Nick Hanley † , Peter McGregor ‡ , Grant Allan ‡ , Kim Swales ‡

1. Do energy efficiency improvements help the environment?Results from an Energy-Economy-Environment Computable General Equilibrium Model of the UK Nick Hanley†, Peter McGregor ‡, Grant Allan ‡, Kim Swales ‡ † Department of Economics, University of Stirling ‡Department of Economics and Fraser of Allander Institute, University of Strathclyde

2. Introduction - policy background • Sustainable development is a key objective of UK government policy • UK government sustainable development indicators (2005) and DEFRA/ DTI “decoupling” indicators (2003, 2005) both include measures of resource productivity • Seen both as a means of improving sustainability of the economy, and as a measure of sustainability

3. Resource productivity Popular interpretation: “doing more with less” Pearce (2001): define as GDP/resource input (Y/m) or GDP/pollution output (Y/e). “Resources” could be material or energy resources. • Untested presumption: improving resource productivity will lower burden of the economy on the environment this depends on absolute levels of energy use/materials use/pollution. This has given rise to a debate in the literature on “rebound” and “backfire” effects.

5. System-wide effects of a stimulus to energy efficiency • Would a 5% increase in energy efficiency result in a 5% reduction in the consumption of energy, as some (engineers, environmentalists) have presumed? A technological boost in energy efficiency reduces the price of energy in efficiency units, which tends to stimulate the demand for energy. • This means that their are four impacts we need to think about, which all help determine the ultimate effect on aggregate energy use and CO2 emissions: • The technical effect, where we need less energy to produce a given unit of output • A substitution effect, where energy is substuted for other inputs as it is now effectively cheaper • An output/competitiveness effect (eg on exports), from this beneficial supply-side shock; and • A compositional effect, since different goods vary in their energy intensities

6. At the system-wide level, the demand for energy (in physical units) from a 5% improvement in energy efficiency could thus: • fall by 5% (zero rebound) • fall by less than 5% (rebound) • remain unchanged (complete rebound) • increase (backfire) • The extent of rebound reflects the responsiveness of the system to changes in energy prices (ie the general equilibrium own-price elasticity). Zero rebound is “unbelievable” – requires Leontief technology in production and complete inflexibility to effective energy price changes throughout the system (eg also in consumption and trade).

7. The need for an empirical analysis of rebound effects • The scale of rebound and backfire effects is thus an empirical issue • But little current evidence, especially on macroeconomic or system-wide effects of energy efficiency changes. • Most studies have been micro-level (eg engineering) or partial equilibrium only. • Some studies have focussed on trends in energy intensities (household, industry), but these have a hard job in dis-entangling cause and effect (Schipper and Grubb, 2000) • Some studies on elasticity of substitution between energy and other inputs (eg Howarth, 1997). Greening’s survey said most studies put this value at way less than 1  concluded that rebound effects would be small

8. Evidence - continued • Some studies estimate factor demand equations for sectors (eg Bentzen 2004, US manufacturing), and also find rebound effects are rather small (about 24% at most). • Other studies look at the household sector. “Satiation” in energy demands has been argued to limit output effects here. Brannlund et al (2004) use data from Swedish consumers and find a backfire effect – energy efficiency improvements result in an increase in household energy use. Roy (2000) looks at households in India and finds a rebound of 50%, due to real income effects.

9. Evidence - continued • Our focus is, however, on system-wide approaches to energy efficiency. Rather few papers look at this. • Examples are Kynes, 1997; Glomsrod and Taoyuan, 2005 and Grepperud and Rasmussen, 2004; Hanley et al, 2006 • Glomsrod and Taoyuan look at improvements in coal technology in China; they find efficiency gain stimulates energy use which swamps the initial energy savings, and economy becomes more energy intensive • Grepperud and Rasmussen find large rebound in metal manufacturing sector in Norway, with significantly different impacts on pulp and paper sector. • What we now turn to look at is the effects of an economy-wide improvement in technology which improves energy efficiency.

