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Before answering the questions posed above, it is worthwhile to discuss in some detail the nature of the energy market. First of all, strictly speaking, there is no such thing as the price elasticity of demand for energy, because energy per se is not really traded. Electricity is traded; coal, oil, gas and other fuels are traded. But to say that energy is traded is really only a manner of speaking, or a way of measuring the trade in the commodities of primary and secondary fuels.

It makes some sense therefore to speak of the price elasticity of demand for primary and secondary fuels. On the other hand, the 'demand' for fuels is only an intermediate demand for commodities which are required to provide certain kinds of services to consumers. The 'final' demand is not for fuel, nor even for energy, but rather for certain 'energy services' which primary and secondary fuels can help to provide. These energy services include, for instance, thermal comfort, hot water, light, motive power (including transportation) and so on.

In order to meet the demand for these services certain kinds of commodities are traded. These commodities include fossil fuels and electricity. They also include energy conversion appliances (boilers, heaters, lights, cars, power stations). Equally, the provision of a particular level of thermal comfort service, for example, depends upon the level of capital investment in the thermal structure of the dwelling. What is clear from this analysis is that a demand for a particular service is met not by a simple transaction involving the trading of certain quantities of primary and secondary fuels, but rather through a network of transactions involving capital investments in various parts of the network as well as trade in consumable goods (fuels) throughout the network.

There are several points to make concerning this supply network. First, it should be noted that the energy service supply network involves investments at different points by different economic actors. The fuel supply elements of the network require corporate investment in coal production and distribution, and in electricity production and distribution; and the fuel demand elements typically require investment mainly by companies and households in appliances to burn fuels and in insulation and other energy-retention characteristics of buildings (also see Chapter 1 for a discussion of the network). Second, it is important to note that any particular demand for energy services can be met by a number of different 'chains' of investment and transaction, within the energy service supply network. For instance, the demand for thermal comfort in an existing poorly insulated dwelling can be met through a supply chain involving an inefficient open fire using a certain quantity of low-grade coal, and perhaps supplemented by direct electric heating with electricity generated by traditional coal-fired electricity generation. Alternatively, the same demand for thermal comfort could be met by improving the thermal insulation of the dwelling (requiring increased investment in a different part of the network) and thereby reducing the requirement for low-grade coal and electricity (and reducing the fuel cost). This alternative represents a second 'energy service supply chain' providing the same energy service. Equally, the demand for thermal comfort could be met by replacing the open fire with a modern, efficient gas-fired boiler (requiring investment in energy conversion capital goods) and purchasing supplies of domestic gas (at a reduced cost in consumable goods). This represents a third energy service supply chain. Of course, investments in both thermal insulation and energy conversion technologies could be made; and this represents yet another energy service supply chain.

Third, for each particular energy service demand, the level of fuel consumption depends heavily on the particular energy service supply chain which supplies that demand. For example, it is usual to define thermal comfort requirements in terms of internal temperatures. Determination of a specific internal temperature, together with a knowledge of the thermal characteristics of the dwelling and the thermal efficiency of the heat conversion equipment, allows us to determine the quantity of fuel required to satisfy that internal temperature requirement. If the internal temperature requirement is given, then the demand for fuels will be determined by the thermal characteristics of the dwelling and the technical characteristics of the conversion equipment. Each different energy service supply chain will allocate different levels of investment to the thermal infrastructure of the dwelling and to the conversion technologies. Clearly therefore each energy service supply chain will imply different levels of primary fuel consumption, and hence different levels of emission of greenhouse gases.

Finally, it is worth mentioning here that the question of defining energy services is not in itself straightforward. Actually we should not even regard internal temperatures as a fixed definition of thermal comfort levels because thermal comfort depends (for a given internal temperature) on the thermal insulation properties of the clothes a person is wearing. It also depends on the metabolic rate of the person, and this metabolic rate differs not only between individuals but also for each individual depending on their activity level. These considerations suggest that the provision of thermal comfort cannot be defined entirely through technical or economic parameters but includes cultural and behavioural elements.

Irrespective of these finer points, however, the provision of thermal comfort is very distinct from the provision of fuel supplies. The total demand for fuel supplies (and implicitly the total emissions of greenhouse gases when the fuels are burned) can differ widely between different energy service supply chains providing the same final demand, e.g. that for thermal comfort.

