Asia-Pacific Research and Training Network on Trade. Working Paper Series, No. 81, July Truong P. Truong

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1 Asa-Pacfc Research and Tranng Network on Trade Workng Paper Seres, No. 8, July 00 Revew of Analytcal Tools for Assessng Trade and Clmate Change Lnkages By Truong P. Truong Truong P. Truong s Honorary Professor of Sustanable Transport Systems, The Insttute of Transport and Logstcs Studes, The Unversty of Sydney, Australa and an advsor of ARTNeT for work on Trade and Clmate Change Lnkages. Ths paper was prepared as part of the Asa-Pacfc Research and Tranng Network on Trade (ARTNeT) ntatve on buldng research capacty n the area of Trade and Clmate Change Lnkages. The techncal support of the Unted Natons Economc and Socal Commsson for Asa and the Pacfc s gratefully acknowledged. The opnons are the responsblty of the author and should not be consdered as reflectng the vews or carryng the approval of the Unted Natons, ARTNeT, or the Unversty of Sydney. Any errors are the responsblty of the author, who can be contacted at The Asa-Pacfc Research and Tranng Network on Trade (ARTNeT) s amed at buldng regonal trade polcy and facltaton research capacty n developng countres. The ARTNeT Workng Paper Seres dssemnates the fndngs of work n progress to encourage the exchange of deas about trade ssues. An objectve of the seres s to get the fndngs out quckly, even f the presentatons are less than fully polshed. ARTNeT workng papers are avalable onlne at All materal n the workng papers may be freely quoted or reprnted, but acknowledgment s requested, together wth a copy of the publcaton contanng the quotaton or reprnt. The use of the workng papers for any commercal purpose, ncludng resale, s prohbted.

2 Table of Contents Executve Summary...4. Introducton...5. Trade and Clmate Change Lnkages Theoretcal Hypothess...5. Impacts of Trade on Clmate Change: Scale, Composton, Technque and Drect effects...6. Impacts of Clmate Change on Trade: Productvty changes, Changes n Comparatve Advantages Trade and Clmate Change Lnkages Emprcal Analytcal Tools Econometrc technques General equlbrum models The Use of Computable General Equlbrum (CGE) Models for Polcy Analyss n the Area of Clmate Change and Trade Lnkages Why 'general equlbrum'? What 'computable'? Uses and ptfalls of CGE models Examples of CGE Models Used for the Study of Trade and Clmate Change Lnkages ORANI-G model GTAP model for the analyss of global trade ssues Conclusons...3 Appendces...3

3 Lst of Fgures Fgure : Trade, nvestment and clmate change lnkages...6 Fgure : Comparatve-statc nterpretaton of results... Fgure 3: ORANI Model data base...5 Fgure 4: ORANI Model Theoretcal structure assocated wth the use of ntermedate goods n current producton...6 Fgure : GTAP Model Producton structure...5 Fgure : GTAP-E Model Producton structure...5 Fgure 3a: GTAP-E Model CO tax frst best...6 Fgure 3b: GTAP-E Model CO tax second best...7 Lst of Tables Table : Percentage devaton of emssons from projected Busness-as-Usual level for perod accordng to the NAP(*)...8 Table : Margnal Abatement Cost (995US$/ton of CO) when there s no emssons trade....8 Table 3: Margnal Abatement Cost (995US$//ton of CO) when there s domestc emssons tradng only....9 Table 4: Margnal Abatement Cost (995US$//ton of CO) when there are domestc emssons tradng as well as regonal emssons tradng...9 Table 5: Macroeconomc effects of Regonal Emsson Tradng (*)

4 Executve Summary Trade and clmate change are clearly among the most mportant economc and poltcal ssues facng the global communty. Although t s generally agreed that the two areas are closely related, the nature and outcome of these lnkages are stll debatable. On the one hand, there s a vew that trade can contrbute negatvely to the problem of clmate change because of ts mpacts on the level of economc actvtes and the mpact on nternatonal transport. On the other hand, there s also the contrary vew that trade s not only helpful, but may even be necessary, for the development, dffuson and transfer of technologes whch can help n the combat aganst clmate change. To assst n the understandng of the nature of these complex nterrelatonshps and to assess ther overall mpacts on the economy and the envronment, especally wth respect to the problem of clmate change, t s mportant that we understand the theores behnd these nterrelatonshps and use the practcal models whch are bult to represent these lnkages n the analyss of clmate change and trade polces. In ths paper, we brefly refer to the essental elements underlyng the theoretcal lnkages between trade, economc development, and clmate change and revew the analytcal tools whch are used to descrbe these lnkages. We look specfcally at a partcular type of analytcal tool called computable general equlbrum (CGE) models; consder ther strengths and lmtatons when used as a tool for the analyss of these trade and clmate change lnkages. The paper fnds that the tool have been more useful than msused, and ths explans for the popularty of ts use n the past. Lookng to the future, to ncrease the usefulness of the tool n the area of polcy analyss, there wll need to be contnung tranng for the polcy analysts n the modern and expandng technques of CGE modellng. Such tranng wll nclude not only the surveyng and readng of the lterature and understandng the basc theores but also hands on experence on ts practcal applcatons. Ths survey paper therefore s only an mportant frst step towards that ultmate drecton. Insofar as trade leads to growth, and growth leads to an ncreased wllngness and ablty to pay for a cleaner envronment, freer trade and nvestment flows wll enable countres to adapt better to any adverse effects of clmate change and to mtgate emssons. Salle James (009). p.4. Globalzaton...has been a major drver behnd global warmng. Ths trade model has promoted the producton and consumpton of goods regardless of ther mpact on our envronment, excessve and wasteful shppng of goods globally, depleton of natural resources at a break-neck pace...free trade has most sgnfcantly contrbuted to global warmng...serra Club (008) p. Trade...can - at best - offer no more than part of the answer to clmate change. It s not n the WTO that a deal on clmate change can be struck, but rather n an envronmental forum, such as the Unted Natons Framework Conventon on Clmate Change. Pascal Lamy, WTO Drector- General, Bal, December 007 4

