“Analysis of Distorted Energy Prices in Iran,” by Mehdi Sadeghi

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THE JOURNAL OF ENERGY

AND DEVELOPMENT

Mehdi Sadeghi,

“ Analysis of Distorted Energy

Prices in Iran ,”

Volume 37, Number 1

Copyright 2012



ANALYSIS OF DISTORTED ENERGY

PRICES IN IRAN

Mehdi Sadeghi*

Introduction

Energy pricing is one of the most fundamental tools in the integrated national

energy planning (INEP) procedure in developing countries. The scope and

objectives of pricing in this integrated framework would include the following.

First, social welfare considerations cannot be attained without rational pricing

mechanisms. If there are distortions in energy prices they easily result in mis-

allocation of resources. Second, energy conservation cannot be realized by im-

proper energy pricing. For instance, in order for the effective implementation of

demand-side management (DSM), rational energy prices are needed. Third, op-

timal investment decisions are based on demand fulfillments and this will not berealized with distorted energy prices. Fourth, to reach partial equilibrium in the

energy sector, prices should be based on marginal opportunity cost of the energy

resources and, therefore, it is argued that energy subsidization will inhibit optimal

resource allocation. Finally, energy is regarded as an essential input in the pro-

duction function; thus, distortions in energy prices will cause higher production

costs.

*Mehdi Sadeghi, Associate Professor at the Imam Sadiq University in Tehran, Iran, holds a Ph.D.

in economics from Tehran University and master’s and bachelor’s degrees in economics from Imam

Sadiq University. The author’s areas of academic expertise are economic planning, econometrics,

energy economics, and energy demand and supply modeling. Dr. Sadeghi previously held positions

with the Iranian Ministry of Energy and is currently President of the School of Economic Sciences.

The author, who has served as Scientific Secretary of the Eighth International Energy Conference

held in Iran, has participated in projects dealing with energy economics and presented papers at

international conferences.

The Journal of Energy and Development , Vol. 37, Nos. 1 and 2

Copyright Ó 2012 by the International Research Center for Energy and Economic Development(ICEED). All rights reserved.

45



The energy sector in Iran is facing a critical situation at the present time (2012).

A reduction of oil revenues, coupled with increasing domestic energy consump-

tion, has forced the government to implement policies to reduce energy subsidies

in order to manage public expenditures in this sector. Quantitative analysis of the

distributional effect of energy subsidies in Iran indicates that they result in thewelfare transfer to higher-income households. This contradictory situation en-

hances the social welfare losses due to energy subsidies, which are the sum of

losses due to the price distortion and unjustified redistribution of economic re-

sources to the benefit of groups with higher incomes.1

In this paper, first the theoretical background for energy pricing and distortion

(subsidization) is introduced. Next, the econometric model and the empirical

evidence of energy price distortions (subsidization) is analyzed using cointegra-

tion analysis. The policy implications of price distortions and the main conclu-

sions comprise the fifth and sixth sections, respectively.

Theoretical Background

Two basic mechanisms can be considered in order to decrease energy con-

sumption growth rates. The first is the removal of price distortions (subsidies),

which is concerned with pricing mechanisms, and the second is autonomous en-

ergy efficiency improvement (AEEI), which represents a non-pricing mechanism.Regarding the removal policy for price distortions, the important issue is the

estimation of the shadow price and its difference with domestic market prices. In

figure 1, efficient energy pricing with shadow prices has been shown. The (sub-

sidized) domestic market-priced demand curve for the energy carrier is given by

the curve D(Q), which is the consumer’s willingness to pay. The dashed curve

b3 D(Q) shows the shadow-priced demand curve. Here b is a conversion factor

that shows the relative distortion or ratio of the shadow price to the domestic

market price of the energy carrier (e.g., if the energy domestic market price is one

half of its shadow price, then b = 2). MOC (Q) and MOC /b represent the shadow- priced and the domestic market-priced supply curves, respectively.

