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Sustainable development A_Scoping_Study_on_the_Macroeconomic_Vie.pdf

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Unformatted text preview: A Scoping Study on the Macroeconomic View of Sustainability Final report for the European Commission, DG Environment 29 July 2010 Hector Pollitt, Anthony Barker, Jennifer Barton (CE) Elke Pirgmaier, Christine Polzin, Stephan Lutter, Friedrich Hinterberger, Andrea Stocker (Sustainable Europe Research Institute – SERI) Cambridge Econometrics Covent Garden Cambridge CB1 2HT Tel Fax Email Web +44 1223 533100 +44 1223 533101 [email protected] A Scoping Study on the Macroeconomic View of Sustainability Contents Page Executive Summary iii 1 Introduction 1 2 Literature Review 4 3 Identification of Existing Models 39 4 What Should Models Take into Account? 67 5 The Potential for Integrated Modelling 90 6 Conclusions and Recommendations 104 7 References 111 Appendices Appendix A: List of Existing models 124 ii A Scoping Study on the Macroeconomic View of Sustainability Executive Summary Introduction This scoping study, carried out by Cambridge Econometrics (CE) and the Sustainable Europe Research Institute (SERI), examines the links between macroeconomic perspectives and sustainable development. It considers how the links are represented in economic theory and asks if the macroeconomic modelling we use today is up to the task of evaluating policy from a sustainable development viewpoint. If not, then models risk missing out on the insights that sustainable development provides: the strong (two-way) linkages between the economy and the environment, the importance of the long term, the necessity of an integrated approach and the danger of thresholds. If these issues are missed by our models, then they risk giving us the wrong answers and leading us in the wrong direction. The study has: examined the theoretical underpinning of macroeconomic analysis from different theoretical traditions; reviewed the wide range of models that operate within one or more of the sustainable development spheres; considered the appropriateness of the existing model toolkit to address policy questions; and identified gaps in the scope of existing models and their methods. We conclude with recommendations for improving the models on which policy makers can call. The role of Macroeconomic analysis looks at the performance of the overall economy. How the sustainability in macroeconomy and macroeconomic factors and their general conditions are examined macroeconomic varies in different schools of economic thought. theory In the neoclassical model of the economy (which is the home of environmental economics) the environment and its natural resources have never found a strong footing. The ecosystem is treated as a subsystem of the economy whose main functions are the limitless extraction of resources and the free disposal of waste. The environment mainly features in microeconomics, where it is assumed that the internalisation of negative externalities through the price mechanism can solve our ecological problems. Mainstream macroeconomic theory is profoundly oriented towards the goal of continuous and exponential economic growth. It is assumed that economic growth can increase innovation and efficiency and lead to decoupling of economic growth from negative environmental impacts. The welfare of future generations is safe because there is full substitutability of natural capital so the depletion of natural resources can be compensated via investments in other forms of capital (a concept known as ‘weak sustainability’). From a neoclassical economics perspective, there is no need for a new macroeconomic framework for sustainability. An alternative macroeconomic framework is being developed by ecological economists by extending the neoclassical framework to explicitly include the environment and its services to the economy. In ecological economics: The economic system is not only embedded in the larger environmental system but is also completely dependent on it as both a source of inputs and as a sink for the matter or energy transformations required by economic activity. iii A Scoping Study on the Macroeconomic View of Sustainability The assumption that capital can substitute for resources is rejected on the basis that certain functions that the environment performs cannot be duplicated by humans (known as ‘strong sustainability’). Environmental constraints imply limits on economic scale and thus limits to growth. Ecological economists are sceptical about the possibility to dramatically change technologies, investment and consumption patterns in a way that decouples economic growth from environmental impacts. In effect, ecological economists argue for a serious rethinking of standard economic assumptions and theories (although a complete macroeconomic model in tune with ecological economists' thinking does not yet exist). This debate matters, as depending on whether a neoclassical or ecological economics perspective is taken, different conclusions can be drawn on how the macroeconomy and macroeconomic factors affect sustainable development and vice versa. Many of the models reviewed in this study are derived from neoclassical economics and general equilibrium theory so they typically focus on economic relationships. Environmental factors, including resource consumption and greenhouse gas emissions, are typically considered as external to the economic system. The possibility of not being able to substitute between input factors, or of the depletion of stocks of resources, is largely ignored. Where external factors, such as environmental emissions or human health effects, are included in the modelling framework they are often assigned monetary values. The macroeconomic models that we consider in this study (see below) could be used to test features of the two different schools of thought, for example estimating substitution elasticities or modelling scenarios without economic growth. The existing situation Policy domain of The study has focused on 60 of the most widely-used existing macroeconomic models existing models (defined as quantitative computer-based tools), and mapped their scope against the ten policy themes from the Sustainable Development Indicators (SDI) framework, and their sub themes. Table 1 summarises the extent to which individual models cover more than one SDI theme by counting the number of linkages in the models that were reviewed. From this it is clear that: The vast majority of existing models focus on the link between economic development and energy use. Other linkages that are well-represented are economic development and climate change; energy use