5 . Introducton Trade and clmate change are clearly among the most mportant economc and poltcal ssues facng the global communty. Although t s generally agreed that the two areas are closely related, the nature and outcome of these lnkages are stll debatable. On the one hand, there s a vew that trade can contrbute negatvely to the problem of clmate change because of ts mpacts on the level of economc actvtes and the mpact on nternatonal transport (Serra Club, 008). On the other hand, there s also the contrary vew that trade s not only helpful, but may even be necessary, for the development, dffuson and transfer of technologes whch can help n the combat aganst clmate change (see, for example, James (009)). To assst n the understandng of the nature of these complex nterrelatonshps and to assess ther overall mpacts on the economy and the envronment, especally wth respect to the problem of clmate change, t s mportant that we understand the theores behnd these nterrelatonshps and use the practcal models whch are bult to represent these lnkages n the analyss of clmate change and trade polces. In ths paper, we brefly refer to the essental elements underlyng the theoretcal lnkages between trade, economc development, and clmate change and revew the analytcal tools whch are used to descrbe these lnkages. We look specfcally at a partcular type of analytcal tool called computable general equlbrum (CGE) models; consder ther strengths and lmtatons when used as a tool for the analyss of these trade and clmate change lnkages. The plan of the paper s as follows. Secton explans the theoretcal lnkages between trade and clmate change ssues. Secton 3 looks at the analytcal tools used n the analyss of these lnkages. Secton 4 looks more closely at a partcular type of analytcal tool: CGE models, and assesses the strengths and lmtatons of ths tool. Secton 5 gves some examples of the use of CGE models n the analyss of trade and clmate change lnkages. Secton 6 concludes.. Trade and Clmate Change Lnkages Theoretcal Hypothess Trade and clmate change can be assumed to be lnked n several ways. Fgure shows a schematc dagram of these lnkages. 5

6 Fgure : Trade, nvestment and clmate change lnkages Source: Cosbey (007). Impacts of Trade on Clmate Change: Scale, Composton, Technque and Drect effects The mpacts of trade and nvestment polcy on clmate change can be summarsed n terms of four dfferent components : scale effects, composton effects, technque effects, and drect effects. In practce, these dfferent components are closely ntertwned and t's hard to separate them out, but from a theoretcal vewpont, t s useful to dstngush between these components so that we can have a better understandng of the nature of the nterrelatonshps. Scale effect: ths s the effect that trade (and nvestment) polcy can have on clmate change va a change n the scale of producton and consumpton actvtes. For example, f trade results n an ncrease n the level of economc actvtes n certan sectors of an economy, and/or certan parts of the world, and f these ncreased actvtes result n hgher levels of GHGs emssons, then trade can be sad to have a negatve mpact on clmate change. The scale effect s almost always negatve; therefore, crtcsms of the current tradng system often resort to ths scale effect to pont to the negatve mpact of globalsaton on the envronment and especally on clmate change. Composton effect: trade and clmate change polces can also have mpacts on the patterns of producton and consumpton actvtes n dfferent countres. For example, through trade openng, "Scale, composton, and technque effects" were frst used by Grossman and Kruger (99) and others to descrbe the mpacts of the North Amercan Free Trade Agreement (NAFTA) on polluton levels n North Amerca. The precse defntons of these terms n the context of a general equlbrum model were subsequently gven n Copeland and Taylor (994). 6

7 the ncome level of tradng countres can ncrease and f we assume that the envronment s a normal good, then an ncrease n ncome level wll lead to an ncrease n demand for ths good. The pressure of demand for more envronmental good means the patterns of producton and consumpton actvtes wll have to change and shft gradually from a relance on envronmentally 'drty' goods (such as steel, cement, and chemcals) towards 'cleaner' goods (such as electroncs, telecommuncatons, and other servces). These composton effects can have a benefcal mpact on clmate change. However, ths depends also on other factors. For example, f clmate change regulatons n rch countres are not matched by smlar regulatons n other poorer countres, then the 'leakage effects' mples the benefcal composton effects n the former countres wll be offset by the negatve composton effects n the latter countres. Technque effects. Trade lberalzaton (and nvestment agreements whch may go wth t) can brng about changes n producton technques whch are often more energy effcent, and hence emt less GHGs per unt of output. The changes n producton technques can come about from the autonomous pressure of competton but can also be nduced by polces. For example, the European Unon clmate polcy of targetng the share of renewable energy n producton and consumpton actvtes of the European Unon n the year 00 to a level of 0% may have the effect of nducng clmate frendly technologcal change n the European Unon. Currently wthn the Doha Round, there are dscussons about how to use trade lberalsaton n the area of socalled envronmental goods and servces (EGS) to help n the dffuson and transfer of clmate frendly technologes between countres. 3 The analyss of these clmate and trade polces lnkages may requre further research usng tools whch can capture the essental elements of these lnkages. Drect effects: free trade ncreases the demand for nternatonal transport of goods. Transport currently uses fossl fuels and hence ths wll ncrease the overall emssons of GHGs. The drect (negatve) effects of trade and transport on the envronment and clmate change, however, must be consdered n the context of trade and transport are only a means to an end ('margn' commodtes) rather than an end n tself (.e. fnal commodtes). Therefore, although the drect effects of trade and transport on the envronment are always negatve, ths does not mean these actvtes are not necessary or useful for other actvtes. Negatve drect effects are only part of the overall scale, composton and technque effects consdered prevously.. Impacts of Clmate Change on Trade: Productvty changes, Changes n Comparatve Advantages The mpacts of clmate change on trade can be summarsed under two headngs:() physcal mpacts of clmate change on the natural resource endowments of a partcular country whch then affects the comparatve advantage of the country n nternatonal trade, and () polcy mpacts of clmate change polces on comparatve advantage or compettveness of frms n these countres. Physcal mpacts: wth rsng temperature, changng level of precptaton, ncreased level of CO concentraton n the atmosphere, productvty of the agrcultural sector may be affected. It has been estmated (see Clne (007) for example) that agrcultural productvty n some regons such as Inda, South East and South West Plans of the Unted States, Mexco, South Afrca, Ethopa can be reduced by these aspects of clmate change by as much as -0% to -30%. Some other regons, however, may gan: For example, Chna, the Unted States (other than South East and Ths s also the man hypothess underlyng the so-called 'Envronmental Kuznets Curve' (EKC) (see World Bank (99), Grossman and Kruger (995)). It has been suggested (see WTO (009, p.5)) that although the hypothess may work well for the case of a local envronmental good attached to a specfc country, t may not apply well to the case of a global envronment ssue such as GHGs emssons because n ths case the bulk of the costs of GHGs emssons are borne by other countres and hence there s always very lttle ncentve left for the pollutng country to reduces ts own emssons even f ts ncome are rsng. 3 See WTO (009). 7

