Ebook Energy economics: Concepts, issues, markets and governance - Part 2

Continued part 1, part 2 of ebook Energy economics: Concepts, issues, markets and governance provide readers with content about: energy markets; energy markets and principles of energy pricing; energy pricing and taxation; international oil market; markets for natural gas; developments in the coal market; issues facing the energy sector; overview of global energy challenges;...

Energy Markets

Energy Markets and Principles

of Energy Pricing

12.1 Introduction: Basic Competitive Market Model

Any standard economics textbook starts with the theoretical world of perfectcompetition In such a case, consumers maximise their utility subject to theirbudget constraints and producers maximise their profits subject to the constraints

of production possibilities There are numerous consumers and producers trying totransact in the market place In a competitive market condition, all agents are pricetakers and there is no market power of any agent In general, the demand for agood reduces as prices rise (i.e inverse relationship with price) and vice versa.This gives rise to the familiar downward sloping demand curve Similarly, pro-ducers face an upward sloping supply curve The higher the price, the more is thesupply, as at higher prices more producers become viable The interaction ofsupply and demand decides the market clearing price of the good and the quantity

of goods that will be sold (or purchased)

Consumers satisfy their utility (or preferences) by consuming a good As utility

is not observable, an alternative parameter for measurement of their satisfaction isthe willingness to pay or accept to move from a situation to another At any givenprice, consumers spend an amount equal to the price times the quantity purchased

No consumer is willing to pay for something that she does not want but someconsumers may be willing to pay more than the market price Thus the totalwillingness to pay at price P0in Fig.12.1 is given by the area ACq0O But theexpenditure for the good at this price is given by the area P0Cq0O The differencebetween these two areas gives excess benefit consumers obtain, known as ‘‘con-sumer surplus’’ This is represented by the area left of the demand curve but abovethe price actually being charged for the good

The sellers on the other hand incur cost for producing the goods sold and aslong as the costs are recovered, they may be willing to sell for any given price.However, even at that price, some sellers will receive more benefits due to lowcost production, while others will just break-even Therefore, the benefits accrued

S C Bhattacharyya, Energy Economics, DOI: 10.1007/978-0-85729-268-1_12,

 Springer-Verlag London Limited 2011

277

to the producers are known as ‘‘producer surplus’’ Total benefits to the producersthen include production costs and the surplus (see Fig.12.2).

At the equilibrium, the willingness to sell equals the willingness to pay At thiscondition, the demand matches the supply This is considered as an optimalallocation in the sense that the equilibrium cannot be replaced by another one thatwould produce higher welfare for some consumers without reducing welfare ofothers This is depicted in Fig.12.3

at price P0 Fig 12.1 Willingness to pay

Competition forces sellers to charge no more than their rivals If one sellercharges more than the market clearing price, consumers will go to others offeringthe same good at lower price If someone charges less than the market price, thedemand will outweigh supply, forcing a return to the market price Individualbuyers and sellers cannot affect the price Buyers and sellers react to changes in themarket price At lower prices, some sellers will leave the market while moreconsumers enter it Similarly, at higher prices more sellers are willing to offer theirgoods while there will be fewer consumers The participation in the market isvoluntarily and consumers or sellers are free to enter or leave the market in aperfectly competitive case Price is equal to the marginal cost of the last supplier.

In mathematical terms, the above can be presented as follows:

The aggregate consumer surplus from consumption of a good at the prevailingprice p* is

equilibrium

The objective is to find the price at which the welfare is maximized This isobtained by setting the first order derivative of the welfare function with respectprice to zero.

(c) The relevant pricing principle is essentially a short run one, with an objective

of clearing the market

However, certain basic conditions have to be satisfied to obtain such efficiencyoutcomes: existence of freely competitive markets, perfect and costless flow ofinformation and knowledge, smooth transferability of resources and absence ofexternalities Clearly, most of these requirements are not satisfied by the today’senergy market In addition, the energy sector is marked by certain specific char-acteristics such as indivisibility of capital, tradability of some products anddepletion of some resources Consequently, the basic model needs to be expandedfor any meaningful analysis We consider these aspects below

12.2 Extension of the Basic Model

Let us consider a number of characteristics of the energy sector and see how thebasic model outcome needs to be modified

at the point where investments take place This is shown in Figs.12.4and12.5.1

In a fixed plant with a capacity of q0, the output cannot go beyond the installedcapacity The marginal cost of supply is assumed to be constant at v for the entirecapacity and when the capacity constraint is reached, the vertical line shows thesupply schedule Thus, at the capacity q0, there is a rupture in the supply curve.Initially, when the demand is given by schedule D, the market clearing price is themarginal cost (v), as at this point, there is excess capacity compared to demand Insuch a situation, the investor would recover his operating costs only But as thedemand shifts to D0 (due to changes in income and other factors), the demandexceeds supply if the price is maintained at the short run marginal cost (i.e v) Amarket clearing price would imply that the pricing mechanism would have to beused to ration demand to bring it down to the available supply level, therebycharging a price p0[which lies between v and (a ? v)], thereby recovering a part ofthe fixed cost (but not fully yet) When the demand grows sufficiently that the pricewould equal (a ? v), then the producer would recover his full cost of supply But

at this stage, entry would not be encouraged because of inadequate cost recovery inthe past As the demand increases further and moves to D00, the price would exceedthe long run marginal cost of supply and would provide high excessive profits toproducers Sustained shortage of capacity, high prices and existence of excesscapacity would encourage new entry to the market

With new capacity, the installed capacity increases to Q1, and brings excesscapacity to the system The intersection of demand schedule D3with the supplycurve brings the prices down to the short run marginal cost Thus in the process theprice passes through a cycle of volatility, bringing boom and bust of the industry.This sort of inherent price instability of the energy industry is a source of majorconcern if the competitive market principle is applied strictly Such instabilitycould affect long-term investment decisions of the consumers and would increaseeconomic uncertainties Moreover, investors would not prefer such an environ-ment for investment decisions Some arrangements would be required to managesuch fluctuations

1 This presentation follows Rees ( 1984 ) Also see Munasinghe ( 1985 ).

It is important to note here that in the literature long-run marginal cost ciples are suggested a solution in such cases As indicated above, the relevantpricing horizon is essentially a short-term one and the long-run marginal costprinciple encounters practical problems in determining the cost and price Oftenthis requires a departure from the marginal cost principle in favour of average costbasis of some sort.2

prin-D

D”

