Substitutability and the Cost of Climate Mitigation Policy

Abstract

We explore how and by how much assumptions about elasticities of substitution affect estimates of the cost of GHG emissions reduction policies in computable general equilibrium (CGE) models using G-Cubed, an intertemporal CGE model, to carry out a sensitivity and factor decomposition analysis. The results suggest that the average abatement cost rises non-linearly as elasticities are reduced. Substitution elasticities between capital, labor, energy and materials in production have a larger impact on mitigation costs than inter-fuel substitution does. There are notable differences in the effect of the elasticities on costs at the regional level due to interactions in international trade and capital flows in such a global model. Although the results in this study are derived from a particular model, the study, in a broader sense, suggests that there is a necessity for sensitivity analysis before making any conclusive policy recommendation using CGE models.