The role of energy in economic growth

The direct influence of energy in economic growth still remains an interesting question among researchers. Unlike the role of energy in economic growth, studies have shown that there is a clear correlation between health and economic growth. For example, Jocelyn E. Finlay of Harvard School of Public Health has put the indirect contribution of health in economic growth using the following words;

…individuals who are healthier have higher returns to labor input. …[they] will have the incentive to invest in education as the time horizon over which returns can be earned is extended. Education is the driver of economic growth, and thus health plays an indirect role. Accounting for the simultaneous determination of the key variables – growth, education, fertility – the results show that the indirect effect of health is positive and significant.

Another author concludes by writing;

…better health does not have to wait for an improved economy; rather, measures to reduce the burden of disease, to give children healthy childhoods, to increase life expectancy etc. will in themselves contribute to creating richer economies.

Energy is a crucial ingredient for economic development. As both agricultural and industrial activities increase, the demand for energy similarly increases. In the developing world provision of a greater access to energy has been suggested by some that will help grow their economies and improve the lives of the poor. As a result progress is being done to provide energy to as much percentage of the population as possible by individuals, firms and governments incentivized from inside and outside the countries and motivated by financial or humanistic interests, valuing it as a human right or a combination of these and others. However whether energy really plays a central role in economic development is unclear. This article will try to answer this question with regard to a survey done by David I. Stern targeting the factors that affect the linkage between energy and economic growth.

The process of converting economic inputs – capital, labor, and various forms of energy such as oil, coal etc – into economic outputs such as manufactured goods and services can be expressed using an equation called production function. This function accepts some values as inputs to yield some results as outputs. In order to study the relationship between energy and economic growth we need to study the effect of the various forms of energy (as inputs in the production function) on aggregate output e.g. gross domestic product. The influence of energy on aggregate output is affected by; substitution between energy and other inputs, technological change, shifts in the composition of the energy input, shifts in the composition of output, and also the shift in the mix of other inputs like a shift to a more capital intensive economy from a labor intensive economy. The latter will not be discussed here for it has not been widely discussed in the literature. The next paragraphs will try to offer a more elaborate discussion of these factors.

The study of the complementarity and substitutability behavior of energy and capital offers varied results. It has been suggested by some that manufactured capital offer both a good and a widely ranged substitution for major metals – most of which are non-renewable resources – and aggregate material inputs while others have asserted that there is little or zero substitutability of manufactured capital and specific metals. “On the whole it seems that capital and energy act more as substitutes in the long-run and more as complements in the short run, and that they may be gross substitutes but net complements.”

As the resources considered so far are mostly non-renewable, it is important to look at the “physical interdependency between manufactured and natural capital.” The results of a study on the effects of substituting capital for fuel in the US forest products sector with capital obtained from the indirect energy produced from other economic sectors have shown that between 1958 and 1984 “the indirect energy costs of capital [mostly] offset a significant fraction of the direct fuel savings.” In some years these costs were greater than the direct fuel savings. In another study it has been found that the use of the materials used in other sectors to produce the capital and labor in the rest of the economy by the receiving sector “lowers the long-run growth path of the economy.” This substitution reduces investment and/or consumption in the rest of the economy.

There are three things related to technology change that can affect economic output; regular change in technology, autonomous energy efficiency and energy saving innovations. Technologically improved energy sources allow capital equipments to produce more efficient products and hence affect TFP (total factor productivity) growth. Technical change can lead to TFP growth if the costs involved in energy use are lower and/or decrease over time. Studies show that since mid-1960s autonomous energy efficiency is declining over time and [they suggest that] this is true even when other factors such as the oil crisis of 1973 are included but energy efficiency increases after the second oil crisis. “Technical innovations tend to introduce more energy using appliances to households and energy saving techniques to industry.”

It has been argued that energy saving innovations “can end up causing even more energy to be used as the money saved is spent on other goods and services which themselves require energy in their production.” To produce energy services one uses energy. Therefore innovations that reduce the amount of energy required to produce a unit of energy services lowers the effective price of energy services which affects the income in a way that leads to an increase in demand for other goods and services and therefore the energy required to produce them. Other results of the reduced costs of energy services can be seen in the capital stocks that “result in an even further increased long-run demand response for energy.” In the end studies lead to a conclusion that improvement in energy efficiency reduces total energy demand.

To determine the effects of energy quality and shifts in composition of energy input on aggregate outputs one needs to measure the marginal product of the energy source. The energy quality of fuel determines its price and it’s argued that higher quality fuels “reduce the amount of energy required to produce a dollar’s worth of GDP.”

Energy quality is the relative economic usefulness per heat equivalent unit of different fuels and electricity. Electricity is the highest quality energy source followed by natural gas, oil, coal, and wood and biofuels.

On another note studies show that the composition of energy in producing higher quality energy tend to affect TFP growth but it is not suggested whether this clearly does increase or decrease TFP growth.

Lastly let’s consider the shift in the composition of output, e.g. a shift from agriculture towards heavy industry, and a shift from more resource intensive extractive and heavy industry towards services and lighter manufacturing. This shift is argued to “increase energy used per unit of output in the early stages of economic development and a result in energy used per unit of output in the later stages of economic development.” “Pollution and environmental disruption would be expected to follow a similar path.”Although “the shift to service industries results in a decoupling of economic growth and energy use” this is an unlike situation because for example while some services such as office towers, shopping malls, and warehouses where energy is used both during their construction and maintenance are less “heavily resource and energy using” services such as transport really are resource and energy using.

Some questions

What does this study teach us about the correlation between energy and economic growth? What can we learn from the currently shortages of electricity in the developing world and recently the “energy crisis” in Tanzania? For Tanzania, what are the implications to the country’s economic growth both in the short and long run?

Some thoughts

Suppose we assumed it was the case that if all of the world was lit by affordable electricity then countries would achieve accelerated economic growth, let’s look at a few things regarding the challenges of energy provision to off-grid areas.

Traditionally development has been approached in a top-down fashion. Provision of energy has been approached in a similar way. It is a fact that the largest part of the population of the world, in developing countries in particular, lives in rural areas. However the provision of electricity energy to these areas (most of which are outside the national grid) is limited by (high) capital investments for low load factors and high costs of building transmission lines. Obviously provision of affordable energy to them is a challenging task, and one that needs an extensive study with methods developed exhaustively tested. Would a bottom up approach be a viable option here?