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.

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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

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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 RD 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

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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 dont 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
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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)

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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

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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???)

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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)

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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 unemployment rate
  due to

• Structural conditions of European labour market

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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

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Cost of electricity shortage
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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)

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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

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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

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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

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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

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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.

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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

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A Simple Energy Model Under Uncertainty
  U(.) Von-Neumann Morgernstern concave utility
function P(x) Inverse demand function for energy
(P(x) lt 0) C(x0) Total cost of domestic energy
(C(x0) gt 0, C(0) lt c1a) c1a Normal cost per unit
of imported energy c1b Cost per unit of imported
energy with disruption x0 Quantity of domestic
energy produced and consumed x1 Quantity of
imported energy produced and consumed 1-p
Probability of a disruption in supply  
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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 is higher and X1 is lower

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A Simple Energy Model Under Uncertainty


MC(x0)
P(x)








Optimal

Domestic Price



c
0




x
x
1

0



x



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A Simple Energy Model Under Uncertainty

• To see how optimal quantities vary with p and the
  parameters of the utility and demand functions we
  use the following forms

• ß lt 1 (1- ß) is coefficient of relative risk
  aversion
• µ gt 0, is price elasticity of demand. B gt 0
• a gt 0, b gt 0 are parameters of unit elastic cost
  function

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Parameter Values
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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

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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

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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

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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

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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 gt 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 gt 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)

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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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