Download Energy Economics prof Stef Proost Chapter Economics of non

Energy Economics prof Stef Proost
Chapter Economics of non renewable resources
. Objectives and outline
Oil, gas and coal are considered as non renewable resources. There stock is limited and it is
increasingly costly to produce them. In this chapter we explain briefly what the theory of
nonrenewable resources can offer as insights. The detailed application to the three primary
resources is left for later chapters. This chapter also prepares for chapters and where we
discuss the climate change problem, environmental externalities and sustainability in the
presence of exhaustible energy resources and long term environmental problems. The key
questions we want to address in this chapter are . What makes a given resource exhaustible
. How to use optimally exhaustible resources save them for later or use them now . How is
the switch between exhaustible and nonexhaustible resources operated . Would profit
maximizing resource owners take the right decisions . How would new information about the
resource stock or future demand affect price levels and production profile over time . This is
to a large extend knowledge derived from theoretical propositions, has this theory been
verified for particular resources Section classifies resources into exhaustible and non
exhaustible resources. Section gives some data on energy reserves. Sections , and analyze
the optimal allocation of exhaustible resources over time. Section studies how markets
allocate resources over time. Section concludes with a brief review of empirical tests of the
theory.
Energy Economics prof Stef Proost
. Classifying resources
The exhaustibility of a resource can be determined using the simple decision criteria of Table
. Natural Replenishment
No nonrenewable resource Recyclable Yes copper, gold No oil, gas, coal
Yes renewable resource Depends on human activity Yes water, biomass No sun, wind
Table . Definition of non renewable resources Within the category of non renewable
resources, two dimensions matter for the classification of resources the cost of producing
them vertical axis in Table . and the geological probability that they exist horizontal axis in
Table ..
Table . Classification of resources into reserves
Taken from Tietenberg T., Environmental and resource economics, Addison Wesley, , the
edition, page
Energy Economics prof Stef Proost The vertical economic dimension has two categories,
economic current price is larger than the marginal production cost, subeconomic current
price is below the marginal production cost,
The horizontal geological certainty dimension has many subdivisions identified geological
location, quality, quantity is known and supported by engineering measurements measured
known from samples with margin of error of , indicated known partly from samples and partly
from geological
undiscovered unspecified bodies of mineral bearing material surmised to exist on the basis of
broad geological knowledge and theory, hypothetical supposed to exist in a well specified
mining district, speculative undiscovered resources that may exist in favorable geological
settings where no discoveries have been made
Often one encounters notions as current reserves resources that are known and cost
effective to produce, resource endowment estimation of the stock in the earths crust that
could be mined without considering the cost. One also uses the static reserve index or R/P
ratio current reserves divided by current consumption, which gives the number of years that
the current consumption could be sustained with the current reserves. But this only holds if
the current consumption is constant and the current reserves do not change.
. Some data on energy resources
Estimates on the available resources of oil, gas and coal vary a lot. Some of the resources
are controlled by governments and they do not update regularly their resource data. Take
SaoudiArabia as example the resource stock of oil is unchanged since although they have
been producing a lot see BP statistical review. We give her first orders of magnitude relying
on mainly sources the BP statistical review and the IEA Energy
Energy Economics prof Stef Proost
Outlook . For oil and gas we will discuss the estimation of reserves more in detail later.
Oil
For oil the BP statistical review gives . Billion barrels or Reserves/ production ratio of . years.
These are proved reserves defined as reserves that are known and can with reasonable
certainty be recovered profitably at current prices. The recent IEA world energy outlook
shows a graph that integrates the cost side and the resource side
Figure . Ultimately recoverable resources of oil source IEA We see that the BP estimate of
reserves is only a small subset of the ultimate recoverable reserves and that the conversion
of gas and coal to liquid fuels can be considered as a backstop technology. A backstop
technology is a technology that produces a substitute at a more or less constant cost. We
also notice that OPEC holds the cheap reserves.
Coal For coal. tight gas sands. . Proven reserves and ultimately recoverable reserves
source IEA. . one can convert billion of m of Natural gas into . Trillion m of gas or an R/P ratio
of . India and Russia IEA. the R/P ratio is larger. Trillion m. times the quantity of oil. The
Using the BP statistical review of World Energy approx conversion factor table.Energy
Economics prof Stef Proost Gas According to the BP statistical review there are . As in the
case of oil one notices a large difference between proved reserves and the ultimate
recoverable resources. million barrels of oil equivalent. gas shales that could total Tcm. the
BP statistical review mentions billion ton of coal current reserves and an R/P ratio of years.
This quantity corresponds to . Table relates the Trillion m proved reserves to the total
resource base ultimately recoverable conventional resources of . with in Canada and US and
each in China. years. Table . Table does not contain the nonconventional gas coalbed
methane. The current reserves of gas are more or less equivalent to those of oil but because
consumption is lower.
Take gasoline for cars as example. we return to this problem later. In Figure the Willingness
to Pay WTP Q curve reports for every unit of the resource. A resource can be used for many
purposes.Energy Economics prof Stef Proost reserves data for coal have since long not
been updated because most producing countries had plenty of coal. . million ton of oil
equivalent and to . this is also the best use of that resource. For a given state of technology.
This is the cost of producing extracting an extra unit of the resource. So reserves are much
larger than reported here IEA.cit. In a world where one is not concerned about income
distribution./. First we explain economic surplus in one period and the discounting and
summation over time. we need a clear definition of economic optimality. A world view means
that we do not care who in the world has the resource. one finds that million of coal is
equivalent to /. the highest willingness to pay. the km/ year are uses that I could do without.
given income distribution and given prices of other goods say cars. . The users of te resource
can be consumers or firms. difficult to substitute and for which people would be prepared to
pay a very high price to uses that could be easily substituted. I can also invest in a more fuel
efficient but more expensive car etc. million barrels of oil. There are many caveats in using
this concept. The other curve reported in Figure is the marginal production cost function
MCQ. . The first quantity of the resource produced. obviously a strong asumption to which
we return later. has a value or benefit A because there is a user prepared Using BP op. one
can rank the uses of a given resource from very valuable. and others are not. Optimal
Allocation of resources basic concepts In order to compare alternative uses of a non
renewable resource over time. I can use a car for km/year but also for km/ year. some uses
are easily substitutable. The simplest notion one can use is the sum of the discounted
economic surplus. if allocated to the user with the highest WTP. Economic surplus We take a
world view here and consider one period say one year.
If this is not the case. economic surplus is clearly lower. First the quantity produced has to
go to those with the highest WTP. the average WTP of the receivers of the good is more like
E and total economic surplus equals only EFBC. How can one guarantee that this economic
surplus is created by producing a quantity Q Two conditions need to be fulfilled. clearly lower
than ABC.Energy Economics prof Stef Proost to pay A. where last unit is sold at price D
could do the job. If the price mechanism is not used it is hard to generate the same economic
surplus. Then all users that have a positive WTP are candidate. . In a market economy with
perfect competition consumers and consumers take the prices as given the economic
surplus would be maximized and the price level would be D. Pushing the production level
further to a level Q would reduce the economic surplus as the extra quantity has uses with
lower and lower value but costs more to produce. the difference between the value to users
and the production cost. so the net benefit of this first unit is the difference AC. To see why
imagine that the good is given to all users that show an interest. The total economic surplus
here ABC is then divided between consumers consumer surplus ADB and producers
producers surplus DBC. driving a km or allows to avoid more expensive solutions for the
same purpose taking the train. using electric home heating. Second. this means some
rationing and if goods are rationed at random. but the quantity available is only Q. Continuing
the reasoning for larger and larger quantities one maximizes the net benefit or economic
surplus by producing a quantity Q. This user is prepared to pay A because it either gives him
direct benefits heating the room. This is guaranteed if one uses the price mechanism to
distribute Q an auction selling the good to the highest bidders. the good has to be produced
by the producers with the lowest costs. This first quantity costs at the economy only C. This
quantity maximizes the economic surplus area ABC.
In our analysis we will assume that there is any year always the opportunity to invest money
in the capital market and realize a certain return at interest rate r. Or equivalently.. that there
exist perfect redistribution instruments that can be used once the economic surplus has been
realized. can we use the simple sum of the economic surpluses used in different years In
principle no. Oxford Univ Press. Economic surplus We will use the notion of economic
surplus many times in this course. It is useful because it allows us to discuss economic
efficiency at the level of one market without having to consider the rest of the economy. This
is only valid under rather strict assumptions . Microeconomic theory. Mass Colell. Green J.
Second condition is that we are indifferent about the distribution of income. Important is first
that there are no distortions important taxes that create wedge between price or WTP of
consumers and the marginal cost. discounted sum When one needs to decide on the
allocation of a given resource stock over different years. Interest rate.Energy Economics prof
Stef Proost A WTP Price Marginal cost Willingness to Pay function WTP Q ranking all
potential uses Marginal production cost Function MCQ E D lu rp su c mi no o Ec s F B C Q Q
Q quantity Figure . p . Whinston.
a firm will use its own nominal cost of capital and that economic surplus is replaced by net
cash flow of the project. In principle the capital market will reward more risky investments
with a higher return.Energy Economics prof Stef Proost In most of the text that follows. we
will always work with a real interest rate r. The latter option is clearly superior to realizing an
economic surplus of Euro next year. so r nr / i We also assume that this is a risk free interest
rate. The interest rate and alternative investment and lending opportunities at fixed rate r
allow us to define the discounted sum of economic surpluses in years . Whenever one can
generate an economic surplus of Euro this year rather than next year. We can now start to
use these concepts to study the allocation of non renewable resources over time. a firm
makes an analysis using nominal values depreciation is in nominal terms. discounted sum r
T ES t t Those interested in business economics will recognize the similarity with the
discounted cash flow method for selecting investment projects. this is equal to the nominal
interest rate nr corrected by the expected inflation rate i.. The three main differences are that.
one will prefer to realize it this year as it allows lending the Euro to the capital market and
getting r Euro next year. The existence of a capital market where a real return of r can be
obtained per year has far reaching implications for the allocation of resources over time. We
have developed up to now criteria for optimal efficiency from a static point of view maximize
economic surplus within one period and from a dynamic point of view allocation of resources
over time.T EST as ES.. first in a period model and then in an n . period model.
the WTP function and its inverse function q fp that is called the demand function.Energy
Economics prof Stef Proost . Q gt We borrow the simple model and numerical example from
Tietenberg . For the numerical illustrations.. q MEC r . all decisions are made by a central
authority that maximizes the discounted sum of economic surpluses. Model assumptions We
use the following definitions and assumptions p fq . Q fixed quantity of the non renewable
resource. we use the following values p . r real interest rate. identical for all the periods we
consider q p or WTP p a b q p price MC MEC constant marginal extraction cost. Optimal
allocation of non renewable resources in a period model Introduction In this section we will
use a simple model with a linear demand function and illustrate the results with a numerical
example that everybody can check. We start with an example without scarcity and tackle
then the case with a scarcity constraint.
this means maximizing the discounted sum of the economic surpluses realized in the two
years as there is no active resource constraint. In Figure we see that this implies a
consumption of units in each period.Energy Economics prof Stef Proost No scarcity case
Consider first the problem of allocating the resource when there is no scarcity. Figure .bq dq
cq r q . the period model without scarcity constraint With scarcity We now introduce the
scarcity constraint. q q q Q or Q q q It is convenient to use Lagranges method for this
optimization problem under constraints. The scarcity constraint does not play any role as
Qgt. For our numerical example. In fact we use here rather the KuhnTucker theorem for
optimisation with inequality constraints . The objective function is to maximize the discounted
sum of economic surplus in each period by choosing quantities of production in each period
q en q such that the total quantity of the resource used is lower than the available quantity Q
q q Max a .bq dq cq a . it is sufficient to push exploration and production up to the point
where WTPMC in each period.
with respect to the decision variables and the lagrange multiplicator will be a constrained
optimum where the weak inequalities allow for non binding constraints and satisfy the
following necessary first order conditions L q L q L a bq c a bq c r Q q q q q L q L q L If there
is no scarcity constraint active.bq dq cq Q q q r In which is the Lagrange multiplicator. The
best one can do is to choose the best quantity in each period. A maximum of the Lagrangian
Lq. When the scarcity constraint is active the solution equals q a c b r Q r r q Q q And we can
solve for the Lagrange multiplicator . q.bq dq cq a . q and q can be chosen freely and the
lagrange multiplier is zero q q Q and And optimal price and quantities are given by pc q q ac
b The interest rate plays no role in the solution. there is no opportunity cost associated to the
use of more resources in one period.Energy Economics prof Stef Proost The Langrangian is
defined as q q L a .
the value generated by the last unit made available abqc only counts for /r because of
discounting. . So the opportunity cost of using one more unit of the resource in period is
actually higher r.. the optimal price in each period equals the marginal production cost c plus
the opportunity cost of using the resource this period .Energy Economics prof Stef Proost L q
a bq c q L q a bq c p c This is the normal procedure to look for an optimum. The Lagrange
multiplier can be shown to equal the shadow cost of relaxing the resource constraint by one
unit at the optimum uses all existing resources optimally. One uses marginal user cost
opportunity cost. This opportunity cost is given different names in the literature. We see that
the price in the first period equals . marginal cost of opportunity cost of using the resource in
this period . Hotelling proposed this rule in the ties and it became known as Hotellings rule
when a scarce resource is optimally used. if there is a scarce resource. It allows to structure
the economic intuition. For an available quantity of and a real discount rate of we have that . .
In the first period this is simply . In our period problem.. In the second period. we have p a bq
c p a bq c r So. d L d Q what is the extra economic value that can be generated when there
is one more unit of the resource available. but in the second period. the margin pc has to
increase over time at the rate of interest rt . given that one . The Lagrange method is not the
most operational method to find an optimum but economists like to use it because it allows
interesting economic interpretations.. the price equals . We return to our numerical example
in the next figure. using the first order conditions.
Optimal allocation of a scarce resource over periodsQ. Only in the last section will we use
continuous techniques to discuss comparative statics over time. r If the available quantity is
lower. One can choose between continuous optimal control techniques and discrete
optimization techniques. Optimal allocation of a nonrenewable resource over time the N
period case We can generalize the problem in different directions and using different
techniques. One will then notice that prices in both periods increase. . Another source is Heal
. We will use discrete techniques and graphs as these are better to convey intuition. Basic
Nperiod model Generalising to N periods we have Pindyck has several interesting
papers.Energy Economics prof Stef Proost Figure . one can look for the optimum solution by
progressively increasing until the total demand obtained by using Hotellings rule letting
margins increase by interest rate satisfies exactly the resource constraint. Those who are
more interested in a mathematical proof of some of the results can consult the basic articles
or an advanced book on natural resources .
The whole resource is used. given identical demand functions... it is important to include the
potential uses in the objective function .T If demand is constant over time and the extracting
cost is constant. The use of the resource decreases continuously over time and stops at T.
we have for the optimal extraction period iT . not using the resource would be economically
inefficient because using the resource in one of the T periods would generate an economic
surplus if one wants to keep some of the resources for later. we have pi c r pi c If all periods i
to T are part of the optimal extraction period. the intuition for this result is that. we have pi c r
i for i. We know that if periods i and i are part of the optimal extraction period. starting with an
identical allocation of resources over time..Energy Economics prof Stef Proost N qi Max a bq
dq cqi i q .. one can gain by advancing slightly the use of the resource because of the
discount rate .... to know what quantities are optimal in every period. qN i r N i q i Q Forming
the lagrangian L N qi a bq dq cqi Q qi i i r i N One obtains the first order conditions L qi L r N i
i a bq c qi L qi L Q qi Solving this optimisation problem requires to check in what periods it is
optimal to make the resource available and once this is known.
if the price in T would be smaller than a. One obtains that . Numerical example of the
optimal price and quantity of a non renewable scarce resource On the left hand panel one
sees the decline of the extraction and use. discount rate and a total quantity of the resource
units. one could extract for one more period and obtain a price higher than the previous
period. we see the margin between price and marginal cost increasing with the interest rate.
and this would be beneficial etc.Energy Economics prof Stef Proost . Graphically. The price
in the last period equals the choke price a the maximum value of the resource in a future
year . and the optimal extraction period T periods. extraction cost . on the right hand pane.
using the same demand function WTP in . until one reaches the choke price Returning to the
simple numerical example. The price of the resource increases over time where the margin
increases with the interest rate not the price but the margin this is the Hotelling rule that also
holds for any path of demand functions also for growing demand functions . Basic N period
model with backstop .q . prices and quantities have the following properties Figure .
. The maximal price for the resource is limited to the production cost k of the substitute
.Energy Economics prof Stef Proost A variant that has received a lot of interest is to add a
backstop technology. The non renewable is fully used and is exhausted in period M . by
using the scarce resource first one saves production costs it costs only c lt k to produce the
exhaustible resource and saving production costs in period iltM is important as these savings
can be reinvested with a return r. Examples for oil would be an oil substitute produced on the
basis of coal FisherTropf process used by Germany during the war and by South Africa
during the oil embargo during the Apartheid period or simply shale oil of which massive
quantities are available. One uses the substitute only when the non renewable resource is
full exhausted. we have the following profiles for quantity and prices . So adding a substitute
speeds up the exhaustion of resources When we return to our numerical example and add a
substitute that can be produced at a cost of per unit. Using our discrete periods optimization
model and adding the possibility of a backstop production at a fixed production cost of k and
using as upper index for the scarce resource t and for the backstop production st we need to
solve the following problem t st N qi qi a bq dq cqit kqist Max i qt i q st i i r q i N t i Q Using
the first order necessary conditions we find the following characteristics when the non
renewable resource is used for M periods . A backstop technology is a technology that can at
a fixed high cost produce a perfect substitute for the resource in unlimited quantities. the
intuition is that.
In the next figure one finds an example with a resource base consisting of only parts with a
different marginal extraction cost.Energy Economics prof Stef Proost Figure . Figure . The
general rule is that it is always optimal to use the cheaper resource first. A non renewable
resource base with a cheap and an expensive part . Price and quantity of the non renewable
resource in the presence of a renewable substitute Increasing marginal cost of extraction
Often the resource base consists of different basins that have different extraction costs.
. Reserve dependent costs The extraction cost in any given year can be made an increasing
function of the production in a given year and a decreasing function of the remaining
reserves R. the second resource takes over.Energy Economics prof Stef Proost We see that
the cheap resource is first fully used and that the margin pmec increases with the factor r
every period.t n t n n r So the price should start above marginal extraction cost and equal the
marginal extraction cost in the last period. When it is fully used. The end result will be a
continuous version of Figure . Making the extraction cost dependent of the remaining
reserves could stand for the production costs of an existing well where the pressure in the
reservoir drops with each barrel extracted. and the price can be seen as the extraction cost
plus the opportunity cost of taking the resource out of the ground and this implies increasing
the extraction costs for the rest of the reserves. The total marginal cost is here the
mecopportunity cost. costs of exploration go up too. More production requires increasing the
pressure by injecting water or steam etc.t T t cR . The cheapest resource is used first
because this allows to save production costs in the first periods and these savings have a
higher weight because of the discount rate.t n where cR . and this is more and more costly.
One sees that the pricemec follows also the Hotelling rule also but only from T onwards. pt
cq . Comparative statics of the basic N period case We now use a model with a more general
formulation that allows to study the properties of the optimal solution using a graphical
construction. When one includes discoveries of always smaller and smaller fields.
. Common.McGilvray. Ch . one obtains the following analytical solutions aS r ra S T P c Ke
R r T t a This solution can be presented graphically I use here the version of the model as
presented by Perman. Pearson.Energy Economics prof Stef Proost We will use a continuous
time model with a different demand function but still a constant demand function over time
and a constant extraction cost T M ax W U R e rt d t T S Rt s u b j to t w here and U R and
Rtdt S R P R d R c R P R K e aR This problem has an exact solution that allows studying the
comparative statics and obtaining unambiguous results.Ma. . nd edition. When it the optimal
solution is to use the resource WTP is large enough. Natural resource and environmental
economics.
Energy Economics prof Stef Proost
The Nperiod Model
Price mec
Demand function
price
mec
q
Total use of the resource
time
q
CENTER FOR ECONOMIC STUDIES
KATHOLIEKE UNIVERSITEIT LEUVEN
Figure . Optimal use of a scarce resource This figure is constructed as follows. The left upper
quadrant represents the demand function that determines quantity for given price in each
period. The left lower quadrant is a to mapping from the left horizontal axis to the negative
part of the vertical axis. Take now one period, on the positive horizontal axis, going upwards,
one finds the optimal price in that period going left one uses the demand function to find the
corresponding quantity, using the lower left quadrant one finds the quantity for that period.
The total use of the resource is the integral over time and thus the area in the lower right
quadrant. We see the properties we know resource is fully used price in last period maximum
price or choke price K price increases over time where margin increases with factor r every
period use of resource decreases over time We discuss the following parameters one by one
a higher discount rate, an increase in the known resource stock, higher demand growth due
to say higher population growth, a
Energy Economics prof Stef Proost
fall in the price of the backstop technology due to a scientific discovery, changes in the
extraction costs.
Higher discount rate
The Nperiod Model higher discount rate
Price mec
Demand function
price
mec
q
Total use of the resource
time
q
CENTER FOR ECONOMIC STUDIES
KATHOLIEKE UNIVERSITEIT LEUVEN
Figure . Effect of a higher discount rate The above figure presents what happens when the
discount rate increases. The intuitive reasoning goes as follows. When the discount rate
increases, we know that the margin and the price must increase more strongly over the
extraction period. So one must start at a lower initial price and one will reach the choke price
more quickly. Total resource is again fully exhausted. A higher discount rate means that it is
better to generate benefits in the near future and so it is logical to advance the extraction of
the resource.
A decrease in the size of the resource stock
Energy Economics prof Stef Proost
The Nperiod Model effect of lower resource base
Price mec
Demand function
price
mec
q
Total use of the resource
time
q
CENTER FOR ECONOMIC STUDIES
KATHOLIEKE UNIVERSITEIT LEUVEN
Figure . Effect of a lower estimate of the resource base We know that the resource is
scarcer, so keeping the initial price path would lead to exhaustion of the resource before T
and this at a price smaller than the choke price. This can not be an optimum, so the initial
price has to be increased and also the total extraction period will be shortened. To see the
latter, imagine one started from the initial T, then going to period T, T ..decreasing the margin
every year by a factor r would lead to exhaustion of the resource before the period . But then
one can as well start the extraction of the resource earlier at a slightly higher price and stop
before moment T.
Effect of a lower marginal extraction cost
This can be due to technological progress. The reverse could happen if there is much more
attention to environmental problems that went unnoticed.
Energy Economics prof Stef Proost
The Nperiod Modeleffect of lower mec
Price mec
Demand function
price
mec
q
Total use of the resource
time
q
CENTER FOR ECONOMIC STUDIES
KATHOLIEKE UNIVERSITEIT LEUVEN
Figure . Effect of a lower marginal extraction cost Using the original price path is not optimum
because the margin pmec is now larger. So in order to restore the Hotelling rule, one needs
to start from a lower initial price. This increases the demand in the early periods and this
shortens the extraction period.
Increase in the expected demand
Energy Economics prof Stef Proost
The Nperiod Model increase in demand
Price mec
Demand function
price
mec
q
Total use of the resource
time
q
CENTER FOR ECONOMIC STUDIES
KATHOLIEKE UNIVERSITEIT LEUVEN
Figure . Increase in demand function An increase in demand can have different meanings.