D3 a+v

v

q1 q0

Fig 12.5 Boom bust cycle

2 This is an area of continuous debate in the economic literature A summary of the debate is provided in Chap 13

12.2.2 Depletion of Exhaustible Resources3

As coal, oil and gas are non-renewable resources, consumption of one unit of theseresources implies foregoing its consumption at any future date This brings inanother dimension of decision-making: whether to use the resource now or later.The use decision is affected by choice of using it now or later As discussed inChap 9, the price should depart from the marginal cost and include an additionalitem called the scarcity rent or user cost This implies that finite resources have avalue over and above their cost of production, which is due to their scarcity Ourtime preference would require us to consume a bit more in period 1 than in period

2 but for this the price in period 1 has to be somewhat lower than that in period 2

If the reserve is very large and if the prospect of export is negligible, the rentcomponent will be practically insignificant, though theoretically it will still exist

Of the reserve is very limited, the estimation of the rent does not pose any problemeither The difference between the extraction cost of the resource and the price ofthe substitute fuel gives the rent cost In all other intermediate cases, the rent can

be significant and its evaluation is more uncertain and complex

12.2.3 Asset Specificity and Capital Intensiveness

The energy sector employs highly specific assets in the sense of transaction costeconomics Assets are considered as highly specific if they have little alternativeuse For example, a power generating plant has little alternative use Similarly,investments made in an oil field could hardly be redeployed elsewhere in any otheruse The asset specificity can arise because of a number of reasons—site speci-ficity, specific investments in human capital, dedicated investment (or idiosyn-cratic investment) and physical (Williamson 1985) The level and nature oftransaction costs depend on the frequency of transaction, the extent of uncertaintyand the degree of asset specificity

The theory of transaction costs also identifies a number of alternativearrangements for performing transactions (Williamson1985):

• Classical contracting which includes the textbook exchanges in the marketplace

• Bilateral contracting using long term contracts;

• Trilateral relationship where a third party determines the damages/adaptationfollowing some specified procedures (such as arbitration);

• Unified governance or vertical integration that internalises the transaction withthe firm

3 Please refer to Chap 9 for further details.

Depending on the transaction attributes it is possible to identify the governancearrangements that would be most appropriate (see Table12.1) In the energyindustry given the frequency of transactions and high asset specificity, the ten-dency for vertically integrated arrangements prevailed This was the case in allenergy industries—oil, gas, coal or electricity but there are some differencesaccording to the industry In the gas industry, the trilateral contracts are morecommon while in the electricity industry, unified governance prevailed.

In addition to specificity, energy sector assets tend to be capital intensive aswell Often the capital cost accounts for a large part of the average cost andconsequently, per unit cost falls with higher sizes, showing economies of scale

An implication of such capital intensiveness and economies of scale is that themarginal costs tend to be low compared to the average costs and any pricing based

on marginal cost would then lead to financial losses (see Fig.12.6) But once inoperation, as long as the firm is able to recover its variable costs, it would continueoperating expecting to make up for the capital cost recovery at a future date Thus,the firm would have a tendency to produce at its maximum capacity, consideringfixed costs as sunk costs This would lead to excess supply and the energy industryhas an inherent tendency to be in excess supply situation But continued over-supply situation is not beneficial for the future of any industry as no new invest-ment would be encouraged and continued financial loss could promote prematureabandonment of certain facilities

It needs to be highlighted that a certain amount of excess capacity has to bemaintained in any energy industry to cater to the unforeseen circumstances (nat-ural calamity, disruptions, etc.), normal demand/supply fluctuations, and to ensurereliability of supply Moreover, as storage is a problem for electricity, instanta-neous supply and demand balancing is required, making the process technicallydemanding as well

Table 12.1 Governance structure for transaction characteristics

Frequency of transactions Specificity of assets

Non-specific Medium High Rare Classical Trilateral Trilateral or unified

= Firm Supply Curve

Fig 12.6 Relevant cost

curve

The energy industry used two approaches to manage the problems related toindivisibility of capital and excess capacity: Oil industry used horizontal inte-gration while the electricity and network industries used regulation In regulation,the tariff relates to the cost of providing the service by maintaining and operating acertain mix of assets, including those required for ensuring reliability However for

a non-regulated industry (like oil), horizontal integration can work Horizontalintegration implies linking with firms at the same stage of the value chain eitherthrough merger and acquisition or through the formation of a cartel The oilindustry has seen significant merger and consolidation in the post oil-shock era,where large international companies merged together to better manage their assets

On the other hand, collusive behaviour has also been used in the oil industry tomanage the problems The major oil companies formed an effective cartel in 1928through the As-Is agreement and froze the respective market shares until thispolicy became public and abandoned in the 1950s, as collusive behaviour is notlegally tenable in most jurisdictions However, the Majors found another way ofinfluencing the market—joint ventures in the Persian Gulf, which provided themwith a legal solution of perfect information exchange and thus control the market.Later when the OPEC was created, the market was controlled through productionquotas and price targets in a collusive manner But as sovereign countries areinvolved in these decisions, such behaviour is not illegal

12.3 Market Failures

The competitive market model discussed above assumes a set of strong tions A market failure occurs when such assumptions cannot be satisfied Someelements of the energy sector have the technical or other characteristics thatamount to the violation of the basic assumptions of a competitive market model.The common sources of market failure are discussed below

assump-12.3.1 Monopoly Problems

The capital intensiveness of the energy sector requires large investments and asbigger installations provide economies of scale, few large suppliers tend todominate the market A profit-maximising monopolist will set her price at theintersection of marginal cost and marginal revenue But as the monopolist faces adown-ward sloping demand curve, the marginal revenue will be less than price.4

4 The total revenue is given by TR = P  Q, where P = price and Q = output Marginal revenue

is then dTR

dQ ¼ P þ QdP

dQ, or MR = P(1 ? 1/e), where MR = marginal revenue and e = priceelasticity of demand As e is less than 1, MR is less than P

As shown in Fig.12.7, the profit maximising output is given by Qm, while theprice charged by the monopolist is Pm.

Mathematically, the problem to maximize the profit

That is, to maximize its profit, the monopolist will charge consumers inversely

to their elasticity of demand Inelastic the demand, higher the price will be

If the monopoly results are compared with the competitive outcome, it is foundthat the monopolist restricts the output to Qm compared to Qc obtained in thecompetitive market Similarly, the price paid by the consumers is Pmcompared to

Pcin a competitive condition Thus the consumers pay Pm-PC as monopoly rent.The consumer surplus is reduced to APmB compared to APcD whereas the pro-ducer surplus increases to PmPcCB which was non-existent in a competitive set

Demand AC=MC

up Monopolisation of the market leads to a deadweight loss equivalent to thetriangle BCD.