10. Our Paper • Here provide some simulation evidence from an energy-economy- environment computable general equilibrium model of the UK (and for Scotland separately) • CGEs widely applied to economy-energy-environment issues because: • Link to micro theory • Have clear, coherent supply-side • Counter-factual is clear • Critical when disturbance is essentially supply-side in nature – exactly the case here, since the exogenous improvement in energy efficiency we model is a beneficial supply-side shock.

11. UKENVI: An Energy-Economy-Environment CGE for the UK • Developed and applied initially to Scotland • Capital – labour – energy – materials (KLEM) production structure using multi-level CES production functions • CO2 emissions depend on fuel use mix and sectoral outputs (endogenous) • Calibrated using 2000 UK Social Accounting Matrix • electricity sector had to be disaggregated • Other pollutants also modelled (eg TSP, SO2), but only with fixed emission-output coefficients. Having said that, only focus on energy use and CO2 in this talk.

12. Sectoral breakdown of the 2000 25 sector extended UKENVI model • Agriculture, Forestry and Fishing • Other mining and quarrying, including gas extraction • Mfr – Food and drink • Mfr – Textiles • Mfr – Pulp, paper and articles of paper and board • Mfr – Glass, glass products, ceramic and clay products • Mfr – Cement, lime, plaster and articles • Mfr – Iron, steel first processing and casting • Mfr – Other metal products • Mfr – Other machinery • Mfr – Electrical and electronics • Mfr – Other manufacturing • Water • Construction • Distribution and transport • Communications, finance and business • Research and development • Public admin and education • Health and social work • Other services • Energy • Coal extraction • Oil (Refining and distribution) and nuclear • Gas • Electricity • Renewable (hydro and wind) • Non-renewable (coal, nuclear and gas)

13. GROSS OUTPUT INTERMEDIATES VALUE-ADDED UK composite LABOUR CAPITAL ROW composite NON-ENERGY composite ENERGY composite Non-energy comm. j=1........20 ELECTRICITY composite NON-ELECTRICITY composite RENEWABLE (comm. j=24) NON-RENEWABLE (comm. j=25) NON-OIL composite OIL (comm. j=22) COAL (comm. j=21) GAS (comm. j=23) Production structure of each sector in the 25 sector/commodity UKENVI framework

14. Simulation strategy • Impact of a once-off 5% improvement in efficiency in the use of energy across all industrial sectors (effected by changing parameters in physical production functions) • Note that energy efficiency change is here the driver, not the response to say a rise in real oil prices. • Initially assume costless changes in efficiency, but return to this. • Labour market: assume as base case a bargaining closure (Blanchflower/Oswald wage curve) • Results are reported as percentage changes from base year values • Run model until hits LR equilibrium (desired = actual K), then compare outcomes to base run which omits the productivity shock

15. Table 1: The aggregate impact of a 5% increase in energy efficiency in all production sectors: central scenario (% changes from base)

16. Figure 2: Change in price of output in UK production sectors in response to a 5% increase in energy efficiency in all sectors

17. Figure 3: Change in output in UK production sectors in response to a 5% increase in energy efficiency in all sectors

18. Figure 4: Impact of a 5% increase in energy efficiencyin all UK production sectors on UK GDP (absolute values – central case)

19. So what about the environment? Energy and resource productivity indicators in UKENVI • Energy consumption • Total use of electricity in UK • Target: decrease • Ratio of output/income per unit of energy • GDP per unit (tonnes oil equiv) non-electricity use • GDP per unit (gigawatt hour) electricity use • Target: increase

20. Figure 5: Impact of a 5% increase in energy efficiency in all UK production sectors on energy indicator variables

21. Indicators of environmental impact • Generation of carbon dioxide: • CO2 (percentage changes in levels of emissions) • Target: decrease • A related (official UK) indicator of sustainable development: • GDP per tonne of CO2 emissions • Target: increase

22. Figure 6: Impact of a 5% increase in energy efficiency in all UK production sectors on environmental indicator variables

23. Sensitivity around the central scenario Important to explore sensitivity of the CGE simulation results to a variety of issues. Here we consider: • Sensitivities to the values of “key parameters” of the model • Closing the government budget constraint • Costly energy efficiency improvements • Alternative views of the supply side of the labour market

