Case Study — Energy Transition, Natural Gas and the Oil Market

Case

Figure 1: Share of net electricity generation, world (per cent)

Figure 1 is a stacked area/line chart of the world’s share of net electricity generation by source from 2010 to a 2050 projection. It shows coal’s share declining over the period while the share generated from renewables rises; natural gas holds a roughly constant share of around 20 per cent over 2010–2020. The chart distinguishes a small number of sources (coal, natural gas, nuclear, renewables, and a residual), so natural gas has only a few close substitutes as a generation fuel.

Source: US Energy Information Administration, accessed 28 Jul 2022.

Extract 1: Increase in electricity prices in Singapore

Since the start of the year, we have seen a rapid increase in inflation in Singapore. One essential area where Singapore households would have experienced inflation is electricity bills. In his May Day Rally speech, Prime Minister Lee Hsien Loong spoke about the impact of soaring energy prices on Singapore and its people. Against a backdrop of increasing electricity cost which fuels inflation, and rising sea levels due to global warming, experts have claimed that Singapore’s move towards renewable energy sources has become more important than ever for the island nation.

But what exactly are the factors that have led to this increase in electricity prices? Singapore is a country with limited natural resources, and imports almost all its energy needs. This means, like many other goods that the country imports, the prices it pays for electricity are largely determined by external factors outside its control.

In Singapore, about 95 per cent of electricity is generated from imported natural gas. The current conflict in Ukraine has resulted in the tightening of oil and natural gas supply. Unfortunately, a confluence of other factors has also caused the prices of oil and natural gas to spike since the second half of 2021. These include an increase in demand for oil and natural gas as major economies recover from the pandemic, seasonally high energy consumption during the winter months in the Northern Hemisphere, and a series of unexpected gas production outages that led to a supply–demand mismatch in global energy markets.

To be clear, natural gas is not the only way to generate electricity. There are other options like coal and oil to generate heat, which is subsequently used to produce steam to generate electricity. However, such fuels, like natural gas, would be extremely pollutive. The use of renewable sources of energy like solar energy is another method to generate electricity in a relatively more non-pollutive way. Due to the small land size of Singapore and high population density, there is a greater need to set up our solar power infrastructure in creative ways. However, whether that is a viable method varies for different countries.

Sources: Adapted from Channel News Asia, 16 May 2022, and Dollars and Sense, 7 July 2022.

Extract 2: OPEC members urge oil producers to focus more on renewable energy

The finance minister of Iraq, one of the founding members of the global oil cartel, the Organisation of the Petroleum Exporting Countries (OPEC), urges oil producers to pursue “an economic renewal focussed on environmentally sound policies and technologies” that would include solar power and potentially nuclear reactors, and reduce their dependency on fossil fuel exports. Along with the executive director of the International Energy Agency, Fatih Birol, he wrote: “To stand a chance of limiting the worst effects of climate change, the world needs to fundamentally change the way it produces and consumes energy, burning less coal, oil and natural gas. If oil revenues start to decline before producer countries have successfully diversified their economies, livelihoods will be lost, and poverty rates will increase.”

Allawi, Deputy Prime Minister of Iraq, suggested current oil price volatility, driven by the pandemic, was only the beginning of problems for producers. The climate crisis will not only require a move away from oil but will strike the Middle East and North Africa particularly badly, where rising temperatures are already causing severe problems. An alternative to remaining tied to increasingly volatile oil prices would be to invest in renewables, especially solar power. The shift away from oil would also translate to keeping the price of oil high and stable.

A common problem that OPEC faces is that, while the OPEC countries would like to maintain a high price of oil, each member of the cartel is tempted to increase its production in order to get a larger share of the total profit. The OPEC members frequently agree to reduce production but then cheat on their agreements.

Source: Adapted from Guardian, 1 Sep 2021.

Extract 3: Singapore’s strategy

Singapore is putting more money into low-carbon research, with two new funds totalling 10 million dollars going to twelve research projects in the areas of hydrogen and carbon capture, utilisation and storage. Second Minister for Trade and Industry Tan See Leng said: “A key prong of our energy transition strategy is to invest in technology and innovation to address our energy challenges and sustainable development objectives.”

The new funding initiatives include a 4 million dollar partnership between the Energy Market Authority (EMA) and technology company Envision Digital International to help local energy companies focus on renewable energy, urban energy efficiency and low-carbon solutions. Another 6 million dollars from EMA and industrial developer JTC, with support from Enterprise Singapore, will fund successful ideas submitted under the Jurong Island renewable energy request for proposals.

Source: The Straits Times, 23 November 2021.

Questions

(a) State one key observation about the share of net electricity generation between 2010 and 2050 and briefly explain one possible reason for this observation. [2]

(b) Using a diagram, explain how the conflict in Ukraine (Extract 1) is likely to have affected both producer surplus and consumer surplus in the market for natural gas. [4]

(c) Explain the likely change in the value of price elasticity of supply of natural gas over time. [2]

(d) From a producer’s perspective, discuss the factors that an individual member of the OPEC cartel would consider when deciding whether to reduce dependency on fossil fuel export by focusing on more environmentally sound policies and technologies. [8]

(e)(i) Explain why the market for energy generated from natural gas fails. [4]

(e)(ii) Discuss whether demand or supply factors have a greater impact on the market for oil. [10]

[Total: 30]

Answers

(a) State one key observation about the share of net electricity generation between 2010 and 2050 and briefly explain one possible reason. [2] (state / explain)

Coal’s share of net electricity generation is decreasing while the share generated from renewables is increasing. As government policies encourage consumers and producers to reduce dependency on fossil fuels, they turn to alternative energy sources, including renewables.

