Handbook of Energy and Environment Policy

Dilek Özçoban

The difference between the primary and secondary energy is summarized in Fig 1.1.

Like all kinds of demand for goods and services, there are factors, elasticities, and determinants that are affecting the energy demand in short and long terms. The most important ones of these determinants are price and income levels. In addition to this, technological improvements, the efficient usage of energy, and weather conditions have significant effects on energy demand (Bhattacharyya and Timilsina, 2009).

In this study, after briefly introducing the types of energy, determinants of energy demand are explained in detail in the context of price and income. After that, the energy demand modelling methods and the theoretical background related to this issue are given. Lastly, the summary and conclusion section is presented.

1 Determinants of the Energy Demand

The traditional economic theory states that the demand for goods and services with given budget constraint and determined price can be generated by two reasons; minimize the costs and/or maximise the utilities. In terms of energy, while households demand it to maximize their utility, for producers it is an important factor for cost minimizing or profit maximizing. In fact, both cases (minimizing the costs and maximizing the utility) are interrelated in energy demand process. On the other hand, Jones (1994) indicates that even though the price and income variables affect the cost and utility (profit), there are other factors that determine the quantity of energy demanded, such as regulations, technology, efficiency standards, air conditions, consumer behaviours, population, expectations, etc.

Analysing the energy demand depends on historical consumption trend and the connection of this trend with other indicators, such as economic, demographic, climatic, etc. (Egelioglu et al., 2001). In parallel with this argument, there are mainly two determinants of energy demand. First one is the price. Price of one good or service certainly affects the quantity of consumption. Therefore, the demand for energy sources responds to the price changes as well as all economic products. The second one, on the other hand, is income. Income is an important factor that determines the quantity of demand. Although other factors are affecting the consumption such as consumer behaviour, air temperature, and efficiency, the price and income are considered as the most significant variables of energy demand pattern.

1.1 Price

In economic theory, it is expected that an increase of one commodity’s price decreases the demand of this commodity, ceteris paribus. The sensitivity in demand against the price changes is defined as the price elasticity of demand. In other words, assuming all factors on demand remain constant, the own-price elasticity of demand can be defined as the percentage change in quantity demanded in response to the change in the percentage of related product’s price. In general, it can be said that there is an inverse proportional relationship between price and demand (Uddin and Sano, 2012).

The estimated elasticities can be classified into three categories (Mankiw, 2012). The price elasticity of demand is defined as inelastic if it is less than one in absolute term, as unit elastic if it is one and as elastic if it is greater than one. This classification reflects the demand behaviour of consumers on a good related to the price changes. For instance, if the demand elasticity is found as inelastic then the expenditure will be affected negatively to the price variations, or if the demand elasticity is elastic, then the expenditure will be influenced positively to the price changes.

On the other hand, cross-price elasticity can be identified as the estimation of the consumer reactions to the changes of the related commodity’s price. In terms of the energy demand, the cross-price elasticity is considerably significant in determining the difference between substitutes and complements since various resources can be utilized for the same objective in the energy market (Mansfield, 1997). For example, the electricity can be produced by using natural gas, coal or renewable energy sources in the electricity generation sector. For this reason, the cross-price elasticity estimation is vital for the energy sector to decide which sources would be used or consumed.

On the other hand, there are also some other factors that affect the price changes in energy markets. For instance, technological changes have an important effect on the price. Energy efficient devices decrease the costs of energy and the usage of these kinds of devices increases in parallel with the technological developments. Therefore, the use of energy as efficiently affects the energy consumption and hence the relative prices of energy can change.

In addition, the sectoral differences have important impacts on energy prices. As it is well known, the price of energy differs from one sector to another. For instance, the price of electricity in the industry may be lesser than residential. Furthermore, the prices are sometimes transferred to the final consumer, such as in the electricity generation sector. The cost-pass-through principle is used in this sector, and the price is directly reflected in final tariffs. Therefore, when modelling the energy demand, sectoral differences should be considered carefully.

Moreover, the price elasticities can be different among sectors. Consumers in the residential sector may be more sensitive to the price changes than that of the other sectors, such as industrial and commercial. In addition, the type of energy can be a significant determinant in terms of price variations. For example, the price elasticity of electricity demand may differ than that of the natural gas. For these reasons, the outcomes of the demand models are interpreted by taking account of the sectoral structures and the types of energy that used.