Chapter 1: Introduction: Societal Challenges Related to Energy Sys-
tems and Markets
Chapter 1 and 2
1. Societal challenges related to energy use
2. Energy systems
1.1 Societal Challenges Related to Energy Use
Sources and Use of Energy
• Primary energy carriers: coal, oil, gas, wind, sunshine.
• Primary energy supply: total supply of primary energy carriers in an economy.
• Secondary energy carriers: commodity used to ’carry’ energy, energy content is added to the
commodity, e.g. water, gasoline, hydrogen.
• Tertiary energy carrier: secondary energy carrier is used to e.g. split water molecules in hydrogen
and oxygen (electrolysis to produce hydrogen).
Energy Markets
• Economic agents: producers, consumers, traders, grid operators, etc.
• Societal issues:
– Consumers: price of energy, availability of energy.
– Produces and traders: level playing field in international market.
– Everyone: environmental effects, geopolitical risks.
• Energy trilemma: the simultaneous pursuit of energy availability, affordability, and sustainability,
which, although may seem conflicting, are essential for the economic development and need to be
achieved together.
• Energy is a fundamental component for societal progress and economic growth and essential for
various human activities, e.g. industrial production, transportation, and heating.
Societal Challenges of Related to Energy Use
• Economic growth/affordability:
– Energy is a crucial input for economic development.
– Energy use is strongly related to income levels. While the energy intensity, or the energy use
per unit of income (macroeconomic measure), has decreased due to improved energy efficiency
and economic restructuring, per capita energy consumption has risen due to higher income
levels and a growing population, leading to overall growth in global energy use. The strength
of this relationship varies across countries.
– Electricity consumption is strongly related to economic growth but this effect is changing as a
result of the energy transition.
– Energy prices can have strong influence on economic activities and income, e.g. 2022 dramatic
increase of energy prices.
– International price differences may distort international competition.
• Security of supply:
– Energy is strongly internationally traded, many countries depend on import for their energy
supply, which makes them vulnerable to geopolitical risks.
1
, – For example, since the gas crisis and Russian invasion of Ukraine, the imports from Russia
have been significantly replaced by LNG imports from a.o. USA.
• Sustainability:
– Emissions from energy have major share in total greenhouse gas emissions.
– Expected increase in temperature is function of size of cumulative emissions in coming decades.
– Higher energy use results in higher carbon emissions. The strength of the relationship depends
on the type of energy use. But the relationship is becoming less strong the higher the energy
use.
– How to explain the change in emissions? Aggregated consumption of energy is function of
energy consumption on individual and firm level and the changes within society and economy,
this can be extended by relating energy use to emissions of carbon; Kaya identity:
EM E GDP
Em = · · · cap
E GDP cap
this means that
Total emissions = Emission intensity · Energy intensity · GDP per capita · number of people
Regulation to Address Societal Challenges
Energy policy:
• Affordability: protecting (vulnerable) consumers against too high prices and tariffs, e.g. through
tariff regulation of grids.
• Economic growth: creating internationally integrated competitive energy markets, e.g. by market
coupling of electricity markets.
• Sustainability: internalizing negative external effects of carbon emissions, e.g. through emissions
trading and support for renewables.
• Security of supply: internalizing negative external effects related to security of supply, e.g. through
strategic reserves.
Approaches to Analyse Regulation
To determine the appropriate role of governments in energy markets, we adopt the Public-Interest
Approach, which is classified as a normative theory approach. Here, government intervention is justified
only if it enhances social welfare, particularly in instances of market failures that the market itself cannot
rectify. For example, government regulation may be necessary to address negative externalities.
• Governments may implement measures such as subsidies or taxes to internalize externalities.
• Governments may prevent firms from acquiring excessive market power or regulate firms with
market power by capping prices at the level of costs of an efficient firm or by imposing regulatory
rules on their behavior.
• Aims to explore how governments can enhance welfare by intervening in energy markets.
• Does not assume government objectives as given but seeks to determine optimal policies from a
social-welfare perspective.
