Topic 2: Fossil Fuel Supply and Demand: E⁄ect of …personal.strath.ac.uk/gary.koop/ec933/Supply_Demand_2015...Here Supply + Demand for fossil fuels But we will also use Supply+Demand

Topic 2: Fossil Fuel Supply and Demand: Effect ofSubsidies and Taxation

() Global Energy Issues, Industries and Markets 1 / 53

Introduction

This topic follows strategy I plan in using in this course

A bit of economic theory in the context of a particular energy marketplus a case study

Here Supply + Demand for fossil fuels

But we will also use Supply+Demand ideas useful in other energymarkets

Effect of taxes and subsidies

Case study: effect of fossil fuel subsidies (general theory plus focus ona few specific countries)


Supply and Demand

Supply and demand graphs are a basic tool for many economicproblems

Involves Q = quantity bought and sold (produced and consumed)

P = price

Supply = what is produced/sold by companies/firms

Demand = what is consumed/bought by consumers

The quantity firms supply increases with price

E.g. price of coal goes up, miners produce more coal

Quantity consumed decreases with price

E.g. price of coal goes up, electricity generators buy less coal (switchto gas)

Next slide illustrates this in Supply-Demand graph


Price

Quantity

Demand Curve

Supply Curve


Supply Equals Demand in Equilibrium

Demand curve: for each price, how much will consumers buy?

Supply curve: for each price, how much will producers produce?

Equilibrium price: quantity demanded equals quantity supplied

Why?

If price too low, then producers will not produce enough to meetdemand

Excess demand means price will be driven up

If price too high, the consumers won’t buy as much as producers wantto produce

Excess supply means price will be driven down


Price

Quantity

Demand Curve

Supply Curve

Plow

Q supplied Q demanded

Pequilibrium


Example: What Influences Supply for Coal?

Supply depends on price of coal (movement along the supply curve)

Other factors will shift entire supply curve

Factor influencing costs of production (e.g. wages, etc.)

In longer run, technology and geology influence supply curve

E.g. mine cheapest seams of coal first before digging deeper for moreexpensive


Example: What Influences Demand for Coal?

Depends on price of coal (movement along the demand curve)

Other factors shift entire demand curve

Coal is heavily used for electricity generation

Anything that influences demand for electricity will also affect coal

Weather (home heating, electricity for air conditioners, etc.)

State of the economy: industry uses a fair degree of coal directly orindirectly as electricity

Price of alternative fuels

In relation to alternative fuel prices, introduce some terminology onnext slide


Electricity generating companies often own both gas and coalgenerating plants

These depend on prices of fuels and influence demand curve

Spark spread = profit margin per unit of electricity produced using gas

Dark spread = profit margin per unit of electricity produced using coal

Switch production depend on so-called spreads

Also including price of CO2 emissions leads to “clean”dark/sparkspreads

Hot issue: in US natural gas price very low, electricity generationswitching to gas, hurting coal miners

Glut of cheap US coal bought by German electricity generators


Government Actions Can Influence Supply and Demand

Example: EU-ETS requires electricity generating companies to buycarbon permits

Electricity generation from coal releases more CO2 than generationfrom other sources

Carbon price rises implies coal generation becomes more costly

How would this appear in a supply-demand graph?

Shift demand curve down

Why?

Electricity generators are demanders of coal

At any price level demand less (the effective price of coal they pay hasincreased since higher carbon price)

Result: equilibrium price and quantity of coal falls

Note: this is what is happening in US to coal industry now due to fallin natural gas price


Price

Quantity

Original Demand Curve

Supply Curve

Original P

Original Q

New P

New Q

New Demand Curve


Government Intervention: Price Supports

Price support: Set minimum price for coal.