In addition, following Leibenstein’s observation (Leibenstein1966), it could beindicated that a monopolist might operate in the inefficient zone of the productionpossibility frontier This in other words means that a monopolist may choose thefactors of production in an inefficient manner, thereby operating at a point aboveits theoretical cost curve This is known as X-inefficiency While X-inefficiency isinconsistent with profit-maximising behaviour, the inefficiency is possible giventhat managers may pursue their own objectives in place of owner’s objective ofprofit maximisation

A third source of monopoly-related inefficiency is the possibility of seeking A monopolist by charging more than the competitive market price earns amonopoly rent, which is equal to the producer surplus of PmPcCB in Fig.12.8.The existence of such rent will set in competition among firms to seek the rent bylobbying and influencing the legislators or regulators, thus wasting resources andcausing welfare loss to the society

rent-A fourth source of complication is the possibility of product differentiation,which allows a firm to increase its price without loosing all its sales to a com-petitor In such a case, the price exceeds marginal cost, which signals misallo-cation of resources

12.3.2 Natural Monopoly

This is a situation where production of a good or service by a single firm ensuresleast cost supply The typical example is a single product where the long-runaverage cost declines for all outputs (see Fig.12.9) As the average cost falls overthe entire range of output, the marginal cost also falls This is a case of permanentnatural monopoly, because irrespective of market demand size, a single firm canproduce the good at least cost

Q AC

Q’

Cost is subadditive for Q<Q’

$ Fig 12.8 Economies of

scale

A temporary natural monopoly on the other hand exists when the average costfalls over a limited range of output as shown in Fig.12.10 In the figure, the costfalls up to Q*and then remains constant thereafter Beyond Q*level of output, aworkable competitive market can develop for demand D0.

Although the economies of scale act as the driving factor for the existence of anatural monopoly, this is not a sufficient condition Instead, the concept of sub-additivity of cost functions is used A cost function is subadditive when it satisfiesthe following condition:

C Qð Þ ¼ c qð 1þ q2Þ\c qð Þ þ c q1 ð Þ2 ð12:10ÞThis implies that instead of two firms producing q1and q2quantities of a good,

it is cheaper for a single firm to produce the entire quantity (q1? q2) Forexample, the cost curve shown in Fig.12.8suggests that the cost declines up to Q0and then starts increasing (i.e it shows economies of scale up to Q0) The costfunction is subadditive for any output up to Q0

Next we consider what happens for outputs exceeding Q0 Figure 12.11presentsthe minimum average cost curves for two firms As for least cost production boththe firms must produce at the same output rate, the second curve is obtained just bydoubling the output rate for a given point on the AC curve Thus, the minimum of

P Fig 12.9 Permanent natural

AC2 is obtained at output equal to 2 Q0 The intersection of AC and AC2 definesthe range of sub-additivity Thus it is clear that for any output less than Q*, theleast-cost option is for one firm to produce the good, even though diseconomies ofscale set in at that level Thus economies of scale are not necessary for a singleproduct natural monopoly.

For the multi-product case, the natural monopoly obtains when the cost function

is sub-additive Economies of scale are neither necessary nor sufficient conditionsfor a natural monopoly for multi-product case The concept of economies of scopebecomes important as well.5If both economies of scale and scope exist, it is likely

to lead to natural monopoly

A related concept is the sustainability of natural monopolies In the singleproduct case, assume that the demand intersects the AC to the left of Q0 In thiscase, there is no incentive for any entrant to enter the market However, if thedemand curve intersects the AC somewhere between Q0 and Q*, the naturalmonopoly would be termed as unsustainable This is because a potential entrantcould enter the market and produce a part of the output The issue of sustainability

is important for entry-related decisions In the case of sustainable monopoly, thethreat of entry is not there On the other hand, in the case of unsustainablemonopoly, entry can be allowed

The public policy dilemma in the case of natural monopoly is as follows: thenatural monopoly characteristics would require a single firm to make the supplybut the society would not like to suffer from the potential monopoly pricing Whatalternative solutions are available to deal with such a situation? This is what weturn to now

Marginal cost pricing: According to the economic theory, prices in a itive market equal the marginal cost of production Applying this principle to anatural monopolist will meet the efficiency requirement The output will be Q0atprice P0 As the price is less than the average cost of production, the firm incurs aloss and is shown by the rectangular area RP0ST in Fig.12.12 As no private

AC2 AC

Q

$

Subadditive for Q<Q* Demand

Fig 12.11 Subadditivity

beyond scale economies

5 Economies of scope imply the potential of cost saving from joint production This is possible because the firm can make better use of facilities and services for producing a certain mix of different outputs than leaving the production of individual products to specialty firms.

enterprise will be interested in providing a good by incurring a loss, in order tomake good of this loss, a subsidy will be required Wherefrom such subsidies willcome?

The theoretical solution is to impose a lump-sum tax that does not distort otherdecisions throughout the economy Such a tax is rarely used in practice Even ifsuch a tax is found, there are some objections to use of such instruments:

• a general tax requires non-buyers of a product to subsidise buyers This is notfair from a distribution point of view

• Subsidies reduce the incentive and capacity to control costs The managementand employees know that the loss will be subsidised, which can lead to ineffi-cient practices

• If the costs are not met, it may so happen that the benefits received by thesociety from the production of a good are less than the costs In such a case,there is no justification for the production of the good Subsidies can obscurethis basic problem

• Subsidising private firms is considered politically unacceptable in manycountries

The above suggests that the lump-sum tax may not be an appropriate solution.The pricing has to be such that the costs are at least covered In the single-productcase, balancing costs and revenues leads to pricing based on average costs fornatural monopolies This is a departure from the marginal cost principles andhence will introduce welfare losses as shown by the shaded area in Fig.12.13.Alternative pricing principles in such a case have been suggested The mostcommon methods are:

12.3.2.1 Two-Part Tariffs

A two-part tariff is a non-linear tariff system that uses a fixed fee or charge (F) and

a price per unit (p) component The price per unit can be set equal to the marginal

Q

$

AC MC

Losses

Q0

T

S R

cost (MC) This, as we have discussed earlier, in the case of a natural monopolywill result in a loss The fixed fee can be designed to cover the loss in revenue.

