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Edited by Terry Barker, Paul Ekins and Nick Johnstone Foreword by Sir John Houghton

Global Environmental Change Programme

London and New York

First published 1995 by Routledge 11 New Fetter Lane, London EC4P 4EE

This edition published in the Taylor & Francis e-Library, 2005.

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Simultaneously published in the USA and Canada by Routledge 29 West 35th Street, New York, NY 10001

© 1995 Terry Barker, Paul Ekins and Nick Johnstone

All rights reserved. No part of this book may be reprinted or reproduced or utilized in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers.

British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library

Library of Congress Cataloging in Publication Data A catalogue record for this book has been requested

ISBN 0-203-98364-5 Master e-book ISBN ISBN 0-415-10980-9 (Print Edition) ISBN 0-415-11601-5 (pbk)

Contents

List of figures vii

List of tables ix

List of contributors xi

Foreword xiii

Sir John Houghton

Preface xiv

1 Introduction 1

Terry Barker, Paul Ekins and Nick Johnstone

Part I Estimating long-term energy elasticities

2 Alternative approaches to estimating long-run energy demand elasticities 14 An application to Asian developing countries

M.Hashem Pesaran and Ron Smith

3 A survey of international energy elasticities 36

Jago Atkinson and Neil Manning

4 Long-run demand elasticities for gasoline 82

Mikael Franzen and Thomas Sterner

5 Responses of energy demand in UK manufacturing to the energy price increases of 1973 95 and 1979-80

Alan Ingham

6 Elasticities for OECD aggregate final energy demand 125

Lakis Vouyoukas

7 Modelling UK energy demand 136

Derek Hodgson and Keith Miller

Part II Energy, the economy and greenhouse gas abatement

8 Endogenous technological progress in fossil fuel demand 149

Laurence Boone, Stephen Hall, David Kemball-Cook and Clare Smith

9 UK energy price elasticities and their implications for long-term CO2 abatement 178

Terry Barker

10 Price elasticity and market structure

Overcoming obstacles to final demand energy efficiency

Tim Jackson

11 Rethinking the use of energy elasticities

Stefan P.Schleicher

12 Revisiting the costs of CO2 abatement

Paul Ekins

13 Asymmetrical price elasticities of energy demand Michael Grubb

14 Conclusions

Terry Barker, Paul Ekins and Nick Johnstone

Bibliography

Index

Figures

1.1 Economy-energy-environment interactions, carbon dioxide emissions and global warming 6

2.1 Time-series and cross-section estimates 25

2.2 Non-linearity and the relationship between coefficients and regressors 26 4.1 Gasoline prices and consumption, OECD 1960-88 92

5.1 Ex ante technology putty-clay 99

5.2 Ex ante technology putty-semi-putty 100

5.3 Ex post decision 101

5.4 Fit of model: labour 102

5.5 Fit of model: energy 103

5.6 Fit of model: investment 104

5.7 K coefficient 106

5.9 K coefficient 108

5.10 ¿4 coefficient 109

5.11 Divisia index of real energy prices, 1965=100 110

5.12 Energy price/wage costs, 1965=100 111

5.13 Energy-output ratio 112

5.14 Fit of model: energy-output ratio 113

5.15 Energy-output ratio: output constant 114

5.16 Energy-output ratio: 0.5 per cent growth 115

5.17 Price elasticities: output constant 116

5.18 Price elasticities: 0.5 per cent growth 117

5.19 Price elasticities: 1 per cent growth 118

5.20 Energy demand: different expectations 119

5.21 Energy-output ratio: different expectations 120

5.22 Energy demand: 1 per cent price increase 121

5.23 Effect of sudden increase in 1980 122

5.24 Effect of unexpected increase 123 7.1 Total domestic sector appliance energy demand 145

8.1 Consumption of petroleum products (log of t.o.e.) for the United States, United Kingdom and 155 Germany

8.2 Consumption of petroleum products (log of t.o.e.) for France, Japan and the United Kingdom 156

8.3 Price and tax of petroleum products in the United States 157

8.4 Price and tax of petroleum products in France 158

8.5 First and second differences for relative price of fossil fuel for Germany 161

8.6 First and second differences for relative price of fossil fuel for Italy 161

8.7 Belgium fossil fuel consumption/GDP and relative price of fossil fuel 162

8.8 Canada fossil fuel consumption/GDP and relative price of fossil fuel 162

8.9 France fossil fuel consumption/GDP and relative price of fossil fuel 163

8.10 Germany fossil fuel consumption/GDP and relative price of fossil fuel 163

8.11 Italy fossil fuel consumption/GDP and relative price of fossil fuel 164

8.12 Japan fossil fuel consumption/GDP and relative price of fossil fuel 164

8.13 Netherlands fossil fuel consumption/GDP and relative price of fossil fuel 165

8.14 United Kingdom fossil fuel consumption/GDP and relative price of fossil fuel 165

8.15 United States fossil fuel consumption/GDP and relative price of fossil fuel 166

8.16 Endogenous technical progress for the UK 173

10.1 Cost-effectiveness of different CO2 emission abatement options (by the year 2005; 10 per cent 198 assumed discount rate)

10.2 Effects of a carbon tax on microeconomic analysis of CO2 abatement options (by year 2005; 10 199 per cent discount rate)

10.3 Cost-effectiveness of CO2 emission abatement options when seen from the investor's perspective 201

10.4 Effects of a carbon tax on microeconomic analysis of CO2 abatement options from the investor's 202 perspective

11.1 Final energy consumption 209

11.2 Real GDP and real energy prices 209

11.3 Estimated income elasticities 210

11.4 Estimated price elasticities 211

11.5 Prediction bounds (two standard deviations) of one to five years ex ante forecasts 211

12.1 Costs of adaptation and damage at a given (net accumulating) level of greenhouse gas emissions 224

12.2 Calculation of the optimum greenhouse gas emission level 225

12.3 GDP losses associated with reductions in global CO2 emissions relative to base projections (various 228 studies and years)

