. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 626 21.3 National and International Oil Companies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 630 21.3.1 National Oil Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 630 21.3.2 International Oil Companies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 631 21.4 Analysis of Changes in the Oil Market. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 632 21.4.1 Evolution of Oil Reserves, Oil Production and Oil Consumption. . . . . . . . . . . 632 21.4.2 Analysis of the OPEC Behaviour. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 635 21.4.3 A Simple Analytical Framework of Oil Pricing. . . . . . . . . . . . . . . . . . . . . . . . . . . . 642 21.5 Low Carbon Energy Transition and the Future of Oil. . . . . . . . . . . . . . . . . . . . 643 21.6 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 644 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 645
Natural Gas Market. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 647 22 22.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 648 22.2 Specific Features of Natural Gas. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 648 22.2.1 Advantage Natural Gas. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 648 22.2.2 Gas Supply Chain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 649 22.2.3 Specific Features. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 651 22.3 Status of the Natural Gas Market. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 652 22.3.1 Reserves. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 652 22.3.2 Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 654 22.3.3 Consumption. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 655 22.3.4 Gas Trade. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 658 22.4 Economics of Gas Transportation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 664 22.4.1 Economics of Pipeline Transport of Gas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 664 22.4.2 Economics of LNG Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 668 22.4.3 LNG Versus Pipeline Gas Transport. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 671 22.5 Gas Pricing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 674 22.5.1 Rules of Thumb. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 674 22.5.2 Parity and Net-Back Pricing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 676 22.5.3 Spot Prices of Natural Gas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 677 22.6 Natural Gas in the Context of Developing Countries. . . . . . . . . . . . . . . . . . . . 679 22.7 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 680 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 681
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23 Coal Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 683 23.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 684 23.2 Coal Facts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 684 23.3 Changes in the Coal Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 693 23.4 Technological Advances and the Future of Coal . . . . . . . . . . . . . . . . . . . . . . . . 695 23.5 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 696 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 697
Markets for Electricity Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 699 24 24.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 701 24.2 Basic Concepts Related to Electricity Systems . . . . . . . . . . . . . . . . . . . . . . . . . . 701 24.3 Alternative Electricity Generation Options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 704 24.3.1 Generation Capacity Reserve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 707 24.4 Economic Dispatch. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 707 24.4.1 Merit Order Dispatch. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 708 24.4.2 Incremental Cost Method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 708 24.5 Unit Commitment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 709 24.6 Investment Decisions in the Power Sector. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 711 24.6.1 Levelised Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 711 24.6.2 Screening Curve Method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 714 24.7 Sophisticated Approaches to Electricity Resource Planning. . . . . . . . . . . . . 716 24.8 Electricity Markets Around the World . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 717 24.8.1 Wholesale Electricity Markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 718 24.8.2 Retail Electricity Markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 723 24.9 Ancillary Services and Their Pricing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 724 24.10 Electricity Markets and Emerging Technologies . . . . . . . . . . . . . . . . . . . . . . . . 727 24.11 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 728 Annex 24.1: Levelisation Factor for a Uniform Annual Escalating Series . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 728 Annex 24.2: A Brief Description of the WASP-IV Model. . . . . . . . . . . . . . . . . . 729 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 731 Carbon Market. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 735 25 25.1 Introduction to Carbon Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 736 25.2 State of the Carbon Markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 737 25.2.1 European Carbon Market. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 739 25.2.2 North American Carbon Market. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 743 25.2.3 Other Emissions Trading Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 745 25.2.4 Offset Market. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 746 25.3 Carbon Market Issues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 746 25.4 Conclusions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 749 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 749
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IV Governance 26 Institutions and the Energy Sector Governance . . . . . . . . . . . . . . . . . 753 26.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 754 26.2 Governance from the Institutional Economics Perspective. . . . . . . . . . . . . . 755 26.3 Global Energy Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 758 26.4 Regional Energy Governance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 761 26.4.1 Governance of the European Energy Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 761 26.4.2 Other Regional Cooperation in Energy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 762 26.5 Governance of Energy at the National Level. . . . . . . . . . . . . . . . . . . . . . . . . . . . 764 26.6 Reforms from an Institutional Economics Perspective . . . . . . . . . . . . . . . . . . 764 26.6.1 Changing the Rules of the Game. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 765 26.6.2 Changing the Organisational Arrangement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 771 26.6.3 Modifying the Governance Mechanism. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 771 26.6.4 Transition Management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 774 26.7 Concluding Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 774 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 775
Reform of the Energy Sector. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 777 27 27.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 778 27.2 Government Intervention in Energy Industries. . . . . . . . . . . . . . . . . . . . . . . . . 778 27.3 Rationale for Deregulation in the 1990s. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 781 27.4 Options for Introducing Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 784 27.4.1 Competition for the Market. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 784 27.4.2 Competition in the Market. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 785 27.5 Restructuring Options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 787 27.5.1 Vertically Integrated Monopoly Model (VIM). . . . . . . . . . . . . . . . . . . . . . . . . . . . . 788 27.5.2 Entry of Independent Power Producers (IPP). . . . . . . . . . . . . . . . . . . . . . . . . . . . . 790 27.5.3 Single Buyer Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 791 27.5.4 Transitional Models. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 793 27.5.5 Wholesale Competition: Price-Based Power Pool Model. . . . . . . . . . . . . . . . . . 796 27.5.6 Wholesale Competition: Net Pool. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 798 27.5.7 Wholesale Competition: Cost-Based Pool. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 799 27.5.8 Wholesale Competition Through Open Access. . . . . . . . . . . . . . . . . . . . . . . . . . . 800 27.5.9 Full Customer Choice: Retail Competition Model. . . . . . . . . . . . . . . . . . . . . . . . . 801 27.6 Reform Sustainability: A Framework for Analysis. . . . . . . . . . . . . . . . . . . . . . . 803 27.7 Experience with the Energy Sector Reform. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 806 27.8 Conclusions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 808 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 809 Regulation of Energy Industries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 811 28 28.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 813 28.2 Traditional Regulation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 814 28.2.1 Rate Level Regulation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 814 28.2.2 Rate Structure Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 821
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28.3 Problems with Traditional Regulatory Approach . . . . . . . . . . . . . . . . . . . . . . . 823 28.4 Regulatory Alternatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 825 28.4.1 Incentive Regulation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 825 28.4.2 Regulation by Contract. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 827 28.4.3 Conduct Regulation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 828 28.5 Price-Cap Regulation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 829 28.5.1 Choice of Inflation Factor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 831 28.5.2 X Factor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 832 28.5.3 Z Factor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 833 28.5.4 Choice of Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 833 28.5.5 Advantages and Disadvantages of a Price Cap Regulation. . . . . . . . . . . . . . . . 834 28.5.6 Comparison of Price Cap and RoR Regulation. . . . . . . . . . . . . . . . . . . . . . . . . . . . 835 28.5.7 Experience with Price Cap Regulation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 835 28.6 Revenue Caps. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 836 28.7 Yardstick Competition. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 837 28.8 Performance Based Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 840 28.8.1 Base Revenue Requirement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 841 28.8.2 Sharing Mechanism. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 842 28.8.3 Quality Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 842 28.9 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 843 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 843
Supplementary Information. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 847 Concluding Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 848
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Abbreviations AAU AC ADB ANN APERC
ARMA
Assigned Allocation Units Average cost Asian Development Bank Artificial neural network Asia Pacific Energy Research Centre Autoregressive Integrated Moving Average Auto regressive moving average
BCM BF BP
Billion cubic metres Blast furnace British Petroleum
ARIMA
DNA DOE
DR(I) DSM DTI DWL
CAIR Clean Air Interstate Rule cal Calories CAPM Capital asset pricing model CBO Congressional Budget Office (US) CC Combined cycle CDD Cooling degree days CDM Clean Development Mechanism CEGB Central Electricity Generation Board CER Certified emissions reductions CERI Canadian Energy Research Institute CES Constant elasticity of substitution CF Capacity factor CFC Chlorofluorocarbon CFL Compact fluorescent lamp CGE Computable General Equilibrium model CHP Combined heat and power CIF Cost insurance freight CNG Compressed natural gas CO2 Carbon-di-oxide COP Conference of Parties COPD Chronic pulmonary obstructive disease CPI Consumer price index CRA Charles River Associates CRF Capital recovery factor DCF DECC DfID
Discounted cash flow Department of Energy and Climate Change (UK) Department for International Development
EB EC ECA ECM EDI EEA EGEAS EIA
EMV EPA EPRI ESI ESP ETS EU FAO
Designate National Authority Designated Operational Entities (CDM ) Department of Energy (US) Direct reduction (of Iron in steel making) Demand-side management Department of Trade and Industry (UK) Deadweight loss Executive Board (CDM) European Commission Energy Commodity Account Error correction model Energy Development Index European Environment Agency Electric Generation Expansion Analysis System Energy Information Administration (of the Department of Energy, USA) Expected monetary value Environment Protection Agency (US) Electric Power Research Institute Electricity supply industry Electrostatic precipitator Emissions trading system European Union
FGD FOB FSU
Food and Agricultural Organization Flue gas desulfurization Free on board Former Soviet Union (countries)
GCC GDP GGFR GHG GWh GWP
Gulf Co-operation Council Gross domestic product Global gas flaring reduction Greenhouse gas Giga watt hour Global Warming potential
HDD HH HHI
Heating degree days Henry Hub (US) Herfindahl Hirschman Index
IAEA
International Atomic Energy Agency
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Abbreviations
IEA IGCC
PDD PES (PEC)
Project design document Primary energy supply (Primary energy consumption) Particulate matters Purchasing power parity
IPP IRR
International Energy Agency Integrated Gasification combined cycle International Institute for Applied Systems Analysis International Monetary Fund International Oil companies Intergovernmental Panel on Climate Change Independent Power producers Internal rate of return
JI JODI
Joint Implementation (projects) Joint Oil Data Initiative
RES RIM RO ROC
kcal KP kW
Kilo calories Kyoto Protocol Kilo watt
RPI
LEAP
Long-range Energy Alternatives Planning Load factor Liquefied Natural Gas Liquid petroleum gas Land use, land use change, and forestry
SAM Social Accounting Matrix SD Sustainable development SHS Solar Home systems SIP call State Implementation Plan call SOE State-owned enterprise Sulphur Oxides SOx SWI Shannon–Wiener Index SWNI Shannon–Wiener–Neumann Index
Model for analysis of energy demand Market Allocation mdoel Multi-buyer multi-seller Marginal cost Middle East and North African countries Million tons (metric)
T&D TCF TE TFC TFP TFS TPA
Transmission and distribution Trillion cubic feet Traditional energies Total final consumption Total factor productivity Total final supply Third party access
UN UNDP
USD
United Nations United Nations Development Programme United Nations Environment Programme United Nations Framework Convention on Climate Change United States Dollar
VIM VOC
Vertically integrated model Volatile organic compounds
WACC
Weighted average cost of capital Wien Automatic System Planning Package IV World Bank
IIASA IMF IOC IPCC
LF LNG LPG LULUCF
MAED MARKAL MBMS MC MENA Mt NBP NEMS NGL NOC NOx NPV OEB OECD
National Balancing Point (UK) National Energy Modeling system Natural Gas Liquids National oil companies Nitrous oxides Net present value
OTC
Overall Energy Balance Organisation for Economic Co-operation and Development Organization of the Petroleum Exporting Countries Ozone Transport Commission
PBR
Performance-based regulation
OPEC
PM PPP R&D RCEP RE
UNEP UNFCCC
WASP IV WB
Research and development Royal Commission on Environmental Protection (UK) Renewable energies (if not otherwise indicated) Reference Energy System Ratepayer impact test Renewable obligation Renewables Obligation Certificates Retail price index
XXI Abbreviations
WEC WEM
World Energy Council World Energy Model
WEO WHO
World Energy Outlook World Health Organization
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Introduction to Energy Economics 1.1 Introduction – 2 1.2 Organisation and Content of the Book – 4 Reference – 4
© Springer-Verlag London Ltd., part of Springer Nature 2019 S. C. Bhattacharyya, Energy Economics, https://doi.org/10.1007/978-1-4471-7468-4_1
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Chapter 1 · Introduction to Energy Economics
1.1 Introduction
Energy plays a crucial role in our life, allowing us to perform our daily routines and to undertake economic, social and developmental activities. In fact, we are so dependent on energy that it is hard to imagine a modern living condition without affordable, reliable and adequate supply of energy. Although the sun is the ultimate source of energy for our planet, humans hardly use this form of energy directly (i.e. without employing any transformation activity). Instead, we have developed an affinity for fossil fuels since the discovery of steam engines, a trend that was further supplemented by internal combustion engines and the arrival of electricity. An elaborate supply system consisting of mines, fields, transport networks, processing and conversion plants has been developed over the years to meet the growing needs of the society. However, the adverse impacts of fossil fuel dependence started to emerge at the local, regional and global levels and the need for a shift towards a low-carbon pathway became apparent. This prompted an extensive global attention to cleaner forms of energies that utilise energy flows rather than stocks. While the above issues and challenges can be studied from different perspectives, the economic dimension and implications play an important role in the development of the sector. Energy economics is the branch of applied economics that studies, inter alia, (1) The economics of energy supply involving exploration, development, production, transportation, storage, transformation and delivery of energy commodities; (2) The economic logic of energy consumption decisions by various users; (3) energy transactions through alternative market arrangements and their governance; (4) the economic dimension of social and environmental impacts of energy use; and (5) the planning, policy and performance of the industries, actors and governance mechanisms. Although energy issues have been analysed from an economic perspective for more than a century now, energy economics did not develop as a specialised branch until the first oil shock in the 1970s (Edwards 2003). The dramatic increase in oil prices in the 1973–74 highlighted the importance of energy in economic development of countries. Since then, researchers, academics and even policymakers have taken a keen interest in energy studies and today energy economics has emerged as a recognised branch on its own. The field has seen a tremendous growth over the past two decades and the subject is being taught as part of the undergraduate and post-graduate programmes in many universities around the world. Like any branch of economics, energy economics is concerned with the basic economic issue of allocating scarce resources in the economy. Thus the microeconomic concerns of energy supply and demand and the macro-economic concerns of investment, financing and economic linkages with the rest of the economy form an essential part of the subject. However, the energy industry is quite complex technically and technical innovation has always influenced the developments in the sector. The shale revolution is a recent example which has brought dramatic changes to the sector over
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International trade, finace, governace, technology transfer, organisations
Regional markets, integration, policies, infrastructure
National policies, regulation, risks, security, environment
Local resources, communities, investors, administrations
. Fig. 1.1 Multi-level interactions in the energy sector
the past few years. Moreover, because of its universal appeal, energy developments at any given point are influenced by interactions at multiple levels. The involvement of multinational players, active participation in international trade and global initiatives to manage the implications of energy use and supply add an international level of influence. The regional influence arises from co-ordinations of markets, policies, investments and initiatives through regional groups and sub-groups and the dynamic evolution of their visions and interactions as well as conflicts leaves a regional footprint. Further, at the national level, differences in resource endowments, spatial distribution of resources, economic and social conditions, institutional arrangements and governance influence the sector activities. But the international and regional influences shape the national policies and interventions. Finally, the resource endowments, institutional arrangements, stakeholder interactions, and local infrastructure at the local level influence the developments (see . Fig. 1.1). The strength and implications of such interactions and influences vary depending on their manifestations in a given
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Chapter 1 · Introduction to Energy Economics
context but an understanding of the basic principles, frameworks of analysis and the tools of investigation can prepare anyone to approach such issues systematically. Accordingly, the objective of this book is to present in a single volume basic economic tools and concepts that can be used to understand and analyse the issues facing the energy sector. The aim is to provide an overall understanding of the energy sector and to equip readers with the analytical tools that can be used to understand demand, supply, investments, energy-economy interactions and related policy aspects. 1.2 Organisation and Content of the Book
The book is organised in four parts. The first part deals with relevant economic concepts related to energy demand and supply. It also introduces energy pricing and the economic treatment of environmental impacts of energy use. To provide a wholesome understanding of demand and supply aspects, the book lays emphasis on energy statistics and builds on energy demand as well as supply aspects. It covers economics of fossil fuel supply and that of renewable energy resources. Similarly, it presents an understanding of demand at the aggregate level as well as at the sector level. Part 2 focuses on contemporary issues facing the energy sector. The Sustainable Development Agenda and the role energy can play in supporting this global initiative sets the agenda. Energy poverty and energy access issue, the security of supply, economic vulnerability due to price volatility, mitigation of pollution from stationary and mobile sources, and energy sector investments are some areas considered in this part. Part 3 introduces the evolution and development of different energy markets, the main players, trading activities and the future outlook. The evolution of international oil market, regional gas markets, electricity markets and the carbon market is covered in this part. The last part discusses the regulatory and governance arrangements for the energy sector. The concepts of regulatory economics as applied to the energy sector are presented here. Similarly, the institutional arrangements following the developments in the institutional economics literature are also covered. The second edition of the book contains updated and revised presentation of all chapters. The content has been rationalized to ensure ease of understanding. Examples, case studies, and further reading materials are included in each chapter to support varying needs of readers. The organization has been completely modified to align the topics with the book title. As before, readers will be able to use different parts independently and there is no prerequisite for any part or chapter. Similarly, no single course is expected to cover all the materials presented in the book. I have used the materials for four courses but courses can easily pick and mix contents from this book as appropriate.
Reference Edwards, B. K. (2003). The Economics of hydroelectric power. Cheltenham, UK: Edward Elgar.