A simple fee could be a uniform fee for all customers This will then be equal tototal loss to be covered divided by the number of consumers using the service orthe good This is a straight forward design and is non-discriminatory But it mightcause some consumers to leave the system (especially those who consume less andhave to pay a relatively high fixed fee) An alternative system is to custom designthe fixed fee to suit different consumers or class of consumers This avoids theproblem of exclusion from the service but is discriminatory in nature and may beillegal in some cases

An example of two-part tariff for electricity may be as follows:

Fixed fee per month—$5, 10 cents per kWh for consumption up to 200 kWh permonth and 7.5 cents per kWh for consumption between 200 and 500 kWh permonth and 5 cents for consumption beyond 500 kWh per month This is shown inFig.12.14

The curve in solid line indicates the applicable rate It indicates that the effectivefixed rate changes and variable rates change as the consumption increases

Fig 12.13 Average cost

pricing for natural

monopolies

5 10 22.5

12.3.2.2 Ramsey Pricing

Ramsey pricing is essentially a taxing method that was developed in an attempt todesign a system that would lead to minimal deadweight loss This has then beenapplied to the pricing issues as well as the basic problem in a natural monopolysubjected to marginal cost pricing is the recovery of losses in a less distortedmanner This principle has been analysed by a number of researcher under variousconditions but Baumol and Bradford (1970) provide the most detailed and generalanalysis of the issue

The Ramsey rule can be presented as follows:

An alternative formulation of the Ramsey pricing is shown in Eq.12.12

Although this deals with the revenue loss problem, the Ramsey pricing rule hasequity implications By suggesting higher prices on inelastic demand, it suggeststhat essential demands would be charged at higher rates This implies that the poormay be in a disadvantageous condition if this rule is followed Explicit accounting

of equity issues has been discussed in the literature but this makes the formulamore complicated and will not be covered here.6

6 Interested readers may consult the following: Diamond and Mirrlees ( 1971 ), Feldstein ( 1972 ).

12.3.2.3 Public Ownership

An alternative solution to deal with the problems of natural monopoly is to transferthe ownership and operation rights to the government This forms the basis forpublic sector involvement in production The logic behind this is that the gov-ernment will not be following the profit maximisation principle but will operate tomaximise economic surplus

The pricing rule for a public enterprise under a budget constraint was studied byBoiteux (1956) His results indicated that the pricing policy should be same asRamsey pricing This implies that the state monopolist should behave like a dis-criminating monopolist in order to reach budgetary equilibrium

Both the options have been widely adopted in practice In the USA, the latory approach was adopted while in Europe and many other parts of the world,the public ownership approach was followed

regu-12.3.3 Existence of Rent

As discussed inChap 8, the energy industry exhibits a number of differential rentsarising from the differential advantages enjoyed by a production unit compared toother similar units These rents appear as the producers’ surplus and increase theprofitability of the producers In addition, the energy sector at certain times hasseen monopoly rents due to the prevalent market structure Similarly, the scarcityrent can also be applicable to non-fossil resources of energy

In theory, the government can capture this rent without affecting supply sincethe company continues to receive its normal profit This is also assumed for anefficient operation of the markets However, in practice any fiscal measure implies

an intervention of the government in the market and introduces distortions Thisalso implies a departure from the marginal cost-based pricing

12.3.4 Externality and Public Goods

Energy products impose different costs on society, a part of which are supported byproducers and consumers, while the rest, known as external costs, remain unac-counted for and are borne by the society In economic terms, an externality is said

to exist if any activity of an economic agent imposes positive or negative effects onthe welfare of any other agent or groups of agents and when economic agentsneither receive nor pay any compensation equal to the costs inflicted or the benefitsconferred upon them While this aspect will be analysed in a another chapter indetail (Chap 25), it is important to note here that the presence of an externalityintroduces distortion in economic decisions and its correction requires governmentintervention either through taxation or through regulation

Similarly, the provision of public goods related to the supply of energy needs to

be highlighted Public goods are those whose provision to one person or partymakes them automatically available to all at zero additional costs In the energysector, a number of such examples can be easily cited: recreational or otherbenefits arising from the construction of a dam, downstream benefits as a result ofupstream reforestation, etc At the same time, ensuring adequate and secure energysupplies, adequate long-term R&D and other economic and socially desirableoutcomes also share public good features Markets may not provide these publicgoods left to it and as these are important issues related to energy, governmentsintervene

12.4 Government Intervention and Role of Government

in the Sector

The above discussion indicates that the energy sector fails to satisfy the ments of a competitive market in a number of ways The presence of naturalmonopoly and existence of rents require corrective intervention to remedy theproblems Externality, which will be considered later, is also quite pervasive in thesector, and requires further intervention In addition, energy being of criticalimportance in the modern world, social, equity related and security-related issuescannot be ignored either This so-called market failure argument is used to justifygovernment intervention in the energy sector Consequently, the governmentpresence in the sector is quite widespread, both in developed and developingcountries, despite waves of liberalization of the market.7

require-Governments use a wide range of instruments or measures to control thefunctioning of the energy sector IEA (1996) categorises them in five followingcategories:

• economic and fiscal instruments;

• trade instruments;

• administration, management and ownership;

• regulation; and

• research and development (R&D)

Table12.2 provides some examples of each category of instruments Taxes,royalties and subsidies constitute the common form of economic instruments used

in the energy sector Although fiscal instruments can be used for various purposesincluding internalisation of externalities, revenue generation remains the mostimportant motive for their widespread use A number of trade-related instrumentsare used in controlling movement of energy resources and include tariffs and

7 However, the market failure argument has been subjected to serious scrutiny See Robinson ( 2004 ) for such a viewpoint.

quotas, licensing, fuel quality restrictions and political restrictions (embargoes orbans) on economic involvement in certain areas or countries or on trade.State participation in the management, ownership and control of production andsupply of energy remains quite pervasive, especially in grid-based industries Thistrend was evident for much of the twentieth century in most countries and surelysince the Second World War These vertically integrated state monopolies pro-duced reasonably satisfactory results initially, with significant growth of the sectorand efficient operation in certain countries But as sector ownership and regulationwas exercised by the government and as politically motivated decision-makingpervaded the sector, performance started to deteriorate, especially in developingcountries The state owned utilities suffered from poor labour productivity, dete-riorating fixed facilities and equipment, poor service quality, chronic revenueshortages, inadequate investment, and serious problems of theft and non-payment(World Bank2004).

