Economic theory and the transition to sustainability: a comparison of general-equilibrium and space-time-economics approaches

Terry Barker November 2004

Tyndall Centre for Climate Change Research

Working Paper 62

The transition to sustainability: a comparison of general-equilibrium and space-time-economics approaches

Dr Terry Barker
Tyndall Centre for Climate Change Research and Department of Applied Economics University of Cambridge Sidgwick Avenue Cambridge CB3 9DE, UK e-mail: terry.barker@econ.cam.ac.uk

Tyndall Centre Working Paper No. 62 November 2004

This paper was presented to the International Workshop on Integrated Assessment of Sustainable Development, April 1-2, 2004, ICTP, Trieste, Italy.

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Please note that Tyndall working papers are "work in progress". Whilst they are commented on by Tyndall researchers, they have not been subject to a full peer review. The accuracy of this work and the conclusions reached are the responsibility of the author(s) alone and not the Tyndall Centre. Summary Computable General Equilibrium (CGE) models are widely used in the assessment of policies directed towards sustainable development, such as emission permits for CO2 abatement. This paper argues that these models, based on marginal neoclassical analysis, are too rigid and stylised to represent the system-wide changes necessary over many years if economic development is to become sustainable. Generally they rely on one year’s data to project decades into the future, relying on unfounded assumptions to generate the transition from the current economic structure to a sustainable one. They purport to measure the costs of policies for sustainability, but these costs are for marginal changes in models that are based on implausible assumptions about technical change, industrial organisation and consumer behaviour. Furthermore the solutions of the models rely on contrived functional forms of equations, chosen not for their realism but for their tractability. The CGE approach is contrasted with a space-time economics (STE) systems approach based on less restrictive measure theory and numerical analysis that emphasises indivisibilities, externalities, socio-political valuations and economies of specialisation. The conclusion of the paper is that CGE models are misleading and inadequate tools for policy analysis. For longrun sustainability analysis, they are not only misleading but represent a fundamental misunderstanding about economic systems and how they change.

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1. Introduction

The main issue for sustainable development is how can the energy-economy system be transformed through efficient and equitable policies so that modern societies can live in harmony with the natural environment, rather than continuing to degrade it, and worse, increasing the risks of irreversible and catastrophic damage from climate change. This challenge has been addressed by the use of large-scale energyenvironment-economy (E3) modeling (Watson et al, 2001). However the large-scale modeling of the long-run economic costs of mitigation reported by the IPCC and reviewed in (Barker et al, 2003) generally follows the computable general equilibrium (CGE) approach1. Böhringer (2002) specifically advocates2 the CGE approach to sustainability; Devarajan and Robinson (2002) provide a more general review of applications of CGE models to policy issues. Both references testify to the wide influence of CGE modeling in policy assessments. This paper criticizes CGE modeling generally and specifically as used for climate change mitigation and other sustainability analysis. The criticisms are divided into those based on developments in general equilibrium theory, those based on the use of data (the econometric critique), and those that are specific to sustainability analysis, the main topic of this paper. General equilibrium theory, the basis for the CGE models, has been criticized (Ackerman, 2002; Ackerman and Nadal, 2004) for yielding multiple and unstable solutions. Stable solutions exist only under very special assumptions about aggregation and the functional forms. The assumption of the representative agent, adopted in CGE models and required to aggregate from the individual household or firm to the economy, is ‘both unjustified, and leads to conclusions that are usually misleading and often wrong.’ (Kirman, 1992, p.117). The main elements of the general econometric critique are as follows. 1) The practice of drawing parameter estimates for CGE models from the literature means that with the same data and the same set of parameters, different functional forms produce different outcomes for policy analysis (McKitrick, 1998). Therefore the choice of functional form determines the results, yet there is a range of suitable forms, so the policy outcomes are ad hoc. 2) CGE modellers generally ignore the rich sources of time series data available for the world economy and energy systems and use just one year’s data for long-term projections (Barker, 1998a; Grassini, 2003). They therefore do not model observations on the long-term processes of income growth, adjustment to price changes (such as responses to oil price shocks) or technological change.

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This paper is concerned with standard, multi-region, multisectoral models, rather than with small, dynamic, optimizing models. 2 “Given the broad agenda of Sustainable Development, the objective of this paper is to advocate computable general equilibrium (CGE) models as a methodological tool that is particularly suitable for assessing the impacts of policy interference on environmental quality, economic performance and equity.” “Without loss of generality, this paper focuses on standard multi-region, multi-trade CGE models of global trade and energy use … employed by many international institutions, research centers, universities and consultancies.” (Böhringer, 2002, pp. 2 and 3)

