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Quantifying Worldwide Demand Elasticities As a Policy Tool Quantifying Worldwide Demand Elasticities as a Policy Tool Tarek Atalla, Simona Bigerna and Carlo Andrea Bollino August 2016 KS-1644-DP038A Quantifying Worldwide Demand Elasticities as a Policy Tool 1 About KAPSARC The King Abdullah Petroleum Studies and Research Center (KAPSARC) is a non-profit global institution dedicated to independent research into energy economics, policy, technology, and the environment across all types of energy. KAPSARC’s mandate is to advance the understanding of energy challenges and opportunities facing the world today and tomorrow, through unbiased, independent, and high-caliber research for the benefit of society. KAPSARC is located in Riyadh, Saudi Arabia. Legal Notice © Copyright 2016 King Abdullah Petroleum Studies and Research Center (KAPSARC). No portion of this document may be reproduced or utilized without the proper attribution to KAPSARC. Quantifying Worldwide Demand Elasticities as a Policy Tool 2 Key Points his paper provides a comprehensive worldwide database of estimated elasticities for electricity and natural gas for households as a function of income, price, capital stocks and weather conditions. TEmerging economies show lower price elasticities than advanced economies as a result of limited physical capital availability and lock in effect pertaining to energy consumption. Hot weather has a higher impact on energy demand in emerging economies than in advanced ones, as a result of higher efficiency and diversified technologically-advanced equipment. We find that the energy demand elasticity to capital stock is positive implying that the rebound effect prevails over the substitution effect when it comes to the deployment of capital stock technologies. For most countries, including former Soviet Union economies, natural gas is considered as an essential good while electricity is perceived, economically, as a luxury where its income elasticity is above unity. Quantifying Worldwide Demand Elasticities as a Policy Tool 3 Summary nderstanding how energy demand responds Our econometric estimation provides new refined to prices changes is crucial for policymakers quantitative evidence on the impact of changes in around the world. Elasticity is a quantitative prices and income on energy demand. Specifically, Umeasure of this response. This subject has been we found that the aggregate energy elasticity to widely analyzed in empirical studies, but the quality price has a world average of 0.19 and the electricity of the results varies, leading to limited comparability elasticity to price is between -0.10 and -0.20 for most across countries. countries, meaning that both energy and electricity have limited price elasticity. The study found that In this paper, we provide a new and more accurate emerging economies have a lower energy demand approach to estimate aggregate energy demand price elasticities than advanced ones. In addition, the elasticity for 117 countries. The model that we have intra-fuel analysis shows that natural gas is generally developed provides a coherent and integrated perceived as more of an essential good than empirical tool for policymakers to quantify how electricity, especially in less developed economies. energy demand responds to policies. The model This is partly due to the fact that natural gas is mostly allows simultaneous variations of prices, income and used for essential needs such as heating and cooking. capital stock or productive capacity, while including We found that the demand elasticity for cooling climate conditions as an uncontrollable factor. needs is triple that of heating, which means more final energy is used for cooling than heating on a per Our approach is unique in accurately estimating capita level. Yet people in richer countries are rooted demand response to prices by explicitly modeling a in their comfortable lifestyle when it comes to their utility-maximizing rational behavior for consumers heating needs, resulting in positive gas elasticity in each of the countries studied. This implies a to heating degree days. This is aligned with the better estimation of the energy demand function general observation that countries with natural gas as it is computed using a structural model based endowments prefer to maximize its usage. These on a simultaneous system of equations, thus findings have welfare-improving policy implications, avoiding potential econometric bias in the resulting because appropriate policy strategies can help parameters. decision-makers to promote production efficiency and consumer welfare. Quantifying Worldwide Demand Elasticities as a Policy Tool 4 Policy Insight ur work quantifies how consumer energy to the demand elasticity, meaning that an increase demand responds to changes in key in tax may result in lower consumption and hence variables, such as income, prices, lower-than-expected revenue. Very elastic behavior Ocapital stock availability and climate conditions. could have the contrarian effect of reducing The calculated response factors are known as government income. Quantifying distortions due to demand elasticities. Policymakers can use demand taxation can be a difficult task, hence the application elasticities in many ways, including in designing of our elasticities can help in the development of efficient price policies and in setting fuel subsidy better calibrated policies. and taxation levels. Another sensitive issue for policymakers is funding Public authorities alter the prices of goods in a limitations and the associated efficiency-equity number of ways. In some cases, they administer trade-off. Many pricing policies have a role in prices for an entire class of products or subject them improving the living conditions of poor households, to uniform taxes or subsidies. Tobacco and energy but usually impose a societal cost in terms of are typical of this first type of price control. In such market inefficiency. The reverse is also true; cases, the demand elasticity is useful for assessing when implementing policies to promote economic how consumption might change with prices: for efficiency, the poorest in the society often get hurt. example, increasing tobacco excise duties or raising gasoline prices. At one level, the policy maker needs instruments to measure inefficiencies in the market caused by tax In other instances, they focus on the price of only distortions or imperfections, such as externalities one particular good and leave the prices of others and non-competitive market behaviors. In this within that class to market forces. Bread and respect, demand elasticities are useful to construct pharmaceuticals may provide examples of this the minimum distortion pricing policy (the so-called second type of price control. Here, only the basic Ramsey pricing), a cornerstone of the efficiency- type of bread would be subject to a price cap to ensure that poor households could afford a basic equity trade-off. On another level, the same policy need. In the case of pharmaceuticals, a basic class maker needs to assess the economic impact of of active ingredient might be the target for policy equitable intervention, like price subsidy to the poor action. All other types of bread and pharmaceuticals and elderly. The maximum equitable solution is the would have free prices, so overall demand would other cornerstone of the efficiency-equity trade-off. be the sum of the quantity consumed under the administered price plus the quantity consumed Our model of estimated demand elasticities under the free market pricing regime. can provide a quantitative assessment of policy interventions on energy prices, income and capital Policy goals can also revolve around raising formation in the household sector. In addition, revenues through price taxation. In this case, the our model can quantify the effect on energy policy maker must know the associated demand consumption of specific climate conditions across elasticity to make accurate budget forecasts. The the world, allowing cross-country comparison net of quantity consumed changes with price according the differences in natural climate conditions. Quantifying Worldwide Demand Elasticities as a Policy Tool 5 Background Review ost previous studies are based on the are modelled as the sum of residential electricity single demand estimation, assuming a and gas consumption. The model assumes that all partial equilibrium viewpoint and neglecting consumers in the market are cost minimizers, but Mthe simultaneity of consumer decision processes still demand a diverse basket of goods. We further (Hodge and Dahl, 2012; Labandeira, 2012). This implement a multistage optimization process, approach is at variance with observed behavior, which uses the minimum number of parameter especially considering the complex relationships requirements while remaining flexible in modeling among consumer goods and services, as complex demand behavior and acknowledging that households optimize their consumption under a both capital and climate conditions affect demand constrained budget. choices. Previously published works used weather conditions This research improves on existing literature in three or capital stock as a regressor, or explanatory ways. First, we improve upon the single equation variable, in the estimation of a single energy approach in the energy and electricity market (e.g. demand function, typically as a production input Bernstein and Griffin, 2006 among others), taking at all aggregation levels. Their primary interest into account work on consumers’ energy demand, was usually the causal
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