One can increase the number of identical households are economies that all use the same
unit demand function then we have an expansion of the demand function rotating at the
same choke price as is shown in this figure. A parallel movement outwards of the demand
function means that also the choke price increases and this would produce a different result.
Imagine that one kept the old price scheme. Then one would exhaust the resource before T
because demand is now higher for every price. Exhausting the resource before reaching T
can however not be optimal. So one needs to increase the initial price and this will also lead
to a shorter extraction period.
A fall in the cost of the backstop technology
Energy Economics prof Stef Proost
The Nperiod Model fall in cost backstop
Price mec price
Demand function
mec
q
Total use of the resource
time
q
CENTER FOR ECONOMIC STUDIES
KATHOLIEKE UNIVERSITEIT LEUVEN
Because the backstop cost falls, the initial price path is no longer optimal it would imply that
one leaves some of the resource in the ground. This implies lowering the price in the final
period, in the initial period and using the resource more quickly.
Interpretation of the comparative statics exercise
We have interpreted the previous exercises as follows given that one has an initial stock of
resources, how would the optimal price and quantity profile change if one of the parameters
changes. One can also give another more general interpretation to our exercise imagine one
is on one of the optimal profiles and suddenly one of the parameters changes because of
extra information that was not anticipated. Then we can see the comparative statics exercise
as a new optimization exercice starting at moment tltT. If nothing would have changed in the
parameters, one would have continued the old price path. When one changes a parameter,
one can by comparing carefully the new and the old price path have a feeling for the change
in the price levels. This is a good exercise to check your understanding of the different
comparative statics cases.
Energy Economics prof Stef Proost
. The allocation of non renewable resources in a market economy
Perfect competition case
The theory of nonrenewable resources that we surveyed in the previous sections was mainly
dealing with the optimal use of a scarce non renewable resource over time. Although we
used market prices auction prices to make sure the right consumers had access to the
resource we assumed that there was an omniscient planner that optimized the extraction
over time. In reality, it are firms and governments who decide on extraction and they look for
a maximum profit or revenues solution. We start by examining the perfect competition case.
This means that all owners of the resource take the market prices as given and choose the
quantities to extract that maximize their profits. As each supplier has to decide when and
how much to produce, he considers a path of future prices. It is not necessary that the total
resource is subdivided among a very large group of owners say students taking this course.
It is sufficient that one has a limited number of suppliers who do not form a cartel and that
have each a reasonable share of the market. In this case they will tend to take the prices as
given as none of them has an interest to restrict his supply to raise prices because the major
beneficiaries will be his competitors who will expand output.. It can be shown that the
equilibrium price path has the same properties as the optimal price path we developed in the
previous section the margin pricemec must rise every period with a factor r. An equilibrium
price path is a path of prices at which none of the suppliers has an interest to supply more,
all consumers are at their demand functions WTP price and demand equals supply in all
periods. Why does the perfect competition case satisfy the Hotelling rule Assume it would not
be true then the price in a future year tgtt would be such that either ptc gt ptcr tt or ptc lt ptcr
tt In the first case every supplier has an interest to sell less in period t and keep that
production volume for period t, so this can not be an equilibrium because supply will be less
than demand in period t etc.. until equilibrium is restored.
Energy Economics prof Stef Proost
In the second case, the reverse will happen, instead of selling in period t, a supply will prefer
to sell more in period t etc. Important assumptions are here that all suppliers use the same
discount rate so that they have all access to the same conditions on the capital market. A
second important condition is the existence of a full set of futures markets for the commodity.
The monopoly case
For oil we have known several periods where OPEC acted as a monopolist, controlling the
quantity in order to increase their revenues. What does this imply for the rate of extraction
The next figure shows that this means higher initial prices and a longer extraction period.
Why is this the case A monopolist knows that by influencing the quantity supplied he can
manipulate prices. In any period he will restrict supply until the marginal profit marginal
revenue marginal cost increases with a factor r.
The Nperiod Model monopoly instead of competition
Demand function
Price mec
price
mec
q
Total use of the resource
time
q
CENTER FOR ECONOMIC STUDIES
KATHOLIEKE UNIVERSITEIT LEUVEN
Figure . Comparing the monopoly solution to the perfect competition case The marginal profit
in one period equals the marginal revenue minus the marginal extraction cost
the cartel is restored. start at the perfectly competitive solution in the first period. the
monopolist has still an interest to lower the quantity and increase the price because the
marginal revenue is higher than the marginal cost plus the opportunity cost. In our case there
is an exact solution the total extraction period with a monopoly is more or less . giving rise to
a pricegtmec. There is a period where both price paths cross as total resource available is
identical. If in period T. In the next Figure we illustrate what happens if one has a change in
market regime from monopoly period T into perfect competition. So the optimal rule is now to
have marginal profit increasing at the discount rate. The oil market has seen these jumps but
whether the theory of non renewable resources is a good explanation is a different matter.
one returns to a monopoly path with an upward jump. For that price.Energy Economics prof
Stef Proost p pq mec q q This is the well known condition for one period. In order to
understand the intuition of the result that monopolists sell less and extend the period of
extraction. . The result is that the price is higher and that he saves one unit for use in future
periods. as long as the extraction period with perfect competition. This could be the case
when a cartel breaks down. Now we also need to take into account that selling one unit this
period rather than in a future period has an opportunity cost . We know that the suppliers
then lower their prices and want to sell more prices jump downwards but increase more
strongly.
the Hotelling rule is the result of arbitrage possibilities of suppliers on forward
markets.Energy Economics prof Stef Proost Price Choke price ME T T Time Figure . If the
royalty tax is a fixed of the net margin. Forward markets are markets where one can buy the
resource in a given future year. so there is no market price for the years and later. . Regime
switches between monopoly and perfect competition Some more issues that arise in a
market context Royalty and revenue tax Most countries charge a royalty tax on their oil and
gas production. Forward markets and expectations In the perfect competition case. Forward
markets exist but only for a limited number of years say . this tax does not affect the
depletion period and path as the Hotelling condition is unchanged by a tax t t pt c t pt c r A
tax on gross revenues will discourage production and has the same effect as an increase in
the resource extraction cost.
An important factor that is still missing in the model is technological progress that lowers
extraction costs and tend to increase the resource base. total available reserves. this is
clearly not the case. How does the model perform in reality The Hotelling rule is an exact
result that holds if reality confirms to the theoretical setup. The world is much more complex.
As can be seen in Figure . Figure .. Price of oil and r growth paths source IEA and Medlock
This is however insufficient to reject the Hotelling theory.Energy Economics prof Stef Proost
Extraction under uncertainty to be completed later . Simple empirical tests of the Hotelling
theory are rejected in most cases. backstop costs and also the . In the case of oil this would
require that the price path neglecting the marginal extraction cost would increase with a
factor r. In fact over the years. expectations on future demand.
Important questions remain Is the model useful to understand reality.. Compute ratio present
consumption over reserves for oil in . Hunt L. Conclusions We have surveyed the theory of
non renewable resources. P. Take BP statistical review. Common.Heal. Ma. McGilvray.B.
Pearson.Energy Economics prof Stef Proost market regimes have changed. International
Handbook of the Economics of Energy.. UK and SaudiArabia . The economics of energy
supply.. Questions for students . . . Ch in Evans J. Do you understand what happened to Gas
reserves in Canada and the US . Imagine that after the events in Libya. . Economic theory
and exhaustible resources. nd edition. What could this imply for the oil prices . Cambridge
University Press Medlock K. G. Can you explain what happened with Oil reserves in Canada.
a point to which we return in our oil and gas chapters Is it acceptable that we use all
exhaustible resources now and leave none for the future generations Is this sustainable
development an issue to which we return in chapter What is the role of environmental
considerations in the extraction of exhaustible resources . . and . III. Ch Tietenberg .
References Dasgupta. Each of these elements changes the current price level and the
fluctuations in the price of oil do therefore not necessarily contradict Hotelling. we have a
more Western oriented regime that does no longer follow OPEC strategy. Natural resource
and environmental economics. Edward Elgar Perman. can you explain the evolution . eds.
Assume there are two suppliers. in and in .Energy Economics prof Stef Proost . . One has a
marginal cost function x. Imagine that scientists found out that from onwards. Find
graphically and algebraically the aggregate marginal cost function. it will be possible to have
cars running on water at a relatively low cost. What do the last years of energy supply teach
us on resource availability in the future . the other has a marginal cost function x. What will
happen to oil prices now.
Initial emission levels are Ea and Eb. different generations etc. The polluters can reduce
emissions by quantities Za and Zb at a total cost CaZa and CbZb. We use a simplified
framework with only polluters a. Objectives and outline Fossil energy use generates different
types of negative side effects for society traditional air pollution but also global warming. b
and victims and to which we add the assumption that they take the actions of the others as
given. . This model is used to discuss the use of different types of policy instruments. In the
first section we survey the the basics of environmental economics with a simple
model.Energy Economics prof Stef Proost Chapter Environment . different countries. . Our
model can be given many different interpretations. This is the crucial assumption we need to
make for our simplified framework to make sense in the real world. every victim and every
polluter will take the aggregated pollution level as given. We know that this can produce
efficient solutions. The polluters and victims can be different firms. Basic environmental
economics Problem setting When there is a large number of polluters and victims. level of
care by the firm or the household If we would not make this assumption. . In the next chapter
we focus on climate change as this is considered at present as the environmental issue with
the highest impact on the energy sector. We do this in three steps. In the second section we
discuss the sustainability concept in abstract terms drawing on a paper by Arrow et al. As
this issue concerns almost all energy use and is the main justification for subsidies to green
energy we need to understand this issue in more depth. This total emission reduction or
abatement cost can be interpreted most easily as efforts equipment. all problems between
our two agents can be solved by bargaining between the two parties.
Figure illustrates the damage relation.This is the simplest transfer function one can imagine.
j iI iI A ij A p i ij s i iI S S .. Aij sulfur and primary PM. summer and annual Figure . minmax.
showing the effect of changes in emissions on life expectancy. S. We will come back to the
measurement of emission abatement costs in later lectures. ij a i ij ni iI W .j Annual mean
concentration of PM. at receptor point j I Set of emission sources countries J Set of receptors
grid cells Primary emissions of PM. S. W. There are victims I.Aij. in country i pi SO emissions
in country i si NOx emissions in country i ni NH emissions in country i ai Linear transfer
matrices for reduced and oxidized nitrogen. The weights T can be interpreted as transfer or
transport coefficients translating distance. Figure illustrates one of the source receptor
relationships used in Gains. for winter. The level of pollution P has dimension effects rather
than emissions is defined as P Ta Ea Z a Tb Eb Z b Where the pollution or damage effects
are a weighted sum of emissions by the two polluters. toxicity etc. c ij ni k j iI PM.
Sourcereceptor relationships for PM. a model used to prepare decisions on European
policies. But in most cases the cost of emission reduction consists also of the lost consumers
and producer surplus due to the price increases for goods produced with dirty inputs. This is
an important element in EU policies on conventional air pollution.Energy Economics prof Stef
Proost to reduce emissions.Wij. In some pollution problems one defines a blame matrix that
tells you what share of the pollution of a country or region ends up in all the other regions.Aij.
derived from the EMEP Eulerian model for primary and secondary PM PM . wind direction. c
ij a i c iI iI W W ij s i k j .W. with a total environmental damage DP and DP.. European air
pollution dispersion model Gains .
Ideal solution Look for solution that maximizes the total welfare assuming that there is
perfect control of all variables All polluters are only interested in their own damage and take
the actions of the others as given NashCournot equilibrium Assume that there is a central
government that has all the information but has to use given policy instruments taxes. to
control the behaviour of polluters with Non cooperative solution centralised government
solution Centralised government imperfect information solutions Table . and a
noncooperative solution.Energy Economics prof Stef Proost Loss in life expectancy
attributable to fine particles months CAFE baseline Current legislation Maximum technical
emission reductions Loss in average statistical life expectancy due to identified
anthropogenic PM. Calculations for meteorology Figure . The different institutional settings
considered . a centralised solution. permits etc. Illustration of effect of a policy on damage of
emissions source GAINS model For the pollution problem we proposed we will analyze three
types of solutions an ideal solution.
Implicitly we assume that we are either indifferent about the distribution of costs and benefits
to the different individuals or that we have other income distribution instruments operating in
the background. An interior solution to this optimisation problem is given by the first order
conditions . we can formulate the optimal pollution problem in a very simple way PROBLEM
choose Z a .Energy Economics prof Stef Proost The ideal or theoretical optimum solution If
we use a quasi linear utility function and we have perfect income distribution instruments.
where P Ta Ea Z a Tb Eb Z b If we use all available resources R and substitute m by the
resource or production constraint of this economy. Z b and mi such as to Maximise mi Di P .
subject to mi Ca Z a Cb Z b Ri . The damage of pollution does not depend on the income
levels We use a linear production technology except for the production of abatement
PROBLEM Minimize D P D P Ca Z a Cb Z b where P Ta Ea Z a Tb Eb Z b By selecting
appropriate abatement efforts Z by the two polluters. . this problem comes down to minimize
overall damage and overall costs PROBLEM often called the efficiency problem.
pollution levels P are achieved at the lowest cost by combining the efforts of the two
polluters.Energy Economics prof Stef Proost Ca D D Z a P P Ta Cb D D Z b P P Tb We see
properties here The optimal level of pollution P is reached when the marginal cost of
reducing pollution Ca/ Za / Ta equals the total environmental damage expression holds for
every polluter Pollution is reduced in a cost minimal way when the marginal cost of pollution
reduction is equal between the two sources of emissions Ca/ Za / Ta Cb/ Zb / Tb where we
see that the transfer coefficients correct the marginal cost of emission reduction to express it
in terms of pollution reduction costs this will determine the optimal distribution of emission
reductions over the two polluters We can show these properties also in steps and that is
what is usely done in the graphical procedure. by construction. . The first step is then cost
efficiency in the reduction of pollution so as to achieve a given level P PROBLEM D/ P D/ P
this Minimize Ca Z a Cb Z b such that Ta Ea Z a Tb Eb Z b P An interior solution to this
problem will satisfy Cb Ca Z b Z a Tb Ta This first step allows the construction of a new
aggregated total cost function CP where.
S d ie s e l o il FG D o il f ir e d p o w e r p la n ts FG D b a s e lo a d p o w e r p la n t s S h e
a v y f u e l o il L o w s u lf u r coal R e m a in in g m e a s u re s P r e s e n t le g is la tio n R
e m a in in g e m is s io n s k t S O Figure . Figure illustrates the marginal cost of reducing
emissions of SO in a particular zone. This is easy Problem D P D P D P The third step is to
choose the correct level of emission reduction given the aggregated damage and abatement
cost functions Problem Minimize D P C P Where an optimum interior solution satisfies the
traditional marginal damage and marginal pollution abatement cost. S h e a v y fu e l o il FG
D la r g e in d u s tr ia l b o ile r s . Illustration of a marginal cost function for the reduction of
emissions in a given zone The second step is to construct an aggregated environmental
damage function DP. S d ie s e l o il FG D s m a ll in d u s t r ia l b o ile r s .Energy
Economics prof Stef Proost Imagine that one does not systematically combine the abatement
efforts of the two polluters in a cost effective way. Then another aggregated cost function
COP has to be used that reaches pollution levels at always higher costs. An example cost
curve for SO Marginal costs EURO/ton SO removed . .
Energy Economics prof Stef Proost A graphical illustration is particularly easy when the
transfer functions are equal for both pollutants. We use here the public good property of
pollution the pollution generates damages to the two victims so we have to add the marginal
damages to obtain total pollution damage. . This generates one point on the aggregated
marginal cost function. The aggregated damage function is constructed by adding vertically
the marginal damage functions of the victims Fig II and Fig III give rise to MD in Figure I. By
the way. Varying the MAC level allows to construct the complete aggregated marginal
abatement cost function. The second aggregated curve. We are interested in the reduction of
pollution at the lowest cost. Fig IV ranks all emission reduction possibilities for the first
polluter in the order of increasing costs this generates the marginal cost function. Then the
total quantity that can be reduced for a marginal cost level lower than the target marginal
cost level MAC at the two emission sources is computed. the abatement cost function is
constructed combining Fig IV and Fig V into Fig I. In this case we can use the dimension
emissions for all cost and damage functions instead of having to use emissions and pollution.
The construction of the aggregated marginal cost function uses a given maximum emission
reduction cost MAC. we use precisely the same procedure to construct an aggregated
marginal cost function for the supply of a private good.
Synthesis figure for simplified environmental problem .Energy Economics prof Stef Proost
MD MAC I MAC A IV MAC B V pollution MD II pollution Optimal abatement for A pollution
Optimal abatement for B MD pollution III pollution Figure .
We assume that there are two countries and and we assume that every country can reduce
its emissions. Obviously there are international agreements but things are not as simple.
Instead of two firms polluting we have the two countries polluting.Energy Economics prof Stef
Proost Non cooperative solution There are situations where there is no central government
that can control the polluters. If a country signs an agreement but finds that it is in its interest
not to comply with the agreement. When both reaction functions exist and satisfy certain
properties continuity one can guarantee the existence of a Nash equilibrium . Here we can
not rely upon a central government because there is no world government. The optimal
solution for every country is for an interior solution D P Z C Z T This is an equation that
expresses the abatement efforts of country as a function of the efforts of country Z R Z This
is called a reaction function. This is typically the case for international pollution problems
where there more than a few nations are involved. there is no international court that can
enforce the agreement. Every country solves the following problem Problem Minimize D P C
Z where P T E Z T E Z where we see that every country minimizes its abatement costs and
its own damage. We can study this problem with our small model. taking the actions of the
other countries as given Z . Indeed it is dificult to make international agreements that can be
enforced. A typical example is climate change the emission of each nation will damage all
other nations of the world.
main policy instruments discussed . He can however not necessarily control all the actions
of the polluters. Eyckmans. the noncooperative solution would produce some of reduction of
emissions while the cooperative solution would generate some of emission reductions. Z N
satisfies ZN R Z N Z N R ZN How does this non cooperative solution compare to the ideal
and the centralised solution The noncooperative solution will be less efficient because of two
reasons a the emission reduction is not produced in the most costeffective way b the overall
emission reduction effort will be too low as every country takes only into account its own
damage and not the damage in the other countries That there are large differences between
the noncooperative solution and the efficient solution can be illustrated for Climate Change.
Centralised government solution Assume the policy maker is interested to achieve the ideal
solution that we described earlier. Schokkaert show that for climate change. Proost. These
restrictions are sometimes called constitutional in the sense that they are part of a more
fundamental contract between citizens that try to preclude the misuse of power by policy
makers.Energy Economics prof Stef Proost Nash equilibrium ZN . standards and tradeable
permits Pollution taxes Tax on all emissions corrected for its effect on pollution .the revenue
of the tax is returned to all the citizens as a subsidy per head Standards Tradeable permits
Emission limit set for every polluter Every polluter receives emission rights that he can trade
freely with other polluters Table . We will discuss three types of centralised solutions that are
presented in the next table pollution taxes. He is restricted in the type of constraints and
incentives he can give to the polluters.
Energy Economics prof Stef Proost The policy maker has now to solve a problem where his
control is more indirect Problem Minimize D P Ca Z a control Cb Z b control where P Ta Ea Z
a Tb Eb Z b Before analysing the problem faced by the government we need to examine how
the polluters react to different types of policy controls by the government. When they are
faced with a tax on emissions. corrected for the transfer coefficient also called ambiant
pollution taxes the polluter faces the following problem minimize the sum of abatement costs
and emission taxes he has to pay. Because all polluters are subject to the same pollution tax
t we have indeed for an interior solution Cb Ca Z b Z t a Tb Ta . A tax on emissions Assume
that the polluters are producers that minimize their total production costs. Problem Minimize
Ca Z a t Ta Ea Z a If we assume that every polluter minimizes indeed this expression. we
can derive his reaction function to a change in controls from the first order conditions for an
interior minimum solution Ca Z a t Ta this is an implicit equation that gives Za in function of
the control t . An interesting property of the ambiant emission taxes is that they always
generate emission reductions in a costminimizing way.
in the final step every polluter has to limit his ambiant emissions in function of the total
number of ambiant emission rights he possesses. We represent the net purchase of ambiant
emission rights by ERP and we assume that there is a perfectly competitive market for
emission rights where the equilibrium market price is per. A tradeable emission scheme The
idea in this scheme is that the policy maker allocates emission rights ER to every polluter.
This will typically be the case if there are a large number of traders on the market and that
none of the traders has a dominant position. This is paradoxical decentralising decisions by
using indirect controls as there is an emission tax may improve a solution where the policy
maker has full control but not all the information. all he needs to do is set the same ambiant
pollution tax rate for all polluters. This is the fundamental reason why economists like to rely
on markets to organize production and consumption decisions. A perfectly competitive
emission rights market means that all players take the price on that market as given. Next
the polluters can trade emission rights. An emission standard In the case of an emission
standard. An equilibrium price per is a price where the sum of the net trades . The
government has full control but this will only lead to a solution that is costefficient if the policy
maker has full knowledge of all the abatement cost functions. the policy maker fixes one
emission limit EL for each polluter. The polluter then minimizes total costs subject to this limit
on emissions Problem Minimize Ca Z a subject to Ea Z a ELa If the constraint is binding we
have that Z is directly controlled by the emission limit.Energy Economics prof Stef Proost
This is indeed an interesting property the policy maker does not need to know the abatement
cost functions to achieve a cost minimizing solution .
ERP subject to Ta Ea Z a ERa ERP And his behaviour choosing Z and ERP will be
characterised for an interior solution by Ca Z per a Ta This equation holds for all polluters.
We can now solve problem with as constraints the behaviour of polluters problems . so we
achieve again the property that all pollution reduction costs are minimised because all
polluters react to the same price signal per Cb Ca Z b Z a per Tb Ta The control variables of
the government are now ER a and b but one can show only the weighted by transfer
coefficients sum of emission rights matters. This is again an interesting property the policy
maker controls in fact total pollution rights and that is all he needs to achieve a cost effective
solution. We can now return to the problem of our policy maker that controls pollution via
indirect policy instruments. or .Energy Economics prof Stef Proost ERPa per ERPb per The
problem of every polluter is now Problem Minimize Ca Z a per . We summarize some of the
properties of the different instruments in the following table. .
Properties of some environmental policy instruments Experience with Emission trading in
the energy field the SO trading scheme in the US See Schmalenzee et al and ppt.Energy
Economics prof Stef Proost Ambiant Pollution taxes Cost efficiency of pollution reduction is
guaranteed reaching the optimal pollution level requires that the ambiant tax is set equal to
the Marginal Damage and this requires knowledge of aggregate MC and MD curve
Standards Cost efficiency of pollution reduction is not guaranteed reaching the optimal
pollution level requires that the total quantity of ambiant pollution allowed corresponds to the
level where aggreg Marginal Damage aggreg Marginal cost Tradeable permits Cost
efficiency of pollution reduction is guaranteed reaching the optimal pollution level requires
that the total quantity of ambiant pollution allowed corresponds to the level where aggreg
Marginal Damage aggreg Marginal cost Table . Tradeable emission permitsSO in US in
TOLEDO .