Assume a small increment of consumption DQ at the market price P. The

traditional optimal pricing approach attempts to compare the incremental benefit

of consumption due to DQ, (the area between the demand curve and the horizontal

axis), with the corresponding supply cost (the area between the supply curve and

the horizontal axis). Since MOC (Q) is shadow-priced, D(Q) also must be trans-

formed into a shadow-priced curve to make the comparison valid. The shadow

cost of expenditure is b( P3DQ). Thus, at the price P, incremental benefits EGJL

exceed incremental costs EFKL. The optimal consumption level is Qopt , where the MOC (Q) and b3 D(Q) curves cross or, equivalently, where market-priced supply

curve MOC (Q)/b and market demand curve D(Q) intersect. The efficient price to

THE JOURNAL OF ENERGY AND DEVELOPMENT46



be charged to consumers (since they react along the market-priced demand curve

not the shadow-priced demand curve) will be Pe = MOC (Q)/b. At this level of

consumption, the shadow costs and benefits of marginal consumption will be

equal, MOC (Q) = b3 D(Q). Since b depends on specific consumption patterns,

different values of the efficient price Pe may be derived for various consumptioncategories. Therefore, Pe = MOC (Q)/b shows a second-best adjustment.

On the other side, autonomous energy efficiency improvement simply represents

the potential increase in non-price efficiency improvements and the decrease in the

energy system supply costs. This mechanism is based on endogenous growth and

learning-by-doing modeling, in which it is argued that energy system costs will

exhibit a downward trend. Market barriers such as asymmetric information and

transaction costs should be removed; otherwise, this mechanism will not be effective.

In terms of Iran’s present situation, the nation’s energy market has its own

special set of characteristics. It has been state-owned for many years and the gov-ernment has responsibility for production, transmission, and distribution of all kinds

of energy carriers. In the case of excess demand, sufficient energy is imported by the

government to fulfill demand. All investments needed for the development of the

energy sector are financed and managed by the government. Thus, the supply side of

the Iranian energy market is exogenous and it is adjusted to the demand for energy.

Accordingly, the energy pricing mechanism is government oriented and supported

by on-budget subsidies. It is quite apparent that off-budget subsidies are less trans-

parent and generally more variable over time than on-budget subsidies.2 However, the

energy price is determined in a socioeconomic context with severe political consid-erations. Iran is an energy abundant country and the general view of the consumers is

that no higher costs would be needed for the provision of energy. Therefore, all the

Figure 1EFFICIENT PRICING WITH SHADOW PRICES

Source: M. Munasinghe, Energy Analysis and Policy (Guildford, United Kingdom: Butterworth

& Co. Ltd., 1990).

IRAN: ANALYSIS OF DISTORTED ENERGY PRICES 47



prices are distorted from their marginal costs and, thus, the demand side of the energy

market is influenced by this kind of pricing mechanism.

The Econometric Model

The main determinants of energy demand are economic activities and real

energy price. Economic theory postulates that there is a long-run relationship

between energy consumption and energy price. This long-run relationship and the

consequences of energy price distortion are investigated in this paper. In order to

express the long-run relationship between energy consumption and energy price,

an autoregressive distributed lag (ARDL) approach, based on cointegration, is

used.3 Since sufficient data were not available, a methodology utilizing a vector-

error correction model (VECM) encountered limitations.

Emprical Results

Stationary tests of the augmented Dickey-Fuller were performed based on en-

ergy consumption, real energy price, and national income data during the period

1967–2009. According to these tests, the time series with which we were concerned

are integrated to the order of one. For testing cointegration, the Johansen and

Juselius approach was applied.

4

This methodology is used because of its advantagesin comparison to the Engle-Granger approach.5 At least one long-run relationship

was proven among energy consumption, economic activity, and real energy price.

Seven ARDL models were designed, and in each ARDL model the optimum lag

length was found to be ‘‘1.’’ This lag length was derived according to the Schwarz

information criterion, the Hannan-Quin information criterion, and the Akaike in-

formation criterion. The results of ARDL approach are reported in table 1.