Figure 10.3 Cost-effectiveness of CO2 emission abatement options when seen from the investor's perspective

10.2

PRICE ELASTICITY, SUBSTITUTION AND MARKET STRUCTURE

Figure 10.3 Cost-effectiveness of CO2 emission abatement options when seen from the investor's perspective

10.2

PRICE ELASTICITY, SUBSTITUTION AND MARKET STRUCTURE

What are the implications of this analysis for the issue of price elasticity? First, by definition, basic services such as thermal comfort, hot water and cooking (for instance) are likely to be very inelastic in demand. As the opening remarks in this chapter suggested, it is also true that historically the demand for primary and secondary fuels has been relatively inelastic. However, it does not follow that the low historical price elasticity in primary and secondary fuels is an inevitable consequence of the low elasticity of demand for basic energy services, for reasons which should by now have become obvious: primary and secondary fuel demand depends heavily on the particular structure of the energy service supply chains. The substitution of one energy service supply chain for another can result in principle in large reductions in demand for energy at no change in the price of fossil fuels.

The issue of substitution does, however, throw considerable light on the price elasticity of demand for fossil fuels. The most important consideration in determining price elasticities of demand for a good or service is the ease with which consumers can substitute another good or service that fulfils approximately the same function. The easier it is to substitute, the higher the elasticity. Thus, for example, it is not easy to substitute for basic energy services such as thermal comfort, and therefore we would expect the demand for such services to be price inelastic. Equally, however, the low historical price elasticity of demand for fuels suggests that—despite the existence of different energy service supply chains with radically different associated primary fuel demands—substitution between these different energy service supply chains has not been easy.

It is well documented in the literature (Johansson et al. 1989; Grubb 1990; Jochem and Gruber 1990; Jackson and Jacobs 1991; Jackson 1992) that there are a number of fundamental obstacles to energy

Figure 10.4 Effects of a carbon tax on microeconomic analysis of CO2 abatement options from the investor's perspective

efficiency improvements. In particular, these obstacles include lack of awareness of energy efficiency measures, lack of information, lack of technical expertise, low availability of technologies, capital constraints, separation of responsibility for costs from benefits (the so-called 'tenant-landlord problem'— Jackson 1992), unfavourability of tariff structures and taxation policies, and the structure and regulation of the fuel supply industries. These obstacles have the result that households typically require very high rates of return before they will invest in energy-saving technologies. Essentially, these market barriers can be thought of as obstacles to substitution between different energy service supply chains. By restricting substitution between fuel-intensive supply chains and fuel-efficient supply chains, these obstacles have the effect of reducing the potential for implementation of cost-effective energy efficiency measures and thereby raising the demand for primary and secondary fuels.

To carry the analysis further, the structure of the energy services market can be characterized in terms of a correspondence between economic actors and energy service supply chains. In each particular market structure, different economic actors are implicated in investments in different parts of the energy service supply chain. Conversely, the set of economic actors investing in each energy service supply chain is determined by a number of economic and institutional factors which in their entirety might be called the structure of the market.

To take a specific example, traditional energy markets are characterized by energy service supply chains in which public-sector monopolistic utilities (now privatized) have invested in the supply and distribution of primary and secondary fuel whilst private agents (manufacturing companies in the industrial sector and individuals in the domestic sector) have invested in energy conversion technology and improvements in the thermal structure of buildings. The utilities have had a major economic interest in keeping the level and growth of energy use as high as possible. This remains true after privatization, although there is increasing pressure for energy efficiency measures from the industry regulators.

The economic implications of market structure arise in particular because different kinds of investor bring different profitability requirements to their economic decision-making. One way of expressing these profitability requirements is in terms of the discount rate or required rate of return of different investors. The old public-sector utilities had rates of return imposed by central government which approach the social discount rate—traditionally somewhere between 5 and 8 per cent. Privatized utilities are likely to have slightly higher required rates of return on capital. In contrast, the required rates of return by private companies for investment in insulation and other energy-saving schemes have varied considerably but can be as high as 30 or 40 per cent. There is evidence that the effective rates of return required by individual consumers are considerably higher even than this (Chernoff 1983; Meier and Whittier 1983).

If the effect of market structure is to allocate specific investors to specific investments within the energy service supply chains, then the economic effect of market structure will be to impose different profitability criteria—different rates of return—on the constituent parts of each energy service supply chain. Thus, investments occurring at different parts of the energy service supply network are not necessarily comparable on an equal footing, and certain energy service supply chains will be preferred over others simply because of the different profitability requirements associated with the different investments in each chain.

The effect of this mapping of investors onto investments in the energy services supply network can be very significant as the following analysis shows.

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