Estimation of substitution elasticities for CGE models

Many studies of climate policy are based on computable general equilibrium (CGE) modeling. The simulation results and conclusions reached by these models depend on the size of the parameters specified. In particular, the substitution elasticities between production factors have a major influence. Therefore, in order to obtain reliable simulation results we should employ empirical evidence gathered on the substitution elasticities. Unfortunately, in many instances, the lack of econometric analysis means we must specify these key parameters based on existing work or borrow them from prominent modeling exercises. In this study, we estimate nested constant elasticity of substitution (CES) production functions using panel data for OECD countries to help improve the reliability of CGE models for climate policy. Our results show higher values for substitution elasticities closely related to energy inputs for energy-intensive industries and lower values for other industries compared to the conventional values often used in existing models. With the new parameters estimated, we find that conventional parameters could overestimate the necessary carbon price by 44%, and obtain evidence of different distributions of CO2 emission reduction costs across industries.