We will show that both views are not that different. industrial output by a facot . Economists
and ecologists tend to use two different views on sustainability.We follow a recent paper by
Arrow et al that is a result of a dialogue between economists and ecologists. In the second
approach originating from the ecologist tradition and translated into economists language is
more policies are sustainable when they guarantee the utility of future generations.Energy
Economics prof Stef Proost . energy use by a factor . In its simplest form this comes down to
Max t t U C t There are three important assumptions embedded in this formulation. The
sustainability discussion is important for many long term issues and will turn out crucial for
the climate change debate. Sustainability as a maximum of discounted utility The simplest
naive approach is to look for policies that maximize the present value of discounted utility for
the rest of the horizon. In the most simple economic approach one would define a policy as
sustainable when it maximizes the discounted future utility over the rest of the horizon.
Ecologists are worried about the future of this planet when you put together some trends.
Sustainability Issue and outline There are many definitions of sustainability around . fishing
output by a factor . We have simplified the utility function so that it has only one argument
aggregate consumption which is not a strong assumption as long as one can easily produce
all goods from a common input say labour. The first is the structure and functional form of the
utility function. population increased with a factor . They consider this as unsustainable. Over
the last years. The utility function is also the same for all individuals and represents an
ethical .
We can do this by using a different discount rate r where is a measure of the concavity of
the utility function and where g is the growth rate of consumption over time r g And use as
objective function W Ct e rt dt T This results from the following steps T W U C t e t d t w ith U
and U e la s t i c i t y o f m a r g i n a l u t i li t y w r t c o n s u m p t i o n c o n c a v i t y o f u t
i li t y f u n c t i o n C U U c o n s u m p t i o n r a t e o f d i s c o u n t o f c o n s u m p t i o n r
a t e a t w h i c h t h e v a lu e o f d e lt a i n c o n s u m p tio n c h a n g e s w h e n w e m o v
e o v e r tim e M a r g i n a l u t i li t y o f c o n s u m p t i o n U e t T h e d iffe re n tia tio n w r
t tim e U C U C r C U e t U e t U e t ta k in g n e g a tiv e o f th is The intuition behind the
transformed discount rate r is simple . The second assumption embedded in this formulation
is the role of the discount rate.Energy Economics prof Stef Proost judgment on what is the
relative value of giving of consumption to one poor individual and one rich individual. One
accepts to weight the utility of consumption now and in the future with one common interest
rate. The degree of concavity of the utility function will tell us by how much. To continue our
reasoning it is actually easier to transform the sustainability objective into an objective that is
only a function of consumption over time. In principle one accepts that this function is
concave so that taken from the rich and given to the poor increases aggregate utility. The
third assumption implicit in this formulation is that it is possible to transfer resources over
time. This is acceptable within one generation but doing this over several generations in the
very long term is another issue.
a reasonable ethical choice would be to take a value as there is no reason to value
differently the utility of persons living at two different moments in time g is rate of growth of
aggregate consumption to in long term is elasticity of marginal social utility to derived from
individual trade offs under uncertainty and is a measure of how fast marginal utility
decreases when income increases So r. the social rate of discount is of the order of or more
We can now see whether current consumption is excessive according to this first
sustainability criterion. In order to maximize our objective under our constraint to carry over
consumption over time. so there is an interest to reduce consumption now and increase
investment If rgt rr . if one would give up one unit of consumption now. we need to compare r
with rr. As future generations get richer it is rather normal that we should not save extra for
them. Assume that any saving of in a given period generates a consumption return of rr in
the next period. . We need to compare the criterion with the possibilities to carry over
resources from one period to another via investments. rr is the real rate of return on invested
capital. this would generate rr units of consumption the next period. If r lt rr this means that
by reducing consumption now and investing more one would generate rr and this would after
social discounting rr/r be larger than . One of the main elements behind a large social
discount rate r is the assumption that future generations will be richer ggt. it is difficult to
claim that present consumption is excessive. In other terms.Energy Economics prof Stef
Proost is the social rate of pure time preference how one should trade off utility of somebody
now and the utility of somebody in the future. it is better to decrease investments and
consume more now Because it is difficult to claim that rr is much bigger than r.
technology and natural capital depletable resources. K n t p m t K m t p m t K m t p m t K m t
K n t t t K m p n t K n t Kn . gives an idea of the evolution of capital stocks for a given country
here UK . K n t V Km V Kn .. biodiversity. d V K m t .. man made capital buildings. K n t . .
We can define future production possibilities via a production function that is function of three
inputs labour kept constant. We can now express the evolution of utility over time as a
function of net production over time Vt that is a function of man made capital Km and natural
capital Kn V t V K m t . d V K m t . .. Now the main question is what determines future
production possibilities This issue was assumed away in the previous simpler approach
where resources could be easily transferred from year to year via a real rate of return rr. K n t
p m t p n t K n t Km Kn ..Energy Economics prof Stef Proost Sustainability as guarantee for
utility of future generations It has become more common to see sustainability asa guarantee
that future generations have the production possibilities to have the same consumption level
as we have. p m t K m t t p m t K m t K n t t K m t p n t K n t e la s t i c i t y o f K n w i t h r e s
p e c t t o K m a lo n g a n i s o q u a n t w h e re p m t K m t o r h o w m a n y u n its o f K n o
n e n e e d s to s u b s titu te o n e u n it o f K m p n a n d p m a re p ric e s o f n a tu ra l a n d
m a n m a d e c a p ita l This implies that we can check evolution of production possibilities
over time by checking the availability of man made and natural capital over time and
confronting this with substitution possibilities. Km t Kn t d V K m t . Figure .
. the increase of man made capital is useless. Man made capital OVER TIME Production
level curves If substitution perfect Natural capital Figure . . . In the optimistic view there is
easy substitution in the example of Figure .Energy Economics prof Stef Proost Man made
Capital stock CURRENT TREND of NATURAL AND MAN MADE CAPITAL OVER TIME
measured with current prices Example UK of GDP Physical Investment Education CO
Energy NET . . .. Optimistic view on substitutability . In the pessimistic view there is no easy
substitution of natural capital. there is a decrease of natural capital but overall production
possibilities still increase because one ends up on a higher isoquant. There is a minimum of
natural capital required and once this limit is reached. See the example of Figure . Source
Arrow et al. Natural capital stock Figure . Evolution of capital stocks over time in the UK But
in order to know what a given evolution of capital stocks means for production possibilities
one needs to make assumptions about substitutability of the two capital stocks.
According to Diamond there have been disasters on Easter Island island h by plane west of
Chile where deforestation has led to internal wars and disappearance of the population.
Some regions sub saharan Africa. Recent cases of interest or Rwanda and Haiti very poor
but sharing the same island with Dominican republic that is much richer. . Another case are
the Anasazi indians in south west US where population growth and drought has led to mere
extinction of certain groups. Pessimistic view on substitutability There is historical evidence
on how mankind has dealt with natural resources and how the economy has grown in a
sustainable or non sustainable way. The next table gives some data on the evolution of
capital stocks.Energy Economics prof Stef Proost Man made capital B OVER TIME A
Production level curves If no substitution possible Natural capital Figure . Middle east
decrease their overall capital stock while in most regions the nman made capaital mainly
education continue to increase. Whether this is sufficient for sustainable development
remains an open empirical question. Another example or the Maya indians.
Energy Economics prof Stef Proost Table .Heal. JEP. S. Joskow.Volume . B.Pages Diamond
J. References K.. Arrow.. Number . Bailey E. vol . Ellerman D. Collapse how societies
choose to fail or to succeed. Are We Consuming Too Much... . KG Maler.Daily. S.P. An
interim evaluation of sulfur dioxide emission trading. . Montero JP. . p . P.Levin. Journal of
Economic Perspectives. n. G.Starrett. Schneider. Dasgupta. G. Penguin books Schmalensee
R. D. Ehrlich. Goulder. L.Walker.. P.
Next we discuss briefly the economics of international negotiations because this is
necessary to understand the EU policy and the international negotiation process. . The third
step briefly presents the types of models that are used for an analysis of the climate
strategies at world level. its drivers and its consequences in mostly physical terms. We first
describe briefly the climate change phenomenon. The second step is to look for an objective
function by which we can rank different strategies to limit emissions of greenhouse gasses.
We start with a problem description at world level. Physics of global warming . In this chapter
we study the economics of Climate Change in sections. as this is accessible for non experts.
Objectives Climate change is considered as one of the major environmental concerns of
fossil fuel energy use. We will mainly integrate comments by Weitzman . The Stern report
has been critically reviewed by several economists.Energy Economics prof Stef Proost
Chapter Economics of Climate Change . In the fourth step we give some idea about the cost
of abatement and the damages associated to climate change. In the last step we discuss
briefly the policy proposals advanced in the Stern report. In order to understand the climate
change problem we work in steps. Nordhaus and Heal . Climate change as a problem for the
world We rely heavily on the Stern report . Very ambitious emission reduction objectives
have been announced for Greenhouse Gas emissions and these will affect strongly the
energy markets. In the last section we analyze the implementation of the European climate
policy in more detail.
The confidence interval would imply global warming in the range of to more than C. At C. . to
ppm per year. Climate change has several effects. gives the average global warming
associated to different levels of GHG concentrations in the atmosphere. Global warming
generates climate change this happens with a delay of years because of the thermal inertia
of the oceans . At present the concentration of GHG gasses is ppm COequivalent and this is
rising between . Humans experienced years ago C cooling ice sheets up to London ice
melted and England became an island. one expects that one reaches a Business As Usual
concentration in of the order of ppm COeq. Figure . If no policy action is undertaken. The
global warming effects are often summarized under the form of the expected change in
average world temperature compared to the preindustrial era. swampy forests appear
everywhere and one could find alligators at the . Human behaviour is at origin of extra GHG
emissions. The increased concentration of GHG traps heat and generates global warming of
the planet . Over the last million years the world has experienced an increase of to C. / year .
NO and HFCs count. most ice and snow would disappear. mainly under form of CO of
problem but also methane. some positive but on average negative Each of these relations
are uncertain what will be the economic growth in the future and to what extent economic
growth will be carbon intensive and emissions will grow rapidly is not clear but also the effect
of the GHG emissions on the climate the physics of the warming and the precise effects
associated to climate change the nature of the damage are uncertain. GHG accumulate in
the atmosphere and stay active for to years decay . In order to illustrate what such a change
in temperature implies one needs to put this change in historical perspective..Energy
Economics prof Stef Proost For dummies climate change is based on the following reasoning
.
. There are also major dislocations of population expected in to years as large parts of the
world become difficult to live in. The GHG emissions come principally from fossil energy use
in different sectors and to a lesser extent from non energy emissions see Figure .
Temperature change associated to different concentrations of GHG source Stern . Given
these expectations it looks reasonable to avoid risks of going beyond ppm and so limit global
warming to C with still risk of reaching C and reaching or Figure .Energy Economics prof Stef
Proost North Pole.
Figure . Emissions profile necessary to reach a given concentration in . Avoiding climate
change effects requires addressing a stock pollution problem and this is more difficult than a
flow pollution problem. Figure . Sources of world GHG emissions in source Stern .Energy
Economics prof Stef Proost Figure . . gives an idea what temporal profile of emissions is
necessary to reach a given concentration of GHG in .
As we know from our sustainability chapter this is an ethical discussion in which one needs
to trade off the well being of different generations emissions now will generate damage for
the coming generations. This means one works with W Ct e rt dt T And the discount rate is
then r g is the social rate of pure time preference how one should trade off utility of
somebody now and the utility of somebody in the future. How to select a climate change
strategy for the world If there would be one benevolent world government. the well being of
different parts of the world some will gain with climate change but others may lose heavily.
what emission profile would be optimal when one considers all costs and benefits of abating
GHG emissions This is a central question that has been the source of many discussions
among economists and policy makers. In addition most elements are uncertain. Usually one
starts with the following objective function for the world now and in the future W U Ct e t dt To
make this expression operational one prefers to work with a discounted sum of consumption
rather than utility and this requires assumptions on the concavity of the utility function and on
the growth rate of consumption. a reasonable ethical choice would be to take a value as
there is no reason to value differently the utility of persons living at two different moments in
time g is rate of growth of aggregate consumption to in long term this is partly endogeneous
as this can be affected by climate change if climate change destroys .Energy Economics prof
Stef Proost As can be seen from this figure even a decrease in emissions from now onwards
will lead to a strong increase of concentration of GHGs in because every ton emitted will
contribute to the accumulation of the stock in the future.
Integrated assessment models In order to determine the best emission reduction profile. one
arrives quickly at discount rates r between . and . In the following formulation of the objective
function we sum over r.. Similarly. BanglaDesh etc. .R regions in the world and over s.Energy
Economics prof Stef Proost ecoservices that are a strongly complementary input into
production.. But a full analysis should also take into account the distribution of gains and
losses over the world and the risks of extreme events. Such models need a climate module
and an economic module that are both reduced forms as shown in Figure . This range of
discount rates tends to discourage large abatement efforts now.S possible states of the world
with probability ps. one needs a long term growth model that tracks the effect of climate
change damage and the costs of emission reduction. the production and consumption will be
lower cfr. the concavity of the utility function would give these damages a larger weight. This
gives for the welfare in period t W t p s..t due to uncertainty in the climate developments. t r s
R S C t When it are particularly the poorest regions in the world Africa. This holds certainly
when some of the effects are irreversible melting of ice caps... tend to have a very high as
high gains become less important than avoiding losses Most discussions center on the
choice of these parameters. extinction of species.. risk aversion then calls for a lot of
preventive actions and a stronger abatement policy. that would suffer the damages. For a
expected growth.. when the climate effects tend to be rather extreme. the associated
damages generate strong losses of utility and consumption.. Ch is elasticity of marginal
social utility to derived from individual trade offs under uncertainty and is a measure of how
fast marginal utility decreases when income increases the latter measure is used in two
types of analysis in redistribution of income issues and in behaviour under uncertainty those
who want to avoid risks.
Integrated assessment models are necessary to have the argumentation right but given the
many uncertainties one should not count on precise results. . the abatement cost b
parameter in and the damage of climate change . Structure of an Integrated assessment
model One of the best known integrated assessment models is the Nordhaus amp Zhang
Rice model.Energy Economics prof Stef Proost E M IS S I O N S E C O N O M IC M OD EL r
e g io n a l g ro w t h m o d e l t o dam ages y e a rs A b a te m e n t c o s ts C L IM A T E M
O D E L L a g S t o c k a c c u m u la t io n T r a n s l a t e d i n to r e g io n a l e f fe c t s
EFFECTS Figure . this is . The most important parameters driving these models are the
discount rate in Fig .. the carbon intensity of the future energy use . Whose structure is
reproduced in Figure . the technological progress A parameter .
html Figure . . Structure of the Rice model Nordhaus amp Zhang.Energy Economics prof Stef
Proost SWF Production function Net output after damage and abatement Net consumption
Capital accumulation Net emissions after abatement Stock of GHG T atmospheric
temperature T deep ocean t F radiative forcing Economic loss factor that accounts for
Abatement and damage For Mini climate model see http//chooseclimate.org/jcm/jcmjul/index.
that summarizes several damage estimates Figure . rainfall. change in sea level and its
biological effects are uncertain. . sunshine and soil quality.Energy Economics prof Stef
Proost Damage of climate change Estimation of climate change damage is difficult for two
reasons. the changes that are anticipated are of another magnitude than the ones we
experienced in the recent past. They related the agricultural product in different counties of
the USA as a function of average temperature. A good example of how to measure damages
to agriculture is the study by Mendelsohn et al. The effects of a global change in temperature
can then be analysed by using the differences observed between counties of the US. Of
course this conclusion only holds for the US. There is a large uncertainty on the damages of
climate change as can be seen in Figure . Second. They conclude that global warming does
not have a negative impact on the agricultural output of the US. storms. Damage estimates
of different sources Stern The damage is primarily a function of the elasticity of marginal
utility risk aversion or aversion to inequality and a damage parameter that tells us how
strongly damages . First there is large uncertainty on the precise physical effects of climate
change because the translation into a new weather pattern rainfall.
Uncertainty on damage costs in the BAU scenario.Energy Economics prof Stef Proost
increase for an increase in global temperature.. while one should have taken only the
production cost of these fuels. Table . One of the errors is the computation of the cost of
emission reduction by making cars more fuel efficient. of permanent consumption. to . In that
computation the high taxes on motorfuels are considered as a real cost. The next table gives
the loss in permanent consumption possibilities associated to a BAU development without
climate policy. For instance for and . Costs of emission abatement Emissions can be reduced
by calling upon two types of actions by reducing the volume of the polluting activity smaller
annual mileage for cars and by reducing the emission intensity per unit of activity production
or consumption. A typical ranking of different options to reduce the emission intensity
activities is given by the cost curve produced by McKinsey Figure . We will later argue that
this cost curve contains several errors. The result depends on the choice of the concavity
parameter of the utility function higher concavity tends to lower the importance of distant
damages but also attaches more weight to catastrophes and on the choice of the damage
function exponent. the uncertainty in the physical effects implies a loss in permanent
consumption possibilities in the range . .
gives an idea of the cost reductions realized for different electricity generation technologies.
Stern .Energy Economics prof Stef Proost Figure . Bottom up approach to abatement costs
by McKinsey source. . later chapter on renewable energy . One of the important parameters
for the cost of GHG emission reduction is the degree of technological progress. These cost
reductions are often a function of learning by doing and so a function of cumulative output
cfr. Figure .
Energy Economics prof Stef Proost Figure . Average cost of electricity for different
technologies as a function of cumulative production Barrett made a review of alternative long
term options to address climate change in the long term one can invest in avoiding the
damage by geoengineering addressing the weather on a global scale think about the hail
cannon used by the fruit industry in Limburg but one can also invest in adaptation lower the
damage of the physical effects by building better dikes etc. The other strategy is prevention
by either capturing more CO or by avoiding the emissions all together. Table . Table . gives
an idea of the energy supply options without CO emissions . gives an overview of carbon
capture technologies.
Table . According to Stern this would cost of GDP in permanence. According to Figure .
emissions per unit of output would have to decrease by to . Stern defends a preventive
strategy that would bring down concentration of GHG to ppm and limit global warming to an
expected C. He counts on a global deal between the rich countries that are responsible for a
large part of the historic emissions and the developing countries. The costs of emission
reduction in would be of the order of /ton of CO. On the basis of decision theory it is not
possible to decide in favour or against the postponement strategy. in order to allow for a
growth in emissions of the developing countries a very strong abatement effort would be
necessary in the rich countries. As can be seen the richer countries emit up to times more
GHG per capita than the developing countries.Overview of carbon capture technologies
source Barrett . gives the emissions of CO per capita for different countries. Figure .Energy
Economics prof Stef Proost What strategy for emission reduction Climate change is a
problem of decision under uncertainty. As the economy in may be three times as large as
now. Furthermore.. Important questions are the extend of emission reduction as well as the
timing of the reductions. One of the ideas is to postpone abatement efforts so that one has a
more precise idea about the level of damages and could possibly count on cheaper
abatement options. one needs to reduce overall emissions by compared to current levels.
Delaying action for years would be much more costly.
Energy Economics prof Stef Proost .
For an outsider. In Copenhagen and Cancun it also proved impossible to have a full
agreement on a climate agreement that would more or less limit the expected concentration
of GHG to ppm. In addition many of the signatories did not comply with their promises. Up to
now the success of the climate negotiations has been rather limited. One country can take
trade sanctions or send fighter jets but this also this enforcement action is costly and will not
be easily undertaken. there is no world authority that can enforce international environmental
agreements.Energy Economics prof Stef Proost . Figure . Economics of international climate
agreements The international climate negotiations started in Rio de Janeiro and led to a first
agreement in Kyoto . These negotiations are an ongoing process and the last rounds of
negotiations took place in Copenhagen in December and Cancun in dec and was based on
reports like the Stern report. India. Contrary to environmental problems at the scale of a
country. Emissions of CO per capita . According to the economic theory reaching a wide
agreement on an environmental issue at world scale is very difficult. an international
agreement is a logical step in an efficient approach to climate change. The Kyoto agreement
was not ratified by some of the key emitters USA and left out some of the important emitters
China.
Illustration of an international environmental negotiation problem. This is called the Nash
noncooperative solution and the total abatement effort equals times cfr.Ch for an example
with only countries. The other solution is an international agreement .Energy Economics prof
Stef Proost Barrett uses a model with identical countries and finds that the equilibrium
number of signatories in an international environmental game that is played only once equals
whatever the number of countries in the world. This can also be called a fully cooperative or
first best solution what could be reached if one could make a binding international agreement
where every country would make an effort of units of abatement. This comes down to
reducing emissions in every country up to the point where MC equals the sum of the
marginal damages of all the victims. Consider now the other extreme where there is no
cooperation at all. Each of them faces a marginal damage function MB that is horizontal. /ton
Total abatement effort Nash x Int Agreem x Full cooperation FB x MB MAC Int agreement
nash MB MB abatement Figure . presents a problem where identical problems face an
environmental problem that is caused by the sum of the emissions of the countries. so MC
MB and this implies a total abatement effort of units. Consider first what would be the ideal
solution for the world. In that case every country compares its Marginal Cost with the
Marginal Damage it avoids in its own country. Figure . We can illustrate the issue using a
simple graph. Every country can also reduce emissions but at increasing marginal cost this is
the MAC curve.
European Climate change policy The European climate policy has an international and an
internal European dimension. . It also promised to increase the . this is a game that is played
over and over again for a few years where players do not take into account past or future
behavior.Energy Economics prof Stef Proost that satisfies the following stability requirement
a country is as well off when it is signing the agreement as when it is not signing the
agreement. it promises a reduction by . As can be seen the selfenforcing requirement for
international agreements is a serious handicap and limits what can be achieved by an
international agreement. The equilibrium for this game is signatories and the total abatement
effort is here countries that make an effort MCMC so x plus others that work non
cooperatively MCMB so x or in total units of abatement. One could argue that this is the right
concept given that the political majorities in countries can change and that a new government
is not responsible for what the previous government did think about Obama and Bush.
International negotiation strategy of the EU The EU has promised to reduce its emissions of
GHG by at least in compared to the baseline level of . When the discount rate is sufficiently
low. We discuss first the international dimension. the sanction consisting of stopping
cooperation forever is important and Barrett proves that more performing international
agreements become possible. Moreover if there is a comprehensive international climate
change agreement. At present the EU plays such a cooperative strategy in the hope that the
others will follow. This is the solution of a one shot game. One could also think about
behavior of countries as more consistent with more continuity and then one could see the
game as a repeated game where each country can start by cooperating and punish those
that stop making efforts by also stopping its efforts and doing this forever . The group that
signs the agreement maximizes its group welfare so it considers the damage of its members.
In the cooperative scenario. This model studies the economic development in the world by
considering or so regions and modelling their emissions of GHG as well as the costs of
reducing these emissions. the assumption is that the USA commits to an identical reduction
as the EU in and progressively more in and that the new industrializing countries commit to
monitor their emission/ output ratios so that they cannot sell emission reduction efforts by
first increasing their emission levels. Simulation of costs of different EU strategies source
GEME Table .Energy Economics prof Stef Proost share of renewables to and have energy
savings of by but these targets have also other objectives than climate change. of GDP in .
