Podcast: Price elasticity of energy demand

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17 January, 2023

Reading time: 18 minutes

Our flexibility podcast explores the concept of price elasticity in energy demand and its importance for energy pricing and energy infrastructure planning.

CREDS in conversation

This podcast explores the concept of price elasticity in energy demand, its importance for understanding consumer energy prices and for energy infrastructure planning and climate policy design.

In conversation, Professors Jacopo Torriti and Anna Alberini, with Dr José Luis Ramírez.

Transcript

Jose Luis Ramirez-Mendiola: [00:00:00] Hello everybody. And welcome to this CREDS podcast on price elasticity. CREDS is the Centre for Research into Energy Demand Solutions, funded by the UK Research and Innovation’s energy programme. Our research focuses on reducing energy demand, improving energy efficiency, and understanding demand-side flexibility.

We are a consortium of over 20 universities with around 140 staff in the UK, led by the University of Oxford. This podcast is part of an international series called CREDS in conversation. My name is Dr. Jose Luis Ramirez-Mendiola. I’m a research fellow at the CREDS centre, and I will be moderating the conversation today.

With me I have Professors Jacopo Torritti and Anna Alberini. Anna is a Professor at the Department of Agriculture and Resource Economics at the University of Maryland in the US and her expertise covers areas such as environmental economics, energy economics, and econometrics and statistics. [00:01:00] Her energy economics research focuses on residential energy demand, energy efficiency, decisions and consequences of such decisions, policies targeted at shaping residential energy demand, and on vehicle fuel economy and driving decisions.

Jacopo is a Professor of Energy, Economics and Policy at the University of Reading, and co-director of CREDS. As part of his work with the CREDS flexibility theme, Jacopo and his team are researching the ways in which our demand loads could be changed by, and made more flexible in response to different stimuli.

Part of this analysis necessarily involves looking into something that is commonly referred to as price elasticity of demand, which is what the conversation in today’s episode will revolve around. Let’s start from the beginning. Anna, could you please start by explaining what exactly it is what we mean by price elasticity, and why it is so [00:02:00] important.

Anna Alberini: Certainly. Thanks for having me, Jose. So, the price elasticity of energy demand is essentially a measure or a number that tells you by how much the demand, or the quantity consumed, of a certain fuel or a certain source of energy, will change following a certain change, a certain percentage change, in the price of that particular type of energy, or that particular fuel.

So, if something costs a dollar per litre, for example, and we’re talking about the price of gasoline, for example, in some very simplified world, and the price were to increase from $1 to $1.20, that would be a 20% increase. If price elasticity of the demand for gasoline was equal to negative one, then there would be a corresponding 20% decline in the quantity of gasoline consumed by people.

Normally, however, we believe that the price elasticity of the demand for gasoline, but also for electricity, natural gas, and [00:03:00] many other types or sources of energy that are consumed by people is actually a lot less than that, so people do not respond that much when they see a price change. It’s very important nowadays to talk about price elasticities for a number of reasons.

One reason is that we’re seeing extremely high prices, and so it’s going to be important to see by how much people will be curtailing their consumption of different sources of energy. That’s going to be important for planning purposes for understanding how much to push things in the direction of renewables, but also to plan for energy assistance, which may be necessary to help poorer families pay their bills.

The price elasticity is also important for infrastructure planning, but also extremely important for energy, excuse me, climate policies. So, a classic example of a type of climate policy that is very much favored by economists would be a carbon tax. A carbon tax would be presumably raising the prices of energy inputs that are coming from fossil fuels or produced using fossil fuels like coal fired [00:04:00] electricity, or natural gas fired electricity.

We would want to see exactly by how much we can expect consumption to go down because in the end that determines how many tonnes of CO2 emissions we can see decline as a result of the carbon tax. So, I hope that helps, Jose.

Jose Luis Ramirez-Mendiola: Thank you very much Anna, that’s really very interesting. And you touched on many very important and very current issues, like the energy crisis that we’re experiencing and climate change. But you also mentioned that the responses of consumers to changes in price are not as consistent as we would expect. Would you say that these vary a lot? Could you give us some examples of why there are some differences in these responses?

