Can the Composition of Energy Use in an Expanding Economy be Altered by Consumers' Responses to Technological Change?

• Author: Turner, Karen

1. INTRODUCTION

   Historically, improvements in energy efficiency have been promoted as cost-effective and efficient ways to reduce energy demand and greenhouse gas emissions (European Commission, 2011; IEA, 2015; UNEP, 2014). Such efficiency increases hold out the prospect of expanding economic activity whilst simultaneously reducing energy use. (1) However, the substitution and income effects that accompany energy efficiency improvements generate rebound and possibly even backfire, which is thought to undermine the role of energy saving in environmental policy (see Revkin, 2014). In this paper we investigate whether the very forces that produce rebound can be channelled more effectively to meet environmental goals.

   The International Energy Agency (2014) has emphasised the possible multiple benefits of improved energy efficiency. Technological change allows us to 'make more using less'; that is, to increase output without a corresponding rise in inputs. This expansion is typically regarded as desirable. For instance, the core focus of the UK Government's industrial strategy is productivity and emphasises the need for the UK to "embrace and benefit from the opportunity of technological change" (DBEIS, 2017, p. 12). But to a certain extent positive rebound effects reflect the expansionary impact on economic activity that accompany improvements in energy efficiency, so that rebound is intimately linked to other central economic policy objectives. In this regard, it could be argued that the literature has been too limited in not recognising the positive benefits linked to rebound effects (for reviews see Gillingham et al., 2016; Greening et al., 2000; Sorrell et al., 2009). Here, we extend the analysis to consider how rebound and macroeconomic benefits are linked, but also that the rebound process might possibly be further redirected so as to favour emissions' reduction.

   The present paper uses partial equilibrium analysis and general equilibrium numerical simulation to address two inter-related research questions. The first is: can environmental policy benefit from more effectively directed energy efficiency improvements? Specifically, we consider whether the policy focus of an efficiency improvement in one type of energy (e.g. electricity) should be wider than just how that is used or extend to others (e.g. gas). The second is: can encouraging the substitution effects associated with efficiency improvements be used to augment energy saving, without jeopardising the other multiple economic benefits of energy efficiency improvements?

   We use as an illustrative example an improvement in the production of electricity which will affect the choice between electricity and gas for domestic space heating, so that a key element of rebound will reflect a shift from a more- to a less-carbon intensive fuel. This is a useful focus for the UK for two reasons. First, given that electricity in Europe tends to be highly priced per kWh relative to gas, there is a real need to improve its competitiveness as a low carbon option. (2) Second, where there are problems in the domestic uptake of energy efficiency initiatives, influencing the relative price of lower, as against higher, carbon options might be an effective way of reducing carbon emissions. In this respect, we highlight the potential for policy action to assist and encourage households in substituting in favour of electricity in heat, as against more carbon-intensive gas heating systems. (3)

   The remainder of the paper is structured as follows. In Section 2, we formally model the impact of an efficiency improvement in the production of electricity on household energy demand in a partial equilibrium context. In Section 3 we present the arguments for augmenting this analysis with general equilibrium numerical simulations. In Section 4 we introduce the UK-ENVI computable general equilibrium (CGE) model. Section 5 reports the results for the base-case simulation where the efficiency improvement is introduced in a model using our default parameter values. This simulation establishes benchmark figures for changes in aggregate economic and energy use indicators. In Section 6 we undertake extensive simulation to identify the sensitivity of these impacts to changes in key household behavioural demand parameters. Conclusions are drawn in Section 7.