What are the costs of this strategy and how will the EU achieve the and objectives This issue
has been studied using the GEME general equilibrium model. A second important
assumption is that there is full trade of carbon permits in the world. presents the economic
effects of the cooperative scenario where the rest of the world also agrees to make efforts
and the unilateral scenario where only the EU commits to emission reductions. This means
that the emission reduction in the EU and the US are partly bought in China and Brazil. The .
The price of a permit of CO emission will be of the order of /ton of CO. Table . The overall
reduction in the world will be and the gross economic cost before accounting for climate
damage will be .
as costs of emission reduction are very different across countries. one in country A and one
in country B that have the same constant variable costs. Individual climate policy initiatives
risk to disturb normal trade patterns. Country B will start exporting to country A although this
does not make any sense from an economic point of view as they have the same technology
and costs. It is also interesting to see what strategy could be followed to realize the if the rest
of the world does not sign any agreement. In that case.Energy Economics prof Stef Proost
cost for the US is lower than for the EU because the US starts from a higher level of
emissions per capita and can therefore more easily reduce emissions than the EU. In fact the
EU has two objectives the reduction of GHG emissions but also a share for renewables in .
First. Take as example two identical steel factories. the EU is in fact a common market with a
minimum of trade barriers and this is beneficial for the EU as a whole. the sum of the
individual efforts would be much lower. In country A there is a high carbon tax and in country
B. Finally. Of course there is still some hope that other countries will follow the EU in
implementing a strong climate policy but as shown in the previous paragraph good
international agreements are very difficult to reach. Second. it makes sense to exchange
efforts so that overall costs of reductions can be reduced. it would pay for the EU to set up a
monitoring system in a country with cheap emission reductions China and start trading
emission reduction efforts even if this country does not sign an agreement. The EU reaches
its overall emission reduction objective by using different policy instruments for the big
industrial emitters the Emission Trading System and for the other polluters home heating. as
we know from international negotiation economics. Compare the EU with a set of individual
countries. Important to note is that the demand for permits will be lower and the price of
permits will drop to a lower level. European climate policy It is important to define a climate
policy at EU level for three reasons. it is better to have transfrontier environmental pollution
problems solved at the broadest policy level. there is a lax emission regulation. transport.
service sector.
. Initially most permits were grandfathered distributed for free but there is a tendency to
oblige member states to auction a greater share of the permits. overall. subsidies for
investment in low carbon equipment etc. . insulation standards for buildings. For the big
emitters every country receives emission permits more or less proportional to an average
emission rate and the type of industrial sectors it has. The firms can then trade permits
nationally and internationally. But when this was a poorer and strongly growing country. the
marginal costs of emission reduction in the ETS and nonETS sector are not too different cfr.
the effort required from the nonETS sector in this country was reduced. The instruments
used for the nonETS sector are left to the discretion of the member states but policies that
affect the intra EU trade are mostly taken in common. Table . Important policies in the
nonETS sector are fuel efficiency standards for cars.Energy Economics prof Stef Proost
energy supply mainly electricity production. The member states are in favor of this policy
because it generates extra tax revenues without having to vote unanimously on a carbon tax
at EU level which would be virtually impossible. the countries with the cheapest options to
emission reduction had to promise larger emission reductions. As regards the distribution of
efforts over EU countries for the nonETS sector. The total emission reduction in the nonETS
sector has been set such that.
To start the ETS system one needs first a good record of past emissions. a year in which
there was no interest yet in GHG emissions so that it was impossible to increase .Energy
Economics prof Stef Proost Table . Results of EU carbon policy. . This was taken from a
database with all thermal plants large than Mw and preferably for . A closer look at the
experience with the ETS in the EU The ETS experience in EU is the first experience with a
pollutant at a multisectoral scale the US has experience with sulfur trading in the electricity
sector.
What was the impact of the ETS system on industry profits Several sectors had an increase
in profits. and every permit used for its own production reduces the amount of permits that
can be sold on the international permit market.. . changes in the total rights attributed by the
Commission. The price of a permit implies that the sector will reduce emissions per unit of
output as long as the marginal cost of emission reduction is lower than the price of a permit.
Overall the system worked well but there were large fluctuations in the prices to /ton of CO.
Figure .. and . The fluctuations were the result of different factors learning by the market
players. Although the member states could auction to of the permits they received.
represents the possibilities of emission reduction per unit of output. New entrants received
often free emission permits. expectations on future economic activity etc. The effect of an
ETS system on the price and profits of a sector can be analyzed using Figures .Energy
Economics prof Stef Proost emissions in order to receive more permits. Firms could bank
save or borrow emission rights that can be used in later years. Those who closed their plant
lost their permits. The EC checked that not too many permits were distributed as this would
generate a very low price level for emission certificates. Those not complying emission in
firm gt amount of permits it had had to pay a fine of / ton CO in and / ton CO in . This penaly
sets a maximum price for the permits. how can this be explained A system of tradable
permits always increases the marginal cost of production even if the firm receives more
permits than it needs. The marginal cost increases because every unit produced requires
some permits. only a few states did this.
Energy Economics prof Stef Proost Marginal cost of emission reduction per unit of emission
reduction Price ETS Euro/ton CO Cost increase due to measures to reduce emissions per
unit of product abatement cost Cost increase due to the purchase Of emission rights
Reduction of emissions Initial emission Per unit produced Per unit produced Figure . Effect
on profits and prices of an ETS sector. Two sources of abatement costs per unit of output
produced Price Spermit system A J Price Increase Cost of permits bought or Value of
permits received Price of Emission permit cost SAbatement A F D A SMarg Cost E H G C
Demand O O O Output Figure . .
the profits of the sector will increase. the gross profit is reduced to E F H. This will also
depend on the priceelasticity of demand. . The main challenges for the European ETS
system are the price formation in an uncertain world environment cfr. The first shift D to F
from curve S to Sabatement cost represents the extra abatement cost per unit of product the
triangle in Figure . Zpafel P. . this reduces the equilibrium price of permits. Oxford Economic
Papers. Table . The objectives for the EU depend on the cooperation or not of other
continents and on the integration or not of the other continents in the ETS system. This is the
case for the electricity sector. On the other hand. Klaassen G. The coming global climate
technology revolution. The new profit level after imposition of the ETS system is now J A F G
when all necessary permits J A F E have been grandfathered. . helps to define the upward
shift of the marginal cost of production in figure . When no permits are received. Journal of
Economic Perspectives. The initial gross profit was H A C.Energy Economics prof Stef
Proost Figure . the demand for permits will increase and so may do the price. Review of
environmental economics and policy. if other continents have also ambitious emission
reduction goals.. Indeed. if one opens to other countries with low emission abatement costs.
.. The role of environmental poliy making at the European Commission. The new equilibrium
in Fig . is now A and this is the result of the cost increase and the price elasticity of demand..
References Barrett S. van Ierland T. corresponds to a cost increase per unit of output.... The
second shift upwards F to A corresponds to the need for permits per unit of output the
rectangle in Fig . p Barrett S. p . it is easy to increase prices and maintain profits. if this is
low. n. vol. corresponds to an increase in cost per unit of output. p Delbeke J. Selfenforcing
environmental agreements. So whenever the sector receives an important share to of its
previous emissions as emission permits. . . .
. Edward Elgar .Energy Economics prof Stef Proost Mendelsohn R. Ch in Evans J. Rev.
Current issues in the design of energy policy. . W. Stern R. . Amer. eds. D. pp. Nordhaus .
The economics of Climate Change. D Shaw. Hunt L. p WeymanJones Thomas. The impact
of global warming on agriculture a ricardian analysis.. . American Economic Review. .
Econom. . International Handbook of the Economics of Energy. Papers and Proceedings.
. Section presents a small model of demand and supply of the coal market. ACCO. The
heating capacity of coal varies from less than kj/kg for lignite to kj/kg for anthracite. Outline
This chapter deals with coal. lignite and coal. This is not necessarily the outlook we prefer
but it helps to put historic trends in perspective. other types that are ideal for household use
anthracite.Energy Economics prof Stef Proost Chapter Coal . Peat and lignite are precursors
of coal that have lower energy density. all coal can be used as fuel in power stations. In the
third section we survey the main uses.Van Herterijck Aardgas . The IEA outlook is based on
many For a good review of mainly technical issues in the gas industry see W. Section
presents some basic economic principles of the coal market. dealing with conventions and
definitions. the main consumers and producers as well as the main trade flows. . tonne of
coal. economische en politieke aspecten. Its future is uncertain there are abundant reserves
but its use generates more air pollution and more GHG emissions than the other fuels. As
coal is a scarce resource. Coal covers of the world energy needs and is the main fuel for
power generation in the world. technische. Units The heating capacity of tonne of oil is more
or less equivalent to the heating capacity of . This is the topic of section . it is important to
know the total available quantity of coal. We start the chapter with a small introductory
section. Within the coal category there are many variants. Some conventions and definitions
Different types of coal For coal one distinguishes traditionally between peat. Section
discusses the history of the natural gas market. Sources of data and forecasts In this chapter
we will use often data of IEA outlook . Some coal types are better suited to make
metallurgical coal.
Energy Economics prof Stef Proost assumptions. nuclear. barrels . Use of gas Home heating
amp cooking Industrial generation Power generation heat Main substitutes Gasoil. heavy fuel
oil The next graph shows that the consumption of coal is growing strongly in Asia China. . for
industrial heat production and home heating. / bbl. Main producers Remember that in terms
of heating capacity. ton of coal . ton of oil . Coal is noawadays primarily used for power
generation. firewood Fuel oil. consumers. producers and trade flows Main uses Coal has
long been the dominant fuel replacing wood in the past. Main uses. natural gas. The price of
coal is expected to stabilize in real terms at per tonne or the equivalent of . India over the last
years and is more or less stable in the rest of the world. natural gas gas.
South Africa. Australia. South Africa. .North America and Colombia to the main importers
Japan.Energy Economics prof Stef Proost Production is also more or less stable in most
continents but growing strongly in China and India. The main producers are China.. Trade
flows The major trade flows are from the exporters. South Korea. Russia. Russia. Germany.
India etc. Australia. India. the US.
times the proved reserves of oil. Estimates are Trillion cubic metres. There is one successful
plant in Uzbekistan where the gas produced is used to run a MW power plant. A technique
useful for the coal at large depth. Idea is to apply the technique to layers below m and to coal
layers lying offshore. as no one seems worried about the extent of the reserves. .
conventional coal The proved reserves are of the order of billion ton of coal or billion TOE or .
much less efforts have been done to estimate the ultimate recoverable reserves. non
conventional coal There are two types considered. How much coal is there We know that for
any resource. In addition. The first is in situ or underground coal gasification. Coal mine
methane is the second type of non conventional coal resource one also calls it a gas
resource as it produces methane. the reserves depend on two factors the market price and
the degree of confidence one has in the estimates.Energy Economics prof Stef Proost .
There are ample reserves of coal and these are in addition distributed more equally than oil
and gas.
put very excise duties.Energy Economics prof Stef Proost . Obviously. give very high
subsidies to local production. the price in the importing country will equal the price in the
exporting country the transport cost per unit of the product. impose regulations on imports
that are very costly etc. Economics of the coal market Opening the coal sector to foreign
trade The following two figures illustrate the effects on welfare of an opening of a sector to
trade. . In equilibrium. for a given degree of protection. There is a small transport cost. The
first figure shows the situation without trade. The price is high in the potential importing
country and low in the potential exporting country. Equilibrium without free trade POTENTIAL
IMPORTER Marginal cost POTENTIAL EXPORTER demand demand Pimp Pexp Marginal
cost Q importing country Q exporting country How does one protect a sector from too much
foreign competition There are different ways of doing this outlawing imports. In the next
Figure we allow free trade. some instruments are more efficient for a country than others
those that generate revenue for the government are better than those that impose extra
costs on imports.
Both countries gain from free trade but in every country there will be losers and winners.
who have access to lower prices and have a gain in consumer surplus equal to P A B P.
have to reduce production and see the price for the remaining production decreased. and
sea transport. Coal has high transport costs Coal is costly to transport as it has low energy
density. the net gain equals CAB.Energy Economics prof Stef Proost POTENTIAL
IMPORTER Marginal cost POTENTIAL EXPORTER demand demand Pimp Pimp C A B
Pexp import Pexp Transport cost export D F E Marginal cost Q importing country Q exporting
country Total gains from tradeABCDEF . In the importing country. one combines inland
waterways. For this reason one prefers to generate electricity near the mine. Transport costs
are an important determinant of coal trade and will be integrated in the modelling approach
that will be presented later. . They lose P A CP. There were very large differences in
production costs of coal some countries had surface coal and thick layers. This is the result
of a gain for consumers. History of the coal market in Western Europe Second World war
.loss for producers in importing countrygain for consumers in importing country gain for
producers in exporting country loss for consumers in exporting country The quantity of
imports and exports are equal because there are only countries trading. But there is also a
loss for the producers who face lower prices. This started with the European Union for Coal
and Steel. . other countries had very deep mines m and thin layers. As the coal industry
occupied a large work force in many countries. Similarly in the exporting country there is a
net gain of DEF but a loss for consumers PDFP and a gain for producers equal to PEFP. it
was difficult to open the coal sector to competition. When one has to export coal. In this
period there is a progressive opening of the European national coal markets to imports of
coal.
it was the result of the first and second oil price shock. Power stations initially designed to
burn coal. Even inside Belgium some regions were protected against the competition of other
regions. The older mines in the Walloon region had higher costs than the Limburg region
where production started after world war. The increased demand for coal was not planned.
The Belgian government restricted the output of Limburg coal in order to let the Walloon
mines survive longer. There was a strong increase in coal exports Figure . Prices increased
strongly in the ties but once capacity of production and transport train. . Production expanded
mainly in Australia because the South African apartheid regime was still facing a trade
embargo. import quotas etc. switched to cheaper natural gas and were retransformed into
coal powered stations. But also the large domestic US market became a net exporter when
prices were high enough Figure . harbours were adapted prices dropped Figure .Energy
Economics prof Stef Proost In Belgium as in most of Europe. were transformed to use HFO
in the ties. the local coal production was threatened by cheap coal from abroad but also by
cheap HFO and natural gas. From In this period there was a renewed interest in the use of
coal. This lead the government to protect the coal industry using a combination of techniques
subsidies for production. Prices of oil and later gas increased strongly and this gave rise to a
much higher demand for coal. so there were problems of capacity to meet demand and this
led to strong price increases for international coal..
Energy Economics prof Stef Proost .
The faster one closed the mines the more funds were available for development. The fund
was used to subsidize the employment of ex miners in other industries. the domestic coal
industry was an important sector in terms of employment and managed to lobby for
protection. This operation was a success and overall employment in Limburg increased.
From onwards We see that coal prices on the international market converge more and
more.Energy Economics prof Stef Proost In Europe. Why did this transfer not happen earlier
The main reasons were first that the miner had a good wage paid by subsidies and the
prospect to find another job is uncertain. . In the ties the real value added measured at world
prices without subsidies of a person employed in the mine was only to of the added value in
the rest of the industry. The final agreement was based on the following idea the expected
subsidies for the next to years were given to a fund for local development. Second there was
the idea that the number of jobs is fixed there is something like a stock of workplaces and it
is very difficult that another industrial activity could be developed in that region. This means
that whenever one can transfer a miner to a job in industry and he produces more than of the
average worker in industry there is an efficiency gain for the country as a whole. One had to
wait for the late ties to find a political compromise to stop the production of coal in Limburg.
Main arguments used were employment and security of energy supplies.
. . . . India. the use of coal becomes more attractive but users of coal need much more CO
permits. Also nuclear power can be considered as a strong competitor for coal powered
stations but there is a long delay in having new power stations accepted. The GHG emission
limit will be the binding constraint on the expansion of coal use in Europe.Energy Economics
prof Stef Proost Coal prices . . . . . . Nort hwest Europe marker price US cent ral Appallachian
Japan coking coal cif japan st eam coal cif years Important developments in this period are
the high oil and gas prices in and the interest for a limitation of the GHG emissions. In the
rest of the world. The competition of nuclear power will also be stronger when there is
binding GHG constraint. In the EU there is a strict limit on GHG emissions implemented via
tradable permits. . there is not yet a binding GHG emission limit so that coal use will continue
to expand in the US. . With high gas prices. China.
Econometrica. we find a that the price for each import line that is used by an importer should
be identical.Energy Economics prof Stef Proost .. This can be used to simulate World trade
flows if one assumes perfect competition on the world coal market.. n p and Takayma T.. i . X
ij In the optimum. n . The competitive equilibrium can be modelled by maximizing the sum of
total consumer surpluses minus the production and transport costs M ax j X j PX j d X j TK X
i i T i j ij X ij i i X ij X i j j X j X ij j i first o rd er co n d itio n s P X j j if X j w ith resp ect to X i .
Modelling the world coal market Perfect competition model We propose to model the coal
market using a simple optimisation technique initially proposed by Samuelson and Takayama
amp Judge ...N producers of coal with a convex continuous total cost function TKiXi where Xi
is tota production by I There are j .. Equilibrium among spatially separated markets a
reformulation. X ij . Judge G. Besides perfect competition.M consumers of coal with a
Willingness to Pay function PXj The quantity deliverd by producer i to consumer j is called Xij
and there are constant transport costs per unit Tij. vol . Vol .. Spatial price equilibrium and
linear programming.G.... X j . American Economic Review. we also assume that consumers
are not interested in diversifying their supply. j g ive yo u M K i i if X i T ij i j if X ij su b st itu tin
g i an d j in last eq u atio n o n e o b tain s at o p tim u m P X j M K i T ij fo r all i w h ere X ij
an d co m b in in g o f th e latter co n d itio n s o n e h as at o p tim u m P X j T ij P X j T ij fo r
all X ij . . Take i.. Samuelson P. p .
. One could use a Cournot model where the main exporters Australia. Non competitive
models Several noncompetitive models have been proposed. . south Africa.Energy
Economics prof Stef Proost b for each producer. control each their production and there is a
competitive fringe. the net revenue from all destinations that are used should be equal. .
There is some evidence that exporters in Australia and South Africa control their exports via
government regulations or private cartels. One of the problems of such a model is that the
competitive fringe is very important the US and China do not export a lot of coal but they
have a large national market so their net export and import can react strongly to price
fluctuations.
it is important to survey what we know about the total available quantity of oil and what are
the determining parameters for this estimate. balances many energy markets in the world.
heavy fuel oil. In the second section we survey the main uses. In addition. can have different
gravities and sulphur contents. For crude oil we distinguish between different types of
products because they have a different cost structure and different properties Concentional
Crude Oil oil produced from conventional wells on land or on sea./specific gravity. We start
the chapter with a small introductory section. the raw material that is. As oil is a scarce
resource. Introduction This chapter deals with the most important energy vector oil. In a
separate chapter we deal briefly with the refining and the price formation for the separate
products. In section we try to use different economic models to understand the history of the
oil market over the last years. This is done in section . where the . dealing with conventions
and definitions.Energy Economics prof Stef Proost Chapter Oil market . Some conventions
and definitions The different types of oil We deal in this chapter with crude oil. Section deals
with policy questions on the oil market what future can we expect What can consumers do to
keep prices low An appendix deals with the price formation of oil products. One uses often
the API gravity . It is still the type of primary energy that has the largest market share.
Section presents a few simple models that can be useful to understand the oil market. the
main consumers and producers as well as the main trade flows. . given its low transport cost.
diesel. after a refinery process transformed into final products like gasoline. it is the fuel that
can be used for almost any energy need and. at different depth. bitumen etc. fuel oil.
We use the BP statistical yearbook conversion factors barrel is approx.API is on average oil
shales is a hard rock that contains oil Natural Gas Liquids Liquid hydrocarbons produced as
a byproduct in the production of gas. Non conventional oil This represents different types of
oil that have lower quality APIlt but could represent a resource stock larger than that of
conventional oil. oil sands tar sand. The sulphur content of crude varies from more than .
million tonnes per year Sources of data and forecasts . Units The oil industry uses mostly
barrels and million barrels a day. Sulphur content matters because consumers prefer end
products with a low sulphur content for environmental or other reasons. ton and this allows
conversion to Ton oil Equivalent million barrel per day /. Alaska. natural bitumen are mixtures
of sand. Light crudes are Algeria Sahara API. Brent .. The higher the API the lighter is the
crude and the more light products gasoline one can extract out of a ton of crude.. etc. They
represent a small source of oil distillates and are therefore often treated together with oil.
heavy crudes are coming from Venezuela.. / .Energy Economics prof Stef Proost specific
gravity of water is and so the API of water is . clay and crude bitumen.. . . to less than . heavy
oil is a dense and viscous oil that requires usually the injection of steam and diluents in the
reservoir to produce it.
. o and the North African producers form the OPEC group that controls some of total oil
supply.Energy Economics prof Stef Proost In this chapter we will use often data of IEA
outlook . consumers. feedstock for chemicals. The middle east producers together with
Venezuela. Main uses. Main energy uses are industrial heat. Russia. Iran. power generation.
The IEA outlook is based on many assumptions. Most important producers are SaudiArabia.
Canada. home heating and motorfuel. This is not necessarily the outlook we prefer but it
helps to put historic trends in perspective. producers and trade flows Main uses Oil has non
energy uses lubricant. It is relatively easy to substitute in most energy uses except as
motorfuel. . So in the next figure OPEC is somewhat larger than Middle East Africa. bitumen
for roads as well as energy uses. per year until . Indonesia. . Main producers The next figure
gives the production of oil by region. Important assumptions are a real oil price of /bbl in and
/bbl in as well as an economic growth in the world of . Venezuela . US .. sometimes acting as
the dominant supplier that controls prices . Nigeria. OPEC acts often as swing producer.
The US consumption continues to increase. In the next Figure one sees the consumption by
region. Figure . Consumption of oil by region source BP statistical review . Production of oil
by region source BP statistical review Some of the main producers are also large consumers.
This is the case of the US and Russia.Energy Economics prof Stef Proost Figure . Important
trends are the smaller consumption in Europe and the strongly increasing demand in Asia.
the EIA Department of energy of US and finally a recent paper by Aguilera et al . . These
can be compared with a present consumption of some million barrels per year. How much oil
resources are there We know that the quantity of oil depends on two factors the market price
and the degree of confidence one has in the estimates. energy outlook One sees that some
regions are strongly dependent on imported oil. Figure . . For many OECD regions it is or
higher. Any oil source can in principle be substituted by another oil source but there can be
adaptation costs at the refinery.Energy Economics prof Stef Proost Trade flows The cost of
oil transport is relatively small because large tankers can be used and the product is easy to
ship. We present here briefly three estimates the IEA OECD energy outlook . Major Trade
flows source IEA. We will use million or trillion barrels of oil for estimates of oil resources.
followed by bitumen or oil sands mainly Canada. As there is an extra conversion
loss.Energy Economics prof Stef Proost The IEA OECD energy outlook Best is to summarize
their view in the following long term cost curve. . For the non conventional oil. So the
extraction of nonconventional oil has an important CO emission drawback. The extraction of
oil from such resources is difficult and may requires a lot of energy and water as these
processes require steam. Figure . In this figure the first block represents oil already
produced. The next resource category are the oil shales that require even more water and
energy if the resources are not near the surface. the cheapest to develop is the heavy oil
mainly Venezuela. Then we have several blocks representing different techniques of
enhanced oil recovery and oil produced in very different conditions. The oil recovery factor is
very important as a doubling of the oil rovery factor from to doubles the quantity of oil that
can be extracted from a given reservoir. Long term oil supply curve IEA. If one really needs
liquid fuels one can also transform natural gas and coal into liquid fuels. The next block is
cheap oil from Middle East and Northern Africa followed by other conventional sources of oil.
this will only make sense if the energy need can not be satisfied by coal or gas directly.
gov/oiaf/ieo/index. Third some technologies are still under development and will only be
available after .eia. the higher the return required. Interesting feature is that they are bound
by law to make all the information and models publicly available http//www.Energy
Economics prof Stef Proost This is a long term cost function and for the production to be
available at these marginal costs. Production will be limited by the recovery rate. The Energy
Information Agency view The EIA US department of Energy is responsible for a regular
outlook on the world energy situation. . Investment in production capacity will only happen if
the producer believes that future prices are high enough to guarantee a sufficient margin.
several conditions need to be satisfied. Second. The EIA produces estimates of the total
resource in place that contains past production gt trillion barrels and the total resource stock
in the reservoirs. First.doe. any production needs production capacity and this requires long
deadlines if it involves difficult production techniques like in the case of production in deep
sea.html. The higher the risk. some of the production needs first exploration resources are
there but statistically.