5
Economic Concepts Applied to the Energy Sector This part introduces essential economic concepts of energy demand and supply that are relevant for developing a good understanding of the developments in the energy sector. This part introduces the ideas of energy data and energy accounting first. Then the economic basis of energy demand is introduced, followed by a presentation of tools for demand analysis and forecasting. The analysis of energy supply starts with the concepts of investment analysis of energy projects. This is followed by specific considerations for fossil fuel supply and renewable energy supply. This part ends with a specific focus on energy pricing and taxation as well as mitigation of energy-related externalities. This part contains eight chapters as follows: 7 Chapter 2 Energy
Data and Energy Balance Demand Analysis 7 Chapter 4 Sectoral Energy Demand Analysis 7 Chapter 5 Energy Demand Forecasting 7 Chapter 6 Economic Analysis of Energy Investments 7 Chapter 7 Economics of Non-renewable Energy Supply 7 Chapter 8 The Economics of Renewable Energy Supply 7 Chapter 9 Energy Pricing and Taxation 7 Chapter 10 The Economics of Environment Protection 7 Chapter 11 The Economics of Climate Change 7 Chapter 3 Energy
I
7
Energy Data and Energy Balance 2.1 Introduction – 9 2.2 Energy Basics – 9 2.2.1 Energy Defined – 9 2.2.2 Alternative Classifications of Energy – 10
2.3 Introduction to the Energy System – 12 2.4 Energy Accounting Framework – 14 2.4.1 Components of the Energy Account – 15 2.4.2 Commodity Accounts and Overall Energy Balance – 17 2.4.3 Units, Conversion Factors and Aggregation of Energy Flows – 20
2.5 Accounting of Traditional Energies – 25 2.6 Special Treatments of Some Entries in the Energy Balance – 27 2.6.1 Treatment of Primary Electricity Production – 27 2.6.2 Treatment of Electricity in Final Consumption – 28 2.6.3 Self Generation – 29
2.7 Analysis of Energy Balance Information – 29 2.8 Alternative Presentation of Energy Accounting Information – 31 2.8.1 Energy Flow Diagrams – 31 2.8.2 Reference Energy Systems (RES) – 32
© Springer-Verlag London Ltd., part of Springer Nature 2019 S. C. Bhattacharyya, Energy Economics, https://doi.org/10.1007/978-1-4471-7468-4_2
2
2.9 Common Energy Data Issues – 34 2.10 Conclusion – 36 Annex 2.1: Worked Out Examples – 36 References – 39
2.2 · Energy Basics
9
2
2.1 Introduction
Data plays an important role in any economic analysis and it is no different for energy economics. In order to develop a good understanding of the evolution and performance of the energy sector, credible and timely information is required. However, availability energy data varies from one country to another and the quality of information remains an issue (UN-DESA 2018). As the energy system varies by countries due to differences in energy resources, conversion processes and uses of energy, it is important that a consistent approach is used to capture and present the information. This chapter introduces to such a framework—known as the energy accounting framework. However, to appreciate this framework, some commonly used terms and definitions are useful to know. Accordingly, the chapter is organised as follows: first some terms commonly used in any energy study are defined. The idea of a national energy system is then presented, which is followed by the energy accounting framework. The data issues related to the energy sector are considered next. Finally, a few ratios are considered to analyse the energy situation of a country. 2.2 Energy Basics 2.2.1 Energy Defined
The definition of energy varies depending on the field of study but in this book, the commonly used definition is retained. Energy is defined as ‘the capacity of a physical system to do work’ (UN-DESA 2018). Energy manifests itself in many forms: heat, light, motive force, chemical transformation, among others. Solar energy is the primary source of energy and initially the mankind relied on solar energy and the energy of flowing water or air to perform their desired activities. Then with the discovery of the fire-making process, the use of biomass began. The use of coal and subsequently oil and natural gas began quite recently—a few hundred years ago. Thus, energy can be found in various physical states, and in different forms. These energies may be available in the nature but may not be used and hence may not have direct impact on the society. For the purpose of energy statistics, energy having a direct impact on the society is measured, monitored and reported (UN-DESA 2018). Two basic laws of thermodynamics govern energy flows. The first law of thermodynamics is a statement of material balance—a mass or energy can neither be created nor destroyed—it can only be transformed. This ensures the overall balance of energy at all times. The second law of thermodynamics on the other hand introduces the concept of quality of energy. It suggests that any conversion involves generation of low grade energy that cannot be used for useful work and this cannot be eliminated altogether. This imposes physical restriction on the use of energy.
10
Chapter 2 · Energy Data and Energy Balance
2.2.2 Alternative Classifications of Energy
2
Energy can be obtained from various sources. Some of them require chemical or other processes to release their energy (e.g. combustion) while others are suitable for direct use (e.g. electricity). Any product used as a source of energy is termed as energy product in energy statistics. This is also commonly called as fuel. They can come from a flow or from a stock. Similarly, the ability to do work may arise from the capability (or potential) of the source to do work (known as potential energy as in stored water in a dam) or its manifestation in terms of motive power (known as kinetic energy as in the case of wind or tidal waves). Energy can be classified under different categories. Three common criteria used are renewability of the resource, reliance on conventional technologies and participation in commercial markets. Classifications based on these are discussed below. Primary and Secondary Forms of Energy
Primary energy is a form of energy source that is extracted from a stock of natural resources or captured from a flow of resources and that has not undergone any transformation or conversion other than separation and cleaning (UN-DESA 2018). Examples include coal, crude oil, natural gas, solar power, nuclear power, and hydroelectricity among others. Secondary energy on the other hand refers to any energy that is obtained from a primary energy source employing a transformation or conversion process. Thus oil products obtained from crude oil upon refining in a refinery is a secondary form of energy. Electricity obtained from burning coal is also a secondary energy as it requires processing coal to generate electricity in a thermal power plant. The knowledge of primary and secondary forms of energy is important to avoid double counting in energy statistics. Renewable and Non-renewable Forms of Energy
A non-renewable source of energy is one where the primary energy comes from a finite stock of resources. Drawing down one unit of the stock leaves lesser units for future consumption in this case. For example, coal or crude oil comes from a finite physical stock that was formed under the earth’s crust in the geological past and hence these are non-renewable energies. On the other hand, if any primary energy is obtained from a constantly available flow of energy, the energy is known as renewable energy. Solar energy, wind, and the like are renewable energies. Some stocks could be renewed and used like a renewable energy if its consumption (or extraction) does not exceed a certain limit. For example, firewood comes from a stock that could be replenished naturally if the extraction is less than the natural growth of the forest. If however, the extraction is above the natural forest growth, the stock would deplete and the resource turns into a non-renewable one. The knowledge of renewability of an energy product is important for energy planning and decision-making purposes.
2
11
2.2 · Energy Basics
. Table 2.1 Categories of energy commodities Form
Primary
Renewability
Secondary Combustible
Non-renewables
Nuclear
Coal, crude oil, NGL, natural gas, oil shale
Petroleum products, manufactured solid fuels and gases
Heat and electricity
Renewables
Heat an non-thermal electricity
Wastes and biofuels
Any fuels derived from renewables
Heat and electricity
Source IEA (2005)
. Table 2.1 provides a classification of energy combining primary/secondary forms and renewable/non-renewable nature of the source. Examples of different categories are also indicated. Both renewable and non-renewable sources of energies can come under primary and secondary categories depending on whether they need processing or not for their use.
Commercial and Non-commercial Energies
Commercial energies are those that are traded wholly or almost entirely in the market place and therefore would command a market price. Examples include coal, oil, gas and electricity. On the other hand, non-commercial energies are those which do not pass through the market place and accordingly, do not have a market price. Common examples include energies collected by people for their own use, particularly biomass1 that is used in a traditional way. These are commonly used in many Asian and African countries, particularly in rural areas. For example, Asian countries and Africa account for almost 50% of the global solid biomass use and these forms of energies provide an estimated 83% and 74% of residential energy use in Africa and Asia respectively (IRENA 2013). But when a non-commercial energy enters the market, by the above definition, the energy product becomes a commercial form of energy. The boundary could change over time and depending on the location. For example, earlier fuel-wood was just collected and not sold in the market. It was hence a non-commercial form of energy. Now in many urban (and even in rural) areas, fuel-wood is sold in the market and hence it has become a commercial energy. At other places, it is still collected and hence a non-commercial form of energy. This creates overlaps in coverage. Another commonly used distinction is modern versus traditional energies. Modern energies are those which require modern technologies to use them. On the other hand, traditional energies are those which are obtained using traditional simple meth-
1
Biomass is any organic matter derived from plants or animals and examples include wood fuel, agricultural residues, manure, etc. IRENA (2013).
12
Chapter 2 · Energy Data and Energy Balance
. Table 2.2 Energy classifications Renewability
Commercial
Noncommercial/ Traditional
Conventional
Renewable
Large hydro Geothermal
Animal residue Crop residue Sustainably sourced fuelwood Windmills and water mills
Solar energy Mini/micro hydro projects
Non-renewable
Fossil fuels (coal, oil, natural gas)
Unsustainable fuelwood
2
Nonconventional
Oil from oil sands Oil from coal or gas
Source Author
ods and can be used without modern gadgets. Often modern fuels are commercial energies and traditional energies are non-commercial. But this definition does not prevent traditional energies to be commercial either. Thus if a traditional energy is sold in the market it can still remain traditional. Thus it reduces some overlap but the definition remains subjective as the practices and uses vary over time and across cultures and regions. Conventional and Non-conventional Energies
This classification is based on the technologies used to capture or harness energy sources. Conventional energies are those which are obtained through commonly used technologies. Non-conventional energies are those obtained using new and novel technologies or sources. Once again the definition is quite ambiguous as conventions are subject to change over time, allowing non-conventional forms of energies to become quite conventional at a different point in time. Based on the above discussion, it is possible to group all forms of energy in two basic dimensions: renewability as one dimension and conventionality as the other. . Table 2.2 provides such a classification. 2.3 Introduction to the Energy System
A number of physical and economic activities are involved to capture the energy and to deliver it in a usable form to the users. The chain of systems or activities required to ensure supply of energy is known as the energy supply system. The supply system is made up of supply-related activities, energy transformation activities and energy consumption. The supply involves indigenous production, imports or exports of fuel and changes in stock levels (either stock pileup or stock draw down). Transformation
• Production
2
13
2.3 · Introduction to the Energy System
Transformation
• Import/ Export
• Refining
• Stock change
• Electricity generation
• Final use of energy and nonenergy uses
• Fuel processing Supply
Use
. Fig. 2.1 Energy supply chain. Source Author
converts different forms of primary energies to secondary energies for ease of use by consumers. Transformation processes normally involve a significant amount of losses. Transportation and transmission of energy also involve losses. The final users utilise various forms of energies to meet the needs of cooling, heating, lighting, motive power, etc. The flow is captured in . Fig. 2.1. The relative importance of the above segments varies from one country to another and even from one fuel to another depending, to a large extent, on the availability of resources in a particular country. For a resource-rich country, the supply segment is evidently well developed, while for a resource-poor country the transformation and final use segments tend to be more developed. An energy-exporting country may export primary energy as well as secondary forms of energies depending on the structure and complexity of its transformation component of the sector. Many resourcerich developing countries rely on primary product exports and second product imports due to inadequate transformation facilities. The activities vary by the type of energy. For non-renewable energies, exploration, development and production of fuel(s) constitute the first step. A variety of exploratory techniques are used to identify the location of the resource but drilling a hole only can confirm the existence of the stock. Upon confirmation of the economic viability and technical feasibility of extraction of the stock, the field is developed and production follows. The fuel so produced often requires cleaning, beneficiation and processing to make it usable. Cleaning and beneficiation processes are used to remove impurities using simple cleaning processes. The fuel is then transported to the centres of conversion or use. Most forms of energies cannot be used as such and require processing (e.g. crude oil to petroleum products). Similarly, depending on consumers’ demand, fuels also undergo conversion processes to convert them in preferred forms (e.g. to electricity). Conversion involves significant energy losses. The processed and converted energy then needs to be transported to consumers. This also involves transmission losses. Before consumption, some storage may
14
2
Chapter 2 · Energy Data and Energy Balance
be required for some forms of energy, while for electricity no practical and economic storage solution exists. Final consumers use energy for various purposes. Normally these are the end-users who cannot sell or transfer the energy to others. These consumers are grouped into different broad categories: industrial, transport, residential, commercial, and agricultural. Some energy is also used as feedstock in production processes or as non-energy purposes (e.g. tar is used in roads). As energy is used for meeting certain needs, it is used in conjunction with appliances. The efficiency of the appliance affects the demand. The consumer is interested in the useful energy (i.e. the energy required to meet the need and not the final or primary energies). Reducing losses can reduce pressure on fuel demand. An example will clarify this point. Example: Your microwave oven of 1 kW has an efficiency of 65%. The transmission and distribution loss in the electricity network is 8% and the overall average efficiency of the power generation system in the country is 40%. How much of primary fuel will be required to supply you with 1 kWh of energy to run your microwave oven? To provide 1 kWh of electric energy, the microwave oven needs 1/0.65 = 1.54 kWh. As there is a loss of 8% in the network, the power station needs to produce (1.54/0.92) = 1.67 kWh. As the power system has 40% efficiency, the input energy required is (1.67/0.4) = 4.18 kWh. This shows the importance of efficiencies at various stages in the energy chain. The more inefficient a process or path is, more energy is required to be produced to meet the needs. 2.4 Energy Accounting Framework
The energy accounting framework is one that enables a complete accounting of energy flows from original supply sources through conversion processes to end-use demands with all double-counting avoided. By accounting for all conversion losses this framework provides an exhaustive accounting for itemizing the sources and uses of energy. The energy flow considered in this framework is indicated in . Fig. 2.2. Flow of each individual fuel or energy in an economy is considered and presented in a matrix form to arrive at the energy account table. The energy account is essentially a matrix where: 5 Each type of fuel is considered along the columns. The columns are chosen based on the importance of energy commodities in the country under consideration. More diversified the energy system, more detailed accounting is required. 5 Each row captures the flow of energy. The rows are organised in three main blocks to indicate the supply of energy, its transformation and final use (see . Fig. 2.3). It is quite common however to focus on the commercial energies given the ease of data collection and flow measurement. Information in the columns is also arranged in terms physical attributes (such as solid fuel, liquid fuel and gaseous fuels), various forms of electricity, nuclear power and renewable energies. A brief description of the three major components of the energy accounting system is provided below.
15
2.4 · Energy Accounting Framework
Indigenous
Imports,
production
exports, stock
2
Imports, exports, stock
changes
changes
Primary commodities
Secondary commodities
Transformation
Final Use
. Fig. 2.2 Energy commodity flow. Source IEA (2005)
2.4.1 Components of the Energy Account
An energy balance table has three main building blocks: the supply-side information (top block), energy transformation (conversion) details (middle block) and the demand information (bottom block). The supply-side information captures domestic supply of energy products through production, international trade, and stock change. Energy production provides the marketable quantities of energy domestically produced in a country. Marketable quantities exclude any part of the production that is not available for use or stock. Examples include wastes (gas flaring), re-injection as part of production process (gas re-injection), removal of impurities, etc. The external trade information captures the transactions of energies taking place across the national boundary of a country, irrespective of whether customs clearance was taken or not. Imports are those quantities that enter the country for domestic use (this excludes transits). Exports are those quantities leaving the country for use by outsiders. As imports expand domestic supply, it is considered as a positive flow in the energy accounts whereas exports are considered as a negative flow. Fuel used by ships for international voyages is considered as a special item and included as bunker. This is treated in a similar manner as international trade and any quantity delivered to ships, irrespective of their country of registration, undertaking international voyages is eligible for this treatment. Stocks of fuels serve as cushions to cover fluctuations in supply and demand and are maintained by the suppliers, importers/exporters and the consumers. A stock rise represents a diminution in available supplies for domestic use, and a draw down in stock represents an increase in the supply for local consumption. For this reason, a minus sign is used to denote a stock accumulation and that a plus sign is used to
16
2
Chapter 2 · Energy Data and Energy Balance
Production (P) (+) Imports (I) (+) Exports (E) (-) Bunkers (B) (-)
Supply
PES = P + (I- E – B) +/- S
Stock Change (S) (+ or -) Primary Energy Supply (PES) Statistical Difference (SD) (+/-) Transformation input (-) and output (+)
Conversion Net Apparent Supply = PES – TI + TO –O – T&D
Energy sector's own use (O) (-)
Net Supply (NS) = Net Apparent Supply +/- SD Transmission and Distribution (T&D) losses (-) Net Supply Available (NS)
Net Domestic Consumption (NDC) Final energy consumption (FEC)
NS = NDC = FEC
Demand
Agriculture (A) Industry (I)
FEC = A + I + T + R + C + N
Transport (T) Residential (R) Commercial (C) Non-energy uses (N)
. Fig. 2.3 Main flows considered in energy accounting. Source Garcia et al. (2017), UN-DESA (2018), and IEA (2005)
denote a stock reduction. The net position of domestic supply considering the above elements gives the primary energy supply of any energy. The transformation section of the energy accounting captures the conversion of primary energies into secondary energies either through physical or chemical changes. Normally the inputs used in the transformation process are given a negative sign while the outputs are given a positive sign. If a single output comes from a number of energy
2.4 · Energy Accounting Framework
17
2
sources, the clarity of input–output relation may be lost when the information is placed in a single row. In such cases, further details are presented as memo items or in additional rows. Commonly used transformation processes are oil refining, electricity generation, gas separation and conversion, coke production from coal, etc. However, as with supply information, transformation or conversion is also a country specific section of the energy account and would normally vary across countries. The conversion section also captures information on energy used by the energy industries and transmission and distribution losses. Both these elements carry a negative sign as they represent reduction in energy flows for use by consumers. Energy sector own use is the energy used in the production process (say in refineries, power plants, coal mines, oil fields, etc.). Although this is essentially energy consumption and hence part of energy demand, sector’s own use is treated separately to obtain a clear picture of the energy use in the rest of the economy. Transmission and distribution (T&D) losses are the wastes in the delivery system—such as pipelines, electric networks—that cannot be eliminated altogether. The final section captures the energy flows available to final consumers. In terms of accounting balance, this is the residual amount available for domestic consumption from primary supplies after accounting for conversion. Generally, net supply is calculated from the supply side while the net demand is calculated from the demand side and these two figures should match, thus ensuring correctness of the accounting. However, it is quite rare that the two items are exactly same. The statistical difference term is used as the balancing item. Its sign would indicate whether the supply-side total is higher (thus requiring a deduction of some balancing amount) or lower (thus requiring some balancing amount) than the demand-side total. The above representation is not the only possible arrangement and in practice, wide variations in the energy balance representation can be found. Generally, the treatment of stocks, import-exports, primary electricity generation, electricity consumption, non-energy use and conversion process details creates differences. Similarly, the coverage and emphasis may be different: for example, some cover only commercial energies while some others include newer and traditional energies. 2.4.2 Commodity Accounts and Overall Energy Balance
Two core accounts are set up to record energy transactions for each and all energy sources, from production or import to final consumption. (a) Energy Commodity Accounts (ECA)—Commodity accounts show all relevant flows of an energy commodity in their original units of measurement (tons, barrels, cubic meters, etc.). See . Table 2.3 for an example. The commodity account uses a format which is conceptually similar to a cash account and captures inflows and outflows of an energy commodity at the national level (IEA 2005). As each energy industry has its own peculiarities in respect of unit of reporting, a commodity account provides the information in original units and the flow balancing is done for each fuel (along the column) but the columns of an ECA cannot be directly compared due to absence of a common unit of reference. Accordingly, the commodity account does not have a total column and it does not permit any overall appraisal of the energy system. The overall energy balance removes this problem.
