Download Fossil Fuel Supply and Demand

Topic 2: Fossil Fuel Supply and Demand: E¤ect of
Subsidies and Taxation
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Introduction
This topic follows strategy I plan in using in this course
A bit of economic theory in the context of a particular energy market
plus a case study
Here Supply + Demand for fossil fuels
But we will also use Supply+Demand ideas useful in other energy
markets
E¤ect of taxes and subsidies
Case study: e¤ect of fossil fuel subsidies (general theory plus focus on
a few speci…c countries)
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Supply and Demand
Supply and demand graphs are a basic tool for many economic
problems
Involves Q = quantity bought and sold (produced and consumed)
P = price
Supply = what is produced/sold by companies/…rms
Demand = what is consumed/bought by consumers
The quantity …rms supply increases with price
E.g. price of coal goes up, miners produce more coal
Quantity consumed decreases with price
E.g. price of coal goes up, electricity generators buy less coal (switch
to gas)
Next slide illustrates this in Supply-Demand graph
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Price
Demand Curve
Supply Curve
Quantity
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Supply Equals Demand in Equilibrium
Demand curve: for each price, how much will consumers buy?
Supply curve: for each price, how much will producers produce?
Equilibrium price: quantity demanded equals quantity supplied
Why?
If price too low, then producers will not produce enough to meet
demand
Excess demand means price will be driven up
If price too high, the consumers won’t buy as much as producers want
to produce
Excess supply means price will be driven down
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Price
Demand Curve
Supply Curve
P-equilibrium
P-low
Q supplied
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Q demanded
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Quantity
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Example: What In‡uences Supply for Coal?
Supply depends on price of coal (movement along the supply curve)
Other factors will shift entire supply curve
Factor in‡uencing costs of production (e.g. wages, etc.)
In longer run, technology and geology in‡uence supply curve
E.g. mine cheapest seams of coal …rst before digging deeper for more
expensive
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Example: What In‡uences Demand for Coal?
Depends on price of coal (movement along the demand curve)
Other factors shift entire demand curve
Coal is heavily used for electricity generation
Anything that in‡uences demand for electricity will also a¤ect coal
Weather (home heating, electricity for air conditioners, etc.)
State of the economy: industry uses a fair degree of coal directly or
indirectly as electricity
Price of alternative fuels
In relation to alternative fuel prices, introduce some terminology on
next slide
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Electricity generating companies often own both gas and coal
generating plants
These depend on prices of fuels and in‡uence demand curve
Spark spread = pro…t margin per unit of electricity produced using gas
Dark spread = pro…t margin per unit of electricity produced using coal
Switch production depend on so-called spreads
Also including price of CO2 emissions leads to “clean” dark/spark
spreads
Hot issue: in US natural gas price very low, electricity generation
switching to gas, hurting coal miners
Glut of cheap US coal bought by German electricity generators
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Government Actions Can In‡uence Supply and Demand
Example: EU-ETS requires electricity generating companies to buy
carbon permits
Electricity generation from coal releases more CO2 than generation
from other sources
Carbon price rises implies coal generation becomes more costly
How would this appear in a supply-demand graph?
Shift demand curve down
Why?
Electricity generators are demanders of coal
At any price level demand less (the e¤ective price of coal they pay has
increased since higher carbon price)
Result: equilibrium price and quantity of coal falls
Note: this is what is happening in US to coal industry now due to fall
in natural gas price
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Price
Original Demand Curve
Supply Curve
Original P
New P
New Demand Curve
New Q Original Q
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Government Intervention: Price Supports
Price support: Set minimum price for coal.
If market price above price support, no e¤ect
If market price below, the government must intervene buying coal to
force price up to price support
Alternatively, governments sometimes set maximum price for fossil
fuels (to protect consumers)
If market price above minimum price, excess demand (black market,
corruption)
Supply-demand graphs can be used to show these
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Government Intervention: Subsidies
Subsidies:
E.g. for each ton of coal produced the government will pay 10 Euros
Or for each 1 Euro of coal you sell, the government will pay an extra
10%
Subsidies are the opposite of energy taxes so I will defer graphs until
taxes discussed
Price supports/subsidies common in Europe in the past (particularly
in the coal industry)
Declining slowly (but even in 2001 Germany was spending almost $5
billion on coal subsidies)
Protect coal industry and jobs
Hot issue: economic consequences of energy subsidies in developing
world
Return to this issue shortly
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Government Intervention: Taxation
Fossil fuels are typically heavily taxed in various ways, including:
Corporation tax (tax on pro…ts as paid by any company)
Severance taxes (popular in US, sometimes called ad valorem taxes)
E.g. percentage of value of coal produced.