Governments use a wide range of regulatory interventions to control the sectorperformance These include price controls, competition and market access rules,private service obligations, monopoly and restrictive trade practice controls, and

Table 12.2 Main energy policy instruments

Economic/fiscal Trade Administration,

management and ownership

Regulation R&D

Taxes, royalties,

fees

Import/export tariffs

Equity participation

in or ownership of energy companies

Price and volume controls

R&D in the public sector

Tax exemptions Import/export

licences

Provision of government services

Market regulation (entry/exit, monopoly rights, anti- cartel legislation)

Funding for private sector R&D

Differential treatment of domestic and foreign suppliers Source IEA ( 1996 )

technical and environmental performance management While the degree ofcontrol varies by industry, normally the networked industries are subjected tohigher levels of control The downstream side of the oil industry, at least indeveloped countries, is perhaps the least regulated, where a large number ofwholesale and retailers compete (IEA 1996) However, the same cannot be saidabout the developing countries where state monopolies often supply the market.

As the oil shocks of the 1970s caught many countries unprepared and ascountries struggled for effective policies and institutions to deal with energy sectorproblems, the government involvement in the sector rose, resulting in highlyinterventionist policies (such as detailed targets for the sector, price controls,support for mega projects, barriers to free trade, etc.) Many countries developedformal energy planning agencies to deal with the concerns for energy security, andprotection of the economy from future shocks But the stable energy and oil marketsituation since the mid-1980s and a change in the economic philosophy towardsgovernance in certain developed countries promoted a wave towards diminishingstate intervention in the energy sector The policy of reform and restructuring ofthe energy sector attempted to reduce government intervention by promotingcompetition wherever possible and limiting regulation to core natural monopolyactivities (World Bank2004)

The World Bank and the IMF were instrumental to promote these liberalisationpolicies in developing countries The ‘‘Washington Consensus’’ policies, as the

1989 policies for Latin America came to be known, were promoted around theworld and many countries under pressure from the bilateral and multi-lateralagencies had to undertake structural adjustments to turn around their economies.The energy sector was one of the targeted sector in many countries as the sectorcontributed significantly to the economic distress of many countries

However, after around two decades of persistent use of the liberalisation icies, the progress has been quite limited Now the World Bank acknowledges thatthe prescription has been oversold, misunderstood and less effective (World Bank

pol-2004) The opposition to these policies has mounted and the rate of acceptance islow With high oil prices in the recent years, the concerns of economic downturnand security of supply are reappearing There are calls for more intervention in themarket once again Thus a partial turn around of interventionist policies, if nottotal, is visible, as if the pendulum has swung back to the other side

12.5 Conclusion

This chapter has introduced the basic economic concepts related to energy kets Starting with the basic competitive market framework, the chapter hashighlighted various specific characteristics relevant for analyzing the energy sectorand indicated the implications on pricing of energy The chapter has thus high-lighted the potential for market failures in the sector, which in turn provides thebasis for the widespread government involvement in the sector The chapter ends

mar-with a brief review of the cyclical nature of market-oriented and oriented developments in the global energy scene However, the debate over theextent of state intervention in the market continues but a understanding of thecritical factors will allow an informed decision-making on the subject.

Williamson O (1985) The economic institutions of capitalism: firms, markets, relational contracting The Free Press, New York

World Bank (2004) Reforming infrastructure: privatisation, regulation and competition World Bank (see http://econ.worldbank.org/files/36237_complete.pdf ) Accessed 5 Jan 2005

Krautkraemer JA (1998) Non-renewable resource scarcity J Econ Lit 36:2065–2107

Robinson C (2004) Markets, imperfections and the dangers of over-regulating energy markets Econ Aff June:52–55

Energy Pricing and Taxation

13.1 Introduction

Energy pricing represents a major instrument of the overall energy policy of anycountry and is used to satisfy different objectives many of which are even con-tradictory Moreover, domestic energy prices are partly determined by the func-tioning and influences of international energy markets on the one hand and by thesociopolitical environment pf the country on the other Additionally, since energy is

an intermediate good as well as a final product, prices should distinguish betweenthe producers and consumers Additional criteria such as exhaustibility, capitalintensiveness, and non-storability must also be taken care of where applicable Thuspricing energy products is a complex and difficult task (Bhattacharyya1996).Energy supply involves a number of activities—production or procurement ofprimary energy from local or external sources, transformation of primary energies

to usable forms, transportation of energy in bulk and distribution of energy to finalconsumers through retail activities Moreover, the retail price also includes char-ges, duties, taxes or subsidies as imposed by the state or its agencies Accordingly,the retail price is the end result of the combination of various cost elementsinvolved in the entire energy value chain A typical example is shown in Fig.13.1

In order to understand and account for inherent complexities of energy pricing,

a two-step approach was suggested by Munasinghe (1985) In the first step, pricesare considered strictly on the basis of economic principles In the second step,economic prices are adjusted to meet other objectives, thus enabling one to knowexactly the departure from the economic prices

13.1.1 Basic Pricing Model

We start with two basic concepts of energy pricing, namely the average costpricing and the marginal cost pricing As these are widely used principles, theessential points are considered below

S C Bhattacharyya, Energy Economics, DOI: 10.1007/978-0-85729-268-1_13,

 Springer-Verlag London Limited 2011

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13.1.1.1 Average Cost Pricing

The principle of average cost pricing uses the cost of production of a firm that canrepresent the average of the lot and such a firm neither incurs huge losses nor earnshigh profits The average cost considers both the capital and operating component

of costs and divides them by the output This simplicity of the method actually liesbehind its wider appeal

From a theoretical perspective, in a competitive market under standardassumptions (of constant economies of scale, constant technologies and perfectdivisibility of capital), the average cost is equal to the marginal cost at the optimallevel in the long run.1This implies that the long-run average cost curve defines theexpansion path of the firm and the average cost pricing works fine when a largenumber of firms are competing in the market and are producing a homogeneousgood

However, in economic terms, the average cost has certain disadvantages aswell:

• It does not provide any incentive for performance improvement and allowsweaker firms to co-exist with the better performing firms

• It relies on the historic costs and does not take the cost of new capacity additioninto consideration The historic costs and the replacement costs could be verydifferent

• It does not provide adequate signals to the investors

Power generation

/ purchases

Transmission

Distribution/ retail supply

Cost of production – a function of (fuel price, efficiency, cost of capital) or terms

of contract

Investment cost in transmission network Operating costs, losses in network

Billed supply Collection efficiency Unaccounted for supply

Investment in distribution network Operating costs

Fig 13.1 Electricity supply value chain and cost determinants

1 In mathematical terms, dAC¼dð ÞTCQ ¼Q dTC

dQ  TC

13.1.1.2 Marginal Cost Pricing

The marginal cost-based approach follows from the competitive market modelwhere prices are decided by the marginal costs of the last supplier This wasintroduced inChap 12 This is obtained under the conditions of pure and perfectcompetition and such a price eliminates wasteful consumption and production of acommodity This also assures the Pareto optimality and hence is desirable in thesense of neoclassical economics

