Measuring the energy input substitution and output effects of energy price changes and the implications for the environment

Abstract

Previous studies of decomposition of factor inputs have limited their analysis on the estimation of substitution and output effects. However, this paper develops a two-step approach to estimate the substitution and output effects of changes in energy demand resulting from changes in prices and further examines the implications of these effects on CO2 emissions using European industrial dataset over the period 1995–2007. In our empirical estimations, instead of relying only on iSUR model like previous studies, we introduced a multilevel model, which is a more befitting model to our data. Our analysis covers industry as a whole and for different sector types. The primary results emerged from our analysis suggest a strong evidence using the multilevel model. Generally, our results show that production inputs are substitutable. We find the substitution and output effects to be negatively related to CO2 emissions, however, the substitution effects dominate. From policy perspectives, our results suggest that output adjustments may not play a significant role in reducing emissions. We find the overall effects of changes in energy demand to be moderate. Then, we argue that increment in energy taxes should be complemented by cleaner factor substitution and sustainable growth to achieve a desirable carbon reduction.