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3) The practice of constructing benchmark data for CGE models3 means that no testing against data is possible, because inconvenient observations, e.g. high profits suggesting lack of competition, are redefined to fit the theory (Grassini, 2003). Many CGE models cannot therefore be falsified, since they always fit the data perfectly. The uncertainties associated with the explanatory power of the theoretical model cannot be addressed. When asked how uncertain are the model projections, the CGE modeler typically resorts to a sensitivity analysis of the model by varying its parameters, but these variations are usually rather arbitrary and not based on formal econometric procedures. The main elements of the specific critique (Barker, 1998 a and b; DeCanio, 2003) are the main topic of this paper and are summarized as follows. 1) CGE models are singularly unsuited to modeling transitional paths because they are concerned with a set of equilibrium positions, not with transitional adjustment paths. 2) The assumption that the economy is at an optimal equilibrium means that the models cannot adequately assess win-win development policies that both improve the economy and the environment. 3) The assumption of maximizing representative agents does not capture the behaviour of interacting social groups, where preferences are affected by interagent and inter-generational comparisons so that some policies for sustainability may be much more effective than others. 4) The treatment of technological progress as an exogenous trend and production as involving constant returns to scale means that the models underplay the potential effects of policies on energy-saving and GHG-saving technologies. These are discussed in the sections of the paper below. The CGE models are the quantitative expressions of the marginal analysis of mainstream neoclassical economics. The approach is compared to the alternative approach that relies on econometric techniques using time-series data to identify dynamic economic behaviour. The approach is based on a different body of theory (Faden, 1977; Barker, 1996), which may be called space-time economics (STE), emphasizing the dependency of behaviour on where social groups are located, on their history and on their institutions. The outline of this paper is as follows. Section 2 briefly describes the two approaches to modeling sustainable development. Sections 3, 4, 5 and 6 then consider in turn the modelling of transitional paths, optimal equilibrium, social preferences and technological change. Section 7 concludes.

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“In practice, benchmark equilibria are constructed from national accounts and other government data sources. In general, the information will be inconsistent (e.g., payments to labor from firms will not equal labor income received by households), and a number of adjustments are required to the basic data to ensure that equilibrium condition hold. Some data are taken as correct and others are adjusted to be consistent in the process of generating a benchmark data set.” (Shoven and Whalley, 1984)

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2. CGE and STE Modelling of Sustainable Development
The usefulness of large-scale modelling Environmental damage and other aspects of unsustainable development are an unwanted byproduct of economic activity, such as the burning of fossil fuels for heat, light and power and the clearing of forests. However, goods and services can be produced from a variety of sources, some with very low environmental damages, and used in a variety of ways, offering the possibility of even lower levels of damage. In general, therefore, there are substantial opportunities for damaging activities and products to respond to relative prices (Barker, Ekins and Johnstone, 1995), so that fiscal policy could make a major contribution to sustainable development. There are technological opportunities for low-emission processes and products, partly stimulated by relative prices, but also by innovation policies.

In the case of climate change, the pervasive use of fossil fuels in economic activity and the absence of a low-cost end-of-pipe technology to remove the CO2 arising, means that fiscal policies are more suited to GHG abatement than regulation. Large-scale models have great potential to inform the policy-making process for three reasons: the economy-wide nature of the problem; the availability of a range of fiscal options for tackling it (carbon/energy tax, emission trading schemes, energy-saving R&D and other incentives); and need to assess the effects of the policies in terms of effectiveness, efficiency and equity. This has been recognised in the research funding of large-scale global E3 models by many national and international organisations4. CGE models CGE models stem from economic theory going back to Walras (1874) and developed by Arrow and Debreu (1954); they have been applied by calibrating them on input-output tables and social accounting matrices. These models began as a means of measuring the effects of tariff and tax policy (Shoven and Whalley, 1984, 1991), but have been developed into global E3 modelling in the OECD GREEN model (Burniaux et al, 1992) and its successor the EPPA model at MIT (Babiker et al 2001). The leading EU E3 model is GEM-E3 (Capros et al, 1997). Most CGE models are based on one year’s data. However, one of the leading US modelling programmes on E3 policies builds on Jorgenson's Dynamic General Equilibrium Model (DGEM) (e.g. Jorgenson and Wilcoxen, 1993). The model combines the CGE approach with time-series econometric estimation of important sets of relationships (eg production functions). The global GCubed model (McKibbin and Wilcoxen, 1992) follows this tradition. CGE models are quantitative expressions of neoclassical economic theory. However, the theory imposes a set of rather special assumptions on the modelling. DeCanio (2003) reviews these assumptions. For consumption, there is rationality and utility maximisation of individual identical consumers. For production there is perfect competition, constant returns to scale, and identical representative firms. Special functional forms have to be chosen to ensure the existence and stability of equilibrium (Ackerman, 2002)

The US government has funded Jorgenson's DGEM model, the OECD has constructed the world GREEN model (taken over by the EPPA project, MIT) and European Commission has funded several models, including GEM-E3 and E3ME in FP4 and FP5.