12.4 Marginal costs and benefits of greenhouse gas emissions 233

Tables

2.1 Individual country estimates of dynamic energy demand equations for ten Asian developing 28 countries (1974-90)

2.2 Individual country estimates of the long-run income and price elasticities 29

2.3 'Average' estimates of dynamic energy demand equations for ten Asian countries, 1974-90 30

2.4 'Average' estimates of long-run income and price elasticities based on static energy demand 31 equations for ten Asian countries (1974-90)

2.5 Tests of order of integration and cointegration 32 2A Country mean growth rates and per capita levels 35

3.1 Energy demand elasticities with respect to income and price 45

3.2 Partial elasticities of substitution 50

3.3 Own- and cross-price partial fuel elasticities 52

3.4 Types of stationarity, fuel balances 68

3.5 Types of stationarity, fuel prices 69

3.6 Types of stationarity, fuel expenditure shares 69

3.7 Lower-stage fuel-expenditure-share equations, long-run own-price elasticities from five 70 specifications: coal

3.8 Lower-stage fuel-expenditure-share equations, long-run own-price elasticities from five 71 specifications: oil

3.9 Lower-stage fuel-expenditure-share equations, long-run own-price elasticities from five 72 specifications: gas

3.10 Lower-stage fuel-expenditure-share equations, long-run own-price elasticities from five 73 specifications: electricity

3.11 Lower-stage fuel expenditure equations: cross-price elasticities for a static homothetic and 76 symmetric model with fuel efficiency bias terms included

3.12 Types of stationarity 78

3.13 Upper-stage results—cointegrating regressions: long-run elasticities and summary diagnostics 79

4.1 Elasticity estimates with pure cross-sections 86

4.2 Individual country elasticities (model Mj) 87

4.3 Comparison of long-run elasticities 89

4.4 Summary of long-run elasticity estimates for the OECD 91

4.5 Elasticities for different regions and time periods 92

5.1 Number of vintages available and used 103

5.2 Scrapping dates for vintages (period 1=1955Q1) 106

6.1 Aggregation scheme for final energy demand in the OECD 126

6.2 Long-term transportation demand elasticities 129

6.3 Long-term industrial energy demand elasticities 131

6.4 Long-term price elasticities of industrial fuel shares 132

6.5 Elasticities for per capita total energy building demand 133

6.6 Long-term elasticities of building fuel shares 134

7.1 DTI energy model own long-term price elasticities 139

7.2 British Coal's own long-term price elasticities 140

7.3 DTI energy model own long-term income-output elasticities 141

7.4 Domestic sector heating price elasticities 143

7.5 Domestic sector cooking price elasticities 144

8.1 Summary of features of global models 152

8.2 Assumptions made by studies about energy elasticity and energy intensity 152

8.3 Summary of stationarity properties for each variable by country 159

8.4 Cointegrating regressions for each country 165

8.5 Own-price elasticities of demand for fossil fuel share of GDP and time trends 167

8.6 Significance of the residuals on two competing cointegrating vectors 169

8.7 Growth rate of the relative price of fossil fuels necessary to maintain fossil fuel consumption 170 constant, given assumptions about real GDP growth

8.8 Calculations required to estimate price changes required to stabilize fossil fuel consumption 170

8.9 Autocorrelation function, Box-Pierce statistic and Ljung-Box statistic 173

9.1 Parameters for the aggregate energy equations—base specification 1970-90 184

9.2 Test statistics for the aggregate energy equations—base specification 1970-90 185

9.3 Price elasticities for various lags in aggregate energy equations —base specifications 1970-90 185

9.4 R2 for various lags in aggregate energy equations—base specifications 1970-90 185

9.5 Parameters for the long-run cointegrating energy equations— base long-term price elasticities 187

9.6 Parameters for the dynamic cointegrating energy equations— base long-term price elasticities 187

9.7 t ratios for the dynamic cointegrating energy equations—base long-term price elasticities 187

9.8 Test statistics for the dynamic cointegrating energy equations— base long-term price elasticities 188

9.9 Estimated and imposed price elasticities of aggregate secondary energy demand, UK 1970-90 189

9.10 Estimated and imposed activity elasticities of aggregate secondary energy demand, UK 1970-90 189

9.11 Tests of predictive failure for dynamic cointegrating aggregate energy equations and base 190 specification—1986-90

9.12 Long-term price elasticities from the share/ratio equations 191

9.13 UK CO2 emissions 1990-2005 from projections using MDM 194

9.14 UK total energy demand 1990-2005 from projections using MDM 194

12.1 Estimates of annual damage and adaptation costs from global warming incurred by the US 221 economy at 1990 scale (billions of 1990 dollars)

12.2 GDP and employment effects in 2005 of constant real $10 per barrel energy tax imposed in 1990 229 with different revenue use, four countries separately and together

12.3 Effects on GDP and employment in four EU countries in 2000 after introduction of $10 energy tax 230 in 1991

Contributors

Jago Atkinson Terry Barker

Laurence Boone Paul Ekins

Mikael Franzen Michael Grubb

Stephen Hall

Derek Hodgson Alan Ingham

Tim Jackson Nick Johnstone

David Kemball-Cook

Neil Manning Keith Miller M.Hashem Pesaran

Stefan P.Schleicher Clare Smith Ron Smith

Formerly a research student in the Department of Economics, University College of Swansea. Currently an economist at the Welsh Development Agency, Cardiff. Senior Research Officer in the Department of Applied Economics, University of Cambridge and Chairman of Cambridge Econometrics. With Paul Ekins he is directing an ESRC-funded project, 'Greenhouse gas abatement through fiscal policy'.

Postgraduate student at the Centre for Economic Forecasting, London Business School.

Research Fellow at Department of Economics, Birkbeck College, University of

London, UK. With Terry Barker, he is directing an ESRC-funded project,

'Greenhouse gas abatement through fiscal reform'.

Postgraduate student at the University of Gothenburg, Sweden.

Head, Energy and Environment Programme, The Royal Institute of International

Affairs.

Director of Research at the Centre for Economic Forecasting, London Business School.

Senior Economic Adviser in the Economics and Statistics division of the DTI. Lecturer in Economics at the University of Southhampton. He has been a visitor at the Catholic University of Louvain and the University of British Columbia, Canada.

