Computable General Equilibrium (CGE) and the Environment

1. Computable General Equilibrium (CGE) and the Environment Set-up of the presentation: What are CGE models? Calibration Environmental issues Application: a dynamic CGE for the Netherlands Contact me at: Rob.Dellink@wur.nl

2. Part I: CGE Modelling

3. The circular flow model of economic activity

4. Computable  numerical solution (empirical data) General  description of the whole economy full economic cycle all markets Equilibrium  demand equals supply prices are adjusted to achieve market equilibrium general: on all markets simultaneously! Model  solvable set of equations CGE models: basics

5. Partial equilibrium: an example • objective:  max • market clearance: , • production: • resource constraints:

6. General equilibrium: an example • objective:  max • market clearance: , • production: • resource constraints: • income balance:

7. 3 classes of equilibrium conditions • Assumptions • constant returns to scale (not in all models) • all agents are rational and are price takers • ... • Equilibrium conditions • market clearance: supply  demand • zero profit: cost of production  revenue • income balance: factor income  expenditure  unique set of equilibrium prices

8. system of equations directly write first order/optimality conditions cryptic and tedious for larger models Negishi format quantities as variables prices as parameters  iterative solution of income balance mixed complementarity format (MCP) quantities and prices as variables prices are complementary to balance equations Find z R s.t. f(z)  0 , z  0 and z’ f(z)=0 MPSGE available as tool for specification of MCP model CGE models: formats

9. CGE models: Walras’ law • Non-satiation  all income is spent • Income balance + zero-profit  total supply equals total demand • Walras’ law: if all markets but one are in equilibrium, then the last market is in equilibrium as well  only relative prices matter (numeraire needed)

10. CGE models: strenghts • Based on well-developed theory (neoclassical microeconomics) • in reasonably simple models, the effects that drive the results are known • rough magnitude of these effects becomes visible (after decomposition and sensitivity analysis) • Standard framework available • tailored model editors (e.g. GAMS/MPSGE), reliable solvers (e.g. PATH) • comprehensive data sets (e.g. GTAP) • Endogenous behaviour of producers and consumers • Suitable for the analysis of complex, price-driven policies • captures general equilibrium effects • simultaneous analysis of efficiency and distribution possible • standard framework can be extended

11. CGE models: weaknesses • Standard CGEs: assumptions of neoclassical economics • entirely price driven behaviour of agents • perfect markets • benchmark equilibrium is considered optimal, etc. • Standard model can be refined, but... • make all assumptions more realistic and you get a black box • time constraint • for some extensions data for calibration can be hard to find • Data and calibration • base year economy in equilibrium? • elasticities are crucial, but most difficult to find good data • good quality data available?

12. Part II: Calibration

13. Spend time on finding and organising your data: The quality of the results depend on the quality of the data Different sources can not always be quickly combined Always carry out the benchmark check! Much data available on internet, e.g. Statistical Offices;search and you will find Empirical calibration

14. Benchmark data base year (Social) Accounting Matrix, based on IO-table often: values in the IO-table interpreted as quantities  all benchmark prices are 1 Essentials of IO-table: value of output equals total value of all inputs for each good value of supply equals value of total demand for each good total value of endowments equals total value of final expenditures (consumption)  row total equals column total CGE models: data (I)

15. A basic input-output table

16. For each production sector: value of output equals total value of all inputs value of supply equals value of total demand total value of endowments equals total value of final expenditures (consumption)  row total equals column total Basic IO-table identities

17. Data describing the reactions of agents  often described in terms of CES functions: substitution elasticities income elasticities output elasticities  Cobb-Douglas, linear and Leontief functions are special cases of a CES function CGE models: data (II)

18. Data and CES function calibration • Elasticities, benchmark quantities and prices determine the CES functions (technologies or preferences) (i) benchmark demand quantities  provide an anchor point for isoquants / indifference curves (ii) benchmark relative prices  fix the slope of the curve at that point (iii) elasticity of substitution  describes the curvature of the indifference curve

19. L C L0 0 K0 K CES function calibration

20. Part III: Environmental issues

21. Emissions input-related or output-related purification / abatement sector (negative emissions) Disaggregated energy sector most IO tables distinguish coal, lignite, oil, gas, electricity data in physical units is ususally more accurate (e.g. IEA) activity analysis Non-emission related environmental issues e.g. depletion of natural resources, waste management CGE models: the environment (I)

22. Environmental damages damages enter utility/production functions environmental modules spatial modeling Environmental policy instruments efficiency targets quotas tradable permits taxes CGE models: the environment (II)

23. Polluters need permits to emit Permits are tradable Auctioning or grandfathering? Externality is internalised: prices reflect social costs Security that target is met In principle least-cost solution is achieved, even though government has limited information Straightforward extension of CGE framework Tradable permits

24. Environmental taxes in second-best equilibria pre-existing tax distortions => possible welfare gain tax interaction effect (lump-sum revenue recycling) tax recycling effect: lowering distorting taxes double dividend? (first: environmental, second: economic) Environmental tax reform

25. Weighing the costs and benefits of abatement Cost Benefit Analysis (CBA) benefits: avoided damages and adaptation costs costs: abatement (or mitigation) costs net benefits = benefits - costs Optimal abatement level is where marginal net benefits are zero marginal benefits equal marginal abatement costs implicitly: marginal damages equal marginal adaptation costs Determining global abatement

26. How to compare values over time? calculate the Net Present Value (NPV) by discounting future costs and benefits how to determine the discount rate? costs come sooner than benefits: higher discount rate implies lower abatement efforts Climate change is caused by concentrations long life time means long delay in effects be precautionary or wait for additional knowledge? future generations are expected to be richer The time dimension