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CGE models incorporate parameters, such as the response of energy use to an increase in the price of energy relative to that of other goods and services, based on expert views or literature surveys without embedding these priors into a formal estimation system. Econometric and STE models Econometric models are those based directly on formal methods of statistical inference involving cross-section and/or time-series data to estimate the parameters of the model. The literature of interest concerns the models built to address large-scale sustainability issues, such as mitigation of climate change. The main examples here are the US models associated with Jorgenson and GCubed (all classed as CGEs), and the econometric nonCGE models: OPEC's World Energy Model, the LBS world model (Mabey et al, 1997), the set of INFORUM national models5 and the UK and EU models MDM-E3 and E3ME6. E3ME is a model based on STE theory (Barker, 1996). This theory treats space, time and institutions as fundamental in understanding economic behaviour. Resources (people, products and institutions) must be in contact or communication with each other across space if they are to interact; the arrow of time requires causation to go from past to future; and institutions provide organisation, stability and inertia in human affairs. Every person, every firm and every country is different although they have characteristics in common. Behaviour is always to be seen in a social context. Externalities (see Anselin, 2003 for a review of new thinking on spatial externalities), economies of specialisation and indivisibilities are pervasive. One of the main functions of money is to make resources appear divisible. Microeconomic behaviour is modelled as a problem in discrete choice theory; macroeconomic behaviour cannot be aggregated from microeconomic behaviour but depends on social interactions and group outcomes and should be modelled as such. The implications of STE theory for modelling can be summarised. First disaggregation into characteristic groups is important to identify institutional structure and behaviour, for example industries with different degrees of competition. Second, models are based on time-series and cross-section observations, particularly using techniques such as cointegration analysis that allow the model builder to identify short- and long-run behaviour and quantify the uncertainties in the explanation7. Third, the models are forward-looking and recognise that parameters are liable to change as tastes and technology changes and as institutions evolve and respond to shocks.

3. Modelling the Transition to Sustainability General equilibrium theory has little to say about how the economy adjusts through time to a new equilibrium, so CGE models inevitably face problems in representing transitional paths. By definition the modelling of a gradual shift from the present over-use of common resources (such as the global atmosphere, North Sea fisheries or fresh water supplies) to sustainable use requires estimates of dynamic, disequilibrium

See http://inforumweb.umd.edu/Models.html See http://www.camecon.co.uk/e3me/intro.htm 7 Abadir (2004) discusses how cointegrating long-run equations can be interpreted as descriptions of long-run disequilibrium outcomes.
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processes. Typically, CGE models are based on one year’s data8. This means that they cannot adequately represent transitional paths, since by definition these require knowledge of dynamic processes. Any dynamics in responses to policy changes have to be imposed on the model outcomes. Use of an annual series of social accounting matrices (SAMs) would reveal strong evidence of disequilibrium, e.g. changes in stocks, excess profits, large balance of payments deficits or unemployment. It may also reveal that there are strong economic forces, primarily increases in incomes and reductions in the real costs of carbon-based energy, leading to even more over-use of resources. Models intended to guide policy must be, in some sense, forward looking. This immediately raises a problem because much of economic theory on which CGE models are based is a-temporal. Agents are assumed to be usually in equilibrium and there is not much explanation as to how or at what speed they move from one position of equilibrium to another. In such theory, history is usually of no consequence. The problem was recognised by Alfred Marshall in his distinction between the short period, during which the capital stock was fixed and the long period when it can change. This treatment of time has leads to several difficulties for CGE modellers. The first is that the choice of a base year for calibration is somewhat arbitrary. Should it be a year when the economy in question is less affected by shocks and so more likely to be in equilibrium? Or should it be the most recent year available so that the calibrated parameters are more up-to-date and hence more relevant for current policy? The next difficulty is in assigning dates to the solutions. Since there are no lags in responses and no modelling of adjustment, the dates of the solution are decided by the projection dates of the assumed exogenous variables, e.g. population, consumer tastes or producer technical change. In other words, the dates that are attached to the CGE projections are those in the exogenous assumptions since each solution is a ‘long-run’ solution. There is a further difficulty here. When a CGE model yields results for the benchmark year with and without a policy change, the results refer to a long-run solution, unless instantaneous adjustment is assumed. But when is the long-run solution attained? After 2 years? After 10 years? This problem is overcome by assuming that the projection horizon is sufficiently far into the future to resolve all the lagged responses; however, this becomes unconvincing for abatement policies involving changes in infrastructure, e.g. use of roads and railways, where the adjustment periods take place over decades if not centuries. Econometric modellers have interpreted economic theory so that equations can be estimated on time-series data. This has been a continuing process since Tinbergen first estimated a macroeconomic model for the Netherlands in the 1930s. Three developments have helped in interpreting that data, identifying long-term behaviour and improving forecasting performance: (1) the technique of cointegration which helps to reduce the effects of spurious temporal association (Engle and Granger, 1987, 1991); (2) the error correction method of Hendry and others (Hendry, Pagan and Sargan, 1984; Hendry, 1994) which allows the separation of a long-term relationship from a short-term adjustment; the use of calibration in macroeconomic modelling (Hendry and Clements,

There is a group of models built by Jorgenson, McKibbin, Wilcoxen, and others (see references) based on a number of years’ data, that are termed general equilibrium, yet include involuntary unemployment and other disequilibrium features. General equilibrium theory requires all markets to be in equilibrium.

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1994; Kim and Pagan, 1995); and (3) finally the interpretation of the long-run solution as a general one, not a path defined to be in equilibrium (Abadir, 2004).
In econometric models, the adjustment to the long run is explicitly estimated, and solutions are defined for different dates over a projection period; and the long-run solution can also be found, depending on what variables are made endogenous in the solution. The long-run properties of several macroeconometric models are reported in (Hargreaves, 1991). Since the models are based on time-series analysis, they can give some information about the time lags involved in adjustment. Church et al (1998) report results on the lags in such models; it is clear that full stock equilibrium can take several decades to achieve. The long time of adjustment is not surprising given the long life of much capital stock and institutional behaviour. Transport infrastructure, which helps to determine the scale of GHG emissions, is very long-lived indeed, and affects where people live and work, the available means of transport and the cost of transport.

