CGE models for climate policy simulation:

Some critical thoughts

Satoshi Kojima
Director, Economy and Environment Group
Institute for Global Environmental Strategies (IGES)

Climate Policy Simulation Tool (CPST) Brainstorming Meeting

15-16 July 2010, Shangri-La Hotel, Bangkok, Thailand

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Outline

Introduction : necessity of critical examination of limitations

Scope of CGE application
 2 types of policy impacts

Difficulty in long-run assessment

 Discounting problems

Policy cost issues (e.g. abatement costs)

Coping with uncertainty
 Policy planning and policy implementation

Conclusions

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CGE-based climate policy simulation?

CGE-based climate policy simulation may play a central role in CPST.

 Economic impacts of climate change and climate change policy through inter-
sectoral linkages are important. Both major consequences and drivers of
environmental and social impacts.
 Multi-regional CGE seems suitable to assess international impacts of domestic
policies as well as impacts of international policy coordination.

To explore such possibility, need to critically examine following limitations:

 Scope of CGE application
 Difficulty in long-run assessment
 Policy cost issues (e.g. abatement costs)
 Coping with uncertainty

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Scope of CGE application: 2 types of climate policy impacts

Direct policy impacts

 Impacts caused by implementation of climate policies itself: e.g. influence of
carbon pricing on market conditions, air pollution mitigation assessment, etc.

Mitigation (or adaptation) impacts

 Impacts of climate change mitigation (or adaptation) induced by climate policies:
e.g. impacts of more stable food production, impacts of less flood, impacts of
less damages from extreme climate conditions, etc.

They have different characteristics.

Time-lag: Direct policy impacts can be generated in much shorter period than
mitigation/adaptation impacts.

Uncertainty: Mitigation/adaptation impacts depend on climate change severity and
they are associated with much higher uncertainty than direct policy impacts.

Climate change dependence: Direct policy impacts matter regardless of actual
climate change events.
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Policy implications

Ends and means of policy

 Mitigation/adaptation impacts are originally ends of climate policies. However,
assessing these impacts are very difficult due to time scale and high uncertainty.
 Direct policy impacts are originally means (or by- products) of climate policies,
but easier to assess. In practice, more justifiable and robust policy ends.

Potential magnitude of impacts
 Mitigation/adaptation impacts are potentially huge as potential damage of
catastrophic climate change is immense (c.f. the Stern Review). But due to high
uncertainty not necessarily convincing to justify policy.

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Recommended scope of CGE analysis

Mitigation impacts for target setting

 Mitigation impacts might not be suitable subject of quantitative assessment for
cost-benefit analysis (CBA). Rather, better to reflect them to target setting
through political process. Inclusion of mitigation impacts in CBA causes
controversy.
 Impacts of adaptation policies need to be addressed by scientific models, e.g.
hydrological models, ecological models, etc.
→ These will be done outside CGE analysis

Direct policy impacts for demonstrating policy benefits

 Direct policy impacts are free from controversy over high uncertainty in climate
science. Once demonstrating net benefits of climate policy based on these
impacts, policy justification is robust.
→ This is suitable for CGE analysis
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How to reflect abatement costs in CGE?

Importance of abatement costs

 Key driver of economic impacts.
 Sector-specific and country-specific abatement costs are crucial information to
analyse impacts of climate policies on competitiveness.

Difficulty in estimating abatement costs

 Bottom-up approach estimates expenditures of sector for abatement actions. But
these expenditures are not necessarily “costs” for an economy (could be
resource reallocation).
 Top-down approach tries to capture abatement costs for an economy as loss of
productivity (e.g. GDP per input) as a result of abatement activities. Many CGE
studies employ this approach.

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Abatement costs in CGE studies

CGE-base estimation merely reflect mitigation mechanisms reflected by the

models.
 Mainly substitution effects due to price change (e.g. carbon pricing).
 Many studies do not estimate sector-specific and country-specific abatement
costs, which are key to analyse competitiveness issues.

Challenges to reflect sector specific abatement costs

 Ideally, abatement costs will be modelled as additional inputs (intermediate
inputs such as equipments, or factor inputs such as labour and capital) for
abatement activities with reduced productivity as these inputs do not directly
contribute to production.
 In practice, such simulation is difficult as these variables are endogenous
variables. Compromise may be just reducing corresponding productivity
parameters.

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CGE models and long-run environmental problems

Is CGE analysis relevant for long-run?

 Model parameters (technology parameters, behavioral parameters such as
preference of commodities) may change for long-run.
 Economic conditions, social structures may drastically change beyond our
expectation.
 Better to restrict short- or mid-term (say, 10 – 20 years).

How to reflect long-run environmental impacts like climate change?

 Rely on scientific results (e.g. climate model) to set policy targets for simulation.
For example, setting a 20% GHG emission reduction by 2020, considering the
potential climate change for long-run.
 CGE model can provide potential impacts of policies to achieve given targets.

Using CGE models for long-run cost-benefit analysis cannot avoid

“discounting” problems.

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Discounting problems

Long-run cost-benefit analysis faces discounting problems: “Normative vs.

Positive”
 For long-run, setting significant discount rate results in ignoring future events.
Example: 100 years consequences: 1%/year -> 37%, 5%/year -> 0.8%!
 Some argue low discounting rate to avoid ignorance of future (Normative
discounting)
 Some argue empirical observation indicates quite high discounting (5 – 10%),
and setting unrealistic low discounting rate is irrelevant.

Kojima (2006) argues that normative and positive rates are different and they
can coexist.

