Switching Economics for Physics and the Carbon Price Inflation: Problems in Integrated Assessment Models and their Implications

TL;DR

This paper critiques the use of Constant Elasticity of Substitution in IAMs, showing it creates unrealistic cost trajectories for carbon and energy transitions, and proposes a dynamic elasticity approach as a more plausible alternative.

Contribution

It identifies a fundamental modeling fallacy in IAMs and introduces a dynamic elasticity of substitution method to better reflect historical and technical energy transition patterns.

Findings

CES application produces artifacts inconsistent with historical energy transitions

Monotonically increasing carbon costs are artifacts of the modeling approach

Dynamic elasticity offers a more realistic modeling of energy substitution

Abstract

Integrated Assessment Models (IAMs) are mainstay tools for assessing the long-term interactions between climate and the economy and for deriving optimal policy responses in the form of carbon prices. IAMs have been criticized for controversial discount rate assumptions, arbitrary climate damage functions, and the inadequate handling of potentially catastrophic climate outcomes. We review these external shortcomings for prominent IAMs before turning our focus on an internal modeling fallacy: the widespread misapplication of the Constant Elasticity of Substitution (CES) function for the technology transitions modeled by IAMs. Applying CES, an economic modeling approach, on technical factor inputs over long periods where an entire factor (the greenhouse gas emitting fossil fuel inputs) must be substituted creates artifacts that fail to match the S-curve patterns observed historically. A policy critical result, the monotonically increasing cost of carbon, a universal feature of IAMs, is called into question by showing that it is unrealistic as it is an artifact of the modeling approach and not representative of the technical substitutability potential nor of the expected cost of the technologies. We demonstrate this first through a simple but representative example of CES application on the energy system and with a sectoral discussion of the actual fossil substitution costs. We propose a methodological modification using dynamically varying elasticity of substitution as a plausible alternative to model the energy transition in line with the historical observations and technical realities within the existing modeling systems. Nevertheless, a fundamentally different approach based on physical energy principles would be more appropriate.