If market price above price support, no effect

If market price below, the government must intervene buying coal toforce price up to price support

Alternatively, governments sometimes set maximum price for fossilfuels (to protect consumers)

If market price above minimum price, excess demand (black market,corruption)

Supply-demand graphs can be used to show these


Government Intervention: Subsidies

Subsidies:

E.g. for each ton of coal produced the government will pay 10 Euros

Or for each 1 Euro of coal you sell, the government will pay an extra10%

Subsidies are the opposite of energy taxes so I will defer graphs untiltaxes discussed

Price supports/subsidies common in Europe in the past (particularlyin the coal industry)

Declining slowly (but even in 2001 Germany was spending almost $5billion on coal subsidies)

Protect coal industry and jobs

Hot issue: economic consequences of energy subsidies in developingworld

Return to this issue shortly


Government Intervention: Taxation

Fossil fuels are typically heavily taxed in various ways, including:

Corporation tax (tax on profits as paid by any company)

Severance taxes (popular in US, sometimes called ad valorem taxes)

E.g. percentage of value of coal produced.

Royalties

VAT and other taxes paid by consumers, etc.

Many other taxes

To give a flavour of the types of tax regimes, faced by fossil fuelcompanies I will give a few examples


Hot Issue: UK Taxation of North Sea Oil

From budget statement on 23 March 2011:

Chancellor of the Exchequer announced increase in the‘supplementary charge’paid by companies involved in North Sea oil &gas production. North Sea companies pay corporation tax on theirprofits from oil and gas extraction in the UK and the UK ContinentalShelf. In its 2002 Budget the Labour Government introduced asupplementary charge on profits set at 10%, and this was increased to20% in January 2006. In his Budget speech Mr Osborne argued thatthe rise in oil prices since this reform had provided unexpected profitsfor the oil companies, and that it was fair to set the supplementarycharge at a new rate of 32%.


But one year later and after sharp fall in North Sea Oil exploration...

From the Financial Times (22 March 2012)

North Sea groups welcome Budget’s change of tax:

A year on from a £ 2bn raid on North Sea profits, industry operators,suppliers and advisers have expressed satisfaction with changes madein this week’s Budget to the taxing of those involved in UK oil andgas production. That raid, used in part to finance a 1p a litrereduction in fuel duty, raised the marginal tax rate facing operators offields to between 62 per cent and 81 per cent....

Note: this tax change related to relief for decommissioning(dismantling rigs and wells once oil and gas fields run dry)


Russian Taxation of Foreign Oil and Gas Companies


Angola Treatment of Foreign Oil and Gas Companies


Other Types of Taxes

But it is not just fossil fuel companies which pay taxes

Companies which use fossil fuels (e.g. electric utility companies) paytaxes

Consumers also pay taxes

Rich countries tend to tax petrol (see next slide)

But many poor countries do the opposite — subsidizing consumptionof fossil fuels

In sum, variety of taxes/subsidies which impact in various ways


Example: Petrol Taxes in OECD Countries


Taxation in a Model of Supply and Demand

Taxes on producers will shift the supply curve

Taxes on consumers will shift the demand curve

Remember: subsidy is the opposite of a tax so shifts in oppositedirection for subsidies

But, before showing effects of tax, I will show how supply-demandgraphs can be used to measure profits and welfare:

Producer surplus and consumer surplus


Consumer Surplus

Consumer surplus is the total benefit consumers get from consuminga productIt is the area above the price charged in the market and below thedemand curve (a triangle)Why?Economists think marginally (one unit at a time)Demand curve plots marginal benefit to consumers of each unitconsumedWhat are consumers willing to pay for first unit? Point on demandcurve above quantity=1What are consumers willing to pay for second unit? Point on demandcurve above quantity = 2, etc.Add up all these marginal benefits to get total benefit = consumersurplusSee next slide


Price

Quantity

Demand CurveA

B C

Consumer Surplus isTriangle ABC


Producer Surplus

Producer surplus is the total benefit producers get from producing aproduct (rent)

It is the area below the price in the market and above the supplycurve (a triangle)

Why? Similar reasoning to consumer surplus

Supply curve reflects marginal cost

What does producer get for producing 1st unit? Price (=B in graph)

