# 7 Conclusion

We have investigated interfuel substitution, taking a flexible functional form approach and using state-of-the-art recent advances in microeconometrics. In particular, to minimize the potential problem of using a misspecified functional form, we have employed a well-known flexible functional form, the locally flexible normalized quadratic (NQ), introduced by Diewert and Wales (1987). Moreover, motivated by the widespread practice of ignoring the theoretical regularity conditions, we have estimated the model subject to theoretical regularity using methods developed by Diewert and Wales (1987). We have produced inference about the demand for fuels, including those about the own- and cross-price elasticities as well as the Allen and Morishima elasticities of substitution, that is consistent with neoclassical microeconomic theory.

Our evidence indicates that the interfuel elasticities of substitution are (in general) consistently below unity, revealing the limited ability to substitute one source of energy with another and suggesting that fossil fuels will continue to maintain their major role as a source of energy in the near future. At the national level, we find a consistent pattern of substitutability between electricity and fossil fuels for a number of countries under investigation. Therefore, policymakers in these countries should base their programs on this particular type of interfuel substitution, and not those involving the substitution of one fossil fuel with another. We also find very little evidence of interfuel substitution using sectoral data. Only in the U.S. transportation sector we find evidence of strong substitutability among some of the fuels. On average, developed countries exhibit higher potential of substitution between energy inputs in their industrial and transportation sectors than developing economies. Hence, policymakers’ efforts are more likely to deliver expected results if they are focused on a particular sector of the economy rather than on the aggregate economy.

Although we find some evidence that the high-income economies have larger potential of interfuel substitution in their industrial and transportation sectors, our results do not suggest any significant differences between the three groups of countries in terms of interfuel substitution in the residential and electricity generation sectors or at the national level. That is, interfuel substitution seems to depend on the structure of the economy, but to be independent of the level of economic development. In this respect, the effectiveness of policymakers’ collegial decisions as to the substitution of one energy input with another will depend on the target sector of the economy. According to our findings, energy policy will be more effective in targeting substitution in the industrial and transportation sectors than in the residential and electricity generation sectors.

Overall, our results highlight the fact that the substitution between different energy inputs has been quite restricted. Therefore, such daunting tasks as curbing carbon emissions and preventing climate change require a more active and focused energy policy. Also, because interfuel substitution is limited in the near term, there will be a greater need for relative price changes to induce switching to a lower carbon economy.

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