Anna Alberini: Certainly. So, this is actually part of my own research agenda, trying to figure out exactly how much, what the price elasticity is, and how much it can vary depending on the type of [00:05:00] data that you’re using, whether you were observing consumers adjust their quantity consumed when the prices were going up and when the prices were going down. There’s a cultural aspect related to the responsiveness to changing energy prices. So, the responses that you see in one place or in one country may not necessarily be the same as you would see in another place or in another country like the United States, for example. So, these are all factors that play a role in determining what the price elasticity of energy demand is.

It’s also perfectly possible that people are more responsive for one type of fuel or energy and less for another. And which is which is really difficult to say, because it depends what people have available at their disposal. If they decide to cut down on the consumption of a certain type of fuel, can they substitute it with something else or are they pretty much stuck with whatever they have?

Now, one thing that I think is really important is the notion of salience. So effectively, how much do people know about the price and how much do people know that [00:06:00] it’s about to change or, or that it has changed at all? So, I suspect, and I have some empirical evidence of that, that people really are aware of the prices when the price changes are very large, as they are right now. So right now it would be a good time to talk about consumers becoming very aware of the prices out there, but at a time in which the prices are low or when they’re regulated, and so they remain stable and unchanging for long period of time, most likely people are not paying attention to that. And so this lack of salience or lack of awareness may very well result in a different type of response to changing prices when you do see a price change.

Jose Luis Ramirez-Mendiola: That is very true, this issue of salience that you mentioned, which as I understand is the fact that people don’t really pay enough attention to prices to be able to respond to that.

Jacopo, could you give us your perspective on these issues?

Jacopo Torriti: Yes, I agree. Energy demand is not [00:07:00] like pasta. If a certain brand of pasta becomes very expensive, one could simply switch to another brand or eat something else should all brands of pasta become expensive. So, you could say that demand for pasta is elastic.

The same cannot be said about energy demand, or not all types of energy demand. Energy enables to meet the demand for cleaning – bodies, clothes, and dishes – cooking, lighting, heating, working, entertainment. So, understanding what energy is for is a key to understand how people may respond to price changes.

And in a sense their salience, or how much they know about price and their elasticity, so how much they’re going to shift consumption or reduce consumption as a response to a price increase.

Jose Luis Ramirez-Mendiola: Absolutely. Like you say, when people are using energy, they perhaps don’t think about the energy they’re [00:08:00] actually using, because they’re thinking they need to do something, they need to cook, they need to put the washing machine on, they want to watch TV. They’re not really worrying about how much energy that’s going to consume. So, perhaps estimating the responses based on price only might be quite complicated. What do you think needs to happen to be able to say a bit more about how demand might change?

Anna Alberini: Jose, this is actually a very, very interesting point. So, there are some situations in which I personally believe that people are very aware of what the price is and how much they’re consuming. And the example that I’m going to bring is actually driving your car. So, first of all you’re very aware of the price because you’re paying when you’re filling up your car, you’re paying at the pump and so you know exactly how much that cost you and you’re paying in advance of consuming. It’s not like, you know, you’re paying a month later after you’ve driven your car for a month. And my experience is [00:09:00] that most people are at least somewhat acquainted with the fuel economy of their car, and so they have a fairly good sense of how much they can drive with each particular gallon or litre of gasoline that they buy.

So, I think that that’s a situation in which people actually know the price, they have certain expectations about, you know, the fuel economy of the car that they’re using, and so how much it’s going to cost them to get to a certain destination or do their normal driving.

The story with the electricity and gas is a little bit different. So, first of all, electricity in your home is used for a gazillion different. It’s used for charging your phone, for watching TV or at least for turning on the TV and keeping it on, for running the dishwasher, the washing machine and all this kind of stuff. But first of all, I am convinced that the majority of the people actually have no idea about the consumption of each of their energy services, so of each load of laundry, of each time that they charged the phone that was completely empty to the point in which it’s a hundred percent charge. So, that’s, the dimension of [00:10:00] their lack of knowledge about this. And plus, I’m convinced that people don’t really know what the price per kilo per hour is, especially if the pricing scheme is complicated, which in many places it can be.

