Energy and Climate Policy in a DSGE Model of the United Kingdom

Main Points

• The introduction of the carbon tax has the effect of shifting the production of electricity from fossil fuels (specifically, gas) to renewable sources. At the same time consumption shifts out of energy and into non-energy and, within energy, out of petrol and gas towards electricity. Output of non-energy goods and GDP fall but electricity output rises in response to the carbon tax. Imposing the carbon tax also leads to a temporary increase in inflation and, in turn, a tightening of monetary policy.
• The effect of bans on the use of fossil fuels on households depended crucially on the elasticity of substitution between different energy sources in consumption. In the baseline parameterisation, a ban on petrol or gas usage also led households to cut down on their use of electricity, whereas if the elasticity of substitution between energy sources increased to 0.4, then households switched into electricity. Regardless of the elasticity of substitution, aggregate consumption and gross output of non-energy fell on impact in response to the bans before rising over time. But GDP falls permanently in response. Banning petrol or gas usage by households also led to an increase in inflation and interest rates.

Through the construction of an open economy Dynamic Stochastic General Equilibrium (DGSE) model with energy, this paper demonstrates 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.

It shows how the introduction of a carbon tax leads to falls in both households’ consumption of energy and firms’ use of energy in production, whilst 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.

Ultimately, both policies result in a temporary increase in inflation and a tightening in monetary policy.