8 South West Plans), Canada, Germany, Span, Russan Federaton can gan n agrcultural productvty, and these gans can range from about 5% to %. The ncrease n temperature as well as other aspects of clmate change such as the bleachng of coral reefs, forest de-off, and fundamental ecologcal changes can also affect other sectors of the economy such as toursm and nfrastructure (harbour, shppng docks, etc.). Polcy mpacts: clmate change polces can affect the comparatve advantage of a country and the compettveness of frms n varous sectors of an economy. One of the prncpal concerns when countres try to mplement unlateral clmate change polces s the fact that such polces may not be effectve from the global envronmental vewpont. Ths s because of the problem of so-called 'leakage': envronmental goods n one country are offset by envronmental bads n other countres due to a lack of nternatonal polcy co-ordnaton. Another mportant concern s the mpacts of such unlateral polces on the relatve comparatve advantages of a country n nternatonal trade, and also the relatve compettveness of dfferent frms n dfferent sectors of the economy n domestc trade. To deal wth these concerns, there have been suggestons that some border tax adjustment (BTA) measures such as envronmental tarffs could be appled. However, the effectveness of such polcy measures can be doubtful and the mpacts of such measures on the world economc and tradng systems can also be unpredctable. Therefore, there s a need for further research nto these trade-clmate change polcy lnkages before such polces measures could be adopted. 3. Trade and Clmate Change Lnkages Emprcal Analytcal Tools The most common tools whch are used n appled analyss of trade-clmate change lnkages are () econometrc technques, and () appled (or computable) general equlbrum models Econometrc technques Generally, these are used to establsh partal statstcal relatonshps between certan envronmental or clmate change varables (temperature, humdty, precptaton, wnd velocty, etc.) and some specfc soco-economc varables. For example, n the study of the (partal or drect) mpacts of clmate change on health ssues, regresson analyss can be used frstly to establsh a statstcal relatonshp between morbdty or mortalty rates (dependent varable) and maxmum daly or average weekly temperature, humdty rato, wnd velocty, etc. (ndependent varables). Ths statstcal relatonshp s then fed nto some other mcro-smulaton or computable general equlbrum models to estmate more generally the overall mpact of a partcular temperature (clmate change) scenaro on the health condton of a partcular regon. 5 Smlarly, n the analyss of the mpact of clmate change on the toursm ndustry, regresson analyss can frst be used to establsh a relatonshp 4 Some authors (e.g. Mtra-Kahn (008)) dstngush between 'appled general equlbrum' (AGE) and 'computable general equlbrum' (CGE) models, ctng manly ther dfferences n hstorcal orgns and computatonal methods as the reasons. However, as Hertel et al. (99) ponted out, these dfferences are not really the man ssue because the two 'schools' have much n common n theory. Dxon (006) also ponted out that computatonal technque of the 'AGE School' (Scarf algorthm) was manly nspratonal rather than practcal or 'appled' and n fact, by the 980s, t was completely abandoned by the 'AGE School' n favour of more tradtonal technques used by the 'CGE school' such as Newton-Ralphson and Euler algorthms. Computatonal technque s also becomng less of an ssue for economsts usng CGE models because now wth the advent of powerful modern computer and computatonal softwares (such as GEMPACK (Pearson (988), Harrson and Pearson (996)) or GAMS (Kendrck et al. (988)), economsts can concentrate on the more productve task of nterpretng and explanng the results rather than the methods of computaton behnd these results. 5 See, for example, Kalksten et al. (987). 8