Stockholm Environment Institute.

Junior Research Officer at the Department of Applied Economics, University of Cambridge, UK.

Lecturer in Economics, Southwark College, London.

Lecturer in Economics, University of Wales at Swansea. Economic Adviser in the Economics and Statistics Division of the DTI. Professor of Economics at the University of Cambridge and University of California at Los Angeles.

Professor of Economics at the University of Graz, Austria.

Research Fellow at the Centre for Economic Forecasting, London Business School.

Professor of Applied Economics at Birkbeck College, University of London.

Thomas Sterner Associate Professor of Environmental Economics at the University of Gothenburg, Sweden.

Lakis Vouyoukas Head, Economic Analysis Division, International Energy Agency.

Foreword

Sir John Houghton

In June 1992 at Rio de Janeiro in Brazil, about 25,000 people gathered for the world's largest conference ever. Often known as the Earth Summit because of the large number of world leaders and heads of government who attended, and held under United Nations' auspices, it was concerned with environment and development. How can the right balance be struck between our need to develop and to improve human quality of life and the important imperative to preserve the environment? In other words how can the goal of sustainable development be achieved?

One of the main outcomes of the Earth Summit was the Framework Convention on Climate Change. The Convention recognizes that climate is changing as a result of the increase in greenhouse gases arising from the burning of fossil fuels and that action needs to be taken to limit these anthropogenic emissions (in particular those of carbon dioxide). The Objective of the Convention, which is to achieve stabilization of the concentration of greenhouse gases in the atmosphere, puts this action in the context of sustainable development. Action taken must allow 'economic development to proceed in a sustainable manner'.

Since a large proportion of carbon dioxide emissions is associated with the provision of energy in its various forms, a vital input to the proper consideration of the Convention's Objective concerns the economics of the energy industry. How can carbon dioxide emissions from energy production be reduced, how much will these reductions cost and how can that cost be minimized are three of the key questions.

International action in response to the requirements of the Climate Convention demands that the very best particular expertise be brought to bear from the disciplines of technology, economics, risk analysis and human behaviour. In the chapters in this book some of this expertise is brought to bear on particular economic analyses; they form a valuable contribution to the lively debate concerning how the Convention's Objective can be realized.

Preface

Energy use is central to many economic and environmental problems, particularly global warming. The responsiveness of energy use to changes in prices, taxes and incomes is critical in assessing the feasibility of a massive reduction in greenhouse gas (GG) emissions, deemed necessary by the climatologists to reduce the rise in atmospheric GG concentrations.

This book originated in a two-day workshop 'Estimating long-run energy elasticities' held at Robinson College, Cambridge, 29-30 September 1992. The workshop was organized as part of a two-year project on 'Policy options for sustainable energy use in a general model of the UK economy' in the Department of Applied Economics, University of Cambridge, which was being funded under Phase 1 of the ESRC's Global Environmental Change Programme. This project has been succeeded by another 'Greenhouse gas abatement through fiscal policy' under Phase 3 of the Programme, also involving the editors of this book. The workshop was seen as covering one important intellectual foundation for research into policy options for reducing fossil fuel use: What do we know about responses of the energy markets to increases in prices? Are these responses applicable in projections of the economy in which policies are designed to minimize costs of adjustment?

The book is not the proceedings of the workshop. The original papers have been revised, some extensively, and new chapters have been specially written to address these questions. The book is a contribution to the ESRC's Programme in that it reviews and extends the literature on energy elasticities in relation to the long-term problem of reducing GG emissions.

Chapter 1 Introduction

Terry Barker, Paul Ekins and Nick Johnstone

THE OBJECTIVES OF THE BOOK

In the light of the Climate Change Convention agreed upon at the Earth Summit in Rio de Janeiro in 1992, it is inevitable that many governments will be addressing the problem of global warming. Moreover, recent discussions in both the United States and the European Union concerning the introduction of carbon and/or energy taxes indicate that significant changes in fiscal policy are likely to result as a consequence. Given the percentage reductions estimated by the Intergovernmental Panel on Climate Change (IPCC) as being necessary to stabilize carbon dioxide (CO2) concentrations, the rates of such a tax will have to be of considerable magnitude.

The purpose of this book is to explore the estimation of the likely responses of energy demand to measures designed to abate greenhouse gas (GG) emissions, particularly fiscal measures to abate CO2 involving changes in energy taxes and thus prices. More particularly, the book is about the problems of estimating energy demand elasticities, the treatment of energy and fuel demand in macroeconomic models, the implications for GG abatement policy and the limitations of the approach: How can energy modelling techniques and results, usually arising from research with a different purpose in mind, be applied to the long-term problem of GG abatement through a carbon or energy tax? How should the published results be interpreted for this purpose? What are their limitations and strengths?

Apart from this introductory chapter, the book is divided into two parts. Part I is concerned with the methods of estimating energy demand elasticities, the resulting estimates, and the modelling of energy-economy interactions by the International Energy Agency (IEA) and the UK Department of Trade and Industry (DTI) for the purpose of informing government policy. Part II links this approach to the problem of abating GG emissions by means of taxation and other government policies: models are developed to assess the response of nine OECD economies and the UK economy to carbon/energy taxes; the limitations of relying on the price mechanism and constant elasticities alone are explored; the literature on the economic costs of global warming is reviewed; and the possibility that the price responses are asymmetric is discussed. The book concludes with an assessment of the elasticities approach and suggests new directions in the treatment of long-term energy demand for the analysis of GG abatement.

This chapter first provides a brief introduction to forecasts of global warming and discusses some of the views of the economic and associated costs. This is preparatory to an explanation of the role of energy markets in contributing to GG emissions from economic activities. The concepts of energy elasticities are introduced and their limitations with respect to analyses of global warming are explored. The chapter also considers wider issues including the treatment of technological change in energy demand modelling, the question of international migration of carbon-intensive activities and, briefly, implications for global energy supply.

