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Finance & Development, December 1980
Article

Managing the demand for energy in the industrial world: With energy expenditures amounting to one tenth of gross national expenditure in industrial countries, energy conservation is a major priority; implications for policymaking

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
December 1980
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Peter J. Quirk

Developments in the energy market have played a major role in shaping the economic events of recent years. The sudden increases in the price of oil during 1973-74 had significant inflationary and deflationary effects and produced large imbalances in the balance of payments (BOP) positions of many countries. Similar developments have emerged again in the wake of the 1979-80 oil price increases. Adjustment to (as opposed to financing of) the macro-economic effects of increased oil prices may take three major forms—absorption, deflation, and conservation. The higher costs of oil can be balanced on an international level (1) by the oil exporting countries increasing their imports, thus absorbing their own surpluses; (2) by the oil importing nations reducing their economic activity; or (3) by the importers reducing their consumption of energy products through conservation. Absorption was the most important form of adjustment to the oil price increases of 1973-74. The oil exporting countries accelerated their imports of goods and services, while the rate of increase in demand for oil fell in the importing countries because of weaker economic growth; since 1973 growth rates of gross national product (GNP) in industrial countries have been, on average, some 2½ percentage points below those of the preceding decade. Conservation of oil, the other principal form of adjustment, played by far the smallest role of the three.

A more detailed treatment of this topic and of related issues can be found in Appendix B of the World Economic Outlook, a report by the staff of the Fund published in May 1980.

Potentially, however, the conservation of energy and a lesser dependence on oil represent a constructive and effective form of adjustment in the industrial countries. Both types of policy can cushion the deflationary effects on aggregate output and employment, as well as the adverse impact on inflation and the BOP. By contrast, absorption can reduce BOP imbalances, but cannot mitigate the effects of higher oil prices on domestic inflation in the oil importing countries, while deflationary policies reinforce the negative effects of the oil price increases on jobs and output.

Energy prices

In analyzing the effects of changes in energy prices on demand for energy in the major importing countries, it is necessary to distinguish the price of the raw energy material at, say, the point of import, from the final price paid by the energy user. While the prices of crude oil exports quadrupled during late 1973 and early 1974 and have more than doubled in 1979–80, the prices to consumers of petroleum derivatives have also increased sharply, but by considerably lower percentages. The difference has been due to the effects of other cost elements on the retail prices of derivatives (resulting from such activities as refining and distribution), to nonproportionate (or fixed amount) taxes, and to measures in some countries, notably Canada and the United States, to keep prices of some domestically produced crude oil below world market levels.

For the group of industrial countries as a whole, the average nominal price to consumers of petroleum products rose by 162 per cent between 1973 and the onset of the second round of oil price increases in the first quarter of 1979. In real terms—that is, in prices adjusted for changes in overall consumer price indices—they rose by only 51 per cent. Most of this increase followed quickly after the initial action of the Organization of Petroleum Exporting Countries (OPEC), so that real consumer prices of Oil derivatives were actually slightly lower in the first quarter of 1979 than at the end of 1974 (see Chart 1). To some extent, countries with lower absolute (U.S. dollar) prices raised them more rapidly than others. For example, the real increase in the prices of U.S. petroleum products has been among the most rapid (some 50 per cent), although prices paid in the United States are still among the lowest.

Chart 1.Industrial countries: real consumer prices of energy and energy products, 1968-791

(Index 1972=100)

Sources: Organization for Economic Cooperation and Development. Energy Statistics, and Fund staff estimates

1 Typical consumer prices (including taxes), as of January 1 In each year, for 21 products in 15 industrial countries, deflated by overall consumer price indices, and weighted by 1977 final consumption weights (1979 estimated) Asterisks denote second quarter 1979.

A particularly significant aspect of the changes in energy prices since 1973 has been the extent to which increases in prices of non-oil energy products have paralleled those of oil derivatives. For the industrial countries as a group, the average prices of all energy products increased between January 1973 and the first quarter of 1979 by 147 per cent in nominal terms and by 44 per cent in real terms—only slightly lower than the increase in prices of petroleum derivatives. This phenomenon may be attributed in part to the short-run inelasticity of supply of oil substitutes. (The substitution effect of the initial shift in oil prices is sufficiently far in the future, and the projection of the future reserves/consumption ratio for each energy source implicit in present prices is correspondingly so uncertain, that the relative price of oil vis-à-vis non-oil sources is almost unaltered in the short term.)

Another factor helped to limit the increase in oil product prices: the relative inertia of prices of gasoline, which accounts for about one quarter of the volume and one half of the value of total oil consumption. Real gasoline prices rose by only 12 per cent from 1973 to the first quarter of 1979. This inertia was due in large measure to a widespread lack of adjustment of nominal gasoline tax rates so as to maintain effective rates (in proportion to the value of the gasoline) in the face of price increases. (See “Energy and the role of gasoline taxation” by Alan A. Tait and David R. Morgan, Finance & Development, June 1980.)

