Energy and climate policy in a DSGE model of the United Kingdom

We build an open economy Dynamic Stochastic General Equilibrium model with energy and use it to simulate the impact of different climate policies – specifically the introduction of a carbon tax and bans on petrol or gas usage by households – on macroeconomic variables. We show how the introduction of a carbon tax leads to falls in both households’ consumption of energy and firms’ use of energy in production, while also having the effect of shifting the production of electricity from fossil fuels to renewable sources. The effects of a ban on household consumption of petrol or gas depend crucially on the elasticity of substitution between different energy sources in consumption. For very low elasticities of substitution, a ban on petrol or gas usage also led households to cut down on their use of electricity, whereas for larger elasticities of substitution, households switched into electricity. Regardless of the elasticity of substitution, aggregate consumption fell on impact in response to the bans before rising over time. GDP and the gross output of non‑energy fall in response to both a carbon tax and a ban on petrol or gas consumption by households. Finally, both policies result in a temporary increase in inflation and a tightening in monetary policy.