18
Chapter 2 · Energy Data and Energy Balance
. Table 2.3 Abridged energy commodity account of the UK for 2016 Coal (kt)
2
Coal products (solid) (kt)
Primary oil (kt)
Petro products (kt)
NG (GWh)
Electricity (GWh)
47,872
59,904
462,750
336,438
0
2,550
0
2,959
Supply Production
4,178
1,332
Other sources Imports
8,494
1,110
48,708
34,854
534,740
19,699
Exports
−443
0
−34,856
−24,312
−116,862
−2,153
Marine bunkers
0
0
−2,659
0
0
Stock change
5,655
−110
−125
89
16,242
0
0
−459
−1,282
−1,268
1,575
0
17,884
1,873
60,317
69,158
898,445
356,943
−6
1
−46
31
1,476
195
Total demand
17,889
1,872
60,363
69,128
896,970
356,748
Transformation
15,678
1,860
60,363
1,094
324,197
0
Energy industry use
0
12
0
3,946
57,773
26,631
Losses
0
0
0
0
5,936
26,322
Transfers Total supply Statistical difference
Final consumption
2,211
0
64,087
509,605
303,795
Industry
1,615
0
3,726
98,006
91,808
0
49,292
0
4,669
0
4,115
406,490
207,318
6,954
5,109
0
Transport
15
Other sectors
581
Non-energy use
0
0
0
Source Digest of UK Energy Statistics (2017)
(b) Overall Energy Balance (OEB)—This shows all the flows in terms of a common accounting unit (like Joule, kilocalories, Btu, etc.). See . Table 2.4 for an example. The ECA is the starting point for an overall energy balance and using appropriate conversion factors, a suitably designed overall energy balance can be developed from it.
2
19 2.4 · Energy Accounting Framework
. Table 2.4 Abridged overall energy balance for the UK for 2016 (unit ktoe) Coal and products
Oil and products
Indigenous production
2,633
51,952
Imports
6,637
Exports
Natural gas
Renewable and waste
Electricity and heat
Total
39,789
10,774
19,987
125,135
91,634
45,979
3,743
1,694
149,687
−349
−64,843
−10,048
−338
−185
−75,763
0
−2,840
0
0
0
−2,840
3,569
−58
1,397
0
0
4,908
12,490
75,845
77,117
14,179
21,496
201,127
−57
−54
127
−1
17
32
12,547
75,899
76,990
14,180
21,479
201,095
27
−11
135
−165
0
−14
−10,012
−902
−27,876
−8,964
8,942
−38,812
−8,073
−559
−25,630
−8,894
8,942
−34,214
−183
−62
−2,246
−70
1,409
−1,152
0
−155
−2,280
0
0
−2,435
−81
0
−2,246
0
0
−2,327
−1,693
−217
0
0
0
−1,910
18
−81
0
0
0
−63
417
4,188
4,968
0
2,308
11,881
Supply
Marine bunkers Stock change Primary supply Statistical difference Primary demand Transfers Transformation Electricity generation Heat generation Petroleum refineries Coke manufacture Blast furnaces Patent fuel manufacture Energy industry use
96
0
464
0
2,263
2,823
Final consumption
Losses
2,049
70,797
43,818
5,050
27,258
148,972
Industry
1,388
4,074
8,427
1,337
8,504
23,730
Transport Other Non energy use
11
54,345
0
1,010
401
55,767
605
4,559
34,952
2,704
18,352
61,172
46
7,818
439
0
0
8,303
Source Digest of UK Energy Statistics (2017)
20
2
Chapter 2 · Energy Data and Energy Balance
The overall energy balance can be used to analyse the dynamics of an energy system, particularly in relation to its economic activities. It also allows understanding of the structural changes in the sector and consequent changes in the energy use patterns, fuel mix and fuel substitution over time. The historical information provided by the energy balance can form the basis for energy demand analysis and demand forecasting, which can then be used for energy planning purposes. As countries often use their own assumptions and accounting conventions, international comparison of energy statistics can be difficult. However, organisations like the International Energy Agency (IEA), United Nations Statistics Division, Eurostat, Energy Information Administration (EIA) of US Department of Energy and the Asian Development Bank regularly publish standardized data sets providing such information. In addition, the BP Statistical Review of World Energy is also a widely used dataset, mostly on the supply of commercial energies. 2.4.3 Units, Conversion Factors and Aggregation of Energy
Flows
Units and Conversion Factors
As energy information comes in different units, any energy economist needs to be familiar with various units of measurement and conversion of them to common units. For example, coal is presented in thousand tonnes, gas and electricity in GWh (gigwatt-hours), and so on. Some commonly used factors for conversion of mass and volume are presented in . Table 2.5 (see IEA 2005; IPCC 2006; UN-DESA 2018 for more detailed conversion tables). . Table 2.5 Some conversion factors Unit
Values
Volume conversion 1 US gallon
3.785 L
1 UK gallon
4.546 L
1 barrel
158.9 L (or 42 US gallons)
1 cubic foot
0.0283 m3
Cubic metre
1000 L
Mass conversion 1 kilogram (kg)
2.2036 lb
1 metric tonne (t)
1000 kg
1 long ton
1016 kg
1 short ton
907.2 kg
1 pound (lb)
453.6 g
1 tonne of crude oil
7.33 barrels
21
2.4 · Energy Accounting Framework
2
. Table 2.6 Some conversion factors for natural gas Description
Conversion factor
1 cubic metre of natural gas
35.3 cubic feet of natural gas
1 cubic feet of natural gas
0.028 cubic metre of natural gas
1 billion cubic metre of natural gas
0.9 Mtoe or 35.7 trillion Btu
1 billion cubic feet of natural gas
0.025 Mtoe or 1.01 trillion Btu
1 cubic feet of natural gas
1000 Btu
1 million tonne of LNG
1.36 billion cubic metres of gas or 48.0 billion cubic feet of gas
1 million tonnes of LNG
1.22 Mtoe or 48.6 trillion Btu
Source BP Statistical Review of World Energy (2017)
. Table 2.7 Net Calorific values of different energies Fuel
Unit
Value
Coal
kcal/kg
7,000
Crude oil
kcal/kg
10,000
Gasoline
kcal/kg
10,500
Diesel
kcal/kg
10,200
Fuel oil
kcal/kg
9,800
Natural gas
kcal/m3
8,300
Commercial butane
kcal/kg
10,938
Commercial propane
kcal/kg
11,082
Ethyl alcohol
kcal/kg
6,500
Biogas
kcal/kg
4,500
Source OLADE (2017)
Natural gas data is generally reported using both the metric system and the imperial system. In common industry and business transactions, both the systems are widely used and in some cases, the units used may be non-standard as well. . Table 2.6 indicates some conversion factors specific to natural gas. Similarly, heating values of fuels vary and it is important to have an understanding of the heat content of different types of fuels. . Table 2.7 gives some representative values for commonly used fossil fuels. However, the heating values vary significant depending on the type and quality of the energy product. For example, for different grades of coal, the heating value varies widely. Anthracite coal has the highest heating value (around 7000 kcal/kg) whereas lignite (which is low grade coal) can have a
Chapter 2 · Energy Data and Energy Balance
22
2
heating value as low as 3000 kcal/kg. Generally, the energy balance of a country uses appropriate conversion factors to reflect the quality of locally produced fuels and imported fuels. However, in the absence of a specific conversion factor, a default value is also used. The Guidelines for National Greenhouse Gas Inventories by the Intergovernmental Panel on Climate Change (IPCC 2006) provide such default values. Energy is measured on the basis of the heat which a fuel can make available. But at the time of combustion some amount of heat is absorbed in the evaporation of moisture present in the fuel, thereby reducing the amount of energy available for practical use. Measurement on the basis of total energy availability is called gross calorific value; measurement on the basis of energy available for practical use is called net calorific value. The differences between the two bases are about 5% for solid fuels and about 10% for liquid and gaseous fuels. Energy balances use a simple aggregation method where each energy source is converted to a common energy unit and aggregated by simple addition. Two types of units are commonly used: 5 Precise (or scientific) units: Scientific units include calorie, joule, Btu and kW h. These indicate the heat or work measures of the energy. A calorie is equal to the amount of heat required to raise the temperature of 1 g of water at 14.5 °C by 1 °C. A joule is a measure of work done and is approximately one-fourth of a calorie and one thousandth of a Btu. A British thermal unit is equal to the amount of heat required to raise the temperature of 1 b of water at 60 °F by 1 °F. Its multiple of 105 is the therm. A kilowatt-hour is the work equivalent of 1000 joules per second over a 1-h period. Thus 1 kW h equals 3.6 million joules (see . Table 2.8). 5 Imprecise (or commercial) units: These units provide a sense of physical quantities of the energy. Ton oil equivalent is the most commonly used commercial unit but ton of coal equivalent is also used in some areas. Commercial units are imprecise because the commodities on which these are based are not uniform in energy content. For example, energy content of coal varies from one type to another and can . Table 2.8 Scientific units and their relations 1 cal
4.1868 J
1 Btu
252 cal
1 kWh
3.6 MJ = 859.845 kcal
. Table 2.9 Prefixes used in metric (or SI) system Prefix
Abbreviation
Multiplier
Kilo
K
103
Mega
M
106
Giga
G
109
Tera
T
1012
Peta
P
1015
Exa
E
1018
23
2.4 · Energy Accounting Framework
2
. Table 2.10 Conversion from precise to imprecise units Energy units 1 Mtoe
107 Gcal
1 Mtoe
3.968 × 107 MBtu
1 GWh
860 Gcal
1 GWh
3412 MBtu
1 TJ
238.8 Gcal
1 TJ
947.8 MBtu
1 MBtu
0.252 Gcal
1 MBtu
2.52 × 10−8 Mtoe
1 Gcal
107 Mtoe
1 Gcal
3.968 MBtu
even vary from one year to another. But such units are easily understood and hence most frequently used. Conversion to scientific units is easy: it requires information on heat content (i.e. calorific value) of the energy. For example, the energy content of 20 Mt of coal having a calorific value 5 Gcal/t is 100 Pcal (or equivalent to 418.68 PJ). Some common prefixes used in the metric system are indicated in . Table 2.9. Commercial units on the other hand require establishing equivalence between the chosen fuel and the rest. For example, IEA defines the ton of oil equivalent as one metric ton of crude oil having a net calorific value of 10 Gcal (= 41.9 GJ). The energy content of all other energies has to be converted to oil equivalence using this rule. As a thumb rule, seven barrels of oil equal one ton. Some conversion factors from precise to imprecise units are given in . Table 2.10.2 The ton of coal equivalent (tce) is the oldest of the commercial units and is mainly used in China. The coal equivalent is equated with one tone of coal with a calorific value of 7 million kilocalories. However, its popularity is declining due to declining importance of coal in many regions and disparities in the energy values of coal from one area to another. Aggregation
Once each type of energy is converted to a common energy unit, it is now possible to obtain a clear picture about the overall energy supply and demand by aggregating
2
A reliable unit converter can be found at 7 http://www.iea.org/interenerstat_v2/converter.asp.
24
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Chapter 2 · Energy Data and Energy Balance
the flows. Different alternative approaches are possible. The most common approach is to use heating values discussed above. The heating value-based simple aggregation scheme is easy to understand but has certain limitations. For example, it just focuses on the energy content and energy flow but ignores other attributes that influence choice of energy use. It assigns same weight to all forms of energies without taking into consideration their differences in quality, efficiency of use, substitution possibility, environmental effects, etc. Moreover, the energy balance information stops at the gate of the user and does not capture the energy actually used by an appliance or equipment. The concept of useful energy becomes relevant here. The useful energy is the amount of energy used by the user to meet their needs of lighting, heating, motive power and so on. An inefficient appliance requires more input energy to perform a duty than that required by an efficient appliance. For example, a 15 W LED lamp can provide the same lighting service of a 100 W incandescent lamp. So, for the same useful energy, two users will have different energy needs depending on the appliance used. However, capturing useful energy in the energy balance is more demanding: (1) Additional information is required regarding appliance stock and their efficiency of energy conversion. As such information tends to be site specific for both resources and technologies, cross-country comparisons become difficult. (2) At any given point of time, a complex mix of appliances is used in a given geographical area and collecting such information on a regular basis is not easy and cost-effective. (3) As use efficiency changes over time, this approach makes inter-temporal comparisons difficult. ‘Useful energy is not practical to measure and therefore, is not part of energy statistics’ IRENA (2013). An alternative to energy-based aggregation could rely on monetary value of energy use. Brendt (1978) suggested this approach. The idea is to include the price information of energy in the aggregation scheme to account for the variations in the attributes of different energies. The inherent assumption here is that prices of different fuels capture the differences in qualities and other attributes relevant for making preferences by the consumers. This could use the national currency of the country concerned or an international currency such as US$ or euro. Such a monetary balance of energy supply and use would provide the market value of domestic use of energy. The monetary value of inland energy consumption in the UK corresponding to the energy balance for 2016 is shown in . Table 2.11. However, given the focus on financial flow, the rows of such a table can be quite different from the conventional energy balance tables. Moreover, the value balance would depend on the price, tax and margins in each country and the results are likely to be highly sensitive to price changes across regions. Such an aggregation obscures the energy demand and supply information by highlighting the monetary value. This is also problematic for developing countries where non-traded energies are still used. Using an estimated monetary value for non-traded energies would not reflect the
2
25
2.5 · Accounting of Traditional Energies
. Table 2.11 Value balance of traded energy in the UK in 2016 Coal and products
Oil and products
Natural gas
Renewable and waste
Electricity and heat
Total
Indigenous production
230
34,680
4,850
2,825
16,810
59,395
Imports
645
23,010
6,300
310
780
31,045
Exports
−55
−16,425
−1,350
−105
−17,935
−835
Marine bunkers
−835
285
−30
205
1,105
40,400
10,005
3,135
17,485
72,130
460
35,735
12,390
1,235
17,390
67,210
Market value of inland consumption
1,565
76,135
22,395
4,370
34,875
139,340
Energy end use
1,565
76,135
22,395
4,370
34,875
139,340
Energy transformation sector
875
17,880
4,865
1,855
1,235
26,710
Industry
360
1,630
1,610
110
6,735
10,445
5
52,925
0
1,605
460
54,995
Other users
310
2,005
15,840
800
26,445
45,400
Non-energy use
15
1,695
80
Stock change Value of inland consumption Tax and margins
Transport
460
1,790
Source Digest of UK Energy Statistics (2017)
actual money flow but ignoring monetary value of non-traded energies will underestimate the domestic energy use. 2.5 Accounting of Traditional Energies
So far, the focus has been on commercial energies but traditional energies (TE) play an important role in many countries, including most of the developing countries. The share of traditional energies varies considerably from one country to another, but its contribution ranges from one-third to one-half of total energy demand of many
26
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Chapter 2 · Energy Data and Energy Balance
developing countries. The share can be even higher in rural areas where commercial/ modern energies are less used. Traditional energies can be acquired through purchase or collection or a combination of purchase and collection. For this reason, traditional energies are also classified as non-commercial energies. There has, however, been a progressive tendency towards monetization of these energies, especially of fuel wood, even in rural areas. When a traditional energy participates in trading, by definition it becomes a commercial energy, although it remains a traditional fuel. To avoid confusion, we are using the term traditional energies in this chapter. Traditional energies already compete with other fuels in productive activities in domestic, commercial and industrial uses. Most of the households, especially in rural areas of developing countries, depend on these sources not only for their cooking needs but also for farm operations, water heating, etc. Although traditional energies predominate in rural areas, their use is not limited there only. Urban and industrial consumers also use a considerable amount of such resources. Despite playing an important role in the economy of many developing countries, statistical information about these energies is relatively weak. In many cases, the energy balances do not include such energies. Wherever they are included, the coverage may be partial. Similarly, the national accounts also do not cover activities involved in traditional energy supply, mainly because of the valuation problem. Nonmoney activities often occupy a far greater share than the monetised part in rural energy of many developing countries. The problem is further complicated by the fact that energy is not for direct consumption but used to derive some end-uses, which can be satisfied by a number of substitutes. Evaluating the contribution in monetary terms when some are acquired through non-monetary activities remains problematic (Bhattacharyya 1995; Bhattacharyya and Timilsina 2009). Yet, neglecting traditional energies and their contribution is not a solution as this creates a number of serious problems. First, neglecting a dominant source of energy from any analysis underestimates the energy demand and supply situation in a country. Second, it reduces the credibility of the analysis and introduces errors in analysis and policy prescriptions. For example, any policy on internalization of environmental costs of commercial fuels loses credibility in a developing economy when traditional energies are excluded from the analysis, since commercial and traditional fuels are complementary to one another. This not only underestimates the problem but also misinterprets it. Third, excluding the contribution of activities involved in TE supply from the national accounts underestimates the national output and the importance of these economic activities. A number of issues arise in dealing with traditional energies in the energy balance. These include the following (IRENA 2013; Denman 1998): (1) First, their production and use is distributed and often takes place in the unorganised sector. Users often collect and use them and in such cases there are no recorded transactions that can be relied on for statistical purposes. Non-standard units (such as bundles, bags, headloads, backloads, baskets, buckets, etc.) used to describe and measure traditional energies make it very difficult to get precise information about energy supply and use. Similarly, outputs of household size biogas plants that provide energy for cooking and lighting in many developing countries are not recorded or monitored. As a consequence, the contribution of biomass or biogas has to be estimated.
2.6 · Special Treatments of Some Entries in the Energy Balance
27
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(2) Estimation of biomass energy supply requires the physical quantity of inputs and their calorific values but they are hard to estimate. Most of the biomass resources are obtained as by-products of the overall activities relating to agricultural production, crop processing and livestock maintenance. These resources have multiple uses as fodder, fuel, fertilizers and construction materials. A detailed understanding of the agricultural processes and systems is required for any reliable information on the production, availability and use of such resources. Limited surveys or rules of thumb cannot provide accurate information and this makes the data uncertain. (3) Similarly, the energy content of biomass depends on the type of biomass being used and its condition (dry or wet). Normally, during wet season, the moisture content is high and net energy will be less. (4) The traditional way of using these energies is highly inefficient. For example, the efficiency of cooking with biomass in traditional three-stone fire oven is between 5% and 10%. The input energy from biomass will enter in the energy balance based on the net calorific value of biomass but the useful energy derived from this resource is very small. Treating biomass like other fuels can be misleading. The gaps in data on traditional use of biomass are being recognised in recent times. The Global Tracking Framework (Sustainable Energy for All 2013) and IRENA (2013) are prime examples. To develop a better understanding of traditional energy use, better data collection is essential. This would require regular surveys of biomass use and an agreed methodology for systematic analysis and reporting of traditional energy data (IRENA 2013). National capacity strengthening and international collaboration are essential as well. 2.6 Special Treatments of Some Entries in the Energy Balance
Certain entries to the energy balance require special attention. The most important ones relate to electricity production and use, self-generation and traditional energies. These are discussed below. 2.6.1 Treatment of Primary Electricity Production
Production and use of electricity pose certain problems for energy balance tables. This is because for other fuels the total energy content is measured rather than the available energy, while for electricity generated from hydroelectric power, nuclear power or geothermal, the available energy is essentially measured. This leads to an inconsistency of approach. In general two approaches are used to resolve this problem: (a) Consumption equivalence: Here the OEB records the direct heat equivalent of the electricity (i.e. converting 1 kWh to kcal or kJ using the calorific value of electricity, note that 1 kWh = 860 kcal). This is done on the premise that the energy could essentially be harnessed by transforming it into electricity and that electricity is the practically first usable form of the energy under consideration. This approach is known as consumption equivalence of electricity treatment for energy balances.
