Environmental Policies that Maximise Social Welfare: the Role of Intergenerational Inequality USAEE Conference 2015 Frédéric Gonand (University of Paris-Dauphine) Pierre-André Jouvet (University of Paris-Nanterre) Pittsburgh, October 26 th,

Carbon emissions can be curbed down through a public intervention, e.g., a public decision increasing directly and exogenously the fraction of renewables in the energy mix, or a carbon tax influencing the optimal decisions of private agents. For a given target of reduction of carbon emissions, each policy instrument triggers different aggregate effects on prices, GDP growth and on intergenerational inequality. In this context, the social choice as concerns the optimal mix of instruments that lessens carbon emissions is not necessarily trivial. We aim to determine the optimal social mix of instruments lessening carbon emissions. Empirical GE-OLG model with energy sector and CO2 emissions, parameterized on German data. Policy relevance. Introduction (1/2) 2

Dynamic GE setting with energy +environment: Böhringer and Rutherford (1997), Böhringer and Löschel (2006), Otto, Löschel and Dellink (2007)… However, literature often relies on static GE models that do not aim to account for intergenerational redistributive effects. -> GE with OLG: Bovenberg and Heijdra (1998), Karp and Resai (2014). However, literature often with theoretical approach + few generations, not mainly designed to analyse interactions between GE-CO2 nor social choice. -> empirical, dynamic GE with OLG (Auerbach and Kotlikoff, 1987 / Carbone et al., 2012 / Rausch, 2013). Our model close to the latter references BUT a) we do not focus exclusively on carbon tax issues but also consider a rise in renewables, b) modeling of carbon emissions, c) modeling of the intertemporal social welfare, d) more than 60 cohorts on annual data. Aim: determine the optimal mix of instruments in an OLG-GE model (see Van der Ploeg and Withagen (2014) in a Ramsey growth model but without OLGs and without empirical parameterization). Introduction (2/2) 3

Dynamic GE model with an energy module… –Models the impact of numerous variables in the energy sector on growth, savings, L supply, K per unit of efficient labor, aggregate substitution between K and energy… –Production function with K, L and Energy (nested CES function) –Long-run macroeconomic equilibrium. 1 good. … an overlapping generations framework (OLG)… –60 cohorts defining optimally each year their level of consumption and labour supply, in interaction with the conditions of the general equilibrium –Dynamic equilibrium, intergenerational redistribution … and public finances : public spending (pensions; non ageing-related public expenditures…); social contributions, income tax, carbon tax Modified version of Gonand & Jouvet (2015) (see July 2015 issue of the JEEM) with renewables as policy variable, modeling of carbon emissions, and of the intertemporal social choice (with variable aversion to social inequality and variable discount rate applying to the welfare of future generations). The model 4

Demographics Labour supply / demand Capital demand Interest rateGross wage - Health contrib (age- related) - Debt disimburst tax - Proportional tax financing non-ageing exp - Pension contrib + Pensions received (variable age of ret., replacement & contribution rates, « décote »…) + Non ageing public lump-sum exp. - Energy expenditures Net annual income of each cohort around 60 overlapping cohorts with increasing life expectancy Consumption /savings and leisure / working time of each cohort Intertemporal utility maximization Profit maximization Aggregate capital supply per unit of efficient unit CES function Real weighted end-use price of energy (past and future) Oil (fuel oil, diesel oil, RON 95) Past consumption of oil Natural gas (household & industry) Coal (steam & coking) Real end-use price of renewables substit. Electricity (households & industry) Past consumption nat gas Past consumption of coal Past consumption of biomass, waste, biofuels, biogas Past consumption of electricity Excise tax and VAT Carbon tax End-use price excl. taxes Transport, distrib / refining costs (Real) supply price (Real) imports prices (Real) nal production prices Imports volume National production volume Reoptimisation in 2010 if new informational set available Energy demand (volume) Public debt reimbursement Numerical convergence to equalize demand of capital per unit of efficient labour with supply of capital per unit of efficient labour Optimal capital per unit of efficient labour (after numerical convergence) Current and intertemporal welfare for each cohort Intertemporal social welfare GDP (after numerical convergence) Future energy mix Excise tax and VAT End-use price excl. taxes Transport, distrib costs (additional costs for renewables) (Real) weighted (wholesale) market price Oil, nat gas & coal prices Electricity prices Tax financing feed-in tariffs Rates of marginality Clean spark / dark spread (-> main peaker either coal of nat gas) Feed- in tariffs for wind & PV Costs of production of electricity out of coal, natural gas, oil, nuclear, hydro, onshore wind, offwhore wind, PV, biomass. Fuel costs, thermal efficiency, carbon price (ETS EU), emission factor, operational costs, overnight investment, cost of capital, lifetime, utilisation rate. For wind and PV: rise in productivity (learning-by-doing). For nuclear: productivity losses (increased safety). Real weighted end-use prices of… Future demand for energy (minus hydro, wind, PV) Future demand for renewables substitutes Future demand for oil / natural / coal Future demand for oil Future demand for natural gas Future demand for coal n-1 Future demand for electricity Future demand for non electric energy n Production function with a CES nested structure Demand of capital per unit of efficient labour Overall energy efficiency CES function with elasticity of substitution Capital / Energy

