Analyzing Climate Policy Impacts: the EPPA Model

The Emissions Prediction and Policy Analysis of the Joint Program on the Science and Policy of Global Change aims to predict the emissions of greenhouse gases and other air pollutants over time, as well as to assess the impact of climate change mitigation policies on the economy.

Technically, EPPA “is a recursive-dynamic multi-regional general equilibrium model of the world economy” (Paltsev et al., 2005). It is a general equilibrium model insofar as it models the whole economy, so that the interactions between the different markets are taken into account – as opposed to a partial equilibrium model in which a few markets are cleared independently from other markets. As can be seen in Figure 10, all flows of goods, services, revenues and expenditures are therefore accounted for in such a general equilibrium model. Goods, services and primary factors enter a first circular flow:

consumers supply labor and capital to producer sectors, which use them to produce goods, which are in turn provided to the consumers. In exchange for the primary factors they supply, consumers receive income, which they use to purchase the goods and

The economic model is closed in the sense that these different flows must be balanced when the model finds a solution. In other words, there is no external creation of goods or wealth (apart from the initial endowments of consumers): the only goods that can be consumed are those that are provided by the production sectors (or that exist as endowments, such as natural resources), and the only primary factors that are available to production sectors are those supplied by consumers, who own them.

Figure 10. The Circular Flow of Goods and Resources in EPPA

Given unavoidable computational limitations, the world has to be divided into a limited number of regions; one cannot model the economy of the entire world with details at the national level for all countries. Accordingly, certain economic models define only one single region, the entire world. EPPA4 is, however, “multi-regional”: it includes 16 regions (see Table 17), which can trade goods and services among each other.

Table 17. EPPA Model Details (from Paltsev et al., 2007)

The model is recursive-dynamic insofar as it solves for an economic equilibrium in each period without taking into account future periods. Once the model has reached equilibrium for a given period, it updates a number of exogenous factors such as population and productivity (of labor, land, and energy), and accounts for changes in stock variables including investment, depreciation of capital and depletion of natural resources. The model next solves for a new equilibrium in the following period.

Recursive-dynamic models can be contrasted with forward-looking models, which solve for price and quantities in all markets in all periods at once, assuming that the future is known with certainty, and assuming a certain discount rate.

In EPPA, production sectors maximize their profits by choosing the most economical combination of inputs to produce a given quantity of output. Their ability to make this tradeoff among inputs is modeled through an elasticity of substitution: with a zero elasticity producers cannot change the share of the different inputs in the production of the output. Conversely, an infinite elasticity of substitution implies that the different

constant elasticity of substitution (CES) function. In the case of more than two inputs, this function is limited in that the substitution elasticity between any two pairs of inputs must be the same. To overcome this limitation, the CES production functions are here nested: separate elasticity parameters allow flexibility to set the rate of substitution between a specific input and a bundle of other inputs. By assumption, producers do not make any profit at the economic equilibrium in a computable general equilibrium model, which is consistent with the hypothesis of working competitive markets. Since the main purpose of EPPA is to predict the emissions of greenhouse gases and to assess policies affecting these emissions, not all production sectors need to be represented with the same level of detail. The energy sector is for instance modeled in greater detail than other sectors, relying on bottom-up analysis to represent the different energy generation technologies. In particular, nuclear power competes against the sectors listed in the electric energy section of Table 17.

Consumers are assumed to maximize a utility function by choosing their preferred goods and services, given their budget constraints. Again, this preference is modeled through elasticities of substitution, which can vary from zero to infinity; consumer sectors are therefore also implemented as nests of goods that can be substituted for each other, depending on the values of the elasticities of substitution.

EPPA solves for an equilibrium that maximizes the producer profits and the consumer utilities, given the initial consumer endowments, the existing production and consumption sector structures, and the policy constraints imposed on the economy. These constraints include taxes, whether on carbon emissions or on factors such as labor or capital, as well as emission limits to represent cap-and-trade systems. The model can therefore be used to assess the impact of mitigation policies by adding constraints to the economy and assessing their impacts on the resulting economic equilibrium. Interesting parameters then include the shadow price on carbon emissions (which can be interpreted as the price of emission permits), and the change in economic welfare (roughly, the aggregate consumption).