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Chapter 2 · Energy Data and Energy Balance
(b) Production equivalence: The second method attempts to measure the equivalent or comparable fossil fuel requirement of primary electricity production. This is done on the premise of consistency in approach. This method estimates the amount of fossil fuel input that would be required to provide the same energy as produced by the primary electricity sources. This approach is known as fossil fuel input equivalent approach or simply production equivalence approach (or partial substitution approach). A two step procedure is followed to determine the input primary energy requirement: (i) the overall thermal efficiency of thermal power generation for the country concerned is estimated first; (ii) this efficiency is applied to primary electricity generation to arrive at the input energy requirement. For example, assume that a country produced 1 GWh of primary electricity in a year. If the OEB shows the physical energy, it records 1 × 860 × 106/1010 = 0.086 kote. However, if the production equivalence is used, assuming a thermal electricity generation efficiency of 30%, the input primary energy would be 0.086/0.3 = 0.287 ktoe. Both the above approaches are used in practice. Normally countries with high hydro or nuclear energy share tend to use the production equivalence concept, while others tend to use consumption equivalence concept. According to IEA (2004), the production equivalence approach has been abandoned now. 2.6.2 Treatment of Electricity in Final Consumption
A similar issue arises regarding the treatment of electricity consumption in the energy balance. This arises because: 5 Electricity, being a secondary form of energy, is a high grade energy compared to other forms of energy; and 5 the appliance efficiency is often much higher than other types of energy-using appliances. The issue is whether electricity should be treated like any other source of energy or differently. Again two options are available to rectify the problem: 5 Useful energy basis: If the OEB is expanded to include useful energy used by consumers, differences in appliance efficiencies can be taken into consideration. However, data availability may be a constraint in implementing this approach. 5 Fossil fuel equivalence: The other alternative is to express all electricity delivered to consumers in terms of its fossil fuel input equivalent. This would follow an approach similar to the production equivalent approach discussed above. This is however rarely followed in practice. The common practice is to reflect the electricity consumed in its direct heat equivalent without accounting for differences in appliance efficiency, although this may underestimate the contribution of electricity in the final consumption.
2.7 · Analysis of Energy Balance Information
29
2
2.6.3 Self Generation
Self generation or auto-production means production of energy (electrical or otherwise) by the user itself essentially for its own consumption. However, in some cases the excess energy or some by-products may even be sold outside as well. Auto-production of electricity plays a significant role in many countries (e.g. coking plants in integrated steel industries, captive or stand-by generating capacities in many developing countries, etc.). Information on this auto-production is extremely important for a complete picture of energy transformation and use. Information on auto-producers is difficult to collect, as there is no compulsory reporting of this activity in many countries. Fuels used for electricity generation or for producing other energy may be shown as final consumption in the sector (industry or others). This lack of information can badly distort analysis of energy statistics at the national level. It also makes comparison with other countries difficult as definitions would not tally between countries. Some energy balances account for self-generation of electricity in the transformation part. This approach is consistent with the logic of the overall energy balance and represents correctly the energy consumption of a country. A separate row is added in the transformation section of the energy balance to report auto-production of electricity. Thus electricity production is split into public electricity and auto-producers of electricity. 2.7 Analysis of Energy Balance Information
Energy balances provide a great deal of information about the energy situation of a country. They are also a source of consistent information that could be used to analyse the supply and demand situations of a country and with appropriate care, can be used for international comparisons. As the energy balance is organized in three sections (supply, transformation and use), it is possible to gain insight in these areas, depending on the need and purpose of the analysis. For example, the primary energy requirement indicates the total energy requirement of the country to meet final demand and transformation needs in the economy. The trend of primary energy requirement of a country shows how the internal aggregate demand has changed over time. Similarly, the transformation section of the energy balance provides information on energy conversion efficiency and how the technical efficiency of aggregate conversion has changed over the study period could be easily analysed from energy balance tables. Final consumption data can be used to analyse the evolution of final energy demand of the country by fuel type and by sector of use. Such analyses provide better understanding of the demand pattern of each sector and energy source. In addition to any descriptive analysis using trends or growth rates, further insights can be obtained by analyzing various ratios. IAEA (2005) has compiled a large set of useful ratios that could be examined and analysed. A few of these ratios are discussed below3: 3
See also Energy Efficiency Indicators Europe project website (7 http://www.odyssee-indicators.org/ index.php).
30
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Chapter 2 · Energy Data and Energy Balance
(a) Energy supply mix: As primary energy supply comes from various types of energies, it is important to know the contribution of each type and its evolution over time. The share of each energy source in primary consumption (i.e. the ratio coal, oil, gas or electricity supply in the total) characterises the energy supply mix of a country. This share shows the diversity of the supply mix (or lack of it) in a country. It is normally considered that a diversified energy mix is better and preferable compared to a highly concentrated mix. For example, from . Table 2.3, the share of coal in the British primary energy supply in 2008 was 16.1%, while that of oil and gas was 35.6% and 40.0% respectively. Thus the share of fossil fuels in the primary energy supply in that year w therefore 91.7%, showing the overwhelming dominance of such energies. (b) Self-reliance in supply: As the supply can come from local production or imports, independence of a country in terms of supply is considered an important characteristic of the supply system. The rate of energy independence (or self-reliance) is the ratio of indigenous production to total primary energy requirement. For importers, self-reliance would be less than 100% while for exporters, the value would be more than 100%. This analysis can be done at a more disaggregated level by considering the self-reliance in respect of each type of energy. Again using the British example, . Table 2.3 indicates that in 2008, about 30% of coal supply came from local sources, while 94% and 74% respectively of oil and gas came from domestic sources. So, the country had an overall self-sufficiency of over 75% in that year. (c) Share of renewable energies in supply: Where the energy balance covers the renewable energies, this could be examined to see the role of alternative energies in the supply mix. (d) Efficiency of electricity generation: The Overall efficiency of power generation can be determined from the ratio of electricity output to energy input for electricity generation. Where input and output values are available by energy type, efficiency can be determined by fuel type as well. This indicator can reflect how the electricity conversion is evolving in the country and whether there is any improvement in this important area. Using the British example again, in 2008, the electricity system efficiency comes to 40%. (e) Power generation mix: The power generation mix of a country can be obtained from the share of electricity production by type of fuel. The higher the concentration of power generation technology, the more vulnerable a country could be in terms of supply risk. For example, in the British case, the electricity generation mix for 2008 was as follows: 38% came from natural gas, 36% from coal, 22.5% from nuclear and the rest from renewable sources including hydropower.4
4
This is based on more detailed information about electricity available in the energy statistics (DUKES 2009).
2.8 · Alternative Presentation of Energy Accounting Information
31
2
(f) Refining efficiency: This is determined from the ratio of output of refineries to refinery throughput. This indicator could be easily compared internationally to see how the refineries are performing in a country. In the British case, the refinery efficiency for 2008 was 99.7%. (g) Overall energy transformation efficiency: This is determined as the ratio of final energy consumption to primary energy requirement. This shows how much of energy is lost in the conversion process. Lower the loss, more efficient the system is. In the case of UK, the overall transformation efficiency was 70%, which represents a high level of performance. (h) Per capita consumption of primary energy and final energy: These two indicators are frequently used in cross country comparisons. The ratio of primary (or Final) energy consumption to population in a country gives the per capita consumption. Generally per capita consumption of energy is higher in developed countries than in developing countries and this index is often used as a rough measure of prosperity. Similarly, per capita electricity (or other fuel consumption) could be used to see the level of electricity (or fuel) use in a country. In 2008, the UK population was 61.38 million. Accordingly, energy consumption per person was 3.82 toe. (i) Energy intensity: This indicator is used to analyse the importance of energy to economic growth. Energy intensity is the ratio of energy consumption to output of economic activities. When energy intensity is determined on a national basis using GDP, it is termed as GDP intensity. GDP intensity can be defined in a number of ways: using primary energy consumption or final energy consumption, using national GDP value or GDP expressed in an international currency or in purchasing power parity. Accordingly, the intensity would vary and one has to be careful in using intensity values for cross-country comparisons. This is considered in more detail in 7 Chap. 3. In 2008 the GDP of UK was £1332.7 billion (at 2005 prices). This leads to an energy intensity of 175.8 toe per million pounds of output. The OEB constructed on this basis can then be used for the analysis of changes in the level and mix of energy sources used for particular purposes before and after transformation. It can also be used for the study of changes in the use of pattern of different fuels, for the examination of the extent of or scope for substitution between fuels at different stages of the flow from primary supplies to final energy uses, and as a source for the generation of time series tables. 2.8 Alternative Presentation of Energy Accounting Information 2.8.1 Energy Flow Diagrams
Flow diagrams present the energy balance information in a pictorial form. There are various diagrammatic ways of presenting the energy balance information and the general practice is to vary the width of the flow to reflect the importance of different energies. Wider bands would represent larger flow and inversely, narrow bands represent
32
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Chapter 2 · Energy Data and Energy Balance
smaller flow. Different shades or colours are used to reflect flow of different fuels. A simple energy flow chart provides the basic information of availability and demand in an aggregated manner. Normally, different fuels would be shown separately but inter-relationships and substitution of fuels is not shown. A simple energy flow chart is shown in . Fig. 2.4. More complex charts describe the flow interactions of various fuels at the end-use level and indicate alternative uses of fuels. These charts would provide a clearer picture of energy flow in the economy and the relative importance of various fuels. Flow diagrams are valuable presentation aids that are useful for training sessions and briefing of high-level officials and general public. They do not serve much analytical purpose and cannot be prepared unless the energy balances are ready. 2.8.2 Reference Energy Systems (RES)
The Reference Energy System is a more formal analytical tool than flow diagrams. RES was developed in the US in 1971 for energy analysis. RES employs a network form to represent the activities and relationships of an energy system. The network follows the energy commodity flow path from its origin through transformation to end-uses. The RES is organised as follows: for each form of energy, a separate line is used. Different forms of energies are presented vertically while the processes and technologies employed for any energy commodity are specified along horizontal axis. RES would cover all phases of energy flow: resource extraction, refining or treatment, transport, conversion, distribution, and utilization in an end-use device for each energy type. A network has two essential elements: a node and a flow represented by an arrow. A node represents the start or completion of a process. For example, the start and end of refining will be shown by two nodes and a line joining the nodes will indicate the flow of energy. The size of the flow is indicated by a numerical value and where appropriate, conversion efficiency is also indicated in the brackets. Processes that are occurring at the same stage of progress of an energy commodity would be shown vertically. Diagonal arrows denote transportation of an energy commodity from (or to) outside system or to a conversion process. Solid line arrows indicate that the fuel undergoes the process or activity; dotted arrows are used when the process or activity is not applicable to the fuel. Energy flows from left to right in a RES. The left side indicates all extraction and production of energies. The right side indicates the demands. . Figure 2.5 presents an example of a RES. Each path indicates a possible route of energy flow from a given energy source to a demand. Multiple flows for any end-use or activity indicated by alternative paths and branches would reflect substitution possibilities of various resources and technologies. For example, . Fig. 2.5 allows determination of the amount of oil products used for agricultural purposes. Both traditional and modern energy sources can be accommodated in this framework. A RES contains all the information of available in an Overall energy balance. It also provides information about conversion efficiencies of each conversion and end-use devices. RES can be used for analytical studies of energy systems using optimization
33
. Fig. 2.4 Example of an energy flow diagram. Source 7 https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/630722/Energy_Flow_ Chart_2016.pdf
2.8 · Alternative Presentation of Energy Accounting Information
2
Chapter 2 · Energy Data and Energy Balance
34
Resources
2
Extraction
Refining and Processing
Hydro
Transportati Conversion on 1185
Transmission and Device distribution
End-use
Industry 651 606 1910 -310
966 Residential+C 14
1826
50
1037
40
489 885
1652 726 Coal
Transport
387
1287
5098 54 Agriculture
Crude oil
15316
170
402
7541
170
Non-energy
15316 177 Natural gas
743
920
. Fig. 2.5 A simple RES diagram
and other techniques. RES can cover sectoral energy balances as well and detailed representation of end-uses and appliances is possible in this framework. It allows one to visualize the entire energy system of a country and analyse it comprehensively. RES is widely used in system-wide modelling tools and packages. RES can be drawn using historical data and also using forecasts. For forecasting and future system analysis applications, RES would incorporate future technological options and possible changes in energy types. The main drawback of RES is that the pictorial presentation becomes unmanageable as the energy system becomes complex and inter-relationships increase. It becomes difficult to incorporate all flows. 2.9 Common Energy Data Issues
A number of conceptual, technical problems and data-related issues are confronted while dealing with energy data (Codoni et al. 1985; Siddayao 1986; IEA 1998; Ailawadi and Bhattacharyya 2002). Data availability: Often multiple agencies collect and publish data. Collection and reporting involves some time lag and delayed publication of information is quite common. Delays reduce usefulness of the information and its value. Data on energy use is often sketchy and inadequate. Even in cases where a network is used for supply, reliable information on consumer category-wise usage is not available. Manual systems for recording and storing information coupled with managerial incompetence are responsible for such poor state of affairs.
2.9 · Common Energy Data Issues
35
2
Data quality: There is doubt about the quality of information whenever data is available. This is because in absence correct sales and consumption information, estimates are used and their basis is often questionable. Besides, consistency problems also arise in data and arithmetic errors, internal inconsistency, logical errors, etc. are not uncommon. For example, in the case of natural gas, production may be reported on gross (i.e. including gas vented, flared and re-injected) or net basis. Similarly, it is almost impossible to obtain export and import statistics that match. For example, exporters’ records of destination of the gas do not correspond to the origin of the gas according to the importer. Trade discrepancies may also arise from use of different conversion factors for different origin of imports. In LNG trade, both methane and natural gas liquids (NGL) are involved but at the receiving point NGL may be separated. So production and export will cover more than import and consumption in the country of destination. For coal, due to differences in the basic characteristics (such as calorific value, ash content, content of impurities, suitability for coking, etc.), a wide variety of classification is used and the systems followed by different countries and international organisations are not necessarily identical. This leads to compatibility problem for data. Boundary problem: This is generally encountered while using data from a number of sources, especially from different countries. Countries use different conventions about energy classifications and consumer categorization. The boundary problem arises due to: (1) exclusion of or inclusion of traditional fuels; (2) different terminologies used for the same product; (3) different user sectors identified for different data (e.g. electricity end use sectors may be different from that for petroleum products); (4) accounting for differences in energy efficiencies, efficiencies of energy delivering equipment, etc. Common measurement unit: Aggregating energy sources of different characteristics is a difficulty faced in energy data. The problem is how to aggregate energy forms of different qualities in a way that will allow appropriate cross-country comparisons. In order to present the variety of units on a comparable basis, a common denominator for all fuels is required. Traditionally, the common denominator is their energy or heat content, expressed in Joules, Btu or kWh. Units like tons of coal or oil, or barrels equivalent are derivatives of the heat content. Conversion factors: This is related to common measurement unit. Once a choice is made about the common denominator, the next question comes is how precise does the conversion factor need to be and how much will the overall picture change if one factor is used rather than the other. The quality of certain products such as coal varies significantly from one country to another and also from one extraction site to another. This necessitates a specific factor for each country and often for each time period as the domination of different extraction sites vary from year to year. For other products, the variation may not be significant and a common factor may be used. To resolve these issues, a number of initiatives have been taken. For oil statistics, the Joint Oil Data Initiative (JODI) has created a platform for interaction of various stakeholders. Similarly, the UN Statistical Commission and UN Statistics Division are working on the challenges facing the energy statistics. The UN organisations are working towards revising the older manuals and recommendations for international energy
36
Chapter 2 · Energy Data and Energy Balance
statistics. However, this is a more recent development and the consultations and preparatory works have just completed in 2009.
2
2.10 Conclusion
This chapter introduced the concepts related to the energy systems and presented the energy accounting principles in simple terms. It has also covered the energy conversion issues and treatment of some special elements of the energy data, including that of traditional energies. The issues related to data are also presented and a few indicators are discussed to describe and analyse the information. This chapter lays the data foundation for the rest of the book.
