Course: Energy Economics and Policy

Course instructor:
Shyamasree Dasgupta
Assistant Professor, Indian Institute of Technology Mandi

Week 4: Energy Supply –Part I

Lecture 3 (W4L3): Economics of non-renewable resources

In this lecture, we will discuss features of non-renewable resources, the economics
of extraction and production of fossil fuel.
1
Bhattacharyya, S. C. (2011). Energy 1. Energy
Economics: Concepts, Issues, Market and as a
Governance. Springer. London. UK resource

2. Energy 5. Special
Demand Topics
Basic concepts
• Investment in economics
and policy
• Economics of non-renewable making
resource

• Economics of Fossil Fuel

• Supply of Electricity 3. Energy 4. Energy

Supply Market
• Economics of Renewable Energy

2
Economics of non-renewable resources

3
 Rent is defined as the payment to the owner
Today or tomorrow? of land/property to allow access.

• Coal, oil, natural gas – these fuels have finite stocks. If x amount is extracted and used
today then the same x will not available for tomorrow.

• Therefore, the market prices of non-renewable resources not only reflect the cost of
extraction and production, but also a ‘depletion premium’ or ‘scarcity rent’.

• Today’s use of resources supports activities and generates utility today, while that leads
to lack of availability for tomorrow and hence lower utility tomorrow. So, the choice is
essentially between present and future.

• Suppose, the utility function is denoted by U = 𝑈 (𝑞1 , 𝑞2 ), where 𝑞1 and 𝑞2 are

respectively present and future consumption of non-renewable resources.

𝜕𝑈1 (𝑞1 ) 𝜕𝑈2 (𝑞2 )

• The Marginal utilities are given by 𝑢1 = 𝑎𝑛𝑑 𝑢2 = . It represents increase in
𝜕𝑞1 𝜕𝑞2
utility with one unit increase in resource consumption.

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 Recap: consumer’s equilibrium
𝑞2

• Consumer’s objective is to attain the highest

Indifference Curve or highest level of utility
R given the budget line.

• So, this is a problem of constrained

optimization:
• Max U= 𝑈 𝑞1 , 𝑞2 subject to
E p1q1+p2q2=M
q2*

• At equilibrium, slope of IC=slope of budget

U
line. So, at E, Marginal rate of substitution
(MRS = 𝑢1 / 𝑢2 ) = relative price (p1/p2).

0 q1* N q1
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 • The vertical axes measure marginal
Today or tomorrow? utility and price while the length of the
horizontal axis represent the total
availability of the finite resource.
• Present use is measured on the
𝜕𝑈2 (𝑞2 ) horizontal axis from left to right and the
𝑢2 =
𝜕𝑈1 (𝑞1 ) 𝜕𝑞2 future use from right to left.
𝑢1 =
𝜕𝑞1
• Marginal utility declines as the
consumption of resource increases.
A
B • If 𝑢1 > 𝑢2 then increase in present
extraction will increase utility by the area
E ABCD. However, that will imply
equivalent reduction in future use and
hence fall in total future utility will be
EBCD.
• Thus, as long 𝑢1 > 𝑢2 , utility increases as
present use increases. On the other hand,
if 𝑢1 < 𝑢2 , then total utility increases as
D C future use increases.
• Therefore, the optimum is likely to be
Total availability of the resource achieved at 𝑢1 = 𝑢2
Present Future 6
Today or tomorrow? • Recall the concept of present value and
future value. Usually, we prefer today’s
𝜕𝑈2 (𝑞2 )
consumption as compared to tomorrow’s
𝑢2 =
𝜕𝑞2
consumption.
𝜕𝑈1 (𝑞1 )
𝑢1 =
𝜕𝑞1
• The rate at which today’s utility is
𝑢2 /(1+r)
preferred to tomorrow’s utility is known
as the rate of time preference/ rate of
discount (g=r, say).

• Therefore, the present value of future

marginal utility 𝑢2 is given by 𝑢2 /(1+r) -
the red broken line.
𝑞1 𝑞2
• Thus, optimum is achieved where
𝑢1 = 𝑢2 /(1+r) i.e. 𝑢2 /𝑢1 = (1+r)
Total availability of the resource

Future
Present Value = Future Value/[(1+g)^T]
Present 7
 Today or tomorrow?
• If the market price of the non-
renewable resource is 𝑃1 for present
𝑢2 =
𝜕𝑈2 (𝑞2 ) and 𝑃2 for future, then the optimal
𝜕𝑈1 (𝑞1 ) 𝜕𝑞2 allocation will be guided by:
𝑢1 =
𝜕𝑞1 𝑢2 𝑃2
𝑢2 /(1+r) = = 1+ 𝑟
𝑢1 𝑃1
𝑃2 −𝑃1
B or, =𝑟
𝑃2 𝑃1
𝑃1 • i.e. Price grows at the rate r that is
K equal to the rate of time preference.

