Climate Policy Simulation Tool

(CPST): BRAINSTORMING MEETING

Scott Livermore, Director of International
Macroeconomic Forecasting
Oxford Economics

July 2010
Introduction
 Oxford Economics - Who We Are

Oxford Economics is a world-leader in high quality, quantitative economic

analysis forecasting, and in practical, evidence-based business and public
policy advice.

Our international reputation is built on:

■ The calibre of our staff: we have over 50 experienced professional
economists in the UK, US and France
■ Our rigorous, quantitative approach to issues, including our range of
models and scenario tools to answer practical questions
■ Our ability to answer the 'So what?' questions, helping our clients to
understand, challenges and strategic choices they face
■ Our close links with Oxford University and a range of partner
institutions, providing access to the latest thinking

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 Relevant experience

Demand and supply of energy modelling (for the US Department of Energy): This
model was then used in work for DoE and the European Commission to analyse the
impact of measures to reduce carbon emissions. Recently update to assess the impact
of global emission reduction strategies for the US government.

Economic modelling of the impact of energy price and policy shocks on the UK
economy for the UK government as part of the first stage of its Energy Review and
reported in the May 2007 White Paper on Energy.

A report for the UK government that models the impacts of a variety of climate
change policies on competitiveness at a detailed sectoral level across each of the
27 members of the European Union.

A review of the UK government’s approach to energy modelling for the Committee

on Climate Change: a review of central government’s approach to energy modelling in
the context of how it may be used to support the Committee on Climate Change. The
review included an assessment of the underlying approach to the modelling and an
econometric review of each of the estimated equations in the model.

Contributed to the report ‘Roadmap 2050: a practical guide to a prosperous, low-

carbon Europe’ (2010) for the European Climate Foundation (ECF)

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 Suite of model

Oxford Global Macroeconomic and Energy Model (OEM) – this model covers some
45 economies in detail and headline statistics for another 35 economies. This Model –
provides a rigorous and consistent structure for analysis and forecasting, and allows
the implications of alternative global scenarios and policy developments to be readily
analysed at both the macro, sectoral and regional level. The OEM captures the
interactions (operating in both directions) between the macroeconomic environment
and the demand, supply and price of energy.

UK Energy Industry Model (UKEIM) – embodies a four-factor production function for

each of thirty industrial sectors in the UK, and shows how demand for each factor of
production (including energy), gross output and value added in each sector plus the
household sector move around in equilibrium in response to changes in the prices of
each of the factors of production – changes such as might reflect the impact of taxes
on the consumption of energy, or on carbon emissions, for example.

Global Energy Industry Model (GEIM) – a general equilibrium model with a focus on
the supply side and on the energy sector. It has a long-term focus, making it better
equipped to represent long-term potential growth paths under different circumstances.

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Oxford Global Economic Model
The Oxford Global Macro Model – Overview

The Oxford Global Model is the most widely used commercial International
Macro Model, with clients including the World Bank, Asian Development
Bank, US and UK Treasury, as well as a large number of blue-chip
companies.

It provides a rigorous and consistent structure for forecasting and scenario

analysis.

The Model covers 45 economies in detail, including many emerging markets,

and provides headline forecasts for another 30 countries.

Forecasts 5, 10 and 25 years ahead are updated each month.

Oxford Economics’ powerful user-friendly software is very easy to use.

Oxford Economics provides telephone and e-mail support, and runs regular
training workshops for clients.

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Country Coverage

Developed economies: US, Japan, Eurozone, Germany, France, Italy, UK,

Canada, Austria, Australia, Spain, Denmark, Finland, Norway, Netherlands,
Belgium, Portugal, Ireland, Sweden, Austria, Switzerland

Emerging markets: China, Taiwan, S.Korea, Hong Kong, Thailand,

Malaysia, Philippines, Indonesia, Singapore, Mexico, Brazil, Argentina, Chile,
Poland, Czech Rep., Hungary, Russia, Bulgaria, Croatia, Slovakia, Romania,
South Africa, Turkey, India, UAE

6 ‘blocs’ covering OPEC, Eastern Europe, Africa, Latin America, rest of

OECD, rest of World.