Annex 2.1: Worked Out Examples Example 1
. Table 2.12 provides information on indigenous production of energy of a country in 2009. Present the information in ktoe and PJ. Answer (see . Table 2.13)
. Table 2.12 Primary energy production in 2009 Fuel
Quantity
Calorific value
Coal
72 Mt
6200 kcal/kg
Crude oil
495 million barrels
8000 kcal/L
Natural gas
2860 billion cft
900 btu/cft
Hydro general
11,600 GWh
860 kcal/kWh
Geothermal
2900 GWh
860 kcal/kWh
. Table 2.13 Answers to the unit conversion problem Fuel
Quantity
Calorific value
Energy content Pcal
PJ
ktoe
Coal
72 Mt
6200 kcal/kg
446.4
1868.9875
44640
Crude oil
495 million barrels
8000 kcal/L
629.64
2636.1768
62964
Natural gas
2860 billion cft
900 btu/cft
648.648
2715.7594
64864.8
Hydro General
11,600 GWh
860 kcal/kWh
9.976
41.767517
997.6
Geothermal
2900 GWh
860 kcal/kWh
2.494
10.441879
249.4
2
37 Annex 2.1: Worked Out Examples
Example 2 The refinery input and output are given in . Table 2.14. Present the information in a common unit (ktoe). Answer (see . Table 2.15) . Table 2.14 Refinery statistics example Refinery
Quantity
Calorific value
Crude oil (‘000 bbls)
−345,868
8000 kcal/L
Natural gas (MNCFT)
−13,219
900 btu/cft
Refining input
Refining output (‘000 bbls)
kcal/bbl
Gasoline
73,642
1,339,000
6432
1,378,000
ATF (Avturbo) Kerosene
58,490
1,437,000
Diesel
99,781
1,501,000
Fuel Oil
24,444
1,576,000
LPG (ktons)
546
OPP/Non energy
12.96 ktoe/ktons
61,735
1,272,000
. Table 2.15 Presents the answer to the above example Refinery
Quantity
Calorific value
Refining input
Energy Pcal
ktoe
Crude oil (‘000 bbls)
−345,868
8000 kcal/L
−439.9441
−43994.4096
Natural gas (MNCFT)
−13,219
900 btu/cft
−2.9980692
−299.80692
Refining output (‘000 bbls)
kcal/bbl
Gasoline
73,642
1,339,000
98.606638
9860.6638
ATF (Avturbo)
6432
1,378,000
8.863296
886.3296
Kerosene
58,490
1,437,000
84.05013
8405.013
Diesel
99,781
1,501,000
149.77128
14977.1281
Fuel oil
244,44
1,576,000
38.523744
3852.3744
LPG (ktons)
546
12.96 ktoe/ktons
70.7616
7076.16
OPP/Non energy
61,735
1272000
78.52692
7852.692
Total output
529.10361
52910.3609
Total input
−442.94217
−44294.21652
Refinery gain
86.161444
8616.14438
Chapter 2 · Energy Data and Energy Balance
38
2
Example 3: Energy balance preparation A small island country does not have any natural resources for energy production. It depends mostly on imported crude oil for its energy needs. Some natural gas is also imported and is used for power generation only. The details are given below for 2008. Crude oil imported: 52 Mtoe; Gas imported: 1.2 Mtoe. Import of Petroleum products: 21 Mtoe; Export of petroleum products: 46.4 Mtoe. The following are uses of petroleum products (Mtoe) in the country: Road transport 1; International transport 16.7, and Industry 5. The details of electricity production and use are given in . Table 2.16. Based on the given information, prepare the overall energy balance of the country for the year 2000. Show only those rows and columns, which are relevant for this case. Answer . Table 2.17 provides the results. . Table 2.16 Data about electricity system Electricity generation
Electricity consumption (Mtoe)
Production 22 TWh
Residential and commercial 0.9
Efficiency 40%
Transport 0.02
Losses and own-use 0.17 Mtoe
Industry 0.8
. Table 2.17 Energy balance for the island country (Mtoe) Crude oil Imports
52
Petro prod
Gas
21
1.2
Electricity
Total 74.2
Exports
−46.4
−46.4
Bunkers
−16.7
−16.7
PES
52
−42.1
−52
51.63
1.2
0
−1.2
1.892
−2.838
Own use and T&D
−0.17
−0.17
Stat diff
−0.002
−0.002
Refining
−3.53
Electricity
TFS
0
6
11.1 −0.37
0
1.72
7.72
TFC
6
1.72
7.72
Ind
5
0.8
5.8
Trans
1
0.02
1.02
0.9
0.9
Rescom
39 References
2
References Ailawadi, V. S., & Bhayyacharyya, S. C. (2002). Regulating the power sector in a regime of incomplete information: Lessons from the Indian experience. International Journal of Regulation and Governance, 2(2), 1–26. Bhattacharyya, S. C., & Timilsina, G. R. (2009). Energy demand models for policy formulation: A comparative study of energy demand models. In World Bank Policy Research Working Paper WPS4866, March 2009. Bhattacharyya, S. C. (1995). Internalising externalities of energy use through price mechanism: A developing country perspective. Energy and Environment, 6(3), 211–221. Brendt, E. R. (1978). Aggregate energy, efficiency and productivity measurement. Annual Review of Energy, 3, 225–273. Codoni, R., Park, H. C., & Ramani, K. V. (Eds.). (1985). Integrated energy planning: A manual. Kuala Lumpur: Asian and Pacific Development Centre. Denman, J. (1998). IEA biomass energy data: System, methodology and initial results. In Biomass Energy: Data, Analysis and Trends, Conference Proceedings, March 23–24. Paris: International Energy Agency. Digest of UK Energy Statistics, (2017). Department for Business, Energy and Industrial Strategy, available for download at 7 http://www.gov.uk/government/collections/digestof-uk-energy-statistics-dukes. Edwards, B. K. (2003). The economics of hydroelectric power. Cheltenham, UK: Edward Elgar. Garcia, F., Yujato, M., & Arenas, A. (2017). Energy statistics manual, 2017. Quito: Latin American Energy Organisation (OLADE). Retrieved March 20, 2018 from 7 http://www.olade.org/publicaciones/ energy-statistics-manual-2017/?lang=en. IAEA. (2005). Energy indicators for sustainable development. Austria. 7 http://www.iea.org/textbase/ nppdf/free/2005/Energy_Indicators_Web.pdf. IEA. (1998). Biomass Energy: Data, Analysis and Trends, Conference Proceedings, Paris 23–24 March, 1998. Paris: International Energy Agency. IEA. (2005). Energy statistics manual. Paris: International Energy Agency. Retrieved March 19, 2018, from 7 http://www.iea.org/training/toolsandresources/energystatisticsmanual/. IEA. (2010). Key world energy statistics. Paris: International Energy Agency. IPCC. (2006). 2006 IPCC guidelines for national greenhouse gas inventories. Volume 2: Energy, prepared by the National Greenhouse Gas Inventories programme. Japan: IGES. IRENA. (2013). Statistical issues: Bioenergy and distributed renewable energy. Abu Dhabi: International Renewable Energy Agency. Retrieved March 21, 2018, from 7 https://www.irena.org/-/media/ Files/IRENA/Agency/Publication/2013/Statistical-issues_bioenergy_and_distributed-renewable-_ energy.pdf. Olade. (2017). Energy Statistics Yearbook 2017. Latin American Energy Organisation. Quito, Ecuador. 7 http://www.olade.org/publicaciones/energy-statistics-yearbook-2017/?lang=en. Siddayao, C. M. (1986). Energy demand and economic growth: Measurement and conceptual issues in policy analysis. Boulder, Colorado, USA: Westview Press. Stevens, P. J. (2000). An introduction to energy economics. In P. Stevens (Ed.), The economics of energy. Volume 1: Cheltenham, Edward Elgar. Also reproduced in two parts in the Journal of Energy Literature—Vol VI No 2 December 2000 and Vol VII No 1 June 2001. Sustainable Energy for All. (2013). Global Tracking Framework. Retrieved March 21, 2013, from 7 http://gtf.esmap.org/data/files/download-documents/gtf-2013-full-report.pdf. UN. (1982). Concepts and methods in energy statistics, with special reference to energy accounts and balances: A technical report, Series F No. 29. New York: Department of International Economic and Social Affairs, United Nations. 7 http://unstats.un.org/unsd/publication/SeriesF/SeriesF_29E.pdf. UN. (1987). Energy statistics: Definitions, units of measure and conversion factors, Series F No. 44. New York: Department of International Economic and Social Affairs, United Nations. 7 http://unstats. un.org/unsd/publication/SeriesF/SeriesF_44E.pdf.
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Chapter 2 · Energy Data and Energy Balance
UN. (1991). Energy statistics: A manual for developing countries. New York: United Nations. 7 http:// unstats.un.org/unsd/publication/SeriesF/SeriesF_56E.pdf. UN-DESA. (2018). International Recommendations for Energy Statistics (IRES). Statistical Papers M 93, Statistics Division, United Nations. New York: Department of Economic and Social Affairs. Retrieved March 19, 2018, from 7 https://unstats.un.org/unsd/energy/ires/IRES-web.pdf. Further Reading Karbuz, S. (2004). Conversion factors and oil statistics. Energy Policy, 32(1), 41–45. Natural Resources Forum, November 2005 issue—Indicators of Sustainable Energy Development. Sinton, J. (2001). Accuracy and reliability of China’s energy statistics. China Economic Review, 12(4), 373–383. Some Data Sources International Energy Agency. 7 http://www.iea.org/Textbase/stats/index.asp. EU: Eurostat UK: Department for Business, Enterprise and Regulatory Reform. 7 http://www.dti.gov.uk/energy/statistics/source/index.html. BP Statistical Review of World Energy. (2017). 7 http://www.bp.com/productlanding.do?categoryId=6848&contentId=7033471. US Department of Energy. 7 http://www.energy.gov/.
41
Energy Demand Analysis 3.1 Introduction – 43 3.2 Basic Rational Choice Model of Energy Demand – 44 3.2.1 Consumer Demand for Energy: Utility Maximization Problem – 44 3.2.2 Cost Minimization Problem of the Producer – 48
3.3 Energy Demand Decisions from a Behavioural Economics Perspective – 50 3.4 Overview of Energy Demand Decisions – 51 3.5 Simple Indicators for Energy Demand Analysis – 53 3.5.1 Visualisation of Demand Trend – 53 3.5.2 Growth Rates – 55 3.5.3 Demand Elasticities – 56 3.5.4 Energy Intensities – 57
3.6 Decomposition Analysis – 61 3.6.1 Analysis of Changes in Total Energy Demand – 62 3.6.2 Analysis of Changes in Energy Intensity – 65 3.6.3 Analysis Using Physical Indicators – 69
3.7 Energy Demand Analysis Using the Econometric Approach – 70 3.7.1 Single Equation Regression Models – 70 3.7.2 Other Econometric Approaches – 73
3.8 Big Data and Energy Demand Analysis – 77 3.9 Conclusion – 78
© Springer-Verlag London Ltd., part of Springer Nature 2019 S. C. Bhattacharyya, Energy Economics, https://doi.org/10.1007/978-1-4471-7468-4_3
3
Annex 3.1: Consumer Demand for Energy—The Constrained Optimization Problem – 79 Annex 3.2: Cost Minimization Problem of Producers – 80 References – 80
3.1 · Introduction
43
3
3.1 Introduction
The term ‘energy demand’ may have different meaning in different contexts and to different users. For example, a scientist may focus on the equipment or process level energy requirements (i.e. energy used in a chemical reaction) whereas a biologist is concerned about the energy requirement of living organisms for their metabolism and growth. Planners and policy-makers tend to view the aggregate demand from a regional or national point of view. In the context of energy statistics, it is used to mean any kind of energy used to satisfy energy needs for cooking, heating, travelling, or moving things either through primary or secondary forms of energy. In such cases, the heat content of the fuel is being used to perform work. Similarly, energy products are also used as raw materials (i.e. for non-energy purposes) in petrochemical industries or elsewhere and the demand for energy here is to exploit certain chemical properties rather than its heat content. We have seen in 7 Chap. 2 that energy demand is categorised in two parts: final energy demand which captures the amount of energy products used by the final users and primary energy demand which combines final energy demand and energy used in the transformation sector in a given country. Often the context would clarify the meaning of the term but to avoid confusion, it is better to define the term clearly whenever used. A distinction is sometimes made between energy consumption and energy demand from an economic perspective. Energy demand describes a relationship between price (or income or some such economic variables) and quantity of energy either for an energy carrier (e.g. electricity) or for final use (such as cooking). It exists before the purchasing decision is made (i.e. it is an ex-ante concept—once a good is purchased, consumption starts). Demand indicates what quantities will be purchased at a given price and how changes in the price will affect the quantities sought. Consumption on the other hand takes place once the decision is made to purchase and consume (i.e. it is an ex-post concept). It refers to the manifestation of satisfied demand and can be measured. In certain cases, particularly in developing countries, demand may not be satisfied due to supply constraints or the demand may not manifest (i.e. it can latent) for one reason or another. In such cases, demand will be different from consumption. In this chapter, both demand and consumption are used interchangeably despite their subtle differences. Energy is not consumed for the sake of consuming it but for an ulterior purpose (e.g. for mobility, for producing goods and services, or for obtaining a certain level of comforts, and the like). Users do not use energy directly but derives the benefits through a set of durable appliances and equipment. Accordingly, energy demand is a derived demand. Moreover, researchers from different backgrounds have left their distinct footprints on energy demand analysis: for example, economists rely on the neoclassical tradition and use econometric approaches to understand economic demand drivers; engineers and technically-oriented researchers on the other hand have placed greater emphasis on the techno-economic dimension (Worrel et al. 2004). A third tradition has emerged that focuses on the identification of drivers influencing the evolution of energy demand (or a similar aggregated measure of change in a data series, such as energy intensity) by defining a set of factors of interest. This method is not
44
3
Chapter 3 · Energy Demand Analysis
directly anchored in any economic theory but uses statistical decomposition techniques. This chapter introduces various concepts related to energy demand and discusses different approaches to energy demand analysis. First, the basic rational choice model of energy demand analysis is presented, This is followed by a description of three-stage process of demand decisions. The behaviour choice model is then briefly introduced. Various tools are then considered with appropriate examples and the evolution of energy demand is finally presented. 3.2 Basic Rational Choice Model of Energy Demand1
The traditional economic principle for estimating and analysing energy demand counts on the rational behaviour of economic agents. But a distinction is made between energy consumption and energy used as an input for productive activities but in both cases the economic agents adopt an optimising behaviour. For example, households consume energy to satisfy certain needs and they do so by allocating their income among various competing needs so as to obtain the greatest degree of satisfaction from total expenditure. Industries and commercial users demand energy as an input of production and their objective is to minimize the total cost of production. Therefore the motivation is not same for the households and the economic treatment of the demand is somewhat different. The demand for a good is represented through a demand function which establishes the relation between amounts of the good consumed and the determinants of those amounts. The main determinants of demand are: price of the good, prices of related goods (including appliances), prices of other goods, disposable income of the consumer, preferences and tastes, etc. To facilitate the analysis, a convenient assumption (known as ceteris paribus) is made which holds other determinants constant (or unchanged) and the relation between price and the quantity of good consumed is considered. This simple functional form can be written as follows: q = f(p), where q is the quantity demanded and p is the price of the good. The familiar demand curve is the depiction of the above function. The consumer demand for energy and the economic energy input selection of the producer are discussed below. 3.2.1 Consumer Demand for Energy: Utility Maximization
Problem
The microeconomic basis for consumer energy demand relies on the principle of consumers’ utility maximisation. It starts with the premise that consumers face the challenge of choosing the preferred bundle of goods from a range of possible consumption
1
This section relies on Bohi (1981), Chap. 2, Estimating the demand for energy: Issues and Methodologies. Similar treatments are also provided in Hartman (1979), Munasinghe and Meier (1993).
3.2 · Basic Rational Choice Model of Energy Demand
45
3
bundles. They characterise their relative desire for consumption bundles through preference sets and they know their preferences exogenously. This knowledge of preferences can be used to make choices. It is also assumed that the consumers can rank the preferences in order and they are rational in that they will always choose a most preferred bundle from the set of feasible alternatives. The ranking of preferences can be presented graphically through ‘indifference curves’ which present combinations of bundles providing same level of satisfaction to a person. Following consumer theory, it is considered that an incremental increase in consumption of a good, keeping consumption of other goods constant, increases the satisfaction level but this marginal utility (or increment) decreases as the quantity consumed increases. The optimal choice of the consumption bundle is achieved through utility maximisation. This process produces a choice of consumption bundle offering the maximum satisfaction to the users. But in doing so, consumers are faced with the budget constraint that indicates the maximum amount of wealth that they can allocate to their consumption. The process thus involves arranging the spending to achieve the highest utility, remaining within the permitted budget. This requires the consumers to consider the additional utility obtained from the purchase of an additional unit of a product (that is the marginal utility). If the marginal utility per dollar is greater for good A than for good B, then transferring a dollar of expenditure from B to A will increase the total utility for the same expenditure. The process of substitution continues until utility is maximised. This is achieved when (1) total expenditure equals the available budget and (2) where the ratios of marginal utilities to prices are equal for all goods and services. It follows that reduction in the relative price of good A will tend to increase the demand for good A and vice versa. This basic idea is explained below using an example. The mathematical treatment is provided in Annex 3.1 for interested readers.2 z Example
Assume that an individual has 100 dollars to allocate between energy E and other goods X. One unit of energy costs 5 dollars while one unit of other goods costs 20 dollars. Accordingly, the individual can buy 20 units of energy or 5 units of other goods or a combination of these goods as shown by the shaded area of . Fig. 3.1. In equation form this is written as
100 = 5E + 20X
(3.1)
Consider a utility function
U = X0.5 E0.5
(3.2)
The combinations of X and E for various levels of utility can be easily determined for this function (see . Fig. 3.2). These curves are called indifference curves. The optimal demand for energy and other commodities could be determined for the given individual form the budget line and the indifference curves (see . Fig. 3.2).
2
See also Chap. 2 of Bohi (1981), Munasinghe and Meier (1993), and Medlock (2009).
46
Chapter 3 · Energy Demand Analysis
20
QE
3 5
QX
. Fig. 3.1 Budget constraint
QE
10
2.5
QX
. Fig. 3.2 Utility maximisation process
The budget line is tangent to the indifference curve (U = 5) and the optimal combinations of energy and other goods can be found from this (which turns out to be 10 units of energy and 2.5 units of other goods). Hence, when the energy price is 5 per unit, given the budget constraint, the individual consumes 10 units of energy. This forms one pair of data set for his/her demand curve. Now consider that the price of energy changes to 10 per unit while the price for other goods remains unchanged. Naturally, the consumer now will be able to consume only 10 units of energy or 5 units of other goods or some combinations of energy and other goods (as shown in . Fig. 3.3). Following the method indicated above, the new optimal combination is found and in this particular case, the individual would
3
47
3.2 · Basic Rational Choice Model of Energy Demand
Energy
20 Old budget line
10
New budget line
5
Other goods
. Fig. 3.3 Effect of changes in energy price on the budget line
12 Energy demand
11 10 9 8 7 6 5 4
4
5
6
7
8
9
10
11
Price
. Fig. 3.4 Energy demand curve of an individual
consume 5 units of energy and 2.5 units of other goods (i.e. just 50% reduction of energy demand). This gives another pair of points on the demand curve. The individual’s energy demand schedule can now be drawn using these points (see . Fig. 3.4). As you have noticed, in the entire process, we have only changed energy prices while keeping other variables unchanged (i.e. assumed that ceteris paribus condition holds). In . Fig. 3.4, the demand curve is downward sloped as is expected. The market demand function for a particular good is the sum of each individual’s demand for that good. The market demand curve for the good is constructed from the demand function by varying the price of the good while holding all other determinants constant.
48
Chapter 3 · Energy Demand Analysis
3.2.2 Cost Minimization Problem of the Producer
3
In the case of producers, the theory of the producers is used to determine the demand for factors of production. Firms use inputs or factors of production (such as labour, capital, energy and material) to produce output. The relationships between inputs and output are known as the production function. We assume that the firm has a simple objective of profit maximisation and it wants to decide its output and the quantities of inputs to produce the output so that its profit is maximised. Our focus here is on the choice of inputs for the chosen level of output. In the production process, it is normally possible to replace one input by the other and the producer would try to find the combination of inputs that would minimize the cost of production. The idea of marginal product is used here: incremental output from an additional unit of input (i.e. how the output changes for an extra unit of input). Similar to the consumer theory, here it is assumed that more inputs generate more outputs but at a decreasing rate (i.e. offers decreasing marginal return). The cost minimisation problem of the firm leads to the condition that the firm should use inputs to the point where the ratio of marginal products of inputs (i.e. the rate of technical substitution) is equal to the ratio of the input prices. This condition provides the conditional input demand—that is the input demand for a given level of output. We use an example below to illustrate the idea. The mathematical presentation is given in Annex 3.2. z Example
Consider that a producer uses capital and energy to produce her output. Assume that the price of K is w1 and that of E is w2. The total cost for the inputs is then given by
C = w1 K + w2 E
(3.3)
An isocost curve is defined as a function where the cost is constant—that is C is constant. Equation 3.3 can be written as
w2 E = constant−w1 K
(3.4)
E = constant − (w1 /w2 )K
(3.5)
This is the equation of a straight line with a slope—(w1/w2). As input prices are known, the isocost lines can be drawn for different levels of outputs. In . Fig. 3.5, isocost curves are shown where w1 and w2 are assumed to be 1. Now assume that the production function follows a simple relationship as given in Eq. 3.6.