• Markets and governments can fail, thus a positive approach is necessary which focuses on explaining
actual policy outcomes based on influence and lobbying of interest groups (capture theory) and/or
the self-interest of politicians seeking re-election (economic theory).
2
,Summary: Framework for Discussing Regulation of Energy Markets
1. Energy is necessary for economic development, it can be provided by various types of energy carriers
and its use has various types of effects (security, sustainability, affordability).
2. Various types of activities related to energy carriers conducted by firms and consumers; exploration,
production, transport, trade, storage, trade and consumption.
3. Firms and consumers make use of energy markets in order to conduct their activities more efficiently.
4. Regulation of energy markets in order to improve the functioning of these markets and to help firms
and consumers to make more efficient choices and to address the societal challenges (=public-interest
perspective).
1.2 Energy Systems
Activities in Energy Supply Chains
Figure 1.1: Energy supply chain with activities: exploration, production, conversion, transport, storage
and consumption.
• For various types of energy carriers, separate supply chains exists, but these are closely connected;
an example of sector coupling.
• These relationships between energy sectors imply that developments in one supply chain, e.g. rising
costs
• or higher demand, affect economic conditions of other supply chains.
Exploration and Economic Problem
• Exploration: geological research. Classification of resources depending on the geological certainty and
economic feasibility can be presented through a McKelvey diagram. Reserves can be distinguished
in proven portable and possible reserves (Table 2.3).
– Proven reserves; probable reserves; possible reserves; conditional resources.
– The volume of proven reserves is an endogenous variable. Size of these reserves can be expressed
in relation to the size of total production, which results in the so-called Reserve-to-Production
3
, (R/P) ratio. R/P ratio does not say anything about the availability of resources in the long-term
future; only refers to proven reserves at given moment in time.
• Economic problem of exploration of natural resources: opportunity costs depend on expected future
prices, current production is increased if rate of increase of prices is expected to be below the
discount rate. This optimizing behaviour may affect effectiveness of green policies.
– Hotelling rule: the intertemporal depletion path is driven by the expected net price (price
minus costs) and the market rate of interest, predicting that the net price (resource rents)
increases annually by the market rate of interest. The underlying idea is that investors choose
between investing in non-renewable resources (by not producing) or in capital markets.
Pt+1 − Pt
>r
Pt
• Green Paradox: ptimizing behavior of fossil energy owners in response to the energy transition leads
to the Green Paradox.
– The energy transition reduces future demand for fossil energy. Future prices of fossil energy will
be lower. Hence, it is optimal (profit-maximizing) for fossil energy owners to bring production
forward.
– Increased current production leads to lower current prices of fossil energy. This makes the
energy transition more expensive.
Storage of Gas
From an economic perspective, energy storage enables the adaptation of the timing of supply to match
consumption without altering the timing of production, and vice versa. This process involves translating
timing differences into current and future price differences if markets exist.
• Costs of Storing (Cost of Carry): This includes handling costs and the opportunity costs of invested
capital. The marginal costs are primarily the cost of capital, as storing commodities involves missed
opportunities to invest the capital elsewhere.
• Expected Inter-temporal Price Difference: Traders will only store commodities if the capital costs of
storing are below the expected relative price change of the commodity.
Traders will not sell gas now for future delivery at prices that do not compensate for storage costs. The
forward prices of storable commodities are linked to both the current spot price and the cost of carry.
The economic roles of gas storage are threefold:
• Intertemporal Arbitrage: This involves taking advantage of seasonal price differences by buying gas
when prices are low and selling when prices are high.
• Balancing the Gas System: Storage helps in balancing the overall gas system or individual trader
portfolios.
• Security of Supply: Storage provides a buffer for supply security, especially during disruptions or
unpredictable short-term price shocks.
Transport of Gas
• Historically, gas was transported through high-pressure networks primarily for international trade
within Europe.
• Pipelines: high CAPEX, OPEX are an increasing function of distance due to energy losses.
• LNG: investments in liquefaction, terminals, ships and regassification terminals. LNG is most
efficient for long-distance gas transport.