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The Oxford Global Macro Model – Outline

Eclectic model:

■ Keynesian in the short run

■ Monetarist in the long run

So, increased demand will lead to higher output and employment initially. But
eventually that feeds through into higher wages and prices. Given an inflation
target, interest rates have to rise, reducing demand again (‘crowding out’).

In the long run, output and employment are determined by ‘supply side’
factors.

Interactions between countries through trade, exchange and interest rates,

capital flows and oil/commodity prices are modelled in detail.

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Overview of the Global Macroeconomic Model

Consumption - function of real income, wealth and interest rates

Investment - ‘q’ formulation with accelerator terms

Exports - depend on world demand and relative unit labour costs

Imports - depend on total final expenditure and competitiveness

Layard-Nickell wage/price system

Inflation is a monetary phenomenon in the long run

Monetary policy endogenised. Options include Taylor rule, fixed money and exchange
rate targeting

Exchange rate determined by UIP

Expectations adaptive

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Linkages between country models

Trade
■ World trade for each country is a weighted average of the growth in total goods imports (excl
oil) of all other countries. The weights are thus the relevant coefficients in the trade matrix.

Competitiveness
■ IMF relative unit labour costs where available. Relative prices elsewhere.

Interest Rates and Exchange Rates

Commodity Prices:
■ Oil depends on supply/demand balance

■ Metals on industrial growth

World Price of Manufactured Goods

Capital flows – new project under way to model bilateral capital flows for major blocs

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Energy prices

Oil prices are determined by the interaction of demand and supply in the global
market. Following drivers are key:
■ World demand (+ve impact on price)
■ World supply (-ve)
■ Oil reserves (-ve)
■ Oil stocks (-ve)

World supply is the aggregate production of oil in oil producing countries

Demand for oil is estimated by adding up the oil demand of the main economies:
■ Oil demand is linked to economic growth and relative oil prices – fully integrated with the rest of
the Oxford Model

Saudi Arabia is assumed to act as swing producer

Gas/coal prices are modelled in a similar way

World prices are translated into domestic energy prices using world fuel prices, local
wage costs and carbon price.

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Elasticity of demand

GDP Price
OECD countries
High 0.56 -0.64
Low 0.40 -0.12

Oxford model (mid 0.48 -0.38

point)

Rest of the world

High 1.2 -0.35

Low 0.7 -0.03

Oxford model (mid 1.0 -0.20

point)
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How a carbon tax feeds into the model

CARBON Public
TAX finances
World
fuel
prices Domestic
Exports
price of
Producer
fuels
prices

Domestic
Demand CPI &
demand
for fuels wages

GDP Interest
Balance of rates
Payments Real
exchange
rate

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Cost of maintaining flat global emissions

GDP impact
% difference
16
14
12 Country specific
carbon tax
10
Global carbon tax
8
6
4
2
0
l
ld

na
a

ne
n

US
a
i
az

di
i

pa
or

ss

hi

zo
In
Br
W

Ja
C
Ru

ro
Eu
Source : Oxford Economics

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UK Energy Industry Model (UKEIM)
UKEIM Overview

The Oxford UK Energy Industry Model (UKEIM) primarily looks at the price
effects of different climate change policies on energy use and output by
detailed sectors.

The model provides a rigorous, detailed framework for assessing the trade-off
between carbon emissions and economic growth, sector by sector. In the long-
run, all variables in the model converge on their long-run equilibrium levels,
determined by theory.