However, it was also indicated there that due to the specific features of theenergy market, the marginal cost-based pricing may not be appropriate The issuerelated to indivisibility of capital showed that following the marginal cost-basedrule would lead to price volatility But the price volatility arising from its strictapplication needs to be taken care of There is a well developed literature on theconsequent policy suggestion: long-run marginal cost based pricing This tends tocharge consumers for future investment in capacity addition each time consumerspay the price of a commodity Reference was also made to monopoly and naturalmonopoly market structures in the energy industry Such adjustments tend to alignthe pricing to average prices and hence it departs from the marginal cost concept

In addition, there are a number of cases where the pricing may have to beadjusted to take care of other special features of energy commodities We considersome of them below

13.2 Tradability of Energy Products and Opportunity Cost2

As energy products can be traded internationally or regionally, four specific casescan arise: a country self-sufficient in energy, a country that resorts to importing so

as to supplement its indigenous supply, an exporter and finally, an importerwithout any indigenous resources The tradable nature of energy goods affects thesupply and demand curves facing each of the above categories of countries andinfluences the pricing outcomes This is explained below

A small producer in the world market would face a demand curve containing ahorizontal section corresponding to the export price This indicates that the pro-ducers would have the opportunity to sell their goods at the international market atthe export parity price (px) Similarly, the supply curve of a small consumercountry will contain a horizontal segment corresponding to the import parity price(pm) This implies that the country has the possibility of importing the good fromthe international market at the relevant price

For a self-sufficient country the demand and costs are such that the countrycould meet its supply from domestic sources without resorting to imports or

2 This section relies on Rangaswamy ( 1989 ) See also Bhattacharyya ( 1996 ).

exports In such a case, the relevant price will be in between pm and px (seeFig.13.2).

For an importing country, the relevant price is import parity price even fordomestic production, because that price level is reached before meeting thedemand (see Fig.13.3) In this case, the domestic production would be Qp and(Qc- Qp) will be imported

For a net exporter, the proper domestic price is the export value, pxbecause thecost of supply is such that the cost curve intersects the horizontal part of the demandcurve In such a case, the country produces Qp but consumes Qc domestically,thereby leaving (Qp- Qc) for exports (Fig 13.4) Thus, for a tradable good, thepricing rule needs to be changed from the marginal cost principle and consumers in

Px Pm

Q Demand

Supply

Qp Pc

in an importing country

these countries may face different prices for energy depending on their demand andcosts of domestic production, imports and exports The inherent logic is that theprice should be based on the opportunity cost of the commodity in question.Arguably, the difference between the import and export price is the cost oftransport and handling the good For products with a true international market, thisdifference is normally small (e.g oil) However, this difference could be quitesignificant for other products (like coal or gas), thereby reducing the tradability aswell.

The economic prescription is that for tradable goods, the opportunity cost of thegood is obtained by considering the international market prices for such goods Inpractice, two methods are commonly referred to in the literature, often with ref-erence to petroleum product pricing: import parity pricing and cost-plus pricing

In import parity pricing, the landed cost of products is calculated by addingdifferent charges such as CIF prices, duties and surcharges, wharfage, and landingand handling charges The marketing and distribution margin is added to the above

to obtain the selling price However, such a pricing policy has three majordisadvantages:

• First, since the freight charges are more for products than for crude oil, importparity pricing inflates the profits of the refiners when some crude oil is locallyrefined;

• Second, the existence of local refineries also poses problem, as import paritypricing does not pay attention to the actual cost of local production By using theinternational benchmark, the local specificity is ignored but this could affect thesecurity of supply

Supply

Demand

p Fig 13.4 Efficient pricing

for an exporting country

• Finally, the domestic prices are subject to the same volatility as internationalprices, which may be difficult for consumers to accept, especially in developingcountry contexts.

In the case of cost-plus pricing, prices are set by adding different cost ponents such as cost of inputs (say crude oil for petroleum products), allowancesfor other operating costs, reasonable profit margin and transport and marketingcosts This is an administered pricing regime where prices are set throughadministrative mechanisms and is still widely used in many developing countries.However, it is difficult to arrive at a price structure that ensures a reasonablemargin to suppliers as well as sends proper price signals to consumers so that thepattern of production becomes consistent with the demand pattern Moreover, acost-plus formula has an inherent defect in reducing the incentive to economize oncosts and to inflate prices

com-Moreover, in the case of some joint products such as petroleum products, onlythe total value of products can be related to total cost The relative price structurewould depend on the demand pattern, so that the net back value can be maximizedand the imbalances can be minimized (Rangaswamy 1989) None of the abovemethods can satisfy this requirement

13.3 Peak and Off-Peak Pricing

Demand of certain energy products shows significant daily and seasonal variations

To meet such varying needs, the suppliers often resort to storage facilities whichcan be used to balance the demand and supply This is the case of gas or oil or coal,where the stock is built during off-peak period and the stock is drawn down duringpeak demand In general terms, the use of storage option depends on the cost ofstorage and the cost difference between peak and off-peak production If the cost ofstorage is less than the difference between the peak and off-peak period produc-tion, it makes sense to opt for storage The issue however becomes more difficultwhen the economic storage possibility is limited as in the case of electricity Here,the suppliers use different types of technologies to meet demand but the costcharacteristics of these technologies are different, thereby imposing different costs

of service during peak and off-peak hours of supply

Many authors have analysed the pricing issue in such situations but a simplepresentation following Munasinghe and Warford (1982,Chap 2) is given here Inthis simple version, consider two demand curves—one corresponding to the peakperiod (Dp) and the other corresponding to the off-peak period (Dop) Assume thatthe marginal cost curve can be simplified assuming a constant operating cost

a (which is the short-run marginal cost) and the fixed cost is b (which added withthe operating cost gives the long-run marginal cost)—see Fig.13.5 During off-peak hours, there is excess capacity and the relevant price is the short-run marginalcost, a During peak period the system feels pressure on capacity and the price

would have to take into consideration the cost for adding capacity Accordingly,the relevant price at this period is the operating cost supplemented by the capacitycost (or fixed cost) The simple rule then is that those consumers who come to thegrid during peak-periods should bear the full responsibility of capacity cost andoperating costs while those who use electricity during off-peak period should payonly for the short-run marginal costs.

