Substitutability and the Cost of Climate Mitigation Policy

The degree of substitutability assumed between inputs in production and commodities in consumption is one of the key factors that might affect the range of predicted climate mitigation costs. We explore how and by how much assumptions about elasticities of substitution affect estimates of the cost of emissions reduction policies in computable general equilibrium (CGE) models.We use G-Cubed, an intertemporal CGE model, to carry out a sensitivity analysis and apply factor decomposition analysis to the outcomes from the model.The results suggest that the average abatement cost rises non-linearly as elasticities are reduced. Substitution elasticities between capital, labor, energy, and materials in production have a larger impact on mitigation costs than inter-fuel substitution does. There are notable differences in the effect of the elasticities on costs at the regional level due to interactions in international trade and capital flows in such a global model. As elasticities are reduced, growth in GDP and emissions also decrease under the business as usual scenario and so the emissions that must be cut to reach a given absolute mitigation target are also reduced. Therefore, there is not much variation in the total costs of reaching a given target across the parameter space.