With natural gas, the story is a little bit different. I’m assuming that in the UK, the majority of homes are heated using natural gas, at least as of now, although this of course, you know, may change in the future. In that case, it’s a little bit easier because when natural gas is used the majority of the cost that you pay, or the bills that you pay, are really coming from heating your house, or maybe heating the water that you’re using for showers and such. Cooking also of course uses natural gas, but it’s a very, very small consumption compared to the rest. And so, if they had to moderate their consumption in a situation in which the prices are very high, they probably would know immediately what to do. They would turn down the thermostat, they would try to maybe wear an extra sweater in the house and keep the house a little bit colder, or they would try to make improvements to their home so that they can reduce consumption. But so, to conclude, it seems to me that [00:11:00] the price elasticity depends on a lot of different things, but it also depends on the usage of the energy and what particular type of energy.

Jose Luis Ramirez-Mendiola: Yeah, I definitely share your views because essentially what you’re saying is that now we have to undo a hundred years of telling people that they should just not worry about how much electricity they consume, because it’s always going to be there, which has led to people taking it for granted. Now we are trying to tell them, okay guys, you know, it’s not the same, whether you use energy now or tomorrow, or at different times of day even, because now we have a lot more renewables feeding energy into the system, so now we have to pay a bit more attention to what happens at different times of day or different days of week, different months and so on.

So, what do you think needs to happen in order to get people more engaged with these kind of issues. Jacopo, you mentioned this connection between energy and [00:12:00] services and how people might respond differently, depending on which services you are talking about. So, do you have a sense of what kind of changes we need to make in order to improve that relationship between people and energy consumption?

Jacopo Torriti: Yes, of course the current electricity and gas prices are very high compared with say, a year ago, right. We hear anecdotal evidence of people switching off their heating or attempting fuel substitution by burning logs in the middle of their living room with disastrous consequences in terms of fires and so on. This is a very sad state of affairs. It is, however, also an opportunity for research. So thorough understanding of what energy is for is a key for understanding how elastic people’s reactions to high prices are.

So, for instance, it might be unlikely that we see all washing machines you know, being replaced by [00:13:00] hand washing clothes or something like that, but it’s possible that fewer drying machines or tumble driers are used and are replaced by outdoor clothes drying, for instance.

Jose Luis Ramirez-Mendiola: Yeah. I mean, you have mentioned it already and it’s almost impossible not to talk about the current global energy price crisis, so, based on what we know, Anna, what would you say we should expect people to do?

Anna Alberini: response to the high energy prices of now? Hmm, good question. So here, I think it’s going to be important to distinguish between different cultures and different countries. I live in the US, and so I know that people are complaining about the high cost of motor fuels, for example.

But I also know that people generally don’t respond to changing prices in motor fuels, much at all. They may perhaps in other countries, and it would be interesting to compare for instance, what happens in the UK or in Italy or in Germany you know, which are obviously going to be impacted by the high prices of energy right now, you know, [00:14:00] high prices of gas and oil and that kind of stuff. In terms of what they can do in the home to reduce their use of energy, they can do a number of small things. You know, I always tell people that I walk around the house, essentially turning off the lights that my husband has left on.

I doubt that people in Europe are so careless as he is. But, you know, that would be one obvious thing to do, just to pay more attention to the stuff that is, you know, the low hanging fruit, so to speak. I’m not sure what’s going to happen in terms of heating. I wouldn’t be surprised if a lot of people are just going be turning down the thermostat a little bit in the winter, and maybe as I was saying earlier, putting on an extra sweater. I’m not quite sure what can be done to reduce consumption of electricity other than doing the obvious type of things, including the obvious conservation type of things. So, including maybe running the dishwasher only when it’s full, running your laundry only when you have a full load, as opposed to running a relatively empty one.

