Monday, 8 August 2011

What is E3MG?

E3MG sounds complicate - it is!
One of the key areas of research that 4CMR is involved with is E3 modelling.  Over the past few years one of the central models, E3MG (Energy-Environment-Economy (E3) Model for the Globe), has been improved as part of a concerted effort by the core research group.  In the near future the improved model will be used to assess policy scenarios related to carbon emissions.  Many of the people who follow this blog will have a vague idea of what such a model is, but this month I will be introducing the model in more detail.  If you are interested in climate change debates but are turned off by the technical details of econometric modelling, then perhaps this month’s blog article is not for you.

OK, so what is E3MG? The model is one of a suite of E3 models maintained and improved by Cambridge Centre for Climate Change Mitigation Research (4CMR) and Cambridge Econometrics under the guidance of Terry Barker.  Each of the models within this suite has a specific territorial focus; E3MG extends coverage across the globe. 

The E3MG model adopts a number of assumptions informed by new interpretations of Keynsian economics and complexity economics.  Economic activity undertaken by individuals, households, firms, government, trade unions and other groups has effects on all groups after a time lag, and the effects may persist into future generations, although many of the effects soon become so small as to be negligible.  While the individual effects may be small, there are many of them, both beneficial and damaging, and they accumulate in economic and physical stocks.  The effects are transmitted through the environment (with externalities such as greenhouse gas emissions leading to global warming), through the economy and through the price and money system (e.g. via the markets for labour and commodities), and through the global transport and information networks.  The markets transmit policy effects in three main ways: through the level of activity creating demand for inputs of materials, fuels and labour; through wages and prices affecting incomes; and through incomes in turn leading to further demands for goods and services.  These interdependencies suggest that an E3 model should be comprehensive, and include the relevant linkages between different parts of the economic and energy systems.

The economic and energy systems in E3MG have the following characteristics: economies and diseconomies of scale in both production and consumption; markets with different degrees of competition; the prevalence of institutional behaviour which may be maximisation, but may also be the satisfaction of more limited, satisfying objectives; and rapid and uneven changes in technology and consumer preferences, certainly within the time scale of greenhouse gas mitigation policy.  Labour markets in particular may be characterised by long-term unemployment.  The E3MG model is capable of representing these features by embodying a variety of behaviours, and by simulating a dynamic system.  This approach can be contrasted with general equilibrium assumptions such as constant returns to scale; perfect competition in all markets; maximisation of social welfare measured by total discounted private consumption; no involuntary unemployment; and exogenous technical progress following a constant time trend. 

E3MG, then, is a macro-econometric non-equilibrium hybrid simulation model of the global E3 system.  The model has been developed by the Cambridge Centre for Climate Change Mitigation Research (4CMR) and Cambridge Econometrics, funded through a variety of research programmes, most recently with a generous grant from the Three Guineas Trust.  E3MG is designed to address issues derived from the interdependencies between energy, the environment, and the economy, by providing a framework for evaluating different policies, particularly those aimed at achieving sustainable energy use over the long term, including climate change mitigation and the development of sustainable technologies.  The methodology and software of the model is based on a long pedigree of Cambridge models.

The model is constructed, estimated and solved on a personal computer: the construction and solution use the software package IDIOM, while the stochastic parameters of the model are estimated using the econometrics software package, Ox.  The estimation methods are for the most part instrumental variables, making use of error correction methodology where applicable. Communication between Ox and IDIOM is generally via databank stores.

E3MG is based on an approach distinct from traditional economic theory and key features of the model include:

• Keynesian disequilibrium macroeconomic economic structure; estimated in time series data using Engle-Granger cointegration.
• Input-Output structure for each region
• Incorporation of long term structural changes and diffusion of new technologies

The emphasis in the modelling is on two sets of estimated equations: the latest version of the model includes aggregate energy demand by 19 fuel users and 20 world regions and exports of goods and services by 41 industries and 20 regions.

E3MG has been used in a wide range of research projects and by organisations including the Tyndall Centre and the Intergovernmental Panel on Climate Change (IPCC) and has a number of distinctive features.  It is a hybrid model that attempts to express the interdependencies between the economy energy supply and demand, and environmental emissions and is designed to address some issues of central importance for economic, energy and environmental policy, and to do so in one modelling framework.  To achieve this objective, the model uses a system of dynamic equations estimated on annual data and calibrated to recent outcomes and short-term forecasts; these equations cover energy demands, fuel substitution, intra and extra-regional commodity imports and exports, investment, expenditure, labour and wages and prices.  E3MG also reflects these interdependencies through the structure of the model – the economy module provides measures of economic activity and general price levels to the energy module; the energy module provides emissions of the main air pollutants to the environment module, which in turn indicates damages to health and buildings (this effect is not yet included in the formal model).  The energy module provides detailed price levels for energy carriers distinguished in the economy module and the overall price of energy as well as energy use in the economy. 

These distinctive characteristics and the detailed nature of the model allow the representation and analysis of complex scenarios, especially those that are differentiated according to sector and to country.  Similarly, the impact of policy measures can be represented in a detailed way.

E3MG is capable of providing short term and medium term economic and industrial forecasts appropriate to the needs of national and international policy makers.  The econometric grounding of the models enables it to represent and forecast performance and provide information that allows for dynamic responses to changes in policy and that is closer to the time horizon of many policy makers.

The data requirements of the model come in five forms:
1. Exogenous data such as levels of industrial production in world areas, or tax rates
2. Classification converters, such as the converter from consumers’ expenditure categories to commodities
3. Other converters, such as the matrix of indirect tax rates for industries
4. Parameter matrices, such as the parameters of the investment functions
5. Calibration values, lagged values and initialisation values (historical data)

• These data are stored in the following ways:
• In databanks (most of the requirements above)
• In special data files (e.g. assumption file)
• As the IDIOM instructions themselves
• As modifications to the solution held in modifications files

Previous versions of E3MG reported overall gains from low-level emissions stabilisation.  In addition to the application of global carbon prices, a major driver of the mitigation strategy in E3MG is the recycling of revenues raised from the full auctioning of carbon permits to the energy sector and applying carbon taxes for non-energy activities.  Key assumptions are that 40% of the revenues collected are recycled and used for R&D investments in renewables as well as for investments in energy savings and conversion of energy intensive sectors towards low-carbon production methods.  Revenue is also recycled via lowering indirect taxes to achieve fiscal neutrality.  Moreover, the early introduction of electric plug-in vehicles has a major impact on the emission path.  In contrast to the other models, E3MG is a simulation model without perfect foresight and optimization, where resources are not fully employed or optimally utilized in the baseline.  The increase in investment induced by climate policy can therefore achieve net GDP gains.  In other words, these gains are attributed to climate policy that induces and accelerates technological change towards low carbon sources, although, that these gains can in principle be achieved by policies other than climate policy.

If you would like any additional information about the modelling work we do, please get in touch with us.

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