The first of two book chapters for Elgar encyclopedias I recently wrote.
What is the Role of Energy in Economic Activity?
The economic system must operate within the constraints determined by the laws of physics and human knowledge of technology. Production, including household production, requires energy to carry out work to convert materials into desired products and to transport raw materials, goods, and people. The second law of thermodynamics implies that energy cannot be recycled and that there are limits to how much energy efficiency can be improved. Therefore, energy is an essential factor of production, and continuous supplies of energy are needed to maintain existing levels of economic activity as well as to grow and develop the economy (Stern, 1997). The first law of thermodynamics states that energy cannot be created and so energy (and matter) must be extracted from the environment. Also, energy must be invested in order to capture useful energy (Hall et al., 1986). Before the Industrial Revolution, economies depended on energy from agricultural crops and wood as well as a smaller amount of wind and waterpower, all of which are directly dependent on the sun (Kander et al., 2015). This is still largely the case in the rural areas of the least developed countries. While solar energy is abundant and inexhaustible, it is very diffuse compared to concentrated fossil fuels. This is why the shift to fossil fuels in the Industrial Revolution relaxed the constraints on energy supply and, therefore, on production and growth (Wrigley, 1988).
How Does Energy Use Change with Economic Development?
Figure 1 shows that energy use per capita increases with GDP per capita, so that richer countries tend to use more energy per person than poorer countries. The slope of the logarithmic regression line implies that a 1% increase in income per capita is associated with a 0.8% increase in energy use per capita. As a result, energy intensity – energy used per dollar of GDP – is on average lower in higher income countries. These relationships have been very stable over the last several decades (Csereklyei et al., 2016). Energy intensity in today’s middle-income countries is similar to that in today’s developed countries when they were at the same income level (van Benthem, 2015).
Figure 1. GDP and Energy Use per Capita 2018
Energy intensity has also converged across countries over time, so that countries that were more energy intensive in the 1970s tended to reduce their energy intensity by more than less energy intensive countries, and the least energy intensive countries often increased in energy intensity. Though data are limited to fewer and fewer countries as we go back further in time, these relationships also appear to hold over the last two centuries – energy use increased, energy intensity declined globally, and countries converged in energy intensity (Csereklyei et al., 2016). Though data is even more limited, it seems that the share of energy consumption expenditure and production costs also declines as countries develop (Csereklyei et al., 2016; Burke et al., 2018).
The mix of fuels used changes over the course of economic development. Figure 2 shows the average mix of energy sources in each of five groups of countries ordered by income per capita in 2018. In the lowest income countries in the sample (approximately below $5,000 per capita in 2017 purchasing power parity adjusted dollars), traditional use of biomass such as wood and agricultural waste dominates and oil use for transportation as well as electricity generation and other uses is the second most important energy source. As we move to richer countries, the relative role of biomass declines radically, and first oil and then natural gas and primary electricity increase in importance. Note that biomass use per capita in the richest quintile (above $40,000 per capita) is actually greater than in the lowest quintile, as total energy use increases with income. The ways in which this biomass is used will of course be quite different. Higher quality fuels are those that provide more economic value per joule of energy content by being converted more efficiently, being more flexible or convenient to use, and by producing less pollution. We would expect that lower income households would be more willing to tolerate the inconvenience and pollution caused by using lower quality fuels to produce energy services. So as household income increases, we would expect households to gradually ascend an “energy ladder” by consuming higher quality fuels and more total energy. Recent studies often find a more ambiguous picture where multiple fuels are used simultaneously as modern fuels are added to the use of traditional fuels (Gregory and Stern, 2014).
Figure 2. Fuel Mix and Development 2018
In 2016, approximately one billion people remained without access to electricity at home (International Energy Agency, 2017). Around 85% of these people lived in rural areas. There has been rapid progress in electrification in recent years with both grid expansion and the spread of off-grid systems (Burke et al., 2018; Lee et al., 2020). Due to the complexity and costs of electricity-sector management and constrained and weak institutions, power supply is usually less reliable in developing countries than in developed countries (Figure 3) and electricity theft is also more common (Burke et al., 2018). Best and Burke (2017) found that countries with higher levels of government effectiveness have achieved greater progress in providing access to reliable electricity. Industry and other electricity consumers, therefore, often rely on self-generation of electricity, but this is a costly solution (Fingleton-Smith, 2020).
Figure 3. Electricity Reliability and Development 2017
Does Energy Use Drive Economic Growth?
Economic growth refers to the process that results in increasing GDP per capita over time while development refers to a broader range of indicators including health, education, and other dimensions of human welfare. However, GDP per capita is highly, although not perfectly, correlated with broader development measures (Jones and Klenow, 2016) and so it is worth considering what the role of energy is in economic growth.