Royalties
VAT and other taxes paid by consumers, etc.
Many other taxes
To give a ‡avour of the types of tax regimes, faced by fossil fuel
companies I will give a few examples
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Hot Issue: UK Taxation of North Sea Oil
From budget statement on 23 March 2011:
Chancellor of the Exchequer announced increase in the
‘supplementary charge’paid by companies involved in North Sea oil &
gas production. North Sea companies pay corporation tax on their
pro…ts from oil and gas extraction in the UK and the UK Continental
Shelf. In its 2002 Budget the Labour Government introduced a
supplementary charge on pro…ts set at 10%, and this was increased to
20% in January 2006. In his Budget speech Mr Osborne argued that
the rise in oil prices since this reform had provided unexpected pro…ts
for the oil companies, and that it was fair to set the supplementary
charge at a new rate of 32%.
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But one year later and after sharp fall in North Sea Oil exploration...
From the Financial Times (22 March 2012)
North Sea groups welcome Budget’s change of tax:
A year on from a £ 2bn raid on North Sea pro…ts, industry operators,
suppliers and advisers have expressed satisfaction with changes made
in this week’s Budget to the taxing of those involved in UK oil and
gas production. That raid, used in part to …nance a 1p a litre
reduction in fuel duty, raised the marginal tax rate facing operators of
…elds to between 62 per cent and 81 per cent....
Note: this tax change related to relief for decommissioning
(dismantling rigs and wells once oil and gas …elds run dry)
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Russian Taxation of Foreign Oil and Gas Companies
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Angola Treatment of Foreign Oil and Gas Companies
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Other Types of Taxes
But it is not just fossil fuel companies which pay taxes
Companies which use fossil fuels (e.g. electric utility companies) pay
taxes
Consumers also pay taxes
Rich countries tend to tax petrol (see next slide)
But many poor countries do the opposite – subsidizing consumption
of fossil fuels
In sum, variety of taxes/subsidies which impact in various ways
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Example: Petrol Taxes in OECD Countries
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Taxation in a Model of Supply and Demand
Taxes on producers will shift the supply curve
Taxes on consumers will shift the demand curve
Remember: subsidy is the opposite of a tax so shifts in opposite
direction for subsidies
But, before showing e¤ects of tax, I will show how supply-demand
graphs can be used to measure pro…ts and welfare:
Producer surplus and consumer surplus
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Consumer Surplus
Consumer surplus is the total bene…t consumers get from consuming
a product
It is the area above the price charged in the market and below the
demand curve (a triangle)
Why?
Economists think marginally (one unit at a time)
Demand curve plots marginal bene…t to consumers of each unit
consumed
What are consumers willing to pay for …rst unit? Point on demand
curve above quantity=1
What are consumers willing to pay for second unit? Point on demand
curve above quantity = 2, etc.