and climate change; energy use and sustainable transport; and economic development and global partnerships. Perhaps the most notable omissions are links involving good governance or public health, suggesting that the interactions between these policy areas and other areas of sustainable development are not well covered. Figure 1 illustrates the dominant direction of the main links between SD policy areas in existing models. There are some clear feedback loops between policy areas, for example environmental Integrated Assessment Models (IAMs) cover the themes in the iv A Scoping Study on the Macroeconomic View of Sustainability bottom-right part of the diagram (economy to energy to climate change to economy), and integrated energy-transport models those in the mid-right section (economy to sustainable transport to energy use). Nevertheless, it is clear that the dominant direction of impact is from the economy, with few policy domains impacting back on to the economy. This is consistent with the neoclassical economic theory, which focuses on the economy as a system and treats other factors as external to this system. For example, while the models may give outputs for consumption of finite fossil fuels, they are less likely to include this as a driving factor of economic growth. TABLE 1: HOW EXISTING MODELS LINK ASPECTS OF SUSTAINABILITY Policy Theme Policy Theme Socio-economic devt Sustainable C & P Social inclusion Demographic change Public health Energy use Climate change Sust. transport Land use Biodiversity Oceans/ freshwater Global partnership Good governance 1 1 2 3 4 5 6a 6b 7 8a 8b 8c 9 10 2 3 4 5 6a 6b 7 8a 8b 0 0 2 0 2 0 0 0 1 23 2 0 1 0 5 0 0 0 1 8 2 1 0 0 0 5 0 2 0 0 0 0 4 4 0 1 0 0 0 0 1 1 0 1 1 0 0 0 0 1 4 1 2 2 6 0 0 0 0 3 0 0 2 0 0 0 0 0 0 0 0 0 0 0 0 0 Sustainable Consumption and Production Demographic Change Natural Resources Sustainable Transport Public Health 9 2 Figure 1: Model Linkages Global Partnership 8c Socio-Economic Development Energy Use Social Inclusion Climate Change Good Governance v 0 A Scoping Study on the Macroeconomic View of Sustainability Overall, existing models appear only to provide limited coverage of SD policy areas (though greater coverage could in principle be achieved through linking models) and little role for developments in non-economic policy areas to influence economic outcomes. Key gaps in The key gaps in the scope of existing models are: existing analyses The good governance theme is not covered by any of the models, although some separate quantitative analysis has been carried out, for example the value of democracy in determining long-term growth rates. The direction of linkages within a particular model is often only one-way, especially in the case of models that include socio-economic development. The socio-economic development and energy themes are well connected to other themes. However, fewer direct linkages exist between the other aspects of sustainable development. Consumption of (non-energy) resources is not very well covered in existing models, but this is an area of potential development (see Box 1). Finally, there are a number of issues relating to the technical structure or functional form of existing models which could be improved upon, particularly the treatments of technology, uncertainty and non-linear relationships. Do the current In our view this leads to three major constraints in macroeconomic modelling analysis, deficiencies which in certain circumstances are material for policy makers: matter? The often one-way linkages from economy to environment can distort the results of analysis and therefore also policy recommendations. For example, environmental factors are usually only allowed to influence the economy through price-based measures, such as taxation. Other environmental impacts, such as loss of tourism due to degradation or loss of ecosystem services, are often excluded. Physical limits, such as stocks and maximum carrying capacities are not usually covered in the analysis (see Box 1). This means that models miss out on a wide range of factors, such as how the price of scarce material inputs changes, or non-linearities in impact. There is a loss of accuracy using conventional modelling approaches to consider the effects of large-scale change. This makes a proper assessment of ‘extreme’ scenarios, for example where fossil fuel stocks dwindle, or of largescale change such as an 80% carbon reduction, difficult with existing tools. Key areas for development Scope for linking models or widening areas of coverage It is not possible to have a single model that covers every aspect of sustainable development. While it is desirable to have a number of models in the tool kit, it is important to recognise boundaries and to ensure that the key relationships are determined endogenously. In some cases this may mean linking individual models to provide a more complete coverage, although it is often a resource-intensive exercise to set up two-way linkages between different models. Our analysis identifies the following improvements as important to adding value to model-based analyses of sustainable development: vi A Scoping Study on the Macroeconomic View of Sustainability The treatment of natural resources could be improved, using existing model structures (see Box 1). Migration: This is clearly important in all areas of sustainable development. It is usually treated as exogenous, but an endogenous treatment may be possible. We also identified areas where exogenous factors should be identified more explicitly: Government actions: It is difficult to model this endogenously, but qualitative checks need to be carried out to make sure that model-based scenarios are politically feasible. For example, if a scenario predicted very high rates of unemployment, it is likely that the government would take action. Models should acknowledge explicitly impacts on stocks of natural resources, even if there is no feedback to behavioural patterns. Implicit assumptions, such as financial stability or availability of energy supplies, should be made much clearer so that they can be assessed in the context of any set of model simulations. Box 1: Incorporating resource use into the explanation of economic development This study finds that it would be possible to integrate demand equations for the physical consumption of materials (minerals and biomass) and water into existing macroeconomic frameworks (including feedback to economic sectors such as agriculture, mining and water supply). Eurostat provides relatively detailed data sets on which such an analysis could be based. However, this is only one step in setting up a system that is capable of carrying out a comprehensive analysis. A