On the environmental, economic and budgetary impacts of fossil fuel prices: A dynamic general equilibrium analysis of the Portuguese case

This paper examines the environmental, economic and budgetary impacts of fuel prices using a dynamic general equilibrium model of the Portuguese economy which highlights the mechanisms of endogenous growth and includes a detailed modeling of the public sector. The fuel price scenarios are based on forecasts by the DOE-US, the IEA-OECD and IHS Global Insight Inc., and represent a wide range of projections for absolute and relative fossil fuel prices. The dramatic differences in relative prices lead to substantially different environmental impacts. Our results suggest that higher fuel prices in the DOE-US scenario would lead to a reduction in emissions that account for 10.2% of the implicit emissions deficit for EU 2020 emissions targets, while relative price changes, led by lower prices for coal, result in a 19.2% increase for the IEA-OECD scenario. Under the IHS scenario, declining fuel prices would increase the emissions deficit by 95.9%. In terms of the long term economic impact, our results suggest a 2.2% drop in GDP in the DOE-US scenario and of 1.9% in the IEA-OECD scenario and an increase of 1.4% in the IHS scenario, which reflect the absolute change in energy costs. As to the budgetary impact, higher fuel prices lead to lower tax revenues, which, coupled with a reduction in public spending translates to lower public deficits. In addition, and from a methodological perspective, our results highlight the importance of endogenous growth mechanisms. A scenario of higher fuel prices would, under exogenous economic growth assumptions, result in larger baseline emissions growth scenarios, substantially smaller economic effects, and rather different budgetary effects. Finally, and from a policy perspective, our results highlight the impact of fossil fuel prices in defining the level of policy intervention required for compliance with international and domestic climate change legislation. As a corollary, we argue that it is critical for both international comparisons and international policy negotiations to define baseline emission targets in function of steady state economic projections under stable price assumptions.