THE FORECASTS OF GLOBAL WARMING

The greenhouse effect is a universally accepted phenomenon whereby certain gases in the earth's atmosphere (most importantly water vapour and CO2) are more transparent to the short-wave radiation from the sun than to the long-wave re-radiation from the earth's surface. Thus the atmosphere traps solar radiation in a manner similar to a greenhouse. It has been estimated that without the greenhouse effect the earth's average surface temperature would be -18°C rather than +15°C (Cline 1992:15).

Human (anthropogenic) activities, especially economic activities, are adding significantly to the atmosphere's greenhouse gases, most importantly through the emission of CO2 from the burning of fossil fuels and deforestation, but also from emissions of chlorofluorocarbons (CFCs), methane and nitrous oxide as well as the formation of low-level ozone. This has led to scientific speculation about an anthropogenic greenhouse effect which could lead to further warming of the earth's average surface temperature, and which may well have already done so. Indeed, CO2 levels in the atmosphere have risen about 25 per cent since pre-industrial times owing to human activities; and the concentration of methane has more than doubled from pre-industrial levels. The different warming potentials of different gases are commonly converted to 'CO2 equivalents', and a benchmark for the assessment of anthropogenic global warming is often taken as the doubling of these CO2 equivalents over pre-industrial levels. On current trends this is expected to be reached by 2025. The 1992 supplementary report of the IPCC (1992) re-affirmed the 1990 estimate that a doubling of CO2 equivalents would lead to a warming of the earth's average surface temperature in the order of 1.5-4.5°C (with a best guess value of 2.5°C), perhaps after a considerable period due to the thermal lag of the oceans. While this assessment does not command total scientific consensus, it does represent a clear majority view among the world's climate scientists. Yet, as Cline emphasizes, without significant policy changes, the atmospheric concentration of greenhouse gases is likely to rise several times beyond a doubling of CO2 equivalent with a concomitant commitment to global warming. Indeed, it is most unlikely, given the political difficulty of abating CO2 emissions, that this first doubling can now be prevented, so that the earth appears already committed to a likely warming of 2.5°C. Cline has calculated, using the IPCC climate parameters, that business-as-usual projections of greenhouse emissions to 2275 would result in global warming of 6-18°C, with a central value of 10°C (Cline 1992:57).

Such estimates are not universally accepted, however. Indeed, Solow's (1991) review of the scientific evidence of climate change casts doubt on the reliability of current climate models' prediction of future warming since they are unable to explain the warming that has taken place over the past century. While the average magnitude of such warming is broadly as predicted, the models do not explain its time profile or spatial distribution. Moreover, the warming that has occurred could be explained as a natural recovery from the last pulse of the 'Little Ice Age' in the late eighteenth century. However, notwithstanding these doubts, Solow concludes: 'Based on a balanced reading of the scientific literature, it is virtually certain that global warming will occur in response to ongoing changes in atmospheric composition' (Solow 1991:25).

ECONOMIC AND ASSOCIATED EFFECTS OF GLOBAL WARMING

The effects of global warming are far more uncertain than the warming itself. On the one hand, as Schelling says: 'We will be moving into a climate regime that has never been experienced in the inter-glacial period' (Schelling 1992: 3). On the other, as Schelling also notes, the absolute temperature differences seem quite small and rather less than migrants in previous ages, and travellers today, have been and are able to adjust to quite comfortably.

However, a relatively modest average warming of the earth's surface is likely to include larger individual variations at local level which have important effects on the environment and humanity. Three economists who have made a detailed study of the consequences of the greenhouse effect have come to the following conclusions. Schelling says: 'Natural ecosystems will be destroyed; plant and animal species will become extinct; places of natural beauty will be degraded. Valuable chemistries of plant and animal life will be lost before we learn their genetic secrets' (Schelling 1992:7-8). Cline's assessment of the economic impacts, although stated less dramatically, is no less disturbing:

Global warming could cause agricultural losses in many regions. The level of the seas would rise, imposing costs of barrier protection of coastal cities and the loss of land area (including valuable wetlands). There would be increased electricity needs for air conditioning, potentially serious declines in the availability of water to agriculture and cities, increased urban pollution, increased intensity and frequency of hurricanes, increased mortality from heat waves, and losses in leisure activities associated with winter sports.

(Cline 1992:30-1)

Like Schelling, Broome also accepts that 'the strains on natural ecologies are likely to be very great' (Broome 1992:13) and, like Cline, identifies substantial costs associated with global warming:

Without increased sea defences low-lying areas will become more susceptible to flooding. The danger will be amplified if storms become more frequent or more severe Regions threatened by flooding include densely populated areas. Eight to ten million people live within one metre of high tide in each of the unprotected river deltas of Bangladesh, Egypt and Vietnam. A flood in Bangladesh, caused by a tropical storm in 1970, killed 300,000 people. Rising sea levels, then, must be expected to kill very large numbers of people. This is an enormous and easily predictable harm that will be caused by global warming. Moreover, sea levels will continue to rise for centuries. This must cause large migrations of population and it is difficult to see where the people can move to. There seems to be inevitable harm in this too: the forced migration of many million people is inevitably a disaster. Another class of bad effects is also quite easily predictable. As the world warms, more people will become subject to tropical diseases. This, too, will shorten many people's lives.

(Broome 1992:14)

Moreover, CO2 pollution is not the only negative environmental effect of the use of fossil fuels. On the basis of UK Department of Environment data, Barker (1993:4) has calculated that, in the UK, 99 per cent of SO2 and NOX, 97 per cent of CO and 91 per cent of particulate matter, as well as substantial contributions to methane (48 per cent) and volatile organic compounds (38 per cent), all come from this source. Barker found that the associated damages from these emissions are substantial.

Solow (1991:25) points out that the estimates of damage from global warming have been moving away from 'apocalyptic scenarios'. For example, likely sea-level rise over the next hundred years is put at less than one metre now, as opposed to three metres or more predicted a few years ago. Global warming could also have some beneficial effects. An atmosphere richer in CO2 may enhance photosynthesis and raise productivity in agriculture and forestry. More northerly latitudes, becoming warmer, may become more agriculturally productive. Warming may also lead to greater physical comfort in such latitudes. Warmer climates in some places may benefit industries as diverse as tourism and construction.

