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2011.2.8 11:28 AM 2 3 MAC2PDF_IN 300DPI 175LPI T

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Abstract i

ABSTRACT

1. Research Purpose

In 2009, approximately 84% of primary energy consumption in

Korea was composed of fossil fuels such as oil, natural gas, and coal.

Moreover, because the Korean economy have entirely imported all of

fossil fuels, fluctuations of international prices of fossil fuels have

seriously affected not only economic performances, but also formation

of energy policy.

In fact, as fossil fuels are highly correlated with each other, the

fluctuations of international prices of fossil fuels can be decomposed

into two components: a common and idiosyncratic part. Therefore,

employing Markowitz's mean-variance model, we are able to interpret

the common part of the fluctuations of international prices of fossil

fuels as the market risk which all fossil fuels are confronted with. On

the other hand, the idiosyncratic part can be thought as the

idiosyncratic risk which comes from peculiar and specific market

conditions of each fossil fuel. As a result, the idiosyncratic risk of the

fluctuations of the international price of each fossil fuel could be

minimized by properly constructing a portfolio of the fossil fuel

consumption. Thus, decomposing the fluctuations of international

prices of fossil fuels into these two parts and employing the portfolio

selection theory make it possible to construct an optimal fossil energy

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consumption portfolio which minimize risks of a return from energy

consumption, given each return level.

The main purpose of our study is to construct this hypothetical

energy consumption portfolio, based on the modern financial theory.

This optimal energy consumption portfolio might be used as a

reference to evaluate the current energy consumption structure and to

rebuild energy policy.

2. Summary

In constructing the optimal energy consumption portfolio, we define

returns on fossil fuel consumption as TOE (Ton of Oil Equivalent)

per 1 cent. In general, as the calorie unit for TOE of each fossil fuel

is not altered, fluctuations of the growth rate of returns on each fossil

fuel consumption presented by the TOE unit mainly is due to the

fluctuations of the international price of each fossil fuel. Hence, the

optimal fossil fuel consumption portfolio to minimize variations of the

growth rates of returns is same to the fossil fuel consumption

portfolio to minimize variations of the growth rates of international

prices of fossil fuels.

To construct the optimal fossil fuel consumption portfolio, first we

decompose the growth rates of returns into two parts, the common

and idiosyncratic part, using the dynamic latent common factor model.

Then, based on the dominance principle indicated by the

Abstract iii

mean-variance model, we construct the efficient frontier of fossil fuel

consumption portfolio. Meanwhile, before building the efficient

frontier, we empirically investigate how the common part of the

growth rates of returns on fossil fuel consumption react to certain

structural shocks to global economic conditions, employing a SVAR

(Structural Vector Autoregression Model). Thus, we identify two

structural shocks, aggregate demand and supply shocks in the global

economy, and then, estimate the impulse response functions of the

common part.

Our finding is that in response to shocks to increase aggregate

demand, the common part of the growth rates of returns rises. It

means that shocks to increase the aggregate demand in the global

economy increase international prices of the fossil fuels. However, the

common part declines in response to shocks to increase total factor

productivity of the global economy. It means that since a rise in total

factor productivity increases the marginal product of fossil fuels, the

shocks to total factor productivity decreases the growth rates of

returns on fossil fuels.

The optimal fossil fuel consumption portfolio, which has the

smallest risk of the growth rates of returns, on the efficient frontier

implied by the mean-variance model is consisted of the following

consumption combination of fossil fuels : 26.5% of oil, 45.8% of

natural gas and 27.7% of coal. Furthermore, based on the portfolios of

fossil fuel consumption on the effective frontier, the actual fossil fuel

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consumption portfolio of the Korean economy in 2009 seems to be

somewhat inefficient.

3. Research Results and Policy Implications

In our study, it has been turned out that oil is the primary factor to

deteriorate returns on the fossil fuel consumption portfolio and to

increase variations of the returns. This result is in line with the recent

studies which indicate decreasing dependency on oil consumption

alleviates the effects of oil shocks on the economy. Therefore, our

results show that it is crucial to change the current energy

consumption structure by substituting other energy resources for oil, in

order to improve returns on the fossil fuel consumption portfolio. In

addition, it is also important to develop more efficient energy

technology and improve total factor productivity.

One limitation of our study is that we only consider the calorie unit

for TOE to calculate returns on fossil fuel consumption. However, as

fossil fuels considered in our study usually emit greenhouse gases,

they cause social costs, causing air pollution. Thus, it is important to

include these socal costs in calculating returns on the fossil fuel

consumption. We leave this task for our future research.

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