Marking points: any one valid observation — 1m; any plausible reason — 1m.

(b) Using a diagram, explain how the conflict in Ukraine is likely to have affected both producer surplus and consumer surplus in the market for natural gas. [4] (explain)

Consumer surplus is the difference between the maximum price buyers are willing and able to pay and the actual equilibrium price; producer surplus is the difference between the actual price and the minimum price producers are willing to sell at. The conflict in Ukraine is a negative supply shock that falls the supply of natural gas from S₀ to S₁. Price rises from P₀ to P₁ and quantity falls. Consumer surplus falls from area ACP₀ to area ABP₁; producer surplus falls from area P₀CE to area P₁BD.

Marking points: define producer and consumer surplus — 1m; explain the impact of the conflict — 1m; identify and explain the change in each surplus — 1m; diagram — 1m.

(c) Explain the likely change in the value of price elasticity of supply of natural gas over time. [2] (explain)

Price elasticity of supply is likely to increase over time, becoming more elastic. Over time, producers can use research and development to raise their productive capacity for natural gas, so that when price rises there is a larger proportionate increase in quantity supplied.

Marking points: identify the correct direction of change — 1m; one reasonable explanation — 1m.

(d) From a producer’s perspective, discuss the factors an individual OPEC member would consider when deciding whether to reduce dependency on fossil fuel export by focusing on more environmentally sound policies and technologies. [8] (discuss)

This is a rational decision-making question: the factors a rational, profit-seeking producer weighs before switching away from fossil fuels.

Introduction. A producer is a rational decision-maker who weighs costs, benefits, and constraints before acting.

Requirement 1 — costs versus benefits. The producer considers the costs of focusing on environmentally sound technologies: explicit costs of building infrastructure and conducting research, and implicit (opportunity) costs of the profits foregone from the next best use of those funds. Renewable infrastructure such as solar panels or wind farms is costly, so the economic cost is high. Against this, the producer weighs the benefits, measured as profits. As prices of non-renewable energy spike (Extract 1), demand for renewable energy — a close substitute — rises, so the total revenue and profits of renewable producers increase, ceteris paribus. By the marginalist principle, if the benefits of switching outweigh the costs, the producer switches.

Requirement 2 — constraints. Even when benefits exceed costs, a producer facing budget or information constraints may be unable to switch: renewables are a niche industry needing costly R&D, and the firm may lack the technical knowledge to switch successfully. If it lacks the budget or information, it is willing but unable, and so does not switch. However, OPEC members operate in a highly concentrated (oligopolistic) industry and are likely to earn high (supernormal) profits, so significant budget constraints are unlikely.

Evaluation and judgement. Costs and benefits are the most important factor. Information is unlikely to bind, because the skills and knowledge of the non-renewable and renewable energy industries overlap substantially, so the producer is unlikely to suffer severe imperfect information. But because producers are profit-maximising, they will not switch unless the long-run benefits outweigh the costs — so the cost–benefit comparison is decisive.

(e)(i) Explain why the market for energy generated from natural gas fails. [4] (explain)

Generating energy from natural gas is “extremely pollutive” (Extract 1), harming the health of third parties living near generation sites. This negative production externality drives a divergence between marginal private cost (MPC) and marginal social cost (MSC). Rational private producers produce where MPB = MPC, at Qₘ, but society’s welfare is maximised where MSB = MSC, at the lower Qₛ. Since Qₘ exceeds Qₛ, there is over-production and over-allocation of resources — allocative inefficiency — and a deadweight welfare loss of triangle ABC.

Marking points: graph — 1m; explain the MPC/MSC divergence — 1m; explain over-production — 1m; identify the deadweight loss — 1m.

(e)(ii) Discuss whether demand or supply factors have a greater impact on the market for oil. [10] (discuss)

Thesis — demand factors. Extract 1 indicates rising demand for oil as major economies recover from the pandemic, reflecting improving consumer and producer confidence. Demand shifts right from D₀ to D₁. At the original price there is a shortage; by the law of demand and the law of supply, the resulting upward pressure raises price from P₀ to P₁ and quantity to a new equilibrium, raising total expenditure on oil.

Anti-thesis — supply factors. Extract 1 also notes the Ukraine conflict has tightened oil supply — a negative supply shock as some producers can no longer produce. Supply falls from S₀ to S₁. Figure 1 suggests demand for this fuel is relatively price-inelastic, since it has few close substitutes (only a handful of generation sources). So as supply falls, price rises more than proportionately while quantity demanded falls less than proportionately, again raising total expenditure on oil.

Evaluation and judgement. Supply factors are likely to have the greater impact. The demand boost from the recovering global economy is a short-run effect, whereas the war in Ukraine is ongoing, and even after it ends the damage to producers’ capital, land, and infrastructure may take years to repair. The fall in supply therefore persists longer, so supply factors dominate the oil market.