9 between the total number of tourst arrvals or departures from a partcular regon and the envronmental or clmate change varables relatng to ths regon. The relatonshp can then be used n a more general mcro or macro smulaton model to estmate the overall mpacts of some clmate change scenaros on toursm. 6 Econometrc technques therefore, can be part of the set of analytcal tools whch are used n the analyss of the mpacts of clmate change on economc actvtes or the lnkages between clmate change and trade polces. 3. General equlbrum models Lnkages between clmate change and the economy and nternatonal trade are much more complex than a smple (and partal) econometrc relatonshp can capture and hence these relatonshps must be used n conjuncton wth a more general or comprehensve smulaton model (such as CGE model) to analyse the overall lnkages between trade and clmate change. In theory the 'general equlbrum' n a CGE model refers to the complete balance between supply and demand n all markets descrbed by the model. In practce, however, dsequlbrum s also routnely allowed nto these models to capture the real stuatons n some specfc markets. For example, f the labour market s n a Keynesan-type dsequlbrum stuaton because of the 'stckness' of labour prce, then one can assume that ths prce s to be determned exogenously of the model (e.g. by unon barganng) and then a 'slack' varable s ntroduced nto the model whch represents the excess demand or supply whch now characterse ths market. The slack varable s now endogenously determned by the model nstead of the labour prce varable. 'General equlbrum' s thus not a very accurate term to be used to descrbe these models. A more accurate term would be 'general nter-connectedness' or 'general lnkages' model The Use of Computable General Equlbrum (CGE) Models for Polcy Analyss n the Area of Clmate Change and Trade Lnkages In ths secton we look more closely at the CGE tools whch are commonly used n the analyss of trade-envronment-clmate change ssues. We explan why these tools are used, what ther strong characterstcs are and what are ther lmtatons or napproprate uses. 4. Why 'general equlbrum'? An alternatve to 'general equlbrum' s 'partal equlbrum' analyss usng methods such as regresson analyss whch s used to estmate parts of the lnkages between trade and clmate change (see prevous secton 3.). Partal equlbrum analyss s not comprehensve enough to account for all the complex nterrelatonshps between trade, economc actvtes and clmate change ssues. These complex nterrelatonshps nvolve the lnkages between dfferent sectors of an economy (upstream/downstream; domestc/foregn, nfrastructure/fnal producton); dfferent agents (consumers, producers, governments, nvestors, savers, mporters, exporters), dfferent economes (developng/developed), and also dfferent generatons (current/future). Dfferent sectors of an economy may face wth dfferent choces or opportuntes for reducng GHGs emssons and the mposton of dfferent clmate change polces focusng on these dfferent sectors may also have dfferent overall mpacts on the economy and on the costs of these 6 See, for example, Lse and Tol (00), Hamlton et al. (005). 7 Apart from the word 'general' whch s used only n a relatve' sense, the word 'equlbrum' s abstract and can be artfcal. For example, n the analyss of trade-economc-envronmental lnkages, the dea of 'equlbrum' between the trade-economc system and the natural envronment s not somethng whch s easy to defne. Therefore a more approprate term to use s 'nterconnectedness', or smply 'lnkages'. 9

10 clmate change polces. For example, f a carbon tax s mposed on producers of fossl fuels (.e. on upstream coal mnng or petroleum refnng sectors) nstead of on the fnal consumers (down stream electrcty generaton, or transport servces sectors). ths may save on transacton and montorng costs (because there are less number of establshments to montors) but ths can result an opportunty for end-of-ppe emssons reducton method such as carbon capture and sequestraton to be utlzed because there s now no ncentve for the downstream polluters to nstall them (see for example, Mansur, 00). Dfferent types of agents may face wth dfferent decsons n respondng to clmate change and trade polces. For example, consumers may want to maxmze ther utltes or welfare, frms may want to mnmze ther costs or maxmze profts, government may have to optmze wth respect to ther fscal budget constrants and/or trade balances. Decsons by prvate ndvduals or frms or dfferent countres may also create 'externaltes' whch regulatory bodes or publc organsatons (such as the UNFCCC or WTO may also want to take nto account (for example, when dealng wth the ssue of carbon leakage) Dfferent types of economes (developng/developed) may follow dfferent types of polces because they face wth dfferent economc/envronmental challenges (e.g. growth or poverty reducton versus envronmental protecton). Fnally, dfferent generatons (current/future) can also have dfferent and sometmes conflctng nterests n the preservaton of the envronment or explotaton of natural resources. Because of all these nterconnectng dfferences, there s a need for an analytcal framework whch can comprehensvely descrbe and also measure up all the dfferences and consstently 'addng up' all the results. For example, all ncome and expendture flows of all economc actvtes from all sectors of an economy (two sdes of the same con) must be balanced; total mports and total exports of all countres must be checked to be equal; total world savngs must balance total world nvestments, etc. These requrements that the world economc and envronmental systems to be n some state of 'general balance' or 'equlbrum - f not for theoretcal reasons then at least for numercal consstency - s the man reason why (computable) general equlbrum' model s the adopted tool for most trade-clmate change lnkage studes. 4. What 'computable'? Computable general equlbrum (CGE) models can be used n dfferent 'modes'. In the tradtonal 'comparatve statcs' analyss, t s used to analyse the mpacts of a partcular polcy on an economy ('what f' or mpact analyss). In a more dynamc approach, CGE models can be run n four dfferent modes: hstorcal, decomposton, forecastng, and polcy (or devaton) modes (see Dxon and Rmmer (998)). Comparatve statc analyss: n ths approach, frst, an economy s assumed to be n a state of equlbrum at poston A at tme t=0 (see Fgure ). Assume there are 'busness as usual' shocks to some exogenous varables but no polcy s appled to the economy at ths pont, the economy wll move away from poston A but after a perod of tme T t wll settle back agan to a new equlbrum poston at pont B. Now, assume that a polcy shock had also been appled to the economy at tme t=0 (n addton to all the BaU shocks). The new equlbrum poston at tme t=t may be at pont C rather than pont B. The 'dstance' BC can be sad as resultng from the mpacts of the polcy. 0

11 In comparatve statc analyss, the mplct assumpton s that the dstance BC due to the mpact of the polcy can be measured ndependently of the tme path of the economy from t=0 to t=t. 8 However, as Dxon and Rmmer (998) dscovered, ths s not to be the case. The polcy mpact BC can depend on assumptons made regardng the tme path of the economy from t=0 to t=t n the 'base case' (.e. when no polcy was appled). 9 Ths means even for polcy mpact analyss, comparatve statc analyss s not suffcent and a more dynamc analyss may be necessary. Fgure : Comparatve-statc nterpretaton of results C Employment Change B A 0 T years Source: Horrdge (003). Dynamc analyses: n dynamc analyss, a CGE model can be run n four dfferent 'modes': hstorcal, decomposton, forecast, and polcy (or devaton) modes. o Hstorcal mode: n ths mode a CGE model s run to retrace the hstory of the economy over a specfc perod of tme n the past to derve nformaton about certan key varables whch are normally assumed to be exogenous n a comparatve statc analyss: changes n technology, consumer preferences, postons of foregn demand curves for domestc products and numerous other naturally exogenous trade varables. To set up the CGE for ths type of run, frst, certan varables whch are often assumed to be endogenous n a CGE model for a comparatve statc run are now assumed to be exogenous: nvestment, domestc output, export, mports, etc. Next, usng publshed nformaton about these varables (also called 'observables') for the hstorcal perod nvolved, the varables can then be shocked by ther actual past values. Now the varables whch are normally 8 Ths assumpton s necessary because n fact, for comparatve analyss, the model contans no tme varable and the analyss s actually 'tmeless',.e. there s no tme path nvolved but the only nformaton avalable are about the postons A, B, and C. 9 Crtcs of the CGE model have always ponted out ths fact, but ths crtcsm only refers to the fact that wthout a tme path, the costs of adjustment to the new equlbrum cannot be estmated. Here, however, Dxon and Rmmer (998) refers to, not just the adjustment costs (whch depends on the 'path' from A to B), but also the dstance BC tself.