The analyses of Broome and Schelling, and of other major contributors in this field such as Nordhaus (1991a), focus exclusively on global warming and its likely effects over the course of the next century. However, as noted above, it is quite likely that the temperature rise will be much more significant in the ensuing years. This much larger temperature change would amplify global warming's negative effects and reduce its benefits. Cline warns:

It is important to recognize from the outset, however, that as a general rule one would expect the economic size of damage from global warming to rise more than linearly with the magnitude of warming. The costs of 10°C warming in the very long term could thus be far more than four times the costs of the 2.5°C benchmark warming for a doubling of carbon dioxide equivalent.

(Cline 1992:72)

Of course, the further one projects into the future, the less reliable are the estimates generated, not least because of the likely technological changes in the meantime. Beckerman (1991:63) considers that 'nobody can suppose that the world of the late twenty-first century will bear much resemblance to the world that we know today' and is generally optimistic that new technologies for energy supply, energy efficiency and agriculture will have rendered largely irrelevant current concerns over these issues. However, this does not appear to change the fact that, unless these new technologies act over the next century to curtail greatly the expanded use of fossil fuels that is expected, global warming will eventually be substantially greater than that associated with the doubling of CO2 equivalents in the atmosphere. Furthermore, with ample world supplies of coal, it is difficult to see what incentive there will be for the development of new carbon-free supplies and energy-efficient technologies without substantial real increases in carbon/energy taxes above present levels (or the development of a global coal cartel capable of raising prices substantially and willing to do so).

This greater warming would increase the possibility of some catastrophic climate reaction to higher average temperatures. Even with the relatively low temperature increase foreseen within the hundred-year time-frame, Broome observed: 'Human-induced global warming, then, could possibly start a chain of events that could lead to the extinction of civilization or even of humanity. This is a remote possibility, but it exists' (Broome 1992:16).

GREENHOUSE GAS EMISSIONS AND THE ECONOMY

Economic behaviour and the availability of fossil fuels have led to greatly increased GG emissions from human activity and the unrestrained future increase in emissions is a risk to life on earth; but the GG emissions are not wanted for their own sake. The conflict between environmental quality (represented by lower GG emissions in the future) and economic welfare (represented by higher economic activity and improved quality of life) is not a direct one. Indeed some greenhouse gases are poisonous (carbon monoxide), others are repugnant (methane), and GG emissions in general are associated with other byproducts of combustion, such as sulphur dioxide, soot and oxides of nitrogen, which also damage health and welfare as well as the environment more generally.

However, there are economic goods which are wanted—such as physical comfort from warm (or cool) buildings, transport services, and all other consumer goods which generate GG emissions in production— yet which are also, at least at present, inextricably bound up with the emission of greenhouse gases. The close relationship between such economic services and emissions of greenhouse gases is due in large part to the fact that the atmosphere has been traditionally treated as common property, with no charge for its use for dumping wastes, so the emissions are only subject at most to local restrictions concerned with local air quality. Although these economic services could be provided at very low levels of emissions, or indeed in some cases with no emissions whatsoever, the alternative processes of production are perceived as being too expensive or inconvenient, or they carry with them other social or environmental costs.

From an economic policy perspective, the problem of global warming possesses a number of characteristics which affect the means by which it can be regulated. On the one hand, since there is no economic technology to absorb the primary greenhouse gas, CO2, any abatement policy must focus on source reductions and not clean-up technologies. Moreover, since each of the individual fuels possess distinct, but unique, carbon contents, CO2 emissions are a function of the type of fuel used. In addition, since global warming is a global common property issue the location of emission sources is irrelevant to the determination of environmental damages. For these reasons, differential taxation of fuel types will effectively tax carbon inputs, CO2 emission outputs and environmental damages. (This is in contrast with the abatement of acid rain. Since different grades of coal possess widely varying sulphur content, since 'end-of-pipe' abatement technology such as flue-gas desulphurization exists, and since there is spatial differentiation in environmental effects, the relationship between fuel and environmental damage is not unique.)

Moreover, since the different primary energy carriers (coal, oil, gas) have clearly defined markets and sources of supply it is a relatively straightforward matter to apply such tax rates. And finally, given that the fuels are already taxed or subsidized extensively, the administrative and institutional costs of further taxation are relatively small (compare the administrative costs of the introduction of the EU's carbon/energy tax with those of VAT for example). For these reasons, in addition to the fact that emissions of most non-CO2 greenhouse gases are closely associated with the burning of fossil fuels (the exceptions being CFCs and methane from gas leaks, animals and waste tips), most of the literature, including this book, is concerned with CO2 abatement in particular rather than with GG abatement in general and with abatement via a carbon tax which is expected to change energy and fuel prices and, via price elasticities, energy demand and CO2 emissions (see Poterba 1991; Pearce 1992; Barker 1993).

These characteristics illustrate the importance of fully specifying the relationship between the environmental consequences of pollution and the economic processes which generate polluting agents. In terms of CO2 emissions, the relationships can be represented as in Figure 1.1. The arrows indicate the direction of flows of energy, emissions, goods or services and the ovals represent energy conversion.

Working backwards from the fundamental source of demand for energy, economic goods and services, the relationship between the economy, energy and the environment can be traced. At the first stage (top left-hand corner of Figure 1.1), a variety of economic processes (e.g. manufacturing, household heating and transportation) employ energy services (e.g. motive power and heat). The provision of such services is realized through the employment of both energy carriers and capital goods. Flows of energy carriers can be subdivided into fuels (e.g. oil products, gas, coal and coal products) and electricity. Energy-related capital can also be subdivided into generating equipment involved in fuel combustion (e.g. electricity generating

Word Map Samples
Figure 1.1 Economy-energy-environment interactions, carbon dioxide emissions and global warming

plants, domestic and industrial boilers and vehicle engines), capital equipment related to energy retention (e.g. building insulation, waste energy recovery systems, and flywheels used in transport systems) and public-energy-related infrastructure (e.g. road networks, railway systems and combined heat and power systems). The first affects the flows of energy directly through combustion while the last two affect the volume of flows required to meet given energy service demands. Carbon is embodied within some fuels (fossil fuels) and is released as CO2 emissions upon combustion in the electricity supply industry and in other sectors as well as in the extraction, processing and distribution processes. The CO2 emissions then impact upon the environment, and thus the economy, in the manner outlined above.