Add up all these marginal bene…ts to get total bene…t = consumer
surplus
See next slide
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A
Demand Curve
Consumer Surplus is
Triangle ABC
Price
B
C
Quantity
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Producer Surplus
Producer surplus is the total bene…t producers get from producing a
product (rent)
It is the area below the price in the market and above the supply
curve (a triangle)
Why? Similar reasoning to consumer surplus
Supply curve re‡ects marginal cost
What does producer get for producing 1st unit? Price (=B in graph)
What does it cost producer? Point on supply curve for Q=1
Di¤erence between these two is pro…t for producer
Adding up for 1st unit, 2nd unit, etc. get producer surplus triangle
See next slide
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Price
Supply Curve
B
C
Producers Surplus is
Triangle BCD
D
Quantity
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Consumer and Producer Surplus in Equilibrium
Now let’s put it all together in a supply-demand graph
Equilibrium price and quantity determined where supply and demand
intersect
Total bene…t = producer plus consumer surplus
See next slide
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Price
A
Total Benefit = Cons + Prod Surplus
= Triangle ACD
Demand Curve
Supply Curve
B
C
D
Q
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The E¤ect of a Tax on Demand, Supply and Consumer
and Producer Surplus
Now let us return to the e¤ect of a tax
In previous example (EU ETS) considered a tax on consumers of coal
(electricity generating plants)
Now consider a tax on suppliers
This will shift supply curve up
Why? Supply curve re‡ects marginal costs, if taxes go up costs will go
up
Next slide illustrates this
Tax will cause price to rise from B to B*
Quantity produced will fall from Q to Q*
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Price
A
B*
Supply Curve With Tax
Demand Curve
C*
B
Supply Curve
C
D*
D
Q*
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Q
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The E¤ect of a Tax on Demand, Supply and Consumer
and Producer Surplus
But what will happen to consumer and producer surplus?
In preceding slide, they both shrink
Consumer surplus falls from ABC to AB*C*
Producer surplus falls from BCD to B*C*D*
Government gains tax revenue which partly balance these losses
But can show (count areas in graph) that there is still a deadweight
loss from taxation
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Who Bears Burden of a Tax?
Burden of taxation depends crucially on shape of supply/demand
curves
Elasticity is usual way of talking of shape of these curves
Elasticity of supply = percentage change in supply caused by one
percent change in price
Elasticity of demand = percentage change in demand caused by one
percent change in price
Inelastic if elasticities are near zero
Think of elastic as “sensitive” – so “inelastic” = “insensitive to
changes in price”
Note: obtaining estimates of this is important, useful for forecasting
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Who Bears Burden of a Tax if Demand is Inelastic?
What if demand is insensitive to price?
Always need oil for cars, etc.
IMF report claims very low price elasticities of oil
“10 percent permanent increase in oil prices reduces oil demand by
about 0.7 percent after 20 years”
Suppose oil production is less inelastic (e.g. Saudi Arabia has excess
production capacity so can adjust production easily to changes in oil
prices)
E¤ect of tax: price rises much more than before
Output falls very little and producer’s surplus falls only a little.
In case of perfectly inelastic demand, tax is simply passed on for
consumers to pay with no e¤ect on producers
Consumers bear burden of tax
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Price
A
B*
B
Supply Curve With Tax
Inelastic Demand
Curve
C*
Supply Curve
C
D*
D
Q* Q
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Who Bears Burden of a Tax if Supply is Inelastic?
What if supply is insensitive to price?
E.g. coal producers have large …xed costs and di¢ cult to adjust
production when prices change
Suppose demand for coal by consumers is less inelastic
E.g. Electric utility companies consumers of coal and can switch to
gas easily
E¤ect of tax: price rises less than before
Output falls more than before and consumer surplus falls only a little.
In case of perfectly inelastic supply, full burden of tax borne by
producers
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Supply Curve With Tax
Price
A
Demand Curve
C*
Inelastic Supply Curve
B*
B
C
Q*
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Q
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Case Study: Fossil Fuel Subsidies
In their 2010 World Energy Outlook, the IEA says: “Fossil-fuel
subsidies result in an economically ine¢ cient allocation of resources
and market distortions, while often failing to meet their intended
objectives”
In this case study, we will examine the IEA’s case
From our supply-demand graphs have shown deadweight loss of
taxes/subsidies
This leads to “ine¢ cient allocation of resources and market
distortions”, but IEA makes some additional points...
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Common Types of Subsidies
There are many types of subsidies to fossil fuels.
A few examples:
Price controls
E.g. Venezuela law: petrol must be sold for equivalent of 3 cents per
litre
Tari¤s of import of competing fuels
Laws which say, e.g., domestic coal must be used for electricity
generation
Implicit subsidies to producers (e.g. favourable tax deductions for oil
and gas …elds, government taking on risk for accidents,
decommissioning, etc.)
etc.
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Why Do Governments Subsidize Fuels?
