The role of money and the financial sector in energy-economy models used for assessing climate policy

TL;DR

This paper critiques current climate-economy models for their unrealistic financial assumptions, compares them with a more empirical non-equilibrium model, and highlights the importance of accurate financial modeling for policy assessment.

Contribution

It identifies a critical gap in climate-economy models' financial assumptions and demonstrates that more realistic modeling can alter policy cost estimates.

Findings

Standard models overestimate climate policy costs by assuming crowding out of capital.

The non-equilibrium model suggests green investment can stimulate the economy.

Improved financial modeling can lead to more accurate climate policy assessments.

Abstract

This paper outlines a critical gap in the assessment methodology used to estimate the macroeconomic costs and benefits of climate policy. It shows that the vast majority of models used for assessing climate policy use assumptions about the financial system that sit at odds with the observed reality. In particular, the models' assumptions lead to `crowding out' of capital, which cause them to show negative impacts from climate policy in virtually all cases. We compare this approach with that of the E3ME model, which follows non-equilibrium economic theory and adopts a more empirical approach. While 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 CGE models consistently over-estimate the costs of climate policy in terms of 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 policy making. Improvements in both modelling 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.