CARBON DIOXIDE EMISSIONS AND ENERGY ELASTICITIES

The fact that there appear to be no economic prospects for end-of-pipe technology for the abatement of CO2 emissions and that there is no spatial differentiation of the effects of such emissions simplifies the problem of designing an optimal environmental policy considerably since a tax on carbon as an input into economic processes will achieve the desired environmental objective. Unlike other pollutants, there is no need to adjust tax rates to reflect the characteristics and location of production processes.

Given these characteristics, the demand elasticities of the fuels which possess carbon should, in some sense, reflect the difficulty involved in achieving the desired environmental objective. However, at the same time that the environmental relations discussed above facilitate the design of an appropriate policy, the economic relations described above indicate that the estimation of such elasticities is rather problematic, and as such the interpretation of such elasticities and their application to economic models must be treated with caution. First, carbon, and indeed primary fuels, are not goods in their own right, but are instead demands derived from the demand for energy services used as inputs in economic processes. Second, both primary fuels and energy-related capital equipment are joint inputs used in the provision of such energy services. On the one hand this implies that estimates of energy elasticities are only useful to the analysis of global warming in so far as energy reflects embodied carbon. In this sense, models which incorporate the possibility of substitution between fuels with different carbon contents are of considerably more interest than those which treat energy as an aggregate. In this volume the chapters by Barker, by Hodgson and Miller and by Manning and Atkinson are of particular relevance to this question. On the other hand, it is important to distinguish between demand for the fuel which is used in the provision of energy services and the energy services themselves. The elasticities estimated are therefore a reflection not of the demand for fuel per se but of demand for fuel in the provision of different energy services. The latter point is closely related to the nature of energy and capital as joint producers of energy services. Reduced fuel consumption may reflect a change in the means by which the service is obtained and not reduced provision of the service. These points are made emphatically by Jackson and Schleicher in Chapters 10 and 11.

This is of some concern for short-term price and income elasticities but is, of course, of considerably more importance for long-term elasticities. Thus, attempts to address the problem of global warming must address the particular features of the demand for carbon (an input which is embodied in fuels which are themselves derived demands for the energy service) and the supply of the energy service (a joint product of the primary fuel and all energy-related capital equipment). Attempts to apply demand elasticities estimated on the basis of historical evidence of fuel consumption must recognize that demand for fuel is derived from the demand for the energy service and that all the various links in the supply network are contextual, and subject to change.

SHORT-TERM AND LONG-TERM ENERGY ELASTICITIES

Given the long-term nature of the environmental consequences of global warming, as well as policies designed to mitigate such warming, estimates of very-long-term energy elasticities (i.e. periods of more than twenty years) are clearly of more relevance than estimates of short-term energy elasticities. However, most empirical studies of energy demand (including those surveyed and presented in this book) have focused on elasticities estimated on data usually covering twenty- to thirty-year periods, since the objectives of the research have not usually extended to issues involving time-frames such as those required for the analysis of global warming and the data for longer periods are either unavailable or unreliable.

There are, moreover, methodological problems associated with the estimation of long-term energy elasticities. For instance, in order to estimate long-term elasticities using time-series data it is necessary to introduce sufficiently long lags to allow the economy to adjust fully to price changes. This implies that all of the energy-related capital stock (e.g. generating plants, domestic and industrial boilers, vehicles and infrastructure) has adjusted to the change in relative prices. A variety of functional forms have been posited to capture these effects, including lagged endogenous models, inverted-V lag models and polynomial distributed lag models. However, given the nature of both the demand for fuels (derived from the demand for energy services as an input in economic processes) and the supply of energy services (a joint product of fuel, capital equipment and public infrastructure) it is exceedingly difficult to estimate elasticities of sufficiently long length on the basis of such models. Thus, not surprisingly, there is wide discrepancy in both the absolute magnitude and the statistical significance of elasticities estimated using different functional forms. In their account of the modelling of UK energy demand Hodgson and Miller discuss some of the difficulties.

In this light, it believed by some (Griffin 1981b) that elasticities estimated on the basis of time-series data are inherently incapable of capturing the long-term effects of price changes due to the length and variability of the adjustment lags involved. As a consequence, in the literature it is commonly asserted that cross-section studies are better able to capture the long-term effects of price changes, since data collected from different countries reflect long-term structural characteristics (Griffin and Gregory 1976). For instance, cross-section studies would capture the structural consequences of persistently low historical energy prices in North American and East European economies relative to some West European and East Asian economies.

A number of chapters address these issues explicitly. In the survey conducted by Manning and Atkinson, results are cited from a wide variety of time-series, cross-section and pooled time-series cross-section studies. For the most part, the price elasticities derived from time-series studies tend to be significantly lower than those of other studies. Conversely, in his chapter Sterner finds that the long-term price elasticities of gasoline demand derived from lagged endogenous models range from +0.1 to -2.3, while the estimates from cross-section data yield elasticities which range from -0.8 to -1.3. Pesaran and Smith attribute some of the discrepancies in results between time-series and cross-section studies to methodological problems biasing the estimates. Using heterogeneous panel data for East Asian economies they suggest that time-series estimates should be estimated for individual groups (countries) and then averaged and these estimates should then be compared with cross-section estimates based on long-term averages.

STRUCTURAL BREAKS IN THE DEMAND FOR ENERGY

Closely related to the question of distinguishing between short-term and long-term elasticities is that of recognizing structural breaks in the demand for energy. Thus, it is felt that there might be instances in which the demand for energy undergoes a fundamental structural change and that this would be reflected not only in changed energy consumption patterns but also in changed elasticities. In particular the oil shocks of 1973 and 1979 are frequently cited as instances where the demand for energy changed qualitatively and not just quantitatively. This is believed to be of particular relevance to the problem of global warming since the price increases experienced were of a similar magnitude to those which would be required to stabilize energy consumption. In addition, the elasticities used in models to assess the effects of abatement policies are estimated from data in which changes in energy and fuel prices are dominated by the effects of the two oil price shocks of 1973 and 1979 and the oil price collapse of 1985.

