June 2005 1

Place of GE analysis in EC4MACS

•Insights into the economic mechanisms involved in adjusting to a wide spectrum of environmental policies and measures•Fewer technological details than sectoral partial equilibrium models GE models simulate responses to environmental policies

•not only through reduction of energy use and inter-fuel substitution,• but also through reductions of overall economic activity and substitution between energy intensive and less energy intensive activities.

•comprehensive perspective in cost calculation,•welfare implications of different policy measures

June 2005 2

GE Cost Calculation (General)

• In addition to the direct costs of abatement as estimated by GAINS, PRIMES, TREMOVE and CAPRI, GEM-E3 assesses the gains/losses:– from revenue recycling and from changes in terms of trade,

both at the national/regional level and at the international level.

– impacts of environmental legislation on industrial competitiveness and activity, either in terms of potential dislocation of activities or of new opportunities and markets for technologies.

– Potential overlapping of internationally coordinated and domestically undertaken emission control strategies.

June 2005 3

GEM-E3 Identity

• GEM-E3 is a multi-country computable general equilibrium model built to evaluate the economic impacts of structural policies and mainly the interactions between the economy, the energy system, the environment and the technological progress

• GEM-E3 is a modelling framework providing the user with many modelling options: a European model, a World model, and a series of different modelling options

• GEM-E3 runs on GAMS on a PC and uses MS-Excel for the data and the results

• A non-developer user may run GEM-E3 after a short training, example IPTS of EC/JRC

June 2005 4

GEM-E3 Data Set

• The European version of GEM-E3 is entirely based on Eurostat statistics: Input-Output tables, National Accounts, Investment Matrix, Consumption Matrix, Bilateral Trade Matrix, Employment and Capital data. Also Energy Balances and emission statistics.

• A distinguishing feature of GEM-E3 is the details in representing income distribution, taxation, subsidies, social security and other elements affecting the public budget. The European model can simulate constraints related to public budget.

• The World version of GEM-E3 is using the GTAP-5 and -6 database.

June 2005 5

GEM-E3 behavioural aspects

• The model adopts a detailed representation for the production function: KLEM with deep nesting, capital vintages, productivity and technical progress with endogenous components, explicit price formation (under Imperfect Competition)

• The model adopts a detailed representation for the consumption, savings and labour supply behaviour, which are treated simultaneously and optionally by class of consumers. The model distinguishes between durable and non durable goods and their linkages, the income expectations from imperfect labour markets, and uses a nested LES-CES formulation.

• The model adopts a separate capital investment decision function which has inter-temporal features, differentiates capital investment premium by origin and destination of investment, and uses adaptive expectations to approximate profitability considerations.

• Trade on a global scale is formulated by assuming imperfect substitution between goods and services by country or region of origin in the presence of economies of scale, a nesting scheme reflecting weak or strong differentiation of commodities by origin, imperfect competition in supply with product varieties and barriers to trade.

June 2005 6

Basic modelling idea

• In the multi-country model, the goods are differentiated by origin and are imperfect substitutes at the final and intermediate demand levels (Armington)

• The perception of differentiation by consumers is further reflected through the form of the demand nesting hierarchy

• The selling price of a good results from the unit cost, an endogenous mark-up (due to imperfect competition) and the eventual barriers to trade

• The mark-ups reduce when enlarging the marketwhen enlarging the market, as a result of more intensive competition, the larger variety of products and the increasing returns to scale (efficient size of company). This further induces growth.

June 2005 7

Supply Technologies

• Calibration– Minimum Efficient Scale– Cost Gradient (engineering

studies)– Number of equivalent equal

size firms from Herfindahl index– Calibration of mark-up

• Entry/exit of firms– Symmetric firms– Number of firms endogenous– To ensure zero profits or non-

zero profits (optional)

• Endogenous mark-ups– Depending on concentration– Depending on average cost

Scale

MES

Average cost curve

Marginal cost curve

Cost

Initialfirm

Firm inthe

enlargedmarket

ProductionUnit_varFixedCost

June 2005 8

Demand nesting hierarchy

• Structural changes such as the EU Internal Market

MARKET SEGMENTATIONDomestic Consumers (final and

intermediate)

demand for goods and services

Domestically producedgoods

Imported goods fromEU or RW

Goods from EU Goods from RW

Domestic firms Other EU firms RW firms

Split in EU countries

MARKET INTEGRATIONDomestic Consumers (final and

intermediate)

demand for goods and services

Goods from EU andDomestic

Imported goods fromRW

Goods from EU

Domestic firms Other EU firms RW firms

Split in EU countries

Goods fromDomestic

June 2005 9

Basic modelling idea

• The core GEM-E3 already covers energy issues and the interactions with the environment– Separate energy supply sectors, energy-intensive industries and

equipment goods in several sub-sectors, etc.– KLEM multiple-level nesting and LES nesting with durable goods

and their linkages to non durable goods– Linkage to a detailed environmental sub-model– Calibration to energy projections by PRIMES and POLES

• However, the core model lacks – Engineering-oriented transparency regarding the energy sector (e.g.

electricity generation technologies, least cost dispatching, load curve, etc.)

