1. Energy investments under the financial crisis Dr. Athanasios Dagoumas Cambridge Centre for Climate Change Mitigation Research (4CMR) IEW2009, Venice 17-19 June 2009

2. Outline E3MG model Theory and structure Hybrid modelling The Energy Technology Model (ETM) of E3MG Applications Modelling the financial crisis Reaction to the financial crisis Modelling emission reduction targets under the financial crisis Conclusions

3. Introduction E3MG is an integrated Economy-Energy-Environment (E3) model E3MG is one of a suite of E3 models: MDM-E3: Multisectoral Dynamic Model of the UK Economy, including energy-environment-economy (E3) interactions E3ME: E3 Model of Europe E3MG: E3 Model at the Global level All follow the same overall principles in their economics, construction and operation (Econometric, dynamic, structural, post-Keynesian, hybrid)

4. “New economics” modelling approach Structural disaggregation of variables (42 industries, 19 energy users, 12 energy carriers… ) Organized around a Social Accounting Matrix i.e. on accounting principles, e.g. System of National Accounts Dynamic detailed, annual, dynamic, non-linear econometric simulation model with database 1970-2003, projecting to 2100 behavioural equations with effects from previous outcomes: i.e. history matters Estimated on cross-section & time-series data identifies current-year responses and long-term trends allows institutional sectoral and regional differences cointegration techniques identify long-run trends in 22 sets of equations Forward-looking projections annually or in 5 or 10 year steps

5. MDM-E3 theory and data Social institutional groups (heterogeneous not representative agents) i.e. parameters as average tendencies, varying across sectors and regions Variable returns to scale and degrees of competition across sectors Demand driven Recognises path-dependence (emphasis on “history” rather than “equilibrium”) and the critical role of technology in the history of economic growth Endogenous technological change e.g. Technological Progress Indicators (TPI) (incl. R&D) in many equations e.g. in energy-use, export, import, price, employment equations Substitution between fossil and non-fossil fuel technologies, accounting for non- linearities resulting from investment in new technology, learning-by-doing, and innovation –induced technological change (ITC) Short-term and long-run solutions Structured into regions of political importance Stochastic parameters are location and time specific “New economics” modelling approach

6. Engineering-Energy-Environment-Economy Interactions ECONOMY as in national accounts TECHNOLOGY specifications & costs ENVIRONMENTAL EMISSIONS as in environmental statistics ENERGY as in energy statistics damage to health and buildings e.g. industrial emissions of SF6 funding R&D prices and activity low-carbon processes & products feedback energy-saving equipment etc fuel use pollution- abatement equipment

7. Hybrid modelling for the energy system

8. Hybrid modelling The main energy submodel Determines aggregate and disaggregate energy demand by fuel user and prices of fuel use Provides feedback to main economic framework In E3MG this 'top-down' approach is supplemented by a set of 'bottom-up' engineering submodels the Energy Technology Model (ETM) provides fuel use for power generation that replaces the econometric estimates. the Transport submodel Provides fuel use for electric vehicles

9. The approach to energy demand modelling No explicit production function 2-level hierarchy: aggregate energy demand equations and fuel share equations Aggregate demand affected by: industrial output of user industry, household spending in total, relative prices, temperature, technical progress indicator Augmented by time trends and/or accumulated investment to represent energy efficiency improvements Some users’ aggregate demands are affected by upward movements in relative prices only (ratchet or asymmetrical price effects) Fuel share (disaggregate energy demand) equations depend upon: activity, technology, relative price effects and temperature Error Correction Model (ECM) - in the econometric equations- distinguishes between long-term and adjustment parameters The approach to energy demand modelling

10. The Energy Technology Model (ETM)

11. The ETM submodel of the E3MG A simulation not optimization model where: Dispatch of electricity generation units is based on history besides economic, technical and environmental issues Electric system expansion considers Investment in new technologies from relative costs Learning curves from cumulated global investment

12. Relative costs in ETM A probabilistic approach (Anderson and Winne) is used for examining the penetration of the energy technologies compared to a marker technology (typically CCGT ). The frequency distribution of feasible technologies is represented by the ratio between the cost of all alternatives and the marker technology. P relative cost C present worth of costs, based on cumulative investment N ‘marker’ technology T taxes on new technology e.g. Carbon tax G tax/subsidy on new technology When the ratio / is greater than unity, the alternative technology costs less than the marker technology.

13. Market share & Frequency distribution of relative costs Market share (1 means 100%) Relative cost of marker to technology i (1 means they cost the same) Elasticity of substitution α (the narrower the distribution – the smaller the standard deviation, the larger the α)

14. Modelling the financial crisis with E3MG

15. Modelling the financial crisis Aspects of crisis a.Banks cut back on expenditure (25% decrease in 2009-2011) b.Banks encourage higher savings rates (0.5% increase in household savings ratios in 2009) c.Reduced access to credit (5% investments’ decrease in 2009-2011) d.A return to “normal” savings rates (7-9% in USA, EU and Japan) e.Uncertainty creates a disincentive to invest (38% decrease in 2009- 2011) f.Reaction of global commodity prices (60 US$/ barrel in 2009) The above assumptions are based on historical precedent, modellers judgements and literature (Reinhart and Rogoff, 2009) Also IEA recently predicted that energy investments are cancelled /delayed by up to 40% for 2009 due to difficulties in financing and uncertainty in profitability (volatility of energy prices)

16. Savings ratios for selected countries in 1960-2008

17. World GDP growth rates, considering sequentially the different aspects of the financial crisis (scenarios Ia-Ib)

18. Main factors influencing loss of output Economic factorExample countries Savings ratios have deviated a long way from long-term averagesUS, UK, Italy, Japan Large banking sectorsUS, UK Private sector investment accounts for a large share of GDPChina, NICs Produce investment goods or components of these goodsGermany, Japan Source: E3MG.