The UKEIM builds a ‘bottom-up’ picture of the UK economy, by aggregating the

information from thirty separately identified industrial sectors. Changes in value
added or in energy prices at the whole-economy level reflect changes to those
variables within each sector and shifts in the composition of output across the
sectors. The UKEIM thus tells us how the long-run equilibrium changes in
response to different policy instruments.
UKEIM: Supply side

Value added in each sector is defined as gross output for that sector less the
costs of energy, other raw materials and intermediate inputs to the production
process.

Gross output in each sector is derived from a Cobb-Douglas production

function incorporating four factors of production: fixed capital; labour;
intermediate inputs; and energy used in that sector..

The long-run behaviour of each sector in the model is determined by the first-
order profit maximising conditions derived from that sector’s production
technology. Each sector will choose the cost-minimising mix of all four factors
of production for any given level of output, and will set the price of its output to
maximise profits.
UKEIM: Demand side

Each sector in the model faces a downwards-sloping demand curve: demand
falls if prices rise due to a supply shock.

Demand is modelled as a function of domestic demand (both final customer

demand and intermediate demand from other industrial sectors) and overseas
demand.
■ An important concept on the demand side is the real exchange rate, determined for
each sector, as a measure of competitiveness.

Outcomes for real variables such as output and employment in the model are
determined by demand in the short run and by supply in the long run.

The long-run behaviour of each sector in the model is determined by the first-
order profit maximising conditions derived from that sector’s production
technology. Each sector will choose the cost-minimising mix of all four factors
of production for any given level of output, and will set the price of its output to
maximise profits.
Schematic overview
Determination of output

In the long run, the whole-economy level of output will be determined by the
quantities of real inputs to the production process employed in each sector.
And the quantities of those inputs will be determined by their relative prices.

A shock that increases the relative price of one factor of production could
have long-run implications for output, for two reasons:
■ It could change the equilibrium quantity of that factor of production that is
employed.

■ It could change the sectoral composition of whole-economy output, with

implications for average labour productivity.

The key drivers in the UKEIM are the impacts of changes in energy prices
on the level of output in each industrial sector. These sectoral effects are in
turn driven by two key factors:
■ The energy intensity of production in each sector

■ The price elasticity of demand for energy in each sector

Energy share by sectors
Energy share in value added in different industrial sectors
Other services
Business services
Financial services
Communications
Transport
Hotels & catering
Retail distribution
Wholesale distribution
Construction
Other utilities
Other transport equip
Motor vehicles
Precision & medical
Electrical engineering
Computers & office
Mechanical engineering
Metal products
Basic metals
Non-metallic minerals
Rubber & Plastics
Chemicals
Other manufacturing
Printing & publishing
Paper products
Wood
Textiles
Food
Other Extraction

0% 5% 10% 15% 20% 25% 30% 35% 40% 45%

Responsiveness to price changes

Price elasticity of demand for energy in different industrial sectors

Other services
Business services
Financial services
Communications
Transport
Hotels & catering
Retail distribution
Wholesale distribution
Construction
Other utilities
Other transport equip
Motor vehicles
Precision & medical equip
Electrical engineering
Computers & office equip
Mechanical engineering
Metal products
Basic metals
Non-metallic minerals
Rubber & Plastics
Chemicals
Other manufacturing
Printing & publishing
Paper products
Wood
Textiles
Food
Other Extraction

0.0 -0.1 -0.2 -0.3 -0.4 -0.5 -0.6 -0.7 -0.8 -0.9 -1.0
Sectoral impacts of reducing carbon emissions
Global Energy Industry Model (GEIM)
GEIM Summary

The Global Energy-Industry Model (GEIM) was developed for a

project for the Department of Trade and Industry (now the
Department for Energy and Climate Change) in the UK and covers
30 industrial sectors for the individual countries in the EU27, as well
as the US, Japan and China.