Cointegrated vectors in energy consumption will show the long-run price elasticity

and long-run income elasticity for the selected energy carriers (table 2). All long-run

price elasticities are significant with the exception of natural gas and electricity.For gasoline demand all short- and long-run price elasticities are less than

unity. The adjustment coefficient is estimated at –0.19, indicating that, following

the occurrence of a shock, it takes at least five years to be removed. The same

adjustment coefficient would be for gas-oil demand. The largest adjustment co-

efficient is for kerosene demand. The short-run price elasticity of kerosene de-

mand is insignificant, indicating an unimportant role of price in the short run. The

short-run price elasticities of natural gas and electricity were not significant. All of

the findings based on the cointegration approach indicate that the removal of

energy price distortions (in fact, subsidization removal) cannot play an effectiverole in energy conservation in Iran. For a measurable energy conservation plan to

be implemented effectively, a considerable energy price adjustment would be




T a b l e 1

T H E A U T O R E G R E S S I V E D

I S T R I B U T E D L A G ( A R D L ) M

O D E L S R E S U L T S F O R E N E

R G Y C O N S U M P T I O N I N I R A

N a

E n e r g y

C a r r

i e r s

V a r

i a b l e s

G a s o

l i n e

G a s

O i l

K e r o s e n e

L i q u e

f i e d P e t r o

l e u m

G a s

( L P G )

F u e

l O i l

N a t u r a

l

G a s

E l e

c t r i c i t y

I n t e r c e p t

1 . 0 2 ( 3 . 5 )

0

. 6 ( 1 . 0 4 )

0 . 9 1 ( 0 . 9 8 )

0 . 1 0 ( 0 . 1 9 )

2 . 4 6 ( 2 . 5 1 )

—

—

D

L G D P

—

0 . 4 4 ( 3 . 1 2 )

0 . 5 1 ( 3 . 6 8 )

0 . 2 2 ( 2 . 7 7 )

—

0 . 3 8 ( 3 . 0 7 )

0 . 4 1

( 5 . 5 )

D

L V A T

0 . 1 8 ( 3 . 8 9 )

—

—

—

—

—

—

D

L V A I M

—

—

—

—

0 . 1 7 ( 5 . 7 )

—

—

D

L R P G

A

– 0 . 2 2 ( – 4 . 0 1 )

—

—

—

—

—

—

D

L R P K

E

—

—

– 0 . 0 0 5 ( 0 . 0 6 )

—

—

—

—

D

L R P G

O

—

– 0 . 1 0 ( – 1 . 5 7 )

—

—

—

—

—

D

L R P F

—

—

—

—

– 0 . 0 7 ( – 1 . 4 5 )

—

—

D

L R P L P G

—

—

—

– 0 . 1 2 ( – 3 . 5 6 )

—

—

—

D

L R P N

G

—

—

—

—

—

– 0 . 1 ( – 0 . 6 4 )

—

D

L R P E L

—

—

—

—

—

—

– 0 . 0 2 ( – 0 . 6 0 )

D 6 8

—

—

—

—

—

0 . 4 8 ( 2 . 3 3 )

—

E c t ( - 1 )

– 0 . 1 9 ( – 5 . 8 2 )

– 0 . 1 9 ( – 2 . 3 0 )

– 0 . 5 2 ( – 4 . 4 2 )

– 0 . 2 1 ( – 6 . 3 9 )

– 0 . 3 5 ( – 2 . 8 2 )

– 0 . 3 4 ( – 3 . 1 7 )

