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AGA EACRNGP 2007-MAR-01 An Economc Analyss of Consumer Response to Natural Gas Prces-F62007

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Demand for natural gas per residential customer has been declining since the 1980's, and in recent years this decline has increased. Between 1980 and 2001, weather adjusted natural gas use per consumer in the US declined almost 1 percent on an annual basis. Since 2000, however, the decline for winter only use has accelerated, decreasing 13.1 percent between 2000 and 2006 for the sample of companies analyzed in this report.

It is important from a budgeting point of view for Local Distribution Companies (LDCs) to understand the cause of this decline. Was it caused by the recent increases in natural gas prices and customer's response to these price increases? Did customers change their behavior in response to these price increases? Have they become more sensitive to natural gas price movements or has the price induced response behavior remained relatively the same over time? Did customers switch to more efficient gas appliances in response to these natural gas price increases? Is it due to technological innovations which lead to increased efficiencies in appliances and thermal shells of homes? These efficiencies are in some sense passive as older appliances are replaced with more efficient models through natural attrition.

To address these issues, the American Gas Association (AGA) funded a study to reestimate the price elasticity of natural gas demand by residential households using a sample of data that covers the recent period of large natural gas price increases. The main objective of this study was to document changes in use per residential customer on a weather normalized basis, particularly since the year 2000, and to identify the reasons for these changes. A second purpose of this study was to test for an increase in the price elasticity7 of demand for natural gas since the year 2000. A third and equally important purpose of this study was to obtain updated elasticity estimates for all nine US Census Regions and for the US as a whole. Finally, the study attempts to estimate a natural rate of decline in use per customer due to technology induced gains in appliance and shell efficiency that would even occur in an environment of constant real natural gas prices.

There are hundreds of studies on the elasticities of natural gas demand. These studies have generated a range of elasticity estimates. If one goes back to the 1970's and even to the 1960s, these estimates vary over a wide range. Estimates of short-run price elasticity range from as low as –0.05 in Beirlein, Dunn and McConnon (1981) to a high of –0.68 in Barnes, Gillingham Hagemann (1982). For long-run price elasticity estimates, the range of estimates is even higher, with the low being -0.017 in Hewlett (1977) to a high of –3.42 in Beirlein, Dunn and McConnon (1981). See Dahl and Roman (2004) and Dahl, et. al. (2005) for recent surveys of energy elasticity demand estimates. Other surveys of energy demand price elasticity estimates are Taylor (1975 and 1977), Bohi (1981), Bohi and Zimmerman (1984), Al-Sahlawi (1989), Dahl (1993), and Espy and Espy (2004). See Appendix C for a brief literature review of price elasticity estimates.

Many of the studies estimated elasticities of natural gas demand with data aggregated at the state and national level and collected by the States; or collected by the Energy Information Administration (EIA). Examples of these are Balestra and Nerlove (1966), Jaskow and Baughman (1976), Berndt and Watkins (1977), and more recently, Maddala, Trost, Li, and Joutz (1997). Other studies use individual micro data to estimate demand elasticities. Examples of these are Hewlett (1977), Barnes, Gillingham and Hagemann (1982), and Green and Gilbert (1983). While the former studies using state and national aggregate data may provide some useful information at the state and national level, and the latter studies may provide good estimates of individual demand elasticities, neither provide adequate estimates at the individual LDC level of aggregation. Most of these studies do not allow for a natural rate of decline in use per customer due to technologically induced efficiency gains in appliances and thermal shells of homes. In addition, there are few, if any, studies that use current data that includes the recent run-up in natural gas prices. This study will fill these gaps in the literature by using high quality data collected and compiled at the individual LDC level and covering the period as recent as March, 2006.

This paper is divided into the following five sections. In Section 1, background information at the regional, as well as the national level, is provided. The information includes residential natural gas consumption, the declining trend of consumption, and price movements. In Section 2, the database constructed from the survey of LDCs is described. Section 3 explains the mathematical equations used to estimate short- and long-run price elasticity of demand. Empirical results of short-run and long-run elasticity and the declining trend in gas usage are presented in Section 4. The report concludes in Section 5 with a summary of the results and policy implications. In addition, there is a list of suggestions for future research. References and technical appendices can be found at the end of the report. The appendices include construction of the weather-normalized series for use per customer, a map of the Census regions, a brief literature review, and a discussion of statistical hypothesis testing.

7 The price elasticity of demand is defined as the ratio of the percent change in quantity demanded of a particular good to the percent change in the price of that good, such as natural gas demand in this study.

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