Energy Security and Climate Change

1. Energy Security and Climate Change Methodologies on risk assessment and cost estimates of supply disruptions Anil Markandya Bath, May 12, 2006

2. Overview • Definition of Energy Security and Main Concerns • Risk Assessment Methodologies • Assessment of risks (can we define probabilities of disruption events)? • Estimation of costs of disruption • Estimation of degree of internalization • Estimation of risk premium • Social costs of energy supply disruptions • Social costs of oil supply disruptions: looking at past shocks • Some quantitative estimates for European Union • Social costs of electricity shortage: qualitative assessment • Conclusions and areas for research

3. Definition of Energy Security • Availability of regular supply of energy at a reasonable price (IEA) • Physical availability and price dimensions • Long term and short term dimensions • Long term: will there be enough energy available at an affordable price? • Short term: the unanticipated cut in supply and sharp increase in price • Definition suggests that any measure of ES should be linked to welfare, but measures are not linked. • We focus here on short term insecurity. Data analyzed elsewhere suggest that long term supply is not an issue at global level.

4. Measures of Energy Security • Stress dependence and vulnerability • Dependence measures include imports of energy and share of imports in total • Vulnerability measures include • Days supply of stocks • Diversity and concentration indices of supply (e.g. Shannon Weiner Index) • Fuel used per capita, per €of GDP • Indices are monotonically related to welfare effects of ES, but precise link has not been established and welfare definition of ES has not been made

5. ES: An Important Dimension of Energy Policy • Measures taken under rationale of ES include • Maintenance of strategic reserves • Diversification of sources • Incentives to reduce imports and increase domestic production beyond competitive levels • Support for R&D to make domestic sources more competitive • Incentives to increase energy efficiency • Treaties and use of force to secure supplies • But theoretical foundations of ES policy remain weak

6. Theoretical Justification for Public Policy on ES • Individual decisions on production, consumption and import of energy do not take account of full social costs (externality) • Disruption of supply has macroeconomic impacts that individual do not take into account • Producers and importers cannot accommodate the risks for competitive reasons (e.g. holding of stocks) • Individuals underestimate the risks of disruption (We don’t know if this is the case)

7. Dependence & Vulnerability Indicators for OECD Europe • The following table derived from WETO, IEA, US-DEA and IIASA Scenarios, shows a wide divergence of views on dependence, but more agreement on supply concentration (increases) and GDP efficiency (also increases) ((*) Figures are only for oil)

8. Overview • Risk Assessment Methodologies

9. Cost of oil disruptions

10. Cost of oil disruptions – Dimensions of past shocks • Typologies of oil disruptions • Quantity shocks, related to physical constraints (political and military conflicts, strikes) • Price shocks, related to producers decision (OPEC) or economic factors (Asian crisis) • Technology shocks, related to new concepts and ideas, or to new constraints (i.e., an unanticipated technical advantage of nuclear over oil with the discovery of the climate change problem) (rare) • Dimensions oil disruptions looking at the past • Magnitude of supply shortfall: absolute value (4 mb/d limit value of main shocks, 3.2 mb/d IEA reference value for Emergency Response System) • Magnitude of supply shortfall: relative value (7% reduction in oil supply, as IEA reference value for Emergency Response System) • Variation of oil price (increase of 100%) • Duration of shocks (maximum 9 months)

11. Cost of oil disruptions – Impacts of past shocks • Factors that affect the magnitude of economic costs • Capacity to anticipate shocks • Level and duration of the shortfall (and price increase) • Response of the oil markets (increase of production elsewhere, price volatility) • Internal oil production and dimensions of strategic stocks • Specific characteristics at macroeconomic level for immediate impacts: • Oil intensity of industrial sectors or transport sector • Degree of flexibility of the energy sector (fuel-switching capacity) • Specific characteristics at macroeconomic level for indirect impacts: • Monetary and fiscal policies (in order to reduce inflation) • Level of petroleum products taxation • Degree of flexibility of labour market • Specific institutional mechanisms

12. Cost of oil disruptions – Impacts of past shocks • Main direct economic impacts of oil disruptions • Losses of GDP due to general increasing cost of energy • Losses via negative balance of payments due to increasing import price • Rise of inflation and interest rates • Main indirect economic impacts of oil disruptions • Reduction in tax revenues with an increase in budget deficit, consequently… • Reduction in welfare expenditure and… (DIRECT SOCIAL COST???) • Increase of interest rate (due to rigidities of government expenditure) • Increase of inflation rate with upward pressure on nominal wage levels • Higher unemployment (due to wage pressure and reduced demand) (DIRECT SOCIAL COST???) • Reduced real incomes of consumers (regressive effects due to short-term inelasticity of oil demand) (DIRECT SOCIAL COST???)