12 assumed to be exogenous n a comparatve statc run (technology, tastes, etc.) can now be set as endogenous, n exchange for the above 'observable' varables whch are now defned as exogenous. Hence, the results of the hstorcal run can be used to estmate the hstorcal values of these technologcal and taste change varables for the hstorcal perod nvolved. In addton to these technologcal and taste change varables (often referred to as 'shft' varables n a tradtonal CGE model because they refer to the changes n demand whch nvolve only a 'shft' n the curve -.e. keepng the relatve ratos of the varous component demands unchanged), other new and mportant varables can also be defned and estmated usng the hstorcal run. For example, n an analogous manner to the 'shft' varables, some 'twst' varables can also be defned whch refer not to the shft n the absolute levels of demand, but to the relatve changes n demand ratos (mports to domestc, captal to labour, motor vehcle relatve to all other goods, etc.). 0 o o o Decomposton mode: gven the mportant results obtaned from the hstorcal run, the model can now be rerun n a 'decomposton' mode. Here, for example, the 'endogenous' (hstorcally estmated) varables representng technology and taste changes (both 'shft' and 'twst' varables) can be reset as 'exogenous'. However, wth ther values havng been estmated from the hstorcal run, these values can be used as shocks n a decomposton run. Ths enables us to estmate the results for other varables n the case 'wth' and the case 'wthout' technologcal change, and hence solate or decompose the results nto pure technologcal change effects, and the effect due to other varables. Smlar exercses can be repeated for other varables whch are assumed to be exogenous n a decomposton run, but allowed to be endogenously estmated n a hstorcal run. In ths way, the combned hstorcal and decomposton runs wll enable a complete decomposton of many hstorcal changes nto varous components (technologcal change component, export shft component, employment change component, etc.). Forecastng mode: Forecastng mode s smlar to hstorcal mode, except that nstead of 'exogenzng everythng that we know about the past', here n a forecastng mode, we 'exogenze everythng that we thnk we know about the future' (Dxon and Rmmer, 998, p. 7). Opnons from experts about future technologcal developments, tastes changes, growth of the economes, changes n the natural envronment and resources, etc., can be ncorporated as 'exogenous shocks' n a forecastng run. It s qute naturally expected, however, that what we thnk we know about the future s much less than what we know about the past, hence n most cases, past nformaton s used n combnaton wth expert opnons about the future to provde some 'guesswork' about the future (e.g. on technologcal developments) for the exogenous varables. Polcy mode: As forecastng mode s smlar to hstorcal mode, polcy mode s smlar to the decomposton mode. If hstorcal smulaton provdes nformaton on certan exogenous varables for the decomposton mode (such as changes n technologes and tastes), then smlarly, forecastng mode provdes nformaton on certan exogenous varables for the polcy mode - except of course for those exogenous varables whch are now controlled or determned by the polcy tself. Whle hstorcal and decomposton smulatons should provde the same results for all varables (except for the swtch n exogenous/endogenous defntons) - ths s because they are both defned by the known past - results for a forecast (of a base case scenaro) are qute naturally not the same as the results for a polcy scenaro, due to dfferences n the values of the polcy varables n the two scenaros. 0 See Dxon and Rmmer (998). Tradtonal neoclasscal analyss assumes that changes n the rato of demands can only come from changes n the relatve (.e. rato of) prces. Here, the twst varables allow for ths relatve demand change even f the relatve prces reman unchanged.