4. Assessing Win-win Policy Options The assumption in CGE models that the economy is at an optimal equilibrium means that the models cannot adequately assess win-win development policies that both improve the economy and the environment. By definition any change brought about by policy towards sustainability will incur economic costs.
However, is it reasonable to assume that the economy is at an optimal equilibrium? In order to measure the equilibrium state of an economy, a substantial exercise would be required to analyse the economy over as many trade cycles are possible, so that the short-run effects can be separated from the long-run ones. What if some markets are in equilibrium and others are not? At any time in an economy there is ample evidence of some markets in a state of adjustment, the evidence taking the form of rationing, queues, unexpected stockbuilding and unforeseen events. If just one market is out of equilibrium, the whole system will be out of equilibrium.

The time-series approach of large-scale econometric models means that they can be based econometric and economic theory and constructed to represent the changing global macroeconomic and industrial structures without assuming equilibrium in the short or long runs. When an economy is showing signs of high unemployment and underutilisation of capacity, win-win policies can be modelled that show how policies can simultaneously reduce unemployment and reduce environmental damages. 5. Social Welfare and Social Behaviour The assumption of representative agents does not capture the behaviour of social groups, where preferences and technologies are affected by inter-agent comparisons so that some policies for sustainability may be much more effective than others. CGE and dynamic optimizing models assume that welfare is a simple aggregation of discounted private consumption over all countries and future generations. The solutions of the models impose these trade-offs, e.g. in the form of discount rates and valuations of human life, when it is clear that they are subject to considerable debate and are in fact the outcome of social and political processes.

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6. Technological Progress and Marginal Abatement Costs The treatment in CGE models of technological progress as an exogenous trend and production as involving continuity and constant returns to scale9 means that the models misrepresent the effect of policies affecting energy-saving and GHG-saving technologies. This treatment involves the concept of marginal abatement costs (MACs)10. In particular, the MAC concept is used by those building and using CGEs to show the costs of mitigating climate change (Weyant and Hill, 2000, p. xxxvii-vl). Under certain special conditions by appropriate mathematical manipulation (Walras, 1874; Arrow and Debreu, 1954; Hildenbrand, 1974; Mas-Colell, 1985), MACs become equal to carbon tax rates and many of those who use the MAC concept do not show MAC estimates but instead show carbon tax rates from their models. Examples of both MACs and carbon tax rates being used in the same charts is given in Weyant and Hill (2000) who use the phrase ‘marginal costs of carbon emission reductions’ in the titles of the charts for different world areas (no dates shown) with ‘carbon tax’ rates in US$ per metric ton shown on the Y-axis. Presumably the authors mean MACs of CO2 emissions, although it appears to be understood that the terms MAC, ‘carbon tax rates’ and ‘shadow price of carbon’ all have the same estimated values. The definition of marginal abatement costs (MACs) In neoclassical economics, when used precisely, the concept of marginal means ‘vanishingly small’ since it is calculated by differentiating cost curves that for the purposes of the theory are assumed to be continuous. However, in many cases it seems that the user or the term is not referring to a vanishingly small change, but rather to a discrete, incremental change for a household or a firm at one end of the scale or for the global economic system at the other. The term ‘marginal’ is just being used rather loosely, although such use can be confusing. The abatement in MAC refers to the reduction in emissions (as in abatement of GHGs). It has a corresponding concept, namely Marginal Abatement Benefit (MAB), referring to the value of the reduction in the damages caused by the emissions (emission-reduction MAC or damage-reduction MAB). It is critical to the theory that these two potential meaning are distinguished. By using a special set of theoretical assumptions the MAC and the MAB are identical at the optimal equilibrium. The costs in MACs can be a large range of disparate costs, both private and public (or social), with and without market-based valuations, but all associated with the abatement, although it is clear that these costs do not normally include any political costs of introducing policies and measures for the abatement. These costs may be offset by ancillary environmental benefits or improvements in efficiency from the use of tax revenues.
9 Scarf remarks: “both linear programming and the Walrasian model of equilibrium make the fundamental assumption that the production possibility set displays constant or decreasing returns to scale; that there are no economies associated with production at a high scale. I find this an absurd assumption, contradicted by the most casual of observations.” (1994, p. 114) 10 The concept is of widespread use in the climate change and environmental-pollution-damage literature, with international organisations hosting important presentations that use the concept: http://www.unece.org/env/nebei/droste.pdf and http://www.iea.org/workshop/emissions/16-9/sijm.pdf Estimates of MACS are also very popular. Some websites give actual numbers that purport to be estimates of MACs, although the fact that with global trading all MACs are identical across regions may seem strange to those who do not know the literature: http://www.snf.no/Statoil/Global/climate/abatecst.htm and http://www.erm.com/ERM/adhocweb.nsf/(Page_Name_Web)/_MarginalAbatementCostCalculator