Third they add unconventional resources.. Also for unconventional oil does one find much
more optimistic estimates in the Aguileras study than in IEA.. Unfortunately no confidence
intervals are given.Energy Economics prof Stef Proost Paper of Aguilera et al. These authors
produce an estimate on the basis of USGS estimates of to which they add three new
elements. . Details can be found in Aguilera et al. One possibility is that the IEA adds a large
risk premium to the capital costs before certain production potentials are made operational.
Depletion and the future availability of petroleum resources. The long run curve shows a
much larger potential of conventional oil than IEA some more and this at cost levels less than
of the ones mentioned in the IEA study. The Energy Journal . It is not clear why the cost
levels are so different. . First they estimate the potential of regions previously not
assessed.Tilton J. oil resources could supply demand for the next years. . Aguilera R.. Lagos
R. Here we concentrate our attention on the long run cumulative availability curve. Second
they add future reserve growth . Vol . Eggert R.The methodology is mainly statistical but is
well documented in the paper. oil would no longer be a very scarce resource as even with a
demand growth of per year. N. Overall if one believes the Aguileras study.
A simple oil market model with exogenous OPEC supply The simplest model one can use is
a model with linear demand and linear non OPEC supply function that is calibrated to long
term equilibrium of the oil market. It will mainly serve to illustrate the difference between short
and long run responses. We will rely on three simple economic models that we review in this
section. Three simple models for the world oil market In the next sections we will discuss the
history and possible futures of the oil market. The first model is a simple demand and supply
model for one period with an exogenous OPEC production level. The data one needs to
calibrate the model are limited to the . Cumulative supply curve oil resources .Energy
Economics prof Stef Proost Figure . The second model is a one period model where a cartel
acts as dominant supplier. The third model is a multiperiod model where OPEC sets the
prices and quantities to optimize its long term profits.
Q Market Price P A ADD Assumption On LR elasticity of Demand to have slope Exogenous
OPEC supply Q Quantity Figure . The starting point needs to be long term equilibrium.Q and
the LR demand elasticity.Energy Economics prof Stef Proost equilibrium price and quantity
on the world oil market say for a year. The procedure is illustrated graphically in Figure X. the
exogenous supply by OPEC in that equilibrium as well as the short run and long run demand
and supply elasticities. These are much smaller as it is much more difficult to react in the .
substracting the exogenous OPEC production gives the initial equilibrium nonOpec supply
point A. This initial nonOPEC supply. It is important to use the elasticities in the observed P.
Price LR demand LR non OPEC supply ADD Assumption on LR elasticity of Supply to have
slope OBSERVED P.Q as the price elasticities of a linear function are not constant.
calibration of the long term model We can proceed the same way to find the short run SR
supply and demand functions.Q as an equilibrium but the demand and supply functions have
a much stronger slope. In the first step one calibrates the long run model.Q. These also have
the point P. This time we use the SR elasticities of demand and supply to calibrate the
demand and supply functions. The LR demand function can be found by using the observed
P. the price P and the elasticity of nonOpec supply allows to find the long run LR non Opec
supply that passes through point A. One starts with the observation of a long run equilibrium
P.
Energy Economics prof Stef Proost short term than in the long term because one needs to
adapt installations. Once one has calibrated the short and long run model for the world oil
market. The calibration is illustrated in Figure XX. Price SR demand SR non OPEC supply
ADD Assumption on SR elasticity of Supply to have slope LR demand OBSERVED P. There
are other functions one could calibrate to a long run equilibrium P. This is illustrated in Figure
. An alternative is a constant elasticity function QaPb .Q. Demand elasticities for durable
goods cars can be larger in the short run because there is a stock of goods one can use for a
longer time. We use linear demand and supply functions. An interesting exercise is to
analyze the effect of a sudden reduction in the exogenous Opec supply. . train personel
etc.Q Market Price P LR non OPEC supply ADD Assumption On SR elasticity of Demand to
have slope Exogenous OPEC supply Q Quantity Figure . Calibration of the short run demand
and supply functions. one can use the model for comparative statics.
Effect in short and long run of a sudden interruption in the Opec supply. we can also see
that the new long run equilibrium involves much smaller price increase and a larger quantity
decrease.. In Figure .Energy Economics prof Stef Proost Price SR demand SR non OPEC
supply New short run equilibrium LR demand New long run equilibrium Market Price P LR
non OPEC supply INITIAL EQUILIBRIUM OBSERVED P. Pindyck and Rubinfeld started
from the following data for World price /bbl. D.Rubinfeld. . the ed. Long run . Prentice Hall .
.Q Exogenous OPEC supply INTERRUPTION Q Quantity Figure . total demand and supply
billion bbl/year and Opec supply of billion bbl/year. . p . Using the following data on price
elasticities PRICE ELASTICITIES Demand Non Opec supply Short run .. Microeconomics.
Pindyck R. The sudden reduction of OPEC production shifts the short run supply curve to the
left. the intersection with the SR demand function gives a new SR equilibrium with a much
higher price and quantity that is only reduced slightly.
.P and this gives a new short run equilibrium where P. Once one knows the amplitude of the
shift one This holds for the oil market but does not need to hold at the level of one private
consumer where we only know that the sign of the compensated price effect is negative.
These could be generated by problems in the supply of a substitute to oil natural gas. .P We
can now compute the possible effects of an interruption of million bbl of OPEC oil using these
two systems of equations.P TS. This very simple model already shows an important
characteristic of the oil market that is often forgotten unexpected supply interruptions
generate very strong price increases in the short run but after a few years the supply and
demand response to a price increase is much larger and the remaining price increase is
much smaller. one can calibrate the following demand and supply functions Short run
demand Short run non Opec supply Total SR supply And the long run functions Long run
demand Long run non Opec supply Total LR supply D. Using this data..Energy Economics
prof Stef Proost As one can see...P and this gives a new equilibrium price of only .P TS.. For
the long run equilibrium we need to solve system new total supply function TS.P D.....P S.
/bbl and a quantity of only .P S. demand elasticities are always negative and supply
elasticities are always positive. /bbl. For the short run equilibrium we need to solve the
system of equations a new total supply function TS. The short run elasticities are much
smaller than the long run elasticities. One could also analyse the effect of unforeseen shifts
in demand. /bbl and Q.
If this is the case.Energy Economics prof Stef Proost can. The implications for the
equilibrium on the oil market can be derived in two steps Step construct the residual Demand
function for OPEC oil by subtracting for each possible price level the competitive supply from
the world oil demand Step Derive OPECs optimal production by considering it as a
Monopolist confronted with the residual demand function for OPEC oil and a cost function
that is the aggregate cost function of the OPEC members. one can derive an algebraic
expression for the dominant supplier model. This is also called Stackelberg equilibrium.
OPEC as dominant firm in a one period model OPEC can be considered as a cartel where
producers agree on the total quantity produced and on the allocation of production among
their members such as to minimize costs of production. analyse what is the effect of this shift
on prices and quantities in the short and long run. using the same procedure. OPEC can be
considered as a dominant supplier because it can supply more than of the market and the
other suppliers called competitive fringe are all smaller producers that take the market price
as given. Demand for OPEC oil equals for any price the difference between world oil demand
and competitive supply Dopec Dm Scs Using a linear competitive supply function qt pt d As
well as a linear world demand function qt pt a b . Using linear demand and supply functions.
Demand function for dominant supplier In the second step we derive the optimal production
of OPEC.Energy Economics prof Stef Proost One obtains the residual OPEC oil demand
function for the prices where the competitive supplier is also active Dopec da bc b d pt bd
Figure . A monopolist will absorb half of the increase in p the marginal cost and this is what
we observe here . z We see that the price p is also increasing in the slope d of the supply
function of the competitive fringe supply a high slope means that the competitive supply has
strongly rising marginal cost so that a price increase . We use for this a constant marginal
cost z and look for the optimal price p da p b d Max p z p bd p z ad ad z b d and q bd b d We
see that the price of the supplier is increasing in his own marginal cost z and in the choke
price a .
. As in the case of a monopolist. We will also add the supply of a backstop technology. This
helps the dominant supply to set high prices. Figure . Modellering van de oliemarkt met
backstoptechnologien. Optimal production for a dominant supplier OPEC as dominant firm in
multiperiod model We can elaborate the previous model by adding a reserve constraint for
the dominant supplier so that OPEC has to distribute its production over time using the
Hotelling rule for a monopolist. Verhandeling Master Economie. In general. the less elastic
will be the residual supply for OPEC oil and the higher will be the price charged by the
dominant supplier. The next figure shows the optimum for the dominant supplier.Energy
Economics prof Stef Proost does not generate a strong increase in competitive supplies. De
Keyzer constructed a spreadsheet model to test the effects of different parameters on the
OPEC strategy if it would follow a Stackelberg or T. the smaller in absolute value the price
elasticity of world oil demand and the smaller the priceelasticity of the competitive supply. De
Keyzer. MC MK in figure determines the optimum quantity and price. the equality MR MO in
Figure .
. Exogeneous growth in demand for oil . . The parameters used are initial equilibrium in
World demand price elasticity . Reserves OPEC billion bbl The model is solved using periods
of year. /bbl Initial quantity world market Mio bbd Initial competitive supply of conventional oil
Mio bbd Initial Backstop oil supply Mio bbd Technological progress in backstop cost
reduction of /year Marginal cost of OPEC oil increases with . The results of this type of model
are summarized in the following tables Price in /bbl Production of OPEC million bbl/day . .
Average price in initial year . . . per Billion bbl Discount rate . per year World elasticity
competitive supply conventional oil . Price elasticity backstop supply .Energy Economics prof
Stef Proost dominant supplier strategy that maximizes discounted profits over time. The
model is simplified one looks only at stable long term strategies and no total resource
constraint was taken into account for the conventional nonOPEC oil and for backstop oil.
Market share OPEC Market share competitive supply Market share backstop . increase its
market share and have a price that is gradually increasing. . . Apparently it is not in the
interest of OPEC to use all its oil. . It increases the market share of OPEC and this allows it
to increase its price. that makes price increases less interesting and the increasing marginal
cost of OPEC oil. . . This results in backstop oil supply that remains rather low. Some
comparative statics The growth rate of demand is an important parameter. . This could be
due to three factors the limited horizon year.Energy Economics prof Stef Proost According to
this optimisation. The resources of OPEC are fully exhausted they are taken as fixed here
and this is an irrealistic simplification. it is in the interest of the long term profits of OPEC to
increase its supply of oil gradually. Prices increase from the first period onwards because the
opportunity cost is higher in the next periods. the low elasticity for OPEC oil approx .. .
Mobil. BP. Scen. The origin of the Royal Dutch Shell is the production of oil in Indonesia. As
early as did Rockefeller acquire a monopoly for oil supply in the US with the Standard Oil
Company and controlled of total supply. Gulf. Socal. the sisters controlled total oil output as a
cartel. it was the discovery of oil in the Middle East. Rockefeller was followed by the sisters
Esso. for BP. One of the big problems of any cartel is to control each others output. After the
breaking up of the monopoly in . Both regions are former colonies of the Netherlands and the
UK. price of oil that max profits of OPEC for different growth rates . This was done by a
system of coownership in each others production facilities. groei wereldvraag groei
wereldvraag Figure . Shell.Energy Economics prof Stef Proost different growth rates of
demand p Periode Periode Periode Periode Periode Ref. Some of the sisters originated from
the breaking up of the Standard Oil Company. Texaco. After the nd world war.
Understanding the history of the world oil market Before History of oil prices is a history of
cartels and monopolies even before OPEC became the dominant supplier. .
can be sold to the highest bidder. This was not a deliberate action by OPEC but rather the
result of a response by Arab countries to the Yom Kippur war where Israel tried successfully
to conquer some strategically important neighbouring land. This is not really possible as
oil.Energy Economics prof Stef Proost The sisters controlled also sea transport. OPEC was
created in in a response to a fall in tax revenues that originated from a recession and the
control of prices by the sisters. Figure . OPEC nationalised most of the production. Real oil
prices over time Source Hamilton This is the first oil shock. once on a tanker. The Arab
coalition denied oil deliveries to the friends of Israel. In this period the economy was growing
very quickly. The result was a restriction of supply and a strong increase in prices. But OPEC
was not really capable to increase prices as the sisters also controlled the downstream
operations. the refineries and the distribution so that the cartel was very effective. oil was
taking over from coal and all this resulted in a strong growth rate for oil to per year before .
OPEC realised almost by accident that it had market power and there was a belief that prices
will stay high forever. .
Strategies for OPECs Pricing and Output Decisions . n .. The Energy Journal. Vol .Energy
Economics prof Stef Proost Initially there was a belief that oil demand will simply not react to
a higher price. Building new nuclear power stations or building new oil platforms in the North
Sea takes to years. coal and nuclear. This is correct in the short term but not in the long
term. Demand response was to switch to natural gas. So the full response to the oil price
increase takes time and was hidden by an economy that kept growing. developments
Gatelys interpretation of oil market Gately D. Converting coal power stations to oil and back
to coal or converting oil powered stations to gas does not take much time. Gately presents
the history of the oil market using two diagrams Figure .
In the period to . In addition Iran and Iraq fought a war and needed oil revenues to finance it.
. any attempt to increase prices by reducing output generates an expansion of the output of
the non cartel members so that price increases are costly for the cartel. oil production of Iran
decreased and none of the OPEC countries wanted to increase production. million bbl/day in
. one sees a strong expansion of demand for oil at constant price and it is mainly OPEC that
satisfies the increase in demand. The second diagram shows the OPEC output and the
nonOPEC output so that rays from the origin show the market share of OPEC. OPEC tried to
defend the price until . SaudiArabia as largest producer cut back its production from . million
bbl/day in to . Moreover the Western economies are in a recession. This generated the
second oil shock. This meant its share came close to / of the market. We know that a
dominant producer can only control prices if his market share is large enough or more. If his
market share is too small. the oil production decrease of worked and allowed to more than
double oil revenues of OPEC in the period to . In these market conditions. With the Iranian
revolution at the end of .Energy Economics prof Stef Proost In the first diagram the real oil
price is related to the output of OPEC and level curves for OPEC revenue price times OPEC
output level of revenues for OPEC show what happened to OPEC gross revenues over time.
But prices decreased strongly and the largest OPEC members decided to regain market
share by increasing their production SaudiArabia increased its production in to . OPEC has
to decrease its output in order to maintain the price. million bbl/day. prices doubled again and
so did the revenues of OPEC It is now more than to years after the first oil shock so that
demand substitution and nonOPEC production can really react. So total demand for oil and
for OPEC oil decreased.
At a certain moment prices decreased below the /bbl and the expensive oil producers North
Sea were fearing bankrupty. OPEC also tried to made agreements with Russia and Norway
expanded output from . A first is that OPEC was not aware of the stronger longer term
demand and supply response. This is a period with strong price fluctuations and different
attempts by OPEC to regain control. There was often disagreement between the different
groups within OPEC because it is difficult to share the costs of output restriction. One can
indeed find official statements that go along that line. OPEC tried to control output much
better but this was often difficult as the smaller members had an interest to sell oil unofficially
via barter trade etc. A second is that the different cartel members had different interest some
want to maximize revenue in the long term because they have ample reserves and do not
want to push the development of substitutes too much but others go for the high revenues in
the short term members with small oil reserve base and large population like Algeria. Million
bb/d. OPEC could have done much better by using more prudent price increases.. There are
different explanations for the cartel behaviour that tried to defend the irrealistic price increase
in .Energy Economics prof Stef Proost Figure . Production of Iran and Iraq source Hamilton
With hindsight. Million bb/d in to . There was also the .
and starting with a price of /bbl. . the expected price of oil should be larger than todays price
storage cost rental cost of Hamilton. One can also try to test statistically the real factors
driving the oil prices. discussion Paper UCEI. A first bound on price fluctuations comes from
the possibility to store oil Denoting the cost of storing oil by C and using an indterest rate I.
Hamiltons statistical analysis of the fundamentals of oil prices Up to now we used an ad hoc
explanation using simple demand and supply basics. In the case of OPEC oil. the uncertainty
is such that one may end up. First demand in newly industrialised countries was growing
more strongly than expected. with a price as low as /bbl or as high as /bbl. In the following
models Hamilton brings in some economic theory. after years . Using the estimates. some
sources suspected speculation by the financial markets. Energy Policy and Economics n .
This model could not be rejected and the result is that oil prices are not predictable in the
short term.Energy Economics prof Stef Proost invasion of Kuwait by Iraq in but this had only
a small effect on the oil price. most production was nationalised and extension of supply was
the priority. . There are several factors. There was again a strong price increase. In the case
of nonOPEC oil. Hamilton has tried to explain oil prices over the period . A first model is a
pure random walk model without any fundamental factors. the strong fluctuations in the
prices were not very encouraging for investors. prices are a function of the changes in the
past with an error term. Second the last years was a period without any real high and stable
prices. Understanding crude oil prices. so there were less investments in oil supply. Third.
shows that the production quota are regularly exceeded by some of the members. In
principle there is a cartel controlling the total output and the price.Energy Economics prof
Stef Proost facilityinterest on cost of oil. there are several statements by OPEC countries that
point to a limitation of production to safeguard oil for their descendants.If this does not hold
all investors would buy oil now and increase their sales net year This theory is unable to
predict large changes in oil prices. . . In more recent years. The following figure Hamilton. . . .
But in order to control prices continuously. The next model is a model testing the hotelling
scarcity rent. It is clear that sudden supply interruptions have strongly influenced prices at
certain moments . So it is only recently that the scarcity rent may explain price movements.
OPEC needs a system of production quota that is observed by its members. This implies that
the margin PriceMarginal cost should rise at the rate of interest Different empirical tests do
not confirm this hypothesis for the period . The same holds for the futures markets arbitrage
between spot and future markets guarantees that the current spot price is a good indicator
for the foreseeable changes at a horizon of a few years.
The oil market is probably like the stock market all available information is included in the
present price.Energy Economics prof Stef Proost Figure . Quotas and actual production
levels for most important OPEC members . But there are a few elements that help to explain
what is more likely to happen a demand and supply take time to react to uncertain events .
we would become very rich. And the future If we would know the future oil prices and are
ready to take a gamble.
every country that uses its stockpiles increases supply on world market and this benefits all
consumers on the oil . Emergency and strategic stockpiles Most consuming countries have a
stock of oil for at least months. This can serve for emergency situations. First the simple fact
that one country uses its stockpiles can be interpreted by all other consumers that there is a
very severe shortage and this may increase the demand and drive up prices. The use of
stockpiles is not so easy..Energy Economics prof Stef Proost b OPECs market share is likely
to increase as they have cheap oil and can extend their production capacity when they want
to c at low prices. . Some countries have a larger stock and can use this stock when they
fear that prices are manipulated and are too high. import taxes. Second. real prices of the
order of in could be an equilibrium. oil demand is growing in the world as long as there is no
cheap substitute available Putting fundamentals of demand and supply together. Policies to
stabilise or decrease oil prices The Western consuming countries have experienced large
fluctuations in oil prices and this has generated large oil rents in the Middle East and in other
producing countries. lower oil dependency and a strong climate action. Four types of
strategies have been followed to address this problem emergency and strategic stockpiles.
most sources expect prices in the / bbl range according to the IEA. We discuss them one by
one. There are two problems.
coal and gas and encouraged a lower oil demand for the transport sector. Decreasing the oil
dependency of the economy This policy has been taken by most consuming
countries.Energy Economics prof Stef Proost market. An optimal coordinated import tax for
oil would be much higher. Again all consuming countries can gain by this action but there is a
benefit for each country to encourage the other countries to do this but not to do it yourself. .
This is somewhat unrealistic as OPEC can. This type of action can positively influence the
terms of trade here the import price would decrease. also act strategically. The EU has
traditionally a higher tax on oil products than the US think about gasoline. When that country
is rather small. Some politicians count on a double benefit from a carbon tax as this tax
would decrease oil demand and decrease the import price of oil. They encouraged the switch
to nuclear. Climate Change policy and the world oil market One of the possible
developments is a strong climate action in the world. as dominant supplier. Another
weakness of this approach is that it assumes non strategic supply behaviour from the side of
OPEC. Import taxes In a competitive market it pays for the consuming countries to
coordinate their actions and to impose an import tax. This could be implemented by a set of
tradable permits or a set of carbon taxes. the action may not have a large effect.
T.. Persson T.Energy Economics prof Stef Proost According to Johannson et al a strong
world wide climate change policy would actually increase the oil rents of Opec if it acts as
dominant supplier. A world wide carbon policy would reduce the oil rent if one implements a
policy based on renewables and on energy efficiency.. Gately D. Energy Outlook . OPEC
Strategies and Oil Rent in a Climate Conscious World. .Strategies for OPECs Pricing and
Output Decisions . n Johansson D. Vol. Energy Outlook . Energy Policy and Economics n
IEA. . IEA. discussion Paper UCEI. Vol .. References Aguilera R. The Energy Journal .
Lindgren K. No.. Modellering van de oliemarkt met backstoptechnologien. Depletion and the
future availability of petroleum resources. The Energy Journal. N De Keyzer.Tilton J. .
Verhandeling Master Economie. Understanding crude oil prices. Azar C. The main reason is
that the oil substitutes based on coal or unconventional oil are also Carbon intensive so that
a carbon policy would reduce the threat of cheap substitutes for oil. . Lagos R. Hamilton..
The Energy Journal. Eggert R.. Vol ..
