The price and income elasticities of natural gas demand in Azerbaijan: Is there room to export more?

Natural gas plays a crucial role in Azerbaijan's energy mix, accounting for 69% of primary energy consumption and 94% of electricity generation. The country possesses significant natural gas reserves, but the energy transition presents challenges. Azerbaijan aims to increase the share of renewables in its energy balance to 30% by 2030, while simultaneously increasing natural gas exports to meet its commitment to the Southern Gas Corridor project and achieve high-income country status by 2025. This creates a potential trade-off between domestic consumption and export commitments. This study addresses the lack of research on Azerbaijan's natural gas demand by analyzing the relationship between natural gas consumption, economic growth, and price. The study collects price data from various sources, overcoming data limitations in previous research and enabling an accurate estimation of price elasticity. The study uses sophisticated econometric techniques to provide robust estimations for policy-making related to energy security and the energy transition.

The literature on price and income elasticities of natural gas demand for resource-rich countries is limited. Studies on Nigeria show mixed results regarding the relationship between natural gas consumption and economic growth. Some studies using STSM approach have modeled natural gas demand for Pakistan and OECD-Europe, revealing inelastic demand. Other studies on China have shown diverse income and price elasticities depending on the time period and sector. Studies for Egypt and Ukraine found mixed results depending on factors such as the availability of substitutes. A study on 44 countries found an average long-run price elasticity of -1.25 and an income elasticity of +1 or higher. These diverse findings highlight the context-specific nature of natural gas demand elasticities and the need for this study on Azerbaijan's unique energy market.

The study uses annual data from 1993 to 2021. The variables include natural gas consumption (per capita), GDP per capita (constant 2015 US$), and a weighted average real price of natural gas. The real price is calculated using weighted shares of residential and industrial consumption and nominal prices are converted to real values using the consumer price index. Unit root tests (ADF and PP) were conducted to assess the stationarity of variables. Cointegration tests (Engle-Granger and Bounds Testing) were performed to determine long-run relationships. Long-run relationships were then estimated using several techniques: General to Specific (Gets) modeling approach, Autoregressive Distributed Lagged models (ARDL), Structural Time Series Modeling (STSM), Fully Modified Ordinary Least Squares (FMOLS), Dynamic Ordinary Least Squares (DOLS), and Canonical Cointegration Regression (CCR). Diagnostic tests were conducted to ensure the validity of the estimated models. The primary model estimated is a conventional energy demand specification, where demand is modeled as a function of price and income, with unobserved components incorporated to account for other influencing factors.

All estimation methods yielded consistent results. The long-run income elasticity of natural gas demand was estimated to be around 0.8, while the long-run price elasticity was approximately -0.1. Both were statistically significant. The positive income elasticity shows that natural gas is a normal good in Azerbaijan. The income elasticity being less than 1 suggests it's also a necessity. The negative and low price elasticity indicates that the demand is inelastic. A 1% increase in income leads to a 0.8% increase in natural gas demand, while a 1% increase in price reduces demand by only 0.1%. The results of the Gets approach passed all diagnostic tests (autocorrelation, heteroscedasticity, normality, and specification tests). The findings suggest that in the short run, it might be difficult to influence consumption through price increases because of the inelasticity of demand.

The findings address the research question by providing robust estimates of income and price elasticity of natural gas demand in Azerbaijan. The inelastic price elasticity highlights the limited substitutability of natural gas, particularly for households and industries, due to limited availability of alternatives. The findings indicate that increasing natural gas prices alone won't significantly reduce consumption, highlighting the importance of alternative strategies for energy security and export potential. The positive income elasticity suggests that economic growth will drive further increases in natural gas demand, creating a challenge to balancing export commitments and domestic needs. The results demonstrate the importance of diversifying energy sources through renewable energy to mitigate reliance on natural gas for power generation, creating space for exports. The study complements existing literature by providing the first comprehensive estimate of natural gas demand elasticity for Azerbaijan, with implications for policy decisions regarding energy security, economic development, and environmental sustainability.

This study provides the first comprehensive estimation of price and income elasticities of natural gas demand for Azerbaijan. The findings indicate a highly inelastic price elasticity and an income elasticity close to one. These results provide insights into the limited potential for demand-side management through price adjustments in the short run, and the need for alternative strategies such as transitioning to renewable energy sources in power generation to free up natural gas for export. Future research could explore the elasticity of substitution between renewable and natural gas resources in power generation and incorporate macroeconomic models for a more comprehensive analysis.

This study's main limitation is its use of a single-equation approach, which provides a partial equilibrium perspective on natural gas demand. Future research should consider using macroeconomic models like DSGE models to account for the complex interactions between natural gas demand, economic growth, and other relevant factors. Further analysis could also explore potential driving factors beyond price and income and incorporate other variables.