Q = 10K0.5 E0.5
(3.6)
The isoquant map for this production function can be graphed by setting Q at different levels (say 50 or 100) and then finding the combinations of K and E that would produce the given level of outputs (see . Fig. 3.6). As can be seen from the figure, the
3
49
3.2 · Basic Rational Choice Model of Energy Demand
35
Energy input
30 25 20 15 10 5 0
0
5
10
15 20 Capital input
25
30
35
. Fig. 3.5 Isocost curves
30 25
Q=50
E (Energy)
20
Q=100
15
Constraint Constraint
10
Constraint
5 0
0
10
20
30
K (capital)
. Fig. 3.6 Optimal input selection for the firm
optimal choice of inputs would be at the point where the cost line is tangent to the isoquant. In this example, 5 units of energy and 5 units of capital are used when cost is minimised for an output level of 50 units. This gives the input requirement for a given level of output. When the output level changes to 100 units, the input quantities change to 10 units each. Accordingly, the input combinations for different outputs and price levels of inputs can be obtained. From the perspective of rational choice theory, the choice of a consumer is influenced by their preference or technologies (in the case of producers), constraints like budget or cost and relative prices of goods and services. The consumers are assumed to perform optimisation calculations in arriving at a choice decision and they make rational choices all the time. While the above theoretical concepts provide some
50
3
Chapter 3 · Energy Demand Analysis
understanding of energy demand, these theoretical ideas are based on quite restrictive assumptions. While the econometric modelling tradition explicitly follows the economic principles for energy demand analysis and forecasting purposes, this is not the only economic philosophy followed in energy demand modelling. Although price, rationality and optimising behaviour within the neoclassical tradition greatly influence the econometric tradition, others do not always believe in the crucial role of these factors. Accordingly, other behavioural assumptions (such as “satisficing” approach in the sense of Herbert Simon or evolutionary approach for technological change) and beliefs are used in some approaches,3 especially in the “bottom-up” approach or “engineering-economic” approach. We consider this alternative view below. 3.3 Energy Demand Decisions from a Behavioural
Economics Perspective
Behavioural economics is a field of study that applies psychological and other insights to human behaviour to understand how economic decisions are made. Research in this area finds evidence that people often deviate from the rational choice behaviour assumed in the traditional economic theory in respect of energy (and in other decisions) and this arises from two main factors –bounded rationality and cognitive bias (EIA 2014). Bounded rationality is a concept developed by Herbert Simon where he argued that decision-makers (or economic agents) have psychological limits with respect to computational and predictive ability that act as an important constraint in complying with the definition of rational choice used in the traditional economic theory. As a consequence of the limited ability to acquire information, assimilate and process them, the decision-makers rely on a sub-set of choice alternatives and they are unlikely to perform pay-off computations for each possible outcome as presumed in the rational choice theory. Instead, they follow ‘simple rules-of-thumb, heuristics and mental ‘short-cuts’ that reduce the demand for information and speed-up the decision-making process (Frederiks et al. 2015). Instead of optimal solutions, decisions can be satisficing in such cases. Cognitive bias on the other hand identifies several powerful and pervasive biases that influence consumer behaviour and affect their choices. In the area of energy demand, these include among others (Frederiks et al. 2015): status quo bias, loss and risk aversion, time inconsistency bias (i.e. higher implied discounting) and reference point bias. For example, people tend to avoid changes and continue with the current setting as moving to a new status is perceived to be complex and demanding in terms of information processing. Similarly, people have a strong preference for loss avoidance and risk aversion than their desire for gains and this will be reflected in their decision-making. Decision-makers have a preference for near-term payoffs compared to those which benefit in the long-term. They may have inconsistent time preference for outcomes—which suggests that they may apply different discounting rates and can use 3
See Wilson and Dowlatabadi (2007).
3.4 · Overview of Energy Demand Decisions
51
3
higher discounting for future outcomes. The short-sighted decision-making preference leads to procrastination, delayed decisions and continuation with the present. Similarly, the decisions are influenced by individual experiences and events: they tend to give higher weights to readily observable effects (salience effect), can anchor their views to an initial reference point or can make social comparisons and be guided by informal and tacit group rules. These biases contribute towards deviations from rational decision-making behaviour and affect outcomes individually or of a community. EIA (2014) concludes that despite the growing body of literature on behavioural economics and its application to energy demand or energy consumption, no single overarching model has emerged as an alternative to the existing tools. The behavioural literature is case based and further work is required to develop a general tools. 3.4 Overview of Energy Demand Decisions
As energy is used for satisfying some need and is done through use of appliances, any commercial energy requires monetary exchanges and the decision to switch to commercial energies can be considered as a three-stage decision-making process (see Hartman 1979; Stevens 2000; Bhattacharyya 2006). 5 First, the household has to decide whether to switch or not (i.e. switching decision). 5 Second, it decides about the types of appliances to be used (i.e. appliance selection decision). 5 In the third stage, consumption decision is made by deciding the usage pattern of each appliance (i.e. consumption decision). All these stages influence energy demand. This is shown in . Fig. 3.7. As Hartman (1979) indicates, any demand analysis and forecasting should consider this three stage decision-making process and capture related policy variables so that interventions, if required, could be properly designed. There are two decision outcomes at the first stage: to purchase an energy consuming appliance or not to purchase. If appliance is not purchased, demand for that particular use does not arise for that consumer. Monetary factors can play an important role in the switching decision: the amount and regularity of money income, alternative uses of money and willingness to spend part of the income to consume commercial energies as opposed to allocating the money to other competing needs. The behavioural aspects are also important: for example, lack of a reference point for comparison can make the decisions harder for the users; similarly, an adverse initial experience with a similar switch over in the past either individually or within the community can also reinforce status quo. Once a buying decision is made, two important parameters are to be decided next. If alternative fuel choices are available, which fuel would be used and what type of appliance for this fuel? Once a decision is made to buy an appliance and the appliance is purchased, the only variable leaves in the hand of the user is its utilisation. The level of utilisation varies from consumer to consumer and consumers can adjust utilisation in response to changes in external factors. 7 Box 3.1 provides the implications of each stage of decision making on the demand analysis.
52
Chapter 3 · Energy Demand Analysis
High use
No
3
App 1 Low use
Fuel 1
High use App 2
Yes Low use Fuel 2 Buying decision
Appliance selection
Capacity utilisation
. Fig. 3.7 Three-stage decision-making. Source Author
Box 3.1: Implication of the three-stage decision-making on energy demand For energy demand, information related to appliance holding pattern is important for two reasons: (1) to understand consumption behaviour: If there is lack of interest in a particular use, it may be that there are important barriers which need to be looked into. These barriers include: cost, financing options, user friendliness but also behavioural factors such as status quo bias, salience effect and inconsistent time preferences. (2) to understand growth potential: If a particular segment of market is saturated, demand growth from new consumers would be less and vice versa. The potential for change and efforts required to bring the change can depend on this. Appliance stock and its growth potential are important determinants of demand. For example, in a developing country there is only one car per hundred thousand people. If the government provides cheap gasoline to promote energy access, would it work? The cheap gasoline would go to those having cars and would not benefit the rest. The barriers to owning car need to be looked into first to promote motorized transport. The second stage has a deciding influence on demand. Often equipment has a long life time (5–10 years) and is costly. Once an appliance is purchased, it will be in operation for some time. This introduces strong path dependence in energy demand (meaning that the choice of appliance forecloses certain options and influences
3.5 · Simple Indicators for Energy Demand Analysis
53
3
the demand path). Strong path dependence affects fuel switching possibility and responsiveness of the consumers to external changes. Fuel switching option would be limited by the appliance choice decision and involves capital expenditure, at times of considerable amounts. The rigidity or strong path dependence leaves limited options to consumers in the event of sudden changes in prices or supply conditions in the short run. They have to depend on their existing stock of appliances in any case. The full reaction to external changes is not instantaneous. It is spread over a number of periods because of the rigidity of the system. This process is called lagged reaction (i.e. the reaction lags behind the action) and only over a number of period, the accumulated effect gives the full reaction. The short term response arises from this factor and its scope is not very broad. Therefore, short-term response is quite limited. This can have a social dimension as low capacity utilisation may lead to deprivation of essential energy services. The three-stage decision process therefore influences: access to energy services, market growth potential in a particular service or use, path dependence, responsiveness in the short run, reaction response, and consumer’s usage behaviour. The above discussion also suggests that technology matters: because energy demand is dependent on technical efficiency, substitution possibility depends on technical options available.
3.5 Simple Indicators for Energy Demand Analysis
Energy data is analysed for different purposes and depending on the source of data, the quantity of information being analysed varies. For example, to understand the historical evolution of energy demand of a country or a region, often annual demand data is used. However, to understand energy use of households or buildings, large data sets are generally available at a much higher level of granularity—modern smart meters record data electricity every 15 or 30 min. Such data can be analysed in greater detail to characterise consumer profile and consumption behaviour. The analytical approaches will vary depending on the application and purpose of analysis of the data. In this section, some commonly used approaches are presented below: simple indicators for demand analysis, descriptive statistics, factor (or decomposition) analysis, and econometric analysis. 3.5.1 Visualisation of Demand Trend
Here we present three simple but commonly used indicators that are used to describe the change in demand or its relationship with an economic variable. These are growth rates, demand elasticities and energy intensities. Any demand analysis starts with a general description of the overall energy demand trends in the past. It enables qualitative characterization of the pattern
54
Chapter 3 · Energy Demand Analysis
14,000 12,000
8,000 6,000 4,000 2,000
North AM
South AM
Europe-Eurasia
ME
Africa
2015
2012
2009
2006
2003
2000
1997
1994
1991
1988
1985
1982
1979
1976
1973
1970
1965
0
Asia-Pacific
. Fig. 3.8 Evolution of global primary energy demand. Source BP Statistical Review of World Energy (2017)
250% Index (Base 2000=100)
3
Mtoe
10,000
200% 150% 100% 50% 0% 1960
1970
1980
1990
2000
2010
2020
North AM
South AM
Europe-Eurasia
ME
Africa
Asia-Pacific
. Fig. 3.9 Global energy demand trend in index form. Source BP Statistical Review of World Energy (2017)
of energy demand evolution and identification of periods of marked changes in the demand pattern (such as ruptures, inflexions, etc.). This preliminary step could set the scope and the priorities of the analysis. Such a historical analysis is first based on a graphical presentation of the evolution of demand through time. Two types of graphs are generally used:
55
3.5 · Simple Indicators for Energy Demand Analysis
3
5 Trend of energy demand in absolute value (Mtoe, PJ, etc.)—see . Fig. 3.8; 5 Trend of energy demand in index—see . Fig. 3.9. The graph in absolute value provides an indication of the trend while that in index allows comparison with respect to the base year. In . Fig. 3.9, 2000 is chosen as the base year—the figure shows that regional demand in North America and Europe-Eurasia remained practically unchanged between 2000 and 2016. On the other hand, the demand in Asia-Pacific and in the Middle East has more than doubled between 2000 and 2016. The demand in South America and Africa grew by 50% over the same period. This allows a better appreciation of demand patterns but it does not indicate the relative importance of demand in different regions. Index also allows comparison of trends of different fuels and energy groups. 3.5.2 Growth Rates
Growth rate is a commonly used indicator to describe the trend. This can be on an annual basis or an average over a period (see . Table 3.1 for the formula). The yearon-year growth rates are calculated year after year so as to get a historical series. The average growth rate over a period on the other hand provides a picture for the entire . Table 3.1 Mathematical relationships for simple indicators of trend Indicator
Formula
Parameter description
Year-on-year growth rate
a = (Et+1 − Et )/Et
Where a = annual growth in demand, Et+1 = energy consumption in year t + 1 and Et = energy demand in year t
Annual average growth rate over a period
ET 1 = ET 0 (1 + ag )(T 1−T 0) ET 1 1/(T 1−T 0) −1 ag = ET 0
Where ET1 = energy demand in period T1 and ET0 = energy demand in period T0, ag = annual growth rate
Demand elasticities
et =
Energy intensity (for a single energy)
EIt =
Et It
EIt =
i=1 It
Energy intensity in case of aggregated fuels
(�ECt /ECt ) (�It /It )
n
Where t is a period given EC is energy consumption I is the driving variable of energy consumption such as GDP, value-added, price, income etc. Δ is the change in the variable EIt = energy intensity for year t, Et = energy consumption in year t and It = value of the driving variable (say GDP or value added)
Eit
Where Eit = energy consumption of ith type of fuel in year t
56
3
Chapter 3 · Energy Demand Analysis
period. Although an arithmetic average of the annual year-on-year growth rates can be calculated, this is not commonly used. Instead, a geometric average is calculated for the period. Annual growth rates can also be calculated at any level of disaggregation. This indicator captures the speed of change in demand and is easily understood. Example: According to BP Statistical Review of World Energy, the world primary energy consumption was 9,390.5 Mtoe in 2000. The demand increased to 13,105 Mtoe in 2015 and to 13,276.3 Mtoe in 2016. Calculate the growth rate of demand between 2015 and 2016. Also calculate the average growth rate between 2000 and 2016. Answer: The primary energy demand increased from 13,105 Mtoe in 2015 to 13,276.3 Mtoe in 2016. This amounts to a growth of = (13,276.3 − 13,105)/13,105 = (171.3/13,105) = 0.013 or 1.3%. The annual average growth rate between 2000 and 2016 is = (13276.3/9390.5)^(1/ 16) − 1 = 0.0219 or 2.2%. 3.5.3 Demand Elasticities
Elasticities measure how much (in percent) the demand would change if the determining variable changes by 1 per cent. In any economic analysis, three major variables are considered for elasticities: output or economic activity (GDP), price and income. Accordingly, three elasticities can be determined. The general formulation is given in . Table 3.1. There are two basic ways of measuring elasticities: using annual growth rates of energy consumption and the driving variable, or using econometric relationships estimated from time series data. The first provides a point estimate while the second provides an average over a period, and accordingly, the two will not give the exactly same result. Output or GDP elasticities of energy demand indicate the rate of change of energy demand for every one percent change in economic output (GDP or value added). Normally the GDP growth is positively related to energy demand but the value of elasticity varies depending on the stage of development of an economy. When the output elasticity is greater than 1, the demand is elastic with respect to output whereas when the elasticity 0 90 Data source Foster et al. (2017)
of the sample from OECD countries and 57% of the sample from the developing world. 43% of the sample from OECD countries had implemented full unbundling but this reduces to only 18% of the developing world. Majority of the low income countries are still continuing with the vertically integrated model and 69% of those continuing with the integrated model have an installed capacity of less than 1 GW. (c) The extent of competition also varies significantly as a result. 96% of the sample from developed countries has introduced some form of competition whereas this falls to 70% in the developing world. 66% of the developed countries have taken the reform to completion and have introduced retail competition. However, only 15% of the developing countries have adopted retail competition in the power sector. Many developing countries have just limited their reform by introducing independent power producers or the single buyer model. Latin America and the Caribbean region has adopted deep reforms but “few of the world’s largest emerging economies have introduced full power markets” (Foster et al. 2017). (d) In terms of private sector participation, both developed and developing countries score similarly. 69% of developing countries in the sample had some sort of private sector participation whereas this figure was 74% for the OECD countries. The study also found that one-third of the developing countries did not follow the original logic of the reform measures and implemented actions unevenly, thereby creating imbalances in their sectors. The overall power sector reform index from Foster et al. (2017) is shown in . Table 27.2. This shows that 65% of the sample from the OECD countries have scored 70% or above where as only 19% of the countries from the developing world come under this category.
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Chapter 27 · Reform of the Energy Sector
A number of factors explain the predicament of the sector reform initiatives: 5 Small size of the industry: The developing world, with a small sized power sector, may gain little from the unbundling exercise. The World Bank (2004) report indicates that “60 developing countries have peak system loads below 150 MW, another 30 between 150 and 500 MW, and possibly another 20 between 500 and 1000 MW. Even a 1000-megawatt system is small for introducing competition. There is no standard template to follow in this regard. 5 Investment issue: It is difficult to ensure investment in expansion of network infrastructure in an unbundled industry. Developed countries are experiencing this problem faced with capacity renewal challenge. Developing countries, with inadequate capacity and high demand growth, face more challenge. 5 Lack of regulatory capacity: The regulatory capacity for ensuring proper functioning of the unbundled system is lacking in many countries. The regulatory task becomes challenging in an unbundled environment and with low regulatory capability. It took developed countries a long time to build and develop expertise in regulatory capabilities. Developing countries with fewer resources will find it more challenging to develop required regulatory capabilities. 5 Strong path dependence: Experience shows that it is difficult to make changes to structural choices once they are introduced. Thus if privatisation precedes restructuring, it is more difficult to restructure the industry as such change requires co-operation and participation of the private parties, which is difficult compared to restructuring state-owned entities. It is often suggested that restructuring should be done first followed by privatisation. In other words proper sequencing is essential to the success of any privatisation programme. There is thus recognition that reform and restructuring options have to be carefully analysed, designed and implemented in order to produce benefits for the society. More important issue is how to manage the energy systems better when the countries are continuing with an intermediate structure. More attention on better management is crucial given that the reform has proved to be challenging. 27.8 Conclusions
This chapter has presented an overview of energy sector reforms, with a special focus on the electricity industry. The energy sector reform is one of the most discussed issues of the energy sector since the 1990s. It is essential to have some understanding of the concepts and issues related to these reforms. Given that the electricity sector was most commonly targeted, this chapter has considered the changes that took place in the electricity industry. It has presented the reasons for reforming the energy sector and the alternative options that were widely used around the world. It ends with a brief review of the experience related to the reform and suggests that despite all the attention received, the reform has not progressed well in the developing world. More attention is now needed to better manage the sector considering the challenges faced in taking the reform agenda forward.