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The use of MACs The usual use of the term ‘marginal abatement cost’ involves reasoning along the following lines. Assume that there are various ways of achieving sustainability. If so, it is rational to choose the ones that achieve the largest improvements per unit cost first. Hence, society can order the methods of abatement as an upward-sloping ‘incremental abatement cost’ schedule (or curve if it is reasonable to treat the costs in principle as continuous). If the costs to society (including future generations) are known for each increment of damage (e.g. the benefit of lower emissions) and if it is assumed that the schedule associated with these costs is also upward sloping, the point on both schedules can be chosen where the incremental cost matches the incremental benefit. At this point, the extent to which emissions should be abated can be calculated. And if it is accepted that those social groups responsible for emissions will response to price signals, a policy can be proposed (a carbon tax or a carbonemissions-trading scheme) that will raise the market price of emissions to the level of the incremental benefit of curbing emissions. The market will then do the rest. There are several serious problems with the MAC concept and the total costs derived from the models that use it.
(1) The treatment of uncertainty and technology The reasoning assumes that the future schedules of costs are known in advance and independent of policy. However they are not known and they are rather uncertain. Moreover it is now accepted that technology responds to policy; in this case low-carbon technologies can be expected to develop in response to higher real prices of carbon (for reviews see Grübler et al, 1999 and 2002; Grubb et al, 2002). If this is the case the MAC schedule is not independent of the cost of carbon, so the schedule is not stable.

If there are indivisibilities, the non-marginal incremental cost of reducing emissions is likely to be different from the non-marginal incremental value of the damages being reduced. There is no longer a unique solution for the equilibrium carbon tax. There is also a problem associated with the uncertainties of the estimates of MAC and MAB. Because the pathways of emission, deposition, accumulation and eventual damage are so complex and diffused over space and time, it is likely that the estimates of incremental emission-reduction costs are much more reliable than the estimates of incremental damage-reduction benefits. The corresponding MAC is likely to be estimated more reliably than the MAB. If decision-makers are risk averse, or wish to follow the Precautionary Principle, the fact that MACs are less uncertain is likely to justify action involving higher MACs than what otherwise would be the case. A deterministic equalisation of estimates of MAC and MAB without taking into account these uncertainties ignores a fundamental difference between them.
(2) The use of MAC as a measure of the macroeconomic costs of abatement The second point is rather technical. If the MAC is used as a measure of costs of mitigation or abatement it is confusing because the concept of an instrument (the tax) is being mixed with the concept of an outcome (the costs of mitigation). For example, the use of rates of carbon tax may be adequate in limited comparisons of costs, e.g. for different emission-trading regimes, but it is inadequate as a general measure of costs for several reasons. First, there are many mitigation policies available (e.g. taxation, regulation, fiscal incentives for low-carbon technologies) and the carbon tax is only one particular tax so its level cannot be used to

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compare costs between policies. Second, the use of carbon prices as a measure of costs from top-down models implies that abatement policies are always costly, whereas macroeconomic effects as measured by GDP in such models and reported in the literature can be negative or positive, i.e. costs or benefits (IPCC, 2001, WGIII, Chapter 8). Mitigation policies based on carbon taxes can lead to increases in GDP, depending on modelling approach, assumptions about revenue recycling and treatment of technical change. Third, the use of the carbon tax rates as a measure of overall costs of mitigation is more partial than the use of GDP effects, since the carbon tax relates to prices, especially those of fossil fuels, whereas GDP effects relate to the incomes and output of the whole economy. Fourth, positing a carbon tax as a measure of cost misrepresents its role as a response to an environmental externality. In most neoclassical economics, provided that it is at or below the ‘optimal’ level, a carbon tax will by definition lead to social benefit rather than cost, so its use at all as a proxy for costs seems in principle misleading. (3) The treatment of discontinuities and economies of scale The third criticism is more profound and is to do with the ‘whole system’ effects of sustainable development policies at the global level over long period. The placing of system changes within the apparatus of continuous cost schedules is misleading because although continuously different mixes of old and new technological systems can be imagined (e.g. a mix of oil-based and hydrogen-based systems), this is in fact highly unlikely because of economies of scale and specialization and lock-in effects. These system effects may be large enough to achieve significant reductions in costs under new technologies. There is evidence for such system properties from the investigation of future costs of energy systems undertaken by researchers at IIASA (Gritsevskyi and Nakicenovic, 2000). It is obvious at the micro scale that the technologies and costs of mitigation are not continuous (see Jackson, 1995). This also appears to be the case at the macro scale because of network economies and technological lock-in. Not only are there significant discontinuities in the abatement cost schedule, the costs are likely to go up or down for different levels of abatement depending on the technological system under study. If the MAC is used for national or global economies and even more for these economies assuming substantial reductions of CO2 (at the most extreme global reduction of CO2 emissions of 60% present levels) (Boeringer, 2002), then the concept becomes stretched well beyond credibility. It is clear that the abatement policies being considered, such as a change from an oil-based to a hydrogen-based vehicle-fuel economy, involve huge network and infrastructure changes as well as changes in engine materials and design that are in some sense indivisible and whose technologies and costs cannot be reduced to the continuous production-function curves of neoclassical theory. It is all or nothing, in the short-run and the long-run, simply because of indivisibilities and economies of networks and scale. An analysis based on neoclassical production functions, is misleading in that it ignores the discontinuities, bursts of investment, and uncertainties associated with such changes. Modelling changes in the energy system with economies of specialization The more flexible STE approach emphasizes the importance of economies of specialization and allows for increasing returns to scale in the factor demand equations. In critical sectors, technology is modeled to allow for reductions in unit costs as the scale of production increases and the markets develop. Scenarios incorporating system-wide changes in technology, e.g. those involving the hydrogen economy, can be developed consistently. This approach does not impose costs of mitigation by assumption, unlike general equilibrium, so that an alternative low-carbon world economy may be less costly than business as usual, depending on the reductions in costs that emerge when new technologies come into widespread use.