4
tems and Markets
Chapter 1 and 2
1. Societal challenges related to energy use
2. Energy systems
1.1 Societal Challenges Related to Energy Use
Sources and Use of Energy
• Primary energy carriers: coal, oil, gas, wind, sunshine.
• Primary energy supply: total supply of primary energy carriers in an economy.
• Secondary energy carriers: commodity used to ’carry’ energy, energy content is added to the
commodity, e.g. water, gasoline, hydrogen.
• Tertiary energy carrier: secondary energy carrier is used to e.g. split water molecules in hydrogen
and oxygen (electrolysis to produce hydrogen).
Energy Markets
• Economic agents: producers, consumers, traders, grid operators, etc.
• Societal issues:
– Consumers: price of energy, availability of energy.
– Produces and traders: level playing field in international market.
– Everyone: environmental effects, geopolitical risks.
• Energy trilemma: the simultaneous pursuit of energy availability, affordability, and sustainability,
which, although may seem conflicting, are essential for the economic development and need to be
achieved together.
• Energy is a fundamental component for societal progress and economic growth and essential for
various human activities, e.g. industrial production, transportation, and heating.
Societal Challenges of Related to Energy Use
• Economic growth/affordability:
– Energy is a crucial input for economic development.
– Energy use is strongly related to income levels. While the energy intensity, or the energy use
per unit of income (macroeconomic measure), has decreased due to improved energy efficiency
and economic restructuring, per capita energy consumption has risen due to higher income
levels and a growing population, leading to overall growth in global energy use. The strength
of this relationship varies across countries.
– Electricity consumption is strongly related to economic growth but this effect is changing as a
result of the energy transition.
– Energy prices can have strong influence on economic activities and income, e.g. 2022 dramatic
increase of energy prices.
– International price differences may distort international competition.
• Security of supply:
– Energy is strongly internationally traded, many countries depend on import for their energy
supply, which makes them vulnerable to geopolitical risks.
1
, – For example, since the gas crisis and Russian invasion of Ukraine, the imports from Russia
have been significantly replaced by LNG imports from a.o. USA.
• Sustainability:
– Emissions from energy have major share in total greenhouse gas emissions.
– Expected increase in temperature is function of size of cumulative emissions in coming decades.
– Higher energy use results in higher carbon emissions. The strength of the relationship depends
on the type of energy use. But the relationship is becoming less strong the higher the energy
use.
– How to explain the change in emissions? Aggregated consumption of energy is function of
energy consumption on individual and firm level and the changes within society and economy,
this can be extended by relating energy use to emissions of carbon; Kaya identity:
EM E GDP
Em = · · · cap
E GDP cap
this means that
Total emissions = Emission intensity · Energy intensity · GDP per capita · number of people
Regulation to Address Societal Challenges
Energy policy:
• Affordability: protecting (vulnerable) consumers against too high prices and tariffs, e.g. through
tariff regulation of grids.
• Economic growth: creating internationally integrated competitive energy markets, e.g. by market
coupling of electricity markets.
• Sustainability: internalizing negative external effects of carbon emissions, e.g. through emissions
trading and support for renewables.
• Security of supply: internalizing negative external effects related to security of supply, e.g. through
strategic reserves.
Approaches to Analyse Regulation
To determine the appropriate role of governments in energy markets, we adopt the Public-Interest
Approach, which is classified as a normative theory approach. Here, government intervention is justified
only if it enhances social welfare, particularly in instances of market failures that the market itself cannot
rectify. For example, government regulation may be necessary to address negative externalities.
• Governments may implement measures such as subsidies or taxes to internalize externalities.
• Governments may prevent firms from acquiring excessive market power or regulate firms with
market power by capping prices at the level of costs of an efficient firm or by imposing regulatory
rules on their behavior.
• Aims to explore how governments can enhance welfare by intervening in energy markets.
• Does not assume government objectives as given but seeks to determine optimal policies from a
social-welfare perspective.