As long as this heating capacity of the gas is not too different. In European cities one started
by using gas manufactured on the basis of coal. economische en politieke aspecten. In the
third section we survey the main uses. As it covers of world energy demand and has been
growing strongly over the last years. Mj/m for Slochteren NL. Section presents some basic
economic principles of the gas market. the rest receives Norwegian and other richer gas. We
start the chapter with a small introductory section. it is important to know the total available
quantity of gas. . Mj/m for Algerian gas. so called town gas.. . it merits our attention. Section
discusses the history of the natural gas market. For a good review of mainly technical issues
in the gas industry see W. technische. ACCO. In Belgium. the main consumers and
producers as well as the main trade flows.Van Herterijck Aardgas . . one of the main policy
concerns in the EU.Energy Economics prof Stef Proost Chapter Natural Gas . This is the
topic of section . As gas is a scarce resource. Section analyses in more detail a model for the
European gas market that focuses on the impact of the liberalisation. they are considered
substitutes in terms of Mj delivered. Section discusses the reliability of Russian gas supply in
Europe. Some conventions and definitions Different types of gas Gas is usually a mix of
different types of gasses. Mj/m for North Sea gas and . This was a gas with a much lower
heating capacity Mj/m than the gas we use nowadays . Most important for us is the heating
capacity of the gas. Outline This chapter deals with natural gas. dealing with conventions and
definitions . the Northern part received the Dutch gas lower heating value.
Gas has not really a captive market. With the arrival of natural gas in the EU much earlier in
the US. We will also use the BP statistical review and outlook . home heating. At present
natural gas is only rarely used as energy source for transport. In a few countries like Italy
there is significant share of vehicles running on natural gas. per year until . consumers. The
relative price of gas compared to oil products is kept constant in the IEA outlook . for
customers it is the heating capacity that counts. The IEA outlook is based on many
assumptions. industrial heat. This is not necessarily the outlook we prefer but it helps to put
historic trends in perspective. . MTOE Trillion Btu Trillion kJ Sources of data and forecasts In
this chapter we will use often data of IEA outlook and . Volumes are important for
transmission so one uses m and cubic feet. In several cities .Energy Economics prof Stef
Proost Units The gas industry has its own units. Useful for us billion m natural gas . Gas can
be used in gasoline and diesel engines when an appropriate tank for compressed natural gas
is build into the vehicle cfr. chemical feedstock and power generation. busses and special
purpose vehicles are adapted to use natural gas mainly because of environmental reasons.
Important assumptions are a real oil price of /bbl in and /bbl in as well as an economic growth
in the world of . gas is used for cooking. producers and trade flows Main uses Manufactured
gas on the basis of coal was initially mainly used for lighting and cooking in cities and in
some industrial processes. In some countries Italy there is a small fleet of natural gas cars
and in some cities. LPG vehicles and when there is a distribution network. This is a working
assumption and not a market equilibrium. the substitutes differ as shown in table .We use as
much as possible the conventions used by BP statistical review of World energy. Main uses.
In these different applications.
Natural gas will probably first enter the transport market via use for busses and trucks. In the
Middle East producers avoid the costs of gas transportation by producing chemicals at home
and using the gas for energy purposes so that more oil can be exported. the natural gas is a
clean substitute for coal in cities and industries. . home heating accounts for / of natural gas
consumption. The transport of gas requires a specific distribution network and is therefore
more costly than the transport of oil and coal.. heavy fuel oil Oil products Table Main
substitutes for natural gas Figure shows that the consumption of natural gas has been
growing continuously in almost the whole world.Energy Economics prof Stef Proost busses
run on natural gas as this reduces the emission of small particles. industrial use and power
generation each account also for / of total use. previously coal furnaces Naphtha heat Fuel
oil. natural gas consumption is stronger in regions that had early and cheap access to natural
gas US. For this reason. nuclear. Most growth is expected in the Middle East and in Asia. An
other option is the conversion to methanol that can be used by gasoline engines MIT. In
Belgium. In Asia. residential and tertiary use cooking. Use of gas Cooking Home heating
Chemical feedstock Industrial generation Main substitutes Electricity Gasoil. coal in the past
Power generation Transport Coal.
Coal Bed Methane and also syngas produced from coal.Energy Economics prof Stef Proost
Figure Main producers Figure shows that the US production is relying more and more on
unconventional gas. . China will rely more and more on unconventional gas shale gas.
Europe is more and more dependent on pipeline imports Russia and LNG imports from North
Africa and Middle East.
The EU is importing much more from Russia and the Middle East Qatar. The next Figure
gives possible intercontinental trade flows for and compared to . Imports by See Van
Herterijck for a more technical description of gas transport and handling. By pipeline for
distances of up to km in pipes of up to .Energy Economics prof Stef Proost Figure The
production of unconventional gas has become interesting by the higher prices and the
development of better techniques. LNG also offers more flexibility to the exporter and to the
importer. Trade flows Gas can be transported by pipeline and by LNG tanker. .
Intercontinental transport requires in general LNG transport except Algeria to EU. As can be
seen. most flows increase. m diameter and at pressure of bar. The exporter can more easily
chose other customers and vice versa for the customer who is less dependent on his pipeline
. This means an average speed of km/h. Since the ties LNG transport is developing and is
becoming more interesting for longer distances.
The next two figures report on LNG terminal extensions. Algeria and Indonesia. Algeria is
mainly delivering to Europe and where Qatar delivers to Europe and Asia. Russia exports
most of its gas via pipelines but is also entering the LNG market. .Energy Economics prof
Stef Proost North America are expected to decrease because of the increased
unconventional gas production in the US and Canada Figure Intercontinental flows of natural
gas source IEA outlook The main exporters of natural gas via LNG are Qatar. Where
Indonesia is mainly delivering to the Asian market.
How much gas is there We know that for any resource.Energy Economics prof Stef Proost
European LNG Terminals OXFORD INSTITUTE FOR ENERGY STUDIES Source J.Stern
OIES .Stern OIES Atlantic Basin LNG Terminals OXFORD INSTITUTE FOR ENERGY
STUDIES Source Suez Source J. the reserves depend on two factors the market price and
the degree of confidence one has in the estimates Cfr .
The fracturing is done by pumping into the well water. this resource can be exploited using
hydraulically fracturing or cracking open in order to release the gas. conventional resources
of gas are of the same order of magnitude as those for oil. It requires also solutions for the
water that is produced together with the gas.hydrates These are crystallike solids that are
formed when methane is mixed with water at low temperature and moderate pressure. . .
The next figure IEA ranks the different types of gas and their volume for the world. The
production is growing rapidly in the US . This production can in certain circumstances be
combined with the storage of CO because fractures in the structure of coal can absorb twice
as much CO as the methane it initially contained. It is important to make a distinction
between conventional gas and non conventional gas. They are found offshore and in Arctic
regions.conventional gas estimate of current reserves at present prices and costs According
to the IEA outlook.shale gas rock formations that are rich in organic matter and are both
source and storage of the gas..tight gas is a resource that can not be profitable developed
with vertical wells due to low flow rates low permeability of the rocks .sour gas gas that
contains a lot of HS and needs extra processing before it can be used often associated to oil
wells .coal bed methane CBM is the natural gas contained in coal beds that are too deep or
too narrow to be exploited as coal supply the production requires again a lot of equipment
and water to extract the gas from the coal beds. A distinction IEA WEO is made between
.Energy Economics prof Stef Proost Chapter . chemicals and sand at high pressurethis type
of gas is being produced since many years in the US and Canada . The exploitation of this
resource requires opening the rock formations and requires more equipment and lots of
water to be pumped in the reservoirs. The estimates of reserves vary between There have
been experiments to produce coalbed methane in the Walloon region and in the Campine
region but the productivity was insufficient. .
The right had side of the figure gives an idea of the transport costs that need to be added for
pipeline and LNG transport. Poland and France have considerable shale gas reserves. There
is also the environmental problem associated to the use of large quantities of water needed
for the exploitation. The overall shale oil reserves for the regions studied are times as large
as the conventional gas reserves. The EIA produced recently a new assessment of the
nonconventional shale gas reserves for some regions see table. . This figure source IEA
combines quantity of reserves and marginal costs.Energy Economics prof Stef Proost and
tcm. Finally the use of gas itself produces less carbon per unit of energy but the production of
non conventional gas is energy intensive and may compensate this advantage of natural
gas. We see that in the EU. These are abundant reserves but they will be costly to produce.
Aguileras et al pay more attention to the regions that have in the past not yet explored
thoroughly and this results in reserve estimates with an order of magnitude to times higher
than the IEA estimates. The first problem in the exploitation of the non conventional gas
reserves is that one needs a lot of land as one needs to drill a lot of wells and equipment.
Energy Economics prof Stef Proost .
One can only start production once the infrastructure is fully in place. Economics of the gas
market The gas industry is characterised by high transport costs and a transport and
distribution network that is dedicated to a particular production site and or customers. One
can try to enforce the original contract but the enforcement of international commercial See
Van Herterijck. Transport by pipeline is also characterised by economies of scale the volume
that can be transported is more than proportional to the diameter while the costs are also
less than proportional to the diameter. As the infrastructure can not be used for other
purposes. In the transport by LNG. This is the risk that the customer. Increasing capacity by
generates a cost increase of only . It is an investment specific for that link without any other
possible use. the customer can threaten to pay a much lower price than the price originally
agreed. This explains how the industry developed. In the past this pipe was only meant to
supply the Belgian gas company. p . wants to renegotiate the contract. once the supplier has
built the specific transport infrastructure.Energy Economics prof Stef Proost . The holdup
problem for specific transport infrastructure The pipeline constructed to connect one
production site with a customer is often very specific example of Seapipe that connects a
Norwegian Gas field to Zeebrugge. The supplier has no choice but to accept the new deal.
High transport costs Whether one transports gas by pipeline or by LNG tanker. op cit. Ships
have a limited capacity per unit m the number of ships needed depends on the distance.
transport operations require always a large upfront investment. Costly investments that are
specific to serve one customer are at the origin of the socalled holdup problem. there are
economies of scale in the liquefaction and regasification plant and in the ships used. We
focus here mainly on Europe.
In Belgium Distrigas had the legal monopoly for importing gas and sold at different prices
according to the type of industrial sector sectors that could not easily substitute gas paid a
higher price. Another solution that is often used is to ask the customer to participate in the
transport investment. Prijs. Price discrimination Whenever there is one importer who controls
the transport network. The following graph shows how an importer facing two different clients
industry and residential can increase his profits by selling at higher prices to the residential
sector higher willingness to pay and lower elasticity of demand than to the industrial
customers more substitutes available so higher elasticity of demand. In this way the importer
can maximize his profits. The main enforcement mechanism is reputation a customer that
does not comply will have problems to obtain new long term contracts. This solution was
common in Western Europe. MK Vraag residentiele sector Pres Prijsdiscriminatie Pce MK
invoer Vraag centrales qre qcen MRre MRce Q .Energy Economics prof Stef Proost
contracts is weak. Nowadays such a practice would no longer be allowed and would no
longer be possible because Distrigas has no longer the monopoly of gas trading. this
importer can use different prices for the same good delivered to different customers.
The figure makes clear that gas exporters and sellers were very much in favour of an
environmental tax on oil products. When the prices of substitutes vary. Many import contracts
used the netback technique to specify the import price of gas. The maximal import price of
gas for residential use is then the consumer price of gasoil containing often also a specific
tax on oil products minus the transmission cost and minus the distribution cost. This is only
possible if the importer can price discriminate on his internal market. The principle is
explained in the following figure where gas is sold to two types of uses industrial consumers
whose alternative fuel is HFO and residential heating customers whose alternative is gasoil.
The import price of gas is then a weighted average of the two maximal import prices where
the weight equals the share of both types of customers. the importer usually also controlled
the transmission network so that he can discriminate prices. one needs a system of price
indexation to guarantee the sales. Consumer price Gasoil heating tax Price/GJ Maximum
Consumer price Residential heating Maximum Consumer price Gas to industry Transmission
cost margin Consumer price HFO tax Distribution Costmargin Transmission Costmargin
Maximal Import Price cif Maximal Import Price cif Netback price principle to determine GAS
import price weighted sum of consumer prices of substitutes costs of transmission and
distribution Figure Netback price principle .Energy Economics prof Stef Proost Netback
pricing of natural gas and take or pay contracts An importer can only guarantee to sell a
given volume of gas if the price is competitive on his market. importers could accept take or
pay clauses that force an importer to import a given quantity with a take or play clause even
if not imported it has to be paid. In the gas industry. With this guarantee on competitiveness
of the imported gas. The maximal import price of gas for industrial use is then the consumer
price of HFO containing often a specific tax on sulphur content minus the transmission cost
of gas.
firm is a monopolist for the remaining demand and chooses the optimal quantity by
equalising marginal revenue and marginal cost. given the quantity that is decided by the
other suppliers.for the same product a GJ of natural gas. How much will each be able to sell
The equilibrium concept that is often used in economics is a Cournot equilibrium. This is a
non competitive equilibrium.. In the next figure we determine in a first step the optimal
quantity to supply to one given market for supplier for different quantities supplied by firm . .
Russia. . Take an example with two suppliers and . He sets this quantity as monopolist on
the remaining market. Example taken from Pindyck amp Rubinfeld .Energy Economics prof
Stef Proost Take or pay clauses were interesting for the exporters because this allows to
guarantee a given volume of sales and this helped to use optimally the production and
transport capacity. Netherlands.. A Cournot equilibrium In the European and Asian natural
gas market there used to be a limited number of suppliers Norway. This information can be
summarised under the form of a reaction function what is the optimal production of firm given
a production level of firm . Algeria. An equilibrium is reached when all quantities produced
are mutual best replies when the quantity sold by him is the best answer to the quantity
chosen by the other suppliers and vice versa. In a Cournot equilibrium every supplier sets
the quantity he want to sell. His optimal production will be .. For each of the quantities
produced by firm ..
If Firm thinks Firm w ill produce units. its demand curve is shifted to the left by this amount.
D . its demand curve. each firm correctly assumes how much its competitors will produce
and thereby maximize its own profits. its demand curve is shifted to the left by this amount.
correspond to the previous model. The relative production of the two producers will be a
function only of their marginal costs because they fact the same total market demand. Firm s
Reaction Curve QQ In Cournot equilibrium.Energy Economics prof Stef Proost Cournot
equilibrium step P D If Firm thinks Firm w ill produce nothing.. A lower marginal cost for firm
generates a larger market share in equilibrium. The xs it thinks Firm produce. Firm s reaction
curve shows how much it will produce as a function of how much it thinks Firm will produce.
If Firm thinks Firm w ill produce units. is the market demand curve. . x Cournot Equilibrium
Firm s Reaction Curve QQ CENTRUM VOOR ECONOMISCHE STUDIEN x Q KATHOLIEKE
UNIVERSITEIT LEUVEN The second step consists in setting the two reaction functions
together and to find a Cournot equilibrium what are the mutual best reply production levels
here . CENTRUM VOOR ECONOMISCHE STUDIEN D W hat is the output of Firm if Firm
produces units Q KATHOLIEKE UNIVERSITEIT LEUVEN Cournot equilibrium step Q Firm s
reaction curve shows how much it will produce as a function ofof how much will produce as a
function how much it thinks Firm willwill produce. D MR MR MC MR .
In general the Bertrand equilibrium results in prices much closer to the marginal cost than
the Cournot equilibrium. History of the gas market in Western Europe Because gas transport
is expensive and resource availability differs by continents. . natural gas was only used in a
few countries Italy. Japan and the US. The total costs of Norway are . given the price set by
his competitor is to undercut the price by . the equilibrium will be that the price will be equal
to the marginal cost of the supplier with the second lowest cost minus . p and served as
exam question in the past. Exercise assume producers Norway and Russia want to supply
the German gas market. q and for Russia q. Before the large gas reserves of Slochteren NL
were discovered in . The inverse demand function of the German gas market is P. France
and Austria. Here we focus on Western Europe and more particularly also on Belgium. The
best price a firm can set. An alternative equilibrium concept is the Bertrand equilibrium where
production can be easily varied and where firms set prices instead of quantities. Find the
perfectly competitive equilibrium. Before Example taken from Dahl. We distinguish periods in
this history before . . market development has been very different in Europe. q represent the
supply by Norway and Russia. The discovery of the Dutch gas was the real take off of the
natural gas market in Europe. the Cournot equilibrium and the Bertrand equilibrium.Energy
Economics prof Stef Proost The Cournot equilibrium is often used to study the natural gas
market because supply requires important production and transport investment so that
suppliers decide on quantities.qq where q. the period and after .
This situation lasts until . Power producers that had . All European countries opted for an
import monopoly with sometimes a partly private ownership The Belgian Distrigaz was
public.Energy Economics prof Stef Proost There were massive amounts of gas available in
the Netherlands. The monopoly allowed to benefit from economics of scale in transport and
to maximize profits. Industry houeholds Small firms Frankrijk Duitsland Belgi Andere
Distribution companies Russia Algeria CENTRUM VOOR ECONOMISCHE STUDIEN
KATHOLIEKE UNIVERSITEIT LEUVEN One had double monopolies each exporter was
state controlled. together they form an oligopoly Cournot and each of the importers had a
monopoly in their own country. Once the main import pipelines are constructed one starts by
supplying first a few big customers as this allows to sell a large volume without large
additional transport investments. Power producers. The next step is to connect smaller
industrial customers and finally smaller consumers. Gas substituted oil and coal in power
stations. and private. The profits were important to guarantee a continuous investment in
transport networks. The national monopolists used their market power to discriminate prices
in function of the willingness to pay of the sellers. The WestEuropean Gasmarket before
liberatisation Consumers National Transport strorageg Importers countries International
transport Exporters countries Netherlands Norway UK. In order to sell the gas one needed
large pipeline investments and an extensive distribution network.
cif / Crude oil price OECD. Troll. .Energy Economics prof Stef Proost cheap coal or HFO as
alternative could bargain a better price than industrial customers that have gasoil as
alternative. Ye a r s . Gas price EU. In addition. The contracts stipulated sometimes prices
for gas fob Algeria that were at the level of the prices of oil substitutes neglecting that the
transport and distribution of gas was much more costly than oil. . One needed additional
suppliers. . cif . From The gas demand was growing rapidly because the price of a close
substitute oil products increased steeply in and . prices of gas were not fully indexed on the
price of oil products so that demand increased quickly. Distrigaz was almost bankrupt and
went for a long international arbitrage procedure. . This is also called Ramsey pricing. In the
case of Belgium. They were found in Norway Ekofisk. Distrigaz tried to minimize the losses
by price discrimination and selling surpluses at discount prices. Natural gas consumption did
grow very rapidly before . . in Algeria and in Russia. there was a pay or take clause in the
contract. if necessary abroad. . This resulted in financial problems for the importers. The high
growth in demand led sometimes to unrealistic projected growth rates and bad contracts.
The best known example are the first contracts with Algeria. . Initially. . . Sleipner fields.
Most importers were able to discriminate between all types of clients so that they sold xa at
prices that approximate the demand function. . If the importer sells at the import price of
Algerian gas ca. As most trade was between public exporting and public importing
companies.Energy Economics prof Stef Proost A large TakeorPay Contract with a too high
price Optimal solution sell x on home market and xaxe abroad total quantity to import Price
ca p cn Price Algerian gas Price Dutch gas Demand Pe x MR CENTRUM VOOR
ECONOMISCHE STUDIEN Export on spot market Quantity Xa KATHOLIEKE
UNIVERSITEIT LEUVEN This figure illustrates the best solution if there is a very large
quantity to be imported at a too large price. the import contracts were not always
economically justified and were used in order to promote other goals employment. The best
the importer can do is to charge the monopoly price p where the Marginal Revenue equals
the Marginal Cost and this is here the price on spot export markets. As gas prices were
indexed on oil prices with a delay of some months.. One of the complicating factors was the
strongly fluctuating oil price. gas was very favourably priced when oil prices were rising and
vice versa when oil prices were decreasing. his sales will be limited and he has to sell the
rest as exports on spot market. foreign affairs etc.
. the trade off between storage and transport capacity changed. A final important element in
terms of demand is the growing use of gas in power plants in the new combined cycle gas
plants their efficiency is instead of some in conventional plants. . . . There was also a
continuous attention for environmental regulations and taxes imposed on oil products and
coal as these were important for the competitive position of gas. As gas was imported from
more and more remote areas.Energy Economics prof Stef Proost Another factor that grew in
importance was storage. . . Importers had the choice between building minimal storage
capacity and a transport capacity in function of the winter peak of demand or a larger storage
and smaller transport capacity. . Gas consumption in Belgium and Luxembourg . . This is
coupled in some countries with a nuclear phase out and a concern for CO emissions that
rules out coal as alternative fuel for power plants. Gas consumption in bcm per year . Years .
A second important development is the growing dependence on nonEU sources of supply.
Russia. We will see in the next section what could be the effects of this liberalisation.Energy
Economics prof Stef Proost From onwards From onwards the EC requires the liberalisation
of the gas trade. This means that large consumers can negotiate their own import contract
and the transport company has to grant access to parties that want to use the transport
network. The IEA expects an increase of gas consumption in the European union from bcm
in to bcm in . We discuss the need for more gas imports and the supply of Russian gas more
in detail in section . This raises serious concerns. Its import dependence will rise from now to
in . prices are more indexed on gas spot markets. The next table shows that in a mature gas
market like the US market. . Africa and Middle East. One of the puzzles in the EU gas market
is the continued reliance on oil price indexation in gas contracts. Most of the increase is met
by Russia. North Africa and Middle East will be responsible for and more of our supplies from
onwards.
Rijkens F. there are multiple segments household. numbered g .. what is the effect of the
number of traders on consumer prices. G ... Many other models of the gas market use a
similar approach. each with its own enduser price.Energy Economics prof Stef Proost .. We
have chosen this model because it is fully documented and describes the European gas
market. N . Structure of the model The model represents the competition at two levels first
between producers exporters to one country and second. there are N G different markets.
Boots M. In each country... Modelling the European gas market In this section we use the
model of Boots et al to study how prices are set after the liberalisation and more particularly.
industry. Structure of the EU gas model UPSTREAM producer Transport costs
DOWNSTREAM Distribution costs Country A Household A Industry A Generation A producer
trader Country B trader Cournot behaviour but each Is Stackelberg leader wrt traders they
take the reaction of traders into account Gazprom Statoil Cournot behaviour in enduse
Markets and Possible price discrimination and sometimes Traders per country Demand
Functions Per category and per country The European consumer countries are numbered n .
n . power generation. vol ... Energy Journal. The following figure represents this dual
structure. within one country between different traders for the same consumers.. As a result.
trading in the downstream European gas market.. Hobbs B..
In each segment. Traders are numbered r . Therefore. R . the producers indexed i . we will
then study the behaviour of the producers. then this means a monopoly game. I play a
Cournot game each takes the sales of the other exporters to a particular market as given and
optimizes his profits by selecting a quantity for that market. g . Using that information. in this
text. Within each country the quotdownstream partquot there can be or traders..Energy
Economics prof Stef Proost In the quotupstream partquot. and png is the resulting market
price enduser price in market ng .. When making their decisions. in Belgium the base case of
the model assumes trader.e.. Distrigaz. The producers are only concerned about the border
price for each country and each segment the price they receive for the gas at the border
where it enters the country and do not get involved in the distribution of gas within the
country.. If there is only one trader in a given country. to analyze the effects of increasing
competition. we will first study the behaviour of the traders. Downstream behaviour of traders
The model assumes that each market ng has a linear demand curve.. i. Note that ng . the
traders play a Cournot game.. A key feature of the model is that it allows to increase the
number of traders beyond the actual number. png ng ng yrng r where yrng is the quantity
supplied by trader r to market ng . e. producers already anticipate how their decisions will
influence the decisions of the traders.. The model assumes that producers have a
Stackelberg leadership position visvis traders producers make their decisions before traders
do. Each trader r sets his quantity yrng to maximize profits r max png bpng dcng yrng yrng
n..g.
and is also taken as given. we find bpng ng ng yrng r with ng ng dcng from which we can
derive the total quantity supplied by all traders as a function of border price or vice versa. i. In
the Cournot equilibrium each trader maximizes his profits while taking the quantities supplied
by other traders as given. The firstorder conditions for yrng to yield the optimal r . the market
price is taken as given. Combining with the demand curve .e.. a trader takes into account
that his quantity decision influences the market price. price equals marginal cost of supply.
and so they take the border prices bpng for each individual country and segment as given.
are r png bpng dcng png yrng yrng There are two possible cases perfect competition and
Cournot competition see section of this chapter. a trader cannot influence the market price by
his actions. Under Cournot competition. .Energy Economics prof Stef Proost Traders decide
after producers have decided. dcng is the transmission tariff for country n and segment g .
and as a result a trader may withhold volumes in order to drive up the market price png ng .
we find that Note that the conditions shown in Boots et al. In this text we ignore this point for
the sake of simplicity. Therefore the firstorder condition reduces to png bpng dcng In words
under perfect competition. Assuming that all traders are identical. Under perfect competition.
hence for each individual trader. we have png . are slightly more complicated in order to take
into account the constraint yrng .