Reducing oil consumption

The substitution of non-oil energy products for oil products since 1973 has been quite slow in the industrial countries, although data for 1979 suggest some speeding up of this process, particularly in the United States. From 1973 to 1978, the indices of the consumption of petroleum products and total consumption of energy products in these countries both declined by some 11 per cent in relation to the index of real GNP (see Chart 2). The fact that demand for gasoline has been largely sustained has, however, strongly affected the demand for petroleum products as a whole. The consumption of petroleum derivatives excluding gasoline declined by 15 per cent in relation to GNP. Some progress has been made in slowing the long-run shift away from coal as a source of energy, and the share of total energy derived from hydronuclear sources has expanded some-what more rapidly since 1973. However, in general, the substitution of other fuels for oil has so far been limited, and this has been a contributing factor to continued demand pressures in the oil market.

Chart 2.Industrial countries: ratios of energy consumption to real GNP, 1960-791

(Index 1972=100)

Sources: Organization for Economic Cooperation and Development. Energy Balances of OECD Countries and Energy Statistics; International Monetary Fund, International Financial Statistics; and Fund staff estimates.

1 Final energy consumption, except that consumption of petroleum products, coal, and gas, includes amounts used in producing electricity scaled to final consumption of electricity. Data for 1979 are for the second quarter.

The progress that has been made since 1973 in reducing consumption of oil relative to GNP therefore largely reflects overall savings in the use of energy. Between 1950 and 1973, world energy consumption had been rising at almost 5 per cent annually. Consumption had accelerated during the 1960s in the industrial countries, but this had been offset by a marked slowing in consumption rates in the centrally planned economies of Asia and Europe. For the world as a whole, energy consumption increased in step with the growth in output; in technical terms the elasticity of energy consumption with respect to aggregate output remained stable at just below unity through the period 1950-78.

However, from 1973 to 1978 global energy consumption slowed down markedly—to about one half of its long-run rate. This slowing was evident almost entirely in the industrial countries, where the 11 per cent reduction in energy consumption per unit of GNP was strongly reinforced by slower growth rates of GNP. Thus, energy consumption in industrial countries increased at an annual rate of only 1 per cent during the period 1973-78, compared with 5 per cent over the years 1960-73. Growth of energy consumption was, however, largely sustained at pre-1973 rates in the developing countries.

This overall reduction in the use of energy, although encouraging, reflects a wide diversity of individual performances. In some countries, it may have reflected variations in the composition of output (away from energy-intensive industries, such as the iron and steel and chemicals industries) that were partly attributable to slow rates of cyclical recovery, and therefore can be regarded to some extent as reversible once output expands more rapidly. The reduction in energy use can also be attributed to a structural shift away from energy-intensive industries due to the change in relative energy prices. It is noteworthy that the reduction has been sustained.

Developments in oil consumption since 1973 have provided a number of examples of the responsiveness of demand to changes in price. Oil consumption prior to 1973 had been growing much faster than consumption of other forms of energy. That this trend has stopped, even if it has not been reversed, must be considered a significant adjustment on the part of consumers to higher oil prices. Diminishing overall rates of energy consumption in the industrial countries have clearly been associated with higher prices for energy products relative to other prices. The substitution of other fuels for oil in some countries also shows that the higher prices of oil vis-à-vis other energy products have been important in reducing oil consumption. On the whole, however, the substitution of other primary energy sources has been very limited, reflecting the small net increase in the retail prices of oil products relative to the prices of alternative fuels.

The progressively larger energy savings in recent years have encouraged somewhat more optimism about the ultimate effectiveness of increased prices in curbing demand for oil and for energy in general. Although available statistical estimates of long-run price elasticities remain fairly divergent, there seems to be a consensus that overall demand for energy is likely to be relatively responsive to price (with a user price elasticity in the range −0.5 to −0.8). But oil, and thus energy, prices have recently moved outside the range of observations on which these estimates have been based, and, as a result, the validity of the estimates may be open to question. It seems likely, in fact, that the elasticity may have moved closer to the top of the indicated range—perhaps even approaching unity. The increases in real price of late 1979 and early 1980 are more likely to be perceived by energy users as lasting than those at the time of the first oil shock, and seem more likely to induce sustained changes in behavior. The reduction in final consumption following those oil price increases should therefore ultimately be more pronounced than the cutbacks which followed the 1973–74 increases.