13.3.1 Peak Load Pricing Principle

In what follows, we use a simple example to illustrate the pricing principle for peakand off-peak periods This follows Munasinghe and Warford (1982, Appendix C).Suppose that the annual load duration curve of the electric utility is composed

of two distinct periods (see Fig.13.6):

• An off-peak period during which the base load plants (using coal, nuclear, etc.)are used to supply the power For simplicity it is assumed that the cost char-acteristics of these plants are uniform The fixed cost per kW of capacity is a andthe variable cost per hour is f Assume also that the base capacity is given by

kW

X Y

Time Fig 13.6 Load duration

curve for the example

• A peak-period during which peaking plants are called to supplement powersupply from the base load plants The fixed cost per kW of capacity is b and therunning cost per hour is g Total load is Y kW, which implies that Y - X is thepeak load capacity.

It is assumed as usual that a [ b but f \ g It is also assumed that the entirecapacity is fully utilised

For any duration, h, the cost of using 1 kW of capacity of base plant is given by

H¼ a  bð Þ= g  fð Þ ¼ difference in fixed costs=difference in variable costs:

ð13:3ÞThis is shown in Fig.13.7

The cost of supplying the load as shown in Fig.13.7can be written as:

C¼ X a þ f  Tð Þ þ Y  Xð Þ b þ g  Hð Þ ð13:4Þwhere T is the total hours in a year (8760)

We are now going to analyse how the cost changes due to changes in peak andoff-peak demand

Case 1 Peak load demand changes by 1 kW

As the installed capacity is fully used, when the peak load demand increases by

1 kW, the utility has to install an additional peak capacity of 1 kW This is shown

by the coloured rectangle above Y The new cost of production is given by:

a b

f g

H

Time

Base plant Peaking plant Fig 13.7 Screening curve

C1¼ X a þ f  Tð Þ þ Y þ 1  Xð Þ b þ g  Hð Þ ð13:5ÞThe incremental cost is DC1¼ C1  C ¼ b þ g  H ð13:6ÞThis suggests that an additional demand during the peak period leads to two types

of costs: the fixed cost and the running cost and the consumers should bear thesecosts if the tariff has to be cost-reflective

Case 2 Demand increases during off-peak period

As the off-peak capacity is fully used, the utility has to install 1 kW of off-peakcapacity As the off-peak capacity will be available for peak load as well, the peakcapacity will be reduced by 1 kW The cost of supply can be written as:

C2¼ X þ 1ð Þ a þ f  Tð Þ þ Y  X þ 1½ ð Þ b þ g  Hð Þ ð13:7ÞThe incremental cost is given by

DC2¼ C2  C ¼ a þ f  Tð Þ  b þ g  Hð Þ ¼ a  bð Þ þ f  T  g  Hð Þ ð13:8ÞFrom Eq.13.8, (a - b) = (g - f) H

Replacing Eq.13.8in Eq.13.7, we get

The supplementary cost is equal to the cost of running the off-peak capacity duringthe off-peak hours (T - H) There is no fixed cost attached here and hence con-sumers coming to the grid during off-peak hours should pay only the running cost.Case 3 Demand increases during the entire period

In this case, the total demand increases by 1 kW throughout The total cost ofsupply is given by:

C3¼ X þ 1ð Þ a þ f  Tð Þ þ Y  Xð Þ b þ g  Hð Þ ð13:10ÞHence, the incremental cost is given by

13.3.2 Short-Run Versus Long-Run Debate

The debate over the use of short-run or long-term marginal cost for energy pricinghas a long history However, the debate returned in the 1980s as the issue ofstranded capacity emerged A study by Andersson and Bohman (1985) tried toreconcile the two views by considering the studies of Boiteux (1956), Turvey(1968,1969) and that of, among others, Munasinghe and Warford (1982) A briefsummary of the debate is presented here

The arguments in favour of pricing following the long-run marginal cost are asfollows:

• When the capacity can be adjusted continuously and hence marginally and if thedemand forecast is correct so that the capacity addition can be adjusted overtime, the short term marginal cost is equal to the long-run marginal cost.However, if the capacity is not adapted to the demand, the pricing policy based

on long-term marginal cost is preferable because the price has to stable overlong term to facilitate correct investment decisions by the consumers

• The pricing has to reflect a long-term policy because consumers can onlyrespond over a long period of time due to lock-in effects and the responsefunction is poorly understood

• If the demand remains uncertain, the utility has to meet the demand in any caseand therefore, the tariff has to rely on long-term pricing to take care of suchuncertainties

• The long-term marginal cost pricing coincides with the optimal resourceallocation objective and allows a transfer of the burden on the consumers(Munasinghe and Warford 1982)

f P*

a +f

Q

$

Off-peak demand Peak demand

Fig 13.8 Loss due to

non-peak pricing Source Viscusi

et al (2005)

The general criticisms against the above arguments are as follows:

• As the energy investments are indivisible, irreversible and long living ex post,the capacity cannot be varied continuously and rapidly;

• The long-run marginal cost is not easy to estimate Schramm (1991) indicatedthat it is the practice in World Bank Studies to use an approximation that dividesthe net present worth of costs by the present worth of production but this bydefinition amounts to averaging and does not really reflect the marginal cost

• If the divisibility of capital is not the concern, then the distinction betweenshort-run and long-run costs is immaterial

• As a forward-looking dynamic approach, the long-run marginal cost is unclear.The estimation depends on the demand forecast, and investment plan and theiraccuracy Also, the future costs depend on the geopolitical situation, interna-tional energy markets and energy policies Accordingly, the prices tend to bequite volatile and therefore, the accuracy of any forecast has been doubtful andmore so for fast developing countries In such cases, there is no guarantee thatthe pricing based on long-run cost will be stable

• Munasinghe and Warford (1982) add a new dimension to the debate by ducing willingness to pay to the tariff issue However, the marginal willingness

intro-to pay for a 1 kWh does not justify investment in a power station, the decisionbeing guided by the total willingness to pay by the society or aggregated con-sumers for the entire life of the project This in turn implies that the link betweentariff and investment is more complex than it is assumed by them

The arguments in favour of pricing based on short term marginal cost can besummarized as follows:

• The tariff-setting process is essentially a short-term phenomenon The short termcost is well defined for a given capacity mix and available options;

• The main difference between the two concepts is that of time In the short term,the capacity is fixed but that is not the case in the long term But in reality, theinstantaneous adjustment of capacity is not possible even in the long-term(unless technological innovation makes it possible to overcome the indivisibility

of capital issue, for example using efficient but small-scale renewabletechnologies)