13 4.3 Uses and ptfalls of CGE models As Dxon (006) ponted out, the 960s wtnessed "the development of large-scale, economywde econometrc models (e.g. the Wharton, DRI, MPS, St Lous, Mchgan and Brookngs models)" and nterests n CGE models were gven a boost only after the 973 ol prce shock. Ths event was an mportant turnng pont for CGE modellng because up to that pont, appled economsts were attracted mostly to the underlyng phlosophy of econometrc modellng of "lettng the data speak" and hence CGE models, beng based on optmsaton theores and nput-output data rather than tmeseres, were not a contender n ths respect. Wth the ol prce shock, however, the stuaton changed, snce tme-seres data do not have much to "speak" about sgnfcant ol prce changes of such magntude as the ol prce shock. Therefore, economsts turned ther attenton to CGE models because at least wth a relance on optmsaton theores rather than merely hstorcal data, the models can provde some foundaton on whch the future can plausbly be assessed. Durng the 990s, the problem of clmate change and trade added yet another challenge for econometrc modellng because hstorcal experence wth respect to these problems were lmted or non-exstent, hence, to predct the future, relance on theores must take an equally mportant role as data. CGE modellng became a popular tool because of ts relance on theores and of ts flexble ablty to ncorporate many dfferent knds of theores nto the model (for example, theores about nduced techncal change and technology dffuson). In summary, as Mattoo (009, p. 3) ponted out: "An econometrc approach seems handcapped by the absence of past events and our nablty to construct experments that are comparable wth the polcy changes of greatest nterest". A CGE model can help to brdge these gaps wth ts relance on theoretcal nsghts and 'expert' opnons to look nto the future rather than just relance on hstorcal data to look at the past. A CGE model also has the flexblty of desgn to allow varous theores and types of polcy experments to be smulated. These are the strengths of the CGE modellng approach and whch explans for ts popularty. On the weaknesses sde, because of ts complexty, a CGE model s often consdered to be a 'black box' and ths can lead to some msuses. McDougall (993) consdered the followng examples where CGE models can be msused: Msnterpretaton of results: The structure of a CGE model s often rch n nter-connectons between dfferent markets and dfferent effects; therefore, these effects can be mxed up or confused. A CGE model whch s used to study the effects of trade lberalsaton on the economy can contan rch detals on both domestc labour market and nternatonal trade. A close connecton between these two areas means that f trade lberalsaton mpacts on the levels of real wages and employment, the man welfare gans from such a polcy may actually come from labour market deregulaton rather than from the theores of comparatve advantage and the 'gans from trade'. 'Confabulaton': Related to the case of msnterpretaton of the results s the case of so-called 'confabulaton', meanng confused nterpretaton of the results of a CGE model to such an extent that the nterpretaton may gve some explanatons whch makes sense from a theoretcal vewpont but whch has nothng to do wth the actual structure of the model. An example s the case of a study lookng at the effect of growth n East Asan countres on the Australan economy. The study clamed adverse welfare effects on the Australan economy due to the outflow of foregn captal from Australa, but the actual structure of the model contaned no government taxes on foregn-owned captal and therefore the welfare effects could not have come from the effects of foregn captal outflow. Other weaknesses of a CGE modellng approach ncludes: Absence of money or fnancal assets n most CGE models: t s not easy to ncorporate money and fnancal assets nto a CGE model, therefore, most CGE are used only for study of the 'real' economy where, only relatve prces matter. Most CGE models therefore, cannot be used for the analyss of monetary or fnancal polces. 3

14 Consstent and up-to-date data for CGE modelng s not easly constructed or readly avalable: All CGE models requre a data set whch must be constructed consstently from nput-output tables, socal accountng matrces (SAMs), trade tables, and, n the case of a global economyenergy-envronment CGE models, also data on energy and envronmental varables such as GHG emssons whch must be lnked to the economc data. The avalablty of such a consstent data set requres consderable efforts whch go beyond the resources of any sngle ndvdual CGE modeler, and therefore, the exstence of a consortum to comple such a database as GTAP (Narayanan and Walmsley (008)) s qute unprecedented and unque. 5. Examples of CGE Models Used for the Study of Trade and Clmate Change Lnkages In ths secton we look at the structures of some publcly avalable CGE models whch have been used for the analyss of trade and clmate change lnkages. The objectve s to gve some nsghts nto the workngs of a CGE model, how t s constructed, what type of database t requres, and how the model can be used for the analyss of trade and clmate change ssues. Emphass s on the hands-on technques for the practcal mplementaton of a CGE approach rather than dscussng the theoretcal ssues - whch have already been covered n sectons -4, hence we concentrate on just one type of CGE models, namely those related to 'GTAP-famly' of models. Even here, lmted space allows us only a bref overvew of the man ponts rather than all the necessary detals whch are requred by a CGE specalst. For the latter, the readers are referred to practcal tranng courses for these models, 5. ORANI-G model ORANI (Dxon et al., 98) was a CGE model of Australa bult durng the late 970s for the analyss of trade ssues n Australa. The model has been extended n several ways and the current verson, ORANI-G, has been used as a template for the creaton of many other CGE models: for South Afrca, Vetnam, Indonesa, Republc of Korea, Thaland, the Phlppnes, Pakstan, Denmark, Chna, Fj and Tawan, Provnce of Chna. Apart from beng among the very frst CGE models bult to look at trade ssues (tarff reform) for a natonal economy (Australa), ORANI was poneerng n the development of technques for data, theory, and software constructon for use n the buldng of a CGE model. These technques were later used n the constructon of other (global) CGE models such as GTAP. Ths secton brefly descrbes the technques of the ORANI-type model. 5.. Data base The data base for ORANI-G s shown n Fgure 3. The basc nformaton used for the constructon of ths database are frstly, nput-output data on flows of ntermedate goods c ={,...,C} from sources s ={dom, mp} to ndustres ={,...,I} used n current producton (.e. producton n current perod) (matrx VBAS); margns servces (whole sale and retal trade, transport) assocated wth these flows (matrx VMAR):; commodty taxes on these ntermedate goods (matrx VTAX) ncludng mport duty on mported goods (matrx V0TAX); prmary factors (labour, captal, land) used n current producton (VLAB, VCAP, VLND); producton tax or subsdy (matrx VPTX); Although all CGE models have smlar theoretcal approaches, ther practcal mplementaton n terms of computer software and mathematcal technques used n solvng the equatons of the model can be dfferent. To enable us to look more closely at the practcal mplementaton of CGE models rather than just theoretcal ssues - whch have already been covered n sectons -4, we concentrate on just one type of CGE models, namely those related to 'GTAP-famly' of models. Even here, the emphass s on a bref overvew rather than detals whch are necessary for a CGE specalst. For the latter, the readers are referred to practcal tranng courses for these models. 4