809 References
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References Arizu, B., Gencer, D., & Maurer, L. (2006). Centralised Purchasing Arrangements: International Practices and Lessons learnt on Variations to the Single Buyer Model, Discussion Paper 16, Energy and Mining Sector Board, World Bank (see World Bank website). Bacon, R., & Besant-Jones, W. (2001). Global electric power reform, privatisation and liberalisation of the electric power industry in developing countries. Annual Review of Energy and the Environment, 26, 331–359. Barnes, D. F., & Halpern, J. (2000). The role of energy subsidies, Chapter 7, in Energy Services for the World’s poor, ESMAP, World Bank. Baumol, W. J. (1982). Contestable markets: An uprising in the theory of industry structure. The American Economic Review, 72(1), 1–15. Benavides, J. M. (2003). Can reforms be made sustainable? Analysis and design considerations for the electricity sector, Technical Paper, Inter-American Development Bank, Washington, D.C. Bhattacharyya, S. C., & Dey, P. (2003). Selection of power market structure using the analytical hierarchy process. International Journal of Global Energy Issues, 20(1), 36–57. Bhattacharyya, S. C. (2007a). Power sector reform in South Asia: Why slow and limited so far? Energy Policy, 35(1), 317–332. Bhattacharyya, S. C. (2007b). Sustainability of power sector reform in India: What does recent experience suggest. Special Issue of Journal of Cleaner Production, 15(2), 235–246. Brennan, T. J., Palmer, K. L., & Martinez, S. A. (2002). Alternating currents: Electricity markets and public policy. Resources for the Future, Chapter 15: Restructuring and environment protection. Washington, D.C. Byrne, J., & Mun, Y. (2003). Rethinking reform in electricity sector: Power liberalisation or energy transformation? In N. Wamukonya (Ed.), 2003. Electricity reform: Social and environmental challenges, UNEP, Riso, Denmark. de Oliveira, A., & MacKerron, G. (1992). Is the World Bank approach to structural reform supported by experience of electricity privatisation in the UK? Energy Policy, February, pp. 153–162. de Oliveira, A. (1997). Electricity system reform: World Bank approach and Latin American reality. Energy for Sustainable Development, 3(6), 27–35. Dubash, N. (Ed.). (2002). Power politics: Equity and environment in electricity reform. Washington, D.C: World Resources Institute. EIA. (1996). The changing structure of the electric power industry: An update. Washington, D.C.: Energy Information Administration. Foster, V., Witte, S., Ghosh Banerjee, S., & Moreno, A. (2017). Charting the diffusion of power sector reforms across the developing world, Policy Research Working Paper 8235, The World Bank, Washington DC. 7 http://documents.worldbank.org/curated/en/576801510076208252/pdf/ WPS8235.pdf. Guasch, J. L., & Spiller, P. (1999). Managing the regulatory process: Design, concepts, issues and the Latin American and Caribbean story, World Bank, Washington D.C. Heller, T. C., & Victor, D. (2004). A political economy of electric power market restructuring: introduction to issues and expectations, Working paper 1, Program on Energy and Sustainable Development, Stanford University, Stanford. Hunt, S., & Shuttleworth, G. (1996). Competition and choice in electricity. London: John Wiley & Sons. IEA. (1999). Electricity Market reform: An IEA Handbook. Paris: International Energy Agency. IEA. (2001). Competition in electricity markets. Paris: International Energy Agency. Jaccard, M. (1995). Oscillating currents: The changing rationale for government intervention in the electricity industry. Energy Policy, 23(7), 579–592. Joskow, P. (2000). Deregulation and regulatory reform in the US electric power sector, MIT Discussion paper. 7 http://www.iasa.ca/ED_documents_various/joskow03.pdf. Klein, M. (1996). Competition in network industries. Washington, D.C.: The World Bank.
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Lee, A. D., & Usman, Z. (2018). Taking stock of the political economy of power sector reforms in developing countries: A literature review, Policy Research Working Paper 8518, The World Bank, Washington DC. 7 http://documents.worldbank.org/curated/en/431981531320704737/pdf/WPS8518. pdf. Ljung, P. (2007). Energy sector reform: strategies for growth, equity and sustainability, SIDA Studies 20, Swedish International Development Corporation Agency, Stockholm. 7 https://www.sida.se/ contentassets/1c3b428bc150489faeef9e796dbc8113/14096.pdf. Lovei, L. (2000). The single buyer model: a dangerous path toward competitive electricity markets, Public Policy for the Private Sector, World Bank, Note 225, December. Newbery, D. M. G. (1999). Privatisation, restructuring and regulation of network utilities. Mass: MIT Press. RAP. (2000). Best practices guide: Implementing power sector reform. Vermont, USA: Regulatory Assistance Project. Tenenbaum, B. R., Lock & Barker, J. (1992). Electricity privatization: structural, competitive and regulatory options. Energy Policy, 1134–1160. Tuttle, D. P., Gülen, G., Hebner, R., King, C. W., Spence, D. B., Andrade, J., Wible, J. A., Baldwick, R., & Duncan, R., The History and Evolution of the U.S. Electricity Industry. White Paper UTEI/2016-05-2, 2016, available at 7 https://energy.utexas.edu/sites/default/files/UTAustin_FCe_History_2016.pdf. Von der Fehr, N.-H. M., & Milan, J. J. (2001). Sustainability of power sector reform in Latin America: An analytical framework, Working paper, Inter-American Development Bank, Washington, D.C. Vrolijk, C. (ed.) (2002). Climate change and power: Economic instruments for European Electricity. London: Earthscan. Wamukonya, N. (Ed.). (2003). Electricity Reform: Social and environmental challenges. UNEP Riso Centre, Denmark: United Nations Environment Programme. Williamson, O. (1985). The economic institutions of capitalism. New York: The Free Press World Bank. (1995). Bureaucrats in business: The economics and politics of government ownership. Waashington, D.C.: World Bank. World Bank. (2004). Reforming infrastructure: privatisation, regulation and competition, World Bank. Zou, C., Zhao, Q., Zhang, G., & Xiong, B. (2016). Energy revolution: from a fossil energy era to a new energy era. Natural Gas Industry B, 3(1), 1–11.
811
Regulation of Energy Industries 28.1 Introduction – 813 28.2 Traditional Regulation – 814 28.2.1 Rate Level Regulation – 814 28.2.2 Rate Structure Regulation – 821
28.3 Problems with Traditional Regulatory Approach – 823 28.4 Regulatory Alternatives – 825 28.4.1 Incentive Regulation – 825 28.4.2 Regulation by Contract – 827 28.4.3 Conduct Regulation – 828
28.5 Price-Cap Regulation – 829 28.5.1 Choice of Inflation Factor – 831 28.5.2 X Factor – 832 28.5.3 Z Factor – 833 28.5.4 Choice of Form – 833 28.5.5 Advantages and Disadvantages of a Price Cap Regulation – 834 28.5.6 Comparison of Price Cap and RoR Regulation – 835 28.5.7 Experience with Price Cap Regulation – 835
28.6 Revenue Caps – 836 28.7 Yardstick Competition – 837 28.8 Performance Based Regulation – 840 28.8.1 Base Revenue Requirement – 841
© Springer-Verlag London Ltd., part of Springer Nature 2019 S. C. Bhattacharyya, Energy Economics, https://doi.org/10.1007/978-1-4471-7468-4_28
28
28.8.2 Sharing Mechanism – 842 28.8.3 Quality Control – 842
28.9 Conclusion – 843 References – 843
28.1 · Introduction
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28.1 Introduction
This chapter introduces the concepts of regulatory economics relevant for the energy industry. The energy industry in general and the network-based energy sector in particular show the problems of natural monopoly and monopoly features. Two solutions have been commonly used to resolve the problem: either to allow monopolies to operate under a system of regulation or to use public ownership to capture monopoly rents and redistribute the proceeds through state policies. Regulation is an essential component of the first solution and is discussed here. In the world of perfect competitive markets, little regulatory effort is perhaps required. But when such ideal markets do not or cannot exist, regulations then aim at controlling the behaviour of the market agents to control the market failures and to produce competitive market-like results through the use of coercive power of the government or its agencies that restrict or constraint the decisions of the economic agents. Such regulatory interventions are quite pervasive in reality and can be categorised under three main groups: economic regulation, regulation of anti-competitive behaviour and social regulation. The first type is concerned with the issue of economic efficiency (and equity) in a non-competitive market environment. Economic regulations refer to government imposed restrictions on firms’ decisions through the control of price, or quantity or control of entry or exit or some combinations of these. The second is concerned with anti-competitive behaviour and protection against anti-competitive practices. The third is a relatively new but more pervasive type of regulation— dealing with the protection against socially undesirable behaviour and promotion of socially desirable goods.1 In this chapter we consider only economic regulation. Within the category of economic regulation, a number of alternatives exist: including the traditional cost of service regulation, or alternative modern variants like the incentive regulation, conduct regulation and regulation by contract. We focus on two most commonly used forms of economic regulation, namely the traditional regulation and the incentive regulation. First, we present the traditional regulation, then the incentive regulation and finally we discuss some issues and experiences related to regulation, especially in developing countries.2
1
2
See for example Viscusi et al. (2005), Shleifer (2005) and Newbery (1999, 7 Chap. 4) for further details. See also the Africa Toolkit (Module 3: Regulation)—here 7 http://africa-toolkit.reeep.org/ modules/Module3.pdf. Body of Knowledge on Utility Regulation, an annotated bibliography and for further references. See 7 http://www.regulationbodyofknowledge.org/). Economic Consulting Associates (2018) provides a detailed review of methodologies for target revenue determination of natural gas transmission system operators in Europe. The review offers a detailed treatment of different methodological options and provides an excellent of the relevant literature.
Chapter 28 · Regulation of Energy Industries
814
28.2 Traditional Regulation
The traditional approach to regulation is known as the rate of return regulation. This approach attempts to balance the total costs and the total revenue of a utility by considering all relevant components. These components can be expressed as follows (Eq. 28.1): n
pi qi = Expenses + s.RB
(28.1)
i=1
where
pi - price of ith good, Qi - quantity of ith good, n - number of goods, s - rate of return on investment; RB - rate base, which indicates the total worth of the investment made by the utility
28
This type of regulation can be viewed as a two-part regulation: rate level regulation and rate structure regulation. The rate level regulation looks at the right hand side of Eq. 28.1 and decides about the appropriateness of the expenses, the allowable rate of return and the rate base. The rate level regulation attempts to regulate the costs of the utility. The rate structure on the other hand deals with the structure of rates to be paid by consumers. The rate structure regulation aims at regulating the revenue earned by a utility. We consider the two parts separately. 28.2.1 Rate Level Regulation
In order to perform the rate level regulation, the regulatory bodies try to build up, item by item, the total permissible expenditure for any given time period, say one year. This is usually based on a test year—usually a past year adjusted for known and measurable changes so as to reflect conditions expected to prevail during the time the proposed tariff will be in effect. This permissible expenditure is known as revenue requirement of the utility, which it will then be allowed to recover through charges and income. As indicated in Eq. 28.1 above, this requires a detailed scrutiny of the expenses and decisions about whether these expenses are permissible for inclusion in the costof-service computations, and whether these permissible expenses will be treated as operating expenses3 or as capitalised expenses. This is a demanding task for any regulatory body following the traditional approach.
3
Operating expenses are directly included in the revenue requirement and the entire amount will be recoverable through tariffs over the test year. Capitalised expenses on the other hand will form part of the investment and depreciations will be allowed for use of the capital and the non-depreciated investments will receive a rate of return.
28.2 · Traditional Regulation
815
28
The choice of test year is an area of concern. A test year can be a historical test year. In this case, the latest available actual performance data is used for determining the revenue requirement. The historical basis allows easy verification but the disadvantage with this method is that the tariffs are unlikely to match with the future condition when the tariff will be applied. A common variation of this method is to allow for adjustments for “known and measurable” changes. Variations in costs due to new power purchase agreements or due to inclusion of new major industrial customers could be considered as “known and measurable changes” for an electric utility. The utility must provide documentary evidence to the regulators to justify all changes in costs and sales. In some cases a “forward-looking test year” is used as the basis for revenue requirement and allowed revenue determination. The “forward-looking test year” costs and sales are estimated based upon a forecast of future costs and future load. While the forecast may rely heavily on past experience, all expected changes are incorporated, not just “known and measurable ones.” The costs here will be based on projected performance, which is difficult to verify ex-ante. Why is the scrutiny of expenses required? Kahn (1989) suggests five reasons as follows: (1) Exaggeration of costs: regulated utilities may exaggerate costs and fool the regulators to allow more than required revenues. The exaggeration may take the form of padded expense figures and inflated capital investments. (2) Depreciation allowance: Depreciation is allowed for using up of capital assets. The rate of depreciation is a matter of judgement and there is room for dispute over the appropriate level. The utility may take advantage by exaggerating the cost. (3) Imprudent expenses: Regulated utilities may be involved in imprudent expenses that are not really for the benefit of their consumers but if they can get such expenses included in the revenue requirement, they will be encouraged to follow such lavish styles. (4) Business with affiliates: It is also possible that the regulated monopoly is involved in transactions with other affiliates and uses these as a conduit for higher profits by offering higher than normal rates for supply of goods and services. (5) Lack of competitive pressures: The regulated industries do not face competition and hence there is no incentive or pressure on them to keep costs down. As regulators act as surrogates for competitive markets, they are required to exercise some control on the costs presented to them by the utilities. While the scrutiny of expenses is required, the regulatory body cannot substitute for the management of the utility and can only allow or disallow some costs ex-post. Hence, although operating costs typically account for a majority of the costs (80–85% according to Viscusi et al. 2005), regulators often have limited their focus to regulating profits and not detailed scrutiny of expenses. It needs to be mentioned that inclusion of fixed costs such as depreciation and return on investment marks the departure from the marginal cost pricing because marginal cost is a measure of changes in variable costs alone. Therefore, regulatory agencies require the revenue requirement to be in line with the full-cost or average cost pricing (Kahn 1989)
Chapter 28 · Regulation of Energy Industries
816
28.2.1.1 Expenses
Expenses included in Eq. 28.1 could be rewritten as
E+D+T where
E - operating expenses, including cost of inputs (such as cost of power in an electric utility), remuneration for labour and other administrative costs;
D - depreciation expenses; and T - taxes on income and other taxes
Thus Eq. 28.1 can be rewritten as n
pi qi = E + D + T + s.RB
(28.2)
i=1
28
Often cost of inputs dominate the operating expenses. For example in a power utility, the cost of power purchase and cost of power generation constitute the major operating cost. Employees cost and administration and maintenance (A&M) costs are the other two components of the operating costs. Cost of power being the most important element of cost of service, regulators tend to exercise some control on the price and quantity of purchase from various sources by establishing some economic rules. The scope for scrutiny of employee costs and A&M charges is quite limited. Although depreciation is included as an expense, it has a different character. Unlike other expenses, it does not constitute a cash outflow for the utility. The purpose of depreciation is to account for the wear and tear and obsolescence of the capital assets. The value of the assets declines over the economic life and this has to be recuperated from the consumers. The depreciation in a sense belongs to the owners and forms part of the return on investment. Accordingly, Kahn (1989) suggests that return on capital has two components: “return of the money capital invested over the estimated economic life of the investment and the return (interest and net profit) on the portion of the investment that remains outstanding.” These two components are inter-linked and hence, it is better to consider depreciation along with return on investment. Depreciation can be used to pay down the debt as the asset for which the capital was provided depreciates or, if the investment was made from equity, increase retained earnings or buy back equity. Taxes paid by the utilities are considered as part of their allowed expenses. Taxes paid in any year are influenced by the depreciation expenses because the depreciation rates for tax purposes are often different from that for the regulatory purposes. Two practices are normally followed in this respect: 5 flow-through accounting which involves the taxes actually paid in a year, and 5 normalised accounting which includes tax paid on average over the period of plant life. Normalised accounting removes the fluctuation of taxes due to depreciation rules and is commonly used.
28.2 · Traditional Regulation
817
28
28.2.1.2 Rate Base
The rate base essentially indicates the aggregate investment made by a regulated utility on which a return has to be allowed. The rate base largely includes net plant in service plus adjustments that vary with regulatory commission. Net plant is the gross value of the plant less accumulated depreciation already charged. In addition, the rate base may include cost of the inventory, work in progress and working capital allowance. The rate base is composed of physical assets and is different from the capital structure of a utility (Voll et al. 1998). In order to determine the rate base, the American regulators use two concepts: whether the assets were used and useful in delivering the goods and services offered by the utility; and whether the investment was prudent. A prudence test asks whether the investment or expense was prudent (least cost) given what the decision-maker knew, or should have known, when the investment was made. The used and useful test asks whether the investment or expense was (and is) necessary for the provision of supply. A commission may disallow any expense or asset that fails either test (Voll et al. 1998). The utility has the burden of proving to the regulatory body’s satisfaction that the plant in question has been used and was useful, and the investment was made prudently. The method of valuation of the rate base has been a major issue of debate. The assets are often valued at original cost less depreciation. On the other hand, economists often suggest valuation based on reproduction or replacement costs. The first method considers the value originally paid by the utility for its plant and equipment less accumulated depreciation. This information is easy to obtain and there is little debate over this data. The problem with this approach is that the cost of old plant might have been cheap but it will cost the utility much more to reproduce the same assets now. Hence, as economic principles suggest that prices should reflect current marginal costs, setting tariff based on historical costs may lead to too low prices. The replacement cost method on the other hand uses the cost to replace the capacity at today’s prices. This better reflects the cost of the plant and equipment but as no such accounting data is available in the records of the utility, the value is less amenable to regulatory verification. This method may also be illegal in some jurisdiction. It may be worthwhile to mention here that the relevant economic pricing principle is short run marginal cost, where the marginal cost is the variable cost. Hence the fixed cost does not enter into picture. When the regulators consider depreciation or rate of return, they essentially consider full cost or average cost pricing and not the marginal cost pricing (Kahn 1989). 28.2.1.3 Rate of Return
Equation 28.1 can be rearranged as follows:
(Revenue−Expenses) = Net income = s.RB
(28.3)
or, s = Net income/Rate base = Net Income/Investment, where investment is equal to rate base. Viewed from this angle, the rate of return is the income which investors are allowed to earn per unit of investment. The regulatory agency sets a rate of return (unless it is already set by the government in a law) and allows the utility an opportunity to earn on its investment. Depending on the actual performance (i.e. revenues
818
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Chapter 28 · Regulation of Energy Industries
earned, expenses incurred and investment made), the rate of return actually earned may deviate from the allowed rate of return. The utility is said to be “under-earning” when “s” actually earned is below that authorized and vice versa. The Commission may ask the utility to adjust the tariff in both the cases. In trying to fix a rate of return the regulatory agencies attempt to strike a balance between the interests of the investors and that of the consumers. According to Kahn (1989) “there is no single, scientifically correct rate of return, but a ‘zone of reasonableness’ within which judgment must be exercised.” The lower limit of this range is the requirement of the utility to be able to attract capital for investment. The upper limit could be the most profitable return that could be obtained from investments of similar type elsewhere (perhaps in a free-from competition environment). As can be imagined, this zone of reasonableness is quite broad. A typical approach towards determination of the rate of return begins with estimation of the cost of capital.4 This relies on the idea that the rate of return is the return on the investors’ and lenders’ capital. The return on the Rate Base should be sufficient to service the capital that was raised to provide the physical assets of the utility. This in turn requires an estimation of the costs based on the utility’s capital structure (i.e. its sources of funds: debt and equity capital). The estimation of cost of debt5 is fairly straightforward as the interest to be paid on debt is known in advance. This will be available in the debt agreement entered between the lenders and the utility. The annual interest payment to be made on the outstanding amount of the debt along with any other legitimate cost of borrowing provides the cost of debt. The calculation is normally done for each individual debt instrument, as the terms and conditions vary. The sum of interest payable divided by the outstanding amount of debt gives the weighted average cost of debt. The cost of equity is on the other hand more difficult to estimate. Utilities compete with other businesses for various inputs of the production process including capital. As the utility has to go to the capital market to sell its stocks, it should be in a position to pay the price at which investors are willing to supply the capital. The problem is then to determine what level of return do investors require in order to provide the capital for the utility’s needs. A number of methods are available for this purpose. The most common methods are: discounted cash flow (DCF), risk premium method and the capital asset pricing model (CAPM). The DCF is most common, and the risk premium method is used as a “sanity check”. The capital asset pricing model is less commonly used. Implementation of the methodologies requires different types and amounts of data, but all require considerable judgment on the part of the analyst. Discounted cash flow method6
Assume that the stock of a utility is currently traded at a price P. This price can be viewed as equivalent to the present value of the dividends expected by the investors. This can be written as: 4 5 6
Cost of capital forms part of an extensive literature in finance. We will not enter into the details of this here. Normally debt includes both short- and long-term debts unless a special provision is made to account for the cost of short-term debts. See Viscusi (et al. 2005) or Appendix A to Chap. 2 of Kahn (1989).