Alleviating energy poverty
Security of energy supply
Redistribute nation’s resource wealth widely
Protecting employment in energy industries
Protect the environment (more relevant for renewables, such as UK’s
subsidy of wind power, will discuss in detail later in course)
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Why Does IEA Not Like Fossil Fuel Subsidies?
Encourage wasteful consumption
Hasten the decline of exports (for producer nations)
Encourage fuel adulteration, smuggling and corruption
Discourage investment in energy infrastucture
Disproportionately bene…t middle class and rich
Drain state budgets
Distort markets (and, in case of fossil fuel subsidies, discourage
development of clean energy)
Increase CO2 emissions and pollution
Encourage volatility in world energy prices by dampening price signals
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IEA’s Justi…cation?
Most are self-evident, but I will elaborate on a few
Note …rst, that economists would argue:
If you want to help the poor, more direct methods better
Type of claim in countries with cheap energy: “If we have lots of oil,
costing $5 per barrel to produce, why should our consumers be paying
more for our oil?”
Economists argue: “Better to sell your oil for $50 per barrel on the
international market. Can show your country will be better o¤ as a
whole if you do this.”
Note: students of economics will know the economic theory
underlying this (gains from trade, comparative advantage, markets are
e¢ cient, etc.), but I will not explain in detail
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Why Might Price Controls Lead to Corruption and Related
Problems?
This can be shown in our initial supply-demand graph
Setting too low a price leads to excess demand
Can make money by trying to satisfy this excess demand
Black market in fuel
Smuggling of cheap fuel to neighbouring country without fuel
subsidies
Recent issue: Argentinian nationalization of YPF (previously owned
by Spanish company Repsol)
Repsol accused of lack of investment/development of resources
Repsol said Argentinian price controls made it uneconomic to invest
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Why Is Volatility of Energy Prices A¤ected by Subsidies?
E.g. what if price of oil (on international market) very di¤erent from
price of oil paid by consumers?
Demand for oil then becomes inelastic
Consumers of oil protected from changes in world oil price and, thus,
do not change their demand with world oil price increases
But look back at our graph with the inelastic demand curve
In it, small shifts in the supply curve cause big changes in world oil
price — increased volatility
Prices can signal useful information (e.g. to resolve a shortage,
conservation is useful), but dampening price signal to consumers
useful information is lost
In early 2008, petrol prices were rising, 2/3 of 131 countries did not
fully pass this price rise on to consumers
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How Big are Energy Subsidies and Where are They Most
Prevalent?
See next three slides
Short answer: They are BIG and mostly in the poor countries which
can least a¤ord them.
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How Much Fuel Could be Saved by Eliminating Subsidies?
IEA estimates that removing fuel subsidies would:
Lead to many bene…ts including:
Saving of oil (particularly in transportation)
Reduction in CO2 emissions (almost halfway to reaching the 450
Scenario)
See next three slides
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Fossil Fuel Subsidies Still in the News
E.g. Financial Times, September 16, 2014
Growth and …ghting global climate change not incompatible
New Climate Economy Report (commissioned by UK, South Korea
and …ve other countries including Ethiopia and Indonesia).
Recommendations: wealthy countries immediately stop building new
coal power plants and all countries phase out fossil fuel subsidies now
valued at about $600bn a year, compared with $100bn for clean
energy subsidies.
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Case Study Topic
In this course, you are asked to do two essays/case studies/projects
The …rst one will be on a speci…c country, second one on a speci…c
policy/issue
The IEA’s World Energy Outlook for 2010 has much more on energy
subsidies, including
Country subsidy pro…les for Iran, Russia, India and Indonesia
Case study: detailed study of energy subsidies in these countries
Discussion of themes in this lecture with detailed facts/experience of
one country
Have things changed since 2010?
The IEA’s World Energy Outlook for 2014 has a section on subsidies
Focus on particular aspect (e.g. impact of energy subsidies on CO2
emissions)
Or broaden beyond subsidies only for general discussion of energy
policy in one country
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Summary
This lecture introduced some basic economic theory: supply+demand
(consumer/producer surplus and elasticities)
Focussed on supply and demand for fossil fuels
Taxation/subsidies are very important in international energy markets
Factors which determine the impact of taxes/subsidies
Possible case study topic: world energy subsidies
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