I know that in many places, including the country that I was born and raised in, and that would be [00:15:00] Italy, they’ve been offering massive amount of subsidies to help people do energy efficiency renovations over the years. And so, I don’t know if people are going to be perhaps know, taking up on that more than they have already. Those are all good questions for us to sort of watch and see what’s going to happen.

Jose Luis Ramirez-Mendiola: Yeah, absolutely. Thanks Anna. One of the reasons the two of you are working together to learn from one another, is that your work deals with different timeframes or different durations, let’s say, of the periods over which you are expecting a response to changes in price.

So, in your case, Anna, your work deals with the timing of these responses over longer periods of time. Whereas in the case of Jacopo, your work is more about changes at shorter time scales, like during the same day. So, what would you say are the main lessons you have learned from each other’s work?

Jacopo Torriti: This is the reason why it’s so [00:16:00] great working with Anna was such a great experience of research on price elasticity.

This is an extremely interdisciplinary space, one that forces economies to think outside the box of a relationship between price and demand, and prompts, behavioral scientists, and social practice theorists to rethink the role of price in relation to other values. So, for instance, as part of the, a project in CREDS, we are looking at how price elasticity varies during the day, based on people’s activities and occupancy of the home. We’re hoping to come out with meaningful connections between energy demand and time of day elasticity, which are of views to policymakers, industry, and research on price elasticity like the one that Anna carries out.

Anna Alberini: Well, I guess, you know, I admire Jacopo’s ability and success in acquiring data that I personally don’t even have access to. So, data that essentially reports or documents [00:17:00] the changing nature of consumption throughout the course of the day. The majority of my research activity has been limited by the fact that I never had access to such data before, although Jacopo and I had a project together that was looking at variation in electricity usage in Italy on an hour by hour type of basis, a little while ago. So, I very much admire his ability to get these data and to make something really, really interesting out of it. It sounds like the data that he has actually contains information about, you know, people’s behaviors on a much more granular level than I have had access to. To my credit, I will say that I am the kind of person that likes to play with the data and try to infer more by looking at different time scales, looking at different types of aggregation, like looking at a single household compared to a group of households in the same county or country or you know, hemisphere or something of this kind.

But I do hope, Jacopo, there will be more opportunities for the two of us to work together into areas that are related to price elasticities [00:18:00] because our work is so nicely complimentary, it seems to me.

Jacopo Torriti: Of course, and I really look forward to that.

Jose Luis Ramirez-Mendiola: Excellent, that’s what I like to hear, let’s keep working on this. So, we are approaching the end of the episode, so I’m just going to ask both of you if you have any final thoughts you would like to share about, you know, your research on these issues of price elasticity, or how would you envision this research evolving in the near future?

Jacopo Torriti: So in recent years, I’ve seen an increase in data in this field. We’re hoping that this trend continues as this will facilitate research for instance on how time varying electricity tariffs will contribute to a net-zero future, new information about real time pricing, the use of heat pumps, and the charging of electric vehicles will improve our knowledge in, in this area.

And we look forward to collaborations with colleagues like Anna to improve this field.

Jose Luis Ramirez-Mendiola: What about you, Anna?

Anna Alberini: I guess one pressing [00:19:00] issue that I personally have as part of my research agenda is really trying to understand how people form expectations or prices in the future and how they base their behavior and their decisions.

So, I think that it would be extremely stimulating if some actual talking to people, serving people, finding out, you know, what kind of expectations they have for the future or whether they don’t have any, whether they are like in the complete darkness about it. I think that that would be a very important part of future research especially given the energy price climate that we’re in right now.

Jose Luis Ramirez-Mendiola: Definitely lots more to do in this area. So, I guess that will keep us busy for years to come. I believe that’s all we have time for today, so thanks so much for sharing your insights with us. And I hope that our listeners find it as interesting as I have. So, thank you very much for joining us and goodbye.

Jacopo Torriti: Thank you.

Anna Alberini: Goodbye, thanks, goodbye.

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