15 'other costs tcket' whch stands for mscellaneous tems such as muncpal taxes or charges (VOCT). IF we sum up the columns of these matrces, we get the values of producton n these ndustres. These values defned the 'basc prce' of commodtes produced n these ndustres. To allow for multple-product ndustres (manly n agrcultural sector), we defne a 'MAKE" matrx whch shows whch commodty s produced by whch ndustry. Next, n addton to usage (as ntermedate gods) n current producton, each commodty can also have other uses: as nvestment goods for next perod producton (VBAS), as fnal goods used for household and government consumpton (V3BAS, V4BAS), as export goods (V5BAS) and as addton t nventory stock (V6BAS). There are margn servces (VMAR, V3MAR, V4MAR, V5MAR) and commodty taxes (VTAX, V3TAX, V4TAX, V5TAX) assocated wth all these uses (except nventory), but there are no prmary factor nputs n these fnal consumpton actvtes. Fgure 3: ORANI Model data base Source: Horrdge (003). 5.. Theoretcal structure The theoretcal structure for ORANI-G s shown n Fgures 4-8. Frst, Fgures 4-6 hghlghts the structure assocated wth current producton. The structure of the demand for ntermedate goods (VBAS) s hghlghted n Fgure 4. Here, each ntermedate good s seen to be a 'composte' of goods produced domestcally and mported goods. The composton s represented by a CES (Constant Elastcty of Substtuton) producton functon whch allows for domestc and mported goods to be treated as though mperfectly substtutable goods (the Armngton approach, see Armngton (969, 970)). Fgure 5 hghlghts the structure assocated wth the use of prmary factors (VLAB, VCAP, VLND). Here, aggregate "Labour" s assumed to be a composte of dfferent types of labours n 5

16 dfferent occupatons whch are combned va a CES functon. Aggregate labour s then combned wth captal and land va a CES functon to produce the aggregate 'prmary factors' nput. Ths s then combned wth composte ntermedate nputs and other costs va a Leontef producton functon (.e. no substtuton) to produce the fnal output for each ndustry. To allow for multple-product ndustres, the 'output' of these ndustres are represented n terms of an 'actvty level', whch s then 'transformed' nto outputs of dfferent commodtes va a constant elastcty of transformaton (CET) producton functon. The theoretcal structure assocated wth nvestment and household consumpton actvtes are shown n Fgures 7-8. Investment actvty s seen to be smply a Leontef functon of varous commodty nputs, whle household fnal consumpton actvty s assumed to follow a Klen- Rubn utlty functon (lnear expendture system of demand). Export demand s defned by a downward-slopng demand functon wth a constant elastcty of demand for each commodty, and the demand for nventory s assumed to be proporton to the level of output (wth changes to be represented by exogenous shocks). Fgure 4: ORANI Model Theoretcal structure assocated wth the use of ntermedate goods n current producton Source: Horrdge (003). 6

17 Fgure 5: ORANI Model Theoretcal structure assocated wth the use of prmary factors n current producton Source: Horrdge (003). 7

18 Fgure 6: ORANI Model Theoretcal structure for the make matrx Source: Horrdge (003). 8

19 Fgure 7: ORANI Model Theoretcal structure of nvestment actvty Source: Horrdge (003). 9

20 Fgure 8: ORANI Model Theoretcal structure of household consumpton actvty Source: Horrdge (003). 0

21 5..3 Detals on the basc buldng block As can be seen from Fgures 4-8, the structure of a CGE model such as ORANI-G can be sad to consst of many dfferent 'branches' joned together to form a 'tree' structure whch descrbes ether producton, consumpton, or other actvtes. The basc 'buldng block' n ths tree structure s ether a CES functon (or ts varants such as Leontef functon -when substtuton elastcty s zero, or CET - when substtuton elastcty s negatve.e. transformaton elastcty s postve) or other functonal forms such as Klen-Rubn, CDE (constant dstance of elastctes). The consumer or producer n a CGE model s assumed to optmze (maxmze utlty or proft, mnmze cost) wth respect to ths functon subject to a (budget, producton, or cost) constrant to derve the demand functons (for fnal consumpton goods), or producer's demand functon (for nputs nto producton). To get famlar wth the structure of most CGE models, therefore, t s mportant to get famlar wth ths basc 'buldng block'. Appendx gves a bref descrpton of how to derve demand functons from a CES (producton, cost, or utlty) functon, n level form, or n percentage change form. Here t can be summarzed that, f gven a basc actvty structure such as gven n Fgure 9, and assumng that the level of Y (producton output, utlty level) s related to the levels of X and X (producton nputs, or consumpton levels) accordng to a CES functon wth substtuton elastcty δ,.e.: Y = α{ δ X () ρ ρ / ρ X + δ } where ρ=( σ)/σ ; α s the scale parameter; δ, δ are dstrbuton parameters; then, maxmze Y wth respect to δ, δ and subject to a (cost, budget) constrant: M P X + () P X where P, P are the prces of X, X respectvely, and M s the producton cost or consumer budget level, then the optmal levels of demand for X, X are gven by: X σ σ = Yδ { P / P } ; =,. (3) ave where P ave = { δ + P (4) σ σρ σ σρ / σρ P δ } Equatons () - (3) are all n level form. If we now convert all varables nto percentage change form, and usng lower case to denote percentage change, we have: x = y σ { p pave} ; =,. (5) p { S p S } ave = + (6) p y = S + (7) x Sx 5..4 Calbraton A CES functon such as gven n equaton () has 4 parameters:, and (or ). The scale parameter can be elmnated by defnng the varables relatve to the ntal (base year) values,.e.: 0 0 ρ 0 ρ / ρ Y / Y = { δ( X / X ) + δ ( X / X ) } (8) Hanoch (975). CDE functon s used n other models, such as GTAP (see secton 5. below).

