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Cross-cutting paper, the role of energy prices for assessing the costs of climate policies (Gernot Klepper and Sonja Peterson)

One key variable in the analysis of climate policies is the marginal cost of reaching a certain emission target. Marginal abatement cost (MAC) curves for CO2 have become a standard tool for analysing the impacts of the Kyoto Protocol and emissions trading.

Once such curves are available for different world regions it is very easy to determine permit prices, total abatement costs and regional emissions for different scenarios of international emissions trading. In general, the MAC of reaching a certain CO2 target is defined as the shadow cost of a certain constraint on carbon emissions for a given region and a given time.

This shadow cost is equal to the tax that would have to be levied on the emissions to achieve the targeted level or the price of an emission permit in the case of emissions trading. The more severe the constraint, the higher the MACs are. Or, put differently, a higher MAC corresponds to higher emission reductions. MAC curves are obtained either by generating the MACs associated with different levels of reductions or the other way around by levying different levels of a “shadow carbon tax” on emissions that result in different corresponding emission levels.

The former approach is most often used in top-down macroeconomic models such as computable general equilibrium (CGE) models. An example are the MAC curves generated from the EPPA model of the MIT (Ellerman & Decaux 1998). The latter approach is most often used by bottom-up energy system models. An example are the MAC curves from the energy systems model POLES (Criqui et al. 1999). The TranSust modelling experiment where the different TranSust Models generated the emission levels associated with different levels of CO2 taxes is also an example of generating MAC curves based on the second approach .

The generation and use of MACs and MAC curves is nevertheless not as unproblematic as it seems. One major problem noted by Klepper & Peterson (2003, 2004) is that MACs associated with a certain emission target are not independent of the underlying policy scenario and especially the associated energy prices. There are two important issues in this context. First, restricting emissions leads to a reduced demand of fossil fuels, which in turn drives down the price of fossil fuels or more generally energy prices.

Thus, part of the emission tax is set off by lower net energy prices. Second, the prevailing energy prices determine the cost of a certain emission constraint respectively the emission reduction resulting from a certain emission tax. Briefly, the line of argument behind this is as follows. The shadow cost of reaching a certain emission target depends on the unconstraint or business-as-usual (BAU) emission level. For CO2 emissions, this is closely linked to the use of fossil fuels, so that BAU emissions depend on BAU demand for fossil fuels, which in turn reacts to fossil fuel or more generally energy prices.

With higher fossil fuel prices, demand for fossil fuels and thus the resulting CO2 emissions are lower than with lower fossil fuel prices that lead to an increased fossil fuel demand and increased CO2 emissions. Thus, the MAC for a certain target depends on the underlying energy prices. To complicate the case even more, energy prices are predominantly determined by world market conditions.

However, these conditions are influenced by the different national climate policies through the just mentioned demand effects of emission constraints. Therefore, the MAC curve in one country depends on the mix of climate policies in the rest of the world that co-determines fossil fuel prices. This linkage between energy prices, international climate policies and the level of the MAC for reaching a certain emission target has consequences for the MACs of climate policies resulting from different models.

For example, a model with fixed energy prices will show a stronger reaction to a global emission tax than a CGE model with flexible energy prices. In the latter case, energy prices are driven down by the reduced global demand for fossil fuels, which partly offsets the emission tax, so that the gross price for fossil fuels is lower compared to the model with fixed, exogenous energy prices. Also in a multi-regional model with flexible energy prices, the cost of reaching a certain emission target in one country, say Spain, depends on the assumptions on the climate policies in the rest of the world.

Thus, a single-country model for Spain with exogenous energy prices will show different emission reductions resulting from a certain emission tax than a regional, but global model that assumes that the tax is levied in all European countries. In this paper, we want to discuss the implications of the link between energy prices and marginal abatement costs for the results of the different types of climate-economy models that are commonly used for climate policy analysis.

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Kiel Institute of World Economics
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