The objective of this chapter is to show how varying estimates of price elasticities of energy demand (crucial parameters in some price-based models projecting the effects of pollution abatement policy) can be imposed on the aggregate energy equations, what this implies for the lags in the response and how the different estimates affect the results of the model in analysing the effects of the European Union's proposed carbon/energy tax. This work is part of a broader research programme to provide a comprehensive treatment of the responses of the UK economy to fiscal incentives, such as a carbon/ energy tax, designed to reduce CO2 emissions over the long term. The comprehensive treatment is achieved through the use of a large-scale model of the economy, the Cambridge Multisectoral Dynamic Model (MDM), which distinguishes output and expenditures in great detail.

The next section of the chapter describes the development of the MDM into an energy-environment-economy (E3) model. This includes an overview of the treatment of secondary energy demand as well as that of energy demand by the energy industries themselves, divided into demand by the electricity supply industry (ESI) for primary fuels and demand by the primary energy industries (coal, gas and oil) for secondary fuels. All these demands may involve the burning of fossil fuels and therefore the emission of CO2 and other pollutants such as SO2 and NOx into the atmosphere.

One crucial set of equations determining the responses of the model is that concerning aggregate energy demand and this chapter primarily focuses on these equations. Section 9.2 of the chapter takes the UK Department of Energy's (DEn) 1989 specification of these equations (DEn 1989a) and re-estimates it on new data and a group of sectors which fits into the rest of the larger model; the model is then extended to use cointegration procedures. However, in studies of CO2 abatement it is important to allow for substitution between fuels because they can have very different carbon contents, and Section 9.3 reports briefly on the allocation of secondary energy demand between the different energy carriers, coal, oil products, gas and electricity. Finally, Section 9.4 describes some sensitivity tests on the values of long-term price elasticities of secondary energy demand which have been imposed in the model. The tests take five sets of equations each with a different assumption about the size of the price elasticities; a new version of the model is created for each set of equations and is used to project the UK economy over the period 1990-2005 with and without the European Union's carbon/energy tax. The effects of the different sets of elasticities and of the tax can then be measured in terms of changes in CO2 emissions and aggregate energy demand.

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