Energy forecasting models, simulations and price sensitivity: New formulation

The top-down, two-stage optimization approach provides energy analysts with a powerful tool for both policy analysis and forecasting. This approach assumes that energy is weakly separable from other inputs to the production process. An aggregate energy Divisia Price Index (DPI) links the two stages. Although the DPI is necessary for the model estimation, it can distort the outcomes of price sensitivity analysis and forecasting exercises when the model is used for forecasting and simulations without adjusting the DPI. This deprives the two-stage optimization procedure of some of its virtues. The present study attempts to explain the reason for these distortions and to show that, by reformulating the same set of estimated coefficients, the simulation module will correct the shortcomings of the conventional formulation.