Analyzing Climate Policy Utilizing Financial and Energy Industry Models

Abstract

This paper outlines a critical gap in the assessment methodology used to estimate the macroeconomic costs and benefits of climate policy. The vast majority of models used for assessing climate policy use assumptions about the financial system that sits at odds with the observed reality. In particular, the models’ assumptions lead to the “crowding out” of capital, which causes them to show negative impacts from climate policy in virtually all cases. We compare this approach with that of the Energy-Environment-Economy macro-econometric (E3I) model, which follows non-equilibrium economic theory and adopts a more empirical approach. The non-equilibrium model also has limitations, its treatment of the financial system is more consistent with reality and it shows that green investment need not crowd out investment in other parts of the economy – and may therefore offer an economic stimulus. The implication of this finding is that standard Computable General Equilibrium (CGE) models consistently overestimate the costs of climate policy in terms of Gross Domestic Product (GDP) and welfare, potentially by a substantial amount. These findings overly restrict the range of possible emission pathways accessible using climate policy from the viewpoint of the decision-maker, and may also lead to misleading information used for policymaking. Improvements in both modeling approaches should be sought with some urgency – both to provide a better assessment of potential climate policy and to improve understanding of the dynamics of the global financial system more generally.