It should be emphasized, however, that the responses to the large fluctuations in energy and fuel prices in the 1970s and 1980s may be different in a number of specific respects to those following the introduction of a carbon or energy tax to curb CO2 emissions.1

1 Motivation The global oil price changes were induced by factors which are perceived to be unstable (e.g. oil cartels); in contrast the motivation to curb emissions is more stable (e.g. government policy). In one instance the price increase may be perceived to be temporary, while in the other it may be perceived as being rather more permanent since taxes are rarely withdrawn once introduced, particularly if the motivation for the tax (GG abatement) represents a long-term objective. In addition, the oil shocks were precisely that—sudden, largely unanticipated, exogenous shocks.

2 Speed of adjustment A second difference between circumstances of the oil price shocks and those of an increase in energy price due to abatement policy is in the speed at which the price will rise and consequently the time period for energy users to adjust. The 300 per cent rise in crude oil prices over the course of six months in 1973-4 should be contrasted with a 10 per cent a year increase in carbon contents of energy carriers over the course of twenty years. The long period of adjustment greatly reduces costs of adjustment (see Chapter 5) since it allows capital stock to be replaced as it comes to the end of its useful like, rather than being scrapped when energy prices rise.

3 Expectations The transformation of fiscal policy so as to address the problem of global warming would be introduced gradually and with significant forewarning. Thus, economic actors will be able to anticipate, and indeed are at present anticipating, the introduction of such measures. In this light, the credibility of government policy, the amount of warning given by the government, and the means by which price expectations are reflected in anticipatory behaviour by the private sector, may be of more significance than the absolute magnitude of the price increase.

4 Revenue recycling The basis for the price increases in the two cases has even more fundamental repercussions when the recipients of the revenues generated are distinguished. In one case (the oil shock) the revenue accrued to the oil-producing countries, while in the other (carbon/energy tax) the governments of the energy-consuming countries would receive the revenue. In the latter case, therefore, the recessionary effects of the price increase could be mitigated, or indeed reversed, by removing other more distortionary taxes. Alternatively, the revenue could be retained, reducing the public-sector borrowing requirement and possibly increasing long-term growth prospects.

5 Macroeconomic effects The oil price shocks were associated with increases in inflation in the consuming countries, which in turn triggered tighter monetary policies and higher interest rates. If the revenues from carbon/energy taxes accrue to the domestic governments, then either they can reduce other indirect taxes and hold down inflation directly, or they can save the revenues and reduce government borrowing. Either way, there would not be an association of higher energy prices with higher interest rates. The estimation of aggregate production functions from data in which increases in the price of energy take place at the same time as increases in the price of capital means that it is difficult to disentangle the two effects, with the risk that energy is treated (wrongly) as complementary to capital equipment rather than as a substitute for it.

TECHNOLOGY AND CHANGES IN ENERGY USE

The distinction between long-term elasticity estimates derived from time-series data and those derived from cross-section and pooled data raises the important question of the treatment of technological change in the characteristics of energy-using capital equipment. In effect, to a great extent difficulties associated with the estimation of long-term energy elasticities arise from difficulties associated with the treatment of changes in the characteristics of the capital stock. This problem is addressed by both Jackson and Schleicher who distinguish between bottom-up engineering-based models which attach considerable importance to the nature of capital and top-down macro-economic models which treat capital as a homogeneous input (see also Wilson and Swisher 1993). Given the joint-product nature of demand for primary fuels and energy-related capital equipment in the provision of energy services it is asserted that it is vitally important to give an empirical content to capital. Thus, the potential for the employment of more energy-efficient production processes (energy conservation) will depend upon the prospects for technological innovation and market penetration of energy-related capital equipment. Similarly, given the limited potential for interfuel substitutability for specific pieces of capital equipment, the potential for the employment of less carbon-

intensive production processes (fuel substitution) will also depend upon the prospects for changes in the characteristics of the capital equipment employed.

The most common means of attempting to incorporate the effects of changing technological characteristics of energy-related capital equipment in economic modelling is through the use of a simple time trend, which is estimated on the basis of historical evidence and then introduced as an exogenous variable over the course of the forecast. Indeed in many of the aggregate production function models which dominate the literature on the economics of global warming a simple trend increase in energy efficiency is applied over the course of forecasts as long as a hundred years. Given the discussion above this is rather unsatisfactory.

Conversely, in the chapter by Boone et al. the problem of technological innovation in energy-using capital equipment is addressed by means of the inclusion of an endogenous trend variable. Thus, technological innovation is determined within the model by a set of explanatory variables such as investment levels, non-fossil-fuel expansion and structural changes in the energy markets. In his chapter Ingham uses quite a different model. Based on capital vintages his analysis distinguishes between short-run responses to price changes, wherein only variable factors of production (labour, materials, energy) and output levels can adjust, and long-run responses wherein fixed factors (capital) can also adjust. However, the degree of variable factor adjustment which can take place is determined at the point of initial investment in fixed factors. Thus, expectations about future price changes become vital to the degree of flexibility incorporated into existing capital. This has profound implications for the path of technological change in the face of anticipated increases in the price of energy. Barker uses bottom-up methodology to give an empirical content to electricity-generating capital. He incorporates a full engineering-based submodel of the electricity supply industry into the macroeconomic model and using plant profiles (capacities, fuels employed, energy efficiency and working lives) he is able to make informed judgements about future fuel inputs into the electricity sector on the basis of technical requirements. And finally, in their chapter, Hodgson and Miller recognize the necessity of conducting similar analyses for industrial boilers in the manufacturing sector and are extending the existing DTI model along these lines.