Nevertheless, the estimated time lag with which consumption responds to price changes tends to be long. The lag depends, for instance, on the speed with which the energy-using capital stock may be modified or replaced, as renovation or accelerated replacement of the household and business capital stock involves certain costs. Accordingly, a response may take almost as long as is required for the energy-using equipment to wear out and be replaced, perhaps as many as ten years for automobiles and up to 80 years for buildings. This implies, of course, that the effects of the 1973-74 oil price increases are still being registered and that the effects of the recent price rises are not evident yet. Ultimately, investment in energy-saving technologies and the development of non-oil energy sources should result in a sweeping and fundamental adjustment of capital stocks.

Appropriate policies

Achievement of substantial energy conservation and diversification (with a shift away from imported oil) depends crucially on the adoption of appropriate national policies, especially those affecting the price of energy—for both the supply and demand sides of the market. The general aim of policies in this area should be to allow the price increases to be fully passed on to consumers in order to provide the necessary marketplace signals about energy conservation and substitution of other energy sources for oil. Such a development could occur without any deliberate policy actions. However, the evidence of the large divergences between countries in the retail prices of the same energy products underscores the fact that in the market in question, governments, either central or local, play a substantial role—either through tax and subsidy policies, or as owners, regulators of output or of prices, or major purchasers. In brief, the market is affected strongly by government decisions in most countries. In terms of international adjustment, it is important that these decisions, insofar as they affect pricing, should be a realistic response to current world market developments if the needed conservation efforts are to be encouraged.

One of the most topical subjects in the field of policies aimed at adjusting the demand for energy is the possible role of taxes, subsidies, and tariffs in promoting conservation and the substitution of other fuels for oil. The question that arises is the extent to which policies are necessary when market prices reflect the full cost of energy imports. Indeed, it could be argued that if taxes or subsidies were imposed permanently, they could lead to possible long-run distortions in resource allocation (additional distortions in most cases, as energy products are already a fruitful source of fiscal revenues). Even if taxes or subsidies were applied only temporarily, they could lead to short-term variations in price signals, which would add to the considerable uncertainties for private consumers or industries who already face difficult investment decisions about energy in the present situation of confusion and volatility in relative energy prices.

In the present circumstances there is little justification for diminishing tax rates or tariffs on energy products, where certain levels of rates have already been accepted (these rates vary widely among countries). Reducing these rates so as to lower the overall inflationary impact of increased energy prices could achieve only a temporary respite; the lower incentives to conserve energy would merely serve to maintain pressure on the energy market, and to drive up energy prices further. Effective tax rates on gasoline have fallen sharply since 1973, and re-evaluation of the effects of these rates seems necessary (see Chart 3). One more specialized area of energy pricing that may also warrant examination is that relating to the provision of bulk discounts or block-pricing arrangements. There has been some reduction in discounts granted to bulk users, but generally speaking, the discounts remain large (see Chart 3).

Chart 3.Industrial countries: factors affecting energy consumer prices, 1970-78

Sources Organization for Economic Cooperation and Development. Energy Statistics, and Fund staff estimates.

1 Weighted average of rates of taxation (value of the gasoline tax divided by the tax-inclusive price).

2 Price for annual consumption of 300,000 tonnes over price for annual consumption of 500 tonnes.

3 Price for annual consumption of 60GWH over price for annual consumption of 4000MWH.

4 Price for annual consumption of 5000 × 106 Kcal over price for annual consumption of 750 × 106 Kcal.

The economic case for additional taxes to promote reductions in energy consumption rests mainly on two considerations: first, the extent to which such stimuli may be used to speed up expected responses to market-determined price incentives, and second, the issue of the global distribution of economic rents pertaining to basic energy resources.

Insofar as the imposition of taxes or tariffs simply speeds up the market response—which accumulates over a long period—these policies are clearly appropriate. From the point of view of global welfare and the international adjustment process, however, it is clear that the second consideration is significant only for the distribution of proceeds between countries of vastly dissimilar per capita income levels. Within a country, of course, income redistribution effects must obviously be taken into account.

Another set of issues concerns the pricing of energy vis-à-vis other factors of production. Although recent evidence is far from conclusive, it suggests that in the short term to medium term, energy complements capital and largely substitutes for labor. If conservation is to take place, therefore, the relative prices of energy goods would have to rise against wages. Complementarity does not imply that the prices of capital inputs should also rise with respect to wages; in fact, there are good reasons why they should fall. (In some countries, investment has been inadequate for both cyclical and structural reasons. Buoyant investment is also likely to be conducive to conservation by permitting more rapid alteration of the energy intensity of the capital stock.) To achieve the most efficient combination of resources, the relative price of the energy-capital combination should rise in order to promote conservation of energy. If real wages are maintained and the relative price of the energy-capital combination does not rise, there would be direct consequences for adjustment in the form of energy conservation. Conservation may therefore be seen to be inextricably linked with these important macroeconomic issues.

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