• So, the price of depletable resource

𝑞1 𝑞2 would rise in future based on the rate
of time preference.

• This r is referred to as Hotelling’s r

Total availability of the resource (1931)
Present Future 8
Economics of fossil fuel:
Exploration, field development, and production

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 Cost of exploration
• The objective of exploration is to
identify stock of fossil fuel and
addition to Reserve.
Marginal cost of exploration

• Difference between stock of resource

and reserve.

• The cost associated with exploration

includes pre-exploration survey and
studies, cost of drilling and the cost of
rentals.

• The reserve addition grows faster at

the early stages of exploration but
slows down as the process continues -
marginal cost increases significantly
after a particular level of total
Total exploration exploration.

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 Invest or not to invest in exploration?
𝑅 𝐶
𝑡
𝑁𝑃𝑉 = σ𝑡 (1+𝑖) 𝑡 - σ𝑡
𝑡
(1+𝑖)𝑡
−𝐼0

• Very high capital cost and the

success is associated with high Probability
risk and uncertainty: leads to a Distribution
complex investment decision. NPV of NPV A*B*C
(A) (B) (C)
• The decision making involves
cost benefit analysis based on a
probabilistic model that 100 0.25 6.25
calculates expected monetary Probability of
value of the project. success = 0.25 200 0.50 25
Drill
500 0.25 31.25
• Exploration activity is
undertaken if total EVM is Probability of -50 1 -37.5
positive. failure =0.75

• The participation of government Expected Value of Money (6.25+25+31.25-37.5) 25

in terms of risk and profit sharing
significantly affects exploration.

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 Change in economic cost changes the size of
Field development reserve but not the size of available resource

Deterministic Resource Classification

• Once the presence of reserve is
guaranteed through Economics Geological Uncertainty
exploration, the next stage is to Feasibility
develop the field for extraction. Identified Undiscovered

• At this stage, uncertainty with Proven Inferred Hypothetical

respect to existence is no longer / speculative
there, but the size is not clearly Economically Reserve Inferred
known. recoverable reserve

• The cost of field development is Uneconomical Demonstrated Inferred sub-

also high and includes field site sub-economic economic
development and operating reserve reserve
cost.

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 Recall Shut down point
Production

• Production is capital intensive – Cost MC

(broken line being the
reflected in high fixed cost as compared supply curve)
to variable cost. AC

AVC
• Since variable cost is low, producer
tends to operate at full capacity and
supply more.

• As long as variable cost is recovered,

production takes place, and fixed cost is
considered more like a sunk cost in
AFC
operation decision.

0 Q

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Resource rent
• Rent is the payment to the owner of
land/property to allow access. Price, Cost
• In energy industry, four types of rents Supply curve
are discussed
• Mining rent arising due to difference
in geographical conditions; for P*
example, in case of oil and gas
operation is easier in flat desert areas. Rent

• Technological rent arising due to

use of efficient technology that reduces
cost of production. Demand curve
• Positional rent arises out of
proximity to market that reduces
transport and other access related
costs. Willingness
to Accept
• Quality rent arises due to favourable
chemical or physical property of fuel.
Eg. Light crude oil has higher price 0 Q*
than heavy crude oil. Q

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Resource rent
• Rent is the payment to the owner of
land/property to allow access. Price, Cost
• In energy industry, four types of rents Supply curve
are discussed
• Mining rent arising due to difference
in geographical conditions; for P*
example, in case of oil and gas
operation is easier in flat desert areas. Producer’s
• Technological rent arising due to surplus or
use of efficient technology that reduces rent
cost of production. Demand curve
• Positional rent arises out of
proximity to market that reduces
transport and other access related
costs.
• Quality rent arises due to favourable
chemical or physical property of fuel.
Eg. Light crude oil has higher price 0 Q*
than heavy crude oil. Q

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Effect of Royalty Supply curve (post
Royalty)

• Since state is the owner of underground Price, Cost

resources, there has to be a contract towards
risk and profit sharing. Supply curve
P’

• If the government imposes a royalty per

unit of production (similar effect as tax), the P* Total
MC increases and hence the supply curve Royalty
shifts upwards.

• It leads to a new equilibrium at lower Demand curve

quantity and higher price.

• The difference between the new and old

price is the per unit Royalty that accrue to
the government.
0 Q’ Q* Q

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End of Week 4_Lecture 3.

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