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Discounting issue: Reconsideration of private utility function

Reconsider the meaning of intertemporal utility optimisaion.

 Gorman (1957) distinguished current satisfaction, termed as “felicity”, from
utility defined as the highest possible average level of felicity.
 Strotz (1956) acknowledged that the current utility may depend on the
consumption of a later date, and criticized the term “instantaneous utility” as a
misnomer.

Let’s define
 Felicity: enjoyment (or satisfaction) derived from the current activities or
environment.
 Utility: enjoyment (or satisfaction) derived not only from the current conditions
but also from the expectations of future felicity.
∞ − ρt
U =∫ e u (t )dt U: Utility function of a household in time t
0 u(t): felicity function in time t
ρ : pure rate of time preference
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Coexistence of 2 discount rates in social welfare function

Then, in the social welfare function, normative and positive rates coexist.

−γG  ∞ − ρt
u (t ) dt  dG
T T
SW = ∫ e U (G ) dG = ∫ e
 ∫G
−γG
e
0 0 
G: Gth generation
γ: a weight for Gth generation’s utility, or in other word “social discounting rate”.

Social discounting rate must be determined from normative perspective. →

Ramsey’s famous aphorism: any nonzero discount rate is “ethically indefensible”
(Ramsey 1928).

But is it an appropriate way to treat intergenerational equity?

Intergenerational equity must be about conservation of the basis of human survival, and
intergenerational considerations must be done outside cost-benefit analysis.
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Uncertainty issues

Uncertainty can be reflected in CGE analysis by separating policy planning
stage and policy implementation stage.
 Policy planning is based on expectation on future conditions (price paths,
productivity fluctuation, climatic conditions, etc.).
 Impacts of policy implementation can be assessed against “realized”
conditions. For example, any random shocks can be introduced through Monte
Carlo simulations.

This approach is conceptually simple, and easy to assess various aspects
such as robustness against bad events.
 This approach seems particularly relevant for policy simulation for adaptation.

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Illustrative example of this approach

Kojima (2007) developed an applied Ramsey type growth model to assess
sustainable development policies:
 Can be regarded as full-dynamic small-scale CGE model (3 production sectors,
and the government as provider of public services such as water and irrigated
land).
 3 sectors are: rain-fed agriculture, irrigated agriculture, and other sectors.
Vulnerability of rain-fed agriculture is modelled through a stochastic risk factor.
 Moreover, uncertainty is modelled as stochastic foreign exchange rate.

Then, optimal policy is determined based on expectation of thee decision-
maker, while policy impacts are derived through Monte-Carlo simulations.

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 Illustrative example: Some numerical results
Mean Equivalent Variations
90  CC1: Standard
60 deviation of rain-fed
EV [DH/capita/year]

agricultural sector’s
30
Alt4 (Base) Alt4 (CC1) risk factor increased
0 20% from the base
-30
scenario,
1 3 5 7 Year 9 11 13 15 representing
200
Annual EV (Base-Alt4)
200
Annual EV (CC1-Alt4) potential negative
impacts of climate
100 100 change.
EV [DH/capita/year]

EV [DH/capita/year]

0 0
 Mean value is not
very affected, but
-100 -100
fluctuation of
-200 -200
possible outcomes
1 3 5 7 9
Year
11 13 15 1 3 5 7
Year
9 11 13 15 is drastically
Source: Kojima 2007 (adapted) increased.
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Conclusion (1)

This presentation critically examines the limitations/problems of CGE
models to be applied for climate policy simulations.

To consider the scope of CGE application to climate policy simulations,
better to distinguish 2 types of policy impacts: direct policy impacts and
mitigation/adaptation impacts.
 Direct policy impacts, e.g. influence of carbon pricing on market conditions,
can be simulated by CGE models
 Assessment of mitigation/adaptation impacts need to be done by scientific
models outside CGE models.

Modelling policy costs (e.g. abatement costs) is a challenge.
 Shocking production inputs (endogenous in default) is practically difficult.
 Potential compromise is to reduce productivity of production inputs.

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Conclusion (2)

CGE models are not suitable for long-run simulations.
 Model parameters may change in the long-run.
 Economic conditions and social structures may drastically change.
 Long-run cost benefit analysis cannot be free from discounting problems.
 Intergenerational equity must be about conservation of the basis of human
survival, not about cost-benefit.
 Better to restrict time frame of CGE analysis to short- or mid-term.

Uncertainty issue can be reflected in CGE models by separating policy
planning based on expectation and policy implementation under uncertainty.
 This approach is particularly relevant for adaptation policy simulation.

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 Thank you for your attention.

Contact address: kojima@iges.or.jp

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Reference

Gorman, William M. (1957), ‘Convex indifference curves and diminishing marginal

utility’, Journal of Political Economy, 65 (1), 40−50.
Hanley, Nick. et al. (1997), Environmental Economics in Theory and Practice, Oxford:
Oxford University Press.
Kojima ,Satoshi (2007) Sustainable Development in Water-stressed Developing
Countries: A Quantitative Policy Analysis. Cheltenham: Edward Elgar.
Kojima ,Satoshi (2006) ‘Reconsideration of dynamic utility optimisation and
intergenerational equity in sustainable development studies’, International Journal
of Ecological Economics and Statistics, 6:26-36.
Ramsey, Frank P. (1928), ‘A mathematical theory of saving’, Economic Journal, 38,
543−59.
Strotz, Robert H. (1956), ‘Myopia and inconsistency in dynamic utility maximisation’,
Review of Economic Studies, 23, 165−80.

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