• It is strange that in the above debate the issue of the status of the company(private or public), market structure (monopolistic or not), and the nature of thetransaction did not find a place For example, Weisman (1991) remarked thatthe tariff decision depends on the nature of the transaction taking place betweenthe company and its consumers The nature of the transaction again depends onrisk-sharing In a spot market, consumers are free to choose their suppliers andtherefore, the long-term marginal cost is not applicable But in case where thesupply is guaranteed by long-term contracts, consumers also share the risk Insuch a case, the long-term concept becomes appropriate

13.4 Energy Taxes and Subsidies3

Energy prices also include various charges, duties and taxes/subsidies whichultimately determine the price paid by the final consumers Energy taxes areutilised for various purposes The generation of revenue for the government is aprincipal objective There are different forms of taxation that bring revenue to thetreasury—excise duties on goods, royalties on domestic production of fossil fuels,and income taxes on the profit of energy companies The relative importance ofeach instrument varies from one country to another but in general, indirect taxesconstitute the major source of government revenue in developing countries, while

in industrialized countries tax on income and profit, and the contribution for socialsecurity represent the major source of revenue

Even for generating revenue, only the petroleum products are given morepreference all over the world due to their inelastic nature of demand which pro-vides for a stable revenue base Consequently, more than 90% of environmentally-related tax revenue even in OECD countries comes from charges and taxes onmotor vehicles and motor fuels.4Motor fuels are often subjected to higher taxes asthey offer some attractive characteristics: (a) large, inelastic and often certain taxbase; (b) easy to administer and control due to existence of a small number ofeconomic agents; and (c) less transparent and politically sensitive compared toother taxes In fact, as Fig.13.9 indicates, the share of tax in the cost of a com-posite barrel of oil (i.e the consumption weighted average of final consumer prices

of refined products that make up a barrel) has greatly increased since 1980s.Energy taxes are also used for demand management, macro-economic con-siderations and revenue redistribution to tackle equity issues Finally, taxes onenergy can also be justified for internalising externalities Table13.1 presents asummary of relevant factors for the determination of energy taxes It becomesclear that the subject is complex and energy taxes, in reality, are a compromiseamong different objectives Note also the value judgement aspect in the deter-mination of relative importance of each factor depending on the country context,demand situation and energy market conditions Therefore, the table should beconsidered only as an example without attaching excessive weight to the entriesshown for different factors Nonetheless, it brings to light several aspects Forinstance, all factors are not equally important for all products Similarly, theimportance of different factors varies according to the sector under consideration.Clearly, all the factors are not relevant is all cases and their importance varies overtime and across regions

3 This section is based on Bhattacharyya ( 1995 , 1996 and 1997 ).

4 See OECD database at http://www2.oecd.org/ecoinst/queries/index.htm

13.4.1 Principles of Optimal Indirect Taxation

The economic analysis of taxation has a long history and therefore there is a developed body of literature on the subject5(See Mankiw et al.2009for a review.The most well-known optimal commodity tax formula dates back to 1927 whenthe Ramsey rule was proposed This theory considered the problem of raising agiven amount of revenue by taxing the commodities consumed by a consumer sothat deadweight loss is or excess burden is minimized In a partial equilibriumsetting, assuming the demand curve DD0and a fixed producer price P and a tax t,the deadweight loss is given by shaded triangle ABC (see Fig.13.10)

well-The optimal indirect tax formula requires that the compensated demand foreach good be reduced by the same proportion More precisely, if tiis the tax rate

on good i, and eiithe price elasticity of demand for good i, and eijrepresents thecross-price elasticity of demand for i with respect to good j, then the tax rule iswritten for the two good case as

2009

Fig 13.9 Importance of tax in the composite barrel Source OPEC Annual Statistical Bulletin 2009

5 See Mankiw et al ( 2009 ) for a recent review See also Newbery and Stern ( 1988 ), Diamond and Mirrlees ( 1971 ) and Feldstein ( 1972 ).

The deadweight loss as shown in Fig.13.9may be written as follows:

equi-Three particular issues related to practical application of theoretical precepts can

be identified The first is related to the theoretical basis of the analysis Any oretical construct is based on certain assumptions It should be ascertained whetherany particular application satisfies these assumptions and what happens if they areviolated The major assumptions inherent in the above formulation are (inter alia)

Quantity Fig 13.10 Deadweight loss

of an indirect tax

that there are no pure rents in the economy; that the production takes place in acompetitive environment; that there are no externalities and that consumers max-imize their utilities These conditions are often violated in the energy market Quitecommonly, markets are dominated by a group of firms and collusion, rather thancompetition, is quite common Unfortunately, for energy products substitutes arenot absent—they need to be taken into account Moreover, all pure rents are difficult

to be taxed away and in such a case, the optimal set of taxes depends not only on thedemand elasticities, but also on supply elasticities and on the share of capital incosts (Boskin and Robinson1986) Moreover, for exhaustible resources, the pattern

of taxes over time is very important for intertemporal consumption decisions Thiscalls for, ceteris paribus, the permanent levying of taxes to keep the present value oftax payments constant, which in turn, necessitates commitment of present andfuture governments to the same tax rates—a demand difficult to meet in reality.Additionally, since energy is an intermediate input for production as well as a finalproduct for consumption, the elasticities of substitution between capital and energymay be important Above all, these so-called optimal tax theories consider onlyefficiency without paying any attention to equity, and are thus vulnerable tocriticism

13.4.2 Equity considerations

No democratic governments can possibly ignore the importance of equity siderations in pricing It is well known that policies that improve economic effi-ciency frequently have distributional impacts Changes in energy prices affectincome in different ways (Kumar 1985): directly through a change in real pur-chasing power and through changes in prices of other goods that use energy, andindirectly through changes in macroeconomic forces, like inflation, exchange rate,and employment The main concern for equity derives from the fact that the poorersection of the population spends proportionately higher amounts on energy thanprice than their richer counterparts, and therefore is adversely affected by anenergy price increase Often the goal of equity is to minimize the adverse effects

con-on the poorer households

Some economists prefer to disregard equity issues either from the feeling thatequity is a subjective criterion or from the belief that over long term the positiveeffects and negative distribution effects on any group average out (Griffin andSteele1980) Others are sympathetic to the equity issue and advocate subsidies forthe fuels used directly by poorer households For any policy maker, at least threeissues complicate the problem further: targeting the poorer sections of the popu-lation and then reaching them, avoiding unintended consequences, and providingsubsidies at low cost Rarely does any subsidy policy meet all these criteria, andthis fact strengthens the anti-subsidy campaign

The initial development of optimal commodity tax theory did not take thedistribution aspect into consideration Ramsey considered only a single individual