more complete list of steps is: Identify and define the most important groups of resources. Measure the available stocks (eg fossil fuels) or maximum carrying capacities (eg annual fresh water supply). Include the demands for these resources and, where possible, available stocks or carrying capacities in macroeconomic models. Allow supplies to influence behaviour, for example (but not limited to) in price formation in the model structures. The last of these steps requires a much larger research input as the behavioural responses to extreme outcomes are unpredictable. However, the other steps are all possible with given model frameworks and supplementary analysis, and the modelling approach required is close to that already applied for energy use. A possible extension to this exercise would be to incorporate a treatment of physical waste that is linked into the consumption of physical inputs. Recommendation 1: All models need to recognise that technology, and its development, is an important The role of factor; an endogenous treatment of technology should therefore be seen as a technology requirement. However, there is no agreed treatment at present and the focus of the modelling is usually on the development rather than the dissemination of technology. The two most common treatments of technology are based on engineering principles, where individual technologies in a sector are explicitly defined (for example gas, vii A Scoping Study on the Macroeconomic View of Sustainability renewables or CCS in the energy sector), and economic theory, where technology is implicitly linked to the capital stock. These two approaches affect efficiency, unit costs and product quality and each has its own advantages. However, when considering future scenarios, both approaches are limited by the fact that it is not possible to predict future trends in technological development. A good assessment of current technological options is therefore seen as a priority and a methodology that combines both approaches is possible. Recommendation 2: Non-linear relationships, thresholds, limits The standard modelling approach is based on linear (or log-linear) elasticities, for example an elasticity of -0.5 would mean a 10% increase in price leads to a 5% decrease in demand. Although there are cases where this assumption is relaxed, our view is that this type of relationship is often forced on model parameters. This potentially negates several important features and leads to the following issues and potential developments: Linear approximations of curved relationships may be reasonably accurate for small changes, but will become less accurate as the model moves further from base. Threshold effects and physical limits should be taken into account (see example in Box 1). However, problems arise in defining thresholds that have not previously been reached (eg mineral resources becoming scarce), or where thresholds vary over time (eg annual rainfall). A proper treatment of asymmetrical relationships could be a relatively easy improvement to make, with separate parameters for positive and negative relationships. For example, if high commodity prices lead to investment in new equipment, this equipment will still be used if prices fall again. The assumption that model elasticities do not change over time should be examined more closely. Recommendation 3: There are two separate issues related to uncertainty: the treatment of uncertainty Uncertainty within the model; and uncertainty resulting from the model itself and its various assumptions. Other recommendations for model development Uncertainty clearly affects human behaviour, particularly in the case of investment decisions, and should therefore be included in a model of sustainability as an explanatory factor. An empirical exercise to identify the main sources of uncertainty would be helpful in this respect. Attempts to address the issue of uncertainty in model outputs are important for putting results in context. They should be carried out outside the structure of the model, for example by using different input assumptions. This is an area where research is already under way. As well as better modelling of uncertainty, non-linear relationships and technology, there are a number of key priorities for model developments to better assess the role of sustainability in macroeconomic development. The report discusses longer-term aspirations, but we consider the following steps to be practical developments given the current state of the art. 1. Models should take biophysical data into account (for example the ecological footprint or physical consumption of resources) as it provides a link to problems that refer to the quality of the environment. This means moving away from only including monetary values to also providing physical outputs. viii A Scoping Study on the Macroeconomic View of Sustainability 2. Models should be adapted to include issues of resource use. Modelling of the supply and demand for material inputs (biomass and minerals) and water could be integrated into existing frameworks relatively easily. This treatment could be extended to include waste, though other issues such as biodiversity are more difficult. The modelling would also need to be disaggregated as looking at (bio)physical data at macro level may not be very informative: materials used in the construction sector, for example, may be bulky but have little environmental impact. The models would need to provide outputs capturing the importance of the environmental impacts of the (non-renewable) resource use, and perhaps also the option loss for future unknown use. 3. Building on this point, models should take into account the stocks of available resources, at least given the available disaggregation. Even if no behavioural responses are included, this would give an indication of whether model results fit inside the limits imposed by bio-physical constraints. 4. The analysis identified gaps in existing data, specifically in data for incomes and spending for different household groups, and a definition of the ecoindustries in standard classifications. 5. Population movement inevitably has an effect on sustainability, so the impact of migration should be included in the models. A more immediate exercise would be to use the models to quantify the effects of population changes. 6. For each set of model simulations, the model user should assess the accuracy of assuming that exogenous factors remaining unchanged. Overall, these developments would move macroeconomic models towards a more systematic way of modelling the two-way linkages between the environment and the economy, and would allow for ...
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