– 0 . 0 6 ( – 2 . 3 2 )

a

N u m b e r s i n t h e p a r e n t h e s i s i n d i c a t

e ‘ ‘ t ’ ’ s t a t i s t i c ; D

L P G D P = f i r s t d i f f e r e n c e o f n a t u r a l l o g a r i t h m

o f G r o s s D o m e s t i c P r o d u c t ; D

L V A T = f i r s t

d i f f e r e n c e o f n a t u r a l l o g a r i t h m o f V a l u e

A d d e d o f T r a n s p o r t a t i o n S e c t o r ; D

L V A I M = f i r s t d i f f e r e n c e o f

n a t u r a l l o g a r i t h m o f V a l u e A d d e d o f I n d u s t r y

S e c t o r ; D

L R P G A = f i r s t d i f f e r e n c e o f n

a t u r a l l o g a r i t h m o f R e a l P r i c e o

f G a s o l i n e ; D

L R P K E = f i r s t d i f f e r e n c e o f n a t u r a l l o g a r i t h m o f

R e a l P r i c e o f

K e r o s e n e ; D

L R P G O = f i r s t d i f f e r e n c e o f

n a t u r a l l o g a r i t h m o f R e a l P r i c e o f G a s O i l ; D

L R P F = f i r s t d i f f e r e n c e o f n a t u r a l l o g a r i t h m o f R e a l P r i c e o f F u e l

O i l ; D L R P L P G = f i r s t d i f f e r e n c e o f n a t u

r a l l o g a r i t h m o f R e a l P r i c e o f L

P G ; D

L R P N G = f i r s t d i f f e r e n c e o f n a t u r a l l o g a r i t h m o f R e a l P r

i c e o f N a t u r a l

G a s ; D L

R P E L = f i r s t d i f f e r e n c e o f n a t u r a l l o g a r i t h m o f R e a l P r i c e o f E l e c t r i c i t y ; D 6 8 = D u m m y V a r i a b l e f o r n a t u r a l g a s n e t w o r k e x p a n s i o n ; a n d E c t =

e r r o r c o r r e c t i o n t e r m .




T a b l e 2

C O I N T E G R A T E D V E C T O R S

F O R E N E R G Y C O N S U M P T I O N a

E n e r g y

C a r r

i e r s

V a r

i a b l e s

G a s o

l i n e

( L G a

)

G a s

O i l

( L G o

)

K e r o s e n e

( L K E )

L i q u e

f i e d P e t r o

l e u m

G a s

( L L P G )

F u e

l O i l

( L F )

N a t u r a

l G a s

( L N G )

E l e

c t r i c i t y

(

L E L )

I n t e r c e p t

– 5 . 5 1 ( 3 . 7 )

– 3

. 1 1 ( 1 . 2 6 )

– 1 . 7 4 ( 1 . 0 3 )

– 0 . 4 9 ( 0 . 1 8 )

– 7 . 0 8 ( 7 . 0 5 )

—

—

L G a

1

—

—

—

—

—

—

L G o

—

1

—

—

—

—

—

L K E

—

—

1

—

—

—

—

L L P G

—

—

—

1

—

—

—

L F

—

—

—

—

1

—

—

L N G

—

—

—

—

—

1

—

L E L

—

—

—

—

—

—

1

L G D P

—

– 0

. 9 5 ( 3 . 7 )

– 0 . 9 8 ( 5 . 5 5 )

– 1 . 0 4 ( 3 . 8 3 )

—

– 1 . 1 1 ( 2 1 . 4 1 )

– 1 . 2 3

( 3 6 . 1 1 )

L V A T

– 0 . 9 7 ( 5 . 9 6 )

—

—

—

—

—

—

L V A I M

—

—

—

—

– 0 . 4 9 ( 3 . 7 6 )

—

—

L R P G A

0 . 4 7 ( – 3 . 0 5 )

—

—

—

—

—

—

L R P K E

—

—

0 . 2 7 ( – 4 . 5 5 )

—

—

—

—

L R P G O

—

0

. 5 1 ( – 3 . 9 3 )

—

—

—

—

—

L R P F

—

—

—

—

0 . 2 1 ( – 2 . 3 4 )

—

—

L R P L P G

—

—

—

0 . 5 6 ( – 5 . 7 4 )

—

—

—

L R P N G

—

—

—

—

—

0 . 2 9 ( – 0 . 7 3 )

—

L R P E L

—

—

—

—

—

—

0 . 3 4

( – 0 . 7 8 )

a

A l l

v a r i a b l e s a r e i n n a t u r a l l o g a r i t h

m f o r m .




needed; yet, such an extraordinary energy price adjustment would cause tre-

mendous and simultaneous inflationary effects.

