Foreword

The Role of Substitution in Understanding the Costs of Climate Change Policy

Eileen Claussen, President, Pew Center on Global Climate Change

The U.S. economy has proven both resilient and adaptive over the past century. From the "bust" of the Great Depression to the current "boom" associated with information technology, the economy's ability to adapt stems largely from the substitution possibilities within it — that is, how businesses and households alter their behavior when a major economic change occurs.

Reducing greenhouse gases could alter future economic conditions, largely through increased energy prices. While these changes could be significant, the economy is rapidly becoming even more flexible and responsive as technology changes the way things are invented, produced, and distributed. Accordingly, the damages to the economy might be less. Yet, many economic models used in predicting the future costs of climate change policies do not adequately capture the economy's full range of substitution possibilities. A recent Pew Center report entitled, An Introduction to the Economics of Climate Change Policy, identified substitution assumptions as one of five key factors having the largest influence on modeling results. The other factors are: how baseline greenhouse gas (GHG) projections are measured; what policy regime is considered; how technological progress is represented; and whether GHG reduction benefits are included.

This analysis by Dale Jorgenson, Richard Goettle, Peter Wilcoxen and Mun Sing Ho explores the role of substitution in adapting to economic change. It begins with what is considered a "flexible" model (a top-down, computable general equilibrium model of the U.S. economy) and then constrains the flexibility parameters within this model to observe its new results. In essence, the authors use the same model to behave both "flexibly" and "inflexibly" in order to observe the effect of this pivotal assumption on model outcomes.

The most striking conclusion of this work is that the failure to depict the full range of historically-observed substitution possibilities (as many economic models do) can lead to as much as a doubling of the estimated costs of a climate change policy, an overestimate that is wholly attributable to this one pivotal assumption. This overestimation may be even more pronounced since the economy appears more flexible today than in the post-war period when these observations were made. Another interesting finding is that v a rying the flexibility households have in choosing to work more or fewer hours can be as important in predicting carbon prices and economic outcomes as the assumptions about flexibility in all of production. In summary, economic models of climate change must represent the full range of flexibility that is achievable or risk significant errors in estimating economic benefits and costs.

This paper would not have been possible without the comments and support from several individuals. The Pew Center and authors would like to thank Larry Goulder, Jeffrey Frankel, and Hadi Dowlatabadi for their thoughtful comments on early drafts of this report. Special thanks are due to Ev Ehrlich for serving as a consultant on this project, and to Judi Greenwald for her editorial assistance.