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Economic theory (and computable applied models) can be developed based on a treatment in which space and time becomes central to social behaviour, as distinct from the mainstream theory in which activities take place at points, and actions are instantaneous, or with an assumed adjustment path. The space-time alternative approach, based on cross-section and time-series data, without assuming a solution in which global private discounted consumption is maximised, comes to a different conclusion on costs. A low-carbon economy does not necessarily mean lower growth in a model with endogenous technological change and increasing returns. This has profound implications for economic policy. 7. Conclusions The mainstream theory has become embodied in computable general equilibrium (CGE) models. Indeed, most of the current generation of structural models (applied to trade policy, taxation, development, as well as long-run climate-change mitigation) are CGE, often based on one year’s data, with assumptions of representative agents, constant returns to scale, divisibility, continuity and perfect competition. Often the models are theoretically incoherent, assuming that some markets do not clear. However, the theoretical basis for the models has been undermined in the literature; the foundations have collapsed but the applications survive. The question arises, why do CGE models continue to be developed, used and financed? There are three reasons for this phenomenon. First, there is the straightforward economic explanation: CGE models (and indeed the dynamic optimisation models DICE and FUND) are very low cost or even free, with the data and parameters available on the web. A global model can be generated and solved, using the software and data provided, in a few days and a potentially publishable article prepared on a new application. This field continues to be very fertile. Second, the body of theory, applications and expertise has become almost overwhelming. This is the mainstream application of choice in many areas. The investment in human capital and information is prodigious and has produced its own lock-in effects in the form of rigid data and software enforcing sets of very special assumptions and mathematical forms. The third reason is the most damaging to CGE modelling. This is that the appeal of the models lies in their coherence of explanation. It lies in the elegance of the theory and its apparent ability to explain the world. The problem is that the appeal rests on a truism, in that CGE models based on one year’s data are inherently unfalsifiable – they fit the data perfectly. They can give messages that come from the unrealistic assumptions adopted, e.g. that there are high costs of mitigation, even when policies are well designed, which can mislead business and policy makers. In CGE models applied to the climate-change mitigation problem, reductions in carbon dioxide emissions as a result of a carbon tax are treated as a constraint on growth and are, by definition, costly. Technological change is usually treated as an autonomous trend, independent of growth and the real cost of carbon. The conclusion of the paper is that CGE models are misleading and inadequate tools for policy analysis. In the assessment of policies for sustainable development in the long run, they are not only misleading but represent a fundamental misconception about

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economic systems and how they change. A less rigid approach is suggested, which allows for economies of specialisation and scale and which allows the model to track the historical path of the economy and the adjustment to long-run sustainable outcomes. With induced technological change is seems possible, even feasible, that century-long decarbonisation of the world economy can be achieved not at cost but at benefit, with higher GDP that might otherwise be the case. To understand how this is possible requires modelling of the economy-technology system and how this is affected by government fiscal policy, especially that inducing low-carbon technological change.
Acknowledgements

This paper is a contribution to the European Commission (DG Research) TranSust project EVG3-2002-00507 http://www.transust.org/. The funding is gratefully acknowledged. The author would also like to thank participants at workshops in ZEW, Mannheim, June 2003 and ICTP, Trieste, April 2004, in particular, Christophe Böhringer, Carlo Carraro, Reyer Gerlagh, Frederik Ghersi, Jean-Charles Hourcade, Gernot Klepper, Ray Kopp, Kurt Kratena, Roberto Roson and Stefan Schleicher, for stimulating debates and comments that helped to clarify the issues. Comments have been received, and are acknowledged with thanks from Richard Lewney.
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The trans-disciplinary Tyndall Centre for Climate Change Research undertakes integrated research into the long-term consequences of climate change for society and into the development of sustainable responses that governments, business-leaders and decision-makers can evaluate and implement. Achieving these objectives brings together UK climate scientists, social scientists, engineers and economists in a unique collaborative research effort. Research at the Tyndall Centre is organised into four research themes that collectively contribute to all aspects of the climate change issue: Integrating Frameworks; Decarbonising Modern Societies; Adapting to Climate Change; and Sustaining the Coastal Zone. All thematic fields address a clear problem posed to society by climate change, and will generate results to guide the strategic development of climate change mitigation and adaptation policies at local, national and global scales. The Tyndall Centre is named after the 19th century UK scientist John Tyndall, who was the first to prove the Earth’s natural greenhouse effect and suggested that slight changes in atmospheric composition could bring about climate variations. In addition, he was committed to improving the quality of science education and knowledge. The Tyndall Centre is a partnership of the following institutions: University of East Anglia UMIST Southampton Oceanography Centre University of Southampton University of Cambridge Centre for Ecology and Hydrology SPRU – Science and Technology Policy Research (University of Sussex) Institute for Transport Studies (University of Leeds) Complex Systems Management Centre (Cranfield University) Energy Research Unit (CLRC Rutherford Appleton Laboratory) The Centre is core funded by the following organisations: Natural Environmental Research Council (NERC) Economic and Social Research Council (ESRC) Engineering and Physical Sciences Research Council (EPSRC) UK Government Department of Trade and Industry (DTI) For more information, visit the Tyndall Centre Web site (www.tyndall.ac.uk) or contact: External Communications Manager Tyndall Centre for Climate Change Research University of East Anglia, Norwich NR4 7TJ, UK Phone: +44 (0) 1603 59 3906; Fax: +44 (0) 1603 59 3901 Email: tyndall@uea.ac.uk