Energy prices in Iran are distorted from their optimal levels. In the year 2009,

total distortion for seven energy carriers was equivalent to U.S. $41.9 billion. Total

goods and services subsidies for the year 2009 were approximately U.S. $8 billion.For the same year, the per-capita subsidy payment, including the energy subsidy,

amounted to U.S. $710.

In order to compute the inflationary impact of an energy price adjustment, an en-

ergy input/output model has been used. Based on this model, all energy price distor-

tions for the year 2006 were removed and their inflationary impacts calculated. The

results show that this removal will cause an inflation growth rate of 65.55 percent.6

Policy Implications

Our results indicate that the energy price short- and long-run elasticities are less

than unity (tables 1 and 2). Therefore, to obtain considerable energy conservation

targets will necessitate extraordinary energy price adjustments. Removing all

energy price distortions in Iran will result in an extremely large inflationary im-

pact. In order to challenge this situation, non-price policies (e.g., autonomous

energy efficiency improvement) in the energy sector could provide the foundation

for optimal energy pricing policies. To fully realize a successful energy efficiency

plan, the energy price distortions removal is a necessary condition, but other market barriers also should be focused upon and taken into consideration.

Conclusions

Clearly, energy pricing issues, price distortions, and building an effective en-

ergy conservation plan are critical for Iran. From our research, we have reached

the following main conclusions. First, short- and long-run energy price elasticities

in Iran are less than unity. Second, in order to perform a considerable energy

conservation plan, a complicated energy price adjustment is needed. Third, energy price distortions (subsidization) removal will cause an inflationary effect resulting

in welfare decreasing. Last, non-price energy policies in the energy sector (such as

autonomous energy efficiency improvement) could provide an appropriate

background for effective energy pricing policies.

NOTES

1Y. Saboohi, ‘‘An Evaluation of the Impact of Reducing Energy Subsidies on Living Expenses

of Households,’’ Energy Policy, vol. 29, no. 3 (2001), pp. 245–52.

2R. Steenblik, ‘‘A Note on the Concept of Subsidy,’’ Energy Policy, vol. 23, no. 6 (1995), pp.

483–84.




3R. Fouquet, ‘‘The Impact of VAT Introduction on U.K. Residential Energy Demand: An In-

vestigation Using the Cointegration Approach,’’ Energy Economics, vol. 17, no. 3 (1995), pp. 237–

47, and M. H. Pesaran and S. Yongcheol, ‘‘An Autoregressive Distributed Lag Modeling Approach

to Cointegration Analysis,’’ in Econometrics and Economic Theory in the 20th Century: The

Ragnar Frisch Centennial Symposium, ed. S. Strom (Cambridge: Cambridge University Press,

1999), chapter 11.

4S. Johansen and K. Juselius, ‘‘Maximum Likelihood Estimation and Inference on Cointegration–

With Applications to the Demand for Money,’’ Oxford Bulletin of Economics and Statistics, vol. 52,

no. 2 (1990), pp. 169–210.

5R. F. Engle and C. W. J. Granger, ‘‘Cointegration and Error-Correction: Representation, Es-

timation and Testing,’’ Econometrica, vol. 55, no. 2 (1987), pp. 251–76.

6The Energy Input-Output Table for Iran in 2006 (Tehran, Iran: Ministry of Energy, 2008) (in

Persian).


“Analysis of Distorted Energy Prices in Iran,” by Mehdi Sadeghi

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