The following figure shows how the consumer demand curve is transformed into curves and
. bpng Demand function of consumers ng equation Perceived demand function for producers
if monopolist trader equation with R Perceived demand function for producers if perfect
competition in trading equation Quantity yrng Note that equations and are the demand
functions perceived by the upstream producers the curves show which quantities the traders
in total will buy from producers as a function of border prices charged by producers. we can
derive the total quantity supplied by all traders as a function of border price or vice versa.
Conversely. Upstream behaviour of producers Given the perceived demand functions and .
they show how border prices will change as producers change the quantities exported to
different markets.Energy Economics prof Stef Proost bpng ng ng yrng ng yrng dcng r ng ng
yrng r with ng ng Rng R ng from which. Behaviour traders downstream Price png. prices in
each market. The model assumes Cournot . again. the producers set quantities and hence.
This expression is similar to equation . reflecting the fact that traders take a
monopoly/oligopoly margin. but has a steeper slope.
and hence the resulting border prices. for a producer. g max ng ng q jng tin qing ci qing qing
n. export quantity to maximize profits. g where qing is the quantity supplied by producer i to
market ng . The firstorder condition for maximizing producer i s profit. is i ng ng q jng ng qing
tin ci qing j Equation allows us to compute all quantities set by producers. The function c
represents the total production cost as a function of the quantity produced. The same
observation as in footnote applies here. the long distance transmission costs to transport gas
from the gas fields to the borders of the consuming countries are assumed to be constant per
km per cubic meter of gas. No transmission capacity limits are assumed. In case the traders
are perfectly competitive. Practically. Furthermore. Producers maximize profits i max bpng tin
qing ci qing qing n. setting a certain production quantity corresponds to investing in a certain
amount of developments of gas fields. g n..e. . taking the quantities set by others as given.
We can extend the previous figure to show the quantity decision by a monopolistic producer
graphically. ng needs to be replaced by ng .Energy Economics prof Stef Proost competition
between producers each producer sets a production quantity i. The model assumes that
producers marginal production costs are increasing. and tin is the transmission cost from
producer i to country n . g j n.
Energy Economics prof Stef Proost Resulting equilibrium illustration for producer and or R
traders R. consumer prices are higher than marginal costs. because in that case both
producers and traders take a margin. estimate these parameters based on actual market
circumstances. as soon as the demand curves parameters ng and ng . However. if only
producer.quot Empirical specification In principle. enduser prices and border prices. vertical
integration of traders and producers would reduce prices. perfect competition Price png.e.
Jean Tirole launched in the famous phrase quotWhat is worse than a monopoly A chain of
monopolies. qing If producers are a monopoly/oligopoly and traders are perfectly
competitive. bpng If only trader per country double monopoly margins margin producer lower
part margin importer upper part If perfect competition in trade only monopoly margin for
producer pngdcnggtbpng if trader pngdcngbpng if perfect competition in trade c tin marginal
production amp transmission cost MR curve for MR curve for producer. This phenomenon is
called double marginalisation each noncompetitive stage of the production process adds a
monopoly margin. increase consumer welfare and increase total profits producers traders. if
traders are a monopoly/oligopoly instead of a perfectly competitive industry. In such
circumstances. thereby disregarding the effect of its margin increase on the profit loss of the
next stage. i. if perfect trader per country competition in trade Quantity yrng . . tariffs dcng .
Boots et al. due to the margin taken by the producers. transmission costs tin and marginal
production costs ci are known. the equations derived above enable us to compute all
quantities. consumer prices are even higher.
. prices. have a constant marginal cost of production i up to the point where capacity limits
are reached. Note in particular the large price discrimination between different segments in
Belgium. and elasticity per segment.Energy Economics prof Stef Proost First of all. the
consumer demand curves can be estimated using the actual volumes. Producers for which i .
which are based on technical estimates. The following table shows the data that is used. The
following table shows assumptions about production costs.
Energy Economics prof Stef Proost Scenarios and results Boots et al. i.e. as shown in the
following table. . g . study scenarios. an additional constraint is applied bpng bpn .. quotNo
price discriminationquot refers to a situation in which producers cannot discriminate between
border prices for different segments. The following table shows the resulting prices in each of
the scenarios. Each cell in the table gives the enduser price and the border price for a given
segment in a given country.
showing that the market is already quite competitive. For example. . in the UK. there is no
competition and both traders and producers have high margins. the simulated
quotbenchmarkquot prices are close to the real prices. Benchmarkquot represents prices if
there is perfect competition among traders and among producers. as shown in Table .Energy
Economics prof Stef Proost The first column quotNo discr. On the other hand. It is interesting
to compare this quotbenchmarkquot column with the actual prices in . in Germany. the actual
prices are much higher than the quotbenchmarkquot prices in reality.
The fourth and fifth column show the effect of oligopolistic behaviour of traders. actual prices
from Table are close to the scenarios in the second and third columns oligopolistic producers
and competitive traders. compared to the first column.Energy Economics prof Stef Proost
The second column. but very large when they have a monopoly/oligopoly. For most
countries. . shows the effect of oligopolistic behaviour of gas producers. The following table
shows the prices that result when the number of traders in each market is increased to and
then to . Producer profits are largest when traders are competitive and border price
discrimination is possible. As mentioned before. the model also enables us to vary the
number of traders. Profits of traders are zero when they are perfectly competitive. The
following figure summarizes the welfare effects of the different scenarios. The third column
shows the extra effect of allowing border price discrimination introducing border price
discrimination leads to much higher price differences between households and power
generators.
We distinguish three issues.Energy Economics prof Stef Proost The results need to be
compared with the fourth column in Table . Transporting Russian gas to Europe . An
increase of the number of traders leads to a decrease of traders profits. the results would
converge to the second column of Table . an increase of producers profits. The security of
European gas supply Introduction Europes dependence on Russian gas imports has been
the subject of increasing political concern after gas conflicts between Russia and Ukraine in
and . an increase in consumer surplus. A first issue is that some of the countries through
which Russian Gas is exported to the EU Belarus. The second issue is the future supply of
natural gas to the EU where it will come from and at what conditions. The third issue is that
Russia itself can threaten to interrupt gas supply to EU or charge higher prices. If the number
of traders were to go to infinity. and in total an increase of social welfare. . Ukraine make use
of their monopoly position to get better deals less expensive gas with Russia.
. they both have interrupted the gas supply to EU for some time. As former allies of Russia
they received Russian gas on better terms than the rest of EU. This makes both Russia and
the EU vulnerable to threats by the transit countries. When Russia wanted to raise their price
to EU levels. Russian Pipelines via Ukraine and Belarus OXFORD INSTITUTE FOR
ENERGY STUDIES Source Stern J.Energy Economics prof Stef Proost The next map shows
that most Russian gas is exported to the EU via Belarus and via Ukraine.
In this EU backed project the idea is to connect to an alternative source of supply in the
Caspian area. the Nabucco project. The main problem here will be to have the cooperation of
Turkey and of the local producers in the Caspian area. Russia and some of the EU countries
have reacted to this threat by building bypasses that diminish the bargaining power of the
two main transit countries.Energy Economics prof Stef Proost Blue Stream/South Stream
Gas Pipelines OXFORD INSTITUTE FOR ENERGY STUDIES Source Stern J. This is the
Nordstream pipeline connecting Russia and Germany via Baltic sea pipeline and the project
to build a Southstream pipeline connecting Russia with Bulgaria via Black Sea or via Turkey.
The purpose of these pipelines is different from still another project in the SouthEast of
Europe and Turkey. .
Middle East Qatar of Africa mainly Algeria. The EU is the major customer of Russian gas.
The figure is also interesting to show how the margins of exporters become much smaller
when they need to supply to remote customers. The EU has to get its gas from
Russia.Energy Economics prof Stef Proost Nabucco a Caspian/Middle East Pipeline
Nabucco O F R IN T U EF RE E G S U IE X O D S IT T O N R Y T D S Source OMV This is
the favourite project of all EU politicians and most media commentators So the purpose of
Nabucco is to rely less on Russian gas and not to avoid dependency on some transit
countries. Where could the EU get its gas supply in the future The IEA WEO looked into the
different options to supply natural gas to the EU in the future. The development of non
conventional gas in the US means that these exporters or more interested to export to the
EU. The nearby suppliers enjoy a rent. .
Energy Economics prof Stef Proost .
The results show that Russian contract volumes and prices decline significantly as a
function of unreliability. and how it affects European gas import strategy. The European gas
import market is described by differentiated competition between Russia and a more reliable
competitive fringe of other exporters.Energy Economics prof Stef Proost How to deal with
unreliable Russian gas supply Introduction Morbee amp Proost assess the potential impact
of Russian unreliability on the European gas market. They study to what extent Europe
should invest in strategic gas storage capacity to mitigate the effects of possible Russian
unreliability. so that not only Europe but also .
Gas import dependence of the European OECD bloc will increase from in to in . For
Europe.Energy Economics prof Stef Proost Russia suffers if Russias unreliability increases.
Russias potential unreliability is modeled by assuming that there is a probability d that Russia
does not comply with the longterm contracts it has . In recent years. with differentiated
competition between one potentially unreliable dominant firm Russia and a reliable
competitive fringe of other nonEuropean import suppliers. buying gas from more reliable
suppliers at a price premium turns out to be generally more attractive than building strategic
gas storage capacity. plus other discrepancies between import and consumption Mainly LNG
from Africa including Algeria Source BP Statistiscal Review of World Energy. given that it
already supplies more than half of Europes gas imports and that it has the largest proven
natural gas. using a partial equilibrium model of the European gas market. according to the
IEA Reference Scenario. UK x Focus of this paper Share of EU consumption Percent
Netherlands Other EU production Total Exports EU Norway production production Russia
pipeline Algeria pipeline Other EU consumption Total nonEuropean gas imports Includes
exports to countries such as Switzerland. Russia plays a crucial role. Europe needs to import
a large share of it gas consumption. especially from Russia Billion cubic meters bcm. security
of gas supply has been high on the political agenda in Europe. We study longterm gas
contracting in a noncooperative setting.
and G is the public expenditure on gas storage capacity investments. We assume that
decisions on longterm gas import contracts and publicly financed strategic storage capacity
investments are based on a combination of the interests of importers. but with a steeper
slope pSR q p SR q q with p. The model Europe is modeled as a large number of
uncoordinated gas consumers and domestic gas producers.Energy Economics prof Stef
Proost signed with probability . domestic producers and taxpayers. We therefore assume that
Europe maximizes the expected total European surplus ES Max E S with SCS D G where
CS is the consumer surplus. Russia defaults and withholds supply to increase its price to
monopolistic levels for a duration of four months. q representing the longrun equilibrium.
endconsumers. and the remaining excess demand q qD needs to be satisfied by
nonEuropean imports. G represents the interests of the recipients of marginal . Shortrun
demand is also linear. D represents the profits of domestic producers. We assume Europe is
a pricetaker with a linear longrun inverse demand curve for gas pq q European domestic
producers supply an exogenous and fixed quantity qD . with an overarching government that
can decide to invest public funds in gas storage capacity.
This is a major assumption. Therefore. Russia is modeled as a monolithic entity. Russia is
assumed to be a risk neutral profit maximizer. we assume that the longterm gas import
contracts between Europe and the competitive fringe are not indexed on any gas spot market
price. the Russian state is not distinguished from the gas exporter Gazprom. Russia defaults.
We assume that the nonEuropean import suppliers have a dominant firm competitive fringe
structure. the competitive fringe delivers the originally promised contract quantity q at the
originally promised contract price p .Energy Economics prof Stef Proost expenditures out of
general government revenue. which can be justified by the difference in scale between
Russia and each of the other non .e. In practice. All participants know the parameter upfront.
i. which would rise sharply in the event of Russian default. i. Russias long run marginal costs
of production are assumed constant at cR . The competitive fringe is a diversified set of
current or potential future nonEuropean gas import suppliers. This requires two assumptions.
First. there is a probability that Russia temporarily does not comply with its supply
commitments. including both pipeline and LNG supplies. Conversely. Excess demand needs
to be satisfied by signing longterm import contracts with nonEuropean import suppliers.
Russia is modeled to be unreliable once the longterm contracts have been signed. we
assume that as a group the competitive fringe is reliable even if Russia defaults. Second. this
condition is fulfilled since most current longterm gas import contracts contain little or no
indexation on gas spot market prices. there is a probability that Russia complies with its
longterm contracts during the entire period.e. Note that this equation assumes riskneutrality.
we assume that the competitive fringe players do not deviate from their contracts. Russia is
the dominant firm and the other nonEuropean gas import suppliers are grouped together as
the competitive fringe.
Figure explains the different stages of the game. The interaction between Europe. even if it
behaves unreliably. In a nutshell in Stage . Russia defaults and q competitive fringe. Stage
consists in the execution of the longterm gas import contracts. pR . Each of the other
nonEuropean import suppliers has much less incentive to be unreliable because the market
impact of each of them is much smaller.Energy Economics prof Stef Proost European import
suppliers. The corresponding prices are denoted pR . We represent the imported gas
quantities by qR . Stage is the stage in which Europe signs longterm gas import contracts
with Russia and the competitive fringe. Europe decides how much to invest in strategic gas
storage capacity. qR . Russia complies with longterm contracts. is modeled as a game in
three stages. European surplus is either SS or SS depending on whether Russia complies
with its longterm contracts or . and p . . a supplier who is perceived as unreliable could face
the threat of being replaced by another supplier in the long term. In Stage . is hard to replace
completely in the long term. Russia and the competitive fringe. Russia. because Europe and
Russia factor the expected value of Stage payoffs into their decisions in Stage . in which
Russia may or may not comply with the longterm contracts it has signed. on the other hand.
Before describing each of the stages in detail. it is important to note that the stochastic
outcome of Stage influences the strategic interaction in Stage . In addition.
Europe therefore tries to maximize the expected surplus ES. in the dominant firm
competitive fringe game in Stage . Therefore. . As for Russia. by finding for given longterm
gas contract prices the optimal longterm gas contract quantities that maximize Europes
expected surplus ES in Stage . European demand for longterm gas import contracts will turn
out to be differentiated between gas import contracts from Russia and gas import contracts
from the . taking into account the longterm gas import contract supply curve of the
competitive fringe and Europes abovementioned demand functions for Russian and other
longterm gas import contracts. or R R . its expected profits in Stage are either R R . dominant
firm Russia sets the optimal gas contract quantity to maximize its expected profits E R in
Stage . This maximization problem can be translated into demand functions for Russian and
other longterm gas import contracts. depending on whether Russia complies with its
longterm contracts or not. In Stage .Energy Economics prof Stef Proost not.
it cannot wait until Stage . and it has perfect and complete information to do so. Europe
decides to foresee a quantity q in bcm. i. who put a quantity q in bcm per year on the market.
puts a quantity qR . . In Stage Europe signs longterm gas import contracts with Russia and
with the competitive fringe. Given the long lead times involved in the development of storage
sites. because their effect in Stage is different.e. . Europe takes into account the strategic
behavior of Stage . The prices pR . before Stage . In Stage . Our approach is
noncooperative. to be used as a buffer in case of withholding of gas supply by Russia. for
which they receive a price p in per tcm. this decision cannot be postponed until it is known
whether Russia will comply with its contracts or not i. The quantityprice pairs qR . and q . In
making the decision about storage capacity investment. Russia already takes into account
the subsequent decision of the competitive fringe. and p are the response of the European
inverse demand functions to the quantities qR . in per tcm.e. Russia. billion cubic meters of
strategic gas storage capacity. Furthermore. In making its decision. The reason is that
investment in storage capacity is a decision that Europe can make unilaterally. for which it
receives a price pR . with Europe as a pricetaker in a dominant firm competitive fringe model
of the longterm gas import contract market. pR . in our model. in bcm per year on the
European market.Energy Economics prof Stef Proost competitive fringe. The rest of this
section describes the three stages in more detail. By making the storage capacity investment
decision in a separate stage upfront Stage . as the dominant firm. the storage capacity
investment decision takes place before decisions are made regarding the amounts of
longterm gas imports that are contracted from Russia and the competitive fringe i.e. Europe
gives its storage capacity investment decision an advantageous Stackelberg leadership
position in the strategic game with its gas import suppliers.
Assuming that neither qD nor q can increase in the short run. S . there is also a probability of
default. in which case Russia withholds supply to maximize shortrun profits. at a price pR .
Endconsumers pay a single price corresponding to p pR . the prices pR . . We study one
representative year although the import contracts and storage capacity investment decisions
are longterm decisions that will hold for multiple years. . Stage . all volumes and monetary
payoffs in Stage are shown as annual amounts. In a representative year. Stage is the stage
that results in actual payoffs for the participants to the game. qR . Although there are
separate inverse demand functions for Russian and other gas resulting from the behavior of
importers the endconsumers face a single price for gas and cannot choose their own mix of
reliable and nonreliable gas.Energy Economics prof Stef Proost and q . there is a probability
that Russia honors its commitments. is the execution of the longterm gas import contracts
signed in Stage . In a representative year. This is Case Russia complies with longterm
contracts. Note that this price is derived from the shortrun . respectively. is the European
surplus according to equation . Because of Russian unreliability. and effectively delivers qR .
p . which is assumed to be exogenous and fixed inelastic. The shaded area. and between
Europe and the competitive fringe. which is depicted in Figure . . Figure illustrates Case
graphically. Russia can set qR . p represent the longterm gas import contracts signed
between Europe and Russia. for which it can command a price pR . There is a single
endconsumer price in each of the two states of the world in Stage . . but without taking
storage capacity investment costs into account. and p do not need to be the same. such that
demand at price p is exactly equal to qD q qR . the final stage of the game. pR . . qD is the
gas supply from European domestic producers. This is Case Russia defaults.
and we assume that this can be done at some point at a price equal to p . the price of using
gas from the storage is therefore p in addition to storage capacity . The gas withdrawn from
the storage will therefore need to be replaced for future crises. The storage capacity
investment only covers the cost of the storage facility and the capital cost of the unused
gas.Energy Economics prof Stef Proost demand curve. Effectively. but not the purchase
price of the stored gas itself. Europe responds by cutting consumption and using the
maximum amount of stored gas. which is constrained by the storage capacity qS chosen in
Stage .
investments in strategic storage c. which are sunk. we do not consider the repeated game.
As before. Figure shows S. p q . the loss in European surplus due to Russian default. the
assumption is that this happens only during a fraction s of the year. whatever happens in
Stage . Russia respects qR . and the average price . The competitive fringe always delivers q
at price p. This loss is discussed in more detail in equation in the next section. . The three
stages of the game represent three distinct decisions. In total. the marginal price for
endconsumers should correspond to pR . While this does create a rent from the fringe supply
contracts equal to pR . this does not mean that identical endconsumers would pay different
prices in the event of Russian default. In summary. the European surplus in case of Russian
default is lower than S from Figure . The parameters of the model are calibrated on cost data
and elasticities from the literature. our model describes Russias unreliability as a potential
default event. because only Russia could increase supply. but because the lead times for
gas projects are very long. Finally. The model takes into account two ways for Europe to
escape from the unreliability of Russian gas supplies on the one hand. if Russia defaults
probability .Energy Economics prof Stef Proost costs. In practice. with a probability of default.
the baseline for volume. . and pR . the game is obviously repeated after a number of years.
and on the other hand. For the remaining fraction s of the year. . the rent is part of the
European surplus. diversification by signing longterm contracts with the competitive fringe.
We assume that this threestage game is played once. Since the marginal unit of gas import
supply in the short run in case of Russian default has a cost pR .
Meanwhile. The graph also shows the discount p p pR. it delivers only an annualized
amount qR . Panel a of Figure shows that the quantity withheld would be around and panel b
shows that the resulting price increase would be around as well. instead of the originally
agreed longterm gas import contract price pR . As increases. goes from to . When Russia
defaults. The simulation shows that in this case. Europe buys q bcm per year from Russia
and q bcm per year from the other suppliers. . Russia was considered a reliable supplier.
there is no risk and there is obviously no price difference between the contract with Russia
and the contracts with the competitive fringe. Indeed. in the UK when considering a typical
daily volatility of . Europe procures a smaller volume qR . For gt Russia becomes unreliable.
at a slowly increasing contract price p . and so it is not surprising that the currently observed
market quantities correspond to the case . such a price increase is only a twosigma event
over three trading days at gas hubs such as NBP National Balancing Point. of longterm gas
import contracts offered by Russia compared to contracts offered by the competitive fringe.
even though Russia is obliged to give an increasing discount p . with longterm contracts from
Russia. which mentions bcm per year from Russia and bcm per year from other
nonEuropean import suppliers. until recently.Energy Economics prof Stef Proost The results
The top half of Figure shows how quantities and prices vary as . . Although substantial.
instead of qR . For . Europe increases its volume q of longterm gas import contracts with the
competitive fringe. the probability of Russian default. This is not too far from the actual data
in as cited by BP . at a higher price pR .
By giving a discount p . Russia can induce Europe to sign the long .Energy Economics prof
Stef Proost to compensate the risk for Europe. It is obvious why Russia would want to give
the discount as increases. there is a higher chance that Russia can charge the monopoly
price p in Stage by supplying only a quantity q of gas.
Despite the discount. Clearly. the Russian contractual discount is . For and . ES is the
expected value of the European surplus. The only party gaining from increased unreliability is
the competitive fringe.Energy Economics prof Stef Proost term gas import contracts qR . .
Although is exogenous in our model. for . Russias expected profits decrease monotonically
with increasing the negative impact of the Russian contract discount and loss of Russian
market share is not sufficiently counterbalanced by Russias increased likelihood of benefiting
from a crisis. the results show that it would be attractive for both Europe and Russia to invest
in a more reliable relationship. Panels c and d of Figure show the effect on European surplus
and on suppliers profits. Clearly. of the price. Russia loses market share as increases and for
supply from the competitive fringe outstrips Russian supply. which puts Europe in a
vulnerable situation. Panel d shows Russias profits in Case R . As d increases. EUR/tcm or
roughly . Russian unreliability causes a loss of expected European surplus. respectively.
because increased Russian unreliability allows them to sell a larger volume at a higher price.