The GEIM captures (in reduced form) the main properties of our
detailed UK Energy-Industry Model (UKEIM) of sectoral output and
energy use. The key results derived from this model reflect three
effects:
■ Direct impacts on sectoral costs and competitiveness across the EU,
US, Japan and China

■ Impact on costs and competitiveness allowing for substitution effects

■ Impact on sectoral output across the the EU, US, Japan and China
 GDP difference under €25/tCO2 carbon price (2019-2023)
EU
UK
Sweden
Spain
Slovenia
Slovakia
Romania
Portugal
Poland
Netherlands
Malta
Luxembourg
Lithuania
Latvia
Italy
Ireland
Hungary
Greece
Germany
Finland
France
Estonia
Denmark
Czech R
Cyprus Whole world action
Bulgaria
Belgium EU only action
Austria
0.0% -0.2% -0.4% -0.6% -0.8% -1.0% -1.2% -1.4% -1.6%
Source: Oxford Economics % difference from baseline
Roadmap 2050 project - Overview

The GEIM was extended for a project for the European Climate Foundation,
‘Roadmap 2050’, in collaboration with partners (McKinsey, KEMA and Imperial
College).

The EU model was adapted to take on board information from abatement cost
curves.

■ We were able to derive the macro implications of micro calculations on

different technologies e.g the model incorporates the likely take-up,
investment costs and energy savings related to
● more efficient heating systems (heat pumps).
● Electric vehicles
● Carbon Capture and Storage

■ Incorporate the positive impacts of decarbonising the power sector

Roadmap 2050 project
EXHIBIT 37

The energy bill decreases in the baseline, but even more in the pathways
thanks to efficiency and cost of generation
Energy cost per unit of GDP output, € (real terms)

0,07
Lower energy cost implies improved
0,06 productivity and competitiveness
across the economy
0,05

0,04 -14%
Decarbonized
pathways
0,03
Already by 2020 the overall -27% Baseline
0,02 energy bill for the economy
starts decreasing
0,01

0
2000 2010 2020 2030 2040 2050

NOTE: Energy prices are a weighted average of prices faced by consumers weighted by the shares of consumption of different fuels
Roadmap 2050 project

Winners and losers
EXHIBIT 40

The reduction of employment in the fossil fuel supply chain is more than
compensated by employment in renewables and efficiency
Job variations in the decarbonized pathways in ‘000s Jobs for additional power capacity (RES+grid)
Difference from the baseline
Jobs linked to efficiency and fuel shift investment
Jobs in coal, petroleum, gas and oil supply chain
600
500 +420
400

300
200
100
2010 2020 2030
0
-100

-200
-300 -260
-400

NOTE: Efficiency and fuel shift inv estment includes all efficiency levers from Mc Kinsey c ost curves (exc luding what already in the baseline), further
penetration of heat pumps in residential and industry and the slow penetration of EVs
Concluding remarks

Oxford Economics has developed a suite of models to assess the economic
impact of carbon mitigation policies.

These models are fully integrated systems that allow different climate
change policies and hence energy prices to impact on economic growth and
allow impacts across countries and sectors to be assessed. Key advantages
include:
■ impact on composition of the economy can be assessed
■ production and employment levels identified:
■ net impact can be decomposed into different channels (e.g. change in energy
intensity, change in sector structure etc.)
■ includes international transmission and competitiveness
■ structure can incorporate micro work on abatement curves and other bottom-up
analysis
■ subject to minimum data requirements and, with some
assumptions/simplifications, the structure of the model can be replicated for a
large number of countries/regions
Thank you
Impact of energy prices on capital accumulation

To capture the impact of the accumulation of energy-saving

capital as a result of shifts in the relative price of energy,
capital and other factors of production, three kinds of effect
are inluded in the UKEIM:

■ Allowing for faster accumulation of energy-saving capital and

scrapping of less energy-efficient capital of an older vintage in
response to increases in energy prices

■ Capturing the impact of that faster capital accumulation /

scrapping on underlying (total factor) productivity in the short to
medium term

■ Identifying the magnitude of any potential spillovers (boosting

total factor productivity across the economy as a whole) from
energy efficiencies achieved in one sector