What does it cost producer? Point on supply curve for Q=1

Difference between these two is profit for producer

Adding up for 1st unit, 2nd unit, etc. get producer surplus triangle

See next slide


Price

Quantity

Supply Curve

D

CB

Producers Surplus isTriangle BCD


Consumer and Producer Surplus in Equilibrium

Now let’s put it all together in a supply-demand graph

Equilibrium price and quantity determined where supply and demandintersect

Total benefit = producer plus consumer surplus

See next slide


Price

Quantity

Demand Curve

Supply Curve

Q

B

A

D

C

Total Benefit = Cons + Prod Surplus= Triangle ACD


The Effect of a Tax on Demand, Supply and Consumerand Producer Surplus

Now let us return to the effect of a tax

In previous example (EU ETS) considered a tax on consumers of coal(electricity generating plants)

Now consider a tax on suppliers

This will shift supply curve up

Why? Supply curve reflects marginal costs, if taxes go up costs will goup

Next slide illustrates this

Tax will cause price to rise from B to B*

Quantity produced will fall from Q to Q*


Price

Quantity

Demand Curve

Supply Curve

Q

B

A

D

C

Supply Curve With Tax

B*

D*

C*

Q*


The Effect of a Tax on Demand, Supply and Consumerand Producer Surplus

But what will happen to consumer and producer surplus?

In preceding slide, they both shrink

Consumer surplus falls from ABC to AB*C*

Producer surplus falls from BCD to B*C*D*

Government gains tax revenue which partly balance these losses

But can show (count areas in graph) that there is still a deadweightloss from taxation


Who Bears Burden of a Tax?

Burden of taxation depends crucially on shape of supply/demandcurves

Elasticity is usual way of talking of shape of these curves

Elasticity of supply = percentage change in supply caused by onepercent change in price

Elasticity of demand = percentage change in demand caused by onepercent change in price

Inelastic if elasticities are near zero

Think of elastic as “sensitive”—so “inelastic”= “insensitive tochanges in price”

Note: obtaining estimates of this is important, useful for forecasting


Who Bears Burden of a Tax if Demand is Inelastic?

What if demand is insensitive to price?

Always need oil for cars, etc.

IMF report claims very low price elasticities of oil

“10 percent permanent increase in oil prices reduces oil demand byabout 0.7 percent after 20 years”

Suppose oil production is less inelastic (e.g. Saudi Arabia has excessproduction capacity so can adjust production easily to changes in oilprices)

Effect of tax: price rises much more than before

Output falls very little and producer’s surplus falls only a little.

In case of perfectly inelastic demand, tax is simply passed on forconsumers to pay with no effect on producers

Consumers bear burden of tax


Price

Quantity

Inelastic DemandCurve

Supply Curve

Q

B

A

D

C


B*

D*

C*

Q*


Who Bears Burden of a Tax if Supply is Inelastic?

What if supply is insensitive to price?

E.g. coal producers have large fixed costs and diffi cult to adjustproduction when prices change

Suppose demand for coal by consumers is less inelastic

E.g. Electric utility companies consumers of coal and can switch togas easily

Effect of tax: price rises less than before

Output falls more than before and consumer surplus falls only a little.

In case of perfectly inelastic supply, full burden of tax borne byproducers


Price

Quantity

Demand Curve

Inelastic Supply Curve

Q

B

A

C


B*

C*

Q*


Case Study: Fossil Fuel Subsidies

In their 2010 World Energy Outlook, the IEA says: “Fossil-fuelsubsidies result in an economically ineffi cient allocation of resourcesand market distortions, while often failing to meet their intendedobjectives”

In this case study, we will examine the IEA’s case

From our supply-demand graphs have shown deadweight loss oftaxes/subsidies

This leads to “ineffi cient allocation of resources and marketdistortions”, but IEA makes some additional points...


Common Types of Subsidies

There are many types of subsidies to fossil fuels.

A few examples:

Price controls

E.g. Venezuela law: petrol must be sold for equivalent of 3 cents perlitre

Tariffs of import of competing fuels

Laws which say, e.g., domestic coal must be used for electricitygeneration

Implicit subsidies to producers (e.g. favourable tax deductions for oiland gas fields, government taking on risk for accidents,decommissioning, etc.)

etc.


Why Do Governments Subsidize Fuels?

Alleviating energy poverty

Security of energy supply

Redistribute nation’s resource wealth widely

Protecting employment in energy industries

Protect the environment (more relevant for renewables, such as UK’ssubsidy of wind power, will discuss in detail later in course)


Why Does IEA Not Like Fossil Fuel Subsidies?