Recent Working Papers Tyndall Working Papers are available online at http://www.tyndall.ac.uk/publications/working_papers/working_papers.shtml Mitchell, T. and Hulme, M. (2000). A Country-byCountry Analysis of Past and Future Warming Rates, Tyndall Centre Working Paper 1. Hulme, M. (2001). Integrated Assessment Models, Tyndall Centre Working Paper 2. Berkhout, F, Hertin, J. and Jordan, A. J. (2001). Socio-economic futures in climate change impact assessment: using scenarios as 'learning machines', Tyndall Centre Working Paper 3. Barker, T. and Ekins, P. (2001). How High are the Costs of Kyoto for the US Economy?, Tyndall Centre Working Paper 4. Barnett, J. (2001). The issue of 'Adverse Effects and the Impacts of Response Measures' in the UNFCCC, Tyndall Centre Working Paper 5. Goodess, C.M., Hulme, M. and Osborn, T. (2001). The identification and evaluation of suitable scenario development methods for the estimation of future probabilities of extreme weather events, Tyndall Centre Working Paper 6. Barnett, J. (2001). Security and Climate Change, Tyndall Centre Working Paper 7. Adger, W. N. (2001). Social Capital and Climate Change, Tyndall Centre Working Paper 8. Barnett, J. and Adger, W. N. (2001). Climate Dangers and Atoll Countries, Tyndall Centre Working Paper 9. Gough, C., Taylor, I. and Shackley, S. (2001). Burying Carbon under the Sea: An Initial Exploration of Public Opinions, Tyndall Centre Working Paper 10. Barker, T. (2001). Representing the Integrated Assessment of Climate Change, Adaptation and Mitigation, Tyndall Centre Working Paper 11. Dessai, S., (2001). The climate regime from The Hague to Marrakech: Saving or sinking the Kyoto Protocol?, Tyndall Centre Working Paper 12. Dewick, P., Green K., Miozzo, M., (2002). Technological Change, Industry Structure and the Environment, Tyndall Centre Working Paper 13. Shackley, S. and Gough, C., (2002). The Use of Integrated Assessment: An Institutional Analysis Perspective, Tyndall Centre Working Paper 14. Köhler, J.H., (2002). Long run technical change in an energy-environment-economy (E3) model for an IA system: A model of Kondratiev waves, Tyndall Centre Working Paper 15. Adger, W.N., Huq, S., Brown, K., Conway, D. and Hulme, M. (2002). Adaptation to climate change: Setting the Agenda for Development Policy and Research, Tyndall Centre Working Paper 16. Dutton, G., (2002). Hydrogen Energy Technology, Tyndall Centre Working Paper 17. Watson, J. (2002). The development of large technical systems: implications for hydrogen, Tyndall Centre Working Paper 18. Pridmore, A. and Bristow, A., (2002). The role of hydrogen in powering road transport, Tyndall Centre Working Paper 19. Turnpenny, J. (2002). Reviewing organisational use of scenarios: Case study - evaluating UK energy policy options, Tyndall Centre Working Paper 20. Watson, W. J. (2002). Renewables and CHP Deployment in the UK to 2020, Tyndall Centre Working Paper 21. Watson, W.J., Hertin, J., Randall, T., Gough, C. (2002). Renewable Energy and Combined Heat and Power Resources in the UK, Tyndall Centre Working Paper 22. Paavola, J. and Adger, W.N. (2002). Justice and adaptation to climate change, Tyndall Centre Working Paper 23. Xueguang Wu, Jenkins, N. and Strbac, G. (2002). Impact of Integrating Renewables and CHP into the UK Transmission Network, Tyndall Centre Working Paper 24 Xueguang Wu, Mutale, J., Jenkins, N. and Strbac, G. (2003). An investigation of Network Splitting for Fault Level Reduction, Tyndall Centre Working Paper 25