24. Sensitivity to “key parameters” • Elasticity of substitution of energy for other inputs in production Why do sensitivity on this? • Argued in literature to be crucial for the scale of rebound effect We explore the impact of: • Ease of substitution of energy for non-energy intermediates • Ease of substitution of intermediates for value added • Base case = 0.3 in both cases, try 0.1 and 0.7 (range of “coffee table” estimates for UK)

25. Table 2: Sensitivity analysis around elasticity of substitution of energy for other inputs (% changes from base)

26. Sensitivity to “key parameters” 2. Sensitivity of export demands to price changes Why do sensitivity on this? • We found it important for the scale of rebound in modelling work for Scotland We vary: • Responsiveness of export demands to changes in prices (competitiveness) • Hardly any effect on size of rebound or on CO2 emissions for UK (unlike Scottish model) : sectors which benefit most from fall in effective energy price are not big exporters.

27. Closing the government budget constraint • Tax revenues increase under central case, and we are currently assuming government saves all revenues Why do sensitivity? • Impact of “closing” the government budget could be important on scale of rebound and size of economic impact (nb: G is exogenous in our model) Our sensitivity analysis explores the impact of increased revenues in two alternative ways: • Increased government expenditure (according to weights in SAM) • Reduction in the standard rate of income tax

29. Costly energy efficiency improvements Have assumed 5% costless improvement in energy efficiency Why do sensitivity? • Clearly may influence the net benefits of energy efficiency improvements. Costs of introducing energy efficiency improvements: • Reduce the scale of economic benefits • Reduce the size of the rebound effect We introduce by increasing the labour input needed to produce a given level of output (eg more workers needed to monitor energy use) to give zero overall effect on costs. Effects: rebound falls from 37% in base case to 17% in this most-extreme case. CO2 still falls by less than 5%.

30. Alternative views of the supply side of the labour market • Bargaining labour market assumed in all simulations so far Why do sensitivity? • Specification of labour market is likely to impact on the size of economic and environmental impacts Our sensitivity analysis considers two limiting cases: • Exogenous labour supply (fixed labour supply) • Real wage resistance (fixed real wage)

31. Table 6: Sensitivity analysis for alternative specificationsof the labour market (long run results)

32. Summary and Conclusions: UK model Rebound is present from energy efficiency improvements; so boosting resource productivity does not give us the “full” environmental benefits we might expect from an engineering perspective Extent of rebound depends on a range of factors including: • Ease of substitution of energy for other inputs • Elasticity of export demands • Use of enhanced tax revenues • Cost of energy efficiency policies • Nature of the labour market Throughout all of the simulations there is significant rebound, but no “backfire” for the UK. But this was NOT so when we did exactly the same simulation for a more open, smaller economy – Scotland.

34. Why does this happen? • Energy intensive sectors in Scotland become relatively more competitive than less energy-intensive sectors, as save more in costs • Some effects from effects of changes in real wage on migration from rest of UK • Energy inputs now relatively cheaper than other inputs, so firms use more, even though need less per unit output • Scottish electricity producers now have competitive advantage over English producers so exports to RUK of electricity increase - this is the big difference over the UK model. • Net effects over medium to long term are then negative in terms of Scottish pollution and official “sustainable development” indicators,

35. Policy implications • Need co-ordinated energy policy which prevents “backfire” and reduce rebound if we are most concerned with environmental impacts e.g by increasing energy taxes • Energy taxes now come with “less pain” than would otherwise be the case. • Possible double dividend also exists if government reduces other taxes to balance budget • But note that this will have implications for economic benefits of energy efficiency improvements, eg on GDP and unemployment • Energy efficiency and induced effects could have significant spill-overs in terms of other pollutants.

36. Contact: n.d.hanley@stir.ac.uk • Full report is available on Defra web site, or from www.economics.stir.ac.uk (The Macroeconomic Rebound Effect and the UK economy:Analysis and Results from an Energy-Economy-Environment Computable General Equilibrium Model of the UK )