22 where the superscrpt '0' denotes ntal value. The dstrbuton parameters can be shown to be related to the value share of the nputs (see Appendx ),.e.: δ = P X /{ P X + P X } ;,. (9) = There remans only one parameter, (or ) to be determned, and ths parameter s normally assumed to be gven exogenously (.e. determned ndependently of the CGE model) Closure Typcally a CGE model has more varables than ndependent equatons. Equatons are derved from theores of consumer and producer behavour, accountng denttes, and varous other constrants such as zero proft condtons, market clearng, etc. Each equaton can be used to estmate the value of one (endogenous) varable. The total number of endogenous varables thus equal the number of equatons, and the rest of the varables must be regarded as exogenous,.e. determned outsde of the model. The splt between endogenous and exogenous varables for a partcular smulaton s referred to as a 'closure'. The choce of closure depends on the specfc objectve of a smulaton. For example, n smulatons whch seek to estmate the mpact of trade or clmate change polces on the economy n the short run, captal stock and real wages are often assumed to be exogenous whle the rates of return on captal and employment level are endogenous. In contrast, n long run smulatons, captal stock and real wages are to be determned endogenously whle rates of return to captal and employment levels are gven exogenously. In some smulatons, the trade balance s allowed to change and hence specfed as endogenous, whle n others, t s constraned to some exogenous value and hence wll be specfed as exogenous. If trade balance s exogenous, some other varable (such as government spendng, or tax rate) must be 'swapped' wth trade balance,.e. specfed as endogenous, and conversely. In Secton 4., we have dscussed the use of CGE model for comparatve statc analyss as well as for hstorcal, decomposton, forecastng and (dynamc) polcy analyss. To enable ths flexblty n the use of a CGE model for varous purposes, the choce of closure must also be flexble. Ths flexblty n the choce of a closure to ft n wth dfferent polcy experment s one of the advantages of a CGE modelng approach. On the other hand, because of ths flexblty n the specfcaton of a closure, t may requre some sklls and experence n CGE modelng before a user of a CGE model can ndependently desgn an approprate closure to ft n wth a partcular experment usng a large CGE model. Wthout ths skll, the user may run nto dffcultes such as non-convergence of a soluton (due to numercal errors whch arse from an napproprate choce of closure), or - even when a soluton s obtaned - the soluton may not make much sense from a theoretcal vewpont due to a poor choce of closure. To llustrate the ssue of closure, we can use the smple economc system of equatons (5)-(7) even f ths represents only the basc buldng block of a CGE model rather than any substantal part of an actual CGE model. Here, we notce that the system conssts of sx varables (x, x, p, p, y, p ave ) and four ndependent equatons. Ths means to 'close' the system, two varables must be treated as exogenous. There are, however, 30 dfferent combnatons of endogenous/exogenous varables for ths smple system that hghlghts the dffcult task of choosng an approprate closure to ensure the system has a soluton and a meanngful one. As a frst choce, we can select the nput prces (p, p ) to be exogenous and let the system to solve for (x, x, y, p ave ). Ths closure resembles the tradtonal assumptons n partal analyss of producton or consumpton actvtes where nput prces are assumed to be gven exogenously and nput quanttes are then determned by relatve nput prces. Output quantty then follows from nput quanttes va the producton or utlty functon, and output prce s determned by nput prces (assumng zero proft condton). Next, we can also assume (x, x ) to be exogenous (for example, when they are determned by a lower 'nest' where (x, x ) are lnked to other varables). In ths case, (p, p, y, p ave ) can be endogenous. Fnally, we can also assume (y, p ave ) as exogenous (e.g. determned by an upper nest), then (x, x, p, p ) n ths case wll be endogenously. The choce between these closures depends on a partcular polcy experment that we are conductng. For example, f x s energy usage and x s the aggregate prmary factor nput (such as labour) and y s output actvty of a partcular sector (such as electrcty generaton), then to smulate an experment

23 where carbon tax s to be mposed on x to ensure some target GHG emssons (from the use of x ) s met, and also to acheve the polcy objectve of keepng the level of employment unchanged n ths sector, then we can set x and x to be exogenous (x determnes the level of GHG emssons and x determnes the level of employment) whle lettng (p, p, y, p ave ) to be determned endogenously. A soluton for p wll determne the level of carbon tax, p gves the nomnal wage of labour, y s the level of electrcty output, and p ave s the prce of electrcty. The mpact of ths partcular polcy therefore may be a change n the level of nomnal wage to keep employment constant, whle lettng the prce of electrcty to ncrease and perhaps also the output to be reduced. Fgure 9: Basc buldng block n a CGE model - CES functon 5. GTAP model for the analyss of global trade ssues GTAP (Hertel, 997) s a global trade CGE model developed at the Center for Global Trade Analyss n the Department of Agrcultural Economcs at Purdue unversty. The model has been wdely used for the analyss of global trade ssues and also for the study of the lnkages between trade polces and clmate change. 5.. Data base of the GTAP model The data base for the GTAP model s smlar to that of ORANI-G except the t has an extra dmenson to denote 'regon' snce ths s a mult-regonal rather than natonal data base (see Fgure 0). In addton, GTAP data base also contans nformaton on nternatonal trade and transport margns. In some other respects, GTAP has fewer detals than ORANI-G. For example, n the standard GTAP data base and model, there s no nformaton on domestc margn 3, all ndustres n GTAP are sngle-product ndustres, labour s splt nto sklled and unsklled rather than nto occupatons, and generally there are fewer tax detals n GTAP than n ORANI-G. 5.. Theoretcal structure of the GTAP model The producton structure n GTAP (see Fgure ) s smlar to that n ORANI-G, except that n GTAP, an mported good can be sourced from many dfferent regons, reflectng the mult-regonal character of the GTAP model. The consumpton structure n GTAP, however, s dfferent from that of ORANI-G: GTAP uses a CDE (constant dfference of elastcty) consumpton functon whereas ORANI-G uses a Lnear Expendture System (LES) of demand based on the Klen-Rubn utlty functon. Wth respect to the nvestment decson, GTAP has a dfferent structure due to the multregonal characterstc of the model (see Hertel, 999, Chapter ). Frstly, total nternatonal nvestment s balanced by total nternatonal savngs. The allocaton of the total volume of global nvestment to dfferent regons s decded accordng to two optons: () regonal and global net 3 Although a specal model called GTAP-M has been bult to nclude domestc margns nformaton nto the standard GTAP data base and model (see Petersen (006)) 3

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