Encourage wasteful consumption

Hasten the decline of exports (for producer nations)

Encourage fuel adulteration, smuggling and corruption

Discourage investment in energy infrastucture

Disproportionately benefit middle class and rich

Drain state budgets

Distort markets (and, in case of fossil fuel subsidies, discouragedevelopment of clean energy)

Increase CO2 emissions and pollution

Encourage volatility in world energy prices by dampening price signals


IEA’s Justification?

Most are self-evident, but I will elaborate on a few

Note first, that economists would argue:

If you want to help the poor, more direct methods better

Type of claim in countries with cheap energy: “If we have lots of oil,costing $5 per barrel to produce, why should our consumers be payingmore for our oil?”

Economists argue: “Better to sell your oil for $50 per barrel on theinternational market. Can show your country will be better off as awhole if you do this.”

Note: students of economics will know the economic theoryunderlying this (gains from trade, comparative advantage, markets areeffi cient, etc.), but I will not explain in detail


Why Might Price Controls Lead to Corruption and RelatedProblems?

This can be shown in our initial supply-demand graph

Setting too low a price leads to excess demand

Can make money by trying to satisfy this excess demand

Black market in fuel

Smuggling of cheap fuel to neighbouring country without fuelsubsidies

Recent issue: Argentinian nationalization of YPF (previously ownedby Spanish company Repsol)

Repsol accused of lack of investment/development of resources

Repsol said Argentinian price controls made it uneconomic to invest


Why Is Volatility of Energy Prices Affected by Subsidies?

E.g. what if price of oil (on international market) very different fromprice of oil paid by consumers?

Demand for oil then becomes inelastic

Consumers of oil protected from changes in world oil price and, thus,do not change their demand with world oil price increases

But look back at our graph with the inelastic demand curve

In it, small shifts in the supply curve cause big changes in world oilprice – increased volatility

Prices can signal useful information (e.g. to resolve a shortage,conservation is useful), but dampening price signal to consumersuseful information is lost

In early 2008, petrol prices were rising, 2/3 of 131 countries did notfully pass this price rise on to consumers


How Big are Energy Subsidies and Where are They MostPrevalent?

See next three slides

Short answer: They are BIG and mostly in the poor countries whichcan least afford them.





How Much Fuel Could be Saved by Eliminating Subsidies?

IEA estimates that removing fuel subsidies would:

Lead to many benefits including:

Saving of oil (particularly in transportation)

Reduction in CO2 emissions (almost halfway to reaching the 450Scenario)

See next three slides





Fossil Fuel Subsidies Still in the News

E.g. Financial Times, September 16, 2014

Growth and fighting global climate change not incompatible

New Climate Economy Report (commissioned by UK, South Koreaand five other countries including Ethiopia and Indonesia).

Recommendations: wealthy countries immediately stop building newcoal power plants and all countries phase out fossil fuel subsidies nowvalued at about $600bn a year, compared with $100bn for cleanenergy subsidies.


Case Study Topic

In this course, you are asked to do two essays/case studies/projectsThe first one will be on a specific country, second one on a specificpolicy/issueThe IEA’s World Energy Outlook for 2010 has much more on energysubsidies, includingCountry subsidy profiles for Iran, Russia, India and IndonesiaCase study: detailed study of energy subsidies in these countriesDiscussion of themes in this lecture with detailed facts/experience ofone countryHave things changed since 2010?The IEA’s World Energy Outlook for 2014 has a section on subsidiesFocus on particular aspect (e.g. impact of energy subsidies on CO2emissions)Or broaden beyond subsidies only for general discussion of energypolicy in one country


Summary

This lecture introduced some basic economic theory: supply+demand(consumer/producer surplus and elasticities)

Focussed on supply and demand for fossil fuels

Taxation/subsidies are very important in international energy markets

Factors which determine the impact of taxes/subsidies

Possible case study topic: world energy subsidies


Documents

Topic 2: Fossil Fuel Supply and Demand: E⁄ect of …personal.strath.ac.uk/gary.koop/ec933/Supply_Demand_2015...Here Supply + Demand for fossil fuels But we will also use Supply+Demand