. we obviously find ESS and ESS. respectively. The most important observation is that both
Russia and Europe suffer when increases. and the expected value E R as well as the profits
obtained by the competitive fringe. despite the unreliability. Europe tries to make itself less
dependent on Russia and therefore less vulnerable in the event of Russian withholding. For
example. ES decreases despite the Russian discount and shifting supply mix. Recall that S
is the European surplus in Case Russia complies with longterm contracts while S is the
European surplus in Case Russia defaults. Case R . The competitive fringe profits increase
with increasing .
n Dahl C. . World sale gas resources an initial assessment of regions outside the US. .
Rubinfeld..Energy Economics prof Stef Proost . The future of natural gas an interdisciplinary
MIT study. World Energy Outlook MIT. interim report MIT Energy Initiative Morbee. CESSA
presentation.. economische en politieke aspecten. technische. vol . . Cambridge W.. vol ..
Rijkens F. April . . p Pindyck . Microeconomics. Proost S.. ACCO. International Energy
Markets. Pennwell EIA. DOE IEA . trading in the downstream European gas market.n. .
quotRussian Gas Imports in Europe How Does Gazprom Reliability Change the Gamequot.
December. Energy Journal. . References Boots M... J.Van Herterijck Aardgas . Hobbs B. .
Stern J. The Energy Journal. European Gas Security what does it mean and what are the
most important issues ..
Energy Economics prof Stef Proost Chapter Basic electricity economics . We start the
chapter with a small introductory section. In section we analyse briefly transport of electricity
and the location of consumption and production over space. For process heat. Sections .
Those are discussed in chapter . For some applications natural gas could be an imperfect
substitute. Main uses. The emphasis in this chapter is on optimal pricing and investment and
not on the market institutions that are needed to implement these optimal allocations. gas is
again a good alternative. and the way electricity is generated at EU and world level.
Introduction Electricity is the energy vector where the domestic value added and the
domestic flexibility is the largest one can chose the type of primary fuel to use and one can
opt for a particular type of organisation of the sector. gas is a good substitute if it is available.
In section we discuss optimal pricing and investment with uncertainty. and present the basic
economics of the electricity market. For cooking and home heating. . dealing with
conventions and definitions. producers and trade flows Main uses Electricity as source of
power for engines and for lighting has no good substitutes. In section we discuss first peak
load pricing and investment in a world where demand is certain. consumers. In the rest of
this chapter we use the following conventions based on BP statistical review conventions
KwhkJkcal Btu MTOE produces approx . except for specific applications. In the second
section we survey the main uses. Twh .
HFO and gas have taken over first. the share of nuclear decreases and one expects
renewables to grow from to of total power supply in the world. previously coal furnaces Gas.
World consumption in Twh/year was less than half the present consumption
Twh/year.Energy Economics prof Stef Proost Use of electricity Cooking Lighting. The
consumption per capita per year in OECD is almost Kwh while consumption per capita in
China is less than Kwh and in India less than Kwh.. coal Oil products Consumption of
electricity is mainly concentrated in the richer Western countries and in the former Soviet
countries. Growth in the OECD area would be rather limited to some per year but growth
rates in China would be rather per year. Production of Electricity by fuel Before . Gasoil.
power Home heating Industrial process Transport Main substitutes Gas. The IEA Outlook
expects the world consumption to double by . . The next table gives shares of generating
technologies in the world and expectations of IEA world outlook . coal was the dominant fuel
for power production. coal. Since then there is also a revival for gas fired units with the
appearance of more performing combined cycle gas turbines that have a conversion
efficiency of the order of to . followed by the expansion of nuclear in the seventies and the
eighties. Fuel oil. firewood Gas Gas. For the share of coal and gas remain large which
means massive investments. Since early nineties there is a nuclear phase out in large parts
of the world following the Chernobyl accident.
corrected for improvements in electricity efficiency to make its outlook for China. .Energy
Economics prof Stef Proost coal oil Gas nuclear hydro biomass Wind Total TWh Source IEA
Outlook Table Expected electricity generation in the world by type of fuel One of the main
uncertainties is the growth of electricity demand in China and India. BP extrapolated the
income elasticities observed in other Asian countries.
Trade flows Trading electricity is mainly regional trade and there are two reasons for this.
Another important issue not dealt with in this chapter is the cost and capacity of electricity
transmission. NL. The national control was considered as more important. First in many
countries EU. This production was organised at the level of the state or the country and trade
between regulated national companies was not a priority even if it could reduce costs. In
Europe there are traditionally some net exporters France and net importers Italy. Belgium.
USA. the production and transport of electricity was in public hands or in the hands of a
regulated private monopoly. Second. .Energy Economics prof Stef Proost . electricity is
costly to transport over large distances.
. As electricity demand can not be rationed easily. prices need to be higher.. one has to
install capacity in function of the peak demand. Optimal pricing and investment when
demand is certain Peak load pricing and investment with only one type of power plants The
demand for electricity is fluctuating strongly within a year there are daily. This means that in
the peak period. This implies that the cost of generating electricity will be different in peak
and off peak periods. We develop this idea shortly with a graph.Energy Economics prof Stef
Proost . Then the optimal price is equal to variable cost in the off peak period here the
marginal cost of one extra Kwh and in the peak period it is equal to the price P that is needed
to ration demand to existing capacity. Assume that peak and off peak are periods of equal
length within the year and that demand in peak does not depend on prices in off peak and
vice versa. Varying prices over time in function of the marginal cost is called peak load
pricing. Peak load pricing and investment Consider Figure . First assume there is only one
type of plant that can operate and its capacity is given Exist Cap vertical line in Figure . a
simple algebraic model and a numerical example. peak load pricing Euro/K wh Dema nd F
unct pea k Exist Cap Optimal Capacity Dema nd F unct o ff peak P P Op tima l price i n peak
fo r give n ca pacity P Op timal price i n peak w Op tima l capaci ty Variable Cost Op tima l
price o ff peak Annuity investment cost/length peak Q Figure . weekly and seasonal
variations. An efficient electricity market will signal this difference in marginal cost to the
consumers. Peak load pricing .
This implies higher prices in off peak period and lower prices in peak period. Then it makes
sense to extend capacity up to the point where the marginal benefit of an extra unit of
capacity equals the marginal cost of this capacity. The marginal cost is in this case equal to
the annuity of the investment equivalent annual cost of one KW of capacity or rental cost
divided by the number of hours this capacity will be used. Assume that this configuration of
demand functions continues forever. illustrates what happens if one implements average
cost pricing rather than marginal cost pricing. as there are extra metering cost involved.
interruptible demand.Energy Economics prof Stef Proost means applying marginal cost
pricing over time and charge the variable cost except when this would give demand levels
that are larger than the existing capacity. In the off peak period the price will still equal the
variable cost as no extra capacity needs to be installed to satisfy off peak demand. He will
select what is best for him and for the company. We can also consider what happens if we
can extend capacity. or a differentiated price between peak and off peak. one leaves the
option to the consumer. one will tend to invest more as the peak period is charged only part
of the investment cost for which it is responsible. Assume that initially customers consume
more or less evenly in both periods. One could then offer a choice between a uniform price
P. here length of the peak period. In the presence of optimal investment we obtain that the
price in the peak P will equal the variable cost plus the cost of capacity. When we add
investment possibilities. The marginal benefit is the distance between the demand function
and the variable cost. at that moment. Figure . Peak load pricing can take different forms
day/night tariff. Average cost pricing would mean charging the same price in peak and off
peak. . the peak price has to be raised. This rationing is very costly as one can not
discriminate between high value and low value consumers. etc. This creates two types of
inefficiencies charging above the marginal cost in the off peak period and rationing of
demand in the peak period. Those who mainly consume in the off peak will opt for the
differentiated price and so will do those consumers that can easily reduce their peak
consumption.
the capacity cost has dimension annuity per KW / h. the variable cost is fuel cost/ Kwh. The
following expression is the total economic surplus to be maximised qL . Average cost pricing
and investment To find the optimal price and capacity algebraically Williamson.qH . . L H And
this gives the following first order conditions for the optimal quantities and associated prices
qL Q L and qH Q H and Q L H pL b pH b . the demand in each period does not depend on
the price in the other period. one needs to solve an optimisation problem.t. We also take into
account the capacity costs per unit of capacity. If one considers a representative year. the
quantity has dimension Kwh during one representative hour. Assuming periods of equal
length with low demand L and high demand H. Each of these periods generates a net
consumer surplus Spq and a producer surplus pqbq where b stands for the variable
cost.Energy Economics prof Stef Proost peak load pricing vs average cost pricing Euro/Kwh
Demand Fct peak Exist Cap Optimal Capacity Demand Fct off peak Optimal price peak for
given capacity Optimal price peak with Optimal capacity Average Cost pricing Variable Cost
Optimal price off peak Extra capacity needed Q Figure .Q Max W SL pLqL SH pH qH pLqL
bqL pH qH bqH Q qL Q qH Q s.
. If the difference in demand functions is smaller and/ or the cost of capacity larger. The
variable cost consists principally in fuel costs. The rental cost contains the annuity of the
plant so includes the investment cost interest plus insurance and other fixed costs operators
for a year We are interested in two questions what is the best plant mix to meet a given load
profile what does this imply in terms of optimal pricing and capacity The optimal mix of peak
and baseload plants for a given level of demand is a cost minimisation problem that is simple
when all the power stations are reliable and one does not need to take into account start up
costs. The total cost function for a plant of kW of type i is expressed as a function of the time
h it is used TCi h Ci ci h . The capacity cost is to be understood as the full rental cost to have
a given capacity kW available during a given year. the marginal cost of an extra Kwh is the
variable cost. there can be quasirents in both periods. At the other extreme one has peak
load units that have low capital cost and high variable cost.rents earned in each period
equals the cost of one unit of capacity . To meet a demand that is not uniform over time it
may be more interesting to classify them in function of the cost of capacity C per unit and
their variable cost c. Peak load pricing and optimal investment with several types of plants
For the production of electricity one can make use of different plants. Graphically this can be
solved using a load duration curve and total cost functions per type of plant. there was a
large difference between peak and off peak demand functions and the cost of capacity was
rather small then there is surplus capacity in the off peak period and the quasi rent earned in
the off peak period is zero. The optimal capacity level in this context means that the sum of
the quasi.Energy Economics prof Stef Proost Because the capacity is not fully used in the off
peak period. They differ in the type of fuel and size. In the peak period. the price equals the
sum of the variable cost and the capacity cost. if the capacity is optimally chosen. In our
graphical example Figure . Base load units are units with high cost of capacity and low
variable costs.
We assume that the demands in the peak High demand H and off peak period Low demand
L are independent.Energy Economics prof Stef Proost Putting the load curve information
electricity power demand rearranged in decreasing order together with the different cost
functions one can select the optimal combination of the different types of plants by taking for
every yearly utilisation rate the least cost plant. Optimal plant mix for fixed load demand
curve When demand is price dependent. Peak load plant MW Load du ra tion curve Base
load plant h Euro Total Cost function of peak plant of kW Total Cost function base load plant
of kW Capacity Cost base load plant Capacity cost peak plant Peak unit cheaper h Base load
unit cheaper Figure . we can use an extended version of the algebraic formulation of the
peak load pricing problem. The optimal choice of capacities needs now to be solved
simultaneously with the pricing problem .
Obviously. .v a ria b le c o sts . Conditions and mean that prices should equal marginal
production cost in that period. q L B . C B c a p a c ity c o s ts fo r a ye a r p e rio d s o f u n it
le n g th o f p e a k in g a n d b a s e lo a d p la n t P ro b le m M a x im is e su m o f g ro ss C
S . As in each period the two plants are used.c a p a c ity c o sts u n d e r c o n s tra in ts b y
c h o sin g p ro d u c tio n q u a n titie s a n d c a p a c ity p ric e s a re d e te rm in e d im p lic
itly b y se le c tin g to ta l p ro d u c tio n in e a c h o f th e p e rio d s m ax S L q L S H q H c
P q LP q HP c B q LB q HB C P Q P C B Q B L q L q LP q LB H q H q HP q HB LP q LP Q P
LB q LB Q B HP q HP Q P HB q HB Q B g e n e ra tin g th e fo llo w in g first o rd e r c o n d
itio n s a s su m in g it is o p tim a l to u s e a ll p la n ts in a ll p e rio d s SL L pL L qL SH H
pH H qH L LP c P LB c B H HP cP HB cB C P LP HP C B LB HB The first order conditions
tell us what are the properties of the optimal solution. q H B p ro d u c tio n s M W in p e rio d
s L . To solve for the optimum we need to solve the system to and do this for all possible
combinations of s as there may be corner solutions where the peak plant is not used in the
low demand period. Optimal capacity is reached when the sum over all periods of the quasi
rents or value equals the unit cost of capacity. in each period. interpretation of Lagrange
multipliers at the optimum. S H q H g ro ss c o n su m e r su rp lu s in d e m a n d p e rio d s
L .B b a s e lo a d Q P .H u s in g p la n ts P p e a k in g . The marginal cost is given by
equations and it is the fuel cost plus a quasi rent or shadow value. q H d e m a n d M W in th
e L o w p e rio d a n d H ig h p e rio d w h e re p e rio d s h a v e sa m e u n it le n g th q L P .
c B v a ria b le c o st fo r a p e rio d o f u n it le n g th o f a p e a k p la n t a n d a b a s e p la
n t C P .Energy Economics prof Stef Proost q L . one follows the merit order use always first
the available capacity with the lowest variable cost. Here we also determine simultaneously
the capacity of the two plants. Q B c a p a c ity a v a ila b le fo r th e tw o p e rio d s o f e q u
a l le n g th w h o le ye a r S L q L . q H P .H quota re a u n d e r W T P fu n c tio n quot c P .
The quasirent for a given plant in a given period is the marginal benefit of having one more
unit of capacity available during that period cfr. every type of plant earns quasirents in each
period.
This is indeed the extra cost to society of satisfying an extra power demand in the peak
period. This capacity credit CP cP cB equals the savings in capacity costs in the peak period
adjusted for the difference in fuel costs. .Energy Economics prof Stef Proost An easier
special case is where it is optimal not to use the peak plant in the low demand period LP SL
L pL L qL SH H pH H qH L LB c B H HP cP HB cB CP CB HP LB HB H p H HB C P cP HB C
P cP cB L p L cB C B c B C B C P c P c B In this case the optimal price marginal cost in the
High demand period equals the price of fuel plus the full capacity cost of the peak load plant .
We illustrate this in Figure . In the Low demand period we obtain that the price equals the
fuel cost the full capacity cost of a baseload unit minus the capacity credit for offering low
cost capacity in the peak period. Price Per Kwh fuel cost peak plant /Kwh annual cost
capacity/ length of peak period in h.
Assume that demand for capacity is given by qH pH qL pL with qH . Using the formulas
calculated above. a baseload power generation technology with CB c EUR/MW and B
EUR/MWh is available. Illustration of optimal plant mix with two demand periods We can use
a numerical example to illustrate this point.Unit conversion yields cP EUR/MW and cB
EUR/MW. assuming USD/EUR parity . a peakload power generation technology with CP
EUR/MW and cP EUR/MWh is now also available .Energy Economics prof Stef Proost cPCP
Peak pH HB cP Base load pL LB cB h Figure . In addition. qL in MW and pH . pL in
EUR/MWh. Assume. we have EUR EUR MW MWh EUR EUR pL CB cB CP cP cB MW MWh
pH CP cP The parameters of the peakload technology are taken from the abovementioned
article by Borenstein .
total consumption of electricity could increase. Figure . With real time pricing. Borenstein
found that gains can be large they depend on the elasticity of demand. presents the effects
on the load duration curve of switching from flat uniform pricing to real time pricing for /rd of
the customers. How important is peak load pricing and correct capacity choice Borenstein
analysed the effects of real time retail pricing with a representative load curve for the US
retail customer and used the following costs for power stations He computed the effects of
real time pricing for different demand elasticities and found that real time pricing can easily
pay its higher metering costs for the larger consumers.e. A customer who agrees to buy a
constant amount of power i.Energy Economics prof Stef Proost and hence. Time of day
pricing day and night only captures a small fraction of the benefits of real time pricing. the
same rate of consumption during peak and offpeak hours. qH MW and qL MW. using the
demand curves. which is also the average total cost of the baseload power plant.. . would
pay an average price of EUR/MWh.
If one starts with no initial capacity. the total . a perfectly competitive market would supply
the right quantities at the right prices and suppliers would cover their costs. the quasirent
would be too small to encourage new investments and capacity would gradually be adjusted
downwards. The next table using data from IEA makes such a comparison. The answer is in
principle Yes. Cost of power plants To decide what type of plant is most appropriate for a
given number of hours of operation. If capacity is too large. Etc.Energy Economics prof Stef
Proost Effect of switching / rd of customers from flat to real time pricing Figure . one can
make a simple static comparison of the costs of generating one Mwh. The main assumptions
driving this result are the absence of returns to scale in production so that many producers
can be active on this market and the absence of reserve capacity requirements. the market
mechanism can in principle also achieve the right adaptation over time. If one would start
from the wrong mix of capacity or a too large or too small capacity. Effect of switching from
uniform flat to real time of day pricing source Borenstein . Can this type of behaviour be
decentralised in a market context This is a question we address in Chapter . In the long term
the marginal cost of one Mwh will depend on the availability of the power plant h/year and
technical lifetime.
. . . This table allows to study the importance of each of the parameters. the availability
factor represents the time the machine is not out for planned or unplanned maintenance. . .
coal and combined cycle gas plant. . . the effective utilisation of a power plant will depend on
the merit order of the available capacities and of the total demand cfr. For wind power. . In
reality. . . Market parameters fuel cost Price of CO Interest rate Hours of operation Results
annuity factor annuity total fixed cost per Mwh total variable fuel cost per hour total variable
CO permit cost total cost per Mwh /Mwh /ton / hours/year . . . . the efficiency of the power
plant. The table allows to make a rough first comparison. . the cost of capital here a simple
interest rate. the availability represents the probability the plant is used for peak service. . . . .
. . . . . . . Variable cost OampM /Mwh . the fuel cost and the cost of the CO permits. per Year/
of investm /Kwyear /MW h /Mwh /Mwh /Mwh . . . . Simple power plant economics comparing
the cost per Mwh for maximum operating hours per year source IEA Nuclear coal CC gas
gas turb Wind o Technical parameters Capacity MW . .. . . . . . . . . Fixed cost of OampM /Kw
. . . Figure . efficiency . . . . . Investment cost /kw . Emission CO kg/Gjinput . A private
investor will also take into account his cost of capital and will look into the risks associated to
his investment. . . . . . . .Energy Economics prof Stef Proost investment cost. . . . What is
missing is the effective contribution to the guaranteed capacity could be only of installed
capacity. the availability factor is a synthesis of wind conditions over the year. . . . The risk
will depend on the price and variability of the price of electricity. . . . . . Technical life years .
For nuclear. . For gas turbine.
rationing when prices can not be . This would mean that one would buy X MW at price p if
there is no unforeseen capacity shortage and buy Z MW at price q if there is no capacity
shortage. This is also known as the reserve capacity requirement. This is difficult for two
reasons. This implies that if there is a shortage. not the consumer that could most easily
forego the electricity consumption. Optimal pricing and investment when demand is uncertain
and availability of plants is uncertain Demand is not known with uncertainty and power plants
can have unforced outages.. A price F DBElost consumer surplus when There is efficient
rationing and Demand is higher than expected D E AEF expected loss of consumer surplus
when there is random rationing probability of not safying a customer in the range OqHH
Q/OqHH AF/FpHH pHH pH B Demand very high HH Demand high H qH Q qHH qHH
Quantity Figure . The problem is that. In theory one can expand the neoclassical market
framework by defining contingent commodities and trade in these commodities. Effect of
different types of adapted to peak demand. second one needs special devices to disconnect
individual customers. it is difficult to suddenly charge higher prices and ration demand in
function of the willingness to pay of each customer. in case of capacity shortage.Energy
Economics prof Stef Proost . the average consumer is interrupted. First the individual WTPs
are not known. We illustrate this in Figure .
shows the different effects at work. Initial existing capacity is fixed at Q. One can also
increase the price so as to balance the marginal reduction in the VOLL and the higher loss of
consumer surplus in the normal demand period. There is a loss of consumer surplus in the
normal demand period because the full capacity is not used we assume that the pricegtfuel
cost Figure . These will be the consumers with the lowest costs of . a proportion Q/qHH will
not be satisfied. Assume now that one will not always satisfy demand in the exceptional peak
period. The power cuts are then either at random or proportional. The optimal solution is to
increase the level of peaking capacity up to the point where the reduction of VOLL equals the
marginal cost of capacity annuity peak capacity/duration of load shedding.Energy Economics
prof Stef Proost Take the case of two demand levels there is the expected demand qH
realised with probability and there is the unexceptionally high power demand qHH with
probability . The best option is to use the price mechanism and increase prices up to pHH.
whatever its level. normal level. The loss of consumer surplus due to insufficient capacity is
now limited to area DBE. In that case. Assume first that the best solution is to always satisfy
demand. Assume that capacity equals Q and that price equals pH. The other solution is to go
for a lower price pH but to increase capacity such that demand is always satisfied QHH.
What is an appropriate price and capacity The problem is that capacity and price in the peak
period have to be chosen beforehand. This requires that the price in the peak period has to
be set at an exceptionally high level pHH but this would also generate a high loss of
efficiency when the peak demand is at a lower. This would be very costly in terms of
capacity. Another option is to offer interruptible contracts to those consumers that can easily
decrease their demand at short notice. price and probability distribution of demand one can
define the Value Of Lost Load VOLL per expected Mwh lost. But it is in general difficult to
ration demand efficiently using a higher price. For each level of capacity. the demand in the
exceptional peak period has to be rationed. In this case the consumer surplus is much higher
and equals AEF for each consumer in the range qHH .
An interruptible demand contract acts like an increase in capacity. One can again optimize
the level of capacity by comparing the cost of extra capacity and the saved LOLL. Effects of
a price increase and a capacity increase . The probability that demand can not be satisfied
fully can be computed by computing all states of the world this means enumerating all
combinations of machines that could have a technical failure.Energy Economics prof Stef
Proost being curtailed. also the availability of plants can be uncertain due to technical
failures. . A price F pHH pH P B D E Reducing the VOLL by installing More capacity Q and
raising the price p At the cost of increasing the loss of consumer surplus under normal
demand conditions pL PL G Demand very high HH Demand high H qH Q q Q HH qHH
Quantity Figure . Optimal pricing and investment when demand is uncertain and availability
of plants is uncertain Not only demand can be uncertain. This allows in principle to compute
for every production park and a given demand the LOLL.. Assume a load duration curve that
is known with certainty. unforeseen weather events etc.
. E. Hunt L. University of California Energy Institute . What are good economic principles to
invest in transport and what are the optimal locations for production and consumption .. .
population density. Edward Elgar Stoft S. References Borenstein .. . p..Energy Economics
prof Stef Proost . IEEE press Williamson. Production and transport of electricity For different
reasons cooling. eds. Peakload pricing and optimal capacity under indivisibility constraints..
CSEM WP r Evans J. Long run efficiency of real time Electricity pricing.. International
Handbook of the Economics of Energy. Power system economics. O. The American
Economic Review. fuel supply production can be located at some distance of the
consumption location.
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