The policy scenarios 5 Scenario A is the no-reform scenario. No energy policy aiming at lowering CO2 emissions: i.e., no centrally implemented rise in public targets for renewables in the energy mix, and no carbon tax. Scenario B adds to scenario A a centrally implemented rise in the fraction of renewables in the energy mix (financed by a specific feed-in tariff) from now on. Its achieves a reduction in carbon emissions of 20% in 2050 as compared to 2009 (i.e., the year preceding the public announcement of the reform in 2010). Scenarios C adds to scenario A a carbon tax created in 2015 and increasing by 5% in real terms per year afterwards, achieving a reduction in carbon emissions of 20% in 2050 as compared to The income associated with the carbon tax is recycled through lower proportional taxes on households’ gross income. This scenario does not encapsulate any centralised policy in favour of renewables.

Results (1/6) 7 For a given target of CO2 emissions reduction, the effect on energy prices of a policy increasing the fraction of renewables in the mix is lower than with a carbon tax, and its effect on the structure of the mix is higher. However, the carbon tax, provided that it is recycled to private agents, has a more favorable impact on economic growth.

Results (2/6) 8

An energy policy bolstering renewables weighs on private agents’ wellbeing but especially so for young and future generations. More renewables = higher future energy prices and lower private agents’ income. Detrimental effect in the short run relatively less pronounced for currently older generations (permanent income effect: the younger a cohort today, the longer it will bear the cost of increasing energy prices). A carbon tax (fully recycled through lower taxes on income) displays pro-youth intergenerational redistributive effects and is more detrimental to currently relatively aged working cohorts and to current retirees (-> more intergenerational redistributive effects). Recycling a carbon tax through a lower proportional tax on income amounts, in absolute terms, to distributing relatively more revenues to cohorts receiving higher income (i.e., currently aged and working cohorts which are more productive than the younger ones). It equivalently amounts to redistributing less, in absolute terms, to cohorts with relatively lower income (i.e., for young active cohorts and retired generations). The net effect of the recycled carbon tax is thus positive for the current income of aged working cohorts at any year in the model, but negative for the current income of young and retired cohorts. Consequently, the influence on the permanent income of a recycled carbon tax is negative for the cohorts which are retired or relatively aged but still active when the tax is implemented, and positive for the permanent income of future generations. Results (3/6): intergenerational redistributive effects 9

Results (4/6): intergenerational effects 10

Results (5/6): social preferences 11

Results (6/6): intertemporal social choice 12

We find that an utilitarist social planner prefers to achieve the target of carbon reduction mostly by implementing a fully recycled carbon tax. However, we also show that this result does not hold for other social preferences because of implied intergenerational redistributive effects. For instance, a social planner that takes account of the welfare of future generations and is highly averse to intergenerational inequality maximizes its welfare by implementing a relatively moderate carbon tax and increasing in parallel the fraction of renewables in the electrical mix. These results have policy implications. While a recycled carbon tax maximizes growth, it does not necessarily maximizes social welfare because of its intergenerational redistributive implications. The optimal policy depends on social preferences as concerns intergenerational inequality and the wellbeing of future generations. Incidentally, our model also suggests that a mix of a carbon tax and of a centralized policy favoring renewables is probably not enough to meet targets of carbon emissions reduction of 70%/80% in 2050, as often advocated for in the public debate. Conclusion 13

Thank you 14