28.2 · Traditional Regulation
P=
D2 Di D1 + + ··· + + ... 1+k (1 + k)2 (1 + k)i
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where
P - price of stock, Di - expected dividend in year i k - cost of equity capital
From Eq. 28.5, the cost of equity capital is simply the discount rate used by the investors to reflect their time preference. This is the return on their next best opportunity at the same degree of riskiness. If investors expect their dividends to grow at a constant rate g, then
D2 = D1 (1 + g); D3 = D2 (1 + g) = D1 (1 + g)2
(28.6)
Substituting Eq. 28.6 in Eq. 28.5, we get
P=
D1 (1 + g) D1 (1 + g)i−1 D1 + + . . . + + ... 1+k (1 + k)2 (1 + k)i
Summation of the above series yields D1 1 P= (1 + k) 1 − (1+g)
(28.7)
(28.8)
(1+k)
Simplifying Eq. 28.8 and rearranging we get,
k=
D1 +g P
(28.9)
For example, if the current yield (D1/P) is 5% and the expected growth in dividends over time is 3%, the cost of capital is 8%. For the US, the data for dividends and stock prices can be obtained from sources such as Standard and Poor’s, the Wall Street Journal and Value Line. However, the measurement of yield and the growth expectation of dividend raises number of questions. Viscusi et al. (2005) indicate the following issues: 5 should the yield be measured as the last year’s dividend divided by the average stock price? 5 Should the growth be the average over past few years? If so, what is the surety that the future dividend growth will follow past trends? 5 Should the cost of capital be measured for a particular industry or for a group of industries with same degree of risk for investors? The calculation therefore depends on the analyst’s judgement, and hence could be controversial.
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Risk Premium
This approach attempts to determine what premium investors would expect over the going debt rate. Given that servicing debt takes precedence to paying dividends in case of a financial difficulty, equity is considered as a riskier investment than debt. Accordingly, equity should receive a higher return commensurate with the risk undertaken. The idea here is to estimate the premium that an equity capital should command. This is done by comparing the average equity price in the capital market and cost of risk free bond rates. The premium for equity thus obtained is a general reflection of the risk premium expected by the investors. In the utility industry, the average stock price may be different from the average stock price in the capital market. Thus a utility specific rate may also be determined. The premium together with the risk free rate gives the cost of equity capital. For example, if the risk free long-term bond rate is 5% and the risk premium is 4%, the cost of capital is 9%. CAPM
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The capital asset pricing model (CAPM) is another method of estimating risk premiums. The model uses a standardized formula for the calculation of the rate of return on equity as shown below:
re = rf + Beta∗(rm −rf )
(28.10)
where
re - is the rate of return on an equity r f - is the risk-free rate of return (e.g., government bonds) rm - is the market rate of return (i.e., the returns on equities in general) Beta - is the coefficient reflecting the volatility (risk) of the utility’s stock relative to the market
For example, if the risk free bond rate is 5%, market rate of return is 10% and Beta is 0.6, then the return on equity is 5% + (10–5) * 0.6 = 5% + 3% = 8%. As can be imagined, this method requires information on Beta and market rates of return. This is widely used by the financial investors but less commonly used by regulatory bodies. Weighted Average Cost of Capital (WACC)
The overall cost of capital is obtained by averaging the cost of debt and the equity by using their shares as weights. For example if the capital structure is composed of 80% debt and 20% equity, and the weighted cost of debt is 8% and the estimate of the required return to equity is 12%, “s”, the total overall cost of capital (WACC) is:
0.80 × 8% = 6.4% 0.20 × 12% = 2.4% Total overall = 8.8%
28.2 · Traditional Regulation
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This figure would then be used in determining the return component to be allowed in the revenue requirement. 28.2.1.4 Problems in Measuring the Cost of Capital
As indicated above, a number of problems are encountered while measuring the cost of capital. Following Kahn (1989), the following problems can be identified: (a) Whose cost of capital? In the utility regulation, the question that arises is whether the cost should be for the particular utility under consideration or whether it should be applicable to a representative group of companies. In case it is for an individual company, the issue of efficiency of the company will enter into picture. If it is well-run, it might have secured the funds at a cheaper rate but permitting lower return for this reason is penalising efficiency of the firm. The opposite argument can be true for inefficient companies. In case of a group of companies, the composition of the group needs to be determined. (b) Cost of capital at what time? Historical or current? This issue is similar to that of valuation. Before performing the cost of capital exercise, it needs to be decided whether we are interested in the cost of capital at the time of raising it (i.e. historical) or its present cost. In practice, the debt is estimated at the historical rate while equity is valued at current rate. Is this mixing appropriate or sensible? (c) Measuring cost of equity capital: As indicated above, the cost of equity capital is not easy to determine, because there is no objective measure of investors’ anticipated earnings. Current yields can either overestimate or underestimate the actual cost of capital. (d) Inconsistency between rate base and cost of equity: If the rate base is valued at book value (i.e. original cost less depreciation) and the rate of return on equity is based on the ratio of earnings to market price of the stock, the two factors are not determined in a consistent manner. (e) Effect of capital structure on cost of capital: It is generally agreed that the overall cost could be reduced by borrowing up to a certain level. This is because the cost of borrowed capital is an allowable expense for tax purposes, while the return on equity is subject to tax on profit. For example, if the cost of debt is 5% and that of equity is 10%, and if a utility wants to raise $100, borrowing adds only $5 to the cost. If the income tax on profit is 50%, the utility has to recover = 10/(1–0.5) = $20 from the charges, $10 for the stockholders and another $10 for the government. As the share of the debt increases, the utility has to pledge equally larger share of its income to service the debt. The cost of debt and equity would increase in recognition of this extra risk. This aspect is not considered in the cost of capital exercise. 28.2.2 Rate Structure Regulation
The objectives of rate design is to strike a judicious balance so that the tariff set becomes economically efficient and fair prices and at the same time it provides the regulated utility a reasonable opportunity to recover costs including return on investments. Often regulators attempt to achieve a number of competing objectives while setting tariffs, including (Weston 2000):
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Chapter 28 · Regulation of Energy Industries
. Table 28.1 Classification of functionalised costs for an electric utility Cost items
Demand related
Energy-related
Power cost
Y
Y
Transmission
Y
Y
Customer-related
Distribution -related Wages
Y
Y
Depreciation
Y
Y
A&M
Y
Y
Return
Y
Total
A
B
C
Note Y—relevant, A, B and C are totals of each column
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5 revenue related objectives such as cost recovery, predictable and stable revenues, predictable and stable rates; 5 cost-related objectives such as rates to promote efficient consumption decision, fair rates without undue discrimination, etc.; 5 practical considerations such as simple, understandable and acceptable rates, ease of administration, non-controversial rates, etc. Once all the elements on the right-hand side of Eq. 28.1 are available, the total revenue requirement is determined. The next step involves allocating the costs to various consumer categories and designing tariffs to be charged for their consumption. The cost allocation process attempts to attribute costs to various classes of consumers so as to reflect the cost of providing utility services to each class. Tariff design on the other hand involves deciding the mechanism of recovering the allocated costs. As in any design, tariff design goes beyond economic aspects and involves non-cost issues as well. The cost allocation process involves three steps: cost functionalisation, cost classification and cost allocation to customer classes. Cost functionalisation entails separating costs according to different functions undertaken by the utility. For example, an electric utility performs generation or purchase of electricity, transmission, distribution, retail supply, customer service and administration and general functions. Costs for each function have to be identified. Cost classification involves attributing the functionalised costs by cost causation. In an electric utility, demand related costs, energy-related costs and customer-related costs are typically identified. Costs that vary with load (kW) are considered as demand-related. Costs that vary with energy consumption or supply are considered as energy-related costs. Costs that vary with the number of consumers served are classified as customer-related costs. An example is given in . Table 28.1. Allocation of classified and functionalised costs to consumer class is the last step of the cost allocation process. Consumers of a utility are grouped under broad categories
28.3 · Problems with Traditional Regulatory Approach
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based on their characteristics (such as load, voltage of supply, whether interruptible or not, etc.). The costs are then allocated to each class of consumers using some allocation principle (for example fairness, contribution to the cost causation, etc.). There are two commonly-used cost-based methodologies for allocation: embedded cost (or fully distributed cost) approach and marginal cost approach. The embedded cost approach uses historical accounting information while the marginal cost approach uses the economic theory of marginal costs for the allocation. According to Parmesano et al. (2004), there is neither any universally accepted principle nor any engineering or economic theory guidelines for classifying and allocating costs using an embedded cost approach. However, the following factors are often used: (1) type of generation plant, (2) planning and operating constraints, (3) load patterns faced by the utility, (4) system load factor, (5) contributions of the classes to the total demand, (6) kilowatt-hours purchased by each class as a percent of total sales, (7) the number of customers in the class as well as many other factors and combinations thereof (Parmesano et al. 2004; Voll et al. 1998). In the marginal cost-based approach, the marginal cost of supplying each consumer class is determined. The expected revenue from the marginal cost-based tariff is then compared with the overall revenue requirement. The gap, if found, is then closed using alternative schemes (fixed charges or Ramsey pricing). Rate makers often confronted with the issue of fairness of rates in the sense of whether one group is subsidising another group. This equity dimension of the problem, while often ignored in theoretical literature, is of great importance for practical tariff setting. As the embedded cost approach uses cost allocation factors without any theoretical backing, they often tend to be controversial in this respect. Similarly, economic efficiency may sometimes require pricing different consumers differently, which may be in conflict with common notions of fairness. We turn to such a case which is commonly known as peak-load pricing. 28.3 Problems with Traditional Regulatory Approach
A number of problems related to the traditional regulatory approach have been identified in the literature. Some of these are discussed below: (a) cost minimising behaviour: one of the objectives of regulation is to ensure market like decision-making in a regulated industry. In a competitive market, competition ensures that the firm minimises its costs. Efficient firms receive rewards in the forms of high profits while the inefficient ones are punished by low profits or losses. In a regulatory environment, there is no incentive for the regulated utilities to minimise costs below that allowed by the regulator, as the rate of return is regulated. As indicated earlier, it is difficult for the regulatory agencies to scrutinise all expenses incurred by a utility without assuming the managerial role of the utility, which is clearly beyond the scope of the regulators. In fact, the regulatory mechanism creates strong incentives to inflate expenses at no cost to stockholders (for example offering higher salaries and expenses to management) and to engage in transactions with affiliates (Kahn 1989).
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Chapter 28 · Regulation of Energy Industries
However, regulatory lags tend to mitigate the above problem to some extent. Regulatory lag refers to the time delay between two consecutive cases for tariff determination. Once a tariff is set, it remains in force until a new tariff is determined. During this intervening period, the utility may earn higher profits by reducing costs and keep the higher profits. Thus rate freeze provides some incentive to the utilities to be cost efficient. Moreover, regulators tend to allow the utility to earn profits within a ‘zone of reasonableness’, which also provides a similar benefit (Kahn 1989). A similar mitigation effect is arises due to the threat of disallowed costs. Regulators can disapprove costs that are considered as unreasonable. This tends to keep a check on the costs. (b) Lack of recognition of efficiency: Regulators while deciding the rate of return often do not pay much attention to the performance of the utility. If a utility is able to attract low cost capital, the rate of return allowed to it will be low, which does not recognise the efficiency of the management in attracting low cost capital. Return is not linked to performance in the case of regulated utilities, which does not provide correct signals to the players. (c) Averch-Johnson Effect: A traditionally regulated monopoly may engage in socially undesirable investments (i.e. social costs may be higher than the social benefits) because such investments can allow them to earn higher returns due to expanded rate base and higher cost of capital. Such investments can also allow them to charge higher rates to recover revenue deficiencies arising out of such investments. These incentives can encourage them ‘(1) to adopt an excessively capital-intensive technology and (2) to take on additional business, if necessary at unremunerative rates’ (Kahn 1989). Although the above claims proved to be difficult to be verified empirically, Kahn (1989) has listed a number of areas which might be influenced or might result due to the Averch-Johnson (A–J) effect. These include: 5 unwillingness of utilities to adopt peak-load pricing, which reduces peak demand and thereby reduces capacity expansion needs; 5 desire to maintain a large reserve margin7; 5 resistance to adopt integrated regional capacity investment planning and integrated form of power pooling. 5 Resistance to the introduction of capital saving technology; 5 Resistance to lease facilities to others; 5 Adopt an excessively conservative reliability standards for generation, with implications for high cost of assets and reserve margins; 5 Less hard bargaining tendency when purchasing equipment from others; 5 A tendency to reach out to expand business, even at unremunerative rates. (d) Problem of inter-company co-ordination: Technological progress brings new opportunities for business and scope for cost reduction. For example, electric utilities can benefit from scale economies and diversified plant mix by using
7
Reserve margin is the excess capacity over peak demand which is maintained to tide over emergency conditions.
28.4 · Regulatory Alternatives
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interconnected transmission system and by entering into power pooling and interchange arrangements. These arrangements allow them to use larger generating plants, to reduce costs of operation and to achieve higher capacity utilisation (Kahn 1989). In a competitive market, players will seize such opportunities by entering into agreements or through mergers and acquisitions. However, traditional regulation may not be successful in ensuring such inter-company co-operations due to lack of adequate incentives or due to passive or negative nature of regulation. (e) Interventionist nature of regulation: RoR regulation requires time consuming detailed scrutiny of the costs and income of the utility. The regulator also tends to ask whether the decision of the utility was prudent and reasonable. Regulators also try to direct the utility what to do and what not. By nature, this form of regulation tends to be interventionist and heavy handed. (f) Cost of regulation: RoR regulation tends to impose high costs on both sides. On the regulatory side, it requires scrutiny while the compliance cost of the utility is also high. The determination of rate base and cost of capital, regular reviews and hearings and subsequent litigations (where they arise) impose cost burdens on the participants (Intven 2000). (g) Lack of innovation: RoR regulation does not provide the utility with a strong incentive to develop innovative products, as there is no incentive for doing so. 28.4 Regulatory Alternatives
A number of regulatory alternatives could be identified from the literature. They include: cost of service regulation, incentive regulation, conduct regulation and regulation by contract. Cost of service (the old style regulation) regulation has been discussed earlier and will not be discussed here. We discuss the three other alternatives below. 28.4.1 Incentive Regulation
Incentive regulation has been defined as “the use of rewards and penalties to induce the utility to achieve desired goals where the utility is afforded some discretion in achieving goals” (Berg, undated). The above definition has three important components: first, the system of rewards and penalties replaces the command and control form of regulation; second, the goals are not unilaterally decided by the regulator but the utility assists in deciding the goals; and finally, the utility decides how to achieve the goals as opposed to regulator prescribing specific actions (Berg, undated). Joskow (2014) provides a detailed presentation of the theoretical underpinning of the incentive regulation and its application to the energy sector. He argues that the incentive regulation was infrequently used earlier because of the absence of a theoretical framework supporting it. But the developments in economic theory, particularly the work of Tirole and Laffont (1993), have overcome this weakness.
Chapter 28 · Regulation of Energy Industries
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A regulator intending to set optimal pricing for the regulated firms faces imperfect and asymmetric information problems. The regulator may not know the cost opportunities of the firm and the behavioural attributes of the managers in realising the expenditures. Managers’ efforts are not visible and lower effort can lead to higher costs and vice versa. The firm would try to convince the regulator that it is a high cost firm and if successful, it will be able to capture consumers’ surplus and generate extra profit. This leads to the adverse selection problem in that the regulator is trying to distinguish the high cost firms from the low cost ones while adhering to a firm budget balance constraint that must be satisfied by either type of firm. In addition, there is a moral hazard problem as well. If the firm finds that the tariff does not allow it and its managers to earn rent, the managers may play golf instead of achieving the efficient operating levels for the firm. The regulator needs to avoid this situation as well. Joskow (2014) then formulates the regulatory problem using two polar cases: the first option is to set a fixed price ex ante mechanism which can be thought of as a pricing formula that adjusts for exogenous changes in input price indices and other exogenous indices of cost drivers. A fixed price regulatory contract or a price cap regulatory mechanism could fit such a pricing mechanism. As prices are fixed and do not vary depending on the managerial efforts, the managers and the firm have the highest incentives to economise on costs and retain the profits. While this eliminates the moral hazard problem, the regulator needs to set a high enough price to ensure that the regulated firm is able to recover its costs if it is a high cost firm. Accordingly, this mechanism performs poorly in terms of adverse selection. At the other extreme is a cost of service contract where the regulator compensates for all of its costs and does not allow any further rent to be captured. This addresses the adverse selection problem but it does not provide any incentives to the firm to optimise its managerial efforts. This mechanism commits the moral hazard problem. Thus the optimal solution lies somewhere in between which will allow a profit sharing mechanism or a sliding scale regulatory contract. The main idea is to make the business profitable for the different types of firms (high cost or low cost) by giving them opportunities to choose appropriate levels of effort through an incentive mechanism. A simple mathematical formulation to capture the above idea is indicated in
R = a + (1 − b)C
(28.11)
where
R - firm’s allowed revenues; a - fixed component; b - sharing parameter C - firm’s realised costs
Under a fixed price contract or price cap regulation, a = C* where C* is the regulator’s assessment of the ‘efficient’ costs of the highest cost type and b = 1. Under pure cost-of-service regulation, a = 0, b = 0 Under a profit-sharing contract or sliding scale regulation, 0