19. Reaction to the Financial Crisis II.Current policy (announced by governments by May 2009) to tackle climate change III.Seven points plan, proposed by 4CMR (Barker, 2009), to restore trust to the financial system so as to boost lending and investments) 1.Allow the markets to work without more interference; let the banks with bad debt go bankrupt (an additional 20% fall in investments from banking sector) 2.Set global interest rates to near-zero (short-term policy, ~1% in 2010) 3.Temporarily fix global prices to remove uncertainty from the system (80US$/barell) 4.A return to investment 5.Consolidating bad debts into regional banks 6.Reforming global regulatory authorities and 7.Reforming international company law Cannot be modelled quantitatively with E3MG

20. World GDP growth rates for different scenarios (II: current policy and III: 7-point plan) facing the financial crisis (scenario If)

21. Change in output in 2012 between scenario If (Financial Crisis) and Baseline scenario SectorChange in outputMain drivers Electrical engineering-37.2Lower demand for investment goods Electronics-32.5Lower demand for investment goods Mech. Engineering-25.4Fall in investment Motor vehicles-23.6Fall in investment and consumption Metal goods-22.6Lower demand for investment goods Basic metals-18.2Lower demand for investment goods Construction-14.3Fall in investment Hotels and catering-13.9Reduction in household spending … Pharmaceuticals-5.2Demand from health services largely unchanged Health and social work-5.0Public services unchanged Gas distribution-3.8Low elasticity of demand Agriculture etc-2.2Low elasticity of demand Public admin and Defence-1.5Public services unchanged Education-1.1Public services unchanged Sectors affected more are those that produce investments goods and the more basic manufacturing sectors that produce inputs for those sectors

22. Modelling the emission reduction targets under the financial crisis with E3MG

23. Mitigation Scenario Under the Copenhagen framework, a realistic “Mitigation Scenario” is being established considering: 30% reduction in CO2 emissions for the Annex I countries by 2020 compared to 1990 Developing countries stabilize their emissions by 2020 to 2010 levels The “Mitigation Scenario” is applied on the scenario If, representing the Financial crisis, with which it is being compared.

24. Policies implemented to apply the “Mitigation Scenario” Emission reduction and stabilization targets are considered as part of an international effort and are achieved through a portfolio of policies: Carbon pricing (Carbon trading for ETS sectors / Carbon Tax for rest of the economy). Revenue recycling (e.g. through auctioning carbon permits) to: Incentives for electricity technologies. Accelerated diffusion of electric plug-in vehicles through technological agreements and behavioural shift in transport. Incentives to energy-intensive industries to low-carbon production methods. Incentives for investments in energy efficiency in households, (by improving the energy efficiency of domestic dwellings and appliances and for introducing new ones such as low-emission dwellings and solar appliances). Accelerated carbon price increase at an earlier year e.g. 2020

25. Investments in million 2000US$ for the scenario If (Financial Crisis)

26. Investments in million 2000US$ for the “Mitigation Scenario” Extra investments of ~1% per year.

27. Results Carbon price is low (10$/tCO2) for this mitigation scenario. Reduced energy demand due to the financial crisis lead to smaller need for extra capacity (investments are increased by 1% pa) This would be different for higher reduction or for long term targets Emissions can be increased if investments are delayed and energy prices work in favour of conventional technologies Developed but even more Developing countries can increase their economic growth and employment. After the recovery (through the current policies or another plan for a sharper shift from the crisis e.g. the 7-points plan) the economic growth will be less from the trend (pre- 2008), unless there is a global commitment to energy investments towards emission reduction targets. There is high variation between countries and sectors. Countries with strong financial sectors and personal debt are affected more, but also countries that supply basic materials are affected due to a fall in demand.

28. Conclusions Current policies have small effect on output (~1%), so tackling the financial crisis requires global coordination towards four main priorities: Restore trust in the global financial system Reduce the level of volatility and uncertainty over future prices Provide remaining banks with the ability to resume lending Stimuli connected with the real economy and especially with the energy investments, so as to face also the climate change and energy security issues The financial crisis leads to a decrease in energy demand and emissions, so for a medium term mitigation target the energy investments needed are not huge. However in the long term, delay in energy investments will lead to an increase of emissions (depending on the energy prices). The implementation of a global mitigation effort in medium term (2020) can lead to: small but beneficial macroeconomic effects (less than 1%). increase in investment (mainly in construction, vehicles, low-carbon technologies) an increase in employment, especially in developing countries, but the scale is small (about 1% more employment for a 25% reduction in CO 2 by 2020).