13. Cost of oil disruptions – Assessment for EU • Some estimates of main direct economic impacts of oil disruptions • Reduction of GDP growth rate with 1-2 years lag • Negative balance of payments with maximum 1 year lag • Reduction of negative effects (especially for GDP growth rate) after 1973 oil shock due to: • More appropriate policy responses • Consistent reduction of oil consumption (demand restraint policies)

14. Cost of oil disruptions – Assessment for EU • Some estimates of main indirect impacts of oil disruptions • Increase of inflation rate with 1 year lag • Increase of unemployment rate with 1-3 years lag • Progressive reduction of negative effects for inflation rate • Small progressive increase of unemploymentrate due to: • Structural conditions of European labour market

15. Cost of oil disruptions – Some general estimates • Some factors influencing future economic effects of oil price increase • How far has it been possible to anticipate price increase? • Elasticity of GDP with respect to oil price for estimation of economic losses • The higher the elasticity the higher the negative impacts • EU estimates: an oil price increase of $10 per barrel would reduce economic growth in the industrialized countries by 0.5% • IMF estimates: an oil price increase of $10 per barrel would reduce economic growth in the industrialized countries by 0.6% • Estimates could be substantially different within different industrialized regions because elasticity of GDP respect to oil price could be reduced due to: • Higher oil reserves • Lower import dependence

16. Cost of electricity shortage

17. Cost of electricity shortage – Impacts of blackouts • Factors that affect the magnitude of economic costs • Extension of the disruption in terms of people and area affected (and demographic density of the territory) • Presence of alternative energy sources that could replace the missing energy • Duration (time) and the continuity of the disruption • The specific moment of the day (morning, afternoon, night) • The season, climate factor is very important both on the consequences side, and on the magnitude of the disruption (usually summer black outs are more serious due to air conditioning) • Availability of advance warning and information (I.e. anticipation of shortage)

18. Cost of electricity shortage – Impacts of blackouts • 1. Expenditure for military, police and emergency actions (excluding health) • Cost of activating the counter-terrorism machine, due to lack of immediate warning about black out • Cost for emergency requests to police and public order forces (arrests, etc.) • Cost for emergencies for fire workers (i.e., elevators, closing doors, subway, fires, etc.) • 2. Expenditures for public transportation • Costs for public railway due to interruption: reduced revenues, increased emergencies, delays (both effects on public system and on consumers), risk of accidents (computers failures in the traffic system) • Cost for subway interruptions: reduced revenues, increased emergencies, risk of accidents, delays (both effects on public system and on consumers) • Cost for flights, increased emergencies, delays (effects on consumers), risk of accidents

19. Cost of electricity shortage – Impacts of blackouts • 3. Health and Sanitary Expenditures • Immediate costs into sanitary structures (hospitals, emergencies, laboratories): emergency surgery, emergency medical-service calls; lost of medicines, organs, blood and analysis (and experiments) due to reduced refrigerating capacity (prolonged shortage) • Post blackout health expenditure (for violence, for intoxications due to fires or food poisoning, for panic attack, for uncomfortable temperature inside buildings) • 4. Sanitation and Waste disposals • Immediate costs for interruption in sanitation services and waste disposal, as recycling systems or composting/incinerator disposals • Further costs due to excessive waste accumulation into deposits • Possible sanitary costs due reduced capacity of wastewater treatment disposals

20. Cost of electricity shortage – Impacts of blackouts • Other Public services • Costs of interruption of classes and lessons into public schools (and university) • Costs of damaged food losses due to reduced refrigeration capacity in all public administrations • Costs for illness (reduced work capacity) • Cost of loss of leisure time, personal injury, fear and panic • Costs for interruption of other public administrative services (Councils, assistance, etc.) • Losses of museum revenues • Political “fallout” • 6. Human life values • Costs for deaths (human life value) • Costs for illness (reduced work capacity) • Costs for loss of leisure time, personal injury, fear and panic

21. Risk Assessment – Some conclusions • Oil disruption costs are partly macroeconomic and partly microeconomic • Should we convert into a single measure? • In ‘adding up’ we need to avoid double counting • In electricity shortage categories overlap • E.g. Health expenditures and costs of illness • E.g. Sanitary costs and costs of illness • In both cases how much of the cost is internalized? (E.g. via insurance for loss)?

22. Risk Assessment – Some conclusions • For both kinds of shocks we should also include risk aversion: • Calculate expected value of losses as laid out here • Then add a premium for the aversion society has to such events • How to measure this risk aversion? • Direct questionnaires on HH and enterprises • Implicit values from government measures to avoid shocks

23. Other Thoughts • The issue of anticipation is also relevant. Not all shocks are equally unanticipated. • How to parameterize ‘anticipation’? • How does cost decrease with anticipation? • What measures can we take to increase level of anticipation? • The issue of anticipation is also related to the issue of internalization.