Brooks, N. and Adger W.N. (2003). Country level risk measures of climate-related natural disasters and implications for adaptation to climate change, Tyndall Centre Working Paper 26 Tompkins, E.L. and Adger, W.N. (2003). Building resilience to climate change through adaptive management of natural resources, Tyndall Centre Working Paper 27 Dessai, S., Adger, W.N., Hulme, M., Köhler, J.H., Turnpenny, J. and Warren, R. (2003). Defining and experiencing dangerous climate change, Tyndall Centre Working Paper 28 Brown, K. and Corbera, E. (2003). A MultiCriteria Assessment Framework for CarbonMitigation Projects: Putting “development” in the centre of decision-making, Tyndall Centre Working Paper 29 Hulme, M. (2003). Abrupt climate change: can society cope?, Tyndall Centre Working Paper 30 Turnpenny, J., Haxeltine A. and O’Riordan, T. (2003). A scoping study of UK user needs for managing climate futures. Part 1 of the pilotphase interactive integrated assessment process (Aurion Project), Tyndall Centre Working Paper 31 Xueguang Wu, Jenkins, N. and Strbac, G. (2003). Integrating Renewables and CHP into the UK Electricity System: Investigation of the impact of network faults on the stability of large offshore wind farms, Tyndall Centre Working Paper 32 Pridmore, A., Bristow, A.L., May, A. D. and Tight, M.R. (2003). Climate Change, Impacts, Future Scenarios and the Role of Transport, Tyndall Centre Working Paper 33 Dessai, S., Hulme, M (2003). Does climate policy need probabilities?, Tyndall Centre Working Paper 34 Tompkins, E. L. and Hurlston, L. (2003). Report to the Cayman Islands’ Government. Adaptation lessons learned from responding to tropical cyclones by the Cayman Islands’ Government, 1988 – 2002, Tyndall Centre Working Paper 35 Kröger, K. Fergusson, M. and Skinner, I. (2003). Critical Issues in Decarbonising Transport: The Role of Technologies, Tyndall Centre Working Paper 36 Ingham, A. and Ulph, A. (2003) Uncertainty, Irreversibility, Precaution and the Social Cost of Carbon, Tyndall Centre Working Paper 37

Brooks, N. (2003). Vulnerability, risk and adaptation: a conceptual framework, Tyndall Centre Working Paper 38 Tompkins, E.L. and Adger, W.N. (2003). Defining response capacity to enhance climate change policy, Tyndall Centre Working Paper 39 Klein, R.J.T., Lisa Schipper, E. and Dessai, S. (2003), Integrating mitigation and adaptation into climate and development policy: three research questions, Tyndall Centre Working Paper 40 Watson, J. (2003), UK Electricity Scenarios for 2050, Tyndall Centre Working Paper 41 Kim, J. A. (2003), Sustainable Development and the CDM: A South African Case Study, Tyndall Centre Working Paper 42 Anderson, D. and Winne, S. (2003), Innovation and Threshold Effects in Technology Responses to Climate Change, Tyndall Centre Working Paper 43 Shackley, S., McLachlan, C. and Gough, C. (2004) The Public Perceptions of Carbon Capture and Storage, Tyndall Centre Working Paper 44 Purdy, R. and Macrory, R. (2004) Geological carbon sequestration: critical legal issues, Tyndall Centre Working Paper 45 Watson, J., Tetteh, A., Dutton, G., Bristow, A., Kelly, C., Page, M. and Pridmore, A., (2004) UK Hydrogen Futures to 2050, Tyndall Centre Working Paper 46 Berkhout, F., Hertin, J. and Gann, D. M., (2004) Learning to adapt: Organisational adaptation to climate change impacts, Tyndall Centre Working Paper 47 Pan, H. (2004) The evolution of economic structure under technological development, Tyndall Centre Working Paper 48 Awerbuch, S. (2004) Restructuring our electricity networks to promote decarbonisation, Tyndall Centre Working Paper 49 Powell, J.C., Peters, M.D., Ruddell, A. & Halliday, J. (2004) Fuel Cells for a Sustainable Future? Tyndall Centre Working Paper 50

Agnolucci, P., Barker, T. & Ekins, P. (2004) Hysteresis and energy demand: the Announcement Effects and the effects of the UK climate change levy, Tyndall Centre Working Paper 51 Agnolucci, P. (2004) Ex post evaluations of CO2 –Based Taxes: A Survey, Tyndall Centre Working Paper 52 Agnolucci, P. & Ekins, P. (2004) The Announcement Effect and environmental taxation, Tyndall Centre Working Paper 53 Turnpenny, J., Carney, S., Haxeltine, A., & O’Riordan, T. (2004) Developing regional and local scenarios for climate change mitigation and adaptation, Part 1: A framing of the East of England, Tyndall Centre Working Paper 54 Mitchell, T.D. Carter, T.R., Jones, .P.D, Hulme, M. and New, M. (2004) A comprehensive set of high-resolution grids of monthly climate for Europe and the globe: the observed record (1901-2000) and 16 scenarios (2001-2100), Tyndall Centre Working Paper 55 Vincent, K. (2004) Creating an index of social vulnerability to climate change for Africa, Tyndall Centre Working Paper 56 Shackley, S., Reiche, A. and Mander, S (2004) The Public Perceptions of Underground Coal Gasification (UCG): A Pilot Study, Tyndall Centre Working Paper 57 Bray, D and Shackley, S. (2004) The Social Simulation of The Public Perceptions of Weather Events and their Effect upon the Development of Belief in Anthropogenic Climate Change, Tyndall Centre Working Paper 58 Anderson, D and Winne, S. (2004) Modelling Innovation and Threshold Effects In Climate Change Mitigation, Tyndall Centre Working Paper 59 Few, R., Brown, K. and Tompkins, E.L. (2004) Scaling adaptation: climate change response and coastal management in the UK, Tyndall Centre Working Paper 60 Brooks, N. (2004) Drought in the African Sahel: Long term perspectives and future prospects, Tyndall Centre Working Paper 61

Barker, T. (2004) The transition to sustainability: a comparison of economics approaches, Tyndall Centre Working Paper 62