ENERGY ELASTICITIES AND MARKET SATURATION

Much as country-specific structural characteristics should be recognized in the estimation of energy elasticities, temporal characteristics related to a given economy's position on the development curve must be recognized as well. For instance, energy use in many of the most energy-intensive sectors may eventually be constrained by market saturation, with respect either to energy-related capital goods or to the energy service itself. Thus, caution must be exercised when applying elasticities estimated on the basis of the existing economic structure to make forecasts stretching into the distant future when the economy may have matured considerably.

For instance, price elasticities may be very different when the market for various pieces of energy-using capital equipment in the domestic sector (e.g. ownership of central heating, electric appliances or vehicles) is saturated. Thus, the response of a household to a change in fuel prices would be reflected, even in the long term, more in adjustments of the variable input (the fuel) and less in changes in the fixed input (the boiler or vehicle) which would be determined by replacement demand. Similarly income elasticities may be very different once the saturation point is reached. Thus, in terms of demand for energy services themselves, increases in real income may have little effect on fuel use in domestic heating once a satisfactory level of physical comfort has been realized. Analogously, with respect to demand for energy-

using capital, changes in real income may have little effect on car ownership, and thus to some extent fuel use, once the market is completely saturated. Indeed, once saturation is complete, energy elasticities in many sectors will probably be asymmetric with little potential for increased consumption but significant potential for downward adjustment, indicating relatively higher downward income elasticity and upward price elasticity. These questions are discussed explicitly in Hodgson and Miller, but are of considerable relevance to the chapters by Sterner and Franzen as well as Grubb.

It should be recognized, moreover, that in a number of important sectors the saturation rate is not a fixed parameter but is instead contextual. For example, households with a saturated demand for domestic heat may find that their demand becomes relatively more price inelastic because warmth becomes accepted as a necessity. Another example is in the transport sector where a number of models indicate that it is average commuting times and not ownership rates per se which represent the fundamental determinant of saturation rates for travel to work, although these averages and the distances travelled have been getting longer. This underlines the importance of distinguishing between the energy service (mobility) and the means by which it is realized (fuel and capital). It would also indicate that public investment in transport infrastructure can be better understood as a significant determinant of transport mode splits (road, rail, air, water) and not purely as a reaction to consumer demand for different modes. Given the different energy intensities of different modes this would indicate that long-term transport-related energy elasticities depend, implicitly or explicitly, upon government policy.

SECTORAL COMPOSITION, COMPETITIVE DISPLACEMENT AND GLOBAL

WARMING

National attempts to address the problem of global warming have significant international repercussions, in both economic and environmental terms. As such it is vitally important to determine the sources of consequent reductions in energy consumption in the economy. Decomposing changes in energy use into those associated with changes in the level of output (activity effects), those associated with a changing sectoral composition of output (sectoral effects) and those associated with increased energy efficiency (intensity effects), it is possible to distinguish between the sources of changes in energy consumption (Schipper and Meyers 1992). Thus, it is quite possible to have decreased energy consumption in a growing economy with no increase in energy efficiency. This would arise if there was a fundamental transformation away from more energy-intensive sectors as the economy matured (Solow 1987). The input-output analysis of Proops et al. (1993) indicates that this has been the case for the UK between 1971 and 1982.

The environmental and economic significance of such a development path depends upon the tradeability of the affected sectors. Thus, it is important to distinguish between changing sectoral composition of output which reflects a demand response and that which reflects a supply response. Given the pure common property nature of the environmental consequences of CO2 emissions such a distinction is of considerable significance. For instance, policies which reduce domestic energy consumption in the non-tradeable transport sector would certainly have benign environmental consequences; policies which result in decreased domestic energy consumption in highly tradeable manufactures may conceivably have malign environmental consequences, depending on international trade flows and production technology elsewhere.

This emphasizes not only the importance of international policy co-ordination, but also the importance of the careful interpretation of the true causes which lie behind changed energy consumption in national economies. For this reason, the causes behind changes in energy consumption in the fastest-growing economies may be of particular significance. In this light, the chapter by Pesaran and Smith on energy elasticities in East Asian economies and many of the results cited in the survey by Manning and Atkinson are of considerable interest.

1.10

MODELLING THE ECONOMIC EFFECTS OF CO2 ABATEMENT POLICIES

All the chapters in the book are concerned ultimately with the modelling of CO2 abatement policies. Chapters 2-4 are concerned with estimating long-term price and income elasticities of the demand for energy and substitution elasticities for the demand for different fuels to meet the energy demand. Chapter 5 is a detailed treatment of the response of UK manufacturing to particular energy price shocks showing how the changes in boiler stock may affect the response. Chapters 6 and 7 show how the elasticity approach is incorporated into national and international models designed to assess policy responses as well as to develop energy scenarios. Chapters 8 and 9 discuss the specification and construction of models incorporating energy demand equations which provide estimates of energy price elasticities for nine OECD countries and for the UK. The models are designed to assess GG abatement policy and Chapter 9 in particular looks at the effects of different estimated price elasticities in relation to the EU's proposed carbon/ energy tax. Chapters 10 and 11 go beyond the price elasticities to consider technological aspects and the potential for energy saving. Chapter 12 reviews the published estimates of the costs of GG abatement, suggesting why in many cases these may have been overestimated. Chapter 13 is a pointer to the way modellers are dealing with the effects of technological change in economic models; it expounds the idea that price responses might be asymmetrical as a result of induced technical change. This direction of research is taken up in the conclusions in Chapter 14: modelling of long-term GG abatement is seen as requiring both an economic and an engineering component if the full range of policy options is to be addressed. Models should then be in a better position to explore policies which could yield net economic benefits if there is a move towards a low-carbon economy.

NOTE

1 The Council of Economic Advisors' Report to the President in 1990 was influential in promoting the idea that the costs of abatement were unimaginably large. The Report quoted estimates of costs to the US economy of $3.6 trillion and suggested that US growth could be cut in half. However, the Report used US experience following the oil shocks as an illustration of the effects of abatement policies and relied on studies of the effects, e.g. Jorgenson and Hogan (1990), which also depended heavily on data dominated by the 1973 and 1979 oil price shocks. Moreover, the $3.6 trillion estimate does not seem quite so large if reinterpreted as a reduction in the US growth

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