24. A Simple Energy Model Under Uncertainty • To evaluate measures for ES and analyze links between ES and CC policies we need to put ES into more of a theoretical framework • The following is a very simple model for ES, in which social goal is to maximize Expected Utility of Consumer Surplus generated by energy consumption • We assume a given probability of disruption and a consequence that can be translated into a higher unit cost of energy

25. A Simple Energy Model Under Uncertainty U(.) Von-Neumann Morgernstern concave utility function P(x) Inverse demand function for energy (P’(x) < 0) C(x0) Total cost of domestic energy (C’(x0) > 0, C(0) < c1a) c1a Normal cost per unit of imported energy c1b Cost per unit of imported energy with disruption x0Quantity of domestic energy produced and consumed x1Quantity of imported energy produced and consumed 1-π Probability of a disruption in supply

26. A Simple Energy Model Under Uncertainty For an interior solution we have • Equation (1) states that at the optimum the MC of domestic production equals the consumer price (I.e. there are no specific subsidies or taxes on domestic production) • Equation (2) states that the expected marginal utility from an additional unit of imports is equal to zero. • The following figure shows how the optimum compares with a solution that ignores the risk. X0 ishigher and X1is lower

27. A Simple Energy Model Under Uncertainty MC(x0) P(x) Optimal Domestic Price c 0 x x 1 0 x

28. A Simple Energy Model Under Uncertainty • To see how optimal quantities vary with π and the parameters of the utility and demand functions we use the following forms: • β < 1 : (1- β) is coefficient of relative risk aversion • μ > 0, is price elasticity of demand. B > 0 • a > 0, b > 0 are parameters of unit elastic cost function

29. Parameter Values

30. Some Results: Sensitive to Cost of Disruption • Even with cost of 1.5 demand is restrained by20% • Total consumption falls further 38%, implying substantial demand restraint • Energy dependence declines substantially: Imports fall 90% • Domestic production increases 48% • Tax on energy goes from 12% to 45%

31. Results: Sensitivity to Probability of Disruption • With 0.1, demand is restrained 20% • Demand falls by 36%, implying substantial demand restraint • Energy dependence declines substantially • Imports fall 46% • Domestic production increases 30% • Tax on Imports goes from 20% to 30%

32. Some Results: Sensitivity to Price Elasticity • Domestic production is unchanged • Imports increase with elasticity – 35% and total demand increases • Taxes are not sensitive to elasticity • Total demand is restrained 25% at high elasticity and 50% at low elasticity

33. Some Results: Sensitivity to Risk Aversion • Total varies little with risk aversion in range considered. • Taxes are not sensitive to aversion coefficient • Demand is restrained 33 - 35%

34. Conclusions From the Simple Model • In all cases demand restraint is a key adjustment for ES. • To the extent this has not been done, CC policies that reduce demand will also move us in the right direction w.r.t. ES • Energy security implies some increase in domestic production and a reduction in imports relative to a solution that ignores risks. • But domestic production is not subsidized

35. Conclusions From the Simple Model • A tax is needed to raise domestic prices above world prices. Tax can vary from 12 to 45% and is most sensitive to cost of disruption followed by probability of disruption. Demand elasticity and risk aversion are not that important. • Domestic output will be increased by having domestic prices above world prices. Based on assumed supply elasticity of one output can be 30% higher than in no risk case. Imports can be as much as 90% lower.

36. Implications of Climate Change for ES • With CC coming as an additional issue, all fossil energy becomes more expensive as costs of carbon constraint are translated into higher energy prices. • For ES, we assume higher energy costs for both domestic and foreign producers. If tax increase is same, the adjustment in consumption for ES reasons becomes smaller, although total tax goes up => carbon constraint does some of the work for ES. Table below is for mean values of all parameters

37. Implications of Climate Change for ES • With CC, incentives increase for development of renewable and cost of renewable energy sources relative to fossil fuel declines. Since renewable sources are less tradable, CC polices should reduce ES needs.Table shows what happens if domestic production is all renewable.

38. Implications of ES for Climate Change • Model shows that ES policy measures should depend critically on how probability of disruption and costs of disruption change in the future. On the cost side we have seen some decline over the 1990s and in this decade. If this continues ES adjustments will be less => lower demand restraint, more imports and less domestic production. These will all increase carbon emissions • As far as probability of events is concerned, there is no clear indication of how things are changing. Some forecasts show increasing dependence (see next table), which would imply greater demand restraint, less imports and more domestic production. One negative possibility for CC is increased development of domestic coal to replace imported oil. • Link between dependence and probability of disruption have not been modeled. • Following table shows some decrease in concentration is expected but dependence as % of total energy can go either way.

39. Dependence & Vulnerability Indicators for OECD Europe • The following table derived from WETO, IEA, US-DEA and IIASA Scenarios, shows a wide divergence of views on dependence, but more agreement on supply concentration (increases) and GDP efficiency (also increases) ((*) Figures are only for oil)

40. Further Developments • Analysis started here is very rudimentary. To make progress we need to: • Model risk and costs more realistically as joint probability distribution for the two • Take account of measures that reduce costs of disruption but have a cost themselves (e.g. holding of stocks) (Stock levels are not calculated in this way at present) • Integrate ES modeling with CC modeling. Bring in renewable energy as an explicit option. • Develop links between measures of dependence and vulnerability and parameters such as risk of disruption. • Assess more carefully exactly how much ES is an externality – how much of the risk has been internalized.

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