Mainstream economic growth models largely ignore the role of energy in economic growth and focus on technological change as the long-run driver of growth. On the other hand, there is a resource economics literature that investigates whether limited energy or other resources could constrain growth. By contrast, many ecological economists believe that energy plays the central role in driving growth and point to the switch traditional energy sources to fossil fuels as the cause of the industrial revolution (Stern, 2011).
To reconcile these opposing views, Stern and Kander (2012) modified Solow’s neoclassical growth model (Solow, 1956) by adding an energy input that has low substitutability with capital and labor. Their model also breaks down technological change into those innovations that directly increase the productivity of energy– energy-augmenting technical change and those that increase the productivity of labor – labor-augmenting technical change. In this model, when energy is superabundant the level of the capital stock and output are determined by the same functions of the same factors as in the Solow model. But when energy is relatively scarce, the size of the capital stock and the level of output depends on the level of energy supply and the level of energy-augmenting technology. Therefore, in the pre-industrial era and possibly when energy was scarce – and possibly in developing countries today – the level of output was determined by the supply of energy and the level of energy augmenting technology. Until the industrial revolution, output per capita was generally low and economic growth was not sustained (Maddison, 2001). After the industrial revolution, as energy became more and more abundant, the long-run behavior of the model economy becomes more and more like the Solow growth model. If this model is a reasonable representation of reality, then mainstream economists are not so wrong to ignore the role of energy in economic growth in developed economies where energy is abundant, but their models have limited applicability to both earlier historical periods and possibly to today’s developing countries. McCulloch and Zileviciute (2017) find that electricity is often cited as a binding constraint on growth in the World Bank’s enterprise surveys. Energy is expensive relative to wages in developing countries. The price of oil is set globally, and the share of electricity in costs or expenditures can be very high in middle income countries (Burke et al., 2018).
Electricity and Development
Access to energy and electricity, in particular, is a key priority for policymakers and donors in low-income countries. For example, the United Nations’ Sustainable Development Goal 7 targets universal access to modern energy by 2030. Electrification can allow poor households to have easy access to lighting for evening chores or studying and power for phone charging and for a range of new small business activities, both on and off the farm (Lee et al., 2020). Electricity access allows a reallocation of household time, especially for women, away from obtaining energy, for example by collecting firewood, and towards more productive activities. Electricity could also provide health benefits by allowing deeper wells, refrigeration, reduced exposure to smoke etc. (Toman and Jemelkova, 2003).
The micro-level effect of electrification is a growing area of empirical research (Lee et al., 2020). While micro studies typically suggest positive impacts of electrification on income and other development outcomes, more recent quasi-experimental approaches such as randomized controlled trials typically find a smaller impact for electrification than earlier studies did (Lee et al., 2020). Estimates of the effect of electricity infrastructure on economic growth are typically small. One of the best studies (Calderón et al., 2015) estimates the elasticity of GDP with respect to electricity generation capacity as 0.03 (Burke et al., 2018).
Lee et al. (2020) argue that providing poor households with access to electricity alone is not enough to improve economic and noneconomic outcomes in a meaningful way. Complementary inputs are needed, which will accumulate very slowly. Imagination and role models are also important in understanding how to exploit electricity to develop businesses (Fingleton-Smith, 2020). When electricity becomes available in rural areas of sub-Saharan Africa, it is often not used to power agricultural or other productive activities (Bernard, 2012). Institutions are also vital for attaining broad-based benefits from electricity in developing countries. Many developing countries have reformed their electricity sectors during the last few decades, mostly towards market liberalization and corporatization. These efforts have only been partially successful in promoting efficient pricing and greater electricity access (Jamasb et al., 2017). Studies assessing the economic effects of these reforms are scarce. The effects on economic growth seem positive, while the effects on poverty are mixed (Jamasb et al., 2017). In this context, technology transfer and development finance will be critical for increasing the use of electricity in developing countries (Madlener, 2009).
Burke et al. (2018) examined electrification success stories - countries that, from a low level of economic development, have now achieved near-universal electricity access as well as relatively high levels of electricity use. These countries are South Korea, China, Thailand, Vietnam, Egypt, and Paraguay. The first four are well-known development success stories too. Paraguay has abundant hydroelectricity and both Paraguay and Egypt have had relatively strong economic growth. Egypt has been less successful in providing a reliable electricity supply. The most successful countries in increasing access in Sub-Saharan Africa have been South Africa and Ghana, which both suffer from unreliable electricity, which constrains economic activity.
References
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Burke P. J., D. I. Stern, and S. B. Bruns, 2018. The impact of electricity on economic development: a macroeconomic perspective. International Review of Environmental and Resource Economics 12(1): 85–127.
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Fingleton-Smith, E., 2020. Blinded by the light: The need to nuance our expectations of how modern energy will increase productivity for the poor in Kenya. Energy Research & Social Science 70: 101731.
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