– Non-linear (decreasing return to scale) mechanism for the supply of energy resources, such as the depletable fossil fuels, the sites for renewables or nuclear and the potential for energy efficiency improvement at the energy consumption side

June 2005 10

Bottom-up for power generation

• Short-term: least-cost dispatching of existing power plants under capacity constraints, for different load segments, placed at the bottom of the electricity sector CES nesting

• Long-term: investment into new power generation plants based on expected demand, unit costs (capital and fuels) and relative risks; logit or reduced Markowitz formulation

• Explicitly represents a variety of old and new technologies of power generation with possibility for semi-endogenous learning; hence, the model covers technologies such as nuclear, renewables and hydro the choice of which depends on capital rather than on fuel inputs.

• Energy investment is linked to the demand for equipment goods, technology progress incorporated through the capital vintages

• Emissions from power generation linked to the environmental sub-model and policy instruments influence power sector decisions (taxes, subsidies, emission trading, green certificates, etc.)

• Imports and exports of electricity are endogenous• Market imperfections at the national level and the multi-national power market

can be reflected; many issues related to the EU Internal Electricity Market can be studied.

June 2005 11

Bottom-up for power generation

Dispatching under capacity constraintsDispatching under capacity constraints Investment in new power plantsInvestment in new power plants

on volume dependingon accumulati

forward timea asrisk and learning

estechnologi

,,ostlifetime_c

,,ostlifetime_c

mequilibriugeneralthefromas

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risklearningf

risklearningffraction

INV

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elec

Price of electricity – optionsPrice of electricity – options• Mark-up (under IC)• Ramsey-Boiteux to recover fixed

costsInfluenced byInfluenced by• Fuel and technology costs• Environmental policies

June 2005 12

Depletable energy resources

• The price of energy resources (e.g. oil, gas) become endogenous at world or regional scales, as a function of– The rate of extraction r from proven reserves and d the rate of

discovery of new reserves which are function of d and yet-to-find-reserves

– The accumulated use of the resources• The reserves are introduced as a separate production factor

into the CES of energy producing sectors, separately from capital

• Reserves, as capital, show a decreasing return to scale pattern, however influenced by technology progress and new discoveries

• In the presence of climate change policies, abatement costs increase as a result of lower fossil fuel prices related to lower demand; opposite effects in case of dash for gas.

June 2005 13

Endogenous energy savings

• The decision to invest in energy saving equipment becomes endogenous

• Production and consumption functions are extended with the energy saving considered as an additional factor

• Energy saving draws from a limited potential for savings per sector, hence follows decreasing return to scale

• Investment in energy saving induces expenses taken into account in the least cost decision of the agent; their unit cost increases as potential is exhausted

• The purchase of goods to implement energy saving influences total demand for goods and services

• Interesting results from a study on “Energy savings and employment effects in the EU”

June 2005 14

Illustrations

Energy saving investment induced by Energy saving investment induced by energy price increaseenergy price increase

Price of the resource

Time

Pb

P0

Price path with no discoveries

New Discoveries

Evolution of prices of depletable Evolution of prices of depletable resources when new discoveries resources when new discoveries

take placetake place

June 2005 15

Studying combined objectives

Policy AgendaPolicy Agenda

1. The Knowledge

Society

2. The Internal

Market

3. The Business

Climate

4. The Labour

Market

5. Environmental

Sustainability

The model extensionsThe model extensions

1. Endogenous Technical Progress

2. Market Integration under imperfect competition and product varieties

3. Capital market and investment flows

4. Labour market under imperfect competition

5. Energy-Environment sustainability driving innovation, demand for equipment goods and exports

June 2005 16

Energy-environment driving growth?

EU is comparatively strong in Equipment Goods Industry and the Services sector

EU internal market area is sufficiently large so as the market integration to sustain competition, scale effects and technology progress

A stringent policy in terms of energy-environment can drive accelerated technical progress and investment in the Equipment Industry and Services, resulting into economies of scale, hence in comparative advantage at world level

The EU-internal demand sustains employment and activity

In the long run, the new exporting potential drives additional accelerated growth of the EU area

Such a strategy, with removal of uncertainties related to capital and investment, may push the EU to enter into a new investment cycle..