27. Different models use different data / specifications and come to qualitatively different conclusions estimate of global damages from doubling concentrations varies widely between models  DICE is extreme case regional damages even more uncertain (but essential) controversial discounting: social rate of time preference data availability has improved substantially over the last 10 years abundance of model simulations and comparisons gives better insight in dependency of results on assumptions and range of likely effects Problems in CBA

28. Use a pre-set target for emissions (or concentrations) target can be based on sustainability or actual policies calculate lowest possible abatement costs (cost-effectiveness) target for concentrations allows for optimal timing of abatement efforts (and hence lower costs) But how to identify and justify targets? implicit approval of targets? implicitly CBA still used? Alternative to CBA

29. Part IV: Application

30. Overview of the DEAN model Multi-sector dynamic Applied General Equilibrium model perfect-foresight behaviour: Ramsey-type model Environmental module: pollution and abatement pollution and abatement are present in the benchmark No impact from environment to economy no amenity value of environmental quality no damages from environment on economy no efficiency analysis, just cost-effectiveness Model specified in GAMS / MPSGE & available on website

31. Specification of economic activity Multi-sector Applied General Equilibrium model description of the national economy producers: profit maximisation under perfect competition consumers: utility maximisation under budget balance & LES structure equilibrium on all markets (Walras’ Law) individual agents are price takers; no money illusion International trade small open economy domestic and foreign goods are imperfect substitutes (Armington) no international co-ordination of environmental policy

32. Specification of economic growth Dynamic model perfect-foresight behaviour: Ramsey-type model with finite horizon exogenous increase in labour supply endogenous accumulation of capital and greenhouse gasses Comparison of dynamic behaviour in Chapter 3 comparative-static specification recursive-dynamic specification perfect-foresight speciciation comparison uses small version of the model

33. Specification of pollution Environmental themes individual pollutants aggregated using ‘theme equivalents’ interactions within theme fully taken into account Polluters need pollution (permits) for their activities necessary input of production process / utility formation tradable permit system implemented in the benchmark autonomous pollution efficiency improvements Government auctions pollution permits environmental policy implemented as restriction of number of permits revenues are recycled lumpsum to private households

34. Specification of abatement Using bottom-up technical abatement information costs and effects of end-of-pipe and process-integrated options: discrete modelling of all available options is practically infeasible measures ordered by increasing marginal abatement costs technical potential: in the short run not all pollution can be abated ‘spending effects’: inputs in Abatement production function Endogenous choice between (i) paying for pollution permits or (ii) investing in abatement or (iii) reducing activity level Estimation of “Pollution - Abatement Substitution” curves: limited substitution between pollution and abatement

35. 120 Sustainability Current Short-term Technical estimate pollution level policy target potential 100 80 Cumulative abatement costs (in % of maximum) 60 40 Data abatement costs PAS curve 20 0 0 20 40 60 80 100 120 Emissions (in % of current level) From MAC to PAS

36. Abatement as an economic good Abatement modelled like ‘normal’ production sector abatement goods are demanded by all polluters (on a perfect market) decisions on ratio between pollution and abatement are reversible The ‘Abatement sector’ production function nested CES production function labour, capital and produced goods are inputs in abatement sector production function (the ‘spending effects’) changes in input costs leads to changes in marginal abatement costs (mainly changes in labour productivity) Autonomous pollution efficiency improvements

37. Output 0 Environmental Production Services Y 0 PAS ID KL Capital Intermediate Labour Abatement Pollution permits -unabatable part Pollution permits -abatable part deliveries Structure of production function

38. Calibration of the model Environmental themes Climate change, Acidification, Eutrophication, Smog formation, Dispersion of fine dust, Desiccation, Soil contamination Benchmark projection model calibrated to the Netherlands, accounting matrix for 1990 balanced growth of 2% per year theme-specific autonomous pollution efficiency improvements 27 production sectors 1 representative consumer for all private households 1 government sector: existing distortionary taxes

39. Data sources Description of initial situation in 1990 Social Accounting Matrix: Statistics Netherlands (National accounts) emissions: Statistics Netherlands / RIVM abatement cost curves: own compilation based on various sources, including RIVM and ICARUS Growth rates own calculations based on data for 1995 and 2000 Parameters elasticities: extended Keller model / SNI-AGE model other parameters: existing literature

40. Impact on GDP

41. Emission reductions (year 2030)

42. Sensitivity analysis Specification of technical potential results highly sensitive to technical potential Smog formation higher technical potential means lower costs and more abatement Specification of PAS-elasticity small impact, as all VOC measures will be implemented anyway higher elasticity means lower costs and less abatement expenditure Specification of endogenous environmental innovation endogenous innovation (read: learning by doing) is likely to occur any excessive economic costs of environmental policy can be prevented

43. Equivalent variation Base specification -5.8 GHG emission policy -7.4 Endogenous innovation -3.2 Labour tax recycling -5.6 Multilateral policy -11.7 High technical potential Smog formation -4.1 Impact of variants on welfare

44. Future research / room for improvement Better modelling of energy carriers and fuel switch options linking emissions of GHGs to input of energy where appropriate top-down modelling of fuel switch options any suggestions on modelling national climate policy? Add more empirical details on abatement options sectoral specification of potential options (if possible) differentiate production function abatement sector improve modelling of negative cost options Add feedback effects from environment to economy (benefits)

45. Conclusions Major (bottom-up) characteristics of abatement options can be integrated in a (top-down) CGE framework Macro-economic impact ‘modest’ 10 percent / 5 years delay / 80 bn Euro net / 145 bn Euro gross Environmental policy creates both threats and opportunities for production sectors Technical measures and economic restructuring are both essential Interactions between environmental problems have substantial influence on results