• Markets and governments can fail, thus a positive approach is necessary which focuses on explaining
actual policy outcomes based on influence and lobbying of interest groups (capture theory) and/or
the self-interest of politicians seeking re-election (economic theory).
2
,Summary: Framework for Discussing Regulation of Energy Markets
1. Energy is necessary for economic development, it can be provided by various types of energy carriers
and its use has various types of effects (security, sustainability, affordability).
2. Various types of activities related to energy carriers conducted by firms and consumers; exploration,
production, transport, trade, storage, trade and consumption.
3. Firms and consumers make use of energy markets in order to conduct their activities more efficiently.
4. Regulation of energy markets in order to improve the functioning of these markets and to help firms
and consumers to make more efficient choices and to address the societal challenges (=public-interest
perspective).
1.2 Energy Systems
Activities in Energy Supply Chains
Figure 1.1: Energy supply chain with activities: exploration, production, conversion, transport, storage
and consumption.
• For various types of energy carriers, separate supply chains exists, but these are closely connected;
an example of sector coupling.
• These relationships between energy sectors imply that developments in one supply chain, e.g. rising
costs
• or higher demand, affect economic conditions of other supply chains.
Exploration and Economic Problem
• Exploration: geological research. Classification of resources depending on the geological certainty and
economic feasibility can be presented through a McKelvey diagram. Reserves can be distinguished
in proven portable and possible reserves (Table 2.3).
– Proven reserves; probable reserves; possible reserves; conditional resources.
– The volume of proven reserves is an endogenous variable. Size of these reserves can be expressed
in relation to the size of total production, which results in the so-called Reserve-to-Production
3
, (R/P) ratio. R/P ratio does not say anything about the availability of resources in the long-term
future; only refers to proven reserves at given moment in time.
• Economic problem of exploration of natural resources: opportunity costs depend on expected future
prices, current production is increased if rate of increase of prices is expected to be below the
discount rate. This optimizing behaviour may affect effectiveness of green policies.
– Hotelling rule: the intertemporal depletion path is driven by the expected net price (price
minus costs) and the market rate of interest, predicting that the net price (resource rents)
increases annually by the market rate of interest. The underlying idea is that investors choose
between investing in non-renewable resources (by not producing) or in capital markets.
Pt+1 − Pt
>r
Pt
• Green Paradox: ptimizing behavior of fossil energy owners in response to the energy transition leads
to the Green Paradox.
– The energy transition reduces future demand for fossil energy. Future prices of fossil energy will
be lower. Hence, it is optimal (profit-maximizing) for fossil energy owners to bring production
forward.
– Increased current production leads to lower current prices of fossil energy. This makes the
energy transition more expensive.
Storage of Gas
From an economic perspective, energy storage enables the adaptation of the timing of supply to match
consumption without altering the timing of production, and vice versa. This process involves translating
timing differences into current and future price differences if markets exist.
• Costs of Storing (Cost of Carry): This includes handling costs and the opportunity costs of invested
capital. The marginal costs are primarily the cost of capital, as storing commodities involves missed
opportunities to invest the capital elsewhere.
• Expected Inter-temporal Price Difference: Traders will only store commodities if the capital costs of
storing are below the expected relative price change of the commodity.
Traders will not sell gas now for future delivery at prices that do not compensate for storage costs. The
forward prices of storable commodities are linked to both the current spot price and the cost of carry.
The economic roles of gas storage are threefold:
• Intertemporal Arbitrage: This involves taking advantage of seasonal price differences by buying gas
when prices are low and selling when prices are high.
• Balancing the Gas System: Storage helps in balancing the overall gas system or individual trader
portfolios.
• Security of Supply: Storage provides a buffer for supply security, especially during disruptions or
unpredictable short-term price shocks.
Transport of Gas
• Historically, gas was transported through high-pressure networks primarily for international trade
within Europe.
• Pipelines: high CAPEX, OPEX are an increasing function of distance due to energy losses.
• LNG: investments in liquefaction, terminals, ships and regassification terminals. LNG is most
efficient for long-distance gas transport.
4
