Fuel-factor nesting structures in CGE models of China

Fuel-factor nesting structures are critical features of CGE models but have rarely been chosen in a robust manner. This study thoroughly examines two popular fuel-factor nesting structures in CGE models of China, namely KL-E11In which, Capital (K) and labour (L) forms of KL bundle, which in turn forms a KL-E bundle with energy (E). and KE-L.22In which, capital (K) and energy (E) forms of KE bundle, which in turn forms a KE-L bundle with labour (L). We use non-linear algorithms to estimate the underlying CES production functions of these two structures. We recommend the latter to be used in CGE models of China, as it exhibits 1) better goodness of fit, 2) better convergence, and 3) better compliance with economic meanings. Our estimations show that the ranges for the inner- and outer-CES parameters33The inner-elasticity in a KE-L nesting structure refers to CES parameter between capital and energy, and the outer-elasticity in a KE-L nesting structure refers to the CES parameter between the capital-energy bundle and labour. in our preferred KE-L structure are 0.6–0.8 and 0.7–0.9, respectively. Applying these in a CGE model, we find nesting strategies used in previous CGE exercises might have overestimated energy conservation costs in China. A decomposition shows that, using our KE-L, changes in energy use are dominate by output effects rather than substitution effects.