2. PARTIAL EQUILIBRIUM AND DOMESTIC HEAT

   In this section we analyse the effect of an x% exogenous, costless, input-neutral improvement in efficiency in the production of electricity. This means that all the unit inputs are reduced by x%, so that with constant input prices domestically produced electricity similarly falls in price by x%. This would operate in a manner similar to an x% improvement in transmission efficiency; for a given generation level x% more electricity would be delivered to final consumers. Note that this is also analogous to an increase in the efficiency of electricity in all uses, if the electricity is measured in efficiency units. In the present case, if the reduction in the electricity price elicits no response in electricity use there is zero rebound; the resources used in the production of electricity will fall by x%. Rebound and backfire therefore occur where electricity use increases by less than, and greater than, x% respectively

   Our specific focus in this section is the analysis in a partial equilibrium setting of the delivery and consumption of household services that provide warmth and comfort. In this context, we treat domestic space heating as a composite good made up of the consumption of electricity, e, and gas, g. The efficiency improvement in the production of electricity generates a fall in the price of electricity, whilst the prices of all other services and commodities (including gas), and household nominal income, remain constant. The price elasticity of demand for domestic space heating and the elasticity of substitution between electricity and gas are labelled as [eta] and [sigma]respectively. Both elasticities take positive values and the initial share of electricity in domestic space heating is s.

   To measure the impact of this price reduction, expressions are required for the elasticity of demand for both electricity and gas with respect to a change in the price of electricity. Holden and Swales (1993) derives expressions for the price elasticity of demand for inputs in a two-factor production function and the same framework can be adapted so as to apply equally well to consumption (Figus et al., 2018; Figus and Swales, 2018). The partial equilibrium demand elasticities are given in equations (1) and (2).

   [e/p] = [sigma](s-1) - s[eta] [less than or equal to] 0 (1)

   [g/[p.sub.e]] = s([sigma]-[eta])

   where the dot notation represents proportionate changes. For the x% Hicks-neutral increase in the efficiency of the production of electricity: [p.sub.e] = -x. Substituting into equations (1) and (2), the proportionate changes in the demand for electricity and gas are:

   e = x([sigma](1-s) + s[eta]) [greater than or equal to] 0 (3)

   g = xs([eta]-[sigma]) [eta] (4)

   Note from equation (3) that the demand for electricity never falls as a result of the increase in efficiency with which it is produced. In the present context, this represents the rebound effect. However, generation inputs per unit of delivered electricity have fallen, so that for the level of electricity generation to rise, then e > x. This requires [sigma](l - s) + s[eta], the weighted sum of the demand and substitution elasticities, to be greater than unity. In that case backfire would occur.

   However, we are more interested in the demand for gas. The fall in the composite price of domestic space heating will increase the demand for both gas and electricity whilst the fall in the price of electricity relative to gas will lead, other things being equal, to a fall in the household use of gas. From equation (4) it is clear that under partial equilibrium, gas use will fall as long as the elasticity of substitution between electricity and gas, [sigma], is greater than the elasticity of demand for domestic space heating, [eta].

   A central concern is the sensitivity of these results to changes in the demand elasticities, which is of particular relevance, given that [sigma] and [eta] are behavioural, rather than technical, parameters and could be influenced by government policy. Differentiating equations (3) and (4) with respect to [eta] gives:

   [[partial derivative]e/[partial derivative][eta]] = [[partial derivative]g/[partial derivative][eta]] = xs (5)

   For both of the energy inputs to domestic heat, increasing [eta] produces the same positive proportionate increase in the use of the energy source. Therefore, making the demand for space heating more price elastic will increase the use of electricity and gas. Of course, where gas use falls as a result of the reduction in the price of electricity, the size of that reduction will be reduced by the increase in the value of [eta].

   Expressions (6) and (7) show the results of differentiating functions (3) and (4) with respect to [sigma].

   [[partial derivative]e/[partial derivative][sigma]] = x(1-S) > 0 (6)

   [[partial derivative]g/[partial derivative][sigma]] = -sx

   Increasing the price sensitivity of the choice between electricity and gas again increases the rebound for electricity, as shown in expression (6), but has a negative effect on the change in the use of gas. The significance of a policy steering the rebound effect away from gas towards the less carbon intensive electricity is clear.

3. GENERAL EQUILIBRIUM

   In a UK context, the increasing capacity for low carbon electricity (via renewables and nuclear generation) is taken as the desired cleaner option as against gas. The UK's Committee on Climate Change (2015) identifies a low-carbon electricity supply as the most cost-effective way to meet the need for more generation in the 2020s, given the nation's climate change commitments. In 2016 the UK...